Level 2 SS8

LOS 25.c: Evaluate capital projects and determine the optimal capital project in situations of 1) mutually exclusive projects with unequal lives, using either the least common multiple of lives approach or the equivalent annual annuity approach, and 2) capital rationing.

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LOS 26.a: Explain the modigliani-miller propositions concerning capital structure, including the impact of leverage, taxes, financial distress, agency costs, and asymmetric information on a company's cost of equity, cost of capital, and optimal capital structure.

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The capital budgeting process involves five key principles

1. Decisions are based on cash flows, not accounting income. The relevant cash flows to consider as part of the capital budgeting process are incremental cash flows, the changes in cash flows that will occur if the project is undertaken. A. sunk costs are costs that cannot be avoided, even if the project is not undertaken. Since these costs are not affected by the accept/reject decision, they should not be included in the analysis. B. Externalaties: are the effects the acceptance of a project may have on other firm cash flows. The primary one is a negative externality called cannibalization, which occurs when a new project takes sales from an existing product. 2. cash flows are based on opportunity costs A. opportunity costs are cash flows that a firm will lose by undertaking the project under analysis. These are cash flows generated by an asset the firm already owns that would be foregone if the project under consideration is undertaken. 3. The timing of cash flows is important: capital budgeting decisions account for the time value of money, which means that cash flows received earlier are worth more than cash flows to be received later . 4. cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing all capital budgeting projects. Firm value is based on cash flows they get to keep, not those they send to the government. 5. Financing costs are reflected in the project's required rate of return. The required rate of return is a function of its risk. Ordinarily, the level of risk is measured relative to the firm's overall risk and the required return relative to the firm's cost of capital.

What are the six primary factors that affect a company's dividend payout policy?

1. investment opportunities 2. expected volatility of future earnings 3. financial flexibility 4. tax considerations 5. flotation costs 6. contractual and legal restriction

There are five common rationales for share repurchases (versus dividends)

1. potential tax advantages 2. share price support/signaling 3. added flexbility 4. offseting dilution from employee stock options 5. increasing financial leverage

27.d: Explain factors that affect dividend policy

a company's dividend payout policy is the approach a company follows in determining the amount and timing of dividend payments to shareholders.

Capital Rationing

capital rationing is the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth.

Costs and their potential effect on the capital structure

costs of financial distress are the increased costs a company faces when earnings decline and the firm has trouble paying its fixed financing costs (i.e. interest on debt).

Half-year convention

half-year convention under MACRS assumes that the asset is placed in service in the middle of the first year. The effect of this is to extend the recovery period of a 3-year class asset to four calendar years and a f year asset to six calendar years

Hard capital rationing

hard capital rationing occurs when the funds allocated to managers under the capital budget cannot be increased

MM Proposition II (With Taxes): WACC is Minimized at 100% Debt

if we assume the marginal tax rate is not zero and then use the WACC formula to solve for return on equity, we get MM proposition II (With Taxes)

Tax Aversion

in many countries, dividends have historically been taxed at higher rates than capital gains. investors will prefer to not receive dividends due to their higher tax rates.

MM No Tax world

in the MM no tax world, the value of a company is not affected by its capital structure

Depreciable Basis

is equal to the purchase price plus any shipping or handling and installation costs. The basis is not adjusted for salvage value regardless of whether the accelerated or straight line method is used.

Soft capital rationing

soft capital rationing occurs when managers are allowed to increase their allocated capital budget if they can justify to senior management that the additional funds will create shareholder value.

Management signals:

taking on the commitment to make fixed interest payments through debt financing sends a signal that management has confidence in the firm's ability to make these payments in the future ◦issuing equity is typically viewed as a negative signal that managers believe a firm's stock is overvalued.

LOS 27.c: Explain how clientele effects and agency issues may affect a company's payout policy

• clientele effect: this refers to the varying dividend preferences of different groups of investors, such as individuals, institutions, and corporations. The dividend clientele effect states that different groups desire different levels of dividends. Rationales for the existence of the clientele effect include. ◦tax considerations: high tax bracket investors (like some individuals) tend to prefer low dividend payouts, while low tax bracket investors (like corporations and pension funds) may prefer high dividend payouts

LOS 26.e: Describe international differences in financial leverage, factors that explain these differences, and implications of these differences for investment analysis

• for international firms, country-specific factors may have a significant impact on a firm's capital structure policy. Observations regarding international differences in financial leverage include the following: ◦total debt: companies in Japan, Italy and France tend to have more total debt in their capital structure than firms in the United States and the UK. ◦Debt maturity: companies in North America tend to use longer maturity debt than companies in japan. ◦emerging market differences: companies in developed countries tend to use more total debt and use longer maturity debt than firms in emerging markets

Other Presentation Formats

• there are two other formats for presenting the analysis of a capital budgeting project with which you should be familiar: ◦table format with cash flows collected by year ◦table format with cash flows collected by type

LOS 26.d: Explain factors an analyst should consider in evaluating the impact of capital structure policy on valuation.

• when evaluating a company's capital structure, the analyst should consider the following factors: ◦changes in the company's capital structure over time. ◦capital structure of competitors with similar business risk ◦company-specific factors (e.g. quality of corporate governance). Recall that better corporate governance systems will reduce agency costs.

LOS 27.g: Explain the choice between paying cash dividends and repurchasing shares

◦ a share repurchase is a transaction in which a company buys back shares of its own common stock. ◦Since shares are bought using a company's own cash, a share repurchase can be considered an alternative to a cash dividend.

A manager can use a number of different approaches for evaluating the profitability of an investment with real options. Examples of different approaches include the following:

◦Determine the NPV of the project without the option ‣ a real option adds value to a project, even if it is difficult to determine the monetary amount of that value. If the NPV of the project without the option is positive, the analyst knows that the project with the option must be even more valuable, and determining a specific value for the option is unnecessary. ‣ calculate the project NPV without the option and add the estimated value of the real option. In equation form, this can be expressed as: • overall NPV = project NPV (based on DCF) - option cost + option value ‣ use decision trees : this method does not determine a value for the option but may allow a manager to make a more informed choice by showing the sequence of decisions made. ‣ use option pricing models: This method may require the use of complex equations of special consultants

What are the three categories that explain the majority of the differences in capital structure?

◦Institutional and legal factors ◦financial markets and banking system factors ◦macroeconomic factor

LOS 25.b: Explain the effects of inflation on capital budgeting analysis.

◦Inflation is a complication that must be considered as part of the capital budgeting process ‣ Analyzing nominal or real cash flows: nominal cash flows reflect the impact of inflation, while real cash flows are adjusted downward to remove inflation effects. Although either type of cash flow can be used in the capital budgeting process, it is important to match the type of cash flows with the discount rate. Nominal cash flows should be discounted as a nominal discount rate, while real cash flows should be discounted at a real discount rate. ‣ Changes in inflation affect project profitability: If inflation is higher than expected, future project cash flows are worth less, and the value of the project will be lower than expected. The opposite is also true, however. If inflation turns out to be lower than originally expected, future cash flows from the project will be worth more, effectively increasing the project's value. ‣ inflation reduces the tax savings from depreciation: if inflation is higher than expected, the firm's real taxes paid to the government are effectively increased because the depreciation tax shelter is less valuable. This is because the depreciation charge, which is based upon the asset's purchase price, is less than it would be if recalculated at current (i.e., inflated) prices. ‣ inflation decreases the value of payments to bondholders: bondholders receive fixed payments that are effectively worth less as inflation increases. This means that higher than expected inflation effectively shifts wealth to issuing firms at bondholder's expense. ‣ Inflation may affect revenues and costs differently: if prices of goods change at a different rate than the prices for inputs used to create those goods, the firm's after tax cash flows may be better or worse than expected

Dividend Irrelevance Theory

◦MM maintain that dividend policy is irrelevant, as it has no effect on the price of a firm's stock or its cost of capital. this is based on theory of homemade dividends. ◦if you are a stockholder and dont like dividend policy: if the cash dividend is too big, you can just take the excess cash received and use it to buy more of the firms stock. If the cash dividend you received was too small, you can just sell a little bit of your stock in the firm to get the cash flow you want. in either case, the combination of the value of your investment in the firm and your cash in hand will be the same. ◦this theory only holds in a perfect world with no taxes no brokerage costs and infinitely divisible shares

MM1 Proposition 1 (No Taxes): The Capital Structure Irrelevance Proposition

◦MM proved that the value of a firm is unaffected by its capital structure. ◦MMS results say that in a perfect world, it does not matter how a firm finances its operations ◦thus capital structure is irrelevant. MM's study is based on the following simplifying assumptions: ‣ capital markets are perfectly competitive; they have the same expectations with respect to cash flows generated by the firm. ‣ riskless borrowing and lending: investors can borrow/lend at the risk free rate ‣ no agency costs: no conflict of interest between managers and shareholders. ‣ Investment decisions are unaffected by financing decisions: operating income is independent of how assets are financed.

Implications for managerial decision making

◦MM's propositions with no taxes: follow a restrictive set of assumptions in that there are no taxes and no costs associated with financial distress. MMs first proposition says that the capital structure of a company is irrelevant because the value of the company is determined by the discounted present value of its operating earnings. MM's second proposition states that increasing the use of cheaper debt financing will increase the firm's cost of equity, resulting in a zero net change in the firm's WACC. The implication for managers decisions regarding capital structure under both propositions is that capital structure is irrelevant. ◦MM's propositions with taxes say that the tax shield provided by interest expense makes borrowing valuable, and that the WACC is minimized (and the value of the firm is maximized) at 100% debt. ◦Static trade-off theory: recognizes that there are tax benefits associated with issuing debt because interest expense is tax deductible, but increasing the use of debt also increases the costs of financial distress. At some point, the costs of financial distress will exceed the tax benefits of debt. Managers following the static trade-off approach will seek to balance the benefits of debt with the costs of financial distress and identify an optimal capital structure.

MM Proposition II (No Taxes): Cost of Equity and Leverage Proposition

◦MMS second proposition with no taxes states that the cost of equity increases linearly as a company increases its proportion of debt financing ◦again, MM assume a perfect market where there are no taxes, no cost of bankruptcy, and homoeneous expectations ◦according to their proposition, debt holders have a priority claim on assets and income, which makes the cost of debt lower than the cost of equity. ◦however, as companies increase their use of debt, the risk to equity holders increases, which in turn increases the cost of equity. ◦therefore, the benefits of using a larger proportion of debt as a cheaper source of financing are offset by the rise in the cost of equity, resulting in no change in the firm's WACC.

Bird-in hand argument for dividend policy

◦Myron Gordon and John Lintner, however, argue that rs, decreases as the dividend payout increases. Why? ‣ because investors are less certain of receiving current (and therefore certain) dividend payments. The main argument of Gordon and Lintner is that investors place a higher value of a dollar of dividends that they are certain to receive than on a dollar of expected capital gains. ‣ they based this argument on the fact that, when measuring total returns, the dividend yield component, B1/Po has less risk than the growth component g. ‣ bird in the hand (dividends) is worth two in the bush (expected capital gains)

The following steps are followed to determine the target payout ratio (dividends per share / earnings per share):

◦Step 1: Identify the optimal capital budget ◦step 2: determine the amount of equity needed to finance that capital budget for a given capital structure ◦meet equity requirements to the maximum extent possible with retained earnings ◦pay dividends with the "residual" earnings that are available after the needs of the optimal capital budget are supported. In other words, the residual policy implies that dividends are paid out of leftover earnings.

Replacement Project Analysis

◦There are two key differences in the analysis of a replacement project versus an expansion project. In a replacement project analysis we have to: ‣ Reflect the sale of the old asset in the calculation of the initial outlay: • outlay=FCInv + NWCInv - Salo + T (Salo - Bo) ‣ Calculate the incremental operating cash flows as the cash flows from the new asset minus the cash flows from the old asset • ∆CF = (∆S - ∆C) (1-T) + ∆DT • see example on page 235

3. Added flexibility

◦a company could declare a regular cash dividend and periodically repurchase shares as a supplement to the dividend. ◦unlike dividends, share repurchases are not a long-term commitment. ◦since paying a cash dividend and repurchasing shares are economically equivalent, a company could declare a small stable dividend and then repurchase shares with the company's leftover earnings to effectively implement a residual dividend policy without the negative impact that fluctuating cash dividends may have on the share price.

Constant Dividend Payout Ratio Policy

◦a payout ratio is the percentage of total earnings paid out as dividends ◦the constant payout ratio represents the proportion of earnings that a company plans to pay out to shareholders. ◦a strict interpretation of the constant payout ratio method means that a company would pay out a specific percentage of its earnings each year as dividends, and the amount of those dividends would vary directly with earnings. This practice is seldom used.

Split rate corporate tax system

◦a split rate corporate tax system taxes earnings distributed as dividends at a lower rate than earnings that are retained. ◦the effect is to offset the higher (double) tax rate applied to dividends at the individual level. ◦Germany has a split rate system ◦the calculation of the effective tax rate under a split rate system is similar to computation of the effective tax rate under double taxation except that the corporate tax rate applicable would be the corporate tax rate for distributed income

LOS 25.h: Calculate and interpret accounting income and economic income in the context of capital budgeting

◦accounting and economic income measures are alternatives to the basic discounted incremental cash flow approach used in the standard capital budgeting model. ◦a project's economic income is equal to the after-tax cash flow plus the change in the investment's market value. As with the basic capital budgeting model, interest is ignored for cash flow calculations and is instead included as a component of the discount rate. ‣ economic income = cash flow + (ending market value - beginning market value) or ‣ economic income = cash flow - economic depreciation ‣ where economic depreciation = ( beginning market value - ending market value)

A project's accounting income is the reported net income on a company's financial statements that results from an investment in a project. Why will accounting income will differ from economic income because?

◦accounting depreciation is based on the original cos (not market value) of the investment. ◦Financing costs (e.g., interest expense) are considered as a separate line item and subtracted out to arrive at net income. In the basic capital budgeting model, financing costs are reflected in the WACC. ◦see example on pg 250

The accounting income differs from the economic income for two reasons:

◦accounting depreciation is based on the original cost of the investment, while economic depreciation (beginning - ending value) is based on the market value of the asset. The economic depreciation for the project is much larger than the accounting depreciation, resulting in an economic income amount that is much smaller than accounting income. ◦interest expense is deducted from the accounting income figure. Interest expense is ignored when computing economic income because it is reflected in the WACC

Static trade off theory formula

◦accounting for the costs of financial distress, the expression for the value of a levered firm becomes:

Agency costs of equity

◦agency costs of equity refer to the costs associated with the conflicts of interest between managers and owners. Managers who do not have a stake in the company do not bear the costs associated with excessive compensation or taking on too much (or too little) risk. ◦because shareholders are aware of this conflict, they will take steps to minimize these costs, and the net result is called the net agency cost of equity

Agency Issues (Between shareholders and managers)

◦agency costs reflect the inefficiencies due to divergence of interests between managers and stockholders. ◦one aspect of agency issue is that managers may have an incentive to overinvest (empire building) ◦This may lead to investment in some negative NPV projects, which reduces stockholder wealth. ◦one way to reduce agency cost is to increase the payout of free cash flow as dividends. Generally, it makes sense for growing firms to retain a larger proportion of their earnings. ◦However, mature firms in cyclical industries do not need to hoard cash. In such cases, higher dividend payout would be welcomed by the investors resulting in increases in stock value

What does an unexpected dividend increase?

◦an unexpected dividend increase can signal to investors that a company's future business prospects are strong and that managers will share the success with shareholders. Studies have found that companies with a long history of dividend increases, such as GE and Exxon Mobil, are dominant in their industries and have high returns on assets and low debt ratios

Terminal year after-tax non-operating cash flows (TNOCF)

◦at the end of the assets life, there are certain cash inflows that occur. ◦These are the after tax salvage value and the return of the net working capital ‣ TNOCF = Salt + NWCInv - T (Salt - Bt) ‣ where Salt = pre-tax cash proceeds from sale of fixed capital ‣ Bt = book value of the fixed capital sold ‣ big T is the marginal tax rate.

Investment opportunities (factors that affect dividend payout policy)

◦availability of positive NPV investment opportunities and the speed with which the firm must react to the opportunities determines the amount of cash the firm must keep on hand. ◦if the firm faces many profitable investment opportunities and has to react quickly to capitalize on the opportunities (it does not have time to raise external capital), dividend payout would be low.

Contractual and legal restrictions (factors that affect dividend payout policy)

◦companies may be restricted from paying dividends either by legal requirements or by implicit restrictions caused by cash needs of the business. ◦common legal and contractual restrictions on dividend payments include: ‣ the impairment of capital rule: A legal requirement in some countries mandate that dividends paid cannot be in excess of retained earnings. ‣ debt covenants: these are designed to protect bondholders and dictate things a company must or must not do. Many covenants require a firm to meet or exceed a certain target for liquidity ratios (e.g. current ratio) and coverage ratios (e.g. interest coverage ratio) before they can pay a dividend

2. Share price support/signaling

◦companies may purchase their own stock, thereby signaling to the market that the company views its own stock as a good investment. ◦signaling is important in the presence of asymmetric information (where corporate insiders have access to better information about the company's prospects than outside investors) ◦management can send a signal to investors that the future outlook for the company is good. This tactic is often used when a share price is declining and management wants to convey confidence in the company's future to investors.

Costs of asymmetric information

◦costs of asymmetric information refer to costs resulting from the fact that managers typically have more information about a company's prospects and future performance than owners or creditors. ◦firms with complex products or little transparency in financial statements tend to have higher costs of asymmetric information, which results in higher required returns on debt and equity capital.

The expected costs of financial distress for a firm have two components

◦costs of financial distress and bankruptcy can be direct or indirect. ‣ direct costs of financial distress include the cash expenses associated with the bankruptcy, such as legal fees and administrative fees. Indirect costs include foregone investment opportunities and the costs that result from losing the trust of customers, creditors, suppliers, and employees. ◦Probability of financial distress: is related to the firm's use of operating and financial leverage. In general, higher amounts of leverage result in a higher probability of financial distress. Other factors to consider include the quality of a firm's management and the company corporate governance structure; lower quality management and corporate governance lead to a higher probability of financial distress

LOS 26.c: Describe the role of debt ratings in capital structure policy

◦debt ratings from rating agencies reflect the creditworthiness of a company's debt. The agencies perform an extensive analysis of a company's ability to make interest and principal payments and assign a rating based on the bond's default risk. Lower debt ratings denote higher levels of default risk for both shareholders and bondholders, who in turn demand higher returns on their capital.

LOS 27.h: Describe broad trends in corporate dividend policies

◦dividend policy is different across countries and over time ◦probably to accommodate differences in investor preferences globally as well as changing investor preferences over time. ◦the following generalizations can be made with respect to global trends in corporate dividend policies ‣ 1. a lower proportion of US companies pay dividends as compared to their european counterparts ‣ 2. globally, in developed markets, the proportion of companies paying cash dividends has trended downwards over the long term. ‣ 3. The percentage of companies making stock repurchases has been trending upwards in the US since the 1980s and the UK and continental europe since the 1990s

LOS 27.i: Calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow. LOS 27.j: Identify characteristics of companies that may not be able to sustain their cash dividend.

◦dividend safety: is the metric used to evaluate the probability of dividends continuing at the current rate for a company. The traditional ratios, such as dividend payout ratio (dividends/net income) or its inverse dividend coverage ratio (net income/dividends), are typically used for this purpose. ‣ a higher than normal dividend payout ratio (and lower than normal dividend coverage ratio) tends to typically indicate a higher probability of a dividend cut (or a lower probability of dividend sustainability) ◦compare ratios to industry average

LOS 27.e: Calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems

◦dividends paid in the US are taxed according to what is called a double taxation system ◦earnings are taxed at the corporate level regardless of whether they are distributed as dividends, and dividends are taxed again at the shareholder level. ◦in 2003, new rate at individual from 39.6% to 15%

LOS 25.i: Distinguish among, and evaluate a capital project using, the economic profit, residual income, and claims valuation models.

◦economic profit is a measure of profit in excess of the dollar cost of capital invested in a project. It is calculated as: ‣ EP = NOPAT - $WACC ‣ where NOPAT = net operating profit after tax = EBIT (1-tax rate) ‣ $WACC = dollar cost of capital = WACC x capital ‣ capital = dollar amount of investment ◦once the economic profit is determined, it is easily applied to the valuation of an asset. The NPV based on economic profit is called the market value added (MVA) and is calculated as: ‣ NPV = MVA = sum of EPt/ (1 + WACC) to the t

Effective Tax Rate

◦effective tax rate = corporate tax rate + (1- corporate tax rate)*(individual tax rate)

What are the pitfalls made when evaluating capital projects?

◦failing to incorporate economic responses into the analysis - low barriers to entry, competitors come in and reduce profitability ◦misusing standardized templates: since managers may evaluate hundreds of projects in a given year, they often create templates to streamline the analysis process. However, the template may not be an exact match for the project, resulting in estimation errors. ◦pet projects of senior management ◦basing investment decisions on EPS or ROE - may avoid positive long term NPV investments that have the short run effect of reducing EPS or ROE. ◦using the IRR criterion for project decisions. ◦poor cash flow estimation ◦misestimation of overhead costs: ◦using the incorrect discount rate ◦politics involved with spending the entire capital budget ◦failure to generate alternative investment ideas - find good idea, just go with it, rather than finding a better idea. ◦proper handling of sunk and opportunity costs

Agency Issues (Between shareholders and bondholders)

◦for firms financed by debt as well as equity, there may be an agency conflict between shareholders and bondholders. ◦when there is risky debt outstanding, shareholders can pay themselves a large dividend, leaving the bondholders with a lower asset base as collateral. ◦This way, there could be a transfer of wealth from bondholders to stockholders. ◦Typically, agency conflict between stockholders and bondholders is resolved via provisions in the bond indenture. ◦These provisions may include restrictions on dividend payment, maintenance of certain balance sheet ratios, and so on

Free cash flow to equity (FCFE)

◦free cash flow to equity is the cash flow available for distribution to stockholders after working capital and fixed capital needs are accounted for. ◦FCFE coverage ratio = FCFE / (dividends + share repurchases) ◦considers both dividends and share repurchases ◦a FCFE coverage ratio significantly less than one is considered unsustainable. ◦in such a case, the company is drawing down its cash reserves for dividends/repurchases.

Fundamental options

◦fundamental options are projects that are option themselves because the payoffs depend on the price of an underlying asset. For example, the payoff for a copper mine is dependent on the market price for copper. If copper prices are low, it may not make sense to open a copper mine, but if copper prices are high, opening the copper mine could be very profitable. The operator has the option to close the mine when prices are low and open it when prices are high.

Disadvantages of the residual dividend model:

◦if a firm follows the residual dividend policy, its dividend payments may be unstable. ◦investment opportunities and earnings often vary from year to year ◦this means that dividends will fluctuate if a firm strictly adheres to a residual dividend policy

Target Payout ratio adjustment model

◦if company earnings are expected to increase and the current payout ratio is below the target payout ratio, and investor can estimate future dividends through the following formula: ‣ expected dividend = (previous dividend) + [(expected increase in EPS) x (target payout ratio) x (adjustment factor)] ‣ where adjustment factor = 1 / number of years over which the adjustment in dividends will take place.

LOS 25.e: Explain and calculate the discount rate, based on market risk methods, to use in valuing a capital project.

◦in CAPM, risk is separated into systematic and unsystematic components. ◦unsystematic, or company specific, risk can be diversified away, while systematic, or market, risk cannot be diversified away. a diversified investor is compensated for taking on systematic risk but not unsystematic risk. ◦in a capital budgeting context, beta, a systematic risk measure, is appropriate for measuring project or asset risk when a company is, or the company's investors, are diversified. ◦beta risk is based on the equation of the CAPM, or the security market line (SML) which defines a project's required rate of return (discount rate) using the equation: ‣ Rproject = Rf + Beta(E(Rmkt) - Rf)

Residual dividend model

◦in the residual dividend model, dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget. ◦the model is based on the firm's (1) investment opportunity schedule (IOS) (2) target capital structure and (3) access to and cost of external capital

Clientele Effect (Individual investor preferences)

◦individual investor preferences: some investors prefer to buy stocks so they can spend the dividends while preserving the principal.

LOS 27.b: Describe types of informaton (signals) that dividend initiations, increases, decreases, and omissions may convey

◦information asymmetry: refers to differences in information available to a company's board and management (insiders) as compared to the investors (outsiders) ◦Dividends convey more credible information to the investors as compared to plain statements ‣ This is so because dividends entail actual cash flow and are expected to be "sticky" (continue in the future). Companies refrain from increasing dividends unless they expect to continue to pay out the higher levels in the future. ‣ similarly, companies loathe cutting dividends unless they expect that the lower levels of dividends reflect long-run poorer prospect of the company in the future. ◦the information conveyed by dividend initiation is ambiguous. ‣ on one hand, a dividend initiation could mean that a company is optimistic about the future and is sharing its wealth with stockholders - a positive signal. ‣ on the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities - a negative signal.

LOS 25.a:Determine the yearly cash flows of expansion and replacement capital projects, and evaluate how the choice of depreciation method affects those cash flows

◦initial investment outlay, operating cash flow over the projects life, and terminal year cash flow ◦initial investment outlay: is the up front costs associated with the project. Components are price, which includes shipping and installation (FCINV) and investment in net working capital (NWCInv) ‣ outlay = FCInv + NWCInv

In other words, the pecking order (from most favored to least favored) is:

◦internally generated equity (i.e., retained earnings) ◦Debt ◦External equity (i.e., newly issued shares) ◦... therefore, the pecking order theory predicts that the capital structure is a by-product of the individual financing decisions

Tax Considerations (Factors that affect dividend policy)

◦investors are concerned about after-tax returns. ◦investment income is taxed by most countries; however, the ways that dividends are taxes vary widely from country to country ◦the method and amount of tax applied to a dividend payment can have a significant impact on a firm's dividend policy ◦generally, in countries where capital gains are taxes at a favorable rate as compared to dividends, high-tax bracket investors (like some individuals) prefer low dividend payouts, and low-tax bracket investors (like corporations and pension funds) prefer high dividend payouts. ◦a lower tax rate for dividends compared to capital gains does not necessarily mean companies will raise their dividend payouts. ◦stockholders may not prefer a higher dividend payout, even if the tax rate on dividends is more favorable, for multiple reasons: ‣ taxes on dividends are paid when the dividend is received, while capital gains taxes are paid only when shares are sold. ‣ the cost basis of shares may receive a step up in valuation at the shareholders death. ‣ this mean that taxes on capital gains may not have to be paid at all. ‣ tax exempt institutions, such as pension funds and endowments, will be indifferent between dividends or capital gains

Macroeconomic Factors

◦inflation: higher inflation reduces the value to investors of fixed interest payments. As a result, firms operating in countries with high inflation tend to use less debt financing, and the debt used has a shorter maturity. ◦GDP growth: Firms operating in countries with higher GDP growth tend to use longer maturity debt.

More on residual method

◦like other capital budgeting methods, discounting the residual income at the required rate of return on equity will give the npv of the investment. ◦the residual income approach focuses only on returns to equity holders; therefore, the appropriate discount rate is the required return on equity.

Financial Markets and banking system factors

◦liquidity of capital markets - more liquid use longer maturity debt ◦reliance on banking system: more reliant on banking than corporate bond tend to be more highly leveraged. ◦institutional investor presence: a greater prevalence of large institutional investors in a country may affect firms capital structure as well. Institutional investors may have preferred maturity ranges for their debt investments (preferred habitat). For example, life insurance companies and pension plans may exhibit a preference for long term debt securities relative to short term debt. There is some evidence that firms in countries with active institutional investors issue relatively more long-term debt compared to short term debt. We may also observe marginally lower debt to equity ratios in these countries

Net agency costs of equity have three components

◦monitoring costs are the costs associated with supervising management and include the expenses associated with making reports to shareholders and paying the board of directors. Note that strong corporate governance systems will reduce monitoring costs. ◦bonding costs are assumed by management to assure shareholders that the managers are working in the shareholders best interest. Examples of bonding costs include the premiums for insurance to guarantee performance and implicit costs associated with non-compete agreements. ◦residual losses may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee.

Pecking order theory

◦pecking order theory, based on asymmetric information, is related to the signals management sends to investors through its financing choices. ◦According to pecking order theory, managers prefer to make financing choices that are least likely to send signals to investors. ◦Financing choices under pecking order theory follow a hierarchy based on visibility to investors with internally generated capital being the most preferred, debt being the next best choice, and external equity being the least preferred financing option.

Capital Budgeting Process

◦process of identifying and evaluating capital projects; that is, projects where the cash flow to the firm will be received over a period longer than a year

LOS 25.f: Describe types of real options and evaluate a capital project using real options:

◦real options allow managers to make future decisions that change the value of capital budgeting decisions made today. ◦real options are similar to financial call and put options in that they give the option holder the right, but not the obligation, to make a decision. The different is that real options are based on real assets rather than financial assets and are contingent on future events. Real options offer managers flexibility that can improve the NPV estimates for individual projects. ◦types of real options include the following: ‣ timing options: allow a company to delay making an investment with the hope of having better information in the future ‣ abandonment options: are similar to put options. They allow management to abandon a project if the present value of the incremental cash flows from exiting a project exceeds the present value of the incremental cash flows from continuing a project. ‣ expansion options: similar to call options. Expansion options allow a company to make additional investments in a project if doing so creates value.

Capital budgeting projects may be divided into the following categories:

◦replacement projects to maintain the business are normally made without detailed analysis. The only issues are whether the existing operations should continue and, if so, whether existing procedures or processes should be maintained. ◦replacement projects for cosh reduction determine whether equipment that is obsolete but still usable, should be replaced. A fairly detailed analysis is necessary in this case. ◦Expansion projects are taken on to expand the business and involve a complex decision-making process since they require an explicit forecast of future demand. A very detailed analysis is required. ◦new product or market development also entails a complex decision making process that will require a detailed analysis due to the large amount of uncertainty involved. ◦mandatory projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. These projects typically generate little to no revenue, but they accompany new revenue-producing projects undertaken by the company. ◦other projects: some projects are not easily analyzed through the capital budgeting process. Such projects may include a pet project of senior management (e.g. corporate perks), or a high-risk endeavor that is difficult to analyze with typical capital budgeting assessment methods (e.g., research and development projects)

4. Offsetting dilution from employee stock options

◦repurchases offset EPS dilution that results from the exercise of employee stock options.

Clientele effect (Requirements of institutional investors)

◦requirements of institutional investors: for legal or strategic reasons, some institutional investors will invest only in companies that pay a dividend or have a dividend yield above some target threshold. Examples are dividend focused mutual funds and some trusts that are required to hold dividend paying stocks.

Residual Income

◦residual income focuses on returns on equity and is determined by subtracting an equity charge from the accounting net income. The equity charge is found by multiplying the required return on equity by the beginning book value of equity. ◦the calculation for residual income is: ‣ residual income = net income - equity charge

Simulation (monte carlo) anaylsis:

◦results in a probability distribution of project NPV outcomes, rather than just a limited number of outcomes as with sensitivity or scenario analysis (e.g. base case, best case, worst case) ◦the steps in simulation analysis are as follows: ‣ step 1: Assume a specific probability distribution for each input variable. ‣ step 2: simulate a random draw from the assumed distribution of each input variable. ‣ step 3: given each of the inputs from step 2, calculate the project NPV ‣ repeat step 2 and step 3 10,000 times ‣ calculate the mean NPV, the standard deviation of the NPV, and the correlation of NPV with each input variable. ‣ Graph the resulting 10,000 NPV outcomes as a probability distribution.

LOS 25.d: Explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the stand-alone risk of a capital project.

◦sensitivity analysis: involves changing an input (independent) variable to see how sensitive the dependent variable is to the input variable. ◦Scenario analysis: a risk analysis technique that considers both the sensitivity of some key output variable (e.g. NPV) to changes in a key input varialbe (eg sales) and the likely probability distribution of these variables. scenario analysis allows for changes in multiple input variables all at once.

5. Increasing financial leverage:

◦share repurchases increase leverage ◦management can change the company's capital structure (and perhaps move toward the company's optimal capital structure) by decreasing the percentage of equity.

Long-term residual dividend:

◦some companies try to mitigate the disadvantages of the residual dividend approach by forecasting their capital budget over a longer time frame (e.g. five to ten years) ◦the leftover earnings over this longest time frame are allocated as dividends and are paid out in relatively equal amounts each year. ◦Any excess cash flows are distributed through share repurchases

LOS 27.f: Compare stable dividend, constant dividend payout ratio, and residual dividend payout policies, and calculate the dividend under each policy.

◦stable dividend policy ‣ focuses on a steady dividend payout, even though earnings may be volatile from year to year. companies that use a stable dividend policy typically look at a forecast of their long-run earnings to determine the appropriate level for the stable dividend. ‣ this typically means aligning the company's dividend growth rate with the company's long-term earnings growth rate. ‣ a stable dividend policy could be gradually moving towards a target dividend payout ratio. A model of gradual adjustment is called a target payout ratio adjustment model.

Institutional and legal factors

◦strength of legal system: weak legal systems lead to higher agency costs due to the lack of legal protection for investors. These firms tend to use more leverage in their capital structure and have a greater reliance on short-term debt. By contrast, firms operating in countries with strong legal systems tend to use less debt overall, and the debt used tends to have longer maturities. ◦information asymmetry: a high level of information asymmetry between managers and investors encourages managers to use more debt in the capital structure. In countries where auditors and financial analysts have a greater presence, information asymmetries are reduced. Increased transparency tends to result in lower financial leverage. ◦taxes: the tax shield provided by debt encourages the use of debt financing; however, this relationship changes somewhat if dividends are taxed at a more favorable rate than interest income. A favorable tax rate for dividends should reduce the return that investors require capital, thus reducing the cost of equity for the firm. The lower cost of equity will cause firms operating in countries with lower tax rates on dividend income to have less debt in their capital structure.

MM Proposition 1 (With Taxes): Value is Maximized at 100% Debt

◦tax shield provided by debt. ◦Removing MMs assumption that there are no taxes changes the result of their propositions regarding capital structure irrelevance. ◦under the tax code of most countries, interest payments are a pretax expense and are therefore tax deductible, while dividends are paid on an after tax basis. ◦the differential tax treatment encourages firms to use debt financing because debt provides a tax shield that adds to the value of the company the tax shield is equal to the marginal tax rate multiplied by the amount of debt in the capital structure. In other words, the value of a levered firm is equal to the value of an unlevered firm plus the tax shield. ◦if we maintain MMS other assumptions (i.e. no cost of bankruptcy), the value of the company increases with increasing levels of debt, and the optimal capital structure is 100% debt.

Equivalent Annual Annuity (EAA) Approach

◦the EAA approach is a simpler approach to evaluating mutually exclusive projects with different lives. ◦The EAA approach finds the sequence of annual payments that is equal to the project's NPV. ◦The resulting calculation is an annual payment that allows for an apples to apples comparison of projects with different lives. ◦three steps: ‣ find each projects NPV ‣ find an annuity (EAA) that equates to the project's NPV over its individual life at the WACC. ‣ select the project with the highest EAA. In this example, the printer should be accepted because: EAAprinter > EAApress

Modified Accelerated Cost Recovery System (MACRS)

◦the choice of depreciation method has important implications for the aftertax cash flows of a capital projects. ◦in US, most companies use straight line depreciation for financial reporting and the modified accelerated cost recovery system for tax purposes. ◦for capital budgeting purposes, we should use the same depreciation method used for tax reporting since capital budgeting analysis is based on after tax cash flows and not accounting income. ◦under MACRS, assets are classified into 3-,5-,7-, or 10 year classes, and each year's depreciation is determined by the applicable recovery percentage given in figure 1

Claims valuation approach

◦the claims valuation approach divides operating cash flows based on the claims of debt and equity holders that provide capital to the company. ◦These debt and equity cash flows are valued separately and then added together to determine the value of the company. ◦the claims valuation method calculates the value of the company not the project. This is different from the economic profit and residual income approaches, which calculate both project and company value. ◦the claims valuation approach is based on the balance sheet concept that assets equal liabilities plus equity. ◦Every asset is financed by some combination of debt and equity, and the claims valuation approach merely separates the cash flows provided by the asset into the proportionate debt and equity components. ‣ the cash flows to debt holders consist of interest and principal payments and are discounted at the cost of debt. ‣ the cash flows to equity holders are dividends and share repurchases and are discounted at the cost of equity.

After-tax operating cash flows (CF)

◦the incremental cash inflows over the capital asset's economic life. Operating cash flows are defined as ‣ CF = (S-C-D)(1-T) + D = (S-C)(1-T) + (TD) ‣ where S = Sales, C = cash operating costs, D = depreciation expense, T = marginal tax rate ◦although depreciation is a non cash operating expense, it is an important part of determining operating cash flow because it reduces the amount of taxes paid by the firm. ◦we can account for depreciation either by adding it back to net income from the project (as in the first cash flow formula) or by adding the tax savings caused by depreciation back to the project's after-tax gross profit (as in the second formula) ◦in general, a higher depreciation expense will result in greater tax savings and higher cash flows. This means that accelerated depreciation methods will create higher after-tax cash flows for the project earlier in the projects life as compared to the straight line method, resulting in a higher net present value for the project.

Initial Investment Outlay

◦the investment in NWC must be included in the capital budgeting decision. Whenever a firm undertakes a new operation, product, or service, additional inventories are usually needed to support increased sales, and the increased additional sales lead to increases in accounts receivable. Accounts payable and accruals will probably also increase proportionally. ◦the investment in net working capital is defined as the difference between the changes in non-cash current assets and changes in non-cash current liabilities (i.e., those other than short term debt). Cash is excluded because it is generally assumed not to be an operating asset ◦NWCInv = ∆non-cash current assets - ∆non-debt current liabilities = ∆NWC ◦if NWCInv is positive, additional financing is required and represents a cash outflow because cash must be used to fund the net investment in current assets. ◦if negative, the project frees up cash, creating a cash inflow. Note that at the termination of the project, the firm will expect to receive an end-of-project cash inflow (or outflow) equal to initial NWC when the need for the additional working capital ends.

Advantages of the residual dividend model:

◦the model is simple to use. The company uses the funds necessary to invest in profitable projects and then gives what is left over to the shareholders. ◦the model allows management to pursue profitable investment opportunities without being constrained by dividend considerations.

Why does the pie analogy hold true?

◦the operating earnings (EBIT) of a firm are available to all providers of capital. ◦in a company with no debt, all of the operating earnings are available to equity holders, and the value of the company is the discounted present value of these earnings. ◦if a company is partially financed by debt, operating earnings are split between debt holders and equity holders. ◦under the assumption of perfect markets, the sum of a firm's debt and equity should equal the value of the all-equity company so the value of the company is unchanged. ◦another way of stating this is that the value of the company with leverage is equal to the value of the company without leverage ‣ VL = VU where VL = value of levered firm and Vu= value of unlevered firm. ◦given our assumptions, an investor can have homemade leverage. He can substitute his own leverage (in addition to owning stock) for company's leverage. ◦as this process is assumed to be costless, a company's capital structure is irrelevant in the presence of perfect capital markets

Conclusions from the three theories

◦the results of empirical tests are unclear as to which of these theories best explains the empirical observations of dividend policy, research suggests that higher tax rates do result in lower dividend payouts. ◦in the US, however, the change in tax law that put dividends and capital gains on common round is likely to make the tax aversion theory irrelevant. ◦there is empirical support for the bird in the hand theory as some companies that pay dividends are perceived as less risky and specific groups of investors do prefer dividend paying stocks. ◦MM counter this argument by saying that different dividend policies appeal to different clienteles, and that since all types of clients are active in the marketplace, dividend policy has no effect on company value if all clienteles are satisfied

MM in terms of pie

◦the size (value) of the pie (firm) depends not on how it is sliced (the capital structure), but rather on the size of the pie pan (the firms asset base) ◦so with a ie pan of a certain size, the value of a firms assets will be the same, no matter how a firm finances (slices) it.

Static Trade-Off Theory

◦the static trade off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. ◦under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt. ◦if we remove the assumption that there are no costs of financial distress, there comes a point where the additional value added from the debt tax shield is exceeded by the value-reducing costs of financial distress from the additional borrowing. this point represents the optimal capital structure for a firm where the WACC is minimized and the value of the firm is maximized

LOS 26.b: Explain the target capital structure and why actual capital structure may fluctuate around the target

◦the target capital structure is the structure that the firm uses over time when making decisions about how to raise additional capital. Managements use of a target capital structure reflects the knowledge that the firm has an optimal capital structure. For managers trying to maximize the value of the firm, the target capital structure will be the same as the optimal capital structure. ◦in practice, the firm's actual capital structure tends to fluctuate around the target capital structure for two reasons: ‣ management may choose to exploit opportunities in a specific financing source. For example, a temporary rise in the firm's stock price may create a good opportunity to issue additional equity, which would result in a higher percentage of equity than the target. ‣ market value fluctuations will occur: changes in stock and bond markets will cause fluctuations in the firms stock and bond prices. Because capital structure weights are determined by market values, market fluctuations may cause the firm's actual capital structure to vary from the target.

What does an unexpected dividend decease or omission mean?

◦typically negative signals that the business is in trouble and that management does not believe that the current dividend payment can be maintained. ◦in rare instances, however, a dividend decrease or omission could be a positive sign. ◦Management may believe that profitable investment opportunities are available and that shareholders would ultimately receive a greater benefit by having earnings reinvested in the company rather than being paid out as dividends.

Imputation tax system

◦under an imputation tax system, taxes are paid at the corporate level but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate. ◦shareholders deduct their portion of the taxes paid by the corporation from their tax return ◦if the shareholder tax bracket is lower than the company rate, the shareholder would receive a tax credit equal to the difference between the two rates ◦if the shareholder's tax bracket is higher than the company's rate, the shareholder pays the difference between the two rates. ◦under an imputation system, the effective tax rate on the dividend is simply the shareholder's marginal tax rate.

MM II formula

◦using the weighted average cost of capital (WACC) formula (assuming the marginal tax rate is zero) and solving for the cost of equity ◦as leverage icreases (i.e. the debt to equity ratio rises), the cost of equity increases, but WACC and the cost of debt are unchanged.

Flotation Costs (factors that affect dividend payout policy)

◦when a company issues new shares of common stock, a flotation cost of 3% to 7% is taken from the amount of capital raised to pay for investment bankers and other costs associated with issuing the new stock. ◦since retained earnings have no such fee, the cost of new equity capital is always higher than the cost of retained earnings. ◦larger companies typically have lower flotation costs as compared to smaller companies. ◦generally, the higher the flotation costs, the lower the dividend payout given the need for equity capital in positive npv projects.

1. Potential tax advantages

◦when tax rate on capital gains are lower than the tax rate on dividend income, share repurchases have a tax advantage over cash dividends

Mutually Exclusive Projects with Different Lives

◦when two projects are mutually exclusive, the firm ma choose one project or the other, but not both. ◦if mutually exclusive projects have different lives, and the projects are expected to be replaced indefinitely as they wear out, an adjustment needs to be made in the decision-making process. ◦There are two procedures to make this adjustment: ‣ least common multiple of lives approach ‣ equivalent annual annuity (EAA) approach

does the second proposition support the first?

◦yes, because the benefits of lower cos debt are offset by the increased cost of equity, the relative amount of debt versus equity in the firms capital structure does not affect the overall value of the firm

Figure 4: Static trade off theory explained

◦figure 4 shows that the after tax cost of debt has an upward slope due to the increasing costs of financial distress that come with additional leverage. ◦as the cost of debt increases, the cost of equity also increases because some of the costs of financial distress are effectively borne by equity holders. ◦the optimal proportion of debt is reached at the point when the marginal benefit provided by the tax shield of taking on additional debt is equal to the marginal costs of financial distress incurred from the additional debt. ◦this point also represents the firms optimal capital structure because it is the point that minimizes the firms WACC and therefore maximizes the value of the firm

Financial flexibility (factors that affect dividend policy)

◦firms with excess cash and a desire to maintain financial flexibility may resort to stock repurchases instead of dividends as a way to pay out excess cash. ◦since stock repurchase plans are not considered sticky (there is no implicit expectation by the market of an ongoing repurchase program), they don't entail reduction in financial flexibility going forward. ◦Having cash on hand affords companies flexibility to meet unforeseen operating needs and investment opportunities. ◦Financial flexibility is especially important during times of crisis when liquidity dries up and credit may be hard to obtain

Flexibility options

◦flexibility options give managers choices regarding the operational aspects of a project. The two main forms are price-setting and production flexibility options. ‣ price-setting options allow the company to change the price of a product. ‣ production-flexibility: options may include paying workers overtime, using different materials as inputs, or producing a different variety of product.

Expected volatility of future earnings (factors that affect dividend policy)

firms tie their target payout ratio to long-run sustainable earnings and are reluctant to increase dividends unless reversal is not expected in the near future. Hence, when earnings are volatile, firms are more cautious in charging dividend payout.