Capital Structure, Taxes, and Dividends

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• Capital Structure, Taxes, and Dividends

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Overview

• Review of the MM Theorems
• Capital Structure and Shareholder Wealth
• Impact of Taxes on Capital Structure
• Dividend Policy Defined
• MM Theorem extended to dividend policy
• Impact of Taxes on Dividend Policy

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Capital Structure

• A firm finances its (long-term) assets by
  raising funds in the capital markets through the
  issuance of financial securities
• The decision as to what financial securities to
  issue is a financing decision and the combination
  (portfolio) of securities used is known as the
  firms Capital Structure
• Typically comprises Debt and Equity
• The optimal capital structure question isIs
  there a debt equity combination that maximizes
  the value of the firm?

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Modigliani-Miller Theorem

• MM made the following assumptions
• Investment decisions are independent of
  financing
• Perfect capital market exist (no transaction
  cost both individuals and corporations can
  borrow at the same rate)
• Investors have homogeneous expectations
• No corporate or personal income taxes
• They arrived at a type of law of conservation of
  value
• The total market value of the firm is
  independent of how the firm is financed

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MM Propositions (no taxes)

• Proposition I The market value of a
  leveraged firm is equal to the market value
  of an unlevered firm. 
•   
• Proposition 2 The required return on the
  equity of a levered firm is equal to the
  required return on the equity of a unlevered
  firm plus a risk premium to reward the
  investors for the additional risk caused by
  debt

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Proof by Example

• We consider two firms, U and L that produce
  identical perpetual real cash flows of 1,000,000
  per year but that are financed differently
• Firm U (unlevered) is all equity with a market
  value of 10,000,000
• D 0 rEU rA 10
• Firm L (levered) is partially financed with
  5,000,000 of risk-less debt that pays a 5
  interest rate.
• D 5,000,000 rD 5, rA 10, rEL ?

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Example continued

• For firm U
•  For firm L

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In summary
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Suppose MM proposition failed to hold !!

• That is, what if VU ? VL ?
• For example, what if L had a equity value of
  6,250,000 (which would imply a return on equity
  of 12.00)?
• Note the value of levered firm is now 11.25
  million.
• MM claimed that if this occurred, then it
  represented an opportunity to make ARBITRAGE
  profits
• How ?
• Consider the new information

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The MM Arbitrage Argument

• Simply sell the overvalued shares, roll your own
  leverage, and buy the undervalued ones 
• For example, suppose you own 10 of the equity
  of firm L, that is 10 of 6.25m 625,000.
  Then 1. Sell levered firm stocks for 625,000
• 2. Borrow an amount equivalent to 10 of
  debt (i.e.10 of 5m500,000)
• 3. Buy 10 of firm Us stocks for 1,000,000
• 4. Invest the balance in the risk-less asset
  (625,000 500,000 1,000,000)125,000

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The Result

• Old Situation 10 of firm VLs equity
  generated equity income of
  0.10(750,000)75,000 
• New situation 10 of VUs equity generates
  100,000. But you borrowed 500,000. You also
  have an extra 125,000 in the bank Equity
  income (0.10 ?1,000,000) 100,000 Debt expenses
  (0.05 ? 500,000) (25,000) Interest income
  (0.05 ? 125,000) 6,250 Total income
  81,250
•  Each year, you make 6,250 of risk-less profit!

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Conclusion

• All the investors will follow the same strategy.
  i.e. 1. Sell L stocks prices (rEL will
  increase and VL will decline) 2. Borrow 3.
  Buy U stocks (rEU will decrease and VU will
  decline)
• This will continue until VL VU
• And no arbitrage is possible
• The conclusion is that there is no optimal
  capital structure, and that the choice between
  using debt or equity to finance the assets of the
  firm is irrelevant to the value of the firm

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More on Irrelevancy

• Note that when the MM theorem says irrelevant
  this does not mean irrelevant to shareholders.
• The MM theorem says V is independent of D/E
• As we have seen, there can be a transfer of
  wealth from bondholders to shareholders when new
  debt is issued.
• That is if default risk increases the value of
  previously held debt will decrease D X/(1 r
  ) p
• This is why their may be covenants on the debt
  (such as all future debt issues will be
  subordinate).

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An Example

• Recall the firm with risk-less debt (q ½ , rf
  10)
• We assume that there are 100 shares each with a
  share price of 22.72
• Suppose the firm undergoes a capital restructure
  by issuing 2 new bonds and using the proceeds to
  pay a special dividend

Vu D E 5000 1000 4000
V0 3181.82 D0 909.09 E0 2272.72

Vd D E 2000 1000 1000
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Post Restructure
Vu D E 5000 3000 2000
V0 3181.82 D0 2272.72 E0 909.09
Vd D E 2000 2000 0

• Each Bond is now worth 2272.72/3 757.57
• Each stock is worth 9.09(new price)
  15.15(dividend) 24.24
• An increase in shareholder wealth and a decrease
  in (old) bond holders wealth !

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Debt Covenants

• To prevent this wealth transfer, i.e. to protect
  themselves, old bond holders may state in the
  bond indenture that all new bonds be subordinate
  (grade B) bonds
• Old bonds have seniority (grade A) ? are paid
  first

Vu Dold Dnew E 5000 1000
2000 2000
V0 3181.82 D0LD 909.09 DNEW 1363.64
E0 909.09
Vd Dold Dnew E 2000 1000 1000
0
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The Result

• The two new bonds are issued at a price of
  1363.64/2 681.82 per bond
• Share holders get a dividend of 13.64 per share.
• New price per share changed from 22.73 to 9.09
• Total shareholders wealth is unchanged!
• Conclusion If original debt holders have a
  senior claim in the event of bankruptcy, then the
  original shareholders and debt holders wealth
  is independent of capital structure.

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The Impact of Corporate Taxes
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What is the Value of the Leveraged Firm?

• Firm U transfers a cash flow with a PV of 350,000
  to government. Firm L has a perpetual Tax Shield
  of 87,500/yr. Assuming that the firm refinances,
  then

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The Impact of Corporate and Personal Taxes

• Let us denote the personal income tax rate on
  equity as ?e and the personal income tax rate on
  debt as ?d
• Stockholders receive
• Bondholders receive
• The total can be rewritten as

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The Result MM with tax

• The first term is the cash flow to a similar all
  equity (un-leveraged) firm. Hence, the present
  value of the first term is VU
• The coefficient of the second term is the cash
  flow to the debt holders. Hence the present value
  of the second term is D
• Combining, we get

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• Empirical implications are
• Firms with substantial taxable earnings before
  interest (i.e. EBIT) should have an incentive to
  issue debt.
• Firms with tax shields and low taxable earnings
  (due to depreciation and RD expenditures) should
  have less debt (all else equal).
• However, empirical studies show
• There seems to be very little positive relation
  between EBIT and debt levels.
• Companies with large tax shields/low EBIT are
  companies with large amounts of cap expenditure
  and debt
• Firms in trouble use debt.

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Dividend Policy

• By dividend policy we mean
• How does the corporation distribute cash to its
  shareholders?

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Historical Evidence U.S. Corporations 1971 - 1992
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Historical Evidence U.S. Aggregate Share
Repurchases
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Historical Evidence Observed Patterns

• On average, dividend payout ratio
  (dividends?profits) has been 50
• Firms tend to smooth their dividend payments.
  i.e. dividend payout ratios rise (fall) when
  earnings fall (rise)
• Firms try to avoid cutting dividends. Managers
  aim to have gradually increasing dividends
• Share repurchases have become more popular

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Dividend Policy

• To focus on this issue, we will take both the
  Investment Decision and Capital Structure
  Decision as being fixed
• Dividend policy is a financing decision.
• Assuming no taxes, perfect information, no
  transactions costs e.t.c. Modigliani and Millers
  irrelevancy argument can be extended to all
  financing decisions.
• We can construct a Proof by Example
• Consider two similar tech firms Mantek and
  Womantek. Both currently have 1 million shares
  outstanding, both will pay 2 million in
  dividends next year with the amount expected to
  grow by 5, and both have the same rE 9

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Proof of MM Theorem continued

• The stocks of both Mantek and Womantek are
  currently selling at
• Management at Mantek decides that it would be
  beneficial to existing shareholders to increase
  next years dividend by 1 million (to 3
  million).
• This will be a one time increase. Dividends
  will go back to the initial levels for years 2,
  3, .... (2.1m in year 2, 2.205m in year 3,
  etc...)
• They will raise the money by selling shares of
  stock (next year).

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Proof of MM Theorem continued

• Management at Womantek believes that this will
  have no impact on the wealth of existing
  shareholders.
• Whos right?
• To answer this we need to determine
• How many shares must be issued to pay for the
  dividend?
• Concurrently, at what price will the new shares
  be issued?
• What dividends will (all) the shareholders
  receive after the new dividend policy is put into
  place?
• Finally, how has existing shareholders wealth
  for Mantek changed

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Proof of MM Theorem continued

• Next year, the value of new issues equals
  additional dividend. i.e.
• Since dividends do not change after next year,
  the expected ex-dividend total value of equity
  next year is
• Solving for both price and number issued

million
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Manteks New Improved Stock Price

• Total of shares outstanding next year will be
  1,019,417
• With the new dividend policy the price is
• What is going on? Hint year 2s dividend (per
  share) will be reduced to 2.1?1,019,417 2.06.
  It is this amount that continue to grow by 5.
• Note An Irrelevancy Argument can similarly be
  proved for the choice between cash payout and
  share repurchase(Try this at home).

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The Impact of Taxes

• One key assumption behind the irrelevancy
  argument is that there is no difference between
  taxes on dividends and taxes on capital gains.
• The U.S. uses the classical tax treatment of
  dividends
• dividends are taxed as ordinary income
• capital gains tax is different (lower, if
  realized)
• Other countries such as Canada, use the
  Imputation tax treatment
• dividends are given a tax credit to partially
  offset the double taxation of dividends.
• Personal taxes can affect a firms choice of
  dividend policy