Investment returns

The rate of return on an investment can be

calculated as follows:
Risk and Rates of Return (Amount received – Amount invested)
Return = ________________________
Amount invested
 Stand-alone risk
For example, if $1,000 is invested and $1,100 is
 Portfolio risk returned after one year, the rate of return for this
 Risk & return: CAPM / SML investment is:
($1,100 - $1,000) / $1,000 = 10%.

5-1 5-2

What is investment risk? Probability distributions

 Two types of investment risk  A listing of all possible outcomes, and the
 Stand-alone risk probability of each occurrence.
 Portfolio risk  Can be shown graphically.
 Investment risk is related to the probability Firm X
of earning a low or negative actual return.
 The greater the chance of lower than
Firm Y
expected or negative returns, the riskier the Rate of
investment. -70 0 15 100 Return (%)

Expected Rate of Return

5-3 5-4

Selected Realized Returns,

1926 – 2001 Investment alternatives
Average Standard
Return Deviation Economy Prob. T-Bill HT Coll USR Market
Small-company stocks 17.3% 33.2% Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%
Large-company stocks 12.7 20.2
Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%
L-T corporate bonds 6.1 8.6
Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%
L-T government bonds 5.7 9.4
U.S. Treasury bills 3.9 3.2 Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%

Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.

5-5 5-6
 Why is the T-bill return independent of
the economy? Do T-bills promise a How do the returns of HT and Coll.
completely risk-free return? behave in relation to the market?
 T-bills will return the promised 8%, regardless of  HT – Moves with the economy, and has
the economy. a positive correlation. This is typical.
 No, T-bills do not provide a risk-free return, as
they are still exposed to inflation. Although, very  Coll. – Is countercyclical with the
little unexpected inflation is likely to occur over economy, and has a negative
such a short period of time. correlation. This is unusual.
 T-bills are also risky in terms of reinvestment rate
risk.
 T-bills are risk-free in the default sense of the
word.
5-7 5-8

Return: Calculating the expected Summary of expected returns

return for each alternative for all alternatives
Exp return
^
k  expectedrate of return HT 17.4%
Market 15.0%
^ n USR 13.8%
k   k i Pi T-bill 8.0%
i1
Coll. 1.7%
^
k HT  (-22.%) (0.1)  (-2%) (0.2) HT has the highest expected return, and appears
 (20%) (0.4)  (35%) (0.2) to be the best investment alternative, but is it
 (50%) (0.1)  17.4% really? Have we failed to account for risk?
5-9 5-10

Risk: Calculating the standard

deviation for each alternative Standard deviation calculation
n ^

  Standard deviation    (k
i1
i  k )2 Pi

  Variance  2 (8.0 - 8.0)2 (0.1)  (8.0 - 8.0)2 (0.2) 

1
2

 T bills   (8.0 - 8.0)2 (0.4)  (8.0 - 8.0)2 (0.2) 

n 2
 (8.0 - 8.0) (0.1)
  (k  k̂ ) P
i1
i
2
i


 T bills  0.0%  Coll  13.4%

 HT  20.0%  USR  18.8%
 M  15.3%
5-11 5-12
 Comments on standard
Comparing standard deviations deviation as a measure of risk
 Standard deviation (σi) measures total, or
Prob.
T - bill stand-alone, risk.
 The larger σi is, the lower the probability that
actual returns will be closer to expected
USR returns.
 Larger σi is associated with a wider probability
HT distribution of returns.
 Difficult to compare standard deviations,
because return has not been accounted for.

0 8 13.8 17.4 Rate of Return (%)

5-13 5-14

Comparing risk and return Coefficient of Variation (CV)

Security Expected Risk, σ A standardized measure of dispersion about
return the expected value, that shows the risk per
T-bills 8.0% 0.0% unit of return.
HT 17.4% 20.0%
Coll* 1.7% 13.4% Std dev 
CV   ^
USR* 13.8% 18.8% Mean k
Market 15.0% 15.3%
* Seem out of place.

5-15 5-16

Risk rankings, Illustrating the CV as a

by coefficient of variation measure of relative risk
CV
T-bill 0.000 Prob.

HT 1.149 A B
Coll. 7.882
USR 1.362
Market 1.020 Rate of Return (%)
0
 Collections has the highest degree of risk per unit
of return. σA = σB , but A is riskier because of a larger
probability of losses. In other words, the same
 HT, despite having the highest standard deviation
amount of risk (as measured by σ) for less returns.
of returns, has a relatively average CV.
5-17 5-18
 Portfolio construction:
Investor attitude towards risk Risk and return
 Risk aversion – assumes investors
Assume a two-stock portfolio is created with
dislike risk and require higher rates
of return to encourage them to hold $50,000 invested in both HT and Collections.
riskier securities.  Expected return of a portfolio is a
 Risk premium – the difference weighted average of each of the
component assets of the portfolio.
between the return on a risky asset
and less risky asset, which serves as  Standard deviation is a little more tricky
compensation for investors to hold and requires that a new probability
riskier securities. distribution for the portfolio returns be
devised.
5-19 5-20

An alternative method for determining

Calculating portfolio expected return portfolio expected return
^
k p is a weightedaverage : Economy Prob. HT Coll Port.
Recession 0.1 -22.0% 28.0% 3.0%
^ n ^ Below avg 0.2 -2.0% 14.7% 6.4%
k p   wi k i Average 0.4 20.0% 0.0% 10.0%
i1
Above avg 0.2 35.0% -10.0% 12.5%
Boom 0.1 50.0% -20.0% 15.0%
^
k p  0.5 (17.4%)  0.5 (1.7%)  9.6% ^
k p  0.10 (3.0%)  0.20 (6.4%)  0.40 (10.0%)
 0.20 (12.5%)  0.10 (15.0%)  9.6%
5-21 5-22

Calculating portfolio standard Comments on portfolio risk

deviation and CV measures
1
 0.10 (3.0 - 9.6)2  2  σp = 3.3% is much lower than the σi of
 0.20 (6.4 - 9.6)2  either stock (σHT = 20.0%; σColl. = 13.4%).
  σp = 3.3% is lower than the weighted
 p   0.40 (10.0 - 9.6)2   3.3% 

 0.20 (12.5 - 9.6)2  average of HT and Coll.’s σ (16.7%).

 2
  \ Portfolio provides average return of
 0.10 (15.0 - 9.6)  component stocks, but lower than average
risk.
3.3% Why? Imperfect correlation between stocks.
CVp   0.34 
9.6%
5-23 5-24
 Returns distribution for two perfectly
General comments about risk negatively correlated stocks (ρ = -1.0)

Stock W Stock M Portfolio WM

 Combining stocks in a portfolio 25 25 25
lowers risk provided that the stocks
in the portfolio are imperfectly 15 15 15

correlated (absence of perfect 0 0 0

positive correlation).
-10 -10 -10

5-25 5-26

Returns distribution for two perfectly

positively correlated stocks (ρ = 1.0) Another formula for portfolio risk.
n n
Stock M Stock M’ Portfolio MM’  p   W j W k  jk
j 1k 1
25 25 25
where: n = total number of securities in the portfolio
Wj = proportion of total funds invested in security j
15 15 15 Wk = proportion of total funds invested in security k
jk = covariance between possible returns for security j and k
0 0 0 (will only be considered only for all possible pairwise combinations of
securities in the portfolio)
= rjk * j * k , jk = kj
-10 -10 -10 where : j is the standard deviation of investment/security j
k is the standard deviation of investment/security k
rjk correlation in the returns of investment/security j and k
5-27 if j=k, rjk =1 and jk = j2 or k2 5-28

Sample Problem For 0.36 correlation:

Blatz Stratz Ret. Risk
 The common stocks of Blatz Company and 1 0 0.15 0.20
Opportunity Set
Stratz, Inc. have expected returns of 15% 0.9 0.1 0.16 0.20
and 20%, respectively, while the standard 0.8 0.2 0.16 0.20
0.21
0.20
Expected Return

0.20
deviations are 20% and 40%. How will the 0.7 0.3 0.17 0.21 0.19
0.19
return and risk of a portfolio containing Blatz 0.6 0.4 0.17 0.23 0.18
0.18
0.17
and Stratz stocks behave if as the proportion 0.5 0.5 0.18 0.25 0.17
0.16
0.4 0.6 0.18 0.28
of total funds placed in each stock are varied? 0.16
0.15
0.3 0.7 0.19 0.31 0.15
Consider this for the following correlation (r ) 0.2 0.8 0.19 0.34
0.14
0.18 0.20 0.22 0.24 0.26 0.28 0.30 0.32 0.34 0.36 0.38 0.40
values : (a) 0.36 (b) 0.10 and (c )-0.5. 0.1 0.9 0.20 0.37 Risk
0 1 0.20 0.40
5-29 5-30
 For 0.1 correlation: For –0.5 correlation:
Blatz Stratz Ret. Risk Opportunity Set Blatz Stratz Ret. Risk Opportunity Set
1 0 0.15 0.20 1 0 0.15 0.20
0.9 0.1 0.16 0.19 0.9 0.1 0.16 0.16 0.21
0.22 0.8 0.2 0.16 0.14

Expected Return
Expected Return
0.8 0.2 0.16 0.19 0.21 0.20

0.7 0.3 0.17 0.19 0.20 0.7 0.3 0.17 0.13 0.19
0.19 0.6 0.4 0.17 0.14 0.18
0.6 0.4 0.17 0.21 0.18 0.17
0.17 0.5 0.5 0.18 0.17
0.5 0.5 0.18 0.23 0.16
0.16 0.4 0.6 0.18 0.21
0.4 0.6 0.18 0.26 0.15 0.3 0.7 0.19 0.26
0.15
0.3 0.7 0.19 0.29 0.14 0.14
0.2 0.8 0.19 0.30 0.12 0.17 0.22 0.27 0.32 0.37
0.2 0.8 0.19 0.33 0.15 0.20 0.25 0.30 0.35 0.40
0.1 0.9 0.20 0.35
0.1 0.9 0.20 0.36 Risk Risk
0 1 0.20 0.40
0 1 0.20 0.40
5-31 5-32

Comparison: Observations
Opportunity Set
1. Diversification effect is seen by comparing the
0.21 curved line with the straight dashed line.
0.2 2. It is possible to reduce the standard deviation from
0.19
what occurs with a 100% investment in one security
only. This counter-intuitive result is actually due to
Expected Return

0.18 R=-0.5
0.17 R=0.1
the diversification effect where expected return
R=0.36
0.16
from one security often are offset by opposite
0.15
movements in returns for the other security (true if
0.14
r<+1).
0.13
3. The portfolio depicted farthest to the left is the
0.12
0.12 0.17 0.22 0.27 0.32 0.37 “minimum variance portfolio”. It is the one with the
Risk
lowest standard deviation that come about by varying
5-33 the mix of the security held. 5-34

Creating a portfolio:
Beginning with one stock and adding
Observations randomly selected stocks to portfolio
4. No one would want to own a portfolio with a lower
expected return than that provided by the minimum  σp decreases as stocks added, because
variance portfolio. The backward bending portion of they would not be perfectly correlated
the opportunity set curve is infeasible. The “efficient with the existing portfolio.
set” is the portion of the curve going from the
minimum variance portfolio to the last point (highest
 Expected return of the portfolio would
expected return and highest risk as well). remain relatively constant.
5. For only two securities in the portfolio, it is only  Eventually the diversification benefits of
possible to be on the opportunity set line, not above adding more stocks dissipates (after
or below it. about 10 stocks
6. General rule is, the higher the “positive correlation”
among securities in the portfolio, the lower the
diversification effect. 5-35 5-36
 Illustrating diversification effects of
a stock portfolio Breaking down sources of risk
p (%)
Company-Specific Risk Total risk = Market risk + Firm-specific risk
35
Portfolio Risk, p
 Market (relevant) risk – portion of a security’s
stand-alone risk that cannot be eliminated
20 through diversification. Measured by beta.
Market Risk  Firm-specific risk – portion of a security’s
stand-alone risk that can be eliminated through
0 proper diversification.
10 20 30 40 2,000+
# Stocks in Portfolio
5-37 5-38

Total Risk and Relevant Risk

Illustration Failure to diversify
 If an investor chooses to hold a one-stock
 Assume that an investor plans to purchase a portfolio (exposed to more risk than a
stock with a risk of 5 units. Assume also that diversified investor), would the investor be
if this stock is added to his current portfolio, compensated for the risk they bear?
which has a risk of 10 units, the resulting risk  NO!
of the portfolio is 13 units. This indicates that  Stand-alone risk is not important to a well-
2 units of risk could be diversified away. Since diversified investor.
investors are rewarded only for the risks that  Rational, risk-averse investors are concerned
they bear, this investor can expect to be with σp, which is based upon market risk.
compensated only for the 3 units of risk.  There can be only one price (the market return)
for a given security.
 No compensation could be earned for holding
5-39 unnecessary, diversifiable risk. 5-40

Capital Asset Pricing Model

(CAPM) Beta
Models the relationship between the relevant
Measures a stock’s market risk, and


risk of an asset and the opportunity cost of
investing in that asset. shows a stock’s volatility relative to the
 Model based upon concept that a stock’s market.
required rate of return is equal to the risk-  Indicates how risky a stock is if the
free rate of return plus a risk premium that
reflects the riskiness of the stock after stock is held in a well-diversified
diversification. portfolio.
 Primary conclusion: The relevant riskiness of
a stock is its contribution to the riskiness of a
well-diversified portfolio.
5-41 5-42
 Calculating betas Illustrating the calculation of beta
_
 Run a regression of past returns of a ki
security against past returns on the 20 . Year kM ki
market. 15 . 1
2
15%
-5
18%
-10
 The slope of the regression line 10 3 12 16
(sometimes called the security’s 5
characteristic line) is defined as the _
-5 0 5 10 15 20
beta coefficient for the security. Regression line:
kM
-5
. -10
^
k = -2.59 + 1.44 ^
i k M

5-43 5-44

Can the beta of a security be

Comments on beta negative?
 If beta = 1.0, the security is just as risky as  Yes, if the correlation between Stock i and
the average stock. the market is negative (i.e., ρi,m < 0).
 If beta > 1.0, the security is riskier than  If the correlation is negative, the
average. regression line would slope downward,
 If beta < 1.0, the security is less risky than and the beta would be negative.
average.  However, a negative beta is highly
unlikely.

5-45 5-46

Beta coefficients for Comparing expected return

HT, Coll, and T-Bills and beta coefficients
_
ki HT: β = 1.30 Security Exp. Ret. Beta
40 HT 17.4% 1.30
Market 15.0 1.00
20 USR 13.8 0.89
T-Bills 8.0 0.00
T-bills: β = 0
_ Coll. 1.7 -0.87
-20 0 20 40 kM
Riskier securities have higher returns, so the
Coll: β = -0.87
rank order is OK.
-20
5-47 5-48
 The Security Market Line (SML):
Calculating required rates of return What is the market risk premium?
 Additional return over the risk-free
SML/CAPM: ki = kRF + (kM – kRF) βi rate needed to compensate investors
for assuming an average amount of
risk.
 Assume kRF = 8% and kM = 15%.
 Its size depends on the perceived risk
 The market (or equity) risk premium is of the stock market and investors’
RPM = kM – kRF = 15% – 8% = 7%. degree of risk aversion.

5-49 5-50

Calculating required rates of return Expected vs. Required returns

^

 kHT = 8.0% + (15.0% - 8.0%)(1.30) k k

^
= 8.0% + (7.0%)(1.30) HT 17.4% 17.1% Undervalued (k  k)
= 8.0% + 9.1% = 17.10% ^
Market 15.0 15.0 Fairly valued (k  k)
 kM = 8.0% + (7.0%)(1.00) = 15.00% ^

 kUSR = 8.0% + (7.0%)(0.89) = 14.23% USR 13.8 14.2 Overvalued (k  k)

^
 kT-bill = 8.0% + (7.0%)(0.00) = 8.00% T - bills 8.0 8.0 Fairly valued (k  k)
 kColl = 8.0% + (7.0%)(-0.87) = 1.91% ^
Coll. 1.7 1.9 Overvalued (k  k)

5-51 5-52

Illustrating the
Security Market Line Using CAPM: Another Example
SML: ki = 8% + (15% – 8%) βi  If the current one-period US T-Bills is 8%, the
expected return on the market is 12%, the beta for
ki (%) SML B&G stock is 1.5, and the expected price of B&G at
the end of the period is $68. Find the fair price of
HT . B&G stock (assume the company doesn’t pay
kM = 15 .. dividends).

kRF = 8 . T-bills USR P0 

$68
 $59.65
. 1  [0.08  1.5(0.12  0.08)]
-1 0 1 2
Risk, βi
Coll.
5-53 5-54
 An example:
Using CAPM: Another Example Equally-weighted two-stock portfolio

 $59.65 is the fair price of B&G stock.  Create a portfolio with 50% invested in
 If the price of B&G stock is $65 today, it HT and 50% invested in Collections.
is overvalued- meaning it is not  The beta of a portfolio is the weighted
advisable to buy the stock. average of each of the stock’s betas.
 If the price of B&G stock is $50 today, it
is undervalued – meaning it could be βP = wHT βHT + wColl βColl
advised that one buys the stock. βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215
5-55 5-56

Calculating portfolio required returns Factors that change the SML

 The required return of a portfolio is the weighted  What if investors raise inflation expectations
average of each of the stock’s required returns.
by 3%, what would happen to the SML?
kP = wHT kHT + wColl kColl
ki (%)
kP = 0.5 (17.1%) + 0.5 (1.9%) SML2
D I = 3%
kP = 9.5%
18 SML1
 Or, using the portfolio’s beta, CAPM can be used 15
to solve for expected return. 11
kP = kRF + (kM – kRF) βP 8
kP = 8.0% + (15.0% – 8.0%) (0.215) Risk, βi
kP = 9.5% 0 0.5 1.0 1.5
5-57 5-58

Factors that change the SML Benefits of CAPM

 What if investors’ risk aversion increased,  Allows for discount rate and market value
causing the market risk premium to increase calculations. It removes problems about
by 3%, what would happen to the SML? potentially different discount rates that the
ki (%) SML2 owners of the firm may have and provides an
D RPM = 3% average discount rate that the manager can
18 SML1 use in an objective way.
15  Separates relevant from irrelevant risk. It
11 gives a very neat way of accounting for
relevant (systematic risk) into the required
8
rate of return from an asset.
Risk, βi
0 0.5 1.0 1.5 5-59 5-60
Verifying the CAPM empirically More thoughts on the CAPM
 The CAPM has not been verified  Investors seem to be concerned with both
market risk and total risk. Therefore, the
completely. SML may not produce a correct estimate of ki.
 Statistical tests have problems that
ki = kRF + (kM – kRF) βi + ???
make verification almost impossible.
 CAPM/SML concepts are based upon
 Some argue that there are additional expectations, but betas are calculated using
risk factors, other than the market risk historical data. A company’s historical data
premium, that must be considered. may not reflect investors’ expectations about
future riskiness.

5-61 5-62
 What sources of long-term capital
CHAPTER 9 do firms use?
The Cost of Capital
Long-Term Capital

Long-Term Debt Preferred Stock Common Stock

 Sources of capital Retained Earnings New Common Stock

 Component costs
 WACC
 Adjusting for flotation costs
 Adjusting for risk
9-1 9-2

Calculating the weighted average Should our analysis focus on before-tax

cost of capital or after-tax capital costs?
 Stockholders focus on A-T CFs. Therefore,
WACC = wdkd(1-T) + wpkp + wcks we should focus on A-T capital costs, i.e.
use A-T costs of capital in WACC. Only kd
 The w’s refer to the firm’s capital structure needs adjustment, because interest is tax
weights. deductible.
 The k’s refer to the cost of each component.

9-3 9-4

Should our analysis focus on historical

(embedded) costs or new (marginal) How are the weights determined?
costs?
 The cost of capital is used primarily to
make decisions that involve raising new WACC = wdkd(1-T) + wpkp + wcks
capital (for new business investments). So,
focus on today’s marginal costs (for  Use accounting numbers or market value
WACC). (book vs. market weights)?
 Use actual numbers or target capital
structure?

9-5 9-6
Weights: Book or Market Value? Weights: Actual or Target Numbers
 Recommendation: Use market value.  “Current proportions are a good starting
 Why? point, but should normally be modified by
- Cost of capital is the expected rate of return specific assumptions about the future
investors demand from company’s asset and
operations. It is the criterion against which to judge direction of the company’s long-term
expected returns of future investments therefore it financing. It maybe useful to generate a
must be based on what investors are actually willing range of assumptions to bracket the findings
to pay for the company’s outstanding securities and (E. A. Helfert)”.
this is based on market value.
- Using cost of capital complements the use of
marginal costs that are also expressed in market
terms. 9-7 9-8

Main Point to Remember Component cost of debt

“The purpose of the analysis WACC = wdkd(1-T) + wpkp + wcks

always determines the choice of
data and methodology.
 kd is the marginal cost of debt capital.
Compromises has sometimes to
be made to approximate  The yield to maturity on outstanding L-T
conditions relevant for purposes debt is often used as a measure of kd.
of analysis.”  Why tax-adjust, i.e. why kd(1-T)?
E. A. Helfert

9-9 9-10

Component cost of debt Component cost of preferred stock

 Interest is tax deductible, so

A-T kd = B-T kd (1-T) WACC = wdkd(1-T) + wpkp + wcks
= 10% (1 - 0.40) = 6%
 Use nominal rate.
 kp is the marginal cost of preferred stock.
 Flotation costs are small, so ignore them.
 The rate of return investors require on the
firm’s preferred stock.

9-11 9-12
What is the cost of preferred stock? Component cost of preferred stock

 The cost of preferred stock can be solved by  Preferred dividends are not tax-deductible,
using this formula: so no tax adjustments necessary. Just use
kp.
kp = Dp / Pp  Nominal kp is used.
= $10 / $111.10  Our calculation ignores possible flotation
= 9% costs.

9-13 9-14

Is preferred stock more or less risky

Component cost of equity
to investors than debt?
 More risky; company not required to pay
preferred dividend. WACC = wdkd(1-T) + wpkp + wcks
 However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay  ks is the marginal cost of common equity
common dividend, (2) difficult to raise using retained earnings.
additional funds, (3) preferred stockholders  The rate of return investors require on the
may gain control of firm. firm’s common equity using new equity is
ke.

9-15 9-16

Why is there a cost for retained Three ways to determine the cost
earnings? of common equity, ks
 Earnings can be reinvested or paid out as  CAPM: ks = kRF + (kM – kRF) β
dividends.
 Investors could buy other securities, earn a
return.  DCF or Dividend Yield + Growth Rate :
 If earnings are retained, there is an opportunity ks = D1 / P0 + g
cost (the return that stockholders could earn on
alternative investments of equal risk).
– Investors could buy similar stocks and earn ks.  Own-Bond-Yield-Plus-Risk Premium:
– Firm could repurchase its own stock and earn ks. ks = kd + RP
– Therefore, ks is the cost of retained earnings.

9-17 9-18
 If the kRF = 7%, RPM = 6%, and the firm’s If D0 = $4.19, P0 = $50, and g = 5%, what’s
beta is 1.2, what’s the cost of common equity the cost of common equity based upon the
based upon the CAPM? DCF approach?
D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
ks = kRF + (kM – kRF) β D1 = $4.3995
= 7.0% + (6.0%)1.2 = 14.2%
ks = D1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%

9-19 9-20

Some Notes on the DCF Approach What is the expected future growth rate?

 Suited for mature companies with a stable history  The firm has been earning 15% on equity (ROE =
of growth; however reality is that companies vary 15%) and retaining 35% of its earnings (dividend
payout = 65%). This situation is expected to
greatly in their rate of dividend payout. continue.
 The ‘g’ is difficult to estimate or quantify for non-
stable companies. How could ‘g’ be estimated? g = ( 1 – Payout ) (ROE)
- Use estimates of financial research firms = (0.35) (15%)
(average). = 5.25%
- Based it on company’s retention rate and  Very close to the g that was given before.
expected ROE.

9-21 9-22

If kd = 10% and RP = 4%, what is ks using the

What is a reasonable final estimate
own-bond-yield-plus-risk-premium method? of ks?
 This RP is not the same as the CAPM RPM. Method Estimate
 This method produces a ballpark estimate of CAPM 14.2%
ks, and can serve as a useful check. DCF 13.8%
kd + RP 14.0%
ks = kd + RP Average 14.0%
ks = 10.0% + 4.0% = 14.0%

9-23 9-24
 If issuing new common stock incurs a
Why is the cost of retained earnings cheaper flotation cost of 15% of the proceeds, what is
than the cost of issuing new common stock? ke?
 When a company issues new common stock D0 (1  g)
they also have to pay flotation costs to the ke  g OR: The
underwriter. P0 (1 - F) estimated
 Issuing new common stock may send a negative $4.19(1.05) monetary amount
  5.0% of floatation
signal to the capital markets, which may depress $50(1- 0.15)
the stock price. could just be
$4.3995 added to the
  5.0%
$42.50 project’s up-front
 15.4% (first) cost.

9-25 9-26

Ignoring floatation costs, what is the

Flotation costs firm’s WACC?
 Flotation costs depend on the risk of the
firm and the type of capital being raised. WACC = wdkd(1-T) + wpkp + wcks
 The flotation costs are highest for common = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
equity. However, since most firms issue = 1.8% + 0.9% + 8.4%
equity infrequently, the per-project cost is
= 11.1%
fairly small.
 We will frequently ignore flotation costs
when calculating the WACC.

9-27 9-28

What factors influence a Should the company use the composite WACC
as the hurdle rate for each of its projects?
company’s composite WACC?
 NO! The WACC is the rate of return that the firm
 Market conditions. must expect to earn on its average-risk investments in
order to provide a fair expected return to al its security
 The firm’s capital structure and dividend
holders. It is used to value new assets that have the
policy. same risk as the old ones and that support the same
 The firm’s investment policy. Firms with ratio of debt. Strictly speaking, the WACC is an
appropriate discount rate only for a project that is a
riskier projects generally have a higher carbon copy of the firm’s existing business.
WACC.
 WACC is often used as a company-wide benchmark
discount rate. Different projects have different risks.
This benchmark is adjusted upward for unusually
risky project and downward for unusually safe ones.
9-29 9-30
 Should the company use the composite
What are the three types of project
WACC as the hurdle rate for each of its
projects? risk?
 A hierarchy of minimum rates of return can be established,  Stand-alone risk
somewhat arbitrarily, that ranges from the computed
WACC. (The company might establish three risk classes  Corporate risk
then assign to average-risk projects the WACC as hurdle
 Market risk
rate, to higher-risk projects a hurdle rate above WACC, to
lower-risk projects a hurdle rate below WACC.)
 When all projects are combined, the result should be an
average return at or above WACC. The proportion of
projects being approved in various risk classes must also
be carefully monitored to ensure that the overall average
will achieve the desired result over time.

9-31 9-32

How is each type of risk used? Problem areas in cost of capital

 Market risk is theoretically best in most  Depreciation-generated funds

situations.  Privately owned firms
 However, creditors, customers, suppliers,  Measurement problems
and employees are more affected by  Adjusting costs of capital for different
corporate risk. risk
 Therefore, corporate risk is also relevant.
 Capital structure weights

9-33 9-34

How are risk-adjusted costs of capital Finding a divisional cost of capital:

determined for specific projects or Using similar stand-alone firms to estimate a
divisions? project’s cost of capital
 Subjective adjustments to the firm’s composite
WACC.  Comparison firms have the following
 Attempt to estimate what the cost of capital
characteristics:
would be if the project/division were a stand- – Target capital structure consists of 40% debt
and 60% equity.
alone firm. This requires estimating the
project’s beta. – kd = 12%
– kRF = 7%
– RPM = 6%
– βDIV = 1.7
– Tax rate = 40%
9-35 9-36
 Calculating a divisional cost of capital

 Division’s required return on equity

– ks = kRF + (kM – kRF)β
= 7% + (6%)1.7 = 17.2%
 Division’s weighted average cost of capital
– WACC = wd kd ( 1 – T ) + wc ks
= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%
 Typical projects in this division are acceptable if
their returns exceed 13.2%.
9-37
 MM’s (Modigliani and Miller) Proposition
I
 When there are no taxes and capital markets
Capital Structure of a Firm function well, it makes no difference whether
the firm borrows or individual shareholders
borrow. Therefore , the market value of a
 Capital Structure Theory
company does not depend on its capital
 Operating and Financial structure. In other words, financial managers
Leverage cannot increase value by changing the mix of
 Decision Tools for Corporate securities used to finance the company.
Capital Structure
13-1 13-2

MM’s (Modigliani and Miller) An Illustration of MMI

Proposition I Proposition
 The value of a firm’s assets is determined  XYZ Corp.’s Original Standing
only by the ability of its manager to Data
Number of Shares 100,000
generate as much cash flow as possible Price per Share $10
from these assets. Simply reshuffling Market Value of Shares $1,000,000
paper claims on these cash flows does not
add value to or subtract value from the State of the Economy
firm’s assets. Furthermore, it does not Outcomes
Operating Income
Slump
$75,000
Normal
$125,000
Boom
$175,000
affect the firm’s share price. Earnings per Share $0.75 $1.25 $1.75
Return on Shares (%) 7.50% 12.50% 17.50%
13-3 13-4

An Illustration of MMI An Illustration of MMI

Proposition Proposition
XYZ is wondering whether to issue $500,000 of debt at 10%

interest and repurchase 50,000 shares. If this happens, the
 Is it correct to say that expected returns
following will be the result: of shareholders could only be increased
Data
Number of Shares 50,000
(if business goes well) by funding a
Price per Share
Market Value of Shares
$10
$500,000
portion of the company’s capital by
Market Value of Debt $500,000 debt?
State of the Economy
Outcomes Slump Normal Boom
Operating Income $75,000 $125,000 $175,000
Interest ($50,000) ($50,000) ($50,000)
Equity Earnings $25,000 $75,000 $125,000
Earnings per Share $0.50 $1.50 $2.50
Return on Shares (%) 5.00% 15.00% 25.00%
13-5 13-6
An Illustration of MMI An Illustration of MMI
Proposition Proposition
 Suppose XYZ does not push through State of the Economy
with borrowing. The shareholders Outcomes Slump Normal Boom
borrow money instead from the bank Earnings on Two Shares $1.5 $2.5 $3.5
and invest it in XYZ’s stocks. Say an Interest at 10% ($1) ($1) ($1)
investor placed $10 of his own money Net Earnings on Invest. $0.5 $1.5 $2.5
into the company’s stock and borrows Return on $10 Invest. 5.00% 15.00% 25.00%
another $10 (at 10% interest) and The return of the investor is exactly the same as the
invest in into the same stock as well. scenario when the company employs debt for a
portion of its capital.
13-7 13-8

An Illustration of MMI An Illustration of MMI

Proposition Proposition
 If XYZ pushes through with debt funding and
State of the Economy
the shareholder does not want to be trapped
to the resulting payoffs, the shareholder can Outcomes Slump Normal Boom
be one of the creditors of the company to Earnings on One Shares $0.5 $1.5 $2.5
maintain the same expected return as the Interest at 10% $1 $1 $1
scenario where company is financed fully by Net Earnings on Invest. $1.5 $2.5 $3.5
equity. Suppose investor buys one share for Return on $20 Invest. 7.50% 12.50% 17.50%
$10 and lends out $10 more.
The investor’s payoff is the same as if the company
is unlevered.
13-9 13-10

Implications Under MMI

Conclusion Proposition
 It doesn’t matter whether the firm borrows to  If rA is the expected return from firm’s
leverage its assets or whether investors
borrow to leverage their own share holdings.
assets, rA = ks if the firm is purely
What firms can do to their capital structures, equity financed. If the firm decides to
investors can replicate on their own. replace some equity with debt, rA will
Therefore, investors would neither reward nor simply be split into the return expected
penalize the firm if it decides to change its
capital structure. by its shareholders (ks) and the rate
 Debt is irrelevant! The value of the firm then required by its debtholders (kd).
is unaffected by the capital structure.
13-11 13-12
 Implications Under MMI Proposition An Illustration of MMI
(Assuming kd remains constant for whatever debt ratio) Proposition (Continued..)
Cost of
Cost of  Comparing expected returns of
Equity, ks
Capital
unlevered and levered scenario:
Current Structure: Proposed Structure:
All Equity Equal Debt and Equity
WACC = rA
Expected Earnings per Share $1.25 $1.50
Cost of Debt, Share Price $10 $10
kd
Expected Return on Share 12.50% 15.00%
D/E

13-13 13-14

Sidetracking A Little
MMI Proposition What is business risk?
 The required rate of return on equity increases as  Uncertainty about future operating income (EBIT),
the firm’s debt-equity ratio increases. However, i.e., how well can we predict operating income?
the kassets, the expected return on the package of Probability Low risk
debt and equity is unaffected.
WACC= kassets = kdebt (D/(D+E)) + kequity (E/(D+E)) High risk

Before debt: kassets = kequity = 0.125 or 12.5% 0 E(EBIT) EBIT

After debt: kequity = kaasets + (D/E) (kassets – kdebt) =  Note that business risk does not include financing
0.15 or 15% effects.
13-15 13-16

What is operating leverage, and how

What determines business risk? does it affect a firm’s business risk?
 Demand variability.  Operating leverage is the use of
 Sales price variability . fixed costs rather than variable
 Input cost variability. costs.
 New product development in a timely,  If most costs are fixed, hence do not
cost-effective manner. decline when demand falls, then the
firm has high operating leverage.
 Foreign risk exposure.
 Operating leverage - the extent to
which costs of the company are fixed.
13-17 13-18
 Effect of operating leverage Using operating leverage
 More operating leverage leads to more
business risk, for then a small sales decline Probability
Low operating leverage
causes a big profit decline.
High operating leverage
$ Rev. $ Rev.
TC } Profit
TC
FC EBITL EBITH
FC
QBE Sales QBE Sales  Typical situation: Can use operating leverage
to get higher E(EBIT), but risk also increases.
 What happens if variable costs change?
13-19 13-20

What then is financial leverage?

Financial risk? Business risk vs. Financial risk
 Financial leverage is the use of debt  Business risk depends on business
and preferred stock. factors such as competition, product
 Financial risk is the additional risk liability, and operating leverage.
concentrated on common  Financial risk depends only on the
stockholders as a result of financial types of securities issued.
leverage.  More debt, more financial risk.
 Concentrates business risk on
stockholders.

13-21 13-22

An example:
Illustrating effects of financial leverage Firm U: Unleveraged
 Two firms with the same operating leverage, Economy
business risk, and probability distribution of Bad Avg. Good
EBIT. Prob. 0.25 0.50 0.25
 Only differ with respect to their use of debt EBIT $2,000 $3,000 $4,000
(capital structure). Interest 0 0 0
EBT $2,000 $3,000 $4,000
Firm U Firm L Taxes (40%) 800 1,200 1,600
No debt $10,000 of 12% debt NI $1,200 $1,800 $2,400
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
13-23 13-24
 Ratio comparison between
Firm L: Leveraged leveraged and unleveraged firms
Economy FIRM U Bad Avg Good
Bad Avg. Good
BEP 10.0% 15.0% 20.0%
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000 ROE 6.0% 9.0% 12.0%
Interest 1,200 1,200 1,200 TIE ∞ ∞ ∞
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120 FIRM L Bad Avg Good
NI $ 480 $1,080 $1,680 BEP 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
*Same as for Firm U.
TIE 1.67x 2.50x 3.30x
13-25 13-26

Risk and return for leveraged The effect of leverage on

and unleveraged firms profitability and debt coverage
Expected Values:  For leverage to raise expected ROE, must
Firm U Firm L have BEP > kd.
E(BEP) 15.0% 15.0%
 Why? If kd > BEP, then the interest expense
E(ROE) 9.0% 10.8%
E(TIE) ∞ 2.5x
will be higher than the operating income
produced by debt-financed assets, so
Risk Measures: leverage will depress income.
Firm U Firm L  As debt increases, TIE decreases because
σROE 2.12% 4.24% EBIT is unaffected by debt, and interest
CVROE 0.24 0.39 expense increases (Int Exp = kdD).
13-27 13-28

Measuring Leverage Conclusions

 Degree of Operating Leverage (DOL)
EBIT  Basic earning power (BEP) is
%ChangeEBIT Q( P  V ) S  VC
DOL 
%ChangeSales
 EBIT 
Sales Q( P  V )  F

S  VC  F
unaffected by financial leverage.
Sales  L has higher expected ROE because
 Degree of Financial Leverage (DFL) BEP > kd.
%ChangeEPS EBIT L has much wider ROE (and EPS)
DFL   
%ChangeEBIT EBIT  I swings because of fixed interest
 Degree of Total Leverage charges. Its higher expected return
is accompanied by higher risk.
Q( P  V )  F S  VC
DTL  ( DOL)( DFL)  
Q( P  V )  F  I S  VC  F  I
13-29 13-30
MMII Proposition..
How about it there are taxes? Things to Observe
 Suppose XYZ Corp. belongs to the 35%  Company incurs interest tax-shield. It pays
tax bracket. lower amount of tax (savings of $17,500)
Zero Debt $500,000 of debt with debt. Also it has higher amount of
Expected Optg. Income $125,000 $125,000 income available to investors if it uses debt.
Debt interest at 10% 0 ($50,000)  Assuming that shareholders will continue to
Before-tax income $125,000 $75,000 demand 12.5% in the all equity financing
Tax at 35% ($43,750) ($26,250) scenario in the presence of tax, the value of
After-tax income $81,250 $48,750 the company can be computed to be
Combined debt and equity income
$81,250 $98,750 $650,000 ($81,250/0.125).
(debt interest+after-tax income)
13-31 13-32

Things to Observe Things to Observe

 With the use of debt, the tax shield realized adds to  The PV of tax shield is $175,000.
the value of the company.
 The present value of tax shields (assuming the  Value of levered firm = Value if all-
company will keep “rolling over” its debt) can be equity financed + PV of tax shield.
computed as:
 The value of XYZ with debt is $825,000.
Tc x ( k d xD) The value of equity is value of company
 Tc D 
kd minus value of debt ($825,000 -
Where: Tc is the corporate tax rate $500,000 = $325,000)
D is the debt level
13-33 13-34

Things to Remember Things to Observe

 Value of Assets = Value of Liabilities  The kequity is $48,750/$325,000 = 0.15.
and Shareholders’ Equity  The new WACC is then:
Value of Cash Flows from Real Assets
WACC  (1  T )k d wd  ke we


and Operations = Value of Debt,

Common Stocks and Other Company 500T 325T
Securities  (1  0.35)0.10( )  0.15( )
825T 825T
 0.0985 or 9.85%
13-35 13-36
 Implications Under MMI Proposition Implications Under MMI Proposition
(Assuming kd remains constant for whatever debt ratio) (Assuming kd remains constant for whatever debt ratio)

 As in a world without taxes, the cost of equity

Cost of
Capital increases with debt because of the financial
risk that comes with debt financing. However,
Cost of
Equity, ks
it increases at a lower rate because
shareholders get an extra return in the form
of interest tax shield. The WACC decreases
when the firm’s borrowing rises because the
WACC
extra return from the interest tax shield and
Cost of Debt, the lower after tax cost of debt more than
kd (1-T)
offset the higher financial risk generated by
D/E
higher levels of debt.
13-37 13-38

Something to Think About Bankruptcy Considerations

 If debt increases the value of the firm  Two types of bankruptcy costs:
a. Direct – legal and accounting fees,
and lowers the WACC, then is it not that reorganization costs and other
a 100% debt capital structure is the administrative expenses.
best? b. Indirect – reflect the difficulties of running
a company while it is going through (or in
situations of imminent) bankruptcy.
Example would be tight credit of suppliers,
loosing employees, customers transferring
to competitors, lenders demanding higher
interest and more restrictive covenants.
13-39 13-40

Bankruptcy Considerations Modigliani-Miller’s Theory

 Generally, the higher the debt, the higher the Value of Firm Considering Taxation
chance of default and therefore the greater (No Bankruptcy)
the expected cost of bankruptcy.
Value Reduced by
 From this, the real value of a levered firm is: Bankruptcy Related Cost

Value of levered firm = Value if all-equity Actual Value

financed + PV of tax shield – PV of
bankruptcy cost No leverage

D/A
0 D1 D2
13-41 13-42
Some Notes on the Graph Some Notes on the Graph
 Interest is a deductible expense that makes  There is some threshold level of debt, D1 in
debt less expensive than stocks. The the figure, below which the probability of
government pays part of the cost of debt bankruptcy is so low as to be immaterial.
capital when a company borrows money Beyond D1 bankruptcy becomes increasingly
causing more of the firm’s EBIT to flow important and it reduces the tax benefits of
through the investors. debt at an increasing rate. Beyond D2,
 In the real world, firms rarely use a 100% bankruptcy related costs exceeds the tax
debt capital structure. This is because they benefits so from this point on increasing the
want to hold down on bankruptcy related debt ratio lowers the value of the firm. D2
costs. then is the optimal capital structure.

13-43 13-44

Some Tools That Could be of Help

Some General Remarks Capital Structure Decisions
 Basic Tools
 Firms whose earnings are volatile, all else - EBIT-EPS Analysis (see handout for details)
equal, face a greater chance of bankruptcy - Ratio Analysis: LTD to Total Assets, TIE, Debt Service
Coverage Ratios
and, therefore, should use less debt than - Downside Risk Analysis (assessing the probability
more stable firm. Likewise, firms that would that EBIT will not be able to cover for the debt service
face high costs in event of financial distress burden)
- Cash Insolvency Analysis (uses probability distribution of cash
should rely less heavily on debt. flows rather than that of EBIT)
 The cost of financial distress will vary with the  Other Comprehensive Tools
- Funds Flow Analysis
type of asset the company possesses. - Inventory of Resources (among uncommitted reserves,
reduction in planned outflows and liquidation of assets which is best to
tap to cover for projected cash deficits)
13-45 - Computer Simulation 13-46

Weakness of EBIT-EPS Factors Affecting A Firm’s Capital

Analysis Structure Decisions

 Focused primarily on level of EPS and  Tax Rate  Lender and Rating
does not take into account its increasing  Business Risk Agency Attitudes
variability with increasing leverage.  Nature of Assets  Growth Rate
 It also does not take into account the  Control  Profitability
effect of a firm’s financing decision on Considerations  Market Conditions
the cost of equity.  Management  Financial Flexibility
Attitudes (make sure an adequate
reserve borrowing capacity is
maintained)

13-47 13-48
Conclusions on Capital Structure
 Need to make calculations as we did, but
should also recognize inputs are
“guesstimates.”
 As a result of imprecise numbers, capital
structure decisions have a large judgmental
content.
 We end up with capital structures varying
widely among firms, even similar ones in
same industry.
13-49
 Capital Structure Decisions
EBIT-EPS Analysis
EBIT- earnings before interest and taxes
EPS – earnings per share

- a tool that is used to analyze and determine the best financing option among different
financing alternatives available to the firm in the hope of achieving the best possible
capital structure (higher EPS, the better)

Steps:
1. Calculate the EPS of each financing alternative based on a certain value of EBIT. (Value
of EBIT is represented by X, a general variable, thus EPS will also be an expression in
terms of X).

EBIT
Less: Interest (due to debt financing)
EBT or NIBT
Less: Taxes
EAT or NIAT
Less: P/S Dividend (due to P/S financing)
EAC or Earnings Available to C/S

EPS = EAC / (No. of C/S shares outstanding after taking financing alternative)

2. Construct the EBIT-EPS chart.

(X-axis: EBIT, y-axis: EPS) EPS(y) is in terms of EBIT(x) to the 1st degree meaning chart
will compose of line and one would need two points to draw a line.

1st Point: Assume any X-value (any hypothetical EBIT level)

2nd Point: The EBIT value that will give 0 EPS. (or EBIT necessary to cover all fixed
financial costs for a particular financing plan)

3. Identify the indifference point for each pair of alternative.

( EBIT *  I )(1  t )  P ( EBIT *  I )(1  t )  P


S1 S2
where: EBIT*= EBIT indifference point
I = interest expense
t= tax rate
P = preferred stock dividends
S1, S2 = # of C/S shares outstanding after taking financing alternative 1 and 2, resp.

4. Analyze which alternative is best at different levels of EBIT.

EBIT-EPS Problems:

1. Dorsey Porridge Company presently has $3.6 million in debt outstanding bearing an
interest rate of 10%. It wishes to finance a $4 million expansion program and is
considering three alternatives: additional debt at 12%, preferred stock with an 11%
dividend, and the sale of common stock at $16 per share. The company presently has
800,000 shares of common stock outstanding and is in a 40% tax bracket.
a. If earnings before interest and taxes are presently $1.5 million, what would be
earnings per share for the three alternatives, assuming no immediate increase in
profitability?
b. Develop a break-even, or indifference, chart for these alternatives. What are the
approximate indifference points?
c. Which alternative do you prefer? How much would EBIT need to increase before
the next alternative would be best?

2. The Lemaster Company is a new firm that wishes to determine an appropriate capital
structure. It can issue 16% debt or 15% preferred stock. Moreover, common can be sold
at $20 per share. In all cases, total capitalization of the company will be $5 million, and it
is expected to have a 30% tax rate. The possible capital structures are:

Plan Debt Preferred Equity

1 0% 0% 100%
2 30 0 70
3 50 0 50
4 50 20 30

a. Construct an EBIT-EPS chart for the 4 plans.

b. Determine the relevant indifference points.
c. Which plan is the best for different levels of EBIT?

3. Hi Grade Regulator Company currently has 100,000 shares of common stock

outstanding with a market price of $60 per share. It also has $2 million in 6% debt. The
company is considering a $3 million expansion program that it can finance with (1) all
common stock at $60 a share, (2) straight bonds at 8% interest, (3) preferred stock at
7%, or (4) half common stock at $60 per share and half 8% bonds.
a. For a hypothetical EBIT level of $1 million after the expansion program, calculate
the earnings per share for each of the alternative methods of financing. Assume a
corporate tax rate of 50%.
b. Construct an EBIT-EPS chart. What are the indifference points between
alternatives? What is your interpretation of them? What is the best financing
alternative under different levels of EBIT?

4. The Power Corporation currently has 2 million shares outstanding at a price of $20 each
and needs to raise an additional $5 million. These funds could be raised with stock or 10%
debentures. Expected EBIT after the new funds are raised will be normally distributed with a
mean of $4 million per year and a standard deviation of $2 million. Power Corporation has a
50% tax rate. What is the probability that the debt alternative is superior with respect to
earnings per share.
 What is dividend policy?
The decision to pay out earnings and eventually
issuing shares versus retaining and reinvesting
them.
Distributions to Shareholders Optimal dividend policy must strike a balance
Dividend Policy and Share Repurchases between current dividends and future growth rate
that will maximize stock price (allow for capital
gains).
Theories of investor preferences
D1
Po 
Signaling effects ks  g
Residual model Dividend policy includes
Stock dividends and stock splits  High or low dividend payout?
Stock repurchases  Stable or irregular dividends?
14-1  How frequent to pay dividends? 14-2

Do investors prefer high or low Dividend Irrelevance Theory

Investors are indifferent between dividends and
dividend payouts? retention-generated capital gains. Investors can
create their own dividend policy:
Three theories of dividend policy:  If they want cash, they can sell stock.
 If they don’t want cash, they can use dividends to buy stock.
 Dividend irrelevance: Investors don’t
care about payout. Proposed by Modigliani and Miller and based on
the following assumptions:
 Bird-in-the-hand: Investors prefer a high - no taxes
- no brokerage costs
payout. - no issuance costs of stocks
- investment and borrowing policy of the firm is held constant
 Tax preference: Investors prefer a low
payout. Conclusion: dividend policy will not affect the
value of the firm, it merely becomes a trade-off
between paying out cash and the issue or
repurchase of stocks.
14-3 14-4

Bird-in-the-Hand Theory Tax Preference Theory

Retained earnings lead to long-term capital
By Gordon and Lintner gains, which are taxed at lower rates than
Investors think dividends are less risky dividends. Capital gains taxes are also
than potential future capital gains, hence deferrable.
they like dividends. This could cause investors to prefer firms with
If so, investors would value high-payout low payouts, i.e., a high payout results in a low
firms more highly, i.e., a high payout would P0.
result in a high P0. Implication: Set a low payout.
Implication: set a high payout.

14-5 14-6
 Possible Stock Price Effects Possible Cost of Equity Effects
Stock Price ($) Cost of Equity (%)
Bird-in-the-Hand
30
40
25 Tax preference
30 Irrelevance
20

20 15 Irrelevance
Tax preference
10
10
5 Bird-in-the-Hand

0 50% 100% Payout 0 50% 100% Payout

14-7 14-8

Which theory is most correct? Dividend Policy Issues

Empirical testing has not been able to Dividend Stability
determine which theory, if any, is correct.
Thus efforts to come out with techniques in Dividend Signaling Effect
determining optimal, value-maximizing Clientele Effect
dividend policy have not produced useful
results so far.
Thus, managers use judgment when
setting policy.
Analysis is used, but it must be applied with
judgment.
14-9 14-10

Dividend Stability What does stability mean?

Investors generally prefer companies whose
dividend policies are relatively stable since
1st: The dividend growth rate is predictable.
they depend on these for their other
expenses. The company’s total return (dividend yield
plus capital gains yield) would be relatively
Reduction of dividends to make funds
available for capital investments of the stable over the long run and its stock would
company could send the incorrect signal that be a good protection against inflation.
the firm’s future earning prospects are 2nd : Even if it will not grow at steady rate
diminished thus pushing down its stock price. there should at least be an assurance that
Thus managers would as much as possible
the current dividend will not be reduced.
avoid cutting down on dividends.

14-11 14-12
 Implications of Investors’ Implications of Investors’
Preference of Dividend Stability Preference of Dividend Stability
a. Firms have long-run target dividend payout c. Dividend changes follow shifts in long-run,
ratios. This ratio is the fraction of earnings sustainable levels of earnings rather than
paid out as dividends. short-run changes in earnings. Managers
are unlikely to change dividend payouts in
b. Managers focus more on dividend changes response to temporary variation in earnings.
than on absolute levels. Thus paying a Instead they “smooth” dividends.
$2.00 dividend is an important financial d. Managers are reluctant to make dividend
decision if last year’s dividend was $1.00, changes that might have to be reversed.
but its no big deal if last year’s dividend was They are particularly worried about having
$2.00. to rescind a dividend increase.

14-13 14-14

Implications of Investors’ The “Information Content,” or “Signaling,”

Preference of Dividend Stability Hypothesis
Main observation: an increase in dividend is often
f. Investors will prefer stocks that pay accompanied by an increase in the price of stock
more predictable dividends to stocks while a dividend cut generally leads to a stock
price decline.
that pay the same average amount of Managers hate to cut dividends, so they won’t
dividends but in a more erratic manner. raise dividends unless they think raise is
Meaning that the cost of equity will be sustainable. So, investors view dividend
increases as signals of management’s view of the
minimized and stock price maximized if future.
a firm stabilizes its dividends. Therefore, a stock price increase at time of a
dividend increase could reflect higher
expectations for future EPS or cashflow , not
14-15 necessarily a desire for dividends. 14-16

Clientele Effect Factors Affecting the Optimal

Different groups of investors, or clienteles, prefer Payout Ratio
different dividend policies.
Firm’s past dividend policy determines its current Investors preference for dividends
clientele of investors. against capital gains.
Clientele effects impede changing dividend Investment opportunities available to
policy. Taxes & brokerage costs hurt investors
who have to switch companies. the company.
The existence of this effect refutes the thinking Target capital structure
that one dividend policy is better than another. It Availability and cost of external capital.
supports the notion that different companies will
really need to have different dividend policies to
provide investors with what they want.
14-17 14-18
 Steps Involved in Using the
The “Residual Dividend Model”
Model
Find the retained earnings needed for Determine the optimal capital budget.
the capital budget. Determine the amount of equity needed to
Pay out any leftover earnings (the finance the budget based on target capital
residual) as dividends. structure.
This policy minimizes flotation and Use retained earnings to meet equity
equity signaling costs, hence minimizes requirements to the extent possible.
the WACC. Pay dividends if there is an excess of
earnings after allocating to the capital budget.

14-19 14-20

Residual Dividend Model:

Residual Dividend Model
Calculating Dividends Paid
 Target Calculate portion of capital budget to be
  Total 
    funded by equity.
Dividends  Net Income -  equity    capital   Of the $800,000 capital budget, 0.6($800,000)
 ratio   budget
  
= $480,000 will be funded with equity.
Calculate excess or need for equity capital.
Capital budget – $800,000  With net income of $600,000, there is more
Target capital structure – 40% debt, 60% than enough equity to fund the capital budget.
There will be $600,000 - $480,000 = $120,000
equity left over to pay as dividends.
Forecasted net income – $600,000 Calculate dividend payout ratio
How much of the forecasted net income  $120,000 / $600,000 = 0.20 = 20%
should be paid out as dividends?
14-21 14-22

What if net income drops to $400,000? How would a change in investment opportunities
Rises to $800,000? affect dividend under the residual policy?

If NI = $400,000 … Fewer good investments would lead

 Dividends = $400,000 – (0.6)($800,000) = -$80,000. to smaller capital budget, hence to a
 Since the dividend results in a negative number, the higher dividend payout.
firm must use all of its net income to fund its budget,
and probably should issue equity to maintain its target More good investments would lead to
capital structure. a lower dividend payout.
 Payout = $0 / $400,000 = 0%

If NI = $800,000 …
 Dividends = $800,000 – (0.6)($800,000) = $320,000.
 Payout = $320,000 / $800,000 = 40%
14-23 14-24
 Comments on Residual
Setting Dividend Policy
Dividend Policy
Advantage – Minimizes new stock Forecast capital needs over a planning
issues and flotation costs. horizon, often 5 years.
Set a target capital structure.
Disadvantages – Results in variable
dividends, sends conflicting signals, Estimate annual equity needs.
increases risk, and doesn’t appeal to Set target payout based on the residual
model.
any specific clientele.
Generally, some dividend growth rate
Conclusion – Consider residual policy emerges. Maintain target growth rate if
when setting target payout, but don’t possible, varying capital structure somewhat
follow it rigidly. if necessary.

14-25 14-26

Types of Dividends (or Income Distribution) Cash Dividend

regular (every period)
extra or special (will probably not be repeated)
Cash Dividend Critical dates:
Stock Split a. declaration date
b. with (or cum) dividend date – holders of stock on this
Stock Dividend date get dividend payment, set by stock exchanges
Stock or Share Repurchase c. ex-dividend date – holders of stock on this date
onwards do not get dividend payment
d. record date – all shareholders recorded in the books
of the company on this date gets a check for the
dividend (the assumption is that the company’s book is
already up-to-date)
e.payment date
14-27 14-28

Stock Dividends vs. Stock Splits Stock Dividends vs. Stock Splits
Done because financial experts believe that
Stock dividend: Firm issues new shares an optimal price range for stocks exists.
in lieu of paying a cash dividend. If Done to make the stocks of the company
10%, get 10 shares for each 100 shares more “trade-able” (reducing the price per
owned. share). However, in general, the investor
Stock split: Firm increases the number wealth as a whole remains unchanged.
of shares outstanding, say 2:1. Sends Both stock dividends and stock splits
shareholders more shares. increase the number of shares outstanding,
so “the pie is divided into smaller pieces.”

14-29 14-30
 Stock Dividends vs. Stock Splits Stock Dividends vs. Stock Splits
On average the stock price of a
company increases after a split or a Stock Split- used after a sharp price
stock dividend declaration because run-up to produce a large price
investors takes this as management’s reduction.
signal of higher future earnings and Stock dividend – used on a regular
brighter prospects. annual basis to keep stock price more
Through these management has a low- or less constrained.
cost way of signaling that the firm’s
prospects look good.
14-31 14-32

Stock Repurchases Advantages of Repurchases

Buying own stock back from Stockholders can tender or not.
stockholders (treasury stocks). Helps avoid setting a high dividend that
cannot be maintained.
Reasons for repurchases:
Repurchased stock can be used in takeovers
 As an alternative to distributing cash as or resold to raise cash as needed.
dividends.
Income received is capital gains rather than
 To dispose of one-time cash from an asset
higher-taxed dividends.
sale.
Stockholders may take as a positive signal--
 To make a large capital structure change.
management thinks stock is undervalued.

14-33 14-34

Disadvantages of Repurchases Summary of Factors

May be viewed as a negative signal (firm has Influencing Dividend Policy
poor investment opportunities).
Constraints: Investment Opportunities:
Government revenue collection agency could
- No. of profitable investment
impose penalties if repurchases were - Bond indenture
opportunities
primarily made to avoid taxes on dividends. - Preferred stock
- Possibility of accelerating or
Selling stockholders may not be well restrictions
delaying projects
informed, hence be treated unfairly. - Impairment of capital
Alternative Sources of
Firm may have to bid up price to complete rule (dividend payment
Capital:
purchase, thus paying too much for its own cannot exceed the
stock to the detriment of the remaining - Cost of selling new stock
balance sheet R/E
stockholders. - Ability to substitute debt for
- Availability of cash equity
Repurchases are less dependable than cash
- Control
dividends.
14-35 14-36
 General Recommendations
Dividend policy decisions should be made jointly
with capital structure and budgeting decisions.
Dividend policy decisions should be made to the
extent that chances of cutting dollar or peso
amount of dividend in the future is negligible and
issuance of new common stock can be avoided.
(Though a stable dividend could mitigate the
negative signal that could possibly be sent out by
new stock issuance. )
Dividend policy decisions are exercises in
informed judgment, not decisions that can be
quantified precisely.
14-37
 Measuring Leverage
 Degree of Operating Leverage (DOL)
Symbol Definition
EBIT
%ChangeEBIT Q( P  V ) S  VC • Q = quantity sold or demand
DOL   EBIT  
%ChangeSales Sales Q( P  V )  F S  VC  F • P= selling price per unit
Sales
 Degree of Financial Leverage (DFL) • V= variable cost per unit
%ChangeEPS EBIT • F = total fixed cost
DFL  
%ChangeEBIT EBIT  I • I = interest expense
 Degree of Total Leverage
• S = total sales revenue
Q( P  V )  F S  VC •
DTL  ( DOL)( DFL)   VC = total variable cost
Q( P  V )  F  I S  VC  F  I

Sample Problem 1 Sample Problem 2

• Arthur Johnson Inc.’s operating income is • A company currently has $2M in sales. Its
variable costs equal 70% of its sales, its fixed
$500T, the company’s interest expense is cost are $100T and its annual interest
$200T and its tax rate is 40%. What is the expense is $50T.
company’s degree of financial leverage? If a. What is the company’s degree of operating
leverage?
the company were able to double its b. If the company’s operating income (EBIT)
operating income, what would be the rises by 10%, how much will its EPS
percentage increase in its net income per increase?
c. If the company’s sales increase 10%, how
share? much will the company’s net income per
share increase?