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Financial
Economics
UNIT
III
|
CORPORATE
FINANCE
CHAPTER
14-
AN
OVERVIEW
OF
CORPORATE
FINANCING
Much
of
the
money
for
new
investments
comes
from
profits
that
companies
retain
and
reinvest.
The
remainder
comes
from
selling
new
debt
or
equity
securities.
PATTERNS
OF
CORPORATE
FINANCING
Corporations
invest
in
long-term
assets
(property,
plant,
equipment)
and
in
net
working
capital
(current
assets
minus
current
liabilities).
Firms
may
raise
funds
from-
Eureka
Wow
Financial
Economics
Secured
&
Unsecured
loan
Shareholders
equity=
Share
capital
+
Reserves
&
Surpluses
DEBT
RATIO=DEBT
/
DEBT
+
EQUITY
In
book-value
terms
the
debt
ratio
crept
upward
until
1990.
So
book
debt
ratio
(doesnt
depend
on
market
conditions)
started
declining
after
1993
when
firms
opted
to
pay
down
debt.
Market
debt
ratio
(depends
on
market
conditions)
decreased
in
1992,
2004-07
when
stock
prices
increased.
But
in
2008-09,
when
stock
prices
declined,
the
debt
ratio
increased.
Its
true
that
lower
debt
ratios
mean
less
number
of
companies
will
fall
into
financial
distress
when
recession
hits
the
economy.
But
it
should
be
remembered
that
debt
has
risks
as
well
as
benefits.
So,
find
the
optimal
debt
ratio.
Comparing
the
average
ratio
of
[total
liabilities/
total
liabilities+
equity]
for
the
manufacturing
industry
in
a
sample
of
countries,
one
can
see
that
debt
ratio
in
all
the
countries
is
greater
than
that
of
India.
TYPES
OF
SECURITIES
EQUITY
DEBT
Common
stock
Bank
loans
Floating-rate
bonds
Preferred
stock
Notes
Zero-
coupon
bonds
COMMON
STOCK
AUTHORIZED
SHARE
CAPITAL
=
Maximum
number
of
shares
that
can
be
issued.
If
management
wishes
to
increase
the
number
of
authorized
shares,
it
needs
the
agreement
of
shareholders.
ISSUED
SHARES
are
the
fraction
of
authorized
shares
that
are
actually
issued/
subscribed.
Eg.
RIL
issues
327
shares
out
of
500
authorized
shares.
The
price
of
new
shares
sold
to
the
public
almost
always
exceeds
par
value.
The
difference
is
entered
in
the
companys
accounts
as
share
premium
reserves
or
capital
surplus.
Eg.
If
RIL
sold
an
additional
1
million
shares
at
Rs
100/share
(where
face
value
was
10),
the
share
capital
account
would
increase
by
1
million
x
Rs
10=
Rs
10
million
and
the
share
premium
account
would
increase
by
1m
x
Rs
90=
Rs
90
million.
RIL
distributes
part
of
its
earnings
as
dividends
and
the
remainder
can
be
used
to
finance
new
investments.
(Book
value
is
a
backward
looking
measure.
It
tells
us
how
much
capital
the
firm
has
raised
from
shareholders
in
the
past.
It
does
not
measure
the
value
that
shareholders
place
on
those
shares
today.
The
market
value
of
the
firm
is
forward
looking,
it
depends
on
the
future
dividends
that
shareholders
expect
to
receive.)
OWNERSHIP
OF
THE
CORPORATION-
EQUITY
A
corporation
is
owned
by
its
ordinary
shareholders.
Ordinary
shares
in
India
are
held
by:
Eureka
Wow
Financial
Economics
If
all
common
stocks
are
owned
solely
by
CEO,
then
he
receives
all
the
cash
flows
and
makes
all
investment
and
operating
decisions
=>
Has
complete
cash-flow
rights
and
complete
control
rights.
But
these
rights
are
split
up
and
reallocated
when
a
company
borrows
money-if
it
takes
a
bank
loan,
it
enters
into
a
contract
with
the
bank
promising
to
pay
interest
and
repay
the
principal.
The
bank
gets
some
right
to
cash
flows
and
the
residual
cash-flow
rights
are
left
with
the
stockholder.
The
bank
protects
its
claim
by
imposing
restrictions
on
what
the
firm
can
or
cannot
do.
For
example,
it
may
require
the
firm
to
limit
future
borrowing.
So,
the
stockholders
control
rights
are
limited.
If
the
firm
fails
to
make
the
promised
payments
to
the
bank,
it
may
be
forced
into
bankruptcy
=>
bank
will
be
the
new
owner
and
will
have
control
rights
of
ownership.
The
common
stockholders
have
residual
rights
over
the
cash
flows
and
have
ultimate
right
of
control
over
the
companys
affairs-
their
control
is
limited
to
vote
for
the
appointments
to
the
board
of
directors,
and
on
other
crucial
matters
such
as
the
decision
to
merge.
THE
DOMINANT
SHAREHOLDER
is
the
one
who
controls
20%
or
more
of
the
votes
of
corporations.
In
India,
this
dominant
shareholder
(known
as
promoter)
controls
on
avg.
about
50%
of
the
votes.
The
US
lies
in
the
middle
of
the
pack.
VOTING
PROCEDURES
Of
the
total
no.
of
directors,
a
max
of
33%
can
be
permanent
directors.
At
an
annual
meeting,
33%
of
the
rotational
directors
retire
and
elections
take
place.
1. MAJORITY
VOTING
SYSTEM:
Here,
each
director
is
voted
upon
separately
and
stockholders
can
cast
1
vote
for
each
share
that
they
own.
Eg.
If
the
promoter
has
51%
of
a
companys
shares,
then
the
promoter
(under
the
majority
voting
system)
can
elect
all
the
directors.
Even
with
the
remaining
49%
shares,
the
minority
shareholders
will
not
be
able
to
appoint
a
single
director.
2. CUMULATIVE
VOTING
SYSTEM:
If
a
companys
articles
permit
cumulative
voting,
the
directors
are
voted
upon
jointly
and
stockholders
can
allot
all
their
votes
to
just
one
candidate.
So,
minority
shareholders
may
be
able
to
elect
a
director
to
the
board,
if
they
act
intelligently.
Eg.
If
5
directors
are
to
be
elected
to
the
board,
then
the
promoter
has
51x5=
255
votes
and
minority
shareholders
have
49x5=245
votes.
Then
the
minority
shareholder
can
elect
2
members
by
casting
123
votes
for
the
1st
and
122
for
the
2nd.
DUAL-CLASS
SHARES
AND
PRIVATE
BENEFITS
In
2000,
companies
were
allowed
to
issue
differential
shares
(which
have
different
voting
rights).The
different
classes
of
share
can
have
the
same
cash-flow
rights,
but
different
control
rights.
Shares
with
superior
voting
power
sell
at
premium
because
of
the
private
benefit
of
control
(to
obtain
a
seat
on
the
board
of
directors).
So,
investors
are
basically
paying
to
gain
voting
rights.
Even
when
there
is
only
one
class
of
shares,
minority
stockholders
may
be
at
a
disadvantage-
the
companys
cash
flow
and
potential
value
may
be
diverted
to
management
or
to
a
few
dominant
stockholders
holding
large
blocks
of
shares.
Financial
economists
refer
to
the
exploitation
of
minority
shareholders
as
TUNNELING-
the
majority
shareholder
tunnels
into
the
firm
and
acquires
control
of
the
assets
for
himself.
REVERSE
STOCK
SPLITS:
Here,
the
company
combines
its
existing
shares
into
smaller,
more
convenient
no.
of
shares.
Its
generally
used
by
companies
with
a
large
number
of
low-priced
shares.
As
long
as
all
shareholdings
are
reduced
by
same
proportion,
nobody
gains
or
loses
by
such
a
move.
Eg-
Owner
of
3
old
shares
are
now
owner
of
2
new
shares.
This
reduces
the
stake
of
minority
shareholder.
Eureka
Wow
Financial
Economics
EQUITY
IN
DISGUISE
Common
stocks
are
issued
by
corporations.
But
a
few
equity
securities
are
issued
not
by
corporations
but
by
partnerships
or
trusts.
Examples:
1. Partnerships-
To
get
a
share
in
profits
of
business
and
receive
dividends
timely
in
partnership
firms,
one
needs
to
buy
units
in
the
partnerships.
Partnerships
avoid
corporate
income
tax.
Eg.
Plains
All
American
Pipeline
LP
is
a
partnership
that
owns
crude
oil
pipelines.
You
can
buy
units
in
this
partnership
on
the
NYSE,
thus
becoming
a
limited
partner
in
Plains
All
American.
2. Trusts
and
REITs-
Eg.
To
own
a
part
of
the
oil
in
the
Prudhoe
Bay
field,
you
need
to
buy
a
few
units
of
the
Prudhoe
Bay
Royalty
Trust.
This
trust
is
the
passive
owner
of
a
single
asset:
the
right
to
a
share
of
the
revenues
from
Prudhoe
Bay
production.
Real
Estate
Investment
Trusts
(REITs)
were
created
to
facilitate
public
investment
in
commercial
real
estate,
specialize
in
lending
to
real
estate
developers.
REIT
shares
are
traded
just
like
common
stocks
though
they
are
restricted
to
real
estate
investment.
PREFERRED
STOCK
It
provides
only
a
small
part
of
most
companies
cash
needs.
A
company
can
choose
not
to
pay
a
dividend
to
its
common
stockholder.
Most
issues
of
preferred
stocks
are
known
as
cumulative
preferred
stocks.
This
means
that
the
firm
must
pay
all
past
preferred
dividends
before
common
stockholders
get
anything.
If
the
company
misses
a
preferred
shareholders
dividend,
they
generally
gain
voting
rights.
COMMON
STOCK
PREFERRED
STOCK
They
are
last
in
line
for
companys
They
have
a
greater
claim
on
companys
assets.
At
the
time
assets.
of
bankruptcy,
they
are
paid
before
common
stockholders
DEBT
When
companies
borrow
money,
they
promise
to
make
regular
interest
payments
and
to
repay
the
principal.
However,
this
liability
is
limited.
Stockholders
have
the
right
to
default
on
the
debt
if
they
are
willing
to
hand
over
the
corporations
assets
to
the
lenders
and
they
will
choose
to
do
this
only
if
the
value
of
the
assets
is
less
than
the
amount
of
the
debt.
Because
lenders
are
not
considered
to
be
owners
of
the
firm,
they
do
not
normally
have
any
voting
power.
Thus
interest
is
paid
from
before-tax
income,
whereas
dividends
on
common,
preferred
stock
are
paid
from
after-tax
income.
So,
govt
provides
a
tax
subsidy
for
debt
that
it
does
not
provide
for
equity.
OWNERSHIP
OF
DIFFERENT
DEBT
SECURITIES
IN
INDIA
Bank
(78%)
Foreign
currency
borrowings
(11.76%)
Financial
institutions
(MF,
Insurance
companies)-
(7%)
Promoters
(0.27%)
Govt.
of
India
(1.6
%)
+
State
govt
(0.04%)
Others
(1.3%)
Eureka
Wow
Financial
Economics
DECISIONS
A. Should
the
company
borrow
short-term
or
long-term?
If
company
needs
to
finance
a
temporary
increase
in
inventories
=>
take
a
short-term
bank
loan.
If
the
cash
is
needed
to
pay
for
expansion
of
a
refinery
=>
its
appropriate
to
issue
a
long-term
bond.
Some
loans
are
repaid
in
a
steady
way;
and
some
loans
are
repaid
entirely
at
maturity.
B. Should
the
debt
be
fixed
or
floating
rate?
The
interest
payment
on
long-term
bonds
is
FIXED
at
the
time
of
issue-
where
firm
continues
to
pay
fixed
coupon
per
year
regardless
of
how
interest
rates
fluctuate.
Most
bank
loans
and
some
bonds
offer
a
VARIABLE/FLOATING
rate.
Here
the
ROI
in
each
period
may
be
set
at
1%
above
MIBOR
(Mumbai
Interbank
Offered
Rate),
which
is
the
ROI
at
which
major
banks
lend
$
to
each
other.
When
MIBOR
changes
=>
the
ROI
on
your
loan
also
changes.
C. Should
you
borrow
dollars
or
some
other
currency?
Rupee/
Foreign
currency
loans
Because
international
bonds
have
usually
been
marketed
by
the
London
branches
of
international
banks
they
have
traditionally
been
known
as
Eurobonds
and
the
debt
is
called
Eurocurrency
debt.
A
Eurobond
may
be
denominated
in
dollars
or
any
other
currency.
D. What
promises
should
you
make
to
the
lender?
Lenders
want
to
make
sure
that
their
debt
is
as
safe
as
possible.
Therefore,
they
may
demand
that
their
debt
is
senior
(paid
before)
to
other
debts.
If
default
occurs,
payments
are
made
in
this
order-
Bondholder
>
senior
debt
holder/creditor/lender
>
junior/subordinate
debt
holders
>
preferred
stockholders
>
common
stockholders
The
firm
may
also
set
aside
some
of
its
assets
for
the
protection
of
creditors.
Such
debt
is
said
to
be
secured
debt
and
the
assets
that
are
set
aside
are
known
as
collateral.
If
defaults
occurs,
the
bank
can
seize
the
collateral
and
use
it
to
help
pay
off
the
debt.
Firm
also
provides
assurance
to
the
lender
that
it
will
not
take
unreasonable
risks.
E. Should
you
issue
straight
or
convertible
bonds?
The
owner
of
a
warrant
can
purchase
a
set
number
of
the
companys
shares
at
a
set
price
before
a
set
date.
A
convertible
bond
gives
its
owner
the
option
to
exchange
the
bond
for
a
predetermined
number
of
shares.
If
companys
share
price
increases
=>
Convertible
bondholder
(CBH)
converts
his
bond
into
share
=>
profits
If
companys
share
price
decreases
=>
No
obligation
to
convert
bond
into
share
=>
CBH
remains
a
bondholder
OTHER
NAMES
OF
DEBT
ACCOUNTS
PAYABLE
is
obligation
to
pay
for
goods
that
have
already
been
delivered.
RENT/LEASE:
Instead
of
borrowing
to
buy
new
equipment,
the
company
may
rent/lease
it
on
a
long-term
basis.
So
the
firm
promises
to
make
lease
payments
to
the
owner
of
the
equipment.
This
is
just
like
an
obligation
to
make
payments
on
an
outstanding
loan.
SPECIAL
PURPOSE
ENTITIES
(SPEs):
Companies
want
to
ensure
that
their
investors
dont
know
how
much
the
companies
have
borrowed.
SPEs
raise
cash
by
a
mixture
of
equity
and
debt
and
then
used
these
debts
to
help
fund
the
parent
company.
None
of
this
debt
shows
up
on
companys
balance
sheet.
Eureka
Wow
Financial
Economics
VARIETY
Financial
managers
have
plenty
of
choice
in
designing
securities.
One
can
find
hybrids
that
incorporate
features
of
both
debt
and
equity.
The
dividing
line
between
debt
and
equity
is
hard
to
locate.
A
securitys
classification
as
debt
or
equity
matters
for
accounting
and
tax
purposes.
Its
not
always
right
to
say
that
Debt
is
safe,
equity
is
risky
because
there
are
examples
of
safe
equity
(preferred
stock)
and
risky
debt
(junk
bonds).
Eureka
Wow
Financial
Economics
CHAPTER
16-
PAYOUT
POLICY
Corporations
can
return/payout
cash
to
their
shareholders
in
2
ways:
Paying
a
DIVIDEND-
Some
companies
do
not
pay
any
dividends
and
invest
their
total
profit
in
the
business
itself.
REPURCHASING
STOCKS-
buy
back
some
of
the
outstanding
shares
There is a trade-off between higher/lower cash dividends and issue/repurchase of common stock.
Eureka
Wow
Financial
Economics
1
NOVEMBER
5
NOVEMBER
7
NOVEMBER
22
NOVEMBER
DECLARATION
EX-DIVIDEND
DATE
OF
DATE
OF
DATE
DATE
RECORD
PAYMENT
The
company
isnt
free
to
declare
whatever
dividend
it
chooses.
Dividend
payments
by
Indian
companies
are
regulated
by
Section
205
of
Companies
Act-
according
to
which
a
company
can
pay
a
dividend
out
of
profits
for
that
year
after
providing
for
:
depreciation
and
after
transferring
atleast
10%
of
the
companys
profits
to
the
reserves.
Most
companies
pay
a
regular
cash
dividend
each
year,
but
this
can
be
supplemented
by
(1)
Extra
or
special
dividend.
(2)
Automatic
Dividend
Re-Investment
Plans
(DRIPs)
where
the
new
shares
are
issued
at
a
discount
from
the
market
price.
(3)
Companies
also
declare
stock
dividends.
For
Eg.
If
the
firm
pays
a
stock
dividend
of
50%
(1:2),
it
sends
each
shareholder
50
extra
shares
for
every
100
shares
currently
owned.
IMPORTANCE
OF
BONUS
ISSUES
IN
INDIA
In
April
2009,
SEBI
made
it
mandatory
for
the
Indian
companies
to
announce
the
dividend
on
a
per
share
basis
and
not
in
percentage
basis.
HOW
FIRMS
REPURCHASE/
BUYBACK
STOCKS
According
to
SEBI
(Buyback
of
securities)
Regulation
1998,
a
company
can
buy
back
its
shares
by-
1. Tender
offer
to
shareholders
2. Open
market
repurchases
3. Dutch
Auction-
Shareholders
submit
offers
declaring
no.
of
shares
they
wish
to
sell
at
each
price
&
the
company
calculates
the
lowest
price
at
which
it
can
buy
the
desired
number
of
shares.
4. Direct
negotiation
HOW
DO
COMPANIES
DECIDE
ON
PAYOUTS?
1. Managers
are
reluctant
to
make
dividend
changes
that
may
have
to
be
reversed.
2. Managers
try
to
avoid
reducing
the
dividend.
3. To
avoid
the
risk
of
a
reduction
in
payout,
managers
smooth
the
dividends.
4. Managers
focus
more
on
dividend
changes
than
on
absolute
levels.
Thus
paying
a
$2.00
dividend
is
an
important
financial
decision
if
last
years
dividend
was
$1.00,
but
no
big
deal
if
last
years
dividend
was
$2.00.
REPURCHASE
DIVIDENDS
Under
stock
repurchasing,
corporations
buys
back
Dividend
is
a
payment
made
by
a
corporation
to
its
some
of
its
outstanding
shares.
shareholders,
usually
as
a
distribution
of
profits.
Its
not
taxed
Its
taxed.
THE
PAYOUT
CONTROVERSY
DIVIDEND
POLICY
IS
IRRELEVANT
IN
PERFECT
CAPITAL
MARKETS
Eureka
Wow
Financial
Economics
The
middle-of-the-road
party
was
founded
in
1961
by
Miller
and
Modigliani
(MM)
-
according
to
them,
a
dividend
policy
is
irrelevant
in
a
world
without
taxes,
transaction
costs,
or
other
market
imperfections.
EXAMPLE-
Suppose
your
firm
has
settled
on
its
investment
program.
You
have
a
plan
to
finance
the
investments
with
cash
on
hand,
additional
borrowing,
and
reinvestment
of
future
earnings.
Any
surplus
cash
is
to
be
paid
out
as
dividends.
Lets
say,
you
want
to
increase
the
payout
by
increasing
the
dividend
without
changing
the
investment
and
financing
policy.
If
the
firm
fixes
its
borrowing,
the
only
way
it
can
finance
the
extra
dividend
is
to
print
more
shares
and
sell
them.
The
new
stockholders
are
going
to
part
with
their
money
only
if
their
new
shares
are
worth
as
much
as
they
cost.
But
how
can
firm
sell
more
shares
when
its
assets,
investment
opportunities
&
market
value
are
unchanged?
So,
there
is
a
transfer
of
value
from
the
old
to
new
stockholders.
The
new
ones
get
the
newly
printed
shares,
each
one
worth
less
than
before
the
dividend
change
was
announced,
and
the
old
ones
suffer
a
capital
loss
on
their
shares.
The
capital
loss
borne
by
the
old
shareholders
just
offsets
the
extra
cash
dividend
they
receive.
So,
the
total
value
is
unaffected.
Eureka
Wow
Financial
Economics
Total
asset
value
10,000
+
NPV
Value
of
the
firm
10,000
+
NPV
Without
dividend-
The
Company
gets
10,000
+
NPV.
With
dividend-
New
Value
of
original
stockholders
share
=
Value
of
company
Value
of
new
shares
=
(10,000+NPV)
(1,000)
=
9,000
+
NPV
But
they
also
get
cash
dividend
of
Rs
1,000
=>
Total
=
10,000+NPV
So,
their
capital
loss
is
offset
by
cash
dividend
=>
Overall
market
value
is
unchanged
at
(10000
+
NPV).
So,
dividend
policy
doesnt
matter.
If
NPV=
Rs
2,000,
then
the
old
stock
is
worth
Rs
10,000
+
NPV
=
Rs
12,000
=>
Rs
12,000/1,000
=
Rs
12/share.
After
the
company
paid
dividends,
old
stock
is
worth
Rs
9,000
+
NPV
=
Rs
11,000
=>
Rs
11,000/1,000
=
Rs
11/share.
So,
after
new
stock
issue,
the
stock
is
valued
at
Rs
11/share.
If
stockholder
gets
a
fair
value
=>
Company
must
issue
91
(=Rs
1000/Rs
11)
new
shares
to
raise
the
needed
Rs
1000.
So,
the
price
of
the
old
stock
falls
by
the
amount
of
dividend
payment
(=
Rs
1/share).
CASE
2:
If
the
new
project
is
a
failure,
so
that
NPV=0
=>
Management
discards
the
project
decided
above
and
so
the
Rs
1,000
earmarked
for
it
will
be
paid
out
as
extra
dividends.
Cash
(held
for
investment)
0
Debt
0
Fixed
assets
9,000
Equity
9,000
+
NPV(=0)
=
9,000
Investment
opportunity
for
the
new
project
NPV=0
Total
asset
value
9,000
Value
of
the
firm
9,000
1000
outstanding
shares
=>
Stock
Price
before
dividend
payment
=
10,000/1,000
=
Rs
10/share
and
Rs
9/share
after
dividend
payment.
Had
the
company
used
the
Rs
1000
to
repurchase
stocks
instead
of
paying
dividends,
company
buys
Rs
1,000/Rs
10
=
100
shares
and
leaves
900
shares
worth
Rs
9,000.
So,
switching
from
cash
dividends
share
repurchase,
has
NO
effect
on
shareholders
wealth.
They
forgo
Rs
1
cash
dividend
but
end
up
holding
shares
worth
Rs
10
instead
of
Rs
9.
STOCK
REPURCHASES
AND
VALUATION
Company
X
has
100
shares
outstanding.
It
earns
Rs
1,000
a
year,
all
of
which
is
paid
out
as
a
dividend.
The
dividend/share
=
Rs
1,000/100=
Rs10/share.
CASE
1:
RECEIVE
DIVIDEND
INDEFINITELY
Suppose
that
investors
expect
the
dividend
to
be
maintained
indefinitely
and
that
they
require
a
return
of
10%
(=>
r=
0.1)
=>
PVshare
=
10/0.1=
Rs
100.
The
total
market
value
of
the
equity=
PV
equity=
100
shares
x
Rs
100=
Rs
10,000.
CASE
2:
STOCK
PURCHASE
IN
YEAR
1
FOLLOWED
BY
DIVIDEND
FOR
REMAINING
(n-1)
YEARS
Eureka
Wow
Financial
Economics
Suppose
the
company
announces
that
instead
of
paying
a
cash
dividend
in
1
year,
it
will
spend
the
same
money
repurchasing
its
shares
in
the
open
market.
a) Value
of
Rs
1000
received
from
the
stock
repurchase
in
year
1=
PVrepurchase=
A/1+r
=
Rs
1,000/1.1=909.1
b) Value
of
the
Rs
1,000/year
dividend
starting
in
year
2=
PVdividends=
Rs
1,000/(.10
x
1.1)=
Rs
9,091
So
the
total
value
of
the
equity
=
Rs
1,000/.10
=
$10,000
=
(a)
+
(b)
So,
the
total
expected
cash
flows
to
shareholders
is
unchanged
at
$1,000
So,
each
share
continues
to
be
worth
Rs
10,000/100
=
Rs
100
as
before
Now,
the
shareholders
who
plan
to
sell
their
stock
back
to
the
company
will
demand
a
10%
return
on
their
investment.
So
the
expected
price
at
which
the
firm
buys
back
shares
must
be
10%
higher
than
todays
price=
Rs
110.
Company
spends
Rs
1,000
to
buy
back
its
stock,
which
is
sufficient
to
buy
Rs
1,000/Rs
110=9.09
shares.
The
company
starts
with
100
shares,
it
buys
back
9.09,
and
therefore
90.91
shares
remain
outstanding.
Each
of
these
shares
can
look
forward
to
a
dividend
stream
of
Rs
1,000/90.91=
Rs
11/share.
So
after
the
repurchase
shareholders
have
10%
fewer
shares,
but
earnings
and
dividends
per
share
are
10%
higher.
MAIN
POINTS
(IMP):
1. Other
things
equal,
company
value
is
unaffected
by
the
decision
to
repurchase
stock
rather
than
to
pay
a
cash
dividend.
2. When
valuing
the
entire
equity,
include
both-
cash
paid
out
as
dividends
and
stock
repurchases.
3. When
calculating
the
cash
flow
per
share,
it
is
double
counting
to
include
both
the
forecasted
dividends
per
share
and
the
cash
received
from
repurchase.
4. A
firm
that
repurchases
stock
instead
of
paying
dividends
reduces
the
number
of
shares
outstanding
but
produces
an
offsetting
increase
in
subsequent
earnings
&
dividends/
share.
Eureka
Wow
Financial
Economics
CHAPTER
17-
Does
Debt
Policy
Matter?
The
Debt
Policy
of
a
company
refers
to
the
manner
in
which
the
company
structures
its
capital.
It
can
be
loosely
interpreted
as
a
debt
vs
equity
financing
debate,
however
there
is
a
lot
of
variety
within
the
debt
structure
and
also
within
equity.
Modigliani
and
Miller
(MM)
put
forth
the
proposition
that
in
perfect
capital
markets
the
payout
policy
and
financing
decisions
do
not
matter.
Its
real
assets,
not
the
securities,
evaluate
the
firm.
We
will
delve
deeper
into
understanding
the
imperfections
of
the
market
that
make
a
difference
and
elevate
the
importance
of
capital
structure.
Financial
analysts
often
want
to
maximize
the
value
of
the
firm
by
using
the
ideal
combination
of
securities.
MM
proved
that
this
would
entail
maximization
of
the
value
to
the
shareholders.
If
company
A
has
100
shares
selling
for
Rs.
20
each,
then
the
equity
(E)
raised
is
Rs.
2000.
In
addition
A
borrows
3000
from
the
market,
which
is
the
Debt
(D).
Thus,
the
market
value
(V)
of
the
company
is
Rs.
5000
(E+D).
The
stock
is
the
levered
equity,
which
exposes
the
shareholders
to
financial
leverage,
or
gearing.
If
A
levers
up,
it
means
that
it
borrows
more
from
the
market
and
distributes
it
amongst
the
shareholders
as
special
dividend.
If
A
borrows
1000
and
gives
a
special
dividend
of
Rs.
10
each,
the
new
debt
(D)
would
be
Rs.
4000.
This
leaves
the
values
of
E
and
V
as
unknowns.
Since
we
know
that
V=E+D,
we
have:
V=E+5000
Thus, V and E move in the same direction. A policy that maximizes V, will maximize E also.
Thus, a financial manager will look for a combination of securities that maximizes the firms value
Eureka
Wow
Financial
Economics
MM
say
that
in
a
perfect
market,
any
combination
of
securities
is
as
good
as
another.
Let
there
be
two
firms
Firm
U
and
Firm
L
Firm U Unlevered
EU = VU (No debt)
Firm L Levered
EL = VL DL
Investment Choice
Strategy 1
Firm U: One percent of the shares cost 0.01VU and the returns are 0.01*Profit
Strategy 2
Purchase
same
fraction
of
both
debt
and
equity
of
Firm
L.
The
cost
of
investment
would
be
0.01(DL+EL)
=
0.01VL.
The
return
on
Debt
is
Interest
=
0.01*Interest
whereas
the
return
on
Leveraged
Equity
is
0.01*(Profits-Interest).
Thus,
total
return
still
remains
0.01*Profits
The
law
of
one
price
says
that
if
two
strategies
have
the
same
return,
then
the
initial
investment
must
also
be
the
same.
Thus
we
have,
0.01VU
=
0.01VL
which
implies,
VU = VL
Strategy 3
Investment = 0.01(VL-DL)
Return= 0.01(Profits-Interest)
Strategy 4
Borrow 0.01DL on your own and purchase 1% of the stock of your unlevered firm
= 0.01(VU DL)
Eureka
Wow
Financial
Economics
Return=
Return
on
Shares
Payment
on
borrowed
funds
= 0.01*Profits 0.01*Interest
We again see that the same return has been yielded, which means that VL = VU
The
risk
appetite
of
the
investor
therefore
does
not
affect
the
fact
that
the
value
of
a
firm
is
independent
of
the
security
mix.
This
finding
by
MM
translates
to
the
fact
that
an
asset
retains
its
value
even
if
it
is
split
into
n
different
streams.
This
is
called
the
law
of
conservation
of
Value.
This
law
applies
to
the
mix
of
debt
securities
as
well
as
to
the
choice
between
common
and/or
preferred
stock.
Throughout,
we
are
assuming
that
borrowers
and
lenders
can
transact
at
the
same
risk
free
interest
rate.
However,
corporate
debt
is
not
risk
free.
If
the
company
cannot
make
profits,
then
it
forfeits
its
debt
obligations.
Many
individuals
would
like
to
assume
this
role
where
they
have
limited
liability.
Thus,
they'll
be
willing
to
pay
a
premium
for
levered
shares
if
their
supply
was
limited
to
below
their
demand.
However,
given
the
multitude
of
companies,
this
is
an
unlikely
situation.
Suppose
theres
a
Company
X.
X
is
entirely
funded
by
equity,
having
1000
shares
of
Rs
10
each.
The
valuation
of
the
company
stands
at
Rs.
10,000.
The
expected
dividend
per
share
is
Rs.
1.5
and
it
is
expected
to
continue
forever.
This
earning/dividend
per
share
can
actually
turn
out
to
be
more
or
less
than
Rs.
1.5.
Returns
Outcomes
Operating
income
500
1000
1500
2000
(Assumed)
Earnings
per
share
0.5
1
1.5
2
Return
on
Shares
(%)
5
10
15
20
X
is
considering
raising
a
debt
of
Rs.
5000
@
10%
interest
and
repurchase
500
shares.
Price
per
share
is
Rs.
10,
which
makes
the
market
value
of
the
shares
and
the
debt
both
stand
at
Rs.
5000.
Interest
@
10%
equals
Rs.
500
Outcomes
Operating
income
500
1000
1500
2000
Eureka
Wow
Financial
Economics
(assumed)
Interest
500
500
500
500
Equity
Earnings
0
500
1000
1500
(operating
income
interest)
Earnings
per
share
0
1
2
3
Return
on
Shares
(%)
0
10
20
30
Since
the
expected
dividend
per
share
was
Rs.
1.5,
we
see
that
the
expected
return
on
shares
increases
to
20%
if
a
fresh
issue
of
debt
for
Rs.
5000
is
made.
As
we
can
see
from
the
data
in
the
tables,
and
from
the
graph
which
is
made
by
plotting
these
data
points,
the
effect
of
leverage
on
earnings
per
share
depends
on
the
income
of
the
company.
Until
Rs.
1000,
the
EPS
is
reduced
by
leverage,
post
which
it
increases
with
leverage.
Thus,
since
you
expect
an
income
of
Rs.
1500,
it
makes
sense
to
support
the
leveraging
of
the
business.
BUT,
THIS
IS
NOT
TRUE.
Your
valuation
of
the
company
remains
the
same.
Why?
As
a
shareholder,
you
get
a
seemingly
higher
EPS
with
leveraged
shares
of
X.
However,
even
if
you
were
faced
with
an
unleveraged
X,
you
could
have
borrowed
Rs.
10
at
the
market
rate,
and
then
bought
2
shares
with
Rs.
20.
You
invest
only
Rs.
10
of
your
own.
Your
return
is
then
2(EPS
of
unleveraged
X)
Interest
payment
on
the
loan
of
Rs.
10.
This
will
give
you
exactly
the
EPS
of
the
leveraged
company
X.
Thus,
even
if
X
borrows
Rs.
5,000
the
valuation
for
the
shareholders
remains
the
same.
Eureka
Wow
Financial
Economics
This
proves
MMs
proposition.
Leverage
increases
the
Expected
returns,
but
not
the
share
price
as
the
change
in
expected
returns
is
exactly
offset
by
a
change
in
the
rate
of
discount
applied
to
earnings.
We
know
that
the
borrowing
decision
will
not
affect
the
numerator
or
the
denominator,
thus
leaving
rA
unchanged.
Expected return on a portfolio is the weighted average of expected returns on all individual holdings.
Expected
return=
(proportion
in
debt
X
expected
return
on
debt)
+
(proportion
in
equity
X
expected
return
on
equity)
this is also called the company cost of capital or the Weighted Average Cost of Capital (WACC)
It
states
that
the
expected
rate
of
return
on
the
common
stock
of
a
levered
firm
increases
in
proportion
to
the
debt-equity
ratio
expressed
in
market
values;
the
rate
of
increase
depends
on
the
spread
between
rA,
the
expected
rate
of
return
on
portfolio
of
all
the
firms
securities,
and
rD,
the
expected
rate
of
return
on
Debt.
Notice that this is exactly the same as the above equation, written in words.
Eureka
Wow
Financial
Economics
=
1500/10000
= 0.15 = 15%
After borrowing,
rE = 0.15 + (0.15-0.10)*(5000/5000)
= 0.20 = 20%
When
the
firm
is
levered,
the
equity
investors
want
a
higher
return
on
their
assets
to
compensate
for
the
higher
risk.
MM Proposition 2: The rate of return they expect increases as the Debt-Equity ration increases
This
may
seem
as
a
bit
of
a
contradiction.
You
should
understand
that
even
though
they
enjoy
a
higher
rate
of
return
on
leveraged
shares,
it
does
not
increase
their
wealth
because
as
the
rate
of
return
is
increasing,
so
is
the
risk.
And
as
the
risk
increases,
the
return
they
require
to
maintain
their
wealth
must
increase,
as
it
does.
If
and
when
the
Operating
Income
(OI)
falls,
the
monetary
loss
borne
by
shareholders
as
a
group
remains
the
same
in
a
leveraged
and
an
unleveraged
company.
So
if
the
OI
falls
from
Rs
1500
to
Rs
500,
in
an
unleveraged
company
thats
a
loss
of
Rs.
1000
total,
divided
by
1000
shares
to
give
a
loss
of
Re
1
per
share.
In
a
leveraged
firm,
there
are
500
shares,
so
the
loss
in
now
Rs.
2
per
share.
However,
we
can
look
at
the
percentage
spread.
With
1000
shares,
the
same
decline
causes
a
reduction
in
return
by
10%.
However,
with
just
500
shares
and
a
equity
value
of
(500*10=5000),
a
Rs.
1000
loss
is
a
20%
reduction
on
returns.
Thus,
the
effect
of
the
leverage
is
to
double
the
volatility
of
Xs
shares.
After
refinancing,
the
beta
of
the
stock
doubles.
The
risk
of
a
firms
cash
flows
is
borne
by
both
equity
holders
and
debt
holders.
However,
the
share
of
the
latter
is
lower.
The
Beta
of
the
portfolio
is,
similar
to
the
returns,
a
weighted
average
of
the
Beta
of
the
individual
components,
i.e.,
the
equity
and
the
debt
Eureka
Wow
Financial
Economics
After
refinancing,
the
risk
of
the
total
package
remains
the
same,
but
the
individual
betas
rise.
Thus,
borrowing
creates
financial
leverage.
Shareholders
demand
a
correspondingly
higher
return
because
of
this
financial
risk
of
increased
betas.
MM
warns
us
that
the
shareholder
value
doesnt
increase
when
returns
to
equity
increases.
It
is
merely
a
reflection
of
greater
risk.
The
diagram
shows
that
RE
increases
linearly
with
D/E.
As
D/E
becomes
really
high,
the
return
to
equity
becomes
less
sensitive
to
the
increase
in
debt.
This
is
because
the
risk
of
the
business
is
transferred
from
stockholders
to
bond
holders
(the
debt
is
taken
tv
purchasing
essentially
risk-free
bonds)
In
the
absence
of
the
MM
propositions,
a
more
traditional
view
was
kept
in
place
which
insisted
that
the
objective
of
financial
decisions
was
to
minimize
the
weighted
average
cost
of
capital
as
opposed
to
maximizing
overall
market
value.
If
MM's
proposition
1
does
not
hold,
then
both
these
goals
are
fulfilled
simultaneously
unless
the
Operating
Income
varies
with
the
Capital
Structure.
Warning
1:
The
shareholders
want
an
increase
in
the
firm's
value
to
become
rich.
They
don't
care
as
much
about
owning
a
firm
with
a
low
WACC.
Warning
2:
trying
to
minimize
WACC
leads
to
"logical
short
circuits".
How?
Imagine
a
scenario
where
an
attempt
is
made
to
reduce
WACC
by
acquiring
more
debt
because
shareholders
demand
(and
deserve)
a
higher
return.
However,
this
is
a
fallacy
because
this
ignores
the
fact
that
the
shareholders
will
require
a
higher
rate
(just
enough
to
keep
WACC
constant)
even
if
debt
increases.
Eureka
Wow
Financial
Economics
The
following
diagram
shows
the
Traditionalist
view.
Their
argument
rests
on
the
assumption
that
returns
to
shareholders
does
not
increase
(or
increased
very
slowly)
as
the
firm
borrows
more.
If
this
is
true,
then
the
WACC
will
fall
as
the
D/E
ratio
increased
because
WACC
is
nothing
but
a
weighted
average
on
the
return
to
equity
and
return
to
debt.
Traditionalist
view
says
that
initially,
as
debt
increases
the
return
to
equity
will
increase
very
slowly
(lower
than
the
increase
MM
predicted),
but
after
a
point,
when
irresponsible
firms
excessively
borrow,
the
return
to
equity
must
rise
really
fast
(greater
than
what
was
predicted
by
MM).
Consequently,
the
WACC
initially
falls,
reaches
a
minimum
and
then
increased
with
an
increase
in
D/E.
The
traditionalists
provide
two
arguments
for
the
intuition
behind
this
theory.
1.
The
shareholders
do
not
appreciate
the
risk
initially,
but
later
they
demand
high
returns
when
the
debt
becomes
excessive
2.
The
second
(better)
argument
is
that
the
assumption
of
perfect
markets
that
MM
had
applied
might
not
be
true.
If
the
shareholders
get
some
other
value
added
by
buying
levered
shared
then
they
might
not
mind
the
extra
risk.
Example:
The
corporate
sector
might
have
access
to
loans
at
a
cheaper
rate
than
consumer
loans.
So,
a
person
might
want
to
buy
shares
so
that
he
can
indirectly
get
loans
cheaply
in-spite
of
the
extra
financial
risk.
This
happens
because
there
are
economies
of
scale
in
borrowing.
However,
it
is
possible
that
these
needs
of
the
clientele
have
already
been
met.
This
created
the
incentive
of
looking
for
unsatisfied
clientele.
We
see
new
exotic
securities
coming
up
everyday
to
satisfy
these
clients
and
sometimes
to
uncover
a
latent
demand
for
that
security.
Every
time
there
is
an
imperfection
in
the
markets,
there
is
an
opportunity
to
step
in
and
fulfill
a
money-
making
opportunity.
This
means
that
the
clientele
will
become
satisfied.
The
Government
creates
most
of
these
imperfections.
For
example,
when
the
government
laid
down
a
limit
on
interest
rates
to
be
paid
Eureka
Wow
Financial
Economics
on
savings,
it
was
done
so
that
competition
amongst
savings
institutions
is
limited.
Then
the
smart
financial
managers
came
up
with
the
floating
rate
notes.
This
satisfies
the
new
clientele
and
then
MM's
proposition
1
is
satisfied
again.
Thus,
if
you
ever
find
an
unsatisfied
clientele,
do
something
right
away,
or
capital
markets
will
evolve
and
steal
it
from
you.
rD(1-Tc)*D/V + rE*E/V
Thus, if companies are getting this tax advantage, then as Debt increased, the WACC falls.