0

TOPIC 2

Long-Term Capital Management

K Structure: Basic Concepts
RWJ_16

2

How should a firm choose its
debtequity ratio?
Define the value (V) of a firm as the sum
of the value of the firms debt (B) and the firms
equity (S): V = B + S


If the goal is to make V as
large as possible, then we
need to pick the D/E ratio
that makes the pie as big as
possible.
Value of the Firm
S B S B S B S B
3

!!!
Note that we defined V as B+S. Can we
define it differently? For e.g., why not ALL
stakeholders, not just owners and creditors?
4
Stockholder Interests


1.Why should shareholders care about maximizing V?
Shouldnt they be interested in strategies that maximize
S not V?
2.The question the manager has to answer is: what B/S
ratio (what K structure) maximizes shareholders value?
As it turns out, changes in K structure increases S if and
only if V increases. To see this, consider the following
example.
5
An all-equity firm consists of 400 shares,
currently priced at $50.
The firm wants to borrow $8,000 at 8%
and use it to buy back 160 shares at $50
each.
How will this restructuring affect V?

e.g. In a world
without taxes
6
K structure: Current and Proposed
Current
Assets $20,000
Debt $0
Equity $20,000
B/S 0.00
Interest rate n/a
Shares outstanding 400
Share price $50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
7
EPS and ROE Under Current Structure
in Two States of the World
(What probabilities are associated with these states of the world?)

Recession Expected Expansion
EBI $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
8
EPS and ROE Under Proposed Structure
in Same Two States of the World

Recession Expected Expansion
EBI $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares
9
Financial Leverage and EPS

(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
E
P
S

Debt
No Debt
Break-even
point :EBI=800
EBI, no taxes
Advantage
to debt
Disadvantage
to debt
10
!!!
Note that leverage increases the risk to
shareholders: if the state turns out recession,
shareholders will suffer a loss under proposed
structure.
11
So,
- which K structure is better? i.e.
- did changing the mix (the ratio) of
equity (S) and debt (B) make S
larger?
- did changing the mix (the ratio) of
equity (S) and debt (B) make V
larger?

12
MM1 __F. Modigliani and M. Miller, The Cost of Capital,
Corporation Finance and the Theory of Investment,
American Economic Review (June 1958)
NO, says MM1. V remains the same under different
B/S values Managers cannot change V by
changing B/S Managers cannot change S by
changing B/S .
MM model (their set of assumptions) + their argument
(homemade leverage) lead to their stunning proposition:
K Structure is Irrelevant
V
levered
= V
unlevered
13
Assumptions of MM Model

Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Firms and investors can borrow/lend at the same rate
Equal access to all relevant information
No transaction costs
No taxes
No Bankruptcy costs
14
MM key argument: Homemade Leverage
Shareholders can achieve any pattern of payouts they desire with homemade
leverage
An investor can match the desired leverage
ratio: purchase 40 shares of the all-equity
firm using $800 of borrowed funds (at 8%)
and $1,200 of own funds.
The personal debt equity ratio is:

3
2
200 , 1 $
800 $
= =
S
B
15
Homemade Leverage
Long 40 shares of an all-equity firm, using $800 in margin at 8% interest
and $1200 of own funds.
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300
Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3.0% 11.3% 19.7%
Investor achieves the same ROE as shareholders of
a levered firm.
16
Homemade Un-leverage Argument

A current levered-firm shareholder with a
total of 40 shares can achieve the desired
leverage ratio of zero by selling 16 shares at
$50 a share and using the proceeds to buy
$800 worth of the firms debt. Thus this
shareholder remains fully invested in the firm
with $1,200 invested in the firms equity and
$800 in its debt.

17
Homemade Un-leverage
Long $1200 worth of shares of levered firm, and $800 of its debt .
Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%
Investor achieves the same ROE as shareholders of
all-equity firm.
18
Hence MM Proposition I
( with No Taxes & No bankruptcy costs)
We can create a levered or unlevered position
by adjusting the trading in our own account
regardless of what management decides.
This homemade leverage suggests that capital
structure is irrelevant in determining the value
of the firm. So,
in a world without taxes, V
L
= V
U


19
MM Proposition II
(with No Taxes & No bankruptcy costs)
Leverage increases the risk and return to
stockholders
R
s
= R
0
+ (B / S
L
) (R
0
- R
B
)

R
B
is the cost of debt
R
s
is the return on (levered) equity (cost of equity)
R
0
is the return on unlevered equity (cost of capital=cost
of equity when debt is 0)
B is the value of debt
S
L
is the value of levered equity
20
MM Proposition II
( with No Taxes & No bankruptcy costs)

Debt-to-equity Ratio
C
o
s
t

o
f

c
a
p
i
t
a
l
:

R

(
%
)

R
0

R
B

S B WACC
R
S B
S
R
S B
B
R
+
+
+
=
) (
0 0 B
L
S
R R
S
B
R R + =
R
B

S
B
21
MM Proposition I
(with Taxes But No bankruptcy costs)
B T V V
C U L
+ =
B R T B R EBIT
B C B
+ ) 1 ( ) (
is rs shareholde & s bondholder to flow cash total The
The present value of this stream of cash flows is V
L

= + B R T B R EBIT
B C B
) 1 ( ) ( Clearly
The present value of the first term is V
U

The present value of the second term is T
C
B
B R T B R T EBIT
B C B C
+ = ) 1 ( ) 1 (
B R BT R B R T EBIT
B C B B C
+ + = ) 1 (
22
MM Proposition II
(with Taxes But No bankruptcy costs)
Start with M&M Proposition I with taxes:
) ( ) 1 (
0 0 B C S
R R T
S
B
R R + =
B T V V
C U L
+ =
Since
B S V
L
+ =
The cash flows from each side of the balance sheet must equal:
B C U B S
BR T R V BR SR + = +
0
B R T R T B S BR SR
B C C B S
+ + = +
0
)] 1 ( [
Divide both sides by S
B C C B S
R T
S
B
R T
S
B
R
S
B
R + + = +
0
)] 1 ( 1 [
B T V B S
C U
+ = +
) 1 (
C U
T B S V + =
Which reduces to
23
MM Propositions I & II
(with Taxes But No bankruptcy costs)
Proposition I (with Corporate Taxes)
Firm value increases with leverage
V
L
= V
U
+ T
C
B
Proposition II (with Corporate Taxes)
Some of the increase in equity risk and return is
offset by the interest tax shield
R
S
= R
0
+ (B/S)(1-T
C
)(R
0
- R
B
)
24
Effect of Financial Leverage

Debt-to-equity
ratio (B/S)
Cost of capital: R
(%)
R
0

R
B

) ( ) 1 (
0 0 B C
L
S
R R T
S
B
R R + =
S
L
L
C B
L
WACC
R
S B
S
T R
S B
B
R
+
+
+
= ) 1 (
) (
0 0 B
L
S
R R
S
B
R R + =
25
Total Cash Flow to Investors


Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 35%) $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950

Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $884+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+T
C
R
B
B $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174
A
l
l

E
q
u
i
t
y

L
e
v
e
r
e
d

26
Total Cash Flow to Stakeholders

The levered firm pays less in taxes than does the all-equity firm.
Thus, V= the sum of the debt plus the equity of the levered firm is
greater than V= equity of the unlevered firm.
This is how cutting the pie differently can make the pie larger. -
the government takes a smaller slice of the pie and by construction,
government is not a stakeholder in the firm!!

S G S G
B
All-equity firm Levered firm

K Structure: Limits to the use
of debt
RWJ_17

28
Example: Company in Distress
Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300
Fixed Asset $400 $0 Equity $300
Total $600 $200 Total $600 $200

What happens if the firm is liquidated today?
$200
$0
29
So, Selfish Strategy 1: Take Risks
Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Cost of investment is $200 (all the firms cash)
Required return is 50%
Expected CF from the Gamble = $1000 0.10 + $0 = $100


NPV = $200 +
$100
(1.50)
NPV = $133
30
Selfish Strategy 1: Take Risks
Expected CF from the Gamble
To Bondholders = $300 0.10 + $0 = $30
To Stockholders = ($1000 $300) 0.10 + $0 = $70
PV of Bonds Without the Gamble = $200
PV of Stocks Without the Gamble = $0
$20 =
$30
(1.50)
PV of Bonds With the Gamble:
$47 =
$70
(1.50)
PV of Stocks With the Gamble:
31
Selfish Strategy 2: Underinvestment
Suppose that this firm has access to a government-
sponsored project that guarantees $350 in one
period.. The cost of investment is $300 (the firm
only has $200 now), so the stockholders will have to
supply an additional $100 to finance the project.
Required return is 10%.
-Should we accept or reject?
NPV = $300 +
$350
(1.10)
NPV = $18.18
32
Selfish Strategy 2: Underinvestment
Expected CF from the government sponsored project:
To Bondholder = $300
To Stockholder = ($350 $300) = $50
PV of Bonds Without the Project = $200
PV of Stocks Without the Project = $0


$272.73 =
$300
(1.10)
PV of Bonds With the Project:
$54.55 =
$50
(1.10)
PV of Stocks With the Project: $100
33
Selfish Strategy 3: Milking the Property
Thru Liquidating dividends
Suppose our firm pays out a $200 dividend to the
shareholders. This leaves the firm insolvent, with
nothing for the bondholders, but plenty for the
former shareholders.
Such tactics often violate bond indentures.
Thru Increasing perquisites to shareholders
and/or management

34
Tax Effects and Financial Distress
There is a trade-off between the tax
advantage of debt and the costs of
financial distress.
It is difficult to express this with a precise
and rigorous formula.
35
Tax Effects and Financial Distress, graphically: The firms
capital structure is optimized where the marginal subsidy to debt
equals the marginal cost.
Debt (B)
Value of firm (V)
0
Present value of tax
shield on debt
Present value of
financial distress costs
Value of firm under
MM with corporate
taxes and debt
V
L
= V
U
+ T
C
B
V = Actual value of firm
B
*
Maximum
firm value
Optimal amount of debt
36
The Pie Revisited
Taxes and bankruptcy costs can be viewed as just
another claim on the cash flows of the firm.
Let G and L stand for payments to the government
and bankruptcy lawyers, respectively.
V
T
= S + B + G + L

The essence of the M&M intuition is
that V
T
depends on the cash flow of the firm;
capital structure just slices the pie.
S
G
B
L
37
Signaling
Investors view debt as a signal of firm value.
Firms with low anticipated profits will take on a low level
of debt.
Firms with high anticipated profits will take on a high
level of debt.
A manager that takes on more debt than is optimal in
order to fool investors will pay the cost in the long
run.
38
Agency Cost of Equity
An individual will work harder for a firm if he is one of the
owners than if he is one of the hired help.
While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
The free cash flow hypothesis also argues that an increase
in debt will reduce the ability of managers to pursue
wasteful activities more effectively than dividend increases.
39
The Pecking-Order Theory

firms prefer to issue debt rather than equity if
internal financing is insufficient. The order is:
Use internal financing first
Issue debt next,
new equity last
The pecking-order theory is at odds with the tradeoff
theory:
There is no target D/E ratio
Profitable firms use less debt
40
Growth and the Debt-Equity Ratio
Growth implies significant equity financing,
even in a world with low bankruptcy costs.
Thus, high-growth firms will have lower
debt ratios than low-growth firms.
41
Personal Taxes
Dividends face double taxation (firm and
shareholder), which suggests a stockholder
receives the net amount:
(1-T
C
) x (1-T
S
)
Interest payments are only taxed at the individual
level since they are tax deductible by the
corporation, so the bondholder receives:
(1-T
B
)
42
Personal Taxes
If T
S
= T
B
then the firm should be financed
primarily by debt (avoiding double tax).
The firm is indifferent between debt and
equity when:

(1-T
C
) x (1-T
S
) = (1-T
B
)


Valuation and Capital
Budgeting for the Levered
Firm
Three approaches
RWJ_18

44
The Adjusted Present Value (APV) Approach
for valuing projects with leverage
APV = NPV + NPVF
The value of a project to the firm can be thought of as
the value of the project to an unlevered firm (NPV)
plus the present value of the financing side effects
(NPVF).
There are four side effects of financing:
The Tax Subsidy to Debt
The Costs of Issuing New Securities
The Costs of Financial Distress
Subsidies to Debt Financing
45
APV Example
0 1 2 3 4
$1,000 $125 $250 $375 $500
50 . 56 $
) 10 . 1 (
500 $
) 10 . 1 (
375 $
) 10 . 1 (
250 $
) 10 . 1 (
125 $
000 , 1 $
% 10
4 3 2
% 10
=
+ + + + =
NPV
NPV
The unlevered cost of equity is R
0
= 10%:
The project would be rejected by an all-equity firm: NPV < 0.
Consider a project of the Pearson Company. The timing and size
of the incremental after-tax cash flows for an all-equity firm are:
46
APV Example
Now, imagine that the firm finances the project with $600 of
debt at R
B
= 8%.
Pearsons tax rate is 40%, so they have an interest tax shield
worth T
C
BR
B
= .40$600.08 = $19.20 each year.
- The net present value of the project under leverage is:
APV = NPV + NPV
debt tax shield

=
+ =
4
1
) 08 . 1 (
20 . 19 $
50 . 56 $
t
t
APV
09 . 7 $ 59 . 63 50 . 56 $ = + = APV
- So, Pearson should accept the project with debt.
47
The Flow to Equity Approach
for valuing projects with leverage
Discount the cash flow from the project to the
equity holders of the levered firm at the cost of
levered equity capital, R
S
.
There are three steps in the FTE Approach:
Step One: Calculate the levered cash flows (LCFs)
Step Two: Calculate R
S
.
Step Three: Value the levered cash flows at R
S
.
48
Step One: Levered Cash Flows
Since the firm is using $600 of debt (interest-only
loan), the equity holders only have to provide $400
of the initial $1,000 investment.
Thus, CF
0
= $400
Each period, the equity holders must pay interest
expense. The after-tax cost of the interest is:
BR
B
(1 T
C
) = $600.08(1 .40) = $28.80
49
Step One: Levered Cash Flows
$400 $221.20
CF
2
= $250 28.80
$346.20
CF
3
= $375 28.80
$128.80
CF
4
= $500 28.80 600
CF
1
= $125 28.80
$96.20
0 1 2 3 4
50
Step Two: Calculate R
S

) )( 1 (
0 0 B C S
R R T
S
B
R R + =

=
+ + + + =
4
1
4 3 2
) 08 . 1 (
20 . 19
) 10 . 1 (
500 $
) 10 . 1 (
375 $
) 10 . 1 (
250 $
) 10 . 1 (
125 $
t
t
PV
B = $600 when V = $1,007.09 so S = $407.09.
% 77 . 11 ) 08 . 10 )(. 40 . 1 (
09 . 407 $
600 $
10 . = + =
S
R
P V = $943.50 + $63.59 = $1,007.09
B
S
B
V
To calculate the debt to equity ratio, , start with
51
!
This assumes we know the value created by
the project. A more straightforward
assumption is to assume that the ratio is
600/400, based on the amount provided by
each source to fund the project. With these
values, R
S
=11.80%.

52
Step Three: Valuation
Discount the cash flows to equity holders at R
S
=
11.77%

56 . 28 $
) 1177 . 1 (
80 . 128 $
) 1177 . 1 (
20 . 346 $
) 1177 . 1 (
20 . 221 $
) 1177 . 1 (
20 . 96 $
400 $
4 3 2
=
+ + + =
NPV
NPV
0 1 2 3 4
$400 $96.20 $221.20 $346.20 $128.80
53
WACC Method
To find the value of the project, discount the
unlevered cash flows at the weighted average cost of
capital.
Suppose Pearsons target debt to equity ratio is 1.50
) 1 (
C B S WACC
T R
B S
B
R
B S
S
R
+
+
+
=
54
WACC Method
% 58 . 7
) 40 . 1 ( %) 8 ( ) 60 . 0 ( %) 77 . 11 ( ) 40 . 0 (
=
+ =
WACC
WACC
R
R
S
B
= 50 . 1
B S = 5 . 1
60 . 0
5 . 2
5 . 1
5 . 1
5 . 1
= =
+
=
+ S S
S
B S
B
40 . 0 60 . 0 1 = =
+ B S
S
55
WACC Method
To find the value of the project, discount the
unlevered cash flows at the weighted average
cost of capital
4 3 2
) 0758 . 1 (
500 $
) 0758 . 1 (
375 $
) 0758 . 1 (
250 $
) 0758 . 1 (
125 $
000 , 1 $ + + + + = NPV
NPV
7.58%
= $6.68
56
Comparing APV, FTE, & WACC Approaches
All three approaches attempt the same task:
valuation in the presence of debt financing.
Guidelines:
Use WACC or FTE if the firms target debt-to-value
ratio applies to the project over the life of the project.
Use the APV if the projects level of debt is known
over the life of the project.
In the real world, the WACC is, by far, the most
widely used.

57
Comparing APV, FTE, & WACC Approaches
Which approach is best?
Use APV when the level of debt is constant
Use WACC and FTE when the debt ratio is
constant
WACC is by far the most common
FTE is a reasonable choice for a highly levered
firm

58
Capital Budgeting When the Discount Rate Must
Be Estimated
A scale-enhancing project is one where the project is
similar to those of the existing firm.
In the real world, executives would make the
assumption that the business risk of the non-scale-
enhancing project would be about equal to the
business risk of firms already in the business.
No exact formula exists for this. Some executives
might select a discount rate slightly higher on the
assumption that the new project is somewhat riskier
since it is a new entrant.
59
Beta and Leverage
Recall that an asset beta would be of the
form:
2
Market
Asset

) , (

Market UCF Cov

=
60
Beta and Leverage: No Corporate Taxes
In a world without corporate taxes, and with riskless
corporate debt (|
Debt
= 0), it can be shown that the
relationship between the beta of the unlevered firm
and the beta of levered equity is:
Equity Asset

Asset
Equity
=
- In a world without corporate taxes, and with risky
corporate debt, it can be shown that the relationship
between the beta of the unlevered firm and the beta of
levered equity is:
Equity Debt Asset

Asset
Equity

Asset
Debt
+ =
61
Beta and Leverage: With Corporate Taxes
In a world with corporate taxes, and riskless
debt, it can be shown that the relationship
between the beta of the unlevered firm and the
beta of levered equity is:

firm Unlevered Equity
) 1 (
Equity
Debt
1
|
|
.
|

\
|
+ =
C
T
- Since must be more than 1 for a

levered firm, it follows that |
Equity
> |
Unlevered firm


|
|
.
|

\
|
+ ) 1 (
Equity
Debt
1
C
T
62
If the beta of the debt is non-zero, then:

L
C
S
B
T + = ) )( 1 (
Debt firm Unlevered firm Unlevered Equity
Beta and Leverage: With Corporate Taxes
63
Summary
1. The APV formula can be written as:


2. The FTE formula can be written as:


3. The WACC formula can be written as

investment
Initial
debt
of effects
Additional
) 1 (
1
0
+
+
=

= t
t
t
R
UCF
APV
|
|
.
|

\
|

+
=

=
borrowed
Amount
investment
Initial
) 1 (
1 t
t
S
t
R
LCF
FTE
investment
Initial
) 1 (
1

+
=

= t
t
WACC
t
WACC
R
UCF
NPV
64

4 Use the WACC or FTE if the firm's target debt to
value ratio applies to the project over its life.
- WACC is the most commonly used by far.
- FTE has appeal for a firm deeply in debt.
5 The APV method is used if the level of debt is
known over the projects life.
- The APV method is frequently used for special
situations like interest subsidies, LBOs, and leases.
6 The beta of the equity of the firm is positively
related to the leverage of the firm.


Payout
RWJ_19

66
Different Types of Payouts
Many companies pay a regular cash dividend
Public companies often pay quarterly.
Sometimes firms will pay an extra cash dividend.
The extreme case would be a liquidating dividend.
Companies will often declare stock dividends
No cash leaves the firm.
The firm increases the number of shares outstanding.
Some companies declare a dividend in kind
Wrigleys Gum sends a box of chewing gum.
Other companies use stock buybacks

67
Price Behavior
In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
$P
$P - div
Ex-
dividend
Date
The price drops
by the amount of
the cash
dividend.
-t

-2 -1 0 +1 +2

68
The Irrelevance of Dividend Policy?
A compelling case can be made that dividend
policy is irrelevant.
Dividend policy will have no impact on the
value of the firm because investors can create
whatever income stream they prefer by using
homemade dividends (i.e. convert shares to
cash at will)

69
Homemade Dividends example
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers a $3 dividend.
Bobs homemade dividend strategy:
Sell 2 shares ex-dividend

homemade dividends
Cash from dividend $160
Cash from selling stock $80
Total Cash $240
Value of Stock Holdings $40 78 =
$3,120

$3 Dividend
$240
$0
$240
$39 80 =
$3,120
70

Dividend Policy Is Irrelevant
In the above example, Bob Investor began with a
total wealth of $3,360:
share
42 $
shares 80 360 , 3 $ =
240 $
share
39 $
shares 80 360 , 3 $ + =
80 $ 160 $
share
40 $
shares 78 360 , 3 $ + + =
- After a $3 dividend, his total wealth is still $3,360:
- After a $2 dividend and sale of 2 ex-dividend shares, his
total wealth is still $3,360:
71
Personal Taxes, Dividends, and Stock Repurchases
To get the result that dividend policy is irrelevant,
we needed three assumptions:
No taxes
No transactions costs
No uncertainty
In the United States, both cash dividends and capital
gains are (currently) taxed at a maximum rate of 15
percent.
Since capital gains can be deferred, the tax rate on
dividends is greater than the effective rate on capital
gains.

72

Stock Repurchase versus Dividend

$10 = /100,000 $1,000,000
=
Price per share
100,000
=
outstanding Shares
1,000,000 Value of Firm 1,000,000 Value of Firm
1,000,000 Equity 850,000 Assets Other
0 Debt $150,000 Cash
sheet balance Original A.
Equity & Liabilities Assets
Consider a firm that wishes to distribute $100,000 to its
shareholders.
73

Stock Repurchase versus Dividend
$9 = 00,000 $900,000/1 = share per Price
100,000 = g outstandin Shares
900,000 Firm of Value 900,000 Firm of Value
900,000 Equity 850,000 Assets Other
0 Debt $50,000 Cash
dividend cash share per $1 After B.
Equity & s Liabilitie Assets
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
74

Stock Repurchase versus Dividend
Assets Li abilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 90,000
Price per share = $900,000 / 90,000 = $10
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
75
The Clientele Effect
Clienteles for various dividend payout policies
are likely to form in the following way:

Group Stock Type
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Zero-to-Low payout
Low-to-Medium payout
Medium payout
High payout
Once the clienteles have been satisfied, a corporation is
unlikely to create value by changing its dividend policy.
76
What We Know
- Corporations smooth dividends.
- Fewer companies are paying dividends.
- Dividends provide information to the
market.
- Firms should follow a sensible policy:
Do not forgo positive NPV projects just to pay a dividend.
Avoid issuing stock to pay dividends.
Consider share repurchase when there are few better uses for the
cash.
77
What we know
- Aggregate payouts are massive and have
increased over time.
- Dividends are concentrated among a small
number of large, mature firms.
- Managers are reluctant to cut dividends.
- Stock prices react to unanticipated changes
in dividends.
78
Stock Dividends
- Additional shares of stock are distributed instead
of cash Increases the number of outstanding
shares.
- we say Small stock dividend if less than 20 to
25%, otherwise Large stock dividend
If you own 100 shares and the company declared a
10% stock dividend, you would receive an
additional 10 shares.


79
Stock Splits
Stock splits are essentially the same as a stock
dividend except expressed as a ratio
For example, a 2 for 1 stock split is the same as a
100% stock dividend.
Stock price is reduced when the stock splits.
Common explanation for split is to return price
to a more desirable trading range