Week 10

Payout Policy & Course Summary

Berk (2018), Chapter 17, Payout Policy
 How the Story of Corporate Finance will be explained:
Financial Mathematics
Week 01
Debt
Cash Types Equity Week 02
of CF
Flows Working capital Week 05
management
𝐶𝐹
𝑁𝑃𝑉 𝐶𝐹 Cash Flow Forecasting Weeks 03 and 04
1 𝑟

Capital Asset Pricing Model Week 07

Discount
rate Cost of capital Week 08
(Risk & Return)
Week 10:
Capital structure Week 09 Payout policy

Important: As you take this course, clarify how to connect the different parts of the story!
2
 Contents
Let’s look at this now
1. Payout (Dividend) Policy 3. MyExperience Survey
1. FCF and Payout
2. Why firms payout & how 4. Final Exam Content
3. Dividends & Share repurchases
4. Dividend payment process 5. Course Summary
5. Why firms pay dividends

2. Four Theories of Payout Policy

1. MM dividend irrelevancy theory
2. Bird-in-hand theory
3. Tax preference theory
4. Classical tax vs. Aust. Imputation Tax System
5. Signalling theory
6. Examples: Perfect vs. Imperfect Capital Mkts

3
 Free cash flow & Payout
Free cash flows (FCF) from operations
• These are Cash Flows that are available to pay debt and equity holders
• FCF to debt holders are obligatory, e.g., interest and principal repayments
• FCF to equity holders are optional, e.g., dividends, share repurchases, investment in new projects, cash reserves
• “Payout policy” refers to the decisions of distributing FCF to equity holders.

Q1. Important question about Payout policy:

How much of FCF to Retain vs. Payout?
to equity holders

Q2. If payout, then

How much to payout as
Dividends vs Repurchases?

Fig. 17.1, Berk (2018)

Growth through Ready for unplanned
planned opportunities opportunities, called
“financial slack”
4
 Equity Payout: Why & How
Why do firms payout cash dividends or engage in share repurchases?
• When firms do not require the cash for new projects
• When there are no more projects with NPV>0
• When the ROI of new projects is less than the cost of capital
• In all cases, better that surplus cash be returned to shareholders than used inefficiently in the firm

How to payout as FCF to equity holders?

Share repurchases Dividends

• Open-market
• Equal access Stock Dividends: Cash Dividends:
• Selective buyback • Dividend • Regular
Reinvestment • Extra
Plans (“DRiP”) • Special
• Liquidating

5
 Equity Payout: Types of Share Repurchases (Buybacks)
Repurchased shares:
• Are held in the corporate treasury and resold if firm needs to raise equity capital.
• Have no value and are not counted among the outstanding shares of the firm.

Types of share repurchases (or share buybacks):

• Open market repurchase: the firm announces its intention to repurchase shares on the open
market and then proceeds to do so just like any other market investor.

• Off-market buyback: the firm invites current shareholders to sell their shares back to the firm.
• An equal access buyback is when the firm offers to repurchase the same proportion of
shares as owned by each shareholder at either a fixed price or through a Dutch auction.

• A selective buyback is when the firm offers to purchase shares from only few shareholders.

6
 Equity Payout: Why Share Repurchases (Buybacks)
Why do firms repurchase their shares?

1. To change capital structure easily and cheaply

• The firm may have too much equity
• Buying back shares is a fast way of increasing leverage

2. To reduce excess cash without paying dividends

• As we shall see, paying dividends has signalling effects that the firm’s manager want to avoid

3. To reduce the excessive shares in the market

• Excess shares causes “equity overhang” – a lot of shares that want to be sold but no major
buyer
• Large blocks of shares caused by a major investor wanting to exit their position
• Excess employee stock options that have been vested
• When the firm repurchases these shares, it removes them from the market

4. To provide a positive signal to the market

• (Explained in the next slide)

7
 Equity Payout: Effect of Repurchases on Share Price
Does a share repurchase increase/ decrease share price?
• When repurchasing shares, the number of outstanding shares reduces, which means the total value of
equity is shared with fewer shareholders.
• At the same time, the total value of equity decreases because cash has been returned to shareholders.
• These two factors offset each other so share price should remain constant during a share repurchase.

Why then does share price often rise after a firm announces a share repurchase?
Q1. Who knows more about what is happening in the firm, A. average shareholder or B. the board of directors?
Q2. Who makes the decision to repurchase shares, A. average shareholder or B. the board of directors?

Q3. When does a firm buy back its shares, when they are U. underpriced or O. overpriced?

Q4. What do investors do when they hear the firm buying back its own shares, B. buy or S. sell?
Q5. What happens to the share price when many investors do the same thing, price R. rises or F. falls? ANS: B B U B R

This is called the Signaling Effect of Share Repurchases.

When a firm buys back its own shares, it’s signaling undervalued share price  market sees this and reacts positively

8 POLL
 Equity Payout: Dividends
Dividends are payments of profits of the firm to its shareholders
• They are not obligatory until a dividend is declared by the board of directors.
• The board decides the amount and date of the dividend.
• Once declared, the total amount is entered into the balance sheet as a current liability.

Types of dividends: Examples

• Regular cash dividend: cash payment directly to Microsoft:
shareholder periodically in the normal course of • Paid its first dividend in March 2003 of $0.08/share
business, usually quarterly (US), semi-annually (AU) • By 2018, it paid regular dividends of $0.42 or $3.3 B.
or annually. • In December 2004, it paid a special dividend of
• Extra cash dividend: a non-periodic cash payment $3.08/share or $32 B.
made at the same time as regular dividend. • (See next slide)
• Special dividend: a one-off payment that is usually
larger than the regular dividend. Vodafone:
• Liquidating dividend (or return of capital): a cash • Paid a liquidating dividend of $84 B following the sale
payment due to the sale of a major assets, such as a of its stake in Verizon Wireless.
division or subsidiary firm.

9
 Microsoft dividend history

MICROSOFT (MSFT) MICROSOFT ALL DIVIDENDS TO

HISTORY OF REGULAR DIVIDENDS 2018
0.5 Microsoft (MSFT) 3.5
0.45 • Founded in 1975 3.08
Cash Dividend Amount ($)

3
0.4
• Publicly listed in 1986 Microsoft dividends:
0.35
• First dividend in 2003 2.5 • 1st dividend (02/2003) $0.08
0.3
• Stable dividends in 2005 • 2nd dividend (10/2003) $0.16
0.25 2
• 3rd dividend (08/2004) $0.08
0.2
0.15
1.5 • 4th dividend (11/2004) $3.08 (Special)
0.1 • 5th dividend (02/2005) $0.08
1
0.05
0 0.5 0.420.46
0.420.46
0.42
0.42
0.310.36
0.31
0.31 0.39
0.360.39
0.36
0.31 0.39
0.360.39
0.2
0.20.23
0.2
0.2 0.28
0.230.28
0.230.28
0.230.28
1/02/2005
1/12/2005
1/10/2006
1/08/2007
1/06/2008
1/04/2009
1/02/2010
1/12/2010
1/10/2011
1/08/2012
1/06/2013
1/04/2014
1/02/2015
1/12/2015
1/10/2016
1/08/2017
1/06/2018
0.16 0.080.090.1
0.090.1
0.09 0.11
0.1 0.13
0.11
0.1 0.13
0.110.13
0.110.13
0.130.16
0.130.16
0.130.16
0.130.16
0 0.08 0.080.08
0.08
0.08

1/02/2003
1/01/2004
1/12/2004
1/11/2005
1/10/2006
1/09/2007
1/08/2008
1/07/2009
1/06/2010
1/05/2011
1/04/2012
1/03/2013
1/02/2014
1/01/2015
1/12/2015
1/11/2016
1/10/2017
1/09/2018
Ex Dividend Dates

10
 Equity Payout: Dividend payment process
Dividend payment process:
4 business days 2-3 weeks

time
Declaration Ex-Dividend Record Payment
Date Date Date Date
Stock trades Stock trades
“cum dividend” “ex dividend”
(with dividend) (without dividend)

1. The Board of 2. To receive the dividend, 3. The company enters into their 4. Payment cheque is
Directors decides on an investor must own the register the name of the share actually sent out on the
dividend payment share before the Ex- owner on the Record Date. This is an Payment Date.
and announcement Dividend Date. administrative step so the dividend
made on the On the Ex-dividend date, is sent to the correct owner.
Declaration Date. any new shareholder will (Note: The record date is not special
not get the dividend. to the dividend payment process.
Every share trade has a record date
4 business days later.)
11
 Equity Payout: Ex-Dividend Price
What is the price before and after the Ex-Dividend Date? An Example
4 business days 2-3 weeks

Time: -3 -2 -1 0 1 2 3 4 ○○○
time
Declaration 3 Ex-Dividend 5 Record 6 Payment
Date Date Date Date
1 Board declares Price: $10 $10 $10 $9 $9 $9 $9 $9 ○○○ The price falls by exactly the dividend amount
$1 dividend. when trading starts on the Ex-Dividend date.

2 Stock trades 4 Stock trades

“cum dividend” “ex dividend”
(with dividend) (without dividend)

12
 Equity Payout: Why firms pay dividends?
Dividends are non-obligatory payments of the firm’s profits to its shareholders
• We know that firms payout excess cash to shareholders, but why specifically in the form of dividends?
• The fact that dividends are optional is extremely important to understand why firms pay them!

Just as there are signalling effects for share repurchases, there are also
signalling effects of increasing the REGULAR dividends of a firm. CBA Final Dividend 1997 to 2022
$2.50

• An increase in the regular dividend is a signal from the firm’s

$2.00
$1.97 $1.98 $1.99 $2.00
managers that the firm is able to sustain this higher level of $2.00 $1.88
$2.00
$1.98 $2.00 $1.75
dividend for the foreseeable future  a commitment by managers! $1.53
$1.70
$1.50
$1.50 $1.30
• Higher dividends are a credible sign that the foreseeable FCF have $1.12
$1.04
$1.49

increased to a new sustainable level  higher share price $1.00 $0.85 $1.15
$0.75
$0.66
$0.57 $0.82
• The firm’s managers choose to pay regular dividends to signal the $0.50
$0.58
$0.72

future prospects of the company!

$0.00
• Hence the firm’s managers show that they have control of the 1995 2000 2005 2010 2015 2020

firm’s future and hence use dividend policy to justify their own
worth and skill as managers!

13
 Why Share Repurchase vs. Dividend?

We have discussed why firms engage in share repurchases and why firms pay dividends.

But why choose Repurchase vs. choose Dividend?

To understand this choice, we need to understand Theories of Payout Policy

14
 Contents
1. Payout (Dividend) Policy 3. MyExperience Survey
1. FCF and Payout
2. Why firms payout & how 4. Final Exam Content
3. Dividends & Share repurchases
4. Dividend payment process 5. Course Summary
5. Why firms pay dividends
Let’s look at this now
2. Four Theories of Payout Policy
1. MM dividend irrelevancy theory
2. Bird-in-hand theory
3. Tax preference theory
4. Classical tax vs. Aust. Imputation Tax System
5. Signalling theory
6. Examples: Perfect vs. Imperfect Capital Mkts

15
 Summary of 4 Theories of Payout Policy
2. Bird-in-hand theory:
We will look at four theories of payout policy*: • We relax the homogeneous expectations assumption:
some investors are more risk averse than others.
1. MM dividend irrelevancy theory*:
• Regardless of paying low or high or no
dividends, firms create no value for
investors.
• This theory depends on the MM’s Perfect
Capital Market Assumptions (PCMA): 3. Tax preference theory:
• Investors have homogeneous • We relax the MM assumption of no taxes.
expectations.
• No taxes.
• Investors and managers have the same
information (No info. asymmetry).
• Relaxing these assumptions lead to different 4. Signalling theory:
theories of payout policy • We relax the assumption that investors and managers
have the same information.

* The general name is “Payout Policy”, but the original name used by MM is “Dividend Policy”.
Both refer to the fact that firms can pay dividends or buyback their own shares.
16
 Theory 1: MM dividend irrelevancy theory

Modigliani & Miller Dividend Irrelevance Proposition:

In perfect capital markets, holding fixed the firm’s investment policy, a
firm’s dividend policy is irrelevant and does not affect the initial share price.

MM argue that with PCMA, regardless of paying high or low dividends, no

value is created by the firm. Hence dividend policy is irrelevant.

MM make “perfect capital market assumptions” (PCMA), some of them include:

• Investors have homogeneous expectations.
• No taxes or transaction costs.
• Investors and managers have the same information.

We later relax each one of these assumptions to see the effect of payout policy
on the value of the firm, i.e. share price.

17
 Theory 1: MM dividend irrelevancy theory
MM argue that investors can create their own “homemade” dividends according to their
preference independent of the firm’s dividend payout policy.
Assuming no personal or corporate taxes: 10% homemade 40% homemade
dividend dividend
Investor starts with Firm pays (low) Investor sells Firm pays (high) Investor sells
$1 dividend 10 shares* $4 dividend 40 shares*
No. Shares 100 100 90 100 60
Price/share $10 $9 $10 $6 $10
Share wealth $1000 $900 $900 $600 $600
Cash in-hand $0 $100 $100 $400 $400
Total Wealth $1000 $1000 $1000 $1000 $1000

Investor’s “10% home-made Investor’s “40% home-made

dividend” provides an equivalent dividend” provides an equivalent
cash flows to firm’s 10% dividend. cash flows to firm’s 40% dividend.

If investors can do what firms do, firm dividend policy is irrelevant!

* “Investors sell shares” to create “a homemade dividend” is equivalent to a firm’s share repurchase of its own shares
18
 Theory 1: MM dividend irrelevancy theory
In summary:

Firm’s different dividend Created no wealth

payout policies for the investor MM: In perfect capital markets,
dividend policy is irrelevant.
Investor’s homemade Created no wealth
dividend strategies for the investor

MM Dividend Irrelevance Proposition:

In perfect capital markets, holding fixed the firm’s investment policy, its dividend policy is irrelevant and does
not affect the initial share price.

Important to remember why we study payout policy under PCMA:

PCMA provide a baseline to understand how market imperfections or frictions affect payout policy.
As we relax each restriction, different things happen, which we could not see if were to start in the real world!
… we start to relax the PCMA now…
19
 Theory 2: The “bird in-hand” theory
MM assumes that investors have homogeneous risk preferences. In reality, this is not true.
When we remove this assumption, we have the “bird in-hand theory”:

Bird in-hand theory says: As a consequence:

• Investors are risk averse. • Investors are more willing to pay higher prices for
• Investors have different expectations to firm stocks that pay higher dividends now than for
managers. stocks that reinvest for uncertain future capital
• Investors prefer certain cash now rather than gains;
uncertain future capital gains. • Payout policy changes the value of the firm.

Bird in-hand theory High dividends in the hand now are worth
more than uncertain future capital gains.
Share Price $

MM Irrelevancy i.e., higher dividend payout is positively

related to share price

E.g., Pensioners with fewer years to live

prefer dividends now than waiting for
capital gains they may never enjoy
Dividend Payout
20
 Theory 3: Tax preference theory
MM assumes that there are no taxes. In reality, this is not true. When we
remove this assumption, we have the Tax Preference Theory:
Because shareholders

1. Pay personal income tax on dividends, and

2. Pay capital gains tax on shares they sell, including

share repurchases

… they will have a preference for the way they are paid.

Conclusions of this theory:

As in most countries the tax on dividends is greater than tax on capital
gains, there is a tax preference for capital gains, i.e., share repurchases.

However, in Australia because of its unique imputation tax system, there is

Why? What’s the evidence?
a tax preference for dividends.
21
 Berk (2018): Figure 17.2
Theory 3: Tax preference theory

Why is there a tax preference for share repurchases

in most countries?

As seen in Figure 17.2, in most countries the

tax on dividend income is greater than the
tax on capital gains.

22
 Classical Tax vs. Australian Imputation Tax systems
However, in Australia, this is NOT the case! In Australia, there is a tax preference for dividends because of this
country’s unique imputation tax system:

“Classical” tax system Classical tax (double-taxation) System:

• Corporate profits taxed at corporate tax rate Corporate Profit: $1000
• What is leftover is distributed to shareholders, who 1st tax: Corporate tax 30%: - $300
pay personal tax on this income Distribute to shareholder: $700
• This is a “double taxation system” 2nd tax: Shareholder pers. tax 45%: - $315
Shareholder left with: $385 Effective tax rate = 61.5%

Australian “imputation” tax system Australian Imputation Tax System:

• In July 1987, Australia effectively abandoned the Corporate Profit: $1000
classical “double taxation” system by introducing Corporate tax 30%: - $300
the imputation tax system. Distribute to shareholder: $700 Add back as franking credit
• Shareholders are now treated as partners in the Shareholder franking credits: $300
firm. It means the firm’s profits are treated as Taxable (gross) personal income: $1000
personal income for shareholders, who only pay Shareholder personal tax 45%: - $450
personal tax. Shareholder left with: $550 Effective tax rate = 45%
• Corporate taxation is effectively collecting taxes on
behalf of individual shareholders.

23
 The Australian Imputation System: Deeper Example

Personal marginal income tax rate 45% 30% 15%

Corporate Level
Operating income 1000 1000 1000
Tax collected here is effectively tax
Corporate tax @ 30% (T=0.3) 300 300 300
collected on behalf of shareholder
After tax income distributed as dividend 700 700 700
Individual Level
[A] Dividend before tax 700 700 700
Taxable personal income (Gross personal income) 1000 1000 1000 = 700 / (1 – T) this called “grossing up the dividend”

Personal income tax @ marginal rate 450 300 150

Franking credit is equivalent to the
Less Franking credit (tax paid on behalf of shareholder) (300) (300) (300)
corporate tax collected
[B] Tax payable to (owed by) Australian Tax Office 150 0 (150)
[C] = [A]-[B] Net Dividend received by shareholder 550 700 850

24
24
 Classical Tax vs. Australian Imputation Tax systems
Table 17.2, Berk (2018)
Note to Students:

Please study this table, which contrasts the

Classical Tax and Australian Imputation Tax
systems.

We use the results from this table later.

25
 Theory 3: Tax preference theory
In Australia, there is a tax preference for dividends because of this country’s unique imputation tax system:

Table 17.2, Berk (2018)

1. In Australia, the tax on dividend income falls under
the imputation tax system:

Use this for later

26
 Theory 3: Tax preference theory
In Australia, there is a tax preference for dividends because of this country’s unique imputation tax system:

Capital Gain = Selling price – Buying price

• Capital gains taxes are paid on shares sold for higher than buying price.
• Share repurchases by the firm mean shareholders have to pay capital gains tax.
Table 17.3, Berk (2018)
2. In Australia, repurchased shares trigger capital gains tax,
which depends on how long you have owned the shares:
1. If ownership > 1 year, then taxed on half the capital gain.
2. If ownership < 1 year, then taxed on the full capital gain.

Use this for later

27
 Theory 3: Tax preference theory
In Australia, there is a tax preference for dividends because of this country’s unique imputation tax system:

Compare After-tax Income from Dividends vs. Share repurchases (Capital Gains):
The table compares dividend income and share repurchase income based on $0.700 before personal tax.
Personal Tax Rate 45% 30% 15%
Dividend or Capital Gain Income Bef. Pers. Tax 0.700 0.700 0.700
From previous Dividend Income After Tax 0.550 0.700 0.850
two slides Capital Gain Income After Tax (held > 1 year) 0.543 0.595 0.648

High personal tax investors are indifferent Middle and low personal tax investors
between Dividends or Capital Gains have a strong preference for dividends

In conclusion:
• In most other countries, investors prefer repurchases to dividends.
• But in Australia, investors prefer dividends to repurchases.
• Firms should be careful changing dividend policy to not lose investors who have a tax preference for dividends.

E.g., CBA should not suddenly change its dividend policy and pay lower dividends because pensioners on low tax brackets
depend on their dividends to live. Changing dividend policy will cause them to sell their shares and buy other shares with
higher dividends that suit their tax preference.
28
 Theory 4: Signalling Theory
MM assumes that managers and investors have the same information. This is unrealistic.
• There is in fact information asymmetry between managers and investors: Managers (including Executive
directors and Non-executive directors on the Board) know much more about the future prospects of the
firm than investors do.
• As a consequence their payout policy decisions contain valuable information about this inside knowledge.
In other words, these decisions signal what they know about the future prospects of the firm.

This is seen in dividend smoothing behaviour: Microsoft (MSFT) History of Quarterly Dividends
Firms infrequently adjust the size of their regular dividends 0.5
0.45
in order to maintain a constant level or smooth dividends.

Cash Dividend Amount ($)

0.4
0.35

Managers smooth dividends because: 0.3

0.25
(1) They believe investors prefer stable dividend with 0.2
sustained dividend growth; and 0.15

(2) They believe it demonstrates their strong managerial 0.1

0.05
capability to maintain control of the firm in good times 0 1/02/2005
1/09/2005
1/04/2006
1/11/2006
1/06/2007
1/01/2008
1/08/2008
1/03/2009
1/10/2009
1/05/2010
1/12/2010
1/07/2011
1/02/2012
1/09/2012
1/04/2013
1/11/2013
1/06/2014
1/01/2015
1/08/2015
1/03/2016
1/10/2016
1/05/2017
1/12/2017
1/07/2018
1/02/2019
and bad.

Ex Dividend Dates
29
 Theory 4: Signalling Theory
• Raising dividends is a signal that managers believe the
firm’s long-term prospects are good enough to sustain Microsoft (MSFT) History of Quarterly Dividends
the higher dividend. 0.5

• They signal that “The future FCF have risen to a 0.45

Cash Dividend Amount ($)

0.4
new level that can sustain a higher dividend for the 0.35
foreseeable future” 0.3

• The market sees this positive signal so share price 0.25

0.2
increases. 0.15
0.1
0.05
• Cutting dividends is a signal that managers believe the 0
long-term future of the firm is too weak to sustain the

1/02/2005
1/09/2005
1/04/2006
1/11/2006
1/06/2007
1/01/2008
1/08/2008
1/03/2009
1/10/2009
1/05/2010
1/12/2010
1/07/2011
1/02/2012
1/09/2012
1/04/2013
1/11/2013
1/06/2014
1/01/2015
1/08/2015
1/03/2016
1/10/2016
1/05/2017
1/12/2017
1/07/2018
1/02/2019
previous level of dividend.
• The level of future FCF has dropped so current Ex Dividend Dates

dividends are no longer sustainable

• The market interprets this as a bad signal so share
price decreases

Important conclusion: Managers use relative dividend size to signal to investors the future prospects of the firm.

30
 Example Payout vs. Retain: perfect capital markets
Example 17.2, Berk (2018)
Barston Mining has $100 000 excess cash. It can either (1) payout all immediately as a dividend, or (2) retain, reinvest in a
6% Treasury bond, and payout the proceeds in one year? In a perfect capital market, which option is best for shareholders?

Now 1 year later

Payout immediately • Shareholders receive $100,000 • Shareholder receives 100,000(1.06) = 106,000

• Shareholders reinvest in a 6% T-bond

Retain, reinvest, • Firm reinvests in a 6% T-bond • Firm receives 100,000(1.06) = 106,000

payout next year
• Firm pays out $106,000 to shareholders

Conclusion In a perfect capital market, shareholders can do what the firm does. No value created by the firm.
Payout policy is irrelevant.

31
 Example Payout vs. Retain: imperfect capital markets
Example 17.3, Berk (2018)
Barston Mining pays 30% corporate tax on interest earned on a one-year Treasury Bond paying 6% interest. Would an
Australian imputation tax paying shareholder with a marginal tax rate of 45% prefer Barston (1) to pay out $100 000 excess
cash immediately or (2) retain the cash and one year later pay a dividend from the accumulated earnings?

Option 1: Barston pays out immediately: Option 2: Barston retains and invests:
• Firm pays out $100 000 dividend immediately. • Invest $100 000 at 6% for one year in Treasury Bond
• Investor’s grossed up income is 100 000/(1-0.3)=142857 • After 1 year, interest is $6000, corporate tax is
• Investor’s net tax payable is $142 857*(45%-30%)=21 429 6000*30%=$800, and after-tax 6000*(1-0.3)= $4200.
• After-tax income is 100 000 – 21 429 = 78 571. The • Dividend of $104 200 is paid to investor
investor reinvests it in the one-year Treasury Bond at 6%. • Investor’s grossed up income is 104200/(1-0.3)=
• A year later, after-tax interest earned is 78 571*6%*(1- $148 857
45%)=2 593 • Net tax payable is 148 857*(45%-30%)=$22 329
• Final after tax income is $78 571 + $2 593 = $81 164 • After-tax income is $104 200 - $22 329 = $81 871.

Conclusion: The 45% marginal personal tax rate investor would be $707 better off if Barston retained and reinvested the
excess cash in the one-year Treasury Bond, i.e. Option 2 is better.

32
 Summary of 4 Theories of Payout Policy
2. Bird-in-hand theory:
We will look at four theories of payout policy*: • We relax the homogeneous expectations assumption:
some investors are more risk averse than others.
1. MM dividend irrelevancy theory*: • Risk averse investors prefer large dividends now rather
• Regardless of paying low or high or no than uncertain capital gains in the future
dividends, firms create no value for • So investors will pay higher prices for stocks that pay
investors. higher dividends
• This theory depends on the MM’s Perfect
Capital Market Assumptions (PCMA): 3. Tax preference theory:
• Investors have homogeneous • We relax the MM assumption of no taxes.
expectations. • Because of differences in personal tax, some investors
• No taxes. will prefer dividend income while others will prefer
• Investors and managers have the same capital gain income.
information (No info. asymmetry).
• Relaxing these assumptions lead to different 4. Signalling theory:
theories of payout policy • We relax the assumption that investors and managers
have the same information.
• As managers know more about the future prospects of
* The general name is “Payout Policy”, but the original name used by MM is “Dividend Policy”. the firm, they will signal to investors what they know
Both refer to the fact that firms can pay dividends or buyback their own shares. through the dividends.
33
 Contents
Let’s look at this now
1. Payout (Dividend) Policy 3. MyExperience Survey
1. FCF and Payout
2. Why firms payout & how 4. Final Exam Content
3. Dividends & Share repurchases
4. Dividend payment process 5. Course Summary
5. Why firms pay dividends

2. Four Theories of Payout Policy

1. MM dividend irrelevancy theory
2. Bird-in-hand theory
3. Tax preference theory
4. Classical tax vs. Aust. Imputation Tax System
5. Signalling theory
6. Examples: Perfect vs. Imperfect Capital Mkts

34
MyExperience Survey
Please take 5 minutes now to complete the survey available in Moodle
Final Exam
 Format of Final Exam
• The final exam will be held on Saturday 2nd December at 2.00pm
• You will have 120 minutes to complete the Moodle exam.
• Exam structure:
• 15 questions in total
• Part 1 (12 questions): Includes 3 questions from CFA Ethics Trading and Analysis
program
• Part 2: 3 qualitative short-answer questions (BCom students: myBCom course
points for PLO3)
• This is an open book exam. You can use any materials from the course. You can use
Excel or a calculator.

37
Course Summary
 Week 1: Review of Financial Mathematics
Single Cash Flows

Present Value: 𝐶 𝐶 1 𝑟 Future Value: 𝐶 𝐶 1 𝑟

Multiple Cash Flows

Perpetuities Annuities
𝑃𝑀𝑇 𝑃𝑀𝑇
𝑃𝑉 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑃𝑉 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 1 1 𝑟
𝑟 𝑟

𝑃𝑀𝑇 𝑃𝑀𝑇 1 𝑔
𝑃𝑉 𝐺𝑟𝑜𝑤𝑖𝑛𝑔 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑃𝑉 𝐺𝑟𝑜𝑤𝑖𝑛𝑔 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 1
𝑟 𝑔 𝑟 𝑔 1 𝑟

Converting Rates

𝐸𝐴𝑅 𝐴𝑃𝑅 m = frequency of compounding per year

1 1 APR = Annual Percent Rate (quoted rate compounded m/year)
1 𝑚
EAR = Effective Annual Rate (rate with m=1 compound/year)
Poll
39
 Week 1: Financial mathematics is all about …
Combining multiple cash flows into
1 a single cash flow and moving it
to the right time.

Correct use of the formulas is all about ...

Following the standard
2 pattern of cash flows.

40
 Week 1: Debt Valuation Other names

Amortizing loans
• Lender lends the principal now. Fixed repayment loans
• Borrower pays back the principal and interest with fixed Diminishing loans
periodic payments. Reducing principal loans
• E.g. Personal loans, home and car mortgages

Discount loans Zero coupon bonds (ZCB)

• Lender lends less than the maturity value now. “Zeros”
• Borrower repays in the future a fixed maturity value.
• E.g. Zero-coupon bonds, promissory notes, commercial
paper, bills of exchange

Interest-only loans Coupon bonds

• Lender buys the bond and receives interest payments from Coupon-paying bonds
the borrower in the form of coupons “Straight bonds”
• Borrower repays a fixed future amount called the face value. “Vanilla bonds”
• E.g. corporate bonds, government bonds

41
 Week 2: Equity Valuation Methods

Three basic methods of valuing stock (equity market shares)

Revise
1. Intrinsic valuation methods – present value of future expected cash flows
Methods we know from financial mathematics.

2. Comparables methods – comparing similar companies

Uses Equity Multiples and Enterprise Value Multiples

3. Options methods – a stock is valued as a put option on debt

Sophisticated option pricing algorithms… beyond this course.

42
 Week 2: Equity Valuation OUR FOCUS

Constant perpetual
DDM

Dividend discount Growing perpetual

models (DDM) DDM
Intrinsic Assume the stock pays regular
dividends. A good model for
valuation large, stable firms in stable 2-stage DDM Multi-stage DDM
models industries. E.g., utilities,
supermarkets, etc.

Discounted Cash Flow

(DCF) Models, or
Free Cash Flow Models
These models are useful for stocks that don’t pay
dividends and the DDM is not useful. It is a more
flexible model because it includes the DDM.

43
 Week 2: The Idea of DDM
For n holding periods: PV of future dividends PV of selling price

𝐷 𝐷 𝐷 𝐷 𝑃
𝑃 ⋯
1 𝑟 1 𝑟 1 𝑟 1 𝑟 1 𝑟

Models’ assumptions about

dividends & selling price
(I) Constant 𝐷
𝐷 𝐷 ⋯ 𝐷 ,𝑛 →∞ 𝑃
perpetual DDM 𝑟

Dividend 𝐷 𝐷 1 𝑔 𝐷
(II) Growing 𝐷 𝐷 1 𝑔 𝑃
discount models 𝑟 𝑔
perpetual DDM …
(DDM)
𝐷 𝐷 1 𝑔 ,𝑛 →∞
𝐷
Constant 𝑃
• Stage 1: Div are anything perpetuity 𝑟
(III) 2-stage DDM • Stage 2: 𝑃 PV(perpuity) Growing 𝐷
perpetuity 𝑃
44 𝑟 𝑔
 Week 2: Estimating Dividends in DDM: the choice
Firms face a trade-off, so they must choose between one of two choices, either:
1. To Retain Earnings and invest in the firm’s operations i.e., low 𝑫𝟏 /high 𝒈, or
2. To Payout Dividends to increase share price, but leaving little to invest, i.e., high 𝐷 /low 𝒈 .

ANOTHER KEY QUESTION: How to decide between these two choices?

An Example of what this mean:

Intuitively, if the rate of return from investing earnings (ROI) is higher than the firm’s You sell shares worth $1000 and
expected return on equity (𝑟 ), then this is good for shareholders, otherwise earnings invest in new a machine. Your
should be paid out as dividends. investors expect a return of 10%
(expected return on equity) and
the machine promises a return of
12% (return on investment).
In other words: Is this a good or bad deal?
If 𝑅𝑂𝐼 𝑟 then retain earnings and invest to increase future dividends
If 𝑅𝑂𝐼 𝑟 then payout dividends by increasing the next dividend ANS: Since 𝑅𝑂𝐼 𝑟 then this is a
good deal!
If 𝑅𝑂𝐼 𝑟 then it would be a
bad one.

45
 Week 3: Different types of Cash Flow & Free Cash Flows
There are five basic types of Cash Flows: Also called

1. EBITDA = Revenue – COGS – S&A

2. Cash Flow (CF) = NI + Depr – Chg NWC CF from Operations in CF Statement

3. Free Cash Flow = NI + Depr – Chg NWC – Capex Free Cash Flow in CF Statement

4. Free Cash Flow to Equity = NI + Depr – Chg NWC – Capex + Debt issued FCFE

5. Free Cash Flow to the Firm = EBIT(1-T) + Depr – Chg NWC – Capex FCFF or Unlevered FCF

Which one is this course all about?

When we talk about FCF in Finance, which one do we mean? POLL

46
 Week 3: What is Free Cash Flow?
Free Cash Flow (FCF) of a project or firm are the incremental cash flows at a particular moment in time that are
available (i.e. “free”) to pay the firm’s capital providers (equity and debt investors). This means after paying all
the employees, suppliers, taxes, new machines and their maintenance, purchase of land and other assets to
start and maintain project operations, what is leftover to pay the capital providers is called FCF.

Dividends +
Repurchases
Firm Shareholders
Operating Net cash flow FCF
Capital providers / Investors in the firm
assets
Reinvested cash flow Interest Debtholders
(Capex & NWC investments) +
Principal

Important: FCF must be seen from the capital providers’ perspective, not the firm’s perspective!!

Ask yourself: The Cash Flows are “FREE” for whom?  Free for the capital providers of the firm!!

47
 Week 3: Formulas to estimate Free Cash Flow Includes operating expenses e.g., COGS
and overhead expenses e.g., SG&A
Formula 1 Formula 2

FCF = EBIT x (1 – Tax Rate) FCF = (Revenue – Cost) x (1 – Tax Rate)

+ Depreciation + Tax Rate x Depreciation
– Change in Net Working Capital – Change in NWC
– Capital expenditures – Capital Expenditure
+ Terminal cash flows + Terminal cash flows
Note 1: EBIT = Earnings Before Interest and Tax = Revenue – Cost – Depreciation
Note 2: “Depreciation” means “Depreciation and Amortization”
Note 3: Terminal cash flows include: decommissioning costs, after-tax salvage, and recovery of Net Working Capital.
Note 4: Textbooks combine Capex and Terminal CF and call it “Capex”. I split them to explicitly teach how to calculate Terminal CF.

Why do these formulas work to estimate FCF?

The following example helps explain why

48
 Week 3: Why use EBIT(1-T) and not Net Income?
Two identical companies are the same in everything excepting financing structure
Called a “levered company”
P&L with NO DEBT (No interest payments) An “unlevered company” P&L WITH DEBT (Includes interest payments)

A 100% equity financed company This company has $5,000 Debt at 10% interest

Revenue $56,339.00 Revenue $56,339.00

Cost $39,331.00 Cost $39,331.00
Gross Margin (or Profit) $17,008.00 Gross Margin (or Profit) $17,008.00
Sales, General & Administrative Costs Sales, General & Administrative Costs
Research & Development Costs Up to here, financing Research & Development Costs
structure does not
Depreciation & Amortization Costs $13,333.33 affect either company
Depreciation & Amortization Costs $13,333.33
Operating Profit $3,674.67 Operating Profit $3,674.67
Other Income Other Income
Earnings Before Interest and Tax (EBIT) $3,674.67 Earnings Before Interest and Tax (EBIT) $3,674.67
Interest expense $500.00
Up to here, companies can Earnings Before Tax (EBT) $3,174.67
Tax @30% $1,102.40 be compared regardless of Tax @30% $952.40
Earnings = EBIT(1-T) $2,572.27 financing structure Net income = (EBIT – Int. Exp.)(1-T) $2,222.27

ANS: Using EBIT(1-T), we can compare companies with different financing structures as if they were all unlevered.
Important concept: EBIT(1-T) is the after-tax profit a levered company would HYPOTHETICALLY have if it were unlevered.
49
 Week 4: Forecasting FCFs begins with historical FCFs

0
time

To forecast the FUTURE

…what happened in most often (but not always)
the past! starts with understanding …

What are we assuming about

the FUTURE when we say this?

50
 Week 4: FCF Forecasting is an iterative process
Assumptions Time
• YoY Sales growth
• COGS as % of sales Forecasting is therefore complicated!
• Inventory as a % of COGS
To help visualize what is happening…
Income Statement
• stack the financial statements vertically!
• Sales • Simplify the financial statements
• COGS • Look first at historical cash flows …. VIDEO 1 on CPU-AU
• SG&A
• Depreciation … • Then look at future cash flows …. VIDEO 2 on CPU-AU
• Need to link the financial statements
Balance Sheet • Make assumptions to simplify forecasting
• Accounts receivable • THIS IS WHAT WE WILL LEARN TO DO NOW!
• Inventory
• Accounts payable NOTE: For this course and for the Team Assignment, it is
NOT necessary to forecast the Cash Flow Statement
• Net PPE …

51
 Week 4: Berk 18.2: Forecasting Financial Statements
- The percentage of sales method
We will follow quite closely the textbook examples using a vertical layout.

Example: A firm called KMS Designs is a boutique women’s fashion house.

• Specializes in affordable fashion-forward apparel.
• The firm is growing and external financing is needed.
• We build pro-forma financial statements to forecast its growth and funding needs
• We assume “As sales grow, so do the Costs and Balance Sheet items”  Percentage sales method

What is the Percentage of Sales method?

That key items of Income Statement and Balance Sheet are a “% of the current year’s sales”
• COGS is a % of current year sales
• Depreciation is a % of current year sales
Some of these don’t make sense!
• Cash and equivalents are a % of current year sales
We handle these differently in another example.
• Net PPE is a % of current year sales

52
 Week 4: Berk 18.4 Growth and Firm Value
Recall from Week 2, we said in general terms: Berk Equation 7.12

𝑔 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜

Now we can distinguish two types of growth rates:

Berk Equation 18.4 Internal Growth Rate assumes:
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 • Growth funded only be Retained Earnings
𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠 • No external financing
• Dividends and Share repurchases are okay
𝑅𝑂𝐴 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 • ROA = Return on Assets (Debt + Equity)
Also called plough back ratio
Or (1 – payout ratio)

Berk Equation 18.5 Sustainable Growth Rate assumes:

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 • Growth funded by external financing while
𝑆𝑢𝑠𝑡𝑎𝑖𝑛𝑎𝑏𝑙𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐸𝑞𝑢𝑖𝑡𝑦 maintaining a fixed Debt/Equity Ratio
• No new equity is issued.
𝑅𝑂𝐸 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 • Dividends and Share repurchases are okay
Or (1 – payout ratio) • ROE = Return on Equity
53
 Week 5: WCM: Operating Cycle vs. Cash Conversion Cycle
With the Working Capital components measured in days, we define:

Operating Cycle = Inventory Days + Accounts receivable days

= Average days from purchasing inventory to receiving cash for goods/services

Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days
= Average days from the time cash goes out to the time cash comes in

A Poll Question:
Which is better from a finance
perspective:
A short CCC or long one?

From a finance perspective, investors need to fund the Cash Conversion Cycle! Poll
54
The longer the cycle, the more capital is tied up, the greater the funding cost.
 Week 7: Risk & Return
Historical vs. Expected & Single Asset vs. Portfolio

Historical Returns Expected Returns

• Return that happened in the past • Return that is hoped for the future
• Actual or realized returns • Different from actual or realized returns
• One-period historical returns • Depends on the probabilities of future
• Historical average returns outcomes

Types of Returns

Single or Individual Asset Returns Portfolio Returns

• Standalone assets • A number of assets taken together as
one “bag” of assets

55
 Week 7: Portfolio Volatility: The idea of diversification
Example: (bringing results together)
𝑤 0.3 , 𝑤 0.7 and 𝜌 0.32
States Recession Neutral Boom Weights E(R) 𝝈 𝑹
Probability 0.25 0.50 0.25
Stock A -20% 15% 35% 30% 𝑬 𝑹𝑨 11.25% 𝝈 𝑹𝑨 19.80%
Stock B 30% 15% -10% 70% 𝑬 𝑹𝑩 12.5% 𝝈 𝑹𝑩 14.36%
Portfolio 𝑬 𝑹𝑷 12.125% 𝝈 𝑹𝑷 9.91%

Portfolio Diversification is defined as:

1. portfolio return = weighted sum of returns
2. portfolio risk < weighted sum of risks
Because of less than perfect correlation, i.e. 𝜌 1
This means for diversification to occur, you don’t need 𝜌 0
𝜎 𝑅 √ 𝜔 𝜎 𝜔 𝜎 2𝜌 𝜔 𝜔 𝜎 𝜎 If 𝜌 0.32, σ 0.3 .198 0.7 .1436 2 0.32 .3 .7 .198 .1436 9.91%
Diversification, 𝜌 1
If 𝜌 0.32, σ 0.3 .198 0.7 .1436 2 0.32 .3 .7 .198 .1436 13.31%

If 𝜌 1.00, σ 0.3 .198 0.7 .1436 2 1.00 .3 .7 .198 .1436 15.99% Wght sum of risks, 𝜌 1
56
 Week 7: Imperfectly correlated: “independent” risk factors
𝜌 1  returns imperfectly correlated  some diversification

60% Stock X 40% Stock Y Portfolio XY

Rate of Rate of Rate of E(r) = 0.6(15%) + 0.4(15%) = 15%
E(r)=15% E(r)=15%
Return Return Return
25 25 25

15 15 15

0 Time 0 Time 0 Time

-10

57
 Week 7: Diversification reduces independent risk only
Total Risk (%)
Total risk = Common risk + Independent risk
35% 𝜎 : Total Risk
𝜎 𝜎 𝜎
𝜎 : Independent Risk
The risk of a portfolio
Common risk High independent risk
with one asset (N=1) 𝜎 : Common Risk
Diversify investment across
many different stocks 20%
The risk of a large Common risk Low independent risk
portfolio (N=40)

Diversification reduces the total risk of a portfolio,

reducing independent risk but common risk stays the same 1 35-40 No. of assets in portfolio
Total risk of a single asset (N=1)
Total risk of a large portfolio (N=40)
= Common risk + High indept risk
= Common risk + Low indept risk

Very Important Conclusion: Diversification reduces independent risks, not common risk
58
 Week 7: Asset pricing: Individual asset vs Market portfolio
In a competitive market, if individual asset 𝑖 is poorly priced with return/risk ratio < market portfolio return/risk ratio, investors will
sell asset 𝑖  price goes down  return goes up  return/risk ratio increases. Similarly, if asset 𝑖 is well priced with return/risk ratio
> market portfolio return/risk ratio, investors will buy asset 𝑖  price goes up  return goes down  return/risk ratio decreases.
So due to competitive forces:

𝐼𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑖 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

𝐼𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑖 𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑖𝑠𝑘

𝐸 𝑅 𝑅 𝐸 𝑅 𝑅
𝜎 , 𝜎 ,

𝐸 𝑅 𝑅 ,
𝐸 𝑅 𝑅
,

This is the famous Capital Asset Pricing Model (CAPM)

𝐸 𝑅 𝛽 𝐸 𝑅 𝑅 𝑅 where 𝛽
,
,

59
 Week 8: Cost of Capital in a Nutshell
In corporate finance, cost of capital refers to two things:

1) A firm’s cost of capital is a composite required return of the firm.

Also thought of as:
• The Weighted Average Cost of Capital (WACC)
• The average return for the average systematic risk of the firm.
• The aggregate return of the capital invested in the firm’s securities,
i.e. loans, bonds, common shares, preference shares, etc.
• Return benchmark for projects with the same systematic risk as the firm.
• Used to discount the Free Cash Flows of the Firm

2) A project’s cost of capital: The required return for a specific project.

Also note:
• May be very different from the firm’s cost of capital
• Depends on the systematic risk of the project not the risk of the firm
• Used to discount the Free Cash flows of a project

60
 Week 8: Weighted Average Cost of Capital: WACC
Once we know the market values of each source of capital,
we can calculate the Before Tax WACC:

𝐷 𝑃 𝐸
𝑟 𝑟 𝑟 𝑟
𝑉 𝑉 𝑉

For an all-equity company (after tax WACC): For a leveraged* company after tax WACC:
𝑟 𝑟 𝐷 𝑃 𝐸
𝑟 𝑟 1 𝑇 𝑟 𝑟
𝑉 𝑉 𝑉
since 𝑟 0 𝑟 1 𝑇 𝑤 𝑟 𝑤 𝑟 𝑤
where T is the marginal tax rate of the firm, D, P, and E are the
market values (not book values) of debt, preference shares, and
equity, and 𝑤 ,𝑤 ,𝑤 are the weights.

* What is “leverage”? Q: Why use Market Values for the weights and not Book Values?
In Finance, it means debt. In general, a lever is a small instrument that ANS: Assets have value because of the future cash flows they
helps you easily move and control objects of greater relative size or promise to produce, and MV is forward-looking and dynamic,
weight. So when a firm leverages, it borrows money to purchase and reflecting the investors’ current required rate of return. BV,
control assets that are more valuable than its equity alone can afford. however, is a historical and hence a static perspective.

61
 Week 8: Firm risk vs Project risk
A firm is defined by the projects it invests in because:
• Projects define the firm’s vision and mission – “who we are”, “why we are in business”
• Projects involve huge long-term commitments of resources (time, money, effort) that
cannot be changed easily

Firms undertake many investment projects

• Each investment project has different levels of risk and are of different sizes
• Firm risk is the sum of risks of all the firm’s projects weighted by project size  firm WACC
Return

Weighted sum
of all projects

Proj C

Firm WACC Firm

Firm

Proj Proj B
A
Proj
D

Firm risk
𝛽 Risk
62
 Week 8: What happens if you use SML to find your cost of
capital benchmark? Which project will you choose?
Firm WACC vs. Systematic Risk
Security Market Line
Return
Expected

Accept if From Week 07: SML tells us the return for holding
Above SML means low risk above SML systematic risk defined by the CAPM:
projects have a high 𝐸 𝑅 𝑅 𝛽 𝐸 𝑅 𝑅
expected return for the risk B
level, so should be Accepted!
Firm WACC
Below SML means high risk
A Reject if projects have a low
below SML expected return for the risk
level, so should be Rejected!
𝑅

𝛽 𝛽 𝛽 Systematic
Risk

63
 Week 9: Capital Structure
Fig. 16.1, Berk (2018)
How is capital structure measured?
Typical measures for capital structure:
• D/V Ratio: (Debt/ Total Value) the ratio of
the market value of a firm’s Debt to the
market value of the firm’s Debt and Equity
• D/E Ratio: (Debt/ Equity) the ratio of the
market value of debt to the market value
of equity.
Does capital structure vary between industries?
D/V ratio varies widely across industries:
• High ratios in Financials, Energy, Utilities
• Lots of tangible assets
• Can be sold to recover debt
• Low ratios in IT, Healthcare, Telecoms
• Lots of intangible assets (e.g. people)
• Can’t be easily sold to recover debt

64
 Week 9: Business Risk and Financial Risk
We distinguish two types of systematic equity risk:
• The firm’s undiversifiable systematic risk tied with the company’s
1. Business Risk
operations, industry, and market regardless of how the firm is financed.

2. Financial Risk • Additional undiversifiable systematic risk due to levered financing.

(Systematic) Equity Risk = Business Risk + Financial Risk

IMPORTANT QUESTION:
If equity risk increases for equity
(Systematic) Equity Risk

holders with leverage, what

Financial Risk happens to the expected rate of
 Leverage concentrates the return for equity holders?
business risk on equity holders.
High risk  high expected return!
Business Risk

Debt / Assets

Main Conclusion of this slide: As a firm borrows, more business risk is concentrated on the
equity investors in the form of financial risk, and the expected return on equity increases.
65
 Week 9: Financing a business: levered equity is riskier!
Berk Ch 16.2

Summary of previous 4 slides!

TWO IMPORTANT CONCLUSIONS FROM GRAPHIC!

• Debt bears no risk – constant return regardless to

changes in FCF.

• Levered equity is riskier than all-equity financing –

higher variability of returns to changes in FCF hence
greater slope

66
 Week 9: The Capital Structure Story in a nutshell
This course will only cover up to Two Frictions

Multiple frictions – Corporate Taxes, Bankruptcy Costs, Information Asymmetry,

Transaction Costs, Different borrowing rates, etc..

Two frictions – Corporate Taxes and Bankruptcy Costs: There is an optimal

capital structure balancing the benefits and costs of debt

One friction – Corporate Taxes: Capital structure

matters because debt increases firm value

Perfect Capital Market Assumptions:

Capital Structure is Irrelevant

67
 Week 9: The Capital Structure Story in a nutshell
Debt
All-equity
firm
Introduction Business risk
Equity concentrates 𝑟 increases
on equity
holders

Assumptions: Perfect capital One friction: Taxes Two frictions: Taxes

Effects on: markets (PCMA) and Bankruptcy
Rest of WACC No change Decreases Decreases
the story Firm Value No change Increases with debt Increases/ Decreases
How firms should Capital structure is Borrow as much as Optimal cap. struct.
change cap. struct. IRRELEVANT! you can!! There are limits.
The lecture notes are organized into these three “mini-stories”

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 Week 9: Capital Structure Story: Formula Summary
No frictions: Perfect capital markets (PCMA) One friction: Taxes (Not PCMA) Two frictions: Taxes & Bankruptcy costs
MM Proposition I: Value and cost of capital MM Proposition I: MM Proposition I:
𝐸𝐵𝐼𝑇 V 𝑉 𝑃𝑉 𝐼𝑛𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑𝑠 𝑉 𝑉 𝑃𝑉 𝐼𝑛𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑𝑠
V 𝑉 𝑃𝑉 𝐹𝑖𝑛 𝐷𝑖𝑠𝑡𝑟𝑒𝑠𝑠 𝐶𝑜𝑠𝑡𝑠
𝑟 where 𝑉
(Note: a perpetuity) and 𝑃𝑉 𝐼𝑛𝑡 𝑇𝑎𝑥 𝑆ℎ 𝐷∗𝑇 (Note: Also called Trade-off theory)
Note: Tax benefit of debt is not a function of the interest
rate, but only of debt amount & tax rate.
The formulas build on each other:
𝐸 𝐷 𝐸 𝐷
𝑟 𝑟 𝑟 𝑟 𝑟 𝑟 𝑟 1 𝑇 𝑟
𝐸 𝐷 𝐸 𝐷 𝐸 𝐷 𝐸 𝐷 1. Start with perfect capital markets
MM Proposition II: equity cost of capital MM Proposition II: to determine the value of the
𝐷 firm.
𝑟 𝑟 𝑟 𝑟 𝑟 𝑟 𝑟 𝑟 1 𝑇
𝐸
2. Then we add each friction, one at
Hamada Equation: Firm risk Hamada Equation:
a time to see how the value of the
𝛽 𝛽 1 𝛽 𝛽 1 1 𝑇 firm changes.
Perfect Capital Market Assumptions (PCMA): Perfect Capital Market Assumptions (Not PCMA): Perfect Capital Market Assumptions (Not PCMA):
(1) No taxes; (1) No taxes; (1) No taxes;
(2) No financial distress or bankruptcy costs; (2) No financial distress or bankruptcy costs; (2) No financial distress or bankruptcy costs;
(3) No transaction costs; (3) No transaction costs; (3) No transaction costs;
(4) Investors and firm managers have the same information; (4) Investors and firm managers have the same information; (4) Investors and firm managers have the same information;
(5) Firms & individuals borrow/lend at the risk free rate. (5) Firms & individuals borrow/lend at the risk free rate. (5) Firms & individuals borrow/lend at the risk free rate.
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 Week 9: Capital structure theory: Trade-off Theory
Benefits of Debt Costs of Debt Fig. 16.8, Berk (2018)
𝑉 𝑉 𝑃𝑉 𝑇𝑎𝑥𝑆ℎ𝑖𝑒𝑙𝑑𝑠 𝑃𝑉 𝐷𝑖𝑠𝑡𝑟𝑒𝑠𝑠𝐶𝑜𝑠𝑡𝑠

If 𝐷 𝐷 ∗ , ∆PV(Tax Shields) > ∆PV(Distress Costs)

If 𝐷 𝐷 ∗ , ∆PV(Tax Shields) < ∆PV(Distress Costs)
Where ∆=“marginal benefit of”
𝐷∗ is the optimal level of financial leverage
depending on the industry.

Explaining differences across firms & industries:

The trade-off theory may explain variations in capital
structure across industries:
• Industries with high distress costs (𝐷∗ ) will have
lower optimal debt levels;
• Those with low distress costs (𝐷∗ ) will have higher
optimal debt levels.

Recall: Differences in asset types (tangible vs intangible),

business risk, competition, etc drive differences in capital Industries with high distress costs 𝐷 ∗ Industries with low distress costs 𝐷 ∗
will have low optimal capital structures. will have high optimal capital structures.
structure.
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 Weeks 1-10: Integrating Team Assignment - Stock Pitch
Working in Analyse the stock Value the stock Watch the videos of
Teams of 4-5 • Financials using all the other teams’
students • Strategy financial tools and recommendations
models in FINS2615 and decide whether
• Competition you (as an investor)
Choose a • Industry should buy or sell
Recommend to
publicly listed • Technology, etc their stock.
investors to BUY or
stock
SELL the stock

Make a video of your

recommendation

Lecture & tutorial time dedicated to help you

71
 How the Story of Corporate Finance was explained:
Financial Mathematics
Week 01
Debt
Cash Types Equity Week 02
of CF
Flows Working capital Week 05
management
𝐶𝐹
𝑁𝑃𝑉 𝐶𝐹 Cash Flow Forecasting Weeks 03 and 04
1 𝑟

Capital Asset Pricing Model Week 07

Discount
rate Cost of capital Week 08
(Risk & Return)
Week 10:
Capital structure Week 09 Payout policy

72 HOW DO YOU MAKE MONEY!??

 TO INVEST OR NOT TO INVEST? That is the question!

73 Image from: https://www.litcharts.com/blog/shakespeare/hamletssoliloquy/

THANK YOU!
GOOD LUCK!!