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Corporate Finance ­FIN 622
VU
Lesson 22
PROBLEMS ASSOCIATED WITH HIGH GEARING
& DIVIDEND POLICIES
The following topics will be discussed in this lecture.
Problems associated with high gearing
Bankruptcy costs
Optimal capital structure
Dividend policy
Types of dividends and important dates
Dividend policies
Factors influencing dividend policy
Irrelevance of dividend policy
1. Problems associated with high gearing
A general term describing a financial ratio that compares some form of owner's equity (or capital) to
borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree to which a firm's
activities are funded by owner's funds versus creditor's funds.
The higher a company's degree of leverage, the more the company is considered risky. As for most ratios,
an acceptable level is determined by its comparison to ratios of companies in the same industry. The best
known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest
earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).
A company with high gearing (high leverage) is more vulnerable to downturns in the business cycle
because the company must continue to service its debt regardless of how bad sales are. A greater proportion
of equity provides a cushion and is seen as a measure of financial strength.
M & M model says that debt financing increases the value of firm due to tax shield. However, there are
certain aspects of high gearing that discourage borrowing. These aspects are:
Bankruptcy Costs:
As debt increases, a chance of default of repayment of principal and interest increases. Investors dislike this
and will result in fall in value of firm's securities. The interest tax shield should overweigh the bankruptcy
cost.
Direct bankruptcy costs: in case of liquidation disposal of assets will fetch less than going concern value of
assets. And there are other costs like liquidation and redundancy costs. The loss in value is normally borne
by the debt holders and that's why they demand higher returns for their investment for higher gearing and
eventually this will drive down the firm's security value.
Indirect Bankruptcy Costs:
When a firm goes into liquidation or approaches near bankruptcy because under sever financial distress.
Employees leaving, supplier refusing to provide goods on credit, and customers even leaving fearing firm
will not be able to honors its warranty and after sales services commitments. This will reduce future cash
flow and therefore, value of firm.
2. Bankruptcy Costs
Bankruptcy is a legal proceeding whereby an individual or a business can declare an inability to pay back
debts. Bankruptcy allows individuals or businesses to either restructure their debt and pays it back within a
payment plan , or have most of their debts absolved completely.
The argument that expected indirect and direct bankruptcy costs offset the other benefits from leverage so
that the optimal amount of leverage is less than 100% debt financing.
3. Optimal capital structure
Capital structure with a minimum weighted-average cost of capital and thereby maximizes the value of the
firm's stock, but it does not maximize earnings per share (Eps). Greater leverage maximizes EPS but also
increases risk. Thus, the highest stock price is not reached by maximizing EPS. The optimal capital structure
usually involves some debt, but not 100% debt. Ordinarily, some firms cannot identify this optimal point
precisely, but they should attempt to find an optimal range for the capital structure. The required rate of
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Corporate Finance ­FIN 622
VU
return on equity capital (R) can be estimated in various ways, for example, by adding a percentage to the
firm's long-term cost of debt. Another method is the Capital Asset Pricing Model (CAPM)
Capital structure is a business finance term that describes the proportion of a company's capital, or
operating money, that is obtained through debt and equity. Debt includes loans and other types of credit
that must be repaid in the future, usually with interest. Equity involves selling a partial interest in the
company to investors, usually in the form of stock. In contrast to debt financing, equity financing does not
involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in
the business, and thus are able to exercise some degree of control over how it is run.
4. Dividend Policy
The policy a company uses to decide how much it will pay out to shareholders in dividends.
Distribution of a portion of a company's earnings, decided by the board of directors, to a class of its
shareholders is called dividend. The dividend is most often quoted in terms of the dollar amount each share
receives (i.e. dividends per share or DPS). It can also be quoted in terms of a percent of the current market
price, referred to as dividend yield.
Lots of research and economic logic suggests that dividend policy is irrelevant (in theory).
5. Types of Dividends and Important Dates:
TYPES OF DIVIDEND
1. Cash (most common) are those paid out in form of "real cash". It is a form of investment
interest/income and is taxable to the recipient in the year they are paid. It is the most common
method of sharing corporate profits.
2. Stock or Scrip dividends (common) are those paid out in form of additional stock shares of the
issuing corporation, or other corporation (e.g., its subsidiary corporation). They are usually issued in
proportion to shares owned (e.g., for every 100 shares of stock owned, 5% stock dividend will yield
5 extra shares). This is very similar to a stock split in that it increases the total number of shares
while lowering the price of each share and does not change the market capitalization
3. Property or dividends in specie are those paid out in form of assets from the issuing
corporation, or other corporation (e.g., its subsidiary corporation). Property dividends are usually
paid in the form of products or services provided by the corporation. When paying property
dividends, the corporation will often use securities of other companies owned by the issuer.
Important Dates:
Dividends must be declared (i.e., approved) by a company's Board of Directors each time they are paid.
There are four important dates to remember regarding dividends.
Declaration date: The declaration date is the day the Board of Director's announces their intention to pay
a dividend. On this day, the company creates a liability on its books; it now owes the money to the
stockholders. On the declaration date, the Board will also announce a date of record and a payment date.
Date of record: Shareholders who properly registered their ownership on or before this date will receive
the dividend. Shareholders who are not registered as of this date will not receive the dividend. Registration
in most countries is essentially automatic for shares purchased before the ex-dividend date.
Ex dividend date: Is set by the exchange where the stock is traded, several days (usually two) before the
date of record, so that all trades made on previous dates can be properly settled and the shareholder list on
the date of record will accurately reflect the current owners. Purchasers buying before the ex-dividend date
will receive the dividend. The stock is said to trade cum dividend on these dates. Purchasers buying on or
after the ex-dividend date will not receive the dividend. The stock trades ex-dividend on these dates.
Payment date: The date when the dividend cheques will actually be mailed to the shareholders of a
company.
6. Dividend Policies
Stable dividend per share: look favorably by investors and implies low risk firm. it increases the
marketability of firm's share. Cash flow can be planned as dividend amount can be ascertained with
accuracy (aid in financial planning)
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Corporate Finance ­FIN 622
VU
Constant dividend payout (div per share/Eps)
A fixed %age is paid out as dividend. Under this policy the dividend amount will vary because the
net income is not constant. Thus results in variability of return to investors. the dividends may drop to nil in
case of loss. market price of share will lower.
Hybrid dividend policy:
This contains feature of both the above mentioned policies. Dividend consists of stable base amount and
%age of increment in fat income years. This is more flexible policy but increases uncertainty of future cash
flow or return to investors. The extra slice of %age is only paid when there is high jump in income. So it is
not regularly paid.
Fluctuating dividends:
When the firm is having investment opportunities on its plate or unstable capital expenditure,
then dividends are of residual amount i.e., amount left after meeting capital expenditure.
7. Factors Influencing Dividend Policy
A-Capital Impairment Rule -- many states prohibit the payment of dividends if these dividends
impair "capital" (usually either par value of common stock or par plus additional paid-in capital).
Incorporation in some states (notably Delaware) allows a firm to use the "fair value," rather than "book
value," of its assets when judging whether a dividend impairs "capital."
B-Insolvency Rule -- some states prohibit the payment of cash dividends if the company is insolvent
under either a "fair market valuation" or "equitable" sense.
C-Undue Retention of Earnings Rule -- prohibits the undue retention of earnings in excess of the
present and future investment needs of the firm
Other Issues to Consider
1. Funding Needs of the Firm
2. Liquidity
3. Ability to Borrow
4. Restrictions in Debt Contracts (protective covenants)
5. Control
8. Irrelevance of Dividend Policy
A. Current dividends versus retention of earnings
M&M contend that the effect of dividend payments on shareholder wealth is exactly offset by other
means of financing.
The dividend plus the "new" stock price after dilution exactly equals the stock price prior to the
dividend distribution.
B. Conservation of value
M&M and the total-value principle ensures that the sum of market value plus current dividends of two
firms identical in all respects other than dividend-payout ratios will be the same.
Investors can "create" any dividend policy they desire by selling shares when the dividend payout is too
low or buying shares when the dividend payout is excessive.
According to M&M, in an ideal market, dividend policy is irrelevant as long as the firm's capital
investments and debt policy are fixed. Dividend payments are simply financed over time by a
combination of excess retained earnings and as necessary new equity financing.
In other words value of firm is only determined by increase in earning and investment policy.
Accordingly to M&M, dividend policy does not matter.
M&M assumes perfect capital markets with no transaction cost, no floatation cost to companies and no
taxes. Also, future profits are known with certainty.
We did cover in our earlier studies that valuation of share is dependent upon dividends, then why this
contradiction?
The dividend irrelevance simply states the PV of dividends remains unchanged even though dividend
policy may change the amount and timing of dividends.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk