Corporate Finance

Prof. Emiliano Pagnotta

Autumn 2017
Recapitalization example

• Biocorpse Pharma is considering moving from its existing policy of not borrowing
money. The firm has 4 million shares outstanding, trading at $ 25 a share, no
cash holdings and a beta of 1.20. The riskfree rate is 5%, the equity risk premium
is 4% and the corporate tax rate is 40%. Assume that the firm can borrow $ 25
million at a pre-tax rate of 7% and buy back shares. Assuming that the firm is
growing 3% a year in perpetuity and that investors are rational, estimate the
change in value per share after the buyback.
Disney: APV at Debt Ratios

Expected Value of
Unlevered Probability Bankruptcy Levered
Debt Ratio $ Debt Tax Rate Firm Value Tax Benefits Bond Rating of Default Cost Firm
0% $0 36.10% $132,304 $0 AAA 0.07% $23 $132,281
10% $13,784 36.10% $132,304 $4,976 Aaa/AAA 0.07% $24 $137,256
20% $27,568 36.10% $132,304 $9,952 Aaa/AAA 0.07% $25 $142,231
30% $41,352 36.10% $132,304 $14,928 Aa2/AA 0.51% $188 $147,045
40% $55,136 36.10% $132,304 $19,904 A2/A 0.66% $251 $151,957
50% $68,919 36.10% $132,304 $24,880 B3/B- 45.00% $17,683 $139,501
60% $82,703 36.10% $132,304 $29,856 C2/C 59.01% $23,923 $138,238
70% $96,487 32.64% $132,304 $31,491 C2/C 59.01% $24,164 $139,631
80% $110,271 26.81% $132,304 $29,563 Ca2/CC 70.00% $28,327 $133,540
90% $124,055 22.03% $132,304 $27,332 Caa/CCC 85.00% $33,923 $125,713

The optimal debt ratio is 40%,

which is the point at which firm
value is maximized.
Tax Shield with Constant Debt Ratio (CDR)
Revisiting Levered and unlevered Betas with CDR
Disney: APV at Debt Ratios, CDR Tax Shield and Levered Beta

The optimal debt ratio is still 40%,

which is the point at which firm
value is maximized.
 Evidence: Do firms target debt ratios?

• In the “real world,” most firms allow their debt-equity ratio to stray from their target
and periodically adjust leverage to bring it back into line with the target.

Source: J. R. Graham and C. Harvey, “The Theory and Practice of Corporate Finance: Evidence from
the Field,” Journal of Financial Economics 60 (2001): 187–243.
What managers consider important in deciding on how much
debt to carry...
¨ A survey of Chief Financial Officers of large U.S. companies provided the following
ranking (from most important to least important) for the factors that they
considered important in the financing decisions
Factor Ranking (0-5)
1. Maintain financial flexibility 4.55
2. Ensure long-term survival 4.55
3. Maintain Predictable Source of Funds 4.05
4. Maximize Stock Price 3.99
5. Maintain financial independence 3.88
6. Maintain high debt rating 3.56
7. Maintain comparability with peer group 2.47
Comparing to industry averages

• The underlying assumptions in this comparison are that firms within the same industry
are comparable and that, on average, these firms are operating at or close to their
optimal. Both assumptions can be questioned.
• Firms within the same industry can have different product mixes, different amounts of
operating risk, different tax rates, and different project returns. In fact, most do. For
instance, Disney is considered part of the entertainment industry, but its mix of
businesses is very different from that of Lion s Gate, which is primarily a movie
company, or Liberty Media, which is primarily a cable broadcasting company.
• The other problem is that Disney is a multi-business company and picking a sector to
compare these firms is difficult to do.
Extending the Relative Analysis to the Entire Market: one
example
¨ Using 2014 data for US listed firms, we looked at the determinants of the market
debt to capital ratio. The regression provides the following results –

DFR = 0.27 - 0.24 ETR -0.10 g– 0.065 INST -0.338 VOI+ 0.59 E/V
(15.79) (9.00) (2.71) (3.55) (3.10) (6.85)

DFR = Debt / ( Debt + Market Value of Equity)

ETR = Effective tax rate in most recent twelve months (“tax benefits”)
g = growth in EPS (“need for flexibility”)
INST = % of Shares held by institutions (“Disciplinary power of debt”)
VOI = Std dev in operating income in last 10 years/ Average OI in last 10 years
E/V = EBITDA/ EV (“Capacity to generate cash”)

The regression has an R-squared of 8%.

Applying the Regression to Disney

¨ Disney had the following values for these inputs

ETR = 31.02%
Expected Revenue Growth = 6.45%
INST = 70.2%
VOI = 0.0296
E/V = 9.35%
Estimated Debt Ratio
= 0.27 - 0.24 (.3102) -0.10 (.0645)– 0.065 (.702) -0.338 (.0296)+ 0.59 (.0935)
= 0.1886 or 18.86%
¨ What does this optimal debt ratio tell you? (actual debt ratio is 12%)
¨ Why might it be different from the optimal calculated using the weighted average
cost of capital?
Debt: Summarizing the trade off
First Principles
Steps to the Dividend Decision…… if equity is treated as a
residual claim
The Roots of Dividend Dysfunction

q In practice, dividend policy is many times dysfunctional and does not follow
the logical process of starting with your investment opportunities and
working your way down to residual cash.
q The two dominant factors driving dividend policy around the world are:
qInertia: Companies seem to hate to let of their past, when it comes to
dividend policy.
qMe-too-ism: Companies want to behave like their peer group.
Measures of Dividend Policy

Dividend Payout = Dividends/ Net Income

• Measures the percentage of earnings that the company pays in dividends
• If the net income is negative, the payout ratio cannot be computed.

Dividend Yield = Dividends per share/ Stock price

• Measures the return that an investor can make from dividends alone
• Becomes part of the expected return on the investment

Total Payout = (Dividends + Buybacks)/ Net Income

• Measures the percentage of earnings that the company pays in dividends or buybacks
 Important Dates. Example: Microsoft’s Special Dividend

• Microsoft had accumulated a cash balance of $ 43 billion by 2002 by paying out

no dividends while generating huge FCFE.
• In 2004, Microsoft announced a huge special dividend of $ 33 billion and made clear
that it would try to return more cash to stockholders in the future.

• Cum-dividend: When a stock trades before the ex-dividend date, entitling anyone
who buys the stock to the dividend
Distributions to Shareholders: Share Repurchases

Open Market Repurchase

• When a firm repurchases shares by buying shares in the open market
• Open market share repurchases represent about 95% of all
repurchase transactions.
Tender Offer
• A public announcement of an offer to all existing security holders to
buy back a specified amount of outstanding securities at a
prespecified price (typically set at a 10%-20% premium to the current
market price) over a prespecified period of time (usually about 20
days)
• If shareholders do not tender enough shares, the firm may cancel the
offer and no buyback occurs.
 Dividends Stylized Facts: I. Dividends are sticky

Dividend Changes at US companies

80.00%

70.00%

60.00%

50.00%

Increase
40.00%
Decrease
No change
30.00%

20.00%

10.00%

0.00%
The last quarter of 2008 put stickiness to the test.. Number of S&P
500 companies that…

Quarter Dividend Increase Dividend initiated Dividend decrease Dividend suspensions

Q1 2007 102 1 1 1
Q2 2007 63 1 1 5
Q3 2007 59 2 2 0
Q4 2007 63 7 4 2
Q1 2008 93 3 7 4
Q2 2008 65 0 9 0
Q3 2008 45 2 6 8
Q4 2008 32 0 17 10
 80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%

2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
S&P 500: Dividends and Earnings - 1960 to 2016

2002
2001
2000

Payout Ratio
1999
1998
1997
1996
1995
1994
1993
II. Dividends tend to follow earnings

1992
1991
1990

Dividends
1989
1988
1987
1986
1985
1984
1983
1982

Earnings
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967
1966
1965
1964
1963
1962
1961
1960

120.00

100.00

80.00

60.00

40.00

20.00

0.00
Earnings/Dividends
III. Are affected by tax laws…
• 2003 : For the first time in decades, the US tax rate on dividends was cut to 15% to
match the tax rate on capital gains. How firms responded in terms of dividend policy
is a good test of the tax effect.
• More firms initiated dividends in 2003 and more dividends were paid. 21 firms of
the S&P500 initiated dividends in 2003. 247 increased them. Only 16 decreased
them or stopped them.
• Last quarter of 2012, with the fiscal cliff looming and the possibility of tax rates
reverting back to pre-2003 levels rose, 233 companies paid out $31 billion in
dividends.
• So dividends respond to taxes. But repurchases increased even more! Lesson: Taxes
are not the only key determinant of the payout policy
 IV. More and more firms are buying back stock, rather than pay
dividends...

Dividends and Buybacks - US Companies

800.00 80.00%

700.00 70.00%
Dividends and Buybacks (in billions)

Proportion of cash from buybacks

600.00 60.00%

500.00 50.00%

400.00 40.00%

300.00 30.00%

200.00 20.00%

100.00 10.00%

0.00 0.00%
1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016
Stock Buybacks Dividends Proportion from Buybacks
V. And there are differences across countries…
Dividend Yields: January 2017

75th Perc. Broad Group 25th Perc. Median 75th Perc.

Australia, NZ and Canada 1.77% 3.39% 5.09%
Developed Europe 1.62% 2.84% 4.68%
Emerging Markets 0.88% 2.27% 4.62%
Japan 1.33% 2.08% 2.81%
United States 1.17% 2.12% 3.47%
Dividend Yields and Payout Ratios: Growth Classes

Dividend Yields and Payout Ratios: By Growth Class

50.00% 4.00%

45.00%
3.50%

40.00%
3.00%
35.00%

2.50%
30.00%

25.00% 2.00% Dividend Payout ratio

Dividend Yield
20.00%
1.50%

15.00%
1.00%
10.00%

0.50%
5.00%

0.00% 0.00%
0-3% 3-5% 5-10% 10-15% 15-20% 20-25% >25%
Three Schools Of Thought On Dividends
(and the middle ground)
1. If there are no tax disadvantages associated with dividends & companies can
issue stock, at no issuance cost, to raise equity, whenever needed
Dividends do not matter, and dividend policy does not affect value.
2. If dividends create a tax disadvantage for investors (relative to capital gains)
Dividends are bad, and increasing dividends will reduce value
3. If dividends create a tax advantage for investors (relative to capital gains) and/or
stockholders like dividends
Dividends are good, and increasing dividends will increase value

1. Balanced viewpoint.
a. If a company has excess cash, and few good investment opportunities (NPV>0), returning
money to stockholders (dividends or stock repurchases) is good.
b. If a company does not have excess cash, and/or has several good investment
opportunities (NPV>0), returning money to stockholders (dividends or stock repurchases)
is bad.
Payout Policy in Perfect Markets: The MM Propositions

¨ Underlying Assumptions:
(a) There are no tax differences to investors between dividends and capital gains.
(b) If companies pay too much in cash, they can issue new stock, with no
flotation costs or signaling consequences, to replace this cash.
(c) If companies pay too little in dividends, they do not use the excess cash for
bad projects or acquisitions.
q Results
1. When a dividend is paid, the share price drops by the amount of the dividend
when the stock begins to trade ex-dividend.
2. Investors are indifferent between the firm distributing funds via dividends or
share repurchases
3. Holding fixed the investment policy of the firm, the firm’s dividend policy is
irrelevant and does not affect the share price
Payout Policy in Perfect Markets: Example

Genron Corporation.
• The firm’s board is meeting to decide how to pay out $20 million in excess cash
to shareholders.
• Genron has no debt, 10 million shares outstanding, and its equity cost of capital
12%.
• The firm expects to generate future free cash flows of $48 million per year, thus
it anticipates paying a dividend of $4.80 per share each year thereafter.
Alternatives:
1. Pay a $2 dividend now
2. Repurchase shares
3. Raise cash now and pay higher dividend now in anticipation of higher FCF
Would you expect any alternative to be preferable?
Alt. Policy 1: Pay Dividend with Excess Cash
• The cum-dividend price of Genron will be
4.80
Pcum = Current Dividend + PV (Future Dividends) = 2 + = 2 + 40 = $42
0.12
• After the ex-dividend date, new buyers will not receive the current dividend
and the share price and the price of Genron will be
4.80
Pex = PV (Future Dividends) = = $40
0.12

When a dividend is
paid, the share price
drops by the amount of
the dividend when the
stock begins to trade
ex-dividend.
Alternative Policy 2: Share Repurchase (No Dividend)

• Suppose that instead of paying a dividend this year, Genron uses the $20 million
to repurchase its shares on the open market.
• With an initial share price of $42, Genron will repurchase 476,000 shares, leaves
9.524 million shares outstanding
• The net effect is that the share price remains unchanged.

• After the repurchase, the future dividend would rise to $5.04 per share ($48
million 9.524 million shares): Prep = 5.04 = $42
0.12

• Investors are indifferent between dividends and re-purchases

• By reinvesting dividends or selling shares, investors can replicate either payout method on their own.
Alternative Policy 3: High Dividend (Equity Issue)

• Now Genron wants to pay dividend larger than $2 per share right now,
but it only has $20 million in cash today.
• Genron needs an additional $28 million to match future cash flows
• Given a current share price of $42, Genron could raise $28 million by
selling $28 million $42 per share =0.67 million shares.
• The new dividend per share will be $48 million 10.67m shares =
$4.50 per share
• What is the new price?

4.50
Pcum = 4.50 + = 4.50 + 37.50 = $42
0.12
Genron’s Dividends per Share Each Year Under the
Three Alternative Policies

• The initial share price is unaffected

• There is a trade-off between current and future dividends
The Dividends are “bad” school: Taxes

Figure 10.10: Tax rates on Dividends and Capital Gains- US

100.00%

90.00%

80.00%

70.00%

60.00%

50.00%
Difference between dividend tax rate
40.00% & capital gains peaks at 66% in 1950s.
30.00%

20.00%

10.00% Dividends & capital gains taxed at

same rate since 2003.
0.00%
1916
1918
1920
1922
1924
1926
1928
1930
1932
1934
1936
1938
1940
1942
1944
1946
1948
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2011
2013
2015
Dividend tax rate Capital gains tax rate
Taxes: What do investors in your stock think about dividends?
q You are the owner of a stock that is approaching an ex-dividend day and you know
that dollar dividend with certainty. In addition, assume that you have owned the
stock for several years.
Initial buy Pcum Pex
At $P
Ex-dividend day
Dividend = $ D

q Pcum is the cum-dividend price Pex is the ex-dividend price, tg is the capital
gains rate tax, td is the dividend tax rate.
Cash flows from Selling around Ex-Dividend Day
¨ The cash flows from selling before ex-dividend day are:
Pcum - (Pcum - P) tg
¨ The cash flows from selling after ex-dividend day are:
Pex - (Pex - P) tg + D(1-td)
¨ Since the average investor should be indifferent between selling before the
ex-dividend day and selling after the ex-dividend day
Pcum - (Pcum - P) tg = Pex - (Pex - P) tg + D(1-td)
¨ Some basic algebra leads us to the following:

⎛1 − t ⎞ ⎛ td − t g ⎞
Pcum − Pex
D
= ⎜
⎝ 1 − t
d

g⎠
⎟ = ⎜
⎝
1 −
1 − t ⎟
g ⎠
= 1 − t (
*
d
)
• t*g the effective dividend tax rate. Additional tax per dollar on
after-tax capital gains income that is instead received as a dividend
对作为股息收⼊入的税后资本利利得收⼊入，每⼀一美元应缴纳的附加税
Intuitive Implications

• The relationship between the price change on the ex-dividend

day and the dollar dividend will be determined by the
difference between the tax rates for the typical investor in the
stock.
Tax Rates Ex-dividend day behavior
If dividends and capital gains are Price change = Dividend
taxed equally

If dividends are taxed at a higher Price change < Dividend

rate than capital gains

If dividends are taxed at a lower Price change > Dividend

rate than capital gains
The empirical evidence…

1966-1969

• Ordinary tax rate = 70%

• Capital gains rate = 28%
• Price change as % of Dividend = 78%

1981-1985

• Ordinary tax rate = 50%

• Capital gains rate = 20%
• Price change as % of Dividend = 85%

1986-1990

• Ordinary tax rate = 28%

• Capital gains rate = 28%
• Price change as % of Dividend = 90%
Dividend Arbitrage
Assume that you are a tax exempt investor, and that you know that the price
drop on the ex-dividend day is only 90% of the dividend. How would you
exploit this differential?
a. Invest in the stock for the long term
b. Sell short the day before the ex-dividend day, buy on the ex-dividend
day
c. Buy just before the ex-dividend day, and sell after.
Example of dividend capture strategy with tax factors
¨ XYZ company is selling for $50 at close of trading May 3. On May 4, XYZ goes ex-
dividend; the dividend amount is $1. The price drop (from past examination of the
data) is only 90% of the dividend amount.
¨ The transactions needed by a tax-exempt U.S. pension fund for the arbitrage are as
follows:
¤ 1. Buy 1 million shares of XYZ stock cum-dividend at $50/share.
¤ 2. Wait till stock goes ex-dividend; Sell stock for $49.10/share (50 - 1* 0.90)
¤ 3. Collect dividend on stock.
¨ Net profit = - 50 million + 49.10 million + 1 million = $0.10 million

¨ Would you focus on one or more stocks?

“Dividends are good” school
Often cited reason for paying dividends
The bird in hand argument: Dividends now are more certain than
capital gains later. Hence dividends are more valuable than capital
gains. Stocks that pay dividends will therefore be more highly valued
⼈人们对于资本利利得与股利利收益的偏好是不不 同的。正常股利利好⽐比⼿手中之⻦鸟，⽽而资本利利得好似停在灌⽊木林林中的两只
than stocks that do not. ⻦鸟，所以资本利利得的⻛风险⾼高于股利利，因此, 随着股利利⽀支付的减少，公 司的资⾦金金成本将上升,导致股票价值下降。

Do you agree?
Three “good” reasons for paying dividends…
Clientele Effect: The investors in your company like dividends
The effective dividend tax rate differs across investors for a variety of reasons.
• Income Level
• Investment Horizon
• Tax Jurisdiction
• Type of Investor or Investment Account
The Signalling Story: Dividends can be signals to the market that you
believe that you have good cash flow prospects in the future.

The Wealth Appropriation Story: Dividends are one way of transferring

wealth from lenders to equity investors (this is good for equity
investors but bad for lenders)
A clientele based explanation

¨ Basis: Investors may form clienteles based upon their tax brackets.
Investors in high tax brackets may invest in stocks which do not pay
dividends and those in low tax brackets may invest in dividend
paying stocks

Note
US Corporations that hold stocks can exclude 70-80% of received dividends from corporate taxes.
Not possible with capital gains
Clientele Effect: Results A study of 914 investors' portfolios. Are portfolio
positions affected by their tax brackets?
tax brackets
!"#. %"&'() = + + - ∗ /) +0 ∗ 12&) +( ∗ 34056&) + & ∗ !"77 9+: ;+<&)
 Evidence from Canadian Utility firms

Company Premium for cash dividend shares

Consolidated Bathurst + 19.30%
Donfasco + 13.30%
Dome Petroleum + 0.30%
Imperial Oil +12.10%
Newfoundland Light & Power + 1.80%
Royal Trustco + 17.30%
Stelco + 2.70%
TransAlta +1.10%
Average across companies + 7.54%

Class A shares pay cash dividend. Class B shares offer the same amount as a stock dividend (capital
gains). Investors holding the stock prefer dividends to capital gains.
Dividend Signaling Hypothesis

q The idea that dividend changes reflect managers’ views about a firm’s future
earning prospects
q If firms smooth dividends, the firm’s dividend choice will contain information
regarding management’s expectations of future earnings.
q When a firm increases its dividend, it sends a positive signal to investors that
management expects to be able to afford the higher dividend for the
foreseeable future.
q When a firm decreases its dividend, it may signal that management has given
up hope that earnings will rebound in the near term and so need to reduce the
dividend to save cash.
Dividends send a signal
Increases in dividends are good news..
The Flip side: Higher or new dividends may signal bad news
• An increase of a firm’s dividend may also signal a lack of investment
opportunities!
• Conversely, a firm might cut its dividend to exploit new positive-NPV
investment opportunities. In this case, the dividend decrease might lead to a
positive, rather than negative, stock price reaction

Dividend Initiations and Earnings Growth

45.00%
40.00%
Annual Earnings Growth Rate

35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-4 -3 -2 -1 1 2 3 4

Year relative to dividend initiation (Before and after)

Both dividend increases and decreases are becoming less
informative…
Market Reaction to Dividend Changes over time: US companies

1.00%

0.00%
1962-1974 1975-1987 1988-2000
-1.00%

Dividend Increases
-2.00%
Dividend Decreases

-3.00%

-4.00%

-5.00%

-6.00%
 3. Dividend increases may be good for stocks… but bad for bonds..

EXCESS RETURNS ON STOCKS AND BONDS AROUND DIVIDEND CHANGES

0.5 Stock price rises

0
t:- -12 -9 -6 -3 0 3 6 9 12 15
-0.5 15 CAR (Div Up)
CAR
-1 CAR (Div down)

-1.5

Bond price drops

-2
Day (0: Announcement date)
• Bondholders view dividend increases as bad news. It makes the bonds much riskier.
• To the extent that the dividend increase was unanticipated and was not built into interest rate, this
transfers wealth from bondholders to stockholders.
Stock Splits

• Splits: Stock dividend

• A firm does not pay out any cash to shareholders.
• As a result, the total market value of the firm’s equity is unchanged. The only
thing that is different is the number of shares outstanding.
• The stock price will therefore fall because the same total equity value is now
divided over a larger number of shares.
• Stock dividends are not taxed, so from both the firm’s and shareholders’
perspectives, there is no real consequence to a stock dividend.
• The number of shares is proportionally increased and the price per share is
proportionally reduced so that there is no change in value.
• The opposite is a reverse split
 Why?
Distribution of Stock Prices for NYSE Firms (June 2009)

• Split: Typical motivation is to keep the share price in a range thought to be attractive to
small investors. Extreme case: BRK.A closed at $235,640 on November 14, 2016
• Motivation for a reverse split?
Spin-offs: eBay and Paypal –July 2015