Decision making in Capital budgeting

Forms of Organisation

Dividend declaration

Dividend policy

Summary of Dividend Policy

Dividend policy is a crucial strategic decision for the firm

Many aspects of dividend policy are puzzling.

The available evidence suggests that for most firms,

small changes in dividend policy have little effect.

DIVIDEND

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The dividend decision is one of the most important decisions facing a corporation

How much of earnings given back to shareholders?

This is the same decision as how much of earnings should be retained

Distribution of cash is the final decision management must make

– The dividend decision returns resources to owners

Types of dividends

Cash dividends (either regular or extra) are cash distributions from earnings and are the most common

Liquidating dividend pay out all cash from sale of assets to end operations of the firm

Stock dividends (issuing new stock as a dividend) are like stock splits and are not really what we mean by dividends since no cash is paid

Institutional Details

Dividends are set by the board of directors and are paid to all recorded shareholders.

There are typically legal restrictions on dividends in order to protect bondholders from agency costs.

Otherwise, firms near bankruptcy could pay “liquidating” dividends from capital, essentially transferring wealth from bondholders to stockholders.

Cost of K and Leverage

Value of the Firm

EBIT-EPS relation

EBIT/EPS Analysis

EBIT - Earnings Before Interest and Taxes. Accountants like to use the term Net Operating Income for this income statement item, but finance people usually refer to it as EBIT. Either way, on an income statement, it is the amount of income that a company has after subtracting operating expenses from sales (hence the term net operating income). Another way of looking at it is that this is the income that the company has before subtracting interest and taxes (hence, EBIT).

EAT - Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but finance people usually refer to it as EAT.

EPS - Earnings Per Share. This is the amount of income that the common stockholders are entitled to receive (per share of stock owned). This income may be paid out in the form of dividends, retained and reinvested by the company, or a combination of both.

The Analysis

I need to raise additional money by issuing either debt, preferred stock, or common stock. Which alternative will allow me to have the highest earnings per share?

This question calls for an EBIT/EPS analysis. Simply put, this simply means that we will calculate what our earnings per share will be at various levels of sales (and EBIT).

Actually, it isn't necessary to start with sales. Since a company's EBIT, or net operating income, isn't affected by how the company is financed, we can skip down the income statement to the EBIT line and begin there. In other words, we assume a certain level of sales, calculate our estimated EBIT at that level, and then calculate what our EPS will be for each alternative form of financing (debt, preferred stock, and common stock).

An Illustration

For example, let's assume that the company:

1. is currently financed entirely with common stock (i.e., no debt and no preferred stock). The firm has 2,000 shares of common stock outstanding.

2. currently pays no common stock dividend; all earnings are retained and reinvested into the company.

3. needs to raise Rs.50,000 in new money. As financial manager, you want to know which financing alternative should be used.

4. is in the 35% tax bracket.

To raise the Rs50,000, you are considering three alternatives:

1. common stock - The company can sell additional shares at the current price of Rs.50 per share. This means that 1,000 new shares of common stock will need be to be sold (Rs50,000/Rs.50 per share).

2. preferred stock - The dividend yield on preferred stock will have to be 7.3% of the amount of money raised. (The preferred can be sold for Rs.40 per share.) The number of shares of common stock will remain unchanged.

3. debt - The interest rate on any new debt will be 4% per year. The number of shares of common stock will remain unchanged.

Let's pick a beginning level for EBIT of RS.10,000. We can then calculate what the earnings per share will be for each financing alternative.

The above table shows us the earnings per share at an EBIT level of Rs.10,000. If sales are sufficiently high to give us an EBIT level of Rs.10,000, then our EPS will be highest by issuing debt, common stock yields the next highest EPS, and the preferred stock alternative results in the lowest level of EPS.

However, we would eventually like to draw a graph of the EPS over a range of sales and EBIT. This will allow us to understand the relationship between sales and EPS more fully. As sales (and EBIT) increase, what will happen to earnings per share?

This is easily answered - we just repeat the above table for a different level of EBIT. Let's assume that we don't think that our company's EBIT will fall below 2,000, so we can reproduce the table for that level of EBIT. If we think that the highest that EBIT will be for the next few years is Rs.30,000, then we might choose that level also. While we're at it, let's throw in an EBIT of Rs.20,000 also. In other words, we will construct the table for four values of

EBIT: Rs.2,000, Rs.10,000, Rs.20,000 and Rs.30,000.

Relationships

Notice the following points:

1. The preferred stock line is parallel to the debt line and lies below the debt line. This will always be the case because debt has two distinct advantages over preferred stock:

a. interest on the debt is tax-deductible and preferred stock dividends are not tax-deductible, and

b. debt is the cheaper form of financing (i.e., the interest rate is less than the preferred dividend yield) because it enjoys greater protection in the event of default).

This means that the EPS will always be higher under debt financing than under preferred stock financing. Since both options pay a fixed rate (e.g., 4% and 7.3%), they offer similar effects of leverage - leading to the parallel lines above. Preferred stock may offset this quantitative advantage with some qualitative ones (less restrictive provisions, etc.), but debt financing will always offer the higher earnings per share - a big advantage.

2. Since common stock financing offers a smaller degree of leverage, the slope of the common stock line is lower than the other two lines. This leads to two "crossover points" where the common stock line crosses the other two lines. These are indifference points.

· At an EBIT level of Rs.6, 000, you would be indifferent between common stock financing and debt financing. Both will give you the same EPS (of Rs.1.30 per share).

· At an EBIT level of Rs.16, 800, you would be indifferent between common stock financing and preferred stock financing. Both will give you the same EPS (of Rs.3.64 per share).

CAPITAL STRUCTURE THEORY

The Firm’s Capital Structure

Capital structure is a complex area of financial decision making due to the relationship between the firm's financing sources, the firm's risk/return profile, and the firm’s value

External Assessment of Capital Structure

Debt Ratios can be used to measure the firm's degree of financial leverage

Measurements of indebtedness

Measurements of ability to service debt

The more risk a firm is willing to take, the greater will be its financial leverage

A firm should theoretically maintain a level of financial leverage consistent with the capital structure that maximizes shareholder wealth

There are significant differences in typical degrees of financial leverage between industries

Capital structure patterns among industries tend to be quite similar around the world

Capital Structure Theory

How a chosen financing mix affects the firm's value has been a topic of considerable study

Modigliani and Miller (hereafter "M & M") demonstrated algebraically that, assuming perfect markets, capital structure has no effect on the firm's value

Subsequent research suggests the existence of an Optimal capital structure based upon the balancing of the benefits and costs of debt financing

The major benefit of debt financing is the tax deduct ability of interest payments, making more earnings available for investors

The major costs of debt financing include

The probability of bankruptcy due to an inability to meet obligations depends on:

Business Risk

Financial Risk

Agency Costs Imposed by Lenders

Asymmetric Information

Asymmetric Information

If a firm's managers feel that the firm's stock is undervalued and there is an available investment that they feel will increase the value of the firm, the managers will use debt financing to fund it

If a firm's managers feel that the firm's stock is overvalued, however, they will use a stock issue to finance the investment

Management action (debt vs. new stock financing) is seen as a signal by investors in the marketplace

Debt is generally seen as a positive signal

Equity is generally seen as a negative signal

Cost Functions

kd = After-tax cost of debt

ke = Cost of equity

kw = Weighted average cost of capital

The cost function graphs illustrate the behavior of the costs of debt and equity as their use increases by the firm. Their combined effect on the weighted average cost of capital is also shown.

A Graphic View of the Optimal Capital Structure

Capital Structure

Capital Structure Policy
Target capital structure
Mix of debt, preferred stock, and common stock
Set equal to estimated 'Optimal Capital Structure'
Balances risk and return
Maximizes the firm’s stock price
Capital Structure Decisions
Ø Business risk
Ø Taxes
Ø Financial flexibility
Ø Managerial conservatism or aggressiveness
Ø Growth opportunities
EPS Indifference Analysis
Used to determine
'when debt financing is advantageous and when equity financing is advantageous'.
Can be illustrated graphically since the relationship between EBIT and EPS is linear.
"INDIFFERENT PIONT "
EPS (debt financing) = EPS (equity financing)




















Financial forecasting models
Can help show how capital structure changes are likely to affect stock prices, coverage ratios, and so on.
Can generate results under various scenarios, but the financial manager must specify appropriate input values, interpret the output, and eventually decide on a target capital structure.
"capital structure decision will be based on a combination of analysis and judgment".

Financial management

“CAPITALISATION COMPRISES OF A COMPANY’S OWNERSHIP
CAPITAL STOCK AND SURPLUS IN WHATEVER FORM IT MAY
APPEAR AND BORROWED CAPITAL WHICH CONSISTS OF
BONDS OR SIMILAR EVIDENCES OF LONG TERM DEBT.”

Financial Management

Long-Term Financial Decisions

Leverage involves the use of fixed costs to magnify returns. Its use in the capital
Structure of the firm has the potential to increase its return and risk.

Leverage and capital structure are closely related concepts that are linked to capital budgeting decisions through the cost of capital. These concepts can be used to minimize the firm’s cost of capital and maximize its owners’ wealth. We discuss leverage and capital-structure concepts and techniques to understand how the firm can use them to create the best capital structure.

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