CHAPTER 9 Theories of Capital Structure

1. CHAPTER 9Theories of Capital Structure Controversy of Capital structure Arbitrage effects Optimum capital structure Signaling effects

2. Leverage effect of EPS

3. Capital Structure Controversy • Relevancy Proposition: Advantage of leverage observed in the last slide demonstrates that firm can maximize wealth by increasing its debt rather than profitability. This is the relevancy proposition of capital structure. • Irrelevancy Proposition: Modigliani-Miller (M-M) argues that wealth can not be influenced by anything other than profitability. So there may be arbitrage effects to adjust the price to give the same return on investment. (See the next slide.) Advantage of leverage may also be compensated by bankruptcy cost and agency cost. (See the following slide.)

4. Arbitrage effect: Irrelevancy Proposition Price S3 150 70 60 D3 S2 S1 D2 D1 Quantity of Shares

5. Optimum Capital Structure Value of the firm Relevancy proposition Bankruptcy and agency cost Actual Irrelevancy Proposition Optimum Capital structure Debt/Assets

6. CHAPTER 10Theories of Dividend Policy Controversy of dividend policy Bird-in-hand view MM proposition of irrelevancy Signaling effects Clientele effect

7. Theories of dividend policy • Dividend policy relates to the company decision to payout the dividends out of the earnings. The management has the choice to go for no distribution to full distribution of earnings. Theories of dividend policy relates such management decision to the value of the firm. Like high payout firms having higher shares price, or low payout firm having lower share price. Or vice versa.

8. Theories of dividend policy • Three theories of dividend policy: • Dividend irrelevance: Investors don’t care about payout. • Bird-in-the-hand: Investors prefer a high payout. • Tax preference: Investors prefer a low payout.

9. MM Proposition of Irrelevancy Dividend irrelevance: Investors don’t care about payout. MM argues that dividend distribution policy should not be related to the value of the firm. The undistributed dividends should increase the share price by the same amount. Distribution of dividend is just an alternative to capital gain. In that case, people can go for ‘home-made dividend policy.’ For example, If investors expect high payout of dividends when the firm goes for low payout of dividends, then they can sell part of their stock as the share price increases, and realize the cash. Conversely, if the investors likes less dividends when the firm goes for high payout, then investors can buy more shares by the dividend earnings. Such home made dividend policy suggests that changing the dividend policy a firm can not maximize its share price

10. Bird-in-the-hand: Investors prefer a high payout. • This group believes that stock holders like more payout firms rather than low payout firm. Because, distribution of dividend is an immediate gain like bird-in-hand, but increase in share price (in consequence of retention) is not so certain, like bird–in-bush.

11. Tax Effects • MM argued that if a firm goes for retention then investors realize capital gain. Capital gain tax is less than dividend tax. So after tax income in case of retention is more than the after tax income from dividend earnings of the same amount. So the apparent advantage of dividend income in terms of certain income is neutralized.

12. Other factors • Signaling effects suggest that distribution or retention of dividends gives a signal. When a good firm goes for retention, investors take the signal positively like the firm has attractive investment opportunity, so share price increases. If a bad firm does the same, investors take the signal negatively, like the firm is suffering from inadequate liquidity, so share price goes down. Similarly, when a good firm goes for high distribution, then investors think that the firm has strong liquidity. If a bad firm does the same, investors think that the firm lacks investment opportunity so share price goes down. • Clientele Effects suggest that every firm should stick to the same dividend policy no matter what is the nature of it. Different types of investors with different preference pattern can then select the right firm that suits him the best.