Chapter 16 - Planning the Firm’s Financing Mix
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Transcript of Chapter 16 - Planning the Firm’s Financing Mix
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Chapter 16 - Planning the Firm’s Financing Mix
Chapter 17 – Dividend Policy and International Financing
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Tujuan Pembelajaran 1
Mahasiswa mampu untuk: Menjelaskan konsep struktur modal yang optimalMenjelaskan inti dari teori struktur modalMemasukkan konsep agency cost dan arus kas bebas dalam siskusi manajemen struktur modal Menggunakan alat dasar pengelolaan struktur modal
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Pokok Bahasan 1
Struktur keuangan dan struktur modalSekilas teori struktur modalAgency cost, arus kas bebas, dan struktur modalAlat dasar pengelolaan struktur modal
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Tujuan Pembelajaran 2
Mahasiswa mampu untuk: Menjelaskan untung rugi antara membayar dividen dan menahan laba di dalam perusahaanMenjelaskan hubungan antara kebijakan dividen terhadap harga sahamMenjelaskan pertimbangan praktis dalam kebijakan dividen Membedakan jenis–jenis kebijakan dividen yang seringkali digunakan Menjelaskan tujuan dan prosedur pembelian kembali saham
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Pokok Bahasan 2
Pembayaran dividen vs menahan labaApakah kebijakan dividen mempengaruhi harga saham?Kebijakan dividen dalam praktekProsedur pembayaran dividenDividen saham dan pemecaham sahamPembelian kembali saham
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Balance Sheet Current Current Assets Liabilities
Debt and Fixed Preferred Assets Shareholders’ Equity
FinancialStructure
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Balance Sheet Current Current Assets Liabilities
Debt and Fixed Preferred Assets Shareholders’ Equity
CapitalStructure
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Why is Capital Structure Important?
1) Leverage: Higher financial leverage means higher returns to stockholders, but higher risk due to fixed payments.
2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital.
The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.
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What is the Optimal Capital Structure?
In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter.This is known as the Independence hypothesis: firm value is independent of capital structure.
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Independence Hypothesis:Rix Camper Manufacturing Company
Capital Structure: 100% equity, no debtStock price: $10 per shareShares outstanding: 2 millionOperating income (EBIT): $2,000,000Calculate EPS:
With no interest payments and no taxes,
EBIT = net income.$2,000,000/2,000,000 shares = $1.00
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Independence Hypothesis:Rix Camper Manufacturing Company
Capital Structure: 100% equity, no debtStock price: $10 per shareShares outstanding: 2 millionOperating income (EBIT): $2,000,000Calculate the Cost of Capital:
k = + g = + 0 = 10%D1 1.00 P 10.00
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Independence Hypothesis:Rix Camper Manufacturing Company
$20 million capitalization$8 million in debt issued to retire $8 million in equity.Equity = $12m / $20m = 60%Debt = $8m / $20m = 40%Capital Structure: 60% equity, 40% debtShares outstanding: $12 million / $10 = 1,200,000 shares.Interest = $8m x .06 = $480,000
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Independence Hypothesis:Rix Camper Manufacturing Company
Capital Structure: 60% equity, 40% debtStock price: $10 per shareShares outstanding: 1.2 millionNet income: $2,000,000 - $480,000 = $1,520,000Calculate EPS:
$1,520,000/1,200,000 shares = $1.267
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Independence Hypothesis:Rix Camper Manufacturing Company
Capital Structure: 60% equity, 40% debtStock price: $10 per shareShares outstanding: 1.2 millionNet income: $2,000,000 - $480,000 = $1,520,000Calculate the Cost of Equity:
k = + g = + 0 = 12.67%D1 1.267 P 10.00
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Independence Hypothesis:Rix Camper Manufacturing Company
Capital Structure: 60% equity, 40% debtStock price: $10 per shareShares outstanding: 1.2 millionNet income: $2,000,000 - $480,000 = $1,520,000Calculate the Cost of Capital:
.6 (12.67%) + .4 (6%) = 10%
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Cost ofCapital
kc
0% debt Financial Leverage 100% debt
.
kc = cost of equitykd = cost of debtko = cost of capital
Independence Hypothesis
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Increasing leverage causesthe cost of equityto rise.
Independence Hypothesis
Cost ofCapital
kc
kd kd
0% debt Financial Leverage 100% debt
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Independence Hypothesis
Cost ofCapital
kc
kd
kc
kd
Increasing leverage causesthe cost of equityto rise.
What will be the net effect
on the overall cost of capital?
0% debt Financial Leverage 100% debt
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Independence Hypothesis
Cost ofCapital
kc
kd
kc
kd
Increasing leverage causesthe cost of equityto rise.
What will be the net effect
on the overall cost of capital?
0% debt Financial Leverage 100% debt
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Independence Hypothesis
If we have perfect capital markets, capital structure is irrelevant. In other words, changes in capital structure do not affect firm value.
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Dependence Hypothesis
Increasing leverage does not increase the cost of equity.Since debt is less expensive than equity, more debt financing would provide a lower cost of capital. A lower cost of capital would increase firm value.
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Dependence HypothesisSince the cost of debt is lowerthan the cost of equity…increasing leverage reduces thecost of capital.
Cost ofCapital
kc
kd
Financial Leverage
kc
kdko
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Moderate Position
The previous hypothesis examines capital structure in a “perfect market.”The moderate position examines capital structure under more realistic conditions.For example, what happens if we include corporate taxes?
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Rix Camper example:Tax effects of financing with debt
unlevered leveredEBIT 2,000,000 2,000,000- interest expense 0 (480,000)EBT 2,000,000
1,520,000- taxes (50%) (1,000,000)
(760,000)Earnings available to stockholders 1,000,000
760,000Payments to all securityholders 1,000,000 1,240,000
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Moderate Position
Cost ofCapital
kc
kd
Financial Leverage
kc
kd
becauseof the tax benefit
associated with debt financing.
Even if the cost of equity risesas leverage increases, the cost of debt is very low...
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Moderate Position
Cost ofCapital
kc
kd
Financial Leverage
kc
kd
The low cost of debt reduces the cost of capital.
ko
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Moderate Position
So, what does the tax benefit of debt financing mean for the value of the firm?The more debt financing used, the greater the tax benefit, and the greater the value of the firm.So, this would mean that all firms should be financed with 100% debt, right?Why are firms not financed with 100% debt?
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Why is 100% Debt Not Optimal?
Bankruptcy costs: costs of financial distress.Financing becomes difficult to get.Customers leave due to uncertainty.Possible restructuring or liquidation costs if bankruptcy occurs.
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Why is 100% Debt Not Optimal?
Agency costs: costs associated with protecting bondholders.Bondholders (principals) lend money to the firm and expect it to be invested wisely.Stockholders own the firm and elect the board and hire managers (agents).Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases.
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Cost ofCapital
Financial Leverage
kc
kd
kc
kd
Moderate Positionwith Bankruptcy and Agency Costs
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Cost ofCapital
Financial Leverage
kc
kd
kc
kd
If a firm borrows too much, thecosts of debt and equity will spike upward, due to bankruptcy costsand agency costs.
Moderate Positionwith Bankruptcy and Agency Costs
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Cost ofCapital
Financial Leverage
kc
kd
kc
kd
Moderate Positionwith Bankruptcy and Agency Costs
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Cost ofCapital
Financial Leverage
kc
kd
kc
kd
ko
Moderate Positionwith Bankruptcy and Agency Costs
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Cost ofCapital
Financial Leverage
kc
kd
kc
kd
ko
Ideally, a firm should use leverageto obtain their optimum capital structure, which will minimize thefirm’s cost of capital.
Moderate Positionwith Bankruptcy and Agency Costs
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Cost ofCapital
Financial Leverage
kc
kd
kc
kd
ko
Moderate Positionwith Bankruptcy and Agency Costs
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Capital Structure Management
EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity.
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Capital Structure Management
EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity.
EPS = (EBIT - I)(1 - t) - P S
I = interest expense, P = preferred dividends,S = number of shares of common stock outstanding.
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EBIT-EPS Example
Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options:Sell 200,000 shares of common stock at $30 per share,Borrow $6,000,000 by issuing 10% bonds.
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If we expect EBIT to be $2,000,000:
Financing stock debt EBIT 2,000,000 2,000,000- interest 0 (600,000)EBT 2,000,000 1,400,000- taxes (40%) (800,000) (560,000)EAT 1,200,000 840,000# shares outst. 1,000,000 800,000EPS $1.20 $1.05
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If we expect EBIT to be $4,000,000:
Financing stock debt EBIT 4,000,000 4,000,000- interest 0 (600,000)EBT 4,000,000 3,400,000- taxes (40%) (1,600,000)
(1,360,000)EAT 2,400,000 2,040,000# shares outst. 1,000,000 800,000EPS $2.40 $2.55
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If EBIT is $2,000,000, common stock financing is best. If EBIT is $4,000,000, debt financing is best.So, now we need to find a breakeven EBIT where neither is better than the other.
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Breakeven PointSet two EPS calculations equal to each
other and solve for EBIT: Stock Financing Debt Financing(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S
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Breakeven Point
Stock Financing Debt Financing(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S
(EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800,000+200,000 800,000
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Breakeven Point
Stock Financing Debt Financing .6 EBIT = .6 EBIT - 360,000 1 .8
.48 EBIT = .6 EBIT - 360,000
.12 EBIT = 360,000
EBIT = $3,000,000
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Breakeven EBITEPS
EBIT$1m $2m $3m $4m
bond financing
stock financing
0
3
2
1
For EBIT up to $3 million,stock financing is best.
For EBIT greaterthan $3 million, debt financing
is best.
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In-class Problem
Plan A: Sell 1,200,000 shares at $10 per share ($12 million total).Plan B: Issue $3.5 million in 9% debt and sell 850,000 shares at $10 per share ($12 million total).Assume a marginal tax rate of 50%.
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Breakeven EBIT
Stock Financing Levered Financing(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S
EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) 1,200,000 850,000
EBIT = $1,080,000
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Analytical Income Statement
Stock LeveredEBIT 1,080,000 1,080,000I 0 (315,000)EBT 1,080,000 765,000Tax (540,000) (382,500)NI 540,000 382,500
Shares 1,200,000 850,000
EPS .45 .45
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Breakeven EBITFor EBIT up to $1.08 m,
stock financing is
best. For EBIT greaterthan $1.08 m,
the levered planis best.
levered financing
stock financing
EPS
EBIT$.5m $1m $1.5m $2m
0
.65
.45
.25
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In-class Problem
Plan A: Sell 1,200,000 shares at $20 per share ($24 million total).Plan B: Issue $9.6 million in 9% debt and sell shares at $20 per share ($24 million total).Assume a 35% marginal tax rate.
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Breakeven EBIT
Stock Financing Levered Financing(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S
(EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) 1,200,000 720,000
EBIT = $2,160,000
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Analytical Income Statement
Stock LeveredEBIT 2,160,000 2,160,000I 0 (864,000)EBT 2,160,000 1,296,000Tax (756,000) (453,600)NI 1,404,000 842,400
Shares 1,200,000 720,000EPS 1.17 1.17
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Breakeven EBITlevered
financingstock
financingEPS
EBIT$1m $2m $3m $4m
0
1.5
1.17
.5
For EBIT greaterthan $2.16 m,
the levered planis best.
For EBIT up to $2.16 m,
stock financing
is best.
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Dilemma: Should the firm use retained earnings for:
a) Financing profitable capital investments?
b) Paying dividends to stockholders?
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If we retain earnings for profitable investments, dividend yield will be zero,
P1 - Po D1
Po Po+Return =
Financing Profitable Capital Investments:
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If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain.
P1 - Po D1
Po Po+Return =
Financing Profitable Capital Investments:
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If we pay dividends, stockholders receive an immediate cash reward for investing,
Paying Dividends:
P1 - Po D1
Po Po+Return =
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If we pay dividends, stockholders receive an immediate cash reward for investing, but the capital gain will decrease, since this cash is not invested in the firm.
P1 - Po D1
Po Po+Return =
Paying Dividends:
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So, dividend policy really involves two decisions:
How much of the firm’s earnings should be distributed to shareholders as dividends, andHow much should be retained for capital investment?
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Is Dividend Policy Important?
Three viewpoints: 1) Dividends are Irrelevant2) High Dividends are Best3) Low Dividends are Best
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Three viewpoints:
1) Dividends are Irrelevant. If we assume perfect markets (no taxes, no transaction costs, etc.) dividends do not matter. If we pay a dividend, shareholders’ dividend yield rises, but capital gains decrease.
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With perfect markets, investors are concerned only with total returns and do not care whether returns come in the form of capital gains or dividend yields.
P1 - Po D1
Po Po+Return =
Dividends are Irrelevant
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Therefore, one dividend policy is as good as another.
P1 - Po D1
Po Po+Return =
Dividends are Irrelevant
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High Dividends are Best
Some investors may prefer a certain dividend now over a risky expected capital gain in the future.
P1 - Po D1
Po Po+Return =
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Low Dividends are Best
Dividends are taxed immediately. Capital gains are not taxed until the stock is sold.Therefore, taxes on capital gains can be deferred indefinitely.
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Do Dividends Matter?
Other Considerations:1) Residual Dividend Theory2) Clientele Effects3) Information Effects4) Agency Costs5) Expectations Theory
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Other Considerations
1) Residual Dividend Theory: The firm pays a dividend only if it has retained earnings left after financing all profitable investment opportunities.This would maximize capital gains for stockholders and minimize flotation costs of issuing new common stock.
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Other Considerations
2) Clientele Effects: Different investor clienteles prefer different dividend payout levels.Some firms, such as utilities, pay out over 70% of their earnings as dividends. These attract a clientele that prefers high dividends.Growth-oriented firms which pay low (or no) dividends attract a clientele that prefers price appreciation to dividends.
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Other Considerations
3) Information Effects: Unexpected dividend increases usually cause stock prices to rise, and unexpected dividend decreases cause stock prices to fall. Dividend changes convey information to the market concerning the firm’s future prospects.
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Other Considerations4) Agency Costs:
Paying dividends may reduce agency costs between managers and shareholders.Paying dividends reduces retained earnings and forces the firm to raise external equity financing.Raising external equity subjects the firm to scrutiny of regulators (SEC) and investors and therefore helps monitor the performance of managers.
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Other Considerations
5) Expectations Theory: Investors form expectations concerning the amount of a firm’s upcoming dividend.Expectations are based on past dividends, expected earnings, investment and financing decisions, the economy, etc.The stock price will likely react if the actual dividend is different from the expected dividend.
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Dividend Policies
1) Constant Dividend Payout Ratio: If directors declare a constant payout ratio of, for example, 30%, then for every dollar of earnings available to stockholders, 30 cents would be paid out as dividends.The ratio remains constant over time, but the dollar value of dividends changes as earnings change.
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Dividend Policies
2) Stable Dollar Dividend Policy: The firm tries to pay a fixed dollar dividend each quarter.Firms and stockholders prefer stable dividends. Decreasing the dividend sends a negative signal!
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Dividend Policies3) Small Regular Dividend plus Year-
End Extras The firm pays a stable quarterly dividend and includes an extra year-end dividend in prosperous years.By identifying the year-end dividend as “extra,” directors hope to avoid signaling that this is a permanent dividend.
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Dividend Payments
1) Declaration Date: The board of directors declares the dividend, determines the amount of the dividend, and decides on the payment date.
Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Paymentdividend date date date
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Dividend Payments2) Ex-Dividend Date: To receive the dividend,
you have to buy the stock before the ex-dividend date. On this date, the stock begins trading “ex-dividend” and the stock price falls approximately by the amount of the dividend.
Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Paymentdividend date date date
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Dividend Payments3) Date of Record: Two days after the ex-
dividend date, the firm receives the list of stockholders eligible for the dividend. Often, a bank trust department acts as registrar and maintains this list for the firm.
Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Paymentdividend date date date
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Dividend Payments
4) Payment Date: Date on which the firm mails the dividend checks to the shareholders of record.
Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Paymentdividend date date date
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Stock Dividends and Stock Splits
Stock Dividend: Payment of additional shares of stock to common stockholders.Example: Citizens Bancorporation of Maryland announces a 5% stock dividend to all shareholders of record. For each 100 shares held, shareholders receive another five shares.Does the shareholders’ wealth increase?
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Stock Dividends and Stock Splits
Stock Split: The firm increases the number of shares outstanding and reduces the price of each share.Example: Joule, Inc. announces a 3-for-2 stock split. For each 100 shares held, shareholders receive another 50 shares.Does this increase shareholder wealth?Are a stock dividend and a stock split the same?
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Stock Dividends and Stock Splits
Stock Splits and Stock Dividends are economically the same: The number of shares outstanding increases and the price of each share drops. The value of the firm does not change.
Example: A 3-for-2 stock split is the same as a 50% stock dividend. For each 100 shares held, shareholders receive another 50 shares.
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Stock Dividends and Stock Splits
Effects on Shareholder Wealth: These will cut the company “pie” into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders two half-sized pieces for each full-sized piece they previously owned.
Example: This would double the number of shares, but would cause a $60 stock price to fall to $30.
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Stock Dividends and Stock Splits
Why bother? Proponents argue that these are used to reduce high stock prices to a “more popular” trading range (generally $15 to $70 per share).Opponents argue that most stocks are purchased by institutional investors who have millions of dollars to invest and are indifferent to price levels. Plus, stock splits and stock dividends are expensive!
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Stock Dividend Example
An investor has 120 shares. Does the value of the investor’s shares change?Shares outstanding: 1,000,000.Net income = $6,000,000. P/E = 10.25% stock dividend.
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Before the 25% stock dividend: EPS = 6,000,000/1,000,000 = $6.P/E = P/6 = 10, so P = $60 per share.Value = $60 x 120 shares = $7,200.
After the 25% stock dividend:# shares = 1,000,000 x 1.25 = 1,250,000.EPS = 6,000,000/1,250,000 = $4.80.P/E = P/4.80 = 10, so P = $48 per share.Investor now has 120 x 1.25 = 150 shares.Value = $48 x 150 = $7,200.
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Stock DividendsIn-class Problem
What is the new stock price?Shares outstanding: 250,000.Net income = $750,000.Stock price = $84. 50% stock dividend.
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Before the 50% stock dividend: EPS = 750,000 / 250,000 = $3.P/E = 84 / 3 = 28.
After the 50% stock dividend:# shares = 250,000 x 1.50 = 375,000.EPS = 750,000 / 375,000 = $2.P/E = P / 2 = 28, so P = $56 per share.
(A 50% stock dividend is equivalent to a 3-for-2 stock split.)
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Stock Repurchases
Stock Repurchases may be a good substitute for cash dividends.If the firm has excess cash, why not buy back common stock?
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Stock Repurchases
Stock Repurchases may be a good substitute for cash dividends.If the firm has excess cash, why not buy back common stock?
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Stock Repurchases
Repurchases drive up the stock price, producing capital gains for shareholders.Repurchases increase leverage, and can be used to move toward the optimal capital structure.Repurchases signal positive information to the market—which increases stock price.
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Stock Repurchases
Repurchases may be used to avoid a hostile takeover.
Example: T. Boone Pickens attempted raids on Phillips Petroleum and Unocal in 1985. Both were unsuccessful because the target firms undertook stock repurchases.
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Stock RepurchasesMethods:
Buy shares in the open market through a broker.Buy a large block by negotiating the purchase with a large block holder, usually an institution (targeted stock repurchase).Tender offer: offer to pay a specific price to all current stockholders.