Corporate Finance - Capital Structure and Dividend Policy

What does M&M Proposition I (without taxes) state?

V_L = V_U — the market value of a firm is independent of its capital structure. Leverage merely shifts cash flows between debt and equity without changing total firm value.

List the key assumptions behind M&M Proposition I.

(1) Competitive, perfect capital markets. (2) No taxes. (3) No bankruptcy costs. (4) No agency issues. (5) No asymmetric information — markets are fully efficient.

What does M&M Proposition II (without taxes) say about the cost of levered equity?

r_E = r_U + (D/E)(r_U − r_D). The equity cost rises linearly with the debt-equity ratio, but WACC stays constant and equal to r_U.

In the Harrison Industries leveraged-recapitalisation example, what happens to share price after borrowing $80m to repurchase shares?

Share price stays at $4. Shares fall from 50m to 30m; equity value drops from $200m to $120m — exactly offsetting the new debt. Total firm value is unchanged (M&M I).

What is the interest tax shield, and how does M&M Proposition I change with corporate taxes?

Governments allow interest to be deducted before tax. This creates a tax saving worth τ_c × D for permanent debt. So V_L = V_U + τ_c × D — the levered firm is worth more.

Write the after-tax WACC formula and explain what the tax term does.

WACC = E/(E+D) · r_E + D/(E+D) · r_D(1 − τ_c). The (1 − τ_c) term reduces the effective cost of debt, lowering WACC below the pre-tax rate as leverage increases.

In the HON example (D/E = 0.5 → 0.4), what happens to equity cost and WACC?

WACC stays at 11.5% (M&M I). The unlevered cost r_U = 11.5%. New r_E = 11.5% + 0.4(11.5% − 5.75%) = 13.8% — lower than the original 14% because less leverage is taken on.

What is the trade-off theory of capital structure?

Firms balance the tax shield benefit of debt against the present value of financial distress costs. Optimal capital structure is where the marginal benefit of the tax shield equals the marginal cost of distress: V_L = V_U + PV(tax shield) − PV(distress costs).

Define financial distress and distinguish its direct vs indirect costs.

Financial distress = difficulty meeting debt obligations. Direct costs: legal, accounting, admin fees. Indirect costs: lost sales, supplier/customer concerns, inability to raise funds, foregone positive-NPV projects, agency conflicts.

How does the trade-off theory differ from M&M Proposition I with taxes in its prediction about optimal gearing?

M&M with taxes predicts firms should gear up as much as possible. Trade-off theory predicts an interior optimal D/E* where the U-shaped WACC is minimised, because distress costs eventually outweigh the tax benefit.

What is the pecking order of financing under Myers & Majluf's theory?

Firms prefer: (1) internal funds (retained earnings) first, (2) debt second, (3) new equity only as a last resort — because equity issuance signals to investors that management believes shares are overvalued.

Why does a new equity issue typically depress share price, according to pecking order theory?

Information asymmetry: managers know true value; investors know managers won't issue undervalued shares. So an equity announcement signals overvaluation → market marks the price down (empirically around −3% on average).

What relationship between profitability and leverage does pecking order theory predict, and why?

A negative relationship. More profitable firms generate more internal cash, so they rely less on external debt and naturally accumulate lower debt-equity ratios over time.

Does pecking order theory imply an optimal capital structure?

No. Capital structure is a residual outcome of financing decisions driven by information asymmetry and resource availability, not a deliberate target. Firms simply work down the pecking order as needed.

List and define the four key dividend dates in order.

(1) Declaration date — board authorises dividend. (2) Ex-dividend date — two days before record; buyers on/after this date do not receive dividend. (3) Record date — shareholders on register receive dividend. (4) Payable date — cheques mailed, usually within a month of record.

What is a stock repurchase, and what three reasons do firms typically give for it?

A buyback: firm uses cash to purchase its own shares. Reasons: (1) return excess free cash flow; (2) increase the debt/equity ratio; (3) obtain shares to cover employee stock-option exercises.

What is the difference between a cash dividend and a stock dividend/split?

Cash dividend — firm pays shareholders cash per share. Stock dividend/split — firm issues additional shares instead of cash, leaving proportional ownership unchanged but reducing the per-share price.

State the M&M Dividend Irrelevance Proposition.

In perfect capital markets, holding investment policy fixed, a firm's dividend policy is irrelevant — it does not affect the initial share price or shareholder wealth. Shareholders can create homemade dividends by selling shares.

In the Merck example, show numerically that dividend and repurchase are equivalent for Mr Hauptmann.

Dividend: receives €1,050,000 cash; remaining shares worth €98.95m. Repurchase: also receives €1,050,000 (1.05% × €100 × 1m); remaining shares also worth €98.95m. Identical outcome in both cases.

Why does a firm's share price fall by exactly the dividend per share on the ex-dividend date in a perfect market?

The firm's assets decrease by the total cash paid out. With the same shares outstanding, equity per share drops by the dividend amount. No value is created or destroyed — cash simply moves from firm to shareholder.

How does the tax preference argument suggest firms should set dividends?

Since dividends are typically taxed at a higher rate than capital gains, investors prefer capital gains. Firms should therefore pay low or no dividends, returning cash via share repurchases instead.

Explain the clientele effect in dividend policy.

Different investor groups have different tax preferences: high-tax individuals prefer low/no dividends; tax-exempt institutions are indifferent; corporations may prefer high dividends. Firms attract the clientele that matches their payout policy.

What is the bird-in-the-hand argument for high dividends, and when does it apply?

In imperfect markets with transaction costs or asymmetric information, some investors prefer certain cash now (dividends) over uncertain future capital gains. The clientele effect and signalling reinforce this preference.

How does signalling theory explain why firms smooth dividends and are reluctant to cut them?

Under information asymmetry, investors treat dividends as signals of future earnings. A dividend increase signals confidence; a cut signals bad news. Firms smooth payouts, use special dividends or buybacks for one-off cash, and accompany cuts with detailed disclosure.

What is an imputation (tax credit) system, and how does it affect investor preference for dividends?

Under imputation (e.g. Australia, UK), shareholders receive a tax credit equal to corporate tax already paid, avoiding double taxation. Low-tax investors can receive a net refund, making dividends attractive and reducing the preference for capital gains.