Cost of capital, capital structure and dividend policy

What are sources of long-term finance?

• equity

• preference shares

• debt

What does Ke stand for?

cost of equity (ordinary share capital)

What does Kd stand for?

cost of debt

What does Kp stand for?

cost of preference share capital

What does WACC stand for?

weighted average cost of capital

What does P stand for?

price

What does MV stand for?

market value

What is the cost of capital?

the minimum risk-adjusted rate of return that a project must make in order to be acceptable to investors

What happens to cost of capital if risk is held constant?

rate of return > cost of capital = increase the value of the firm

What investments reduce shareholder wealth?

When it does not cover the firms cost of capital

What project do investors accept?

ones that increase their wealth

What is the weighted average cost of capital (WACC)?

the average cost a company pays for its financing, weighted between debt and equity.

What must a firms overall cost of capital reflect?

the required return on the firms assets as a whole

What must the cost of capital include if a firm uses both debt and equity financing?

its cost of capital is the weighted average of the cost of each based on their proportions.

What is the diagram for the overview of the cost of capital?

What are the 3 reasons knowledge of cost of capital is important?

• capital budgeting analysis

• capital structure choice

• performance assessment

What is capital budgeting analysis?

Firms invest in things like equipment and research, and finance these using sources such as shares and debt.

What is capital structure choice?

The cost of capital depends on the cost of each source of finance and their mix. To maximise firm value, companies should choose the mix that gives the lowest overall cost.

What is performance assessment?

cost of capital is useful in evaluating management performance

How does good management add to shareholder wealth?

Consistently producing a return on capital which is higher than the firms cost of capital

What factors can the firm not control?

• the level of interest rates

• tax rates

• capital structure policy

• dividend policy

• investment policy

How does the capital structure policy affect the firms cost of capital?

changes to the capital structure

How does the dividend policy affect the cost of capital?

Affects the level of retained earnings. Firms consider cost of capital when they establish their dividend policy

How does the level of interest rates affect the cost of capital?

higher interest rates= increase in the cost of debts, because firms will have to pay debt holders more to obtain debt capital

How do tax rates affect the cost of capital?

lower capital gain tax rate relative to the rate on ordinary income makes stocks more attractive, reduces cost of equity

How do investment policies affect the cost of capital?

• most firms invest similar assets to the ones they currently operate

• if they invest in a new line of business, the marginal cost of capital should reflect the riskiness

What are the two main approaches to calculating the cost of equity (Ke)?

• the dividend valuation model

• the capital asset pricing model (CAPM)

What is the dividend valuation model?

the cost to the company is the discount rate that makes the present value of future dividends equal to the share price.

What is the capital asset pricing model?

the idea of risk v return, applies a risk premium to the risk free rate

What is the cost to the company?

The interest payment

What is the equation for Market value?

What is the equation for cost of debt (Kd)?

For tax purposes, what is interest on a loan?

It is an allowable expense

What is the equation for cost of debt (Kd) including tax?

Are dividends for preference shares tax deductible?

No

What is the formula for cost of irredeemable preference shares?

Doesnt include taxation, as they are not tax deductible

What is the equation for weighted average cost of capital (WACC)?

What is risk?

the higher the level of fixed costs, the greater the variability in profit

What does increasing the level of debt do for ordinary shareholders?

increases the fixed cost, returns to ordinary shareholders more risly

What is financial gearing?

how much a company uses debt compared to equity to finance its operations.

What is a geared (levered) firm?

firm financed by both, debt + equity

What is a ungeared (unlevered) firm?

firm financed entirely by equity

What does the Traditional View say about capital structure and WACC?

There is an optimal capital structure that minimises WACC and maximises firm value. Increasing debt initially lowers WACC (since debt is cheaper than equity), but too much debt increases financial risk, causing WACC to rise.

What does the graph for the traditional view look like?

What do we assume for Miller and Modigliani?

• perfect capital markets

• no bankruptcy costs

• no tax

What happens to the market value of a firm if there is no taxation?

firm is independent of its capital structure

What is the formula for the value of a leveraged firm (without tax)?

How does financial gearing affect the return required by shareholders?

With debt, shareholders require a return equal to the ungeared return plus a risk premium, which increases as gearing rises.

What happens to the cost of equity (Ke) as gearing increases?

The cost of equity increases in direct proportion to the level of gearing due to higher financial risk.

What is the overall effect of higher gearing on cost of capital in this theory?

The increase in the cost of equity (Ke) exactly offsets the benefit of cheaper debt (Kd), so overall cost of capital remains unchanged.

What does the graph for M&M view with no taxation look like?

What is the equation for M&M view (with tax)?

What happens to the WACC when there is a higher level of debt?

lower WACC

What is optimal capital structure?

To borrow as much as possible (100% gearing)

Who does the tax relief from interest payments on loans benefit?

Provides a benefit to shareholders

What does M&M view with tax ignore?

bankruptcy risk

What does the graph for M&M view with tax look like?

What are practical matters?

• Pecking Order Theory

• Signalling Theory

• Taxation

• Attitudes of owners

• Attitudes of management

• Attitudes of lenders

• Costs of financial distress

What are dividends?

a permanent distribution of residual earnings of the company to its owners

they can be in cash or other forms

What is the dividend policy?

approach managers take to decide how much of the company’s earnings will be paid out to shareholders as dividends

Can the pattern of dividend payments affect shareholder wealth?

Increasing the dividend payment this year may not increase the value if it means future dividends fall

What are the 2 theories showing wether dividend payments affect shareholder wealth?

• the modernist (M&M)

• the traditional view

According to the Modigliani & Miller (M&M) view, how do dividend payments affect shareholder wealth?

• Dividend pattern has no effect on shareholder wealth

• Wealth depends on the investment projects the business undertakes

• Shareholder wealth is maximised by accepting all projects with positive NPV

• Lower dividends are offset by an increase in share price, so returns (dividends vs. retention) are unimportant

What is the M&M view?

• investments are made through retained profits or taking out loans

• investors can create or reinvest their own dividends by selling or buying shares

What does the M&M view suggest and assume?

Suggests: no optimal dividend policy

Assumes:

• perfect and efficient markets

• no share issue costs

• no transaction costs

• no taxation

Is the dividend policy for traditional view important?

Yes

Why do shareholders prefer to recieve dividends today?

• future dividends/capital gains, less certain and valued less highly

• investors apply higher discount rates to future dividends, as higher risk

• implies businesses that retained earnings are adversely affected

Why are dividends important

• Clientele effect

• practical aspects

• information signalling

• reducing agency costs

What factors influence the level of dividends?

• investment opportunities

• financing opportunities

• legal requirements

• loan covenants

• profit stability

• threat of takeover

• expectations

• policies of other firms

What is dividend smoothing?

a company aims to keep dividends stable or gradually increasing over time, even if earnings fluctuate.

What are alternatives to cash dividends?

• scrip dividends

• share repurchase

What are scrip dividends?

• bonus share dividend

• no increase in wealth

• sign of confidence

• positive if dividend per share stays the same

What is share repurchase

• returning cash to shareholders by buying back shares

• one-off event

• reduces equity

• more flexible than dividend

• whether buy backs are beneficial