Lvl 2: Corporate issuers

Stock dividend

• not taxable

• does not affect the shareholder’s proportionate ownership

• does not change the value of each shareholder’s ownership

• favors long-term investors, lower the company’s cost of equity financing

• increase the stock’s float, improves the liquidity of the shares and dampens share price volatility

• lower stock price will attract more investors

• cash dividend affects a company’s capital structure, whereas a stock dividend has no economic impact on a company

Stock Splits

• no economic effect on the company

• shareholders’ total cost basis does not change

• same dividend payout ratio

perfect capital market assumptions

• dividend policy should have no impact on its cost of capital

• assuming a company has a given capital budget, accepts all projects with a positive net present value + current capital structure and debt ratio are optimal

• issue additional common shares in the amount of its capital budget

• newly issued shares would exactly offset the value of the dividend

dividend policy matters

• investors prefer a dollar of dividends to a dollar of potential capital gains from reinvesting earnings

• dividend income has traditionally been taxed at higher rates than capital gains

factors that affect dividend policy

• investment opportunities

• expected volatility of future earnings

• financial flexibility

• tax considerations - double taxation; dividend imputation tax system (taxed once); split rate tax (distributed earnings taxed lower)

• shareholder preference for current income

flotation cost

• fees to issue shares

• adverse price impact from increase supply of shares

impairment of capital rule

• net value of the remaining assets as shown on the balance sheet be at least equal to some specified amount

Lintner’s model

Expected increase in dividends = (Expected earnings × Target payout ratio − Previous dividend) × Adjustment factor

• Adjustment factor = 1 / no. of years the adj will take place

share repurchase methods

• buy in open market - flexible - no legal obligation

• buy fixed number at fixed price - if more demand, prorate - done quickly

• dutch auction - range of acceptable prices - fill lowest first

• direct negotiation - premium to market price

impact of share repurchase on EPS

• internally financed - increase EPS if the funds would not earn the cost of capital if retained

• externally financed - increase EPS if earnings yield > after tax cost of debt

impact of share repurchase on BV per share

• BVPS decrease if market price > bv per share

dividend vs share repurchase

• high dividend tax - share repurchase have tax advantage

• if management views shares as undervalued - share repurchase

• share repurchase flexible - not obliged to carry through

• offset dilution from employee stock options

• increase leverage - change capital structure

dividend coverage ratio

income / dividends

FCFE coverage ratio

FCFE / (Dividends + share repurchases)

principal–agent vs principal–principal

• principal–agent - dispersed ownership - weak shareholders + strong managers

• principal–principal - concentrated/dispersed ownership + concentrated voting power- strong shareholders + weak managers (minority weak shareholders)

cost of debt

r_d = r_f + Credit spread

• traded debt - YTM - more liquid better

• credit rating - YTM of companies with similar credit ratings

• infer credit rating with IC ratios, financial leverage ratio

• amortizing loan lower cost of debt

Top-Down External Factors

• Capital availability - lower cost of capital

• market conditions - interest rate, inflation, macro

• legal and regulatory consideration - country risk

• tax jurisdiction - higher marginal tax rate - greater benefit of using debt

Bottom-Up Company Specific Factors

• revenue, earnings , cf volatility - sales risk (uncertainty of price and units); customer concentration risk; financial leverage

• asset nature and liquidity - highly liquid assets - lower cost of capital

• financial strength, profitability leverage

• security features - callability (higher); putable (lower); convertible (lower); cumulative (lower); share class

equity risk premium - forward dividend discount model

Macroeconomic Modeling - Grinold-Kroner

ERP = [DY + Δ(P/E) + i + g – ΔS] – E(r_f).

Expected capital gain = Δ(P/E) + i + g – ΔS

Expected repricing = Δ(P/E)

Earnings growth per share = i + g – ΔS

g = real economic growth

ΔS = change in shares outstanding

expected inflation

Bond Yield Plus Risk Premium Approach

r_e = r_d + RP,

RP is a risk premium to compensate equity investors for additional risk relative to the risk of investing in the company’s debt

Expanded CAPM

size premium

company specific risk premium

Build-Up Approach

r_e = r_f + ERP + SP + IP + SCRP,

country risk premium (CRP)

CRP = Sovereign yield spread x (Volatility of equity market) / (volatility of bond market)

Restructuring

• cost restructuring - outsourcing / offshoring (relocating operations)

• balance sheet restructuring - sale leaseback; dividend recapitalization (reduce equity share repurchase with cheaper debt)

• Reorganization

• leveraged buyout -

comparable company analysis

• data readily available

• difficult to find comparable

• sensitive to mispricing on market

• yields fair-trading price ; must add takeover premium to get fair takeover price

comparable transaction analysis

• no takeover premium - embedded in multiple

• few comparables

• exclude old transactions

• risk that acquirers over/under paid.

takeover premium

• PRM = takeover premium (as a percentage of stock price)

• DP = deal price per share of the target

• SP = unaffected stock price of the target (one week prior)