|
|
All page numbers are references to Fundamentals of Corporate Finance, 7th edition by Brealey, Myers, and Marcus (McGraw-Hill, 2012)
This module covers two different, but related topics. In finance, we are fairly convinced that investment decisions are the key to value creation. In these two chapters, we look at capital structure and dividend policy. In Chapter 16, we investigate whether we can impact a firm’s Weighted Average Cost of Capital by adjusting the mix of Debt and Equity. In Chapter 17, we investigate whether we can impact a firm’s stock price by our choice of Dividend Policy. Other than the Capital Asset Pricing Model, this is the first time we will discuss Finance theory. In Chapter 16, we discuss M&M’s Perfect Capital Markets Theory of Capital Structure. The 1958 paper that contained this theory is generally regarded as the first Corporate Finance paper.
The "high concept" review of Chapter 16. The optimal capital structure is the mix of debt and equity that minimizes WACC and therefore maximize firm value (and possibly stock price). There is disagreement among finance theories as to whether an optimal capital exists, and if it exists, what is the proper mix. We know that capital structure varies by industry (page 446). Most companies seem to actually set their capital structure using "ad hoc" rules similar to those described in the Pecking Order Theory (page 260) and Tradeoff Theories (pages 259-260).
Need to Absorb - Definition of optimal capital structure, the basic logic and conclusions of the M&M no tax (Case 1), M&M with corporate tax (Case 2), tradeoff theory (Case 3), and pecking order theory. Business risk (often measured by operating leverage/operating risk) is largely out of the control of management) whereas financial risk (due to the use of debt and measured by financial leverage/financial risk) is in the control of management. The M&M Proposition II (Equation 16.1) is a reasonable method of estimating the impact on debt on the required return of stock.
Calculations to be covered and therefore potentially tested; WACC (from chapter 13), M&M with and without tax equations (page 242-254), Proposition II equation (equation 16.1), and Tax shield (equation 16.2).
Need to Read - Read the Chapter. Be prepared to do some internet searches where you need additional information about the Theories discussed.
Need to Do - Make 100 on the Chapter 16 Quiz. Questions and Problems that you should be able to answer - 1-22, 23 parts a and b only, 23-30. Some of the problems take many steps to solve, which is why they are listed as be able to solve. Note, many of the problems require thought and may require you do internet searches. I think my videos are better than the Chapter at explaining the M&M theories, so you should probably watch my videos or plan on doing some outside reading.
1. Read the Chapter Summary on Page 263-264, then read the Chapter introduction on pages 240-241. Watch the Chapter Overview video and the Chapter Lecture video. The Chapter Lecture video is an extended discussion of the concepts in the chapter, most will benefit from viewing the video. The Powerpoints for all of this chapter's videos are located here.
2. After viewing the Chapter Lecture video, be able to answer end of chapter Questions 9, 11, and 14.
3. Read pages 242-250. Watch the video on Case I: M&M No Taxes also known as M&M Perfect Capital Markets . The Powerpoints for all of this chapter's videos are located here, starting at about slide 19.
4. Be able to answer end of Chapter Questions 1, 2, and 15-18.
5. Read pages 250-254. Watch the video on Case II: M&M Corporate Taxes. The Powerpoints for all of this chapter's videos are located here, starting at about slide 35.
6. Be able to answer end of chapter Questions 3, 4, 21, and 22.
7. Read the rest of the chapter. Watch the Case III: Tradeoff Theory, Pecking Order Theory, and Financial Slack video. The Powerpoints for all of this chapter's videos are located here, starting at about slide 52.
8. If you need additional instruction, here are audio solutions to the most common types of Capital Structure type questions;
a. Audio Solution to: What is the return on equity for a firm with 15% return on assets, 10% return on debt, and a .75 debt-equity ratio? a. with no taxes? b. with a 30% tax rate?
b. Audio Solution to: A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this will generate $12.50 earnings per share. What will happen to EPS if operating income increases to $2.0 million?
c. Audio Solution to: Use the following information for the next several questions. Consider a world of Perfect Capital Markets. This world has no corporate or personal taxes, all investors have homogeneous expectations, no bankruptcy costs, and M&M’s no-tax theory of capital structure is true. Company Y is financed has the following market value balance sheet: Assets = $500.00 Liabilities = $0.00 Equity = $500.00
The firm had $40.00 in EBIT last year, and has just paid its annual dividend. The firm has 50 shares outstanding. The firm expects these same returns for the foreseeable future. The firm is a zero growth firm that pays out all excess earnings as a once per year, end-of-year dividend. Any time the firm changes its capital structure; it changes only the debt/equity mix and does not change its total physical assets. The firm’s liabilities consist entirely of perpetual debt with annual interest payments. The firm’s debt is risk-less, selling at par, and has a 3% current yield. If the firm were to change its capital structure, new debt would still have a 3% yield. The return on the market portfolio is 7%. Given this information, answer the following questions: a. What is the firm’s Return on Equity? b. What is the firm’s WACC? c. What is the Beta of the firm’s levered equity? Now assume that the firm issues $400.00 in debt and uses the funds to redeem equity. d. Write out the firm’s new Balance Sheet, with labels. e. What is the firm’s new stock price? f. What is the firm’s new Return on Equity? g. What is the firm’s new Weighted Average Cost of Capital?
9. Be able to answer the other suggested End of Chapter questions and problems. Be prepared for a moderately long quiz.
From Chapter 17
Need to Absorb - In this chapter we need to learn both the mechanics and the theories of dividend policy. We need to learn how dividends are paid and how corporations decide how much to pay. You should be able to explain how stock repurchases are used to distribute cash to investors. Most Finance professionals would argue that the optimal dividend policy is a “€long-run residual,”€¯ where we first determine the optimal capital budget and capital structure, with dividends being what is left over. Thus a third topic is to understand businesses determined a long-run dividend payout ratio, which establishes the percentage of earnings to be paid in dividends. You should be able to explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Finally, understand how market imperfections, especially the different tax treatment of dividends and capital gains, can affect payout policy. The impact of dividend policy impact upon firm value then depends on the extent of market inefficiency.
Need to Read - Reading the Chapter should be sufficient to understand this chapter’s materials.
Need to Do - Make 100 on the quiz. Be able to answer end-of-chapter Questions and Problems 1-14, and 19-22.
1. Watch the Chapter Overview video. Read the Chapter 17 Summary and pages 272-273. Then, watch the Chapter Lecture video. The Powerpoints for all of this chapter's videos are located here.
2. Read pages 274-281.
3. Watch the Dividend dates, Stock Dividends and their impact on Stock Price. The Powerpoints for all of this chapter's videos are located here, starting at about slide 20. Be ables to answer end of chapter Questions 1, 2, 9-11.
4. Read the rest of Chapter 17.
5. Watch the video on Dividend Theories. The Powerpoints for all of this chapter's videos are located here, starting at about slide 35.
6. If you need additional instruction, here are audio solutions to the most common types of dividend calculations;
7. Take the Chapter 17 Quiz.
Revised November 2, 2014.
