PROBLEMS ASSOCIATED WITH HIGH
GEARING
– M&M Model says that debt financing
increases the value of firm due to tax
shield.
– However, there are certain aspects of
high gearing that discourage
borrowing.
• BANKRUPTCY COSTS
– Direct bankruptcy costs
– Indirect bankruptcy costs
• FINANCIAL RELEVANCY COSTS
• These aspect are:
• BANKRUPTCY COSTS:
– As debt increases chances of default of
repayment of principal and interest
increases.
• Direct Bankruptcy Costs:
– In case of liquidation disposal of assets will
fetch less than going concern value of
assets. And there are other.
– Costs like liquidation and redundancy costs. The
loss in value is normally borne by the debt holders
.
INDIRECT BANKRUPTCY
COSTS
• When a firm goes into liquidation or approaches
near bankruptcy because under sever financial
distress.
– Employees leaving
– Vendors refusing to supply goods on
credit.
– Customers even leaving fearing firm
will not be able to honor its warranty
and after sales services commitments.
– Value of firm down as sale decline.
– TAX POSITION:
– Firm must ensure that it will pay tax in
future because the value increase is
incidental with paying of taxes. High
gearing reduces the taxable income
against which to off set interest expense.
– DEPRECIATION:
– Depreciation is also tax deductible and
also affects the EBIT.
OPTIMAL CAPITAL STRUCTURE
• Debt has a magic in it. It increases the risk
and reward to the firm and investors.
• Static theory of capital structure says that
a firm should borrow to the extent where
the tax shield benefit is at least equal to
the bankruptcy and financial distress costs
incidental to high gearing.
• We can see the optimal combination of
debt and value of the firm in graphical
form.
OPTIMAL STRUCTURE
STATIC THEORY OF CAPITAL STRUCTURE
VALUE OF FIRM
PV OF TAX SHEILD VL= VU + T x D
Bankruptcy & FD
VL
ACTUAL FIRM VALUE
MAX
FIRM VU
VALUE Value of No-Debt Firm
TOTAL DEBT
D
OPTIMAL DEBT LEVEL
DIVIDEND POLICY
–DVIDENDS
–HIGH & LOW PAYOUT
–DIVIDEND STRATEGIES
Two Components of Incomes:
Capital Gains – Price
Appreciation
Income – Dividends
TYPES OF DIVIDENDS
• Cash dividends
• Stock dividends
• CASH & STOCK DIVIDENDS
– Declaration date: The date on which dividend
is announced.
– Ex-dividend date: to ensure dividend goes to
right persons, this is two business days before
the record date.
– Record Date: On which the share register of
the firm is updated for shareholders record.
– Date of Payment: On which the dividend
cheques are sent to shareholders.
– Ex-Dividend: For example, the Board of
Directors declares dividend and record
date is set to Monday 18 September 2006,
then the ex-date will be Thursday 14
September 2006. If someone buys the
share in question on 13th Sept 2006,
he/she will be entitled to receive the
dividend just declared. Someone buying
the share on 14th will not be.
WHY DIVIDEND POLICY IS
IMPORTANT?
a) Affects shareholders attitude.
b) Dividend policy has implications on
capital budgeting program.
c) It reduces cash flow position.
d) It effects Debt Equity Ratio.
DIVIDEND POLICIES
• STABLE DIVIDEND PER SHARE:
– per share fixed amount of dividend paid
every year.
– Look favorably by investors and implies
low risk firm.
– Investors can easily forecast and
predict their earnings.
– Aid in financial planning.
CONSTANT DIVIDEND PAYOUT
(DIV PER SHARE/EPS)
• A fixed %age is paid out as dividend.
• Under this policy the dividend
amount will vary because the net
income is not constant.
HYBRID DIVIDEND POLICY
• This contains feature of both the
above mentioned policies.
• Dividend consists of stable base
amount and %age of increment in
FAT income years.
• This is more flexible policy but
increases uncertainty of future cash
flow or return to investors.
• The extra slice of %age is only paid
when there is high jump in income.
So it is not regularly paid.
FLUCTUATING
DIVIDENDS
• When the firm is having investment
opportunities on its plate or unstable
capital expenditure, then Dividends
are of residual amount i.e. amount left
after meeting capital expenditure.
FACTORS INFLUENCING
DIVIDEND POLICY
• GROWTH OF FIRM
• STABLE EARNINGS
• DEGREE OF FINANCIAL
LEVERAGE
• AVAILABILITY OF EXTERNAL
FINANCING
• CONTROL
IRRELEVANCE OF DIVIDEND
POLICY
•M&M assumes Perfect Capital
Markets with no cost, no
floatation cost to companies
and no taxes.
•Also, future profits are known
with certainty.
IRRELEVANCE OF DIVIDEND
POLICY
•According to M&M: As long as the
firm’s capital budgeting program
and debt policy is fixed, dividend
policy is irrelevant and does not add
some value to the company or firm.
•The dividend irrelevance simply
states the PV of dividends remains
unchanged even though div policy
may change the amount and timing
of dividends.
Example: Firm’s Dividend
Policy is fixed %age of
Dividend payout i.e. 50%
of EPS paid out as
Dividend.
Y FIRM A – DIV PAY OUT
EPS
3 DIV/SHARE
VALUE
1.50
TIME
• EXAMPLE: STABLE DIVIDEND
POLICY
Y FIRM B – DIV PAY OUT
EPS
VALUE
DIV/SHARE
1.50
TIME
POINTS TO REMEMBER
• Firm A’s pay out ratio is 50%. It means whatever
it earns, half of is paid as dividend.
• Firm B although has the same earning level, but
maintains stable dividend over time.
• Total dividend $ value is same under both
situations.
• There may be more value for firm b for
maintaining stable dividend because investors
may perceive more value.
• Brokerage fee, Floatation Cost and transaction
cost are also consider.
