L5- Payout Policy and Capital Structure

Question 1

Characteristics of Payout Policy (I think)

Answer 1

–Dividend payments
–Stock repurchase plans
–Dividends have gradually been replaced as a means of payout by stock repurchase plans (starting around 1980)
–Proportion of dividend paying firms has declined, from about 64% in 1980 to 41% in 2005

Question 2

Who decides on dividend payments, and what key date do they set?

Answer 2

the board of directors, who also set a
record date

Question 3

What is the ex-dividend date, and why is it important?

Answer 3

the ex-dividend date occurs a few days before the record date. Investors who buy the stock before the ex-dividend date receive the dividend; those who buy on or after do not.

Question 4

How does a stock’s price typically react on the ex-dividend date?

Answer 4

The stock price typically drops on the ex-dividend date to reflect the loss of dividend entitlement. The number of shares remains the same, but the price adjusts downward.

Question 5

Why are managers reluctant to adopt dividend policies that may need to be reversed?

Answer 5

Managers see dividends as a “smooth” version of earnings, protecting the investors from fall in earning by holding back on
dividend payments when the earnings are high

Question 6

How do managers use dividends to “smooth” earnings for investors?

Answer 6

Managers aim to keep dividends stable by holding back on payments during high earnings periods so they can continue payouts when earnings decline.

Question 7

Which is more significant: dividend levels or dividend changes? Why?

Answer 7

Dividend changes are more significant. For example, an increase from $1 to $2 per share signals strong growth, whereas a constant $2 dividend may not be as impactful.

Question 8

Who approves stock repurchase plans, and who decides the timing and form?

Answer 8

The board of directors approves the plan, but often management decides the timing and method of execution.

Question 9

What are the three main ways to implement a stock repurchase plan?

Answer 9

–Open market operations
–Auction methods
–Negotiated trades

Question 10

Are stock repurchase plans a direct substitute for dividend payments?

Answer 10

No, firms that pay dividends also participate in stock repurchases, meaning repurchases complement rather than replace dividends.

Question 11

How do stock repurchases impact stock price and shares outstanding?

Answer 11

Stock repurchases reduce the number of shares in the market, helping the price per share remain stable.

Question 12

Which is more volatile: dividend payments or stock repurchases?

Answer 12

Stock repurchases are more volatile than dividend payments, as companies adjust repurchases more flexibly based on market conditions.

Question 13

What does an increase in dividend payments typically signal to investors?

Answer 13

An increase in dividend payments is interpreted as good news, suggesting confidence in future earnings.

Question 14

How do investors view a reduction in dividend payments?

Answer 14

A reduction in dividends is seen as bad news, possibly indicating financial difficulties or lower expected earnings.

Question 15

Do investors see stock repurchase plans as a long-term commitment?

Answer 15

No, investors do not view stock repurchase plans as a long-term commitment, unlike dividends

Question 16

Why do stock prices respond positively to stock repurchase plans?

Answer 16

–Management believes the stock is undervalued.
–Returning cash to investors prevents management from misusing “free cash flow”

Question 17

What does the Modigliani-Miller (MM) theory say about dividend policy?

Answer 17

MM-theory states that dividend policy does not affect shareholder wealth, as long as the firm’s investment policy remains fixed

Question 18

Under MM-theory, how does a firm fund a new investment while maintaining dividends?

Answer 18

If a firm pays out dividends and still wants to invest, it must raise new funds, either through debt or equity issuance

Question 19

In MM-theory, what happens if a firm funds an investment directly from cash instead of paying dividends?

Answer 19

If the firm uses cash for investment instead of dividends, shareholders receive value through future investment returns rather than immediate payouts.

Question 20

REVISE BALANCE SHEET MM THEORY AND INVESTMENT

Question 21

What key assumption does the Modigliani-Miller (MM) dividend irrelevance theory rely on?

Answer 21

MM-theory assumes no market frictions

Question 22

What are market frictions

Answer 22

–Taxation
–Agency costs
–Signalling

Question 23

What is Taxation in context of payout policy

Answer 23

If dividends are taxed more heavily than capital gains, investors may prefer firms to retain earnings or repurchase shares rather than pay dividends

Question 24

What are agency costs in the context of payout policy?

Answer 24

dividend payments to the shareholders may undermine the debt holders’ claim on the firm’s assets

Question 25

How does dividend signaling theory explain payout decisions?

Answer 25

Dividends can signal strong future prospects, as firms are unlikely to increase payouts unless they expect sustainable earnings.

Question 26

What is the Discounted Dividend Model (DDM) formula for valuing a stock? value per share formula

Answer 26

P0=D1/(r-g)..... g=growth, r= required return

Question 27

REDO Discounted Dividend Model and MM-Irrelevance

Question 28

What is capital structure?

Answer 28

refers to the mix of debt and equity on the liability side of the corporate balance sheet.

Question 29

What is the main focus of capital structure theory?

Answer 29

It examines the effects of a pure exchange of debt and equity on the total value of the firm

Question 30

What are 3 Capital structure Theories

Answer 30

--Modigliani-Miller irrelevance theory (no frictions) --Trade off theory --Pecking order theory

Question 31

REVISE MM IRRELEVANCE ON SLIDES

Question 32

What does the Modigliani-Miller theorem say about capital structure and WACC?

Answer 32

--Capital structure is irrelevant, but this does not imply that the cost of debt and equity remain constant when leverage changes. --The WACC (Weighted Average Cost of Capital) remains constant as leverage changes, but both debt and equity risks increase as leverage rises, which causes their respective costs to increase.

Question 33

What is the formula for the Weighted Average Cost of Capital (WACC)?

Answer 33

r= [(D/V) * rD] + [(E/V) * rE] V=D+E, rd=cost of debt, D=debt

Question 34

What is the formula for beta (β) in the context of capital structure?

Answer 34

β= [(D/V) * βD] + [(E/V) * βE] βD= beta of debt, D=debt, V=D+E

Question 35

What is the leverage formula for cost of equity (r_E)?

Answer 35

rE= r + [D/E * (r - rD)] r= cost of capital, rD= cost of debt, D=debt

Question 36

What is the leverage formula for beta (β_E)?

Answer 36

βE= β +[D/E * (β - βD)] β=beta, βD= beta of debt, D= debt

Question 37

REVISE CHANGING LEVERAGE

Question 38

What does the Trade-Off Theory of capital structure suggest?

Answer 38

The Trade-Off Theory suggests that a company balances the benefits of borrowing (like the debt tax shield) with the costs of borrowing (like the risk of financial distress and bankruptcy) to find an optimal level of debt.

Question 39

What are the benefits of borrowing according to the Trade-Off Theory?

Answer 39

--Debt tax shield: Interest on debt is tax-deductible, reducing taxable income and providing value. --Reduced agency costs: Borrowing can limit cash available to management, encouraging more disciplined decision-making.

Question 40

What are the costs of borrowing according to the Trade-Off Theory?

Answer 40

--Financial distress send a bad signal to customers --Financial distress makes dealings with suppliers harder --Financial distress distracts management from focusing on medium to long term strategic planning, and therefore the firm can lose competitive advantage

Question 41

REVISE Linking Trade Off Theory with MM-Theory

Question 42

What is the Pecking Order Theory?

Answer 42

Pecking Order Theory suggests that due to information asymmetry between management and outside investors, firms prefer to finance projects in a specific order. The hierarchy is: --Retained earnings (free cash flow) --Debt --Equity (last resort when debt becomes too risky).

Question 43

According to Pecking Order Theory, why is equity financing considered the last resort?

Answer 43

Equity financing is the last resort because it involves the highest adverse selection costs due to information asymmetry. When the firm issues equity, investors may suspect the firm is overvalued, leading to higher costs for the firm.

Question 44

What is the role of information asymmetry in the Pecking Order Theory?

Answer 44

Information asymmetry refers to the fact that management knows more about the firm's future prospects than outside investors. This creates adverse selection costs when seeking external funding. To minimize these costs, firms prefer to first use retained earnings, then debt, and only issue equity when necessary

Question 45

What does Trade Off Theory predict about profitable firms and borrowing?

Answer 45

Trade Off Theory predicts that profitable firms (with greater need for tax deductions and lower probability of financial distress) should borrow more, as they benefit from the tax shield that debt provides.

Question 46

What does Pecking Order Theory predict about profitable firms and borrowing?

Answer 46

Pecking Order Theory predicts that profitable firms (with greater access to free cash flow) should borrow less, as they can finance their investments using retained earnings rather than taking on debt.

Question 47

What is the relationship between growth and borrowing according to Trade Off Theory?

Answer 47

According to Trade Off Theory, high-growth firms should borrow less because they face higher costs of financial distress and agency costs. The increased risk of financial distress reduces their ability to take on debt

Question 48

What is the relationship between growth and borrowing according to Pecking Order Theory?

Answer 48

Pecking Order Theory predicts that high-growth firms should borrow more, as they have greater investment opportunities and a greater reliance on external capital, which often requires debt financing.

Question 49

REVISE EMPIRICAL PREDICTIONS RUSHED FLASH CARDS