Objectives of the Course On successful completion of this course, you should be able to: Identify the purpose and relevance of Corporate Finance; Explain the use of a variety of advance capital budgeting techniques; Discuss the importance of risk and return in Corporate Finance; Discuss the process determining the capital structure and dividend policy; Apply financial derivatives in risk management; and Discuss factors that affect shareholders’ wealth.
Topic 1: Value and Capital Budgeting Net Present Value How to Value Bonds and Stocks Some Alternative Investment Rules Net Present Value and Capital Budgeting Risk Analysis, Options and Capital Budgeting
Topic 2: Risk and Return Capital Market Theory: An Overview Return & Risk: The Capital Asset Pricing Model (CAPM) An Alternate View of Risk and Return: The Arbitrage Pricing Theory Risk, Cost of Capital, and Capital Budgeting
Topic 3: Capital Structure and Dividend Policy Corporate Financing Decisions and Efficient Capital Markets Long-Term Financing: An Introduction Capital Structure: Basic Concepts Capital Structure: Limits to the Use of Debt Valuation and Capital Budgeting for the Levered Firm Dividend Policy: Why Does It Matter?
Topic 4&5: Long-Term Financing & Derivatives Issuing Securities to the Public Long-Term Debt Leasing Topic 5: Options, Futures, and Corporate Finance Options and Corporate Finance: Basic Concepts -Warrants and Convertibles , Derivatives and Hedging Risk
Research! Research is the art of seeing what everyone else has seen, and doing what no-one else has done.
The Time Value of Money Which would you rather have -- $1,000 today or $1,000 in 5 years? Obviously, $1,000 today. Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!!
Why TIME? NOT having the opportunity to earn interest on money is called OPPORTUNITY COST Remember, one CANNOT compare numbers in different time periods without first adjusting them using an interest rate.
Compound Interest When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest. FV = Principal + (Principal x Interest) = 2000 + (2000 x .06)
Future Value If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals? FV1= PV (1+i)n= $2,000(1.06)2 = $2,247.20 FV = future value, a value at some future point in time PV = present value, a value today which is usually designated as time 0 i = rate of interest per compounding period n = number of compounding periods
Future Value Example John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years. FVn = PV (1+i)nFV5= $5,000 (1+ 0.08)5 = $7,346.64
Present Value Since FV = PV(1 + i)n. PV= FV / (1+i)n. Discounting is the process of translating a future value or a set of future cash flows into a present value.
Present Value Example • Joann needs to know how large of a deposit to make today so that the money will grow to $2,500in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually. • Calculation based on general formula: PV0 = FVn / (1+i)n • PV0= $2,500/(1.04)5= $2,054.81
Finding “n” or “i” when one knows PV and FV If one invests $2,000 today and has accumulated $2,676.45 after exactly five years, what rate of annual compound interest was earned?
Annuities • An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods. • Examples of Annuities Include: Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings
Dividend Policy Learning Objectives Important Terms Mechanics of Dividend Payments Cash Dividend Payments M&M’s Dividend Irrelevance Theorem The “Bird in the Hand” Argument Dividend Policy in Practice Relaxing the M&M Assumptions Stock Dividends and Stock Splits Share Repurchases Summary and Conclusions
Dividend PolicyWhat is It? • Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation. • This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.
Types of Dividends • Dividends are a permanent distribution of residual earnings/property of the corporation to its owners. • Dividends can be in the form of: • Cash • Additional Shares of Stock (stock dividend) • Property • If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend.
Retained Earnings Corporate Profits After Tax Dividends Dividends a Financing Decision • In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm. • When a cash dividend is declared, those funds leave the firm permanently and irreversibly. • Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.
Dividends versus Interest Obligations Interest Interest is a payment to lenders for the use of their funds for a given period of time Timely payment of the required amount of interest is a legal obligation Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy Dividends A dividend is a discretionary payment made to shareholders The decision to distribute dividends is solely the responsibility of the board of directors Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)
Dividend Payments Cash Dividend - Payment of cash by the firm to its shareholders. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Record Date - Person who owns stock on this date received the dividend.
Mechanics of Cash Dividend Payments Declaration Date • this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class. • when CARRIED, this resolution makes the dividend a current liability for the firm. Date of Record • is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend. Ex dividend Date • is the date that the value of the firm’s common shares will reflect the dividend payment (ie. fall in value) • ‘ex’ means without. • At the start of trading on the ex-dividend date, the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend. Date of Payment • is the date the cheques for the dividend are mailed out to the shareholders.
Dividend PolicyDividends, Shareholders and the Board of Directors • There is no legal obligation for firms to pay dividends to common shareholders • Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because: • Board members are jointly and severally liable for any damages they may cause • Board members are constrained by legal rules affecting dividends including: • Not paying dividends out of capital • Not paying dividends when that decision could cause the firm to become insolvent • Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)
Dividend Reinvestment Plans (DRIPs) • Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm • DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash • Leads to shareholders owning odd lots (less than 100 shares) • Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders.
Dividend PaymentsStock Dividends Stock dividends simply amount to distribution of additional shares to existing shareholders They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account. Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future.
Dividend PaymentsStock Dividends Implications • reduction in the R/E account • reduced capacity to pay future dividends • proportionate share ownership remains unchanged • shareholder’s wealth (theoretically) is unaffected Effect on the Company • conserves cash • serves to lower the market value of firm’s stock modestly • promotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have more • adjusts the capital accounts • dilutes EPS Effect on Shareholders • proportion of ownership remains unchanged • total value of holdings remains unchanged • if former DPS is maintained, this really represents an increased dividend payout
Dividend PaymentsStock Dividends ABC Company Equity Accounts as at February xx, 20x9 Common stock (215,000) $5,000,000 Retained earnings 20,000,000 Net Worth $25,000,000 The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share. This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is: $40.00 (21,500) = $860,000 This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:
Dividend PaymentsStock Dividends After the stock dividend: ABC Company Equity Accounts as at March 1, 20x9 Common stock (236,500) $5,860,000 Retained earnings 19,140,000 Net worth $25,000,000 The market price of the stock will be affected by the stock dividend: New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36 The individual shareholder’s wealth will remain unchanged.
Cash Dividend PaymentsThe Macro Perspective • Aggregate after-tax profits run at approximately 6% of GDP but are highly variable • Aggregate dividends are relatively stable when compared to after-tax profits. • They are sustained in the face of drops in profit during recessions • They are held reasonably constant in the face of peaks in aggregate profits.
Cash Dividend PaymentsThe Macro Perspective - Question • Why are dividends smoothed and not matched to profits? • The companies chosen here illustrate the dramatic differences between companies: • Some pay no dividends • Some pay consistent cash dividends representing substantial yields on current shares prices • The highest yields are found in the case of Income Trusts and large stable ‘blue-chip’ financials and utilities
Modigliani and Miller’s Dividend Irrelevance Theorem The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.
M&M’s Dividend Irrelevance TheoremAssumptions • No Taxes • Perfect capital markets • large number of individual buyers and sellers • costless information • no transaction costs • All firms maximize value • There is no debt
M&M’s Dividend Irrelevance TheoremResidual Theory of Dividends The Residual Theory of Dividends suggests that logically, each year, management should: • Identify free cash flow generated in the previous period • Identify investment projects that have positive NPVs • Invest in all positive NPV projects • If free cash flow is insufficient, then raise external capital – in this case no dividend is paid • If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.
M&M’s Dividend Irrelevance TheoremResidual Theory of Dividends - Implication The implication of the Residual Theory of Dividends are: Investment decisions are independent of the firm’s dividend policy • No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken. • If the firm can’t make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own. • The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure on the following slide:
FIGURE OPTIMAL INVESTMENT Rate of Return WACC MC=MR Internal Funds Available $11,976 Million $177,607 Million M&M’s Dividend Irrelevance TheoremInternal Funds, Investment, and Dividends CHAPTER 22 – Dividend Policy
The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed Risk is a real world factor. Firm’s that reinvest free cash flow, put that money at risk – there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost! Remember the two-stage DDM?
The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed • Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors. • This implies that investors perceive non-dividend paying firms to be riskier and apply a higher discount rate to value them causing the share price to fall. • The difference between the M&M and Gordon arguments are illustrated in Figure 2 on the following slide: • M&M argue that dividends and capital gains are perfect substitutes
FIGURE 2 OPTIMAL INVESTMENT Gordon M&M The “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand Theory CHAPTER 22 – Dividend Policy
The “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand Theory Conclusions: • Firms cannot change underlying operational characteristics by changing the dividend • The dividend should reflect the firm’s operations through the residual value of dividends
Dividend Policy in Practice • Firms smooth their dividends • Firms tend to hold dividends constant, even in the face of increasing after-tax profit • Firms are very reluctant to cut dividends
Relaxing the M&M AssumptionsWelcome to the Real World! Dividends and Signalling • Under conditions of information asymmetry, shareholders and the investing public watch for management signals (actions) about what management knows. • Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon) (The Signalling Model is explained in Figure 3 found on the next slide.)
FIGURE 3 et $ et* dt* dt 1 2 3 Time Relaxing the M&M AssumptionsThe Signalling Model
Relaxing the M&M AssumptionsWelcome to the Real World! Agency Theory • Investors are wary of senior management so they seek to put controls in place. • There is a fear that managers may waste corporate resources by over-investing in low or poor NPV projects. • Gordon Donaldson argued this is the reason for the pecking order managements tend to use when raising capital • Shareholders would prefer to receive a dividend and then have management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend. • Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.
Relaxing the M&M AssumptionsWelcome to the Real World! Taxes and the Clientele Effect • Table (on the following slide) illustrates that different classes of investors face different tax brackets • Preference for dividends versus capital gains income depends on the province of residence and taxable income level leading to tax clienteles. • High income earners tend to prefer capital gains (there is an additional tax incentive for such individuals in that they can choose the timing of the sale of their investment…remember only ‘realized’ capital gains are subject to tax • Low income earners tend to prefer dividends Conclusion – firm’s should not change dividend policy drastically since it upsets the existing ownership base.
Share Repurchases Simply another form of payout policy. An alternative to cash dividend where the objective is to increase the price per share rather than paying a dividend. Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.