Parrino

16.2 The Benefits and Costs of Using Debt 517

Value of firm with debt

Firm Value (VFirm) Value of the
interest tax shield

Value of firm with no debt

0 Debt/Firm Value (VDebt/VFirm) 1

EXHIBIT 16.6
How Firm Value Changes with Leverage When Interest Payments Are Tax
Deductible and Dividends Are Not

The value of a firm increases with leverage when interest payments are tax-deductible
and dividend payments are not, and when the second and third M&M conditions—that
there are no information or transaction costs and that the real investment policy of the
firm is not affected by its capital structure decisions—apply.

of its taxable income. As before, the firm is financed entirely with common equity, and manage-
ment is considering changing its capital structure by selling a $200 perpetual bond with an interest
rate of 5 percent and paying a one-time special dividend of $200. The firm produces annual cash
flows of $100, and the appropriate discount rate for these cash flows is 10 percent. What is the
value of the firm without any debt, and what will the value be if the restructuring is completed?

We begin by calculating the value of Millennium Motors without any debt. If the entire
$100 in pretax cash flows that the firm generates is taxable, Millennium’s after-tax cash flows
will equal $65 per year [$100 ϫ (1 Ϫ 0.35) ϭ $65]. Using the perpetuity formula, we find that
the value of the unleveraged firm is $650 ($65/0.10 ϭ $650) with a 10 percent discount rate.

We next calculate the value of the interest tax shield that would accompany the new debt.
This value is $70 (D ϫ t ϭ $200 ϫ 0.35 ϭ $70). The total value of the firm after the restructur-
ing is equal to the value of the unleveraged firm plus the value of the tax shield. In this case,
that is $720 ($650 ϩ $70 ϭ $720).

We can also calculate the WACC for Millennium Motors after the financial restructuring
using Equation 13.7. To do so, we must first calculate the value of the equity (VEquity). In this
case, since we know from Equation 16.1 that VFirm ϭ VEquity ϩ VDebt, we can calculate the value
of the equity to be $520 (VEquity ϭ VFirm Ϫ VDebt ϭ $720 Ϫ $200 ϭ $520). Since we also know
that the cash flows available to stockholders after the restructuring will equal $58.50 [($100 Ϫ
$10) ϫ (1 Ϫ 0.35) ϭ $58.50], we can calculate the required return on equity to be 11.25 per-
cent ($58.50/$520 ϭ 0.1125). This is the same number we got when we used Equation 16.3.
With these values, we are now ready to calculate the WACC:

WACC ϭ xDebtkDebt pretax11 Ϫ t2 ϩ xpskps ϩ xcskcs

ϭ a $200 b10.052 11 Ϫ 0.352 ϩ0 ϩ a $520 b10.11252 ϭ 0.0903, or 9.03%
$720 $720

As Exhibit 16.4 illustrates, the cost of common stock increases with the amount of debt in the
firm’s capital structure. In this example, it goes from 10 percent to 11.25 percent. However,
with the interest tax deduction, the WACC actually decreases from 10 percent (recall that the
cost of equity equals the WACC for a firm with no debt) to 9.03 percent.

When we perform the same calculations for other potential debt levels at Millennium, we
see how the value of the firm increases and the WACC decreases with the amount of debt in the
capital structure. This is illustrated in Exhibit 16.7 for levels of debt ranging from $0 to $800.

You should note several other points concerning Exhibit 16.7. First, we do not show the
calculations for a firm with 100 percent debt because all firms must have some common equity.

518 CHAPTER 16 I Capital Structure Policy

EXHIBIT 16.7 The Effect of Taxes on the Firm Value and WACC of Millennium Motors

The value of Millennium Motors increases and its WACC decreases with the amount of
debt in the capital structure. The calculations assume that the cost of debt remains constant
regardless of the amount of leverage and that the second and third M&M conditions apply.

Total debt

Cost of debt $0 $200 $400 $600 $800

EBIT 5.00% 5.00% 5.00% 5.00% 5.00%
Interest expense
Earnings before taxes $100.00 $100.00 $100.00 $100.00 $100.00
Taxes (35%) — 10.00 20.00 30.00 40.00
Net income
$100.00 $ 90.00 $ 80.00 $ 70.00 $ 60.00
Dividends 35.00 31.50 28.00 24.50 21.00
Interest payments
Payments to investors $ 65.00 $ 58.50 $ 52.00 $ 45.50 $ 39.00

Value of equity $ 65.00 $ 58.50 $ 52.00 $ 45.50 $ 39.00
Cost of equity — 10.00 20.00 30.00 40.00

Firm value $ 65.00 $ 68.50 $ 72.00 $ 75.00 $ 79.00
WACC
$650.00 $520.00 $390.00 $260.00 $130.00
10.00% 11.25% 13.33% 17.50% 30.00%

$650.00 $720.00 $790.00 $860.00 $930.00
10.00% 9.03% 8.23% 7.56% 6.99%

increases. This is because the size of the government’s slice of the pie gets smaller. Third, for
simplicity, we assume that the cost of debt remains constant. However, even though the cost of
equity increases, the WACC decreases. This decrease is entirely due to the interest tax shield.
Finally, while the value of the firm under each scenario is calculated as we have illustrated, you
can confirm the answer by noting that the firm value for each capital structure equals the pay-
ments to investors for the unleveraged firm, $65, divided by the WACC. The payments to in-
vestors for the unleveraged firm are used in this calculation, regardless of the firm’s capital
structure, because, as was the case for project analysis in Chapter 10, the effects of capital struc-
ture choices are reflected in the discount rate rather than the cash flows.

Other Benefits

Any firm that must pay taxes can benefit from the interest tax shield. Not surprisingly, most
financial managers cite it as a major benefit from using debt in a firm’s capital structure.

Although the tax benefit is important, you should be aware of other benefits. For example,
it is less expensive to issue debt than to issue stock. Underwriting spreads and out-of-pocket
costs are more than three times as large for stock sales as they are for bond sales. Recall from
Chapter 15 (in Exhibit 15.6) that a firm raising between $25.0 million and $49.9 million will
typically pay 7.09 percent of the amount raised to sell stock, but only 1.63 percent of the amount
raised to sell bonds—a substantial difference. This benefit is related to the second of the three
conditions identified by M&M. Issuance costs are a form of transaction costs. If there were no
transaction costs, then debt issues would not have this cost advantage.

Another benefit associated with using debt financing is that debt provides managers with
incentives to focus on maximizing the firm’s cash flows. Unlike dividends, which are discre-
tionary, interest and principal payments must be made when they are due. Because managers
must make these payments or face the prospect of bankruptcy, the use of debt puts more pres-
sure on managers to focus on the efficiency of the business. Because a bankruptcy filing can
destroy a manager’s career, managers will work very hard to avoid letting this happen. Provid-
ing managers with these incentives can increase the overall value of the firm.

Finally, debt can be used to limit the ability of bad managers to waste the stockholders’ money
on things such as fancy jet aircraft, plush offices, and other negative NPV projects that benefit the
managers personally. It does this by forcing managers to distribute excess cash to the investors. In
some very famous cases, such as General Motors in the 1980s and WorldCom in the 1990s, managers
wasted large amounts of corporate assets on negative NPV projects. Clearly, the managers at these
firms had a great deal of discretion over the use of the large sums of cash generated by their busi-

16.2 The Benefits and Costs of Using Debt 519

Calculating the Effect of Debt on Firm Value and WACC LEARNING
BY
PROBLEM: Up to this point, you have financed your pizza chain entirely with equity. APPLICATION 16.3
You have heard about the tax benefit associated with using debt financing and are con- DOING
sidering borrowing $1 million at an interest rate of 6 percent to take advantage of the
interest tax shield. You do not need the extra money, so you will distribute it to yourself
through a special dividend. You are the only stockholder.

Your pizza business generates taxable (pretax) cash flows of $300,000 each year and
pays taxes at a rate of 25 percent; the cost of assets, kAssets (which equals kcs for your un-
leveraged firm), is 10 percent. What is the value of your firm without debt, and how much
would $1 million of debt increase its value if you assume that all cash flows are perpetuit-
ies and that the second and third M&M conditions hold (that is, there are no information
or transaction costs and the real investment policy of the firm is not affected by its capital
structure decisions)? Also, what would the WACC for your business be before and after
the proposed financial restructuring?

APPROACH: The value of your restaurant chain equals the present value of the after-tax
cash flows that the stockholders and debt holders expect to receive in the future. Without
debt, this value equals the present value of the dividends that you can expect to receive
as the only stockholder. The value with debt equals the value without debt plus the value
of the interest tax shield.

The WACC before the financial restructuring equals kcs, since your firm currently has
no preferred stock or debt. Equation 13.7 can be used to calculate the WACC with debt.

SOLUTION: The value of your business without debt can be calculated using the perpetuity
model as follows:

VFirm ϭ 3 $300,000 ϫ 11 Ϫ 0.252 4 /0.10 ϭ $2,250,000
The value of the tax shield is:

D ϫ t ϭ $1,000,000 ϫ 0.25 ϭ $250,000

Therefore, after the restructuring, the value of the firm would be $2.5 million ($2,250,000
ϩ $250,000 ϭ $2,500,000).

The WACC before the financial restructuring equals:

WACC ϭ kcs ϭ 10%

To calculate the WACC after the restructuring, we must first calculate the cost of the com-
mon stock. Since the values of the firm and debt will be $2.5 million and $1 million, re-
spectively, the value of the equity must equal $1.5 million. The after-tax cash flows to
stockholders will equal $180,000 {[$300,000 Ϫ ($1,000,000 ϫ 0.06)] ϫ [1 Ϫ 0.25] ϭ
$180,000}. Therefore, kcs equals 12 percent ($180,000/$1,500,000 ϭ 0.12, or 12 percent).
We can now calculate the WACC using Equation 13.7 as follows:

WACC ϭ xDebtkDebt pretax11 Ϫ t2 ϩ xpskps ϩ xcskcs

ϭ a $1,000,000 b10.062 11 Ϫ 0.252 ϩ 0 ϩ a $$21,,550000,,000000 b 1 0.122
$2,500,000

ϭ 0.090, or 9.0%

The benefits arising from providing managers with incentives to focus on the cash flows
generated by their firms and limiting their ability to make poor investments are related to the
second and third conditions identified by M&M. These benefits are related to information and
transaction costs because if investors had enough information to know whether managers
were doing the right thing, or if it were reasonably inexpensive to provide the managers with
pay packages that gave them incentives to do the right thing on their own, there would be no
such benefits from debt. The benefits also relate directly to the M&M condition that capital

520 CHAPTER 16 I Capital Structure Policy

using debt to limit the investments managers can make is to change firms’ real investment
policies so that managers focus on investing in only positive NPV projects.

bankruptcy costs, or costs The Costs of Debt

of financial distress We have discussed several benefits associated with using debt. If this were the whole story,
osts associated with financial choosing the optimal capital structure would be straightforward. More debt would imply a
difficulties a firm might higher firm value, and financial managers would use as much debt as possible. In other words,
experience because it uses a plot of a firm’s value against the proportion of debt in its capital structure would look like the
debt financing upward-sloping line in Exhibit 16.6. Managers would try to move their firms’ capital structures
as far to the right as possible, and we would expect to see firms using as close to 100 percent
debt financing as possible.

Recall, however, that the debt of a typical public firm represents only about 30 percent of the
value of the firm. The fact that this number is so much lower than 100 percent raises a question: Is
it just that financial managers do not understand the benefits of debt, or is something else going on?
As you might suspect, the answer to this question is that financial managers are pretty smart and are
limiting the amount of debt in their firms’ capital structures for some very good reasons. Offsetting
the benefits of debt are costs, and these costs can be quite substantial at high levels of debt.

Exhibit 16.8 illustrates how the costs of using debt combine with the benefits to result in
an optimal capital structure that includes less than 100 percent debt. At low levels of debt, the
benefits are greater than the costs, and adding more debt increases the overall value of the firm.
However, at some point, the costs begin to exceed the benefits, and adding more debt financing
destroys firm value. Financial managers want to add debt just to the point at which the value
of the firm is maximized.

The costs of using debt fall into two general categories: bankruptcy costs and agency costs.

Bankruptcy Costs

Bankruptcy costs, also referred to as costs of financial distress, are costs associated with fi-
nancial difficulties that a firm might get into because it uses debt financing. The term bank-
ruptcy costs is used rather loosely in capital structure discussions to refer to costs incurred

Value of firm with only benefits from debt

Firm Value (VFirm) Value of firm with no debt Costs of
debt

Value of firm
with debt

Capital structure that maximizes
firm value

0 Debt/Firm Value (VDebt/VFirm) 1

EXHIBIT 16.8
Trade-Off Theory of Capital Structure

The benefits and costs of debt combine to affect firm value. For low levels of
debt, adding more debt to a firm’s capital structure increases firm value because
the additional (marginal) benefits are greater than the additional (marginal) costs.
However, at some point, which is the point at which the value of the firm is maximized,
the costs of adding more debt begin to outweigh the benefits, and the value of the
firm decreases as more debt is added. The difference between the upward-sloping
line and the curved line reflects the costs associated with debt.

16.2 The Benefits and Costs of Using Debt 521

when a firm gets into financial distress. Financial distress occurs when a firm is not able to direct bankruptcy costs
make all of the interest and principal payments that it owes its lenders. A financially distressed out-of-pocket costs that a
firm might subsequently enter into a formal legal bankruptcy process, such as those under firm incurs when it gets into
Chapter 11 or Chapter 7 of the U.S. bankruptcy code, but not all financially distressed firms financial distress
will do this.11 Consequently, as you will see shortly, firms can incur the bankruptcy costs dis-
cussed in this section even if they never actually file for bankruptcy. indirect bankruptcy costs
costs associated with changes
Direct Bankruptcy Costs. Direct bankruptcy costs are out-of-pocket costs that a firm in the behavior of people who
incurs as a result of financial distress. These costs include fees paid to lawyers, accountants, and deal with a firm when the firm
consultants. One of the first actions a firm’s management takes when the firm gets into finan- gets into financial distress
cial distress is to initiate negotiations with its lenders to defer its interest and principal pay-
ments. This deferment can give management more time to correct whatever went wrong with
the firm’s operations that made it difficult to make interest and principal payments in the first
place. Lawyers are experienced in assisting in these negotiations and in writing the necessary
legal documents. Additional accounting support often becomes necessary to satisfy demands
for information from lenders and to help management figure out what went wrong. Consul-
tants might be hired to help identify and implement changes to improve the firm’s perfor-
mance. The costs of hiring all of these people are included in direct bankruptcy costs. Since the
probability of financial distress increases with the amount of debt that a firm uses, the expected
size of these costs increases with leverage, driving up the interest rate that investors charge the
firm for its debt. Investors charge a higher interest rate when the expected value of direct bank-
ruptcy costs increases because the payment of these costs is likely to come out of the cash flows
that they would otherwise receive.

You might be asking yourself why the lenders to a firm would defer interest and princi-
pal payments. After all, pushing these payments further into the future reduces the present
value of the payments that the lenders are promised. The reason is simple: it can cost lenders
even more if they refuse to work with management and the firm is forced to file for bank-
ruptcy. Once a firm files for bankruptcy, legal fees increase because the firm must hire attorneys
to help with the bankruptcy process, and accounting fees increase because the bankruptcy
process will require the firm to generate even more information. In addition, the firm must
reimburse the court for the costs that it incurs. By negotiating with management up front,
the lenders might be able to help the firm avoid incurring the costs associated with the
formal bankruptcy process. This leaves more value in the firm, which can be used to satisfy
the lender’s claims.

Direct bankruptcy costs are a form of transaction costs that must be incurred to facilitate
negotiations with lenders and to navigate the bankruptcy process. The second condition iden-
tified by M&M—that there are no transaction and information costs—assumes that these
transaction costs do not exist. Because the costs do exist, they tend to offset, at least to some
extent, the benefits associated with debt. In fact, researchers have estimated that direct bank-
ruptcty costs can amount to as much as 3 to 5 percent of firm value. Although these costs are
substantial, they are not large enough on their own to cause the firm value curve to turn down-
ward in the manner illustrated in Exhibit 16.8.

Indirect Bankruptcy Costs. Indirect bankruptcy costs are costs associated with changes in
the behavior of people who deal with a firm when it becomes financially distressed. The interests
of many people who deal with a firm are normally similar to those of the stockholders—they
all want to maximize the firm’s value. However, when a firm gets into financial distress, the
interests of these people begin to differ, and the actions they take to protect their interests often
reduce firm value.

For example, suppose a firm’s products come with warranties or require after-sales service
or parts (automobiles, for example) and it becomes known that the firm is having financial
difficulties. Some of this firm’s potential customers will decide to purchase a competitor’s prod-
ucts because of concerns that the firm will not be able to honor its warranties or that parts or
service will not be available in the future. Other customers will demand a lower price to com-
pensate them for these risks. In either case, the firm’s revenues will decline below what they
would otherwise have been.

11You can find a discussion of the U.S. bankruptcy process on WileyPlus if you would like to read about what happens

522 CHAPTER 16 I Capital Structure Policy

When suppliers learn that a firm is in financial distress, they worry about not being paid.

They can do little about goods they have already shipped, but to protect against losses for fu-

ture shipments, they often begin to require cash on delivery. In other words, they will deliver

supplies only if the firm pays cash for them. This requirement can be devastating for a finan-

cially distressed firm because such a firm typically does not have much cash. For example, if a

retailer, like a department store, cannot pay cash for its merchandise, the amount of merchan-

dise on the shelves in its stores will decline over time. Customers will not be able to find what

they want, and they will respond by shopping at competitors’ stores. This will cause revenues

to decline even faster than they might otherwise have. In the worst case, suppliers’ demands for

cash payments can force a firm to stop operating altogether.

Employees at a distressed firm worry that their jobs or benefits are in danger, and some start

looking for new jobs. The loss of highly skilled employees can reduce the value of the firm, espe-

cially if they take jobs with direct competitors. Even when employees do not leave, their produc-

tivity will often decline because the firm’s problems lead to lower morale and distractions.

Like direct bankruptcy costs, indirect bankruptcy costs are transaction costs that would not

exist under the second condition identified by M&M. They are transaction costs because they

represent costs incurred in the course of contracting with the people who deal with the firm.

If the firm enters into the formal bankruptcy process, it incurs another indirect bank-

ruptcy cost. This cost stems from the fact that the bankruptcy judge must approve all of the

firm’s major investments. Bankruptcy judges are responsible for representing the interests of

the creditors and tend to be more conservative than the stockholders would like. This results

in a change in the firm’s real investment policy and a violation of the third M&M condition.

The nature of indirect bankruptcy costs differs from company to company. For example,

loss of skilled workers is more damaging to a technology firm than to a retailer. Potential cus-

tomers of an auto manufacturer worry a lot more

PEOPLE BEHAVE DIFFERENTLY TOWARD A about the implications of financial distress than
potential customers of a company that makes T-
BUILDING FIRM IN FINANCIAL DISTRESS, AND THIS shirts, whereas suppliers are concerned in both of
INTUITION INCREASES BANKRUPTCY COSTS these cases. In spite of these differences, indirect
bankruptcy costs are often very substantial and are
When a firm gets into financial distress, the peo- reflected in the interest rates that firms must pay.
Researchers have estimated that indirect bank-
ple who deal with the company take actions to ruptcy costs range from 10 to 23 percent of firm

protect their interests. These actions often contribute to the firm’s

problems because when the firm is financially distressed, the inter-

ests of customers, suppliers, and employees, among others, differ

from those of stockholders. value, suggesting that they can be large enough to

offset the interest tax shield benefit by themselves.

DECISION Capital Structure and Tax Rates
MAKING
SITUATION: You are the Chief Financial Officer at Maricopa Manufacturing Company
EXAMPLE 16.1 in Phoenix, Arizona. The company is currently financed with 30 percent debt and 70 per-
cent equity. Maricopa’s chief lobbyist in Washington D.C. just told you that he expects
the Federal government to reduce the top corporate income tax rate from 35 percent to
28 percent beginning next year. What action should you take with regards to Maricopa’s
capital structure?

DECISION: Assuming that state and local taxes are not also expected to change next
year, the reduction in the top Federal corporate income tax rate means that the interest
tax shield benefit your company receives from its outstanding debt will be going down.
If the current capital structure maximizes Maricopa’s value when the Federal income tax
rate is 35 percent and you expect all of the other costs and benefits of debt to remain
the same, you should reduce the amount of debt that is used to finance Maricopa when
the new tax rate goes into effect. This is because the smaller benefits from debt will be
offset by the costs of debt at a lower debt level. Precisely how much you should reduce
the company’s debt will depend on exactly how large the total benefits and costs will
be next year.

16.2 The Benefits and Costs of Using Debt 523

It is worth stressing that indirect bankruptcy costs occur at absolutely the worst time for a firm.
The point at which a firm gets into financial distress is the point at which it can benefit most from
the support of people who deal with it. However, this is exactly when it is often in the best interests
of those people to provide less support and, in many cases, abandon the firm. The associated changes
in behavior can accelerate the firm’s deterioration and push it into formal bankruptcy.

Agency Costs

The managers and stockholders of a firm also often behave in ways that reduce a firm’s value
when the firm becomes financially distressed. The resulting costs are a type of agency cost. You
may recall from Chapter 1 that agency costs result from conflicts of interest between principals
and agents. In agency relationships, one party, known as the principal, delegates decision-making
authority to another party, known as the agent. The agent is expected to act in the interest of the
principal. However, agents’ interests sometimes conflict with those of the principal.

To better understand agency costs, consider the following example. Suppose that you have
a newspaper route and you want to go out of town for a week. You offer a friend $100 to deliver
your papers while you are gone. If your friend agrees to the arrangement, you will have entered
into a principal-agent relationship. Now assume that you deliver the Wall Street Journal and
that all papers are supposed to be on your customers’ doorsteps by 6:00 a.m., before they leave
home for work. You tell this to your friend before you leave town, but he likes to sleep late in
the morning, so he doesn’t get all the papers delivered until 9:00 a.m. Because the papers are
late for five days in a row, a few customers complain, and some don’t give you a tip at the end
of the year as they have in the past. Any problems that arise because of the complaints and the
lost tips are examples of agency costs. These costs arose because you delegated decision-making
authority to your friend and he acted in his best interest rather than yours.

Stockholder-Manager Agency Costs. Stockholders hire managers to manage the firm
on their behalf. In this relationship, managers receive considerable decision-making authority.
While the board of directors approves major decisions and monitors the performance of the
managers on behalf of the stockholders, managers still make many decisions that the board
never observes. To the extent that the managers’ incentives are not perfectly identical to those
of the stockholders, managers will make some decisions that benefit themselves at the expense
of the stockholders.

As we saw in our discussion of the benefits of debt, a firm’s use of debt financing can help
align the interests of managers with those of stockholders. Using debt financing provides man-
agers with incentives to focus on maximizing the firm’s cash flows and limits the ability of bad
managers to waste the stockholders’ money on negative NPV projects. These benefits amount
to reductions in the agency costs associated with the principal-agent relationship between
stockholders and managers.

Although the use of debt financing can reduce agency costs, it can also increase these costs
by altering the behavior of managers. Managers often have a high proportion of their wealth
riding on the success of the firm, through their stockholdings, future income, and reputations.
Consequently, they tend to prefer less risk than stockholders who hold more diversified port-
folios. As you know, the use of debt increases the volatility of a firm’s earnings and the probabil-
ity that the firm will get into financial difficulty. This increased risk causes managers to make
more conservative decisions. For example, managers of firms with more financial leverage will
have greater incentives to turn down positive NPV projects with high risk than otherwise
similar managers at firms with less leverage. Similarly, managers at highly financially leveraged
firms will prefer to distribute fewer profits to stockholders because earnings retained as cash
provide a buffer against possible bankruptcy. These types of actions reduce the overall value of
the firm and are examples of agency costs associated with the use of debt financing.

Recall that the third M&M condition is that the use of debt financing does not affect the
firm’s real investment policy. To the extent that using debt financing causes managers to turn
down high-risk positive NPV projects and distribute fewer earnings, however, financing deci-
sions do affect real investment policies. Leverage provides managers with incentives to invest
in lower-risk positive NPV projects rather than in all positive NPV projects. It also provides
them with incentives to retain excess earnings. They might even have incentives to invest some
of the excess retained earnings in low-risk negative NPV projects. The fact that managers may

524 CHAPTER 16 I Capital Structure Policy

Stockholder-Lender Agency Costs. A principal-agent relationship also exists between
lenders and stockholders. When investors lend money to a firm, they delegate authority to the
stockholders to decide how that money will be used. The lenders expect that the stockholders,
through the managers they appoint, will invest the money in a way that enables the firm to make
all of the interest and principal payments that have been promised. However, stockholders may
have incentives to use the money in ways that are not in the best interests of the lenders.

For example, stockholders might decide that instead of investing the money to grow the
firm, they will distribute it to themselves as a dividend. In the U.S. corporate system, the liabil-
ity of stockholders is limited to the amount of money they have invested in the firm. Since
loans that are made to a corporation are contracts between the lenders and the corporation,
not the stockholders, paying such a dividend reduces the resources in the firm that are avail-
able to repay the lenders and therefore the value of the lender’s claims. Unless the dividend
violates the loan agreement or otherwise violates the law, the lenders have no way to get that
money back. This is an example of what we call a wealth transfer from the lenders to the stock-
holders. Wealth has been transferred because the stockholders have made themselves better off
at the expense of the lenders.

Lenders know that stockholders have incentives to distribute some or all of the funds that
they borrow as dividends. To protect themselves against this sort of behavior, lenders often
include provisions in loan agreements that limit the ability of stockholders to pay dividends.
However, these provisions are not entirely foolproof. Stockholders can be very innovative in
transferring wealth from lenders to themselves.

For example, in October 1992 Marriott Corporation had a substantial amount of debt that
had been borrowed to build new hotels. The economy was in a recession, and there was growing
concern about the ability of Marriott to make all of its promised interest and principal payments.
If the company defaulted, the stockholders stood to lose a good deal of the value of their stock.

In response to this situation, Marriott management announced a spin-off in which the
company would be split into two separate companies. After the spin-off, stockholders would
own one share of stock in each of the two new companies for every share that they had owned
in the original company. While spin-offs are quite common, this one was unique in that the
company was spinning off its most profitable businesses into one company and leaving much
of its debt, some real estate, and a small operating business in the other. The spin-off effectively
reduced the value of the assets that the lenders would have to rely on to receive their interest
and principal payments while reducing the assets that the stockholders could lose if there was
a default. When the spin-off was announced, the market value of Marriott’s public bonds de-
creased 16.51 percent, or $333.3 million, while the market value of Marriott’s outstanding
stock increased by $236.3 million.12 The increase in the value of the stock represented a wealth
transfer from the lenders to the stockholders. In addition, the fact that the value of the debt
went down more than the value of the equity increased suggests that the capital markets did
not like this transaction: the total value of the firm (debt plus equity) went down.

Notice that when we talk about stockholder-lender agency costs, we assume that manag-
ers do exactly what the stockholders would like them to do. However, in the discussion of
stockholder-manager agency costs, we saw that managers are not always so cooperative. This
results in some conflicting possibilities with respect to how financial leverage affects the man-
agers’ decisions. For example, in a firm that uses debt financing, managers prefer to invest in
low-risk projects, whereas diversified stockholders prefer high-risk projects. Stockholders will
pressure managers to invest in riskier projects, but whether stockholders get what they want
will depend on how strong the corporate governance system is in the firm.

To better understand the nature of the conflict between stockholders and lenders, con-
sider the following example. Suppose a firm has $50 million invested in 10 percent risk-free
bonds that will pay $55 million in one year. The firm also has one-year debt on which $50 mil-
lion of interest and principal will be due when it matures in a year. In other words, this firm is
solvent and will be able to repay its debt, but the equity will be worth only $5 million, since this
is all that will be left over after the lenders are paid.

Now suppose that the stockholders decide to sell the risk-free bonds and invest in a project
that has a 50 percent chance of returning $95 million in one year and a 50 percent chance of
returning only $15 million. Instead of receiving $50 million with no risk, the lenders will now

16.2 The Benefits and Costs of Using Debt 525

face a 50 percent chance of receiving the $50 million they are owed and a 50 percent chance of asset substitution problem
receiving only $15 million. The value that the lenders expect to receive is $32.5 million: the incentive that stockholders
in a financially leveraged firm
E1VBonds2 ϭ 10.50 ϫ $502 ϩ 10.50 ϫ $152 ϭ $32.5 million have to substitute more risky
assets for less risky assets
This amount is $17.5 million less than the $50 million that the lenders expected to receive
when the firm held the risk-free bonds. The value that the stockholders expect to receive, on Learn more about the
the other hand, has increased by $17.5 million, from $5 million to $22.5 million: savings and loan crisis of
the 1980s at http://www
E1VStock2 ϭ 3 0.50 ϫ 1$95 Ϫ $502 4 ϩ 10.50 ϫ $02 ϭ $22.5 million .fdic.gov/bank/
historical/s&l and http://
The change to riskier assets has resulted in a $17.5 million wealth transfer. This is known as the www.fdic.gov/bank/
asset substitution problem. Once a loan has been made to a firm, the stockholders have an analytical/banking/
incentive to substitute more risky assets for less risky assets. 2000dec/brv13n2_2.pdf.

Under certain circumstances, stockholders will actually have incentives to invest in risky underinvestment problem
negative NPV projects. To see how this can happen, assume that the stockholders in our ex- the incentive that stockholders
ample sell the $50 million of risk-free bonds and invest the proceeds in a project that has a 50 in a financially leveraged firm
percent chance of returning $70 million and a 50 percent chance of returning $10 million. The have to turn down positive
expected return on the $50 million investment is $40 million [(0.50 ϫ $70) ϩ (0.50 ϫ $10) ϭ NPV projects when the firm is
$40 million]. This is a negative NPV project. However, the value that the stockholders can ex- in financial distress
pect to receive is $10 million—twice as much as the $5 million they could expect to receive
when the firm owned the risk-free bonds:

E1VStock2 ϭ 3 0.50 ϫ 1$70 Ϫ $502 4 ϩ 10.50 ϫ $02 ϭ $10 million

The lenders bear the $15 million loss in firm value ($55 million Ϫ $40 million ϭ $15 million), and
they pay for the $5 million gain to the stockholders. The lenders now expect to receive $20 million
less than the $50 million they would have received if the risk-free bonds had not been sold:

E1VBonds2 ϭ 10.50 ϫ $502 ϩ 10.50 ϫ $102 ϭ $30 million

A situation similar to that just described confronted stockholders of firms in the savings
and loan industry in the mid-1980s. Many small savings and loan firms had a very high ratio
of debt to equity and faced the possibility that they would have to file for bankruptcy. With
little to lose, managers at savings and loan firms, who were often also large stockholders, started
making very risky real estate loans with high rates of interest. They knew that if the loans were
repaid, their firms would avoid bankruptcy and the stockholders would realize much of the
benefit. If the loans were not repaid the government, which insured all of the deposits used to
finance the loans, would have to bear the loss. Ultimately, these sorts of investments led to what
became known as the savings and loan crisis.

Stockholders of financially distressed firms can also have incentives to turn down positive
NPV projects. This situation is known as the underinvestment problem. It occurs in a finan-
cially distressed firm when the value that is created by investing in a positive NPV project is
likely to go to the lenders instead of the stockholders.

To see how this can happen, suppose that a company has debt with a face value of $50 mil-
lion outstanding and that the value of the company’s assets is $32.5 million. If the assets of
this financially distressed firm were sold today, the lenders would receive $32.5 million, and
the stockholders would receive nothing. Now suppose that the managers of the firm identify
a project that requires a $5 million investment and will return $17.5 million tomorrow with
no risk. Since the firm is distressed, management will have to sell stock to raise the $5 mil-
lion required for this investment. Does it make sense for the stockholders to make the
investment?

The answer is no, because if the stockholders invest the $5 million, they can expect to get
nothing back if the firm is subsequently sold. Both the $5 million that the stockholders invest
and the $12.5 million NPV from the project will go to the lenders. Instead of receiving $32.5
million, the lenders will receive $50 million, and the stockholders will be out $5 million. This
example illustrates why, in the real world, financially distressed businesses have a very difficult
time raising equity capital.

It is important to note that without financial leverage, there would be no asset substitution
or underinvestment problems. Stockholders would always want to invest in positive NPV proj-
ects and reject negative NPV projects regardless of their risk.

Lenders know that debt provides stockholders with incentives to alter their firms’ invest-

526 CHAPTER 16 I Capital Structure Policy

it is difficult to write contracts that protect lenders against this sort of behavior. Therefore, as
with any other risk that they cannot eliminate, lenders compensate by increasing the interest
rate that they charge. This increases the cost of adding more debt to a firm’s capital structure.

The fact that there are a number of different benefits and costs associated with the use of
debt financing suggests that managers will balance, or trade off, the benefits against the costs
when they choose a firm’s capital structure. We discuss this idea along with an alternative
theory for how managers choose their firms’ capital structures in the next section.

> BEFORE YOU GO ON

1 . What are some benefits of using debt financing?

2 . What are bankruptcy costs, and what are the two types of bankruptcy costs?

3 . What are agency costs, and how are they related to the use of debt financing?

16.3 TWO THEORIES OF CAPITAL STRUCTURE

LEARNING OBJECTIVE How do managers choose the capital structures for their firms? Next, we consider two theories that
attempt to explain how this choice is made: the trade-off theory and the pecking order theory.
rade-off theory
he theory that managers trade The Trade-Off Theory
off the benefits against the
osts of using debt to identify The trade-off theory of capital structure states that managers choose a specific target capital struc-
he optimal capital structure ture based on the trade-offs between the benefits and the costs of debt. This target capital structure
or a firm is the capital structure that maximizes the value of the firm, as illustrated in Exhibit 16.8.

pecking order theory Underlying the trade-off theory is the idea that when a firm uses a small amount of debt
he theory that in financing financing, it receives the interest tax shield and possibly some of the other benefits we dis-
projects, managers first use cussed. Since leverage is low and the chances that the firm will get into financial difficulties are
etained earnings, which they also low, the costs of debt are small relative to the benefits, and firm value increases. However,
iew as the least expensive as more and more debt is added to the firm’s capital structure, the costs of debt increase and
orm of capital, then debt, and eventually reach the point where the cost associated with the next dollar that is borrowed
finally externally raised equity, equals the benefit. Beyond this point, the costs of adding additional debt exceed the benefits,
which they view as the most and any additional debt reduces firm value. The trade-off theory of capital structure says that
expensive managers will increase debt to the point at which the costs and benefits of adding another dol-
lar of debt are exactly equal because this is the capital structure that maximizes firm value.

The Pecking Order Theory

The trade-off theory makes intuitive sense, but there is another popular theory of how the
capital structures of firms are determined. This is known as the pecking order theory. The
pecking order theory recognizes that different types of capital have different costs and that this
leads to a pecking order in the financing choices that managers make. Managers choose the
least expensive capital first then move to increasingly costly capital when the lower-cost sources
of capital are no longer available.

Under the pecking order theory, managers view internally generated funds, or cash on
hand, as the cheapest source of capital.13 Debt is more costly to obtain than internally gener-
ated funds, but is still relatively inexpensive. In contrast, raising money by selling stock can be
very expensive. As we saw in Exhibit 15.6, the out-of-pocket costs of selling equity are much
higher than the comparable costs for bonds. In addition, the filings required by government
agencies, such as the SEC, are greater, and the stock market tends to react negatively to an-
nouncements that firms are selling stock. When firms announce that they will sell stock, their
stock prices often decline because such sales can be interpreted as evidence that the firms are
not profitable enough to fund their investments internally. Of course, a lower stock price re-
duces the value of everyone’s shares and makes future stock issues even more costly, since more
shares will have to be sold to raise the same dollar amount.

13Since internally generated funds are reinvested on behalf of the stockholders, the true cost of these funds equals the
cost of equity. However, using internally generated funds enables the firm to avoid the costs associated with borrowing

16.3 Two Theories of Capital Structure 527

The pecking order theory says that firms use internally generated funds as long as they
are available. Following that, they tend to borrow money to finance additional projects until
they are no longer able to do so because of restrictions in loan agreements or until high inter-
est rates make debt unattractive. Only then will managers choose to sell equity. Notice that
the pecking order theory does not assume that managers have a target capital structure.
Rather, it implies that the capital structure of a firm is, in some sense, a by-product of the
firm’s financing history.

The Empirical Evidence

At this point, you might be asking yourself what we actually know about how capital structures
are determined in the real world. A great deal of research has been done in this area, and the
evidence supports both of the theories we have just described. When researchers compare the
capital structures in different industries, they find evidence that supports the trade-off theory.
Industries with a great many tangible assets, such as the air transportation, automobile, and gas,
electric, and sanitary services industries, typically use relatively large amounts of debt. In con-
trast, industries with more intangible assets and numerous growth opportunities, such as the
computer and drug industries, use relatively little debt. What accounts for this difference? At least
in part, the difference exists because indirect bankruptcy costs and stockholder-lender agency
costs tend to be lower in industries with more tangible assets. The assets in these industries have
higher liquidation values, and it is more difficult for stockholders to engage in asset substitution.
Exhibit 16.9 shows the extent of the variation in capital structures across industries.

Some researchers argue that, on average, debt levels appear to be lower than the trade-off
theory suggests they should be. Firms pay large amounts of taxes that could be reduced through
greater debt financing, even though their current capital structures are such that they face little
possibility of financial distress. For example, in 2010 the computer industry firms listed in the
opener to this chapter each held cash and short-term securities that exceeded the face value of
all of their interest-bearing debt. These firms pay out a great deal of money each year in taxes
and yet do not use long-term debt to reduce their taxes.

EXHIBIT 16.9 Average Capital Structures for Selected Industries at the End of 2009

This table shows average capital structures for different industries as of the end of 2009. The
industries are arranged in order of declining debt-to-firm value ratios, where firm value is
estimated as the market value of equity plus the book value of debt. Industries with a great
many tangible assets, such as the building construction, air transportation, and gas, electric,
and sanitary services industries, tend to have larger debt-to-firm value ratios.

Industry Description Number of Firms Debt/Firm Value

Building construction 23 0.52
Financial services 1,090 0.48
Air transportation 0.47
Paper and allied product manufacturers 51 0.42
Gas, electric, and sanitary services 56 0.40
Communications (including telephone companies) 225 0.38
Printing, publishing, and related industries 231 0.33
Transportation equipment (including automobiles) 55 0.31
Food stores 127 0.29
Furniture and fixture manufacturers 54 0.24
Food manufacturers 27 0.24
Electronic and other electrical equipment 142
(including computer) manufacturers 0.18
Business service companies 516 0.15
Chemicals and allied products 667
(including drug companies) 0.15
629

Source: Estimated by authors using data from the Standard and Poor’s Compustat database.

528 CHAPTER 16 I Capital Structure Policy

More general evidence also indicates that the more profitable a firm is, the less debt it
tends to have. This is exactly opposite what the trade-off theory suggests we should see. Under
the trade-off theory, more profitable firms pay more taxes, so they should use more debt to take
advantage of the interest tax shield. Instead, this evidence is consistent with the pecking order
theory. Highly profitable firms have plenty of cash on hand that can be used to finance their
projects, and over time, using this cash will drive down their debt ratios.

The pecking order theory is also supported by the fact that, in an average year, public firms
actually repurchase more shares than they sell. In the United States, internally generated funds
represent the largest source of financing for new investments, and debt represents the largest
source of external financing.

Both the trade-off theory and the pecking order theory offer some insights into how man-
agers choose the capital structures for their firms. However, neither of them is able to explain all
of the capital structure choices that we observe. The truth is that capital structure decisions are
very complex, and it is difficult to characterize them with a single general theory. In the next
section, we briefly discuss some of the practical issues that managers say they consider when
they make capital structure decisions.

> BEFORE YOU GO ON

1 . What is the trade-off theory of capital structure?

2 . What is the pecking order theory of capital structure?

3 . What does the empirical evidence tell us about the two theories?

16.4 PRACTICAL CONSIDERATIONS IN CHOOSING A CAPITAL STRUCTURE

LEARNING OBJECTIVE When managers talk about their capital structure choices, their comments are sprinkled with
terms such as financial flexibility, risk, and earnings impact. Managers don’t think only in terms
of a trade-off or a pecking order. Rather, they are concerned with how their financing decisions
will influence the practical issues that they must deal with when managing a business.

For example, financial flexibility is an important consideration in many capital structure
decisions. Managers must ensure that they retain sufficient financial resources in the firm to
take advantage of unexpected opportunities and to overcome unforeseen problems. In theory,
if a positive NPV investment becomes available, managers should be able to obtain financing
for it. Unfortunately, financing might not be available at a reasonable price for all positive NPV
projects at all times. For example, it might be difficult to convince investors that a project is as
good as management thinks it is. As a result, investors may require too high a return, making
the project’s NPV negative and causing the firm to pass up a good opportunity. Similarly, if the
firm does not have enough financial flexibility, an unforeseen problem might end up being
more costly than it should be. For instance, suppose that a firm’s major manufacturing facility
is destroyed by a hurricane. Insurance would eventually cover much of the loss, but by the time
the insurance settlement is received, the company might be out of business. In such cases, cash
is needed immediately to help employees so that key skills are not lost and to relocate or start
rebuilding as quickly as possible.

Managers are also concerned about the impact of financial leverage on the volatility of the
firm’s net income. Most businesses experience fluctuations in their operating profits over time,
and we know that fixed-interest payments magnify fluctuations in operating profits, thereby
causing even greater variation in net income. Managers do not like volatility in reported net
income because it causes problems in their relationships with outside investors, who do not
like unpredictable earnings. Furthermore, as we have seen, if a firm is too highly leveraged, it
runs a greater risk of defaulting on its debt, which can lead to all sorts of bankruptcy and
agency costs. Managers use the term risk to describe the possibility that normal fluctuations in
operating profits will lead to financial distress. They try to manage their firms’ capital struc-
tures in a way that limits the risk to a reasonable level—one that allows them to sleep at night.

A third factor that managers think about when they choose a capital structure is the impact

Summary of Learning Objectives 529

debt financing reduces the reported dollar value of net income. However, depending on the mar-
ket value of the firm’s stock, using debt instead of equity to finance a project can increase the
reported dollar value of earnings per share. Many managers are very concerned about the earn-
ings per share that their firms report because they believe that it affects the stock price. Financial
theory states that managers should not be so concerned about accounting earnings because
cash flows are what really matter. Whether they are right or wrong, if managers believe that ac-
counting earnings matter to investors, their capital structure decisions will reflect this belief.

Another factor that managers consider when making capital structure decisions is the
control implications of their decisions. The choice between equity and debt financing affects the
control of the firm. For example, suppose that a firm is controlled by the founding family,
which owns 55 percent of the common stock, and that the firm must raise capital to fund a
large project. The project has a zero NPV and will result in a 20 percent increase in the value of
the firm. On the one hand, using equity financing will drop the founding family’s ownership
(voting rights) below 50 percent if the family does not buy some of the new shares. In fact, they
will end up with 45.8 percent of the stock [55/(100 ϩ 20) ϭ 0.458, or 45.8 percent]. On the
other hand, their ownership will remain at 55 percent, and they will retain absolute control of
the firm if the project is financed entirely with debt. In such a situation, the founding family is
likely to prefer debt financing. Of course, although debt can help a controlling stockholder
retain control of a firm, too much debt can cause that stockholder to lose control. This can
happen if the firm uses so much debt that fluctuations in business conditions put the firm in
financial distress. When this happens, the ability of the creditors to control what happens to
the firm can overwhelm the ability of the controlling stockholder to do so.

These are just some examples of practical considerations that managers must deal with
when choosing the appropriate capital structure for a firm. There is no set formula that they
can follow in making financing decisions because many of these considerations are difficult to
quantify and their relative importance is unique to each firm. Nevertheless, it is safe to say that
the ultimate objective of a firm’s stockholders—and of managers who have the stockholders’
interests in mind—is to choose the capital structure that maximizes the value of the firm.

> BEFORE YOU GO ON

1 . Why is financial flexibility important in the choice of a capital structure?

2 . How can capital structure decisions affect the risk associated with net income?

3 . How can capital structure decisions affect the control of a firm?

S um m a ry of Learning Objectives

1 Describe the two Modigliani and Miller propositions, 2 Discuss the benefits and costs of using debt financing
the key assumptions underlying them, and their rele- and calculate the value of the income tax benefit as-
vance to capital structure decisions. Use Proposition 2 sociated with debt.
to calculate the return on equity.
Using debt financing provides several benefits. A major benefit
M&M Proposition 1 states that the value of a firm is unaffected arises from the deductibility of interest payments. Since inter-
by its capital structure if the following three conditions hold: (1) est payments are tax deductible and dividend payments are not,
there are no taxes, (2) there are no information or transaction distributing cash to investors through interest payments can in-
costs, and (3) capital structure decisions do not affect the real crease the value of a firm. Debt is also less expensive to issue
investment policies of the firm. This proposition tells us the three than equity. Finally, debt can benefit stockholders in certain situ-
reasons that capital structure choices affect firm value. ations by providing managers with incentives to maximize the
cash flows produced by the firm and by reducing their ability to
M&M Proposition 2 states that the expected return on a firm’s invest in negative NPV projects.
equity increases with the amount of debt in its capital structure.
This proposition also shows that the expected return on equity can The costs of debt include bankruptcy and agency costs.
be separated into two parts—a part that reflects the risk of the un- Bankruptcy costs arise because financial leverage increases the
derlying assets of the firm and a part that reflects the risk associated probability that a firm will get into financial distress. Direct bank-
with the financial leverage used by the firm. This proposition helps ruptcy costs are the out-of-pocket costs that a firm incurs when
managers understand the implications of financial leverage for the it gets into financial distress, while indirect bankruptcy costs are
cost of the equity used to finance the firm’s investments. Equation associated with actions the people who deal with the firm take to

530 CHAPTER 16 I Capital Structure Policy funds, then moving to debt, then to the sale of equity. In contrast to
the trade-off theory, the pecking order theory does not imply that
Agency costs are costs associated with actions taken by manag- managers have a particular target capital structure. There is empiri-
ers and stockholders who are acting in their own interests rather cal evidence that supports both theories, suggesting that each helps
than in the best interests of the firm. When a firm uses financial explain the capital structure choices made by managers.
leverage, managers have incentives to take actions that benefit
themselves at the expense of stockholders, and stockholders have 4 Discuss some of the practical considerations that man-
incentives to take actions that benefit themselves at the expense agers are concerned with when they choose a firm’s
of lenders. To the extent that these actions reduce the value of capital structure.
lenders’ claims, the expected losses will be reflected in the interest
rates that lenders require. Practical considerations that concern managers when they
choose a firm’s capital structure include the impact of the capital
Equation 16.4 can be used to calculate the value of the in- structure on financial flexibility, risk, net income, and the control
come tax benefit associated with debt. of the firm. Financial flexibility involves having the necessary fi-
nancial resources to take advantage of unforeseen opportunities
3 Describe the trade-off and pecking order theories of and to overcome unforeseen problems. Risk refers to the possi-
capital structure choice and explain what the empirical bility that normal fluctuations in operating profits will lead to fi-
evidence tells us about these theories. nancial distress. Managers are also concerned with the impact of
financial leverage on their reported net income, especially on a
The trade-off theory says that managers balance, or trade off, the per-share basis. Finally, the impact of capital structure decisions
benefits of debt against the costs of debt when choosing a firm’s capi- on who controls the firm also affects capital structure decisions.
tal structure in an effort to maximize the value of the firm. The peck-
ing order theory says that managers raise capital as they need it in
the least expensive way available, starting with internally generated

S um m a ry of Key Equations

Equation Description Formula
16.1 VFirm ϭ VAssets ϭ VDebt ϩ VEquity
16.2 Value of the firm as the sum of the debt and
equity values WACC ϭ xDebtkDebt ϩ xcskcs
16.3
16.4 Formula for the weighted average cost of capital (WACC) kcs ϭ kAssets ϩ a VDebt b 1kAssets Ϫ kDebt2
for a firm with only debt and common stock and no taxes Vcs

Cost of common stock in terms of the required VTax-savings debt ϭ D ϫ t
return on assets and the required return on debt

Value of the tax savings from debt (upper bound)

Self-Study Problems

16.1 If any of the three assumptions in Modigliani and Miller Proposition 1 are relaxed, which has the
most predictably quantifiable impact on the value of the firm?

16.2 If we assume that the cash flows for a firm with financial leverage are equal to the cash flows for
the same firm without financial leverage, what can we say about the value of this firm if its cost of
capital also does not vary with the degree of leverage utilized?

16.3 Are taxes necessary for the cost of debt financing to be less than the cost of equity financing?
16.4 You are offered jobs with identical responsibilities by two different firms in the same industry. One

has no debt in its capital structure, and the other has 99 percent debt in its capital structure. Will
you require a higher level of compensation from one firm than from the other? If so, which firm
will have to pay you more?
16.5 You are valuing two otherwise identical firms in the same industry. One firm has a corporate jet
for every executive at the vice president level and above, while the other does not have a single
corporate jet. More than likely, which firm has the greatest stockholder-manager agency costs?

Solutions to Self-Study Problems

16.1 The assumption with the most measurable impact is that involving taxes. We can calculate the
present value of the tax shield generated by the interest costs of borrowing. The impacts of the
other two assumptions, though real, are more difficult to predict.

16.2 If the cash flows produced by the firm and the cost of capital for the firm are the same, regardless
of the amount of leverage utilized, we can say that the value of the firm is also the same, regardless

Questions and Problems 531

16.3 The deduction for interest expense does make debt borrowing more attractive than it would oth-
erwise be. However, even without the interest deduction benefit, the cost of debt is less than the
cost of equity because equity is a riskier investment than debt. This means that the pretax cost to
the firm for debt is still lower than the cost of equity.

16.4 The firm with the large amount of debt financing (the 99 percent debt firm) has a higher probability
of becoming financially distressed. Therefore, you should require greater compensation from that firm
because your income is less certain and working at that firm poses a greater risk to your career.

16.5 While corporate jets can make economic sense because they enable managers to use their time
more efficiently, one jet per vice president is very unlikely to be cost effective. The multijet firm
most likely has higher stockholder-manager agency costs than the no-jet firm. It is probably
spending too much on jets. The cash that is being spent on excess jets could be invested in positive
NPV projects or returned to the firm’s stockholders.

Critical Thinking Questions

16.1 List and briefly describe the three key assumptions in Modigliani and Miller’s Proposition 1 that
are required for total firm value to be independent of capital structure.

16.2 Evaluate the statement that the weighted average cost of capital (WACC) for a firm (assuming
that all three assumptions of Modigliani and Miller’s propositions hold) is always less than or
equal to the cost of equity for the firm.

16.3 If the value of the firm remains constant as a function of its capital structure and the three Modi-
gliani and Miller assumptions apply, why might the overall cost of capital change or not change
as capital structure changes?

16.4 Consider the WACC for a firm that pays taxes. Explain what a firm’s best course of action would
be to minimize its WACC and thereby maximize the firm value. Use the WACC formula for
your explanation.

16.5 The Modigliani and Miller propositions, when the no-tax assumption is relaxed, suggest that the
firm should finance itself with as much debt as possible. Taking this suggestion to the extreme, is
it even possible to finance a firm with 100 percent debt and no equity? Why or why not?

16.6 Crossler Automobiles sells autos in a market where the standard auto comes with a 10-
year/100,000-mile warranty on all parts and labor. Describe how an increased probability of
bankruptcy could affect sales of autos by Crossler.

16.7 Agency problems occur because the nonowner managers and stockholders of a firm have
different interests. Propose a capital structure change that might help better align these
different interests.

16.8 If a firm increases its debt to a very high level, then the positive effect of debt in aligning
the interests of management with those of stockholders tends to become negative. Explain
why this occurs.

16.9 Using the Modigliani and Miller framework but excluding the assumptions that there are no
taxes and no information or transaction costs, describe the value of the firm as a function of the
proportion of debt in its capital structure.

16.10 When we observe the capital structure of many firms, we find that they tend to utilize lower
levels of debt than that predicted by the trade-off theory. Offer an explanation for this.

Questions and Problems

16.1 M&M Proposition 1: The Modigliani and Miller theory suggests that the value of the firm’s assets < BASIC
is equal to the value of the claims on those assets and is not dependent on how the asset claims are
divided. The common analogy to the theorem is that the total amount of pie available to be eaten
(the firm) does not depend on the size of each slice of pie. If we continue with that analogy, then
what if we cut up the pie with a very dull knife such that the total amount of pie available to be
eaten is less after it is cut than before it was cut. Which of the three Modigliani and Miller assump-
tions, if relaxed, is analogous to the dull knife? Hint: Think about the process by which investors
could undo the effects of a firm’s capital structure decisions.

16.2 M&M Proposition 1: Describe what exactly is meant when someone is describing the value of the

532 CHAPTER 16 I Capital Structure Policy

16.3 M&M Proposition 1: Under Modigliani and Miller’s Proposition 1, where all three of the as-
sumptions remain in effect, explain how the value of the firm changes due to changes in the
proportion of debt and equity utilized by the firm.

16.4 M&M Proposition 1: Cerberus Security produces a cash flow of $200 and is expected to con-
tinue doing so in the infinite future. The cost of equity capital for Cerberus is 20 percent, and the
firm is financed entirely with equity. Management would like to repurchase $100 in shares by
borrowing $100 at a 10 percent rate (assume that the debt will also be outstanding into the infi-
nite future). Using Modigliani and Miller’s Proposition 1, what is the value of the firm today, and
what will be the value of the claims on the firm’s assets after the stock repurchase? What will be
the rate of return on common stock required by investors after the share repurchase?

16.5 M&M Proposition 1: A firm that is financed completely with equity currently has a cost of capi-
tal equal to 15 percent. If Modigliani and Miller’s Proposition 1 holds and the firm’s management
is thinking about changing its capital structure to 50 percent debt and 50 percent equity, then
what will be the cost of equity after the change if the cost of debt is 10 percent?

16.6 M&M Proposition 1: Swan Specialty Cycles is currently financed with 50 percent debt and 50
percent equity. The firm pays $125 each year to its debt investors (at a 10 percent cost of debt),
and the debt has no maturity date. What will be the value of the equity if the firm repurchases all
of its debt and raises the funds to do this by issuing equity? Assume that all of the assumptions
in Modigliani and Miller’s Proposition 1 hold.

16.7 M&M Proposition 1: The weighted average cost of capital for a firm, assuming all three Modigliani
and Miller assumptions hold, is 10 percent. What is the current cost of equity capital for the firm if
the cost of debt for the firm is 8 percent, and the firm is 80 percent financed with debt?

16.8 Interest tax shield benefit: Legitron Corporation has $350 million of debt outstanding at an
interest rate of 9 percent. What is the dollar value of the tax shield on that debt, just for this year,
if Legitron is subject to a 35 percent marginal tax rate?

16.9 Interest tax shield benefit: FAJ, Inc. has $500 million of debt outstanding at an interest rate of 9
percent. What is the present value of the tax shield on that debt if it has no maturity and if FAJ is
subject to a 30 percent marginal tax rate?

16.10 Interest tax shield benefit: Springer Corp. has $250 million of debt outstanding at an interest
rate of 11 percent. What is the present value of the debt tax shield if the debt has no maturity and
if Springer is subject to a 40 percent marginal tax rate?

16.11 Interest tax shield benefit: Structural Corp. currently has an equity cost of capital equal to 15
percent. If the Modigliani and Miller Proposition 1 assumptions hold, with the exception of the
assumption that there are no taxes, and the firm’s capital structure is made up of 50 percent debt
and 50 percent equity, then what is the weighted average cost of capital for the firm if the cost of
debt is 10 percent and the firm is subject to a 40 percent marginal tax rate?

16.12 Practical considerations in capital structure choice: List and describe three practical consider-
ations that concern managers when they make capital structure decisions.

I N T E R M E D I AT E > 16.13 M&M Proposition 1: Keyboard Chiropractic Clinics produces $300,000 of cash flow each year. The

firm has no debt outstanding, and its cost of equity capital is 25 percent. The firm’s management
would like to repurchase $600,000 of its equity by borrowing a similar amount at a rate of 8 percent
per year. If we assume that the debt will be perpetual, find the cost of equity capital for Keyboard
after it changes its capital structure. Assume that Modigliani and Miller Proposition 1 holds.

16.14 M&M Proposition 1: Marx and Spender currently has a WACC of 21 percent. If the cost of debt
capital for the firm is 12 percent and the firm is currently financed with 25 percent debt, then
what is the current cost of equity capital for the firm? Assume that the assumptions in Modigliani
and Miller’s Proposition 1 hold.

16.15 M&M Proposition 1: What is the effect on Modigliani and Miller’s Proposition 1 of relaxing the
assumption that there are no information or transaction costs?

16.16 M&M Proposition 1: The weighted average cost of capital for a firm (assuming all three Modigliani
and Miller assumptions apply) is 15 percent. What is the current cost of equity capital for the firm if
its cost of debt is 10 percent and the proportion of debt to total firm value for the firm is 0.5?

16.17 M&M Proposition 2: Mikos Processed Foods is currently valued at $500 million. Mikos will be
repurchasing $100 million of its equity by issuing a nonmaturing debt issue at a 10 percent an-
nual interest rate. Mikos is subject to a 30 percent marginal tax rate. If all of the Modigliani and
Miller assumptions apply, except the assumption that there are no taxes, what will be the value of

Questions and Problems 533

16.18 M&M Proposition 2: Backwards Resources has a WACC of 12.6 percent, and it is subject to a 40
percent marginal tax rate. Backwards has $250 million of debt outstanding at an interest rate of
9 percent and $750 million of equity (market value) outstanding. What is the expected return on
the equity with this capital structure?

16.19 The costs of debt: Briefly discuss costs of financial distress to a firm that may arise when employ-
ees believe it is highly likely that the firm will declare bankruptcy.

16.20 The costs of debt: Santa’s Shoes is a retailer that has just begun having financial difficulty. Santa’s
suppliers are aware of the increased possibility of bankruptcy. What might Santa’s suppliers do
based on this information?

16.21 Stockholder-manager agency costs: Deficit Corp. management has determined that they will
come up short by $50 million on the firm’s debt obligations at the end of this year. Management
has identified a positive NPV project that will require a great deal of effort on their part. How-
ever, this project is expected to generate only $40 million at the end of the year. Assume that all
the members of Deficit’s management team will lose their jobs if the firm goes into bankruptcy at
the end of the year. How likely is management to take the positive NPV project? If management
declines the project, what kind of cost will Deficit’s stockholders incur?

16.22 Two theories of capital structure: Use the information in the following table to make a sugges-
tion concerning the proportion of debt that the firm should utilize in its capital structure.

Benefit or (Cost) No Debt 25% Debt 50% Debt 75% Debt

Tax shield $0 $10 $20 $30
Agency cost Ϫ$10 Ϫ$ 5 Ϫ$ 5 Ϫ$20
Financial distress cost Ϫ$ 1 Ϫ$ 3 Ϫ$10 Ϫ$10

16.23 Two theories of capital structure: Problem 16.22 has reintroduced taxes and information and
transaction costs to the simplified Modigliani and Miller model. If the marginal tax rate for the
firm were to suddenly increase by a material amount, would the capital structure that maximizes
the firm include less or more debt?

16.24 Two theories of capital structure: Describe the order of financial sources for managers who
subscribe to the pecking order theory of financing. Evaluate that order by observing the costs of
each source relative to the costs of other sources.

16.25 Two theories of capital structure: The pecking order theory suggests that managers prefer to
first use internally generated equity to finance new projects. Does this preference mean that these
funds represent an even cheaper source of funds than debt? Justify your answer.

16.26 The costs of debt: Discuss how the legal costs of financial distress may increase with the
probability that a firm will formally declare bankruptcy, even if the firm has not reached that
point yet.

16.27 Operating a firm without debt is generally considered to be a conservative practice. Discuss how < ADVANCED
such a conservative approach to a firm’s capital structure is good or bad for the value of the firm
in the absence of information or transaction costs and any effect of debt on the real investment
policy of the firm.

16.28 Finite Corp. has $250 million of debt outstanding at an interest rate of 11 percent. What is the
present value of the debt tax shield if the debt will mature in five years (and no new debt will
replace the old debt), assuming that Finite is subject to a 40 percent marginal tax rate?

16.29 The Boring Corporation is currently valued at $900 million, but management wants to com-
pletely pay off its perpetual debt of $300 million. Boring is subject to a 30 percent marginal tax
rate. If Boring pays off its debt, what will be the total value of its equity?

16.30 If we drop the assumption that there are no information or transaction costs, in addition to drop-
ping the no-tax assumption, then will the Modigliani and Miller model still suggest that the firm
should take on greater proportions of debt in its capital structure? Explain.

16.31 PolyAna Corporation has an abundant cash flow. It is so high that the managers take Fridays off
for a weekly luncheon in Cancun using the corporate jet. Describe how altering the capital struc-
ture of the firm might make the management of this firm stay in the office on Fridays in order to

534 CHAPTER 16 I Capital Structure Policy

CFA PROBLEMS > 16.32 Consider two companies that operate in the same line of business and have the same degree of

operating leverage: the Basic Company and the Grundlegend Company. The Basic Company
has no debt in its capital structure, but the Grundlegend Company has a capital structure that
consists of 50 percent debt. Which of the following statements is true?
a. The Grundlegend Company has a degree of total leverage that exceeds that of the Basic Com-

pany by 50 percent.
b. The Grundlegend Company has the same sensitivity of net earnings to changes in earnings

before interest and taxes as the Basic Company.
c. The Grundlegend Company has the same sensitivity of earnings before interest and taxes to

changes in sales as the Basic Company.
d. The Grundlegend Company has the same sensitivity of net earnings to changes in sales as the

Basic Company.

16.33 According to the pecking order theory:
a. New debt is preferable to new equity.
b. New equity is preferable to internally generated funds.
c. New debt is preferable to internally generated funds.
d. New equity is always preferable to other sources of capital.

16.34 According to the static trade-off theory:
a. The amount of debt a company has is irrelevant.
b. Debt should be used only as a last resort.
c. Debt will not be used if a company’s tax rate is high.
d. Companies have an optimal level of debt.

Sample Test Problems

16.1 Valentin’s Acting School produces annual cash flows of $5,000 and is expected to continue do-
ing so in the infinite future. The cost of equity capital for Valentin’s is 16 percent, and the firm is
financed completely with equity. The firm’s management would like to repurchase as much equity
as possible but will not pay more than $500 in interest expense to service the debt on the borrow-
ing to finance the repurchase. Valentin’s can borrow at a 10 percent rate (assume that the debt will
also be outstanding into the infinite future). Using Modigliani and Miller’s Proposition 1 and all
of its assumptions, what will be the value of each of the claims on the firm’s assets after the stock
repurchase?

16.2 Attic & Garage, Inc. is considering issuing $25 million of debt to repurchase shares of the firm. If Attic
& Garage follow through on the capital restructuring, what is the present value of the tax shield on that
debt if it has no maturity and Attic & Garage is subject to a 34 percent marginal tax rate?

16.3 GreenBack Landscapers produces an enormous amount of cash flow each year. The stockholders
of the firm believe that this level of cash flow has left the managers without much motivation for
finding new projects. The stockholders have hired a financial consultant to give them estimates
concerning the value of the tax shield, agency costs, and financial distress costs of the firm, given
four alternative capital structure scenarios. Use the following table to make a recommendation for
the proportion of debt that GreenBack should utilize for its capital structure.

Benefit or (Cost) No Debt 25% Debt 50% Debt 75% Debt

Tax shield $0 $3 $6 $9
Agency cost Ϫ$10 Ϫ$1 $0 Ϫ$ 5
Financial distress cost Ϫ$ 0 Ϫ$2 Ϫ$4 Ϫ$20

16.4 It may be difficult to provide incentives for managers to work hard when the firm is not experienc-
ing any financial distress. One solution that capital structure theory provides for that problem is to
increase the proportion of debt in the capital structure of the firm. If a firm is currently financed
with 90 percent debt, will additional debt help to further reduce the agency costs between stock-
holders and managers?

16.5 Mayan Imports has recently found a number of new positive NPV projects that it will need to
finance. Mayan has $100 million of cash on hand. It also has plenty of financial room to increase
its debt as a proportion of its capital structure. If Mayan follows the pecking order theory, what

Appendix: Leasing 535

Appendix: Leasing

Learning Objective

Describe what a lease is and discuss the motivations for leasing, what
types of assets are more likely to be leased, and the conflicts that arise
in lease agreements, and how the costs of these conflicts are limited by
lessors. Evaluate the choice between leasing and purchasing an asset.

Leasing is an alternative way of financing the acquisition of an asset. When the managers of a

firm decide to acquire an asset, they can often choose between (1) purchasing the asset with a

combination of debt and equity or (2) leasing it. A lease (or rental agreement) is a financial lease (rental agreement)

arrangement in which the user of an asset (the lessee) pays the owner of that asset (the lessor) a financial arrangement in
to use it for a period of time.1 which the user of an asset pays
the owner of the asset to use it
A lease divides the right to use an asset into two parts: (1) the right to use it during the for a period of time

term of the lease and (2) the right to use it after the lease ends—the salvage rights. The lessee

pays for the right to use the asset during the term of the lease while the lessor, who owns the lessee

asset, receives the lease payments in return for giving up the right to use the asset during the the user of a leased asset

term of the lease. As an example, consider a rental agreement through which an oil company lessor
leases an oil drilling rig for six months. This lease gives the oil company (the lessee) the right the owner of a leased asset
to use the rig for six months in return for payments to the owner of the rig (the lessor). The

owner retains all rights to use the rig after the agreement expires in six months.

Virtually all firms lease some of their assets. Commonly leased assets include office space,

furniture, computers, copy machines, cars, trucks, rail cars, airplanes, ships, and oil drilling rigs.

The length of a lease can be as short as a few minutes

(e.g., when someone leases the use of a supercom- LEASING IS AN ALTERNATIVE MEANS
puter to run a simulation) or as long as many years
(as is common with leases involving office space). OF FINANCING THE ACQUISITION OF BUILDING
AN ASSET INTUITION
Since leasing is an alternative means of financ-
ing the acquisition of an asset, whether leasing is When managers in a firm decide to acquire
more or less attractive than purchasing the asset
depends on the same factors that affect the choice an asset, they often have a choice between
of how much debt and equity should be used to
purchase an asset. In other words, the same three purchasing the asset using debt and equity or leasing the asset.

The firm gets the use of the asset in either case, but the ownership

rights are different.

M&M conditions that affect the choice between

debt and equity also affect the choice between leasing and purchasing an asset. If this choice

affects firm value, it must be because of (1) taxes, (2) information or transaction costs, or (3)

because it affects the real investment policy of the firm.

In this Appendix we first describe the two general types of lease agreements that busi-

nesses enter into. We then use the M&M conditions to provide a framework for understanding

why leasing can be more attractive than purchasing an asset and what types of assets are more

likely to be leased vs. owned. We next examine the types of conflicts that arise between lessees

and lessors and the different ways in which lessors limit the cost of these conflicts. Finally, we

discuss how managers choose between purchasing and leasing an asset.

Two Types of Leases

The value of an asset to a lessor is equal to the sum of the present value of the lease payments
that the lessor will receive plus the salvage value of the asset at the end of the lease. The present
value of the lease payments, as a percentage of the total value of an asset, varies with the length
of a lease agreement. For example, consider a rental company that both rents cars by the day and
leases them for up to seven years. The value of a one-day rental fee will be very small compared
to the total value of the car. If the daily rental fee for a $20,000 car is $50, this fee represents only

536 CHAPTER 16 I Capital Structure Policy

operating lease 0.25 percent ($50/$20,000 ϭ 0.0025 or 0.25 percent) of the total value. On the other hand, the
a lease which does not have lease payments on a seven-year lease might have a present value that equals the entire $20,000
he characteristics of a sale value of the car. In such a lease, the lessee is effectively paying as much as it would cost to buy
the car and, since the salvage value is likely to be quite small after seven years, the lease pay-
apital lease ments represent most of the value that the lessor will receive from the car. Note that the seven-
a lease which has the year lease is pretty close to an outright sale in which the lessor is selling the car to the lessee and
haracteristics of a sale providing 100 percent debt financing.

You can read more The fact that a lease can look like a sale is of concern to accountants and the IRS because
about the accounting accounting rules and tax laws treat leases and asset sales differently. Generally Accepted Ac-
treatment of operating counting Principles (GAAP) and the IRS distinguish between leases which are truly rentals
and capital leases at (known as operating leases) and leases that have the key elements of an outright sale (known
http://www.investopedia as capital leases). Specifically, a lease is considered to be a capital lease if any of the following
.com/study-guide/ four conditions hold: (1) the lease transfers ownership of the asset to the lessee at the end of the
cfa-exam/level-1/ lease term; (2) the lease contains a bargain purchase option;2 (3) the lease cannot be cancelled
liabilities/cfa16.asp. for a period that is greater than 75% of the estimated economic life of the asset; or (4) the pres-
ent value of the minimum lease payments is greater than 90% of the fair market value of the
asset. If none of these conditions holds, then a lease is classified as an operating lease.

The accounting and tax treatments of assets under capital leases are like those for assets
which are purchased by the user. Specifically, with a capital lease, the asset is recorded on the
balance sheet of the lessee, along with an offsetting liability that equals the present value of the
lease payments. The lessee must depreciate the asset and can only deduct, when calculating its
income taxes, the portion of the lease payments that the lessee would have paid on a loan to
purchase the asset. In contrast, with an operating lease, the asset is recorded on the books of
the lessor and is depreciated by the lessor. With an operating lease, the lessee is able to deduct
the entire lease payments when calculating income taxes.

Motivations for Leasing

The common motivation for leasing an asset is that doing so is a less-expensive way of obtain-
ing the use of the asset than purchasing it. In other words, leasing the asset will create more
value for stockholders than purchasing it.

Taxes

To see how leasing can create value for stockholders, consider how relaxing the first of the
M&M conditions, the assumption that there are no taxes, affects the choice between purchas-
ing and leasing an asset. Suppose that you need a new delivery truck for your pizza restaurant
business and that you can either (1) buy the truck outright using a loan or (2) lease the truck
from a truck leasing company. Assume that the truck will cost $30,000 and will be depreciated
for tax purposes using straight-line depreciation over three years to a salvage value of $0. Also
assume that your business pays a marginal tax rate of 10 percent on its taxable income and that
the truck leasing company, which is larger and more profitable, pays a marginal tax rate of 35
percent on its taxable income. Finally, assume that both you and the truck leasing company can
finance the entire $30,000 purchase price with a 5 percent three-year “balloon” loan from a
bank. The entire face value of a balloon loan is repaid at the end of the life of the loan, which
in this case is the end of the three-year life of the truck.

If you purchased the truck, you would receive a deduction of $10,000 per year for depre-
ciation and this would save you $10,000 ϫ 0.10 ϭ $1,000 per year in taxes. You would also save
$150 each year in taxes because of the interest deduction ($30,000 ϫ 0.05 ϫ 0.10 ϭ $150), for
a total tax saving of $1,150. By comparison, if the truck leasing company purchased the truck,
it would save $3,500 on its taxes each year because of the depreciation tax shield ($10,000 ϫ
0.35 ϭ $3,500) and $525 because of interest the interest deduction ($30,000 ϫ 0.05 ϫ 0.35 ϭ
$525). The truck leasing company’s total tax savings would be $3,500 ϩ $525 ϭ $4,025.

The difference between your total tax savings and that of the truck leasing company, $4,025 Ϫ
$1,150 ϭ $2,875, is a potential tax benefit that can be realized if you let the truck leasing
company purchase the truck and lease it to you. Furthermore, if the monthly lease payments

2A bargain purchase option is an option to buy the asset at a price that is so low, relative to the expected fair market

Appendix: Leasing 537

are set so that you and the truck leasing company split this $2,875 tax benefit, the leasing ar-
rangement is a win-win situation. You get the use of the truck for less than it would cost you to
buy it, and the truck leasing company profits from its share of the tax savings.

Reducing the combined tax obligations of two companies can provide an important mo-
tivation for leasing. The delivery truck example illustrates how a lease contract can increase
stockholder value when a company that uses an asset has a lower marginal tax rate than an-
other company. These types of tax differences, which exist between companies within coun-
tries as well as between companies in different countries, contribute to the wide range of leas-
ing opportunities that exist today.

Information and Transaction Costs firm-specific asset
an asset that is substantially
Tax savings represent only one potential source of savings from lease contracts. Reducing in- more valuable to a particular
formation and transaction costs can also provide an incentive to lease an asset. Furthermore, firm than to any other firm
information and transaction costs help provide us with insights as to what types of assets are
more or less likely to be leased.

Information and transaction cost motivations for leasing: To see how leasing can
reduce information and transaction costs, consider the choice between buying and leasing a
car. The cost of acquiring a car and of selling it after you have finished using it can be quite
high. When someone purchases a car they typically spend a considerable amount of time
learning about the alternative makes and models that are being offered for sale, visiting dealer-
ships, taking test drives, negotiating the price, etc. Similarly, selling a car can require spending
time searching for a buyer and negotiating and completing the sale. While it can make sense to
incur such information and transaction costs if you are going to keep a car for several years, it
makes no sense to do this if you only plan to use the car for a few days. This is the main reason
that there is such a large car rental industry. Car rental companies incur the information and
transaction costs associated buying and selling a car and spread them across a large number of
short-term renters, thereby reducing the cost of obtaining the use of a car for a few days. The
same motivation explains the short-term rental agreements that we see for assets like power
tools, moving trucks, and aircraft.

Of course, individuals and businesses also often lease cars for several years at a time. While
the information and transaction costs associated with purchasing and selling a car are spread
out (amortized) over a longer period and are therefore smaller on a per-day basis, there are
circumstances under which it can still make sense to enter into a leasing contract. For example,
a company can find it less costly to lease the cars in its fleet because a leasing company is able to
manage the fleet, including activities such as providing regular maintenance, more efficiently.
Furthermore, because the leasing company buys and sells a lot of cars in the ordinary course of
its business, it is likely to be able to acquire cars at a lower price and to realize a higher value
from used car sales. Cost reductions such as these contribute to the prevalence of long-term
lease agreements on assets like copiers, computers, and office space, as well as vehicles.

Finally, lease agreements in business are often written with clauses that allow the lessee to
terminate the agreement before the end of the lease term by providing 60 or 90 days’ notice to
the lessor. Early termination provisions like these provide the lessee with operational flexibil-
ity. For example, in the airline industry early termination provisions enable managers to rap-
idly, and at relatively low cost, adjust fleet sizes during economic downturns by reducing the
number of leased aircraft. This flexibility is valuable to airlines because the opportunity cost of
the capital tied up in an idle airplane is high. For example, if the cost of capital for an airline is
10 percent, the opportunity cost of capital that is tied up in a $150 million aircraft is $15 mil-
lion per year.

Why Certain Types of Assets are Leased: Information and transaction costs can also
help to explain what types of assets are leased rather than owned by companies. In order to see
why this is true, you must be familiar with the concepts of firm-specific asset and general-use
asset. A firm-specific asset is an asset that is substantially more valuable to a particular firm
than to any other firm. For example, the big signs with company names that you often see on
the top of office buildings are firm-specific assets. They are valuable to the company whose
name is on them, but virtually worthless to any other firm. Similarly, a company that has a

538 CHAPTER 16 I Capital Structure Policy

general-use asset would be of little value to any other company. In contrast to firm-specific assets, general-use
an asset which is of similar assets are of similar value to potential users, such as office buildings or office equipment.
alue to potential users
Firm-specific assets are leased less frequently than general-use assets because it is easier for
one party to engage in opportunistic behavior that harms the other party when a firm-specific
asset is leased. To see why this is the case, suppose that managers at Pfizer Inc., the pharmaceu-
tical firm, have decided to replace an old manufacturing plant. Instead of owning the new plant,
they are in discussions with potential investors who would build the plant to Pfizer’s specifica-
tions using their own money and then lease it to Pfizer.

Assume that the plant will cost $50 million and will have a useful life of 20 years. Also as-
sume that while it will be worth $50 million to Pfizer, the highest price anyone else would pay
for the plant is $40 million. In other words, the plant is a firm-specific asset in which $10 million
of the value can only be realized by Pfizer. Finally, assume that the firm-specific and general-use
values of the plant both decline in a straight line over its 20-year life as illustrated in the
following table:

Value component Year 0 Value Year 20
Pfizer-specific $10 mil Year 10 $ 0 mil
General $40 mil $ 5 mil $ 0 mil
$20 mil

Pfizer management does not want to include the plant on their company’s balance sheet, so
they decide to propose a leasing arrangement which avoids any possibility of the transaction
being classified as a capital lease. In particular, they decide to propose paying the investors for
making the investment using two consecutive 10-year operating leases. In order to avoid capital
lease treatment (which can negate some of the benefits from leasing), both Pfizer management
and the investors know that the first agreement cannot specify any of the conditions in the second
lease. In other words, all of the terms of the second lease will be negotiated in 10 years. The managers
propose to the investors that the value of the lease payments over the first 10-year lease should be
$25 million since the lease will cover half of the life of the $50 million facility.

This proposal concerns the investors. They worry that at the end of the first lease, Pfizer
won’t agree to lease payments in the second lease that have a value equal to the remaining $25
million that they invested. Since Pfizer managers know that the plant will be worth only $20
million to another user in year 10, the investors are afraid that if they accept $25 million in the
first lease that Pfizer managers will offer them only $20 million for the second lease and that
they will end up losing $5 million ($50 million invested Ϫ $25 million from first lease Ϫ $20
million from second lease ϭ $5 million). This is what economists call a hold-up problem.

To avoid being held up like this, the investors respond to Pfizer management by proposing
that the payments for the first lease be set so that their total present value equals $30 million.
This way, regardless of whether Pfizer leases the plant in the last 10 years the investors will re-
cover their investment. Unfortunately, while protecting the investors from the hold-up prob-
lem, this proposal subjects Pfizer to a hold-up problem. Specifically, in year 10 when it is time
to renew the lease, the investors will know that use of the plant in the last 10 years of its life will
be worth $25 million to Pfizer and that Pfizer would have to pay $25 million to obtain a com-
parable plant. Knowing this, the investors are likely to demand more that $20 million in the
second lease. In fact, they would be able to charge Pfizer up to $25 million. If they did this, use
of the plant for 20 years would end up costing Pfizer $55 million ($30 million ϩ $25 million ϭ
$55 million). Pfizer would be better off building the plant itself for $50 million.

There is no easy solution to the hold-up problem in the Pfizer example. Both parties will be
concerned about being held up because they cannot agree, in writing, on the terms for the second
lease without the overall transaction being classified as a capital lease. The potential for this sort
of problem arises whenever someone considers leasing a firm-specific asset. As a result, because
the firm-specific component in the value of firm-specific assets creates such a costly bargaining
environment, firm-specific assets are rarely leased. Because general-use assets tend to have a
similar value to a number of users, they are not as subject to hold-up problems and therefore are
more likely to be leased. Examples of commonly leased assets include transportation equipment,
such as cars, trucks, rail cars, and planes, office furnature and equipment, such as copiers and
computers, buildings with general office space, and other assets with a relatively large number of

Appendix: Leasing 539

Real Investment Policy

Even in the absence of taxes and information and transaction cost considerations, having the
ability to structure lease agreements can affect stockholder value by changing the real invest-
ment opportunities that are available to a firm. For example, managers at manufacturing firms
can sometimes use lease contracts to maximize the value of a product line by charging a higher
price to customers who are willing to pay more and yet still making their products accessible
to customers who are not willing to pay as much.

To see how this might be done, consider a manufacturing company that has developed a
new product for which there is limited direct competition in the market. The manufacturer can
choose whether to sell the product or just make it available through lease contracts.3 Leasing
provides more flexibility in setting prices than selling the product. For example, suppose a
manufacturing firm has two types of customers. One type of customer is not willing to pay
much more than the marginal cost to the manufacturing firm of producing its product because
these customers won’t be using it very intensively. The other type of customer is willing to pay
considerably more than the marginal cost because these customers will get a lot of use out of
the asset. In a situation like this, the company can set a lease price which provides a modest
return on producing an additional unit of the product, but which limits its use. The high-volume
users who are willing to pay more can be charged higher prices based on their usage levels.
Products such as office copiers, telephones, and TV cable boxes have all been made available to
consumers with such leasing schemes at one time or another.

It is worth noting that a firm can also achieve similar results by using a combination of
sales and leasing. This is done by setting a high sales price and a lower lease price. The high-
volume users will pay a high price to purchase the product, and low-volume users will lease.

Regardless of which strategy is used, using leases to charge different prices to different
customers affects the mix of real assets within a firm. A firm that leases the products it manu-
factures will have different assets than a firm that only sells its products. The former will be in
both the manufacturing and leasing businesses while the latter will be only in manufacturing.

Conflicts Between Lessees and Lessors

Separating the right to use an asset during the term of a lease from the right to use the asset
afterwards creates two natural conflicts of interest between lessees and lessors. These conflicts
concern how intensely the asset is used and how well it is maintained during the term of the
lease. The intensity of use and maintenance conflicts lead to what we refer to as the asset abuse
problem in leasing. The asset abuse problem can increase the cost of leasing for the lessor when
it is not controlled.

Intensity of Use Conflict: This conflict arises because the lessee can have an incentive to use a

leased asset more intensely than the lessor would prefer. As long as using the asset more intensely

does not significantly affect the lessee’s ability to use it during the lease term, the lessee does not

have an incentive to be concerned about how intensely the asset is used. To the extent that more

intense use reduces the value of the asset, this reduction is borne by the lessor. For example, if you

rent a car for a week you are unlikely to be concerned about driving it too many miles. On the

other hand, the company that leases it to you is likely to be concerned. If rental car customers aver-

age 1,000 miles a week instead of 500 miles a week,

the value of a rental fleet will decline more rapidly.

Maintenance Conflict: To the extent that cut- SPLITTING THE RIGHTS TO AN ASSET
ting back on maintenance expenditures does not
significantly affect a lessee’s ability to use a leased BETWEEN THE LESSEE AND LESSOR BUILDING
asset, the lessee has an incentive to spend less on CAN CREATE COSTLY CONFLICTS INTUITION
maintenance than the lessor would like. Spending
less on maintenance, or avoiding it altogether, can Separating the right to use an asset during
save the lessee money and time, but it can also re-
duce the asset’s salvage value and increase the out- the term of a lease from the right to use the

asset afterwards creates conflicts concerning how intensely the

asset is used and how well it is maintained during the term of the

lease. These conflicts can increase the cost of leasing.

of-pocket maintenance costs for the lessor.

3In practice, the leasing alternative would be accomplished by setting up a leasing subsidiary that is owned by the

540 CHAPTER 16 I Capital Structure Policy

The intensity of use and maintenance conflicts are related. The quantity of services that an
asset will provide over its life is generally related to how well it is maintained. Cutting back on
maintenance can magnify the negative effects of using an asset more intensely.

Lessors know all about the intensity of use and maintenance conflicts and do a number of
different things to protect themselves. It is important to recognize that it only makes sense to
lease an asset if these actions are able to reduce the cost of the asset abuse problem so that it is
smaller than the benefits of leasing. The things that lessors do to limit the cost of the asset
abuse problem include:

1. Invest in assets that are less subject to abuse: For example, hotel operators invest
in room furniture that is durable and less likely to show abuse. They that know that
people tend to take better care of their own furniture than furniture in hotels, and
so they tend to avoid purchasing furniture that shows wear and tear or breaks easily.
This is why, even in some of the best hotels, the furniture is made of veneer-covered
particle board.

2. Price the lease so that the expected return on invested capital is equal to its opportu-
nity cost: In doing this, lessors factor in the expected costs associated with asset abuse and
under-maintenance. A higher rental price compensates the lessor for the greater suscep-
tibility to asset abuse. This is the reason that the lease prices are so high for assets that are
more subject to abuse. You will see this if you ever rent a laptop computer. The daily rental
price can easily equal 20 percent of the cost of buying a comparable one. Unfortunately,
pricing the lease to compensate for asset abuse costs can also make the problem worse
because it discourages people who are less likely to abuse an asset from leasing it.

3. Track the total services obtained from the asset and charge the lessee based on useage:
This reduces the incentive for the lessee to use the asset intensively and compensates the
lessor if the lessee does this. An example of tracking useage and pricing based on it is seen
in Ryder or U-Haul truck rental agreements. In these agreements, the base rental price
includes a prespecified number of miles that the truck can be driven. The lessee must pay
an additional per-mile charge for each mile the truck is driven over that limit.

4. Require a damage deposit: Such deposits are commonly required in lease agreements
involving apartments or other assets where it is easy to observe abuse. They provide an
incentive for the lessee not to abuse the asset and make it easier for the lessor to recover
the cost if the asset is abused.

5. Bundle the lease contract with a service contract: Where under-maintenance is of particu-
lar concern, lessors often bundle a maintenance (service) contract with the lease contract.
In other words, the lessee must purchase a maintenance contract along with the lease.
Since the lessee simply has to make a phone call (or for a vehicle, bring it to the shop) in
order to have maintenance performed, he or she is more likely to do so.

6. Place explicit restrictions on how an asset may be used: Bundling a maintenance con-
tract with a lease might work well with an asset such as a copier where you are dealing
with ordinary maintenance. However, it will be less effective with a car where you are also
concerned about how the vehicle is driven. For this reason auto leasing companies often
place restrictions on the use of leased vehicles. For example, they might prohibit driving
the vehicle off-road or hauling a trailer with a weight in excess of a prespecified limit.
Restrictions on use also take other forms, such as prohibitions on commercial use of a
piece of equipment that is designed for home use or limits on sub-leasing office space or
an apartment.

7. Provide the lessee with the right to buy the asset when the lease expires: Having the
right to buy the asset gives the lessee an option on the salvage rights. This reduces his
incentive to abuse the asset during the lease term.

Evaluating a Leasing Opportunity

The analytical techniques that are used to choose between buying and leasing an asset are
identical to those used in capital budgeting. Analysts typically use NPV analysis. Since the as-
set that would be purchased is often exactly the same as the asset that would be leased, many

Appendix: Leasing 541

asset is owned or leased. These identical cash flows, which often include the revenues and costs
of goods sold associated with the sale of products produced using the leased asset, can be ig-
nored when comparing the two alternatives. For this reason, the NPV values in a buy versus
lease analysis only reflect cash flows that are not the same between the two alternatives. To see
how this analysis is done, consider the following example.

The owner of a small furniture manufacturing company in Athens, Ohio has to replace an
old wood lathe that has reached the end of its useful life. She is considering either buying or
leasing a replacement lathe. Under either alternative she plans to use the lathe in her business
for only six years, even though its economic life is expected to be considerably longer. Assume
that the furniture manufacturing company has a marginal tax rate of 25 percent.

Purchase alternative: It would cost $20,000 to purchase the replacement lathe, and a local
bank has offered to lend the entire amount to the company at an interest of 8 percent. The
loan would be a six-year balloon loan in which the company would not have to repay any
of the principal until the loan matures in six years. The lathe would be depreciated using
the five-year MACRS depreciation method shown in Exhibit 11.7. As a percentage of the
purchase price, the annual depreciation deductions would be 20 percent, 32 percent, 19.2
percent, 11.52 percent, 11.52 percent, and 5.76 percent in years 1 through 6, respectively.
Maintenance of the lathe would cost $500 per year, and the lathe is expected to have a
salvage value of $10,000 after six years.

Lease alternative: The company that manufactures the lathe offers a leasing option under
which the furniture manufacturing company can lease the lathe for an annual lease pay-
ment of $3,400 per year. With this option, the lessor will be responsible for maintenance
of the lathe and will take it back after six years. The lease will be classified as an operating
lease under the accounting and tax rules.

Analysis: We can assume that the revenues and cost of goods sold associated with the use
of the lathe are the same under either alternative and ignore these cash flows in comparing
the two alternatives. In making this assumption we are also assuming that the asset abuse
problem is not an important concern with this lease. There are two reasons this is reason-
able in this situation. First, the manufacturing company is unlikely to significantly alter its
production rates just to use this one machine more intensely. Second, the maintenance
arrangement, which bundles a service contract with the lease contract, will limit the main-
tenance conflict.

With the above information, the analysis of the purchase vs. lease options involves calcu-
lating the present value of the after-tax cash flows that are unique to each of them. The cash
flows that are unique to the purchase option are the interest and principal payments associated
with the loan, the tax savings associated with the depreciation of the lathe, the cost of the main-
tenance, and the salvage value of the lathe after six years. Exhibit A16.1 illustrates how the
annual after-tax value of these cash flows and their NPV are calculated and shows that the
present value of these cash flows is Ϫ$12,904.97.4 This NPV represents the total cost of obtain-
ing the use of this machine for six years if it is purchased.

Exhibit A16.2 shows the annual after-tax cash flows and the NPV for the lease alternative.
Since the lease is an operating lease, the furniture manufacturing company will be able to de-
duct the entire lease payment when calculating its taxes each year. Furthermore, since the lathe
will be owned, maintained, and depreciated by the lessor, the lessee does not have to worry
about the cash flows associated with the purchase or sale of the lathe, maintenance, or deprecia-
tion deductions. The NPV of the after-tax cash flows associated with the lease is Ϫ$12,539.18.5

Since the after-tax cost of owning the wood lathe for six years is greater than the after-tax
cost of leasing it for six years (the NPV is more negative), the owner of the furniture manufac-
turing company should lease the lathe.

4Note that we simply used the after-tax cost of the 8 percent loan as the discount rate. We did this because the bank
has agreed to lend the company the entire $20,000 purchase price at that rate. It only makes sense to do this if the
bank would lend the entire amount at that rate without any guarantees from the furniture manufacturing company or
its owner. If there were such guarantees, using the 8 percent stated cost of debt would understate the true cost of 100
percent debt financing.
5We use the same discount rate in the lease analysis that we used for evaluating the purchase alternative. We can do this
because the lease is effectively 100 percent debt financing, and we can assume that the risk associated with the lease

EXHIBIT A16.1 NPV of the Cash Flows for Purchasing the Wood Lathe

This table shows the cash flows and the NPV of the cash flows associated with purchasing the wood lathe. This analysis excludes cash flows which would be the same
under both the purchase and lease alternatives.

Loan Depreciation After-Tax After-Tax Total

Interest Percent Depreciation Maintenance Salvage After-Tax

Principal Pre-Tax After-Tax of Asset Deduction Tax Savings Cost Valuea Cash Flows

Repayment (8% ϫ $20,000) (2) ϫ (1 Ϫ 0.25) Cost (4) ϫ $20,000 (5) ϫ 0.25 $500 ϫ (1 Ϫ 0.25) $10,000 ϫ (1 Ϫ 0.25) (1)ϩ(3)ϩ(6)ϩ(7)ϩ(8)

Year (1) (2) (3) (4) (5) (6) (7) (8) (9)

1 Ϫ$1,600 Ϫ$1,200 20.00% $4,000 $800.00 Ϫ$375 $7,500 Ϫ$775
2 Ϫ$1,600 Ϫ$1,200 32.00% $6,400 $2,048.00 Ϫ$375 $473
3 Ϫ$1,600 Ϫ$1,200 19.20% $3,840 Ϫ$375
4 Ϫ$1,600 Ϫ$1,200 11.52% $2,304 $737.28 Ϫ$375 Ϫ$838
5 Ϫ$1,600 Ϫ$1,200 11.52% $2,304 $265.42 Ϫ$375 Ϫ$1,310
6 Ϫ$20,000 Ϫ$1,600 Ϫ$1,200 5.76% $1,152 $265.42 Ϫ$375 Ϫ$1,310
$66.36 Ϫ$14,009

After-tax cost of debt ϭ 0.08 ϫ (1 Ϫ 0.25) ϭ 0.06, or 6 percent
NPV of total after-tax cash flows at 6 percent ϭ Ϫ$12,904.97

aSince the lathe will be fully depreciated at the end of the sixth year, the entire salvage value will be taxable.

Summary of Learning Objectives 543

EXHIBIT A16.2 NPV of the Cash Flows for Leasing the Wood Lathe

This table shows the cash flows and the NPV of the cash flows associated
with leasing the wood lathe. This analysis excludes cash flows which
would be the same under both the purchase and lease alternatives.

Pre-Tax After-Tax

Lease Lease Payment

Payment (1) ϫ (1-0.25)

Year (1) (2)

1 Ϫ$3,400 Ϫ$2,550

2 Ϫ$3,400 Ϫ$2,550

3 Ϫ$3,400 Ϫ$2,550

4 Ϫ$3,400 Ϫ$2,550

5 Ϫ$3,400 Ϫ$2,550

6 Ϫ$3,400 Ϫ$2,550

After-tax cost of debt ϭ 0.08 ϫ (1 - 0.25) ϭ 0.06, or 6 percent

NPV of total after-tax cash flows at 6 percent ϭ Ϫ$12,539.18

Lease or Purchase Decision DECISION
MAKING
SITUATION: You work for a courier firm that offers fast physical delivery of packages in
downtown New York City (Manhattan). If someone wants to have a package delivered be- EXAMPLE A16.1
fore the postal service or one of the big courier firms, such as FedEx or UPS, can deliver
it, they will call your office and you will send a courier on a bicycle to pick up the package
and make the delivery. Your couriers have used their own bicycles up to this point, but you
have decided that it conveys a more professional image if they use identical bicycles with
your company’s logo on them. A bicycle manufacturing company has offered to lease or sell
you the bicycles that you want. After performing an NPV analysis, you find that the NPV as-
sociated with leasing a bicycle for two years is Ϫ$545.12 and that the NPV associated with
purchasing and maintaining the same bicycle is Ϫ$515.00. Should you purchase or lease
the bicycles?

DECISION: The NPV analysis suggests that you should purchase the bicycles because
it is less expensive to purchase them than to lease them. Of course, this assumes that all
the relevant costs are reflected in your analysis.

> BEFORE YOU GO ON

1 . What is a lease? What are the two types of leases?

2 . What is the most common motivation for leasing?

3 . What types of conflicts arise with leases, and why?

S um m a ry of Learning Objectives

1 Describe what a lease is and discuss the motivations for someone wants to obtain the right to use the asset for a period of
leasing, what types of assets are more likely to be leased, time. The most common motivation for leasing an asset is that
and the conflicts that arise in lease agreements, and how it is less expensive than purchasing the asset. However, leasing
the costs of these conflicts are limited by lessors. Evalu- might also be preferred because it provides the user with more
ate the choice between leasing and purchasing an asset. flexibility. General-use assets are more likely to be leased because
the hold-up problem will be less severe with them than with
A lease is a financial contract that divides the right to use an as- firm-specific assets. Because of the way a lease divides the right
set into two parts: (1) the right to use it during the term of the to use an asset, it leads to conflicts concerning how intensely it is
lease and (2) the right to use it after the lease expires (the salvage used and how well it is maintained. Ways in which lessors limit

544 CHAPTER 16 I Capital Structure Policy

less subject to abuse, (2) pricing leases to reflect expected abuse, assets can be used, and (7) offering the lessees the right to pur-
(3) tracking how intensely the leased assets are used and charg- chase the assets at the end of the lease. The analytical techniques
ing based on that intensity of use, (4) requiring damage deposits, that are used to choose between buying and leasing an asset are
(5) bundling lease and service contracts, (6) restricting how the identical to those used in capital budgeting.

Self-Study Problem

A16.1 You own a real estate investment firm and have been asked by the owner of Big Box Ship-
ping Company if you would be willing to construct an office building and lease it to Big Box.
The owner of Big Box has some very unusual requirements for the interior layout of the
building and is only willing to commit to leasing the building for 10 years, even though
the life of the building is likely to be many times that long. What should concern you about
this proposal?

Solution to Self-Study Problem

Assuming that there is likely to be sufficient demand for office space in the same area by other busi-
nesses at the end of the 10 years, the biggest concern would be the interior layout requirements. If
the owner of Big Box wants permanent interior walls for this layout and future potential tenants
are likely to demand costly changes, this building would be a firm specific asset, and might not be a
good investment for you. You should consider making the investment only if the the lease payments
include the cost of reconfiguring the space when Big Box moves out. Avoiding this sort of problem
is a major reason that modern office buildings are often built without permanent interior walls and
tenants use moveable cubicles instead.

Critical Thinking Questions

A16.1 Your boss just read an article about the tax benefits of leasing. He states that your firm should
lease all of its assets since it faces a low tax rate. How would you respond?

A16.2 You have decided to open a Segway Personal Transporter (PT) rental shop on your campus. A
Segway PT is a two-wheeled electric personal transportation system that enables a person to move
around more efficiently in urban settings. If you plan to rent Segway PTs by the day, what sort of
asset abuse problem(s) are you likely to be concerned about and how might you control it/them?

Questions and Problems

B A S I C > A16.1 Leasing: What characteristic of a lease leads to conflicts between the lessee and the lessor?

I N T E R M E D I AT E > A16.2 Leasing: Fresno Machine Shop has decided to acquire a new machine that costs $3,000. The

machine will be worthless after three years. Only straight-line depreciation is allowed by the IRS
for this type of machine. ABC Leasing, Inc. offers to lease the same machine to Fresno under an
operating lease. Annual lease payments are $1,200 per year and are due at the end of each of the
three years. The market-wide borrowing rate is 8 percent for loans on assets such as this. Fresno’s
marginal tax rate is 35 percent. Should Fresno lease the machine or buy it? Assume that Fresno
would not borrow to purchase the machine.

ADVANCED > A16.3 Your firm is considering leasing an emachine.® The lease lasts for three years and calls for four

payments of $100 per year with the first payment due immediately. The emachine would cost
$360 to buy and would be depreciated using straight-line depreciation over three years to a sal-
vage value of zero. The actual salvage value is expected to be $100 after three years. The market-
wide borrowing rate is 10 percent for loans on assets such as this, and your firm’s marginal tax
rate is 25 percent. Should your firm lease or buy the emachine?

Dividends,

17Stock

Repurchases,
and Payout
Policy

Learning Objectives

Praxair, Inc.

I 1 Explain what a dividend is, and describe
n July 2010, managers at Praxair, Inc., an international producer the different types of dividends and the CHAPTER SEVENTEEN
dividend payment process. Calculate the

and distributor of industrial gasses such as oxygen, nitrogen, argon, expected change in a stock’s price around

helium, hydrogen, and acetylene, announced a $1.5 billion stock an ex-dividend date.

repurchase program. Under this program the company’s manage-
ment was authorized to use up to $1.5 billion of excess cash to buy 2 Explain what a stock repurchase is and how
companies repurchase their stock. Calculate
Praxair stock on the open market. Management noted that repur-
how taxes affect the after-tax proceeds that
chasing stock made sense in light of the company’s strong balance
a stockholder receives from a dividend and
sheet (debt was less than 15 percent of the total market value of
from a stock repurchase.
the company) and management’s expectation that future operating

cash flow would be considerably greater than the company’s capital 3 Discuss the benefits and costs associated

investment requirements. with dividend payments and compare the

Stock repurchase programs are commonly used to distribute relative advantages and disadvantages of

excess cash to stockholders. However, these programs are not the dividends and stock repurchases.

only way to do this. Such distributions can also be accomplished by 4 Define stock dividends and stock splits and
paying dividends. In fact, until 2005 U.S. public firms distributed
explain how they differ from other types of
considerably more money each year through dividends than
dividends and from stock repurchases.
through stock repurchases. Since then, the total value of stock re-

purchases has exceeded the total value of dividends. 5 Describe factors that managers consider

At the time that Praxair management announced its stock when setting the dividend payouts for

repurchase program, the company was also paying a regular quar- their firms.

terly dividend of $0.45 per share. With just over 306 million shares

outstanding, these quarterly dividends totaled over $550 million

each year. Praxair managers could have simply increased the firm’s dividend to distribute

the $1.5 billion, but instead made a conscious decision not to do so. Why did they do this?

What factors led management to choose to repurchase stock rather than increase dividends?

This chapter discusses concepts that help us answer questions like these and ultimately to

546 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

understand why managers make the dividend and stock repurchase decisions that they make.
It also helps us understand why firms distribute capital to stockholders in the first place and
the implications of such distributions.

CHAPTER PREVIEW when a company makes an announcement about future divi-
dend payments. These discussions provide insights into the
In Chapter 16, we discussed factors that influence capital struc- ways in which payout policies affect firm value. We end this
ture decisions at firms. In this chapter, we look at some different part of the chapter by directly comparing the benefits and
but related financing decisions—those concerning how and costs of dividends with those of stock repurchases.
when to return value (cash or other assets) to stockholders.
We then describe stock splits and stock dividends and dis-
We begin by describing the various types of dividends and cuss the reasons managers might want to split their com-
the dividend payment process. We then introduce an alterna- pany’s stock or pay a stock dividend. Finally, we conclude
tive to dividends—stock repurchases. Stock repurchases are a the chapter with a discussion of factors that managers and
potential component of any payout policy because, like divi- their boards of directors consider when they set payout
dends, they are a means of distributing value to stockholders. policies.

We next discuss the benefits and costs associated with mak-
ing dividend payments and describe how stock prices react

17.1 DIVIDENDS

LEARNING OBJECTIVE Decisions concerning whether to distribute value to stockholders, how much to distribute, and

how best to distribute it are very important financing decisions that have implications for a

firm’s future investment and capital structure policies. Any time value is distributed to a firm’s

stockholders, the amount of equity capital invested in the firm is reduced. Unless the firm

raises additional equity by selling new shares, distributions to stockholders reduce the avail-

ability of capital for new investments and increase the firm’s financial leverage.

payout policy The term payout policy refers to a firm’s overall policy regarding distributions of value

he overall policy concerning to stockholders. In this section, we discuss the use of dividends to distribute this value. A
he distribution of value from a dividend is something of value that is distributed to a firm’s stockholders on a pro-rata basis—
firm to its stockholders that is, in proportion to the percentage of the firm’s shares that they own. A dividend can involve

dividend the distribution of cash, assets, or something else, such as discounts on the firm’s products that
omething of value distributed are available only to stockholders.

o a firm’s stockholders on a When a firm distributes value through a dividend, it reduces the value of the stockhold-

pro-rata basis—that is, in ers’ claims against the firm. To see this, consider a firm that has $1,000 in cash plus other as-
proportion to the percentage of sets that have a market value of $9,000. If the firm has no debt and there are 10,000 shares
he firm’s shares that they own outstanding, what is the value of each share? Each share of this firm is worth $1, since the

total value of the cash and the other assets is

BUILDING DIVIDENDS REDUCE THE STOCKHOLDERS’ $10,000 and the stockholders own it all.
INVESTMENT IN A FIRM Now, suppose management distributes the

INTUITION A dividend reduces the stockholders’ investment $1,000 of cash as a dividend. Each stockholder re-
ceives 10 cents ($1,000/10,000 shares ϭ $0.10) for
in a firm by distributing some of that investment each share that he or she owns, and the value of
each share declines to 90 cents. This is true because
to them. The value that stockholders receive the firm is now worth $9,000 and there are still
through a dividend was already theirs. A dividend simply takes this 10,000 shares. Note that each stockholder still has

value out of the firm and returns it to them.

$1 of value for each share owned, but the share rep-

resents only 90 cents of the total. The other 10 cents is in the hands of the stockholder, who can
spend or reinvest it.1

1The investors will actually have less than 10 cents per share to invest if they are required to pay taxes on the dividend.
Later in this chapter, we discuss how tax laws affect the attractiveness of dividends to investors and the dividend deci-

17.1 Dividends 547

Types of Dividends regular cash dividend
a cash dividend that is paid on
As we mentioned, dividends can take various forms. The most common form is the regular a regular basis, typically
cash dividend, which is a cash dividend that is paid on a regular basis. These dividends are quarterly
generally paid quarterly and are a common means by which firms return some of their profits
to stockholders. By one estimate, more than 1,850 U.S. firms paid cash dividends during the extra dividend
year 2000.2 The dividend payments made by the vast majority of these firms were part of regu- a dividend that is generally
lar cash dividend payment programs. paid at the same time as a
regular cash dividend to
In the chapter opener, you saw that in 2010 Praxair, Inc. was paying a regular cash divi- distribute additional value
dend of $0.45 each quarter. The size of a firm’s regular cash dividend is typically set at a level
that management expects the company to be able to maintain in the long run. This is because, special dividend
barring some major change in the fortunes of the company, management does not want to a one-time payment to
have to reduce the dividend. As we will discuss later, stock market investors often view a divi- stockholders that is normally
dend reduction negatively. used to distribute a large
amount of value
Management can afford to err on the side of setting the regular cash dividend too low
because it always has the option of paying an extra dividend if earnings are higher than ex- liquidating dividend
pected. Extra dividends are often paid at the same time as regular cash dividends, and some the final dividend that is paid
companies use them to ensure that a minimum portion of earnings is distributed to stockhold- to stockholders when a firm is
ers each year. For example, suppose that the management of a company wants to distribute 40 liquidated
percent of the company’s net income to stockholders each year. If the company earns $2 per
share in a particular year and the regular cash dividend is 60 cents per share, management can
pay an extra 20 cent dividend at the end of the year to ensure that the company hits its 40 per-
cent payout target [($0.60 ϩ $0.20)/$2.00 ϭ 0.40, or 40 percent].

A special dividend, like an extra dividend, is a one-time payment to stockholders.
However, special dividends tend to be considerably larger than extra dividends. They are
normally used to distribute unusually large amounts of cash. For instance, a company might
use a special dividend to distribute excess cash from operations that has accumulated over
time. Microsoft did this in a very dramatic way in 2004 when it paid a $32.4 billion special
dividend. A special dividend might also be used to distribute the proceeds from the sale of a
major asset or business or as a means of altering a company’s capital structure.

Sealed Air Corporation, the company that first produced those plastic sheets of packaging
materials with the air bubbles, provides a good example of how a special dividend can be used
to dramatically change a company’s capital structure. In April 1989, Sealed Air borrowed
$306.7 million, which it combined with cash it already had on hand to pay a $40 per share
($329.8 million) dividend. Since the price of Sealed Air’s stock was only about $45 before
the dividend, most of the equity was distributed to stockholders. The net effect of borrowing
the money to pay a large dividend like this was to substantially increase the debt-to-total-
capital ratio at Sealed Air—from 8.1 percent to more than 76.2 percent.3 Sealed Air senior
management increased the company’s leverage so dramatically in order to provide managers at
all levels with incentives to focus on maximizing the firm’s cash flows. We discussed this potential
benefit from using debt financing in Chapter 16.

A liquidating dividend is a dividend that is paid to stockholders when a firm is liqui-
dated. When we say that a firm is liquidated, we mean that its assets are sold, the proceeds from
the sale of the assets are distributed to creditors, stockholders, and others who have a claim on
the firm’s assets, and the firm ceases to exist. In the United States, the proceeds from the sale of
a company’s assets are first used to pay all wages owed to employees and the company’s obliga-
tions to suppliers, lenders, the various taxing authorities, and any other party that has a claim
on those assets. Only after all of these obligations are satisfied can the company pay a liquidat-
ing dividend to the stockholders. These priorities highlight the fact that the stockholders are
truly the residual claimants to a firm’s assets.

Distributions of value to stockholders can also take the form of discounts on the compa-
ny’s products, free samples, and the like. Often, these noncash distributions are not thought of

2Harry DeAngelo, Linda DeAngelo, and Douglas J. Skinner, “Are Dividends Disappearing? Dividend Concentration

and the Consolidation of Earnings,” Journal of Financial Economics 72 (2004), 425–456.
3This was the increase in the debt-to-total-capital ratio from the day before the initial public announcement of the

restructuring to the ex-dividend date. For a detailed discussion of the Sealed Air restructuring, see Karen Hooper

Wruck, “Financial Policy, Internal Control, and Performance: Sealed Air Corporation’s Leveraged Special Dividend,”

548 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

as dividends, in part because the value received by stockholders is not in the form of cash and
in part because the value received by individual stockholders does not often reflect their pro-
portional ownership in the firm.

For example, CSX Corporation used to own a swanky resort in West Virginia called the
Greenbrier. CSX stockholders received a discount on the cost of their hotel room when they
stayed at the Greenbrier. For a three- or four-day stay, this discount could easily equal the value
of the regular cash dividend for someone who owned 200 shares. However, the value of the
discount was exactly the same for someone who owned 1 million shares. Obviously, for this
large stockholder the value of the discount would be small compared with the value of the cash
dividend. Note that the discount could actually exceed the total value of the shares owned by a
stockholder who only had five or ten shares.

The discounts offered to CSX stockholders were true distributions of noncash value. Be-
cause the resort could rent the discounted rooms at full price, there was a very real opportunity
cost associated with these discounts.

declaration date The Dividend Payment Process
he date on which a dividend
s publicly announced A relatively standard sequence of events takes place before a dividend is paid. This process is
more easily defined for companies with publicly traded stock than for private companies. For
this reason, we first focus on the process for public companies and then discuss how it differs
for private companies. The time line for the sequence of events in the dividend payment pro-
cess at a public company is illustrated in Exhibit 17.1.

The Board Vote

The process begins with a vote by a company’s board of directors to pay a dividend. As stock-
holder representatives, the board must approve any distribution of value to stockholders.

The Public Announcement

After the board vote, the company announces to the public that it will pay the dividend. The
date on which this announcement is made is known as the declaration date, or announcement
date, of the dividend. The announcement typically includes the amount of value that stock-
holders will receive for each share of stock that they own, as well as the other dates associated
with the dividend payment process.

The price of a firm’s stock often changes when a dividend is announced. This happens
because the public announcement sends a signal to the market about what management thinks
the future performance of the firm will be. If the signal differs from what investors expected,
they will adjust the prices at which they are willing to buy or sell the company’s stock accord-
ingly. For example, the announcement that a company will pay an unexpectedly large dividend

Board vote Ex-dividend date Payable date

Public announcement Record date
(declaration date)

EXHIBIT 17.1
The Dividend Payment Process Time Line for a Public Company

The dividend payment process begins when the board votes to pay a dividend.
Shortly afterward, the firm publicly announces its intent to pay a dividend,
along with, at a minimum, the amount of the dividend and the record date. The
ex-dividend date, which is set by the stock exchange, normally precedes the
record date by two days. The payable date is the date on which the firm actually
pays the dividend.

17.1 Dividends 549

can indicate that management is optimistic about DIVIDEND ANNOUNCEMENTS SEND
future profits—suggesting that future cash flows
are higher than expected. This, in turn, can result SIGNALS TO INVESTORS BUILDING
in an increase in the company’s stock price. In con-
trast, the decision to cut or eliminate a dividend A dividend announcement reveals informa- INTUITION
can send a signal that management is pessimistic
and can cause the stock price to go down. We have tion about management’s view of a com-
more to say about how stock prices react to divi-
dend announcements later in this chapter. For now, pany’s prospects. Investors use this infor-
it is important to remember that a dividend deci-
sion sends information to investors and that infor- mation to refine their expectations concerning future cash flows
mation is incorporated into stock prices at the time
of the public announcement. from the company. A change in investor expectations will cause

the company’s stock price to change at the time of the public

announcement.

The Ex-Dividend Date ex-dividend date
the first day on which a stock
An important date included in the public announcement is the ex-dividend date—the first trades without the rights to a
date on which the stock will trade without rights to the dividend. An investor who buys shares dividend
before the ex-dividend date will receive the dividend, while an investor who buys the stock on
or after the ex-dividend date will not. Before the ex-dividend date, a stock is said to be trading You can read more
cum dividend, or with dividend. On or after the ex-dividend date, the stock is said to trade about the ex-dividend
ex dividend. date and the dividend
payment process on the
It is important for investors to know the ex-dividend date because it can have signifi- SEC Web site at http://
cant implications for the taxes and transaction costs they pay. If an investor purchases the www.sec.gov/answers/
company’s shares before the ex-dividend date, the investor knows that he or she will soon dividen.htm.
receive a dividend on which taxes will have to be paid. (Dividends received by investors are
taxed by state and federal governments unless the investor is a tax-exempt organization,
such as a university endowment.) In addition, a dividend can create difficulties for a stock-
holder who wants to have a specific amount of money invested in the firm. By returning
value to the stockholder, a firm that pays a dividend may reduce the stockholder’s invest-
ment below the level preferred by the stockholder, thereby making it necessary for the stock-
holder to purchase additional shares and incur the associated brokerage fees and possibly
other transaction costs.

As you might suspect, the price of the firm’s shares changes on the ex-dividend date
even if there is no new information about the firm. This drop simply reflects the difference
in the value of the cash flows that the stockholders are entitled to receive before and after
the ex-dividend date. To see how this works, consider a company that recently announced
a $1 per share dividend. The company’s stock is currently trading for $10 per share, and the
ex-dividend date is tomorrow. In this example, the $10 price includes the value of the divi-
dend because an investor who purchases this company’s stock before the ex-dividend day
will receive the dividend. You can think of the $10 as consisting of a $1 dividend plus the
value of the stock on the ex-dividend date.4 Since an investor who buys the stock tomorrow
will receive only the stock, and not the dividend, the price of the stock will certainly be
below $10 tomorrow.

Does it follow that the stock price will drop by $1 tomorrow? No. Research has shown that
stock prices drop on the ex-dividend date but that this drop is smaller than the full amount of
the dividend. In our example, this means that the drop will be less than $1. Why would the
price not drop by the full $1? Because the dividend will be taxed. If you knew that you would
have to pay a 15 percent tax on a dividend that you received (this was the maximum tax rate
for dividends in 2010), would you pay 100 percent of the value of that dividend? We hope not.
By this point in the book, you should realize that a $1 dividend has an after-tax value of only
$0.85 if you have to pay a 15 percent tax on it [$1.00 ϫ (1 Ϫ 0.15) ϭ $0.85]. If investors pay a
15 percent tax on dividends, the $10 price of the stock in our example should include $0.85 for
the dividend and $9.15 ($10.00 Ϫ $0.85 ϭ $9.15) for other cash flows, so the stock price should
drop to $9.15 on the ex-dividend date.

4We do not have to worry about the time value of money in this example since we are assuming that the ex-dividend
date is tomorrow.

550 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

ecord date The Record Date
he date by which an investor
must be a stockholder of The record date typically follows the ex-dividend date by two business days. The record date is
ecord in order to receive a the date on which an investor must be a stockholder of record (that is, officially listed as a stock-
dividend holder) in order to receive the dividend. The board specifies the record date when it votes to
make the dividend payment. Once the company informs the exchange on which its stock is
traded what the record date is, the exchange sets the ex-dividend date. The ex-dividend day
precedes the record date because it takes time to update the stockholder list when someone
purchases shares. If you buy the shares before the ex-dividend date, the exchange will ensure
that you are listed as a stockholder of record for that company as of the record date.

LEARNING APPLICATION 17.1 Stock Prices and Dividend Payments
BY
DOING PROBLEM: It is December 15, 2011 and J&W Corporation’s stock is trading at $23.50
per share. Earlier today, J&W announced that the record date for its next regular cash
dividend will be January 18, 2012, and that the dividend payment will be $0.40 per share.
The stock exchange has just announced that the ex-dividend date will be January 16,
2012. If all investors pay taxes of 15 percent on dividends, what do you expect to happen
to J&W’s stock price between the time the market closes on Friday, January 13, 2012 and
the time it opens on Monday, January 16, 2012?

APPROACH: The stock price should decline by an amount that equals the after-tax
value of the dividend; you can therefore answer this question by calculating this after-tax
value.

SOLUTION: You would expect the price of J&W’s stock to decrease by $0.40 ϫ (1 Ϫ 0.15)
ϭ $0.34. You cannot say what the actual stock price will be after this decrease because
you do not know what the price will be beforehand. The $23.50 price is for December 15,
2011, not for January 13, 2012, the day immediately before the ex-dividend date.

payable date The Payable Date
he date on which a company
pays a dividend The final date in the dividend payment process is the payable date, when the stockholders of
record actually receive the dividend. The payable date is typically a couple of weeks after the
record date.

An Example of the Dividend Payment Process

We can use Wal-Mart Stores, Inc., to illustrate the dividend payment process. In early 2010, the
board of directors of Wal-Mart approved an increase in the company’s regular cash dividend to
$1.21 per share per year. As is commonly done, Wal-Mart pays its regular cash dividend quar-
terly. In other words, after the board vote, its stockholders could expect to receive dividends of
$0.3025 per share each quarter.5 The dividend increase was announced on March 4, 2010, and
so this was the declaration, or announcement, date.

Wal-Mart’s announcement also specified the other key dates. The next regular cash divi-
dend would be paid to investors of record as of March 12, 2010. This was the record date. The
ex-dividend date was March 10, 2010—two days earlier—and the payable date was April 5,
2010. Exhibit 17.2 summarizes the sequence of events for Wal-Mart’s dividend.

The Dividend Payment Process at Private Companies

The dividend payment process is not as well defined for private companies as it is for public
companies, because in private companies shares are bought and sold less frequently, there are

5Note that this announcement does not obligate Wal-Mart to continue paying quarterly dividends at that level. In fact,
Wal-Mart has increased its dividend payment on a regular basis, but there is no reason that the board could not reduce

Board vote This was the first day 17.2 Stock Repurchases 551
on which the shares
traded without the right The dividend
to receive the dividend. was paid

Ex-dividend date: on this date.
March 10, 2010
Payable date:
April 5, 2010

Declaration date: Record date;
March 4, 2010 March 12, 2010

The dividend payment Stockholders of record

was publicly announced on this date

on this date. received the dividend

EXHIBIT 17.2
Key Dates for Wal-Mart’s First Quarter 2010 Dividend

This exhibit summarizes the key dates and time line for the regular cash dividend that
Wal-Mart paid on April 5, 2010.

fewer stockholders, and no stock exchange is involved in the dividend payment process. The
board members know the identities of the stockholders when they vote to authorize a dividend—
generally, the list of stockholders is relatively short and the largest stockholders are on the
board. As a result, it is easy to inform all stockholders of the decision to pay a dividend, and it
is easy to actually pay it. There is no public announcement, and there is no need for an ex-
dividend date. Consequently, the record date and payable date can be any day on or after the
day that the board approves the dividend.

> BEFORE YOU GO ON

1 . How does a dividend affect the size of a stockholder’s investment in a firm?

2 . List and define four types of dividends.

3 . What are the key events and dates in the dividend payment process?

17.2 STOCK REPURCHASES

Stock repurchases are another popular method of distributing value to stockholders. With a LEARNING OBJECTIVE 2
stock repurchase, a company buys some of its shares from stockholders.
stock repurchase
How Stock Repurchases Differ from Dividends the purchase of stock by a
company from it stockholders;
Stock repurchases differ from dividends in a number of important ways. First, they do not an alternative way for the
represent a pro-rata distribution of value to the stockholders, because not all stockholders company to distribute value to
participate. Individual stockholders decide whether they want to participate in a stock repur- the stockholders
chase. Some stockholders participate, while others do not. In contrast, in a dividend distribu-
tion, all stockholders receive the dividend.

Second, when a company repurchases its own shares, it removes them from circulation.
This reduces the number of shares of stock held by investors. Removing a large number of
shares from circulation can change the ownership of the firm. It can increase or decrease the
fraction of shares owned by the major stockholders and thereby diminish their ability to con-
trol the company. Also, if a company with a relatively small number of shares in the public
market distributes a lot of cash to investors through a stock repurchase, there will be less

552 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

repurchases most of its outstanding shares and “goes private.” Since a dividend does not affect
who owns the shares or the number of shares outstanding, it does not have these effects on
ownership and liquidity.

Third, stock repurchases are taxed differently than dividends. As we saw in the discussion
of the ex-dividend date, the total value of dividends is normally taxed.6 In contrast, when a
stockholder sells shares back to the company, the stockholder is taxed only on the profit from
the sale. For example, suppose a stockholder purchased 100 shares for $150 and then sold them
to the company for $200 a year later. In this example, the $50 profit ($200 Ϫ $150 ϭ $50) that
the stockholder earned on the sale would be treated as a capital gain and would be taxed at no
more than a 15 percent rate (the maximum rate on capital gains in 2010), depending on the
stockholder’s income. The maximum total tax on the sale of the stock would be $7.50 ($50 ϫ
0.15 ϭ $7.50). In contrast, if the company had distributed the $200 as a dividend, the tax would
have been $30 ($200 ϫ 0.15 ϭ $30)—four times as much! Of course, this difference is even
more significant when you remember that stockholders who receive dividends have no choice
as to when they must pay the tax because a dividend is not optional. In contrast, since stock-
holders choose whether to participate in a repurchase plan, they are able to choose when they
pay taxes on the profits from selling their stock.

Finally, dividends and stock repurchases are accounted for differently on the balance
sheet. For example, when a company pays a cash dividend, the cash account on the assets side
of the balance sheet and the retained earnings account on the liabilities and stockholders’ eq-
uity side of the balance sheet are reduced. In contrast, when a company uses cash to repurchase
stock, the cash account on the assets side of the balance sheet is reduced, while the treasury
stock account on the liabilities and stockholders’ equity side of the balance sheet is increased
(becomes more negative). The balance sheet in Exhibit 3.1 includes a treasury stock account,
indicating that Diaz Manufacturing repurchased 571,320 shares for $23.3 million in 2011.

LEARNING APPLICATION 17.2 Stock Repurchases and Taxes
BY
DOING PROBLEM: Your pizza parlor business has been doing very well, and, as a result, you
have more cash than you can productively reinvest in the business. You have decided to
distribute this cash to yourself, the only stockholder, through a stock repurchase. When
you started the business, you invested $300,000 and received 10,000 shares of stock. In
other words, each share cost you $30. There are no other shares outstanding, and your
business valuation adviser tells you that the stock is worth $800,000 today. If you want to
distribute $80,000 through a stock repurchase, how many shares will the company have
to repurchase? If you pay taxes of 15 percent on capital gains, how much money will you
have left over after paying taxes on the proceeds from the sale of your stock?

APPROACH: First calculate the current share price. Next, divide the amount of cash
that you want to distribute by the share price to obtain the number of shares the company
will have to repurchase. To calculate the amount of money you would have left over after
paying taxes, first compute the capital gain (profit) per share on the stock and multiply this
amount by the tax rate and the number of shares the company will have to purchase to
obtain the total tax. Then, subtract the total tax from $80,000 to obtain the answer.

SOLUTION: Each share of stock is worth $80 ($800,000/10,000 shares ϭ $80 per share)
today. This means that the company would have to repurchase 1,000 shares ($80,000/
$80 per share ϭ 1,000 shares) in order to distribute $80,000.

The capital gain per share from the sale would be $50 ($80 Ϫ $30 ϭ $50). With a 15
percent tax rate, you would pay taxes of $7,500 ($50 ϫ 0.15 ϫ 1,000 shares ϭ $7,500)
on the capital gain, leaving you with gross proceeds from the sale of $72,500 ($80,000 Ϫ
$7,500 ϭ $72,500).

6An exception is when the dividend is viewed as a return of the capital that the stockholders have invested in the firm,
rather than a distribution of profits. Dividends generally are not a return of capital unless they are very large or when

17.2 Stock Repurchases 553

How Stock Is Repurchased open-market repurchase
the repurchase of shares by a
Companies repurchase stock in three general ways. First, they can simply purchase shares in company in the open market
the market, much as an individual would. These kinds of purchases are known as open-market
repurchases and are a very convenient way of repurchasing shares on an ongoing basis. For tender offer
example, a company might use such repurchases to distribute some of its profits instead of an open offer by a company to
paying a regular cash dividend. purchase shares

When a company has a large amount of cash to distribute, open-market repurchases can Go to the Gartner, Inc.,
be cumbersome because the government limits the number of shares that a company can re- Web site at http://www.
purchase on a given day. These limits, which are intended to restrict the ability of firms to influ- gartner.com/press_
ence their stock price through trading activity, mean that it could take months for a company releases/asset_89747_
to distribute a large amount of cash using open-market repurchases. 11.html to read about
the Dutch auction
When the management of a company wants to distribute a large amount of cash at one time tender offer that Gartner
and does not want to use a special dividend, it can repurchase shares using a tender offer. A tender announced in 2004.
offer is an open offer by a company to purchase shares.7 There are two types of tender offers: fixed-
price and Dutch auction. With a fixed-price tender offer, management announces the price that targeted stock repurchase
will be paid for the shares and the maximum number of shares that will be repurchased. Interested a stock repurchase that targets
stockholders then tender their shares by letting management know how many shares they are will- a specific stockholder
ing to sell. If the number of shares tendered exceeds the announced maximum, then the maxi-
mum number of shares are repurchased, and each stockholder who tendered shares participates
in the repurchase in proportion to the fraction of the total shares that he or she tendered.

With a Dutch auction tender offer, the firm announces the number of shares that it would
like to repurchase and asks the stockholders how many shares they would sell at a series of
prices, ranging from just above the price at which the shares are currently trading to some
higher price. The alternative prices are set higher than the market price to make the offer at-
tractive to stockholders. Stockholders then tell the company how many of their shares they
would sell at the various offered prices. Once these offers to sell have been collected, manage-
ment determines the price that would allow them to repurchase the number of shares that they
want. All of the tendering stockholders who indicate a willingness to sell at or below this price
will then receive this price for their shares.

The third general way in which shares are repurchased is through direct negotiation with
a specific stockholder. These targeted stock repurchases are typically used to buy blocks of
shares from large stockholders. Such repurchases can benefit stockholders who are not selling
because managers may be able to negotiate a per-share price that is below the current market
price. This is possible because the only alternative for a stockholder who owns a large block of
shares and wants to sell them at one time often involves offering the shares for a below-market
price in the open market. Of course, targeted stock repurchases can also be attractive to man-
agers for other reasons—notably, if the company repurchases the block of shares, there is less
chance that the shares will fall into the hands of an unfriendly investor.

Exhibit 17.3 presents statistics for the different types of stock repurchases from a sample
of repurchases involving public U.S. firms over the 1984–2001 period. The exhibit indicates
that the most common way to repurchase shares is through open-market repurchases (6,470
observations versus 737 for targeted stock repurchases, the second most common method).
However, the average percentage of shares repurchased, at 7.37 percent, is considerably smaller for
open-market repurchase programs than for the other repurchase methods. This confirms what we
stated earlier—managers tend to use methods other than open-market repurchases when they
want to distribute a large amount of cash at one time. Finally, Exhibit 17.3 shows that almost half
of the targeted stock repurchases involve a purchase price that is below the stock’s price in the open
market. This is consistent with the idea that managers can often negotiate discounts when making
such purchases. Interestingly, the average stock price reaction to a targeted stock repurchase is
negative. The reason for this is not obvious. In some cases, investors may think that managers are
repurchasing shares to entrench themselves to the detriment of the stockholders. In other cases, a
large stockholder’s willingness to sell his or her shares may signal this investor’s pessimism about
the firm’s prospects, thereby causing other market participants to drive down the stock price.

7The term tender offer is commonly used to refer to any open offer to purchase any shares, not just the shares of the
firm making the announcement. For example, when a company tries to take over another company, it might begin

554 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

EXHIBIT 17.3 Descriptive Statistics for Stock Repurchases in the United States, 1984–2001

Open-market repurchase programs are the most common means of repurchasing shares. However, managers tend to use other
methods when they want to repurchase a large percentage of their firm’s total shares.

Open-Market Fixed-Price Dutch Auction Targeted Stock
Repurchase Programs Tender Offers Tender Offers Repurchases

Average percentage of shares repurchased 7.37% 29.46% 15.88% 13.00%
NA 20.74% 14.72% 1.92%
Average premium paid over market price
NA 0.00% 0.40% 44.78%
Percentage of cases where repurchase
price was below market price

Average market-adjusted stock price 2.39% 7.68% 7.60% Ϫ1.81%
change following repurchase
announcement

Number of observations 6,470 303 251 737

ource: Information from Urs C. Peyer and Theo Vermaelen, “The Many Facets of Privately Negotiated Stock Repurchases,” Journal of Financial Economics
5 (2005), 361–395.

> BEFORE YOU GO ON
1 . What is a stock repurchase?
2 . How do stock repurchases differ from dividends?
3 . In what ways can a company repurchase its stock?

17.3 DIVIDENDS AND FIRM VALUE

LEARNING OBJECTIVE One reason that we devote so much space in this book to dividends is that they can affect the
value of a firm. In this section, we explain why. The best way to begin is by recalling, from Chap-
ter 16, the general conditions under which capital structure policy does not affect firm value:

1. There are no taxes.

2. There are no information or transaction costs.

3. The real investment policy of the firm is fixed.

These are the three conditions identified by Modigliani and Miller (M&M). Since a dividend
payment has implications for a firm’s capital structure, as illustrated earlier in the Sealed Air
example, the factors that cause dividends to affect firm value are very closely related to the
conditions identified by M&M. In fact, if the above conditions hold, then the dividends a firm
pays will not affect its value.

Dividends do not matter under these conditions because a stockholder can “manufacture”
any dividends he or she wants at no cost, and the total cash flows a firm produces from its real
assets are not affected by the dividends that it pays. To see how a stockholder can manufacture
dividends, consider a retired stockholder who owns 50,000 shares of a company’s stock and
needs to receive a $1 per share dividend each year on this investment to cover his or her living
expenses. If the company pays such a dividend, there is no problem. But what if the company
does not pay such a dividend? Well, under the above conditions, the stockholder could “manu-
facture” his or her own dividend by selling $50,000 worth of stock each year. This would reduce
the total value of this investor’s stock by $50,000, just as a $50,000 dividend would. Remember
that we are assuming that no taxes must be paid, so the decline in the value of the shares would
exactly equal the value of the dividend if one were paid.

A stockholder could also undo the dividend decisions made by managers by simply rein-
vesting the dividends that the company pays in new shares. For instance, if a company paid a
$50,000 dividend, thereby reducing the value of a stockholder’s shares, that stockholder could
increase his or her ownership in the company’s shares to its previous level by purchasing

17.3 Dividends and Firm Value 555

Just as with changes in capital structure policy, if investors could replicate the dividends
paid by a company on their own at no cost and the managers’ dividend decisions do not affect
the total cash flows the firm produces, investors would not care whether or not the company
paid a dividend. In other words, they would not be willing to pay more or less for the stock of
a firm that pays a dividend than for the stock of a firm that does not pay a dividend.

Benefits and Costs of Dividends

Of course, we know that the M&M assumptions do not apply in the real world. But that is good
news in the sense that the imperfect world we live in provides companies with the opportunity
to create value through their dividend decisions. Doing so involves balancing benefits and
costs, just as we do in choosing a capital structure. We now turn our attention to a discussion
of the benefits and costs associated with paying dividends.

Benefits of Dividends

One benefit of paying dividends is that it attracts investors who prefer to invest in stocks that
pay dividends. For example, consider the retired stockholder we discussed earlier. While he or
she could simply sell some stock each month to cover expenses, in the real world it may be less
costly—and it is certainly less trouble—to simply receive regular cash dividend payments in-
stead. Recall that under the M&M conditions, there are no transaction costs. In the real world,
though, the retiree will have to pay brokerage commissions each time he or she sells stock. The
dividend check, in contrast, simply arrives each quarter. Of course, the retiree will have to con-
sider the impact of taxes on the value of dividends versus the value of proceeds from the sale of
stock; but it is quite possible that receiving dividends might, on balance, be more appealing.

Another type of investor that might prefer income-paying stocks is an institutional investor,
such as an endowment or a foundation. Because of their investment guidelines, some institu-
tional investors are only allowed to spend proceeds that are received as income from their invest-
ments. These institutions face limitations on their ability to sell shares to replicate a dividend.

Unfortunately, the ability to appeal to certain investors is not a very compelling reason for
paying dividends. While retirees and some institutional investors might prefer dividends,
investors with no current need for income from their investment portfolios might prefer not
to receive dividends. Those investors might actually choose to avoid stocks that pay high
dividends, since they might have to pay taxes on the dividends and would face transaction
costs when they reinvest the dividends they receive.

Furthermore, the fact that some investors prefer to receive dividends does not necessarily
mean that an individual company can increase the value of its stock by paying dividends.
After all, a wide range of dividend-paying stocks is already available on the market. The addi-
tion of one more such stock is unlikely to markedly increase the options available for inves-
tors looking for dividends. Therefore, these investors will not be willing to pay a higher price
for that stock.

Some people have argued that a large regular dividend indicates that a company is finan-
cially strong. This “signal” of strength, they say, can result in a higher stock price. This argument
is based on the assumption that a company that is able to pay a large dividend, rather than hold-
ing on to cash for future investments, is a company that is doing so well that it has more money
than it needs to fund its available investments. The problem with this line of reasoning is that
such a company might have more than enough money for all its future investment opportuni-
ties because it does not have many future investment opportunities. In this situation, the fact
that the company does not need the cash would be a bad signal, not a good one.

Another benefit of paying dividends is suggested by the fact that many companies pay
regular cash dividends on the one hand while routinely selling new shares on the other. For
example, FPL Group pays a regular dividend and occasionally raises capital by issuing new
equity. Why might FPL reduce its equity by paying a dividend and then turn around and in-
crease it by selling new shares? One possible explanation is that management is just trying to
appeal to investors who prefer dividends, as we discussed earlier. But another explanation is
that this practice helps to align the incentives of managers and stockholders.

Let’s look more closely at this second explanation. Consider a company that is so profit-
able that it never has to go to the debt or equity markets to raise external capital. This company

556 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

company might have incentives to operate the business less efficiently than the stockholders
would like them to. For example, they might invest in negative NPV assets—such as corporate
jets, plush offices, or a company apartment in Manhattan—that benefit them but do not create
value for the stockholders. These managers might also spend more time than they should away
from the office, perhaps serving on the boards of other companies or golfing, letting the oper-
ating performance of the company fall below the level that could be achieved if they focused
on running the business. Stockholders understand that managers at highly profitable firms
have these incentives. Thus, they are likely to reduce the price that they are willing to pay for
this company’s stock to reflect the loss of value associated with the managers’ unproductive
behaviors.

Now suppose that the company’s board of directors votes to pay dividends that amount to
more than the excess cash that the company is producing from its operations. Since the money
to pay the dividends will have to come from somewhere, the board is effectively forcing man-
agement to sell equity periodically in the public markets. The need to raise equity in the capital
markets will help align the incentives of managers with those of stockholders. Why? Because it
increases the cost to managers of operating the business inefficiently. In order to raise equity at
a reasonable cost, the managers must be careful how efficiently they are operating the business.
The process of raising new equity involves a special audit that is more detailed than an annual
audit and invites the close attention of lawyers, investment bankers, and outside experts. These
outside parties provide a certification function that increases the amount of public informa-
tion about the firm’s activities. Voluntarily submitting to such outside certification—by paying
a dividend and issuing equity rather than just keeping cash inside the firm—can ultimately
lead to better company performance and the willingness of investors to pay a higher price for
the company’s stock.

One last potential benefit of paying dividends is that dividends can be useful in managing
the capital structure of a company. The trade-off theory of capital structure, which we dis-
cussed in Chapter 16, tells us that there is an optimal mix of debt and equity that maximizes
the value of a firm. To the extent that a company is internally generating more equity than it
can profitably invest, the fraction of debt in its capital structure will always be decreasing over
time unless the company borrows more money (which it doesn’t need) or distributes cash to
stockholders. Paying dividends can help keep the firm’s capital structure near its optimal mix.

Costs of Dividends

In addition to benefits, there are costs associated with dividends. Taxes are among the most
important of these costs. As we discussed earlier, dividends are taxable, and the stockholders
of firms that pay dividends have no choice but to receive the dividends and pay the associated
taxes if they want to own the stock. Before 2003, dividends were taxed as ordinary income. This
meant that, depending on the stockholder’s income, as much as 36 percent of the dividend
would be paid to the government in taxes. Tax law changes made in 2003 temporarily lowered
this top rate to 15 percent, but dividends will once again be taxed as ordinary income after
2012 unless Congress and the President take action to extend the reduction. In addition, divi-
dends are taxed by a number of states, which means that, depending on where you live, the tax
rate can be even higher.

Stockholders can always sell some of their shares to “manufacture” their own dividends, as
we discussed earlier. If they do this, they pay taxes only on the profit on the sale. Unless the
stockholder received the stock for free, this profit is a smaller amount than the amount the
dividend would be. Furthermore, the U.S. tax system has typically treated capital gains differ-
ently from dividends. If you own a stock for some specified period of time, currently 12 months,
any gain on the sale of that stock is treated as a capital gain. Until 2003, as mentioned, divi-
dends were taxed as ordinary income, and the ordinary income tax rate for most taxpayers was
higher than the capital gains tax rate. Thus, before 2003, if you sold shares rather than receiving
dividends, you not only paid taxes on a smaller amount, but you also paid a lower rate on the
amount that was taxable. Since 2003, the tax rates have been the same for dividends and capital
gains. If history is any indication, however, tax rates on dividends will be higher again in the
not-too-distant future.

In addition to paying taxes on dividends, owners of stocks that pay dividends often have to

17.3 Dividends and Firm Value 557

offer dividend reinvestment programs (DRIPs). Through a DRIP, a company sells new shares, dividend reinvestment
commission free, to dividend recipients who elect to automatically reinvest their dividends in
the company’s stock. While DRIPs eliminate transaction costs, they do not affect the taxes that program (DRIP)
must be paid on the dividends. Also, since it is costly to administer a DRIP, these programs a program in which a company
effectively transfer the cost from the stockholders who want to reinvest to the firm (which means sells new shares, commission
all stockholders). free, to dividend recipients
who elect to automatically
It is worth remembering that the total value of the assets in a company goes down when a reinvest their dividends in the
dividend is paid. To the extent that a company uses a lot of debt financing, paying dividends company’s stock
can increase the cost of debt. This will happen if the payment of dividends reduces the value of
the assets underlying debt holder claims on the cash flows from the firm. With less valuable
assets, the debt holders face greater risk of default. To compensate for this greater risk, they will
charge the company a higher rate on its debt.

Stock Price Reactions to Dividend Announcements

In the earlier discussion of the dividend payment process, we stated that the price of a company’s
stock often changes when a dividend is announced. We also noted that this happens because the
public announcement sends a signal to the market about what management thinks the future
performance of the firm will be. Let’s consider this issue in more detail.

We can think about the market’s reaction to a dividend announcement in the context of
what we call the cash flow identity, a term which means that, during any period, the sources
of cash must equal the uses of cash in a firm:

Sources 5 Uses

CFOAt ϩ Equityt ϩ Debtt ϭ Divt ϩ Repurchasest ϩ Interestt ϩ Principalt ϩ Invt

where:

CFOAt ϭ cash flow to investors from operating activity in period t
Equityt ϭ proceeds from the sale of stock in period t

Debtt ϭ proceeds from the sale of debt in period t
Divt ϭ dividends paid in period t

Repurchasest ϭ cash used to repurchase stock in period t
Interestt ϭ interest payments to debt holders in period t

Principalt ϭ principal payments on debt in period t
Invt ϭ investments in net working capital and fixed assets period t

How can this identity help us to understand how investors use dividend announcements to infer

what management thinks the firm’s future performance will be? Let’s consider an example. As-

sume that a company has just announced an increase in its dividend payments that investors did

not expect. If the company is not selling new equity or debt, not repurchasing stock, and its in-

vestment in fixed assets and net working capital does not change, this means that Divt is going
up and that Equityt, Debtt, Repurchasest, Interestt, Principalt, and Invt are not changing. Since
investors know that the cash flow identity must hold, CFOAt, the cash flow to investors from
operating activity, must be expected to increase. This situation can be illustrated as follows:

CFOAt ϩ Equityt ϩ Debtt ϭ Divt ϩ Repurchasest ϩ Interestt ϩ Principalt ϩ Invt

An expected increase in the cash flow to investors from operating activity is a good signal, and
investors will interpret it as suggesting that cash flows to stockholders will increase in the fu-
ture. As a result, the stock price should go up.

Evidence from studies of stock price reactions to dividend announcements is generally
consistent with this theory. This evidence indicates that when a company announces that it will
begin paying a regular cash dividend, its stock price increases by an average of about 3.5 per-
cent. Similarly, announcements of increases in regular cash dividends are associated with an
average stock price increase of 1 to 2 percent. In contrast, the announcement that a company
will reduce its regular cash dividend is associated with a 3.5 percent decrease in its stock price,
on average. An announcement that a company will pay a special dividend is associated with an
average stock price increase of about 2 percent.

It is important to recognize that we cannot interpret these studies as proof that changes in

558 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

change dividends when something fundamental has changed in the business. It is this funda-
mental change that causes the stock price to change. The dividend announcement is really just
the means by which investors find out about the fundamental change. Although there are ben-
efits and costs associated with dividend payments, the sizes of these benefits and costs tend to
be relatively small compared with the changes in value associated with the fundamental
changes that take place in firms. By the same token, there is no evidence that it is possible to
increase firm value by increasing dividends. Again, dividend changes only provide a signal
concerning a fundamental change at the firm. In this sense, they are only by-products of
the change.

Dividends versus Stock Repurchases

As we noted earlier, stock repurchases are an alternative to dividends as a way of distributing
value. Our discussion has already suggested that stock repurchases have some distinct advan-
tages over dividends. They give stockholders the ability to choose when they receive the distri-
bution, which affects the timing of the taxes they must pay as well as the cost of reinvesting
funds that are not immediately needed. In addition, stockholders who sell shares back to a
company pay taxes only on the gains they realize, and historically these capital gains have been
taxed at a lower rate than dividends.

From management’s perspective, stock repurchases provide greater flexibility in distribut-
ing value. We have already discussed how stock prices react to announcements of changes in
dividend payments. We can therefore imagine why managers might find stock repurchases rela-
tively more attractive. Even when a company publicly announces an ongoing open-market stock
repurchase program, as opposed to a regular cash dividend, investors know that management
can always quietly cut back or end the repurchases at any time. In contrast, dividend programs
represent a stronger commitment to distribute value in the future because they cannot be qui-
etly ended. For this reason, investors know that managers will initiate dividend programs only
when they are quite confident that they will be able to continue them for the long run.

Thus, if future cash flows are not certain, managers are likely to prefer to distribute extra
cash today by repurchasing shares through open-market purchases because this enables them
to preserve some flexibility. If cash flows decline in the future, management can reduce the
repurchases without a pronounced effect on the company’s stock price.

Potentially offsetting the advantages of stock repurchases are a few notable disadvantages.
One of these disadvantages is the flip side of the signaling benefit discussed in the previous
paragraph. Since most ongoing stock repurchase programs are not as visible as dividend pro-
grams, they cannot be used as effectively to send a positive signal about the company’s pros-
pects to investors.

A more subtle issue concerns the fact that managers can choose when to repurchase shares
in a stock repurchase program. Just like other investors, managers prefer purchasing shares
when they believe that the shares are undervalued in the market. The problem is that since
managers have better information about the company’s prospects than do other investors, they
can take advantage of this information to the detriment of other investors. If managers are tak-
ing advantage of superior information, their repurchases are effectively transferring value from
stockholders who choose to sell their shares (perhaps because they simply need money to live
on) to stockholders who choose to remain invested in the company. A transfer of wealth from
one group of stockholders to another is a problem. Remember that management is supposed
to act in the best interest of all its stockholders.

Companies in the United States have historically distributed more value through dividend
payments than through stock repurchases. This suggests that managers have, on balance, found
dividends more attractive. However, in recent years the popularity of stock repurchases has
increased. In 2006, the total dollar value distributed through stock repurchases exceeded the
value distributed through dividends for the first time. At the same time, the way companies
pay dividends and how much they pay have changed substantially. Between 1978 and 2000, the
number of public industrial companies in the United States that paid dividends declined from
approximately 2,250 to 926.8 Interestingly, the companies that stopped paying dividends were

8DeAngelo, DeAngelo, and Skinner. See full reference in footnote 2. Section 17.1 reported that an estimated 1,850

17.3 Dividends and Firm Value 559

$1,200

$1,000

Total Dividends and $800
Stock Repurchases
$600
($ billions)
$400 Total dollar value
of dividends paid
$200
Total dollar value of
$0 repurchased shares
1980
1985 1990 1995 2000 2005
Year

Total Dividends and Stock 8%
Repurchases as a Percent of
U.S. Public Firm Market Capitalization 7%

6%
Dividends

5%

4%

3% Stock repurchases

2%

1%

0% 1985 1990 1995 2000 2005
1980 Year

EXHIBIT 17.4
Dividend Payments and Stock Repurchases by U.S. Public Firms, 1980–2009

Both the dollar value of dividends paid by U.S. public firms and the dollar value of
stock repurchases increased over the period from 1980 to 2009, as shown in the top
figure. However, the increase was more pronounced for stock repurchases. Despite
these increases in dollar values, total distributions of value as a percentage of the
total market capitalization (total equity value) of U.S. firms actually decreased, as
shown in the bottom figure.

Source: Estimated by authors using data from the Standard and Poors’ Compustat database.

primarily those that had paid small dividends. The total value of dividends paid has actually To read more about the
increased since 1978 even after adjusting for inflation. The net result is that the firms that pay increasing popularity of
dividends are, on average, paying larger dividends. stock repurchases, see
the discussion of recent
These trends are illustrated in Exhibit 17.4, which shows the total dollar value of dividends reseavarch at http://
paid and stock repurchased by public U.S. firms from 1980 to 2009. The exhibit also shows the www.umich.edu/
total value of dividends and of stock repurchases as a percentage of the total market capitaliza- ~urecord/0405/Dec13_
tion (total equity value) of public U.S. firms. You can see that the fraction of total equity value 04/14.shtml.
that is being distributed to stockholders has declined somewhat.

> BEFORE YOU GO ON
1 . What are the benefits and costs associated with dividends?
2 . How do stock prices react to dividend announcements?
3 . Why might stock repurchases be preferred to dividends?

560 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

DECISION Choosing a Payout Method
MAKING
SITUATION: You are the Chief Executive Officer of San Marcos Pharmaceuticals, a
EXAMPLE 17.1 generic drug manufacturing firm. With patents on a lot of brand-name drugs sold by
other pharmaceutical firms expiring, San Marcos has been doing very well manufacturing
generic copies of those drugs. In fact, business has been going so well that San Marcos
is generating more cash flow than is required for investment in the positive NPV projects
that are available to the company.

You have decided that you want to distribute the excess (free) cash flow to stockhold-
ers rather than accumulate it in the company’s cash accounts. You expect the company
to continue to generate free cash flow in the future, but the amount is likely to vary con-
siderably as the new national health law goes into effect. You want to be able to adjust
distributions as free cash flows rise and fall, but do not want to make San Marcos’s stock
price any more volatile than it already is. Furthermore, relatively few of the company’s
shares are held by investors that do not pay taxes, such as pension funds and university
endowments, so you would prefer that the distributions be as tax efficient as possible.

Your Chief Financial Officer tells you that the most feasible means of distributing
the excess cash on an ongoing basis are to pay a regular cash dividend or to repur-
chase shares through open-market repurchases. Which of these two options should you
choose?

DECISION: As long as the ownership structure of the company or the liquidity of its
shares are not severely altered or impaired, the open-market repurchase alternative is the
best choice. Open-market repurchases can easily be adjusted to accommodate changes
in the amount of free cash flow that San Marcos generates without adding to stock price
volatility. In contrast, increasing and decreasing a regular cash dividend as free cash flows
rise and fall would most likely add to the volatility of the company’s stock price. Since an
open-market repurchase program is more tax efficient than a regular cash dividend, it will
also enable stockholders to keep more of the money that is distributed to them. Finally,
it will let individual stockholders choose whether they want to participate in the program
in the first place.

17.4 STOCK DIVIDENDS AND STOCK SPLITS

LEARNING OBJECTIVE Recall that earlier we defined a dividend as something of value distributed to a firm’s stock-
holders on a pro-rata basis The term dividend is not always used so precisely. In this section,
tock dividend we discuss actions taken by financial managers that are associated with dividends but that do
a distribution of new shares not involve a distribution of value, and are therefore not really dividends.
o existing stockholders in
proportion to the percentage Stock Dividends
of shares that they own (pro
ata); the value of the assets in One type of “dividend” that does not involve the distribution of value is known as a stock
a company does not change dividend. When a company pays a stock dividend, it distributes new shares of stock on a pro-
with a stock dividend rata basis to existing stockholders. For example, if a company pays a 10 percent stock dividend,
it gives each stockholder a number of new shares equal to 10 percent of the number of shares
the stockholder already owns.9 If an investor owns 100 shares, that investor receives 10 addi-
tional shares. An investor that owns 500 shares receives 50 additional shares, and so on.
Although stock dividends are not as common as regular cash dividends, a number of compa-
nies pay stock dividends. For example, Southside Bancshares, TGC Industries, Parke Bancorp,
and Fort Orange Financial Corporation all paid stock dividends in 2010.

17.4 Stock Dividends and Stock Splits 561

To understand why no value is distributed when a stock dividend is paid, consider again a
company that pays a 10 percent stock dividend. Assume that the company has total assets with
a market value of $11,000, that it has 10,000 shares of stock outstanding, and that it has no
debt. Since there is no debt, the stockholders own all of the assets in the firm and each share is
worth $1.10 ($11,000/10,000 shares ϭ $1.10 per share).

When the 10 percent stock dividend is paid, the number of shares outstanding increases by
10 percent, from 10,000 to 11,000. Notice that this is really just an accounting change, since no
assets are going out of the company. As a result, the value of the total assets in the company does
not change, and the value of each share decreases from $1.10 to $1.00 ($11,000/11,000 shares
ϭ $1.00 per share). All that happens when the stock dividend is paid is that the number of
shares each stockholder owns increases and their value goes down proportionately. The stock-
holder is left with exactly the same value as before. In our example, a stockholder who owned
one hundred shares worth $110 ($1.1 ϫ 100 shares ϭ $110) before the stock dividend will own
110 shares worth $110 ($1.0 ϫ 110 shares ϭ $110) afterward.

Stock Splits stock split
a pro-rata distribution of new
A stock split is quite similar to a stock dividend, but it involves the distribution of a larger shares to existing stockholders
multiple of the outstanding shares.10 As the name suggests, we can think of a stock split as an that is not associated with any
actual division of each share into more than one share. For example, in a stock split, stockhold- change in the assets held by
ers frequently receive one additional share for each share they already own. This is known as a the firm; stock splits involve
two-for-one stock split. Stock splits can also involve even larger ratios. For example, there might larger increases in the number
be a three-for-one stock split in which each stockholder receives two additional shares for each of shares than stock dividends
share of stock he or she owns. Besides their size, a key distinction between stock dividends and
stock splits is that stock dividends are typically regularly scheduled events, like regular cash
dividends, whereas stock splits tend to occur infrequently during the life of a company.

An example of a stock split is the two-for-one stock split that Magna International
announced on November 4, 2010. In this stock split, each Magna stockholder received one
additional share for each share that he or she owned on November 26, 2010.

As with a stock dividend, nothing substantial changes when a stock split takes place. A
stockholder might own twice as many shares after the split, but because the split does not
change the nature of the company’s assets, those shares represent the same proportional own-
ership in the company as the original shares. In the Magna International example, adjusting for
a cash dividend paid at the time of the stock split, the prices per share at the close of trading on
November 25 and 26 were $96.16 and $48.82, respectively. This 49.2 percent [($48.82 Ϫ
$96.16)/$96.16 ϭ Ϫ0.492, or Ϫ49.2 percent] price decline was almost equal to the 50 percent
decline that you would expect from a two-for-one stock split.11 The number of shares doubled,
while the value of the expected cash flows against which stockholders had claims remained
largely unchanged.

Reasons for Stock Dividends and Splits

At this point, you might be asking why companies pay stock dividends or split their stock. The
most often cited reason is known as the trading range argument. This argument proposes that
successful companies use stock dividends or stock splits to make their shares more attractive
to investors. Why would stock dividends or splits have this effect? Suppose the price of the
stock of a successful company was allowed to continue to increase over a long period of time.
Eventually, few investors would be able to afford to purchase a round lot of 100 shares. This, in
turn, could affect the company’s stock price.

To understand this argument, you must know that it has historically been more expensive
for investors to purchase odd lots, which consist of less than 100 shares, than round lots, which
are multiples of 100 shares. Odd lots are less liquid than round lots because more investors want

10Note that for accounting purposes, a stock split and a stock dividend are treated differently. From a finance point of

view, however, they are similar events.
11If nothing else happened, and the split had none of the effects discussed in the following section, we would expect

the Magna International stock price to drop by exactly 50 percent. However, changes in market conditions and other

circumstances at the firm, as well as possible effects of the split on the attractiveness of Magna’s stock, apparently com-

562 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

to buy round lots. Furthermore, it is relatively expensive for companies to service odd-lot own-
ers. (Consider, for example, the cost per share of sending stockholders annual reports and pro-
spectuses or writing and mailing quarterly dividend checks.) Because of these disadvantages,
investors tend to be less than enthusiastic about purchasing odd lots of less than 100 shares and
managers prefer that they do not. According to the trading range argument, when buying a
round lot becomes too expensive, investors might avoid buying the stock at all. Stock dividends
and splits offer ways to bring the price of the stock down to the appropriate “trading range.”

Although the trading range argument may be appealing to some, researchers have
found little support for it. After a stock split, the stock’s dollar trading volume does not ap-
pear to be higher than it was before the split. Also, the transaction costs argument no lon-
ger carries much weight, as there is now little difference in the costs of purchasing round
lots and odd lots.

In fact, shares of some companies trade at per-share prices that are far above what is typi-
cally thought of as a normal trading range. The most famous of these companies is Berkshire
Hathaway, Inc. Its class A shares were trading for $119,073 per share on December 16, 2010,
with no apparent negative effects.12

One real benefit of stock splits is that they can send a positive signal to investors about
management’s outlook for the future. This, in turn, can lead to a higher stock price. After
all, management is unlikely to want to split the stock of a company two-for-one or three-
for-one if it expects the stock price to decline. It is only likely to split the stock when it
is confident that the stock’s current market price is not too high. A number of research
studies have reported evidence indicating that investors tend to interpret stock splits as
good news.13

Companies occasionally do reverse stock splits, in which the number of shares owned by
each stockholder is reduced. For example, in a 1-for-10 reverse split, a stockholder receives
one share in exchange for each ten shares he or she owned before. If you owned 1,000 shares
of the stock of such a company, you would have only 100 (1,000/10) shares after the reverse
stock split.

Reverse stock splits may be undertaken to satisfy exchange requirements. For example,
the New York Stock Exchange generally requires listed shares to trade for more than $5, and
the NASDAQ requires shares to trade for at least $1. Being removed from the NYSE or NAS-
DAQ can dramatically reduce the liquidity of the company’s stock and harm management’s
ability to raise capital in the future. A reverse stock split can help avoid these negative effects
by keeping the per-share price above the required thresholds.

> BEFORE YOU GO ON

1 . What is a stock dividend?

2 . How does a stock dividend differ from a stock split?

3 . How does a stock dividend differ from other types of dividends?

17.5 SETTING A DIVIDEND PAYOUT

LEARNING OBJECTIVE An important question that you may be asking yourself is exactly how managers set the
dividend payouts for their firms. In this section, we discuss the results from two important
surveys. These surveys deal with how managers select their dividend payouts and what prac-
tical considerations managers must balance when they choose a dividend payout.

12In 1996, Berkshire Hathaway issued a second class of stock, which was trading at $79.47 on December 16, 2010, but

which had no voting rights. Until 2010, when these shares were split 50-to-1, even they were trading for as much as

$4,500 per share.
13For an example of such a study, see R. M. Conroy and R. S. Harris, “Stock Splits and Information: The Role of Share

17.5 Setting a Dividend Payout 563

What Managers Tell Us

The best known survey of dividend decisions was published in 1956, more than 55 years ago,
by John Lintner.14 The survey asked managers at 28 industrial firms how they set their firms’
dividend payouts. The key conclusions from the Lintner study are as follows:

1. Firms tend to have long-term target payout ratios.

2. Dividend changes follow shifts in long-term sustainable earnings.

3. Managers focus more on dividend changes than on the level (dollar amount) of the dividend.

4. Managers are reluctant to make dividend changes that might have to be reversed.

These results are consistent with the idea that managers tend to use dividends to distribute
excess earnings and that they are concerned about unnecessarily surprising investors with
bad news.

A more recent study, published in 2005, updates Lintner’s findings.15 The authors con-
ducted a survey of 384 financial executives and personally interviewed 23 other managers.
They found that managers continue to be concerned about surprising investors with bad news.
Indeed, maintaining level dividend payouts is as important to executives as the investment
decisions they make. The authors also found, as Lintner did, that the expected stability of fu-
ture earnings affects dividend decisions. However, the link between earnings and dividends is
weaker today than when Lintner conducted his survey.

In response to the increased use of stock repurchases, the authors of the 2005 study
asked managers about their views on repurchases. They found that rather than setting a
target level for repurchases, managers tend to repurchase shares using cash that is left over
after investment spending. In addition, many managers prefer repurchases because repur-
chase programs are more flexible than dividend programs and because they can be used to
time the market by repurchasing shares when management considers a company’s stock
price too low. Finally, the managers who were interviewed appeared to believe that institu-
tional investors do not prefer dividends over repurchases or vice versa. In other words, the
choice between these two methods of distributing value has little effect on who owns the
company’s stock.

Practical Considerations in Setting a Dividend Payout

In this chapter, we have discussed a wide range of factors that enter into managers’ decisions
regarding the selection of their firms’ dividend payouts. While the details are important, it is
easy to get caught up in them and to lose sight of the big picture. A company’s dividend pay-
out decision is largely about how the excess value in a company is distributed to its stockhold-
ers. Central to choosing this payout is the question of how much value should be distributed.
It is extremely important that managers choose their firms’ dividend payouts in a way that
enables them to continue to make the investments necessary for the firm to compete in its
product markets. With this in mind, managers should consider several practical questions
when selecting a dividend payout, including the following:

1. Over the long term, how much does the company’s level of earnings (cash flows from
operations) exceed its investment requirements? How certain is this level?

2. Does the firm have enough financial reserves to maintain dividend payouts in periods
when earnings are down or investment requirements are up?

3. Does the firm have sufficient financial flexibility to maintain dividends if unforeseen
circumstances wipe out its financial reserves when earnings are down?

4. Can the firm quickly raise equity capital if necessary?

5. If the company chooses to finance dividends by selling equity, will changes in the number
of stockholders have implications for control of the company?

14J. Lintner, “Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes,” American
Economic Review 46 (1956), 97–113.
15A. Brav, J. R. Graham, C. R. Harvey, and R. Michaely, “Payout Policy in the 21st Century,” Journal of Financial

564 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

> BEFORE YOU GO ON
1 . How are dividend payouts affected by expected earnings?
2 . What did the 2005 study conclude about how managers view stock repurchases?
3 . List three practical considerations managers should take into account when

setting a dividend payout.

S um m a ry of Learning Objectives

1 Explain what a dividend is, and describe the different The potential benefits from paying dividends include (1) attract-
types of dividends and the dividend payment process. ing certain investors who prefer dividends, (2) sending a posi-
Calculate the expected change in a stock’s price around tive signal to the market concerning the company’s prospects,
an ex-dividend date. (3) helping to provide managers with incentives to manage the
company more efficiently, and (4) helping to manage the com-
A dividend is something of value that is distributed to a firm’s pany’s capital structure. One cost of dividends is the fact that a
stockholders on a pro-rata basis—that is, in proportion to the stockholder must take a dividend, and pay taxes on the dividend,
percentage of the firm’s shares that they own. There are four types whether or not he or she wants the dividend. Stockholders who
of dividends: (1) regular cash dividends, (2) extra dividends, (3) want to reinvest the dividend in the company must, unless there
special dividends, and (4) liquidating dividends. Regular cash is a dividend reinvestment program (DRIP), pay brokerage fees
dividends are the cash dividends that firms pay on a regular ba- to reinvest the money. Finally, paying a dividend can increase a
sis (typically quarterly). Extra dividends are paid, often at the company’s leverage and thereby increase its cost of debt.
same time as a regular cash dividend, when a firm wants to dis-
tribute additional cash to its stockholders. Special dividends are With a stock repurchase program, investors can choose
one-time payments that are used to distribute a large amount of whether they want to sell their shares back to the company.
cash. A liquidating dividend is the dividend that is paid when a Stock repurchases also receive more favorable tax treatment.
company goes out of business and is liquidated. From management’s point of view, stock repurchase programs
offer more flexibility than dividends and can have less of an ef-
The dividend payment process begins with a vote by the board fect on the company’s stock price. One disadvantage of stock
of directors to pay a dividend. This vote is followed by public an- repurchases involves an ethical issue: Managers have better in-
nouncement of the dividend on the declaration date. On the ex- formation than others about the prospects of their companies,
dividend date, the shares begin trading without the right to receive and a stock repurchase can enable them to take advantage of this
the dividend. The record date, which follows the ex-dividend date information in a way that benefits the remaining stockholders at
by two days, is the date on which an investor must be a stockholder the expense of the selling stockholders.
of record in order to receive the dividend. Finally, the payable date
is the date on which the dividend is paid. 4 Define stock dividends and stock splits and explain
how they differ from other types of dividends and from
Learning by Doing Application 17.1 shows how to calculate stock repurchases.
the expected change in a stock’s price around the ex-dividend date.
Stock dividends involve the pro-rata distribution of additional
2 Explain what a stock repurchase is and how companies shares in a company to its stockholders. Stock splits are much
repurchase their stock. Calculate how taxes affect the like stock dividends but involve larger distributions of shares
after-tax proceeds that a stockholder receives from a than stock dividends. Stock dividends and stock splits differ
dividend and from a stock repurchase. from other types of dividends because they do not involve the
distribution of value to stockholders. The total value of each
A stock repurchase is a transaction in which a company pur- stockholder’s shares is the same after a stock dividend or stock
chases some of its own shares from stockholders. Like dividends, split as it was before the distribution. Since they do not involve
stock repurchases are used to distribute value to stockholders. the distribution of value, stock dividends are not really divi-
The three ways in which stock is repurchased are (1) open-market dends at all.
repurchases, (2) tender offers, and (3) targeted stock repur-
chases. With open-market repurchases, the company purchases 5 Describe factors that managers consider when setting
stock on the open market, just like any investor does. A tender the dividend payouts for their firms.
offer is an open offer by a company to purchase shares. Finally,
targeted stock repurchases are used to purchase shares from spe- A company’s dividend payout decision is largely about how
cific stockholders. excess value in the company is distributed to its stockholders.
Setting the payout depends on several factors: the expected level
The calculation of the after-tax proceeds that a stock- and certainty of the firm’s future profitability, the firm’s future
holder receives is illustrated in the text and in Learning by investment requirements, the firm’s financial reserves and
Doing Application 17.2. financial flexibility, the firm’s ability to raise capital quickly
if necessary, and the control implications of financing divi-
3 Discuss the benefits and costs associated with dividend dends by selling equity.
payments and compare the relative advantages and
disadvantages of dividends and stock repurchases.

Critical Thinking Questions 565

Self-Study Problems

17.1 You would like to own a common stock that has a record date of Friday, September 9, 2011. What
is the last date that you can purchase the stock and still receive the dividend?

17.2 You believe that the average investor is subject to a 15 percent tax rate on dividend payments. If a
firm is going to pay a $0.30 dividend, by what amount would you expect the stock price to drop on
the ex-dividend date?

17.3 The Veil Acts Company just announced that instead of a regular dividend this quarter, it will be
repurchasing shares using the same amount of cash that would have been paid in the suspended
dividend. Should this be a positive or negative signal from the firm?

17.4 The Bernie Rubbel Company has just declared a three-for-one stock split. If you own 12,000 shares
before the split, how many shares will you own after the split? What if it were a one-for-three re-
verse stock split?

17.5 Two publicly traded companies in the same industry are similar in all respects except one. Where-
as Publicks has issued debt in the public markets (bonds), Privicks has never borrowed from any
public source. In fact, Privicks always uses private bank debt for its borrowing. Which firm is likely
to have a more aggressive regular dividend payout? Explain.

Solutions to Self-Study Problems

17.1 The ex-dividend date is the first day that the stock will be trading without the rights to the divi-
dend, and that occurs two days before the record date, or on September 7, 2011. Therefore, the
last day that you can purchase the stock and still receive the dividend will be the day before the
ex-dividend date, or Tuesday, September 6, 2011.

17.2 If the tax rate of the average investor is reflected in the stock price change, we would expect investors
to receive 85 percent (1.0 Ϫ 0.15 ϭ 0.85, or 85 percent) of the dividend after paying taxes. This im-
plies a $0.255 (0.85 ϫ $0.30ϭ $0.255) drop in the stock price of the firm on the ex-dividend date.

17.3 Veiled Acts has replaced a committed cash flow with one that is stated but does not have to
be acted on. Therefore, the firm’s actions should be greeted with suspicion. The signal is not a
positive one.

17.4 You will own three shares of Bernie Rubbel for every one share that you currently own. Therefore,
you will own 3 ϫ 12,000 shares ϭ 36,000 shares of the company. In the case of the reverse split,
you will own 1/3 ϫ 12,000 shares ϭ 4,000 shares of the company.

17.5 If all other characteristics of the two companies are the same, then Publicks could be expected to
have a more aggressive dividend payout. Since Publicks has issued debt in the past, while Privicks
has not, Publicks is likely to have greater access to the capital markets than Privicks. Firms with
greater access to capital markets can be more aggressive in their dividend payouts to the extent
that they can raise capital more easily (cheaply) if necessary.

Critical Thinking Questions

17.1 Suppose that you live in a country where it takes 10 days to settle a stock purchase. By how many
days will the ex-dividend date preceed the record date?

17.2 The price of a share of stock is $15.00 on November 8, 2011. The record date for a $0.50 dividend is
November 11, 2011. If there are no taxes on dividends, what would you expect the price of a share
to be on each day from November 8 through 11 if no other information relevant to the price of the
shares becomes public.

17.3 You find that you are the only investor in a particular stock who is subject to a 15 percent tax rate
on dividends (all other investors are subject to a 5 percent tax rate on dividends). Is there greater
value to you in holding the stock beyond the ex-dividend date or selling the stock and then repur-
chasing it on or after the ex-dividend date? Assume that the stock is currently selling for $10.00 per
share and the dividend will be $0.25 per share.

17.4 Discuss why the dividend payment process is so much simpler for private companies than for

566 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

17.5 You are the CEO of a firm that appears to be the target of a hostile takeover attempt. Thibeaux
Piques has been accumulating the shares of your stock and now holds a substantial percentage
of the outstanding shares. You would like to purchase the shares that he owns. What method of
stock repurchase will you opt for?

17.6 You have accumulated stock in a firm that does not pay cash dividends. You have read that, ac-
cording to Modigliani and Miller, you can create a “homemade” dividend should you require
cash. Discuss why this choice may not be very good for the value of your position.

17.7 You have just read a press release in which a firm claims that it will be able to generate a higher
level of cash flows for its investors going forward. Justify the choice of a dividend payout that
could credibly convey that information to the market.

17.8 Some may argue that a high tax rate on dividends creates incentives for managers to go about
their business without credibly convincing investors that the firm is doing well, even when it is.
Discuss how this may be true.

17.9 Fled Flightstone Mining’s management does not like to pay cash dividends due to the volatility
of the company’s cash flows. Fled management has found, however, that when it does not pay
dividends, its stock price becomes too high for individual investors to afford round lots. What
course of action could Fled take to get its stock price down without dissipating firm value for
stockholders?

17.10 Lintner found that firms are reluctant to make dividend changes that might have to be reversed.
Discuss the rationale for that behavior.

Questions and Problems

B A S I C > 17.1 Dividends: The Poseidon Shipping Company has paid a $0.25 dividend per quarter for the past

three years. Poseidon just lowered its declared dividend to $0.20 for the next dividend payment.
Discuss what this new information might convey concerning Poseidon management’s belief
about the future of the company.
17.2 Dividends: Marx Political Consultants has decided to discontinue all of its business operations.
The firm has total debt of $7 million, and the liquidation value of its assets is $10 million. If the
book value of the firm’s equity is $5 million, then what will be the amount of the liquidating
dividend when the firm liquidates all of its assets?
17.3 Dividends: Place the following in the proper chronological order, and describe the purpose of
each: ex-dividend date, record date, payment date, and declaration date.
17.4 Dividends and firm value: Explain how the issuance of new securities by a firm can pro-
duce useful information about the issuing firm. How can this information make the shares of
the firm more valuable, even if it only confirms existing information about the firm?
17.5 Dividends: Explain why holders of a firm’s debt should insist on a covenant that restricts the
amount of cash dividends the firm pays.
17.6 Stock splits and stock dividends: Explain why firms prefer that their shares trade in a moderate
per-share price range rather than in a high per-share price range. How do firms keep their shares
trading in a moderate price range?
17.7 Dividends: Scintilla, Inc., is trading for $10.00 per share on the day before the ex-dividend date.
If the dividend is $0.25 and there are no taxes, what should the price of the shares be on the ex-
dividend date?
17.8 Dividends: A company announces that it will make a $1.00 dividend payment. Assuming all
investors are subject to a 15 percent tax rate on dividends, how much should the company’s share
price drop on the ex-dividend date?

I N T E R M E D I AT E > 17.9 Dividends and firm value: Explain how a stock repurchase is different from a dividend

payment.
17.10 Dividends and firm value: You have just encountered two identical firms with identical in-

vestment opportunities, as well as the ability to fund these opportunities. One of the firms has
just announced that it will pay a dividend, while the other has continued to pay no dividend.