Unit 5: Capital Structure and Dividend Theory

Part 1: Capital Structure

1. Introduction to Capital Structure

Capital Structure refers to the specific mix or proportion of long-term sources of funds used by a company to finance its operations and growth. It is essentially the composition of a firm's liabilities side of the Balance Sheet regarding long-term capital.

• Equation: Capital Structure = Debt + Equity (Common Stock + Preferred Stock + Retained Earnings).
• Difference between Capital Structure and Financial Structure:
  • Financial Structure: Includes all long-term and short-term liabilities.
  • Capital Structure: Includes only long-term sources of funds.

Major Components:

1. Equity Share Capital: Ownership stake; carries no fixed burden of dividend; permanent capital.
2. Preference Share Capital: Hybrid security; fixed dividend rate; preferential right over equity during liquidation.
3. Debentures/Long-term Debt: Borrowed capital; tax-deductible interest payments; increases financial risk.
4. Retained Earnings: Internal financing; plowing back profits.

2. Concept of Optimum Capital Structure

An Optimum Capital Structure is the specific debt-equity mix at which:

1. The Weighted Average Cost of Capital (WACC) is minimized.
2. The Market Value of the Firm is maximized.

At this point, the advantages of financial leverage (using cheaper debt) are perfectly balanced against the financial risks (risk of bankruptcy) associated with debt.

Features of an Optimum Capital Structure:

• Simplicity: Easy to manage and understand.
• Flexibility: The firm should be able to raise additional funds easily without altering the risk profile drastically.
• Solvency: Debt levels should not threaten the firm's ability to meet obligations.
• Profitability: It should leverage earnings per share (EPS).
• Conservatism: Debt capacity should not be exceeded.

3. Theories of Capital Structure

These theories attempt to explain the relationship between the Debt-Equity mix, the Cost of Capital (), and the Value of the Firm ().

A. Relevance Theories

These theories suggest that capital structure affects the value of the firm.

1. Net Income (NI) Approach (Durand)

• Premise: Capital structure acts as a lever to increase firm value.
• Logic: Debt is generally cheaper than equity (Cost of Debt < Cost of Equity ) and interest is often tax-deductible. Therefore, increasing the proportion of debt in the capital structure reduces the overall WACC.
• Conclusion: A firm can increase its value and lower its overall cost of capital by using more debt.
• Optimum Structure: 100% Debt (Theoretical extreme).

2. Traditional Approach

• Premise: This is an intermediate view (Compromise between NI and NOI).
• Logic:
  • Stage 1: Using debt initially lowers WACC because debt is cheaper. remains constant or rises slightly. Value rises.
  • Stage 2: Once an optimal range is reached, further debt increases financial risk. rises faster to offset the benefit of cheap debt. WACC bottoms out (Optimum Point).
  • Stage 3: Beyond the optimum point, excessive debt causes financial distress. Both and rise sharply. WACC increases; Value falls.
• Conclusion: An optimum capital structure exists at a specific debt-equity ratio.

B. Irrelevance Theories

These theories suggest that capital structure does NOT affect the value of the firm.

1. Net Operating Income (NOI) Approach (Durand)

• Premise: The market value of the firm depends on its operating income (EBIT), not how it is financed.
• Logic: While debt is cheaper, increasing debt increases the financial risk for equity holders. As a result, equity holders demand a higher return ( increases).
• Mechanism: The benefit of cheaper debt is exactly offset by the increase in the cost of equity.
• Conclusion: WACC remains constant regardless of the leverage. There is no optimum capital structure.

2. Modigliani-Miller (MM) Hypothesis (Without Taxes)

• Assumption: Perfect capital markets, no taxes, no transaction costs, homogeneous expectations.
• Proposition I: The value of a levered firm () is equal to the value of an unlevered firm ().
• Arbitrage Process: MM argues that if two identical firms have different values due to capital structure, investors will engage in "arbitrage" (selling overvalued shares and buying undervalued shares using personal leverage) until the prices equalize.
• Conclusion: Capital structure is irrelevant.

MM Hypothesis (With Taxes) - Relevance Reintroduced

• Adjustment: MM later acknowledged that corporate taxes exist.
• Logic: Interest payments are tax-deductible, creating a "Tax Shield."
• Proposition: The value of a levered firm is higher than an unlevered firm by the present value of the tax shield.
• Conclusion: Firms should maximize debt to maximize value (implies 100% debt is optimal in a world with taxes but no bankruptcy costs).

Part 2: Dividend Theory

1. Objectives of Dividend Policy

Dividend policy determines the division of earnings between payments to shareholders and reinvestment in the firm.

1. Wealth Maximization: To maximize the current price of shares.
2. Stable Income: providing a predictable income stream to investors who rely on dividends.
3. Capital Structure Maintenance: Retained earnings are an internal source of equity; the policy affects the debt-equity ratio.
4. Information Signaling: Dividends convey management's confidence in future earnings (high dividends = strong future; cut dividends = trouble).
5. Liquidity: Ensuring the company has enough cash for operations before paying out dividends.

2. Forms of Dividend

1. Cash Dividend: The most common form. Paid in cash/bank transfer to shareholders. Reduces the firm's assets (cash) and net worth.
2. Stock Dividend (Bonus Shares): Issuing additional shares to existing shareholders instead of cash.
   • Effect: Capitalizes reserves; does not change total shareholder equity or cash balance; increases number of shares outstanding; decreases EPS.
3. Scrip Dividend: A promissory note to pay the dividend at a later date. Used when the firm is short on liquid cash but has sufficient retained earnings.
4. Property Dividend: Distribution of assets (e.g., inventory or shares of a subsidiary company) instead of cash. Rare.

3. Theories of Dividend Policy

Theories regarding whether dividend distribution affects share price.

A. Dividend Irrelevance Theory

Modigliani-Miller (MM) Dividend Hypothesis

• Core Concept: Under perfect market conditions, dividend policy has no effect on share price or firm value. Value is determined solely by the earning power of the firm's assets and its investment policy.
• Logic:
  • If a company pays a dividend, it reduces retained earnings. To finance new investments, it must issue new equity.
  • The value transfer to old shareholders (dividend) is exactly offset by the dilution of their ownership caused by issuing new shares.
• Assumptions: Perfect markets, no taxes, fixed investment policy, no uncertainty.

B. Dividend Relevance Theories

These theories argue that dividend policy does affect firm value.

1. Walter’s Model

• Premise: Dividend policy is relevant and depends on the relationship between the firm's Internal Rate of Return () and the Cost of Capital ().
• Logic: The firm should treat retained earnings as an investment opportunity.
  • Growth Firm (): The firm earns more than the shareholder could earn elsewhere.
    • Policy: 0% Payout (Retain everything).
  • Declining Firm (): The firm earns less than the shareholder could earn elsewhere.
    • Policy: 100% Payout (Distribute everything).
  • Normal Firm (): Indifferent.
• Formula:
  
  
  Where:
  • = Market price per share
  • = Dividend per share
  • = Earnings per share
  • = Internal rate of return
  • = Cost of equity

2. Gordon’s Model (Bird-in-the-Hand Theory)

• Premise: Investors are risk-averse and prefer current income (dividends) over future capital gains (retained earnings).
• Logic: Current dividends are a "bird in the hand," while future capital gains are a "two birds in the bush" (uncertain).
• Impact: A higher dividend payout ratio reduces the risk perception of investors, lowering the cost of equity () and increasing share price. Conversely, retaining earnings increases risk and lowers share price.
• Formula:
  
  
  Where:
  • = Current price
  • = Expected dividend next year
  • = Cost of equity
  • = Growth rate of dividends (, where is retention ratio).

Summary Table: Capital Structure & Dividend Theories