Question

1. This question is on capital structure.
   1. List and explain all the theories on capital structure.
   2. As the CEO of Pokebook, you are contemplating debt issuance. In particular, your CFO suggests a capital restructuring program where the company will issue $7 billion of perpetual debt. Beginning with the definition of a capital restructuring program, explain to your board of directors the reasons of issuing (or not issuing) debt and consequently to restructure the capital of Pokebook.
   3. What factors affect your decision to choose dividend or share repurchase as a way to distribute the money raised under the capital restructuring program?

2. You should highlight different factors (including those not covered in a) to get full credits. All parts have equal weights.

Answer 1

A) There are two theories

MM Theory for capital structure irrelevance - which states that the returns of a company does not depend on their capital structure but only depends on the sustainability of their cashflows. This theory has multiple assumptions with the biggest being that Floation costs are 0, and taxes are 0

The other is the modern theory, where the value of a company does depend on the capital structure as debt and equities have different costs, which will eventually impact firm value

B) When we present it to the board, we want to show the impact of taking on debt, on the bottom line of the firm. By taking on debt, the firm can reduce its cost of capital, and hence generate a higher return on capital, but the risk off is that it will add some pressure on the balance sheet and create a risk. If the project suffers, the company will still have to pay their debt. So if the overall benefis are much higher than the cost of capital and the risk are within the risk parameters of the firm, then they should add the debt otherwise they should not add on debt

C) Cash-rich companies distribute part of their after-tax profits as dividends to their shareholders. They distribute dividends – a specific amount per share – to all shareholders for showing faith in the company and holding its shares. All eligible shareholders get a dividend amount in proportion to the number of shares they hold.

Once companies start paying dividends or increase the payout, it becomes difficult for them to cut dividends. Reducing dividends could signal investors that the company is not doing well financially. It encourages the management to be more responsible with the capital. It also prevents the management from hoarding large piles of cash.

In the share buyback process, a company uses the excess cash to purchase its own shares in the open market or directly from shareholders. The company fixes the amount earmarked for buybacks, the buyback price, as well as the offer period.

Buybacks reduce the total number of outstanding shares. After the buyback, each remaining share has a greater percentage ownership in the company. It boosts the share price as well as earnings per share (EPS). It makes it easier for the company to meet or exceed analysts’ expectations.

Dividend is the cash the company returns to all shareholders on specified intervals. It’s up to investors whether they want to reinvest or use it to pay their bills. Long-term investors often choose to reinvest dividends to take advantage of compounding. For others, dividends provide a regular stream of income.

In contrast, stock buybacks are applicable only to a small number of shareholders who surrender their shares at a premium. Investors can choose whether they want to participate in the buyback process. While dividends have no impact on the number of outstanding shares, the buyback reduces the number.