Question

Consider the two major managerial decisions we discussed in class: the firm’s payout policyand the firm’s financing decision. When does a firm’s choice of capital structure matter toshareholders? What factors drive the difference between the value of a levered firm and thevalue of an unlevered firm, if any? According to the tradeoff theory of capital structure, howmuch debt should a firm issue? When does a firm’s payout policy matter to shareholders?How should managers decide the firm’s payout policy?

Answer 1

The firm's choice of capital structure matter to shareholders when-

1. There are taxes on earnings

2. Sufficient alternatives are not available

3. Cost of debt is very low

4. Cost of borrowing are different for company and shreholders

Debt taken by a levered firm, is often a cost-effective source of capital and also helps it to invest in growth opportunities such as M&A, launch of newer products/ entry in new geographies thus enhancing its earnings potential. Also, since debt is typically a cheaper source of capital owing to the deduction on interest allowed for tax purposes, a levered firm will have a lower weighted average cost of capital (WACC) and thus higher value than any unlevered firm. However, too much share of debt in the capital can increase the financial risk for shareholders. Thus, for maximization of value, the firm must choose the optimal capital structure, which will minimize its WACC. Optimal capital structure varies from industry to industry.

Besides, investors' expectations of rise/ decline in credit costs ( with bearing on interest and thus its earnings), leverage of the levered firm, and its competitors ( will decide the attractiveness as target), taxation rates, efficiencies in the capital market, industry's prospect in market, chances of capital expenditure in near-to-mid term, availability of good value-additive projects in the firm's industry will drive the difference between the value of a levered firm and an unlevered firm.

According to the trade-off theory, a firm should issue as much debt as to reach optimal capital structure..when its weighted average cost of capital (WACC) is minimum.

A firm's payout policy will matter to shareholders when there is a difference in tax rates on capital gains and dividend, market imperfections or transaction costs.

The payout policy shapes shareholders' expectations of future dividend and company's performance. An increase in dividend is understood by the investors that the business will be stable over short-to-mid term. 100% payment signals that the company doesn't have enough projects at hand which can generate better returns than cost of equity. Decline in payout ratio/ dividend is indicative of company's focus on increasing reliance on retained earnings to drive projects, which it expects to generate higher returns than cost of equity.

Managers should decide the firm's payout policy based on:

1. Growth and profitability of firm : Firms with strong growth prospects should maintain low target payout ratios.

2. Liquidity position: Firms in cyclical industries should maintain low payout ratios even in good times.

3. The cost and availability of alternate forms of financing : When finance is available from external sources at cheaper rates, it may be possible to go for high dividend payout.

4. Concerns about the managerial control over firm : A high dividend ratio will mean lower cash with the company and can lower the attractiveness as a target for hostile takeover.

5. Existence of legal restriction, if any

6. Impact of inflation of cash flow