IFM lecture 9

• Adjusted present value
• Flow to equity approach
• WACC method  

• Value of levered firm (APV) is value of project to an unlevered firm (NPV) + net present value of financing side effects (NPVF) à APV = NPV + NPVF
• Side effects summarized by NPVF 
  • Tax subsidy to debt
  • Costs of financing distress
  • Costs of issuing new securities 
  • Subsidies to debt financing 
• With a negative NCP, and all equity firm would reject the project 
• But the NPV of the project under leverage = adjusted present value (APV) 
  • Positive APV: a levered firm can accept the project
  • Using debt enables saving taxes 

• FTE is alternative capital budgeting approach 
• Formula: cash flow from project to equity-holders of levered firm ÷ cost of equity capital (Rs) 
• Steps

1. Calculated levered cash flow (LCF): cash inflows – cash costs – interest (= income after interest) – corporate tax 
2. Calculate Rs
3. Valuation of levered cash flow: NPC is difference between present value of LFC and investment not borrowed 

• Project of levered firms are concurrently financed with both equity and debt 
• Cost of capital = weighted average of cost of equity and cost of debt with corporate taxes included 

Dividend = distribution from earnings 

Most common: form of cash, 2 or 4 x p.y. 

• Stock dividend: paid in shares of equity
  • Increases number of shares outstanding, reducing value of each share 
• Dividend per share: amount of dividend expressed as currency per share 
• Dividend yield: amount of dividend expressed as % of market price 
• Dividend payout: amount of dividend expressed as % of earnings per share 
• Stock split: when firms declare stock split, increases number of shares outstanding
  • Resembles stock dividend, but usually larger 

1. Declaration date: the board of directors declares a payment of dividends
2. Record date: the declared dividends are distributable to shareholders of record 
3. Ex-dividend date: share of equity becomes ex-dividend on the date the seller is entitled to keep the dividend
4. Payment date: dividend cheques are mailed to shareholders of record 

• The change in dividend policy does not affect the value of a share of equity 
  • Managers can achieve any payout along the diagonal line 
  • An individual investor can achieve any net cash payout along the diagonal line 
• Investors can make homemade dividends 

• Open market purchases: firm purchases own equity as anyone would by shares, not revealing itself
• Tender offer: firm announces to all shareholders that it intends to buy back x shares at x price 
• Targeted repurchase: repurchase shares from specific shareholder, to
  • Buy him out at lower price
  • Lower legal fees 
  • Avoid unfavorable takeover to management 

• Flexibility: dividends as commitments
• Executive compensation: repurchase increases share price -> share options will have greater value
• Offset to dilution: offset the increase of shares outstanding coming from share options 
• Undervaluation: repurchase when equity is undervalued 
• Taxes: repurchases offer tax advantage over dividends 

• If a firm does not have sufficient cash to pay a dividend in a world of personal taxes, it should not issue equity to pay dividends (loses money to government) 
• But if company has large and steady degree of cash flow for many years, it can issue equity if cash flow dries up
  • Shareholders prefer dividend stability

1. Select additional capital budgeting projects with negative NPV: keep funds in firm
2. Acquire other companies: acquire profitable assets 
3. Purchase financial assets: dividend payout decision depends on personal and corporate tax rates 
4. Repurchase shares: reasonable alternative. But often penalized by authorities because risk of illegal price manipulation 

• desire for current income
  • Pro: individuals desire current income -> bid up share price if dividend rise, bid down share price if dividend falls 
  • Con: individual could sell off shares to provide necessary funds to buy higher cash flow 
• behavioral finance
  • Self-control: avoid selling off too much to consume more than earlier years, leaving little for later years 
  • -> increased dividends rather than share purchases
  • Investors would sell shares that firms repurchase, but selling involves too much leeway (derive)
• agency costs 
  • Pro: by paying dividends = to surplus cash flow, firm reduces managers’ ability to squander firm’s resources (vs bondholders or shareholders)
  • Con: also applies to share repurchases (could profit managers or board directors at expense of others) 

• Share price rises when firm announces dividend increase, falls when announced dividend reduction 
  • Dividend increase = market signal that firm is expected to do well 
• Information content effect of dividend: rise in share price follows the dividend signal

• Managers can increase dividends to make market think that cash flows will be higher
• Problems
  • There are costs to raising dividends
  • The market will learn, share price will fall below its original level as punishment
• It is not enough for manager to set dividend policy to maximize true value of firm -> consider effect of dividend policy on current share price 

• Clientele effect: the two sets of factors can cancel each other out 
  • Personal taxes favor low-dividend policy
  • Other factors favor high dividends 
• A firm cannot boost its share price by paying high dividends if there are already enough high-dividend firms to satisfy investors -> need unsatisfied clientele 
• Equities should attract clienteles based on dividend yield 
• Clientele effect can lead demand for dividend-paying shares to shift to new equilibrium, if proportion of dividend-paying firms increases or decreases
  • Some companies are mispriced

• Catering theory of dividends: managers will respond rationally to time variation in investor demand for dividends by modifying their firm’s dividend policy 
• With low demand for dividend-paying shares, dividend increase will not lead to positive price reaction 
  • Dividend omission can have more positive market response 

• Stock or share dividend: dividend paid out in shares of equity
• Stock split: stock dividend expressed as ratio
• Stock splits and dividends leave value of form either unaffected, increased or decreased 
  • Difficult to determine 
• Benchmark case: stock splits or dividends do not change wealth of shareholder or wealth of firm 

• Security has a proper trading range
• When priced above: investors don’t have funds to buy unit of 100 shares 
  • Buy fewer = higher commissions 
• Con: in reality, trading activities increased, individual share price is of little concern
  • -> Large share prices don’t cause problems, stocks splits decrease liquidity of firm’s shares 

• Reverse split: ex one-for-five reverse split, each investor exchanges 5 old shares for a new share (no real effect)
• Reasons for reverse splits 
  • Less transaction costs to shareholder 
  • Better liquidity & marketability of firm 
  • Shares sold below a certain level are not considered respectable 
  • Bring share price up to minimum requirements