SMB2F2 2

Strategic Financial Management
Block
2
STRATEGIC CAPITAL STRUCTURE
UNIT 5
Capital Structure
05
UNIT 6
Dividend Policy
58
UNIT 7
Allocating Capital and Corporate Strategy
112
UNIT 8
Financial Distress and Restructuring
133
Expert Committee
Dr. J. Mahender Reddy
Vice Chancellor
IFHE (Deemed University), Hyderabad
Prof. P. A. Kulkarni
Vice Chancellor
Icfai University, Dehradun
Prof. Y. K. Bhushan
Vice Chancellor
Icfai University, Meghalaya
Dr. O. P. Gupta
Vice Chancellor
Icfai University, Nagaland
Dr. Lata Chakravorty

Director
IBS Bangalore
Prof. D. S. Rao
Director
IBS Hyderabad
Prof. P. Bala Bhaskaran

Director
IBS Ahmedabad
Dr. Dhananjay Keskar

Director
IBS Pune
Prof. P. Ramnath
Director
IBS Chennai
Course Preparation Team

Shri T. S. Rama Krishna Rao
Icfai University
Prof. Hilda Amalraj

IBS Hyderabad
Dr. M. Syambabu
Icfai University
Prof. Bratati Ray

IBS Kolkata
Ms. C. Padmavathi
Icfai University
Dr. Vijaya Lakshmi S

IBS Hyderabad
Ms. Sudha
Icfai University
Dr. Vunyale Narender

IBS Hyderabad
Ms. Sunitha Suresh

Icfai University
Prof. Arup Chowdhury

IBS Kolkata
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BLOCK 2
This block briefly reviews the basic concepts of cost of capital, capital structure and
dividend policy. It also explains how to allocate capital, methods of valuation of
investment opportunities, financial distress, and reconstruction. This block consists of
four units.
Unit 5 outlines the concept of capital structure and various factors affecting it. The
combination of different long-term finances of a company is called its capital structure.
In addition to this, it covers different theories of capital structure.
Unit 6 discusses about Dividend Policy of a firm. Dividend policy determines retention
ratio and pay-out ratio of the profits earned by the company during the financial year. It
affects the share price of the company in the market. This unit outlines various models
of divided policies available to a firm to maximize the present market price of the
companys shares.
Unit 7 covers the calculation of economic value of a project which is very essential for
allocating capital. There are a number of methods to evaluate the projects. This unit also
covers allocating capital and corporate strategy.
Unit 8 discusses all the models to predict bankruptcy, explains how to reorganize a
distressed firm and details the rules of liquidation. A firm never goes bankrupt
immediately. Before a firm goes bankrupt, it exhibits a number of symptoms, which
when diagnosed and corrected in time can save the company from bankruptcy. A
number of models are available to predict bankruptcy.
UNIT 5 CAPITAL STRUCTURE

Structure
5.1
Introduction
5.2
Objectives
5.3
The Effect of Leverage on EPS
5.4
Capital Market Equilibrium Approach
5.5
Theories of Capital Structure
5.6
Modigliani and Miller (M&M)
5.7
Merton Miller Hypothesis
5.8
The Effect of Leverage on the Standard Deviation of Returns
5.9
Capital Structure in the Imperfect Market
5.10
Corporate Taxes and Firm Distress
5.11
The Interest Tax Shield
5.12
Bankruptcy Costs and the Capital Structure
5.13
Circumstances that Lead to Financial Distress and Bankruptcy
5.14
Agency Costs and the Capital Structure
5.15
Trade-off Theory of Financing
5.16
Signaling through Capital Structure
5.17
Summary
5.18
Glossary
5.19
Suggested Readings/Reference Material
5.20
Suggested Answers
5.21
Terminal Questions
5.1 INTRODUCTION
An optimal capital structure of a company can be properly defined as that security mix,
which minimizes the firms cost of capital and maximizes its values. The capital
structure should be balanced with adequate equity cushion to absorb the shocks of
business cycle and afford flexibility. As a finance manager, you can achieve this by
identifying the factors affecting capital structure, both internal and external, keeping the
capital cost at the minimum, level assist financing and reduce the hazards of
insolvency[v1]. This unit explains the theories of capital structure, various factors
affecting capital structure and focuses on the capital structure decisions in both perfect
markets as well as imperfect markets. This unit focuses on capital structure theories,
cost of capital, tax shield, and strategic determinants of the capital structure.
5.2 OBJECTIVES
After going through the unit, you should be able to:
Understand the relationship between Leverage and Rate of Return on Equity;
Define operational structure;
Understand the theories of capital structure;
Build the relationship between Corporate Taxes and Firm Distress;
Recognize the role of Interest Tax Shield and Bankruptcy Costs on capital
structure; and
Develop the long-term performance plan for a company.
5.3 THE EFFECT OF LEVERAGE ON EPS

An appropriate (optimal) capital structure is an important decision for any business
organization. The importance of the decision lies not only because of the need to
maximize returns to various organizational constituencies, but also because of the
impact such a decision would be having on the organizations ability to deal with its
competitive environment.
The theory of capital structure analyzes the impact of the financing mix on the valuation
of the firm. The theory also attempts to discover whether there exists an optimal capital
structure for a firm. This is one of the most controversial topics in the theory of finance.
There are broadly two schools of thought. One school believes that the composition of
the financing mix does not affect the cost of capital. This school does not believe in the
existence of an optimal capital structure. Hence, the capital structure has no relevance in
the valuation of the firm. The proponents of the other school believe that the cost of
capital is determined by the composition of the capital structure. The application of
leverage results in a change in the cost of capital. They try to determine the optimal
capital structure, at which level the overall cost of capital is minimal. They conclude
that it is the capital structure which determines the valuation of the firm.
The most discussed proposition on capital structure calls forth the Miller and
Modigliani proposition that was originally developed by Modigliani and Miller (1958).
Basically, it speaks about an optimal capital structure which balances the risk of
bankruptcy with the tax savings of debt. Once established, this capital structure should
provide greater returns to stockholders than they would receive from an all-equity firm.
In this context, the chapter focuses on the capital structure decisions in both perfect
markets as well as imperfect markets.
OPTIMAL FINANCIAL LEVERAGE
The goal of the firm is to maximize its value. For a given invested capital and a given
number of shares outstanding, this goal can also be thought of from the angle of
maximizing the firms stock price. Suppose a particular firm raises Rs.1,000 by issuing
100 shares of stock at Rs.10 per share. In this case, the firms market value will be
Rs.1,000. Suppose, at the same time, the firm finances its operations by issuing Rs.500 of
debt and 50 shares of stock. If the market prefers this financial mix to all-equity, the firm
6
Capital Structure
may be able to sell the stock for a higher price, say, Rs.11 per share. In this case the firms
value will be:
[Rs.500 debt + (50 shares x Rs.11)] = Rs.1,050.
This example illustrates that as the value of the firm increases, so does the stock price.
Therefore, when the value of the firm is maximized, it can be said that the stock price is
also maximized. The level of financial leverage that maximizes the firms market value
is the optimal financial leverage or the optimal capital structure. Let us consider the
following illustration that shows how a firms optimal capital structure affects its value
and its stock price.
Illustration 1
Investors Corporation needs Rs.100 million for investment. If the firm uses equity only,
investors will issue 10 million shares at Rs.10 a share. Alternatively, if the firm issues a
combination of debt and equity, it will reduce the number of shares issued
proportionately to the amount of debt issued. For example, if investors employ Rs.50
million of debt, it will reduce the number of shares issued by 50% to 5 million.
Investors estimate that its shares will be sold at the following prices:
Debt Issue
(Rs. million)
Number of Shares Issued

(million)
Stock Price Estimate

(Rs.)
20
11
50
12
70
What is Investors optimal capital structure? What is the firms corresponding value?
What is the corresponding stock price?
Solution
If the firm raises Rs.20 million of debt, investors will issue 8 million shares at Rs.11.
The firms value will be
Rs.20 million + (8 million shares x Rs.11) = Rs.108 million
For other levels of debt, we have
Rs.50 million + (5 million shares x Rs.12) = Rs.110 million, and
Rs.70 million + (3 million shares x Rs.9) = Rs.97 million
Thus, the firms optimal policy is to issue Rs.50 million of debt. With this capital
structure, the firms value will be Rs.110 million, and its stock price will be Rs.12. In
analyzing the optimal capital structure, we hold investment in physical assets constant
and focus on how the financing mix affects the firms value. In the above problem, the
firm obtains more cash (Rs.110 million) than it needs for the investment (Rs.100
million). To keep the investment and the NOI constant, the firm could issue fewer
shares or, alternatively, distribute the extra Rs.10 million as dividends and thereby
maintain a debt/equity ratio of 1 (Rs.50 million debt/Rs.50 million equity = 1).
7
LEVERAGE AND THE RATE OF RETURN ON EQUITY

Leverage decisions in a firm affects its rate of return on equity when cash flows are
either certain or uncertain. Let us first consider the case with certain cash flows. Prior to
that, let us define leverage.
Box 1: Financial Leverage
When a firm finances a portion of its operations by debt, it is said that the firm
employs financial leverage or in other words, it is a levered firm. If a firm does not
employ debt, it is said that it is an all-equity firm and has no leverage.
CERTAIN CASH FLOWS
Let us initially consider a case of an all-equity firm, say Heavenly Industries, which has
100 outstanding shares with a market price of Rs.10 per share. Here the firms value
equals its equity value.
V = E = Rs.1,000.
Let us also assume perfect certainty in the cash flows of the firm, that is, the company
knows its cash flow Net Operating Income (NOI) in advance.
Table 1 presents Heavenlys basic financial data and profitability. The market value of
the firms equity is Rs.1,000. It is also assumed that there exists a tax-free world. Since
Heavenly knows its Rs.150 NOI with certainty, the rate of return on the firms equity is
15% (Rs.150/Rs.1,000).
Now let us suppose that Heavenly is considering a mix of 25% debt and 75% equity
such that the total amount of money raised remains constant at Rs.1,000. This financing
mix would change the capital structure. However, since the total investment would
remain constant, the firms investment plans and its NOI would be unaffected. Would
the change in the capital structure increase the rate of return on the firms equity?
Market value of equity
Debt
NOI
Rate of return on equity
Rs.1,000
Rs.0
Rs.150
15%
Table 1: Heavenly Industries Financial Data

Before the Change in
Capital Structure
(Rs.)
Basic Data:
Market value of debt
Total capital
NOI
Interest:
a.
10%
b.
15%
c.
20%
Stockholders Income:
a.
10%
b.
15%
c.
20%
Rate of Return on Equity:
a.
10%
b.
15%
c.
20%
After the Change in Capital Structure (75%

equity, 25% debt)
(Rs.)
1,000
0
1,000
150
750
250
1,000
150
0
0
0
25
37.50
50
150
150
150
125
112.50
100
15%
15%
15%
16.67%
15%
13.33%
Table 2: Heavenly Industries

Rate of Return on Equity for Various Interest Rates
8
Capital Structure
Table 2 shows that the answer to this question depends on the interest rate that the firm
would have to pay on the debt. In the table, the rate of return on equity is calculated for
three alternative interest rates: 10%, 15%, and 20%. When the interest rate on debt is
below 15%, the rate of return on equity increases after the change in the capital
structure. The reason is that the firm earns 15% on the investment but pays a lower
interest rate, 10%, on its debt financing. The extra 5% is the stockholders additional
rate of return. When the interest rate is above 15%, the rate of return on equity
decreases; but when the interest rate is exactly 15%, the return on equity is unaffected
by the change in capital structure.
Estimation of the Figures in Table 2
When the interest rate on debt (B = Rs.250) is r = 10%, the stockholders net income is
Rs.125 [NOI rB = Rs.150 (0.10 x Rs.250) = Rs.125].
Stockholders invested Rs.750 in equity; therefore, the rate of return as a percentage of
the invested equity is approximately 16.67%
(Rs.125/Rs.750 = 0.1667 or 16.67%). When the interest rate on debt is 15%, the
stockholders net income is Rs.112.50
[NOI rB = Rs.150 (0.15 x Rs.250) = Rs.112.50],
and the rate of return on equity is 15% (Rs.112.50/Rs.750 = 0.15 or 15%). When the
interest rate is 20%, the stockholders net income is Rs.100
[NOI rB = Rs.150 (0.2 x Rs.250) = Rs.100],
and the rate of return on equity is approximately 13.33%
(Rs.100/Rs.750 = 0.1333 or 13.33%).
Findings from the Problem
Financing part of a firms operations by debt is similar to having a partner who is
entitled to fixed interest rate on his or her investment. If such a silent partner (who has
no voting rights) charges less than the firms rate of return on its operations (in our
example less than 15%), the profit after paying this interest bill will enhance the rate of
return on equity. This is why it can be said that a firm levers or enhances the rate of
return on equity when it issues debt. If the partners charge exactly equals the interest
rate, the rate of return on equity will not be affected. Finally, if the partner charges more
than the firms rate of return on its invested equity, the rate of return on the equity will
decline. As Table 2 illustrates, the effect of Heavenlys leverage on the rate of return on
equity can be positive (if interest is below 15%), negative (if interest is above 15%), or
neutral (if interest is exactly 15%).
Since Heavenly would know the interest rate its bondholders (or the bank) charge, the
firms decision should be simple. If the market interest rate is above 15%, Heavenly
should not issue debt; if it is below 15%, Heavenly should exploit this opportunity by
issuing debt to enhance (lever) the profit on its invested equity.
9
The Question of Optimality

How much debt should it issue? Should it be 25% of total investment, or 50%, or more?
In order to answer the question, let us assume that Heavenly pays a 10% interest rate on
its debt. Table 3 shows the rates of return on equity for various proportions of leverage:
0%, 25%, 50% and 75%. To understand the calculations, look at the last column of table
3. With debt of Rs.750, the interest is Rs.75 (Rs.750 x 0.10 = Rs.75), and the
shareholders net income is Rs.75 (Rs.150 Rs.75 = Rs.75). Dividing this net income
by the invested equity of Rs.250, we obtain a rate of return on equity of 30%.
The figures in the table 3 are calculated in the same manner. The rate of return on equity
increases from 15% in the case of no leverage, to 16.67% for 25% leverage, to 20% for
50% leverage, and to 30% for 75% leverage. In the certainty case the solution of the
optimal capital structure question is straight forward: As long as the interest rate is
below the rate of return on invested assets (15% in our example), the more leverage the
firm employs and the better its shareholders fare, because the rate of return on their
investment increases.
Capital Structure
Data:
Market value of debt
Total value of the firm
NOI
Interest (at 10%)
Net income (NOI Interest)
0%
Rs.1,000
Rs.0
Rs.1,000
Rs.150
Rs.0
15%
25%
750
250
1,000
150
25
16.67
50%
500
500
1,000
150
50
20
75%
250
750
1,000
150
75
30
Table 3: Heavenly Industries: Rates of

Return on Equity for Various Capital Structures
Reality Check
A firm like Heavenly simply does not exist. A real-world firm would have more
difficulty choosing the optimal capital structure because it would not know the NOI
with certainty. NOI depends on the firms success. Leverage can enhance the rate of
return on equity in good years, but it can have the opposite effect in bad years. We shall
now turn from Heavenly Industries to Realistic Industries, where we will analyze the
impact of leverage in the more relevant case of uncertain future cash flows.
UNCERTAIN CASH FLOWS
It is realistic to assume that a firms NOI will be high during an expanding economy
and low, or even negative, during recession. Because a firm has to pay a fixed interest
rate on its debt, the actual rate of return on equity may be enhanced in years of
prosperity but may decline in times of recession. Depending on market conditions,
leverage can have a positive or a negative effect. Moreover, the more leverage a firm
employs, the stronger the leverage effect.
To illustrate the leverage effect when NOI is uncertain, let us use Heavenlys basic data
but change the firms name to Realistic Industries. (The relevant figures are given in
Table 4.) For the sake of simplicity, it is assumed that there are only three possible NOIs:
10
Capital Structure
Rs.80 with a probability of 1/3; Rs.100 with a probability of 1/3; and Rs.150 with a
probability of 1/3. Let us first consider here, the recession scenario when NOI = Rs.80.
Case 1: If Realistic Industries employs no leverage scenario (the firm finances its
Rs.1,000 investments completely by equity), it pays no interest and the rate of return on
equity is 8% (Rs.80/Rs.1,000 = 0.08 or 8%).
Case 2: When the firm employs 25% leverage, it issues Rs.250 debt at 10% interest, and
the total invested capital is, as before, Rs.1,000. Since the interest is Rs.25 (0.10 x Rs.250
= Rs.25), Realistic has only Rs.55 (Rs.80 Rs.25 = Rs.55) left to distribute among the
stockholders. Realistics rate of return on equity is approximately 7.33% (Rs.55/Rs.750 =
0.0733 or 7.33%). Other figures in Table 4 are calculated in the same manner.
Findings of Table 3
First, we see that leverage affects the rate of return on equity. Generally speaking, the
higher the leverage, the greater its effect on the rate of return on equity. For example, at
25% leverage the rate of return on the equity falls in the range of 7.33% and 16.67%;
while for 50% leverage, the range widens from 6% to 20%.
When the rate of return on investment equals the interest rate, the selected leverage,
regardless of its magnitude, does not affect the rate of return on equity. Indeed, it is seen
that in this example corresponding to a normal economy, the rate of return on equity is
equal to our assumed 10% interest rate, regardless of the leverage employed, moreover,
the larger the leverage, the stronger the positive leverage effect. In the above example,
when the rate of return on the investment is 125%, the rate of return on equity increases
to 16.67% with 25% leverage and to 20% with 50% leverage. Beyond 50% leverage the
rate of return on equity increases even more.
During a recession, the opposite holds good. The rate of return on equity declines from
8% with no leverage, to 7.33% with 25% leverage, and to 6% with 50% leverage.
Leverage is commonly called a double-edged sword, in the sense that it can help, but
it can also harm. The larger a firms leverage, the larger its potential profit or loss.
NOI
Probability
Zero leverage:
Equity
Debt
Rate of return on investment
25% debt:
Equity
Debt
Interest (at 10%)
Net income
50% debt:
Equity
Debt
Interest (at 10%)
Recession
Rs.80
1/3
Normal
Rs.100
1/3
Expansion
Rs.150
1/3
Rs.1,000
0
8%
Rs.1,000
0
10%
Rs.1,000
0
15%
Rs.750
250
25
55
7.33%
Rs.750
250
25
75
10%
Rs.750
250
25
125
16.67%
Rs.500
500
50
Rs.500
500
50
Rs.500
500
50
11
Recession
Net income
30
Normal
50
Expansion
100
6%
10%
20%
Per-Share Data*
Unlevered firm
Number of shares
EPS: Distribution: U
100
100
100
Rs.0.80
Rs.1.00
Rs.1.50
50
50
50
Rs.0.60
Rs.1.00
Rs.2.00
Levered firm with 50% debt

Number of shares
EPS: Distribution: L
Table 4: Economic Scenario

The way how leverage affects earnings per share can be viewed similar to how it affects
the rate of return on equity. The only differences are that EPS is measured in rupee
terms, rather than in percentages, and that its magnitude depends on the number of
shares issued. However, changes in the number of shares do not affect the percentage
rate of return on equity, and therefore percentage rates are more meaningful in financial
leverage analysis. Nevertheless, firms use the EPS in their financial statements, and the
financial media uses EPS as a convenient benchmark for probability.
LEVERAGE AND EARNINGS PER SHARE: BREAK EVEN ANALYSIS
Suppose an all-equity firm (which has already decided on the projects it is going to
undertake) issues n shares and the firms value is denoted as V. Because it has already
determined capital expenditure, if the firm decides to employ leverage by issuing debt,
denoted as B, it should issue less equity. Otherwise, it will have more cash than it needs
for its capital expenditure. As it is assumed that leverage has no effect on the stock
price, a levered firms number of shares should be reduced to n (E/V), where E/V is the
proportion of equity when leverage is applied.
The EPS of an unlevered firm (EPSU) is
EPSU =
NOI
n
The EPS of the levered firm (EPSL) is

EPSL =
NOI rB NOI rB
=
N1
n(E/V)
This can be rewritten as:

EPSL =
NOI
rB
n
n(E/V)
EPSL = a + b NOI
Where,
a=
12
rB
V
and b =
nE
n(E/V)
(1)
Capital Structure
A linear relationship exists between the EPS of the levered firm (EPSL) and its NOI.
The break even point condition can be written as:
EPSL =
NOI rB NOI
=
=EPSU
n(E/V)
n
Multiplying by nE/V, we get

NOI rB = NOI (E/V)
or
NOI [1 (E/V)] = rB
This can be written as:
V E
NOI
= rB
V
However, V E = B.
Therefore, NOI x B = rVB
Dividing by B, we find that the BEP is the point where NOI = rV.
Thus,
EP: NOI = rV
(2)
The above analysis states that if the firms percentage earnings, as measured by NOI/V,
exactly equal the interest paid on its bonds, then no matter how much leverage the firm
employs, the EPS will be unaffected. That is why all lines cross at the same point,
regardless of the proportion of the leverage employed.
It is to be noted here that taxes do not affect equation (2) because the break even point is
given by the NOI, which solves the equation:
EPSL =
(1 T)(NOI rB) (1 T)NOI

=
= EPSU
n(E / V)
n
and (1 T) cancels out, yielding the same break even point as with the no-tax case, thus
leverage will always increase its earnings per share. However, the firm will not always
know when NOI is above the break even point, and management can only speculate as
to the likely distribution of its NOI.
5.4 CAPITAL MARKET EQUILIBRIUM APPROACH

A capital market equilibrium approach is used to identify and isolate factors other than
leverage, which affect the valuation of the firm. The theories of capital structure are
based on the following premises:
i.
There are no corporate or personal taxes. Thus the impact of tax shields
associated with debt is abstracted.
ii.
There are no bankruptcy costs. The assets of a bankrupt company can be sold at
their economic value without incurring any liquidating and legal expenses. This
eliminates any bias in favor of an unlevered firm due to existence of bankruptcy
costs.
13
iii.
The firm is allowed to issue and repurchase any amount of debt or equity. These
transactions can be executed instantaneously without any time lag. The securities
are infinitely divisible.
iv.
The composition of the capital structure can be changed without any transaction
costs like issue expenses and underpricing.
v.
The firm consistently follows the policy of 100% dividend pay-out. Thus the
possible impact of dividend policy on the valuation of the firm is eliminated.
vi.
All the investors in the market have homogenous expectations of the expected
future earnings of all the firms. The expected value of the subjective probability
distributions of the anticipated future earnings (operating income) is identical to
all investors.
vii.
The operating earnings of the firm is expected to remain constant for all future
periods. Hence there is neither any growth nor decline in the expected future
earnings.
Given the above assumptions, the cost of each component of the capital structure can be
computed as follows:
kd =
1
B
Where,
kd
is the cost of debt;
is the annual interest expense; and
is the market value of the outstanding debt.
ke =
E
S
where,
ke
is the cost of equity;
is the earnings available for distribution to equity shareholders of

the firm; and
is the market value of the outstanding debt.
The overall capitalization rate of the firm is its weighted average cost of capital. It can
be obtained by multiplying the cost of each component in the capital structure by its
respective weight.
ko = kd
B
S
+ ke
B+S
B+S
Where, k0 is the weighted average cost of capital.

14
Capital Structure
5.5 THEORIES OF CAPITAL STRUCTURE

The theory of capital structure analyzes the impact of the financing mix on the valuation
of the firm. The theory also attempts to discover whether there exists an optimal capital
structure for a firm. This is one of the most controversial topics in the theory of finance.
There are broadly two schools of thought. One school believes that the composition of
the financing mix does not affect the cost of capital. This school does not believe in the
existence of an optimal capital structure. Hence, the capital structure has no relevance in
the valuation of the firm. The proponents of the other school believe that the cost of
capital is determined by the composition of the capital structure. The application of
leverage results in a change in the cost of capital. They try to determine the optimal
capital structure, at which level the overall cost of capital is minimal. They conclude
that it is the capital structure which determines the valuation of the firm.
NET INCOME APPROACH

This approach postulates that the cost of debt and equity of a firm remains constant.
Hence, the overall capitalization rate can be changed by varying the financing mix in
the capital structure. Hence, the valuation of the firm is a function of its capital
structure. The valuation of the firm can be increased by the application of leverage,
provided the cost of equity is greater than the cost of debt.
The same is graphically represented as follows:
Figure 1: Net Income Approach

It can be observed from the figure 1 that as the leverage increases, the cost of capital
(ko) declines because of the substitution of high cost equity with low low cost debt.
Illustration 2
There are three firms Alpha, Beta and Gamma which are identical in all respects, except
for their capital structure.
Particulars
Operating Income
Interest Expenses
Net Income
Cost of Equity (ke)
Cost of Debt (kd)
Market Value of Equity
Market Value of Debt
Market Value of the Firm
Cost of Capital (ko)
Alpha
100
0
100
10%
Beta
100
25
75
10%
Gamma
100
50
50
10%
-NA-
5%
5%
1,000
1,000
10%
750
500
1,250
8%
500
1,000
1,500
6.67%
15
It can be seen from the above illustration that the cost of capital is highest for Alpha
and correspondingly its valuation is the lowest. Beta employs moderate amount of
leverage and is thus able to reduce its cost of capital. Gamma employs high level of
leverage and consequently its cost of capital is the lowest. Hence, it has the highest
market valuation.
NET OPERATING INCOME APPROACH
This theory is built on the premise that a firm is valued by capitalizing its net operating
income at an appropriate discount rate. The value of the firm remains constant
irrespective of its degree of leverage. The market value of the equity is obtained by
deducting the market value of the debt from the total value of the firm. The break up of
the firms value between the value of debt and equity is a matter of distribution. It has
no impact on the firm valuation.
The theory assumes that each firm has a predetermined capitalization rate. The cost of
debt is also constant at all levels of leverage. In case a firm increases the leverage by
employing more debt, it becomes more riskier. The advantage of using cheaper debt
financing will be offset by higher cost of equity due to its increased riskiness.
Ke
Cost(%)
Ko
Kd
Leverage
Figure 2: Net Operating Income Approach

It can be observed from figure 2 that the cost of capital (ko) remains constant,
irrespective of the level of leverage.
Illustration 3
There are three firms Delta, Sigma and Omega which are identical in all respects, except
for their capital structure.
It can be seen from illustration 2 that all the three firms generate identical operating
incomes and share the same capitalization rate (10%). Hence, the market value of all the
firms is the same. Delta being an all equity firm, the cost of equity is equal to the cost of
capital. As Sigma employs debt in its capital structure, it is more riskier than Alpha.
Hence, the shareholders of Sigma require a higher return on 15%. Omega has very high
reliance on debt which constitutes 80% of its total capital employed. Consequently, the
cost of equity for Omega is much higher at 30%.
16
Capital Structure
Particulars
Delta
Sigma
Omega
Operating Income
200
200
200
Interest Expenses
50
80
Net Income
200
150
120
Cost of Capital (ko)
10%
10%
10%
NA
5%
5%
2000
2000
2000
Cost of Debt (kd)

Market Value of the Firm
Market Value of Debt
1000
1600
Market Value of Equity
2000
1000
400
Cost of Equity (ke)
10%
15%
30%
TRADITIONAL APPROACH
The traditional approach contends that there is an optimal capital structure for every
firm. The firm can attain optimality in capital structure through judicious use of
leverage. The theory postulates that the cost of debt (kd) remains constant up to a certain
degree of leverage and rises gradually thereafter. The cost of equity (ke) rises at a slow
pace up to a certain degree of leverage and increases rapidly thereafter. The cost of
capital (ko) initially declines due to moderate application of leverage. After a certain
degree of leverage, the increase in the cost of equity is more than the benefits obtained
due to cheaper debt. At this point the cost of capital begins to rise. The rise in cost of
capital becomes much more sharper, once the cost of debt begins to rise.
Figure 3: Traditional Approach

It can be observed from figure 3 that at X, ko is the lowest. Hence, the leverage level at
X is the optimal capital structure.
The theory explains that the cost of capital is dependent on the capital structure of the
firm. The optimal capital structure is the one which minimizes the cost of capital. The
main drawback of this theory is that it is not precisely quantifiable unlike the net income
approach.
5.6 MODIGLIANI AND MILLER (M&M)

17
Modigliani and Miller hypothesis claims that in a perfect market, capital structure does
not matter and is irrelevant. Let us once again review the figures presented in table 4. In
this illustration the rate of return on equity for an all-equity firm is 8%, 10% and 15%,
each with a probability of 1/3. As before, let us assume that the all-equity firm issues
100 shares at Rs.10 per share. Therefore, the EPS will be Rs.0.8, Rs.1, and Rs.1.50 with
an equal probability of 1/3. The stock price, by assumption, is Rs.10. Now suppose a
similar firm (with the same NOI) issues 50 shares at Rs.10 a share and then
complements the investment by issuing Rs.500 debt. With this 50% leverage, the rates
of return on equity will be 6%, 10%, and 20%, respectively. In this case the EPS will be
Re.0.60, Re.1, or Rs.2 respectively.
M&M theory claims that in a perfect market the stock prices of any two similar firms,
one levered and the other unlevered, will be equal. If differences in prices are observed
in the market, arbitragers will restore the equilibrium.
MM PROPOSITION I
The value of the levered firm, VL, must be equal to the value of the unlevered firm, VU.
The firms market value and average cost of capital are completely independent of the
capital structure that the firm chooses. That is,
VL = VU
Where,
VU is the value of an unlevered or all equity firm, and
VL is the value of a levered firm (a firm which has some debt in its capital
structure).
Proof: Without loss of generality, we first make the following simplifying assumptions.
The levered firm is financed with two types of securities, stocks or equity (EL),
and bonds or debt (DL).
Earnings before interest is X per year in perpetuity for both firms, where, X is
random.
The bonds of the levered firm are risk less and perpetual. That is
DL = C/rd where, C is the coupon payment, and rd is the bondholders required
return. Note that this also implies that C = DLrd
Individuals can borrow at the same rate of interest as the firm.
Under these conditions the value of the levered firm can be written as:
VL
= EL + DL
=
XC
reL
C X
=
rd roL
Where, is the average cost of capital of the levered firm and is given by:
18
Capital Structure
roL = reL
EL
VL
+ rd
DL
VL
Of course, for an unlevered firm

VL = EL and = roU = reU
Where,
roU = Average cost of capital for as unlevered firm.

Consider two firms that are identical in all respects except capital structure. Firm U has
no debt in its capital structure, while Firm L has some debt. Since, the two firms are
identical in all respects, their earnings before interest payments are equal, that is,
XU = XL = X
MM Proposition I (without tax) can be stated as VL = VU. To prove that this is the case,
we will assume this is not the case, and show that costless arbitrage profits can be
earned. If the market does not have costless arbitrage opportunities, then MM
Proposition I must hold.
To begin, suppose we observed that VL < VU in the marketplace. To profit from such an
opportunity, buy a proportion of the levered firms stock, buy a proportion of the
levered firms bonds, and sell a proportion of the unlevered firms stock. The portfolio
transactions are:
Position
Buy a of levered firms stock
Buy a of levered firms bonds
Sell a of unlevered firms stock
Total
Time 0
a E L
a D L
aV U
A (V U V L)
Time 1
a (X L C)
a C
a X L
0
Note that the portfolio is certain to have a terminal income of zero and yet the initial
value is positive. This implies a costless arbitrage profit of VU VL may be earned. If
such an opportunity arose, arbitrage activity would begin, driving the levered firms
share price up and the unlevered firms share price down until the market realized an
equilibrium where VL = VU.
To complete the proof, we need to consider the case where VL > VU. If such an
opportunity appeared, investors would consider forming a portfolio just the opposite of
that described above. They would borrow an amount of money, a DL, sell a proportion
of the levered firms shares, and buy a proportion of the unlevered firms shares. The
arbitrage transactions are:
Position
Time 0
Time 1
Sell a of levered firms stock
aEL
a Ca
Sell a of levered firms bonds
aDL
(X L C)
Buy a of unlevered firms stock
aV
aXL
Total
a (V L V U)
19
Again, an arbitrage profit can be earned. The price of the levered firms stock would fall
and the price of the unlevered firms stock would rise as a result of the arbitrage
activity. Market equilibrium would occur where VL = VU.
Let us now suppose two such firms are in the market. Stockholders will face both
probability distributions of EPS denoted by U (unlevered), and L (levered). Let us take
the extreme case and assume all investors prefer the levered firms probability
distribution. Will that firms stock price be higher than the unlevered firms stock price?
The issue is whether investors will be willing to pay more than Rs.10 for a share of the
levered firm. M&M theory claims that the stock prices of the two firms will be
identical. Otherwise, an arbitrage profit would exist and the market would not be in
equilibrium.
If the unlevered firms stock price is Rs.10, it is impossible to have a higher price for
the levered firms stock. This is simply because, according to M&M, no rational
investor will pay more for the levered firms stock than for the unlevered firms stock.
Even if investors do prefer probability distribution L to U, a price differential cannot be
maintained in the long run. The reason that can be attributed to this is that investors can
create their own leverage by selling the levered firms stock and taking out a loan to buy
the unlevered firms stock. For the sake of simplicity, let us assume that the unlevered
firms stock price remains Rs.10. If the levered firms price is higher, say Rs.11, M&M
recommend that investors sell the levered firms expensive stock for Rs.11 and
borrow Rs.10 at 10% (the interest rate in our example). They then will have Rs.21 to
invest. Putting aside Re.1 (the certain profit from the transaction), investors can then
buy two shares of the unlevered firm at Rs.10 each. The cash flows from this transaction
are shown on the right-hand column of the table. For example, if the unlevered firms
EPS is Rs.0.80, then investors will earn Rs.1.60 when they buy two shares of the
unlevered firm. However, since they must pay 10% interest on the Rs.10 borrowed,
investors will be left with
(2 x Rs.0.80) (0.10 x Rs.10) = Rs.1.60 Rs.1 = Rs.0.60
This amount is exactly what investors would have earned with one share in the levered
firm. Table 5 shows that by adopting this borrowing strategy, investors replicate the
desired cash flow that they would receive by holding one share of the levered firm, and
gain Re.1 which they put aside.
This process will continue as long as the levered firms stock price is higher than that of
the unlevered firm. However, selling the levered firms stock will push its price down,
and profit from the transaction will decrease. If the levered firms share price drops to
Rs.10.50, selling will continue, and the transaction will yield a certain Rs.0.30.
This process will stop when the levered stock and unlevered stock prices are identical.
Thus, according to M&Ms argument, in equilibrium, the levered firms stock price
cannot be higher than the unlevered firms stock price.
20
Capital Structure
Earnings per Share (Rs.)

Economic
Scenario
Unlevered
Firm
Probability
Cash Flows from

Arbitrage Transaction
Levered Firm
Recession
1/3
0.80
0.60
(2 x Rs.0.80)
(0.10 x Rs.10) = 0.60
Normal
1/3
1.00
1.00
(2 x Rs.1.00)
(0.10 x Rs.10) = 1.00
Expansion
1/3
1.50
2.00
(2 x Rs.1.50)
(0.10 x Rs.10) = 2.00
Stock price
Rs.10
Rs.11: Is it possible?
(2 x Rs.0.80)
(0.10 x Rs.10) = 0.60
Figures taken from Table 4

50% leverage is assumed.
Table 5: Earnings Per Share on Levered and Unlevered Firms

While earning a certain profit an arbitrage transaction allows investors to switch from
one investment to another without changing the distribution of returns. When investors
sell the levered firms stock and buy the unlevered stock with borrowing, they replace
the firms borrowing with their personal borrowing. This procedure is home-made
leverage. In M&Ms arguments home-made leverage is assumed to a perfect substitute
for the firms leverage. If so, the firms leverage has no effect on the stock price, and
capital structure is irrelevant. The reason is: Even if all the investors prefer the levered
firms distribution of rates of return, they will not pay a premium because they can use
home-made leverage and achieve the desired distribution.
This arbitrage process conforms to the law of one price. Because the two distributions
corresponding to the levered firm and arbitrage transaction given on the two columns of
Table 5 are identical, the net investment on each must be identical Rs.10 per share. To
see this, recall the net investment in the levered firm is Rs.10. The net investment in the
unlevered firm is 2PU Rs.10, which is the price investors pay for two shares of the
unlevered firm (2PU) less the Rs.10 loan. By the law of one price we must have, in
equilibrium, an equal price for assets that yield identical returns. We, therefore, have
2PU Rs.10 = Rs.10; hence PU = Rs.10
So far we have seen that the return on the levered firms stock can be replicated by
investing in the unlevered firm plus borrowing. No one will pay a higher price for the
levered firm and, therefore, the price cannot exceed Rs.10. But what about the opposite
situation? If all investors prefer the unlevered firms return over that of the levered firm,
will
they
be
willing
to
pay
more
for
the
unlevered
firms
stock?
If the price of the levered firms share is Rs.10, is it possible for the unlevered firms
price to be higher, say Rs.11? This would constitute paying a premium to the firm
without leverage, or penalizing the firm with leverage.
Such a scenario can easily be shown as impossible. If the levered firms price is Rs.10
per share and the unlevered firms price is higher, say Rs.11, investors can conduct an
21
arbitrage transaction, obtain the same distribution as before the arbitrage, and make a
certain profit. To see this, suppose you hold two shares in the unlevered firm. Your
return will be:
2 x Rs.0.80 = Rs.1.60; 2 x Rs.1 = Rs.2; or 2 x Rs.1.50 = Rs.3
with a probability of 1/3 for each possible outcome, (Table 5). Your investment is Rs.22
(Rs.11 x 2 = Rs.22) because, by assumption, you hold two shares and the unlevered
firms stock price is Rs.11 per share. M&M would suggest that you conduct the
following transaction: Sell your two shares to receive Rs.22; put aside Rs.2; and with
the remaining Rs.20, buy one share of the levered firm and invest Rs.10 in riskless
bonds. The return on this transaction will be as follows:
Return on the
Return on the Bond
Total Return on a
Stock
Portfolio of Stocks and Bonds
Rs.0.60
0.10 x Rs.10
Rs.1.60 with a probability of 1/3
Rs.1.00
0.10 x Rs.10
Rs.2.00
0.10 x Rs.10
In this way, one not only replicates the distribution of income that he had before the
arbitrage transaction, but also saves Rs.2.
This kind of arbitrage transaction is very attractive. Indeed, all investors offered this
opportunity would sell the unlevered firms stock, and its price would drop until it
equaled the levered firms stock price. By selling the unlevered firms stock, buying the
levered firms stock, and lending at 10% (investing in a risk less bond), investors could
undo the leverage because the bond they hold cancels the leverage effect of the
levered firms stock. Using this argument, M&M claim that a firm cannot increase its
value by changing its leverage; that is, capital structure is irrelevant. In equilibrium two
firms identical in all respects, except their capital structure, will have the same value.
VL = VU
. (3)
The firms goal is to select the capital structure that maximizes its value. Irrelevance of
capital structure implies that one capital structure is as good as another and that the
firms value will be the same, regardless of the selected capital structure. This argument
has been based on a number of assumptions some explicit and some implicit that
M&M made in devising the arbitrage transaction. Let us review these to be sure that we
understand the foundation on which the conclusion rests.
First, M&M assumes the two firms are identical, except for their capital structures. In
particular, their NOI distributions are identical. This assumption is not crucial, and
M&Ms argument is valid even if the assumption is relaxed.
22
Capital Structure
However, M&M did make the following crucial assumptions characterizing a perfect
market:
Only one interest rate exists at which both individuals and firms can borrow and lend.
The traditional approach to capital structure claims that using leverage increases the
firms value. To refute this claim, M&M needs to assume that individual investors and
firms can borrow at the same interest rate. Home-made leverage serves as a perfect
substitute for the firms leverage; that is, if investors like leverage, they can borrow
themselves. For this reason leverage does not increase the firms value. Without the
ability for firms and individuals to borrow and lend at the same rate, the whole
argument collapses.
No transaction costs exist. Investors pay no commission when they conduct an arbitrage
transaction.
No taxes are assessed or paid. All earnings are tax-free.
The possibility of bankruptcy does not exist. Because they borrow at the risk less
interest rate, firms and individuals cannot claim bankruptcy. (Otherwise, the higher the
risk of bankruptcy, the higher the interest rate.)
Assumptions 1, 2 and 3 are explicit in the arbitrage transaction, whereas assumption 4 is
implicit. In the arbitrage transaction we use the risk less interest rate on borrowing,
which implies no risk of bankruptcy. Finally, M&M does not assume that investors
either like or dislike leverage. Actually, M&M provides no information on investor
preference. They claim that investors will not pay a premium for a firms leverage
because those investors can create leverage by borrowing on their personal account.
Similarly, investors will not pay a premium on unlevered firms when they can buy the
levered firms stock and undo the leverage by buying bonds.
Self-Assessment Questions 1
a.
Define Financial Leverage.

..
..
..
b.
What are the assumptions underlined in theories of capital structure?

..
..
..
c.
What is the essence of traditional approach?

..
..
..
23
DO MODIGLIANI AND MILLER IGNORE RISK?

According to M&M, the capital structure a firm selects has no effect on its value. One
might then be made to conclude that leverage has no effect on the distribution of rates of
return to stockholders. This is not the case. Actually, VL = VU implies that an increase in
leverage has the following effects:
The cost of equity (expected rate of return) increases.
Stockholders risk exposure increases.
The Weighted-Average Cost of Capital (WACC) remains unchanged.
M&M do not ignore risk. On the contrary, they recognize that leverage increases
stockholders risk and that the cost of equity must increase to compensate for that
additional risk. Moreover, they can determine the exact increase of risk and the cost of
equity with an increase in leverage.
5.7 MERTON MILLER HYPOTHESIS

Prof. Merton Miller holds the position that the capital structure decision is irrelevant
even in the presence of corporate and personal taxes. The changes in the capital
structure have no impact on the valuation of the firm. This stand is in sharp
contradiction to the article Corporate Income Taxes and the Cost of Capital: A
Correction jointly authored by Modigliani and Miller wherein they agreed that debt
enjoyed substantial tax advantage. According to him, the effect of corporate taxes and
personal taxes tend to get canceled out and the MM hypothesis continues to be valid
even in the existence of taxes. This position implies an assumption that income on
equity is tax-free i.e., ps = 0. Further the corporate tax rate is equal to the personal tax
rate on interest income i.e., pd = c. Thus the post-tax income to the investors will
remain the same.
Miller explains that different investors have different rates of personal income tax.
The investors who are in tax exempt would prefer to invest in debt, while investors in
higher tax brackets prefer equity investments. Miller argues that when the market is in a
state of disequilibrium, companies will alter their capital structures to align with the tax
incidence on the investors. As companies increase the quantum of debt in their capital
structure, the supply of debt in the market increases. This will exhaust the capacity of
tax exempt clientele (investors) to absorb debt. The companies will then market their
debt to investors in the next tax bracket. This process will continue till the companies
cover the class of investor in the tax bracket equal to the corporate tax rate. The market
will reach its equilibrium when the personal tax rate of the investors is equal to the tax
rate on corporate income, at which point it is no longer possible for the company to
increase its valuation by altering its capital structure.
The Effect of Leverage on the Firms Cost of Equity
Stockholders expected rate of return on equity is the firms cost of equity. Let us now
see how capital structure irrelevance implies that the larger the leverage, the higher the
24
Capital Structure
cost of equity. To see this, let us denote the expected value of the firms Net Operating
Income by NOI . Without leverage, the rate of return on equity is RU = NOI/V , where,
U
NOI is uncertain. The cost of equity is the expected rate of return:
NOI
ku = R =
Vu
(The bar denotes expected value.) The rate of return on the levered firms equity is,
RL =
NOI rB
E
NOI VU rB
L L
Vu
E
E
It follows that the levered firms cost of equity is,

L
KL = R =
NOI rB
E
NOI V U
= U L
E
V
rB
L
E
Where, rB is the interest, and EL is the levered firms equity. The superscript L
distinguishes EL from the unlevered firms equity, E. However, if capital structure is
irrelevant, VU = VL and, by definition, VL = EL + B (the levered firms total value is the
sum of its equity and debt). Substituting EL + B for VU, one can rewrite the rate of return
on the levered firms equity as:
NOI E L + B rB NOI NOI B

R L = U
= U + U r L
E L E L
V
V
E
V
Using the definitions of RU and RL one can obtain equation (4), which gives the
relationship between rates of return on levered and unlevered firms shares:
R L = R U + (R U r)
B
EL
(4)
Taking expected values of both sides, one can obtain the relationship between levered
and unlevered firms cost of equity:
k L = k U + (k U r)
B
EL
(5)
Or, in words:
Expected rate of
Expected rate of Positive premium that
return on the
return on the + increases with
levered firms equity unlevered firms equity leverage, B/EL

From equation (4) we see that the realized leverage effect may be positive or negative in
a given year. In a good year, RU > r, and the leverage effect is positive. In a recession
when RU < r, the leverage effect is negative because RL < RU. However, equation (5)
shows that the cost of equity increases with leverage when kU > r, otherwise, the firm
does not receive a risk premium for its business risk.
25
Let us return to the numerical example of Table 4 and investigate the effect of leverage
on the rate of return and cost of equity.
First, it is to be noted that in a recession (NOI = Rs.80), the rate of return on an
all-equity firm is 8% and the rate of return on a 50% levered firm is only 6%. Equation
(4) confirms this result:
RL = RU + (RU r)
B
EL
For a 50% leveraged firm, B/EL = 1, and we obtain RL = 8% + (8% 10%) x 1 = 6% as

before.
The unlevered firms cost of equity (or expected rate of return) is
kU =
1
1
8% + 15% = 11%
3
3
For a 50% levered firm it is

kL =
1
1
1
6% + 10% + 20% = 12%
3
3
3
Equation (5) confirms this direct calculation since

kL = kU + (kU r)
B
=11% + (11% 10%) 1 = 12%
EL
Figure (4) illustrates the relationship among an unlevered firms cost of equity (11%),
the interest rate (10%), and a levered firms cost of equity. For example, take the point
L1, where, B/EL = 1. The levered firms cost of equity at this point is 12%. Now take the
point denoted by L2, where, B/EL = 3. At this point, the levered firms cost of equity will be
14% [11% + (11% 10%) x 3]. Thus, the higher the leverage, the higher the levered firms
cost of equity. Equation 5 is used to determine the straight line, UL that describes the
relationship between the expected rate of return with leverage and the debt/equity ratio.
UL
Figure 4: Cost of Equity and Leverage

26
Capital Structure
Technically, M&Ms results imply that the stockholders expected EPS and the discount
rate employed to evaluate this EPS increases at the same pace when leverage is
employed. The stock price, which is simply the discounted value of the future expected
cash flows, will be the same regardless of the firms capital structure.
To demonstrate this notion, let us first recall that the cost of equity increases from 11%
for the unlevered firm to 12% for a levered firm with 50% debt. The cost of equity used
to evaluate the stock increases by approximately 9.09% (12%/11% 1). Returning to the
figures presented in table 6.4, the unlevered and levered firms expected EPS are:
Unlevered firm:
EPS
= (Rs.0.80 x 1/3) + (Rs.1 x 1/3) + (Rs.1.50 x 1/3) = Rs.1.10
Levered firm with 50% debt:
EPS
= (Rs.0.60 x 1/3) + (Rs.1 x 1/3) + (Rs.2 x 1/3) = Rs.1.20
The expected EPS also increases by approximately 9.09% (Rs.1.20)/(Rs.1.10 1)

= 0.0909 x 100 = 9.09%. Because the expected EPS and the cost of equity increase at
the same rate when leverage is employed, the firms capital structure does not affect
the stock price. Indeed, using the above results, we find that the stock price is as
follows:
PU =
EPS
kU
Rs.1.10
= Rs.10 per share
0.11

L
PL =
EPS
k
Rs.1.20
= Rs.10 per share
0.12
Therefore, the price is the same regardless of the capital structure, just as M&M
claimed.
5.8 THE EFFECT OF LEVERAGE ON THE STANDARD

DEVIATION OF RETURNS
Equation 4 can be rewritten as:
R L = R U 1 + L
E
EL + B
B
B
r L
r L = RU
L
E
E
E
Where,
Ru = rate of return on equity without leverage.
RL = rate of return on equity of a levered firm.
Since VL = Vu and EL + B = VL, we have
RL = RU
VU
EL
B
EL
27
Because rB/EL is constant, the variance is

2
VU
2L = L 2U
E
Where,
2U is the variance of returns on the unlevered firm.

The standard deviation is
L =
VU
E
(6)
Because VU/EL > 1, so that leverage increases the standard deviation of the rate of
return. Let us demonstrate equation 6 with the numerical data from table 4. The
variances of the rate of return for the unlevered and 50% levered firms are as follows:
Unlevered firm:
1
1
1
2U = (8% 11%) 2 + (10% 11%) 2 + (15% 11%) 2 = 8.67
3
3
3
Thus,
U = (8.67)1/ 2 = 5.89%
1
1
1
2L = (6% 12%)2 + (10% 12%) 2 + (20% 12%)2 34.67
3
3
3
Thus,
L =
VU
U = 2 2.94% = 5.88%
EL
Using equation 7 and VU/VL = 2 (by assumption), we obtain
L =
VL
U = 2 2.94% = 5.88%
EL
Figure 5 illustrates the distributions of the rates of return on a levered and an unlevered
firms equity. The figure shows that leverage increases both the expected rate of return
(the shift to the right in the distribution), and the dispersion of the rates of return (the
distribution of the levered firm is flatter than that of the unlevered firm).
Figure 5: Cost of Equity and Leverage
28
Capital Structure
THE EFFECT OF LEVERAGE ON BETA
Denoting the rates of return on unlevered and levered firms by RU and RL, an unlevered
firms beta is bU = Cov(RU, Rm)/ 2m . Similarly, a levered firms beta is
b L = Cov(R L , R m ) / m
2 . Using equation (4), we can rewrite the levered firms rate of
return as:
RL = RU
VU
E
B
EL
Therefore,
U VU rB
2
L , R m m
BL = Cov R
L
E
E
Since rB/EL is a constant, its covariance with Rm is zero, VU/EL is also a constant;
therefore, we get
BL =
VU
EL
Cov(R U , R m ) / m
Or
bL =
VU
EL
bU
(7)
Because VU = VL = EL + B it must be that VU > EL or VU/EL > 1. The levered firms beta
is larger than the unlevered firms beta; and the higher the leverage, the higher the beta.
Using the numerical example of Table 4 with bU assumed to equal 1 and with 50%
leverage, VU/EL = 2. Therefore, bL = 2 x 1 = 2.
LEVERAGE AND THE FIRMS WEIGHTED AVERAGE COST OF CAPITAL
As leverage increases, the proportions of debt and equity as sources of financing

change: Debt increases and equity decreases. An all-equity firms cost of capital is
greater than the risk less interest rate. Otherwise, the firm would fare better by investing
all its funds in the risk less asset. The difference, kU r, is compensation for business
risk. According to equation (6), kL > kU and therefore kL is also greater than r. We
conclude that equity is a more expensive source of financing than debt. Therefore, a
reasonable question is: What effect does leverage have on the firms weighted average
cost of capital? We shall see next that leverage does not affect the WACC. The reason,
simply stated, is: Although the cost of equity increases with leverage, the proportion of
this expensive source of financing decreases as leverage increases and the WACC
remains constant. We show this first in M&Ms framework and then in the CAPM
framework.
M&MS FRAMEWORK
The levered firms cost of equity is kL , whereas the unlevered firms cost of equity or
cost of capital is kU . By equation (5), we have
KL = kU+(kU r)
B
EL
Where, r denotes the cost of debt. The levered firms WACC is

WACC =
EL
V
kL +
BL
VL
r
29
Where, EL/VL and BL/VL are the weights of equity, and debt in the firms financing,
respectively.
Using equation (6), we have
EL + B
EL U
B B
EL
B
B
U
k + k U r L + L r = L k U L r + L r = k U
=k
L
L
V
E V
V
V
V
V
(Recall that EL + B = VL.) Thus, leverage has no effect on the levered firms WACC; it
remains equal to the unlevered firms cost of capital.
Using the numerical example of Table 4, we see that kL = 12%, kU = 11%. The WACC
is, therefore, 11% [0.5(12%) + 0.5(10%) = 11%]. The WACC is the same for levered
and unlevered firms, regardless of the degree of leverage.
CAPM FRAMEWORK
The levered firms cost of equity can be written as follows:
kL = r + R m r
VU
EL
bU
The levered firms WACC is

WACC =
EL
VL
kL +
B
VL
Substituting for kL, the WACC becomes
EL
VU U B
r
+
(R
b + L r
m r)
VL
EL
V
Rearranging, we get
WACC =
EL
VL
r+
B
VL
r+
VU
VL
r + R m bU
VU
VL
rb U
Also
VU = VL
We finally get WACC = r + (R m r) bU, which equals the unlevered firms cost of
equity. Therefore, WACC = kU.
In the CAPM framework, as in the M&M framework, the WACC equals the
all-equity firms cost of capital; this means that leverage does not affect the firms cost
of capital.
5.9 CAPITAL STRUCTURE IN THE IMPERFECT MARKET

Till now we have discussed that capital structure does not affect firm value in a perfect
capital market. However, optimal capital structure may vary as market conditions (such
as prevailing interest rates) change. Apart from this, firm-specific factors may determine
the optimal capital structure.
30
Capital Structure
An imperfect capital market has transaction costs, taxes, possible bankruptcy (which
involves bankruptcy costs and causes the interest rate to vary directly with risk), and
possible conflicts of interest among stockholders, bondholders, and management (giving
rise to agency costs). These factors are enough to destroy Modigliani and Millers
conclusion that capital structure does not matter. To determine its optimal capital
structure, a firm must consider taxes, bankruptcy costs, and agency costs.
Let us now use the arbitrage argument discussed in the earlier section in order to show
that whenever VL = VU, a financial transaction that guarantees a certain profit can be
made. Such transaction will continue to be available until in equilibrium
VL = VU. In practice, however, these transactions involve costs that reduce the profit
from arbitrage. This implies that VL should not be expected to equal VU in equilibrium,
but does not tell us what factors determine the best capital structure.
Another reason why the Modigliani-Miller arbitrage argument does not hold is that the
interest rate relevant for borrowing is typically greater than the one for lending. Your
local bank pays a lower interest rate on a savings account than it charges on a loan. The
two principal reasons why the rates differ between borrowing and lending are as
follows:
The bank operates as an intermediary; that is, it obtains money from savers and
channels it to borrowers. To make a profit on such deals, the bank must charge a
higher rate on the loans it makes than the rate it pays on savings accounts. If the
borrowing and lending rates were equal and ignoring expenses, the banks profit
would be zero.
Any lending institution, including a bank, must consider the possibility that the
borrower will go bankrupt. The higher the probability of bankruptcy, the higher
the interest rate the bank must charge to compensate for this risk.
If a firm and an individual have different bankruptcy risks, they will be able to
borrow at different interest rates; in most cases, a firm can borrow at a lower
interest rate than an individual can.
Relevance of Interest Rates to the Capital Structure Issue
As discussed in the earlier section, if VL > VU, a person could sell a levered firms
shares, buy an unlevered firms shares, and borrow on personal account to create homemade leverage. However, if a firm can borrow at, say, 8% while an individual can only
borrow at 10%, home-made leverage is not a perfect substitute for the firms leverage.
Therefore, VL can exceed VU in equilibrium.
Similarly, VU can exceed VL. It was earlier argued that an individual could sell
unlevered firms shares, buy levered firms shares, and lend money or buy bonds that
would undo the firms leverage. However, if the interest rate at which an individual can
lend money is lower than the rate at which the levered firm borrows money, the
individual may not be able to make an arbitrage profit; this is why it is possible that
VU > VL in equilibrium.
31
So, contrary to the assumptions made earlier, the interest rate can be different for
borrowing and for lending and can differ among borrowers to reflect different
bankruptcy risks.
For example, Barrons reported the following interest rates (August 4, 1997):
Instrument
Yield (%)
One-year Treasury bills
5.26
Midwest Savings Bank one-year CDs
6.10
Sears bonds
9.00
Prime rate
8.50
All four rates are for one year. If one loaned money to the US government by
purchasing a Treasury bill, he would have earned 5.26%. If one were a very good
customer, a bank would charge him 8.50% for a loan. The 3.24% difference between
borrowing and lending rates is one reason why the M&M arbitrage argument is not
valid for an imperfect market.
This discussion makes two suggestions:
Because borrowing and lending interest rates differ, no arbitrage transactions

may be available. So VL and VU may differ in equilibrium.
The borrowing interest rate increases with the risk of bankruptcy. (For example,
compare Barrons reported Sears rate with the US Treasurys rate.)
Capital structure does matter and is one of the most important issues confronting a
firms CFO. In practice the capital market is far from perfect: transaction costs exist,
taxes exist, and the interest rates for borrowing and lending are not identical. A firm can
generally borrow at a lower interest rate than an individual, and home-made leverage is
not a perfect substitute for the leverage that a firm can obtain. Bankruptcies occur and
are costly. In addition, professional managers, not owners, usually manage a firm, and
managers interests may run counter to those of the stockholders. Factors such as these
render the capital structure very relevant. We discuss below the major imperfections in
the capital market and how they affect the firms capital structure. We start with
corporate tax, which makes it cheaper for a firm to borrow relative to the individual
investor. Then we discuss bankruptcy costs and agency costs.
5.10 CORPORATE TAXES AND FIRM DISTRESS

The earlier discussions have assumed a tax-free world. Let us now consider the real
world in which governments levy taxes. This section discusses on how corporate taxes
affect the firms value and capital structure. M&Ms argument that capital structure is
irrelevant relies on the assumption that both a levered and an unlevered firm have the
same expected Net Operating Income (NOI). This may well be true on a pre-tax basis.
However, M&M show that a levered firm enjoys tax advantages because tax laws
permit it to deduct any interest paid as an expense for tax purposes. This tax advantage
increases the levered firms average cash flow. Capital structure, therefore, is relevant
because, other things being equal, the more leverage a firm employs, the higher the
firms value.
32
Capital Structure
To illustrate how corporate income tax affects the firms value, let us review the
example given in Table 6, which shows the after-tax incomes of a levered and an
unlevered firm. The NOI is assumed to be Rs.150, the interest rate is 10%, the
unlevered firm has Rs.1,000 equity, and the levered firm has Rs.500 debt and Rs.500
equity. The NOI produced by the total investment is the same for both the firms. From
Table 6, it is seen that bondholders and stockholders total income increases with
leverage.
Unlevered Firm
(Rs.)
NOI
Levered Firm
(Rs.)
150
Interest
150
50
150
100
Taxes (assumed rate = 40%)
60
40
Stockholders after-tax income
90
60
Bondholders after-tax income
50
90
110
Net income before tax
Total after-tax income of stockholders and bondholders
Table 6: After-Tax Income of a Levered and an Unlevered Firm (in Rupees)
Figure 6 illustrates the division of two hypothetical firms income among the
shareholders, bondholders, and the IRS (International Revenue Service).
Levered Firm
IRS
($40)
Stockholders
($60)
Unlevered Firm
IRS
($60)
Stockholders
($90)
Bondholders
($50)
Figure 6: Division of Hypothetical Firm
The interesting features of Table 6 and Figure 6 are:

With leverage, the tax liability is lower for the levered firm (Rs.40, as opposed to Rs.60
for the unlevered firm), and the tax saving is distributed to the shareholders. The levered
firms total cash flow to shareholders and bondholders is Rs.110, compared to only
Rs.90 for the all-equity firm. The Rs.20 difference represents the tax saving due to the
interest deduction.
Let us not think here that the levered firms shareholders fare worse because they
receive only Rs.60 rather than the Rs.90 that the unlevered firms shareholders receive.
In this example, the Rs.60 income is based on a much lower investment by the
33
stockholders because half of the levered firm is financed by debt. The reason the
unlevered firms stockholders fare better is that the IRS takes a smaller slice of their
income (i.e., the firms tax burden is reduced through leverage). Indeed, the rate of
return to stockholders is 9% (Rs.90/Rs.1,000 = 0.09 or 9%) for an unlevered firm and
12% (Rs.60/Rs.500 = 0.12 or 12%) for a levered firm.
5.11 THE INTEREST TAX SHIELD

The tax saving due to leverage is the interest tax shield. In the example given in Table 6,
the interest expense is Rs.50 (rB = 0.10 x Rs.500 = Rs.50). Since this is tax-deductible,
T percent (the average income tax rate) of this Rs.50 is saved. The tax saving, or the
interest tax shield, is given by
Interest tax shield = TrB
(8)
To analyze how leverage affects the firms value, let us first examine the unlevered
firms cash flows and then turn to the levered firms flows. For an unlevered firm the
after-tax cash flow will be
(1 T) x NOI
For a levered firm with the same capital investment, business risk, and NOI, the total
cash flow (to stockholders and bondholders) will be
(1 T) x (NOI rB) + rB = (1 T) x NOI + TrB
Here we are interested in studying how leverage affects the firms net income (i.e.,
bondholders and stockholders total net income combined). Therefore, the interest rB is
first deducted, which reduces the firms tax burden, and then is added back to show the
cash flow to bondholders.
In our example for the unlevered firm we obtain
(1 T) x (NOI rB) + rB
= (1 0.4) (Rs.150 Rs.50) + Rs.50

=
0.6 x Rs.100 + Rs.50 = Rs.110.
After-tax income increases by Rs.20 [TrB = 0.4(0.1) Rs.500 = Rs.20] due to leverage.
Thus, Rs.20 is the interest tax shield.
Let the appropriate discount rate for the uncertain cash flow, (1 T) x NOI, be denoted
by k. The value of the unlevered firm (assuming a perpetuity) will be
VU =
(1 T)NOI
,
k
Where,
NOI is the NOIs expected value.

The expected value of the levered firms cash flow has two components: (1 T) NOI,
and TrB. Since the first component is identical to that of the levered firm, by the law of
34
Capital Structure
one price, its value must be VU. Also, since the interest tax shield, TrB, is assumed to be
certain, it is discounted at the risk less interest rate, r, and therefore its PV is TB.
If the firms income is positive, it will enjoy the interest tax shield, TrB. If income is
negative, the firm pays no taxes but does not forfeit the benefits of the interest tax
shield. If the firm loses money in a given year, the IRS allows the firm to carry such
losses forward and backward. Thus, the firm obtains TrB with virtual certainty,
regardless of its taxable income in a given year.
The levered firms value will be VL,
VL = VU + TB
(9)
Value of levered firm = Value of unlevered firm + PV of the interest tax shield where
TB is the gain due to leverage.
Figure 7 illustrates the value of two firms with the same NOI as a function of debt level,
B. For zero debt both firms are unlevered and have the same value. As one firms debt
level increases, the gap between the two firms values grow. This gap represents the PV
of the levered firms interest tax shield. The higher the proportion of debt in the firms
capital structure, the larger the firms value. Other things being equal, extreme debt
financing would be recommended.
Value of the Firm (Rs.)
Value of Levered Firm = V
PV of Levered tax
shield
Leverage, B (Rs.)
Figure 7
Equation (9) implies that the more debt the firm employs, the greater its tax benefit and
the greater its value. Do managers really behave according to equation (9) and employ
extreme levels of debt? If not, why not? A small sample of firms shows they employ
various levels of long-term debt relative to their total assets:
Colgate-Palmolive
50%
Intel
4.1%
Coca-Cola
72.2%
Microsoft
0%
Interest Deductibility versus Costs of Financial Distress and Bankruptcy
The Traditional Trade-off Theory provides the following insight towards the
understanding of capital structure. According to this theory, as a firm increases debt
relative to equity in its capital structure, expected costs of future financial distress and
35
bankruptcy also rise, eventually enough to fully offset the benefit to the tax shield, at the
margin. At this point, firm value is maximized, and beyond this point firm value
actually falls.
Thus, the Traditional Trade-off Theory suggests:
For a given firm there exists a unique optimal capital structure that consists of a
finite level of leverage, and
The optimal amount of leverage varies across firms, for two reasons:
(i) corporate tax rates vary across firms, and (ii) the rate at which expected costs
of future financial distress and bankruptcy increase with leverage also varies
across firms.
A Closer Look at the Effects of Leverage on Equity Value Accounting only

for Interest Deductibility
Let us now see how a firms market-to-book equity ratio is affected. Suppose a new
firm, Fortunate Company, is being proposed that consists of assets that will be
purchased to pursue a project. The project is expected to generate earnings into
perpetuity. However, the project generates only ordinary earnings after taxes which are
to say that the firm, as a project, has an NPV of zero.
This firm does not appear to create value for the firms shareholders, so we would
question why it should be developed at all. However, Fortunate Companys developers
intend to partially finance the firm with perpetual debt, using interest deductibility to
create value for shareholders. If the firm employs the amount D of perpetual debt in its
capital structure, the value of the firm increases by cD and shareholders gain this
amount of cD as added value. In addition as leverage increases the amount of equity
that the firm employs simultaneously decreases. As a result, as leverage increases, an
ever-larger tax benefit of debt is concentrated on an ever-smaller equity base. Therefore,
the developers use leverage not only to take advantage of interest deductibility per se,
but also because it creates value for shareholders on an ever-more-concentrated basis as
leverage increases.
By this assumption, if Fortunate companies were financed entirely with equity, the
market value of the equity would be equal to the book value of its assets. Thus, the
firms market-to-book equity ratio would be 1.0. However, as the firm adds leverage,
the tax benefit of debt should increase this ratio. From this viewpoint, a particularly
revealing analysis involves charting the effect of interest deductibility on a firms
market-to-book equity ratio as a function of both c and leverage, where, as explained
above, the book value of a firms equity represents the value of the equity in the absence
of (or ignoring) the tax benefit of debt. (a) Use four alternative values of c 10, 20, 30,
and 40 percent, and (b) Calculate the firms market-to-book
equity ratio as a function
of the firms debt ratio for each value of c; the resulting chart is shown in figure 8.
36
Capital Structure
Figure 8: Market-to-Book Equity Ratio

Hypothetical Market-to-Book Equity Ratios as Functions of Corporate Tax
Rate and Leverage (D/V)
As expected, the firms market-to-book equity ratio increases with both c and leverage.
Also, for all tax rates the effect of leverage on the market-to-book equity ratio is highly
convex, increasing at a fairly slow rate at lower levels of leverage, and then accelerating
at more extreme leverage ratios. For the highest tax rate considered 40 percent, the
market-to-book equity ratio does not exceed 1.5 until leverage reaches a fairly high
level of 45 percent. However, the ratio then reaches 2.0 with a further small increase in
leverage to 55.5 percent, 3.0 as leverage increases to 62.5 percent, and 10.0 at a
leverage ratio of 69 percent.
a.
What are the costs involved in imperfect capital market?

..
..
..
b.
Write the effect of corporate taxes on capital structure.

..
..
..
5.12 BANKRUPTCY COSTS AND THE CAPITAL STRUCTURE

The various theories of capital structure have not addressed to the existence of
bankruptcy costs. In a perfect capital market, it is assumed that all the assets of a firm
can be sold at their economic value without incurring any liquidating expenses.
However, in real life situation, the liquidation costs like legal and administrative
expenses are significant. Further, the assets may have to be sold at a distress price which
is below its economic value. Thus, the net realizable value of the firm is less than the
economic value, which represents a dead weight loss to the system. The lenders will
assume the ex post bankruptcy costs, but they will pass on ex ante bankruptcy costs to
37
the firm in the form of higher cost of debt (kd). Ultimately the shareholders bear the
burden of ex ante bankruptcy costs and the consequent lower valuation of the firm.
A levered firm has greater possibility of bankruptcy than an unlevered firm. Hence the
bankruptcy cost for a levered firm is correspondingly higher. However, the bankruptcy
costs are not a linear function of the leverage. When a firm employs low levels of
leverage in its capital structure, the risk of bankruptcy is insignificant. Therefore, there
is no impact of bankruptcy costs on the valuation of the firm, till a threshold limit is
reached. However, after the threshold level of leverage, the threat of bankruptcy
becomes real. The probability of bankruptcy dramatically increases with further
application of leverage. The bankruptcy costs rise at an increasing rate beyond the
threshold level.
The same is graphically represented as under:
Figure 9: Bankruptcy Costs and Capital Structure
5.13 CIRCUMSTANCES THAT LEAD TO FINANCIAL

DISTRESS AND BANKRUPTCY
Let us now see those circumstances that lead a firm into financial distress and
bankruptcy. To illustrate, suppose Fortunate Company has established its business plan
and is about to purchase the assets required to execute the plan, which could be financed
by various means ranging from all-equity to high leverage. Through subsequent
operations over time, either (a) the business plan proves successful, in which case all
requisite payments of interest and principal (if any) are made on a timely basis, and
shareholders receive returns on their investment; or (b) the business plan proves
unsuccessful, and cash outflow chronically exceeds cash inflow. Let us here primarily
focus on the latter case.
FINANCIAL DISTRESS
Clearly, if Fortunate Company is experiencing chronic net cash outflow it cannot

continue in that state forever. At some point, the firm will face financial distress, a
situation in which available cash is insufficient to pay suppliers, employees, and, if the
firm has debt, creditors, signs of first-stage financial distress including negative net cash
flow and earnings, and this results in a falling market equity value. If the haemorrhaging
continues, management must take action to rectify the situation. Signs of second-stage
financial distress include managements attempts to reduce costs, such as employee
layoffs and temporary plant closings.
38
Capital Structure
If the situation persists, the firm enters third-stage financial distress, characterized by
late payments to suppliers, employees, and creditors, and possibly more drastic actions
such as (a) issuing a new debt or equity securities, if indeed this would be possible, (b)
selling assets, (c) merging with a more successful firm in the industry, or (d) negotiating
with creditors to reschedule debt payments. If none of these actions resolves the
problem, the firm will enter end-stage financial distress: bankruptcy.
The US Bankruptcy Code: Liquidation or Reorganization
The US bankruptcy code provides for two types of corporate filings; liquidation, which
is a filing under Chapter 7 of the bankruptcy code and reorganization, which is a filing
under Chapter 11 of the code.
Under Chapter 7, a trustee is appointed to oversee the liquidation of the firms assets
and the distribution of the proceeds to claimants. The trustee distributes proceeds in
strict order of priority:
i.
Claims for administrative expenses and expenses incurred in preserving and

collecting the estate.
ii.
Claims of trades and people who extended unsecured credit after an involuntary
case has begun but before a trustee is appointed.
iii.
Wages due to workers if earned within the 90 days preceding the earlier of either
the filing of the petition or the cessation of business. The amount of wages is
limited to Rs.4,000 per person.
iv.
Claims for unpaid contributions to employee benefit plans that were to have been
paid within 180 days prior to filing. However, these claims plus wages are not to
exceed the Rs.4,000 per employee limit.
v.
Unsecured claims for customer deposits, not to exceed Rs.1,800 per individual.
vi.
Taxes due to federal, state, and any other governmental agency.
vii.
Unfunded pension plan liabilities. These claims are superior to those of general
creditors for an amount up to 30 percent of the common and preferred equity;
any remaining unfounded pension claims rank with those of the general
creditors.
viii.
Claims of general or unsecured creditors.
ix.
Claims of preferred shareholders, who may receive an amount up to the par value
of the issue.
x.
Claims of common shareholders.
The second, and more commonly used, bankruptcy alternative is Chapter 11

reorganization. Here the firms assets, liabilities, and equity are restricted with the
objective of providing the business with a chance to survive. The firm must file a
reorganization plan within 120 days of receiving the courts order for relief. The plan
39
must address creditors claims within general classes. The reorganization plan is subject
to the approval of creditors and court confirmation, and all administrative expenses
must be paid. Though the process involves mandated deadlines, firms often request
extensions that result in years of litigation.
COSTS OF FINANCIAL DISTRESS AND BANKRUPTCY
A firm incurs several dead weight costs when its financial position weakens, even if the
firm does not declare bankruptcy. These are called costs of financial distress.
Bankruptcy involves additional dead weight costs. When a firm considers adding debt
to its capital structure, both the borrowing firm and its creditors must be concerned that
the firm might incur such costs in the future.
As a general definition, any loss of value that can be attributed to a firms deteriorating
financial strength is a cost of financial distress. Such costs fall into any one of the three
categories: (a) loss of competitiveness in a product/service market, (b) concessions to
stakeholders to compensate them for the risk of doing business with a distressed firm,
and (c) loss of the value of the interest tax shield (as well as the value of depreciation as
a tax shield).
Perhaps the greatest cost of financial distress for a firm is a loss of competitiveness,
which may occur for several reasons. First, the firm may be forced to pass up valuable
projects because it lacks internal financing and has little or no access to the external
capital markets. Second, the distressed firm may be forced to sell valuable assets,
subsidiaries, or divisions to shore up its liquidity. Third, its competitors may push new
business. A distressed firm may also be forced to renegotiate contracts with its
suppliers, employees, customers, and creditors. Suppliers want prompt payment and
continuing business. They generally are willing to provide trade credit, but only to
financially secure buyers. In an industry with few suppliers, a distressed firm may be
forced to pay higher prices to its suppliers to compensate for risk, and may be denied
trade credit. Employees may demand greater wages or salaries to compensate for the
heightened risk that they will lose their jobs. If the distressed firm cannot comply, it
may lose many of its best employees, and thereby incur additional losses in terms of lost
workforce talent and experience.
A firms customers generally demand warranties and after-sales service, and their longterm availability is in question for a distressed firm. Therefore, buyers may either
demand compensation in the form of lower prices, or take their business elsewhere.
A distressed firm may also lose valuable relationships with its creditors. For instance, a
bank that has hither to provided a line of credit to the firm may rescind the line in the
face of the firms financial distress. Alternatively, the firm may be forced to accept
onerous terms in debt renegotiations.
Finally, a distressed firm also may lose the value of the interest deductibility on its debt.
The tax advantage of debt can be realized only if a company generates earnings (though
40
Capital Structure
the IRS allows limited tax-loss carry forwards). As earlier calculations suggest, the
value of the interest tax shield is large and increases with leverage. Symmetrically, the
opportunity cost of losing the usefulness of the interest tax shield is large and increases
with leverage.
Bankruptcy costs include legal, administrative, and accounting costs associated with the
bankruptcy process. Additional costs are associated with a subsequent private debt
workout, or with the liquidation of some or all of the firms assets, often at low sales
prices.
IMPLICATIONS OF FINANCIAL DISTRESS FOR A FIRMS VALUE AND
CAPITAL STRUCTURE
Let us here assume that the expected Cost of Future Financial Distress, denoted as
E (CFFD), is expressed as the product of the probability of Future Financial Distress,
Prob (FFD), times the cost of future financial distress, should it actually occur. It is
denoted as:
E (CFFD) = [Prob (FFD)] CFFD
The present value of the expected Costs of Future Financial Distress is denoted as PV
[E (CFFD)]. In turn, it can be expressed mathematically if we make the further
simplifying assumptions that financial distress, if it does occur, will occur in year T, and
that the appropriate discount rate to applied to E(CFFD) is rcfd. These assumptions yield
the following equation:
PV [E (CFFD)] =
E(CFFD)
. (10)
(1 + rcfd )T
Of course, a firm can experience financial distress even if the firm has no debt in its
capital structure. That is, even if the firm has no debt, it can experience chronic losses
that deplete its financial resources, eventually affecting relationships with suppliers,
customers, and employees, and ultimately its competitive position. However, PV [E
(CFFD)] is likely to increase with leverage for two reasons. First, debt obligates the
firm to make periodic fixed payments, which the firm may not be able to meet if it
experiences chronic losses. Second, referring to equation (8), the periodic payments
required on debt securities are an ongoing burden, which may shorten the amount of
time, T, until financial distress occurs.
To gauge the effect of leverage of PV [E (CFFD)] and thus the value of the firm we
must recognize that it is an incremental effect. That is, to the extent the
PV [E (CFFD)] increases with leverage, each marginal increase is attributable to the
amount of debt to the firms capital structure on PV [E (CFFD)]. And thus the value of
the
firm
is
the
accumulation
of
the
associated
marginal
increases
in
PV [E (CFFD)]. We denote that portion of the overall value of PV [E (CFFD)] that is

due to a specific amount of debt as PV [E (CFFD debt)].
41
With this specification, one can now provide an equation for the value of levered firm
that accounts for both the positive and negative effects of debt namely, the value of
the tax shield and the effect of leverage on the present value of expected future financial
distress:
VL = VU + cD PV [E (CFFD debt)]
According to the Traditional Trade-off Theory, for low levels of leverage the marginal
value of cD exceeds the marginal value of PV [E (CFFD debt)], and therefore firm
value increases with leverage. However, at high levels of leverage, marginal increases
in PV [E (CFFD debt)] are greater than c (which is the marginal value of the tax shield),
so firm value decreases with leverage. Consequently, the optimal or firm valuemaximizing amount of leverage is finite.
As we noted earlier, an additional implication of the Traditional Trade-off Theory is that
the optimal amount of leverage differs across firms, because firms differ in terms of the
tax rate and the rate of increase in PV [E (CFFD debt)] as leverage increases.
Personal Taxes and the Miller Equilibrium
Miller (1977) provided an alternative offsetting factor to explain why firms do not adopt
extremely high leverage ratios to take full advantage of interest deductibility. The
offsetting factor in Millers model is personal taxes. Miller argues that, although debt is
a tax-advanced security at the corporate level, it is a tax-disadvantaged security at the
personal level. Moreover, Millers model yields an equilibrium in terms of the aggregate
amount of corporate debt that should exist in the economy as a function of corporate
and personal tax rates. This equilibrium is called the Miller equilibrium.
Personal Tax Clienteles
Millers argument is based on the observation that investors differ with respect to the
tax rates that they face on ordinary income (such as dividends and interest) versus
capital gains. In particular, Miller assumes that most investors face a relatively high tax
rate on ordinary income, but low effective tax rate on capital gains. The effective tax
rate on capital gains is low for two reasons. First, though in some recent years realized
capital gains have been taxed at the same rate as ordinary income, currently, and for the
most part historically, the tax rate on realized capital gains has been lower than an
ordinary income. Second, capital gains are subject to taxation only upon their realization
that is, when an investor sells an asset such as a stock at a profit. Thus, an investor
who holds a purchased stock for a long time defers the realization of any gains on the
stock, and thereby lowers the effective tax rate on such gains. Historically, the bulk
(perhaps three-quarters) of an investors total return on a typical stock is from taxfavored capital gains, with the remainder accounted for by dividends that are taxed as
ordinary income. In contrast, historically the bulk of investors returns on corporate
bonds are from interest income, which is taxed as ordinary income. Therefore, at the
level of the individual investor who faces taxation, corporate equity may well be taxfavored relative to corporate debt.
42
Capital Structure
Of course, other individuals may face low effective tax rates on both ordinary income
and capital gains. We noted earlier that many investors hold their securities in taxsheltered vehicles such as a pension fund, a 401(k) plan, (as in the US) or an insurancecompany variable annuity. Other investors, such as non-profit institutions, face no taxes
on investment income or capital gains because they are tax exempt.
Let us see as to what are the implications of different personal tax rates among investors
for their preferences for corporate securities and a firms choice of debt versus equity
financing. At the level of the individual investor, one likely implication is that each
investor would rationally invest in those securities that, for that investor, provide the
highest (risk-adjusted) after-tax return, all other factors ignored. For instance, highincome investors may rationally tend to avoid high-dividend-paying stocks as well as
corporate bonds, purchasing instead non-dividend-paying stocks and tax-exempt
municipal bonds. On the other hand, depending on their need for current income, a taxexempt individual or non-profit institution would prefer high-yielding stocks or
corporate bonds. Consequently, a given corporate security may attract a particular
clientele of investors for whom that security carries a relative tax advantage.
Illustration 4
To illustrate the nation of tax clienteles, we provide a numerical example that uses the
following notation for various tax rates:
p = an investors personal tax rate on ordinary income from dividends or interest,

cg = an investors effective tax rate on realized capital gains, adjusted for deferral,
pe = an investors effective personal tax rate on the overall income from a given
equity investment, which depends on, and the issuing firms policy of providing
returns in the form of dividends versus capital gains, and
c = a firms corporate income tax rate.
Suppose Fortunate Company is considering three alternatives to finance a new capital

expenditure:
a.
Issue equity, and elect to pay an annual dividend that represents half of the
projects annual earnings;
b.
Issue equity, but do not pay dividends at all, in which case the investors entire
return would be in the form of capital gains; or
c.
Issued debt.
Regardless of the financing the project produces earnings before interest and taxes of
Rs.100 million annually. As such, the only two consequences of the choice are (a) the
exposure of the projects annual earnings to corporate taxes, and (b) the form of the
return to investors and the associated personal tax effects. Management examines the
preferences of each of four classes of investors for each alternative security.
43
Investor Class A: Non-profit Institutions. These investors are tax-exempt, so
p = 0, cg = 0, pe = 0.
Investor Class B: Retirement Fund Investors. For these investors, securities are placed
in a tax-deferred retirement account. They are subject to an effective ordinary income

tax rate of p = 40 percent on ordinary income. However, they are long-term investors,
so cg = 0. Thus, if they purchase the firms equity the effective value of the equity is
highly sensitive to the firms dividend policy.
Investor Class C: These investors are not eligible for tax-deferred investments. They
are subject to a tax rate of p = 40% on ordinary income. However, they are long-term
investors, so highly sensitive to the firms dividend policy.
Investor Class D: Wealthy Short-Term Investors. These investors are not eligible for
tax-deferred investments. These investors face a tax rate of p = 40 percent on ordinary

income; because they are short-term investors, cg = 40 percent as well, so pe = 40
percent regardless of the firms dividend policy.
5.14 AGENCY COSTS AND THE CAPITAL STRUCTURE

A significant amount of research during the last two decades has been devoted to
models in which capital structure is determined by agency costs, i.e. costs due to
conflict of interest.
Firstly, conflicts between shareholders and managers arise because managers are not
entitled to 100% of the residual claims. Consequently the managers do not capture the
entire gain from the profit enhancement activities, but they do bear the entire costs of
these activities. The managers may, therefore, put in less efforts in value enhancement
activities and may also try to maximize their private gains by lavish perquisites, plush
offices, empire building through sub-optimal investments, etc. While the managers
would have the entire costs of refraining from such inefficiencies, they are entitled to
only a fraction of the gains. These inefficiencies decrease with the increase in the
managers stake in the firm.
Secondly, conflicts also arise between the interests of debt holders and equity holders. If
an investment financed with debt yields high returns (higher than the cost of debt),
equity holders are entitled to the gains. On the other hand, if the investment fails, the
debt holders suffer the losses due to limited liability of the equity holders. As a result,
equity holders may benefit from investing in very risky projects even if they are value
decreasing. Such investments result in a decline in the value of debt. The loss in the
value of equity from poor investments can be more than offset by the gains in equity
value at the expense of the lenders. The lenders to the firm protect themselves against
expropriation by imposing certain conditions on the firm. These conditions are called
protective covenants and remain in force till the debt is repaid. These conditions may
relate to restrictions on further borrowings by the firm, cap on payment of dividends,
44
Capital Structure
managerial remuneration, sale of assets, limitations on new investment, etc. These

conditions may lead to sub-optimal operations resulting in inefficiencies. Further, the
lenders put in place strong monitoring and corrective mechanisms to enforce the debt
covenants. The monitoring and enforcement costs are passed on to the firms in the form
of higher cost of debt (kd). These costs together with the cost of inefficiencies (due to
the covenants) are called agency costs. As residual owners, the shareholders have an
incentive to ensure that agency costs are minimized. The existence of agency costs acts
as a disincentive to the issuance of debt. The agency cost may be virtually non-existent
at low levels of leverage. However, after the threshold point, the lenders start perceiving
the firm to be increasingly risky. This may result in a disproportionate increase in the
agency costs due to the need for extensive monitoring.
Figure 10: Agency Cost and Capital Structure

AGENCY COSTS
Another set of market imperfections that make the mix of debt and equity relevant to the
firms value is agency costs. Agency costs arise when the interests of stockholders
conflict with those of the bondholders or the managers. The agency costs are the
reduction in the value of the firm due to this conflict. These conflicts were assumed not
to exist in Modiglianis and Millers perfect market environment. Similar to the interest
tax shield, agency costs that are generated by these conflicts in interest cause a firms
capital structure to affect its total value.
Some agency costs are actually reduced by using debt, while others are magnified at
high debt levels. In contrast to corporate taxes, which strictly favor the increased use of
debt, different types of agency costs exert opposite influences on corporate capital
structures. Focusing on this factor only, the firms objective is to select a capital
structure that, other things being equal, minimizes total agency costs.
AGENCY COSTS THAT ENCOURAGE THE USE OF DEBT
The separation of ownership and control within publicly-held corporations causes

various conflicts of interest between the firms equity holders and managers. These
conflicts can be controlled through the effective application of debt claims in the capital
structure. In the following discussion, we show that agency costs may encourage the use
of debt.
45
Consumption of management perks occurs when managers use corporate resources to

acquire goods and services for their personal benefit. Examples of such goods and
services include excessive travel, plush offices, use of corporate jets, and luxury hotel
accommodations.
A 100% owner-manager has an incentive to use perquisites only when they create value
for the firm. In contrast, the manager of a large, publicly-held corporation typically
owns a small percentage of the common equity and has an incentive to engage in
excessive use of perquisites, because the personal utility these perks provide come
largely at other equity holders expense.
Suppose that repurchasing stock with borrowed funds moves the debt/equity ratio to 2.0
and increase the managers proportion of shares from 10% to 30%. Since every dollar of
perquisites consumed now costs the manager three times what it did before the capital
structure change, the manager has fewer tendencies to over indulge. Debt helps control
perquisite consumption by better aligning the interests of managers and equity holders.
A firm can also use debt to control its over investment problem. Over investment occurs
when managers reinvest excess cash flows in projects with negative net present values.
Motivations to over invest are driven by empire building ambitions or size-based
compensation arrangements. During the 1980s financial leverage was often used to
force unwieldy conglomerates to eliminate over investment by divesting unprofitable
lines of business and by cutting costs.
AGENCY COSTS THAT DISCOURAGE THE USE OF DEBT
The separation of ownership and control in publicly held corporations can also cause
conflicts of interest between stockholders and bondholders and among various types of
creditors. Some of these conflicts occur in the ordinary course of business; others are
present only when the firm is in financial distress. In the following discussion, we
explain the nature of these conflicts and show how the firm can augment its total value
by selecting the appropriate type and level of debt obligations.
Managers have a number of incentives to pursue growth-oriented strategic options. The
larger the organization, the greater the economic and political power of the top
management teams, and the greater the ability of the organization to marshal resources
necessary to deal effectively with its competitive and social environment. Also, larger
organizations are seen as being able to maintain their freedom from the discipline of the
capital markets. As a generalization, it can be said that growth does lead to increasing
the wealth of shareholders. However, the concern is that too many of the activities
associated with increasing the size of organizations are motivated not by a desire for
maximizing shareholder wealth, but by opportunities for the self-aggrandizement of
management.
The contractual device suggested by agency theory to accomplish the transfer of wealth
from the organization to the investors is debt creation. Debt provides a means of
bonding managers promises to pay out future cash flows. It also provides the means for
46
Capital Structure
controlling opportunistic behavior by reducing the cash flow available for discretionary
spending. Top managers attention is then clearly focused on those activities necessary
to ensure that debt payments are made. Companies failing to make interest and principal
payments can be declared insolvent and can be dissolved. This use of debt as a
disciplinary tool makes survival in the short-term the central issue for all concerned.
Agency theory also has important implications for the relationship between
stockholders and debt-holders. Stockholders are interested in the return over and above
that amount which is required to repay debt. Debt-holders are only interested in the debt
payment specified in the contract. Stockholders are seen as sometimes being interested
in pursuing riskier business activities than debt-holders would prefer. When this occurs
debt-holders may charge higher prices for debt capital and institute greater control
measures to prevent top managers from investing capital in riskier undertakings.
However, agency theory does not take into consideration competitive environments, nor
does it consider the necessity for managers to make choices beyond a stockholder
wealth-maximizing perspective. This would seem to be a serious omission for two
reasons. First, debt and equity represent different constituencies with their own
competing, and often mutually exclusive, goals. Second, as the level of debt increases,
the corporate governance structure can change from one of internal control to one of
external control. For firms that adopt debt as a control mechanism, lenders become the
key constituents in the corporate governance structure. This can have a significant
impact on both managerial discretion, and on the ability of an organization to deal
effectively with its competitive environment.
5.15 TRADE-OFF THEORY OF FINANCING

The principal benefit of debt financing is that it provides tax shelters which increase the
residual available for distribution to equity shareholders. However, the main drawback
associated with debt financing is the risk of bankruptcy. The increase in the levels of
leverage, while resulting in the availability of larger tax shields also involves a
correspondingly higher cost of financial distress. The firm attempts a trade-off between
the size of the tax shelter and the cost of financial distress.
The chances of financial distress is higher in case of start-ups and high growth ventures.
Such firms are exposed to the risk of erratic cash flow stream and the tangible asset base
is low. Hence, such firms should not place high reliance on debt in their capital
structure. On the other hand, firms with stable income stream and sound asset base face
lower risk of bankruptcy. Such firms can apply relatively higher levels of leverage in
their capital structure.
ASYMMETRIC INFORMATION AND CAPITAL STRUCTURE
This hypothesis is based on the premise that managers/insiders have private information
about the characteristics of the firms returns stream or investment opportunities. Hence,
capital structure is designed to mitigate inefficiencies caused due to such information
asymmetries.
Stewart Myers and Nicholas Majluf in their pioneering article Corporate Financing and
Investment Decisions When Firms have Information That Investors Do not Have
47
postulated that if investors are less informed than the firm insiders about the valuation
of the firm, the equity may be mispriced by the market. If firms are to finance new
projects by issuing equity, underpricing may be so severe that new investors capture more
than the NPV of the new project, resulting in a net loss to the existing shareholders. In this
case, the project is rejected even though its NPV is positive. The underinvestment problem
can be avoided if the firm can finance the investment by issuing securities that will have
lesser or nil undervaluation. For example, internal accruals do not have any element of
undervaluation and in case of debt the undervaluation will be less severe. Therefore,
firms use equity financing only as a last resort.
5.16 SIGNALING THROUGH CAPITAL STRUCTURE

Some theories postulate that changes in capital structure have information content about
the valuation of the firm. These theories explain that capital structure changes are
explicit signals about the firms valuation, sent intentionally by the management. An
increase in the debt content of the capital structure is generally taken as a signal of
undervaluation of the firm. As the increased level of leverage is accompanied by higher
risk of bankruptcy, the increased level of debt indicates the confidence of the
management in the future prospects of the firm. Hence, it carries greater conviction than
a mere announcement of undervaluation of the firm, by the management. On the other
hand, an issue of equity is a signal that the firm is overvalued. The market concludes
that the management has decided to offer equity because it is valued higher than its
intrinsic worth by the market. The markets normally react favorably to moderate
increases in leverage and negatively to fresh issue of equity.
EBIT-EPS ANALYSIS
This is an important tool to analyze the impact of alternative methods of financing on

the Earnings Per Share (EPS) of the firm. This tool captures the sensitivity of the EPS to
any changes in the Earnings Before Interest and Tax (EBIT). It gives an insight into the
risk-return trade-off that governs valuation.
The relation between EBIT and EPS is as follows:
EPS =
(EBIT I)(1 T)
n
Where,
I is the annual interest payment
T is the tax rate of the firm.

n is the number of shares.
The EBIT indifference point is the level at which the EPS of the firm is the same for
two different capital structures. The EBIT-EPS indifference point can be
mathematically represented as follows:
(EBIT I1 )(1 T) (EBIT I 2 )(1 T)

=
n1
n2
48
Capital Structure
Illustration 5
Particulars
Operating Income
II
3000
Interest Paid
Net Income
3000
400
3000
2600
Tax Paid @ 40%
1200
1040
Distributable Earnings
1800
1560
10000
6000
4000
Share Capital
Debt
No. of Shares Outstanding
1000
600
Earnings Per Share
1.80
2.60
To compute the indifference point:
(EBIT I1 )(1 T)
n1
(EBIT I 2 )(1 T)
n2
(EBIT 0)(1 0.4)

=
1000
(EBIT 400)(1 0.4)

600
0.6 EBIT
1000
0.6 EBIT 240

600
Solving the above equation, we can get the value of EBIT as 1000. It may be observed
that when the EBIT is 1000, the EPS is 0.6 under both the capital structure patterns.
The EBIT indifference point can be graphically represented as follows.
Figure 11: EBIT-EPS Indifference Chart
The EBIT-EPS analysis helps in understanding the impact on the earnings per share
under alternative methods of financing. In case of the indifference point being lower
than the expected level of EBIT, the use of debt financing is supported. The case for
equity financing is stronger if the indifference point is higher than the expected level of
EBIT. Further, assigning probabilities to various levels of EBIT would make the EBIT49
EPS analysis more rigorous. If the probability of the EBIT being lower than the
indifference point is insignificant, there is a stronger case for applying leverage. On the
other hand, if the probability of the EBIT being lower than the indifference point is
high, use of debt financing becomes riskier.
Thus financial leverage magnifies the underlying business risk of the firm on the
earnings per share.
ROI-ROE ANALYSIS
The relationship between the Return on Investment (total capital employed), and the
return on equity (net worth) at different levels of financial leverage needs to be
analyzed.
The relation between ROI and ROE is as follows:

ROE = {ROI + (ROI kd) D/E} (I t).
Where,
ROE is the return on equity
ROI is the return on investment
kd
is the cost of debt (pre-tax)
is the debt component in the total capital
is the equity component in the total capital
is the tax rate.
The ROE of an unlevered firm (or a firm with a lower leverage) is higher than the ROE
of a levered firm (or a firm with a higher leverage) when the ROI is lower than the cost
of debt. Conversely, the ROE of a levered firm is higher than the ROE of an unlevered
firm (or a firm with lower leverage) when the ROI is higher than the cost of debt. The
ROE will remain constant irrespective of the levels of leverage if the ROI is equal to the
cost of debt.
Illustration 6
Beta and Theta are identical firms except for their capital structure.
Particulars
Debt
Beta
Theta
500
Equity
1000
500
Total Investment
1000
1000
Tax Rate
40%
40%
10%
Cost of Debt
We shall examine the impact on ROE of both the firms if the ROI is 5%, 10% and 20%.
50
Capital Structure
Particulars
Beta
Theta
ROI
5%
10%
20%
5%
10%
20%
EBIT
50
100
200
50
100
200
Interest
50
50
50
PBT
50
100
200
50
150
Tax
20
40
80
20
60
PAT
30
60
120
30
90
ROE
3%
6%
12%
0%
6%
18%
It can be observed that firm Beta is better off (generates a higher ROE) when the ROI at
5% is less than the cost of debt at 10%. On the other hand, firm Theta is better off when
the ROI at 20% is higher than the cost of debt at 10%. When the ROI is equal to the cost
of capital, both the firms generate an identical ROE of 6%.
Strategic Determinants of the Capital Structure
The capital structure should be designed with the aim of maximizing the market
valuation of the firm in the long run. The important determinants in designing capital
structure are:
Type of Asset Financed: Ideally short-term liabilities should be used to create short-
term assets and long-term liabilities for long-term assets. Otherwise a mismatch
develops between the time to extinguish the liability and the asset generation of returns.
This mismatch may introduce elements of risks like interest rate movements and market
receptivity at the time of refinancing.
Nature of the Industry: A firm generally relies more on long-term debt and equity if
its capital intensity is high. All short-term assets need not be financed by short-term
debt. In a non-seasonal and non-cyclical business, investments in current assets assume
the characteristics of fixed assets and hence need to be financed by long-term liabilities.
If the business is seasonal in nature, the funding needs at seasonal peaks may be
financed by short-term debt. The risk of financial leverage increases for businesses
subject to large cyclical variations. These businesses need capital structures that can
buffer the risks associated with such swings.
Degree of Competition: A business characterized by intense competition and low entry
barriers faces greater risk of earnings fluctuations. The risks of fluctuating earnings can
be partially hedged by placing more weightage for equity financing. Reductions in the
levels of competition and higher entry barriers decrease the volatility of the earnings
stream and present an opportunity to safely and profitably increase the financial
leverage.
Obsolescence: The key factors that lead to technological obsolescence should be
identified and properly assessed. Obsolescence can occur in products, manufacturing

processes, material components and even marketing. Financial maneuverability is at a
premium during times of crisis triggered by obsolescence. Excessive leverage can limit
51
the firms ability to respond to such crisis. If the chances of obsolescence are high, the
capital structure should be built conservatively.
Product Life Cycle: At the venture stage, the risks are high. Therefore equity, being
risk capital per se, is usually the primary source of finance. The venture cannot assume
additional risks associated with financial leverage. During the growth stage, the risk of
failure decreases and the emphasis shifts to financing growth. Rapid growth generally
signals significant investment needs and requires huge sums of capital to fuel growth.
This may entail large doses of debt and periodic induction of additional equity capital.
As growth slows, seasonality and cyclicality become more apparent. As the business
reaches maturity stage, leverage is likely to decline as cash flows accelerate.
Financial Policy: Designing an optimum capital structure should be done in response to
overall financial policy of the firm. The management may have evolved certain
financial policies like maximum debt-equity ratio, predetermined dividend pay-out,
minimum debt service coverage level, etc. Designing of capital structure will become
subservient to such constraints and the solution provided may be suboptimal.
Past and Current Capital Structure: The proposed capital structure is often
determined by past events. Prior financing decisions, acquisitions, investment decisions,

etc. create conditions which may be difficult to change in the short run. However, in the
medium- to long-term, capital structure can be changed by issuing or retiring debt,
issuing equity, equity buy-backs (when permitted), securitization, altering dividend
policies, changing asset turnover, etc.
Corporate Control: Firms which are vulnerable to takeover are averse to further
issuance of equity as it can result in the dilution of the ownership stake. Such firms
place an excessive reliance on debt and retained earnings. Firms with strong
management (having controlling stake) are unlikely to have reservations over further
issue of equity.
Credit Rating: The market assigns a great deal of weightage to the credit rating of a
firm. Hence, obtaining and maintaining a target rating has become imperative for most
firms. Rating agencies maintain constant watch to identify any signs of deterioration in
the creditworthiness of the company. The market reacts negatively to any downgrading
of the rating of a firm. This may result in a denial of access to capital either due to the
provision of any law/regulations (companies below a certain rating cannot issue CPs) or
by the market forces (investors may not subscribe to debt with low ratings). The
possibility of downgrading of rating due to the increase in leverage should be factored
in while making capital structure decisions.
5.17 SUMMARY
Capital structure theories analyze the proportion of debt and equity in the capital
structure of a firm. There are conflicting views regarding the impact of capital structure
on the valuation of a firm.
52
Capital Structure
Net income approach contends that the valuation of the firms can be increased by the
application of leverage, provided the cost of equity is greater than the cost of debt.
Net operating income approach assumes that the value of the firm remains constant
irrespective of the degree of leverage.
Traditional approach contends that the cost of capital is dependent on the capital
structure of the firm.
MM approach postulates that the composition of the capital structure is an irrelevant
factor in the market valuation of a firm.
Modigliani and Miller explain the arbitrage process to support their view that the value
of a levered firm cannot be higher than the value of an unlevered firm and vice versa.
The imperfections that can affect the capital structure are taxation, bankruptcy costs,
difference between home-made leverage and corporate leverage and agency costs.
Pecking order theory of financing assumes that firms follow a specific order of
preferences in the financing decisions and the most popular mode is the retained
earnings.
Trade off theory of financing assumes that the firm attempts a trade off between the size
of the tax shelter and the cost of financial distress.
The major determinants of capital structure are type of asset financed, nature of the
industry, degree of competition, obsolescence, product life cycle, financial policy, past
and current capital structure, corporate control and credit rating.
5.18 GLOSSARY
Capital Structure means the composition of a firms long-term financing consisting of
equity, preference capital, and long-term debt.

Cost of Capital implies the minimum rate of return the firm must earn on its
investments in order to satisfy the expectations of investors who provide the funds to
the firm. It is often measured as the weighted arithmetic average of the cost of various
sources of finance tapped by the firm.
Cost of Debt is the rate that has to be received from an investment in order to achieve
the required rate of return for the creditors.

Optimal Capital Structure is referred to the capital structure that minimizes the firms
composite cost of capital (maximizes the common stock price) for raising a given
amount of funds.
In financial context, Leverage means use of various financial instruments to increase
the potential return on an investment. A firm with debt in its capital mix is referred to as
a levered firm whereas a zero debt or a pure equity firm is referred to as an unlevered
firm.
53
Return on Equity is the return earned on equity capital of the firm, also known as
return on net-worth. Equity or Net-worth is the sum of Equity capital and reserves and
surplus less the miscellaneous expenditure not written off. It is calculated as:
ROE = PAT/ Networth
EBIT is a measure of companys earning power on its operating activities which is
equal to earnings before deduction of interests and income taxes. It is also referred to as
operating profit.
EPS is the earning per share of a firm, which is calculated by dividing the equity
earnings (Profit After Tax- Preference Dividend) by the number of outstanding shares of
the firm.
The tax saving due to leverage is known as Interest Tax Shield.
Costs of financial distress means the dead weight costs when the firms financial
position weakens, even if the firm does not declare bankruptcy.
5.19 SUGGESTED READINGS/REFERENCE MATERIAL
Brealey Myers. Principles of Corporate Finance. 6th ed. US: Mcgraw-Hill

Companies Inc., 2000.
James C. Van Horne. Financial Management and Policy. 11th ed. US: PrenticeHall, 1998.
Eugene F. Brigham, and Michael C. Ehrhardt. Financial Management Theory

and Practice. 12th ed. US: South-Western College Publishers, 2007.
Prasanna Chandra. Financial Management Theory and Practice. 6th ed. New
Delhi: Tata Mcgraw-Hill, 2004.
5.20 SUGGESTED ANSWERS

a.
When a firm finances a portion of its operations by debt, it is said that the firm
employs financial leverage or in other words, it is a levered firm. If a firm does
not employ debt, it is said that it is an all-equity firm and has no leverage.
b.
The theories of capital structure are based on the following premises:

i.
There are no corporate or personal taxes. Thus the impact of tax shields
associated with debt is abstracted.
ii.
There are no bankruptcy costs. The assets of a bankrupt company can be

sold at their economic value without incurring any liquidating and legal
expenses. This eliminates any bias in favor of an unlevered firm due to
existence of bankruptcy costs.
54
Capital Structure
iii.
The firm is allowed to issue and repurchase any amount of debt or equity.
These transactions can be executed instantaneously without any time lag.
The securities are infinitely divisible.
iv.
The composition of the capital structure can be changed without any

transaction costs like issue expenses and underpricing.
v.
The firm consistently follows the policy of 100% dividend pay-out. Thus
the possible impact of dividend policy on the valuation of the firm is
eliminated.
vi.
All the investors in the market have homogenous expectations of the

expected future earnings of all the firms. The expected value of the
subjective probability distributions of the anticipated future earnings
(operating income) is identical to all investors.
vii.
The operating earnings of the firm is expected to remain constant for all
future periods. Hence there is neither any growth nor decline in the
expected future earnings.
c.
The traditional approach contends that there is an optimal capital structure for
every firm. The theory postulates that the cost of debt (kd) remains constant up to
a certain degree of leverage and rises gradually thereafter. The cost of equity (ke)
rises at a slow pace up to a certain degree of leverage and increases rapidly
thereafter. The cost of capital (ko) initially declines due to moderate application
of leverage. After a certain degree of leverage, the increase in the cost of equity
is more than the benefits obtained due to cheaper debt. At this point the cost of
capital begins to rise. The rise in cost of capital becomes much more sharper,
once the cost of debt begins to rise. The point where ko is the lowest is the
optimal capital structure point.
a.
An imperfect capital market has transaction costs, taxes, possible bankruptcy

(which involves bankruptcy costs and causes the interest rate to vary directly
with risk), and possible conflicts of interest among stockholders, bondholders,
and management (giving rise to agency costs).
b.
A levered firm enjoys tax advantages because tax laws permit it to deduct any
interest paid as an expense for tax purposes. This tax advantage increases the
levered firms average cash flow. Unleveraged firm has to pay more tax than
levered firm. Capital structure, therefore, is relevant because, other things being
equal, the more leverage a firm employs, the higher the firms value.
55
5.21 TERMINAL QUESTIONS

A. Multiple Choice
1.
2.
3.
4.
5.
The Modigliani and Miller argument is that

a.
The value of the levered firm will be more than that of the unlevered firm.
b.
The value of the unlevered firm will be more than the levered firm.
c.
Either (a) or (b) may be true depending on other circumstances.
d.
Levered firms cannot enjoy a premium over unlevered firms as the

investors will abolish the difference through personal leverage.
e.
Effects of leverage of the firm cannot be nullified through personal

leverage.
Business risk refers to

a.
Variability of sales.
b.
Variability of the market value of the firm.
c.
Variability of cost of raw materials.
d.
Variability of the selling price of the products.
e.
All (a), (c) and (d) of the above.
Total leverage measures the relationship between

a.
EBIT and sales
b.
EPS and EBIT
c.
Sales and EPS
d.
PAT and sales
e.
PBDT and sales.
The ultimate objective of any company is

a.
Profit maximization
b.
Wealth maximization
c.
Sales maximization
d.
Improving market share
e.
Improving its reputation.
Which of the following long-term sources of finance puts maximum restraint on

managerial freedom?
56
a.
Retained earnings.
b.
Equity capital.
c.
Preference capital.
d.
Debenture capital.
e.
Term loans.
Capital Structure
B. Descriptive
1.
How do agency costs affect the capital structure?
2.
Explain the Net Income approach to the capital structure?
3.
What are the strategic determinants of capital structure?
These questions will help you to understand the unit better. These are for your
practice only.
57
UNIT 6
DIVIDEND POLICY
Structure
6.1
Introduction
6.2
Objectives
6.3
Dividend Decisions
6.3.1 Dividend Pay-Out Models
6.4
Strategic Determinants of Dividend Policy

6.4.1 Corporate Dividend Behavior
6.4.2 Dividend Preference
6.4.3 Dividend Aversion
6.4.4 Distribution Policy in Frictionless Markets
6.5
Affect of Dividend Taxes on Financing and Investment Choices
6.6
The Irrelevance of Dividends and Stock Repurchases in an Ideal Capital Market
6.7
Financial Signal through Dividends
6.8
Bonus Issues and Stock Splits
6.9
Share Repurchases as a Mode of Earnings Distribution
6.10
Theories of Dividends
6.11
Information Asymmetry and Signaling with Dividends
6.12
Summary
6.13
Glossary
6.14
6.15
Suggested Answers
6.16
Terminal Questions
6.1 INTRODUCTION
The dividend policy of a firm determines what proportion of earnings is paid to
shareholders by way of dividends and what proportion is ploughed back in the firm for
reinvestment purpose. Thus, the dividend policy affects both the long-term sources of
finance and the market price of shares. A firm should treat its dividend policy as
relevant because shareholders bother a great deal about the dividends. As a finance
manager, you must carefully evaluate the circumstances and the environment in which
the firm is operating in order to determine its dividend policy. Recognizing the
importance of dividend policy, this unit highlights dividend decisions and some models
which help in arriving at good dividend policy decisions. In addition to dividend
models, the strategic determinates of dividend policy and financial signaling are covered
in this unit.
Dividend Policy
6.2 OBJECTIVES
Understand the relevance of dividend policy of a firm;
Know the Strategic Determinants of Dividend Policy;
Calculate the effect of Dividend Taxes on Investment Choices;
Identify Information Asymmetry and Signaling with Dividends; and,
Explain different models of dividend policy.
6.3 DIVIDEND DECISIONS

Dividends refer to that portion of a firms net earnings, which are paid out to the
shareholders. Since dividends are distributed out of profits, the alternative to the
payment of dividend is the retention of earnings/profits. The retained earning constitutes
an easily accessible important source of financing, for the investment requirements of
the firm. There is, an inverse relationship between retained earnings and cash dividend:
larger retention, lesser dividends; smaller retention, larger dividends.
The dividend policy of a firm refers to the views and practices of the management with
regard to distribution of earnings to the shareholders in the form of dividends. The
portion of the earnings which is undistributed is called retained earnings. The retained
earnings are often used as means of financing the capital expenditure of the firm. The
higher the dividend pay-out, the lower will be the retained earnings. This would entail
dependence on other sources of financing by the firm. Hence the dividend policy has
implications on the financing decision of the firm. As the ultimate objective of any
company is to maximize the wealth of the shareholders, the impact of dividend policy
on the market valuation of the firm needs to be analyzed.
6.3.1 Dividend Pay-Out Models

The following are the various models which analyze the relationship between the
dividends and the stock prices.
GRAHAM-DODD MODEL
This model postulates that the market price of a share is a function of its dividends and
earnings. However, the model assigns higher weightage to dividends as against retained
earnings. The equity valuation model proposed by them is as follows:
P = m (D + E/3)
Where,
P
is the market price per share
is the multiplier
is the dividend per share
is the earnings per share.

59
The earnings of a company is equal to the sum of dividend and retained earnings.
Hence,
E=D+R
Where,
R represents the retained earnings.
In the above model if E is replaced with (D + R).
P
D+R
(4D + R)
= mD +
= m
3
3
The model thus gives 4 times more weightage to dividends in relation to retained
earnings. It may be noted that the weightages are subjective and are not derived from
any empirical data. While the weightages assigned are debatable, the essence of the
theory is that the market is overwhelmingly in favor of liberal dividend
pay-out. The dividend policy has a critical impact on the market valuation of the firm.
Illustration 1
Alpha Ltd., has recorded an EPS of Rs.6 for 1998-99. The company follows a fixed
dividend pay-out ratio of 75%. If the multiplier for the industry is 12, compute the
expected market price for the share based on the Graham-Dodd Model.
Solution
The dividend per share is Rs.6 0.75 = Rs.4.50
Based on the Graham-Dodd Model, the expected market price would be
P = m(D + E/3) = 12(4.50 + 6/3) = Rs.78 per share.
WALTER MODEL
The model devised by Prof. James Walter considers dividend as one of the factors
determining the market valuation. It also considers the returns earned by the firm on its
retained earnings vis--vis the cost of capital of the firm. The model says that the market
price of a share is the sum of the present value of the future stream of dividends and the
present value of the future stream of returns from the retained earnings.
The model makes the following assumptions:
The firm is a going concern and has a perpetual life span.
The only source of finance available to the firm is retained earnings. The firm
does not have any alternative means of financing.
The cost of capital and the return on investment are constant throughout the life
of the firm.
60
Dividend Policy
According to the model, the market valuation of its shares is

P=
D + (E D)r/k
k
Where,
P
is the market price per share
is the dividend per share
is the earnings per share
is the return on investments
is the cost of capital.
The model implies that a firm should have 100% dividend pay-out if the IRR on its
investments is less than its cost of capital. Conversely, a firm which is able to generate
higher IRR on its investments in relation to its cost of capital should retain its entire
earnings and no dividends should be declared. The dividend policy of a firm is
irrelevant if the IRR is equal to its cost of capital.
Illustration 2
Beta Ltd., paid a dividend of Rs.4 per share for 1998-99. The company follows a fixed
dividend pay-out ratio of 50%. The company earns a return of 18% on its investments.
The cost of capital to the company is 12%. Determine the expected market price of the
share using the Walter model.
Solution
The EPS of the company is
EPS =
Dividend
Pay-out Ratio
Rs.4.00
= Rs.8.00 per share
0.5
According to the Walter model

P
D + (E D)r /k
k
4.00 + (8.00 4.00)0.18 / 0.12

= Rs.83.33 per share.
0.12
GORDON MODEL
The Gordon model values the share by capitalizing its future stream of dividends.
Myron Gordon maintains that the growth rate of a firm is a product of its retention ratio
and the return on its investments. The assumptions of the model are similar to those of
the Walter model:
The firm is a going concern and has a perpetual life span.
The only source of finance available to the firm is retained earnings. The firm
does not have any alternative means of financing.
61
The cost of equity and the return on investment are constant throughout the life
of the firm.
The cost of equity is greater than its growth rate.
The model is expressed as:

P0 =
Y0 (1 b)
k br
Where,
P0
is the market price per share at the beginning of Year 0
Y0
is the expected earnings per share for Year 0
is the retention ratio (retained earnings/total earnings)
is the return on investments
is the cost of equity.
The following implications can be drawn from the model:
When the cost of equity exceeds the return on investment, the pay-out ratio
should rise to increase the market price;
When the cost of equity equals the return on investment, the changes in the payout ratio will have no impact on the market price;
When the cost of equity is less than the return on investment, the pay-out should
be reduced to increase the market price.
Illustration 3
Gamma Ltd., follows a policy of fixed dividend pay-out of 75%. The EPS for 2008-09
is Rs.4 per share and the same is expected to grow by 25% during
2009-10. The firm earns a return of 20% on its investment. The cost of equity of the
company is 15%. Compute the value of the share as on 31.03.2010 using the Gordon
Model.
Solution
The expected EPS for 2009-2010 is
Rs.4.00 1.25 = Rs.5.00 per share
The retention ratio of the firm is calculated as
Retention Ratio
= 1 Pay-out Ratio = 1 0.75 = 0.25
According to the Gordon Model, the expected value of the share is

P0
62
Y0 (1 b)
k br
5.00 0.75
= Rs.37.50 per share.
0.15 (0.25 0.20)
Dividend Policy
a.
State relationship between retained earnings and cash dividend.

.
.
.
b.
In accordance to Walter Model, what would a firm do, when the return on
investment is more than cost of equity capital?
.
.
.
6.4 STRATEGIC DETERMINANTS OF DIVIDEND POLICY

Some of the key factors which influence dividend pay-out of a firm are delineated
below:
Liquidity: Traditional theories have postulated that a dividend decision is solely a
function of the earnings of the firm. While earnings are an important determinant for
the dividend decision, the role of liquidity cannot be ignored. Dividend pay-out entails
cash outflow for the firm. Hence the quantum of dividends proposed to be distributed
critically depends on the liquidity position of the firm. In practice, firms often face cash
crunch in spite of having good earnings. Such firms may not be in a position to declare
dividends despite their profitability.
Investment Opportunities: Another key determinant to the dividend decision is the
requirement of capital by the firm. Normally firms tend to have low pay-out if profitable
investment opportunities exist and conversely firms tend to resort to high pay-outs if
profitable investment opportunities are lacking. Generally, firms operating in industries
which are in the nascent and growth phases of the product life cycle are characterized
by high dependence on retained earnings. On the other hand, firms operating in
industries which are in the maturity and decline stages normally distribute a larger
proportion of their earnings as dividends.
Access to Finance: A company which has easy access to external sources of finance
can afford to be more liberal in its dividend pay-out. The dividend policy of such firms
is relatively independent of its financing decisions. Firms having little or no access to
external financing have rather limited flexibility in their dividend decisions.
Flotation Costs: Issue of securities to raise capital in lieu of retained earnings involves
flotation costs. These costs include fees payable to the merchant bankers, underwriting
commission, brokerage, listing fees, marketing expenses, etc. Moreover smaller the size
of the issue, higher will be the flotation costs as a percentage of amount mobilized.
Further there are indirect flotation costs in the form of underpricing. Normally issue of
shares are made at a discount to the prevailing market price. The cost of external
financing has an influence on the dividend policy.
63
Corporate Control: Further issue of shares (unless done through rights issue) results in
dilution of the stake of the existing shareholders. On the other hand, reliance on retained
earnings has no impact on the controlling interest. Hence companies vulnerable to
hostile takeovers prefer retained earnings rather than fresh issue of securities.
In practice, this strategy can be a double edged sword. The niggardly pay-out policy of
the company may result in low market valuation of the company vis--vis its intrinsic
value. Consequently the company becomes a more attractive target and is in the danger
of being acquired.
Investor Preferences: The preference of the shareholders has a strong influence on the
dividend policy of the firm. A firm tends to have a high pay-out ratio if the shareholders
have a strong preference towards current dividends. On the other hand, a firm resorts to
retained earnings if the shareholders exhibit a clear tilt towards capital gains.
Restrictive Covenants: The protective covenants in bond indentures or loan agreements
often include restrictions pertaining to distribution of earnings. These conditions are
incorporated to preserve the ability of the issuer/borrower to service the debt. These
covenants limit the flexibility of the company in determining its dividend policy.
Taxes: The incidence of taxation on the firm and the shareholders has a bearing on the
dividend policy. India levies a 10% tax on the amount of distributed profits. This tax is
a strong fiscal disincentive on dividend distribution. These dividends are totally tax-free
in the hands of the shareholders. The capital gains (long-term) are taxed at 20%.
Dividend Stability: The earnings of a firm may fluctuate wildly between various time
periods. Most firms do not like to have an erratic dividend pay-out in line with their
varying earnings. They try to maintain stability in their dividend policy. Stability does
not mean that the dividends do not vary over a period of time. It only indicates that the
previous dividends have a positive correlation with the current dividends. In the long
run, the dividends have to be invariably adjusted to synchronize with the earnings.
However, the short-term volatility in earnings need not be fully reflected in dividends.
6.4.1 Corporate Dividend Behavior

John Lintner made an empirical study on the corporate dividend behavior. He developed
a quantitative model to express the dividend behavior.
Dt = crEPSt + (1 c) Dt 1
Where,
Dt
is the dividend per share for the time period t;
is the weightage given to current earnings by the firm;
is the target pay-out rate;
EPSt
is the earnings per share for the time period t; and
Dt 1
is the dividend per share for the time period t 1.
The Lintner model states that the current dividend of a firm depends on its current
earnings and its past dividends. The degree of dividend stability can be deduced from
the weightages in the model. A conservative firm which prefers a high level of dividend
64
Dividend Policy
stability will assign relatively insignificant value to c in the above equation. On the
other hand, an aggressive firm which does not attach much significance to past
dividends would give a high value to c in the equation. The dividends of such firms
would be more reflective of their current earnings. He concludes that On the evidence
so far available, it appears that our basic model incorporates the dominant determinants
of corporate dividend decisions, that these have been introduced properly and that the
resulting parameters are reasonably stable over long periods involving substantial
changes in many external conditions.
6.4.2 Dividend Preference

The dividend preference theory maintains that generally stockholders prefer receiving
dividends to not receiving them. The argument is based on the uncertainty of the future.
It asserts that stockholders prefer current dividends to future capital gains, because
something paid today is more certain to be received than something expected in the
future. The idea can be put in somewhat cynical terms by saying that stockholders do
not trust management to use the cash on hand today to grow the firm into something
larger and more valuable later on.
Notice that this is not a time value of money argument. It does not say people prefer the
dividend today because it is worth more. It says they would rather have it now to be
sure of getting it. The argument is often called the bird in the hand theory from the old
clich, A bird in the hand two in the bush (because you may not catch either of those
in the bush).
The reasoning has one rather substantial flaw. If stockholders are concerned about
reinvesting dividend money in a firm because they are afraid it will be lost, why have
they invested in that firm in the first place?
6.4.3 Dividend Aversion

The dividend aversion position asserts that investors generally prefer that companies not
pay dividends in order to enhance stock prices later on. The argument is based on
capital gains taxes, so its persuasiveness depends on current tax law.
The logic underlying the idea is that dividends are taxed at ordinary income rates
while capital gains are taxed at lower capital gains rates. Notice that in equation 1
the dividend decision involves trading early dividends for a higher selling price in
period n. The current dividend is ordinary income, but the appreciated price
represents a capital gain when the stock is sold. Hence the trade off between a
dividend today and a higher price later has to be modified to reflect that fact that, after
taxes, investors get to keep more of the appreciation than the dividends. That clearly
makes the deferred gain more desirable.
In the years immediately before 1986, capital gains were taxed at rates that were 40% of
those applied to ordinary income. However, the Tax Reform Act of 1986 ended that
favorable treatment by setting capital gains rates equal to ordinary rates. Under that rule
the dividend aversion argument was not very persuasive.
65
But during the 1990s, congress slowly moved the tax code back toward favoring capital
gains. In 1998 the system was shifted most of the way back by capping the tax rate on
long-term capital gains at 20%. Since the top ordinary bracket is 39.6%, this change
means the capital gains rate for high income taxpayers is about 50% of the ordinary rate.
That is not quite as favorable as the 40% per-1986 rate, but it is getting close. Thus, as
of 1998, the dividend aversion argument again makes sense.
It is important to realize that Congress is capable of reversing itself again and reducing or
eliminating capital gains benefits in the future. The issue is politically sensitive because
capital gains largely accrue to the wealthy, so favorable rates are a break for the rich.
There are two other less obvious tax benefits associated with capital gains that support a
dividend aversion argument. First, taxes on capital gains are deferred until stock is sold.
Second, all taxes on capital gains are avoided if stock is not sold when an investor dies.
Then the shares pass to the heirs with a tax basis equal to their current market value, so
the price appreciation up to that date is never taxed.
6.4.4 Distribution Policy in Frictionless Markets

The dividend choice in a firm is closely related to the capital structure choice and, like
the capital structure choice, is strongly influenced by market frictions like taxes and
transaction costs. Let us here examine a simple case where there are no transaction costs
and no taxes, and where the dividend choice conveys no information to investors. Let us
start with the case in which the firm knows how much cash it would like to distribute,
but has not decided whether to distribute the cash by paying a dividend or by
repurchasing shares.
1993
1999
Dividend Yield
Pay-out Ratio
Dividend Yield
Pay-out
(%)
(%)
(%)
Ratio (%)
AT&T
2.51
44.92
1.73
49.72
Apple Computer
1.64
64.39
0
0
Boeing
2.31
27.34
1.35
22.22
Deere
2.70
92.74
2.43
85.44
Disney
0.54
18.35
0.20
8.25
Dow Chemical
4.58
110.82
2.60
57.81
General Motors
1.46
23.36
2.75
22.99
1993
1999
1993
Hewlett-Packard
1.14
19.32
0.86
20.78
McDonalds
0.74
13.82
0.48
13.54
Microsoft
0
0
0
0
Minnesota Mining & Mfg.
3.05
56.45
2.29
51.03
Philip Morris
4.67
63.91
8.00
57.32
Safeway
0
0
0
0
Taxaco
4.94
65.84
3.31
84.11
Wal-Mart
0.52
12.81
0.37
16.00
Note: These ratios were calculated with data taken from COMPUSTAT.
Company
Table 1: Selected Dividend Yields and Pay-out Ratios, 1993 and 1999
6.5 AFFECT OF DIVIDEND TAXES ON FINANCING AND

INVESTMENT CHOICES
Although it is very difficult to determine whether the taxation of dividends is reflected
in stock returns, it is true that some investors incur a tax penalty when they receive
66
Dividend Policy
dividends. In addition, firms impose taxes and transaction costs on their shareholders
when they distribute excess cash by repurchasing shares. These taxes and transaction
costs can distort investment and financing choices.
THE INVESTMENT POLICY FAVORED BY TAX-PAYING SHAREHOLDERS
Let us assume that one owns shares in Streamline Corporation and have a marginal tax
rate on personal income of 50%. Suppose that Streamline Corporation must decide
whether to pay an additional Rs.1 million in dividends or to retain the earnings for
internal investment. As the holder of 10% of the outstanding shares, you have a major
say in the decision and need to consider the possibilities seriously. Your advisors
calculate that over the next five years the firm will earn 6% after corporate taxes with
certainty on the Rs.1 million and that these earnings will be distributed to the
shareholders in addition to the dividends they would have received otherwise. At the
end of the five years, the Rs.1 million retained this year will be distributed to
shareholders. In essence, the choice for shareholders is whether to deferral, additional
annual dividends of Rs.60,000 per year (= Rs.1 million 0.60) in the interim period.
Deferral does not seem particularly attractive at first glance because the rate of return
on five-year US Treasury bonds (in this case) is 7%, which is where you would invest
the dividend if it was paid now. Your tax advisors, however, urge you to compare the
after-tax cash flows from these Alternatives, which appear in the following Box 1A.
They suggest that, given your 50% marginal tax rate on personal income, you are
better off if the money is retained within the corporation. After taxes, the immediate
Rs.1,00,000 dividends (10% of the Rs.1 million distributions) would be worth only
Rs.50,000, which, according to Alternative 1 in the Box 1A, generates only Rs.1,750
per year after taxes if invested at 7%. The after-tax cash flows on the internally
invested retained earnings, Alternative 2 in the Box 8.1B are higher than those on the
distributed dividends Alternative 1. A return is earned on the entire Rs.1 million of
earnings kept within the firm rather than on half this amount, as is the case for
Alternative 1, because the earnings are distributed. As a result, tax-paying investors
tend to prefer retaining the earnings within the firm rather than receiving a cash
dividend.
THE INVESTMENT POLICY FAVORED BY TAX-EXEMPT SHAREHOLDERS
Tax-exempt institutions would evaluate these alternatives quite differently. From their
perspective, assuming the same 10% ownership of the outstanding shares, cash flows
would be as specified in Box 1B. Thus, from the perspective of a tax-exempt institution,
a cash dividend, Alternative 1, would be preferred.
Box 1A: After Cash Flows for a Taxable Investor
Alternative 1: Investment of after-tax dividend of Rs.50,000 in Treasury bonds.
After-Tax Cash Flows
Year 1
Year 2
Year 3
Year 4
Year 5
Principal Payment
Rs.1,750
Rs.1,750
Rs.1,750
Rs.1,750
Rs.1,750
Rs.50,000
Alternative 2: Retain earnings and invest internally for five years, which returns 6% to stockholders per
year with a final dividend in year 5.
67
After-Tax Cash Flows

Year 1
Year 2
Year 3
Year 4
Year 5
Deferred Dividend
Rs.3,000
Rs.3,000
Rs.3,000
Rs.3,000
Rs.3,000
Rs.50,000
Box 1B: Cash Flows for a Tax-Exempt Investor
Alternative 1: Investment of Rs.100,000 dividend in Treasury bonds.
Cash Flows
Year 1
Year 2
Year 3
Year 4
Year 5
Principal Payment
Rs.7,000
Rs.7,000
Rs.7,000
Rs.7,000
Rs.7,000
Rs.100,000
Alternative 2: Retain earnings and invest internally for five years, which returns 6% to stockholders per
year with a final dividend in year 5.
Cash Flows
Year 1
Year 2
Year 3
Year 4
Year 5
Deferred Dividend
Rs.6,000
Rs.6,000
Rs.6,000
Rs.6,000
Rs.6,000
Rs.100,000
PAY-OUT POLICY AND THE PERSONAL TAX RATE ON DISTRIBUTIONS

Note that the tax rate on the distribution to the equity holders does not directly affect the
comparison in the following box 2. If the distribution were taxed at a capital gains rate
that is considerably less than the 50% rate, the conclusion would be exactly the same.
What is important is the difference between the after-tax rates of return from investing
inside the corporation versus investing outside the corporation.
The tax rate on the distribution is irrelevant because the cash must eventually be
distributed, either now or later, and the tax rate on the distribution is assumed to be the
same in either case. However, if there are expected to be changes in the tax rate on the
distribution, such changes could affect the pay-out/reinvestment decision. If, for
example, tax rates on distributions are expected to increase, there will be an increased
incentive to pay out cash flows now, when the tax on distributions is low, rather than
later, when the tax rate on distributions is higher. Similarly, a corporation will have an
inventive to delay distributions if it believes that the tax on distributions is going
decline.
6.6 THE IRRELEVANCE OF DIVIDENDS AND STOCK

REPURCHASES IN AN IDEAL CAPITAL MARKET
The Miller and Modigliani (1961) proposition of dividend irrelevance in an ideal capital
market put forth the argument that, in an ideal capital market, dividend policy is
irrelevant as long as the firms capital investments and debt policy are kept constant.
Dividend payments are simply financed over time by a combination of excess retained
earnings and, as per requirement, new equity financing. Let us now try to see that not
only is the dividend irrelevant but also the stock repurchases are irrelevant in an ideal
capital market.
THE BASIC ARGUMENT
Let us assume here that the entrepreneur of a new firm has a profitable single-period
capital investment project that requires an initial investment of INV0 at time zero. The
projects expected return is r*, which is greater than the discount rate applicable to the
projects expected future cash flow, r. The present value of the project is
68
Dividend Policy
(1 + r*)INV0
PV =
(1 + r)
(1)
And the projects Net Present Value (NPV) is

NPV = INV0 + PV > 0.
(2)
Let us now consider the basic argument of the model in the context of the following
cases.
Situation where there is No Dividend
We initially assume that, to finance the project, the entrepreneur sells some combination
of debt and outside equity securities (owned by the outside share holders), denoted as
DEBT0 and STOCK 0 , respectively. So the initial investment of INV0 at time 0

equals:
INV0 = DEBT0 + STOCK 0
. (3)
In an ideal market, the value of the debt and equity securities sold will be equal to the
proceeds received (i.e., the sales themselves are the transactions that have NPV of zero).
Following the sale of the securities, the entrepreneur retains equity with a value equal to
the full amount of the projects NPV.
Let us denote the value of the entrepreneurs share of the firms equity as EQ0, then EQ0
= NPV. Modigliani and Millers (1958) Proposition I is actually applicable here.
Situation that includes a Dividend Payment
The entrepreneur could sell debt and equity securities sufficient not only to finance the
project, but also to pay himself an immediate dividend, which is denoted as DIV0,
INV0 + DIV0 = DEBT0 + STOCK 0 .
(4)
In this case, the value of the entrepreneurs equity is

EQ '0 = PV DEBT0 STOCK 0 DIV0 = NPV DIV0
The entrepreneur also receives the dividend DIV0, so his wealth is the same as in the
situation where there no dividend
(i.e., EQ'0 + DIV0 = EQ0 ) .
The constraint on the total value of securities that can be sold is that the sum
DEBT0 = STOCK 0 cannot exceed the present value (PV) of the projects
expected pay-off:
DEBT0 + STOCK 0 PV
(5)
The dividend is correspondingly constrained:
DIV0 PV INV0 = NPV
(6)
Again, an arbitrage proof of the above argument is analogous to the proof of

M&M Proposition I.
69
Findings of the above Proof

The above analyses illustrate the two main postulates of Miller and Modigliani that they
made in their paper. They are:
a.
The higher the dividend pay-out in any period, the more the new capital that
must be raised from external sources to maintain any desired level of investment.
b.
The irrelevance of dividend policy, given investment policy, is obvious, once

you think of it.
A Numerical Illustration
Suppose the founder of a new firm has a single-period project that requires an
initial investment of INV 0 = $10 million. The projects expected return is r* =
30%, and the appropriate discount rate is r = 12%. The percent value of the projects
expected pay-off is calculated as follows:
PV =
(1 + r*)INV0 1.3(Rs.10 million)

=
= Rs.11.607 million,
(1 + r)
(1.12)
And the projects NPV is

NPV = Rs.10 million + Rs.11.607 million = Rs.1.607 million.
If the entrepreneur sells just enough debt and equity securities to finance the project,
say, DEBT0 = Rs.4 million and STOCK 0 = Rs.6 million, then he would retain equity
with a value of
EQ0 = Rs.1.607 million (= Rs.11.607 million Rs.10 million).
If instead the entrepreneur sells debt and equity securities with total values of DEBT0 =
Rs.4 million and STOCK 0 = Rs.7 million, he could finance the project, pay himself a
dividend of DIV0 = Rs.1 million, and hold equity with a value of EQ '0 = Rs.0.607 million.
EXTENDING THE ARGUMENT TO INCLUDE STOCK REPURCHASES
Miller and Modiglianis dividend irrelevance argument can be further extended to show
the irrelevance of stock repurchases. Let us consider a seasoned firm that has just
received net cash flows from its current operations through date t, denoted as NCFt.
For the sake of simplicity, let us assume that the firms assets temporarily consist only
of cash in the amount of NCFt. The firm has decided to make capital investments that
require outlays that amount to INVt.
In addition, the firm could issue:
Debt securities in the amount, or
Issue equity securities in the amount, or
Repurchase shares in the amount of REPt, or
Pay a dividend in the amount of DIVt.
Regarding these choices, the firm must adhere to the following cash flow constraint for
period t, which is organized to solve the focal variables of our discussions, dividends
and stock repurchases,
70
Dividend Policy
NCFt INVt + DEBTt + STOCK t = DIVt + REPt
(7)
As long as the firm does not alter its commitment to capital spending in the amount of
INVt, any combination of values of the other variables that obeys Equation 7 results in
the same wealth for the firms shareholders. That is, both dividend and stock repurchase
policies are irrelevant.
EXAMPLES OF THE CASH FLOW CONSTRAINT
Let us now examine the composite values of the cash flow items in equation (7). As a
starting point of our discussion, examples of cash flow constraints for eight large US
non financial firms for the calendar year 2000 are being provided. The firms are CocaCola, Exxon Mobil, General Electric, General Motors, International Business Machines
(IBM), Merck & Co., Sears Roebuck, and Verizon Communications. The cash flows for
each firm are displayed in the following table 2. (These values were taken from each
firms sources and used statement.)
The following four observations summarize the data in table 2, first, the bulk of each
firms NCft in 2000 consisted of the sum of income before extraordinary items plus
depreciation and amortization. Second, NCFO was generally sufficient to fund
investment activities, which in turn consisted primarily of capital expenditures. Third,
sales of stock generally provided very little cash inflow, whereas net debt issuance
(issuance less reduction) generally provided somewhat more substantial cash inflow.
Fourth, stock repurchases exceeded dividends in 2000 for four of the eight firms.
(Amounts in $ millions)
CocaCola
Exxon
Mobil
General
Electric
$2,177
$15,990
$12,735
$773
$8,130
$7,736
Extraordinary items and Disc. Oper.
$0
-$308
$0
Deferred taxes
$3
$10
General
Motors
International
Business
Machines(IBM)
Merck
& Co.,
Sears
Roebuck
Verizon
Commu
nications
$4,452
$8,093
$6,822
$1,343
$10,810
$13,411
$4,995
$1,277
CF
$12,261
$0
$0
$0
$0
$0
$1,153
$0
$29
$0
$0
$3,434
Operations
Income before extraordinary items
Depreciation and amortization
Equity in net loss (earnings)
$380
$387
CF
CF
CF
CF
CF
$3,792
Sale of PP&E and Sale of Investments
$127
$0
$0
$0
$792
$0
-$19
$3,793
Funds from operations-other
$1,231
$576
$239
$1,342
$0
$612
$2,053
$1,832
$39
$4,832
$537
$1,351
$4,720
$940
$93
$2,440
$2
$297
$924
$297
$55
$210
$560
$530
$84
CF
$3,297
CF
$2,245
$17
CF
$1,973
Receivables
Inventory
Accounts payable and accrued
liabilities
Income taxes-accrued
-$96
CF
CF
CF
CF
CF
$0
CF
Other assets and liabilities
$631
$5,207
$1,009
$4,877
$521
$110
$22
$264
Net cash flow from operations
$3,585
$22,937
$22,690
$19,750
$9,274
$7,687
$2,702
$15,827
$1,648 $16,076
$243,950
$1,079
CF
$40
$1,024
Investing Activities
Increases in investments
CF
Sale of investments
CF
CF
CF
$228,794
$1,393
CF
CF
$0
Change in short-term investments
CF
$41
CF
CF
CF
CF
CF
$221
International
Business
Machines(IBM)
Merck
& Co.,
Sears
Roebuck
Verizon
Commu
nications
CocaCola
Capital expenditures
$733
Exxon
Mobil
General
Electric
$8,446 $13,967
General
Motors
$31,605
$5,616
$1,084 $17,633
$2,728
Sale of PP&E
$45
CF
$6,767
$15,993
$1,619
$0
CF
CF
Acquisitions
CF
$0
$2,332
$6,379
$0
CF
$1
CF
71

Other investing activities
Net cash flow
from investing
$477
$6,755 $12,091
$1,165
$3,374
$565
$914
$4,248
$3,298 $37,699 $33,773
$75
$2,823
- $16,055
$3641
$1,050
activities
Financial Activities
Sale of common and preferred stock
$331
$493
$469
$2,792
CF
$2,141
$58
$576
Stock repurchases
$133
$2,352
CF
$1,613
$6,073
$3,545
$1,233
$2,294
Cash dividend Issuance of
$1,685
$6,123
$5,401
$1,294
$929
$2,798
$322
$4,421
long-term debt
$3,671
$238
$47,645
$35,558
$9,604
$442
$824
$8,781
Retirement of long-term debt
$4,256
$901
$32,762
$22,392
$7,561
$443
$2,277
$7,238
Change in current debt
CF
$5,042
$8,243
CF
$1,400
$906
$1,295
$3,515
Other financing activities
$0
$478
$12,942
$1,069
$0
$149
$118
$33
-$2,072
14,165
$14,650
$14,120
$6,359
$1,537
1,048
Net cash flow from financing activities
$3,447
Other Items
Exchange rate effect
Change in cash and equivalents
Reconciliation
$140
$82
$0
$255
$147
$84
$2
$0
$208
$5,392
$359
$158
$1,480
$515
$113
$1,276
$0
$0
$0
$0
$0
$0
$0
$0
Note: CF = Combined figure (item was combined with another item).
Source: Raw data from Standard & Poors Research insight database.
Table 2
For the sake of the analysis of composite cash flows, the variables are compressed into
six items; they are, Net Cash Flow from Operations (NCFO), net cash flow from
investing activities (INV), Net Change in Debt ( DEBT = issuance of Long-term debt
less retirement of long-term debt, plus change in current debt), sales of stock
(STOCK), Cash Dividends (DIV), and Stock Repurchases (REP). Thus, we ignore
three other cash flow items, which are generally small in magnitude: other financing
activities, exchange rate effect, and change in cash and equivalents.
MODIGLIANI-MILLER POSITION
Franco Modigliani and Merton Miller propound that the dividend pay-out is an
irrelevant factor in the market valuation of firms. They assert that the value of shares is
solely determined by real considerations i.e., the earning power of the firm and its
investment policy. The distribution of earnings in the form of dividends has no bearing
on the valuation of the firm. The proportion in which the earnings are split between
dividends and retained earnings has no affect on the wealth of the shareholders.
Assumptions
The MM hypothesis is constructed on the assumption of an ideal economy. An ideal
economy is characterized by perfect capital markets, rational behavior and perfect
certainty.
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Dividend Policy
Perfect Capital Markets has a large number of issuers and investors. The transactions of
no single participant can have an appreciable impact on the market prices. Information
is costless and is equally accessible to all. There are no transaction costs in the form of
brokerage fees, transfer taxes, etc., for buying and selling of securities. There are no
flotation costs like issuing costs and underpricing, to the issuer, for the issue of new
securities. There are no tax differentials between distributed and undistributed profits or
between dividends and capital gains.
Rational Behavior means that investors always prefer more wealth to less. Further they
are indifferent as to whether a given increment to their wealth takes the form of
dividend flow or an increase in the value of their shares. Modigliani and Miller
extended the usual postulate of rational behavior by introducing the concept of
symmetric market rationality. The Symmetric Market Rationality hypothesis is based on
the premise that every investor also imputes rationality to the market. He assumes that
all other investors are rational and they, in turn, also impute rationality to the market.
This concept not only covers the choice behavior of individuals but also their
expectations of choice behavior of others. The symmetric market rationality cannot be
deduced from individual rational behavior. If an ordinarily rational investor has good
reasons to believe that other investors would not behave rationally, then it might be
rational for him to adopt a strategy he would have otherwise rejected as irrational. This
hypothesis thus rules out the possibility of speculative bubbles, wherein an otherwise
rational investor buys an overpriced security (too expensive in relation to its expected
long-term return to merit its addition to his portfolio) in the expectation that he can
resell it at an even more inflated price before the bubble bursts. Thus Symmetric Market
Rationality hypothesis extends the concept of rationality to the market as a whole.
Perfect Certainty means complete assurance on the part of every investor as to the future
investment program and the future profits of all the firms. It is latter proved that MM
approach holds good even when this assumption is dropped.
DIVIDENDS AND MARKET VALUATION
The substance of the MM approach is that the dividend payments have no impact either
on the valuation of the firm or the wealth of the shareholders. When a firm declares
dividends it foregoes retained earnings to the extent of the dividend amount. As the
investment needs of a firm are taken as a constant, the firm finances the amount of
retained earnings foregone, by issuing new shares. MM asserts that the sum of
discounted value of the shares after the financing and the amount of dividends paid is
exactly equal to the market value of the share before the payment of dividends. In other
words, the fall in the stock price offsets the amount of dividends received. There is no
change in the overall wealth of the shareholders. The shareholders are therefore
indifferent between dividend payments and retained earnings. Further, while the market
price of each share may decline, the number of shares outstanding increases due to the
fresh issue of equity. Therefore, the market capitalization of the firm remains constant.
Hence dividend policy of a firm is irrelevant.
73
The current market price of a share is the sum of the present values of the dividend paid
and the market price at the end of the investment horizon t1. The market price can be
represented as:
P0
D1 + P1
1+ p
(8)
Where,
P0
is the market price per share at the beginning of Year 0.
D1
is the expected dividend per share for Year 1.
P1
is the market price per share at the end of Year 1.
is the capitalization rate for the firms in that risk class.
If m is the number of shares issued at the end of the period at a price of P1 (the
prevailing market price), the above equation can be rewritten as:
nP0 =
nD1 + (n + m)P1 mP1

1+ p
(9)
where,
n is the number of shares at the beginning of the period.
The above equation signifies that the total valuation of the firm at the beginning of the
period (t0) is the sum of present value of the dividend and the market value of the
outstanding shares at t1 less the total value of the new shares issued.
The total value of the new shares issued is
mP1 =
I (X nD1)
(10)
where,
I
is the value of the total investments.
is the earnings of the firm during the period t.
By substituting the value of mP1 in the equation 9

nP0 =
(n + m) P1 I + X
1+ p
(11)
It may be noted that the term D1 does not appear in the above equation. Further all other
variables in the equation are independent of D1. Thus it can be concluded that the
dividend decision has no bearing on the valuation of the firm. Hence there is nothing
like an optimal dividend policy.
MM HYPOTHESIS UNDER CONDITIONS OF UNCERTAINTY
The hypothesis continues to remain valid even if the assumption of perfect certainty is
dropped. The condition of uncertainty implies that the values of dividends and the
expected future share price are uncertain. Hence, they are treated as random variables
74
Dividend Policy
from the point of view of the investors. These variables will, therefore, not assume
definite value but a probability distribution of possible values.
The solution is that individual investors can replicate the pattern of any stream of
dividends. Let us assume that the investors require a certain desired pay-out to
compensate for the uncertainty. If the actual dividends are less than the target pay-out,
the investors can sell a part of their holdings to generate the desired amount of cash. The
investors can thus generate home-made dividends to obtain the required pay-out.
Conversely, if the actual dividends are more than the target pay-out, the investors can
invest the surplus cash into buying more shares of the company. Thus dividend payment
would be a matter of irrelevance even under conditions of uncertainty.
MM HYPOTHESIS AND MARKET IMPERFECTIONS
The assumption of perfect capital market is abandoned. However, there is no unique set
of circumstances that constitute imperfection. There can be a multitude of possible
departures from strict market perfections, either singly or in combinations.
Tax differentials exist in the real world, where substantial advantages are accorded to
capital gains as compared to dividends. This can be countered by pointing out that the
tax structure on dividends is generally progressive while that on capital gains is a flat
rate. Therefore, the investors in lower tax bracket may have no differentials or even
negative differentials (when dividend income attracts lower tax rate than capital gains).
The investors in higher tax brackets have significant tax differentials. Hence, it is
difficult to generalize the tax implications of dividend policy on the investors. The
advantages and disadvantages of various classes of investors generally tends to get
canceled out. It is further argued that if the tax structure is significantly tilted in favor of
capital gains vis--vis dividends, then companies which have zero to minimal pay-outs
should command a premium over companies with high pay-outs. In this context, it is
paradoxical that other dividend theories emphasize on liberal pay-outs to increase the
firm valuation. From the corporate taxation angle, most countries do not have tax
differentials between distributed and undistributed profits. (India is, however, a notable
exception due to imposition of 10% tax on distributed profits.)
The transaction costs have an impact on the arbitrage opportunities to generate cash
flows which can replicate the dividend streams of any target policy. The existence of
brokerage and transfer taxes hinder the arbitrage process. Investors preferring high
pay-out incur transaction costs in selling their shares to increase their current cash flow.
On the other hand, investors preferring low to zero pay-outs have such costs as a
deterrence in buying further shares of the company. Thus transaction costs have equal
impact on both sides and have no directional implications on the dividends versus
retained earnings debate. However, flotation costs like issue expenses and underpricing
results in dilution of the wealth of the existing shareholders.
Hitherto, it was assumed that firms would issue equity to the extent of retained earnings
foregone. It was argued that firms can issue debt or a combination of equity and debt to
75
finance the same. The MM position on this criticism was anchored on their leverage
irrelevance theory of capital structure. They countered that the real cost of equity and
debt was the same. Hence, the issue of debt did not negate their proposition of dividend
irrelevance.
Lastly, most dividend theories assume that there is a systemic bias in favor of
dividends over capital gains through retained earnings. This assumption can be
subsumed by pointing out that investors are in a position to replicate any stream of
dividend pay-out by applying home-made dividends. MM argued that if the
frequency distribution of corporate pay-out ratios happened to correspond exactly
with the distribution of investor preferences of pay-out ratios, it would ultimately lead
to a situation where each firm tends to attract investors consisting of those preferring
its particular pay-out ratio. As every class of investors are assumed to be equally
rational, there would be no implications on the valuation of the firm. They further
argued that if the distributions do not match and there is a shortage of a particular
pay-out ratio, even then the investors need not pay any premium for the shares in
short supply. They have the option of achieving their investment objectives by buying
appropriately weighted combinations of plentiful stocks with different pay-outs,
which are currently quoting at a discount. This process of arbitrage will eliminate any
premium or discount.
TAILORING THE CASH FLOW STREAM
The irrelevance argument clearly makes sense if investors do not have a preference for
current income. If they do, we have to reason a little harder.
A preference for current income means people care about the pattern of cash flows from
an investment as well as about the present value of the entire stream of payments (the
securitys price). For example, retirees who need a certain amount of current income
from investments to live comfortably will be upset if a stock they hold reduces its
dividends, regardless of the fact that the present value of the whole stream does not
change.
Does this imply that if management reduces or eliminates dividends in the near term,
investors who need current income have to get out of the stock? In theory the answer is
no, because an investor in need of cash can always sell some of his or her stock for cash.
The portion of the holding that is not sold appreciates because of the retention of
additional earnings, so the value of the original investment can be maintained in spite of
the sell off, even though the number of shares owned decreases.
Illustration 4
Jack and Wendy Winter are retirees who have most of their savings invested in 10,000
shares of Ajax Corporation. Ajax sells for Rs.10 per share and pays a yearly dividend of
Rs. 50 per share. The firm has no growth for some time. The Winters depend on their
Ajax dividends to supplement their retirement income.
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Dividend Policy
This year Ajax discontinued the dividend, but began to grow at 5% per year because of
the additional retained earnings. How can the Winters maintain their income and their
position in Ajax? Assume there are no costs to buy or sell securities.
Solution
At Rs.10 each, the Winters 10,000 Ajax shares were originally worth a total of
(10,000 Rs.10 = Rs.100,000). That is, the principal amount of their investment that
they want to maintain. At the same time, they have to generate a yearly income stream
of (10,000 Rs.50 = Rs.5,00,000) to replace the dividend that is no longer being paid.
After a year of growth at 5%, Ajaxs shares are worth Rs.10.50 each. The Winters can
raise Rs.5,000 in cash by selling
Rs.5, 000
= 476 shares
Rs.10.50
At the appreciated price, the remaining (10,000 476 = 9,524) shares are worth
Rs.10.50 9,524 = Rs.10,00,002.
Hence, the gross amount of the Winters investment is maintained. (The numbers are
not quite exact because we have to deal in whole shares.) As an exercise, calculate the
required selloff in the second year.
THE EFFECT OF TAXES AND TRANSACTION COSTS ON DISTRIBUTION
POLICY
It is a common practice for the corporations to first pay corporate taxes on their
earnings, and then the shareholders pay tax again on the distributed profits. The
following example illustrates that from a shareholders perspective, the effective tax on
corporations can be considerable.
A COMPARISON OF THE CLASSICAL AND IMPUTATION TAX SYSTEMS
A number of countries outside the United States have changed their tax systems to
eliminate the double taxation of corporate profits. Greece and Norway, for example,
allow dividends to be deducted from corporate taxes and thus treat dividends and
interest payments symmetrically. Australia, Canada, France, Germany, Italy, and the
United Kingdom have introduced imputation systems, under which investors who
receive taxable dividends get a tax credit for part or all of the taxes paid by the
corporation. This tax credit at least partly offsets the personal taxes these investors must
pay on dividend income.
Let us discuss here on what is known as the classical tax system which is observed in
the United States. In a classical tax system, dividends are taxed as ordinary income and
capital gains are generally taxed at a lower rate than ordinary income. Shareholders do
not receive tax credits offsetting the taxes paid by corporations, implying that the
classical tax system effectively double taxes corporate profits.
77
Under the classical system the cost of funding investments through retained earnings is
lower than the cost of funding investment by issuing new equity. As a result, new firms
with promising opportunities but insufficient amounts of internally generated cash will
find it more expensive to fund their investment needs than more mature firms with less
promising opportunities.
THE TAX DISADVANTAGE OF DIVIDENDS
The following exhibit details the immediate tax consequences to an individual investor,
if a firm chooses to distribute Rs.100 million in the form of a dividend versus
distributing Rs.100 million as a share repurchase. It assumes that the investor currently
owns 10% of the outstanding shares and plans on maintaining the 10% ownership. It
also assumes that the shares if repurchased will be repurchased at a price of Rs.50 a
share and that they were originally purchased at a price of Rs.38 a share. It uses 35% as
the tax rate on dividends and 20% as the tax rate on capital gains.
(Rs. in millions)
Dividend Alternative:
Dividend
Rs.100.0
Tax rate
X35%
Immediate tax liability
Rs.35.0
Share Repurchase Alternative:

Proceeds from sale of 2 million shares
Rs.100
Less Original cost (at Rs.38/share)

Taxable capital gain
76.0
Rs.24.0
Tax rate
X20%
Immediate tax liability
Rs.4.8
Table 3: Tax Consequences Dividend versus Share Repurchase

Although the immediate tax liability is considerably higher with the dividend
alternative, the future tax liability incurred by shareholders when their shares are
eventually sold is higher when shares are repurchased. This is because the share prices
drop by the amount of the dividend when a dividend is paid, making the future capital
gains lower for shareholders who purchased stock prior to the dividend. However, the
total amount paid in taxes (and its present value) is still considerably lower with the
repurchase alternative.
In countries like the United States, taxes favor share repurchases over dividends. The
gain associated with a share repurchase over a cash dividend depends on:
The difference between the capital gains rate and the tax rate on ordinary
income.
78
Dividend Policy
The tax basis of the shares that is, the price at which the shares were purchased.
The timing of the sale of the shares (if soon, the gain is less, but if too soon, the
gain may not qualify for the long-term capital gains rate).
6.7 FINANCIAL SIGNAL THROUGH DIVIDENDS

Most dividend theories imply that changes in dividends have information content about
future earnings of the firm. Some theories explain that dividend variations are explicit
signals about future earnings sent intentionally, at some costs, by the management. The
signaling costs include flotation costs of issuing new shares, the stream of returns on the
investments foregone and the higher incidence of taxes on dividends vis--vis capital
gains. A rise in dividend is generally taken as a signal of increased future earnings of
the firm. It carries greater conviction than a mere announcement of better prospects by
the management. A reduction of dividends reflects negatively on the future earnings
prospects of the firm. The markets normally react favorably to dividend initiations and
increases and negatively to announcements of dividend decreases or emissions.
ARE STOCK REPURCHASES REPLACING DIVIDEND?
The most obvious question that arises from the empirical evidence that has been
provided here is, are stock repurchases replacing dividends as the preferred pay-out
method? Fama and French (2001) also briefly address this issue empirically: because
repurchases are largely the province of dividend payers, they leave the decline in the
percent of payers largely unexplained. Instead, the primary effect of repurchases is to
increase the already high earnings pay-outs of cash dividend payers.
6.8 BONUS ISSUES AND STOCK SPLITS

Bonus issue (also called stock dividend) involves capitalization of reserves by issuing
new shares to the existing shareholders. A part or the whole of the reserves are
capitalized. The new shares (bonus) are issued to the existing shareholders pro rata to
their existing holdings. The proportional stake of the shareholders in the firm remain
unchanged though the size of their individual holdings may be significantly different.
Hence, bonus issue has no implications on the controlling interests. From the
accounting point of view, the paid-up equity capital of the company increases and the
size of the reserves decreases. The overall quantum of the shareholders funds (net
worth) remain constant but there is a change in its composition. Thus, a bonus issue
essentially represents a recapitalization of the company. It aligns the share capital with
the total shareholders funds.
Stock splits involve increase in the number of shares outstanding through a decrease in
the par value of the share. The total size of the share capital remains the same. For
example, the recent reduction in the face value of the shares of ACC from Rs.100 to
Rs.10. Each shareholder will be given 10 shares with a par value of Rs.10 each in lieu of
every old share of Rs.100 each. This move of ACC is called 10-to-1 stock split. Stock
splits like bonus issues have no implications on the proportion of individual stakes in
the company. Conversely, a company might want to reduce the number of outstanding
shares. It can accomplish this through a reverse stock split. A new share with a higher
par value is created in exchange of the old shares with lower par values. Reverse stock
79
splits are generally employed to increase the market price of its shares. Market reacts
negatively to reverse stock splits and hence firms are generally disinclined to undertake
this exercise.
SIGNALING THROUGH STOCK DIVIDENDS AND STOCK SPLITS
Researchers have been surprised over the role of stock splits and stock dividends in the
valuation of the company. Theoretically, stock splits and stock dividends should have
no impact on the wealth of the shareholders. They were puzzled that companies engage
in these transactions at all and even more so because stock prices rise when these
transactions were announced. The significant positive announcement effects led to the
hypothesis that firms signal information about their future earnings or valuation through
these decisions. Practitioners have long contended that the purpose of stock splits and
stock dividends is to the firms share price into the optimal trading range. The trading
range hypothesis is anchored on the arguments that there exists informational
asymmetry between the management and the investors. Hence, the stock splits and stock
dividends have information content about the future earnings or firm valuation and the
market reacts to the same by revising the valuation. They also pointed that the lower
share prices (post-split or post-bonus) enhances the liquidity of the scrip in the market.
6.9 SHARE REPURCHASES AS A MODE OF EARNINGS

DISTRIBUTION
Dividends are increasingly losing their status as the primary vehicle of earnings
distribution. Firms are often adopting a strategy of share repurchases as a method to
reward the shareholders. The share repurchase plan has benefits to the shareholders. The
buy-back provides liquidity to the scrip and presents an exit opportunity (often at a
premium to the prevailing market price) to the investors who wish to offload their
holdings. The shareholders who continue to hold the shares are benefitted by better
market valuation of their shares after the repurchase program. There are three principal
methods of share repurchase:
Open Market Repurchases: A firm purchases its own shares like any other investor on
the stock exchange. Normally the repurchase program is carried on over an extended
period of time. The firm gradually accumulates the required block of shares. The price
of the shares rises in the market due to the increased demand for the shares. Such
repurchase programs have to comply with stringent norms of the regulatory bodies to
prevent their abuse for rigging up the market.
Fixed Price Tender Offers: This mode of repurchase involves making an offer to the
shareholders to buy their shares at a certain predetermined price. Such an offer is in the
nature of a reverse rights issue. The advantage of fixed price tender offer is that it
provides equal opportunities to all the shareholders to participate in the repurchase
program. The shareholders can either tender the shares at the stated price or turn down
the offer and continue to hold them. The tender offer is kept open for a specified period
of time. If the shareholders tender more shares than originally specified, the firm has the
discretion to purchase the whole or a part of the excess shares.
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Dividend Policy
Dutch Auction Tender Offers: This method involves making a tender offer to the
shareholders of the firm to repurchase their shares. The firm does not fix any
predetermined price but announces the number of shares it proposes to buy-back. The
firm may indicate a price band, consisting of a floor price and a ceiling price, for the
tender offer. The tender offer is open to all the shareholders of the firm. The
shareholders have the discretion to either participate in the repurchase program or to
reject the offer and retain their holdings. They can participate in the tender offer by
submission of their offer indicating the number of shares and the price at which they are
ready to sell. The information relating to the number of shares tendered at various ask
prices is assembled. The firm then determines the lowest possible price at which the
required number of shares sought can be repurchased. The offers received at or below
this cut-off price are accepted. However, the same price (cut-off price) is paid to all the
shareholders whose offers have been accepted.
Dutch auctions are gaining increasing popularity as a mode of stock repurchase. A dutch
auction is considered as a financial hybrid combining some features of open market
purchases with others of fixed price tender offer. Dutch auctions are less riskier to the
management than fixed price premium offers. The fact that all the shares repurchased
receive a uniform price may induce some shareholders to submit their offers at very low
ask prices to ensure their acceptance in the auction. This would benefit the firm by
reducing the final repurchase price. Further, with an upward sloping supply curve for
the stock, the entire segment of the curve below the cut-off price is repurchased. Thus, it
eliminates those shareholders who assign relatively lower valuations to the stock.
SIGNALING THROUGH STOCK REPURCHASE
Stock repurchases have strong signaling effect on the market. The market views a
repurchase program as a reflection of the management belief that the firm is
undervalued. The amount of premium in the repurchase price over the current market
price of the share is normally taken as an indication of the magnitude of undervaluation
of the firm. The rise in the share prices after the repurchase can be pointed as an
evidence of the positive signaling effect. There is also strong empirical evidence that the
degree of improvement in the share price has a positive correlation with the magnitude
of the premium, the percentage of shares repurchased and the fraction of insider
holdings.
There is an inherent disincentive for false signaling through stock repurchase. False
signaling occurs when the management announces a premium that significantly exceeds
the degree of stock undervaluation. This signaling cost is ultimately borne by the nontendering shareholders. As the management normally pre-commits to refrain from
tendering to enhance the signaling power, false signal through excess premium
ultimately reduces their own wealth.
Dividend pay-outs and stock repurchase entail cash outflows and have similar
informational content. The dividend pay-outs provide regular informational
reinforcements of the underlying ability of the firm to generate earnings. A stock
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repurchase is not a regular event and is taken as a strong pointer on the degree of
undervaluation. Hence stock repurchase is considered to have a greater signaling power
than regular dividend pay-out.
STRATEGIC FRAMEWORK FOR DISTRIBUTION OF EARNINGS
A firm that intends to distribute cash to its shareholders can do so by way of dividend
pay-out or stock repurchase. The MM hypothesis has demonstrated that under perfect
capital market settings, the investors would be indifferent between dividends and
buy-backs. A number of exogenous factors like taxes, signaling, shareholder
heterogeneity, informational asymmetry and vulnerability of the company to hostile
takeovers influence the distribution decision.
Michael Brennan and Anjan Thakor have suggested a model for the choice of corporate
cash distribution. They postulate that dividends are likely to be the choice for smaller
distributions and tender offer repurchases dominate for larger distributions. Open market
purchases are favored for intermediate distributions. The essential insight of the model is
that pro rata share repurchases are functionally equal to dividends. In case of nonproportional repurchases, the lesser informed shareholders are left vulnerable to
expropriation by better informed shareholders. The cost of information acquisition being
constant, it pays only for the larger shareholders to become informed in a repurchase.
Thus it is the smaller shareholders who suffer the expropriation in a repurchase program.
Hence the smaller shareholders tend to prefer dividend pay-out, provided the tax rates are
not too high. As the size of the distribution increases, it pays more shareholders to become
informed in repurchase. If the votes of the potentially informed determines the outcome,
there will be a trend for open market repurchase for intermediate size distributions and
tender offer for large size distributions. This is because the redistributive gain per share
for the informed shareholders is a decreasing function of the fraction of the informed
shareholdings supporting open market but opposing tender offer.
HAVE THE BENEFITS OF DIVIDENDS DECLINED?
Having found evidence of the widespread decrease in the propensity of firms to pay
dividends, Fama and French concluded their article by suggesting that the benefits of
dividends may have declined over time. They mention three such benefits:
Dividends provide shareholders with periodic cash returns that can be used for
consumption. If dividends are not paid, many shareholders would be forced to
sell shares periodically to generate cash, and would thereby incur transaction
costs. However, if transaction costs for selling stocks have fallen over time, the
relative benefit of a dividend is correspondingly reduced.
Managers have increased their holdings of stock options that are not protected
against the price-reducing effect of a dividend, thus, they have a private
preference not to sanction dividend payments.
Dividends may be less essential as a tool of corporate governance because of the

advent of alternative mechanisms for controlling agency problems between
shareholders and managers.
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Dividend Policy
6.10 THEORIES OF DIVIDENDS

THE RESIDUAL DIVIDEND THEORY
The residual dividend theory focuses on the firms internal need for capital. Earlier we
mentioned that dividends reduce retained earnings, and therefore can force the sale of
additional stock when a company needs equity capital for projects. Further, we noted
that equity from new stock is more expensive than retained earnings because of flotation
costs.
Under the residual dividend concept, companies recognize the cost effectiveness of
retained earnings, and fund the equity portion of all viable projects with earnings before
paying any dividends. Anything leftover is paid out as a dividend. The term residual
comes from this leftover status of the dividend.
The residual theory has an intuitive appeal, but it is not the way most companies work.
Most management sees a value in dividends and set them aside first rather than last.
Further, most companies can come up with a virtually unlimited number of capital
projects that look good on paper. As a result, a firm that truly adhered to the residual
theory might never be a dividend.
THE SIGNALING EFFECT OF DIVIDENDS
Rightly or wrongly, financial markets have come to read a great deal of information into
the payment or non-payment of a dividend. Indeed, the dividend is viewed as a way for
management to send a message to its shareholders. People seem to have more faith in
the message carried by dollars and cents than in spoken words. The phenomenon is
called the signaling or information effect of dividends, and is especially significant
when earnings change.
If earnings turn down, the continuation of a regular dividend is viewed as a statement
by management that the business is fundamentally sound and that the downturn is
temporary. As a result, firms generally continue paying their normal dividends in the
face of temporary decreases in earnings. The message to shareholders is, EPS is off a
little, but dont worry about it. Things will be fine. In the long run, we expect to have
plenty of money, so heres your regular dividend.
In the same vein, an increase in the dividend is a stronger statement of managements
confidence in the future. An increase accompanying rising earnings is a statement that
the earnings improvement is expected to be permanent, and signifies a generally bright
future. An increase in the fact of a downturn is a clear attempt to allay stockholders
fears.
On the other hand, a decrease in dividends is taken as terrible news. It generally comes
after a sustained reduction in earnings, and tells the market that management does not
expect the company to have the cash it had in the past. Investors usually react negatively
and tend to sell off the stock, depressing its price. A decrease without an associated
decline in earnings is a more mysterious but nevertheless dark message that is not well
received either.
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As a result of all this, managements sometimes maintain or even raise dividends in an

attempt to forestall negative investor reactions to serious problems. This practice is
clearly inappropriate.
The signaling effect is very real and makes it difficult to tell what investor preferences
for cash dividends really are. For example, suppose a firm has steady earnings but
reduces its regular dividend, explaining to stockholders that it needs more money for
capital projects. In spite of the explanation, the stocks price drops.
Is the drop due to the fact that investors prefer a higher dividend, or is it because they do
not quite believe managements explanation and suspect operationing problems are
coming? It is very difficult to tell.
THE EXPECTATIONS THEORY
The expectations theory is a refinement of the signaling effect. It says that investors
form expectations of what a companys next dividend will be and can become alarmed
if those expectations are not met, even if the dividend actually paid is steady or
increasing.
THE MECHANICS OF DIVIDEND PAYMENTS
Key Dates: Every quarterly dividend has four key dates associated with it.
The Declaration Date: The amount of each quarterly dividend is authorized by the
firms board of directors. A separate authorization occurs every quarter even if the
firms policy is to pay the same amount repeatedly. The date on which the board
authorizes the dividend is called the declaration date.
The Date of Record: Stocks are registered securities, meaning that a list is kept
indicating the name of the owner of record of very share. When a share is sold,
ownership is transferred on the record from the seller to the buyer. When the board
authorizes a dividend, it stipulates a date of record. The dividends is payable to owners
of record as on the date of record.
The Payment Date: The board also stipulates the date on which the dividend check is
to be mailed. This is the payment date.
The Ex-dividend Date: When shares are sold, it can take a few days to update the
ownership records, so a sale made shortly before the date of record might not be
recognized for payment purposes. To allow for a paperwork lag, brokerage firms have
agreed to cut off sales for dividend purposes four business days prior to the date of
record. The cutoff is called the ex-dividend date.
TYPES OF DIVIDENDS AND THE DIVIDEND PAYMENT PROCESS
Types of Dividends
Dividends are paid by firms generally in the form of cash or additional stock.
Occasionally, a firm pays an extra or special cash dividend, which may not necessarily be
intended to be a recurring event. The most common cash dividend is the regular quarterly
cash dividend. Some firms pay a stock dividend, either in addition to or instead of a cash
dividend. Stock dividends that involve a larger percentage distribution of additional stock
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Dividend Policy
are called stock splits. For instance, say a firm may declare a 2-for-1 stock split, in which
each shareholder receives an additional share for each share he owns. In this case, the
market value of each share should fall by 50%. In another case suppose a firm declares a
5% stock dividend (20%), so that a shareholder receives 1 new share of stock for each 20
shares that he or she owns. This stock dividend actually represents a dilution of the market
value of each share. Let us see its implication in an ideal capital market. In an ideal capital
market, after the 5% dividend is paid to the shareholders, the market value of each share
should decrease by 5%. However, each shareholder has 5% more shares, so the total value
of their shares remains unchanged.
The Dividend Payment Process
The process of paying out dividend initiates with a decision by the firms board of
directors to declare a dividend. The date of the boards vote to declare a dividend is
called the declaration date. Apart from declaring the type and amount of the dividend,
the board determines the date on which the dividend is to be distributed or paid (the
payable date), and the date on which the payment of the upcoming dividend (the record
date) is to be made. Further the date of the ex-dividend day or ex-day is also
determined. The ex-dividend day is related to those stocks that trade publicly. For these
stocks an earlier date must then be established on which new purchasers of the stock
will no longer have the right to the upcoming dividend. In other words, they will not be
an owner of record with respect to the upcoming dividend.
Dividends Versus Earnings: The Smoothing Phenomenon
A firms management must make its decisions on cash dividends within the context of
overall equity management. The practical implications of dividends on a firms equity
are as follows:
a.
Dividends reduce the amount of internal equity available for future investments,
b.
Dividends increase the probability that the firm will have to sell new equity if
new investments should be funded with equity, and
c.
Dividends increase the firms leverage, if the firm has debt.
These effects suggest that a typical firm would pay a dividend that is highly volatile
over time, for a variety of reasons. First, the typical firms profitable investment
opportunities and therefore consequently its need for internal funds vary considerably
over time. Second, equity offerings can be expensive and perhaps should be avoided.
Third, most managers are concerned about their firms leverage, which will tend to be
higher if dividends are paid than if they are not. These reasons bolster a traditional
argument that a firm should adopt a residual dividend pay-out policy, or in other words,
dividends should be paid only if the firm has excess cash after all of these concerns are
taken into account.
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LINTNERS DIVIDEND SMOOTHING MODEL

In contrast to the arguments made above, firms that pay dividends appear to go to great
pains to smooth dividends over time, especially relative to earnings. This smoothing
tendency was first modeled and empirically documented by Lintner (1956).
Lintners model of the co-dynamics of a firms earnings and dividends is depicted in the
following equation:
DIVt DIVt 1 = DIVt = DIVt = ( X EARN t DIVt 1 )
(12)
Where,
is the firms long run target pay-out ratio, and
r is a speed of adjustment coefficient.
If = 1, dividends are always equal to the fraction of current earnings. If < 1, the
firm only partially adjusts dividends to deviations of current earnings from the trend.
Let us now take a numerical example.
Illustration 5
Suppose a firm ABC paid a dividend of Rs.2 per share last year, and this year the firm
posted per-share earnings of Rs.5. The firms target pay-out ratio is = 0.50, and the
value of the firms speed of adjustment coefficient is = 0.2. What is the firms
dividend for this year? The value of the dividend for this year is found to be Rs.2.10.
Alternatively, if the value of the firms speed of adjustment variable is = 1.0, its
dividend this year would be Rs.2.50.
Lintners Model in Regression Form
Equation 8 can be modified by dividing through by DIVt1 and rearranging the terms in
the equations thus the resulting equation yields,
DIVt DIVt-1
*EARN t
= +
DIVt-1
DIVt-1
(13)
This specification allows us to see that the percentage change in a firms dividend
depends on (a) the firms current earnings relative to the previous dividend, and (b) the
parameters r and .
For instance, if the firm had no current earnings (i.e., EARNt = 0), then dividends
would fall by the percentage rate of r. Generally, dividends would fall in all instances
in which x EARNt < DIVt1, would remain unchanged if x EARNt = DIVt1 and
would rise if x EARNt > DIVt1.
The advantage of (8.13) is that it is in the form of a regression equation, i.e. without an
error term. The dependent variable in the equations is the percentage change in the
firms dividends, the intercept is P rho or r, the independent variable is
[EARNt/DIVt-1], and the slope of coefficient is r x . This regression form of the model
will now be used in the empirical analyses in the following section.
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Dividend Policy
DIVIDENDS, TAXES, AND TRANSACTION COSTS

Let us now focus on the review of theoretical argument and empirical evidence on the
effects of taxes on a firms dividend policy and the market value of its equity. The
following sections:
a.
Explain the basic possible effects of taxes and transaction costs on the dividend
decision,
b.
introduce the concept of a dividend clientele, and
c.
discuss two approaches to investigating whether a firms dividend policy affects

its market equity value.
TAXES AND TRANSACTION COSTS: CORPORATE AND PERSONAL

EFFECTS
To illustrate the effects of taxes and transaction costs on a firms dividend policy, let us
consider ABC Company, which has 1,00,000 shares outstanding. All of the firms
shareholders expect to receive regular cash income in the pre-tax amount of Rs.4 per
share per year, for consumption purposes. The market price of ABC stock is Rs.100 per
share. Further, because of the reason that the stock price has raised recently, all
shareholders face taxes on capital gains if they liquidate shares.
Each shareholder faces tax rates of = 39.6% on dividend income and = 28% realized
capital gains, and transaction costs of tc = 5% on any stock sales. Initially it is assumed
that the firm has no positiveNPV investments to pursue in the current year, and it has
the idle cash to pay dividends. If it does not pay dividends, idle cash is invested in zeroNPV investments such as Treasury bills.
Under these circumstances, let us determine whether the shareholders are better off if,
a.
The firm pays a Rs.4 dividend, or
b.
Each shareholder liquidates 4% of his shares.
If a dividend is paid, Shareholders receive Rs.2.416 after taxes

[Rs.2.416 = Rs.4 (1 0.396)].
If no dividend is paid, Shareholders liquidate 4% of their shares, receiving Rs.4 in
proceeds per share. After paying transaction costs of Rs.0.20 (i.e., 5% on each Rs.4 in
sales) and capital gains taxes of Rs.1.12 [= Rs.4 x 0.28], they net Rs.2.68 by a slim
margin, the shareholders are better off if the firm does not pay a dividend.
However, if either shareholders tax rates on dividend income and capital gains, or the
transaction cost for selling shares is altered, shareholders preference regarding
dividends could easily change.
Now suppose ABC has positive NPV projects in the current year, which must be funded
with equity. If the firm pays dividends totaling Rs.4 million, it must raise this amount
by selling new equity. Assuming that issuance costs for new equity are 12% of
87
proceeds, then the resulting issuance costs would be 12% of Rs.4 million, or
Rs.4,80,000. Hence, the market value of pre-issuance shares would fall by Rs.0.48 per
share to Rs.99.52, reflecting the issuance decision. In effect, shareholders receive the
net only of Rs.1.936 (= 2.416 0.48) from the payment of the dividend, as compared to
Rs.2.68 from personal stock sales, as calculated earlier. In this case, shareholders are
much better off if the firm refrains from paying a dividend. This illustrates one reason
why firms with profitable investment opportunities generally refrain from paying
dividends.
DIVIDEND CLIENTELES
As it has been observed in the above example, personal taxes, shareholders liquidity
needs, transaction costs (applicable to both for shareholders and for the firm), and the
firms investment opportunities all affect investors preference for dividends. On one
hand, the individual investors, as well as pension funds, may face low or no taxes and
prefer dividends for the income they provide. On the other hand, the other investors face
low effective tax rates because they are invested in a tax deferred retirement plan, and
these investors do not need dividends for current income.
On the other hand, many high-income investors are in high tax brackets, have long
investment horizons, and have no need for additional cash income. Such investors
would prefer to hold stocks that pay little or no dividends, and will engage in a buy-andhold strategy to minimize capital gains taxes. Finally, other investors may be in either
low or high tax brackets, but require dividends for cash income.
Such differential preferences for dividends naturally lead to dividend clienteles.
A dividend clientele is a set of investors who are attracted to the stocks of firms that
have the dividend policy they prefer, based on their tax or liquidity circumstances. This
suggests that a given firm may be able to increase its market value if it adopts a
dividend policy that appeals to investors whose preferences are not satisfied by firms
currently in the market.
However, if existing firms collectively satisfy all dividend clienteles, no individual firm
can affect the market value of its equity by adopting any particular dividend policy, a
condition called dividend clientele equilibrium. Nevertheless, managers should monitor
the changing desires of investors with respect to dividend policy, because they may be
able to identify an unsatisfied clientele, adopt the policy that they desire, and thereby
enhance market equity value.
For two reasons, it is important for a manager to know whether the firms dividend payout policy attracts particular investors via the clientele effect. First, according to the
clientele hypothesis, the firms dividend policy influences the firms ownership
structure, at least in terms of the type of investors who are attracted to the firms shares.
Second, as we discuss later, a firms dividend policy can affect the equilibrium expected
return on the firms stock, and thus the firms cost of equity capital.
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Dividend Policy
The tax advantages of a share repurchase do not apply to all investors. A large
percentage of investors are tax exempt (for example, pension funds and university
endowments). As previously demonstrated, these investors are indifferent between
receiving dividends and having the firm repurchase shares when there are no transaction
costs. In reality, however, transaction costs do exist. Shareholders and the firm must pay
brokerage fees as part of a share repurchase. Also, shares repurchased with a tender
offer usually carry underwriting fees and registration costs. Although these transaction
costs are small relative to the tax gains enjoyed by taxable investors with repurchases,
they might lead tax-exempt investors to prefer dividends.
Corporations that hold shares in other corporations may also prefer dividends to share
repurchases since only 30% of their dividend income is taxable while their capital gains
are fully taxed. Large investors who hold their shares within a corporate form also may
prefer dividends to a share repurchase. In addition, many individuals and institutions
that receive income from trust funds may prefer higher dividend-paying stocks if the
beneficiary of the trust is allowed to spend the income but not the principal of the trust.
It is also suggested by many that different firms have different dividend pay-out ratios
to appeal to different investor clienteles; that is, different groups of investors with
different tastes for receiving dividend income. Firms that pay no dividends are likely to
attract individual investors in high tax brackets while firms that pay large dividends are
likely to attract tax-exempt institutions, individual investors in low marginal tax
brackets, and corporations attracted by the dividend tax preference.
Empirical tests by Pettit (1977) and Lewellwn, Stanley, Lease, and Schlarbaum (1978)
provide evidence that the dividend yields of investors portfolios are indeed related to
their marginal tax rates. Investors with high marginal tax rates tend to select stocks with
low dividend yields and investors with low or zero marginal tax rates tend to select
stocks with high dividend yields. Firms, however, do not appear to vary their dividends
in order to satisfy the demands of different tax clienteles. Dividend policies of similar
firms usually exhibit great similarity. This makes it extremely difficult for investors to
specialize in terms of dividend yields for their portfolios and still diversify their
portfolios adequately. For example, an investor in a high tax bracket would find it very
difficult to find a utility with a low dividend yield while an investor with a desire for
dividends would find it equally difficult to find a biotech firm with a high dividend
yield.
CAN INDIVIDUAL INVESTORS AVOID THE DIVIDEND TAX?
Miller and Scholes (1978) claimed that individual investors should be indifferent
between repurchases and dividends because they can avoid the tax on dividends. Their
dividend tax avoidance scheme is quite simple: An individual borrows money and
invests in tax-deferred insurance annuities. The interest on the loan is tax deductible and
can offset the taxable dividend income but not the individuals labor income. However,
the tax on the insurance annuity can be deferred indefinitely. These transactions are
illustrated in the following example.
89
Box 8: Deferring the Dividend Tax

Illustration: Mr. Raj has Rs.12,000 in dividend income. How can he defer the taxes on this dividend if he
can borrow at 6% and insurance annuities pay an interest rate of 6%?
Solution: Elliot should borrow Rs.2,00,000 at 6% and invest the proceeds in a tax-deferred insurance
annuity. By doing this, the tax on the Rs.12,000 dividend is deferred (since the dividend is offset by the
Rs.12,000 interest payment) until the money is withdrawn from the insurance annuity.
In reality, individual investors rarely avoid the dividend tax in the way that Miller and
Scholes suggest. Indeed, Feenberg (1981) found that individual investors paid over Rs.8
billion in taxes on dividend income in 1977. Similar findings by Peterson, Peterson, and
Ang (1985) indicated that individual tax returns included more than Rs.33 billion of
dividend income in 1979, which was slightly more than two-thirds of the total amount
of dividends paid by US corporations. Thus, since shareholders seem unable to avoid
taxes on dividends, the argument of Miller and Scholes fails to explain why
corporations continue to pay dividends given the tax advantages of share repurchases.
The Miller and Scholes insights may be useful for individuals wishing to reduce their
own taxes. However, deferring taxes may be more difficult in practice than in theory. It
requires, for example, that investors be able to borrow on the same terms that they
invest in the insurance annuity, matching investment horizon as well as rates. It also
assumes that there are no costs associated with such transactions.
DIVIDEND CLIENTELES AND THE INFORMATION CONTENT OF DIVIDEND
CHANGES
Can the Dividend Clientele Hypotheses explain variation in the markets reaction to
dividend change announcements? Bajaj and Vijh (1990) investigated this issue. They
found that the magnitude of abnormal returns (both positive and negative) to dividend
change announcements is positively related to the firms anticipated dividend yield, the
firms size, and the firms stock price. The authors interpret this evidence as follows.
Regarding the dividend yield relationship, dividends are clearly more important to
investors who hold high-yield stocks than they are to investors who hold low-yield
stocks. Therefore, dividend changes will have a more dramatic effect on the values of
high-yield stocks than low-yield stocks. The firm-size and stock-price relationships,
they argue, can be explained by recognizing that the flow of value-relevant information
is substantially less for small firms, which also tend to be low-priced stocks, than for
large firms (or, similarly, high-priced stocks). That is, for information-poor firms,
dividends are relatively more important as an indicator of the firms financial status.
TAXES AND THE EX-DIVIDEND DAY BEHAVIOR OF STOCK PRICES
One way to examine the effects of taxes on stock prices is to examine the change in the
firms stock price as it goes ex-dividend. In an ideal market, the price of a paying firms
stock should decrease by the amount of the dividend per share, denoted as DPS, at the
moment that the stock goes ex-dividend. However, tax effects may alter this conclusion.
Elton and Gruber (1970) developed a formal expression for the relationship between a
paying firms DPS and the difference between the firms stock prices before versus after
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Dividend Policy
the ex-day, denoted as (PB PA). This relationship is a function of tax rates for the
marginal investor in the stock. This relationship is
PB PA 1 p
=
DPS
1 pc
(14)
If pc < p for the marginal investor, the price-change-to-dividend ratio will be less than
one. By rearranging Equation 14, we can solve for the ex-day price change:
PB PA = DPS.
(15)
A Numerical Example
Suppose firm XYZ declares a dividend of DPS = Rs.3. The stock is held by investors
who share common tax rates of 36% and 18%. The ex-day price change should be
1 0.36
PB PA = Rs.3
= Rs.3[0.78] = Rs.2.34.
1 0.18
That is, the price should fall by 78% of the amount of the dividend per share.
Ex-Dividend Stock Price Movements
Let us consider the following example, which assumes that a dividend is taxed at an
investors personal income tax rate and that capital gains are not taxed at all.
TAX CLIENTELES AND EX-DAY PRICE CHANGES
Elton and Gruber also argued that investors will cluster into dividend clienteles
according to,
a.
The different dividend yields that stocks offer, and
b.
The different tax rates that individual investors face.
Investors who face high tax rates on dividends relative to capital gains will tend to hold
stocks with low dividends, whereas investors with low tax rates on dividends relative to
capital gains will tend to hold stocks with high dividend yields. As a result, the ratio of
ex-day price change to dividends, which is the implied tax rate differential according to
equation 14, should be inversely related to dividend yield; it should be low for high
dividend yield stocks and high for low dividend yield stocks.
The authors empirically examined the evidence to find the consistency with these
predictions. They found that the ratio of ex-day price change to dividend is less than 1.0,
on average. They further observed that firms with low dividend yields have high
implied tax rate differentials, while firms with high dividend yields have low implied
tax rate differentials. These results proved to be consistent with the clientele hypothesis.
Apart from the above theory that has been postulated, numerous empirical studies have
challenged Elton and Grubers analyses. As a result of these studies, a couple of
important issues have emerged. First being, given that stocks are traded at discrete
prices that are largely governed by bid and ask prices and minimum tick sizes, it is
possible that the results first observed by Elton and Gruber could be due at least in part
91
to the fact that a stock price will tend to drop by less than the amount of the dividend
purely due to this price-discreteness effect, reference to this has also been made in the
papers authored by Bali and Hite (1998).
The other important issue that has surfaced is that, it may be unreasonable to assume
that the marginal trader in a given stock around the ex-day is always the one who has a
tax preference consistent with the stocks dividend yield. For instance, many
arbitrageurs have no preference for dividends versus capital gains. Kalay (1982), Eades,
Hess, and Kim (1985), Boyd and Jagannathan (1994), Lasfer (1995), Bali and Hite
(1998), Koski and Scruggs (1998), and Kalay and Michaely (2000) document evidence
suggesting that the ex-day behavior of stock prices may not be due to tax effects.
DIVIDENDS, EQUITY VALUE, AND THE COST OF EQUITY CAPITAL
Though the results that have been discussed on the ex-dividend day price behavior of
stocks casts doubt on the effects of dividend taxation on stock prices, it is still possible
that the equilibrium pricing of stocks reflects differences in the taxation of dividends
versus capital gains. The following equation adapted from Brennan (1970) and
Litzenberger and Ramaswamy (1979, 1980, 1982), reveals how the Capital Asset
Pricing Model (CAPM) can be modified to account for the tax-related effect of
dividends on a stocks equilibrium expected return:
ri = rf + i [rm rf ] + [dyi rf ]
(16)
Where,
ri and rm are the (pre-tax) expected returns on stock i and the market,
respectively,
rf
is the risk-free rate,
is the stocks systematic risk,
dyi
is stock is dividend yield, and
is the equilibrium tax premium per unit of dividend yield (in excess of
the risk-free rate).
Explanation
If investors demand a premium for the tax effect of dividends, then d > 0 should hold.
The value of d depends on the distribution of tax rates across investors, and also reflects
individual investors optimal holdings as a function of their tax rates (i.e., the tax
clientele effect).
Litzenberger and Ramaswamy (1979, 1980, and 1982) tested equation 16 using data on
US stocks over various periods from 1936 to 1980. They consistently found evidence
that the market demands a premium that is positively related to a stocks dividend yield.
They also document evidence of the clientele effect, as d is negatively related to
dividend yield. There have been numerous empirical studies that have tested the crosssectional relationship between dividend yield and stock returns. These studies have
generally found that after adjusting for risk, a stocks expected return is positively
related to its dividend yield.
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Dividend Policy
However, Chen, Grundy, and Stambaugh (1990) found that dividend yields over time
are related to changes in the investment opportunity set (e.g., the state of the economy
and the risk aversion of investors). After adjusting for this relationship, they found that
the return on a stock is not reliably related to dividend yield. Kalay and Michaely (2000)
document evidence of a positive relationship between expected returns and dividend
yield, but also provided evidence that casts doubt on the tax argument as the correct
interpretation of the results.
Fama and French (1998) recently conducted an intriguing empirical study of the effects
of dividends on the value of a firms equity. They analyzed the pricing of US firms over
the years 1965 to 1992. Their evidence indicates that dividends have information about
value that is missed by earnings, investment, Research and Development (R&D)
expenditures, and debt. The relationship between value and dividends is positive, a
result that is inconsistent with the argument that dividends reduce value due to tax
effects.
THE CROSS-SECTIONAL RELATION BETWEEN DIVIDEND YIELDS AND
STOCK RETURNS
If a firms dividend policy is determined independently of its investment and operating

decisions, the firms future cash flows also are independent of its dividend policy. In
this case, dividend policy can only affect the value of a firm by affecting the expected
returns that investors use to discount those cash flows. For example, if dividends are
taxed more heavily than capital gains, then, as noted earlier, investors must be
compensated for this added tax by obtaining higher pre-tax returns on high-dividend
yielding stocks. (They would not hold shares in such stocks and supply would not equal
demand if this were not true.)
Stocks with high dividend yields do, in fact, have higher returns, on average, than
stocks with low dividend yields. However, Blume (1980) documented that the
relationship between returns and dividend yield is actually U-shaped. Stocks with zero
dividend yields have substantially higher expected returns than stocks with low
dividend yields, but for stocks that do pay dividends, expected returns increase with
dividend yields. This finding is consistent with the idea that stocks with zero dividend
yields are extremely risky, but for firms that pay dividends, higher dividends require
higher expected returns because of their tax disadvantage.
To test whether a return premium is associated with high-yield stocks, a number of
studies estimate cross-sectional regressions of the following general form:
Rj = a + 1 j + 2Divyldj + j
(17)
Where,
j
= the firms beta,
Divyldj
= the firms expected dividend yield, and
= the error term.

93
The hypothesis is that g2, which measures the effect of dividend yield on required
returns, is positive to reflect the tax disadvantage of dividend payments, and that g1, the
coefficient of beta, is positive to reflect the effect of systematic risk on returns. Most of
these studies found that the coefficient of the expected dividend yield was positive,
which they interpreted as evidence favoring a tax effect. These interpretations assume
that the beta estimates used as independent variables in the regression equation (17)
provide an adequate estimate of the stocks risks. However, finance academics find
weak support for the idea that market betas provide a good measure of the kind of risk
that investors wish to avoid. Distinguishing between tax and risk effects is further
compounded by the relation of the dividend yield to other firm characteristics that are
likely to be related to risk and expected returns. For example, Keim (1985) showed that
both firms paying no dividends and firms paying large dividends were primarily small
firms paying large dividends were primarily small firms. In addition to being related to
firm size, dividend yield is correlated with a firms expected future investment needs
and its profitability both attributes that are likely to affect the riskiness of a firms
stock. Thus, it can be said that stocks with high dividend yields are fundamentally
different from stocks with low dividend yields in terms of their characteristics and their
risk profiles. Therefore, it is nearly impossible to assess whether the relation between
dividend yield and expected returns is due to taxes or risk. Since, it may be impossible
to detect whether paying dividends increases a firms required expected rate of return,
one cannot be certain that a policy of substituting share repurchases for dividends will
have a lasting positive effect on the firms share price.
HOW DIVIDEND POLICY AFFECTS EXPECTED STOCK RETURNS
We have asserted that share repurchases provide a better method of distributing cash
than dividends because most investors prefer capital gains income to an equivalent
dividend taxed at a higher rate. Stocks with higher dividend yields, to compensate
investors for their tax disadvantage, should thus offer higher expected returns than
similar stocks with lower dividend yields. Firms with higher dividend yields, but
equivalent cash flows, should then have lower values, reflecting the higher rates that
apply to their cash flows.
Researchers have taken two approaches to evaluate the effect of dividend yield on
expected stock returns. The first approach measures stock returns around the date that
the stock trades ex-dividend. The ex-dividend date (or the ex-date) is the first date on
which purchasers of new shares will not be entitled to have an ex-dividend date of
February 5, which means that purchasers of stock on and after February 5 will not
receive the dividend. Since investors who purchase the stock before the ex-dividend
date (February 4 or earlier in this example) receive the dividend while those who
purchase stock on or after this date do not, the decline in the stock price on the
ex-dividend date provides a measure of how much the market value the dividends. The
second
approach
cross-sectionally.
94
measures
how
dividend
yield
affects
expected
returns
Dividend Policy
DIVIDENDS AND PRINCIPAL-AGENT CONFLICTS
In reality there are two principal-agent problems that can be associated to a firms
dividend policy. These are the free cash flow problems and the other problem deals with
the incentive of a levered firm to expropriate wealth from its creditors. Let us see some
of the literature that has been devoted to the influence of these problems on a firms
dividend policy.
DIVIDENDS AND THE SHAREHOLDER-MANAGEMENT CONFLICT
One of the fundamental principal-agent problems between shareholders and

management is the one that involves the free cash flow problem (Jensen 1986). The
problem stems from managements private incentive to increase the size of the firm.
Management has this incentive for two reasons. First, senior managers salaries are
closely tied to firm size, so if they can succeed in simply making the firm larger
(presumably even at the expense of profitability), their salaries will be higher. Second, if
in the process of making the firm larger the firm becomes very complex, it becomes
more difficult for incumbent management to be fired and replaced by new management,
thus serving the incumbent managements entrenchment incentive.
One way in which management can build a large and complex empire is to refrain from
paying dividends; instead, they use excess cash to invest in unprofitable projects and
acquisitions. This problem is most severe for highly profitable firms that have relatively
few profitable investment opportunities. Managements ability to pursue empirebuilding by refraining from paying dividends is limited by internal and external
governance mechanisms. Internally, the firms board of directors, if they have the
gumption, can discipline management by forcing the firm to pay dividends. Externally,
the market for corporate control induces managers to pay at least a minimum amount of
dividends to prevent outside intervention (see Zwiebel 1996; Warther 1997; Myers
2000). Hence, we have a rationale for dividends despite the possible adverse tax
consequences.
The empire-building problem is less severe for firms that are either unprofitable or have
profitable investment opportunities whose required expenditures equal or exceed the
firms available internal funds. In either case the firm has no free cash flow. For such
firms, there is no rationale for dividends based on a management-shareholder principalagent conflict, so, given the adverse tax effects of dividends, it is optimal to pay little or
no dividends.
Dividends and the Shareholder-Creditor Conflict
It has been often observed that, when a firm has risky debt outstanding, the firms
management, acting in shareholders interest, has an incentive to take actions to
expropriate wealth from the firms creditors. One means of expropriation is to increase
dividends. By increasing dividends, the firm has fewer assets against which creditors
have a (priority) claim, and thus the value of a creditors claim is lower than if the firm
did not pay dividends.
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Myers (1977) underinvestment problem also comes into play if the firm is levered.
If the firm has both risky debt outstanding and profitable investment opportunities,
management, acting in the interests of shareholders, may forgo profitable investments if
they provide no benefit to shareholders because they also benefit creditors. Instead, the
firm will pay dividends.
These problems lead creditors to demand a contract covenant that restricts the amount
of dividends that the borrowing firm can pay. Such restrictions can serve both to protect
creditors and to mitigate the underinvestment problem.
a.
What is the essence of dividend preference theory?

.
.
.
b.
Is dividend pay-out termed as irrelevant factor in the market valuation of firms?

.
.
.
Dividends and the Interaction of Shareholder-Management and ShareholderCreditor Conflicts
The two dividend-related principal-agent problems as noted above are not independent.
Suppose a levered firms board of directors seeks to increase dividends both to
discipline management and to expropriate wealth from creditors. At the same time,
creditors, acting in their own interests, seek to decrease dividends. A serious conflict
may emerge among competing stakeholders over the firms dividend policy. For a
profitable, levered firm, the conflict over dividend policy may be particularly severe
between the firms management and the board. This is so because management and
creditors both prefer lower dividends and lower leverage (though for very different
reasons), while the board presses for higher dividends and higher leverage, both of
which are disciplining devices (i.e., both dividends and debt payments soak up free cash
flow) (see Jensen, Solberg, and Zorn 1992).
Additional Agency Issues Relating to Dividend Policy
Rozeff (1982) developed a model of a firm that chooses its dividend pay-out ratio to
minimize the sum of agency costs and transaction costs. The former is a decreasing
function of insider ownership percentage, while the latter is an increasing function of
the dividend pay-out ratio. The model shows that an increase in insider stock ownership
leads to lower agency costs and, thus, to a lower optimal dividend pay-out ratio. Rozeff
argues that dividend pay-out and insider stock ownership are substitute mechanisms to
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Dividend Policy
control agency costs. Thus, firms with high insider ownership can have low dividend
pay-out, but firms with low insider ownership must have high dividend pay-out. These
predictions appear to be consistent with casual observation, as small firms tend to have
high insider ownership and low (or no) dividend pay-out, while large firms have low
insider ownership and (relatively) high dividend pay-out.
Schooley and Barney Jr. (1994) further develop Rozeffs model. They argue that the
substitution between insider ownership and dividend pay-out works only for lower
levels of insider ownership. Beyond a critical insider ownership percentage,
management entrenchment starts to occur, which tends to increase agency costs of
managerial discretion. Thus, one should observe a non-monotonic relationship between
dividend pay-out (or dividend yield) and insider ownership. At lower levels of insider
ownership, the inverse relationship holds; at higher levels, dividends must increase
again to mitigate agency costs of entrenchment. The authors document evidence
consistent with this non-monotonic relationship.
Separately, a generalization of Rozeffs substitution argument appears to have power to
simultaneously explain two major developments regarding US firms over the last 20
years. First, several new mechanisms have emerged to mitigate agency costs of
managerial discretion. These include:
a.
Advancements in incentive devices in managers compensation contracts,
b.
An increase in the effectiveness of boards of directors,
c.
The emergence of the takeover market, and
d.
The increasing institutionalization of stock ownership, which may increase

monitoring. Second, the propensity of firms to pay dividends has decreased
markedly in the past 20 years. Perhaps the new mechanisms have partially
supplanted the role of dividends in mitigating agency problems.
Easterbrook (1984) argued that dividends provide two valuable functions in an agency
context. The first function is that dividends, keeping firms in the capital market, where
monitoring of managers is available at lower cost. Keeping the firms capital investment
policy fixed, as dividends increase, the firm will have to enter the market more
frequently to issue either debt or equity securities to new investors. New investors are in
a better position to monitor the firms management because, when it issues new
securities, the firms affairs will be reviewed by an investment banker or some similar
intermediary acting as a monitor, this will enable the new managers to examine
managers behavior before investing, and they will not buy new stock unless they are
offered compensation (in the form of reduced prices) for any remediable agency costs of
management. Coupled to this, if this is the major function of dividends, then dividends
would not be closely tied to earnings. Because the first function of dividends is to keep
firms in the capital markets, one would not expect to see a very strong correlation
between short-term profits and dividends.
97
The second function of dividends according to Easterbrook is that they may be useful in
adjusting the level of risk taken by managers and the different classes of investors. For
this argument, the author assumes that the firms manager is risk averse and
undiversified, and that the firm has debt outstanding. The managers situation induces
him or her to reduce the riskiness of firms equity so as to reduce the risk that the firm
will go bankrupt and the manager will lose his or her job. One way to reduce risk over
time is to refrain from paying dividends (even out of excess cash) because, as equity
builds up in the firm, the leverage, and thus the firms risk of bankruptcy, falls. But such
actions benefit creditors at the expense of shareholders. Thus, a judicious amount of
dividends can serve to maintain the firms leverage and thus minimize inadvertent
expropriation from shareholders to creditors.
6.11 INFORMATION ASYMMETRY AND SIGNALING WITH

DIVIDENDS
A signaling model is based on the idea that firms with exceptionally high value cannot
easily convey that value to the market for two reasons. First, they cannot convey valuerelevant information directly because such information is generally strategic in nature,
and thus communicating it to public shareholders is tantamount to divulging it to the
firms competitors. Second, it is difficult to devise a credible signal of the firms value
relative to that of other, weaker firms, because weaker firms have an incentive to mimic
any such signal so that their stock too would receive a higher valuation in the market.
Thus, a high-value firm must devise a credible and affordable signal of its higher
valuation one that lower-value firms would find prohibitively expensive to mimic. If
the signal is successful, a separating equilibrium is obtained.
Several authors have developed theoretical models in which dividends are an effective
signal of a firms true value in a market beset by information asymmetry. As in every
signaling model, the signal must be costly so as to prevent mimicking. In the models
that have been developed, the reason why dividends are a costly signal varies. In
Bhattacharyas (1979) model, the cost of the signal is the increased probability of
bearing costs of issuing shares in the future. The cost of dividends in Miller and Rocks
(1985) model is forgone investment in profitable projects. In John and Williams (1985)
and Bernheims (1991) models, the cost of the signal is higher taxes on dividends
relative to capital gains.
DIVIDEND CHANGES AND INFORMATION CENTER
Empirical studies have consistently found that, on average, the market reacts positively
to dividend increase announcements, and negatively to dividend cuts. Thus, dividend
changes appear to convey information to the market.
Interpreting the Evidence
What information is conveyed by a dividend change? The most straightforward

interpretation of the evidence is that a dividend change reveals new information to the
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Dividend Policy
market about managements assessment of the firms long-term earnings prospects.

Indeed, the idea behind Lintners dividend smoothing model is that a firms
management will increase dividends only when they believe that the firms permanent
earnings have increased. But this does not imply that dividend policy is relevant, as
Miller and Modigliani (1961) argued: That is, where a firm has adopted a policy of
dividend stabilization with a long-established and generally appreciated target pay-out
ratio, investors are likely to (and have good reason to) interpret a change in the
dividend rate as a change in managements views of future profit prospects for the firm.
The dividend change, in other words, provides the occasion for the price change though
not its cause, the price still being solely a reflection of future earnings and growth
opportunities.
At least three facets of agency theory explain the basic empirical results. First, a
dividend increase reveals that the firms governance mechanisms (e.g., the board) have
succeeded in curbing managements penchant for empire building, and a dividend cut
reveals the opposite. Second, a dividend increase indicates that threats from the external
market for corporate control have persuaded management to disgorge free cash flow,
and a decrease means the opposite. Third, a dividend increase for a levered firm
constitutes an expropriation of wealth from the firms creditors, and a decrease means
the opposite.
Theory also suggests that in some cases a dividend increase is bad news, while a
dividend decrease is good news. For instance, a firm may decide to cut its dividend
because management is planning to increase its capital expenditures in pursuit of
profitable investments of which the market was unaware. Conversely, a dividend
increase could indicate that a firms supply of profitable projects has dried up.
DIVIDEND CHANGES AND FUTURE PROFITABILITY
Early studies by Watts (1973) and Gonedes (1978) found no evidence that dividend
changes are related to a firms future earnings. More recently, Benartzi, Michaely, and
Thaler (1997) also find no evidence that dividend-increasing firms have higher earnings
going forward. Moreover, consistent with Lintners model on dividend policy, firms
that increase dividends are less likely than nonchanging firms to experience a drop in
future earnings. Thus, their increase in concurrent earnings can be said to be somewhat
permanent.
The Primary Question
Brook, Charlton, and Hendershott (1998) addressed the following basic question: Do
firms that increase their dividends subsequently experience an increase in cash flow?
The answer to this question is summarized as follows:
It has been found that firms poised to experience large, permanent cash flow increases
after four years of flat cash flow tend to boost their dividends before their cash flow
jumps. These firms also have a high frequency of relatively large dividend increases
prior to the cash flow shock. Investors appear to interpret the dividend changes as
99
signals about future profitability: Firms that sharply increase their dividends earn large
market-adjusted stock returns in the year before their cash flow rises. This direct link
between positive cash flow shocks, dividend decisions, and stock returns supports the
hypothesis that dividend changes signal positive information about permanent future
cash flow levels. However, the results also suggest that signaling plays a relatively
minor role in corporate dividend policy.
DIVIDEND CHANGES AND SUBSEQUENT CAPITAL EXPENDITURES
Yoon and Starks (1995) attempted to determine the source of the wealth effects
surrounding dividend change announcements by pursuing two essentially competing
hypothesis. On the one hand, a dividend increase (or vice versa, a decrease) may
represent managements signal that the firms investment opportunity set has improved (or
vice versa, deteriorated), and as such the firm will be more (or less) profitable in the
future, and therefore will be able to support a higher (or only a lower) dividend. This Cash
Flow Signaling Hypothesis (originally espoused by Miller and Modigliani in 1961)
reveals a positive relationship between dividend changes and capital expenditure
changes.
On the other hand, the Free Cash Flow Hypothesis reflects that a dividend increase is
good news because it means that the firms management is being disciplined to pay a
higher dividend, and therefore in the future will tend to reduce its (largely wasteful)
capital expenditures, whereas a dividend decrease is bad news because it suggests that
management will have greater flexibility to waste free cash flow on unprofitable
investments. As such, the Free Cash Flow Hypothesis posits a negative relationship
between dividend changes and subsequent capital expenditures. Because these
hypotheses provide opposing predictions about the relationship between dividend
changes and subsequent changes in capital expenditures, Yoon and Starks devise an
effective test to distinguish these two hypotheses. They found that dividend changes are
positively related to subsequent changes in capital expenditures; thus, the results are
consistent with the Cash Flow Signaling Hypothesis.
DIVIDEND CHANGES AND WEALTH REDISTRIBUTIONS
For a levered firm, there exists two alternative hypotheses about the markets positive
and negative reactions to announcements of a dividend increase and a dividend
decrease, respectively. The first is the Information Content Hypothesis, which posits
that the announcement conveys information about the value of the firm that it is
higher than the market expected in the case of a dividend increase, and lower than
expected in the case of a cut. The second is the Wealth Redistribution Hypothesis: A
dividend increase constitutes an expropriation of wealth from the firms creditors to the
firms shareholders, while a dividend reduction induces an expropriation of wealth from
shareholders to creditors.
Both hypotheses predict that a firms stock price will move in the same direction as the
announced dividend changes. However, they represent competing hypotheses about the
effect of a dividend change on the price of the announcing firms bonds. The
Information Content Hypothesis predicts that bond prices will move in the same
direction as the dividend change, because bondholders also benefit from an increase in
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Dividend Policy
the overall value of the firm. The Wealth Redistribution Hypothesis predicts that bond
prices will move in the opposite direction of the dividend change.
In the end, the effects predicted by these two hypotheses on bond prices probably work
in tandem. Even if a dividend change reveals information about the value of the firm in
the same direction, the price effect on bonds would be partially muted, for both dividend
increases and decreases, relative to the simpler case in which the firm reveals that its
value has increased or decreased, respectively (i.e., with no accompanying change in
dividends). This is because a dividend increase surely constitutes a strengthening of
shareholders claim on the firms future cash flows, ceteris paribus (all other things
equal), while a dividend decrease constitutes a weakening of shareholders claim.
Moreover, a firms bondholders anticipate expropriation from shareholders via dividends,
so they include covenants in the debt contract that restrict dividends in some manner. The
general effect of such restrictions is to allow a dividend increase if the firms value increases
(and management, acting in the shareholders interest, should always take advantage of such
a circumstance), and to force a dividend cut if the firms value decreases. Indeed, this
argument supports the Information Content Hypothesis to the extent that, at the time of a
dividend announcement, the market was unaware of the altered status of the creditorimposed restriction on dividends relative to the firms value.
DIVIDEND INITIATIONS AND OMISSIONS
A dividend initiation or omission is a radical change in a firms dividend policy. In this
sense, either of them is a more important, if more unusual, event than a mere change in
dividend amount. Below we briefly discuss several event studies of dividend initiations
and omissions.
Dividend Initiations
According to evidence from several empirical studies, the market generally welcomes a
firms announcement that it will initiate dividends. All studies have found that the
average announcement-period abnormal return is not only positive, but also quite
substantial. Asquith and Mullins (1983) identified 168 firms in the period 1964 to 1980
that either began paying dividends for the first time in their history or resumed paying
dividends after a hiatus of at least 10 years. The average two-day announcement-period
abnormal return on these firms stocks was +3.7%. This figure is several times larger
than the average abnormal return associated with dividend increases in general, which is
about 1 percent (e.g., Pettit 1972; Aharony and Swary 1980). The authors suggest that
the market reaction to dividend initiations is greater because a dividend initiation is
more of a surprise than a general dividend increase. They also found that abnormal
returns are positively related to the relative size of the initiated dividend. Venkatesh
(1989) found two interesting aspects of the post-announcement price behavior of firms
that initiated dividends. First, stock return volatility generally decreases after a dividend
is initiated. Second, the markets reaction to subsequent earnings announcement
diminishes after dividend initiation. His interpretation is that, after a dividend initiation,
the market focuses more on the firms dividend policy and less on earnings
announcements. Dyl and Weigand (1998) have a different interpretation of Venkateshs
101
evidence. They found that earnings volatility diminishes after dividend initiation. Thus,
they argue, The decrease in returns volatility and the markets diminished reaction to
earnings announcements are also consistent with firms having fewer earnings surprises
following the initiation of dividends. If earnings volatility and the number of earnings
surprises are reduced in the post-dividend period, one can also expect stock return
volatility and the markets reaction to earnings announcements to decrease. This
decrease in firm risk is what makes managers willing to initiate cash dividends.
Dividend Omissions
Dividend omissions are qualitatively different from dividend cuts because they
represent a change in dividend policy rather than simply amount. Several empirical
studies have found that the market generally reacts very negatively to a dividend
omission, including: Ghosh and Woolridge (1988); Healy and Palepu (1988); Christie
(1994); and Michaely, Thaler, and Womack (1995). For example, the dividend-omitting
firms in Christies sample were met with abnormal returns of 6.94%, on average.
Stock Repurchases
Stock Repurchases Mechanics
A firm can use any of three methods to repurchase outstanding shares. First, it can adopt
and execute an open-market stock repurchase program, whereby the firm conducts
open-market purchases of its shares, generally on a gradual basis over time. Second and
third, the firm can repurchase shares on a one-time basis, employing either the Dutch
auction self-tender method or the fixed-price self-tender method.
In the Dutch auction method, the firm solicits and collects sell offers from shareholders,
after establishing an acceptable range of offer prices. A shareholder can submit an offer
to sell a specified number of shares, at a specified price within the established price
range. If and when the requisite number of shares has been offered, the firm determines
the (share-weighted) average price of all offers, applies this price to all tendered shares,
and purchases all of them at that price.
In a fixed-price tender offer, the firm also solicits and collects sell offers from
shareholders. However, in this case the firm specifies and announces, in advance, both
(a) the price at which it will repurchase shares and (b) the total number of shares that it
will repurchase, where offers are considered in the temporal order received. Regarding
(a), the offer price in a fixed-price tender is invariably substantially in excess of the
current market price. Regarding (b), the tendering firm generally retains an option to
purchase additional shares in the event that the tender offer is oversubscribed.
Treasury Shares and the Potential Effects of Repurchases
By repurchasing its own shares, the firm reduces the number of its outstanding shares.
Repurchased shares become treasury shares, which can be resold later (e.g., in
conjunction with an executives execution of his or her stock options), or reissued as
compensation in an acquisition.
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Dividend Policy
Meanwhile, stock repurchases have at least six potentially important practical effects.
First, the firms assets are reduced, because a portion of the firms cash assets flows out.
Second, the firms equity base is reduced. Third, if the firm has debt outstanding,
leverage increases. Fourth, the firm is adding substantially to the demand for its shares
in the market, so the market of the firms stock may rise. Fifth, the firms active
involvement in the secondary market may enhance liquidity, as investors realize that
there is a ready buyer if they wish to sell. On the other hand, and sixth, repurchases may
reduce liquidity by reducing the number of free-floating shares, or by causing dealers in
the stock to increase their bid-ask spreads because they face the firm as an ongoing
informed trader (i.e., in the case of an open-market repurchase program).
Comparing Stock Repurchases to Dividends
We can compare stock repurchases to the payment of regular or special dividends,

because all involve cash flow from a firm to its shareholders, though under different
circumstances. Indeed, all are included under the purview of the firms pay-out policy.
However, as we mentioned earlier, stock repurchases differ from dividends in that cash
dividends are paid to all shareholders in equal amounts, and thus the market value of all
shares falls by an amount related to the per-share amount of the dividend, whereas in a
stock repurchase the firm uses cash to retire the outstanding shares of any investors who
choose to sell their shares to the firm. In addition, we recall that US tax law treats a
regular cash dividend as ordinary income, whereas by selling via a stock repurchase, the
investor creates a realized capital gain (or loss), just as if the investor sold his or her
shares to another investor in the open market.
From another perspective, we might argue that an open-market stock repurchase
program is more closely aligned to a regular dividend, and a Dutch auction or fixedprice tender offer repurchase is more akin to a special dividend. The former pair
compare because, like regular dividends, a stock repurchase program generally involves
a protracted outflow of cash from the firm to shareholders over time, though in neither
case is the firm legally obligated to continue the flow. The latter are comparable
because they are strictly one-time events.
Explaining the Markets Favorable Reaction to Stock Repurchase Announcements
Many researchers have conducted event studies of the markets reaction to a firms
announcement to repurchase shares. Early studies by Masulis (1980), Dann (1981), and
Vermaelen (1981), based on samples from the 1960s and 1970s, found substantial
positive average abnormal returns of about 16% to 17%. Later studies, based on
samples from the 1980s, document smaller but still very substantial average abnormal
returns of about 8%.
Hypotheses
Researchers have tried to explain these results by,

a.
Appealing to modern corporate finance theory, and

103
b.
Generating additional evidence either to test a particular hypothesis or to

distinguish among competing hypotheses.
Most authors have pursued one or more of the following three hypotheses:
i.
The Signaling Hypothesis based on information asymmetry theory;
ii.
The Free Cash Flow Hypothesis based on agency theory; and
ii.
The Expropriation Hypothesis, also based on agency theory.
The Signaling Hypothesis posits that a firms management, who possess private
information about the firms value, will conduct a stock repurchase if and when they
believe the firms stock is underpriced. This can be an effective signal (i.e., not easily
mimicked) simply because it is costly in terms of precious corporate cash. Therefore,
the stock repurchase decision reveals managements private information about firm
value, and specifically about its ability to generate cash in the future.
The Free Cash Flow Hypothesis applies here because the firm uses internal cash to
repurchase shares, cash that is paid directly to (selling) shareholders. Thus, management
has less surplus cash flow to pursue inefficient, empire-building, value-destroying
investments.
The Expropriation Hypothesis refers to the incentive of a levered firm with risky debt
outstanding to take actions that will shift value from the firms creditors to its
shareholders. In the present context, by reducing the firms assets and its equity base via
stock repurchases, the value of the firms debt will fall. Absent any other factors,
bondholders losses will be shareholders gains.
STOCK REPURCHASES VERSUS DIVIDENDS
Underpricing, Management Compensation, and Institutional Ownership
Bartov, Krinsky, and Lee (1998) identified and tested three factors that may determine a
firms choice between dividend increases and stock repurchases as means of distributing
cash to shareholders. The first is underpricing. A stock repurchase would be a more
effective means of taking advantage of, and eventually eliminating, the underpricing of
the firms stock in the market. The second factor is management compensation. Many
companies use stock options and stock appreciation rights as part of their compensation
packages for key employees. Unlike stock repurchases, which have no direct effect on
the value of these options, dividend payments reduce their value. Consequently,
managers who own stock options or stock appreciation rights may be more likely to
distribute cash to stockholders through an open-market repurchase.
The third factor is the extent of holdings by institutional investors. A number of
prominent institutional investors, notably Fidelity, have expressed a preference for stock
repurchases over cash dividends. One reason is that, for taxable investors, selling shares,
rather than collecting dividends, has a more favorable tax consequence. Therefore,
institutional investors who play an important role in the area of shareholder activism
will pressure firms to consider the income tax consequences to shareholders of their
pay-out policy.
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Dividend Policy
The authors examined 130 companies announcing the start of open-market repurchase
programs between 1986 and 1992, comparing them to other firms from the same
industries that did not initiate repurchase programs. As predicted, our findings suggest
that equity undervaluation, extensive use of stock options, and the level of institutional
holdings are all important contributors to corporate decisions to use open-market
repurchases along with (if not in place of) dividend increases.
Dividends and Repurchases as Alternative Signaling Devices
Several theoretical papers have addressed the issue of the relative usefulness of
dividends and stock repurchases as signaling devices. These include the models of
Asquith and Mullins Jr. (1986), Ofer and Thakor (1987), and Williams (1988). Here we
briefly discuss Ofer and Thakors model.
Ofer and Thakors model admits both dividends and (tender-offer) stock repurchases as
costly signals in an integrated framework. The authors determine conditions under
which a mispriced firm prefers one mechanism to the other. Dividends and stock
repurchases are both costly because they may necessitate external financing at a later
date. However, stock repurchases are more costly to the firms manager. This is so
because the manager has precommitted to owning a certain number of the firms shares,
so his or her fractional holding of the firms shares, and thus his or her personal risk
exposure, increases more after a repurchase than after a dividend.
Under these conditions, the model provides the following prescription for the choice
between dividends and repurchases:
When the disparity between the true intrinsic worth of an undervalued firm and its
market price is relatively low, the firm employs dividend-based signaling because the
incentive-compatible dividend is relatively small, implying that the associated signaling
cost is lower than that attached to a stock repurchase. However, when the true value of
the firm is very high compared with the cross-sectional average, a relatively large
dividend is needed for informationally consistent signaling. The attendant cost is
excessive, and the manager now finds repurchase a less costly alternative.
Consequently, only a firm that perceives a relatively large undervaluation will attempt a
stock repurchase. Smaller undervaluations will be rectified through dividend increases.
Repurchase Premiums as a Reason for Dividends
Chowdhry and Nanda (1994) developed a theoretical model that incorporates trade-offs
between cash dividends and stock repurchases as alternative means of distributing cash
to shareholders. Cash dividends involve a greater cost in terms of taxes; however, the
attractiveness of stock repurchases is inversely related to the market price of the stock
relative to its true value, the latter of which insiders know better than the market due to
information asymmetry.
Their model has several implications that are consistent with empirical evidence. First,
dividends are smoothed relative to earnings over time because a portion of unexpected
earnings is retained for future dividends and repurchases. Second, stock repurchases
will be sporadic, occurring only when the firms shares are substantially undervalued in
the market. As discussed earlier, repurchase premiums are generally substantial, so the
undervaluation must be substantial to justify a tender offer.
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Cash Flow Permanence, Financial Flexibility, and the Choice between

Dividend and Stock Repurchases
Three closely related empirical papers tested the Flexibility Hypothesis, a firm conducts
a stock repurchase to the extent its free cash flow is temporary and uncertain, and pays
(or increases) regular dividends to the extent that its free cash flow is more permanent
and reliable.
Jagannathan, Stephens, and Weisbach (2000) generated evidence that is consistent with
the Flexibility Hypothesis. Stock repurchases and dividends are used at different times
from one another, by different kinds of firms. Stock repurchases are very pro-cyclical,
while dividends increase steadily over time. Dividends are paid by firms with higher
permanent operating cash flows, while repurchases are used by firms with higher
temporary, non-operating cash flows. Repurchasing firms also have much more
volatile cash flows and distributions. Finally, firms repurchase stock following poor
stock market performance and increase dividends following good performance.
Guay and Harford (2000) examined firms that have either increased their dividends or
instigated stock repurchases, focusing on the nature of the commensurate change in
their cash flows. They find that firms that increased their dividends have a more
permanent increase in their cash flow, while firms that conduct stock repurchases have
had a more temporary increase in cash flow. They also find that the price reaction is
greater for a dividend increase announcement than for the announcement of a stock
repurchase program, which is rational given that the former implies a more permanent
increase in cash flows.
Finally, working in an agency framework, Lie (2000) simultaneously tested the
Flexibility Hypothesis and the Free Cash Flow Hypothesis by examining samples of
firms that either (a) increased their regular quarterly dividend, (b) paid a one-time
special dividend, or (c) made a self-tender offer to repurchase shares. He finds that all
three types of firms have relatively high levels of excess cash before these events. The
excess cash tends to be recurring in the case of the firms that increased regular
dividends, but is non-recurring for both the special dividend and share-repurchasing
firms.
Managerial Incentives and Corporate Pay-out Policy
Fenn and Liang (2000) employ agency theory to formally address linkages among three
of the major corporate finance developments of the past 20 years: the proliferations of
executive stock options, the relative decline in dividends, and the rise of stock
repurchase activity. The authors argue that, although executive stock options appear to
have served well to align managers and shareholders interests, they engender an
unfortunate and partially defeating incentive for managers to reduce dividends. This
incentive exists because the value of an executive stock option, like a call option, is
negatively affected by the value-leakage effect of dividends.
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Dividend Policy
The incentive is unfortunate and partially defeating because managers already have a
self-serving incentive to reduce dividends, as we have argued previously. Stock
repurchases, however, do not have this flaw, because they do not result in a fall in the
stock price. To the contrary, as we suggested earlier, stock repurchases increase the
overall demand for the firms shares in the secondary market, so they actually might
cause the price of the shares to rise, a result that is clearly desirable to executive holding
stock options. Thus, stock repurchases are likely to cancel senior managements selfserving desire to minimize the firms pay-outs, which is otherwise exacerbated if
management holds stock options.
Tax Clienteles and Dividends versus Stock Repurchases
Allen, Bernardo, and Welch (2000) developed a theoretical model to address the
question of why some firms prefer to pay dividends rather than to repurchase shares.
This seems puzzling given the evidence shown in figure 1 indicating that stock
repurchases are becoming more important than dividends as the firms pay-out means.
However, from a longer historical view, dividends clearly have been the more important
pay-out means. In any event, they develop their model to address this question.
Their model is built on two critical assumptions. First, they assume (for simplicity) that
two types of investors exist in the market,
a.
Individuals who face taxation of their investments, and
b.
Institutions that are untaxed.
Second, they assume that the untaxed institutions have a greater incentive, and therefore
a greater tendency, to become informed about a firms prospectus than do the taxed
individuals. An important implication under these assumptions is that a firm can attract
institutional investors by paying dividends. This will be so simply because, in an
equilibrium that spans both types of investors, the prices of dividend-paying stocks will
be lower (because the taxed individual investors, who influence the equilibrium price,
will demand a higher expected return on dividend-paying stocks due to the adverse tax
effects of the dividend), and therefore their expected returns will be higher.
Given these assumptions, the authors argue that a separating equilibrium can develop in
which good firms pay dividends and bad firms do not. That is, good firms pay dividends
deliberately to attract the scrutiny of institutional investors. They also develop an
agency model in which dividends exist to attract informed institutions whose presence
ensures that the firms will remain well run (p. 2501). In both the signaling model and
the agency model, dividends must be paid reliably to have the intended effect hence
the practice of smoothing dividends.
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6.12 SUMMARY
Dividend policy refers to the managements views regarding distribution of earnings to
their shareholders.
Graham-Dodd model postulates that the market price of a share is function of its
dividend and earnings.
Walter model contends that the market price of a share is the sum of the present value of
the future stream of dividends and the present value of the future stream of returns from
the retained earnings.
Gordon model values the share by capitalizing its future stream of dividends.
Modigliani and Miller propounds that the dividend pay out is an irrelevant factor in the
market valuation of firms.
The strategic determinants of dividend policy are liquidity, investment opportunities,
access to finance, floatation costs, corporate control, investor preferences, restrictive
covenants, taxes and dividend stability.
Lintner model states that the current dividend of a firm depends on its current earnings
and its past dividends.
Bonus issue, stock dividends, stock splits and share repurchases have strong signaling
effects on the market.
6.13 GLOSSARY
Pay-out Ratio is a part of equity earnings, which is distributed as dividends to the
shareholders.
Retention Ratio is a part of equity earnings, which is retained by a firm. This part is
ploughed back in the business to finance some capital expenditure in the future. It
serves as a long-term source of finance to a firm.
Dividend Policy is the views and practices of the management with regard to
distribution of earnings to the shareholders in the form of dividends.

Flotation Costs The costs which are incurred to raise capital such as the merchant
bankers, underwriting commission, brokerage, listing fees, marketing expenses, etc..[v1]
Brealey Myers. Principles of Corporate Finance. 6th ed. US: Mcgraw-Hill

James C. Van Horne, Financial Management and Policy. 11th ed. US: PrenticeHall, 1998.
Eugene F. Brigham, and Michael C. Ehrhardt. Financial Management Theory

and Practice. 12th ed. US: South-Western College Publishers, 2007.
Prasanna Chandra. Financial Management Theory and Practice. 6th ed. New
Delhi: Tata Mcgraw-Hill, 2004.
108
Dividend Policy
Apte, P.G. International Financial Management. New Delhi: TATA Mc Grawhill Publishing Company Limited, 2005.
Charles Moyer. R., James R. Mcguigan, and William T. Kretlow. Contemporary

Financial Management. 8th ed. Ohio (US): South-Western College Publishing
Company, 2001.

a.
Inverse relationship exists between retained earnings and cash dividend: larger
retention, lesser dividends; smaller retention, larger dividends.
b.
According to the Walter Model, when the return on investment is more than the
cost of equity capital, the firm would reinvest retained earnings at a rate which is
higher than the rate expected by the shareholders.
a.
The dividend preference theory maintains that generally stockholders prefer

receiving dividends to not receiving them. The argument is based on the
uncertainty of the future. It asserts that stockholders prefer current dividends to
future capital gains, because something paid today is more certain to be
received than something expected in the future. The idea can be put in
somewhat cynical terms by saying that stockholders do not trust management
to use the cash on hand today to grow the firm into something larger and more
valuable later on.
b.
Franco Modigliani and Merton Miller propound that the dividend pay-out is an
irrelevant factor in the market valuation of firms. They assert that the value of
shares is solely determined by real considerations i.e., the earning power of the
firm and its investment policy. The distribution of earnings in the form of
dividends has no bearing on the valuation of the firm. The proportion in which
the earnings are split between dividends and retained earnings has no affect on
the wealth of the shareholders.

A. Multiple Choice
1.
According to the Gordon model, when the rate of return is greater than the
discount rate ________.
a.
The share price falls as the dividend pay-out decreases.
b.
The share price rises as the dividend pay-out increases.
c.
The share price rises as the dividend pay-out decreases.
d.
The share price and dividend pay-out are independent.
e.
The share price just increases sharply and later increases at a declining
rate as the pay-out increase.
109
2.
3.
4.
A final dividend once declared_________.

a.
Creates a debt in favor of the shareholders in whose favor it is declared.
b.
Can be revoked with the consent of the shareholders
c.
Cannot be revoked
d.
Both (a) and (b) of the above
e.
Both (a) and (c) of the above.
The Graham Dodd model gives ___________.

a.
3 times more weightage to dividends than retained earnings
b.
3 times more weightage to retained earnings than dividends
c.
Same weightage to both dividends and retained earnings
d.
4 times more weightage to dividends in relation to retained earnings
e.
4 times more weightage to retained earnings in relation to dividends.
In accordance with the Efficient Market Hypothesis ________.

a.
Stock splits and Bonus issues are of absolutely no consequence to

investors
b.
Investors prefer corporate diversification through mergers etc. to personal

diversification through investment portfolios
c.
Timing of security issues is of the utmost importance
d.
Selling large quantities of securities will automatically depress prices

because of excess supply over demand
e.
New issues should preferably be underpriced to enhance shareholder

wealth.
5.
110
Under Walters model of dividend relevence, it is assumed that ________.

a.
New debt is not raised
b.
New equity is not raised
c.
Retained earnings represent the only source of finance for the firm
d.
Both debt and equity can be raised
e.
The firm does not use retained earnings to finance its investments.
Dividend Policy
B. Descriptive
1.
What are the different uses which the net earnings of a firm can be put to?
2.
Why do firms follow a policy of stable dividends?
3.
Why do investors prefer dividend incomes over the capital gains?
4.
What are the factors that influence the pay-out ratio of a firm?
practice only.
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UNIT 7 ALLOCATING CAPITAL AND

CORPORATE STRATEGY
Structure
7.1
Introduction
7.2
Objectives
7.3
Valuing Strategic Options with the Derivatives
7.4
The Ratio Comparison Approach
7.5
The Competitive Analysis Approach
7.6
Weighted Average Cost of Capital
7.7
Adjusted Present Value Approach
7.8
Combining the APV with the Real Option Approach
7.9
The Importance of Unlevered Cost of Capital for a Levered Firm
7.10
Summary
7.11
Glossary
7.12
7.13
Suggested Answers
7.14
Terminal Questions
7.1 INTRODUCTION
In the last two units, we discussed the ways in which capital is raised and earnings are
distributed. In this unit, we will discuss how to allocate the collected funds (capital) in
various projects. Investment in long term projects is not a simple task. The survival of
the firm depends on long term investments. The investments made in projects must be
evaluated at strategic points. There are various methods and models which help in
allocating capital and building corporate strategy.
7.2 OBJECTIVES
Know the valuation of strategic options with the derivatives;
Calculate cash flows associated with abandonment of projects;
Understand factors affecting the decision to abandon a project; and
Identify various methods of valuation.
Allocating Capital
and Corporate Strategy
7.3 VALUING STRATEGIC OPTIONS WITH THE DERIVATIVES

A lot of discussion has been made about the positive net present value of projects that
have been undertaken, but very little has been done in answering the question of what is
the real source of this positive net present value. Generally, the generation of the net
present values of the firms arise due to the existence of investments that are made
earlier in the project. It is a general practice of the firms to discount only those cash
flows that are directly attached to the project, in doing so they sometimes ignore the
total value of the project as such. Thus they fail to recognize that while adopting an
investment project may successfully lead to the generation of future investment
opportunities. But at the same time, it has been observed that many companies tend to
grow as a result of the benefits they reap out of past investments.
Sources of Competitive Advantage
Usually, the ability of a company to generate profits in a competitive market can be
attributed to the competitive advantages it enjoys over its competitors. These
competitive advantages arise out of certain factors that may be due to barriers to entry,
economies of scale, economies of scope, discounted cash flow, and options. Barriers to
entry results in preventing competition by other firms from eroding profits. Economies
of scale facilitates a company in taking advantage of larger production by decreasing the
per unit cost. Economies of scope is perhaps the most important source of competitive
advantage to a firm. It is generally seen that if at all any firm generates net positive cash
flow it has been only due to the opportunities that have been created because of earlier
investment decisions taken. It is also a known fact that firms rarely consider the indirect
cash flows that might come in future years and they focus mainly on the direct cash
flows associated with the project. Following this process may lead to serious
implications. It is important to note here that the use of the discounted cash flows may
give erroneous results. DCF is biased against long-term projects, this is because the use
of DCF involves the quantifiable parameters of the project thereby giving less
importance to the indirect cash flows.
Option Pricing Theory as a Tool for Quantifying Economies of Scope
Most investment projects include a certain number of options. This not only involves
the option of undertaking certain new projects but also options to cancel, downsize, or
expand the project.
Taking this decision depends on a number of factors which may include certain
underlying economic variables such as the demand for the product, the level of interest
rates, the health of the economy, the success of competitors, the political climate, and so
forth. These underlying variables have a direct effect on the values of many traded
securities, as well as the companys own stock.
Any continuing project that has been subject to alteration in its midway or even
subjected to further investment that was not earlier called for may result in creating
opportunities in future. This, put in other words, can be explained in terms of strategic
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options. The opportunities that are created can be due to the fact that strategic options
represent strategies of whether the firm has an option to pursue any project only by
taking on the earlier project or going on to any new projects. Here it can be said that
unless the firm carries on with the earlier project, the possibility of obtaining the cash
flows from the strategic option does not exist. A good example of this can be a stock
option, which has a value that is determined by the price of the underlying stock. Thus
put otherwise the traditional methods of performance appraisal tend to treat the
investments either as reversible or as irreversible one off decision that must be taken at
a single point of time, with any opportunity being lost in the process. Though this might
be the case with certain investment decisions it definitely does hold good for all. In
many situations, it is preferable to delay the concerned project and try to gain valuable
information which might facilitate the viability of the investment decision. In such cases
the existence of the opportunity to invest may be considered as a case very similar to a
call option, which by definition gives the right but not the obligation to a stream of cash
flows associated with the project at some future date. So when a company goes ahead or
completely rejects a particular investment proposal it actually brings the projects to an
end. So in order to proceed with a project, the value of the NPV would not only have to
be positive but also be sufficient to cover the value of the option. In certain cases though
the delay in projects may be of advantage, but at the same time the speeding up of the
project may also add value to it. This especially is true in the projects that involve
research and development; this is because such projects involve a lot of information that
seeks to bring new opportunities which are ultimately important to the organization.
Similarly, there may be situations where it may be worthwhile to abandon certain
projects. All these situations can be best analyzed from the option framework. Let us
now illustrate a situation where a project needs to be abandoned.
ABANDONING PROJECTS
As stated in numerous occasions, companies do not consider the past costs of projects
while making any decision regarding its future. This may hold good in those situations
where a project is already in progress and the company decides to continue with it or
even go on considering that it has to abandon the project in mid way. In such cases the
relevant costs will be the future costs that have to be compared with the future revenues
so as to determine whether it is viable to abandon the project. Thus as these decisions
are always not easy to take, the projects under consideration must be constantly
monitored.
Cash Flows Associated with the Decision to Abandon the Project
Let us consider two basic patterns of cash flows:
a.
Negative cash flow followed by positive cash flow
b.
Project life having both positive and negative cash flows.
The former type of project cash flow can be associated with the conventional types of
projects, say for example, a particular project is undertaken which, through subsequent
years, generates positive cash flows.
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Allocating Capital
Period
Cash flows 000
1,000
2,000
400
1,500
1,200
1,000
800
From the above example, it can be said that abandonment of the project seems
unlikely before period 3 is reached, except in cases where the project has come to an
end before its scheduled period. Subsequently, once the third year period is over, it
would be ignorant to consider abandoning the project. The reason being, commencing
from the period 4, the project starts generating positive cash inflows. But at the same
time it is essential to keep monitoring the future cash flows of the company, for if the
company fails to generate the estimated positive cash flow from period 4, and instead
generate negative cash outflow it might be disastrous for the company. Let us now
look at the former type of cash flow pattern of the project.
Period
Cash flows 000
200
300
140
120
160
200
300
This type of cash flow might be generated if considerable replacement were necessary
in the periods 2 and 5, or if there was any opportunity cost that arose in those periods. In
such situations, decisions regarding the abandonment may not be safe even after a
negative cash flow, keeping in mind of the expectations of future positive cash flows.
So the project may not be abandoned after a period of 2 or 5, rather consideration has to
be taken at the end of period 1 as to whether one should proceed with the project at the
end of period 3 or 4 and at the end of period 4, whether one should proceed to period 6.
FACTORS AFFECTING THE DECISION TO ABANDON THE PROJECT
While taking decisions regarding the abandonment or continuation of a project, the
following factors are taken into account:
a.
The cost associated with proceeding with the project.
b.
The revenue generated in the project.
c.
Revenue that might be generated if the project is subjected to abandonment.
d.
Other projects that might be viewed as alternatives to the project, or those that
have more profitable use of funds.
7.4 THE RATIO COMPARISON APPROACH

A popular way of valuing firms, projects, or assets is to compare them with other traded
firms, projects, or assets. The Ratio Comparison Approach provides a way by which
such valuation can be accomplished. This is generally predominant in cases of real asset
valuations. Though the standard discounted cash flow method is often used to value real
estate, but it is not a very proper approach. Most commercial real estate is valued
relative to comparable real estate that has been recently sold. Say a building should sell
for Rs.10 lakh if it has twice the annual cash flow as compared to a building that has
been recently sold for Rs.5 lakh. Here the underlying assumption that is made is that
115
cash flows of the two buildings will grow at the same rate. This method sounds
reasonable only if all future cash flows of the building under consideration are going to
be twice as large as those of the building with which the building is compared. But
when this assumption do not hold good, other variables besides current cash flows
might serve as better representatives for generating the tracking investment.
These approaches to valuation are predominantly based on the assumption that a new
investment should sell for at approximately the same ratio of price to some salient
economic variable as an existing investment with an observable ratio; this is the main
reason of why this approach is called the ratio comparison approach. The ratio
comparison approach uses the ratio of price to earnings, P/NI, where NI stands for net
income (that is, earnings).
THE PRICE/EARNINGS RATIO METHOD
With the price/earnings ratio method, the present value of a projects future cash flows
can be calculated by taking the following steps.
On Subtracting the cost of initial investment in the project from this Present Value (PV)
gives the Net Present Value (NPV). It is always advisable for a company to adopt a
project whenever the projects NPV is positive, that happens only when the project
produces the future cash flow stream at a cheaper rate than the comparable investment.
Or in other words, if the cost-to-earnings ratio of the project is less than the
price/earnings ratio of a comparison investment, the project is an acceptable one.
The price/earnings ratio method assumes, however, that the comparison investment on
which the price/earnings multiple is based has the same discount rate and earnings
growth as the project being valued.
EFFECT OF EARNINGS GROWTH AND ACCOUNTING METHODOLOGY
ON PRICE/EARNINGS RATIOS
Though the price/earnings ratio approach is useful in many ways, yet it has certain
drawbacks associated with it. The earnings of the project and the comparison portfolio
must have similar growth rates. For example, if the earnings of the comparison portfolio
are growing at a rate that is more than that of the project, the price/earnings ratio method is
invalid. This is primarily because the value of the comparison portfolio will be enhanced
by the faster growth rate. Even if the project costs less to initiate and appears to have a
favorable cost-to-earnings ratio compared to the price/earnings ratios available from
similar investments, the project could get diluted of its value if the low cost does not make
up for the projects low earnings growth rate. Further care should be taken so that the
earnings calculations reflect the true economic earnings of the firm. For example,
accounting changes, such as one-time write-downs, can dramatically affect the reported
earnings of firms without affecting their cash flows or their market values.
So it should be borne in mind that the reported earnings used to calculate the
appropriate value of a project may substantially misvalue the project. For this reason,
users who employ the price/earnings ratio method use EVA or similar measures of
adjusted earnings in place of earnings as such. However, it is also easy to distort the
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Allocating Capital
comparison with the price-to-cash-flow ratio. For example, a comparison firm may
find itself cash rich simply because a major customer decides to obtain an income tax
deduction by paying its bill at the end of the year instead of at the beginning of the
new year.
The Effect of Leverage on Price/Earnings Ratios
While taking decisions regarding capital allocation by using the price/earnings ratio
method, it is also necessary to understand how leverage affects a firms net income per
share (EPS) and, even more its price/earnings ratio. So while evaluating a project using
the price/earnings ratio method, care should be taken to calculate the earnings of the
project based on the assumption that the project is financed with the same ratio of debt
to equity, that in other words the leverage ratio as the comparison firm. It can be further
elaborated that an increase in leverage, keeping the firms operations and total value
constant, will result in the increase or decrease in the firms net income per share and
price/earnings ratio.
a.
What are the factors to be considered abandon a project?

..
..
..
b.
State the main assumption underlined in the ratio comparison approach.

..
..
..
7.5 THE COMPETITIVE ANALYSIS APPROACH

It has been found in many instances that it is almost an impossible task to determine the
contribution of a particular division of a firm to the total value of the company. Say for
example, trying to obtain the appropriate price/earnings ratio for an investment in soap
production by probing into the details of the financial statements of multiproduct
company that goes into manufacturing a lot of different products. This is because the
companys soap division may account for only a small part of the performance reported
in its consolidated financial statements. Further it can also be said that the positive net
present value project can be attributed to the fact only if the company can produce the
soap more cheaply or sell it more effectively than its competitors. If this is not the case,
the projects net present value is probably negative.
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DISADVANTAGES OF THE COMPETITIVE ANALYSIS APPROACH

As it is the case with any other valuation methods, the competitive analysis approach
too encounters certain drawbacks. Here it is worthwhile to mention that as the
competitive analysis approach is implicitly based on the assumption of the existence of
the value-maximizing competitors, in some cases it could even lead to not considering a
value-maximizing firm astray when this assumption does not hold good.
USE OF DIFFERENT APPROACHES
Having discussed the derivatives approach, the ratio comparison approach and the
competitive analysis approach of valuing the company, the only question that comes in
the mind is what method is the best for the purpose of valuation. Let us now try to
discuss in brief the applicability of these approaches and how they can be practically
implemented. Let us first take into account the derivative valuation approach. Though
this method of valuation provides an advanced way of valuing the companys assets but
at the same time it should also be remembered that this is not a technique that can be
applied with ease. Take for example, the various strategic options that are available with
different investment projects are difficult to recognize even before the project is actually
initiated. A further problem is estimating the random process that aids in generating the
future prices of the assets that in turn results in determining the investments present
value. This results in the applicability of the derivatives valuation approach in the
practical sense. Similarly, the discounted cash flow method also fails practical
implementation. This is due to the fact that in many cases it is difficult to estimate the
expected or the certainty equivalent cash flows of an investment.
Valuing Asset Classes versus Specific Assets
Now let us consider valuing asset classes versus specific assets. Let us start with real
estate valuation and try to answer the question of whether real estate is a good
investment or not. In this aspect it is important to note that the derivatives valuation
method and the ratio comparison approaches pose certain problems in their applications.
These approaches are based on a comparison between highly similar or related
investments and as a result they seem to reveal very less about the relative pricing of the
unrelated or even the widely disparate classes of assets, as a result of which they are not
effective for identifying whether broad asset classes are mispriced. In order to determine
the attractiveness of real estate investments as a group, it is necessary to ascertain the
risk of a broadly spread portfolio of real estate investments and assess as to whether the
financial markets are correctly pricing that risk. This calls for the use of the CAPM or
the APT that considers the risk return relation across asset classes. On the other hand,
keeping in mind the shortcomings of the CAPM and APT it is advisable to have
alternatives in more specific cases when they are available. As an example, the use of
the CAPM and APT to value an office building would be inappropriate when a suitable
comparable office building exists.
Tracking Error Considerations
Using the tracking portfolio method of valuation may be considered as the best
valuation approach.
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Allocating Capital
As per the Capital Asset Pricing Model, it is essential that every investment be tracked
against a weighted average of the market portfolio and a risk-free asset. Tracking with
the CAPM may not always yield the desired result considering the dissimilarities
between a particular office building (in our case) and the market portfolio. Using the
CAPM to value a real asset is based on the assumption that CAPM-based tracking error
has a zero present value and the valuation done on this basis is correct. If the CAPM as
a theory is totally incorrect or even incorrect in certain circumstances, this conclusion
may not be called for.
Now as mentioned earlier, the tracking error does not have zero present value for those
stocks that have low market to book ratios, small market capitalizations, and high past
returns.
On the other hand, the cash flows from a portfolio composed of a comparable office
building and the risk-free asset tracks the evaluated buildings cash flows more closely
than a combination of the market portfolio and a risk-free asset. In this case, there is no
theoretical reason to believe that the tracking error will have zero present value. At the
same time if the tracking error is so small as to be negligible, a better present value can
be obtained by using the comparable office building in a ratio comparison than by using
the CAPM.
Other Considerations
Though the ratio comparison approach and the competitive analysis approach appear
easy to implement for the strategic options embedded in most projects, in reality their
application seems to be limited by the degree to which the comparison investments and
firms exhibit rationality, either in their pricing (e.g., in the price/earnings approach) or
in their behavior (e.g., in the competitive analysis approach). Added to this, it may be
difficult to ensure that the comparison investment (or firm) is truly an appropriate
comparison and takes into account all factors which stems from the differences between
the comparison entity and the project. So it can be said that there cannot be any single
method in valuing a firms project, rather any of the methods can be applied keeping in
mind the type of the project under consideration and its size.
7.6 WEIGHTED AVERAGE COST OF CAPITAL

Unlike the APV method, the WACC method deals with the estimation of only levered
cash flows, and even considers the debt tax subsidy by the proper adjustment of the
discount rate that can be applied to the unlevered cash flows. This adjusted cash flow is
in fact the weighted average cost of capital of the project. It is to be noted here that
valuing projects that have different risks and different debt capacities using the WACC
may not always give the satisfactory result. It can be explained that using the WACC to
discount cash flows of an entire business may be comparatively easier than obtaining a
WACC for an entire project.
119
WACC VALUATION
Illustration 1
Consider valuation of ABC Company, which is for sale for Rs.4,75,000, and has the
following characteristics:
Cash sales
Rs.5,00,000 per year for the indefinite future
Cash costs
72% of sales
Corporate tax rate
34%
Cost of capital if unlevered (r0)
20%
Interest rate (rB)
10%
Target debt to equity ratio
1/3
Cost of levered equity rS = r0 + (B/S) (1 TC)(r0 rB) = 22.2%,

where B/S = 1/3
We can then calculate weighted average cost of capital.
rWACC
[(Cost
of
levered
equity)(Proportion
of
equity
finance)]
+ [(Cost of debt finance)(Proportion of debt finance)(1 tax rate)]

rWACC = (3/4) x 0.222 + (1/4) x 0.10(0.66) = 18.3%
Annual Cash Flows if the Firms were All Equity Financed:
Cash Inflows
Rs.5,00,000
Cash Costs
Rs.3,60,000
Operating Income
Rs.1,40,000
Corporate Tax (0.34)
Rs.47,600
Unlevered Cash Flow (UCF) Rs.92,400

The present value of the company is thus
PV = 92,400/0.183 = 504,918
And the NPV of the acquisition would be
NPV = 5,04,918 4,75,000 = Rs.29,918
It is to be noted here that when using WACC, the value of the debt tax shield is
reflected in the denominator (discount rate), rather than the numerator (cash flows).
Capital Budgeting for Projects that are not Scale-enhancing
A scale-enhancing project is one where the project is similar to those of the existing
firms. In the real world, executives would make the assumption that the business risk of
the non-scale enhancing project would be about equal to the business risk of firms
already in the business. No exact formula exists for this. Some executives might select a
120
Allocating Capital
discount rate slightly higher on the assumption that the new project is somewhat riskier
since it is a new entrant.
Let us go into one example.
ABC Enterprise is planning to enter into a new line of business.
XYZ is a firm in the widget industry.
ABC has a B/S of 1/3, XYZ has a B/S of 2/3.
Borrowing rate for ABC is 10%.
Borrowing rate for XYZ is 12%.
XYZ = 1.5
Market risk premium = 8.5%, rf = 8%, Tc = 40%; rb = 12%
The following four-step procedure can be taken to calculate discount rates:
Determining the cost of equity capital of XYZ (rs).
Determining the hypothetical all-equity cost of capital of XYZ (r0).
Determining rs for ABCs venture.
Determining rWACC for ABCs venture.
Determining ABCs cost of equity capital (rs)

rs
8% + 1.5(8.5 8.0)% = 8% + 1.5 8.5% = 20.75%
r0 +
rs
0.2075
B
(1 Tc )(r0 rB )
S
= r0 +
r0
1
3
(0.6) (r0 0.12)
= 18.25%
Determining rs for XYZs widget venture

rs
rf + ( rM rf )
Determining ABCs all-equity cost of capital (r0)
B
(1 t c )(r0 rB )
S
r0 +
0.1825 + (0.6) (0.1825 0.1) = 0.199
Determining rwacc for XYZs widget venture
121
S
S
rs +
rb (1 Tc )
S+B
S+B
rWACC =
3
1
0.199 + 0.1 0.6 = 16.42%
4
4
7.7 ADJUSTED PRESENT VALUE APPROACH

Adjusted Present Value (APV) Method considers evaluating a project as if it is
undertaken by an all equity company. The tax shield on debt and the issue costs are not
accounted for. The method calls for the estimation of the base case NPV followed by
the calculation of the present value of the issue costs and the tax shields. These, when
added to the base case NPV, yield Adjusted Present Value (APV), which reflects the net
effect on the shareholders wealth adopting the project. Thus the APV can be written as:
(Project value if entirely equity financed)
+ (Present value of the tax shield on loan)
+ (Present value of other side effects)
The adjusted present value method begins by calculating the value of the firm with all
equity financing. Then the value of the debt tax shield (or other side effects), is
calculated separately and added together. Mathematically, it can be represented as:
APV = NPVU + NPVF
The NPV of the Unlevered firm (NPVU) is calculated by discounting the unlevered
cash flows (UCF) by r0, Where, (r0) denotes the cost of capital if the firm is unlevered.
Thus:
NPVU = UCFt/(1 + r0)t
The NPV of the Financing side effects (NPVF) is calculated by discounting the debt tax
shields by the cost of debt:
NPVF = Interest Expense t x TC/(1 + rB)t
Where,
rB denotes Interest Rate.
TC denotes corporate tax rate.
Costs of financial distress, debt financing subsidies, and issuance costs can all be
incorporated into the financing side effects.
APV VALUATION
Illustration 2
Let us take the ABC Company example.
122
Cash sales
Rs.500,000 per year for the indefinite future
Cash costs
72% of sales
Corporate tax rate
34%
Allocating Capital
Cost of capital if unlevered (r0): 20%

Interest rate (rB)
: 10%
Target debt to equity ratio: 1/3 (B/S)

The unlevered cash flows (UCF) are Rs.92,400 annually. Thus the present value of the
unlevered company (Vu) be:
Vu = 92,400/0.2 = 4,62,000
Since the price for the company is Rs.4,75,000, we find
NPVu = 4,75,000 + 4,62,000 = 13,000.
Comment: So it is not advisable to purchase the companys shares if the company were
to maintain an all equity capital structure.

We now want to calculate the NPV of the tax shield from the debt financing.
ABCs annual interest expense will be B x rB. Discounting the resulting tax shield
perpetuity by rB, we arrive at:
NPVF = (B x rB x TC) / rB TCB
We still need to calculate how much debt ABC will have. Let us say that we want 25%
of the levered firms value (VL) to be financed by debt, so
B = 0.25 x VL
We also know from the APV rule that
VL = Vu + TCB
Solving B = 0.25 x (Vu + TCB) gives B = Rs.126,229.50 and NPVF = Rs.42,918.
Finally, APV = Rs.29,918, which is the same result we found using WACC.
PROBLEMS ENCOUNTERED IN THE APV APPROACH
a.
The estimation of the adjusted present value calls for the determination of the
ungeared industry beta which in turn is based on the authenticity of the Miller
and Modigliani theory. But in reality the theory may not always be true if there is
the existence of market imperfections such as bankruptcy costs.
b.
Estimation of the discount rates used in the evaluation of the side effects
becomes difficult.
c.
In certain cases, the complex investment decisions involve extremely lengthy

calculations.
ADVANTAGES OF THE APV APPROACH
In order to mention about the advantages of the APV approach, let us compare it with
the WACC and the net of tax operating cash flows so as to get the present value of
NPV:
a.
The adjustment of WACC based on the assumption of perpetual risk free debt
poses problems.
123
b.
The very assumption of the M&M theory that tax relief on debt interest is risk
free which might not always be the case.
c.
APV accounts for any change in the capital structure that include the value of
any additional tax shield obtained from financing existing assets.
d.
The approach is useful for valuing any type of financial advantage.
THE APV AND THE CERTAINTY EQUIVALENT METHOD
Having studied the various approaches of project evaluation, the APV method coupled
with the certainty equivalent method provides the most comprehensive way for
evaluating risky assets. And this gains prominence when the existence of debt tax shield
is certain. When there is the debt tax shield, the evaluation of the project can be easily
done by simply adding up the debt tax shield to the certainty equivalent followed by
discounting the above sum at the chosen risk-free rate. Let us explain this with the help
of an illustration.
Illustration 3
ABC Company wishes to get into the manufacture of car cleaners. The cost of the dice
is estimated to be Rs.75,000 and the project is estimated to last five years at the end of
which it yields zero salvage value. The estimated unlevered cash flows per year are
Rs.25,000 for the next five years and zero after that. The certainty equivalent cash flows
are given as follows:
Cash Flows (000s) at the End of
Year 1
Year 2
Year 3
Year 4
Year 5
90
80
70
60
50
The dice adds to Rs.50,000 to the firms debt capacity in the years 1 and 2, and
Rs.25,000 in the years 3 and 4 and zero in year 5. The Company has a borrowing rate of
6% and a tax rate of 50%, and it will also use the tax shields with certainty. Given the
risk free rate is 5%, estimate the NPV of the investment.
Solution
Years
50,000
50,000
25,000
25,000
Tax shields (6%)
3,000
3,000
1,500
1,500
Post tax debt capacity (50%)
1,500
1,500
750
750
CE cash flows (000)
90
80
70
60
50
Total CE cash flows
91.5
81.5
70.75
60.75
50
0.9524
0.9070
0.8638
0.8227
0.7835
87.1446
73.920
61.113
47.979
39.175
Debt capacity
PVIF (5% x years)

PV Discounted CE cash flows
NPV= 75.000 + 87.1446 + 73.920 + 61.113 + 47.979 + 39.175 = 234.3316
124
Allocating Capital
7.8 COMBINING THE APV WITH THE REAL OPTION

APPROACH
Valuation of projects involves deciding upon strategic choices. In this regard it can be
said that the financing choice is also a strategic variable in many cases, as the firms
have the option to either increase or decrease the level of debt financing as per the
requirement. It has been seen in many cases that the APV method works well with the
real option approach.
Corporate Taxes and the Evaluation of Equity Financed Capital
Expenditures
The APV approach as well as the WACC approach calls for estimating the unlevered
cash flows of the firm that is under consideration. Let us now make the assumption that
the firm is entirely financed by equity. Based on this it can be safely said that the
unlevered cash flow is the after tax cash flow of the firm. Having calculated the
unlevered cash flows of the project, it becomes necessary to estimate the appropriate
cost of capital or the discount rate for these cash flows.
The Cost of Capital
For a company that is financed by only equity, the appropriate risk adjusted discount
rate for the projects cash flow is considered to be the companys cost of capital. Further
the required rate of return on the firms assets is the same as the expected rate of return
on the unlevered firms equity. Let us now turn our focus on two costs of capital, one
being the unlevered cost of capital, which is actually the expected return on the equity
for an all equity financed firm. Now as the firm is totally financed by equity and there is
no debt tax shield, the unlevered cost of capital is also the required rate of return on the
firms unlevered assets. The other cost of capital is the weighted average cost of capital
which, in other words, is the weighted average of the after tax expected return paid by
the firm on its debt and equity. So it can be safely said that in the absence of any debt
tax shield, or debt subsidy the WACC is the expected return on the firms assets. In
essence, in such conditions the WACC and the unlevered cost of capital hold the same
meaning. But what happens when there is the presence of debt shield? The necessity to
distinguish between the two forms of cost of capital gains importance. It is to be
mentioned here that the return that the firm pays to its equity holders for the use of
capital is the same as the expected rate of return that the investors receive for providing
the capital. From a general point of view this might hold true, but the inclusion of
government taxing authority that encourages one form of financing over the other
explains it differently. In such situations the cost of favored form of financing will
certainly differ from that of the expected return to investors. Take for example, the cost
of debt financing may be less than the rate of return on the firms debt that is received
by the firms debt holders. Thus we can see that the existence of the debt tax shield
distinguishes the WACC from the unlevered cost of capital of the firm.
125
a.
When will Adjusted Present Value (APV) Method to be considered?
b.
What are the Advantages of the APV Approach?
7.9 THE IMPORTANCE OF UNLEVERED COST OF CAPITAL

FOR A LEVERED FIRM
In case of valuing all equity financed project when the comparison firm has debt
financing, it becomes important to estimate the required rate of return on the
comparison firms equity in the fictitious case of comparison firm that is completely
equity financed. Moreover when the project takes on a tax advantage debt, it becomes
essential to analyze how the shifting of the comparison firms debt affects the risk of the
comparison firms equity.
A finance manager who uses either the WACC or the APV method has to take into
account of how the debt financing and taxes affect the risks of the various components
of the firms balance sheet. Let us consider the following simplified balance sheet and
explain the phenomenon.
Assets
Liabilities and Equity
Debt tax shield (TX)
Debt
Unlevered assets (UA)
Equity
The above figure shows that the assets of a firm contain two components, one being the
unlevered assets, UA that can be defined as the present value of the unlevered cash
flows and the other being the debt tax shield which is the present value of the financing
subsidy. Now it is important to note here that the beta of the assets is the portfolio
weighted average of the betas of the unlevered assets and the debt tax shields.
DISCOUNTING CASH FLOWS TO EQUITY HOLDERS
The common valuation models are used to value the cash flows of the real assets that
accrue to the equity as well as the debt holders. We will discuss about the flow to equity
holders method in our valuation.
Flows to Equity (FTE)
This method values only the equity portion of a firm or project. In this method one uses
the Levered Cash Flows (LCF) of the firm, after accounting for interest payments to
debt holders. This is followed by discounting the levered cash flows at the required rate
of return on the levered equity (rS).
126
Allocating Capital
This can be mathematically denoted as:

NPV = LCFt / (1+rS)t
Illustration 4
We will again use the ABC Company for our example.

Cash sales
Rs.5,00,000 per year for the indefinite future
Cash costs
72% of sales
Corporate tax rate
34%
Cost of capital if unlevered (r0)
Interest rate (rB)
10%
Target debt to equity ratio
1/3
20%
Let us calculate the required return on equity.

This is obtained by
rS = r0 + (B/S) (1 TC)(r0 rB) = 22.2%.
Thus, rS = 22.2% and the amount of debt is B = Rs.126,229.50.
Now the levered cash flows can be calculated as:
Cash inflows
Rs.5,00,000
Cash costs
3,60,000
Interest expense
12,622.95
Income after interest
127,377.05
Corporate tax (0.34)
43,308.20
Levered Cash Flow (LCF) 84,068.85

The present value of the equity portion of the company is thus
PV = 84,068.85/0.222 = 378,688.135
To calculate the NPV of this equity investment, care must be taken to deduct only the
part of the purchase price paid by equity, that is
(4,75,000 1,26,229.50) = Rs.3,48,770.50.
Thus,
NPV = 3,48,770.50 + 3,78,688.50 = Rs.29,918
Obtaining the All-equity Cost of Capital
Use the following notation.
ro: the all-equity cost of capital.
127
rs: the required return on levered equity.

rB: the required return on debt.
B: the market value of debt.
S: the market value of equity.
In order to obtain the all-equity cost of capital when given data for a levered firm, you
need to remember your delevering/relevering formulas,
For betas
B(1 T)
S
A =
E +
D
S
+
B(1
T)
S + B(1 T)
When we assume the debt beta = 0, we get the delivering/relevering formula
E = 1 + (1 T) A
S
For expected returns:
MM Proposition II with taxes

Rs = r 0 +
This gives the following unlevering formula for the all-equity cost of capital
R0 =
S
B
rs +
(1 T)rB
S + B(1 T)
S + B(1 T)
Note that, although this looks very similar to the formula for WACC
R0 =
B
(1 T)(r0 rB)
S
S + B(1 T)
x r0
S+B
This corresponds with our intuition that WACC falls as debt to equity ratio
increases.
7.10 SUMMARY
Firms should evaluate investment projects on the basis of their potential to generate
valuable information and the direct cash flows they generate.
Most projects can be viewed as a set of mutually exclusive projects. For instance,
undertaking a project today is one project, taking it a year later is another project, that is
forgoing the capital investment immediately (which might have a present NPV). It is
done if the other alternative, waiting to invest, has a higher NPV.
In the ratio comparison approach, firms value projects on the basis of comparison with
other traded projects/assets.
The other approach is the P/E ratio method. This is done by
Obtaining the appropriate P/E ratio for the project from a comparable investment
whose P/E ratio is known.
128
Allocating Capital
Multiplying this P/E ratio with the first years net income of the project.
The company should accept the project when the ratio of its initial cost to
earnings is lower than the P/E ratio of the comparison investment.
P/E ratio of a portfolio of stocks is the sum of their respective P/E ratio times
their weight.
The competitive analysis approach
The firm in a competitive market can achieve a positive NPV from a project if
they have sense advantage over their competitors. When other firms have a
competitive edge, the project will then have a negative NPV.
Strategic options exist whenever the firm has any flexibility regarding the
implementation of the project.
The existence of these options improves the value of the investment project. If the
management ignores these options, the project shall stand under valued.
7.11 GLOSSARY
Book Value Weights[v1] is the percentage of financing provided by different sources as
measured by their book values from the companys balance sheet.

Business Risk is the risk arising from variation in earnings before interest and tax.
Capital Structure is the composition of a firms long-term financing consisting of
equity, preference capital, and long-term debt.

Cost of Capital is the minimum rate of return the firm must earn on its investments in
order to satisfy the expectations of investors who provide the funds to the firm. It is
often measured as the weighted arithmetic average of the cost of various sources of
finance tapped by the firm.
Cost of Debt is the rate that has to be received from an investment in order to achieve
the required rate of return for the creditors.

Cost of Preferred Stock is the rate of return that must be earned on the preferred
stockholders investment to satisfy their required rate of return.

Net Present Value or NPV is a method for evaluating investment proposals. NPV is
defined as present value of benefits minus present value of costs.

Net Working Capital is the difference between Total Current Assets and Total Current
Liabilities.
The Operating Cycle of a firm begins with the acquisition of raw materials and ends
with the collection of receivables.
Price/Earnings (P/E) Ratio is the ratio of market price per share to earnings per share.
This ratio shows what investors are willing to pay per rupee of earnings.
129
Brealey Myers, Principles of Corporate Finance, 6th edition, USA: Mcgraw-Hill

James C. Van Horne, Financial Management and Policy, 11th edition,

USA: Prentice-Hall, 1998.
Eugene F. Brigham, Michael C. Ehrhardt, Financial Management Theory and

Practice, 12th edition, USA: South-Western College Publishers, 2007.
Prasanna Chandra, Financial Management Theory and Practice, 6th edition,

New Delhi: Tata Mcgraw-Hill, 2004.
Apte. P.G. International Financial management,

Mc Graw-hill Publishing Company Limited, 2005.
Charles Moyer. R., James R. Mcguigan, and William T. Kretlow, Contemporary

Financial Management, 8th Edition. Ohio (USA): South-Western College
New
Delhi,
TATA
Publishing Company, 2001.

a.
While taking decisions regarding the abandonment or continuation of a project,

the following factors are taken into account:
i.
The cost associated with proceeding with the project.
ii.
The revenue generated in the project.
iii.
Revenue that might be generated if the project is subjected to

abandonment.
iv.
Other projects that might be viewed as alternatives to the project, or those

that have more profitable use of funds.
b.
The ratio comparison approach to valuation are predominantly based on the

assumption that a new investment should sell for at approximately the same ratio
of price to some salient economic variable as an existing investment with an
observable ratio; this is the main reason of why this approach is called the ratio
comparison approach. The ratio comparison approach uses the ratio of price to
earnings, P/NI, where NI stands for net income (that is, earnings).
a.
Adjusted Present Value (APV) Method considers evaluating a project as if it is

undertaken by an all equity company. The tax shield on debt and the issue
costs are not accounted for. The method calls for the estimation of the base
case NPV followed by the calculation of the present value of the issue costs
and the tax shields. These, when added to the base case NPV, yield Adjusted
Present Value (APV), which reflects the net effect on the shareholders wealth
adopting the project.
130
Allocating Capital
b.
In order to mention about the advantages of the APV approach, let us compare it
with the WACC and the net of tax operating cash flows so as to get the present
value of NPV:
i.
The adjustment of WACC based on the assumption of perpetual risk free

debt poses problems.
ii.
The very assumption of the M&M theory that tax relief on debt interest is
risk free which might not always be the case.
iii.
APV accounts for any change in the capital structure that include the
value of any additional tax shield obtained from financing existing assets.
iv.
The approach is useful for valuing any type of financial advantage.

A. Multiple Choice
1.
2.
3.
4.
From which factors, the competitive advantages arise?

a.
barriers to entry.
b.
economies of scale.
c.
economies of scope.
d.
discounted cash flow.
e.
All (a), (b) (c) and (d) of the above.
Which ratio/s are used in ratio comparison approach?

a.
price to earnings ratio.
b.
Price to net income ratio.
c.
Price to fixed assets ratio.
d.
Price to cost ratio.
e.
Both (a) and (b) above.
WACC method gives best results when?

a.
valuing projects that have different risks.
b.
valuing projects that have levered cash flows.
c.
valuing projects that have unlevered cash flows.
d.
valuing projects that have different debt capacities.
e.
valuing projects that have unequal cash flows.
On which assumption, the adjustment of WACC is based?

a.
perpetual risk free debt.
b.
perpetual risk free equity.
c.
Perfect Market conditions.
d.
Leveraged Beta.
e.
imperfect market conditions.

131
5.
A project can have as many as different internal rates of return as it has

_____________.
a.
Cash inflows
b.
Cash outflows
c.
Periods of cash flows
d.
Changes in the sign of cash flows
e.
No connection with cash flows.
B. Descriptive
1.
Explain the Ratio Comparison Approach to value firms, projects.
2.
How APV method does is better than WACC method to valuation?
3.
What is the importance of Corporate Taxes in valuation?
practice only.
132
UNIT 8
FINANCIAL DISTRESS AND

RESTRUCTURING
Structure
8.1
Introduction
8.2
Objectives
8.3
Meaning of Bankruptcy
8.4
Prediction of Bankruptcy
8.5
Financial Distress
8.6
Causes and Effects of Financial Distress
8.7
Summary
8.8
Glossary
8.9
8.10
Suggested Answers
8.11
Terminal Questions
8.1 INTRODUCTION
The basic causes of business failure can be categorized into four major heads the
economic factors, the financial factors, factors relating to neglect, disorder and fraud
and some other factors. The economic factors relate to industry weakness and poor
location of the firm. The financial factors relate to the over burdening debt capacity and
insufficient capital. The importance of the different factors varies over the time,
depending on such things as the state of the economy and the level of interest rates.
Apart from this, sometimes some factors produce a combining effect so as to make the
business unsustainable. Studies have provided further evidence that the causes of
financial distress are a result of a series of errors, misjudgments and interrelated
weaknesses that can be attributed directly or indirectly to the management of the firm.
This unit highlights factors leading to failure of business and models to predict
bankruptcy and financial distress.
8.2 OBJECTIVES
Understand the meaning of bankruptcy;
Recognize the factors leading to bankruptcy;
Identify the symptoms of bankruptcy;
Use mathematical models to predict bankruptcy; and
Know the effects of financial distress.
8.3 MEANING OF BANKRUPTCY

A firm is said to be bankrupt if it is unable to meet its current obligations to the
creditors. Bankruptcy may occur because of a number of external and internal factors.
DEFINITIONS
Sick Industrial Company
The Sick Industrial Companies (Special Provisions) Act, 1985 or SICA defines a sick
industry as an industrial company (being a company registered for not less than five
years) which has at the end of any financial year accumulated losses equal to or
exceeding its net worth.
Weak Unit
A non-SSI industrial unit is defined as weak if its accumulation of losses as at the end
of any accounting year resulted in the erosion of fifty percent or more of its peak net
worth in the immediately preceding four accounting years. It is clarified that weak units
will not only include those which fall within the purview of Sick Industrial Companies
(Special Provisions) Act, 1985 (of industrial companies) but also other categories such
as partnership firms, proprietary concerns, etc. A weak Industrial Company should be
termed as potentially sick company.
Sick SSI Unit
A small-scale industrial (SSI) unit, as per the RBI is classified as sick when:
a.
Any of its borrowal accounts has become a doubtful advance, i.e. principal or
interest in respect of any of its borrowal accounts has remained overdue for
periods exceeding 21/2 years and
b.
There is erosion in net worth due to accumulated cash losses to the extent of 50
percent or more of its peak net worth during the preceding two accounting years.
In case of tiny/decentralized sector units, if requisite financial data is not available, a

unit may be considered as sick if the loan/advance in which any amount to be received
has remained past due for one year or more.
FACTORS LEADING TO BANKRUPTCY
External Factors
134
a.
Change in government policies affecting the firm
b.
Increased competition
c.
Scarcity of raw material
d.
Prolonged power cuts
e.
Changes in consumer buying pattern
f.
Shrinking demand
g.
Natural calamities
h.
Cost overruns
i.
Inadequate funds.
Internal Factors
a.
Mismanagement
b.
Fraudulent practices and misappropriation of funds by the management
c.
Labor unrest
d.
Technological obsolescence
e.
Disputes among promoters.

Causes of Bankruptcy
Percentage
Mismanagement
52
Faulty initial planning
14
Labor trouble
Market recession
Others
23
9
100
Table 2: An RBI Study

SYMPTOMS OF BANKRUPTCY
A firm goes bankrupt gradually. Before a firm goes bankrupt, it exhibits a number of
symptoms, which when diagnosed and corrected in time can save the company from
bankruptcy.
Some of these symptoms are
Production
Low capacity utilization
High operating cost
Failure of production lines
Accumulation of finished goods
Sales and Marketing
Declining/Stagnant sales
Loss of distribution network to competitors
Finance
Increased borrowing at exorbitant rates
Increased borrowing against assets
Failure to pay term loans
Failure to pay current liabilities, salaries etc.
Failure to make statutory payments
Others
A declining trend in market price of share
Rapid turnover of key personnel
Persistent cash losses
Frequent changes in accounting policies to enhance profits
Frequent change of accounting years for undeclared reasons.

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8.4 PREDICTION OF BANKRUPTCY

As the incidence of sickness became more frequent, a need was felt to evolve
techniques and methods to predict failure of a firm. While symptoms listed earlier are
good indicators of the financial health, they are not the best predictors of sickness.
A number of models are available to accurately predict sickness of a firm. These models
provide early warning signals, so that a potentially disastrous situation can be averted.
Most of these techniques involve financial ratio analysis. A study has revealed that
financial ratios are useful in predicting the failure of a firm for a period up to 5 years
before sickness accurately. A number of Indian models are also available. Some of the
models are discussed below.
International Models:
Beaver Model
The Wilcox Model
Blum Marcs Failing Company Model
Altmans Z Score Model
Argenti Score Board.
Indian Model:
L.C. Gupta Model.
Beaver Model
Beaver was the first to make a conscious effort to use financial ratios as predictors of
failure. He defined failure as inability of a firm to pay its financial obligation as they
mature.
He used 30 ratios classified under 6 categories. Beaver tested these ratios to predict the
failure of a company. The ratio of cash flow to total debt was found to be the best single
predictor of failure. The study further revealed that financial ratios are useful in
prediction of failure of at least five years prior to the event.
The Wilcox Model
Wilcox proposed that the net liquidation value of a firm is the best indicator of its
financial health. The net liquidation value can be obtained by the difference in
liquidation value of firms assets and the liquidation value of liabilities. Liquidation
value is the market value of assets and liabilities, if liquidated at that point of study.
Blum Marcs Failing Company Model
Blum Marcs model predicts the financial health of a firm using 12 ratios divided into 3
groups: Liquidity ratios, Profitability ratios and Variability ratios. Using these ratios,
Blum Marc tried to accurately predict failure and draw a distinction between bankrupt
and non-bankrupt firms.
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Altmans Z Score Model

Altman improved upon the earlier models using ratio analysis to predict failure.
Altmans model is based on the fact that various ratios when used in combinations, can
have better predictive ability than when used individually. 22 ratios were considered in
various combinations as predictors of failure. He used a statistical technique called the
Multiple Discriminant Analysis (MDA) to distinguish between bankrupt and nonbankrupt firms.
Out of these 22 ratios, a final set of 5 ratios were selected as they were found to be
better predictors of failure. Weights were given to these ratios on the basis of their
significance to predict health of the model. He developed a discriminant score called the
Z-score on the basis of these ratios.
Z
1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Discriminant score
X1
Working capital/Total assets
X2
Retained earnings/Total assets
X3
EBIT/Total assets
X4
Market value of equity/Book value of debt
X5
Sales/Total assets.
Where,
If Z score for a firm is less than 1.81, the firm is likely to go bankrupt. If Z score is
more than 2.99, it is regarded as a healthy company. The range between
1.81 2.99 is treated as an area of ignorance.
Z Score
Classification
< 1.81
Bankrupt firm
1.81 2.99
Area of ignorance
> 2.99
Healthy firm
Argenti Score Board

J. Argenti in his famous article Company Failure Long Range Prediction is Not
Enough, developed a score board for evaluating the health of the firm. The model is
based on numerical assessment of the firms weaknesses. The weaknesses are classified
as defects (management and accounting), mistakes and symptoms. He has delineated a
list of factors to be looked into along with the respective scores. All the scores are to be
summed up. The cut-off point for a healthy firm is a score of 25. This model has been
criticized for being subjective and arbitrary.
Defects
Box 1
In management Score
8
The chief executive is an autocrat
4
He is also the chairman
2
Passive board an autocrat will see to that
2
Unbalanced board too many engineers or too many finance
types
2
Weak finance director
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Poor management depth
15
Poor response to change, old-fashioned product, obsolete

factory, old directors, out-of-date marketing
43
In accountancy
No budgets or budgetary controls (to assess variance, etc.)
No cash flow plans, or not updated
No costing system. Cost and contribution of each product
unknown
Pass should be less than
10
3
3
3
Total Score Mistakes
Total Score Symptoms
15
High leverage, firm could get into trouble by stroke of bad luck
15
Overtrading. Company expanding faster than its funding. Capital

base too small or unbalanced for the size and type of business
15
Big project gone wrong. Any obligation which the company

cannot meet if something goes wrong
45
Financial signs, such as Z-score, appear near failure
Creative accounting. Chief executive is the first to see signs of

failure and, in an attempt to hide it from creditors and the banks,
accounts are glossed over by, for instance, overvaluing stocks,
using lower depreciation, etc. Skilled observers can spot these
things.
Non-financial signs, such as untidy offices, frozen salaries, chief

executive ill, high staff turnover, low morale, rumors
Total Score
12
Total possible score
100
15
25
Source: J. Argenti, Company Failure Long Range Prediction is Not Enough,

Accountancy, August, 1977.
L.C. Gupta Model
L.C. Guptas model was the first Indian model proposed to predict failure. He used 56
ratios and sought to determine the best set of ratios to predict failure. These were
categorized as profitability ratios and balance sheet ratios. He applied these ratios to a
sample of sick and non-sick companies and arrived at the best set of ratios.
These are given below:
Profitability Ratios:
EBDIT/Net Sales
OCF/Sales (Operating Cash Flow/Sales)
EBDIT/(Total Assets + Accumulated Depreciation)
OCF/Total Assets
EBDIT/(Interest + 0.25 Debt).
Balance Sheet Ratios:
Net Worth/Total Debt
All Outside Liabilities/Tangible Assets.
The model was found to have a high degree of accuracy in predicting sickness for 2/3
years before failure.
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8.5 FINANCIAL DISTRESS

The primary cause of a firm encountering financial distress starts when it finds it
difficult to meet the scheduled payments or when the cash flow projections of the firm
are indicative of the fact that it will soon be unable to do so. Few of the pivotal issues
that arise in due course are as follows:
a.
Primary cause of failure on part of the firm to meet the debt obligations. To
ascertain whether such a failure is due to a temporary cash flow problem or
because of the fact that the asset values of the firm has fallen much below its
debt obligation.
b.
If it is found out that the problem is a temporary one, then an agreement with the
creditors of the firm can be worked out so that the firm has time to recover and
satisfy every one. But in case the long run asset values have truly declined then
the firm is said to have incurred economic losses. In such a situation it is
important to ascertain, who should bear the losses and how much of share should
be given to each.
c.
To ascertain the value of the firm both on liquidation as well as on working

conditions and to take the decision on whether it is profitable to continue the
business or liquidate it based on the valuations.
d.
Whether the firm should file protection under chapter 11 of Bankruptcy Act, or
should it go for informal procedures. It is to be noted here that in both the cases
of reorganization and liquidation a firm can either resort to informal procedures
or work under the direction of the bankruptcy Court.
e.
Ascertaining the controlling force of the firm while it is being liquidated or

rehabilitated. To ascertain whether the existing management be left in charge or
should a trustee be placed in charge.
a.
What do the external factors lead to bankrupt?

..
..
..
b.
How do you predict bankruptcy under Altmans Z Score Model?
Settlements without going through Formal Bankruptcy

When a firm goes through the period of financial distress, it is very important for its
management and creditors to decide whether the problem is a temporary one and it is
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possible for the firm to continue its operations or whether the problem is more serious
and permanent in nature that has the possibility of endangering the life of the firm. So
having done this, the parties involved in the process decides upon solving the problem
either through the intervention of the bankruptcy court or through informal process. If
the firm goes for filing a formal bankruptcy under chapter 11 of the Bankruptcy Act it
involves certain costs. Coupled to this, there is also the possibility of the fact that when
the creditors come to know that the firm has resorted to the Court, it might lead to
disruptions. Thus it is preferable to go for reorganization and liquidation through
informal means. Here we first start our discussion with the informal reorganization and
then go into the details of the procedures of the formal bankruptcy.
Informal Reorganization
Those companies that possess more strong economic fundamentals, are always prepared
to work with these companies so as to help then to come out of their distress conditions
and to re-establish themselves on a sound financial basis. Such voluntary plans rendered
by the creditors, generally termed as the workouts, involves restructuring of the firms
debt; because of the fact that the current cash flows of the firm are insufficient to service
the existing debt. The restructuring process typically consists of extension and
composition. In the former case, the creditors postpone the dates of the interest or the
principal payments as well as both. In case of the latter, the creditors voluntarily reduce
their claims on the debt by accepting a lower principal amount or by reducing the
interest rate on the debt. They may even take equity for debt or they may resort to the
combination of all these three possible ways.
The process of debt restructuring begins with the initiation of both the firms managers
and the creditors meeting for seeking a proper balance. The creditors form a committee
with four to five representatives of the larger creditors and a few of the smaller ones so
that each side is equally represented. The meeting is often arranged and conducted by an
adjustment bureau that is associated with and run by local credit managers association.
The first step involves drawing up a list of creditors with the amount of debt that is
owed to each. This follows by developing the information that shows the value of the
firm in different scenarios. One such scenario may be the firm going out of business,
selling off its assets and then distributing the proceeds to the various creditors as per the
importance of the claim that is associated with each of them with the surplus going to
the common stock holders. The firm may even take help of an appraiser who can
appraise the value of the firms property that can be used as a basis for ascertaining the
value of the firm in different scenarios. Other scenarios may include continued
operations, frequently with some improvements in the capital equipments, marketing
and perhaps some management changes. This information is then shared with the
bankers and the creditors of the firm. It has been frequently observed that the debt
capacity of the firm exceeds its liquidation value and it is further observed that the legal
fees and the other costs that are associated with the formal liquidation process under the
bankruptcy lowers the proceeds available to the creditors. Added to this, the process of
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resolving the case through formal procedure is also very time consuming, it may take a
year or even more than a year. This reduces the present value of the proceeds to much
lower level. When the creditors are supplied with this information, they might be
somewhat convinced to accept something less than their full value of the claim. In case
where the management and the primary creditors agree for a resolution, then a formal
plan is drafted and is presented to all the creditors providing them the reasons why they
should be willing to compromise on their claims.
While framing the reorganization plan, creditors offer extension because that promises
them their full payment at some point of time. In certain cases, the creditors may agree
to not only postpone the date of payment but also to subordinate the existing claims to
the vendors who show their willingness to extend new credit during the workout period.
In a similar way, the creditors may also be willing to accept a lower interest rate on the
loans during the extension period. This may be perhaps in exchange for a pledge of
collateral. Because of the sacrifices that are involved, the creditors should have more
faith than the debtor firm will able to solve the problems.
In comparison to this, the creditors agree to reduce their claims. Typically, the creditors
receive the cash and the new securities that have a combined market value that is less
than the amounts owed to them. Generally it is observed that bargaining is taking place
between the debtors and the creditors over the savings that in turn results from avoiding
the cost of legal bankruptcy, administrative cost, legal fees, and investigative cost and
so on. In addition to get away from such costs the debtor feels relieved that the stigma
of bankruptcy is not put on him. It is also sometimes seen that the bargaining process
may lead to the process of restructuring that may involve both extension as well as
composition. As an example, the settlement may provide for a cash payment of 25% of
the debt amount immediately, along with a new note that promises six future
installments of 10% each for a total payment of 85%.
The process of voluntary settlement is both informal as well as simple. They are also
relatively cheap because the legal and the administrative expenses that are associated
with it are limited to the minimum amount as a result of which the voluntary procedures
normally result in the maximum return to the creditors. Although the creditors do not
receive the payments immediately, and may some times have to accept an amount that
is lower than that owed to them, they generally recover more money and sooner than in
case the firm were to file a bankruptcy. Restructuring process also enjoys the benefit of
avoiding the loss that is incurred by the creditors. So a bank that is facing distress with
its regulators over weak capital ratios may even agree to extend further loans that may
be used to pay the interest on the earlier loans in order to keep the bank from having to
write down the values of the earlier loans. It is to be kept in mind that the informal
voluntary settlements are not limited to the smaller firms. Recent studies have
confirmed that they can extensively be used even by the larger firms. The biggest
problem that is encountered by informal reorganization is getting all the parties to agree
to the voluntary plan. This problem termed as the hold out problem is discussed in the
chapter.
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Informal Liquidation
When the management of the firm realizes that the value of the firm is more when it is
dead than it is alive, it may resort to informal procedures to liquidate the firm.
Assignment is an informal procedure for the purpose of liquidating a firm. This process
generally yields them a greater return that they would have received in formal
bankruptcy liquidation. However, the feasibility of the assignments finds its
significance only when the firm is small and the affairs of the firm are not that complex.
Assignments enjoy certain advantages over the process of liquidation in the American
bankruptcy Courts, in terms of time, legal formality, and expense. The assignee has
more flexibility in disposing a property than does a federal bankruptcy trustee. So an
action can be taken much faster when the inventory becomes obsolete or the machine
rusts. At the same time it is to be remembered that the assignment does not
automatically result in a full and legal discharge of all the debtors liabilities and neither
does it protect the creditors against fraud. Formal liquidation in bankruptcy can help in
solving both these problems.
8.6 CAUSES AND EFFECTS OF FINANCIAL DISTRESS

Before going in for a detailed analysis of the causes and effects of financial distress, let
us first try to find an answer to the following questions. These questions basically
revolve round the primary reasons for a firm experiencing financial distress; the effects
of the distressed firms etc., let us answer these questions using a top-down approach.
The discussion will be dealt in two separate sections. The first will speak more about
the macroeconomic growth and the government policies and the regulations that center
around the financial distress rates. The second section will deal with the ways by which
the financial distress can be related to the industrial factors. It is to be borne in mind that
the concept of financial distress is nothing new in the area of corporate finance. Here we
try to focus more on the causes and effects of the financial distress that is encountered
by firms around the globe.
Macro Level factors affecting the Financial Distress, Liquidity and
Recession
In his study, Bernanke (1981) made some key findings on the relationship among
liquidity, economic growth and financial distress. His argument stressed on the fact that
the existence of bankruptcy risk plays a role in the propagation of recession for both the
firms as well as individuals. He says, that bankruptcy leads to social costs, as a result of
which almost all the agents try to avoid the consequence of bankruptcy costs. From the
viewpoint of the consumers, they try to avoid it by retaining considerable amount of
liquid assets so as to meet their fixed expenses, the banks and the tenders try to avoid it
by being selective as far as their borrowers are concerned and by limiting the size of the
loan with recession creeping into any system, there is the reduction in the cash flow
income that is available to meet the current obligation. This, in turn, increases the
uncertainty about the future liquidity needs.
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There is also the general demand to bring solvency which consequently results in a
reduced demand for consumer and producer durables, which again may generate further
income reduction. Bernankes study focused on the critical relationship among the
changes in liquidity, financial distress and recession for both the consumer and firms.
He postulates, that recession leads to the creation of financial distress by bridging the
gap of margin between cash flow and debt service. When there is a constrained flow,
the fall in the current income reduces the expenditure on illiquid, long lived assets.
Two reasons can be attributed for this. The first being, the lower level of current income
enhances the short run probability, so that the flow constraint has to be satisfied through
expensive means. Say for example, the distress rate of assets, borrowing at unfavorable
terms, severe reduction in the current standards of living or even the last possible resort,
the bankruptcy of the firm. The other reason being, the fall in the current level of
income, reflects a hazy implication for the estimate by the consumer of the future
income flows and thus too, for the level of durables holding consistent with
maintenance of solvency in the long run. It must be remembered that, firms must bring
together and balance the long-term spending plans with the need for having the cash
flow so as to meet the short-term obligations. With a low level of internal liquidity,
coupled with many fixed expenses, there is the possibility of increase in the level of
financial embarrassment, for at least they raise the cost of new financing. At the same
time, postponement of capital expenditures is a proper defence mechanism of the
balance sheet, against any expected fall in the current income. Bernanke has also stated
the cause of bankruptcy. His suggestion is somewhat based on moral hazard. It is not
possible for the tenders to perceive the objective conditions on which borrowers base
their portfolio decisions. If a tender does not build a reputation for pressing his claims
the borrowers will have an incentive to become more of illiquid so as to force an
improvement in terms.
MONETARY POLICY
Bernankes study on the liquidity takes us back to the critical role of the monetary
policy on the overall liquidity of a nation. The overall liquidity of the US is governed by
the Federal Reserve Board through its open market transactions. These operations may
include the Feds buying and selling of the US treasury bills out of its considerable
inventory, so as to have an effect on its liquidity on either ways. When the Fed buys the
bills, as an expansionary mechanism, it adds on to the legal reserves to the banking
industry, that the nations banks can use in creation of new loans on a multiplied basis.
On the other hand, selling of the T-bills has a contractionary effect. The short-term
interest rates fall when the Fed is pursuing an expansionary policy and rises when the
contractionary policy is followed. The primary duty of the Fed is protecting the
purchasing power of the dollar, while at the same time ensuring a sustainable level of
real growth in the economy. The operation of the Fed is under the assumption that
inflation and real economic growth is positively correlated. But, if the real economic
growth is weak, the Fed can pursue an expansionary policy without concerning much
about inflation. In situations, where the economy is growing at a high and presumably at
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a rate that is unsustainable, the Fed steps in to make corrections. It is the contractionary
policy to bring down the level of inflation. At the same time, it is to be remembered
that, as a result of such monetary policies, the interest rates also rise, and entail a much
tighter limit on the availability of the short-term loans. These events, along with the
subsequent slow down of the economy itself, leads to an increase in the financial
distress of all firms, particularly those firms that are relatively weak in financial terms
or those that are highly levered.
Reversal Fortune: From Diversification to Focus
The effect of the reversal on financial distress can be viewed from many angles. In one
instance, it was found that when the changes to the corporate focus began to take shape,
many of the inefficient conglomerates that were facing keener competition became
financially distressed. The traditional thinking says that, the economies of scope have
been reversed in the 1980s. Managers of today tend to focus more on the core business,
and they are more likely to rationalize mergers and growth strategies, as well as
divestitures and restructuring, as a reflection of a strategy for specialization. This
particular view is a deviation from the steady increase in diversification since the 1950s,
and from the several theoretical justifications for diversification that have since been
evolved. They may include
i.
Managerial economies of scale.
ii.
Economies of scope in production and marketing.
iii.
Financial synergies.
Industry Level Causes of Financial Distress

The industry level causes of financial distress can be said to be a three tier system. They
are competition, industry shocks and deregulation. Let us now discuss each of these
factors in detail.
Competition
For identifying the possible industry level causes of financial distress, one can resort to
Michael Porters five forces model. The five forces that are included in it are:
a.
Barriers to entry.
b.
Bargaining power of suppliers.
c.
Bargaining power of buyers.
d.
Threat of substitute products.
e.
Rivalry among the competing firms.
Each of the above stated factors is associated with the financial distress of an individual
firm that operates within the industry. One of the possible implications of the stated
factors is that the firms in the different industries display different level of competition
as well as different profit sensitivities to the changes in the macroeconomic and industry
144
conditions over time. Financial distress is likely to be more in case of larger firms than
that of the smaller ones as per conclusions drawn from Williams analysis. The author
further states that a highly leveraged firm will commit to riskier projects as well as
aggressive product market strategies so as to prevent other firms from entry.
Industry Shocks
Any negative shock to the demand of the product or its cost, especially over a period of
time, eventually forces a shakeout of firms in the industry. The weakest of the firms are
forced into bankruptcy or they must consider being taken over by a stronger firm in the
industry. Studies conducted by Mitchell & Mulherin (1996) tested the proposition that
industry shocks contribute to the frequency of takeover and restructuring activities. The
shocks include, deregulation, changes in input costs of innovations in financial
technology that brings about changes in the industry structures. In a separate study,
Long and Stulz (1992) examined the effect of bankruptcy announcements by one firm
on the values of other firms in the industry. They tested for two contradicting effects.
One may be the contagion effect. The market may pull down the values of other firms
within the industry because of the fact that the bankruptcy announcement brings new,
negative information about the status of the industry as a whole. On the other hand, the
market may also raise the value of other firms in the industry because one of their rival
firms has failed. It has been found out that the balance between these contrary views is
dependent on the financial characteristics of the firm, within the industry.
Industry Deregulation
The process of deregulation in an industry can bring in financial distress in many firms.
This is mainly because of the fact, that deregulation within the industry brings forth a
change in the economic structure of the industry. Let us now try to focus on some of the
studies that reveal the effects of financial position of a firm due to deregulation creeping
in. In their studies conducted in 1986, Chen and Mercrilte studied the forced break up of
AT&T, that was initiated by Court Order on first of January 1984, and continued for
almost two years. The authors concentrated on the issue on whether the break up
resulted in wealth transfers among the security claimants of AT&T and other
stakeholders as well. The findings of their studies showed that economically significant
events took place during the deregulation process, which resulted in the transfer of
funds from third parties to the operating company shareholders. At the same time, it was
also observed that, no transfer of wealth from the bondholders to stockholders took
place during the deregulation process. In another study, Kote and Lehn (1999) examined
the effects of the Airlines Deregulation Act of 1978, along with the associated increase
in competition, on airline firms governance structures. They were able to develop
several hypotheses about the expected effects based on the agency theory. They stated
that deregulation may bring in the concentration of equity ownership. Deregulation may
also lead to the increase in the costs of monitoring managers. This can have a dual
effect. The first being, the outside shareholder will engage in monitoring only if his
private benefits, which are proportional to his equity stake, exceed the cost of
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monitoring. The other effect being, in order to internalize the agency problems that are
associated with higher monitoring costs, the managers themselves may own larger
stakes so that they can have a larger proportion of wealth associated with their
decisions. The authors also made predictions regarding the increase in the level of
executive compensation for the airline executives, and also involving a change in the
form of the compensation provided. They also put forth the argument that before the
process of deregulation, the executives pay would relatively be more sensitive towards
the firms earnings, whereas it would be more sensitive towards the stocks price after
the process of deregulation.
Firm Level Causes of Financial Distress
Though it is needless to mention about the importance that macroeconomic and industry
factors have on the firms financial distress, but it is also to be said that there are certain
firm specific factors that contribute substantially to the firms risk of financial distress.
These factors can be the firms,
i.
Ownership and governance structures.
ii.
Operating risk.
iii.
Leverage.
Say for instance, the firms operational efficiency, leverage and profitability of risk may
be affected by the existence of the agency cost that is associated with both managerial
discretion and debt. At the same time, it is also seen that when a firm is experiencing
financial distress and even if the cause behind such distress can be traced out, it might
be difficult to distinguish whether the decisions that resulted in the distress are due to
the managements self serving behavior or due to incompetence.
Financial versus Economic Distress
Economic distress was pointed by Andrade & Kaplan in 1998. A fine point of
distinction between financial and economic distress was pointed by them in 1998.
Economic distress is the result of fall in the operating income, or operating income
becoming negative.
On the other hand, financial distress takes place when the firm is unable to meet its legal
obligations, especially in matters concerning debt payments, irrespective of the fact that
a firm has an operating profit. Studies conducted on 31 firms characterized by highly
leveraged transactions during the 1980s, which later on became financially distressed,
have revealed to create value initially. Their operating income increased and was seen to
be more than the industry norms, on an average. Thus it was concluded that, the
existence of high level of leverage was the primary cause of their distress.
EFFECTS OF FINANCIAL DISTRESS

Loss of Tax Benefits of Debt and Depreciation
If a levered firm fails to earn profits on a regular basis, it loses the value of the tax
shield provided by the debt interest and depreciation. These losses alone can put a firm
at a most competitive and strategic disadvantage, based on the firms initial leverage
and depreciation.
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Transaction Costs
For a firm that is facing financial distress, the transaction costs in the financial market
seem to be much higher. It may also happen that the capital market has close proximity
to the distressed firm. This may be partly due to the high underwriting spread offered by
the investment bank to raise the firms equity. Added to this it is also to be remembered
that the transaction costs are high for a distressed firm that is in the process of debt
restructuring.
Agency Costs
For a firm that is in financial distress, the agency costs associated with managerial
discretion and debt are pretty high. As far as the former is concerned, the firms senior
management may be compelled to make decisions that keep their pay secured rather
than making long-term strategic, risky decisions on behalf of the shareholders. To
worsen the situation, the key employees of the firm may leave the firm, or may look for
other avenues of employment. The agency costs of debt may also be severe as the firm
has very little equity value against a relatively large amount of debt. Such situations can
be considered to be ideal for the expropriation of creditors.
Negative Liquidity Effects
The substantial loss in the market value of a firms equity can result in several liquidity
effects. They can be summarized as follows
a.
The firm may go on losing out its professional analysts who play a vital role in
supporting the flow of information about a stock.
b.
This may result in the normal trading activities of the stock and increase the
normal bid ask spread.
c.
The exchange may also delist its stocks based on its listing requirements.
When this situation comes, the firm loses most of its potential to raise equity funds. At
the same time, rising of debt funds becomes equally problematic. And this may happen
in such situations when the firm is in severe need of external finance in order to survive.
So, lack of access to external capital may even lead the firm to bankruptcy. It has been
seen that firms with higher growth opportunities and riskier cash flows tend to have a
relatively high ratio of cash to total non-cash assets. Those firms that have the highest
credibility in the capital markets, such as firms with highest credit ratings, tends to have
lower ratio of cash to total non-cash assets. At the same time, it is found that firms that
perform well, accumulates more cash than that is predicted by the static trade off model.
Where the managers maximize shareholder wealth.
Corporate Performance under Distress
There have been several studies that have been conducted to examine the performance
of firms under financial distress. Among those studies, a couple of them have gained
prominence. Both of them in fact focus on the leverage that acts as an important
determinant of the firms performance before it actually experiences the financial
147
distress. In his study conducted in 1993, Ofek has studied the relation between the
capital structure of the firm and its response to short-term financial distress. Out of the
358 firms included in the study, majority have shown that a higher level of pre-distress
leverage enhanced the chances of probability of operations, particularly activities
involving asset restructuring and employee lay-offs, and it also increases the chances of
dividend acts. These results can be seen consistent with the findings of Jensen (1988),
whereby higher pre-distress leverage increases the speed with which a firm reacts to
poor performance. An interesting point is to be noted here, that higher levels of
managerial holdings reduces the probability of operational actions, especially those
which do not generate cash. In a separate study, Titman (1994) found out of firms that
are high leveraged loses substantial market share to their more conservatively financed
competitors in situations of industry downturns. These findings are suggestive of the
fact that the indirect costs of financial distress are significant and positive. Keeping in
mind the fact that firms with specialized products are especially vulnerable to financial
distress, it has been observed that highly leveraged firms that carry out research and
development activities are the worst sufferers in times of financial distress. It has also
been seen that the adverse consequences of leverage are predominant in case of
concentrated industries.
Operational Cutbacks: Causes and Effects
When a firm experiences operating losses and reduced demand for the product it may
take the decision to cut-back its operating activities or workforce for a temporary
period. For a manufacturing firm this cost cutting may be lay-off or even to the extent
of closing down the firm. Let us discuss some of the papers on the cut backs, a couple
of them involves downsizing and a couple on closing down a plant.
Downsizing
Vasudevan et al. (2000) has studied the performance of 118 firms that downsized
between the years from 1989 to 1993. Their studies concluded that the firms that
downsized has encountered decline in operating performance before their downsizing
announcements. Most importantly there was evidence for improved performance after
the firms downsizing announcement and why actually they occurred. Following the
downsizing activity, there was significant improvement in the operating performance,
because the firms were able to reduce their cost of sales, labor cost, capital
expenditures, and research and development expenditures. It was also observed that
firms that performed poorly before downsizing, had actually improved their level of
performance after downsizing. The improvements have been more for those firms that
increase their focus.
Plant Closing
Blackwell et al. (1990) studied the causes and effects of plants closing down. As far as
the cable were concerned, the authors tested the competing hypothesis that closing
down of a plant is due to:
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a.
Decline in its profitability.
b.
Threats of a takeover.
As far as the effects were concerned, their studies forward on the effects of a plant
closing announcement on a firms market equity value, of the subsequent closing on its
profitability. The closing down of the plants did not appear to have any relation to
takeover activities, opined the authors. Rather they seemed more to be influenced due to
decline in their profitability.
In another study, Gombola and Jsetsekos (1992), examined the events of plant closing,
focusing more on the information effects. They found out a negative stock price relation
to the announcement of a plant closing, further, they also found out that closing down of
a plant seemed to be followed by additional negative news, including those of declining
profitability and activities of retrenchments that included cutbacks in employments,
asset acquisition and growth in dividends. It was also found out that the variation in the
abnormal returns during the periods of announcements was partially due to the markets
anticipation of the other subsequent events to the extent they occur.
Theoretical Perspective of Asset Sales
A theoretical model as developed by Sheifer & Vishy (1992), reveals a more general
picture of asset sales for a firm that is in financial distress. This model was discussed
with more detail by Pulvino, in 1998. The discussion of the model can be summarized
in the following way. While developing the model, Sheifer and rising had considered
situations whereby a firm responds towards financial distress by selling off its assets.
The party to whom the assets are sold say a buyer within the industry or outside it
depends on the buyers fundamental values as well as their abilities to pay. Further, the
differences on the valuations of the assets largely depend on the characteristics of the
assets being sold say if the assets are industry specific, an inside buyer is more likely to
put a higher value on the assets than an outside buyer. For example, the oil refineries are
industry specific assets that generate larger cash flows when used to refine oil, but
comparatively less amount of cash flows when they are deployed elsewhere. On the
other hand, if the assets are more of a generic nature then both inside and outside buyers
will place similar values on the assets. Computers are an example of generic products.
They can be used productively in any kind of industry. So, even if the inside buyer is
more productive and offers a better value for the assets the firm selling the assets may
still consider it as selling to the firms outside the industry. This is true in case of
industrial recessions, when the factor that forces the seller to liquidate will create
financial constraints for the potential inside buyers also. In such circumstances, the
inside buyer will be unable to offer the fundamental value for selling the firms assets. If
the financial constraints involved for the insiders are more severe than that of the
outsider, the outsider will bid more than the insider, resulting in the redeployment of the
assets at a lower value.
In contrast to the above argument, title et al. (1987) provided a theoretical argument
which is named as the efficient development hypothesis by Long, Poulson and Stulz
(1995). They say, managers tend to retain assets for which they have a comparative
advantage and sell the assets as soon as another party can manage them more efficiently
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irrespective of their financial situations. Irrespective of the fact that the managers reinvest the proceeds of the asset rates or pay them out, the stockholders enjoy the
benefits.
The Gainers from Asset Sales
Studies conducted by Datta & Iskandar Datta (1996), has examined the distribution of
gains from the asset sales among the security holders of the selling firm. The study
confirmed the fact, that on an average, the sell off enhances the value of a firm. It was
also found out that sell off can result in redistribution of wealth, value destroying or
value enhancing that depends on the way the proceeds of the sales are distributed and
the motive that underlies the sell offs. The wealth effects of the stockholders and the
bondholders are not always seen to be symmetrical. The results of the findings were
suggestive of the fact that those benefits arising from the sale of assets that are not
stockholders, on the other hand the benefits from distress related sell offs accrue to the
bondholders.
Sell-off activities results in transfer of wealth between the security holders. The authors
also suggest the fact that the relative size of the asset sales, the uses of the sales
proceeds, the degree of protection enjoyed by the bondholders through dividend
restriction may be relevant in explaining the direction of wealth transfer.
Debt Holder-Equity Holder Conflicts
It is to be kept in mind that bankruptcy cost is not the only cost that is associated with
debt financing. If it were so, it would not have been possible for companies like IBM to
have relatively low debt ratios and at the same time having histories of generating
taxable earnings. Added to this, such companies were also able to lower their costs of
capital by increasing their leverage. Here one can conclude that the predicted present
value of the direct costs of bankruptcy is incorporated into the firms borrowing costs.
So one can say that these direct costs cannot be more than the present value of the
yearly difference between the firms borrowing rate and the comparable default rates of
interest. In order to provide a justification for the use of the costlier equity financing to
finance their projects, one must take into account the bankruptcy cost that is associated
with it. The basic cause of indirect costs due to the threats of bankruptcy and is relevant
even if the firm never defaults on its obligations. This is one of the reasons, why they
are termed as financial distress costs. The threats of bankruptcy may affect a firms
relationships with its tenders. They in turn may have an influence on the firms ability
to operate efficiently.
Equity Holder Incentives
It is to be kept in mind, that the incentives of the equity holders in order to maximize the
value of their shares are not necessarily consistent with the incentives to maximize the
total value of the firms debt and equity. As a matter of fact it has been observed that the
shareholders of a leveraged firm often have an incentive to put into practice the
investment strategies that reduce the value of the firms outstanding debt. Here it is
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important to note that the total value of a firm equals the value of the firms debt along
with its equity; so it can be said that these strategies that reduce the value of the firms
debt keeping its total value in tact, actually increases the share price of the firm. So, the
equity holders have an incentive to carry out these kind of strategies if permitted to do
so. At the same time, they may also implement strategies that reduce the total value of
the firms debt and equity claims if these strategies are capable of transferring a
sufficient amount from the debtholders to the equity holders. For a sophisticated lender
it is important to anticipate the equity holders incentives to implement strategies of self
interest and thus he will determine the interest rates they charge on their loans. For the
lender who anticipate that the equity holders will take actions in the future that reduces
the value of the lenders claim will charge a higher rate of interest. From this point of
view, the equity holders bear the expected costs of their future adverse incentives in the
form of higher interest rates at the time they borrow. As a consequence, the firms find it
important to convince their lenders that they will not indulge in such behavior and they
will act so as to maximize the total value of the firm. At the same time, firms may have
difficulty in committing credibility to a policy of maximizing its total value rather than
the value of their shares. There can be several ways by which the firms equity holders
can expropriate wealth from its debtholders say for example, the equity holders of the
firm can instruct the firms managers to sell-off all its assets and pay off the proceeds
as dividends to the shareholders. This leaved the debtholders with value less papers. The
debtholders, on the other hand, having knowledge of such actions to be taken by the
equity holders start demanding for covenants, which are actually contracts between the
lender and the borrower that prevents such actions. There can be several types of
conflicts arising between the debtholders and the equity holders some of which can be
categorized as follows:
a.
The debt overhang problem, which involves the equity holders under- investing,
that is to say, pass up profitable investments due to the reason that the firms
existing debt captures most of the projects benefits. That is also referred to as
the underinvestment problem.
b.
The asset substitution problem, whereby the equity holders have a tendency to take
on too risky projects, even when they entail a negative net present value.
c.
Short-sighted investment problem in which the equity holders show a tendency

to pass up profitable investment projects that pay off over a long time horizon in
favor of ten profitable projects that may pay off more quickly.
d.
The reluctance to liquidate problems involves the equity holders to keep a firm
operating when its liquidation value exceeds its operating value.
Minimizing the Debtholder-Equityholder Inventive Problems

One of the simplest way to deal with the debtholder-equity holder problem is to
eliminate the debtholders. These problems actually does not step in case the firm is
totally equity financed. But it is to be noted, that the inclusion of debt also carries some
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advantages along with it. So, the firms do have an incentive to include the debt in such
ways so as to minimize the potential conflicts between the borrower and the lenders.
The following may be some of the ways by which a firm may minimize the incentive
costs associated with debt financing. They are
a.
Protective covenants
b.
Bank and privately placed debt
c.
Use of short-term debt
d.
Security design
e.
Project financing
f.
Management compensation contracts.
Protective Covenant
Typically a bond or a loan covenant specifies dividend restrictions as a function of a
firms earnings. The drawback of the type of covenant is that it provides an incentive to
the firms to artificially enhance their earnings so that they can pay out more in the form
of dividends. Thus the restrictions on dividends that are tied to corporate earnings may
not keep the firms from cutting back on items such as maintenance and service. These
may be considered to be good investments from the standpoint of the firm, but they
have the effect of initially reducing the reported income. Added to the one stated above,
there may also be examples of covenants that require the firm to satisfy the restrictions
on the various accounting ratios, such as debt-equity ratio, interest coverage ratio, and
working capital ratio.
In their study of bond covenants, Smith & Warner (1979) had observed that of the total
amount of bonds issued in 1979, 90% restricted the issue of additional debt, 23%
restricted dividends, 39% placed constraints on merger activities, and 35% placed
restrictions on how a firm can sell its assets, these covenants actually provide coverage
to the original debt holders, against the firms tendency to undertake high risk
investment projects in the future. On the other hand, the availability of those types of
covenants that directly limits the type of projects that the firms can undertake are often
common. The reason being, it is very difficult to specify in a contract the exact types of
investments that can be allowed over a 20 to 30 year life of a bond. In many cases it
might happen that a subtle change in technology may bring a change in the risk.
Do the protective covenants solve all the problems?
It may not be always possible to eliminate all the incentive related problems, with the
aid of contractual provisions. Say for example, initially the debt overhanging problem
may result in the firm to pass up positive net present value, while it is advisable that
contracts can be written so as to prevent certain projects. At the same time, it may not
be possible to include the debt covenants that prevent the firm from turning down
positive net present value projects that reduces the value of the firms common stock.
There may be another problem that involves the inclusion of the equity and thereby
influencing the original equity holders and thus allowing the firm to keep performing at
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the expense of the debtholders. In this regard, the gain to the equity holder is less as
compared to the loss of the debtholder. But, taking the ground reality, the firm would
consider the inclusion of equity, as the equity issues that fund positive NPV projects
benefit both the debt holders and the equity holders.
It is to be mentioned here, that while debt covenants may solve some of the incentive
related problems, they are associated with some degree of costs. They can be costly to
write and enforce, and they can even limit the flexibility of the firm. Thus it is observed
that, the publicly traded investment grade debt rarely has covenants that could trigger a
technical default. This type of covenants are more observed in private debt, the holders
of which can more easily monitor the compliance criteria of these covenants and also in
case of non-investment grade debts, that is more subject to the kinds of concerns, that
will be discussed in more detail later.
Bank and Privately Placed Debt
Debt financing can sometimes cause either the problem of debt overhang or asset
substitution, depending on the circumstances. Bond covenants that can effect the
firms ability to issue debt that is senior to the existing debt, can effect the firms
tendency to experience these problems. Use of debt may be advantageous in certain
situations as it helps in solving the free rider problems that influences the debt
overhanging problems. It is possible to eliminate the free rider problem if the firm has
only one lender associated with it. Say for example a bank, which can take into
account how its new loans affect the value of its existing loans, the debts that are
privately placed with the insurance companies as well as pension funds, have an
added advantage as compared to the publicly traded bonds. The banks and the other
private providers of debt capital are in a better position to be able to monitor the
investment decisions of the firms and enforce the protective covenants. Coupled with
this, there can be imposition of more stringent covenants on the private debt as it is
much easier to renegotiate and to enforce a covenant with a bank loan covenants
restrict the flexibility far less than equivalent bond covenants. Firms raising their debt
capital through the public markets instead of doing it through banks are the larger,
higher quality, less risky firms. These firms are less likely to be subject to the types of
financial distress costs. There can be a number of costs that are associated with bank
debts that a firm may be able to avoid by directly accessing to the bond or commercial
paper market. One such cost may be intermediation cost that arises because the banks
require buildings and labor and are unable to loan out all their funds because of the
reserve requirement. Another cost may arise because of the loan officers extending an
additional credit to the marginal borrowers. One reason for this being, the loan
officers does not want to reveal that their initial loan to the firm was bad or because
they did not want to face the unpleasant task of forcing a client into bankruptcy.
Finally, it is also to be mentioned here of the hold up problem that makes the debt
more attractive to some borrowers. The hold up problem takes place when the firm
has too much reliance on any single bank, and the bank takes advantage of their and
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charges the firm a much higher interest rate on its subsequent loans. When such
situations occur, the firm may find it difficult to access capital from other
comparatively cheaper sources which may be due to the fact that the firms reliance to
any single bank for raising capital may indicate unfavorable future prospects.
Use of Short-Term versus Long-Term Debts
The debtholder-equity holder conflicts are more severe when the firms actually use the
long-term debts rather than the short-term debt financing. This is more so, because the
equity holders have an incentive to implement the investment strategies that are more
advantageous to them by lowering the value of the firms outstanding debt. Thus one
can conclude that as the value of the short-term debt is much less sensitive to change in
the firms investment strategies that the value of long-term debts, the conflicts is lower
for firms that are financed with short-term debt. The use of short-term debt structures
can be helpful in mitigating the debt overhang problem as well as reducing the asset
substitution problem. Myers (1977) pointed out the possibility of eliminating the debt
overhang problem in case the firms existing debt matures before the time when it must
raise additional debt in order to fund a new project. An inclusion of a risk free project,
that would lower the overall risk of the firm, would also lower the borrowing cost of the
firm, making it attractive for the firm to accept the project. As far as the asset
substitution problem is concerned, it can be said that the use of short-term debt makes it
even more difficult for the equity holders to gain at the expense of debtholders by
selecting riskier projects. The equity holders of a highly leveraged firm may give
preference to more risky projects because the upside potential is higher and they share
any downside risk with the debtholders. On the other hand, if the firms debt is basically
short-term, the incentive to increase the asset risk diminishes.
Drawbacks of Short-Term Debts: As it is a case with other forms of financing, the
short-term debts are also not free from drawbacks.
With short-term financing, firms that are highly leveraged, may face bankruptcy in case
of unexpected rise in the interest rates. This has actually resulted in some authors going
for short-term borrowing coupled with hedging interest rate risk in the futures and swap
markets.
Security Designs: Use of Convertibles
A convertible bond is one that provides the holder of the bond with the option to
exchange the bonds for a prespecified number of the issuing firms shares. Some times
convertibles are considered as a combination of a call option on the firms stock and a
straight bond. It should be held here that the options, and thus the option element in the
convertible bond become more valuable as the stock price volatility of the firm
increases. It is to be noted that, the increase in the value of the option component can
compensate for the decrease in the value of the convertibles straight bond component
that takes place when the volatility of the firm increases. In fact, based on the relative
importance of the option and the straight bond components, the convertible bond can
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either increase or decrease the value with the overall increase in the firms level of risk.
It has been suggested by many that it may be possible to design a convertible bond
whose value may be insensitive to change the volatility of the firm. As a result, the
equity holders of such firms that are financed with debts would have no incentives to
select a high risk project as their gain from the debtholders would be nothing and they
would not gain anything from adopting the project unless the project has a positive net
present value.
Use of Project Financing
Project financing is the capital required to finance an investment project for which both
the projects assets as well as its liabilities that are associated to its financing can be
viewed as separate entities from the rest of the firm. In most of the cases, the provider of
equity is the parent company that appears on the firms balance sheets. However, the
responsibility of the debt does not lie with the parent, which implies that the value of the
debt does not come on the firms balance sheet. Added to this, the projects debt has a
senior claim on the cash flow generated by the project. The use of project financing can
help in lessening of the debtholder-equity holder conflicts in a number of ways. Project
financing results in reducing the amount of wealth transfer from the equity holders to
debtholders as the projects debts would have a senior claim on the cash flow of the
project. Further, as project financing is attached to specific projects, there is also a lesser
scope for the kind of asset substitution problem. But it should also be remembered here,
that project financing cannot solve all problems. In many situations, it becomes difficult
to define a firms project in a way that allows it to be financed as a separate entity.
Project financing though helps in reducing the underinvestment problems, it can often
enhance the asset substitution problems. Let us consider the behavior of a manager
with different projects that can be financed either as ten independent projects or
together as one firm. If say, each of the ten projects are financed with non-recourse
debt, the incentive to increase the risk of any project may be quite high as the
manager will try to take advantage of all the upside benefits that are associated with
the more favorable outcomes whereas the debt holders bear the increased downside
costs that are associated with the unfavorable outcomes.
Management Compensation Contracts
It may sometimes happen that the firm may be under tremendous pressure to please the
debt holders rather than the equity holders. This is especially the case with highly
leveraged firms which depend on their banks to finance their day-to-day operations.
There are also some natural tendencies of the managers to satisfy the interest of the debt
holders as compared to the equity holders. As compared with the other shareholders, the
managers have a much larger portion of their wealth tied up in the firms they manage
and thus they are more likely to act as though they are more risk averse. This would
increase their tendency to take on the less risky of diversifying investments which might
counteract the incentive to take on too much risk. There is also the case of prestige and
power that go hand in hand with operating a growing firm that provides an incentive for
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the managers to over invest. In order to maximize the current value of the firm, a firm
must commit its managers to make future choices that are in the combined best interest
of all the claimants, which maximizes the combined value of the firms debt and equity.
A firm will be in a position to borrow at more attractive rates if the manager is able to
assure the lender that the interests of both the debtholders as well as the equity holders
will be duly considered while making the investment choices. This implies that firms
will find an incentive to compensate the managers that can make them sensitive to the
welfare of both the debt holders and the equity holders.
EMPIRICAL IMPLICATIONS OF FINANCIAL CHOICES
Investment Opportunities Influencing Financing Choices
Debt financing distorts the investment incentives, so firms with substantial investment
opportunities are more conservative in their use of debt financing. For the purpose of
conducting the study, the variables that are used to measure future investment
opportunity includes, R&D expenditures, ratio of the firms market value to book
value. Both of these variables are found to have a negative relation to the amount of
debt that is included in a firms capital structure. Those firms that have a high element
of these two variables have little debt in their capital structure.
Financing Choices influencing Investment Choices
There can be primarily two reasons that can be attributed to the fact that the
debt holder equity holder conflict can be worse for the smaller firm. They are
a.
Being more flexible, the smaller firms are better able to increase the risk of their
investment projects.
b.
The major shareholders of the smaller firms are the top managers. This gives
them the incentive to make choice that in turn benefits the equity holders at the
expense of the debt holders.
These reasons are actually points to the fact, that smaller firms should have lower debt
ratios. But, in reality this does not seem to happen. The smaller firms tend to choose the
debt instrument that minimizes the conflicts between debt holders and equity holders.
To be more specific, their long-term debt seems to be more convertible of a major
portion of their total debt financing tends to be short-term debt.
It is also seen that the small firms avoid the long-term debt because of the involvement
of transaction costs. As a result, the smaller firms may go for less expensive loans from
banks that have lower fixed transaction cost than bond issues, but which at the same
time provides only short-term financing.
Debt Restructuring
Most of the firms that are in financial distress find it very difficult to service their debt.
If it is otherwise viable, for longer span of time, a distressed firm may even go for
private debt restructuring or work out with its creditors so as to restructure its debt
obligations. But this can be a very difficult task, especially in case the firm has any
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public debt outstanding. One of the problems that is often encountered in a debt
restructuring process is that of a hold out problem. The problem involves the issue that
all the debt claimants must agree on the re-assignment of debt claims, but one or more
of the claimants is likely to have an incentive to hold out for a better deal. Getting to an
agreement among the creditors that is outside the formal process of bankruptcy depends
upon the type of debt that is restructured, i.e., public debt or private debt. In exchange
offers, the bondholders are given the option to exchange their bonds for a package of
new securities. They are often accompanied by modifications of the original bonds
covenants through a technique that is better known as consent solicitation or exit
covenants.
Investment Incentives under Financial Distress
As it has been stated, the financial distress can enhance the distortion of a firms
investment incentives that takes place when a firm has debt as a component of its capital
structure. This especially applies to those firms that are in severe financial distress.
In their studies, Bergman & Callen (1991) examined the strategic behavior of
management and the creditors during the process of debt renegotiations. In those
conditions where the value of the firm at debt maturity hardly finds it opposable to
repay the promised amount, the management will resort to optimal use of its discretion
over the investment decisions of the firm to get concessions for its creditors by
threatening to squeeze out the firms value through sub optimal investment policies. As
long as the potential loss was observed to be small, the threats were communicated and
the creditors were seen to succumb to the reasonable demands. In another study,
Mooradian (1994) stated that asymmetric information and conflicts of interest combined
to force the distressed but efficient firms in order to liquidate, and distressed inefficient
firms to continue. This can happen, when the inefficient firms can imitate the efficient
firms in the process of debt restructurings so that in the resulting pooling equilibrium,
both the efficient and the inefficient firms are equally likely to continue or to liquidate.
Thus one can observe either of the two investment inefficiencies
i.
Inefficient firms continue when they should be liquidated.
ii.
Efficient firms are liquidated when they should continue.
It has been further observed that chapter 11 can be used as a useful mechanism for
shielding the inefficient firms out of debt renegotiations (we will briefly discuss chapter
11 in the following section). The inefficient firms voluntarily choose chapter 11 as
negotiations therein generally result in some value that is retained by shareholders. So,
although inefficient firms continue under chapter 11 reorganizations, at least the
efficient firms avoid liquidation through private debt renegotiations. Certain problems
that were associated with exit-exchange offers were studied by Bernando and Talley
(1996). The problem that existed with such offers were, each creditor had to decide
simultaneously on whether to consent to restructure their claim or to accept the new
debt or debt packages that were offered to them by the firm.
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The authors of the paper had suggested that the manager and the shareholders may, in
their self interest, go for inefficient investment projects strategically, so as to enhance
their bargaining positions as against the creditors. They have also observed several
transactional frictions that can influence efficient restructuring, including the situation
in which the debt holders are many which may hinder them to co-ordinate their
bargaining strategy amongst themselves. That kind of collective action problems can
compel the individual bondholder to behave more strategically against one another.
Discussions of Chapter 11 of the US Bankruptcy Code
Chapter 11 of the US Bankruptcy Code is a type of corporate filing that involves reorganization. In this type of bankruptcy alternative, the firms assets, liabilities and
equity are restructured with the objective of providing the business a chance to survive.
The firm is asked to file a reorganization plan within 120 days (4 months) of receiving
the Courts order for itself. The plan must further address the creditors claims within
general classes. The reorganization plan is subject to the approval of creditors and Court
confirmation, and all the administrative expenses must be paid. Though the process
involves mandated deadlines, firms often request extension that results in years of
litigations.
Vulture Investors
Vulture investors gained prominence during the 1980s. These investors specialized in
the debt or equity of the distressed firms. They generally engage themselves in
purchasing substantial blocks of the firms equity or debt with the intention of
influencing management or to the extent the vulture investors were on the high. In most
of the cases, these investors purchased the debt claims that accounted for over one third
of the firms outstanding debt, that was sufficient to provide them the influence. Studies
conducted by Hotchkiss and Mooradian (1997) examined 228 firms that were in distress
and found that in sixty percent of the cases where the vulture investors were involved,
played a key role in the governance, restructuring or re-organizing of the firms. It was
found that when the vulture investor became the CEO or chairman, thus gaining control
over the target firm, there was vast improvement in the post restructuring operating
performance relative to the pre-default level. It was further observed that there was
positive abnormal returns for the targets common stock and bonds in the two-day
surrounding the announcements of a vulture purchase of public debt or equity. The
authors concluded that vulture investors add value by disciplining managers of
distressed firms.
Exchanging Equity for Debt
There have been several academic papers that have focused on the agreements between
a distressed firm and its creditors that involve the exchange of equity for debt. This is
done in order to reduce the leverage of the firm and thereby levering distress. James
(1995) examined 102 cases of debt restructuring over the years 1981 to 1990. Out of the
total sample size, in 31% cases, banks went in for taking equity in exchange of debt.
Their studies have revealed that the roles that the banks play in debt restructuring
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depends upon the financial conditions of the firm, the level of public debt in the firms
capital structure and the ability of the public debt that is to be restructured. It has been
found out that, when banks do take equity, on an average, they take a substantial
proportion of the firms stock, and they maintain it for over a couple of years. James had
also observed that, the participation of banks play a crucial role in resolving information
and hold out problems that impede a public debt exchange offer. Sometimes it may also
happen that in the absence of hold out and information problems, bank concessions may
occur in conjunction with concessions by public bondholders.
Determinants of Success in Private Debt Restructuring Negotiations
Gilson, John, and Lang (1990) made an effort to find those circumstances under which a
distress firm might be successful in a private debt restructuring. They focused their
study on the incentives of financially distressed firms to restructure their debt privately
rather than through the formal process of bankruptcy. Firms that reveal a better
tendency to restructure their debt privately have more intangible assets, owe more of
their debts to banks and owe fewer of tenders. Studies conducted by Asquith et al.,
examined the restructuring decisions of 102 firms that had issued junk bonds and later
on became distressed. Their main finding was that a firms debt structure affects the
way financially distressed firms restructure. The combination of secured private debt
and numerous public debt issues seems to impede out of Court restructuring and
increase the probability of a chapter II filing.
Acquisition or Takeover of a Distressed Firm can Create Value
The financial distress that any target firm faces contributes to a major factor in a
substantial proportion of acquisitions when a firm acquired by another stronger firm
within the industry can result in its value creation for its shareholders. This is mainly
due to the following reasons:
a.
The combination may result in increased economies of scale.
b.
The combination may increase the product market power.
c.
The acquiring firm may be able to enhance the troubled firms operations
through superior management techniques.
d.
The acquiring firm may be able to contribute badly needed capital to the troubled
firms, which may have been lacking both internally generated cash and effective
access to external capital markets.
It is also seen that hostile takeovers are also often triggered by financial distress. Before
the takeover process, the takeover firms generally substantially underperform other
firms in their industry and the motives behind such takeover may be to correct the
management failures. Further, it is to be noted that diversified firms that perform poorly
and loose value are often targets for a bust up takeover.
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LBOs and Financial Distress

Leverage buyouts are often resorted to by firms that lack incentives to pursue value
enhancing activities. An LBO can alleviate this problem by both increasing managerial
equity ownership and imposing the discipline of debt. Though it was observed by Opter
and Titman (1993) the firms with high expected costs of financial distress are less likely
to go for a leveraged buy out.
Alternatives available with the Firm
A firm faced with imminent bankruptcy has two alternatives to choose from:
Reorganization and Liquidation.
Reorganization of a firm is a more sensible solution when faced with the possibility of
bankruptcy as it will be in a better position to repay its debts, when it is alive and
operating, than when it is liquidated. There are a number of cases of firms that have
been successfully turned around from a state of hopeless bankruptcy.
In case, reorganization is not a viable option and the firm no longer has the ability to
operate and earn profits to pay-off its liabilities, liquidation is the only alternative
available. All the assets are sold and the proceeds are distributed to creditors and other
concerned parties.
In the Indian context, the decision to organize/liquidate a firm vests with BIFR (Board
of Industrial and Financial Reconstruction). The BIFR takes this decision based on a
thorough techno-economic viability study of the firm in co-ordination with the
management of the firm, the financial institutions, etc.
If the study reveals that it is possible for a sick industry to make its net worth exceed the
accumulated losses by itself within a reasonable time, the BIFR may give the company
the necessary time under conditions, to reorganize itself. In case BIFR decides that it is
not possible for a sick company to make its net worth positive, it may decide to provide
financial assistance, or alternatively, it may decide to wind up the company and forward
its opinion to the concerned Court.
Reorganization
The steps involved in reorganization of a firm are:
Techno-economic viability study
Formulation and execution of the reorganization plan
Monitoring the activities of the firm.
Techno-economic Viability Study

A reorganization plan is worked out on the basis of a techno-economic viability study of
the firm. This study sets out to identify the strengths and weaknesses of the firm, the
causes of failure, the viability of future operations and the course of action to be taken
to bring about a turnaround. The techno-economic viability study is undertaken by the
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operating agencies assigned to the firm. These operating agencies are generally financial
institutions and banks such as IDBI, IFCI, ICICI, IRBI, SBI, PNB, etc.
The techno-economic viability study covers all the functional areas of a firm:
management, finance, production and marketing.
Management: The effectiveness and ability of the management is one of the most
important factors that determines the success or failure of a firm. A detailed study is
done in terms of the objectives of the firm, both short-term and long-term, the corporate
strategy, the corporate culture, the management-labor relations, the organizational
hierarchy, the decision-making process, etc. The study tries to determine the
effectiveness of management and its integrity. The areas of mismanagement are also
determined.
Finance: Finance is the main functional area of business. It is a measurable indicator of
the firms health and performance. A thorough analysis of the firms Balance Sheet and
Profit/Loss statement is made.
These statements when properly analyzed give the financial stability and liquidity of the
firm; profitability and uses of funds. The analysis also identifies the capital structure
and the sources of funds. The analysis gives insight into working capital management
and management of earnings.
Production and Technology: Production and Technology function assumes immense
importance in the viability study. The various areas that are looked into are, the firms
equipment and machinery, maintenance of the equipment, technology used in
production, production capacity and utilization, products being offered by the firm,
quality control system, production planning and inventory control.
Marketing: A number of firms have failed because of lack of good marketing
management. The various areas of marketing that are studied are, the product mix of the
firm, the past sales of the product in terms of quantity and value, the market share of the
firm, demand for the product range, the study of the customer profile, price of the
products, the distribution channels being used, the kind of promotion mix being used
and the most important of all is the marketing team. This study is done in comparison
with the competitors.
Formulation and Execution of the Plan
The viability study serves as the basis for formulation of a rehabilitation plan.
A thorough study of the various functional areas of the firm reveals the strengths,
weaknesses, opportunities and threats of the firm. It gives a comprehensive idea about
the status of the firm, the viability of the firm both technically and economically and the
additional funds required for rehabilitation.
The formulation plan involves the changes and action to be taken regarding the various
functions of the firm. It may decide to make changes in the management, if it is not
found competent. Some of the labor may be retrenched/recruited depending on the
situation. The amount of financial assistance to be given is determined and
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arrangements are made to secure the loan. Various steps are taken to improve the
production function in terms of new machinery and new technology. The viable level of
operations are determined and steps are taken to achieve this production level.
The product-mix, the pricing, the quality of the products, distribution channels and the
promotion-mix are to be changed to suit the needs of the customers, to achieve the
desired sales levels. Once the plan is formulated, the plan is carefully executed. All the
necessary changes prescribed by the plan are made. The funds are disbursed in a phased
manner as and when required. The necessary concessions and reliefs are provided.
A close watch is kept on the activities of the firm and a continuous evaluation is done.
Monitoring: Monitoring is a very important part of a rehabilitation plan. It is done to
evaluate the execution of the plan. Regular meetings are held between the firm, the
bankers, the financial institutions and other concerned parties to verify and evaluate the
process of execution. Monitoring is done to ensure the proper utilization of funds and
adherence to the terms of rehabilitation plan. It also ensures the proper working of the
firm. Feedback is obtained and remedial measures are taken as and when the situation
demands. The impact of rehabilitation becomes evident in a short period. Once the
success of the firm becomes evident, the role of agencies and banks is confined to
constantly hold meetings to assess and review the process. This continues till the firm is
successful. In case the firm is found incapable of making a turnaround despite the plan,
then the steps to liquidate the firm are undertaken.
Liquidation: A firm is faced with liquidation when it is established that there is no hope
of bringing about a turnaround and coming out of financial crisis. Liquidation requires
the firm to dispose its claims and settle liabilities on a priority basis.
Section 425 of the Companies Act, 1956 gives the ways in which a company may be
liquidated:
Compulsory winding up under the Court Order.
Voluntary winding-up; (a) members voluntary winding-up, and (b) creditors

voluntary winding-up.
Voluntary winding-up under supervision of the Court.
Section 433 of the Companies Act, 1956 gives the circumstances under which a
company be wound up by an order of the Court.
Compulsory Winding-Up
If the company passes a special resolution to wind up by the Court.
If the firm fails in holding the statutory meeting or in delivering the statutory
report to the registrar.
If the firm fails to commence business within a year from its incorporation.
Reduction in members of the company, below seven in case of a public company

and below two in case of a private company.
If it is unable to pay its debts.
When the Court is of opinion that it is just and equitable that the firm be
wound-up.
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In all the above cases, the Court reserves the discretionary power to order for a wind up
or direct the firm to take remedial action.
The following are the steps involved in liquidation by Court Order:
a.
A petition is made by the company or creditors or shareholders or the Registrar

or the Central Government for winding-up. This is dealt with in terms of Section
439 of the Companies Act.
b.
The Court Orders for a hearing of the winding-up petition and takes a decision
on the issue (Section 443).
c.
The Court appoints the official liquidator after informing the company about the
appointment so as to enable it to make its representation (Section 450).
d.
The Court sends the winding up order to the registrar and the official liquidator.
The petitioner has to file with the registrar, within thirty days, a certified copy of
the Order (Sections 444 and 445).
e.
Within twenty one days of the order a statement of the affairs of the company
has to be made. It should show the assets of the company, showing separately
cash in hand and at bank and negotiable securities, its debts and liabilities, the
names and addresses of the creditors indicating the amount of secured/unsecured
debts, the debts due to the company and the names and addresses of the persons
from whom they are due and the amount likely to be realized (Section 454).
f.
Within six months of the order, the official liquidator is required to submit a
preliminary report to the Court showing the amount of issued and paid-up capital
and the estimated amount of assets and liabilities, the causes of failure and whether
any further enquiry is desirable into the matters of the firm (Section 455).
g.
The liquidator then sells the immovable and movable property and actionable
claims of the company, by public auction or by private contract. He raises money
on the security of the assets of the company if required and do all that is
necessary for winding-up the affairs for the company and distributing its assets
(Section 457).
h.
The order of priority in which the distribution is done given below:

i.
Revenues, taxes, cesses etc.,
ii.
Wages or salary.
iii.
Holiday remuneration of an employee.
iv.
Contribution to ESI.
v.
Compensation under WCA, 1923.
vi.
Dues from provident fund, pension fund.
vii.
Expenses of investigation.
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Voluntary Liquidation: Voluntary liquidation is a form of liquidation under which the

firm and creditors come up with a creative plan to dispose off the liabilities in a manner
that makes sense to everybody involved. This happens when the firm realizes that there
is no hope of turnaround and liquidation is the only option that either occurs without the
involvement of the Court or under the supervision of the Court.
Voluntary winding-up is of two kinds:
Members voluntary winding up (Section 489): In this case the majority of the
directors declare that the company has no debts or will be able to pay its debts in full,
within a certain period, not exceeding three years from commencing of winding up. The
declaration must be delivered to the Registrar for registration, accompanied by a copy of
the auditors report, profit and loss account and the balance sheet of the company. A
liquidator is appointed and his remuneration is fixed by the company. The liquidator has
to inform the Registrar of his appointment within thirty days and publish the fact in the
official gazette. On the appointment of the liquidator, all the powers of the Board of
Directors cease. The liquidator summons a creditors meeting and winding-up
procedure starts. Once the affairs of the company are fully wound-up, the liquidator
makes a statement of the accounts of winding-up. He calls a general meeting of the
company and sends the accounts to the Registrar, who registers the documents and the
company is deemed to be dissolved.
Creditors Winding Up (Section 499): In this case, the company calls a meeting of its
creditors. The full statement of the position of the companys affairs and a list of the
creditors of the company and the estimated amount of their claims is laid down in the
meeting. A copy of the resolution passed at the creditors meeting must be filed with the
Registrar. A liquidator is appointed by the members of the board and the creditors. The
creditors and the company may appoint five members each to a committee of
inspection. The liquidator then follows the procedure of winding up which is essentially
the same for all kinds of liquidation.
The Liquidation Alternative
In the process of corporate liquidation, the assets of the firm are solo, the proceeds are
used to retire debt, and remaining cash, if any, is distributed to the stockholders of the
firm as a liquidating dividend. The liquidation of a firm may be of two types voluntary
and involuntary. A firm may be able to generate more value for its creditors and
shareholders by going in for liquidation than by continuing to operate. Let us now dwell
in some of the empirical studies that have been conducted on the same.
Studies conducted by Titman (1984) suggested that a firms liquidation can impose
costs on its customers, workers, and suppliers. There exists a relationship between these
individuals, and the liquidation decision controlled by the firm affects the other
individuals. This suggests that the capital structure can control the incentive and conflict
problem. Studies conducted by Kim and Schatzberg (1987), examined the possible
motives for as well as the consequences of voluntary corporate liquidations. An
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empirical investigation of successful liquidations shows that the announcements of

liquidation reduces the risk of liquidating share and the shareholders receive the
substantial gains from the resulting successful liquidation. It has also been seen that the
firm is liquidated, its assets are underutilized before liquidation and that voluntary
liquidations results in higher valued reallocations of corporate resources.
Reorganization in Bankruptcy
It is a matter of general notion that most of the reorganizations should be done in a more
informal way, because handling the reorganizations in an informal way is much faster
and also less costly than the formal bankruptcy. But there are two grueling problems
that deter the firms from resorting to the informal reorganization procedures and thus
force the debtors to go in for the chapter 11 bankruptcy. These problems relate to that of
the common pool problem and the hold out problem.
To properly illustrate this problem, let us consider a firm that is going through a phase
of financial difficulties. The value of the firm is assumed to be worth 0.9 crore as a
going concern. This value is the present value of the expected cash flows of the future
periods. But the firm is estimated to yield only 0.7 crore when it is subject to
liquidation. The face value of the firms debt amounts to 1.0 crore with ten creditors
each having a claim of 0.1 crore. Now suppose that the liquidity of the firm further
deteriorates and it defaults on one of its loans. The holder of the loan has a contractual
right to accelerate the claim, which implies that the creditor can foreclose on the loan
and demand payment of the entire balance. Further, since most of the debt agreements
have a cross default provisions, defaulting on one loan in turn places all the loans in
default. The market value of the firm is less than 1.0 crore the face value, regardless of
whether it remains in the business or goes into liquidation. Thus it will always be
impossible to pay off all the creditors of the firm to the full amount. But as a whole, the
creditors would be better off if the firm continues its operation, because they can realize
0.9 crore if the firm remains in business but only to the extent of 0.7 crore if it is
liquidated. This problem is referred to as the common pool problem. It says that in the
absence of protection under the Bankruptcy Act, the individual creditors would have an
incentive to foreclose on the firm even though it is worth more as an outgoing concern.
This is because in doing so, the creditor can in turn force the firm to liquidate a portion
of its assets whose proceeds would then be used for paying his claim of 0.1 crore in full.
Well, the payment of that particular creditor may be as a result of selling off some of the
major assets of the firm which in turn might result in the shut down of the firm and
eventually lead to the firms liquidation. This would result in the decrease in the value
of the claims of other creditors. But as a matter of fact, all the creditors would try to
realize the gains to be had from this strategy, thus they would storm the debtors with the
foreclosure notices. Even those creditors who realize the importance of keeping the firm
alive would be forced to foreclose, because the foreclosures of the other creditors would
ultimately reduce the pay off to those who do not. Say in our example, if seven of the
creditors foreclosed and forced the liquidation of the firm, they would be paid in full
whereas the remaining three creditors would receive nothing.
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A firm having a lot of creditors whenever defaults on one loan, there can be a potential
for a flood of disclosures that would in turn make the creditors worse off. In our
example the creditors would lose an amount of 0.2 crore (0.9 0.7) in case the flood of
foreclosures forced the firm to liquidate. In case the firm has only one creditor, say a
bank loan, the common pool problem would not exist. If the bank had loaned the
company 1.0 crore, it would force the liquidation so as to recover an amount of 0.7
crore when it could keep the firm alive and then eventually realize 0.9 crore. Chapter 11
of the Bankruptcy Act provides solution to the common pool problem through its
automatic stay provision. An automatic stay which is forced on all the creditors in a
bankruptcy limits the ability of the creditors to foreclose and to collect their individual
claims. It is worth mentioning here that even though the process of bankruptcy provides
a means to sort out the financial conditions of the firm, the management does not enjoy
the supreme power over the firms assets. This is because the law requires the debtor to
request permission from the Court to take many actions and the law further provides the
creditors with the right to petition the bankruptcy Court so as to block any action the
firm might resort to while in bankruptcy. Added to this, the fraudulent conveyance
statutes, which form a part of the debtor creditor law, provides protection from any
unjustified transfers of property by a firm that is going through financial distress.
Bankruptcy law also mitigates the hold out problem. In order to illustrate this problem,
let us consider our initial problem, with ten creditors owed 0.1 crore each, but with the
assets worth only 0.9 crore. The objective of the firm is to void the process of
liquidation by remedying the default. If carried out in an informal way, this would call
for a reorganization plan that is agreed to by each of the ten creditors. Suppose the firm
offers each of the creditors with a new debt of 0.085 crore in exchange for the old debt
of 0.1 crore face value. If each of the creditors accepts the offer, the reorganization of
the firm can be successfully carried out. It would leave the equity holders with some
value, i.e., the market value of the equity would be [0.9 10(0.85)] crore = 0.5 crore.
Added to this, the creditors will be having claims that is worth 0.85 crore, which is
much more than the value of 0.7 crore that they would have got in case of liquidation. In
resolving the hold out problem in bankruptcy, the bankruptcy Court has the ability to
categorize the creditors into classes and thereby aid in reducing such problems. Each of
the classes is expected to have accepted the reorganization plan if two thirds of the
amount of the debt and one half of the amount of the claimants vote in favor of the plan
and the approval of the plan will be obtained by the Court if it is considered to be fair
and equitable to the parties that are involved in the process of resolution. Such a
procedure in which the Court steps in to mandate the reorganization process in spite of
dissent is termed as a cramdown. This is because the Court crams down the throats of
the parties who dissent. Thus the incentive of the creditors to hold out is greatly reduced
with the Courts ability to force the reorganization plan. Thus in our example, the
reorganization plan offered each of the creditors a new claim that is worth 0.058 crore in
face value, along with the information that each creditor would probably receive only
0.07 crore under the liquidation alternative.
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The basic role of the bankruptcy Court in the process of reorganization is to determine
the fairness and the feasibility of the proposed reorganization plan. Here the term
fairness means that the claims must be reorganized in the order of their legal and
contractual priority. Feasibility means that there is a considerable chance that the
reorganized company will be viable. Fairness and feasibility involves the following
steps:
Estimation of the future sales.
Analyzing the operating conditions so that the future earnings and the cash flows
are predicted.
Determination of the appropriate capitalization rate.
Applying the capitalization rate to the cash flows of the concern so as to

determine the value of the firm.
Determination of an appropriate capital structure for the company after it

emerges chapter 11.
Allocation of the reorganized firms securities to all the claimants of the firm in a
fair and equitable manner.
It might apparently appear that the stockholders have very little to say in situations of
bankruptcy when the worth of the firms assets are less than the face value of the debt.
Under the absolute priority rule, the stockholders should get nothing of the value under
the reorganization plan in such situations though in fact the stockholders may be able to
extract some value out of the reorganization plan. The reasons being:
a.
During the bankruptcy proceeding the stockholders continue to control.
b.
They have the first right to file a reorganization plan.
c.
It is expensive as well as time consuming affair for the creditors to develop a

plan and taking it through the Courts.
Thus, given such conditions, the creditors may support a plan in which they are not
paid-off in full and where the old stockholders control the reorganized company simply
because the creditors get away from the problem and to get some money in the near
future.
Prepackaged Bankruptcies
Having discussed the relative merits and the demerits of formal as well as the informal
ways of reorganization, let us now discuss something that combines the advantages of
both these ways. In recent times, such a new type of reorganization has come up that
actually combines the advantages of both the informal workout and the formal chapter
11 bankruptcy. This new type of hybrid structure is termed as the prepackaged
bankruptcy or the pre-pack. In an informal workout, the restructuring process starts with
the debtor who negotiates with the creditors. The complex work outs involve the
corporate officers, lenders, lawyers and the investment bankers. The process is less
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expensive as well as less damaging to the reputation of the firm than the chapter 11
bankruptcy proceedings of the reorganization. In a prepackaged bankruptcy, the debtor
firm gets all or most of the creditors to agree to the reorganization plan prior to filing of
the bankruptcy. Followed by this, the reorganization plan is then filed along with or
shortly after the bankruptcy position. If there is considerable number of creditors that have
signed on or before the filing, a cramdown can be used to bring the reluctant creditors
along. The major advantages of the prepackaged bankruptcy can be cited as follows:
Mitigation of the holdout problem.
Preserving the claims of the creditors.
Taxes.
One of the primary benefits provided by the prepackaged bankruptcy is helping in

mitigating the hold out problem. A bankruptcy filing helps in the application of
cramdown that otherwise would be impossible. By eliminating the problem of hold out,
the bankruptcy forces all the creditors that fall in each class to participate on a pro rata
basis, which at the same time, preserves the value of all the claimants. Another aspect of
filing of the formal bankruptcy is the tax implications that are associated with it. In an
informal reorganization process, which involves the debenture holders trading debt for
equity, the company may end up losing its accumulated tax losses if the original equity
holders end up with less than 50% ownership. In case of formal bankruptcy, the firm
may keep its loss carry forwards. Further, in a workout problem, when a debt worth say
Rs.1,000 is exchanged for a debt which is worth say Rs.500, the reduction in the value
of the debt to the extent of Rs.500 is considered to be a taxable income to the
corporation. On the other hand, if a similar situation arises in case of chapter II
reorganization, the difference is not treated as a taxable income. Over all, it is to be kept
in mind that the prepackaged bankruptcies are advantageous in many situations. If there
is a possibility in getting a considerable number of agreements among the creditors
through the informal negotiations, a subsequent filing can solve the holdout problem
and results in a favorable tax treatment. These are the primary reasons for the
prepackaged form of reorganization to have gained prominence in recent years.
Reorganization of Time and Expenses
Given all the advantages of the process of reorganization, it is worth mentioning that the
time, expense and the headaches that are involved are almost beyond ones imagination.
Even a bankruptcy of $2 to $3 million involves many people and groups. These may
include the lawyers representing the company, the US bankruptcy trustee, each class of a
secured creditor, the general creditors as a group, the tax authorities and the stockholders
if they are upset with the management. Though these are time bound matters, but in the
actual situations they take one year or sometimes more than that in their completion.
The company needs time to file the plan, and the creditor group needs time to study it and
seek clarification to it and then file counter plans to which the company must respond.
Also there is the issue of arguments among the creditor class regarding how much each
should receive. To resolve such conflicts, hearings must be held.
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From the firms point of view, it is important that it should remain in business, whereas
some well secured creditors will want the company to be liquidated as quickly as
possible. Some of them might even think of selling the business to some other concern.
In reality it may take several months to seek out and negotiate with the potential merger
candidates. Generally, a bankruptcy case takes almost a couple of years for completion.
This process includes the total time from filing for the protection under chapter 11 till
the final reorganization plan is approved or rejected. It is the companys business that
suffers while all this is going on. Sales would be disrupted, the employees may leave the
firm and those who remain in the job would be worried about their future prospects
rather than concentrating on their normal job. Added to this, the management of the firm
may be more concentrated on the bankruptcy proceedings rather than carrying out the
day-to-day business. At the same time, it would not be able to take any concrete action
without the approval of the Court which again requires a formal petition with the Court
and giving all the parties a chance to respond. Even if the operations of the firm does
not get affected, the assets of the company are sure to get reduced by its value because
of the companys own legal fees, and the costs that are associated with the Court and the
trustee. Any good lawyers in the bankruptcy cases tend to charge fees in the vicinity of
$200 to $400 per hour. At the same time, the creditors to the firm also incur their own
legal costs. So here it is worth mentioning that the creditors of the company also lose
time as well as money in the process. So a creditor who has a claim of $100,000 claim
and an opportunity cost of 10% who ends up getting $50,000 after two years would
have been better off settling for $41,500 initially. When the creditors legal fees,
executive time and the general aggravation are all taken into account, it might make
sense to settle for an amount of $20,000 or $25,000. Both the company as well as its
creditors are quite aware of the drawbacks that are associated with the formal
bankruptcy, if they are not their lawyers would make them aware. When the
management is equipped with a strong knowledge of bankruptcy, it finds itself in a
stronger position to persuade the creditors to accept a workout which apparently might
appear to be unfair and unreasonable.
Some Further Motives of Bankruptcy
It is to be always kept in mind that the bankruptcy proceedings do not commence until a
company has become financially so weak that it cannot meet its current obligations. At
the same time the bankruptcy law also allows a company to file for a bankruptcy, if its
financial forecast indicates that the continuation of the current business may ultimately
lead the company into the stage of insolvency. The application of bankruptcy law has
also been done to hasten up the settlements in major product liability suits.
a.
How does Acquisition or Takeover of a Distressed Firm Create Value to the

shareholders?
.
.
.
b.
Define Voluntary liquidation.

.
.
.
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MULTIPLE DISCRIMINANT ANALYSIS

Case History
The following section sketches two of the more prominent business failures. They
provide additional insights into the bankruptcy process.
Eastern Airlines during the 1980s, was plagued by seemingly unending woes, from
incessant labor strife to occasionally poor service, which caused the airline to lose
hundreds of millions of dollars. Finally, under its Chairman, Frank Lorenzo, the
company led for Chapter 11 bankruptcy in March 1989 after a showdown with its
unions. Lorenzo, who was determined to break the unions strike, insisted that he could
restore Eastern to profitability if given enough time. Every few months later, the
company would submit projections to the bankruptcy Court showing that the airline was
about to turn the corner, while creditors complained that the forecasts were wildly
optimistic.
The bankruptcy judge started early on that keeping Eastern flying was in the public
interest and that this goal outweighed the parochial concerns of the creditors. Thus,
the Court allowed Lorenzo to sell-off assets and use the proceeds to cover operating
losses. In early 1990, the unsecured creditors demanded that a trustee be appointed to
run Eastern, and Martin Shugrue was appointed by the Court in April. By then,
however, $1.2 billion in assets that could have gone to creditors had been sold, and the
funds had evaporated. Although analysts gave Eastern almost no chance of surviving,
Shugrue launched an expensive program to restore the carrier to health. About $35
million was spent on national TV ads featuring the trustee as the leader of a new
Eastern, and millions more were poured into new leather seats and increased flight
attendants for first-class passengers to try to steal full-fare passengers from rival carriers
which had better reputations for service, such as Delta.
When the Persian Gulf War slowed air travel and sent fuel prices upward, it became
obvious to all, even the Court, that Eastern would never make it, so the Court finally
agreed to shut it down for good on January 18, 1991. By that time, however, Eastern
had wasted another $530 million in its attempt to stay afloat.
It took from January 1991 to December 1994 for the bankruptcy Court to approve the
liquidation plan. By that time, more than $95 million had been paid out to lawyers and
other bankruptcy officials, and hundreds of millions had been vaporized in operating
losses. All priority claims including those to employees, the pension plan, and secured
creditors were paid in full, which required more than $1 billion of the liquidation
proceeds. The 70,000 general creditors fared less well: They received roughly 11 cents
on the dollar. Clearly, a more timely liquidation would have greatly increased the
payout to the unsecured creditors.
What about Martin Shugrue, the trustee? He moved on to greener pastures; he is now
president of a resurrected Pan American, which is trying to muscle its way back into the
very competitive skies of commercial aviation.
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Revco
On December 29, 1986, Revco Drug Stores went private in a leveraged buyout. At that
time, Revco was one of the nations largest retail drug chains, operating over 2,000
stores in 30 states. The buyout increased managements ownership in the company from
3 percent to 31 percent, but it also raised the companys indebtedness from $309 million
to $1.3 billion, including $700 million in subordinated notes (junk bonds). Immediately
after the buyout, the company only had $35 million in common equity out of $1.7
billion in capital, for an equity ratio of only 2 percent. Given the heavy debt burden,
several analysts stated that a hiccup would throw the company into bankruptcy. Indeed,
on April 15, 1988, Revco announced that it could not make a $46 million interest
payment on its subordinated notes. In a press release issued that day, the company said:
Revco believes that its business is strong and its operations solid; however, our current
capitalization is not the appropriate one for the company. After evaluation, Revcos
board has determined that a financial restructuring is appropriate. The company and its
creditors wanted to avoid the costs of a Chapter 11 bankruptcy, so they made several
attempts at a workout. For example, in mid-May Revcos management proposed that
bondholders exchange their subordinated notes for a new class of common stock that
would leave then-current stockholders with only 5 percent ownership. Such a
restructuring was consistent with the argument that the LBO team paid too much for the
company and that any equity value remaining after the overpayment was destroyed by
poor operating performance. However, this proposal failed because the companys
stockholders would not agree to go along with it. As Revcos fortunes fell, Magten
Asset Management, a firm that specializes in investing in distressed companies, began
buying Revcos senior subordinated notes at about 50 cents on the dollar. By late June,
Magten had accumulated more than 25 percent of that particular security, which gave it
veto power over any reorganization plan, whether private or under Court supervision.
Such power gave Magten the right to hold out for higher returns before consenting to
any reorganization plan. On July 7, 1988, bondholders agreed to a one-month
standstill, whereby creditors agreed not to take action against Revco for missing its
June interest payments. However, the companys cash flow was not improving, and on
July 22 Magten demanded full and immediate payment of all principal and interest due.
This action triggered cross-default provisions, which put Revco in default on all its
borrowings. On July 28, 1988, Revco filed for protection under Chapter 11 of the
Bankruptcy Act.
Following the formal bankruptcy filing, numerous reorganization plans were proposed,
but most failed because of disagreements among the various claimants. In September
1991, creditors led a plan in which they would get 100 percent ownership of the
company in return for agreeing to lighten Revcos current debt load of $1.5 billion. In
addition, the plan called for Salomon Brothers, an investment bank that had collected
almost $40 million in fees on the original over leveraged LBO deal, to pay $9.5 million
to the creditors in return for an agreement to drop several proposed suits against
171
Salomon. In the plan, banks that had lent Revco $306 million would receive $205
million of new 12 percent notes due December 31, 1998, a small amount of cash, and
some new convertible preferred stock. The value of this package of securities was
estimated at about 60 cents on the dollar. Holders of Revcos subordinated notes did not
fare even that well. They would get common stock in the post-bankruptcy Revco, but no
cash or notes. These notes had been trading at about 18 cents on the dollar, rejecting
investors beliefs that the final reorganization plan would leave little for bondholders.
Revcos stockholders would receive nothing stockholders are almost always wiped
out when creditors are forced to accept less than their original claims.
Finally, in June 1992 the plan was accepted, and Revco emerged from bankruptcy but
with fewer than 1,200 stores. With several former creditors now on the board, the first
order of business was to be the Chairman, Boake Sells. Then, the board created a
committee of five executives to lead the company. In spite of its years of problems,
many analysts predicted a bright future for Revco once it shed its onerous debt burden.
In fact, the company did well, becoming an industry leader in the use of technology to
fell and track prescriptions. Today, Revco is the second largest drug store chain, with
more than 2,200 stores. It has fully recovered from its reorganization, and it is poised
for rapid growth as the population ages.
Using Multiple Discriminant Analysis to Predict Bankruptcy
As we have seen, bankruptcy, or even the possibility of bankruptcy, can cause
significant trauma for a firms managers, investors, suppliers, customers, and
community. Thus, it would be beneficial to be able to predict the likelihood of
bankruptcy so that steps could be taken to avoid it or at least to reduce its impact. One
approach to bankruptcy prediction is Multiple Discriminant Analysis (MDA), a
statistical technique similar to regression analysis. In this section, we discuss MDA in
detail, and we illustrate its application to bankruptcy prediction.
The Basics of Multiple Discriminant Analysis
Suppose a bank loan officer wants to segregate corporate loan applications into those
likely to default and those not likely to default. Assume that data for some past period
are available on a group of firms which includes both companies that went bankrupt and
companies that did not. For simplicity, we assume that only the current ratio and the
debt/assets ratio are analyzed. These ratios for our sample of firms are given in Columns
2 and 3 of table 1. The Xs in the graph represent firms that went bankrupt, while the
dots represent firms that remained solvent. For example, Point A in the upper left
section is the point for Firm 2, which had a current ratio of 3.0 and a debt ratio of 20
percent, and a dot indicates that the firm did not go bankrupt. Point B, in the lower right
section, represents Firm 19, which had a current ratio of 1.0 and a debt ratio of 60
percent, and the X indicates that it did go bankrupt.
172
Table 1: Components of Multiple Discriminant Analysis

Firm
Number (1)
Current
Ratio (2)
Debt/Assets
Ratio (3)
3.6x
60%
2(A)
3.0
3
4
Did Firm Go
Bankrupt? (4)
Z Score
(5)
Probability of
Bankruptcy (6)
No
0.780
17.2%
20
No
2.451
0.8
3.0
60
No
0.135
42.0
3.0
76
Yes
0.791
81.2
2.8
44
No
0.847
15.5
2.6
56
Yes
0.062
51.5
2.6
68
Yes
0.757
80.2
2.4
40
Yes
0.649
21.1
2.4
60
No
0.509
71.5
10
2.2
28
No
1.129
9.6
11
2.0
40
No
0.220
38.1
12
2.0
48
No
0.244
60.1
13
1.8
60
Yes
1.153
89.7
14
1.6
20
No
0.948
13.1
15
1.6
44
Yes
0.441
68.8
16
1.2
44
Yes
0.871
83.5
18
1.0
24
No
0.072
45.0
18
1.0
32
Yes
0.391
66.7
19(B)
1.0
60
Yes
2.012
97.9
Table 1: Components of Multiple Discriminant Analysis

The objective of discriminant analysis is to construct a boundary line through the graph
such that if the firm is to the left of the line, it is not likely to become insolvent, whereas
it is likely to go bankrupt if it falls to the right. This boundary line is called the
discriminant function, and in our example it takes this form:
Z = a + b1 (Current ratio) + b2(Debt ratio).
Here, Z is called the Z score, a is a constant term, and b1 and b2 indicate the effects of
the current ratio and the debt ratio on the probability of a firm going bankrupt.
Although a full discussion of discriminant analysis would go well beyond the scope of
this book, some useful insights may be gained by observing these points:
1.
The discriminant function is fitted (that is, the values of a, b1, and b2 are
obtained) using historical data for a sample of firms that either went bankrupt or
did not during some past period. When the data in the lower part of Figure 13.1
were fed into a canned discriminant analysis program (the computing centers
of most universities and large corporations have such programs), the following
discriminant function was obtained:
Z = 0.3877 1.0736 (Current ratio) + 0.0579(Debt ratio).
173
Figure 1: Discriminant Boundary between Bankrupt and Solvent Firms

2.
This equation was plotted on Figure 1 as the locus of points for which Z = 0. All
combinations of current ratios and debt ratios shown on the line result in Z = 0.4.
Companies that lie to the left of the line (and also have Z values less than zero)
are not likely to go bankrupt, while those to the right (and have Z greater than
zero) are likely to go bankrupt. It can be seen from the graph that one X,
indicating a failing company, lies to the left of the line, while two dots,
indicating no bankrupt companies, lie to the right of the line. Thus, the
discriminant analysis failed to properly classify three companies.
3.
Once we have determined the parameters of the discriminant function, we can

calculate the Z scores for other companies, say, loan applicants at a bank. The Z
scores for our hypothetical companies, along with their probabilities for going
bankrupt, are given in Columns 5 and 6 of Figure 1. The higher the Z score, the
worse the company looks from the standpoint of bankruptcy. Here is an
interpretation:
Z = 0: 50-50 probability of future bankruptcy (say, within two years). The
company lies exactly on the boundary line.
Z = 0: If Z is negative, there is a less than 50 percent probability of bankruptcy.
The smaller (more negative) the Z score, the lower the probability of bankruptcy.
The computer output from MDA programs gives this probability, and it is shown
in Column 6 of Figure 1.
Z = 0: If Z is positive, the probability of bankruptcy is greater than 50 percent,
and the larger Z, the greater the probability of bankruptcy.
4.
The mean Z score of the companies that did not go bankrupt is 0.583, while that
for the bankrupt firms is 0.648. These means, along with approximations of the Z.
To plot the boundary line, let D/A = 0% and 80%, and then find the current ratio
that forces Z = 0 at those two values. For example, at D/A= 0,
Z
= 0.3877 1.0736 (Current ratio) + 0.0579(0) = 0
0.3877
= 1.0736 (Current ratio)
Current ratio = 0.3877 (11.0736) = 0.3611

174
Thus, 0.3611 is the vertical axis intercept. Similarly, the current ratio at
D/A = 80% is found to be 3.9533. Plotting these two points on Figure 2, and then
connecting them, provides the discriminant boundary line, which is the line that
best partitions the companies into bankrupt and no bankrupt. It should be noted
that nonlinear discriminant functions may be used, and we could also use more
dependent variables.
Figure 2: Probability distribution of Z-Score
Score probability distributions of the two groups, are shown in Figure 2. We may
interpret this graph as indicating that if Z is less than about 0.3, there is a very
small probability that the firm will go bankrupt, whereas if Z is greater than 0.3,
there is only a small probability that it will remain solvent. If Z is in the range
0.3, called the zone of ignorance, we are uncertain about how the firm should
be classified.
5.
The signs of the coefficients of the discriminant function are logical. A high
current ratio is good, and since its coefficient is negative, the higher the current
ratio, the lower the probability of failure. Similarly, high debt ratios produce high
Z scores, and this is consistent with a higher probability of bankruptcy.
6.
Our illustrative discriminant function has only two variables, but other
characteristics could be introduced. For example, we could add such variables as
the rate of return on assets, the times-interest-earned ratio, the days sales
outstanding, the quick ratio, and so forth. Had the rate of return on assets been
introduced, it might have turned out that Firm 8 (which failed) had a low ROA,
while Firm 9 (which did not fail) had a high ROA. A new discriminant function
would be calculated:
Z = a + b1 (Current ratio) + b2 (D/A) + b3 (ROA)
Firm 8 might now have a positive Z, while Firm 9s Z might become negative.
Thus, it is likely that by adding more characteristics we would improve the
accuracy of our bankruptcy forecasts. In terms of Figure B, this would cause
each probability distribution to become tighter, narrow the zone of ignorance,
and lead to fewer misclassifications.
175
Altmans Model
In a classic paper, Edward Altman applied MDA to a sample of corporations, and he
developed a discriminant function that has seen wide use in actual practice. Altmans
function was fitted as follows:
Z = 0.012X1 + 0.0414X2 + 0.033X3 + 0.006X4 + 0.999X5
(1)
Here
X1 = net working capital/total assets.
X2 = retained earnings/total assets.
X3 = EBIT/total assets.
X4 = market value of common and preferred stock/book value of debt.
X5 = sales/total assets.
The first four variables in Equation A are expressed as percentages rather than as
decimals. (For example, if X3 13.3%, then 13.3, not 0.133, is used as its value.) Also,
Altmans 50-50 point was 2.675, and not 0.0 as in our hypothetical example; his zone of
ignorance was from Z 1.81 to Z 2.99; and in his model the larger the Z score, the less
the probability of bankruptcy.
Altmans function can be used to calculate a Z score for MicroDrive Inc. Here is the
calculation, ignoring the small amount of preferred stock, for 2001:
X1 = $400/$2,000 = 0.200
20.0 x 0.012 = 0.240 = 20.0%
X2 = $660/$2,000 = 0.330
33.0 x 0.014 = 0.462 = 33.0%
X3 = $266/$2,000 = 0.133
13.3 x 0.033 = 0.439 = 13.3%
X4 = [50($28.50) = 1($102)]/($300 = $800) = 1.388 = 138.8 x 0.006

= 0.833 = 138.8%
X5 = $3,000/$2,000 = 1.5
1.5 x 0.999 = 1.499

Z = 3.473
Because MicroDrives Z score of 3.473 is above the 2.99 upper limit of Altmans zone
of ignorance, the data indicate that there is virtually no chance that MicroDrive will go
bankrupt within the next two years. (Altmans model predicts bankruptcy reasonably
well for about two years into the future.)
Altman and his colleagues later work updated and improved his original study. In their
more recent work, they explicitly considered such factors as capitalized lease
obligations, and they applied smoothing techniques to level out random fluctuations in
the data. The new model was able to predict bankruptcy with a high degree of accuracy
for two years into the future, and with a slightly lower but still reasonable degree of
accuracy (70 percent) for about five years.
176
MDA has been used with success by credit analysts to establish default probabilities for
both consumer and corporate loan applicants and by portfolio managers considering
both stock and bond investments. It can also be used to evaluate a set of pro forma
ratios or to gain insights into the feasibility of a reorganization plan led under the
Bankruptcy Act. Altmans model has also been used by Salomon Smith Barney,
Morgan Stanley, Dean Witter, and other investment banking houses to appraise the
quality of junk bonds used to finance takeovers and leveraged buyouts. The technique is
described in detail in many statistics texts, while several articles cited at the end of this
chapter discuss financial applications of MDA. The interested reader is urged to study
this literature, for MDA has many potentially valuable applications in finance.
When using MDA in practice it is best to create your own discriminant data using a
recent sample from the industry in question. It is not reasonable to assume that the
financial ratios of a steel company facing imminent bankruptcy are the same as for a
retail grocery chain in equally dire straits. If both firms were analyzed using Z scores
calculated with the same equation, it might turn out that the grocery chain had a
relatively high score, signifying (incorrectly) a low probability of bankruptcy, while the
steel company had a relatively low score, indicating (correctly) a high probability of
bankruptcy. The misclassification of the grocery company could result from the fact that
it has very high sales for the amount of its book assets, hence its X5, which has the
largest coefficient, is much higher than for an average firm in an average industry facing
potential bankruptcy. To remove any such industry bias, the MDA analysis should be
based on a sample with characteristics similar to those of the firm being analyzed.
Unfortunately, though, it is often not possible to find enough firms that have recently
gone bankrupt to conduct an industry MDA.
8.7 SUMMARY
Sick Industrial Companies Act, 1985 (SICA), defines a sick industry as an industrial
company (being a registered company for not less than five years) which has at the end
of any financial year accumulated losses equal to or exceeding its net worth.
Factors for bankruptcy is divided into external and internal.
A firm that faces imminent bankruptcy has two alternatives reorganization, and
liquidation.
8.8 GLOSSARY
Sick Industrial Company is a industrial company (being a company registered for not
less than five years) which has at the end of any financial year accumulated losses equal
to or exceeding its net worth.
Acquisition is buying of a firm by another firm.
Agency Problem means the Conflicts of interests among stockholders, bondholders and
managers.
Joint Venture is an agreement between two or more companies where there will be an
agreed contribution and participation of the respective companies.
Leveraged Buy-Out is the purchase of the company by a small group of investors,
financed largely by debt. Usually involves going private.
177
Liquidating Value means the value of a company based on the market value of its
assets, net of liabilities.[v1]
Liquidation is divestiture of all the assets of the firm so that the firm ceases to exist.
Merger is the fusion of two or more companies (OR) Merger is a combination of two or
more companies into a single company where, it survives and others lose the corporate
identity. The survivor acquires the assets and liabilities of the rest.

Aswath Damodaran Investment Valuation, 2002 by John Wiley & Sons, Inc.
Donald De Pamphillis Mergers, Acquisitions and other Restructuring Activities,
2001 by Academic Press
Frank C. Evans, David M. Bishop Valuation for M&A Building Value in
Private Companies, 2001 by John Wiley and Sons, Inc.

a.
b.
The External Factors to become bankruptcy are:

a.
Change in government policies affecting the firm
b.
Increased competition
c.
Scarcity of raw material
d.
Prolonged power cuts
e.
Changes in consumer buying pattern
f.
Shrinking demand
g.
Natural calamities
h.
Cost overruns
i.
Inadequate funds.
Altmans model is based on the fact that various ratios when used in
combinations, can have better predictive ability than when used individually. 22
ratios were considered in various combinations as predictors of failure. He used a
statistical technique called the Multiple Discriminant Analysis (MDA) to
distinguish between bankrupt and non-bankrupt firms. He developed a
discriminant score called the Z-score on the basis of these ratios.
Z
1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
If Z score for a firm is less than 1.81, the firm is likely to go bankrupt. If Z score
is more than 2.99, it is regarded as a healthy company.
178
a.
The financial distress that any target firm faces contributes to a major factor in a
substantial proportion of acquisitions when a firm acquired by another stronger
firm within the industry can result in its value creation for its shareholders.
This is mainly due to the following reasons:
a.
The combination may result in increased economies of scale.
b.
The combination may increase the product market power.
c.
The acquiring firm may be able to enhance the troubled firms operations
through superior management techniques.
d.
The acquiring firm may be able to contribute badly needed capital to the
troubled firms, which may have been lacking both internally generated
cash and effective access to external capital markets.
b.
Voluntary liquidation is a form of liquidation under which the firm and creditors
come up with a creative plan to dispose off the liabilities in a manner that makes
sense to everybody involved. This happens when the firm realizes that there is no
hope of turnaround and liquidation is the only option that either occurs without
the involvement of the Court or under the supervision of the Court.

A. Multiple Choice
1.
2.
3.
As per the Beaver model which ratio was found to be the best predictor of failure
of a firm?
a.
Liquidity ratio.
b.
Ratio of cash flow to total debt.
c.
Debt service coverage ratio.
d.
Net profit margin ratio.
e.
Interest coverage ratio.
As per Altmans Z score model, a healthy firm should have a Z score

a.
Of 1.81
b.
In the range of 1.81 and 2
c.
Less than 2.9
d.
More than 2.9
e.
More than 2.99.
According to the Wilcox model, the best indicator of the financial health of a
firm is
a.
The profitability ratios
b.
The coverage ratios
c.
Net liquidation value of the firm
d.
Market capitalization of the firm
e.
Share price of the firm.

179
4.
5.
In the Indian context, the decision to liquidate/ organize a firm vests with
a.
BIFR
b.
Company Law Board
c.
Registrar of companies
d.
SEBI
e.
Board of directors of the company.
Which of the following ratios is not applied in L.C. Gupta model for prediction
of bankruptcy?
a.
EBDIT/Net sales.
b.
Operating cash flow/Total assets.
c.
Net worth/Total debt.
d.
Working capital/Total assets.
e.
Operating cash flow/Sales.
B. Descriptive
1.
What are the Issues facing by a Firm in Times of Financial Distress?
2.
What is meant by Exchanging Equity for Debt? What are its advantages?
3.
What is the essence of Section 425 of the Companies Act, 1956?
practice only.
180
NOTES
181
NOTES
182

Block
Unit
Nos.
Unit Title
INTRODUCTION TO STRATEGIC FINANCIAL
MANAGEMENT
1.
Strategic Financial Management: An Overview
2.
Firms Environment, Governance and Strategy
3.
Valuing Real Assets in the Presence of Risk
4.
Real Options
II

5.
Capital Structure
6.
Dividend Policy
7.
Allocating Capital and Corporate Strategy
8.
III
STRATEGIC ENVIRONMENT ANALYSIS

9.
Industry Analysis, Financial Policies and Strategies
10.
Information Asymmetry and the Markets for Corporate

Securities
11.
Managerial Incentives
12.
Decision Support Models
IV
CORPORATE ACCOUNTING AND BUSINESS

STRATEGY
13.
Financial Statement Analysis
14.
Inflation Accounting
15.
Working Capital Management
16.
Strategic Cost Management
STRATEGIC RISK MANAGEMENT

17.
Corporate Risk Management
18.
Risk Management and Corporate Strategy
19.
Organization Architecture, Risk Management, and

Security Design
20.
The Practice of Hedging
21.
Enterprise Risk Management

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Strategic Financial Management

Dr. Lata Chakravorty

Prof. P. Bala Bhaskaran

Dr. Dhananjay Keskar

Course Preparation Team

Prof. Hilda Amalraj

Prof. Bratati Ray

Dr. Vijaya Lakshmi S

Dr. Vunyale Narender

Ms. Sunitha Suresh

Prof. Arup Chowdhury

The ICFAI University Press, All rights reserved.

The ICFAI University Press, Hyderabad

STRATEGIC CAPITAL STRUCTURE

UNIT 5 CAPITAL STRUCTURE

The Effect of Leverage on EPS

Capital Market Equilibrium Approach

Theories of Capital Structure

Modigliani and Miller (M&M)

Merton Miller Hypothesis

The Effect of Leverage on the Standard Deviation of Returns

Capital Structure in the Imperfect Market

Corporate Taxes and Firm Distress

The Interest Tax Shield

Bankruptcy Costs and the Capital Structure

Circumstances that Lead to Financial Distress and Bankruptcy

Agency Costs and the Capital Structure

Trade-off Theory of Financing

Signaling through Capital Structure

Suggested Readings/Reference Material

Strategic Financial Management

Understand the relationship between Leverage and Rate of Return on Equity;

Define operational structure;

Understand the theories of capital structure;

Build the relationship between Corporate Taxes and Firm Distress;

Develop the long-term performance plan for a company.

5.3 THE EFFECT OF LEVERAGE ON EPS

Number of Shares Issued

Stock Price Estimate

Strategic Financial Management

LEVERAGE AND THE RATE OF RETURN ON EQUITY

Table 1: Heavenly Industries Financial Data

After the Change in Capital Structure (75%

Table 2: Heavenly Industries

Strategic Financial Management

The Question of Optimality

Table 3: Heavenly Industries: Rates of

Strategic Financial Management

Levered firm with 50% debt

Table 4: Economic Scenario

The EPS of the levered firm (EPSL) is

This can be rewritten as:

Multiplying by nE/V, we get

(1 T)(NOI rB) (1 T)NOI

5.4 CAPITAL MARKET EQUILIBRIUM APPROACH

Strategic Financial Management

is the cost of debt;

is the annual interest expense; and

is the market value of the outstanding debt.

is the cost of equity;

is the earnings available for distribution to equity shareholders of

is the market value of the outstanding debt.

Where, k0 is the weighted average cost of capital.