Corporate finance is spread over two study sessions.  The subject of corporate finance will likely represent at least 5% (one item set, six questions), but no more than 10% (two item sets, 12 questions) of the Level II exam.  It is also possible that corporate finance concepts will be combined with equity and/or financial reporting to comprise about 7-8% of the exam questions.

This week’s study session will attempt to highlight key corporate finance concepts within the parameters of CFAI curriculum.  Going beyond simple memorization and base theoretical understanding, candidates must actively apply the concepts in question practicing sessions, as it may not be readily apparent as to how these ideas will manifest themselves in question format.

<strong>Note:</strong>

This material builds upon the corporate finance foundation established in the Level 1 exam.  When necessary, students are encouraged to refer to Level 1 curriculum in order refresh necessary cornerstone competencies.  These key cornerstones definitely include a firm understanding of net present value (NPV) and internal rate of return (IRR) analysis.

<strong>Material:</strong>

I.          Capital Budgeting Decisions

II.        Capital Structure for Corporations

III.       Dividend and Share Repurchase Policies

CFA Level 2: Corporate Finance Part 1 – Introduction

<strong>Capital Structure</strong>
<ul>
	<li>A firm’s <a href="https://financetrain.com/an-introduction-to-capital-structure" target="_blank">capital structure</a> represents its mix of capital sources, i.e. its mix of debt financing and equity financing.</li>
	<li>In theory, companies should seek an optimal capital structure with the objective of minimizing the cost of capital.</li>
	<li>The cost of capital is typically its weighted average cost of capital (WACC), applying the marginal cost of debt financing and equity financing.  Since interest is typically a tax deductible expense, the WACC calculation will incorporate the after tax cost of debt.</li>
</ul>
<strong>Leverage</strong>
<ul>
<ul>
	<li>Leverage is the utilization of fixed costs by a company.</li>
	<li>Leverage can be operating (fixed assets that depreciate) or financial (debt).</li>
	<li>While financial leverage and operating leverage can amplify earnings during periods of growth, they can also increase the risk of financial distress during periods of economic decline.</li>
	<li>Financial leverage exposes a company to financial risk.</li>
	<li>The degree of financial leverage (DFL) can be calculated as:</li>
</ul>
</ul>
<div class="formula1">DFL = EBIT/EBTWhen a firm has no debt, EBIT = EBT, so DFL will = 1.  Upon assuming debt, a firm’s DFL will increase above 1.

</div>
<ul>
	<li>Another method of considering financial leverage is a company’s debt to equity ratio.</li>
</ul>

Introduction to Capital Structure and Leverage

<ul>
	<li>Capital budgeting is the diligence process that a company performs to determine what investment projects it will undertake.</li>
	<li>Application of these principles is relevant as an internal corporate <a href="https://financetrain.com/financial-analyst-a-rapidly-growing-career-option-in-finance/" title="Financial Analyst: A Rapidly Growing Career Option in Finance">finance analyst</a> or as an external debt or equity analyst at a financial services company.</li>
	<li>Theoretically, a company will only commence projects which are expected to increase the firm’s value.</li>
	<li><strong>Value of a capital project</strong> = present value of expected after tax cash flows, discounted at an appropriate risk adjusted rate.</li>
	<li><strong>Discount Rate:</strong>  commonly the firm’s marginal <a href="https://financetrain.com/weighted-average-cost-of-capital-wacc/" title="Weighted Average Cost of Capital (WACC)">weighted average cost of capital (WACC)</a>, however in certain circumstances it may be appropriate to revise WACC depending on a project’s increased or decreased exposure to market risk.</li>
</ul>

Introductory Capital Budgeting Remarks

Two types of capital projects that a firm may consider are:
<ul>
	<li><strong>Expansion Projects:</strong> these are projects where the firm seeks to profitably increase sales of current products or introduce new products into the market.</li>
	<li><strong>Replacement Projects:</strong> these are projects where the firm must either: replace worn out equipment or invest in new equipment that is expected to lower current production costs and/or increase current sales.</li>
</ul>
<h2 class="hdpline"><span>Calculating Cash Flows for Expansion Projects</span></h2>
<img src="https://financetrain.com/wp-content/uploads/ep1.gif" alt="" />
<div style="display: block; border: 2px solid #0099FF; background: url('/assets/noticeBG.jpg') bottom repeat-x; padding: 8px;">Initial Investment = Fixed Capital Investment + Working Capital Investment</div>
<img src="https://financetrain.com/wp-content/uploads/ep2.gif" alt="" />
<div style="display: block; border: 2px solid #0099FF; background: url('/assets/noticeBG.jpg') bottom repeat-x; padding: 8px;">

OCF = EBIT(1 - tax rate) + Deprecation

Notes on OCF:
<ul class="list2">
	<li>OCF must only be calculated based on incremental values that are a direct result of the capital project.</li>
	<li>Sunk costs are always excluded from the calculation.</li>
	<li>Depreciation is added back after taxes because this is a non-cash charge.</li>
	<li>Interest expense is not included because that cost will be captured in the discount rate applied when calculating the present value of future cash flows.</li>
</ul>
</div>
<img src="https://financetrain.com/wp-content/uploads/ep3.gif" alt="" />
<div style="display: block; border: 2px solid #0099FF; background: url('/assets/noticeBG.jpg') bottom repeat-x; padding: 8px;">

TNOCF = Sale of Fixed Capital + Working Capital Investment Recovery - ((Sale of Fixed Capital - Book Value of Fixed Capital) * (tax rate))

<strong>Notes on TNOCF:</strong> the sale of fixed capital might be at a gain or loss, depending on whether or not the fixed capital is sold above or below book value.

</div>
<img src="https://financetrain.com/wp-content/uploads/ep4.gif" alt="" />
<div style="display: block; border: 2px solid #0099FF; background: url('/assets/noticeBG.jpg') bottom repeat-x; padding: 8px;">

Calculate a net present value (NPV) for the project to determine if it should be undertaken by the firm.
<ul class="list2">
	<li>The NPV calculation typically applies the firm's marginal weighted average cost of capital (WACC) as the discount rate.</li>
	<li>A project with a negative NPV should be rejected by the firm.</li>
</ul>
</div>
&nbsp;&nbsp;
<h2 class="hdpline"><span>Calculating Cash Flows for Replacement Projects</span></h2>
<img src="https://financetrain.com/wp-content/uploads/rp1.gif" alt="" />
<div style="display: block; border: 2px solid #0099FF; background: url('/assets/noticeBG.jpg') bottom repeat-x; padding: 8px;">

Initial Investment = Fixed Capital Investment + Working Capital Investment - Sale of Old Equipment + ((Sale of Old Equip - Book Value of Old Equip)(tax rate))

<strong>Notes on initial investment for a replacement project:</strong> replacement projects commonly include the sale of old equipment, so there is an additional consideration in the calculation that is not included in the analysis of an expansion project.

</div>
<img src="https://financetrain.com/wp-content/uploads/rp2.gif" alt="" />
<div style="display: block; border: 2px solid #0099FF; background: url('/assets/noticeBG.jpg') bottom repeat-x; padding: 8px;">
<ul class="list2">
	<li>The calculation is the same for a replacement project as it is an expansion project (EBIT (1-tax rate) + Depreciation), but there are two considerations that the analyst must make:</li>
	<li>First, will the project increase sales?</li>
	<li>Second, by how much is the replacement project reducing annual operating expenses?</li>
	<li>Each of these questions must be considered when calculating OCFs for a replacement project. It could be that the replacement project does not increase sales at all, but is being considered solely on its potential to reduce operating costs.</li>
</ul>
</div>
<img src="https://financetrain.com/wp-content/uploads/rp3.gif" alt="" />
<div style="display: block; border: 2px solid #0099FF; background: url('/assets/noticeBG.jpg') bottom repeat-x; padding: 8px;">Replacement projects apply the same approach as an expansion project.</div>
<img src="https://financetrain.com/wp-content/uploads/rp4.gif" alt="" />
<div style="display: block; border: 2px solid #0099FF; background: url('/assets/noticeBG.jpg') bottom repeat-x; padding: 8px;">Replacement projects apply the same approach as an expansion project.</div>

Expansion Projects vs. Replacement Projects and Cash Flows

<ul>
	<li>When analyzing capital projects, companies are incentivized to apply accelerated <a title="Depreciation Methods for Property, Plant, and Equipment (PPE)" href="https://financetrain.com/depreciation-methods-for-property-plant-and-equipment-ppe/">depreciation methods</a> (refer to <a href="https://financetrain.com/series/cfa-level-2-financial-reporting-part-1/">Financial Reporting part 1</a> for more on these methods) because accelerating depreciation generates higher after tax cash flows in the project’s early years.</li>
	<li>As a result of higher early year after-tax cash flows, accelerated depreciation methods typically create higher <a title="Net Present Value of a Project" href="https://financetrain.com/net-present-value-of-a-project/">net present values</a> when compared to the straight line depreciation method.</li>
	<li>Some countries allow the use of special depreciation methodologies solely for tax reporting purposes, but not for financial reporting purposes.</li>
	<li>The U.S. tax code allows companies to use the Modified Accelerated Cost Recovery System (MACRS), which has a specific depreciation schedule for different categories of capital investment.</li>
	<li>An objective of MACRS is to incentivize companies to make investments by reducing their tax burden.</li>
</ul>

Impacts of Depreciation Method Choice on Capital Budget Analysis

<ul>
	<li><a title="Inflation vs Deflation?" href="https://financetrain.com/inflation-vs-deflation/">Inflation</a> has ramifications for the realized value of a capital project.</li>
	<li>When evaluating capital projects, companies can evaluate capital projects in nominal or real (i.e. inflation adjusted) terms.</li>
	<li>Real cash flows are based on purchasing power at the time the decision to invest would is made.
<ul>
	<li>Under a real cash flow approach, the discount rate would remove the expected inflation rate, as the cash flows will already reflect the effects of inflation.</li>
</ul>
</li>
	<li>Commonly, capital projects are analyzed in nominal terms, so the discount rate applied is inclusive of expected inflation; however actual inflation may veer from expectations and inflation may impact the different project variables in different ways.</li>
	<li>There are several aspects of inflation that an analyst must consider when evaluating a capital project:
<ul>
	<li><strong>Inflation and the Depreciation Tax Shied</strong>: if inflation is higher than expected at the time of the investment decision, then the value of the depreciation tax shield is lowered and true net present value of the project is lowered.</li>
	<li><strong>Inflation and Debt Payments</strong>: the discount rate may be based on a company’s cost of debt, if debt is used to finance the capital project.  When inflation is lower than expected, this increases the firm’s debt costs and lowers the net present value of the project.</li>
	<li><strong>Inflation, Revenues, and Expenses</strong>: the revenues and expenses associated with a capital project will not be equally affected by inflation.  When a firm is not able to pass the costs of inflation to product inputs on to customers in the form of higher prices, the net present value of the project will be lower.</li>
</ul>
</li>
</ul>

Inflation and Capital Budgeting

<ul>
	<li>It is possible for a firm to face a scenario where multiple capital projects show a positive <a title="Net Present Value of a Project" href="https://financetrain.com/net-present-value-of-a-project/">net present value</a>, but only enough resources are available to fund one of them. In this situation, the projects are considered to be mutually exclusive.</li>
	<li>Analyzing mutually exclusive projects can be complicated when the projects have unequal lifetimes and simply choosing the project with the highest NPV can lead to an incorrect decision.</li>
	<li><strong>TNOCF and Mutually Exclusive Projects:</strong> Note that mutually exclusive projects exclude terminal year non-operating cash flows; the assumption is that the projects will be repeated in perpetuity.</li>
	<li>There are two methods for choosing between mutually exclusive projects with unequal lives:
<ul>
	<li><a title="Equivalent Annual Annuity (EAA) Approach" href="https://financetrain.com/equivalent-annual-annuity-eaa-approach/">Equivalent Annual Annuity Approach</a></li>
	<li><a title="Least Common Multiple of Lives Approach" href="https://financetrain.com/least-common-multiple-of-lives-approach/">Least Common Multiple of Lives Approach</a></li>
</ul>
</li>
</ul>

Mutually Exclusive Capital Projects with Unequal Lives

The EAA value represents the required size of an annual payment over an asset’s life to make the present value of the project’s operating cash flows equal to the net present value, when the <a title="Weighted Average Cost of Capital (WACC)" href="https://financetrain.com/weighted-average-cost-of-capital-wacc/">cost of capital </a>is applied as the discount rate.

<strong>EAA Process</strong>

<strong><img class="aligncenter size-full wp-image-5833" title="EAA Approach" src="https://financetrain.com/wp-content/uploads/eaa_process.gif" alt="" /></strong>

<strong><img class="aligncenter size-full wp-image-5833" title="EAA Calc" src="https://financetrain.com/wp-content/uploads/eaa_calc.gif" alt="" /></strong>

Equivalent Annual Annuity (EAA) Approach

Least Common Multiple of Lives Approach process:

<img class="aligncenter size-full wp-image-5833" title="LCM approach" src="https://financetrain.com/wp-content/uploads/lcm.gif" alt="" />

Least Common Multiple of Lives Approach

When only a single project is evaluated, then only its stand-alone risk is measured.

The single project in question likely has a range of possible cash flow outcomes, so the company really needs to evaluate risk around these multiple outcomes.

Three methods for measuring Stand Alone Risk:

<strong>1. Sensitivity Analysis</strong>

This approach focuses on a project’s <a title="Net Present Value of a Project" href="https://financetrain.com/net-present-value-of-a-project/">NPV</a> sensitivity to a single variable.  The approach starts with a base case and calculates the change in NPV in the event of a change to an input variable in the NPV calculation.

For example, a firm may want to determine a project’s NPV sensitivity to a change in forecasted sales.  The change can be favorable or unfavorable.  The analyst may create three NPVs for the project: one with a base sales case, one with a favorable sales case, and one with an unfavorable sales case.  The different NPVs will show the project’s sensitivity to a change in sales.  The sensitivity can be calculated for any input variable: operating expenses, discount rate/cost of capital, tax rates,<a title="Depreciation Methods for Property, Plant, and Equipment (PPE)" href="https://financetrain.com/depreciation-methods-for-property-plant-and-equipment-ppe/"> depreciation method</a>, or expected salvage value.

For candidates with calculus familiarity, the sensitivity analysis can be conceptually viewed as backing into the derivative of a single variable in a multi-variable NPV equation.

<strong>2. Scenario Analysis </strong>

This is a multi-variable adjustment version of sensitivity analysis.  The base, favorable and unfavorable scenarios will reflect NPVs where multiple inputs have been adjusted, rather than just one.

<strong>3. <a title="Monte Carlo Simulation – Example" href="https://financetrain.com/monte-carlo-simulation-example/">Monte Carlo Simulation</a></strong>

This capital project risk analysis will use a computer program to simulate likely events and generate an internal rate of return (IRR) or NPV for the project in question.

The computer will pick a random variable and calculate an IRR and NPV; the process will be repeated many times, generating new IRRs and NPVs.

Each of the IRRs and NPVs will be analyzed and a statistical report will be generated for the number of iterations ran, showing data on the mean, standard deviation, median, etc.

Stand Alone Risk and Capital Projects

<ul>
	<li>Stand-alone project analysis (sensitivity, scenario, and simulation analysis) looks at a project’s risk in isolation.</li>
	<li>Projects also have exposure to market risk and company management should consider how a project’s future cash flows will correlate with market returns (think <a title="How to Calculate Stock Beta in Excel" href="https://financetrain.com/how-to-calculate-stock-beta-in-excel/">beta</a>).</li>
	<li>A project with heightened sensitivity to market changes (i.e. higher market risk) should be discounted with a higher cost of capital.  Alternatively, a lower market risk project could be discounted with a lower rate.</li>
	<li>A common way to incorporate market risk into capital budgeting analysis is by applying the principles of the <a title="The Capital Asset Pricing Model" href="https://financetrain.com/the-capital-asset-pricing-model/">capital asset pricing model (CAPM)</a>.</li>
	<li>In applying CAPM to capital budgeting, the analyst will need to determine the project’s beta, the risk free rate of return and the market rate of return.</li>
	<li>The project’s discount rate in calculating <a title="Net Present Value of a Project" href="https://financetrain.com/net-present-value-of-a-project/">NPV</a> will then be determined by the following equation:</li>
</ul>
<div class="formula1">r <sub>project</sub> = r <sub>risk free</sub> + β <sub>project</sub> ( r <sub>market</sub> – r <sub>risk free</sub>)</div>

CAPM and a Capital Project’s Discount Rate

Real options represent a company’s rights to make chronological decisions in a capital project.

Real options increase the <a title="Net Present Value of a Project" href="https://financetrain.com/net-present-value-of-a-project/">NPV</a> of a project because a firm would not rationally exercise an option which lowers value.

<strong>Types of Real Options</strong>

<img class="aligncenter size-full wp-image-5833" title="real options" src="https://financetrain.com/wp-content/uploads/real_options.gif" alt="" />

<strong>Evaluating Real Options</strong>

Calculate the project’s NPV without any options.  If the project has a positive NPV, then real options will increase its value.

If the project without any options has a negative NPV, then make adjustments based on the value of associated real options.  The analyst must determine if the value of the real options is sufficient to create a positive NPV.

Incorporate the use of decision trees or <a title="Black-Scholes Option Pricing Model" href="https://financetrain.com/black-scholes-option-pricing-model/">option pricing models</a> to evaluate a capital project.

Capital Projects and Real Options

Company managers commonly make errors when evaluating capital projects.  Some of these errors include:
<ul>
	<li>The failure to account for economic reactions.  If a company introduces a highly profitable product to the market, then competitors will enter the market and future profitability will deteriorate.</li>
	<li>Standard approaches for different capital projects.  A company may use a common model to analyze all of its capital projects despite differences across all the capital projects that it considers.</li>
	<li>Focusing on accounting results.  A company’s management may be incentivized to initiate projects that show positive short term accounting results at the expense of long term projects with high net present values.</li>
	<li>Utilizing <a title="Calculating Net Present Value (NPV) and Internal Rate of Return (IRR) in Excel" href="https://financetrain.com/net-present-value-npv-internal-rate-of-return-irr-excel/">IRR</a> over <a title="Net Present Value of a Project" href="https://financetrain.com/net-present-value-of-a-project/">NPV</a>.  IRR may not lead to optimal decision making when evaluating mutually exclusive projects.  NPV is considered the superior approach.</li>
	<li>Pet projects.  Influential company managers may initiate projects which advance their own interests but do not create company value (or even destroy it).</li>
	<li>Cash flow errors.  Many estimates and assumptions go into forecasting cash flows and these are subject to error.</li>
	<li>Inappropriate discount rate.  A company might use too low of a discount rate for a high risk project and overstate the project’s NPV.</li>
	<li>Misunderstanding sunk costs and opportunity costs.  A company may incorrectly include sunk costs into its capital budgeting analysis, but exclude opportunity costs.</li>
</ul>

Common Pitfalls in Capital Budgeting

The discounting cash flow methods of <a title="Calculating Net Present Value (NPV) and Internal Rate of Return (IRR) in Excel" href="https://financetrain.com/net-present-value-npv-internal-rate-of-return-irr-excel/">net present value and internal rate of return</a> analysis are common for capital project analysis, but other methods exist.
<ul>
	<li><strong>Economic Income:</strong> applies the same after tax cash flow analysis as NPV modeling, but adds an adjustment to account for the change in the market value of the asset.</li>
	<li><strong>Accounting Income:</strong> this method represents the income that would be reported under local accounting regulations.  Deprecation will reflect historic asset values (unlike economic income) and interest expense will be deducted rather than captured as part of the discounting of future cash flows.</li>
	<li><strong>Economic Profit (EP) or Economic Value Added (EVA):</strong> this method takes net operating profit after tax (NOPAT) and makes a reduction based on the weighted average cost of capital (WACC).  The following formula represent the EP/EVA method:</li>
</ul>
<div class="formula1">EP = EBIT (1 – tax rate) – <a title="Weighted Average Cost of Capital (WACC)" href="https://financetrain.com/weighted-average-cost-of-capital-wacc/">WACC</a> (capital invested)</div>
<ul>
	<li><strong>Residual Income (RI):</strong> similar to EP, RI starts with net income and deducts an equity charge to the prior accounting period’s book value of equity.</li>
</ul>
<div class="formula1">

RI = Net Income <sub>t</sub> – (return <sub>required on common equity</sub> * BV <sub>Equity t-1</sub>)

The NPV of a project is equal to the sum of its residuals incomes discounted by the required return on common equity.

</div>
<ul>
	<li><strong>Claims Valuation:</strong> this method is a similar to standard NPV modeling.  Under the claims valuation method, the analyst discounts cash flows to the different claimants (debt holders versus equity holders) at their respective costs of capital.</li>
</ul>

Capital Budgeting Alternatives to NPV and IRR Analysis

Modigliani and Miller (MM) are great academics in economics and finance who broadly studied the impact of <a href="https://financetrain.com/an-introduction-to-capital-structure/" title="An Introduction to Capital Structure">capital structure</a> on a company’s value.

<strong>MM Proposition 1 without Taxes: </strong>Capital Structure Irrelevance

Under Prop 1, MM theorized that in a tax free environment, with perfect information and no costs for financial distress, capital structure is irrelevant and changing a firm’s capital structure will not impact the firm’s valuation.

A unique characteristic of Prop 1 is that it assumes that operating earnings are split equally between stock and bondholders; in other words, neither has a higher residual claim on earnings.

<strong>MM Proposition 2 without Taxes: </strong>Increasing Financial Leverage Increases the <a href="https://financetrain.com/estimating-the-cost-of-common-stock/" title="Estimating the Cost of Common Stock">Cost of Equity</a>

Under Prop 2, MM assumes that the cost of equity is a linear function of the company’s debt to equity ratio.

A key distinction from the assumptions of Prop 1 is that Prop 2 assumes that debt has a superior claim to earnings than equity, which gives debt a lower cost than equity.

In return for their increased risk, equity holders receive a larger proportion of profit.  However, increased equity returns are offset by an increased required return on equity (this is reflected by the cost of equity being a linear function of a company’s debt to equity ratio).  Therefore the leveraged firm is valued the same as the unleveraged firm.

<strong>MM with Taxes</strong>

In most countries, interest is tax deductible.

When MM assumes there are no costs for financial distress, the value of the firm increases as it takes on more debt and under this scenario the firm maximizes value using 100% debt capitalization.

<strong>Relaxing MM Assumptions</strong>

The scenarios presented by MM are not necessarily reflective of business reality.  Additional factors for consideration include:

<ul>
	<li><span style="text-decoration: underline;">Financial Distress</span>: as a firm assumes more debt (i.e. increases its financial leverage), its bankruptcy risk increases.  This increased risk should be factored in to any analysis.</li>
	<li><span style="text-decoration: underline;"><a href="https://financetrain.com/agency-costs-of-equity-and-debt/" title="Agency Costs of Equity and Debt">Agency Costs</a></span>: these are the costs incurred by stockholders to monitor company managers; agency costs are increased when monitoring mechanisms fail and equity value losses are absorbed.</li>
	<li><span style="text-decoration: underline;">Asymmetric Information</span>: MM assumes perfect information, but company managers commonly know more about the firm than the investing public.  This is asymmetric information.</li>
<span style="text-decoration: underline;">The pecking order theory</span> states that company management prefers to use internal financing (cash on hand, retained earnings) as these sources are not as readily visible to the public as stock and bond offerings, which invite scrutiny.  Typically management is biased to debt, unless the equity is considered overvalued.
</ul>

<strong>Static Trade-Off Theory</strong>

Outside the MM construct, this theory views capital structure as a decision that balances costs and benefits.

Under static trade-off, the company should continue to capitalize itself with debt until the increased costs associated with financial distress exceed the value of the tax shield.

Modigliani-Miller and Capital Structure Theory

Analysts can compare a company’s <a title="An Introduction to Capital Structure" href="https://financetrain.com/an-introduction-to-capital-structure/">capital structure</a> to that of its primary competitors.

Analysts can also compare a company’s current capital structure to its historical capital structure. If a company is trending toward higher financial leverage, this may signal future bankruptcy.

Company management may never publicly state its target capital structure, but the analyst knows that the company’s primary capital structure goal should be to minimize its cost of capital. Armed with this understanding, analysts can model scenarios that calculate the impacts to debt and equity valuation, if the perceived ideal capital structure is realized.

<strong><a title="Applications of Cost of Capital" href="https://financetrain.com/application-of-cost-of-capital/">Optimal Capital Structure</a>:</strong> Theoretically this is the mix of financing that minimizes the firm’s <a title="Weighted Average Cost of Capital (WACC)" href="https://financetrain.com/weighted-average-cost-of-capital-wacc/">WACC</a>.

<strong>Debt Ratings and Capital Structure Policy</strong>
<ul>
	<li>Companies must pay debt rating agencies, such as Moody’s, to rate the investment quality of their bonds.</li>
</ul>
<ul>
	<li>Debt rated at and above a certain mark is considered investment grade.</li>
</ul>
<ul>
	<li>Debt rated below a certain mark is considered speculative (commonly called high yield or “junk”).</li>
</ul>
<ul>
	<li>As a company’s financial leverage increases (i.e., its ratio of debt to equity rises), rating agencies tend to lower the grade/mark assigned to that company’s debt.</li>
</ul>
<ul>
	<li>Lower debt ratings not only show increased risk to bondholders, but also to stockholders.  Therefore, lower ratings increase the cost of both debt financing and equity financing.</li>
</ul>
<ul>
	<li>Company management is very sensitive to the firm’s debt rating, as a lower rating leads to a higher cost of capital.</li>
</ul>

Evaluating Capital Structure Policy

While industry norms can say a lot about capital structure, other relevant variables such as taxation, regulation, bankruptcy costs, agency costs, and culture can vary widely across national borders.

Factors that help explain capital structure in an international environment:
<ul>
	<li>Legal and Institutional Environment</li>
</ul>
<ul>
	<li>Financial Markets and Banking System</li>
</ul>
<ul>
	<li>Macroeconomic Climate</li>
</ul>
The table below summarizes how these factors may influence capital structure (not exhaustive).
<table class="mytable">
<tbody>
<tr>
<th scope="colspan">FACTOR</th>
<th scope="colspan">COUNTRY TRAIT</th>
<th scope="colspan">FINANCIAL LEVERAGE IMPACT</th>
<th scope="colspan">DEBT MATURITY</th>
</tr>
<tr>
<th class="spec" scope="row">Court efficiency</th>
<td>Highly efficient</td>
<td>Lower</td>
<td>Longer</td>
</tr>
<tr>
<th class="specalt" scope="row">Legal system</th>
<td class="alt">Civil law</td>
<td class="alt">Higher</td>
<td class="alt">Shorter</td>
</tr>
<tr>
<th class="spec" scope="row">Legal system</th>
<td>Common law</td>
<td>Lower</td>
<td>Longer</td>
</tr>
<tr>
<th class="specalt" scope="row">Tax system</th>
<td class="alt">Equity biased</td>
<td class="alt">Lower</td>
<td class="alt">N/A</td>
</tr>
<tr>
<th class="spec" scope="row">Inflation</th>
<td>High</td>
<td>Lower</td>
<td>Shorter</td>
</tr>
<tr>
<th class="specalt" scope="row">Institutional Investors (ex. pension funds)</th>
<td class="alt">Many and well developed</td>
<td class="alt">Lower</td>
<td class="alt">Longer</td>
</tr>
</tbody>
</table>

International Differences in Financial Leverage

Every year, a company three options as to what it can do with earnings in order to create value for shareholders:
<ol start="1">
	<li>Reinvest in the business;</li>
	<li>Pay cash dividends to shareholders; and/or</li>
	<li>Buy back shares.</li>
</ol>
Note that option 1 assumes that company management profitably reinvests in the company, otherwise value can actually be destroyed.

Keep in mind that paying dividends reduces a company’s retained earnings, which is a reduction to equity in the <a title="An Introduction to Capital Structure" href="https://financetrain.com/an-introduction-to-capital-structure/">capital structure</a>.
<h2 class="hdpline"><span>Dividend Payout Policy</span></h2>
A company’s dividend payout policy is the amount and timing of its dividend payout.

<strong>Payout Ratio</strong>: The percent of net income that is paid out in dividends (recall that dividends are not expensed and thus not part of the net income calculation).

<strong>Example:</strong> A company with net income of $100 million pays out $60 million in dividends; therefore it has a payout ratio of 60% or 0.60 and retained earnings will increase by $40 million.

Cash Dividend Policy types include:

<strong>Residual Dividend Approach</strong>
<ul>
	<li>This is where a firm does not pay dividends until the equity portion of its capital budget is funded.</li>
	<li>Under the residual approach a firm must determine if attractive (i.e. <a title="Net Present Value of a Project" href="https://financetrain.com/net-present-value-of-a-project/">NPV</a> positive) capital projects exist.</li>
	<li>A disadvantage of the residual approach is that it can lead to inconsistency in dividend payouts, making it difficult for investors to set return expectations.</li>
	<li>When investors have difficulty forecasting returns they may place higher return requirements on equity, which raises the firm’s cost of equity capital.</li>
</ul>
<strong>Longer-Term Residual Dividend Approach</strong>
<ul>
	<li>A version of the simple residual approach, under this policy management designs a capital budget for the next five to ten years, which leads to steadier dividend payments to shareholders.</li>
	<li>Consistent expectations around dividend payments can lower investor required return on equity, which in turn lowers the firm’s cost of equity capital.</li>
</ul>
<strong>Stable Dividend Policy</strong>
<ul>
	<li>Under this approach, management makes a calculation about the firm’s long-term sustainable earnings and announces the payment of stable dividends to shareholders.</li>
	<li>Investors tend to prefer certainty and the stable approach eliminates the inconsistency that can be created by the residual approach.</li>
</ul>
<strong>Target Payout Ratio Approach</strong>
<ul>
	<li>Under this approach, company management creates a long-term strategic goal of paying a certain percentage of corporate dividends out to shareholders in the form of cash dividends.</li>
	<li>In mid 20<sup>th</sup> century, an academic named Lintner developed a model to show how a company steadily moves toward its target payout ratio.</li>
</ul>
<div class="formula1">

Expected Dividend Increase = Expected Earnings Increase * Target Payout Ratio * Adjustment Factor

Adjustment Factor = 1 / # of years over which the dividend adjustment occurs

The adjustment factor reduces dividend volatility.

</div>
<h2 class="hdpline"><span>Share Repurchases</span></h2>
This is the act of a company buying back its common shares.  Like dividends, share repurchases require the use of corporate funds.

Sometimes firms buyback shares simply to offset the dilutive effects of issuing stock options to employees.

Firms may issue debt for the purpose of buying back shares. When the after-tax cost of debt exceeds the company’s earnings yield (EPS/share price), then earnings per share will actually drop and the repurchase is dilutive.

Share buybacks can also impact book value per share. If the company pays more per share to repurchase shares than the current book value per share, then the firm’s book value per share will fall.

<strong>Reasons that firms buyback shares</strong>
<ul>
	<li>If the company’s management believes that the market is undervaluing its shares, then the buyback can be a quality investment.</li>
	<li>Management may use share buybacks as an attempt to signal a positive outlook to investors.</li>
	<li>Share repurchases can be a means of altering its capital structure.</li>
	<li>Share repurchases can be more flexible than cash dividends.  Dividend announcements tend to set regular expectations, while repurchases can be used to return value to shareholders when cash flows are unexpectedly high.</li>
</ul>

Dividend and Share Repurchase Policies

Factors that affect a company’s <a title="Dividend and Share Repurchase Policies" href="https://financetrain.com/dividend-and-share-repurchase-policies/">dividend policy</a> decision include:

<strong>Taxation</strong>
<ul>
	<li>Investors are primarily concerned with the after-tax returns of their investments.</li>
	<li>Differences in tax rates for dividends versus capital gains can materially influence an investor’s stock investment choices.</li>
	<li>In addition, frequent dividends create frequent tax events, while capital gains taxes can be deferred until an investor decides to sell a stock.</li>
	<li>Tax systems affecting dividends can be divided into three general classes:</li>
<ul>
	<li><strong>Double Taxation System</strong>: this occurs in the U.S., where the company pays taxes on its earnings prior to any dividend distribution and investors receiving dividends pay taxes on dividend income.</li>
	<li><strong>Split Rate System</strong>: earnings paid as dividends are taxed at different rates from earnings retained by the company.</li>
	<li><strong>Imputation System</strong>: companies pay corporate income taxes, but shareholders can subtract the portion of taxes paid by the company from their individual tax bills.</li>
</ul>
</ul>
<strong>Flotation Costs of Issuing Equity</strong>
<ul>
	<li>When issuing new stock, companies must pay investment banking fees.</li>
	<li>As a result of these costs, firms may hesitate to pay dividends if they anticipate financing needs for upcoming capital projects.  In other words it is less expensive for a firm to reinvest its earnings, rather than pay a dividend and face the prospect if issuing new equity.</li>
</ul>
<strong>Dividend Restrictions</strong>
<ul>
	<li>Dividend payments reduce a company’s retained earnings, which in turn reduce equity.</li>
	<li>Companies may be constrained by debt covenants from paying dividends if shareholder equity falls below a specified level, for example.</li>
</ul>
<strong>The Clientele Effect</strong>
<ul>
	<li>Investors face different financial situations, which lead to different attitudes toward dividends.</li>
	<li>A key difference across investors is tax status.  A high tax bracket individual may not value dividends as much as a tax exempt charity.</li>
	<li>Some institutional investors, such as mutual funds, pension funds, banks, or insurance companies may only buy stocks which have a record of steady dividends, as the equity of these dividend paying companies is viewed as less risky.</li>
	<li>Investor preferences for investing in equity based on dividends is called the clientele effect.</li>
</ul>
 

Factors Affecting Corporate Dividend Policy Decisions

<ul>
	<li>Commonly announcement of cash <a title="Dividend and Share Repurchase Policies" href="https://financetrain.com/dividend-and-share-repurchase-policies/">dividend payment</a> increases are viewed by the investing community as a positive development and that management believes earnings will increase in the future.</li>
	<li>Alternatively, some investors may interpret a dividend increase announcement as a sign that a firm cannot find attractive investment opportunities.  This interpretation may be relevant when a firm’s industry is transitioning from a growth to a mature stage.</li>
	<li>Alternatively, when a company announces that it is cutting its dividend payments, this is viewed by investors as a negative.</li>
	<li><strong>Example:</strong> As the financial crisis of 2008 began to take shape, publicly traded U.S. banks began to announce dividend payment reductions in anticipation of mounting losses on their real estate loan portfolios.</li>
	<li>The reactions to dividend changes above largely reflect U.S. investor sentiment and investing cultures in other countries may react differently to announced increases or cuts to dividend payments.</li>
</ul>
 

Signals from Dividend Policies

Corporate Finance Part 1

This frontmatter description will appear below the title

COURSE

Corporate Finance Part 1

Lessons

R Programming Bundle: 25% OFF