Lecture 9 Quiz

As leverage increases from a low level to a high level, the expected return on equity will increase linearly with the debt to equity ratio.

Debt to equity ratio (leverage) does not affect the return on asset. This is because EBIT does not depend on how assets are financed (it is before interest and tax) and because the market value of assets does not depend on how assets are financed.

In a perfect capital market, small investors can use their borrowing to replicate leveraged firms or unleveraged firms. Therefore, companies do not add value to shareholders by merely increasing or decreasing leverage. Capital structure has no impact on firm value.

Increases in leverage does not affect the expected return on debt when the leverage is low, but increase the the expected return on debt when the leverage is high. This is because further increases in leverage when leverage is already high will significantly increase the default risk of the firm.

Cost of financial distress includes direct and indirect costs of bankrupcy. Direct costs include litigation costs and administrative fees while indirect costs include higher costs of capital, loss of market share and inefficient asset sales (‘fire sale’).

Trade-off theory on capital structure says that M&M I with tax overestimates the value of a leverage firm. The overestimated amount is equal to the present value of the cost of financial distress due to leverage.

Cost of financial distress is high for industries that have more intangile assets. This means that IT and pharmaceutical companies have low financial distress cost while airlines have high financial distress costs.

The modified Modigliani and Miller theory on capital structure (M&M I with tax) says that the value of a leverage firm is higher than the value of the same firm with no leverage. The difference between the values of the two firms is the present value of tax shield.

M&M I with tax theory on capital structure predicts that when corporate tax is positive, all firms would be financed by debt only.

Pecking order theory says that firms prefer internal finance to external finance because they do not want to send unwanted signal to the market. If external finance must be used, shares are issued first before debts are issued, although floatation cost is higher for share issues.

Trade-off theory on capital structure predicts that no firms should be financed with 100% debt. This is because with 100% debt, the marginal financial distress cost is much higher than the benefit of tax shield and firms would be better off to have a lower level of leverage.

Trade-off theory on capital structure is successful in explaining why IT and pharmaceutical firms have low leverage while airlines have high leverage. It cannot explain why many successful firms do not have debt at all.

To receive dividend payment, you need to purchase the share before the ex-dividend date

A firm should pay out cash through dividend payment or share repurchase only when it has financed all positive NPV projects, retained sufficient cash for solvency and reached the target debt ratio.

Dividend payment reduces share price by the same amount as the dividend payment. Dividend payment reduces the cash of the company and reduces equity by the same amount.

Share repurchase will reduce the number of shares but do not affect share price. Upon share repurchase, the company’s cash decreases and liability decreases.

In Australia, dividend imputation means that company income is effectively taxed at individual marginal tax rates while capital gain discount reduces tax for capital gain. The net effect is that shareholders with low marginal tax rates prefer dividend payment while those with high marginal tax rates prefer the company to retain cash and reinvest.

Income tax will reduce the price of stocks that pay dividend. This is because the net of tax amount received by shareholders is lower than the dividend payment.

With a dividend payment financed by share issue, the share price will be decreased by the dividend payment per share and the number of share will increase. The effect is similar to the effect of right issues or share splits.

In the real world with income tax, companies sometimes issue shares to finance dividend payments. This happens when high demand for dividend paying stocks exists such that paying dividend helps to increase the share price.