This Assessment comprises of 1500 words, due 27 May Assessment 3 Case Study 1 Finance for Managers. This is the first Assessment and I have already submitted the second Assessment, Finance for Managers Assessment 4 Case Study 2. I want the same expert to do both Assessments. Please forward both Assessments to expert for review.
11/04/2019 SCU online https://scu-online.com.au/course/week/6/page/1 1/3 FINANCE FOR MANAGERS Capital structure and payout policies Topic 6: Capital structure and payout policies Learning Objectives On completion of this topic, you should be able to: discuss major theories of capital structure and their contributions to the debate surrounding the optimal capital structure identify the factors that influence a firm’s capital structure choice and apply those factors to compare, appraise and explain different capital structures describe, critique, and make recommendations on a firm’s payout policy describe the methods for distributing cash to shareholders and the cash dividend payment process 1 2 3 4 11/04/2019 SCU online https://scu-online.com.au/course/week/6/page/1 2/3 discuss share repurchases, share splits, bonus shares and dividend reinvestment plans outline factors for consideration in determining a payout policy describe and explain dividend smoothing problems describe and evaluate the residual distribution model and alternative dividend policies. Introduction Last week we finished our study of investment decisions. In this final week, we cover financing and payout decisions. Our key purpose links back to our goal of the firm, value maximisation. We will look at whether financing and payout decisions affect firm value and if so, how. In considering financing decisions, we focus on the big picture — capital structure. This is the proportion of the firm’s funds contributed by equity and the proportion contributed by debt. From last week’s topic, you would realise that business risk and financial risk play a role in decisions here. We will build on that idea. 5 6 7 8 11/04/2019 SCU online https://scu-online.com.au/course/week/6/page/1 3/3 After making some broad observations about capital structure patterns in practice, we review key theories of capital structure to identify factors that help determine the optimal capital structure for specific organisations. The optimal capital structure is the mix of debt and equity that maximises the value of the firm, but keep in mind as you progress through the topic that the exact nature of the link between capital structure and firm value is still an open question. Payout policy is concerned with the level, form and stability of cash distributions to shareholders. Recall there is no requirement for ongoing companies to make these distributions. If a firm decides to do so, a distribution policy needs to be determined. Decisions need to be made on how much to distribute (level), the form of distribution (for example, cash dividends or share repurchases) and whether the firm should attempt to maintain stability in its distributions. © Southern Cross University | ABN: 41 995651 524 | CRICOS Provider: 01241G 11/04/2019 SCU online https://scu-online.com.au/course/week/6/page/2 1/3 FINANCE FOR MANAGERS Capital structure and payout policies Observed capital structure patterns Before moving to a full examination of issues related to capital structure decisions, it is useful (and hopefully interesting) to consider observed capital structure patterns. These empirical observations are what any good capital structure theory should seek to explain. Observation 1: Capital structure varies across countries Figure 6.1 shows the market leverage ratio (debt/assets based on market values) for a sample of 39 countries across a 15-year period. The reasons for country variations reflect differences in tax systems, legal environments, banking system development, industry composition, history, culture and other factors. For example, the use of debt tends to be lower in countries such as Australia that have full dividend imputation tax systems, perhaps because the tax benefit of debt is lowest in these countries (Twite 2001; Fan, Titman & Twite 2012). In classical tax systems, increases in company tax rates tend to be associated with increases in debt ratios. (We will outline the differences in these tax systems a little later in the topic.) Figure 6.1. Source: Fan, Titman & Twite (2012, p. 33) 11/04/2019 SCU online https://scu-online.com.au/course/week/6/page/2 2/3 Observation 2: Capital structure varies across industries with some distinct patterns More debt is used in utilities, manufacturing and transportation industries than in retailing and wholesaling industries. Resources and high-technology and some services industries use the least debt. This pattern is probably at least in part due to the extent of tangible fixed assets that can be used as collateral when borrowing. Industries that have a large proportion of tangible assets tend to use more debt than industries where value depends on intangible assets and growth opportunities. (Again, we will outline the differences between tangible and intangible assets a little later in the topic.) Another reason relates to operating earnings volatility (business risk), which tends to vary by industry. Take, for example, firms in the resources industries. These firms tend to have fluctuating operating income streams due to commodity prices changes, and therefore they have lower debt ratios than firms in industries with less volatile income streams, such as non-cyclical consumer industries (e.g. supermarkets). Table 6.1, which you can download below, shows substantial variation in sector and industry capital structures in Australia. Banks have the highest ratio (88.1%) because their business is based on borrowing and lending. Utilities, industrials and consumer stables sectors have ratios over 25%. These sectors have significant tangible assets or stable earnings or both. Healthcare and materials (made up mostly of mining companies) sectors have ratios less than 10%. There are also variations within sectors. For example, ratios for industries within the consumer discretionary group range from 14.7% (retailing) to 29.3% (consumer durables and apparel). Download table 6.1 Observation 3: Capital structure also varies within industries. There are several reasons why capital structure also varies within an industry. Growth opportunities provide one reason. Firms with lots of investment opportunities and growth potential tend to maintain reserve-borrowing capacity so they can borrow to take up those opportunities. Therefore, they often have lower debt ratios. Larger firms tend to use more debt, probably because they have access to a greater number of debt financing sources. Take for example the two companies shown in Table 6.2. Both companies are telecoms with about the same operating rate of return (measured by return on assets, ROA). Compared to its competitor Telstra, TPG is smaller (measured by market capitalisation) but has more growth potential. TPG also has much less debt in its capital structure. Table 6.2: Telecommunication company comparison as at 30 June 2017 https://s3-ap-southeast-2.amazonaws.com/assets.scu.online/content/docs/ACC91210+Finance+for+Managers/finance-week-6-table-6-1-new.pdf 11/04/2019 SCU online https://scu-online.com.au/course/week/6/page/2 3/3 Market cap. ROA Market debt ratioMarket cap. ROA Market debt ratio Telstra Corporation Limited $51,141,180,776 10.83% 25.3% TPG Telecom Limited $5,187,676,103 11.66% 14.9% © Southern Cross University | ABN: 41 995651 524 | CRICOS Provider: 01241G 11/04/2019 SCU online https://scu-online.com.au/course/week/6/page/3 1/4 FINANCE FOR MANAGERS Capital structure and payout policies Capital structure theories We have found that many students struggle with the study of capital structure because textbooks often explain the theories using numbers and formulae. Although your text does a good job (in our opinion) of explaining capital structure theory more intuitively, we provide here our own version of a summary, focussing on the key concepts and logic to help guide you through the key ideas before working through the text. There is some overlap but we hope reading about the theories twice, in different ways, will help. In 1958, Franco Modigliani and Merton Miller (MM) challenged the established wisdom of the day by questioning whether the value of a firm depends on the way in which it is financed. Are the underlying assets of the firm and the cash flows they generate independent of the way in which the firm is financed? You may be wondering why we would be interested in a theory developed in 1958. The reason is that this theory provided the theoretical underpinnings for the development of modern capital structure theory. Indeed, it resulted in a Nobel prize in economics for MM. MM built their theory on the concept of perfect capital markets, which has a number of restrictive assumptions. This provided a base from which later work could gradually relax these assumptions to examine their impact on the optimal capital structure. In this way, researchers could build up a theory that better reflected the real world instead of a perfect world. It is difficult to understand these later theories without first having an understanding of the early work. Therefore, we begin by examining capital structure in MM’s perfect world. We then begin relaxing their assumptions, moving into a not-so-perfect world, to see what effect this has on our conclusions about capital structure, covering the relevant later theories as we go. This is not an academic exercise. The practical implications are that we are developing a checklist of relevant factors for management to consider in capital structure decisions. Unfortunately, there is no one formula for such decisions, as you will see. MM (no taxes) 11/04/2019 SCU online https://scu-online.com.au/course/week/6/page/3 2/4 MM’s seminal theory is often referred to as MM with no taxes or MM’s irrelevance theory. It addressed the fundamental capital structure question: Does a firm’s capital structure have any impact on its value? If the goal is to maximise value, the answer to this question is clearly important. If the answer is no, then managers don’t need to worry about the mix of debt and equity the firm uses. And that is exactly the conclusion reached by MM in their famous (in the financial world!) Proposition 1: the value of the firm is independent of its capital structure. In other words, capital structure is irrelevant. MM also made another conclusion, Proposition 2, which says that the cost of equity increases proportionately with the debt/equity ratio. As a firm takes on higher debt levels, the risk to shareholders increases (financial risk) and so they require a higher return. MM showed that the increase in the required return on equity exactly offsets the effect of using cheaper debt and so the weighted average cost of capital (WACC) remains constant at the level of a firm with no financial leverage. This means that if WACC does not change as we change the mix of debt and equity used by the firm and we keep the nature of our investments constant, the value of the firm will stay the same. An implication is that the only way managers can affect the value of the firm is through investment decisions, not capital structure decisions (and, as we will see later, dividend decisions). This puts capital budgeting decisions front and centre in managing firm value maximisation. MM reached their conclusions in an analysis relying on the assumptions of a perfect market in which, for example, there are no taxes and no transaction costs. Clearly, these assumptions are not realistic but the theory provides a basis from which rigorous analysis of the effect of market imperfections (such as taxes) can proceed. Management can then determine if they need to adjust the firm’s capital structure in order to exploit those market imperfections. The kinds of market imperfections considered in later theoretical developments by MM and others include taxes, insolvency costs, agency costs and asymmetric information. We will consider these in turn, but