B40.2302 Class 8

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. . The Dividend Controversy. Standards of Corporate FinanceBrealey and Myers Sixth Edition. Slides byMatthew Will, Jeffrey Wurgler. Section 16.5-16.8. The McGraw-Hill Companies, Inc., 2000. Irwin/McGraw Hill. Subjects Covered. Sees on profit relevanceThe

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B40.2302 Class #8 BM6 parts 16.5-16.8,18.1-18.3,18.5,19 16.5-16.8: Dividend significance under duties and so on 18.1-18.3, 18.5: Capital structure importance under assessments and money related misery 19: Valuation under financing impacts Based on slides made by Matthew Will Modified 10/31/2001 by Jeffrey Wurgler

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Principles of Corporate Finance Brealey and Myers Sixth Edition The Dividend Controversy Slides by Matthew Will, Jeffrey Wurgler Chapter 16.5-16.8 Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000

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Topics Covered Views on profit pertinence The "Rightists" (profits increment esteem) The "Radical Left" (profits diminish esteem) The "Center of-the-Roaders" (next to zero impact)

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Dividends Increase Value A "rightist" (high-payout) see … the considered and nonstop decision of the share trading system is overwhelmingly for liberal profits as against stingy ones… Benjamin Graham and David Dodd Security Analysis (1951) (1 st ed. 1934)

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Dividends Increase Value Rightist contention: M&M overlook chance Dividends are trade out hand, however capital additions are not "Flying creature close by versus winged animal in bramble" So isn't the profit to be favored? Flawed contention Declaring high profit makes (leftover) capital pick up part more hazardous, general hazard to shareholders does not change Can get profit like "winged animal close by" at whatever point you like, just by offering some of your stock M&M expect effective capital market: $1 in profit would somehow or another be promoted at $1 in share cost. Insofar as this is valid, the "winged animal close by" contention is invalid. In the event that this is not valid (as Graham and Dodd suggest), contention is substantial.

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Dividends Increase Value Rightist contention: There are "customers" that lean toward profits Some monetary organizations can't hold stocks that don't have set up profit records Trusts and blessings might be demoralized from spending capital additions (which might be seen as "essential") however permitted to spend profits (might be seen as "wage") Retirees(?)/Small financial specialists(?) may like to spend from their AT&T profit checks as opposed to offer a couple shares each month. (Diminishes exchange costs, burden) Corporations pay corporate pay assess on just 30% of profits they get, yet 100% of capital additions. The request of these "profit customers" may expand the cost of a profit paying stock But… Unclear whether a specific firm can profit by expanding profits. There may as of now be sufficient high-profit stocks to look over.

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Dividends Increase Value Rightist contention: Dividends can't be squandered Investors may not trust directors to contribute held income admirably Firms that decline to pay out money may offer at a markdown Comments For this situation profit choice is attached to speculation choice May have specific legitimacy in nations with poor corporate administration frameworks

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Dividends Decrease Value Leftist (low-payout) contention: Taxes If profits are saddled more intensely than capital additions, financial specialists hate profits. Firms ought to pay low profit, hold money or repurchase offers Investors ought to require higher pre-assessment form on profit paying stocks (i.e, profit paying stocks offer at a rebate cost)

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Dividends diminish esteem Effect of speculator expenses (half profit, 20% capital pick up) on share costs and returns

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Dividends diminish esteem 1998 Marginal Income Tax Brackets Dividends are exhausted at the individual wage rate Capital increases are, for most financial specialists, saddled at 28% High-impose section financial specialists subsequently still incline toward capital additions

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Dividends diminish esteem Empirical confirmation on profits, costs, returns: Mixed. By and large a positive relationship between profit yield and pre-assessment forms, as anticipated by "liberals" But measurably unreliable

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Middle of the street Maybe M&M finish of unimportance is correct notwithstanding when a portion of the suppositions are casual: High-or low-payout customer bases may exist, yet they are now fulfilled, so no firm can expand its incentive by changing profits This "widely appealing" view contends that profits have next to zero impact on esteem

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Principles of Corporate Finance Brealey and Myers Sixth Edition How Much Should a Firm Borrow? Slides by Matthew Will, Jeffrey Wurgler Chapter 18.1-18.3, 18.5 Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000

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Topics Covered Corporate Taxes Corporate and Personal Taxes Costs of Financial Distress Financial trouble diversions The "exchange off hypothesis" of capital structure

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Corporate Taxes Main favorable position of obligation in U.S. : Corporations can deduct premium Whereas held profit and profits are saddled at the corporate level Thus, more money left for financial specialists if firm uses obligation back

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Corporate Taxes Example – Firm U is unlevered, firm L is levered. Firms have same venture approach (so same working money streams). U L EBIT 1,000 1,000 Interest Pmt 0 80 Pretax Income 1,000 920 Tax @ T c = 35% 350 322 Net Income to shhs $650 $598 Net to bhhs 80 Total to financial specialists 650 678 Interest impose shield (.35*interest) 28

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Corporate Taxes What is available estimation of duty shield? On the off chance that similar reserve funds happen each year, esteem as an unendingness If the investment funds are as dangerous as the obligation, rebate at cost of obligation Under these suppositions: PV of Tax Shield = D x r D x Tc r D = D x Tc Example (D = 1000, r D =.10, Tc=.35): Yearly reserve funds = 1000 x (.10) x (.35) = $35 PV Perpetual Tax Shield @ 10% = 35/.10 = 1000*.35 = $350

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Corporate Taxes Taxes don't change the aggregate size of the pretax "pizza." But now the legislature gets a cut. Government's cut is littler (and speculators' cuts are greater) when obligation is utilized. M&M suggestion I with corporate expenses : Firm Value = Value of All Equity Firm + PV(Tax Shield) … and in exceptional situation where obligation is lasting … Firm Value = Value of All Equity Firm + Tc*D

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Corporate Taxes So why not 100% obligation, then, or near it? Possibly taking a gander at corporate and individual tax collection will reveal an individual assessment detriment to acquiring (to balance the corporate duty advantage) Or, perhaps firms that obtain bring about different costs –, for example, expenses of monetary misery – that balance premium assessment shield

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Corporate and Personal Taxes T C orporate impose rate T P ersonal charge rate on premium wage T PE P ersonal impose rate on E quity salary (= T P if all value income comes in type of money profits, yet < T P if comes as capital increases, << on the off chance that they are conceded) - - - - - $1 in working wage paid as premium: = $(1 – T P ) to bondholder (escapes corporate assessment) $1 in working wage paid as value pay: = $ (1 – T PE )*(1 – T C ) (hit by corporate expense, then personal impose)

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Corporate and Personal Taxes Relative Tax Advantage of Debt over Equity 1-T P = (1-T PE )*(1-T C ) Tax advantage RA > 1 Debt RA < 1 Equity

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Corporate and Personal Taxes Example 1 Interest Equity pay Income before tax 1.00 1.00 Corp charges Tc=.35 0.00 0.35 To investor 1.00 0.65 Pers. charges T P =.40, T PE =.10 0.40 0.065 Income after all taxes 0.60 0.585 RA = 1.025  Advantage: Debt (scarcely)

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Corporate and Personal Taxes Example 2 Interest Equity wage Income before tax 1.00 1.00 Corp charges Tc=.35 0.00 0.35 To investor 1.00 0.65 Pers. charges T P =.40, T PE = 0 0.40 0.00 Income after all taxes 0.60 0.65 RA = 0.923  Advantage: Equity

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Corporate and Personal Taxes So then … value or obligation? Merton Miller's contention: Suppose T PE = 0 and T P differs crosswise over speculators. At that point expansive expense limiting blend of obligation and value depends on dispersion of individual duty rates But there still might be are no assessment increases left for singular firms to get by shifting their own particular use "Low-charge " financial specialists as of now hold every one of the securities they need If "negligible speculator" has high assessment rate, might be no assessment increase left from issuing obligation to him! Current assessment law still appears to support getting, however ( T PE not as low as Miller expected )

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Costs of Financial Distress Costs of Financial Distress - Costs emerging from chapter 11 or mutilated business choices on the precarious edge of insolvency. Firm esteem = Value of All Equity Firm + PV(Tax Shield) -PV(Costs of Financial Distress)

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Trade-off Theory Costs of money related pain PV of premium assessment shields Market Value of levered firm Value if All Equity Debt proportion Optimal measure of obligation

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Costs of Financial Distress Bankruptcy is not expensive in itself; insolvency expenses are the cost of utilizing this lawful component Bankruptcy expenses and expenses of budgetary misery are borne by shareholders Creditors anticipate the expenses and predict that they will pay them if default happens For this, they request higher loan costs ahead of time This lessens the present market estimation of shares

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Costs of Financial Distress Direct costs (lawful, managerial charges) Manville (1982, asbestos): $200m on charges Eastern Airlines (1989): $114m on expenses overall, coordinate expenses = 3% of book resources, or 20% of market value in year preceding liquidation Indirect costs Customers may stray if firm may not associate with, providers might be unwilling to give much push to company's record, great representatives difficult to draw in … Hard to quantify, however most likely vast

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Costs of Financial Distress US insolvency techniques Chapter 11 Aims to restore fir