Module 4-Background CAPITAL STRUCTURE AND DIVIDENDS

Module 4-Background CAPITAL STRUCTURE AND DIVIDENDS

Capital Structure and Dividend Policy Podcast. (2014). Pearson Learning
Solutions, New York, NY.
Capital Structure and Dividend Policy Interactive Video. (2014). Pearson
Learning Solutions, New York, NY.
Review these website links:
Damodaran, A. (2005). Finding the right financing mix: The capital
structure decision. Retrieved June 2014
from http://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/capstr.pdf
Harvey, C. (1995). WWWFinance: capital structure and payout policies.
Retrieved June 2014
from http://www.duke.edu/~charvey/Classes/ba350/capstruc/capstruc.htm
Peavler, R. (2012). Debt and equity financing. Retrieved June 2014
from http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm
There are advantages and disadvantages to having debt in a corporation’s
capital structure.
Corporations get a tax deduction from the interest paid on debt. On the
other hand, dividends are not tax deductible. This helps to reduce the cost
of debt since the after-tax cost of debt is used in the weighted average cost
of capital and not the pre-tax cost of debt. The cost of equity is usually
much higher and can be estimated through the Capital Asset Pricing Model
(CAPM). If a firm is very successful, the stockholders don’t have to share
the profits with debtholders since the return on debt is not a variable.
There are some problems with debt, though. As a company uses more
debt in its capital structure, it increases the company’s risk. This increases
the costs of equity and debt. If a company has financial problems and
can’t cover its interest charges, the firm may have to go bankrupt if it can’t
obtain additional financing.
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Firms that have quite variable earnings and operating cash flows are better
off having limited debt in their capital structures. Companies with more
stable earnings and operating cash flows can utilize more debt in their
capital structures.
Business risk is probably the most important factor that drives capital
structure decisions. Business risk is the riskiness of a company’s
operations if it doesn’t utilize debt. Financial risk is the increased
shareholders’ risk from the use of debt in the capital structure. There’s no
set optimal capital structure for all firms.
An investor’s total return consists of the capital gains yield and the dividend
yield. Not all companies pay dividends; however, for those that do, it is an
important component of an investor’s return, particularly for those seeking
income. Individuals who are retired are usually the clientele most
interested in dividends. If a stock’s price didn’t change all year, yet the
company paid a healthy dividend yield, the investor would still earn a
positive total return.
Successful companies typically accumulate a large amount of cash on their
balance sheet. If the company has funded all the positive NPV projects
that it wants to, it can look to paying a dividend or buying back stock. If it
currently already pays a dividend, it can look to increase the dividend.
A company that increases its dividend or institutes a dividend provides a
signal to the marketplace that it anticipates higher future cash flows at the
firm since once a company increases or starts a dividend it rarely reduces
or eliminates the dividend. On the other hand, a company that decreases
its dividend or eliminates a dividend provides a signal to the marketplace
that it anticipates lower future cash flows at the firm.