Corporate Finance

Course Introduction

Corporate Finance is concerned with the financing and investment decisions made by the
management of companies in pursuit of corporate goals. This subject is concerned to the
study of how the companies actually make financing and investment decisions, and it’s is
often the case that theory and practice disagree. In Corporate Finance, the fundamental goal
is usually taken to be to increase the wealth of shareholders. Corporate finance gives an
understanding of the reasons why shareholder wealth maximization is the primary financial
objective of a company, rather than other objectives a company may consider.

The object of the Corporate Finance is the acquisition and allocation of corporate funds or
resources with the maximizing shareholders wealth. In the financial management of a
corporation funds are generated from various sources and allocated or invested for desired
assets. The primary function of corporate finance is resource acquisition, refers to the
generation of funds from both internal and external sources at the lowest possible cost to the
corporation. There are two main categories of resources are equity (shares) and liability
(Borrowings). The equities are proceeds from the sale of stock, returns from investments
and retained earnings. Liabilities include bank loans or other debts, accounts payable,
product warranties and other types of commitments from which an entity derives value. The
second function of corporate finance is resources allocation and investment of funds with
the intent of increasing share holders wealth over a period of time.

There are two basic categories investments are current assets and fixed assets. Current
assets include cash, inventory and accounts receivable. The fixed assets are buildings, real
estate and machinery. In addition, the resource allocation function is concerned with
intangible assets such as goodwill, patents and brand names.

It is the duty of financial manager of a corporation to conduct the above functions in a

manner that maximizes shareholders wealth or stock price and he must balance the interests
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of owners or shareholders and creditors including banks and bondholders and other parties,
such as employees, suppliers and customers. For example a corporation may choose to
invest its resources in risky ventures in an effort to offer its share holders the potential for
large profit. However, risky investments may reduce the perceived security of the
companies bond, thus decreasing their value in the firm must pay to borrow money in the
future.

Conversely, if the corporation invests too conservatively, it could fail to maximize the value
of its equity. If the firm performs better than other companies its stock price will rise, in
theory, enabling it to raise additional funds at a labor cost, among other benefits. Practical
issues and factors influenced by corporate finance include employee’s salaries, marketing
strategies customer credit and the purchase of new equipment.

The Financial decision affects both the profitability and risk of a firm’s operation. An
increase
in cash holdings, for instance risk, but, because of cash is not an earning asset, converting
other types of assets to cash reduces the other firm’s profitability. Similarly, the issue of
additional debt can raise the profitability of a firm, but more debt means more risk. Striking
a balance between risk and profitability that will maintain the long term value of a firm’s
securities in the large of finance. This course is divided into two modules and seven units.

The first module will constitute three units and will discuss on the subjects of risk and
return, the capital structure debate and the dividend policy controversy. The second module
on the other hand will constitute four units which will dwell on long term financing
including Lease financing, Mergers, acquisition, restructuring and consolidation of firms
and also on the issue of business failure and reorganization.

Dear Student, there are self test questions following each topic discussion, and you are
advised to do them all. Answers to the self test questions and activities are given on end of
the course material. GOOD LUCK!!

Course Objectives

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Upon completion of this course students will be able to;

 Explain the subject, the measurement, and the management of risk

 Identify the various theories related to risk management
 Describe the different theories and arguments related to capital structure
 Determine the extent of the effort of establishing optimum capital structure for
a firm
 Identify the different types of argument provided on dividend policy
 Determine the factors considered in establishing dividend policy for a firm
 Describe what lease financing is
 Identify the various forms of lease and their implication on cost of financing
 Determine the possible sources of finance for a firm
 Describe the features and characteristics of sources of finance
 Explain the reason for merging of firms
 Describe the synergistic reasons of firm acquisition and takeover
 Identify the causes of business failure
 Determine the approaches of reorganization of firms

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 Module I

Risk, Capital Structure and Dividend decisions

Module Introduction

Corporate finance is concerned with the efficient and effective management of the finances
of an organization in order to achieve the objectives of that organization. This involves
planning and controlling the provision of resources (where funds are raised from), the
allocation of resources (where funds are deployed to) and finally the control of resources
(whether funds are being used effectively or not). The fundamental aim of financial
managers is the optimal allocation of the scarce resources available to them – the scarce
resource being money. Corporate finance theory there-fore draws heavily on the subject of
economics.

The discipline of corporate finance is frequently associated with that of accounting.

However, while financial managers do need to have a firm understanding of management
accounting (in order to make decisions) and a good understanding of financial accounting
(in order to be aware of how financial decisions and their results are presented to the
outside world), corporate finance and accounting are fundamentally different in nature.
Corporate finance is inherently forward-looking and based on cash flows: this differentiates
it from financial accounting, which is historic in nature and focuses on profit rather than
cash.

Corporate finance is concerned with raising funds and providing a return to investors: this
differentiates it from management accounting, which is primarily concerned with providing
information to assist managers in making decisions within the company. However, although
there are differences between these disciplines, there is no doubt that corporate finance
borrows extensively from both. While in the following section s we consider in detail the

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many and varied problems and tasks faced by financial managers, the common theme that
links these section s together is the need for financial managers to be able to value
alternative courses of action available to them.

This allows them to make a decision on which is the best choice in financial terms.
Therefore before we move on to look at the specific roles and goals of financial managers,
we introduce two key concepts that are pivotal in financial decision-making. In the course
of maximizing value of the firm it becomes imperative to look into essential factors
including risk, financing, investment and reward payment profile, among others.

Hence, this module is to discuss about risk, capital structure and dividend decisions. Risk is
prevalent in any investment decision in business. Hence, it is worth discussing about its
nature, measurement and also its management. The first unit will discuss about risk and
return. The second unit will dwell on another important issue in business-The capital
structure decision. It is to deliberate on a controversial issue of whether manipulating
capital structure will help increase value of the firm. Different theories and arguments will
be seen in this second unit. The final unit in this module is about dividend policy issues. It
will look into debates on dividend payment influences. Like in the second unit, the dividend
policy issues are controversial and interesting.

Module Objectives

Upon completion of this module, students are expected to be able to;

 Differentiate the concept between return risk

 Measure risk a stand alone or in a portfolio setting

 Classify the sources of risk

 Describe efficient set of portfolios

 Differentiate between CAPM and other factor models

 Explain each type of derivative used in managing of risk

 Describe what capital structure is about

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 Identify the broad sources of funds for investment decision
 Explain the M & M theory of capital structure Irrelevance
 Determine the relationship between M & M irrelevance theory and the pie Model
 Describe the order of financing in the pecking order theory
 Explain what the trade of theory is about
 Demonstrate how introduction of taxes will alter the irrelevance theory of M & M
 Identify the different forms of dividend
 Determine the different terms and dates related to dividend payment
 Describe M & M irrelevance theory
 Explain what Home made dividend is implying
 Determine the reasons behind high dividend advocacy
 Describe the rationale behind low dividend paying
 Explain the reasons behind the consideration of clientele in dividend payment

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 Unit 1

Risk and Return

1.1 Unit Introduction

An investment decision typically involves taking of risk. A company that borrows money
faces the risk that interest rates may change, among others. A company that builds a new
factory faces the risk that product sales may be lower than expected, input costs may rise
more than expected, etc. These and many other possible occurrences can make future cash
flows different from expected and thus make things risky. Investors generally will be
willing to take little risk, but they are also unable to avoid it. Dear Student, remember in our
previous financial management course, the valuation of shares and debt securities outlined
showed that the price of a risky asset depends on its expected future cash flows, the time
value of money, and risk. However, then little attention was paid to the causes of risk or to
how risk should be managed and measured.

To make effective financial decisions, managers need to understand what causes risk, how it
should be measured and the effect of risk on the rate of return required by investors. These
issues are discussed in this unit using the framework of portfolio theory, which shows how
investors can maximize the expected return on a portfolio of risky assets for a given level of
risk. The relationship between risk and expected return is first described by the capital asset
pricing model (CAPM), which links expected return to a single source of risk, and second,
by models that include additional factors to explain returns.

Besides, this unit will classify the broad sources of risk, how different types of risk are
measured in a stand alone and in a portfolio setting. Alternate methods of looking at risk in
a portfolio will be discussed.

The methods and tools used to manage risk are also discussed. We will see financial
engineering in the context of hedging risk. Different tools of derivatives will be up for

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discussion and we will examine each how it is used in the course of managing financial risk
in a developed economic setting.

To understand the material in this unit it is necessary to understand what is meant by return
and risk. Therefore, we begin by discussing these concepts.

1.2 Unit Objectives

Upon completion of this unit students are expected to be able to;

 Differentiate the concept between return risk

 Measure risk a stand alone or in a portfolio setting

 Classify the sources of risk

 Describe efficient set of portfolios

 Differentiate between CAPM and other factor models

 Explain each type of derivative used in managing of risk

1.3 Risk and Return

1.3.1 Return

With most investments, an individual or business spends money today with the expectation
of earning even more money in the future. The concept of return provides investors with a
convenient way of expressing the financial performance of an investment.

Dear Student, we will illustrate this as follows: Suppose you buy 10 shares of a stock for
Birr1,000. The stock pays no dividends, but at the end of one year, you sell the stock for
Birr1,100. What is the return on your Birr1,000 investment? One way of expressing an
investment return is in Birr terms. The Birr return is simply the total Birrs received from the
investment less the amount invested:

Birr return =Amount received -Amount invested

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 Birr1,100 - Birr1,000
Birr100.

If at the end of the year you had sold the stock for only Birr900, your Birr return would
have been Birr -100. Although expressing returns in Birrs is easy, two problems arise:
(1) To make a meaningful judgment about the return, you need to know the scale
(size) of the investment; a Birr100 return on a Birr100 investment is a good return
(assuming the investment is held for one year), but a Birr100 return on a Birr10,000
investment would be a poor return.
(2) You also need to know the timing of the return; a Birr100 return on a Birr100
investment is a very good return if it occurs after one year, but the same Birr return
after 20 years would not be very good.

The solution to the scale and timing problems is to express investment results as rates of
return, or percentage returns. For example, the rate of return on the 1-year stock investment,
when Birr1,100 is received after one year, is 10 percent: how? See the following,

Rate of return = Amount received - Amount invested

Amount invested

= Birr return = Birr100

Amount invested Birr1,000

= 0.10 =10%.

The rate of return calculation “standardizes” the return by considering the return per unit of
investment. In this example, the return of 0.10, or 10 percent, indicates that each Birr
invested will earn 0.10(Birr1.00) = Birr0.10. If the rate of return had been negative, this
would indicate that the original investment was not even recovered. For example, selling
the stock for only Birr900 results in a minus 10 percent rate of return, which means that
each invested Birr lost 10 cents.

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Dear Student, note also that a Birr10 return on a Birr100 investment produces a 10 percent
rate of return, while a Birr10 return on a Birr1,000 investment results in a rate of return of
only 1 percent. Thus, the percentage return takes account of the size of the investment.

Expressing rates of return on an annual basis, which is typically done in practice, solves the
timing problem. A Birr10 return after one year on a Birr100 investment results in a 10
percent annual rate of return, while a Birr10 return after five years yields only a 1.9 percent
annual rate of return.

Although we illustrated return concepts with one outflow and one inflow, rate of return
concepts can easily be applied in situations where multiple cash flows occur over time. For
example, when, for example, Intel makes an investment in new chip-making technology,
the investment is made over several years and the resulting inflows occur over even more
years. For now, it is sufficient to recognize that the rate of return solves the two major
problems associated with Birr returns—size and timing. Therefore, the rate of return is the
most common measure of investment performance.

SELF TEST QUESTION 1

1. Differentiate between Birr return and rate of return.

2. Why is the rate of return superior to the Birr return in terms of accounting for the
size of investment and the timing of cash flows?
1.3.2 Risk

Risk is a likelihood of an event that undermines the value of an asset. An asset’s risk can be
analyzed in two ways:
(1) On a stand-alone basis, where the asset is considered in isolation, and
(2) On a portfolio basis, where the asset is held as one of a number of
assets in a portfolio. Thus, an asset’s stand-alone risk is the risk an
investor would face if he or she held only this one asset. Obviously,
most assets are held in portfolios, but it is necessary to understand
stand-alone risk in order to understand risk in a portfolio context.

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To illustrate the risk of financial assets, suppose an investor buys Birr100,000 of short-term
Treasury bills with an expected return of 5 percent. In this case, the rate of return on the
investment, 5 percent, can be estimated quite precisely, and the investment is defined as
being essentially risk free. However, if the Birr100,000 were invested in the stock of a
company just being organized to prospect for oil in the mid-Somali Region, then the
investment’s return could not be estimated precisely.

If in another situation, say a Birr 100 invested today is expected to fetch Birr 20 more than
the invested amount, after one year, one might analyze the situation and conclude that the
expected rate of return, in a statistical sense, is 20 percent, but the investor should recognize
that the actual rate of return could range to a much lower figure to another. Because there is
a significant danger of actually earning much less than the expected return, the stock would
be relatively risky.

No investment should be undertaken unless the expected rate of return is high enough to
compensate the investor for the perceived risk of the investment. In our earlier example, it
is clear that few if any investors would be willing to buy the oil company’s stock if its
expected return were the same as that of the T-bill.

Risky assets rarely produce their expected rates of return—generally, risky assets
earn either more or less than was originally expected. Indeed, if assets always produced
their expected returns, they would not be risky. Investment risk, then, is related to the
probability of actually earning a different amount than expected—the greater the chance of
a low or negative return, the riskier the investment. However, risk can be defined more
precisely, and we do so in the next section.

1.3.2.1 Probability Distributions

An event’s probability is defined as the chance that the event will occur. For example, a
weather forecaster might state, “There is a 40 percent chance of rain today in Addis Ababa
and a 60 percent chance that it will not rain.” If all possible events, or outcomes, are listed,
and if a probability is assigned to each event, the listing is called a probability distribution.
For our weather forecast, we could set up the following probability distribution:

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Table 1.1 Probability Distribution of a Possible Outcome-Single Asset

Possible Outcome Probability

Rain 40% = 0.4

No Rain 60% =0.6

The possible outcomes are listed in Column 1, while the probabilities of these outcomes,
expressed both as decimals and as percentages, are given in Column 2. Notice that the
probabilities must sum to 1.0, or 100 percent.

Probabilities can also be assigned to the possible outcomes (or returns) from an investment.
If you buy a bond, you expect to receive interest on the bond plus a return of your original
investment, and those payments will provide you with a rate of return on your investment.
The possible outcomes from this investment are (1) that the issuer will make the required
payments or (2) that the issuer will default on the payments.

Table 1.2 Probability Distribution of a Possible Outcome-Two Assets

Demand for Probability Rate of return on stock if this demand
The product Of this to happen occurs
X product Y product
Strong 0.3 100% 20%
Normal 0.4 15 15
Weak 0.3 (70) 10

Dear Student please note that, the higher the probability of a default, the riskier the bond
would be; and the higher the risk, the higher the required rate of return. If you invested in a
stock instead of buying a bond, you will again expect to earn a return on your money. A
stock’s return will come from dividends plus capital gains. Again, the riskier the stock—

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which means the higher the probability that the firm will fail to perform as you expected—
the higher the expected return must be to induce you to invest in the stock.

With this in mind, consider the possible rates of return (dividend yield plus capital gain or
loss) that you might earn next year on a Birr10,000 investment in the stock of either
Yohannis Products Inc. or ADDIS Water Company, in the following example. Let us say,
Yohannis manufactures and distributes routers and equipment for the rapidly growing data
transmission industry. Because it faces intense competition, its new products may or may
not be competitive in the marketplace, so its future earnings cannot be predicted very well.
Indeed, some new company could develop better products and literally bankrupt Yohannis.
ADDIS Water, private service provider, on the other hand, supplies an essential service, and
because it has city franchises that protect it from competition, its sales and profits are
relatively stable and predictable.

1.3.2.2 Measuring Stand-Alone Risk: The Standard Deviation

Risk is a difficult concept to grasp, and a great deal of controversy has surrounded attempts
to define and measure it. However, a common definition, and one that is satisfactory for
many purposes, is the likelihood that a future event will become different from our
expectation. The tighter or closer the probability distribution of expected future returns,
the smaller the risk of a given investment.

Water is less risky than Yohannis Products because there is a smaller chance that its actual
return will end up far below its expected return. To be most useful, any measure of risk
should have a definite value—we need a measure of the tightness of the probability
distribution. One such measure is the standard deviation, the symbol for which is δ,
pronounced “sigma.” the tighter the probability distribution the smaller the standard
deviation, and, accordingly, the lower the riskiness of the stock. To calculate the standard
deviation, recall your elementary statistics, where you do the following:
1. Compute the expected value i.e the mean first,

Mean = (Pb1 x X1) + (Pb2 x X2) + (Pb3 x X4) +…

Where:

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 Pb1 = the probability of occurrence of event 1

X1 is the result or event like rate of return shown above on Table 1.2

2. Then compute the sum of the squared deviation of each observation from the
expected value or the mean. That is the variance-which is the squared value of the
standard deviation. Thus the under rooted value will be the standard deviation.

1.3.2.3 Risk Premium

There are times and conditions where investment is made on certain assets, like in Treasury
bill, (riskless asset)which pays back exactly the expected value-known rate. That rate of
return is called Risk Free rate of return. Investors who put their money in other investment
vehicles like corporate bonds or stocks essentially are taking risk. They do so to earn more
than they do by investing in a Treasury bill-Risk free asset.

Hence, the portion of a risky asset’s expected return that is attributed to the additional risk
of an investment over and above the “risk-free” rate of return is what is called risk
premium.

Therefore Risk premium = Return on asset – Risk free rate of return= Rx - Rf.

SELF TEST QUESTION 2

Given are the following:

Return on an asset, X = 16%
Risk Free assets Return = 6%
What is the Risk Premium on asset X?

1.4 Portfolio Theory

This is a discussion about the theory behind modern portfolio management. Essentially,
Portfolio managers construct investment portfolios by measuring a portfolio’s risks
and returns. An understanding of the relationship between portfolio risk and correlation is
critical to understanding modern portfolio theory. A grasp of variance, standard deviation,
the Markowitz model, the risk-free rate, and the Capital Asset Pricing Model (CAPM) are
also needed.

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The basic concept of the portfolio theory is that holding more assets is likely to reduce risk
on investment than putting one’s money all in one asset. As the saying goes ‘Don’t put all
your eggs in one basket’, all resources exposed to one type of risk will result in loosing all
when risk on that asset strikes. In effect, portfolio theory is about advocacy for
diversification. How would it be possible to compute returns on a portfolio? How about
measuring the risk in investing on more than one asset?
The following discussion will answer, step by step, the aforementioned questions. Hence we
will determine the expected rate of return on a portfolio first-like we did to stand alone
assets. Then we will determine the portfolio risk.

1.4.1 Calculating Portfolio Returns

The expected return of a portfolio is simply the weighted average of returns on individual
assets within the portfolio, weighted by their proportionate share of the portfolio at the
beginning of the measurement.
Example 1:
Oliver’s portfolio holds security A, which returned 12.0% and security B, which returned
15.0%. At the beginning of the year 70% was invested in security A and the remaining
30% was invested in security B. Calculate the return of Oliver’s portfolio over the year.

Rp = (.6x12%)+(.3x15%) = 12.9%

Example 2:

Oliver’s portfolio holds security A, which returned 12.0%, security B, which returned
15.0% and security C, which returned –5.0%. At the beginning of the year 45% was
invested in security A, 25.0% in security B and the remaining 30% was invested in security
C. Calculate the return of Oliver’s portfolio over the year.

Rp = (.45x12%)+(.25x15%)+(.3x(-5%)) = 7.65%

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 1.4.2 Calculating Portfolio Risk

As said earlier, there can be different approaches of defining risk, when it comes to
measurement; however, one widely-used measure of risk is called variance. Variance
measures the variability of realized returns around an average level. The larger the
variance the higher the risk in the portfolio would be.

Dear Student, what we did in 1.3.2.2 above. We remind you that standard deviation is a
measure of risk. True it is standard deviation is the square root of the variance. Hence, we
can also measure risk using variance. Variance of a portfolio is dependent on the way in
which individual securities interact with each other. This interaction is known as
covariance. Covariance essentially tells us whether or not two securities returns are
correlated.

Covariance measures by themselves do not provide an indication of the degree of

correlation between two securities. As such, covariance is standardized by dividing
covariance by the product of the standard deviation of two individual securities. This
standardized measure is called the correlation coefficient.
Statistically, covariance between two variables, X and Y is calculated as follows:

Covxy = Corrxy x δx Xδy

Where
Covxy = Covariance between variable X and Variable Y
Corrxy = Correlation between Variable X and Varaible Y
δx = Standard deviation of X
δy = Standard deviation of Y

Example 3:

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Oliver’s portfolio holds security A, which returned 12.0% and security B, which returned
15.0%. At the beginning of the year 70% was invested in security A and the remaining

30% was invested in security B. Given a standard deviation of 10% for security A, 20%
for security B and a correlation coefficient of 0.5 between the two securities, calculate the
portfolio variance.

Pσ 2 = Aw 2A σ 2 + Bw 2B σ 2 + 2Aw B
+covAB

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 Portfolio Variance = (.72x102)+(.32x202)+(2x.7x.3x10x20x.5) = 127
Portfolio standard deviation is the square root of the portfolio variance.

Pσ = 127 = 11.27%

Equivalently:

Portfolio Standard Deviation = (127) .5=11.27%

The above example is for a portfolio that consists of two assets. You will find an
example of a three asset portfolio in the practice questions at the end of this section .

Self Test Question 3

What is the difference between variance as a measure of portfolio risk and covariance of
return of two assets?
Correlation Coefficients

Cov AB .01A
=
ρ AB B =.5
ρ AB or
= 10% A 20
σ Aσ B
%B

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Correlation is the covariance of security A and B divided by the product of the standard
deviation of these two securities. It is a pure measure of the co-movement between the two
securities and is bounded by –1 and +1.

• A correlation of +1 means that the returns of the two securities always move in the
same direction; they are perfectly positively correlated.

• A correlation of zero means the two securities are uncorrelated and have no
relationship to each other.
• A correlation of –1 means the returns always move in the opposite direction and
are negatively correlated.

Portfolio risk can be effectively diversified (reduced) by combining securities with

returns that do not move in tandem with each other.
Example 4:

What happens to the portfolio standard deviation (risk) when the two securities are
negatively correlated rather than positively correlated? Using the same data as in
Example 3 but now with negative correlation equal to -.5:

Portfolio Variance = (.72x102)+(.32x202)+(2x.7x.3x10x20x(-.5)) = 43

Portfolio Standard Deviation = (43) .5 = 6.55%

The portfolio’s risk is reduced from 11.27% to 6.55% when securities that are negatively
correlated are combined.

Self Test Question 4

What is the difference between correlation coefficient and standard deviation of an asset?

1.5 The Efficient set for two Assets

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It is so evident that when one wants to earn more, there will be the need to expose more of assets
to risk or same assets to more risk. Hence, the relationship of risk and return is positive. i.e the
correlation is positive.

Supposing that you have two assets X and Y where, from past data we found out that the
expected rate of return, standard deviation and the correlation of the two assets is calculated to be
as follows.
o Expected Rate of return of X = 17.5%
o Expected Rate of return of Y = 5.5%
o Standard deviation of X = 25.86%
o Standard deviation of Y = 11.5%
o Correlation between the two assets = 0.1639
Thus, from the data above, we calculate the covariance of the two assets as = 0.004875. Let us
further assume that you have decided to invest 60% of your money on X, and the rest, 40%, on
Y. Expected Rate of Return on the Portfolio [Portfolio Mean] = [0.6 x 17.5] = [0.4 x 5.5] =
12.7%

Expected Returns and Standard Deviations for X, Y, and a Portfolio Composed of 60 Percent in
X and 40 Percent in Y

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Figure 1.1 Combination of asset X and asset Y

Expected Return

17.5
X
12.7
P

5.5

Y
Standard deviation

11.5 15.44 25.86

The box or “P” in the graph represents a portfolio with 60 percent invested in X and
40 percent invested in Y. You will recall that we have previously calculated both the
expected return and the standard deviation for this portfolio. The choice of 60 percent in X
and 40 percent in Y is just one of an infinite number of portfolios that can be created. The
set of portfolios is sketched by the curved line in the next figure below.
Figure 1.2: Efficient Set Markings
Expected Return

P
17.5 3
X
12.7
2

MV
5.5 1’
1
Y

11.5 25.86 Standard deviation

Dear Student note that in the above setting, there are different portfolios of the two assets to

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illustrate the concept of returns and risk inherent within them. Given, in all cases, that the
correlation between asset X and asset Y is 0.1639, notice the following points in the graph:
Point 1 is a portfolio composed of 90 percent Y and 10 percent X. Point 2 is a Portfolio
composed of 50 percent Y and 50 percent X. Point 3 is a Portfolio composed of 10 percent Y
and 90 percent X. Point 1’ is a Portfolio composed of 90 percent Y and 10 percent of X. Point
MV denotes the minimum variance portfolio. This is the portfolio with the lowest possible
variance. By definition, the same portfolio must also have the lowest possible standard
deviation.

Consider portfolio 1. This is a portfolio composed of 90 percent Y and 10 percent X.

Because it is weighted so heavily toward Y, it appears close to the Y point on the graph.
Portfolio 2 is higher on the curve because it is composed of 50 percent Y and 50 percent
X. Portfolio 3 is close to the X point on the graph because it is composed of 90 percent X
and 10 percent Y.
Dear Student, there are a few important points concerning this graph.

1. We argued that the diversification effect occurs whenever the correlation

between the two securities is below 1. The correlation between X and Y is 0.1639. The
diversification effect can be illustrated by comparison with the straight line between the X
point and the Y point. The straight line represents points that would have been generated had
the correlation coefficient between the two securities been 1. The diversification effect is
illustrated in the figure since the curved line is always to the left of the straight line.
Consider point 1′. This represents a portfolio composed of 90 percent in Y and 10
percent in X if the correlation between the two were exactly 1. We argue that there is no
diversification effect. However, the diversification effect applies to the curved line, because
point 1 has the same expected return as point 1′ but has a lower standard deviation.

Though the straight line and the curved line are both represented in Figure 1.2, they do not
simultaneously exist in the same world. Either 0.1639 or the curve exists or 1 and the
straight line exist. In other words, though an investor can choose between different points
on the curve if 0.1639, she cannot choose between points on the curve and points on the
22
straight line.

2. The point MV represents the minimum variance portfolio. This is the portfolio with the
lowest possible variance. By definition, this portfolio must also have the lowest possible
standard deviation. (The term minimum variance portfolio is standard in the literature, and
we will use that term. Perhaps minimum standard deviation would actually be better,
because standard deviation, not variance, is measured on the horizontal axis of Figure 1.2
3. An individual contemplating an investment in a portfolio of Y and
X faces an opportunity set or feasible set represented by the curved line in Figure 1.2.
That is, he can achieve any point on the curve by selecting the appropriate mix between the
two securities. He cannot achieve any point above the curve because the investor cannot
increase the return on the individual securities, decrease the standard deviations of the
securities, or decrease the correlation between the two securities. Neither can he
achieve points below the curve because he cannot lower the returns on the individual
securities, increase the standard deviations of the securities, or increase the correlation. (Of
course, he would not want to achieve points below the curve, even if he was able to do so.)

Were he relatively tolerant of risk, he might choose portfolio 3. (In fact, he could even
choose the end point by investing all his money in X.) An investor with less tolerance for
risk might choose portfolio 2. An investor wanting as little risk as possible would choose
MV, the portfolio with minimum variance or minimum standard deviation.

4. Note that the curve is backward bending between the Y point and MV. This indicates
that, for a portion of the feasible set, standard deviation actually decreases as one increases
expected return. Students frequently ask, “How can an increase in the proportion of the
risky security, X, lead to a reduction in the risk of the portfolio?”
This surprising finding is due to the diversification effect. The returns on the two securities
are negatively correlated with each other. One security tends to go up when the other
goes down and vice versa.

Thus, an addition of a small amount of X acts as a hedge to a portfolio composed only of

23
Y. The risk of the portfolio is reduced, implying backward bending. Actually, backward
bending always occurs if correlation is less than zero. It may or may not occur when
greater than zero. Of course, the curve bends backward only for a portion of its length. As
one continues to increase the percentage of X in the portfolio, the high standard deviation
of this security eventually causes the standard deviation of the entire portfolio to rise.

5. No investor would want to hold a portfolio with an expected return below that of the
minimum variance portfolio. For example, no investor would choose portfolio 1. This
portfolio has less expected return but more standard deviation than the minimum variance
portfolio has. We say that portfolios such as portfolio 1 are dominated by the minimum
variance portfolio. Though the entire curve from Y to X is called the feasible set, investors
only consider the curve from MV to X. Hence, the curve from MV to X is called the
efficient set or the efficient frontier.

Dear Student, as is inferred from the previous discussions, the standard deviation of a portfolio
depends on both the standard deviation of the individual securities and the covariance between the
two securities. Please recall the standard deviation of a security measures the variability of an
individual security’s return. Covariance measures the relationship between the two securities. For
given standard deviation of the individual securities, a positive relationship or covariance
between the two securities increases the standard deviation of the entire portfolio. A negative
relationship or covariance between the two securities decreases the standard deviation of the
entire portfolio.

This important result seems to go with common sense. If one of your securities tends to go up
when the other goes down, or vice versa, your two securities are offsetting each other. You are
achieving what we call a hedge in finance, and the risk of your entire portfolio will be low.
However, if both your securities rise and fall together, you are not hedging at all. Hence, the risk
of your entire portfolio will be higher.

24
Self Test Question 5

What does the efficient set show? What happens to the curve’s shape when correlation value
becomes one far away from +1.

1.6 Systematic and Unsystematic Risk

The type of risk which is firm-Specific and that can be diversifiable is called Unsystematic Risk.
This is shown as ‘a’ on Figure 1.4 below. It is that part of a security’s risk associated with
random outcomes generated by events or behaviors specific to the firm; firm-specific risk can be
eliminated by proper diversification. i.e as the number of assets held increases, the total risk
assumed by the investor will come down. It is induced by factors such as inefficiency in
managing companies’ affairs.

On the other hand the Systematic or Market risk is non diversifiable and is pervasive. It affects
almost all kinds of investment assets to a varying degree. The Systematic Risk, shown as ‘b’
below on the same diagram, is that part of a security’s risk that cannot be eliminated by
diversification because it is associated with economic or market factors that will affect most
firms.

Figure 1.3 : Systematic and Unsystematic Risk

Risk a

Number of assets
Remember, investment in assets imply taking of risk. If one wants to generate more income,
he/she has to be willing to take more risk. However, taking the type of risk that is related to
specific circumstances created within the company, that can be eliminated through portfolio
holding is not expected to pay. Thus, the risk that pays back is Systematic risk. With this
assertion, we have models that insist the rate of return assets are generating is related to the level
of systematic risk inherent in each asset. One of these models is the Capital Asset Pricing Mode
25
(CAPM) that is developed by W. Sharpe, to developed to price assets related to the intensity of
the systematic risk assumed by each asset. Another one is the Arbitrage Pricing Model/Theory
(APT), developed by S. Ross.

There are inherent risks in holding any asset, and the capital asset pricing model (CAPM) and the
arbitrage pricing model (APT) are both ways of calculating the cost of an asset and the rate of
return which can be expected based on the risk level inherent in the asset. i.e the systematic risk.

Self Test Question 6

Which type of risk is related to firm’s management inefficiency? And which type can be
diversified?
1.6.1 The Capital Asset Pricing Model

In the 1960s, Jack Treynor, William F. Sharpe, John Lintner and Jan Mossin developed the
capital asset pricing model (CAPM) to determine the theoretical appropriate rate that an asset
should return given the level of risk assumed. Thereafter, in 1976, economist Stephen Ross
developed the arbitrage pricing theory (APT) as an alternative to the CAPM. The APT
introduced a framework that explains the expected theoretical rate of return of an asset, or
portfolio, in equilibrium as a linear function of the risk of the asset, or portfolio, with respect to a
set of factors capturing systematic risk.

The CAPM formula is: ra = rf + βa (rm – rf)

Where
ra :is the rate of return for a risk-free security

rm :is the broad market expectation on the rate of return

βa : is the beta of the asset [the level of systematic risk in asset a]

26
Dear Student, the figures used for rf, rm and βa are decided on by the analyst, although most
investors use a Beta figure which has been calculated by a third party. The most common use for
the CAPM is calculating the fair price of an asset.

The CAPM allows investors to quantify the expected return on investment given the investment
risk, risk-free rate of return, expected market return and beta of an asset or portfolio. The risk-
free rate of return that is used is typically the federal funds rate or the 10-year government bond
yield.

An asset's or portfolio's beta measures the theoretical volatility in relation to the overall market.
For example, if a portfolio has a beta of 1.25 in relation to the Standard & Poor's 500 Index (S&P
500), it is theoretically 25% more volatile than the S&P 500 Index[US stock Index]. Therefore, if
the index rises by 10%, the portfolio rises by 12.5%. If the index falls by 10%, the portfolio falls
by 12.5%.

Risk Free Assets

• The introduction of a risk free security to the Markowitz model changes the
efficient frontier from a curved line to a straight line called the Capital Market Line
(CML). This CML represents the allocation of capital between risk free securities
and risky securities for all investors combined.

• The optimal portfolio for an investor is the point where the new CML is tangent to
the old efficient frontier when only risky securities were graphed. This optimal
portfolio is normally known as the market portfolio.

Portfolio Beta Calculation

• A portfolio’s beta is the weighted average of the individual betas of the securities in
the portfolio.

27
 Example 6:

Suppose a portfolio contains three securities with weights of 50%, 25% and 25%
respectively. The beta of security A is 1.25. Security B’s beta is 0.95 and security C’s beta
is 1.05. Calculate the beta of the portfolio.

Portfolio Beta = (0.5*1.25) + (0.25*0.95) + (0.25*1.05) = 1.125

Issues with the CAPM

The CAPM makes several assumptions, among them are the following:

 There are no transaction costs (e.g. taxes)

 Assets are dividable
 There are no restrictions to investment in assets
 Investors will maximize their expected utility
 Prices cannot be influenced by investors
 There is a homogeneity of beliefs
 All assets are marketable
 The calculations are on a single time period

There are issues over the linearity of the equation used to calculate the CAPM, but perhaps the
most critical issue, argued by many, is that recent calculations have shown that the CAPM
calculations do not match empirical results.

1.6.2 Arbitrage Pricing Theory

The APT serves as an alternative to the CAPM, and it uses fewer assumptions and may be harder
to implement than the CAPM. Ross developed the APT on a basis that the prices of securities are
driven by multiple factors, which could be grouped into macroeconomic or company-specific
factors. Unlike the CAPM, the APT does not indicate the identity or even the number of risk
factors. Instead, for any multifactor model assumed to generate returns, which follows a return-
generating process, the theory gives the associated expression for the asset’s expected return.
28
While the CAPM formula requires the input of the expected market return, the APT formula uses
an asset's expected rate of return and the risk premium of multiple macroeconomic factors.

The APT formula is:

E(rj) = rf + bj1RP1 +bj2 RP2 +......bjnRPn
Where

E(rj) : is the expected rate of return on the asset

Rf :is the risk-free rate
βj :is the sensitivity of the asset’s return in this particular case
RP :is the risk premium in this particular case

The thinking behind the APT is that there are two main issues which can influence the rate of
return on an asset: the macroeconomic environment in general, and how likely it is that the
environment might influence the movement of the asset. Influences in the macroeconomic
environment include inflation, levels of confidence of investors, changes in interest rates, oil
prices and so on. Hence, Dear Student, the difference between CAPM and APT is that the
later is a multi variant model while the former is a single variable model.
The assumptions made by the APT are:

 It is assumed that returns will follow the above equation

 Investors tend towards risk aversion
 There are no transaction costs
 There are no restrictions on the availability of assets
 Short sales are not restricted
 No arbitrage possibilities exist (in equilibrium)
 All investors think alike.

Issues with the APT

The major issue with the APT is attempting to accurately define the level of risk which applies to
any given asset. It may be possible to find a ‘factor portfolio’ where the risks are very similar but
generally the level of risk is determined by macroeconomic factors.
29
1.7 Comparison between the CAPM and the APT

At first glance, the CAPM and APT formulas look identical, but the CAPM has only one factor
and one beta. Conversely, the APT formula has multiple factors that include non-company
factors, which requires the asset's beta in relation to each separate factor. However, the APT does
not provide insight into what these factors could be, so users of the APT model must analytically
determine relevant factors that might affect the asset's returns. On the other hand, the factor used
in the CAPM is the difference between the expected market rate of return and the risk-free rate
of return. Since the CAPM is a one-factor model and simpler to use, investors may want to use it
to determine the expected theoretical appropriate rate of return rather than using APT, which
requires users to quantify multiple factors.

APT may be informative over the medium to long term, but are not considered to be accurate in
the short term. The CAPM, on the other hand, is a snapshot, and appears to be more accurate in
the short term than it is in the long term. The APT focuses on risk factors rather than assets, so it
has an advantage over the CAPM in that it does not have to create an equivalent portfolio to
assess risk.

The CAPM assumes that there is a linear relationship between the assets, whereas the APT
assumes that there is a linear relationship between risk factors. This means that where there no
linear relationship exists, the models are unable to adequately predict outcomes.

Therefore, although the CAPM and APT are useful as rule-of-thumb heuristics of the market as it
currently operates, they are both static models which use a limited number of factors to predict
risk in a highly complex market. Although they are based on mathematical principles, they are
subjective in that the analyst performing the calculation has the freedom to decide which factors
are relevant in each particular case.

Self Test Question 7

Which of the two, CAPM or APT is a multifactor model?

30
1.8 Risk Management

In the world of finance, risk management refers to the practice of identifying potential risks in
advance, analyzing them and taking precautionary steps to reduce/curb the risk. When an entity
makes an investment decision, it exposes itself to a number of financial risks. The quantum of
such risks depends on the type of financial instrument. These financial risks might be in the form
of high inflation, volatility in capital markets, recession, bankruptcy, etc.

So, in order to minimize and control the exposure of investment to such risks, fund managers and
investors practice risk management. Not giving due importance to risk management while
making investment decisions might wreak havoc on investment in times of financial turmoil in
an economy. There are different types of actions management takes to reduce risk. One of these
is to involve in the hedging business.

1.8.1 Hedging & Derivatives

Hedging is a consented transferring of risk seen on an asset to another asset through entering into
a contractual arrangement of commitment/buying it. We use derivatives to hedge.

Derivatives are specific types of instruments that derive their value over time from the
performance of an underlying asset: eg equities, bonds, commodities. A derivative is traded
between two parties – who are referred to as the counterparties. These counterparties are subject
to a pre-agreed set of terms and conditions that determine their rights and obligations. Most
derivatives take the following forms:

Derivatives have changed the world of finance as pervasively as the Internet has
changed communications .Well they are everywhere nowadays. The most significant event in
finance during the past decade has been the extraordinary development and expansion of
financial derivatives.

These instruments enhance the ability to differentiate risk and allocate it to those investors who
are most able and willing to take it -- a process that has undoubtedly improved national
productivity, growth and standards of living.

31
Derivatives products provide certain important economic benefits such as risk
management or redistribution of risk away from risk-averse investors towards those
more willing and able to bear risk. Derivatives also help price discovery, i.e. the
process of determining the price level for any asset based on supply and demand.

Self Test Question 8

What is Hedging?

Here under, Dear Student, we will see the types and nature of derivatives that are used to hedge
risk in the financial assets.

A. Options

An option is a contract that gives its holder the right to buy (or sell) an asset at some
predetermined price within a specified period of time. All managers should under- stand
option pricing theory, since many projects create opportunities that are in essence
options. In addition, financial managers must understand option pricing the- ory when they
use derivative securities for risk management or issue hybrid securities such as convertible
bonds.

Exchange-traded options are standardized contracts whereby one party has a right to purchase
something at a pre-agreed strike price at some point in the future. The right, however, is not an
obligation as the buyer can allow the contract to expire and walk away. The cost of buying an
option is the seller’s premium which the buyer must pay to obtain the option right. There are two
types of option contracts that can be either bought or sold:

• Call Option
– A buyer of a call option has the right but not the obligation to buy the asset at the strike price
(price paid) at a future date. A seller has the obligation to sell the asset at the strike price if the
buyer exercises the option.

32
• Put Option
– A buyer of a put option has the right, but not the obligation, to sell the asset at the strike price
at a future date. A seller has the obligation to repurchase the asset at the strike price if the buyer
exercises the option.
B. Futures:

Futures are exchange-traded standard contracts for a pre-determined asset to be delivered at a

pre-agreed point in the future at a price agreed today. The buyer makes margin payments
reflecting the value of the transaction. The buyer is said to have gone long and the seller to have
gone short. Counterparties can exit a commitment by taking an equal but offsetting position with
the exchange, so that the net position is nil and the only delivery will be a cash flow for profit or
loss. Futures coverage includes currencies, bonds, agricultural and other commodities such as
gold.

Self Test Question 9

What is the difference between a call option and a put option?

C. Forwards:
There are no sure things in global markets. Deals that looked good six months ago can quickly
turn sour if unforeseen economic and political developments trigger fluctuations in exchange
rates or commodity prices Over the years traders have developed tools to cope with these
uncertainties. One of this tool is the forward agreements

A contract that commits one party to buy and other to sell a given quantity of an asset for fixed
price on specified future date. In Forward Contracts one of the parties assumes a long position
and agrees to buy the underlying asset at a certain future date for a certain price. The specified
price is called the delivery price. The contract terms like delivery price, quantity are mutually
agreed upon by the parties to contract. No margins are generally payable by any of the parties to
the other

33
Forwards are non-standardized contracts between two parties to buy or sell an asset at a specified
future time at a price agreed today. For example, pension funds commonly use foreign exchange
forwards to reduce FX risk when overseas currency positions are required at known future dates.

D. Futures
Futures are standardized forward contracts. In the case of futures the size and date of contracts is
known and available to all. Besides, usually, in future contracts, trustees are established to stand
between the counter parties and ensure the contract is honored. In other words, commonly we see
the following features in future contracts:
 It is negotiated contract between two parties i.e. Forward contract being a bilateral
contracts, hence exposed to counterparty risk.
 Each Contract is custom designed and hence unique in terms of contract size, expiration
date, asset quality, asset type etc.
 A contract has to be settled in delivery or cash on expiration date
 In case one of two parties wishes to reverse a contract, he has to compulsorily go to the
other party. The counter party being in a monopoly situation can command at the price he
wants.

E. Swaps:
Swaps are agreements to exchange one series of future cash flows for another. Although the
underlying reference assets can be different, eg equity or interest rate, the value of the underlying
asset will characteristically be taken from a publicly available price source. For example, under
an equity swap the amount that is paid or received will be the difference between the equity price
at the start and end date of the contract.

Self Test Question 10

What are the underlying differences between a forward contract and a future?

Activities:

34
1. Oliver’s portfolio holds security A, which returned 12.0%, security B, which
returned 15.0% and security C, which returned –5.0%. At the beginning of the year
45% was invested in security A, 25.0% in security B and the remaining 30% was
invested in security C. The correlation between AB is 0.75, between AC 0.35, and
between BC –0.5. Securities As standard deviation is 12%, security B’s standard
deviations is 15% and security C’s is 10%. Calculate the expected return of Oliver’s
Portfolio, the portfolio variance and standard deviation.

2. Explain what happens to a portfolio’s overall risk when securities that are
uncorrelated are combined.

3. List the steps that go into selecting an optimal portfolio of risky assets.

4. Define systematic risk and non-systematic risk.

5. Big Boy Ltd. has a beta of 1.25, the risk free rate is 5% and the excess return on the
market is 6%. Calculate the expected return on Big Boy Ltd using CAPM.

6. Name and describe one type of multi-factor model.

7. given the following probability distribution of returns for a stock, what is the expected
rate of return, standard deviation of the returns, and coefficient of variation on the
investment?

Probability Rate of Return

.10 -10%

.20 5%

.30 10%
35
 .40 25%

1) Using the CAPM, determine the appropriate required rate of return for each of the three
stocks listed below, given that the risk-free rate is 5% and the expected rate of return for the
market is 17%.
STOCK BETA ()

A .75

B .90

C 1.40

2) Determine the expected return and beta for the following three-stock portfolio:

EXPECTED

STOCK INVESTMENT BETA RETURN

A Birr 60,000 1.00 12.0%

B 37,500 0.75 11.0%

C 52,500 1.30 15.0%

8. A stock has an expected return of 14.25%. The beta of the stock is 1.25 and the risk-free rate

is 6.0%. What is the market risk premium?

36
 Unit 2

Capital Structure Decisions

2.1 Unit Introductions

Each economic activity requires capital engagement. Capital is necessary for financing assets
constituting first company equipment, it determines company’s production capability
(manufacturing, trade, services) in the course of conducting activity, enables financing
development enterprises. The need for capital engagement on each stage of company activity
rises a problem of selecting the type of capital and determining its sources, what directly
translates into a creation of specific capital structure.

The finance theory is not able to determine a universal formula which would enable an indication
of a target optimal capital structure for a particular company. Research on the way of indicating
an optimal capital structure and its influence on company value have triggered a creation of
range of theories.

The composition of a company's capital can be viewed in terms of equity (common and preferred
stock), debt (including bonds and loans) and hybrid securities (such as convertible debt and
preferred shares).

Dear Student, as you may recall, Equity financing is provided by the shareholders. Debt
financing is provided by banks or bondholders who, respectively, receive loan contracts and
publicly traded bonds in return for their money. The capital structure shows the composition of a
group’s liabilities as it shows who has a claim on the group's assets and whether it is a debt or
equity claim. The leverage ratio is the proportion of the group’s liabilities that is financed by
debt claims.

The capital structure of corporations can be quite complex as there are many different types of
debt and equity claims. For example, debt claims vary according to their maturity (short term or
long term), seniority (senior or junior), the type of covenants associated with the debt, whether
the debt is secured or unsecured, and whether the debt is privately held or publicly traded.

37
The optimal debt-equity mix is explained by a number of capital structure theories. According to
these theories there are costs and benefits associated with debt as well as equity. The company
should choose the combination of debt and equity that maximizes its value.

A company’s capital structure is arguably one of its most important choices. From a technical
perspective, the capital structure is defined as the careful balance between equity and debt that a
business uses to finance its assets, day-to-day operations, and future growth.

From a tactical perspective however, it influences everything from the firm’s risk profile, how
easy it is to get funding, how expensive that funding is, the return its investors and lenders
expect, and its degree of insulation from both microeconomic business decisions and
macroeconomic downturns.

This unit will discuss about this controversial issue of capital structure choice. It will bring to
light different theories related to this debate. M & M theories with taxes and without taxes, the
pecking order theory, and the agency cost theory among others will be due. This is an important
subject for it is related to the previous risk section . Therefore, Dear student, you can make
connection to what is concluded in the previous unit.

Unit Objectives

At the end of this unit, students are expected to be able to;

 Describe what capital structure is about

 Identify the broad sources of funds for investment decision
 Explain the M & M theory of capital structure Irrelevance
 Determine the relationship between M & M irrelevance theory and the pie Model
 Describe the order of financing in the pecking order theory
 Explain what the trade of theory is about
 Demonstrate how introduction of taxes will alter the irrelevance theory of M & M

38
By design, the capital structure reflects all of the firm’s equity and debt obligations. It shows
each type of obligation as a slice of the stack. This stack is ranked by increasing risk, increasing
cost, and decreasing priority in a liquidation event (e.g., bankruptcy).

STQ 1

i. Broadly speaking, what are the two main sources of capital?

ii. What is a Company’s Capital Structure?

For large corporations, it typically consists of senior debt, subordinated debt, hybrid securities,
preferred equity, and common equity.

STQ 2

What is meant by capital structure?

2.3 Capital Structure Theories

The modern theory of capital structure began with the celebrated paper of Modigliani and Miller
(1958). They (MM) pointed the direction that such theories must take by showing under what
conditions capital structure is irrelevant. Since then, many economists have followed the path
they mapped. Now, some 50 years later it seems appropriate to take stock of where this research
stands and where it is going. Our goal in this discussions, Dear Student, is to identify each with
their merits and arguments forwarded to the recent literature.

2.3.1Trade off Theory

Researchers have proposed that the optimal capital structure involves a trade off between the
advantages and disadvantages of leverage. Fama and French (2002) state that by weighting
the benefits of debt, tax deductibility of interest, and the costs of bankruptcy and agency
conflicts; the optimal balance of debt and equity can be identified.

As Modigliani and Miller (1958) explained in the M&M proposition, the investment
behaviors and financing techniques used by firms are selected to ensure survival and growth.

39
Based on the view that owner and management are rational decision makers who will strive to
maximize the value of the firm they derive the two initial propositions, maximization of
profits and maximization of market value. They state that profits will increase if the yield on
an asset exceeds the interest paid, and that an asset is worth acquiring if it adds more value

than the cost of acquiring it. Under perfect market conditions and in a world without taxation,
the Modigliani and Miller proposition states that the value of the firm is independent of its
capital structure.

Dear Student, we illustrate this idea by taking the following example:

A. M & M Proposition I Without Taxes

M & M hold the position that firm value is not dependent on the source of finance. Though a
levered firm appears to give more EPS (earning per share) than an unlevered firm does, using
homemade leverage, it is possible to earn the same without going to invest in a levered firm.
We will illustrate this with examples.

Homemade leverage-M & M Proposition I: Supposing that the following are the two
options a firm can take either to add debt or work on all equity stature. Given are, the total
capital of the firm is Br10m, share are sold each for Br1000 and debt is obtained at 12%
interest. Hence, in the 40% leverage, there are 6,000 shares sold. Cost of obtaining equity
capital in the market is found to be 16%.

Table 2.1: Earning Summary of a Levered & Unlevered firm

Debt of 40%[Levered] No Debt [Unlevered]

EBIT br5m br5m

Interest expense [12% of 4m] 0.48m 0

EBT Br4.52 Br5m

Tax 0 0

EAT Br4.52m Br5m

EPS Br4.52 / 6000 = Br753.3 Br5m /10,000 = Br500

40
It appears that investors in a levered firm ear more than investors in all equity firm. [Br753.3
> Br500]. Thus investors will divest from an all equity firm and buy shares from a levered
firm. However, M & M said using homemade leverage, investors can still earn the same EPS
by borrowing at the same interest rate and buy from the same firm more shares.

To further illustrate this, supposing that Yohannis, an investor in the all equity firm, has 75
shares bought each at Br1000. Hence, his investment totals Br75,000. Now, to lever himself,
like the firm is, could have borrowed Br50,000 at 12% interest like the firm did. Thus, if he
has done that Yohannis would have Br125,00 investment in the equity of the firm and had 125
shares instead of 75. His investment is levered like40% debt and 60% equity.

If he had done this, total earning and EPS would be the same as one who earns in a levered
firm. Dear Student, look below how the stocks earn him same EPS:

Total Earning from 125 shares in the all equity firm will be = Br62,500

Less interest expense on debt [12% of Br50,000] - 6,000

Net Earning on 125 shares Br56,500

EPS Br753.3

Hence, in the absence of taxes, the value of the firm levered and unlevered can be calculated
is the same.

VL = Vu

Where:

Vl: = Value of Levered firm

Vu = Value of unlevered firm

The conclusion is that the value of the firm is not dependent on leverage and levering a firm
will not bring about any change in its stock of value.

STQ 3

What is Homemade Leverage?

B. M & M Proposition II without Taxes: M and M, however, said that when
more and more debt is added, equity owners will be unwilling to take the same rate of return

41
on their investment. They demand more as the share of funds of creditors’ increases.

Dear Student, we recall that WACC = [Wd x Kd] + [We x Ke]

Where:

WACC = Weighted Average Cost of Capital

Wd =Weight of Debt

Kd =Cost of Debt capital

We = Weight of Equity

Kd =Cost of Equity capital

The same expression above can be rewritten as follows:

Ke = WACC + [Ke – Kd]D/E

Where:

D = Debt total

E =Equity total

This equation is what is called the famous M & M Proposition II, which implies that the cost
of providing equity in a levered firm is dependent on the WACC (the required rate of return of
the firm), the cost of debt, and the debt to equity ratio.

STQ 4

What happens to WACC when a firm’s value remain the same? Will it change overtime
or remain the same?

This relationship can be illustrated in the following diagram.

42
Figure 2.1: Behavior of Equity cost of capital in a levered firm

Ke

Cost of capital

WACC

Kd

Debt to Equity Ratio (D/E)

As can be inferred from the above figure, when the ratio of debt to equity increases, as the
firm value remains the same-WACC is constant, equity providers demand more and they will
be willing to provide additional funds only when they can be compensated with more returns.
This is what is being displayed by Ke in the figure above.

C. M & M Proposition I with Taxes: when taxes are introduced, the result will
be different and understandable. Taxes provide earning shield when capital comes from debt.
Thus the value of the levered firm will be always increasing when more and more debt is
introduced. We will illustrate this using the previous table, Table 2.1 above.

Table 2.2: Earning Summary of a Levered & Unlevered firm

Debt of 40%[Levered] No Debt [Unlevered]

EBIT br5m br5m

Interest expense [12% of 4m] 0.48m 0

EBT Br4.52 Br5m

Tax [40%] -1.808 -2.0

EAT Br2.712m Br3.00m

43
Value of unlevered firm, where cost of equity capital is 16% for example is computed as
follows:

Vu = Br3.00/.16 = Br18.75m

On the other hand the value of the levered firm is the sum of the value of return on debt and
that of equity in perpetuity; and it will be computed as follows:

Total return from investing in the firm is the sum of return from debt and return from equity.
i.e it is [Br0.48 + Br2.712] = Br3.192. that is Br0.192 more than unlevered firms income.
Note, Dear Student, this excess earning has come due to leverage and it is assumed that it will
be available in perpetuity.

Hence, the value of a levered firm is more than the unlevered firm by Br0.192m in perpetuity.
That is,

VL = Vu + Br0.192/0.12 = Br18.75m + Br1.6m +Br20.35m

OR

VL = Vu + Tr x D

= Br18.75 + 0.4 x Br4m

= Br18.75 + Br1.6m

= Br20.35m

Where:

VL = Value of a Levered firm

Vu = Value of Unlevered firm

Tr = Tax rate

D = Debt size

44
Figure 2.2 Value of a levered and unlevered firm VL

Value of
the firm

Br20.35m Tr x D

Br18.75m Vu

Vu

Br4m Debt

The discussion and illustration above will eventually takes us to an unreasonable conclusion.
That is 100% debt is what the firm has to opt for. This is unacceptable for it excludes
shareholders and the firm is no more of its owners. There is no such a thing as a perpetual
firm owned by creditors to the tune of 100%. Hence, it is an absurd conclusion. The creditors
too will not be willing to provide loans at same rate till it reaches that level because the firm is
assuming more and more risk. The likelihood of going in to financial distress and then to
bankruptcy is increasing. Hence, there will be a point where no more debt is going to be
accepted there after.

STQ 5

What happens to WACC when a firm realizes a tax shield on more and more debt?

D. M & M Proposition II with taxes: the conclusion reached with Proposition I

above is possible to be examined from WACC point of view too. Firm value increases
because of continuous reduction of WACC.

Thus, our previous assertions was as follows:

WACC = [We x Ke] + [Wd xKd (1 – Tr)]

M & M proposition II with taxes therefore states that the cost of equity is:

Ke = Keu + [Keu –Kd] x [D/E] x [1 –Tr]

Where:

45
 Ke = Cost of equity of a levered firm

Keu = cost of equity of unlevered firm

Kd = Cost of debt

Thus to illustrate, we can recall that we have the firm worth Br18.75 when unlevered and Br
20.35m when levered.

Ke = .16 + [.16 - .12] x [1.6/18.75] x [1 - .4]

= 16.2%

As you might witness from the above discussion, Dear Student, taking taxes and the
advantage of the tax shield into consideration, a firm would benefit from maximizing the
use of debt. However, adding the disadvantages associated with debt to the equation,
bankruptcy costs and agency costs, the advantage of cheaper debt will be offset as the risk
of financial distress increases with levels of debt.

Other researchers also state that taxes as well as bankruptcy costs need to be taken into
account when determining the optimal leverage level and the optimal debt level. Hence, the
value of the levered firm will therefore equal the value of the unlevered firm, add the tax rate
times the market value of a firm’s debt, and subtract the tax rate times costs associated with
bankruptcy (Kraus, Litzenberger, 1973). As can be seen in Figure 3.1.1.1, the trade off theory
suggests the use of debt up to a certain point where costs of financial distress offset the
advantage of the interest tax shield.

46
Figure 2.3 Company Market value with debt

The Figure above shows that after the optimum point on the debt axis the present value of the
tax shield goes down at the same time as the present value of costs for financial distress goes
up. As time passes by the costs overweigh the benefits and a company might suffer
economically ending up in bankruptcy.

Since the first major publications on trade off theory were released researchers have, to
various degrees, failed to determine what the optimal leverage may be. Moreover, according
to empirical findings and with regards to the trade off theory; companies do not appear to act
entirely rationally in their capital structure decisions, which is why the area still remains
puzzling. There is theoretical support for the trade off theory, but findings have led
researchers to question whether firms actually strive to achieve an optimal balance in their
capital structure.

Fama and French (2002) note that debt ratios tend to adjust to specific target levels.
Additionally, Leary and Roberts (2005) state that firms respond to equity issuances and equity
price shocks by appropriately rebalancing the actual leverage towards target leverage within
two to four years. Furthermore, they state that persistent effects of shocks on leverage are due
to optimizing strategies as opposed to indifference regarding their capital structure (Leary,
Roberts, 2005). Beattie et al. (2006) performed a comprehensive survey in the UK among
47
 industrial and commercial, listed companies with the objective to increase understanding of
the overall financing strategies employed by the average company. The overall result showed
that current capital structure theory affects and contributes to the decision making practices of
firms in general and that certain parts of theories are more useful while other parts are
strongly refuted.

A key finding closely connected to the trade off theory was that elements that have strong
theoretical support such as the tax advantage of debt interest and the need for collateral when
issuing debt were supported in the study. Furthermore, the study shows that firms are
concerned with the signal debt and equity issues send to the market and also that debt is
raised when a firm perceives their stock to be undervalued.
STQ6
What are preventing the value of the firm rising when more debt is introduced?

A problem with the trade-off theory is that it predicts the relationship between leverage and
earnings to be positive while numerous researchers present empirical findings of the opposite.
Fama and French (1999) state that the big contradiction is the earnings-leverage relationship
and that profitability seems to be negatively related to leverage.

Similarly, Myers (1989) refers to the inverse relationship between financial leverage and
profitability as the most striking proof against the trade off theory. Other factors
contradictory to one of the fundaments in the trade off theory were found in the UK survey
(Beattie et al., 2006) where it is stated that the respondents do not agree that the tax shield
advantage and the costs of bankruptcy are balanced.

In contrast to determining the optimal mix of debt and equity, other theories suggest that there
is a hierarchic preference order when firms decide upon their capital structure. The pecking
order theory, as will be discussed next, suggests that firms have a preference for using internal
equity over debt.

48
 2.3.2 Pecking Order Theory
An alternative way of explaining why firms apply a certain capital structure over another is
the pecking order theory presented by Myers in 1984. Donaldson (1961) proposed that
management favors internally generated funds over external funds in his study of capital
structures among large corporations. These findings by Donaldson gave a hint of a pecking
order before the theory was presented by Myers (1984).

The pecking order theory is a preference order, explained as the law of least effort, and
describes how companies raise new capital when financing their future activities and growth.
This order contains three steps where every next step is less and less preferred. In order to
finance its own growth companies prefer to use internally generated funds first, i.e. retained
earnings. When these funds are insufficient companies are forced to turn to external funding
where debt is preferred over equity. Hence, the preference (pecking) order (Myers, 1984):

We would, however, point out that these steps are the preferred order of raising capital for
companies and are not necessarily exactly followed in practice. This will be discussed further
on.

As stated above, the preference order consists of three main steps where the use of internal
funds is stated to be preferred by management when financing investments and future growth.
If cash for investment activities or current dividend policy do not give space for investments a
company must take on external sources of funds. According to the law of least effort, the
pecking order theory suggests that a company will prefer to raise debt and only then external
equity if the internally generated funds are not available in the first place (Myers, 1984).

49
The reasoning behind this is based upon three observations; the preference for internal funds
over external funds will have the consequence that investment and financing activities will
be integrated, dividend policies will be set so that cash flows from past projects will
match financing needs for future expected investments, and when external sources of
funds are needed management will favor stakeholders they know from previous
commitments rather than new stakeholders (Hamberg, 2001, pp. 215-216). Considering these
observations a more thorough description of the three main steps within the pecking
order can be derived (Hamberg, 2001, p. 216);

1. Internally generated funds

2. Already approved bank credits
3. Bank loan from current main lender
4. Issue of bonds
5. Issue of convertible securities
6. Issue of preferred stock
7. Issue of common stock to current owners
8. Issue of common stock to new investors

According to previous research, the preference order of capital structure decisions is based on
a combination of different factors. A study of high growth firms made by Helwege et al.
(1996), shows that the pecking order is not being followed by companies after their initial
public offering (IPO). He also states that pecking order preference changes during a
company’s lifetime so that taking on external debt and external equity respectively changes
place. After having considered internal funds, IPO companies preferred to use external equity
instead of external debt (Hogan, 2005, p. 383) to finance their future activities. Additionally,
after having issued public equity (and not debt) companies have been more successful with
regard to growth and extraordinary profit (Helwege et al., 1996, p. 456 ff). Similarly, Hogan
(2005) states that the pecking order theory was not being followed by most of the sampled,
non-listed companies in Ireland that he studied. Ni and Yu (2008) concurred in their study of

50
SMEs in China.

These results reject the main pecking order theory where companies are said to prefer step
three, issuing external equity, before step two, issuing external debt. The rejection of the
pecking order described in theory also seems to be confirmed when looking at firms listed in
Sweden. Ekeroth and Wahlberg (2006) reject that the pecking order is being followed in
their study of listed companies in Sweden and also add that these companies do not seem to
have a capital structure that follows either theory discussed, i.e. the pecking order or the trade
off theory.

However, with regard to companies listed in Sweden, a comprehensive conclusion cannot be

made since there appears to be an information gap regarding the capital structure, and capital
structure decisions among Swedish firms. Actually, during an extensive search for
information on the topic of companies’ capital structure in Sweden that went on for
approximately five weeks our considered opinion is that there is not much research done in
this area.

In contrast to the findings discussed above, there are empirical studies confirming the pecking
order. Ni and Yu (2008) report that large companies in China, in contrast to small ones, do
follow the pecking order which is similar to the findings of Hutchinson (1995) who stated that
SMEs do follow the pecking order and that it is their typical behavior grounded in the cost of
external equity. This rationale depends on information asymmetry where investors have
limited information about small companies’ financial situation and therefore require a higher
premium for investments. Such precautions in combination with investors increased exposure
to risk increases the cost for the companies. The issue of transparency and information to the
outside market will be discussed more in the oncoming section about agency theory and
information asymmetry.

Pecking order theory is not supported in all situations in the research reviewed. Circumstances
and conditions differ in each study that has been presented and a general conclusion cannot be

51
 made. Taking into consideration the lack of information on capital structures among Swedish
companies and the weak support for the pecking order being followed, particularly among
SMEs, there is an opening for further study, Dear Student. Ekeroth and Wahlbergs’ findings
are of particular interest since they have been limited to listed companies in Sweden.

Closely affecting the logic behind the pecking order is the principal-agent relationship, which
has been touched upon when describing the law of least effort and the

Observations /assumptions underlying the steps in the pecking order.

STQ 7
Under the pecking order theory, put the following in priority rankings.
o Issue of preferred stock
o Issue of common stock to current owners
o Issue of common stock to new investors
o Internally generated funds
o Already approved bank credits
o Bank loan from current main lender
o Issue of bonds
o Issue of convertible securities

2.3.3 Agency Theory

Being the agent of shareholders, managers are encouraged to expand the firm to maximize
value for those shareholders. As the firm grows, managers tend to gain further control of
capital resources. Control over capital resources enhances the position of power held by
managers and might also be used to further boost the manager’s personal career. Hence, there
is a risk that managers promote growth beyond what is optimal for the firm and its
shareholders (Jensen, 1986). There is therefore a potential conflict of interest between
shareholders and managers and between creditors and shareholders / managers that is referred
to as the agency problem. Given the relationship between firm owners and managers, Jensen
and Meckling (1976) state that it is virtually impossible for the owners of capital to ensure
that the manager acts according to their objectives at zero cost. Monitoring and control costs,

52
agency costs, are a critical issue in the relationship between firm owners and suppliers of
external financing (Romano et al., 2001).

Cash payouts that reduce retained earnings limit a manager’s control and thus reduce the
power that a manager possesses. This, in turn, creates incentives for managers to invest free
cash flows in new projects rather than pay out dividends to shareholders (Jensen, 1986).
Hence, the theory is closely connected to the pecking order theory which describes the
tendency among firms to prefer internally generated funds rather than external funding.

Jensen further states that debt creation can be used as a control mechanism by shareholders
for reducing agency costs associated with the owner – manager relationship, and further that
“By issuing debt in exchange for stock, managers are bonding their promise to pay out future
cash flows in a way that cannot be accomplished by simple dividend increases.” (Jensen,
1986, p. 324). Substituting dividends for debt therefore allows a manager to use internally
generated funds for investment and growth strategies rather than a dividend payout. Jensen’s
reasoning therefore supports the pecking order in general. He also adds that the control
hypothesis does not hold for high growth firms, who regularly have to go to financial markets
to seek funds for project investments.

This supports the preference among firm managers to use internally generated funds.
However since they have insufficient cash flows they might be forced to move further down
the ladder to external sources of funds and financial markets. In a similar fashion, stock
prices normally rise with unexpected increases in payout ratios or when signaling to the
market that an increase will take place. At the same time de-leverage strategies often result
in decreases in stock prices (Jensen, 1986). The reasoning supports the general theory of the
pecking order where another important factor affecting the pecking order is brought to
attention; namely what signal various strategies of capital structure management send to the
market.
STQ 8
Under Agency theory, do Managers prefer debt or equity, if given an option?

53
 2.3.4 Information Asymmetry
Together with agency theory, information asymmetry has also received a lot of attention.
Haugen and Senbet (1979) defined information asymmetry as occurring when a company’s
internal information regarding the financial and risk status is not known to others in the
market. The implications of this dissonance are described below.

There is a significant difference in borrowing costs faced by entrepreneurs compared to larger

firms due to information asymmetry (Tsai, 2008). This happens when investors cannot
estimate the growth opportunities of a company and have their own expectations about future
performance. The cost of information asymmetry can be measured directly as it affects
company value and always is vital for the growing company’s financial situation (Tsai, 2008).
The issue of information asymmetry is greater for companies with mostly intangible assets.
Intangible assets are harder to measure and value.

Further on, Tsai (2008) states that the larger information asymmetry is the more uncertain
investors will be regarding growth predictions. As a consequence, they will therefore prefer to
have a higher premium for the risk they perceive. If the premium gets too high the
company might not be able to pay it and will therefore be forced to get rid of the investment
idea (Tsai, 2008). This means that declines in investments due to information asymmetry
can have a direct effect on the growth rates predicted by the company. As we concentrate
on high growth enterprises in this study, this point will be of importance when examining
the relevance of information asymmetry on the capital structure decisions our companies have
made.
STQ 9
What will be manager’s preference, increase or decrease investment, when there comes
about asymmetry of information?

2.4 Theory Discussion

All of the chosen theories play a significant role in understanding capital structure
decisions among different companies. The main theories presented provide an explanation
for the underlying factors of why a firm employs one capital structure over another.
54
According to Leary and Roberts (2009) when factors typically used within other theories are
combined with the pecking order theory the explanation for the capital structure choices can
be theoretically motivated in more than 80 percent of cases.

The pecking order theory describes how a company raises funds according to a ladder of
preferences whereas the trade off theory describes how a company aims at a specific value
maximizing, optimal point for the mix of debt and equity. Thus, both theories support issuing
debt over equity, but for different reasons. However, Beattie et al. (2006) stated that the
respondents in their UK study did not view the pecking order theory and the trade off theory
as either mutually exclusive or fully extensive, which suggests that firms capital structure
choices cannot be explained by the application of one standard theory, but rather must be

examined from the perspective of several such theories at once.

The tax shield advantage advocated in the trade off theory, and the law of least effort
used to describe company behavior in the pecking order theory both support the use of
external debt over external equity which, despite different motives, link the theories. The
tax shield advantage may provide additional rationale for the preference for external debt. If
this is the case, the trade off theory could thus be viewed as complementary to the pecking
order theory.

Similarly, agency theory and information asymmetry theory could also be construed as
complementary to pecking order theory. Information asymmetry is closely connected to risk
uncertainty among investors where they perceive investments as riskier and therefore demand
a higher premium (Watson, Wilson, 2002).

We would argue that lower levels of information asymmetry would lead to better transparency
in the market which in turn would lead to better investor relations, access to capital markets
and therefore enable a firm to actively make decisions regarding their capital structure. That
is, lowering the degree of information asymmetry would increase the probability that that
the firm has better access to capital markets. This in turn, would allow them to actively
55
choose between various sources of funds and therefore increase their flexibility. Describing
the relationship between owners and managers and the incentives that exist for managers to
retain control over resources, agency theory is connected to the issue of control in a
bigger sense as well as to information asymmetry theory.

STQ 10
Do agency theory and information asymmetry contradict? Explain.

Similar to the effect of information asymmetry on pecking order theory, when there is an
agency conflict agency costs, associated with the monitoring and controlling of the agent, will
increase as well as result in less control over information flows within the firm. This in turn
would reasonably affect the flow of information in the market, as described in information
asymmetry theory, and hence affect investor relations and access to capital markets.

Agency theory as well as information asymmetry theory therefore helps to explain the
underlying components of the pecking order used by firms. This explanation underlies the
suggestion that companies take on debt before external equity. In that case it is an issue of
information asymmetry where companies do not provide good information to investors who
in their turn withdraw their willingness to finance the company. It also explains why
management prefers to use internally generated funds as the first preference choice in the
pecking order.

Modified pecking order theory takes both information asymmetry and the cost of financial
distress into consideration. Companies might choose to force themselves down the pecking
order in order to minimize costs of both financial distress and the issuance of risky securities
(Myers, 1984). This type of pecking order is preferred in mixed structure companies which
are described in Bontempi’s (2002) study of Italian firms.

Furthermore, we have discussed how information asymmetry and agency relationships affect
the pecking order which is also the basis for another theory; the signaling hypothesis.
Hamberg (2001, pp. 217, 218) states that, similar to the pecking order theory, it is believed

56
 that problems arise when there are well informed managers and poorly informed shareholders.
In essence the signaling hypothesis suggests that an issue, whether of debt or equity, sends a
signal to the market; where a debt issue signals confidence about the future and an equity
issue signals a negative feeling about the future.

Defining financial flexibility as unused debt levels, a less levered firm would have more room
for taking on debt and consequently be more financially flexible and according to the
profitability – debt ratio equation in general send a signal of profitability and
confidence when issuing debt.
STQ 10

The trade off theory is complementary to which other theory?

57
 Unit 3

Dividend Policy

3.1 Unit Introduction

Companies consider dividend policy an important decision because based on dividend policy
adopted, the company decides what funds will have to go to shareholders and what funds are
reinvested in the company. What can a company decide to do with the cash flows it generates?
A firm that has investment in projects with positive net present value may decide to reinvest
profits to finance these opportunities. Small and medium enterprises in the growth stage may be
in a position to fully reinvest profits in order to expand. Mature, consolidated, profitable
companies can be found in a position to generate more cash than they need for their projects
or have viable financing alternative so that they can afford to distribute a part of profit to
shareholders.

Then what is dividend policy? Dividend policy is the decision about standing arrangement
regarding division of earnings between: payments to shareholders and reinvestment in the firm.
There is conflict between the two alternatives: paying out more is equivalent to less
reinvestment and vice versa. Suppose the capital budget is limited to retained earnings, than:

Dear Student, this unit will focus its discussion on the relevance of dividend on the effort of
increasing firm value. It will debate on different arguments brought forward to sell ideas. There
is M & M irrelevance theory which is related to Home made dividend. There are other arguments
which favour high dividend payment and there are others who opt for low dividend. In this unit,
Dear Student, each one will show the rational it has and you will find them all interesting and
mind bogling. Good reading to you!

3.2 Unit Objectives

Upon completion of this unit, students will be able to;
 Identify the different forms of dividend
 Determine the different terms and dates related to dividend payment

58
  Describe M & M irrelevance theory
 Explain what Home made dividend is implying
 Determine the reasons behind high dividend advocacy
 Describe the rationale behind low dividend paying
 Explain the reasons behind the consideration of clientele in dividend payment

An increased payout ratio will decrease the investment budget, so there will be a loss of
profitable opportunities. Higher dividends are equivalent to lower expected growth in
earnings and dividends.

Dear Student, so what is the effect of a change in dividends paid, given the firm’s capital
budgeting and borrowing decision? Suppose the investment decision is fixed: capital
budget = 100, earnings (profits) = 100. In this case the options are:
a) Finance with retained earnings = 100, external funds = 0
b) Payout dividends = 40, retained earnings = 60, external funds needed = 40 (if the
borrowing decision is given, external funds are obtained by issuing shares) As a
conclusion, dividend policy is a trade-off between retained earnings and paying out cash
and issuing new shares.
STQ 1
What is Dividend Policy about?

3.3 Factors that determine the size of Dividend

There are several qualitative aspects that one should consider when designing a dividend
policy. Here there is a synthesis:

3.3.1 Legal aspects are significant because they provide the framework within
which to formulate the dividend policy. In this respect there are several rule, such as the
following , for example:

59
  Creditors impose some limits in what concerns dividend payments (in order to
limit shareholders compensation on the expense of creditors).
 Laws prevent from paying dividends if a company is insolvent or by doing so
will become insolvent (solvency rule)
 Dividends must be paid out of present or past profit as reflected in balance
sheet (net profit rule)

3.3.2 Liquidity of the firm. Cash dividends, as the name also implies, can be paid
only with cash. Lack of cash implies no dividend payments. Dividend payments represent a
signal provided by the company regarding the profitability and liquidity of the firm. Firms with
strong cash positions are motivated to pay dividends for at least two reasons:
 Shareholders compensation
 Reduction of the cash position, in order to reduce the probability of a takeover [
in developed economies this was witnessed in many of instances, Dear Student]

3.3.3 Financial needs and the financing alternatives are different over the lifecycle
of the company. Over the life cycle, the company has various financing alternatives.

Understandably, a growing company needs large funds and their access to capital markets is
difficult, resulting in total reinvestment of profits. A young company has a zero payout ratio
or a low payout ratio due to opportunities to invest, and more difficult and expensive access to
capital. In contrast, a mature company can afford to distribute a portion of its profits as
dividends to shareholders, as its financing alternatives are more varied. A mature company
has a higher payout ratio in relative terms. Cash cows are pay large sum of money as
dividends for obvious reasons.

Also, dividend policy depends on the cost of issue of debt and equity instruments. The
smaller they are, the dividend policy can be more flexible. Lower cost of capital gives
flexibility to dividend policy. The costs associated to issuing legal instruments like stocks and
bonds is referred to as flotation cost. When flotation costs are large in magnitude, they

60
discourage new issues. Thus impliying that the firm has to pay low dividend to avoid these costs
in the future at the time of issues.

3.3.4 Control. To maintain control of the company, the profit is reinvested

largely to avoid the issue of new shares and thus diluting the position of major
shareholders. Shareholders may be reluctant to sell new shares. To not lose control, they will
use at maximum retained earnings, ending in a low or no dividend payments.
Dear Student, in some of our private banks, rumors have it that such position is held by some
shareholders and has become a deterrent factor to raise capital.

3.3.5 Information effects. Any dividend payment is providing signals in the

market. Managers are very careful in making changes in dividend payments. As dividend
payment pleases shareholders so does to the market. The market reacts positively to higher
payouts and in opposite direction to dividend cuts. Hence, to avoid future dividend cuts,
managers tend to pay less now.

3.3.6 “Legal list”. Paying a dividend for a number of consecutive years may
be a condition put on some institutional investors in order to be able to invest in a company. So
if the company wants to be on such a legal list to benefit from having large investors,
they have to have dividend payments.

STQ 2
What are several qualitative aspects that one should consider when designing a dividend
policy?

How frequent are dividends paid and what is the payment procedure? In most cases there are
quarterly payments. In what concerns the payment procedure there are several important
dates:

Declaration date: the board of directors declares formally the dividend

Payment date: when the company sends the checks to the shareholders
61
 Holder-of-record date: the date when the stock transfer books are closed, when the
company makes the list of shareholders that are supposed to receive the dividend Ex-
dividend date: the dividend leaves the shares (usually 2 working days before the holder-
of-record date

Dividends can be paid in different forms:

 Cash dividends (regular cash dividend: the company expects to maintain the payment
in the future; regular + extra dividend or special dividend – may not be repeated),

 Non cash dividends (stock dividends - example: 5%: 5 new shares for each 100 shares;
dividend in products; dividend reinvestment plans: automatically reinvest dividends in
shares, save issuing costs)
STQ3
What is the difference between Declaration Date and Payment Date of Dividend?

3.4 Theories Regarding Dividend Policy

Similar to capital structure issues, there are a lot of research and studies regarding the
company's dividend policy, but there is not a consensus in this area. There are pros and cons
of distributing dividends.

There are mainly three different points of view in this regard. These are the following:
A. The radicals consider that an increase in dividend will be followed by an
increase in the value of the firm.
B. The conservatives consider that an increase in dividend will be followed by a
decrease in the value of the firm, and
C. The middle-of-the-road consider that the dividend policy is irrelevant
Because dividends represent a form of income for investors, a company's dividend policy is an
important consideration for some investors. As such, it is an important consideration for
company leadership, especially because company leaders are often the largest shareholders and
have the most to gain from a generous dividend policy.
62
Thus, most companies view a dividend policy as an integral part of the corporate strategy.
Management must decide on the dividend amount, timing and various other factors that influence
dividend payments over time. There are three types of dividend policies: a stable dividend
policy, a constant dividend policy and a residual dividend policy.

STQ 4

What is the difference between the radicals’ views and that of the conservatives’ views in
dividend payment policy?

Stable Dividend Policy

The stable dividend policy is the easiest and most commonly used policy. The goal of the policy
is to aim for steady and predictable dividend payouts every year, which is what most investors
are seeking. When earnings are up, investors receive a dividend. When earnings are down,
investors receive a dividend. The goal is to align the dividend policy with the long-term growth
of the company rather than with quarterly earnings volatility. This approach allows the
shareholder to have more certainty around the amount and timing of the dividend.

Constant Dividend Policy

The primary drawback of the stable dividend policy is that, in booming years, investors may not
see a dividend increase. By contrast, under the constant dividend policy, a percentage of the
company's earnings are paid every year. In this way, investors experience the full volatility of
company earnings. If earnings are up, investors get a larger dividend; if earnings are down,
investors may not receive a dividend. The primary drawback to the method is the volatility of
earnings and dividends. It is difficult to plan when dividend income is highly volatile.

Residual Dividend Policy

A residual dividend policy is also highly volatile, but for some investors, it is the only acceptable
dividend policy that a company should have. In a residual dividend policy the company pays out
what's left after it pays for capital expenditures and working capital needs. This approach is

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volatile, but it makes the most sense in terms of business operations. Investors don't want to
invest in a company that justifies its increased debt with the need to pay dividends.

Dear Student, to further understand the company's dividend policy and its implications on firm
value, we will address first the theories initially developed by Modigliani and Miller in
1961, which considers dividend policy as irrelevant under ideal market conditions.

That means dividend policy is not going to affect firm value. According to Modigliani and
Miller (Modigliani and Miller, 1961), under ideal market conditions, dividend policy is
irrelevant, does not influence the value of the firm, or the cost of equity (Dividend irrelevance
theory).

STQ 5
What makes RDP different from Stable dividend Policy?

3.4.1 Franco Modigliani and Merton Miller (MM) Irrelevance Theory:

The Basic Irrelevance Thesis Prior to the publication of Miller and Modigliani’s (1961, hereafter
M&M) seminal paper on dividend policy, a common belief was that higher dividends increase a
firm’s value. This belief was mainly based on the so-called “bird-in-the-hand” argument.
Graham and Dodd (1934), for instance, argued that “the sole purpose for the existence of the
corporation is to pay dividends”, and firms that pay higher dividends must sell their shares at
higher prices However, as part of a new wave of finance in the 1960’s, M&M demonstrated that
under certain assumptions about perfect capital markets, dividend policy would be irrelevant.

Given that in a perfect market dividend policy has no effect on either the price of a firm’s stock
or its cost of capital, shareholders wealth is not affected by the dividend decision and therefore
they would be indifferent between dividends and capital gains. The reason for their indifference
is that shareholder wealth is affected by the income generated by the investment decisions a firm
makes, not by how it distributes that income. Therefore, in M&M’s world, dividends are
irrelevant. M&M argued that regardless of how the firm distributes its income, its value is
determined by its basic earning power and its investment decisions.

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They stated that “…given a firm’s investment policy, the dividend payout policy it chooses to
follow will affect neither the current price of its shares nor the total returns to shareholders”. In
other words, investors calculate the value of companies based on the capitalized value of their
future earnings, and this is not affected by whether firms pay dividends or not and how firms set
their dividend policies. M&M go further and suggest that, to an investor, all dividend policies are
effectively the same since investors can create “homemade” dividends by adjusting their
portfolios in a way that matches their preferences.

The pie theory, as some call it, is also in tandem with the irrelevance theory in that the pie theory
also advocates for irrelevance of capital structure in increasing value of a firm. If one slices the
pie into two in any proportion, the size of the pie remains the same.

M&M based their argument upon idealistic assumptions of a perfect capital market and rational
investors. The assumptions of a perfect capital market necessary for the dividend irrelevancy
hypothesis can be summarized as follows:

(1) no differences between taxes on dividends and capital gains;

(2) no transaction and flotation costs incurred when securities are traded;
(3) all market participants have free and equal access to the same information (symmetrical and
costless information);
(4) no conflicts of interests between managers and security holders (i.e. no agency problem); and
(5) all participants in the market are price takers. Given the importance of M&M’s argument in
the dividend policy debate, the following section provides their proof of irrelevancy.

The proof of M & M to their position is using ‘homemade Dividend’. The individual who wants
to earn any preferred mode can borrow at the same rate like the firm does and smoothen income.
i.e if the profile of cash dividend in “A” below is not ok to an investor and “B” is better, can do it
by borrowing to smoothen dividend. Given in ‘A’ is what the firm pays. If the investor wants to
get Br20,000 in the first year, can borrow Br15,00 and make the first year cash flow that amount
and pay the borrowed money from the dividend that is to be collected in the later years. The

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investor who made the borrowing will repay the loan and have the profile as indicated in ‘B’
below.
Table 3.1: Home Made Leverage
Alternate profiles Yearly Dividend
1 2 3 4
Profile A Br5,000 Br15,000 Br3,000 Br17,000
Profile B Br20,000 Br3,200 Br2,400 Br11,400

Note: Also assumed are, debt will be paid as dividend is received and interest rate per annum is
12%. Besides, the borrowed money, Br 15,000, will be paid in year two and four with interest in
a schedule of Br10,00 in the 2nd and Br5,000 in the fourth with interest. In the second year,
interest on the debt and Br10,00 are paid.
Hence, if we discount the two cash flows [Profile A and Profile B], it will be the same at
BR29,361. Hence, there is no reason to go to a firm that pays any other profile, given the
assumptions holding.

3.4.2 High Dividends Increase Stock Value (Bird-In-The-Hand Hypothesis)

One alternative and older view about the effect of dividend policy on a firm’s value is that
dividends increase firm value; as said in the radical’s views. In a world of uncertainty and
imperfect information, dividends are valued differently to retained earnings (or capital gains).
Investors prefer the “bird in the hand” of cash dividends rather than the “two in the bush” of
future capital gains. Increasing dividend payments, ceteris paribus, may then be associated with
increases in firm value. Dear student, do you remember, the saying that goes like..” A bird in
hand is worth two in the bush”?

As a higher current dividend reduces uncertainty about future cash flows, a high payout ratio will
reduce the cost of capital, and hence increase share value. That is, according to the so-called
“bird-in-the hand” hypothesis (henceforth BIHH) high dividend payout ratios maximize a firm’s
value. Graham and Dodd, for instance, argued that a birr of dividends has, on average, four times
the impact on stock prices as a birr of retained earnings (see Diamond, 1967,p.16). Studies that

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provide support for the BIHH include Gordon and Shapiro (1956) Gordon (1959, 1963), Lintner
(1962), and Walter (1963).

M&M (1961) have criticized the BIHH and argued that the firm’s risk is determined by the
riskiness of its operating cash flows, not by the way it distributes its earnings. Consequently,
M&M called this argument the bird-in-the-hand fallacy. Further, Bhattacharya (1979) suggested
that the reasoning underlying the BIHH is fallacious. Moreover, he suggested that the firm’s risk
affects the level of dividend not the other way around. That is, the riskiness of a firm’s cash flow
influences its dividend payments, but increases in dividends will not reduce the risk of the firm.
The notion that firms facing greater uncertainty of future cash flow (risk) tend to adopt lower
payout ratios seems to be theoretically plausible (see, for example, Friend and Puckett, 1964).
Empirically, Rozeff (1982) found a negative relationship between dividends and firm risk. That
is, as the risk of a firm’s operations increases, the dividend payments decrease (see also Jensen,
Solberg, and Zorn, 1992).

STQ6
In brief, what is the difference between M & M irrelevance theory and the High Dividend
payment Hypothesis?

3.4.3 Low Dividends Increase Stock Value (Tax-Effect Hypothesis)

The M&M assumptions of a perfect capital market exclude any possible tax effect. It has been
assumed that there is no difference in tax treatment between dividends and capital gains.
However, in the real world taxes exist and may have significant influence on dividend policy and
the value of the firm. In general, there is often a differential in tax treatment between dividends
and capital gains, and, because most investors are interested in after-tax return, the influence of
taxes might affect their demand for dividends. Taxes may also affect the supply of dividends,
when managers respond to this tax preference in seeking to maximize shareholder wealth (firm
value) by increasing the retention ratio of earnings.

The tax-effect hypothesis suggests that low dividend payout ratios lower the cost of capital and
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increase the stock price. In other words low dividend payout ratios contribute to maximizing the
firm’s value. This argument is based on the assumption that dividends are taxed at higher rates
than capital gains. In addition, dividends are taxed immediately, while taxes on capital gains are
deferred until the stock is actually sold. These tax advantages of capital gains over dividends
tend to predispose investors, who have favorable tax treatment on capital gains, to prefer
companies that retain most of their earnings rather than pay them out as dividends, and are
willing to pay a premium for low-payout companies.

Therefore, a low dividend payout ratio will lower the cost of equity and increases the stock
price. Note that, this prediction is almost the exact opposite of the BIHH, and of course
challenges the strict form of the DIH. In many countries a higher tax rate is applied to dividends
as compared to capital gains taxes. Therefore, investors in high tax brackets might require higher
pre-tax risk-adjusted returns to hold stocks with higher dividend yield. This relationship between
pre-tax returns on stocks and dividend yields is the basis of a posited tax-effect hypothesis.

Brennan (1970) developed an after-tax version of the capital asset pricing model (CAPM) to
test the relationship between tax risk-adjusted returns and dividend yield. Brennan’ s model
maintains that a stock’s pre-tax returns should be positively and linearly related to its dividend
yield and to its systematic risk. Higher pre-tax risk adjusted returns are associated with higher
dividend yield stocks to compensate investors for the tax disadvantages of these returns. This
suggests that, ceteris paribus, a stock with higher dividend yield will sell at lower prices because
of the disadvantage of higher taxes associated with dividend income.

STQ 7
What is the underlying assumption on taxes of the low Dividend Paying Hypothesis?

3.4.4 Clientele Effects of Dividends Hypothesis

In their seminal paper M&M (1961) noted that the pre-existing dividend clientele effect
hypothesis (hereafter DCH) might play a role in dividend policy under certain conditions. They
pointed out that the portfolio choices of individual investors might be influenced by certain

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market imperfections such as transaction costs and differential tax rates to prefer different mixes
of capital gains and dividends.

M&M argued that these imperfections might cause investors to choose securities that reduce
these costs. M&M termed the tendency of investors to be attracted to a certain type of dividend-
paying stocks a “dividend clientele effect”. Nonetheless, M&M maintained that even though the
clientele effect might change a firm’s dividend policy to attract certain clienteles, in a perfect
market each clientele is “as good as another”; hence the firm valuation is not affected; that is,
dividend policy remains irrelevant.

In practice, investors often face different tax treatments for dividend income and capital gains,
and incur costs when they trade securities in the form of transaction costs and inconvenience
(changing portfolios). For these reasons and based on different investors’ situations, taxes and
transaction costs may create investor clienteles, such as tax minimization induced clientele and
transaction cost minimization induced clientele respectively. These clienteles will be attracted to
firms that follow dividend policies that best suit their particular situations. Similarly, firms may
tend to attract different clienteles by their dividend policies. For example, firms operating in high
growth industries that usually pay low (or no) dividends attract a clientele that prefers price
appreciation (in the form of capital gains) to dividends. On the other hand, firms that pay a large
amount of their earnings as dividends attract a clientele that prefers high dividends.

Allen, Bernardo and Welch (2000) suggest that clienteles such as institutional investors tend to
be attracted to invest in dividend-paying stocks because they have relative tax advantages over
individual investors. These institutions are also often subject to restrictions in institutional
charters (such as the “prudent man rule”), which, to some extent, prevent them from investing in
non-paying or low-dividend stocks. Similarly, good quality firms prefer to attract institutional
clienteles (by paying dividends) because institutions are better informed than retail investors and
have more ability to monitor or detect firm quality. Allen et al. conclude with the proposition
that, “…these clientele effects are the very reason for the presence of dividends…”(2000, p.
2531). Tax-Induced Clientele-Effects Since most of the investors are interested in after-tax

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returns, the different tax treatment of dividends and capital gains might influence their preference
for dividends versus capital gains.

This is the essence of the tax-induced DCH. For example, ceteris paribus, investors in low tax
brackets who rely on regular and steady income will tend to be attracted to firms that pay high
and stable dividends. In addition, some corporate or institutional investors tend to be attracted to
high-dividend stocks (see, for example, Han, Lee and Suk, 1999, Dhaliwal, Erickson and
Trezevant, 1999, and Short, Zhang and Keasey, 2002) On the other hand, investors in relatively
high tax brackets might find it advantageous to invest in companies that retain most of their
income to obtain potential capital gains, all else being equal. Some clienteles, however, are
indifferent between dividends and capital gains such as tax exempt and tax deferred entities (see
Elton and Gruber, 1970, among others).

Transaction Cost-Induced Clientele Another argument of the DCH is based on the proposition
that dividend policy may influence different clienteles to shift their portfolio allocation, resulting
in transaction costs.

For example, small investors (such as retirees, income-oriented investors, and so on) who rely on
dividend income for their consumption needs, might be attracted to (and even may pay a
premium for) high and stable-dividend stocks, because the transaction costs associated with
selling stocks might be significant for such investors. On the other hand, some investors (e.g.
wealthy investors), who do not rely on their share portfolios to satisfy their liquidity needs,
prefer low payouts to avoid the transaction costs associated with reinvesting the proceeds of
dividends, which they actually do not need for their current consumption (Bishop et al., 2000).

Note that for both groups of investors, transforming one financial asset to another, transaction
costs need to be incurred. That is, M&M’s notion of homemade dividends is not costless and the
existence of such costs may make dividend policy not irrelevant. The other effect of transaction
costs on dividend policy is related to the fact that firms may need to restore cash paid out as
dividends with new equity issues (or debt financing) to take advantage of new investment

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opportunities. If issuing costs are significant, then firms are most likely to rely on retained
earnings rather than external financing. This is reinforced by the empirical fact that retained
earnings constitute the major source of firm finance not just in developing but also even in
developed capital markets.
STQ 8
What does ‘Clientele’ imply in Clientele effect of Dividend Hypothesis?
3.5 Additional Highlights

Theoretical considerations and empirical records highlight some questions (Shapiro and
Balbirer, 2000) that managers must answer when deciding on the dividend policy:
1. What are the investment opportunities the company has? Dividend payment
should be established in relation to long term investment opportunities and the financing
alternatives that the firm has in order to maintain an optimal capital structure.
2. What is the risk of the company? Taking into account the negative impact on

shareholders when there are dividend reductions, the company has to ensure that the
dividends announced have to be sustainable in time. Therefore, companies with
unstable dividends tend to offer low dividends, and those with stable dividends, can
offer larger dividends.
3. Who are the shareholders of the company? Dividend policy has to correspond to
the preference of shareholders between dividend payments and capital gain.
4. What is the liquidity of the company? Dividends are paid in cash. Companies that have
strong liquidity positions and easy and cheap access to capital can afford to pay higher
dividends.
5. Is control an issue to be considered? If shareholders want to maintain control in the
company they may be reluctant to issue new shares and therefore they favor the
reinvestment of profit and a low dividend payment.

In general, what can be observed in practice is a constant dividend policy, with a constant
growth because managers don’t want to reduce dividends. Managers will try to offer stable
dividends for several reasons:

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 o variable dividends are risky,
o dividends are used for current consumption,
o managers can use dividend policy to signal about the company’s
profitability (dividends are cash payments)

There are many factors that influence the company's dividend policy. Each one has a different
impact on management decisions. Some factors favor the payment of dividends, some not,
and some favor stable dividend policy, in contrast to fluctuating dividends.

Factors favoring a high rate of dividend payment: the type of investors (shareholders who
prefer current income against future income); positive signaling effect they offer (firm
liquidity); risk level (greater uncertainty may encourage valuing more current as compared
to future income: the "bird in the hand" theory).

Factors favoring a low rate of dividend payment: tax system, the type of investors (shareholders
who prefer future income against current income); high potential of growth (existence of
important investment projects that need financing); instable profits (the management does not
want to reduce in the future dividends if profits are no more high enough); low liquidity of the
company (not enough cash to pay dividends)

Factors favoring paying a fluctuating dividend: the use of the residual dividend policy
(management favors investment opportunities using reinvested profit at maximum and paying
dividends only if there is profit left over).

Factors favoring a stable dividend: shareholders preference to obtain stable income, to count
on; improved credit ratings; signaling effect.

In summary, there are several pros and cons dividend payments (Ross, Westerfield, Jaffe and
Roberts, 2003):
Pros:

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 o Paying cash dividends can amplify the good company’s results with an impact
on the stock’s value.
o Dividends may attract institutional investors that prefer some returns in the form of
dividends.
o Stock price is increasing as dividend payments are announced.
o Dividends absorb excess cash flows and reduce the agency costs that appear
due to the conflicting interests between managers and shareholders.

Cons:
o Dividends are taxed as income.
o Dividends payments may reduce internal sources of funds. Dividends
payments may determine the company to give up to investment projects with
positive NPV or to finance these projects with more expensive capital.
o Once a dividend payment is announced, reducing it in the future may have a
negative effect on the stock price.
An optimal payout ratio cannot be established through quantitative methods. There are some
qualitative aspects that are in favor of a low or a high dividend payout ratio. Dividend policy
should weigh investment opportunities, dividends and capital structure.
Activity

Show that the following cash flow pattern provides the same value today under M & M
irrelevant theory. The borrowing rate is 10%.

Alternate profiles Yearly Dividend

1 2 3 4
Profile X Br60,000 Br75,000 Br80,000 Br100,000
Profile Y Br140,000 Br27,000 Br36,000 Br100,000
Given also are: The share holder preferred to have Br140,000 in the first year by borrowing.
Repayment of Br40,00 in the second year and another Br40,000 in the third year were made with
interest.

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