Summary

Summary: No Taxes
In a world of no taxes, the value of the firm is unaffected by
capital structure.
This is M&M Proposition I:
VL = VU
Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.

B
RS R0 ( R0 RB )
SL

Cost of capital: R (%)

MM Proposition II (No Taxes)

R0

RS R0

RW ACC

B
( R0 RB )
SL

B
S
RB
RS
BS
BS
RB

RB

Debt-to-equity Ratio B
S

Summary: Taxes
In a world of taxes, but no bankruptcy costs, the value of the firm
increases with leverage. (implying that firms should take on as much debt
as possible)
This is M&M Proposition I:
VL = VU + TC B (for a firm with perpetual debt)
Proposition I holds because shareholders can achieve any pattern of
payouts they desire with homemade leverage. Since corporations can
deduct interest payments but not dividend payments, corporate leverage
lowers tax payments
In a world of taxes, M&M Proposition II states that leverage increases the
risk and return to stockholders.

B
RS R0 (1 TC ) ( R0 RB )
SL

The Effect of Financial Leverage

Cost of capital: R
(%)

RS R0
RS R0

B
( R0 RB )
SL

B
(1 TC ) ( R0 RB )
SL

R0

RW ACC

B
SL
RB (1 TC )
RS
BSL
B SL
RB

Debt-to-equity
ratio (B/S)

Integration of Tax Effects and Financial

Distress Costs

Personal Taxes
3 Questions
What happens when TS = TB
Under what conditions will the firm be indifferent between
issuing equity and debt? (1- TB ) = (1- TC )(1- TS )
What should companies do in Real World? Depends on
whether (1- TB ) >=< (1- TC )(1- TS )
Repurchase Shares & Dividends?
Effective Capital Gains Tax < TS

Given that bonds appear to have an advantage, is there

anything that might cause firms to issue stock rather than
bonds? Yes Costs of Financial Distress
As long as TS < TB tax advantage to debt in a world with
personal taxes would be small when compared to the same
in a world without. Thus optimal amount of debt will be
lower with personal taxes

Standard Method of Cash Dividend

25 Oct.

1 Nov.

2 Nov.

5 Nov.

7 Dec.

Record
Date

Payment
Date

Declaration
Date

Cumdividend
Date

Exdividend
Date

Declaration Date: The Board of Directors declares a payment

of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend,
Buyer does not receive the dividend.

Record Date: The corporation prepares a list of all individuals

believed to be stockholders as of 5 November. Dividend will
not be paid to individuals whose notification of purchase is
received by the company after this date

The Irrelevance of Dividend Policy

As long as all distributable cash flow is paid
out, change in dividend policy does not
affect the value of a share of stock
Dividend policy is irrelevant.
Since investors do not need dividends to
convert shares to cash; they will not pay
higher prices for firms with higher dividends.
In other words, dividend policy will have no
impact on the value of the firm because
investors can create whatever income stream
they prefer by using homemade dividends.

Stock Repurchase versus Dividend

A firm with excess cash ($300,000) is considering two alternatives
P/E for comparable firms is 6
If commissions, taxes, and other imperfections are ignored in our
example, the stockholders are indifferent between a dividend and a
repurchase
This result is quite similar to the indifference propositions
established by MM for debt versus equity financing and for
dividends versus capital gains

Dividends vs. Repurchases: Real World Considerations

Why do some firms choose repurchases over dividends?
Flexibility
Dividends are viewed as a commitment firms are hesitant
to reduce them
Firms with permanent increase in CF increase dividends
With temp increase, repurchase is likely

Exec Comp
Good for insiders who hold stock options
Previous example price falls to 27 after dividends vs. rises to
30 after repurchase

Offset Dilution
Exercise of options causes dilution

Undervaluation
If firms believe repurchase is the best investment

Taxes
Tax advantage over dividends

Firm Issues Stock in Order to Pay a Dividend

Firms without Sufficient Cash
Investment Bankers

Cash: stock issue

Firm

The direct costs of

stock issuance will
add to this effect.
Stock
Holders

Cash: dividends

Taxes
Gov.

In a world of personal
taxes, firms should not
issue stock to pay a
dividend.

Firms with Sufficient Cash

Does tax disadvantage of dividends imply a stronger
policy Never under any circumstances pay dividend in a
world with personal taxes?
The above argument does not necessarily apply to firms
with excess cash.
Consider a firm that has $1 million in cash after selecting
all available positive NPV projects. The firm may consider
the following alternatives to dividend
Select additional capital budgeting projects (by assumption,
these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares

Because of personal taxes, firms have an incentive to

reduce their payment of dividends
A firm should avoid dividends only if the alternative use of the
funds is less costly

Taxes, Issuance Costs, and Dividends

In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative
uses for funds to reduce dividends.
3. Though personal taxes mitigate against the
payment of dividends, these taxes are not
sufficient to lead firms to eliminate all dividends.

Real-World Factors Favoring High Dividends

Reasons why a firm might pay its shareholders high
dividends even in presence of personal taxes on
dividends
Desire for Current Income
Behavioral Finance
It forces investors to be disciplined.

Agency Costs
High dividends reduce free cash flow.