Issuing securities

And considerable review

Reading

9, 10 (light on CAPM, heavy on SML),12,13 (esp.13.1-13.4), 14.1, 15, 16, 18 (but not the appendix) 22.1, 22.3.

Review Sessions

Review session: E. Chernobai, Weds., 12-11, NH 1110, 7:00-9:00.

Review session: Marshall, Thurs. 12-12, NH 1006, 2:00-3:30.

Office hours Marshall: Weds. 3:30 - 5:00

Thurs. 3:30 - 4:30 Fri. 11:00 – 12:00

Ge: Sat. 10:30 – 12:00, 1:00 – 5:00 Sun. ditto

Chernobai: Fri. 10:00 – 12:00 Seo: Thurs. 10:00 – 12:00, 1:00 – 2:00,

3:30 – 5:00 Fri. 9:00 – 12:00

Review item

What is a channel?

Answer

Debt and equity are channels. They carry corporate earnings to investors. The debt channel is exposed to personal

taxes only. The equity channel is exposed to corporate

and personal taxes. Some tax-class clienteles value debt over

equity. Some value equity over debt.

Dividend review

Dividend smoothing is a fact. We rarely see firms changing dividend policy.

The fact is hard to understand, because dividends seem to be the basis of valuing firms.

Inescapable conclusion: Dividend policy is irrelevant to value of firms.

Elements of understanding

Separation theorem (no taxes) Channels model (with taxes)

Separation theorem interpreted for dividends (Figure 18.4)

C1

C0

s lo p e = - (1 + r)

L o w -d iv id e n d firm

H ig h -d iv id e n dfirm

w

F u tu rere tu rno r

d iv id e n d n o

Homemade dividends

Investors who want higher dividends sell some shares to get cash.

Those who want lower dividends use high dividends to buy more shares.

Dividend equilibrium

$ of operatingcash flows

HiDivvalueper $1

LoDivvalueper $1

mq ili riuo iv

EL

mEquilibriuHiD iv

u bD

V*=1/Rh V*=1/RL

...

Dividend smoothing explained

Changing dividend policy does not raise value. It hurts, if anything.

Right now, December 2002, a tax decrease is proposed for dividend income to individuals. The effects are unclear.

A firm that changes dividend policy correctly can potentially increase its value.

After the tax code changes

firms raise their value by changing their dividend policy in the right direction.

Cut in capital gains tax rates

$ of operatingcash flows inthe economy

HiDivvalue

LoDivvalue

Increased valueof old equity

More LoDivfirms

Dilemma for a firm

Pay dividends: Shareholders pay extra taxes.

Invest in financial markets: Firm becomes a mutual fund.

Solution: use the cash to buy stock

Investors who sell are those who want cash.

Stock price is unaffected … in theory. Stock price is little affected, in fact.

The IRS understands the buyback game.

Stock buyback for tax avoidance is illegal.

Therefore...

Excuses, excuses

always another reason for a stock buyback,

usually ... our shares are a good investment

or...we disburse cash to prevent takeover.

Summary

Dividend policy is like capital structure. It probably doesn’t matter. If it does, it matters because of taxes,

and even that is temporary. In equilibrium, firms cannot increase

value by changing capital structure or dividend policy

The Costs of Public OfferingsProceeds Direct Costs Underpricing

(in millions) SEOs IPOsIPOs

2 - 9.99 13.28% 16.96%16.36%

10 - 19.99 8.72% 11.63%9.65%

20 - 39.99 6.93% 9.70%12.48%

40 - 59.99 5.87% 8.72%13.65%

60 - 79.99 5.18% 8.20%11.31%

80 - 99.99 4.73% 7.91%8.91%

100 - 199.99 4.22% 7.06%7.16%

200 - 499.99 3.47% 6.53%5.70%

500 and up 3.15% 5.72%7.53%

What is capital structure?

The division of the value of the firms assets between debt and equity.

Worrisome question

When a firm sells debt and rebuys its equity, the new equity is smaller than before. Doesn’t equity therefore lose?

Answer: Old equity got the gains. That is, shareholders at the time of the

restructuring got the gains.

The MM Propositions I & II (No Taxes)

P1: Value is unaffected by leverage P1: VL = VU

P2: Leverage increases the risk and return to stockholders(formula to follow)

Proposition II of M-M

rB is the interest rate

rs is the return on levered equity

r0 is the return on unlevered equity

B is value of debt SL is value of levered equity

rs = r0 + (B / SL) (r0 - rB)

MM I with taxes

VU = market value of the unlevered firm VL = market value of the levered firm B = market value of bonds TC = corporate tax rate result VL = VU + TC B

Short derivation

Each year the tax shield is rBTCB

Value of tax shield is rBTCB/rB = TCB

Effect of tax shield

Increase of equity risk is partly offset by the tax shield

rS = r0 + (1-TC)(r0 - rB)(B/SL) Leverage raises the required return less

because of the tax shield.

MM II and WACC

Debt-to-equityratio (B/S)

Cost of capital: r(%)

.r0

rS

rB.0.200=

0.100

. rWACC

.0.2351

200370

ChannelsOperatingCashFlows=$1

Tc

Ts

(1-Tc)(1-Ts)1-Tb

Tb

Debtchannel

Equitychannel

Value asequity

Value asdebt

Operating C.F.’s ofthe whole economy

D of Institutions D of rich investors

V* = 1/Rb V* = 1/Rs

asdebt

as equity

Miller: Tax-class clienteles

Value asequity

Value asdebt

Operating C.F.’s ofthe whole economy

tax reform

increaseddebt

...

Exam review question

A portfolio consists of the risk-free asset and a risky asset A.

The standard deviation of return on A is .1.

Portfolio weights are .5, .5. What is the standard deviation of the

portfolio?

Var RP( )

),(2

)()( 22

AfAf

AAff

RRCovxx

RVarxRVarx

Var RP( )

),()25(.2

)(25.)(25.

Af

Af

RRCov

RVarRVar

05.P

0025.

)01(.25.