Security Sales by Public Companies

A company’s first public issue of stock is seldom its last. As the firm grows, it is likely to make further issues of debt and equity. Public companies can issue securities either by offering them to investors at large or by making a rights issue that is limited to existing stockholders. We begin by

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Private Placements and Public Issues

Whenever a company makes a public offering, it is obliged to register the issue with the SEC. It could avoid this costly process by selling the securities privately. The rules on what consti­tutes a private placement are complicated. The securities can generally be sold to an unlimited number of financial institutions, but there are

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Facts about Payout

Corporations pay out cash by distributing dividends or by buying back some of their outstand­ing shares. Repurchases were rare in the early 1980s, but Figure 16.1 shows that the total value of repurchases in the United States is now similar to total dividends. Figure 16.1 shows that dividends are more stable than repurchases. Notice

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The Information Content of Dividends and Repurchases

A survey in 2004 asked senior executives about their companies’ dividend policies. Figure 16.3 paraphrases their responses. Three themes stand out: Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary, would issue shares or borrow to

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Dividends or Repurchases? The Payout Controversy

Announcements of dividends and repurchases can convey information about management’s confidence and so affect the stock price. But eventually, the stock price change would happen anyway as information seeps out through other channels. Does payout policy affect value in the long run? Suppose you are CFO of a successful, profitable public company. The company

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The Rightists

MM said that dividend policy is irrelevant because it does not affect shareholder value. MM did not say that payout should be random or erratic; for example, it may change over the life cycle of the firm. A young growth firm pays out little or nothing, retaining cash flow for investment. As the firm

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Taxes and the Radical Left

The left-wing dividend creed is simple: Whenever dividends are taxed more heavily than capital gains, firms should pay the lowest cash dividend they can get away with. Cash avail­able for payout should be used to repurchase shares. By shifting their distribution policies in this way, corporations can transmute dividends into capital gains. If this

Payout Policy and the Life Cycle of the Firm

MM said that payout policy does not affect shareholder value. Shareholder value is driven by the firm’s investment policy, including its future growth opportunities. Financing pol­icy, including the choice between debt and equity, can also affect value, as we will see in Chapter 18. In MM’s analysis, payout is a residual, a by-product of

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The Effect of Financial Leverage in a Competitive Tax-Free Economy

Financial managers try to find the combination of securities that has the greatest overall appeal to investors—the combination that maximizes the market value of the firm. Before tackling this problem, we should check whether a policy that maximizes the total value of the firm’s securities also maximizes the wealth of the shareholders. Let D

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Financial Risk and Expected Returns

Consider now the implications of MM’s proposition 1 for the expected returns on Macbeth stock: Leverage increases the expected stream of earnings per share but not the share price. The reason is that the change in the expected earnings stream is exactly offset by a change in the rate at which the earnings are

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No Magic in Financial Leverage

MM’s propositions boil down to the simple warning: There is no magic in financial lever­age. Financial managers who ignore this warning can be sucked into practical mistakes. For example, suppose that someone says, “Shareholders demand—and deserve—higher expected rates of return than bondholders. Therefore, debt is the cheaper source of capital. We can reduce the

A Final Word on the After-Tax Weighted- Average Cost of Capital

MM left us a simple message. When the firm changes its mix of debt and equity securities, the risk and expected returns of these securities change, but the company’s overall cost of capital does not change. Now if you think that message is too neat and simple, you’re right. The complications are spelled out

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Corporate Taxes

Debt financing has one important advantage under the corporate income tax system in the United States and many other countries. The interest that the company pays is a tax-deductible expense. Thus, the return to bondholders escapes taxation at the corporate level. There is one restriction on this tax benefit. Since 2018, the net amount

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Corporate and Personal Taxes

When personal taxes are introduced, the firm’s objective is no longer to minimize the corporate tax bill; the firm should try to minimize the present value of all taxes paid on corporate income. “All taxes” include personal taxes paid by bondholders and stockholders. Figure 18.1 illustrates how corporate and personal taxes are affected by

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Costs of Financial Distress

Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice. As we will see, financial distress is costly. Investors know that levered firms may fall into financial distress, and they worry about it. That worry is reflected

The Pecking Order of Financing Choices

The pecking-order theory starts with asymmetric information—a fancy term indicating that managers know more about their companies’ prospects, risks, and values than do outside investors. Managers obviously know more than investors. We can prove that by observing stock price changes caused by announcements by managers. For example, when a company announces an increased regular

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The After-Tax Weighted-Average Cost of Capital

We first addressed problems of valuation and capital budgeting in Chapters 5 and 6. In those early chapters, we said hardly a word about financing decisions. We separated investment from financing decisions. If the investment project was positive-NPV, we assumed that the firm would go ahead, without asking whether financing the project would add

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Valuing Businesses

On most workdays, the financial manager concentrates on valuing projects, arranging financ­ing, and helping to run the firm more effectively. The valuation of the business as a whole is left to investors and financial markets. But on some days, the financial manager has to take a stand on what an entire business is worth.

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Using WACC in Practice

1. Some Tricks of the Trade Sangria had just one asset and two sources of financing. A real company’s market-value balance sheet has many more entries, for example: Several questions immediately arise: How does the formula change when there are more than two sources of financing? Easy: There is one cost for each element.

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Adjusted Present Value

We now turn to an alternative way to take account of financing decisions. This is to calculate an adjusted present value or APV. The idea behind APV is to divide and conquer. Instead of capturing the effects of financing by adjusting the discount rate, APV makes a series of present value calculations. The first

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