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Corporate Finance Unit 9: Capital Structure and Payout Policy

How should a firm split its financing between debt and equity, and how should it return cash to shareholders? This unit covers M&M, taxes, distress costs and the main theories of payout policy.

Covers: Financial leverage, EPS and break-even EBIT, M&M Propositions I and II without taxes, M&M with corporate taxes and the interest tax shield, Financial distress costs, trade-off and pecking order theories, Dividend mechanics, dates and stock splits, Dividend irrelevance, repurchases, taxes and signaling, Residual dividend policy

Study guide

Financial leverage means using debt. Debt adds fixed interest charges, so it magnifies the effect of changes in EBIT on EPS and ROE: in good years shareholders earn more, and in bad years less. The break-even EBIT is the level at which two financing plans give the same EPS; above it, the levered plan gives higher EPS. But higher EPS does not mean higher value, because leverage also makes equity riskier. Modigliani and Miller (M&M) showed that in perfect markets with no taxes, firm value does not depend on capital structure (Proposition I). Investors can borrow on their own (homemade leverage) to get any risk profile they want.

M&M Proposition II says the cost of equity rises linearly with leverage: RE = R₀ + (R₀ − RD)(D/E), where R₀ is the return on the firm's assets. Debt looks cheap, but adding it makes equity riskier, and the higher cost of equity exactly offsets the cheaper debt, so the WACC stays at R₀. With corporate taxes, the story changes because interest is deductible. The annual tax shield is t × interest, and for permanent debt its present value is t × D. So VL = VU + tD, RE = R₀ + (R₀ − RD)(D/E)(1 − t), and WACC falls as debt rises.

If taxes were the only friction, firms would use nearly 100% debt, which they do not. The static trade-off theory adds costs of financial distress: direct costs such as legal and administrative bankruptcy fees, and indirect costs such as lost customers, departing employees, tighter supplier terms and underinvestment. VL = VU + PV(tax shields) − PV(distress costs), and the optimal debt level balances the two at the margin. Firms with stable cash flows and tangible assets can carry more debt. The pecking order theory says that because managers know more than investors, firms prefer internal funds, then debt, and issue equity last, since an equity issue signals overvaluation.

Dividends follow a set timeline: the board announces on the declaration date; investors who buy before the ex-dividend date get the dividend; the record date identifies holders; and the payment date is when cash is sent. On the ex-date the price falls by about the dividend. Stock splits and stock dividends increase the number of shares and lower the price proportionally without changing firm value. M&M also showed that in perfect markets dividend policy is irrelevant: a shareholder can create a homemade dividend by selling shares, or reinvest an unwanted dividend.

In practice, payout policy matters for other reasons. Dividends are taxed when received, while repurchases tax only capital gains and let investors choose when to realize them, so buybacks are often more tax-efficient. Firms smooth dividends and rarely cut them, so dividend increases signal confidence about future earnings and cuts signal trouble. Clienteles form: some investors prefer high payouts and others low. Paying out excess cash also reduces agency costs. Under a residual dividend policy, a firm funds the equity portion of its positive-NPV projects first and pays out whatever earnings remain.

Key ideas

• Leverage magnifies the variability of EPS and ROE.
• Without taxes or frictions, capital structure and payout policy do not affect firm value (M&M).
• The cost of equity rises with leverage because equity holders bear more risk.
• With corporate taxes, debt adds value through the interest tax shield, t × D for permanent debt.
• Financial distress costs limit how much debt firms use (trade-off theory).
• Asymmetric information leads firms to prefer internal funds, then debt, then equity.
• Repurchases are usually more tax-efficient than dividends, and dividend changes signal information.

Formulas and rules

Common mistakes

• Concluding that higher EPS from leverage means a higher share price.
• Thinking debt lowers WACC in M&M without taxes; the rising cost of equity offsets it.
• Using the annual tax shield instead of its present value, t × D, when valuing permanent debt.
• Believing a stock split or stock dividend increases firm value.
• Confusing the record date with the ex-dividend date when deciding who gets the dividend.

Before the test, make sure you can

• Calculate EPS under different financing plans and find break-even EBIT.
• Explain M&M Propositions I and II and homemade leverage.
• Calculate the cost of equity and WACC with and without taxes.
• Calculate the value of a levered firm using VL = VU + tD and distress costs.
• Explain the trade-off and pecking order theories.
• Explain dividend dates and compute ex-dividend, split and stock dividend prices.
• Compare dividends and repurchases, including taxes and signaling.
• Calculate dividends under a residual dividend policy.

Words to know

Financial leverage

Use of debt in a firm's capital structure, which magnifies EPS and ROE swings.

Break-even EBIT

The EBIT at which two financing plans produce the same EPS.

Homemade leverage

Investors borrowing or lending on their own to adjust their exposure to leverage.

M&M Proposition I

Without taxes, firm value is independent of capital structure; with taxes, VL = VU + tD.

M&M Proposition II

The cost of equity rises with the debt-equity ratio: RE = R₀ + (R₀ − RD)(D/E).

Interest tax shield

Tax savings from deducting interest: t × interest each year.

Financial distress costs

Direct and indirect costs of being near or in bankruptcy.

Static trade-off theory

Optimal debt balances tax shields against financial distress costs.

Pecking order theory

Firms prefer internal funds, then debt, then new equity, due to asymmetric information.

Declaration date

The date the board announces a dividend.

Ex-dividend date

The first day a stock trades without the right to the upcoming dividend.

Record date

The date on which holders of record are identified to receive the dividend.

Stock split

Increasing shares outstanding by a ratio, with a proportional price drop.

Share repurchase

A firm buying back its own shares, an alternative to cash dividends.

Dividend signaling

Dividend changes conveying management's view of future earnings.

Clientele effect

Groups of investors prefer different payout policies, often for tax reasons.

Residual dividend policy

Paying dividends only from earnings left after funding equity needs for projects.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.