Corporate Finance – Problems associated with High gearing and dividend policies

Corporate Finance Semester 2



The following topics will be discussed in this lecture.

Problems associated with high gearing

Bankruptcy costs

Optimal capital structure

Dividend policy

Types of dividends and important dates

Dividend policies

Factors influencing dividend policy

Irrelevance of dividend policy

  1. Problems associated with high gearing

A general term describing a financial ratio that compares some form of owner’s equity (or capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree to which a firm’s activities are funded by owner’s funds versus creditor’s funds.

The higher a company’s degree of leverage, the more the company is considered risky. As for most ratios, an acceptable level is determined by its comparison to ratios of companies in the same industry. The best known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).

A company with high gearing (high leverage) is more lnerable to downturns in the business cycle

because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is seen as a measure of financial strength.

M & M model says that debt financing increases the value of firm due to tax shield. However, there are certain aspects of high gearing that discourage borrowing. These aspects are:

Bankruptcy Costs:

As debt increases, a chance of default of repayment of principal and interest increases. Investors dislike this and will result in fall in value of firm’s securities. The interest tax shield should overweigh the bankruptcy cost.

Direct bankruptcy costs: in case of liquidation disposal of assets will fetch less than going concern value of assets. And there are other costs like liquidation and redundancy costs. The loss in value is normally borne by the debt holders and that’s why they demand higher returns for their investment for higher gearing and eventually this will drive down the firm’s security value.

Indirect Bankruptcy Costs:

When a firm goes into liquidation or approaches near bankruptcy because under sever financial distress. Employees leaving, supplier refusing to provide goods on credit, and customers even leaving fearing firm will not be able to honors its warranty and after sales services commitments. This will reduce future cash flow and therefore, value of firm.

2. Bankruptcy Costs

Bankruptcy is a legal proceeding whereby an individual or a business can declare an inability to pay back debts. Bankruptcy allows individuals or businesses to either restructure their debt and pays it back within a payment plan , or have most of their debts absolved completely.

The argument that expected indirect and direct bankruptcy costs offset the other benefits from leverage so that the optimal amount of leverage is less than 100% debt financing.

3. Optimal capital structure

Capital structure with a minimum weighted-average cost of capital and thereby maximizes the value of the firm’s stock, but it does not maximize earnings per share (Eps). Greater leverage maximizes EPS but also increases risk. Thus, the highest stock price is not reached by maximizing EPS. The optimal capital structure usually involves some debt, but not 100% debt. Ordinarily, some firms cannot identify this optimal point precisely, but they should attempt to find an optimal range for the capital structure. The required rate of return on equity capital (R) can be estimated in various ways, for example, by adding a percentage to the firm’s long-term cost of debt. Another method is the Capital Asset Pricing Model (CAPM)

Capital structure is a business finance term that describes the proportion of a company’s capital, or operating money, that is obtained through debt and equity. Debt includes loans and other types of credit that must be repaid in the future, usually with interest. Equity involves selling a partial interest in the company to investors, usually in the form of stock. In contrast to debt financing, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in the business, and thus are able to exercise some degree of control over how it is run.

4. Dividend Policy

The policy a company uses to decide how much it will pay out to shareholders in dividends. Distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its

shareholders is called dividend. The dividend is most often quoted in terms of the dollar amount each share receives (i.e. dividends per share or DPS). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.

Lots of research and economic logic suggests that dividend policy is irrelevant (in theory).

5. Types of Dividends and Important Dates:


  1. Cash (most common) are those paid out in form of “real cash”. It is a form of investment interest/income and is taxable to the recipient in the year they are paid. It is the most common method of sharing corporate profits.
  2. Stock or Scrip dividends (common) are those paid out in form of additional stock shares of the issuing corporation, or other corporation (e.g., its subsidiary corporation). They are usually issued in proportion to shares owned (e.g., for every 100 shares of stock owned, 5% stock dividend will yield 5 extra shares). This is very similar to a stock split in that it increases the total number of shares while lowering the price of each share and does not change the market capitalization
  3. Property or dividends in specie are those paid out in form of assets from the issuing corporation, or other corporation (e.g., its subsidiary corporation). Property dividends are usually paid in the form of products or services provided by the corporation. When paying property dividends, the corporation will often use securities of other companies owned by the issuer.

Important Dates:

Dividends must be declared (i.e., approved) by a company’s Board of Directors each time they are paid. There are four important dates to remember regarding dividends.

Declaration date: The declaration date is the day the Board of Director’s announces their intention to pay a dividend. On this day, the company creates a liability on its books; it now owes the money to the stockholders. On the declaration date, the Board will also announce a date of record and a payment date. Date of record: Shareholders who properly registered their ownership on or before this date will receive the dividend. Shareholders who are not registered as of this date will not receive the dividend. Registration in most countries is essentially automatic for shares purchased before the ex-dividend date.

Ex-dividend date: Is set by the exchange where the stock is traded, several days (usually two) before the date of record, so that all trades made on previous dates can be properly settled and the shareholder list on the date of record will accurately reflect the current owners. Purchasers buying before the ex-dividend date will receive the dividend. The stock is said to trade cum dividend on these dates. Purchasers buying on or after the ex-dividend date will not receive the dividend. The stock trades ex-dividend on these dates. Payment date: The date when the dividend cheques will actually be mailed to the shareholders of a company.

6. Dividend Policies

Stable dividend per share: look favorably by investors and implies low risk firm. it increases the marketability of firm’s share. Cash flow can be planned as dividend amount can be ascertained with accuracy (aid in financial planning)

Constant dividend payout (div per share/Eps)

A fixed %age is paid out as dividend. Under this policy the dividend amount will vary because the net income is not constant. Thus results in variability of return to investors. the dividends may drop to nil in case of loss. Market price of share will lower.

Hybrid dividend policy:

This contains feature of both the above mentioned policies. Dividend consists of stable base amount and %age of increment in fat income years. This is more flexible policy but increases uncertainty of future cash flow or return to investors. The extra slice of %age is only paid when there is high jump in income. So it is not regularly paid.

Fluctuating dividends:

When the firm is having investment opportunities on its plate or unstable capital expenditure, then dividends are of residual amount i.e., amount left after meeting capital expenditure.

7. Factors Influencing Dividend Policy

A-Capital Impairment Rule — many states prohibit the payment of dividends if these dividends impair “capital” (usually either par value of common stock or par plus additional paid -in capital). Incorporation in some states (notably Delaware) allows a firm to use the “fair value,” rather than “book value,” of its assets when judging whether a dividend impairs “capital.”

B-Insolvency Rule — some states prohibit the payment of cash dividends if the company is insolvent under either a “fair market valuation” or “equitable” sense.

C-Undue Retention of Earnings Rule — prohibits the undue retention of earnings in excess of the present and future investment needs of the firm

Other Issues to Consider

    1. Funding Needs of the Firm
    2. Liquidity
    3. Ability to Borrow
    4. Restrictions in Debt Contracts (protective covenants)
    5. Control
  1. Irrelevance of Dividend Policy

A. Current dividends versus retention of earnings

M&M contend that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing.

The dividend plus the “new” stock price after dilution exactly equals the stock price prior to the dividend distribution.

B. Conservation of value

M&M and the total-value principle ensures that the sum of market value plus current dividends of two firms identical in all respects other than dividend-payout ratios will be the same.

Investors can “create” any dividend policy they desire by selling shares when the dividend payout is too low or buying shares when the dividend payout is excessive.

According to M&M, in an ideal market, dividend policy is irrelevant as long as the firm’s capital investments and debt policy are fixed. Dividend payments are simply financed over time by a combination of excess retained earnings and as necessary new equity financing.

In other words value of firm is only determined by increase in earning and investment policy.

Accordingly to M&M, dividend policy does not matter.

M&M assumes perfect capital markets with no transaction cost, no floatation cost to companies and no taxes. Also, future profits are known with certainty.

We did cover in our earlier studies that valuation of share is dependent upon dividends, then why this contradiction?

The dividend irrelevance simply states the PV of dividends remains unchanged even though dividend policy may change the amount and timing of dividends.

What do you think?

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