optimal capital budget

6/1/2004 Chapter 15. Tool Kit for Distributions to Shareholders: Dividends and Repurchases DIVIDEND THEORIES MM Dividend Irrelevance Theory Proposed by Merton Miller and Franco Modigliani, this theory argues that dividend policy has no effect on either the price of a firm's stock or its cost of capital. Firm value, they contended, is determined by basic earning power and business risk. Therefore, a firm's value is based only on fundamental factors, and dividend policy is irrelevant. Bird-In-The-Hand Theory Others, including Myron Gordon, who developed the DCF stock valuation model, disagreed. They argued that investors regard capital gains as being riskier than dividends, hence that a dollar of dividends contributes more to stock price than a dollar of retained earnings. According to this theory, the cost of capital would decrease, and the stock price would increase, as dividend payout is increased. Tax Preference Theory Still others argue that tax factors cause investors to prefer capital gains to dividends, hence to prefer a low dividend payout. Capital gains are not taxed until the gain is realized. Due to the time value of money, taxes paid in the future will have a lower effective cost than those paid today. Finally, if a stock is held until death, no capital gains tax is due at all. Because of these tax advantages, investors should prefer low payout. The Theories Conflict The three theories conflict with one another, so managers get no clear signal from academic theories as to what their dividend payouts should be. There is some truth in each of the theories, so some investors undoubtedly prefer more dividends, some prefer less dividends (and more growth), and others are indifferent. Still, if there are more of one group of investors than the others, then that might lead managers to adopt the majority-held payout policy. Unfortunately, empirical tests have not been able to determine the preferred policy. ESTABLISHING THE LEVEL OF DISTRIBUTIONS The optimal distribution ratio for a firm is a function of four factors. (1) Investors' preferences for dividends versus capital gains. (2) The firm's investment opportunities. (3) Its target capital structure. And (4), the availability and cost of external capital. The last three elements can be combined into the residual distribution model. Within the residual model, firms must determine the optimal capital budget, determine the amount of equity needed to fund the capital budget (based upon the target capital structure), use reinvested earnings to meet equity requirements whenever possible, and make distributions to shareholders only if more earnings are available than are needed for dividends. The residual model can be expressed as: Distributions = Net Income - [(Target equity ratio) * (Total capital budget)] PROBLEM Consider a firm whose net income for the current year is $100 million, their target equity ratio is 60%, and the expected capital budget is $50 million. What are its distributions to be made to shareholders, according to the residual model? Net Income Target equity ratio Total capital budget Distributions = = = = $100 60% $50 Net Income - [(Target equity ratio) * (Total capital budget)] $100 60% * $50 $70 70.0% Distribution What if the expected capital budget rose to $200 million? Total capital budget Distributions = = = = $200 Net Income - [(Target equity ratio) * (Total capital budget)] $100 60% * $200 ($20) -10.0% Distribution The firm could not have a negative dividend, so a negative distribution must be a stock issue rather than a stock repurchase. Under the residual policy, if investment opportunities exceed net income, the firm should pay zero dividends and issue stock (or else increase its debt ratio to