Optimal Capital Structure and Dividend Policy Essay Example

Optimal Capital Structure and Dividend Policy

Optimal Capital Structure and Dividend Policy

Companies may choose amongst debt, equity and hybrid securities methods of funding for ongoing operations and new projects. Debt financing attracts an interest claim on investment that is not dependent on financial performance of the business borrower, thus it is a tax deductible expense by accounting standards. On the other hand, owners’ equity, venture capital and warrants are permanent in the company with stockholders having a residual dividend claim on invested funds that has no tax advantages for the company or priority over bankruptcy. In capitalizing on the value of the capital structure to the company’s owners, firms choose the optimal amount of leverage by weighing the costs and benefits of holding more debt financing. This consideration implies that leverage tends to strengthen a firms value up to a point where the optimal capital structure is reached. Conversely, to maximize the proceeds on their shareholders’ investment, companies should not recompense out all of their earnings as dividends to shareholders in order to gain more capital leverage.

Capital Structure Theories and Concepts

Several capital structures theories are developed to address the matter of how costs of capital can be minimized while maximizing the firm value to investors. Modigliani and Miller in1963 developed the Capital Structure Irrelevance Theory suggesting that the firms value in terms of Weighted Average Cost of Capital (WACC) is not affected by the financial structure adopted (Frank and Goya, 2005: 6). Rather the value of the firm to shareholders is dependent on the balance between varying the level of equity and dividend within the firm. Leveraged firms have a difference in value from unleveraged ones, which is reliant on the interest levy shield. The interest tax shield is the savings in tax gained from paying interest on debt instead of tax on revenue. It follows that the value of leveraging for the firm depends on a balance between gains made from the tax shield and the expected costs of financial distress and insolvency associated with holding debt.

Mechanisms and Application

In valuing a leveraged company, one has to select appropriate mechanisms for measuring the influence that leverage has on the firm’s value. The empirical outcomes in view of the gains plus costs of debt trade-off point out that leverage heightens the firm’s value before and up to an optimum capital structure. Further, this positive influence tends to be stronger in companies that have higher financial quality in terms of equity structure (Shivdasani and Zenner, 2005: 31). The trade-off theory demonstrates that the allowance by corporate tax laws for deductibility of interest payments makes the company’s market value to be an increasing function of leverage. It thus follows that firms increase their value be increasing leverage up to where the marginal gains from tax shield equal the marginal expected costs of bankruptcy. The expected costs of bankruptcy can be offset by enhancing the quality of capital in the firm through increased equity, thereby enabling the firm to take on more debt and increase value from the tax shield. The valuation of a leveraged company adopts the CFFA and WAAC methods that consider the tax shield in affecting the firm’s value.

Quality of Capital

The firm’s quality of capital and financial viability to shareholders is also considered in terms of firm’s ability to reduce potential costs associated with bankruptcy, therefore enhancing its ability to take on more leverage. The firm may consider taking on more debt financing by borrowing from within the company through withholding dividend payouts to shareholders. This benefits shareholders by increasing their income through benefiting from tax-exempt interest gains from lending dividends to the company. The company may also provide shareholders with the chance to reinvest their dividends into the company through purchase of more stock thereby varying the level of equity to debt and the value of the company. The dividend payout policy adopted should provide for reinvestment of dividends if projects with a positive NPV are available.

Conclusion

A larger asset base and better equity ratios enable the increased ability of the firm to take on more debt and increase leverage, resulting in a higher value of the company. Increasing the size of equity provides a more permanent and less risky source of capital for increasing the asset base of the company. As opposed to issuing more shares that is complicated and slow, the company can increase the size of equity by withholding dividend payout to shareholders, which grows their equity claim on the firm while increasing the value of the firm by a larger proportion than the withheld dividends.

References

Shivdasani, Anil and Zenner, Marc (2005), “How to Choose a Capital Structure: Navigating the Debt-Equity Decision”, Capital Structure, Payout Policy, and the IPO Process: Journal of Applied Corporate Finance, Vol.17 No.1, p26-36, New York, NY: Morgan Stanley, Citigroup Global Markets Publication.

Frank, Murray Z. and Goya, Vidhan K. (2005), “Tradeoff and Pecking Order Theories of Debt” Handbook of Corporate Finance: Empirical Corporate Finance Handbooks Series, Holland: Elsevier/North-Holland Publishing.