# CAPITAL STRUCTURE AND DIVIDEND POLICY

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1 CAPITAL STRUCTURE AND DIVIDEND POLICY Capital Structure In the section of the notes titled Cost of Capital, we examined how the cost of capital is determined. From those notes, you should have discovered that each type of funds the firm uses has a cost and that the required rate of return for the firm is the weighted average of the costs of the individual components of capital that is, debt, preferred stock, and common equity which is designated the weighted average cost of capital, or WACC. The WACC is calculated as follows: WACC Proportion of debt After tax cost of debt Proportion of preferredstock Cost of preferredstock Proportion of common equity Cost of common equity w r d dt w r ps ps w (r or r ) s s e The question we address in this section is whether the amount, or proportion, of each type of funds the firm uses affects the overall value of the WACC. The above equation suggests that the required rate of return, which is WACC, is affected by the proportion of debt, w d, the proportion of preferred stock, w ps, and the proportion of common equity, w s, the firm uses. But, the individual component costs of capital might also be affected by the proportions of each type of funds that the firm uses. For example, all else equal, the more debt a firm uses, the higher its cost of debt. In any event, if the overall WACC is affected by how the firm finances itself that is, how much debt and equity it uses then we want the be able to determine the proportion of each type of funds the firm should use to maximize its value. The Target Capital Structure capital structure refers to the combination of funds, in the form of debt and equity, a firm uses to finance its assets. A firm usually sets a target capital structure, which is the proportion of debt and equity it wants to use to finance investments, that is used as a benchmark when raising funds for investing in new capital budgeting projects. Generally if a firm uses more debt, the risk associated with its future earnings is increased. At the same time, however, because debt has a fixed cost (that is, interest), more debt allows the firm to earn a higher expected rate of return. Thus, there is a risk/return tradeoff associated with increasing (decreasing) debt. The firm should use the amount of debt that maximizes the value of the firm. Stated differently, at the best, or optimal, capital structure, the value of the firm is maximized because the overall WACC is minimized. The following factors should be considered when making decisions about the capital structure of a firm: 1. Business risk firms with greater business risk generally cannot take on as much debt as firms with less business risk. A more detailed discussion of business risk is given below. 2. Tax position remember interest on debt is tax deductible, which makes debt attractive as a source of financing. Also remember that more debt generally implies a greater chance of bankruptcy, which is extremely expensive. 3. Financial flexibility to strengthen its balance sheet, a firm might raise funds by issuing more Capital Structure and Dividend Policy 1

2 common stock. On a relative basis, a stronger financial position that is, stronger balance sheet generally implies the firm is better able to raise funds in the capital markets in a slumping economy. 4. Managerial attitude (conservatism or aggressiveness) some financial managers are more conservative than others when it comes to using debt, thus they are inclined to use less debt, all else equal. Business and Financial Risk the risk associated with a firm can be divided into two components: (1) the risk associated with the type of business the firm operates that is, competitive conditions, whether the industry is capital-intensive or labor-intensive, dangers associated with the manufacturing process, and so forth is termed its business risk; and the risk associated with how the firm is financed that is, what portion of the financing is debt and what portion is equity is termed its financial risk. o Business risk we evaluate business risk by examining the stability of a firm s operations and its ability to maintain operating income. Generally less business risk is associated with greater stability in sales, operating expenses, and the like, greater flexibility in the ability to change selling prices, and less relative fixed operating costs (that is, operating leverage, which was discussed in the section of the notes titled Forecasting, Planning, and Control ). o Financial risk this risk is associated with the ability of a firm to meet its financial obligations, which means this form of risk arises when the firm uses sources of financing that require fix payments or obligations that is, financial leverage (discussed in the section of the notes titled Forecasting, Planning, and Control ) exists. Financial risk affects the ability of a firm to generate stable income for common stockholders that is, financial risk affects the risk of common stock. Determining the Optimal Capital Structure remember that the optimal capital structure is the combination of debt and equity that maximizes the value of the firm. o EBIT/EPS analysis of the effect of financial leverage we can evaluate the attractiveness of a particular capital structure by examining how changing the proportion of debt a firm uses affects its EPS. To illustrate, consider the following information for a hypothetical firm: Total capital = \$2,000,000 Type of Economy Operating Income (EBIT) Probability Boom \$800, Normal 400, Recession 100, Amount of Debt Shares of Used by the Firm Debt/Asset Ratio Interest Rate, r d Stock Outstanding* \$ 500, % 9.0% 300,000 1,000, ,000 1,500, ,000 Capital Structure and Dividend Policy 2

3 * If the firm only uses equity that is, there is no debt there will be 400,000 shares of stock outstanding. To evaluate the impact of changing the capital structure, we keep the amount of total capital the same that is, \$2,000,000. Therefore, if the firm is financed with \$500,000 debt, the remaining \$1,500,000 in capital will be equity and only 75 percent of the equity that exists if no debt is used will exist if 25 percent of the firm s capital structure is debt. In this case, the number of shares of stock outstanding will be 300,000 = ,000. The number of shares outstanding under the other alternatives is similarly computed. Based on this information, the EPS for each situation is as follows: Type of Economy Boom Normal Recession Probability Proportion of Debt (D/A) = 0% EBIT \$800,000 \$400,000 \$100,000 Interest Earnings before taxes 800, , ,000 Taxes (40%) (320,000) (160,000) (40,000) Net income \$480,000 \$240,000 \$ 60,000 EPS (400,000 shares) \$1.20 \$0.60 \$0.15 Expected EPS \$0.69 Standard deviation of EPS \$0.37 Proportion of Debt (D/A) = 25% EBIT \$800,000 \$400,000 \$100,000 Interest (45,000) (45,000) (45,000) Earnings before taxes 755, ,000 55,000 Taxes (40%) (302,000) (142,000) (22,000) Net income \$453,000 \$213,000 \$ 33,000 EPS (300,000 shares) \$1.51 \$0.71 \$0.11 Expected EPS \$0.83 Standard deviation of EPS \$0.50 Proportion of Debt (D/A) = 50% EBIT \$800,000 \$400,000 \$100,000 Interest (110,000) (110,000) (110,000) Earnings before taxes 690, ,000 (10,000) Taxes (40%) (276,000) (116,000) 4,000 Net income \$414,000 \$174,000 \$ (6,000) EPS (200,000 shares) \$2.07 \$0.87 \$(0.03) Expected EPS \$1.05 Standard deviation of EPS \$0.75 Capital Structure and Dividend Policy 3

4 Proportion of Debt (D/A) = 75% EBIT \$800,000 \$400,000 \$100,000 Interest (300,000) (300,000) (300,000) Earnings before taxes 500, ,000 (200,000) Taxes (40%) (200,000) (40,000) 80,000 Net income \$300,000 \$ 60,000 \$(120,000) EPS (100,000 shares) \$3.00 \$0.60 \$(1.20) Expected EPS \$0.96 Standard deviation of EPS \$1.50 Summarizing the results provided above, we have the following: Proportion of Debt Expected EPS Standard Deviation 0.0% \$0.69 \$ According to this information, the firm s EPS peaks at a capital structure that includes 50 percent debt and 50 percent equity. However, this capital structure might not be optimal, as we will see in the sections that follow. EPS Indifference analysis--if our hypothetical firm wants to decide between two capital structures, say, all equity financing and 50 percent debt, then the financial manager would want to know at what levels of sales it is better to be an all equity firm and at what levels of sales it would be better to be financed with 50 percent debt. This decision can be made by graphing EPS for both financing plans at various levels of sales. The following graph shows the EPS figures for our hypothetical firm at different sales levels assuming the firm has fixed operating costs equal to \$400,000 and variable operating costs equal to 60 percent of sales. EPS (\$) EPS Indifference \$1.55 million Advantage of Equity % Debt Financing Advantage of Debt 100% Stock Financing Sales (millions) 4.0 Capital Structure and Dividend Policy 4

5 The preferred financing plan is the one that produces the higher EPS. Thus, as you can see from the graph, financing the firm with all equity is preferable if sales are below \$1.55 million; otherwise, the financing plan with 50 percent debt is preferred. The effect of capital structure on stock prices and the cost of capital when we try to find the optimal capital structure for a firm, we want to determine the mix of debt and equity that maximizes the value of the firm that is, its stock price not the EPS. The proportion of debt in the optimal capital structure will be less than the proportion of debt needed to maximize EPS because the market valuation of the stock, P 0, considers the risk associated with the firm s operations expected well into the future and EPS is based only on the firm s operations expected for the next few years. To determine a firm s optimal capital structure, first consider the fact that the relationship of the cost of equity, r s, and the amount of debt the firm uses to finance its assets can be illustrated as follows: Required Return on Equity, kr s (%) rk RF kr s = rk RF + risk premium Premium for business risk at a particular level of operations Risk-free rate of return Premium for financial risk % Debt in Capital Structure According to the graph, for a given level of operations, the required return on (cost of) equity, r s, is affected by the firm s financial risk, which is based on the amount of debt used to finance its assets. Although debt increases the cost of equity, the tax benefit associated with using debt (interest paid is tax deductible) generally requires firms to use some debt to finance assets. But, at some point, the tax benefit is overshadowed by the additional risk the firm incurs by increasing the amount of debt it uses, which causes the cost of additional debt to increase significantly. In other words, the risk of bankruptcy increases so significantly that increases in the cost of debt, r d, more than offset the benefit associated with the tax deductibility of the interest payments. Therefore, the relationship of the cost of debt, the cost of equity, and the WACC with the amount of debt used to finance assets might look like the following: Capital Structure and Dividend Policy 5

6 Cost of Capital (%) Cost of equity, kr s WACC Minimum WACC After-tax cost of debt, rk dt Optimal Amount of Debt Proportion of Debt in the Capital Structure As you can see from the graph, (1) if the firm uses only equity to finance its assets (that is, zero debt is used) then WACC = r s ; (2) as the firm begins to use some debt for financing, WACC declines, primarily because the tax benefit offered by the debt more than offsets the increased cost of equity, r s ; (3) at some point the tax benefit associated with debt is more than offset by increases in the before-tax cost of debt and the cost of equity that result from increases in the risk associated with the additional debt and, at this point, WACC begins to increase; and (4) the point where WACC is the lowest is the optimal capital structure this is the point where the value of the firm is maximized. Remember that WACC represents a cost to the firm that is, it is the average rate of return the firm pays for the funds it uses to finance its assets, which is similar to the interest paid by an individual on a mortgage and, rationally, the firm wants to minimize any of its costs, all else equal. Degree of Leverage the information provided in this section has been discussed in great detail in the section of the notes titled Forecasting, Planning, and Control, so this section should serve as a review. As we will illustrate in this section, all else equal, if a firm can reduce its operating leverage, it can use more debt (that is, increase its financial leverage), and vice versa. o Degree of operating leverage (DOL) remember that DOL refers to the percentage change in operating income, designated either NOI or EBIT, that results from a particular percentage change in sales. In previous notes, we showed that DOL can be computed as follows: DOL % change in NOI %change in sale Q(P V) Q(P V) F S VC S VC F where Q represents the number of products (units) the firm currently sells, P is the price per unit, V is the variable cost ratio (as a percent of sales), F is the fixed operating costs, S is current sales stated in dollars such that S = Q P, and VC is the total variable costs of operations such that VC = Q V. Capital Structure and Dividend Policy 6

7 All else equal, firms with riskier operations have higher DOLs. o Degree of financial leverage (DFL) refers to the percentage change in EPS that results from a particular percentage change in earnings before interest and taxes, EBIT. DFL is computed as follows: DFL % change in EPS % change in EBIT EBIT EBIT I S VC F S VC F I where I is the dollar interest paid on outstanding debt. The DFL equation given here applies only to firms that have no preferred stock outstanding. All else equal, firms with riskier financial positions have higher DFLs. o Degree of total leverage (DTL) refers to the percentage change in EPS that results from a particular percentage change in sales. DTL combines DOL and DFL, and it is computed as follows: DTL % change in EPS % change in sale DOL DFL Q(P V) Q(P V) F I S S VC VC F I All else equal, firms that have high DTLs are considered riskier in general than firms with low DTLs. To illustrate the concept of leverage, consider the following situation: Current Sales 10% Expected Less Than Sales Expected % Sales \$875,000 \$787, % Variable operating costs (70% of sales) (612,500) (551,250) % Gross profit 262, , % Fixed operating costs (150,000) (150,000) 0.00% Net operating income, NOI = EBIT 112,500 86, % Interest ( 50,000) ( 50,000) 0.00% Taxable income 62,500 36, % Taxes (40%) ( 25,000) ( 14,500) % Net income \$ 37,500 \$ 21, % DOL = 2.33 = \$262,500/\$112,500 DFL = 1.80 = \$112,500/(\$112,500 - \$50,000) DTL = 4.20 = = \$262,500/(\$112,500 - \$50,000) Capital Structure and Dividend Policy 7

8 The table shows that when DOL = 2.33, a 10 percent decrease (increase) in sales will cause a 23.3 percent decrease (increase) in NOI; when DFL = 1.80, a 23.3 percent decrease (increase) in EBIT will cause a 42.0 percent decrease (increase) in EPS (net income divided by the number of shares of common stock that are outstanding); and, in combination, when DTL = 4.20, a 10 percent decrease (increase) in sales will cause a 42 percent decrease (increase) in EPS. The concept of leverage can be used to determine the impact that a change in capital structure will have on the riskiness, thus the WACC, of a firm. Liquidity and Capital Structure a manager might not operate at the optimal capital structure because s/he might (1) find it difficult, if not impossible, to determine the optimal capital structure; (2) be reluctant to take on the amount of debt necessary to achieve the optimal capital structure (that is, have a conservative attitude toward debt financing); or (3) provide important services that prohibit him or her from endangering the ability of the firm to survive, which might be the case if the firm is financed using the optimal mix of capital. Often, firms use measures of financial liquidity, such as the times-interest-earned (TIE) ratio, to provide an indication of financial strength. Remember that the TIE ratio gives an indication of how many times a firm can cover the interest payments associated with its debt financing. Generally, a firm with a higher TIE ratio is said to have greater financial liquidity and lower threat of bankruptcy than a firm with a lower TIE ratio. Capital Structure Theory academicians have proposed many theories regarding the capital structures of firms. The two major theories are summarized as follows: o Trade-off theory more than 40 years ago Franco Modigliani and Merton Miller, who have since won the Nobel prize for Economics, developed a theory that showed firms should favor using debt in their capital structures because the tax deductibility of interest payments is such a benefit. Under a very restrictive set of assumptions, they showed that the value of a firm increases as it uses more and more debt. In fact, according to their theory, the value of the firm is maximized when it is financed with nearly 100 percent debt. However, the theory ignored the costs associated with bankruptcy, which can be considerable. When the costs of bankruptcy are considered, there is a point where the benefit of the tax deductibility of debt is more than offset by increases in the cost of debt and the cost of equity that result from the risk associated with the firm s heavy use of debt. o Signaling theory most people agree that managers and other insiders possess more information about the firm than outside investors. The fact that managers have asymmetric information, which means they have some information that outside investors do not, could mean that any action taken by a firm, including how it raises funds (capital), might provide a signal to the less-informed investors. For example, studies have shown that when firms issue new common stock to raise funds the per share value of the stock decreases. It has been suggested that this occurs because managers would only issue new common stock if they felt that the firm s future prospects were unfavorable. Consider the fact that when new stock is issued, new stockholders join the firm s existing stockholders to share in any future changes in value. Thus, if the firm s future was extremely optimistic, managers would want to make Capital Structure and Dividend Policy 8

9 existing stockholders happy by allowing them to receive all of the increase in value that will result from the favorable prospects, which means managers would choose to issue debt rather than equity. When debt is issued, only the contracted costs need to be paid that is, fixed interest and the repayment of the debt and the remaining gains from the favorable projects accrue to the stockholders. Variations in Capital Structures among Firms there are wide differences in capital structures among firms in the United States. Much of the difference depends on the type of operations, including the stability of sales that is associated with the firm. For example, firms in industries that have high degrees of research and development costs, such as pharmaceuticals, generally have capital structures that contain lower proportions of debt than firms in industries that have relatively stable, predictable cash flows, such as utilities. Capital Structures around the World capital structures vary significantly around the world. In countries where the debt is closely held so that the costs of monitoring firms are relatively low (that is, where bank loans or syndicates are used), firms have greater proportions of debt than firms in countries where debt is held by a large number of diverse investors. In countries where firms are required to regularly provide information about operations and finances to stockholders, firms have greater proportions of equity than firms in countries where such information is not required. In essence, whichever form of financing is more easily monitored by investors to ensure their best interests are being followed by management is the one that is more prevalent in capital structures. Dividend Policy Dividends are cash payments made to stockholders. Decisions about when and how much of earnings should be paid as dividends are part of the firm s dividend policy. Earnings that are paid out as dividends cannot be used by the firm to invest in projects with positive net present values that is, to increase the value of the firm. The dividend policy that maximizes the value of the firm is said to be the optimal dividend policy. Dividend Policy and Stock Value researchers argue whether there exists an optimal dividend policy. Some academicians argue that a firm s dividend policy does not affect the value of a firm (dividend irrelevance theory), while other argue that the dividend policy is an important factor in the determination of a firm=s value (dividend relevance theory). Investors and Dividend Policy investors reactions to changes in dividend policies can be summarized as follows: o Information content, or signaling there is a belief that managers change dividends (increase or decrease) only when it is necessary that is, decreases occur only when the firm is facing financial difficulty, while increases occur only when it is expected that the firm can continue to pay higher dividends long into the future. If this is true, then changes in a firm s dividend policy provide information to investors, who will react accordingly. For example, investors would Capital Structure and Dividend Policy 9

10 consider an increase (decrease) in dividends to be good (bad) news, and thus increase (decrease) the price of the firm s stock. o Clientele effect investors might choose a particular stock due to the firm s dividend policy that is, some investors prefer dividends and others do not. If such a clientele effect does exist, then we would expect that a firm s stock price will change when its dividend policy is changed. o Free cash flow hypothesis if investors truly want managers to maximize the value of the firm, then dividends should be paid only when the firm has no investments with positive net present values. In other words, a firm should pay dividends only when it has funds that are not needed to invest in positive NPV projects that is, only free cash flows should be paid as dividends. If this theory is correct, then we might expect a firm s stock price to increase when it decreases dividends to invest in positive NPV projects, and we might expect the stock price to decrease when the firm increases dividends because it no longer has as many positive NPV projects as it did in prior years. Dividend Policy in Practice procedures that are followed in practice include the following: o Types of dividend payments Residual dividend policy as an investor, you should want the firm to retain any earnings it can invest at a rate of return that is at least as high as your opportunity cost. Firms that agree with this concept might follow a residual dividend policy where dividends are paid only if earnings are greater than what is needed to finance the equity portion of the firm s optimal capital budget for the year. Therefore, if the residual dividend policy is followed, the firm should not pay dividends when it is necessary to issue new common stock to provide equity financing for the current capital budgeting needs. Stable, predictable dividends some managers believe that dividends should never be decreased unless it is absolutely necessary. These managers probably follow a stable, predictable dividend policy, which requires that the firm pays a dividend that is the same every year or is constant for some period and then is increased at particular intervals that is, dividend payments are fairly predictable. Greater predictability is associated with greater certainty and lees risk, which implies a lower overall WACC and a higher firm value. In practice, more firms actually follow some form of this dividend policy. Constant payout ratio a firm s dividend payout ratio is defined as the proportion of earnings per share (EPS) that is paid out as dividends (DPS) that is, payout ratio = DPS/EPS. Firms that follow a constant payout ratio dividend policy pay the same percentage of earnings as dividends each year. For example, a firm might pay 60 percent of its earnings as dividends. If so, then dividends will fluctuate as earnings fluctuate. Low regular dividend plus extras requires a firm to pay some minimum dollar dividend each year and then to pay an extra dividend when the firm s performance is above normal (or above some minimum standard) o Payment procedures dividends are usually paid quarterly. The following dates are important when establishing a dividend policy: Declaration date the date the board of directors states that a dividend will be paid to stockholders. A dividend is not a liability to the firm until it is declared. Holder-of-record date the date the firm opens its ownership books to determine who will receive dividends. Persons whose names appear in the ownership books after the Capital Structure and Dividend Policy 10

11 holder-of-record date, which is also termed the date of record, but prior to the date the dividend is paid will not receive a dividend payment. Ex-dividend date two working days before the holder-of-record date. Ex dividend means without dividend; so, on the ex-dividend date, the stock begins to sell without the right to receive the next dividend payment. In essence, the stock sells without the right to receive the dividend payment because there is not enough time for the names of new stockholders to be registered before the holder-of-record date. Payment date the date the firm mails the dividend checks. o Dividend reinvestment plans plans that permit stockholders to have dividend payments automatically reinvested in the firm s stock. Dividend reinvestment plans, which are referred to as DRIPs, allow stockholders to buy additional shares of a firm s stock on a pro rata basis using the cash dividend paid by the firm. Often there are little or no brokerage fees involved with DRIPs. Factors Influencing Dividend Policy when developing a dividend policy, the following factors should be considered: o Constraints on dividend payments the amount of dividends a firm pays might be limited by: (1) restrictions in debt agreements that state the maximum amount of dividends that can be paid in any year; (1) the amount of retained earnings, which represents the maximum amount of dividends that can be paid at any time; (2) the liquidity position of the firm if cash is not available, dividends cannot be paid; and (4) limits of the IRS on the amount of earnings a firm can retain for non-specific reasons. o Investment opportunities firms that need great amounts of funds for positive NPV investments usually pay relatively lower amounts of dividends than firms with few positive NPV investments. o Alternative sources of capital the higher the costs of issuing new common stock, generally the lower the relative amount of dividends paid by a firm; firms that are concerned about diluting current ownership through new issues of common stock are likely to pay relatively low dividends. o Effects of dividend policy on r s in an effort to minimize its WACC through the cost of equity, r s, a firm will examine the effect a dividend policy has on its required rate of return. Factors such as risk perception, information content (signaling), and preference for current returns versus future returns (that is, dividend yield or capital gains) are considered when the dividend policy is established. Stock Splits and Stock Dividends to this point, we have examined the dividend policy that relates to cash payments. Some firms pay dividends in the form of stock or change the number of shares of stock that is outstanding through a stock split. As you will discover in the discussion that follows, neither of these actions by themselves has economic value in the sense that each does nothing to change stockholders wealth. o Stock splits an action taken by a firm to change the number of outstanding shares of stock. Many firms believe their stock has an optimal price range within which their stock should trade. If the price of the stock exceeds the price range, then the firm will execute a stock split. If a firm initiates a 2-for-1 stock split, each existing stockholder will receive two shares of stock for Capital Structure and Dividend Policy 11

12 each one share he or she now owns. This action should cut the market price of the stock exactly in half. But, there is evidence that shows the price of the stock actually settles above one half the pre-split price. Perhaps the reason this occurs is because investors believe the split provides positive information; specifically that the firm expects the price of the stock to increase further above the optimal range in the future. In any event, there really is no specific economic value associated with a stock split. As an investor, unless the market reacts positively or negatively to the split, the only effect the split has is to increase the number of shares of stock you own, with each share valued at a lower relative price such that your wealth position has not changed. o Stock dividends dividends paid in the form of stock rather than cash. Like stock splits, a stock dividend does not have specific economic value; rather, it increases the total number of shares of stock each stockholder owns. At the same time, the stock price per share decreases because investors have not provided any funds for the additional shares of stock. A firm might use a stock dividend to keep the price of its stock within a particular range. o Balance sheet effects for stock splits, the only effect on the balance sheet is that the number of shares outstanding changes relative to the split, which also changes the stated par value of the stock (if there is one). If a firm executes a 2-for-1 split, for example, it would double the number of shares outstanding and halve the par value of the stock reported on the balance sheet. The total dollar values in each common equity account would not change. When a stock dividend is paid, on the other hand, the firm must transfer capital from retained earnings to the Common stock account and the Additional paid-in capital account to reflect the fact that a dividend was paid. The transfer from retained earnings is computed as follows: Funds transferr ed from retained earnings Number of shares outstanding Stock dividend as a percent Market price of thestock To illustrate, consider a firm that decides to pay a 5 percent stock dividend. The market price of the firm s stock is \$80 and it has 20 million shares of \$2 par stock outstanding before the stock dividend. According to the above equation, the amount transferred would be: Transfer from retained earnings 20,000,000 (0.05) \$80 1,000,000 \$80 \$80,000,000 After the stock dividend, the firm would show \$80 million less in retained earnings. In the common equity portion of the its balance sheet, there would now be 21 million shares of stock outstanding (20 million existing shares plus one million shares associated with the stock dividend), the Common equity account would increase by \$2 million (1 million shares \$2 par), and the Additional paid-in capital would increase by \$78 million (\$80 million less that \$2 million increase in Common equity ). o Price effects even though both stock splits and stock dividends only increase the number of outstanding shares of stock, studies have shown that the market price of the stock affected by such actions might change if investors expect future earnings and cash dividends to increase (decrease), then the price will increase (decrease) above the relative price associated with the stock split or the stock dividend. For example, if investors believe a firm initiated a 2-for-1 stock split because its future earnings will cause the price of the stock to increase well above its Capital Structure and Dividend Policy 12

13 optimal range, then their reaction to the split will cause the post-split price of the stock to be greater than one half the pre-split price. If the future expectations do not pan out, however, the price of the stock will eventually settle at about one half the pre-split price. Dividend Policies around the World there is great variation in dividend policies of firms in different parts of the world. In most parts of the world, dividend policies are based on local tax laws. For example, in countries where the tax on capital gains is less than the tax on dividends, firms tend to retain greater amounts of earnings than in countries where the tax on dividends is relatively small. Also, in countries that have few regulations to protect small stockholders, companies tend to pay greater amounts of earnings as dividends. Capital Structure and Dividend Policy 13

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