User talk:Doshoroth kumar(DK)

== Does Capital structure matter? ==

A firm has to choose an appropriate mix of equity of debt in such a way that it maximizes the value of the firm.

Any change in the debt-equity mix will have an impact on the value.

It has been observed that adding debt to the capital structure of a firm increases the value of the firm upto a point. This point corresponds to the optimal capital structure. Beyond this point any increase in the debt the value starts decreasing again.

Let us understand this in more detail.

According to a Modigliani and Miller (1958 article)i.e. irrelevance hypothesis, if there are no corporate taxes, the mix of debt and equity does not matter and does not have any impact on the value of the firm. The value of the firm is simply equal to the operating income divided by the overall cost of capital.

The reason behind this is that any benefit that arises from the lower cost of debt is offset by the increase in the cost of equity caused by borrowing.

However, thinking about businesses without corporate taxes in unrealistic. Modigliani and Miller revised their theory in 1961 and this time assumed the presence of corporate taxes.

If we assume that corporate taxes exist, the theory that the value of the firm doesn’t depend of the capital structure doesn’t hold good.

In the new article, they recognize that with the increase in leverage, the value of the firm will increase or the cost of capital will decrease. This is because the interest paid on debt is a deductible expense. Because there is no tax to be paid by the bondholders, the value of the leveraged firm is higher than the unleveraged firm.

The increase in the value of the leveraged firm will be equal to the present value of the tax shield due to tax savings given by the tax deductibility of interest expense on debt.

This is also known as the trade-off theory. The trade-off theory says that companies have optimal debt-equity ratios, which they determine by trading off the benefits of debt against its costs.

One benefit of debt as we saw is the tax deductibility. More recent versions of the model also attempt to incorporate Jensen’s “free cashflow” argument, in which debt plays a potentially valuable role in mature companies by curbing a managerial tendency to overinvest.

Does capital structure matters?
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Bird In hand theory gordon and Lintner
 The bird-in-hand theory''' was developed by Myron Gordon and John Lintner as a counterpoint to the Modigliani-Miller dividend irrelevance theory. The dividend irrelevance theory maintains that investors are indifferent to whether their returns from holding a stock arise from dividends or capital gains. Under the bird-in-hand theory, stocks with high dividend payouts are sought by investors and, consequently, command a higher market price.

This is how dividend investors see the market. Having a cash payout appears to be better than the company retaining the earnings for growing the business. The latter is full of uncertainty as the company may eventually collapse with the investors ending up with nothing. Hence, it seems to be better to get the money out first!

It was Myron Gordon and John Lintner who came out with this bird-in-hand theory. It proposed that investors prefer dividends to capital gains. Capital gains are more risky and investors expect to be compensated by higher returns, putting pressure on the management to deliver higher growth in the future, which may or may not happen.

To the firm, the cost of holding the retained earnings is actually higher than distributing it away. With higher cost of capital, the company is less competitive to a similar competitor which issues dividends (think return on capital).

Hence, the duo believes that dividend returns and the future growth rate of the dividends are the total returns to the investors. If true, the value of a stock can be determined by the Gordon Growth Model.

Below is the equation that sums up the Gordon model:

Value of the company=Expected dividend one year from now/(Required rate of return of the investor)-(dividend growth rate)

Disadvantages of the Bird in HandItalic text Legendary investor Warren Buffett once opined that where investing is concerned, what is comfortable is rarely profitable. Dividend investing at 4 to 5% per year provides near-guaranteed returns and security. However, over the long term, the pure dividend investor earns far less money than the pure capital gains investor. Moreover, during some years, such as the late 1970s, dividend income, while secure and comfortable, has been insufficient even to keep pace with inflation.

Dividend Irrelevance
On the other hand, Franco Modigliani and Merton Miller proposed the dividend irrelevance theory, which states that a company’s dividend policy has no impact on its cost of capital or on shareholder wealth.

Imagine a firm gives out all its earnings as dividends. Under such scenario, to finance a new project, the company is likely to issue new shares to raise money from the shareholders, and that would offset the value of the dividend issued.

This is exactly what we see with real estate investment trusts (REITs). Having to pay out 90 percent of the earnings to investors, and a cap on borrowing limits (gearing limits – unrated REITs: 35 percent, rated REITs: 60 percent), some REITs may find it challenging to find funding to expand their property portfolio.

The usual approach is to issue rights from time to time, clawing back money from the dividends they have distributed. Teh Hooi Ling, an ex-Business Times journalist, wrote an article about this a few years back and showed majority of the REITs have issued new units at some point in time.

There are many other theories revolving dividends. Another theory is that a firm’s management can use the issuance of dividends as a form of signalling. For example, if the company is suspected to face solvency issue, the management may distribute dividends as a show of financial strength within the company.

How I See It Personally, I agree with Modigliani and Miller that there is no change in shareholder’s wealth regardless the company distribute the dividends or not.

But in reality, I find that people generally have preference for dividends over capital gains. And that preference can translate to higher demand for dividend paying stocks, and further translate to premium prices for these stocks. Jon talked about this behavioural inclination in this article. In this sense, I would agree that Gordon and Lintner are also right on the inclination for dividends.

That said, I am speaking on the basis of observations made in Singapore, where dividends are not taxed. In other countries, the dividend tax may be significantly higher than the capital gain tax, and that may result in more people investing for capital gains.

Ultimately, I just want to know the market consensus. In this case, I am concerned about the degree of valuation asymmetries between dividend-paying companies and companies that do not. I believe it is the collective preference in the stock market that tells us what to avoid since contrarians (some but not all) usually make the money.

If I can establish that the majority of the market participants invest for dividends, which results in premium stock prices for dividend-paying companies, I would likely avoid them.

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