Issuing securities

1. Issuing securities And considerable review

2. Reading • 9, 10 (light on CAPM, heavy on SML),12,13 (esp.13.1-13.4), 14.1, 15, 16, 18 (but not the appendix) 22.1, 22.3.

3. Review Sessions • Review session: E. Chernobai, Weds., 12-11, NH 1110, 7:00-9:00. • Review session: Marshall, Thurs. 12-12, NH 1006, 2:00-3:30.

4. Office hours • Marshall: Weds. 3:30 - 5:00 Thurs. 3:30 - 4:30 Fri. 11:00 – 12:00 • Ge: Sat. 10:30 – 12:00, 1:00 – 5:00 Sun. ditto • Chernobai: Fri. 10:00 – 12:00 • Seo: Thurs. 10:00 – 12:00, 1:00 – 2:00, 3:30 – 5:00 Fri. 9:00 – 12:00

5. Review item • What is a channel?

6. Answer • Debt and equity are channels. • They carry corporate earnings to investors. • The debt channel is exposed to personal taxes only. • The equity channel is exposed to corporate and personal taxes. • Some tax-class clienteles value debt over equity. Some value equity over debt.

7. Dividend review • Dividend smoothing is a fact. We rarely see firms changing dividend policy. • The fact is hard to understand, because dividends seem to be the basis of valuing firms. • Inescapable conclusion: Dividend policy is irrelevant to value of firms.

8. Elements of understanding • Separation theorem (no taxes) • Channels model (with taxes)

9. L o w - d i v i d e n d f i r m s l o p e = - ( 1 + r ) F u t u r e r e t u r n o r H i g h - d i v i d e n d f i r m d i v i d e n d n o w Separation theorem interpreted for dividends (Figure 18.4) C1 C0

10. Homemade dividends • Investors who want higher dividends sell some shares to get cash. • Those who want lower dividends use high dividends to buy more shares.

11. L o D i v H i D i v v a l u e v a l u e p e r $ 1 p e r $ 1 V * = 1 / Rh V * = 1 / RL E q u i l i b r i u m E q u i l i b r i u m H i D i v L o D i v $ o f o p e r a t i n g c a s h f l o w s Dividend equilibrium ...

12. Dividend smoothing explained • Changing dividend policy does not raise value. It hurts, if anything. • Right now, December 2002, a tax decrease is proposed for dividend income to individuals. The effects are unclear. • A firm that changes dividend policy correctly can potentially increase its value.

13. After the tax code changes • firms raise their value by changing their dividend policy in the right direction.

14. Increased value of old equity More LoDiv firms Cut in capital gains tax rates HiDiv value LoDiv value $ of operating cash flows in the economy

15. Dilemma for a firm • Pay dividends: Shareholders pay extra taxes. • Invest in financial markets: Firm becomes a mutual fund.

16. Solution: use the cash to buy stock • Investors who sell are those who want cash. • Stock price is unaffected … in theory. • Stock price is little affected, in fact.

17. The IRS understands the buyback game. • Stock buyback for tax avoidance is illegal. • Therefore...

18. Excuses, excuses • always another reason for a stock buyback, • usually ... our shares are a good investment • or...we disburse cash to prevent takeover.

19. Summary • Dividend policy is like capital structure. • It probably doesn’t matter. • If it does, it matters because of taxes, and even that is temporary. • In equilibrium, firms cannot increase value by changing capital structure or dividend policy

20. The Costs of Public Offerings Proceeds Direct Costs Underpricing (in millions) SEOs IPOs IPOs 2 - 9.99 13.28% 16.96% 16.36% 10 - 19.99 8.72% 11.63% 9.65% 20 - 39.99 6.93% 9.70% 12.48% 40 - 59.99 5.87% 8.72% 13.65% 60 - 79.99 5.18% 8.20% 11.31% 80 - 99.99 4.73% 7.91% 8.91% 100 - 199.99 4.22% 7.06% 7.16% 200 - 499.99 3.47% 6.53% 5.70% 500 and up 3.15% 5.72% 7.53%

21. What is capital structure? • The division of the value of the firms assets between debt and equity.

22. Worrisome question • When a firm sells debt and rebuys its equity, the new equity is smaller than before. Doesn’t equity therefore lose? • Answer: Old equity got the gains. • That is, shareholders at the time of the restructuring got the gains.

23. The MM Propositions I & II (No Taxes) • P1: Value is unaffected by leverage • P1: VL = VU • P2: Leverage increases the risk and return to stockholders (formula to follow)

24. Proposition II of M-M • rB is the interest rate • rs is the return on levered equity • r0 is the return on unlevered equity • B is value of debt • SL is value of levered equity • rs = r0 + (B / SL) (r0 - rB)

25. MM I with taxes • VU = market value of the unlevered firm • VL = market value of the levered firm • B = market value of bonds • TC = corporate tax rate • result • VL = VU + TC B

26. Short derivation • Each year the tax shield is rBTCB • Value of tax shield is • rBTCB/rB = TCB

27. Effect of tax shield • Increase of equity risk is partly offset by the tax shield • rS = r0 + (1-TC)(r0 - rB)(B/SL) • Leverage raises the required return less because of the tax shield.

28. . rS 0.2351 . rWACC 200 370 MM II and WACC Cost of capital: r(%) . 0.200= r0 . rB 0.100 Debt-to-equityratio (B/S)

29. Channels

30. Value as debt Value as equity D of rich investors D of Institutions V* = 1/Rs V* = 1/Rb as debt as equity Operating C.F.’s of the whole economy Miller: Tax-class clienteles

31. Value as debt Value as equity tax reform increased debt Operating C.F.’s of the whole economy ...

32. Exam review question • A portfolio consists of the risk-free asset and a risky asset A. • The standard deviation of return on A is .1. • Portfolio weights are .5, .5. • What is the standard deviation of the portfolio?