**Section IV. CORPORATE FINANCIAL POLICIES

****PART ONE. CAPITAL STRUCTURE POLICIES

Chapter 32. CAPITAL STRUCTURE AND THE THEORY OF PERFECT CAPITAL MARKETS

Does paradise exist in the world of finance?

The central question of this chapter (and of the following one) is: is there an optimal capital structure? That is to say, is there a “right” combination of equity and debt that allows us to reduce the weighted average cost of capital and therefore to maximise the value of capital employed (enterprise value)?

The reader may be surprised by this question when Chapter 13 showed clearly how return on equity could benefit from the leverage effect. But we have now left the world of accounting in order to enter the universe of finance. Indeed, if we jumped straight to the conclusion, this part of the book could be renamed “the uselessness of the leverage effect in finance”!

Note that we consider the weighted average cost of capital (or cost of capital), denoted k, to be the rate of return required by all the company’s investors either to buy or to hold its securities. It is the company’s cost of financing and the minimum return its investments must generate in the medium term. If not, the company is heading for ruin.

k_D is the rate of return required by the lenders of a given company, k_E is the cost of equity required by the company’s shareholders, and k is the weighted average rate of the two types of financing, equity and net debt (from now on often referred to simply as debt). The weighting reflects the breakdown of the value of equity and the value of debt in enterprise value.

With V_D the market value of net debt and V_E the market value of equity, we get:

or, since the enterprise value is equal to the value of net debt plus equity (EV = V = V_E + V_D):

If, for example, the rate of return required by the company’s creditors is 4%, the corporate tax rate is 25%, the rate of return required by the shareholders is 10% and the value of debt is equal to that of equity, then the return required by all of the company’s sources of funding will be 6.5%.¹ Its weighted average cost of capital is thus 6.5%.

To simplify our calculations and demonstrations in this chapter, we shall assume infinite durations for all debt and investments. This enables us to apply perpetual bond analytics and to assume that the company’s capital structure remains unchanged during the life of the project, income being distributed in full. The assumption of an infinite horizon is just a convention designed to simplify our calculations and demonstrations, but they remain accurate even with more realistic hypotheses.

Section 32.1 THE ENTERPRISE VALUE

While accounting looks at a company by examining its past and focusing on its costs, finance is mainly a projection of the company into the future. Finance reflects not only risk but also – and above all – the value that results from the perception of risk and future returns.

From now on, we will speak constantly of value. As we saw previously, by value we mean the present value of future cash flows discounted at the rate of return required by investors:

equity (E) will be replaced by the value of equity (V_E);
net debt (D) will be replaced by the value of net debt (V_D);
capital employed (CE) will be replaced by enterprise value (EV), or firm value.

As operating assets are financed by equity and net debt (which are accounting concepts), logically, a company’s enterprise value will consist of the market value of net debt and the market value of equity (which are financial concepts). This chapter therefore reasons in terms of:

Enterprise value or firm value (EV)	Value of net debt (V_D)
	Equity value (V_E)

Important: Enterprise value is sometimes confused with equity value. Equity value is the enterprise value remaining for shareholders after creditors have been paid. To avoid confusion, remember that enterprise value is the sum of equity value and net debt value.

Similarly, we will reason not in terms of return on equity, but rather required rate of return, which was discussed in depth in Chapter 19. In other words, the accounting notions of ROCE (return on capital employed), ROE (return on equity) and i (cost of debt), which are based on past observations, will give way to WACC or k (required rate of return on capital employed), k_E(required rate of return on equity) and k_D(required rate of return on net debt), which are the returns required by those investors who are financing the company and who hope to get them.

Section 32.2 DEBT AND EQUITY

The fundamental differences between debt and equity should now be crystal clear.

Debt:
- provides a return for the investor that is independent of the performance of the firm. Except in extreme cases (default, bankruptcy), the lender will earn the interest due (no more, no less) regardless of whether the earnings of the company are excellent, average or bad;
- always has a term, even if remote in time, that is defined contractually. We will not consider for the time being the extremely rare cases of perpetual debts (which are usually only named so when you analyse them more carefully) or a bit more frequent debt with undetermined term;
- is repaid in priority to equity in case of liquidation of the company – the proceeds of the sale of assets will primarily go to lenders, and only if and when lenders have been fully repaid will shareholders receive cash.
Equity:
- yields returns depending on the profitability of the company. Dividends and capital gains will be nil if the results are not good on a long-term basis;
- does not benefit from a repayment commitment. The only exit for equity can be found by selling to a new shareholder, which will take over the role from the previous one;
- in case of bankruptcy is repaid only after all creditors have been fully repaid. Our readers probably know that in most cases the proceeds from liquidation are not sufficient to repay 100% of creditors. Shareholders are then left with nothing as the company is insolvent.

Shareholders fully run the risk of the firm as the cash flows generated by the capital employed (free cash flows to the firm) will first be allocated to lenders; only when they have collected what is due will shareholders be entitled to the remainder.

Given these elements, it becomes natural that the voting rights and therefore the right to choose management lies in the hands of shareholders. Voting rights are only a logical consequence of the first three differences. Shareholders, second to lenders in the collection of cash flows generated by capital employed, run greater risks than the lenders. Lenders are willing to entrust shareholders with power within the company, especially the power to choose the management through voting rights, because they know that it is in the shareholders’ interest to manage the company optimally to maximise its cash flows over time, since the shareholders will only receive a share if the cash flows are sufficient to ensure that the lenders receive what is owed to them first.

The higher the enterprise value, the higher also the equity value. As debt does not run the risk of the firm (except in case of financial distress), its value will largely be independent of the changes in enterprise value. We find here again the concept of leverage, as a small change in enterprise value can have a large impact on equity value.

It should be noted that these two graphs are not on the same scale (the first one on annual cash flows, the second one on values).

Section 32.3 WHAT OUR GREAT-GRANDPARENTS THOUGHT

We shall start by assuming a tax-free environment, both for the company and the investor, in which neither income nor capital gains are taxed. In other words, an illusionary heaven! Concretely, the optimal capital structure is one that minimises k, i.e. that maximises the enterprise value (V). Remember that the enterprise value results from discounting free cash flow at rate k. However, free cash flow is not related to the type of financing. The demonstrations below endeavour to measure and explain changes in k according to the company’s capital structure.

We know that ex-ante debt is always cheaper than equity (k_D < k_E) because it is less risky. Consequently, a moderate increase in debt will help reduce k, since a more expensive resource (equity) is being replaced by a cheaper one (debt). This is the practical application of the preceding formula and the use of leverage.

However, any increase in debt also increases the risk for the shareholder. Markets then demand a higher k_E, the more debt we add in the capital structure. The increase in the expected rate of return on equity cancels out part of the decrease in cost arising on the recourse to debt. The higher the relative share of debt, the greater the risk to shareholders and the more shareholders demand a high rate of return on equity, to the point of cancelling out the positive effect of the use of debt.

At this level of financial leverage the company has achieved the optimal capital structure, ensuring the lowest weighted average cost of capital and thus the highest enterprise value. Should the company continue to take on debt, the resulting gains would no longer offset the higher return required by shareholders.

Moreover, the cost of debt increases after a certain level because it becomes more risky. At this point, not only has the company’s cost of equity increased, but also that of its debt.

According to the traditional approach, an optimal capital structure can be achieved where the weighted average cost of capital is minimal, with some – but not too much – leverage.

In this example, the debt-to-equity ratio that minimises k is 0.45. The optimal capital structure is thus achieved with 45% debt financing and 55% equity financing.

Section 32.4 THE CAPITAL STRUCTURE POLICY IN PERFECT FINANCIAL MARKETS

We shall demonstrate this proposition by means of an example given by Franco Modigliani and Merton Miller (1958), who showed that, in a perfect market and without taxes, the traditional approach is wrong. If there is no optimal capital structure, then the overall cost of equity (k or WACC) remains the same regardless of the firm’s debt policy.

The main assumptions behind the theorem are:

companies can issue only two types of securities: risk-free debt and equity;
financial markets are frictionless;
there is no corporate and personal taxation;
there are no transaction costs;
firms cannot go bankrupt;
insiders and outsiders have the same set of information.

According to Modigliani and Miller, investors can take on debt just like companies. So, in a perfect market, they have no reason to pay companies to do something they can handle themselves at no cost.

Imagine two companies that are completely identical except for their capital structure. The value of their respective debt and equity differs, but the sum of both, i.e. the enterprise value of each company, is the same. If the reverse were true, equilibrium would be restored by arbitrage.

We shall demonstrate this using the examples of Companies X and Y, which are identical except that X is unlevered and Y carries debt of 80,000 at 5%. If the traditional approach were correct, Y’s weighted average cost of capital would be lower than that of X and its enterprise value higher. This can be seen in the following table:

	Company X	Company Y
Operating profit: EBIT	20,000	20,000
Interest expense (at 5%): IE	0	4,000
Net profit: NP	20,000	16,000
Dividend: DIV = NP²	20,000	16,000
Cost of equity: k_E	10%	12%
Equity value: V_E = DIV/k_E	200,000	133,333
Debt value: V_D = IE/k_D	0	80,000
Enterprise value: V = V_E + V_D	200,000	213,333
Weighted average cost of capital: k = EBIT/V³	10%	9.4%
Gearing: V_D/V_E	0%	60%

Y’s cost of equity (12%) is higher than that of X (10%), since Y’s shareholders bear both the operating risk and that of the capital structure (debt), whereas X’s shareholders incur only the same operating risk. As a matter of fact, the operating risk of X is the same as that of Y, as X and Y are identical but for their capital structures.

Modigliani and Miller demonstrated that Y’s shareholders can achieve a higher return on their investment by buying shares of X, at no greater risk.

Thus, if a shareholder holding 1% of Y shares (equal to 1,333) wants to obtain a better return on their investment, they must:

sell their Y shares for 1,333…
… replicate Y’s debt/equity structure by borrowing money for 60% of the equity value, in proportion to their 1% stake; that is, borrow 1,333 × 60% = 800, at 5% …
… invest all this (800 + 1,333 = 2,133) in X shares.

The shareholder’s risk exposure is the same as before the operation: they are still exposed to operating risk, which is the same on X and Y, as well as to financial risk, since their exposure to Y’s debt has been transferred to their personal borrowing for the same amount (1% of 80,000 or 800). The situations are therefore financially equivalent. Previously, the shareholder of Y was not indebted in their personal capacity and was a shareholder of a company Y with a financial leverage of 60%. Now they have a personal leverage of 60% (800 / 1,333) but is a shareholder of a company X without debt.

Formerly, the investor received annual dividends of 160 from Company Y (12% × 1,333 or 1% of 16,000). Now, their net income on the same investment will be:

They are now earning 173 every year instead of the former 160, on the same personal amount invested and with the same level of risk.

Y’s shareholders will thus sell their Y shares to invest in X shares, reducing the value of Y’s equity and increasing that of X. This arbitrage will cease as soon as the enterprise values of the two companies come into line again.

It can be seen that as k_D increases, the rate of progression of k_E slows down, so that k remains constant.

This relieves the shareholders of part of the company’s risk, which is transferred to the creditors as soon as the amount of the debt becomes significant (see Chapter 34):

V_D/V	0	0.1	0.2	0.3	0.4	0.5	0.6	0.7	0.8	0.9
k_D	3%	3.1%	3.2%	3.4%	3.7%	4.2%	5.0%	6.2%	7.5%	8.8%
k_E	10%	10.8%	11.7%	12.8%	14.2%	15.7%	17.4%	18.7%	19.8%	20.3%
k	10.0%	10.0%	10.0%	10.0%	10.0%	10.0%	10.0%	10.0%	10.0%	10.0%

In an efficient market, the increase in expected profitability due to the leverage of debt and the increase in risk offset each other, so that the share value remains the same.

Investing in a leveraged company is neither more expensive nor cheaper than investing in a company without debt; in other words, the investor should not pay twice, first when buying shares at enterprise value and then to reimburse the debt. The value of the debt is deducted from the value of the capital employed to obtain the price paid for the equity.

While obvious, this principle is frequently forgotten. And yet it should be easy to remember: the value of an asset, be it a factory, a painting, a subsidiary or a house, is the same regardless of whether it was financed by debt, equity or a combination of the two. As Merton Miller explained when receiving the Nobel Prize for Economics, “it is the size of the pizza that matters, not how many slices it is cut up into”.

Or, to restate this: the weighted average cost of capital does not depend on the sources of financing. True, it is the weighted average of the rates of return required by the various providers of funds, but this average is independent of its different components, which adjust to any changes in the financial structure. Increasing indebtedness (i.e. a resource with a low cost) seems a priori to lower the cost of capital. But this is forgetting that increasing debt will increase its cost, automatically inducing additional leverage, therefore an increase in risk for shareholders. This increase in the risk that they bear will mechanically translate into an increase in the rate of return that they demand on equity and finally into a constancy of the global company’s cost of financing.

In Chapter 33 we will deepen this analysis by integrating into our reasoning parameters that have been neglected until now (taxation, interests, bankruptcy costs) which will show that the choice of a financial structure is more complicated than what we have just seen, without however calling into question the conclusion of this chapter.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Is there such a thing as an optimal capital structure, i.e. a way of splitting the financing of operating assets between debt and equity which would enhance the value of the operating assets and minimise the company’s cost of capital? This is the central question that this chapter attempts to answer.

The real-world camp says yes, but without being able to prove it, or to set an ideal level of net debt and equity.

Modigliani and Miller said no in 1958, and showed how, if it were so, there would be arbitrages that re-established the balance.

For an investor with a perfectly diversified portfolio, and in a tax-free universe, there is no optimal capital structure. The following rules can be formed on the basis of the above:

if no taxes are levied, value cannot be instantly created by the choice of a “good” capital structure;
Selling a given company in shares only, or in a whole range of different securities (shares, debt, hybrid shares), will not change the value of its operating assets;
the debt leverage effect on accounting returns is an illusion. The cost of capital is linked to the company’s assets and is independent from the method of financing.

But a world without taxes is a Utopia, which is why the next chapter brings tax and other “distortions” into the equation.

QUESTIONS

1/Why is the cost of equity for a company with no debt equal to the average weighted cost of capital?
2/What is the cost of capital equal to?
3/What are the two risks incurred for a shareholder of an indebted company?
4/Of the following decisions, which one is the most important: An investment decision? A financing decision? Why?
5/Explain what impact an increase in debt will have on the β of shares.
6/What are Modigliani and Miller’s theories based on?
7/The fact that shareholders’ expected returns rise with the level of debt does not run contrary to the approach taken by Modigliani and Miller. Why?
8/Is the cost of capital an accounting or financial concept?
9/Why can it be dangerous to use a spreadsheet to create simulations of the cost of capital?
10/Can a company create value by going into debt?
11/What is the cost of the net debt of a company that has no more shareholders’ equity? And the cost of capital?
12/What are we forgetting when we say that by increasing return on equity, the leverage effect of debt cannot increase value?
13/True or false? “By reducing financial leverage, we reduce the cost of debt and the cost of equity and, accordingly, the weighted average cost of capital?” Why?
14/True or false? “The more debt we incur, the higher the interest rate we are charged. Our shareholders also require a higher return. So, if we want a low cost of capital, we have to have a low level of debt.” Why?
15/What type of investors engage in the arbitrations described by Modigliani and Miller?
You’ll find more questions at www.vernimmen.com.

EXERCISES

1/60% of Company A’s needs are equity-financed at a cost of 9%, and 40% are debt-financed at 5%. Excluding tax, what is the weighted average cost of capital of this company?
2/In a tax-free world, Companies B and C are similar in every respect, except for their capital structures. B has no debts while C has debts of 24,000 at 5%. The companies have been valued as follows:
Company B Company C
Operating income 10,000 10,000
Financial expense 0 1,200
Net income 10,000 8,800
k_E 8% 11%
V_E 125,000 80,000
V_D 0 24,000
V 125,000 104,000
k 8% 9.62%
V_D/(V_E + V_D) 0% 23%
Payout 100% 100%
You own 1% of Company B’s shares. How much will you receive every year? Show how you can increase this amount without altering the amount of your investment or increasing the level of risk.
When will arbitrage cease? What will the P/E be for Companies B and C?
3/A company with no debts has a weighted average cost of capital of 8%.
1. What is the cost of equity for this company?
2. It decides to borrow 33.3% of the value of its operating assets at a rate of 5% in order to finance a share buy-back of the same amount. What is the cost of equity now?
3. If the market risk premium is 4% and the β of the company’s shares before it went into debt was 1.2, what is the new β of shares after the capital reduction?
4. Why does the formula of Section 29.2, 1/, not allow you to find the previous result?
5. What is the β of the debt if the β of the capital employed is equal to the average β of the equity and the β of the debt weighted by the relative share of debt and equity in financing the capital employed?
4/Deutsche Telekom and Orange have a similar economic risk. The beta of Orange shares is 0.67, and it is 0.8 for Deutsche Telekom. If the risk-free rate is 3% and the equity risk premium is 9%, what are the shareholders’ required returns? If the net debt/shareholders’ equity ratio is 1 in value for Orange, what is it for Deutsche Telekom, which has a cost of debt of 5.4% compared with 5% for Orange (imagine that this is a tax-free world)?

ANSWERS

Questions

1/Because shareholders’ equity alone bears the risk of operating assets.
2/The average weighted by the values of the cost of equity and the cost of net debt.
3/The risk of operating assets and the risk of capital structure.
4/Investment, because it is easier to create value by making a good investment, and we learnt in this chapter that there is no such thing as good financing as for value creation.
5/Debt capital, by increasing the risk of shares, increases their β.
6/Arbitrage.
7/Because the risk also increases.
8/Financial, because only market values (rates and values) come into the calculation of the cost of capital, it corresponds to the return required by investors and not to accounting returns of the firm.
9/Because by modifying the relative weights of debt/shareholders’ equity, we often forget that the cost of shareholders’ equity and debt depends on this relative weight, and that they are not constant, no matter what the capital structure.
10/No, this would be too good to be true and all companies would have huge debts, which is far from the reality.
11/It is equal to the cost of shareholders’ equity of a debt-free company in the same sector as lenders have become shareholders in practice. Ditto.
12/The risk of shareholders’ equity increases and accordingly the returns required by shareholders increases at the same time which compensate the increase in actual returns. Overall it is neutral on value.
13/False, by reducing leverage, an “expensive” resource (shareholders’ equity, the cost of which is reduced) replaces a “cheap” resource (debt, the cost of which is reduced). In sum, the weighted average cost of capital remains constant.
14/False, the company is replacing an “expensive” resource (shareholders’ equity) with a “cheap” resource (debt) even though the cost will rise. In sum, the weighted average cost of capital remains constant.
15/Typically hedge funds, which can easily go into debt.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/k = 60% × 9% + 40% × 5% = 7.4%.
2/A shareholder of 1% of Company B will receive the following sum every year: 1% × 125,000 × 8% = 100. They sell their shares in Company B and buy shares in Company C. However, because the company is indebted, as a shareholder they carry a higher risk than before. If they want to keep the same level of risk, they must put an equivalent amount into the debt underlying the shares they have bought in Company C. Accordingly, if n is the percentage of 1,250 paid for the shares in Company C, n × 23.1% = 1 − n. The solution to this equation is n = 1 / (1 + 23.1%) = 81%. Or, for assets totalling 1,250: 19% is lent at 5% and 81% is invested in Company C shares. Which is an income of 19% × 1,250 × 5% + 81% × 1,250 × 11% = 123, more than the initial income of 100. Arbitrage will cease when the value of the capital employed of Companies B and C is equal, for example 111,400, which gives an equity value for Company C of 114,000 – 24,000 = 90,000 and a P/E of 10.2 for Company C and 11.4 for Company B.
3/(a) k_E = 8%. (b) k_E = (8% − 5% × 33.3%) / 66.7% = 9.5%. (c) Subtracting the equation of cost of equity with and without debt allows to deduce that β = 1.57. (d) As debt is not negligible, being one third of the enterprise value (e) β_D = 0.45.
4/DT: k_E = 3% + 0.8% × 9 = 10.2%; Orange: k_E = 9%; V_D/V_E = 2.

BIBLIOGRAPHY

NOTES

1 4% × (1 − 25%) × 50/100 + 10% × 50/100 = 6.5%.
2 To simplify calculations, the payout ratio is 100%.
3 To simplify calculations, we adopt an infinite horizon with constant flows.
4 It is not absurd to think that the interest rate will be the same as before, especially if we speculate that firm X’s shares held by the investor are given to the lending bank as collateral.

Chapter 33. CAPITAL STRUCTURE, TAXES AND ORGANISATION THEORIES

There’s no gain without pain

In the previous chapter we saw that the value of a firm is the same whether or not it has taken on debt. True, shareholders will pay less for the shares of a levered company, but they will have to pay back the debt (or buy it, which amounts to the same thing) before obtaining access to the enterprise value. In the end, they will have paid, directly or indirectly, the same amount (value of equity plus repayment of net debt¹); that is, the enterprise value.

Now, what about the financial manager who must issue securities to finance the creation of enterprise value? It does not matter whether they issue only shares or a combination of bonds and shares, since again the proceeds will be the same – the enterprise value.

Enterprise value depends on future flows and how the related, non-diversifiable risks are perceived by the market.

But if that is the case, why diversify sources of financing? The preceding theory is certainly elegant, but it cannot fully explain how things actually work in real life.

In this chapter we look at two basic explanations of real-life happenings. First of all, within the same market logic, biases occur which may explain why companies borrow funds, and why they stop at a certain level. The fundamental factors from which these biases spring are taxes and financial distress costs. Their joint analysis will give birth to the “trade-off model”.

There are features of debt that can modify the optimal capital structure. Trade-off models generally limit their attention to the pros and cons of tax shields and financial distress costs. We believe that the elements of the balance are more numerous than just these factors. Other factors may also be added:

information asymmetries;
disciplining role of debt;
financial flexibility;
agency costs;
signalling aspects.

Maybe the main reasons for the interference between capital structure and investment are the divergent interests of the various financial partners regarding value creation and their differing levels of access to information. This lies at the core of the manager/shareholder relationship we shall examine in this chapter. A full chapter (Chapter 34) is devoted to an analysis of the capital structure resulting from a compromise between creditors and shareholders.

Section 33.1 THE BENEFITS OF DEBT OR THE TRADE-OFF MODEL

1/ CORPORATE INCOME TAXES

Up to now, our reasoning was based on a tax-free world, which of course does not exist. The investor’s net return can be two to five times (or more) lower than the pre-tax cash flows of an industrial investment.

It would therefore be foolhardy to ignore taxation, which forces financial managers to devote a considerable amount of their time to tax optimisation.

But we ought not go to the other extreme and concentrate solely on tax variables. All too many decisions based entirely on tax considerations lead to ridiculous outcomes, such as insufficient earnings capacity or a change in fiscal regulations. Tax deficits alone are no reason to buy a company!

In 1963, Modigliani and Miller pushed their initial demonstration further, but this time they factored in corporate income tax (but no other taxes) in an economy in which companies’ financial expenses are tax-deductible, but not dividends. This is pretty much the case in most countries.

The conclusion was unmistakable: once you factor in corporate income tax, there is more incentive to use debt rather than equity financing.

Interest expenses can be deducted from the company’s tax base, so that creditors receive their coupon payments before they have been taxed. Dividends, on the other hand, are not deductible and are paid to shareholders after taxation.

Thus, a debt-free company with equity financing of 100, on which shareholders require a 7.5% return, will have to generate profit of at least 10.4 in order to provide the required return of 7.5 after 28% tax.

If, however, its financing is equally divided between debt at 4% interest and equity, a profit of 9.6 will be enough to satisfy shareholders despite the premium for the greater risk to shares created by the debt (i.e. 11%).

Allowing interest expenses to be deducted from companies’ tax base is a kind of subsidy the state grants to companies with debt. But to benefit from this tax shield, the company must generate a profit.

A company that continually resorts to debt will benefit from tax savings that must be factored into its enterprise value.

Take, for example, a company with an enterprise value of 100, of which 50 is financed by equity and 50 by perpetual debt at 4%. Interest expenses will be 2 each year. Assuming a 28% tax rate and an operating profit of more than 2 regardless of the year under review (an amount sufficient to benefit from the tax savings), the tax savings will be 28% × 2, or 0.56 for each year. The present value of this perpetual bond increases shareholders’ wealth by 0.56 / 14.5% = 3.9 if 14.5% is the cost of equity. Taking the tax savings into account increases the value of equity by 8% to 53.9 (50 + 3.9).

TAX SAVINGS AS A PERCENTAGE OF EQUITY

		Maturity of debt
V_D/V	k_E	5 years	10 years	Perpetuity
0%	7.5%²	0%	0%	0%
25%	9.8%	1%	2%	4%
33%	10.9%	2%	3%	5%
50%	14.5%	4%	6%	8%
66%	21.1%	6%	9%	10%

The value of a levered company is equal to what it would be without the debt, plus the amount of savings generated by the tax shield.³

The question now is what discount rate should be applied to the tax savings generated by the deductibility of interest expense? Should we use the cost of debt, as Modigliani and Miller did in their article in 1963, the weighted average cost of capital or the cost of equity?

Using the cost of debt is justified if we are certain that the tax savings are permanent. In addition, this allows us to use a particularly simple formula:

Nevertheless, there are good reasons to prefer to discount the savings at the cost of equity, since it would be difficult to assume that the company will continually carry the same debt, generate profits and be taxed at the same rate. As the tax savings accrue to the shareholders, so should it be reasonable to discount them at the rate of return required by those shareholders.

Bear in mind that these tax savings only apply if the company has sufficient earnings power and does not benefit from any other tax exemptions, such as tax-loss carryforwards.

2/ COSTS OF FINANCIAL DISTRESS

We have seen that the more debt a firm carries, the greater the risk that it will not be able to meet its commitments. If the worst comes to the worst, the company files for bankruptcy, which in the final analysis simply means that assets are reallocated to more profitable ventures.

For investors with a well-diversified portfolio, the cost of the bankruptcy will theoretically be nil, since when a company is discontinued, its assets (market share, customers, factories, etc.) are taken over by others who will manage them better. One person’s loss is another person’s gain! If the investor has a diversified portfolio, the capital losses will be offset by other capital gains.

In practice, however, markets are not perfect and we all know that even if bankruptcies are a means of reallocating resources, they carry a very real cost to those involved. These include:

Direct costs: redundancy payments, legal fees, administrative costs, shareholders’ efforts to receive a liquidation dividend.
Indirect costs: order cancellations (for fear they will not be honoured), less trade credit (because it may not be repaid), reduced productivity (strikes, underutilisation of production capacity), no more access to financing (even for profitable projects); as well as incalculable human costs.

One could say that bankruptcy occurs when shareholders refuse to inject more funds once they have concluded that their initial investment is lost. In essence, they are handing the company over to its creditors, who then become the new shareholders. The creditors bear all the costs of the malfunctioning company, thus further reducing their chances of getting repaid.

Even without going to the extremes of bankruptcy, a highly levered company in financial distress faces certain dysfunctions that reduce its value. It may have to cut back on R&D expenditure, maintenance, training or marketing expenses in order to meet its debt payments and will find it increasingly difficult to raise new funding, even for profitable investment projects.

After factoring all these costs into the equation, we can say that:

or, as illustrated by the following figure:

Because of the tax deduction, debt can, in fact, create value. A levered company may be worth more than if it had only equity financing. However, there are two good reasons why this advantage should not be overstated. Firstly, when a company with excessive debt is in financial distress, its tax advantage disappears, since it no longer generates sufficient profits. Secondly, the high debt level may lead to restructuring costs and lost investment opportunities if financing is no longer available. As a result, debt should not exceed a certain level.

In 2000, Graham found that the value of the tax advantage of interest expenses is around 9.7%, and it goes down to 4.3% if personal taxation of investors is also considered. Almeida and Philippon (2007) have, on the other hand, estimated the bankruptcy costs; they believe the right percentage is around 4.5% – in brief, it seems that one effect “perfectly” compensates the other. More recent works quoted in the bibliography found similar results.

In fact, Modigliani and Miller’s theory states the obvious: all economic players want to reduce their tax charge! A word of caution, however. Corporate managers who focus too narrowly on reducing tax charges may end up making the wrong decisions.

3/ INTRODUCING PERSONAL TAXES, A MAJOR IMPROVEMENT TO THE PREVIOUS REASONING

In 1977, Miller released a new study in which he revisited the observation made with Modigliani in 1958 that there is no one optimal capital structure. This time, however, he factored in both corporate and personal taxes.

Miller claimed that the taxes paid by investors can cancel out those paid by companies. This would mean that the value of the firm would remain the same regardless of the type of financing used. Again, there should be no optimal capital structure.

Miller based his argument on the assumption that equity income is not taxed, and that the tax rate on interest income is marginally equal to the corporate tax rate. In other words, the tax advantage of debt at the level of the company is neutralised by the tax advantage of equity at the level of the investor.

Who benefits from taxation? No research has shown that the tax advantage of debt is not shared equally between creditor and debtor. In recent years, tax reforms have led to the disappearance of tax friction and thus the debt advantage is tending to disappear. For certain types of investors, there is therefore no longer any tax friction when collecting their income, which is fundamental.

Say a company has an enterprise value of 1,000. Regardless of its type of financing, investors require a 7.5% return after corporate and personal income taxes. Bear in mind that this rate is not comparable with that determined by the CAPM (r _F + β × (r _M − r _F)), which is calculated before personal taxation.

Let’s take a country where (realistically) the main tax rates are:

corporate tax: 28.4%;
tax on dividends: 17.2%;
tax on interest income: 30%.

Now let us assume that the company has an operating profit of 135. This corresponds to a cost of equity of 8% if it is entirely equity-financed.

Enterprise value	1,000	1,000	1,000	1,000
Equity	1,000	750	500	250
Debt	0	250	500	750
Interest rate		2.0%	3.0%	5.0%
Operating profit	135	135	135	135
− Interest expense	0	5	15	37.5
= Pre-tax profit	135	130	120	98
− Corporate income tax at 28.4%	38	37	34	28
= Net profit	97	93	86	70
Dividend	97	93	86	70
Personal income tax:
On dividends (17.2%)	17	16	15	12
On interest (30%)	0	2	5	11
Shareholders’ net income	80	77	71	58
Shareholders’ net return	8%	10.3%	14.2%	23.1%
Creditors’ net income	0	4	11	26
Creditors’ net return		1.4%	2.1%	3.5%
Net income for investors	80	81	82	84
Total taxes	55	54	53	51

The net return of the investor, who is both shareholder and creditor of the firm, can be calculated depending on whether net debt represents 0%, 33.3%, 100% or three times the amount of equity.

The value created by debt must thus be measured in terms of the increase in net income for investors (shareholders and creditors). Our example shows that flows do not increase significantly even when the debt level is particularly high.

Using the table below, we can even see that in certain countries, such as the UK, the tax savings on corporate debt are more than offset by the personal taxes levied.

TAX RATES IN VARIOUS COUNTRIES (%)

Country	On dividends	On capital gains	On interests	On corporate earnings
France	17.2%	17.2%	30%	28.41%
Germany	26.4%	26.4%	26.4%	30%–33%
Italy	26%	26%	12.5% or 26%	27.9%
Côte d’Ivoire	10% or 15%	0%	13.5% or 18%	25%
Lebanon	10%	15%	10%	17%
Morocco	10%	15% (listed) – 20%	30%	10%, 20% and 31%
Spain	19% to 26%	19% to 26%	19% to 26%	25%
Switzerland	19% to 41%	0%	19 to 41%	11.5%–24.2%
Tunisia	10%	10%	0 to 35% (income tax)	10%, 15% or 35%
UK	0%, 7.5%–32.5% or 38.1%	10% or 20%	0%, 20%, 40% or 45%	21%
US	Income tax or 0% to 20%	0 to 20%	37% (income tax)	27%

Bear in mind, too, that companies do not always use the tax advantages of debt since there are other options, such as accelerated depreciation, provisions, etc.

4/ LIMITS TO THE DEDUCTIBILITY OF INTEREST AND NOTIONAL INTEREST, THE THIRD LIMIT

In a certain number of jurisdictions, governments have introduced mechanisms to rebalance taxation of revenues from capital gains and debt.

These measures can take the form of a limitation of the deductibility of interest. For example in Belgium, France, Germany, Italy, Spain, the UK and USA, interest is deductible only up to 30% of EBITDA.

In some countries, to make equity financing more attractive, firms can deduct notional interest computed on equity from taxable income. This is the case in Belgium, Brazil and Italy.

Section 33.2 DEBT TO CONTROL MANAGEMENT

Now let’s use the agency theory concepts on our first financial question: the analysis of the capital structure.

1/ DEBT AS A MEANS OF CONTROLLING CORPORATE MANAGERS

Now let us examine the interests of non-shareholder executives. They may be tempted to shun debt in order to avoid the corresponding constraints, such as a higher breakeven threshold, interest payments and principal repayments. Corporate managers are highly risk averse and their natural inclination is to accumulate cash rather than resort to debt to finance investments. Debt financing avoids this trap, since the debt repayment prevents surplus cash from accumulating.

Shareholders encourage debt as well, because it stimulates performance. The more debt a company has, the higher its risk. In the event of financial difficulties, corporate executives may lose their jobs and the attendant compensation package and remuneration in kind. This threat is considered to be sufficiently dissuasive to encourage sound management, generating optimal liquidity to service the debt and engage in profitable investments.

Shareholders are keen to leverage the firm as debt is an efficient tool to put managers under pressure and hence solve agency issues.

Given that the parameters of debt are reflected in a company’s cash situation while equity financing translates into capital gains or losses at shareholder level, management will be particularly intent on the success of its debt-financed investment projects. This is another, indirect, limitation of the perfect markets theory: since the various forms of financing do not offer the same incentives to corporate executives, financing does indeed influence the choice of investment.

This would indicate that a levered company is more flexible and responsive than an unlevered company. This hypothesis was tested and proven by Ofek, who showed that the more debt they carry, the faster listed US companies react to a crisis, by filing for bankruptcy, curtailing dividend payouts or reducing the payroll.

Debt is thus an internal means of controlling management preferred by shareholders. In Chapter 45 we shall see that another is the threat of a takeover bid.

However, the use of debt has its limits. When a group’s corporate structure becomes totally unbalanced, debt no longer acts as an incentive for management. On the contrary, the corporate manager will be tempted to continue expanding via debt until the group has become too big to fail, like RBS, Fortis, AIG, Citi, etc., until the concept of “too big to fail” is tested (Lehman Brothers). This risk is called “moral hazard”.

2/ LBOS: THIS LOGIC PUSHED TO THE EXTREME

An LBO (or Leveraged Buy-Out, see Chapter 47) is the acquisition, generally by management (MBO), of all of a company’s shares using largely borrowed funds. It becomes a leveraged buildup if it then uses debt to buy other companies in order to increase its standing in the sector. It is generally thought that the purpose of the funds devoted to LBOs is to use accounting leverage to obtain better returns. In fact, the success of LBOs cannot be attributed to accounting leverage, since we have already seen that this alone does not create value.

The real reason for the success of LBOs is that, when it has a stake in the company, management is far more committed to making the company a success. With management most often holding a share of the equity, resource allocation will be designed to benefit shareholders. Executives have a two-fold incentive: to enhance their existing or future stake in the capital and to safeguard their jobs and reputation by ensuring that the company does not go broke. It thus becomes a classic case of the carrot and the stick!

Mature, highly profitable companies with few investments to make are the most likely candidates for an LBO. Jensen (1986) demonstrated that, in the absence of heavy debt, the executives of such companies will be strongly tempted to use the substantial free cash flow to grow to the detriment of profits by overinvesting or diversifying into other businesses, two strategies that destroy value.

Section 33.3 SIGNALLING AND DEBT POLICY

Signalling theory is based on the strong assumption that corporate managers are better informed about their companies than the suppliers of funding. This means that they are in a better position to foresee the company’s future flows and know what state their company is in. Consequently, any signal they send indicating that flows will be better than expected, or that risks will be lower, may enable the investor to create value. Investors are therefore constantly on the watch for such signals. But for the signals to be credible, there must be a penalty for the wrong signals in order to dissuade companies from deliberately misleading the market.

In the context of information asymmetry, markets would not understand why a corporate manager would borrow to undertake a very risky and unprofitable venture. After all, if the venture fails, they risk losing their job or worse, if the venture causes the company to fail. So debt is a strong signal for profitability, but even more for risk. It is unlikely that a CEO would resort to debt financing if they knew that in a worst-case scenario they would not be able to repay the debt.

Ross (1977) has demonstrated that any change in financing policy changes investors’ perception of the company and is therefore a market signal.

It is thus obvious that an increase in debt increases the risk on equity. The managers of a company that has raised its gearing rate are, in effect, signalling to the markets that they are aware of the state of nature, that it is favourable and that they are confident that the company’s performance will allow them to pay the additional financial expenses and pay back the new debt.

This signal carries its own penalty if it is wrong. If the signal is false, i.e. if the company’s actual prospects are not good at all, the extra debt will create financial difficulties that will ultimately lead, in one form or another, to the dismissal of its executives. In this scheme, managers have a strong incentive to send the correct signal by ensuring that the firm’s debt corresponds to their understanding of its repayment capacity.

Ross has shown that, assuming managers have privileged information about their own company, they will send the correct signal on the condition that the marginal gain derived from an incorrect signal is lower than the sanction suffered if the company is liquidated. “They put their money where their mouths are.” This explains why debt policies vary from one company to another: they simply reflect the variable prospects of the individual companies.

When a company announces a capital increase, research has shown that its share price generally drops by an average of 3%. The market reasons that corporate managers would not increase capital if, based on the inside information available to them, they thought it was undervalued, since this would dilute the existing shareholdings in unfavourable conditions. If there is no pressing reason for the capital increase, investors will infer that, based on their inside information, the managers consider the share price to be too high and that this is why the existing shareholders have accepted the capital increase. On the other hand, research has shown too that the announcement of a bond issue has no material impact on share prices.

This explains why financial investors prefer to subscribe to capital increases rather than buy from existing shareholders. It is also the reason why in most countries, top managers and all directors must disclose the number of shares they hold or control in the companies they work for or of which they are board members.

Section 33.4 INFORMATION ASYMMETRIES AND THE PECKING ORDER THEORY

Having established that information asymmetry carries a cost, our next task is to determine what type of financing carries the lowest cost in this respect.

The uncontested champion is, of course, internal financing, which requires no special procedures. Its advantage is simplicity.

Debt comes next, but only low-risk debt with plenty of guarantees (pledges) and covenants restricting the risk to creditors and thus making it more palatable to them. This is followed by riskier forms of debt and hybrid securities.

Capital increases come last, because they are automatically interpreted as a negative signal. To counter this, the information asymmetry must be reduced by means of roadshows, one-to-one meetings, prospectuses and advertising campaigns. Investors have to be persuaded that the issue offers good value for money!

In an article published in 1984, Myers elaborates on a theory initially put forward by Donaldson in 1961, stating that, according to this pecking order theory, companies prioritise their sources of financing.

As can be seen, although corporate managers do not choose the type of financing arbitrarily, they do so without great enthusiasm, since they all carry the same cost relative to their risk. The pecking order is determined by the law of least effort. Managers do not have to “raise” internal financing, and they will always endeavour to limit intermediation costs, which are the highest on share issues.

This theory explains fairly well the situation of highly profitable listed companies with little debt because they are almost exclusively self-financing, or that of SMEs which only increase their capital when their debt capacity is saturated.

In Chapter 34 we will see how potential or actual conflicts of interest between shareholders and lenders due to the financial structure of the company can be analysed and resolved through options.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

In this chapter we went beyond the simplified structure of perfect markets, and looked at a number of different factors (tax, bankruptcy costs, information asymmetry, conflicts of interest) which make analysis more complex, but also more relevant.

Modigliani and Miller demonstrated how, when corporate tax is included in the equation (financial expenses are tax-deductible whereas dividends are not), debt financing becomes an attractive option. The value of a levered company is equal to what it would be without the debt, plus the present value of savings generated by the tax shield.

There are, however, two major drawbacks to this approach. Firstly, the higher a company’s debts, the greater the probability of bankruptcy costs, whether direct or indirect. Secondly, if the personal tax situation of the investor is taken into account, this offsets the tax shield that debt enjoys at a corporate level. For individual taxpayers, the tax breaks on income on equity are better than they are for debt.

All in all, recent research shows that the costs of bankruptcy and personal taxation offset the tax advantage of debt at the corporate level. Taxation therefore does not explain capital structure.

Agency theory analyses debt as an internal means of controlling management, which has to work hard to ensure that debt repayments are met. For a mature company making healthy profits but without major growth prospects, incurring large debts is a way of discouraging managers from spending cash on risky diversification projects or rash expansion projects, which both destroy value. The LBO, an innovation of the 1980s, is what has come out of this theory. LBOs create value, not on the basis of the accounting illusion of the leverage effect, but thanks to the high motivation of managers who are under pressure to repay debts, and who have a financial incentive to work harder as a result of the potentially very lucrative profit-sharing schemes that have been set up.

Problems stemming from information asymmetry between shareholders and investors have an obvious impact on the choice of capital structure. Managers believing that their companies are undervalued would prefer to increase debt levels rather than to issue new shares at a low price, and possibly carry out a capital increase once the share price has gone up. Similarly, a decision to use debt finance for a project is a sign of management’s confidence in its ability to service the debt and an indirect sign that the project is likely to be profitable.

Pushing the information asymmetry problem to the limit brings us to the pecking order theory, which holds that managers choose sources of financing on the basis of the amount of intermediation costs and agency costs: cash flow, debt and only then a capital increase.

This takes us a long way from the simplistic assumptions made in the first models designed by Modigliani and Miller!

QUESTIONS

1/According to the approach by Modigliani and Miller (1963), how does the value of a levered company differ from the value of an unlevered company?
2/What are the two drawbacks to Modigliani and Miller’s 1963 theory?
3/What is Miller’s 1977 theory based on and what conclusions does he draw?
4/Describe the tax breaks for debt financing and for equity financing.
5/What are the latest tax trends with regard to sources of financing?
6/What is the value of a levered company when there is a strong likelihood that it will file for bankruptcy?
7/What is your view of the following statement: “X went bankrupt because its financial expenses amounted to 13% of its sales”?
8/Why do managers tend to be wary of debt?
9/Why is it a good thing for a highly profitable company that has reached maturity to carry a lot of debt?
10/From 1990 to 2021, interest rates in Europe were generally revised downwards. If Modigliani and Miller’s 1963 theory was right, should debt levels of companies have increased or decreased? Debt levels actually fell. State your views.
11/According to signal theory, should undervalued companies carry more or less debt than other companies? Why?
12/If Modigliani and Miller’s 1963 theory had been right, how much corporate income tax would the state have collected every year?
13/In your view, after a failed takeover bid, will the debt-to-equity ratio of the target tend to rise or fall? Why?
14/In your view, can the theories of capital structure described in this chapter be proven with as much certainty as, say, the put/call parity described in Chapter 23 that deals with options? Why?
15/Is it better to calculate a leverage ratio on the basis of book values or market values of debt and equity to assess the level of risk taken by a company? Why?
16/Does the pecking order theory imply that the company has an optimal capital structure? What are the criteria for determining capital structure according to this approach?
17/If there was an optimal debt-to-equity ratio, should it be stable over time? Why?
18/An LBO fund is prepared to pay 3,000 for operating assets if the financing is split equally between debt and equity, and 3,500 if the split is 75% debt and 25% equity. State your views.
More questions are waiting for you at www.vernimmen.com.

EXERCISES

1/70% of Company A’s needs are equity-financed at a cost of 10% and 30% debt-financed at 6%. What is the weighted average cost of capital of this company if the tax rate is 20%, 50% and 80%?
2/A company is totally financed by equity capital for a market value of 200m. The only tax it has to pay is corporate income tax at a rate of 30%. Calculate the value of this company if it borrows 50m at 6% to perpetuity, to be used to repay a part of shareholders’ equity. Shareholders would then require an 11% return.
3/Company C is financed by equity with a market value of 40 and by debt with a market value of 30. This debt is perpetual and its interest rate is 6%. The corporate income tax rate is 30%.
1. How much of C’s enterprise value is due to debt? The shareholders’ required rate of return is 11%.
2. By how much will the enterprise value increase if the company borrows 5 on the same terms as previously (assume a required rate of return of 11% to simplify calculations)?
3. By how much will the enterprise value fall if there is a change in the tax laws and in four years’ time financial expenses will no longer be tax-deductible?
4/Redo the table on page 611 for Côte d’Ivoire and the USA assuming two situations: no debt and 500 of debt at 7%. Assume the investor and the firm are taxed in the highest bracket of the tax scale.

ANSWERS

Questions

1/Difference: present value of tax savings due to the fact that financial expenses are tax-deductible.
2/The cost of bankruptcy and individual income tax.
3/The individual tax payable by the investor cancels out the impact of the corporate tax payable. Conclusion: no optimal capital structure.
4/Financial expenses are tax-deductible. Tax credit.
5/More favourable treatment for equity due to the drop in the corporate income tax rate, and heavier taxes on debt income for creditors.
6/Value of unlevered company + present value of tax saving – present value of cost of filing for bankruptcy.
7/This line of reasoning is false. A company goes bankrupt because its present and expected profits are inadequate compared with its risk, and not because it is carrying too much debt. If it is carrying too much debt, this is because its profits are too low, and not the other way round.
8/Because by increasing the risk to which their companies are exposed, they increase their chances of losing their jobs.
9/Because it can avoid using its free cash flows, it will not destroy value by diversifying or making unprofitable investments.
10/Debt levels should have risen to set off the drop in interest rates so that tax-deductible financial expenses at least remained constant. Conclusion: either this theory does not stand up or there are other factors which explain the situation.
11/More debt, because they are not keen to issue new equity while the value of their shareholders’ equity is undervalued.
12/Close to zero, since all companies would incur sufficient debts to reduce their tax bills to zero.
13/Rise, as shareholders will increase pressure so that the company achieves better financial performance.
14/No, because we are not dealing with mathematical certainties but with behaviour.
15/Market value, because if the company is very profitable, its equity capital will be worth much more than its book value. A more accurate assessment of the company’s ability to meet its debt repayments will then be possible.
16/No, because financial resources are used in a given order in line with requirements. The difference between operating inflows and investment outflows.
17/No, because interest rates, tax rates, risk aversion, volatility of operating assets, the maturity of a sector, etc. change over time.
18/A difference of this amount cannot simply be due to the tax break on debt. It is also difficult to believe that management would be more motivated by the higher level of debt (50/50 is already a high level). This can only be some sort of trap.

Exercises

1/8.44%; 7.9%; 7.36%.
2/200 + 50 × 30% × 6% / 11% = 208.2.
3/
1. (30 × 6% × 30%) / 11% = 4.9.
2. The value increases by 0.8.
3. Reduction of the value by 3.8.

4/In Côte d’Ivoire there can be an incentive to increase corporate debt, not in the USA.

	Côte d’Ivoire		USA
	D = 0	D = 500 at 7%	D = 0	D = 500 at 7%
Operating income	135	135	135	135
− Interest expense	0	35	0	35
= Pre-tax profit	135	100	135	100
− Income tax expense	34	25	36	27
= Net earnings	101	75	99	73
Dividend paid	101	75	99	73
Income tax:
on dividends	15	11	20	15
on interest	0	6	0	13
Shareholders’ revenue	86	64	79	58
Shareholders’ rate of return	8.6%	12.8%	7.9%	11.7%
Debtholders’ revenue	0	29	0	22
Debtholders’ revenue	0%	5.7%	0%	4.4%
Investors’ revenue	86	92	79	80
Total taxes	49	43	56	55

BIBLIOGRAPHY

Modigliani and Miller’s main work on capital structure:

B. Grundy, Merton H. Miller: His contribution to financial economics, Journal of Finance, 56(4), 1183–1206, August 2001.
M. Miller, Debt and taxes, Journal of Finance, 32(2), 261–276, May 1977.
M. Miller, The M&M proposition 40 years later, European Financial Management, 4(2), 113–120, July 1998.
F. Modigliani, M. Miller, Corporate income taxes and the cost of capital: A correction, American Economic Review, 53(3), 433–443, June 1963.

Following on from the above work, on the problems of capital structure and taxes:

J. van Binsbergen, J. Graham, J. Yang, The cost of debt, Journal of Finance, 65(6), 2089–2136, December 2010.
H. DeAngelo, R. Masulis, Optimal capital structure under corporate and personal taxation, Journal of Financial Economics, 8(1), 3–29, March 1980.
C. Doidge, A. Dyck, Taxes and corporate policies: Evidence from a quasi natural experiment, Journal of Finance, 70(1), 45–89, February 2015.
E. Fama, K. French, Taxes, financing decisions and firm value, Journal of Finance, 53(3), 819–843, June 1998.
P. Fernandez, The value of tax shields is NOT equal to the present value of tax shields, Journal of Financial Economics, 73(1), 145–165, July 2004.
M. Flannery, L. Lin, Do personal taxes affect capital structure? Evidence from the 2003 cut, Journal of Financial Economics, 109(2), 549–565, August 2013.
J. Graham, How big are the tax benefits of debt?, Journal of Finance, 55(5), 1901–1941, October 2000.
J. Graham, Taxes and corporate finance: A review, Review of Financial Studies, 16(4), 1075–1129, Winter 2003.
R. Green, B. Hollifield, The personal tax advantages of equity, Journal of Financial Economics, 2(67), 175–216, February 2003.
C. Hennessy, T. Whited, Debt dynamics, Journal of Finance, 3(60), 1129–1165, June 2005.
H. Huizinga, L. Laeven, G. Nicodème, Capital structure and international debt shifting, Journal of Financial Economics, 88(1), 80–108, April 2008.
A. Korteweg, The net benefits to leverage, Journal of Finance, 65(6), 2137–2170, December 2010.

On the financial structure and its interactions with the people in the firm:

J. Berk, R. Stanton, J. Zechner, Human capital, bankruptcy, and capital structure, Journal of Finance, 65(3), 891–926, June 2010.
H. Cronqvist, A. Makhija, S. Yonker, Behavioral consistency in corporate finance: CEO personal and corporate leverage, Journal of Financial Economics, 103(1), 20–40, January 2012.
U. Malmendier, G. Tate, J. Yan, Overconfidence and early-life experiences: The test of managerial traits on corporate financial policies, Journal of Finance, 66(5), 1687–1733, October 2011.

On bankruptcy costs:

H. Almeida, T. Philippon, The risk-adjusted cost of financial distress, Journal of Finance, 6(62), 2557–2586, December 2007.
K.-H. Bae, J.-K. Koo, J. Wang, Employee treatment and firm leverage: A test of the stakeholder theory of capital structure, Journal of Financial Economics, 100(1), 130–153, April 2011.
G. Brown, D. Matsa, Boarding a sinking ship? An investigation of job applications to distressed firms, Journal of Finance, 71(2), 507–549, April 2016.
R. Elkamhi, J. Ericsson, C. Parsons, The cost and timing of financial distress, Journal of Financial Economics, 105(1), 62–81, July 2012.
E. Gilje, E. Loutskina, D. Murphy, Drilling and debt, Journal of Finance, 75(3), 1287–1325, June 2020.
A. Hortaçsu, G. Matvos, C. Syverson, S. Venkataraman, Indirect costs of financial distress in durable goods industries: The case of auto manufacturers, Review of Financial Studies, 26(5), 1248–1290, May 2013.

On the application of the theory of signals to capital structure:

G. Donaldson, Corporate Debt Capacity: A Study of Corporate Debt Policy and the Determination of Corporate Debt Capacity, Harvard University Division of Research, 1961.
S. Myers, Determinants of corporate borrowing, Journal of Financial Economics, 5(2), 147–175, November 1977.
S. Myers, The capital structure puzzle, Journal of Finance, 39(3), 575–592, July 1984.
S. Ross, The determination of financial structure: The incentive signaling approach, Bell Journal of Economics, 8(1), 23–40, Summer 1977.

On the application of agency theory to problems relating to capital structure:

M. Jensen, The agency costs of free cash flow, corporate finance, and takeovers, American Economic Review, 76(2), 323–329, May 1986.
M. Jensen, Agency costs of overvalued equity, Financial Management, 34(1), 5–19, Spring 2005.
M. Jensen, W. Meckling, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics, 3(4), 305–360, October 1976.
H. Leland, Agency costs, risk management and capital structure, Journal of Finance, 53(4), 1213–1243, August 1998.
C. Mao, Interaction of debt agency problems and optimal capital structure: Theory and evidence, Journal of Financial and Quantitative Analysis, 2(38), 399–423, June 2003.
E. Ofek, Capital structure and firm response to poor performance: An empirical investigation, Journal of Financial Economics, 34(1), 3–30, August 1993.

And finally, for tax rates around the world:

www.dits.deloitte.com

https://home.kpmg/xx/en/home/services/tax/tax-tools-and-resources/tax-rates-online/corporate-tax-rates-table.xhtml

NOTES

1 Again, we use net debt and debt synonymously.
2 Based on a β of 1.1, a 7% risk premium and a risk-free rate of 0.5%. The other costs of equity are deduced from the formula on page 529.
3 This is the basis of the APV method (adjusted present value).

Chapter 34. DEBT, EQUITY AND OPTIONS THEORY

Light too bright to see by

The theories of corporate finance examined so far may have given the impression that the only difference between debt and equity is the required rate of return. However, there is a big difference between the 10% return required by creditors and that required by shareholders.

Shareholders simply hope to achieve this rate, which forms an average of rates that can be either positive or negative. The actual return can range from 0% to infinity, with the entire range of variations in between!

Creditors are assured of receiving the required rate, but never more. They can only hope to earn the 10% return but, with a few exceptions, this hope is almost always fulfilled.

So here we have the first distinction between creditors and shareholders: the probability distribution of their remuneration is completely different.

That said, although the creditor’s risk is very low, it is not nil. Capitalism is built on the concept of corporation, which legally restricts shareholders’ liability with respect to creditors. When a company defaults, shareholders hold a “trump card” that allows them to hand the company, including its liabilities, over to the lenders.

In the rest of this chapter, we will concentrate on the valuation of companies in which shareholders’ responsibility is limited to the amount they have invested. This applies to the vast majority of all companies in modern capitalism, be they corporations, limited liability companies or sole proprietorship with limited liability.

This is the fundamental difference between shareholders and creditors: the former can lose their entire investment, but also hope for unlimited gains, while the latter will at best earn the flows programmed at the beginning of the contract.

Keep this in mind as we use options to analyse corporate structure and, more importantly, the relationship between shareholders and creditors.

Section 34.1 ANALYSING THE FIRM IN LIGHT OF OPTIONS THEORY

To keep our presentation simple, we shall take the example of a joint stock company in which enterprise value EV is divided between debt (V_D) and equity (V_E).

We shall also assume that the company has issued only one type of debt – zero-coupon bonds – redeemable upon maturity at full face value (principal and interest) for 100.

Depending on the enterprise value when the debt matures, two outcomes are possible:

The enterprise value is higher than the amount of debt to be redeemed (e.g. EV = 120). In this case, the shareholders let the company repay the lenders and take the residual value of 20.
The enterprise value is lower than the amount of debt to be redeemed (e.g. EV = 70). The shareholders may then invoke their limited liability clause, forfeiting only their investment, and transfer the company to the lenders who will bear the difference between the enterprise value and their claim.

Now let us analyse this situation in terms of options. From an economic standpoint, shareholders have a call option (known as a European call if it can only be exercised at the end of its life) on the firm’s assets. Its features are:

Underlying asset = operating assets.
Exercise price = amount of debt to be reimbursed (100).
Volatility = volatility of the underlying assets, i.e. operating assets.
Maturity = expiration date.
Interest rate = risk-free rate corresponding to the maturity of the option.

At the expiration date, shareholders either exercise their call option by repaying the lenders, or they abandon it. The value of the option is none other than the value of equity (V_E).

The lender, on the other hand, who has invested in the firm at no risk, has sold the shareholders a put option on operating assets. We have just seen that in the event of default, the creditors may find themselves the unwilling owners of the company. Rather than recouping the amount they lent, they get only the value of the company back. In other words, they have “bought” the company in exchange for the outstanding amount of debt.

The sale of this (European-style) put option results in additional remuneration for the debtholder, which, together with the risk-free rate, constitutes the total return. This is only fair, since the debtholder runs the risk that the shareholders will exercise their put option; in other words, that the company will not pay back the debt.

The features of the put option are:

Underlying asset = operating assets.
Exercise price = amount of debt redeemable upon maturity (100).
Volatility = volatility of the underlying asset, i.e. the operating assets.
Maturity = maturity of the debt.
Interest rate = risk-free rate corresponding to the maturity of the option.

The value of this option is equal to the difference between the value of the loan computed by discounting its cash flows at the risk-free rate and its market value (discounted at a rate that takes into account the default risk, i.e. the cost of debt k_D). This is the risk premium that arises between any loan and its risk-free equivalent.

All this means is that the debtholder has lent the company 103 at an interest rate equal to the risk-free rate. The company should have received 103, but the value of the loan is only 100 after discounting the flows at the normal rate of return required in view of the company’s risk, rather than the risk-free rate.

The company uses the balance of 3, which represents the price of the credit risk, to buy a put option on its operating assets. In short, the company receives a net of 100 while the bank pays a net of 100 for a risky claim since it has sold a put option on its operating assets that the company, and therefore the shareholders, will exercise if its value is lower than that of the outstanding debt at maturity. By exercising the option, the company, and thus its shareholders, discharges its debt by transferring ownership of the operating assets to the creditors.

In conclusion, we see that, depending on the situation at the redemption date, one of the following two will apply:

if V_D < V, the value of the call option is higher than 0, the value of the put option is zero and equity is positive;
if V_D > V, the value of the call option is zero, the value of the put option is higher than 0 and the equity is worthless.

Section 34.2 CONTRIBUTION OF OPTIONS THEORY TO THE VALUATION OF EQUITY

We have demonstrated that the value of a firm’s equity is comparable to the value of a call option on its operating assets. The option’s exercise price is the amount of debt to be repaid at maturity, the life of the option is that of the debt, and its underlying asset is the firm’s operating assets.

This means that, at the valuation date, the value of equity is made up of an intrinsic value and a time value. The intrinsic value of the call option is the difference between the present value of operating assets and the debt to be repaid upon maturity. The time value corresponds to the difference between the total value of equity and the intrinsic value.

Take, for example, a company where the return on capital employed is lower than that required by investors in view of the related risk. The market value is thus lower than the book value:

If the debt were to mature today, the shareholders would exercise their put option since operating assets are worth only 70 while the outstanding debt is 80. The company would have to file for bankruptcy. Fortunately, the debt is not redeemable today but only in, say, two years’ time. By then, the enterprise value, i.e. the value of operating assets, may have risen to over 80. In that case, equity will have an intrinsic value equal to the difference between the enterprise value at the redemption date and the amount to be redeemed (in our case, 80).

Today, however, the intrinsic value of equity is zero (it cannot be negative as seen in Section 23.3) and the present value of equity (8) can only be explained by its time value. It represents the hope that, when the debt matures two years hence, enterprise value will have risen enough to exceed the amount of debt to be repaid, giving the equity an intrinsic value.

As seen in the following graphs, a company’s financial position can be considered from either the shareholders’ or the creditors’ standpoint.

By now you must (might) be eager to apply your new-found knowledge of options to corporate finance!

The time value of an option increases with the volatility of the underlying asset.
The more economic or industrial risk on a company, the higher the volatility of its operating assets and the higher the time value of its equity.
The options method is thus theoretically relevant to value large, risky projects financed by debt, such as oil drilling in northern Siberia, leisure parks, etc., or those with inherent volatility, such as biotech start-ups.
The time value of an option depends on the position of the strike price relative to the market value of the underlying asset.

When the call option is out-of-the-money (enterprise value lower than outstanding debt), the company’s equity has only time value. Shareholders hope for an improvement in the company, whose equity has no intrinsic value.

When the call option is at-the-money (enterprise value equal to debt at maturity), the time value of equity is at its highest and anything can happen. Using the options method to value equity is now particularly relevant, since it can quantify shareholders’ anticipation.

When call option is in-the-money (enterprise value higher than outstanding debt at maturity), the intrinsic value of equity quickly outweighs the time value. The risk on the debt held by the lenders decreases and becomes nearly non-existent when the enterprise value tends towards infinity. This brings us back to the traditional idea that the higher the enterprise value, the less risk creditors have of a default, and the more the cost of debt approaches the risk-free rate.

The options method is therefore applied to companies that carry heavy debt or are very risky.

The time value of an option increases with its maturity.

This is why it is so important for companies in distress to reschedule debt payments, preferably at very long maturities.

The example below illustrates the use of options to value equity.

Take a company that has both debt and equity financing and let us assume its debt is 100, redeemable in one year. If, based on its degree of risk, the debt carries 6% interest, then the amount to be paid to creditors one year later is 106.

If the firm’s value is 150 at the time of calculation, then the value of equity – defined as the difference between enterprise value and the value of debt – will be 150 − 100 = 50.

What happens if we apply options theory to this value?

We shall assume the risk-free rate is 5%. The discounted value of the debt + interest payment at the risk-free rate is 106 / 1.05, or 100.95.

The value of debt can be expressed as:

Value of debt = Value of debt at the risk-free rate – Value of a put

i.e. the value of the put = 100.95 − 100 = 0.95.

We know that the value of equity breaks down into its intrinsic and time value:

You can see that, for this company with limited risk, the time value measuring the actual risk is far lower than the intrinsic value. Similarly, the value of the put, which acts as a risk premium, is very low as well.

Now, let’s increase the risk of operating assets and assume that the interest rate required by the creditors is 15% rather than 6%, corresponding to a 10% risk premium as the risk-free rate is 5%. The amount to be repaid in one year is thus 115.

The value of the debt discounted at the risk-free rate is 115 / 1.05, or 109.52. The value of the put is thus 109.52 − 100 = 9.52.

Note that the risk premium for this company is much higher than in the preceding example, reflecting the increasing probability that the company will default on its debt. This debt is now very similar to a high-yield or non-investment grade debt (see Section 20.6).

The value of equity, which is still 50, breaks down into an intrinsic value of 35 (150 − 115) and a time value of 15 (50 − 35). Since there is more risk than in our previous example, the time value accounts for a higher share of the equity value.

Section 34.3 USING OPTIONS THEORY TO ANALYSE A COMPANY’S FINANCIAL DECISIONS

Options theory helps us understand how major corporate financial decisions (choice of capital structure, dividend payout, investment decisions, etc.) affect shareholders and creditors differently, and how they can result in a transfer of value between the two.

The table below lists the closing prices for a call option on a Daughter plc share at various exercise prices:

Exercise price (£)	Value of a 3-year call option on Daughter plc (£)
2,600	130
2,800	80
3,000	45
3,200	31

The enterprise value of Holding plc is equal to the number of Daughter plc shares multiplied by their market price, i.e. £223,000.

Consider each of the 100 shares issued by Holding plc as being an option on its operating assets (the shares of Daughter plc), i.e. £223,000, with an exercise price that is equal to the amount of Holding plc debt outstanding, giving 300 bonds × £1,000 = £300,000.

Each Holding plc share can thus be considered to be a call option with an exercise price of £300,000 / 100 shares = £3,000, and a maturity of three years.

According to the table above, Holding plc’s equity value is thus £45 × 100 shares = £4,500.

The value of debt is equal to the difference between the enterprise value (£223,000) and that of equity (£4,500), i.e. £218,500.

One bond is therefore worth £728.3 (£218,500 / 300), corresponding to an implied yield of 11.1% (in fact: 728.3 = 1,000 / (1 + 0.111)³).

We will now discuss a few major financing or investment decisions in a context of equilibrium – that is, where the debt, shares and assets held are bought or sold at their fair value, without the market having anticipated the decision.

1/ INCREASING DEBT

Suppose the shareholders of Holding plc decide to issue 20 additional bonds and use the proceeds to reduce the company’s equity by distributing an exceptional dividend. The overall exercise price corresponding to the redemption value of the debt at maturity is:

A look at the listed prices of the options shows us that at an exercise price of £3,200, Holding plc’s equity is valued as £31 × 100 shares = £3,100, indicating that the value of its debt at the same date is £219,900 (£223,000 − £3,100).

The new bondholders will thus pay £13,744 (20 bonds × £219,900/320 bonds), which will go to reduce the equity of Holding plc.

The shareholders consequently have £13,744 in cash and £3,100 in shares, i.e. a total of £16,844 compared with the previous £4,500. They have gained £12,344 to the detriment of the former creditors, who have seen the value of their claim fall from £218,500 to 300 bonds × £687.19, or £206,156.

Their loss (£218,500 − £206,156 = £12,344) exactly mirrors the shareholders’ gain. The implicit yield to maturity has risen to 13.3%, reflecting the fact that the borrowing has become riskier since it now finances a larger share of the same amount of operating assets.

Increasing the risk to creditors has enhanced the value of the shares, thereby reducing that of the bonds. The existing creditors have lost out because they were not able to anticipate the change in corporate structure and have been harmed by the dividend distribution.

Common (accounting) sense seems to indicate that distributing £13,744 in cash to shareholders should translate into an equivalent decrease in the value of their Holding plc shares. According to this reasoning, after the buy-back the Holding plc shares should have been revalued at −£9,244 (£4,500 − £13,744), but that cannot be!

Options theory solves this apparent paradox. It shows that when new debt is issued to reduce equity, the time value of the shares decreases less than the amount received by shareholders and remains positive. True, the likelihood that the value of Daughter plc shares will be higher than that of the redeemable debt upon maturity has lessened (since debt has increased), but it is still not nil, giving a time value that, while lower, is still positive.

Of course, this example is exaggerated. Such a decision would have catastrophic consequences for shareholders, who would be taken to court by the creditors and lose all credibility in the eyes of the market. But it effectively illustrates the contribution of options theory to equity valuations.

Increasing debt increases the value of shareholders’ investment, to the detriment of the claims held by existing creditors. Thus, value is transferred from creditors to shareholders.

Conversely, when debt is reduced by a capital increase, the overall value of shares does not increase by the value of the shares issued. The old debt, which has become less risky, has, in fact, “confiscated” some of the value, to the benefit of creditors and the detriment of shareholders.

2/ THE INVESTMENT DECISION

Now let us return to our initial scenario and assume that Holding plc manages to exchange the 100 shares of Daughter plc for 100 shares of a company with a higher risk profile called Risk plc, for £223,000 (100 × £2,230).

Each share of Holding plc is equal to a call option on a Risk plc share with an exercise price of £3,000 (300 × £1,000/100).

Suppose the value of a call option on a Risk plc share is £140 with an exercise price of £3,000 and an exercise date in three years’ time.

The Holding plc shares are consequently worth £14,000.

Exchanging a low-risk asset (Daughter plc) for a highly volatile asset (Risk plc) has redistributed value to the benefit of shareholders, whose gain is £9,500 (£14,000 − £4,500).

Their gain exactly mirrors an equivalent loss to creditors, since the value of the debt has fallen from £218,500 to £223,000 − £14,000 = £209,000, i.e. a £9,500 decline.

The higher risk led to an increase in the implicit yield to maturity of the bonds from 11.1% to 12.8%.

As in our previous examples, the transfer of value was only possible because creditors underestimated the power shareholders have over the company’s investment decisions.

3/ RENEGOTIATING THE TERMS OF DEBT

What if we now return to our initial situation and imagine that the company is able to reschedule its debt? This happens when creditors prefer to let a company in financial distress attempt a turnaround rather than precipitate its demise.

So let’s assume the debt is due in four years, rather than the initial three years. A look at our options price list for Daughter plc shares with a four-year maturity shows us that they carry a higher premium.

Exercise price (£)	Value of put on Daughter plc shares in 4 years (£)
2,600	140 (versus 130)
2,800	89 (versus 80)
3,000	53 (versus 45)
3,200	40 (versus 31)

This, of course, comes as no surprise to our attentive readers who remember learning in Chapter 23 that the value of an option increases with the length of its life.

The value of equity is thus £53 × 100 shares = £5,300. A bond is therefore worth £725.7 ((£223,000 − £5,300) / 300). Without having abandoned any flows, creditors’ generosity will have cost them £800.²

4/ OTHER PRACTICAL APPLICATIONS

As our readers may have understood, shareholders’ equity is effectively only valued using the option models for distressed companies.

These theoretical developments have been the basis for the creation of models to assess the default risk of the firm. In particular, the consulting company KMV has developed well-known models from the work of Merton, Black and Scholes. Such models have been greatly developed by banks. The volatility of operating assets is a fundamental input to these models. As we have seen, a company with highly volatile operating assets has a high probability of bankruptcy. Unfortunately, volatility in the value of operating assets is not directly measurable in the markets. However, through the reasoning we have applied throughout this section, the market value of equity is used to determine the implied volatility of its operating asset.

Hedge funds have developed arbitrage strategies between debt and equity markets (capital structure arbitrage) based on this approach. These techniques use mainly credit default swaps (CDSs). Lastly, some borrowers hedge their credit risk by selling shares of the firm short. In doing so, they earn on one side what they may lose on the drop in value of their loan.

Section 34.4 RESOLVING CONFLICTS BETWEEN SHAREHOLDERS AND CREDITORS

Creditors have a number of means at their disposal to protect themselves and overcome the asymmetry from which they suffer. They can be grouped under two main headings:

hybrid financial securities;
restrictive covenants.

1/ HYBRID FINANCIAL SECURITIES

Hybrid financial securities, combining features of both debt and equity – such as convertible bonds, bonds with equity warrants, participating loan stock, hybrid bonds of indefinite maturity, etc. – would not be necessary in a perfect market.

In fact, should shareholders make investment or financing decisions that are detrimental to creditors, the latter can exercise their warrants or convert their bonds into shares, thus becoming shareholders themselves and, if all goes well, recouping in equity what they have lost in debt!

Jensen and Meckling (1976) have demonstrated that the issue of convertible bonds reduces the risk of the firm’s assets being replaced by more risky assets that increase volatility and thus the value of the shares. The same reasoning is applied when “free” warrants are granted to creditors who agree to waive some of their claims during a corporate restructuring plan (see Chapter 24).

2/ RESTRICTIVE COVENANTS

Covenants act like an atomic bomb, whose purpose lies in convincing shareholders not to take decisions that would result in transferring value from lenders to themselves. Like an atomic bomb, the aim is not to trigger it but rather to incite parties to negotiate.

In practice, when a company does not meet its covenants, banks generally agree either to grant a delay to restore the situation (covenant holiday) or to change the covenants to make them less constraining (covenant “reset”), in exchange for additional compensation (waiver fee) and/or an increased interest.

Covenants are analysed in more detail in Chapter 39.

Section 34.5 ANALYSING THE FIRM’S LIQUIDITY

In most cases, the company pays off part of its debt with its free cash flows and refinances the balance of its debt by taking out a new loan. Most of the time, the sum of free cash flows is higher than the amount of debt to be repaid, but the flows generally are further off in time than the due date for the debt, and can be insufficient in the short term. The duration (see Chapter 20) of cash flows is generally longer than the duration of debt flows, which rarely exceed six to seven years.

The firm is then exposed to a double risk:

the risk of the interest rate at which it will refinance part of its current debt in the future;
a liquidity risk since, at the time the firm has to take out a new loan, market conditions may not allow it to if there is a major liquidity crisis under way (as was the case in late 2008/early 2009).

It is possible to hedge against these two risks, as we shall see in Chapter 51. Frequently, however, the liquidity risk is unhedged, either because it is not always possible to hedge against it, or because the cost of hedging is seen as prohibitive, or possibly because severe liquidity crises are so rare that it is not deemed necessary to hedge against this risk.

The difference between the duration of a firm’s free cash flows and the duration of its debt (often a shorter period) constitutes an asset liability refinancing gap (ALRG). Aït-Mokhtar (2008) has shown that it is the same as a liability for a firm, as if it had entered into an interest rates swap (see Section 51.3) in which it pays the floating interest rate and receives the fixed rate. On maturity of its debt, the firm will only be able to make the repayment if it is able to find lenders that are prepared to lend to it, since the free cash flows it receives will be insufficient to pay off the whole of the debt. So, what it has done is undertaken to contract future debt at an unknown interest rate in order to continue its activity (hence the swap’s leg with a variable rate payment which corresponds to the interest rate of the future loan). In normal times, this liability is worth a negligible amount as it is reasonable to expect that a healthy firm will have no problems in refinancing in the future. But in the event of a liquidity crisis and for firms with imminent debt repayment deadlines (a few months or quarters), this ALRG has a very high value. It is equal to the existing uncertainty as to the possibility of the company being able to find the necessary financing.

So we can say:

Value of operating assets (i.e. enterprise value)

– Value of net debt

– Value of ALRG

= Value of equity capital

Which corresponds to:

When investors start to worry about the ability of the company to refinance in the near future, the value of the ALRG increases, pushing down the value of equity. And the phenomenon can pick up speed if the current lenders try and hedge their risks by selling short the firm’s shares, hoping to gain on this short-selling what they will lose as a result of the decline in the value of their debt.

When the firm is able to find refinancing for its debt, for example through a share issue, we see in some cases (Europcar in 2021) an increase in the share price, which contradicts what we have seen up to now. On the one hand, the value of the share is negatively impacted by the transfer of value to the creditors, but on the other hand, it benefits fully from the disappearance of the ALRG. And if the latter were worth more than the discount on the debt, the net impact would be positive and the value of the share would rise.

Section 34.6 CONCLUSION

The concept of time value for equity is the main added value of the application of option theory to corporate finance.

We are now quite far away from the simple book leverage effect that seemed to prove that shareholders could create value by investing funds at a higher rate than the interest rate. The relationship between shareholders and lenders is in practice quite different. Their interests can actually diverge significantly due to a change in the risk profile of the firm, even if there are no cash flow exchanges between them and the enterprise value remains constant.

We hope that our readers will have understood the importance of reasoning in value terms and now have the reflex of assessing any financial decision not only in terms of return, but also risk. The use of options may have been overwhelming. We hope so, as readers will now always remember to assess risk and value transfers in financial decisions.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

The status of the creditor differs radically from that of the shareholder. The shareholder stands to gain a potentially unlimited amount and their risk is limited to their investment, while the creditor, who can also lose their investment, can only expect a fixed return.

This asymmetry brings options to mind. This chapter showed that there is more than one similarity.

The shareholders’ equity of a levered company can be seen as a call option granted by creditors to shareholders on the company’s operating assets. The strike price is the value of the debt and the maturity is the date on which the debt is payable. When the debt falls due, if the value of the operating assets is higher than the amount of the debt to be repaid, the shareholders exercise their call option on the operating assets and pay the creditors the amount of the debt outstanding. If, however, the value of the operating assets is lower than the amount of the debt to be repaid, the shareholders decline to pay off the debt and the creditors appropriate the operating assets.

Similarly, we can show that lending to a company is a means of investing in its assets at no risk. The lender sells the shareholders a put option at a strike price that is equal to the debt to be repaid.

Using this options-based approach, we can break down the value of equity into intrinsic value and time value. Intrinsic value is the difference between the present value of operating assets and the debt to be repaid upon maturity. Time value is the hope that when the debt matures, enterprise value will have risen to exceed the amount of the debt to be repaid.

This leads to a better understanding of the impact of certain decisions on the financial situation of creditors and shareholders:

a dividend payout financed by the sale of assets or a debt increase will increase creditors’ risk, reduce the value of the debt owed to them and, at the same time, increase the value of shareholders’ equity;
investing in high-risk projects (but for which the net value at the required rate of return is nil) does not result in an immediate change in enterprise value, but increases creditors’ risk, reduces the value of debt and increases the value of shareholders’ equity by the same amount;
by financing its own investments (or carrying out a capital increase), the company increases enterprise value by this amount (if the return on the investment is equal to the required rate of return). Part of this additional value will go to the creditors, whose risk is reduced, to the detriment of shareholders, as the overall value of their shares will not rise by the amount of the funds invested or the capital increase.

All financial decisions must be examined from an overall point of view, but also in terms of the creation or destruction of value for the various stakeholders. A given financial decision could be neutral in terms of overall value, but could enhance the value of some financial securities at the expense of others.

QUESTIONS

1/When making a comparison with options, what does shareholders’ equity correspond to?
2/When making a comparison with options, what does a credit risk correspond to?
3/For what type of company can we apply the options theory for the valuation of shareholders’ equity?
4/According to this theory, can the value of a company’s equity be nil?
5/Why is the application of this theory more efficient for companies in difficulty?
6/Is this view of the company opposed to the theory of markets in equilibrium?
7/Give an example of a decision where creditors are “expropriated” by shareholders, without the debt agreement being renegotiated. Explain.
8/Is the effect of expropriation a result of market inefficiency?
9/A company is in trouble as a result of low profits and excessive debts.
1. Do you think that the creditors and the shareholders have the same concerns? More specifically, in the event of the following:
  - massive new investments carrying a very high risk but that will possibly lead to high returns which will enable the company to get back on its feet with a low level of profits;
  - an increase in debt;
  - an increase in shareholders’ equity.
2. Would your answer be different if the company were profitable and carrying very little debt?
3. What financial product do these examples of creditor–shareholder relationships bring to mind?
10/Can you give an example of a kind of company where shareholders’ equity is made up of pure time value?
11/If lenders are seeking to hedge their loan, should the impact be positive or negative on the share price of the borrower?
More questions are waiting for you at www.vernimmen.com.

EXERCISES

1/The investment firm Verfinance owns 5,000 shares in Uninet, a group involved in the maintenance products sector, worth 10m. This asset is financed by a five-year zero-coupon bond (issued today) whose redemption value is 6m, and by equity for the balance.
The following table relating to the Uninet share appears in the financial press in the section on European call options:
Strike price 5-year option 7-year option
1,200 1,010 1,085
1,600 731 832
2,000 510 627
2,400 348 468
1. Does the above table seem consistent to you?
2. Can you value the shareholders’ equity and the debt of Verfinance with the data you have?
3. What could you do to increase the value of the company’s shareholders’ equity? Make several suggestions. Which would seem to be the most realistic to you? Why? Would you be creating value? Why? All in all, have you created value or transferred value?
2/Companies A and B each have to pay 100 to their creditors in one year. The risk-free rate is 5% per year. Below are the key figures for companies A and B, before and after a capital increase of 50 that they are planning for the purpose of financing new investments:
A B
Before After Before After
Value of operating assets 100 150 100 150
Volatility of operating assets 10% 10% 40% 40%
Equity value 7 ? 18 ?
Value of debt 93 95.1 82 92.1
Implicit interest rate on debt 7.5% 5.2% 22% 8.6%
What is the equity value of A and B after the capital increase? Show that it is not in the interests of the shareholders of A or B to carry out a capital increase to finance investments. Does the capital increase create value? Show that, nevertheless, shareholders’ wealth is increased. Do you think that the creditors would agree to finance new investments? Why? How do you explain this paradox?
3/Take the figures for Holding plc (Section 34.3) and assume that the shareholders in the company decide to pay out a cash dividend of £13,380 totally financed by the sale of 63 shares in Daughter plc (£13,380 / £2,230).
1. What is the new value of Holding plc’s equity according to the options theory?
2. What is the value of Holding plc’s debt according to the options theory? What is the yield to maturity?
3. What is the result of the operation?

ANSWERS

Questions

1/A call option on the operating assets, the strike price of which is the amount of debt to be repaid.
2/The risk-free assets minus a put option, the strike price of which is the amount of debt to be repaid.
3/Companies in difficulty and high-risk companies.
4/No, because there is always some hope, no matter how little, that the enterprise value will rise before the debt must be repaid, to above the amount to be repaid.
5/Because the time value of their equity is higher.
6/No, it is not incompatible.
7/Investing at a fair price, but in a much more risky venture.
8/No, only the lack of anticipation.
9/
1. No, better for the shareholder, better for the shareholder, better for the shareholder.
2. Fundamentally no, but the problem is considerably reduced.
3. Options.
10/Companies in distressed situations close to bankruptcy (LatAm, Eramet).
11/Negative as this leads them to short sell the stock.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/
1. The table is consistent. The higher the strike, the lower the value of the option, the longer the maturity, the higher the price of the option.
2. The shares can be compared to options on the assets (i.e. the Uninet shares). Strike price = 6m / 5,000 = 1,200, maturity = same as debt = 5 years. Value of these options = 1,010. Value of Verfinance’s shareholders’ equity = 1,010 × 5,000 = 5.05m. Value of debt = 4.95m.
3. Capital reduction. “Exchange” Uninet shares for much more volatile shares. There would then be a transfer of value from creditors to shareholders, but no creation of net value.
2/54.9; 57.9. The capital increase of 50 will only increase the value of shareholders’ equity by 47.9 for A and 39.9 for B. The capital increase creates value for the creditors (2.1 for A and 10.1 for B), but destroys the same amount of shareholder value. Accordingly, this is a simple transfer of value. No, because unlike the capital increase, an increase in debt level will reduce the value of the debt.
3/
1. Shareholders have a call option on 94 Daughter plc shares (100 − 6) with a strike price of 300,000 (300 bonds × 1,000). This option is equal to 94% of an option of an asset made up of 100 Daughter plc shares (94 / 94%) and the strike price is equal to 319,149 (300,000 / 94%). The new value of shareholders’ equity is thus 94% × 31.6 × 100 shares = 2,970. The value of the option (31.6) is calculated by linear interpolation on the basis of the table provided.
2. The value of the debt will then be 94 × 2,230 × 2,970 = 206,650, a decrease of 11,850. The yield to maturity on the debt rises to 13.3%, which means an increase in the risk on Holding plc’s debts.
3. The shareholders will have 2,970 worth of Holding plc shares and 13,380 in cash (dividends paid), a total of 16,350 compared with 4,500 initially. Their gain of 11,850 (16,350 – 4,500) is made at the expense of the creditors, who lose 218,500 − 206,650 = 11,850.

BIBLIOGRAPHY

Black, Scholes and Merton were the first to analyse the value of shares and debts using options as a reference:

F. Black, M. Scholes, The pricing of options and corporate liabilities, Journal of Political Economy, 81, 637–654, May/June 1973.
R. Merton, Theory of rational option pricing, Bell Journal, 4(1), 141–183, Summer 1973.
R. Merton, On the pricing of corporate debt: The risk structure of interest rates, Journal of Finance, 29(2), 449–470, May 1974.

For an overall view of options theory applied to capital structure:

M. Chesney, R. Gibson-Asner, The investment policy and the pricing of equity in a levered firm: A re-examination of the contingent claims “valuation approach”, European Journal of Finance, 5, 95–107, June 1999.
D. Galai, R. Masulis, The option pricing model and the risk factor of stock, Journal of Financial Economics, 33, 53–81, 1976.
R. Geske, H. Johnson, The valuation of corporate liabilities as compound options: A correction, Journal of Financial and Quantitative Analysis, 7, 6–81, March 1979.

For a deeper insight:

Y. Aït-Mokhtar, Cap Arb, Hidden value and investment opportunities, Exane BNP Paribas Quantitative Research, 63, 1–4, March 2008.
J. Campbell, G. Taksler, Equity volatility and corporate bond yields, Journal of Finance, 6(58), 2321–2349, December 2003.
S. Chava, M. Robert, How does financing impact investment? The role of debt covenants, Journal of Finance, 63(5), 2085–2121, October 2008.
E. Gilje, Do firms engage in risk-shifting? Empirical evidence, Review of Financial Studies, 29(11), 2925–2954, November 2016.
Z. He, W. Xiong, Rollover risk and credit risk, Journal of Finance, 67(2), 391–430, April 2012.
M. Jensen, W. Meckling, The theory of the firm: Managerial behavior, agency costs and capital structure, Journal of Financial Economics, 3(4), 305–360, October 1976.
H. Leland, Corporate debt value, bond covenants and optimal capital structure, Journal of Finance, 4(49), 1213–1252, September 1994.
E. Morellec, B. Nikolov, N. Schürhoff, Corporate governance and capital structure dynamics, Journal of Finance, 67(3), 803–848, June 2012.
G. Sicard, The Origins of Corporations, Yale University Press, 2015.
J. Turc, CDS vs. stock – the quest for the optimum hedge ratio, Banques & Marchés, 80, 29–39, January–February 2006.
F. Yu, How profitable is capital structure arbitrage?, Financial Analysts Journal, 5(62), 47–62, September–October 2006.

NOTES

1 In reality, it was invented well before, but its generalisation as a company form goes back to the 19th century.
2 (728.33 – 725.67) × 300 = 800.

Chapter 35. WORKING OUT DETAILS: THE DESIGN OF THE CAPITAL STRUCTURE

Steering a course between Scylla and Charybdis

By way of conclusion to the part on capital structure policy, we would like to reflect once again on the thread that runs throughout this set of chapters: the choice of a source of financing.

We begin by restating for the reader an obvious truth that is too often forgotten: If the objective is value creation, then the choice of investments is much more important than the choice of capital structure. Because financial markets are liquid, situations of disequilibrium do not last. Arbitrage inevitably takes place to erase them. For this reason, it is very difficult to create value by issuing securities at a price higher than their value. In contrast, industrial markets are much more viscous. Regulatory, technological and other barriers make arbitrage – building a new plant, launching a rival product, and so on – far slower and harder to implement than on a financial market, where all it takes is a telephone call or an online order.

In other words, a company that has made investments at least as profitable as its providers of funds require will never have insurmountable financing problems. If need be, it can always restructure the liability side of its balance sheet and find new sources of funds. Inversely, a company whose assets are not sufficiently profitable will, sooner or later, have financing problems, even if it initially obtained financing on very favourable terms. How fast its financial position deteriorates will depend simply on the size of its debt.

Section 35.1 THE MAJOR CONCEPTS

1/ COST OF A SOURCE OF FINANCING

Several simple ideas can be stated in this context.

The required rate of return is basically independent of the method of financing and the nationality of the investor. It depends solely on the market risk of the investment itself.

This presents the following consequences:

it is generally not possible to link the financing to the investment;
no “portfolio effect” can reduce this cost;
only the bearing of systematic risk will be rewarded.

It is therefore short-sighted to choose a source of financing based on what it appears to cost. To do so is to forget that all sources of financing will cost the same, given the risk.

We have too often heard it said that the cost of a capital increase was low, because the dividend yield on the shares was low, that internal financing costs nothing, that convertible bonds can lower a company’s cost of financing, and so on. Statements of this kind confuse the accounting cost with the true financial cost.

A source of financing is a bargain only if, for whatever reason, it brings in more than its market value. A convertible bond can be a good deal for the issuer not because it carries a low coupon rate, but only if the option embedded in it can fetch more than its market value.

Let us dwell briefly on the error one commits by confusing apparent cost and true financial cost.

The difference is minor for debt. It may arise from changes in market interest rates or, more rarely, from changes in default risk. In matters of financial organisation, debt has the merit that its accounting cost is close to its true cost; furthermore, that cost is visible on the books, since interest payments are an accounting expense.
The error is greater for equity, inasmuch as the dividend yield on the share needs to be augmented for prospective growth in dividends.
The error is extreme for internal financing, where, as we have seen and will see in Chapter 36, the apparent cost of reinvested cash flow is nil.
The error is hard to evaluate for all forms of hybrid securities – and this is often the explanation for their success. But let the reader beware: the fact that such securities carry low yields does not mean their financial cost is low. As we have shown in the foregoing chapters, an analysis of the hybrid security using both present value and option valuation techniques is needed to identify the true cost of this financing source.

Debt, by virtue of the liability that it represents for timely payments of interest and principal, has a direct consequence on the company’s cash flow. Debt can plunge the company into the ditch if it runs into difficulties; on the other hand, it can turn out to be a turbocharger that enables the company to take off at high speed if it is successful.

Source	Instrument	Theoretical cost to be used in investment valuation	Cost according to financial theory (A)	Apparent or explicit cost (accountability, cash flow) (B)	Difference (A) – (B)	Determinants of the difference
Debt			Market rate at which the company can refinance	Nominal rate	Small	Evolution of market interest rates; evolution of default risk
Equity	Share issue		Expected return required by the market on shares with the same risk profile	Nil in income statement; apparent cost measured by the dividend yield	Significant	Expected dividend growth rate
	Self-financing	The same for all products, it is a function of the systematic (non-diversifiable) risk of the investment being analysed	Expected return required by the market on shares with the same risk profile	Nil in the income statement; no apparent cost	Very significant	Total absence of apparent cost
Hybrid products	Convertible bonds, Bonds with warrants attached		Yield to maturity + value of the conversion option	Nominal interest rate (partially restated according to IFRS)	Medium	Value of conversion option
	Preference shares		Return should be slightly lower than the ordinary shares	Higher than ordinary shares and fixed throughout the life of the instrument	Small	They are shares for which a part of the value is guaranteed (present value of fixed dividends)
	Hybrid bond		Rate higher than the cost of a plain vanilla debt	Nominal interest rate	Difficult to evaluate	Variability used for the subordination clause

If a company is successful, the cost of a share issue will appear to be much higher, as the company will pay out much higher dividends than they initially expected. They will notice, looking backwards, that the issuance price of the share was very cheap. On the contrary, if the firm is in financial distress, the cost of the share issue will be close to nil, as the company will not be able to pay the expected dividends. The same is rarely true for debt, as it only occurs if the firm’s financial distress leads debtholders to forgive part of their loans.

2/ IS THERE A “ONCE-AND-FOR-ALL” OPTIMAL CAPITAL STRUCTURE?

The answer is clear: no, the optimal capital structure is a firm-specific policy and changes across time.

At the same time, there are a few loose ideas on the subject that the reader will have absorbed. Otherwise, how could one explain why the notion of what constitutes a “good” or “balanced” capital structure should have “changed” so much, and so often, over the course of time?

Large groups on both side of the Atlantic are rarely leveraged as being generally very profitable (which explains their size), they do not need debt.
*Source*: Data from Factset‐ Eurostoxx 600 et S&P 500

In the 1980s, a good capital structure was characterised by gradual diminution of debt, improved profitability and heightened reliance on internal financing.
In the early 1990s, in an environment of low investment and high real interest rates, there was no longer a choice: being in debt was not an option. Share buy-backs appear in Europe.
In the late 1990s, though, debt was back in favour if used either to finance acquisitions or to reduce equity. The reason: nominal interest rates were at their lowest level in 30 years.
The 2000s started with a financial crisis (the bursting of the Internet bubble) followed by an economic crisis that led to a closure of financial markets. This prevented firms from rebalancing their financial structure towards more equity. The lesson was learnt, as when the second economic crisis of the decade arrived in 2007–2008, corporates were lowly geared, except for groups involved in leveraged buyouts who suffered first. In all sectors, firms were trying to lower their debt level (by lowering capex and reducing working capital) to maintain flexibility as the timing of the upturn remained uncertain.
In the middle of the 2010s, companies that built up cash reserves resumed share buy-back operations or distributed large dividends, sometimes even going back to external growth operations.
With the Covid-19 crisis in 2020 forcing companies to react very quickly, losses from confinements are financed in the first instance by available cash or debt, which weighs on the financial structure in many sectors. Share issues will certainly come at a later stage.

*Source*: Data from Factset‐ Eurostoxx 600 et S&P 500

3/ CAPITAL STRUCTURE, INFLATION AND GROWTH

Because inflation is always a disequilibrium phenomenon, it is quite difficult to analyse from a financial standpoint. We can observe, however, that during a period of inflation, of high-volume growth, and negative real interest rates, overinvestment and excessive borrowing lead to a general degradation of capital structures. For companies that invest and reap the benefit of inflated profits, adjusted for inflation, their cost of financing is low. Shareholders can benefit from this phenomenon as well: a low rate of return on investment will be offset by the low cost of financing. Chinese groups in the early 2000s are proof of this.

*Source*: Data from Factset ‐ Eurostoxx 600 and S&P 500

Disinflation leads to exactly the opposite behaviour: high real interest rates encourage companies to get rid of debt, all the more so given that high rates are usually accompanied by anaemic economic activity and a business climate not conducive to borrowing.

A period of negative or zero percent real interest rates as we have seen in Europe since the mid-2010s, due to low nominal interest rates and low inflation, does not necessarily lead to a significant increase in corporate debt. Indeed, the high margins achieved (see Chapter 10) inflate cash flows, and reduce the need for debt. Moreover, the weakness of volume growth, which explains the ECB’s policy of negative or zero interest rates in order to revive it, does not imply heavy capital expenditure that would have to be financed.

4/ WHAT IS EQUITY FOR?

Equity capital thus plays two roles. Its first function is, of course, to finance part of the investment in the business. Another purpose, just as important, though, is to serve as a guarantee to the company’s creditors who finance the other part of the investment. For this reason, the cost of equity includes a risk premium.

Hence, equity capital is like an insurance policy (cf. discussion in Chapter 34 of equity as an option): like insurance, equity financing always costs too much until the crisis happens, in which case one is happy to have a lot of it. As we will see later, when a crisis does come, having considerable equity on the balance sheet gives a company time – time to survive and restructure when earnings are depressed, to introduce new products, to seize opportunities for external growth, and so on.

By comparison, a company with considerable debt suffers greatly because it has fixed expenses (interest payments) and fixed maturities (principal repayment) that will drag it down further. In a crisis, the companies with the most leverage are the first to disappear.

It is true also that financing geared towards equity does not lead management to react quickly when a crisis happens… and can sometimes mean that non-performing firms survive for a long time.

Section 35.2 HOW TO CHOOSE A CAPITAL STRUCTURE

A number of researchers have surveyed top executives and finance directors to determine what criteria they use in taking a financing decision. The tax saving on debt does not appear to be an essential criterion in the choice of capital structure, nor is fear of substantial bankruptcy costs. Rather, maintaining flexibility and concern about the impact of financing on the company’s credit rating came top of the list.

Even if companies say they have a fairly precise target for the level of their debt, more than half of all finance directors base their choice of financing on preserving flexibility. Although some theoreticians and some finance professors emphasise the limitations of EPS dilution as a criterion (it is not automatically synonymous with destruction of value), among practitioners it remains the most important factor in deciding whether or not to undertake a capital increase. This criterion seems to us a bit outmoded, but we will address it nonetheless in a following section.

The reader will by now have grasped that capital structure is the result of complex compromises between the following elements:

need to keep flexibility, i.e. keeping some financing capacity in case positive events (investment opportunities) or negative events (crises) happen;
need to maintain an adequate rating;
lifecycle of the company and the economic characteristics of the company’s sector;
risk aversion of shareholders and their wish not to be diluted;
existence of opportunities or constraints on financial markets;
the capital structure of competitors;
and finally the character of management.

1/ FINANCIAL FLEXIBILITY

Having and retaining flexibility is of strong concern to finance directors. They know that the choice of financing is a problem to be evaluated over time, not just at a given moment; a choice today can reduce the spectrum of possibilities for another choice to be made tomorrow.

Thus, taking on debt now will reduce borrowing capacity in the future, when a major investment – perhaps foreseeable, perhaps not – may be needed. If borrowing capacity is used up, the company will have no choice but to raise fresh equity. From time to time, though, the primary market in equities is closed because of depressed share prices (or can be accessed at such high price conditions, as was the case at the end of 2008, that most issuers are discouraged from tapping this market). If this should be the case when the company needs funds, it may have to forego the investment.

True, the markets for high-yield debt securities react as the equity markets do and may at times be closed to new issues or, equally, require such high interest rates that they are de facto closed.

Raising money today with a share issue, however, does not preclude another capital increase at a later time. Moreover, an equity financing today will increase the borrowing capacity that can be mobilised tomorrow.

The desire to retain flexibility prompts the company to carry less debt than the maximum level it deems bearable, so that it will at all times be in a position to take advantage of unexpected investment opportunities. Here again, we find the option concept applied to corporate finance.

In addition, the CFO will have taken pains to negotiate undrawn lines of credit with the company’s bank; to have in hand all the shareholder authorisations needed to issue new debt or equity securities; and to have effective corporate communication on financial matters with rating agencies, financial analysts and investors.

If amounts at stake allow it (i.e. are not to be reduced) to face financial crises that are difficult to forecast (but that appear from time to time, e.g. 1990, 2001, 2008, 2011, 2020), the quest for financial flexibility will require the CFO to open up different capital markets to the company. A company that has already issued securities on the bond market and keeps a dialogue going with bond investors can come back to this market very quickly if an investment opportunity appears.

The proliferation of financing sources – bilateral or syndicated bank loans, securitised receivables, factoring schemes, bonds, convertibles, shares, and so on – allows the company to enhance its financial flexibility even further.

2/ THE RATING OF THE COMPANY

Ratings agencies have clearly gained in importance – especially in Europe – due mostly to the transition from an economy based mostly on banking intermediaries to one where the financial markets are becoming predominant.

Ratings are becoming one of the main concerns of CFOs. Financing, distribution, investment, disposal decisions are thus frequently taken based partly on their rating impact; or, more precisely, decisions having a negative rating impact will be adjusted accordingly. Some companies even set rating targets (Pepsi, Diageo and Danone, for example). This can seem paradoxical in two ways:

although all financial communication is based on creating shareholder value, companies are much less likely to set share price targets than rating targets;
in setting rating targets, companies have a new objective: that of preserving value for bondholders! This is praiseworthy and, in a financial market context, understandable, but has never been part of the bargain with shareholders.

We see several possible explanations for this paradox:

first of all, a debt rating downgrade is clearly a major event for a group and goes well beyond bondholder information. A downgrade is traumatic and messy and almost always leads to a fall in the share price. So, in seeking to preserve a financial rating, it is also shareholder value that management is protecting, at least in the short term;
a downgrade (in particular losing investment grade status) can sometimes lead to forced debt repayments and consequently liquidity problems;
it can also have an immediate cost if the company has issued a bond with a step-up in the coupon, i.e. a clause stating that the coupon will be increased in the event of a rating downgrade;
a good debt rating guarantees a higher degree of financial flexibility. The higher the rating, the easier it is to tap the bond markets, as transactions are less dependent on market fluctuations.

3/ LIFECYCLE OF THE COMPANY AND THE ECONOMIC CHARACTERISTICS OF THE COMPANY’S SECTOR

A start-up will have a hard time getting any debt financing. It has no past and thus no credit history, and it generally has no tangible assets to pledge as security. The technological environment around it is probably quite unsettled, and its free cash flow is going to be negative for some time. For a lender, the level of specific risk is very high. The start-up consequently has no choice but to seek equity financing.

At the other extreme, an established company in a market that has been around for years and is reaching maturity will have no difficulty attracting lenders. Its credit history is there, its assets are real and it is generating free cash flow (predictable with low forecast error), which are all the greater if the major investments have already been made. In short, it has everything a creditor craves. In contrast, an equity investor will find little to be enthusiastic about: not much growth, not much risk, thus not much profitability.

Similarly, in an industry with high fixed costs, a company will seek to finance itself mostly with equity, so as not to pile the fixed costs of debt (interest payments) on top of its fixed operating costs and to reduce its sensitivity to cyclical downswings. But sectors with high fixed costs – steel, cement, paper, energy, semi-conductors, etc. – are generally highly capital-intensive and thus require large investments, inevitably implying borrowing as well.

An industry such as retailing with high variable costs, on the other hand, can make the bet that debt entails, as the fixed costs of borrowing come on top of low fixed operating costs.

Lastly, the nature of the asset can influence the availability of financing to acquire it. A highly specific asset — that is, one with little value outside of a given production process — will be hard to finance with debt. Lenders will fear that if the company goes under, the asset’s market value will not be sufficient to pay off their claims.

4/ SHAREHOLDER PREFERENCES

If the company’s shareholder base is made up of influential shareholders, majority or minority, their viewpoints will certainly have an impact on financing choices.

Some holders will block share issues that would dilute their stake because they are unable to take up their share of the rights. A company in this situation must then go deeply into debt. Others may have a marked aversion to debt because they have no desire to increase the level of risk they are bearing (L’Oreal, for example).

The most ambitious shareholders will accept both dilution of their control and risk linked to a high level of debt. Their control and the survival of the firm will only be possible thanks to the success of the strategy (Pernod Ricard, for example).

5/ OPPORTUNITIES

Since markets are not systematically in equilibrium, opportunities can arise at a given moment. A steep run-up in share prices will enable a company to undergo a capital increase on the cheap (by selling shares at a very high price). The folly of a bank that says yes to every loan application and the sudden (and temporary!) infatuation of investors for a particular kind of stock (renewable energy companies and electric vehicles in 2020, SPAC (Special Purpose Acquisition Company) listings in 2021), a high volatility together with a limited volume of new issues making the issue of convertible bonds attractive, are other examples.

Furthermore, if the company at some point in time is enjoying exceptionally low-cost financing, investors, for their part, will have made a bad mistake. In their fury, they risk tarnishing the company’s image, and it will be a long time before they can be counted on to put up new money. Deliveroo, which went public on the stock market in March 2021, benefiting from Covid frenzy, will surely have raised money at low cost, but will it raise more capital a year later, after its share price still trades 36% below the IPO price? We very much doubt it.

6/ CAPITAL STRUCTURE OF COMPETITORS

To have higher net debt than one’s rivals is to bet heavily on the company’s future profitability – that is, on the economy, the strategy, and so forth. It is therefore to be more vulnerable to a cyclical downturn, one that could lead to a shake-out in the sector and extinction of the weakest.

Experience shows that business leaders are loath to imperil an industrial strategy by adopting a financing policy substantially different from their competitors’. If they have to take risks, they want them to be industrial or commercial risks, not financial risks.

With the analyses in hand, the person or body taking the financing decision will be able to do so with full knowledge of the facts. The investor will bear in mind that, statistically (and thus for a diversified portfolio), their dream of multiplying their wealth through judicious use of debt will be the nightmare of the company in financial distress. The financial success of a few tends to make one forget the failure of companies that did not survive because they were too much in debt.

7/ MANAGERS’ CHARACTER

The character of managers will materially influence the capital structure of the firm. Managers averse to risk choose a capital structure with low leverage, whereas those with high self-confidence adopt a highly geared financial structure. Malmendier et al. (2011) have shown that managers who experienced the Great Depreciation favour self-financing and are very prudent towards raising debt. There is no doubt that in a few years, other researchers will draw the same conclusions about CFOs who experienced the 2008–2009 financial or the 2020 coronavirus crisis!

This may seem obvious, but it reminds us that choices in corporate finance can be highly subjective; behavioural finance is not to be underestimated.

Section 35.3 EFFECTS OF THE FINANCING CHOICE ON ACCOUNTING AND FINANCIAL CRITERIA

With this description of the key ideas in mind, the time has come for the reader to implement a choice of capital structure as part of a financing plan. To this end, we suggest that the following documents be at hand:

Past financial statements: income statements, balance sheets, cash flow statements.
Forecast financial statements and financing plan, constructed in the same form as past cash flow statements. These can either be mean forecasts or simulations based on several assumptions; the latter strikes us as the better solution. A simulation model will be very useful for establishing the probable future course of the company’s capital structure, profitability, business conditions, and so on, given a set of assumptions. This kind of exercise is facilitated by using spreadsheet software and simulation assumptions that allow for a dynamic analysis.
To be fully prepared, the analyst will also want to have sector average ratios, which can be obtained from various industry studies or by calculating them from a sample of listed, comparable companies.

1/ IMPACT ON LIQUIDITY

The liquidity of the company is its ability to meet its financial obligations on time in the ordinary course of business, obtain new sources of financing and thereby ensure balance at all times between its income and expenditure.

In a truly serious financial crisis, companies can no longer obtain the financing they need, no matter how good they are. This is the case in a crash brought on by a panic. It is not possible to protect oneself against this risk, which fortunately is altogether exceptional. The more common liquidity risk occurs when a company is in trouble and can no longer issue securities that financial markets or banks will accept; investors have no confidence in the company at all, regardless of the merit of its investment projects.

Liquidity is therefore related to the term structure of financial resources. It is analysed both at the short-term level and at the level of repayment capacity for medium- and long-term debt. This leads to the use of traditional concepts and ratios that we have already seen: working capital, equity, debt, current assets/current liabilities, and so on.

For analysing the impact on liquidity, the simulation must bear on free cash flow. The analyst will need to simulate different levels of debt and repayment terms and test whether free cash flow is sufficient to pay off the borrowings without having to reschedule them. This is also a method used by rating agencies to determine their rating and by bankers to assess whether they want to lend to a firm or not.

If the company bears a high level of debt, the analyst will consider worst-case scenarios to assess when the liquidity situation will become critical.

2/ IMPACT ON SOLVENCY

Debt increases the company’s risk of becoming insolvent. We refer the reader to the development of this topic in Chapter 14.

3/ IMPACT ON EARNINGS

Indeed, interest payments constitute a fixed cost that cannot be reduced except by renegotiating the terms of the loan or filing for bankruptcy. Take, as an example, a company with fixed costs of 40 and variable costs of 0.5 per unit sold. If the selling price is 1, the breakeven point is 80 units. If the company finances an investment of 50 with debt at 4%, the breakeven point rises to 84 units because fixed costs have increased by 2 (interest expense on the borrowing). If the investment is financed with equity, the breakeven point stays at 80.

The problem is trickier when the interest rate is indexed to market rates, but the interest payments are still a fixed cost in the sense of being independent of the level of activity. Typically, interest rates rise when general economic activity is weakening. In such a case, it is important to test the sensitivity of the company’s earnings to changes in interest rates. We have a tendency to forget this in times where interest rates are very low, such as today.

4/ IMPACT ON EARNINGS PER SHARE

An investment financed by debt increases the company’s net profit, and thus earnings per share, only if the after-tax return generated by its investments is greater than the after-tax cost of debt. If this is not the case, the company should not make the investment. If an investment is particularly sizeable and long term, it may happen that its rate of return is less than the cost of debt for a period of time, but this must be a temporary situation.

To study these phenomena, companies are accustomed to analysing changes in earnings per share relative to operating profit (EBIT).

		Period 1		Period 2
	Period 0	Case A	Case B	Case A	Case B
Operating profit (EBIT)	300	300	300	370	370
− Interest expense at 3%	0	0	6	0	6
= Pre-tax profit	300	300	294	370	364
− Income tax at 25%	75	75	74	93	91
= Net profit	225	225	220	277	273
Number of shares	100	120	100	120	100
Earnings per share	2.25	1.88	2.21	2.30	2.73

In period 2, earnings per share will be greater if the investment is financed by debt. In case B, the interest expense reduces EPS, but by less than the dilution due to the capital increase in case A.

This conclusion cannot be generalised, however. The following chart simulates various levels of EPS as a function of operating profit in period 2.

The reader will be able to verify that if operating profit is less than 36, the preceding assertion is reversed. However, a steep decline in earnings (–88%) is required to produce this result. Obviously if the cost of debt was higher the decline would be less.

In short: beware! The faster growth of EPS with debt financing is a purely arithmetic result; it does not indicate greater value creation. It is due simply to the leverage effect, the counterpart of which is a higher level of risk to the shareholder.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Whereas frequent disequilibria in industrial markets engender the hope of creating value through judicious investment, the same cannot be said of choosing a source of financing. Financial markets are typically close to equilibrium, and all sources of financing have the same cost to the company given their risk.

The cost of financing to buy an asset is equal to the rate of return required on that asset, regardless of whether the financing is debt or equity and regardless of the nationality of the investor.

It follows that the choice of source of financing is not made on the basis of its cost (since all sources have the same risk-adjusted cost!). Apparent cost must not be confused with financial cost (the true economic cost of a source of financing). The difference between apparent cost and financial cost is low for debt; it is attributable to the possibility of changes in the debt ratio and default risk. The difference is greater for equity owing to growth prospects; greater still for internal financing, where the explicit cost is nil; and difficult to evaluate for all hybrid securities. Lastly, a source of financing is cheap only if it has brought in more than its market value (inefficient markets).

Because there is no optimal capital structure, the choice between debt and equity will depend on a number of considerations:

Macroeconomic conditions. High real (inflation-adjusted) interest rates and low activity growth will prompt companies to deleverage. Inversely, rapid growth and/or low real interest rates will favour borrowing.
The desire to retain a degree of financial flexibility so that any investment opportunities can be quickly seized. To this end, equity financing is preferred because it creates additional borrowing capacity and does not compromise future choices. Inversely, if current borrowing capacity is used up, the only source of financing left is equity; its availability depends on financial markets holding up, which is never certain.
The maturity of the industry and the capital structure of competitors. A start-up will get no financing but equity because of its high specific risk, whereas an established company with sizeable free cash flow but little prospect of growth will be able to finance itself largely by borrowing. Companies in the same business sector often mimic each other (what matters is to be no more foolish than the next guy!).
Shareholder preferences. Some will favour borrowing so as not to be diluted by a capital increase in which they cannot afford to participate. Others will favour equity so as not to increase their risk. It is all a question of risk aversion, financial capacity of shareholders and extent of control.
Financing opportunities. These are, by definition, unpredictable, and it is hard to construct a rigorous financing policy around them. When they occur, they make it possible to raise funds at less than the normal cost – but at the expense of the investors who have deluded themselves.

The reader who performs simulations of the principal financial parameters, differentiating according to whether the company is using debt or equity financing, should be fully aware that such simulations mainly show the consequences of financial leverage:

raising the breakeven point;
accelerating EPS growth;
increasing the rate of return on book equity;
degrading solvency;
affecting liquidity in a way that varies with the term of the debt.

QUESTIONS

1/Can a good financing plan make up for a mediocre investment?
2/What disorder afflicts the investor who mistakes the coupon rate on a convertible bond for its financial cost?
3/A 17% rate of return is required on a certain asset. The acquisition of that asset is financed entirely by equity. What rate of return do shareholders require on it? If the asset were financed entirely by debt, what rate of return would lenders require on it?
4/What is the source of financing for which the difference between financial cost and apparent cost is greatest?
5/Would you advise a start-up to seek debt financing? If yes, could it get it?
6/Is there an optimal capital structure?
7/Equity capital has two roles in a financing plan. What are they?
8/In the final analysis, isn’t the cheapest financial resource short-term borrowing?
9/How do you reconcile these two statements:
- “You can’t make money without borrowing money.”
- “Borrowing can’t create value.”
10/Will a company with ample growth opportunities tend to issue short-term, medium-term or long-term debt? Why?
11/Give two examples of inflation profits. Under what conditions can they occur?
12/If you believe a finance director’s main concern is financial flexibility, would you expect a company ever to use up its borrowing capacity?
13/Is a company destined always to be financed with equity capital?
14/Can an entrepreneur with an industrial strategy be opportunistic in their financing choices over time?
15/Why did European companies rid themselves of so much debt in 1980–1998? Why did they stop doing it in 1998–2002?
16/A hotel group is able to finance itself more easily through debt than a high-tech company. Why?
17/A mineral water company is able to finance itself through debt more easily than a pharmaceutical group. Why?
18/Can an airline company finance itself through debt despite its heavy fixed costs? Why?
19/Why is it that despite real interest rates being zero or close to zero since 2015, European companies are not taking on more debt?
You’ll find more questions at www.vernimmen.com.

EXERCISE

1/A company is considering the following:
Year 0 1 2 3 4 5
Cash flow −100 −10 0 0 10 150
which can be financed with equity:
Year 0 1 2 3 4 5
Debt/equity 30% 22% 22% 22% 22% 22%
EPS 10 8.25 9.1 10.3 11.8 13.6
EPS growth rate −17.5% +10% +13% +15% +15%
Rate of return on equity 15% 11% 11% 11.4% 11.6% 12%
or with debt:
Year 0 1 2 3 4 5
Debt/equity 30% 67% 67% 67% 67% 67%
EPS 10 9.3 10.4 12 14.1 16.5
EPS growth rate −7% +12% +15% +17% +17%
Rate of return on equity 15% 14% 17% 18% 21% 22%
If the cost of capital is 10%, the shareholder-required rate of return is 12% and the cost of debt is 5%, do you think this investment should be financed with equity or with debt? Isn’t there another question that should be asked first?

ANSWERS

Questions

1/No, because it is very difficult to create value at the level of the financing plan.
2/Myopia, because they are not noticing that holders of convertible bonds expect the share price to rise so that they can convert them.
3/17%, 17%, as they run the same risk, the risk of operating assets.
4/Internal financing, as its apparent cost is nil.
5/No, because it would be far too risky for a start-up, requiring certain outflows from uncertain inflows. Probably not until its business model is proved.
6/No! We advise our readers who answered ‘yes’ to read Chapters 32 to 35 again.
7/Providing part of the financing and providing security to lenders.
8/No, no and no! You forget to take into account the risk (here liquidity risk).
9/“You can’t make money without borrowing money” applies to an investor with a poorly diversified portfolio; it’s all or nothing if they go into debt to leverage it. “Borrowing can’t create value” applies to a perfectly diversified portfolio.
10/Short-term, so as to be able to refinance on better terms as growth opportunities become profitable investments.
11/Inventory profits and opportunity profits on investment realised sooner than expected. Provided the inflation rate is higher than the interest rate.
12/No, because the finance director will always want to retain some room to manoeuvre, just in case.
13/No, the less risky it becomes, the more readily it can be financed with debt.
14/No, because an industrial strategy can’t wait for opportunities to arrive.
15/High real interest rates and low investment. Because virtually all their debt had already been paid off, they could not go on deleveraging.
16/Because it holds assets (the walls of the hotels, business capital) which have a value independent of operations and can be given as collateral for loans. In high technologies, the never-ending changes make cash flow predictions hazardous.
17/Because its cash flows are more predictable than those of a pharmaceutical group, the patents of which expire regularly.
18/Yes, because it controls two assets which have a value on the secondary market: aircraft and landing rights.
19/This is because the margins, and therefore the self-financing capacity, of companies are high (see end of Section 9.1), reducing the need for financing. Moreover, in Europe a firm takes on debt mainly to finance investments, which implies growth in volume. However, this growth remains low, hence why the interest rates are kept very low in the first place by the ECB in an attempt to revive it.

BIBLIOGRAPHY

For the factors of choice of the financial structure:

N. Aktas, I. Bellettre, J.-G. Cousin, Capital structure decisions of French very small businesses, Finance, 32(1), 43–73, June 2011.
M. Baker, J. Wurgler, Market timing and capital structure, Journal of Finance, 57(1), 1–32, February 2002.
F. Bancel, Focus on financial flexibility, Bankers Markets and Investors, 121, 60–65, November–December 2012.
F. Bancel, U. Mittoo, The determinants of capital structure choice: A survey of European firms, Financial Management, 33(4), 103–133, Winter 2004.
D. Brounen, A. de Jong, K. Koedijk, Capital structure policies in Europe: Some evidence, Journal of Banking and Finance, 30(5), 1409–1422, May 2006.
H. DeAngelo, A. Goncalves, R. Stulz, Corporate deleveraging and financial flexibility, Review of Financial Studies, 31(8), 3122–3174, August 2018.
P. DeMarzo, Presidential address: Collateral and commitment, Journal of Finance, 74(4), 1587–1619, August 2019.
D. Denis, S. McKeon, Debt financing and financial flexibility: Evidence from pro-active leverage increases, Review of Financial Studies, 25(6), 1897–1929, June 2012.
M. Frantz, V. Goyal, Capital structure decisions: Which factors are reliably important?, Financial Management, 38(1), 1–37, Spring 2009.
A. Gamba, A. Triantis, The value of financial flexibility, Journal of Finance, 63(5), 2263–2296, October 2008.
J. Graham, C. Harvey, The theory and practice of corporate finance: Evidence from the field, Journal of Financial Economics, 63(2&3), 187–243, May 2001.
J. Graham, M. Leary, A review of empirical capital structure research and directions for the future, Annual Review of Financial Economics, 3, 309–345, December 2011.
A. Kayhan, S. Titman, Firms’ histories and their capital structures, Journal of Financial Economics, 83(1), 1–32, January 2007.
R. Korajczyk, A. Levy, Capital structure choice: macroeconomic conditions and financial constraints, Journal of Financial Economics, 68(1), 75–109, April 2003.
M. Leary, M. Roberts, Do firms rebalance their capital structures?, Journal of Finance, 60(6), 2575–2619, December 2005.
M. Leary, M. Roberts, Do peer firms affect corporate financial policy, Journal of Finance, 69(1), 139–177, February 2014.
U. Malmendier, G. Tate, J. Yan, Overconfidence and early-life experiences: The effect of managerial traits on corporate financial policies, Journal of Finance, 66(5), 1687–1733, October 2011.
S. Myers, Still searching for optimal capital structure, Journal of Applied Corporate Finance, 6(1), 4–14, Spring 1993.
S. Myers, Capital structure, Journal of Economic Perspectives, 15(2), 81–102, Spring 2001.
J. Tierny, C. Smithson, Implementing economic capital in an industrial company: The case of Michelin, Journal of Applied Corporate Finance, 15(4), 8–22, Summer 2003.

For statistical studies of financial structures:

H. DeAngelo, R. Roll, How stable are corporate capital structures?, Journal of Finance, 17(1), 373–418, February 2015.
European Central Bank, Corporate finance in the euro area, Occasional Paper Series, 63, August 2013.
T. Khurana, W. Rehm, A. Srivastava, Rising corporate debt: Companies are safe, for now, McKinsey, May 2019.

To deepen the study of equity financing:

E. Fama, K. French, Financing decision: Who issues stock?, Journal of Financial Economics, 76(3), 549–582, June 2005.

For the interaction between financial structure and investments:

M. Campello, Capital structure and product market interactions: Evidence from business cycles, Journal of Financial Economics, 68(3), 353–378, June 2003.
S. Chava, M. Roberts, How does financing impact investment? The role of debt covenants, Journal of Finance, 63(5), 2085–2121, October 2008.
E. Dudley, Capital structure and large investment projects, Journal of Corporate Finance, 18(5), 1168–1192, December 2012.
V. Gatchev, T. Pulvino, V. Tarhan, The interdependent and intertemporal nature of financial decisions: An application to cash flow sensitivities, Journal of Finance, 65(2), 725–763, April 2010.
A. Kolosinski, Subsidiary debt, capital structure and internal capital markets, Journal of Financial Economics, 94(3), 327–343, November 2009.
P. MacKay, G. Phillips, How does industry affect firm financial structure?, Review of Financial Studies, 18(4), 1433–1466, August 2005.
M.-T. Marchica, R. Mura, Financial flexibility, investment ability and firm value: evidence from firms with spare debt capacity, Financial Management, 39(4), 1339–1365, Winter 2010.
S. Reinartz, Production flexibility, product markets, and capital structure decisions, Review of Financial Studies, 29(6), 1501–1548, June 2016.
L. Riddick, T. Whited, The corporate propensity to save, Journal of Finance, 64(4), 1729–1768, August 2009.

For clinical analyses of financing choices:

Y. Le Fur, P. Quiry, How did Air Liquide, Danone and SEB finance their 2016 acquisitions?, The Vernimmen.com Newsletter, 100, 1–4, January 2017.

****PART TWO. EQUITY CAPITAL

Equity capital policy is of such importance in corporate finance that it must be addressed in depth. The chapters in this part deal, in turn, with dividend policy, share buy-backs and share issues.

Chapter 36. RETURNING CASH TO SHAREHOLDERS

It’s all grist to the mill

Net income has only two possible destinations: either it is reinvested in the business in the form of internal financing or it is redistributed to shareholders in dividends or share buy-backs.

In fact, when the capital structure of the firm already corresponds to the target fixed by shareholders and management, every cent left in the company in the form of cash will only yield the short-term interest rate, i.e. much less than the cost of equity. Today this may even mean yielding a negative return, given the negative interest rates in certain regions of the world. It is true that the financial risk of the firm is then reduced, but it is not what shareholders are looking for (shareholders theoretically manage financial risks at their portfolio level). In this context, it is very likely that shareholders will value it at less than a cent given its insufficient profitability. After all, shareholders do not need the firm to place cash at the bank. All in all, failure to comply with this rule will most likely lead to value destruction. It also means moving away from the target financial structure defined by the shareholders and management by reducing net indebtedness.

Additionally, the business risk should be financed through equity; otherwise, the firm is likely to face strong liquidity issues at the first downturn. Conversely, a company that has reached economic maturity with a strong strategic position may reduce its equity financing and select a higher gearing. The business cash flows have become sufficiently sound to support the cash requirements of debt.

Section 36.1 REINVESTED CASH FLOW AND THE VALUE OF EQUITY

1/ PRINCIPLES

An often-heard precept in finance says that a company ought to fund its development solely through internal financing – that is, by reinvesting its cash flow in the business. This position seemingly corresponds to the interests of both its managers and its creditors, and indirectly to the interests of its shareholders:

For shareholders, reinvesting cash flow in the business ought to translate into an increase in the value of their shares and thus into capital gains on those shares. In virtually all of the world’s tax systems, capital gains are taxed less heavily than dividends. Other things being equal, shareholders will prefer to receive their returns in the form of capital gains. They will therefore look favourably on retention rather than distribution of periodic cash flows.
By funding its development exclusively from internal sources, the company has no need to go to the capital markets – that is, to investors in shares or corporate bonds – or to banks. For this reason, its managers will have greater freedom of action. They, too, will look favourably on internal financing.
Lastly, as we have seen, the company’s creditors will prefer that it rely on internal financing because this will reduce the risk and increase the value of their claims on the company.

This precept is not wrong, but here we must emphasise the dangers of taking it to excess. A policy of always or only reinvesting internally generated cash flow postpones the financial reckoning that is indispensable to any policy. It is not good for a company to be cut off from the capital markets or for capital mobility to be artificially reduced, allowing investments to be made in unprofitable sectors. The company that follows such a policy in effect creates its own internal capital market independent of the outside financial markets. On that artificial market, rates of return may well be lower, and resources may accordingly be misallocated.

The sounder principle of finance is probably the one that calls for distributing all periodic earnings to shareholders and then going back to them to request funding for major projects. In the real world, however, this rule runs up against practical considerations – substantial tax and transaction costs and shareholder control issues – that make it difficult to apply.

2/ INTERNAL FINANCING AND VALUE CREATION

We begin by revisiting a few truisms.

The reader should fully appreciate that, given unchanged market conditions, the value of the company must increase by the amount of profit that it reinvests. This much occurs almost automatically, one might say. The performance of a strategy that seeks to create “shareholder value” is measured by the extent to which it increases the value of shareholders’ equity by more than the amount of reinvested earnings.
The apparent cost of internal financing is nil. This is certainly true in the short term, but what a trap it is in the long term to think this way! Does the reader know of any good thing that is free, except for things available in unlimited quantity, which is clearly not the case with money? Reinvested cash flow indeed has a cost and, as we have learned from the theory of markets in equilibrium, that cost has a direct impact on the value of the company. It is an opportunity cost. Such a cost is, by nature, not directly observable – unlike the cost of debt, which is manifested in an immediate cash outflow. As we explained previously, retaining earnings rather than distributing them as dividends is financially equivalent to paying out all earnings and simultaneously raising new equity capital. The cost of internal financing is therefore the same as the cost of a capital increase: to wit, the cost of equity.
Does this mean the company ought to require a rate of return equal to the cost of equity on the investments that it finances internally? No. As we saw in Section 29.3, it is a mistake to link the cost of any source of financing to the required rate of return on the investment that is being financed. Whatever the source or method of financing, the investment must earn at least the cost of capital.¹ By reinvesting earnings rather than borrowing, the company can reduce the proportion of debt in its capital structure and thereby lower its cost of debt. In equilibrium, this cost saving is added on top of the return yielded by the investment to produce the return required by shareholders. Similarly, an investment financed by new debt needs to earn not the cost of debt, but the cost of capital, which is greater than the cost of debt. The excess goes to increase the return to the shareholders, who bear additional risk attributable to the new debt.
Retained earnings add to the company’s financial resources, but they increase shareholder wealth only if the rate of return on new investments is greater than the weighted average cost of capital. If the rate of return is lower, each euro invested in the business will increase the value of the company by less than one euro, and shareholders will be worse off than if all the earnings had been distributed to them. This is the market’s sanction for poor use of internal financing.

Consider the following company. The market value of its equity is 135, and its shareholders require a rate of return of 7.5%:

Year	Book value of equity	Net profit	Dividend (Div)	Market value of equity (V) P/E = 9	Gain in market value (ΔV)	Rate of return (ΔV + Div)/V
1	300.0	15.0	4.5	135.0
2	310.5	15.6	4.7	140.4	5.4	7.2%
3	321.4	16.2	4.9	145.8	5.4	7.1%
4	332.7	16.8	6.7	151.2	5.4	8.0%

Annual returns on equity are close to 7.5%. Seemingly, shareholders are getting what they want. But are they?

To measure the harm done by ill-advised reinvestment of earnings, one need only compare the change in the book value of equity over four years (+32.7) with the change in market value (+16.2). For each €1 the shareholders reinvested in the company, they can hope to get back only €0.50. Of what they put in, fully half was lost – a steep cost in terms of foregone earnings.

Beware of “cathedrals built of steel and concrete” – companies that have reinvested to an extent not warranted by their profitability!

Reinvesting earnings automatically causes the book value of equity to grow. It does not cause symmetrical growth in the market value of the company unless the investments it finances are sufficiently profitable – that is, unless those investments earn more than the required rate of return given their risk. If they earn less, shareholders’ equity will increase but shareholders’ wealth will increase less than the amount of the reinvested funds. Shareholders would be better off if the funds that were reinvested had instead been distributed to them.

In our example, the market value of equity (151) is only about 45% of its book value (333). True, the rate of return on equity (5%) is, in this case, far below the cost of equity (7.5%).

More than a few unlisted mid-sized companies have engaged in excessive reinvestment of earnings in unprofitable endeavours, with no immediate visible consequence on the valuation of the business.

The owner-managers of such companies get a painful wake-up call when they find they can sell the business, which they may have spent their entire working lives building, only for less than the book value of the company’s assets. The sanction imposed by the market is severe.

In other words, dividends and share buy-backs, which are tools for returning surplus funds to shareholders (and not a remuneration for shareholders as we will see), prevent waste of a scarce resource, equity. By allowing money to circulate, they make the creation and development of new companies to compete with existing ones possible. These are therefore, in the long-run, effective anti-trust and anti-monopoly tools.

3/ INTERNAL FINANCING AND TAXATION

From a tax standpoint, reinvestment of earnings has long been considered a panacea for shareholders. It ought to translate into an increase in the value of their shares and thus into capital gains when they liquidate their holdings. Generally, capital gains are taxed less heavily than dividends.

Other things being equal, then, shareholders will prefer to receive their income in the form of capital gains and will favour reinvestment of earnings. Since the 1990s, however, as shareholders have become more of a force and taxes on dividends have been reduced in most European countries, this form of remuneration has become less attractive.

4/ INTERNAL FINANCING, SHAREHOLDERS AND LENDERS

We have seen (see the discussion of options theory in Chapter 34) that whenever a company becomes riskier, there is a transfer of value from creditors to shareholders. Symmetrically, whenever a company pays down debt and moves into a lower risk class, shareholders lose and creditors gain.

Reinvestment of earnings can be thought of as a capital increase in which all shareholders are forced to participate. This capital increase tends to diminish the risk borne by creditors and thus, in theory, makes them better off by increasing the value of their claims on the company.

The same reasoning applies in reverse to dividend distribution. The more a company pays out in dividends, the greater the transfer of value from creditors to shareholders.

5/ INTERNAL FINANCING, SHAREHOLDERS AND MANAGERS

As we will see in Section 36.3, 2/ under the agency theory approach, internal financing represents a major issue in the relationship between shareholders and managers. Internal financing represents a blank cheque for managers without any control by shareholders. Internal financing is therefore one of the main sources of conflict between managers and shareholders.

Section 36.2 INTERNAL FINANCING AND FINANCIAL CRITERIA

1/ INTERNAL FINANCING AND ORGANIC GROWTH

Growth of the equity of a firm that does not issue shares depends on its return on equity and its payout ratio.

The net profit of a firm with equity of 100 and a return on equity of 15% will be 15. If its payout ratio is 1/3, it will keep 2/3 of its profits, i.e. 10. Equity will then become 110 the next year, a 10% increase, as shown in the table below:

Year	Book value of equity at beginning of year	Net profit (15% of equity)	Retained earnings	Book value of equity at end of year
1	100.0	15.0	10.0	110.0
2	110.0	16.5	11.0	121.0
3	121.0	18.2	12.1	133.1
4	133.1	20.0	13.3	146.4

The book value of a company that raises no new money from its shareholders depends on its rate of return on equity and its dividend payout ratio.

The growth rate of book value is equal to the product of the rate of return on equity and the earnings retention ratio, which is the complement of the payout ratio.

We have:

where g is the rate of growth of shareholders’ equity,² ROE (return on equity) is the rate of return on the book value of equity and d is the dividend payout ratio.

This is merely to state the obvious, as the reader should be well aware.

In other words, given the company’s rate of return on equity, its reinvestment policy determines the growth rate of the book value of its equity.

2/ MODELS OF INTERNAL GROWTH

If capital structure is held constant, growth in equity allows parallel growth in debt and thus in all long-term funds required for operations. We should make it clear that here we are talking about book values, not market values.

We need only recall that the rate of return on book value of equity is equal to the rate of return on capital employed adjusted for the positive or negative effect of financial leverage (gearing) due to the presence of debt:

or:

where g is the growth rate of the company’s capital employed at constant capital structure and constant rate of return on capital employed (ROCE).

This is the internal growth model.

It is clear that the rates of growth of revenue, production, EBITDA and so on will be equal to the rate of growth of book equity if the following ratios stay constant:

To illustrate this important principle, we consider a company whose assets are financed 50% by equity and 50% by debt, the latter at an after-tax cost of 5%. Its after-tax return on capital employed is 15%, and 80% of earnings are reinvested. Accordingly, we have:

Period	Book equity at beginning of period	Net debt	Capital employed	Operating profit after tax	Interest expenses after tax	Net profit	Dividends	Retained earnings	Book equity at end of period
1	100	100	200	30	5	25	5	20	120
2	120	120	240	36	6	30	6	24	144
3	144	144	288	43.2	7.2	36	7.2	28.8	172.8

This gives us an average annual growth rate of book equity of:

The reader can verify that, if the company distributes half its earnings in dividends, the growth rate of the book value of equity falls to:

The growth rate of capital employed thus depends on the:

rate of return on capital employed: the higher it is, the higher the growth rate of financial resources;
cost of debt: the lower it is, the greater the leverage effect, and thus the higher the growth rate of capital employed;
capital structure;
payout ratio.

In a situation of equilibrium, then, shareholders’ equity, debt, capital employed, net profit, book value per share, earnings per share and dividend per share all grow at the same pace, as illustrated in the example above. This equilibrium growth rate is commonly called the company’s growth potential.

3/ ADDITIONAL ANALYSIS

The first of the models above – the internal growth model – assumes all the variables are growing at the same pace and also that returns on funds reinvested by organic growth are equal to returns on the initial assets. These are very strong assumptions.

Suppose a company reinvests two-thirds of its earnings in projects that yield no return at all. We would observe the following situation:

Period	Book equity at beginning of period	Net profit	Return on equity	Dividends	Retained earnings	Book equity at end of period
1	100	15	15.0%	5	10	110 (+10.0%)
2	110	15 (+0%)	13.6%	5 (+0%)	10	120 (+9.1%)
3	120	15 (+0%)	12.5%	5 (+0%)	10	130 (+8.3%)

We see that if net profit and earnings per share do not increase, then growth of shareholders’ equity slows and return on equity declines because the incremental return (on the reinvested funds) is zero.

If, on the other hand, the company reinvests two-thirds of its earnings in projects that yield 30%, or double the initial rate of return on equity, all the variables will rise.

Period	Equity at beginning of period	Net profit	Rate of return on equity	Dividends	Retained earnings	Equity at end of period
1	100	15	15.0%	5	10	110 (+10.0%)
2	110	18³ (+20%)	16.4%	6 (+20%)	12	122 (+10.9%)
3	122	21.6⁴ (+20%)	17.7%	7.2 (+20%)	14.4	136.4 (+11.8%)

Although the rate of growth of book equity increases only slightly, the earnings growth rate immediately jumps to 20%.

The rate of growth of net profit (and earnings per share) is linked to the marginal rate of return, not the average.

Here we see that there are multiplier effects on these parameters, as revealed by the following relation:

This means that, barring a capital increase, the rate of growth of earnings (or earnings per share) is equal to the marginal rate of return on equity multiplied by the earnings retention ratio (1 − dividend payout ratio).

Section 36.3 WHY RETURN CASH TO SHAREHOLDERS?

When the company is no longer able to find investment projects that return at least their cost of capital, then the question arises as to the use of these funds. Should the company return this excess equity to its shareholders? Even if the theoretical answer is yes, the amount of funds returned to shareholders is not generally equal to the funds that could not be invested at a minimum return equal to the cost of capital. Beyond this simple theory, other factors need to be taken into account.

1/ DIVIDENDS AND EQUILIBRIUM MARKETS

In markets in equilibrium, payment of a dividend has no impact on the shareholder’s wealth, and the shareholder is indifferent about receiving a dividend of one euro or a capital gain of one euro.

At equilibrium, by definition, the company is earning its cost of equity. Consider a company, Equilibrium plc, with share capital of €100 on which shareholders require a 10% return. Since we are in equilibrium, the company is making a net profit of €10. Either these earnings are paid out to shareholders in the form of dividends, or they are reinvested in the business at Equilibrium plc’s 10% rate of return. Since that rate is exactly the rate that shareholders require, €10 of earnings reinvested will increase the value of Equilibrium plc by €10 – neither more nor less. Thus, either the shareholders collectively will have received €10 in cash, or the aggregate value of their shares will have increased by the same amount. Dividend is not therefore a remuneration for the shareholder but a mere choice to reinvest or not in the company.

If the company pays out a high proportion of its earnings, its shares will be worth less but its shareholders will receive more cash. If it distributes less, its shares will be worth more (provided that it reinvests in projects that are sufficiently profitable) and its shareholders will receive less cash – but the shareholder, if they wish, can make up the difference by selling some of their shares.

In a universe of markets in equilibrium, paying out more or less in dividends will have no effect on shareholder wealth. Companies should thus not be concerned about dividend policy and should treat dividends as an adjustment to cash flow. This harks back to the Modigliani–Miller approach to financial policy: there is no way to create lasting value with merely a financing decision.

The chart below plots the share price of SMTPC, which in June 2021 paid an extraordinary dividend of €1.9 in cash. The price of the shares adjusted immediately.

The share price of SMTPC dropped by €1.9, but the net worth of its shareholders does not change as they are now in possession of an additional €1.9 in cash, as well as a share worth €21, for a total value of €22.9, i.e. the value of the SMTPC share prior to the extraordinary dividend payment.
*Source*: Data from Yahoo Finance

Another demonstration can be found in the fact that a stock market order, if not executed, is automatically adjusted to take into account the payment of a dividend that has taken place after the order has been submitted.

In any case, it’s a fallacy to present dividend distribution as remuneration for shareholders, similar to salaries for the company’s employees.

The wealth of the employee increases with the salary. Conversely, the wealth of shareholders is not modified by the dividends they receive: while they are certainly happy about getting this periodical remuneration, they must consider that the value of their shares will fall by an equivalent amount.

If you are in search of an analogy, look no further than the ATM. You do not become richer by withdrawing cash (unfortunately!), because your bank account balance decreases by an equivalent amount, as you have undoubtedly already noticed.

What about firms that have never paid a dividend, like Google or Berkshire Hathaway (Warren Buffet’s firm)? Have they never remunerated their shareholders? Of course they have, and those firms have been very good investments for their shareholders. The return for shareholders comes from the increase in value of their portfolios (including dividends, if any). The dividend is taken into account not because it represents a return for the shareholder, but solely to compensate the drop in value of the share following the dividend payment.

2/ DIVIDENDS AND AGENCY THEORY

Equilibrium market theory has a hard time finding any good reason for dividends to be paid at all. Since in the real world, dividends are paid to investors, new explanations must be sought for the earnings distribution problem.

Creditors and managers are seen as having a common interest in favouring reinvestment of earnings. When profits are not distributed, “the money stays in the business”, whereas shareholders “always want more”.

If the manager directs free cash flow into unprofitable investments, their ego may be gratified by the size of the investment budget, or their position may become more secure if those investments carry low risk.

In addition, retained earnings are one source of financing about which not much disclosure is necessary. The cost of any informational asymmetry having to do with internal financing is therefore very low. It is not surprising that, as predicted by Jensen (1986) and observed in a study conducted by Harford (1999), companies that have cash available make less profitable investments than other companies. Money seems to burn a hole in managers’ pockets.

There is a sanction, however, for taking reinvestment to excess (for listed firms with an uncontrolled capital structure) put forward by Jensen (1986): the takeover bid or tender offer in cash or shares.

If a management team performs poorly, the market’s sanction will, sooner or later, take the form of a decline in the share price. If it lasts, the decline will expose the company to the risk of a takeover. Assuming the managers themselves do not hold enough of the company’s shares to ensure that the tender offer succeeds or fails, a change of management may enable the company to get back on track by once again making investments that earn more than the cost of capital, and thereby lead to a rise in the share price.

The threat of a takeover is not theoretical, it has struck a number of mismanaged groups (Aventis, Reuters, ABN Amro, Club Med, Syngenta, etc.), but the takeover often comes later, after years of underperformance. The dividend policy can help to prevent this situation.

The arrival of activist funds in the shareholding of groups deemed to be poorly managed often takes the form of healthy pressure to increase idle cash returns to shareholders in the form of share buybacks or dividends (Apple, Vivendi).

By requiring managers to pay out a fraction of the company’s earnings to shareholders, dividend policy is a means of imposing “discipline” on those managers by forcing them to include in their reckoning the interest of the company’s owners. But let us be clear: it is not in the interest of shareholders to receive dividends, but for the company to make investments that at least return their cost of capital. In other words, to prevent a company with too much cash from making bad investments.

A generous dividend policy will increase the company’s dependence on either shareholders or lenders to finance the business. In either case, those putting up the money have the power to say no. In the extreme, shareholders could demand that all earnings be paid out in dividends in order to reduce managers’ latitude to act in ways that are not in the shareholders’ interest. The company would then have to have regular rights issues, to which shareholders would decide whether to subscribe based on the profitability of the projects proposed to them by the managers. This is the virtuous cycle of finance. Although attractive intellectually, this solution runs up against the high costs of carrying out a capital increase – not just the direct costs, but the cost in terms of management time as well.

Bear in mind also that creditors watch out for their interests and tend to oppose overly generous dividends that could increase their risk, as we saw in Chapter 34.

3/ DIVIDENDS AS SIGNALS

A justification for the existence of dividends is proposed by the theory of signalling, around which an entire literature has developed, mainly during the 1980s.

The financial information that investors get from companies may be biased by selective disclosure or even manipulative accounting. Managers are naturally inclined to present the company in the best possible light, even if the image they convey does not represent the exact truth. Companies that really are profitable will therefore seek to distinguish themselves from those that are not through policies that the latter cannot imitate because they lack the resources to do so. Paying dividends is one such policy, because it requires the company to have cash. A company that is struggling is not able to imitate a company that is prospering.

For this reason, dividend policy is a pertinent means of signalling that cannot be faked, and managers use it to convince the market that the picture of the company they present is the true one.

Dividend policy is also a way for the company’s managers to show the market that they have a plan for the future and are anticipating certain results. If a company maintains its dividend when its earnings have decreased, that signals to the market that the decline is only temporary and earnings growth will resume. Dividends are paid a few months after the close of the year, therefore the level of the dividend depends on earnings during both the past and the current period. That level thus provides information – a signal – about expected earnings during the current period.

If a firm maintains its dividend while its profits are decreasing, it tells the market that the decrease is temporary and that the increase in profit should resume soon. By contrast, if it drastically reduces or cancels its dividend, it sends a signal on its earnings prospects that will most likely be analysed negatively.

A dividend reduction, though, is not necessarily bad news for future earnings. It might also indicate that the company has a new opportunity and needs to invest. Hence we saw, in the late 1990s, a shift of companies traditionally positioned on mature markets and sectors to geographies and businesses with more growth potential.

Managements will need to avoid the trap of an increase in dividend being interpreted by the market as a decrease in investment opportunities.

4/ BECAUSE SHAREHOLDERS WISH IT

Baker and Wurgler (2004a, b) have demonstrated that in some periods shareholders demand dividends and are thus ready to pay higher prices for shares with more generous dividends. While our readers know that dividends do not enrich shareholders (since the value of the shares falls correspondingly), shareholders may nonetheless be happy about receiving more dividends. John Rockefeller who in the 1920s said: “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in!” was practising behavioural finance ahead of his time!

Conversely, there are some periods when investors prefer companies that retain most of their earnings. In these cases, the stock market penalises generous shares, as happened in the second half of the 1990s: at the end of 1998, Telefónica announced the suppression of its dividend for financing its expansion in Latin America. At the announcement, the stock increased by 9%.

The reader may wonder why a series of opposite phases are often observed. Waves of optimism lead to the reinvestment of earnings; conversely, pessimism pushes companies to distribute a higher portion of earnings. Finance is a human activity, it is therefore made of trends.

5/ TO PROVIDE SHAREHOLDERS WITH CASH

This is particularly true for private companies, illiquid by nature and for which it is hard to divest shares. It can also apply to small listed companies unable to attract investors’ interest, and therefore suffering from low liquidity on the market and low valuations, making them unattractive for selling. Shareholders are human beings after all; they have needs and may need cash for day-to-day life.

6/ TO MODIFY THE FIRM’S SHAREHOLDER BASE

In most cases, giving back cash to shareholders means giving back the same amount on each share. If this is not the case (i.e. through share buy-backs), the shareholder base of the company will be modified. As we will see in the next chapter, the control of the firm can be reinforced by key shareholders not participating in share buy-backs. Shareholders receiving cash will then be diluted.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Net profit can only be used in two ways: it can be reinvested in the firm in the form of retained earnings or distributed in the form of dividends, share buy-backs or a capital reduction.

Internal financing by reinvestment of cash flow enjoys an excellent image: it reduces risk for the creditor and results in capital gains rather than more heavily taxed dividends for the shareholder. For managers, it is a resource they can mobilise without having to go to third parties; as such, it reduces the company’s risk and increases the value of their stock options.

For the same reason, though, systematic reinvestment of cash flow can be dangerous. It is not appealing from a financial standpoint if it allows the company to finance investments that bring in less than the rate of return required given their risk. To do so is to destroy value. If the penalty for value destruction is delayed, as it often is because companies that reinvest excessively are cut off from the capital markets, the eventual sanction is all the harsher.

The trap for the unwitting is that internal financing has no explicit cost, whereas its true cost – which is an opportunity cost – is quite real.

Reinvesting cash flow makes organic growth possible at a rate equal to the rate of return on equity multiplied by the earnings retention ratio (1 minus the payout ratio). With constant financial leverage and a constant rate of return on capital employed, the organic growth rate is the same as the growth rate of book equity and capital employed. Lastly, the rate of growth of earnings per share is equal to the marginal rate of return on book equity multiplied by the earnings retention ratio.

Dividends as well as share buy-backs aim at giving back to shareholders funds that cannot be invested by the firm at the appropriate cost of capital. This then allows the firm to avoid value destruction. In macroeconomic terms, it makes it possible to reallocate funds from mature companies to start-ups and developing companies that require equity to finance their business risk.

Dividend payments can serve secondary goals:

reducing the flexibility of the management, who may otherwise invest in value-destroying projects;
signalling that the firm has sufficient stable cash flow to support a high level of debt;
answering the wishes of shareholders, who, depending on the environment, might be willing to pay more for high-payout firms or, on the contrary, low-dividend firms;
granting shareholders cash, as they may need it, in particular when the company is private;
modifying gradually the shareholder base, reinforcing the power of certain shareholders compared to others.

QUESTIONS

1/Why does internal financing enjoy such a positive image?
2/Why is a policy of sticking strictly to internal financing unsound?
3/What determines the rate of growth of capital employed?
4/What should a company do if its rate of return on reinvested earnings is below the weighted average cost of capital?
5/What is the market’s sanction for over-reliance on internal financing?
6/In your opinion, which theory best explains the interest of internal financing from an overall standpoint?
7/Show with an example why reinvestment of earnings by the company has no cost for a holder of call options on the company’s shares.
8/By what criterion should a policy of reinvesting cash flow be judged?
9/What kind of companies rely heavily on internal financing? What kind do not?
10/Can internal financing lower the cost of capital?
11/What are the advantages and drawbacks of 100% internal financing for family shareholders?
12/Why is internal financing the financial resource with the lowest implementation cost?
13/Under what condition can the dividend growth rate be superior to the growth rate of free cash flow?
14/On the day of the dividend payment, the value of the share drops by the amount of the dividend. Has the shareholder become poorer?
15/Under what condition can you accept that a firm does not pay a dividend?
16/A firm that used to pay no dividends announces its first dividend payment. How would you interpret this according to efficient market theory, signalling theory, agency theory?
17/Do you think tobacco companies have high or low payout ratios? Why?
18/What does this story illustrate? Thanks to the profits made on the distribution of knitting yarns and wools under the Phildar brand, which were very large at the time, the Mulliez family was able to launch the first Auchan supermarkets in the 1960s. Then, with the profits from Auchan, which were very large at the time, it was able to finance investments in renewable energy (Voltalia) from 2005 onwards.
You’ll find more questions at www.vernimmen.com.

EXERCISES

1/An entrepreneur is determined to retain control of his company and refuses to accept any outside investors. The company’s return on capital employed is 7.5% after tax. He wishes to achieve growth of 20% a year. The cost of debt is 3% before tax, and the tax rate is 25%.
1. If he has no earnings distribution policy, what capital structure is he choosing implicitly?
2. If instead he has to pay out one-third of the company’s earnings, what capital structure is he choosing?
3. If he chooses financial leverage (debt/equity) equal to 1, what is the implied normal growth rate of the company?
4. Which other parameters can he play with?
2/Choose an example of “death spiral” deterioration of capital structure, with an initial positive leverage effect that becomes negative. Construct tables like those presented in this chapter.

ANSWERS

Questions

1/Because it reduces risk to creditors, results in capital gains rather than more heavily taxed dividends and increases the value of managers’ stock options.
2/It isolates the company from the capital markets.
3/The rate of return on capital employed, the capital structure and the interest rate on debt.
4/Pay out all its earnings.
5/A takeover bid takes place after years of underperforming investments. Or activists that will pressure management of listed firms.
6/Agency theory (interest of a manager to reduce the company risk).
7/Holders of call options get no benefit from earnings paid out as dividends, but retained earnings increase the value of the shares and therefore the value of their options.
8/The marginal rate of return on investment.
9/Mature companies that generate cash. Growth companies with high rates of return.
10/No. Unless it changes the risk on capital employed, it has no impact on the cost of capital.
11/Capital increases that could dilute the family’s shareholding are avoided, but potential dividends are reduced.
12/Because nobody else’s agreement need be sought before going ahead with it.
13/When the company has positive net debt that is being repaid.
14/No, as the share price is lower but the shareholder has received in cash (the dividend) the same amount as compensation. Otherwise, there would be arbitrage.
15/If its ROCE is above the cost of capital.
16/No difference – reduction in agency costs as manager will have less flexibility – growth is slowing down.
17/Yes, as growth opportunities are low (but also in order to drug shareholders like they drug their customers!).
18/That dividends, by turning over money, allow equity to be reallocated from mature sectors that no longer need it to new sectors where it is needed.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/
1. D/E = [(g / (1 − d)) − r_ce] / (r_ce − i(1 − 25%)) = 2.4. Which is a lot for a poor performing firm!
2. D/E = 4.3.
3. g = 12.7% if he pays no dividend, g = 8.5% if he pays out one-third of earnings.
4. He can try to improve his rate of return on capital employed.

2/Dubai is a good example of a death spiral with a high leverage effect. This Emirate financed fast growth mainly with debt. When the crisis arrived in 2008, its difficulties accelerated. It had to be saved from bankruptcy by Abu Dhabi.

Consider the following example of a company for which the leverage effect changes sign in year 4:

	Equity	Debt	Capital employed	Operating earnings after tax	Interest expenses after tax	Net profit	Dividends	Reinvested earnings	Equity at end of period
1	100	100	200	20	8	12	2	10	110
2	110	140	250	25	12	13	1	12	122
3	122	190	312	28	17	11	0	11	133
4	133	258	391	31	26	5	0	5	138
5	138	350	488	34	35	−1	0	−1	137
6	137	474	611	43	47	−4	0	−4	133

BIBLIOGRAPHY

On internal financing:

B. Becker, M. Jacob, M. Jacob, Payout taxes and the allocation of investment, Journal of Financial Economics, 107(1), 1–24, January 2013.
M. Jensen, Agency costs of free cash flow, corporate finance and takeovers, American Economic Review, 76(2), 323–329, May 1986.

Overview of the dividend policy problem:

K. Baker, Dividends and Dividend Policy, John Wiley & Sons, Inc., 2009.
M. Baker, J. Wurgler, A catering theory of dividends, Journal of Finance, 59(3), 1125–1165, June 2004a.
M. Baker, J. Wurgler, Appearing and disappearing dividends: The link to catering incentives, Journal of Financial Economics, 73(2), 271–288, August 2004b.
F. Black, The dividend puzzle, Journal of Portfolio Management, 2, 634–639, Summer 1976.
L. Brav, J. Graham, C. Harvey, R. Michaely, Payout policy in the 21st century, Journal of Financial Economics, 77(3), 483–527, September 2005.
D. Denis, I. Osobov, Why do firms pay dividends? International evidence on the determinants of dividend policy, Journal of Financial Economics, 89(1), 62–82, July 2008.
Y. Le Fur, P. Quiry, Does paying dividends make shareholders wealthier?, The Vernimmen.com Newsletter, 91, 1–3, December 2015.
Y. Le Fur, P. Quiry, Are capital expenditures and dividends mutually exclusive?, The Vernimmen.com Newsletter, 109, 1–5, January 2018.
W. Li, E. Lie, Dividend changes and catering incentives, Journal of Financial Economics, 80(2), 293–308, 2006.

Equilibrium markets:

E. Fama, K. French, Testing trade-off and pecking order prediction about dividends and debt, Review of Financial Studies, 15(1), 1–33, Spring 2002.
M. Miller, F. Modigliani, Dividend policy, growth, and the valuation of shares, Journal of Business, 34(4), 411–433, January 1961.
M. Miller, M. Scholes, Dividends and taxes, Journal of Financial Economics, 6(4), 332–364, December 1978.

Signalling theory:

S. Benartzi, R. Michaely, R. Thaler, Do changes in dividends signal the future or the past?, Journal of Finance, 52(3), 1007–1034, July 1997.
S. Bhattacharya, Imperfect information, dividend policy and the “bird in the hand fallacy”, Bell Journal of Economics, 10(1), 259–270, Summer 1979.
N. Doron, Z. Amir, Dividends changes and future profitability, Journal of Finance, 56(6), 2111–2133, December 2001.
M. Miller, The information content of dividends, in J. Bossons, R. Dornbush and S. Fisher (eds), Macroeconomics: Essays in Honor of Franco Modigliani, MIT Press, 1987.
A. Ofer, D. Siegel, Corporate financial policy, information and market expectations: An empirical investigation of dividends, Journal of Finance, 42(4), 889–911, September 1987.

Agency theory:

P. Brockman, E. Unlu, Dividend policy, creditor rights, and the agency cost of debt, Journal of Financial Economics, 92(2), 276–299, May 2009.
F. Easterbrook, Two agency-cost explanations of dividends, American Economic Review, 74(4), 650–659, September 1984.
J. Harford, Corporate cash reserves and acquisitions, Journal of Finance, 54(6), 1969–1997, December 1999.
P. Healy, K. Palepu, Earnings information conveyed by dividend initiations and omissions, Journal of Financial Economics, 21(2), 149–176, September 1988.
M. Jensen, W. Meckling, A theory of the firm: Managerial behavior, agency cost and ownership structure, Journal of Financial Economics, 3(4), 305–360, October 1976.
R. La Porta, F. Lopez-de-Silanes, A. Shleifer, Agency problems and dividend policies around the world, Journal of Finance, 55(1), 1–33, February 2000.
S. Myers, Outside equity, Journal of Finance, 55(3), 1005–1037, June 2000.

Clientele effect:

B. Becker, Z. Ivkovic, S. Weisbenner, Local dividend clienteles, Journal of Finance, 66(2), 655–683, April 2011.
M. Desai, L. Jin, Institutional tax clienteles and payout policy, Journal of Financial Economics, 100(1), 68–84, April 2011.
J. Graham, A. Kumar, Do dividend clienteles exist? Evidence on dividend preferences of retail investors, Journal of Financial Economics, 61(3), 1305–1336, June 2006.

NOTES

1 For the same level of business risk as for the company’s existing operating assets.
2 Note that in this section, since no new shares are issued, the growth rate of book value per share is always equal to the growth rate of book value.
3 15 + 10 × 30% = 18.
4 15 + (10 + 12) × 30% = 21.6.

Chapter 37. DISTRIBUTION IN PRACTICE: DIVIDENDS AND SHARE BUY-BACKS

Now, give the money back

The topics addressed in this chapter are the logical complement of the preceding chapter. Distribution of cash can take the form of ordinary dividend payments, but also of exceptional dividends, share buy-backs or capital reductions.

Section 37.1 DIVIDENDS

The dividend is fixed by the board of directors or the ordinary general meeting of shareholders who decide the allocation of earnings based upon the proposal from the board of directors (or the supervisory board). It is then paid to shareholders in the following days or weeks.

1/ PAYOUT RATIO AND DIVIDEND GROWTH RATE

In practice, when dividends are paid, the two key criteria are:

the rate of growth of dividends per share;
the payout ratio (d), represented by

All other criteria are irrelevant, frequently inaccurate and possibly misleading. For example, it is absurd to take the ratio of the dividend to the par value of the share, since par value has little to do with equity value.

As established by John Lintner, management therefore has an objective expressed in terms of the payout rate applied to the level of future profits. Their objective is to distribute a fixed percentage of the company’s profits. This is the case of Schneider, which pays out around 50% of its profits in dividends excluding exceptional items, as it announced in 2015.

In Europe, a payout ratio lower than 20% is considered to be a low dividend policy, whereas one greater than 70% is deemed high. The average in 2020 was about 50%. A important proportion of large groups have reduced or eliminated their dividends in 2020, which explains why so many 2020 payouts are zero, or abnormally high because some groups, while their profits temporarily fell, maintained their dividends.

Payout ratio for large European listed groups in 2020
d ≈ 0%		0%<d<30%		30%<d<50%		50%<d<70%		70%<d
Critéo	0%	Casino	0%	Fresenius	29%	Orange	52%	LafargeHolcim	73%
Unibail-Rodamco	0%	Alstom	0%	Colruyt	30%	Covestro	52%	BHP Billiton	75%
Continental	0%	Air France KLM	0%	Puma	30%	Air Liquide	53%	Thales	78%
Worldline	0%	Barclays plc	11%	Dassault Av.	34%	Richemont	55%	Eiffage	78%
Vallourec	0%	Serco Group	13%	Capgemini	34%	Metro	55%	Publicis	83%
Thyssenkrupp	0%	Cie Automotive	17%	Hermès	35%	Henkel	57%	Energias de Portugal	87%
Tarkett	0%	Atos	18%	Moncler	38%	Arkema	58%	Tesco	92%
Telecom Italia	0%	Biomérieux	18%	Burberry	38%	L’Oréal	63%	Vinci	92%
Sodexo	0%	Bonduelle	23%	Almirall	38%	LVMH	64%	Nexity	95%
Renault	0%	Apple	24%	SEB	39%	Danone	64%	Axa	114%
Nokia	0%	Ferrari	26%	SAP	44%	Michelin	65%	Saint-Gobain	156%
Airbus Group	0%	Erste Bank	27%	Kering	46%	Schneider	68%	TF1	171%
Compass	0%	Carrefour	28%	Vivendi	48%	Deutsche Telekom	68%	Pernod Ricard	213%

Source: Data from Factset.

In 2020, 122 out of the 600 largest listed companies in Europe paid no dividend (vs. 35 the year before!). The Covid-19 pandemic has for sure had an impact on dividends.

The payout ratio can, from time to time, vary to allow a smooth evolution of dividends compared to more volatile changes in earnings.

*Source*: Factset ‐ Datastream ‐ Exane BNP

In 1991–1993, 2009, and 2014–2016, payout ratios in Europe and the US were quite high (over 50%), but the explanation has more to do with poor earnings than with any change in dividend policy. To avoid a cut in dividend per share, managers allowed the payout ratio to rise temporarily. Conversely, in 1986–1989, 2000–2001, and 2005–2007, years of very good profits, payout ratios were low. The American payout ratios appear to be lower because of the share buy-backs not taken into account in the payout ratio computation, which are far more frequent in the US, and because of the larger number of fast-growing (and/or loss making) listed companies distributing few dividends or none at all.

Some degree of regularity is desirable, either in earnings growth or in dividends paid out, so the company must necessarily choose an objective for the profile of dividends over time. Dividend profiles typically fit one of the following three descriptions:

If earnings growth is regular, dividend policy is of lesser importance and the company can cut its payout ratio at no risk (while increasing the absolute value of the dividend).
If earnings are cyclical owing to the nature of the business sector, it is important for the dividend to be kept steady. The company needs to retain enough room to manoeuvre to ensure that phases of steady dividends are followed by phases of rising dividends.
Lastly, an erratic dividend conveys no useful information to the investor and may even suggest that the company’s management has no coherent strategy for doing business in its sector. A profile of this kind can hardly have any beneficial effect on the share price.

Compare, for example, the dividend and earnings profiles of two industrial groups since 1983: Nestlé (a growth company) and Ford (a cyclical one):

On the stock market, a high payout ratio implies low price volatility, other things being equal. The share price of a company that pays out all its earnings in dividends will behave much like the price of a bond.

Of course, the payout ratio is not the only determinant of a share’s volatility. For a company, paying out little or none of its earnings translates into growth in book value, an increase in market value and thus eventually into capital gains. To realise those gains, though, the shareholder has to sell. If selling the company’s shares is a “crime” – and some managers come close to regarding it as one – then a low-dividend policy is an inducement to crime. A family-owned company that pays low dividends risks weakening the family control.

A high-dividend policy, on the other hand, is certainly one way of retaining the loyalty of shareholders that have got used to the income and have forgotten about the value. This tends to be particularly true of shareholders without management roles in unlisted family companies.

2/ HOW DIVIDENDS ARE PAID

(a) Interim dividend

This practice consists in paying a fraction of the forthcoming dividend in advance. The decision is taken by the board of directors (or the executive board) and need not be approved by the AGM (the AGM retrospectively ratifies this choice). A dividend offers a way of smoothing cash inflows to shareholders and cash outflows from the company. The interim dividend is typically paid in December or January (midway between two annual dividend dates) and represents between a quarter and a half of the annual dividend. In the US, Canada and the UK, quarterly or semi-annual dividends are common.

(b) Dividend paid in shares (scrip dividend)

Companies may offer shareholders a choice of receiving dividends in cash or in shares of the company, if such a possibility is provided for in the company’s by-laws.¹ The decision is taken by shareholders at the ordinary general meeting at which the accounts of the year are approved.

Paying the dividend in shares allows the company to make a distribution of earnings while retaining the corresponding cash funds.

Offering to pay dividends in shares may lead to some limited redistribution of ownership among the shareholders, since some will accept and others will decline.

A share dividend represents no special financial advantage for shareholders other than the ability to reinvest dividends at no charge and generally at a slight discount to the market price (at most 10%). Some investors have no compunctions about taking payment of their dividends in shares and immediately selling those shares in order to pocket the discount. Manipulation of this kind drives down the price. This explains why this technique, which was very popular at the beginning of the 1990s, had practically disappeared before finding a new lease on life since 2008 when groups (Total, Carrefour, etc.) used it to strengthen their equity while trying to avoid the negative signal of a suppressed dividend during bad economic times for them. Even with a 10% discount, the firm cannot be sure of whether its shareholders will choose cash or shares, since there is a delay between the EGM that fixes the price and the actual choice of the shareholders and issue of the shares. The changes in share price during this period can erase the discount and make a cash dividend more attractive.

In a 2015 study, Edith Ginglinger and Thomas David found in a large sample that the payment of a scrip dividend was not interpreted negatively by shareholders (in contrast to the reduction of the dividend). It is also interesting to note that investors are not perfectly rational in their choice. For example, when the discount to the share price is still present at the time of payment, the option rate for the scrip dividend is far from 100%. And when the discount no longer exists or is even negative, about one third of shareholders still accept the payment of the dividend in shares.

(c) Preferential dividend

To reward loyal shareholders that have held their shares for over a certain period (e.g. more than two years), some companies (for example, Air Liquide) have instituted the practice of paying a preferential dividend. A preferential dividend can be established only by decision of an extraordinary general meeting when authorised by local laws.

Lastly, we should mention once again preference shares, which have a higher dividend than ordinary shares.

Section 37.2 EXCEPTIONAL DIVIDENDS, SHARE BUY-BACKS AND CAPITAL REDUCTION

A company may, in certain circumstances, buy back its own shares and either keep them on the balance sheet or cancel them, in which case there is said to be a capital decrease or capital reduction. Even when shares are repurchased but not cancelled, analysts will (in their own calculations) reduce the number of shares in circulation by the quantity of shares bought back.

Neglecting taxes, if one supposes that the company buys back shares from all shareholders in proportion to their holdings and then cancels those shares, the resulting share buy-back is strictly identical to the payment of a dividend. Cash is transferred from the company to the shareholders with no change in the structure of ownership. As we shall see below, however, an actual capital reduction most often does not even involve all shareholders.

1/ SPECIAL DIVIDEND

The special dividend (or exceptional dividend) is a dividend of an exceptionally high amount compared to the ordinary dividend. It is obviously not paid on a regular basis and usually corresponds to an exceptional event within the business life of the company (disposal of a large subsidiary, end of a lawsuit, etc.). For example, Orange paid an exceptional dividend of €0.2 in 2021 as a result of a tax refund from the State.

The special dividend is sometimes the tool used by a group to dispose of an asset (22% of Hermès by LVMH) or a branch (Faurecia by Stellantis).

2/ SHARE BUY-BACKS

Only listed firms can buy their own shares back on the market. Depending on the country, the buy-backs have to be authorised by shareholders and may be limited in volume (for example, a maximum of 10% of the shares every year or 18 months) and in price (a maximum share buy-back price is set). Generally, the shares bought back will be cancelled but they can also be kept by the company (as treasury stocks) to be handed over in the case of an acquisition, for the exercise of stock options or for the conversion of convertible bonds. Treasury shares lose their voting right and their right to a dividend. They can also be used to enhance liquidity through a liquidity programme implemented by a broker.

The implementation of share buy-backs of listed companies is often outsourced to banks for a predefined period of time and with predefined amounts to be repurchased, thus avoiding constraints linked out blackout periods before earnings announcement and the risk of insider trading for the company!

In this context, an ESG dimension can be included in the buy-back programme. The bank, which buys the shares on behalf of the company, contributes to an NGO the difference between the market price over the execution period and the actual purchase price of the shares, i.e. the gain made from a (marginally) lower price than the average market price. In March 2021, BIC launched ESG impact share buy-back.

Furthermore, share buy-backs can be used to ease the exit of a large minority shareholder. In this way, Regeneron eased the exit of Sanofi from its capital in buying back some $5bn of shares in 2020 (the rest of the participation has been sold on the market).

Under US GAAP and IFRS, treasury stocks are deducted from the amount of shareholders’ equity.

3/ CAPITAL REDUCTION

A capital reduction corresponding to a distribution of cash can be accomplished:

By reducing the par value of all shares, thereby automatically reducing authorised capital.
By tender offer. In practice, the board of directors, using an authorisation that must have been granted to it at an extraordinary general meeting, makes an offer to all shareholders to buy all or part of their shares at a certain price during a certain period (usually about one month). If too many shares are tendered under the offer, the company scales back all the surrender requests in proportion. If too few are tendered, it cancels the shares that are tendered. If management decides on a tender offer, it has the option of considering the traditional fixed-price offering or the Dutch auction method. In Dutch auctions, the firm no longer offers to repurchase shares at a single price, but rather announces a range of prices. Each shareholder thus must specify an acceptable selling price within the prescribed range set by the company. If they choose a high selling price, their proceeds will increase, provided that the shares are accepted by the company, but the probability that shares will be accepted for repurchase will be reduced. At the end of the offer period, the firm tabulates the received offers, and determines the lowest price that allows repurchasing the desired number of shares.
In some countries, a share buy-back can be accomplished by issuing put warrants to each shareholder, each warrant giving the holder the right to sell one share to the company at a specified price. Such a warrant is a put option issued by the company.

A capital decrease changes the capital structure and thereby increases the risk borne by creditors. To protect the latter, the law generally allows creditors to require additional guarantees or call their loans early, although they cannot block the operation outright.

4/ THE IMPACT ON THE COMPANY AND ITS RATIOS

Consider a company with book value of equity of €400m, one million shares outstanding and earnings of €20m. Suppose that it reduces its share capital by 20% by buying back its own shares at their market value, in one case at €200 per share and in another case at €800 per share. It pays for the buy-back by borrowing at 3% after tax (or by liquidating short-term investments earning 3%, which amounts to the same thing).

BEFORE
Price per share	Book value of equity	Market value of equity	Earnings	EPS	P/E
€200	€400m	€200m	€20m	€20	10
€800	€400m	€800m	€20m	€20	40

AFTER
Price per share	Book value of equity	Market value of equity	Earnings	EPS	P/E
€200	€360m	€160m	€18.8m	€23.5 + 17.5%	8.5
€800	€240m	€640m	€15.2m	€19 − 5%	42.1

After the transaction, the book value of equity has decreased by the amount of funds spent on the repurchase – €40m in one case, €160m in the other – and so has the market value. Going forward, earnings are reduced by the additional interest charges. The relevant analysis, however, is at the per-share level. The repurchase is made at the current share price (or at current value, if the company is not quoted), possibly increased by a premium of 5% or 10% to induce holders to tender their shares under the offer.

In our example, with a repurchase at €200, earnings per share increase by 17.5% and decrease by 5% with repurchase at €800.

The transaction is thus the inverse of a share issue, which should come as no surprise to the reader. Bear in mind that, although the calculation of the change in earnings per share is of interest, it is not an indicator of value creation. The real issue is not whether a capital decrease will mechanically dilute earnings per share, but whether:

the price at which the shares are repurchased is less than their estimated value;
the increase in the debt burden will translate into better performance by management; and
the marginal rate of return on the funds returned to shareholders by the buy-back was less than the cost of capital.

These are the three sources of value creation in a capital decrease.

We frequently see it argued that a capital decrease, by replacing a more costly form of financing (equity) with a less costly one (debt), lowers the weighted average cost of capital. The reader who has absorbed the lessons of Modigliani and Miller and understands that cost of capital is independent of capital structure (remember “the size of a pizza is the same no matter how you slice it”?) may be indulgent. To err is human; only to persist in error is diabolical!

As an illustration, here are the top 20 share buy-backs in 2020 in Europe:

Top 20 Share Buy-backs in Europe in 2020
	Company	€m		Company	€m
1	Nestlé	6 368	11	Siemens	1 517
2	Iberdrola	2 710	12	SAP	1 492
3	ABB	2 491	13	Aon	1 441
4	Accenture	2 383	14	Diageo	1 432
5	E.ON	2 377	15	Iliad	1 400
6	Novartis	2 323	16	Royal Dutch Shell	1 391
7	Novo Nordisk	2 264	17	UBS	1 296
8	Vivendi	2 148	18	ASML	1 208
9	Linde	2 008	19	ACS	1 193
10	Johnson Controls	1 801	20	Barclays	1 180

Source: Data from FactSet, Companies information

Section 37.3 THE CHOICE BETWEEN DIVIDENDS, SHARE BUY-BACKS AND CAPITAL REDUCTION

Dividends, share buy-backs and capital reductions are all ways to return cash to shareholders, but as they have different impacts on a company’s parameters, one cannot be used instead of another. For instance, in Europe, share buy-backs amounted to almost nothing in the mid-1990s, while they reached about €230bn in 2007 and then dropped sharply in 2008 and 2009 before coming back to average levels in 2011–2016. We illustrate that with the example of the French market:

*Source*: La Lettre Vernimmen.net janvier 2021, n°185.

Five criteria can be used to understand the choice of the best technique for distributing the excess cash, given the desired objective.

1/ FLEXIBILITY

Once a dividend has been increased, it is tricky, especially for listed companies, to reduce it unless there is a significant deterioration in earnings. Any change in the dividend policy raises concerns about the future evolution of the business model and any increase creates expectations regarding the medium-term sustainability of the new level of dividends. This is the major reason for which changes in the dividend policy generally occur very slowly and produce effects on the capital structure only after some periods.

Conversely, share buy-backs, capital reductions and extraordinary dividends are specific una tantum decisions, and investors do not expect any regularity regarding them. They can perfectly fit situations where the company wants to distribute the cash generated by an important asset (disposal by Sword of its French subsidiaries in 2021), an asset itself to refocus the group (UMG by Vivendi in 2021) or intends to modify the capital structure rapidly.

TotalEnergies operates in a cyclical sector and does not want to have to reduce its dividend per share. Therefore, in the early 2000s, when its results start to rise sharply, it increased its dividend less rapidly and bought back the balance of its shares. These were then gradually reduced as the dividend increased and disappeared altogether when the results become less good from 2008. Then, when the latter fell sharply between 2014 and 2017, Total maintained its dividend per share, despite insufficient free cash flow, but paid it in part in shares so as not to increase its debt. With the recovery in oil prices in 2018, Total resumed share buy-backs to neutralise the shares created by the payment of the dividend in shares in previous years. While it had planned to stop stock dividends altogether, the Covid-19 pandemic forced it to resort to them again.

Share buy-back programmes are as flexible and are appropriate for returning temporary excess cash flows to shareholders pending an increase in payout, a drop in earnings, or an increase of the company’s investment needs. This is how groups stopped them in 2008–2009 before gradually resuming them from 2010, or how Sanofi stopped them in 2019, after its 2018 acquisitions (totalling €13.4bn), before resuming them in 2020.

2/ SIGNALLING

All financial decisions send signals to investors, and thus the company must ponder the expected perception investors may have following the adoption of a specific financial tool for redistributing liquidity.

Applying this principle to dividends, we can reasonably say that the most neutral solution is represented by the extraordinary dividend: it is non-recurring and it does not imply any judgement on the value of the stock. Moreover, it benefits all investors.

Changes in ordinary dividends and capital reductions, however, are clearly perceived as signals sent to the market: in the former case, regarding the level of future earnings; in the latter case, regarding the stock price because a company would not buy a portion of its shares if the management believed that the shares were overvalued.

Jagannathan et al. (2000) have demonstrated that share buy-backs give little information about future results compared to dividends. While companies that increase dividends show an improvement of results, a similar conclusion cannot be reached with share buy-backs. The distribution of dividends contains a commitment from the management to maintaining the same level of dividend (or increasing them) for a certain number of periods; share buy-backs do not imply an analogous commitment. Thus, cyclical companies are more inclined to use share buy-backs than non-cyclical companies.

3/ IMPACT ON SHAREHOLDER STRUCTURE

Ordinary and extraordinary dividends do not affect the shareholding structure because they do not modify the number of outstanding shares. On the contrary, capital reductions and share buy-backs affect shareholder composition because some shareholders may simply decide not to participate in the capital reduction or to sell their shares in the case of a share buy-back. Their percentage of control increases.

As an example, the share buy-backs of Dassault Aviation on 14% of its capital allowed the Dassault family to increase its stake from 50% to 59% in 2015. An increase in dividend would probably have been complex in such a cyclical sector as military and business aircrafts; a special dividend would not have allowed for an impact on shareholding.

4/ IMPACT ON STOCK OPTIONS

According to the current legislation of some countries, the capital reduction realised by buying back shares at a high price requires an adjustment of the exercise price of the stock options with a neutral effect on stock option holders.

However, some legal systems do not regulate similar adjustments in the case of ordinary or extraordinary dividends. Since an extraordinary dividend can strongly reduce the stock price, the absence of any adjustment of the exercise price of the stock options explains why this instrument is not favoured by the management.

The strong decrease in the number of companies distributing a dividend (66% in 1978 vs. 21% in 1999²) in America until early this century can also be at least partially explained by the increasing popularity of share buy-backs, probably pushed up by the managers holding stock options.³

In fact, the distribution of a dividend mechanically reduces the stock price, thus decreasing the probability of a high capital gain for stock option holders. The share buy-back does not generate this negative effect on the value of the stock options. It also leaves unsophisticated investors believing that the stock price will go up.

5/ TAX ISSUES

Tax is naturally an important element that requires close attention. For individual investors belonging to the top classes of personal income, generally speaking taxation is lower on capital gains than ordinary dividends. This pushes shareholders to consider share repurchases more favourably.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

A dividend policy is assessed on the basis of the payout ratio and the growth rate of the dividend per share. The dividend does not constitute a remuneration of the shareholder since its collection is accompanied by a decrease in the share value by the same amount.

An exceptional dividend by its amount may be paid in addition to the ordinary dividend.

A company may buy back small quantities of shares that it will cancel or keep or larger quantities of shares through a public share buy-back tender offer in which the shareholders are free to participate or not.

The capital reduction or share buy-back leads to growth in earnings per share if the reverse of the P/E ratio of the share is higher than the after-tax interest rate of the debt incurred (or short-term investments used to finance it). But make no mistake, this has nothing to do with value creation.

Value is only created if the increased debt burden forces managers to perform better, or if shares are bought back at a price below their value, or if the funds thus returned to shareholders are invested in the company at an insufficient return.

The big difference between, on the one hand, the dividend and, on the other hand, the exceptional dividend, the share buy-back and the capital reduction, is that the dividend is normally recurrent and any change in its level is perceived as a signal. On the other hand, exceptional dividends, share buy-backs and capital reductions are one-off operations, not recurring in nature.

The choice of tools used to return cash to the shareholder also depends on the impact on the composition of the shareholder base and on management stock options and, finally, on tax considerations.

QUESTIONS

1/What are the two criteria by which a dividend policy should be judged?
2/Does an increase in the dividend result in an increase in the value of the share?
3/Given tax neutrality, would you prefer to receive dividends or realise capital gains?
4/Does a manager who holds stock options in the company prefer buy-backs or dividends? Why?
5/Is there a cost to the company of issuing bonus shares? Does such an issue change shareholder wealth? What purpose does it serve?
6/Does a high dividend provide assurance of a stable share price? Why?
7/Can a company have a target dividend yield for its shareholders? Why or why not?
8/What is the natural temptation of a company that is required by its shareholders to pay out 100% of its earnings, in terms of how much earnings it records?
9/Is a manager who holds stock options in favour of a high-dividend policy? Why or why not?
10/What signal is sent by paying a dividend in shares?
11/Explain why a sharp increase in dividend often results in a decrease in the value of the company’s borrowings.
12/What is the impact of a debt-heavy capital structure on the payout ratio?
13/In what circumstances does a company have a good reason to undertake a capital decrease?
14/Forgetting tax considerations, can a capital decrease enhance the value of the company’s operating assets? The value of its shares?
15/What difference do you see between payment of dividends and capital reduction?
16/What is the necessary condition for a share buy-back to increase earnings per share? To increase the book value of equity capital per share?
17/What does a share buy-back programme mean for the company’s creditors?
18/Under what conditions might a fast-growing company with opportunities to invest at a rate of return higher than its cost of capital undertake a capital decrease?
You’ll find more questions at www.vernimmen.com.

EXERCISES

1/On 21 May 2021, you observe the following data on Yahoo! Finance:
- Publicis share price: €55
- Net dividend per share: €2.15
- Earnings per share: €4.46
Calculate Publicis’s payout ratio and the dividend yield. What do you think?

2/What do you think of the dividend policies of the following companies?

		2014	2015	2016	2017	2018	2019	2020
(A)	EPS	100	115	131	150	160	165	167
	DPS	20	23	26	30	35	41	60
(B)	EPS	350	402	458	524	559	577	584
	DPS	70	80	92	105	112	115	117
(C)	EPS	100	50	0	−50	−50	0	50
	DPS	5	5	5	5	5	5	6
(D)	EPS	500	520	550	600	500	400	300
	DPS	100	80	70	100	120	150	200

3/Gassoumi plc has the following characteristics:
- Net earnings: £100m
- Number of shares: 1,000,000
- Market price per share: £1,000
- Book value of equity: £1,200m
- EPS: £100
- Book value per share: £1,200
The company decides to take advantage of a sudden stock market slump by buying back a quarter of its shares at a price of £500 per share. Its after-tax cost of debt is 5%.
Calculate EPS and book value per share. Same question if the buy-back price is £1,500 per share. What do you conclude?

4/Rowak plc is a Syldavian industrial company listed on the Klow stock exchange. The number of shares in issue has been constant over the period at one million. The corporate income tax rate is 33%.

Calculate Rowak’s after-tax ROCE and ROE in each year. What do you think?
What do you think of the fact that Rowak has never paid a dividend?
In early February 2020, the company’s market capitalisation is 200 million and its managers believe the shares are worth 150 each. Rowak’s chairman proposes to the board of directors that 50 million be devoted to buying back (and cancelling) outstanding shares. The programme is to be financed by borrowing at 10% before tax. The board of directors refuses. Why, in your opinion?
In March 2020, the company’s market capitalisation has fallen to 90 million (still with the same number of shares in issue) and the estimated value of the share is 120. Rowak’s chairman puts forward his proposal again. What do you think now?

(Figures in millions)	Revenue	Net profit	Pre-tax interest expenses	Book value of equity	Net debt	Market capitalisation
2015	170	8	9	50	60	55
2016	130	10	10	60	70	90
2017	170	11	10	71	75	152
2018	220	13	9	84	76	195
2019	230	13	7	97	70	210
2020	240	13	6	110	65	200

ANSWERS

Questions

1/Dividend growth rate and payout ratio.
2/Not according to equilibrium market theory, but it could be a positive signal.
3/According to equilibrium market theory, you should not care; according to agency theory, you should prefer dividends.
4/They prefer buy-backs because paying a dividend reduces the value of the shares and therefore the value of their stock options.
5/The company does not gain or lose. An issue of bonus shares does not increase shareholder wealth. It can improve liquidity by increasing the number of shares in circulation. It can be a positive signal if the dividend per share is maintained.
6/A high dividend helps to ensure stability of the share price but in no way guarantees it.
7/No, since the company does not have the power to set the share price (numerator of the dividend yield).
8/Conceal earnings to avoid having to pay them out in dividends and thereby maximise internal financing.
9/No, because high dividends hold down the price of the shares on which the manager holds stock options.
10/The company does not have the cash to pay a cash dividend!
11/Because there is a transfer of value from creditors, whose claims on the company become riskier, to shareholders.
12/Reduces the payout ratio because there are periodic interest and principal payments to be made.
13/Whenever the marginal rate of return on its investments is less than the rate of return required by its shareholders.
14/It will increase pressure on management (more debts), and can therefore increase value.
15/Fundamentally, the two are the same, but the dividend goes to all shareholders whereas the capital reduction may be reserved for only some of them. The tax treatment may also be different.
16/EPS increases whenever the reverse of P/E ratio is higher than the after-tax interest rate on debt (or short-term investments). If the purchase price of the shares is less than the book equity per share.
17/An increase in risk borne by them.
18/If its shares are particularly undervalued.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/d = 2.15 / 4.46 = 48%, dividend yield: 2.15 / 55=3.9%. Relatively high distribution policy of a group at maturity.
2/
1. Fast growth has been slowing, payout ratio increasing. This is fairly logical.
2. Same growth pattern, but payout ratio is constant. This is surprising because the marginal rate of return has become very low (1.5% in 2020: (584 – 577) / (577 – 115)) and is surely below the cost of capital.
3. Cyclical company that keeps its dividend per share steady. Payout ratio is very low at the top of the cycle (5%) and very high at the bottom (>100%).
4. No coherent dividend policy at all.
3/At a cost of £500 per share – repurchase amount: £125m. Associated interest costs = £6.25m. EPS after the repurchase = £125. Book value per share = £1,433.
At a cost of £1,500 per share: EPS = £108.3; book value per share = £1,100.
4/
1. 2015 2016 2017 2018 2019 2020
  ROCE 12.7 12.8 12.1 11.9 10.6 9.7
  ROE 16.0 16.7 15.5 15.5 13.4 11.8
  Returns on equity and capital employed have declined, reducing the leverage effect and the company’s financial risk.
2. 2015 2016 2017 2018 2019
  Δ earnings/Δ equity 20% 9.1% 15.4% 0 0
  The dividend policy of Rowak (no dividend) was consistent with its situation until 2017 since it was getting adequate returns on reinvested earnings. This is no longer the case. Earnings are not growing, and shareholders are becoming relatively poorer.
3. Why would you want to pay 200 for shares that you believe are worth 150?
4. The proposal makes sense now because a gross disequilibrium in the market means the shares can be bought back at a price below their estimated value.

BIBLIOGRAPHY

For empirical studies on dividends:

P. Asquith, D. Mullins, The impact of initiating dividend payments on shareholders’ wealth, Journal of Business, 56, 77–96, January 1983.
F. Black, M. Scholes, The effect of dividend yield and dividend policy on common stock prices and returns, Journal of Financial Economics, 1(1), 1–22, May 1974.
J.B. Chay, J. Suh, Payout policy and cash flow uncertainty, Journal of Financial Economics, 93(1), 88–107, July 2009.
T. David, E. Ginglinger, When cutting back dividends is not bad news: The case of optional stock dividends, Journal of Corporate Finance, 40, 2016.
H. DeAngelo, L. DeAngelo, D. Skinner, Are dividends disappearing? Dividend concentration and the consolidation of earnings, Journal of Financial Economics, 72, 425–456, December 2004.
H. DeAngelo, L. DeAngelo, The irrelevance of the MM dividend irrelevance theorem, Journal of Financial Economics, 79(2), 293–315, 2006.
E. Fama, K. French, Disappearing dividends: Changing firm characteristics or lower propensity to pay?, Journal of Financial Economics, 60, 3–43, April 2001.
A. Fatemi, R. Bildik, Yes, dividends are disappearing: Worldwide evidence, Journal of Banking and Finance, 36(3), 662–677, March 2012.
G. Fenn, N. Liang, Corporate policy and managerial stock incentives, Journal of Financial Economics, 60(1), 45–72, April 2001.
B. Lambrecht, S. Myers, A Lintner model of payout and managerial rents, Journal of Finance, 67(5), 1761–1810, October 2012.
J. Lintner, Distribution of incomes of corporations among dividends, retained earnings and taxes, American Economic Review, 46(2), 97–116, May 1956.
D. Skinner, The evolving relation between earnings, dividends, and stock repurchases, Journal of Financial Economics, 87(3), 582–609, March 2008.
H. Von Eije, W. Megginson, Dividends and share repurchases in the European Union, Journal of Financial Economics, 89(2), 347–374, August 2008.
Y. Wu, What’s behind smooth dividends? Evidence from structural estimation, The Review of Financial Studies, 31(10), 3979–4016, October 2018.

On share buy-backs:

D. Andriosopoulos, M. Lasfer, The market valuation of share repurchases in Europe, Journal of Banking and Finance, 55, 327–339, June 2015.
A. Dittmar, Why do firms repurchase stocks?, Journal of Business, 73(3), 331–355, July 2000.
G. Grullon, D. Ikenberry, What do we know about stock repurchases?, Journal of Applied Corporate Finance, 13(1), 31–51, Spring 2000.
G. Grullon, R. Michaely, Dividends, share repurchases and the substitution hypothesis, Journal of Finance, 57, 1649–1684, August 2002.
G. Grullon, R. Michaely, The information content of share repurchase programs, Journal of Finance, 59(2), 651–680, April 2004.
I.-M. Haw, S. Ho, B. Hu, X. Zhang, The contribution of stock repurchases to the value of the firm and cash holdings around the world, Journal of Corporate Finance, 17(1), 152–166, February 2011.
M. Jagannathan, C. Stephens, M. Weisbach, Financial flexibility and the choice between dividends and stock repurchases, Journal of Financial Economics, 57, 355–384, September 2000.
W. Maxwell, C. Stephens, The wealth effects of repurchases on bondholders, Journal of Finance, 58, 895–919, April 2003.

NOTES

1 In addition, if its by-laws allow, a company may distribute shares that it holds in its portfolio in place of a cash dividend. This is not the same as paying the dividend in its own shares.
2 See Fama and French (2001).
3 See Lambrecht and Myers (2012) and Fenn and Liang (2001).

Chapter 38. SHARE ISSUES

There are no victories at bargain prices

The previous chapters have already begun assessing the reasons for equity financing. This chapter analyses the consequences for the shareholder of a share issue (or capital increase). Capital increases resulting from mergers and acquisitions will be dealt with in Chapter 46.

The strong increase in share issues in 2008 and 2009 is mainly explained by the strengthening of financial institutions’ balance sheets, which had been negatively impacted by the crisis (UBS, Citi, RBS, etc.), by the financing of external growth (Carlsberg, Inbev, etc.) or refinancing of external growth initially implemented with debt (Lafarge, Pernod-Ricard, etc.), or finally by capital-raising in anticipation of future transactions (CRH).

Section 38.1 A DEFINITION OF A SHARE ISSUE

1/ A SHARE ISSUE IS A SALE OF SHARES …

A share issue is, first of all, a sale of shares. But who is the seller? The current shareholder. The paradox is that the seller receives no money. As we shall see in this chapter, to avoid diluting their stake in the company at the time of a share issue, the shareholder must subscribe to the same proportion of the new issue that they hold of the pre-existing shares. Only if they subscribe to more than that is the shareholder (from the standpoint of their own portfolio) buying additional control; if less, they are selling control.

Up to now, we have presented market value as a sanction on the company’s management, an external judgement that the company can ignore so long as its shareholders are not selling out and it is not asking them to stump up more money. A share issue, which conceptually is a sale of shares at market value, has the effect of reintroducing this value sanction via the company’s treasury, i.e. its cash balance. For the first time, market value, previously an external datum, interferes in the management of the company.

2/ … THE PROCEEDS OF WHICH GO TO THE COMPANY, AND THUS INDIRECTLY TO ALL OF ITS INVESTORS …

This may seem paradoxical, but it is not. The proceeds of the capital increase indeed go to the company. Shareholders will benefit to the extent that the additional funds enable the company to develop its business and thereby increase its earnings. Creditors will see their claims on the company made less risky and therefore more valuable.

3/ … WHICH IMPLIES SHARING BETWEEN OLD AND NEW SHAREHOLDERS

When a company issues bonds or takes out a loan from a bank, it is selling a “financial product”. It is contracting to pay interest at a fixed or indexed rate and repay what it has borrowed on a specified schedule. As long as it meets its contractual obligations, the company does not lose its autonomy.

In contrast, when a company issues new shares, the current shareholders agree to share their rights to the company’s equity capital (which is increased by the proceeds of the issue), their rights to its future earnings and their control over the company itself with the new shareholders.

To illustrate, consider Company E with equity capital worth $1,000m split between two shareholders, F (80%) and G (20%).

If G sells their entire shareholding ($200m) to H, neither the value nor the proportion of F’s equity in the company is changed. If, on the other hand, H is a new shareholder brought in by means of an issue of new shares, they will have to put in $250m to obtain a 20% interest, rather than $200m as previously, since the value of equity after a capital increase of $250m is $1,250m (1,000 + 250). The new shareholder’s interest is indeed 20% of the larger amount. Percentage interests should always be reckoned on the post money value, i.e. value including the newly issued shares.

After this $250m share issue has been added to the $1,000m base, the value of F’s shareholding in the company is the same as it was ($800m), but their ownership percentage has decreased from 80% to 64% (800 / 1,250), while G’s has decreased from 20% to 16%.

We see that if a shareholder does not participate in a capital increase, their percentage interest declines. This effect is called dilution.

In contrast, if the share issue is reserved entirely for F, their percentage interest in the company rises from 80% to 84% (1,050 / 1,250), and the equity interest of all other shareholder(s) is necessarily diluted.

Lastly, if F and G each take part in the share issue in exact proportion to their current shareholding, the market value of equity no longer matters in this one particular case. Their ownership percentages remain the same, and each puts up the same amount of funds for new shares regardless of the market value. In effect, F and G are selling new shares to themselves.

This is illustrated in the table below¹ for equity values of $500m, $1,000m and $2,000m.

($m)	Value of equity in E	Value of shares held by F	Value of shares held by G	Value of shares held by H
Before share issue	1,000	800 or 80%	200 or 20%
G sells 20% of the shares to H for 200	1,000	800 or 80%	0 or 0% (+200)	200 or 20% (−200)
H subscribes to a cash share issue of 250	1,250	800 or 64%	200 or 16%	250 or 20% (−250)
G sells 20% of the shares to F for 200	1,000	1000 or 100%(−200)	0 or 0% (+200)
F subscribes to a cash share issue of 250	1,250	1050 or 84% (−250)	200 or 16%
F and G subscribe to a share issue increase of 250 in proportion to their ownership percentage at different initial values of equity (1,000, 2,000 and 500, respectively)	1,250	1000 or 80% (−200)	250 or 20% (−50)
	2250	1800 or 80% (−200)	450 or 20% (−50)
	750	600 or 80% (−200)	150 or 20% (−50)

Section 38.2 CURRENT AND NEW SHAREHOLDERS

1/ DILUTION OF CONTROL

Returning to the examples given above, we see that there is dilution of control – that is, reduction in the percentage equity interest of certain shareholders – whenever those shareholders do not subscribe to an issue of new shares in proportion to their current shareholding.

The dilution is greatest for any shareholder who does not participate at all in the capital increase. It is nil for any shareholder who subscribes in proportion to their holding. By convention, we will say that:

Recall that if new shares are issued at a price significantly below their value, current shareholders will usually have pre-emptive subscription rights that enable them to buy the new shares at that price. This right of first refusal is itself tradeable and can be acquired by investors who would like to become shareholders on the occasion of the capital increase.

In the absence of subscription rights, the calculation of dilution of control by a share issue is straightforward:

When the issue of shares is made with an issue of pre-emptive subscription rights, this calculation no longer holds. Rights allow the shareholder to partially participate in the issue of shares without spending any money, as they can sell part of their rights and participate with these funds and the remaining rights to the rights issue. This transaction does not imply any cash-in or cash-out. Hence, the dilution suffered is overestimated by the previous calculation. It is therefore necessary to compute the dilution due only to the share issue regardless of the method used (rights issue).

The simplest way to calculate real dilution is to reckon on an aggregate basis rather than per share. Real dilution is then calculated as follows:

Dilution computed using the formula at the top of this page is sometimes referred to as apparent dilution when it is (improperly) used in the presence of preferential subscription rights. The difference between real dilution and apparent dilution is called technical dilution as it is due to the existence of subscriptions rights.

This dilution reflects the dilution of the power of the shareholder in the company and has nothing to do with the dilution of EPS, which we will analyse in Section 38.3.

2/ ANTICIPATION MECHANISM

Take the example of a highly profitable company, entirely equity-financed, that now has investments of 100. With these investments, the company is on track to be worth 400 in four years, which corresponds to an annual internal rate of return of 41.4%.² Suppose that this company can invest an additional 100 at a rate of return similar to that on its current investments. To finance this additional capital requirement, it must sell new shares. Suppose also that the shareholders’ required rate of return is 10%.

Before the company announces the share issue and before the market anticipates it, the value of its equity capital four years hence is going to be 400, which, discounted at 10%, is 273 today.

If, upon the announcement of the capital increase, management succeeds in convincing the market that the company will indeed be worth 800 in four years, which is 546 today, the value accruing to current shareholders is 546 − 100 = 446. There is thus instantaneous value creation of 173 (446 – 273) for the current shareholders.

The anticipation mechanism operates in such a way that new shareholders will not receive an excess rate of return. They will get only the return they require, which is 10%. If the intended use of funds is clearly indicated when the capital increase is announced, the share price before the capital increase will reflect the investment opportunities, and only the current shareholders will benefit from the value creation arising from them.

Some share prices that show very high P/E ratios are merely reflecting anticipation of exceptional investment opportunities. The reader will be able to observe companies whose share prices are at times so high that they cannot correspond to growth opportunities financed in the traditional way by operating cash flow and borrowing. The shareholders of these companies have placed a bet on the internal and external growth opportunities the company may be able to seize, as it may have done in the past, financed in part by issuing new shares.

Section 38.3 SHARE ISSUES AND ACCOUNTING CRITERIA

In this section, we reckon only in terms of adjusted figures. The reader is referred to Chapter 22 for the calculation of the share price adjusted for a rights issue.

Accountants and lawyers are accustomed to apportioning the proceeds of a capital increase between the increase in authorised capital (the number of new shares issued multiplied by the par value of the share) and the increase in the share premium account (the remainder). We are confident they will know how to distinguish between the two meanings of “capital increase”.

1/ SHARE ISSUE AND EARNINGS PER SHARE

A capital increase will change earnings per share instantaneously. If EPS decreases, there is said to be dilution of earnings; if it increases, there is said to be accretion (or the operation is said to be “earnings-enhancing”, which may sound better). But be careful! This dilution has nothing in common with the dilution of Section 38.2 other than the name, and is calculated differently. That one has to do with a shareholder’s percentage of ownership, this other one with earnings per share.

Consider Company B, the shares of which carry a low P/E (5) justified by the company’s high risk and low growth prospects and Company A, where high prospects for EPS growth justify a high P/E (20). For both companies, shareholders require an after-tax rate of return on equity of 10%, and we will assume that both Company B and Company A invest the funds raised by a capital increase at 10%; there is neither creation nor destruction of value on this occasion. For both, the value of equity capital therefore increases by the amount of the capital increase.

Company A and Company B each increase the number of shares by 50%, which, invested at 10%, will increase their net earnings. The impact of the capital increase will be as shown in the table below.

	Before capital increase					After capital increase
	Market value of equity	P/E	Earnings	Number of shares	EPS	Market value of equity	Earnings	Number of shares	EPS
Company A	€3,000m	20	€150m	10m	€15	€4,500m	€300m	15m	€20 (+33%)
Company B	€3,000m	5	€600m	200m	€3	€4,500m	€750m	300m	€2.5 (−17%)

Company B’s EPS decreases by 17%, whereas the transaction does not destroy value. Similarly, Company A’s EPS increases by 33% but the transaction does not create value.

This demonstrates once again that earnings per share are not a reliable indicator of value creation or destruction. These changes are merely mechanical and depend fundamentally on:

the company’s P/E ratio; and
the rate of return on the investments made with the proceeds of the share issue.

More generally, the rule the reader will want to retain is that any capital increase will:

mechanically lead to a dilution of EPS whenever the reverse of P/E is greater than the rate of return on the investments financed by the share issue;
be neutral whenever the reverse of P/E is equal to this incremental return; and
mechanically lead to an increase or “enhancement” of EPS whenever the reverse of P/E is less than incremental return.

It can easily be demonstrated that the earnings dilution occasioned by a capital increase at the market price is equal to:

For Company A, any investment that generates a return per year greater than 5% (the reverse of P/E of 20) will increase earnings per share, whereas for Company B the bar is set higher at 20% (reverse of 5). Hence the appeal of issuing new shares when P/Es are high, even when the capital increase does not create value in and of itself.

In the short term, it is rare for funds raised by a capital increase to earn the required rate of return immediately, either because they are sitting in the bank waiting for the investments to be made or because some period of time must elapse before the achieved rate of return reaches the required level. Consequently, it is not rare for EPS to decrease following a capital increase – but this does not necessarily mean that value is being destroyed.

Three measures of EPS dilution might be distinguished here: instantaneous dilution, with no reinvestment of the funds raised, which is seldom calculated because it holds no interest; dilution, assuming investment of the funds at the risk-free rate of interest, which is the measure that financial analysts generally calculate; and dilution with reinvestment of the funds, which is obviously the measure of most interest, but is difficult to get hold of because it requires forecasting the rate of return on future investments.

In the long term, EPS dilution should normally be offset by the earnings generated by the investment financed by the capital increase or by risk reduction via a more balanced financial structure. It is therefore necessary to study the expected rate of return on that investment, for it will determine the future course of the company’s value.

2/ SHARE ISSUE AND VALUE OF EQUITY CAPITAL

To say that the book value of a company’s equity increases after a capital increase is to state the obvious, since the proceeds of the share issue are included in that book value.

It is of more interest to compare the percentage increase in book value with the ratio of the proceeds of the capital increase to the market value of equity and to calculate the growth in value per share.

Let’s take the example of Company C, whose equity value represents 50%, 100% or 200% of its book value. In all cases, we set the proceeds of the capital increase at the actual percentage level, which is 33% of the group’s equity value before the transaction.

(in $m)	Case 1	Case 2	Case 3
Book value of equity	300	300	300
Market value of equity	150	300	600
Capital increase	50	100	200
Dilution	25%	25%	25%
Increase in book value	+17%	+33%	+66%

In case 1, because the market value (150) is below the book value of equity (300), the increase in capital requires a major effort from shareholders (25%) and leads only to a limited increase in Company C’s book equity: +17%.

On the contrary, when the market value of equity is way above its book value (case 3), the same effort by shareholders in dilution terms (25%) leads to a much higher increase in book equity (+66% vs. +17%).

We can illustrate this with the example of Credit Suisse, that issued shares in April 2021. It was valued at the time of its IPO at CHF 20.1bn and had CHF 42.7bn book equity. The IPO was implemented partly through an issue of new shares for CHF 1.8bn. The new shareholders, who brought 4% of the book equity of Credit Suisse post-transaction (1.8 compared to 42.7 + 1.8 = CHF 44.5bn), have 8% of capital. The existing shareholders have had their equity per share reduced from CHF 18.3 to CHF 17.5 (–4.4%). The new shareholders, who contributed CHF 8.65 per Credit Suisse share, now have CHF 17.5 book equity per share (hence an immediate accretion of 102%)! This is the entrance bonus that a high risk low profit bank has to offer to convince new investors to buy shares.

At a constant capital structure, the increase in equity allows a parallel increase in debt and thus in the company’s overall financial resources. This phenomenon is all the more important when the company is profitable and its market value is greater than its book value. Here we link up again to the PBR (price-to-book ratio) notion that we examined in Chapter 22.

A capital increase may increase a company’s financial power considerably, with relatively little dilution of control.

If market value is greater than book value, the dilution of control will be countered by a greater increase in financial resources.
If market value of equity coincides with book value, the dilution of control will be accompanied by a similar increase in the company’s overall financial resources.
If market value is less than book value, the dilution of control will be accompanied by a lesser increase in financial resources.

For shareholders of a highly profitable company, i.e. of which the market value of equity is much higher than the book value, the share issue will have a very positive impact in the short term.

In the mid-term all depends on the use of the proceeds of the share issue and obviously on the return of the investment undertaken compared to its cost of capital.

Section 38.4 SHARE ISSUES AND FINANCE THEORY

1/ SHARE ISSUES AND MARKETS IN EQUILIBRIUM

A share issue is analysed first and foremost as a sale of new shares at a certain price. If that price is equal to the true value of the share, there is no creation of value, nor is any current shareholder made worse off. This is an obvious point that is easily lost sight of in the analysis of financial criteria that we will get to later on.

If the new shares are sold at a high price (more than their value), the company will have benefited from a low-cost source of financing to the detriment of its most recent shareholders. Tesla, which was able to raise money on very advantageous terms in the second half of 2020, can be cited as an example.

As we have seen, however, this cost is eminently variable. The sanction for not meeting it is that, other things being equal, the value of the share will decline. The company will be worth less, but in the short term there will be no impact on its cash position.

2/ SHAREHOLDERS AND CREDITORS

For a company in financial distress, a share issue results in a transfer of value from shareholders to creditors, since the new money put in by the former enhances the value of the claims held by the latter. According to the contingent claims model, the creditors of a “risky” business are able to appropriate a large share of the increase in the company’s value due to an injection of additional funds by shareholders. The value of the put option sold by creditors to shareholders has a lower value. This is the reason why recovery plans for troubled companies always link any new equity financing to prior or concomitant concessions on the part of lenders.

Recapitalisation increases the intrinsic value of the equity and thereby reduces the riskiness of the company, thus increasing the value of its debt as well. Creditors run less risk by holding that debt. This effect is perceptible, though, only if the value of debt is close to the value of operating assets – that is, only if the debt is fairly high-risk.

3/ SHAREHOLDERS AND MANAGERS

A capital increase is generally a highly salutary thing to do because it helps to reduce the asymmetry of information between shareholders and managers. A call on the market for fresh capital is accompanied by a series of disclosures on the financial health of the company and the profitability of the investments that will be financed by the issue of new shares. This practice effectively clears management of suspicion and reduces the agency costs of divergence between their interest and the interest of outside shareholders. A share issue thus encourages managers to manage in a way that maximises the shareholders’ interest.

4/ SHARE ISSUE AS A SIGNAL

If one assumes that managers look out for the interests of current shareholders, it is hard to see how they could propose an issue of new shares when the share price is undervalued, as shareholders would be diluted in bad financial conditions.

If one believes in asymmetry of information, a share issue ought to be a signal that the share price is overvalued. A share issue may be a sign that managers believe the company’s future cash flows will be less than what is reflected in the current share price. The management team takes advantage of the overvaluation by issuing new shares. The funds provided by this issue will then serve not to finance new investments but to make up for the cash shortfall due to lower-than-expected operating cash flows.

In practice, the announcement of a capital increase produces a downward adjustment of 3–5% in the share price. Only the current shareholders suffer this diminution of value. Some claim that this effect is due to the negative consequences of the share issue on the company’s accounting ratios (see Section 38.3). We do not think so. Others explain it by invoking a market mechanism: a product sells for a bit less when there is a larger quantity of it; “You catch more flies with honey than with vinegar”. Lastly, still others explain it as being due to the negative signal that a share issue sends. The reader who wants to raise fresh capital for their company should take this effect into account and be able to respond in advance to the criticisms.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

A share issue is a sale of shares, the proceeds of which go to the company and thus indirectly to all shareholders who will therefore share future cash flows.

In the theory of markets in equilibrium, the cost of a capital increase is equal to the cost of equity given the valuation of the shares. This is neither the dividend yield nor the earnings yield (reverse of P/E). It is a forward-looking cost and one to which there is no firm commitment on the company’s part. (Ex post it may be quite different: exorbitantly high or actually negative.) Value is created for current shareholders if the capital increase captures the value creation stemming from the new funds.

A capital increase tends to benefit lenders to the detriment of shareholders insofar as the market re-rates the company’s debt to reflect the reduced risk of its share issue. A capital increase tends to favour current shareholders over new, via a transfer of value, if the rate of return on new investments is correctly anticipated. The a priori negative signal that any capital increase sends – namely, that the shares are overvalued – has to be countered (signalling theory). A capital increase entails a temporary reduction in informational asymmetry (agency theory).

The reduction in equity rights of a shareholder that neither puts in nor takes out funds on the occasion of a capital increase is called real dilution. In the case of a rights issue, real dilution is different from apparent or overall dilution.

This dilution of power and control is to be distinguished from the dilution (or its opposite) in the company’s financial parameters in the short term. Any share issue increases EPS when the reciprocal of P/E is less than the after-tax rate of return on reinvested funds. Book value per share is diluted for current shareholders if the company’s market capitalisation is less than its book value.

QUESTIONS

1/Is the issue price of the new shares important in a capital increase where each shareholder subscribes their share of the capital increase?
2/What is dilution of control?
3/When are there three different measures of dilution of control? What are they?
4/What is the purpose of subscription rights? What is their theoretical value?
5/At what price is a capital increase effected when made with an issue of subscription rights? When made without?
6/How can a company be sold by means of a capital increase?
7/What is the consequence of a capital increase on EPS in the short term? In the long term?
8/Should there be an issue of new shares whenever the share price is overvalued?
9/Why are the most profitable companies the ones that gain the most by issuing new shares?
10/Does a capital increase with pre-emptive subscription rights signal overvaluation of the shares more strongly than one without?
11/What can happen if rights trade significantly below their theoretical price? What is the limit?
12/Why are share issues a complex decision to take for family-owned companies?
13/What is most important in a capital increase?
14/In the presence of subscription rights, what is the most relevant dilution of control?

EXERCISES

1/
1. A company has a market value of €100m divided into 1 million shares. It proposes to raise funds equivalent to 25% of its value by issuing new shares at €75. Calculate the value of the subscription right, the apparent, technical and real dilutions, the adjustment coefficient and the subscription ratio.
2. A shareholder holds 90 shares of the company above. Show the bonus share aspect inherent in a capital increase of this kind.
3. If the shareholder does not subscribe to the new issue, what is their new ownership percentage? Calculate it in two different ways.
4. Show that if all shareholders subscribe to the capital increase, the issue price does not matter.
5. What is EPS after the capital increase if previously it was €10?
6. If the book value of equity was €80m before the capital increase, what is the percentage increase in it? What is the book value per share before the operation? What is it after the operation?
7. Answer questions (a) through (f) again assuming that, after a sharp run-up in share prices, the market value of the company has doubled. The amount of the capital increase is still €25m, but the issue price rises to €150. What conclusions do you draw?
2/Case study: Carbios share issue in May 2021.
Issue of 3m new shares without pre-emptive subscription rights:
Number of shares before the capital increase: 8.164m
Issue price: €38
Latest price: €41
Issue proceeds (gross): €114m
1. Compare consolidated shareholders’ equity (€49m) with the amount of the capital increase, the amount of the latter to market capitalisation before the operation. What do you conclude?
2. Calculate the real dilution entailed by the capital increase. Compare it with the increase in book equity from the share issue.
3. Calculate the share that new shareholders will hold in the capital and the shareholders’ equity of Carbios.
4. What is your conclusion? Carbios is a green chemistry company that develops innovative biological processes to recycle plastics (PET) over and over again.
3/Other case studies of share issues are available on the Vernimmen.com website, including Rubis, Neovacs, Générale de Santé.

ANSWERS

Questions

1/No, because regardless of the issue price, the shareholding is not modified.
2/Reduction in the equity rights of shareholders that do not subscribe to the capital increase in proportion to their current shareholding.
3/When there is a capital increase along with an issue of pre-emptive subscription rights. Apparent dilution (ignoring the value of the rights), real dilution (the one that matters) and technical dilution (solely attributable to the rights).
4/Subscription rights ensure that the current shareholders can take part in the share issue if they wish. Their theoretical value is presented on Section 25.4, 3/.
5/With or without rights, the capital increase is made at the value of the share. With rights because the investor’s cost price must include acquired rights. Without rights because the discount, in relation to the value, is usually very small.
6/By having a very large capital increase with a very small issue price and hence a large value for rights.
7/Generally, dilution in the short term. For the long run, it depends on the returns generated by the projects that are financed.
8/In theory, yes. In practice, this is quite difficult to do.
9/Because this is the virtuous circle of the share issue.
10/Yes, because the substantial discount provides a cushion against a sharp drop in the market price and because the banks were unwilling to get caught up in a process that would have led to them guaranteeing a price close to the market price.
11/Arbitrage will take place: some investors will buy rights and short sell shares. This short sell will be repaid with the shares subscribed by the use of the rights. The lack of market efficiency is usually explained by the low liquidity of rights.
12/Because it leads to a dilution of control.
13/The profitability of the investments financed in this way.
14/Real dilution, because it takes into account the proceeds from the sale of the subscription rights as opposed to apparent dilution.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/
1. Subscription right = €6.25, apparent dilution = 25%, real dilution = 20%, technical dilution = 5%, adjustment coefficient = 0.9375, subscription ratio = 1 new for 3 shares held.
2. The shareholder has 90 subscription rights. If they sell 72 of them and keep 18, they will be able to buy 6 new shares without expending any cash. This is equivalent to receiving 6 bonus shares.
3. (90 + 6) / (1,000,000 + 333,333) = 0.0072 = (90 / 1,000,000) × (1 – 20%).
4. Since the control percentages are unchanged and the amount of increase is fixed, the price has no effect.
5. Before the funds raised are invested, EPS falls to €7.5.
6. Book value of equity increases by 31.25%. Book value per share drops from €80 before to €78.75 after.
7. Subscription right = €7.14, apparent dilution = 14.3%, real dilution = 11.1%, adjustment coefficient = 0.9643, subscription ratio = 1 new for 6 shares held. Book value per share after: €90.
2/Carbios case study.
1. The share issue increases the market cap by 34% but the book value of shareholders’ equity by 133%.
2. Apparent dilution is 114 / (114 + 335) = 25%. But book equity increases by 133% for only a 25% dilution of current shareholders as equity is worth 7 times its book value.
3. 3 / (3 + 8.164) = 26.9% of capital and 114 / (114 + 49) = 70% of equity.
4. It is because Carbios is perceived as a value-creating company (equity value higher than book value of equity), that the new shareholder, although contributing 70% of the equity, is entitled to only 26.9% of the shares.

BIBLIOGRAPHY

P. Asquith, D. Mullins, Equity issues and offering dilution, Journal of Financial Economics, 15(1), 61–89, January–February 1986.
H. DeAngelo, L. DeAngelo, R. Stulz, Seasoned equity offerings, market timing and the corporate lifecycle?, Journal of Financial Economics, 95(3), 275–295, March–February 2010.
A. Dittmar, A. Thakor, Why do firms issue equity?, Journal of Finance, 62(1), 1–54, February 2007.
I. Ducassy, Equity issues and ownership structure in France, Banques & Marchés, 96, 20–30, September–October 2008.
A. Kalay, A. Shimrat, Firm value and seasoned equity issues: Price pressure, wealth redistribution, or negative information, Journal of Financial Economics, 19(1), 109–126, September 1987.
B. Larrain, F. Urzúa, Controlling shareholders and market timing in share issuance, Journal of Financial Economics, 109(3), 661–681, September 2013.
Y. Le Fur, P. Quiry, To sell assets or issue shares?, TheVernimmen.com Newsletter 63, 9–10, December 2011.
T. Loughran, J. Ritter, The new issues puzzle, Journal of Finance, 50(1), 23–51, March 1995.
R. Masulis, A. Korwar, Seasoned equity offerings: An empirical investigation, Journal of Financial Economics, 15(1), 91–118, January–February 1986.
S. Myers, N. Majluf, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, 13(2), 187–221, June 1984.

NOTES

1 Figures in parentheses indicate cash flows: positive means an inflow; negative an outflow.
2 41.4% = (400 / 100)^1/4 – 1.

****PART THREE. DEBT CAPITAL

This part addresses debt policy: features of debt and the liquidity that is to be kept on the balance sheet.

Chapter 39. IMPLEMENTING A DEBT POLICY

Just the right mix

Once a certain level of net debt has been chosen, CFOs should think about the amount, the structuring of the firm’s gross debt, the amount of cash that they want to keep, on average, on the asset side of the balance sheet, and the amount of the undrawn available credit facility that they want to keep. But as we’ll see with the SEB example, implementing a debt policy goes beyond the simple choice of the parameters of the debt products issued or contracted, and includes the strategy of relationships over time between the firm and its various debt providers.

Section 39.1 DEBT STRUCTURE

Structuring a debt means defining its main parameters and negotiating them with lenders. The most important points are:

The types of lenders and guarantees:
- should loans be backed up by assets or not;
- should financing be sought on the bond market or on the bank market;
- diversifying risk among lenders (nature and number of lenders);
choice of a structure:
- choosing a maturity date and an amortisation profile;
- choosing a currency;
- choosing a type of interest rate;
related terms and conditions:
- defining a hierarchy (seniority) for repayment;
- defining appropriate legal agreements and in particular the covenants to be accepted.

1/ SHOULD LOANS BE BACKED UP BY ASSETS OR NOT?

Lenders wish to ensure that the firm will pay the interest and reimburse the loan. One of the most secure ways of guaranteeing reimbursement is to use one of the company’s assets as a form of collateral. This results in heavy restrictions on the company (impossible to sell the asset), but could enable it to bring down its cost of financing and to find more financing than in the overall financing of the firm. Accordingly, we distinguish between:

Loans to companies, guaranteed solely by the borrowing company’s ability to generate future free cash flows and by its current financial solidity.
Asset-backed loans, which are loans backed by a specific asset, the material existence of which constitutes both the basis and the collateral. Generally, the maximum amount of the loan is equal to the value of the collateral provided by the borrower. In most cases, it is inferior to it, since the disposal of the asset is always uncertain.

The difference between loans to companies and asset-backed loans is sometimes unclear. A loan to a company may be backed by a pledge on an asset, which only guarantees a small portion of the loan. An old asset that generates cash flows with little risk can be used as collateral to finance a new development.

The financial manager will highlight the guarantees provided in order to isolate them and obtain cheaper financing. But let’s not deceive ourselves. In a world in equilibrium, if backing a loan with an asset makes it possible to reduce the cost of financing, there is a risk that the corollary could be an increase in the cost of other financings which do not have this guarantee, and will, accordingly, be more risky.

Pushing the logic of asset-backed financing to the extreme, we get non-recourse financing and project finance (see Chapter 21). This is financing that is backed by a whole project. This technique makes it possible to isolate the different economic risks. As these risks are perceived differently by investors depending on their respective resources and preferences, the sum of the components of the financing may be less expensive than the financing of the whole.

2/ OBTAINING FINANCING FROM BANKS OR ON THE FINANCIAL MARKET

This is a theoretical choice for the small company which, in general, only has access to bank or similar financing. Nevertheless, given Basel III (and soon Basel IV) and changing banking regulations, the share of market financing in the debt of medium- and large-sized eurozone companies is tending to increase and is getting a bit closer to the situation in the US. Additionally, medium-sized companies are seeing the development of private debt placements: private placements in the US (see Chapter 21), Schuldschein (see Chapter 21) and now euro private placements.

Bank loans (or more generally private loans) follow a negotiation and intermediation logic, which runs contrary to the market logic of bond financing or financing using commercial paper.¹ Bond loans and commercial paper enable the company to seek financing from financial investors directly, without going through the “screen” that is created by the balance sheet of a financial institution.

Although since 2010, bonds account for an increasingly large share of company financing in the eurozone, bank financing remains predominant with a share of 81%, unlike in the US, where the proportions are more or less reversed (66% for bonds and 34% for bank loans).
*Source*: Data from Banque de France, from national accounts

The main differences between these two major categories of financing are cost, volumes, term and management flexibility.

The costs relating to bank loans and to bonds are by nature very different. Readers may believe that the bank’s intermediation cost is the only difference. In reality, the interest rate on a bank loan does not generally correspond to the real cost of financing the company. Under pressure from competitors, banks may offer loans on very attractive terms that are not linked to the counterparty risk. Their hope is that they will make money by selling the company other products (cash flow management, foreign exchange transactions, management of employee benefits, M&A mandates, etc.), which is called the “side business”.

It also means that investors have to be continually informed of the company’s results and prospects and generally (though not always) require that the company or issue in question be rated (see Chapters 20 and 25), which means additional costs. The interest rate at which the market is prepared to buy the company’s bonds, given its appreciation of the risk, is the real cost of financing the company.

In both cases, an intermediation fee or flat fee must be added to the cost of interest rates. Such fees are paid on signature of the loan agreement.

The amount of loans offered by banks is perfectly adapted to a company’s requirements, as long as they can be drawn as and when the company needs them. On the other hand, the financial markets impose heavy restrictions on borrowers in terms of volumes. A debt security is hard to list unless it has sufficient liquidity for investors, who want to be able to buy it and then sell it easily if necessary. The necessary minimum is often €200–300m. Nevertheless, SMEs can issue directly or via investment funds, listed bonds for amounts of between €5m and €20m. Unfortunately, the liquidity of a €5m bond will be non-existent on the secondary market, preventing large funds and institutional investors from financing SMEs. Private investors and some specialised funds will be the main holders of such bonds. This moves away from a market logic, but remains in a disintermediation logic.
The bond market generally offers financings over a longer period than those offered by the bank market. Bank loans rarely have a maturity of over five years (with the possibility of an extension of 1 or 2 years at the hand of the banks), while it is possible for companies to issue bonds over 12 years, or even longer, especially in dollars or in pounds sterling. Additionally, bonds have a longer duration because they are practically all reimbursed at the end of the loan term (bullet repayment) and not in instalments like most bank loans.
While bank loans can normally be obtained relatively quickly, preparations to tap the debt market can take weeks if the issuer is a first-time issuer, and there is no guarantee of success. The need to provide investors with information explains the length and difficulty of the process. Moreover, the unpredictable nature of the market sometimes results in major uncertainty in terms of the success of the debt issue. It’s also ill-advised to issue debt during periods of tension on the financial markets. However, most of the time, groups with a good rating (investment grade) can issue amounts of several hundreds of millions of euros or dollars or even several billions in a few hours on the markets.

The principle of bilateral banking arrangements naturally offers a greater availability of funds. Similarly, for commercial reasons, banking terms can be renegotiated if the company’s situation deteriorates or improves. This is extremely complicated and costly for listed debt securities, which are held by a multitude of investors who will all have to be invited to a general meeting where they will have to approve these changes by a given majority.

Additionally, bank loans are generally more restrictive in terms of restrictions on the borrower. In particular, they impose compliance with covenants (Section 39.2), while documentation relating to bond loans is substantially less complex and standardised.

On the other hand, a bank loan offers additional flexibility by allowing borrowers to defer drawing down funds, i.e. to defer the moment when the funds are made available and when interest starts to accrue. Borrowers then pay a commitment fee (or non-utilisation fee). This is not possible for a bond loan as the funds are paid to the issuer immediately after the close of the issue. Private debt placements offer a certain amount of flexibility in this regard.

3/ CHOOSING A MATURITY

The choice of a maturity depends on how liquid the company is (see Chapter 12).

Naturally, the treasurer will base decisions on the forecast cash flow budgets. Let us assume that they are certain they will have to invest €10m during the year under way and that the company’s cash flows will only be positive from the third year. In this case, it would be worth looking for financing where no capital has to be reimbursed during the first two years; for example, a bank loan with deferred repayment or a five-year bullet bond.

The treasurer will look at these issues separately by drawing up a financing plan with different maturities. Once this has been done, they can carry out arbitrages between short-, medium- and long-term financing, taking advantage of specific opportunities on one of the types of loans. First and foremost, care must be taken not to create a “debt wall” by grouping together too large an amount of repayments on any given year.

The treasurer will first rely on the least expensive resources for the most foreseeable portion of their financing requirements. They will then adapt the level of credit on the basis of loans obtained the most quickly (credit line, revolving loan, overdraft), as new information comes in. When major funds have to be allocated without being anticipated in advance, the treasurer will rely on immediately available resources (cash, bridge financing, etc.), then gradually replace them with less expensive or more structured resources (maturity, guarantees, etc.).

4/ CHOOSING A CURRENCY FOR DEBT

As we’ll see in Chapter 51, taking out debt in a foreign currency can turn out to be a good way for the company to reduce its exposure to the foreign exchange risk. Accordingly, the treasurer of a group operating on an international scale should add the foreign currency dimension to their financing plans. But taking out debt in a foreign currency when most of the company’s business is in the eurozone on the pretext that interest rates are lower than in the eurozone is a serious mistake! It is speculating that the difference in interest rates will not be set off, or even worse, by a depreciation of the euro against this foreign currency between now and the loan’s maturity. It is taking a very big foreign exchange risk for a very small interest rate saving, it is playing against economic theory and it is certainly not the type of behaviour that shareholders signed up to finance when they invested in the company.

5/ CHOOSING BETWEEN A FIXED RATE AND A FLOATING RATE

The choice between a fixed and a floating rate is a lot more complex than it seems.

Firstly, you should remember that it is quite different from the choice of a maturity. Short-term fixed-rate debt (e.g., USCPs or NEU CPs) is floating-rate debt because the interest rate changes when a new debt is taken out to replace the previous one. Medium- and long-term loans can be taken out at a floating rate. This is generally the case for bank loans indexed to a short rate like the 1.3- or 6-month Euribor, regardless of their maturity. Additionally, through swaps (see Chapter 51), the financial markets offer a simple way of moving from fixed to floating rates and the other way around.

In order to make the best choice, financial directors have to focus on other criteria – minimising costs, reducing risk, optimising value and following the siren’s call of their expectations.

Studies show that for the past 35 years, companies that took out debt on the basis of short rates (so at floating rates) were winners in terms of costs. Nevertheless, generally, taking out debt at a fixed rate is seen as playing it safe, as the company knows today what its expense on the income statement will be for the years to come. But this is forgetting that when interest rates fall (generally during periods of crisis), the value of the debt at a fixed rate will increase, thus reducing the value of equity, even if effectively there is no impact on the income statement. In this case, accounting that does not record the opportunity costs on the income statement does not shine any light on the decision made.

It is, however, difficult for a heavily indebted company, or a company operating in a cyclical sector, to take the risk of interest rates rising, which would increase its costs. For such companies, a fixed rate is a form of insurance policy. On the other hand, a company in a sector protected from inflation (because its prices are more or less indexed to it, such as energy, real estate, highways, etc.), can take on the risk of a variable rate. In fact, most of the time, the rise in interest rates is due to a rise in inflation: what it loses on its financial costs, it recovers on its operating income.

In the end, financial directors’ expectations of rising or falling interest rates will obviously have a major influence on their choice. Under the cover of good management, they become speculators, taking out debt at a floating rate when they think that interest rates are going to fall and at a fixed rate when they find that current interest rates are very low. This is speculation, because if they are wrong, the company will suffer the consequences, which include a rise in the future cost of financing and an opportunity loss on the cost of its present debt.

Bank loan agreements contain covenants which set out the obligation to hedge part of the interest rate risk when the company takes out debt at a floating rate. In this case, the cost of hedging must be added to the real cost of the loan. The interest rate risk is theoretically described in the notes to the accounts of the company, and its hedging policy must also be set out.

The result of these considerations is often an arbitrary proportion (50–50, 2/3–1/3) of fixed and floating rates.

6/ DEFINING THE SENIORITY OF REPAYMENTS

A creditor that has no guarantee is called a chirographic creditor. It is also possible to introduce, legally or contractually, “less advantaged” creditors than chirographic creditors. Such creditors are known as subordinated creditors. If the company is liquidated, they will be reimbursed after the senior creditors and after the chirographic creditors, but before the shareholders. Creditors that will have priority over subordinated creditors are called senior creditors. Senior debts may be unsecured or even privileged if they benefit from a specific guarantee (pledge, collateral, etc.).

Of course, in exchange for accepting additional risk, subordinated creditors will demand a higher interest rate than the other creditors, who run less of a risk, and especially the holders of senior debt.

Within the same debt category (subordinated debt, chirographic debt), it is important that the legal features are similar (the notion of pari passu).

Section 39.2 COVENANTS

Covenants are undertakings to do or not to do something. Any breach of a covenant results in a debt becoming immediately due, or even directly the default of the company on this debt, which often leads to default on other debts (through the cross-default mechanism).

The addition of covenants is generally reserved for the most indebted companies (non-investment grade if they are rated), while companies with low debt levels manage to force banks or bondholders to do without them. The level of severity of covenants also depends on the intensity of competition between banks and their willingness to lend at a given time.

1/ CLAUSES OVER CORPORATE INVESTMENT AND PRODUCTION POLICIES

The purpose of such covenants is chiefly to protect debtholders against the possibility that the firm will substitute more risky assets for the existing ones or will simply reduce the total assets. Any investment in other companies, mergers, absorption or asset disposals are either restricted or subject to approval by the debtholders.

In some cases, inventories, client receivables, the securities of certain subsidiaries or the equipment the issue served to finance are given as collateral (pledge). Some covenants restrict the granting of certain assets as collateral for future debt (negative pledge).

2/ CLAUSES OVER NET DEBT AND SUBSEQUENT DEBT ISSUES

Any unforeseen, subsequent issue of equal or higher-ranking debt reduces value for existing debtholders; yet it would not be in the interests of either the current bondholders or the shareholders to rule out any further debt issues. To protect themselves against a reduction in the value of their claims, debtholders can impose limits on the amount of net debt and the nature of the new debt issued based on certain ratios:

If the limits, assessed at least once a year at the closing of the accounts, are exceeded, then the loan becomes immediately due and payable (this is known as the financial maintenance covenant). The excess may result from additional debt or a deterioration in the company’s results.

In practice, these are chiefly rendez-vous clauses that force the company to arrange a restructuring plan with its creditors to contain the risk to the latter, which increases with the financial distress of the company. In addition, waivers (i.e. the fact that banks may allow the borrower not to respect covenants) may be granted against a specific increase in rates or a waiver fee, thereby increasing the remuneration of the lender (as the borrower has become more risky).

Alternatively, or jointly, the spread on the loan can be moved up or down following a margin grid, depending on the level of the covenants, to reflect in the remuneration of lenders the variation in the company risk.

3/ CLAUSES OVER DIVIDEND PAYMENTS

These covenants are designed to avoid the massive dividend distributions financed by increases in debt or asset disposals that make the lenders poorer (see Chapter 34). For example, they can link dividend distribution to a minimum level of equity during the life of the debt. Similarly, they can restrict or rule out the distribution of reserves or share buy-backs.

4/ CLAUSES CONCERNING CONTROL OVER THE BORROWER

In the event of a change of control at the borrower, the lenders may reserve the right to request that the amounts owed to them be repaid. Their goal is to be in a position to negotiate should this change in shareholders result in an increase in the risk on their loans, so that they can re-evaluate the terms, or, if necessary, pull out completely.

* * *

Covenants are often the bugbear of the financial director as they are sources for reducing room for future manoeuvre. There are some very solid groups that, on principle, refuse to agree to covenants. Others do not have this luxury and they negotiate them reluctantly with lenders, hoping they will never have the humiliation of having to announce that they have been unable to comply with them.

Section 39.3 RENEGOTIATING DEBT

First of all, we’ll eliminate cases of extreme financial difficulties which we will deal with in Chapter 48.

During the ordinary course of business, it may be in the company’s best interests to renegotiate the terms of its loans, either to extend or reduce the term as a result of changes in its free cash flows (change in the economic situation, disposal or acquisition of major assets). It could also be seeking to take advantage of better market conditions (term, interest rates), as for example since 2014; or it may want to get rid of its covenants if its financial situation has improved.

The company can, finally, be forced to negotiate in order to prevent the lenders from calling in the loan in advance if the covenants are not complied with, which most often involves the payment of ad hoc fees, an increase in the interest rate and/or the provision of new guarantees.

Roberts and Sufi (2009) have shown that in the US, the probability that a loan will be renegotiated before the end of its term is 27% for loans of less than one year and 72% for loans of between one and three years, 94% for those between three and five years and close to 100% (98%) for those of over five years.

For bonds, negotiations are more complicated. Usually, the bond loan is held by a larger number of investors than there are banks involved in a bank loan, and over which the company has not the power of negotiation, which for a bank is called side business (see Section 39.5).

There are more or less four ways in which a bond debt can be reimbursed or renegotiated:

buy up the bond on the market or through a public offer (the term used is then liability management or LM), which means paying a bit more (around 1%) than its market price and provides no assurance of being able to buy up all of the bonds issued. In practice, the success rate of such offers is generally around 30%;
offer to exchange existing bonds for new bonds to be issued for a longer term or with a lower interest rate. But the reader should not be misled. If interest rates have fallen since the issue of the initial bond, the exchange for bonds issued at a lower interest rate will not make it possible to pay a lower yield to maturity over the residual term of the initial bonds, as these will have to be bought at above the nominal. The Altarea exercise at the end of this chapter illustrates this point;
invite the bondholders to attend a meeting at which they will vote on the plan to modify the initial bond contract. They are paid a fee (consent fee) in order to encourage them to vote. Once a majority is reached (which depends on the legal regime under which the bond is placed), the new provisions apply to all of the bondholders, even those who abstained or who voted against.
use a contractual provision allowing for early redemption of the entire bond issue (make-whole call), often in return for the payment of a significant premium.

Section 39.4 WHY KEEP CASH ON THE BALANCE SHEET?

Since the early 2000s, the share of cash and cash equivalents on companies’ balance sheets has continued to grow:

Part of this cash is not the result of a choice but of a constraint and it is not really available. Some funds are blocked in countries that have strict foreign exchange control rules, other funds involve the payment of additional taxes (withholding taxes) before they can be transferred to the parent company, and other funds are serving as deposits, guarantees, advance payments, etc., which in some countries have to be blocked in special accounts.

And even if funds are not blocked, advance payments by customers will be used to make the products or services orders and to pay suppliers. Accordingly, they cannot be used to repay debts, especially in sectors where activity fluctuates.

Alongside these restrictions, conscious choices have to be made:

firstly for operational reasons: to cover the cash requirements of the different sites (stores, outlets, etc.) or to cover seasonality in working capital;
the liquidity crisis in the autumn of 2008 showed that cash can disappear as quickly as water in sand. A lot of financial directors who spent sleepless nights worrying about their companies’ cash shortages have vowed that this will never happen to them again and have set up precautionary cash reserves. The Covid-19 crisis has demonstrated that corporates were better prepared. It is also clear that the more difficult it is for a firm to tap the financial markets in normal times, the more it will tend to accumulate cash on its balance sheet;
paying back debts early by using surplus cash can trigger the payment of dissuasive penalties and it sometimes happens that a debt contracted in the past at a fixed rate costs less than what the cash can earn, which will not encourage the financial director to use one to pay off the other;
having cash on the balance sheet ensures that the firm will always be in a position to seize investment opportunities which may arise unexpectedly; Frésard (2010) has shown that companies that keep a lot of cash on the asset side of their balance sheet tend, in the following years, to win market share from their “poorer” competitors;
clients, suppliers and workers can only but be impressed by large amounts of cash (public works, defence, etc.). This is why Tereos keeps around €655m in cash on its balance sheet (with gross debt of €3.2bn), so as to reassure third parties of its liquidity, whilst its rating (B+/BB–) is non-investment grade;
for companies with a lot of R&D or intangible assets (pharmaceuticals, technology), having cash on the balance sheet partly counterbalances the fluctuations in cash flow and reduces the risk of investment for the shareholder;
investment does not necessarily immediately follow divestment. Hence Sanofi in May 2020 has explained to the market that it would keep the €10bn from the disposal of its stake in Regeneron for future acquisitions that took place end-2020 and in 2021.

As it is unlikely that the world is getting any less volatile than it is today, cash on the balance sheet will still be a popular choice for many years to come. However, this should not justify excesses, such as keeping large sums on the balance sheet in a permanent way that could be better used in the rest of the economy (see Chapter 36).

Instead of holding cash, firms can opt to keep some undrawn revolving credit facilities (RCF) to maintain the required flexibility and allow for sufficient liquidity.

Section 39.5 THE LEVERS OF A GOOD DEBT POLICY

We can’t end this chapter without giving readers some advice drawn from our experience, from observation, but also from common sense. All of this advice is stamped with the seal of flexibility. We use the example of SEB as an illustration.

It is preferable to concentrate most of a firm’s banking business on a limited number of banks with which long-term and trusting relationships can be built, rather than dispersing this business among a myriad of banks that may be frustrated not to work sufficiently with the company.

In addition to the loans that they grant (which usually tend not to be very profitable), banks appreciate it when the firm gives them other business, which increases the earnings the banks can get out of the relationship without necessarily requiring additional costly commitments in equity: the side business. It is not unlimited, sharing it out among too many banks will make none of them happy. Concentrating on 3–10 banks (depending on the size of the group and its international deployment) will, on the other hand, provide these banks with additional, welcome earnings and help to strengthen the relationship. They will then be motivated to spend more time analysing and will better understand the company, and this in turn will help them to feel at ease. The more they understand its day-to-day operations, its management, its strategy and its development, the more they will be inclined to lend to the company.

In this way, SEB reduced the number of banks involved in its syndicated loan from 40 to 9 in 2004, and then to 7 in 2006, before climbing back up to 8 in 2016 and at the same time increasing the amount of the loan from €300m to €960m. This only serves as backup to the €1bn commercial paper program.

It is prudent to diversify a company’s sources of debt financing among bank debt, bonds, commercial paper, private placements, etc. as the new and restrictive liquidity regulations to which banks are subject limit their capacity to lend, particularly over the medium and long term. Additionally, one market may close while others remain open as long as the borrower is already known to the active investors on these markets.

SEB complemented its existing sources of financing with banks and the commercial paper market (peak of €975m in 2020) by tapping the listed bond market (€1,650m in four tranches with maturities of 2021, 2022, 2024 and 2025) and the private bond market (€625m issued in Schuldschein bonds, maturing between 2021 and 2026, subscribed to by German, French and Asian investors).

It is a good idea to maintain cash reserves that can be drawn on in order to be able to cope with the unexpected, whether the result of changes in the economic situation or acquisition opportunities. In this area, the financial director should take good heed of the advice given by St Matthew: “Watch ye, therefore, for ye know not the day nor the hour.”

Which also means that the company bears a cost for this flexibility, since the medium-term resources drawn down and not used to finance capital employed, and thus booked as cash, do not earn the same interest rate as they cost. Similarly, commitment fees have to be paid on credit lines that have been confirmed but not drawn down. But, like any insurance policy, flexibility has a financial cost.

Although SEB had bank and financial net debt of €1,187m at the end of 2020, it also has confirmed medium-term credit lines of around €1,010m that have not been drawn down, as well as €2,432m in cash. That’s enough for it to go shopping or to cope with any shocks it may encounter. This certainly made it easier for SEB to cope with the Covid-19 crisis.

It is advisable to adapt the maturity of debts to the likely profile of free cash flows in order to avoid feeling too much pain during cash crises, even if that means paying more for a loan because long-term borrowing is generally more expensive than short-term borrowing (see Section 19.6).

For SEB, extending the maturity of financing mainly meant heavily reducing the share of commercial paper (see Section 21.1), resources which are by definition short term. The issuance in 2017 of €500m of 7-year bonds allowed them to reduce this type of financing by 60%. Reducing them does not mean cutting them out altogether. The €1,000m programme was never stopped, so that investors on this market would not get the unpleasant impression that SEB only calls on them when it needs them and is unable to secure resources elsewhere. €975m was consequently issued in 2020.

It is advisable to renegotiate with zeal the covenants that lenders require so that the company is able to maintain room for manoeuvre.

Since 2006 SEB does not have covenants anymore. The low level of risk of its activities and its low level of debt explain this situation.

It is wise to use asset-backed financing with moderation, as the lower cost of financing such loans is often apparent and the real cost is the difficulty of obtaining standard financings. Similarly, sophisticated products (convertible bonds, deeply subordinated securities, etc.) are rarely without a downside: complexity, arbitrage on the share price, and so on.

Obviously, having an intelligent financial policy is a lot easier when the company is performing well operationally and its debt level is low. Limiting the number of banks and concentrating debt on long-term loans with uncomplicated bank documents becomes a lot less easy for groups that are heavily indebted. Having said that, it is when business is ticking over nicely that it is important to be rigorous and demanding, because when the situation deteriorates, it’s often too late to do things properly.

Similarly, diversification of sources of financing is more complicated for smaller groups given that it is harder for them to gain access to the bond market or even to commercial paper. But other sources of financing remain available (factoring, leasing, private placements).

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Once a financial structure has been chosen, the task of the treasurer is to reduce the cost of debt, while retaining as much flexibility as possible.

To manage the company’s net debt and raise funds in line with the main items on the cash flow budget, the treasurer can:

use the assets on the balance sheet or not;
negotiate OTC products with banks or tap the financial markets.

Bank financing is a question of negotiation and intermediation, whereas primary market financing is governed by market forces. The choice for SMEs between bank financing and tapping the markets is a theoretical one, given that bank financing is in a much stronger position and due to the virtual impossibility of SMEs being able to use market products, given their size.

Using collateral definitely reduces the cost of a loan and may sometimes allow a company to obtain financing that it could not get based only on its intrinsic qualities. Using collateral makes it possible to isolate the various economic risks.

Legal or contractual provisions may rank certain creditors behind chirographic creditors, thus making them “subordinated creditors”. This means that if the company is wound up, they are paid after the preferred creditors (who have access to a specific guarantee), and after the chirographic creditors (these two categories of creditors being “senior” in comparison with the subordinated creditors), but before the shareholders. In exchange for taking on a greater risk, subordinated creditors demand a higher interest rate than the holders of less risky debt, in particular the senior creditors.

Other important debt parameters include the type of interest rate, fixed or floating, the choice of which depends, often wrongly, on the financial director’s expectations of what interest rates are going to do.

Once a bank debt has been contracted, it is quite often renegotiated. This is because either the company, having improved its financial situation, wishes to reduce the cost of its debt or to modify the duration, or because it is forced to do so because it has failed to comply with the covenants.

A good debt policy is a policy that leaves cash on the balance sheet in order to be able to deal with the unexpected and to reduce risk, to reassure the company’s partners and to enable it to seize investment opportunities.

Finally, the financial director would be advised to have close relationships with a limited number of banks to diversify the company’s sources of financing among the different providers of debt, to adapt the maturity of debts to the likely profile of cash flows, and to agree to covenants and asset-backed financings very cautiously, in order to retain as much room for manoeuvre as possible.

QUESTIONS

1/What is the point of backing a loan with an asset?
2/What are the main restrictions on issuing bonds on the market?
3/Why could it be a good thing for a group to issue bonds?
4/What is the point of using subordination when raising financing?
5/When should a treasurer be more inclined to use market products?
6/What is a covenant? Provide a theoretical example of the usefulness of covenants.
7/Is a covenant more of an obstacle to doing or a clause that encourages discussion among the creditors?
8/What is the negative side effect of backing up a financing with an asset?
9/Are there more covenants in a bond loan than in a bank loan? Why?
10/Why do companies keep cash on their balance sheets?
11/A treasurer has to invest cash, but over a period of two years. Should they opt for a fixed or a floating rate? Why?
12/What is the treasurer who takes out debt over five years at a fixed rate betting on? Why?
13/How are reasoning in terms of value and reasoning in terms of cost on the income statement in opposition to each other with regard to the choice of a fixed or a floating rate for debt?
14/What is the limit on the amount of cash that should be kept on the balance sheet?
15/Is it a bad thing to renegotiate debt?
16/Is it more complicated to renegotiate bond debt than to renegotiate bank debts? Why?
17/Does diversifying sources of financing by debt come without cost for the company? Should it be avoided? Why?

EXERCISE

Altarea had issued €500m of bonds in 2017, maturing in July 2024, with a coupon of 2.25% and a redemption at par. In December 2020, Altarea proposed to redeem these bonds by issuing new bonds at the current market rate for this level of risk, i.e. 1.75%, maturing in December 2027.

Is the Altarea 2017 2.25% bond trading above, below or at par at the end of 2020? Why or why not?
What is the difference between the price of the 2017 2.25% bond and its nominal value in December 2020, given the interest rate in force at that time for a borrower such as Altarea with a residual maturity of 3.5 years?
On what condition can the holders of the 2017 2.25% bond agree to sell it to Altarea?
If Altarea obtains the redemption of 100% of the 2017 2.25% bonds and finances itself by issuing December 2020 1.75% bonds, could you say that from December 2020 to July 2024 (i.e. over the residual life of the 2017 2.25% bond), Altarea benefits from an interest rate of 1.75% on this €500m debt contracted in 2017? Why?
Under what condition could you say that Altarea benefits, in total, from a cost of debt reduced to 1.75% from December 2020 to July 2024 on the €500m borrowed in 2017? Does this seem realistic to you? Why or why not?
What is the cost to Altarea of the December 2020 1.75% bonds from July 2024 to July 2027, i.e. beyond the life of the 2017 2.25% bonds that they replace?
What are the two interests that explain why groups proceed, under conditions similar to those of Altarea, to repurchase or exchange their previously issued bonds?

ANSWERS

Questions

1/To obtain financing that the constrained financial structure of the company might not enable it to obtain at a favourable rate, because the risk for the lender is lowered.
2/Minimum size of the bond loan, bullet repayment, which could amount to a large sum when the time comes, often mandatory with a rating.
3/Diversify creditors, obtain long-term financing that the restrictions of Basel III make it more difficult for banks to provide.
4/Share the risk in line with creditors’ appetite and get tighter financing costs by having customised the loans.
5/To take advantage of a window of opportunity on the markets when prices are temporarily abnormal.
6/A restriction that the lenders place on shareholders so that they cannot increase the risk of the lenders.
7/Covenants force management/shareholders to approach lenders to renegotiate loan agreements if they wish to exceed the limits set in these covenants.
8/A rise in the cost of the company’s other financings because the other lenders do not have access to the collateral that this asset represents, therefore their risk is increased.
9/More in bank loans that are held by a limited number of banks, which have the material means to monitor them and possibly renegotiate them, than in bonds which are often held by tens or hundreds of bondholders.
10/As a precautionary measure; because there is friction with cash being sent to the head of the group in large international groups; to reassure the company’s partners.
11/At a floating rate so that the asset, in the event of a fluctuation of market interest rates, does not lose any value at the time when the treasurer has to sell it, if this happens before the asset matures.
12/On a rise in interest rates, because if they were betting on a drop, they would take out debt at a floating rate.
13/The value of a debt at a floating rate is stable at the cost of variability in the interest rate, which is on the income statement. The annual interest of a debt at a fixed rate is stable at the cost of variability in the value of the debt at a fixed rate. Accordingly, you have to choose your source of instability, knowing that in accounting, fluctuations in the value of debt are only recognised, at best, in the notes to the account.
14/The pressure of shareholders who say that enough is enough and that the surplus cash should be returned to them (see Chapter 36).
15/No, it is good management when the company takes the initiative following an improvement in its financial situation or in financial conditions on the market.
16/Yes, because there may be a lot more investors holding a portion of the company’s bond debt than there are bankers holding bank debt, which will complicate the renegotiation process.
17/No, for example, obtaining a rating, or continuing to issue commercial paper when the company temporarily no longer needs these funds. But this is the price to pay for keeping room for manoeuvre.

Exercise

A detailed Excel solution to the exercise is available at www.vernimmen.com.

The 2.25% bond is trading above its par value because rates in December 2020 for a borrower like Altarea have fallen to 1.75% for an average duration of 7 years, and even less for a residual duration of 4 years (2024).
The spread between the price and the nominal is the present value, over the remaining life of the bond, of the difference between the coupon rate of 2.25% and the market rate (1.75%), applied to the nominal value of the bond, all discounted at the current market rate.
Provided they are offered a (small) premium on the price of the bond quoted on the secondary market. Otherwise, they have no interest in proceeding with a sale.
No, because Altarea will not buy back the bonds at 100% of the nominal value of €500m, but at a higher price, i.e. the market value plus a small premium.
This would only be possible if Altarea could buy back its debt on the basis of the nominal amount of €500m. This is totally unrealistic, as it would require bondholders to accept a redemption below the market value of their bonds.
Beyond the life of the initial 2017 bond, the cost to Altarea of the 2020 bonds is 1.75% per annum.
Extending the maturity of the debt to improve the liquidity of the companies and taking advantage of what they perceived to be low interest rates in 2020 to lock in low interest rates for a relatively long period of time, 7 years for Altarea, rather than waiting until the maturity of the initial bonds (2024 for Altarea) to refinance at interest rates that may be higher at that time.

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On covenants:

K. Bhanot, A. Mello, Should corporate debt include a rating trigger?, Journal of Financial Economics, 79(1), 69–98, January 2006.
S. Chava, M. Roberts, How does financing impact investment? The role of debt covenants, Journal of Finance, 63(5), 2085–2121, October 2008.
G. Nini, D. Smith, A. Sufi, Creditor control rights, corporate governance and firm value, Review of Financial Studies, 25(6), 1713–1761, June 2012.
C. Smith, J. Warner, On financial contracting: Analysis of bond covenants, Journal of Financial Economics, 7(2), 117–161, June 1979.

NOTE

1 We note that financing using commercial paper is rather hybrid by nature, since even though this is a market financing, it requires de facto confirmed bank credit lines for an equivalent amount (see Chapter 21).

Dividends (Company X)	2,133 × 10% = 213
− Interest expense⁴	800 × 5% = 40
= Net income	= 173

Strike price	5-year option	7-year option
1,200	1,010	1,085
1,600	731	832
2,000	510	627
2,400	348	468

Year	0	1	2	3	4	5
Debt/equity	30%	22%	22%	22%	22%	22%
EPS	10	8.25	9.1	10.3	11.8	13.6
EPS growth rate		−17.5%	+10%	+13%	+15%	+15%
Rate of return on equity	15%	11%	11%	11.4%	11.6%	12%

	2015	2016	2017	2018	2019	2020
ROCE	12.7	12.8	12.1	11.9	10.6	9.7
ROE	16.0	16.7	15.5	15.5	13.4	11.8

Number of shares before the capital increase:	8.164m
Issue price:	€38
Latest price:	€41
Issue proceeds (gross):	€114m