In theory
According to MM, the dividend policy of the firm is irrelevant in a perfect capital market because the shareholder can effectively undo the firm’s dividend strategy. If a shareholder receives a greater dividend than desired, he or she can reinvest the excess. And conversely he/she can sell off extra shares of stocks.
But when we take into account personal taxes and new issues costs, the firm should not issue stock to pay
a dividend.
When there is not taxes: MM1: the value of the firm is unaffected by the debt-to-ratio equity. Because this can be offset by a homemade leverage. MM2 The expected rate of return on equity is positively related to the firm’s leverage. (because the risk of equity rises with leverage) The expected return on a security is positively related to its dividend yield. If we take into account taxes, firm value is an increasing function of leverage. So firms should have almost only debts. But the reality is different.
It is because we have to consider the cost of bankruptcy. Then the moderate level of leverage observed is easy to understand
Furthermore, we have to take into account the level of personal taxes (higher for interests)in the real world, the debt-equity ratio depends much on
- the sector:eg. much debt in the steel industry and very little for pharmaceutical firms.
- taxes: when you plan to make profits, debts are useful
- the type of assets (if it is R&D, it is difficult to resale them, so the cost of bankruptcy is higher),
- uncertainty of operating income (when it’s risky, it is better to have few debts),
- the pecking order / pecking order theory: firms prefer internal financing with retained earnings, if insufficient debt then equities (pb: large fees to banks/investment companies and so on ; asymmetric information that makes the shareholders reluctant to buy shares/ and financial slack (money kept during good times to serve during bad)
Long-term financial planning >>
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Corporate finance
The subject: corporate finance
PART ONE: CAPITAL EXPENDITURE
The present value
Investment
decisions
Practical
problems in capital budgeting
Firms evaluation
PART TWO. BASICS OF FINANCE
The financial
markets
Options
The market
efficiency
Risk
Mergers,
Acquisitions, and Corporate Control
International
Financial Management
PART THREE FINANCING DECISIONS
Corporate
financing
Dividend policy
and capital structure
PART FOUR FINANCIAL MANAGEMENT
Financial
planning
Short-term
financial management
Courses created and updated by Dr David Chelly, PhD in Management sciences from the University of Tours.
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