Advantages and Disadvantages of Short-Term Financing

The three possible financing policies described above were distinguished by the relative amounts of short-term debt used under each policy. The aggressive policy called for the greatest use of short-term debt, while the conservative policy called for the least. Maturity matching fell in between. Although short-term credit is generally riskier than long-term credit, using short-term funds does have some significant advantages. The pros and cons of short-term financing are considered in this section.

Speed

A short-term loan can be obtained much faster than long-term credit. lenders will insist on a more thorough financial examination before extending long-term credit and the loan agreement will have to be spelled out in considerable detail because a lot can happen during the life of a 10 to 20 year loan. Therefore if funds are needed in a hurry the firm should look to the short-term markets.

Flexibility

If its needs for funds are seasonal or cyclical, a firm may not want to commit itself to long-term debt for three reasons: (1) Flotation costs are higher for long-term debt than for short-term credit. (2) Although long-term debt can be repaid early, provided the loan agreement includes a prepayment provision, prepayment penalties can be expensive. Accordingly, if a firm thinks its need for funds will diminish in the near future, it should choose short-term debt. (3) Long-term loan agreements always contain provisions, or covenants, which constrain the firm’s future actions. Short-term credit agreements are generally less restrictive.

Cost of Long-Term Versus Short-Term Debt

The yield curve is normally upward sloping, indicating that interest rates are generally lower on short-term debt. Thus, under normal conditions, interest costs at the time the funds are obtained will be lower if the firm borrows on a short-term rather than a long-term basis.

Risks of Long-Term Versus Short-Term Debt

Even though short-term rates are often lower than long-term rates, short-term credit is riskier for two reasons: (1) If a firm borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term credit, its interest expense will fluctuate widely, at times going quite high. For example, the rate banks charge large corporations for short-term debt more than tripled over a two-year period in the 1980s, rising from 6.25 to 21 percent. Many firms that had borrowed heavily on a short-term basis simply could not meet their rising interest costs and as a result, bankruptcies hit record levels during that period. (2) If a firm borrows heavily on a short-term basis, a temporary recession may render it unable to repay this debt. If the borrower is in a weak financial position, the lender may not extend the loan, which could force the firm into bankruptcy. Braniff Airlines, which failed during a credit crunch in the 1980s, is an example. Another good example of the riskiness of short-term debt is provided by Transamerica Corporation, a major financial services company. Transamerica’s chairman, Mr. Beckett, described how his company was moving to reduce its dependency on short-term loans whose costs vary with short-term interest rates. According to Beckett, Transamerica had reduced its variable-rate (short-term) loans by about $450 million over a two-year period. We aren’t going to go through the enormous increase in debt expense again that had such a serious impact on earnings, he said. The company’s earnings fell sharply because money rates rose to record highs. We were almost entirely in variable rate debt, he said, but currently about 65 percent is fixed rate and 35 percent variable, We’ve come a long way, and we’ll keep plugging away at it. Transamerica’s earnings were badly depressed by the increase in short-term rates, but other companies were even less fortunate they simply could not pay the rising interest charges and this forced them into bankruptcy.

Alternative Current Asset Financing Policies

Most businesses experience seasonal and/or cyclical fluctuations. For example, construction firms have peaks in the spring and summer, retailers peak around Christmas and the manufacturers who supply both construction companies and retailers follow similar patterns. Similarly, virtually all businesses must build up current assets when the economy is strong. but they than see off inventories and reduce receivables when the economy slacks off. still, current assets rarely drop to zero-companies have some permanent current assets, which are the current assets on hand at the low point of the cycle. Then, as sales increase during the upswing, current assets must be increased and these additional current assets are defined as temporary current assets. The manner in which the permanent and temporary current assets are financed is called the firm’s current asset financing policy.

Maturity Matching, or “Self-Liquidating”, Approach

The maturity matching, or “self-liquidating”, approach calls for matching asset and liability maturities as shown in Panel a of Figure 17-1. This strategy minimizes the risk that the firm will be unable to pay off its maturing obligations. To illustrate, suppose a company borrows on a one year basis and uses the funds obtained to build and equip a plant. Cash flows from the plant (profits plus depreciation) would not be sufficient to pay off the loan at the end of only one year, so the loan would have to be renewed. If for some reason the lender refused to renew the loan, then the company would have problems. Had the plant been financed with long-term debt, however, the required loan payments would have been better matched with cash flows from profits and depreciation, and the problem of renewal would not have arisen.

At the limit, a firm could attempt to match exactly the maturity structure of its assets and liabilities. Inventory expected to be sold in 30-days could be financed with a 30-day bank loan; a machine expected to last for 5-years could be financed with a 5-year loan; a 20-year building could be financed with a 20-year mortgage bond; and so forth. Actually of course, two factors prevent this exact maturity matching: (1) there is uncertainty about the lives of assets, and (2) some common equity must be used and common equity has no maturity. To illustrate the uncertainty factor, a firm might finance inventories with a 30-day loan, expecting to sell the inventories and then use the cash to retire the loan. But if sales were slow, the cash would not be forthcoming, and the use of short-term credit could end up causing a problem. Still if a firm makes an attempt to match asset and liability maturities, we would define this as a moderate current asset financing policy.

Aggressive Approach

Panel b of Figure 17-1 illustrates the situation for a relatively aggressive firm which finances all of its fixed assets with long-term capital and part of its permanent current assets with short-term, nonspontaneous credit. Note that we used the term “relatively” in the title for panel b because there can be different degrees of aggressiveness. For example, the dashed line in panel b could have been drawn below the line designating fixed assets, indicating that all of the permanent current assets and part of the fixed assets were financed with short-term credit; this would be a highly aggressive, extremely nonconservative position and the firm would be very much subject to dangers from rising interest rates as well as to loan renewal problems. However, short-term debt is often cheaper than long-term debt, and some firms are willing to sacrifice safety for the chance of higher profits.

Conservative Approach

Panel c of Figure 17-1 has the dashed line above the line designating permanent current assets indicating that permanent capital is being used to finance all permanent asset requirements and also to meet some of the seasonal needs. In this situation, the firm uses a small amount of short-term, nonspontaneous credit to meet its peak requirements, but it also meets a part of its seasonal needs by “storing liquidity” in the form of marketable securities. The humps above the dashed line represent short-term financing, while the troughs below the dashed line represent short-term security holdings. Panel c represents a very safe, conservative current asset financing policy.

Chrysler, which in 1996 had $8.7 billion of cash and marketable securities, fits the panel c pattern. Its chairman, Robert Eaton, stated that these liquid assets will be needed during the next recession and he cited as evidence the fact that Chrysler had an operating cash deficit of more than $4 billion during the 1991-1992 recession. However, some of Chrysler’s could borrow funds in the future if need be, so the extra $6.7 billion should be redeployed to earn more than the 3 percent after taxes it was getting. The Chrysler example illustrates the fact that there is no clear, precise answer to the question of how much cash and securities a firm should hold.

Influencing Credit Policy

In addition to the factors discussed in previous sections two other points should be made regarding credit policy.

Profit Potential

We have emphasized the costs of granting credit. However, if it is possible to sell on credit and also to impose a carrying charge on the receivables that are outstanding, then credit sales can actually be more profitable than cash sales. This is especially true for consumer durables (autos, appliances, and so on), but it is also true for certain types of industrial equipment. Thus, GM’s General Motors Acceptance Corporation (GMAC) unit, which finances automobiles, is highly profitable, as is Sears’s credit subsidiary. Some encyclopedia companies even lose money of cash sales but more than make up these losses from the carrying charges on their credit sales. Obviously, such companies would rather sell on credit than for cash!

The carrying charges on outstanding credit are generally about 18 percent on a nominal basis: 1.5 percent per month, so 1.5% × 12 = 18%. This is equivalent to an effective annual rate of (1.015)¹² – 1.0 = 19.6%. Having receivables outstanding that earn more than 18 percent is highly profitable unless there are too many bad debt losses.

Legal Considerations

It is illegal under the Robinson Patman Act, for a firm to charge prices that discriminate between customers unless these differential prices are cost-justified. The same holds true for credit it is illegal to offer more favorable credit terms to one customer or class of customers than to another, unless the differences are cost-justified.

Cash Discounts

The last element in the credit policy decision, the use of cash discounts for early payment, is analyzed by balancing the costs and benefits of different cash discounts. For example, a firm might decide to change its credit terms from “net 30”, which means that customers must pay within 30 days to “2/10. net 30”, where a 2 percent discount is given if payment is made in ten days. This change should produce two benefits: (1) It should attract new customers who consider the discount to be a price reduction and (2) the discount should cause a reduction in the days sales outstanding, because some existing customers will pay more promptly in order to get the discount. Offsetting these benefits is the dollar cost of the discounts. The optimal discount percentage is establish at the point where the marginal costs and benefits are exactly offsetting.

If sales are seasonal, a firm may use seasonal dating on discounts. For example Slimware Inc. a swimsuit manufacturer, sells on terms of 2/10, net 30, May I dating. This means that the effective invoice date is May I, even if the sale was made back in January. The discount may be taken up to May 10; otherwise the full amount must be paid on May 30. Slimware produces throughout the year, but retail sales of bathing suits are concentrated in the spring and early summer. By offering seasonal dating, the company induces induces some of its customers to stock up early, saving Slimware some storage costs and also nailing down sales.

Collection Policy

Collection policy refers to the procedures the firm follows to collect past-due accounts. For example, a letter might be sent to customers when a bill is 10 days past due: a more severe letter, followed by a telephone call, would be sent if payment is not received within 30 days and the account would be turned over to a collection agency after 90 days.

The collection process can be expensive in terms of both out-of-pocket expenditures and lost goodwill-customers dislike being turned over to a collection agency. However, at least some firmness is needed to prevent an undue lengthening of the collection period and to minimize outright losses. A balance must be struck between the costs and benefits of different collection policies.

Changes in collection policy influence sales, the collection period and the bad debt loss percentage. All of this should be taken into account when setting the credit policy.

The Credit Period And Standards

A firm’s regular credit terms, which include the credit period and discount, might call for sales on a 2/10. net 30 basis to all “acceptable” customers. Here customers who pay within 10 days would be given a 2 percent discount, and others would be required to pay within 30 days. its credit standards would be applied to determine which customers qualify for the regular credit terms, and the amount of credit available to each customer.

Credit Standards

Credit standards refer to the financial strength and creditworthiness a customer must exhibit in order to qualify for credit. If a customer does not qualify for the regular credit terms, it can still purchase from the firm, but under more restrictive terms. For example, a firm’s regular credit terms might call for payment after 30 days, and these terms might be extended to all qualified customers. The firm’s credit standards would be applied to determine which customers qualified for the regular credit terms and how much credit each should receive. The major factors considers when setting credit standards relate to the likelihood that a given customer will pay slowly or perhaps end up as a bad debt loss.

Setting credit standards requires a measurement of credit quality, which is defined in terms of the probability of a customer’s default. The probability estimate for a given customer is, for the most part, a subjective judgment. Nevertheless, credit evaluation is a well-established practice, and a good credit manager can make reasonably accurate judgments of the probability of default by different classes of customers.

Managing a credit department requires fast, accurate, and up-to-date information. To help get such information, the National Association of Credit Management (a group with 43,000 member firms) persuaded TRW, a large credit reporting agency, to develop a computer-based telecommunications network for the collection, storage, retrieval, and distribution of credit information. A typical business credit report would include the following pieces of information:

1. A summary balance sheet and income statement.
2. A number of key rations, with trend information.
3. Information obtained from the firm’s suppliers telling whether it pays promptly or slowly, and whether it has recently failed to make any payments.
4. A verbal description of the physical condition of the firm’s operations.
5. A verbal description of the backgrounds of the firm’s owners, including any previous bankruptcies, lawsuits divorce settlement problems, and the like.
6. A summary rating, ranging from A for the best credit risks down to F for those that are deemed likely to default.

Although a great deal of credit information is available, it must still be processed in a judgmental manner. Computerized information systems can assist in making better credit decisions, but in the final analysis, most credit decisions are really exercises in information judgment.

Credit Policy

The success or failure of a business depends primarily on the demand for its products as a rule, the higher its sales, the larger its profits and the higher its stock price. Sales, in turn, depend on a number of factors, some exogenous but others under the firm’s control. The major controllable determinants of demand are sales prices, product quality, advertising and the firm’s credit policy. Credit policy in turn, consists of these four variables.

1.    Credit period, which is the length of time buyers are given to pay for their purchases.

2.    Credit standards, which refer to the required financial strength of acceptable credit customers.

3.    Collection policy, which is measured by its toughness or laxity in attempting to collect on      slow-paying accounts.

4.    Discounts given for early payment, including the discount percentage and how rapidly payment must be made to qualify for the discount.

                  

The credit manager is responsible for administering the firm’s credit policy. However, because of the pervasive importance of credit, the credit policy itself is normally established by the executive committee, which usually consists of the president plus the vice-presidents of finance, marketing and production.

Marketable Securities

Realistically the management of cash and marketable securities cannot be separated-management of one implies management of the other. We focused on cash management. Now we turn to marketable securities.

Marketable securities typically provide much lower yields than operating assets. For example, recently Chrysler held a $8.7 billion portfolio of short-term marketable securities that yielded about 6 percent but its operating assets provided a return of about 14 percent. Why would a company such as Chrysler have such large holdings of low-yielding assets?

In many cases, companies hold marketable securities for the same reasons they hold cash. Although these securities are not the same as cash, in most cases they can be converted to cash on very short notice (often just a few minutes) with a single telephone call. Moreover, while cash an most commercial checking accounts yield northing, marketable securities provide at least a modest return. For this reason, many firms hold at least some marketable securities in lieu of larger cash balances, liquidating part of the portfolio to increase the cash account when cash outflows exceed inflows. In such situations the marketable securities could be used as a substitute for transactions balances, for precautionary balances for speculative balances or for all three. In most cases the securities are held primarily for precautionary purposes most firms prefer to rely on bank credit to make temporary transactions or to meet speculative needs, but they may still hold some liquid assets to guard against a possible shortage of bank credit.

A few years ago Chrysler had essentially no cash it was incurring huge losses and those losses had drained its cash account. Then a new management team took over improved operations and began generating positive cash flows, Chryslers cash (and marketable securities) was up to $8.7 billion, and analysts were forecasting a further buildup over the next year or so to more than $10 billion. Management indicated, in various statements, that the cash hoard was necessary to enable the company to weather the next downturn in auto sales.

Although setting the target cash balance is to a large extent judgmental analytical rules can be applied to help formulate better judgments. For example, years ago William Baumol recognized that the trade-off between cash and marketable securities is similar to the one firms face when setting the optimal level of inventory. Baumol applied the EOQ inventory model to determine the optimal level of cash balances, he suggested that cash holdings should be higher if costs are high and the time to liquidate marketable securities is long, but that those holdings should be lower if interest rates are low. His logic was that if it is expensive and time consuming to convert securities to cash and if securities do not earn much because interest rates are low, then it does not pay to hold securities as opposed to cash. It does pay to hold securities if interest rates are high and the securities can be converted to cash quickly and cheaply.

Cash Management Techniques

Cash management has changed significantly over the last 20 years for two reasons. First, from the early 1970s to the mid-1980s, there was an upward tread in interest rates which increased the opportunity cost of holding cash. This encouraged financial managers to search for more efficient ways of managing cash. Second, technological developments, particularly computerized electronic funds transfer mechanisms, changed the way cash is managed.

Most cash management activities are performed jointly by the firm and its banks. Effective cash management encompasses proper management of cash inflows and outflows, which entails (1) synchronizing cash flows, (2) using float, (3) accelerating collections, (4) getting available funds to where they are needed, and (5) controlling disbursements. Most business is conducted by large firms, many of which operate regionally, nationally, or even globally. They collect cash from many sources and make payments from a number of different cities or even countries. For example, companies such as IBM, General Motors, and Hewlett Packard have manufacturing plants all around the world, even more sales officers, and bank accounts in virtually every city where they do business. Their collection points follow sales patterns. Some disbursements are made from local offices, but most are made in the cities where manufacturing occurs, or else from the home office. Thus, a major corporation might have hundreds or ever thousands of bank accounts and since there is no reason to thinks that inflows and outflows will balance in each account, a system must be in place to transfer funds from where they come in to where they are needed, to arrange loans to cover net corporate shortfalls, and to invest net corporate surpluses without delay. We discuss the most commonly used techniques for accomplishing these tasks in the following sections.

Cash Flow Synchronization

If you as an individual were to receive income once a year, you would probably put it in the bank, draw down your account periodically, and have an average balance during the year equal to about half your annual income. If you received income monthly instead of once a year, you would operate similarly, but now your average balance would be much smaller. If you could arrange to receive income daily and to pay rent, tuition, and other charges on a daily basis, and if you were confident of your forecasted inflows and outflows, then you could hold a very small average cash balance.

Exactly the same situation holds for businesses – by improving their forecasts and by arranging things so that cash receipts coincide with cash requirements, firms can reduce their transactions balances to a minimum. Recognizing all this, utility companies, oil companies, credit card companies and so on, arrange to bill customers and to pay their own bills, on regular “billing cycles” throughout the month. This synchronization of cash flows provides cash when it is needed and thus enables firms to reduce cash balances, decrease bank loans, lower interest expenses, and boost profits.

Speed up the Check-Clearing Process

When a customer writes and mails a check, this does not mean that the funds are immediately available to the receiving firm. Most to us have been told by someone that “the check is in the mail”, and we have also deposited a check in our account and then been told that we cannot write our own checks against this deposit until the check-clearing process has been completed. Our bank must first make sure that the check we deposited is good and the funds are available before it will give us cash.

In practice, it may take a long time for a firm to process incoming checks and obtain the use of the money. A check must first be delivered through the mail and then be cleared through the banking system before the money can be put to use. Checks received from customers in distant cities are especially subject to delays because of mail time and also because more parties are involved. For example, assume that we receive a check and deposit it in our bank. Our bank must send the check to the bank on which it was drawn. Only when this latter bank transfers funds to our bank are the funds available for us to use. Checks are generally cleared through the Federal Reserve System or through a clearinghouse set up by the banks in a particular city. Of course, if the check is deposited in the same bank on which it was drawn, that bank merely transfers funds by bookkeeping entries from one depositor to another. The length of time required for checks to clear is thus a function of the distance between the payer’s and the payee’s banks. In the case of private clearinghouses, it can range from one to three days. Checks are generally cleared through the Federal Reserve System in about two days, but mail delays can slow down things on each end of the Fed’s involvement in the process.

The Cash Budget

The firm estimates its needs for cash as a part of its general budgeting, or forecasting, process. First, it forecasts sales, its fixed asset and inventory requirements, and the times when payments must be made. This information is combined with projections about when accounts receivable will be collected, tax payment dates, dividend and interest payment dates, and so on. All of this information is summarized in the cash budget, which shows the firm’s projected cash inflows and outflows over some specified period. Generally, firms use a monthly cash budget forecasted over the next year, plus a more detailed daily or weekly cash budget for the coming month. The monthly cash budgets are used for planning purposes, and the daily or weekly budgets for actual cash control.

The cash budget provides more detailed information concerning a firm’s future cash flows than do the forecasted financial statements. We developed Allied Food Products 2012 forecasted financial statements. Allied projected 2012 sales were $3,300 million, resulting in a net cash flow from operations of $162 million. When all expenditures and financing flows are considered, Allied cash account is projected to increase by $1 million in 2012. Does this mean that Allied will not have to worry about cash shortages during 2012? To answer this question, we must construct Allied cash budget for 2012.

To simplify the example, we will only consider Allied cash budget for the last half of 2012. Further, we will not list every cash flow but rather focus on the operating cash flows. Allied sales peak is in September, shortly after the majority of its raw food inputs have been harvested. All sales are made on terms of 2/10, net 40, meaning that a 2 percent discount is allowed if payment is made within 10 days, and if the discount is not taken, the full amount is due in 40 days. However, like most companies, Allied finds that some of its customers delay payment up to 90 days. Experience has shown that payment on 20 percent of Allied dollar sales is made during the month in which the sale is made – these are the discount sales. On 70 percent of sales, payment is made during the month immediately following the month of sale, and on 10 percent of sales payment is made in the second month following the month of sale.

The costs to Allied of foodstuffs, spices, preservatives, and packaging materials average 70 percent of the sales prices of the finished products. These purchases are generally made one month before the firm expects to sell the finished products, but Allied purchase terms with its suppliers allow it to delay payments for 30 days. Accordingly, if July sales are forecasted at $300 million, then purchases during June will amount to $210 million, and this amount will actually be paid in July.

Such other cash expenditures as wages and rent are also built into the cash budget, and Allied must make estimated tax payments of $30 million on September 15 and $20 million on December 15. Also, a $100 million payment for a new plant must be made in October. Assuming that Allied target cash balance is $10 million, and that it projects $15 million to be on hand on July 1, 2012, what will its monthly cash surpluses or short fails be for the period from July to December?

Stock Dividends and Stock Splits

Stock dividends and stock splits are related to the firm’s cash dividend policy. The rationale for stock dividends and splits can best be explained through an example. We will use Porter Electronic Controls Inc, a $700 million electronic components manufacturer, for this purpose. Since its inception, Porter’s markets have been expanding and the company has enjoyed growth in sales and earnings. Some of its earnings have been paid out in dividends, but some are also retained each year, causing its earnings per share and stock price to grow. The company began its life with only a few thousand shares outstanding, and after some years of growth, each of Porter’s shares had a very high EPS and DPS. When a ‘normal’ P/E ratio was applied, the derived market price was so high that few people could afford to buy a “round lot” of 100 shares. This limited the demand for the stock and thus kept the total market value of the firm below what it would have been if more shares, at a lower price had been outstanding. To correct this situation, Porter “split its stock” as described in the next section.

Stock Splits

Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in financial circles that an optimal price range exists for stocks. “Optimal” means that if the price is within this range, the price/earnings ratio, hence the firm’s value will be maximized. Many observers, including Porter’s management, believe that the best range for most stocks is from $20 to $80 per share. Accordingly if the price of Porter’s stock rose to $80, management would probably declare a two-for-one stock split, thus doubling the number of shares outstanding halving the earnings and dividends per share, and thereby lowering the stock price. Each stockholder would have more shares, but each share would be worth less. If the post-split price were $40, Porter’s stockholders would be exactly as well off as they were before the split, However, if the stock price were to stabilize above $40, stockholders would be better off. Stock splits can be of any size-for example, the stock could be split two-for-one, three-for-one, one-and-a half-for-one, or in any other way.

Stock Dividends

Stock dividends are similar to stock splits in that they “divide the pie into smaller slices” without affecting the fundamental position of the current stockholders. On a 5 percent stock dividend, the holder of 100 shares would receive an additional 5 shares (without cost); on a 20 percent stock dividend the same holder would receive 20 new shares; and so on. Again, the total number of shares is increased so earnings dividends and price per share all decline.

If a firm wants to reduce the price of its stock, should it use a stock split or a stock dividend? Stock splits are generally used after a sharp price run-up to produce a large price reduction. Stock dividends used on a regular annual basis will keep the stock price more or less constrained. For example, if a firm’s earnings and dividends were growing at about 10 percent per year, its stock price would tend to go up at about that same rate, and it would soon be outside the desired trading range. A 10 percent annual stock dividend would maintain the stock price within the optimal trading range. Note, though that small stock dividends create bookkeeping problems and unnecessary expenses so firms today use stock splits far more often than stock dividends.

Dividend Stability

The stability of dividends is also important. Profits and cash flows vary over time, as do investment opportunities. Taken alone, this suggests that corporations should vary their dividends over time, increasing them when cash flows are large and the need for funds is low and lowering them when cash is in short supply relative to investment opportunities. However, many stockholders rely on dividends to meet expenses and they would be seriously inconvenienced if the dividend stream were unstable. Further reducing dividends to make funds available for capital investment could send incorrect signals and that could drive down stock prices. Thus, maximizing its stock price requires a firm to balance its internal needs for funds against the needs and desires of its stockholders.

How should this balance be struck: that is, how stable and dependable should a firm attempt to make its dividends? It is impossible to give a definitive answer to this question, but the following points are relevant:

1.    Virtually every publicly owned company makes a five to ten year financial forecast of earnings and dividends. Such forecasts are never made public they are used for internal planning purposes only. However, security analysts construct similar forecasts and do make them available to investors; see value line for an example. Further, virtually every internal five to ten year corporate forecast we have seen for a normal company projects a trend of higher earnings and dividends. Both managers and investors know that economic conditions may cause actual results to differ from forecasted results, but “normal” companies expect to grow.

2.    Years ago, when inflation was not persistent, the term “stable dividend policy” meant a policy of paying the same dollar dividend year after year. AT&T was a prime example of a company with a stable dividend policy - it paid $9 per year ($2.25 per quarter) for 25 straight years. Today, though most companies and stockholders expect earnings to grow over time as a result of retained earnings and inflation. Further, dividends are normally expected to grow more or less in line with earnings. Thus today a “stable dividend policy” generally means increasing the dividend at a reasonably steady rate. For example, Rubbermaid made this statement in a recent annual report:

Dividends per share were increased for the 34^th consecutive year out goal is to increase sales, earnings and per share by 15% per year, while achieving a 21% return on beginning shareholders equity. It is also the Company’s objective to pay approximately 30% of current year’s earnings as dividends, which will permit us to retain sufficient capital to provide for future growth.

Rubbermaid used the word “approximately” in discussing its payout ratio because ever if earnings vary a bit from the target level the company still planned to increase the dividend by the target growth rate. Even though Rubbermaid did not mention the dividend growth rate in the statement, analysts can calculate the growth rate and see that it is the same 15 percent as indicated for sales and earnings:

g=b(ROE)

=(1-Payout) (ROE)

=0.7(21%)=15%

Here b is the fraction of earnings that are retained, or 1.0 minus the payout ratio.

Companies with volatile earnings and cash flows would be reluctant to make a commitment to increase the dividend each year so they would not make such a detailed statement even so most companies would like to be able to exhibit the kind of stability Rubbermaid has shown, and they try to come as close to it as they can.

Dividend stability has two components: (1) How dependable is the growth rate, and (2) can we count on at least receiving the current dividend in the future? The most stable policy, from an investor’s standpoint, is that of a firm whose dividend growth rate is predictable such a company’s total return (dividend yield plus capital gains yield) would be relatively stable over the long run, and its stock would be a good hedge against inflation. The second most stable policy is where stockholders can be reasonably sure that the current dividend will not be reduced it may not grow at a steady rate, but management will probably be able to avoid cutting the dividend. The least stable situation is where earnings and cash flows are so volatile that investors cannot count on the company to maintain the current dividend over a typical business cycle.

3.    Most observers believe that dividend stability is desirable. Assuming this position is correct; investors prefer stocks that pay more predictable dividends to stocks which pay the same average amount of dividends but in a more erratic manner. This means that the cost of equity will be minimized and the stock price maximized, if a firm stabilizes its dividends as much as possible.

Other Dividend Policy Issues

Before we discuss how dividend policy is set in practice, we must examine two other theoretical issues that could affect our views toward dividend policy: (1) the information content or signaling hypothesis and (2) the clientele effect.

Information Content, or Signaling, Hypothesis

When MM set forth their dividend irrelevance theory, they assumed that every-one investors and managers alike has identical information regarding the firm’s future earnings and dividend. In reality, however, different investors have different views on both the level of future dividend payments and the uncertainty inherent in those payments and managers have better information about future prospects than public stockholders.

It has been observed that an increase in the dividend is often accompanied by an increase in the price of a stock while a dividend cut generally leads to a stock price decline. This could indicate that investors, in the aggregate, prefer dividends to capital gains. However, MM argued differently. They noted the well-established fact that corporations are reluctant to cut dividends, hence do not raise dividends unless they anticipate higher earnings in the future. Thus, MM argued that a higher-than-expected dividend increase is a “signal” to investors that the firm’s management forecasts good future earnings.⁴ Conversely a dividend reduction or a smaller-than-expected increase, is a signal that management is forecasting poor earnings in the future. Thus MM argued that investor’s reactions to changes in dividend policy do not necessarily show that investors prefer dividends to retained earnings. Rather, they argue that price changes following dividend actions simply indicate that there is an important information or signaling content in dividend announcements.

Like mot other aspects of dividend policy, empirical studies of signaling have had mixed result. There is clearly some information content in dividend announcements. However, it is difficult to tell whether the stock price changes that follow increase or decreases in dividends reflect only signaling effects or both signaling and dividend preference. Still signaling effects should definitely be considered when a firm is contemplating a change in dividend policy.

Clientele Effect

As we indicated earlier, different groups, or clienteles of stockholders prefer different dividend payout policies. For example retired individuals and university endowment funds generally prefer cash income so they may want the firm to pay out a high percentage of its earnings. Such investors (and pension funds) are often in low or even zero tax brackets so taxes are of no concern. On the other hand, stockholders in their peak earning years might prefer reinvestment, because they have less need for current investment income and would simply reinvest dividends received, after first paying income taxes on those dividends.

If a firm retains and reinvests income rather than paying dividends those stockholders who need current income would be disadvantaged. The value of their stock might increase but they would be forced to go to the trouble and expense of selling off some of their shares to obtain cash. Also some institutional investors (or trustees for individuals) would be legally precluded from selling stock and then “spending capital”. On the other hand, stockholders who are saving rather then spending dividends might favor the low dividend policy for the less the firm pays out in dividends the less these stockholders will have to pay in current taxes, and the less trouble and expense they will have to go through to reinvest their after-tax dividends. Therefore, investors who want current investment income should own shares in high dividend payout firms, while investors with no need for current investment income should own shares in low dividend payout firms. For example investors seeking high cash income might invest in electric utilities, which averaged a 79 percent payout from 1991 through 1995, while those favoring growth could invest in the semiconductor industry, which paid out only 7 percent.

To the extent that stockholders can switch firms, a firm can change from one dividend payout policy to another and then let stockholders who do not like the new policy sell to other investors who do. However, frequent switching would be inefficient because of (1) brokerage costs, (2) the likelihood that stockholders who are selling will have to pay capital gains taxes, and (3) a possible shortage of investors who like the firms newly adopted dividend policy. Thus, management should be hesitant to change its dividend policy, because a change might cause current shareholders to sell their stock, forcing the stock price down. Such a price decline might be temporary, but it might also be permanent if few new investors are attracted by the new dividend policy, then the stock price would remain depressed. Of course, the new policy might attract an even larger clientele than the firm had before in which case the stock price would rise.

Evidence from several studies suggests that there is an fact a clientele effect.⁵ MM and others have argued that one clientele is as good as another, so the existence of a clientele effect does not necessarily imply that one dividend policy is better than any other. MM may be wrong, though and neither they nor anyone else can prove that the aggregate makeup of investors permits firms to disregard clientele effects. This issue, like most others in the dividend arena, is still up in the air.

Dividends Versus Capital Gains : What Do Investors Prefer?

When deciding how much cash to distribute to stockholders, financial managers must keep in mind that the firm’s objective is to maximize shareholder value. Consequently, the target payout ratio-defined as the percentage of net income to be paid out as cash dividends –should be based in large part on investors, preferences for dividends versus capital gains: do investors prefer (1) to have the firm distribute income as cash dividends or (2) to have it either repurchase stock or else plow the earnings back into the business, both of which should result in capital gains? This preference can be considered in terms of the constant growth stock valuation model:

D₁

P₀ = -------------

    K_s - g

If the company increases the payout ratio, it raises D₁. This increase in the numerator, taken alone, would cause the stock price to rise. However, if D₁ is raised, then less money will be available for reinvestment, that will cause the expected growth rate to decline, and that would tend to lower the stock’s price. Thus any change in payout policy will have two opposing effects. Therefore, the firm’s optimal dividend policy must strike a balance between current dividends and future growth so as to maximize the stock price.

In this section we examine three theories of investor preference: (1) the dividend irrelevance theory, (2) the “bird-in-the-hand” theory and (3) the tax preference theory.

Dividend Irrelevance Theory

It has been argued that dividend policy has no effect on either the price of a firm’s stock or its cost of capital. If dividend policy has no significant effects, then it would be irrelevant. The principal proponents of the dividend irrelevance theory are Merton Miller and Franco Modigliani (MM)¹. They argued that the firm’s value is determined only by its basic earning power and its business risk. In other words, MM argued that the value of the firm depends only on the income produced by its assets not on how this income is split between dividends and retained earnings.

To understand MM’s argument that dividend policy is irrelevant, recognize that any shareholder can construct his or her own dividend policy. For example, if a firm does not pay dividends, a shareholder who wants a 5 percent dividend can “create” it by selling 5 percent of his or her stock. Conversely, if a company pays a higher dividend than an investor desires, the investor can use the unwanted dividends to buy additional shares of the company’s stock. If investors could buy and sell shares and thus create their own dividend policy without incurring costs, then the firm’s dividend policy would truly be irrelevant. Note, though that investors who want additional dividends must incur brokerage costs to sell shares, and investors who do not want dividends must first pay taxes on the unwanted dividends and then incur brokerage costs to purchase shares with the after-tax dividends. Since taxes and brokerage costs certainly exist, dividend policy may well be relevant.

In developing their dividend theory. MM made a number of assumptions, especially the absence of taxes and brokerage costs. Obviously, taxes and brokerage costs do exist, so the MM irrelevance theory may not be true. However, MM argued (correctly) that all economic theories are based on simplifying assumptions, and that the validity of a theory must be judged by empirical tests, not by the realism of its assumptions. We will discuss empirical tests of MM’s dividend irrelevance theory shortly.

Bird-in-the-Hand Theory

The principal conclusion of MM’s dividend irrelevance theory is that dividend policy does not affect the required rate of return on equity K_s. This conclusion has been hotly debated in academic circles. In particular, Myron Gordon and John Lintner argued that K_s decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which are supposed to result from retaining earnings than they are of receiving dividend payments.² Gordon and Lintner said, in effect that investors value a dollar of expected dividends more highly than a dollar of expected capital gains because the dividend yield component, D₁/P₀, is less risky than the g component in the total expected return equation, K_s=D₁/P₀ + g.

MM disagreed. They argued that K_s is independent of dividend policy, which implies that investors are indifferent between D₁/P₀ and g and, hence, between dividends and capital gains. MM called the Gordon-Lintner argument the bird-in-the-hand fallacy because, in MM’s view, most investors plan to reinvest their dividends in the stock of the same or similar firms, and in any event the riskiness of the firm’s cash flows to investors in the long run is determined by the riskiness of operating cash flows not by dividend payout policy.

Tax Preference Theory

There are three tax-related reasons for thinking that investors might prefer a low dividend payout to a high payout: (1) Long-term capital gains are taxed at a maximum rate of 28 percent, whereas dividend income is taxed at effective rates which go up to 39.6 percent. Therefore, wealthy investors (who own most of the stock and receive most of the dividends) might prefer to have companies retain and plow earnings back into the business. Earnings growth would presumably lead to stock price increases, and lower-taxed capital gains would be substituted fro higher-taxed dividends. (2) Taxes are not paid on the gain until a stock is sold. Due to time value effects, a dollar of taxes paid in the future has a lower effective cost than a dollar paid today. (3) If a stock is held by someone until he or she dies, no capital gains tax is due at all-the beneficiaries who receive the stock can use the stocks’ value on the death day as their cost basis and thus completely escape the capital gains tax.

Because of these tax advantages, investors may prefer to have companies retain most of their earnings. If so investors would be willing to pay more for low-payout companies than for otherwise similar high-payout companies.

Capital Structure Decisions

In addition to the types of analyses discussed above, firms generally consider the following factors when making capital structure decisions:

1.    Sales Stability. A firm whose sales are relatively stable can safely take on more debt and incur higher fixed changes than a company with unstable sales.

2.    Asset structure. Firms whose assets are suitable as security for loans tend to use debt rather heavily. General-purpose assets which can be used by many businesses make good collateral. Whereas special-purpose assets do not. Thus real estate companies are usually highly leveraged, whereas companies involved in technological research are not.

3.    Operating leverage. Other things the same, a firm with less operating leverage is better able to employ financial leverage because it will have less business risk. (This is discussed in greater detail in Appendix 13.A.)

4.    Growth rate. Other things the same, faster-growing firms must rely more heavily on external capital. Further, the flotation costs involved in selling common stock exceed those incurred when selling debt, which encourages them to rely more heavily on debt. At the same time, however rapidly growing firms often face greater uncertainty, which tends to reduce their willingness to use debt.

5.    Profitability. One often, observes that firms with very high rates of return on investment use relatively little debt. Although there is no theoretical justification for this fact, one practical explanation is that very profitable firms such as Intel, Microsoft, and Coca-Cola simply do not need to do much debt financing, Their high rates of return enable them to do most of their financing with internally generated funds.

6.    Taxes. Interest is a deductible expense, and deductions are most valuable to firms with high tax rates. Therefore the higher a firm’s tax rate, the greater the advantage of debt.

7.    Control. The effect of debt versus stock on a management’s control position can influence capital structure. If management currently has voting control (over 50 percent of the stock) but is not in a position to buy any more stock, it may choose debt for new financings. On the other hand management may it may choose debt for new financings. On the other hand, management may decide to use equity if the firm’s financial situation is so weak that the use of debt might subject it to serious risk of default, because if the firm goes into default, the managers will almost surely lose their jobs. However, if too little debt is used, management runs the risk of a takeover. Thus, control considerations could lead to the use of either debt or equity, because the type of capital that best protects management will very from situation to situation. In any event, if management is at all insecure, it will consider the control situation.

8.    Management attitudes. Since no one can prove that one capital structure will lead to higher stock prices than another, management can exercise its own judgment about the proper capital structure. Some managements tend to be more conservative than others and thus use less debt than the average firm in their industry, whereas aggressive managements use more debt in the quest for higher profits.

9.    Lender and rating agency attitudes. Regardless of managers own analyses of the proper leverage factors for their firms, lenders and rating agencies attitudes frequently influence financial structure decisions. In the majority of cases, the corporation discusses its capital structure with lenders and rating agencies and gives much weight to their advice. For example, one large utility was recently told by Moody and Standard & Poor that its bonds would be downgraded if it issued more bonds. This influenced its decision to finance its expansion with common equity.

10.  Market conditions. Conditions in the stock and bond markets undergo both long and short run changes that can have an important bearing on a firm’s optimal capital structure. For example, during a recent credit crunch, the junk bond market dried up and their was simply no market at a reason able interest rate for any new long term bonds rated below triple B. Therefore, low rated companies in need of capital were forced to go to the stock market or to the short term debt market, regardless of their target capital structures. When conditions eased, however these companies sold bonds to get their capital structures back on target.

11.  The firm’s internet condition. A firm’s own internal condition can also have a bearing on its target capital structure. For example, suppose a firm has just successfully completed an R&D program and it forecasts higher earnings in the immediate future. However, the new earnings are not yet anticipated by investors, hence are not reflected in the stock price. This company would not want to issue stock it would prefer to finance with debt until the higher earnings materialize and are reflected in the stock price. Then it could sell an issue of common stock, retire the debt and return to its target capital structure. This point was discussed earlier in connection with asymmetric information and signaling.

12.  Financial flexibility. An astute corporate treasurer made this statement to the authors:

       Our company can earn a lot more money from good capital budgeting and operating decisions than from good financing decisions. Indeed we are not sure exactly how financing decisions affect our stock price, but we know for sure than having to turn down a promising venture because funds are not available will reduce our long run profitability. For this reason my primary goal as treasurer is to always be in a position to raise the capital needed to support operations.

We also know that when times are good we can raise capital with either stocks or bonds but when times are bad, suppliers of capital are much more willing to make funds available if we give them a secured position and this means debt. Further when we sell a new issue of stock this sends a negative signal to investors, so stock sales by a mature company such as ours are not desirable.

Putting all these thoughts together gives rise to the goal of maintaining financial flexibility, which from an operational viewpoint means maintaining adequate reserve borrowing capacity. Determining an adequate reserve borrowing capacity is judgmental bit it clearly depends on the factors discussed including the firm’s forecasted need for funds, predicted capital market conditions management’s confidence in its forecasts and the consequences of a capital shortage.

Trade off Theory

The preceding arguments led to the development of what is called “the trade-off theory of leverage,” in which firms trade off the benefits of debt financing (favor-able corporate tax treatment) against the higher interest rates and bankruptcy costs. A summary of the trade-off theory is expressed graphically in Figure 13-10. Here are some observations about the figure:

1. The fact that interest is a deductible expense makes debt less expensive than common or preferred stock. In effect, the government pays part of the cost of debt capital, or to put it another way, debt provides tax shelter benefits. As a result, using debt causes more of the firm’s operating income (EBIT) to flow through to investors, so the more debt a company uses, the higher its value and stock price. Under the assumptions of the Modigliani-Miller with-taxes paper, a firm’s stock price will be maximized if it uses virtually 100 percent debt, and the line labeled “MM Result Incorporating the Effects of Corporate Taxation” in Figure 13-10 expresses their idea of the relationship between stock prices and debt.

2. In the real world firms rarely use 100 percent debt. One reason is the fact that stocks benefit from the lower capital gains tax. More importantly, firm’s limit their use of debt to hold down bankruptcy-related costs.

3. There is some threshold level of debt, labeled D₁ in Figure 13-10, below which the probability of bankruptcy is so low as to be immaterial. Beyond D₁, how-ever, bankruptcy-related costs become increasingly important, and they reduce the tax benefits of debt at an increasing rate. In the range from D₁ to D₂ bankruptcy-related costs reduce but do not completely offset the tax benefits of debt, so the firm’s stock price rises (but at a decreasing rate) as its debt ratio increases. However, beyond D₂, bankruptcy-related costs exceed the tax benefits, so from this point of increasing the debt ratio lowers the value of the stock. Therefore, D₂ is the optimal capital structure. Of course, D₁ and D₂ vary from firm to firm, depending on their business risk and bankruptcy costs.

4. While theoretical and empirical work supports the general shape of the curves in Figures 13-8 and 13-10, these graphs must be taken as approximations, not as precisely defined function. The numbers in Figure 13-8 are shown out to two decimal places, but that is merely for illustrative purposes the numbers are not nearly that accurate in view of the fact that the data on which the graph is based are judgmental estimates.

5. Another disturbing aspect of capital structure theory as expressed in Figure 13-10 is the fact that many large, successful firms, such as Intel and Microsoft use far less debt than the theory suggests. This point led to the development of signaling theory, which is discussed below.

Capital Structure Theory

Modern capital structure theory began in 1958, when Professors Franco Modigliani and Merton Miller (hereafter MM) published what has been called the most influential finance article ever written.¹¹ MM proved under a very restrictive set of assumptions, that a firm’s value is unaffected by its capital structure. Put another way – MM’s results suggest that it does not matter how a firm finances its operations, so capital structure is irrelevant. However, MM’s study was based on some unrealistic assumptions, including the following:

1. There are no brokerage costs.

2. There are no taxes.

3. There are no bankruptcy costs.

4. Investors can borrow at the same rate as corporations.

5. All investors have the same information as management about the firm’s future investment opportunities.

6. EBIT is not affected by the use of debt.

Despite the fact that some of these assumptions are obviously unrealistic, MM’s irrelevance result is extremely important. By indicating the conditions under which capital structure is irrelevant, MM also provided us with some clues about what is required for capital structure to be relevant and hence to affect a firm’s value. MM’s work marked the beginning of modern capital structure research, and subsequent research has focused on relaxing the MM assumptions in order to develop a more realistic theory of capital structure. Research in this area is quite extensive, but the highlights are summarized in the following sections.

The Effect of Taxes

MM published a follow-up paper in 1963 in which they relaxed the assumption that there are no corporate taxes.¹³ The tax code allows corporations to deduct interest payments as an expense, but dividend payments to stockholders are not deductible. This differential treatment encourages corporations to use debt in their capital structures. Indeed, MM demonstrated that if all their other assumptions hold, this differential treatment leads to a situation which calls for 100 percent debt financing.

However, this conclusion was modified several years later by Merton Miller (this time without Modigliani) when he brought in the effects of personal taxes.¹⁴ He noted that all of the income from bonds is generally interest, which is taxed as personal income at rates going up to 39.6 percent, while income from stocks generally comes partly from dividends and partly from capital gains. Further capital gains are taxed at a maximum rate of 28 percent and this tax is deferred until the stock is sold and the gain realized. If stock is held until the owner dies, on capital gains tax whatever must be paid. So, on balance, returns on common stocks are taxed at lower effective rates than returns on debt.

Because of the tax situation, Miller argued that investors are willing to accept relatively low before-tax returns on stock relative to the before-tax returns on bonds. For example, an investor might require a return of 10 percent on Bigbee’s bonds, and if stock income were taxed at the same rate as bond income, the required rate of return on Bigbee’s stock might be 16 percent because of the of the stock’s greater risk. However, in view of the favorable treatment of income on the stock, investors might be willing to accept a before-tax return of only 14 percent on the stock.

Thus, as Miller pointed out, (1) the deductibility of interest favors the use of debt financing, but (2) the more favorable tax treatment of income from stocks lowers the required rate of return on stock and thus favors the use of equity financing. It is difficult to say what the net effect of these two factors is. Most observers believe that interest deductibility has the stronger effect, hence that our tax system still favors the corporate use of debt. However, that effect is certainly reduced by the lower capital gains tax rate.

One can observe changes in corporate financing patterns following major changes in tax rates. For example, in 1993 the top personal tax rate on interest and dividends was raised sharply, but the capital gains tax rate was not increased. This could be expected to result in a greater reliance on equity financing, especially through retained earnings, and that has indeed been the case.