Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

share price of $20 (PJan16 = $20). Payout’s managers want to pay out the company’s earnings as dividends

and finance the $2 million investment by issuing new shares. Retention’s managers prefer to retain the

company’s earnings to fund the $2-million investment program. If each management team pursues its

preferred strategy, assuming perfect and frictionless capital markets, will the two companies still have

identical values next year?

Yes. To see how, we first examine Retention’s strategy. Retention’s managers finance the $2 million

investment project by retaining $2 million in profits. Retention’s market value on 31 December 2016,

equals the $20 million beginning value, plus the $2 million ($2 per share) in reinvested earnings, plus

the investment’s net present value. For simplicity, assume that the project’s NPV is positive, but small

enough to be ignored. Retention’s year-end 2016 value is $22 million ($20 million + $2 million), or

$22 per share (PDec16 = $22), because the company did not have to issue any new shares in order to

finance its investments. Plugging these data into our basic valuation equation from Chapter 5 verifies

that Retention’s shareholders indeed earn their required 10% return on investment:

=

+−

=

+−

r =

DPP

P

$0 $22 $20

$20

2016 Dec16Jan16 10%

Jan16

We can extend this example indefinitely into the future. In each period, Retention commits to

reinvesting all its annual profits (10% return on assets), and shareholders earn an acceptable return

because their share values increase 10% each year. Retention never issues new shares, so the number of

outstanding shares remains fixed at 1 million.

So far, so good. But what about company Payout? This company’s managers decide to pay a $2

million dividend at the end of the year, so they must raise the $2 million needed for investment

by selling new shares. But how many shares must they sell? To answer that, we must deduce what

the price of Payout’s shares will be on 31 December 2016. After it distributes the dividend, Payout

will have assets worth $20 million, exactly what it started with on 1 January. With 1 million shares

outstanding, the share price will still be $20, so Payout must issue 100,000 new shares to raise the $2

million it needs to undertake its investment project. After the company issues new shares and invests

the proceeds, Payout’s total market value will equal $22 million ($20 per share × 1.1 million shares

outstanding). Payout’s market value of $22 million on 31 December 2016 matches Retention’s value.

We can verify that Payout’s original shareholders earn the same 10% return earned by Retention’s

investors:

=

+−

=

+−

r =

DPP

P

$0 $22 $20

$20

10%

2016 Dec16Jan16

Jan16

Once again, we can repeat this process indefinitely. Each year, Payout distributes all of its net cash

flow as a dividend, issuing new shares to finance new investments.

We have shown that the market values of Retention and Payout are equal on 31 December

2016, even though they follow radically different dividend policies. Retention has 1 million shares

outstanding worth $22 each, while Payout has 1.1 million shares outstanding worth $20 each. Because

both companies have a total value of $22 million, we can say that dividend policy is irrelevant to

valuing a company, at least when markets are frictionless. But what if Retention’s investors prefer

that the company pay out earnings rather than reinvest them, or if Payout’s shareholders prefer that