3.5 Raising Capital & Dividend Policy

Debt Instruments: Bonds

A bond is a long-term debt contract promising periodic coupon interest and repayment of par (face) value at maturity. Key features:

• Coupon rate: the stated annual interest as a percent of par.
• Call provision: lets the issuer redeem the bond early (usually at a premium) when rates fall; bad for investors, who demand a higher yield to accept it.
• Put provision: lets the holder sell the bond back early; favorable to investors.
• Convertible bond: can be exchanged for a set number of shares, lowering the coupon.
• Covenants: contractual restrictions (e.g., limits on additional debt) that protect lenders.
• Secured vs. debenture: secured bonds are backed by collateral; debentures are unsecured.

Credit Ratings

Agencies (Moody's, S&P, Fitch) rate default risk. Investment grade runs from AAA down to BBB- (S&P) / Baa3 (Moody's). Below that is speculative grade (junk), which pays higher yields. Lower ratings mean higher borrowing costs.

Equity: Common and Preferred Stock

Common stock represents residual ownership. Holders get voting rights, the residual claim on assets after all creditors and preferred holders, and dividends only if declared. Their upside is unlimited but they are last in line in liquidation.

Preferred stock is a hybrid: it pays a fixed dividend with priority over common dividends and a higher claim in liquidation, but usually carries no vote. Cumulative preferred accrues any missed dividends, which must be paid before common dividends resume.

Raising Equity: The IPO

An Initial Public Offering (IPO) is a firm's first sale of shares to the public, underwritten by investment banks that price and distribute the shares. A later sale by an already-public firm is a seasoned (secondary) offering. Equity issuance incurs flotation costs (underwriting fees, legal, registration) that raise the effective cost of new equity above retained earnings. Existing shareholders may also receive preemptive rights, the option to buy new shares first and avoid dilution of their proportional ownership.

Leasing: Operating vs. Finance

A lease is a contract to use an asset for periodic payments.

• Operating lease: conveys only the right to use the asset for part of its life; the lessor keeps ownership risks and rewards. The lessee records a right-of-use asset and lease liability but recognizes a single straight-line lease expense.
• Finance (capital) lease: transfers substantially all the risks and rewards of ownership (e.g., transfer of title, bargain purchase option, lease term covering most of the asset's life, or present value of payments near the asset's fair value). It is capitalized, with the asset depreciated and interest recognized separately.

Dividend Policy Theories

Residual dividend policy: pay dividends only from cash remaining after funding all positive-NPV projects, so dividends fluctuate year to year.

Dividend irrelevance (MM): in perfect markets, dividend policy does not affect value because investors can create homemade dividends.

Signaling theory: dividend changes convey management's private information; a dividend increase signals confidence, while a cut is read as bad news, often triggering a price drop.

Clientele effect: different investor groups prefer different payout levels (income-seeking retirees vs. growth-oriented investors), so a firm attracts a clientele matched to its policy and disrupting it has costs.

Stock Dividends, Splits, and Repurchases

• A stock dividend (e.g., 10%) and a stock split (e.g., 2-for-1) both increase shares outstanding without changing total firm value or a shareholder's proportional ownership; the share price adjusts down proportionally. A stock dividend transfers retained earnings to paid-in capital; a split only restates par value and count.
• A share repurchase (buyback) returns cash by buying back shares, reducing shares outstanding and raising EPS. Buybacks offer tax flexibility (capital-gains timing) and signal that management views the stock as undervalued.

Reverse Stock Split

A reverse split (e.g., 1-for-5) reduces share count and raises the per-share price proportionally, again with no change in total value. Firms use it to lift a depressed price above an exchange's minimum listing requirement or to shed a penny-stock image.

Bond Valuation Reminder

A bond's price is the present value of its coupon stream plus the present value of par, discounted at the market yield. When the market yield rises above the coupon rate, the bond trades at a discount (below par); when the yield falls below the coupon, it trades at a premium. Price and yield move inversely, and longer-maturity bonds are more sensitive to rate changes (higher duration).

Lease vs. Buy Analysis

The lease-versus-buy decision compares the present value of after-tax lease payments against the present value of after-tax ownership cash flows (purchase cost, depreciation tax savings, and any salvage value). Leasing conserves cash and shifts obsolescence risk to the lessor but is often more expensive over the asset's life. Discount the cash flows at the after-tax cost of debt, since leasing is a financing substitute for borrowing.

Choosing a Distribution Method

Managers weigh dividends against buybacks based on the signal sent, tax effects, and the stability of cash flows. A stable cash dividend appeals to income clienteles and is costly to cut, so firms set it conservatively. Buybacks are more flexible because they carry no ongoing commitment, letting a firm distribute temporary windfalls without raising expectations of a permanently higher payout.