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Homework answers / question archive / How would a financial manager determine optimal capital structure? How this would fit in with the company's capital expenditures, growth plans and operating results? In a "perfect world" capital market, how important is a firm's decision to pay dividends versus repurchase shares? Under what conditions would you have a tax preference for share repurchase rather than dividends? Would managers acting in the interests of long-term shareholders be more likely to repurchase shares if they believed the stock to be either undervalued or overvalued?
How would a financial manager determine optimal capital structure? How this would fit in with the company's capital expenditures, growth plans and operating results?
In a "perfect world" capital market, how important is a firm's decision to pay dividends versus repurchase shares? Under what conditions would you have a tax preference for share repurchase rather than dividends? Would managers acting in the interests of long-term shareholders be more likely to repurchase shares if they believed the stock to be either undervalued or overvalued?
The capital structure of an organization is the mix of the various parts of capital. A financial manager can decide the ideal capital structure where the investor's riches is most extreme. The capital structure is mix of obligation and the value mix. The obligation content is remembered for the Capital Structure to the degree the expense of obligation is not exactly the Overall expense of capital. Because of the duty impact the expense of capital is in every case less Return on Capital of the organization, which will improve the arrival on the investor's capital. The capital structure of an organization is made up a few sorts of capital like obligation, value, favored value, held income and so forth. Every one of these wellsprings of capital have their own arrangement of advantages and disadvantages. The organization chooses the ideal capital structure as the ideal mix of the various wellsprings of capital. The ideal capital structure is the best obligation value proportion that amplifies the estimation of the organization, (CFI Education Inc., 2015-2020).
If a company raises too much capital during a given time period, the costs of debt, preferred stock, and common equity will begin to rise, and as this occurs, the marginal cost of capital will also rise. This proposition states that in perfect markets the capital structure a company uses doesn’t matter because the market value of a firm is determined by its earning power and the risk of its underlying assets. Capital structure is the particular combination of debt and equity used by a company to funds its ongoing operations and continue to grow. Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. A company with good prospects will try to raise capital using debt rather than equity, to avoid dilution and sending any negative signals to the market. Thus, the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth). Companies with consistent cash flows can tolerate a much larger debt load and will have a much higher percentage of debt in their optimal capital structure. The irrelevance proposition theorem is a theory of corporate capital structure that posits that financial leverage has no effect on the value of a company, (Hayes, 2019).
CFI Education Inc. (2015-2020). Capital Structure. Financing assets with debt and equity. https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-structure-overview/
Hayes, A. (2019). Optimal Capital Structure. The Basics of Optimal Capital Structure. https://www.investopedia.com/terms/o/optimal-capital-structure.asp
according to Picardo (2020), “The main difference between dividends and buybacks is that a dividend payment represents a definite return in the current timeframe that will be taxed, whereas a buyback represents an uncertain future return on which tax is deferred until the shares are sold.” With the way the world is wanting instant gratification, companies may see more fit to provide instant cash dividends. Not knowing what the future may bring will result in shareholder risk and uncertainty. If a company is interested in long term buyback would be the route to take, as it would want to continue to build and relate to future results. Well established companies are said to be doing both events.
The dividend is the part of the profit which is paid by the company to its shareholder on regular intervals. On the other hand, share buyback means purchase by company of its share from the market place. Companies mainly give rewards to there shareholders in two ways. First is by paying dividends. The second one is by buying back their shares. A number of companies are doing both of these things together.
Share buyback may be better for building wealth over time for investors because of the beneficial impact on earnings-per-share from a reduced share count, as well as the ability to defer tax until the shares are sold. Buybacks enable gains to compound tax-free until they are crystallized, as compared to dividend payments that are taxed annually. Buyback provides more flexibility to the company as well as its investors. Since it is not mandatory to buyback the share, the company is not under any obligation as compared to dividends which are an obligation of the company.
The major benefit of dividend payments is that they are highly visible. Information on dividend payments is easily available through financial websites and corporate investor relations portals. Information on buybacks, however, is not as easy to find. The managers are more likely to participate in the share repurchase program if they believe that the stock is undervalued. This sends a signal to the market that the firm has a promising future.
Reference
Brigham, E., and Ehrhardt, M. (2017). An Overview of Financial Management and the Financial Environment. In Financial Management: Theory & Practice (15th ed.). Retrieved from https://www.gcumedia.com/digital-resources/cengage/2017/financial-management_theory-and-practice_15e.php
Picardo, E. (2020, February 5). Dividend vs. Buyback: What's the Difference? Retrieved from https://www.investopedia.com/articles/active-trading/073015/dividend-versus-buyback-which-better.asp