5. Adjusting the Capital Structure

In the previous section, we have seen that different financing policies can have different value implications. The purpose of this section is to understand how firms can actually adjust their capital structure and which step in the process is responsible for the value effect. To be able to study the financing effect in isolation, we maintain the assumption that the firm in question does not adjust its operating activities and merely rearranges how these activities are financed.

We start by looking at the announcement effects of leveraged recapitalizations: How does the market react if the firm announces a change in its financing policy? We learn how to assess the change in the debt tax shield (DTS) at the time of the announcement and how this affects the firm's valuation.

Next, we investigate whether it matters how the firm distributes cash to its shareholders. We consider dividend payments and share repurchases and see that the distribution decision itself has no effect on the overall shareholder value.

Many mature firms hold considerable amounts of excess cash on their balance sheets. We discuss how to adjust the preceding approach to understand the tax penalty of excess cash and how and why distributing excess cash could increase firm value.

Finally, we look into the relevance of Earnings per Share (EPS) as a performance metric and valuation input. Many practitioners look at EPS when assessing the attractiveness of a firm as an investment target. We show that EPS is not a value indicator and that it is in fact easy to create a simple corporate transaction that improves EPS but destroys value.