1. Introduction

In the previous section, we have considered two otherwise identical firms that differ in their financing policy. Both firms had the same unlevered value (VU), but they differed greatly in their levered value because of their respective financing policies. The difference was that one of the firms was fully equity financed whereas the other one had a fairly high degree of debt financing.

We start by investigating how the unlevered firm can get access to the same benefits of debt financing. To isolate the value implication of the financing decision, we consider a leveraged recapitalization in which the firm borrows money and distributes the proceeds to its shareholders. This way, we can make sure that the operating activities of the firm remain unaffected and that "only" its financing mix changes.

Then we turn to the question whether it matters how the firm distributes cash to its shareholders. We consider the two main forms of cash distribution, namely dividend payments and share repurchases and we compare these two alternatives with respect to their value implication as well as other important corporate dimensions (see the module Payout Policy for a detailed discussion of the various forms of payout and their relevance in the real world).

Many mature firms hold considerable amounts of excess cash on their balance sheets. We have argued before that it makes sense for firms to use debt financing because of the associated tax savings. By the same token, however, firms should try to avoid holding cash, because the interest income they earn on these balances constitutes taxable income. 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. We do so because levered recapitalizations often greatly affect EPS. We show that EPS is a very noisy value indicator and that it is in fact easy to create a simple corporate transaction that improves EPS but destroys value. Management decisions should therefore NOT be judged based on their impact on EPS.