Capital Structure, Policy Model and Theory

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Capital structure refers to the manner in which a corporation finances its assets using a composite of equity, debt or another form of funding. Hence restated, the capital structure is the composition of a firm’s liabilities. Capital structure is derived from determining the ratio of total assets of a company by its total debt or total equity. In a perfect capital market, the capital structure would be irrelevant as money from equity and debt would have the same cost of capital. This is not so in the real world, where different kinds of equity and different kinds of debt all carry varying levels of cost.

Corporate dividend policy has been relevant in the field of economics for the past five decades and has been significantly studied and modeled via empirical examination. Yet most theoretical models remain lacking in strong empirical support in their attempts to define corporate dividend behavior.

The capital structure theories will be used as tools to study three companies; Northern Foods PLC, Premier Foods PLC and Greggs Group PLC. With a view towards shedding light on how these capital structure theories and dividend policy theories are affirmed or contradicted by the existing capital structure of these companies.

Modigliani-Miller Theorem

Also known as the capital structure irrelevance principle, this theory is the progenitor of all other modern capital structure theories, this theory presupposes that in the absence of taxes, bankruptcy costs and asymmetric information in the presence of an efficient market capital structure has no effect on the value of the firm. It matters not if the assets are financed with debt or with the equity since both are assumed to have the same cost to the company.

Applied to the Northern Foods PLC, Premier Foods PLC and Greggs Group PLC this theory would suggest that their varying levels of debt ratios and equity ratios are irrelevant. The theory suggests that for all three companies the level of increase in assets funded by equity or debt would be equally beneficial in an environment where there are no taxes. This form of capital structure is idealistic since it does not exist anywhere in the world. However, it is still important to note because in every scenario it is possible to determine which one or more assumptions of the model is violated. Hence isolating this variable for further study in order to obtain the optimal capital structure.

Pecking Order Theory

The Pecking Order Theory is based on the belief that due to adverse selection, firms prefer internal to external finance. Firms prefer debt to equity because of lower information costs associated with debt issues[1]. Equity is seldom used financing deficit should be matched dollar for dollar by a change in corporate debt. The theory supposes that there are three forms of funding available to firms: retained earnings, debt and equity. Retained earnings have no adverse selection problem, Equity is subject to serious selection problems while debt has only a minor adverse selection problem. The firm will then use the least risky form of funding, retained earnings, then move on to Debt and Equity as the sources are exhausted. Thus, a firm will use debt issues to finance the deficit.

This theory holds true for both Northern Foods Group PLC and Premier Foods Group PLC both of which have debt in excess of 65%, up to 85% for Northern foods. It would appear that historically, both companies have used debt to finance their growth needs in lieu of raising additional equity. This affirms the theory because the two companies would rather raise debt which would require less inquiry into their business to raise.

But the theory appears to be rebutted by Greggs Group PLC which has a debt ratio that hovers at approximately 40%. Greggs Group PLC has been using both debt and equity to finance growth in roughly equal measure. Contrary to the Pecking Order Theory, Greggs Group PLC appears willing to have to raise equity even if it would be more costly for them to do so, since they would have to convince investors to provide new equity, as opposed to raising more debt which should be easier.

Trade-Off Theory of Capital Structure

This theory postulates that a company chooses how much debt finance and how much equity finance will be used by balancing the costs and benefits. This theory is based on the work of Kraus and Litzenberger[2] who held that there was a balance between the dead weight costs of bankruptcy and the tax benefits of debt. Agency costs are also included. It is also known as the antithesis of the Pecking Order Theory of Capital Structure. The purpose of this model is to explain the tendency of corporations to finance deficits with a mixture of debt and equity instead of just one or the other. The theory holds that there is a trade-off of benefits that must be weighed when choosing between which method of raising financing to choose.

In the case of Northern Foods Group PLC and Premier the cost of acquiring debt has been sufficiently outweighed by the potential benefits of debt over equity and its own set of potential benefits and costs. Debt has the advantage of being relatively easier to obtain since it only requires that the company has the financial strength to repay debt and its concomitant interest. Debt can also come with tax breaks for the company. The marginal benefit of debt also increases as the number of debt increases. Premier foods take advantage of this by increasing its Debt ratio through the three year period of the study. Northern Foods Group gradually reduces its Debt ratio which suggests that its own benefit from debt has declined to the point that it chose equity to finance its operations. It is also possible that Northern Foods has improved its ability to repay its debt as shown by its improving Net Profit Margin. By way of comparison even the increasing Net Profit Margin of Premier has not resulted in improved repayment of debt.

The opposite holds true for Greggs Group PLC because the greater part of its assets is funded with equity. This could be because Greggs Group PLC finds it easier to raise equity and has more benefits from doing so than incurring more debt. This could also mean that they are not expanding because their net profit margin is too low to finance growth. The fact that their debt is growing suggests that their modest profits are not even sufficient to maintain existing operations.

Dividend Policy Theory

Dividend policy strictly refers to the strategy employed by company managers in determining how to distribute earnings. Various theories suggest once a form of cash distribution over the other. The majority of corporations prefer to issue stock dividends instead of cash dividends because these do not actually result in cash being taken from the corporation’s coffers. In fact, a stock dividend even has the effect of diluting the value of individual shares. Regardless of which strategy a firm chooses to distribute wealth with, a firm’s distribution policy still matters as it can affect overall shareholder wealth.

Dividend policy can also be used as a tool to create value for shareholders owing to the many imperfections in the real world market. One way to understand how this creates value to shareholders is by understanding the interactions involved in crafting a dividend policy[3]. However there is a lack of empirical support for any particular dividend policy due to the difficulty in quantitatively measuring market frictions and the statistical complications in dealing with the myriad interactive imperfections that likely affect individual firms differently. In other words, since each firm faces a combination of potentially different market frictions with varying levels of relevance, the optimal dividend policy for each firm may be unique. On the other hand, if each firm had a uniquely optimal dividend policy it would not be surprising that significant statistical generalizations would nevertheless elude researchers.

Most dividend theories fail because they do not consider the potentially complex interactions among the various imperfections in the market. Furthermore, dividend theories take a “one-size-fits-all” approach by trying to generalize their findings[4].

A problem with most existing theories is that they fail to consider the potentially complex interactions among the various imperfections. Another problem is that each theory typically takes a ‘‘one-size-fits-all’’ approach by trying to generalize the findings. Not surprisingly, due to the fact that various imperfections affect firms differently, dividend policy may vary substantially from one firm to another. Hence, different firms have different dividend policies. For example, some critical factors for some firms may be totally irrelevant to others. Ultimately the dividend policy theories remain attempts to try to create some way to model what for the most part remains a process that is unique to most firms individually.

Full Information Dividend Policy Model

Tax adjusted models propose that investors require and receive higher expected returns on shares of dividend paying stocks. The imposition of a tax liability on dividends causes the dividend payment to be grossed up to increase the shareholder’s pretax return. Under capital asset pricing theory, investors offer a lower price for the shares because of the future tax liability of the dividend payment. If there is full information investors with differing tax liabilities will not be uniform in their ideal firm investment/dividend policy. As the tax liability on dividends increases or decreases the dividend payment consequently decreases or increases while earnings reinvestment increases or decreases. Differences are minimized by the segregation of investors into clienteles. In a partial equilibrium framework, investors have two choices. Individuals choose the amount of personal and corporate leverage and also whether to receive corporate distributions as dividends or capital gains. This model contends that no dividends should be paid; rather, that share repurchase should be used to distribute corporate earnings.

As Public Limited Corporations, the companies studied make filings to the appropriate regulating bodies which a reasonably diligent stockholder can easily have access to this information found in the filings or barring that receive the information from the company itself by virtue of their character as shareholders. Hence the Full Information Dividend Policy Model appears to apply to them.

Dividends as having a negative impact on stock

Blau and Fuller[5] Developed a model of corporate dividend policy based on the idea that management will value operating flexibility when there is a possibility that shareholders will reject a profitable investment project because they overcompensate for the potential of management dressing up the project because it is not wealth maximizing and is instead personally beneficial. Hence when a firm pays a dividend, it reduces management’s ability to reserve cash for investing in projects which it believes are good but their belief is not shared by the stockholders. On the other hand, paying dividends increases the current stock price of the firm. Management is required to weight these two aspects of dividends. Hence, dividend payments are negatively correlated with stock prices, and investors value dividends more when prices are lower. As the risk of the investment increases, the dividend payment decreases, and there is a positive correlation between the perceived risks of a firm and its stock price. A firm with low debt to equity ratios or high liquidity tends to have significantly lower dividend payments than firms with high debt-to-equity ratios and less liquidity. Hence it is this flexibility consideration that may be the missing piece of the puzzle as to the question of dividend policy. Restated, dividends actually have a negative impact on stockholder perceptions because the stockholders see that the company is giving away dividends at the expense of retaining earnings for future expansions.

Managing Earnings to Meet dividend thresholds

Daniela et al.[6] found that firms used expected dividend levels as important earnings thresholds. As a result, companies manipulated their earnings in order to meet expected dividend levels despite the absence of any cash flow consequences of such moves and, there, has no effect on the ability of the firm to pay dividends. The implication on this is that shareholder expectations of dividends actually have an impact on the management decisions of the firms so much so that managing the earnings to provide for expected dividends becomes a major concern for the companies. Discretionary accruals tend to reverse, the persistence of earnings will be lower for dividend payers who increase discretionary accruals. There is also indirect evidence on the importance of dividends to firms since the management of retained earnings can result in higher taxes accruing to the firm[7] and the potential for a higher cost of capital[8].

The present information on the companies studied does not indicate the possibility of such manipulation. One possible explanation for this is the facts that the companies studied are Public Limited Corporations or PLCs which unlike ordinary corporations have less to gain in manipulating stock prices by changing the dividends


The profitability of a company is important because all corporations are organized for profit. A corporation that consistently loses money has no business staying in business. In terms of profitability Greggs Group PLC has a consistent gross profit margin of 62% which is significantly higher than the gross profit margin of Northern Foods Groups PLC and Premier Foods Group PLC has lower GPMs of 20.75% and an average of 30% respectively. This would indicate that Greggs has a much lower cost of goods sold, higher profit margin per unit sold or both than the two other companies. This translates to a modest Net Profit margin which on average reaches around 5%which is significantly better than the Net profit margin of Northern and Premier. Premier even has a negative net profit margin indicating net loss. One of the reasons for these lower margins for both Premier and Northern Foods is the fact that those companies finance their operations with significantly more debt. Hence, their profits are reduced by their heavy interest payments while Greggs which has a higher equity ratio does not lose as much to interest payments.

Dividend payout ratio

The dividend payout ratio of Greggs remains fairly consistent through the period covered while Nothern’s payout has a declining trend. Premier shows some consistency and then collapses to a negative figure in 2008. Both Northern and Greggs offer moderate returns on investment for their stockholders. The negative dividend payout of Premier is due to its negative net profit margin for the year 2008. The dividend payout ratio is of especial interest in the case of Greggs because the majority of its capital is financed by equity meaning that their earnings per share and dividend are significantly better than Northern despite the apparently similar numbers.

Dividend Cover

The dividend cover ratio is computed by dividing the earnings per share by the number of dividends per share. The ratios for Greggs are consistent with the impression that it is a well managed company with a majority of its capital funded by equity. By comparison Northern’s dividends cover is less consistent in part because much of its capital is sourced from debt. Premier’s Dividend cover hits negative in 2008 because its net earnings per share are negative due to the occurrence of a net loss for that period.


Capital structure is the manner in which a corporation obtains financing for its asset capitalization which is composed of equity, debt and other sources of funding. Hence restated, the capital structure is the composition of a firm’s liabilities and owners equity. At its basest level, the capital structure irrelevance principle it is assumed that capital structures are irrelevant because in a perfect environment both liability and equity have the same cost and benefits. The capital structure irrelevance model is useful because The two other major theories covered are the Tradeoff Theory of capital structure and the Pecking Order theory. Both suppose that there is a difference between capital from debt and capital from equity. In this paper, two companies follow a debt heavy model supposing that debt is easier to obtain and less costly to sustain than equity. While one company has more equity than debt suggesting that that company is better able to attract investors.

Corporate dividend policy has been relevant in the field of economics for the past five decades and has been significantly studied and modeled via empirical examination. Yet most theoretical models remain lacking in strong empirical support in their attempts to define corporate dividend behavior. Three theories were considered, the first consider dividends as attractive with a positive influence on stock prices, the second holds that stock prices are negatively correlated with dividend payout and the final proposes that dividend policy has no impact on the stock. However, unlike capital structure theories, dividend policy requires further study because most models and theories still lack sufficient empirical grounding.


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Daniela, N.D., Denisb, D.J. Naveenc L. Do firms manage earnings to meet dividend thresholds? Journal of Accounting and Economics 45 (2008) 25

Erickson, M., Hanlon, M., Maydew, E., 2004. How much will firms pay for earnings that do not exist? Evidence of taxes paid on allegedly fraudulent earnings. Accounting Review 79, 387–408.

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Frankfurter, G. M., & Wood, B. G. (1997). The evolution of corporate dividend policy. Journal of Financial Education, 23, 31.

Lease, R. C., John, K., Kalay, A., Loewenstein, U., & Sarig, O. H. (2000). Dividend policy. Boston: Harvard Business School Press. p.179

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Appendix A: Ratios for Premier Foods Group Plc

  • Gross Profit Margin = Gross Profit /Sales * 100%

2006: 244.0/840.7*100 = 29%

2007: 648.6/2125.2*100 = 30.50%

2008: 784.1/2603.6*100 = 30.10%

  • Net Profit Margin = Profit After Tax/turnover * 100%

2006: 47.90 /840.7*100 = 5.7%

2007: -37.80/2125.2*100 = -1.78%

2008: -373.3/2603.6*100 = -14.34%

  • Dividend Cover = Earnings Per Share/Dividends Times

2006: 18.05/7 = 2.58Times

2007: 16.58/7.04 = 2.36Times

2008: -5.35/6.06 = -0.88Times

  • Dividend Payout = Dividend/Earnings Per Share * 100%

2006: 7/18.05*100 = 38.78%

2007: 7.04/16.58*100 = 42.46%

2008: 6.06/-5.35*100 = -113.27%

  • Debt to Capital Ratio = Debt/Debt + equity

2006: 969.30/969.30+461*100 = 67.77%

2007: 2634.40/2634.40+146.30*100 = 64.34%

2008: 3103.60/3103.60+991.80*100 = 75.78%

  • Equity to Capital Ratio = Equity/Debt + Equity

2006: 461/969.30+461*100 = 32.23%

2007: 146.30/2634.40+146.30*100 = 35.66%

2008: 991.80/3103.60+991.80*100 = 24.22%

Appendix B: Ratios for Northern Foods Group Plc

  • Gross Profit Margin = Gross Profit /Sales * 100%

2006: 178.87/862.00*100 = 20.75%

2007: 184.40/888.50*100 = 20.75%

2008: 193.40/931.90*100 = 20.75%

  • Net Profit Margin = Profit After Tax/turnover * 100%

2006: 1610/862.00*100 = 1.86%

2007: 28/888.50*100 = 3.15%

2008: 34.50/931.90*100 = 3.7%

  • Dividend Cover = Earnings Per Share/Dividends Times

2006: 5.56/9.1 = 0.61Times

2007: 6.14/2.35 = 2.62Times

2008: 8.10/4.30 = 1.88Times

  • Dividend Payout = Dividend/Earnings Per Share * 100%

2006: 9.1/5.56*100 = 163%%

2007: 2.35/6.14*100 = 38.37%%

2008: 4.30/8.10*100 = 53.08%

  • Debt to Capital Ratio = Debt/Debt + equity

2006: 776.10/776.10+152.10*100 = 83.61%

2007: 471/471+121.20*100 = 79.53%

2008: 517/517+165.40*100 = 75.76%

  • Equity to Capital Ratio = Equity/Debt + Equity

2006: 152.10/776.10+152.10*100 = 16.39%

2007: 121.20/471+121.20*100 = 20.47%

2008: 165.40/517+165.40*100 = 24.23%

Appendix C: Ratios for Greggs Group Plc

  • Gross Profit Margin = Gross Profit /Sales * 100%

2006: 341.32/550.85*100 = 62%

2007: 365.45/586.30*100 = 62%

2008: 387.10/628.20*100 = 62%

  • Net Profit Margin = Profit After Tax/turnover * 100%

2006: 27.06/550.85*100 = 4.9%

2007: 36.35/586.3*100 = 6.2%

2008: 34.10/628.20*100 = 5.4%

  • Dividend Cover = Earnings Per Share/Dividends Times

2006: 26.83/10.80 = 2.48 Times

2007: 32.21/12.40 =2.60 Times

2008: 29.58/14.30 = 2.07Times

  • Dividend Payout = Dividend/Earnings Per Share * 100%

2006: 10.80/26.83*100 = 40.25%

2007: 12.40/32.21*100 = 38.50%

2008: 14.30/29.58*100 = 48.34%

  • Debt to Capital Ratio = Debt/Debt + equity

2006: 83.75/83.75+144.89*100 = 36.62%

2007: 92.61/92.61+145.59*100 = 38.88%

2008: 102.48/102.48+147.95*100 = 40.92%

  • Equity to Capital Ratio = Equity/Debt + Equity

2006: 144.89 /83.75+144.89*100 = 63.37%

2007: 145.59 /92.61+145.59*100 = 61.12%

2008: 147.95/102.48+147.95*100 = 59.08%

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