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Capital Structure Basics. Chapter 13. Learning Objectives. Break-even level of sales. Operating and financial leverage and risk. Risks and returns of leveraged buy-outs (LBOs). Effect of capital structure on value. Break-even Analysis. Steps to Solution

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Capital Structure

Basics

Chapter 13


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Learning Objectives

  • Break-even level of sales.

  • Operating and financial leverage and risk.

  • Risks and returns of leveraged buy-outs (LBOs).

  • Effect of capital structure on value.


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Break-even Analysis

  • Steps to Solution

  • Construct a chart to find the sales break-even point = level of sales necessary to cover operating (not financial) costs.

  • This requires that you calculate EBIT for different unit sales amounts.

  • The point at which EBIT = 0 is the break-even level of sales.


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Costs $

Units Produced

Break-even Analysis

  • Assumptions

    • Fixed costs remain constant as quantity changes.

    • Variable costs vary as quantity of output changes.

Variable Costs

Fixed Costs


Fixed vs variable costs l.jpg
Fixed vs. Variable Costs

  • Fixed costs may include salaries, depreciation, rent.

  • Variable costs may include commissions, materials, labor.

  • This is a generalization. For example, some salaries may be considered fixed and others variable. In the long-run all costs are variable.


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EBIT = Sales – Variable Costs - Fixed Costs

Break-even Analysis

  • Calculation of Break-even Quantity

Find Quantity which results in EBIT = $0


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FC

p – vc

Unit Salesbe =

Break-even Analysis

  • Calculation of Break-even Quantity

Where:

Unit Salesbe = Break-even quantity

FC = Total fixed costs

p = Sales price per unit

vc = Variable costs per unit


Break even analysis8 l.jpg

FC

p – vc

Unit Salesbe =

Break-even Analysis

  • Calculation of Break-even Quantity

Example:

Fixed Costs = $1,000,000/year

Price = $800/unit

Variable Costs = $400/unit


Break even analysis9 l.jpg

FC

p – vc

Unit Salesbe =

$1,000,000

$800 – $400

=

= 2,500 units

Break-even Analysis

  • Calculation of Break-even Quantity

Example:

Fixed Costs = $1,000,000/year

Price = $800/unit

Variable Costs = $400/unit


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TR = p x Q

Break-even Analysis

  • Now calculate total revenue.

p = Sales price per unit

Q = unit sales


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TR = p x Q

Break-even Analysis

  • Calculate total revenue for different levels of sales.

Unit sales (Q) xPrice (p)= Total Revenue (TR)

0 x $800 = $ 0

500 x $800 = $ 400,000

1,000 x $800 = $ 800,000

2,000 x $800 = $1,600,000

2,500 x $800 = $2,000,000


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The Concept of Leverage

You cannot easily move a large boulder.


The concept of leverage13 l.jpg
The Concept of Leverage

However, with the aid of a lever you can

move an object many times your size.


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The Concept of Leverage

The longer the lever, the bigger the

rock you can move.


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The Concept of Leverage

  • In a financial context, the magnifying power of leverage can be used to help (or hurt) a firm’s financial performance.

  • Operating leverage occurs due to fixed costs in the production process.

  • With high fixed operating costs, a small change in sales will trigger a large change in operating income (EBIT).


Operating leverage l.jpg

% Change in EBIT

% Change in Sales

DOL=

Operating Leverage

  • Measurement of Operating Leverage

    • Degree of Operating Leverage (DOL)

  • DOL > 1 means the firm has operating leverage.


Operating leverage17 l.jpg

% Change in EBIT

% Change in Sales

DOL=

100

33.33

($1 - $.5) / $.5

($4 - $3) / $3

DOL=

=

= 3.0

Operating Leverage

  • Example:S1 = 3,750 units S2 = 5,000 units

  • FC = $1mil and VC = $400/unit P = $800/unit

  • Sales of 3,750 units = (3,750 * $800) = $3mil

  • EBIT = $3mil - $1mil – $1.5mil= $.5mil

  • Sales of 5,000 units = (5,000 * $800) = $4mil

  • EBIT = $4mil - $1mil - $2mil = $1mil


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Sales - Total VC

Sales -Total VC - FC

DOL=

Operating Leverage

  • Measurement of DOL

    • Calculation using alternate formula:


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Sales - Total VC

Sales -Total VC - FC

DOL=

Operating Leverage

  • Measurement of DOL

    • Calculation using alternate formula:

DOL = ($3 - $1.5) / ($3 - $1.5 - $1)

= 1.5 / .5

= 3


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Sales - Total VC

Sales -Total VC - FC

DOL=

Q = 3,750 units

P = $800 per unit

VC = $400 per unit

FC = $1,000,000 per year.

Example:

Operating Leverage

  • Measurement of DOL

    • Calculation using per unit information:


Operating leverage21 l.jpg

Sales - Total VC

Sales -Total VC - FC

DOL=

3,750(800) – 3,750(400)

3,750(800) –3,750(400) – 1,000,000

DOL3,750 units =

Operating Leverage

  • Measurement of DOL

    • Calculation using per unit information:

Interpretation: If sales change 1%, then EBIT will change 3% (same direction).

= 3


Operating leverage22 l.jpg

Quantity DOL

2,500 (Qbe) Undefined

3,250 4.33

3,750 3

5,000 2

Operating Leverage

  • Degree of Operating Leverage falls as sales rise


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Quantity DOL

2,500 (Qbe) Undefined

3,250 4.33

3,750 3

5,000 2

Operating Leverage

  • Degree of Operating Leverage falls as sales rise

  • The higher the sales level above break-even, the less the percent change in EBIT for a given percent change in sales

  • If FC = $0, DOL = 1


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Leverage

Table Number 1


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% Change in NI

% Change in EBIT

DFLEBIT =

Financial Leverage

  • Degree of Financial Leverage

    • Finance a portion of the firm’s assets with securities that have fixed financial costs

      • Debt

      • Preferred Stock

    • Financial Leverage measures changes in earnings per share as EBIT changes.

Base Level of EBIT


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% Change in NI

% Change in EBIT

DFL=

167

100

(480.6 - 180) / 180

($1 - $.5) / $.5

DFL=

=

= 1.67

Financial Leverage

Example: EBIT1 = $500,000

EBIT2 = $1,000,000

NI1 = $180,000

NI2 = $480,600


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EBIT

EBIT – I

DFLEBIT =

Financial Leverage

  • Measurement of DFL (Alternate formula)

  • If DFL > 1, the firm has financial leverage. A given percent change in EBIT will result in a larger percent change in NI.


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500,000

500,000 – 200,000

DFLEBIT=500,000 =

Financial Leverage

Example:

EBIT = $500,000

Interest Charges = $200,000

= 1.67 times

Interpretation: When EBIT changes 1% (from an existing level of $50,000) Net Income will change 1.67% in the same direction.


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Leverage

Table Number 1


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% Change in NI

% Change in Sales

DCLS =

Combined Leverage

  • Degree of Combined Leverage

    • Measures changes in Net Income given changes in Sales

    • Combines both Operating and Financial Leverage

    • Computed for a specific level of sales

Base Level of Sales


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% Change in NI

% Change in Sales

DCL=

166.7

33.3

(480.6 - 180) / .180

($4 - $3) / $3

DCL=

=

= 5.0

Combined Leverage

Example: SALES1 = $3,000,000

SALES2 = $4,000,000

NI1 = $180,000

NI2 = $480,600


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DCLS = DOLS x DFLEBIT

Example:

DOLS = 3.0

DFLEBIT = 1.67

Combined Leverage

DCL3,750 = 3.0x 1.67

= 5.0 times


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Sales – VC

Sales - VC - FC - I

DCLS =

3,750(800) – 3,750(400)

3,750(800) – 3,750(400) – 1,000,000 - $200,000

DCL3,750 =

3 mil – 1.5 mil

3 mil – 1.5 mil – 1 mil - .2 mil

=

Combined Leverage

Example:

= 1,500,000  300,000 = 5


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DCLS = DOLS x DFLEBIT

DCLS = DOLS x DFLEBIT

Example:

DOLS = 3.0

DFLEBIT = 1.67

Combined Leverage

DCL3,750 = 3.0x 1.67

= 5.0 times

Interpretation: When sales change 1%, Net Income will change 5.0% in the same direction


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Leverage

Table Number 1


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Effect of Leverage

  • Leverage can help the firm or hurt it.

  • If EBIT increases, financial leverage will magnify the increase in net income.

  • If EBIT decreases, financial leverage will magnify the decrease in net income.


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Capital Structure Theory

  • Capital Structure is the mixture of sources of funds a firm uses.

    • Debt

    • Preferred Stock

    • Common Stock


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Capital Structure Theory

  • A benefit of debt financing is that interest is tax deductible to the paying firm whereas payments to equity providers are not.

  • Firms must trade-off this benefit against the increased financial risk associated with higher debt levels.


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Capital Structure TheoryModigliani and Miller (M&M)

  • M&M wrote an important paper in 1958 in which they proved that with certain assumptions there is no optimal capital structure. One is as good as any other.

  • M&M’s Assumptions: No transaction costs, no taxes, everyone has same information and borrowing rates, debt is riskless, debt does not affect operations.


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Capital Structure TheoryModigliani and Miller (M&M)

  • In a later paper, M&M showed that when the tax deductibility of interest is considered, their model indicates that a capital structure of 100% debt is optimal.


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Capital Structure in the Real World

  • Firms attempt to balance the costs and benefits of debt to reach the optimal mix that maximizes the value of the firm.

  • Affect on costs of capital:

    • Since debt is cheaper than equity, use of debt will initially lower the WACC.

    • At high levels of debt, the WACC will increase as investors perceive the risk of the firm to be increasing substantially.


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Cost of Capital and Capital Structure

kd

ks

ks

ka

ka

K*

kd

We minimize K* at 50% debt


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Homework Problems

1. You are given the following information for Firm XYZ:

Fixed operating costs = $500,000

Variable operating costs per unit = $40/unit

Sales price per unit = $50/unit

Calculate the break-even point in units for: (treat each scenario independently)

a. fixed costs decrease to $450,000

b. variable cost decreases to $37 per unit

c. sales price increases to $55/unit

d. changes for a, b, c, occur simultaneously

2. Company X has a sales price of $4.00 per unit and a variable cost of $3.40 per unit; fixed costs are $13,000, no debt, and sales of 250,000 units per year. Company Y has a sales price of $10.00 per unit and a variable cost of $7.00 per unit with fixed costs of $135,000 and sales of 200,000 units per year. Company Y also has interest payments of $60,000 annually. Both companies are in the 40% tax bracket.

a. compute DOL, DFL, and DCL for Company X

b. compute DOL, DFL, and DCL for Company Y

c. compare the relative risk of both companies

3. Why is the Modigliani and Miller theory of capital structure not really practical for firms in the real world?

4. Debt financing is often called a two-edged sword. What does this mean?

5. Given a net income of $50,000, sales of $2,000,000, variable costs of $25,000, fixed operating costs of $175,000, price per unit of $5.00, interest expense of $20,000, and EBIT of $1,800,000:

a. calculate DOL

b. calculate DFL

c. calculate DCL


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Corporate Bonds,

Preferred Stock,

and Leasing

Chapter 14


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Learning Objectives

  • Bond contract terms

  • Differences among types of bonds

  • Features of preferred stock

  • Lease versus purchase

  • Balance sheet treatment of leases


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Bond Basics

  • Bondholders are lending the corporation funds for some stated period of time.

  • The corporation promises to make certain payments to the owner of the bond.


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Bond Basics

  • Indenture

    • Definition: the contract between the corporation and the investor

  • Provisions included in the indenture:

    • par value

    • coupon rate and payment dates

    • maturity date

    • any special features


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Bond Basics

  • Par Value

    • (e.g. $1,000) also called Face Value

  • Coupon Interest Rate

    • The stated rate of interest. The rate that is multiplied by the par value to determine the annual dollar interest paid.

  • Maturity

    • Time at which the original principal (Par Value) is repaid to the bondholder.


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Special Features of Bond Indentures

  • Collateral

    • If the debt is secured by specific assets, the lender is entitled to take the assets in the event of default.

  • Plan for repayment at maturity

    • Staggered maturities makes it easier for the firm to raise the necessary funds.

Sinking funds allow the firm to set aside the funds over time to ensure the ability to repay the loan.


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Special Features of Bond Indentures

  • Provisions for early repayment

    • Call provisions allow the issuer to refinance the debt, usually done if interest rates fall.

    • Issuing new bonds to replace old bonds is known as refunding.


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Call example

  • Original issue: 12% coupon

  • Coupon currently required for similar risk bonds: 10% coupon

  • Refinancing will save $20 per year on each $1,000 bond.

  • Interest savings offset by the expenses of calling the original issue and issuing the new bonds. In addition, the call price the issuer must pay is usually greater than the face value.


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Special Features of Bond Indentures

  • Restrictions on company operations that are designed to reduce risk to bondholders.

    • Restrictions on additional debt

    • Restrictions on payment of dividends

    • Minimum working capital required

  • Name of independent trustee to oversee the bond issue


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Bond Ratings

  • Moody’s and Standard & Poor’s regularly monitor issuer’s financial condition and assign a rating to the debt


Bond ratings54 l.jpg

AAA Best Quality

AA High Quality

A Upper Medium Grade

BBB Medium Grade

BB Speculative

B Very Speculative

CCC Very Very Speculative

CC

C No Interest Being Paid

D Currently in Default

Bond Ratings

  • Moody’s and Standard & Poor’s regularly monitor issuer’s financial condition and assign a rating to the debt

Investment

Grade

Below Investment Grade (Junk)


Types of bonds l.jpg
Types of Bonds

  • Debenture

  • Subordinated Debenture


Types of bonds56 l.jpg

A debenture is an unsecured bond.

A subordinated debenture is a

debenture that has lower priority for payment than other debentures

designated as senior.

Types of Bonds

  • Debenture

  • Subordinated Debenture


Types of bonds57 l.jpg

A mortgage bond is secured by real

assets such as airplanes, railroad cars,

or real estate.

Types of Bonds

  • Debenture

  • Subordinated Debenture

  • Mortgage Bond


Types of bonds58 l.jpg

A convertible bond is a bond that gives the

investor the right to convert the bond into a

given number of shares of stock on or after

a given future date.

The conversion ratio is the number of shares

the investor will get for each bond converted.

Types of Bonds

  • Debenture

  • Subordinated Debenture

  • Mortgage Bond

  • Convertible Bond


Types of bonds59 l.jpg

The conversion value is the market price per

share times the conversion ratio.

e.g. If the stock price = $20 and the conversion

ratio = 45, the conversion value = $20 x 45 = $900.

Types of Bonds

  • Debenture

  • Subordinated Debenture

  • Mortgage Bond

  • Convertible Bond


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A variable rate bond pays investors interest that

is adjusted according to an established time

table and a market rate index.

e.g. Coupon rate is LIBOR + 300 basis points

Types of Bonds

  • Debenture

  • Subordinated Debenture

  • Mortgage Bond

  • Convertible Bond

  • Variable Rate Bond


Types of bonds61 l.jpg

A putable bond can be cashed in

before maturity at the option of

the bond’s owner.

Types of Bonds

  • Debenture

  • Subordinated Debenture

  • Mortgage Bond

  • Convertible Bond

  • Variable Rate Bond

  • Putable Bond


Types of bonds62 l.jpg

A junk bond is a bond that is rated below

investment grade.

Types of Bonds

  • Debenture

  • Subordinated Debenture

  • Mortgage Bond

  • Convertible Bond

  • Variable Rate Bond

  • Putable Bond

  • Junk Bond


Types of bonds63 l.jpg

International bonds are bonds that

are sold in countries other than

where the issuer is domiciled.

Types of Bonds

  • Debenture

  • Subordinated Debenture

  • Mortgage Bond

  • Convertible Bond

  • Variable Rate Bond

  • Putable Bond

  • Junk Bond

  • International Bond


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Bond Risk Hierarchy

Common Stock

More

Risk

Preferred Stock

Subordinated Debentures

Senior Debentures

2nd Mortgage Bonds

1st Mortgage Bonds

Less

Risk

Higher

Priority of Claim

Lower


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Features of Preferred Stock

  • A hybrid security with both debt and equity characteristics.

  • Has priority over common stock in receipt of dividends and in liquidation.

  • Dividends are fixed as a percentage of par value.

  • Only participating preferred stock (which is rare) shares in the residual income with the common stockholders.


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Investors in Preferred Stock

  • Corporations can generally exclude from taxable income 70% of dividend income received on preferred stock issued by another corporation.

  • e.g. Company X owns Company Y preferred stock that pays 4% dividends. If Company X’s marginal tax rate = 40%, the after tax yield on this investment AT yield = 4%[1-(.3x.4)] = 3.52%

  • Compare to 4% on fully taxable investment: AT yield = 4%(1-.4) = 2.4%


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Leasing

  • A lease is a contractual arrangement where a party who needs an asset (lessee) contracts with another party who owns the asset (lessor) to use that asset for a specified period of time, without conveyance of title.

  • A long-term non-cancelable lease contract is very similar financially to a debt obligation from the perspective of the lessee.


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Benefits of Leasing to the Lessee

  • Flexibility and convenience

  • Few restrictions

  • Avoid the risk of obsolescence

  • 100 percent financing

  • Tax savings

  • Ease of obtaining credit


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Genuine Leases Versus Shams

  • Lease payments for operating leases are fully deductible to businesses but only interest portions of debt payments are deductible.

  • The IRS strictly examines lease arrangements to ensure that they are genuine lease agreements and not installment sales in disguise.


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Operating and Capital Leases

  • An operating lease has a term that is substantially shorter than the useful life of the asset and is cancelable by the lessee (e.g. car rental for a business trip).

  • A capital lease is long term and non-cancelable. The economic value is mostly depleted by the end of the lease (e.g. a ten year lease of a truck.)


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Accounting Treatment of Leases

  • Both operating and capital leases appear on the income statement.

    • Payments on operating leases are tax-deductible expenses.

    • Depreciation for the leased asset and imputed interest from capital lease payments are deductible.

  • Capital leases also appear on the balance sheet because they are the functional equivalent of a purchase financed with debt.


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  • Homework Problems

  • Four years ago, you purchased a convertible bond at par with a ten year maturity with an 8% coupon. The conversion ratio of the bond is 25. The current market price of the stock is $50. Calculate the conversion value.

  • Using the information in the previous question, if the current market interest rate is 9.5% on similar non-convertible bonds, should you convert? Explain.

  • You purchased a fifteen-year 10% coupon bond at par five years ago. The bond can be redeemed for $900 after five years. The current required rate of return on similar non-convertible bonds is 9%. Should you redeem the bond? Explain.

  • Why are junk bonds called high-yield bonds?

  • Explain why preferred stock is known as a hybrid security.


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Common

Stock

Chapter 15


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Learning Objectives

  • Characteristics of common stock.

  • Advantages and disadvantages of equity financing.

  • Process of issuing common stock.

  • Understand rights and warrants.


Stock quote l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Stock Quote

Company Issuing the Stock


Stock quote76 l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Stock Quote

Description of Preferred Stock

(Class B Preferred and Class C Preferred)


Stock quote77 l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Stock Quote

Ticker Symbol


Stock quote78 l.jpg

52 Weeks YldVol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Stock Quote

Annual Dividend per Share in dollars

p = Initial Dividend


Stock quote79 l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Stock Quote

Volume of Trading

The number of shares changing hands.


Stock quote80 l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Stock Quote

Daily Trading Range

6½ = $6.50


Stock quote81 l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Stock Quote

Closing Price


Stock quote82 l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Stock Quote

Price Change from Close on Previous Trading Day


Stock quote83 l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Trading Range over the Past Year

s = stock split

= new 52 week high achieved on this day

Stock Quote


Stock quote84 l.jpg

52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Dividend Yield

Dividend

Closing Price

=

Stock Quote


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52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 PepsiCo PEP 1.14 3.3 24 5067 35 34¼ 34¼ -¾

s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾

237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...

7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -1/8

Price to Earnings (PE) Ratio

Closing Price

Earnings per Share

=

Stock Quote


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Characteristics of Common Stock

  • Dividends

    • Vary over time

    • Not guaranteed

  • Residual Claim

  • Voting Rights

  • Sometimes Preemptive Right to buy New Stock


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Management of Publicly Traded Corporations

  • Shareholders elect a group of individuals called the Board of Directors who oversee the management of the corporation.

  • The Board of Directors selects the managers who are responsible for day-to-day operations of the firm.


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Board of Directors Elections

  • Majority voting

    • For each seat open, one vote can be cast per share. Each position on the board is voted for separately.

  • Cumulative voting

    • Each shareholder gets one vote per share times the number of seats open. Votes may be spread out among candidates as desired. The top X vote getters are elected to the X seats to be filled.


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(40,000-1)(3+1)

100,000

Cumulative Voting Example

  • Excalibur Corporation has 3 seats open on its 9 member Board of Directors. There are 100,000 shares outstanding. The minority interest owns 40,000 shares.

  • Does the minority have a chance of electing one Director if all shares are voted?

  • The minority has 40,000 x 3 = 120,000 votes.

  • Number they can elect =

Number of Directors Electable

=1.6= 1 director (always round down)


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2 X 100,000

5+1

+1

Cumulative Voting Example

  • Excalibur Corporation has 5 seats open on its 9 member Board of Directors. There are 100,000 shares outstanding.

  • How many shares does the minority need to control to elect 2 directors?

  • Number of shares needed =

Number of Shares Needed for X Directors

= 33,334.33


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Pros and Cons of Equity Financing

Disadvantages of Equity Financing

  • Dilution of ownership and power.

  • Flotation costs

    • Fees paid to investment bankers, lawyers, and accountants

    • Usually higher than for debt issues.


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Pros and Cons of Equity Financing

Signaling Effects

  • Investors may think that managers would not issue stock unless it were overvalued in the market.

  • Therefore, a stock issue is seen as a negative signal and investors will respond by selling the stock.

  • Selling pressure causes the stock price to fall.

Disadvantages of Equity Financing (cont.)


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Pros and Cons of Equity Financing

Advantages of Equity Financing

  • No interest to pay.

  • No obligation to pay dividends.

  • Reduces financial risk.

    • This may be a more important advantage to firms that already are relatively risky due to the kind of business they do (e.g. high tech)


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Issuing Common Stock

  • Sell to existing shareholders or to new shareholders?

  • Initial Public Offering (IPO)

  • Role of Investment Bankers

    • Underwriting

    • Best efforts

  • Pricing the issue


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Rights and Warrants

  • Securities issued by a corporation that allow investors to buy new stock at a given price.

  • Preemptive Right

    • Allows a shareholder the right to maintain their % ownership by buying a proportional share of any new issue.

    • The rights can also be sold in the open market.


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Preemptive Right Example

  • There are 60,000 shares outstanding and another 20,000 will be issued.

  • Each shareholder will receive one right for for each share held, a total of 60,000 rights.

  • To buy one share of the new issue, you will need to pay the subscription price plus 60,000/20,000 = 3 rights.


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Rights and Warrants

  • A warrant is a security giving the owner the option to buy shares of common stock at a certain exercise price for a set period of time.

  • Like rights except that they are sold to investors rather than given away.

  • Each warrant allows you to buy a particular number of shares.


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Homework Problems

1. Describe the difference between a preemptive right and a warrant.

2. Company XYZ has 30 million shares of common stock outstanding. It wishes to issue another 1,500,000 shares. The current market price per share is $25 and the rights offering subscription price is $20 per share.

a. How many rights will current stockholders receive?

b. How many rights are needed to buy one additional share?

3. The Whitcomb Bank has 10 directors on its board and 1,000,000 voting shares of common stock outstanding. The company uses cumulative voting rules and is planning to elect four new directors. How many shares of common stock would a group of shareholders need to insure that they could elect at least two directors at the next election?

4. How do you value a stock that is not publicly traded?

5. What are the advantages and disadvantages of equity financing?


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Dividend

Policy

Chapter 16


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Learning Objectives

  • Factors that influence dividend policy

  • How to pay dividends

  • Major dividend theories

  • Alternatives to cash dividends


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Factors in Dividend Policy

  • Need for funds

  • Management expectations for the firm’s future prospects

  • Stockholders’ preferences

  • Restrictions on dividend payments

  • Availability of cash


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On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006

Dividend Payment Procedures


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On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006

25 31 1 5 9 15

August

September

Dividend Payment Procedures

Declaration Date

Date that dividend is announced


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On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006

25 31 1 5 9 15

August

September

Declaration Date

Dividend Payment Procedures

Date of Record

All owners of record will receive the dividend.


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On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006

25 31 1 5 9 15

August

September

Declaration Date

Date of Record

Dividend Payment Procedures

4 days


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On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006

25 31 1 7 9 15

August

September

Declaration Date

Date of Record

Dividend Payment Procedures

Ex-Dividend Date

To allow time for the official list of stockholders to be updated, stockholders must buy stock before the ex-dividend date which is 2 days prior to date of record.


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On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006

25 31 1 7 9 15

August

September

Ex-Dividend Date

Declaration Date

Date of Record

Dividend Payment Procedures

Payment Date

Date that the dividend is paid out to the stockholders.


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Dividend Reinvestment Plans quarterly dividend of $1 per share

  • A dividend reinvestment plan (DRIP) is a plan in which stockholders are allowed to reinvest their dividends in additional shares of stock instead of receiving them in cash.

  • Popular with investors because they can avoid commission costs.

  • Dividends paid and reinvested are still taxable income to the investor.


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Leading Dividend Theories quarterly dividend of $1 per share

  • Residual Theory of Dividends

    • Hypothesizes that dividends should be determined only after the firm has first examined their need for retained earnings to finance the equity portion of funds needed for their capital budget.

    • Thus, dividends arise from the “residual” or left-over earnings.


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Leading Dividend Theories quarterly dividend of $1 per share

Example:

  • Net Income = $150 million

  • Total Amount of Funds Needed to Finance Positive NPV Projects = $100 million

  • Optimal Capital Structure: 60%D, 40%E

  • Equity Funds Needed = $100 million x .4 = $40,000,000

  • Dividend to be Paid = $110 million ($150 million NI - $40,000,000 Equity Funds Needed)

  • Residual Theory of Dividends


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Leading Dividend Theories quarterly dividend of $1 per share

  • Clientele Dividend Theory

    • Hypothesizes that different firms have different types of investors.

    • Some investors, such as elderly people on fixed incomes, tend to prefer to receive dividend income.

    • Others, such as young investors often prefer growth, and tend to like their income in the form of capital gains rather than as dividend income.


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Leading Dividend Theories quarterly dividend of $1 per share

  • Signaling Dividend Theory

    • Hypothesizes that since management is better informed about the firm’s prospects, dividend announcements are seen as signals of future performance.

    • Since investors usually respond negatively to dividend decreases, managers tend not to increase dividends unless the increase is expected to be sustainable.


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Leading Dividend Theories quarterly dividend of $1 per share

  • Bird in the Hand Theory

    • Hypothesizes that stockholders prefer to receive dividends instead of having earnings reinvested.

    • The dividend payment is more certain than the unknown future capital gain.


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Leading Dividend Theories quarterly dividend of $1 per share

  • Modigliani and Miller Dividend Theory

    • M&M originally argued in 1961 that, without taxes or transactions costs, the way that the firm’s earnings are distributed (capital gains versus dividends) is irrelevant to firm value.


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e.g. if there is a 10% stock dividend, you would receive one additional share for every 10 that you currently own.

Alternatives to Cash Dividends

  • Stock Dividends

    • Existing shareholders receive additional shares of stock instead of cash dividends.

    • Payment is expressed as a percentage of current stock holdings.


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e.g. a 2-1 split means that each investor will end up with twice as many shares.

Alternatives to Cash Dividends

  • Stock Splits

    • If total shares will increase by more than 25%, the company will usually declare a stock split.

    • Purpose is usually to bring the stock price into a more popular trading range.

    • Expressed as a ratio to original shares.


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  • Homework Problems and Questions twice as many shares.

  • 1. Explain the difference between a stock dividend and a stock split.

  • 2. Net income is $2,500,000; dividends declared are $500,000. What is the dividend payout ratio?

  • 3. Why is it important for a firm to understand the makeup of its stockholders before it determines a dividend policy?

  • 4. Would it be a common practice for a high-growth firm to have a 100% dividend payout ratio? Explain.

    • 5. What is the rationale of managers who view a stock split as a way to increase the total value of their firm’s stock?


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