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# Capital Structure Basics - PowerPoint PPT Presentation

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

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#### Presentation Transcript

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

• 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.

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

• 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.

EBIT = Sales – Variable Costs - Fixed Costs

### Break-even Analysis

• Calculation of Break-even Quantity

Find Quantity which results in EBIT = \$0

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

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

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

TR = p x Q

### Break-even Analysis

• Now calculate total revenue.

p = Sales price per unit

Q = unit sales

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

TotalCosts

Variable Costs

Fixed Costs

Quantity Produced

### Graphical Analysis of Break-even point

Step 1:

TotalCosts

Variable Costs

Fixed Costs

Quantity Produced

### Graphical Analysis of Break-even Point

Step 2:

Total Costs

\$1,000,000

TotalCosts &

Revenue

Variable Costs

Fixed Costs

Quantity Produced & Sold

Step 3:

Total Revenue

Total Costs

\$1,000,000

### The Break-even Graph

• The slope of the total revenue line is p, the price per unit.

• The slope of the total cost line is vc, the variable cost per unit.

TotalCosts &

Revenue

Total Revenue

Variable Costs

Fixed Costs

\$1,000,000

Quantity Produced & Sold

Total Costs

\$2,000,000

Qbe = 2,500

### The Concept of Leverage

You cannot easily move a large boulder.

### The Concept of Leverage

However, with the aid of a lever you can

move an object many times your size.

### The Concept of Leverage

The longer the lever, the bigger the

rock you can move.

### 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).

% 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.

% 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

Sales - Total VC

Sales -Total VC - FC

DOL=

### Operating Leverage

• Measurement of DOL

• Calculation using alternate formula:

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

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:

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

QuantityDOL

2,500 (Qbe)Undefined

3,2504.33

3,7503

5,0002

### Operating Leverage

• Degree of Operating Leverage falls as sales rise

QuantityDOL

2,500 (Qbe)Undefined

3,2504.33

3,7503

5,0002

### 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

Leverage

Table Number 1

% 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

% 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

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.

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.

Leverage

Table Number 1

% 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

% 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

DCLS = DOLS x DFLEBIT

Example:

DOLS = 3.0

DFLEBIT = 1.67

### Combined Leverage

DCL3,750 = 3.0x 1.67

= 5.0 times

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

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

Leverage

Table Number 1

### 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.

### Capital Structure Theory

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

• Debt

• Preferred Stock

• Common Stock

### 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.

### 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.

### 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.

### 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.

ke

ka

K*

kd

Corporate Bonds,

Preferred Stock,

and Leasing

Chapter 14

### Learning Objectives

• Bond contract terms

• Differences among types of bonds

• Features of preferred stock

• Lease versus purchase

• Balance sheet treatment of leases

### 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.

### 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

### 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.

### 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.

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.

### 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.

Special Features of Bond Indentures

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

• Restrictions on payment of dividends

• Minimum working capital required

• Name of independent trustee to oversee the bond issue

### Bond Ratings

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

Link to Standard and Poor’s Rating Services

AAABest Quality

AAHigh Quality

BBSpeculative

BVery Speculative

CCCVery Very Speculative

CC

CNo Interest Being Paid

DCurrently in Default

### Bond Ratings

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

Investment

### Types of Bonds

• Debenture

• Subordinated Debenture

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

A mortgage bond is secured by real

assets such as airplanes, railroad cars,

or real estate.

### Types of Bonds

• Debenture

• Subordinated Debenture

• Mortgage Bond

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

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

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

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

A junk bond is a bond that is rated below

### Types of Bonds

• Debenture

• Subordinated Debenture

• Mortgage Bond

• Convertible Bond

• Variable Rate Bond

• Putable Bond

• Junk Bond

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

### Bond Risk Hierarchy

Common Stock

More

Risk

Preferred Stock

Subordinated Debentures

Senior Debentures

2nd Mortgage Bonds

1st Mortgage Bonds

Less

Risk

Priority of Claim

Higher Lower

### 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.

### 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 12% dividends. If Company X’s marginal tax rate = 40%, the after tax yield on this investment AT yield = 12%[1-(.3x.4)] = 10.56%

• Compare to 12% on fully taxable investment: AT yield = 12%(1-.4) = 7.2%

### 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.

### 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

### 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.

### 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.)

### 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.

### Accounting Treatment of Leases

• A lease is classified as capital if any of the following conditions is met:

• Lessee becomes owner at end of lease

• Lessee has option to buy the asset at a bargain price at the end of lease

• Lease period > 75% of useful life

• PV of lease payments > 90% of market value at time of lease origination (using the lesser of the lessee’s cost of debt or the lessor’s rate of return on the lease)

Common

Stock

Chapter 15

### Learning Objectives

• Characteristics of common stock.

• Process of issuing common stock.

• Understand rights and warrants.

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### Stock Quote

Company Issuing the Stock

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### Stock Quote

Description of Preferred Stock

(Class B Preferred and Class C Preferred)

52 WeeksYldVolNet

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### Stock Quote

Ticker Symbol

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### Stock Quote

Annual Dividend per Share in dollars

p = Initial Dividend

52 WeeksYldVolNet

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### Stock Quote

The number of shares changing hands.

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### Stock Quote

6½ = \$6.50

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### Stock Quote

Closing Price

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### Stock Quote

Price Change from Close on Previous Trading Day

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Trading Range over the Past Year

s = stock split

= new 52 week high achieved on this day

### Stock Quote

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Dividend Yield

Dividend

Closing Price

=

### Stock Quote

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Price to Earnings (PE) Ratio

Closing Price

Earnings per Share

=

### Characteristics of Common Stock

• Dividends

• Vary over time

• Not guaranteed

• Residual Claim

• Voting Rights

• Sometimes Preemptive Right to buy New Stock

Link to the New York Stock Exchange

### 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.

### 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.

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

100,000

### Cumulative Voting Example

Number of Directors Electable

• 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 =

=1.6= 1 director (always round down)

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

### Pros and Cons of Equity Financing

• Dilution of ownership and power.

• Flotation costs

• Fees paid to investment bankers, lawyers, and accountants

• Usually higher than for debt issues.

### 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.

### Pros and Cons 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)

### 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

### 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.

### 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.

### Value of Right, Stock Selling Rights-On

• The subscription price is generally set lower than the market price of the common stock.

• As long as the stock’s market price is higher than the subscription price, the rights have exercise value.

• Value of Right = (Mo - S)/(N+1)whereMo = market price, rights-onS = subscription priceN = # rights needed to buy a new share

### Value of Right, Stock Selling Ex-Rights

• When the stock begins to sell ex-rights (without entitlement to the forthcoming rights), the stock price drops by approximately the value of the right.

• Value of Right = (Mx - S)/NwhereMx = market price, ex-rightsS = subscription priceN = # rights needed to buy a new share

### 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.

### Value of a Warrant

• Exercise value of a warrant is the amount saved by exercising the warrant rather than buying the stock in the open market.

• XV = (M-XP) x N

where XV = Exercise valueM = Market price of stockXP = Exercise priceN = # shares obtained per exercised warrant

Dividend

Policy

Chapter 16

### Learning Objectives

• Factors that influence dividend policy

• How to pay dividends

• Major dividend theories

• Alternatives to cash dividends

### Factors in Dividend Policy

• Need for funds

• Management expectations for the firm’s future prospects

• Stockholders’ preferences

• Restrictions on dividend payments

• Availability of cash

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

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

253115915

August

September

### Dividend Payment Procedures

Declaration Date

Date that dividend is announced

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

253115915

August

September

Declaration Date

### Dividend Payment Procedures

Date of Record

All owners of record will receive the dividend.

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

253115915

August

September

Declaration Date

Date of Record

### Dividend Payment Procedures

4 days

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

25311 7915

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.

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

25311 7915

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.

### Dividend Reinvestment Plans

• 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.

• 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.

• Residual Theory of Dividends

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)

• 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.

• 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.

• 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.

• 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.

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

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

### Stock Dividends

BEFORE DIVIDEND

Common Stock (200,000 shares, \$1 par)\$200,000

Capital in Excess of Par \$1,800,000

Retained Earnings \$10,000,000

TOTAL COMMON STOCK EQUITY \$12,000,000

AFTER 10% STOCK DIVIDEND (Stock price = \$21)

Common Stock (200,000 shares, \$1 par)\$220,000

Capital in Excess of Par \$2,200,000

Retained Earnings \$9,580,000

TOTAL COMMON STOCK EQUITY \$12,000,000

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.

Stock Splits

BEFORE DIVIDEND

Common Stock (200,000 shares, \$1 par) \$200,000

Capital in Excess of Par \$1,800,000

Retained Earnings \$10,000,000

TOTAL COMMON STOCK EQUITY \$12,000,000

AFTER THE 20 to 1 STOCK SPLIT

Common Stock (4,000,000 shares, \$.05 par) \$200,000

Capital in Excess of Par \$1,800,000

Retained Earnings \$10,000,000

TOTAL COMMON STOCK EQUITY \$12,000,000