MODULE 7 Dividend policy and leasing

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MODULE 7
Dividend policy and leasing

In Module 6 you examined capital structure. You learned what capital structure is, why it is important, and some factors that
management considers when planning the firm’s capital structure. Module 7 examines two other important considerations for
the firm: dividend policy, and factors to consider when deciding whether to lease or buy assets.

Comments on the required reading

      ●   Read Chapter 22 prior to reading Topics 7.1 to 7.5. The Module Notes provide supplemental commentary on selected
          aspects of a company’s dividend policy.
      ●   Read Chapter 16 prior to reading Topic 7.6 and 7.7. The Module Notes provide supplemental commentary on selected
          aspects of the lease versus buy decision.

Module topics and learning objectives

7.1       Dividend policy and payment procedures                                   Describe how firms determine, declare, and pay
                                                                                   dividends. (Level 2)

7.2       Alternative dividend policies                                            Describe three alternative dividend policies:
                                                                                   constant dividend payout ratio, residual dividends,
                                                                                   and constant dollar dividends. (Level 2)

7.3       Factors affecting dividend policies                                      Describe factors that affect dividend policy. (Level
                                                                                   2)

7.4       Stock dividends and stock splits                                         Describe how stock dividends and stock splits
                                                                                   affect a shareholder’s position. (Level 2)

7.5       Share repurchases                                                        Describe how share repurchases can serve as
                                                                                   substitutes to cash dividends under perfect market
                                                                                   conditions. (Level 2)

7.6       Types of leases                                                          Describe the different types of leases and how a
                                                                                   firm evaluates the leasing decision. (Level 2)

7.7       Analyzing the lease versus buy decision                                  Explain the lease versus buy decision using the
                                                                                   equivalent loan approach, and use a spreadsheet
                                                                                   application to evaluate the leasing decision. (Level
                                                                                   1)



Module summary


    Print this module




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7.1 Dividend policy and payment procedures

      Learning objective

      ●   Describe how firms determine, declare, and pay dividends. (Level 2)


      Required reading

      ●   Chapter 22, Section 22.1, (pages 862 – 864, excluding subsection “Dividend Reinvestment Plans …”)
      ●   Chapter 22, Sections 22.2 to 22.4 (pages 866 – 881)

LEVEL 2


Overview of dividend policy

The term “dividends” refers to the distribution of earnings to shareholders, primarily in the form of cash. After a firm has
distributed dividends to preferred shareholders, the firm may distribute residual net earnings to common shareholders, or
keep the net earnings as retained earnings to fund investment projects, or pay a portion as dividends and keep the
remainder for investment purposes. The dividend payout ratio is the proportion of earnings that is available to common
shareholders that the firm pays out in the form of dividends.

The following factors are important to the decision of what proportion of a firm's earnings should be retained and what
proportion it should return to its shareholders.

      ●   The firm's investment
          opportunities                                     . The firm should retain earnings for investment in the company's
          projects only if it can achieve returns that exceed those that the shareholders can obtain by investing the same
          funds. This maximizes shareholder wealth. In Module 5, you learned that a project's NPV must be greater than 0
          when calculated using the required risk-adjusted rate of return. When this is done, then the firm retains earnings to
          the extent that it has appropriate projects and the dividends issued are residual.

      ●   The investor's other investment
          opportunities                                   . This is the other side of the previous factor. When a firm is trying to
          decide whether to issue a dividend or not, it must be aware of the expectations of its shareholders. It needs to know
          their required return, which would be based on other available opportunities.

      ●   The tax implications                                                      . Investors are not neutral with respect to
          earning dividends versus capital gains because of the differences in applicable taxes. Investors want to maximize
          their after-tax return. Therefore, the tax legislation is an important consideration from an investor's point of view.

      ●   The investor's current
          consumption needs                                              . Example 1.2-1 in Topic 1.2 dealt with an investor who
          had invested in BCE because she required a steady stream of dividend payments, as these funds were her sole
          source of income. In the example, BCE wanted to invest in a project that, while risky, had positive returns that would
          raise BCE's stock price. The example showed that BCE should invest in the project rather than pay out the dividends.
          Shareholders who require the liquidity have the option of selling their shares in the highly liquid stock market and
          reinvesting the funds in other stock that provide the needed dividend returns. Therefore, when making the dividend
          or re-investment decision, the company should not worry about this factor.

In explaining the effects of dividend policy, this module assumes that the capital budget, investment policy, and capital
structure are all fixed. This assumption is required to isolate the impact of dividend policy from the effects of the investment
and capital structure decisions. Thus, dividend policy involves the decision of whether or
not           to pay cash dividends, not how          the cash is obtained. In cases where the cash is not available and the
firm’s policy is to pay dividends, it is assumed that the firm will sell shares to raise the required cash.

Declaring and paying dividends



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Unlike interest on debt, dividends on common shares are not contractual obligations. The board of directors decides whether
to pay a dividend, the amount to be paid, and the payment date. Firms with established dividend records often pay dividends
quarterly, semi-annually, or annually.

Exhibit 7.1-1 shows the sequence of the key dates that relate to the payment of dividends.

Exhibit 7.1-1
Dates related to the process of dividend payments




Announcement date:                                                  Many publicly traded corporations announce their board of
directors’ decision to declare a dividend by posting a press release on their Web site and placing advertisements in financial
newspapers. The announcement includes the type and class of shares affected, the amount of dividend per share, as well as
timing information.

Payment date:                                                This is the date on which the dividend is paid to all shareholders who are
entitled to receive the dividend.

Record date:                               This is the cut-off date that determines who is entitled to receive the declared
dividend. All shareholders who are registered as owners of shares at the close of business on the record date are entitled to
receive payment.

The record date is important for shares that are actively traded because share ownership is continually changing. The record
date is typically set two to four weeks in advance of the payment date to allow time for processing.

Dividend-on date and ex-dividend
date:               The dividend-on date and ex-dividend date are important for investors who are buying or selling shares
close to the record date, because they specify whether it is the buyer or the seller who is entitled to the dividend when it gets
paid. In Canada and the US, share purchases settle three business days after a trade is executed (sometimes referred to as “T
+3,” which represents the trade date plus three days). Therefore, if an investor wants to receive the dividend, the investor
has to buy the shares at least three days before the record date; that way they will be the registered owner of the shares on
the record date. The last day that an investor can buy shares, in time to be entitled to the dividend declared on those shares,
is called the dividend-on date. Because of the settlement rules, the dividend-on date is always three business days before the
dividend record date.

Any shares traded after the dividend-on date will not have settled by the record date. This means that on the record date,
the seller would still be listed as the registered shareholder, and would therefore be the one entitled to the dividend, even
though they had already sold the shares. Because of this, the day after the dividend-on date is known as the ex-dividend
date, and shares are said to be trading ex-dividend as of this date.




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7.2 Alternative dividend policies

       Learning objective

       ●   Describe three alternative dividend policies: constant dividend payout ratio, residual dividends, and constant dollar
           dividends. (Level 2)


       Required reading

       ●   Chapter 22, Section 22.5 (pages 881 – 884)

LEVEL 2

The text describes theories which explain whether a firm’s dividend policy is relevant or not to its value. While these theories
do not predict a consistent relationship between dividend policy and firm value, they provide insights that managers can use
to set dividend policies. In practice, dividend policies of publicly traded firms fail to provide evidence of a consistent
relationship. It appears that firms choose from several feasible dividend policies. This topic looks at three alternative dividend
policies:

       ●   Constant dividend payout ratio
           policy:               The firm pays out the same percentage of earnings, say 30%, as dividends on an ongoing
           basis.

       ●   Residual dividend policy:                                                                As described on page 872, the
           firm pays out dividends equal to its free cash flow. (As set out on page 871, free cash flow = cash flow from
           operations – capital expenditures.)

       ●   Constant dollar dividend policy:                                                                                The
           firm pays out the same dollar amount per outstanding common share each period, say $1.25. In practice this is by far
           the most common policy observed for Canadian, publicly-traded, companies that pay dividends.

Example 7.2-1 examines the effect of each of the three dividend policies on a company’s earnings.

Example 7.2-1: Dividend policies

Constant dividend payout ratio policy

Fast Shipping and Transportation (FST) has 12.5 million outstanding shares. It pays out 40% of earnings as dividends. FST’s
projected net earnings, earnings per share and dividends per share are for the next five years are shown in Exhibit 7.2-1.

Exhibit 7.2-1
FST’s projected dividends per share


                                        Year 1           Year 2        Year 3             Year 4     Year 5
Net earnings in $
million                                   $ 45.00         $ 25.00         $ 60.00          $ 75.00    $ 21.00
Earnings per share in $1                      3.60            2.00            4.80            6.00       1.68
Dividend per share in $2                      1.44            0.80            1.92            2.40      0.672

1   Earnings per share (EPS) = net earnings ÷ 12.5 million shares
2   Dividend per share = EPS × 40%

The expected earnings per share, expected dividends per share, standard deviation of expected earnings per share, and
standard deviation of dividends per share are calculated as:


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Expected earnings per share = $3.616
Expected dividends per share = $1.4464
Standard deviation of expected earnings per share = $1.6398
Standard deviation of the dividends per share = $0.6559

Expected dividends per share = expected earnings per share × dividend payout ratio

Standard deviation of dividends per share = standard deviation of earnings per share × dividend payout ratio

Under a strict policy of a constant dividend payout ratio, dividend instability is a direct function of the instability of earnings.
The higher the uncertainty of earnings, the higher the uncertainty of dividends will be.

Suppose that Chen is a major shareholder of FST. As he is not a well-diversified investor, he considers the coefficient of
variation (Equation 6-4) to be the measure of risk relevant to his situation. What is the coefficient of variation (CV) of FST’s
expected dividends per share?

CV = $0.6559 ÷ $1.4464 = 0.4535

In this case, the CV indicates that one unit of percent return increases risk by 0.4535%.

Residual dividend policy

FST would now like to follow a residual dividend policy. Its capital structure includes 40% debt, and FST would like to
maintain this structure. Exhibit 7.2-2 provides information on FST’s investments and dividend policy over the next five years.

Exhibit 7.2-2
FST’s dividends over the next five years under a residual dividend policy
($millions except per share figures)


                                                 Year 1 Year 2 Year 3 Year 4 Year 5
Net earnings                                      $ 45.00 $ 25.00 $ 60.00 $ 75.00 $ 21.00
Investments                                         35.00   40.00   40.00   35.00   35.00
Equity required for
investments1                                         21.00         24.00         24.00    21.00   21.00
Dividends2                                           24.00           1.00        36.00    54.00    0.00
Dividends per share3                                  1.92           0.08         2.88     4.32    0.00

1   Equity required for investments = 60% of investments
2   Dividends = net earnings – equity required for investments
3   Dividends per share = dividends ÷ 12.5 million shares

The expected dividends per share, expected investments, standard deviation of investments, and standard deviation of
dividends per share are calculated as:

Expected dividends per share = $1.84
Expected investments = $37.00 million
Standard deviation of investments = $2.4495 million
Standard deviation of dividends per share = $1.6566

The expected dividends per share and standard deviation of dividends per share under the residual dividend policy are
respectively higher than the expected dividends and standard deviation using the constant dividend payout ratio.

The CV of FST’s expected dividends per share under the residual dividend policy is

CV = $1.6566 ÷ $1.84 = 0.9003

This value is higher than the CV of 0.4535 under the constant dividend payout ratio policy.

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Given that Chen is primarily concerned with the CV, he would prefer the dividend policy with the lower CV. Chen would prefer
the constant dividend payout ratio policy because it provides the lowest risk per dollar of expected dividends.

Does the residual dividend policy always increase the CV?

The answer is no. As demonstrated above, the risk inherent in the dividends of a firm that follows a policy of constant
dividend payout is directly related to earnings volatility. In contrast, the residual dividend policy has a higher or lower risk per
dollar of dividends depending on the correlation between the firm’s earnings and the cash required for investment purposes.

For example, the correlation is negative when the firm’s earnings and its investment needs exhibit the following pattern. In
periods with a high level of earnings, the level of cash required for investments is low, while in periods with low earnings, the
level of cash needed for investments is high. In this case, a residual dividend policy leads to higher dividend variability
because the variability of earnings is further magnified by the variability of investment needs. This is what happens with FST.

In contrast, the correlation is positive when the level of earnings and level of cash required for investment demonstrate
similar changes. That is, in periods in which the level of earnings is high, the level of cash needed for investment is also high.
In periods in which the level of earnings is low, the level of cash is also low. In this case, a residual dividend policy will lead
to lower dividend variability, as the variability of earnings is reduced by the variability of the investment needs.

How is the residual dividend policy affected by investment needs?

FST would like to follow a residual dividend policy and use a debt ratio of 40% in financing its investments. Its earnings and
investments are positively correlated, as shown in Exhibit 7.2-3. That is, when FST’s earnings are high (low), its investment
needs are also high (low). The exhibit also shows dividends per share in this situation.

Exhibit 7.2-3
FST’s dividends per share over the next five years
($millions except for per share figures)


                                                                              Year 1      Year 2     Year 3     Year 4     Year 5
Net earnings                                                                   $ 45.00     $ 25.00    $ 60.00    $ 75.00    $ 21.00
Investments                                                                      37.00       17.00      52.00      67.00      12.00
Equity required for investments1                                                 22.20       10.20      31.20      40.20       7.20
Dividends2                                                                       22.80       14.80      28.80      34.80      13.80
Dividends per share3                                                             1.824       1.184      2.304      2.784      1.104

1   Equity required for investments = 60% of investments
2   Dividends = net earnings – equity available for investments
3   Dividends per share = dividends ÷ 12.5 million shares

The expected dividends per share, expected investments, expected dividends per share, standard deviation of investments,
and standard deviation of dividends per share are now calculated:

Expected dividends per share = $1.84
Expected investments = $37.00 million
Standard deviation of investments = $20.7364 million
Standard deviation of dividends per share = $0.6448

The CV of FST’s expected dividends per share is

CV = $0.6448 ÷ $1.84 = 0.3504

The expected dividends per share increased while the standard deviation of dividends per share dropped. As a result, the
coefficient of variation dropped from 0.4535 under a constant dividend payout ratio policy to 0.3504. The new pattern of
investments makes the residual dividend policy preferable over the constant dividend payout ratio policy because it reduces
the variations of the firm’s expected dividends.

Constant dollar dividend policy


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The management of FST wishes to set the dividend payment so that it does not have to raise long-term funds to pay
dividends or to finance profitable investment projects. The firm’s capital structure includes 40% debt, and the firm would like
to maintain this structure. Exhibit 7.2-4 shows the distribution of earnings between dividends and retained earnings, and the
firm’s yearly investments and borrowing or lending needs.

Exhibit 7.2-4
Distribution of earnings between dividends and retained earnings
and the firm’s annual borrowing or lending needs ($millions)


                                                         Year 1         Year 2            Year 3     Year 4     Year 5
Net earnings                                              $ 45.00        $ 25.00           $ 60.00    $ 75.00    $ 21.00
Investments                                                 35.00          40.00             40.00      35.00      35.00
Equity required for investments1                            21.00          24.00             24.00      21.00      21.00
Earnings available for dividends2                           24.00           1.00             36.00      54.00       0.00
Dividends3                                                  23.00          23.00             23.00      23.00      23.00
Cumulative surplus (deficit)4                                1.00        (21.00)            (8.00)      23.00       0.00

1   Equity required for investment = 60% of investments
2   Earnings available for dividends = net earnings – equity required for investment
3   Dividends = 12.5 million shares × expected dividend per share
4   For simplicity, interest to be paid on the borrowed money is ignored

Recall that for FST, the average value of dividends per share over the next five years is $1.84 per share, or $23 million in
total. This is the maximum amount of dividends that the firm can pay per year over the next five years, without forcing it to
raise long-term funds to pay dividends or finance new investments. However, this dividend payment will require FST to lend
and borrow in the short-term market to smooth out the fluctuations.

Exhibit 7.2-4 shows that the firm will have a cumulative surplus after the first year, but then a cumulative deficit until the
fourth year.




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7.3 Factors affecting dividend policies

      Learning objective

      ●   Describe factors that affect dividend policy. (Level 2)


      Required reading

      ●   Chapter 22, Section 22.6 (pages 884 – 890)

LEVEL 2

There are four factors that may limit a firm’s ability to follow its dividend policy:

      ●   Legal and mandated restrictions                                                                                                 .
          Lenders may impose restrictions on dividends to protect payments to debtholders.

      ●   Firm liquidity                                                 . The amount of cash on hand affects the firm’s ability to pay
          dividends.

      ●   Earnings volatility                                                    . If a firm has widely fluctuating earnings, it will
          likely maintain a low dividend payout ratio. If earnings are stable, the firm is in a better position to pay a larger
          percentage of its earnings as dividends.

      ●   Control                    . To maintain shareholder control, particularly in small- and medium-size firms, firms will
          maintain low payout ratios to retain earnings to meet investment needs.

In addition to the above considerations, there are two dominant features that influence dividend policy — stability and
industry norms. A discussion of each follows.

Stability

Observing the pattern of corporate dividends over time reveals preference for stability. Generally, a firm’s earnings fluctuate
more widely than its dividend payments. This happens for a number of reasons, including transaction costs and signalling.
With respect to transaction costs, most firms, irrespective of how long they have been established are continually investing in
new projects or reinvesting in maintaining or strengthening existing product lines. These expenditures can range from
research and development to simply replacing existing machinery. If the firm pays all earnings out as dividends, at some
point it would have to issue new equity to fund the portion of these expenditures not financed by debt. As raising equity
capital is an expensive and time-consuming proposition, it is imprudent to pay out all earnings as dividends.

Corporations also set their dividend payments lower than expected earnings to ensure the same dividend is paid irrespective
of earnings, as in the constant dollar payout policy. Firms resist cutting dividends to avoid conveying negative signals about
their prospects. This is consistent with the signalling hypothesis and expectations view of dividend policy.

Transaction costs and signalling are discussed on page 885 of the text.

Corporations also try to convey stability of earnings by keeping the frequency and the timing of dividend payments consistent
over time. The majority of dividend payments are made quarterly, although some firms pay dividends semi annually or
annually.

The proportion of earnings paid in dividends is generally a function of the firm’s maturity. As mentioned above, firms
generally need capital for investment or reinvestment irrespective of where they are in their life cycle. This need for capital is
most acute though in young, rapidly growing firms whose capital expenditures often exceed their net earnings. Clearly it does
not make sense to pay dividends when this would increases the firm’s need to raise capital by selling shares. One of the most
well known examples of "retain and grow" is Microsoft. Bill Gates and Paul Allen took Microsoft public on May 13, 1986, but
did not pay their first dividend until January 16, 2003 — almost 17 years later!

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The pattern of not paying dividends during the early stages of a firm’s life cycle may also be a sign of preference for stability.
During these early stages, earnings are highly uncertain and fluctuate widely from one year to the next. Thus, concerns
about stability prohibit the firm from paying dividends for fear that these dividends may have to be temporarily cut in the
future because of lack of earnings to support them.

Dividend stability and increasing dividend payouts over time are both signs of stability and high quality of earnings. Also,
dividend increases can have an immediate positive impact on share prices, as they tend to signal improved operations and
that management expects that the firm will remain sufficiently profitable to sustain the incremental payments on an ongoing
basis.

Industry norms

Financial managers often consult industry norms when setting their dividend policies. Empirical studies generally show that
dividend payout ratios vary across industries. This evidence suggests that the investment opportunities and business risk
facing a particular industry are important factors in determining dividend payout ratios. For example, a growing industry,
such as the software sector, is likely to be associated with low payout dividend policies. Such an industry needs funds for
investment and faces substantial business risk, both of which are reasons for low dividend payout ratios. Indeed, it is difficult
to find software companies paying any dividends.

In contrast, companies in a mature industry, such as telecommunications and other utility companies, or banks, can afford
higher payout ratios because of either relatively limited investment opportunities or lower business risk. As a proxy for the
level of dividend distribution among industries, Exhibit 7.3-1 shows the dividend yields for a sample of North American
companies in various industries: telecommunications, financial, software and other technologies.

Exhibit 7.3-1
Dividend yields for a sample of Canadian companies at March 9, 2010


       Telecommunications                                             Financial                            Software and other
            companies                                                companies                           technology companies
Company             Dividend yield                       Company              Dividend yield      Company              Dividend yield
BCE                     4.77%                            Bank of Montreal         4.37%           Apple Inc.                N/A
Rogers
Communications
Inc.                    3.46%                            Royal Bank                       3.41%   Microsoft Corp.          1.82%
                                                         Toronto Dominion
TELUS Corporation                     4.98%              Bank                             3.93%   Symantec Corp.            N/A

Source: Yahoo! Finance                                                     , March 9, 2010.




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7.4 Stock dividends and stock splits

     Learning objective

      ●   Describe how stock dividends and stock splits affect a shareholder’s position. (Level 2)


     Required reading

      ●   Chapter 22, Section 22.1, from “Dividend Reinvestment Plans …” to the end of the section (pages 864 – 866)

LEVEL 2

This topic introduces the concepts and characteristics of stock dividends and stock splits, and the differences in their
accounting treatment.

Ignoring tax effects, stock dividends and stock splits do not change a shareholder’s financial position. If you owned 10% of a
company before the dividend or split, you will still own 10% of the company afterwards. While you own more shares in the
company, there are also more shares outstanding, so your percentage of ownership remains unchanged. Moreover, cash has
not flowed from the company to you, so the composition of your wealth remains unchanged as well.

You should recall from your Financial Accounting
Fundamentals                                     (FA1       ) course that from an accounting perspective, a stock dividend
requires that a firm capitalize their earnings, that is to say that they transfer monies from the retained earnings account to
the share capital account. Stock splits do not require a supporting journal entry. Rather, a memorandum entry is required to
record the increase in the number of outstanding shares.




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7.5 Share repurchases

      Learning objective

      ●   Describe how share repurchases can serve as substitutes to cash dividends under perfect market conditions. (Level 2)


      Required reading

      ●   Chapter 22, Section 22.7 (pages 890 – 893)

LEVEL 2


A company may reacquire its shares by paying cash to shareholders in return for their share rights. Such share
repurchases decrease the number of shares outstanding. The repurchased shares that are held in the company treasury as
opposed to being immediately re-sold are called treasury shares. They are issued shares, but they are not counted as
outstanding.

In Canada, the practice is to retire treasury shares because companies registered under the Canada
Business Corporations Act                                                                  are discouraged from using
treasury shares. Furthermore, treasury shares do not have voting privileges and do not receive dividends. They are not
included in any of the ratios that measure values per common share, such as earnings per share.

Share repurchases as alternatives to cash dividends

When a firm has accumulated cash from earnings and wants to distribute the cash to shareholders, it can repurchase its own
shares in the open market instead of paying cash dividends. This causes the number of outstanding shares to decrease, and
both the book value and market value per share to increase. Example 7.5-1 demonstrates this point.

Example 7.5-1: Share repurchase and the dividend decision

Precision Calculation Instruments (PCI) has expected annual earnings of $45 in perpetuity. It has 100 shares outstanding and
no debt in its capital structure. The required return on equity is 10%. It also has $50 in cash surplus to its needs.

What is the market price per share?

The total value of the firm should be equal to the present value of the expected earnings capitalized at the 10% discount rate
plus the value of the surplus cash. Therefore, PCI’s total value is:

V = $45 ÷ 0.10 + $50 = $500

Given that the firm has 100 shares outstanding, the market price per share is $5.00.

What is the effect of a payment in cash dividends on share price?

After careful analysis, PCI realizes that keeping the cash serves little purpose, as the firm has had only minor emergencies in
the past. The firm announces plans to use the $50 surplus cash to pay dividends.

The announcement implies that PCI’s earnings will not be affected. The firm continues to earn $45 despite the payment of
$50 in dividends, as this cash will not be used in operations. Capitalizing the earnings at the 10% discount rate produces
$450 ($45 ÷ 0.10).

The $450 is the present value of PCI’s earnings. Because the number of outstanding shares remains 100, each share should
have at least $4.50 of value because of its entitlement to earnings. In addition, PCI has $50 in cash that will soon be paid in

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dividends. Each share will receive $0.50. Therefore, after the announcement and prior to the payment of the dividend, the
total market value per share will be $5. After the payment of the dividend, the price will drop to $4.50.

What is the effect of a share repurchase on share price?

Suppose that instead of announcing the payment of cash dividends, PCI announces that it will use the $50 in surplus cash to
repurchase shares. What will the market price per share be after the announcement?

The announcement implies that PCI’s earnings will not be affected by the repurchase plan. The firm continues to earn $45
despite using $50 in cash to repurchase shares. Capitalizing the earnings at the 10% discount rate produces $450 ($45 ÷
0.10).

The $450 is the present value of PCI’s earnings. Following the announcement and prior to repurchasing any shares from the
market, the number of outstanding shares remains 100. Thus, each share should have at least $4.50 of value because of its
entitlement to earnings. In addition, PCI has $50 in cash that will be used to repurchase shares. The present value of this
cash per share is $0.50. Therefore, after the announcement and prior to repurchasing shares from the market, the total
market value per share will be $5.

Using the $50, PCI can purchase 10 shares. The firm will have 90 shares outstanding, and these shares will be entitled to $45
of earnings. Capitalizing these earnings at 10% yields $450 or $5 per share.

Ignoring tax-effects, the shareholder’s wealth is the same irrespective of whether PCI retains the excess cash, pays it out as
a cash dividend, or uses it to repurchase shares.

      ●   If PCI retains the cash, the shareholder owns a share worth $5.00.

      ●   If PCI pays a cash dividend, the shareholder’s wealth is $5.00 comprised of the $0.50 cash from the dividend and a
          share worth $4.50 after the dividend.

      ●   If PCI repurchases shares, the shareholders who tender (sell) their shares receive $5.00. Those who hold onto them
          own a share worth $5.00.

Implications for dividend policy

In the context of perfect capital markets, both methods of distribution, cash dividends and share repurchases, have an
identical effect on shareholder wealth. Taxes and transaction costs do exist, though. In the presence of these costs, there is
no clear answer as to which is the most cost-effective manner of distribution for the investor as it depends on who is
receiving the benefit, their marginal tax bracket, and what province they live in. For example, for individuals who are in the
top marginal tax bracket, Exhibit 7.5-1 suggests that residents of BC, Alberta, and Ontario would prefer to receive dividends,
while those who live in Quebec would prefer the capital gains that would result from a share buyback.

Exhibit 7.5-1

2010 top combined marginal tax rates*


                             Ordinary income**                     Capital gains          Eligible dividends***
British Columbia             43.70%                                21.85%                 21.45 %
Alberta                      39.00%                                19.50%                 15.88 %
Ontario                      46.41%                                23.20%                 26.57 %
Quebec                       48.22%                                24.11%                 30.68 %


*   Includes federal and provincial rates
** Includes salary and interest
*** Expressed as a percentage of actual dividends




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7.6 Types of leases

     Learning objective

      ●   Describe the different types of leases and how a firm evaluates the leasing decision. (Level 2)


     Required reading

      ●   Chapter 16, Sections 16.1, 16.2, and 16.4 (pages 632 – 640 and 650 – 653)

LEVEL 2

A lease is an arrangement in which the lessor, the entity or individual who owns the asset, makes the asset available to the
lessee, the individual who will have the full use of the asset, in return for periodic lease payments. Leasing allows the lessee
to obtain the right to use an asset without having to own it. It is an alternative to borrowing and owning an asset.

Text Section 16.1 discusses the different types of leases. Section 16.2 looks at the accounting and tax treatments of leases.
Finally, Section 16.4 examines why firms enter into leasing arrangements.




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7.7 Analyzing the lease versus buy decision

      Learning objective

      ●   Explain the lease versus buy decision using the equivalent loan approach, and use a spreadsheet application to
          evaluate the leasing decision. (Level 1)


      Required reading

      ●   Chapter 16, Section 16.3 (pages 641 – 649)

LEVEL 1

In this topic, you learn how to analyze the lease versus buy decision.

While the terminology is slightly different, the computer activity that follows is very similar in structure to Example 16-6 in the
text on pages 646 – 648. The primary differences in terminology are as follows:

Text                                                             Module Notes
NPV (leasing)                                                    NVL
CF0                                                              Initial cash outlay
PV (maintenance savings)                                         PV (incremental differences in after-tax operating costs or other
                                                                 costs between the borrowing and leasing alternatives)*
PV (foregone depreciation tax savings)                           PV (CCA tax shields)*
PV (foregone salvage value)                                      PV (salvage value)*
PV (after-tax lease payments)                                    PV (after-tax leasing payments)*

The asterisked terms "*" above are component parts of the equivalent loan discussed in the Module Notes. This is an interim
step that the text does not use.

Computer illustration 7.7-1 shows you how to determine the equivalent loan and net value to leasing (NVL). The commentary
explains how to calculate each component of the after-tax cash outflows under the lease option. For assignment and
examination purposes, know how to use the equivalent loan approach.

Computer illustration 7.7-1: Equivalent loan approach to financing

In this exercise, you will analyze the decision on whether to lease or to purchase by borrowing, by calculating the amount of
the equivalent loan and the NVL. This approach identifies an equivalent loan that commits the firm to the same cash flows, as
would the lease.

Cold Cutts Incorporated (CCI) has decided to acquire refrigeration equipment for its new store in downtown Calgary. An NPV
analysis indicates that the acquisition creates shareholder wealth. To minimize the firm’s costs, Mr. Cutts, owner and
manager, wants to evaluate whether to purchase by borrowing or to lease the new refrigeration equipment.

If CCI decides to borrow to buy, Mr. Cutts expects that the CCA class will be kept open after the refrigeration equipment is
sold. Annual operating costs for the buying alternative are paid at the end of each year. Under the leasing alternative, the
lessor maintains the machine and pays any costs related to insurance, delivery, and installation.

For the leasing alternative under consideration, annual payments are made at the beginning of each year, with the first
payment due on delivery and installation of the refrigeration equipment.

The following data relates to this lease/borrow decision:



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Cost                                                                         $126,000
Delivery and installation                                                      $6,000
Investment tax credit to purchase
equipment                                                                     $20,000
CCA rate (Class 8)                                                                 20%
Useful life                                                                   10 years
Salvage value                                                                 $25,000
Annual operating costs for buying
alternative                                                                    $12,000
CCI’s tax rate                                                                      30%
Borrowing alternative: 10-year term loan                                             9%
Leasing alternative: 10-year financial lease                                   $13,500/year

Determine whether Mr. Cutts should lease or borrow to buy the new refrigeration equipment, by calculating the following:

     1.   initial investment outlay of the refrigeration equipment
     2.   present value of the after-tax lease payments
     3.   present value of the after-tax operating costs that will be incurred under the borrowing option
     4.   present value of the CCA tax shields
     5.   present value of the salvage value
     6.   amount of the equivalent loan
     7.   net value to leasing (NVL)

Procedure

     1. Open Excel file FN1M7P1 and click the worksheet tab M7P1. The data table in rows 4 through 15 contains the
        information given for CCI. The after-tax bank loan rate is calculated in cell C14. Rows 18 to 47 are set up for you to
        calculate the amount of the equivalent loan and the NVL.

     2. Referencing the values in the data table, enter formulas in columns D and E to calculate the following:

               1. initial investment outlay (cell E24)
               2. PV of the after-tax lease payments (cell E28). Remember that lease payments are due at the beginning of the
                  year.
               3. PV of the annual after-tax operating costs under the borrowing option (cell E33)
               4. PV of lost CCA tax shields (cell E38)
               5. PV of lost salvage value (cell E41)
               6. amount of the equivalent loan (cell E44)
               7. the net value to leasing (cell E47)
     3. Click the sheet tab for M7P1S and compare the solution to your worksheet. Reconcile any differences.

Explanation of calculations1

     1. Initial investment outlay = purchase price + delivery and installation cost – investment tax credit = $126,000 +
        $6,000 – $20,000 = $112,000

          In terms of leasing, the initial investment outlay of owning the asset represents a savings to the lessee. The lessee
          does not have to buy the asset for cash. Delivery and installation costs are included in the purchase cost if the lessor
          agrees to deliver and install the equipment.

     2. The first step in determining the costs of leasing is to calculate the present value of the after-tax lease payments.
          The lease payments are deducted from income as expenses. Thus, they lead to tax savings, and you use the after-tax
          costs to calculate the present value.
          The discount rate required to calculate the present value of lease payments is the after-tax cost of borrowing. As the
          bank is willing to lend at 9% for CCI to acquire the machine, the after-tax cost of borrowing is

          9.00% (1 – 0.30) = 6.30%
          Because most lease contracts require the lessee to make the first lease payment at the beginning of the lease period,
          you calculate the present value of the after-tax lease payments as the present value of an annuity due.
          The annual after-tax lease payment is



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         $13,500 (1 – 0.30) = $9,450
         PV of the lease payments = $9,450 × PVIFA(6.3%, 10) × (1 + 0.063) = $72,895

         Using a financial calculator:                                                                         Set mode =
         BGN; PMT= 9,450; I/Y = 6.3; N = 10; FV = 0; CPT PV = $72,895

     3. Next, calculate the present value of the after-tax operating costs that CCI would incur under the borrowing option.
         Sometimes, the lessor may agree to service and maintain the equipment without direct charges associated with these
         services. In this case, the costs of operating the equipment are less than the costs of operating under ownership and
         represent savings under the leasing option. Other costs that may be incurred with owning but not with leasing include
         property taxes and insurance.
         The operating cost savings are relatively certain and occur at the end of the year.

         The annual after-tax operating cost savings is

         $12,000 (1 – 0.30) = $8,400
         PV of the operating costs under the borrowing option = $8,400 × PVIFA(6.3%, 10) = $60,955

         Using a financial calculator:                                                                         Reset mode =
         END; PMT= 8,400; I/Y = 6.3; N = 10; FV = 0; CPT PV = $60,955

     4. The third step is to determine the present value of the CCA tax shields. This is calculated as the present value of the
        perpetual tax shield (PVTS) minus the present value of the lost tax shield when the machine is sold (PVTSL). These
        equations were introduced in Module 4. (See also top of page 648 in the text.)




         The present value of tax shield lost if CCI leases the refrigeration equipment is
         $24,794 - $3,096 = $21,698

     5. The fourth step is to calculate the present value of the $25,000 salvage value.



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         PV of the salvage value = $25,000 × PVIF(6.3%,10) = $13,571

         Using a financial calculator:                                                                        PMT= 0; I/Y =
         6.3; N = 10; FV = 25,000; CPT PV = $13,571

     6. The equivalent loan represents the maximum amount that the lessee can borrow if the firm dedicates its future
        incremental cash flows to service a conventional loan. The amount of the equivalent loan includes cash flows
        resulting from leasing payments less any incremental difference in operating or other expenses between the
        borrowing and leasing alternatives. In other words, it represents the incremental after-tax operating savings because
        of the leasing alternative. The equivalent loan amount also includes the present value of the CCA tax shields and the
        present value of the salvage value because these cash flows would normally be used to service a conventional loan.

          Equivalent loan               = PV(after-tax leasing payments)
                                             – PV(incremental difference in after-tax operating costs or other costs
                                             between the borrowing and leasing alternatives)
                                             + PV(CCA tax shields)
                                             + PV(salvage value)


          Equivalent loan               = $72,895 – $60,955 + $21,698 + $13,571 = $47,209

     7. The net value to leasing (NVL) = Initial investment outlay – equivalent loan

         NVL = $112,000 – $47,209 = $64,791

         Because the amount that could be borrowed under the equivalent loan ($47,209) is less than the initial investment
         outlay ($112,000) saved under the lease, leasing is preferable to purchase by borrowing. The NVL is $64,791.

Summary

Computer illustration 7.7-1 demonstrates the equivalent loan approach that you can use to make the decision whether to
borrow and buy or to lease. The decision focuses on identifying an equivalent loan that commits the firm to exactly the same
cash flows as it would incur in the leasing alternative.

You should first conduct a cost/benefit analysis to establish that the acquisition creates shareholder wealth. If the amount
that could be borrowed under the equivalent loan is more than the initial investment outlay saved under the lease, then
borrowing to purchase is preferable to leasing. If the amount that could be borrowed is less than the initial investment outlay
saved under the lease, then leasing is preferable. If the amount that could be borrowed is equal to the initial investment
outlay saved under the lease, then the firm will be indifferent in its choice between leasing and borrowing to purchase.

The difference between the initial investment outlay and the equivalent loan is equal to net value to leasing (NVL). The
equivalent loan approach has the added advantage in indicating the amount of conventional debt that lease financing can
displace. In Computer illustration 7.7-1, leasing displaces $47,209 in conventional debt.




1 Because salvage value is considered to be the only risky cash flow in leases, some finance texts use a higher discount rate
for salvage value (such as WACC) than the after-tax cost of debt. For this course, follow the text method in Example 16-6 on
pages 646 – 648 and use the after-tax cost of debt to discount all cash flows.




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Module 7 summary
Dividend policy and leasing
Describe how firms determine, declare, and pay dividends.

      ●   Factors that influence a firm’s dividend policy include:
               r  the firm’s investment opportunities
               r  the investor’s other investment opportunities
               r  the tax implications
               r  the investor’s current consumption needs

      ●   Key dates for declaring and paying dividends:
               r announcement date
               r record date
               r ex-dividend date
               r dividend-on date
               r payment date

      ●   Capital gains are generally taxed at a lower effective rate than dividend income, and the investor has the ability to
          defer capital gains.

      ●   Low dividend paying stocks provide the opportunity for higher capital gains and less dividend income than stocks
          paying high dividends.

      ●   The impact of taxes is complicated by the existence of tax-exempt institutional investors and individual investors who
          prefer capital gains.

      ●   The clientele effect suggests that investors will invest in shares that suit their tax needs.

      ●   The “bird in hand” concept suggests that dividend payments are considered to be a less risky return than share price
          appreciation.
      ●   In perfect markets with no transaction costs, investors who do not like a firm’s dividend policy can create “homemade
          dividends” to compensate for the firm’s dividend policy.

      ●   The three forms of dividends are:
               r regular cash dividends
               r extra or special cash dividends
               r stock dividends

      ●   Changes in dividends are considered to signal useful information to investors concerning a firm’s future prospects.

      ●   The quality of the information contained in dividend changes depends on the pattern of dividends established by a
          firm.

      ●   An increase in the current dividend payout is viewed as a message that management anticipates a permanently
          higher level of cash flows from investment.

      ●   An increase in dividend is often accompanied by an increase in share price.

Describe three alternative dividend policies: constant dividend payout ratio, residual
dividends, and constant dollar dividends.

      ●   Constant dividend payout ratio policy: The firm pays out the same percentage of earnings in dividends.

      ●   Residual dividend policy: The firm pays out dividends equal to its free cash flow, which is cash not needed for
          financing projects.

      ●   Constant dollar dividend policy: The firm pays out the same dollar amount per outstanding common share each
          period (often quarterly).

Describe factors that affect dividend policy.


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      ●   Legislative authorities may impose legal restrictions.

      ●   Investors may impose restrictive constraints in the form of protective covenants included in debt and preferred share
          contracts.

      ●   There may be restrictions on cash distributions because of the lack of liquidity.

      ●   The volatility of a firm’s earnings may constrain the firm from increasing dividends.

      ●   Two dominant features that influence dividend policy are stability and industry norms.
      ●   Firms resist cutting dividends to avoid conveying negative signals about their prospects.

      ●   Firms avoid paying dividends during the early stages of their life cycles.

Describe how stock dividends and stock splits affect a shareholder’s position.

      ●   Stock dividends are additional shares of stock distributed to existing shareholders in place of cash dividends.

      ●   Firms often maintain the cash dividend per share following a stock dividend.
      ●   A stock split increases the number of shares outstanding without issuing new shares and selling them in the market.

      ●   Stock splits are often accompanied by an increase in total dividends.

      ●   Stock dividends and stock splits do not change a shareholder’s ownership of the firm.

Describe how share repurchases can serve as substitutes to cash dividends under perfect
market conditions.

      ●   Share repurchases decrease the number of shares outstanding and lead to a higher market price per share.

      ●   Treasury shares are repurchased shares held in the firm’s treasury and not immediately re-sold.

      ●   Shareholders who wish to receive cash can sell a portion of their holdings to substitute for the cash dividend.

      ●   Share repurchases are perfect substitutes for cash dividends when markets are perfect.

      ●   Shareholders who pay higher taxes on dividends than on capital gains prefer stock repurchases to dividends.

      ●   Reasons a firm may wish to repurchase its shares:
              r  offset the exercise of executive stock options to maintain a constant number of outstanding shares
              r  re-align the firm’s capital structure
              r  send a market signal that management considers the firm’s share value underpriced
              r  repurchase shares of dissident shareholders
              r  return cash to shareholders without creating future dividend expectations
              r  take the firm private

      ●   In an open market purchase, the firm acquires shares at the going market price.

      ●   In an offer to purchase, shareholders tender their shares at a premium within a particular time period.

      ●   In a negotiated purchase, the firm purchases a large block of shares from one or more holders on a negotiated basis.

Describe the different types of leases and how a firm evaluates the leasing decision.

      ●   Leasing uses up the firm’s debt capacity in the same manner as debt.
      ●   Lease payments magnify the variability of the net cash flows to shareholders.

      ●   Leasing allows the lessee to avoid the investment outlays that would be required to purchase.

      ●   Leasing requires periodic cash outflows similar to those required to service debt.

      ●   The entire periodic lease payment can be claimed as a tax-deductible expense.


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      ●   Lessees cannot claim capital cost allowances on the leased equipment.
      ●   The lessee loses the advantages derived from the asset’s residual value.

      ●   In an operating lease, the lessor is entitled to claim capital cost allowance for the equipment.
      ●   The leased equipment provides more security than a mortgage, enabling risky customers to qualify for leasing.

      ●   Costs of leasing may be lower than borrowing.

      ●   Leasing may allow a firm to finance the acquisition of equipment, in spite of restrictive covenants included in the
          firm’s loan agreements or bond indentures.

Explain the lease versus buy decision using the equivalent loan approach, and use a
spreadsheet application to evaluate the leasing decision.

      ●   Identify the costs and benefits of leasing, as opposed to those of borrowing to buy.

      ●   Discount the incremental costs and benefits of leasing at the after-tax cost of debt.
      ●   Identify an equivalent loan that exactly commits the firm to the same cash outflows that the lease would.

      ●   Leasing is preferable to borrowing, if the amount of the equivalent loan is less than the initial investment outlay saved
          under the lease.

      ●   A positive net present value of leasing means the firm should lease rather than borrow to buy.




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Module 7 self-test
Question 1

Multiple choice

     1. Which of the following is the date after the dividend-on date?
            1. announcement date
            2. payment date
            3. record date
            4. ex-dividend date

     2. Which of the following statements applies to dividend payment procedures?
            1. Once management approves a dividend payment, the firm announces the dividend on the announcement
               date.
            2. An investor who sells a share on the ex-dividend date will receive the dividend payment, although the
               investor no longer owns the share.
            3. The firm transfers the dividend amount from retained earnings to an accrued liability on the ex-dividend date.
            4. Dividend cheques are mailed on the record date to the holders of record.

     3. Melba Corporation declared a dividend for shareholders of record Thursday, April 24, 20X9 payable on Friday, May
        16, 20X9. Which of the following statements is true?
            1. The ex-dividend date is Tuesday, April 22, 20X9.
            2. The ex-dividend date is Friday, April 25, 20X9.
            3. The ex-dividend date is Monday, April 21, 20X9.
            4. The ex-dividend date is Wednesday, May 14, 20X9.
     4. Which of the following statements best describes the meaning of the ex-dividend date for common shares?
            1. It is the date on which the amount of dividends per share is announced.
            2. It is the date of approval of a dividend by the company’s board of directors.
            3. It is the date that determines whether a buyer of a new share is entitled to the dividend.
            4. It is the date the dividend is paid.

     5. Which of the following statements regarding dividend policies in practice is true?
            1. A company’s maturity has no influence on the proportion of earnings paid in dividends.
            2. Mature companies often pay out a small percentage of their earnings as dividends.
            3. The average growing company in high technology industries is likely to keep a high proportion of earnings to
               finance new projects.
            4. The amount of retained earnings determines a firm’s ability to pay dividends.

     6. What will a company be paying when it announces a “special” dividend for common shareholders?
           1. An extra cash dividend over and above the regular dividend
           2. A dividend higher than that paid by other firms in the industry
           3. A large dividend early in the year that may result in a reduction in remaining dividends during the same year
           4. A dividend paid in the form of common shares, rather than cash
     7. Which of the following dividend policies is likely to provide common shareholders with the most stable dividend
        income?
            1. Constant dividend payout ratio policy
            2. Residual dividend policy
            3. Constant dollar dividend policy
            4. Constant dollar dividend policy plus extras

     8. When the rate of return that the firm can earn on reinvested earnings exceeds the rate of return that investors can
        obtain on their own, what is the optimal dividend policy according to the residual dividend policy approach?
            1. 100% earnings retention and zero dividends
            2. 0% earnings retention and pay out all earnings as dividends
            3. Pay out dividends as a constant percentage of earnings
            4. Pay out dividends as a residual, after financing all positive NPV investment projects

     9. What is the effect of a share repurchase on the share price?
           1. an immediate increase in the market price per share
           2. an immediate decrease in the market price per share
           3. a decrease in the market price per share in the long run
           4. no effect


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   10. Which of the following statements best describes an advantage of share repurchases as an alternative to cash
       dividends?
            1. The firm may bid up the share price, paying too much for the shares to the selling shareholders.
            2. Shareholders have a choice with a share repurchase — they can tender their shares or they can refuse to
               tender.
            3. The firm can use a share repurchase program to signal to investors that shares are currently overvalued.
            4. An unexpected share repurchase will alter the market's expectations regarding future dividends.
   11. Which of the following statements best describes the main features of an operating lease?
           1. The lessee pays property taxes and insurance on the asset.
           2. The term of the agreement is the useful life of the asset.
           3. Some leases require the lessor to handle all maintenance and servicing.
           4. The lessee has no recourse in returning the equipment to the lessor if it becomes obsolete or is no longer
              needed.

   12. Which of the following statements best describes the general benefits of leasing?
           1. Operating leases enable the lessor to claim the investment tax credits and tax deductions associated with
              ownership.
           2. Leasing is always cheaper than borrowing and buying because the lessee can claim the entire lease payments
              as expenses.
           3. Lessees can provide certain types of leased equipment as security for mortgages.
           4. Leasing provides similar benefits regardless of whether the lease is classified as operating or capital.

   13. Which of the following statements about operating leases is true?
           1. They are usually not cancellable.
           2. They generally encompass the entire life of the project.
           3. They generally require that the lessor handle all maintenance and servicing.
           4. The lease payments are sufficient to amortize the full purchase price of the asset.
   14. Which of the following statements about capital leases is false?
           1. A capital lease can be a substitute for debt.
           2. Capital leases are financial leases.
           3. Lease payments amortize the full purchase price of the asset.
           4. Capital leases only need to be reported in the notes to the financial statements.

Solution

Question 2

Sunshine Sideways (SS) has 7.5 million shares outstanding with a current market price of $16 per share. The firm's expected
earnings are $15.6 million in perpetuity. The firm can reinvest the annual earnings in a new project, which will provide $2.34
million in perpetuity. Alternatively, it can pay the earnings in dividends and sell shares to finance the new project. The firm
pays dividends, if any, once a year at the end of the fourth quarter. The firm is financed with 100% equity and pays no
taxes.

Belinda owns 25,000 shares of SS.

     1. What is SS’s value before announcing the new project?

     2. What is the required rate of return on equity?
     3. What are SS’s expected earnings after undertaking the project?

     4. What is SS’s market value after capitalizing these earnings at the required rate of return?
     5. What is SS’s market value after the dividend payment?

     6. What is Belinda’s total wealth after the dividend payment?
     7. If SS pays $15.6 million in dividends, how many shares should SS sell in order to make up this amount for the
        financing of the new project?

     8. What is the value of Belinda’s shares if SS pays no dividends and uses earnings to finance the new project?

     9. Belinda needs $52,000 in cash. Assuming SS does not pay a dividend, how many shares will Belinda have to sell to
        create her own homemade dividends (ignoring transaction costs)?


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Solution

Question 3

Exhibit OEI-1 shows the owners’ equity accounts of Oakville Engineering Incorporated (OEI).

Exhibit OEI-1
OEI’s equity portion of the balance sheet


Common stock
(10 million shares outstanding)                                                       $10 million
Retained earnings                                                                     $50 million
Total                                                                                 $60 million

OEI’s expected earnings are $12 million in perpetuity. Currently, OEI’s common stock sells for a market price of $20 per
share. Yuen owns 1,000 shares.

     1. Compare Yuen’s wealth under the following two situations:

         Situation 1: OEI does not declare any dividends.
         Situation 2: OEI declares a 20% stock dividend.
     2. Suppose that OEI has excess cash equal to $2 million. How are the value of the firm, the market price per share, the
        number of shares outstanding, and Yuen’s wealth affected under the following two situations:

         Situation 1: OEI pays out the $2 million as cash dividends to shareholders.
         Situation 2: OEI uses the $2 million to repurchase shares.

     3. Why might OEI choose cash dividends over stock dividends, or vice versa?

Solution

Question 4

Artemis Company has a policy of maintaining a debt-to-equity ratio of 40%. Management has approved three new
investment projects that will require a total investment outlay of $1,000,000. The firm’s WACC is 10%, and it has net
earnings of $750,000. Artemis follows a residual dividend policy. It is considering whether to maintain this policy, or to
conserve cash and substitute a stock dividend or a stock split for the cash dividend this year.

     1. Under current policies, what amounts of debt and equity should Artemis use to finance the three projects, and how
        will it finance these amounts?

     2. Calculate the firm’s cash dividend payment for this year.

     3. What is the most that Artemis can invest if it pays no cash dividend this year?
     4. How much new debt must Artemis issue in order to maintain the 40% debt-to-equity ratio?

Solution

Question 5

     1. Explain what a stock dividend is and how it is recognized in a company’s books.
     2. Explain what a stock split is and how it is recognized in a company’s books.

Solution




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Question 6

ARB Inc. had 750,000 outstanding common shares, and paid $5 per share in dividends last year. The current share price is
$30. For the past five years, ARB maintained a policy of paying out 80% of earnings as cash dividends. Exhibit ARB-1
contains the projected balance sheet for ARB for the upcoming year end, assuming no dividends. Earnings after tax are
projected at $4.5 million.

Exhibit ARB-1
ARB Inc. Projected Balance Sheet (assuming no dividends)
December 31, 20X9

Assets

Current assets
Cash                                                          $ 6,000,000
Accounts receivable                                             1,200,000
Inventories                                                     1,750,000
                                                                8,950,000
Equipment                                                    2,570,000
Land                                                         1,580,000
                                                           $13,100,000
Liabilities and shareholders'
equity

Current liabilities
Accounts payable                                               1,700,000
Notes payable                                                    650,000
                                                               2,350,000
Long-term debt                                               2,500,000
Common shares                                                  750,000
Retained earnings                                            7,500,000
                                                           $13,100,000

     1. If ARB maintains its steady 80% cash dividend payout policy, what is the total cash dividend payout and what
        dividend payment will a holder of 100 common shares receive? What is ARB’s total-debt-to-total-equity ratio following
        the payout?

     2. Suppose that ARB retains all of its cash in order to finance a purchase of a large piece of real estate that it will use
        for future development of a new manufacturing plant. Instead of a cash dividend, the company will pay a 20% stock
        dividend. Assess the impact of a stock dividend as follows:

               1. What will the holder of 100 common shares receive?
               2. How will the balance sheet change, given the stock dividend, and what is the total-debt-to-total-equity ratio if
                  earnings are projected to be unchanged after the real estate purchase?
               3. What can this same shareholder expect to receive in cash dividends next year if ARB returns to its steady
                  80% cash dividend payout policy?

     3. Suppose that ARB has no investment plans and would like to pay out 80% of its earnings to shareholders in the form
        of a share repurchase this year, and then return to its policy of paying cash dividends in future years. Earnings are
        projected to be unchanged. Assess the impact of a share repurchase as follows:
               1. Calculate the number of shares ARB can repurchase if the share price remains at $30.
               2. Calculate the number of shares that will remain outstanding.
               3. In the next year, when cash dividends are resumed, calculate the per share dividend and the amount of
                  dividends the original or former holder of 100 shares will receive.
     4. Referring to your calculations in parts (a) to (c), briefly explain which of the three policies would be most attractive to
        ARB’s shareholders.

Solution

Question 7



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Whenever available, a firm should use its after-tax cost of secured debt to discount lease payments. What is the justification
behind this recommendation?

Solution

Question 8

Interprovincial Regional Airline (IRA) has decided to acquire a regional jet from an airplane manufacturer. The jet has an
initial purchase price of $15 million. Company management now needs to determine whether it should buy or lease the jet.

If IRA purchases the jet, there is a Federal government one-time subsidy of $500,000 to apply to the purchase price of the
jet. The company would finance the purchase with a $15 million bank installment loan at an interest rate of 12% and 10
years to maturity. IRA would incur costs associated with maintenance and insurance of $300,000 per year.

If IRA acquires the jet by leasing from the airplane manufacturer, it would have to pay lease payments of $2.5 million per
year over 10 years, with the lease payments payable in advance. For the duration of the jet’s lease, the manufacturer would
pay the maintenance and insurance costs.

The salvage value of the jet after 10 years is expected to be $1 million. IRA has a corporate tax rate of 35%. Assume the
CCA rate is 25%.

     1. Calculate the initial outlay for the jet.

     2. Calculate the present value of the lease payments after taxes.

     3. Calculate the after-tax operating costs.

     4. Calculate the present value of the CCA tax shields over the expected life of the jet.

     5. Calculate the present value of the salvage value lost by leasing.

     6. Calculate the value of the equivalent loan.

     7. Calculate the net value to leasing and conclude whether IRA should purchase or lease the jet.

Solution

Question 9

Sally Industries (SI) has decided to replace a major piece of industrial equipment and must now decide how to finance the
acquisition. The equipment costs $690,000 to purchase and install and is expected to have a useful life of five years. At that
time it will be sold on the open market and is expected to have a salvage value of $200,000.

The new equipment will be one of a large group of assets with a CCA rate of 20%. As this equipment is involved in SI’s main
line of business, the asset class is expected to always contain assets and to have a positive balance.

One financing alternative is a bank loan at the rate of 7% per annum, which is consistent with current debt. Another
alternative is to lease the equipment for $200,000 per year for five years with the payments at the start of each year. The
corporate tax rate is 40%. If SI leases the asset, it will not be responsible for maintenance and insurance costs of $40,000
per annum due at year end, but it will have the same basic operating costs as if it had purchased the equipment. If the firm
purchases the equipment, it will be entitled to an investment tax credit of 5% of the purchase price.

     1. Calculate the net value to leasing this piece of equipment; specifically, calculate and identify the initial investment
        outlay and the equivalent loan.

     2. Summarize your analysis and recommend how SI should finance its equipment acquisition.

Solution




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Self-test 7

Question 1 solution

    1.   4)   Topic   7.1
    2.   2)   Topic   7.1
    3.   1)   Topic   7.1
    4.   3)   Topic   7.1
    5.   3)   Topic   7.3
    6.   1)   Topic   7.1
    7.   3)   Topic   7.2
    8.   4)   Topic   7.2
    9.   1)   Topic   7.5
   10.   2)   Topic   7.5
   11.   3)   Topic   7.6
   12.   1)   Topic   7.6
   13.   3)   Topic   7.6
   14.   4)   Topic   7.6




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Self-test 7

Question 2 solution

     1. Total market value before announcing the project

         = price per share × outstanding shares
         = $16 × 7.5 million = $120 million
     2. The calculated total market value is a result of the $15.6 million of perpetual earnings.

         Required rate of return on equity
         = $15.6 million ÷ $120 million = 13%

     3. Total expected earnings = $15.6 million + $2.34 million = $17.94 million
     4. Market value at required rate of return = $17.94 million ÷ 13% = $138 million
     5. Market value = $138 million - $15.6 million = $122.4 million

     6. Dividend payment per share = $15.6 million ÷ 7.5 million = $2.08

         Belinda’s dividend payment = 25,000 × $2.08 = $52,000
         Price per share = $122.4 million ÷ 7.5 million = $16.32
         Belinda’s total wealth = $52,000 + ($16.32 × 25,000) = $460,000

     7. SS should sell $15.6 million ÷ $16.32 = 955,883 shares

     8. Price per share if SS retains all earnings = $138 million ÷ 7.5 million = $18.40

         Belinda’s shares are worth 25,000 × $18.40 = $460,000

     9. Belinda will need to sell $52,000 ÷ $18.40 = 2,826 shares




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Self-test 7

Question 3 solution

     1. Situation 1: OEI does not declare any dividends.

         Yuen owns 1,000 shares at a market price of $20 per share. If OEI does not declare any dividends, neither the
         market price per share nor the number of shares outstanding changes. Yuen’s wealth is
         1,000 × $20 = $20,000

         Situation 2: OEI declares a 20% stock dividend.
         If OEI declares a 20% stock dividend, the number of shares outstanding increases by 20%. Thus, the number of
         shares outstanding is

         10 million × 1.2 = 12 million shares
         Because OEI’s earnings potential does not change, its market value remains unchanged. OEI’s original market value
         was $200 million (10 million shares each worth $20). The new market price per share is

         $200 million ÷ 12 million = $16.6667

         After the stock dividend is declared, Yuen owns 1,000 × 1.20 = 1,200 shares, each worth $16.67. Yuen’s wealth is
         1,200 × $16.6667 = $20,000.

         Comparison: Yuen’s wealth is the same whether OEI declares a stock dividend or not.

     2. Situation 1: OEI pays out the $2 million as cash dividends to shareholders.
         OEI’s earnings are not affected by the announcement. The company continues to earn $12 million in perpetuity, and
         its value remains unchanged at $200 million. The number of outstanding shares remains at 10 million. Each share has
         a value of at least $20 because of its entitlement to earnings. In addition, $2 million of cash soon to be paid in
         dividends adds $ 0.20 ($2 million ÷ 10 million shares) to the value of each share. Therefore, after the announcement
         and prior to the payment of the dividend, the total market value per share is $20.20. Yuen’s wealth is $20.20 × 1,000
         shares = $20,200.

         After the dividends are paid, OEI’s market value remains at $200 million and the number of shares outstanding
         remains unchanged at 10 million. The market price per share drops back to $20.00 to reflect only the entitlement of
         each shareholder to future earnings. Yuen’s wealth will consist at that time of the dividends paid on 1,000 shares
         which is $200 (1,000 × $2 million ÷ 10 million) plus the value of 1,000 shares at $20,000 (1,000 × $20) for a total of
         $20,200.

         Situation 2: OEI uses the $2 million to repurchase shares.

         As in situation 1, the market value per share is $20.20 after the announcement and prior to repurchasing shares from
         the market.

         OEI could buy back $2 million ÷ $20.20 = 99,009.90 rounded to 99,010 shares. The number of shares outstanding is
         then 10 million – 99,010 = 9,900,990.

         Because Yuen owns 1,000 shares at $20.20 per share, her wealth is 1,000 × $20.20 = $20,200.

         Comparison: Yuen’s wealth is the same whether OEI distributes the $2 million as a dividend or uses the cash to
         repurchase shares.
     3. Stock dividends do not use cash, and therefore preserve liquidity.

         Investors generally prefer cash dividends to stock dividends.
         Because issuing stock dividends rather than cash dividends may be associated with financial difficulties, investors
         tend to view stock dividends as a negative sign.

         If stock dividends are issued and shareholders want cash, they can sell their additional shares.
         Stock dividends are usually more expensive to administer than cash dividends.


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Self-test 7

Question 4 solution

     1. Artemis follows a residual dividend policy, and it maintains a 40% debt-to-equity ratio. It must finance $1,000,000 for
        the three new projects with this debt-to-equity ratio.

         Given D/E = 0.40, then D = 0.40E and E + D = 1.40E
         E = $1,000,000 ÷ 1.40 = $714,286
         The amount of $714,286 is what Artemis should finance from current earnings attributable to common shareholders.
         The company should raise the remaining $285,714 by issuing new debt.
         To confirm: 285,714 ÷ 714,286 = 40%

     2. Artemis has $750,000 current earnings available to common shareholders and requires $714,286 of equity financing
        for its new investments. The company can pay out the remainder as dividends:
         $750,000 – $714,286 = $35,714

     3. If Artemis pays no dividends to its shareholders and invests all $750,000 of earnings in new projects, then the most it
        can invest is

         $750,000 ÷ 0.714286, or $750,000 (1.40) = $1,050,000
     4. New debt of $750,000 × 0.40 = $300,000 is required to maintain a 40% debt-to-equity ratio.




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Self-test 7

Question 5 solution

     1. A stock dividend is the distribution of additional shares to existing shareholders. There is no cash involved; instead,
        there is an accounting transfer or capitalization from the retained earnings account to the common share account.
        The number of outstanding shares increases, but there is no change in the total value of equity — it is just distributed
        proportionately to its existing shareholders.
     2. A stock split is an action taken to increase the number of shares outstanding without issuing new shares. A firm
        issues new shares and distributes them to current shareholders in proportion to shareholders’ ownership in the
        original shares. The book value of shares is split to reflect the new number of shares. Total shareholders’ wealth and
        firm value are unaffected.




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Self-test 7

Question 6 solution

     1. Under the cash dividend policy, ARB Inc. will pay out 80% of earnings as dividends. Earnings are projected to be
        $4,500,000, and there are 750,000 shares outstanding.

          Total cash dividends is 0.80 ($4,500,000) = $3,600,000
          Dividend per share is $3,600,000 ÷ 750,000 = $4.80

          A holder of 100 shares will receive $480.
          The cash dividends will reduce retained earnings to
          $7,500,000 – $3,600,000 = $3,900,000
          Total-debt-to-total-equity ratio is
          ($2,350,000 + $2,500,000) ÷ ($750,000 + $3,900,000) = 1.043

               1. If ARB retains all of its cash and pays a 20% stock dividend, the number of common shares outstanding will
                  increase to 750,000 (1.20) = 900,000 shares.

                    A holder of 100 shares will receive 20 additional common shares.

               2. There is a transfer from the retained earnings account to the common shares account, equal to 20% of the
                  market value of all outstanding shares:

                    0.20 ($30) (750,000) = $4,500,000
                    The new balance of common shares is $750,000 + $4,500,000 = $5,250,000

                    The new balance of retained earnings is $7,500,000 – $4,500,000 = $3,000,000
                    The total-debt-to-total-equity ratio is

                    ($2,350,000 + $2,500,000) ÷ ($5,250,000 + $3,000,000)
                    = $4,850,000 ÷ $8,250,000 = 0.5879

               3. Next year, if earnings remain at $4,500,000 and the payout remains at 80%, ARB will pay out cash dividends
                  of $3,600,000 to holders of the 900,000 shares:
                    Dividend per share = $3,600,000 ÷ 900,000 = $4

                    A holder of 120 shares will receive $480.
     3.
               1. If ARB opts for a share repurchase with a payout of $3,600,000 and assuming the share price remains at $30,
                  the firm can repurchase $3,600,000 ÷ $30 = 120,000 shares.
               2. Remaining shares outstanding is 750,000 – 120,000 = 630,000

               3. If earnings and payout remain unchanged in the following year, the per share dividend is earnings x 0.80 ÷
                  new number of shares:
                    $4,500,000 (0.80) ÷ 630,000 = $3,600,000 ÷ 630,000 = $5.7143

                    Assuming the shareholder sold the proportionate number of shares to ARB in the share repurchase, this
                    investor sold 100 x (120,000 ÷ 750,000) = 16 shares for 16 x $30 = $480. The shareholder now holds 84
                    (100 – 16) shares.
                    For 84 shares, the dividend is 84 x $5.7143 = $480

                    Note: If the shareholder chose not to tender or sell shares, the shareholder would retain 100 shares worth
                    $30 = $3,000, and receive next year’s dividend of 100 x $5.7143 = $571.43.

     4. The policies differ on a variety of dimensions. If tax differences are not present, a cash dividend is equivalent to a


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         share repurchase. ARB’s capital structure, as measured by the debt-to-equity ratio, is affected by its dividend payout
         policy. If there is a link between investment opportunities and dividend payout policies, ARB should restrict cash
         dividends so as to enable it to undertake positive NPV projects, as implied in part (b). This would especially be true in
         situations of hard capital rationing, when ARB would need to retain share capital to support investments. Otherwise,
         the firm could not obtain the necessary financing.




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Self-test 7

Question 7 solution

Lease payments are like debt payments in that they are contractual obligations to the lessor. In addition, any obligations
under a lease agreement are secured because the lessor retains ownership of the asset. If the lease payments are not made
fully and on time, the lessor can demand the asset back and sue the lessee for the missed lease payments. The lessor
becomes a general creditor and is able to force the firm into bankruptcy.

Similarly, secured debt provides lenders with a lien on certain assets just like a lease. If the secured debt payments are not
made fully and on time, the secured lender will force the sale of the collateral and receive all the proceeds from the sale. If
the cash received by the lender does not satisfy the secured loan, the lender becomes a general creditor and is able to share
in the proceeds from the sale of other assets. Therefore, the default risk to the lessor is similar to the default risk to a
creditor secured by the same asset (the leased asset).




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Self-test 7

Question 8 solution

     1. The initial outlay for the jet is

         $15,000,000 – $500,000 = $14,500,000
     2. The lease payments are $2.5 million per year. IRA’s before-tax cost of debt is 12%. Its after-tax cost of debt, at a tax
        rate of 35%, is

         12% × (1 – 0.35) = 7.80%
         Because the lease payments are paid at the beginning                                               of each year, the PV of the 10 lease
         payments on an after-tax basis is an annuity due:

         $2,500,000 × (1 – 0.35) × PVIFA               (7.80%, 10)   (1 + 0.078) = $11,861,163

     3. PV of the after-tax operating costs of $300,000 per year, incurred if IRA buys the jet, but not if it decides to lease, is
         $300,000 × (1 – 0.35) × PVIFA(7.80%, 10) = $1,320,352

     4. PV of the CCA tax shield:




         PV of the CCA tax shields lost due to the salvage value:




         PV of the CCA tax shields over the 10 years is

         $3,728,198 – $125,877 = $3,602,321
     5. PV of the salvage value lost by leasing = $1,000,000 × PVIF                       (7.8%, 10)   = $471,859

     6. The value of the equivalent loan is

         $11,861,163 – $1,320,352 + $3,602,321 + $471,859 = $14,614,991
     7. The net value to leasing is
         $14,500,000 – $14,614,991 = –$114,991. Because the NPV of leasing is negative, IRA should purchase the jet.




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Self-test 7

Question 9 solution

     1. The net value to leasing has several components.

         Initial investment outlay = purchase price – investment tax credit of 5% of purchase price = 0.95 (purchase price) =
         0.95 ($690,000) = $655,500
         After-tax cost of debt = 7%(1 – 0.40) = 4.2%

          Equivalent loan                = + PV of lease payments
                                              –    PV of maintenance and insurance costs saved, after tax
                                              + PV of CCA tax shields if buying the asset and keeping it indefinitely
                                              –    PV of CCA tax shields lost on salvage
                                              + PV of expected salvage value
                                              + PV of investment tax credits lost under the lease option


            PV of lease payments (annuity due)

            = ($200,000) × (1 – 0.40) × PVIFA                       (4.2%, 5)    × (1 + 0.042)
                                                                                                    $ 553,542

            PV of maintenance & insurance costs saved, after tax

            = $40,000 (1 – 0.40) × PVIFA                    (4.2%, 5)                               (106,246)

            PV of CCA tax shields if buying the asset and keeping it indefinitely




                                                                                                      212,327

            PV of CCA tax shields lost due to salvage




                                                                                                     (53,823)

            PV of expected salvage value

            = $200,000 × PVIF              (4.2%, 5)                                                  162,814

            PV of lost investment tax credits

            = 0 (no annual investment tax credits)                                                          0

            Equivalent loan                                                                         $ 768,614

         Net value to leasing = initial investment outlay – equivalent loan = $655,500 – $768,614 = $(113,114)
     2. Your summary should include the following:

                r   a description of the proposed project


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                r   an explanation of type of analysis you conducted (NVL)
                r   a summary of your numerical results
                r   an explanation of your results and implication for the decision

         The conclusion is the lease alternative displaces $768,614 of conventional debt, so it is too costly. The borrowing to
         purchase alternative is less expensive. SI should finance its equipment acquisition by borrowing.




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