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					Capital Structure
     Basics




                    1
   Break-even level of sales.
   Operating and financial leverage
    and risk.
   Risks and returns of leveraged
    buy-outs (LBOs).
   Effect of capital structure on value.




                                            2
   Steps to Solution
   Construct a chart to find the sales break-
    even point = level of sales necessary to
    cover operating (not financial) costs.
   This requires that you calculate EBIT for
    different unit sales amounts.
   The point at which EBIT = 0 is the break-
    even level of sales.



                                                 3
   Assumptions
    ◦ Fixed costs remain constant as quantity changes.
    ◦ Variable costs vary as quantity of output changes.

    Costs $                            Variable Costs



                                            Fixed Costs




                                        Units Produced


                                                           4
   Fixed costs may include salaries,
    depreciation, rent.
   Variable costs may include commissions,
    materials, labor.
   This is a generalization. For example, some
    salaries may be considered fixed and others
    variable. In the long-run all costs are
    variable.



                                                  5
   Calculation of Break-even Quantity


       EBIT = Sales – Variable Costs - Fixed Costs



Find Quantity which results in EBIT = $0




                                                     6
   Calculation of Break-even Quantity



            Unit Salesbe =
                               FC
                             p – vc
         Where:
         Unit Salesbe = Break-even quantity
                 FC = Total fixed costs
                  p = Sales price per unit
                 vc = Variable costs per unit


                                                7
   Calculation of Break-even Quantity



           Unit Salesbe =
                              FC
                            p – vc
      Example:
      Fixed Costs    = $1,000,000/year
      Price          = $800/unit
      Variable Costs = $400/unit



                                         8
   Calculation of Break-even Quantity



            Unit Salesbe =
                             FC
                           p – vc
      Example:
      Fixed Costs    = $1,000,000/year
      Price          = $800/unit
      Variable Costs = $400/unit   =   $1,000,000
                                       $800 – $400
                                    = 2,500 units
                                                     9
   Now calculate total revenue.



                   TR = p x Q

              p = Sales price per unit
              Q = unit sales




                                         10
   Calculate total revenue for different levels of
    sales.


                              TR = p x Q
    Unit sales (Q)   x    Price (p)   = Total Revenue (TR)
               0      x    $800       =    $        0
            500       x    $800       =    $ 400,000
          1,000       x    $800       =    $ 800,000
          2,000       x    $800       =    $1,600,000
          2,500       x    $800       =    $2,000,000
                                                         11
You cannot easily move a large boulder.




                                          12
However, with the aid of a lever you can
 move an object many times your size.




                                           13
The longer the lever, the bigger the
       rock you can move.




                                       14
   In a financial context, the magnifying power
    of leverage can be used to help (or hurt) a
    firm’s financial performance.
   Operating leverage occurs due to fixed
    costs in the production process.
   With high fixed operating costs, a small
    change in sales will trigger a large change
    in operating income (EBIT).


                                                   15
   Measurement of Operating Leverage
    ◦ Degree of Operating Leverage (DOL)



                     % Change in EBIT
            DOL =
                     % Change in Sales

         DOL > 1 means the firm has operating
          leverage.


                                                 16
Example: S1 = 3,750 units S2 = 5,000 units
FC = $1mil and VC = $400/unit P = $800/unit

Sales of 3,750 units = (3,750 * $800) = $3mil
 EBIT = $3mil - $1mil – $1.5mil= $.5mil
Sales of 5,000 units = (5,000 * $800) = $4mil
 EBIT = $4mil - $1mil - $2mil = $1mil


            DOL =      % Change in EBIT
                       % Change in Sales
                 ($1 - $.5) / $.5        100
        DOL=                        =           = 3.0
                 ($4 - $3) / $3         33.33
                                                        17
   Measurement of DOL
    ◦ Calculation using alternate formula:




               DOL =     Sales - Total VC
                        Sales -Total VC - FC




                                               18
   Measurement of DOL
    ◦ Calculation using alternate formula:




           DOL =     Sales - Total VC
                    Sales -Total VC - FC
        DOL = ($3 - $1.5) / ($3 - $1.5 - $1)
              = 1.5 / .5
              =3
                                               19
   Measurement of DOL
    ◦ Calculation using per unit information:




               DOL =     Sales - Total VC
                        Sales -Total VC - FC
             Example:    Q   =   3,750 units
                         P   =   $800 per unit
                        VC   =   $400 per unit
                        FC   =   $1,000,000 per year.
                                                        20
   Measurement of DOL
    ◦ Calculation using per unit information:




               DOL =        Sales - Total VC
                           Sales -Total VC - FC

       DOL3,750 units =         3,750(800) – 3,750(400)
                          3,750(800) –3,750(400) – 1,000,000
                               Interpretation: If sales change 1%,
                     = 3       then EBIT will change 3% (same
                               direction).
                                                                     21
   Degree of Operating Leverage falls as
    sales rise

          Quantity        DOL
          2,500 (Qbe)   Undefined
          3,250           4.33
          3,750            3
          5,000            2




                                            22
   Degree of Operating Leverage falls as sales rise


            Quantity        DOL
            2,500 (Qbe)   Undefined
            3,250           4.33
            3,750            3
            5,000            2


     The higher the sales level above
      break-even, the less the percent change
      in EBIT for a given percent change in sales
     If FC = $0, DOL = 1
                                                       23
Leverage
Table Number 1




                 24
   Degree of Financial Leverage
    ◦ Finance a portion of the firm’s assets with
      securities that have fixed financial costs
      Debt
      Preferred Stock
    ◦ Financial Leverage measures changes in
      earnings per share as EBIT changes.


                          % Change in NI
            DFLEBIT =
                         % Change in EBIT
             Base Level of EBIT
                                                    25
Financial Leverage
Example: EBIT1 = $500,000
         EBIT2 = $1,000,000

          NI1 = $180,000
          NI2 = $480,600

          DFL =      % Change in NI
                     % Change in EBIT
        (480.6 - 180) / 180       167
DFL=                          =         = 1.67
        ($1 - $.5) / $.5          100
                                                 26
   Measurement of DFL
    (Alternate formula)

                             EBIT
               DFLEBIT =
                           EBIT – I

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



                                                            27
Example:
             EBIT = $500,000
  Interest Charges = $200,000
                            500,000
     DFLEBIT=500,000 = 500,000 – 200,000

                  = 1.67 times

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


                                                    28
Leverage
 Table Number 1




                  29
   Degree of Combined Leverage
    ◦ Measures changes in Net Income given
      changes in Sales
    ◦ Combines both Operating and Financial
      Leverage
    ◦ Computed for a specific level of sales

                    % Change in NI
            DCLS = % Change in Sales


             Base Level of Sales
                                               30
Combined Leverage
Example: SALES1 = $3,000,000
         SALES2 = $4,000,000

         NI1 = $180,000
         NI2 = $480,600

         DCL =     % Change in NI
                   % Change in Sales
       (480.6 - 180) / .180       166.7
DCL=                          =           = 5.0
       ($4 - $3) / $3             33.3
                                                  31
  DCLS = DOLS x DFLEBIT
Example:
           DOLS = 3.0
       DFLEBIT = 1.67

       DCL3,750 = 3.0 x 1.67
               = 5.0 times



                               32
         DCLS =           Sales – VC
                       Sales - VC - FC - I
Example:
                        3,750(800) – 3,750(400)
DCL3,750 =
             3,750(800) – 3,750(400) – 1,000,000 - $200,000
                     3 mil – 1.5 mil
        =
             3 mil – 1.5 mil – 1 mil - .2 mil

         = 1,500,000  300,000 = 5


                                                              33
  DCLS = DOLS x DFLEBIT
     S      S      EBIT

Example:
           DOLS = 3.0
         DFLEBIT = 1.67

         DCL3,750 = 3.0 x 1.67
                 = 5.0 times
Interpretation: When sales change 1%, Net
Income will change 5.0% in the same direction
                                                34
Leverage
Table Number 1




                 35
   Leverage can help the firm or hurt it.
   If EBIT increases, financial leverage will
    magnify the increase in net income.
   If EBIT decreases, financial leverage will
    magnify the decrease in net income.




                                                 36
   Capital Structure is the mixture of
    sources of funds a firm uses.
    ◦ Debt
    ◦ Preferred Stock
    ◦ Common Stock




                                          37
   A benefit of debt financing is that interest
    is tax deductible to the paying firm
    whereas payments to equity providers are
    not.
   Firms must trade-off this benefit against
    the increased financial risk associated
    with higher debt levels.




                                                   38
   M&M wrote an important paper in 1958
    in which they proved that with certain
    assumptions there is no optimal capital
    structure. One is as good as any other.
   M&M’s Assumptions: No transaction
    costs, no taxes, everyone has same
    information and borrowing rates, debt
    is riskless, debt does not affect
    operations.
                                              39
   In a later paper, M&M showed that when
    the tax deductibility of interest is
    considered, their model indicates that a
    capital structure of 100% debt is optimal.




                                                 40
   Firms attempt to balance the costs and
    benefits of debt to reach the optimal mix
    that maximizes the value of the firm.
   Affect on costs of capital:
    ◦ Since debt is cheaper than equity, use of debt will
      initially lower the WACC.
    ◦ At high levels of debt, the WACC will increase as
      investors perceive the risk of the firm to be
      increasing substantially.




                                                            41
kd

 ks                      ks

       ka


                         ka
      K*
                         kd


            We minimize K* at
               50% debt




                                42
                                            Homework Problems
1. You are given the following information for Firm XYZ:
             Fixed operating costs                  = $500,000
             Variable operating costs per unit     = $40/unit
             Sales price per unit                  = $50/unit

              Calculate the break-even point in units for: (treat each scenario independently)
              a. fixed costs decrease to $450,000
              b. variable cost decreases to $37 per unit
              c. sales price increases to $55/unit
              d. changes for a, b, c, occur simultaneously

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

              a. compute DOL, DFL, and DCL for Company X
              b. compute DOL, DFL, and DCL for Company Y
              c. compare the relative risk of both companies

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

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

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

                                               a. calculate DOL
                                               b. calculate DFL
                                               c. calculate DCL

                                                                                                                         43
Corporate Bonds,
Preferred Stock,
  and Leasing




                   44
   Bond contract terms
   Differences among types of bonds
   Features of preferred stock
   Lease versus purchase
   Balance sheet treatment of leases




                                        45
   Bondholders are lending the corporation
    funds for some stated period of time.
   The corporation promises to make certain
    payments to the owner of the bond.




                                               46
   Indenture
    ◦ Definition: the contract between the corporation
      and the investor
   Provisions included in the indenture:
    ◦   par value
    ◦   coupon rate and payment dates
    ◦   maturity date
    ◦   any special features




                                                         47
   Par Value
    ◦ (e.g. $1,000) also called Face Value
   Coupon Interest Rate
    ◦ The stated rate of interest. The rate that is
      multiplied by the par value to determine the
      annual dollar interest paid.
   Maturity
    ◦ Time at which the original principal (Par Value)
      is repaid to the bondholder.



                                                         48
   Collateral
    ◦ If the debt is secured by specific assets, the lender
      is entitled to take the assets in the event of
      default.
   Plan for repayment at maturity
    ◦ Staggered maturities makes it easier for the firm
      to raise the necessary funds.

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


                                                          49
    Special Features of Bond Indentures

   Provisions for early repayment
    ◦ Call provisions allow the issuer to refinance the
      debt, usually done if interest rates fall.
    ◦ Issuing new bonds to replace old bonds is known as
      refunding.




                                                           50
   Original issue: 12% coupon
   Coupon currently required for similar risk
    bonds: 10% coupon
   Refinancing will save $20 per year on each
    $1,000 bond.
   Interest savings offset by the expenses of
    calling the original issue and issuing the
    new bonds. In addition, the call price the
    issuer must pay is usually greater than the
    face value.


                                              51
    Special Features of Bond Indentures
   Restrictions on company operations that are
    designed to reduce risk to bondholders.
    ◦ Restrictions on additional debt
    ◦ Restrictions on payment of dividends
    ◦ Minimum working capital required
   Name of independent trustee to oversee the
    bond issue




                                                  52
   Moody’s and Standard & Poor’s regularly
    monitor issuer’s financial condition and
    assign a rating to the debt




                                               53
    Moody’s and Standard & Poor’s regularly
     monitor issuer’s financial condition and
     assign a rating to the debt
Investment       AAA       Best Quality
   Grade         AA        High Quality
                 A         Upper Medium Grade
                 BBB       Medium Grade
                 BB        Speculative
      Below      B         Very Speculative
    Investment   CCC       Very Very Speculative
       Grade     CC
      (Junk)     C         No Interest Being Paid
                 D         Currently in Default     54
   Debenture
   Subordinated Debenture




                             55
   Debenture
   Subordinated Debenture


          A debenture is an unsecured bond.

          A subordinated debenture is a
          debenture that has lower priority for
          payment than other debentures
          designated as senior.

                                                  56
   Debenture
   Subordinated Debenture

   Mortgage Bond


         A mortgage bond is secured by real
         assets such as airplanes, railroad cars,
         or real estate.



                                                    57
    Debenture
    Subordinated Debenture
    Mortgage Bond
    Convertible Bond

A convertible bond is a bond that gives the
investor the right to convert the bond into a
given number of shares of stock on or after
a given future date.
The conversion ratio is the number of shares
the investor will get for each bond converted.


                                                 58
       Debenture
       Subordinated Debenture
       Mortgage Bond
       Convertible Bond

The conversion value is the market price per
share times the conversion ratio.

e.g. If the stock price = $20 and the conversion
ratio = 45, the conversion value = $20 x 45 = $900.

                                                      59
        Debenture
        Subordinated Debenture
        Mortgage Bond
        Convertible Bond
        Variable Rate Bond


A variable rate bond pays investors interest that
is adjusted according to an established time
table and a market rate index.
e.g. Coupon rate is LIBOR + 300 basis points
                                                    60
   Debenture
   Subordinated Debenture
   Mortgage Bond
   Convertible Bond
   Variable Rate Bond
   Putable Bond

    A putable bond can be cashed in
    before maturity at the option of
    the bond’s owner.


                                       61
   Debenture
   Subordinated Debenture
   Mortgage Bond
   Convertible Bond
   Variable Rate Bond
   Putable Bond
   Junk Bond

    A junk bond is a bond that is rated below
    investment grade.

                                                62
      Debenture
      Subordinated Debenture
      Mortgage Bond
      Convertible Bond
      Variable Rate Bond
      Putable Bond
      Junk Bond
      International Bond
International bonds are bonds that
  are sold in countries other than
   where the issuer is domiciled.
                                     63
More                                Common Stock
Risk                       Preferred Stock
           Subordinated Debentures

                           Senior Debentures
                    2nd Mortgage Bonds
           1st Mortgage Bonds


Less
Risk
       Higher         Priority of Claim            Lower

                                                           64
   A hybrid security with both debt and equity
    characteristics.
   Has priority over common stock in receipt of
    dividends and in liquidation.
   Dividends are fixed as a percentage of par
    value.
   Only participating preferred stock (which is
    rare) shares in the residual income with the
    common stockholders.


                                               65
   Corporations can generally exclude from
    taxable income 70% of dividend income
    received on preferred stock issued by
    another corporation.
   e.g. Company X owns Company Y
    preferred stock that pays 4% dividends. If
    Company X’s marginal tax rate = 40%,
    the after tax yield on this investment
          AT yield = 4%[1-(.3x.4)] = 3.52%
   Compare to 4% on fully taxable
    investment: AT yield = 4%(1-.4) = 2.4%

                                                 66
   A lease is a contractual arrangement
    where a party who needs an asset
    (lessee) contracts with another party
    who owns the asset (lessor) to use
    that asset for a specified period of
    time, without conveyance of title.
   A long-term non-cancelable lease
    contract is very similar financially to a
    debt obligation from the perspective
    of the lessee.


                                                67
   Flexibility and convenience
   Few restrictions
   Avoid the risk of obsolescence
   100 percent financing
   Tax savings
   Ease of obtaining credit




                                     68
   Lease payments for operating leases are
    fully deductible to businesses but only
    interest portions of debt payments are
    deductible.
   The IRS strictly examines lease
    arrangements to ensure that they are
    genuine lease agreements and not
    installment sales in disguise.



                                              69
   An operating lease has a term that is
    substantially shorter than the useful life
    of the asset and is cancelable by the
    lessee (e.g. car rental for a business trip).
   A capital lease is long term and non-
    cancelable. The economic value is
    mostly depleted by the end of the lease
    (e.g. a ten year lease of a truck.)


                                                70
   Both operating and capital leases appear on
    the income statement.
    ◦ Payments on operating leases are tax-deductible
      expenses.
    ◦ Depreciation for the leased asset and imputed
      interest from capital lease payments are
      deductible.
   Capital leases also appear on the balance
    sheet because they are the functional
    equivalent of a purchase financed with debt.



                                                        71
                                     Homework Problems

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

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

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

4. Why are junk bonds called high-yield bonds?

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




                                                                                                            72
Common
 Stock




         73
   Characteristics of common stock.
   Advantages and disadvantages of equity
    financing.
   Process of issuing common stock.
   Understand rights and warrants.




                                             74
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




                         Company Issuing the Stock

                                                                         75
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




                  Description of Preferred Stock
             (Class B Preferred and Class C Preferred)
                                                                               76
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




                                  Ticker Symbol
                                                                               77
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




            Annual Dividend per Share in dollars
            p = Initial Dividend
                                                                         78
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




            Volume of Trading
    The number of shares changing hands.
                                                                           79
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




                 Daily Trading Range
                      6½ = $6.50
                                                                         80
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




                                   Closing Price

                                                                               81
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




                      Price Change from Close on
                          Previous Trading Day

                                                                               82
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




                 Trading Range over the Past Year
                       s = stock split
                         = new 52 week high achieved
                           on this day
                                                                           83
 52 Weeks                        Yld       Vol                       Net
 Hi   Lo Stock       Sym   Div   % PE     100s   Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067   35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263   29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966   24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248   6½    6¼       63/8    -1/8




   Dividend Yield

         =         Dividend
                 Closing Price                                             84
 52 Weeks                        Yld       Vol                        Net
 Hi   Lo Stock       Sym   Div   % PE     100s    Hi    Lo      Close Chg
s 42½ 29 PepsiCo       PEP 1.14 3.3 24    5067    35    34¼      34¼     -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12       6263    29¾   285/8    287/8   -¾
  237/8 20 RJR Nab pfB     2.31 9.7 ...    966    24    235/8    23¾     ...
  7¼ 5½ RJR Nab pfC        .60 9.4 ...    2248    6½    6¼       63/8    -1/8




                                    Price to Earnings (PE) Ratio
                                                   Closing Price
                                          =
                                                 Earnings per Share
                                                                 85
   Dividends
    ◦ Vary over time
    ◦ Not guaranteed
   Residual Claim
   Voting Rights
   Sometimes Preemptive Right to buy New
    Stock




                                            86
   Shareholders elect a group of individuals
    called the Board of Directors who oversee
    the management of the corporation.
   The Board of Directors selects the
    managers who are responsible for day-
    to-day operations of the firm.




                                                87
   Majority voting
    ◦ For each seat open, one vote can be cast per
      share. Each position on the board is voted for
      separately.
   Cumulative voting
    ◦ Each shareholder gets one vote per share times
      the number of seats open. Votes may be
      spread out among candidates as desired. The
      top X vote getters are elected to the X seats to
      be filled.



                                                         88
Number of Directors Electable
   Excalibur Corporation has 3 seats open on its 9
    member Board of Directors. There are 100,000
    shares outstanding. The minority interest owns
    40,000 shares.
   Does the minority have a chance of electing one
    Director if all shares are voted?
   The minority has 40,000 x 3 = 120,000 votes.
   Number they can elect =
                                  (40,000-1)(3+1)
                                      100,000
                       = 1.6 = 1 director
                               (always round down)    89
Number of Shares Needed for X Directors

    Excalibur Corporation has 5 seats open on its
     9 member Board of Directors. There are
     100,000 shares outstanding.
    How many shares does the minority need to
     control to elect 2 directors? 2 X 100,000
                                               +1
                                       5+1
    Number of shares needed =
                               = 33,334.33


                                                     90
Disadvantages of Equity Financing
 Dilution of ownership and power.
 Flotation costs
 ◦ Fees paid to investment bankers, lawyers, and
   accountants
 ◦ Usually higher than for debt issues.




                                                   91
Disadvantages of Equity Financing (cont.)
 Signaling Effects
   ◦ Investors may think that managers would not
     issue stock unless it were overvalued in the
     market.
   ◦ Therefore, a stock issue is seen as a negative
     signal and investors will respond by selling
     the stock.
   ◦ Selling pressure causes the stock price to
     fall.


                                                      92
Advantages of Equity Financing
 No interest to pay.
 No obligation to pay dividends.
 Reduces financial risk.
 ◦ This may be a more important advantage to firms
   that already are relatively risky due to the kind of
   business they do (e.g. high tech)




                                                          93
   Sell to existing shareholders or to new
    shareholders?
   Initial Public Offering (IPO)
   Role of Investment Bankers
    ◦ Underwriting
    ◦ Best efforts
   Pricing the issue




                                              94
   Securities issued by a corporation that
    allow investors to buy new stock at a given
    price.
   Preemptive Right
    ◦ Allows a shareholder the right to maintain their
      % ownership by buying a proportional share of
      any new issue.
    ◦ The rights can also be sold in the open market.




                                                         95
   There are 60,000 shares outstanding and
    another 20,000 will be issued.
   Each shareholder will receive one right for
    for each share held, a total of 60,000
    rights.
   To buy one share of the new issue, you
    will need to pay the subscription price
    plus 60,000/20,000 = 3 rights.



                                                  96
   A warrant is a security giving the owner
    the option to buy shares of common stock
    at a certain exercise price for a set period
    of time.
   Like rights except that they are sold to
    investors rather than given away.
   Each warrant allows you to buy a particular
    number of shares.



                                                   97
                                     Homework Problems

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

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

           a. How many rights will current stockholders receive?
           b. How many rights are needed to buy one additional share?

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

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

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




                                                                                                            98
Dividend
 Policy




           99
   Factors that influence dividend policy
   How to pay dividends
   Major dividend theories
   Alternatives to cash dividends




                                             10
                                              0
   Need for funds
   Management expectations for the firm’s
    future prospects
   Stockholders’ preferences
   Restrictions on dividend payments
   Availability of cash




                                             10
                                              1
On August 25, 2006 Southside Bankshares
announced a quarterly dividend of $1 per share
to be paid to share holders of record September 9,
2006, payable September 15, 2006




                                                     10
                                                      2
 On August 25, 2006 Southside Bankshares
 announced a quarterly dividend of $1 per share
 to be paid to share holders of record September 9,
 2006, payable September 15, 2006

25                 31 1        5            9         15
      August                       September



     Declaration Date
                          Date that dividend is
                              announced
                                                           10
                                                            3
 On August 25, 2006 Southside Bankshares
 announced a quarterly dividend of $1 per share
 to be paid to share holders of record September 9,
 2006, payable September 15, 2006

25                 31 1       5             9         15
      August                      September



     Declaration Date     Date of Record

                          All owners of record will
                           receive the dividend.           10
                                                            4
 On August 25, 2006 Southside Bankshares
 announced a quarterly dividend of $1 per share
 to be paid to share holders of record September 9,
 2006, payable September 15, 2006

25                 31 1            5            9     15
      August                           September

                          4 days
     Declaration Date
                               Date of Record

                                                           10
                                                            5
 On August 25, 2006 Southside Bankshares
 announced a quarterly dividend of $1 per share
 to be paid to share holders of record September 9,
 2006, payable September 15, 2006

25                   31 1                  7         9           15
      August                              September
               Ex-Dividend Date

     Declaration Date
                                   Date of Record
     To allow time for the official list of stockholders to be
     updated, stockholders must buy stock before the ex-
     dividend date which is 2 days prior to date of record.           10
                                                                       6
 On August 25, 2006 Southside Bankshares
 announced a quarterly dividend of $1 per share
 to be paid to share holders of record September 9,
 2006, payable September 15, 2006

25                   31 1                7         9             15
      August                             September

               Ex-Dividend Date
                                                       Payment
     Declaration Date
                                  Date of Record       Date
               Date that the dividend is paid
               out to the stockholders.
                                                                      10
                                                                       7
   A dividend reinvestment plan (DRIP) is
    a plan in which stockholders are
    allowed to reinvest their dividends in
    additional shares of stock instead of
    receiving them in cash.
   Popular with investors because they
    can avoid commission costs.
   Dividends paid and reinvested are still
    taxable income to the investor.
                                              10
                                               8
   Residual Theory of Dividends
    ◦ Hypothesizes that dividends should be
      determined only after the firm has first
      examined their need for retained earnings
      to finance the equity portion of funds
      needed for their capital budget.
    ◦ Thus, dividends arise from the “residual” or
      left-over earnings.




                                                     10
                                                      9
   Residual Theory of Dividends
    Example:
      Net Income = $150 million
      Total Amount of Funds Needed to Finance Positive
       NPV Projects = $100 million
      Optimal Capital Structure: 60%D, 40%E
      Equity Funds Needed = $100 million x .4
                          = $40,000,000
      Dividend to be Paid = $110 million
       ($150 million NI - $40,000,000 Equity
       Funds Needed)


                                                          11
                                                           0
   Clientele Dividend Theory
    ◦ Hypothesizes that different firms have different
      types of investors.
    ◦ Some investors, such as elderly people on fixed
      incomes, tend to prefer to receive dividend
      income.
    ◦ Others, such as young investors often prefer
      growth, and tend to like their income in the form
      of capital gains rather than as dividend income.




                                                          11
                                                           1
   Signaling Dividend Theory
    ◦ Hypothesizes that since management is better
      informed about the firm’s prospects, dividend
      announcements are seen as signals of future
      performance.
    ◦ Since investors usually respond negatively to
      dividend decreases, managers tend not to increase
      dividends unless the increase is expected to be
      sustainable.




                                                          11
                                                           2
   Bird in the Hand Theory
    ◦ Hypothesizes that stockholders prefer to
      receive dividends instead of having
      earnings reinvested.
    ◦ The dividend payment is more certain than
      the unknown future capital gain.




                                                  11
                                                   3
   Modigliani and Miller Dividend Theory
    ◦ M&M originally argued in 1961 that, without
      taxes or transactions costs, the way that the
      firm’s earnings are distributed (capital gains
      versus dividends) is irrelevant to firm value.




                                                       11
                                                        4
   Stock Dividends
    ◦ Existing shareholders receive additional shares
      of stock instead of cash dividends.
    ◦ Payment is expressed as a percentage of
      current stock holdings.



    e.g. if there is a 10% stock dividend, you
     would receive one additional share for
         every 10 that you currently own.
                                                        11
                                                         5
   Stock Splits
    ◦ If total shares will increase by more than 25%,
      the company will usually declare a stock split.
    ◦ Purpose is usually to bring the stock price into
      a more popular trading range.
    ◦ Expressed as a ratio to original shares.




      e.g. a 2-1 split means that each investor
      will end up with twice as many shares.
                                                         11
                                                          6
                        Homework Problems and Questions


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

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

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

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

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




                                                                                             11
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