FINANCIAL MANAGEMENT REVISION Chapter 8 Stock valuation Theory questions come from questions in text book.

. Computational questions cover exercises similar to E8-1, 8-2 textbook, page 348 and the question below. Question Stock valuation

1. Mitt Inc., just paid a $2 annual dividend on its common stock. The dividend is expected to increase at 8% per year indefinitely. If the required rate of return is 16%, what is the value of the stock today? What is the price of the stock next year ? 2. Pittway Corporation's next annual dividend (D1) is expected to be $4. The growth rate in dividends over the following three years is forecasted at 15%. After that, Pittway's growth rate is expected to equal the industry average of 5%. If the required return is 18%, what is the current value of the stock? What is the price after one year (P1)?

Suggested answer Question Stock valuation 1 D1 $2*1.08 Stock price P0 = ---------------- = -------------------- = $27 ks g 0.16 0.08 P1 = P0 *(1+g) = 27*(1+0.08) = $29.16 2 D1 = $4

D2 = D1 * (1 + g) = $4 * (1+ 0.15) = $4.6 D3 = D2 * (1 + g) = $4.6 * (1+ 0.15) = $5.29 D4 = D3 * (1 + g) = $5.29 * (1+ 0.15) = $6.0835 D5 = D4 * (1 + g) = $6.0835 * (1+ 0.05) = $6.388 D5 $6.388 Stock price P4 = ---------------- = -------------------- = $49.136 ks g 0.18 0.05 4 4.6 5.29 6.0835 + 49.136 P0 = ----------- + ----------- + ----------- + --------------------------- = $38.39 (1.18)3 (1.18)4 (1.18) (1.18)2 4.6 5.29 6.0835 + 49.136 P1 = ----------- + ----------- + --------------------------- = $41.3 (1.18)1 (1.18)2 (1.18)3

8-1

DPS calculation

D0 = $1.5 g = 5% for the next 3 years g = 10% a year thereafter Expected dividend for each of the next 5 years: D1 = 1.5 * 1.05 = 1.575 D2 = 1.5 * (1.05)2 = 1.654 D3 = 1.5 * (1.05)3 = 1.736 D4 = 1.736 * (1.1)1 = 1.91 D5 = 1.736 * (1.1)2 = 2.1 8-2 Constant growth valuation

D1 = 0.5 g = 7% ks = 15% Value per share of companys stock: D1 0.5 Po = ----------- = ------------------- = $6.25 0.15 - 0.07 ks g Chapter 10 Capital budgeting Theory questions come from questions in text book. Computational questions cover exercises similar to E10-16 textbook, page 418 and the question below. Question Capital budgeting Your company is considering two proposed projects. The estimated cost of capital is 15%. The projects will produce the following cash flows: Year Project A ($) Project B ($) 0 (20,000) (24,000) 1 6,400 10,000 2 8,100 10,000 3 9,200 10,000 4 12,000 10,000 What is the regular payback period for each project? (4 marks) Calculate the NPV for each project? (5 marks) Calculate the IRR for each project? (5 marks) Which project should the firm undertake: (2 marks) i. if the two projects are independent ii. If the two projects are mutually exclusive e. Discuss the advantages and disadvantages of payback method? (4 marks) a. b. c. d.

Suggested answer Question Capital budgeting a. Payback period Project A: = 2 years + $5,500/$9,200 = 2.597 years or 2 years 7 months Project B: = 2 years + $4,000/$10,000 = 2.4 years or 2 years 5 months b.
Year Project A Project B 0 (20,000) (24,000) 1 6,400 10,000 2 8,100 10,000 3 9,200 10,000 4 12,000 10,000 Project Project 15% A B 1 (20,000) (24,000) 0.870 5,565 8,696 0.756 6,125 7,561 0.658 6,049 6,575 0.572 6,861 5,718 NPV IRR 0.2515542 0.2422169 4,600 Project Project 25% A B 1 (20,000) (24,000) 0.800 5,120 8,000 0.640 5,184 6,400 0.512 4,710 5,120 0.410 4,915 4,096 (70) (384)

4,550 NPV

c. i. If the two projects are independent Accept both projects A & B since they have positive NPV and IRR greater than cost of capital ii. If the two projects are mutually exclusive Accept project A because of higher positive NPV 10-16 Capital budgeting criteria (textbook, page418) Cumulative cash flows Project A Project B (400) (600) (345) (300) (290) 0 (235) 50 (10) 100 215 150 Cumulative discounted CF Project A Project B (400) (600) (350.01) (327.3) (304.58) (79.5) (263.28) (41.95) (109.58) (7.8) 30.12 23.25

Year 0 1 2 3 4 5

Payback A = 4 + 10/225 = 4.04 years Payback B = 2 years Project B should be accepted because of shorter payback Discounted payback A = 4 + 109.58/139.7 = 4.78 years Discounted payback B = 4 + 7.8/31.05 = 4.25 years Project B should be accepted because of shorter payback

Year Discount factor at 10% 0 1 1 0.909 2 0.826 3 0.751 4 0.683 5 0.621 NPV

Cash flows A (400) 55 55 55 225 225

PV of CF A (400) 49.99 45.43 41.3 153.7 139.7 30.12

Cash flows B (600) 300 300 50 50 50

PV of Discount CF factor at B 15% (600) 1 272.7 0.870 247.8 0.756 37.55 0.657 34.15 0.572 31.05 0.497 23.25

PV of CF A (400) 47.85 41.58 36.14 128.7 111.83 (33.91)

PV of CF B (600) 261 226.8 32.85 28.6 24.85 (25.9)

Project A should be accepted because of higher NPV IRRA = 10% + 30.12/(30.12+33.91) * 5% = 12.35% IRRB = 10% + 23.25/(23.25+25.9) * 5% = 12.36% Project B should be accepted because of higher IRR Chapter 13 Capital structure and leverage Theory questions come from questions in text book. Computational questions cover exercises similar to ST-2 textbook, page 511 and the question below. Question Capital structure and leverage

Hadway Ltd has EBIT of $550,000. Debt to total assets ratio is currently at 30%. Debt is raised at the cost kd = 12%. The company reports a total assets of $4,240,000. Market for Hadways product is stabIe and the company expects no growth. Hadway maitains 100% payout. There are 150,000 shares outstanding. It is estimated that the current required return on equity is 16%. The corporate tax rate is 40%. a. What is the companys net income, EPS, DPS? b. What is the company's weighted average cost of capital c. What is the current share price of the stock? d. The company is considering changing its capital structure by increasing debts by $848,000 achieving a debt to total assets of 50% and use the proceeds of new debts to repurchase stocks. Its interest on debt will be 13% (it will have to call and refund the old debt) and its cost of equity will rise to 18%. Assuming that the company maintains the same payout ratio, EBIT and total assets remain unchanged, should the company change its capital structure? e. Operating leverage varies from industry to industry. What would you expect the operating leverage of airline industry to be high or low in comparison with grocery stores? Explain f. Utility companies tend to use more financial leverage than industrial firms. Is it true? Explain

Suggested answer Question Capital structure leverage EBIT = 550,000 a. Debt = $4,240,000 * 0.3 = $1,272,000 Interest exp =1,272,000 * 12% = 152,640 Net income = ($550,000 - $152,640)*0.6 = $238,416 EPS = $238,416/150,000 = $1.58944 DPS = $1.58944*100% = $1.58944 b. WACC = 0.3*12%*(1-0.4) + 0.7*16% = 13.36% c. Current stock price = $1.58944/0.16 = $9.934 d. Total debt = $1,272,000 + $848,000 = $2,120,000 Number of shares bought back = $848,000/9.934 = 85,363 shares Number of shares outstanding = 150,000 85,363 = 64,637 shares Net income = ($550,000 - $2,120,000*0.13)*0.6 = $164,640 New EPS = $164,640/64,637 = $2.547 DPS = $2.547 Current stock price = $2.547/0.18 = $14.15 The company should change its capital structure. e. Operating leverage of airline industry should be higher than that of grocey stores since airline industry is capital intensive, needs heavy investment in fixed assets. The proportion of fixed costs would be high resulting in high operating leverage. f. Yes. Utility companies have stable demand and stable cash flows. They also need large capital investments. The industry tends to borrow more because they have available cash flows to cover interest and principal commitment ST-2, textbook, page 511
a. b. Total equity Debt outstanding Total capital WACC Use new debt to buy back shares New debt Total debt kd ks 6,000,000 2,000,000 8,000,000 12.88% 8000000 10000000 12% 17% EPS Po 4.12 27.44 % 75% 25% 100%

c.

No of shares bought back using 8mil new debt No of outstanding shares

291,498 308,502

New EPS New share Price

5.90 34.70

higher than Po

The company should change its capital structure because the change will increase share price d. EBIT Interest expense EBT Net income New share price Original situation TIE Under situation in part c TIE 4,000,000 1,160,000 2,840,000 1,846,000 35.20 20 higher than share price in part c times

e.

3.33

times

Chapter 14 Dividend policy Theory questions come from questions in text book. Computational questions cover exercises similar to 14-9, part a, b, c textbook, page 557 and the question below. Question 4 1 Dividend policy

A firm which adopted a residual dividend approach has $30,000 in earnings and a target capital structure of 40% debt and 60% equity. What is the maximum amount of capital spending possible if the firm does not obtain any new equity financing and maintains the current target capital structure? Suppose the firm has positive NPV projects available which require the investment of $24,000. How will these projects be financed? How much will the firm pay in dividends? Morris Technologies Inc has net income of $180,000. It has 100,000 shares of common stock outstanding. The companys stock currently trades at $24 a share. Morris is considering a plan to buy back 20% of its shares in the open market. The repurchase is expected to have no effect on either net income or the companys PE ratio. What will be its stock price following the stock repurchase

Suggested answer Question Dividend policy 1. Maximum amount of retained earnings used for reinvestment = 30,000 Maximum amount of capital spending = 30,000/0.6 = 50,000 Required investment = $24,000 Debt financing = 24,000 *0.4 = $9,600 Equity financing needed = 24,000 * 0.6 = $14,400 Under residual model Dividends = 30,000 14,400 = $15,600 6

Current EPS = $180,000/100,000 = $1.8 Current PE = 24/1.8 = 13.333 Shares bought back = 100,000 * 20%= 20,000 shares Shares outstanding = 80,000 New EPS = $180,000/80,000 = $2.25 Share price = $2.25 * 13.33 = $30 Alternative dividend policies

14-9

a. Calculate total dividends for 2003 (1) Dividend growth = 10% Dividend payment = $3,600,000 * 1.1 = $3,960,000 (2) Continue div payout of 2002 $3,600,000 Dividend payout of 2002 = ------------------ * 100 = 33.33% 10,800,000 Dividend payment = $14,400,000 * 33.33% = $4,800,000 (3) Residual dividend policy with investment of $8,400,000 and E=60% Dividend payment = 14,400,000 8,400,000 * 60% = 9,360,000 (4) Regular dividend = 3,960,000 Extra dividend = 14,400,000 3,960,000 8,400,000*60% = 5,400,000 b. Students to justify c. Dividend in 2003 = 9,000,000 g = 10% Market value = 180,000,000 $9,000,000 = -------------------- + 10% = 15% 180,000,000

ks

Facts about common stock CHAPTER 8 Stocks and Their Valuation

Features of common stock Determining common stock values Represents ownership Ownership implies control Stockholders elect directors Directors elect management Managements goal: Maximize the stock price
8-1 8-2

Types of stock market transactions

Secondary market Primary market Initial public offering market (going public)

Different approaches for valuing common stock

Dividend growth model Corporate value model Using the multiples of comparable firms

8-3

8-4

Dividend growth model

Value of a stock is the present value of the future dividends expected to be generated by the stock.

Constant growth stock

A stock whose dividends are expected to grow forever at a constant rate, g.
D1 = D0 (1+g)1 D2 = D0 ( (1+g)2 ) Dt = D0 (1+g)t

P0 =

D1 D2 D3 D + + + ...+ (1+ks )1 (1+ks )2 (1+ks )3 (1+ks )

If g is constant, the dividend growth formula converges to:

P0 =
^

D1 D 0 (1 + g) = ks - g ks - g
8-6

8-5

Future dividends and their present values

$

What happens if g > ks?

t

Dt = D0 ( 1 + g )

0.25

PVD t =

Dt ( 1 + k )t

If g > ks, the constant growth formula leads to a negative stock price, which does not make sense. The constant growth model can only be used if:
ks > g g is expected to be constant forever
Years (t)
8-7 8-8

P0 = PVDt
0

If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs.

What is the stocks market value?

Using the constant growth model:
D1 $2.12 = k s - g 0 13 - 0 06 0.13 0.06

0 D0 = 2.00

g = 6%

1 2.12
ks = 13%

2 2.247

3 2.382

P0 = =

1.8761 1.7599 1.6509

8-9

$2.12 0.07 = $30.29

8-10

What is the expected market price of the stock, one year from now?
D1 will have been paid out already. So, P1 is the present value (as of year 1) of D2, D3, D4, etc. ^ D2 $2.247 P1 = = k s - g 0.13 - 0.06 = $32.10 Could also find expected P1 as:
^

What is the expected dividend yield, capital gains yield, and total return during the first year? Dividend yield Cap ta ga s y e d Capital gains yield Total return (ks)
= D1 / P0 = $2.12 / $30.29 = 7.0% = (P1 P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0% = Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%
8-12

P1 = P0 (1.06) = $32.10
8-11

What would the expected price today be, if g = 0?

The dividend stream would be a perpetuity.
0
ks = 13%

Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%?
Can no longer use just the constant growth model to find stock value. However, the growth does become g constant after 3 years.

...
2.00 2.00 2.00

P0 =

PMT $2.00 = = $15.38 k 0.13

8-13 8-14

Valuing common stock with nonconstant growth

0 k = 13% 1 s
g = 30% g = 30%

Find expected dividend and capital gains yields during the first and fourth years.
4

2
g = 30%

3
g = 6%

Dividend yield (first year)

= $2.60 / $54.11 = 4.81%

...

Capital gains yield (first year)

4.658 4 658 = 13.00% - 4.81% = 8.19%

D0 = 2 00 2.00 2.301 2.647 3.045 46.114 54.107

2.600 2 600

3.380 3 380

4.394 4 394

$ P3 =
= P0
^

4.658 0.13 0.06

= $66.54
8-15

During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield g. After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
8-16

Nonconstant growth: What if g = 0% for 3 years before longrun growth of 6%?

0 k = 13% 1 s
g = 0% g = 0%

Find expected dividend and capital gains yields during the first and fourth years. Dividend yield (first year)
= $2.00 / $25.72 = 7.78%

2
g = 0%

3
g = 6%

...

D0 = 2 00 2.00 1.77 1.57 1.39 20.99 25.72

2.00 2 00

2.00 2 00

2.00 2 00

2.12 2 12

Capital gains yield (first year)

= 13.00% - 7.78% = 5.22%

$ P3 =
= P0
^

2.12 0.13 0.06

= $30.29
8-17

After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
8-18

If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value?
The firm still has earnings and pays dividends, even though they may be declining, they still have value.

Find expected annual dividend and capital gains yields.

Capital gains yield
= g = -6.00%

Dividend yield
= 13.00% - (-6.00%) = 19.00%

D (1 + g ) D1 = 0 P0 = ks - g ks - g
^

$2.00 (0.94) $1.88 = = $9.89 0.13 - (-0.06) 0.19

8-19

Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.
8-20

Corporate value model

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firms firm s free cash flows. Remember, free cash flow is the firms after-tax operating income less the net capital investment
FCF = NOPAT Net capital investment
8-21

Applying the corporate value model

Find the market value (MV) of the firm.
Find PV of firms future FCFs

Subtract MV of firms debt and preferred stock to get MV of common stock. t f t k

MV of = MV of MV of debt and common stock firm preferred

Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).
P0 = MV of common stock / # of shares
8-22

Issues regarding the corporate value model

Often preferred to the dividend growth model, especially when considering number of firms that dont pay dividends or when dividends d d d are hard to forecast. h d f Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate. Terminal value (TVn) represents value of firm at the point that growth becomes constant.
8-23

Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find the firms intrinsic value.

0 k = 10%

1 -5

2 10

3 20
g = 6%

...

21.20

-4.545 8.264 15.026 398.197 416.942

21.20

530 =

0.10 - 0.06

= TV3
8-24

If the firm has $40 million in debt and has 10 million shares of stock, what is the firms intrinsic value per share?
MV of equity = MV of firm MV of debt = $416.94m - $40m = $376 94 million $376.94 Value per share = MV of equity / # of shares = $376.94m / 10m = $37.69

Firm multiples method

Analysts often use the following multiples to value stocks.
P/E P / CF P / Sales

EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.
8-26

8-25

Factors that affect stock price

Required return (ks) could change
Changing inflation could cause kRF to g change Market risk premium or exposure to market risk () could change

Problems
ST-2 P8-1 P8-2 P8 2 P8-10 P8-14 P8-19

Growth rate (g) could change

Due to economic (market) conditions Due to firm conditions
8-27

8-28

12/15/2008

What is capital budgeting? CHAPTER 10

The Basics of Capital Budgeting
Should we build this plant?

Analysis of potential additions to fixed assets. Long-term decisions; involve large g ; g expenditures. Very important to firms future.

10-1

10-2

Steps to capital budgeting

1. 2. 3. 4. 5.

What is the difference between independent and mutually exclusive projects?

Independent projects if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.

Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.

10-3

10-4

What is the difference between normal and nonnormal cash flow streams?
Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.
10-5

What is the payback period?

The number of years required to recover a projects cost, or How long does it take to get our money back? back? Calculated by adding projects cash inflows to its cost until the cumulative cash flow for the project turns positive.

10-6

12/15/2008

Calculating payback
Project L CFt Cumulative PaybackL Project S CFt Cumulative PaybackS
0 -100 -100 1 10 -90 2 60 -30

Strengths and weaknesses of payback

2.4
100 0 3 80 50

Strengths
Provides an indication of a projects risk q y and liquidity. Easy to calculate and understand.

= 2 =
0 -100 -100

+
1

30 / 80 1.6
2

= 2.375 years
3 20 40

Weaknesses
Ignores the time value of money. Ignores CFs occurring after the payback period.
10-7 10-8

70 -30

100 50 0 20

= 1 =

30 / 50

= 1.6 years

Discounted payback period

Uses discounted cash flows rather than raw CFs.
0 CFt PV of CFt Cumulative -100 -100 -100 2 +
10%

Net Present Value (NPV)

Sum of the PVs of all cash inflows and outflows of a project:

1 10 9.09 -90.91

2 60 49.59 -41.32

2.7 3
80 60.11 18.79 = 2.7 years
10-9

NPV =

CFt ( 1 + k )t t =0
n

Disc PaybackL = =

41.32 / 60.11

10-10

What is Project Ls NPV?

Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -$100 9.09 49.59 60.11 $18.79

Rationale for the NPV method

NPV = PV of inflows Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. In this example, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent. 10-12

NPVS = $19.98
10-11

12/15/2008

Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

Rationale for the IRR method

If IRR > cost of capital, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.

0=

CFt ( 1 + IRR ) t t =0
n

10-13

10-14

IRR Acceptance Criteria

If IRR > k, accept project. If IRR < k, reject project. If projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept S, because IRRs > IRRL.
10-15

NPV Profiles
A graphical representation of project NPVs at various different costs of capital. k 0 5 10 15 20 NPVL $50 33 19 7 (4) NPVS $40 29 20 12 5
10-16

Drawing NPV profiles

NPV 60 ($)
50

Comparing the NPV and IRR methods

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive
If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions.
10-18

. . 40
30 20 10 0

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

. .
15

5 -10

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)

10-17

12/15/2008

Finding the crossover point

1. 2.

Reasons why NPV profiles cross

Size (scale) differences the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so h l bl h f d high k favors small projects. Timing differences the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
10-20

3. 4.

Find cash flow differences between the projects for each year. Enter these differences in CFLO register, then press IRR Crossover rate = 8.68%, IRR. 8 68% rounded to 8.7%. Can subtract S from L or vice versa, but better to have first CF negative. If profiles dont cross, one project dominates the other.
10-19

Reinvestment rate assumptions

NPV method assumes CFs are reinvested at k, the opportunity cost of capital. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.
10-21

Project P has cash flows (in 000s): CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000. Find Project Ps NPV and IRR.
0 -800
k = 10%

1 5,000

2 -5,000

Enter CFs into calculator CFLO register. Enter I/YR = 10. NPV = -$386.78. IRR = ERROR Why?
10-22

Multiple IRRs
NPV

Why are there multiple IRRs?

NPV Profile
IRR2 = 400% At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. At very high discount rates, the PV of both g CF1 and CF2 are low, so CF0 dominates and again NPV < 0. In between, the discount rate hits CF2 harder than CF1, so NPV > 0. Result: 2 IRRs.
10-23 10-24

450 0 -800 100 IRR1 = 25% 400 k

12/15/2008

Lecture Example
CompKare is considering purchasing one of two new diagnostic machines. Both machines would make it possible for the company to bid on jobs that it currently isnt equipped to do. Estimates regarding each machine are provided below:
10-25

Lecture Example
Machine A Original Cost Estimated Life Residual Value Estimated cash inflows p.a. $80,000 8 years 16,000 Machine B $180,000 8 years 27,000

Required: Calculate the payback period, net present value and internal rate of return of each machine. Assume a 9% discount rate, which is the required return. Which machine should be purchased and why? 10-26

Practice questions
ST-2, exclude MIRR, parts d and e 10-7 10-13 10 13 10-16, exclude part e. 10-23, exclude parts f and g

10-27

12/15/2008

What is business risk? CHAPTER 13

Capital Structure and Leverage
Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory
13-1

Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
Probability Low risk

High risk 0 E(EBIT) EBIT

Note that business risk does not include financing effects.

13-2

What determines business risk?

Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. costs Product, other types of liability. Operating leverage.

What is operating leverage, and how does it affect a firms business risk?
Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

13-3

13-4

Effect of operating leverage

More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
$ Rev. Rev $ TC Rev. Rev Profit } TC FC FC QBE Sales QBE Sales
13-5

Using operating leverage

Low operating leverage Probability High operating leverage g g g

EBITL

EBITH

What happens if variable costs change?

Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.
13-6

12/15/2008

What is financial leverage? Financial risk?

Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

Business risk vs. Financial risk

Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued.
More debt, more financial risk. Concentrates business risk on stockholders.
13-7 13-8

An example: Illustrating effects of financial leverage

Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only differ with respect to their use of debt (capital structure).
Firm U No debt $20,000 in assets 40% tax rate Firm L $10,000 of 12% debt $20,000 in assets 40% tax rate
13-9

Firm U: Unleveraged
Prob. EBIT Interest EBT Taxes (40%) NI Bad 0.25 $2,000 $2 000 0 $2,000 800 $1,200 Economy Avg. 0.50 $3,000 $3 000 0 $3,000 1,200 $1,800 Good 0.25 $4,000 $4 000 0 $4,000 1,600 $2,400

13-10

Firm L: Leveraged
Prob.* EBIT* Interest EBT Taxes (40%) NI
*Same as for Firm U.
13-11

Ratio comparison between leveraged and unleveraged firms

Good 0.25 $4,000 $4 000 1,200 $2,800 1,120 $1,680

Bad 0.25 $2,000 $2 000 1,200 $ 800 320 $ 480

Economy Avg. 0.50 $3,000 $3 000 1,200 $1,800 720 $1,080

FIRM U
BEP ROE TIE

Bad
10.0% 6.0%

Avg
15.0% 9.0%

Good
20.0% 12.0%

FIRM L
BEP ROE TIE

Bad
10.0% 4.8% 1.67x

Avg
15.0% 10.8% 2.50x

Good
20.0% 16.8% 3.30x
13-12

12/15/2008

Risk and return for leveraged and unleveraged firms

Expected Values: E(BEP) E(ROE) E(TIE) Risk Measures: ROE CVROE Firm U 2.12% 0.24 Firm L 4.24% 0.39
13-13

The effect of leverage on profitability and debt coverage

For leverage to raise expected ROE, must have BEP > kd. Why? If kd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = kdD).
13-14

Firm U 15.0% 9.0% 9 0%

Firm L 15.0% 10.8% 10 8% 2.5x

Conclusions
Basic earning power (BEP) is unaffected by financial leverage. L has higher expected ROE because BEP > kd. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

Optimal Capital Structure

That capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. Trades off higher E(ROE) g ( ) and EPS against higher risk. The taxrelated benefits of leverage are exactly offset by the debts risk-related costs. The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.
13-15 13-16

Stock Price, with zero growth

P0 = D1 EPS DPS = = ks - g ks ks

What effect does increasing debt have on the cost of equity for the firm? If the level of debt increases, the riskiness of the firm increases. We have already observed the increase y in the cost of debt. However, the riskiness of the firms equity also increases, resulting in a higher ks.
13-18

If all earnings are paid out as dividends, E(g) = 0. EPS = DPS To find the expected stock price (P0), we must find the appropriate ks at each of the debt levels discussed.
13-17

12/15/2008

Finding Optimal Capital Structure

The firms optimal capital structure can be determined two ways:
Minimizes WACC. Maximizes stock price.

Table for calculating WACC and determining the minimum WACC

Amount borrowed D/A ratio $ 0 250 500 750 1,000 E/A ratio ks kd (1 T) WACC 12.00% 12 00% 11.55 11.25 11.44 12.00
13-20

0.00% 0 00% 100.00% 12 00% 0 00% 12.00% 0.00% 12.50 25.00 37.50 50.00 87.50 75.00 62.50 50.00 12.51 13.20 14.16 15.60 4.80 5.40 6.90 8.40

Both methods yield the same results.

* Amount borrowed expressed in terms of thousands of dollars

13-19

Table for determining the stock price maximizing capital structure

Amount Borrowed DPS ks P0

What debt ratio maximizes EPS?

Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50%. (Remember DPS = EPS because payout = 100%.) Risk is too high at D/A = 50%.

0 250,000 500,000 750,000

$3.00 3.26 3.55 3.77 3.90

12.00% 12.51 13.20 14.16 15.60

$25.00 26.03 26.89 26.59 25.00

13-21

1,000,000

13-22

What if there were more/less business risk than originally estimated, how would the analysis be affected?
If there were higher business risk, then the probability of financial distress would be greater at any debt level, and the optimal capital structure would be one l l ld b that had less debt. On the other hand, lower business risk would lead to an optimal capital structure with more debt.

Other factors to consider when establishing the firms target capital structure
1. 2. 3. 3 4. 5. 6. 7.

Industry average debt ratio TIE ratios under different scenarios Lender/rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure Expected tax rate
13-24

13-23

12/15/2008

How would these factors affect the target capital structure?

1. 2. 3. 3 4. 5. 6.

What can managers be expected to do?

Issue stock if they think stock is overvalued. Issue debt if they think stock is y undervalued. As a result, investors view a common stock offering as a negative signal-managers think stock is overvalued.

Sales stability? High operating leverage? Increase in the corporate tax rate? Increase in the personal tax rate? Increase in bankruptcy costs? Management spending lots of money on lavish perks?
13-25

13-26

Conclusions on Capital Structure

Need to make calculations as we did, but should also recognize inputs are guesstimates. As a result of imprecise numbers, capital structure decisions have a large judgmental content. We end up with capital structures varying widely among firms, even similar ones in same industry.
13-27

Questions
Q13-3 Q13-5

13-28

Problems
ST-2 P13-2 P13-6 P13 6 P13-7 P13-10

13-29

CHAPTER 14 Distributions to shareholders:

Dividends and share repurchases
Theories of investor preferences Signaling effects Residual model Dividend reinvestment plans Stock dividends and stock splits Stock repurchases
14-1

What is dividend policy?

The decision to pay out earnings versus retaining and reinvesting them. Dividend policy includes
High or low dividend payout? Stable or irregular dividends? How frequent to pay dividends? Announce the policy?
14-2

Do investors prefer high or low dividend payouts?

Three theories of dividend policy:
Dividend irrelevance: Investors dont p y care about payout. Bird-in-the-hand: Investors prefer a high payout. Tax preference: Investors prefer a low payout.

Dividend irrelevance theory

Investors are indifferent between dividends and retention-generated capital gains. Investors can create their own dividend policy:
If they want cash, they can sell stock. cash stock If they dont want cash, they can use dividends to buy stock.

14-3

Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need an empirical test. Implication: any payout is OK.

14-4

Bird-in-the-hand theory
Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so investors would value high-payout so, high payout firms more highly, i.e., a high payout would result in a high P0. Implication: set a high payout.

Tax Preference Theory

Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 20% vs. up to 38.6%. Capital gains taxes are also deferred. deferred This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P0. Implication: Set a low payout.

14-5

14-6

Possible stock price effects

Stock Price ($)

Possible cost of equity effects

Cost of Equity (%)

Bird-in-the-Hand 40 30 20 10 Irrelevance

30 25 20 15 10 5 Bird-in-the-Hand 0 50% 100%

Payout
14-8

Tax preference

Tax preference

Irrelevance

50%

100%

Payout

14-7

Which theory is most correct?

Empirical testing has not been able to determine which theory, if any, is correct. Thus, managers use judgment when setting policy. Analysis is used, but it must be applied with judgment.

Whats the information content, or signaling, hypothesis?

Managers hate to cut dividends, so they wont raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of managements view of the future. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.
14-10

14-9

Whats the clientele effect?

Different groups of investors, or clienteles, prefer different dividend policies. Firms past dividend policy determines its current clientele of investors. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.
14-11

What is the residual dividend model?

Find the retained earnings needed for the capital budget. Pay out any leftover earnings (the y y g ( residual) as dividends. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

14-12

Residual dividend model

Target Dividends = Net Income - equity ratio Total capital budget

Residual dividend model: Calculating dividends paid

Calculate portion of capital budget to be funded by equity.
Of the $800,000 capital budget, 0.6($800,000) q y = $480,000 will be funded with equity.

Calculate excess or need for equity capital.

With net income of $600,000, there is more than enough equity to fund the capital budget. There will be $600,000 - $480,000 = $120,000 left over to pay as dividends.

Capital budget $800,000 Target capital structure 40% debt, 60% equity Forecasted net income $600,000 How much of the forecasted net income should be paid out as dividends? 14-13

Calculate dividend payout ratio

$120,000 / $600,000 = 0.20 = 20%
14-14

Residual dividend model: What if net income drops to $400,000? Rises to $800,000?
If NI = $400,000
Dividends = $400,000 (0.6)($800,000) = -$80,000. Since the dividend results in a negative number, the firm must use all of its net income to fund its budget, and probably should issue equity to maintain its target capital structure. Payout = $0 / $400,000 = 0%

How would a change in investment opportunities affect dividend under the residual policy? Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. More good investments would lead to a lower dividend payout.

If NI = $800,000
Dividends = $800,000 (0.6)($800,000) = $320,000. Payout = $320,000 / $800,000 = 40% 14-15
14-16

Comments on Residual Dividend Policy

Advantage Minimizes new stock issues and flotation costs. Disadvantages Results in variable dividends, sends conflicting signals, f increases risk, and doesnt appeal to any specific clientele. Conclusion Consider residual policy when setting target payout, but dont follow it rigidly.
14-17

Whats a dividend reinvestment plan (DRIP)?

Shareholders can automatically reinvest their dividends in shares of the companys common stock. Get more stock than cash. There are two types of plans:
Open market New stock

14-18

Open Market Purchase Plan

Dollars to be reinvested are turned over to trustee, who buys shares on the open market. Brokerage costs are reduced by volume purchases. Convenient, easy way to invest, thus useful for investors.

New Stock Plan

Firm issues new stock to DRIP enrollees (usually at a discount from the market price), keeps money and uses it to buy assets. assets Firms that need new equity capital use new stock plans. Firms with no need for new equity capital use open market purchase plans. Most NYSE listed companies have a DRIP. Useful for investors.
14-20

14-19

Setting Dividend Policy

Forecast capital needs over a planning horizon, often 5 years. Set a target capital structure. Estimate annual equity needs. needs Set target payout based on the residual model. Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.
14-21

Stock Repurchases
Buying own stock back from stockholders Reasons for repurchases: p
As an alternative to distributing cash as dividends. To dispose of one-time cash from an asset sale. To make a large capital structure change.
14-22

Advantages of Repurchases
Stockholders can tender or not. Helps avoid setting a high dividend that cannot be maintained. Repurchased stock can be used in takeovers or resold to raise cash as needed. Income received is capital gains rather than higher-taxed dividends. Stockholders may take as a positive signal-management thinks stock is undervalued.
14-23

Disadvantages of Repurchases
May be viewed as a negative signal (firm has poor investment opportunities). IRS could impose penalties if repurchases were primarily to avoid taxes on dividends. dividends Selling stockholders may not be well informed, hence be treated unfairly. Firm may have to bid up price to complete purchase, thus paying too much for its own stock.
14-24

Stock dividends vs. Stock splits

Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for each 100 shares owned. Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares.

Stock dividends vs. Stock splits

Both stock dividends and stock splits increase the number of shares outstanding, so the pie is divided into smaller pieces. Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investors wealth unchanged. But splits/stock dividends may get us to an optimal price range.
14-26

14-25

When and why should a firm consider splitting its stock?

Theres a widespread belief that the optimal price range for stocks is $20 to $80. Stock splits can be used to keep the price in this optimal range. range Stock splits generally occur when management is confident, so are interpreted as positive signals. On average, stocks tend to outperform the market in the year following a split.
14-27

Problems
P14-1 P14-2 P14-3 P14 3 P14-4 P14-6 P14-7 P14-9
14-28