Professional Documents
Culture Documents
QUESTIONS
Home Depots market capitalization of $105 billion reflects the capital markets
assessment of the firm based on what the market expects to transpire with
respect to the firms future operations; it is the markets assessment of the
firms current value as a function of its expectations about Home Depots future
operating performance. The companys book value is not a forward-looking
measure of value but rather is a reflection of a firms historical performance.
Thus, while market capitalization is based on expectations about the future,
book value is based on actual past events. Since Home Depots market
capitalization is almost six times its book value, the capital market appears to
believe that the companys future is brighter than its past.
Q11.2 Free Share Distributions. It is appropriate to label stock dividends and stock
splits as free share distributions for two reasons. First, in both a stock split
and a forward stock dividend, shareholders end up with a greater number of
shares which are distributed free of charge to shareholders (i.e., there is no
purchase price associated with the new shares). Second, the value of the newly
distributed shares is zero; that is, the total cost basis of a shareholders
investment in a company is unchanged by a stock dividend or stock split. The
cost basis of each individual share declines as a result of the greater number of
outstanding shares, as does the market value per share, but no wealth is
transferred from the company to its shareholders in either of these share
transactions.
Q11.4 Multiple Classes of Voting Rights. A two-class stock structure found in many
family-centered businesses allows the members of the founding family to sell
shares in the business while maintaining a disproportionate level of control over
the business. The two-class stock structure is, for example, typical of the
newspaper industry (e.g., The Washington Post, Dow Jones & Co., and Viacom
Inc., have multiple class structures). A representative of Morgan Stanley,
quoted in The Wall Street Journal article, explained why the firm opposed the
two-class structure:
Declassifying the share structure will foster a culture of
accountability that will ultimately benefit all shareholders, by
improving financial and operational performance and closing the
gap between the market price of the stock and its intrinsic value.
Thus, Morgan Stanleys motivation appears to be two-fold:
1. Increase the share value of the Class A shares.
2. Foster accountability and governance.
A useful discussion concerns why the elimination of the Times Class B shares
would cause the value of the Class A shares to increase.
Q11.5 Oversubscribed Initial Public Offering. Given the large oversubscription to its
IPO, Reliance Petroleum has a number of options:
1. Increase the number of shares offered for sale in the IPO, assuming
that there are additional authorized but unissued shares available.
2. Maintain the IPO offering at 1.8 million shares but raise the IPO share
price above the estimated range of 57 to 62 rupees to capture some of
the excess demand via a price increase.
3. Some combination of Option 1 (volume increase) and Option 2 (price
increase).
Assuming that 25 percent of the company will be worth $2.5 billion to $2.7
billion under the current IPO plan, the implicit value of 100 percent of the
company would be $10 billion to $10.8 billion.
Q11.7 Dividend Reductions. Most public companies set their dividend policy after
first assessing their capacity to generate excess future discretionary operating
cash flow. Since a change in dividend policy (either an increase or decrease) is
an important signal about a firms future financial health, these changes are
carefully monitored by the capital market and usually induce significant share
price reactions. Cutting a dividend would normally cause a significant share
price reduction; however, in the case of The Mills Corporation, the decision
appears to have been already priced into its share price as news of the
announcement led to an increase in share price, probably for two reasons.
First, analysts may have been expecting a steeper dividend cut than the
company actually announced. Second, the announcement may have signaled
the market that The Mills Corporation was finally taking positive steps to correct
its operational problems.
Q11.8 Dividend Payout Ratio. The dividend payout ratio indicates the percentage of
current net income paid to shareholders in the form of a dividend. Generally,
high-growth companies have a low or zero dividend payout ratio because these
companies use their operating income to fund their future growth. Mature or
low-growth companies generally pay high dividends, and hence, have a high
dividend payout policy. Mature companies pay large dividends as a way to
attract and retain investors. By definition, mature companies are unlikely to
show large share price appreciation, and thus, investors must be attracted to
such firms through their dividend payouts. Individual investors in search of
regular income flows (e.g., retired persons) are likely to prefer companies like
Procter & Gamble or Pfizer, to companies like Intel or Cisco, which pay no
dividends.
It will give the board a strong incentive not to look too closely at
the numbers. It puts directors on the same side as management.
In short, the new plan could change the role of the board of directors from being
a watchdog to being a cheerleader.
Peter Drucker, the management guru, stated that the purpose of business is to
create and keep a customer. From this concept it follows that the well-being of
the other stakeholders of a business should cascade from that focus. The logic
behind this is that if the customer is satisfied in terms of quality, price, etc., they
will continue to demand the product. This, in turn, is necessary for healthy and
sustainable financial rewards for the company. Further, the proper treatment of
employees, the community, and the environment should all factor into how the
customer views a company and its products and services. Ultimately
stakeholder theory and shareholder maximization appear intertwined rather
than being competing theories.
(Note: This answer was based on the writings of Bill Bramer and Leak Emkin.)
Stockholders Equity
12/31
Common stock $ 600,000
Additional paid-in-capital 89,400,000
Retained earnings 36,500,000
Treasury stock (8,450,000)
Total shareholders equity $ 118,050,000
The capital market response to a preferred stock conversion into common stock
can be both positive and negative. On the one hand, converting the preferred
shares into common will free up cash flow to be used to support operations or
to increase the common stock dividendpreferred stock usually pays a higher
dividend than common stock. On the other hand, adding additional common
shares to the number of shares outstanding may drive the share price down
that is, the event may be price dilutive! Another concern is that the cost of
equity on common shares is usually higher than the cost of capital associated
with preferred shares. In short, it is unclear how the market will weigh each of
these factors and impound them into the new common share price
E11.20 Adjusting Conversion Ratios for Stock Splits and Stock Dividends.
Convertible Convertible
Preferred Stock Debenture
Original conversion ratio 3-to-1 46-to-1
Revised conversion ratio after
o 10% stock dividend 3.3-to-1 50.6-to-1
o 2:1 stock split 6.6-to-1 101.2 to 1
E11.21 Contrasting the Contributed Capital of a Firm with Treasury Stock. The
ratio of treasury stock (TS) divided by contributed capital indicates the portion
of a firms contributed capital (CC) that is outstanding:
Cisco
Systems Intel Microsoft
(TS CC) 1.00 1.38 0.13
Each of the above three companies have active stock repurchase plans, in part
to offset the dilutive effect of the many employee stock options. A ratio 1.0 or
greater (e.g., Cisco and Intel) indicates that the firm has repurchased treasury
shares at least equivalent to the value of the firms contributed capital. In the
case of Intel, it has repurchased shares valued at 138 percent of its contributed
capital. Thus, for Intel, while there are shares outstanding, the book value of
those shares in terms of the contributed capital is effectively negative (i.e., the
value of treasury shares exceeds the value of contributed capital).
b Par value
.
At IPO $1.00
After 3-for-1 stock split $1/3 = $0.333
2.
The Mayfair Corporation
Initial Balance
Transaction Public Stock Stock Share Cash Sheet
(in thousands) Offering Dividend Split* Repurchase Dividend Totals
Assets
Cash 30,000 (7,500) (3,250) 19,250
Shareholders Equity no
entry
Ordinary shares 10,000 1,000 11,000
APIC 20,000 5,000 25,000
Retained earnings (6,000) (3,250) (9,250)
Treasury stock (7,500) (7,500)
Total Shareholders Equity 19,250
Cambridge Business Publishers, 2014
Solutions Manual, Chapter 11 11-11
* No financial effect: par value declines from $1 to $0.333 while shares outstanding
increase from 11 million to 33 million
3.
CompX International
Stock Stock Share Balance Sheet
Transaction Split* Dividend Repurchase Totals
Assets
Cash no (3,000,000) (3,000,000)
Shareholders Equity entry
Common stock 6,100 6,100
APIC 24,393,900 24,393,900
Retained earnings (24,400,000) (24,400,000)
Treasury stock (3,000,000) (3,000,000)
Total Shareholders Equity (3,000,000)
* No financial effect: par value declines from $.01 to $0.005 while shares outstanding
increase from 6.1 million to 12.2 million
3. A small stock dividend, in and of itself, would not make the shareholders
happy because the stock price adjusted for the stock dividend will fall
leaving the shareholders with their wealth unchanged. However, typically
share prices increase after the announcement of a stock dividend because
they are thought to provide information to the market that a firms future
prospects look promising.
5. The company issued either a 100 percent stock dividend or a 2-for-1 stock
split and chose to account for the dividend/split by capitalizing additional
paid-in-capital instead of adjusting the par value or capitalizing retained
earnings.
Conversion
Account Financial Effects
Preferred stock Declines by the amount of its book value
(not reported in problem)
Common stock, Increases by 1 million euros (i.e., 1 million
1 euro par value shares @ 1 euro per share)
APIC Increases by the difference (a plug figure)
between the book value of the preferred
shares and 1million euros (i.e., par value of
common shares issued)
2. Common stock repurchases totaled $4.632 billion (i.e., $1.714 million plus
$2.918 billion), probably to offset the dilutive share price effect of the
issuance of common shares under the employee stock option and stock
purchase plans. Note: It is unclear why Microsoft accounts for $1.714
million in share repurchases under common stock and the remaining $2.918
billion under Retained Earnings.
The U.S. dollar depreciated against the Australian dollar during the year,
making the translated value of Grahams net assets in Australia worth more.
3. Appreciated
b. Financing Policy
2012 2011
Total debt total assets 51.6% 50.8%
Total shareholders equity total assets 48.4% 49.2%
Total 100.0% 100.0%
Weighted-average cost of debt: short-term 0.6% 0.9%
Cost of debt: long-term 3.3% 3.4%
(see footnote no. 5)
Cost of equity (using CAPM) 6.19%
re = 1.78 + 0.31(16.00 1.78) = 6.19%
P&Gs short-term cost of debt decreased by a third, while its long-term cost
of borrowing remained almost flat.
b. The accounts most likely to have been impacted to reflect the 2,819
euros include the asset accounts land and financial investments.