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by: Mrs. Oleta Okuneva


Mrs. Oleta Okuneva
GPA 3.74

Qingfeng Liu

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Qingfeng Liu
Class Notes
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This 129 page Class Notes was uploaded by Mrs. Oleta Okuneva on Saturday September 26, 2015. The Class Notes belongs to COB 300B at James Madison University taught by Qingfeng Liu in Fall. Since its upload, it has received 22 views. For similar materials see /class/214042/cob-300b-james-madison-university in College of Business at James Madison University.

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Date Created: 09/26/15
W Pl aaratlon fOLEx m f P i I I m Chapters 7 8 12 13 14 r Cont class ignments are NOT require Imp rtant Review the endof c assi ents solutions and lecture notes on board Read the textbook fo context 5 durin xam K 3 festi0nspr0blems all multi lechoice 3 A Chapter 7 Bonds Bonds Type of debt or longterm promissory note issued by a borrower promising to its holder a predetermined and xed amount of interest per year and repayment of principal at maturity Issuers or Borrowers Corporations US Government State and Local Municipalities Bonds A Type of LongTerm Debt Making Money Inc Balance Sheet At December 31 2004 ASSETS LIABILITIES amp SE Current Assets Current Liabilities Cash and equivalents 15 Accounts Payable 30 S T Investments 65 Accrued Liab 20 Accounts Rec net 315 S T Notes payable 30 Inventories 415 WP Bank LOC 4 Total Current Assets 810 Curr Bond redempt 6 Total Current Liab 220 PP amp E at cost 920 Less ND 50 L T bonds excl current 560 Net PP amp E 0 Preferred stock 4k sh 40 Bonds Common stock50ksh 30 Addition paid in capital 100 Retained earnings 710 Total common equity 840 Total Assets 1680 Total Liab and equity 1680 Bonds contain two parts Periodic interest payments Lump sum principal payments This IS an ordinary annuity 7 This is a single sum Types of Bonds Debentures Subordinated Debentures Mortgage Bonds Eurobonds Convertible Bonds Debentures Debentures are unsecured longterm debt Secured debt has collaterals e g the rm s assets 0 For issuing rm debentures provide the bene t of not tying up property as collateral 0 For bondholders debentures are more risky than secured bonds and provide a higher yield than secured bonds Subordinated Debenture 0 There is a hierarchy of payout in case of insolvency The claims of subordinated debentures are honored only m the claims of secured debt and unsubordinated debentures have been satis ed Mortgage Bond Mortgage bond is secured by a lien on real property 0 Typically the value of the real property is greater than that of the bonds issued Eurobonds Eurobonds Issued in a country different from the one in Whose currency the bond is denominated Country and currency do not match 0 For example a bond issued by an American corporation in Japan that pays interest and principal in dollars 0 Foreign bonds Country and currency do match Convertible Bonds Convertible bonds are debt securities that can be converted into a rm s stock at a prespeci ed price Bond Terminology Claims on assets and income in case of bankruptcy 0 Par value Current yield Coupon interest rate 0 Maturity Call provision Indenture Bond ratings Par Value Par value is the face value of the bond returned to the bondholder at maturity regardless of the price paid at the time of purchase In general corporate bonds are issued at denominations or par value of 1000 Prices are quoted as a of face value Thus a bond quoted at 112 can be bought at 112 of its par value in the market Coupon Interest Rate The percentage of the par value of the bond that will be paid periodically in the form of interest 0 Example A bond with a 1000 par value and 5 coupon rate will pay 50 annually 05 1000 or 25 if interest is paid semiannually Maturity Maturity of bond refers to the length of time until the bond issuer returns the par value to the bondholder and terminates 0r redeems the bond Call Provision Call provision gives corporation the option to redeem the bonds before the maturity date 0 For example if the prevailing interest rate goes down the rm may want to pay off the bonds early and reissue at a more favorable interest rate Issuer must pay the bondholders a premium Not all bonds have a call provision Indenture 0 An indenture is the legal agreement between the rm issuing the bond and the trustee who represents the bondholders 0 Many of the terms seek to protect the status of bonds from being weakened by managerial actions or by other security holders Bond Ratings 0 Bond ratings re ect the future default risk of the bonds 0 Three prominent bond rating agencies are Standard amp Poor Moody s and Fitch Investor Services Lower bond rating indicates higher probability of default It also means that the rate of return demanded by the capital markets will be higher on such bonds Bond Ratings Moody s and Standards and Poor s SampP Ratings AGENCY INVESTMENT GRADE JUNK BONDS Moody s Aaa Aa A Baa Ba B Caa C SampP AAA AA BB BB B 000 V high grade medium grade low and very low grade 1 Highrisk highyield What risk do bond ratings rate Favorable Factors affecting Bond Rating A greater reliance on equity as opposed to debt in nancing the rm Pro table operations Low variability in past earnings Large rm size Minimal use of subordinated debt Junk Bonds Junk bonds are highrisk bonds with ratings of BB or below by Moody s and Standard amp Poor s Junk bonds are also referred to as high yield bonds as they pay high interest rate 35 more than AAA rated bonds Bond Valuation What Determines Asset Value Value of an Asset Present value of its expected future cash ows using the investor s required rate of return as the discount rate 0 Thus value is affected by three elements Amount and timing of the asset s expected future cash ows Riskiness of the cash ows Investor s required rate of return for undertaking the investment Bond Valuation The value of a bond V is a combination of C Future expected cash ows in the form of interest and repayment of principal n The time to maturity of the loan r The investor s required rate of return Typical cash ows on a Bond for Corporation l m Cash ow 0 Cash in ow from Bond Issue l Maturity Pay Interest Maturity Repay Principal Exceptions Bankruptcy Bond Recalled and paid off before the due date Mergers and acquisitions Typical cash ows on a Bond for M l Time Cash ow 0 Pay for bond Buy l Maturity Receive Interest Maturity Receive Par value back Excegtions Bankruptcy Bond Recalled Bond sold by investor in the market before maturity date Mergers amp acquisitions Example 011 Bond Valuation Consider a bond issued by Toyota with a maturity date of 2010 and a stated coupon of 435 In December 2005 with 5 years left to maturity investors owning the bonds are requiring a 36 rate of return Toyota Bond Example reg I CFZ Estimate amount and timing of the expected future cash ows Annual Interest payments 0435 x 1000 4350 every year for ve years The par value of 1000 to be received in 2010 Summary of Cash Flows I For One Bond m Bondholder Corporation 0 Price Price 1 5 435 435 5 1000 1000 Toyota Bond Example reg 2 r2 Determine the investor s required rate of return by evaluating the riskiness 0f the bond s future cash ows The required rate of return r is given as 36 Toyota Bond Example Steg 3 Calculate the intrinsic value of the bond Bond Value PV Interest received every year PV Par received at maturity Toyota Bond Example PV435 for 5 years r 36 PV1000 at year 5 139 36 PVofAnnuity A 435 N 5 r 36 P V of single cash ow FV 1000 N 5 139 36 103377 In calculator FV 1000 N 5 IY R 36 PMT 435 solve for PV Toyota Bond Example PV435 for 5 years r 36 PV1000 at year 5 139 36 PVofAnnuity A 435 N 5 r 36 P V of single cash ow FV 1000 N 5139 36 103377 Toyota Bond Example Annual coupon FV 1000 N 5 IYR 36 PMT 435 solve for PV 103377 Semiannual coupon N IY R PMT need adjustments FV 1000 N 52 10 IYR 362 18 PMT 4352 2175 solve for PV PV Bond Price negative sign FV 1000 Par Value PMT Coupon Payment Coupon rate X 1000 2 N Number of years X 2 IYR Semiannual YTM Assume semiannual coupon payments Boninelds Yield to Maturity YTM YTM refers to the rate of return the investor will earn if the bond is held to maturity YTM is also known as bondholder s expected rate of return YTM Discount rate Bond Yields To nd YTM ie annualized lYR we need a current bond price PV b time left to maturity N c par Value FV usually 1000 d coupon payment PMT coupon ratc l 000 Remember that N lYR and PMT need to be on the same compounding basis Bond Yield Example 0 What is the Yield to Maturity on a 1000 par value bond that pays 4 coupon interest compounded semiannually With 4 years remaining if the bond is currently selling for 850 0 Info Recap Par Value 1 000 Semi Period t0 Maturity 4 x 2 8 Semi Coupon Rate 4 2 1000 20 Market Price ofBond 850 Note It is important that this problem is set up semiannually Bond Yields Example 20 20 850 lt YTM 1000 Calculator Steps 20 PMT 1000 FV 850 PV Note you must enter this as a negative 8 n Solve for IYR 425 Is YTM equal to 425 YTM 425 x 2 85 Your turn What is the Yield to Maturity on a 1000 par value bond that pays 9 coupon interest compounded semiannually With 6 years remaining if the bond is currently selling for 737 Answer 1598 Current Yield 0 Current Yield Annual interest payment current market price of the bond Example The current yield on a 1000 par value bond with 8 coupon rate and market price of 700 80700 114 Total Yield ie Total Return Total Yield from Bond Current Yield Capital gainloss from sale of bond 0 Thus in the previous example if the bond was bought for 700 and sold for 725 and the bondholder received one annual coupon payment Total Yield 80 725 700 105 or 105700 2 15 Bond Valuation Three Important Relationships 1 gt Relationship 1 As interest rates increase decrease the value of the bond decreases increases Bond Valuation Three Important Relationships Relationship 2 The market value of a bond will be below the par value ie a discount bond if the interest rate is above the coupon rate 0 The market value of a bond will be above the par value ie a premium bond if the interest rate is below the coupon rate Bond Prices and Interest Rates Market Interest Rate YTM Market Interest Rate Coupon Market Interest Rate Interest Rate Market Interest Rate Discount Bond Valuation Three Important Relationships l quot Relationship 3 0 Longterm bonds have greater interest rate risk than do shortterm bonds 0 In other words a change in interest rate will have relatively greater impact on longterm bonds see Excel worksheet Risk vs Return A Historical View 10000 T i 0 Large Company Stocks 2587 11 00 1 000 0 Government Bonds 39 0 Treasury Bills Ending Averag 0 Inflation Wealth Return 100 49 53 17 38 10 quot M 939 10 31 1 in Mam gquot 0 1 i l i l l l 1925 1935 1945 1955 1965 1975 1985 2000 Main Risks for Bondholders 0 Interest Rate Risk if interest rates rise the market value of bonds will fall 0 Default Risk this may mean no or partial payment on debt as in bankruptcy cases Call Risk If bonds are called before maturity date bonds are generally called when interest rates decrease Thus investors will have to reinvest the money received from corporation at a lower rate Chapter 8 Stocks 0 TWO types Preferred stock Common stock Preferred Stock 0 Preferred stock is often referred to as a hybrid security because it has many characteristics of both common stock and bonds Hybrid nature of Preferred stocks 0 Like common stocks preferred stocks Have no xed maturity date Failure to pay dividends does not lead to bankruptcy Dividends are not a taxdeductible expense 0 Like Bonds Dividends are xed in amount either as a amount or as a of par value Characteristics of Preferred Stocks 0 Multiple series of preferred stock 0 Preferred stock s claim on assets and income Cumulative dividends Protective provisions Convertibility 0 Retirement Features Multiple Series 0 If a company desires it can issue more than one series of preferred stock and each series can have different characteristics such as different protective provisions and convertibility rights Claim on Assets and Income Claim on Assets Preferred stock has priority over common stock with regard to claim on assets in the case of bankruptcy Preferred stockholders claims are honored before common stockholders but after bonds 0 Claim on Income Preferred stock also has priority over common stock with regard to diVidend payments Thus preferred stocks are safer than common stock but riskier than bonds Cumulative Dividends Cumulative feature if it exists requires that all past unpaid preferred stock dividends be paid before any common stock dividends are declared Protective Provisions Protective provisions generally allow for voting rights in the event of nonpayment of dividends or they restrict the payment of common stock dividends if sinkingfunds payments are not met or if the rm is in nancial dif culty Convertibility Convertible preferred stock can at the discretion of the holder be converted into a predetermined number of shares of common stock 0 Almost onethird of preferred stock issued today is convertible preferred Retirement Features 0 Although preferred stock has no set maturity associated with it issuing rms generally provide for some method of retiring the stock such as a call provision or sinking fund provision Call provision entitles the corporation to repurchase its preferred stock at stated prices over a given time period Sinking fund provision requires the firm to set aside an amount of money for the retirement of its preferred stock Differences Between Debt amp Equity Type of capital Characteristic Debt Equity Voice in managementquot No Yes Claims on income and assets Senior to equity Subordinate to debt Maturity Stated None Tax treatment Interest d eduCtion No deduction quotIn the event that the issuer violates its stated contractual obligations to them d btholdcrs and preferred Stockholders may receive a voice in management otherwise onlyr common stockholders have voting rights Financinq with debt or equity which is cheaper Valuing Preferred Stock The value of a preferred stock is equal to the present value of all future dividends annual dividend D I required rate of return rps ie PV of perpetuity equation How is it derived Valuing Preferred Stock annual dividend D 1 required rate of return rps Example Assume lNGA s preferred stock pays an annual dividend of 375 and the investors required rate of return is 6 Common Stock Common stock is a certi cate that indicates ownership in a corporation When you buy a share you buy a part share of the company and attain ownership rights in proportion to your share of the company Common stockholders are the true owners of the rm Bondholders and preferred stock holders can be Viewed as creditors What do bondholders and preferred stock holders receive as income How about common stock holders Common Stock 0 Status Owners 0 Life No maturity date 0 Rights to votes and assets In proportion to number of shares held 0 Liability Limited to amount of investment 0 Source of Return Dividends if paid and Capital gain if sold at a higher price 0 Dividends Neither xed nor guaranteed 0 Seniority In the event of bankruptcy common stockholders will not receive any payment until all the creditors including the bondholders and preferred stockholders have been satis ed Features of Common Stocks Claim on income Claim on assets Voting rights Preemptive rights Claim on Income Common shareholders have the right to residual income after bondholders and preferred stockholders have been paid Residual income can be paid in the form of dividends or retained Within the rm and reinvested in the business Claim on Assets Common stock has a residual claim on assets in the case of liquidation Residual claim implies that the claims of debt holders and preferred stockholders have to be met prior to common stockholders Generally if bankruptcy occurs claims of the common shareholders are typically not satis ed Who gets the money rst Voting Rights Most often common stockholders are the only security holders with a vote Majority of shareholders generally vote by proxy Proxy ghts are battles between rival groups for proxy votes 0 Common shareholders are entitled to elect the board of directors approve any change in the corporate charter Voting Rights Usually shareholders do not really pick the board Rather they simply select from a list of nominees chosen by the management Do you see any problems here Preemptive Rights Preemptive right entitles the common shareholder to maintain a proportionate share of ownership in the rm Thus if a shareholder currently owns 5 of the shares she has the right to purchase 5 of the new shares being issued 0 These rights are issued in the form of certi cates that give shareholders the option to buy new shares at a speci c price during a 2 to 10 week period eg IBMRT These rights can be exercised sold in the open market or allowed to expire Valuing Common Stock 0 Like bonds and preferred stock the value of common stock equals the present value of all future expected cash ows ie dividends However dividends are neither fixed nor guaranteed which makes it harder to value common stocks compared to bonds and preferred stocks Valuing Common Stock D1 D2 D3 Dr 2 2 3 I 1R 1R 1R 1R Note R rcs in textbook Constant Dividend D1 D2 D3 Dt 0 D1 D1 D1 D1 2 3 t 1R 1R 1R 1R 0 then D1 Constant Dividend Growth D2 D11 g D3 D11 g2 D1 D11g D11g2 0 1R 112 1R3 Then the Gordon Growth Model D1 Do 1 g R g R g P0 Note R rcs in textbook Dividend Valuation Model Value of Common stock PV of future dividends Vcs Dlrcs VCS Common stock value D1 dividend in year 1 rcs required rate of return g growth rate Example Dividend valuation model Consider the valuation of a common stock that paid 100 dividend at the end of the last year and is expected to pay a cash dividend in the future Dividends are expected to grow at 10 and the investors required rate of return is 17 Example Dividend valuation model z39 The dividend last year was 1 Was it D1 or Do Vcs Dlrcsg Your turn Suppose Big D Inc just paid a dividend of 50 It is expected to increase its diVidend by 2 per year If the market requires a return of 15 on assets of this risk how much should the stock be selling for HOW can a company gI OW 0 Through Infusion of capital by borrowing or issuing new common stock 0 Through Internal growth Management retains some or all of the rm s pro ts for reinvestment in the rm resulting in future earnings growth and value of stock 0 Internal growth directly affects the existing stockholders and is the only growth factor used for valuation purposes Internal Growth How is g determined g ROE gtlt pr where g the growth rate of future earnings and the growth in the common stockholders investment in the rm ROE the return on equity net income common book value pr of pro ts retained pro t retention rate What does 1 pr mean Example Suppose ABC Inc expects an ROE of 20 and plans to retain 60 of the pro t in the rm What is the rm s expected growth rate g gROEgtltpr Expected Rate of Return of stockholders 0 Preferred Stock Expected Return Annual dividendmarket price 0 Example If the current market price of preferred stock is 75 and the stock pays 5 preferred dividend Then the expected rate of return 575 667 Common Stock Expected Return Common Stock Expected Return Dividend in year 1 market price growth rate Dividend Yield growth Rate rcs g rearrange and solve for res D1 PO g f Dividend Growth Yield Rate res Example The current market price of stock is 90 and the stock pays dividend of 3 with a growth rate of 5 Expected Rate of Return w 5 90 35 5 85 Expected Rate of Return of stockholders Growth rate is also called the Capital Gains Yield 0 Historically most of the returns on stocks has come from capital gains 0 The SampP 500 Index has returned an average annual return of 10 since 1926 with dividend yield accounting for only about 2 of the return How about the capital gains yield Expected Rate of Return VS Required Rate of Return b 0 Expected Rate of Return The return expected of a security based on its market price Preferred Stock Expected Return Annual dividendmarket price Common Stock Expected Return Dividend in year 1 market price growth rate Expected Rate of Return vs Required Rate of Return 39 Required Rate of Return The return required of a security by an investor based on its risk If Expected Rate of Return gt Required Rate of Return would the investor be Willing to buy the security TwoStage Growth Zylon Corporation Stock is Selling for 60 Growth Rate 20 for 2 years Growth will level off thereafter at 6 Firm just paid a dividend of 2 Do Required Rate of Return 10 Is Zylon a good buy TwoStage Growth Steps 1 Solve for nonconstant dividends Years 1 amp 2 2 Solve for stock value once constant growth begins 3 Solve for the PV of the 2 cash ow streams TwoStage Growth 0 D1 D0 1g 2120 240 0 D2 D1 1g 240120 288 Solve for stock value when constant growth begins i e Year 3 P2 D3kg D21gkg 2881061006 7625 TwoStage Growth O 1 2 n years I I I 240 288 7625 Calculator Steps PV I10 0 CFJ 240 CFj 2887625 CFj 10 IYR Function NPV 6757 Given a current price of 60 will you buy the stock Your turn Duke Corporation Stock is Selling for 95 Growth Rate 10 for 2 years Growth will level off thereafter at 5 Firm just paid a dividend of 3 Do Required Rate of Return 9 Is Duke a good buy In the final Business Plan 0 1 2 3 4 5 n I I I I I I CFO CF1 CFZ CF3 CF4 CF5 0 We assume that the business becomes mature and net incomedividends grow by a constant rate beginning in Year 6 0 From the standpoint of equity investors both founders and outside equity investors CFO all contributed guity capital upfront CF1 CF2 CF3 CF4 CFS are dividends in Years 15 For Year 6 to in nity use the Gordon Growth Model Use all the cash ows to solve for NPV IRR and MIRR IRR and MIRR are used as Return On Investment ROI Chapter 12 Determining the Financing Mix 0 M Risk is variability associated With expected revenue or income streams Such variability may arise due to Choice of business line business risk Choice of an operating cost structure operating risk Choice of capital structure nancial risk Business Risk 0 Business Risk The variation in the rm s expected earnings attributable to the industry in which the rm operates There are four determinants of business risk The stability of the domestic economy The exposure to and stability of foreign economies Sensitivity to the business cycle Competition in the rm s industry Operating Risk Operating risk The variation in the rm s operating earnings that results from rm s cost structure mix of xed and variable operating Lsts Earnings of rms with higher proportion of xed operating costs are more vulnerable to change in revenues Why Financial Risk 0 Financial Risk is the variation in earnings as a result of rm s nancing mix or proportion of nancing that requires a xed return Which proportion Why does it create risk Breakeven Analysis Use of breakeven model enables the nancial manager 1 To determine the quantity of output that must be sold to cover all operating costs 2 To calculate the EBIT that Will be achieved at various output levels This is covered by Marketing Operating Leverage Operating leverage measures the sensitivity of the rm s EBIT to uctuation in sales when a rm has xed operating costs EBIT Sales Operating Costs xed amp variable If the rm has no xed operating costs and sales go up by 10 then What will be the growth in EBIT Operating Leverage change in EBIT Operating Leverage 0L 2 9 change in sales Thus change in EBIT 0L gtlt change in sales Where change in EBIT EBITI1 EBITt EBITt change in sales Salest1 Salest Salest Operating Leverage 0 Example If Duke Inc s sales increase from 1 billion to 25 billion the rm s EBIT will rise from 100 million to 1 billion What s the rm s operating leverage change in EBIT change in sales Operating Leverage OL Operating Leverage Example For Duke Inc what is the change in EBIT if sales increase by 5 change in EBIT 0L gtlt change in sales Thus if the rm increases sales by 5 EBIT will increase by What if sales go down by 5 Operating Leverage Operating leverage is present when change in EBIT change in sales is gt 100 or there s xed operating cost 0 The higher the operating leverage the more the pro ts will vary in response to change in sales 0 The higher the xed operating cost the higher the operating leverage How Operating Leverage Affects EBIT An Increase in Pierce Grain Company s Sales Base Sales Forecast Sales Item Level t Level 1 1 Percentage Change Sales 300000 360000 20 LesszTotal va r a ble costs 180000 216300 Revenue before fixed costs 120000 144000 LesszTotal fixed costs m m EBIT 20090 mm 00 How Operating Leverage Affects EBIT A Decrease in Pierce Grain Company39s Sales Base Sales Forecast Sales Item Level t Level 1 1 Percentage Change Sales 300000 240000 e20 LessTutal variable costs M M Revenue before xed costs 120000 96000 LesszTotal xed costs mm M000 EBrr mm mm 13920 What s the Operating Leverage Financial Leverage 0 Financial leverage means nancing with securities bearing a xed rate of return Which securities It measures the sensitivity of the rm s Earnings Per Share EPS to uctuation in EBIT when a rm nances with these securities Financial Leverage change in EPS change in EBIT 0 Operating Leverage change in EBIT change in Sales Possible Capital Structures for Pierce Grain Company PLAN A 0 DEBT Total debt 5 0 K Common equity Mo K 000 dEDt Total assets m Total liabilities and equity m PLAN 8 25 DEBT AT 8 INTEREST RATE Total debt 5 50000 K Common equity ml 2500 debt Total assets 9ng Total liabilities and equity 200I000 PLAN C 40 DEBT AT 8 INTEREST RATE Total debt 5 80000 Common equity JED 009 4000 debt Total assets 52mm Total liabilities and equity 99999 a2000 common shares outstanding l 1500 common shales outstanding 1200 common shares outstanding An Analysis of Financial Leverage at Different EBWT Lewis Pierce Grain Company r F39Fr agar r339 rm 373 FLU 120 0 ME MEU quot1 0L H340 F 01 2 31 V if533001101139tE60110 a 0 0 5 0 0 0 20000 20000 10000 1 0000 500 100 100 40000 40000 20000 20000 1000 60000 00000 30000 30000 1 500 80000 80000 40000 40000 2000 PLAN B 25 DEBT 8 INTEREST RATE 150000 COMMON EQUITY 1500 SHARES 5 0 4000 4000 00003 0000 1 m20000 4000 16000 8000 8000 39 39 40000 4000 36000 18000 13000 60000 4000 56000 28000 28000 80000 4000 76000 38000 38000 PLAN C 40 DEBT 8 INTEREST RATE 120000 COMMON EQUITY 1200 SHARES 0 6400 6400 8200 13200 20000 6400 39 3600 6800 6800 1 00 40000 6400 33600 16800 1 6800 60000 6400 53600 26800 26800 80000 6400 73600 36800 36800 51 33 533 1 1200 25 1867 2533 5967 557 Tm4m147 2233 3067 l39he negative tax bill recognizes the credit arising from the carryback and carryforward provision ofthe tax code Combined Leverage 0 Combined leverage Operating Leverage gtlt Financial Leverage Combined Leverage change in EBIT change in Sales change in EPS change in EBIT change in EPS change in sales Leverage and Earnings Fluctuations Combined leverage J EPS or NI 1 aeASales I I t Dperating leverage Financia leverage Chapter 13 Dividends What are Dividends Dividends are distribution from the rm s assets to the shareholders Firms are not obligated to pay dividends or maintain a consistent policy with regard to dividends Dividends could be paid in cash or stocks How about an LLC Dividend Policy 0 A rm s dividend policy includes two components Dividend Payout ratio Indicates amount of dividend paid relative to the company s earnings xample If dividend per share is 1 and earnings per share is 2 the payout ratio is 50 12 Stability of dividends over time Dividend Policies vary General Electric GE Has paid dividends continuously since 1899 0 Microsoft MSFT Went public in 1986 but did not pay dividends until June 2003 However it distributed 115 billion to shareholders in dividend and share repurchases over the next ve years Berkshire Hathaway BRK has not yet paid dividend Tradeoff bw Dividend amp Retained Earnings 391 DividendversusRetention TradeOffs Given the rmfs investment decisions and debt equity mix theniit39s a thoice between or Dividend Policy and Shareholder s Wealth Does a rm s dividend policy affect the company s stock price View 1 Dividend policy is irrelevant Irrelevance implies shareholder wealth is not affected by dividend policy whether the rm pays 0 or 100 of its earnings as dividends More dividends lower g less dividends higher g P0 2 D1 rcs g View 2 0 High dividends increase stock value This position in based on birdin thehand theory which argues that investors may prefer dividend today as it is less risky compared to uncertain future capital gains This implies a higher required rate for discounting a dollar of capital gain than a dollar of dividends View 3 0 Low dividend increases stock values In 2003 the taX rates on capital gains and dividends were made equal to 15 percent However dividends are taxed immediately While the taX on capital gains can be deferred until the stock is actually sold Thus using present value of money capital gains have de nite nancial advantage for shareholders Chapter 14 Financial Forecasting 0 Financial forecasting is the process of attempting to estimate a rm s future nancing requirements 0 Three basic steps are involved 1 Project the rm s sales revenues and expenses over the planning period Income Statement 2 Estimate the levels of investment in current and xed assets that are needed to support the projected sales Lefthand side of Balance Sheet 3 Determine the rm s nancing needs throughout the planning period Righthand side of Balance Sheet Forecasting financial variables We begin with sales forecast and projects its impact on the rm s various expenses assets and liabilities 0 Most common method used for making these projections is the percent of sales method Percent of Sales Method Involves estimating the level of an expense asset or liability for a future period as a percentage of the sales forecast The percentages used can come from recent nancial statements or from averages over past years from the judgment of an analyst or some combination of sources Spontaneous Financing 0 Accounts payable and accruals are referred to as spontaneous sources of nancing They normally yary directly With the level of sales Discretionary Financing DFN Requires decisions on the part of the rm s management every time funds are raised 0 Example Notes payable longterm debt common stock paid in capital 0 They do NOT normally vary directly with the level of sales Calculation of DFN 4 Steps 1 Current assets as a of sales Convert each asset and liability account that varies directly with rm sales to a percentage of the current year s sales Current Assets Sales 2M 10M 2 or 20 Calculation of DFN 2 Predicting current assets Project the level of each asset and liability account using its percentage of sale multiplied by projected sales or by leaving the account balance unchanged when the account does not vary with the level of sales Projected current assets projected sales current assets sales 12M 2 24M Calculation of DFN 3 Predicting additional Retained earnings Project the addition to retained earnings available to help nance the rm s operations This equals projected net income for the period less planned common stock dividends Projected addition net income cash dividends prejected sales gtlt gtlt l to retained earnings sales net income 12M x 105 gtlt 1 05 300000 Calculation of DFN 1 4 Predicting DFN Project the rm s DFN as the projected level of total assets less projected liabilities and owners equity ie the plug variable Discretionary nancing needed projected total assets prejeetetl total liabilities F projected ownersquot equity 72h 1 49M 18M 500000 DFN Relationships DFN Predicted change in total assets Predicted change in spontaneous liabilities Predicted change in retained earnings External Financing Needs EFN EFN includes all the rm s needs for nancing beyond the funds provided internally through the retention of earnings DFN is part of EFN as EFN includes spontaneous nancing 0 EFN Predicted change in total assets Change in retained earnings Limitations of the Percent of Sales Forecast Method It provides reasonable estimates of nancing requirements only when asset requirements and nancing sources can be accurately forecast as a constant percent of sales 0 However this relationship may not always hold true Some assets may not grow as fast as sales Some assets are lumpy assets or assets that must be purchased in large nondiVisible components


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