1

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) (1.18)2 (1.18)3 (1.18)4

4.6 5.29 6.0835 + 49.136 P1 = ----------- + ----------- + --------------------------- = $41.3 (1.18)1 (1.18)2 (1.18)3

2

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 company’s stock: D1 0.5 Po = ----------- = ------------------- = $6.25 ks – g 0.15 - 0.07 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

a. What is the regular payback period for each project? (4 marks) b. Calculate the NPV for each project? (5 marks) c. Calculate the IRR for each project? (5 marks) d. 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)

3

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 15%Project A

Project B 25%

Project A

Project B

0 (20,000) (24,000) 1 (20,000) (24,000) 1 (20,000) (24,000)1 6,400 10,000 0.870 5,565 8,696 0.800 5,120 8,000 2 8,100 10,000 0.756 6,125 7,561 0.640 5,184 6,400 3 9,200 10,000 0.658 6,049 6,575 0.512 4,710 5,120 4 12,000 10,000 0.572 6,861 5,718 0.410 4,915 4,096

NPV 4,600 4,550 NPV (70) (384)

IRR 0.2515542 0.2422169 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 Cumulative discounted CF

Year Project A Project B Project A Project B 0 (400) (600) (400) (600)1 (345) (300) (350.01) (327.3)2 (290) 0 (304.58) (79.5)3 (235) 50 (263.28) (41.95)4 (10) 100 (109.58) (7.8)5 215 150 30.12 23.25

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

4

Year Discount

factor at 10%

Cash flows

A

PV of CF A

Cash flows

B

PV of CF B

Discount factor at

15%

PV of CF A

PV of CF B

0 1 (400) (400) (600) (600) 1 (400) (600)1 0.909 55 49.99 300 272.7 0.870 47.85 2612 0.826 55 45.43 300 247.8 0.756 41.58 226.83 0.751 55 41.3 50 37.55 0.657 36.14 32.854 0.683 225 153.7 50 34.15 0.572 128.7 28.65 0.621 225 139.7 50 31.05 0.497 111.83 24.85

NPV 30.12 23.25 (33.91) (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 Hadway’s 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 company’s 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

5

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. EPS 4.12

Po 27.44 b. %

Total equity 6,000,000 75%Debt outstanding 2,000,000 25%Total capital 8,000,000 100%

WACC 12.88%c. Use new debt to buy back shares

New debt 8000000Total debt 10000000kd 12%ks 17%

No of shares bought back using 8mil new debt 291,498

No of outstanding shares 308,502

6

New EPS 5.90 New share Price 34.70 higher than Po

The company should change its capital structure because the change will increase share price

d. EBIT 4,000,000

Interest expense 1,160,000 EBT 2,840,000 Net income 1,846,000

New share price 35.20

higher than share price in part c

e. Original situation TIE 20 times Under situation in part c

TIE 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 Dividend policy

1 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?

2 Morris Technologies Inc has net income of $180,000. It has 100,000 shares of common stock outstanding. The company’s 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 company’s 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

7

2 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

14-9 Alternative dividend policies 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 ks = -------------------- + 10% = 15% 180,000,000

1

CHAPTER 8Stocks and Their Valuation

8-1

Features of common stockDetermining common stock values

Facts about common stock

Represents ownershipOwnership implies controlStockholders elect directors

8-2

Stockholders elect directorsDirectors elect managementManagement’s goal: Maximize the stock price

Types of stock market transactions

Secondary marketPrimary marketInitial public offering market

8-3

Initial public offering market (“going public”)

Different approaches for valuing common stock

Dividend growth modelCorporate value modelUsing the multiples of comparable

8-4

Using the multiples of comparable firms

Dividend growth model

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

8-5

∞∞

+++

++

++

+=

)k(1D

... )k(1

D

)k(1D

)k(1

D P

s3

s

32

s

21

s

10

^

Constant growth stockA stock whose dividends are expected to grow forever at a constant rate, g.

D1 = D0 (1+g)1

( )2

8-6

D2 = D0 (1+g)2

Dt = D0 (1+g)t

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

g -kD

g -kg)(1D

Ps

1

s

00

^

=+

=

2

Future dividends and their present values

t0t ) g 1 ( DD +=$

8-7

tt

t ) k 1 (D

PVD+

=

t0 PVDP ∑=

0.25

Years (t)0

What happens if g > ks?

If g > ks, the constant growth formula leads to a negative stock price, which does not make sense.

8-8

does not make sense.The constant growth model can only be used if:

ks > gg is expected to be constant forever

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

g = 6%0 1 2 3

8-9

1.87611.7599

D0 = 2.00

1.6509

ks = 13%

2.247 2.3822.12

What is the stock’s market value?

Using the constant growth model:

0 060 13$2.12

kD

P0 == 1

8-10

$30.29

0.07$2.12

0.06 - 0.13g-ks0

=

=

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.

8-11

Could also find expected P1 as:

$32.10 0.06 - 0.13

$2.247 g - k

D Ps

2^

1

=

==

$32.10 (1.06) P P 0

^

1 ==

What is the expected dividend yield, capital gains yield, and total return during the first year?

Dividend yield= D1 / P0 = $2.12 / $30.29 = 7.0%

Capital gains yield

8-12

Cap ta ga s y e d= (P1 – P0) / P0

= ($32.10 - $30.29) / $30.29 = 6.0%Total return (ks)

= Dividend Yield + Capital Gains Yield= 7.0% + 6.0% = 13.0%

3

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

The dividend stream would be a perpetuity.

0 1 2 3

8-13

2.00 2.002.00

0 1 2 3ks = 13% ...

$15.38 0.13$2.00

k

PMT P

^

0 ===

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

8-14

gconstant after 3 years.

Valuing common stock with nonconstant growth

ks = 13%

g = 30% g = 30% g = 30% g = 6%

0 1 2 3 4

D 2 00 2 600 3 380 4 394

...

4 658

8-15

$P =0.06

$66.5434.658

0.13 −=

2.301

2.647

3.045

46.114

54.107 = P0^

D0 = 2.00 2.600 3.380 4.394 4.658

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

Dividend yield (first year)= $2.60 / $54.11 = 4.81%

Capital gains yield (first year)

8-16

= 13.00% - 4.81% = 8.19%

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%.

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

ks = 13%

g = 0% g = 0% g = 0% g = 6%

0 1 2 3 4

D 2 00 2 00 2 00 2 00

...

2 12

8-17

0.06$ $30.29P3

2.12

0.13=

−=

1.77

1.57

1.39

20.99

25.72 = P0^

D0 = 2.00 2.00 2.00 2.00 2.12

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

Dividend yield (first year)= $2.00 / $25.72 = 7.78%

Capital gains yield (first year)

8-18

Capital gains yield (first year)= 13.00% - 7.78% = 5.22%

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

4

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.

8-19

$9.89 0.19$1.88

(-0.06) - 0.13(0.94) $2.00

g - k) g 1 (D

g - k

D P

s

0

s

1^

0

===

+==

Find expected annual dividend and capital gains yields.

Capital gains yield= g = -6.00%

Dividend yield

8-20

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

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.

Corporate value model

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s

8-21

equals the present value of the firm s free cash flows.Remember, free cash flow is the firm’s after-tax operating income less the net capital investment

FCF = NOPAT – Net capital investment

Applying the corporate value model

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

Subtract MV of firm’s debt and preferred stock to t MV f t k

8-22

get MV of common stock.MV of = MV of – MV of debt and

common stock firm preferredDivide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).

P0 = MV of common stock / # of shares

Issues regarding the corporate value model

Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when d d d h d f

8-23

dividends are hard to forecast.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.

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

k = 10%0 1 2 3 4

8-24

g = 6%21.20-5 10 20

...

416.942

-4.5458.264

15.026398.197

21.20530 = = TV30.10 0.06-

5

If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per share?

MV of equity = MV of firm – MV of debt= $416.94m - $40m= $376 94 million

8-25

$376.94 millionValue 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

8-26

P / CFP / 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.

Factors that affect stock price

Required return (ks) could changeChanging inflation could cause kRF to change

8-27

gMarket risk premium or exposure to market risk (β) could change

Growth rate (g) could changeDue to economic (market) conditionsDue to firm conditions

Problems

ST-2P8-1P8 2

8-28

P8-2P8-10P8-14P8-19

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CHAPTER 10The Basics of Capital Budgeting

10-1

Should we build this

plant?

What is capital budgeting?

Analysis of potential additions to fixed assets.Long-term decisions; involve large

10-2

g ; gexpenditures.Very important to firm’s future.

Steps to capital budgeting

1. Estimate CFs (inflows & outflows).2. Assess riskiness of CFs.3. Determine the appropriate cost of capital.

10-3

3. Determine the appropriate cost of capital.4. Find NPV and/or IRR.5. Accept if NPV > 0 and/or IRR > WACC.

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.

10-4

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

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.

10-5

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.

What is the payback period?

The number of years required to recover a project’s cost, or “How long does it take to get our money back?”

10-6

does it take to get our money back?Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.

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2

Calculating payback

CFt -100 10 60 100Cumulative -100 -90 0 50

0 1 2 32.4

80-30

Project L

10-7

PaybackL = 2 + / = 2.375 years= 30 80

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50-30

Project S

Strengths and weaknesses of payback

StrengthsProvides an indication of a project’s risk and liquidity.

10-8

q yEasy to calculate and understand.

WeaknessesIgnores the time value of money.Ignores CFs occurring after the payback period.

Discounted payback period

Uses discounted cash flows rather than raw CFs.

0 1 2 32.710%

10-9

Disc PaybackL = 2 + / = 2.7 years

CFt -100 10 60 80

Cumulative -100 -90.91 18.79

=

60.11-41.32

PV of CFt -100 9.09 49.59

41.32 60.11

10%

Net Present Value (NPV)

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

10-10

∑= +

=n

0tt

t

) k 1 (CF

NPV

What is Project L’s NPV?

Year CFt PV of CFt

0 -100 -$1001 10 9.09

10-11

1 10 9.092 60 49.593 80 60.11

NPVL = $18.79

NPVS = $19.98

Rationale for the NPV methodNPV = PV of inflows – Cost

= Net gain in wealthIf projects are independent, accept if the

10-12

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.

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3

Internal Rate of Return (IRR)

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

∑n

tCF0

10-13

∑= +

=0t

tt

) IRR 1 (CF

0

Rationale for the IRR method

If IRR > cost of capital, the project’s rate of return is greater than its costs. There is some return left over

10-14

costs. There is some return left over to boost stockholders’ returns.

IRR Acceptance Criteria

If IRR > k, accept project.If IRR < k, reject project.

10-15

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

NPV ProfilesA graphical representation of project NPVs at various different costs of capital.

k NPV NPV

10-16

k NPVL NPVS0 $50 $405 33 2910 19 2015 7 1220 (4) 5

Drawing NPV profiles

50

60NPV ($) .

10-17-10

0

10

20

30

40

5 10 15 20 23.6Discount Rate (%)

IRRL = 18.1%

IRRS = 23.6%

Crossover Point = 8.7%

SL

..

...

..

.. .

Comparing the NPV and IRR methods

If projects are independent, the two methods always lead to the same accept/reject decisions.

10-18

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.

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4

Finding the crossover point1. Find cash flow differences between the

projects for each year.2. Enter these differences in CFLO register,

then press IRR Crossover rate 8 68%

10-19

then press IRR. Crossover rate = 8.68%, rounded to 8.7%.

3. Can subtract S from L or vice versa, but better to have first CF negative.

4. If profiles don’t cross, one project dominates the other.

Reasons why NPV profiles cross

Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher the opportunity

h l bl h f d

10-20

cost, the more valuable these funds, so 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.

Reinvestment rate assumptions

NPV method assumes CFs are reinvested at k, the opportunity cost of capital.IRR method assumes CFs are reinvested at IRR.

10-21

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.

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

-800 5,000 -5,000

0 1 2k = 10%

10-22

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

Multiple IRRs

NPV Profile

IRR 400%

NPV

10-23

450

-800

0400100

IRR2 = 400%

IRR1 = 25%

k

Why are there multiple IRRs?

At very low discount rates, the PV of CF2 is large & negative, so NPV < 0.At very high discount rates, the PV of both

10-24

gCF1 and CF2 are low, so CF0 dominates and again NPV < 0.In between, the discount rate hits CF2harder than CF1, so NPV > 0.Result: 2 IRRs.

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5

Lecture Example

CompKare is considering purchasing one of two new diagnostic machines. Both machines would make it possible

10-25

Both machines would make it possible for the company to bid on jobs that it currently isn’t equipped to do. Estimates regarding each machine are provided below:

Lecture ExampleMachine A Machine B

Original Cost $80,000 $180,000Estimated Life 8 years 8 years

10-26

Residual Value - -Estimated cash inflows p.a.

16,000 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?

Practice questions

ST-2, exclude MIRR, parts d and e10-710 13

10-27

10-1310-16, exclude part e.10-23, exclude parts f and g

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1

CHAPTER 13Capital Structure and Leverage

13-1

Business vs. financial riskOptimal capital structureOperating leverageCapital structure theory

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

What is business risk?

Probability Low risk

13-2

Note that business risk does not include financing effects.

EBITE(EBIT)0

High risk

What determines business risk?

Uncertainty about demand (sales).Uncertainty about output prices.Uncertainty about costs

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Uncertainty about costs.Product, other types of liability.Operating leverage.

What is operating leverage, and how does it affect a firm’s business risk?

Operating leverage is the use of fixed costs rather than variable costs.

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If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

Effect of operating leverageMore operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.

$ Rev $ Rev

13-5What happens if variable costs change?

Sales

$ Rev.TC

FC

QBE Sales

$ Rev.

TCFC

QBE

} Profit

Using operating leverage

ProbabilityLow operating leverage

High operating leverage

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

EBITL

g g g

EBITH

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2

What is financial leverage?Financial risk?

Financial leverage is the use of debt and preferred stock.Financial risk is the additional risk

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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.

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Financial risk depends only on the types of securities issued.

More debt, more financial risk.Concentrates business risk on stockholders.

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

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Only differ with respect to their use of debt (capital structure).

Firm U Firm LNo debt $10,000 of 12% debt$20,000 in assets $20,000 in assets40% tax rate 40% tax rate

Firm U: UnleveragedEconomy

Bad Avg. GoodProb. 0.25 0.50 0.25EBIT $2 000 $3 000 $4 000

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EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400

Firm L: LeveragedEconomy

Bad Avg. GoodProb.* 0.25 0.50 0.25EBIT* $2 000 $3 000 $4 000

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EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

*Same as for Firm U.

Ratio comparison between leveraged and unleveraged firms

FIRM U Bad Avg GoodBEP 10.0% 15.0% 20.0%ROE 6.0% 9.0% 12.0%

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TIE ∞ ∞ ∞

FIRM L Bad Avg GoodBEP 10.0% 15.0% 20.0%ROE 4.8% 10.8% 16.8%TIE 1.67x 2.50x 3.30x

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3

Risk and return for leveraged and unleveraged firms

Expected Values:Firm U Firm L

E(BEP) 15.0% 15.0%E(ROE) 9 0% 10 8%

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E(ROE) 9.0% 10.8%E(TIE) ∞ 2.5x

Risk Measures:Firm U Firm L

σROE 2.12% 4.24%CVROE 0.24 0.39

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

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dwill 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).

ConclusionsBasic earning power (BEP) is unaffected by financial leverage.L has higher expected ROE because BEP k

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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 P0is maximized. Trades off higher E(ROE)

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g ( )and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debt’s 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.

Stock Price, with zero growth

sss

10 k

DPS

kEPS

g - k

D P ===

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

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

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yin the cost of debt.However, the riskiness of the firm’s equity also increases, resulting in a higher ks.

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4

Finding Optimal Capital Structure

The firm’s optimal capital structure can be determined two ways:

Minimizes WACC.

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Maximizes stock price.Both methods yield the same results.

Table for calculating WACC and determining the minimum WACC

D/A ratio

0 00%

WACC

12 00%

E/A ratio

100.00%ks

12 00%

kd (1 – T)

0 00%

Amount borrowed

$ 0

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0.00%

12.50

25.00

37.50

50.00

12.00%

11.55

11.25

11.44

12.00

100.00%

87.50

75.00

62.50

50.00

12.00%

12.51

13.20

14.16

15.60

0.00%

4.80

5.40

6.90

8.40

$ 0

250

500

750

1,000

* Amount borrowed expressed in terms of thousands of dollars

Table for determining the stock price maximizing capital structure

AmountBorrowed DPS ks P0

$ 0 $3.00 12.00% $25.00

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250,000 3.26 12.51500,000 3.55 13.20

26.03

26.89

750,000 3.77 14.16 26.59

1,000,000 3.90 15.60 25.00

What debt ratio maximizes EPS?

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

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Risk is too high at D/A = 50%.

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

l l ld b

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optimal capital structure would be one 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 firm’s target capital structure

1. Industry average debt ratio2. TIE ratios under different scenarios3 Lender/rating agency attitudes

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3. Lender/rating agency attitudes4. Reserve borrowing capacity5. Effects of financing on control6. Asset structure7. Expected tax rate

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5

How would these factors affect the target capital structure?

1. Sales stability?2. High operating leverage?3 Increase in the corporate tax rate?

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3. Increase in the corporate tax rate?4. Increase in the personal tax rate?5. Increase in bankruptcy costs?6. Management spending lots of money

on lavish perks?

What can managers be expected to do?

Issue stock if they think stock is overvalued.Issue debt if they think stock is

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yundervalued.As a result, investors view a common stock offering as a negative signal--managers think stock is overvalued.

Conclusions on Capital Structure

Need to make calculations as we did, but should also recognize inputs are “guesstimates.”

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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.

Questions

Q13-3Q13-5

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Problems

ST-2P13-2P13 6

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P13-6P13-7P13-10

1

CHAPTER 14Distributions to shareholders:Dividends and share repurchases

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Theories of investor preferencesSignaling effectsResidual modelDividend reinvestment plansStock dividends and stock splitsStock repurchases

What is dividend policy?

The decision to pay out earnings versus retaining and reinvesting them.Dividend policy includes

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Dividend policy includesHigh or low dividend payout?Stable or irregular dividends?How frequent to pay dividends?Announce the policy?

Do investors prefer high or low dividend payouts?

Three theories of dividend policy:Dividend irrelevance: Investors don’t care about payout.

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p yBird-in-the-hand: Investors prefer a high payout.Tax preference: Investors prefer a low payout.

Dividend irrelevance theoryInvestors are indifferent between dividends and retention-generated capital gains. Investors can create their own dividend policy:

If they want cash they can sell stock

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If they want cash, they can sell stock.If they don’t want cash, they can use dividends to buy stock.

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.

Bird-in-the-hand theoryInvestors think dividends are less risky than potential future capital gains, hence they like dividends.If so investors would value high payout

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If so, investors would value high-payout firms more highly, i.e., a high payout would result in a high P0.Implication: set a high payout.

Tax Preference TheoryRetained 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

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gains taxes are also 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.

2

Possible stock price effects

40

Stock Price ($)Bird-in-the-Hand

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30

20

10

0 50% 100% Payout

Irrelevance

Tax preference

Possible cost of equity effects

Tax preference

30

25

Cost of Equity (%)

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Tax preference

Irrelevance

Bird-in-the-Hand

20

15

10

5

0 50% 100% Payout

Which theory is most correct?

Empirical testing has not been able to determine which theory, if any, is correct.

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Thus, managers use judgment when setting policy.Analysis is used, but it must be applied with judgment.

What’s the “information content,” or “signaling,” hypothesis?

Managers hate to cut dividends, so they won’t raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of

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dividend increases as signals of management’s 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.

What’s the “clientele effect”?

Different groups of investors, or clienteles, prefer different dividend policies.

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Firm’s 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.

What is the “residual dividend model”?

Find the retained earnings needed for the capital budget.Pay out any leftover earnings (the

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y y g (residual) as dividends.This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

3

Residual dividend model

⎥⎥⎥

⎦

⎤

⎢⎢⎢

⎣

⎡

⎟⎟⎟

⎠

⎞

⎜⎜⎜

⎝

⎛×

⎟⎟⎟

⎠

⎞

⎜⎜⎜

⎝

⎛=

budget capital

Total

ratioequity Target

- IncomeNet Dividends

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⎥⎦⎢⎣ ⎠⎝⎠⎝ budgetratio

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

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) = $480,000 will be funded with equity.

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q yCalculate 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.

Calculate dividend payout ratio$120,000 / $600,000 = 0.20 = 20%

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

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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%

If NI = $800,000 …Dividends = $800,000 – (0.6)($800,000) = $320,000.Payout = $320,000 / $800,000 = 40%

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.

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More good investments would lead to a lower dividend payout.

Comments on Residual Dividend Policy

Advantage – Minimizes new stock issues and flotation costs.Disadvantages – Results in variable

f

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dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele.Conclusion – Consider residual policy when setting target payout, but don’t follow it rigidly.

What’s a “dividend reinvestment plan (DRIP)”?

Shareholders can automatically reinvest their dividends in shares of the company’s common stock. Get more

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stock than cash.There are two types of plans:

Open marketNew stock

4

Open Market Purchase Plan

Dollars to be reinvested are turned over to trustee, who buys shares on the open market.

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Brokerage costs are reduced by volume purchases.Convenient, easy way to invest, thus useful for investors.

New Stock PlanFirm issues new stock to DRIP enrollees (usually at a discount from the market price), keeps money and uses it to buy assets

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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.

Setting Dividend PolicyForecast capital needs over a planning horizon, often 5 years.Set a target capital structure.Estimate annual equity needs

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Estimate annual equity 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.

Stock Repurchases

Buying own stock back from stockholdersReasons for repurchases:

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pAs an alternative to distributing cash as dividends.To dispose of one-time cash from an asset sale.To make a large capital structure change.

Advantages of RepurchasesStockholders can tender or not.Helps avoid setting a high dividend that cannot be maintained.Repurchased stock can be used in takeovers or

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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.

Disadvantages of RepurchasesMay be viewed as a negative signal (firm has poor investment opportunities).IRS could impose penalties if repurchases were primarily to avoid taxes on dividends

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were primarily to avoid taxes on 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.

5

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

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owned.Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares.

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

Stock dividends vs. Stock splits

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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 investor’s wealth unchanged.But splits/stock dividends may get us to an “optimal price range.”

When and why should a firm consider splitting its stock?

There’s 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

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optimal 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.

Problems

P14-1P14-2P14 3

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P14-3P14-4P14-6P14-7P14-9