# Gibson10e_ch09

Chapter 9
For the Investor
COPYRIGHT &copy;2007 Thomson South-Western, a part of the Thomson Corporation. Thomson,
Financial Leverage
• The use of debt is referred to as financial
leverage
• Interest as related to debt financing
– A contractual obligation
– Must be paid regardless of entity’s current profits
• Contrast with dividends which are discretionary
– Interest is tax deductible
• Reduces taxable income
• Reduces income tax
Chapter 9, Slide #2
Definition of Financial Leverage and
Magnification Effects
DOWELL COMPANY (Exhibit 9-1)
Financial Leverage
Partial Income Statement to Illustrate Magnification Effects
Base Year
Figures
Earnings before interest and tax
Interest
Earnings before tax
Income tax (40%)
Net income
\$1,000,000
(200,000)
800,000
(320,000)
\$ 480,000
20% Decrease
in Earnings
Before Interest
and Tax
\$ 800,000
(200,000)
600,000
(240,000)
\$ 360,000
Percentage change in net income [A]
Percentage change in earnings before
Interest and tax [B]
Degree of financial leverage [A &divide; B]
10% Increase
in Earnings
Before Interest
and Tax
\$1,100,000
(200,000)
900,000
(360,000)
\$ 540,000
25.0%
12.5%
20.0%
1.25
10.0%
1.25
Net income increase [A] is greater than change in EBIT [B] due
to the fixed nature of interest expense
Chapter 9, Slide #3
Computation of the Degree of Financial
Leverage
% Change Net Income
% Change EBIT
Earnings Before
Interest and Tax
Earnings Before Tax
The degree of financial leverage is the
multiplication factor by which the net
income changes in respect to changes
in EBIT
A more simple formula for degree of
financial leverage
Chapter 9, Slide #4
Computation of the Degree of Financial
Leverage (cont’d)
• Degree of financial leverage calculations
should exclude
– Minority share of earnings
– Equity income
– Nonrecurring items
Earnings Before Interest, Tax,
Minority Share of Earnings,
Equity Income, and Nonrecurring Items
Earnings Before Tax,
Minority Share of Earnings,
Equity Income, and Nonrecurring Items
The all-inclusive
formula for degree of
financial leverage
Chapter 9, Slide #5
Earnings per Share
• Required disclosure for corporate income
statements
• Pertains only to common stock
• Per-share amounts are disclosed for
–
–
–
–
Income from recurring items
Discontinued operations
Extraordinary items
Net income
Chapter 9, Slide #6
Basic Earnings per Share
Net Income - Preferred Dividends
Weighted Average Number of
Common Shares Outstanding
• Earnings pertain to an entire fiscal period
• Average common shares outstanding is used
Chapter 9, Slide #7
Calculation of Weighted Average Common
Outstanding
Months Shares
Are Outstanding
January–June
July–September
October–December
Shares
Outstanding
10,000
12,000
15,000
&times;
Fraction of Year
Outstanding
=
&times;
&times;
&times;
6/12
3/12
3/12
=
=
=
Weighted
Average
5,000
3,000
3,750
11,750
• Must take into account all stock dividends and stock
splits
Chapter 9, Slide #8
Diluted Earnings Per Share
• Complex capital structure contains potentially dilutive
securities:
–
–
–
–
Options, rights, warrants
Convertible debt
Convertible preferred equity
Contingent shares
Net Income - Preferred Dividends
Weighted Average # of Shares Outstanding
+ All Above potential # of Shares
Chapter 9, Slide #9
Price/Earnings Ratio
Market Price per Share
Diluted Earnings per Share
Before Nonrecurring Items
• Measures the relationship between the market
price of a share of common stock and that
stock’s current earnings per share
– Use of diluted earnings per share gives more
conservative price/earnings ratio
Chapter 9, Slide #10
Price/Earnings Ratio (cont’d)
• Compare with
– Industry competitors
– Industry average
– Exchange (e.g., NYSE) average
• Interpretation
– High-growth-potential firms have higher P/E ratios
– P/E ratio can be a function of the market
Chapter 9, Slide #11
Percentage of Earnings Retained
Net Income Before Nonrecurring
Items - All Dividends
Net Income Before
Nonrecurring Items
• Reflects the proportion of current earnings
retained for internal growth
• Trend analysis is improved by exclusion of
nonrecurring items
• Higher percentage typically found in
– New firms
– Growing firms and firms perceived as growth firms
Chapter 9, Slide #12
Dividend Payout
Dividends per Common Share
Diluted EPS Before Nonrecurring Items
• Measures the portion of current earnings per
common share being paid out in dividends
• A stable dividend policy is developed by
consideration of recurring earnings
• Lower payout typically found in
– New firms
– Growing firms and firms perceived as growth firms
Chapter 9, Slide #13
Dividend Yield
Dividends per Common Share
Market Price per Common Share
• Indicates the relationship between the
dividends per common share and the market
price per common share
• The yield is a function of
– The firm’s dividend policy
– Market price
Chapter 9, Slide #14
Book Value per Share
Total Stockholders' Equity
- Preferred Stock Equity
Number of Common Shares Outstanding
Chapter 9, Slide #15
Stock Options
• Stock option expensing is required
• Allocate option fair value to the service period
Chapter 9, Slide #16
Impact of Stock Option Expense
Net Income Before
Net Income Before
Nonrecurring Items Not Nonrecurring Items
Including Option Expense
Including Option Expense
Net Income Before Nonrecurring Items
Not Including Option Expense
Stock Option Expenses
Net Income Before Nonrecurring Items
Not Including Option Expense
Chapter 9, Slide #17
Restricted Stock
• Sometimes offered to employees in lieu of
stock option plans
• Restrictions
– Employee cannot sell stock for a specified period of
time
– Employee may forfeit the shares if they leave
employer
– Awards may be linked to financial goals
Chapter 9, Slide #18
Stock Appreciation Rights
• Employee receives compensation in cash or
stock
– Difference between option price and market price
• Expense is a function of market price