Capital Structure
Basics
1




Break-even level of sales.
Operating and financial leverage
and risk.
Risks and returns of leveraged
buy-outs (LBOs).
Effect of capital structure on value.
2




Steps to Solution
Construct a chart to find the sales breakeven point = level of sales necessary to
cover operating (not financial) costs.
This requires that you calculate EBIT for
different unit sales amounts.
The point at which EBIT = 0 is the breakeven level of sales.
3

Assumptions
◦ Fixed costs remain constant as quantity changes.
◦ Variable costs vary as quantity of output changes.
Costs $
Variable Costs
Fixed Costs
Units Produced
4



Fixed costs may include salaries,
depreciation, rent.
Variable costs may include commissions,
materials, labor.
This is a generalization. For example, some
salaries may be considered fixed and others
variable. In the long-run all costs are
variable.
5

Calculation of Break-even Quantity
EBIT = Sales – Variable Costs - Fixed Costs
Find Quantity which results in EBIT = $0
6

Calculation of Break-even Quantity
Unit Salesbe =
FC
p – vc
Where:
Unit Salesbe = Break-even quantity
FC = Total fixed costs
p = Sales price per unit
vc = Variable costs per unit
7

Calculation of Break-even Quantity
Unit Salesbe =
FC
p – vc
Example:
Fixed Costs
= $1,000,000/year
Price
= $800/unit
Variable Costs = $400/unit
8

Calculation of Break-even Quantity
FC
Unit Salesbe =
p – vc
Example:
Fixed Costs
= $1,000,000/year
Price
= $800/unit
$1,000,000
Variable Costs = $400/unit
=
$800 – $400
= 2,500 units
9

Now calculate total revenue.
TR = p x Q
p = Sales price per unit
Q = unit sales
10

Calculate total revenue for different levels of
sales.
TR = p x Q
Unit sales (Q)
0
500
1,000
2,000
2,500
x
x
x
x
x
x
Price (p)
$800
$800
$800
$800
$800
= Total Revenue (TR)
=
$
0
=
$ 400,000
=
$ 800,000
=
$1,600,000
=
$2,000,000
11
You cannot easily move a large boulder.
12
However, with the aid of a lever you can
move an object many times your size.
13
The longer the lever, the bigger the
rock you can move.
14



In a financial context, the magnifying power
of leverage can be used to help (or hurt) a
firm’s financial performance.
Operating leverage occurs due to fixed
costs in the production process.
With high fixed operating costs, a small
change in sales will trigger a large change
in operating income (EBIT).
15

Measurement of Operating Leverage
◦ Degree of Operating Leverage (DOL)
DOL =

% Change in EBIT
% Change in Sales
DOL > 1 means the firm has operating
leverage.
16
Example: S1 = 3,750 units S2 = 5,000 units
FC = $1mil and VC = $400/unit P = $800/unit
Sales of 3,750 units = (3,750 * $800) = $3mil
 EBIT = $3mil - $1mil – $1.5mil= $.5mil
Sales of 5,000 units = (5,000 * $800) = $4mil
 EBIT = $4mil - $1mil - $2mil = $1mil
DOL =
DOL=
% Change in EBIT
% Change in Sales
($1 - $.5) / $.5
($4 - $3) / $3
=
100
= 3.0
33.33
17

Measurement of DOL
◦ Calculation using alternate formula:
DOL =
Sales - Total VC
Sales -Total VC - FC
18

Measurement of DOL
◦ Calculation using alternate formula:
DOL =
Sales - Total VC
Sales -Total VC - FC
DOL = ($3 - $1.5) / ($3 - $1.5 - $1)
= 1.5 / .5
=3
19

Measurement of DOL
◦ Calculation using per unit information:
DOL =
Example:
Sales - Total VC
Sales -Total VC - FC
Q
P
VC
FC
=
=
=
=
3,750 units
$800 per unit
$400 per unit
$1,000,000 per year.
20

Measurement of DOL
◦ Calculation using per unit information:
Sales - Total VC
Sales -Total VC - FC
DOL =
DOL3,750 units =
3,750(800) – 3,750(400)
3,750(800) –3,750(400) – 1,000,000
= 3
Interpretation: If sales change 1%,
then EBIT will change 3% (same
direction).
21

Degree of Operating Leverage falls as
sales rise
Quantity
2,500 (Qbe)
3,250
3,750
5,000
DOL
Undefined
4.33
3
2
22

Degree of Operating Leverage falls as sales rise
Quantity
2,500 (Qbe)
3,250
3,750
5,000


DOL
Undefined
4.33
3
2
The higher the sales level above
break-even, the less the percent change
in EBIT for a given percent change in sales
If FC = $0, DOL = 1
23
Leverage
Table Number 1
24

Degree of Financial Leverage
◦ Finance a portion of the firm’s assets with
securities that have fixed financial costs
 Debt
 Preferred Stock
◦ Financial Leverage measures changes in
earnings per share as EBIT changes.
DFLEBIT =
% Change in NI
% Change in EBIT
Base Level of EBIT
25
Financial Leverage
Example: EBIT1 = $500,000
EBIT2 = $1,000,000
NI1 = $180,000
NI2 = $480,600
DFL =
DFL=
% Change in NI
% Change in EBIT
(480.6 - 180) / 180
($1 - $.5) / $.5
=
167
100
= 1.67
26

Measurement of DFL
(Alternate formula)
DFLEBIT =

EBIT
EBIT – I
If DFL > 1, the firm has financial leverage. A given
percent change in EBIT will result in a
larger percent change in NI.
27
Example:
EBIT = $500,000
Interest Charges = $200,000
500,000
DFLEBIT=500,000 = 500,000 – 200,000
= 1.67 times
Interpretation: When EBIT changes 1% (from an
existing level of $50,000) Net Income will change
1.67% in the same direction.
28
Leverage
Table Number 1
29

Degree of Combined Leverage
◦ Measures changes in Net Income given
changes in Sales
◦ Combines both Operating and Financial
Leverage
◦ Computed for a specific level of sales
% Change in NI
DCLS = % Change in Sales
Base Level of Sales
30
Combined Leverage
Example: SALES1 = $3,000,000
SALES2 = $4,000,000
NI1 = $180,000
NI2 = $480,600
DCL =
DCL=
% Change in NI
% Change in Sales
(480.6 - 180) / .180
($4 - $3) / $3
=
166.7
33.3
= 5.0
31
DCLS = DOLS x DFLEBIT
Example:
DOLS = 3.0
DFLEBIT = 1.67
DCL3,750 = 3.0 x 1.67
= 5.0 times
32
DCLS =
Sales – VC
Sales - VC - FC - I
Example:
DCL3,750 =
=
3,750(800) – 3,750(400)
3,750(800) – 3,750(400) – 1,000,000 - $200,000
3 mil – 1.5 mil
3 mil – 1.5 mil – 1 mil - .2 mil
= 1,500,000  300,000 = 5
33
DCLSS = DOLSS x DFLEBIT
EBIT
Example:
DOLS = 3.0
DFLEBIT = 1.67
DCL3,750 = 3.0 x 1.67
= 5.0 times
Interpretation: When sales change 1%, Net
Income will change 5.0% in the same direction
34
Leverage
Table Number 1
35



Leverage can help the firm or hurt it.
If EBIT increases, financial leverage will
magnify the increase in net income.
If EBIT decreases, financial leverage will
magnify the decrease in net income.
36

Capital Structure is the mixture of
sources of funds a firm uses.
◦ Debt
◦ Preferred Stock
◦ Common Stock
37


A benefit of debt financing is that interest
is tax deductible to the paying firm
whereas payments to equity providers are
not.
Firms must trade-off this benefit against
the increased financial risk associated
with higher debt levels.
38


M&M wrote an important paper in 1958
in which they proved that with certain
assumptions there is no optimal capital
structure. One is as good as any other.
M&M’s Assumptions: No transaction
costs, no taxes, everyone has same
information and borrowing rates, debt
is riskless, debt does not affect
operations.
39

In a later paper, M&M showed that when
the tax deductibility of interest is
considered, their model indicates that a
capital structure of 100% debt is optimal.
40


Firms attempt to balance the costs and
benefits of debt to reach the optimal mix
that maximizes the value of the firm.
Affect on costs of capital:
◦ Since debt is cheaper than equity, use of debt will
initially lower the WACC.
◦ At high levels of debt, the WACC will increase as
investors perceive the risk of the firm to be
increasing substantially.
41
35%
Cost of Debt
Costs of Capital
30%
kd
Cost of Equity
25%
ks
ks
Weighted Avg. Cost of Capital
ka
20%
ka
K*
15%
kd
10%
We minimize K* at
50% debt
5%
0%
0%
25%
50%
75%
100%
Debt to Firm Value Ratio
42
Homework Problems
1. You are given the following information for Firm XYZ:
Fixed operating costs
= $500,000
Variable operating costs per unit
= $40/unit
Sales price per unit
= $50/unit
Calculate the break-even point in units for: (treat each scenario independently)
a. fixed costs decrease to $450,000
b. variable cost decreases to $37 per unit
c. sales price increases to $55/unit
d. changes for a, b, c, occur simultaneously
2. Company X has a sales price of $4.00 per unit and a variable cost of $3.40 per unit; fixed costs are $13,000, no
debt, and sales of 250,000 units per year. Company Y has a sales price of $10.00 per unit and a variable cost of $7.00
per unit with fixed costs of $135,000 and sales of 200,000 units per year. Company Y also has interest payments of
$60,000 annually. Both companies are in the 40% tax bracket.
a. compute DOL, DFL, and DCL for Company X
b. compute DOL, DFL, and DCL for Company Y
c. compare the relative risk of both companies
3. Why is the Modigliani and Miller theory of capital structure not really practical for firms in the real world?
4. Debt financing is often called a two-edged sword. What does this mean?
5. Given a net income of $50,000, sales of $2,000,000, variable costs of $25,000, fixed operating costs of $175,000,
price per unit of $5.00, interest expense of $20,000, and EBIT of $1,800,000:
a. calculate DOL
b. calculate DFL
c. calculate DCL
43
Corporate Bonds,
Preferred Stock,
and Leasing
44





Bond contract terms
Differences among types of bonds
Features of preferred stock
Lease versus purchase
Balance sheet treatment of leases
45


Bondholders are lending the corporation
funds for some stated period of time.
The corporation promises to make certain
payments to the owner of the bond.
46

Indenture
◦ Definition: the contract between the corporation
and the investor

Provisions included in the indenture:
◦
◦
◦
◦
par value
coupon rate and payment dates
maturity date
any special features
47

Par Value
◦ (e.g. $1,000) also called Face Value

Coupon Interest Rate
◦ The stated rate of interest. The rate that is
multiplied by the par value to determine the
annual dollar interest paid.

Maturity
◦ Time at which the original principal (Par Value)
is repaid to the bondholder.
48

Collateral
◦ If the debt is secured by specific assets, the lender
is entitled to take the assets in the event of
default.

Plan for repayment at maturity
◦ Staggered maturities makes it easier for the firm
to raise the necessary funds.
Sinking funds allow the firm to set aside the
funds over time to ensure the ability to repay
the loan.
49
Special Features of Bond Indentures

Provisions for early repayment
◦ Call provisions allow the issuer to refinance the
debt, usually done if interest rates fall.
◦ Issuing new bonds to replace old bonds is known as
refunding.
50




Original issue: 12% coupon
Coupon currently required for similar risk
bonds: 10% coupon
Refinancing will save $20 per year on each
$1,000 bond.
Interest savings offset by the expenses of
calling the original issue and issuing the
new bonds. In addition, the call price the
issuer must pay is usually greater than the
face value.
51
Special Features of Bond Indentures

Restrictions on company operations that are
designed to reduce risk to bondholders.
◦ Restrictions on additional debt
◦ Restrictions on payment of dividends
◦ Minimum working capital required

Name of independent trustee to oversee the
bond issue
52

Moody’s and Standard & Poor’s regularly
monitor issuer’s financial condition and
assign a rating to the debt
53

Moody’s and Standard & Poor’s regularly
monitor issuer’s financial condition and
assign a rating to the debt
Investment
Grade
Below
Investment
Grade
(Junk)
AAA
AA
A
BBB
BB
B
CCC
CC
C
D
Best Quality
High Quality
Upper Medium Grade
Medium Grade
Speculative
Very Speculative
Very Very Speculative
No Interest Being Paid
Currently in Default
54


Debenture
Subordinated Debenture
55


Debenture
Subordinated Debenture
A debenture is an unsecured bond.
A subordinated debenture is a
debenture that has lower priority for
payment than other debentures
designated as senior.
56

Debenture
Subordinated Debenture

Mortgage Bond

A mortgage bond is secured by real
assets such as airplanes, railroad cars,
or real estate.
57




Debenture
Subordinated Debenture
Mortgage Bond
Convertible Bond
A convertible bond is a bond that gives the
investor the right to convert the bond into a
given number of shares of stock on or after
a given future date.
The conversion ratio is the number of shares
the investor will get for each bond converted.
58




Debenture
Subordinated Debenture
Mortgage Bond
Convertible Bond
The conversion value is the market price per
share times the conversion ratio.
e.g. If the stock price = $20 and the conversion
ratio = 45, the conversion value = $20 x 45 = $900.
59





Debenture
Subordinated Debenture
Mortgage Bond
Convertible Bond
Variable Rate Bond
A variable rate bond pays investors interest that
is adjusted according to an established time
table and a market rate index.
e.g. Coupon rate is LIBOR + 300 basis points
60






Debenture
Subordinated Debenture
Mortgage Bond
Convertible Bond
Variable Rate Bond
Putable Bond
A putable bond can be cashed in
before maturity at the option of
the bond’s owner.
61







Debenture
Subordinated Debenture
Mortgage Bond
Convertible Bond
Variable Rate Bond
Putable Bond
Junk Bond
A junk bond is a bond that is rated below
investment grade.
62








Debenture
Subordinated Debenture
Mortgage Bond
Convertible Bond
Variable Rate Bond
Putable Bond
Junk Bond
International Bond
International bonds are bonds that
are sold in countries other than
where the issuer is domiciled.
63
Common Stock
Preferred Stock
More
Risk
Subordinated Debentures
Senior Debentures
2nd Mortgage Bonds
1st Mortgage Bonds
Less
Risk
Higher
Priority of Claim
Lower
64




A hybrid security with both debt and equity
characteristics.
Has priority over common stock in receipt of
dividends and in liquidation.
Dividends are fixed as a percentage of par
value.
Only participating preferred stock (which is
rare) shares in the residual income with the
common stockholders.
65



Corporations can generally exclude from
taxable income 70% of dividend income
received on preferred stock issued by
another corporation.
e.g. Company X owns Company Y
preferred stock that pays 4% dividends. If
Company X’s marginal tax rate = 40%,
the after tax yield on this investment
AT yield = 4%[1-(.3x.4)] = 3.52%
Compare to 4% on fully taxable
investment: AT yield = 4%(1-.4) = 2.4%
66


A lease is a contractual arrangement
where a party who needs an asset
(lessee) contracts with another party
who owns the asset (lessor) to use
that asset for a specified period of
time, without conveyance of title.
A long-term non-cancelable lease
contract is very similar financially to a
debt obligation from the perspective
of the lessee.
67






Flexibility and convenience
Few restrictions
Avoid the risk of obsolescence
100 percent financing
Tax savings
Ease of obtaining credit
68


Lease payments for operating leases are
fully deductible to businesses but only
interest portions of debt payments are
deductible.
The IRS strictly examines lease
arrangements to ensure that they are
genuine lease agreements and not
installment sales in disguise.
69


An operating lease has a term that is
substantially shorter than the useful life
of the asset and is cancelable by the
lessee (e.g. car rental for a business trip).
A capital lease is long term and noncancelable. The economic value is
mostly depleted by the end of the lease
(e.g. a ten year lease of a truck.)
70

Both operating and capital leases appear on
the income statement.
◦ Payments on operating leases are tax-deductible
expenses.
◦ Depreciation for the leased asset and imputed
interest from capital lease payments are
deductible.

Capital leases also appear on the balance
sheet because they are the functional
equivalent of a purchase financed with debt.
71
Homework Problems
1. Four years ago, you purchased a convertible bond at par with a ten year maturity with an 8%
coupon. The conversion ratio of the bond is 25. The current market price of the stock is $50.
Calculate the conversion value.
2. Using the information in the previous question, if the current market interest rate is 9.5% on similar
non-convertible bonds, should you convert? Explain.
3. You purchased a fifteen-year 10% coupon bond at par five years ago. The bond can be redeemed
for $900 after five years. The current required rate of return on similar non-convertible bonds is 9%.
Should you redeem the bond? Explain.
4. Why are junk bonds called high-yield bonds?
5. Explain why preferred stock is known as a hybrid security.
72
Common
Stock
73




Characteristics of common stock.
Advantages and disadvantages of equity
financing.
Process of issuing common stock.
Understand rights and warrants.
74
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Company Issuing the Stock
75
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Description of Preferred Stock
(Class B Preferred and Class C Preferred)
76
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Ticker Symbol
77
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Annual Dividend per Share in dollars
p = Initial Dividend
78
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Volume of Trading
The number of shares changing hands.
79
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Daily Trading Range
6½ = $6.50
80
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Closing Price
81
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Price Change from Close on
Previous Trading Day
82
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Trading Range over the Past Year
s = stock split
= new 52 week high achieved
on this day
83
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Dividend Yield
=
Dividend
Closing Price
84
52 Weeks
Hi
Lo Stock
Yld
% PE
Vol
100s
Hi
Lo
s 42½ 29 PepsiCo
PEP 1.14 3.3 24
s 36¼ 25 RJR Nabisco RN .08p ... 12
237/8 20 RJR Nab pfB
2.31 9.7 ...
7¼ 5½ RJR Nab pfC
.60 9.4 ...
5067
6263
966
2248
35
29¾
24
6½
34¼
285/8
235/8
6¼
Sym
Div
Net
Close Chg
34¼
287/8
23¾
63/8
-¾
-¾
...
-1/8
Price to Earnings (PE) Ratio
=
Closing Price
85
Earnings per Share

Dividends
◦ Vary over time
◦ Not guaranteed



Residual Claim
Voting Rights
Sometimes Preemptive Right to buy New
Stock
86


Shareholders elect a group of individuals
called the Board of Directors who oversee
the management of the corporation.
The Board of Directors selects the
managers who are responsible for dayto-day operations of the firm.
87

Majority voting
◦ For each seat open, one vote can be cast per
share. Each position on the board is voted for
separately.

Cumulative voting
◦ Each shareholder gets one vote per share times
the number of seats open. Votes may be
spread out among candidates as desired. The
top X vote getters are elected to the X seats to
be filled.
88
Number of Directors Electable

Excalibur Corporation has 3 seats open on its 9
member Board of Directors. There are 100,000
shares outstanding. The minority interest owns
40,000 shares.
Does the minority have a chance of electing one
Director if all shares are voted?
The minority has 40,000 x 3 = 120,000 votes.

Number they can elect =


(40,000-1)(3+1)
100,000
= 1.6 = 1 director
(always round down)
89
Number of Shares Needed for X Directors



Excalibur Corporation has 5 seats open on its
9 member Board of Directors. There are
100,000 shares outstanding.
How many shares does the minority need to
control to elect 2 directors? 2 X 100,000
+1
5+1
Number of shares needed =
= 33,334.33
90
Disadvantages of Equity Financing
 Dilution of ownership and power.
 Flotation costs
◦ Fees paid to investment bankers, lawyers, and
accountants
◦ Usually higher than for debt issues.
91
Disadvantages of Equity Financing (cont.)
Signaling Effects
◦ Investors may think that managers would not
issue stock unless it were overvalued in the
market.
◦ Therefore, a stock issue is seen as a negative
signal and investors will respond by selling
the stock.
◦ Selling pressure causes the stock price to
fall.
92
Advantages of Equity Financing
 No interest to pay.
 No obligation to pay dividends.
 Reduces financial risk.
◦ This may be a more important advantage to firms
that already are relatively risky due to the kind of
business they do (e.g. high tech)
93



Sell to existing shareholders or to new
shareholders?
Initial Public Offering (IPO)
Role of Investment Bankers
◦ Underwriting
◦ Best efforts

Pricing the issue
94


Securities issued by a corporation that
allow investors to buy new stock at a given
price.
Preemptive Right
◦ Allows a shareholder the right to maintain their
% ownership by buying a proportional share of
any new issue.
◦ The rights can also be sold in the open market.
95



There are 60,000 shares outstanding and
another 20,000 will be issued.
Each shareholder will receive one right for
for each share held, a total of 60,000
rights.
To buy one share of the new issue, you
will need to pay the subscription price
plus 60,000/20,000 = 3 rights.
96



A warrant is a security giving the owner
the option to buy shares of common stock
at a certain exercise price for a set period
of time.
Like rights except that they are sold to
investors rather than given away.
Each warrant allows you to buy a particular
number of shares.
97
Homework Problems
1. Describe the difference between a preemptive right and a warrant.
2. Company XYZ has 30 million shares of common stock outstanding. It wishes to issue another
1,500,000 shares. The current market price per share is $25 and the rights offering subscription price is
$20 per share.
a. How many rights will current stockholders receive?
b. How many rights are needed to buy one additional share?
3. The Whitcomb Bank has 10 directors on its board and 1,000,000 voting shares of common stock
outstanding. The company uses cumulative voting rules and is planning to elect four new directors.
How many shares of common stock would a group of shareholders need to insure that they could elect
at least two directors at the next election?
4. How do you value a stock that is not publicly traded?
5. What are the advantages and disadvantages of equity financing?
98
Dividend
Policy
99




Factors that influence dividend policy
How to pay dividends
Major dividend theories
Alternatives to cash dividends
10
0





Need for funds
Management expectations for the firm’s
future prospects
Stockholders’ preferences
Restrictions on dividend payments
Availability of cash
10
1
On August 25, 2006 Southside Bankshares
announced a quarterly dividend of $1 per share
to be paid to share holders of record September 9,
2006, payable September 15, 2006
10
2
On August 25, 2006 Southside Bankshares
announced a quarterly dividend of $1 per share
to be paid to share holders of record September 9,
2006, payable September 15, 2006
25
31 1
August
5
9
15
September
Declaration Date
Date that dividend is
announced
10
3
On August 25, 2006 Southside Bankshares
announced a quarterly dividend of $1 per share
to be paid to share holders of record September 9,
2006, payable September 15, 2006
25
31 1
August
Declaration Date
5
9
15
September
Date of Record
All owners of record will
receive the dividend.
10
4
On August 25, 2006 Southside Bankshares
announced a quarterly dividend of $1 per share
to be paid to share holders of record September 9,
2006, payable September 15, 2006
25
31 1
5
August
9
15
September
4 days
Declaration Date
Date of Record
10
5
On August 25, 2006 Southside Bankshares
announced a quarterly dividend of $1 per share
to be paid to share holders of record September 9,
2006, payable September 15, 2006
25
31 1
August
7
9
15
September
Ex-Dividend Date
Declaration Date
Date of Record
To allow time for the official list of stockholders to be
updated, stockholders must buy stock before the exdividend date which is 2 days prior to date of record.
10
6
On August 25, 2006 Southside Bankshares
announced a quarterly dividend of $1 per share
to be paid to share holders of record September 9,
2006, payable September 15, 2006
25
31 1
August
7
9
15
September
Ex-Dividend Date
Declaration Date
Date of Record
Payment
Date
Date that the dividend is paid
out to the stockholders.
10
7



A dividend reinvestment plan (DRIP) is
a plan in which stockholders are
allowed to reinvest their dividends in
additional shares of stock instead of
receiving them in cash.
Popular with investors because they
can avoid commission costs.
Dividends paid and reinvested are still
taxable income to the investor.
10
8

Residual Theory of Dividends
◦ Hypothesizes that dividends should be
determined only after the firm has first
examined their need for retained earnings
to finance the equity portion of funds
needed for their capital budget.
◦ Thus, dividends arise from the “residual” or
left-over earnings.
10
9

Residual Theory of Dividends
Example:
 Net Income = $150 million
 Total Amount of Funds Needed to Finance Positive
NPV Projects = $100 million
 Optimal Capital Structure: 60%D, 40%E
 Equity Funds Needed = $100 million x .4
= $40,000,000
 Dividend to be Paid = $110 million
($150 million NI - $40,000,000 Equity
Funds Needed)
11
0

Clientele Dividend Theory
◦ Hypothesizes that different firms have different
types of investors.
◦ Some investors, such as elderly people on fixed
incomes, tend to prefer to receive dividend
income.
◦ Others, such as young investors often prefer
growth, and tend to like their income in the form
of capital gains rather than as dividend income.
11
1

Signaling Dividend Theory
◦ Hypothesizes that since management is better
informed about the firm’s prospects, dividend
announcements are seen as signals of future
performance.
◦ Since investors usually respond negatively to
dividend decreases, managers tend not to increase
dividends unless the increase is expected to be
sustainable.
11
2

Bird in the Hand Theory
◦ Hypothesizes that stockholders prefer to
receive dividends instead of having
earnings reinvested.
◦ The dividend payment is more certain than
the unknown future capital gain.
11
3

Modigliani and Miller Dividend Theory
◦ M&M originally argued in 1961 that, without
taxes or transactions costs, the way that the
firm’s earnings are distributed (capital gains
versus dividends) is irrelevant to firm value.
11
4

Stock Dividends
◦ Existing shareholders receive additional shares
of stock instead of cash dividends.
◦ Payment is expressed as a percentage of
current stock holdings.
e.g. if there is a 10% stock dividend, you
would receive one additional share for
every 10 that you currently own.
11
5

Stock Splits
◦ If total shares will increase by more than 25%,
the company will usually declare a stock split.
◦ Purpose is usually to bring the stock price into
a more popular trading range.
◦ Expressed as a ratio to original shares.
e.g. a 2-1 split means that each investor
will end up with twice as many shares.
11
6
Homework Problems and Questions
1. Explain the difference between a stock dividend and a stock split.
2. Net income is $2,500,000; dividends declared are $500,000. What is the dividend payout
ratio?
3. Why is it important for a firm to understand the makeup of its stockholders before it
determines a dividend policy?
4. Would it be a common practice for a high-growth firm to have a 100% dividend payout
ratio? Explain.
5. What is the rationale of managers who view a stock split as a way to increase the total
value of their firm’s stock?
11
7