Chapter 1 Foundation

What is Finance?

Lecture Notes in Financial

 Art and science of
handling money
 Management of money
Management (Lasher 7e)
Two areas:
 Investments and financial markets
 Financial management of companies
The financial system involves the flow of money
and paper between the two.
ContentsNo table of contents entries found.
What are financial assets?

Money, debt security and equity securities are financial

assets.

 Both debt and equity securities represent claims

against the assets and future earnings of the
corporation.
 Debt and equity securities are financial assets of
the investors who own them, and, at the same
time, these securities appear on the liabilities
and stockholders’ equity side of the issuing
company’s balance sheet.

Financial assets are income not currently needed.

1. Real Assets – an object that provides a service
(cars, house).
 Real assets derive their value because
they provide services of some kind.
2. Financial Assets – a legal document
representing an income claim.
 Owners have claims to certain future
cash flows.
 Stocks or bonds (ownership or debt)
 Most financial assets are either stocks or
bonds, and their claim to future income
is based on debt/equity.

3. Stock represents an ownership interest.

 Holder owns a piece of the company,
entitled to share of the firms profits.
  Dividends or retained earnings to enhance A security is issued by a company only once, but
prospects for growth it may be traded among investors many times
 2 sources of cash flows: (1) dividends (2) thereafter.
eventual selling price of the share.
“market” describes the combined actions of
4. Bonds represent a debt relationship
investors acting within the marketplace.
 Buying a bond is lending money
Financial management answers:
Companies issue financial assets to raise money to
buy real assets used in running the business. 1. How to raise money
2. What to do with it?
Financial assets are purchased by people to earn
income they don’t currently need. Market Companies

Stock or bond is also called security.

Investors Financial
A person buying a financial asset is investing, managements of
therefore called an investor.
evaluate and
buy stocks firms raise and
Financing means raisingspend
moneymoney
Investments in financial assets can be made directly
to acquire or to do
by buying shares in a mutual fund.
something.
 A mutual fund pools the contributions of
- Leased financed.
many investors and employs a professional
- Debt financed (bond, borrow)
manager to select securities that match a
- Equity financed (stock, selling)
particular set of investment goals.
 “Field of Finance” is concerned on both raising
What are financial markets? money and its providers.
 Where financial assets are issued by
companies and purchased by investors  “Modern Finance” includes goals and activities,
 A framework or organization in which concerned with the notion of risk in investing. It
people can buy and sell securities in also involves the roles and function of financial
accordance with well-defined rules and within firms.
regulations (ex. stock market)
 Financial markets are the vehicles through  “Portfolios” are where investors put together a
which financial assets are bought, sold, and group of securities.
traded. Financial markets are generally
classified as money or capital markets and
primary or secondary markets.

Financial management – the management and

control of money and money-related operations
within the business. It also involves finance
What is a stockbroker? departments.
A medium; licensed to trade securities on behalf of Chief Financial Officer (CFO) – executive in
investors. charge of finance, also called vice president of
Investors buy and sell the same financial assets finance. They report to the president of the
among themselves; they are most of the company. “Financial management” is what the CFO
transactions. and the finance department do.
Business Decisions – financial management also What is financial theory? (In economics) it is the
refers to the financial input that goes into general body of thought that is studied and continually
business decisions. developed by highly trained experts
Oversight – is looking over everyone’s shoulder to Forms of business organization:
make sure they’re using money effectively.
 Sole partnership (can be partnership)
Oversight responsibility.
 Partnership
The link between company management and  Corporation
investments comes from the relationship between  C type
price and expected financial results. Everything  S type Small
firms and their managers do is watch the market and  LLC
has an impact on investor’s perception of future 1. Proprietorship
performance and risk. Those perceptions determine  Simple
the prices of stocks and bonds.  Taxed as personal income.
 Raise money (loan, family, friends,
“All about future performance”
bank)
Accounting is a system of record-keeping designed  Difficulty in raising money
to portray a firm’s operations to the world in a fair  “Collateral” – loan banked by asset.
and unbiased way. The records are used periodically 2. Corporation
to produce financial statements.  Legal process of incorporation
 A corporation is a separate legal entity
Treasury department – raise money, analyze subject to a corporate tax on whatever it
results, handle relationships with outsiders such as earns. The leftover after-tax belongs to
banks, shareholders and representatives of the the corporation.
investment community.  Although the entrepreneur owns the
Finance department – consists of the accounting business, he needs to declare dividend
department handled by a controller and the treasury before getting the money.
department handled by a treasurer. Both reports to This “dividend” is taxable to the
the CFO. individual.
 Double taxation of earnings is a major is
 Treasury functions are called a major financial disadvantage of
finance. traditional corporate form.
 Controller functions are called  Ease of raising money by selling stocks
accounting. is an advantage.
CFO Corporation has double taxation:
Treasurer Controller 1. Tax of the corporation
Cash is King! Finance concentrates on cash flow. 2. Tax of individuals

Important Notes: Personal guarantees – side agreements that make

owners personally responsible for repayment.
 Depreciation expense lowers the profit.
 Financial transactions are recorded within LLC and S-type Corp –are corporations that have
the structure of accounting systems. limited liability and earnings are not subject to
corporate income tax. Personal rates only (Tax of
Accounting is the language of finance individuals). LLC and S-type corporations let small;
businesses avoid double taxation.
  The tax system considers them as The ownership of a widely held company is
partnerships. They are called “pass- dispersed so no one has enough control to influence
through”, they pass profit through owners management.
and are taxed only at personal rates; can be
Agency Problem
large but owned by few people.
The special position of management in widely held
In economics, the goal of the firm is to maximize
companies leads to a particularly onerous conflict of
profits.
interest known as the agency problem.
The appropriate managerial goal is to maximize
 Agency problem – is the conflict of interest
shareholder wealth equivalent to maximizing the
between stockholders and management.
price of the company stock.
An agency relationship is created when a person
Shareholder wealth maximization is a practical goal
hires another and gives him or her decision-making
for corporate management.
authority over something.
Terminologies:
 Example: if Smith hires Jones to run his
 Conflict of Interest – when something that business, Jones is the agent of smith, who is
benefits one group takes away from another. a principal. If Smith hires Jones to sweep
 Agency problem – onerous conflict of interest the floor, no agency relationship is created
 Agency relationship – a person hires another because no decision-making authority is
and gives him or her decision-making authority involved.
over something. There should be decision-
making authority. The agency relationship creates an opportunity for
 Prerequisites or perks abuse by the agent who has no control over the
 Agency costs – ensure to control agency to assets of the principal.
avoid agency problems. Corporate managers are the agents of the firm’s
 Security analysis – estimating the value of a stockholders.
particular stock.

Abuse of agency is when corporate managers

Stakeholders or Constituencies – are interested (agent) receive excessive compensation. The
groups where each has a stake or vested interest in conflict is with stockholders because the excessive
the way the firm is operated. payment is company profit which belongs to them.
Management – has a special position among Another form is using company assets for personal
stakeholder groups; they have little accountability to use.
stockholder group. A creditor is anyone owed money by a business,
 If ownership is widely dispersed that no one including lenders, vendor, employees or the
holds more than 1% or 2% of the company, government.
stockholders have limited influence because
no one can muster enough power to force a Chapter 3 Cash Flows and Financial Analysis
change in the management team.
What is Financial Information?
 Top managers become entrenched in
positions controlling vast company  Results of business operations in money
resources and are able to use those resources terms
for their own benefit rather than for the  Not only a document
benefit of shareholders.  Used by stakeholders in and out for
decisions and relationships.
  It is created by accountants and auditors; Investment advisory services might ask for a fee
they review it to guarantee correctness.
Advertisements use flowery words, marketing, and
 Preparing financial information is the
strategic information.
responsibility of management.
Finance uses financial statements to evaluate
business and their future prospects.
Who are the users of financial information?
 Look for problems
1. Investors and financial analysts – must be
 Why do we borrow money? What does it
interested in buying stocks or might be
mean? Can the firm pay? Will we need
asked to lend money.
more?
 Lenders – concerned with the firms'
stability and cash flow (will they In finance, attitude is critical and investigative.
lend you)
 Stockholders – prospects for growth Statement of Cash Flows – the movement of cash
in and out the company.
They may also analyze financial statements and
may rely on the reports of financial analysts (work  Statement of changes in financial position
in large brokerage firms or other financial  In (+) where it came (sold); and out (-) are
institutions. what we bought shown in parentheses as
negative numbers.
 Constructed from balance sheet and income
statement; NOT CLOSED.
 Financial analysts – study the company and
predict the firm’s performance. 2 balance sheets 1 income statement
They are the main audience for Beginning and end; the From the period
investor oriented information beginning is the end of
They present financial statements the previous; it carries
(relate to the past) on

2. Vendors or Creditors – advancing funds in 1. Net income and adjust it

the form of product and services. They are 2. Two consecutive balance sheets and analyze
invested like lenders. Does the firm have the changes and how it affect the cash
cash available to pay its debts in the balance.
immediate future?
Cash Flow notes:
3. Management – final group interested. They
Asset Increase Use -
study the successes and failures to pinpoint
Liability Decrease Use -
strengths and weaknesses. They know where Asset Decrease Source +
to put effort to correct problems and Liability Increase Source +
improve performance. Income is represented by adjusting net income
Sources of financial information (BIASED) Operating – day2day basis
 Annual report for stockholders (several years of Investing – buys or sells that return more than its
financial info) cost
 Must be audited, level of assurance in
accordance with GAAP Financing – borrow money, pay loan, sell stock, pay
 Minimize or ignore failures, exaggerate success, dividend. Raise money
build opportunities unrealistically. Operating
Brokerage firms offer free financial information.
Operating Activities – cash generated from  EBIT – (T) (EBIT) = EBIT (1-T)
operations; produce net income  Equals net income (if no debt)
Operating Income – net income with non-cash Operating Cash Flow
(depreciation)
 NOPAT + Depreciation
Operating transactions = current balance sheet  Fixed assets must exceed depreciation
(Depreciation is noncash)
Current Accounts:
FCF = Operating Cash Flow – Increase in Gross
Accounts receivable Accounts Payable
Fixed Assets – Increase in Current Accounts
Inventories Accruals
Money available to investors is operating cash flow
less funds to support asset growth.
Depreciation is non-cash that is why you add it to
Net Income. Positive operating cash flow provides enough cash
for asset growth
Investing
Negative, investors have to makeup shortfall
Investing includes (gross) fixed assets. It is NOT
net because “net” includes reduction for It helps the investor decide whether they buy a
accumulated depreciation which was already company or not. Will it generate cash? Or will it
included in the operating section. require cash?
Financing  Increase fixed assets
 Increase working capital or current accounts
1. Increase in long-term debt.
2. Sale of stock results in increase in source of There is a principal payment if there is a long-term
equity (liability) debt, there is NO principal payment.
3. Dividend payment is the use of money
Free Cash Flow + Equity (FCFE)
which decreases equity (liability)
Company can distribute cash to stockholders while
Investors buy whole companies with a history of
continuing to perform as it has if company is
steady growth. Can it generate cash?
acquired subject to existing debt.
Free Cash Flow (FCF) – will a company provide
FCFE = Operating cash flow – increase in gross
cash or require it in the future?
fixed assets – increase in current accounts – (1-
 Positive business operations fund their own T)Interest (after tax) - Principal reduction
growth, upkeep, money is available to pay
The result will either show whether company can
interest and dividends.
support own performance or is in need of new
 Negative require cash contributions outside
funds.
 Cash is generated by operations available for
distributions to investors Cash conversion cycle (racetrack diagram)
 Operating cash flow plus assumption that
firm will remain competitive Product is converted into cash, which is transformed
into more product, creating cash conversion cycle.
Earnings before interest and taxes (EBIT)
Cash – Product – Cash
 Cost – Expenses (except interest and tax)
 Not influenced by how the company is Ratio Analysis
financed  Is the general technique they use in
 Operating profit (EBIT) exclude financing analyzing transformation.
Net Operating Profit After Tax (NOPAT)
  Financial ratios are formed from sets of Return on sales – net income of percentage of
financial statement figures. sales.
 Ratios highlight different aspect of
2. Ratio for balance sheet
performance.
 Ratios don’t provide answers they help you
Current Ratio ask the right questions
 Depends on what the ratio is measuring
 Ratio that gives a quick indication of
(beginning, ending or average) WE WILL
whether the company will have the means to
USE ENDING.
pay its bills during the next year.
 Beginning values are never appropriate
 “current” – cash will be generated or
 If the firm is shrinking rapidly, average and
required within a year
ending values are important
 To be solvent, a company must have at least
as much money coming in as it has going Liquidity management – the firm’s ability to
out. pay its bills in the short-run
 Current ratio = current assets / current
Asset management – how the company uses its
liabilities (both end)
resources to generate revenue and profit and to
 In every assets, there is a liability. 1:1
avoid cost
 Measures liquidity (company’s ability to pay
its bills in the short-run) Debt management – how effectively the firm
uses other people’s money and whether its using
Financial Ratio
too much borrowed money.
 Are formed from sets of financial statement
Profitability – gives us several measures by
figures. Ratios highlight different aspects of
which to assess the success of the whole venture
performance.
in making money.
 Comparisons are made with respect to
history, the competition and the budget. Market value – give an indication of how
 Liquidity is the ability to pay its bills in the investors feel about the company’s financial
short-run. future.
History – looking at ratio next to the same figure Liquidity ratio – measures the ability to meet
calculated for the same organization in one or more short-term obligations
immediately preceding accounting periods. The
idea is to look for trends. Current Ratio

Competition – Other company’s performance is a  Primary measure of company liquidity

good yardstick for evaluating a firm’s performance.  Current ratio = current assets/current
Find out why. Industry average data. liabilities

Budget – plan involves a projected set of financial Quick ratio or Acid test
statements from which ratios can be developed.  Inventory cannot be immediately converted
1. Common size statements to cash
 First step, calculation of a set of ratios  Also deduct prepaid expenses and other
 Each line item as a percentage of revenue assets that never become cash
 Frequently used.  Quick ratio is nearest to cash, easy to avail
cash
Cost ratio – cost of sales/sales revenue  Quick ratio = current assets – inventory/
current liabilities
Expense ratio – expense as percentage of revenue
Asset Management Ratio – fundamental efficiency  Important to creditors and stockholders, how
with which a company is run the firm uses other people’s money to its
own advantage
Average Collection Period (ACP)
 Firms should not use this as much
 Average number of days the firm takes to (borrowing, trade credit)
collect its receivables  Total debt figure = current liabilities + long-
 How long does it take to get paid on credit term debt
sales
Debt Ratio
 Also DSO or days sales outstanding,
receivable cycle  Total debt concept and measures the
 Stated in days (units of measure) relationship between total debt and equity in
 ACP = accounts receivable/average daily supporting a firms assets
sales (360)  Debt ratio = long-term + current liabilities
 ACP = accounts receivable /average daily total/ current assets
sales x 100
Debt to Equity Ratio
 The longer to collect money, the worse
 Most credit business runs on 30 days  Uses long-term debt
 Discounts offered to encourage early  Debt to equity ratio : long-term debt : equity
payment  Interest is fixed and must be paid regardless
 Old receivables should be written off of whether revenue is healthy or not.
without delay or reserved through allowance  Financial risk is the risk associated with debt
for doubtful accounts. The value of and interest
receivables balance net of ADA should be
used in calculation. Time Interest Earned (TIE)
 ACP = (end) ar/sales x 360  Burdening the income statement with
Inventory turnover ratio interest more directly. Measures the number
of times interest can be paid out earnings
 Measure excess funds tied up in inventory before interest and taxes (EBIT)
 Gives an indication of the quality of  TIE = EBIT /Interest
inventory as well as how well it is managed.
 Inventory turnover = COGS/inventory Cash coverage
 High turnover is better because holding  interest is cash payment but EBIT is not
inventory causes costs. exactly a source of cash. It is income
 Inventory turnover = Sales/inventory statement subtotal. More or less cash than
Fixed Asset and Total Asset Turnover EBIT may be available in any given year to
pay interest.
 Measure the relationship of the firms asset  Depreciation- subtracted as part of cost and
to a year’s sale. Relationship between assets expense in the calculation of EBIT
and sales  Cash coverage – depreciation added to EBIT
 Fixed asset turnover = sales/fixed asset in numerator
 Total assets turnover = sales/total assets  Cash coverage = EBIT + depreciation/
 Better is generate more sales with a given interest.
level of assets
 Not if generate few sales with same assets Fixed charge coverage
 Stated in times, x  leased equipment is necessary to stay in
Debt Management Ratio business or if noncancellable
 To come to EBIT, lease payments are
 Any source of money other than equity subtracted along other costs and expenses
  It needs to be added back in the numerator Market value ratios- not controlled by management,
to arrive at the cash figure available to pay but can influence. Market value of a company is
all fixed charges. reflected in its stocks.
 Fixed coverage charge = EBIT + lease
Price or Earning Ratio
payments/ interest + lease payments
 Other fixed charges can be added to  Compares market price of stock to the EPS
numerator and denominator calculated from the latest income statement
 EPS = net income/number of shares of
Earning before Interest, Tax, Depreciation and
common stock
Amortization (EBITDA)
 PE ratio = stock price/EPS
 EBITDA = EBITDA + lease payments/
Market to Book value ratio
interest+ lease payment+ principal payment
 a book value is the total value of the equity
Profitability Ratio
on its balance sheet.
 Fundamental measure of a business success  =A-L.
is profit  A healthy company is expected to have
 No profit, no dividends market value in excess of book value.
 No dividends, no expectation  Market to book value ratio = stock
 Give relative measures of the firm’s money- price/book value per share.
making success
 Percentages
Return on Sales (ROS)
 Also called profit margin or net profit
margin. Net income as percentage of sales. Du Point Equations – express the relationship
 ROS = net income/sales between ratios that gives insights into
 Measures the control of the income successful operations.
statement: revenue, expense, cost
 Overall indication of business profitability 1. ROA = net income/total assets x
sales/sales
2. ROA = net income/sales x sales/total
Return on Assets (ROA) assets
 Uses assets and the skills of its people to 3. ROA = ROS x total asset turnover
earn a profit. ROA quantifies the success of ROA is a fundamental measure of
that effort with respect to assets by stating performance, how a company uses its assets to
net income as a percentage of total assets. generate profits.
 ROA adds the effectiveness of asset
management ROS 1. ROE = net income/equity x sales/sales
 ROA = net income/total assets x total assets/total assets
2. ROE = net income/sales x sales/total
Return on Equity (ROE) assets x total assets/equity
 Most fundamental profitability ratio. Net Economic Value Added (EVA) – subtract cost
income as percentage of equity of debt and equity. Cost of capital average
 Measures the firm’s ability to earn a return “interest rate” that reflects the rate of return
on the owner’s invested capital. the business pays to suppliers
 ROE = net income/ equity
EVA = EBIT (1-T) – (debt+equity) (cost of
%capital)
 4. Deduct the new bond price to the face value of
the bond to calculate the gain.
5. Divide the gain to the face value of the bond to
get the percentage of return on investment.

Chapter 7: Convertible Bonds

Convertible bonds are exchangeable for a fixed To get the return from common stock:
number of shares of the issuing company’s stock
1. Face value of the note divided by the price of
at the bondholder’s discretion. The number of
the common stock to get the shares.
shares exchanged for the bond is determined by
2. Deduct the new price of the stock from the price
a conversion ratio that’s set at the time the bond is
of the common stock to get the gain.
issued. Stating the conversion along with the
3. Multiply the total gain to the shares calculated
bond’s par value implies a conversion price.
to get the price of the stock.
Ordinary bonds are generally safer 4. Divide the price of the stock to the face value to
investments compared to stocks that offer get the rate on return.
price appreciation. A convertible
feature allows bondholders to price.
appreciation if the firm is successful. It is usually
set at 15 to 30 percent above the stock market’s Effect of Conversion on the Financial Statements
price at the time the convertible is issued. and Cash Flow
This method makes investors accept lower yields During conversion, an accounting entry is made
on convertibles than on ordinary bonds. That that takes the par value of converted bonds out of
means they can be issued at lower coupon rates long-term debt and places it in the equity accounts
and cost borrowers less in interest expense. as if new shares had been sold at the conversion
Convertibles are less risky than stocks. price.
Convertibles are always debentures, unsecured There is no immediate cash flow impact from
bonds. conversion, but affects ongoing cash flow, and the
transaction is strictly on the company's books. It is
important for the ongoing cash flow because it
To get the return on investment of makes the original debt go which makes the interest
convertible bonds: payments immediately stop, however, the newly
created shares are entitled to dividends if any are
paid.

Shares exchanged = Par value If the company that issues convertibles doesn’t
pay dividends, it implies a decrease in cash flow.
Conversion also strengthens balance sheet by
Conversion Price
removing debt and adding equity, which improves
all debt management ratios.
1. The answer will be the resulting number of
Convertibles as Deferred Stock Purchases
shares. The proceeds will be multiplied to the
current price of stock. Convertibles can be thought of as deferred stock
2. Get the interest payment of the bond with its purchases or deferred purchases of equity (stock). A
coupon rate. substantial increase in stock price guarantees
3. Add the market shares price to the interest eventual conversion which means that the bond and
payment of the bond. The answer will be the associated interest payments can be viewed as
new bond price. temporary, and the long-term effect of the
transaction is a sale of stock.
 Advantages of Convertible Bonds 2. Limit the risk associated with stock investments
which may cause big gains or loss.
Advantages to Issuing Companies
Forced Conversion
1. Offer lower interest rates. Convertible debt
tends to be offered by risky companies that Lenders of convertible bonds may delay exercising
have problems with conventional borrowing. the conversion of bonds if they believe that the
Risky businesses often pay higher interest rates current stock price will remain the same all
which makes it difficult to borrow. This makes throughout the years. This enables them to collect
lenders accept lower rates or lend where they interest until they decide to call it off and then
would not. receive the stock price when they decided to
convert the bonds to stock
a. Companies with a low credit rating and
high growth potential often issue  (meaning makakareceive sila ng interest
convertible bonds. For financing throughout the years of the bond, tapos pag
purposes, the bonds offer more ayaw na nila, pwede nila iconvert ung bond
flexibility than regular bonds. They may sa prices ng stock para more money).
be more attractive to investors since
convertible bonds provide growth The management wants to convert their bonds for
potential through future capital two reasons:
appreciation of the stock price.
1. Avoid paying further interest.
b. Companies issue convertible bonds to 2. Want to exchange debt for equity
lower the coupon rate on debt and to (strengthen the balance sheet)
delay dilution. They trade in relatively This makes them issue call features to force
illiquid market. conversion which typically have call premiums
2. Illiquid – a market that is of one year’s coupon interest. This makes the
3. difficult to sell assets in due to a lack of lender either accept the call premium or convert the
interested buyers, available assets, or because bonds to stocks.
the market itself is not viable as a financial
asset. Issuers call convertibles when stock prices have
4. It can be viewed as a way to sell equity at a risen to levels that are 10-15 percent above
price above the market. They may sell stock conversion prices.
above the market. Overhanging Issues
5. They have few restrictions. Lenders insist on
reducing their risk with contracts called bond Issuing convertibles may not be to borrow money
indentures that limits the activities of borrowers but may be to sell equity at a price above market.
while debt is outstanding. If the debt is a Convertibles can become problems if stock prices
convertible debt, lenders view is as purchasing don’t increase enough to make the bonds’
equity (because they can change bond to stocks) conversion values more than their call prices
which makes them less concern with (premiums). Calls won’t force conversion. If the
restrictions (bonds have indentures). lender accepted the call price and don’t convert, the
company will be stuck with debt it doesn’t want
Advantages to Buyers (because they would rather have equity to avoid
paying interest and to make its balance sheet
1. They offer the buyers chance to participate in
stronger).
stock price appreciation offered by risky equity
investments. (Risky businesses have volatile Valuing (Pricing) Convertibles
interest rates. If it is a bond, the lender may face
a loss because of its fixed rate. If it is a stock, Valuing the convertible is complicated because the
lenders can convert it to stocks when the stocks security’s value (price) can depend on either its
increase. In stocks high risk=high rewards).
value as traditional bond or market value of the firm’s money-making power stated on a per-share
stock which it can be converted. basis. EPS is a key factor in determining the value
of stocks. Investors decide how much they’re
➢ The convertible value as a bond does not willing to pay for shares based in large part on
require it to be at par because it depends on the issuing company EPS. Growing EPS is a very
interest rate . positive sign, a stagnant or declining can lead to
depressed stock price. EPS is related to related
➢ Convertibles value as a stock is calculated price earnings per ratio because it is the first thing
as: investors look at.
Number of shares exchanged for one
bond(conversion ratio) multiplied by the current Dilution
stock price. Assuming the bond is convertible to 50
shares of stocks, The additional issuance of stock would increase the
value of the company enough to keep the value of
old shares constant. If new shares are issued at a
Pb = 50Ps
lower price, new investors would gain higher return
Pb = Price of bond because of the stocks of old investors. The old
Ps = Price of stock investors’ stocks were diluted. Earnings dilution is
 At low stock price, the convertible’s value a drop in EPS caused by a sale of stock at a below-
as a bond is higher than its value as a market price.
stock. At higher prices, it’s worth more as
stock. Convertibles and Dilution
 At ANY STOCK PRICE the convertible is Convertible securities cause dilution.
worth atleast larger of its value as a bond If the convertible bond has a stock price of 25, and
or as a stock. the stock market has 29, the owner of the
convertible would receive 29 but the issuer will
The higher the stock and bond value line’s receive only 25.
represents the minimum value of the convertible. Dilution happens when a company’s stock price
The market value of a convertible lies above the rises after a convertible is issued. The existence of
minimum value line because of the possibility that unexercised convertibles always represents
the stock’s price will go up and improve the potential dilution in a firm’s EPS.
return, this idea gives the convertible extra value.
The difference between market value and the Disclosure of the Dilutive Potential of
appropriate minimum is the conversion premium. Convertibles
Unexercised convertibles may cause smaller EPS
❖ A conversion premium is the excess of a
because of their dilutive effect. This made FASB
convertible’s market value over its value as a
(Financial Accounting Standards Board) make the
stock or bond.
companies report potential dilution from
 The minimum values as stock and as a convertible and certain other securities in their
bond are equal at the intersection of the two financial statements. FASB 128 requires that
minimum value lines. That point can be companies report two EPS figures, basic EPS and
found by substituting the value as a bond diluted EPS.
into the equation of the diagonal value as
 Basic EPS is what you would expect,
stock line.
earnings after tax divided by the number of
Pb = 50Ps shares outstanding during the year. If the
1000 = 50 Ps Ps = 1,000/50 number of shares isn’t constant during the
=20 year, an average over time is used.
Effect on Earnings Per Share – Diluted EPS EPS  Diluted EPS is calculated assuming all
is net income (earnings after tax) divided by the existing convertibles are exercised creating
number of shares of stock outstanding. It is the
 new shares as of the beginning of the year. Institutional Characteristics of Bonds
It shows the worst case scenario for
dilution. A bond is a device that enables an organization
(generally a corporation or a government unit) to
How to Calculate Basic and Diluted EPS for the borrow from a large number of people at the same
year: time under one agreement.

Basic EPS: Registration, Transfer Agents, and

Owners of Record
Basic EPS = net income
A record of owners of registered securities is kept
by a transfer agent. Payments are sent to owners of
Shares outstanding record as of the dates the payments are made.
Bonds are classified as either:
Diluted EPS (new shares issued):
1. Bearer bonds – belong to whoever possesses
Shares exchanged = bond’s par value them, a convention that makes them
dangerously subject to loss and theft. They have
Conversion price
coupons attached for the payment of interest.
And then: 2. Registered bonds – the owners are called
transfer agents. This is an organization, a bank,
1. Shares from conversion = issued convertible that keeps track of the owners of stocks and
bonds x new shares issues (diluted eps) bonds for issuing companies. When one
2. New shares outstanding = outstanding share + investor sells a security to another, the agent
shares from conversion transfers ownership in its records as of the date
3. Interest saved = coupon rate x par value x of sale. On any date, there is a particular owner
issued convertible bonds of record on the transfer agent’s books for every
4. Saved taxes = interest saved x marginal tax rate bond (and share) outstanding. Interest payments
5. Improvement in net income from eliminating are sent directly to the owners.
interest is interest saved minus saved taxes.
6. Net income for calculating diluted EPS is net Kinds of Bonds
income plus improvement in net income from
Secured Bonds and Mortgage Bonds – Secured
eliminating interest.
bonds are backed by the value of specific assets that
7. Diluted EPS is net income divided by new
holders can take possession and sell to recover their
shares outstanding.
claims on the company. Assets tied to a specific
Other Convertible Securities debt are not available to other creditors until that
debt is satisfied. When the securing assets are real
Convertible features can be associated with certain estate, the bond is called a mortgage bond.
other securities, such as preferred stock.
Convertible preferred shares are similar to Debentures – are unsecured bonds. They rely on
convertible bonds in that both are potentially the general credit-worthiness of the issuing
dilutive. They’re treated similarly in the calculation company rather than the value of specific assets.
of diluted EPS. Debentures are clearly more risky than the secured
debt of the same company. They must be usually
Securities that are not convertibles can also result in
issued to yield higher returns to investors.
issuing new stock at prices below the market. Until
exercised they also present potential dilution, the Subordinated Debentures and Senior Debt
calculated diluted EPS should be adjusted to them. – Subordinated means lower rank or priority. In
A warrant is an example, which gives its owner the terms of debt, it means having lower priority than
right to buy a limited amount of new stock at a other debt for repayment in the event the issuing
fixed price during a specified period. company fails. Debentures can be subordinated to
specific assets or to all other debentures in general. good financial results and a prosperous financial
The debt having priority over a subordinated debt is outlook but faces a major lawsuit. If the lawsuit is
called a senior debt. serious, it can lower the rating.
Subordination arises with the senior debt. Bond ratings are NOT precise because they also
Some security is afforded to the first lender by rely heavily on qualitative judgments made by the
writing a clause into the loan agreement requiring rating agencies. Rating Symbols and Grades
the subordination of all future debt.
Investment grade or medium quality have low
Subordinated debt is riskier than senior or default risk
unsubordinated debt, it requires a higher yield.
Substandard graded bonds are called junk
Junk Bonds – issued by risky company (companies bonds.
not in good financial condition) and pay high
Why Ratings Are Important
interest rate by paying 5 percent higher than strong
companies. They are also called high-yield Risk and return are related and investors require
securities. higher returns on riskier investments. Ratings are
the primary measure of the default risk associated
Negative Interest Rates
with bonds. They’re an important determinant of
It happens from time to time in the market for the interest rates investors demand on the bonds of
short-term securities issued by strong governments. different companies.
Securities are called bills, not bonds called T-Bills
Rating associated with a firm’s bonds determines
or treasury bills.
the rate at which the firm can borrow. A lower
The phenomenon of lending money with little rating implies the company has to pay higher
return happens in secondary markets; when interest rates which means it’s more difficult for the
investors trade the bills among themselves. They do company to do business and earn a profit, because
it for safety of the economy of the country. it’s burdened with a higher cost of debt financing.

Bond Ratings- Assessing Default Risk All bonds yield interest rates; the differential is
between the rates required on high and low quality
Bonds are assigned quality ratings that reflect the issues. Lower curves associated with high-quality
probability of going into default. Higher ratings bonds means that the issuing companies can borrow
mean lower default probabilities. Bond ratings are at lower rates (more cheaply). Highest quality bond
developed by rating agencies that make a business that can borrow at lower interest rate is the federal
out of staying on top of the things that make bonds treasury bond (high quality bond indicates the
and the underlying firms more or less risky. safety).
They rate bonds examining the financial and market A bond’s rating affects the size of the differential
condition of the issuing companies and the between the rate it must pay to borrow and the rate
contractual provisions supporting individual bonds. demanded of high-quality issues. It does not affect
It’s important to realize that the analysis has these the overall up and down motion. The differential
two parts. reflects the risk of default perceived to exist with
Bond ratings gauge the probability that issuers will lower quality bonds (default risk premium).
fail to meet their obligations.
The differential over time – The differential
A bond’s strength is fundamentally dependent on between the yields on high- and low-quality bonds
that of the issuing corporation. The process pf is an indicator of the health of the economy. Higher
rating a bond begins with a financial (ratio) rates are associated with recessions and tough
analysis. Then, the agencies add any knowledge economic times. Marginal companies are prone to
they have about the company, its markets, and its fail. The risk of default associated with weak
other dealings. For example, suppose a firm has companies is greater in bad times than in good
times. It expresses level of risk, differential tends to principal to be repaid. This approach is the
be larger in recessionary periods. future value of an annuity.
2. Randomly calling in some bonds for
This phenomenon can be considered an economic
indicator . A high differential is taken as a signal retirement prior to maturity.
that a harder times are on the way. Other terms:
The Significance of the Investment
 Diluted EPS - EPS considers a company’s
Grade Rating common shares, whereas diluted EPS takes
Most bonds are purchased by institutional investors into account all convertible securities, such
such as banks, mutual funds and insurance as convertible bonds or convertible
companies, rather than individuals. The law preferred stock, which are changed into
requires these institutions to make only relatively equity or common stock.
safe, conservative investments and can only deal in  Unexercised convertible bond –
investment grade bonds. This requirement limits the unconverted convertible bond
market for the debt of companies whose bonds are  Exercised convertible bond – converted
not considered investment grade. convertible bond
Is EPS an equity? - The earnings per share (EPS)
ratio is effectively a restatement of the return on
Bond Indentures- Controlling Default equity (ROE) ratio. While the ROE ratio is
Risk calculated as a percentage, taking total net profit
and total equity into consideration, the EPS ratio
The conflict of interest arises because the rewards shows how much profit has been earned by each
of successful risk taking accrue largely to ordinary share (common share) in the year. Bond
stockholders while the penalties for failure can be Outstanding
shared between stockholders and creditors.
Junk bond
To ensure that the bond-issuing companies maintain
an even level of risk, lenders usually insist that Risky enterprise
bond agreements contain restrictions on the Default risk
borrower’s activities until the bonds are paid off.
The contractual document containing such
Chapter 8
restrictive covenants is called bond indenture.
Typical indenture provisions prelude entering The Valuation and Characteristics of Stock
certain high-risk businesses and limit borrowing
more money from other sources. They may also Common Stock
require for certain ratios held above minimum
levels.
• Corporations are owned by holders of their
common stock.
Every bond issue has a trustee whose job is to
administer and enforce the terms of the indenture • Stockholders choose directors, who appoint
on behalf of bondholders. Trustees are usually managers to run the company.
banks.
• This means that stockholders have a voice
Sinking Funds in running the company through BoD
This spreads the repayment of principal over time. Most large companies are widely held, stock
Two types: ownership is held by a large number of people and
no individuals or groups control more than a few
1. Periodic deposits such that amount percent.
available at maturity is equal to the
Stockholders have little power to influence payment that can be thought of as the return of the
corporate decisions, and stock ownership is simply original investment.
an investment.
 Dividends – analogous to interest payments
When buying stock, our role is not as owner. Most  Final sale of stock – appears to be like the
equity investors are not interested in a role of return of a bond’s principal.
owners. We’re just interested in the future cash
flows that come from owning shares. The reality is that the similarity is superficial
because of the differing natures of the cash flows in
Equity (stock) investments are like debt (bond) the two cases.
investments; we’re only interested in money.
a) Bond – interest payments are guaranteed by
the borrower, are certain to be received.
The Return on an Investment in Common Stock Companies have to be VERY close to
failures before they declare default on bond
The income in stock investment comes in two interest. Interest payments in bonds are in
forms: constant or fixed amount, making it easy to
develop a formula to value bonds, because
(1) Receiving dividends interest can be represented as annuity.
Payments are contractually promised loan
(2) Realize a gain or loss on the difference
principal equal to bond’s face value
between the price they pay for stock and
the price which they eventually sell it
b) Dividends – carry NO guarantee. There’s
(capital gain or loss)
NO agreement associated in common stock
that makes any representation about the
The future cash flow associated with stock
payment of dividends. Investors depend on
ownership consists of dividends and the eventual
them for value but nothings is committed,
selling price of the shares.
promised, or guaranteed by the company.
The return on stock investment is the interest rate Even with a long history of payments,
that equates the present value of the investment’s companies could stop paying anytime.
expected future cash flows to the amount invested Interest on dividends are rarely constant,
today. people can expect dividends to increase
over time as company grows. Stockholders
 The return on any stock investment is the rate has to sell their shares at the prevailing
that makes the present value of future cash market price to realize a final payment
flows equal to the price paid for the investment which can be higher or lower than the price
today. This principle also holds for investments originally paid.
held for more than one year.

Dividend and Capital Gain Yields – The return on

a stock investment can be broken into two parts There’s NO provision in a common stock
related to the two sources of income of stocks. The investment for the repurchase of shares or for any
return on a stock investment comes from dividends return of the investor’s capital by the company,
and capital gains. which means that the money for the final payment
comes from another investor rather than from the
The Nature of Cash Flows from Common issuing company as it does with a bond.
Stock Ownership Both the cash flows with stock ownership are
Comparison of Cash Flows from Stocks and dividends and the proceeds of the eventual sales of
Bonds – Cash flow pattern for stocks appears the share are imprecise and difficult to forecast.
similar to the one associated with bonds. A series of
regular payments is followed by a single larger
The Basis of Value The basis for stock value is Generally, we can’t forecast the future in detail.
the present value of expected cash inflows even We’re likely to look at a company and simply
though dividends and stock prices are difficult to forecast a growth rate of earnings and dividends
forecast. into the future starting from wherever they are now.
The future is uncertain, it’s difficult to make the
A stock’s value is the sum of the present value of
detailed forecast of dividend and future prices
dividend payments and the present value of the
needed to use. Stock valuation models are based on
selling price in a period. Successive dividends have
predicted growth rates because forecasting exact
different values.
future prices and dividends are very difficult.
Valuing a stock involves making some assumptions Developing Growth-Based Models
about what its future dividends and its eventual
selling price will be. Once this has been done, we Stock dividends and eventual selling price are
take the value assumed (projected) cash flows at an separate amounts in the present valuing process,
appropriate interest rate to estimate the share’s each multiplied to the present value factor for the
current price. appropriate interest rate and time.

 Contrast to bond valuation, bonds have no A stock’s value today is the sum of the present
need to make assumptions about the future values of the dividends received while the investor
cash flows because they were spelled out by holds it and the price for which it is eventually sold.
the bond contract.
An Infinite Stream of Dividends – The concept of
stock ownership is :
A generalized stock valuation formula from these
ideas by treating the dividends and the selling price 1. Buy
as a series of independent amounts to be received at 2. Hold for a while
various time in the future. 3. Sell
The Intrinsic (Calculated) Value and The present value of any amount that is infinitely
Market Price – The present value cash flows is far away in time is clearly zero.
fundamentally what the stock is worth (the stock’s
Conceptually, it’s possible to replace the final
intrinsic value).
selling price with an infinite series of dividends.
 If other investors does not agree with the
Market-Based Argument – Individual investors are
stated dividend and price estimates, their
a whole community; Individual investors will
ideas of the intrinsic value of that dividend
subsequently trade the stock back and forth among
will differ from the statement of the other
themselves, and act as one unified body setting a
investor.
price for the stock when it is issued. The price must
The firm’s market price is the consensus of the be based on the present value of future cash flows
intrinsic values calculated by everyone watching moving from the company to the investing
the stock. The process of developing intrinsic community, with only one kind of payment moving
values and comparing them with market prices is from company to investors (dividends).
known as fundamental analysis.
The only basis for valuation by the community as a
A stocks intrinsic value is based on the assumptions whole is the entire future stream of dividends;
about future cash flows made from fundamental nothing else.
analysis of the firm and its industry.
Working with Growth Rates – Growth rates usually
Growth Models of Common Stock used to predict future values of variables whose
Valuation values are known today.
The Constant Growth Model
Subsequent dividends can have any values, We know something about the near – term future
randomly chosen or a regular progression of that can be expected to have a temporary effect on
numbers. When the last dividend is paid, we the firm’s prospects.
assume that dividends will grow at some constant
rate in the future. The usual two-stage forecast involves a rapid, super
normal growth rate for one, two, or even three years
Any fraction whose denominator is much larger and a normal rate thereafter. Super normal means a
than its numerator is a very small number. rate in excess of return of stock (k).
The entire expression in brackets is a finite number The model gives us a value for a share of stock at
when K (return) is greater than g (growth rate). In the beginning of an infinite periods of constant,
this case, we’re forecasting normal growth. When g normal growth.
os greater than k, we have super normal growth
which lasts for limited periods. A normal growth that starts at the end of the second
year, when the Gordon model will be applied, the
Constant Normal Growth – The Gordon result is a price for the stock at the end of the
Model – Constant growth model assumes that the second year, or equivalently at the beginning of the
stock’s dividends are going to grow at a constant third. It includes the value of all dividends to be
rate into the indefinite future. It is also called the paid subsequent to the second year but not the
Gordon Model after Myron J. Gordon, a scholar dividend of the second year itself.
behind its development and popularization. It only
works if growth is normal, K>g. Otherwise the The two – stage growth model allows us to value a
denominator is negative (or zero) leading to a stock that’s expected to grow at an unusual rate for
negative (or undefined) price which isn’t a limited time.
meaningful.
The value of a security today is the present value of
The Gordon Model is a simple expression for future cash that comes from owning it.
forecasting the price of a stock that’s expected to
grow at a constant, normal rate.

The Zero Growth Rate – A Constant

Dividend – A perpetuity is an unchanging
payment made regularly for the indefinite period
of time. Common stock will not pay the same
Practical Limitations of Pricing Models
dividend forever. A security called preferred stock
pays the same dividend year after year with no The inputs in the model are only projected growth
expectation of increase or decrease. rates and interest rates. They are not accurate.

Comparison with Bond Valuation – The

The Expected Return inaccuracy only refers to stock valuation; bonds
have bond pricing model that gives a precise
The Gordon Model can be recast to focus on the valuation for the security, because the future cash
return on the stock investment implied by the flows are contractually guaranteed in amount and
constant growth rate assumption. The capital gain time, unless a borrowing company defaults its
yields in the Gordon Model is nothing but the obligations (rare in higher grade issues), we can
growth rate. predict the exact pattern of future interest and
principal payments. Yields in turn are established
The expected return reflects the investors’ accurately by market forces influenced by the
knowledge of the company. It is input to the stability of the issuing company and the term of
Gordon model through the growth rate assumption. debt.
Two – Stage Growth
Stock Valuation models give approximate results IPOs for bonds than stocks because new bonds can
because the inputs are approximation of reality. be issued to replace older, maturing bonds as well
Bond valuation is precise because the inputs are as to raise new money.
exact.
The sale of new shares of an existing stock is
Stocks That Don’t Pay Dividends – Some handled like an IPO but is actually a seasoned
companies don’t pay dividends even when their equity offering (SEO) or a secondary equity
profits are high; many openly states that they never offering. These aren’t especially interesting from a
pay dividends. However, the stocks of these firms pricing perspective, but the market value of old
have substantial values. shares determines the price of the new. (The new
shares may be offered slightly below market to
The previous growth models have been working ensure their sale).
with base stock values solely on the present value
of a dividend stream. The IPOs here are the first public sales of a new
company stocks, that is, the first time people other
Firms that don’t pay dividends even when their than founders and private investors have an
earning are good are usually in an early period of opportunity to buy in, which happens when the
their development and are growing rapidly. Growth founding group wants to raise a lot of money, to
requires cash, and management feels it’s futile to support growth.
pay dividends only to borrow or issue more stocks
to support the growth of the company. Stockholders The shares sold in an IPO are new, but the offering
agree because they hope to own a piece of a much usually includes some existing shares that were
larger company if growth continues. previously issued to founders and early investors.
Although these shares are sold within the IPO
Most people understand that rapid growth is not process, they actually constitute a secondary
forever. When the growth in the industry and firm offering.
slow down, even the most vocal non-dividend pays
are eventually begin paying. Stock that don’t pay IPOs may include shares owned by founders and
dividends today are expected to pay large dividends early investors.
at some time in the future; those distant dividends
Investment Banking
impart value.
The first step toward an IPO is establishing a
If a company truly never paid a dividend, there
relationship with an investment bank, an
would be no way for the investing community as a
organization that specializes in marketing new
whole to ever get a return on its investment.
securities. This banks specializes in different areas.
Valuing New Stocks – Investment An investment bank sells new securities to
Banking and the Initial Public Offering (IPO) investors.
Emerging stocks that are being sold to the public
1. Syndication – Most IPOs are too big and carry
for the time are called Initial Public Offerings
too much risk for a single investment bank, so a
(IPO). They are valued differently than stocks that
lead bank recruits others, forming a syndicate
have been around for a while, which shouldn’t be
which shares the process. The lead bank
the case, but as a practical matter, things are less
(Principal or Managing investment bank) is in
rational in IPO segment of the equity market.
charge.
2. Registration – Filing a registration statement,
IPOs for Different Securities Form S-1 with the SEC. A summary of the
information, known as Prospectus, is part of the
IPOs that generate the most excitement sell the S-1 document, intended for distribution to
stocks of new companies, but there are IPOs for potential investors. The lead investment bank
other new securities, notably bonds. There are advises the company during this stage.
actually more
3. Underwriting – Investment banks solve the IPO to potential institutional clients held by
problem of lowering the price of shares by investment bank.
underwriting IPOs. Underwriting IPOs makes a
firm commitment to buy the stock from the The purpose of the trip is to make promotional
new company at a fixed price and is then presentations on the new company and the IPO to
responsible for reselling the shares to investors. potential investors, which most are the investment
The bank sells the shares at a higher price than banks institutional client. After each shows, the
it paid. The difference is the underwriting banks asks the investors how much shares they’re
spread. This way, investment banks earn profits; willing to buy, recorded in the book that builds into
companies understands that the spread act as the an order list.
fee paid for banking services. The investment The road show generally ends at about the same
bank syndicate is also called an underwriting time the SEC approves the registration statement
syndicate and the investment bank is called which is shortly before the IPO date.
underwriter.
The bank then allocates the IPO shares among the
Best Efforts – Smaller deals does not use investor who expressed interest during the road
underwriting but accept a placement on a best effort show. In most cases, the investment bank places the
basis. It means that issuing company gets whatever majority of the IPO stock with these large, special
the bank is able to sell the new shares for, less relationship investors rather than with the general
expenses and commission. public who are called retail investors. IPO buyers
Promoting and Pricing the IPO tend to be large, powerful organizations that are
“insiders“ in the financial system.
Quiet Period - is the period that begins when the
registration statement is filed until the SEC accepts The sale of the IPO shares is an off market
the statement by declaring it effective. During this transaction, meaning it isn’t the result of an
period, executives and representatives show auction- like process as are ordinary stock trades.
potential investors the prospectus stamped with red The price is set by the investment bank and the
ink “preliminary“ but may not share any other issuing company, based on information from the
information about the company or finalize any book building process, and all shares sold at that
orders for stock. Preliminary prospectus are known price.
as red herring. The prospectus contains price range Prices After the IPO
for the IPO stock but not the exact offering.
The Investment Bank in the Middle – The
The second quiet period begins days after trading investment bank is in the center of the IPO
begins. None associated with the company or IPO process. It stands between the issuing company
can issue any forecast or analysis of the company’s and the investors who buy the shares. Both of
projected performance. This ensures all investors these are the bank’s clients and have put their trust
have equal access to information. in the banker, but their interests conflict. The
During the quiet period, the preliminary prospectus company wants to get as much as it can for its
(red herring) is distributed, but no stock may be stock, while the investors want a very high return
sold. on their money, only when securities are acquired
for less than full value. The issuing company ang
Book Building and the Road Show investors are both clients of the investment bank.
IPOs are promoted during road shows, in the IPOs have a strong tendency to be underpriced to
process of book building. reward investors to make the stock’s price go up
right after the IPO. A rapid increase in price when
The road show is fast and intense trip of companies
trading begins is an IPO pop.
around the country, with the purpose of
promotional presentations on the new company and
Underpricing may happen because investment are made by the board, but big issues such as
bankers know they’re likely to be marketing shares mergers must be voted by stockholders. Corporate
in another IPO to the same investors. boards are generally made of the company’s top
managers and a number of outside directors. Board
The idea of IPO pop is to purchase shares, hold members may be a major stockholder.
them while the price increases quickly and then sell
after only a few days before the price falls again. Companies are widely held when stock ownership
Investors that use this strategy is called a stag and is distributed among a large number of people and
the gain is a stage profit. A pop – based strategy no single party or group has a significantly large
available to less privileged investors is simply to share.
buy as soon as possible after the trading starts,
watch the rising price very carefully, and sell the This makes it difficult to make a change in the
moment it starts down. board because it’s hard to organize voting
stockholders against incumbent members. In
Market Stabilization Investment banks support situations like this, members of top management on
the new stock’s price to keep it above the IPO price. the board have effective control of the company
The lead investment bank is actually committed to with little accountability to stockholders. Top
supporting a small pop by keeping the price of the managers effectively control widely held
stock above the IPO price during the first few days companies, because no stockholder group has
of trading. It does that by purchasing shares if the enough power to remove them.
market for the issue is weak. If demand is very
weak, stabilization may be impossible. Kasi all shareholders nagvote para ielect sila, so
others might not want to remove them from the
Price in the Longer Run and the Retail Investor board, lets say 100 shareholders elected them, e
Most IPO pops don’t last, and the stocks usually hindi full 100 wants them out, so unless lahat
underperform for years. The result of underpricing nagkaisa para alisin sila, they can’t be ousted. This
and the pop phenomenon is bad for retail investors. gives them control over the company.
Interested in the company but unable to participate
in the IPO, they buy at pop – inflated prices only to Outside directors are supposed to be a restraint on
lose out when the stocks go down and stay down. this autonomy of management, but generally don’t
do much along those lines.
Some Institutional Characteristics of
The Role of the Equity Investor Most of the
Common Stock
investors who buy equity stock are not interested in
Common stock represents an investment in equity running the company, they’re only interested in
(ownership) that theoretically implies control of the cash flows.
company. Ownership interest means a stockholder
Preemptive Rights It allows stockholders to
has influence on the way the company is run,
maintain their proportionate ownership. When new
depending on how much stock they own. Most
shares are issued, common stock – holders have the
management issues are decided by a majority of
right to purchase a portion of the new shares issued
vote, stockholders owning minority interest have
equal to the percentage of the outstanding shares
little power when someone else has a clear majority
they already own. Preemptive rights allow current
or when no one owns a substantial percentage of
stockholders be offered this option before the new
the firm.
shares are sold to others.
Corporate Organization and Control
Preemptive rights are common, but no laws require
Corporations are controlled by boards of directors them. If stockholders have preemptive rights it’s
whose members are elected by stockholders. The because they were in the company’s charter.
board appoints the senior management that appoints
Voting Rights and Issues
the middle and lower management and runs the
company on a day-to-day basis. Strategic decisions
Most common stock comes with voting rights, Common stockholders are last in line to receive
each share gets an equal vote in the election of income or assets and bear more risk than other
directors and major issues. Voting issues are investors, but their residual interest is large when
usually limited to changes in the company’s the firm does well. Stockholders have a residual
charter (broadly defines what it does, and claim on both income and assets.
questions about mergers).
For Income, stockholders own what’s left after all
Stockholders vote on directors and other items at operating costs and expenses are paid, after
an annual meeting that corporations are required bondholders receive their interest and any principal
by law to hold. Each share of common stock has due, and after any preferred stockholders get their
one vote in the election of directors, usually cast dividends.
by proxies. Proxies give the authority to vote
shares to a designated party, they are the person When business is bad, stockholders may not be paid
appointed to stand in for a shareholder at a general because the company might run out of money
meeting of members. A proxy fight is when parties before they’re paid.
with conflicting interest solicit proxies at the same This makes common stock the riskiest investment.
time, usually happens when a stockholder group is The residual income belonging to stockholders is
unhappy with management and tries to take over essentially the net income line on the income
the board. Proxy solicitations are efforts made by a statement, which may be paid out in dividends or
corporation or interested parties to persuade retained and reinvested in the business.
shareholders to vote in a particular way on certain
issues during a shareholders’ meeting.  Dividends – immediate money in their
Majority and Cumulative Voting Traditional pockets
voting (majority)gives the larger group control of  Retained Earnings – contribute to growth
the company to the virtual exclusion of the minority that makes the stock more valuable.
group because each director is chosen in a separate For Assets, the residual position means that if the
election, so the majority vote can win every seat. corporation fails and is liquidated, stockholders
Cumulative Voting gives minority interests a don’t get anything until everyone else is paid which
chance at some representation on the board. Each often means they don’t get anything at all.
share of stock gets one vote for every seat being Preferred Stock
elected, the minority stockholders can cast all their
votes for one seat or split them up among several It is a security that is between the bonds and
elections. Minority interest can concentrate its votes common stock, and has the characteristics of both;
on one or two seats and be likely to win, getting a hybrid of the two. Preferred stock pays constant
some board representation. dividend forever. When a share is initially issues,
two things are specified: the initial selling price in
Shares with Different Voting Rights It’s possible the primary market call the stock’s par value, and
to issue more than one class of stock with different the dividend. The ratio between the two reflects the
rights associated with each class. A practice that current return on investments of similar risk, the
affects control involves issuing a class of stock with market interest rate.
limited voting rights or with no votes at all, and if
such an issue receives the same dividends as The rate of preferred stock is similar to the coupon
traditional voting stock, it may attract typical rate of a bond, and the preferred’s initial selling
investor without interest in control. price (issue price) is similar to the bond’s face
value. Preferred stock is issued at prices (par
values). Like common stock, preferred stock carries
no provision for the return of capital to the investor.
Stockholders’ Claims on Income and The issuing company never has to pay the initial
Assets selling price back.
 Valuation of Preferred Stock somewhere between bonds and stocks. A bond has a
maturity date and can force bankruptcy while
Purchasing a share of preferred stock receives a common stock can be passed indefinitely.
constant dividend forever. All securities are worth
the present value of their future cash flows; a Priority in Bankruptcy- Bondholders have a claim
preferred share is worth the present value of that on company assets to the extent of unpaid principal
infinitely long stream of dividend payments. of the bonds. Common stockholders are entitled to
Preferred stock pays a constant dividend and is only what’s left, and Preferred stock are in between
valued as a perpetuity. because they have a claim in the amount of the
original selling price of the stock, but subordinate
PMT = Dp to the claims of bondholders. It comes before the
Present value of the perpetuity PVp = Pp or the interests of common stock and after the
security’s price. bondholders.

Pp = Dp Voting Rights - Common stockholders have voting

rights,. While preferred stockholders do not (like
bonds).
K
Tax Deductibility of Payments to
Valuation of a preferred share is identical to zero Investors - Interest is tax deductible to the paying
growth common share. Similar to bonds, preferred company, while dividends, common or preferred,
shares issued yields the current rate of interest, are not. Preferred stock is equity.
which when interest changes, they have to offer
competitive yields to new secondary market buyers. Legally, preferred stock is equity, but it acts like
This is accomplished through price change. Prices debt which is why it is treated separately in
of preferred stocks also moves inversely with financial analysis.
interest rates.
The Order of Risk
Characteristics of Preferred Stock
Bonds are safest, common stock is risky and
Cumulative Feature Enhances the safety for preferred is in the middle. “Preferred stock comes
investors, states that if preferred dividends are from the idea that of the two types of equity, you’d
passed (not paid), no common dividends can be rather have preferred stock if the firm does poorly
paid until the preferred dividends in arrears are or fails.
caught up. Common dividends can’t be paid unless
the dividends on cumulative preferred are current.
Securities Analysis
The features of preferred stock allow it to be
characterized as a cross between common stock and It is the art and science of selecting investments.
bonds. Valuation is part of a broad process aimed at
selecting investments (securities analysis).
Comparing Preferred Stock with Common Stock
Fundamental Analysis looks at a company and its
Payment to Investors - Preferred dividends are
business to forecast value.
constant and don’t grow even when the company
grows similar to bonds. Common stocks however, Technical Analysis bases value on the pattern of
grow with the firm. past prices and volumes. Volume refers to the
Maturity and Return of Principal - Preferred stock number of shares traded in a period. A price change
has no maturity and never returns principal unlike at a low volume of trading isn’t generally as
bonds and common stocks. significant as the same change accompanied by a
higher volume.
Assurance of Payment - Preferred dividends can be
passed, subject to cumulative feature, which is
The Efficient Market Hypothesis (EMH) says the end of that time, the option expires and can no
information moves so rapidly in financial markets longer be exercised.
that price changes occur immediately, so it’s
impossible to consistently beat the market to An option to buy a stock at a strike price
bargains. (underlying stock) sells for the option price.
Underlying stock with increase (buy because
Options and Warrants increase will benefit firm).
Options and Warrants make it possible to invest in An option on volatile stock is worth more than one
stocks without holding shares. Options are on a stable issue, because volatile stock price is
securities that make it possible to invest in stocks likely to go above the strike price in the allotted
without holding shares. Option is a contract that time.
gives one party a temporary right to buy an asset
from the other at a fixed price. The option is a People also pay more for options with more time
purchase contract that’s suspended at the discretion until expiration, because that gives the stock’s price
of the buyer for a limited time after which it more time to move past the strike price.
expires. Option holders can speculate on asset price
changes without holding the asset. The Call Option Writer Two parties to an option
Stock Options contract, a buyer and a seller. Don’t confuse buying
Stock Options convey the right to buy or sell and selling the option contract with buying and
shares ON or BEFORE a specific date at a specific selling the optioned stock. Option originators write
price. They are bought to speculate (gamble) on the options. Once it’s written, the option contract
price movements. Stock options are themselves becomes a security and a writer sells it to the first
securities and can be traded in financial market. buyer who may sell it to others.
Call options are options to buy. Put options are
options to sell. Options are an example of No matter how many times the option is sold, the
derivative security. The value of derivative writer remains bound by the contract to sell the
security is based on that of another underlying underlying stock to the current option owner at a
security. strike price if she exercises.

• Earnest – Deposit or downpayment to A call option writer hopes the underlying stock
demonstrate seriousness about buying price will remain stable. If it does he will recognize
something (part of purchase price) a gain from the receipt of the option price.

• Option – amount distinct from purchase Intrinsic Value It is the difference between the
price, to secure for the buyer the stock’s current price and the strike price.
opportunity to make up their mind. Out the money In the money

Leverage amplifies the return on investment (ROI).

Strk
The longer the option, the higher the cost because
the seller could’ve sold it; the opportunity cost is If Vic is out of money, Vic is zero. It is when the
lost, so to compensate, they increase option price. stock price is less than strike price.

Call Options Vic = Ps – Pstrk

Vic = Intrinsic value of call option
The longer time, the better cause you could
speculate. Ps = current price of the underlying stock

Basic Call Option grants its owner the right to buy Pstrk = the option’s strike price
a share at a fixed price for a specified period, and at
The price of the option is directly proportional to stocks are traded on a number of exchanges
the price of the underlying stock. throughout the country.
Price Volatility in the Options Market Option prices
Option’s Value has a market value. move up and down with the price of the underlying
Time premium is the conversion premium or the securities (strike price) but the relative movement is
convertible bonds. greater for options. Option prices move rapidly, and
are rarely exercised until immediately before
The difference between the intrinsic value and the expiration because exercising requires throwing
option price is called the option’s time premium. away whatever value is in the time premium. The
Time premium = Pop – Vic Downside and Risk Speculating in options involves
a good chance of total loss. It amplifies both losses
Investors are willing to pay premiums over intrinsic and gains.
value for options because of the chance that they Writing Options
will profit if the underlying stock’s price goes
higher. People write options for the premium income
received when they’re sold, but option writers give
Time premium is generally largest when a stock’s up whatever profits their buyer makes.
price is near but a little below the option’s strike
price; it diminishes as the stock price rise. Covered Option – the writer owns the underlying
stock at the time the option is written. You know
Options and leverage the shares you are holding, so when the call option
buyer exercises, the writer must sell at the strike
(financial) Leverage amplifies return on investment price (price of the written option).
(ROI). Options represent one of a number of
leveraging techniques. Options offer a great deal of May shares na hawak si writer, pero nagsulat sya ng
leverage. The option isn’t quite as good a deal when call option na ibebenta nya at a strike price (agreed
the stock is trading above the strike price: price). So if mataas ung current value nung stock na
1. Stock price has to rise higher to make a given hawak nya, and the holder of the call option
profit, and decided to buy the shares na hawak ni writer, may
2. The buyer has to pay positive intrinsic value in opportunity loss si writer. Bakit? Kasi if hindi
addition to the time premium for the option, nagsulat ng option si owner ng shares, kanya ung
which makes his investment larger and gain from the share’s increase in market value. E
decreases the leverage effect. Options That kaso nga nagsulat sya tapos binenta nya, so
Expire Options are exercisable only for a marereceive Nyang income is the strike price while
limited period, and become worthless when ang marereceive ni buyer is the current price nung
they expire. If an option is purchased out of the stock.
money and the underlying stock’s value never
exceeds the strike price, the option expires and Formulas:
the buyer loses the price paid for it.  Intrinsic value = Vic = Ps – Pstrk
 Time premium = Pop – Vic
If an option is purchased at a price that includes
 Pop (Market price of option)
positive intrinsic value and the underlying stock
 Investment = Ps – Pop
goes down in value, the option buyer’s loss at
expiration is the time premium plus the decrease in
Call Owner Exercises:
intrinsic value.
Market price of stock at the time of exercise
Trading In Options xx
Less: Pstrk
Options can be bought and sold between investors (xx)
at any time until they expire. Options on selected (Loss)
  Time remaining until the option’s expiration
Naked:  Volatility of the market price of the
Market price of stock at the time of exercise underlying stock
xx  Risk – free interest rate
Less: Pstrk xx Warrants
Pop
Stock warrant is a contract between a company and
xx
Gain Market price of stock at the time an investor giving the investor the right to buy or
Covered:
xx sell the company stock within a certain time frame
of exercise (xx)
for a specific price.
Less: Pstrk xx
Pop xx Stock Options are second market phenomena,
traded between investors and the companies that
Gain xx issue the underlying stocks are not involved.
Options are secondary market activities and the
Naked Option – writer doesn’t own the underlying underlying companies are not involved. Those
stock at the time she writes the option, which puts companies don’t get any money when options re
her more on risk. Wala pang hawak na shares, written or exercised.
mabibili mo palang the moment you exercised.
Risky kasi kung magkano lang bayad sayo (Pop Warrants are similar to call options but are issued
– strk) yun lang yung kita mo. So if the contract by the underlying companies themselves. When a
price is lower, and the buyer exercised, if market warrant is exercised, the company issues a new
prices is high, you could lose. stock in return for the exercise price. Warrants are
Put Options primary market instruments.
Is an option to sell at a specified price, simply
Warrants are like options but are issued by
called put. Investors buy puts if they think the price
companies which receive equity at exercise.
of the underlying security is going to fall.
A put buyer profits if the optioned stock’s price
Warrants are sweeteners attached to other
falls.
securities.
When the stock is trading above the strike price, the Warrants are generally detachable and traded
intrinsic value is zero. As with call options, puts sell independently.
for a time premium over their intrinsic value. Employee Stock Options

Vip = Pstrk – Ps They are more like warrants than traded options
because they don’t expire for several years and
Option Pricing Models strike prices are always set well above current stock
prices. Employees who receive options generally
Options, like stocks and bonds, are traded securities
get less in salary. Stock options are used instead of
so it’s logical to ask if a similar pricing model
a portion of salary.
exists for them. Models are more difficult for stocks
than bonds because it’s hard to express an option’s
Employee stock options don’t cost the company
value as the present value of a stream of future cash
anything in cash when issued.
flows.
The Executive Stock Option Problem Senior
Option prices can be estimated using the
executives are the biggest recipients of employee
Black – Scholes Option Pricing model. stock options. Stock options provide an incentive
Variables are used such as: for executives to misstate financial statements to
 Underlying stock’s current price keep stock prices up. Misstatements of financial
 Option’s strike price results uncovered in the early 2000s undermined
confidence in the honesty of corporate (1) EBIT (operating income), earning
management. The executive stock options system
before interest and taxes. It’s the lowest
sets up a conflict of interest that can lead to
line on the income statement,
dishonest reporting.
independent of financing. EBIT is above
interest expense and is unaffected by
Chapter 14 : Capital Structure and Leverage whether the company is leveraged.

Capital structure is the mix of debt and equity.

(2) ROE and EPS are return on equity and
earnings per share.
Capital consists f debt unlike in accounting where
ROE = Net income
there is only equity. “Leverage“ amplifies the return
Equity
on investment. It is a general term that refers to an
ability to multiply the effect of some effort.
Financial leverage refers to debt in the capital EPS = Net income
structure, it is using more debt than equity Number of shares
(Financial leverage of 10 percent is 10 percent
equity, 90 percent debt). It multiplies the ROE and EPS are overall measures of business
effectiveness of equity but adds risk. Leverage performance because they include both the results
refers to using borrowed money to multiply the of financing. EPS is an indicator of future earning
effectiveness of the equity invested in a business power of the firm and the major determinant of the
enterprise. stock’s market price. Redefining Risk for
Leverage – Related Issues
The borrowed money with which financial leverage Business Risk is the variation in EBIT. It is the
is concerned is the debt in a company’s capital variation in a firm’s operating performance as
structure, which is why “financial leverage“ and measured by EBIT.
“capital structure“ are somewhat synonymous. Financial Risk is the additional variation in ROE
and EPS brought about by financial leverage
To be leveraged means to have debt. To be (debt).
unleveraged means to operate with only equity
capital. • In an unleveraged firm (no debt), the
variation in ROE and EPS is identical to the
The Central Issue variation in EBIT.
Capital restructuring involves changing leverage by
shifting the mix of debt and equity. The process
• In a leveraged firm, the variation in ROE
shouldn’t affect the price of the shares still and EPS is always greater than the variation
outstanding. Under certain conditions, changing in EBIT. The more leverage the firm uses,
leverage increase stock price. An optimal capital the larger the incremental variation. EBIT
structure maximizes stock price. Adding financial measures operations, but ROE and EPS
leverage in the manner we’ve just described often measure overall performance, which is a
increases the price of the remaining shares and the combination of operations and financing.
value of the firm, but this effect is inconsistent
Business risk flows down into ROE and EPS by
which may mean that sometimes adding leverage
itself.
decreases stock price and the firm’s value.
Financial risk is added only if there is debt
Risk in the Context of Leverage financing.

Risk plays an important role in setting values.

Leverage influences stock price because it alters the
risk or return relationship in an equity investment.
Measure Performance :
 Leverage and Risk – Two Kinds of Each ROCE measures the profitability of operations
before financing charges on a basis comparable to
Financial leverage is associated with and causes
ROE.
financial risk. Operating leverage is related to a
company’s cost structure rather than to its capital
Operating income (EBIT) represents an after – tax
structure. Cost structure describes the relative
return on capital that exceeds its cost of debt (it
amounts of fixed and variable costs in productive
means that the company makes more with
and administrative processes. “Leverage“ means
borrowed money than it pays for the privilege of
financial leverage.
borrowing.
Financial Leverage
Leverage influences stock price.
Leverage measures performance, it may increase
stock prices under certain conditions such as when The after – tax return on capital can be measured by
there is improvement in in the financial a ratio called “return on capital employed“. ROCE
performance measured in ROE and EPS. It looks at the profitability of operations without
sometimes make performance worse and always regard to how the firm is financed, but does so after
increase risk, hence, it is not always clear when – tax. This amounts to calculating what the after –
leverage will be a benefit or not. tax earnings on EBIT would be if there were no
The Good News About Financial Leverage In the deductible interest, and then dividing by total
progression of ROE and EPS, as leverage increases, capital.
both measures go up dramatically.
ROCE > After – tax cost of debt = Okay to increase
Going well = earning costs of profit. Can the use financial leverage (debt). Excludes the effect of
of debt (leverage) increase the value of stock financing and tax.
price?
After – tax = Interest rate x (1 – T).
Increase in debt, Decrease in Net income, Decrease
When ROCE exceeds the after – tax cost of debt,
in Equity and Shares outstanding.
more leverage improves ROE and EPS.
EPS = Net income
Number of shares outstanding
ROCE = EBIT (1 – T)
When profitability is good, EPS and ROE increases
as leverage increases. ROE and EPS are calculated
by dividing net income by equity and the number of Debt + Equity
shares respectively.

As debt is added, net income declines because of ROCE is an indicator of a company’s efficiency
increasing interest charges. Equity and the number because it measures the company’s profitability
of shares outstanding also shrink as debt replaces after factoring in the capital used to achieve that
equity in the capital structure and shares are retired. profitability.
Equity and shares are shrinking proportionately
faster than earnings, so the ratio increase. The Bad News About Leverage When ROCE is less
than the after – tax cost of debt, leverage makes
If profitability is good, a dollar for dollar result worse. If EBIT is lower, after – tax is higher.
replacement of equity with debt improves financial Interest is deductible in expense. ROE and EPS
performance as measured by ROE and EPS. This is decrease with increasing leverage because the firm
good news. is earning less on
The Return on Capital Versus the Cost of Debt capital than it’s paying for the use of borrowed
funds.
When ROCE is less than the after – tax cost of Real Investor Behavior and the Optimal Capital
debt, more leverage makes ROE and EPS worse. Structure Low to moderate levels of debt, investors
value the positive effects of leverage a great deal
Decrease in EBIT, Decrease in ROE and and ignore the increased risk. Increases in leverage
EPS tend to raise stock prices when leverage is low or
Financial Leverage and Financial Risk moderate.

Financial leverage multiplies good results into great As leverage increases, its effect goes from positive
results, but it also multiplies bad results into terrible to negative, which results in an optimum capital
results. When business conditions change, structure. Optimum capital structure is the capital
performance measured by ROE or EPS makes structure (percent debt, level of leverage) that
wider swings for more leveraged organizations than maximizes stock price.
for those with relatively less debt. The incremental Finding the Optimum As a practical matter, the
variation in results is what we’ve called financial optimum capital structure cannot be precisely
risk. located. A volatile business uses less leverage than
No financial leverage, the difference in the ROEs a stable business. A high level of business risk
represents the variability of the basic business compounded by a high level of leverage produces
results due to business risk. an extremely risky company.

ROE representing the sum of the variabilities 1. A firm with good profit prospects and little
arising from operations and from financing. The to no debt is probably missing an
incremental variability, the differences is a result of opportunity by not using borrowed money
financial risk. if interest rates are reasonable.
Financial risk is the increased variability in 2. For most businesses, the optimal capital
financial results that comes from additional
structure is somewhere between 30 percent
leverage.
and 50 percent debt.
Leverage magnifies changes in operating income 3. Debt levels above 60 percent create
(EBIT) into larger changes in
excessive risk and should be avoided.
ROE and EPS. The more leverage, the larger the
Target Capital Structure It is the one that
magnification.
management prefers over any other and attempts to
The Effect on Stock Price maintain as it raises money. A firm’s target capital
structure is management’s estimate of the optimal
Leverage enhances performance while it adds risk, capital structure.
pushing stock prices in opposite directions.
Effect of Leverage When Stocks Aren’t Trading at
1. During periods of reasonably good Book Value When stock is purchased for retirement
performance, leverage enhances results in at book value, the book value per share of the
terms of ROE and EPS. remaining shares stays the same, and the
transaction has essentially the same effect on EPS
2. Leverage adds variability to financial that it does on ROE. Stock purchased for retirement
performance when operating results change. at a price different from its book value, the book
This means performance is riskier with value of the remaining shares changes.
more leverage.
EPS = ROE x (book value per share) Degree of
When leverage is low, a little more has a positive Financial Leverage (DFL)
effect on investors, but at high debt levels concerns
about risk dominate, and the effect is more Financial leverage magnifies changes in EBIT into
negative. larger changes in ROE and EPS. The higher the
DFL, the more it is financially leveraged, which
means that they are riskier. The DFL relates relative are largely fixed, it has a great deal of operating
changes in EBIT to relative changes in EPS. leverage.
DFL = EBIT Operating leverage increases as the proportion of
fixed cost increases.
EBT
a. Factory with a lot of people – labor
EBIT – EPS Analysis intensive or utilizing manual processes.
Financial leverage can enhance results at normal b. A lot of machines and a few people –
levels of operating profit, but makes those results
capital intensive or automated.
more volatile at the same time. There needs to be a
quantification and analyzation of trade – off People represent variable cost because they can be
between results and risk implied by moving from let go when sales and production decline.
one level of leverage to another. EBIT – EPS Machines, on the other hand, represent fixed cost
analysis provides a graphic portrayal of the trade – because they can’t be laid off during a downturn.
off that makes the choice relatively straightforward. Hence, an automated plant has more operating
It also involves graphing EPS as a linear function of leverage than labor intensive plant.
EBIT for two or more levels of leverage.
Breakeven Analysis
EBIT – EPS analysis portrays the results of
Is used to determine the level of activity a firm
leverage and helps to decide how much to use.
must achieve to stay in business in the long run. It
Operating Leverage lays out the effect of sales volume on a firm’s use
of fixed and variable cost.
It deals with cost rather than capital, but the effects
are similar to financial leverage. Combining the Overview of Breakeven it means zero profit or loss,
two results to high volatility. measured at EBIT (operating income). At
breakeven, income (revenue) exactly equals outgo
Terminology and Definitions (costs and expenses), and the firm just survives.
“Operations“ refer to a firm’s business activities Breakeven analysis shows the mix of fixed and
exclusive of long – term financing. In income variable cost and the volume required for zero
statement, those statement, those activities involve profit or loss. It is a way of looking at operations to
the items from sales down to operating income determine the volume, in either units or dollars, a
(EBIT). company must sell achieve this zero – profit, zero
– loss situation.
Risk in Operations – Business Risk Variation in
“Cost“ broadly refers to expense. Both cost and
EBIT is a business risk. Most variation in EBIT
expenses can be fixed or variable (associated with
comes about because of changes in the level of
sales). Breakeven Diagrams
sales.
Fixed cost is constant as sales increases, while
Fixed and Variable Cost and Cost Structure Fixed
variable costs increase proportionately with sales.
cost (overhead) doesn’t change when the level of
sales changes, but a variable cost does. Breakeven is the level of sales at which revenue
equals cost. It is at the intersection of revenue and
Cost structure is the mix of fixed and variable costs
total cost. At any sales volume, the firm’s profit or
in a firm’s operations.
loss is the difference between revenue and total
Variable costs are items that go up and down with cost.
volume, like sales commissions.
Contribution Margin(Ct) The price that exceeds the
Operating Leverage Defined It refers to the amount unit variable cost is the contribution made by sale.
of fixed cost in the cost structure. If a firm’s cost
Every sale makes a contribution of the difference Or
between price and variable cost.
Qb/e = Fc
Ct = P – V
Ct is the contribution Ct
P is the price
V is variable cost per unit Dollar Breakeven Sales ($$)
The term implies a contribution to profit and fixed Sb/e = Fc
cost. Unit contribution is the same anywhere at any
level of sales.
Cm (decimal form)
Contribution expressed as percentage of revenue
Effect of Operating Leverage
by dividing by the price is called the contribution
margin. As volume moves away from breakeven Profit or
Loss increase faster with more operating leverage.
Cm = P – V
Increased leverage magnifies the change in EBIT
that results from a given change in sales volume.
P
Operating leverage can be said to increase in the
Or variation in EBIT as a result of variation in sales.
Because variation in EBIT is defined as business
Cm = Ct risk, it follows that increased operating leverage
increases business risk. Variation in EBIT
P (business risk) is larger with more operating
leverage.
Calculating the Breakeven Sales Level EBIT is
revenue minus cost, which can be expressed in High – leverage firm gets a larger contribution from
terms of price, quantity, and cost as each sale, so it accumulates profits or losses faster
as it moves away from the breakeven. The trade –
EBIT = PQ – VQ – Fc off is that the high – leverage firm has more fixed
P is the price per unit cost to cover it before it makes a profit than the low
leverage firm.
V is the variable cost
The Effect on Expected EBIT More operating
Q is quantity leverage implies higher operating profit at any
Fc is fixed cost output above the breakeven. Always determine the
level of fixed cost you have. Higher fixed cost,
P and V are multiplied to Q to find the revenue and higher profit. If a firm is relatively sure of its output
the variable cost. If revenue and variable cost is level, it’s better to trade variable costs for fixed.
given, no need to find Q. Increasing operating leverage multiplies operating
income (EBIT) at output levels that are likely to be
Breakeven value (volume units). It tells us how
high.
many units have to be sold to contribute enough
money to cover (pay for ) fixed costs. Breakeven Degree of Operating Leverage (DOL)
volume is fixed cost divided by contribution.
Operating leverage amplifies changes in sales
Qb/e = Fc volume into larger changes in EBIT.
The DOL relates relative changes in volume (Q) to
P–v relative changes in EBIT.
 DOL = Q(P – V) while management can decide the amount of debt
they will use.
Q(P – V) - Fc Or The Compounding Effect of Operating Leverage
DOL = Q Ct and Financial Leverage
Changes in sales are amplified by operating
Q Ct – Fc leverage into larger relative changes in EBIT, which
in turn are amplified into still larger relative
Comparing Operating and Financial Leverage changes in ROE and EPS by financial leverage. The
Financial and operating leverage are similar in that effects of financial and operating leverage
both can enhance results while increasing variation. compound (multiplicative) one another. Modest
Operating leverage connect sales with EBIT in changes in sales can lead to dramatic changes in
much the same way that financial leverage connects ROE and EPS for companies that uses both
EBIT with ROE and EPS. leverage.

Financial leverage can improve performance in EBIT to ROE and EPS

ROE and EPS, it amplifies changes in EBIT into Degree of Total Leverage
larger relative changes in those ratios.
The DTL reflects the combined effect of both kinds
Operating leverage can enhance EBIT at a given of leverage.
sales level, and expands variations in sales into
larger relative variations in EBIT. Capital Structure Theory
Financial leverage involves substituting debt for Structure does affect price and value, and there
equity in the firm’s capital structure, while is an optimum, but there’s no way to find it with
operating leverage involves substituting fixed cost any precision. The Value of the Firm
for variable cost in its cost structure.
Market value increases through manipulating
Debt is a fixed cost method as it pays a fixed capital structure which increases stock price.
amount of interest regardless of the firm’s health.
Equity is a variable cost because the dividends paid The more heavily a firm is leveraged, either
to stockholders can be varied or eliminated if the financially or operationally, the more quickly it
firm is not doing well. Both forms of leverage loses money when volume decreases. The effect is
involves substituting fixed cash outflows for compounded when both forms of leverage are
variable cash outflows. present. This means leveraged companies react
aggressively when something threatens their
Financial risk is the additional variation in ROE volume.
and EPS caused by financial leverage while
business risk is variation in EBIT enhanced by Theory begins by assuming a world without taxes
operating leverage. or transaction costs, so investors’ returns are
exactly component capital costs.
Financial leverage is the sole cause of financial
risk, while some business risk would exist even Value is Based on Cash Flow, Which Comes from
without operating leverage. Income The value of any security is the present
value of the cash flows that come from owning it,
All production involves use of equipment that and all cash flows paid to investors come from
generates fixed cost, meaning that all firms have earning.
operating leverage. Many firms use no debt and
have no financial leverage. Operating income (EBIT) is the earnings stream
available to either debt or equity investors.
Financial leverage is more controllable than
operating leverage. Technology is unpredictable, Debt is assumed to be perpetual, because whenever
principal is paid off, a new amount of equal size is
immediately borrowed, hence, income is constant The Result the firm’s total value is unaffected by
year after year. Dividend and interest payments are capital structure (independence hypothesis) Value is
both perpetuities, and the firm’s market value is the independent of capital structure. The firm’s cost of
sum of their present values. debt and equity and its average cost of capital.
The value of the firm is determined by the costs of An investment in debt is safer than an investment in
its debt and equity (total leverage). Lower rates equity.
means higher values. Returns drive value in an
inverse relationship. If the return on debt remains As cheaper debt is added, the cost of equity
the same, the cost of capital will also rise and increases because of increased risk such that the
overall value will drop. Average cost of capital is weighted average cost of capital remains constant.
our concern. MM’s Result Supports the Operating Income View
Franco Modigliani and Merton Miller (MM The firm’s value is the present value of its expected
Theory) operating income stream, a rational market will
hold that total value of that stream constant no
The theory is about the effect of capital structure on matter how the capital is divided between debt and
value. equity. The firm’s investment value is whatever it is
on the basis of income.
1. There are no income taxes The Arbitrage Concept Equity investors seeking to
2. Securities trade in perfectly efficient capital maximize their returns would hold the value of a
markets in which there are no transaction firm constant through changes in leverage.
costs. Arbitrage between leveraged and unleveraged firms
will hold value constant as debt increases.
3. Investors and companies can borrow as
much money as they want at the same rate. Interpreting the Result MM result implies that
That is, (a) Rates don’t go up as one leverage affects value because of market
borrows more money imperfections (tax and transaction cost)
(b) The rate is the same for investors and The tax system favors debt financing because
companies. interest is tax deductible while dividends are not.
The assumption includes that there are no costs Total payments to investors are higher for the
associated with bankruptcy. Zero bankruptcy cost leveraged company because they can deduct
implies that no legal or administrative fees are interest from taxable income and pay less tax.
incurred in restructuring or liquidating, and if
liquidation is required, assets are sold for a value In the MM model with taxes, interest provides tax
close to what they were worth to the company. shields that reduces government’s share of the
Bankruptcy refers to the fees and losses on the sale firm’s earnings.
of the used assets, not the value of the firm.
Value is increased by the PV of the tax shield. The
Assumptions and Reality benefit of debt is the tax rate times the debt amount.
The benefit of debt accrues entirely to stockholders
✓ There are income taxes because bond returns are fixed.
✓ Legal and administrative expenses of In the MM model with taxes, value increases
bankruptcy are large and assets sold under steadily as leverage is added.
duress usually bring a fraction of their
original value Bankruptcy costs are additional losses that accrue
primarily to stockholders when companies fail. It
✓ Individuals pay higher interest rates than eventually make investors raise required rates
companies and rates go up higher as more which lowers value.
money is borrowed.
The MM model with taxes and bankruptcy costs
concludes that an optimal capital structure exists.
Insights to Mergers and Acquisitions
Borrowing to pay a premium in an acquisition may
be theoretically justified if value is increasing with
leverage.