Convertible Bonds
The answer will be resulting
Convertible bonds are exchangeable for
a fixed number of shares of the issuing
company’s stock at the bondholder’s
discretion. The number of shares
exchanged for the bond is determined by
a conversion ratio that’s set at the time
the bond is issued. Stating the conversion
along with the bond’s par value implies a
conversion price.
Ordinary bonds are generally safer
investments compared to stocks that
offer price appreciation. A convertible
feature allows bondholders price
appreciation if the firm is successful. It is
usually set at 15 to 30 percent above the
stock market’s price at the time
convertible is issued.
This method make investors accept lower
yields on convertibles than on ordinary
bonds. That means they can be issued at
lower coupon rates and cost borrowers
less in interest expense.
Convertibles are less risky than stocks
Convertibles are always debentures,
unsecured bonds.
To get the return on investment of
convertible bonds:
Shares exchanged = Par value
Conversion Price
1.
number of shares. The proceeds will
be multiplied to the current price
of stock.
2. Get the interest payment of the
bond with its coupon rate.
3. Add the market shares price to the
interest payment of the bond. The
answer will be the new bond price.
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.
To get the return from common stock:
1. Face value of the note divided by
the price of the common stock to
get the shares.
2. Deduct the new price of the stock
from the price of the common stock
to get the gain.
3. Multiply the total gain to the
shares calculated to get the price
of the stock.
4. Divide the price of the stock to the
face value to get the rate on
return.
Effect of Conversion on the Financial
Statements and Cash Flow
During conversion, an accounting is
entry is made that takes the par value of
converted bonds out of long-term debt
and places it in the equity accounts as if
new shares had been sold at the
conversion price.
There is no immediate cash flow impact
from conversion, but affects ongoing
cash flow, andthe transaction is strictly
on the company books. It is important on
the ongoing cash flow because it makes
the original debt gone which makes the
interest payments immediately stop,
however, the newly created shares are
entitled to dividends if any are paid. If
the company that issues convertibles
don’t pay dividends, it implies a decrease
in cash flow. Conversion also strengthens
balance sheet by removing debt and
adding equity, which improves all debt
management ratios.
Convertibles as Deferred Stock Purchases
Convertibles can be thought of as
deferred stock purchases or deferred
purchase of equity (stock). Substantial
increase in stock price guarantees
eventual conversion which means that the
bond and associated interest payments
can be viewed as temporary, and the
long-term effect of the transaction is a
sale of stock.
Advantages of Convertible Bonds
Advantages to Issuing Companies
1. Offer lower interest rates.
Convertible debt tends to be
offered by risky companies that
have problems with conventional
borrowing. Risky businesses often
pay higher interest rates which
makes it difficult to borrow. This
makes lenders accept lower rates
or lend where they would not.
➢ Companies with a low credit
rating and high growth
potential often issue convertible
bonds. For financing purposes,
the bonds offer more flexibility
than regular bonds. They may
be more attractive to investors
since convertible bonds provide
growth potential through
future capital appreciation of
the stock price.
➢ Companies issue convertible
bonds to lower the coupon rate
on debt and to delay dilution.
They trade in relatively illiquid
market.
o Illiquid – a market that is
difficult to sell assets in due
to a lack of interested
buyers, available assets, or
because the market itself is
not viable as a financial asset.
 2. It can be viewed as a way to sell
equity at a price above the market.
They may sell stock above the
market.
3. They have few restrictions. Lenders
insist on reducing their risk with
contracts called bond indentures
that limits the activities of
borrowers while debt is
outstanding. If the debt is a
convertible debt, lenders view is as
purchasing equity (because they
can change bond to stocks) which
makes them less concern with
restrictions (bonds have
indentures).
Advantages to Buyers
1. They offer the buyers chance to
participate in stock price
appreciation offered by risky
equity investments. (Risky
businesses have volatile interest
rates. If it is a bond, the lender
may face a loss because of its fixed
rate. If it is a stock, lenders can
convert it to stocks when the
stocks increase. In stocks high
risk=high rewards).
2. Limit the risk associated with stock
investments which may cause big
gains or loss.
Forced Conversion
Lenders of convertible bonds may delay
exercising the conversion of bonds if
they believe that the current stock price
will remain the same all throughout the
years. This enables them to collect
interest until they decide to call it off
and then receive the stock price when
they decided to convert the bonds to
stock (meaning makakareceive sila ng
interest throughout the years of the
bond, tapos pag ayaw na nila, pwede nila
iconvert ung bond sa prices ng stock
para more money).
The management wants to convert their
bonds for two reasons:
1. Avoid paying further interest
2. Want to exchange debt for equity
(strengthen the balance sheet)
This makes them issue call features to
force conversion which typically have call
premiums of one year’s coupon interest.
This makes the lender either accept the
call premium or convert the bonds to
stocks.
Issuers call convertibles when stock
prices have risen to levels that are 10-15
percent above conversion prices.
Overhanging Issues
Issuing convertibles may not be to
borrow money but may be to sell equity
at a price above market. Convertibles
can become problems if stock prices don’t
increase enough to make the bonds’
conversion values more than their call
prices (premiums). Calls won’t force
conversion. If the lender accepted the
call price and don’t convert, the company
will be stuck with debt it doesn’t want
(because they would rather have equity
to avoid paying interest and to make its
balance sheet stronger).
Valuing (Pricing) Convertibles
Valuing the convertible is complicated
because the security’s value (price) can
depend on either its value as traditional
bond or market value of the stock which
it can be converted.
➢ The convertibles value as a bond
does not require it to be at par
because it depends on the
interest rate .
➢ Convertibles value as a stock is
calculates as:
Number of shares exchanged
for one bond(conversion ratio)
multiplied by the current stock
price. Assuming the bond is
convertible to 50 shares of
stocks,
Pb = 50Ps
Pb = Price of bond
Ps = Price of stock
o At low stock price, the convertible’s
value as a bond is higher than its
value as a stock. At higher prices it’s
worth more as stock.
o At ANY STOCK PRICE the convertible
is worth atleast larger of its value as
a bond or as a stock.
o The higher the stock and bond value
lines represents minimum value of the
convertible. The market value of a
convertible lies above the minimum
value line because of the possibility
that the stocks price will go up and
improve the return, this idea gives the
convertible extra value. The
difference between market value and
the appropriate minimum is the
conversion premium.
❖ A conversion premium is the
excess of a convertible’s market
value over its value as a stock
or bond.
o The minimum values as stock and as
a bond are equal at the
intersection of the two minimum
value lines. That point can be found
by substituting the value as a bond
into the equation of the diagonal
value as stock line.
Pb = 50Ps
1000 = 50 Ps
Ps = 1,000/50
=20
Effect on Earnings Per Share –
Diluted EPS
EPS is net income (earnings after
tax) divided by the number of
shares of stock outstanding. It is
the firm’s money-making power
stated on a per-share basis.
EPS is a key factor in determining
the value of stocks. Investors
decide how much they’re willing to pay
for shares based in large part on issuing
company EPS. Growing EPS is a very
positive sign, a stagnant or declining can
lead to depressed stock price. EPS is
related to related price earnings per
ratio because it is the first thing
investors look at.
Dilution
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
lower price, new investors would gain
higher return because of the stocks of
old investors. The old investors’ stocks
were diluted. Earnings dilution is a drop in
EPS caused by a sale of stock at a below
market price.
Convertibles and Dilution
Convertible securities cause
dilution.
If the convertible bond has a stock
price of 25, and the stock market
has 29, the owner of the
convertible would receive 29 but
the issuer will receive only 25.
Dilution happens when a company’s
stock price rises after a
convertible is issued. The existence
of unexercised convertibles always
represent potential dilution in a
firm’s EPS.
Disclosure of the Dilutive Potential
of Convertibles
Unexercised convertibles may cause
smaller EPS because of their
dilutive effect. This made FASB
(Financial Accounting Standards
Board) make the companies report
potential dilution from convertible
and certain other securities in
their financial statements. FASB 128,
requires that companies report two
EPS figures, basic EPS and diluted
EPS.
❖ Basic EPS is what you would
expect, earnings after tax
divided by the number of shares
outstanding during the year. If
the number of shares isn’t
constant during the year, an
average over time is used.
❖ Diluted EPS is calculated
assuming all existing
convertibles are exercised
creating new shares as of the
beginning of the year. It shows
the worst case scenario for
dilution.
How to Calculate Basic and Diluted EPS for
the year:
Basic EPS:
Basic EPS = net income
Shares outstanding
Diluted EPS (new shares issued):
Shares exchanged = bond’s par value
Conversion price
And then:
1. Shares from conversion = issued
convertible bonds x new shares
issues (diluted eps)
2. New shares outstanding =
outstanding share + shares from
conversion
3. Interest saved = coupon rate x par
value x issued convertible bonds
4. Saved taxes = interest saved x
marginal tax rate
5. Improvement in net income from
eliminating interest is interest
saved minus saved taxes.
6. Net income for calculating diluted
EPS is net income plus improvement
in net income from eliminating
interest.
7. Diluted EPS is net income divided by
new shares outstanding.
Other Convertible Securities
Convertible features can be associated
with certain other securities, such as
preferred stock. Convertible preferred
shares are similar to convertible bonds in
that both are potentially dilutive. They’re
treated similarly in the calculation of
diluted EPS.
Securities that are not convertibles can
also result in issuing new stock at prices
below the market. Until exercised they
also present potential dilution, the
calculated diluted EPS should be adjusted
to them. A warrant is an example, which
gives its owner the right to buy a limited
amount of new stock at a fixed price
during a specified period.
Institutional Characteristics of Bonds
A bond is a device that enables an
organization (generally a corporation or
a government unit) to borrow from a
large number of people at the same time
under one agreement.
Registration, Transfer Agents, and
Owners of Record
A record of owners of registered
securities is kept by a transfer agent.
Payments are sent to owners of record
as of the dates the payments are made.
Bonds are classified as either:
1. Bearer bonds – belong to whoever
possesses them, a convention that
makes them dangerously subject to
loss and theft. They have coupons
attached for the payment of
interest.
2. Registered bonds – the owners are
called transfer agents. This is an
organization, a bank, that keeps
track of the owners of stocks and
bonds for issuing companies. When
one investor sells a security to
another, the agent transfers
ownership in its records as of the
date of sale. On any date, there is a
particular owner of record on the
transfer agent’s books for every
 bond (and share) outstanding.
Interest payments are sent
directly to the owners
Kinds of Bonds
Secured Bonds and Mortgage Bonds –
Secured bonds are backed by the value of
specific assets that holders can take
possession and sell to recover their claims
on the company. Assets tied to a specific
debt are not available to other creditors
until that debt is satisfied. When the
securing assets are real estate, the bond
is called a mortgage bond.
Debentures – are unsecured bonds. They
rely on the general credit-worthiness of
the issuing company rather than the
value of specific assets. Debentures are
clearly more risky than the secured debt
of the same company. They must be
usually issued to yield higher returns to
investors.
Subordinated Debentures and Senior Debt
– Subordinated means lower rank or
priority. In terms of debt, it means
having lower priority than other debt
for repayment in the event the issuing
company fails. Debentures can be
subordinated to specific assets or to all
other debentures in general. The debt
having priority over a subordinated debt
is called a senior debt.
Subordination arises with the senior debt.
Some security is afforded to the first
lender by writing a clause into the loan
agreement requiring the subordination
of all future debt.
Subordinated debt is riskier than senior
or unsubordinated debt, it requires a
higher yield.
Junk Bonds – issued by risky company
(companies not in good financial
condition) and pay high interest rate by
paying 5 percent higher than strong
companies. They are also called high-yield
securities.
Negative Interest Rates
It happens from time to time in the
market for short-term securities issued
by strong governments. Securities are
called bills, not bonds called T-Bills or
treasury bills.
The phenomenon of lending money with
little return happens in secondary
markets; when investors trade the bills
among themselves. They do it for safety
of the economy of the country.
Bond Ratings- Assessing Default Risk
Bonds are assigned quality ratings that
reflect the probability of going into
default. Higher ratings mean lower
default probabilities. Bond ratings are
developed by rating agencies that make a
business out of staying on top of the
things that make bonds and the
underlying firms more or less risky.
They rate bonds examining the financial
and market condition of the issuing
companies and the contractual provisions
supporting individual bonds. It’s
important to realize that the analysis has
these two parts.
Bond ratings gauge the probability that
issuers will fail to meet their obligations.
A bond’s strength is fundamentally
dependent on that of the issuing
corporation. The process pf rating a bond
begins with a financial (ratio) analysis.
Then, the agencies add any knowledge
they have about the company, its
markets, and its other dealings. For
example, suppose a firm has good
financial results and a prosperous
financial outlook but faces a major
lawsuit. If the lawsuit is serious, it can
lower the rating.
Bond ratings are NOT precise because
they also rely heavily on qualitative
judgments made by the rating agencies.
Rating Symbols and Grades
Investment grade or medium quality
have low default risk
Substandard graded bonds are called
junk bonds
Why Ratings Are Important
Risk and return are related and investors
require higher returns on riskier
investments. Ratings are the primary
measure of the default risk associated
with bonds. They’re an important
determinant of the interest rates
investors demand on the bonds of
different companies.
Rating associated with a firm’s bonds
determines the rate at which the firm can
borrow. A lower rating implies the
company has to pay higher interest rates
which means it’s more difficult for the
company to do business and earn a profit,
because it’s burdened with a higher cost
of debt financing.
All bonds yield interest rates; the
differential is between the rates required
on high and low quality issues. Lower
curves associated with high-quality bonds
means that the issuing companies can
borrow at lower rates (more cheaply).
Highest quality bond that can borrow at
lower interest rate is the federal
treasury bond (high quality bond
indicates the safety).
A bond’s rating affects the size of the
differential between the rate it must pay
to borrow and the rate demanded of
high-quality issues. It does not affect
the overall up and down motion. The
differential reflects the risk of default
perceived to exist with lower quality
bonds (default risk premium).
The differential over time – The
differential between the yields on high-
and low-quality bonds is an indicator of
the health of the economy. Higher rates
are associated with recessions and tough
economic times. Marginal companies are
prone to fail. The risk of default
associated with weak companies is greater
in bad times than in good times. It
expresses level of risk, differential tends
to be larger in recessionary periods.
This phenomenon can be considered an
economic indicator . A high differential is
taken as a signal that a harder times are
on the way.
The Significance of the Investment
Grade Rating
Most bonds are purchased by institutional
investors such as banks, mutual funds and
insurance companies, rather than
individuals. The law requires these
institutions to make only relatively safe,
conservative investments and can only
deal in investment grade bonds. This
requirement limits the market for the
debt of companies whose bonds are not
considered investment grade.
Bond Indentures- Controlling Default
Risk
The conflict of interest arises because
the rewards of successful risk taking
accrue largely to stockholders while the
penalties for failure can be shared
between stockholders and creditors.
To ensure that the bond-issuing
companies maintain an even level of risk,
lenders usually insist that bond
agreements contain restrictions on the
borrower’s activities until the bonds are
paid off. The contractual document
containing such restrictive covenants is
called bond indenture.
Typical indenture provisions prelude
entering certain high-risk businesses and
limit borrowing more money from other
sources. They may also require for
certain ratios held above minimum levels.
Every bond issue has a trustee whose job
is to administer and enforce the terms of
the indenture on behalf of bondholders.
Trustees are usually banks.
Sinking Funds
This spreads the repayment of principal
over time. Two types:
1. Periodic deposits such that amount
available at maturity is equal to
the principal to be repaid. This
approach is the future value of an
annuity.
2. Randomly calling in some bonds for
retirement prior to maturity.
Other terms:
o Diluted EPS - EPS considers a
company’s common shares, whereas
diluted EPS takes into account all
convertible securities, such as
convertible bonds or convertible
preferred stock, which are changed
into equity or common stock.
Unexercised convertible bond –
unconverted convertible bond
Exercised convertible bond – converted
convertible bond
Is EPS an equity? - The earnings per
share (EPS) ratio is effectively a
restatement of the return on equity
(ROE) ratio. While the ROE ratio is
calculated as a percentage, taking total
net profit and total equity into
consideration, the EPS ratio shows how
much profit has been earned by each
ordinary share (common share) in the
year.
Bond Outstanding
Junk bond
Risky enterprise
Default risk
Chapter 8
The Valuation and Characteristics
of Stock
Common Stock
• Corporations are owned by holders
of their common stock.
• Stockholders choose directors, who
appoint managers to run the
company.
• This means that stockholders have
a voice in running the company
through BoD
Most large companies are widely held,
stock ownership is held by a large
number of people and no individuals or
groups control more than a few percent.
Stockholders have little power to
influence corporate decisions, and stock
ownership is simply an investment.
When buying stock, our role is not as
owner. Most equity investors are not
interested in a role of owners. We’re just
interested in the future cash flows that
come from owning shares.
Equity (stock) investments are like debt
(bond) investments; we’re only interested
in money.
The Return on an Investment in Common
Stock
The income in stock investment comes in
two forms:
(1) Receiving dividends
(2) Realize a gain or loss on the
difference between the price
they pay for stock and the price
which they eventually sell it
(capital gain or loss)
The future cash flow associated with
stock ownership consists of dividends and
the eventual selling price of the shares.
The return on stock investment is the
interest rate that equates the present
value of the investment’s expected future
cash flows to the amount investment
today.
- The return on any stock investment
is the rate that makes the present
value of future cash flows equal to
the price paid for the investment
today. This principle also holds for
investments held for more than one
year.
Dividend and Capital Gain Yields – The
return on a stock investment can be
broken into two parts related to the two
sources of income of stocks. The return
on a stock investment comes from
dividends and capital gains.
The Nature of Cash Flows from Common
Stock Ownership
Comparison of Cash Flows from Stocks and
Bonds – Cash flow pattern for stocks
appears similar to the one associated with
bonds. A series of regular payments is
followed by a single larger payment that
can be thought of as the return of the
original investment.
- Dividends – analogous to interest
payments
- Final sale of stock – appears to be
like the return of a bond’s
principal.
The reality is that the similarity is
superficial because of the differing
natures of the cash flows in the two
cases.
(a) Bond – interest payments are
guaranteed by the borrower,
are certain to be received.
Companies have to be VERY close
to failures before they declare
default on bond interest.
Interest payments in bonds are
in constant or fixed amount,
making it easy to develop a
formula to value bonds, because
interest can be represented as
annuity. Payments are
contractually promised loan
principal equal to bond’s face
value
(b) Dividends – carry NO guarantee.
There’s NO agreement
associated in common stock that
makes any representation about
the payment of dividends.
Investors depend on them for
value but nothings is committed,
promised, or guaranteed by the
company. Even with a long
history of payments, companies
could stop paying anytime.
Interest on dividends are rarely
constant, people can expect
dividends to increase over time
as company grows. Stockholders
has to sell their shares at the
prevailing market price to
realize a final payment which
can be higher or lower than the
price originally paid.
There’s NO provision in a common stock
investment for the repurchase of shares
or for any return of the investor’s
capital by the company, which means that
the money for the final payment comes
from another investor rather than from
the issuing company as it does with a
bond.
Both the cash flows with stock ownership
are dividends and the proceeds of the
eventual sales of the share are imprecise
and difficult to forecast.
The Basis of Value
The basis for stock value is the present
value of expected cash inflows even
though dividends and stock prices are
difficult to forecast.
A stock’s value is the sum of the present
value of dividend payments and the
present value of the selling price in a
period. Successive dividends have
different values.
Valuing a stock involves making some
assumptions about what its future
dividends and its eventual selling price
will be. Once this has been done, we take
the value assumed (projected) cash flows
at an appropriate interest rate to
estimate the share’s current price.
• Contrast to bond valuation, bonds
have no need to make assumptions
about the future cash flows
because they were spelled out by
the bond contract.
A generalized stock valuation formula
from these ideas by treating the
dividends and the selling price as a series
of independent amounts to be received at
various time in the future.
The Intrinsic (Calculated) Value and
Market Price – The present value cash
flows is fundamentally what the stock is
worth (the stock’s intrinsic value).
- If other investors does not agree
with the stated dividend and price
estimates, their ideas of the
intrinsic value of that dividend will
differ from the statement of the
other investor.
The firm’s market price is the consensus
of the intrinsic values calculated by
everyone watching the stock. The process
of developing intrinsic values and
comparing them with market prices is
known as fundamental analysis.
A stocks intrinsic value is based on the
assumptions about future cash flows made
from fundamental analysis of the firm
and its industry.
Growth Models of Common Stock
Valuation
Generally, we can’t forecast the future in
detail. We’re likely to look at a company
and simply forecast a growth rate of
earnings and dividends into the future
starting from wherever they are now.
The future is uncertain, it’s difficult to
make the detailed forecast of dividend
and future prices needed to use. Stock
valuation models are based on predicted
growth rates because forecasting exact
future prices and dividends are very
difficult.
Developing Growth-Based Models
Stock dividends and eventual selling price
are separate amounts in the present
valuing process, each multiplied to the
present value factor for the appropriate
interest rate and time.
A stock’s value today is the sum of the
present values of the dividends received
while the investor holds it and the price
for which it is eventually sold.
An Infinite Stream of Dividends – The
concept of stock ownership is :
(1) Buy
(2) Hold for a while
(3) Sell
The present value of any amount that is
infinitely far away in time is clearly zero.
Conceptually, it’s possible to replace the
final selling price with an infinite series
of dividends.
Market-Based Argument – Individual
investors are a whole community;
Individual investors will subsequently
trade the stock back and forth among
themselves, and act as one unified body
setting a price for the stock when it is
issued. The price must be based on the
present value of future cash flows
moving from the company to the
investing community, with only one kind
of payment moving from company to
investors (dividends).
The only basis for valuation by the
community as a whole is the entire future
stream of dividends; nothing else.
Working with Growth Rates – Growth
rates usually used to predict future
values of variables whose values are
known today.
The Constant Growth Model
Subsequent dividends can have any
values, randomly chosen or a regular
progression of numbers. When the last
dividend is paid, we assume that dividends
will grow at some constant rate in the
future.
Any fraction whose denominator is much
larger than its numerator is a very small
number.
The entire expression in brackets is a
finite number when K (return) is
greater than g (growth rate). In this
case, we’re forecasting normal growth.
When g os greater than k, we have super
normal growth which lasts for limited
periods.
Constant Normal Growth – The Gordon
Model – Constant growth model assumes
that the stock’s dividends are going to
grow at a constant rate into the
indefinite future. It is also called the
Gordon Model after Myron J. Gordon, a
scholar behind its development and
popularization. It only works if growth is
normal, K>g. Otherwise the denominator
is negative (or zero) leading to a
negative (or undefined) price which isn’t
meaningful.
The Gordon Model is a simple expression
for 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 dividend forever. A
security called preferred stock pays the
same dividend year after year with no
expectation of increase or decrease.
The Expected Return
The Gordon Model can be recast to focus
on the return on the stock investment
implied by the constant growth rate
assumption. The capital gain yields in the
Gordon Model is nothing but the growth
rate.
The expected return reflects the
investors’ knowledge of the company. It
is input to the Gordon model through the
growth rate assumption.
Two – Stage Growth
We know something about the near –
term future that can be expected to have
a temporary effect on the firm’s
prospects.
The usual two-stage forecast involves a
rapid, super normal growth rate for one,
two, or even three years and a normal
rate thereafter. Super normal means a
rate in excess of return of stock (k).
The model gives us a value for a share of
stock at the beginning of an infinite
periods of constant, normal growth.
A normal growth that starts at the end
of the second year, when the Gordon
model will be applied, the result is a price
for the stock at the end of the second
year, or equivalently at the beginning of
the third. It includes the value of all
dividends to be paid subsequent to the
second year but not the dividend of the
second year itself.
The two – stage growth model allows us
to value a stock that’s expected to grow
at an unusual rate for a limited time.
The value of a security today is the
present value of future cash that comes
from owning it.
 Practical Limitations of Pricing Models
The inputs in the model are only
projected growth rates and interest
rates. They are not accurate.
Comparison with Bond Valuation – The
inaccuracy only refers to stock
valuation; bonds have bond pricing model
that gives a precise valuation for the
security, because the future cash flows
are contractually guaranteed in amount
and time, unless a borrowing company
defaults its obligations (rare in higher
grade issues), we can predict the exact
pattern of future interest and principal
payments. Yields in turn are established
accurately by market forces influenced
by the stability of the issuing company
and the term of debt.
Stock Valuation models give approximate
results because the inputs are
approximation of reality. Bond valuation is
precise because the inputs are exact.
Stocks That Don’t Pay Dividends – Some
companies don’t pay dividends even when
their profits are high; many openly states
that they never pay dividends. However,
the stocks of these firms have substantial
values.
The previous growth models have been
working with base stock values solely on
the present value of a dividend stream.
Firms that don’t pay dividends even when
their earning are good are usually in an
early period of their development and are
growing rapidly. Growth requires cash,
and management feels it’s futile to pay
dividends only to borrow or issue more
stocks to support the growth of the
company. Stockholders agree because
they hope to own a piece of a much
larger company if growth continues.
Most people understand that rapid
growth is not forever. When the growth
in the industry and firm slow down, even
the most vocal non-dividend pays are
eventually begin paying. Stock that don’t
pay dividends today are expected to pay
large dividends at some time in the
future; those distant dividends impart
value.
If a company truly never paid a dividend,
there would be no way for the investing
community as a whole to ever get a
return on its investment.
Valuing New Stocks – Investment
Banking and the Initial Public Offering
(IPO)
Emerging stocks that are being sold to
the public for the time are called Initial
Public Offerings (IPO). They are valued
differently than stocks that have been
around for a while, which shouldn’t be the
case, but as a practical matter, things
are less rational in IPO segment of the
equity market.
 IPOs for Different Securities
IPOs that generate the most excitement
sell the stocks of new companies, but
there are IPOs for other new securities,
notably bonds. There are actually more
IPOs for bonds than stocks because new
bonds can be issued to replace older,
maturing bonds as well as to raise new
money.
The sale of new shares of an existing
stock is handled like an IPO but is
actually a seasoned equity offering
(SEO) or a secondary equity offering.
These aren’t especially interesting from
a pricing perspective, but the market
value of old shares determines the price
of the new. (The new shares may be
offered slightly below market to ensure
their sale).
The IPOs here are the first public sales
of a new company stocks, that is, the
first time people other than founders and
private investors have an opportunity to
buy in, which happens when the founding
group wants to raise a lot of money, to
support growth.
The shares sold in an IPO are new, but
the offering usually includes some
existing shares that were previously
issued to founders and early investors.
Although these shares are sold within the
IPO process, they actually constitute a
secondary offering.
IPOs may include shares owned by
founders and early investors.
Investment Banking
The first step toward an IPO is
establishing a relationship with an
investment bank, an organization that
specializes in marketing new securities.
This banks specializes in different areas.
An investment bank sells new securities to
investors.
(1) Syndication – Most IPOs are too
big and carry too much risk for
a single investment bank, so a
lead bank recruits others,
forming a syndicate which
shares the process. The lead
bank (Principal or Managing
investment bank) is in charge.
(2) Registration – Filing a
registration statement, Form S-1
with the SEC. A summary of the
information, known as
Prospectus, is part of the S-1
document, intended for
distribution to potential
investors. The lead investment
bank advises the company during
this stage.
(3) Underwriting – Investment
banks solve the problem of
lowering the price of shares by
underwriting IPOs.
Underwriting IPOs makes a firm
commitment to buy the stock
 from the new company at a fixed
price and is then responsible for
reselling the shares to
investors. The bank sells the
shares at a higher price than it
paid. The difference is the
underwriting spread. This way,
investment banks earn profits;
companies understands that the
spread act as the fee paid for
banking services. The investment
bank syndicate is also called an
underwriting syndicate and the
investment bank is called
underwriter.
(4) Best Efforts – Smaller deals
does not use underwriting but
accept a placement on a best
effort basis. It means that
issuing company gets whatever
the bank is able to sell the new
shares for, less expenses and
commission.
Promoting and Pricing the IPO
Quiet Period is the period that begins
when the registration statement is filed
until the SEC accepts the statement by
declaring it effective. During this period,
executives and representatives show
potential investors the prospectus
stamped with red ink “preliminary“ but
may not share any other information
about the company or finalize any orders
for stock. Preliminary prospectus are
known as red herring. The prospectus
contains price range for the IPO stock
but not the exact offering.
The second quiet period begins days after
trading begins. None associated with the
company or IPO can issue any forecast
or analysis of the company’s projected
performance. This ensures all investors
have equal access to information.
During the quiet period, the preliminary
prospectus (red herring) is distributed,
but no stock may be sold.
Book Building and the Road Show
IPOs are promoted during road shows, in
the process of book building.
The road show is fast and intense trip of
companies around the country, with the
purpose of promotional presentations on
the new company and IPO to potential
institutional clients held by investment
bank.
The purpose of the trip is to make
promotional presentations on the new
company and the IPO to potential
investors, which most are the investment
banks institutional client. After each
shows, the banks asks the investors how
much shares they’re willing to buy,
recorded in the book that builds into an
order list.
The road show generally ends at about
the same time the SEC approves the
registration statement which is shortly
before the IPO date.
The bank then allocates the IPO shares
among the investor who expressed
interest during the road show. In most
cases, the investment bank places the
majority of the IPO stock with these
large, special relationship investors
rather than with the general public who
are called retail investors. IPO buyers
tend to be large, powerful organizations
that are “insiders“ in the financial system.
The sale of the IPO shares is an off
market transaction, meaning it isn’t the
result of an auction- like process as are
ordinary stock trades. The price is set by
the investment bank and the issuing
company, based on information from the
book building process, and all shares sold
at that price.
Prices After the IPO
The Investment Bank in the Middle – The
investment bank is in the center of the
IPO process. It stands between the
issuing company and the investors who
buy the shares. Both of these are the
bank’s clients and have put their trust in
the banker, but their interests conflict.
The company wants to get as much as it
can for its stock, while the investors
want a very high return on their money,
only when securities are acquired for less
than full value. The issuing company ang
investors are both clients of the
investment bank.
IPOs have a strong tendency to be
underpriced to reward investors to make
the stock’s price go up right after the
IPO. A rapid increase in price when
trading begins is an IPO pop.
Underpricing may happen because
investment bankers know they’re likely to
be marketing shares in another IPO to
the same investors.
The idea of IPO pop is to purchase
shares, hold them while the price
increases quickly and then sell after only
a few days before the price falls again.
Investors that use this strategy is called
a stag and the gain is a stage profit. A
pop – based strategy available to less
privileged investors is simply to buy as
soon as possible after the trading starts,
watch the rising price very carefully, and
sell the moment it starts down.
Market Stabilization Investment banks
support the new stock’s price to keep it
above the IPO price. The lead investment
bank is actually committed to supporting
a small pop by keeping the price of the
stock above the IPO price during the
first few days of trading. It does that by
purchasing shares if the market for the
issue is weak. If demand is very weak,
stabilization may be impossible.
Price in the Longer Run and the Retail
Investor Most IPO pops don’t last, and
the stocks usually underperform for
years. The result of underpricing and the
pop phenomenon is bad for retail
investors. Interested in the company but
unable to participate in the IPO, they buy
at pop – inflated prices only to lose out
when the stocks go down and stay down.
Some Institutional Characteristics of
Common Stock
Common stock represents an investment
in equity (ownership) that theoretically
implies control of the company. Ownership
interest means a stockholder has
influence on the way the company is run,
depending on how much stock they own.
Most management issues are decided by a
majority of vote, stockholders owning
minority interest have little power when
someone else has a clear majority or
when no one owns a substantial
percentage of the firm.
Corporate Organization and Control
Corporations are controlled by boards of
directors whose members are elected by
stockholders. The board appoints the
senior management that appoints the
middle and lower management and runs
the company on a day-to-day basis.
Strategic decisions are made by the
board, but big issues such as mergers
must be voted by stockholders. Corporate
boards are generally made of the
company’s top managers and a number of
outside directors. Board members may be
a major stockholder.
Companies are widely held when stock
ownership is distributed among a large
number of people and no single party or
group has a significantly large share.
This makes it difficult to make a change
in the board because it’s hard to
organize voting stockholders against
incumbent members. In situations like
this, members of top management on the
board have effective control of the
company with little accountability to
stockholders. Top managers effectively
control widely held companies, because no
stockholder group has enough power to
remove them.
Kasi all shareholders nagvote para ielect
sila, so others might not want to remove
them from the board, lets say 100
shareholders elected them, e hindi full
100 wants them out, so unless lahat
nagkaisa para alisin sila, they can’t be
ousted. This gives them control over the
company.
Outside directors are supposed to be a
restraint on this autonomy of
management, but generally don’t do
much along those lines.
The Role of the Equity Investor Most of
the investors who buy equity stock are
not interested in running the company,
they’re only interested in cash flows.
Preemptive Rights It allows stockholders
to maintain their proportionate
ownership. When new shares are issued,
common stock – holders have the right made by a corporation or interested
to purchase a portion of the new shares parties to persuade shareholders to vote
issued equal to the percentage of the in a particular way on certain issues
outstanding shares they already own. during a shareholders’ meeting.
Preemptive rights allow current Majority and Cumulative Voting
stockholders be offered this option Traditional voting (majority)gives the
before the new shares are sold to others. larger group control of the company to
Preemptive rights are common, but no the virtual exclusion of the minority
laws require them. If stockholders have group because each director is chosen in
preemptive rights it’s because they were a separate election, so the majority vote
in the company’s charter. can win every seat.
Voting Rights and Issues Cumulative Voting gives minority
interests a chance at some
Most common stock comes with voting
representation on the board. Each share
rights, each share gets an equal vote in
of stock gets one vote for every seat
the election of directors and major
being elected, the minority stockholders
issues. Voting issues are usually limited to
can cast all their votes for one seat or
changes in the company’s charter
split them up among several elections.
(broadly defines what it does, and
Minority interest can concentrate its
questions about mergers).
votes on one or two seats and be likely to
Stockholders vote on directors and other win, getting some board representation.
items at an annual meeting that
Shares with Different Voting Rights It’s
corporations are required by law to hold.
possible to issue more than one class of
Each share of common stock has one vote
stock with different rights associated
in the election of directors, usually cast
with each class. A practice that affects
by proxies. Proxies give the authority to
control involves issuing a class of stock
vote shares to a designated party, they
with limited voting rights or with no
are the person appointed to stand in for
votes at all, and if such an issue receives
a shareholder at a general meeting of
the same dividends as traditional voting
members. A proxy fight is when parties
stock, it may attract typical investor
with conflicting interest solicit proxies at
without interest in control.
the same time, usually happens when a
stockholder group is unhappy with
management and tries to take over the
board. Proxy solicitations are efforts
 Stockholders’ Claims on Income and
Assets
Common stockholders are last in line
to receive income or assets and bear
more risk than other investors, but
their residual interest is large when
the firm does well. Stockholders have
a residual claim on both income and
assets.
For Income, stockholders own what’s
left after all operating costs and
expenses are paid, after bondholders
receive their interest and any
principal due, and after any preferred
stockholders get their dividends.
When business is bad, stockholders may
not be paid because the company might
run out of money before they’re paid.
This makes common stock the riskiest
investment. The residual income
belonging to stockholders is
essentially the net income line on the
income statement, which may be paid
out in dividends or retained and
reinvested in the business.
• Dividends – immediate money in
their pockets
• Retained Earnings – contribute
to growth that makes the stock
more valuable.
For Assets, the residual position means
that if the corporation fails and is
liquidated, stockholders don’t get
anything until everyone else is paid
which often means they don’t get
anything at all.
Preferred Stock
It is a security that is between the
bonds and common stock, and has the
characteristics of both; a hybrid of
the two. Preferred stock pays
constant dividend forever. When a
share is initially issues, two things are
specified: the initial selling price in the
primary market call the stock’s par
value, and the dividend. The ratio
between the two reflects the current
return on investments of similar risk,
the market interest rate.
The rate of preferred stock is similar
to the coupon rate of a bond, and the
preferred’s initial selling 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. The issuing company
never has to pay the initial selling
price back.
Valuation of Preferred Stock
Purchasing a share of preferred stock
receives a constant dividend forever.
All securities are worth the present
value of their future cash flows; a
preferred share is worth the present
value of that infinitely long stream of
 dividend payments. Preferred stock
pays a constant dividend and is valued
as a perpetuity.
PMT = Dp
Present value of the perpetuity PVp =
Pp or the security’s price.
Pp = Dp
K Preferred stock has no maturity and
Valuation of a preferred share is
identical to zero growth common share.
Similar to bonds, preferred shares issued
yields the current rate of interest, which
when interest changes, they have to
offer competitive yields to new secondary
market buyers. This is accomplished
through price change. Prices of
preferred stocks also moves inversely
with interest rates.
Characteristics of Preferred Stock
Cumulative Feature Enhances the safety
for investors, states that if preferred
dividends are passed (not paid), no
common dividends can be paid until the
preferred dividends in arrears are
caught up. Common dividends can’t be paid
unless the dividends on cumulative
preferred are current.
The features of preferred stock allow it
to be characterized as a cross between
common stock and bonds.
Comparing Preferred Stock with Common
Stock
Payment to Investors Preferred
dividends are constant and don’t grow
even when the company grows similar to
bonds. Common stocks however, grow with
the firm.
Maturity and Return of Principal
never returns principal unlike bonds and
common stocks.
Assurance of Payment Preferred
dividends can be passed, subject to
cumulative feature, which is somewhere
between bonds and stocks. A bond has a
maturity date and can force bankruptcy
while common stock can be passed
indefinitely.
Priority in Bankruptcy Bondholders have
a claim on company assets to the extent
of unpaid principal of the bonds. Common
stockholders are entitled to only what’s
left, and Preferred stock are in between
because they have a claim in the amount
of the original selling price of the stock,
but subordinate to the claims of
bondholders. It comes before interests of
common stock and after the bondholders.
Voting Rights Common stockholders have
voting rights,. While preferred
stockholders do not (like bonds).
Tax Deductibility of Payments to
Investors Interest is tax deductible to
the paying company, while dividends,
common or preferred, are not. Preferred
stock is equity.
Legally, preferred stock is equity, but it
acts like debt which is why it is treated
separately in financial analysis.
The Order of Risk
Bonds are safest, common stock is risky
and preferred is in the middle. “Preferred
stock comes from the idea that of the
two types of equity, you’d rather have
preferred stock if the firm does poorly
or fails.
Securities Analysis
It is the art and science of selecting
investments. Valuation is part of a broad
process aimed at selecting investments
(securities analysis).
Fundamental Analysis looks at a company
and its business to forecast value.
Technical Analysis bases value on the
pattern of past prices and volumes.
Volume refers to the number of shares
traded in a period. A price change at a
low volume of trading isn’t generally as
significant as the same change
accompanied by a higher volume.
The Efficient Market Hypothesis (EMH)
says information moves so rapidly in
financial markets that price changes
occur immediately, so it’s impossible to
consistently beat the market to bargains.
Options and Warrants
Options and Warrants make it possible to
invest in stocks without holding shares.
Options are securities that make it
possible to invest in stocks without
holding shares. Option is a contract that
gives one party a temporary right to buy
an asset from the other at a fixed price.
The option is a purchase contract that’s
suspended at the discretion of the buyer
for a limited time after which it expires.
Option holders can speculate on asset
price changes without holding the asset.
Stock Options
Stock Options convey the right to buy or
sell shares ON or BEFORE a specific date
at a specific price. They are bought to
speculate (gamble) on price movements.
Stock options are themselves securities
and can be traded in financial market.
Call options are options to buy. Put
options are options to sell.
Options are an example of derivative
security. The value of derivative security
is based on that of another underlying
security.
• Earnest – Deposit or downpayment
to demonstrate seriousness about
buying something (part of
purchase price)
• Option – amount distinct from
purchase price, to secure for the
buyer the opportunity to make up
their mind.
Leverage amplifies the return on
investment (ROI).
The longer the option, the higher the
cost because the seller could’ve sold it;
the opportunity cost is lost, so to
compensate, they increase option price.
Call Options
The longer time, the better cause you
could speculate.
Basic Call Option grants its owner the
right to buy a share at a fixed price for
a specified period, and at the end of that
time, the option expires and can no
longer be exercised.
An option to buy a stock at a strike price
(underlying stock) sells for the option
price. Underlying stock with increase
(buy because increase will benefit firm).
An option on volatile stock is worth more
than one on a stable issue, because
volatile stock price is likely to go above
the strike price in the allotted time.
People also pay more for options with
more time until expiration, because that
gives the stock’s price more time to move
past the strike price.
The Call Option Writer Two parties to an
option contract, a buyer and a seller.
Don’t confuse buying and selling the
option contract with buying and selling
the optioned stock. Option originators
write the options. Once it’s written, the
option contract becomes a security and a
writer sells it to the first buyer who may
sell it to others.
No matter how many times the option is
sold, the writer remains bound by the
contract to sell the underlying stock to
the current option owner at a strike
price if she exercises.
A call option writer hopes the underlying
stock price will remain stable. If it does
he will recognize a gain from the receipt
of the option price.
Intrinsic Value
It is the difference between the stock’s
current price and the strike price.
If Vic is out of money, Vic is zero. It is
when the stock
price is less than strike price.
Vic = Ps – Pstrk
Vic = Intrinsic value of call option
Ps = current price of the underlying
stock
Pstrk = the option’s strike price
The price of option is directly
proportional to the price
of the underlying stock.
Option’s Value has a market value.
Time premium is the conversion premium
or the convertible bonds.
The difference between the intrinsic
value and the option priced is called the
option’s time premium.
Time premium = Pop – Vic
Investors are willing to pay premiums
over intrinsic value for options because
of the chance that they will profit if the
underlying stock’s price goes higher.
Time premium is generally largest when a
stock’s price is near but a little below the
option’s strike price; it diminishes as the
stock price rise.
Options and leverage
(financial) Leverage amplifies return on
investment (ROI). Options represent one
of a number of leveraging techniques.
Options offer a great deal of leverage.
The option isn’t quite as good a deal when
the stock is trading above the strike
price:
(1) Stock price has to rise higher to
make a given profit, and
(2) The buyer has to pay positive
intrinsic value in addition to the
time premium for the option,
which makes his investment
larger and decreases the
leverage effect.
Options That Expire Options are
exercisable only for a limited period, and
become worthless when they expire. If an
option is purchased out of the money and
the underlying stock’s value never
exceeds the strike price, the option
expires and the buyer loses the price paid
for it.
If an option is purchased at a price that
includes positive intrinsic value and the
underlying stock goes down in value, the
option buyer’s loss at expiration is the
time premium plus the decrease in
intrinsic value.
Trading In Options
Options can be bought and sold between
investors at any time until they expire.
Options on selected stocks are traded on
a number of exchanges throughout the
country.
Price Volatility in the Options Market
Option prices move up and down with the
price of the underlying securities (strike
price) but the relative movement is
greater for options. Option prices move
rapidly, and are rarely exercised until
immediately before expiration because
exercising requires throwing away
whatever value is in the time premium.
The Downside and Risk Speculating in
options involves a good chance of total
loss. It amplifies both losses and gains.
Writing Options
People write options for the premium
income received when they’re sold, but
option writers give up whatever profits
their buyer makes.
Covered Option – the writer owns the Naked:
underlying stock at the time the option is Market price of stock at the time of
written. You know the shares you are exercise (xx)
holding, so when the call option buyer Less: Pstrk xx
exercises, the writer must sell at the Pop xx
strike price (price of the written option). Gain
xx
May shares na hawak si writer, pero Covered:
nagsulat sya ng call option na ibebenta Market price of stock at the time of
nya at a strike price (agreed price). So exercise (xx)
if mataas ung current value nung stock Less: Pstrk xx
na hawak nya, and the holder of the call Pop xx
option decided to buy the shares na Gain
hawak ni writer, may opportunity loss si xx
writer. Bakit? Kasi if hindi nagsulat ng
option si owner ng shares, kanya ung Naked Option – writer doesn’t own the
gain from the share’s increase in market underlying stock at the time she writes
value. E kaso nga nagsulat sya tapos the option, which puts her more on risk.
binenta nya, so marereceive Nyang Wala pang hawak na shares, mabibili mo
income is the strike price while ang palang the moment you exercised. Risky
marereceive ni buyer is the current price kasi kung magkano lang bayad sayo (Pop
nung stock. – strk) yun lang yung kita mo. So if the
contract price is lower, and the buyer
Formulas: exercised, if market prices is high, you
✓ Intrinsic value = Vic = Ps – Pstrk could lose.
✓ Time premium = Pop – Vic Put Options
• Pop (Market price of option) Is an option to sell at a specified price,
✓ Investment = Ps – Pop simply called put. Investors buy puts if
they think the price of the underlying
Call Owner Exercises: security is going to fall.
Market price of stock at the time of A put buyer profits if the optioned stock’s
exercise xx price falls.
Less: Pstrk (xx) Vip = Pstrk – Ps
Pop (xx) When the stock is trading above the
Loss strike price, the intrinsic value is just
(xx) zero. As with call options, putse sell for a
time premium over their intrinsic value.
 Option Pricing Models
Options, like stocks and bonds, are traded
securities so it’s logical to ask if a similar
pricing model exists for them. Models are
more difficult for stocks than bonds
because it’s hard to express an option’s
value as the present value of a stream of
future cash flows.
Option prices can be estimated using the
Black – Scholes Option Pricing model.
Variables are used such as:
✓ Underlying stock’s current price
✓ Option’s strike price
✓ Time remaining until the option’s
expiration
✓ Volatility of the market price of the
underlying stock
✓ Risk – free interest rate
✓ always set well above current stock
Warrants
Stock warrant is a contract between a
company and an investor giving the
investor the right to buy or sell the
company stock within a certain time
frame for a specific price.
Stock Options are second market
phenomena, traded between investors and
the companies that issue the underlying
stocks are not involved. Options are
secondary market activities and the
underlying companies are not involved.
Those companies don’t get any money
when options re written or exercised.
Warrants are similar to call options but
are issued by the underlying companies
themselves. When a warrant is exercised,
the company issues a new stock in return
for the exercise price. Warrants are
primary market instruments.
Warrants are like options but are issued
by companies which receive equity at
exercise.
Warrants are sweeteners attached to
other securities.
Warrants are generally detachable and
traded independently.
Employee Stock Options
They are more like warrants than traded
options because they don’t expire for
several years and strike prices are
prices. Employees who receive options
generally get less in salary. Stock
options are used instead of a portion of
salary.
Employee stock options don’t cost the
company anything in cash when issued.
The Executive Stock Option Problem
Senior executives are the biggest
recipients of employee stock options.
Stock options provide an incentive for
executives to misstate financial
statements to keep stock prices up.
Misstatements of financial results
uncovered in the early 2000s
undermined confidence in the honesty of
corporate management. The executive
stock options system sets up a conflict of
interest that can lead to dishonest
reporting.
Chapter 14
Capital Structure and Leverage
Capital structure is the mix of debt and
equity. Capital consists f debt unlike in
accounting where there is only equity.
“Leverage“ amplifies the return 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 structure, it is
using more debt than equity (Financial
leverage of 10 percent is 10 percent
equity, 90 percent debt). It multiplies
the effectiveness of equity but adds risk.
Leverage refers to using borrowed
money to multiply the effectiveness of
the equity invested in a business
enterprise.
The borrowed money with which financial
leverage is concerned is the debt in a
company’s capital structure, which is why
“financial leverage“ and “capital
structure“ are somewhat synonymous.
To be leveraged means to have debt.
To be unleveraged means to operate with
only equity capital.
The Central Issue
Capital restructuring involves changing
leverage by shifting the mix of debt and
equity. The process shouldn’t affect the
price of the shares still outstanding.
Under certain conditions, changing
leverage increase stock price. An optimal
capital structure maximizes stock price.
Adding financial leverage in the manner
we’ve just described often increases the
price of the remaining shares and the
value of the firm, but this effect is
inconsistent which may mean that
sometimes adding leverage decreases
stock price and the firm’s value.
Risk in the Context of Leverage
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 :
(1) EBIT (operating income),
earning before interest and
taxes. It’s the lowest line on the
income statement, independent
of financing. EBIT is above
interest expense and is
unaffected by whether the
company is leveraged.
(2) ROE and EPS are return on
equity and earnings per share.
ROE = Net income
Equity
EPS = Net income
Number of shares

ROE and EPS are overall measures of
business performance because they
include both the results of financing. EPS
is an indicator of future earning power
of the firm and the major determinant of
the stock’s market price.
Redefining Risk for Leverage – Related
Issues
Business Risk is the variation in EBIT. It
is the variation in a firm’s operating
performance as measured by EBIT.
Financial Risk is the additional variation in
ROE and EPS brought about by financial
leverage (debt).
• In an unleveraged firm (no debt),
the variation in ROE and EPS is
identical to the variation in EBIT.
• In a leveraged firm, the variation
in ROE and EPS is always greater
than the variation in EBIT.
The more leverage the firm uses, the
larger the incremental variation. EBIT
measures operations, but ROE and EPS
measure overall performance, which is a
combination of operations and financing.
Business risk flows down into ROE and EPS
by itself.
Financial risk is added only if there is debt
financing.
Leverage and Risk – Two Kinds of
Each
Financial leverage is associated with and
causes financial risk.
Operating leverage is related to a
company’s cost structure rather than to
its capital structure. Cost structure
describes the relative amounts of fixed
and variable costs in productive and
administrative processes.
“Leverage“ means financial leverage.
Financial Leverage
Leverage measures performance, it may
increase stock prices under certain
conditions such as when there is
improvement in in the financial
performance measured in ROE and EPS.
It sometimes make performance worse
and always increase risk, hence, it is not
always clear when leverage will be a
benefit or not.
The Good News About Financial Leverage
In the progression of ROE and EPS, as
leverage increases, both measures go up
dramatically.
Going well = earning costs of profit.
Can the use of debt (leverage) increase
the value of stock price?
Increase in debt, Decrease in Net income,
Decrease in Equity and Shares
outstanding.
EPS = Net income
Number of shares outstanding
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 shares
respectively.
As debt is added, net income declines
because of increasing interest charges.
Equity and the number of shares
outstanding also shrink as debt replaces
equity in the capital structure and shares
are retired. Equity and shares are
shrinking proportionately faster than
earnings, so the ratio increase.
If profitability is good, a dollar for
dollar replacement of equity with debt
improves financial performance as
measured by ROE and EPS. This is good
news.
The Return on Capital Versus the Cost of
Debt
ROCE measures the profitability of
operations before financing charges on a
basis comparable to ROE.
Operating income (EBIT) represents an
after – tax return on capital that
exceeds its cost of debt (it means that
the company makes more with borrowed
money than it pays for the privilege of
borrowing.
Leverage influences stock price.
The after – tax return on capital can be
measured by a ratio called “return on
capital employed“. ROCE looks at the
profitability of operations without regard
to how the firm is financed, but does so
after – tax. This amounts to calculating
what the after – tax earnings on EBIT
would be if there were no deductible
interest, and then dividing by total
capital.
ROCE > After – tax cost of debt = Okay
to increase financial leverage (debt).
Excludes the effect of financing and tax.
After – tax = Interest rate x (1 – T).
When ROCE exceeds the after – tax cost
of debt, more leverage improves ROE and
EPS.
ROCE = EBIT (1 – T)
Debt + Equity
ROCE is an indicator of a company’s
efficiency because it measures the
company’s profitability after factoring in
the capital used to achieve that
profitability.
The Bad News About Leverage When ROCE
is less than the after – tax cost of debt,
leverage makes result worse. If EBIT is
lower, after – tax is higher. Interest is
deductible in expense. ROE and EPS
decrease with increasing leverage
because the firm is earning less on
capital than it’s paying for the use of
borrowed funds.
When ROCE is less than the after – tax
cost of debt, more leverage makes ROE
and EPS worse.
Decrease in EBIT, Decrease in ROE and
EPS
Financial Leverage and Financial Risk
Financial leverage multiplies good results
into great results, but it also multiplies
bad results into terrible results. When
business conditions change, performance
measured by ROE or EPS makes wider
swings for more leveraged organizations
than for those with relatively less debt.
The incremental variation in results is
what we’ve called financial risk.
No financial leverage, the difference in
the ROEs represents the variability of the
basic business results due to business
risk.
ROE representing the sum of the
variabilities arising from operations and
from financing. The incremental
variability, the differences is a result of
financial risk.
Financial risk is the increased variability
in financial results that comes from
additional leverage.
Leverage magnifies changes in operating
income (EBIT) into larger changes in
ROE and EPS. The more leverage, the
larger the magnification.
The Effect on Stock Price
Leverage enhances performance while it
adds risk, pushing stock prices in opposite
directions.
1. During periods of reasonably good
performance, leverage enhances
results in terms of ROE and EPS.
2. Leverage adds variability to
financial performance when
operating results change. This
means performance is riskier with
more leverage.
When leverage is low, a little more has a
positive effect on investors, but at high
debt levels concerns about risk dominate,
and the effect is more negative.
Real Investor Behavior and the Optimal
Capital Structure Low to moderate levels
of debt, investors value the positive
effects of leverage a great deal and
ignore the increased risk. Increases in
leverage tend to raise stock prices when
leverage is low or moderate.
As leverage increases, its effect goes
from positive to negative, which results
in an optimum capital structure. Optimum
capital structure is the capital structure
(percent debt, level of leverage) that
maximizes stock price.
Finding the Optimum As a practical
matter, the optimum capital structure
cannot be precisely located. A volatile
business uses less leverage than a stable
business. A high level of business risk
compounded by a high level of leverage
produces an extremely risky company.
1. A firm with good profit prospects
and little to no debt is probably
missing an opportunity by not using
borrowed money if interest rates
are reasonable.
2. For most businesses, the optimal
capital structure is somewhere
between 30 percent and 50 percent
debt.
3. Debt levels above 60 percent
create excessive risk and should be
avoided.
Target Capital Structure It is the one
that management prefers over any other
and attempts to maintain as it raises
money. A firm’s target capital structure
is management’s estimate of the optimal
capital structure.
Effect of Leverage When Stocks Aren’t
Trading at Book Value When stock is
purchased for retirement at book value,
the book value per share of the
remaining shares stays the same, and the
transaction has essentially the same
effect on EPS that it does on ROE. Stock
purchased for retirement at a price
different from its book value, the book
value of the remaining shares changes.
EPS = ROE x (book value per share)
Degree of Financial Leverage (DFL)
Financial leverage magnifies changes in
EBIT into 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
changes in EBIT to relative changes in
EPS.
DFL = EBIT
EBT
EBIT – EPS Analysis
Financial leverage can enhance results at
normal levels of operating profit, but
makes those results more volatile at the
same time. There needs to be a
quantification and analyzation of trade –
off between results and risk implied by
moving from one level of leverage to
another. EBIT – EPS analysis provides a
graphic portrayal of the trade – off
that makes the choice relatively
straightforward. It also involves
graphing EPS as a linear function of
EBIT for two or more levels of leverage.
EBIT – EPS analysis portrays the results
of leverage and helps to decide how much
to use.
Operating Leverage
It deals with cost rather than capital,
but the effects are similar to financial
leverage. Combining the two results to
high volatility.
 Terminology and Definitions
“Operations“ refer to a firm’s business
activities exclusive of long – term
financing. In income statement, those
statement, those activities involve the
items from sales down to operating
income (EBIT).
Risk in Operations – Business Risk
Variation in EBIT is a business risk. Most
variation in EBIT comes about because of
changes in the level of sales.
Fixed and Variable Cost and Cost
Structure Fixed cost (overhead) doesn’t
change when the level of sales changes,
but a variable cost does.
Cost structure is the mix of fixed and
variable costs in a firm’s operations.
Variable costs are items that go up and
down with volume, like sales commissions.
Operating Leverage Defined It refers to
the amount of fixed cost in the cost
structure. If a firm’s cost are largely
fixed, it has a great deal of operating
leverage.
Operating leverage increases as the
proportion of fixed cost increases.
a. Factory with a lot of people – labor
intensive or utilizing manual
processes.
b. A lot of machines and a few people
– capital intensive or automated.
People represent variable cost because
they can be let go when sales and
production decline. Machines, on the
other hand, represent fixed cost because
they can’t be laid off during a downturn.
Hence, an automated plant has more
operating leverage than labor intensive
plant.
Breakeven Analysis
Is used to determine the level of activity
a firm must achieve to stay in business in
the long run. It lays out the effect of
sales volume on a firm’s use of fixed and
variable cost.
Overview of Breakeven it means zero
profit or loss, measured at EBIT
(operating income). At breakeven, income
(revenue) exactly equals outgo (costs
and expenses), and the firm just survives.
Breakeven analysis shows the mix of fixed
and variable cost and the volume
required for zero profit or loss. It is a
way of looking at operations to
determine the volume, in either units or
dollars, a company must sell achieve this
zero – profit, zero – loss situation.
“Cost“ broadly refers to expense. Both
cost and expenses can be fixed or
variable (associated with sales).
Breakeven Diagrams
Fixed cost is constant as sales increases,
while variable costs increase
proportionately with sales.
Breakeven is the level of sales at which EBIT = PQ – VQ – Fc
revenue equals cost. It is at the
P is the price per unit
intersection of revenue and total cost. At
any sales volume, the firm’s profit or loss V is the variable cost
is the difference between revenue and Q is quantity
total cost.
Fc is fixed cost
Contribution Margin(Ct) The price that
exceeds the unit variable cost is the P and V are multiplied to Q to find the
contribution made by sale. Every sale revenue and the variable cost. If
makes a contribution of the difference revenue and variable cost is given, no
between price and variable cost. need to find Q.
Ct = P – V Breakeven value (volume units). It tells
us how many units have to be sold to
Ct is the contribution contribute enough money to cover (pay
P is the price for ) fixed costs. Breakeven volume is
fixed cost divided by contribution.
V is variable cost per unit
Qb/e = Fc
The term implies a contribution to profit
and fixed cost. Unit contribution is the P–v
same anywhere at any level of sales. Or
Contribution expressed as percentage of
revenue by dividing by the price is called Qb/e = Fc
the contribution margin. Ct
Cm = P – V
P Dollar Breakeven Sales ($$)
Or Sb/e = Fc
Cm = Ct Cm (decimal form)
P Effect of Operating Leverage
Calculating the Breakeven Sales Level As volume moves away from breakeven
EBIT is revenue minus cost, which can be Profit or Loss increase faster with more
expressed in terms of price, quantity, and operating leverage.
cost as
Increased leverage magnifies the
change in EBIT that results from a given
change in sales volume. Operating
leverage can be said to increase in the
variation in EBIT as a result of variation
in sales. Because variation in EBIT is
defined as business risk, it follows that
increased operating leverage increases
business risk. Variation in EBIT (business
risk) is larger with more operating
leverage.
High – leverage firm gets a larger
contribution from each sale, so it
accumulates profits or losses faster as it
moves away from the breakeven. The
trade – off is that the high – leverage
firm has more fixed cost to cover it
before it makes a profit than the low
leverage firm.
The Effect on Expected EBIT More
operating leverage implies higher
operating profit at any output above the
breakeven. Always determine the level of
fixed cost you have. Higher fixed cost,
higher profit. If a firm is relatively sure
of its output level, it’s better to trade
variable costs for fixed. Increasing
operating leverage multiplies operating
income (EBIT) at output levels that are
likely to be high.
Degree of Operating Leverage (DOL)
Operating leverage amplifies changes in
sales volume into larger changes in EBIT.
The DOL relates relative changes in
volume (Q) to relative changes in EBIT.
DOL = Q(P – V)
Q(P – V) - Fc
Or
DOL = Q Ct
Q Ct – Fc
Comparing Operating and Financial
Leverage
Financial and operating leverage are
similar in that both can enhance
results while increasing variation.
Operating leverage connect sales with
EBIT in much the same way that
financial leverage connects EBIT with
ROE and EPS.
Financial leverage can improve
performance in ROE and EPS, it
amplifies changes in EBIT into larger
relative changes in those ratios.
Operating leverage can enhance EBIT
at a given sales level, and expands
variations in sales into larger relative
variations in EBIT.
Financial leverage involves
substituting debt for equity in the
firm’s capital structure, while
operating leverage involves
substituting fixed cost for variable
cost in its cost structure.
Debt is a fixed cost method as it pays a
fixed amount of interest regardless of
the firm’s health. Equity is a variable cost
because the dividends paid to stockholders
can be varied or eliminated if the firm is
not doing well. Both forms of leverage
involves substituting fixed cash outflows
for variable cash outflows.
Financial risk is the additional variation in
ROE and EPS caused by financial leverage
while business risk is variation in EBIT
enhanced by operating leverage.
Financial leverage is the sole cause of
financial risk, while some business risk
would exist even without operating
leverage.
All production involves use of equipment
that generates fixed cost, meaning that
all firms have operating leverage. Many
firms use no debt and have no financial
leverage.
Financial leverage is more controllable
than operating leverage. Technology is
unpredictable, while management can
decide the amount of debt they will use.
The Compounding Effect of Operating
Leverage and Financial Leverage
Changes in sales are amplified by
operating leverage into larger relative
changes in EBIT, which in turn are
amplified into still larger relative
changes in ROE and EPS by financial
leverage. The effects of financial and
operating leverage compound
(multiplicative) one another. Modest
changes in sales can lead to dramatic
changes in ROE and EPS for companies
that uses both leverage.
EBIT to ROE and EPS
Degree of Total Leverage
The DTL reflects the combined effect of
both kinds of leverage.
Capital Structure Theory
Structure does affect price and value,
and there is an optimum, but there’s no
way to find it with any precision.
The Value of the Firm
Market value increases through
manipulating capital structure which
increases stock price.
The more heavily a firm is leveraged,
either financially or operationally, the
more quickly it loses money when volume
decreases. The effect is compounded when
both forms of leverage are present. This
means leveraged companies react
aggressively when something threatens
their volume.
Theory begins by assuming a world
without taxes or transaction costs, so
investors’ returns are exactly component
capital costs.
Value is Based on Cash Flow, Which Comes
from Income The value of any security is
the present value of the cash flows that
come from owning it, and all cash flows
paid to investors come from earning.
Operating income (EBIT) is the earnings
stream available to either debt or equity
investors.
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 year
after year. Dividend and interest
payments are both perpetuities, and the
firm’s market value is the sum of their
present values.
The value of the firm is determined by
the costs of its debt and equity (total
leverage). Lower rates means higher
values. Returns drive value in an inverse
relationship. If the return on debt
remains the same, the cost of capital will
also rise and overall value will drop.
Average cost of capital is our concern.
Franco Modigliani and Merton Miller (MM
Theory)
The theory is about the effect of capital
structure on value.
1. There are no income taxes
2. Securities trade in perfectly
efficient capital markets in which
there are no transaction costs.
3. Investors and companies can
borrow as much money as they
want at the same rate. That is,
(a) Rates don’t go up as one
borrows more money
(b) The rate is the same for
investors and companies.
The assumption includes that there are
no costs associated with bankruptcy. Zero
bankruptcy cost implies that no legal or
administrative fees are incurred in
restructuring or liquidating, and if
liquidation is required, assets are sold for
a value close to what they were worth to
the company. Bankruptcy refers to the
fees and losses on the sale of the used
assets, not the value of the firm.
Assumptions and Reality
✓ There are income taxes
✓ Legal and administrative expenses
of bankruptcy are large and assets
sold under duress usually bring a
fraction of their original value
✓ Individuals pay higher interest
rates than companies and rates go
up higher as more money is
borrowed.
The Result the firm’s total value is
unaffected by capital structure
(independence hypothesis) Value is
independent of capital structure. The
firm’s cost of debt and equity and its
average cost of capital.
An investment in debt is safer than an
investment in equity.
As cheaper debt is added, the cost of
equity increases because of increased
risk such that the weighted average cost
of capital remains constant.
MM’s Result Supports the Operating
Income View The firm’s value is the
present value of its expected operating
income stream, a rational market will
hold that total value of that stream
constant no matter how the capital is
divided between debt and equity. The
firm’s investment value is whatever it is
on the basis of income.
The Arbitrage Concept Equity investors
seeking to maximize their returns would
hold the value of a firm constant
through changes in leverage. Arbitrage
between leveraged and unleveraged
firms will hold value constant as debt
increases.
Interpreting the Result MM result
implies that leverage affects value
because of market imperfections (tax and
transaction cost)
The tax system favors debt financing
because interest is tax deductible while
dividends are not.
Total payments to investors are higher
for the leveraged company because they
can deduct interest from taxable income
and pay less tax.
In the MM model with taxes, interest
provides tax shields that reduces
government’s share of the firm’s
earnings.
Value is increased by the PV of the tax
shield. The benefit of debt is the tax rate
times the debt amount.
The benefit of debt accrues entirely to
stockholders because bond returns are
fixed.
In the MM model with taxes, value
increases steadily as leverage is added.
Bankruptcy costs are additional losses
that accrue primarily to stockholders
when companies fail. It eventually make
investors raise required rates which
lowers value.
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.