Transcript [title slide]

Chapter 9
For the Investor
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Leverage
• The use of debt is referred to as financial
leverage
• Interest as related to debt financing
– A contractual obligation
– Must be paid regardless of entity’s current profits
• Contrast with dividends which are discretionary
– Interest is tax deductible
• Reduces taxable income
• Reduces income tax
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #2
Definition of Financial Leverage and Magnification
Effects
DOWELL COMPANY (Exhibit 9-1)
Financial Leverage
Partial Income Statement to Illustrate Magnification Effects
Base Year
Figures
Earnings before interest and tax
Interest
Earnings before tax
Income tax (40%)
Net income
Percentage change in net income [A]
Percentage change in earnings before
Interest and tax [B]
Degree of financial leverage [A ÷ B]
$1,000,000
(200,000)
800,000
(320,000)
$ 480,000
20% Decrease
in Earnings
Before Interest
and Tax
$ 800,000
(200,000)
600,000
(240,000)
$ 360,000
10% Increase
in Earnings
Before Interest
and Tax
$1,100,000
(200,000)
900,000
(360,000)
$ 540,000
25.0%
12.5%
20.0%
1.25
10.0%
1.25
Net income increase [A] is greater than change in EBIT [B] due
to the fixed nature of interest expense
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #3
Computation of the Degree of Financial
Leverage
% Change Net Income
% Change EBIT
Earnings Before
Interest and Tax
Earnings Before Tax
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
The degree of financial leverage is the
multiplication factor by which the net
income changes in respect to changes
in EBIT
A more simple formula for degree of
financial leverage
Chapter 9, Slide #4
Computation of the Degree of Financial
Leverage (cont’d)
• Degree of financial leverage calculations
should exclude
– Noncontrolling interest
– Equity income
– Nonrecurring items
Earnings Before Interest, Tax,
Noncontrolling Interest,
Equity Income, and Nonrecurring Items
Earnings Before Tax,
Noncontrolling Interest,
Equity Income, and Nonrecurring Items
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
The all-inclusive
formula for degree of
financial leverage
Chapter 9, Slide #5
Earnings per Share
• Required disclosure for corporate income
statements
• Pertains only to common stock
• Per-share amounts are disclosed for
–
–
–
–
Income from recurring items
Discontinued operations
Extraordinary items
Net income
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #6
Earnings per Share
Basic Earning per share=
Net Income - Preferred Dividends
Weighted Average Number of
Common Shares Outstanding
• Earnings pertain to an entire fiscal period
• Average common shares outstanding is used for parity
of information
• Current guidelines require basic and diluted earning
per share presentation.
- Diluted earning per share is calculated the same as
basic plus the dilutive effect of potentially dilutive
securities
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #7
Weighted Average Common Outstanding
Months Shares
Are Outstanding
January–June
July–September
October–December
Shares
Outstanding
10,000
12,000
15,000
×
Fraction of Year
Outstanding
=
×
×
×
6/12
3/12
3/12
=
=
=
Weighted
Average
5,000
3,000
3,750
11,750
• Stock dividends and stock splits
– Retroactive recognition to all comparative data
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #8
Earnings Per Share and Capital Structure
• Simple capital structure
• Complex capital structure contains potentially
dilutive securities:
–
–
–
–
Options, rights, warrants
Convertible debt
Convertible preferred equity
Contingent shares
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #9
Price/Earnings Ratio
Market Price per Share
Diluted Earnings per Share
Before Nonrecurring Items
• Measures the relationship between the market
price of a share of common stock and that
stock’s current earnings per share
– Use of diluted earnings per share gives more
conservative price/earnings ratio
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #10
Price/Earnings Ratio (cont’d)
• Compare with
– Industry competitors
– Industry average
– Exchange (e.g., NYSE) average
• Interpretation
– High-growth-potential firms have higher P/E ratios
– P/E ratio is a function of the market
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #11
Percentage of Earnings Retained
Net Income Before Nonrecurring
Items - All Dividends
Net Income Before
Nonrecurring Items
• Reflects the proportion of current earnings
retained for internal growth
• Trend analysis is improved by exclusion of
nonrecurring items
• Higher percentage typically found in
– New firms
– Growing firms and firms perceived as growth firms
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #12
Dividend Payout
Dividends per Common Share
Diluted EPS Before Nonrecurring Items
• Measures the portion of current earnings per
common share being paid out in dividends
• A stable dividend policy is developed by
consideration of recurring earnings
• Lower payout typically found in
– New firms
– Growing firms and firms perceived as growth firms
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #13
Dividend Yield
Dividends per Common Share
Market Price per Common Share
• Indicates the relationship between the
dividends per common share and the market
price per common share
• The yield is a function of
– The firm’s dividend policy
– Market price
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #14
Book Value per Share
Total Shareholders' Equity
- Preferred Stock Equity
Number of Common Shares Outstanding
• Preferred equity should be measured at
liquidation value, if available
• Market value vis-à-vis book value
– Book value reflects past unrecovered asset costs
– Market value reflects the potential of the firm
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #15
Stock Options
• Stock option fair value
– Expensing is required per SFAS 123R
• Allocate option fair value to the service period
– Date of grant through vesting date
• Noncompensatory plans
– Encourage widespread ownership by employees
– Slight discount from fair value
– No compensation expense is recognized
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #16
Impact of Stock Option Expense
Net Income Before
Net Income Before
Nonrecurring Items Not Nonrecurring Items
Including Option Expense
Including Option Expense
Net Income Before Nonrecurring Items
Not Including Option Expense
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #17
Restricted Stock
• Sometimes offered to employees in lieu of
stock option plans
• Restrictions
– Employee cannot sell stock for a specified period of
time
– Employee may forfeit the shares if they leave
employer
– Awards may be linked to financial goals
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #18
Stock Appreciation Rights
• Employee receives compensation in cash or
stock
– Difference between option price and market price
• Expense is a function of market price
– Year-end spread is measured
– Current expense is spread minus prior recognition
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #19
Stock-Based Compensation
• May be awarded through the use of
– Stock options
– Restricted stock
– Stock appreciation rights
• Firms vary in their use of these methods of
granting stock-based compensation
– Select a single method
– Use two of the three methods
– Use all three in combination
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 9, Slide #20