FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES CHAPTER 10 pot

CHAPTER 10 ANALYSIS OF FINANCING CHOICES Let’s now turn to analyzing the third aspect of the three-part decisional systems context introduced in Chapter 2: investment, operations, and financing. We’ll con- centrate on the choices available in arranging a company’s long-term financing, while setting aside the incremental operational funds sources used routinely by companies in line with practices in a particular industry or service, and broadly discussed in Chapter 3. We choose this focus because, as we observed earlier, the nature and pattern of long-term funding sources is intricately connected with the types of business investments made and is critical to the growth, stability, or de- cline of operations. Indeed, management must fund its strategic business design with an appropriate mix of capital sources that will assist in bringing about the desired increase in shareholder value. This chapter will deal with the key considerations in assessing the basic fi- nancing options open to management. While the choice among long-term debt, preferred, and common equity is blurred by a bewildering array of modifications and specialized instruments in each category, we’ll discuss only the main charac- teristics of the three basic types of securities. Because our emphasis is on quanti- tative analysis, we must keep in mind that many other considerations enter into these choices. For example, the specific type of business and the industry in which it operates will affect the long-term capital structure chosen at various stages of a company’s development, as will the preferences and experiences of senior man- agement and the board of directors. These aspects cannot be adequately covered within the scope of this book. We’ll begin with a broad framework for analysis that defines the key areas to be analyzed and weighed in choosing sources of long-term financing. Next, we’ll look at the techniques of calculating the impact on a company’s financial performance resulting from the introduction of new capital supplied by each of the three basic sources. Then we’ll turn to a graphic representation of these results, the range of earnings (EBIT) break-even chart, in order to demonstrate the 325 hel78340_ch10.qxd 9/27/01 11:30 AM Page 325 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. 326 Financial Analysis: Tools and Techniques dynamic impact that funds choices have on changing company conditions. After touching on leasing as a special source, we’ll briefly discuss capital structure pro- portions and list the key issues involved in the area of funds choices. Framework for Analysis Several key elements must be considered and weighed when a company is faced with raising additional (incremental) long-term funds. We’ll take up the five most important ones in some detail: • Cost. • Risk exposure. • Flexibility. • Timing. • Control. This discussion is intended to serve as a conceptual checklist to ensure that the most important considerations have been covered in the choice of long-term financing. Cost of Incremental Funds One of the main criteria for choosing from among alternative sources of additional long-term capital is the cost involved in obtaining and servicing the funds. In Chapter 9, we discussed in detail the specific and implicit costs a company incurs in using debt, preferred stock, or common equity. As a general rule, we found that funds raised with various forms of debt are least costly in specific terms, in part because the interest paid by the borrowing company is tax deductible under current U.S. laws. The actual rate of interest charged on incremental debt will depend, of course, on the credit rating of the company and on the degree of leverage introduced into the capital structure by the new debt, as discussed in Chapter 6. In other words, the specific cost will be affected not only by current market conditions for all long-term debt instruments, but also as a function of the company-specific risk as perceived by lenders, under- writers, and investors. As we mentioned at the time, other costs are also implicit in raising long-term debt, including legal and underwriting expenses connected with the issue, and the nature and severity of any restrictions imposed by the creditors. The stated cost of preferred stock is generally higher than debt, partly be- cause preferred dividends are not tax deductible, and partly because preferred stock has a somewhat weaker position on the risk/reward hierarchy. Holders of these shares expect a higher return to compensate for their ownership risk. The comparative specific cost of preferred stock is relatively easy to calculate. The hel78340_ch10.qxd 9/27/01 11:30 AM Page 326 TEAMFLY Team-Fly ® CHAPTER 10 Analysis of Financing Choices 327 dividend level is clearly defined, and legal and underwriting costs incurred at the time of the issue are reflected in the net proceeds to the company. However, at times a variety of specific provisions can involve implicit costs to the company. In Chapter 9 we found that determining the cost of common equity turned out to be a fairly complex task. It involved constructing a theoretical framework within which to assess the risk/reward expectations of the shareholder. Direct ap- proaches (shortcuts) to measuring the specific cost of common equity were found wanting because they didn’t address the company’s relative risk as reflected in common share values. We had to use a more integrated framework involving some surrogates and approximations to arrive at a practical result based on the theoretical model. The cost of common equity based on the CAPM approach could be directly compared to the specific costs of debt and preferred stock, and it also could be used to arrive at a weighted overall cost of the company’s capital structure. As we’ll see shortly, however, increasing common equity in the capital structure by issuing new shares involves additional considerations. The incremental shares dilute earnings per share, require additional and even growing dividends where these are paid, and also change the capital structure proportions. These effects introduce implicit economic costs or advantages into the funding picture. Risk Exposure If we use variability of earnings as a working definition of risk, we find that a company’s risk is affected by the specific cost commitments, such as interest on debt or dividends on preferred shares, that each funding source entails. These commitments introduce financial leverage effects in the company’s earnings per- formance, or will heighten any financial leverage already existing. As we dis- cussed in Chapter 6, the use of instruments involving fixed financial charges will widen the swings in earnings as economic and operating conditions change. Given the responsibility for providing holders of common shares with growing economic value, management must therefore expend much thought and care in determining the appropriate mix of debt and equity in the company’s capi- tal structure. This balance involves providing enough lower-cost debt to boost the shareholders’returns, but not so much debt as to endanger shareholder value crea- tion during periods of low earnings, to arrive at a mix of capital sources carefully tailored to industry and company conditions. The ultimate risk, of course, is that a company will not be able to fulfill its debt service obligations. The proportion of debt in the capital structure, and simi- larly, the proportion of preferred stock, affects the degree of risk of partial or total default. Analyzing risk exposure is based on establishing a historical pattern of earnings variability and cash flows from which future conditions are projected. These must take into account the extent to which a company’s strategy is chang- ing, any shifts in exposure to the business cycle, shifting competitive pressures, and potential operating inefficiencies. hel78340_ch10.qxd 9/27/01 11:30 AM Page 327 328 Financial Analysis: Tools and Techniques Clearly, company-specific risk (earnings variability) and the company’s ability to service its debt burden are intimately related to the particular character- istics of the business or businesses in which the company operates. Moreover, they’re affected by general economic conditions—apart from management’s abil- ity to generate satisfactory operating performance. The degree of financial leverage advisable and prudent will therefore vary greatly among different industries and services, and also will depend on the firm’s relative competitive position and maturity stage. A new business entails a far dif- ferent risk exposure for the creditor than does the established industry leader, apart from specific industry conditions. Flexibility The third area we must consider is the question of flexibility, defined here as the range of future funding options that remain open once a specific alternative has been chosen. As each increment of financing is completed, the choice among fu- ture alternatives might be more limited during the next round of raising capital. For example, if long-term debt obligations are chosen as a major funding source, the level of total debt in the capital structure, restrictive covenants, encumbered assets, and other constraints that impose minimum financial ratios might mean that the company can use only common equity as a future source of capital for some time ahead. Flexibility essentially requires forward planning. Careful consideration must be given to matching strategic plans and corporate financial policies. Po- tential acquisitions, expansion, and diversification all are affected by the degree of flexibility management has in choosing appropriate funding, and by the funds drain resulting from servicing debt commitments or preferred dividends. To the extent possible, management must coordinate its planned future cash flows and investment patterns with the pattern of successive rounds of financing that will support them. Being in a situation where future funds sources are limited to only one option because of present commitments can pose a significant problem. Changing conditions in the financial markets for different types of securities might make this single option unappealing or even unavailable when funds needs become critical. Timing The fourth element in choosing long-term funding is the timing of the transaction. Timing is important in relation to the movement of prices and yields in the secu- rities markets. Shifting conditions in these markets affect the specific cost a com- pany incurs with each option, in the form of the stated interest rate on new debt or the preferred dividend rate carried by new preferred stock, as well as in terms of the net proceeds to be received from each of the alternatives. Therefore, the tim- ing of the issue will affect the cost spread between the several funding alternatives hel78340_ch10.qxd 9/27/01 11:30 AM Page 328 CHAPTER 10 Analysis of Financing Choices 329 available. Also, specific market conditions might in fact either preclude or dis- tinctly favor particular choices. For instance, in times of depressed stock prices, bonds might prove to be the most suitable alternative from the standpoint of both cost and market demand. Inasmuch as the proceeds from any issue depend on the success of the place- ment—public or private—of the securities, the conditions encountered in the stock or bond markets can seriously affect the choice. Potential uncertainty in financial markets is therefore a strong argument for always maintaining some degree of flexibility in the capital structure. Control Finally, the degree of ownership control of the company held by existing share- holders is an important factor as funding choices are considered. Obviously, when new shares of common stock are issued to new shareholders, the effect is a dilu- tion of both earnings per share and the proportion of ownership of the existing shareholders. Such dilution becomes a significant issue for the owners of com- panies that could be subject to potential takeovers. In the past decade, the issue of control has been raised to new heights in the many battles over control during the corporate merger and acquisition boom. Even if debt or preferred stock is used as the source of long-term funding, existing shareholders can be affected indirectly because restrictive provisions and covenants might be necessary to obtain bond financing, or because concessions must be made to protect the rights of the more senior preferred shareholders. Dilution of ownership is a very important issue in closely held corporations, particularly new ventures. In such situations, founders of the company or the major shareholders might exercise full effective control over the company. Issu- ing new shares will dilute both control over the direction of the company and the key shareholders’ability to enjoy the major share of economic value growth from successful performance. Dilution of earnings and possible retardation of growth in earnings per share brought about by diluting common equity ownership is, of course, not limited to closely held companies. Rather, it’s a general phenomenon that we’ll discuss shortly. Finally, dilution of control and earnings is a major consideration in convert- ibility, a feature found in certain bonds and preferred stocks. This provision allows conversion of the security into common stock under specified conditions of tim- ing and price. In effect, such instruments are hybrid securities, as they represent delayed issues of common stock at a price higher than the market value of the common stock at the time the convertible bond or preferred stock is issued. We mentioned this feature in earlier chapters in terms of its effect on financial ratios, particularly when discussing the concept of diluted earnings per share, and we’ll return to it later in this chapter. Control becomes an issue in convertible financing options because the eventual conversion of the bond or preferred stock will add new common shares hel78340_ch10.qxd 9/27/01 11:30 AM Page 329 330 Financial Analysis: Tools and Techniques to the capital structure and thus cause dilution. The ultimate effect is just like a direct issue of new common stock. The Choice It should be clear from this brief résumé of the considerations involved that any decision about alternative sources of long-term funding can’t be based on cost alone, even though cost is a very important factor and must be analyzed early in the decision-making process. Unfortunately, there are no hard-and-fast rules spelling out precisely how the final decision should be made, because the choice depends so much on the conditions prevailing in the company and in the securi- ties markets at the time, and on the preferences of the board and senior manage- ment. The best approach is to consider carefully the five areas we’ve presented above and to examine the pros and cons of each as an input to the decision. Need- less to say, one very significant consideration is the effect of each funding source on a company’s future earnings performance. In the section that follows, we’ll ex- amine methods of calculating this effect. Techniques of Calculation For purposes of illustration, we’ll employ the basic statements of a hypothetical company, ABC Corporation. The company is weighing alternative ways of raising $10 million to support the introduction of a new product. After analyzing the corporation’s current performance, we’ll successively discuss the impact on that performance level caused by introducing long-term debt, preferred stock, and common equity, in equal amounts of $10 million each. We’ll focus on the impli- cations of financing alternatives on the company’s reported earnings, but will also test the cash flow implications of the choices to be made. ABC’s abbreviated balance sheet is shown in Figure 10–1. The company currently has 1 million shares of common stock outstanding, with a par value of $10 per share. From the company’s income statement (not shown), we learn that FIGURE 10–1 ABC CORPORATION Balance Sheet ($ millions) Assets Liabilities and Net Worth Current assets . . . . . . . . $15 Current liabilities . . . . . . . . . . . . . . . . $ 7 Fixed assets (net) . . . . . 29 Common stock. . . . . . . . . . . . . . . . . . 10 Other assets . . . . . . . . . 1 Retained earning . . . . . . . . . . . . . . . . 28 Total assets . . . . . . . . $45 Total liabilities and net worth . . . . . $45 hel78340_ch10.qxd 9/27/01 11:30 AM Page 330 CHAPTER 10 Analysis of Financing Choices 331 ABC Corporation has earned $9 million before taxes on sales of $115 million in the most recent year. Income taxes paid amounted to $3.06 million, an effective rate of 34 percent. Current Performance We begin our appraisal of the current performance of ABC Corporation by calcu- lating the earnings per share (EPS) of common stock. Throughout the chapter, this format of calculating EPS and related measures will be used. It’s a step-by-step analysis of the earnings impact of each type of long-term capital. First, we’ll establish the earnings before interest and taxes (EBIT), a mea- sure we discussed in Chapter 4. From that figure we must subtract a variety of charges applicable to different long-term funds. The first of these is interest charges on long-term debt. Normally short-term interest can be ignored unless it’s a significant amount, because we assume—given the temporary nature of short- term obligations that arise from ongoing operations—that the related interest charges have been properly deducted from income before arriving at the EBIT figure. The calculations of earnings per share are shown in Figure 10–2. A provi- sion is made in the table for both long-term interest and preferred dividends. No amounts are shown for these, however, because our hypothetical company at this point has neither long-term debt nor preferred stock outstanding. The calculations result in earnings available to common stock of $5.94 per share. From that figure we must subtract $2.50, which represents a cash dividend voted by the board of directors. We find that this fairly high level of dividend payout (between 40 and 50 percent of earnings) has been maintained for many years, impacting ABC’s FIGURE 10–2 ABC CORPORATION Earnings per Share Calculation ($000, except per share figures) Earnings before interest and taxes (EBIT). . . . . . . . . . . . . . . . . . . . . . . . . $9,000 Less: interest charges on long-term debt. . . . . . . . . . . . . . . . . . . . . . . . -0- Earnings before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Less: Income taxes at 34% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,060 Earnings after income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,940 Less: Preferred dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -0- Earnings available for common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,940 Common shares outstanding (number) . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 million Earnings per share (EPS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5.94 Less: Common dividends per share. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.50 Retained earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3.44 Retained earnings in total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,440 hel78340_ch10.qxd 9/27/01 11:30 AM Page 331 332 Financial Analysis: Tools and Techniques financing flexibility somewhat. The company’s earnings have steadily grown by about 4 percent on average over the past decade. The stock is widely held and traded, and currently commands a market price ranging from about $38 to $47, which means it’s trading at roughly seven to eight times earnings. The latest se- curity analyst’s report suggests a ␤ of 0.9, while the risk-free rate of return is judged to be 6.5 percent, and the expected stock market return from the S&P 500 is forecast at 14.0 percent. Long-Term Debt in the Capital Structure As debt is introduced into this structure, both the financial condition and the earn- ings performance of ABC Corporation are significantly affected. To raise the $10 million needed to fund the new product, management has found that it’s pos- sible, as one alternative, to issue debenture bonds. Debentures are not secured by any specific assets of the company; instead they’re issued against the company’s general credit standing. These bonds, under assumed market conditions, will carry an interest (coupon) rate of 11.5 percent, will become due 20 years from date of issue, and will entail a sinking fund provision of $400,000 per year beginning with the fifth year. The balance outstanding at the end of 20 years will be repaid as a balloon payment of $4 million. The company expects to raise the full $10 mil- lion from the bond issue after all underwriting expenses, in effect receiving the par value. Once the new product financed with the proceeds has been successfully introduced, the company projects incremental earnings of at least $2.0 million before taxes. Little risk of product obsolescence or major competitive inroads is expected by management for the next 5 to 10 years, because the company has developed a unique process protected by careful patent coverage. We can now trace the impact of long-term debt on the company’s perfor- mance, observing both the change in earnings and dividends, and the specific cost of the newly created debt itself. (A fairly high interest rate and preferred dividend were chosen for this illustration to make the impact of the choices more visible in the graphic analysis shown later.) We’ll analyze two contrasting conditions: • The immediate impact of the $10 million debt without any offsetting benefits from the new product. • The improved conditions expected once the investment has become operative and the new product has begun to generate earnings, probably after one year. The results of the two calculations are shown in Figure 10–3. The instanta- neous effect of adding debt is a reduction of the earnings available for common stock. This is caused by the stated interest cost of 11.5 percent on $10 million of bonds, or $1,150,000 before taxes. Earnings after interest and taxes drop by $759,000 as compared to the initial conditions in Figure 10–2. This earnings hel78340_ch10.qxd 9/27/01 11:30 AM Page 332 CHAPTER 10 Analysis of Financing Choices 333 reduction represents, of course, the after-tax cost of the bond interest, or $1,150,000 times (1 Ϫ .34). As a consequence, earnings per share decline to $5.18, a drop of 76 cents, or an immediate dilution of 12.8 percent from the prior level. This change is purely due to the incremental interest cost, which on a per share basis amounts to the same 76 cents, that is, the after-tax interest of $759,000 divided by one million shares. In Chapter 8 we discussed the stated annual cost of debt funds, defined as the tax-adjusted rate of interest carried by the debt instrument. Assuming an ef- fective tax rate of 34 percent in our example, the stated cost of debt for ABC Cor- poration is therefore 7.59 percent. We also explained in Chapter 9 that the specific annual cost of debt is found by relating the stated annual cost to the actual pro- ceeds received. If these proceeds differ from the par value of the debt instrument, the specific annual cost of the debt will, of course, be higher or lower than the stated rate. In the case of ABC Corporation, we assumed that net proceeds were effec- tively at par, and therefore the specific cost of ABC’s new debt is also 7.59 per- cent, a figure which we’ll compare with the specific cost of the other alternatives for raising capital. When we turn to the second column of Figure 10–3, we find that the as- sumed successful introduction of the new product will more than compensate ABC Company for the earnings impact of the interest paid on the bonds. In other FIGURE 10–3 ABC CORPORATION Earnings per Share with New Bond Issue ($ thousands, except per share figures) Before New With New Product Product Earnings before interest and taxes (EBIT). . . . . . . . . . $ 9,000 $ 11,000 Less: Interest charges on long-term debt . . . . . . . . 1,150 1,150 Earnings before income taxes . . . . . . . . . . . . . . . . . . . 7,850 9,850 Less: Income taxes at 34% . . . . . . . . . . . . . . . . . . . 2,669 3,349 Earnings after income taxes . . . . . . . . . . . . . . . . . . . . 5,181 6,501 Less: Preferred dividends . . . . . . . . . . . . . . . . . . . . -0- -0- Earnings available for common stock . . . . . . . . . . . . . $ 5,181 $ 6,501 Common shares outstanding (number) . . . . . . . . . . . . 1 million 1 million Earnings per share (EPS) . . . . . . . . . . . . . . . . . . . . . . $ 5.18 $ 6.50 Less: Common dividends per share . . . . . . . . . . . . 2.50 2.50 Retained earnings per share . . . . . . . . . . . . . . . . . . . . $ 2.68 $ 4.00 Retained earnings in total . . . . . . . . . . . . . . . . . . . . . . $ 2,681 $ 4,001 Original EPS (Figure 9–2) . . . . . . . . . . . . . . . . . . . . . . $ 5.94 $ 5.94 Change in EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ϫ0.76 ϩ0.56 Percent change in EPS . . . . . . . . . . . . . . . . . . . . . . . . Ϫ12.8% ϩ9.4% hel78340_ch10.qxd 9/27/01 11:30 AM Page 333 334 Financial Analysis: Tools and Techniques words, the investment project is earning more than the specific cost of the debt employed to fund it. After-tax earnings have risen to $6,501,000, a net increase of $561,000 over the original $5,940,000 in Figure 10–2. As a consequence, earnings per share rose 56 cents above the original $5.94, an increase of almost 10 percent. By more than offsetting the total after-tax interest cost of the debentures of $759,000, the successfully implemented new investment is projected to boost the common shares’ earnings. Incremental earnings of $1,320,000 ($2 million pretax earnings less tax at 34 percent) significantly exceed the incremental cost of $759,000. Therefore, the investment—if ABC’s earnings assumptions prove real- istic—has made possible an increment of economic value. In effect, the financial leverage introduced with the debt alternative is positive. Yet, several questions might be asked. For example, suppose the investment earned just $759,000 after taxes, exactly covering the cost of the debt supporting it and maintaining the shareholders’ position just as before in terms of earnings per share. Would the investment still be justified? Would this mean that the in- vestment was made at no cost to the shareholders? At first glance, one might believe this, but a number of issues must be con- sidered here. First of all, no mention has been made of the sinking fund obliga- tions which will begin five years hence and which represent a cash outlay of $400,000 per year. Such principal payments are not tax deductible and must be paid out of the after-tax cash flow generated by the company. Thus, debt service (burden coverage) will require 40 cents per share over and above the interest cost of 76 cents per share, for a total of $1.16 per share. The $400,000 will no longer be available for dividends or other corporate purposes, because it is committed to the repayment of debt principal. If we suppose that earnings from the investment exactly equaled the interest cost of the debt, how would the company repay the principal? At what point are the shareholders better off than they were before? There’s an obvious fallacy in this line of discussion. It stems from the use of accounting earnings to represent the benefits of the project and comparing these to the after-tax cost of the debt capital used to finance it. This isn’t a proper eco- nomic comparison, as we pointed out in Chapters 8 and 9. Only a discounted cash flow analysis can determine the true economic cost/benefit trade-off. We could say that the project was exactly yielding the specific cost of the debt capital asso- ciated with it only if the net present value of the project was exactly zero when we discount the incremental annual cash flows at 7.59 percent. This result would then represent an internal rate of return of 7.59 percent, a level of economic performance that would scarcely be acceptable to management. Yet even under that limited condition, the project’s cash flows (as contrasted to the accounting profit recorded in the operating statement) would have to be higher than the $759,000 after-tax earnings required to pay only the interest on the bonds. This must be so because under the present value framework of investment analysis, the incremental cash flows associated with a project must not only pro- vide the specified return but also amortize the investment itself, as we saw in Chapters 7 and 8. hel78340_ch10.qxd 9/27/01 11:30 AM Page 334 [...]... $1,042,000 (before taxes) (1 Ϫ 34) hel78340_ch10.qxd 338 9/27/01 11:30 AM Page 338 Financial Analysis: Tools and Techniques We can directly compare this earnings requirement of about $1.05 million to the alternative bond requirement of $1.15 million and the preferred stock requirement of $1.90 million From both an earnings and a cash-planning standpoint, these amounts and the differences between them are clearly... each line with the horizontal axis, that is, the exact spot where EPS is zero These points can be found easily by working the EPS calculations backward, that is, starting with an hel78340_ch10.qxd 9/27/01 11:30 AM Page 340 340 Financial Analysis: Tools and Techniques F I G U R E 10 6 ABC CORPORATION Recap of EPS Analyses with New Product ($ thousands, except per share figures) Original Debt Preferred... between the subscription price and the market price of the stock We’ll return to determining the value of rights to the investor in Chapter 11 hel78340_ch10.qxd 9/27/01 352 11:30 AM Page 352 Financial Analysis: Tools and Techniques The analytical implications of this alternative are quite similar to those of a public offering, which we assumed to be the case earlier in the chapter The subscription price... cash flow and operational trade-offs that must be weighed in relation to both the company’s capital structure and its business direction It cannot serve as a means of justification for obtaining the asset involved; only economic analysis is the appropriate foundation for adding investments hel78340_ch10.qxd 9/27/01 11:30 AM 354 Page 354 Financial Analysis: Tools and Techniques Summary In this chapter. .. hel78340_ch10.qxd 9/27/01 11:30 AM Page 341 CHAPTER 10 Analysis of Financing Choices 341 F I G U R E 10 8 ABC CORPORATION* Range of EBIT and EPS Chart Original EPS EPS with bonds EPS with preferred EPS with common 7.00 Original level of EPS 6.00 5.94 EPS ($) 5.00 Break-even point: Common and preferred (at $8.76 million EBIT and $4.53 EPS) 4.00 3.00 2.50 2.00 Dividends per share Break-even point: Common and. .. In contrast, the parallel shift by the debt and preferred stock lines to the right of the original line is caused by the introduction of fixed interest or dividend charges, while at the same time the number of common shares outstanding remains constant over the EBIT range studied hel78340_ch10.qxd 342 9/27/01 11:30 AM Page 342 Financial Analysis: Tools and Techniques The significance of the two intersections... calculations one step further and arriving at the so-called uncommitted earnings per share (UEPS) for each alternative after provision for any repayments We simply subtract the per share cost of such repayments (that require after-tax dollars) from hel78340_ch10.qxd 344 9/27/01 11:30 AM Page 344 Financial Analysis: Tools and Techniques the respective EPS of the alternative thus affected, and redraw the lines... equity in various forms The specific risk characteristics of the company and its industry clearly will affect this general result The evidence also shows that the overall cost of capital generally moves in a relatively narrow band between the extremes of hel78340_ch10.qxd 9/27/01 11:30 AM Page 346 346 Financial Analysis: Tools and Techniques TE AM FL Y leverage conditions, usually no more than two percentage... balance sheet directly, even though the hel78340_ch10.qxd 348 9/27/01 11:30 AM Page 348 Financial Analysis: Tools and Techniques lease contract usually extends over several periods Instead, if operating leases are material in the cost structure of the company, a footnote disclosing the current and future annual lease totals is required to accompany the financial statements, disclosing the size of this... is often able to use economies of scale in acquiring and servicing the assets that might favorably affect the cost of leasing, as is the case with major equipment leasing companies, for example hel78340_ch10.qxd 9/27/01 11:30 AM 350 Page 350 Financial Analysis: Tools and Techniques In the comparative analysis of the final choice between leasing and ownership we have to weigh such elements as the periodic . pressures, and potential operating inefficiencies. hel78340_ch10.qxd 9/27/01 11:30 AM Page 327 328 Financial Analysis: Tools and Techniques Clearly, company-specific risk (earnings variability) and. stock will add new common shares hel78340_ch10.qxd 9/27/01 11:30 AM Page 329 330 Financial Analysis: Tools and Techniques to the capital structure and thus cause dilution. The ultimate effect. backward, that is, starting with an hel78340_ch10.qxd 9/27/01 11:30 AM Page 339 340 Financial Analysis: Tools and Techniques assumed EPS of zero and deriving an EBIT that just provides for this