Financial Analysis: Tools and Techniques Phần 8 potx

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 CHAPTER 10 Analysis of Financing Choices 335 Let’s now return to the real purpose of this analytical framework. Our analysis isn’t designed to judge the desirability of the investment; we must assume that this has been adequately done by management. Instead, we’re interested only in which alternative form for financing the approved investment is most advanta- geous for the company under the specific circumstances presented. In this context, the impact of each alternative on the company’s earnings is one of several aspects considered when deciding on new funding. In the case of debt, which under normal conditions is the lowest-cost alter- native, we would indeed expect a financial leverage effect in favor of the share- holder. When the project was chosen, it must have met a return standard based approximately on the weighted cost of capital—a return which is far higher than the cost of debt capital alone. In summary, the introduction of debt immediately dilutes earnings per share, but this impact is followed by a boost in earnings per share when the project’s reported accounting earnings exceed the interest cost as reflected in the company’s income statement. Also, the company must allow for the future sinking fund payments from a cash flow planning standpoint, because beginning with the fifth year, 40 cents per share of the company’s cash flow will be committed annually to repayment of principal. It’s generally useful to examine the implications of these facts under a vari- ety of conditions, that is, the risk posed by earnings fluctuations in both the basic business and in the new products’incremental profit contribution, which all along we’ve assumed to be successful. We’ll take such variations into account later. Preferred Stock in the Capital Structure ABC Corporation could also meet its long-term financing needs with an alterna- tive issue of $10 million of preferred stock, at $100 per share, which carries a stated dividend rate of 12.5 percent. For simplicity, we’ll again assume that the net proceeds to the company will be equivalent to the nominal price of $100, after legal and underwriting expenses. Figure 10–4 analyzes the conditions before and after implementation of the new product investment. This time we find a more severe drop in the earnings available for common stock, due to the impact of the preferred dividends of $1.25 million per year. Not only is the stated cost (as well as the specific cost, given that the net proceeds were again at par) of the new preferred stock higher by one full percentage point than the stated cost of the bonds, but also the dividends paid on the preferred stock are not tax deductible under current laws. In fact, we’re dealing with an alterna- tive which costs, in comparable terms, 12.5 percent after taxes versus 7.59 percent after taxes for the bonds. Therefore, the immediate dilution in earnings with the preferred issue is $1.25 per share, or 21 percent, when compared to the initial situation. Over time, as the earnings from the new product are realized, the eventual increase in earn- ings per share amounts to only 7 cents, or a slight improvement of 1.2 percent. hel78340_ch10.qxd 9/27/01 11:30 AM Page 335 336 Financial Analysis: Tools and Techniques The $1.25 million annual commitment of after-tax funds for dividends leaves very little room for any net gain in reported profit from the earnings generated by the investment—which we know are estimated as $2.0 million before taxes and $1,320,000 after taxes. In this situation, the assumed conditions allow for very limited financial leverage. Only little more than a 1 percent rise in earnings per share is achieved over the starting level, whereas the fixed after-tax financing costs have nearly doubled when compared to the bond alternative. Earnings per share would be un- changed if the product were to achieve minimum earnings in the amount of the pretax cost of preferred dividends: ϭ $1,894,000 At that level, the incremental earnings from the new product would just off- set the incremental financing cost—a break-even situation. Note that the sizable earnings requirement of almost $1.9 million is two-thirds larger than the $1,150,000 pretax interest cost with the bond alternative. Common Stock in the Capital Structure A new issue of common stock as the third alternative for raising $10 million has an even more severe impact on earnings. Let’s assume that ABC Corporation will issue 275,000 new shares at a net price to the company of $36.36 after underwrit- $1,250,000 (1 Ϫ .34) FIGURE 10–4 ABC CORPORATION Earnings per Share with New Preferred Stock Issue ($000, 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 . . . . . . . . -0- -0- Earnings before income taxes . . . . . . . . . . . . . . . . . . . 9,000 11,000 Less: Income taxes at 34% . . . . . . . . . . . . . . . . . . . 3,060 3,740 Earnings after income taxes . . . . . . . . . . . . . . . . . . . . 5,940 7,260 Less: Preferred dividends . . . . . . . . . . . . . . . . . . . . 1,250 1,250 Earnings available for common stock . . . . . . . . . . . . . $4,690 $ 6,010 Common shares outstanding (number) . . . . . . . . . . . . 1 million 1 million Earnings per share (EPS) . . . . . . . . . . . . . . . . . . . . . . $4.69 $ 6.01 Less: Common dividends per share . . . . . . . . . . . . 2.50 2.50 Retained earnings per share . . . . . . . . . . . . . . . . . . . . $ 2.19 $ 3.51 Retained earnings in total . . . . . . . . . . . . . . . . . . . . . . $2,190 $ 3,510 Original EPS (Figure 9–2) . . . . . . . . . . . . . . . . . . . . . . $ 5.94 $ 5.94 Change in EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ϫ1.25 ϩ0.07 Percent change in EPS . . . . . . . . . . . . . . . . . . . . . . . . Ϫ21.0% ϩ1.2% hel78340_ch10.qxd 9/27/01 11:30 AM Page 336 TEAMFLY Team-Fly ® CHAPTER 10 Analysis of Financing Choices 337 ers’ fees and legal expenses are met. Such a discount from the current market price of $40 should help ensure successful placement of the issue. The number of shares outstanding thus increases by 27.5 percent over the current 1.0 million shares. Figure 10–5 shows the impact on earnings in the same way as was done for the other two alternatives. We observe that immediate dilution is a full $1.28 per share, a drop of 21.5 percent, which is the highest impact of the three choices analyzed. Common stock, in terms of this comparison, is the costliest form of capital—if only because it results in the greatest immediate dilution in the earnings of current shareholders. Moreover, there also will be an annual cash drain of at least $687,500 in after-tax earnings from the 275,000 new shares, if the current $2.50 annual divi- dend on common stock is maintained. Further, we can project that this cash drain could grow at the historical earnings growth rate of 4 percent per year. This as- sumption will hold if the directors continue their policy of declaring regular cash dividends at a fairly constant payout rate from future earnings that continue grow- ing. For the present, the pretax earnings required to cover the $2.50 per share divi- dend amount to: $2.50 ϫ 275,000 shares ϭ $687,500 (after taxes) ϭ $1,042,000 (before taxes) $687,500 (1 Ϫ .34) FIGURE 10–5 ABC CORPORATION Earnings per Share with New Common Stock Issue ($000, 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 . . . . . . . -0- -0- Earnings before income taxes . . . . . . . . . . . . . . . . . 9,000 11,000 Less: Federal income taxes at 34% . . . . . . . . . . . 3,060 3,740 Earnings after income taxes . . . . . . . . . . . . . . . . . . . 5,940 7,260 Less: Preferred dividends . . . . . . . . . . . . . . . . . . . -0- -0- Earnings available for common stock . . . . . . . . . . . . $5,940 $7,260 Common shares outstanding (number) . . . . . . . . . . 1.275 million 1.275 million Earnings per share (EPS). . . . . . . . . . . . . . . . . . . . . $ 4.66 $ 5.69 Less: Common dividends per share . . . . . . . . . . . 2.50 2.50 Retained earnings per share. . . . . . . . . . . . . . . . . . . $ 2.16 $ 3.19 Retained earnings in total . . . . . . . . . . . . . . . . . . . . . $2,752 $4,072 Original EPS (Figure 9–2). . . . . . . . . . . . . . . . . . . . . $5.94 $ 5.94 Change in EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ϫ1.28 Ϫ0.25 Percent change in EPS. . . . . . . . . . . . . . . . . . . . . . . Ϫ21.5% Ϫ4.2% hel78340_ch10.qxd 9/27/01 11:30 AM Page 337 338 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 re- quirement of $1.90 million. From both an earnings and a cash-planning stand- point, these amounts and the differences between them are clearly significant. The effect of immediate dilution of earnings is only part of the considera- tion. There will be the second-stage effect of continuing dilution, because in con- trast to the other two types of capital, the new common shares created represent an ongoing residual claim on corporate earnings on a par with that of the existing shares. Thus, the rate of growth in earnings per share experienced to date will be slowed in the future, merely because more shares will be outstanding—unless, of course, the earnings provided by the investment of the proceeds are superior in level and potential growth to the existing earnings performance. When we turn to the second column of Figure 10–5, it’s apparent that de- spite the incremental earnings from the new product, a net dilution of earnings per share in the amount of 25 cents, or 4.2 percent, will in fact continue. The contri- bution of the new product to reported earnings wasn’t sufficient to meet the earn- ings claims of the new shareholders and maintain the old per share earnings level. The negative impact on earnings of the common stock alternative thus is greater than the earnings generated by the new capital raised. Up to this point, we’ve dealt with the earnings impact of common stock fi- nancing. To find a first rough approximation of the specific cost of this alternative, we can establish as a minimum condition the maintenance of the old earnings per share level, and relate this to the proceeds from each new share of common stock. The current EPS of $5.94 (Figure 10–2) and the proceeds of $36.36 result in a cost of about 16 percent. ϭ 16.34% (after taxes) Recall from the discussion in Chapter 9, however, that using accounting earnings in measuring the cost of common equity is not appropriate. If we employ the dividend approach to find the specific cost of the incremental common stock, as discussed in Chapter 8, we must relate the current dividend per share to the net price received, and add prospective dividend growth. We know that the company has experienced fairly consistent growth in earnings of 4 percent per year, and we’ll assume that, given a constant rate of dividend payout, common dividends will continue to grow at the same rate. The result is a cost of about 11 percent: ϩ 4.0% ϭ 10.9% As we stated in Chapter 8, however, the dividend approach is limited in concept and usefulness. Therefore, let’s now use the background data provided to test the specific cost of capital for ABC’s common equity with the CAPM ap- proach explained in Chapter 9. $2.50 $36.36 $5.94 $36.36 hel78340_ch10.qxd 9/27/01 11:30 AM Page 338 CHAPTER 10 Analysis of Financing Choices 339 The resulting cost of common equity, k e , is approximately 13.25 percent when we put into the CAPM formula the risk-free return R f of 6.5 percent, the ␤ of 0.9, and the expected average return R m represented by the S&P 500 estimate of 14 percent: k e ϭ R f ϩ ␤ (R m Ϫ R f ) k e ϭ 6.5 ϩ 0.9 (14.0 Ϫ 6.5) ϭ 13.25% This result is the most credible one for judging the specific cost of the com- mon stock. It can be compared to the specific cost of the bonds of 7.59 percent, and that of the preferred stock of 12.5 percent. Clearly, the common equity alternative is the most expensive source of financing, and we have already established that the dilution effect is also serious. In addition, the cash flow requirements for paying the current dividend of $2.50 per share plus any future increases in the common dividend have to be planned for. Because it’s difficult to keep all of these quantitative aspects visible in our de- liberations, let’s turn to a graphic representation of the various earnings and dilu- tion effects to compare the relative position of the three alternatives. Range of Earnings Chart We’ve referred several times to changes in the earnings performance of the com- pany and the different impact the three basic financing alternatives have under varying conditions. The static format of analysis we’ve used so far doesn’t read- ily allow us to explore the range of possibilities as earnings change, or to visual- ize the sensitivity of the alternative funding sources to these changes. It would be quite laborious to calculate earnings per share and other data for a great number of earnings levels and assumptions. Instead, we can exploit the direct linear rela- tionships that exist between the quantitative factors analyzed. A graphic break-even approach can be used to compare the earnings impact of alternative sources of financing. In this section, we’ll show how such a model, keyed to fluctuations in EBIT and resulting EPS levels, can be employed to display important quantitative aspects of the relative desirability of the choices available. As we’ll see, the break-even model allows us to perform a variety of analytical tests with ease. To begin with, we’ve summarized the data for ABC Corporation in Figure 10–6. Variations in these data can then be displayed graphically in a simple break- even chart which shows earnings per share (EPS) on the vertical axis and EBIT on the horizontal axis. This EBIT chart allows us to plot on straight lines the EPS for each alternative under varying conditions, and to find the break-even points between them. Commonly, one of the reference points is the intersection of 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 339 340 Financial Analysis: Tools and Techniques assumed EPS of zero and deriving an EBIT that just provides for this condition. The calculation is shown in Figure 10–7 for the original situation and for each of the three alternatives. The data in Figures 10–6 and 10–7 give us sufficient points with which to draw the linear functions of EPS and EBIT for the various alterna- tives, as shown in Figure 10–8. FIGURE 10–6 ABC CORPORATION Recap of EPS Analyses with New Product ($ thousands, except per share figures) Original Debt Preferred Common EBIT . . . . . . . . . . . . . . . . . . . . . $9,000 $11,000 $11,000 $11,000 Less: Interest. . . . . . . . . . . . . -0- 1,150 -0- -0- Earnings before taxes . . . . . . . . 9,000 9,850 11,000 11,000 Less: Taxes at 34%. . . . . . . . 3,060 3,349 3,740 3,740 Earnings after taxes . . . . . . . . . 5,940 6,501 7,260 7,260 Less: Preferred dividends . . . -0- -0- 1,250 -0- Earnings available for common stock . . . . . . . . . . . . $5,940 $6,501 $6,010 $ 7,260 Common shares outstanding (number) . . . . . . . . . . . . . . . . 1 million 1 million 1 million 1.275 million Earnings per share (EPS) . . . . . $5.94 $6.50 $6.01 $ 5.69 Less: Common dividends per share . . . . . . . . . . . . . . . 2.50 2.50 2.50 2.50 Retained earnings per share. . . $3.44 $4.00 $3.51 $3.19 Retained earnings in total . . . . . $3,440 $4,001 $3,510 $ 4,072 Change from original EPS. . . . . Ϫ12.8% Ϫ21.0% Ϫ21.5% Final change in EPS . . . . . . . . . ϩ9.4% ϩ1.2% Ϫ4.2% Specific cost . . . . . . . . . . . . . . . 7.59% 12.5% 13.25% FIGURE 10–7 ABC CORPORATION Zero EPS Calculation ($ thousands, except per share figures) Original Debt Preferred Common EPS . . . . . . . . . . . . . . . . . . . . . . -0- -0- -0- -0- Common shares . . . . . . . . . . . . 1 million 1 million 1 million 1.275 million Earnings to common . . . . . . . . . -0- -0- -0- -0- Preferred dividends . . . . . . . . . . -0- -0- $1,250 -0- Earnings after taxes . . . . . . . . . -0- -0- 1,250 -0- Taxes at 34%. . . . . . . . . . . . . . . -0- -0- 644 -0- Earnings before taxes . . . . . . . . -0- -0- 1,894 -0- Interest . . . . . . . . . . . . . . . . . . . -0- $1,150 -0- -0- EBIT for zero EPS. . . . . . . . . . . -0- $1,150 $1,894 -0- hel78340_ch10.qxd 9/27/01 11:30 AM Page 340 CHAPTER 10 Analysis of Financing Choices 341 We can quickly observe that the conclusions about the earnings impact of the alternatives we drew from the two EBIT levels previously analyzed, $9 mil- lion and $11 million, hold true over the fairly wide range of earnings presented. That is, every alternative considered causes a significant reduction in earnings per share relative to the original condition. There’s a major new observation, however. Under the common stock al- ternative, the slope of the EPS line is different. In fact, the line for common stock intersects both the debt and the preferred stock lines at different points in the graph. The latter two lines are parallel with each other and also with the line representing the original situation, both appearing to the right of the original line. The lesser slope of the common stock line is easily explained. Introducing new shares of common stock results in a proportional dilution of earnings per share at all EBIT levels. As a consequence, the incremental shares cause earn- ings per share to rise less rapidly with growth in EBIT. In contrast, the parallel shift by the debt and preferred stock lines to the right of the original line is caused by the introduction of fixed interest or dividend charges, while at the same time the number of common shares outstanding remains constant over the EBIT range studied. FIGURE 10–8 ABC CORPORATION* Range of EBIT and EPS Chart *This diagram is available in an interactive format (TFA Template)—see “Analytical Support” on p. 354. EPS ($) Original EPS EPS with bonds EPS with preferred EPS with common 7.00 6.00 5.94 5.00 4.00 3.00 2.50 2.00 1.00 Original level of EPS Dividends per share Break-even point: Common and preferred (at $8.76 million EBIT and $4.53 EPS) Break-even point: Common and bonds (at $5.32 million EBIT and $2.75 EPS) (old) (new) EBIT ($ millions) 0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 hel78340_ch10.qxd 9/27/01 11:30 AM Page 341 342 Financial Analysis: Tools and Techniques The significance of the two intersections should now become apparent. They are break-even points at which, for a given EBIT level, the EPS for the com- mon stock alternative and one of the other two alternatives are the same. Note that the break-even point of common stock line with the bond alternative occurs at about $5.3 million EBIT, while the break-even point of common stock with pre- ferred stock occurs at about $8.8 million EBIT. Below about $5.0 million EBIT, therefore, the common stock alternative causes the least EPS dilution, while above $9 million EBIT, it causes the worst relative dilution in EPS. Recall that ABC’s current EBIT level is $9.0 million, and is expected to be at least $11 million once the new product is fully contributing its projected earnings. Both break-even points thus lie below the likely future EBIT performance, which makes the common stock alternative the costliest in terms of earnings dilution. Therefore, it’s not possible to assess the three alternatives without first defining a “normal” range of EBIT for the company’s expected performance, given that relative earnings effects of the three alternatives are different over the wide range of EBIT shown. If future EBIT levels could in fact be expected to occur fairly well within the two break-even points, common stock looks more attractive than preferred stock from the standpoint of EPS dilution, but worse than debt. If EBIT can be expected to grow and move fairly well to the right of the sec- ond break-even point, as is almost certain in the case of ABC Corporation, new common stock is not only least attractive from the standpoint of EPS dilution, but will remain so. All of these considerations depend, of course, on unchanging assumptions about the terms under which the three forms of incremental capital could be issued. If we can expect any of these terms to change significantly, such as the offering price of the common stock, or the terms of the bond, an entirely new chart must be drawn up, or we must at least reflect any possible discontinuities in cost or proportions of the alternatives as EBIT levels change. The intersections between the EPS lines that represent the EBIT break-even points for the common stock alternative with the other two choices can be calcu- lated easily. For this purpose, we formulate simple equations for the conditions underlying any intersecting pair of lines. EPS are then set as equal for the two alternatives, and the equations are solved for the specific EBIT level at which this condition holds. To illustrate, let’s first establish the following definitions: E ϭ EBIT level for any break-even point with the common stock alternative. i ϭ Annual interest on bonds in dollars (before taxes). t ϭ Tax rate applicable to the company. d ϭ Annual preferred dividends in dollars. s ϭ Number of common shares outstanding. hel78340_ch10.qxd 9/27/01 11:30 AM Page 342 [...]... periods) 3 .80 % 3 .85 3.90 3.95 4.00 4.05 4.10 4.15 4.20 4.25 1.224 1.2 18 1.212 1.206 1.201 1.195 1. 189 1. 184 1.1 78 1.173 043 284 559 86 8 210 585 993 434 9 08 414 1.230 1.224 1.2 18 1.212 1.207 1.201 1.195 1. 189 1. 184 1.1 78 661 709 793 913 0 68 260 486 747 043 374 1.237 1.231 1.224 1.2 18 1.212 1.206 1.200 1.194 1. 189 1. 183 155 012 907 84 1 81 2* 82 1 86 8 952 073 230 1.243 1.237 1.230 1.224 1.2 18 1.212 1.206... Click Here for Terms of Use hel 783 40_ch11.qxd 9/27/01 11:31 AM 3 58 Page 3 58 Financial Analysis: Tools and Techniques cash flows and the creation of economic value is the ultimate expression of success or failure of business decisions on investment, operating, and financing Recognition of this linkage spurred the wave of takeovers and restructuring activities of the 1 980 s—essentially a reassessment of... semiannually Total Cash Flow 28 receipts of $30 over 14 years ( 28 periods) Receipt of principal 14 years hence ( 28 periods) Totals *From Table 7–II and 7–I (end of Chapter 7), respectively $ 84 0 1,000 $1 ,84 0 Present Value Factors, 4 Percent* 16.663 (ϫ $30) 0.333 Present Value $499 .89 333.00 $83 2 .89 hel 783 40_ch11.qxd 9/27/01 11:31... 21. 281 (ϫ $30) $ 6 38. 43 0.574 574.00 $1,212.43 hel 783 40_ch11.qxd 9/27/01 11:31 AM Page 366 366 Financial Analysis: Tools and Techniques Bond Yields TE AM FL Y A related but common task for the analyst or investor is the calculation of the yield produced by various bonds, when quoted prices differ from par value The key to this analysis again is the relationship of value and yield as discussed above, and. .. the balance sheet directly, even though the hel 783 40_ch10.qxd 3 48 9/27/01 11:30 AM Page 3 48 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... shortcut will always introduce some error, because it imperfectly simulates what is in fact a progressive present value structure As yield rates and the number of time periods increase, larger hel 783 40_ch11.qxd 9/27/01 11:31 AM 3 68 Page 3 68 Financial Analysis: Tools and Techniques errors will result Yet the rough calculation provides a satisfactory result for use as an initial analytical check Had a premium... 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 hel 783 40_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... is financially able to pay as the amount becomes due F I G U R E 11–2 Bond Valuation with Lower Return Standard (4 percent per year) Total Cash Flow 28 receipts of $30 over 14 years ( 28 periods) Receipt of principal 14 years hence ( 28 periods) Totals *From Tables 7–II and 7–I (end of Chapter 7), respectively $ 84 0 1,000 $1 ,84 0... Ϫ10 ,88 0 Ϫ10 ,88 0 Ϫ11,520 9,146 15,674 11,194 7,994 5,715 5,715 Ϫ3,430 Operating cash outflows 0 Ϫ454 6,074 954 Ϫ2,246 Ϫ5,165 Present value factors @ 12% Present values of equipment cash flows Present values of operating cash flows 1.000 0 .89 3 0.797 0.712 0.636 0.567 0.507 Ϫ100,000 0 0 0 0 0 0 2,011 0 Ϫ406 4 ,84 1 679 Ϫ1,429 Ϫ2,9 28 Ϫ2,619 Ϫ6,7 58 Ϫ406... 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 hel 783 40_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 . percentages (14.29%; 24.49%; 17.49%, 12.49%; 8. 93%; 8. 93%; 8. 93%; 4.45% residual). hel 783 40_ch10.qxd 9/27/01 11:30 AM Page 349 350 Financial Analysis: Tools and Techniques In the comparative analysis. . . . . Ϫ1. 28 Ϫ0.25 Percent change in EPS. . . . . . . . . . . . . . . . . . . . . . . Ϫ21.5% Ϫ4.2% hel 783 40_ch10.qxd 9/27/01 11:30 AM Page 337 3 38 Financial Analysis: Tools and Techniques We. calculations backward, that is, starting with an hel 783 40_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