Chapter 13 Capital Structure Basics

Chapter 13 Capital Structure Basics Overview: This chapter examines how fixed costs affect the volatility of a firm s operating and net income. Fixed costs in operations create operating leverage and fixed interest expense from debt obligations creates financial leverage. Operating leverage provides the potential for increases in sales to result in greater increases in operating income, but it also increases the risk of variation in operating income. Financial leverage further increases fluctuations in net income. The use of leverage to finance leveraged buyouts (LBOs) is considered as well as the impact of capital structure on firm value. What You Should Know From This Chapter: 1. Define capital structure: Capital structure is the mixture of funding sources (debt, preferred stock, or common stock) that a firm uses to finance its assets. A central question in finance is what blend of these financing sources is best for the firm. That is, how much of a firm s assets should be financed by borrowing? How much should be financed by preferred stockholders? How much should be financed by the common stockholders? The question is important because each of these financing sources has a different cost, as you learned in Chapter 12, and each of them has a different degree of risk. Therefore, the choice of financing directly affects a firm s weighted average cost of capital and the degree of riskiness in the firm. 2. Explain operating, financial, and combined leverage effects and the resulting risks: Firms with high fixed costs have high operating leverage. An increase in sales will generally cause such firms to experience a greater increase in operating income; a decrease in sales will cause the firm to experience a greater decrease in operating income. The formula used to measure the degree of operating leverage is: DOL = % ΔEBIT % ΔSALES or SALES VC SALES VC FC 164

Business risk refers to the volatility of a company s operating income. Business risk is related to the volatility of a firm s sales, which depends on the line of business and economic conditions. However, greater operating leverage magnifies the business risk. If a firm uses debt in its capital structure and is obligated to make fixed interest payments, financial leverage is created. The impact of financial leverage is similar to that of operating leverage: it magnifies the effect on net income of changes in sales. Firms with high leverage are riskier since there is a greater likelihood that they might not be able to make their payments in the event of a business downturn. The equation used to measure the degree of financial leverage is: DFL = % ΔNI EBIT or EBIT % Δ EBIT I The total effect of operating leverage and financial leverage is called combined leverage, which given by: DCL = DOL x DFL. The impact that each type of leverage has on the firm s earnings is given by: %Δ EBIT = %Δ SALES x DOL %Δ NI = %Δ EBIT x DFL %Δ ΝΙ = %ΔSALES x DOL x DFL 3. Find the breakeven level of sales for a firm: Firms generally have both fixed costs (FC) and variable costs (VC) in their operations. Fixed costs are those that do not change as the number of units produced increases and include costs such as building rent and utilities. Variable costs vary directly with units produced and include the costs of raw materials used in production and the cost of hourly labor. The sales breakeven point is the level of sales that a firm must reach to cover both types of costs; i.e., the sales level that will cause operating income to be zero. The formula used to calculate the breakeven point in unit sales at price p is: Q be..= FC p vc Firms with high fixed costs (FC) relative to variable costs (VC) will have higher breakeven points than firms that have more variable costs and lower fixed costs. 165

4. Describe the risks and returns of a leveraged buyout: Leverage buyouts (LBOs) are when one firm uses mostly debt financing to buy out another firm. The purchase is highly leveraged in that the buyers are not putting up much money on their own but have borrowed from another source to pay for the firm. If the buying firm is able to turn the company around so that its value rises, they will have been able to make a large return on a very small equity investment. However, they are in a very risky position since they are beginning their operations with a highly leveraged financial structure. 5. Explain how changes in capital structure affect a firm s value: An important question in finance is whether the debt and equity mix chosen by a firm has an impact on the firm s value. Capital structure is the mixture of sources of funds that a firm uses (debt, preferred stock, and common stock). Although the amount of operating leverage is mostly a function of the type of business, the degree of financial leverage depends on the degree to which the firm is financed with debt. When firms borrow money, they increase financial leverage and the risk of the firm. Although Modigliani and Miller argued that the value of the firm was independent of capital structure under some restrictive assumptions, in practice there are several factors that make capital structure an important factor in the value of the firm. First, debt creates the potential for leveraged increases in net income since interest paid on debt is tax deductible and dividends paid to shareholders are not. This benefit must be balanced against the increased risk associated with fixed financial costs. As risk increases, all suppliers of capital will require a higher rate of return. The optimal mix of debt and equity will therefore balance the leverage benefits from the tax deductibility against the increased risk of higher debt usage. 166

Terminology and Concept Review 13-1. costs are those costs that do not vary with the company s level of production. 13-2. Costs that change as the company s production levels change are called costs. 13-3. A sales chart shows graphically how fixed costs, variable costs, and sales revenue interact. 13-4. A measure of the magnitude of the effect of fixed costs on operating income is. 13-5. Whenever fixed costs are greater than, the degree of operating leverage is greater than 1. 13-6. Firms that have low fixed costs and high variable costs are generally risk than firms that have high fixed costs and low variable costs, but they will also have profit potential. 13-7. is the additional volatility of net income caused by the presence of fixed costs associated with having debt in the capital structure. 13-8. Firms that have higher proportions of debt in their capital structure will have financial leverage. 13-9. The total effect of operating and financial leverage is called leverage. 13-10. A is when one firm buys out another using a large amount of borrowed money. 13-11. Higher leverage is helpful when sales. 13-12. is the mixture of sources of funds that a firm uses (debt, preferred, and common). 13-13. One of the primary advantages of using debt financing is. 13-14. The weighted average cost of capital generally as more capital is added. 167

13-15. Modigliani and Miller suggested that if debt costs did not increase with additional borrowing, the tax deductibility benefit would imply that firms should finance with percent debt. 13-16. Financial managers use capital structure theory to help determine the mix of debt and equity that the weighted average cost of capital. 13-17. Bonds pay a lower rate of return to investors because investors have lower. 168

Problems and Short-Answer Questions 13-18. What are the risks and benefits of having fixed costs in your operations? 13-19. What are the risks and benefits of having debt in your capital structure? 13-20. Under what circumstances will high combined leverage be most beneficial to a company? 13-21. What was the main contribution made by Modigliani and Miller, and why doesn t their model work in practice? 169

Use the following information to answer questions 13-22 through 13-30: The Funky Ties Company sells novelty neckties for men. They have variable costs per tie of $5.00 and fixed costs of $500 per week. Funky sells the ties for $20 each and sells 3,000 ties per year. 13-22. Calculate Funky s total revenue. 13-23. Calculate Funky s total costs. 13-24. Calculate Funky s breakeven point in unit sales. 13-25. Calculate Funky s earnings before interest and taxes (EBIT). 13-26. If Funky only sells the breakeven number of ties, what is its operating income? 170

13-27. Calculate the degree of operating leverage for a 10% change in sales. 13-28. If Funky has financed partially with debt and has annual interest cost of $1,000, what is its degree of financial leverage? 13-29. What is Funky s degree of combined leverage? 13-30. If Funky has 20% higher sales than expected, by what percentage will net income change? If the sales are 20% lower than expected? 13-31. Wyman Incorporated estimates that it will sell 9,000 widgets in the coming year. The variable cost per widget is $30. Fixed costs associated with the widgets will total $180,000. What is the breakeven price? 171

13-32. In Problem 13-31, if Wyman plans to price the widgets at $60 each, what is the breakeven point in unit sales? 13-33. American Beauty Contractors has operating income (EBIT) of $160,000 and interest expense of $20,000. One of their competitors, Kitchens Unlimited, has operating income of $160,000 and interest expense of $40,000. Calculate the degree of financial leverage for each firm. 13-34. If the economic climate caused a sharp downturn in the demand for contractors services so that they each experienced a 25% decline in operating income, how would the financial leverage affect their net income? 172

Answers 13-1. Fixed (Page 391) 13-2. Variable (Page 391) 13-3. Sales breakeven (Page 391) 13-4. Degree of operating leverage (Page 384) 13-5. Zero (Page 385) 13-6. Higher; higher (Page 387) 13-7. Financial leverage (Page 387) 13-8. Greater (Page 387) 13-9. Combined (Page 389) 13-10. Leveraged buyout (LBO) (Page 398) 13-11. Increase (Page 391) 13-12. Capital structure (Page 383) 13-13. The tax deductibility of interest (Page 399) 13-14. Rises (Page 400) 13-15. 100 (Page 399) 13-16. Minimizes (Page 400) 13-17. Risk (Page 400) 13-18. Fixed costs in your operations will cause EBIT to rise by a larger percentage than sales when unit sales are increasing. However, if unit sales decline, the firm s EBIT will decrease by a greater percentage than does sales. (Page 384) 13-19. Since financial leverage has two major advantages related to the cost of capital. Because interest payments are deductible, the after-tax cost of this type of financing is cheaper to the firm. Furthermore, since debt is less risky to investors, they generally demand a lower return on their investment. These two factors combine to make debt financing cheaper than equity financing. However, since debt providers are generally promised regular interest payments, higher debt financing creates financial leverage. The fixed interest payments cause a magnifying effect similar to other fixed costs. If unit sales are increasing, higher leverage will cause EBIT to increase by a larger percentage than sales, but when unit sales are decreasing, EBIT will decrease at a faster rate. (Page 389) 13-20. High combined leverage will be most beneficial when a firm is experiencing increasing sales and has a low cost of debt. (Page 389) 13-21. Under some relatively restrictive assumptions, M&M showed that the taxdeductibility of debt makes it so beneficial to firms that they would choose to finance entirely with debt. While this is impossible, of course, the main reason that it doesn t work in practice is that M&M assumed that the weighted average cost of capital would not change as the debt ratio increased. In fact, we know that higher leverage is viewed as being more risky by investors and so the firm s managers must balance the benefits of debt against the greater risk. (Page 399) 13-22. Total Revenue = $20 x 3,000 = $60,000 (Page 392) 173

13-23. Total Costs = ($500 x 52) + ($5 x 3,000) = $41,000 (Page 392) 13-24. Breakeven Point in Unit Sales = $26,000/($20-$5) = 1,733 ties (Page 392) 13-25. $60,000 $41,000 = $19,000 (Page 384) 13-26. 0 (Page 384) 13-27. EBIT (10% increase) = ($20 x 3,300) [$26,000 + ($5 x 3,300)] = $23,500 % change in EBIT = ($23,500 $19,000)/ 19,000 = 23.7% Degree of Operating Leverage = 23.7%/10% = 2.37 (Page 384) 13-28. DFL = $19,000/($19,000 $1,000) = 1.055 (Page 387) 13-29. DCL = DOL x DFL = 2.37 x 1.055 = 2.5 (Page 390) 13-30. % Δ NI = % Δ Sales x DCL = +20% x 2.5 = +50% -20% x 2.5 = -50% (Page 390) 13-31. Q b.e. = FC/(p - vc) p = [FC/Q be ] +vc = [$180,000/$9,000] + $30 = $50 (Page 393) 13-32. Q b.e. = $180,000/($60-$30) = 6,000 widgets (Page 393) 13-33. American Beauty: DFL = $160,000/($160,000-$20,000) = 1.14 Kitchens Unlimited: DFL = $160,000/($160,000-$40,000) = 1.33 (Page 387) 13-34. American Beauty: % Δ NI = % Δ Sales x DFL = -25% x 1.14 = -28.50% Kitchens Unlimited: % Δ NI = % Δ Sales x DFL = -25% x 1.33 = -33.25% (Page 387) 174

Overview: Chapter 14 Corporate Bonds, Preferred Stock, and Leasing This chapter takes the valuation techniques learned in Chapter Twelve and shows how the financial manager uses the information to make decisions about the firm s financing decisions. The student is introduced to convertible bonds, the pros and cons of leasing, variable rate bonds, junk bonds, and other forms of debt and equity instruments. What You Should Know From This Chapter: 1. Describe the contract terms of a bond issue: A corporate bond is the security that represents a promise by the issuing company to make certain payments to the holder of the bond. The indenture is the contract that spells out the terms of the bond issue including the face value, coupon interest rate, interest payment dates, maturity date, and other details. A call provision gives the issuer the option to buy back the bonds before the scheduled maturity date. This is beneficial to the issuer if current interest rates on comparable debt have fallen below the coupon interest rate. Issuing new bonds to replace old bonds is called bond refunding, and that decision must weigh the benefits of lower interest against the cost of retiring the old debt and issuing the new debt. Restrictive covenants may include limits on future borrowings by the issuer, minimum working capital levels that must be maintained, and restrictions on dividends paid to common stockholders. 2. Distinguish the various types of bonds and describe their major characteristics: All bonds are debt instruments that give the holder a liability claim on the issuer. A mortgage is a bond secured by real property. A debenture is an unsecured bond. A convertible bond is convertible, at the option of the bondholder, into a certain number of shares of common stock (sometimes preferred stock or another security). The conversion value is the money a bond owner receives if he or she converts the bond and sells the stock. Conversion Value = Conversion Ratio x Stock Price 175

A variable-rate bond has a coupon interest rate that is not fixed but is tied to a market interest rate indicator. A callable bond can be repurchased by the issuer at its option. A putable bond can be cashed in by the bondholder before maturity. Bonds that have below-grade investment rating are junk bonds. An international bond, a bond sold in a country other than the country of the corporate headquarters of the issuing company, differs from a Eurobond. A Eurobond is a bond denominated in the currency of the issuing company s home country and sold in another country. A super long-term bond is one that matures in one hundred years. 3. Describe the features of preferred stock: Preferred stock is a hybrid security that has debt and equity characteristics. Preferred stockholders have a superior claim relative to the common stockholders to a firm s earnings and assets, and their dividend payments are usually fixed. Those traits resemble debt. In addition, preferred stock has an infinite maturity and lower priority claim to assets and earnings than bondholders. These traits resemble equity. If a dividend is missed in a given year (due to insufficient earnings), cumulative preferred stockholders must be paid back dividends in later years before any distributions can be made to common stockholders. If preferred stock is non-cumulative, missed dividends will never be received. Corporations can exclude 70 percent of preferred stock dividend income from taxable income. This tax exclusion implies that corporations are much more likely to invest in preferred stock of other corporations than individuals. 4. Compare and contrast a genuine lease and a disguised purchase contract: A lease is an arrangement where the owner of an asset contracts to allow another party the use of the asset over time. Because lease payments are entirely tax deductible for businesses, many attempt to disguise purchase contracts as genuine leases. In order for the lease to be genuine, the lessee (the party to whom the asset is leased) cannot have an effective ownership of the asset. The IRS has six standards that a lease must meet to qualify for the lease tax deductions. Failure to comply with IRS rules will result in the less favorable tax treatment of a purchase contract. 5. Explain why some leases must be shown on the balance sheet: Operating leases are usually short-term and cancelable. Financial (capital) leases are long-term and non-cancelable. Both operating and financial leases appear on the income statement of the lessee because the lease payments are taxdeductible business expenses. Because financial leases are functionally equivalent to a purchase financed with debt, FASB rules require that businesses treat them similarly for accounting purposes. Financial leases, therefore, appear 176

on the balance sheet in both the asset and liability sections. The decision to lease or to borrow and purchase an asset can be made by comparing the present value of the cash flows associated with each alternative. 177

Terminology and Concept Review 14-1. Which has a higher priority of claim: Senior Debentures or a second mortgage bond? 14-2. The is the number of shares of common stock that an investor would get if the convertible bond were converted. 14-3. are the promises made by the issuer to the bond investor. 14-4. The excess of the call price over the face value of the bond is known as the. 14-5. The is the name of the contract between the issuing corporation and the bond s purchaser. 14-6. A debenture is. 14-7. Bonds rated below investment grade are referred to as. 14-8. When the initial coupon rate on a bond is adjusted according to an established timetable and a market rate index, it is said to be a. 14-9. With respect to a lease, the is the party who uses the asset and the is the party who owns the asset. 14-10. The lease is long-term and the lease is short term and cancelable. 14-11. The sinking fund is. 14-12. Another name for staggered maturities is. 14-13. Issuing new bonds to replace old bonds is known as a operation. 14-14. The conversion value of a bond equals. 14-15. The straight bond value is. 178

Problems and Short-Answer Questions 14-16. You have invested in a semiannual coupon convertible bond that has a conversion ratio of 15. The market price of the company s stock is $45 per share. The face value of the bond is $1,000 with a coupon rate of 7.5%. The bond is due in 15 years and similar non-convertible bonds are yielding 10% YTM. Calculate the straight bond value of this bond. 14-17. Use the same data from problem 14-16 and assume annual coupon payments. Calculate the straight bond value of this bond. 14-18. Using the same data from problem 14-16, calculate the conversion value of the convertible bond. 14-19. If the conversion value of a convertible bond is $1,200 and the market price of the stock is $60 per share, calculate the conversion ratio. 14-20. If the conversion value of a convertible bond is $1,000 and the conversion ratio is 50, calculate the market price per share of the stock. 14-21. A company issued 10,000 bonds eight years ago with a par value of $1,000 each. The annual coupon rate is 9% and the bonds are callable after five years. This year the market yield on the company s bond is 7.5%. What would be the annual savings in interest payments of the company should they choose to finance a call through a refunding operation? 179

14-22. Should a company always refund if interest rates are lower? Explain. 14-23. You have invested in a $1,000 par, 15-year semiannual coupon convertible bond with a coupon rate of 8% and a conversion ratio of 25 that was issued by a company five years ago. What is the conversion value of your investment if the current market price of the company s common stock is $25 per share? 14-24. Using the information from question 14-23, if the current required yield to maturity on similar nonconvertible bonds is 9%, should you convert? 14-25. Company Zeroite is in bankruptcy. The company has the following liability and equity claims: Senior Debentures 1st Mortgages Common Stock Subordinated Debentures 2nd Mortgages $ 5 million 10 million 5 million 8 million 10 million Assets have been sold for a total value of $30 million. According to priority of claims, determine the distribution of the $30 million obtained from the sale proceeds. 180

14-26. What are decision rules used for a lease or buy choice? 14-27. Describe the differences between a capital and an operating lease. 14-28. You have invested in a $1,000 par, 10-year semiannual coupon convertible bond with a 6% coupon rate and a conversion ratio of 15 issued by a company five years ago. What is the conversion value of your investment if the current market price of the company s common stock is $75 per share? 14-29. Using the information from question 14-28, if the current required yield to maturity on similar nonconvertible bonds is 5%, should you convert? 14-30. Why are junk bonds sometimes called fallen angels? 181

Answers 14-1. Second mortgage (Page 422) 14-2. Conversion ratio (Page 424) 14-3. Restrictive covenants (Page 421) 14-4. Call premium (Page 418) 14-5. Indenture (Page 416) 14-6. A bond that does not pledge any specific assets as security (Page 422) 14-7. Junk bonds (Page 426) 14-8. Variable rate bond (Page 425) 14-9. Lessee; lessor (Page 428) 14-10. Financial; operating (Page 429) 14-11. A provision included in the bond s indenture whereby the issuing company makes regular contributions to a fund that is used to buy back outstanding bonds. (Page 417) 14-12. Serial payments (Page 418) 14-13. Refunding (Page 418) 14-14. Conversion ratio times the market price of the stock (Page 424) 14-15. The sum of the present values of the bond s interest and principal payments. (Page 4125) 14-16. PVIFA x PMT + par value/pvif = 15.372 x 37.50 + 1000/4.32 = $807.83; Calculator: PMT = 37.50, FV = 1000, N=30, I=5, Solve for PV=$807.84 (Page 425) 14-17. PVIFA x PMT + par value/pvif = 7.606 x 75 + 1000/4.177 = $809.84 Calculator: FV = 1000, PMT = 75, N=15, I=10, Solve for PV = $809.85 (Page 425) 14-18. Conversion ratio x market price = conversion value 15 x $45 = $675 (Page 424) 14-19. Market price/conversion value = conversion ratio 1200/60 = 20 (Page 424) 14-20. Conversion value/conversion ratio = market price 1000/50=20 (Page 424) 14-21. 9% 7.5% = 1.5% 10,000 x 1,000 = 10,000,000 x 1.5% = $150,000 (Page 420) 14-22. Firms usually provide a call premium which if high enough could negate any savings from refunding at a lower interest rate. (Page 418) 182

14-23. Conversion ratio x market price = conversion value 25 x $25 = $625 (Page 424) 14-24. Straight debt value = PVIFA x PMT + par value/pvif = 3.008 x 40 + 1,000/2.4117 = $934.96; Calculator: FV= 1000, PMT=40,N=20,I=4.5, Solve for PV = 934.96 Don t convert; the straight bond value is greater than the CV. (Page 424) 14-25. All of the first mortgages, second mortgages, and senior debentures will be paid off; however, only $5 million is left toward the subordinated debentures and nothing is left for the common stockholders. (Page 422) 14-26. You should look at the relative costs of the two alternatives. The alternative that has the lower present value of after-tax costs is usually chosen. Also companies that are likely to see a clear advantage to leasing instead of buying are those that are losing money they pay no taxes. (Page 430) 14-27. An operating lease has a term substantially shorter than the useful life of the asset and is usually cancelable by the lessee. A capital lease is long-term and noncancelable. The lessee uses up most of the economic value of the asset by the end of the lease s term with a financial lease. (Page 429) 14-28. Conversion ratio x market price = conversion value 15 x $75 = $1125 (Page 424) 14-29. Straight debt value = PVIFA x PMT + par value/pvif = 8.752 x 30 = 262.56 + 1,000/1.28 = $1044. Calculator: FV=1000,PMT=30,N=10,I=2.5, Solve for PV = 1043.76 Yes, you should convert as the CV is greater than the SBV. (Page 424) 14-30. These types of junk bonds start out as investment-grade bonds but then suffer a downgrade because the company may have fallen on hard financial times or may have increased the overall risk of the firm in some other manner. They fall from investment grade to junk status as a result. (Page 426) 183

Chapter 15 Common Stock Overview: Common stock is a security that represents an equity claim on a firm. This chapter provides an overview of the characteristics and types of common stock and the ownership rights of common stockholders. It also discusses the pros and cons of issuing stock to raise capital and details the process of issuing stock. Preemptive rights, which protect existing owners from dilution of their equity interest, are also explained, as are warrants that are options issued by the corporations. What You Should Know From This Chapter: 1. Describe the characteristics of common stock: Common stock represents an ownership claim on a corporation. This ownership claim is also referred to as an equity interest. The owners of shares of stock generally have voting rights and are entitled to the residual income of the firm, i.e., the income that is left over after all other claimants of the firm have been paid. This may be paid in the form of a cash dividend, or it can be reinvested in the firm thereby increasing the market value of the common stock. Due to the uncertainty associated with future payments, common stock is considered to be riskier than other claims on the firm and will generally have higher required return. Firms may have more than one class of common stock that differ in dividend payment or in voting rights. For example, target stock may represent a claim only on a particular part of the business and is sometimes used to finance new riskier ventures. Stock may be issued by private (closely held) corporations, but it will not be available for purchase by the general public. Publicly traded corporations issue stock that can be bought or sold by any interested party, and these corporations are subject to Securities Exchange Commission (SEC) reporting and disclosure requirements. Corporations are not managed by the shareholders. Instead, the shareholders elect a board of directors who oversee the management of the company and usually hire professional managers to handle the day-to-day operations of the firm. The directors have a fiduciary duty to act in the best interests of the shareholders. Since many shareholders do not attend meetings, they will usually be asked to give their proxy to another person, thus allowing that person to vote for them at the meeting. The two major types of voting are majority voting and cumulative 184

voting. Under majority voting, each share gets one vote for a given candidate for each contested seat, and the winners are the candidates who get the greatest number of the votes cast for the contested seats. Under cumulative voting, shareholders have one vote per share owned times the number of empty seats and can split the total among the candidates, casting all for one candidate if they want. Candidates do not run for a specific seat. The top vote-getters overall are elected to the board. Under this system, a minority group is more likely to get representation on the board. The formula for determining the number of directors that a stockholder group could elect under cumulative voting, given the number of voting shares they control, is: (SHARES CONTROLLED 1) x (TOT NUM DIR T.B.E. + 1) NUM DIR = TOT NUM VOTING SHARES where NUM DIR is the number of directors to be elected by a given group, SHARES CONTROLLED is the number controlled by a given group, TOT NUM DIR T.B.E. is the total number to be elected, and TOT NUM VOTING SHARES is the total number of voting shares in the election. The number of shares needed to elect a given number of directors under cumulative voting is given by: NUM SHARES = NEEDED NUM DIR DESIRED x TOT NUM VOTING SHARES TOT NUM DIR T. B. E. + 1 + 1 2. Explain the advantages and disadvantages of equity financing: The main disadvantages of equity financing are dilution of ownership, flotation costs of issuing new stock, and the negative signal that new issues give to investors. When new common shares are issued, the existing owners must now share the residual income with a larger number of shareholders, thus diluting their equity interest. This could result in lower returns if the new funds raised have not been invested in projects that will earn enough to provide additional residual income to the firm. In addition, the new shareholders also cause a dilution in voting power. Flotation costs are fees paid to investment bankers, lawyers, accountants, and others when new securities are issued. These costs are usually much higher than for a comparably sized issue of debt. The negative signal of equity financing is due to the belief by investors that managers will not issue equity unless the current price of the stock is favorable to the firm. This will generally be the case when the price is high in relation to what the managers think is justified based on the future prospects for earnings. 185

Therefore, when equity is issued, if investors interpret this as a sign that the managers think the prospects for the firm are bad, their reaction will cause the stock price to fall. The advantages of equity financing are related to the fact that dividends do not have to be paid. Therefore, equity reduces the riskiness of the firm s earnings stream. Some firms avoid debt financing because the cost of borrowing is higher than they are willing to pay. Improved borrowing capacity due to reduction in the debt ratio may make borrowing easier and cheaper in the future. 3. Explain the process of issuing new common stock: Firms can raise new equity capital by selling new stock to existing stockholders or by seeking new outside investors. If a private corporation is expanding rapidly, they may find it necessary to go public with an initial public offering (IPO) and sell stock to outside investors. The first step in selling stock to the public is to contact an investment bank who will handle all the details associated with pricing the stock and marketing it to the public. By law, all potential investors in a new security must be given a prospectus, which is a disclosure document that describes the security and the issuing company in detail. An investment bank usually underwrites the issue, which means that it agrees to purchase the entire issue of stock from the issuing company at a certain price. They will then try to resell the stock to other investors, often in large blocks to institutional investors. If the investment bank does not offer a guarantee, then the agreement is known as best efforts, and it is possible that the firm will not be able to sell the entire issue or will have to reduce the price of the shares to do so. 4. Describe the features of rights and warrants: In order to avoid dilution of ownership from new issues of stock, a firm may give existing common stockholders preemptive rights, also called rights, that allow them to purchase additional shares, often at below market value. Stockholders who do not wish to exercise the rights can sell them on the open market. When a stock is sold to an investor who will be entitled to the right after purchase, the stock is said to be trading rights-on. The value of a right when a stock is trading rights-on, R, is given by: M0 S R = N + 1 where M 0 is the market price of the stock, S is the subscription price, and N is the number of rights needed to purchase one of the new shares of common stock. At the opening of trading on the day following the rights-on period, the stock is said to be trading ex-rights since the buyer of the stock will not be entitled to the rights after purchase. The approximate value of a right when the stock is trading ex-rights is: 186

Mx S R = N where M x is the market price of the stock that is trading ex-rights. Warrants are securities that give the holder the option to buy a certain number of shares of common stock of the issuing company at a certain price, the subscription price, for a specified period of time. Warrants have value only until the expiration date at which time they become worthless. The value of a warrant depends on the difference between the price of the stock and the exercise price, the price that the warrant entitles the holder to buy the stock for. The exercise value of a warrant, XV, is given by: XV = ( M x XP) x # where M is the is the market price of the stock, XP is the exercise price of the warrant, and # is the number of shares that may be purchased if the warrant is exercised. Warrants have high return potential because, if the stock price increases, the value of the warrant increases at a much higher rate due to leverage. The downside risk of a warrant is limited because the maximum loss potential is the price of the warrant. As a result of the high return and low risk, warrants have time value that is greatest when the stock price is volatile and the time to maturity is great. 187

Terminology and Concept Review 15-1. A security that represents an ownership claim on a corporation, including voting rights and the right to residual income of the firm, is called. 15-2. The income of a corporation that is left over after other claimants of the firm have been paid is called. 15-3. Stock that is issued to fund a new line of business for a firm but which gives stockholders a claim only on the new business is called. 15-4. A corporation whose available common stock can be bought by any interested party on the open market is called a corporation. 15-5. A corporation s stock is not traded openly in the marketplace, and this type of corporation does not have to file financial statements with the Securities Exchange Commission. 15-6. The is elected by the common shareholders to represent their interests and oversee the management of the corporation. 15-7. The board of directors of a corporation has a responsibility to the common shareholders. 15-8. A stockholder or group of stockholders that own enough shares to control the board of directors is said to have a interest in the firm. 15-9. Stockholders who cannot make the annual shareholders meeting can allow another person to vote their shares for them by. 15-10. The two different types of voting rules that are used for board of directors elections are voting and voting. 15-11. Three disadvantages of equity financing are,, and. 15-12. An is the issuance of common stock to the public for the first time. 15-13. The Securities Exchange Commission requires that potential investors be given a, a disclosure document that describes the security and the issuing company. 188

15-14. An investment banking firm a stock issue when it agrees to buy a certain number of shares from the issuing company at a certain price. 15-15. A gives the stockholder the option to buy enough additional shares of an issue of common stock to maintain his or her current ownership interest in the firm. 15-16. A is a security that gives its owner the option to buy a certain number of shares from the issuing company at a certain exercise price until a specified expiration date. 189

Problems and Short-Answer Questions 15-17. What are the most important characteristics of common stock? 15-18. How does regulation of publicly held corporations differ from that of private corporations? 15-19. Explain the ownership structure of a typical corporation, including the roles of shareholders, professional managers, and the board of directors. 15-20. What is the role of the investment banking firm in the process of issuing new common stock? 15-21. Why do corporations issue preemptive rights and warrants? 190

15-22. What are the main advantages and disadvantages of issuing common stock? 15-23. Mary owns 2,000 shares common stock in Zed Corporation. The company has 100,000 shares of common stock outstanding. What percent of the firm does Mary own? If the company issues another 20,000 shares and Mary does not buy any, what is her new ownership interest? 15-24. Blue Sky Inc. s stockholders have a disagreement as to how the firm should be managed. The majority group holds 55% of the outstanding stock, and the minority group has 45%. There are 100,000 outstanding shares. There are five positions on the board of directors that are up for reelection in the near future. If the firm follows a majority voting system, how many of these positions can the minority group possibly elect? 15-25. If Blue Sky Inc. in the previous problem followed a cumulative voting system, how many of the open positions could the minority group possibly elect? 191

15-26. The Alpha Corporation has 200,000 shares of common stock currently outstanding. They plan to sell 25,000 more shares of common stock to the existing shareholders through a rights offering. How many rights will it take to buy one share? 15-27. In the previous question, if the current market price of the stock selling rights-on is $27 and the subscription price is $25, what is the value of a right? 15-28. If the stock in the previous question were trading ex-rights, what would be the value of the right? 192

15-29. The Tender Toy Company has issued warrants that entitle an investor to purchase 5 shares of common stock at an exercise price of $40/share during the next year. If the current stock price is $45, what is the exercise value of the warrant? 15-30. In the previous question, does the amount of time remaining until expiration affect the exercise value of the Tender Toys Co. warrant? 15-31. Prior to the expiration date of a warrant, will the market price of the warrant be greater than or less than the exercise value? Why? 15-32. Could a group of shareholders in a large publicly held corporation ever have a controlling interest with less than 50% of the outstanding shares? Explain. 15-33. Under what circumstances would a firm choose a best efforts agreement with an investment banking firm? 193

15-34. Why is a stock more valuable when it is trading rights-on than when it is selling ex-rights? 15-35. Why is it difficult to price common stock for an initial public offering? 194

Answers 15-1. Common stock (Page 441) 15-2. Residual income (Page 441) 15-3. Target stock (Page 442) 15-4. Publicly traded (Page 443) 15-5. Closely held (Page 443) 15-6. Board of directors (Page 444) 15-7. Fiduciary (Page 443) 15-8. Controlling (Page 444) 15-9. Proxy (Page 444) 15-10. Majority; cumulative (Page 444) 15-11. Flotation costs; dilution of earnings and control; negative signal to investors (Page 447) 15-12. Initial public offering (IPO) (Page 448) 15-13. Prospectus (Page 449) 15-14. Underwrites (Page 449) 15-15. Preemptive right (Page 451) 15-16. Warrant (Page 454) 15-17. The most important characteristics of common stock are the right to vote and the right to receive residual income in the form of dividends or reinvestment of firm earnings. The residual nature of the claim makes common stock have higher risk than other claimants, but it also has higher potential for return. (Pages 441) 15-18. Privately held corporations are usually small, and the owners are actively involved in the management. Under these circumstances, there are not substantial agency or information asymmetry problems. Therefore, these corporations are not held to the same reporting standards that publicly held corporations must meet. The Securities Exchange Commission requires extensive disclosure for the sale of new securities and requires that firms file regular audited financial statements. (Page 443) 15-19. In a typical corporation, the owners are the shareholders. They have the right to elect the board of directors who oversee the management of the corporation. The board of directors will usually appoint a management team to take care of the dayto-day business of the corporation. The board of directors owes a fiduciary responsibility to the owners of the firm. (Pages 443) 15-20. The first step in selling stock to the public is to contact an investment bank that will handle all the details associated with pricing the stock and marketing it to the public. An investment bank usually underwrites the issue, which means that it agrees to purchase the entire issue of stock from the issuing company at a certain price. They will then try to resell the stock to other investors, often in large blocks to institutional investors. If the investment bank does not offer a 195

guarantee, then the agreement is known as best efforts, under which the investment bank merely promises to do its best to sell the issue. (Page 449) 15-21. The main purpose of preemptive rights is to protect the ownership interest of the original shareholders. (Page 451) 15-22. The main disadvantages of equity financing are dilution of ownership, flotation costs of issuing new stock, and the negative signal that new issues give to investors. The advantages of equity financing are related to the fact that dividends do not have to be paid. Therefore, equity reduces the riskiness of the firm s earnings stream. Improved borrowing capacity is another advantage. (Pages 447) 15-23. 2,000/100,000 =.02 or 2% 2,000/120,000 =.017 or 1.7% (Page 444) 15-24. Majority voting: 0 directors They would need 51% to elect any one director and they only have 45%. (Page 445) 15-25. Cumulative voting: NUM DIR = [(45,000-1) x (5 + 1)]/100,000 = 2.7 ~ 2 directors (Page 445) 15-26. 200,000/25,000 = 8 rights to buy one share (Page 452) 15-27. R = (27-25)/(8+1) = $.22 (Page 452) 15-28. R = (27-25)/8 = $.25 (Page 453) 15-29. XV = (45-40) x 5 = $25 (Page 454) 15-30. No. The exercise value is fixed. (Page 454) 15-31. The greater the volatility of the stock price and the greater the time to maturity, the greater the market value of the warrant. (Page 455) 15-32. Control can be achieved with a small amount of voting shares if the voting shares are widely distributed among many thousands of stockholders, each of whom owns a tiny percentage of the outstanding voting shares, and who do not act in concert with each other. (Page 444) 15-33. Best efforts is a cheaper alternative to underwriting because the investment banker is not taking on any risk in agreeing to sell the issuing company s shares at whatever price they can get for them. Thus the fees charged for marketing stock on a best efforts basis are considerably less than those charged for underwriting. (Page 449) 196

15-34. The preemptive right has value to the owner. Thus, if you are purchasing the stock after the rights-on period has passed, the stock value to you has declined by approximately the amount of the right. (Page 453) 15-35. When a stock has never traded before, there is no previous market activity to establish what investors will think the stock is worth. Investment bankers, with the help of senior management, will try to determine the price by using traditional financial techniques, but they are often off the mark, as in the case of the Netscape IPO. (Page 448) 197