Ch09.ppt

Chapter 9 For the Investor COPYRIGHT ©2009 South-Western, a part of Cengage Learning.  For the Investor This chapter concerns with types of analysis useful to investors. The investors also are interested in liquidity, debt &...

Chapter 9 For the Investor COPYRIGHT ©2009 South-Western, a part of Cengage Learning.  For the Investor This chapter concerns with types of analysis useful to investors. The investors also are interested in liquidity, debt & profitability ratios Covered in prior chapters. Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #2  Financial Leverage Is successful if firms earn more on borrowed funds than it pay to use them. The use of debt is referred to as financial leverage Interest as related to debt financing – A contractual obligation – Must be paid regardless of entity’s current profits Contrast with dividends which are discretionary – Interest is tax deductible Reduces taxable income Reduces income tax Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #3 Definition of Financial Leverage and Magnification Effects DOWELL COMPANY (Exhibit 9-1) Financial Leverage Partial Income Statement to Illustrate Magnification Effects 20% Decrease 10% Increase in Earnings in Earnings Base Year Before Interest Before Interest Figures and Tax and Tax Earnings before interest and tax $1,000,000 $ 800,000 $1,100,000 Interest (200,000) (200,000) (200,000) Earnings before tax 800,000 600,000 900,000 Income tax (40%) (320,000) (240,000) (360,000) Net income $ 480,000 $ 360,000 $ 540,000 Percentage change in net income [A] 25.0% 12.5% Percentage change in earnings before Interest and tax [B] 20.0% 10.0% Degree of financial leverage [A ÷ B] 1.25 1.25 Net income increase [A] is greater than change in EBIT [B] due to the fixed nature of interest expense Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #4 Computation of the Degree of Financial Leverage (A) The degree of financial leverage is the % Change Net Income multiplication factor by which the net % Change EBIT income changes in respect to changes (B) in EBIT Earnings Before Interest and Tax A more simple formula for degree of Earnings Before Tax financial leverage Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #5  Earnings per Share Required disclosure for corporate income statements Pertains only to common stock Per-share amounts are disclosed for – Income from recurring items – Discontinued operations – Extraordinary items – Net income Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #6  Basic Earnings per Share Net Income - Preferred Dividends Weighted Average Number of Common Shares Outstanding Earnings pertain to an entire fiscal period Average common shares outstanding is used for parity of information Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #7 Weighted Average Common Outstanding Months Shares Shares Fraction of Year Weighted Are Outstanding Outstanding × Outstanding = Average January–June 10,000 × 6/12 = 5,000 July–September 12,000 × 3/12 = 3,000 October–December 15,000 × 3/12 = 3,750 11,750 Stock dividends and stock splits – Retroactive recognition to all comparative data Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #8 Earnings Per Share and Capital Structure Simple capital structure (Basic earnings per share) Complex capital structure contains potentially dilutive securities: – Options, rights, warrants – Convertible debt – Convertible preferred equity – Contingent shares Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #9  Price/Earnings Ratio Market Price per Share Diluted Earnings per Share Before Nonrecurring Items Measures the relationship between the market price of a share of common stock and that stock’s current earnings per share – Use of diluted earnings per share gives more conservative price/earnings ratio Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #10  Price/Earnings Ratio (cont’d) Compare with – Industry competitors – Industry average – Exchange (e.g., NYSE) average Interpretation – High-growth-potential firms have higher P/E ratios – P/E ratio is a function of the market Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #11  Percentage of Earnings Retained Net Income Before Nonrecurring Items - All Dividends Net Income Before Nonrecurring Items Reflects the proportion of current earnings retained for internal growth Trend analysis is improved by exclusion of nonrecurring items Higher percentage typically found in – New firms – Growing firms and firms perceived as growth firms Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #12  Dividend Payout Dividends per Common Share Diluted EPS Before Nonrecurring Items Measures the portion of current earnings per common share being paid out in dividends A stable dividend policy is developed by consideration of recurring earnings Lower payout typically found in – New firms – Growing firms and firms perceived as growth firms Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #13  Dividend Yield Dividends per Common Share Market Price per Common Share Indicates the relationship between the dividends per common share and the market price per common share The yield is a function of – The firm’s dividend policy – Market price Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #14  Book Value per Share Total Stockholders' Equity - Preferred Stock Equity Number of Common Shares Outstanding Preferred equity should be measured at liquidation value, if available Market value vis-à-vis book value – Book value reflects past unrecovered asset costs – Market value reflects the potential of the firm Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 9, Slide #15