Corporate Finance Unit 5 Study Guide PDF

**UNIVERSITY OF TECHNOLOGY, JAMAICA** **SCHOOL OF BUSINESS ADMINISTRATION** **CORPORATE FINANCE** **Unit 5 Study Guide** **Long Term Financing Decisions** **At the end of this unit, students should be able to:** 1. 2. 3. 4. 5. 1. critique the dividend irrelevance theory, bird in...

**UNIVERSITY OF TECHNOLOGY, JAMAICA** **SCHOOL OF BUSINESS ADMINISTRATION** **CORPORATE FINANCE** **Unit 5 Study Guide** **Long Term Financing Decisions** **At the end of this unit, students should be able to:** 1. 2. 3. 4. 5. 1. critique the dividend irrelevance theory, bird in hand theory and tax preference theory 2. assess dividend payout policy based on the residual dividend model 3. outline the implications for managers and shareholders when using preferred stocks 4. compare the lease versus borrow and buy decisions 5. examine the use of warrants and convertibles for corporations and investors **The Choices in Financing** - There are only two ways in which a business can raise money. - The first is debt. The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business. - The other is equity. With equity, you do get whatever cash flows are left over after you have made debt payments. **DEBT VS EQUITY** Rather than categorizing financing based on what it is called or categorized as by accountants, we should be thinking whether financing is debt or equity by looking at the following questions: *1. Are the payments on the securities contractual or residual?* If contractually set, it is closer to debt. If residual, it is closer to equity. *2. Are the payments tax-deductible?* If yes, it is closer to debt. If no, if is closer to equity. *3. Do the cash flows on the security have a high priority or a low priority if the firm is* *in financial trouble?* If it has high priority, it is closer to debt. If it has low priority, it is closer to equity. *4. Does the security have a fixed life?* If yes, it is closer to debt. If no, it is closer to equity. *5. Does the owner of the security get a share of the control of management of the firm?* If no, it is closer to debt. If yes, if is closer to equity **Advantages and Disadvantages of Preferred Stock** - - **Disadvantages** - - **Lessee:** borrower, user (of asset) **Lessor:** lender, owner** ** **Operating vs. capital lease** **Operating lease:** - - - - - - *It is a form of off-B/S financing* **Capital lease:** - - **Sale and Leaseback** - An arrangement whereby a firm sells land, buildings, or equipment and simultaneously leases the property back for a specified period under specific terms. - Two sets of cash flows occur: - The lessee receives cash today from the sale. - **Capital leases are different from operating leases:** - Capital leases do not provide for maintenance service - Capital leases are not cancellable - Capital lease are fully amortized **Criteria for identifying Capital lease** 1. Under the terms of the lease, ownership of the property is effectively transferred from the lessor to the lessee. 2. The lessee can purchase the property or renew the lease at less than a fair market price when the lease expires. 3. The lease runs for a period equal to or greater than 75% of the asset's life. 4. The present value of the lease payments is equal to or greater than 90% of the initial value of the assets. **Analysis: Lease vs. Borrow-and-Buy** - New machine costs \$1,200,000 - 3-year MACRS class life. (0.33, 0.45, 0.15, 0.07) - Tax rate of 40% - K~d~ = 10% - maintenance of \$25,000/year, payable at beginning of each year. - residual value in year 4 of \$125,000 - 4 year lease include maintenance - Lease payment is \$340,000/year payable at beginning of each year. **Depreciation schedule**  **In a lease analysis, what discount rate should cash flows be discounted at?** - - A-T K~d~ =10%(1-T) = 10%(1-0.4)=6% **Cost of owning Analysis (In thousands)** Depreciation is a tax deductible expense, so it produces a tax savings of T(Depreciation). Year 1 = 0.4(\$396) = \$158.4. Each maintenance payment of \$25 is deductible so the after-tax cost of the lease is (1 -- T)(\$25) = \$15. The ending book value is \$0 so the full \$125 salvage (residual) value is taxed. **Cost of leasing analysis (in thousands)**  **Net Advantage of leasing** **What effect would a cancellation clause have on the riskiness of the lease?** - **Warrant and Convertibles** - - ***Conversion Price = P*** = [Par value of bond ] Shares received ***Conversion ratio =*** [Par value of bond ] Conversion Price ***Conversion value =*** Market price of common stock x Conversion ratio ***Market conversion price*** = [Market price of convertible security ] Conversion Ratio ***Market conversion premium per share*** = Market conversion price -- Current market price ***Market conversion premium ratio*** = [Market conversion premium per share ] Market price of common stock **What is "dividend policy"?** It's the decision to pay out earnings versus retaining and reinvesting them. Includes these elements: 1\. High or low payout? 2\. Stable or irregular dividends? 3\. How frequent? 4\. Do we announce the policy? ***Dividends as a Passive Residual*** **Can the payment of cash dividends affect shareholder wealth?** **If so, what dividend-payout ratio will maximize shareholder wealth?** - - **Do investors prefer high or low payouts? There are three theories:** - Dividends are irrelevant: Investors don't care about payout. - Bird in the hand: Investors prefer a high payout. - Tax preference: Investors prefer a low payout, hence growth. **Dividend Irrelevance Theory** - Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don't want cash, they can use dividends to buy stock. - Modigliani-Miller support irrelevance. - - - - Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test. **Bird-in-the-Hand Theory** - Investors think dividends are less risky than potential future capital gains, hence they like dividends. - If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P~0~. **Tax Preference Theory** - - **Implications of 3 Theories for Managers**  **Which theory is most correct?** - Empirical testing has not been able to determine which theory, if any, is correct. - Thus, managers use judgment when setting policy. - Analysis is used, but it must be applied with judgment. **What's the "information content," or "signaling," hypothesis?** - - - - - - - - - - Managers hate to cut dividends, so won't raise dividends unless they think raise is sustainable. So, investors view dividend increases as *signals* of management's view of the future. - Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends. **What's the "clientele effect"?** - Different groups of investors, or clienteles, prefer different dividend policies. - Firm's past dividend policy determines its current clientele of investors. - Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies. **What's the "residual dividend model"?** - Find the retained earnings needed for the capital budget. - Pay out any leftover earnings (the residual) as dividends. - This policy minimizes flotation and equity signaling costs, hence minimizes the WACC. **Using the Residual Model to Calculate Dividends Paid** **How would a change in investment opportunities affect dividend under the residual policy?** - Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. - More good investments would lead to a lower dividend payout. **Advantages and Disadvantages of the Residual Dividend Policy** - Advantages: Minimizes new stock issues and flotation costs. - Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn't appeal to any specific clientele. - Conclusion: Consider residual policy when setting target payout, but don't follow it rigidly. **Unit 5 Self Test** 1. Discuss the pros and cons of having the directors formally announce what a firm's dividend policy will be in the future. 2. What is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see your company declare a 100% stock dividend or a two-for-one split? Assume that either action is feasible. 3. Axel Telecommunications has a target capital structure that consists of 70 percent debt and 30 percent equity. The company anticipates that its capital budget for the upcoming year will be \$3,000,000. If axel reports net income of \$2,000,000 and it follows a residual dividend payout policy. What will be its dividend payout ratio? 4. What effect does the expected growth rate of a firm's stock price have on its ability to raise additional funds through (1) convertibles (ii) warrants? 5. Whitman Antique Cars Inc. has the following data, and it follows the residual dividend model. Some Whitman family members would like more dividends, and they also think that the firm\'s capital budget includes too many projects whose NPVs are close to zero. If Whitman reduced its capital budget to the indicated level, by how much could dividends be increased, holding other things constant? Original capital budget \$3,000,000 New capital budget \$2,000,000 Net income \$3,500,000 \% Debt 40% **Unit 5 Self Test Solution:** 1. **ANS:** The biggest advantage of having an announced dividend policy is that it would reduce investor uncertainty, and reductions in uncertainty are generally associated with lower capital costs and higher stock prices, other things being equal. The disadvantage is that such a policy might decrease corporate flexibility. However, the announced policy would possibly include elements of flexibility. On balance, it would appear desirable for directors to announce their policies. 2. **ANS:** The difference is largely one of accounting. In the case of a split, the firm simply increases the number of shares and simultaneously reduces the par or stated value per share. In the case of a stock dividend, there must be a transfer from retained earnings to capital stock. For most firms, a 100 percent stock dividend and a 2-for-1 stock split accomplish exactly the same thing; hence, investors may choose either one. 3. **ANS:** 70% Debt; 30% Equity; Capital Budget = \$3,000,000; NI = \$2,000,000; PO = ? Equity retained = 0.3(\$3,000,000) = \$900,000. NI \$2,000,000 -Additions to RE [900,000] Earnings Remaining \$1,100,000 Payout = 4. **ANS:** The trend in stock prices subsequent to an issue influences whether or not a convertible issue will be converted, but conversion itself typically does not provide a firm with additional funds. Indirectly, however, conversion may make it easier for a firm to get additional funds by lowering the debt ratio, thus making it easier for the firm to borrow. In the case of warrants, on the other hand, if the price of the stock goes up sufficiently, the warrants are likely to be exercised and thus to bring in additional funds directly. 5. [Old] [New ] **Unit 5 Tutorial Sheet** 1. Sheehan Corp. is forecasting an EPS of \$3.00 for the coming year on its 500,000 outstanding shares of stock. Its capital budget is forecasted at \$800,000, and it is committed to maintaining a \$2.00 dividend per share. It finances with debt and common equity, but it wants to avoid issuing any new common stock during the coming year. Given these constraints, what percentage of the capital budget must be financed with debt? 2. Grullon Co. is considering a 7-for-3 stock split. The current stock price is \$75.00 per share, and the firm believes that its total market value would increase by 5% as a result of the improved liquidity that should follow the split. What is the stock\'s expected price following the split? 3. What is meant by the term "distribution policy"? 4. The terms "irrelevance," "bird-in-the-hand," and "tax effect" have been used to describe three major theories regarding the way dividend payouts affect a firm's value. Explain what these terms mean, and briefly describe each theory. 5. What do the three theories indicate regarding the actions management should take with respect to dividend payout? 6. Discuss (A) the information content, or signaling, hypothesis, (B) the clientele effect, and (C) their effects on distribution policy. 7. In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy? 8. What are the advantages and disadvantages of the residual policy? (Hint: don't neglect signaling and clientele effects.) 9. Warren Corporation's stock sells for \$42 per share. The company wants to sell some 20-year, annual interest, \$1,000 par value bonds. Each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of \$47. The firm's straight bonds yield 10%. Each warrant is expected to have a market value of \$2.00 given that the stock sells for \$42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par? 10. Carolina Trucking Company (CTC) is evaluating a potential lease for a truck with a 4-year life that costs \$40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 9%, and the loan would be amortized over the truck's 4-year life. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of \$12,000. If CTC buys the truck, it would purchase a maintenance contract that costs \$1,500 per year, payable at the end of each year. The lease terms, which include maintenance, call for a \$10,000 lease payment (4 payments total) at the beginning of each year. CTC\'s tax rate is 35%. What is the net advantage to leasing? (Note: MACRS rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.) 11. Bev's Beverages is negotiating a lease on a new piece of equipment that would cost \$80,000 if purchased. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is \$25,000. A maintenance contract on the equipment would cost \$2,500 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of \$23,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 8%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: MACRS rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.) 12. Valdes Enterprises is considering issuing a 10-year convertible bond that would be priced at its \$1,000 par value. The bonds would have an 8.00% annual coupon, and each bond could be converted into 20 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.00%. The stock currently sells for \$40.00 a share, has an expected dividend in the coming year of \$2.00, and has an expected constant growth rate of 5.00%. What is the estimated floor price of the convertible at the end of Year 4? 13. Emerson Electrical Engineering Inc. is issuing new 20-year bonds that have warrants attached. If not for the attached warrants, the bonds would carry an 11% interest rate. However, with the warrants attached the bonds will pay a 9% annual coupon. There are 25 warrants attached to each bond, which have a par value of \$1,000. The exercise price of the warrants is \$25.00 and the expected stock price 10 years from now (when the warrants may be exercised) is \$50.77. What is the investor\'s expected overall pre-tax rate of return for this bond-with-warrants issue? 14. Quaid Co.\'s common stock sells for \$28.00, pays a dividend of \$2.10, and has an expected long-term growth rate of 6%. The firm\'s straight-debt bonds yield a 10.8% return. Quaid is planning a convertible bond issue. The bonds will have a 20-year maturity, pay a 10% annual coupon, have a par value of \$1,000, and a conversion ratio of 25 shares per bond. The bonds will sell for \$1,000 and will be callable after 10 years. Assuming that the bonds will be converted at Year 10, when they become callable, what will be the expected return on the convertible when it is issued? 15. The following data apply to Saunders Corporation\'s convertible bonds. Maturity 10 Stock price \$30.00 Par value \$1,000 Conversion price \$35.00 Annual coupon 5.00% Straight-debt yield 8.00% a. What is the bond\'s [conversion ratio]? b. What is the bond\'s initial conversion value when issued? c. What is the bond\'s straight-debt value at the time of issue? d. Based on your answers to the three preceding questions, what is the minimum price (or "floor" price) at which the Saunders\' bonds should sell?