for the investor chapter 9 © 2011 cengage learning. all rights reserved. may not be scanned, copied...

For the Investor

Chapter 9

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #2

• 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

Financial Leverage


Chapter 9, Slide #3

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

Definition of Financial Leverage and Magnification Effects


Chapter 9, Slide #4

Computation of the Degree of Financial Leverage

% Change Net Income

% Change EBIT

Earnings BeforeInterest and Tax

Earnings Before Tax

The degree of financial leverage is the multiplication factor by which the net income changes in respect to changes in EBIT

A more simple formula for degree of financial leverage


Chapter 9, Slide #5

Computation of the Degree of Financial Leverage (cont’d)

• Degree of financial leverage calculations should exclude– Noncontrolling interest– Equity income– Nonrecurring items

Earnings Before Interest, Tax, Noncontrolling Interest,

Equity Income, and Nonrecurring Items

Earnings Before Tax, Noncontrolling Interest,

Equity Income, and Nonrecurring Items

The all-inclusive formula for degree of financial leverage


Chapter 9, Slide #6

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


Chapter 9, Slide #7

Earnings per Share

Basic Earning per share= Net Income - Preferred Dividends

Weighted Average Number ofCommon Shares Outstanding

• Earnings pertain to an entire fiscal period• Average common shares outstanding is used for parity

of information• Current guidelines require basic and diluted earning

per share presentation.

- Diluted earning per share is calculated the same as basic plus the dilutive effect of potentially dilutive securities


Chapter 9, Slide #8

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


Chapter 9, Slide #9

• Simple capital structure• Complex capital structure contains potentially

dilutive securities:– Options, rights, warrants– Convertible debt– Convertible preferred equity– Contingent shares

Earnings Per Share and Capital Structure


Chapter 9, Slide #10

Price/Earnings Ratio

• 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

Market Price per Share

Diluted Earnings per ShareBefore Nonrecurring Items



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



Percentage of Earnings Retained

• 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

Net Income Before NonrecurringItems - All Dividends

Net Income BeforeNonrecurring Items



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



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



Book Value per Share

Total Shareholders' 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



Stock Options

• Stock option fair value– Expensing is required per SFAS 123R

• Allocate option fair value to the service period– Date of grant through vesting date

• Noncompensatory plans– Encourage widespread ownership by employees– Slight discount from fair value– No compensation expense is recognized



Impact of Stock Option Expense

Net Income Before Net Income BeforeNonrecurring Items Not - Nonrecurring Items

Including Option Expense Including Option ExpenseNet Income Before Nonrecurring Items

Not Including Option Expense



Restricted Stock

• Sometimes offered to employees in lieu of stock option plans

• Restrictions– Employee cannot sell stock for a specified period of

time– Employee may forfeit the shares if they leave

employer– Awards may be linked to financial goals



Stock Appreciation Rights

• Employee receives compensation in cash or stock– Difference between option price and market price

• Expense is a function of market price– Year-end spread is measured– Current expense is spread minus prior recognition



• May be awarded through the use of– Stock options– Restricted stock– Stock appreciation rights

• Firms vary in their use of these methods of granting stock-based compensation– Select a single method– Use two of the three methods– Use all three in combination

Stock-Based Compensation


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