Earned Surplus
= Accumulated Profits Accumulated Losses Dividends paid out of Earned Surplus
Total Assets
= Current Assets + Long Term Assets (stuff not to be converted into case w/in 1 yr)
Working Capital
= Current Assets Current Liabilities
First way: Simple Interest interest is only eanred on the invested sum itself over
the course of the investment.
b.
Second way: Compound Interest Interest earned during one period is reinvested
and earns interest on itself in subsequent periods. Interest can be compounded
annually, semi-annually, quarterly (every three months), monthly, or even daily.
2. Formula:
a.
Simple Interest
i.
FV = s (1 + r)
b.
Compound Interestinterest is compounded and added to the sum. At the end of
year 2, the value of s is:
i.
V2 = (1 + r)2
3. Rule of 72s: The result of dividing the number 72 by the rate of compound interest to be
earned approximates the number of years it would take for a given sum of money to double.
a.
Ex. An investment earning compound interest at an annual rate of 6% would double
in ~12 years [72 6]
B. The Frequency of Compounding
1. Effective Annual Rate:
a.
Formula: Determine the future value you will have at the end of the year for each
dollar invested, and subtract one from that amount:
i.
Effective annual rate =
(1 + Annual Percentage Rate)m 1
N
ii.
m = number of periods in each year; N = the total number of periods.
C. Present Value
1. Basic Discounting to Present Value
a.
Formula: In calculating PV we move backwards through timefrom a future date
back to todaythrough the process of discounting.
i.
PV of a Lump Sum
o PV = Sum
(1 + r)n
o PV = present value, S = sum, n = the number of years, and r =
interest rate/discount rate
D. Annuities
1. PV of an annuity
o
PV = P ____P_____
r
r(1 +r)n
E. Valuing a Perpetuity
1. Formula:
a.
b.
Calculation
S (Dividend Value)
(1 + r)n
Ex) Y1: $1.00/(1 + .1)1 = .9091
Y2: $1.04/(1 + .1)2 = .8595
Y5: $1.17/(1.1)5 = .7264
Positive Net Present Value: When the present value of returns exceeds that of
investments. A manage should acept investmeny opportunities offering rates of
return in excess of the opportunity cost of capital.
b.
Negatie Net Present Value: Opposite.
2. Formula: Testing the net present value of a project
Net Present Value of Project =
[PV of funds to be received (income) PV of funds of project (investments)]
3. QC
3.8: A
factory costs $400,000. You calculate that it will produce net cash after operating expenses of
$100,000 in year 1, $200,000 in year 2, and $300,000 in year 3, after which it will shut down
with zero salvage value.
a.
Use the present value equation; insert P for earch year ($100k); add the total; and
then subtract from CoC.
2. These results can be converted into an expected value for each from by weighting each
outcome by its probablity and summing up the results:
3. The next step is to determine the variance of the expected earning for each firm. This is
done by measuring the deviations from the mean in each case, using a weighting process.
a.
Problem: Some deviations are less than $100 and are thus negative numbers here.
b.
Solution: alter negative numbers into positive numbers
c.
Probability
.5
.5
Single-Firm Probabilities
Payoff
Rate of Return
0
-100%
$400,000
+300%
Two-Firm Probabilities
Probability
Payoff
Rate of Return
.25
0
-100%
.5
$200,000
+100%
.25
$400,000
+300%
4. Applying the Standard Deviation: While both investments have the same expected value,
the two-drug investment has a lower STDwe can see this because zeros return probability
is reduced from .5 to .25.
a.
Formula:
STD = Square root of the sum of (Probability) (Possible Payoff-Expected Payoff) 2
b.
Result:
Risk Preimium
Formula: The expected risk premium on a stock equals:
beta times x expected market risk premium (market rate minus risk free rate).
o
Cost of Capital:
Cost of Capital = Risk Free Return + (beta x equity premium (Market rate of return Risk Free Rate))
--OR
COC = Risk-Free Return + Risk Premium
o
Ex)
12% = 5% + (B x EP)
12% = 5% + (B x 10 5)
12 = 5 + B5
7 = B5
7/5 = B
1.4 = B
Example
i.
Set-Up:
o Firm 1: An all equity firm with $100,000 invested that has an
expected return to shareholders of $12,000.
o Firm 2: doubles F1s by borrowing an additional $100k @ 8%
interest and would have an expected return to shareholders of
$16,000.
Firm #1
Net Income
$12,000
Firm #2
@ 8% = Net Income
The traditional approach looks only at net income, and valued earnings per share. Under this assumption, if Firm
One and Firm Two are identical, the expressed earnings should be capitalized at 12%:
ii.
iii.
iv.
v.
Better to borrow right? Set cap rate (pre-determined potential rate of return
on an investment) at 12%:
o Equity of F1: 12,000/.12 = $100k
o Equity of F2: 16,000/.12 = $133k
Thus, F2 has $133k worth
Problem with this is that it does not account for variance
o Expected earnings of associated with F2 are more volatile than F1
b/c of fixed demands of creditors regardless of whether the firm has
a good year or not.
Effect of Leverage on Profits
o
Scenerio A (Bad)
B (Normal)
C (good)
$2,000
$12,000
$22,000
Earnings to S/H
$2,00
$12,000
$22,000
Rate of Return
2%
12%
22%
$2,000
12,000
22,000
Interest
($4,000)
(4,000)
(4,000)
Earnings to S/H
($2,000)
8,000
18,000
Rate of Return
-4%
16%
36%
(18/50k
loan) =
36 RoR
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2. Interest Tax Shield: Every dollar paid as interest reduces corporate tax by 35% (the corp. tax
rate). So, interest tax shield = .35 x (interest payments)
a.
The funds saved from big brother are then available to the SH or for reinvestment in
the firm.
b.
Capitalizing the Deductions from Corporate Tax:
PV Tax Shield = calculated interest tax shield/interest rate on debt
Basic Components:
11
i.
b.
c.
Rate of return on debt = face value of debt/value of the firm x the interest
rate
ii.
Rate of return on equity = value of equity/value of firm x capitalization rate
Basic WACC:
ii.
2. Basic Example: Assume 50/50 structure, with 8% i-rate (cost of debt) & 15% cost of equity.
Value of firm = $100k.
3. Advanced Example: Same facts as above but with a 35% Corp tax rate
4. Note: Multiply the Overall Rate of Return % (final product) times total firm value to get the
actual return that results.
The Essence:
12
13
Rights exercisable at 50% discount from FMV The $40 exercise price would pruchase 2x of c/s that the s/h
would be able to purchase for $40 on the market; in otherwords, get double that worth in c/s, or $80 woth of c/s.
* could also be cash inflows, depending on which side of the tx you are working from.
So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd
calculate its current yield:
CY =
I. Contract Interpretation
II. Contract Terms
III. The Indenture Trustee and the Trust Indenture Act
IV. Capital Leasing
V. Asset-Backed Financing
Chapter 7 (Preferred Stock)
14
I. Introduction
i.
II. Dividends
III. Altering the Preferred Contract
IV. Board Duties
Options and Convertible Securities (Chapter 8)
I. Introduction
A. Long and Short Positions and Position Diagrams
1. Long Position is where an investor buys an option expecting that its value will increase.
a.
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1. Exercise Price The higher the exercise price in realtion to the market price of the
underlying stock, the lower the value of a call option
a.
Ex.
i.
Exercise price of $200 for a current stock price of $100 is likely to be
worthless
ii.
Exercise price of $100 for a $100 valued stock price = a 50/50 chance the
stock price will rise above the exercise price during the life of the option.
2. Stock Price == The higher the stock price relative to the exercise price, the more valuable the
call option will be.
a.
Once the stock prices rise above the exercise price, the excess of the stock price over
the exercise price represents the miniumum value of an option.
3. Exercise Price The longer the life of the option, the greater its value, all other things being
equal.
4. Variance of the Underlying Stocks Value This is the most important factor in
determining option values. The greater the variance in the value of the underlying asset, the
more valuable the call option will be.
5. Interest Rate The value of the option is partly related to opportunity cost how much
interest can you earn on your money investing it somewhere else duirng the life of the
option?
a.
Thus, when interest rates are high, not purchasing the stock and leaving the option in
existence increases the value of the option as you get your $ through investing it in
govt treasuries.
B. Bionomial Option Valuation Method (Simple - Not on exam)
1. Gain is twice as much when buying with borrowed $.
2. Ex. Current stock price = $100, 1 yr European call option @ $100, Stock price has a 50/50
chance being either $80 or $120 in 1 yr w/ a 10% i-rate.
a.
Alt. #1: Call Option. Buy 1 option which in 1 year will be worth either $0 (low) or
$20 (high).
b.
Alt. #2: Leveraged Stock Purchase. Borrow discounted present value of low bond
($80) w/ 10% i-rate = 80/1.1 = $72.73. Then buy one one share of stock at its current
price $100, both for one year.
i.
Investment in option = 100 72.73 = $27.27
ii.
Possible Outcomes:
o Low ($80) stock value loan repayment ($80) = $0
o High ($120) stock value loan repayment ($80) = $40
3. Law of One Price: Payoff on levereged investment is 2 times the payoff of 1 call option
a.
Value of 2 calls = current value of share ($100) bank loan ($72.73) = $27.27
b.
Value of 1 call = 27.27/2 = $13.63
4. Option Delta/Hedge Ratio
a.
The number of shares needed to replicate one call option.
b.
Ex. In the preceeding example, 2 calls are replicated by a levered position on 1 share.
The option delta is therefore .
i.
Option Delta =
spread of possible option prices/spread of possible share prices = 20 0/120 80 = 1/2
16
iv.
Ex.) One additional share issued for .01. Just factor in this one additional
share.
o # of shares previously outstanding = 1,000,000
o Conversion Price = 1.00
o Consideration for additional shares = .01
o # of shares outstanding after additional issue = 1,000,001.
o =$.999999999
See how the effect of the WAC leads to a better result?
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ii.
Right hand side = what each share is worth after the dividend. This is 1/3
less because of the lost productive capacity of that capital.
b.
What is it?
i.
Dividend Hypo- See pg 672
o Note that the dividend also has no effect on the value of the firm if
new funds are raised to replace the dividended funds.
ii.
Retained Earnings Hypo- See pg 673
o Share holder gets the same result simply by checking out and selling
its shares.
o This is the investor home-making the value of dividends
through sales of stocks rather than relying on dividends.
AKA home-made dividend
c.
Applying the Tax Consequences to the M&M Hypothesis: One problem for the
M&M model is that it did not account for differing tax policies on Dividends versus
Capital Gains
o When shares are sold, only the amount above what she paid for
the shares is taxable while the entire dividend is subject to the
tax.
II. Restrictions on Dividends and Other Distributions to Shareholders
A. The Revolution in Legal Capital Rules: There are certain situations where the Corp is forbidden
from paying out dividends when the Corp is INSOLVENT or the distribution will make the Corp
insolvent
1. Statutory Limits in Granting Dividends
a.
Modern Approach (MCBA 6.40):
i.
Dividends ok unless
o (1) Make Corporation unable to pay its debts as they become due in
the usual course of business
Equity test
o (2) Assets < liabilities + preference in dissolution for superior classes
of stock.
bankruptcy test
b.
Traditional/Delaware Approach 170 (more stirct)
i.
Earned Surplus (Retained earnings)
o Formula:
Accumulated profits Accumulated losses dividends
(which are paid out of eanred surplus)
o An earned surplus would indicate business is making money and
may be used to pay distribution
ii.
Stated Capital: gets the par value from the issuance. [if par = $2 and then
sold 1000 shares = $2000]
iii.
Capital Surplus: the excess over par goes into this fund [if par = $2 and the
Corp sold 1000 shares for $5, then the fund has $3000]
o (assets) (liabilities) (stated capital) i.e. the excess of the net assets
over stated capital.
III. Board Discretion and Duties in Declaring Dividends
IV. Stock Dividends and Stock Splits
A. Accounting for Dividends and Splits
1. Valuing Diluted Value of Shares Post-Dividend:
a.
Corp has 1M shares outstanding with a market value of $100 each and decalres a
stock dividend of 30% or another 300K shares. Issuing new shares means
reallocating SHs equity amounts since their value of individual stocks has been
diluted.
i.
Per the calculation above they had $100M in shareholder equity.
18
ii.
iii.
Now divide that by 1.3M shares and we get the diluted value per share down
from $100 per share to 76.92 per share.
Thus the value of the dividend is: 76.92 x 300,000 = $23,076,000.
V. Stock Repurchases
VI. Spin-Off Transactions
VII. Tracking Stock
19