CH 13: The Weighted-Average

Cost of Capital
1 06/04/2014
CeoLhermals Cost of Capital
Capital Structure - 1he flrms mlx of long-term
financing [debt and equity].
Cost of Capital - 1he reLurn Lhe flrms lnvesLors
could expect to earn if they invested in securities
with comparable risk.
The WACC represents a standard discount rate for
average risk projects.
For higher-than-average risk projects, the WACC can
be adjusted up; and for lower-than-average risk
projects it can be adjusted down.


06/04/2014 2
CeoLhermals CosL of CaplLal
Calculate the company cost of capital for Geothermal
given the following capital structure, and assuming it
pays 8% for debt and 14% for equity.





Portfolio return = 0.3 8% + 0.7 14% = 12.2%
100% $647 Assets Value Market
70% $453 Equity Value Market
30% $194 Debt Value Market
06/04/2014 3
Weighted average cost of capital (WACC)
The cost of capital with debt (no taxes)
Suppose a firm is financed by both debt and
equity. We denote the values of the outstanding
debt and the equity as D and E, respectively. So
the total market value of the firm, V = D+E.


The cost of capital must be based on the
securlLles markeL values noL book values.


E D
E D
asset
r
V
E
r
V
D
V
E r D r
r + =
+
= = =
investment of value
income total
WACC
4 06/04/2014
WACC: an example
Consider a firm whose debt has a market value of $40
million and whose stock has a market value of $60
million (3 million outstanding shares of stock, each
selling for $20 per share). The firm pays 15% rate of
interest on its new debt and equity investors want
25%, what is the firms WACC?


% 21 % 25
60 40
60
% 15
60 40
40

equity in proportion debt in proportion WACC
=
+
+
+
=
+ =
E D
r r
5 06/04/2014
WACC
Taxes and WACC
After-tax cost of debt =r
D
(1 T
C
)
The WACC adjusted for tax savings due to interest payments is


For the above example, if the tax rate is 34%, the after-tax cost of debt
is
r
D
(1 T
C
) = 15%(1 34%) = 9.9%, and




E C D asset
r
V
E
T r
V
D
r + = = ) 1 ( WACC

% 96 . 18 % 25
100
60
%) 34 1 %( 15
100
40
WACC = + =
6 06/04/2014
WACC: an example
Suppose a firm has both a current and target debt-equity ratio of 0.6, a cost
of debt of 15.15%, and a cost of equity of 20%. The company tax rate is
34%.
The firm is considering a project. The project requires an initial investment of
$50 million and is expected to generate a perpetual cash flow of $8.125
mllllon a year. lf Lhe pro[ecL has Lhe same rlsk as Lhe flrms exlsLlng
business, should the firm go ahead with it?
Because D/E = 0.6, so (D+E)/E = 1.6
E/V = 1/1.6 = 0.625 (equity-value ratio)
D/V = 1- E/V = 1-0.625 = 0.375 (debt-to-value ratio)

NPV =8.125/16.25% - 50 = 0




% 25 . 16 2 . 0 625 . 0 %) 34 1 ( % 15 . 15 375 . 0 ) 1 ( WACC = + = + =
E C D
r
V
E
T r
V
D
7 06/04/2014
WACC
WACC: an extension
Suppose the firm also has outstanding preferred stock. Let
P denote the value of these preferred stocks and V = D + E
+ P

If a firm has issued 3 types of securities: debt, preferred stock
and common stock, and r
D
=6%, r
E
=18%, r
P
=12%. D=$4, P=$2,
E=$6, T
C
= 35%. So, V = D + P + E = 4+2+6=12




P E C D
r
V
P
r
V
E
T r
V
D
+ + = ) 1 ( WACC
% 3 . 12 % 12
12
2
18 . 0
12
6
%) 35 1 ( % 6
12
4
) 1 ( WACC
= + + =
+ + =
P E C D
r
V
P
r
V
E
T r
V
D
8 06/04/2014
Calculating required rates of return: The expected
return on bonds (YTM)
The YTM is defined as the interest rate that
makes Lhe presenL value of Lhe bonds
payments equal to its price.
Example: If you bought a 3-year bond with a
coupon rate of 10% for $1,136.16, the YTM, r,
satisfies the following equation:


Solve for r, r = 5%



( ) ( )
3 2
1
000 , 1 100
1
100
1
100
16 . 136 , 1
r r r +
+
+
+
+
+
=
9 06/04/2014
Calculating required rates of return: The
expected return on common stock
Estimates based on CAPM
Expected return on stock = risk-free raLe + sLocks
beta expected market risk premium.
Dividend discount model (DDM)

We can rearrange this formula to provide an
estimate of r
E


g r
DIV
P
E

=
1

g
P
DIV
r
E
+ =
1
10 06/04/2014
Calculating required rates of return: The expected return
on preferred stock
Preferred stock that pays a fixed dividend can be
valued from the perpetuity formula:


Therefore, the expected rate of return on preferred
stock can be obtained by rearranging the formula to



P
preferred
r
DIV
P =

preferred
P
P
DIV
r =
11 06/04/2014
Measuring capital Structure
Capital sLrucLure ls Lhe flrms mlx of flnanclng.
Example. Suppose a flrms book values of debL
and equity are follows:

Bank debt $200 million
Long-term bonds 200 (coupon rate 8%, 12 year)
Common stock 100 (100 million outstanding shares of stock $1 per share)
Retained earnings 300
Total 800
12 06/04/2014
Measuring capital structure
The differences between market values and book values for bank
loans are negligible, because the interest rate on bank loans usually
changes with market interest rate.
1he markeL value of a companys bonds ls Lhe v of all coupons and
par value discounted at the current interest rate.
For these bonds, if the interest rates have risen to 9% since bonds
were originally issued, we can calculate the value of the bonds.
There are 12 payments of $0.08 200 =$16 million, and then
repayment of $200 million face value at the end of 12 years. So,


( ) ( )
7 . 185 $
% 9 1
200 16
% 9 1
16
% 9 1
16
12 2
=
+
+
+ +
+
+
+
= A PV
13 06/04/2014
Measuring capital structure
1he markeL value of a companys equlLy ls Lhe
market price per share multiplied by the
number of shares outstanding.
If Lhe flrms sLock ls $12 per share, Lhen Lhe markeL value of
equity = $12 100 million = $1200 million.
Bank debt $200 million
Long-term bonds 185.7
Common stock 1200
Total 1585.7

14 06/04/2014
Capital structure and WACC when
there are no corporate taxes
Suppose a firm has the following market-value balance sheet:



If the r
D
= 8% and r
E
= 20%,

If the firm changes its capital structure as follows




Will WACC change? No


Assets Liabilities and Equity
Debt: $40
Equity: $60
Total $100 100


% 2 . 15 % 20
100
60
% 8
100
40
= + = WACC
Assets Liabilities and Equity
Debt: $50
Equity: $50
Total $100 100
15 06/04/2014
Asset beta and equity beta (no taxes)
The asset beta is the weighted average of the
equity and debt betas,

If we assume that debt beta is zero, then

This formula shows the two sources of risk: the
business risk, measured by the asset beta, and
the financial risk, reflecting the impact of
leverage, dependent on the debt-equity ratio.
Increasing leverage raises the debt-equity ratio
and increases the financial risk to shareholders.



16

equity debt assets
V
E
V
D
| | | + =

|

\
|
+ =
E
D
assets equity
1 | |
06/04/2014
Capital structure and WACC when
there are corporate taxes
If there are taxes, changes in the capital
structure will affect WACC.
Changes in the capital structure will change the
interest payments and will affect taxes.
An increase in debt-to-asset ratio increases the
flrms cash flow, lL wlll make Lhe debL and equlLy
riskier. As a result, r
D
and r
E
will increase.
Changing the capital structure might affect beta.
Beta of firm is the weighted average of the beta
of its debt and equity.
17 06/04/2014
Flotation costs and WACC
Flotation costs are the costs of issuing new
securities to the public.
Flotation costs should be treated as negative
cash flows, because the cost of capital
depends on the interest rates, taxes, and the
risk of the project.
So floLaLlon cosLs do noL affecL Lhe pro[ecLs
cost of capital.

18 06/04/2014
Interpreting the Weighted Average
Cost of Capital
When ?ou Can and CanL use WACC
The WACC is the rate of return that the firm must
expect to earn on its average-risk investments in
order to compensate its investors.
Thus, WACC may be used to value new assets
that:
Have the same risk as the old ones.
Will support the same ratio of debt as the firm itself.
19 06/04/2014
Valuing Entire Business
In order to value the business, we take the free cash
flows up to the year it is available, calculate the horizon
value, and then discount these all by the WACC of the
company to get its market value.



PVH = FCFH(1+g)/(WACC-g)
Free cash flow: cash flow that is not required for investment in
fixed assets or working capital and is therefore available to
investors.


20 06/04/2014
Valuing Entire Business
Calculating the free cash flow:
21 06/04/2014
Valuing Entire Business
Estimation of WACC
Capital structure: D/V =60%
Required rate of return on equity = 12%
Cost of debt = 5%
WACC = 40% 12% + 60% 5% (1-35%) =
6.75%
22 06/04/2014
Valuing Entire Business
Horizon value = FCF in year 6/(r-g) =
79.5/(6.75%-5%)=$2,271.4 thousand
PV of the business = 73.6/1.085
87.1/1.0675^2 -102.9/1.0675^3 -
34.1/1.0675^4 +
40.2/1.0675^5+2,271.4/1.0675^5 = $3562.34
thousand
23 06/04/2014
CH. 14: Corporate Financing
1
Common stock: Terminology
The term common stock (or, common shares) means different things to
different people, but is usually applied to stock that has no special
preference either in dividends or bankruptcy.
Owners of common stock in a firm are referred to as shareholders or
stockholders.
There can be a stated value on each stock certificate called the par value.
The difference between issue price and par value of stock is called
additional paid-in capital, or capital surplus, contributed surplus or paid-in
surplus.
Shares that have been issued by the company and are held by investors
are called outstanding shares.
The maximum number of shares that can be issued is known as the
authorized share capital.
Treasury stock: in the U.S., when a company repurchases some of its
shares, it can continue to hold them as its own stock. These shares appear
in the balance sheet as treasury stock.
2
Common stock: characteristics of
dividends
Unless a dividend is declared by the board of directors of a
corporation it is not a liability of the corporation. A
corporation cannot default on an undeclared dividend.
Dividends are not a business expense and are not
deductible for corporate tax purpose.
Dividends received by individual shareholders are taxed at
reduced rates. Dividend income is generally not taxed when
received by Canadian corporations.
The earnings that are not paid out as dividends are called
retained earnings. The sum of accumulated retained
earnings, contributed surplus, common shares, and
adjustments to equity is known as net common equity of
the firm.

3
An example
1he followlng ls Lhe book value of common shareholders equlLy
of a Canadian firm (in millions):
Common shares $10,000
Contributed surplus 1,000
Retained earnings 5,000
Foreign currency exchange adjustments 500
(the currency transaction gains
from Lhe flrms forelgn operaLlons)
Net common equity 16,500

lf Lhe flrms ouLsLandlng shares are 1,000, Lhe book value per share
=16,500/1,000 = $16.5/per share

4
An example
Now suppose the firm has profitable investment
opportunities and decides to sell 1,000 shares of new
stock to raise the necessary funding. The issuing price is
$20 per share. Now new net common equity account is
Common shares $30,000
Contributed surplus 1,000
Retained earnings 5,000
Foreign currency exchange adjustments 500
Net common equity 36,500
Book value per share = 36,500/2,000 =$18.25/share
If the current stock price is $20/share, then the total market
value of common stock is 2,000 $20 =$40,000 thousands
=$40 million, which is higher than the book value.


5
Common stock
Book Value vs Market Value

Book value is a backward-looking measure.
It tells you how much capital the firm raised from its shareholders
in the past.
Market value is forward looking.
It is a measure of the value investors place on the shares today.
It depends on the future dividends which shareholders expect to
receive.
The market-to-book value ratio is usually greater than
one because the firm has invested projects with a
positive NPV. The firm will be able to generate earnings
that exceed initial cost.

6
Shareholders rlghL
Shareholders elect directors who, in turn, hire management to carry
out their directives. Shareholders, therefore, control the
corporation through the right to vote on appointments to the board
of directors.
The mechanism for electing directors differs across companies.
In the case of majority voting, each director is voted on separately (in
a separate election), and shareholders can cast one vote for each
share they own.
In the case of cumulative voting, the directors are voted on jointly (at
once); therefore, all the votes one shareholder is allowed to cast can
be cast for one candidate for the board of directors.
Proxy voting: Shareholders can either vote in person or appoint a
proxy to vote.
If shareholders are not satisfied with management or with the
corporate governance of the firm, an outside group of shareholders
can try to obtain as many votes as possible via proxy. They can vote to
replace managemenL or change Lhe companys governance. 1hls ls
called proxy contest, or proxy battle, which are often led by large
pension funds.
7
Voting mechanisms: an example
Suppose that one firm has two shareholders: A and B. A has
25 shares and B has 75 shares. Both want to be on the
board of directors. Let us assume that there are 4 directors
to be elected.
Under majority voting, A can cast a maximum of 25 votes for
each candidate and B can cast a maximum of 75 votes for
each. As a consequence, B will elect all of the candidates.
Under the cumulative voting, A has a total of 25 4 =100
votes, B has a total of 75 4 = 300 votes. If A gives all his
votes to himself, he is assumed of a directorship. It is not
possible for B to divide 300 votes among four candidates in
such a way Lo preclude As elecLlon Lo Lhe board.

8
Corporate Governance
Although shareholders own the company, they usually do not
manage it. This principal of separation of ownership and
control of a firm is prevalent around the world.
Separation of ownership and management creates a potential
conflict between the shareholders (owners) and their agents
(the managers).
Several mechanisms have evolved to mitigate this conflict:
The Board oversees management and can fire them.
Management remuneration can be tied to performance.
Poorly performing firms may be taken over and the managers
replaced by a new team.
Classes of stock
Many firms have more than one class of common stock.
They differ in their right to vote or receive dividends. They
are called class A, Class B, etc. Often, the classes are
created with unequal voting rights. The class B shares could
have limited voting rights. For instance, class A shares could
carry 10 votes per share, while class B shares carry only one
vote per share.
Common shares without full voting rights are called
restricted shares.
Restricted shares could be non-voting, which means they have
no votes.
They could be subordinate-voting, which means they have fewer
votes per share than another class of common shares.
Multiple voting shares carry multiple votes.

10
Preferred stock
Preferred stocks have preference over common stocks in the
payment of dividends and in the distribution of corporation assets
in the event of liquidation.
Preference means that holders of preferred shares must receive a
dividend before holders of common shares are entitled to anything. If
the firm goes into bankruptcy, preferred shareholders rank behind all
creditors but ahead of common shareholders. Preferred shares are a
form of equity from legal, tax, and regulatory standpoints; however,
holders of preferred shares often have no voting privileges.
Like debt, most preferred stock promises a series of fixed payments
to the investors and in general the dividends are paid in full and on
time. But preferred dividends are not like interests on bonds. The
board of directors may decide not to pay the dividends on preferred
stocks.
The sum of common equity and preferred stock is known as net
worth.

11
Types of preferred shares
Cumulative preferred shares: If the dividends are not paid in a particular year, they
will be in arrears. Usually, both the cumulative dividends plus current dividends
must be paid before the common stock shares are receiving anything.
Non-cumulative preferred shares: If a preferred share is non-cumulative then
investors are only entitled to the payment of dividend if the board declares a
dividend. If the preferred dividend is not paid, it does not go into arrears, and is
lost forever. Unpaid preferred dividends are not debts of the firm. The board of
directors can defer preferred dividends indefinitely.
Redeemable preferred shares: A company has the right to repurchase these shares
from the shareholders at a pre-specified price. This price is known as the call price.
Retractable preferred shares: The investor can force the company to buy back
his/her shares at a specified date.
Convertible preferred shares: They may be converted into another type of security,
usually common shares.
In general the yields on preferred shares are lower than the interest rates of debt.
Dividend income is not taxed when received by Canadian corporations and is taxed
at reduced rates when received by individuals.
12
Preferred stock vs bank loan
x?Z co. pays no Lax. A banks marglnal Lax raLe ls
35%. Interest rate on the bank loan is 8%, while
preferred dividend yield is 6%.
lrom Lhe banks polnL of vlew:
after-tax return on the bank loan is 8%(1-35%)=5.2%
Return on preferred shares = 6%
From the Cos point of view:
after-tax costs of the bank loan is 8%
costs of funds if selling preferred shares = 6%


13
Corporate long-term debt:
terminology
When companies borrow money, they promise to make
regular interest payments and to repay the principal.
The person or firm making the loan is called a creditor or a
lender.
The company borrowing the money is called debtor or
borrower.
The amount owed the creditor is a liability of the company.
However, it is a liability of limited value. The corporation
can legally default at any time on its liability and hand over
the assets to the creditors. Clearly, the company will choose
bankruptcy only if the value of the assets is less than the
amount of the debt.

14
Characteristic of debt
Debt is not an ownership interest in the firm.
Creditors do not usually have voting power.
1he companys paymenLs of lnLeresL are regarded
as a cost and are fully tax deductible.
Unpaid debt is a liability of the firm. If it is not
paid, the creditors can legally claim the assets of
the firm. This action may result in liquidation or
bankruptcy. Thus, one of the costs of issuing debt
is the possibility of financial failure, which does
not arise when equity is issued.

15
Corporate long-term debt: Interest
rate
The interest payment or coupon on most long-
term loans is fixed at the time of issue.
Most loans from a bank and some long-term
loans may have a floating interest rate. The
interest rate is often reset according to a
benchmark rate regularly.
Prime Rate: Benchmark interest rate charged by banks
to large customers with good to excellent credit.
London Interbank Offered Rate (LIBOR): Rate at which
international banks lend to each other.


16
Corporate long-term debt: Maturity
Typically, debt securities are called notes,
debentures, or bonds.
In legal language, a debenture is an unsecured
corporate debt.
A bond is secured by a mortgage on the corporate
property.
A note usually refers to a short-term obligation.
Debentures and bonds are long-term debt. Debt due
in less than a year is called short-term. Long-term
debt is any debt repayable more than one year from
the date of issue.

17
Corporate debt
Investment Grade: Bonds rated above Baa or BBB .
Junk Bond: Bond with a rating below Baa or BBB.
Eurodollars: Dollars held on deposit in banks
outside the US.
Eurobond: Bond that is denominated in the
currency of the issuer but issued to investors in
other countries.
Foreign bond: Bond issued in another country and
denominated in the currency of that country.

18
Corporate long-term debt: Repayment
Bonds can be repaid at maturity or earlier through the use of a
sinking fund.
A sinking fund is the fund established to retire debt before maturity.
Each year the firm puts aside a sum of cash into a sinking fund that is
then used to buy back the bonds.
A callable bond is the bond that can be repurchased by the firm
before maturity at a pre-specified call price.
The option to buy back the bond at a pre-specified price before
maturity is valuable to the issuer. If interest rates decline and bond
prices rise, the issuer may repay the bonds at the pre-specified call
price, and borrow the money back at a lower rate of interest.
On the other hand, the call provision comes at the expense of
bondholders because lL llmlLs lnvesLors caplLal galn poLenLlal.
So, other things being equal, the price of a callable bond should be
lower than the bond without call provisions.

19
Seniority
In general terms, seniority indicates preference
in position over other lenders. Some debt is
subordinated. In the event of default, holders
of subordinated debt get in line behind the
flrms general credlLors. 1hls means Lhe
subordinated lenders will be paid off only
after all senior creditors are satisfied.

20
Corporate long-term debt: Security
Secured Debt: Debt that has first claim on specified
collateral in the event of default.
When companies borrow, they may set aside
certain assets as security for the loan. The assets
are termed collateral and the debt is said to be
secured. In the event of default, the secured
lenders have the first claim on the collateral;
unsecured lenders have a general claim on the
resL of Lhe flrms asseLs buL only a [unlor clalm on
the collateral.

21
Corporate long-term debt: Public
versus private placements
Publicly issued bonds are sold to anyone who
wishes to buy and once they have been issued
they can be freely traded in the markets.
In a private placement, the bonds are sold to a
limited number of investors without a public
offering.

22
Corporate long-term debt: Protective
covenant
To ensure that the company will use the
money borrowed well and not take
unreasonable risks. Lenders usually impose a
number of conditions on the company. These
restrictions are called protective covenants.
For example, limitations are placed on the amount
of dividends a company may pay; the firm cannot
issue additional long-term debt; the firm may not
sell or lease its major assets without approval
given by the lender.

23
Convertible securities
Warrant: Companies sometimes issue bonds with provisions that
allow the bondholders to buy shares from the company at a
stipulated price before a set date. So the warrant is valuable to
bondholders.
Convertible bonds: A convertible bond gives its owner the option to
exchange the bond for a pre-specified number of common shares.
Obviously, these options are valuable to bondholders.
The owner of a convertible bond owns a bond and a call option on
Lhe flrms sLock, so does Lhe owner of a package of a bond and a
warrant. However, there are differences with the most important
belng LhaL a converLlble bonds owner musL glve up Lhe bond Lo
exercise the option. The owner of a package of bonds and warrants
exercises the warrants for cash and keeps the bond.

24
Patterns of corporate financing
Funds for investment may be raised from external (debt or equity
security issues) or internal sources, such as cash flow from
operations.
Internal financing is defined as net income plus depreciation minus
dividends.
The first form of financing used by firms for positive NPV projects is
internally generated cash flows.
When a firm has insufficient cash flow from internal sources, it sells
off part of its investment in marketable securities.
As a last resort, a firm will use externally generated cash flow. First
debt is used and common stock is used last.
Reasons: (1) managers do not wish to be critically assessed or
monitored by the financial markets and financial institutions. (2)
The cost of financing externally is avoided when internally
generated funds are used.


25
Patterns of Corporate Financing
Sources of Financing for Non-financial Private
Corporations (1988-2006):
26
CH. 15: Venture Capital, IPOs and
Seasoned Offerings
1
The initial public offering
IPO: A flrms flrsL offerlng of sLock Lo Lhe general publlc ls
called an initial public offering and the firm is said to go
public.
Stock market can be either organized exchanges with centralized
locations or over-the-counter market consisting of a network of
security dealers who trade with each other over the phone and
through electronic networks.
The listing requirements : the minimum amount of net assets,
earnings, cash flow, adequate working capital and an
appropriate capital structure.
Before any stock can be sold to the public, the firm must satisfy
the requirements of provincial securities laws and regulations.
Regulations of the securities market in Canada are carried out
by provincial commissions and through provincial securities
acts. In the US, regulation is handled by a federal body, the
Securities and Exchange Commission (SEC). The stock to be sold
to public may have to be registered with an appropriate
securities commission.

2
The Basic Procedure for an IPO
The firm must prepare and distribute copies of preliminary
prospectus to (Ontario Securities Commission) OSC and to
potential investors.
Prospectus is a formal summary that provides information on an
issue of securities.
The preliminary prospectus is sometimes called a red herring, in
part because bold red letters are printed on the cover warning
that OSC has neither approved nor disapproved of the
securities.
The securities commission studies the preliminary
prospectus and notifies the company of any changes
required.
Once the revised, formal prospectus meets with the
securities commlsslons approval, a prlce ls deLermlned and
a full-fledged selling effort gets under way.
3
The initial public offering
One important advantage of going public is that public
firms have greater access to new capital once their
shares are traded on secondary markets. Further,
publicly traded firms must meet OSC and other
disclosure requirements that reduce information risk
for potential investors. In addition, going public makes
lL posslble for Lhe flrms prlnclpal owners Lo sell some
of their shares and diversify their personal portfolios
while retaining control of the company.
Going public also has disadvantages. Public firms are
subject to stricter disclosure and other potentially
costly regulatory requirements.

4
The initial public offering: Underwriting
Underwriters are lnvesLmenL dealers LhaL acL as flnanclal mldwlves" Lo a new
issue. They perform the following services for corporate issues ( they play a triple
role):
Providing the company with procedural and financial advice
Buying the new securities
Selling the new securities
A small IPO may have only one underwriter, but for large issues a group of
underwriters called a syndicate or banking group will usually be formed to handle
the sale. Syndication helps to market and distribute the issue more widely and also
to share its risks. In a syndicate, one or more underwriters arrange or co-manage
the offering.
Typically, the underwriter buys the securities for less than the offering price and
accepts the risk of not being able to sell them. The difference between the
underwrlLers buylng prlce and Lhe offerlng prlce ls called Lhe spread.
In a typical underwriting arrangement, which is called a firm commitment, the
underwriters buy the securities from the issuing firm and re-sell them to the public
for the purchase price plus an underwriting spread. In this case, the underwriters
accept the risk of not being able to sell the securities.
Another type of underwriting is on a best efforts basis. In this case, the
underwriter agrees to sell as much of the issue as possible but does not guarantee
the sale of the entire issue. This form of underwriting is more common with IPOs.
The fees tend to be less in a best-effort distribution.
5
The Underwriters
Canadas Lop underwrlLers for equlLy and debL
in 2007.

The initial public offering: Pricing IPOs
The issuing firm faces a potential cost if the offering price is
set too high or too low.
If the issue is priced too high, it may be unsuccessful and have
to be withdrawn.
If Lhe lssue ls prlced below Lhe Lrue markeL prlce, Lhe lssuers
existing shareholders will experience an opportunity loss.
The managers of the firm are eager to secure the highest
possible price for their stock.
The underwriters typically try to underprice the IPO, as
they argue that underpricing is needed to attract investors
to buy stock and to reduce the cost of marketing the issue
to customers. So, generally the stock price increases
substantially from the issue price in the days following an
issue.

7
The initial public offering: underpricing
A firm has 2 million shares outstanding, which are owned by
Lhe flrms founders. now Lhe flrm decldes Lo go publlc and
issue a further 1 million shares to investors at $50. On the
first day of trading, the share price jumps to $80.
The total market capitalization of the firm is 3 $80 =$240
million.
The value of Lhe founders shares ls equal Lo Lhe value of Lhe
firm less the value of shares that have been sold to the public,
i.e., $240 - $ 80 = $160.
If the price were at $80/share, it would only need to issue
0.625 million shares to raise the $50 million. In this case,
the share price will be $240/2.625 =$91.43. so the value of
Lhe founders share would be 240 240/2.625 0.625 =
240 57.14 = $182.86

8
The initial public offering: The wlnners
curse
Underpricing does not mean that anyone can become wealthy by
buying stock in IPOs.
When the price of an issue is too low, the issue is often
oversubscribed. This means investors will not be able to buy all of
the shares they want and the underwriters will allocate the shares
among investors. The average investor will find it difficult to get
shares in an oversubscribed offering because underwriters will not
have enough shares to go around.
When the issue is overpriced, other investors are unlikely to want it
and the underwriters will be only too delighted to sell it to you.
1hls ls called Lhe wlnners curse, and lL explalns much of Lhe reason
why IPOs have such a large average return. Unless you know the
true value of every IPO, you cannot earn an abnormal return by
buying shares in IPOs.

9
The initial public offering: The costs of
IPOs
Flotation Costs: The costs incurred when a firm issues
new securities to the public. It includes commissions,
legal, accounting and other administrative costs.
Costs of IPOs
The spread. The underwriting spread consists of direct fees
by the issuer to the underwriting syndicate.
Other direct expenses. These are direct costs incurred by
the issue that are not part of the compensation to
underwriters. These costs include filing fees, legal fees and
taxes, the costs of management time spent working on the
new issue.
Underpricing. For IPOs losses arise from selling the stock
below the correct value.
10
The initial public offering: The costs of
IPOs
For example, a firm went public last month. The underwriters acquired
a total of 100 million shares for $50 each and sold them to the
publlc aL an offerlng prlce of $33. 8y Lhe end of Lhe flrsL days
Lradlng, Lhe flrms sLock prlce had rlsen Lo $70. 1he flrm also pald a
total of $10 million in legal fees and other costs. Let us see the total
costs of this IPO.
Underwriting spread = 100 (55 50) = $500 million
Other direct expenses = $10 million
The cost of underpricing = 100 (70 55) = $1500 million
So, total cost = 500 + 10 + 1500 = $2010 million
Total market value of the issue shares = 100 70 = $7000 million
Total cost as a percentage of gross proceeds for the company is
2010/7000 = 28.7%
11
Rights issues and general cash offers
An issue of additional stock by a company
whose stock already is publicly traded is called
a seasoned offering.
The stock may be offered only to existing
shareholders, called a rights issue, or
sold to the general public, called a general cash
offer.

12
Rights issues
In a rights issue, shareholders would be able to purchase additional
shares at a price below current market price. In other words, in a
rights issue, the company offers the shareholders the right to buy a
specified number of new shares at a specified price within a
specified time, after which time the rights are said to expire.
Shareholders get one right for each share of stock they own. The
terms of the rights offering are evidenced by certificates known as
rights. Such rights are often traded on securities exchanges or over-
the-counter.
To execute a rights offering, the financial manager of a firm must
answer the following questions:
What price should the existing shareholders be allowed to pay for a
share of new stock?
How many rights will be required to purchase one share of stock?
What effect will the rights offering have on the price of the stock?
13
Rights issues: Subscription price
In a rights offering, the subscription price is the
price that existing shareholders are allowed to
pay for a share of stock.
A rational shareholder will only subscribe to the
rights offering if the subscription price is below
Lhe markeL prlce of Lhe sLock on Lhe offers
expiration date.
So, the subscription price is set below the market
price to ensure the rights offering will succeed. In
practice, the subscription price is typically 20 to 25%
below the prevailing stock price.

14
Rights issues: Number of rights needed
to purchase a share
Number of new shares = funds to be raised/subscription price
Number of rights needed to buy one share = number of old
shares/number of new shares
For example, suppose a firm has a million shares outstanding, selling at $20 a
share. To finance a planned expansion, the firm intends to raise $5 million
of new equity funds by a rights offering. If the subscription price is set at
$10 per share, how many new shares will be issued? How many rights are
needed to buy one share? What will be the stock price after the rights
issue?
Number of new shares = $5,000,000/$10 = 500,000 shares
Number of rights needed to buy one share = 1,000,000/500,000 = 2 rights
So, a shareholder will need to give up two rights and $10 to receive a
share of new stock. So the stock price after the issue = (2 20 + 10)/3 =
16.67
After the rights issue, the firm will have a total of 1.5 million shares
outstanding (1+0.5), and the total value of the firm will be: 1 20 + 5 =$
25 million. So, the stock price will be =25/1.5 = $16.67/ per share.
15
Rights issues: The value of a right
Note that the shareholder needs two rights to buy one share at
$10, however, the market price of the share after the rights issue
(the ex-rights price) is $16.67.
Subscription price + # of rights value of a right = ex-rights price
Therefore, theoretically, the value of a right is worth



It can also be calculate as follows



Rights-on price of shares = ex-rights price + value of a right

335 . 3
2
10 67 . 16
share a buy to needed rights of #
price on subscripti - price rights - ex
right one of value

335 . 3
1 2
10 20
1 share a buy to needed rights of #
price on subscripti - price on - rights
right one of value

16
Rights issues: an example
Assume a firm has proposed a rights offering. The stock currently sells for $40 per
share. Under the terms of the offer, shareholders will be allowed to buy one new
share for every five that they own at the price of $25 per share. What is the value
of a right and what is the ex-rights price?
Value of one right = (40-25)/(5+1) = 2.5
Ex-right price = rights-on price value of one right = $40 2.5 = $37.5/share
Shareholders can exercise their rights or sell them. In either case, the shareholder
will not win or lose by the rights offering.
For the above example, suppose the investor hold 5 ex-rights shares with a total value
of $200. If he/she exercises the right, he/she ends up with 6 shares worth a total of
$223. ln oLher words, by spendlng $23, Lhe lnvesLors holdlng lncreases ln value by
$25.
On the other hand, if the shareholder sells the five rights for $2.5 each. The cash flow
will be:
Share held = 5 37.5 = 187.5
Rights sold = 5 2.5 = 12.5
Total =$200

17
Rights Issues
Example
ABC Corp currently has 9 million shares outstanding. The
market price is $15 per share. ABC decides to raise
additional funds via a 1 for 3 rights offer at $12 per share.
If we assume 100% subscription, what is the value of each
right?

Current Market Value = 9 mil $15 = $135 mil
Total Shares = 9 mil + 3 mil = 12 mil
Amount of new funds = 3 mil $12 = $36 mil
New Share Price = (135+ 36) / 12 = $14.25 per share
Value of a Right = Rights-on price Ex-rights price
= 15 - 14.25 = $0.75

Rights issues: Ex-rights
The standard procedure for issuing rights is similar to that
for paying a dividend.
It beglns wlLh Lhe flrms seLLlng holder-of-record date. This
ls Lhe daLe on whlch shareholders appearlng on companys
records are entitled to receive the stock rights.
Following the stock exchange rules, the stock will usually go
ex-rights 4 trading days before the holder-of-record date.
If the stock is sold before the ex-rights date--- its value will
be rights on, with rights, cum rights--- the new owner will
receive the rights.
If the stock is sold on or after the ex-rights date, the buyer
will no longer be entitled to the rights.

19
Rights issues: The underwriting
arrangement
Rights offerings are typically arranged using a standby
underwriting. In a standby underwriting, the issuer
makes a rights offering, and the underwriter makes a
firm commitment to purchase any unsubscribed
shares. The underwriters usually get a standby fee.
Standby underwriting protects the firm against under
subscription.
Through a rights offering, a company could hope to
save on issuing and underwriting expenses. Also,
shareholders do not run a risk of dilution of their
proportional shareholding and are able to retain their
voLlng poslLlon on companys ma[or buslness declslons.

20
General cash offers
After IPO, firms can raise money by issuing securities to the general public.
These are called general cash offers. In a general cash offer, the procedure
is the same as that in an IPO. This means that the issue must be registered
in compliance with regulations of relevant provincial commissions. This
issue is then sold to an underwriter (or syndicate) who, in turn, offers the
securities to the public.
In a bought deal, the issuer sells the entire issue to one investment dealer
or to a group that then attempts to resell it. This form of underwriting is
often used by large, well-known companies for their seasoned equity
issues. As in firm commitment underwriting, the investment dealer
assumes all the price risk.
To llmlL Lhe underwrlLers rlsk, many underwrlLlng agreements may
contain a market-out clause, which can enable the underwriter to
terminate the underwriting agreement without penalty under
extraordinary circumstances or if the state of the financial market is not
deemed good for the security issue.
Like IPOs, costs of the general offer include underwriting spread,
administrative costs and underpicing. In addition, there is another type of
cost; that is, abnormal returns, arising from the market reaction to stock
issues.
21
Market reaction to stock issues
Statistics show that the price of the stock drops on average by 3% on the
announcement of a new issue of common stock. This represents losses of
Lhe markeL value of Lhe flrms equlLy.
Example, a firm just issued $250 million of equity which caused its stock price
Lo drop by 3. CalculaLe Lhe loss ln value of Lhe flrms equlLy glven LhaL lLs
market value of equity was $1 billion before the new issue.
1 3% = $30 million, and 30/250 = 12% of the amount of money raised.
Reasons:
Does adding more shares depress stock prices below their true value? No.
One possible reason for this strange result is that the stock issue could be a
signal to investors that management feels the stock is overpriced by the
market. Investors can predict that managers are more likely to issue stock
when they think it is overvalued and therefore, they mark the price of the
stock down accordingly.

22
The private equity market
Venture capital : Equity capital provided to a promising new business is
called venture capital. Or, the money invested to finance a new firm is
called venture capital.
Venture capital is provided by specialized venture capital firms, financial and
investment institutions such as banks and pension funds, and government
agencies.
If you need very early stage financing for your new enterprise, you may seek
financing from an angel investor. Angels are wealthy individual investors in
early-stage ventures. Angels can play a critical role in the creation of new
ventures by making small-scale investments in local start-ups and early-stage
ventures.
Private placement: sale of securities to a limited number of investors
without a public offering.
When a firm makes a public offer, it must register the issue with the relevant
provincial commission. Private placement can avoid this costly process. So this
issue can be placed quickly and at a lower cost of financing.
The biggest drawback of privately placed securities is that the securities
cannot be easily resold. As a result, the yield demanded by investors will likely
be higher.

23
CH. 16: Debt policy
1
How Borrowing Affects Value in a Tax Free Economy
The value of a firm from two angles:































A flrms capital structure is the mix of debt and equity its financial
managers choose.
Does the choice of capital structure affect the value of a firm?

Assets
Liabilities and Stockholders Equity
Value of cash flows
from firms real
assets and operations
Market value of debt
Market value of equity
Value of Firm



Value of Firm
2
MMs proposlLlon l wlLh no taxes
Consider a firm that has no debt in its capital structure. In other
words, the firm is all-equity financed. This firm is called unlevered
company. Assume Lhe flrms asseLs are $1 mllllon. 1here are
100,000 shares outstanding. This implies that the price of each
share is $10. We further assume the firm pays all its operating
income as dividends to its shareholders and there are no corporate
taxes. So the financial structure of the firm can be summarized as
follows:

Debt 0
Equity $1 million
Total $1 million
Shares outstanding: 100,000
Price per share $10
3
MMs proposlLlon l wlLh no Laxes
Assume LhaL Lhe flrms reLurns Lo shareholders
under different economic conditions are given
as follows:




Slump Normal Boom
Operating income $75,000 $125,000 $175,000
Return on assets (ROA=income/assets) 7.5% 12.5% 17.5%
Earnings per share (EPS=income/100,000) 0.75 1.25 1.75
Return on equity (ROE = income/equity) 7.5% 12.5% 17.5%

4
MMs proposlLlon l wlLh no Laxes
Now, suppose the financial manager of the firm proposes to
issue $0.5 million of debt at an interest rate of 10% and to
use the proceeds to repurchase 50,000 shares.
This is called restructuring. The assets of the firm are not
affected; only the capital structure changes.
After the issuance of debt, the firm becomes levered.
1he flrms proposed flnanclal sLrucLure ls as follows:
Debt $500,000 million
Equity $500,000 million
Total $1 million
Shares outstanding: 50,000
Price per share $10
5
MMs proposlLlon l wlLh no Laxes
1he flrms reLurns Lo shareholders under dlfferenL
economic conditions are (operating income is the
same)






Is leverage beneficial?


Slump Normal Boom
Operating income $75,000 $125,000 $175,000
Return on assets (ROA=income/assets) 7.5% 12.5% 17.5%
Interest $50,000 $50,000 $50,000
Equity earnings $25,000 $75,000 $125,000
Earnings per share (EPS=equity income/50,000) 0.5 1.5 2.5
Return on equity (ROE =equity income/equity) 5% 15% 25%

6
MMs proposlLlon l wlLh no Laxes
In the case of current capital structure, consider the following
strategy
An investor borrows $10 at 10% from a bank.
Use the borrowed proceeds plus your own investment of $10 to buy 2
shares of the current unlevered equity at $10 per share.
The initial cost of this strategy = $10 2 -10 = $10.
The payoff of this strategy:







Slump Normal Boom
Earnings on two shares of the unlevered firm $1.5 $2.5 $3.5
Interest at 10% on $10 $1 $1 $1
Net Earnings 0.5 1.5 2.5
Return on $10 investment 5% 15% 25%

7
MMs proposlLlon l wlLh no Laxes
MM Assumptions:
CaplLal markeLs have Lo be well funcLlonlng".
Investors can borrow/lend on the same terms as firms.
Capital markets are efficient.
There are no taxes or costs of financial distress.
M&Ms proposlLlon l (debL lrrelevance proposlLlon):
The value of the firm must be unaffected by its
capital structure.
In other words, managers cannot increase firm value
by changing the mix of securities used to finance the
company .

8
Risk to equityholders rises with
leverage
From that example, we see that investors expected return
rlses afLer resLrucLurlng, buL MMs proposlLlon l Lells us LhaL
they are not better off. Why not?
The reason is that shareholders bear more risk.
Restructuring does not affect operating income regardless
of the state of the economy. So debt financing does not
affecL Lhe operaLlng rlsk, whlch ls Lhe rlsk ln flrms
operating income, but debt increases the uncertainty about
percentage stock returns. For example, in a slump the
return on equity drops by 10% if the firm issues debt (is
levered), but it only drops by 5% if the firm is all-equity
financed.
The risk to shareholders resulting from the use of debt is
called financial risk. so, debt finance increases financial risk.
9
How Borrowing Affects Value in a Tax Free Economy
How borrowing affects risk and return.








Even though the value of the firm remains unchanged,
shareholders of the levered firm face a higher risk and
therefore demand a higher return.
Firm Value:
All Equity Financing After Restructuring
$1 million
Debt:
Equity:
$500,000
$500,000
10
Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
E
P
S

Debt
No Debt
Break-even
point
EBI in dollars, no taxes
Advantage to
debt
Disadvantage to
debt
EBIT
MMs proposlLlon II
Restructuring does noL change Lhe flrms operaLlng
earnings; it does not change the return on assets or the
flrms welghLed average cosL of caplLal.


Rearranging the above formula gives


This ls called MMs proposlLlon ll. lL says LhaL Lhe
requlred raLe of reLurn on equlLy lncreases as Lhe flrms
debt-equity ratio increases.



U E L E D asset
r r
V
E
r
V
D
r WACC
, ,


) (
, , , D U E U E L E
r r
E
D
r r
12
MMs proposlLlon ll: an example
For the unlevered firm:


For the levered firm:


% 5 . 12
000 , 000 , 1
000 , 125
,

asset U E
r r

% 15 %) 10 % 5 . 12 (
000 , 500
000 , 500
% 5 . 12 ) (
, , ,

D U E U E L E
r r
E
D
r r
13
Capital structure and corporate taxes: Interest tax shield
uppose Lhe flrms Lax raLe ls 33. LeL us see Lhe expecLed earnlngs for boLh Lhe
unlevered and the levered firms. Firm A: unlevered, D = 0, E = $1,000,000.
Firm B: D = 500,000, E = 500,000, T
C
= 35%, r
D
= 10%.









For the levered firm, the annual interest tax shield is 50,000 0.35 = $17,500
In general, annual interest tax shield = T
C
r
D
D, if debt is permanent. If the
tax shield is perpetual, the PV of tax shields is

PV of tax shields = .


A (zero debt) B (debt = $500,000)
Annual expected operating income (EBIT) $125,000 $125,000
Debt interest at 10% 0 50,000
Earnings before taxes (EBT) $125,000 75,000
Taxes (35%) $43,750 26,250
Earnings after taxes 81,250 48,750
Total income to both $81,250 98,750
Equitholders and debtholders difference $17,500


D T
r
D r T
C
D
D C


14
Value of the levered firm
Value of levered firm = value of all-equity firm
+ PV of interest tax shields = value of all-equity
firm + T
C
D
Or, V
L
= V
U
+ T
C
D
1hls ls MMs proposlLlon l under corporaLe Laxes.
The value of levered firm is positively related
to the amount of debt. By raising the debt-
equity ratio, the firm can lower its taxes and
thereby increase its total value.
15
MMs proposlLlon ll under corporaLe
taxes
MMs proposlLlon ll under no Laxes poslLs a poslLlve
relationship between the expected return on equity and
leverage. This result occurs because the risk of equity
increases with leverage. The same intuition also holds in a
world of corporate taxes. MMs proposlLlon ll wlLh corporaLe
taxes


Corporate taxes and WACC


16

) )( 1 (
, , , D U E C U E L E
r r T
E
D
r r
L E C D
r
V
E
T r
V
D
WACC
,
) 1 (
MM proposition II: an example
D = $500,000 and r
D
=10%, EBIT
L
=EBIT
U
= $125,000, T
C
=35%. Assume the cost
of capital if the firm were unlevered = 12.5% = r
E,U

Annual interest tax shields = T
C
r
D
D = 35% 10% 500,000 = $17,500
PV of the interest tax shields = T
C
D =35% 500,000 = $175,000

The value of unlevered firm V
U
=

The value of the levered firm V
L
= V
U
+ T
C
D = 650,000 + 175,000 =
825,000. Therefore, the value of equity of the levered firm is E = V
L
- D =
825,000 500,000 = 325,000.
Accordlng Lo MMs proposlLlon ll under corporaLe Laxes,



WACC
L
=

17

000 , 650 $
% 5 . 12
%) 35 1 ( 000 , 125 ) 1 (

asset
C
r
T EBIT

% 15 %) 10 % 5 . 12 %)( 35 1 (
000 , 325
000 , 500
% 5 . 12 ) )( 1 (
, , ,

D U E C U E L E
r r T
E
D
r r

% 85 . 9 % 15
000 , 825
000 , 325
% 10 %) 35 1 (
000 , 825
000 , 500
) 1 (
,

L E D C
r
V
E
r T
V
D
Costs of Financial Distress: Trade-off
theory
Debt provides tax benefits to the firm.
Debt puts pressure on the firm, because interest and principal
payments are obligations. If these obligations are not met, the firm
may risk some sort of financial distress. The ultimate distress is
bankruptcy. Financial distress is costly. Costs of financial distress
arise from bankruptcy or distorted business decisions before
bankruptcy.
Financial distress costs tend to offset the advantages to debt. The
overall value of the firm should be
Value of the levered firm = value of the all-equity financed firm + PV
of interest tax shields PV costs of financial distress
The Trade-Off Theory says that financial managers choose the level of
debL whlch wlll balance Lhe flrms lnLeresL Lax shlelds agalnsL lLs cosLs of
financial distress.

18
Trade-off Theory
Bankruptcy in Canada


Direct and indirect costs of financial distress
Direct costs
Legal fees: Courts and lawyers are involved throughout all the stages before
and during bankruptcy.
Administrative and accounting fees can substantially add to the total bill.
Indirect costs of bankruptcy reflect the difficulties of running a company while it is
going through bankruptcy.
Agency costs: When a firm has debt, conflicts of interest arise between
shareholders and bondholders, and shareholders are tempted to pursue
selfish strategies. These conflicts of interest impose agency costs on the firm.
Selfish strategies:
Incentive to take large risk. Firms near bankruptcy often take great chances,
because Lhey feel LhaL Lhey are playlng wlLh someone elses money. 1hey have
nothing to lose by taking great risks. If they lose the game, they have nothing
to lose. If they win the game, they may have more than enough assets to pay
off the debt, and receive the surplus.
Incentive toward underinvestment. Shareholders of a firm with a significant
probability of bankruptcy often find that new investment helps the
bondholders aL Lhe shareholders expense. 1he reason ls LhaL shareholders
contribute the full investment, but the shareholders and bondholders share
the benefits.

20
The pecking order theory
The pecking order theory of capital structure states that:
Firms prefer internal finance because these funds are raised
without sending any positive or negative signals.
If external finance is required, firms issue debt first, and issue
equity as a last resort.
The theory starts with the observation that managers know
more Lhan ouLslde lnvesLors abouL Lhe flrms value and
prospects. Therefore, investors find it difficult to value new
security issues, particularly issues of common stock.
Investors may interpret the announcement of a stock issue
as a pessimistic manager signal. That is why stock sales
announcements tend to drive stock prices down. Internal
finance avoids this problem. If external financing is
necessary, debt is the first choice.
21
The pecking-order model
The pecking order theory explains why the most profitable firms
generally borrow less, because Lhey donL need ouLslde money. Less
profitable firms issue debt because they do not have sufficient internal
funds for their capital investment and because debt is the first in the
pecking order for external finance.
The pecking-order model explains why firms hold vast cash and
marketable securities reserves.
A firm will sometimes forgo positive-NPV projects if accepting them
forces the firm to issue undervalued equity to new investors.
This in turn provides a rationale for firms to value financial slack.
Financial Slack means having cash, marketable securities, readily
saleable real assets and ready access to the debt markets or to bank
financing.
Financial slack permits firms to undertake projects that they might
decline if they had to issue new equity to invest.
22
CH. 18: Payout Policy
1
How dividends are paid: Cash
dividends
The term dividend usually refers to cash distributions of earnings.
Public companies usually pay regular cash dividends four times a year.
Sometimes firms pay a regular cash dividend and an extra cash dividend.
1he Lerm regular" lndlcaLes LhaL Lhe flrm expecLed Lo malnLaln Lhe
payment in the future.
The date on which the board of directors declares a payment of dividend
is called the declaration date.
Record date: This is the date on which shareholders appear on the
company records are entitled to receive the dividend.
In practice, stock exchanges fix a cut-off date, called ex-dividend date, 2
business days prior to the record date. All the shareholders are entitled to
receive the dividend if they purchased the stock before the ex-dividend
date. Before this date, the stock is said to trade cum-dividend, or with
dividend.
The payment date is the date on which the dividend cheques are mailed
to the investors. So the key dates for dividend payments

2
Chapter 16 -3
How dividends are paid: cash dividends
A company has declared a dividend with a payment date of June
30
th
. The date of record is Monday, June 6
th
.








In a world with neither taxes nor transaction costs, the stock price is
expected to fall by the amount of the dividend when the stock
goes ex".


2 3 4 5
6
Wed Thu Fri Sat Sun Mon
1
Date of Record
Count back 2 business days
Ex-dividend Date
x x
Cum-dividend
Date
How dividends are paid: stock
dividends
Stock dividend: Distribution of additional shares, instead of
cash, Lo Lhe flrms shareholders.
A stock dividend is commonly expressed as a ratio. For example,
with a 100% stock dividend, a shareholder receives one new
share for every share owned. With a 5% stock dividend, a
shareholder receives one new share for every 20 shares
currently owned.
Stock dividends and stock prices: an example
Consider a flrms sLock LhaL ls selllng for $30 per share. lf Lhe
firm declares a 50% stock dividend which means the
shareholder will receive one additional share for every two
shares currently held, what is the price of a share of stock
after stock dividend?
Stock price =$100/3 = $33.3/share.


4
How Dividends are Paid
An example of stock dividend: XYZ Inc. has 2 million shares
currently outstanding at a price of $15 per share. The company
declares a 50% stock dividend. How many shares will be
outstanding after the dividend is paid? After the stock dividend
what is the new price per share and what is the new value of the
firm?

Additional shares issued = 2 mil 0.50 = 1 mil
New total shares outstanding = 2 mil + 1 mil = 3 mil
Old value = 2 mil $15 = $30 mil = New value
New price per share = $30 mil/3 mil = $10


5
How dividends are paid: stock splits
A stock dividend is very much like a stock split. In both cases, the shareholder is
given a fixed number of new shares for each share held. So they increase the
number of shares outstanding.
For example, in a two-for-one split, each shareholder receives one additional share of stock
for each share already held. So, a two-for-one stock split is equivalent to a 100% stock
dividend.
After Lhe sLock spllL, each share ls enLlLled Lo a smaller percenLage of Lhe flrms cash flow. o
the stock price should fall. If the managers of a firm whose stock is selling at $50 declare a
two-for-one stock split, the price of a share of stock should fall to about $25/share.
In a reverse split, the firm issues new shares in exchange for old shares, which
effectively reduces its number of outstanding shares.
For example, in a one-for-two reverse split, shareholders would exchange two shares held for
one new share.
Obviously, Lhe sLock prlce wlll lncrease afLer a reverse spllL. lf a flrms sLock ls selllng aL $30 per
share, after a one-for-two reverse split, the stock price should be $100 per share.
By doing this, the firm wishes to bring the share price to a more acceptable trading
range and increases its market participation and improve its liquidity.

6
Stock splits: an example
Home electronics has one million shares of common stock
outstanding. Its EPS is $7.5, and its P/E is 12. In order to
bring the stock price back into its optimal trading range, the
company declares a 5-for-4 stock split.
How many shares of common stock will be outstanding
after the split?
What will be the new EPS
How far will the share price fall as a result of the split?
Number of new shares = number of old shares split ratio
= 1,000,000 5/4 = 1,250,000 shares.
Total earnings = 1,000,000 7.5 =$7,500,000. EPS =
7,500,000/1,250,000 =$6/share.
The old price = 7.5 12 = 90. The new price = old price/split
ratio = 90/(5/4) = $72/share.

7
How dividends are paid: Share
repurchases
Share repurchase: Firm buys back stock from
its shareholders.
A share repurchase is similar to a cash
dividend.
Recently, share repurchases have become an
important way of distributing earnings to
shareholders.
8
Share repurchases vs cash dividends
To see why a share repurchase is similar to a dividend,
consider the following example

Assets liabilities and shareholders equity
A. Original balance sheet
Cash $150,000 debt $0
Other assets $850,000 equity: $1,000,000
Total $1,000,000 $1,000,000
Shares outstanding = 100,000, price = $10/share

B. After cash dividend ($100,000)
Cash $50,000 debt $0
Other assets $850,000 equity $900,000
Total $900,000 $900,000
Shares outstanding = 100,000, price = $9/share

C. After stock repurchase ($100,000)
Cash $50,000 debt $0
Other assets $850,000 equity $900,000
Total $900,000 $900,000
Shares outstanding = 90,000, price = $10/share
9
Share repurchases vs cash dividends
now, suppose you have 1,000 shares of Lhe flrms
stock, which are worth $10,000.
If the firm pays out $100,000 as a cash dividend,
shareholders will receive $1 per share. Therefore, after
the cash dividend, you will receive $1,000 in cash, and
you still own 1000 shares of the stock, which are worth
only $9,000.
If the firm repurchases its own stock with $100,000,
and you sell 100 shares to the firm, then you will
receive $1,000 in cash. You still own 900 shares of the
flrms sLock, whlch are worLh $9,000.

10
Share repurchases vs cash dividends
In the real world, there are some accounting differences between a
share repurchase and a cash dividend. The important difference is
in the tax treatment. A repurchase has a significant tax advantage
over a cash dividend.
A dividend is taxed and a shareholder has no choice about whether or
not to receive the dividend.
In a repurchase, a shareholder pays taxes only if (1) the shareholders
actually choose to sell, and (2) the shareholder has a taxable capital
gain on the sale.
Because of the favourable tax treatment of capital gains, a
repurchase is a very sensible alternative to an extra dividend.
Stock repurchase can be used to achieve other corporate goals such
as alLerlng Lhe flrms caplLal sLrucLure or as a Lakeover defence.
Many firms repurchase shares because management believes the
stock is undervalued. Firms repurchasing shares in general
experience an increase in shareholder return.


11
MM dividend-irrelevance proposition
We define dividend policy as the trade-off
between retaining earnings on the one hand and
paying out cash and issuing shares on the other.
MM proves that in an ideal world, that is there
are neither taxes nor transaction fees, the market
is efficient, investors are indifferent to dividend
policy. The value of the firm is unaffected by
dividend policy.
Since investors do not need dividends to convert
shares to cash they will not pay higher prices for firms
with higher dividend payouts.
12
MM dividend-irrelevance proposition:
an illustration
Assume that at date 0, the managers of all equity firm A know that the firm
will receive a cash flow of $10,000 immediately and another $10,000 next
year. In addition, the discount rate is 10% and the number of shares
outstanding is 1,000.
The current dividend policy: At the present time, dividends at each date
are set equal to the cash flow of $10,000. The value of the firm can be
calculated by discounting these dividends.
The dividends per share = $10, so the price is P = 10 +10/(1+10%) =
$19.09/share.
After the dividend is paid, at date 0, the stock price will immediately fall to
19.09 10 = $9.09.
Alternative Policy: Pay a dividend of $11/share at date 0, which is a total
dividend of $11,000.
Because the cash flow is only $10,000, the extra $1,000 must be raised by
issuing stock. As the required rate of return is 10%, the new shareholders will
demand $1,100 of date 1 cash flow, leaving only $8,900 to the old shares.
The value of each share is 11 + 8.9/(1+10%) = $19.09
ame! o, Lhe flrms value ls unaffecLed by dlvldend pollcy.
13
MM dividend-irrelevance proposition:
an illustration
Suppose investor X prefers the current dividend policy; that is, $10
dividends at both date 0 and date 1.
If the firm proposes to adopt the alternative policy, will she be
disappointed? No, because she can easily reinvest the $1 of
unneeded funds received at date 0, yielding an incremental return
of $1.1 at date 1. Thus, she could receive her desired net cash flow
of $11 1 = $10 at date 0 and $8.9 + 1.1 = $10 at date 1.
Conversely, if investor Y prefers $11 of dividend payment at date 0
and $8.9 of dividend payment at date 1, but the firm adopts the
current dividend policy. At date 0, he can sell off shares totalling $1,
his cash flow at date 0 would be $10 + 1 = 11. As a sale of $1 of
stock at date 0 will reduce his CFs by $1.1 date 1. So his net cash
inflow at date 1 would be $10 - $1.1 = $8.9.
The extra $1 is called homemade dividend. So if an investor prefers
more dividend today, he or she can create a homemade dividend.
14
Why dividends may increase firm value
Market imperfections: Theoretically, lnvesLors can generaLe homemade
dlvldends" from sLocks paylng no dlvldends aL all by selllng off a small fracLlon of
his or her holdings. But some investors have a natural preference for high payout
stocks, because the costs of homemade dividends may be high (transaction cost,
taxes), it is simpler and cheaper to receive a cash dividend. These clients increase
the price of the stock through their demand for a dividend paying stock.
Dividend as signals: Dividend increases represent signals of favourable expected
earnings. Firms will raise dividends only when future earnings and cash flows are
expected to be large enough to sustain the dividend in the new level. Similarly, a
dividend cut is often a signal that the firm is in trouble. Such a cut is usually not a
voluntary, planned change in dividend policy. Instead, it typically signals that
management does not think that the current dividend policy can be maintained. In
other words, dividend policy is a form of communications to the market about
future prospects. This is called the information content of dividends.
So firm value is not increased by increased dividends, but firm value increases if
dlvldend lncreases slgnal Lhe flrms fuLure prospecLs. ulvldend lncreases send good
news about CF and earnings. Dividend cuts send bad news.
15
Why Dividends May Reduce Firm Value
If dividends are taxed more heavily than capital
gains, then a policy of paying high dividends
would hurt firm value.

In Canada, both capital gains and dividends are
taxed at a lower rate than interest and other types
of income.

16
Why Dividends May Reduce Firm Value
17
Why dividends may reduce firm value:
an example
We consider a situation in which dividends are taxed at 30% and capital gains
are not taxed at all. Suppose a shareholder is considering the stock of firm
G, which pays no dividends and firm D which pays a dividend. Firm G stock
currenLly sells for $100. nexL years prlce ls expecLed Lo be $120. 1he
shareholders in firm G thus expect a $20 capital gain.
For firm G, no dividend is paid.
Pre-tax rate of return = 20/100 = 20%
After-tax rate of return = 20%, because capital gains are not taxed.
Suppose firm D is expected to pay a $20 dividend next year. The stock price is
expected to be $100 after the dividend payment.
If the stocks of firms G and D are equally risky, the market prices must be set
so that their after-tax return on firm D must thus be 20%. What will be the
price of stock in firm D, P
D
?

, then P
D
= $95.

18

D
D
P
P ) 3 . 0 1 ( 20 ) 100 (
% 20

Taxes vs capital gains: dividend

clientele effects
For dividends, individuals face a lower tax rate due to the dividend tax
credit, whereas Canadian public corporations do not pay any tax on
dividend income received from another Canadian corporation.
For capital gains, only 50% of the realized capital gains are taxable. In
addition, taxation takes place only when capital gains are realized.
Stockholders can choose when to sell their shares and thus when to pay
the capital gains tax.
For some investors, dividends may be taxed more heavily than capital
gains. Obviously, these investors prefer income from capital gains. Firms
that can convert dividends to capital gains by shifting their dividend
policies would attract these investors. For others, capital gains may be
taxed more heavily than dividends. These investors would prefer high-
dividend yield stocks. Such investors would be attracted to companies that
switch a low dividend payout to a high dividend payout policy.
This effect is called dividend clientele effect. Because different groups of
investors desire different levels of dividends, when a firm chooses a
particular dividend policy, the only effect is to attract a particular clientele.
19
CH 26: Risk Management
1 06/04/2014
Derivatives, hedging, and risk
A derivative is a financial instrument whose
payoffs and values are derived from, or
depend on, something else (the underlying).
Options
Forwards
Futures
Swaps
2 06/04/2014
Types of traders
Hedgers: hedgers use derivatives to reduce
the risk they face from potential future
movements in a market variable.
Hedging: when a firm reduces its risk exposure, it
is said to be hedging.
Speculators: they use derivatives to bet on the
future direction of a market variable.
Arbitrageurs: they take offsetting positions in
two or more instruments to lock in a profit.

06/04/2014 3
Why hedge
Most companies are in the business of manufacturing or
retailing or wholesaling or providing a service. They have no
particular skills or expertise in predicting variables such as
interest rates, exchange rate, and commodity prices. It makes
sense for them to hedge the risks associated with these
variables as they arise. The companies can then focus on their
main activities, in which they do have particular skills and
expertise. By hedging, they avoid unpleasant surprises such as
sharp rises in the prices of a commodity. It makes life simpler
for the firm and allows it to concentrate on its own business.
Secondly, it does not cost much ( if forwards are used, the cost
is zero if the forward price equals the expected future price).
Finally, the financial market seems reasonably efficient.
Speculation should be a zero-sum game unless financial
managers have special information.
4 06/04/2014
Hedging with forwards
Forward contracts: A forward contract is an agreement
to buy or sell an asset at a certain future time for a
certain price. It can be contrasted with a spot contract,
which is an agreement to buy or sell an asset today.
A forward contract is traded in the over-the-counter
market ---- usually between two financial institutions or
between a financial institution and one of its clients.
One of the parties to a forward contract assumes a long
position and agrees to buy the underlying asset on a
certain specified future date for a certain specified price.
The other party assumes a short position and agrees to sell
the asset on the same date for the same price.
5 06/04/2014
Hedging with forwards
The payoff from a long position in a forward
contract on one unit of an asset is S
T
K, where K
is the delivery price and S
T
is the spot price of the
asset at maturity of the contract.
Similarly, the payoff from a short position in a
forward contract on one unit of an asset is K - S
T
.
The payoff can be positive or negative.
Forward contracts are designed to neutralize risk
by fixing the price that the hedger will pay or
receive for the underlying asset.

6 06/04/2014
Hedging with forwards
A Canadian company knows that 3 months from today the firm must
pay $1 million US for goods it will receive in the US. The current
exchange rate is CDN 1.2 per US$ and if the rate does not change in
3 months, the Canadian dollar cost of the goods to the firm is 1.2
1 = CAD 1.2 million. If during the 3 months the USD rises to
CAD1.3/USD, the company will have to pay 1.3 million Canadian
dollars. This is the exchange risk. Of course, if in 3 months the USD
falls to CAD1.1/USD the firm only needs to pay CAD 1.1 million.
How to hedge the exchange risk?
Assume the 3-month forward rate is CDN $ 1.25/USD. The firm
simply buy $1 million USD 3 months forward at $1.25 CDN per USD.
The company then has a long forward contract on USD. 3 months
later, the company will receive $1million USD and will have to pay
$1.25 million CAD.

7 06/04/2014
Futures contracts
Like a forward contract, a futures contract is an
agreement between two parties to buy or sell an asset
at a certain time in the future for a certain price.
Futures vs forwards:
Unlike forward contracts, futures contracts are normally
traded on an exchange. To make trading possible, the
exchange specifies certain standardized features of the
contract. So, a futures contract is a standardized forward
contract.
lorward conLracLs are cusLom deslgned" fuLures
contracts. They have specific amounts and expiration
daLes Lo meeL Lhe buyers needs. 1hey are Lraded ln Lhe
OTC market.

8 06/04/2014
Futures Contracts: Preliminaries
Standardizing Features:
Contract Size
Delivery Month
Delivery location
Prices of futures contracts are marked to the market on a
daily basis: Daily resettlement
It means that every day any profits or losses on the
contract are calculated.
The effect of marking a futures contract to market is
similar to closing the current position and opening a
new position daily.
Minimizes the chance of default

9 06/04/2014
Futures: an example
We consider an investor who contacted his or her broker
on Thursday, June 5 to buy two December gold futures
contracts on the New York Commodity Exchange
(COMEX). We suppose the current futures price is $400
per ounce. Since the contract size is 100 ounces, the
investor has contracted to buy a total of 200 ounces at
this price. The broker will require the investor to
deposit funds in a margin account. The amount that
must be deposited at the time the contract is entered
into is known as the initial margin. We suppose that
this is $2,000 per contract, or $4,000 in total.
10 06/04/2014
Futures: an example
Suppose, for example, that by the end of June 5, the futures
price has dropped from $400 to $399. This investor has a
loss of $200 (1 X 200). The balance in the margin account
would therefore be reduced by $200 to $3,800. Similarly, if
the price of December gold rose to $403 by the end of the
first day, the balance in the margin account would be
increased by $600 to $4,600.
To ensure the balance in the margin account never becomes
negative, a maintenance margin is set. If the balance in the
margin account falls below the maintenance margin, the
investor receives a margin call and is expected to top up the
margin account to the initial margin level. Assume that the
maintenance margin is $1,750 per contract, or $3,500 in
total, let us see what happens after June 5.
11 06/04/2014
Futures: an example
Day Futures price
($)
Daily gain
(loss) ($)
Margin
account
balance ($)
Margin call
400 4,000
June 5 399 (200) 3,800
June 6 396.1 (580) 3,220 X (780)
June 9 398.2 420 4,420
June 10 396.7 (300) 4,120
June 11 395.4 (260) 3,860

.
Dec. 20, 2014
12 06/04/2014
Futures: an example
As the date for delivery approaches, the
futures contract becomes more and more like
a spot contract, and the price of the futures
contract approaches the spot price.
A very high proportion of the futures contracts
are closed out before the delivery period is
reached.
The marked to market provisions minimize the
chance of default on a futures contract.
13 06/04/2014
Hedging with futures
If you have an asset to sell in the future and want to lock in a
future sales price, you can sell a futures contract on it.
Example: suppose, in June, a Canadian farmer in
Saskatchewan, expects a harvest of 50,000 bushels of wheat
at the end of September. If the price of wheat falls at that
time, his revenue will fall. To hedge this risk, he decides to sell
the September wheat contract on the Winnipeg Commodity
Exchange. Suppose the Sept. wheat futures contract price is
$3.75 a bushel on June 1. the contract size for wheat futures is
5,000 bushels. So, he needs to sell 10 September futures
contracts. For simplicity, we assume there are no transaction
costs.
14 06/04/2014
Hedging with futures



At the delivery date, the price of wheat is $3.2 per
bushel



The futures contracts allow the farmer to lock in a
total revenue of $187, 500 ($3.75/bushel)
Date of transaction Transaction Price per
bushel
Total price
June 1 Sell 10 Sept. wheat
futures contracts
$3.75 105,0003.75=$187,500

Sale of wheat at the spot price 50,0003.2=$160,000
Profit of futures contracts 50,000(3.75-3.2)=$27,500
total $187,500

15 06/04/2014
Chapter 26 -16
Swaps
An arrangement by two counterparties to
exchange one stream of cash flows for another
for a certain time period.
Interest rate swaps: an agreement between 2 parties to
exchange interest payments for a specific maturity on an agreed
upon notional amount.
Notional principal: a reference amount used only to
calculate interest expense but never repaid.
Maturities: less than 1 to over 15 years
currency swaps
Swap Usage: To reduce risk potential and costs.



06/04/2014
Chapter 26 -17
Interest rate swaps
Suppose CP Inc. has just issued a $100mn floating-rate bond,
which pays LIBOR. CP can hedge its interest rate exposure
using an interest rate swap with a swap dealer. Suppose that
the current rates in the swaps market are LIBOR for 8% fixed.
C can enLer lnLo a swap agreemenL Lo pay 8 on noLlonal
prlnclpal" of $100 mllllon Lo Lhe swap dealer and recelve
payment of the LIBOR rate on the same amount of notional
principal.


Company Swap Dealer
8%
LIBOR
LIBOR
to bondholders
06/04/2014
Chapter 26 -18
Interest rate swaps
This table shows the Cos net payments for three
possible interest rates.




The total payment on the bond with swap
agreement equals $8,000,000 regardless of the
interest rate.

06/04/2014
Currency swaps
A currency swap is an exchange of debt-service
obligations denominated in one currency for the
service on an agreed-upon amount of debt
denominated in another currency.
By swapping their future cash-flow obligations,
the counterparties are able to replace cash flows
denominated in one currency with cash flows in a
more desired currency.
With a currency swap, there is always an
exchange of principal amounts at maturity at a
predetermined exchange rate.
19 06/04/2014
Currency swaps: an example
Suppose that a Canadian company A borrows $1.1 million CDN for 3 years at
10% in Canada. At the same time, a US company B borrows $1 million USD
for 3 years at 8% from a US bank. Interest rate payments are made once a
year, and the exchange rate is $1.1 CDN/USD. If the Canadian company
needs $1million USD to finance its new investments in the US, and the US
company needs $1.1 million CDN to finance its investments in Canada,
both companies can arrange a currency swap.
Under this arrangement, the Canadian Company exchanges $1.1 million
CDN for $1 million USD now from company B, and will pay a fixed rate of
interest at 8% in USD to the US company. At the end of the life of the
swap, it pays a principal of $1 million USD and receives a principal of $1.1
million CDN.
The US Company exchanges $1 million USD for $1.1 million CDN now from
company A, and will pay a fixed rate of interest at 10% in CDN to the
Canadian company. At the end of the life of the swap, it pays a principal of
$1.1 million CDN and receives a principal of $1 million USD.
20 06/04/2014
Currency swaps: an example
Cash flows to the Canadian company in the currency swap




For the Canadian company, the swap has the effect of
transferring its 10% CAD loan into an 8% USD loan.
This is a fixed-for-fixed currency swap. Similarly, a fixed-for-
floaLlng swap has Lhe effecL of Lransferrlng Lhe flrms
fixed-rate CAD loan into a floating-rate USD loan.




21
year 0 1 2 3
Original CAD loan ( million
$)
1.1 -0.11 -0.11 -1.1 - 0.11
CAD Cash Flows ( million $) -1.1 0.11 0.11 1.1 + 0.11
USD cash flows (million $) 1 -0.08 -0.08 -0.08 -1
Net Cash flows (USD) 1 -0.08 -0.08 -0.08 -1

06/04/2014