What is “wealth”? How do dividends and investments play into that? Be very descriptive and show the mathematical reasoning behind your answers. How does long term debt play into the capital structure of an organization and how does it play into potential grow or innovation?

What is “wealth”? How do dividends and investments play into that? Be very descriptive and show the mathematical reasoning behind your answers. How does long term debt play into the capital structure of an organization and how does it play into potential grow or innovation?

This paper should be no less than 800 words. (not includes title and reference.)

Essential Activities:

1. Reading chapters 16-18 in in Textbook Finance: Applications and Theory will help in the completion of the assignment.

Notes:

This paper must be formatted in APA Style 7th edition.

Please refer to the written assignment rubric on the start here tab for this paper.

Requirements: in-depth example

530cor91411_ch16_530-563.indd 530 01/27/17 03:43 PMviewpointsPART EIGHTBusiness ApplicationSuppose that Kieran has decided that itÕs time to take her photography business, currently run on an all-equity basis, and leverage it so that itÕs funded with 50 percent debt. The business currently has $30,000 worth of assets and a 15 percent marginal tax rate. Kieran has in hand a bank quote at an interest rate of 9.5 percent on an interest-only loan. As long as Kieran doesnÕt anticipate any chance that the firm wonÕt be able to cover the required interest payments on the loan, or that the bank wonÕt renew the loan at the end of its term, what economic benefits will accrue to Kieran by re-leveraging the firm? (See the solution at the end of the chapter.)Personal ApplicationGunter has just graduated from college and started a new job. HeÕs thinking about buying a townhouse for $150,000 but doesnÕt have a down payment. His bank has offered to lend him 80 percent of the moneyÑa 30-year mortgage at a rate of 5.875 percent. Further, the bank will lend Gunter the other $30,000 through a home equity loan at a rate of 7.90 percent. His applicable tax rate is 25 percent. If he accepts the bankÕs offer, what weighted-average after-tax interest rate will Gunter pay for the purchase of the townhouse? (See the solution at the end of the chapter.)What other options does Gunter have for financing his home purchase?Assessing Long-Term Debt, Equity, and Capital Structure16Final PDF to printer

531cor91411_ch16_530-563.indd 531 01/27/17 03:43 PM© Maksym yemelyanov/123RF So far, weÕve assumed that a firmÕs capital structureÑthe mix of debt and equity the firm uses to finance its operationsÑis either given or irrelevant to the deci-sions weÕve been making. Although this assumption works well in the short term, firms can and do change their capital structures in the longer term. Therefore, we need to analyze factors that affect the firmÕs decision to change its funding mix over the longer term.As weÕll see, two main factors come into play: (1) whether debt interest payments are tax deduct-ible and (2) how increased debt might affect the likelihood of the firm either going bankrupt or enter-ing into financial distress (i.e., approaching bankruptcy). Financial managers carefully choose a capital structure that sets these two factorsÕ marginal effects equal to one another. capital structureThe mixture of debt and equity used to finance the firmÕs operations.financial distressThe condition in which a firm is near bankruptcy.By doing so, they simultaneously maximize firm value and minimize any new projectÕs financing costs.Learning Goals LG16-1 Differentiate between active and passive changes to capital structure. LG16-2 Explain why finance professionals refer to debt as Òleverage.Ó LG16-3 Show how the firm apportions risk and return among stock-holders and bondholders in a Òperfect world.Ó LG16-4 Describe how the optimal capital structure changes under corporate taxation. LG16-5 Demonstrate how individual shareholders can affect capital structure by borrowing and lend-ing on their own account. LG16-6 Calculate the EBIT and EPS levels at which sharehold-ers become indifferent when choosing between two capital structures. LG16-7 Describe how the firmÕs choice of optimal capital structure changes under the possibility of bankruptcy. LG16-8 Analyze whether real-world business practices reflect the theoretical basis for optimal capital structure.Final PDF to printer

532 part eight Capital Structure Issuescor91411_ch16_530-563.indd 532 01/27/17 03:43 PM16.1 ∙ Active versus Passive Capital Structure ChangesIn theory, firms seeking to change their capital structure can take one of two approaches. The first approach is to immediately sell additional claims of one type of capital and use the proceeds to retire other kinds of claims. This is a strategy of active management, and an example of this strategy would be if a firm sold bonds and used the proceeds to buy back shares of stock in order to increase (decrease) its debt ratio (equity ratio). The second approach is to simply wait until the firm requires additional capital to cover new capital budgeting needs, such as new projects or expansion in existing projects, and to then raise the necessary new capital by selling only the type(s) of claims it wants to weigh more heavily in its capital structure. This is a strategy of passive management. An example of this type of strategy would be if an all-equity firm wanted to increase its leverage from debt but held off on doing so until it had new projects to fund, at which time it would raise the capital for those new projects solely through a bond issue.For example, suppose that Kennemore Corp. currently has $10 million in assets, financed entirely with equity. The firm has decided to switch to a 50 percent debt/ 50 percent equity structure. With active capital structure management, it would sell $5 million of debt immediately and use the proceeds to retire half of the equity. Thus Kennemore would wind up with $5 million of debt and $5 million of equity today. With passive capital structure management, it would attempt to fund the next $10 million of assets for future projects entirely with debt, winding up with $10 million of debt and $10 million of equity at some point in the future.We sometimes call active capital structure management restructuring. If the firm wishes to dramatically change its capital structure in a relatively short period of time, restructuring is preferable, both from the firmÕs point of view and from financial analystsÕ perspective. The downside to restructuring, however, is the cost. The firm will need to pay at least one ÒextraÓ set of flotation costs: those associated with selling additional securities of the type of capital it wishes to increase and that it wouldnÕt incur if it wasnÕt doing the restructur-ing. It might also have to pay additional costs associated with retiring the type of capital it wishes to reduce as well, such as having to pay a call premium on bonds retired early.Which approachÑactive or passiveÑis better? It depends on ¥ How quickly the firm is growing. ¥ How much the firm will have to pay in flotation costs if it undertakes the active management approach. ¥ How strongly and how quickly the firm wishes to change the capital structure.In general, for businesses that expect to add significant assets in the near future (either due to growth or by replacing existing assets), the passive management approach works best. Such firms will be able to alter their structure relatively quickly without incurring the additional costs of active management.LG16-1 active capital structure managementThe policy of selling one type of claim (debt or equity) explicitly to retire the other type.passive capital structure managementThe policy of changing the capital structure gradually over time by funding new capital projects dispropor-tionately with the type of capital you want to increase in the capital structure.TIME OUT 16-1 Which strategy, active or passive capital structure management, would make the process of changing the firmÕs capital structure a longer-term proposition? Why?   16-2 Suppose that a firm was simultaneously evaluating the addition of a new capital budgeting project and a proposed capital structure change: Should the old capital structure or the proposed new capital structure be used in determining the WACC for the new project?  Having said that, in this chapter we will focus on examining situations involving active capital structure management. This focus will allow us to examine the benefits of a proposed capital structure change without having to separate out the additional impacts of capital budgeting decisions.Final PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 533cor91411_ch16_530-563.indd 533 01/27/17 03:43 PM16.2 ∙ Capital Structure Theory: The Effect of Financial LeverageIn finance, we refer to using debt within a firmÕs capital structure as financial leverage.1 Why? Because just as a physical lever magnifies force in one direction and movement in another, the force of debt on one side magnifies the effect of potential expected return on the other. It also magnifies variability, or risk, around that return. To see why it does so, we first need to tie up some theoretical loose ends.Modigliani and MillerÕs ÒPerfect WorldÓThe basic tool for examining various variablesÕ effects on the firmÕs choice of optimal capital structure is the Modigliani-Miller (M&M) theorem, named after its authors, Franco Modigliani and Merton Miller, who completed the theorem in 1958. The full development of the M&M theorem starts with a Òperfect world,Ó one that features ¥ No taxes. ¥ No chance of bankruptcy. ¥ Perfectly efficient markets. ¥ Symmetric information sets for all participants.In this perfect world, the M&M theoremÕs two main propositions are Proposition I  ( perfect world ) : V L = V U (16-1)whereVU is the value of an unleveraged, or all-equity-financed, firm.VL is the value of a leveraged firm (i.e., one whose capital structure contains debt). Proposition II  ( perfect world ) :   i E = i E, 0 + D __ E ( i E, 0 − i D ) (16-2)whereiE,0 is the cost of capital for an all-equity firm.iE and iD are the costs of equity and debt in a leveraged firm.Both of these propositions reflect a common underlying intuition, which we sometimes refer to as the capital structure irrelevance assertion. Merton Miller, in his testimony in Glendale Federal BankÕs lawsuit against the U.S. government in December 1997, prob-ably put it best:I have a simple explanation [for the first Modigliani-Miller proposition]. ItÕs after the ball game, and the pizza man comes up to Yogi Berra and he says, ÒYogi, how do you want me to cut this pizza, into quarters?Ó Yogi says, ÒNo, cut it into eight pieces, IÕm feeling hungry tonight.Ó Now when I tell that story, the usual reaction is, ÒAnd you mean to say that they gave you a [Nobel] prize for that?ÓIn terms of Proposition I, what Miller is saying is that, in this perfect world, the firm will be worth the same no matter how it is financed. However, if we were to think of the risk of the firm as the toppings of the pizza, having those toppings distributed unevenly would imply that slices with more toppings (risk) would be expected to offer more Òtaste sensationÓ (i.e., rate of return). To see why, letÕs take a closer look at Proposition II.THE EFFECT OF LEVERAGE ON THE COST OF EQUITY Even Proposition II, which explicitly deals with the cost increase of equity capital as a function of the firmÕs D/E ratio, LG16-2 financial leverageThe extent to which debt securities are used by a firm.Modigliani-Miller (M&M) theorem In an efficient market with-out taxes and bankruptcy costs, the value of a firm does not depend upon the firmÕs capital structure.capital structure irrelevance assertionAnother name for the Modigliani-Miller theorem.1In addition to financial leverage, firms also make use of operating leverage, which refers to the use of fixed versus variable expenses to potentially magnify the firmÕs earnings. Together, these two types of leverage are often referred to as total leverage.Final PDF to printer

534 part eight Capital Structure Issuescor91411_ch16_530-563.indd 534 01/27/17 03:43 PMstems from this same argument of capital structure irrelevance. To see this, we need to combine a couple of observations from earlier chapters with a new bit of information: 1. First, think back to our previous discussion of WACC in Chapter 11. From this, we know that WACC will have to be equal to iE,0 for an all-equity firm, as equity will be the only component cost of capital with any weight in the WACC: WACC = E _____ E + 0 i E,0 + 0 ______ E + D i D × (1 − T C ) = i E,0  for an all-equity firm  2. Second, think back to the IRR rule discussed in Chapter 13. If firms will only accept projects for which the expected rate of return is at least as large as the required, or target, rate of return, then we can think of the WACC not only as the average rate that the firm will pay to capital providers but also as the minimum average expected rate of return on the firmÕs asset investments that must be earned if the firm wants to be able to pay back the capital providers. IRR ≥ i E,0 ⇒ i E,0 = Minimum acceptable expected rate of return 3. Finally, letÕs address the question of what will happen to a firmÕs WACC in M&MÕs perfect world as the capital structure changes. Irving FisherÕs seminal work on the the-ory of investment2 included the separation principle, which states that, with a well-functioning capital market, the firmÕs capital budgeting decisions are separate from its capital structure decisions. That is, what you do with the money and where you get it are two distinctly separate decisions. So changing the firmÕs capital structure in our perfect world should not affect the group of projects chosen, or the minimum accept-able rate of return dictated by those projectsÕ lower boundary of expected returns. WACC = i E,0  for all values of  D __ E Putting all of this together with a simplified3 version of the formula for WACC from Chapter 11 allows us to solve the WACC formula for iE: WACC = E ______ E + D i E + D ______ E + D i D i E,0 = E ______ E + D i E + D ______ E + D i D ⇒ i E = E + D ______ E [ i E,0 − D ______ E + D i D ] = E + D ______ E i E,0 − ( E + D ______ E × D ______ E + D ) i D = ( E __ E + D __ E ) i E,0 − D __ E i D = i E,0 + D __ E i E,0 − D __ E i D i E = i E,0 + D __ E ( i E,0 − i D )   separation principleTheory maintaining that the sources and uses of capital should be decided upon independently.2See Irving Fisher, The Theory of Interest, as Determined by Impatience to Spend Income and Opportunity to Invest It (New York: Macmillan, 1930).3The two simplifications that we have made are that we can use the before-tax cost of debt instead of the after-tax cost (as we are operating in a world without taxes for right now), and we have left out any consideration of preferred stock so as to make our analysis a little more succinct. Given preferred stockÕs aspect as a hybrid form of debt and equity, leaving it in wouldnÕt really add any intuition to the subsequent discussion, but would instead merely make it needlessly more complex.Final PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 535cor91411_ch16_530-563.indd 535 01/27/17 03:43 PMThis derivation shows that the firmÕs cost of equity increases with the use of debt in the capital structure. But the fact that WACC, iE,0, is constant in the D/E ratio implies that a positive relationship between the cost of equity capital and the use of debt in the capital structure is solely due to reapportioning the expected rate of return to the firmÕs assets among claimholders. It does not imply any addition or subtraction of the total amount of return available. That is, the cost of equity goes up as the amount of debt increases, but the WACC stays the same.THE EFFECT OF LEVERAGE ON THE WACC Since debt is cheaper than equity, the firm uses less expensive equity and more relatively cheap debt at a rate that just off-sets the effect on WACC of the increased cost of equity. This leads us to what we will call Proposition IIa, which M&MÕs theorem implies (but to which we donÕt usually refer so formally): Proposition IIa (perfect world): WACC = i E,0 = E ______ E + D i E + D ______ E + D i D (16-3)which will be constant in D/E.LetÕs extend Merton MillerÕs pizza analogy and turn that pizza into a two-layer cake, dividing up the two layers among a group of people on the TV show Survivor. If you have ever seen this show, you are probably aware that it consists of following the day-to-day activities of groups of people ÒstrandedÓ in some exotic locale with very few resources. The survivors usually have access to some plentiful staple food source, but the partici-pants all get rather sick of this plain fare after the first couple of weeks. Periodic infu-sions of small delicacies, either as prizes in a game or simply to stave off a rebellion, go a long way toward making the winners more satisfied with their participation.Assume that one such group has been given the task of eating the two-layered cake. If itÕs a cake that everyone likes, then the most basic logical distribution of the finished product would be to give each person a proportionate share of the cake. However, show producers are rarely nice enough to just drop off delicacies for no reason at all. So letÕs assume that, while one layer of this cake is filled with some savory delight that everyone likes, the other layer is filled with exotic cockroaches, which all group members loathe, albeit to different degrees. Furthermore, letÕs assume that the showÕs producers have dic-tated that the group must finish off the entire cake in a certain amount of time, or some-one will be Òkicked off the island.ÓYou can see that this situation might prompt the group to make some very interesting allotment decisions concerning who gets to/has to eat how much of the cake. The group might decide that the people who agree to take more of the cockroach layer get a larger, proportionate share of the enjoyable layer, too. Or the group may decide that people who eat a slight majority of the disgusting layer get virtually all of the enjoyable layer.These two allocation schemes correspond exactly to the situation seen in all equity and mixed debt/equity capital structures, respectively. If we logically assume that all humans are risk averse, then any financial claim against a firm comes with some of the layer that everyone wantsÑreturns. But any financial claim will also come with some less desirable layer that everyone loathesÑrisks. In an all-equity firm, the equity hold-ers share the firmÕs expected return and expected risk in strictly proportional amounts. Someone who has put in one-fourth of the equity, thereby buying one-fourth of the firmÕs shares, can in return expect to receive one-fourth of the firmÕs returns on its assets. That investor has at risk only the money sheÕs paid for those shares. Someone who put in twice as much money would expect twice as much in return but would also run the risk of los-ing twice as much money, and so forth.In a firm that employs a mixture of debt and equity, however, the parties have implic-itly agreed to a disproportionate sharing of the risk and return layers of the firm. The debt holders have put in a certain portion of the firmÕs capital and thereby expect exactly the return (and the return of their capital) as spelled out in the bond indenture. Their Final PDF to printer

536 part eight Capital Structure Issuescor91411_ch16_530-563.indd 536 01/27/17 03:43 PMEXAMPLE 16-1Impact on Expected Return and Volatility of Increasing Leverage in a Perfect WorldSuppose we are in M&MÕs perfect world, and we have a firm with $100 million in assets, cur-rently financed entirely with equity. Equity is worth $100 per share, and book value of equity is equal to market value of equity.4 Also, letÕs assume that the firmÕs expected EBIT values depend on which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:StateRecessionAverageBoomProbability of state0.20.60.2Expected EBIT in state$10 million$25 million$35 millionThe firm is considering switching to either a 30-percent- or 60-percent-debt capital structure and has determined that it would have to pay an 8 percent yield on perpetual debt in either event.5 What will be the effect on expected EPS and the volatility of that EPS if the firm stays with its current capital structure or switches to either of the two proposed structures?SOLUTION: If the firm stays with its all-equity structure, it will have $100 million/$100 = 1 million shares outstanding, and the EPS under each state of nature will beStateRecessionAverageBoomEBIT$10,000,000$25,000,000$35,000,000Less: Interest 0 0 0EBT$10,000,000$25,000,000$35,000,000Less: Taxes 0 0 0Net income$10,000,000$25,000,000$35,000,000EPS$ 10.00$ 25.00$ 35.00The expected EPS and standard deviation of the EPS will be E (EPS) = 0.2 × $10.00 + 0.6 × $25.00 + 0.2 × $35.00 = $24.00 σ EPS = √ ___________________________________________________________ 0.2($10.00 − $24.00 ) 2 + 0.6($25.00 − $24.00 ) 2 + 0.2($35.00 − $24.00 ) 2 = $8.00 If the firm refinances 30 percent of the capital by selling $30 million in debt and uses the pro-ceeds to retire $30 million in equity, the interest on the debt will amount to 0.08 × $30 million = $2.4 million, and the firm will have $70 million/$100 = 700,000 shares outstanding, and the EPS under each state of nature will beFor interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG16-34Please note that this assumption is made purely to simplify the math. Having the market and book values of equity differ would add to the complexity of this example, but would not change the basic intuition.5This assumption is also made to simplify the calculations. We could consider a situation in which debt had a finite maturity, but to the extent that a firm would want to stick with a particular capital structure, any retire-ment of debt would have to be perfectly offset with an equivalent issue of new debt, which would add much numerical complexity of the example, but nothing to the intuition.expected returns will never change; they will get exactly what they signed up for, with no business risk on the line. The equity holders, in accepting for themselves a residual claim on the companyÕs future proceeds, have agreed to accept more than their fair share of the risk layerÑthey take on both business and financial risk. In return, they also expect a disproportionately large share of the expected return layer.This is what we are seeing in equation 16-2. The reason that iE increases as D/E increases is to compensate the remaining stockholders for bearing more and more resid-ual risk as the number of stockholders declines.Final PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 537cor91411_ch16_530-563.indd 537 01/27/17 03:43 PMStateRecessionAverageBoomEBIT$10,000,000$25,000,000$35,000,000Less: Interest2,400,0002,400,0002,400,000EBT$ 7,600,000$22,600,000$32,600,000Less: Taxes 0 0 0Net income$ 7,600,000$22,600,000$32,600,000EPS$ 10.86$ 32.29$ 46.57The expected EPS and standard deviation of the EPS will be E(EPS) = 0.2 × $10.86 + 0.6 × $32.29 + 0.2 × $46.57 = $30.86 σ EPS = √ ________________________________________________________________ 0.2($10.86 − $30.86 ) 2 + 0.6($32.29 − $30.86 ) 2 + 0.2($46.57 − $30.86 ) 2 = $11.43 If the firm refinances 60 percent of the capital by selling $60 million in debt and using the proceeds to retire $60 million in equity, the interest on the debt will amount to 0.08 × $60 million = $4.8 million, and it will have $40 million/$100 = 400,000 shares outstanding, and the EPS under each state of nature will beStateRecessionAverageBoomEBIT$10,000,000$25,000,000$35,000,000Less: Interest4,800,0004,800,0004,800,000EBT$ 5,200,000$20,200,000$30,200,000Less: Taxes 0 0 0Net income$ 5,200,000$20,200,000$30,200,000EPS$ 13.00$ 50.50$ 75.50The expected EPS and standard deviation of the EPS will be E ( EPS ) = 0.2 × $13.00 + 0.6 × $50.50 + 0.2 × $75.50 = $48.00 σ EPS = √ ________________________________________________________________ 0.2($13.00 − $48.00 ) 2 + 0.6($50.50 − $48.00 ) 2 + 0.2($75.50 − $48.00 ) 2 = $20.00 Similar to Problems 16-5, 16-6, 16-7, 16-8, Self-Test Problem 1As this example shows, increasing the amount of debt in the capital structure will increase the expected EPS level, but it will also increase the variationÑalso known as riskÑthat we can expect around that expected EPS. This basic intuition is driven by the fact that stockholders hold the residual claim to earnings. Thus they bear more of the business risk, also known as the state-of-nature-induced volatility, than debt holders do. In fact, as long as EBIT is large enough to ensure that debt holders receive their promised interest payments even in the worst state of nature, then equity holders are the only claim holders of the firm that can possibly lose money; therefore, they bear all of the risk once debt is introduced into a firmÕs capital structure.Of course, please keep in mind that this intuition only holds true here because weÕre assuming weÕre in M&MÕs perfect world, the one where, since thereÕs no chance of bankruptcy, thereÕs also no chance that debt holders wonÕt get all the money owed them, regardless of which state of the economy occurs.M&M with Corporate TaxesThe value of the M&M theorem does not really lie in the wisdom of their two proposi-tions, which are driven by the very unrealistic set of Òperfect worldÓ assumptions listed previously. Instead, the value lies in examining what happens to these two propositions when we relax the unrealistic assumptions and move closer to what we see in real life.LG16-4 Final PDF to printer

538 part eight Capital Structure Issuescor91411_ch16_530-563.indd 538 01/28/17 01:09 PMFor example, if we slightly relax the assumptions above and allow ourselves to assume that corporations are taxed, that corporate debt is perpetual, and that interest is tax deductible, then the main propositions of the M&M theorem become:6 Proposition I ( with corporate taxes ) : V L = V U + D T C (16-4)whereVU is the value of an unleveraged firm.VL is the value of a leveraged firm.D is the level of perpetual firm debt.TC is the applicable coporate tax rate. Proposition II (with corporate taxes): i E = i E,0 + D __ E ( i E,0 − i D ) × (1 − T C ) (16-5)whereiE,0 is the cost of capital of capital for an all-equity firm.iE and iD are the costs of equity and debt in a leveraged firm.Proposition IIa ( with corporate taxes ) : WACC = E ______ E + D i E + D ______ E + D i D (1 − T C ) (16-6) which will be decreasing in D/E.We often refer to this situation as the ÒThe More Debt, the BetterÓ condition. Under this condition implied by M&M, the firmÕs value forever increases (and the WACC forever decreases) as the firm takes on larger and larger amounts of debt, as implied in Proposition I.Note how a relatively minor change in our assumptions has dramatically altered the firmÕs suggested capital structure strategy. In the perfect world, capital structure did not matter, so the firm was free to choose whichever level of debt it preferred. In this slightly more realistic world with corporate taxes, managers can maximize the firmÕs value by taking on as much debt as possible. Thus the firm should try to be as close to 100 percent debt-financed as possible.What caused this change in optimal strategy? ItÕs not so much that we have added taxation, but that we have added it differentially: any money paid out to stockholders is taxable, so that a dollar paid in dividends actually means removing $1.00/(1 − TC) in company earnings. On the other hand, paying a dollar in interest to service debt carries no equivalent tax Òsurcharge.ÓHowever, though adding corporate taxes to our environment changes the firmÕs opti-mal strategy, it does not really change the effect that an increase in leverage has on the stockholdersÕ expected returns and the volatility of those returns.6The assumption of perpetual debt makes the mathematical expressions for Propositions I and II concise: with perpetual debt, the present value of the tax shields to interest on debt are the present value of the perpe-tuity, PV = [(D × iD) × TC]/iD, which simplifies to DTC.EXAMPLE 16-2LG16-4Impact of Leverage on ShareholdersÕ Expected Return and Volatility with Corporate TaxesReexamine the situation we described in Example 16-1. Now suppose that the firm faces a 35 percent tax rate. What will be the effect on expected EPS and the volatility of that EPS if the firm stays with its current capital structure or switches to either of the two proposed structures?For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.Final PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 539cor91411_ch16_530-563.indd 539 01/27/17 03:43 PMSOLUTION: If the firm stays with its all-equity structure, it will have $100 million/$100 = 1 million shares outstanding, and the EPS under each state of nature will be:StateRecessionAverageBoomEBIT$10,000,000$25,000,000$35,000,000Less: Interest000EBT$10,000,000$25,000,000$35,000,000Less: Taxes (35%)3,500,0008,750,00012,250,000Net income$ 6,500,000$16,250,000$22,750,000EPS$ 6.50$ 16.25$ 22.75The expected EPS and standard deviation of the EPS will be E(EPS) = 0.2 × $6.50 + 0.6 × $16.25 + 0.2 × $22.75 = $15.60 σ EPS = √ _______________________________________________________________ 0.2($6.50 − $15.60 ) 2 + 0.6($16.25 − $15.60 ) 2 + 0.2($22.75 − $15.60 ) 2 = $5.20 If the firm refinances 30 percent of the capital by selling $30 million in debt and using the proceeds to retire $30 million in equity, the interest on the debt will amount to 0.08 × $30 million = $2.4 million, and the firm will have $70 million/$100 = 700,000 shares outstanding, and the EPS under each state of nature will beStateRecessionAverageBoomEBIT$10,000,000$25,000,000$35,000,000Less: Interest2,400,0002,400,0002,400,000EBT$ 7,600,000$22,600,000$32,600,000Less: Taxes (35%)2,660,0007,910,00011,410,000Net income$ 4,940,000$14,690,000$ 21,190,000EPS$ 7.06$ 20.99$ 30.27The expected EPS and standard deviation of the EPS will be E(EPS) = 0.2 × $7.06 + 0.6 × $20.99 + 0.2 × $30.27 = $20.06 σ EPS = √ _______________________________________________________________ 0.2($7.06 − $20.06 ) 2 + 0.6($20.99 − $20.06 ) 2 + 0.2($30.27 − $20.06 ) 2 = $7.43 If the firm refinances 60 percent of the capital by selling $60 million in debt and using the proceeds to retire $60 million in equity, the interest on the debt will amount to 0.08 × $60 million = $4.8 million, and the firm will have $40 million/$100 = 400,000 shares outstanding, and the EPS under each state of nature will beStateRecessionAverageBoomEBIT$10,000,000$25,000,000$35,000,000Less: Interest4,800,0004,800,0004,800,000EBT$ 5,200,000$20,200,000$30,200,000Less: Taxes (35%)1,820,0007,070,00010,570,000Net income$ 3,380,000$13,130,000$19,630,000EPS$ 8.45$ 32.83$ 49.08The expected EPS and standard deviation of the EPS will be E(EPS) = 0.2 × $8.45 + 0.6 × $32.83 + 0.2 × $49.08 = $31.20 σ EPS = √ ___________________________________________________________ 0.2($8.45 − $31.20 ) 2   + 0.6($32.83 − $31.20 ) 2 + 0.2($49.08 − $31.20 ) 2 = $13.00 Similar to Problems 16-9, 16-10, 16-11, 16-12, Self-Test Problem 2Final PDF to printer

540 part eight Capital Structure Issuescor91411_ch16_530-563.indd 540 01/28/17 01:09 PME(EPS)0% Debt30% Debt60% DebtPerfect world$24.00$30.86$48.00With corporate taxes15.6020.0631.20EPS S.D.0% Debt30% Debt60% DebtPerfect world$ 8.00$11.43$20.00With corporate taxes5.207.4313.00TABLE 16.1 Expected EPS and Volatility in EPS in Examples 16-1 and 16-2EXAMPLE 16-3LG16-5Undoing a Change in LeverageFor example, letÕs suppose that an investor originally owned 100 shares in the unleveraged firm that we started with in Example 16-2, but that the firm switched to the proposed 30 percent debt level in its capital structure. How could the investor change her holdings For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.To summarize, the expected EPS and volatility in EPS for the three different proposed capital structures in Examples 16-1 and 16-2 are shown in Table 16.1. As we can see, adding corporate taxes to the mix reduces both the level and volatility of EPS between worlds (i.e., as move from an assumption of no taxation to one of corporate taxation), but increasing leverage within a particular world still makes both expected EPS and its volatility increase.A casual glance at the two versions of Proposition I that we have encountered so far, the one in equation 16-1 for the perfect world and the one in equation 16-4 for the world with corporate taxes, would probably lead one to believe that itÕs better to be a leveraged firm in a world with taxes: After all, VL = VU + DTC sounds like a good deal compared to VL = VU, right? Well, not really: We have to remember that VU in a world with taxes is going to be less than VU in a world without taxes, so the equations for VL in these two versions of Proposition I really are not comparable.Or, returning once more to our cake analogy, in this with-tax world, the cake starts out the same size as it did in the world without taxes, but the taxman gets to take a bite before the bondholders or the stockholders get their portions. Most important, the size of the bite that the taxman gets is based on how the rest of the cake will be divided between the bondholders and stockholders: If we can precommit to giving the bondholders as much cake as possible (and the stockholders as little as possible), then the taxman will not take anythingÑthat is, then the value of the firm that goes to the bondholders and stockhold-ers (considered as one single group) is maximized.The Choice to Re-LeverageIn both of the worlds we have talked about so far, we have seen that increasing the amount of firm debt increases both the expected cash flows to equity holders and the volatility of those cash flows. Considering our discussion of the CAPM and the SML in Chapter 10, we should probably be wondering what happens to the firmÕs investors if it decides to change its capital structure. If they were happiest with the mix of risk and expected return the firm was offering before, are they going to be upset if they are ÒbootedÓ off their optimal mix to something that has a different mixture of risk and expected return?So far, the answer is no. Remember that the worlds we have been working in so far assume perfectly efficient capital markets, implying that any investors who were unhappy with a change in the firmÕs capital structure would be able to costlessly undo any changes inflicted upon them.Final PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 541cor91411_ch16_530-563.indd 541 01/27/17 03:43 PMso that they could return to exactly the same combination of expected return and risk that they had before the change?SOLUTION: Owning 100 shares in the original unleveraged firm, the shareholder would expect to receive total earnings of $650, $1,625, or $2,275 on those 100 shares, depend-ing on the state of the economy that occurred:StateRecessionAverageBoomEBIT$10,000,000$25,000,000$ 35,000,000Less: Interest 0 0 0EBT$10,000,000$25,000,000$ 35,000,000Less: Taxes (35%) 3,500,000 8,750,000 12,250,000Net income$ 6,500,000$16,250,000$22,750,000EPS$ 6.50$ 16.25$ 22.75Average EPS$ 15.60EPS S.D.$ 5.20Shareholder earnings$ 650$ 1,625$ 2,275Average earnings$ 1,560Earnings S.D.$ 520Once the firm re-leveraged, that same shareholder would face a stream of earnings that would be, on average, higher than before, but also more volatile:StateRecessionAverageBoomEBIT$10,000,000$ 25,000,000$35,000,000Less: Interest 2,400,000$ 2,400,000$ 2,400,000EBT$ 7,600,000$ 22,600,000$32,600,000Less: Taxes (35%) 2,660,000$ 7,910,000$11,410,000Net income$ 4,940,000$ 14,690,000$21,190,000EPS$ 7.06$ 20.99$ 30.27Average EPS$ 20.06EPS S.D.$ 7.43Shareholder earnings$ 705.71$ 2,098.57$ 3,027.14Average earnings$ 2,005.71Earnings S.D.$ 742.86To undo the firmÕs Òleveraging upÓ move, the shareholder would need to Òleverage down.Ó That is, since the firm borrowed 30 percent of its capital structure, the shareholder would need to lend 30 percent of her own personal investment portfolio to counter that borrow-ing. To do so, she would sell 30 of her 100 shares, which would yield 30 × $100 per share = $3,000. She would then turn around and invest this $3,000 in the firmÕs bonds. The bonds would earn a before-tax return of $3,000 × 0.08 = $240 per year, or $240 × (1 − 0.35) = $156 per year after taxes. Combining these after-tax earnings with the after-tax earnings on the 70 shares of stock she still owned would give her the exact same distribution of total earnings she would have earned if the firm had not leveraged up:StateRecessionAverageBoomAfter-tax earnings on 3 bonds$156$ 156$ 156After-tax earnings on 70 shares 494 1,469 2,119Total after-tax earnings$650$1,625$2,275Similar to Self-Test Problem 3Final PDF to printer

542 part eight Capital Structure Issuescor91411_ch16_530-563.indd 542 01/27/17 03:43 PMNote that investors could also leverage themselves more than the firm if they wished to. All they would have to do is to borrow enough money and invest it in stock along with the money they started with, so that the ratio of borrowed money to their initial money was set equal to the D/E ratio that they wished the firm had chosen.EXAMPLE 16-4LG16-5Exceeding the FirmÕs LeverageAssume that the firm in the previous example decided not to add debt to its capital struc-ture, but one of its investors, who currently owns 50 shares in the company, has decided that she would like to have the same risk/expected return combination that she would have had if the firm had adopted a capital structure that was 60 percent debt. What could this investor do?SOLUTION: Since she currently owns 50 shares in the unleveraged firm, her ÒstartingÓ wealth will be equal to 50 × $100 = $5,000, and she is facing a distribution of total earnings per period, dependent on the state of the economy, that look like this:StateRecessionAverageBoomEBIT$10,000,000$25,000,000$35,000,000Less: Interest 0 0 0EBT$10,000,000$25,000,000$35,000,000Less: Taxes (35%)3,500,000 8,750,000 12,250,000Net income$ 6,500,000$16,250,000$22,750,000EPS$ 6.50$ 16.25$ 22.75Average EPS$ 15.60EPS S.D.$ 5.20Shareholder earnings$ 325.00$ 812.50$ 1,137.50Average earnings$ 780.00Earnings S.D.$ 260.00For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.! want to know more?Key Words to Search for Updates: syndicated loan, management buyout, LBOOne of the most extreme examples of firm re-leveraging occurs when someone uses a firmÕs debt capacity to buy out the majority of the firmÕs equity holders. Such a leveraged buyout is designed to allow the acquirer to gain control of a firm without having to commit a lot of capital.A typical LBO uses a ratio of 70 percent debt to 30 percent equity, although debt can reach as high as 90 percent to LEVERAGED BUYOUTS (LBOs)finance at work corporate95 percent of the target companyÕs total capitalization. In fact, when LBOs first became popular back in the 1960s, they were originally known as bootstrap transactions, a reference to the expression Òpulling yourself up by your own bootstraps,Ó which reflected the general consensus that the firm was, more or less, paying for its own acquisition.Final PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 543cor91411_ch16_530-563.indd 543 01/27/17 03:43 PMShe would rather have a distribution that looks like this:StateRecessionAverageBoomEBIT$10,000,000$25,000,000$35,000,000Less: Interest4,800,0004,800,0004,800,000EBT$ 5,200,000$20,200,000$30,200,000Less: Taxes (35%) 1,820,000 7,070,000 10,570,000Net income$ 3,380,000$13,130,000$19,630,000EPS$ 8.45$ 32.83$ 49.08Average EPS$ 31.20EPS S.D.$ 13.00Shareholder earnings$ 422.50$ 1,641.25$ 2,453.75Average earnings$ 1,560.00Earnings S.D.$ 650.00To replicate this distribution of earnings across the possible states of the economy, she will need to borrow enough money, B, so that the borrowed money will be 60 percent of the total amount and that her initial capital will be 1 − 0.60 = 40% of the total amount she will invest in the stock: $5,000 = 0.4 ( $5,000 + B ) $5,000 ______ 0.4 − $5,000 = B $12,500 − $5,000 = B $7,500 = B If she follows this strategy, borrowing $7,500 and putting the entire $12,500 into the stock of the nonleveraged firm, then she will have to pay 0.08 × $7,500 × (1 − 0.35) = $390 in after-tax interest no matter what the state of the economy is, and her distribution of net payoffs will be exactly the same as if she had been able to buy shares in a lever-aged firm:StateRecessionAverageBoomAfter-tax payments on $7,500 loan−$390.00−$ 390.00−$ 390.00After-tax earnings on 125 shares 812.502,031.252,843.75(= 125 × $22.75)Total after-tax earnings$422.50$1,641.25$2,453.75Similar to Problems 16-3, 16-9, 16-10Break-Even EBIT and EBIT ExpectationsThe last few examples have had us examining what we expect the distribution of EPS to look like, given a particular choice of capital structure. ItÕs also possible to analyze this issue Òbackwards,Ó solving for a particular expected EPS level that would make investors indifferent between two proposed capital structures. To do so, we simply need to express EPS for each capital structure as a function of EBIT, set the two EPS expressions equal to one another, and then solve for the EBIT level that will solve the equality, called the break-even EBIT.LG16-6 break-even EBITThe level of EBIT at which EPS will be equal for two different capital structures.Final PDF to printer

544 part eight Capital Structure Issuescor91411_ch16_530-563.indd 544 01/27/17 03:43 PMEXAMPLE 16-5For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.Calculating Break-Even EBITCalculate the break-even EBIT between the all-equity and 30-percent-debt capital structures for the firm used in the previous examples.SOLUTION: Remember that the formula for EPS is net income divided by the number of shares, and that, for an all-equity firm, EBIT will be the same as EBT. Then EPS for the all-equity firm can be written as EP S All-equity = EBIT ( 1 − T C ) ______________ Number of shares = EBIT(1 − 0.35) ___________ 1,000,000 For the capital structure with 30 percent debt, EPS can be expressed as EP S 30% Debt = (EBIT − Interest)(1 − T C ) ______________ Number of shares = (EBIT − $2,400,000) ( 1 − 0.35 ) __________________ 700,000 Setting these two equations equal to one another and solving for EBIT will give us the break-even EBIT: EPS 30% Debt = EPS All-equity (EBIT − $2,400,00)(1 − 0.35) _____________________ 700,000 = EBIT(1 − 0.35) ___________ 1,000,000 0.65EBIT − $1,560,000 ___________________ 700,000 = 0.65EBIT ________ 1,000,000 650,000EBIT − $1,560,000,000,000 = 455,000EBIT 195,000EBIT = $1,560,000,000,000 EBIT = $1,560,000,000,000 _________________ 195,000 EBIT = $8,000,000 To show that this level of EBIT really will set EPS equal for the two alternative capital struc-tures, we can compute the two EPS figures and compare: EP S All-equity = EBIT ( 1 − 0.35 ) __________ 1,000,000 = $8,000,000 ( 1 − 0.35 ) ________________ 1,000,000 = $5.20 versus EP S 30% Debt = ( EBIT − $2,400,000 ) ( 1 − 0.35 ) _____________________ 700,000 = ( $8,000,000 − $2,400,000 ) ( 1 − 0.35 ) ___________________________ 700,000 = $5.20 Similar to Problems 16-13, 16-14, Self-Test Problem 4 LG16-6Final PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 545cor91411_ch16_530-563.indd 545 01/27/17 03:43 PM16.3 ∙ M&M with Corporate Taxes and BankruptcyWe can relax the final M&M unrealistic assumption even more by allowing for the pos-sibility that the firm may go bankrupt. By doing this, we imply that the firmÕs debt hold-ers will have to allow for the possibility that they might not receive everything they have been promised. In this more realistic type of situation, debt holders will be asked to bear some firm risk; in return, they will then ask for a little more compensation than they would if their investment was perfectly safe.As we will discuss, it turns out that a firm does not actually have to go bankrupt for the costs of financial distress to start affecting firm value: being close to going bankrupt can bring with it sufficient costs to start having that type of effect, as well.Types of Bankruptcies in the United StatesThe United StatesÕ Bankruptcy Code allows for two types of bankruptcy for which most businesses can file. We generally refer to the two types by the chapter of that code that describes the procedure for eachÑChapter 7 and Chapter 11 bankruptcies.Chapter 7 bankruptcy involves a business liquidation. When the firm files for Chapter 7, it must immediately cease operations, and the bankruptcy court will very quickly appoint a trustee whose primary responsibility will be to sell the firmÕs assets and use the proceeds to pay off as many claimants as possible.These claimants are paid according to the absolute priority rule in the following order: 1. Secured lenders, including bondholders where the bonds give them liens on spe-cific assets. 2. Lawyers, primarily those handling the bankruptcy for the company. 3. Employees. 4. Government. 5. Unsecured debt holders. 6. Equity holders.Depending on the size and number of claims above them, unsecured debt holders (such as those who hold debentures) rarely receive all the money owed them in a Chapter 7 liquidation, and stockholders seldom receive anything at all.A Chapter 11 bankruptcy, on the other hand, involves an attempt to allow the firm to reorganize under court supervision with the hopes of remaining in business. When a firm files for Chapter 11, it is allowed to remain in operation, but its creditors must refrain from contacting the company about debts due except through the bankruptcy court. This explains why you will sometimes hear a Chapter 11 filing referred to as the company seeking protection.Once a company files for Chapter 11, all of its creditors must register with the bank-ruptcy court and may file informational briefs concerning their preferences for the form that the firm reorganization will take. The court will consider this input and will try to come up with a reorganized capital structure for the firm that follows the LG16-7 Chapter 7 bankruptcyForm of bankruptcy in which the firm is liquidated, with the assets sold off to satisfy the claims of the capital providers.Chapter 11 bankruptcyForm of bankruptcy in which the firm seeks to reorganize, restructur-ing debt claims to remain viable.TIME OUT 16-3 Why does the optimal capital structure shift from Òdebt doesnÕt matterÓ to Òthe more debt, the betterÓ when we add corporate taxation to our assumptions?   16-4 If a firm increases its leverage and one of its shareholders doesnÕt like the EPS impact of the change, how can the firm undo the effects of the change?  Final PDF to printer

546 part eight Capital Structure Issuescor91411_ch16_530-563.indd 546 01/27/17 03:43 PMguidelines in Section 507 of the bankruptcy code. In general, such reorganizations usu-ally involve maintaining (in some form) any higher claimantsÕ stake in the firm, but it is not unusual for the process to result in a reorganization plan that involves canceling unsecured debt.Within a period of a few months to several years, companies that file for Chapter 11 may ÒemergeÓ from bankruptcy if a proposed reorganization plan gains approval by a sufficient majority7 of the firmÕs debt holders. The firm may also find its bankruptcy converted to a Chapter 7 filing if the court feels that the firm is not viable or if a sufficient majority of the firmÕs debt holders cannot agree on a reorganization plan.Costs of Financial DistressA firm filing for bankruptcy will most certainly incur some substantial costs, such as fees to lawyers, consultants, and accountants, in addition to the reorganization or restructuring costs. However, a long list of costs is incurred if a firm even gets close to bankruptcyÑa situation called financial distress.When firms come close to bankruptcy (or if they are perceived as being close to bank-ruptcy), many groups start treating those troubled firms differently: ¥ Customers may be leery of buying from them, especially if buyers are concerned about post-sales support. ¥ Suppliers will be concerned about selling to the firm, particularly on credit, so sellers will start to tighten the credit terms they offer the firm. ¥ Other firms will be less likely to offer the firm valuable partnering opportunities, decreasing the number of wealth-enhancing projects the firm might be able to choose from. ¥ The firmÕs better employees may decide to look elsewhere for jobs, resulting in a loss of efficiency in the firmÕs operations.EQUITY AS A CALL OPTION ON THE VALUE OF THE FIRM If the firm gets close enough to bankruptcy that the equity market value is close to worthless, even the equity holders may start treating the firm differently. To see why, letÕs envision what the payoff diagram for equity in a leveraged firm looks like.In an all-equity firm, the total value of equity will simply equal the firm value. Thus if we graph the value of the equity holdersÕ claims against the firm, value will simply be a 45-degree line, as illustrated in Figure 16.1.However, if we allow debt holders into the firm, the bondholdersÕ claims will take precedence over those of equity holders, up to the amount of promised repayment. So the debt holdersÕ claims will be equal to that shown by the yellow line in Figure 16.2.In such a situation, the equity holders will receive a residual claim, equal to the amount left over after debt holders have been paid. The size of this claim is represented by the area highlighted in Figure 16.3.Taking the absolute magnitude of this portion of the equity holdersÕ claim, along with the minimum equity value of zero implied by equityÕs limited liability attribute, the pay-off to the entire claim of the equity holders will appear as shown in Figure 16.4.As you can see, the size of the equity holdersÕ claim if the firm were not lever-aged would be divided into two partsÑa debt holdersÕ portion and an equity holdersÕ portionÑif the firm became leveraged. This payoff diagram is interesting because this payoff diagram for equity holders looks exactly like the payoff to someone who owns a long position on a call option. A call option is a contract that gives the owner long positionThe position of buying and owning a particular security, which will show a profit if the security increases in value.call optionA derivative instrument that grants the holder the right, but not the obligation, to buy the underlying asset at some prespecified price for a finite length of time.7Proposed reorganization plans must meet with approval of two-thirds of outstanding claimants in terms of dollars due and one-half of claimants by numbers.Final PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 547cor91411_ch16_530-563.indd 547 01/31/17 07:25 PMFIGURE 16.2Value of BondholdersÕ Claim against FirmBondholdersÕ claims take precedence over those of equity holders, so the face value of debt will be equal to that shown by the yellow line.$100$90$80$70$60$50$40$30Value of all-equity Þrm (A)BondholdersÕ claim if risky$20$10$0$0$10$20$30$40$50$60$70$80$90$100Value of ClaimValue of FirmFace value of debt (B)FIGURE 16.1Total Value of Equity in an All-Equity FirmIn an all-equity firm, the total value of equity simply equals the firm value, shown in the graph as a 45-degree line.Value of all-equity Þrm (A)$0$10$20$30$40$50$60$70$80$90$100Value of ClaimValue of Firm$100$90$80$70$60$50$40$30$20$10$0FIGURE 16.3Residual Value of Equity in FirmEquity holders receive a residual claim, one equal to the amount left over after debt holders have been paid. The shaded area shows the size of this claim.$100$90$80$70$60$50$40$30Value of all-equity Þrm (A)BondholdersÕ claim if riskyFace value of debt (B)$20$10$0$0$10$20$30$40$50$60$70$80$90$100Value of ClaimValue of FirmFinal PDF to printer

548 part eight Capital Structure Issuescor91411_ch16_530-563.indd 548 01/28/17 01:09 PMthe right, but not the obligation, to purchase an underlying asset at a certain price. In this case, the equity in a leveraged firm has the right to ÒbuyÓ the firm back from the debt holders by paying them an amount, B, that the debt holders are due under the debt contract.THE OVERINVESTMENT AND UNDERINVESTMENT PROBLEMS More important, equity actually represents a very special case of a long call position, one in which the call owners (the equity holders) presumably also have some control over the potential value of the underlying asset through their choice of investment projects between now and when the debt is due.Envision a leveraged firm that has assets with a current value of exactly ($B − $1,000,000), all currently held in cash. Also assume that the firm has one more chance to invest in a project before $B are due to the debt holders, and that management is trying to choose between two projects, both of which will cost the entire ($B − $1,000,000) stock of cash. Project X will return $B with no risk. Project Y will return ($B + $5,000,000) with a probability of 1 percent and $0 with a probability of 99 percent.If we ignore TVM (just to make our calculations simpler), project XÕs NPV will be $B − ($B − $1,000,000) = $1,000,000, while project YÕs expected NPV will be 0.01 × [($B + $5,000,000) − ($B − $1,000,000)] + 0.99 × [$0 − ($B − $1,000,000)] = $60,000 − 0.99 × ($B − $1,000,000). As long as $B is greater than $50,505.05 (which seems likely, given that project X is offering a risk-free return of $1,000,000), project XÕs NPV will be greater than project YÕs expected NPV, and we would expect the firm to chose project X, right?Wrong. If stockholders have their way, the firm will choose project Y every time. Why? Because on the slim chance that it pays off, they will have $5 million above what they need to pay to the debt holders. In the very probable event that the project fails to return any money, thereby losing the entire investment . . . well, it was not like the equity holders were ever going to get any of that money, anyway, because they would just have had to pay it out to the debt holders if they had not invested it in this project.We call this tendency on stockholdersÕ part in leveraged firmsÑwhere equity is close to being worthlessÑto invest in arguably bad projects Ògambling with other peopleÕs moneyÓ or, more formally, the overinvestment problem. Equity holdersÕ overinvestment problemA situation that arises when a firmÕs equity is close to worthless, equity hold-ers will prefer to invest in overly risky projects with a small chance of success rather than simply paying debt holders their regularly scheduled payments.FIGURE 16.4StockholdersÕ Claim with Debt in the FirmIf the firm is not leveraged, the size of the equity hold-ersÕ claim is divided into two partsÑa debt holdersÕ por-tion and an equity holdersÕ portion.$100$90$80$70$60$50$40$30Value of all-equity Þrm (A)BondholdersÕ claim if riskyFace value of debt (B)StockholdersÕ claimif debt exists$20$10$0$0$10$20$30$40$50$60$70$80$90$100Value of ClaimValue of FirmFinal PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 549cor91411_ch16_530-563.indd 549 01/27/17 03:43 PMassociated decision not to invest in the safe project XÑbecause the resulting increase in wealth from ($B − $1,000,000) to $B would simply go to the debt holdersÑthe underinvestment problem.The Value of the Firm with Taxes and BankruptcyWe modeled the functional relationship between the impact of debt on firm value and the tax rate in the previous section under the assumption that debt was perpetual. This impact of debt on firm value represents a fairly well-known linear relationship, with the slope being equal to the tax rate, as shown in Figure 16.5.The relationship between the amount of debt and the expected costs of bankruptcy or financial distress is not as well known. We have discussed some of the factors that we believe can reasonably affect this relationship. In light of that discussion, we are going to assume that the relationship between the amount of debt and the expected costs of bankruptcy or financial distress is nonlinear and convex in the amount of debt, as shown in Figure 16.6.underinvestment problemThe situation that arises when a firmÕs equity is close to worthless, equity holders will prefer not to invest in safe projects.FIGURE 16.5Value of a Leveraged Firm: Taxes but No BankruptcyThe slope is equal to the tax rate, which reflects the linear relationship of the impact of debt on firm value.D/EValue of FirmVL = VU + DTC∆y/∆x = TCVUFIGURE 16.6Financial Distress Costs as a Function of D/ELetÕs start with the assump-tion that the relationship between the amount of debt and the expected costs of bankruptcy or financial dis-tress is nonlinear, creating a convex debt curve.D/ECost/BeneÞtFinancial distresscostsFinal PDF to printer

550 part eight Capital Structure Issuescor91411_ch16_530-563.indd 550 01/27/17 03:43 PMSo letÕs combine the linearly increasing benefits of debt created by the interest tax shield with nonlinearly increasing costs of debt posed by the potential costs of financial distress. Doing so, we will eventually come to a point where we are increasing the D/E ratio of the firm beyond which the marginal costs of financial distress starts to outweigh the marginal benefits of the interest tax shield. Such a situation is shown in Figure 16.7.Exactly which D/E level will be optimal for a particular firm will depend on both the firmÕs tax rate and how quickly the potential costs of financial distress increase as a function of debt. For example, a firm with a very low marginal tax rate would have the financial distress costs offsetting the tax deductibility of interest very quickly (i.e., at a low level of D/E), while a firm with a large debt capacity/high marginal tax rate would find a higher level of D/E optimal.In this world (as opposed to M&MÕs ideal world), we can write a version of M&MÕs Proposition I as long as we are willing to be rather vague about the functional relation-ship between debt and the costs of financial distress. However, we really cannot formu-late an analogous form of Proposition II because doing so would require us to come up with a more specific function of the costs of financial distress than we are capable of. Proposition I  ( with corporate taxes and bankruptcy ) :    V L = V U  + D T C − PV ( costs of financial distress ) (16-7) whereVU is the value of an unleveraged firm.VL is the value of a leveraged firm.D is the level of perpetual firm debt.TC is the applicable corporate tax rate.Simply put, in this world, Proposition I is effectively saying, ÒThe more debt the better, but only up to a certain point.Ó If we could write a nice, concise functional form for Proposition II in this world, it would still have iE increasing in the D/E ratio. But the rate of increase would be nonlin-ear since, as the amount of debt in the firm got larger and larger, making the probability/costs of bankruptcy increasingly higher, the debt holders would have to bear some of that risk.FIGURE 16.7Value of Leveraged Firm: Taxes and BankruptcyExactly where the D/E level will be optimal for a firm depends on the firmÕs tax rate and how quickly the costs of financial distress increase as a function of debt.D/ECost/BeneÞtFinancial distresscostsVU- Financial distress costsOptimal capitalstructureVL = VU + DTCVL = VU + DTCFinal PDF to printer

chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure 551cor91411_ch16_530-563.indd 551 01/27/17 03:43 PMLikewise, a form of Proposition IIa would have the WACC decreasing up until the opti-mal debt level was achieved, but increasing past that point. In effect, the WACC would initially be decreasing as the firm switched from the ÒexpensiveÓ capital (i.e., equity) to the ÒcheapÓ capital (debt). But in this world the debt would not stay cheap but would itself get more and more expensive as the firm used more of it because the debt holders would ask for a higher and higher rate of return to compensate them for the increasingly higher chance of bankruptcy. Past the optimal debt level, it would just be too expensive to use more of it.FIGURE 16.8Average D/E Ratios for Major Sectors of U.S. EconomySectors with the lowest D/E ratios tend to have low or quite variable income streams, while sectors with the highest D/E ratios tend to have high, stable income streams.Source: Yahoo! http://biz.yahoo.com/p/sectors.html011.523ConglomeratesFinancialUtilitiesServicesConsumer goodsIndustrial goodsBasic materialsTechnology0.52.5Health careTIME OUT 16-5 What causes the overinvestment problem discussed in this section?   16-6 If the bondholders of a firm in financial distress felt that they could recoup more of their investment by renegotiating their claims with the firm and allowing it to continue to operate, what type of bankruptcy would they probably push for?  16.4 ∙ Capital Structure Theory versus RealityOptimal Theoretical Capital StructureBased on our discussions of M&MÕs theory of optimal capital structure, we cannot develop a closed-end formula that will tell us how much debt a particular firm should have in its capital structure. Instead, we can do the next best thing: We can list the factors that should affect firmsÕ capital structures: ¥ Firms facing relatively high tax rates should make more use of debt. ¥ Firms with stable, predictable income streams should be able to make more use of debt than would otherwise be the case.Observed Capital StructuresThough debt levels vary, the general levels of debt we see across segments of our econ-omy do tend to follow these rough rules. As shown in Figure 16.8, the sectors of the U.S. economy with the lowest D/E ratiosÑhealth care and technologyÑboth tend to have low or quite variable income streams, and the sectors with the highest D/E ratiosÑutilities, financial, and conglomeratesÑtend to have high, stable income streams.LG16-8 Final PDF to printer

552cor91411_ch16_530-563.indd 552 01/27/17 03:43 PMviewpoints REVISITEDBusiness Application SolutionIf she re-leverages, Kieran will be financing 50 percent of the assets, or $15,000, with debt. The tax savings per year will be equal to $15,000 × 0.095 × 0.15 = $213.75 And the present value of those tax savings, assuming that they continue on indefinitely, will be $213.75 ________ 0.095 = $2,250 Personal Application SolutionSince both the first mortgage and the home-equity loan would be tax deductible under current IRS guidelines, GunterÕs weighted-average after-tax interest rate will be equal to 0.8 × 0.05875 × (1 − 0.25) + 0.2 × 0.079 × (1 − 0.25) = 4.71%.TIME OUT 16-7 What effect is the Ògraying of AmericaÓ (i.e., the increasing number of baby boomers reaching retirement age) likely to have on debt ratios in the health care industry? Why?   16-8 Explain why utility companies tend to have fairly high debt ratios.  summary of learning goalsThis chapter has explored the concept of the firmÕs optimal capital structure. While we were not able to construct a closed-form equation to tell us exactly how much debt a particular firm should take on, we were able to identify the attributes of the firm that should affect such a decision. Differentiate between active and passive changes to capital structure. When firms wish to change their capital structure, they will often do so by raising capital for new projects gradually to minimize underwriting costs. This passive approach is in contrast with the firm actively selling one type of financial claim (usually debt) and using the proceeds to retire another type of capital (usually equity).Explain why finance professionals refer to debt as Òleverage.Ó Debt in the firmÕs capital structure magnifies both the potential earning power of equity and its volatility or risk.LG16-1LG16-2Show how the firm apportions risk and return among stockholders and bondholders in a Òperfect world.Ó In such a world, the entire ÒlayersÓ of risk and return are split between the equity holders and the debt holders, but they are not split proportionately. Equity holders, in agreeing to take more than their fair share of the risk of the firm, also get a disproportionately larger portion of the return, too.Describe how the optimal capital structure changes under corporate taxation. With corporate taxation, the tax deductibility of the interest payments to debt holders means that such payments are LG16-3LG16-4Final PDF to printer

553cor91411_ch16_530-563.indd 553 01/27/17 03:43 PMpartially subsidized by the taxing authority, making them more attractive. Since we have not yet relaxed the assumption of no chance of bankruptcy, this attractiveness applies no matter how much debt is used, so a capital structure that is as close as possible to all-debt will maximize the subsidy and minimize the firmÕs WACC.Demonstrate how individual shareholders can affect capital structure by borrowing and lending on their own account. Individual shareholders can choose to borrow part of their investment in the firmÕs stock if they wish to increase their own personal leverage, or they can choose to lend part of their personal wealth if they wish to reduce their personal leverage.Calculate the EBIT and EPS levels at which shareholders become indifferent when choosing between two capital structures. We can calculate the break-even EBIT by setting EPS as a function of the firmÕs EBIT at two different capital structures equal to LG16-5LG16-6one another and then solving for the level of EBIT that makes this equality hold.Describe how the firmÕs choice of optimal capital structure changes under the possibility of bankruptcy. Once we relax the Òno possibility of bankruptcyÓ assumption from M&MÕs perfect world, increasing the firmÕs debt level increases both this probability and the expected costs of financial distress. Past a certain level of debt, increasing the debt further will cause the expected costs of financial distress to outweigh the benefits of the tax-deductibility of interest.Analyze whether real-world business practices reflect the theoretical basis for optimal capital structure. As observed from real data, firms that have higher chances of financial distress tend to use less debt, while those firms for whom the tax benefits are substantial tend to use more. This more or less confirms the theory derived from M&MÕs work.LG16-7LG16-8chapter equations 16-1 Proposition I  ( perfect world ) : V L = V U 16-2 Proposition II (perfect world): i E = i E,0 + D __ E ( i E,0 − i D ) 16-3 Proposition IIa (perfect world): WACC = i E,0 = E __________ E + D i E + D __________ E + D i D 16-4 Proposition I (with corporate taxes): V L = V U + D T C 16-5 Proposition II (with corporate taxes): i E = i E,0 + D __ E ( i E,0 − i D ) × (1 − T C ) 16-6 Proposition IIa (with corporate taxes): WACC = E __________ E + D i E + D __________ E + D i D (1 − T C ) 16-7 Proposition I (with corporate taxes and bankruptcy): V L = V U + D T C − PV (costs of financial distress) Final PDF to printer

554cor91411_ch16_530-563.indd 554 01/27/17 03:43 PMkey termsactive capital structure management The policy of selling one type of claim (debt or equity) explicitly to retire the other type. p. 532break-even EBIT The level of EBIT at which EPS will be equal for two different capital structures. p. 543call option A derivative instrument that grants the holder the right, but not the obligation, to buy the underlying asset at some prespecified price for a finite length of time. p. 546capital structure The mixture of debt and equity used to finance the firmÕs operations. p. 531capital structure irrelevance assertion Another name for the Modigliani-Miller theorem. p. 533Chapter 7 bankruptcy Form of bankruptcy in which the firm is liquidated, with the assets sold off to satisfy the claims of the capital providers. p. 545Chapter 11 bankruptcy Form of bankruptcy in which the firm seeks to reorganize, restructuring debt claims to remain viable. p. 545financial distress The condition in which a firm is near bankruptcy. p. 531financial leverage The extent to which debt securities are used by a firm. p. 533long position The position of buying and owning a par-ticular security, which will show a profit if the security increases in value. p. 546Modigliani-Miller (M&M) theorem In an efficient market without taxes and bankruptcy costs, the value of a firm does not depend upon the firmÕs capital structure.  p. 533overinvestment problem A situation that arises when a firmÕs equity is close to worthless, equity holders will prefer to invest in overly risky projects with a small chance of success rather than simply paying debt holders their regularly scheduled payments. p. 548passive capital structure management The policy of changing the capital structure gradually over time by funding new capital projects disproportionately with the type of capital you want to increase in the capital struc-ture. p. 532separation principle Theory maintaining that the sources and uses of capital should be decided upon inde-pendently. p. 534underinvestment problem The situation that arises when a firmÕs equity is close to worthless, equity holders will prefer not to invest in safe projects. p. 549self-test problems with solutions1 Computing Expected Return and Standard Deviation in a Perfect World ILKD, Inc., doesnÕt face any taxes or chance of bankruptcy and has $50 million in assets, currently financed entirely with equity. Equity is worth $80 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend on which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:StateRecessionAverageBoomProbability of state0.150.550.30Expected EBIT in state$2 million$15 million$25 millionThe firm is considering switching to a 30-percent-debt capital structure and has deter-mined that it would have to pay a 10 percent yield on perpetual debt whether or not it changed the capital structure. What will be the effect on expected EPS and the volatility of that EPS if the firm switches to the proposed capital structure? Solution:Expected values and standard deviations of EPS will be as shown:LG16-2, 16-3Final PDF to printer

555cor91411_ch16_530-563.indd 555 01/27/17 03:43 PMAs expected, the expected average EPS is larger if the firm is leveraged, but so is the standard deviation of EPS.2 Impact of Leverage on Expected Return and Volatility with Corporate Taxes Reexamine the situation described in Self-Test Problem 1, but now suppose that the firm faces a 34 percent tax rate. What will be the effect on expected EPS and the volatility of that EPS if the firm stays with its current capital structure or switches to a 30-percent-debt capital structure?  Solution:The expected values and standard deviations for EPS will be as follows:LG16-4EPS without DebtStateRecessionAverageBoomEBIT$2,000,000$15,000,000$25,000,000Less: Interest 0 0 0EBT$2,000,000$15,000,000$25,000,000Less: Taxes 0 0 0Net income$2,000,000$15,000,000$25,000,000EPS$ 3.20$ 24.00$ 40.00Average EPS$ 25.68EPS S.D.$ 11.78EPS with 30% DebtStateRecessionAverageBoomEBIT$2,000,000$15,000,000$25,000,000Less: Interest1,500,0001,500,0001,500,000EBT$ 500,000$13,500,000$23,500,000Less: Taxes 0 0 0Net income$ 500,000$13,500,000$23,500,000EPS$ 1.14$ 30.86$ 53.71Average EPS$ 33.26EPS S.D.$ 16.83EPS without DebtStateRecessionAverageBoomEBIT$2,000,000$15,000,000$25,000,000Less: Interest 0 0 0EBT$2,000,000$15,000,000$25,000,000Less: Taxes (34%) 680,000 5,100,000 8,500,000Net income$1,320,000$ 9,900,000$16,500,000EPS$ 2.11$ 15.84$ 26.40Average EPS$ 16.95EPS S.D.$ 7.78EPS with 30% DebtStateRecessionAverageBoomEBIT$2,000,000$15,000,000$25,000,000Less: Interest 1,500,000 1,500,000 1,500,000EBT$ 500,000$13,500,000$23,500,000Less: Taxes (34%) 170,000 4,590,000 7,990,000Net income$ 330,000$ 8,910,000$15,510,000EPS$ 0.75$ 20.37$ 35.45Average EPS$ 21.95EPS S.D.$ 11.11Final PDF to printer

556cor91411_ch16_530-563.indd 556 01/27/17 03:43 PM3 Undoing a Change in Leverage LetÕs suppose that investors originally owned 100 shares each in the unleveraged firm that we started with in Self-Test Problem 2, but that the firm switched to the proposed 30-percent-debt level in its capital structure. How could the investors change their holdings to return themselves to exactly the same combination of expected return and risk that they had before the change?  Solution:Owning 100 shares in the original, unleveraged firm, the shareholders would expect to receive total earnings of $211.20, $1,584.00, or $2,640.00 on those 100 shares, depending on the state of the economy that occurred.LG16-5Once the firm re-leveraged, those same shareholders would face a stream of earnings that would be, on average, higher than before, but also more volatile:To undo the firm Òleveraging up,Ó the shareholders would need to Òleverage downÓ; that is, since the firm borrowed 30 percent of its capital structure, the shareholders would need to lend 30 percent of their own personal investment portfolio to counter that out. To do so, they would sell 30 of their 100 shares, which would yield 30 × $80 per share = $2,400. They would then turn around and invest this $2,400 in the firmÕs bonds, which would earn a before-tax return of $2,400 × 0.10 = $240 per year, or $240 × (1 Ð 0.34) = $158.40 per year after taxes. Combining these after-tax earnings with the after-tax earnings on the 70 shares of stock they still owned would give them the exact same distribution of total earnings they would have earned if the firm had not leveraged up.EPS without DebtStateRecessionAverageBoomEBIT$2,000,000$15,000,000$25,000,000Less: Interest 0 0 0EBT$2,000,000$15,000,000$25,000,000Less: Taxes (35%) 680,000 5,100,000 8,500,000Net income$1,320,000$ 9,900,000$16,500,000EPS$ 2.11$ 15.84$ 26.40Average EPS$ 16.95EPS S.D.$ 7.78Shareholder earnings$ 211.20$ 1,584.00$ 2,640.00Average earnings$1,694.88Earning S.D.$ 777.77EPS with 30% DebtStateRecessionAverageBoomEBIT$2,000,000$15,000,000$25,000,000Less: Interest 1,500,000 1,500,000 1,500,000EBT$ 500,000$13,500,000$23,500,000Less: Taxes (35%) 170,000 4,590,000 7,990,000Net income$ 330,000$ 8,910,000$15,510,000EPS$ 0.75$ 20.37$ 35.45Average EPS$ 21.95EPS S.D.$ 11.11Shareholder earnings$ 75.43$ 2,036.57$ 3,545.14Average earnings$2,194.97Earning S.D.$1,111.11Final PDF to printer

557cor91411_ch16_530-563.indd 557 01/27/17 03:43 PM4 Calculating Break-Even EBIT: Calculate the break-even EBIT between the all-equity and 30-percent-debt capital structures for the firm used in the previous problems.  Solution:EPS for the all-equity firm can be written as: EPS All-equity = EBIT(1 − T C ) _______________ Number of shares = EBIT(1 − 0.34) ____________ 625,000 For the capital structure with 30 percent debt, EPS can be expressed as: EPS 30%Debt = (EBIT − Interest)(1 − T C ) ____________________ Number of shares = (EBIT − $1,500,000)(1 − 0.34) ________________________ 437,500 Setting these two equations equal to one another and solving for EBIT will give us the break-even EBIT: EPS 30%Debt = EPS All-equity (EBIT − $1,500,000)(1 − 0.34) ________________________ 437,500 = EBIT(1 − 0.34) ____________ 625,000 0.66EBIT − $990,000 __________________ 437,500 = 0.66EBIT _________ 625,000 412,500EBIT − $618,750,000,000 = 288,750EBIT 123,750EBIT = $618,750,000,000 EBIT = $618,750,000,000 _______________ 123,750 EBIT = $5,000,000 LG16-6After-tax earnings on $2,400 invested in bonds$158.40$ 158.40$ 158.40After-tax earnings on 70 shares 52.80 1,425.60 2,481.60Total after-tax earnings$211.20$1,584.00$2,640.00questions 1. How will passive and active capital structure changes differ? (LG16-1) 2. Why is debt often referred to as leverage in finance? (LG16-2) 3. In M&MÕs perfect world, will the debt holders ever bear any of the risk of the firm? (LG16-3) 4. Why does allowing for the existence of corporate taxation cause firms to prefer the maximum amount of debt possible? (LG16-4)Final PDF to printer

558cor91411_ch16_530-563.indd 558 01/27/17 03:43 PM 5. If a firm increased the amount of debt in its capital structure, but a shareholder wanted to switch back to the mixture of expected return and risk she had before the switch, how would she go about doing so? (LG16-5) 6. If an investor wanted to reduce the risk of a leveraged stock in his portfolio, how could he go about doing so while still retaining shares in the company? (LG16-5) 7. Suppose you were the financial manager for a firm and were considering a pro-posed increase in the amount of debt in the firmÕs capital structure. If you thought the firm was going to consistently earn a level of EBIT above its break-even level of EBIT (based on the current and proposed new capital structures), would this cause you to prefer leveraging the firm up or staying at your current capital struc-ture? (LG16-6) 8. Explain why, in a world with both corporate taxes and the chance of bankruptcy, a small firm with volatile EBIT is unlikely to have much debt. (LG16-7) 9. If the U.S. government completely eliminated taxation at the corporate level, how would this influence the capital structures of firms in a world with bankruptcy? (LG16-7) 10. Would you expect a utility company to have high or low debt levels? Why? (LG16-8)problems 16-1 Capital Structure Weights Suppose that Lil John IndustriesÕ equity is currently selling for $37 per share and that 2 million shares are outstanding. If the firm also has 30,000 bonds outstanding, and they are selling at 103 percent of par, what are the firmÕs current capital structure weights? (LG16-3) 16-2 Capital Structure Weights Suppose that Papa Bell, Inc.Õs, equity is currently selling for $55 per share, with 4 million shares outstanding. If the firm also has 17,000 bonds outstanding, and they are selling at 94 percent of par, what are the firmÕs current capital structure weights? (LG16-3) 16-3 Restructuring Strategy Suppose that Lil John IndustriesÕ equity is currently sell-ing for $27 per share and that 2 million shares are outstanding. The firm also has 50,000 bonds outstanding, which are selling at 103 percent of par. If Lil John was considering an active change to its capital structure so that the firm would have a D/E of 1.4, which type of security (stocks or bonds) would it need to sell to accomplish this, and how much would the firm have to sell? (LG16-1) 16-4 Capital Structure Weights Suppose that Papa Bell, Inc.Õs, equity is currently sell-ing for $45 per share, with 4 million shares outstanding. The firm also has 7,000 bonds outstanding, which are selling at 94 percent of par. If Papa Bell was con-sidering an active change to its capital structure so as to have a D/E of 0.4, which type of security (stocks or bonds) would the firm need to sell to accomplish this, and how much would it have to sell? (LG16-1) 16-5 Expected EPS after Leveraging Daddi Mac, Inc., doesnÕt face any taxes and has $290 million in assets, currently financed entirely with equity. Equity is worth $37 per share, and book value of equity is equal to market value of equity. Also, basic problemsintermediate problemsFinal PDF to printer

559cor91411_ch16_530-563.indd 559 01/27/17 03:43 PMletÕs assume that the firmÕs expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associ-ated probabilities shown as follows:StateRecessionAverageBoomProbability of state0.250.550.20Expected EBIT in state$5 million$10 million$17 million The firm is considering switching to a 20-percent-debt capital structure and has determined that it would have to pay an 8 percent yield on perpetual debt in either event. What will be the level of expected EPS if the firm switches to the proposed capital structure? (LG16-3) 16-6 Expected EPS after Leveraging HiLo, Inc., doesnÕt face any taxes and has $150 million in assets, currently financed entirely with equity. Equity is worth $7 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associ-ated probabilities shown as follows:StatePessimisticOptimisticProbability of state0.450.55Expected EBIT in state$5 million$19 million The firm is considering switching to a 40-percent-debt capital structure and has determined that it would have to pay a 12 percent yield on perpetual debt in either event. What will be the level of expected EPS if the firm switches to the proposed capital structure? (LG16-3) 16-7 Standard Deviation in EPS after Leveraging Daddi Mac, Inc., doesnÕt face any taxes and has $350 million in assets, currently financed entirely with equity. Equity is worth $37 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:StateRecessionAverageBoomProbability of state0.250.550.20Expected EBIT in state$5 million$10 million$17 million The firm is considering switching to a 20-percent-debt capital structure and has determined that it would have to pay an 8 percent yield on perpetual debt regard-less of whether it changes the capital structure. What will be the standard devia-tion in EPS if the firm switches to the proposed capital structure? (LG16-3) 16-8 Standard Deviation in EPS after Leveraging HiLo, Inc., doesnÕt face any taxes and has $100 million in assets, currently financed entirely with equity. Equity is worth $7 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which Final PDF to printer

560cor91411_ch16_530-563.indd 560 01/27/17 03:43 PMstate of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:StatePessimisticOptimisticProbability of state0.450.55Expected EBIT in state$5 million$19 million The firm is considering switching to a 40-percent-debt capital structure and has determined that it would have to pay a 12 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if the firm switches to the proposed capital structure? (LG16-3) 16-9 Expected EPS after Leveraging with Taxes NoNuns Cos. has a 25 percent tax rate and has $350 million in assets, currently financed entirely with equity. Equity is worth $37 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:StateRecessionAverageBoomProbability of state0.250.550.20Expected EBIT in state$5 million$10 million$17 million The firm is considering switching to a 20-percent-debt capital structure and has determined that it would have to pay an 8 percent yield on perpetual debt in either event. What will be the level of expected EPS if the firm switches to the proposed capital structure? (LG16-4) 16-10 Expected EPS after Leveraging with Taxes GTB, Inc., has a 34 percent tax rate and has $100 million in assets, currently financed entirely with equity. Equity is worth $7 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:StatePessimisticOptimisticProbability of state0.450.55Expected EBIT in state$5 million$19 million The firm is considering switching to a 40-percent-debt capital structure and has determined that it would have to pay a 12 percent yield on perpetual debt in either event. What will be the level of expected EPS if GTB switches to the pro-posed capital structure? (LG16-4) 16-11 Standard Deviation in EPS after Leveraging with Taxes NoNuns Cos. has a 25 percent tax rate and has $350 million in assets, currently financed entirely with equity. Equity is worth $37 per share, and book value of equity advanced problemsFinal PDF to printer

561cor91411_ch16_530-563.indd 561 01/27/17 03:43 PMis equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:StateRecessionAverageBoomProbability of state0.250.550.20Expected EBIT in state$5 million$10 million$17 million The firm is considering switching to a 20-percent-debt capital structure and has determined that it would have to pay an 8 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if NoNuns switches to the proposed capital structure? (LG16-4) 16-12 Standard Deviation in EPS after Leveraging with Taxes GTB, Inc., has a 34 percent tax rate and has $100 million in assets, currently financed entirely with equity. Equity is worth $7 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:StatePessimisticOptimisticProbability of state0.450.55Expected EBIT in state$5 million$19 million The firm is considering switching to a 40-percent-debt capital structure and has determined that it would have to pay a 12 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if it switches to the pro-posed capital structure? (LG16-4) 16-13 Break-Even EBIT with Taxes NoNuns Cos. has a 25 percent tax rate and has $350 million in assets, currently financed entirely with equity. Equity is worth $37 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associ-ated probabilities shown as follows:StateRecessionAverageBoomProbability of state0.250.550.20Expected EBIT in state$5 million$10 million$17 million The firm is considering switching to a 20-percent-debt capital structure and has determined that it would have to pay an 8 percent yield on perpetual debt in either event. What will be the break-even level of EBIT? (LG16-6) 16-14 Break-Even EBIT with Taxes GTB, Inc., has a 34 percent tax rate and has $100 million in assets, currently financed entirely with equity. Equity is worth $7 per share, and book value of equity is equal to market value of equity. Also, letÕs assume that the firmÕs expected values for EBIT depend upon which state of Final PDF to printer

562cor91411_ch16_530-563.indd 562 01/27/17 03:43 PMthe economy occurs this year, with the possible values of EBIT and their associ-ated probabilities shown as follows:StatePessimisticOptimisticProbability of state0.450.55Expected EBIT in state$5 million$19 million The firm is considering switching to a 40-percent-debt capital structure and has determined that it would have to pay a 12 percent yield on perpetual debt in either event. What will be the break-even level of EBIT? (LG16-6)research it! Investigating FirmsÕ Debt RatiosGo to the Yahoo! Industry Center at http://biz.yahoo.com/ic/, choose an industry from among the ÒTop IndustriesÓ listed in the left column, and choose three of the leading firms for that industry.What are these firmsÕ debt ratios? Investigate each firmÕs background to try to deter-mine whether the factors we discussed in this chapter are driving any differences in the amount of debt that they each have in their capital structures.integrated mini-case: Change in Equity OwnershipThe CEO of JJJ, Inc., owns 27 percent of his currently all-equity-financed firm worth $100 million. He has proposed splitting off one of the divisions (worth $25 million) of his company to let it operate as an independent firm. Existing shareholders will not get shares in the new firm; instead, the new firm is expected to raise $25 million through an IPO, the proceeds from which are to be used to repurchase shares in JJJ.Assuming that the CEO does not participate in the stock buyback, what will his percentage ownership be after the division is split off?ANSWERS TO TIME OUT 16-1 Passive capital management would take longer, as the firm would have to wait until new capital budgeting projects required funds before altering the capital structure. 16-2 The new capital structure should be used. As pointed out in Chapter 11, new projects should be evaluated using the capital structure that will actually be used to fund them. 16-3 With interest on debt being tax deductible, the government essentially picks up part of the tab for debt. This makes it even cheaper, so firms maximize their use of debt so as to maximize the interest tax shield.Final PDF to printer

563cor91411_ch16_530-563.indd 563 01/27/17 03:43 PM 16-4 The firm can unleverage, or lend, part of its portfolio. 16-5 When stockholdersÕ equity stake is close to worthless, they can gamble on risky proj-ects without any risk to themselves but with the opportunity of regaining some value if such projects earn a high rate of return. Given this, they will tend to actually prefer such projects in this type of situation. 16-6 They would prefer a Chapter 11 reorganization. 16-7 Given that the health care industry will likely experience higher, more stable revenues and profits, we should expect that the industry will be able to support higher debt ratios. 16-8 Utility companies have fairly high debt ratios because they have relatively high, stable cash flows, both due to the nature of their product and due to the barriers to entry rep-resented by the large initial capital investment necessary to build a power plant and a power distribution infrastructure.Final PDF to printer

564cor91411_ch17_564-587.indd 564 01/27/17 03:43 PMPART EIGHTviewpointsBusiness ApplicationSuppose that SWV Corp. has consistently followed the pure residual dividend policy in the past, but is considering switching to a ÒsmoothedÓ residual dividend policy, where dividends would be set at a level that management feels they could comfortably maintain for the foreseeable future. If SWV does have a considerable amount of excess cash, it will consider either issuing an extraordinary dividend or buying back some of its stock. What would be the probable impact on the firmÕs stock price if it does adopt this new policy? (See the solution at the end of the chapter.)Personal ApplicationAssume that personal tax rates on dividends and capital gains have shifted back so that the rate on dividends is significantly higher than that on capital gains. Marc is considering buying stock to put into his Roth IRA, a type of retirement account established by U.S. tax law that allows individuals to deposit funds into an account up to a certain maximum each year. Contributions are taxed before they are deposited, but all deposits plus any earnings can be withdrawn tax-free after the individual reaches 59.5 years of age. Marc is interested in two stocks. One pays returns primarily as a dividend yield, and the other returns primarily a capital gains yield. If he canÕt buy both stocks under the annual contribution limit, which should he choose for his Roth IRA? (See the solution at the end of the chapter.) Pay taxes now (Roth IRA) or pay them later (traditional IRA)? Check out the dynamics.Sharing Firm Wealth: Dividends, Share Repurchases, and Other Payouts17Final PDF to printer

565cor91411_ch17_564-587.indd 565 01/27/17 03:43 PM© Adam Gault/Getty Images RFThus far, weÕve examined the firmÕs investment and financ-ing decisions. Both kinds of decisions are vitally important for the firm to achieve its primary goal: maximizing shareholder wealth. But few shareholders would be satisfied with maximized share value if they didnÕt get to benefit from that share value, so the firm also needs to worry about getting that wealth back into shareholdersÕ pockets. ThatÕs what this chapter is all about.In a theoretically perfect world without any taxes, or where all of the firmÕs cash disbursements were taxed equally (whether capital gains, regu-lar interest payments, or dividends), distributing capital to sharehold-ers would be a simple proposition. It would be based entirely upon the firmÕs available opportunities for investment in prospective projects. In the real world, though, itÕs not so straightforward. As weÕll discuss, the U.S. government treats dividends and interest payments differently than it does capital gains for individual tax returns. Further, potentially varying personal tax rates throughout a share-holderÕs investment horizon dictate that firms will confront varying bond-holder and shareholder preferences when the firms design their payout strategies.Learning Goals LG17-1 Identify factors that affect a firmÕs payout policies. LG17-2 Discuss how investorsÕ pref-erences regarding differen-tial tax rates and timing can guide the firmÕs policies on the distribution of dividends and capital gains. LG17-3 Summarize the information effect, the clientele effect, and other corporate control issues. LG17-4 Analyze a firmÕs decision to distribute constant ordinary dividends or extraordinary dividends. LG17-5 Explain the effect that cash dividend payment procedures have on stock prices. LG17-6 Differentiate between a stock dividendÕs impact and a stock splitÕs impact on the firmÕs books. LG17-7 Note the advantages and dis-advantages of a firmÕs stock repurchases.Final PDF to printer

566 part eight Capital Structure Issuescor91411_ch17_564-587.indd 566 01/27/17 03:43 PM17.1 ∙ Dividends versus Capital GainsWe can see the basic choice between a firm paying out money in the form of a cash divi-dend or using the money to repurchase shares of stock by examining the formula for a constant-growth stock we used in Chapter 8: P 0 =  D 1 _____ i − g (17-1)You will recall from Chapter 8 that the amount of the next dividend, D1, links to the capi-tal gains rate, g, through the dividend payout ratio, defined as Dividend payout ratio =  Dividends __________ Net income (17-2)Firms that pay out a relatively high percentage of current earnings will have fewer retained earnings, and hence less capital to fund future growth in earnings and dividends. The opposite is also true: Firms that hold onto retained earnings wonÕt have much left with which to pay dividends and interest payments. Assuming that the capital markets to which firms turn to raise capital are competitive, firms should only retain earnings to the extent that they can invest those funds in projects that will earn at least as high a rate of return as the rate that investors could earn by taking the same money and investing it in other firms with similar risk profiles.Dividend Irrelevance TheoremThe idea that it does not matter whether a firm pays dividends or not derives from another Modigliani and Miller theorem. This is referred to, appropriately enough, as the dividend irrelevance theorem. As with their theory about capital structure irrelevance discussed in the last chapter, the dividend irrelevance theorem is set in a perfect world, one that features ¥ No taxes. ¥ No transaction costs (including trading commissions). ¥ Perfectly efficient markets. ¥ Completely rational investors.In such an environment, M&M show that the decision to pay or not to pay dividends doesnÕt matter. If a firm pays dividends, doing so will simply reduce the value of each share by the amount paid in dividends. If share owners donÕt want the value of their shares reduced by dividends, they can simply turn around and buy additional shares in the company with the dividend proceeds. Doing so will keep the total amount of wealth they have invested in the firm constant. Similarly, if a firm chooses not to pay dividends, but investors wish that the firm would pay out regularly, then they can simply sell enough shares to reap the same dollars of income that they would have gotten if the firm had paid dividends.Of course, just as with the capital structure irrelevance theorems discussed in the last chapter, relaxing the Òno taxesÓ assumption substantially changes the implications concerning optimal firm dividend policy. Until fairly recently, the capital gains tax rate was substantially lower than was the tax rate on dividends, which were taxed as normal income. This inequality led some firms to prefer to pay out lower dividends/retain higher levels of earnings than probably would have been the case otherwise.However, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 (Public Law 108-27) changed the general tax rate applicable to net capital gains for indi-viduals to 15 percent or 5 percent (depending on the taxpayerÕs total taxable income). The new capital gains rates also apply to most dividends paid from domestic corporations and certain qualified foreign corporations. The upshot: Investors find that dividends are LG17-1 LG17-2 dividend irrelevance theoremA theorem showing that, in M&MÕs perfect world, it doesnÕt matter if a firm pays out funds through divi-dends or capital gains.Jobs and Growth Tax Relief Reconciliation Act (JGTRRA)A 2003 law that lowered the rate on both dividends and capital gains for indi-vidual investors in most situations.Final PDF to printer

chapter 17 Sharing Firm Wealth: Dividends, Share Repurchases, and Other Payouts 567cor91411_ch17_564-587.indd 567 01/27/17 03:43 PMmuch more attractive relative to capital gains than they have been in the past, when divi-dends were taxed at a higher rate than capital gains income.For most investors, this equalization of the tax rates on capital gains and dividends has moved the real world closer to the concept of dividend irrelevance embodied in M&MÕs perfect world, but additional factors might give investors strong preferences for or against dividends.Why Some Investors Favor DividendsGordon and Lintner proposed one of the strongest arguments for dividends, sometimes referred to as the bird-in-the-hand theory. This theory argues that dividends that the firm has committed to pay are less risky (and hence more attractive) to risk-averse inves-tors than are potential future capital gains. Allowing the firm to retain ÒextraÓ earnings instead of paying them out as dividends increases the risk that the firm will spend those earnings on non-value-maximizing investments.M&M are the ones that refer to this argument as the bird-in-the-hand fallacy, claim-ing that many, if not most, investors will reinvest their dividends in the same or similar firms anyway. Further, the long-run riskiness of the firmÕs cash flows to investors is determined only by the riskiness of the firmÕs asset cash flows and not by its dividend payout policy.Why Some Investors Favor Capital GainsEven if the tax rates on capital gains and dividends are identical, some investors may prefer capital gains over dividends because capital gains may offer them more choice concerning the timing of cash flows.When a firm pays out dividends in a certain time period, all stockholders share in the dividend distribution, and all must therefore pay taxes on those dividends in that period. If, instead, the firm retains earnings, consequently causing share price to increase, then only shareholders who sell shares of stock will experience a capital gain, and so only those shareholders will have to pay taxes.Investors who donÕt need or want any cash will not sell their stock and they therefore will not incur any obligation to pay taxes on capital gains until they choose to do so. Note that this ability to ÒtimeÓ tax assessments will be especially attractive for investors who expect their capital gains tax rate to decline over time. Not only will these investors be able to push the tax bill off into later in the future, they may also be able to reduce the total tax in doing so.bird-in-the-hand theoryThe argument that receiv-ing a dividend today is preferable to letting man-agement have the chance to spend or waste the money between now and the future.EXAMPLE 17-1Dividend PreferenceSuppose that a firm has a retention ratio of 45 percent and net income of $9 million. The firmÕs investors are currently subject to a 15 percent tax rate on both dividends and capital gains, but everyone expects the tax rate on capital gains to increase to 35 percent over the next year. If the firm is considering temporarily suspending the dividend in order to fund a new, one-year project, and both the firm and investors face an 11 percent interest rate, what rate of return on the project would be necessary for the firm to retain the money, consider-ing only the tax implications for its shareholders?SOLUTION: The firm is currently paying out (1 − 0.45) × $9,000,000 = $4,950,000 in divi-dends. At the current tax rate, investors get to keep (1 − 0.15) × $4,950,000 = $4,207,500 of this after taxes. If the firm were to stop paying dividends and instead put this $4,950,000 LG17-2 For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.Final PDF to printer

568 part eight Capital Structure Issuescor91411_ch17_564-587.indd 568 01/27/17 03:43 PMTIME OUT 17-1 Why should increasing a firmÕs dividend payout ratio cause the future dividend growth rate to decrease?   17-2 Would dividends truly be irrelevant in a more realistic world that features trading costs?  17.2 ∙ Other Dividend Policy IssuesRisks, taxation, and cash flow timing, which we discussed in the previous section, are all fairly tangible. Managers must also consider some additional, intangible factors in setting the firmÕs optimal dividend payout policy.The Information EffectManagers hate to cut dividendsÑand investors hate to have them cutÑso firms do not do so except in very dire circumstances. Along the same lines, managers will hesitate to raise dividends unless they feel that the firm can maintain dividends at the new, higher level for the foreseeable future. Because of managementÕs hesitation to ever cut dividends, if a firm announces an increase in the next dividend, analysts often interpret that as an expected increase in all future dividends and, therefore, see such announcements as a very positive signal concerning the firmÕs performance and its expected future cash flow levels.The Clientele EffectThe clientele effect refers to the fact that, in real life, investors do not have identical desires about the taxability and timing of firm payouts. Different groups of investors, or clienteles, will be attracted to different firms based on those firmsÕ varying payout policies.Shareholders who desire a particular mix of dividend policy attributes will invest in firms with dividend policies that have those particular attributes. If firms then change LG17-3 clientele effectThe tendency of investors to find a payout policy that they prefer and stick with it.into new projects, the new projects would return an expected future value of $4,950,000 × (1 + r) in one year, which, assuming that the new tax rate goes into effect, would increase the shareholdersÕ after-tax wealth by $4,950,000 × (1 + r) × (1 − 0.35). The firm should only retain the money if the present value of the after-tax increase in shareholder wealth would be larger than the present value of the after-tax increase in shareholder wealth due to the dividend: If  $4,950,000 × (1 + r) × (1 − 0.35) _________________________ 1.11 > $4,207,500  $2,898,648.65 × (1 + r) > $4,207,500 (1 + r) > $4,207,500 ____________ $2,898,648.65 (1 + r) > 1.4515  r >  0.4515 Unless the firm expects to earn a 45.15 percent return on the project, the tax implications rule against retaining the money.Similar to Problems 17-3, 17-4Final PDF to printer

chapter 17 Sharing Firm Wealth: Dividends, Share Repurchases, and Other Payouts 569cor91411_ch17_564-587.indd 569 01/27/17 03:43 PMtheir dividend policy, the investors who desired the previous policy will sell their shares to reinvest in another firm with a policy closer to that which they desire. New inves-tors who were previously uninterested in the stock may be attracted to it because of the policy change.If we assume that investors face no transaction fees for buying or selling stock, and that unlimited demand exists for both old and new dividend policies, then a firm chang-ing its policy in this manner would not see any effect on its stock price. However, inves-tors do incur transaction fees for trading shares, and some evidence suggests that changes in tax laws or in the macroeconomic environment result in a demand shift from one divi-dend policy type to another. If demand for a certain dividend policy increases enough, then a firm changing to that dividend policy might actually see its demand for its stock increase enough to positively affect its stock price, even though investors will have to pay transaction fees to switch into the stock.For example, MicrosoftÕs September 2003 announcement that it would double its divi-dend was particularly well received, as this dividend change occurred approximately four months after JGTRRA made dividends more attractive for most investors.Corporate Control IssuesWhile the clientele effect implies a rather passive role for shareholdersÑone in which they are forced either to accept a companyÕs dividend policy or leave to look for one more to their likingÑfirms that have shareholders with significant stakes in the firm may actually find those shareholders dictating the dividend payout policy. For example, in Germany, where banks are allowed to have sizable equity investments in firms to which they lend, recent studies1 show that bank-controlled firms pay out lower dividends and are much more likely to omit dividends than any other type of firm.Similar research also shows this tendency in closely held corporations, where owners have historically sought to avoid double taxation by leaving the profits in the corporation as accumulated earnings.2 As long as the firm can justify accumulating earnings as nec-essary to the businessÕs reasonable needs, such as funding a possible expansion or similar activity, then shareholders will have at least some latitude in determining when they wish to pay the earnings out.TIME OUT 17-3 What type of clientele would you expect to prefer dividends over capital gains? Why?   17-4 When might raising a firmÕs dividend payout ratio be seen as a negative signal?  17.3 ∙ Real-World Dividend PolicyTaking into account all of the factors noted previously, it would still seem intuitive that the firmÕs basic dividend policy should be to pay out as dividends any cash flow that is surplus after the firm has invested in all available positive net present value projects: Dividends = Net income  − Retained earnings necessary to fund positive NPV projects (17-3)LG17-4 1See, for example, Luis Correia da Silva et al., Dividend Policy and Corporate Governance (New York: Oxford University Press, 2004).2In fact, many recent tax court cases related to closely held C corporations involve the nonpayment of suffi-cient dividends relative to profits, which subjects the C corporation to the accumulated earnings tax.Final PDF to printer

570 part eight Capital Structure Issuescor91411_ch17_564-587.indd 570 01/27/17 03:43 PMThe Residual Dividend ModelWe generally refer to this dividend policy approach as the residual dividend model, or the free cash flow theory of dividends. Though we would expect that the firm might respond to the factors discussed previously and thus to deviate somewhat from this ideal, the current low tax rates on dividends would seem to be a prime environment for it to apply.However, the residual dividend model doesnÕt really seem to explain the observed dividend policies of real-world companies. Most companies pay relatively consistent divi-dends from one year to the next, and managers seem to prefer paying a steadily increas-ing dividend rather than paying a dividend that fluctuates dramatically from one year to the next. For example, consider the dividends and EPS figures for General Electric Co. (GE) shown in Figure 17.1.GE has very consistently kept the dividend for all four quarters stable when possible, raising the dividend smoothly from year to year when circumstances allowed. However, EPS was quite volatile throughout this time period, and in 2009 GE decided to revise its quarterly dividend from $.31 per quarter to $.10 per quarter in response to prevailing economic conditions. Since then, GEÕs dividend has once again been increasing steadily from year to year, despite large, negative values for EPS in 2015.Many companies follow an approach similar to GEÕs. The general consensus about why firms follow this approach seems to be that managers at these firms feel that their investors value dependability and stability in their personal dividend streams more than investors resent the burden that such a strategy places on the firmÕs cash flows.Paying a constant yet steadily increasing dividend does impose a burden on the firm, for several different reasons. For example, firms in this situation frequently find them-selves simultaneously issuing new equity (and paying the associated underwriting fees for doing so) and paying dividends to existing equity holders.Probably the most compelling reason that most firms have for paying a consistent dividend like this is that most investors are very risk averse, so they actually prefer a slightly lower, consistent dividend stream to one that is, on average, higher but more volatile.residual dividend modelThe policy of a firm paying out only funds that are left over after all positive-NPV projects are funded.free cash flow theory of dividendsAnother name for the resid-ual dividend model.Ð$1.50Q1Ð2007Q3Ð2007Q1Ð2008Q3Ð2008Q1Ð2009Q3Ð2010Q1Ð2010Q1Ð2011Q3Ð2011Q1Ð2012Q3Ð2012Q1Ð2013Q3Ð2013Q1Ð2014Q3Ð2014Q1Ð2015Q3Ð2015Q3Ð2009Ð$1.00Ð$0.50$0.00$0.50$1.00Fully diluted quarterly EPSQuarterly dividendsFIGURE 17.1General Electric CompanyÕs Dividend and EPS HistoryFinal PDF to printer

572 part eight Capital Structure Issuescor91411_ch17_564-587.indd 572 01/27/17 03:43 PM17.4 ∙ Dividend Payment LogisticsTechnically, dividends do not become firm obligations until the firm declares them. The firm must allow itself some lead time between announcing the dividend and actually pay-ing it. The firm must also allow time to determine the owner of record for each share as LG17-5 !want to know more?Key Words to Search for Updates: The article ÒMicrosoft Announces Payouts to InvestorsÓ (www.washingtonpost.com)In 2004, Microsoft amassed a cash balance of nearly $60 bil-lion. It then announced that it would pay out more than $32 billion of that war chest as a one-time, extraordinary dividend. This was one of the largest extraordinary dividend payments in history and came about because of a confluence of several different factors.First, Microsoft had been enjoying monopoly-like profits on its software products for quite a few years, which allowed it to MICROSOFTÕS EXTRAORDINARY DIVIDENDfinance at work corporateamass a large amount of cash. Second, the JGTRRA had just been passed, making the payment of such a large dividend less burdensome to investors from a tax standpoint. Third, MicrosoftÕs opportunities for new products, and hence the need for capital investment in new projects, didnÕt seem to be keeping up with the accumulation of cash.$Ð$0.20$0.40$0.60$0.80$1.00$1.20$1.40Feb-81Feb-82Feb-83Feb-84Feb-85Feb-86Feb-87Feb-88Feb-89Feb-90Feb-91Feb-92Feb-93Feb-94Feb-95Feb-96Feb-97Feb-98Feb-99Feb-00Feb-01Feb-02Feb-03Feb-04Feb-05Feb-06Feb-07Feb-08Feb-09Feb-10Feb-11Feb-12Feb-13Regular dividendExtra dividendFIGURE 17.2Recent Dividend History for Bassett FurnitureTIME OUT 17-5 What would prompt a firm like GE to start paying out a much higher percentage of its earnings as dividends?   17-6 Would extraordinary dividends be more likely to be used by a firm with cyclical sales or by one with stable sales?  Final PDF to printer

chapter 17 Sharing Firm Wealth: Dividends, Share Repurchases, and Other Payouts 573cor91411_ch17_564-587.indd 573 01/27/17 03:43 PMwell as provide processing time between determining owners of record and actually mail-ing the checks. These different tasks require corporations to establish a definitive set of dates associated with paying out a dividend: ¥ The declaration date. ¥ The ex-dividend date. ¥ The record date. ¥ The payment date.Payment ProceduresThe board of directors announces its intention to pay a dividend on the declaration date. On the declaration date, that specific dividend becomes a firm liability, and the company records that liability on its books accordingly. On the declaration date, the board will also announce a date of record and a payment date.The ex-dividend date is the first day that the shares will trade without the dividend attached. Prior to that date, anyone purchasing a share of the firmÕs stock can claim the right to receive the dividend. So the stock is said to trade cum dividend (or, with dividend) until the ex-dividend date; subsequent to the ex-dividend date, anyone purchasing the share will purchase the share ex-dividend and can no longer claim the right to the divi-dend. On the record date, the firm will look on its books to find the registered owners of record so that it can start addressing payments. The record date is usually set at least a couple of business days after the ex-dividend date to allow time for shares purchased before the ex-dividend date to be properly registered.3 The firm sends dividends out on the payment date.Effect of Dividends on Stock PricesAs you will recall from Chapter 8, a stock shareÕs price should equal the present value of its expected future dividends. If dividends were paid as a continuous, steady stream at every instant through time, then we wouldnÕt expect dividend payment procedures to have much impact on the stockÕs price. But the fact that firms pay dividends as discrete cash flows received at certain intervals implies that the price of a share of stock will appreciate as the next, and every subsequent, dividend gets closer, and then fall precipi-tously once that dividend no longer accompanies the stock.For example, consider a stock that is expected to pay a $1.00 per year dividend forever and that the next dividend is expected exactly one year from now. If the appropriate rate of return on this share of stock is 10 percent, then the stock price should simply be set as the present value of the perpetuity: P 0 =  D __ i =  $1 ___ 0.1 = $10 (17-4)Now, to see whatÕs going to happen as we get closer to the dividend payment date, letÕs express this as the sum of the present value of the next dividend (D1) and the present value of the perpetuity of all subsequent dividends (starting with D2): P 0 =  D 1 _____ 1 + i  +  ( D 2 ___ i  ×  1 _____ 1 + i )  (17-5)declaration dateThe date the board of directors announces its intention to pay a dividend.ex-dividend dateThe first day that shares will trade without the purchaser receiving an upcoming dividend.record dateThe day that the firm will determine the owner of record for the purposes of an upcoming dividend payment.payment dateThe actual date that a divi-dend will be sent out.3In most countries, registration is essentially automatic for shares purchased before the ex-dividend date, so the likelihood of people who bought the shares prior to the ex-dividend date not receiving the dividends they are due is pretty small.Final PDF to printer

574 part eight Capital Structure Issuescor91411_ch17_564-587.indd 574 01/27/17 03:43 PMWe can also express the lump sum portions of this formula in terms of a daily interest rate so that we can examine what happens as the number of days until the next dividend payment approaches zero: P 0 =  D 1 __________ (1 +  i daily ) n  +  ( D 2 _____ i yearly    ×  1 __________ (1 +  i daily ) n ) =  $1 _______________ (1 + 0.000261) 365  +  ( $1 _____ 0.10   ×  1 _______________ (1 + 0.000261) 365 ) = $0.9091 + $9.0909 = $10 (17-6)Note that the daily interest rate in this problem can be computed as shown in Chapter 5: i daily  =  365 √ ________ 1 +  i yearly  − 1  (17-7)=  365 √ _____ 1 .10  − 1= 0.000261 As the number of days until the next dividend decreases, the present value will increase. For example, when there are only 200 days left, the present value becomes P 0 =  D 1 __________ (1 +  i daily ) n  +  ( D 2 _____ i yearly    ×  1 __________ (1 +  i daily ) n ) =  $1 _______________ (1 + 0.000261) 200  +  ( $1 _____ 0.10   ×  1 _______________ (1 + 0.000261) 200 ) = $0.9491 + $9.4912 = $10.44 If we temporarily ignore the difference between the ex-dividend date and the payment date, then the present value upon payment becomes P 0 =  D 1 __________ (1 +  i daily ) n  +  ( D 2 _____ i yearly    ×  1 __________ (1 +  i daily ) n ) =  $1 ______________ (1 + 0.000261) 0  +  ( $1 _____ 0.10   ×  1 ______________ (1 + 0.000261) 0 ) = $1 + $10 = $11 This pattern in the present value of the dividends leading up to the next dividend is shown in Figure 17.3.After that next dividend has been paid, the stock once again becomes a perpetuity for which the next cash flow is one year away, so the price will immediately fall back to $10. This process of a buildup in price followed by a precipitous drop once the next dividend is paid will continue through time as shown in Figure 17.4.Adding back in the gap between the ex-dividend date and the payment date causes the present value both to peak at a lower value (the present value of $11 on the ex-dividend date instead of the explicit value of the $11 on the payment date itself). Then the present value falls a little further after the ex-dividend date. For example, taking the hypothetical stock discussed previously and further assuming a 30-day gap between the ex-dividend Final PDF to printer

chapter 17 Sharing Firm Wealth: Dividends, Share Repurchases, and Other Payouts 577cor91411_ch17_564-587.indd 577 01/27/17 03:43 PM17.5 ∙ Stock Dividends and Stock SplitsIn addition to disbursing cash through the dividend payment system as described pre-viously, firms may also distribute additional shares of stock through either a stock dividend or a stock split. Though the mechanics and accounting treatments of these two approaches are different, they both have the end result of increasing the number of shares outstanding without changing the total market value of ownerÕs equity. So either a stock dividend or a stock split will decrease the stock price.Stock DividendsWhen they wish to distribute a stock dividend, companies perform a pro rata distri-bution of additional shares of stock to the current owners of the stock. For example, a 20  percent stock dividend would increase the number of shares held by each stockholder by 20  percent, so an investor who owned 100 shares before the dividend would own 120 afterwards. For accounting purposes, the fair market value of these shares is transferred from retained earnings to the common stock and paid-in-surplus accounts, meaning that no change occurs in the shareÕs par value.Stock SplitsIn a stock split, the company exchanges new shares for old shares in the firm. A split usually involves converting each old share into more than one new share, which increases the shares outstanding. Sometimes you will also hear of ÒreverseÓ stock splits, in which stockholders trade in multiple shares for fewer new shares. For example, if you owned 250 shares in a firm and it announced a 2-for-1 stock split, you would receive 2 × 250 = 500 new shares of stock. If, instead, it announced a 1-for-5 reverse split, you would receive 250/5 = 50 new shares once you turned in your original 250 shares (likely held in street name).Although a stock split will alter the par value of a firmÕs stock on the companyÕs books, it will not cause any shift in money among the ownerÕs equity accounts.Effect of Splits and Stock Dividends on Stock PricesThe purpose of either a stock dividend or stock split is to lower (or, in the case of a reverse split, raise) the shareÕs market price proportionately. For example, in a 3-for-1 split, you should expect to see the post-split shares trading at approximately one-third of the presplit price.Why do firms do this? The general consensus seems to be that firms like to have their shares trade in a particular price range. If their share price moves outside that range, then the firms split their shares or announce a stock dividend to move their share price back into the desired range. Given investorsÕ preference to trade in Òround lotsÓ (i.e., in increments of 100 shares), as well as the fact that many brokersÕ commission schedules encourage trading in round lots, this strategy of keeping the price within a certain range may not be a bad one. If typical investors invest in ÒchunksÓ of $10,000 or less, then theyÕll find it more cost-effective to buy 100 shares of a $75 stock (100 × $75 = $7,500) rather than investing in an odd lot of a $150 stock.LG17-6 stock dividendA pro-rata distribution of additional shares of stock to the current owners of the stock.stock splitAn exchange of existing shares for a different (usu-ally large) number of ÒnewÓ shares, with proportionately different par and market values.EXAMPLE 17-4Stock Split versus Stock DividendSuppose that LilyMac Industries currently has 50,000 shares outstanding, which are sell-ing for $37.00 per share, and that the current values of the common stock, paid-in-surplus, and retained earnings accounts are $100,000, $1,000,000, and $2,500,000, respectively. If LilyMac performs a 50 percent stock dividend, how would these accounts and the current LG17-6 For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.Final PDF to printer

578 part eight Capital Structure Issuescor91411_ch17_564-587.indd 578 01/27/17 03:43 PM17.6 ∙ Stock RepurchasesFirms sometimes use another method to return capital to shareholders: They engage in a stock repurchase or buyback. In the United States, the most common method to do this is through an open-market stock repurchase. In such a repurchase, the firm simply buys shares of its own stock on the stock market just like any other investor. The firm may or may not publicly announce its intention to buy back shares, but any such announcement is not binding. Open market repurchases can span months or even years, allowing the firm to choose to repurchase only when the price is within a particular range or when it feels the advantages outweigh the disadvantages.Prior to 1981, all repurchases were carried out using a fixed-price tender offer. Such an offer is announced publicly and specifies in advance a single purchase price, the number of shares sought, and the duration of the offer. The offer may allow tendered shares to be withdrawn prior to the offerÕs expiration date and may also be made con-ditional upon receiving tender offers for a minimum acceptable number of shares. If the number of shares tendered exceeds the number sought, then the company usually purchases shares from those tendered on a pro rata basis. For example, if a company is seeking to repurchase 1 million shares of stock but shareholders offer 2 million shares, then it would buy half of the offered shares from each seller. If the number of shares tendered is less than the number sought, then the company might choose to extend the offerÕs expiration date.Since 1981, firms have been increasingly using an alternative form of tender offer, the Dutch auction share repurchase. A Dutch auction offer specifies a price range within which the shares will ultimately be purchased and the number of shares desired by the company, and shareholders are invited to offer their shares for sale at any price within that stated range. At the close of the auction, the firm then analyzes all sub-mitted sale offers to choose the lowest purchase price that allows the firm to buy the LG17-7 repurchase or buybackThe firm buys back shares of its own stock.fixed-price tender offerA repurchase offer specify-ing a single purchase price.market price be affected? How would the accounts and the share price be affected if Lily-Mac instead chose to perform a 3-for-2 stock split?SOLUTION: Under a 50 percent stock dividend, the number of shares would increase by 0.50 × 50,000 = 25,000, and the current market value of those 25,000 shares, 25,000 × $37 = $925,000, would be transferred out of retained earnings into the common stock and paid-in-surplus accounts. Since, by inference from the current number of shares out-standing and the current balance of the common stock account, the par value per share is $100,000/50,000 = $2.00 per share, $2.00 × 25,000 = $50,000 of the $925,000 would go into the common stock account, and the remainder of the $925,000, $925,000 − $50,000 = $875,000, would go into the paid-in-surplus account. In summary, the stock dividend would not affect the share price, but would cause retained earnings to decrease by $925,000 to $2,500,000 − $925,000 = $1,575,000, paid-in-surplus to increase to $1,000,000 + $875,000 = $1,875,000, and the common stock account to increase to $100,000 + $50,000 = $150,000, and would cause the number of shares outstanding to increase to 50,000 + 25,000 = 75,000.The 3-for-2 stock split, on the other hand, would also cause the number of shares to increase to 3/2 × 50,000 = 75,000 and the current market price to decrease to 2/3 × $37 = $24.67, but the current balances of the common stock, paid-in-surplus, and retained earnings accounts would remain unchanged (though the par value per share would have to be adjusted to $100,000/75,000 = $1.33 per share).Similar to Problems 17-7, 17-8Final PDF to printer

chapter 17 Sharing Firm Wealth: Dividends, Share Repurchases, and Other Payouts 579cor91411_ch17_564-587.indd 579 01/27/17 03:43 PMnumber of shares it is seeking. The firm pays that price to all investors who tendered at or below that price but does not purchase any shares that are offered at higher prices. If too few shares are tendered, then the firm either cancels the offer (provided it had been made conditional on a minimum acceptance), or it buys back all tendered shares at the maximum price bid by the shareholders who chose to participate in the auction.Dutch auction share repurchases have increased in popularity for several reasons. First, the Dutch auction process relies on the companyÕs shareholders to value the stock rather than an independent valuation assessment. To the extent that such valuations are often inaccurate or result in an offer price that the shareholders find unsatisfactory, this seems to be a more efficient, market-driven approach to coming up with a bid price. Second, the Dutch auction process offers at least the possibility that the firm will pay less than the maximum price of the specified range, implying that the stock is less likely to be overvalued in the offer. Finally, since Dutch auctions increase the uncer-tainty concerning the final price at which a repurchase may take place, they tend to discourage arbitrageurs, who often drive up the price in fixed-price tender offers, from participating.Advantages of RepurchasesUnder tax structures in which capital gains rates are significantly less than dividend tax rates, repurchases can offer the firm a very efficient way to return money to shareholders. Even if capital gains arenÕt preferentially taxed relative to dividends, shareholdersÕ choice of whether to participate in a buyback implies that capital gains taxes can be deferred until the shareholder wishes to incur them.Stock repurchases offer another advantage in that reductions in or cessations of repurchase programs donÕt seem to be perceived as a negative informational signal in the same way that reduced dividends are. So starting a buyback program doesnÕt imply the same kind of long-term commitment on the firmÕs part that increasing the dividend would.Finally, though the cessation of a repurchase program isnÕt perceived negatively, the announcement of the initiation of a stock repurchase program is usually viewed as a positive signal. The reasoning here: If management, who knows the firmÕs prospects better than anyone, thinks that the shares are worth buying, then the stock is probably underpriced.Disadvantages of RepurchasesAs you might suspect, repurchases also pose several potential disadvantages. First, that very same positive informational effect that a share repurchase announcement gives may actually be a double-edged sword. Say a shareholder sells shares to the firm in a repur-chase. Subsequently, the shareholder finds out that management had information about good future prospects for the firm that was not publicly announced prior to the repur-chase. Such a situation will make the firm vulnerable to litigation.A stock repurchase announcement may even be viewed as a negative signal if investors perceive the repurchase as a signal that the firm doesnÕt have enough attrac-tive capital budgeting projects available to use the cash used for the repurchase. Even if the announcement is perceived as a positive signal, that isnÕt necessarily a good thing if it results in the firm paying more for the shares than they are worth. Doing so will result in share dilution, which basically involves a transfer of wealth from the shareholders staying in the firm (i.e., those not tendering their shares) to those leaving it.Final PDF to printer

580cor91411_ch17_564-587.indd 580 01/27/17 03:43 PMFinally, the IRS may impose penalties on the firm if tax authorities can show that the repurchase was performed primarily to avoid dividend taxation. This possibility makes the attractiveness/legality of using a repurchase in lieu of a cash dividend questionable.Effect of Repurchases on Stock PricesA large body of evidence supports the idea that, on average, the advantages of share repurchases outweigh the disadvantages. For example, Josef Lakonishok and Theo Ver-maelen4 have shown that repurchasing companies experience economically and statisti-cally significant abnormal returns in the two years after the repurchase. The upward price drift seems to be mainly caused by the behavior of the small firms in their sample.TIME OUT 17-9 If the par value of stock might represent a superior claim in the event of bankruptcy, would stockholders profit more from a stock dividend or stock split? Why?   17-10 Explain why shareholders who do not participate in a firmÕs stock repurchase will normally see a concentration of their equity stake.  viewpoints REVISITEDBusiness Application SolutionIf SWV does adopt the new payout policy, the firm should probably expect its stock price to benefit (i.e., go up) because of it. Since investors are risk averse, they will value the increased certainty in the ÒpromisedÓ dividend.To the extent that it can disburse any extra funds in a stock repurchase instead of an extraordinary dividend, SWV should probably be able to increase the stock price even more by doing so.Personal Application SolutionMarc should think in terms of leaving the stock for which he will face the lowest tax rate for gains outside the Roth account, which means that he should put the high-dividend-yield stock in the Roth.summary of learning goalsIn this chapter, weÕve explored major factors affecting the firmÕs decisions about how much cash to pay out to share-holders and what form this payout should take. WeÕve seen that tax considerations stemming from differential taxation of dividends and capital gains must be a significant consideration in these decisions. Firms should also be concerned with the signaling aspect of changes in the firmÕs dividend stream. Finally, managers must remain conscious of their investorsÕ timing preferences.4See Josef Lakonishok and Theo Vermaelen, ÒAnomalous Price Behavior around Repurchase Tender Offers,Ó The Journal of Finance 45, no. 2 (June 3 1990), pp. 455Ð477.Final PDF to printer

581cor91411_ch17_564-587.indd 581 01/27/17 03:43 PMIdentify factors that affect a firmÕs payout policies. Factors include the impact of differential investor tax rates on dividends and capital gains, information effects of changes to a firmÕs dividend policy, the shareholdersÕ preference for a particular payout policy, and the impact on corporate control issues of a change in the firmÕs dividend payout policy.Discuss how investorsÕ preferences regard-ing differential tax rates and timing can guide the firmÕs policies on the distribution of dividends and capital gains. Capital gains are normally taxed at a lower rate than are dividends for the firmÕs investors. Investors may choose to some extent when they incur capital gains taxes but donÕt have that freedom with dividends. Both of these factors tend to make capital gains the preferred method for firms to disseminate excess cash. However, some regulatory restrictions against doing so too often will tend to mitigate this tendency.Summarize the information effect, the clientele effect, and other corporate control issues. Dividends act as signals, not just of managementÕs opinion concerning the firmÕs short-term prospects, but also of the firmÕs perceived ability to maintain that level of dividends for the foreseeable future. So a relatively small change in a firmÕs dividend payout can have a relatively large impact on the stock price. Similarly, investors will find it relatively expensive to change their investments due to a change in the companyÕs payout policy, so firms will tend to exhibit ÒinertiaÓ with regard to their payout policy, if for no other reason than to placate the clientele that theyÕve managed to attract while using past and current payout policies.Analyze a firmÕs decision to distribute constant ordinary dividends or extraordinary dividends. Analysts tend to see dividend changes as signals about persistent changes in the firmÕs future prospects. Therefore, managers are loathe to either LG17-1LG17-2LG17-3LG17-4lower dividends or increase them unless they are fairly confident that the new level can be sustained into the foreseeable future. The residual dividend policy lets managers commit to a fairly conservative dividend payout policy in that they donÕt raise the ÒnormalÓ dividend without very good cause, but they can and do issue extraordinary dividends to share occasional ÒwindfallsÓ with equity holders without fear of such extraordinary dividends committing them to continued higher payouts in the future.Explain the effect that cash dividend pay-ment procedures have on stock prices. Firms delay between the last date that a dividend accompanies a share of stock (i.e., the day before the ex-dividend date) and the actual payment date. Because of this delay, stock prices will get larger and larger as the front end of the infinite stream of dividends approaches, but will peak and decline on the ex-dividend date by the present value of the dividend.Differentiate between a stock dividendÕs impact and a stock splitÕs impact on the firmÕs books. Stock dividends involve a transfer from the retained earnings account into the common stock and paid-in-surplus accounts but do not cause any change in par value per share. Stock splits do not involve a transfer of funds between any of the companyÕs bookkeeping accounts, but the increase in the number of shares dictates that the amounts in each account must be shared over a new, different number of shares than was previously the case, so a stock split does change both the par value and book value per share.Note the advantages and disadvantages of a firmÕs stock repurchases. The primary advantage of a stock repurchase arises when capital gains are taxed at a significantly lower rate than dividends, while the primary disadvantage of a repurchase is the potential for the dilution of existing ownersÕ value if the firm pays too much for the repurchased shares.LG17-5LG17-6LG17-7chapter equations 17-1 P 0  =  D 1 ____ i − g 17-2 Dividend payout ratio =  Dividends __________ Net income 17-3 Dividends = Net income − Retained earnings necessary to fund  positive NPV projects Final PDF to printer

582cor91411_ch17_564-587.indd 582 01/31/17 07:26 PM17-4 P 0 = D __ i 17-5 P 0 = D 1 _____ 1 + i + ( D 2 ___ i × 1 _____ 1 + i ) 17-6 P 0 = D 1 __________ (1 + i daily ) n + ( D 2 _____ i yearly × 1 __________ (1 + i daily ) n ) 17-7 i daily = 365 √ ________ 1 + i yearly − 1 key termsbird-in-the-hand theory The argument that receiving a dividend today is preferable to letting management have the chance to spend or waste the money between now and the future. p. 567buyback The firm buys back shares of its own stock. p. 578clientele effect The tendency of investors to find a payout policy that they prefer and stick with it. p. 568declaration date The date the board of directors announces its intention to pay a dividend. p. 573dividend irrelevance theorem A theorem showing that, in M&MÕs perfect world, it doesnÕt matter if a firm pays out funds through dividends or capital gains. p. 566ex-dividend date The first day that shares will trade with-out the purchaser receiving an upcoming dividend. p. 573fixed-price tender offer A repurchase offer specifying a single purchase price. p. 578free cash flow theory of dividends Another name for the residual dividend model. p. 570Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) A 2003 law that lowered the rate on both div-idends and capital gains for individual investors in most situations. p. 566payment date The actual date that a dividend will be sent out. p. 573record date The day that the firm will determine the owner of record for the purposes of an upcoming divi-dend payment. p. 573repurchase The firm buys back shares of its own stock. p. 578residual dividend model The policy of a firm paying out only funds that are left over after all positive-NPV proj-ects are funded. p. 570stock dividend A pro-rata distribution of additional shares of stock to the current owners of the stock. p. 577stock split An exchange of existing shares for a different (usually large) number of ÒnewÓ shares, with proportion-ately different par and market values. p. 577self-test problems with solutions1 Computing Pattern of Stock Prices Due to Dividend Payments Stone Woof Beds is expected to pay a dividend of $2.25 per year, indefinitely. If the appropriate rate of return on this stock is 12 percent per year, and the stock consistently goes ex-dividend 25 days before the dividend payment date, what will be the expected minimum and maximum prices in light of the dividend payment logistics? Solution:The daily interest rate will be equal to i daily = 365 √ ____ 1.12 − 1 = 0.000311 LG17-5Final PDF to printer

583cor91411_ch17_564-587.indd 583 01/27/17 03:43 PMAs with the example in the chapter, the stock will hit its highest value one day before its ex-dividend date: P 0 = D 1 _____________ (1 +  i daily ) n  + ( D 2 _ i yearly  ×  1 _____________ (1 +  i daily ) n ) = $2.25 __________________ (1 + 0.000311) 26  + ( $2.25 _ 0.12  ×  1 __________________ (1 + 0.000311) 26 ) = $2.2319 + $18.5992 = $20.83 and it will hit its lowest value on the ex-dividend date: P 0 = D 1 _____________ (1 +  i daily ) n  + ( D 2 _ i yearly  ×  1 _____________ (1 +  i daily ) n ) = $2.25 __________________ (1 + 0.000311) 390  + ( $2.25 _ 0.12  ×  1 __________________ (1 + 0.000311) 390 ) = $1.9934 + $16.6116 = $18.61 2 Calculating shares in a stock split. You own 300 shares in a firm that are selling for $20 per share. The firm has just announced a 5-for-4 stock split. How many shares will you have after the split, and what do you expect them to be selling for?  Solution:You should wind up with 300 ×  5 __ 4 = 375 shares, and each share should sell for $20 ×  4 __ 5 = $16. LG17-6questions 1. Why might a firmÕs investors wish to delay receiving cash from the firm? (LG17-1) 2. Why might the government actually want the capital gains tax rate to be lower than the dividend tax rate? (LG17-2) 3. What condition would be necessary in order for the riskiness of the firmÕs cash flows to investors to be affected by the firmÕs dividend payout policy? (LG17-2) 4. Explain how an announced increase in a firmÕs divi-dend payout might be perceived as either a good or a bad information signal. (LG17-3) 5. We talked about how a firm might attract a differ-ent clientele by switching dividend payout policies. Might a particular clientele change its preference for dividends versus capital gains through no action of the firm? Explain. (LG17-3) 6. Suppose that federal banking regulators in the United States announced that they are going to allow banks to take on significant equity investments in firms to which they have lent. What would you expect, on average, to happen to those firmsÕ divi-dend payout ratios over time? (LG17-4) 7. If a firm follows the modified residual dividend model discussed in this chapter, are extraordinary dividends paid out of residual net income? (LG17-4) 8. Suppose a firm announces a new dividend amount every year with the first quarterly dividend declara-tion, but never explicitly states that the dividend will be continued for the other three quarters of the year. However, in the past the firm has always continued the first quarterÕs dividend into the other three quar-ters of the year. How much would you expect this firmÕs share price to react when it announced the new, first-quarter dividend at the beginning of a new year? (LG17-4) 9. Could the record date ever be before the ex – dividend date? Why or why not? (LG17-5)Final PDF to printer

584cor91411_ch17_564-587.indd 584 01/27/17 03:43 PM 10. Suppose a firm managed to consistently lower the length of time between the ex-dividend date and the payment date. On average, how would this affect the firmÕs stock price? (LG17-5) 11. If a firm announces a dividend decrease, would you expect the stock price to go down more or less than the present value of that decrease? Why? (LG17-5) 12. How big of a stock dividend would a firm have to announce for the stock price to be affected as much as it would through a 3-for-1 stock split? (LG17-6) 13. Why might a firm announce a reverse stock split? (LG17-6) 14. Would it be possible for a firm to announce a Òreverse stock dividendÓ? (LG17-6) 15. Why might firms prefer to conduct stock repur-chases through open-market operations rather than through fixed-price tender offers? (LG17-7)problems 17-1 Payout Ratio Suppose a firm pays total dividends of $500,000 out of net income of $2 million. What would the firmÕs payout ratio be? (LG17-2) 17-2 Payout Ratio Suppose a firm pays total dividends of $750,000 out of net income of $5 million. What would the firmÕs payout ratio be? (LG17-2) 17-3 Total Dividend Amount Suppose a firm has a retention ratio of 35 percent and net income of $5 million. How much does it pay out in dividends? (LG17-2) 17-4 Total Dividend Amount Suppose a firm has a retention ratio of 56 percent and net income of $9 million. How much does it pay out in dividends? (LG17-2) 17-5 Dividend per Share Suppose a firm has a retention ratio of 40 percent, net income of $17 million, and 10 million shares outstanding. What would be the dividend per share paid out on the firmÕs stock? (LG17-2) 17-6 Dividend per Share Suppose a firm has a retention ratio of 60 percent, net income of $35 million, and 140 million shares outstanding. What would be the dividend per share paid out on the firmÕs stock? (LG17-2) 17-7 Stock Dividend Effects If a firm has retained earnings of $3 million, a common shares account of $5 million, and additional paid-in capital of $10 million, how would these accounts change in response to a 10 percent stock dividend? Assume market value of equity is equal to book value of equity. (LG17-6) 17-8 Stock Dividend Effects If a firm has retained earnings of $23 million, a com-mon shares account of $275 million, and additional paid-in capital of $100 million, how would these accounts change in response to a 20 percent stock divi-dend? Assume market value of equity is equal to book value of equity. (LG17-6) 17-9 Extraordinary Dividend JBK, Inc., normally pays an annual dividend. The last such dividend paid was $2.50, all future dividends are expected to grow at 5 percent, and the firm faces a required rate of return on equity of 11 percent. If the firm just announced that the next dividend will be an extraordinary dividend of $17 per share that is not expected to affect any other future dividends, what should the stock price be? (LG17-4) 17-10 Extraordinary Dividend MMK Cos. normally pays an annual dividend. The last such dividend paid was $2.25, all future dividends are expected to grow at a rate of 7 percent per year, and the firm faces a required rate of return on equity of 13 percent. If the firm just announced that the next dividend will be an extraor-dinary dividend of $25 per share that is not expected to affect any other future dividends, what should the stock price be? (LG17-4)basic problemsintermediate problemsFinal PDF to printer

585cor91411_ch17_564-587.indd 585 01/27/17 03:43 PMresearch it! Identifying a FirmÕs Dividend PolicyGo to Ford Motor CompanyÕs Investor Relations website and download the dividend history from http://corporate.ford.com/investors/stock-info-and-tools/historical-dividends.html. Adjust the dividends for stock splits and graph them; identify any trends in dividends you see. Does Ford seem to follow a residual dividend policy or another policy? 17-11 Effects of Dividends on Stock Prices Gen Corp. is expected to pay a dividend of $3.50 per year indefinitely. If the appropriate rate of return on this stock is 11 percent per year, and the stock consistently goes ex-dividend 35 days before divi-dend payment date, what will be the expected minimum and maximum prices in light of the dividend payment logistics? (LG17-5) 17-12 Effects of Dividends on Stock Prices Kenzie Cos. is expected to pay a dividend of $2.75 per year indefinitely. If the appropriate rate of return on this stock is 16 percent per year, and the stock consistently goes ex-dividend 40 days before divi-dend payment date, what will be the expected minimum and maximum prices in light of the dividend payment logistics? (LG17-5) 17-13 Dividends versus Capital Gains Show mathematically that, with a tax rate on both dividends and capital gains of 5 percent, it doesnÕt matter whether earnings are paid out as dividends or kept in the firm to cause g to grow for a constant-dividend stock. (LG17-2) 17-14 Dividends versus Capital Gains Show mathematically that, with a tax rate on both dividends and capital gains of 15 percent, it doesnÕt matter whether earnings are paid out as dividends or kept in the firm to cause g to grow for a constant-dividend stock. (LG17-2) 17-15 Dividends Set Annually Suppose that a firm always announces a yearly divi-dend at the end of the first quarter of the year, but then pays the dividend out as four equal quarterly payments. If the next such ÒannualÓ dividend has been announced as $4, it is exactly one quarter until the first quarterly dividend from that $4, the effective annual required rate of return on the companyÕs stock is 13 percent, and all future ÒannualÓ dividends are expected to grow at 3 percent per year indefinitely, how much will this stock be worth? (LG17-4) 17-16 Dividends Set Annually Suppose that a firm always announces a yearly divi-dend at the end of the first quarter of the year, but then pays the dividend out as four equal quarterly payments. If the next such ÒannualÓ dividend has been announced as $6, it is exactly one quarter until the first quarterly dividend from that $6, the effective annual required rate of return on the companyÕs stock is 17 percent, and all future ÒannualÓ dividends are expected to grow at 6 percent per year indefinitely, how much will this stock be worth? (LG17-4) 17-17 Change in Lead Time of Dividend Announcement Everything else held con-stant, if a firm announces that it will double the length of time between its ex-dividend date and its payment date, what should be the effect on the stock price? (LG17-5) 17-18 Change in Lead Time of Dividend Announcement Everything else held con-stant, if a firm announces that it will halve the length of time between its ex-dividend date and its payment date, what should be the effect on the stock price? (LG17-5)advanced problemsFinal PDF to printer

586cor91411_ch17_564-587.indd 586 01/27/17 03:43 PMintegrated mini-case Investor Perceptions of Dividend GrowthYour firm currently pays a quarterly dividend of $1.35. You are planning on doubling this dividend but then keeping it flat for the next three years, after which it is expected to increase at the industry standard rate of 4 percent per year indefinitely. Your required rate of return on your companyÕs stock is 12.5 percent, and the last $1.35 dividend was just paid.What will be the time value of money impact on your stock price if investors are fully informed concerning your future intentions for all dividends? What will be the present value of all expected future dividends if you donÕt tell the investors that you will be keeping the quarterly dividend constant for the first three years, and they assume after the fifth coming dividend that dividends will remain at $2.70 indefinitely? ANSWERS TO TIME OUT 17-1 Increasing the dividend payout ratio will reduce the amount of retained earnings, which therefore reduces the amount of money that can be invested in projects that would cause future earnings (and dividends) to grow. 17-2 No. Having to pay trading costs when selling shares would cause investors to increase their preference for dividends, which donÕt involve trading costs. 17-3 Investors who need a stable payment stream over time and for whom the tax burden of dividends wouldnÕt be very large prefer dividends over capital gains. The typical example of this is a retiree. 17-4 Raising a firmÕs dividend payout ratio might be seen as a negative signal if investors interpret it as indicating that the firm has run out of good investment opportunities. 17-5 In general, a firm would increase its payout ratio if earnings became more stable or if commitments on earnings (such as future investments in projects) decrease. 17-6 A firm with cyclical sales would be more likely to use extraordinary dividends, as it would be unwilling to commit to a higher, fixed dividend amount. 17-7 A firm sets the ex-dividend date one month in advance of the dividend payment date to give itself plenty of time to determine the owner of record for each share and to provide ample processing time between determining owners of record and actually mailing the checks. 17-8 Stock prices would peak higher, following the blue path shown in Figure 17.5. 17-9 It would be more to stockholdersÕ advantage for the firm to pay a stock dividend, as this would give shareholders more shares while keeping the par value of each share constant. 17-10 The shareholders who do not participate will see their equity stake stay more-or-less constant on a dollar basis, but that constant dollar amount will represent a larger pro-portion of the firmÕs equity because the shareholders who do participate are taking their money out of the firm.Final PDF to printer

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588cor91411_ch18_588-613.indd 588 01/27/17 03:44 PMPART EIGHTviewpointsBusiness ApplicationADK Industries, a publicly traded firm in the online social networking industry, is considering building its own dedicated Web server firm at a cost of $5 million. The firm currently has $20 million of assets on its balance sheet, financed with $6 million in debt and $14 million in equity. Firm managers are considering options about how to finance the $5 million. What types of issues do managers need to consider as they make their decisions? (See the solution at the end of the chapter.)Personal ApplicationAfter spending several years raising her children, Marge Upton has decided to reopen her bicycle repair shop. Prior to the time away, Marge operated a successful bicycle repair business in her hometown. Marge remained involved in civic activities while she was raising her children and has maintained her relations with local bankers and other business people. To get the business up and running again, Marge will need to rent a building for the repair shop and purchase equipment and supplies. She estimates that she will need $25,000 to get started. Marge has $5,000 in savings to invest in the business. She also has friends and relatives who will invest another $5,000. What can Marge do to get the remaining funds needed to reopen her bicycle repair shop? (See the solution at the end of the chapter.)Issuing Capital and the Investment Banking Process18What if Marge found a business partner? Things to consider . . .Final PDF to printer

589cor91411_ch18_588-613.indd 589 01/27/17 03:44 PMFirms finance their existing and new assets with capital. Some capital used to finance assets comes from retained earningsÑthe profits that firms retain and reinvest. In addition, firms use debt financing (borrowed funds, usually loans or bonds) and equity financing (owner-ship shares that the firm sells). A firm will choose its preferred type of capi-tal funding depending upon its size, its stage in its life cycle, and, as a related issue, its prospects for future growth.In this chapter, we describe the decisions that firms face when they raise capital. We first look at small firms in their early operating stages. Small firms that are just getting started depend mainly on banks and venture capital firms for their capital funding. We then look at the process of going public, as well as publicly traded firmsÕ subsequent issues of debt and equity. Then we describe the types of securities that public firms issue and explore the role that investment banks play in the process. As we go through the chapter, note how important financial institutions become in raising capital funds to finance a firmÕs assets. For example, banks and institutions known as ven-ture capital firms provide short- and medium-term financing to small and newer firms, while investment banks assist publicly traded firms to arrange new securities issues.Learning Goals LG18-1 Evaluate different methods for small firms to get funding. LG18-2 Appreciate what venture capital is and how it encour-ages entrepreneurship. LG18-3 Differentiate among sources of capital funding for public firms. LG18-4 Trace the process by which securities are underwritten.© Image Source/Getty Images RFFinal PDF to printer

590 part eight Capital Structure Issuescor91411_ch18_588-613.indd 590 01/27/17 03:44 PM18.1 ∙ Sources of Capital for New and Small FirmsMost new and small firms finance their business assets by borrowing funds from private or public sources. Private capital fund suppliers fall into two basic categories: suppli-ers of debt financing and suppliers of equity financing. Debt financing includes capital funds borrowed from personal savings, friends or relatives, financial institutions such as commercial bank loans, or venture capitalists. Equity financing includes capital funds invested by venture capitalists. Venture capitalists, or venture capital firms, purchase equity interests in firms and have the same rights and privileges as other owners of equity investments. Public sources of capital include debt and equity financing provided by government agencies such as the U.S. Small Business Administration (SBA).Debt FinancingDebt financing includes personal capital (loans from friends and relatives) or external capital (loans from banks or venture capitalists). Most new businesses use personal capital. So often, the firmÕs ownersÕ personal wealth ties directly to the firmÕs success. However, almost all new and small business owners must borrow capital from external sources. Most external capital providers require that a significant percentage of the firm ownersÕ funds be invested in the business. This investment serves as a signal to capital providers that the firmÕs owners, with a lot at stake, will work hard to make the firm suc-ceed. Work generally increases the probability that the loan will be paid back in full.BANK LOANS Most new and small firms rely on bank loans as a major part of their capital funding. Bank loans, including mortgages, represent more than 60 percent of debt financing and more than 20 percent of total financing in non-publicly traded firms. However, the financial crisis of 2008 and 2009 had a huge impact on small firmsÕ abili-ties to get bank loans. Extraordinary changes in the lending environment developed after August 2008 as the financial health of major financial institutions deteriorated. Further, the collapse of the financial markets, in the fall of 2008, dramatically disrupted the availability of loans to small businesses. Between June 30, 2008, and June 30, 2009, outstanding small business loans declined by more than $14 billion. In addi-tion to supply-side changes in bank loan availability, demand for credit by small firms fell precipitously. The most severe recession since the Great Depression hit the United States. The historic economic slowdown resulted in high levels of unemployment and consequently reduced demand for goods and services produced by all businesses, includ-ing small firms. Because of reluctance to make new investments in this economic envi-ronment, demand for loans by small businesses declined. Small business bank lending continued to suffer even as the U.S. economy slowly recovered. Outstanding small busi-ness loans at banks decreased by over $47 billion from 2007 levels. Further, 87  percent of loan applications filed by small businesses were rejected. Many small businesses stopped even trying to get bank loans. According to a poll conducted by the New York Federal Reserve Banks in 2012, 59  percent of small businesses in the New York area did not apply for loans in 2011; half of these stated that they did not apply because they felt they would not be approved.Small business lending improved in the mid-2010s. The percentage of loan applica-tions approved by big banks reached 22.8 percent, a post-recession high. However, small business loans were still difficult to get during the recovery years. While large business lending rose on the balance sheets of commercial banks, small business lending contin-ued to fall. As of 2015, small business loans issued by banks were down about 20 percent since the financial crisis, while loans to larger businesses rose 4 percent over the same period. Further, smaller banks and credit unions granted loan requests at decreasing rates. Small banks, which make a large number of Small Business Administration loans (see below), are now approving less than half of the applications they receive.LG18-1 venture capital firmsOrganizations that pur-chase equity interests in firms and have the same rights and privileges as other owners of equity investments.Final PDF to printer

592 part eight Capital Structure Issuescor91411_ch18_588-613.indd 592 01/27/17 03:44 PMnew information could be revealed, significantly changing the firmÕs situation and forc-ing the account officer to begin the process again.Once the firm owners and loan officer tentatively agree on a loan, the loan officer must obtain internal approval from the bankÕs credit risk management team. Generally, even for the smallest midmarket credit, at least two officers must approve a new loan customer. Larger credit requests must be presented formally (either in hard copy or through a com-puter network) to a credit approval officer and/or committee before they can be signed.Having reviewed the financial and other applicant conditions, the bank can include loan covenants (similar to bond covenants discussed in Chapter 7) as a part of the loan agreement. Loan covenants reduce the bankÕs risk of granting and carrying the loan. Cov-enants can include a variety of conditions, such as ratio maintenance at or within stated ranges or key-person insurance policies on employees critical to the businessÕs success.The credit process does not end when the applicant signs the loan agreement. Before allowing the loan to be finalized, the account officer must make sure that any condi-tions that are required for the loan have been cleared, that is, Òclearing conditions prec-edent.Ó These include various searches, registration of collateral, and confirmation of the officerÕs authority to borrow. Credit must then be monitored throughout the loanÕs life to ensure that the borrower is living up to its commitments and to detect deterioration should it occur to protect the bankÕs interest.Typically, the firmÕs credit needs will change from time to time. A growing firm will have expanding credit needs. A firm moving into the international arena will need for-eign exchange. Further, even if the credit agreements offered do not change, bank loan officers review the firmÕs credit needs annually to ensure that the firm complying with the original credit agreement terms. Banks typically wish to maintain close contact with new and small firms to meet their ongoing financial service requirementsÑboth credit and noncreditÑso that the relationship will develop into a permanent, mutually benefi-cial one as the firm grows.Loan Commitments In the past, businesses borrowed spot loans, in which the firm would receive the funds as soon as the bank approved the loan. These days, most business loans are made as firms Òtake downÓ (or borrow against) prenegotiated lines of credit or loan commitments. Banks make loan commitment agreementsÑcontractual commit-ments to loan the firm a certain maximum amount (say, $10 million)Ñat given interest rate terms (say, 12 percent). The loan commitment agreement also defines the length of time over which the borrower may take down this loan. In return for making the loan commitment, the bank may charge an up-front (or facility) fee of, say, ⅛ of 1 percent of the commitment size, or $12,500 in this example. In addition, the bank must stand ready to supply the full $10 million at any time over the commitment periodÑfor example, one year. Meanwhile, the firm has a valuable option to take down any amount between $0 and $10 million. The bank may also charge the borrower a back-end (or commitment) fee on any unused balances on the commitment line at the end of the period. In this example, if the firm takes down only $8 million in funds over the year and the fee on unused commitments is ¼ percent, the firm must pay an additional expense of ¼ percent times $2 million, or $5,000.spot loanA loan in which the firm receives the funds as soon as the loan is approved.take downBorrowing against a line of credit or loan commitment.loan commitment agreementA contractual commitment by a bank to loan a firm a certain maximum amount at given interest rate terms for a stated length of time over which the firm has the option to take down this loan.up-front (or facility) feeA fee charged by a bank for making funds available through a loan commitment.back-end (or commit-ment) feeA fee charged by a bank on any unused balances of a loan commitment line at the end of the loan commit-ment period.Calculating Fees on a Loan CommitmentCalculate the total fees a firm would have to pay if its bank offers the firm the following loan commitment: A loan commitment of $1 million with an up-front fee of 1 percent and a back-end fee of 50 basis points (0.5 percent). The take down on the loan is 85 percent.EXAMPLE 18-1For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG18-1 Final PDF to printer

chapter 18 Issuing Capital and the Investment Banking Process 593cor91411_ch18_588-613.indd 593 01/27/17 03:44 PMDuring the financial crisis of 2008 and 2009, loan commitments set up prior to the market meltdown proved to be a lifeline for many businesses. During the crisis, finan-cial markets (including loan markets) dried up. Banks that held illiquid loans, mortgage-backed securities, and asset-backed securities at the start of the crisis tended to increase holdings of liquid assets and decrease investments in loans and new commitments to lend. At the same time, loan requests by businesses increased not only because these firms needed a substitute in the absence of market liquidity, but also to meet increased precautionary demands for cash. Because of concern about the liquidity of their exist-ing loans and securitized assets, the banks rationally protected themselves by hoarding liquidity, to the detriment of their customers and markets. Unable to get new loans, busi-nesses that had existing loan commitments were able to draw on them to meet their fund-ing needs. In fact, some firms drew funds from existing loan commitments simply due to fears about disturbances in the credit markets. To take one example, American Electric Power (AEP) drew down $3 billion from an existing credit line issued by J.P. Morgan and Barclays. According to its SEC filing, ÒAEP took this proactive step to increase its cash position while there are disruptions in the debt markets. The borrowing provides AEP flexibility and will act as a bridge until the capital markets improve.ÓFixed- versus Floating-Rate Loans Banks make loans (both spot loans and loan com-mitments) available to firms at either (1) fixed interest rates as fixed-rate loan commit-ments or (2) floating (or variable) rates as variable-rate loans. With fixed-rate loans, the firm makes fixed interest payments over the life of the loan. With variable-rate loans the loanÕs interest rate (and thus the interest payments the firm must make) changes over the loanÕs life. A floating rate is set at a fixed spread over a prevailing benchmark rate, such as a Treasury-bill rate, the federal funds rate, or a prime rate. If the bench-mark rate rises during the loan period, so does the firmÕs loan cost. The floating interest rate is specified in the loan contract. The spread is also stated in the loan contract; the bank sets the spread as a function of the firmÕs credit risk and the ownersÕ credit history.SMALL BUSINESS ADMINISTRATION The U.S. Congress created the Small Business Administration (SBA) on July 30, 1953, to Òaid, counsel, assist and protect, insofar as is possible, the interests of small business concerns.Ó For qualified new and small firms that cannot obtain long-term financing on reasonable terms from banks or other financial institutions, the SBA offers a basic loan guarantee program. Through this program, the SBA can guarantee up to $3.75 million (representing 75 percent of the loan value) at an interest rate not to exceed 2.75 percent more than the prime lending rate. Maturities on these loans can extend up to 7 years for working-capital loans, 10 years for equipment, and 25 years for real estate loans.While the SBAÕs primary function is to guarantee loans made to new and small busi-nesses by private financial institutions (such as banks), the SBA offers direct loan pro-grams as well. The SBAÕs Certified Development Company Loan Program provides long-term, fixed-rate capital funding to small businesses that use the funds to purchase real estate, machinery, or equipment for expansion or modernization. Private, nonprofit corporations called certified development companies offer these loans to contribute fixed-rate loanA loan on which the inter-est payments the firm must make cannot change over the life of the loan.variable-rate loanA loan on which the inter-est rate on the loan (and thus the interest payments the firm must make) can change over the life of the loan.SOLUTION: Up-front fee = $1,000,000 × 0.0100 = $10,000 Back-end fee = $1,000,000 × 0.0050 × ( 1 − 0.85 ) = 750Total = $10,750 Similar to Problems 18-1, 18-2, Self-Test Problem 1Final PDF to printer

594 part eight Capital Structure Issuescor91411_ch18_588-613.indd 594 01/27/17 03:44 PMto communitiesÕ or regionsÕ economic development. The SBA funds the loans via a 100  percent SBA-guaranteed debenture and a bank generally secures the loans. SBA loans require an investment of at least 10 percent ownerÕs equity. The SBAÕs Microloan Loan Program provides up to $50,000 in short-term loans to small businesses to fund working-capital purchases. Through this program the SBA makes or guarantees a loan to a bank, which then makes the microloan to the firm. The bank also provides the fledgling firm with management and technical assistance.Equity Financing and ExpertiseNew and small firms have difficulty obtaining debt financing from banks because banks are generally not willing or able to make loans to new companies with no assets and little or no business history. In these cases, new and small firms often turn to venture capital firms to get capital financing as well as advice. Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided by investment institutions or private individuals willing to back an untried company and its managers in return for an equity investment in the firm.Venture capital firms do not make outright loans. Rather, they purchase equity inter-ests in firms that give the venture capitalists the same rights and privileges associated with equity investments made by the firmÕs other owners. As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firmÕs managers and sometimes even help in recruiting senior managers for the firm. They also generally expect to be kept fully informed about the firmÕs operations, any problems, and whether all firm ownersÕ joint goals are being met.Many types of venture capital firms have sprung up, especially since 1980. Institutional venture capital firmsÕ sole purpose is to find and fund the most promis-ing new firms. Private-sector institutional venture capital firms include venture capital limited partnerships (that are established by professional venture capital firms, acting as general partners in the firm: organizing and managing the firm and eventually liquidat-ing their equity investment); financial venture capital firms (subsidiaries of banks); and corporate venture capital firms (subsidiaries of nonfinancial corporations that generally specialize in making start-up investments in high-tech firms). Limited partner venture capital firms dominate the industry.In addition to private sector institutional venture capital firms, the federal government, through the SBA, operates Small Business Investment Companies (SBICs). SBICs are privately organized venture capital firms licensed by the SBA to make equity invest-ments (as well as loans) to entrepreneurs for start-up activities and expansions. As feder-ally sponsored entities, SBICs rely on their unique opportunity to obtain investment funds from the U.S. Treasury at very low rates relative to private-sector institutional venture capital firms. In contrast to institutional venture capital firms, angel venture capitalists (or angels) are wealthy individuals who make equity investments. Angel venture capital-ists have invested much more in new and small firms than institutional venture capital firms have.Venture capital firms receive many unsolicited proposals of funding from new and small firms. The venture capital firms reject the majority of these requests. Venture capi-tal firms look for two things in making their decisions to invest in a firm. The first is a high return. Venture capital firms are willing to invest in high-risk new and small firms. However, they require high levels of returns (sometimes as high as 700 percent within five to seven years) to take on these risks. The second is an easy exit. Venture capital firms realize a profit on their investments by eventually selling their firm interests. They want a quick and easy exit opportunity when it comes time to sell. Basically, venture LG18-2 venture capitalA professionally managed pool of money used to finance new and often high-risk firms.institutional venture capital firmsBusiness entities whose sole purpose is to find and fund the most promising new firms.angel venture capital-ists (or angels)Wealthy individuals who make equity investments.Final PDF to printer

chapter 18 Issuing Capital and the Investment Banking Process 595cor91411_ch18_588-613.indd 595 01/27/17 03:44 PMThe Choice to Go PublicIf they succeed, at some point new and small firms grow until they need more capital than they can raise on their own and do not want or need to pay to get additional funds from banks and venture capitalists. At this point, the firm decides to make an initial public offering (IPO) of stock. That is, the firm allows its equity, some of which was held privately by managers and venture capital investors, to be publicly traded in stock markets for the first time. The number of IPOs in the United States averages about 200 deals per year. However, the financial crisis brought about a drought in these firm events. For a 10-week period, starting in August 2008, no firm conducted an IPO, the longest stretch of inactivity since IPO data began to be tracked in 1980. Even through 2015, the IPO market had not recovered. For the year, 137 companies undertook an IPO. This was up 11.3  percent from 2010 and is 2.5 times the number of deals in 2008. However, the num-ber of deals in 2015 was down from the 201 IPOs in 2013 and was still far below the long-term average.The technical details associated with the sale of public stock appear below. However, in making the decision to go from a private to a public firm, managers must consider the benefits versus the costs of doing so. As mentioned previously, a major benefit of going public is that the firm will have a new, larger pool of equity capital than is available from any previous source (bank or venture capitalist). This new equity allows a firm to undertake new and profitable investment opportunities that it could not undertake as a private firm. The market provides a market value for the firmÕs common stock, which is really a readily available measure of firm performance (another advantage of going public). Such a transparent measure of firm performance can attract even more stock-holders and can provide a tool that can be used to reward firm managers (i.e., through stock or option payments as part of compensation packages). Finally, as private firms, managers generally must invest much of their personal wealth and human capital in the firm. From Chapters 9 and 10, we know that this results in a poorly diversified portfolio for the firmÕs original owners. By going public, the original owners can reallocate their personal wealth away from the firm and into more diversified portfolios.However, some significant costs are attached to the decision to become a public firm. First and foremost is the direct financial cost of an IPO. Cash expenses associated with an IPO (e.g., legal services, printing) can sometimes total as much as $1 million. These expenses must be paid regardless of whether the IPO succeeds or not. Additionally, underwriters charge a discount (on average about 7 percent) to sell the stock and IPOs are typically underpriced (on average about 15 percent) to ensure a successful sale. Thus, a significant amount of the issue proceeds do not actually become available to the newly public firm.Add to these financial costs a substantial demand for time from the firmÕs own-ers during the IPO process. That is, the firmÕs owners and top managers must spend a significant amount of time with the investment bankers to discuss all aspects of initial public offerings (IPOs)A first-time issue of stock by a private firm going pub-lic (e.g., allowing its equity, some of which was held privately by managers and venture capital investors, to be publicly traded in stock markets for the first time).TIME OUT 18-1 What sources of debt financing are available to new and small firms?   18-2 What is venture capital?  capital firms provide equity funds to new, unproven, and young firms. This willingness separates venture capital firms from commercial banks and investment firms, which pre-fer to invest in existing, financially secure businesses.Final PDF to printer

596 part eight Capital Structure Issuescor91411_ch18_588-613.indd 596 01/27/17 03:44 PMthe firm and with major potential stockholders before the IPO is completed. These time demands grow even more significantly as the offering date approaches. Further, throughout the IPO process, managers must disclose firm details that may be valuable to competitors. Further, shareholders of a public firm have the right to a great deal of information about the firm. The release of this information to stockholders also releases it to competitors.Finally, the firm is exposed to reputational costs if the IPO is unsuccessful or is beset with problems. Such was the case with the Facebook IPO in 2012. The IPO was touted as one of the largest IPOs of a technology firm, with a market capitalization of over $104 billion at its peak. For many years, Mark Zuckerberg, FacebookÕs founder and chief executive, resisted taking the firm public. However, as the number of private share-holders exceeded 500, the firm was required to go public. With great anticipation, the IPO occurred on May 18, 2012. However, as described in the Finance at Work box, the event was plagued by a series of missteps and technical issues, including the last minute increase in the number of shares issued and a computer malfunction on the NASDAQ exchange during the first hours of trading. FacebookÕs shares lost over a half of their ini-tial value in less than three months of the IPO and brought doubt to the firmÕs reputation as the leader in social networking.Two newer methods of going public include a Dutch auction IPO and a direct IPO. A Dutch auction IPO uses a bidding process to discover the highest price at which the issuing company can sell shares to the public. The company announces the number of shares being sold, and then investors submit their bids, stating the number of shares they want and at what price. The lowest successful bid, which allows the firm to sell all of the shares, becomes the price for all bidders, even those who bid a higher price. The Dutch auction method guarantees that the initial offering price is set so that all of the shares are sold at a price that reflects market demand. Further, unlike the traditional IPO (which gives an advantage to larger investors and investment banks), this method gives individual investors a chance to buy shares at the IPO price. Finally, this method of IPO allocation allows young and growing companies to raise as much cash as the market is willing to afford it.The drawback of a Dutch auction IPO is that if the initial market demand is not suf-ficient, a company using a Dutch auction rather than an investment bank to issue and sell its shares may not raise the funds it needs. One of the more notable Dutch auction IPOs was GoogleÕs $2.7 billion initial public offering in August 2004. GoogleÕs initial price range for the stocks was between $108 and $135 per share. Several well-publicized prob-lems with the IPO caused that price to drop. When the Dutch auction finished, the price was $85 per share.A direct IPO involves the issuance of stock directly to investors without using an investment bank as an intermediary. Direct IPOs allow a firm to avoid various costs associated with a traditional IPO. For example, the average commission charged by IPO underwriters is 13 percent of the proceeds of the securities sale: A direct IPO involves costs that are, on average, 3 percent. Further, direct IPOs are exempt from many of the Securities and Exchange CommissionÕs registration and reporting require-ments. Direct IPOs can also be completed within a shorter time frame and without extensive disclosure of firm-sensitive information. Finally, because only a limited number of investors may buy stock in a direct IPO they tend to have a long-term investment horizon. Thus, the pressure for the newly public firm to produce short-term profits is reduced.A disadvantage of a direct IPO, however, is that the amount that a company can raise through a direct IPO over a 12-month period is limited. In addition, to ensure that all shares are sold, the stock must generally be offered at a price that is lower than might be achieved through a traditional IPO. Finally, since shares are sold through exempt offerings, shares are not generally freely traded. Thus, no market price is established for the shares.Final PDF to printer

chapter 18 Issuing Capital and the Investment Banking Process 597cor91411_ch18_588-613.indd 597 01/27/17 03:44 PM18.2 ∙ Public FirmsÕ Capital SourcesIn contrast to small and new firms that can only get capital funding from mainly pri-vate sources, public firms raise the majority of their capital funds from public debt and equity markets. Public firms raise large amounts of short-term debt in the money market, primarily as commercial paper. Further, public firms raise long-term capital by issuing securities in the public debt and equity markets.Debt FinancingPublic firms or corporations obtain debt financing to meet their capital needs in two major ways: commercial paper and corporate bonds. As we noted in Chapter 6, both of these types of debt financing trade in the financial markets. Commercial paper is LG18-3 Less than three days before Facebook Inc.Õs IPO, a main adviser at lead underwriter Morgan Stanley assured Chief Financial Officer David Ebersman that there was plenty of demand for the firmÕs shares. On this advice, Ebersman decided to boost the number of shares the company would offer investors by 25 percent. That advice and the resulting decision may have doomed any real chance the company had that its stock would jump on its first day of tradingÑa mark of successful IPOs. On the first day of trading, Facebook shares fell 11 percent. On the second full day of trading, the shares fell another 8.9  percent, to $31. Investors blamed the tumble on the last-moment expansion of the offering. In an effort to ensure confidence in public markets after such an unexpected event, Securities and Exchange Commission Chairman Mary Schapiro said that her agency would examine ÒissuesÓ sur-rounding the IPO. Shortly after the IPO, it was reported that analysts at Morgan Stanley and another underwriter, Goldman Sachs Group, had told their clients earlier in the month that they were reducing their earnings estimates for Facebook based on a filing that said the companyÕs ad-sales growth was not keeping up with the expansion of its user base. On that same day, NASDAQ OMX Group Inc. said that if it had fully realized the extent of the technical problems that hampered the first day of trading it would have delayed the IPO.FacebookÕs offering was one of the most widely antici-pated IPOs. It was a success in terms of the companyÕs fun-draising goals: raising $16 billion for Facebook, the biggest ever for a U.S. Internet company. Some investors valued the company at $104 billion. However, the offering left many inves-tors with losses. The outcome of this IPO damaged the repu-tation of Morgan Stanley, long considered the marquee bank for technology offerings. A month before the IPO, Facebook announced that its revenue and profit had declined in the first quarter, from the fourth quarter of 2011. This news came two weeks before the company began its ÒroadshowÓ intended to promote its shares to large investors. And despite this news, one week into the roadshow, on advise of underwriters, the INSIDE THE FUMBLED FACEBOOK OFFERINGfinance at workmarketscompany raised its price range for the share sale, to between $34 and $38, from $28 to $35.Making matters even worse, on May 15, The Wall Street Journal reported that, after deciding that paid ads on the site have little impact on consumersÕ car purchases, Gen-eral Motors planned to stop advertising with Facebook. This action raised serious concerns about whether FacebookÕs business prospects could support its valuation. Then came the announcement that Facebook was increasing the size of the deal by asking private investors to sell more shares. Mr.  Ebersman insisted that the lead three banks on the dealÑMorgan Stanley, J.P. Morgan Chase & Co., and Goldman SachsÑget regular and equal access to the so-called ÒbookÓ showing investor orders (generally updated about every six hours during the roadshow). As news came out that the deal would be growing, investors got nervous that demand would be satisfied before the shares even began to trade. As all of this was happening, some bankers felt ill-prepared to respond to investorsÕ questions about the change in size of the deal. Many learned of the growth after the change was filed with regulators. One source stated that decisions were kept quiet to prevent leaks. Another source said that, after the disclosure, underwriters made Òhundreds of callsÓ to investors explaining the move.Days short of the IPO, there was one major decision left: the share price. Early Thursday morning, Mr. Ebersman called bankers at J.P. Morgan and Goldman Sachs to get their opin-ions on the price. After some discussion, there was agreement about the $38. Around 1:30 p.m. Eastern time, Mr. Ebersman dialed onto a conference call with the Òpricing committeeÓ of board members. He informed them that he intended to go with a $38 share price. Nobody stated objections and the call was short. The shares opened at around $42, then the price quickly fell.Source: Shayndi Raice, Anupreeta Das, and Gina Chon, ÒInside Fumbled Face-book Offering,Ó The Wall Street Journal Online, May 3, 2012.!Want to Know More?Key Words to Search for Updates: Facebook IPO, largest tech IPOsFinal PDF to printer

Year0246810121416182022Jan-73Jan-76Jan-79Jan-82Jan-85Jan-88Jan-91Jan-94Jan-97Jan-00Jan-03Jan-06Jan-09Jan-12Jan-15Interest RatePrimeCommercial paper598 part eight Capital Structure Issuescor91411_ch18_588-613.indd 598 01/27/17 03:44 PMshort-term debt sold and traded in the money markets, while long-term debt is sold and traded in the capital markets.COMMERCIAL PAPER Commercial paper is an unsecured short-term promissory note issued by a public firm to raise short-term cash, often to finance working-capital requirements. Commercial paper is one of the largest (in terms of dollar value out-standing) of the money market instruments, with $1.05 trillion outstanding as of 2016. One reason that so much commercial paper is outstanding is that companies with strong credit ratings can generally borrow money at a lower interest rate by issuing commercial paper than by directly borrowing (via loans) from banks. Indeed, although business loans were the major asset on bank balance sheets between 1965 and 1990, they have dropped in importance since 1990. This trend reflects the growth of the commercial paper market.Figure 18.2 illustrates the difference between commercial paper rates and the prime rate for borrowing from banks from 1973 through 2016. Notice that in the late 1990s, as the U.S. economy thrived and default risk on the highest quality borrowers decreased, the spread between the prime rate and the commercial paper rate increased. Further, during the latter part of and following the financial crisis, commercial paper rates fell to near zero, falling as low as 0.13 percent in January 2010 and 0.09 in the last quarter of 2013. Despite these low rates, the commercial paper market shrank in size, from over $2.2 trillion in August 2007 to as low as $0.95 trillion in April 2013, for two reasons. First, while commercial paper rates were historically low from 2009 through 2013, so were long-term bond rates. Wanting to lock in to low rates for the long run, firms issued and used debt with longer maturity and less short-term commercial paper financing. Second, at the height of the financial crisis there was a run on money market mutual funds. Money market mutual funds invested heavily in the commercial paper market. As investors pulled their money from these funds, the commercial paper market shrank by $52.1 billion. In response to the commercial paper crisis, the Federal Reserve Board announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that complemented the Federal ReserveÕs existing credit facilities to help provide liquidity to short-term funding markets.commercial paperAn unsecured short-term promissory note issued by a public firm to raise short-term cash, often to finance working capital requirements.FIGURE 18.2Commercial Paper and Prime RatesNotice the cohesive relation-ship between the prime rate and the commercial paper rate over time.Final PDF to printer

chapter 18 Issuing Capital and the Investment Banking Process 599cor91411_ch18_588-613.indd 599 01/31/17 07:28 PMTrading Process for Commercial Paper Commercial paper is sold to investors either directly (about 12 percent of all issues in 2016Ñsee Figure 18.3), using the issuersÕ own sales force (e.g., GMAC), or indirectly through brokers and dealers (about 88 percent of all issues in 2016), such as commercial banks and investment banks underwriting the issues. Commercial paper underwritten and issued through brokers and dealers is more expensive to the issuer, usually increasing the cost of the issue by 1 Ú 10 to 1 Ú 8 of a percent, reflecting an underwriting cost. In return, the dealer guarantees the sale of the whole issue. To help achieve this goal, the dealer contacts prospective buyers of the commercial paper, determines the appropriate discount rate on the commercial paper, and relays any special requests in terms of specific quantities and maturities to the issuer. If a potential investor (such as a money market mutual fund) issues commercial paper through a dealer and makes a request at the beginning of the day for a particular maturity, the request is often completed by the end of the day.When a firm issues commercial paper directly to a buyer, the company saves the cost of the dealer (and the underwriting services). This became the dominant method of com-mercial paper placement from 2010 to 2013. However, with a direct placement, the issu-ing firm must find appropriate investors and determine the appropriate discount rate that will place the complete paper issue. When the firm decides how much commercial paper it wants to issue, it posts offering rates to potential buyers based on its own estimates of investor demand. The firm then monitors the flow of money during the day and adjusts its commercial paper rates depending on investor demand. These costs associated with direct placements leave them as the less preferred method of commercial paper place-ment during the majority of the period shown in Figure 18.3.Because commercial paper is unsecured debt, the issuing companyÕs credit rating is of particular importance in determining how marketable a commercial paper issue Jan-91Jan-93Jan-95Jan-97Jan-99Jan-01Jan-03Jan-05Jan-09Jan-11Jan-13Jan-15Jan-07Year$0$200$400$600$800$1,000$1,200$1,400$1,600$1,800Dollars (in billions)Direct placementsDealer placementsFIGURE 18.3 Direct versus Dealer Placements of Commercial PaperA huge price spread between direct purchases of commercial paper and purchases through dealers or brokers occurred during the financial crisis of 2008 and 2009.Final PDF to printer

600 part eight Capital Structure Issuescor91411_ch18_588-613.indd 600 01/27/17 03:44 PMwill be. Credit ratings provide potential investors with information regarding the ability of the issuing firm to repay the borrowed funds as promised and to compare the com-mercial paper issues of different companies. Several credit rating firms rate commercial paper issues (e.g., Standard & PoorÕs, MoodyÕs, and Fitch ICBA, Inc.). Standard & PoorÕs rates commercial paper from A1 for highest quality issues to D for lowest quality issues, MoodyÕs rates commercial paper from P1 for highest quality issues to ÒNP, not prime,Ó for lowest quality issues, and Fitch rates issues from F1 to F5. Table 18.1 summarizes the credit ratings assigned to commercial paper by Standard & PoorÕs, MoodyÕs, and Fitch. Only the top three of the five categories are relevant because issuers usually will not attempt to market lower grade commercial paper. Virtually all companies that issue com-mercial paper obtain ratings from at least one rating services company, and most obtain two rating evaluations. The better the credit rating on a commercial paper issue, the lower the interest rate (or discount from par) on the issue.Commercial paper issuers with lower than prime credit ratings often back their com-mercial paper issues with lines of credit from commercial banks. In these cases, banks agree to make the promised payment on the commercial paper if the issuer cannot pay off the debt at maturity. Thus, a letter of credit backing commercial paper effectively substi-tutes the credit rating of the issuing firm with the credit rating of the bank. This reduces the paper purchasersÕ risk and results in a lower interest rate (and higher credit rating) on the commercial paper.LONG-TERM DEBT As Chapter 7 described in detail, corporate bonds are long-term debt securities issued by public corporations ($9,599.7 billion outstanding in 2015; approximately 25 percent of all outstanding long-term bonds). The minimum denomina-tion on publicly traded corporate bonds is $1,000, and coupon-paying corporate bonds generally pay interest semiannually.The Trading Process for Corporate Bonds The initial or primary sale of corporate bond issues occurs either through a public offering, using an investment bank serving as a security underwriter, or through a private placement to a small group of investors (often financial institutions). Generally, when a firm issues bonds to the public, many investment banks are interested in underwriting the bonds. The bonds can generally be sold in a national market. Total dollar volume of new debt issues was $2,609.8 billion in 2015, up slightly from $2,562.3 billion in 2014. Table 18.2 lists the activity of the top 10 bond underwriters in 2015. Most bonds issued by smaller firms are underwrit-ten by small regional investment banks located in the immediate area of the municipal issuer (e.g., Bernardi Securities located in Chicago). The high cost of gathering informa-tion about smaller corporate bond issuers limits smaller investorsÕ interest in the sales of these issues.Most often, corporate bonds are offered publicly through investment banking firms acting as underwriters. Normally, the investment bank facilitates this transaction using a firm commitment underwriting, illustrated in Figure 18.4. The investment bank guar-antees the firm a price for newly issued bonds by buying the whole issue at a fixed price LG18-4firm commitment underwritingA security issue in which the investment bank guar-antees the issuer a price for newly issued securities by buying the whole issue at a fixed price from the secu-rity issuer (the bid price). The investment bank then seeks to resell the securi-ties to investors at a higher price (the offer price).MoodyÕsS&PFitchSuperiorP1A1+ or A1F1+ or F1SatisfactoryP2A2F2AdequateP3A3F3SpeculativeNPB or CF4DefaultedNPDF5TABLE 18.1 Commercial Paper Credit Ratings as Assigned by Major Rating AgenciesFinal PDF to printer

Underwriter(investment bank)Pays bid pricePays offer priceSell bondsSell bondsCorporationInvestors←←←←←←←←←←←← chapter 18 Issuing Capital and the Investment Banking Process 601cor91411_ch18_588-613.indd 601 01/27/17 03:44 PMfrom the bond-issuing firm at a discount from par. The investment bank then seeks to resell these securities to investors at a higher price. As a result, the investment bank takes a risk that it may not be able to resell the securities to investors at a higher price. This may occur if a firmÕs bond value suddenly falls due to an unexpected change in interest rates or negative information being released about the issuing firm. If this occurs, the invest-ment bank takes a loss on its security underwriting. However, the bond issuer is protected by being able to sell the whole issue.The investment bank can purchase the bonds through competitive bidding against other investment bankers or by directly negotiating with the issuer. In a competitive sale, the bond-issuing firm invites bids from a number of underwriters. The investment bank that submits the highest bid to the bond issuer wins the bid. The underwriter may use a syndicate of other underwriters and investment banks to distribute (sell) the issue to the public. With a negotiated sale, a single investment bank obtains the exclusive right to originate, underwrite, and distribute the new bonds through a one-on-one negotiation process. With a negotiated sale, the investment bank provides the origination and advis-ing services to the issuers.Some corporate securities are offered on a best efforts underwriting basis, in which the underwriter does not guarantee a firm price to the issuer (as with a firm commitment offering). Here, the underwriter acts more as a placing or distribution agent for a fee. Unlike firm commitment underwriting, with best efforts underwriting, the investment bank incurs no risk of mispricing the security since it simply seeks to sell the securities at the best market price it can get for the issuing firm.In a private placement, a public firm (sometimes with an investment bankÕs help) seeks to find a large institutional buyer or group of buyers (usually fewer than 10) to purchase the whole issue. To protect smaller individual investors against a lack of dis-closure, the Securities Exchange Act of 1934 requires publicly traded securities to be registered with the Securities and Exchange Commission (SEC). Private placements, on the other hand, can be unregistered and can only be resold to large, financially competitive saleA sale of securities in which the issuing firm invites bids from a number of underwrit-ers. The investment bank that submits the highest bid to the issuer wins the bid. The winning bid under-writer then distributes (sells) the issue to the public.negotiated saleA sale of securities in which the investment bank obtains the exclusive right to originate, underwrite, and distribute the new securi-ties through a one-on-one negotiation process. With a negotiated sale, the invest-ment bank provides the origination and advising services to the issuers.best efforts underwritingA security issue in which the underwriter does not guarantee a firm price to the issuer (as with a firm commitment offering) and acts more as a placing or distribution agent for a fee.TABLE 18.2 Top Underwriters of Domestic Debt (in billions of dollars)ManagerAmount2015 Market ShareNumber of Deals2016 Market ShareJ.P. Morgan$296.311.4%86811.8%Bank of America Merrill Lynch265.010.28999.5Citigroup254.79.87769.6Barclays Capital221.48.56438.4Wells Fargo181.87.08515.5Goldman Sachs180.36.95216.9Morgan Stanley 177.86.86206.9Deutsche Bank AG 155.76.05227.2Credit Suisse147.75.75006.0HSBC Holdings88.63.42473.5Top 10 total$1,969.275.7%6,44775.3%Industry total$2,609.8100.0%4,239$2,562.3Source: Thomson Reuters website 2016. www.thompsonreuters.comFIGURE 18.4Firm Commitment Underwriting of a Corporate Bond IssueTwo-way arrows show the interdependence between participants.Final PDF to printer

602 part eight Capital Structure Issuescor91411_ch18_588-613.indd 602 01/27/17 03:44 PMsophisticated investors. These large investors supposedly possess the resources and expertise to analyze a securityÕs risk.Privately placed bonds (and stocks) have traditionally been among the most illiquid securities, with only the very largest financial institutions or institutional investors being able or willing to buy and hold them without an active secondary market. In April 1990, however, the Securities and Exchange Commission (SEC) amended its Regulation 144A. The amendment allowed large investors to begin trading privately placed securities among themselves even though, in general, privately placed securities do not satisfy the stringent disclosure and informational requirements that the SEC imposes on approved publicly registered issues. Rule 144A private placements may now be underwritten by investment banks on a firm commitment basis. Of the total $573.5 billion in private debt and equity placements in the first half of 2015, $544.6 billion (95 percent) were Rule 144A placements. J.P. Morgan was the lead underwriter of Rule 144A debt placements over this period (underwriting $51.1 billion, 9.4 percent of the total placements).The SEC defined Òlarge investorsÓ as those with assets of $100 million or moreÑwhich excludes all but the very wealthiest household savers. We might well ask how long this size restriction will remain. As they become more sophisticated and information acquisition costs fall, savers will increasingly demand access to the private placement market. In such a world, savers would have a choice not only between the secondary securities from financial institutions and the primary securities publicly offered by public firms, but also between publicly offered (registered) securities and privately offered (unregistered) securities.The secondary market for corporate bonds is thin (i.e., trades are relatively infre-quent). Thin trading is mainly a result of a lack of information on bond issuers, as well as special features (such as covenants) that are built into those bondsÕ contracts. Information on corporate bond issuers (particularly smaller firms) is generally more costly to obtain and evaluate, although this is in part offset by bond rating agencies (see Chapter 7).Equity FinancingPublic firms can also issue corporate stock or equity as another major source of capital financing. As Chapter 8 described in detail, corporate stock represents ownership shares in a public corporation. In exchange for funds, the firm gives the stockholders owner-ship rights in the firm, as well as cash flows in the form of dividends. Further, common stockholders have voting privileges on major issues in the firm, such as the election of the board of directors, which oversees the day-to-day operations of the firm.Before a corporation can issue common stock, a majority of both the board of direc-tors and the firmÕs existing common stockholders must authorize the sale of shares. In the 1990s, the market value of corporate stock outstanding increased faster than any other type of financial security. From 1994 through 2000, stock values increased over 200 percent, from $6,333.3 billion to $19,522.8 billion outstanding. A slow U.S. economy saw market values fall to a low of $11,900.5 billion at the end of 2002, but by 2007 stock market values had rebounded to $25,577.3 billion. The period of the financial crisis and the worldwide recession saw equity values fall 45 percent, to $13,965.7 billion, in March 2009 before rebounding to $20,008.5 at the end of that year. Equity values finally surpassed their pre-crisis levels in 2012, rising to $25,905.9 by yearÕs end, and rose to $37,465.6 in the first quarter of 2015 before falling back to $34,084.9 later that year.THE TRADING PROCESS FOR CORPORATE EQUITY Primary markets are markets in which corporations raise funds through new stock issues. Initial investors (fund suppliers) buy new stock securities in exchange for funds (money) that the issuer (user of funds) needs. A primary market sale may be a first-time issue by a private firm going pub-lic (i.e., an IPO). Alternatively, a primary market sale may be a seasoned offering, in which the firm already has shares of the stock trading in the secondary markets. In both cases, the issuer receives the sale proceeds and the primary market investors receive the securities.primary marketsMarkets in which corpora-tions raise funds through new issues of securities.Final PDF to printer

chapter 18 Issuing Capital and the Investment Banking Process 603cor91411_ch18_588-613.indd 603 01/27/17 03:44 PMAs illustrated in Figure 18.5, most primary securities market transactions go through investment banks (e.g., Goldman Sachs or Morgan Stanley), which serve as intermediar-ies between the issuing firms (fund users) and ultimate investors (fund suppliers). Total dollar volume of new equity issues was $229.5 billion in 2015, down from $258.5 billion in 2014. Table 18.3 lists the activity of the top 10 equity underwriters in 2015.As with the primary sales of bonds (discussed previously), investment banks can conduct a primary sale of stock using a firm commitment underwriting or on a best efforts underwriting basis. In a firm commitment underwriting, the investment bank purchases stock from the issuing firm for a guaranteed price (called the bid price or net  proceeds) and resells the stock to investors at a higher price (called the offer price or gross proceeds). The difference between the gross proceeds and the net proceeds on an issue (called the underwriterÕs spread) is compensation for the expenses and risks incurred by the investment bank. In the 2000s, underwriterÕs gross spread on first-time equity issues (i.e., private firms going publicÑthe initial public offering, or IPO) averaged 7.23 percent and on seasoned equity issues (i.e., publicly traded firms issuing additional shares) averaged 4.86 percent.net proceedsThe guaranteed price at which the investment bank purchases the stock from the issuing firm in a firm commitment underwriting.gross proceedsThe higher price at which the investment bank resells the stock to inves-tors in a firm commitment underwriting.underwriterÕs spreadThe difference between the gross proceeds and the net proceeds.FIGURE 18.5Primary Market Stock TransactionInvestment banks are inter-mediaries between fund users and fund suppliers.IssuingCorporationInvestmentBankInvestorsFundsStocksFundsStocksSource: Thomson Reuters website 2016. www.thompsonreuters.comTABLE 18.3 Top Underwriters of Domestic Equity (in billions of dollars) ManagerAmount2015 Market ShareNumber of Deals2016 Market ShareJ.P. Morgan$29.512.9%20311.0%Morgan Stanley22.69.916210.5Credit Suisse22.59.81457.1Citigroup21.99.616111.3Bank of America Merrill Lynch21.89.518410.7Goldman Sachs21.39.315410.8Barclays Capital19.58.51369.1Wells Fargo11.34.91094.8Deutsche Bank AG10.64.6915.8RBC Capital6.42.8944.2Top 10 total$187.581.71,43985.3%Industry total$229.5100.0%848$258.5Calculating Costs of Issuing StockReneeÕs, Inc., needs to raise $100 million to finance firm expansion. In discussions with its investment bank, ReneeÕs learns that the bankers recommend a gross proceeds price of $40 per share, and they will charge an underwriterÕs spread of 6.5 percent of the gross price. Calculate the net proceeds to ReneeÕs from the sale of stock. How many shares of stock will ReneeÕs need to sell in order to receive the $100 million needed?EXAMPLE 18-2For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG18-4 Final PDF to printer

604 part eight Capital Structure Issuescor91411_ch18_588-613.indd 604 01/27/17 03:44 PMOften, investment banks will bring in a number of other investment banks to help sell and distribute a new security issue. Such a group of sellers is called a syndicate. For example, Figure 18.6 describes the offering of an issue of senior debt by Virginia Electric and Power Company, including a list of the syndicate of three investment banks involved in the initial issue. The investment banks are listed according to their degree of participation in new share sales. The lead bank(s) in the syndicate (Citigroup Global Markets), who directly negotiate with the issuing firm on behalf of the syndicate, are syndicateThe group of investment banks used to help sell and distribute a new security issue.SOLUTION: Net proceeds = Gross proceeds − UnderwriterÕs spread = $40 − ( 0.065 × $40 ) = $37.40 Funds needed = $100 million = $37.40 × Number of shares sold Number of shares sold = $100 million / $37.40 = 2,673,797 shares Similar to Problems 18-3, 18-4, Self-Test Problem 2FIGURE 18.6Debt Issue AnnouncementThis debt issue announce-ment clearly spells out all details and serves as a refer-ence point.Title of Senior Notes: 2016 Series A 3.15% Senior Notes due 2026 Aggregate Principal Amount: $750,000,000Initial Price to Public: 99.991% of the principal amount of the Senior Notes plus accrued interest, if any, from the date of issuanceInitial Purchase Price to be Paid by Underwriters: 99.341% of the principal amount of the Senior NotesTime of Delivery:January 14, 2016, 10:00 A.M.Closing Location:McGuireWoods LLPGateway Plaza800 East Canal StreetRichmond, Virginia 23219The Senior Notes will be available for inspection by the Representatives at:McGuireWoods LLPGateway Plaza800 East Canal StreetRichmond, Virginia 23219New Issue of DebtVIRGINIA ELECTRIC AND POWER COMPANY$750,000,000 2016 Series A 3.15% Senior Notes due 2026 UNDERWRITING AGREEMENT January 12, 2016 Pricing Term Sheet Citigroup Global Markets Inc.Goldman, Sachs & Co.Morgan Stanley & Co.Underwriter$250,000,000$250,000,000$250,000,000$750,000,000Total:Principal Amount of Senior Notes to bePurchasedFinal PDF to printer

chapter 18 Issuing Capital and the Investment Banking Process 605cor91411_ch18_588-613.indd 605 01/27/17 03:44 PMcalled the originating house(s). Once an issue is arranged and its terms set, each syn-dicate member is assigned a given number of shares in the issue it is responsible for selling. Shares of stock issued through a syndicate of investment banks spread the risk associated with the stock sale among several investment banks. A syndicate also results in a larger pool of potential outside investors, widening the scope of the investor base and increasing the probability of a successful sale.Just as with primary sales of corporate bond issues, firms may initially issue corporate stocks through public sales (wherein the stock issue is offered to the general investing public). New stock issues may also be sold by private placement (wherein stock is sold privately to a limited number of large investors). In a public sale of stock, once the issu-ing firm and the investment bank have agreed on the stock issue details, the investment bank must get SEC approval in accordance with the Securities Exchange Act of 1934. Stock registration can be a lengthy process. We illustrate the process in Figure 18.7. The process starts with the preparation of the registration statement to be filed with the SEC. The registration statement includes: ¥ Information about the issuing firmÕs business. ¥ The key provisions and features of the security to be issued. ¥ The risks involved with the security. ¥ ManagementsÕ background.The focus of the registration statement is to fully disclose information about the firm and the securities issued to the public at large. At the same time that the issu-ing firm and its investment bank prepare the registration statement to be filed with the SEC, they must also prepare a preliminary version of the public offeringÕs pro-spectus called the red  herring prospectus. The red herring prospectus is similar to the registration statement, but is distributed to potential equity buyers. Once the SEC registers the issue, the red herring prospectus is replaced with the official or final prospectus.After the firm submits the registration statement, the SEC has 20 days to request addi-tional information or changes to the registration statement. This review period is called the waiting period, during which the SEC works through the new security issue approval process. First-time or infrequent issuers can sometimes wait up to several months for SEC registration, especially if the SEC keeps requesting additional information and revised red herring prospectuses. However, companies that know the registration process well can generally obtain registration in a few days.Once the SEC is satisfied with the registration statement, it registers the issue. At this point, the issuing firm (along with its investment bankers) sets the final share selling price, prints the official prospectus describing the issue, and sends it to all potential buyers of the issue. Upon issuance of the prospectus (generally the day following SEC registration), the firm may sell the shares.originating house(s)The lead bank(s) in a syndi-cate, who directly negotiate with the issuing firm on behalf of the syndicate.red herring prospectusA preliminary registra-tion statement filed with the SEC.prospectusOfficial document in which the issuing firm (along with its investment bankers) sets the final selling price on the securities and describes the issue.FIGURE 18.7Getting Shares of Stock to the Investing PublicSteps in the process of issu-ing shares to the public must pass through an SEC evalua-tion period.PrepareSEC evaluation (waiting period)1Ð20 daysFew daysÐSeveral months1 dayDecideto IssueRegistrationStatementSent to SECRed HerringProspectusSent toProspectiveBuyersSECRequestsChanges orAdditionalInformationOfficialProspectusIssuedSharesOfferedto PublicFinal PDF to printer

606 part eight Capital Structure Issuescor91411_ch18_588-613.indd 606 01/27/17 03:44 PMTo reduce registration time and costs, yet still protect the public by requiring issuers to disclose information about the firm and the security to be issued, the SEC passed a rule in 1982 allowing for Òshelf registration.Ó As illustrated in Figure 18.8, shelf registration allows firms that plan to offer multiple issues of stock over a three-year period to submit one registration statement as described above (called a master registration statement). The registration statement summarizes the firmÕs financing plans for the three-year period. Thus, the securities are shelved for up to three years until the firm is ready to issue them. Once the issuer and its investment bank decide to issue shares during the three-year shelf registration period, they prepare and file a short-form statement with the SEC. Upon SEC approval, the shares can be priced and offered to the public usually within one or two days of deciding to take the shares Òoff the shelf.ÓThus, shelf registration allows a firm to get stocks into the market quickly (e.g., in one or two days) if the firm feels conditions (especially the price it can get for the new stock) are right, without the time lag generally associated with full SEC registration. For exam-ple, on January 12, 2016, Equity One, Inc., announced the sale of 11,357,837 shares of its common stock. The shares were registered under the Securities Act of 1933, pursuant to Equity OneÕs shelf registration statement filed with the SEC on April 10, 2013. Liberty International Holdings Limited and UBS Securities led the underwriting of shares that were sold just days after this announcement.shelf registrationA method of registering securities that allows firms that plan to offer multiple issues of the security over a three-year period to submit one registration statement.FIGURE 18.8Getting Shelf Registrations to the Investing PublicThe process of getting shelf registrations to the public can occur over two years.0Ð3 yearsDecideto IssueDecideto IssueFile ShortFormStatementwith SECFile ShortFormStatementwith SECSharesOfferedto PublicRegistrationStatementApprovedby SECSharesOfferedto Public1Ð2 days1Ð2 daysTIME OUT 18-3 What sources of debt and equity financing are available to public firms?   18-4 What is the difference between a public firmÕs commercial paper and its long-term debt?  viewpoints REVISITEDBusiness Application SolutionBecause ADK Industries is a publicly traded firm, the managers need to consider several factors as they decide how to finance the $5 million needed for firm expansion. The first issue managers must consider is whether to finance the $5 million with debt, equity, or a combination of the two forms of capital. Public firms obtain debt financing in two major ways: commercial paper and corporate bonds. Commercial paper is sold to investors either directly or indirectly through brokers and dealers. The initial or primary corporate bond issue sales occur either through a public Final PDF to printer

chapter 18 Issuing Capital and the Investment Banking Process 607cor91411_ch18_588-613.indd 607 01/27/17 03:44 PMoffering, using an investment bank serving as a security underwriter, or through a private placement to small groups of investors. ADK Industries could also raise capital by selling corporate stock or equity. Like the primary sale of corporate bonds, corporate stocks may initially be issued through either a public sale or a private placement. In a public sale of stock, once the issuing firm and the investment bank have agreed on the details of the stock issue, the investment bank must get SEC approval in accordance with the Securities Exchange Act of 1934.Personal Application SolutionMarge Upton has to consider several issues as she seeks to find the $15,000 she needs to reopen her bicycle repair shop. Marge will want to consider borrowing funds from private or public sources. Private debt financing includes capital funds borrowed from personal savings, friends or relatives, financial institutions such as commercial bank loans, or venture capitalists. Private equity financing includes capital funds invested by venture capitalists. Public sources of capital include debt and equity financing provided by government agencies such as the U.S. Small Business Administration (SBA).summary of learning goalsThis chapter presented an overview of the decisions firms face when they raise capital. The chapter noted the impor-tant role that financial institutions play in this process.Evaluate different methods for small firms to get funding. Most new and small firms finance their assets by borrowing funds from private or public sources. Private debt financing includes capital funds borrowed from friends or relatives, financial institutions such as commercial bank loans, or venture capitalists. Private equity financing includes capital funds invested by venture capitalists. Public sources of capital include debt and equity financing provided by government agencies such as the U.S. Small Business Administration.Appreciate what venture capital is and how it encourages entrepreneurship. Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided by investment institutions or private individuals willing to back an untried company and its managers in return for an equity investment in the firm.Differentiate among sources of capital funding for public firms. The initial or primary sale of corporate bond or stock issues occurs through either a public offering or a private placement. In a public offering, an investment bank facilitates this transfer using a firm commitment underwriting. The investment bank guarantees the firm a price for newly issued bonds or stock by buying the whole issue at a LG18-1LG18-2LG18-3fixed price from the issuing firm. The investment bank then seeks to resell these securities to investors at a higher price. In a private placement, the issuing firm seeks to find a large institutional buyer to purchase the whole issue.Trace the process by which securities are underwritten. The process starts with the preparation of the registration statement to be filed with the SEC. At the same time that the issuing firm and its investment bank prepare the registration statement to be filed, they must also prepare a preliminary version of the public offeringÕs prospectus, called the red herring prospectus. Once the SEC registers the issue, the red herring prospectus is replaced with the official or final prospectus. After the firm submits the registration statement, the SEC has 20 days to request additional information or changes to the registration statement. This review period is called the waiting period, during which the SEC works through the new security issue approval process. Once the SEC is satisfied with the registration statement, it registers the issue. At this point, the issuing firm (along with its investment bankers) sets the final share selling price, prints the official prospectus describing the issue, and sends it to all potential buyers of the issue. Upon issuance of the prospectus (generally the day following SEC registration), the firm may sell the shares.LG18-4Final PDF to printer

608cor91411_ch18_588-613.indd 608 01/27/17 03:44 PMkey termsangel venture capitalists (or angels) Wealthy individu-als who make equity investments. p. 594back-end (or commitment) fee A fee charged by a bank on any unused balances of a loan commitment line at the end of the loan commitment period. p. 592best efforts underwriting A security issue in which the underwriter does not guarantee a firm price to the issuer (as with a firm commitment offering) and acts more as a placing or distribution agent for a fee. p. 601commercial paper An unsecured short-term promis-sory note issued by a public firm to raise short-term cash, often to finance working capital requirements. p. 598competitive sale A sale of securities in which the issu-ing firm invites bids from a number of underwriters. The investment bank that submits the highest bid to the issuer wins the bid. The winning bid underwriter then distrib-utes (sells) the issue to the public. p. 601firm commitment underwriting A security issue in which the investment bank guarantees the issuer a price for newly issued securities by buying the whole issue at a fixed price from the security issuer (the bid price). The investment bank then seeks to resell the securities to investors at a higher price (the offer price). p. 600fixed-rate loan A loan on which the interest payments the firm must make cannot change over the life of the loan. p. 593gross proceeds The higher price at which the investment bank resells the stock to investors in a firm commitment underwriting. p. 603initial public offerings (IPOs) A first-time issue of stock by a private firm going public (e.g., allowing its equity, some of which was held privately by managers and venture capital investors, to be publicly traded in stock markets for the first time). p. 595institutional venture capital firms Business entities whose sole purpose is to find and fund the most promis-ing new firms. p. 594loan commitment agreement A contractual commitment by a bank to loan a firm a certain maximum amount at given interest rate terms for a stated length of time over which the firm has the option to take down this loan. p. 592negotiated sale A sale of securities in which the invest-ment bank obtains the exclusive right to originate, underwrite, and distribute the new securities through a one-on-one negotiation process. With a negotiated sale, the investment bank provides the origination and advis-ing services to the issuers. p. 601net proceeds The guaranteed price at which the invest-ment bank purchases the stock from the issuing firm in a firm commitment underwriting. p. 603originating house(s) The lead bank(s) in a syndicate, who directly negotiate with the issuing firm on behalf of the syndicate. p. 605primary markets Markets in which corporations raise funds through new issues of securities. p. 602prospectus Official document in which the issuing firm (along with its investment bankers) sets the final selling price on the securities and describes the issue. p. 605red herring prospectus A preliminary registration state-ment filed with the SEC. p. 605shelf registration A method of registering securities that allows firms that plan to offer multiple issues of the secu-rity over a three-year period to submit one registration statement. p. 606spot loan A loan in which the firm receives the funds as soon as the loan is approved. p. 592syndicate The group of investment banks used to help sell and distribute a new security issue. p. 604take down Borrowing against a line of credit or loan commitment. p. 592underwriterÕs spread The difference between the gross proceeds and the net proceeds. p. 603up-front (or facility) fee A fee charged by a bank for mak-ing funds available through a loan commitment. p. 592variable-rate loan A loan on which the interest rate on the loan (and thus the interest payments the firm must make) can change over the life of the loan. p. 593venture capital A professionally managed pool of money used to finance new and often high-risk firms. p. 594venture capital firms Organizations that purchase equity interests in firms and have the same rights and privileges as other owners of equity investments. p. 590self-test problems with solutions1 Calculating Fees on a Loan Commitment SandyÕs Bed and Breakfast has been approved for a $125,000 loan commitment from its local bank. The bank has offered the following terms: term = one year, up-front fee = 45 basis points, LG 18-1Final PDF to printer

609cor91411_ch18_588-613.indd 609 01/27/17 03:44 PMback-end fee = 65 basis points, and rate on the loan = 8.25 percent. SandyÕs expects to immediately take down $110,000 and no more during the year unless there is some unforeseen need. Calculate the total interest and fees SandyÕs Bed and Breakfast can expect to pay on this loan commitment.Solution: Up-front fee = $125,000 × 0.0045 = $ 562.50Back-end fee = ($125,000 − $110,000) × 0.0065 = 97.50Interest = $110,000 × 0.0825 = 9,075.00Total = $9,735.00 2 Calculating Costs of Issuing Stock JerryÕs Bait & Tackle Corp. recently went public with an initial public offering of 3.75 million shares of stock. The underwriter used a firm commitment offering in which the net proceeds were $13.875 per share and the underwriterÕs spread was 7.5 percent of the gross proceeds. JerryÕs also paid legal and other administrative costs of $850,000 for the IPO. Calculate the gross proceeds and the total funds received by JerryÕs Bait & Tackle Corp. from the sale of the 3.75 million shares of stock.Solution: Net proceeds = $13.875 = Gross proceeds − UnderwriterÕs spread = Gross proceeds − (0.075 × Gross proceeds) = (1 − 0.075) × Gross proceedsGross proceeds = $13.875 (1 − 0.075) = $15.00 Total funds received by JerryÕs Bait & Tackle = ($13.875 × 3,750,000) − $850,000 = $51,181,250 LG 18-4questions 1. Describe the various sources of capital funding available to new and small firms. (LG18-1) 2. What processes do banks use to evaluate bank loans to small versus midmarket business firms? (LG18-1) 3. What is the difference between a spot loan and a loan commitment? (LG18-1) 4. Why do banks charge up-front fees and back-end fees on loan commitments? (LG18-1) 5. What is the difference between a fixed-rate and a floating-rate loan? (LG18-1) 6. What types of programs does the Small Business Administration offer to new and small businesses? Under what conditions would a new or small firm use each program? (LG18-1) 7. What is venture capital? (LG18-2) 8. What are the different types of venture capital firms? How do institutional venture capital firms differ from angel venture capital firms? (LG18-2) 9. What are the advantages and disadvantages to a new or small firm of getting capital funding from a venture capital firm? (LG18-2) 10. As a new or small firm considers going public, what must the owners consider? (LG18-1) 11. Describe the various sources of capital funding available to public firms. (LG18-3) 12. What is the difference between a direct and an indirect placement of commercial paper? (LG18-3) 13. Can a public firm with a lower-than-prime credit rating issue commercial paper? (LG18-3) 14. How does a best efforts underwriting differ from a firm commitment underwriting? If you operated a company issuing stock for the first time, which type of underwriting would you prefer? Why might you still choose the alternative? (LG18-4) 15. How does a competitive sale of corporate bonds differ from a negotiated sale? Which type of Final PDF to printer

610cor91411_ch18_588-613.indd 610 01/27/17 03:44 PMunderwriting would you prefer? Why might you still choose the alternative? (LG18-4) 16. How does a public offering of debt or equity secu-rities issued by a public firm differ from a private placement? (LG18-4) 17. What are the net proceeds, gross proceeds, and underwriterÕs spread? How does each affect the funds received by a public firm when debt or equity securities are issued? (LG18-4) 18. Why would an investment bank use a syndicate to assist in underwriting debt or equity securities? (LG18-4) 19. What is the difference between a prospectus and a red herring prospectus? (LG18-4) 20. What is a shelf registration? Why would a public firm want to issue securities using a shelf registra-tion? (LG18-4)problems 18-1 Calculating Fees on a Loan Commitment You have approached your local bank for a start-up loan commitment for $250,000 needed to open a computer repair store. You have requested that the term of the loan be one year. Your bank has offered you the following terms: size of loan commitment = $250,000, term = one year, up-front fee = 50 basis points, back-end fee = 75 basis points. If you take down 80 percent of the total loan commitment, calculate the total fees you will pay on this loan commitment. (LG18-1) 18-2 Calculating Fees on a Loan Commitment Calculate the total fees a firm would have to pay when its bank offers the firm the following loan commitment: A loan commitment of $4.25 million with an up-front fee of 75 basis points and a back-end fee of 25 basis points. The take down on the loan is 50 percent. (LG18-1) 18-3 Calculating Costs of Issuing Stock HuskerÕs TuxedoÕs, Inc., needs to raise $250 million to finance its plan for nationwide expansion. In discussions with its investment bank, HuskerÕs learns that the bankers recommend an offer price (or gross price) of $35 per share and they will charge an underwriterÕs spread of $1.75 per share. Calculate the net proceeds to HuskerÕs from the sale of stock. How many shares of stock will HuskerÕs need to sell in order to receive the $250 million needed? (LG18-4) 18-4 Calculating Costs of Issuing Stock DonÕs Captain Morgan, Inc., needs to raise $12.5 million to finance plant expansion. In discussions with its investment bank, DonÕs learns that the bankers recommend an offer price (or gross proceeds) of $25.50 per share and DonÕs will receive $23.75 per share. Calculate the under-writerÕs spread on the issue. How many shares of stock will DonÕs need to sell in order to receive the $12.5 million it needs? (LG18-4) 18-5 Calculating Costs of Issuing Debt The Fitness Studio, Inc., with the help of its investment bank, recently issued $43.125 million of new debt. The offer price (and face value) on the debt was $1,000 per bond and the underwriterÕs spread was 7 percent of the gross proceeds. Calculate the amount of capital funding The Fitness Studio raised through this debt offering. (LG18-4) 18-6 Calculating Costs of Issuing Debt HarperÕs Dog Pens, Inc., with the help of its investment bank, recently issued $191.5 million of new debt. The offer price on the debt was $1,000 per bond and the underwriterÕs spread was 5 percent of the gross proceeds. Calculate the amount of capital funding HarperÕs Dog Pens raised through this bond issue. (LG18-4)basic problemsFinal PDF to printer

611cor91411_ch18_588-613.indd 611 01/27/17 03:44 PM 18-7 Calculating Fees on a Loan Commitment You have approached your local bank for a start-up loan commitment for $250,000 needed to open a computer repair store. You have requested that the term of the loan be one year. Your bank has offered you the following terms: size of loan commitment = $250,000, term = one year, up-front fee = 50 basis points, back-end fee = 75 basis points, and rate on the loan = 8 percent. If you immediately take down $150,000 and no more during the year, calculate the total interest and fees you will pay on this loan commitment. (LG18-1) 18-8 Calculating Fees on a Loan Commitment CaseyÕs One Stop has been approved for a $127,500 loan commitment from its local bank. The bank has offered the following terms: term = one year, up-front fee = 85 basis points, back-end fee = 35 basis points, and rate on the loan = 7.75 percent. CaseyÕs expects to immediately take down $119,000 and no more during the year unless there is some unforeseen need. Calculate the total interest and fees CaseyÕs One Stop can expect to pay on this loan commitment. (LG18-1) 18-9 Calculating Costs of Issuing Debt DiPitroÕs Paint and Wallpaper, Inc., needs to raise $1 million to finance plant expansion. In discussions with its invest-ment bank, DiPitroÕs learns that the bankers recommend a debt issue with gross proceeds of $1,000 per bond and they will charge an underwriterÕs spread of 6.5 percent of the gross proceeds. How many bonds will DiPitroÕs Paint and Wallpaper need to sell in order to receive the $1 million it needs? (LG18-4) 18-10 Calculating Costs of Issuing Debt ReneeÕs Boutique, Inc., needs to raise $58 million to finance firm expansion. In discussions with its investment bank, ReneeÕs learns that the bankers recommend a debt issue with an offer price of $1,000 per bond and they will charge an underwriterÕs spread of 5 percent of the gross price. Calculate the net proceeds to ReneeÕs from the sale of the debt. How many bonds will ReneeÕs Boutique need to sell in order to receive the $58 million it needs? (LG18-4) 18-11 Calculating Costs of Issuing Stock The Fitness Studio, Inc., with the help of its investment bank, recently issued 2.5 million shares of new stock. The offer price on the stock was $20.50 per share and The Fitness Studio received a total of $48,687,500 through this stock offering. Calculate the net proceeds and the underwriterÕs spread on the stock offering. What percentage of the gross price is the investment bank charging The Fitness Studio for underwriting the stock issue? (LG18-4) 18-12 Calculating Costs of Issuing Stock HarperÕs Dog Pens, Inc., with the help of its investment bank, recently issued 8.5 million shares of new stock. The offer price on the stock was $12.00 per share and HarperÕs received a total of $97.75 million from the stock offering. Calculate the net proceeds and the underwriterÕs spread charged by the underwriter to HarperÕs Dog Pens, Inc. What percentage of the gross proceeds is the investment bank charging HarperÕs Dog Pens for underwriting the stock issue? (LG18-4) 18-13 Calculating Costs of Issuing Stock Zimba Technology Corp. recently went public with an initial public offering of 2.5 million shares of stock. The under-writer used a firm commitment offering in which the net proceeds was $8.05 per share and the underwriterÕs spread was 8 percent of the gross proceeds. Zimba also paid legal and other administrative costs of $250,000 for the IPO. Calculate the gross proceeds and the total funds received by Zimba from the sale of the 2.5 million shares of stock. (LG18-4) 18-14 Calculating Costs of Issuing Stock Howett Pockett, Inc., plans to issue 10 million new shares of its stock. In discussions with its investment bank, Howett Pocket intermediate problemsFinal PDF to printer

612cor91411_ch18_588-613.indd 612 01/27/17 03:44 PMlearns that the bankers recommend a net proceed of $33.80 per share and they will charge an underwriterÕs spread of 5.5 percent of the gross proceeds. In addi-tion, Howett Pockett must pay $3.4 million in legal and other administrative expenses for the seasoned stock offering. Calculate the gross proceeds and the total funds received by Howett Pockett from the sale of the 10 million shares of stock. (LG18-4)advanced problems 18-15 Calculating Fees on a Loan Commitment During the last year, you have had a loan commitment from your bank to fund inventory purchases for your small business. The total line available was $500,000, of which you took down $400,000. It is now the end of the loan commitment period and your bank had you pay the back-end fees. You have misplaced the paperwork that listed the terms of the commitment, but you know you paid total fees (this does not include any interest paid to borrow the $400,000) of $3,250 on this loan com-mitment. You remember that the up-front fee was 50 basis points. Calculate the back-end fee on this loan commitment. (LG18-1) 18-16 Calculating Fees on a Loan Commitment During the last year, you have had a loan commitment from your bank to fund working capital for your business. The total line available was $17 million, of which you took down $13 million. It is now the end of the loan commitment period and your bank had you pay the back-end fees. You have misplaced the paperwork that listed the terms of the commitment, but you know you paid total fees (this does not include any inter-est paid to borrow the $13 million) of $72,500 on this loan commitment. You remember that the back-end fee was 75 basis points. Calculate the up-front fee on this loan commitment. (LG18-1) 18-17 Calculating Costs of Issuing Stock DiPitroÕs Paint and Wallpaper, Inc., needs to raise $1 million to finance plant expansion. In discussions with its investment bank, DiPitroÕs learns that the bankers recommend a gross price of $25 per share and that 45,000 shares of stock be sold. If the net proceeds on the stock sale leaves DiPitroÕs with $1 million, calculate the underwriterÕs spread on the stock issue. (LG18-4) 18-18 Calculating Costs of Issuing Stock ReneeÕs Boutique, Inc., needs to raise $58 million to finance firm expansion. In discussions with its investment bank, ReneeÕs learns that the bankers recommend an offer price of $33.75 per share and that 1.8 million shares of stock be sold. If the net proceeds on the stock sale leaves ReneeÕs with $58 million, calculate the underwriterÕs spread on the stock issue. (LG18-4) 18-19 Calculating Costs of Issuing Stock Hughes Technology Corp. recently went public with an initial public offering in which it received a total of $60 million in new capital funding. The underwriter used a firm commitment offering in which the offer price was $10 and the underwriterÕs spread was $0.75. Hughes also paid legal and other administrative costs of $1.05 million for the IPO. Calculate the number of shares issued through this IPO. (LG18-4) 18-20 Calculating Costs of Issuing Stock Howett Pockett, Inc., needs to raise $12 million in new capital funding from a seasoned equity offering. In discus-sions with its investment bank, Howett Pockett learns that the bankers recom-mend a gross price of $13.50 per share and they will charge an underwriterÕs spread of $1.00 per share. In addition, Howett Pockett must pay $500,000 in legal and other administrative expenses for the seasoned stock offering. Calcu-late the number of shares of stock that Howett Pockett will need to sell to raise the $12 million. (LG18-4)Final PDF to printer

613cor91411_ch18_588-613.indd 613 01/27/17 03:44 PMresearch it! UnderwritersGo to the Thomson FinancialÑInvestment Banking and Capital Markets Group website at www.thomsonreuters.com/DealsIntelligence and find the latest information available for debt and equity securities underwriting. Click on ÒQUARTERLY REVIEWS.Ó Click on the latest quarter for ÒGlobal Equity Capital Markets.Ó This will download a file onto your computer that will contain the most recent information on top underwriters for equity securities. Go back and repeat the last step, clicking on ÒGlobal Debt Capital Markets.Ó What is the most recent dollar value of global debt and equity underwritten by investment banks? Who are the top underwriters of debt and equity? How have the top writersÕ market shares changed in the last year?integrated mini-case Capital Funding in a Public FirmNuran Security Systems, Inc., needs to raise $150 million for asset expansion. As it raises the capital funding, Nuran wants to maintain its current debt ratio of 60 percent. Nuran has been approved for a loan commitment from its local bank. The bank has offered the following terms: term = one year, up-front fee = 60 basis points, back-end fee = 90 basis points. Nuran expects it will take down 90 percent of the loan commitment.NuranÕs will also issue new shares of stock to support this asset growth. NuranÕs investment bank will use a firm commitment offering in which the net proceeds are $23.875 per share and the underwriterÕs spread is 7 percent of the gross proceeds. Nuran Security Systems will also pay legal and other administrative costs of $750,000 for the stock issue.Calculate the amount of debt and equity funding Nuran Security Systems will need to keep its current debt ratio constant and the number of shares of stock the firm must issue to raise the needed funds. What can Nuran Security Systems, Inc., expect to pay for fees on this loan commitment and stock issue?ANSWERS TO TIME OUT 18-1 Most new and small firms finance their business assets by borrowing funds from private or public sources. Private capital fund suppliers fall into two basic catego-ries: suppliers of debt financing and suppliers of equity financing. Debt financing includes capital funds borrowed from friends or relatives, financial institutions such as commercial bank loans, or venture capitalists. Equity financing includes capital funds invested by venture capitalists. Public sources of capital include debt and equity financing provided by government agencies such as the U.S. Small Business Administration (SBA). 18-2 Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. 18-3 In contrast to small and new firms that can only get capital funding from mainly pri-vate sources, public firms raise the majority of their capital funds from public debt and equity markets. Public firms raise large amounts of short-term debt in the money market, primarily as commercial paper. Further, public firms raise long-term capital by issuing securities in the public debt and equity markets. 18-4 Commercial paper is short-term debt sold and traded in the money markets, while long-term debt is sold and traded in the capital markets.Final PDF to printer

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