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Corporate Finance Professor Shepherd

Math Work Sheet


Miscellaneous (Background Equations Alphabetized)
Balance Sheet
Assets = Liabilities + Equity
Book Value
= Value of Co.s Assets Total Liabilities taken from Balance Sheet
Capitalization (Cap) Rate
= annual net operating income/cost (or value)
Cash Ratio
= Cast + Short-term liabilities/Current liabilities
Current Ratio
= Current Assets/Current Liabilities
Debt/Assets Ratio (the higher the ratio, the higher the burden on the company of interest payments and repaying debt.
= Total Liabilities/Total Assets
Debt/Equity Ratio
= Total Liabilities/Total Stockholders Equity
Dividend Yield Ratio
= Dividend per Share/stock price
Gross Profit
= Sales Cost of Goods Sold
Gross Profit Margin
= Gross Profit/Sales
Earnings per Share
Divide net earnings by # of shares
Basic: # of earnings can be either average # of shares issued and outstanding in a given year
Diluted: # of shares and # of shares that would have been outstanding if all stock options were exercised and all
convertible securities were converted to stocks
Market-to-Book Ratio
= Stock Price/Book Value per Share
Net Asset Value of a Stock
See Book Value
Net Operating Income (NOI)
= Operating Income Operating Expenses
Poison Pill Flip-Over Clause
B/H or S/H is allowed to obtain each # of shares of the acquiring company, equaling the current purchase price
by:
(1) Multiplying the then current purchase price times the # of shares for which the right was exercisable; and
(2) Dividing that product by 50% of the then current per share market price of the C/S.
Price-Earnings (P/E) Ratio
= Market Price per Share/Earnings per Share
Profit Margin
= Net Income/Sales
Return on Equity
= Net Income/average SHs equity
Shareholders Equity
= Assets - Liabilities
Surplus
Capital Surplus
= Assets Liabilities Stated Capital (Capital protected via Par)

Earned Surplus
= Accumulated Profits Accumulated Losses Dividends paid out of Earned Surplus
Total Assets
= Current Assets + Long Term Assets (stuff not to be converted into case w/in 1 yr)
Working Capital
= Current Assets Current Liabilities

Valuing Firm Output (Chapter 3)


I. Discounting and Present Value
A. Compounding
1. What is it? One of two ways to calculate interest on an investment.
a.

First way: Simple Interest interest is only eanred on the invested sum itself over
the course of the investment.
b.
Second way: Compound Interest Interest earned during one period is reinvested
and earns interest on itself in subsequent periods. Interest can be compounded
annually, semi-annually, quarterly (every three months), monthly, or even daily.
2. Formula:
a.
Simple Interest
i.
FV = s (1 + r)
b.
Compound Interestinterest is compounded and added to the sum. At the end of
year 2, the value of s is:
i.
V2 = (1 + r)2
3. Rule of 72s: The result of dividing the number 72 by the rate of compound interest to be
earned approximates the number of years it would take for a given sum of money to double.
a.
Ex. An investment earning compound interest at an annual rate of 6% would double
in ~12 years [72 6]
B. The Frequency of Compounding
1. Effective Annual Rate:
a.
Formula: Determine the future value you will have at the end of the year for each
dollar invested, and subtract one from that amount:
i.
Effective annual rate =
(1 + Annual Percentage Rate)m 1
N
ii.
m = number of periods in each year; N = the total number of periods.
C. Present Value
1. Basic Discounting to Present Value
a.
Formula: In calculating PV we move backwards through timefrom a future date
back to todaythrough the process of discounting.
i.
PV of a Lump Sum
o PV = Sum
(1 + r)n
o PV = present value, S = sum, n = the number of years, and r =
interest rate/discount rate
D. Annuities
1. PV of an annuity
o

PV = P ____P_____
r
r(1 +r)n

E. Valuing a Perpetuity
1. Formula:
a.

P/r (Payment/discount rate)


The calculation assumes the perpetuity will continue indefinitely.
c.
As the discount rate exceeds 10%, the incremental value of each new years payment
is only a fraction of 1%
2. Valuing a perpetuity intended to be sold:
a.
Dividend value + value of the sale:
i.
[S (current dividend value)/(1 + r)] + [S (sale)/1 + r]
b.

b.

[$1.00/1+r = $1.00/1 + .1 = .909] + [$10.00(sale)/1+r = $10.000/1+.10 = $9.09] =


$9.999999999
3. Hypo: What is the value of a share of preferred stock carrying an $8.00 annual dividend,
discounted at 7%, assuming it is neither redeemable by the company ("callable") nor subject
to forced redemption by the holder?
a.
If the discount rate is 7%, PV =
$8.00 = $114.29
.07
b.
If the discount rate is 10%, PV = $8.00 = $80.00
.10
F. Valuing Common Stock (re: perpetuity)
1. Price-Earnings Ratio:
= Market Value per Share
Earnings per Share (EPS)
a.
A high P/E suggests that investors are expecting higher earnings growth in the future
compared to companies with a lower P/E.
2. Valuing Perpetuities with Constant Growth:
a.
Formula: PV = __P__
r-g
i.
Note: g = constant growth rate
G. Valuing Investments with Different Cash Flows at Different Times
1. Valuing a Perpetuity with Initial Growth: Not all stocks can be expected to have growing
earnings indefinitely. In this event, there will be two periods of calculations to consider.
a.
Steps for Calculating:
i.
(1) For first year of initial growth, determine PV of initial dividend payment
(dividend * discount rate in Table for year 1)
ii.
(2) For X year of growth, dividend payment = dividend from year before *
(1+ growth rate). Then find PV of that dividend (multiply dividend * interest
rate from Table 3-4 using year X)
iii.
(3) Sum all of these PV values for initial growth years
iv.
(4) Once it stops growing, use (Dividend/interest rate) * PV from Table 3-4
(using the number of growth years + 1 as the year)
v.
(5) Add values during growth period (Step 3) + perpetuity after initial growth
(Step 4)
b.
Ex.
i.
Assumptions:
o Initial Earnings = $1.00, growing at 4% for 5 years.
o Stable Earnings thereafter, discounted @ 10%
ii.
Calculation:

Calculation
S (Dividend Value)

(1 + r)n
Ex) Y1: $1.00/(1 + .1)1 = .9091
Y2: $1.04/(1 + .1)2 = .8595
Y5: $1.17/(1.1)5 = .7264

Then you add them all up = 4.0759

Then calculate the perpetuity of 1.17 once initial growth


ceases (P/r-g) and then multiply by the discount factor
- Standard Perpetuity with constant growth:
$1.17/.10 = 11.70
- Discount Factor:
1/(1 + .1)6 = .5645
- Result: $11.70 x .5645 = 6.6046

Lastly, add the two #s together for a complete valuation of an


investment with differing growth periods = $10.6805

H. Net Present Value


a.

Positive Net Present Value: When the present value of returns exceeds that of
investments. A manage should acept investmeny opportunities offering rates of
return in excess of the opportunity cost of capital.
b.
Negatie Net Present Value: Opposite.
2. Formula: Testing the net present value of a project
Net Present Value of Project =
[PV of funds to be received (income) PV of funds of project (investments)]

3. QC
3.8: A

factory costs $400,000. You calculate that it will produce net cash after operating expenses of
$100,000 in year 1, $200,000 in year 2, and $300,000 in year 3, after which it will shut down
with zero salvage value.
a.

Use the present value equation; insert P for earch year ($100k); add the total; and
then subtract from CoC.

II. The Cost of Capital


1. Declining Marginal Utility of Wealth:
5

B. Measurment of RiskOf Expected Values and Standard Deviations


1. Firm A (Wal-Mart) and Firm B (Amazon) expected values in 10 years:

2. These results can be converted into an expected value for each from by weighting each
outcome by its probablity and summing up the results:

3. The next step is to determine the variance of the expected earning for each firm. This is
done by measuring the deviations from the mean in each case, using a weighting process.
a.
Problem: Some deviations are less than $100 and are thus negative numbers here.
b.
Solution: alter negative numbers into positive numbers

c.

Variance is the expected squared deviation of the expected returns.


4. Standard Deviation is the square root of our variance. 68% of the results of any distribution
of outcomes normally fall within one standard deviation of the mean and 95% fall within two
standard deviations.
a.
Because we had to square our deviations to eliminate negative numbers, we have
arrived at results that are out of scale with the original results. To eliminate this, we
calculate the square root of each result:
i.
500 = 22.36
ii.
3,000 = 54.77
b.
Thus, Firm As STD is 22.36% of its expected value and Firm Bs STD is 54.77% of
its expected value.
c.
With higher STDs, investors expect higher returns. See table 3-6 on pg. 95 of the
text.
C. Risk and Diversification
1. General Principal: Diversification reduces risk.
2. Formula:
Expected Payoff = Sum of (Probability of Payoff) (Possible Payoff)

3. Ex) Assuming $100k invested initially


Outcome
x
Drug Fails
Drug Suceeds

Probability
.5
.5

Single-Firm Probabilities
Payoff
Rate of Return
0
-100%
$400,000
+300%

Single Drug: Expected Payoff = .5 x 0 + .5 x $400,000 = $200,000


Outcome
x
All drugs fail
One drug suceeds
Both drugs suceed

Two-Firm Probabilities
Probability
Payoff
Rate of Return
.25
0
-100%
.5
$200,000
+100%
.25
$400,000
+300%

Two Drugs: Expected Payoff - .25 x 0 + .5 x $200,000 + .25 x $400,000 = $200,000

4. Applying the Standard Deviation: While both investments have the same expected value,
the two-drug investment has a lower STDwe can see this because zeros return probability
is reduced from .5 to .25.
a.
Formula:
STD = Square root of the sum of (Probability) (Possible Payoff-Expected Payoff) 2
b.

Result:

Single Drug: = (.5)(0 - $200,000)2 + (.5)($400,000 - $200,000)2 = $200,000


Two Drugs: = (.25)(0-$200,000)2 + (.5)($200,000 -- $200,000)2 + (.25)($400,000 - $200,000)2 = $141,421
Thus, diversification across two stocks of the same industry reduces the STD of an investment from
$200,000 to $141,421.

D. Pricing Risk in MarketsThe Capital Assets Pricing Model (CAPM)

Risk Preimium
Formula: The expected risk premium on a stock equals:

beta times x expected market risk premium (market rate minus risk free rate).
o

Equity Premium = Market Rate Risk-Free Rate

Cost of Capital:

Cost of Capital = Risk Free Return + (beta x equity premium (Market rate of return Risk Free Rate))
--OR
COC = Risk-Free Return + Risk Premium
o

Ex)

Market Rate: 10%


Risk-Free Rate: 5%
CoC: 12% (given)
FIND BETA

12% = 5% + (B x EP)
12% = 5% + (B x 10 5)
12 = 5 + B5
7 = B5
7/5 = B
1.4 = B

Capital Structure (Chapter 4)


I. Modigliani & Millers Irrelevance Hypothesis
A. Perspectives
1. Net Income Perspective
a.

Example
i.
Set-Up:
o Firm 1: An all equity firm with $100,000 invested that has an
expected return to shareholders of $12,000.
o Firm 2: doubles F1s by borrowing an additional $100k @ 8%
interest and would have an expected return to shareholders of
$16,000.

Firm #1

Net Income

$12,000

Firm #2

Operating Income Less interest

$24,000 8,000 = $16,000

@ 8% = Net Income
The traditional approach looks only at net income, and valued earnings per share. Under this assumption, if Firm
One and Firm Two are identical, the expressed earnings should be capitalized at 12%:
ii.

iii.
iv.

v.

Better to borrow right? Set cap rate (pre-determined potential rate of return
on an investment) at 12%:
o Equity of F1: 12,000/.12 = $100k
o Equity of F2: 16,000/.12 = $133k
Thus, F2 has $133k worth
Problem with this is that it does not account for variance
o Expected earnings of associated with F2 are more volatile than F1
b/c of fixed demands of creditors regardless of whether the firm has
a good year or not.
Effect of Leverage on Profits
o

Firm 1- $100,000 Equity

Scenerio A (Bad)

B (Normal)

C (good)

Assumed Operating Earnings

$2,000

$12,000

$22,000

Earnings to S/H

$2,00

$12,000

$22,000

Rate of Return

2%

12%

22%

Firm 2- 50% Equity 50% Debt (slighly modified from above


example). To fit these #s with the above example just double the $.
A

Assumed Operating Earnings

$2,000

12,000

22,000

Interest

($4,000)

(4,000)

(4,000)

Earnings to S/H

($2,000)

8,000

18,000

Rate of Return

-4%

16%

36%
(18/50k
loan) =
36 RoR

Leverage vastly increases the variance on returns, so investors would


be expected to demand a higher return/cap rate: 14%.
2. The Net Operating Income Approach (Modigliani and Miller Home-Made Leverage
Approach):
a.
Point: Corporations will say theyre earning more because theyre levered, but this is
crap because you can do this yourself and get the same result.
II. Capital Structure in the Real World: Relaxing the Assumptions in the M&M Hypothesis
o

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A. Debt and Taxes


1. Owning all the debt and equity in a leveraged firm increases total after tax wealth of
SHs because interest paid on loans reduces corporate taxes:

2. Interest Tax Shield: Every dollar paid as interest reduces corporate tax by 35% (the corp. tax
rate). So, interest tax shield = .35 x (interest payments)
a.
The funds saved from big brother are then available to the SH or for reinvestment in
the firm.
b.
Capitalizing the Deductions from Corporate Tax:
PV Tax Shield = calculated interest tax shield/interest rate on debt

3. The Impact of Expected Bankruptcy Costs


a.

Not on a linear rate, but on an upward sloping rate:

B. Weighted Average Cost of Capital


1. Calculations:
a.

Basic Components:

11

i.

b.

c.

Rate of return on debt = face value of debt/value of the firm x the interest
rate
ii.
Rate of return on equity = value of equity/value of firm x capitalization rate
Basic WACC:

Advanced WACC: Adjusting for the Tax Shield


i.

Step 1: Calculate After tax cost of debt


After tax cost of debt = (interest rate)(1 corp. tax rate)

ii.

Step 2: Calculate Advanced WACC

2. Basic Example: Assume 50/50 structure, with 8% i-rate (cost of debt) & 15% cost of equity.
Value of firm = $100k.

3. Advanced Example: Same facts as above but with a 35% Corp tax rate

4. Note: Multiply the Overall Rate of Return % (final product) times total firm value to get the
actual return that results.

C. Debt and Agency Costs


a.

The Essence:

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III. Capital Structure in the Courts


IV. Wages and Excessive Debt
Common Stock (Chapter 5)
I. Limited Liability of Stockholders
II. The Problem of Dilution
A. Simple Dilution: Where a person owns 10 out of 100 outstanding shares, and the company issues
another 100 shares to third parties. Your claim has been diluted from 10% to 5% of the shares and
your voting power and claim to share and profits is less.
B. Dilution Formula
1. L = ma _(mx + p) * (a)
x+d
2. What?
a.
L = existing SHs loss through dilution
b.
m = market price of a share before issuance
c.
a = a shareholders share ownership at the ime new shares are issued
d.
x = shares outstanding before dilutive distribution; and
e.
p = proceeds from sale of new shares.
f.
d = number of shares issued in dilutive issuance
C. Forms of Dilution
1. Voting Dilution w/o Economic Dilution
a.
S/h loses voting power, but shares are not worth any less because capital doubled
with additional issuance
b.
In a close corporation, voting power may be crucial to protect your investment
c.
In a large corporation, voting power is essentially irrelevant
2. Extreme Economic Dilution (cb 289)
a.
Value of share goes from $15 to $10 when shares outstanding doubled but no
additional capital paid in (shares transferred w/o consideration)
3. Penalty Dilution (cb 290-91)
a.
Hypo: Assume a $1M investment has gone bad and creditors will have the firms
assets; however, if additional $1M is contributed, investment will be worth $1.75M.
If 100 original units were sold at $10,000 each, consider the options:
i.
Sell 100 new units at $10,000 each:
o Value after sale: $1.75M, or $8,750/unit
o Loss on original unit: $1,250
o Loss on new unit: $1,250

13

Creates free rider problem: Old investor has no incentive to invest


b/c he wont get anything out of it, just added losses.
ii.
Sell 133.33 new units at $7,500 each; at the end of the day, 233.33 units will
share a value of $1,750,000 or $7,500 per unit.
o Value after the sale: $1.75M, or $7,500/unit
o Loss on original unit: $2,500
o Loss on new unit: $0
o Eliminates the free rider problem but creates indifference (the
investor is now indifferent: he can invest another $10k and own
2.333 units woth a total of $17,500 and lose $2,500. If he fails to
invest, his original unit is worth $7,500 and his loss is the same.
iii.
Penalty Dilution: Sell 200 new units at $5,000 each
o Value after sale $1.75M, or $5,833/unit
o Loss on original unit: - $4,167
o Profit on 2 new units: $1,667
o Investor has a loss of $2,500 but if previous investor didnt
contribute additional money, has loss of $4,167
iv.
Extreme Penalty Dilution: Sell 400 new units at $2,500 each
o The Investor who buys 4 new units has now invested $20,000 for
$17,500 of machines, losing a total of $2,500. The free-rider who
does not invest has a unit that is now worth $3,500, so he has lost
$6,500.
o Why? We have the value of $1.75M shared by 500 units where each
is $3,500.
D. Dilution as a Takover DefenseThe Poison Pill (AKA Shareholder Rights Plan)
o

Rights exercisable at 50% discount from FMV The $40 exercise price would pruchase 2x of c/s that the s/h
would be able to purchase for $40 on the market; in otherwords, get double that worth in c/s, or $80 woth of c/s.

Corporate Debt (Chapter 6)


Bond Quotations:
Adv Current Yield =

Annual Dollar Interest Paid * 100


Market Price

* could also be cash inflows, depending on which side of the tx you are working from.
So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd
calculate its current yield:
CY =

.05 x $100 * 100% = 5.21%


$95.92

Simple Current Yield = yearly payment


Price

I. Contract Interpretation
II. Contract Terms
III. The Indenture Trustee and the Trust Indenture Act
IV. Capital Leasing
V. Asset-Backed Financing
Chapter 7 (Preferred Stock)
14

I. Introduction
i.

B. The Uses of Preferred Stock


1. For Development-Stage Companies
2. For Public Companies
a.

For public companies, P/S is tax favored:


i.
70% of dividends received on ANY stock are tax deductible
ii.
If recipient owns 20% or more of the stock, 80% of the dividends are
deductible.
iii.
If recipient owns 80% or more of the stock, 100% is deductible.
3. For the Issuer:

II. Dividends
III. Altering the Preferred Contract
IV. Board Duties
Options and Convertible Securities (Chapter 8)
I. Introduction
A. Long and Short Positions and Position Diagrams
1. Long Position is where an investor buys an option expecting that its value will increase.
a.

Long Positions in Call Options:


i.
Benefits opposed to buying stock:
o Buyer of stock bears the risk that its price will decline rater than
increase. Puts an entire purchase price of $100 at risk.
o Option buyer only risks the amount spent to purcahse the call
options.
ii.
Time-Value: the difference between intrinsic value and market value. The
longer a security has time to increase in value the greater its time value
o Over time this value gradually decreases to zero as the possibility of
stock increases diminishes.
o An American options time value is greater than that of a European
option because it can be exercised at any time rather than at a single
moment.
b.
No upper bound on potential profits, but there is a limit to how much you can lose
The price of the option
2. Short Position is where an investor anticipates that a stocks value will decrease over time
and therefore borrows $ to buy stock at its present value and then pay back lender with the
amount received from the sale when the stock drops and therefore pocketing the difference.
a.
Calculation:
Value of Short = Proceeds of short sale Replacement Cost
b.

Unlimited downside & limited upside

II. How Options Operate


A. Call Options (See above)
B. Put Options: Put options give the holder the right to sell (put) the underlying asset to the writer of the
option at a previously specified price.
1. Calcluation:
Value of Put Option = Exercise Price Market Price of Stock
Note: the value of the put option can never be less than zero. If price of stock goes up
beyond the option price, the holder simply does not sell.
III. Valuation of Options
A. 5 Factors That Enter into Pricing Options

15

1. Exercise Price The higher the exercise price in realtion to the market price of the
underlying stock, the lower the value of a call option
a.
Ex.
i.
Exercise price of $200 for a current stock price of $100 is likely to be
worthless
ii.
Exercise price of $100 for a $100 valued stock price = a 50/50 chance the
stock price will rise above the exercise price during the life of the option.
2. Stock Price == The higher the stock price relative to the exercise price, the more valuable the
call option will be.
a.
Once the stock prices rise above the exercise price, the excess of the stock price over
the exercise price represents the miniumum value of an option.
3. Exercise Price The longer the life of the option, the greater its value, all other things being
equal.
4. Variance of the Underlying Stocks Value This is the most important factor in
determining option values. The greater the variance in the value of the underlying asset, the
more valuable the call option will be.
5. Interest Rate The value of the option is partly related to opportunity cost how much
interest can you earn on your money investing it somewhere else duirng the life of the
option?
a.
Thus, when interest rates are high, not purchasing the stock and leaving the option in
existence increases the value of the option as you get your $ through investing it in
govt treasuries.
B. Bionomial Option Valuation Method (Simple - Not on exam)
1. Gain is twice as much when buying with borrowed $.
2. Ex. Current stock price = $100, 1 yr European call option @ $100, Stock price has a 50/50
chance being either $80 or $120 in 1 yr w/ a 10% i-rate.
a.
Alt. #1: Call Option. Buy 1 option which in 1 year will be worth either $0 (low) or
$20 (high).
b.
Alt. #2: Leveraged Stock Purchase. Borrow discounted present value of low bond
($80) w/ 10% i-rate = 80/1.1 = $72.73. Then buy one one share of stock at its current
price $100, both for one year.
i.
Investment in option = 100 72.73 = $27.27
ii.
Possible Outcomes:
o Low ($80) stock value loan repayment ($80) = $0
o High ($120) stock value loan repayment ($80) = $40
3. Law of One Price: Payoff on levereged investment is 2 times the payoff of 1 call option
a.
Value of 2 calls = current value of share ($100) bank loan ($72.73) = $27.27
b.
Value of 1 call = 27.27/2 = $13.63
4. Option Delta/Hedge Ratio
a.
The number of shares needed to replicate one call option.
b.
Ex. In the preceeding example, 2 calls are replicated by a levered position on 1 share.
The option delta is therefore .
i.
Option Delta =
spread of possible option prices/spread of possible share prices = 20 0/120 80 = 1/2

C. Black-Scholes Option Pricing Model (Advanced/Complicated)


a.

Demonstrates the day-to-day changes

IV. Disclosure Issues with Options


V. Convertible Securities, Deal Protection, and Venture Capital
A. Destruction of Option Rights
B. Dilution of Option Rights
i.

Formula (for determining adjusted conversion price):

16

ACP = CP x CMP FMV/CMP


CMP Current Market Price
Total Assets (probably something in the billions) multiplied by
1/total # of shares of C/S & P/S (probably something in the millions)
ACP Adjusted Conversion Price
CP Conversion Price
FMV Fair Market Value
Dividend value divided by total # of C/S
o i.e. dividend for $400M with 10M assets = 400/10 = $40 per
outstanding common share.
b.

Examples See p.603-4


2. Use of Convertible Options in Venture Capital Financing: Companies w/ VCs can use two
different types of Anti-Dilution Clauses to protect its VCs (and thereby encourage their
funding)
a.
Full-Ratchet Clause: If any shares are sold cheaply in a later round, then the
conversion price of Series A stock is reduced to the cheapest price of any shares that
are sold later on.
i.
Personifies the VCs bargainning power in negotiating their involvment.
ii.
Ex.) 1 million common shares outstanding, plus 250,000 conversion rights at
$1/share
o Conversion would yield conversion holders 20% of company
o Suppose sale of 1 share at 1 cent
o 250,000 conversion holders could now purchase 25 million shares,
out of 26 million, or 96% if there was a full-ratchet clause.
250k/.01 = 25 M
Add the extra 1 M previous shares to get 26
b.
Weighted-Average Clause: If any shares are sold cheaply, the WAC takes the average
of the shares sold for a cheaper price.
i.
This is far more desirable for the company (and existing SHs) seeking VC
financing.
ii.
Formula:
(Number of Shares previously Outstanding x Conversion Price)
+ (Consideration for additional shares)
.
Number of Shares Outstanding after additional issue
iii.

iv.

Ex.) One additional share issued for .01. Just factor in this one additional
share.
o # of shares previously outstanding = 1,000,000
o Conversion Price = 1.00
o Consideration for additional shares = .01
o # of shares outstanding after additional issue = 1,000,001.
o =$.999999999
See how the effect of the WAC leads to a better result?

Dividends and Distributions (Chapter 9)


I. Distributions and Investor Wealth
A. Explaining Dividend Practices
1. M&M Irrelevance Hypothesis
a.

First See figure 9-1 on page 672


i.
Left hand side = what each share is worth before the dividend

17

ii.

Right hand side = what each share is worth after the dividend. This is 1/3
less because of the lost productive capacity of that capital.
b.
What is it?
i.
Dividend Hypo- See pg 672
o Note that the dividend also has no effect on the value of the firm if
new funds are raised to replace the dividended funds.
ii.
Retained Earnings Hypo- See pg 673
o Share holder gets the same result simply by checking out and selling
its shares.
o This is the investor home-making the value of dividends
through sales of stocks rather than relying on dividends.
AKA home-made dividend
c.
Applying the Tax Consequences to the M&M Hypothesis: One problem for the
M&M model is that it did not account for differing tax policies on Dividends versus
Capital Gains
o When shares are sold, only the amount above what she paid for
the shares is taxable while the entire dividend is subject to the
tax.
II. Restrictions on Dividends and Other Distributions to Shareholders
A. The Revolution in Legal Capital Rules: There are certain situations where the Corp is forbidden
from paying out dividends when the Corp is INSOLVENT or the distribution will make the Corp
insolvent
1. Statutory Limits in Granting Dividends
a.
Modern Approach (MCBA 6.40):
i.
Dividends ok unless
o (1) Make Corporation unable to pay its debts as they become due in
the usual course of business
Equity test
o (2) Assets < liabilities + preference in dissolution for superior classes
of stock.
bankruptcy test
b.
Traditional/Delaware Approach 170 (more stirct)
i.
Earned Surplus (Retained earnings)
o Formula:
Accumulated profits Accumulated losses dividends
(which are paid out of eanred surplus)
o An earned surplus would indicate business is making money and
may be used to pay distribution
ii.
Stated Capital: gets the par value from the issuance. [if par = $2 and then
sold 1000 shares = $2000]
iii.
Capital Surplus: the excess over par goes into this fund [if par = $2 and the
Corp sold 1000 shares for $5, then the fund has $3000]
o (assets) (liabilities) (stated capital) i.e. the excess of the net assets
over stated capital.
III. Board Discretion and Duties in Declaring Dividends
IV. Stock Dividends and Stock Splits
A. Accounting for Dividends and Splits
1. Valuing Diluted Value of Shares Post-Dividend:
a.
Corp has 1M shares outstanding with a market value of $100 each and decalres a
stock dividend of 30% or another 300K shares. Issuing new shares means
reallocating SHs equity amounts since their value of individual stocks has been
diluted.
i.
Per the calculation above they had $100M in shareholder equity.

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ii.

iii.

Now divide that by 1.3M shares and we get the diluted value per share down
from $100 per share to 76.92 per share.
Thus the value of the dividend is: 76.92 x 300,000 = $23,076,000.

V. Stock Repurchases
VI. Spin-Off Transactions
VII. Tracking Stock

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