Management the financial resources of firm

The NPV and IRR results show that the Vineyard Project has a higher NPV than the Mining Project ($194 035.65 versus $65 727.39), but the Mining Project has a higher IRR than the Vineyard Project (16.05% versus 14.00%). AddVenture is faced with a conflict between NPV and IRR results. Because the projects are mutually exclusive, the firm can only accept one. In cases of conflict among mutually exclusive projects, the one with the highest NPV should be chosen because NPV indicates the dollar amount of value that will be added to the firm if the project is undertaken. In our example, then, AddVenture should choose the Vineyard Project (the one with the higher NPV) if its primary financial goal is to maximize firm value.

Topic 8. Capital Budgeting Decision Methods (part II)

In this topic we examine non-simple projects, projects that have a negative initial cash flow, in addition to one or more negative future cash flows. Next, we explore projects that have multiple IRRs. Finally, we discuss how to compare mutually exclusive projects with unequal project lives.

Non-Simple Projects:

Most capital budgeting projects start with a negative cash flow - the initial investment - at t₀ followed by positive future cash flows. Such projects are called simple projects. Non-simple projects are projects that have one or more negative future cash flows after the initial investment.

To illustrate a non-simple project, consider Project N, the expected cash flows for a nuclear power plant project. The initial investment of $500 million is a negative cash flow at t₀, followed by positive cash flows of $25 million per year for thirty years as electric power is generated and sold. At the end of the useful life of the project, the storage of nuclear fuel and the shutdown safety procedures require cash outlays of $100 million at the end of year 31.

With a 20 percent discount rate, an initial investment of -$500 million, a thirty-year annuity of $25 million, and a shutdown cash outlay of -$100 million in year 31, the NPV of Project N follows (in million):

NPV = - $500+ $25- $100= (- $500 Ч 1) + ($25 Ч 4.979) - ($100Ч0.0035) = - $375.88

We find that at a discount rate of 20 percent, Project N has a negative NPV of-375.878, so the firm considering Project N should reject it.

Multiple IRRs:

Some projects may have more than one internal rate of return. That is, a project may have several different discount rates that result in a net present value of zero.

Here is an example. Suppose Project Q requires an initial cash outlay of $160 000 and is expected to generate a positive cash flow of $1 000 000 in year one. In year two, the project will require an additional cash outlay in the amount of $1 million. The cash flows for Project Q are shown in the following table:

Period	t0	t1	t2
Cash flows	- 160 000	1 000 000	- 1 000 000

We find the IRR of Project Q by using the trial and error procedure. When r = 25%, the NPV is zero.

0 = - - $160000 = $800000 - $640000 - $160000 = $0

Since 25 percent causes the NPV of Project Q to be zero, the IRR of the project must be 25%. But wait! If we had tried r = 400%, the IRR calculation would look like this:

0 = - - $160000 = $200000 - $40000 - $160000 = $0

Since 400 percent results in an NPV of zero, 400 percent must also be the IRR of the Project Q. Figure below shows the NPV profile for Project Q. By examining this graph we see how 25% and 400% both make the NPV equal to zero. As the graph shows, Project Q's NPV profile crosses the horizontal axis (has a zero value) in two different places, at discount rates of 25% and 400%.

Project Q had two IRRs because the project's cash flows changed from negative to positive (at t₁) and then from positive to negative (at t₂). It turns out that a non-simple project may have (but does not have to have) as many IRRs as there are sign changes. In this case, two sign changes resulted in two internal rates of return.

Whenever we have two or more IRRs for a project, the IRR method is not a useful decision-making tool. Remember the IRR accept/reject decision rule: firms should accept projects with IRRs higher than the discount rate, and reject projects with IRRs lower than the discount rate. With more than one discount rate, decision makers will not know which IRR to use for the accept/reject decision. In projects that have multiple IRRs, then,switch to the NPV method.



Mutually Exclusive Projects with Unequal Project Lives:

When mutually exclusive projects have different expected useful lives, selecting among the projects requires more than comparing the projects' NPVs. To illustrate, suppose you are a business manager considering a new business telephone system. One is the Cheap Talk System, which requires an initial cash outlay of $10 000 and is expected to last three years. The other is the Rolles Voice System, which requires an initial cash outlay of $50 000 and is expected to last twelve years. The Cheap Talk System is expected to generate positive cash flows of $5 800 per year for each of its three years of life. The Rolles Voice System is expected to generate positive cash flows of $8 000 per year for each of its twelve years of life. To decide which project to choose, we first compute and compare their NPVs. Assume the firm's required rate of return is 10 percent. We solve for the NPVs as follows:

NPV of Cheap Talk:

NPV = $5800- $10000 = $5800(2.487) - $10000 = $4424

NPV of Rolles Voice:

NPV = $8000- $50000 = $8000(6.814) - $50000 = $4510

We find that Project Cheap Talk has an NPV of $4 424, compared to Project Rolles' NPV of $4 510. We might conclude based on this information that the Rolles Voice System should be selected over the Cheap Talk System because it has the higher NPV. However, before making that decision, we must assess how Project Cheap Talk's NPV would change if its useful life were twelve years, not three years.

Comparing Projects with Unequal Lives:

Two possible methods that allow financial managers to compare projects with unequal lives are the replacement chain approach and the equivalent annual annuity (EAA) approach.

The Replacement Chain Approach. The replacement chain approach assumes each of the mutually exclusive projects can be replicated, until a common time period has passed in which the projects can be compared. The NPVs for the series of replicated projects are then compared to the projects with the longer life. An example illustrates this process. Project Cheap Talk could be repeated four times in the same time span as the twelve-year Rolles Voice Project. If a business replicated project Cheap Talk four times, the cash flows would look like this:

t0

t1

t2

t3

t4

t5

t6

t7

t8

t9

t10

t11

t12

+$5.8

+$5.8

+$5.8

+$5.8

+$5.8

+$5.8

+$5.8

+$5.8

+$5.8

+$5.8

+$5.8

+$5.8

- $10

- $10

- $10

- $10

The NPV of this series of cash flows, assuming the discount rate is 10 percent, is (in thousands) $12 121. Each cash flow, be it positive or negative, is discounted back the appropriate number of years to get the NPV of the four consecutive investments in the Cheap Talk Systems.

The NPV of $12 121 for Cheap Talk System is the sum of the NPVs of the four repeated Cheap Talk projects, such that the project series would have a life of twelve years, the same life as the Rolles Voice System Project. We are now comparing apples to apples. Cheap Talk's replacement chain NPV is $12 121, while the NPV of Project Rolles Voice is $4 510 over the same twelve year period. If a firm invested in project Cheap Talk four successive times, it would create more value than investing in one project Rolles Voice.

The Equivalent Annual Annuity (EAA). The equivalent annual annuity (EAA) approach converts the NPVs of the mutually exclusive projects into their equivalent annuity values. The equivalent annual annuity is the amount of the annuity payment that would give the same present value as the actual future cash flows for that project. The EAA approach assumes that you could repeat the mutually exclusive projects indefinitely as each project came to the end of its life.

The equivalent annual annuity (EAA) is calculated by dividing the NPV of a project by the present value interest factor for an annuity (PVIFA) that applies to the project's life span. Formula for an equivalent annual annuity (EAA)

EAA =

The NPVs of Cheap Talk ($4 424) and Rolles Voice ($4 510) were calculated earlier, assuming required rate of return of 10 percent. With the project's NPV and the discount rate, we calculate each project's EAA, as follows:

EAA of Project Cheap Talk:

EAA = = $1778.96

EAA of Project Rolles:

EAA = = $661.9

The EAA approach decision rule calls for choosing whichever mutually exclusive project has the highest EAA. Our calculations show that Project Cheap Talk has an EAA of $1778.96 and Project Rolles Voice System has an EAA of $661.90. Because Project Cheap Talk's EAA is higher than Project Rolles', Project Cheap Talk should be chosen. Both the replacement chain and the EAA approach assume that mutually exclusive projects can be replicated. If the projects can be replicated, then either the replacement chain or the equivalent annual annuity methods should be used because they lead to the same correct decision. Note in our case that the EAA method results in the same project selection (Project Cheap Talk) as the replacement chain method. If the projects can not be replicated, then the normal NPVs should be used as the basis for the capital budgeting decisions.



Topic 9. Estimating Incremental Cash Flows

Incremental cash flows - positive and negative cash flows that will occur if an investment is undertaken, but won't occur if it isn't.

For instance, suppose that the chief financial officer is analyzing the cash flows associated with a proposed project. He finds that the CEO hired a consultant to assess the proposed project's environmental effects. The consultant will be paid $10 000 for the work. Although the $10 000 is related to the project, it is not an incremental cash flow because the money must be paid whether the project is accepted or rejected. Therefore the fee should not be included as a relevant cash flow of the expansion project decision. Cash flows that have already occurred, or will occur whether a project is accepted or rejected, are sunk costs.

Types of Incremental cash flows:

· Initial investment cash flows

· Operating cash flows

· Shutdown cash flows

Initial investment cash flows include the purchase price of the asset or materials to produce the asset, the installation and delivery costs, and the additional investment in net working capital. Financial managers usually obtain quotes on the purchase price and installation and delivery costs from suppliers.

Net working capital is defined as current assets minus current liabilities.

Current asset changes	Current liabilities changes
$5000 increase in Cash	$8000 increase in Accounts Payable
$7000 increase in Receivables	$2000 increase in Accruals
$15 000 increase in Inventory
Total Current Asset Changes: $27 000	Total Current Liability Changes: $10 000
Increase in Net Working Capital (NWC): 27 000 - 10 000 = $17 000



Operating cash flows are the cash flows that the project generates after it is in operation.

Sales	100 000
Operating Expenses	- 50 000
Depreciation Expense	- 10 000
EBIT	40 000
Taxes (30%)	- 12 000
Net Profit	28 000
Depreciation Expense(added back)	+ 10 000
Net Incremental Operating Cash Flow	38 000

Cash flows at the end of the project are the shutdown cash flows that are expected to occur at the end of the useful life of a project.

Type of Sale	Tax Effect
The asset is sold for more than its purchase price	This difference is taxed as the capital gains rate. In addition, the purchase price minus the depreciation book value is ordinary income and is taxed at the ordinary income tax rate.
The asset sold for less than its purchase price but fore more than its depreciation book value	The sales price minus the depreciation book value is ordinary income and is taxed at the ordinary income tax rate.
The asset is sold for its depreciation book value	There is no tax effect
The asset is sold for less than its depreciation book value	The depreciation book value minus the sales price is an ordinary loss and reduces the firm's tax liability by that amount times the ordinary income tax rate.

Example:

Photon Manufacturing makes torpedoes. It is considering a project to install $3 million worth of new machine tools in its main plant.

The new tools are expected to last for five years.

Photon operation management and marketing experts estimate that during the five years the tools will result in a sales increase of$800 000 per year.

The specialists estimate the following changes in Net working capital:

Current asset changes	Current liabilities changes
$10 000 increase in Cash	$20 000 increase in Accounts Payable
$90 000 increase in Receivables	$10 000 increase in Accruals
$40000 increase in Inventory
Total Current Asset Changes: $140 000	Total Current Liability Changes: $30 000
Increase in Net Working Capital (NWC): $140 000 - $30 000 = $110 000

If purchased, the tools will be used to perform maintenance on other equipment at Photon, so operating expenses (other than depreciation) are expected to decrease by $100000 per year.

To calculate depreciation expense we will use the following scheme: 33.3% of the new tool's cost will be charged to depreciation expense in the first year, 44.5% in the second year, 14.8 % in the third year, and 7.4 % in the fourth year.

At the end of the fifth year company wants to sell the equipment for $800 000. The income tax rate is 40%. The discount rate is 10%.

Task: calculate the NPV, PI, IRR and payback period of the project.

1. Initial investment:

Purchase price and installation and delivery costs	3 000 000
Net working capital	110 000
Total:	3 110 000

2. Operating Cash Flow:

	1	2	3	4	5
Sales	800 000	800 000	800 000	800 000	800 000
Reduction in Operating Expenses	+ 100 000	+ 100 000	+ 100 000	+ 100 000	+ 100 000
Depreciation expense	999 000	1 335 000	444000	222 000	0
EBIT	(99 000)	(435 000)	456 000	678 000	900 000
Income Tax	(39 600)	(174 000)	182 400	271 200	360 000
Net Income	(59 400)	(261 000)	273 600	406 800	540 000
Depreciation Expense (add back)	999 000	1 335 000	444000	222 000	0
Net Incremental Operating Cash Flow	939 600	1 074 000	717 600	628 800	540 000

3. Shutdown Cash Flow:

Salvage Value	800 000
Income Tax	320 000
Net Cash Inflow from sale of Tools	480 000
Cash from Reduction in NWC	+ 110 000
Total	590 000

4. Summary of Incremental Cash Flows:

	0	1	2	3	4	5
Purchase price and installation and delivery costs	- 3000000
Net working capital	- 110 000
Net Incremental Operating Cash Flow		939 600	1 074 000	717 600	628 800	540 000
Shutdown Cash Flow						590 000
Net Incremental Cash Flow	- 3110 000	939 600	1 074 000	717 600	628 800	1130 000

Topic 10. The Cost of Capital

A firm's capital is supplied by its creditors and owners. Firms raise capital by borrowing it (using bonds to investors or promissory notes to banks), or by issuing preferred or common stock. The overall cost of a firm's capital depends on the return demanded by each of these suppliers of capital.

To determine a firm's overall cost of capital, the first step is to determine the cost of capital from each supplier. The cost of capital from a particular source, such as bondholders or common stockholders, is known as the component cost of capital.

Sources of Capital:

The firm's cost of debt when it borrows money by using bonds is the interest rate demanded by the bond investors. When borrowing money from an individual or financial institution, the interest rate of the loan is the firm's cost of debt.

The after-tax cost of debt, AT r_d, is the cost to the company of obtaining debt funds. Because the interest paid on bonds or banks loans is a tax-deductible expense for a business, a firm's AT r_d is less then the required rate of return of the suppliers of debt capital. For example, suppose Ellis Industries borrowed $100 000 for one year at 10% interest compounded annually. The interest rate on the loan is 10 %, so Ellis must pay the lender $10 000 in interest each year the loan is outstanding (10% of $100 000). However, look at what happens when Ellis takes its taxes for the year into account:

	Before making loan	After making loan
EBIT	50 000	50 000
Interest Expense	0	10 000
EBT	50 000	40 000
Income Tax (40%)	20 000	16 000
Net Income	30 000	24 000

The $10 000 interest charge caused a $6 000 decrease in Ellis's net income ($30000 - $24 000 = $6 000).

Assuming a tax rate of 40%, we see that the true cost of the loan is only $6 000 (6 %), not $10 000 (10 %).

The following formula converts r_d into AT r_d:

AT х r_d = r_d х (1 - T)

Where _d - the before-tax cost of debt

T - the firm's marginal tax rate

AT r_d = 0.1 (1 - 0.4) = 0.06

The Cost of Preferred and Common Stock Funds.

The cost of preferred stock: r_p = D_p/ PV

D_p - the amount of the expected preferred stock dividend.

PV - the current price of the preferred stock.

Example, Ellis Industries issued preferred stock that has been paying annual dividends of $2.50 and is expected to continue to do so indefinitely. The current price of Ellis's preferred stock is $20 a share.

r_p = 2.5/20 = 0.125 = 12.5%

The cost of common stock:

r_s = D₁/PV + g

Where:

D₁ - the dollar amount of the common stock dividend expected one period from now

PV - the current price of the common stock

g - expected constant growth rate per period of the company's common stock dividends

Example:

Ellis Industries' common stock is selling for $40 a share. Next year's common stock dividend is expected to be $4.20, and the dividend is expected to grow at a rate of 5% per year indefinitely.

r_s = 4.2/40 + 0.05 = 0.155 = 15.5%

The cost of common stock might be calculated using the CAPM model:

The cost of new common stock:



r_sn = D₁/(PV - F) + g

Where:

D₁ - the dollar amount of the common stock dividend expected to be paid in one year.

PV - the price of one share of the common stock.

g - expected constant growth rate per period of the company's common stock dividends.

F - the flotation cost per share.

Example:

Suppose, again that Ellis Industries' anticipated dividend next year is $4.20 a share, its growth rate is 5% a year, and its existing common stock is selling for $40 a share. New shares of stock can be sold to the public for the same price. But to do so Ellis must pay its investment bankers 5% of the stock's selling price, or $2 per share. r_sn = 4.2/(40 - 2) + 0.05 = 0.1605 = 16.05%

The Weighted Average Cost of Capital (WACC)

WACC = (W_d * AT r_d) + (W_p * r_p ) + (W_s * r_s)

WhereW_d W_p W_s - the weight, or proportion of the sources of capital

Example: from our previous calculations, we know the following costs of capital:

AT r_d = 6%

r_p = 12.5%

r_s = 15.5%

Capital Ctructure: (from balance sheet)

	in dollars	in %
Long-& Short-Term Debt	400 000	40%
Preferred Stock	100 000	10%
Common Stock	500 000	50%
Total Liabilities & Equity	1 000 000	100%

WACC = (0.4 * 0.06) + (0.1 * 0.125) + (0.5 * 0.155) = 11.4%

Thus, a firm must earn a return equal to the weighted average cost of capital (WACC) to pay suppliers of capital the return they expect. In the case of Ellis Industries, for instance, its average risk capital budgeting project must earn a return of 11.4% to pay its capital suppliers the return they expect.

To illustrate how earning the WACC ensures that all capital suppliers will be paid their required cost of capital, let's return to our example. Suppose Ellis Industries undertakes a plant expansion program that costs $1 million and earns an annual return of 11.4 %, equal to Ellis's WACC. Capital for the project is supplied as follows:

· 40 % оf the $1 mln. ($400 000) is supplied by lenders expecting a return equal to before-tax r_d, 10%.

· 10 % оf the $1 mln.($100000) - is supplied by prferred investors expecting a return equal 12.5%

· 50 % оf the $1 mln. ($500000) - is supplied by common stockholders expecting a return equal 15.5%. If the project does in fact produse the expected 11.4 % return, will all these suppliers of capital receive the return they expect?

First-year return from the project
10 % paid to the bondholders
Tax
Net interest cost to the firm
Preferred dividend paid to preferred stockholders
Dividends paid to common stockholders

The Marginal Cost of Capital (MCC).

A firm's WACC will change if one component cost of capital changes.

The weighted average cost of the next dollar of capital to be raised is the marginal cost of capital (MCC).

To find the MCC, financial managers must:

1. assess at what point a firm's cost of debt or equity will change the firm's WACC;

2. estimate how much the change will be;

3. calculate the cost of capital up to and after the points of change.

The Firm's MCC Schedule:

The breakpoint in the firm's MCC schedule is the point where one of the component sources of capital changes.

Finding the breakpoints in the MCC schedule.

To find breakpoints in the MCC schedule, financial managers determine what limits, if any, there are on the firm's ability to raise funds from a given source at a given cost. Suppose that Ellis Industries' financial managers, after consulting with bankers, determined that the firm can borrow up to $300 000 at an interest rate of 10%, but any money borrowed above that amount will cost 12%.

AT r_d (up to $300000) = 6%; AT r_d (over $300000) = 0.12 * (1- 0.4) = 7.2%

To find a firm's marginal cost of capital breakpoint, we use the formula:

ВР = limit/proportion of total; BP_d= 300000/0.4 = 750000

The Equity Breakpoint is the point at which the marginal cost of capital changes because the cost of equity changes. We will assume that Ellis Industries expects to realize $600 000 in income this year after it pays preferred stockholders their dividends. The $600 000 in earnings belong to the common stockholders. The firm may either pay dividends, or retain the earnings. Let's assume Ellis retains the $600 000. The finite supply of capital from the existing common stockholders is the $600 000 addition to retained earnings. To find the equity breakpoint, then, Ellis's managers must know at what point the firm will exhaust the common equity capital of $600 000, assuming existing common stock equity is 50 % of the firm's capital budget.

BP_s =600000/0.5 = 1200000

Calculating the Amount the MCC Changes.

We've identified two breakpoints at which the firm's MCC will change:

BP_d= 750000; BP_s =1200000

Since the MCC is simply the weighted average cost of the next dollar of capital to be raised, we can use the WACC formula.

We assume that Ellis Industries wants to maintain its current capital structure of 40% debt, 10% preferred stock, and 50% common equity.

Then, МСС up to:

BP_d (750000) = (0.4 Ч AT r_d) + (0.1 Ч r_p) + (0.5 Ч r_s) = (0.4 Ч 0.06) + (0.1 Ч 0.125) + (0.5 Ч 0.155) = 0.114 = 11.4%

We see from our calculations that up to the first breakpoint, the Ellis MCC is 11.4 percent - the WACC we calculated earlier. We know, however, that the Ellis lenders will raise the interest rate to 10% if the firm raises more than $750 000, at which point the AT r_d increase from 6% to 7.2%.

Then, МСС between:

BP_d (750000) and BP_s (1200000) = (0.4 Ч AT r_d) + (0.1 Ч r_p) + (0.5 Ч r_s) = (0.4 Ч 0.072) + (0.1 Ч 0.125) + (0.5 Ч 0.155) = 0.1188 = 11.88%

At the second breakpoint, BP_s, we know from our earlier Ellis calculations that r_sof 15.5% changes to r_n that has a value of 16.05%.

Then, МСС over:

BP_s (1200000) = (0.4 Ч AT r_d) + (0.1 Ч r_p) + (0.5 Ч r_s) = (0.4 Ч 0.072) + (0.1 Ч 0.125) + (0.5 Ч 0.1605) = 0.1216 = 12.16%

A graph of Ellis' MCC is shown below:



The MCC Schedule and Capital Budgeting Decisions

Firms use the MCC schedule to identify which new capital budgeting projects should be selected for further consideration and which should be rejected.

For example, Ellis Industries has identified the following projects for possible adoption:

Projects	Initial Investment Required	Project's IRR, %
A	500 000	18
B	300 000	14
C	200 000	12.05
D	300 000	11.50
E	200 000	9

The projects are ranked from highest to lowest IRR.

The list of proposed capital budgeting projects ranked by IRR is the firm's investment opportunity schedule (IOS).

To compare the project's IRRs to the firm's cost of capital, the financial managers plot the IOS on the same graph as the MCC.

The projects with the highest IRR are plotted first.

The Ellis financial managers should start with Project A, which has an IRR of 18%.

That project requires a capital investment of $500 000.

Next, they should add Project B, a project with an IRR of 14% and an investment of $300 000. the total capital budget with Project A and B is $800 000. Then Project C, with an IRR of 12.05%, should be added.

Project C's investment requirement of $200 000 increases the capital budget to $1 000 000.

The addition of Project D, a project with an IRR of 11.5% and investment of $300 000, results in a capital budget to $1 300 000.

Because the Project D's IRR is less than the MCC, the company should reject it.

Project E, a project with an even lower IRR, is also rejected.



Topic 11. Leverage

In physics the term leverage describes how a small force can be magnified to create a larger force. For example, a farmer wants to move a large boulder in a field. He wedges a long board (a lever) between the large boulder and a small rock ( a fulcrum), which gives him enough leverage to push down on the end of the long board and easily move the boulder.

The power of leverage can also be harnessed in a financial setting. Its magnifying power can help or hurt a business. A firm that has leverage will earn or lose more than it would without leverage.

Operating leverage:

Operating leverage refers to the phenomenon whereby a small change in sales triggers a relatively large change in operating income (or EBIT). Operating leverage occurs because of fixed costs in the operations of the firm. A firm with fixed costs in the production process will see its EBIT rise by a larger percentage than sales when unit sales are increasing. If unit sales drop, however, the firm's EBIT will decrease by a greater percentage than does its sales.

The degree of operating leverage, or DOL, measures the magnitude of the operating leverage effect. The degree of operating leverage is the percent change in EBIT divided by the percent change in sales:

DOL=

	Period 1	Period 2	% change
Sales	10 000	11 000	10%
FC	5 000	5 000
EBIT	5 000	6 000	20%



DOL = 20%/10% = 2

We see that for a firm with 10% change in sales and a 20% change in EBIT, the DOL is 2.A DOL greater than 1 show, that the firm has an operating leverage. That is, when sales changes by some percentage, EBIT will change by a greater percentage.

The Alternate Method of Calculating DOL

We may also find the DOL by using only numbers found in the base-year income statement.

DOL =

	Period 1	Period 2	% change
Sales	30 000	33 000	10%
VC	1 200	1 320
FC	12 000	12 000
EBIT	16 800	19 680	17.1%

DOL = = 1.71

Whenever fixed costs are greater than zero, DOL is greater than 1, indicating a leverage effect. The larger the amount of fixed costs, then, the greater the leveraging effect.

Financial Leverage:

Financial leverage is the additional volatility of a firm's net income caused by the presence of fixed-cost funds (such as fixed rate dept) in the firm's capital structure.

The degree of financial leverage (DFL) - is the % change in net income divided by the % change in EBIT.



DFL =

	Period 1	Period 2	% change
Sales	30 000	33 000	10%
VC	1 200	1 320
FC	12 000	12 000
EBIT	16 800	19 680	17.1%
I	800	800
EBT	16 000	18 880
Tax (15%)	2 400	2 832
NI	13 600	16 048	18%

DFL = 18 % / 17.1 % = 1.05

The Alternate Method of Calculating DFL

DFL =

DFL = = 1.05

The DFL will be greater than 1 if interest expense is greater than zero.

Combined leverage:

The combined effect of operating leverage and financial leverage is known as combined leverage.

DCL =

The alternate DCL formula follows:



DCL =

We can also calculate the DCL a third way:

DCL = DOL * DFL

Topic 12. Dividend Policy

Dividends are the cash payments that corporations make to their common stockholders. Factors affecting dividend policy:

Does the firm need the cash for investment?	No	Dividend more likely
	Yes	Dividend less likely
Does the firm have access to cash or borrowing opportunities?	Yes	Dividend more likely
	No	Dividend less likely
Does management expect the future to be bright?	Yes	Dividend more likely
	No	Dividend less likely
Do stockholders prefer capital gains?	No	Dividend more likely
	Yes	Dividend less likely
Are there restrictions on dividend payments by law or agreement?	No	Dividend more likely
	Yes	Dividend less likely

Cash versus earnings

Dividend payout ratio = dividends paid/net income

When a company generates earnings, this usually results in cash flowing into the firm. The earnings and cash flows do not necessarily occur at the same time.

Sales (all on credit payment due in next year)	1 000 000
Total expenses	400 000
Net income	600 000
Cash received this year	0



Leading dividend theories:

The residual theory of dividends hypothesizes that the amount of dividends should not be the focus of the company. Instead, the primary issue should be to determine the amount of earnings retained within the firm for investment. The amount of earnings retained depends on the number and size of acceptable capital budgeting projects and the amount of earnings available to finance the equity portion of the funds needed to pay for these projects. Any earnings left after this projects have been funded are paid out in dividends.

Investment needed for new projects	10 000 000
Optimal capital structure	30% debt - 70% equity
Equity funds needed	70% * 10 000 000 = 7 000 000
Earnings available	12 000 000
Residual earnings	12 000 000 - 7 000 000 = 5 000 000
Amount of dividends to be paid	5 000 000

The clientele dividend theory is based on the view that investors are attracted to a particular company in part because of its dividend policy. For example, young investors may want their portfolios to grow in value from capital gains rather from the dividends. Elderly investors, in contrast, may want to live off the income their portfolios provide. They would tend to seek out companies that pay high dividends rather than reinvesting for growth.

The signaling dividend theory is based on the premise that the management of a company knows more about the future financial prospects of the firm than do the stockholders. According of this theory, if a company declares a dividend larger than that anticipated by the market, this will be interpreted as a signal that the future financial prospects of the firm are brighter than expected. Investors presume that management would not have raised the dividend if it did not think that this higher dividend could be maintained. As a result of this signal of good times ahead, investors buy more stock, causing a jump in the stock price.

The bird-in-the-hand theory claims that stockholders prefer to receive dividend instead of having earnings reinvested in the firm on their behalf. Although stockholders should expect to receive benefits in the form of higher future stock prices when earnings are retained and reinvested in their company, there is uncertainty as to whether the benefits will actually be realized. However, if the stockholders were to receive the earnings now they could invest them now in whatever they desired. investment risk budgeting

According to the Modigliani and Miller's dividend theory, the way a firm's income is distributed doesn't affect the overall value of the firm. Stockholders are indifferent as to whether they receive their return on their investment in the firm's stock from capital gains or dividends - so dividends don't matter.

Alternatives to cash dividends:

Stock dividend means the existing common stockholders receive new shares, proportionate to the number of shares currently held.

Stock split means an attempt to bring the firm stock price into what management perceives to be a more popular trading range.

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