Tag Business

Stock splits and reverse stock splits

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Organizations undertake stock splits when it is perceived within the firm that shares of the company are traded at a too high price and this may slow down trading activity. If a stock split is undertaken, the market value of shares can slightly increase. Such increase tends to be maintained as long as dividends after the split also increase.

If a firm undertakes a 2 for 1 split than 2 new shares will be given in exchange for every 1 old share. The stock split does not affect the organizational capital structure.

Organizations can also do reverse stock splits when firm wants to increase the share price. Increase in share price may help to enhance trading of a shares activity. This occurs because unsophisticated investors tend to equate low priced stocks to low quality investments.

If firm undertakes a 1 for 2 split, one new share will be exchanged for 2 old shares.

Establishing a dividend policy

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Dividend policy refers to the policy which is used as a guide when a firm makes dividend decisions. It assists the board of directors in establishing how much should be paid to shareholders in dividends.

Dividend policy should be established in such a way that it provides for adequate financing for the firm. Dividend policy must also be aligned with the main objective of the firm which is to maximize shareholders’ wealth.

Investors tend to prefer stable increasing dividends as opposed to fluctuating dividends.

Factors which affect dividend policy

There are number of external and internal factors which affect dividend policy.

External factors which affect dividend policy

Contractual constraints – refer to restrictive provisions in a loan agreement and may include dollar or percentage of earnings limit on dividends and an inability to make dividend payments until certain levels of earnings is reached.

Legal constraints – this type of constraints depends on the location of the firm. Usually, due to legal constraints, firms are not able to pay out any dividends if the firm has any overdue liabilities or if it is bankrupt.

Firm also cannot pay any part of par value of common stock. Sometimes, in addition to the inability to pay any part of par value of common stock, firm also may not pay any part of paid-in capital in excess of par.

Market reactions – a firm needs to consider how markets will react to its dividend decisions. For example, if dividends are not paid or decreasing then markets will see it as a negative signal and the stock price will likely to drop. This will decrease shareholders’ wealth. If dividends are paid out consistently or even increasing in amounts, this can be seen as a positive signal by the market participants and stock price will likely to increase. This will increase shareholders’ wealth.

Shareholders generally prefer fixed or increasing dividends. This decreases uncertainty and investors are likely to use lower rate at which earnings will be discounted. This will lead to an appreciation of share and an increase in shareholders’ wealth.

Current and expected state of the economy – If state of the economy is uncertain or heading downward than it may be wise for management to pay smaller or no dividends to prepare a safety reserve for the company which can help to deal with future negative economic conditions.

However, if the economy is growing very fast then the firm may have more acceptable investments to take advantage of. It can be best not to distribute dividends but rather use these funds for investments.

Changes in government policies and state of the industry must also be taken into account.

Internal factors which affect dividend policy

Financing needs of the firm – Mature firms usually have better access to external financing. Therefore, they are more likely to pay out a large portion of earnings in dividends. If a company is young and rapidly growing than it will likely be unable to pay a large portion of earnings in dividends as it will require retained earnings to finance acceptable projects and its access to external financing is likely to be limited.

Preference of the shareholders – a firm should consider the needs and interests of the majority of its shareholders when making dividend decisions. For example, if shareholders will be able to earn higher returns by investing individually then what firm can earn by reinvesting funds than a higher dividend payment should be considered.

If the firm will have to issue more stock to be able to pay out dividends than it may be in the best interest of the current stakeholders not to issue dividends to avoid potential dilution of ownership. Dilution of ownership occurs because after issuing of additional stock, retained earnings will have to be distributed over a larger amount of the shareholders. This leads to dilution of earnings for existing shareholders. This also leads to dilution of control.

Firms also need to consider the wealth level of the majority of its shareholders. If the majority of shareholders are lower income earners than they likely will need dividend income and will prefer payment of dividends. However, if the majority of shareholders are high income earners then they will likely to prefer appreciation of share as it will defer tax payment even if the tax applicable on dividends and capital gains is the same, as in US after 2003 Tax Act.

Interestingly, in an efficient market, preferences of the shareholders should be met by price mechanism. If dividend payments are lower than required by many investors than those investors will sell their shares. Share prices will drop and this will raise an investors’ expected return. Higher expected return will increase the weighted marginal cost of capital and intersection between IOS and WMCC schedules will occur at a lower optimal capital budget point. Due to higher WMCC, fewer of the projects will be acceptable and more of the retained earnings can be paid out as dividends. Therefore the owners’ preferences are satisfied by price mechanism.

Stability of earnings – If earnings of the company are not stable from period to period than it is wise to follow conservative payments of dividends.

Earnings requirement – this constraint is imposed by the firm. It consists of a firm not being able to pay out in dividends more than the sum of the current and the most recent past retained earnings. However, the firm still can pay out dividends even if it incurred losses in the current financial period.

One of the reasons firms may want to pay dividends in years when the firm incurred a loss is to send positive signal to the market indicating that the loss is only a temporary phenomenon and that the company has its operations under control. Otherwise, shareholders may start selling shares which will decrease price of the shares and even further decrease wealth of the owners of the company (shareholders).

Lack of adequate cash and cash equivalents – occurs when firm do not have adequate cash and cash equivalents, such as marketable securities, to make dividend payments. Borrowing with intention to use funds to pay out dividends is usually not welcomed by lenders because the use of funds is not aligned with activity that would help firm to pay back debt to the lender. Borrowing to pay dividends is also usually not a wise business decision.

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Factors favouring higher and lower dividends

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Higher dividends

There are factors that make higher dividends beneficial. For example, higher dividends tend to decrease an agency’s costs. This occurs because the more dividends management needs to pay out, the more external financing the firm will require. External financing increases the scrutiny that management actions have to undergo and, therefore, decreases the agency problem and agency costs.

It is also suggested that for investors to sell current stock to obtain income equivalent to dividends is not the same psychologically as receiving dividends. It is harder psychologically to sell stock to obtain income than to use dividends to obtain income. Therefore, it is argued, that these two actions cannot be viewed as substitutes, as proposed by the dividend irrelevance theory. The above point suggests that shareholders who need income that comes from dividends are psychologically more comfortable with receiving dividends than with selling part of their shares.

Another argument for the benefits of higher dividends refers to the fact that $1 of dividends received now cannot be seen as equivalent to $1 of future dividends or stock appreciation to be received at some point in the future.

Investors will prefer $1 to be received now to $1 to be received in the future. The only way they will be indifferent is if the amount to be received in the future will be adjusted to account for the time value of money.

Time value of money refers to the fact that investors will prefer $1 today to $1 tomorrow. For example, if an investor can receive $100 today or a certain amount 1 year from now, the only way the investor will be indifferent is if the amount 1 year from now is larger by an equivalent to investor’s required return.

In other words, future dividends or share appreciation must bring benefit of $1 plus additional return based on the required return of the investor. Only in such case investor will be indifferent. If investor’s required return is 9% per year than the investor will be indifferent if $100 is received today or $109 received in 1 year from now.

Lower dividends

Transactions costs often make lower dividends more beneficial for stockholders and for the firm. It is more beneficial for a stock holder to have lower dividends if an investor intends to reinvest dividends in stock. This occurs because there are transactions costs that investor have to incur to buy stock such as brokerage fees.

The firm will benefit from paying lower dividends in the case where external financing is required. This is because external financing results in costs such as flotation costs. If firm just uses retained earnings available instead of paying out dividends then the costs of external financing will be avoided or decreased.

Tax that investors have to pay on capital gains is generally lower than tax that they have to pay on dividends (this, however, may differ depending on location of investors and is no longer applicable to US investors as a result of the 2003 Tax Act).

Moreover, tax on capital gains must only be paid in the future, when the gain will be realized. The tax on dividends must be paid when payment of dividends occurs. Therefore, from this perspective, it is generally more beneficial to reinvest earnings compared to paying it out as dividends to the shareholders.

Also, if investors want to reinvest dividends by buying more stock, investors still lose money by paying taxes on dividends. Therefore, an argument made by dividend irrelevance theory suggesting that investors can reinvest dividends by buying more stock and therefore obtaining the same result as by funds being reinvested is irrelevant as soon as assumptions of a perfect world (which includes the assumption that there are no taxes) is no longer hold.

 

Operating leverage

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Operating leverage is the relationship between sales and revenue (Price*Quantity of units sold) and operating profit (which is also called EBIT (earnings before interest and taxes)). It is a measure of how the potential use of fixed costs can enlarge the effect that change in sales volume has on operating profit (EBIT).

We can represent the calculation of operating leverage as follows:

Sales (P * Q)

Less: Fixed operating costs (FC)

Less: Variable operating costs (VC*Q)

= EBIT

Or

EBIT = (P*Q)-FC-(VC*Q)

This simplifies into:

EBIT = Q * (P-VC) – FC

When do firms have operating leverage?

If a firm has fixed costs, it has operating leverage. Because fixed cost (FC) is unchanged, an increase in sales revenue (P*Q) results in a proportionally bigger increase in EBIT (earnings before interest and taxes, which is also called operating profit). However, decrease in sales revenue (P*Q) will result in a proportionally bigger decrease in EBIT.

Increase in operating leverage increases business risk, which is a chance that the business will not be able to cover its operating costs.

How to calculate the degree of operating leverage (DOL) of the firm?

To calculate degree of operating leverage, which is just a way to measure operating leverage of the firm, we can use the following formula:

DOL =% change in EBIT/% change in sales

Therefore, if the degree of operating leverage is greater than 1, than operating leverage exists (which is the case as long as the company has fixed operating costs).

Businesses can increase their operating leverage by substituting variable costs for fixed costs, where possible. For example, salaries to sales personnel could be fixed instead of variable of units sold. Of course, many other variables need to be taken into account to make such a decision, such as consideration of how such changes would affect motivation levels of sales personnel.

Related Articles:

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Financial Position Statement Format (Balance Sheet)

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As we mentioned earlier, a balance sheet (financial position statement) is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity. A balance sheet (financial position statement) outlines the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

Below we present the general format of the balance sheet (financial position statement). We also explain the items in the balance sheet.

General balance sheet format

(1) ASSETS

(1.1) Current assets comprise:

Cash

+

Marketable securities

+

Accounts receivable

+

Inventories

=

Total current assets

(1.2) Non-current assets (fixed assets) comprise

Land and buildings

+

Machinery and equipment

+

Vehicles

+

Fixtures and Furniture

+

Other (for example financial leases)

=

Total gross fixed assets

Less: Accumulated depreciation

=

Net fixed assets

+

Other assets (investments, goodwill, copyrights and patents)

=

TOTAL ASSETS

(2) LIABILITIES AND (3) EQUITY

Liabilities comprise current and non-current liabilities:

(2.1) Current liabilities:

Accrued expenses

+

Accounts payable

+

Short-term notes (notes payable)

=

Total current liabilities

(2.2) Non-current liabilities

Mortgage

+

Other long-term debt

=

Total Non-current liabilities

(3) Equity comprises:

Common stock

+

Paid-in capital in excess of par on common stock

+

Preferred stock

+

Retained earnings

=

TOTAL EQUITY

=

TOTAL LIABILITIES AND EQUITY

Assets

CURRENT ASSETS

Current assets are listed first in the balance sheet (financial position statement). Current assets are those that can be converted into cash within 12 months. The main reason why small businesses often experience financial trouble is inefficient management of current assets. That is, they run out of cash. This can happen for such reasons as having insufficient cash on hand or underestimating the amount of time it takes to liquidate assets to create cash.

Marketable securities, also often called “near cash”, are liquid securities such as US Treasury bills.

Accounts payable refer to money that has not yet been received from the firm’s debtors. Debtors are the firm’s customers who bought from the firm on credit and still need to pay for a product or service provided.

Inventories refer to the raw materials, products in the process of production and completed products ready for sale. Basically, inventory is the physical products the business intends to sell.

In the balance sheet (financial position statement), the most liquid assets are usually listed before less liquid assets. That is why we also listed current assets in terms of decreasing liquidity: cash, marketable securities, accounts receivable and inventories.

NON-CURRENT ASSETS OR FIXED ASSETS

After current assets are listed, we can list non-current assets in the balance sheet. Non-current assets or fixed assets refer to assets that cannot be converted into cash within a 12 months period. The majority of fixed assets are depreciable. It means that the cost of the asset is allocated over its useful life and deducted as expenses on the income statement. This decreases the amount of tax the firm has to pay.

On the balance sheet we need to show the net fixed assets, which refer to the gross fixed assets (assets before depreciation is taken into account) less accumulated depreciation (depreciation deducted over the useful life of the asset, up to this point). The net fixed assets of the firm is also referred to as the book value.

OTHER ASSETS

Other assets show assets on the balance sheet that do not fit under the first two categories and include such assets as goodwill, copyrights and patents. For some companies this can contribute a sizable portion, if not the majority, of their value.

Liabilities and equity

The second part of the balance sheet presents how the business was financed. It basically shows from which sources assets were financed. The two main sources of financing are debt and equity.

CURRENT LIABILITIES

We start the second part of the balance sheet with current liabilities. Current liabilities include accrued expenses, accounts payable and short-term notes.

Accrued expenses are expenses which the company is obligated to pay within 12 months and includes such items as salaries and wages.

Accounts payable refer to payments that company is still obligated to make within 12 months to the creditors which supplied their product on credit to the company.

Short-term notes refer to the money that must be repaid to the lenders within 12 months.

LONG-TERM LIABILITIES

The next step in compiling the balance sheet requires us to list long-term liabilities. Long-term liabilities refer to debt payment which is due in a period longer than 12 months.

EQUITY

The last step in compiling the balance sheet requires us to illustrate the equity position of the firm. Equity indicates the claims of firm’s owners on the firm.

Items “common stock” and “paid-in capital in excess of par on common stock” indicate the amount paid by common stock shareholders for their shares of common stock.

Preferred stock shows the amount of money received from issuing preferred stock.

Retained earning show the earnings of the firm which were not distributed in the form of dividends to the shareholders.

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Overview of the Balance Sheet (Financial Position Statement)

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A balance sheet – financial position statement is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity.

A balance sheet is the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

How to think about a balance sheet (financial position statement)

A good way to compare the balance sheet statement, income statement and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over a specific period. The balance sheet – financial position statement is the dam. Everything collects there.

Therefore, by looking at the balance sheet we can see how everything comes together at a given point in time. If the company is reporting strong cash-flow in the statement of cash-flows, then that cash must be collecting somewhere, in the balance sheet. Provided a balance sheet is constructed honestly and correctly, it is a wonderful source of information about the company. Like a dam, any poisonous material or waste, gets washed down into the balance sheet. Therefore, paying careful attention to the balance sheet (financial position statement) allows to evaluate important information about the company.

Understanding the balance sheet (financial position statement)

To understand the balance sheet (financial position statement), one first needs to understand the difference between assets and liabilities. A simple explanation is as follows: if you take an unpaid vacation or are between jobs for a while, assets will or will have the potential of adding money to your bank account every month. Liabilities, however, will deduct money from your bank.

For example, if you own a fully paid-off house, which is currently empty, this is an asset. You may choose to earn money from this asset by renting it out. Therefore, even if you are not working, you will have rental income generated from your asset. However, if you leased an expensive car and lost your job, the bank will still deduct money from your bank account every month. Therefore, this is a liability. Alternatively, if the car is fully paid-off, it is an asset and you could generate income from it.

We also can define assets and liabilities more formally.

ASSETS

Assets are any tangible or intangible economic resources that a company or individual possesses and which can be used to cover the individual’s or company’s debt. For example, in the case of an individual, retirement savings and stocks are examples of assets. In the case of a company, fully owned equipment and buildings are examples of assets.

As represented on the balance sheet, current assets are assets which are excepted to be converted into cash within 12 months and non-current assets are assets which are expected to be converted into cash at some point in the future which is longer than 12 months.

LIABILITIES

Liability is a legal obligation to settle debt which arises as a result of a past transaction or event. A liability should, by law, be settled at a specified future period or over a specified period and, possibly, at specified intervals.

As represented on the balance sheet, current liabilities are debts which must be settled within 12 months and non-current liabilities are debts which must be settled at some point in the future which is longer than 12 months.

An example of personal liability can be a personal loan that must be repaid to the bank. Company liability examples include accrued expenses such as wages as well as long-term loans.

 

Entrepreneur Mindset

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Entrepreneurship and development go together. Learning to think like an entrepreneur, whether you run your own business or work for an organization, is a critical skill to be successful in business.

Entrepreneurs need to have a mix of skills at hand: knowledge of marketing, leadership, basic finance, operations, talent management, business management, technology and other skills. They need to have these skills since initially their companies usually consist of 1 or 2 employees and they do not have the luxury of having specialists.

Learning enough of these skills will give you an advantage. You do not need to be an expert in all of these areas. You just need to have a basic knowledge and be able to see an opportunity from all angles so you can have an overall picture. An entrepreneur’s mindset is a great advantage in business. Thinking like an entrepreneur forces you to look for opportunities which otherwise can be overlooked.

If you surveyed employers today, the vast majority would say they wish their employees were more entrepreneurial. This has been something employers have sought for the last 20 years and it will continue to be highly sought after.

There is another more compelling reason to think like an entrepreneur. No matter how happy you may be in your career today, there will likely come a time when you will want to make a change. This could be due to having a terrible manager, poor working conditions, a faltering company or you may just have outgrown your job. Either way, you need to have options. Thinking like an entrepreneur and having the skills of one, allows you to see opportunities and to exploit them.

Reasons to act like an entrepreneur

1 – One of the reasons is because you need to keep your options open to someday run your own business.

On average, you will never be as wealthy as you could be by working for someone else.

Moreover, you never will be “FREE” and, at some point in your career, being “FREE” may become a requirement for you rather than a preference. This happens very often with successful employees of corporations of all sizes and types. Consequently, many of them leave to start their own businesses to satisfy their need for freedom, personal satisfaction, the feeling of building something of their own and the opportunity to spend more time with family, amongst others.

2 – You need to learn to think like an owner and entrepreneur. If you adapt your attitude and acquire a feeling of accountability that comes with being an owner – you will stand out amongst peers and have a greater chance for accelerated career development.

3 – Learning to think like an entrepreneur helps you to see the big picture and this is crucial for your career development. The higher you move up along your business career ladder, the more conceptual skills you will need and the less technical skills you will need. Conceptual skills refer to the ability to think strategically and see the big picture.

Entrepreneurship, DEVELOPMENT and Innovation

It can also be argued that entrepreneurship and development of the economy as a whole go together. The distinguished Harvard economist Joseph Schumpeter argued that capitalism exists in the state of “creative destruction”, where innovation leads to new companies replacing old ones. Entrepreneurship leads to development. He viewed entrepreneurship as a catalyst for growth of the economy. He argued that it is entrepreneurs who are the driver for the sustainable long-term growth of the economy. Therefore, he argued that entrepreneurship and development of the economy are inseparable.

***

Most employees know their job well, but they are weak at understanding the overall business. Acquiring the mindset of an entrepreneur will allow you to see the big picture. You can set yourself apart.

 

Weighted Marginal Cost of Capital (WMCC) and Investment Opportunities Schedule

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By finding all break points, we can construct the weighted marginal cost of capital – WMCC – schedule. (WMCC) schedules show the relationship between the level of total new financing and a company’s weighted average cost of capital.

Thereafter, we can construct the investment opportunities schedule (IOS), which is a graph where the business’s investment opportunities are ranked based on their returns and financing required, arranged from the highest returns and all the way to the lowest returns. It is the decreasing function of the level of total financing.

If we combine the weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS), we can use it to make investment decisions. The rule is to invest in projects up to the point on the graph where marginal return from investment equals its WMCC (where IOS=WMCC).

All projects on the left of the point where IOS=WMCC will maximize shareholders wealth and all points on the right of the point where IOS=WMCC will decrease shareholders’ wealth.

It is important to note that the majority of firms stop investing before the marginal return from investment equals its weighted marginal cost of capital (WMCC). Therefore, the majority of businesses prefer a capital rationing position (the position below the optimal investment budget, which is also called the optimal capital budget).

Test yourself

ABC Company has to make an investment of $1,000,000. The long-term debt weight in the capital structure is 35%. ABC has $700,000 of retained earnings but 50% of it must be paid to common stock shareholders in the form of dividends. Preferred stock is currently not used as a source of finance by ABC.

What are the weights that ABC will have for each source of capital?

SOLUTION:

Firstly, we need to find out how much of retained earnings ABC has left after payment of dividends to shareholders: $700,000*0.5=$350,000.

Therefore, the weight of retained earnings is 35% ($350,000 out of $1,000,000).

$1,000,000-$350,000 (35%, funds available from long-term debt source) – $350,000 (35%, funds available from retained earnings) = $300,000 (30%)

Therefore, the weights are as follows:

Long-term debt – 40%

Retained earnings – 35%

Common stock – 30%

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Weighted Marginal Cost of Capital (WMCC)

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Weighted Marginal Cost of Capital – WMCC – is the WACC applicable to the next dollar of the total new financing. Related to the concept is the break point concept. Weighted average cost of capital (WACC) may change over time due to changes in the volume of financing. This occurs as the volume of financing increases, the risk increases and providers of funds require higher return on the funds that they make available.

The WACC of the next dollar of the total financing may be different from the WACC of the last dollar of the total financing.

Related articles: Break Point, Weighted Average Cost of Capital (WACC)

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(WACC) Weighted average cost of capital (ra)

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Weighted average cost of capital (WACC) (ra) is a very simple concept. Weighted average cost of capital (WACC) refers to the weighted cost of both debt and equity financing, according to the firm’s specific optimal mix of financing (debt and equity). Knowing the weighted average cost of capital (WACC) enables better decision making about proposed projects.

The formula for weighted average cost of capital (WACC) (ra) is as follows:

WACC=(wd*rd)+(we*re)+(ws*rn or rr)

Where:

wd = a weight for the long-term debt

we = a weight for the preferred stock

we = a weight for the common stock

rd = the cost of long-term debt

re = the cost of preferred stock

rn = the cost of new common stock

rr = the cost of retained earnings

All sources of capital and their weights must be taken into account.

Example

Project Omega was proposed with an expected return of 9% and the firm’s cost of capital for debt financing is 7% and cost of capital for equity financing is 12%. Further, the optimal mix of debt and equity of the firm is 40 percent of debt and 60 percent of equity. Then, the weighted average cost of capital (WACC) is calculated as follows:

weighted average cost of capital (WACC) = 7% * 0.40 + 12% * 0.60

2.8 + 7.2 = 10%

The weighted average cost of capital (WACC) is 10%.

Given the information above, the proposed project with expected return of 9% should be rejected as it is below the firm’s 10% weighted average cost of capital (WACC).

When making investment decisions, business must only choose projects that bring returns higher than the weighted average cost of capital (WACC).

Test yourself

Company ABC has the following sources of capital:

Long-term debt at 7% after-tax cost with weight of 35% in the capital structure.

Preferred stock at 9% after-tax cost with weight of 10% in the capital structure.

Common stock at 14% after-tax cost with weight of 55% in the capital structure.

REQUIRED: Find the weighted average cost of capital (WACC).

SOLUTION:

weighted average cost of capital (WACC) =7%*.35+9%*.10+14%*.55

WACC=2.45+.9+7.7

WACC=11.05%

Calculating weights

As per above, to calculate the weighted average cost of capital (WACC) we need to know the weight of each source of financing. When calculating weights, market values or book values can be used. Market values evaluate the proportion of capital at the market value and book values evaluate the proportion of capital at the book (accounting) value. It is better to use market values, as it is a more realistic value.

Further, when calculating weights, we can use either target or historical proportions. Target proportions refer to the optimal capital mix that a business would like to achieve. Historical proportion refers to the proportion based on the past. The target proportion is preferred.

***

Weighted average cost of capital (WACC) is a VERY important concept to understand. It is one of the central concepts in business and finance. The basic idea of weighted average cost of capital (WACC) concept is that it shows us the expected average cost of funds in the long-term. Make sure you are comfortable with explanations and calculations of the weighted average cost of capital (WACC) before progressing to the next section.

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