FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES CHAPTER 10 pot

The cost of common equity based on the CAPM approach could be directlycompared to the specific costs of debt and preferred stock, and it also could beused to arrive at a weighted overall

ANALYSIS OF FINANCING CHOICES

Let’s now turn to analyzing the third aspect of the three-part decisional systemscontext introduced in Chapter 2: investment, operations, and financing We’ll con-centrate on the choices available in arranging a company’s long-term financing,while setting aside the incremental operational funds sources used routinely bycompanies in line with practices in a particular industry or service, and broadlydiscussed in Chapter 3 We choose this focus because, as we observed earlier, thenature and pattern of long-term funding sources is intricately connected with thetypes of business investments made and is critical to the growth, stability, or de-cline of operations Indeed, management must fund its strategic business designwith an appropriate mix of capital sources that will assist in bringing about thedesired increase in shareholder value

This chapter will deal with the key considerations in assessing the basic nancing options open to management While the choice among long-term debt,preferred, and common equity is blurred by a bewildering array of modificationsand specialized instruments in each category, we’ll discuss only the main charac-teristics of the three basic types of securities Because our emphasis is on quanti-tative analysis, we must keep in mind that many other considerations enter intothese choices For example, the specific type of business and the industry in which

fi-it operates will affect the long-term capfi-ital structure chosen at various stages of acompany’s development, as will the preferences and experiences of senior man-agement and the board of directors These aspects cannot be adequately coveredwithin the scope of this book

We’ll begin with a broad framework for analysis that defines the key areas

to be analyzed and weighed in choosing sources of long-term financing Next,we’ll look at the techniques of calculating the impact on a company’s financialperformance resulting from the introduction of new capital supplied by each of thethree basic sources Then we’ll turn to a graphic representation of these results,the range of earnings (EBIT) break-even chart, in order to demonstrate the

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326 Financial Analysis: Tools and Techniquesdynamic impact that funds choices have on changing company conditions Aftertouching on leasing as a special source, we’ll briefly discuss capital structure pro-portions and list the key issues involved in the area of funds choices.

Framework for Analysis

Several key elements must be considered and weighed when a company is facedwith raising additional (incremental) long-term funds We’ll take up the five mostimportant ones in some detail:

Cost of Incremental Funds

One of the main criteria for choosing from among alternative sources of additionallong-term capital is the cost involved in obtaining and servicing the funds InChapter 9, we discussed in detail the specific and implicit costs a company incurs

in using debt, preferred stock, or common equity

As a general rule, we found that funds raised with various forms of debt areleast costly in specific terms, in part because the interest paid by the borrowingcompany is tax deductible under current U.S laws The actual rate of interestcharged on incremental debt will depend, of course, on the credit rating of thecompany and on the degree of leverage introduced into the capital structure by thenew debt, as discussed in Chapter 6 In other words, the specific cost will beaffected not only by current market conditions for all long-term debt instruments,but also as a function of the company-specific risk as perceived by lenders, under-writers, and investors As we mentioned at the time, other costs are also implicit

in raising long-term debt, including legal and underwriting expenses connectedwith the issue, and the nature and severity of any restrictions imposed by thecreditors

The stated cost of preferred stock is generally higher than debt, partly cause preferred dividends are not tax deductible, and partly because preferredstock has a somewhat weaker position on the risk/reward hierarchy Holders ofthese shares expect a higher return to compensate for their ownership risk Thecomparative specific cost of preferred stock is relatively easy to calculate The

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dividend level is clearly defined, and legal and underwriting costs incurred at thetime of the issue are reflected in the net proceeds to the company However, attimes a variety of specific provisions can involve implicit costs to the company.

In Chapter 9 we found that determining the cost of common equity turnedout to be a fairly complex task It involved constructing a theoretical frameworkwithin which to assess the risk/reward expectations of the shareholder Direct ap-proaches (shortcuts) to measuring the specific cost of common equity were foundwanting because they didn’t address the company’s relative risk as reflected incommon share values We had to use a more integrated framework involvingsome surrogates and approximations to arrive at a practical result based on thetheoretical model

The cost of common equity based on the CAPM approach could be directlycompared to the specific costs of debt and preferred stock, and it also could beused to arrive at a weighted overall cost of the company’s capital structure Aswe’ll see shortly, however, increasing common equity in the capital structure

by issuing new shares involves additional considerations The incremental sharesdilute earnings per share, require additional and even growing dividends wherethese are paid, and also change the capital structure proportions These effectsintroduce implicit economic costs or advantages into the funding picture

Risk Exposure

If we use variability of earnings as a working definition of risk, we find that acompany’s risk is affected by the specific cost commitments, such as interest ondebt or dividends on preferred shares, that each funding source entails Thesecommitments introduce financial leverage effects in the company’s earnings per-formance, or will heighten any financial leverage already existing As we dis-cussed in Chapter 6, the use of instruments involving fixed financial charges willwiden the swings in earnings as economic and operating conditions change.Given the responsibility for providing holders of common shares withgrowing economic value, management must therefore expend much thought andcare in determining the appropriate mix of debt and equity in the company’s capi-tal structure This balance involves providing enough lower-cost debt to boost theshareholders’ returns, but not so much debt as to endanger shareholder value crea-tion during periods of low earnings, to arrive at a mix of capital sources carefullytailored to industry and company conditions

The ultimate risk, of course, is that a company will not be able to fulfill itsdebt service obligations The proportion of debt in the capital structure, and simi-larly, the proportion of preferred stock, affects the degree of risk of partial or totaldefault Analyzing risk exposure is based on establishing a historical pattern ofearnings variability and cash flows from which future conditions are projected.These must take into account the extent to which a company’s strategy is chang-ing, any shifts in exposure to the business cycle, shifting competitive pressures,and potential operating inefficiencies

328 Financial Analysis: Tools and TechniquesClearly, company-specific risk (earnings variability) and the company’sability to service its debt burden are intimately related to the particular character-istics of the business or businesses in which the company operates Moreover,they’re affected by general economic conditions—apart from management’s abil-ity to generate satisfactory operating performance.

The degree of financial leverage advisable and prudent will therefore varygreatly among different industries and services, and also will depend on the firm’srelative competitive position and maturity stage A new business entails a far dif-ferent risk exposure for the creditor than does the established industry leader,apart from specific industry conditions

Flexibility

The third area we must consider is the question of flexibility, defined here as therange of future funding options that remain open once a specific alternative hasbeen chosen As each increment of financing is completed, the choice among fu-ture alternatives might be more limited during the next round of raising capital.For example, if long-term debt obligations are chosen as a major funding source,the level of total debt in the capital structure, restrictive covenants, encumberedassets, and other constraints that impose minimum financial ratios might meanthat the company can use only common equity as a future source of capital forsome time ahead

Flexibility essentially requires forward planning Careful considerationmust be given to matching strategic plans and corporate financial policies Po-tential acquisitions, expansion, and diversification all are affected by the degree

of flexibility management has in choosing appropriate funding, and by the fundsdrain resulting from servicing debt commitments or preferred dividends To theextent possible, management must coordinate its planned future cash flows andinvestment patterns with the pattern of successive rounds of financing that willsupport them Being in a situation where future funds sources are limited to onlyone option because of present commitments can pose a significant problem.Changing conditions in the financial markets for different types of securitiesmight make this single option unappealing or even unavailable when funds needsbecome critical

Timing

The fourth element in choosing long-term funding is the timing of the transaction.Timing is important in relation to the movement of prices and yields in the secu-rities markets Shifting conditions in these markets affect the specific cost a com-pany incurs with each option, in the form of the stated interest rate on new debt orthe preferred dividend rate carried by new preferred stock, as well as in terms ofthe net proceeds to be received from each of the alternatives Therefore, the tim-ing of the issue will affect the cost spread between the several funding alternatives

available Also, specific market conditions might in fact either preclude or tinctly favor particular choices.

dis-For instance, in times of depressed stock prices, bonds might prove to be themost suitable alternative from the standpoint of both cost and market demand.Inasmuch as the proceeds from any issue depend on the success of the place-ment—public or private—of the securities, the conditions encountered in thestock or bond markets can seriously affect the choice Potential uncertainty infinancial markets is therefore a strong argument for always maintaining somedegree of flexibility in the capital structure

Control

Finally, the degree of ownership control of the company held by existing holders is an important factor as funding choices are considered Obviously, whennew shares of common stock are issued to new shareholders, the effect is a dilu-tion of both earnings per share and the proportion of ownership of the existingshareholders Such dilution becomes a significant issue for the owners of com-panies that could be subject to potential takeovers In the past decade, the issue ofcontrol has been raised to new heights in the many battles over control during thecorporate merger and acquisition boom

share-Even if debt or preferred stock is used as the source of long-term funding,existing shareholders can be affected indirectly because restrictive provisions andcovenants might be necessary to obtain bond financing, or because concessionsmust be made to protect the rights of the more senior preferred shareholders.Dilution of ownership is a very important issue in closely held corporations,particularly new ventures In such situations, founders of the company or themajor shareholders might exercise full effective control over the company Issu-ing new shares will dilute both control over the direction of the company and thekey shareholders’ ability to enjoy the major share of economic value growth fromsuccessful performance Dilution of earnings and possible retardation of growth

in earnings per share brought about by diluting common equity ownership is, ofcourse, not limited to closely held companies Rather, it’s a general phenomenonthat we’ll discuss shortly

Finally, dilution of control and earnings is a major consideration in ibility, a feature found in certain bonds and preferred stocks This provision allowsconversion of the security into common stock under specified conditions of tim-ing and price In effect, such instruments are hybrid securities, as they representdelayed issues of common stock at a price higher than the market value of thecommon stock at the time the convertible bond or preferred stock is issued Wementioned this feature in earlier chapters in terms of its effect on financial ratios,particularly when discussing the concept of diluted earnings per share, and we’llreturn to it later in this chapter

convert-Control becomes an issue in convertible financing options because theeventual conversion of the bond or preferred stock will add new common shares

330 Financial Analysis: Tools and Techniques

to the capital structure and thus cause dilution The ultimate effect is just like a direct issue of new common stock

The Choice

It should be clear from this brief résumé of the considerations involved that any decision about alternative sources of long-term funding can’t be based on cost alone, even though cost is a very important factor and must be analyzed early in the decision-making process Unfortunately, there are no hard-and-fast rules spelling out precisely how the final decision should be made, because the choice depends so much on the conditions prevailing in the company and in the securi-ties markets at the time, and on the preferences of the board and senior manage-ment The best approach is to consider carefully the five areas we’ve presented above and to examine the pros and cons of each as an input to the decision Need-less to say, one very significant consideration is the effect of each funding source

on a company’s future earnings performance In the section that follows, we’ll ex-amine methods of calculating this effect

Techniques of Calculation

For purposes of illustration, we’ll employ the basic statements of a hypothetical company, ABC Corporation The company is weighing alternative ways of raising

$10 million to support the introduction of a new product After analyzing the corporation’s current performance, we’ll successively discuss the impact on that performance level caused by introducing long-term debt, preferred stock, and common equity, in equal amounts of $10 million each We’ll focus on the impli-cations of financing alternatives on the company’s reported earnings, but will also test the cash flow implications of the choices to be made

ABC’s abbreviated balance sheet is shown in Figure 10–1 The company currently has 1 million shares of common stock outstanding, with a par value of

$10 per share From the company’s income statement (not shown), we learn that

F I G U R E 10–1

ABC CORPORATION

Balance Sheet ($ millions)

Current assets $15 Current liabilities $ 7

Fixed assets (net) 29 Common stock 10

Other assets 1 Retained earning 28

Total assets $45 Total liabilities and net worth $45

ABC Corporation has earned $9 million before taxes on sales of $115 million inthe most recent year Income taxes paid amounted to $3.06 million, an effectiverate of 34 percent.

Current Performance

We begin our appraisal of the current performance of ABC Corporation by lating the earnings per share (EPS) of common stock Throughout the chapter, thisformat of calculating EPS and related measures will be used It’s a step-by-stepanalysis of the earnings impact of each type of long-term capital

calcu-First, we’ll establish the earnings before interest and taxes (EBIT), a sure we discussed in Chapter 4 From that figure we must subtract a variety ofcharges applicable to different long-term funds The first of these is interestcharges on long-term debt Normally short-term interest can be ignored unless it’s

mea-a significmea-ant mea-amount, becmea-ause we mea-assume—given the tempormea-ary nmea-ature of term obligations that arise from ongoing operations—that the related interestcharges have been properly deducted from income before arriving at the EBITfigure

short-The calculations of earnings per share are shown in Figure 10–2 A sion is made in the table for both long-term interest and preferred dividends Noamounts are shown for these, however, because our hypothetical company at thispoint has neither long-term debt nor preferred stock outstanding The calculationsresult in earnings available to common stock of $5.94 per share From that figure

provi-we must subtract $2.50, which represents a cash dividend voted by the board ofdirectors We find that this fairly high level of dividend payout (between 40 and

50 percent of earnings) has been maintained for many years, impacting ABC’s

332 Financial Analysis: Tools and Techniquesfinancing flexibility somewhat The company’s earnings have steadily grown byabout 4 percent on average over the past decade The stock is widely held andtraded, and currently commands a market price ranging from about $38 to $47,which means it’s trading at roughly seven to eight times earnings The latest se-curity analyst’s report suggests a  of 0.9, while the risk-free rate of return is

judged to be 6.5 percent, and the expected stock market return from the S&P 500

is forecast at 14.0 percent

Long-Term Debt in the Capital Structure

As debt is introduced into this structure, both the financial condition and the ings performance of ABC Corporation are significantly affected To raise the

earn-$10 million needed to fund the new product, management has found that it’s sible, as one alternative, to issue debenture bonds Debentures are not secured byany specific assets of the company; instead they’re issued against the company’sgeneral credit standing These bonds, under assumed market conditions, will carry

pos-an interest (coupon) rate of 11.5 percent, will become due 20 years from date ofissue, and will entail a sinking fund provision of $400,000 per year beginningwith the fifth year The balance outstanding at the end of 20 years will be repaid

as a balloon payment of $4 million The company expects to raise the full $10 lion from the bond issue after all underwriting expenses, in effect receiving thepar value

mil-Once the new product financed with the proceeds has been successfullyintroduced, the company projects incremental earnings of at least $2.0 millionbefore taxes Little risk of product obsolescence or major competitive inroads isexpected by management for the next 5 to 10 years, because the company hasdeveloped a unique process protected by careful patent coverage

We can now trace the impact of long-term debt on the company’s mance, observing both the change in earnings and dividends, and the specific cost

perfor-of the newly created debt itself (A fairly high interest rate and preferred dividendwere chosen for this illustration to make the impact of the choices more visible inthe graphic analysis shown later.) We’ll analyze two contrasting conditions:

• The immediate impact of the $10 million debt without any offsettingbenefits from the new product

• The improved conditions expected once the investment has becomeoperative and the new product has begun to generate earnings,probably after one year

The results of the two calculations are shown in Figure 10–3 The neous effect of adding debt is a reduction of the earnings available for commonstock This is caused by the stated interest cost of 11.5 percent on $10 million ofbonds, or $1,150,000 before taxes Earnings after interest and taxes drop by

instanta-$759,000 as compared to the initial conditions in Figure 10–2 This earnings

reduction represents, of course, the after-tax cost of the bond interest, or

$1,150,000 times (1 34)

As a consequence, earnings per share decline to $5.18, a drop of 76 cents,

or an immediate dilution of 12.8 percent from the prior level This change ispurely due to the incremental interest cost, which on a per share basis amounts tothe same 76 cents, that is, the after-tax interest of $759,000 divided by one millionshares In Chapter 8 we discussed the stated annual cost of debt funds, defined asthe tax-adjusted rate of interest carried by the debt instrument Assuming an ef-fective tax rate of 34 percent in our example, the stated cost of debt for ABC Cor-poration is therefore 7.59 percent We also explained in Chapter 9 that the specificannual cost of debt is found by relating the stated annual cost to the actual pro-ceeds received If these proceeds differ from the par value of the debt instrument,the specific annual cost of the debt will, of course, be higher or lower than thestated rate

In the case of ABC Corporation, we assumed that net proceeds were tively at par, and therefore the specific cost of ABC’s new debt is also 7.59 per-cent, a figure which we’ll compare with the specific cost of the other alternativesfor raising capital

effec-When we turn to the second column of Figure 10–3, we find that the sumed successful introduction of the new product will more than compensateABC Company for the earnings impact of the interest paid on the bonds In other

334 Financial Analysis: Tools and Techniqueswords, the investment project is earning more than the specific cost of the debtemployed to fund it After-tax earnings have risen to $6,501,000, a net increase of

$561,000 over the original $5,940,000 in Figure 10–2 As a consequence, earningsper share rose 56 cents above the original $5.94, an increase of almost 10 percent

By more than offsetting the total after-tax interest cost of the debentures of

$759,000, the successfully implemented new investment is projected to boost thecommon shares’ earnings Incremental earnings of $1,320,000 ($2 million pretaxearnings less tax at 34 percent) significantly exceed the incremental cost of

$759,000 Therefore, the investment—if ABC’s earnings assumptions prove istic—has made possible an increment of economic value In effect, the financialleverage introduced with the debt alternative is positive

real-Yet, several questions might be asked For example, suppose the investmentearned just $759,000 after taxes, exactly covering the cost of the debt supporting

it and maintaining the shareholders’ position just as before in terms of earningsper share Would the investment still be justified? Would this mean that the in-vestment was made at no cost to the shareholders?

At first glance, one might believe this, but a number of issues must be sidered here First of all, no mention has been made of the sinking fund obliga-tions which will begin five years hence and which represent a cash outlay of

con-$400,000 per year Such principal payments are not tax deductible and must bepaid out of the after-tax cash flow generated by the company Thus, debt service(burden coverage) will require 40 cents per share over and above the interest cost

of 76 cents per share, for a total of $1.16 per share The $400,000 will no longer

be available for dividends or other corporate purposes, because it is committed tothe repayment of debt principal If we suppose that earnings from the investmentexactly equaled the interest cost of the debt, how would the company repay theprincipal? At what point are the shareholders better off than they were before?There’s an obvious fallacy in this line of discussion It stems from the use ofaccounting earnings to represent the benefits of the project and comparing these

to the after-tax cost of the debt capital used to finance it This isn’t a proper nomic comparison, as we pointed out in Chapters 8 and 9 Only a discounted cashflow analysis can determine the true economic cost/benefit trade-off We couldsay that the project was exactly yielding the specific cost of the debt capital asso-ciated with it only if the net present value of the project was exactly zero when wediscount the incremental annual cash flows at 7.59 percent

eco-This result would then represent an internal rate of return of 7.59 percent, alevel of economic performance that would scarcely be acceptable to management.Yet even under that limited condition, the project’s cash flows (as contrasted to theaccounting profit recorded in the operating statement) would have to be higherthan the $759,000 after-tax earnings required to pay only the interest on the bonds.This must be so because under the present value framework of investmentanalysis, the incremental cash flows associated with a project must not only pro-vide the specified return but also amortize the investment itself, as we saw inChapters 7 and 8

Let’s now return to the real purpose of this analytical framework Ouranalysis isn’t designed to judge the desirability of the investment; we must assumethat this has been adequately done by management Instead, we’re interested only

in which alternative form for financing the approved investment is most geous for the company under the specific circumstances presented In this context,the impact of each alternative on the company’s earnings is one of several aspectsconsidered when deciding on new funding

advanta-In the case of debt, which under normal conditions is the lowest-cost native, we would indeed expect a financial leverage effect in favor of the share-holder When the project was chosen, it must have met a return standard basedapproximately on the weighted cost of capital—a return which is far higher thanthe cost of debt capital alone In summary, the introduction of debt immediatelydilutes earnings per share, but this impact is followed by a boost in earnings pershare when the project’s reported accounting earnings exceed the interest cost asreflected in the company’s income statement Also, the company must allow forthe future sinking fund payments from a cash flow planning standpoint, becausebeginning with the fifth year, 40 cents per share of the company’s cash flow will

alter-be committed annually to repayment of principal

It’s generally useful to examine the implications of these facts under a ety of conditions, that is, the risk posed by earnings fluctuations in both the basicbusiness and in the new products’ incremental profit contribution, which all alongwe’ve assumed to be successful We’ll take such variations into account later

vari-Preferred Stock in the Capital Structure

ABC Corporation could also meet its long-term financing needs with an tive issue of $10 million of preferred stock, at $100 per share, which carries astated dividend rate of 12.5 percent For simplicity, we’ll again assume that the netproceeds to the company will be equivalent to the nominal price of $100, afterlegal and underwriting expenses Figure 10–4 analyzes the conditions before andafter implementation of the new product investment

alterna-This time we find a more severe drop in the earnings available for commonstock, due to the impact of the preferred dividends of $1.25 million per year Notonly is the stated cost (as well as the specific cost, given that the net proceedswere again at par) of the new preferred stock higher by one full percentage pointthan the stated cost of the bonds, but also the dividends paid on the preferred stockare not tax deductible under current laws In fact, we’re dealing with an alterna-tive which costs, in comparable terms, 12.5 percent after taxes versus 7.59 percentafter taxes for the bonds

Therefore, the immediate dilution in earnings with the preferred issue is

$1.25 per share, or 21 percent, when compared to the initial situation Over time,

as the earnings from the new product are realized, the eventual increase in ings per share amounts to only 7 cents, or a slight improvement of 1.2 percent

earn-336 Financial Analysis: Tools and Techniques

The $1.25 million annual commitment of after-tax funds for dividends leaves verylittle room for any net gain in reported profit from the earnings generated by theinvestment—which we know are estimated as $2.0 million before taxes and

$1,320,000 after taxes

In this situation, the assumed conditions allow for very limited financialleverage Only little more than a 1 percent rise in earnings per share is achievedover the starting level, whereas the fixed after-tax financing costs have nearlydoubled when compared to the bond alternative Earnings per share would be un-changed if the product were to achieve minimum earnings in the amount of thepretax cost of preferred dividends:

 $1,894,000

At that level, the incremental earnings from the new product would just set the incremental financing cost—a break-even situation Note that the sizableearnings requirement of almost $1.9 million is two-thirds larger than the

off-$1,150,000 pretax interest cost with the bond alternative

Common Stock in the Capital Structure

A new issue of common stock as the third alternative for raising $10 million has

an even more severe impact on earnings Let’s assume that ABC Corporation willissue 275,000 new shares at a net price to the company of $36.36 after underwrit-

$1,250,000(1 34)

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ers’ fees and legal expenses are met Such a discount from the current marketprice of $40 should help ensure successful placement of the issue The number ofshares outstanding thus increases by 27.5 percent over the current 1.0 millionshares Figure 10–5 shows the impact on earnings in the same way as was donefor the other two alternatives.

We observe that immediate dilution is a full $1.28 per share, a drop of21.5 percent, which is the highest impact of the three choices analyzed Commonstock, in terms of this comparison, is the costliest form of capital—if only because

it results in the greatest immediate dilution in the earnings of current shareholders.Moreover, there also will be an annual cash drain of at least $687,500 inafter-tax earnings from the 275,000 new shares, if the current $2.50 annual divi-dend on common stock is maintained Further, we can project that this cash draincould grow at the historical earnings growth rate of 4 percent per year This as-sumption will hold if the directors continue their policy of declaring regular cashdividends at a fairly constant payout rate from future earnings that continue grow-ing For the present, the pretax earnings required to cover the $2.50 per share divi-dend amount to:

$2.50 275,000 shares  $687,500 (after taxes)

 $1,042,000 (before taxes)

$687,500(1 34)

Earnings before interest and taxes (EBIT) $9,000 $11,000

-0-Earnings before income taxes 9,000 11,000 Less: Federal income taxes at 34% 3,060 3,740 Earnings after income taxes 5,940 7,260 Less: Preferred dividends -0- -0- Earnings available for common stock $5,940 $7,260 Common shares outstanding (number) 1.275 million 1.275 million Earnings per share (EPS) $ 4.66 $ 5.69 Less: Common dividends per share 2.50 2.50 Retained earnings per share $ 2.16 $ 3.19 Retained earnings in total $2,752 $4,072 Original EPS (Figure 9–2) $5.94 $ 5.94 Change in EPS  1.28  0.25 Percent change in EPS  21.5%  4.2%

338 Financial Analysis: Tools and Techniques

We can directly compare this earnings requirement of about $1.05 million

to the alternative bond requirement of $1.15 million and the preferred stock quirement of $1.90 million From both an earnings and a cash-planning stand-point, these amounts and the differences between them are clearly significant.The effect of immediate dilution of earnings is only part of the considera-tion There will be the second-stage effect of continuing dilution, because in con-trast to the other two types of capital, the new common shares created represent anongoing residual claim on corporate earnings on a par with that of the existingshares Thus, the rate of growth in earnings per share experienced to date will beslowed in the future, merely because more shares will be outstanding—unless, ofcourse, the earnings provided by the investment of the proceeds are superior inlevel and potential growth to the existing earnings performance

re-When we turn to the second column of Figure 10–5, it’s apparent that spite the incremental earnings from the new product, a net dilution of earnings pershare in the amount of 25 cents, or 4.2 percent, will in fact continue The contri-bution of the new product to reported earnings wasn’t sufficient to meet the earn-ings claims of the new shareholders and maintain the old per share earnings level.The negative impact on earnings of the common stock alternative thus is greaterthan the earnings generated by the new capital raised

de-Up to this point, we’ve dealt with the earnings impact of common stock nancing To find a first rough approximation of the specific cost of this alternative,

fi-we can establish as a minimum condition the maintenance of the old earnings pershare level, and relate this to the proceeds from each new share of common stock.The current EPS of $5.94 (Figure 10–2) and the proceeds of $36.36 result in a cost

of about 16 percent

 16.34% (after taxes)

Recall from the discussion in Chapter 9, however, that using accountingearnings in measuring the cost of common equity is not appropriate If we employthe dividend approach to find the specific cost of the incremental common stock,

as discussed in Chapter 8, we must relate the current dividend per share to the netprice received, and add prospective dividend growth We know that the companyhas experienced fairly consistent growth in earnings of 4 percent per year, andwe’ll assume that, given a constant rate of dividend payout, common dividendswill continue to grow at the same rate The result is a cost of about 11 percent:

 4.0%  10.9%

As we stated in Chapter 8, however, the dividend approach is limited inconcept and usefulness Therefore, let’s now use the background data provided totest the specific cost of capital for ABC’s common equity with the CAPM ap-proach explained in Chapter 9

$2.50

$36.36

$5.94

$36.36

The resulting cost of common equity, k e , is approximately 13.25 percent

when we put into the CAPM formula the risk-free return R fof 6.5 percent, the

 of 0.9, and the expected average return Rmrepresented by the S&P 500 estimate

com-Clearly, the common equity alternative is the most expensive source offinancing, and we have already established that the dilution effect is also serious

In addition, the cash flow requirements for paying the current dividend of $2.50per share plus any future increases in the common dividend have to be plannedfor Because it’s difficult to keep all of these quantitative aspects visible in our de-liberations, let’s turn to a graphic representation of the various earnings and dilu-tion effects to compare the relative position of the three alternatives

Range of Earnings Chart

We’ve referred several times to changes in the earnings performance of the pany and the different impact the three basic financing alternatives have undervarying conditions The static format of analysis we’ve used so far doesn’t read-ily allow us to explore the range of possibilities as earnings change, or to visual-ize the sensitivity of the alternative funding sources to these changes It would bequite laborious to calculate earnings per share and other data for a great number

com-of earnings levels and assumptions Instead, we can exploit the direct linear tionships that exist between the quantitative factors analyzed

rela-A graphic break-even approach can be used to compare the earnings impact

of alternative sources of financing In this section, we’ll show how such a model,keyed to fluctuations in EBIT and resulting EPS levels, can be employed todisplay important quantitative aspects of the relative desirability of the choicesavailable As we’ll see, the break-even model allows us to perform a variety ofanalytical tests with ease

To begin with, we’ve summarized the data for ABC Corporation in Figure10–6 Variations in these data can then be displayed graphically in a simple break-even chart which shows earnings per share (EPS) on the vertical axis and EBIT onthe horizontal axis This EBIT chart allows us to plot on straight lines the EPSfor each alternative under varying conditions, and to find the break-even pointsbetween them

Commonly, one of the reference points is the intersection of each line withthe horizontal axis, that is, the exact spot where EPS is zero These points can befound easily by working the EPS calculations backward, that is, starting with an

340 Financial Analysis: Tools and Techniques

assumed EPS of zero and deriving an EBIT that just provides for this condition.The calculation is shown in Figure 10–7 for the original situation and for each ofthe three alternatives The data in Figures 10–6 and 10–7 give us sufficient pointswith which to draw the linear functions of EPS and EBIT for the various alterna-tives, as shown in Figure 10–8

F I G U R E 10–6

ABC CORPORATION

Recap of EPS Analyses with New Product ($ thousands, except per share figures) Original Debt Preferred Common

EBIT $9,000 $11,000 $11,000 $11,000

-0-Earnings available for

common stock $5,940 $6,501 $6,010 $ 7,260 Common shares outstanding

(number) 1 million 1 million 1 million 1.275 million

Less: Common dividends

EPS -0- -0- -0- Common shares 1 million 1 million 1 million 1.275 million