FINA1221 Lecture Notes - Lecture 2: Market Capitalization, Root Mean Square, Stock Market

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20 Jun 2019

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Don"t need to remember any formulas - can bring in a sheet in the exam to write them all on, or will be provided in the question. But be familiar with how to use them and with any possible example questions practice. Private corp = limited number of owners and no organised market. Public corp = unlimited owners and organised share market (stock exchange). Able to raise capital from external investors (adv). Listed company - shares are traded by the public on a stock exchange. Primary markets - corp sells shares to investors on this market (company receives capital directly rather than shareholders receiving capital when they sell their shares) Secondary markets - shares continue to trade in this market. Financial statements - accounting reports issued periodically to present past performance and a snapshot of the rm"s assets and the nancing of those assets. For public listed companies they will be shown on the companies website.

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Can the endangered public company survive? Should it survive?Evaluate the challenges that for-profit public companies face from recurrent scandals, political attacks and alternative corporate structures such as the B-corp. Can public companies survive? Should they survive?Use the Special Report from The Economist as a starting point. Draw on additional sources as appropriate.[10-12 pages, typed.

The endangered public company The big engine that couldnât Public companies have had a difficult decade, battered by scandals, tied up by regulations and challenged by alternative corporate forms May 19th 2012 | from the print edition PUBLIC companies have been the locomotives of capitalism since they were invented in the mid-19th century. They have installed themselves at the heart of the worldâs largest economy, the United States. In the 1990s they looked as if they would spread round the world, shunting aside older forms of corporate organisation such as partnerships, and newer rivals such as stateowned enterprises (SOEs). Chinaâs former president, Jiang Zemin, described NASDAQ as âthe crown jewel of all that is great about Americaâ. Russia rejected five-year plans in favour of stockmarket listings and Wall Street banks abandoned cosy partnerships in favour of public equity: Goldman Sachs, the last big holdout, went public as the decade came to an end. The Endangered Public Company, The Economist, 19-May-2012 2 Related topics ï· Private equity ï· Google ï· Mark Zuckerberg ï· Facebook ï· Asia Public companies triumphed because they provided three things that make for durable success: limited liability, which encourages the public to invest, professional management, which boosts productivity, and âcorporate personhoodâ, which means businesses can survive the removal of a founder. In 1997 the number of American companies reached an all-time high of 7,888 (see chart 1). Even now, American listed companies are as profitable as than they have been for 60 years. But during the past decade, the title of a 1989 essay, âEclipse of the Public Corporationâ, by Michael Jensen of Harvard Business School, has turned out to be prescient. In 2001-02 some of Americaâs most prominent public companies imploded. They included Enron, Tyco, WorldCom and Global Crossing, which, before their demise, were admired. Six years later Lehman Brothers collapsed and Citigroup and General Motors turned to the government for salvation. Meanwhile, SOEs were growing in emerging markets, challenging the idea that public companies are the biggest fishes in the sea. Private-equity firms flourished in the West, challenging the idea that public companies are the best managed. And the rise of the Asian economies, with their legions of family-owned conglomerates, challenged the idea that they are best equipped to advance capitalismâs geographical frontier. So, even though public companies are flush with cash (American firms are sitting on $2.23 trillion, see Free Exchange) and even though the worldâs most talked-about entrepreneur, Facebookâs Mark Zuckerberg, is due to take his company public on May 18th, the signs of health are misleading. Public companies are in danger of becoming like a fading London club. Their The Endangered Public Company, The Economist, 19-May-2012 3 membership is falling. They spend their time fussing over club rules. And, as they peer out of the window, they see the bright young things heading elsewhere. The number of public companies has dropped dramatically in the Anglo-Saxon worldâby 38% since 1997 in America and by 48% in Britainâs main markets. The number of initial public offerings (IPOs) in America dropped from an average of 311 a year in 1980-2000 to just 81 in 2011 (chart 2). Going public no longer has the glamour it once had. Entrepreneurs have to wait longerâan average of ten years for companies backed by venture capital, compared with four in 1985âand must jump through more hoops. Lawyers and accountants are increasingly specialised and expensive; bankers are less willing to take them public; qualified directors are harder to find, since even ânon-execsâ can go to prison if they sign false accounts. The great IPO famine Even when their firms do go public, the most successful technology entrepreneurs manage to preserve a lot of personal control. Google introduced a third class of non-voting shares despite the fact that its three bosses, Eric Schmidt, Sergey Brin and Larry Page owned 60% of voting shares. Mr Zuckerberg put off taking Facebook public until he had little choice (you have to publish quarterly accounts like a public company once you have more than 500 private shareholders); he will control more than half of Facebookâs voting stock. The IPO crisis has coincided with a boom in other corporate life forms. Familiar companies have started to put unfamiliar letters after their names: Chrysler LLC and Sears Brands LLC. The University of Illinoisâs Larry Ribstein called this âthe rise of the uncorporationâ. The Endangered Public Company, The Economist, 19-May-2012 4 Private-equity companies have taken some of the most familiar names on the high street private, including Boots, J.Crew, Toys âRâ Us, and Burger King. They also bagged some of the biggest stockmarket beasts: in 2007 Blackstone bought Hilton Hotels for $25.8 billion. Partnerships, too, are thriving, reversing a decline that began in the era of Charles Dickensâs âDombey and Sonâ (1848). Partnerships provided unlimited liability to the partners but limited their number. This meant partners could be ruined if their company failed (as Dombey was) but could not expand if it boomed. Now, thanks to three decades of legal reforms, partnerships can offer most of the benefits of listing, such as limited liability and tradable shares. In America they also boast a big tax advantage: partnerships are liable for only one lot of taxes, whereas companies must pay corporate taxes as well as taxes on dividends. The result has been a revolution: one-third of Americaâs tax-reporting businesses now classify themselves as partnerships. They have adopted exotic forms of corporate organisation, such as Limited Liability Limited Partnerships (LLLPs), Publicly Traded Partnerships (PTPs) and Real Estate Investment Trusts (REITs). Private-equity firms are typically organised as private partnerships. The individual funds through which they raise money are limited partnerships. And they treat their managers more like partners than employees, rewarding them accordingly. The former CEO of the Gap retail chain made $300m running J.Crew, a clothing firm, on behalf of Texas Pacific. Policymakers have embraced alternatives to the public company, too. Britainâs Conservative prime minister, David Cameron, is happier praising employee-owned John Lewis than your average PLC (public limited company). American corporate reformers regularly cite a private firm, W.L. Gore, as a model; the maker of the eponymous Gore-Tex employs 9,500 âassociatesâ and âsponsorsâ (not workers and bosses). Such companies use shares to motivate their employees but shield themselves from the capital markets. Employees become co-owners when they join and may not sell their shares when they leave. Governments have made it easier to create such alternative corporate structures. Seven American states have passed laws to allow companies to register as âBâ corporations which explicitly subordinate profits to social benefits. The British government has established a class of Community Interest Companies which issue shares and dividends but exist to promote social purposes. It has also handed over the management of hospitals to âtrustsââ public-private hybrids. The rise of new economic powers has further changed corporate organisation. In the 1990s it seemed that emerging-market companies would take the Western public company as their model. In fact they have embraced two slightly different corporate forms: SOEs and family conglomerates. These companies list on the stockmarket but do little to constrain the power of the state or of family shareholders. In June 2011 SOEs accounted for 80% of the value of Chinaâs market, 62% of Russiaâs and 38% of Brazilâs. They include some of the worldâs most important concerns: the 13 largest oil companies, the biggest gas company (Gazprom), the biggest mobile-phone company (China Mobile), the biggest ports operator (Dubai Ports). The Endangered Public Company, The Economist, 19-May-2012 5 The most serious challenge to SOEs comes from family-controlled conglomerates. Family businesses account for about half of listed companies in the Asia-Pacific region and two-thirds in India. Families exercise tight control of their empiresâand limit the power of other shareholdersâthrough a variety of mechanisms such as family-controlled trusts (which have more power than boards), appointing family members to managerial positions and attaching different voting rights to different classes of stock. Diversified family firms are good at taking a long-term view, diverting money from cash cows to new industries that might take a long time to produce results. They are also good at dealing with the government failures that plague emerging markets. It is remarkable how fast even Indiaâs lumbering government can move if a Tata or an Ambani calls. Family companies of a different type have had a good decade in Europe. German family firms have led the countryâs export boom by dominating niche markets such as printing presses (Koenig & Bauer), licence plates (UTSCH) and fly swatters (Aeroxon). These firms pride themselves on a professional approach to management: Nicholas Bloom and John Van Reneen, of the London School of Economics, point out that only 10% of German family firms choose their CEOs through primogeniture compared with two-thirds of family-owned firms in Britain and France. They also pride themselves on long-termism, investing heavily in training and upgrading their machinery. Getting better versus getting worse Some of the reasons for the decline of public companies and the success of alternatives may prove temporary. The fall in the number of listed firms owes something to the dotcom bust, a one-off event. The private-equity boom was fuelled by cheap debt. SOEs have been turbocharged by the rise in the price of oil and other commodities. The next decade may not be as easy for the emerging-worldâs family conglomerates as the past decade. But there is also something more fundamental going on: these various corporate forms have all learned how to manage their problems better than public companies have, while continuing to exploit their advantages. The biggest advantage of SOEs is political: ties with governments can protect them from unwelcome competition. That, of course, is also their problem: they can easily become bloated and lazy. So state-capitalist governments, particularly the Chinese, have turned to overseas listings to force staid monopolies to become nimbler, capable of responding to market demands, as well as government fiat. The big advantage for family firms is their capacity for long-termism. The drawbacks are family feuds and a lack of professionalism in the second or third generations. So, like state-capitalist governments, family companies are turning to market mechanisms: professional managers, private-equity firms and private markets such as SecondMarket and SharesPost, which allow private firms to trade shares without public scrutiny. In contrast, public companies have got worse at managing their problems, three in particular. Mr Jensen argues that their biggest drawback is what economists call the principal-agent problem: the split between the people who own the company (principals) and those who run it (agents). The Endangered Public Company, The Economist, 19-May-2012 6 Agents have a nasty habit of trying to feather their own nests. Dennis Kozlowski, Tycoâs former boss, even spent company money throwing a $2.1m birthday bash for his wife that featured a Manneken-Pis-like replica of Michelangeloâs David dispensing vodka. But, as the current âshareholder springâ attests, principals have been bad at monitoring their agents. Mr Jensenâs solution was to give managers âskin in the gameââthat is, make their pay reflect company performance so they act like owners. This has backfired: some bosses manipulated their companiesâ share prices to enrich themselves and most have seen their pay outpace company performance. The total remuneration of FTSE 100 chief executives rose by an annual average of 10% in 1999-2010, whereas returns on the FTSE 100 rose by an annual 1.9%. The second problem is regulation. Public companies have always had to put up with more regulation than private ones because they encourage ordinary people to risk their capital. But the regulatory burden has become heavier, especially after the 2007-08 financial crisis. America has introduced a raft of new rules, from the 2002 Sarbanes-Oxley legislation on accounting to the Dodd-Frank financial regulations of 2010. According to one calculation, Sarbanes-Oxley increased the annual cost of complying with securities law from $1.1m per company to roughly $2.8m. But that is nothing compared with the costs of distraction. In 2007 Oaktree Capital Management, a hedge-fund advisory firm, chose to raise $880m in a private placement rather than an IPO because, as the founders put it, âthey were happy to sacrifice a little public market liquidity, and even take a slightly lower valuation, in return for a less onerous regulatory environment and the benefits of remaining private.â The third problem is growing short-termism. The capital markets have increased their power dramatically with the rise of huge institutional investors and the intensification of shareholder activism. Mutual funds count their money in trillions rather than billions. Data providers such as Risk Metrics arm shareholder activists with plenty of ammunition. And hedge funds are not afraid to take on corporate Goliaths such as McDonaldâs and Time Warner if they think they are failing. And as capital markets have flourished, corporate life has become riskier. The average life expectancy of public companies shrank from 65 years in the 1920s to less than ten in the 1990s. So has the life expectancy of CEOs. The average job tenure of the CEO fell from 8.1 years in 2000 to 6.3 years in 2009, according to Booz & Co, a consultancy. LÃ©o Apotheker lasted just nine months as head of SAP and ten as head of Hewlett-Packard. Sometimes, investors are right to kick out managers (they own the firm, after all). Companies must strike a balance between the short and long term, satisfying the marketâs demand for profits today, while planning for the future. The worry is that regulators and owners both seem to be making it harder for bosses to look beyond quarterly earnings. Boards are devoting less time to strategy and more to enforcing regulations. Leo Strine, a judge with expertise in corporate law, accuses institutional investors of âgerbil-likeâ activity as they move money from one company to another. Standard Life Investors complains that the noise generated by quarterly earnings has become an âunwelcome distractionâ from thinking about the long term. Public company as public good The Endangered Public Company, The Economist, 19-May-2012 7 What should one make of the public companyâs travails? There is every reason to celebrate the fact that businesses have more corporate forms to choose from. Indeed, the menu should be lengthened by inventing new arrangements or revisiting old ones. Franceâs âSCAsâ or SociÃ©tÃ©s en Commandite par Actions have two tiers of partners: general ones jointly and severally liable for a companyâs debts, and limited partners who are ordinary shareholders with little power and who can lose only what they invest. This might provide a model for investment banks. But there are reasons to worry that the downgrading might go too far. Can the private-equity industry function properly if private investors cannot easily cash out through IPOs? Can SOEs avoid stagnation if conventional multinationals are struggling? Public companies are parts of an ecosystem of innovation and job creation. IPOs give venture capitalists and entrepreneurs a chance to make fortunes if they spot a game-changing idea. They also provide new companies with capital. The Kauffman Foundation has shown that one reason America has been better at generating jobs than Europe is its skill at creating innovative companies such as Amazon, eBay and Google. These companies took off when they went public. William Draper, one of Silicon Valleyâs most successful investors, speaks for many when he argues that this ecosystem may be drying up. Venture capitalists are recouping their investment by selling new companies to established ones rather than preparing them for independent life. In 2010 five large companies gobbled up 134 start-upsâmore than the entire crop of American IPOs that year. Two of the most talked-about start-ups of recent yearsâSkype and Zapposâ chose to sell themselves to giant firms (Microsoft and Amazon respectively). This may not be good for the start-ups. Imagine if Microsoft or Apple had sold themselves to IBM in the 1980s and you get a sense of the problem. Public companies produce annual reports, hold shareholder meetings and explain themselves to analysts. Private companies by comparison operate behind a veil of secrecy. The danger is that regulators are creating a corporate version of the dual labour market. By shining a spotlight on public companies, they are encouraging businesses to take refuge in the shade of the private sector. The Endangered Public Company, The Economist, 19-May-2012 8 Public companies also foster popular capitalism. The 20th century saw shareholding broadened thanks to privatisations in the 1980s and the rise of mutual funds. Today shareholding is in danger of narrowing again. The reduction in the number of IPOs is making it harder for ordinary people to put money into a future Google. The rise of the private-equity industry and the proliferation of private markets such as SecondMarket gives more power to a magic circle of company founders and experienced investors. Public companies have shown an extraordinary resilience. They have survived the Depression, the fashion for nationalisation, and the buy-out revolution of the 1980s. But the challenge to them looks unusually strong at the moment, and the auguries for the future grim. Rival versions of capitalism The endangered public company The rise and fall of a great invention, and why it matters May 19th 2012 | from the print edition The Economist. AS THIS newspaper went to press, Facebook was about to become a public company. It will be one of the biggest stockmarket flotations ever: the social-networking giant expects investors to value it at $100 billion or so. The news raises several questions, from âIs it worth that much?â to âWhat will it do next?â But the most intriguing question is what Facebookâs flotation tells us about the state of the public company itself. At first glance, all is well. The public company was invented in the mid-19th century to provide the giants of the industrial age with capital. That Facebook is joining Microsoft and Google on the stockmarket suggests that public listings are performing the same miracle for the internet age. Not every 19th-century invention has weathered so well. The Endangered Public Company, The Economist, 19-May-2012 9 But look closer and the picture changes (see article). Mark Zuckerberg, Facebookâs young founder, resisted going public for as long as he could, not least because so many heads of listed companies advised him to. He is taking the plunge only because American law requires any firm with more than a certain number of shareholders to publish quarterly accounts just as if it were listed. Like Google before it, Facebook has structured itself more like a private firm than a public one: Mr Zuckerberg will keep most of the voting rights, for example. The number of public companies has fallen dramatically over the past decadeâby 38% in America since 1997 and 48% in Britain. The number of initial public offerings (IPOs) in America has declined from an average of 311 a year in 1980-2000 to 99 a year in 2001-11. Small companies, those with annual sales of less than $50m before their IPOsâhave been hardest hit. In 1980-2000 an average of 165 small companies undertook IPOs in America each year. In 2001- 09 that number fell to 30. Facebook will probably give the IPO market a temporary boostâ several other companies are queuing up to follow its leadâbut they will do little to offset the long-term decline. Companies are like jets; the elite go private Mr Zuckerberg will be joining a troubled club. The burden of regulation has grown heavier for public companies since the collapse of Enron in 2001. Corporate chiefs complain that the combination of fussy regulators and demanding money managers makes it impossible to focus on long-term growth. Shareholders are also angry. Their interests seldom seem to be properly aligned at public companies with those of the managers, who often waste squillions on empirebuilding and sumptuous perks. Shareholders are typically too dispersed to monitor the men on the spot. Attempts to solve the problem by giving managers shares have largely failed. At the same time, alternative corporate forms are flourishing. Once âgoing publicâ was every CEOâs dream; now it is perfectly respectable to âgo privateâ, like Burger King, Boots and countless other famous names. State-run enterprises have recovered from the wreck of communism and now include the worldâs biggest mobile-phone company (China Mobile), its most successful port operator (Dubai World), its fastest-growing big airline (Emirates) and its 13 biggest oil companies. No doubt the sluggish public equity markets have played a role in this. But these alternative corporate forms have addressed some of the structural weaknesses that once held them back. Access to capital? Private-equity firms, helped by tax breaks, and venture capitalists both have cash to spare, and there are private markets such as SecondMarket (where $1 billion-worth of shares has changed hands since 2008). Limited liability? Partners need no longer be fully liable, and firms can have as many partners as they want. Professional managers? Family firms employ them by the HBS-load and state-owned ones are no longer just sinecures for the well-connected. Make capitalism popular again The Endangered Public Company, The Economist, 19-May-2012 10 Does all this matter? The increase in the number of corporate forms is a good thing: a varied ecosystem is more robust. But there are reasons to worry about the decline of an organisation that has spread prosperity for 150 years. First, public companies have been central to innovation and job creation. One reason why entrepreneurs work so hard, and why venture capitalists place so many risky bets, is because they hope to make a fortune by going public. IPOs provide young firms with cash to hire new hands and disrupt established markets. The alternative is to sell themselves to established firmsâ hardly a recipe for creative destruction. Imagine if the fledgling Apple and Google had been bought by IBM. Second, public companies let in daylight. They have to publish quarterly reports, hold shareholder meetings (which have grown acrimonious of late), deal with analysts and generally conduct themselves in an open manner. By contrast, private companies and family firms operate in a fog of secrecy. Third, public companies give ordinary people a chance to invest directly in capitalismâs most important wealth-creating machines. The 20th century saw shareholding broadened, as state firms were privatised and mutual funds proliferated. But today popular capitalism is in retreat. Fewer IPOs mean fewer chances for ordinary people to put their money into a future Google. The rise of private equity and the spread of private markets are returning power to a club of privileged investors. All this argues for a change in thinkingâespecially among the politicians who have heaped regulations onto Western public companies, blithely assuming that businessfolk have no choice but to go public in the long run. Many firms now go (or stay) private to avoid red tape. The result is that ever more business is conducted in the dark, with rich insiders playing a more powerful role. Public companies built the railroads of the 19th century. They filled the world with cars and televisions and computers. They brought transparency to business life and opportunities to small investors. Because public companies sell shares to the unsophisticated, policymakers are right to regulate them more tightly than other forms of corporate organisation. But not so tightly that entrepreneurs start to dread the prospect of a public listing. The public company has long been the locomotive of capitalism. Governments should not derail it.

Take a look at and read this article that discusses the cost of capital. What are your thoughts? Elaborate and Explain

Capital for a small business is simply money. It is the financing for the small business or the money used to operate and buy assets. Cost of capital is the cost of obtaining that money or financing for the small business. The cost of capital is also called the hurdle rate.

Should very small businesses even worry about their cost of capital? The answer to that is absolutely yes! Even very small businesses need money to operate and that money is going to cost something. Companies want that cost to be as low as possible.

What is Capital?

Capital is the money businesses use for financing their operations. The cost of capital is simply the rent, or interest rate, it costs the business to obtain financing. In order to understand cost of capital, you must first understand the concept of capital. Capital for very small businesses may just be the supplier credit they rely on. For larger businesses, capital may be the supplier credit and longer term debt or liabilities, which are the firm's liabilities.

If a company is public or takes on investors, then capital will also include equity capital or common stock. Other equity accounts will be retained earnings, paid-in capital, perhaps preferred stock.

Why is Capital Important?

In order to build new plants, buy new equipment, develop new products, and upgrade informationtechnology, businesses have to have money or capital. For every decision like this, a business owner or Chief Financial Officer (CFO) has to decide if the return on the investment is greater than the cost of capital or the cost of the money it takes to invest in the project.

Business owners do not usually invest in new projects unless the return on the capital they invest in these projects is greater than or at least equal to the cost of the capital they have to use to finance these projects. Cost of capital is the key to all business decisions.

What is the Cost of Capital?

A company's cost of capital is simply the cost of money the company uses for financing. If a company only uses current liabilities and long-term debt to finance its operations, then it uses debt and the cost of capital is usually the interest rate on that debt.

If a company is public and has investors, then cost of capital gets more complicated. If the company only uses funds provided by investors, then the cost of capital is the cost of equity. Usually, this type of company has debt but it also finances with equity financing or money that investors supply. In this case, the cost of capital is the cost of debt and the cost of equity.

The combination of debt and equity financing for a company is the company's capital structure.

What is Return on Capital?

Return on capital is the amount of profit you earn out of a business or project as compared to the amount of capital you invested. The key to cost of capital for a company is that a company's return on capital must always equal or exceed the cost of capital for any project in which the firm wants to invest. In other words, the company's investment rate of return (return on capital) must equal or exceed their financing rate of return (cost of capital) in order for the firm to be profitable.

What Composes the Cost of Capital

One component of the cost of capital is the cost of debt financing. For larger businesses, debt usually means large loans or bonds. For very small companies, the debt can mean trade credit. For either, the cost of debt is the interest rate the company pays on debt.

Another component of the cost of capital is the cost of equity financing if your company is a public company; in other words, if you have investors in your company who provide money in exchange for an ownership stake in the company.

There are several components of the cost of equity capital. First, there is the cost of retained earnings or the money that the company invests back into the company, instead of paying outdividends. Next, there is the cost of new common stock or stock that the company issues to raise money. Last, the company may even issue preferred stock to raise money.

For very small firms, the cost of capital may be much simpler. There are advantages and disadvantages to both debt and equity financing, including cost, that any business owner must consider before adding them to the capital structure of the company. Very small firms may just useshort term debt, in which case we have to establish a cost for this capital component.

The Company's Weighted Average Cost of Capital

Once the business owner understands the concepts of capital and cost of capital, the next step is to understand weighted average cost of capital. Each capital component is a certain percentage of the company's capital structure. In order to arrive at the true cost of capital for a business firm, the owner must multiply the percentage of the company's capital structure for each component by the cost of that component and sum them.

Summary of Cost of Capital

Before a company can engage in buying assets or obtaining financing for its operations, it must make some determination of its cost of capital -- what it really costs the firm for the money it has to have to for all its financing. That cost of financing must never exceed its return on capital. Here is a cost of capital video series that you may find helpful. It helps put the return on capital and cost of capital in real world terms for you.

Grand Canyon University

Complete the following problems from the textbook: Chapter 1, P1-2 Chapter 2, P2-4, P2-6, and Integrative Case 1 Follow these instructions for completing and submitting your assignment: Do all work in Excel. Do not submit Word files or *.pdf files. Submit a single spreadsheet file for this assignment. Do not submit multiple files. Place each problem on a separate spreadsheet tab. Label all inputs and outputs and highlight your final answer. Follow the directions in "Guidelines for Developing Spreadsheets."

P1â2 Accrual income versus cash flow for a period Thomas Book Sales, Inc., supplies

textbooks to college and university bookstores. The books are shipped with a proviso

that they must be paid for within 30 days but can be returned for a full refund

credit within 90 days. In 2014, Thomas shipped and billed book titles totaling

$760,000. Collections, net of return credits, during the year totaled $690,000. The

company spent $300,000 acquiring the books that it shipped.

a. Using accrual accounting and the preceding values, show the firmâs net profit for

the past year.

b. Using cash accounting and the preceding values, show the firmâs net cash flow

for the past year.

c. Which of these statements is more useful to the financial manager? Why?

P2â4 Interest versus dividend income During the year just ended, Shering Distributors,

Inc., had pretax earnings from operations of $490,000. In addition, during the year

it received $20,000 in income from interest on bonds it held in Zig Manufacturing

and received $20,000 in income from dividends on its 5% common stock holding in

Tank Industries, Inc. Shering is in the 40% tax bracket and is eligible for a 70% dividend

exclusion on its Tank Industries stock.

a. Calculate the firmâs tax on its operating earnings only.

b. Find the tax and the after-tax amount attributable to the interest income from

Zig Manufacturing bonds.

c. Find the tax and the after-tax amount attributable to the dividend income from

the Tank Industries, Inc., common stock.

d. Compare, contrast, and discuss the after-tax amounts resulting from the interest

income and dividend income calculated in parts b and c.

e. What is the firmâs total tax liability for the year?

P2â6 Capital gains taxes Perkins Manufacturing is considering the sale of two nondepreciable

assets, X and Y. Asset X was purchased for $2,000 and will be sold today for

$2,250. Asset Y was purchased for $30,000 and will be sold today for $35,000. The

firm is subject to a 40% tax rate on capital gains.

a. Calculate the amount of capital gain, if any, realized on each of the assets.

b. Calculate the tax on the sale of each asset.

Merit Enterprise Corp.

Sara Lehn, chief financial officer of Merit Enterprise Corp., was reviewing her

presentation one last time before her upcoming meeting with the board of directors.

Meritâs business had been brisk for the last 2 years, and the companyâs CEO

was pushing for a dramatic expansion of Meritâs production capacity. Executing the

CEOâs plans would require $4 billion in capital in addition to $2 billion in excess

cash that the firm had built up. Saraâs immediate task was to brief the board on options

for raising the needed $4 billion.

Unlike most companies its size, Merit had maintained its status as a private

company, financing its growth by reinvesting profits and, when necessary, borrowing

from banks. Whether Merit could follow that same strategy to raise the $4 billion

necessary to expand at the pace envisioned by the firmâs CEO was uncertain,

although it seemed unlikely to Sara. She had identified the following two options for

the board to consider.

Option 1: Merit could approach JPMorgan Chase, a bank that had served Merit

well for many years with seasonal credit lines as well as medium-term loans. Lehn

believed that JPMorgan was unlikely to make a $4 billion loan to Merit on its own,

but it could probably gather a group of banks together to make a loan of this magnitude.

However, the banks would undoubtedly demand that Merit limit further borrowing

and provide JPMorgan with periodic financial disclosures so that it could

monitor Meritâs financial condition as Merit expanded its operations.

Option 2: Merit could convert to public ownership, issuing stock to the public

in the primary market. With Meritâs excellent financial performance in recent years,

Sara thought that its stock could command a high price in the market and that many

investors would want to participate in any stock offering that Merit conducted.

Becoming a public company would also allow Merit, for the first time, to offer

employees compensation in the form of stock or stock options, thereby creating

stronger incentives for employees to help the firm succeed. On the other hand, Sara

knew that public companies faced extensive disclosure requirements and other regulations

that Merit had never had to confront as a private firm. Furthermore, with

stock trading in the secondary market, who knew what kind of individuals or institutions

might wind up holding a large chunk of Merit stock?

TO DO

a. Discuss the pros and cons of option 1, and prioritize your thoughts. What are the

most positive aspects of this option, and what are the biggest drawbacks?

b. Do the same for option 2.

c. Which option do you think that Sara should recommend to the board, and why?

FINA1221 Lecture Notes - Lecture 2: Market Capitalization, Root Mean Square, Stock Market

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