For the Investor Chapter 9 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #2 The use of debt is referred to as financial leverage Interest as related to debt financing –A contractual obligation –Must be paid regardless of entity’s current profits Contrast with dividends which are discretionary –Interest is tax deductible Reduces taxable income Reduces income tax Financial Leverage © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #3 Net income increase [A] is greater than change in EBIT [B] due to the fixed nature of interest expense Definition of Financial Leverage and Magnification Effects © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #4 Computation of the Degree of Financial Leverage The degree of financial leverage is the multiplication factor by which the net income changes in respect to changes in EBIT A more simple formula for degree of financial leverage © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #5 Computation of the Degree of Financial Leverage (cont’d) Degree of financial leverage calculations should exclude –Noncontrolling interest –Equity income –Nonrecurring items The all-inclusive formula for degree of financial leverage © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #6 Earnings per Share Required disclosure for corporate income statements Pertains only to common stock Per-share amounts are disclosed for –Income from recurring items –Discontinued operations –Extraordinary items –Net income © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #7 Earnings per Share Earnings pertain to an entire fiscal period Average common shares outstanding is used for parity of information Current guidelines require basic and diluted earning per share presentation. - Diluted earning per share is calculated the same as basic plus the dilutive effect of potentially dilutive securities © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #8 Weighted Average Common Outstanding Stock dividends and stock splits –Retroactive recognition to all comparative data © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #9 Simple capital structure Complex capital structure contains potentially dilutive securities: –Options, rights, warrants –Convertible debt –Convertible preferred equity –Contingent shares Earnings Per Share and Capital Structure © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #10 Price/Earnings Ratio Measures the relationship between the market price of a share of common stock and that stock’s current earnings per share –Use of diluted earnings per share gives more conservative price/earnings ratio © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #11 Price/Earnings Ratio (cont’d) Compare with –Industry competitors –Industry average –Exchange (e.g., NYSE) average Interpretation –High-growth-potential firms have higher P/E ratios –P/E ratio is a function of the market © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #12 Percentage of Earnings Retained Reflects the proportion of current earnings retained for internal growth Trend analysis is improved by exclusion of nonrecurring items Higher percentage typically found in –New firms –Growing firms and firms perceived as growth firms © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #13 Dividend Payout Measures the portion of current earnings per common share being paid out in dividends A stable dividend policy is developed by consideration of recurring earnings Lower payout typically found in –New firms –Growing firms and firms perceived as growth firms © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #14 Dividend Yield Indicates the relationship between the dividends per common share and the market price per common share The yield is a function of –The firm’s dividend policy –Market price © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #15 Book Value per Share Preferred equity should be measured at liquidation value, if available Market value vis-à-vis book value –Book value reflects past unrecovered asset costs –Market value reflects the potential of the firm © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #16 Stock Options Stock option fair value –Expensing is required per SFAS 123R Allocate option fair value to the service period –Date of grant through vesting date Noncompensatory plans –Encourage widespread ownership by employees –Slight discount from fair value –No compensation expense is recognized © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #17 Impact of Stock Option Expense © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #18 Restricted Stock Sometimes offered to employees in lieu of stock option plans Restrictions –Employee cannot sell stock for a specified period of time –Employee may forfeit the shares if they leave employer –Awards may be linked to financial goals © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #19 Stock Appreciation Rights Employee receives compensation in cash or stock –Difference between option price and market price Expense is a function of market price –Year-end spread is measured –Current expense is spread minus prior recognition © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 9, Slide #20 May be awarded through the use of –Stock options –Restricted stock –Stock appreciation rights Firms vary in their use of these methods of granting stock-based compensation –Select a single method –Use two of the three methods –Use all three in combination Stock-Based Compensation © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.