Business Finance - Accounting Week 7 Assignment- Healthcare Finance

Chapter07UHFM8thEdPPT-1.pptx

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CHAPTER 7 Equity Financing

In the last chapter we covered debt financing. Now, we turn our attention to equity financing, the second major source of capital for healthcare businesses. In addition, we will discuss the process by which businesses raise both debt and equity capital.

Introduction

The second major source of long-term capital is equity financing.

In for-profit (investor-owned) businesses, equity is supplied by owners.

In not-for-profit (NFP) businesses, “equity” (sometimes called fund capital) is supplied by “the community.”

Equity in For-Profit Businesses

For-profit businesses are organized as:

Proprietorships

Partnerships

Corporations

Hybrid forms

Although all of these forms use equity financing, we will assume the corporate form in our discussion, so we will focus on stockholders (shareholders) as owners.

Stockholders’ Rights and Privileges

Claim on residual earnings

Net income “belongs” to shareholders.

Some portion may be paid out as dividends.

Control of the firm

Proxy fight

Hostile takeover

Poison pill

Preemptive right

The Market for Common Stock

Privately held stock is normally held by founders and managers and is not traded in an organized market.

Publicly held stock is traded:

In the over-the-counter (OTC) market (NASDAQ).

On stock exchanges (listed stock), primarily the New York Stock Exchange (NYSE).

Advantages of Going Public

Permits founder diversification

Increases liquidity

Facilitates raising new equity capital

Establishes a market value for the business

Disadvantages of Going Public

Cost of reporting

Disclosure requirements

Self-dealings are restricted

Inactive market / low price

Control

The Decision to List

Listing a stock on an exchange moves trading from the OTC market.

Exchanges set higher minimum requirements for size, number of shareholders, and number of shares held by outsiders (float).

Historically, listing has been perceived to be of value to the firm and its stockholders, although more and more large companies are electing to remain on the OTC market.

Stock Market Transactions

Initial public offerings (IPOs) occur when shares of a privately held company are sold to the public for the first time. (The company “goes public.”)

The primary market is used when new (additional) shares are sold by publicly owned companies.

Share sales between individuals take place in the secondary market. The company receives no capital from these transactions.

Methods Used by Corporations to Sell New (Non-IPO) Shares of Common Stock

Rights offering

Public offering

Private placement

Employee stock purchase plan

Dividend reinvestment plan (DRIP)

Direct purchase plan

Advantages of Common Stock Financing

No fixed (interest) charges

No maturity date

Creates additional debt capacity

May be easier to sell than debt

Disadvantages of Common Stock Financing

Dilutes control

May dilute value

Issuance costs are high

Negative signaling

Equity in Not-For-Profit Businesses

NFP businesses must have “equity” capital, but it is not supplied by stockholders.

Start-up equity typically comes from:

Religious organizations

Governmental entities

Ongoing equity comes from:

Profits

Contributions

Grants

Which of the following statements is most correct?

Only investor-owned corporations can retain earnings.

Charitable contributions to investor-owned corporations are tax-deductible.

Restricted charitable contributions can only be used for the designated purpose.

Only not-for-profit corporations can qualify for government grants.

Equity in a not-for-profit corporation is called “fund capital” while equity in an investor-owned corporation is called “net assets.”

Self-Check

Common Stock Valuation

For valuation, for-profit businesses can be classified into three categories:

Start-up businesses, which can be valued (roughly) using option pricing models.

Young businesses, which can be valued on the basis of their expected operating cash flows (see chapter 16).

Mature businesses, which can be valued on the basis of their expected dividend stream. We will illustrate the dividend valuation model here.

Common Stock Valuation (cont.)

In the dividend valuation model, the value of a share of stock is estimated by the present value of the expected cash flow stream to shareholders.

In general, this stream consists of dividends and a future selling price.

But regardless of the holding period, a share of stock can be valued solely on the basis of its future dividend stream.

Why?

Dividend Valuation Model



R(R)

E(D1)

E(D)

E(D2)

...

PV E(D1)

PV E(D2)

PV E(D)

Value = E(P0)

What’s the problem in implementing this model?

Constant Growth Model

If dividends are expected to grow at a constant rate forever, then the general stock valuation model can be simplified to this form:

E(P0) =

E(D1)

R(Rs) - E(g)

D0 x [1 + E(g)]

R(Rs) - E(g)

Constant Growth Model (cont.)

E(P0) is the value of the stock. (P0 is the current price.)

E(g) is the expected constant dividend growth rate.

R(Rs) is the stock’s required rate of return.

D0 is the last dividend paid (assumed to be paid yesterday).

E(D1) is the next expected dividend (assumed to be received in one year).

Which of the above input variables are most uncertain?

Constant Growth Model (cont.)

Four assumptions are necessary for the constant growth model:

E(g1) = E(g2) = E(gN) = E(g)

R(Rs)  E(g)

The last dividend was just paid yesterday.

Dividends are paid annually.

Are these assumptions realistic?

Assume b = 1.5, RF = 7%, and R(RM) = 13%. What is the required rate of return on the stock?

R(Rs) = RF + [R(RM) - RF] x b

= 7% + (13% - 7%) x 1.5

= 7% + (6% x 1.5)

= 16.0%

Use the SML to calculate R(Rs):

If D0 = $1.82 and E(g) = 10%, what is the stock’s value?

E(P0) =

D0 x [1 + E(g)]

R(Rs) - E(g)

$1.82 x 1.10

0.16 - 0.10

= = $33.33

$2.00

0.06

Constant Growth Model (cont.)

Dividend growth is primarily caused by:

Inflation

Earnings retention

Note that the model can be used when E(g)= 0 (zero growth) or when growth is negative.

What happens to the constant growth model when E(g) = 0?

Rate of Return Form

of the Constant Growth Model

The constant growth model can be rearranged as follows:

E(Rs) = + E(g)

E(D1)

= + E(g)

D0 x [1 + E(g)]

If P0 = $33.33, E(D1) = $2.00, and E(g) = 10%, what is the stock’s expected rate of return?

E(Rs) = + E(g)

E(D1)

= + 10.0%

$2.00

$33.33

= 6.0% + 10.0% = 16.0%

What is the expected stock price (value) at the end of Year 1?

E(P1) =

D1 x [1 + E(g)]

R(Rs) - E(g)

$2.00 x 1.10

0.16 - 0.10

= = $36.67

$2.20

0.06

Find the dividend yield, capital gains yield, and total return expected during the first year of stock ownership.

DY = = = 6.0%

E(D1)

$2.00

$33.33

CGY = = 10.0%

$36.67 - $33.33

$33.33

Total return = DY + CGY

= 6.0% + 10.0% = 16.0%

Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is correct?

The two stocks must have the same dividend per share.

If one stock has a higher dividend yield, it must also have a lower dividend growth rate.

If one stock has a higher dividend yield, it must also have a higher dividend growth rate.

The two stocks must have the same dividend growth rate.

The two stocks must have the same dividend yield.

Self-Check

E(P0) = D0 x ([1+ E(g)]

R(Rs) – E(g)

Two stocks with the same expected price and required rate of return:

Self-Check

If the two stocks have the same expected price and required rate of return but one has a higher dividend yield, then it must have a lower expected growth rate.

Constant Growth Stock Conditions

The dividend is expected to grow at a constant rate forever.

The stock price is expected to grow at the same rate.

The expected dividend yield is constant over time.

The expected capital gains yield is a constant equal to the growth rate.

Nonconstant Growth Model

Clearly, most “real world” stocks do not exhibit constant growth.

A somewhat more complicated model is required to value such stocks.

However, because of the uncertainties in the inputs required for stock valuation, the constant growth model is useful for many mature firms.

Security Market Equilibrium

Investors will buy a security when its:

Expected rate of return exceeds the required rate of return.

Value exceeds the current price.

In equilibrium:

E(Rs) = R(Rs)

P0 = E(P0)

In efficient markets, buying and selling actions continuously move security prices toward equilibrium.

Informational Efficiency

A market is informationally efficient if:

Relevant information can be easily obtained at low cost.

The market contains many buyers and sellers who act on the information.

The theory of market efficiency has profound implications for both investors and businesses.

Implications of Market Efficiency

Prices reflect all publicly available information.

Investors should not expect to “beat the market.”

In the short run, expect to earn average returns for the risk assumed.

In the long run, expect only to earn returns commensurate with the risk assumed.

Managers with no private (inside) information should not question the “correctness” of securities prices (or interest rates).

Why might the major stock and bond markets be efficient?

Major financial firms, such as Merrill Lynch, Fidelity Investments, and Prudential Insurance, have thousands of well qualified analysts with immediate access to information along with billions of dollars to invest.

Thus, new information is almost instantaneously reflected in current prices.

What Markets Are Efficient?

In general, the markets for the stocks and bonds of large companies and for Treasury securities are efficient.

However, there is evidence that “pockets of inefficiency” exist and that “emotional excesses” can distort values.

The markets for real assets (real estate, buildings, and so on) are not efficient.

What evidence supports stock market efficiency?

Risk/Return Trade-Off

In efficient markets, the only way to obtain a higher return is to assume more risk.

Consider the following investment alternatives:

The stock of Tenet Healthcare

The bonds of Tenet Healthcare

Which offers the higher expected rate of return? Why?

Which of the following statements is most correct?

If your uncle earns a return higher than the overall stock market, this means the stock market is inefficient.

If your uncle has information about past stock prices, he should be able to profit from this information in a weak-form efficient market.

If your uncle has insider information about a publicly traded company, he should be able to profit from this information in a strong-form efficient market.

If your uncle has information from an article in the Wall Street Journal, he should be able to profit from this information in a semi-strong form efficient market.

None of the answers above is correct.

Self-Check

In for-profit businesses, equity is supplied by owners. In not-for-profit businesses, equity (or fund capital) is supplied by “the community.”

The value of a stock whose dividends are expected to grow at a constant rate for many years is found by applying the constant growth model.

The efficient markets hypothesis holds that (1) stocks are always in equilibrium and fairly valued, (2) it is impossible for an investor to consistently beat the market, and (3) managers should not try to forecast interest rates or time security issues.

Three Key Learning Points

CHAPTER 7 EXTENSION

This chapter extension focuses on classified stock, preferred stock, securities regulation, and the investment banking process.

Types of Common Stock

Most firms issue only one type of common stock, but some firms use multiple types, called classified stock.

Generally called Class A and Class B, but these classifications do not have standard meanings.

An example is a corporation with both founders shares and regular shares.

Preferred Stock

Preferred stock is a hybrid form of capital; accountants treat it as equity but it creates a fixed charge like debt.

It has a par (face) value.

The dividend usually is stated as a percent of par value.

Preferred stock dividends must be paid before common stock dividends can be paid.

Preferred stock generally carries no voting or ownership rights.

Advantages of Preferred Stock

Omitting (passing) a dividend cannot force bankruptcy.

Preferred stock avoids dilution of common stock and hence does not require more sharing of control.

Preferred stock typically has longer maturities than debt, so the principal repayment is “pushed out.”

Disadvantages of Preferred Stock

Unlike interest, preferred dividends are not tax deductible, so the after-tax cost of preferred is higher than on debt.

Although dividends can be passed, bad consequences often occur.

Unpaid dividends accrue as arrearages.

Common dividends cannot be paid.

Preferred stockholders often get a seat (or more) on the board.

The company is perceived as being riskier, so capital costs rise.

Preferred Stock Valuation

Preferred stock dividends are perpetuities (but typically callable):

E(Rp) = Dp / Pp

where

E(Rp) = expected rate of return

Dp = preferred dividend

Pp = price of preferred stock

Regulation of Securities Markets

Markets are regulated by the SEC, the Federal Reserve Board, and state commissions.

Key features of regulation:

New issues must be registered.

Investors must be given a prospectus.

Goals of regulation:

Ensure investors have accurate information.

Prevent market manipulation.

Reduce insiders’ advantage.

The Investment Banking Process

Investment banks (such as Bank of America Merrill Lynch and Goldman Sachs) assist businesses in issuing securities.

The procedures followed when businesses (including NFPs) issue new securities is called the investment banking process.

What securities do NFPs issue?

Stage I Decisions

Dollars to be raised

Type of securities used

Competitive bid versus negotiated deal

Selection of an investment banker

Stage II Decisions

Reevaluating the initial (Stage 1) decisions

Contractual basis of sale

Best efforts

Underwritten issue

Banker’s compensation and other expenses

Setting the offering price

Registration statement and prospectus

Underwriting syndicates

The larger the issue, the greater the number of underwriters

Unsyndicated stock offerings

Shelf registrations

Selling Procedures

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Sheet1

	Stock A	Stock B
D0	$1.82	$2.47
E(g)	10%	8%
R(Rs)	16%	16%
E(P0)	$33.37	$33.37
Div yield	6%	8%

Business Finance - Accounting Week 7 Assignment- Healthcare Finance

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