You should make original posts discussing any three of the following statements.

Question

You should make original posts discussing any three of the following statements.

Explain how the use of leverage can increase the shareholder’s wealth.

Leverage can also impact you in your personal life. Explain how you can use it to your advantage.

In theory, what happens to the shareholder’s worth before and after he/she receives a dividend from the company.

What are the advantages of stock repurchases versus paying dividends?

What is the impact of a stock split on the value of a corporation? Why do companies do stock splits?

What is the difference between a stock dividend and a stock split?

If a company is highly leveraged from an operating standpoint is it more likely or less likely to use financial leverage? Why or why not?

Explanation / Answer

1

Leverage is the strategy of using borrowed money to increase return on an investment. If the return on the total value invested in the security (your own cash plus borrowed funds) is higher than the interest you pay on the borrowed funds, you can make significant profit or increase the shareholder's wealth.

Example : Let’s say we have $100 of our own money, and we can borrow $1500 from the bank at an interest rate of 6%. Let’s say we invest the entire $1600 amount in an investment, which we are confident will grow 15% in a year, and return the borrowed money plus interest at the end of a year.

The value of the investment will be 1600 + 15% * 1600 = $ 1600 + $ 240 = $1840 at the end of the year and

We will pay the bank back $1500 + 6%* 1500 = $ 1500 + $90 = $1590,

leaving us with a total of $250 ( $ 1840 - $ 1590) and a net gain of $150 ( $ 250 - $100) once we subtract the initial $100 we invested.

ROI = 150/100 * 100 = 150% return!

Leverage measures a firm's efficiency at generating profits from every unit of shareholders' equity. ... At an ideal level of financial leverage, a company's return on equityincreases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.

2

The standard way to accomplish leverage is through borrowing, via debt and equity, to invest at a much higher scale than one’s current assets would allow. In order to borrow substantial amounts of capital, firms must pursue a variety of financial sourcing and be able to back up their debts with valuable assets ( collateral ).

We borrow to buy our homes, we borrow to buy depreciating assets like cars. Leveraging can be incredibly productive when it is understood and used properly. When used properly, leverage can be an amazing tool to build wealth.

3

Shareholder’s worth before and after he/she receives a dividend from the company depends on type of dividend - cash dividend or stock dividend

Stockholders' equity, also called owners' equity, is the surplus of a company's assets over its liabilities.

Cash dividends reduce stockholders' equity by distributing excess cash to shareholders. Cash and Retained Earnings decrease leading to decrease in Shareholder's equity

Stock dividends distribute additional shares to shareholders and do not affect the balance of stockholders' equity.

4 Stock Repurchase versus Dividend

A share repurchase refers to the purchase by a company of its shares from the marketplace. The biggest benefit of a share repurchase is that it reduces the number of shares outstanding for a company. This usually increases per-share measures of profitability like earnings-per-share (EPS) and cash-flow-per-share, and also improves performance measures like return on equity. These improved metrics will generally drive the share price higher over time, resulting in capital gains for the shareholders. However, these profits will not be taxed until the shareholder sells the shares and crystallizes the gains made on the shareholdings.

A firm’s dividend policy has the effect of dividing its net earnings into two parts: retained earnings and dividends. The retained earnings provide funds to finance the firm’s long-term growth.

It is one of the most significant sources of financing for the firm in terms of raising funds to undertake investments. Dividends are generally paid in cash. Thus the distribution of earnings uses the available cash funds of the firm. The net result of the declaration and payment of the dividend is that the corporation's assets and stockholders' equity decreases. Specifically, the balance sheet accounts Cash and Retained Earnings decrease.

In recent decades, a fundamental shift away from dividends has developed. Partly responsible is the U.S. tax code, which charges an additional 15% tax on dividends paid out to shareholders.

As a result, high profile boards made the decision to return excess capital to shareholders by repurchasing stock and destroying it, resulting in fewer shares outstanding and giving each remaining share a larger percentage ownership in the business.

5 Stock Split

A stock split occurs when a company feels its stock is above the popular price range for their stock. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (a regular lot = 100 shares). Companies tend to want to keep their stock price within an optimal trading range.

The company uses the split to bring the stock price into the desired range. The value of the corporation will remain the same. Stock splits increase the number of shares outstanding and reduce the par or stated value per share of the company's stock.

Say there are one million shares outstanding and the company's initial equity value is $60 million ($60 per share x 1 million shares outstanding). The company initiates initiates a 2-for-1 stock split. For each share they own, all holders of stock will receive two shares priced at $30 each, and the company's shares outstanding will double. The equity value after the split is still $60 million ($30 per share x 2 million shares outstanding).

6 Stock Dividend and Stock Split

Companies that are pursuing growth will want to keep any cash they have to invest in the company. In this case, a stock dividend is issued. A stock dividend occurs when the company uses the amount of money that would be paid as a cash dividend to purchase additional common shares for the shareholder. As a result, a company's shares outstanding will increase, and the company's stock price will decrease.
A stock dividend is issued to keep earnings in the company and make the company more valuable in the future. When a company is considered more valuable, stock prices rise.

A stock split occurs when a company feels its stock is above the popular price range for their stock. The company uses the split to bring the stock price into the desired range. A stock split happens when a company issues two or more new shares for every existing share an investor holds.A stock split is performed because a company's stock is outperforming the company's goals. Because a company does not want to encourage speculative bubbles that cannot be sustained by the market, it uses a stock split to decrease the price of stock and bring it into a more acceptable price range.

7

Financial leverage = Total Debt / ShareholdersEquity

The ratio between debt and equity is a strong sign of leverage. Equity is ownership of the organization and pays out fairly significant dividends. Debt is often lower cost access to capital, as debt is paid out before equity in the event of a bankruptcy (thus debt is intrinsically lower risk for the investor).

Leverage is exponentially more risky the more it is utilized. A useful way to view leverage is the overall existing assets of an organization compared to the amount of money they owe.

At an ideal level of financial leverage, a company’s return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.

If earnings before interest and taxes are greater than the cost of financial leverage than the increased risk of leverage will be worthwhile.

However, if a company is financially over-leveraged a decrease in return on equity could occur. Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments. If the risk of the investment outweighs the expected return, the value of a company’s equity could decrease as stockholders believe it to be too risky. So a company which is highly leveraged from an operating standpoint is less likely to use financial leverage.

When evaluating the riskiness of leverage it is also important to factor in the value of the company itself and its activities. If a company borrows money to modernize, add to its product line, or expand internationally, the additional diversification will likely offset the additional risk from leverage. The upshot is, if value is expected to be added from the use of financial leverage, the added risk should not have a negative effect on a company or its investments.

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