Stockholders' Equity: Classes of Capital Stock

Read this chapter, which introduces long-term bonds, their value, how they compare with stock. Some companies expand using stock, while some use debt (bonds). The example exercises refer to Appendix A, which is included here.

Analyzing and using the financial results – Times interest earned ratio

The times interest earned ratio (or interest coverage ratio) indicates the ability of a company to meet required interest payments when due. We calculate the ratio as follows:

\text { Time interest earned ratio }=\frac{\text { Income before interest also taxes }(\text { IBIT })}{\text { Interest expense }}

Income before interest and taxes (IBIT), also called "earnings before interest and taxes (EBIT)", is the numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. To find IBIT when the income statement is not complex, take net income and add back interest expense and taxes. However, in complex situations, when there are discontinued operations, changes in accounting principle, extraordinary items, interest revenue, and/or other similar items, analysts often use "operating income" to represent IBIT. The higher the ratio, the more comfortable creditors feel about receiving interest payments in the future.

An ethical perspective:
Rawlings furniture company

The Rawlings brothers inherited 300,000 shares (30 percent) of the common stock of the Rawlings Furniture Company from their father, who had founded the company 55 years earlier. One brother served as president of the company, and the other two brothers served as vice presidents. The company, which produced a line of fine furniture sold nationwide, earned an average of USD 4 million per year. Located in Jamesville, New York, USA, the company had provided steady employment for approximately 10 percent of the city's population. The city had benefited from the revenues the company attracted to the area and from the generous gifts provided by the father.

The remainder of the common stock was widely held and was traded in the over-the-counter market. No other stockholder held more than 4 percent of the stock. The stock had recently traded at USD 30 per share. The company has USD 10 million of 10 percent bonds outstanding, which mature in 15 years.

The brothers enjoyed the money they received from the company, but did not enjoy the work. They also were frustrated by the fact that they did not own a controlling interest (more than 50 percent) of the company. If they had a controlling interest, they could make important decisions without obtaining the agreement of the other stockholders

With the assistance of a New York City brokerage house, the brothers decided to pursue a plan that could increase their wealth. The company would offer to buy back shares of common stock at USD 40 per share. These shares would then be canceled, and the Rawlings brothers would have a controlling interest. The stock buy-back would be financed by issuing 10-year, 14 percent, high-interest junk bonds. The brokerage house had located some financial institutions willing to buy the bonds. The interest payments on the junk bonds would be USD 3 million per year. The brothers thought the company could make these payments unless the country entered a recession. If need be, wage increases could be severely restricted or eliminated and the company's pension plan could be terminated. If the junk bonds could be paid at maturity, the brothers would own a controlling interest in what could be an extremely valuable company. If the interest payments could not be met or if the junk bonds were defaulted at maturity, the company could eventually be forced to liquidate. The risks are high, but so are the potential rewards. If another buyer entered the picture at this point and bid an even higher amount for the stock, the brothers could sell their shares and exit the company. Two of the brothers hoped that another buyer might bid as much as USD 50 per share so they could sell their shares and pursue other interests. The changes a new buyer might make are unpredictable at this point.

The times interest earned ratios in a recent year for several companies (described in footnotes to the table) were as follows:

Company Earnings beforeInterest and Taxes (millions) Interest Expense (Millions) Times Interest Earned Ratio
Ford Mother Companya $19,136 $10,902 1.76
Proctor & Gamble Companyb 6,258 722 8.67
AMR Corporationc 1,754 467 3.76
Dell Computer Corporationd 3,241 47 68.96
Hewlett-Packard Companye 4,882 257 19.00

a Ford Motor Company is the world's largest producer of trucks and the second largest producer of cars and trucks combined.
b Proctor and Gamble markets more than 300 brands to nearly five billion customers in over 140 countries.
c AMR's principal subsidiary is America Airlines.
d Dell is the world's largest direct computer systems company.
e Hewlett-Packard Company designs, manufactures, and services products and systems for measurement, computation, and communications.

You can see from these data that a great deal of variability exists in the times interest earned ratios for real companies. To judge the ability of companies to pay bond interest when due, bondholders would carefully examine other financial data as well.

Some companies that issued high-interest junk bonds in the 1980s defaulted on their interest payments and had to declare Chapter 11 bankruptcy or renegotiate payment terms with bondholders in the 1990s. Other companies with high-interest bonds issued new low-interest bonds and used the proceeds to retire the highinterest bonds.

Chapter 16 discusses the fourth major financial statement – the statement of cash flows, which we mentioned in Chapter 1. This statement shows the cash inflows and outflows from operating, investing, and financing activities.