Text 5 Leverage

When part of a firm's capital is raised through preferred stocks and bonds, fluctuations in total earnings have a magnified effect on the income of common stockholders. This phenomenon called leverage arises because preferred stocks and bonds are fixed income securities. Leverage is best illustrated by example. Suppose a corporation's ownership equity of $10 million consists entirely of 100,000 shares of common stock. Since they are not fixed income securities, earnings per common share vary exactly in proportion to total earnings. Total earnings of $500,000 would be $5 per share. If total earnings doubled to $1 million, earnings per common share would likewise double to $10. If earnings shrank 80 percent from $500,000 to 100,000, earnings per common share would likewise decline 80 percent from $5 to $1.

Now suppose, however, the same corporate ownership consists of 5 million of 5 percent preferred stock and $5,000,000 divided into 50,000 shares of common stock. Regardless of total earnings, the preferred stock is entitled to dividends of $0,05 × 5 million or $ 250,000. This fixed income gives leverage to the common stock. Thus, when total earnings are $500,000, preferred stockholders receive $250,000, leaving $250,000, or $5 per share of common stock, just as before. But when total earnings double to $1,000,000, the leverage provided by the fixed income securities triples the earnings per common stock share. Preferred stockholders still get only their $250,000, leaving earnings of $750,000, or $15 per share, to the common stock. Unfortunately, leverage also works when earnings decline. Should total earnings fall to $100,000, preferred stockholders would still be entitled to their fixed $250,000. This would leave common stockholders a loss of $ 150,000, or $3 per share, despite the positive total earnings made by the company.

Discussion

These are some helpful word-combinations to translate, memorise and use while discussing the texts.

To transfer shares, to sell/buy stock, to make (good) profits, to sustain losses, to tap capital, to raise funds/ capital, to issue bonds, to pay an interest rate, to repay principal, to carry dividends, to forego the chance of, to recover equity, to borrow money, to benefit from, to give up the chance of, to declare dividends, to be entitled to.

1. Now you know the main kinds of securities. Explain the difference between common stock, preferred stock and bonds. What is their role in organisation of the corporation?

2. What shares of what enterprises of your town would you buy? Give your reasons.

3. Your business is going to raise funds by borrowing. What should you do for that? Would you like to be a securities dealer? What should you know to become a dealer?

Дата добавления: 2015-11-16