Electronic Presentation by Douglas Cloud Pepperdine University Chapter 11 Stockholders’ Equity: Capital Stock and Dividends Electronic Presentation by Douglas Cloud Pepperdine University

After studying this chapter, you should be able to: Learning Goals 1. Describe the nature of the corporate form of organization. 2. List the major sources of paid-in capital, including the various classes of stock. 3. Describe the financial statement effects of issuing stock. 4. Describe the financial statement effects of treasury stock transactions. After studying this chapter, you should be able to: Continued

Learning Goals 5. Describe the effect of stock splits on the financial statements. 6. Analyze the impact of issuing common stock on bonds. 7. Describe the financial statement effects of cash dividends and stock dividends. 8. Compute and interpret the dividend yield and dividend payout ratio on common stock. 9. Describe financial statement presentations of stockholders’ equity.

Learning Goal 1 Describe the nature of the corporate form of organization.

Characteristics of a Corporation Advantages Separate legal existence Continuous life An ability to raise large amounts of capital Owners can transfer ownership rights without affecting the corporation Limited liability

Characteristics of a Corporation Disadvantages Owner is separate from management Double taxation of dividends

Organizational Structure of a Corporation Stockholders (owners of corporation stock) Board of Directors (elected by stockholders) Officers (selected by board of directors) Employees

Forming a Corporation First step is to file an application of incorporation with the state. Because state laws differ, corporations often organize in states with more favorable laws. More than half of the largest companies are incorporated in Delaware. State grants a charter or articles of incorporation which formally create the corporation. Management and board of directors prepare bylaws which are operation rules and procedures.

Learning Goal 2 List the major sources of paid-in capital, including the various classes of stock.

Major Rights that Accompany Ownership of a Share of Stock 1. The right to vote in matters concerning the corporation. 2. The right to share in distribution of earnings. 3. The right to share in assets on liquidation.

Sources of Paid-In Capital Authorized Issued Outstanding Number of Shares

Market for Common Stock Types of stock market transactions An initial public offering (IPO) Additional shares sold by an established public company Market exchanges between owners of a publicly held company

Classes of Stockholders The two primary classes of paid-in capital are common stock and preferred stock. The primary attractiveness of preferred stocks is that they are preferred over common as to dividends. Preferred stockholder

Classes of Stockholders Common Stock – the basic ownership of stock with rights to vote in election of directors, share in distribution of earnings, and purchase additional shares. Preferred Stock – A class of stock with preferential rights over common stock in payment of dividends and company liquidation.

Cumulative Preferred Stock So, preferred dividends are two years in arrears. Assume 1,000 shares of $4 cumulative preferred stock and 4,000 shares of common stock. No dividends have been paid in the preceding two years.

Cumulative Preferred Stock On March 7, 2005, the board of directors declares dividends of $22,000.

Cumulative Preferred Stock Preferred Stock Dividends Dividends Paid in 2005 Total dividends paid, $22,000 $4,000 2003 (In arrears) $4,000 $10,000 $4,000 2004 (In arrears) $4,000 $4,000 2005 (Current dividend) $4,000 Preferred Stock Common Stock

Learning Goal 3 Describe the financial statement effects of issuing stock.

Issuing Stock A corporation issues 5,000 shares of preferred stock, $100 par, and 50,000 shares of common stock, $20 par. Cash 1,500,000 Preferred Stock 500,000 Common Stock 1,000,000

Premium on Stock Stock issued for assets other than cash should be recorded at the fair market value of the asset or fair market value of the stock, whichever can be more clearly determined. FAIR VALUE

Premium on Stock Caldwell Company issues 2,000 shares of $1 par common stock for cash at $55. Cash 110,000 Common Stock 2,000 Paid-in Capital in Excess of Par—Common Stock 108,000

Premium on Stock Archer Company issues 10,000 shares of its $10 par preferred stock for land. The land’s fair market value cannot be determined and the stock has a current market value of $12 per share. 10,000 x $12 Land 120,000 Preferred Stock 100,000 Paid-in Capital in Excess of Par—Preferred Stock 20,000

No-Par Common Stock Also, no-par stock may be assigned a stated value per share. The stated value is recorded like a par value.

No-Par Common Stock Fargo Company issues 10,000 shares of its no-par common stock at $40 a share, and at a later date issues 1,000 additional shares at $36. Cash 400,000 Common Stock 400,000 Cash 36,000 Common Stock 36,000

No-Par Common Stock Some states require that the entire proceeds from the sale of no-par stock be treated as legal capital.

No-Par Common Stock Fargo Company issues 10,000 shares of its no-par common stock at $40 a share, and at a later date issues 1,000 addition shares at $36. The stated value is $25 per share. Cash 36,000 Common Stock 25,000 Paid-In Capital in Excess of Stated Value 11,000 Cash 400,000 Common Stock 250,000 Paid-In Capital in Excess of Stated Value 150,000

Learning Goal 4 Describe the financial statement effects of treasury stock transactions.

Treasury Stock Transactions Occasionally, a corporation buys back its own stock for the purpose of later reissuing it. This stock is referred to as treasury stock.

Treasury Stock Transactions Earlier, Elrod Corporation issued 20,000 shares of its $25 par common stock at $32.50 a share. Elrod repurchased 1,000 shares as treasury stock at $45 per share. Treasury Stock 45,000 Cash 450,000 Continued

Treasury Stock Transactions Later, 200 shares of the treasury stock were resold for $60 per share. Cash 12,000 Treasury Stock 9,000 Paid-In Capital from Sale of Treasury Stock 3,000 Continued

Treasury Stock Transactions Later, another 200 shares of the treasury stock are for $40 per share. Cash 8,000 Paid-In Capital from Treasury Stock 1,000 Treasury Stock 9,000 Remember: Treasury stock is not an asset!

Treasury Stock Transactions Stockholders’ Equity Paid-in capital: Common stock, $25 par (20,000 shares authorized and issued) $500,000 Excess of issue price over par 150,000 From sale of treasury stock 2,000 Total paid-in capital $652,000 Retained earnings 130,000 Total $782,000 Deduct treasury stock (600 shares at cost) 27,000 Total stockholders’ equity $755,000 Debit balance of Treasury Stock account.

Learning Goal 5 Describe the effect of stock splits on the financial statements.

Stock Splits A corporation sometimes reduces the par or stated value of their common stock and issues a proportionate number of additional shares. This is called a stock split.

Stock Splits 20 shares, $20 par AFTER 5-1 STOCK SPLIT BEFORE STOCK SPLIT 4 shares, $100 par $400 total par value $400 total par value

Learning Goal 6 Analyze the impact of issuing common stock or bonds.

Common Stock Financing Earnings before interest and taxes—base case (EBIT) $1,220,000 Return on investment (12% x $1,500,000) 180,000 Earnings before taxes $1,400,000 Income tax (@ 40%) 560,000 Net income $ 840,000 Base number of shares outstanding 500,000 Plus additional shares issued 100,000 Total shares outstanding 600,000 Earnings per share (EPS) $1.40

Bond Financing Earnings before interest and taxes—base case (EBIT) $1,220,000 Return on investment (12% x $1,500,000) 180,000 Interest on bonds (10% x $1,500,000) (150,000) Earnings before taxes $1,250,000 Income tax (@ 40%) 500,000 Net income $ 750,000 Base number of shares outstanding 500,000 Total shares outstanding 500,000 Earnings per share (EPS) $1.50

No Financing Earnings before taxes $1,220,000 Income tax (@ 40%) 488,000 Net income $ 732,000 Base number of shares outstanding 500,000 Total shares outstanding 500,000 Earnings per share (EPS) $1.464

Learning Goal 7 Describe the financial statement effects of cash dividends and stock dividends.

Accounting for Cash Dividends Cash dividends are declared and paid on shares outstanding with three conditions: 1. Sufficient retained earnings 2. Sufficient cash 3. Formal action by the board of directors Retained Earnings 50,000

Accounting for Cash Dividends There are three important dates relating to dividends.

Accounting for Cash Dividends First is the date of declaration. Assume that on December 1, Hiber Corporation declares a $42,500 dividend.

Accounting for Cash Dividends Date of Declaration Dec. 1 Retained Earnings 42,500 Cash Dividends Payable 42,500

Accounting for Cash Dividends The second important date is the date of record. For Hiber Corporation, this would be December 11.

Accounting for Cash Dividends On this date, ownership of shares determines who receives the dividend. No entry is required.

Accounting for Cash Dividends Date of Declaration Dec. 1 Retained Earnings 42,500 Cash Dividends Payable 42,500 Date of Record No entry

Accounting for Cash Dividends The third important date is the date of payment. On January 2, Hiber issues dividend checks. 2

Accounting for Cash Dividends Date of Declaration Dec. 1 Retained Earnings 42,500 Cash Dividends Payable 42,500 Date of Record No entry Date of Declaration Jan. 2 Cash Dividends Payable 42,500 Cash 42,500

Accounting for Stock Dividends A distribution of shares to stockholders is called a stock dividend.

Accounting for Stock Dividends Stock dividends transfer pro rata shares of stock to stockholders. On December 15, Hendrix Corporation issues a 5% stock dividend on common stock, $20 par, 2,000,000 shares issued.

Hendrix Corporation, December 15 (before dividend) Accounting for Stock Dividends Hendrix Corporation, December 15 (before dividend) Common Stock, $20 par $40,000,000 Paid-in Capital in Excess of Par--Common Stock 9,000,000 Retained Earnings 26,600,000 Dec. 15 Retained Earnings 3,100,000 Stock Dividend Distributable 2,000,000 Paid-In Capital in Excess of Par— Common Stock 1,100,000 100,000 shares x $31 market price 100,000 shares x $20 par value

Accounting for Stock Dividends On January 10, Hendix Corporation issues the stock. This action increases the number of shares outstanding by 100,000. Jan. 10 Stock Dividends Distributable 2,000,000 Common Stock 2,000,000

Hendrix Corporation, December 15 (before dividend) Accounting for Stock Dividends Hendrix Corporation, December 15 (before dividend) Common Stock, $20 par $40,000,000 Paid-in Capital in Excess of Par—Common Stock 9,000,000 Retained Earnings 26,600,000 $75,600,000 Hendrix Corporation, January 10 (after dividend) Common Stock, $20 par $42,000,000 Paid-in Capital in Excess of Par—Common Stock 10,100,000 Retained Earnings 23,500,000 $75,600,000

Learning Goal 8 Compute and interpret the dividend yield and dividend payout ratio on common stock.

Profitability Measures —The Common Stockholder 2005 2004 Dividends per share of common $ 0.80 $ 0.60 Market price per share of common $20.50 $13.50 Cash Dividends per Share of Common Stock Market Price per Share of Common Stock Dividend Yield $.60 $13.50 Dividend Yield, 2004 = 4.4% $.80 $20.50 = 3.9% Dividend Yield, 2005

Profitability Measures —The Common Stockholder The purpose of the dividend yield ratio is to indicate the rate of return to common stockholders in terms of dividends

Profitability Measures —The Common Stockholder 2005 2004 Cash dividends per share $0.80 $0.60 Annual earnings per share $7.50 $5.80 Annual Cash Dividend per Share Annual Earnings per Share Dividend Payout Ratio $.60 $5.80 Dividend Payout Ratio, 2004 = 10.3% $.80 $7.50 Dividend Payout Ratio, 2005 = 10.7%

Profitability Measures —The Common Stockholder The dividend payout ratios indicate that the firm paid out slightly more than 10 percent of its annual earnings in dividends.

Learning Goal 9 Describe financial statement presentations of stockholders’ equity.

Most corporations report changes in retained earnings by preparing a separate “retained earnings” column in the statement of stockholders’ equity.

Make a note to examine Exhibit 8 in the textbook Make a note to examine Exhibit 8 in the textbook. It shows the statement of stockholders’ equity for Outback Steakhouse, Inc.

Chapter 11 The End