COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1 Chapter 11 Equity Financing Albrecht, Stice, Stice, Swain

2 Debt vs. Equity Debt –Company is obligated to repay the principal amount, even during bad times. –Lender does not share in the success of the company. Equity –Company is not obligated to repay the principal amount (investors can lose all of their investment). –Investor shares in the success of the company.

3 Proprietorships and Partnerships Proprietorship –A business owned by one person. Partnership –An association of two or more individuals or organizations to carry on economic activity. Characteristics –Ease of formation. –Limited life. –Unlimited liability

4 Corporations Corporation –A legal entity chartered by a state; ownership is represented by transferable shares of stock. Characteristics –Limited liability. –Easy transferability of ownership. –Ability to raise large amounts of capital. –Double taxation. –Close government regulation.

5 Common Stock Rights of the common stockholder –Voting rights. –Preemptive right. The right to purchase additional shares whenever stock is issued. Allows stockholders to maintain the same proportion of ownership. –Dividend rights. –Corporate asset rights. Once all loans have been repaid and the claims of preferred shareholders are met, all of the excess assets belong to the common stockholders.

6 Preferred Stock Rights of the preferred stockholder –Usually no voting rights. –Limited to a fixed cash dividend. –In the event the corporation is liquidated, preferred stockholders are entitled to have their claims repaid fully before any cash is paid to common stockholders. –Many times includes a conversion option.

7 Issuance of Stock Par value –A nominal value assigned to and printed on the face of each share of a corporation’s stock. –Has no real significance today. To record the issuance of 1,000 shares of $1 par stock for $10: Cash ,000 Common Stock ,000 Paid-In Capital in Excess of Par, Common Stock ,000

8 Issuing Stock for Property The asset should be recorded at the current market value of the stock. If the market value of the asset cannot be determined then the market value of the asset should be used as the basis to record the transaction. To record the issuance of 1,000 shares of no par stock for land. Assume the market value of the stock is $10 per share at the date of the exchange: Land ,000 Common Stock ,000

9 Stock Repurchases Reasons why management repurchases stock –The stock is wanted for a profit-sharing, bonus, or stock-option plan for employees. –Management feels the stock is selling for an unusually low price and is a good buy. –Management wants to stimulate trading. –To remove shares from the market in order to avoid a hostile takeover. –To increase reported earnings per share by reducing the number of shares outstanding.

10 Repurchasing Stock Treasury Stock –Issued stock that has subsequently been reacquired by the corporation. –The stock is debited at its cost (market value) on the date of the repurchase. To record the repurchase of 1,000 shares of $1 par stock when the market value of the stock is $20: Treasury Stock, Common ,000 Cash ,000

11 Reissuance of Treasury Stock If the stock is reissued for more than the company paid for it, the excess goes in “Paid-In Capital, Treasury Stock.” If the stock is reissued for less than the company paid for it, the loss is recognized as a reduction in Paid-In Capital, Treasury Stock (if a balance exists) or as a reduction in retained earnings.

12 Reissuance Examples To record the reissuance of 500 shares of stock when the market value of the stock is $25. The stock was originally purchased for $20: Cash ,500 Treasury Stock, Common ,000 Paid-In Capital, Treasury Stock ,500 To record the reissuance of the other 500 shares of stock when the market value of the stock is $10: Cash ,000 Paid-In Capital, Treasury Stock ,500 Retained Earnings ,500 Treasury Stock, Common ,000

13 Balance Sheet Preparation Par values are listed separately from paid- in capital. Common stock is listed separately from preferred stock. Treasury stock is recognized as a contra- stockholders’ equity account.

14 Retained Earnings Retained earnings –The portion of a corporation’s owners’ equity that has been earned from profitable operations and not distributed to stockholders since incorporation. –NOT cash! –Increased by net income. –Decreased by dividends, net losses, and some treasury stock transactions.

15 Dividends –Distributions to the owners (stockholders) of a corporation. Should a company pay dividends? –Stable companies pay out a large portion of earnings. –Growing companies pay little or no dividends. –If a company declares dividends, they are expected to continue that level of dividends in future periods.

16 Accounting for Cash Dividends Recorded as a payable when declared. Dividend account is closed to retained earnings at the end of the year. To record the declaration of a $20,000 dividend: Dividends ,000 Dividends Payable ,000 To close Dividends to Retained Earnings at the end of the year: Retained Earnings ,000 Dividends ,000

17 Dividend Preferences Cumulative-dividend preference –The right of preferred stockholders to receive current dividends PLUS all dividends in arrears before common stockholders receive any dividends. Dividends in arrears –Missed dividends for past years that preferred stockholders have a right to receive if and when dividends are declared.

18 Dividend Preferences Calculate the amount of the preferred dividend and the common dividend for each case. CasePreferred Dividend Feature Years in Arrears Total Dividend Preferred Dividend Common Dividend 15%, NoncumulativeN/A$ 1,500 25%, NoncumulativeN/A3,000 35%, Cumulative25,000 45%, Cumulative211,000

19 Dividend Preferences Calculate the amount of the preferred dividend and the common dividend for each case. CasePreferred Dividend Feature Years in Arrears Total Dividend Preferred Dividend Common Dividend 15%, NoncumulativeN/A$ 1,500 $ 0 25%, NoncumulativeN/A3,0002,0001,000 35%, Cumulative25, %, Cumulative211,0006,0005,000

20 Dividend Payout Ratio Dividend –The percentage of earnings paid out in dividends. –Most large U.S. companies pay out 40 to 60% of their annual income as dividends. Cash Dividends Net Income

21 Other Equity Items Equity items that bypass the income statement –Foreign currency translation adjustment. –Unrealized gains and losses on available-for- sale securities. –Unrealized gains and losses on hedging. –Minimum pension liability. Designed to exclude uncontrollable gains and losses from affecting net income.

22 Comprehensive Income Accumulated other comprehensive income –Equity category that summarizes the effect on equity of certain market-related gains and losses. (It is a cumulative account.) Comprehensive income Net Income + Unrealized gain (loss) on investments + Unrealized gain (loss) on hedging +/– Foreign currency translation adjustments – Minimum pension liability = Comprehensive income

23 Statement of Stockholders’ Equity –A financial statement that reports all changes in stockholders’ equity. –Reconciles the beginning and ending balances for all stockholders’ equity accounts reported on the balance sheet.