Stockholders’ Equity Chapter 10

Explain the advantages and disadvantages of a corporation.

What is the Best Way to Organize a Business? Proprietorship Partnership Corporation

Advantages and Disadvantages of a Corporation 1. Can raise more capital than a proprietorship or partnership can 2. Continuous life is possible 3. Ease of transferring ownership 4. Limited liability of stockholders Advantages 1. Separation of ownership 2. Corporate taxation 3. Government regulation Disadvantages

Stockholders’ Equity Owners’ equity in a corporation has two main components: Paid-in capital (contributed capital) Retained earnings

Capital Stock Corporate ownership is evidenced by a stock certificate which may be for any number of shares.

Capital Stock Common Stock Preferred Stock A class of stock that has several preferences over common stock. The most basic form of capital stock issued by every corporation.

Measure the effect of issuing stock on a company’s financial position.

Common Stock at Par Suppose IHOP’s common stock carries a par value of $10 per share. The company issues 6,200,000 shares of common stock at par. What is the entry?

Common Stock at Par January 8 Cash (6,200,000 × $10) 62,000,000 To issue common stock

Common Stock Above Par IHOP’s common stock has a par value of $0.01 per share. The company issues 6,200,000 shares of common stock at $10 per share. What is the entry?

Common Stock Above Par July 23 Cash (6,200,000 × $10) 62,000,000 (6,200,000 × $0.01) 62,000 Paid-in Capital in Excess of Par – Common (6,200,000 × $9.99) 61,938,000 To issue common stock

Common Stock Above Par Stockholders’ Equity Common Stock, $.01 par; 40 million shares authorized, 6.2 million shares issued $ 62,000 Paid-in capital in excess of par 61,938,000 Total paid-in capital $ 62,000,000 Retained earnings 194,000,000 Total stockholders’ equity $256,000,000

No-Par Common Stock When a company issues no-par stock, it debits the asset received and credits the stock account. August 14 Cash (3,000 × $20) 60,000 Common Stock 60,000 To issue no-par common stock

Preferred Stock Accounting for preferred stock follows the pattern illustrated for common stock. Stockholders’ equity on the balance sheet lists preferred stock, common stock, and retained earnings – in that order.

Describe how treasury stock transactions affect a company.

Treasury Stock Transactions Treasury stock are shares that a company has issued and later reacquired. Reasons for purchasing their own stock: Stock purchase plan distribution Increase net assets (i.e. SE) Avoidance of a takeover

IHOP Corp. Purchase of Treasury Stock During 2000, IHOP paid $5,170 to purchase 288 shares of its common stock as treasury stock. ($000) November 12, 2000 Treasury Stock 5,170 Cash 5,170 Purchased treasury stock

IHOP Corp. After Purchase of Treasury Stock Common Stock $ 203 Paid-in capital in excess of par 69,655 Retained earnings 193,632 Less: Treasury stock (288 shares at cost) – 5,170 Total equity $258,320 Stockholder’s Equity at December 31, 2000 (with treasury stock purchased – $000)

Sale of Treasury Stock Assume that on July 22, 2002, the shares of treasury stock are sold for $5,300. Cash 5,300 Treasury Stock 5,170 PIC from T Stock Transactions 130 Sold treasury stock

Account for dividends and measure their impact on a company.

Dividends A dividend is a corporation’s return to its stockholders of some of the benefits of earnings.

Three relevant dates for dividends are: Dividend Dates Three relevant dates for dividends are: Declaration date Date of record Payment date

Preferred Stock Dividends When a company has issued both preferred and common stock, the preferred stockholders receive their dividends first. Pinecraft Industries, Inc., has both common stock and 90,000 shares of preferred stock outstanding.

Preferred Stock Dividends Preferred dividends are paid at the annual rate of $1.75 per share. Assume that in 2004, the company declares an annual dividend of $1,500,000. Preferred dividend (90,000 × $1.75 per share) $157,500 Common dividend ($1,500,000 – $157,500) 1,342,500 Total dividend $1,500,000

Expressing the Dividend Rate on Preferred Stock Percentage rate (% of Par) Dollar amount per share

Preferred Stock Dividends The preferred stock of Pinecraft is CUMULATIVE Suppose the company passed/ skipped/ did NOT pay the 2004 preferred dividend of $157,500. They didn’t pay ANY div In 2005, the company declares a $500,000 dividend. Retained Earnings 500,000 Divs Payable, Pfd ($157,500 × 2 years) 315,000 Divs Payable, CS ($500,000 – $315,000) 185,000 To declare a cash dividend

Why Issue a Stock Dividend? To continue dividends but conserve cash To reduce the per-share market price of its stock

Stock Dividend IHOP declared a 10% stock dividend in 2001. Assume IHOP had 20,000,000 shares of common stock outstanding. The stock is trading for $15 per share. How would this stock dividend be recorded?

Stock Dividend CS (20,000,000 × 10% × $0.01) 20,000 Retained Earnings (20,000,000 × 10% × $15) 30,000,000 CS (20,000,000 × 10% × $0.01) 20,000 Paid-in Capital 29,980,000 Distributed a 10% stock dividend

Stock Splits A stock split is an increase in the number of authorized, issued, and outstanding shares of stock, coupled with a proportionate reduction in the stock’s par value. A stock split decreases the market price of stock.

Stock Splits The market price of a share of Quaker Oats has been approximately $25. Assume that the company wants to decrease it to $12.50. This 2-for-1 split means that the company would have twice as many shares outstanding after the split.

Use different stock values in decision making.

(amount pfd SH’s will get paid if company liquidates) Stock Values Market value Redemption value Liquidation value (amount pfd SH’s will get paid if company liquidates) Book value

Book Value Book value of preferred stock = Redemption value + Dividends in arrears Book value of common stock = Total stockholders’ equity – Preferred equity

Assume that a company’s balance sheet reports the following: Book Value Assume that a company’s balance sheet reports the following: Preferred stock, 6%, $100 par, 5,000 shares authorized, 400 shares issued, redemption value $130 per share $ 40,000 Additional paid-in capital in excess of par – preferred 4,000 Common stock, $10 par, 20,000 shares authorized, 5,500 shares issued 55,000 Additional paid-in capital in excess of par – common 72,000 Retained earnings 85,000 Treasury stock – common, 500 shares at cost – 15,000 Total stockholders’ equity $241,000 Stockholders’ Equity

Book Value Suppose that four years’ (including the current year) cumulative preferred dividends are in arrears. The book-value-per-share computations for this company are as follows:

Book Value Preferred equity: Redemption value (400 shares × 130) $ 52,000 Cumulative dividends ($40,000 × $0.06 × 4 years) 9,600 Preferred equity $ 61,600 Common equity: Total stockholders’ equity $241,000 Less preferred equity – 61,600 Common equity $179,400 Book value per share: $179,400 ÷ 5,000 shares* $ 35.88 *5,500 shares issued minus 500 treasury shares

Evaluate a company’s return on assets and return on stockholders’ equity.

Return on Assets Rate of return on total assets = (Net income + Interest expense) ÷ Average total assets It is a measure of a company’s ability to generate profits from the use of its assets.

Return on Equity Rate of return on common stockholders’ equity = (Net income – Preferred dividends) ÷ Average common stockholders’ equity It is a measure of the income earned from the common stockholders’ investment in the company.

End of Chapter 10