1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell Electronic presentation adaptation by Dr. Barbara L. Hassell & Dr. Harold O. Wilson

2. Chapter 5

3. FINANCING DECISIONS (Reducing Outstanding Equity and Debt) Topics –Identify conditions leading to reduction of equity financing –Identify methods of equity reduction –Identify conditions leading to reduction of debt financing –Identify methods of debt reduction –Review of Statement of Owners’ Equity

4. Conditions for Reducing Debt and Equity Financing Availability of free cash flow –Free cash flow: The excess cash available after funding all profitable projects. –Modern finance theory: A firm should invest in all projects that will generate a higher return than the related cost of capital (i.e., projects that have a positive net present value). –Free cash flow is used to reduce outstanding debt, increase dividends, and buy back shares.

5. Market conditions favor “refunding existing debt” –If interest rates fall substantially, firms are able to issue debt at current market rates and repurchase and retire high interest rate debt issued previously. Frequently, firms will include call provisions in the debt agreement to increase the chances of subsequent “refunding of existing debt.” Strategic planning results in reallocating debt and equity financing (e.g., to reach a target ratio of debt to equity). NEW i < OLD i

6. Methods of Equity Reduction Purchase treasury stock Retire common stock Liquidating dividends

7. Purchase of Treasury Stock Treasury Stock: A corporation’s own stock which has been reacquired, but not retired, with the intent of holding it temporarily and reissuing it later. –Two methods of accounting for treasury stock: cost method (predominant) and par method (not illustrated here) Treasury stock is contra-equity and is reported as such in the balance sheet. (Not an asset!)

8. The following two slides indicate the “before & after” balance sheet of Shane Co. that acquired 50,000 shares of treasury stock for $40 per share (presumably in the open market).

9. Treasury Stock Example (Cost Method) Stockholders’ Equity [before] Common stock, $5 par; 10,000,000 shares authorized; 1,000,000 shares issued and outstanding$ 5,000,000 Additional paid-in capital30,000,000 Retained earnings42,000,000 Total stockholders’ equity$77,000,000 Note: Average price per share = $35: $35,000,000 (in common stock and additional paid-in capital)  1,000,000 shares

10. Stockholders’ Equity [after] Common stock, $5 par; 10,000,000 shares authorized; 1,000,000 shares issued, 950,000 shares outstanding$ 5,000,000 Additional paid-in capital30,000,000 Retained earnings42,000,000 77,000,000 Treasury Stock (50,000 shares at cost)( 2,000,000) Total stockholders’ equity$75,000,000 Note: The difference between the number of shares issued (1,000,000) and outstanding (950,000) is the number of shares of treasury stock.

11. REISSUE SHARES: Assume Shane reissued 20,000 of the 50,000 treasury shares (which were acquired at $40 per share), at $42 per share.

12. Results: Shane realizes a $40,000 “economic gain:” 20,000 shares x ($42 reissue price - $40 repurchase price). The “economic gain” increases additional paid-in capital because no “outsiders” were involved. Both cash and stockholders’ equity increase by $840,000 (20,000 shares x $42).

13. Reissue Shares: Stockholders’ Equity Results Stockholders’ Equity Common stock, $5 par; 10,000,000 shares authorized; 1,000,000 shares issued; 970,000 shares outstanding$ 5,000,000 Additional paid-in capital30,040,000 Retained earnings42,000,000 $77,040,000 Treasury Stock (30,000 shares at cost)( 1,200,000) Total stockholders’ equity$75,840,000

14. Retire Common Stock When common stock shares are acquired and retired … –The par value and original premium over par value are written off. –Any “economic gain/loss” is credited/charged directly to the premium account, if any, in the stockholders’ equity section. –The shares revert to the status of unissued.

15. The following two slides indicate the “before & after” balance sheet of Beneish Co. that acquired and retired (cancelled) 10,000 shares of its common stock (for $56 per share.)

16. Retire Common Stock Example Stockholders’ Equity [before] Common stock, $10 par; 10,000,000 shares authorized; 500,000 shares issued and outstanding$ 5,000,000 Additional paid-in capital25,000,000 Retained earnings42,000,000 Total stockholders’ equity$72,000,000 Note: The average price per share received by Beneish = $60: $30,000,000 (in common stock and additional paid-in capital)  500,000 shares

17. Acquire and Retire Common Stock: Stockholders’ Equity Results Stockholders’ Equity [after] Common stock, $10 par; 10,000,000 shares authorized; 490,000 shares issued and outstanding$ 4,900,000 Additional paid-in capital24,540,000 Retained earnings42,000,000 Total stockholders’ equity$71,440,000 Note: Both cash and total stockholders’ equity decrease by $560,000 (10,000 shares x $56).

18. SUPP0RTING COMPUTATIONS: Beneish realizes $40,000 “economic gain” on combination of two transactions, issuing stock and retiring stock: –Originally received 10,000 shares x $60 (average price) = $600,000 –Repurchase price was $560,000 –“Economic gain” = $40,000

19. –Common stock decreases $100,000: 10,000 shares x $10 par –Additional [original] paid in capital in excess of par decreases by $500,000: 10,000 shares x $50 premium in original issuance –Additional paid-in capital from retirement of stock increases by the $40,000 “economic gain” If a net “economic loss” had resulted, the loss would be charged either to additional paid-in capital, if any, or to retained earnings, likely dependent on state law.

20. Liquidating Dividends Normally, regular dividends are limited to the amount of free and unappropriated retained earnings. –Regular dividends are considered a return on capital. “Dividend distributions” paid that are greater than the free and unappropriated retained earnings are designated as a liquidating dividend. –Liquidating dividends are considered a return of capital. –What is the debit after retained earnings hits zero?

21. Methods of Debt Reduction –Normal payments –Early extinguishment of debt –Troubled debt: Settlements Modifications of terms

22. Methods of Debt Reduction Normal payments on debt as payments are due (covered in Chapter 4) Early extinguishment of debt –Management decides to pay debt off early Open market purchase Call debt pursuant to call option –GAAP requires the gain/loss on repurchase be reported as an extraordinary gain/loss Troubled debt –Settlement negotiated with lender –Modification of terms negotiated with lender

23. Early Extinguishment of Debt: Financial Statement Presentation The difference between the net book value of the debt and the net repurchase price is accounted for as an...

24. Early Extinguishment of Debt: Financial Statement Presentation Per Atlantic Richfield Co. (ARCO) Annual Report Income Statement ($ millions) Income before extraordinary item$1,899 Extraordinary loss on extinguishment of debt, net of income taxes of $74 million( 118) Net Income$1,771

25. ARCO Note 5 (in part) : Extraordinary Item. ARCO retired debt with a face value of $756 million prior to maturity. The debt repurchase resulted in an extraordinary charge of $118 million against net income, after tax of $74 million.

26. Early Extinguishment of Debt: Example Liu Co.: Trial balance excepts on July 1, as of the opening of business: Bond payable, face value$5,000,000 Unamortized premium on bond payable250,000 Accrued interest payable, July 175,000 Unamortized bond issue costs40,000 On July 1, Liu repurchases debt for $5.1 million (including accrued interest to date).

27. Extraordinary gain computation: Bonds payable$5,000,000 Bonds payable premium250,000 Interest payable75,000 Unamortized bond issue costs(40,000) Net book value of debt prior to settlement $5,285,000 Repurchase price5,100,000 Extraordinary gain$ 185,000

28. Troubled Debt: Settlement Assume here that settlement only occurs if debtor has an economic gain and creditor an economic loss (the typical scenario). Usually, debt is settled by either transferring assets to the lender and/or issuing stock to the lender. –If assets are to be transferred, they must first be written up/down to FMV, resulting in an ordinary gain/loss. Excess of the carrying value of the debt over FMV of assets given or stock issued = an extraordinary gain for the debtor!

29. Troubled Debt: Settlement Example Mufasa Co. owed First National Bank a $5,000,000 note payable plus accrued interest of $90,000. In complete settlement of the debt, Mufasa... –transferred to First National Bank land with a book value of $750,000 (FMV = $1,200,000), and –issued First National Bank 700,000 shares of $1 par common (FMV = $5 per share; $3,500,000 in total).

30. SOLUTION Mufasa would write up the land by $450,000 (i.e., up to FMV), resulting in recognizing an ordinary gain. Mufasa would record a $390,000 extraordinary gain on the debt settlement ($5,090,000 - $4,700,000): –Debt owed = $5,090,000 –FMV of assets = $1,200,000 –FMV of stocks = $3,500,000

31. Troubled Debt: Modification of Terms The accounting depends on comparison of the pre-modification debt carrying value and the total future cash flows under the modified debt agreement: –Pre-modification carrying value < total future cash flows (checks to be written) New effective interest rate is computed using new future cash flows Debtor records no gain (because the net interest rate still calculates as positive!)

32. –Pre-modification carrying value > total future cash flows Debtor records extraordinary gain = total future cash flows – pre-modification carrying value New effective interest rate = 0, or calculates to a negative! A “negative” rate calculation would simply mean that the principal amount is to be adjusted and a 0% rate used in the bookkeeping.

33. Troubled Debt: Modification of Terms Example, Situation 1 Situation 1: On January 1, 2001, the Mufasa Co. owed First National $5,000,000 plus accrued interest of $90,000 on a 7.2%, $5,000,000 note payable due December 31, 2005. First National agrees to restructure the note as follows: Principal reduced to $4,500,000 due December 31, 2005; accrued interest of $90,000 waived; stated interest rate reduced to 6% to be paid annually on December 31 of each year.

34. Carrying value before modification = $5,090,000 (total payoff needed) Total of future cash payments as modified = $5,850,000 (130% of $4,500,000) Note that the “real” interest rate remains positive (although interest cost is reduced); thus, no gain recognition.

35. RESULT: Mufasa records no gain because $5,850,000 > $5,090,000 New effective interest rate of 3.13% must be computed: n = 5 present value = $5,090,000 future value = $4,500,000 interest payment (ordinary annuity) = $4,500,000 x 6% = $270,000 i = ? = 3.13%

36. Troubled Debt: Modification of Terms Example, Situation 2 Situation 2. On January 1, 2001, the Mufasa Co. owed First National $5,000,000 plus accrued interest of $90,000 on a 7.2%, $5,000,000 note payable due December 31, 2005. First National agrees to restructure the note as follows: principal reduced to $4,000,000 due December 31, 2005; accrued interest of $90,000 waived; stated interest rate reduced to 4% to be paid annually on December 31 of each year.

37. Carrying value before modification = $5,090,000 (total payoff needed) Total of future cash payments as modified = $4,800,000 (120% of $4,000,000) Note that the “real” interest rate becomes negative (principal reduced so much that interest rate is below zero); thus, an extraordinary gain is recognized.

38. Result: Mufasa records an extraordinary gain because $4,800,000 < $5,090,000: Extraordinary gain = $5,090,000 – $4,800,000 = $290,000 The note’s carrying value reduces from $5,090,000 to $4,800,000 and all payments are principal! New effective interest rate = 0%: n = 5; present value = $4,800,000 (carrying value of note after modification); future value = $4,000,000; Interest payment (ordinary annuity) = $4,000,000 x 4% = $160,000; i = ? = 0%

39. Statement of Owners’ Equity A statement of owners’ equity reconciles the beginning balances to the ending balances of each component of stockholders’ equity. It is an analysis (not a schedule). A template for the a corporate statement is as follows:

40. Statement of Stockholders’ Equity Common Stock Additional Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income* Treasury Stock Balance Jan 1 …… Balance Dec 31 * Topic covered in future chapters with discussions of transactions that affect accumulated other comprehensive income

41. Items appearing in the statement of stockholders’ equity covered in chapters 2-5 include: –Net income –Issue common stock –Dividends (cash, property, stock, liquidating) –Stock splits –Treasury stock transactions –Retirement of common stock

42. End of Chapter 5