Chapter 11 Solutions Manual

© The McGraw-Hill Companies, Inc., 2010Overview

CHAPTER 11SHAREHOLDERS' EQUITY:

CAPITAL

Brief LearningExercises Topic Skills

B. Ex. 11.1 Shareholders' equity 4 AnalysisB. Ex. 11.2 Shareholders' equity 4 AnalysisB. Ex. 11.3 Dividends on preference shares 5 Analysis, communicationB. Ex. 11.4 5 Analysis

B. Ex. 11.5 5 Analysis, communication

B. Ex. 11.6 Book value 7 Analysis, communicationB. Ex. 11.7 Book value 7 AnalysisB. Ex. 11.8 Share split 8 Analysis, communicationB. Ex. 11.9 Treasury shares 4, 9 AnalysisB. Ex. 11.10 Treasury shares 4, 9 Analysis

Exercises Topic Skills11.1 Form of organization Analysis, communication11.2 Accounting terminology 1–9 Analysis11.3 Prepare equity section 4, 5 Analysis, communication11.4 4, 5 Analysis, communication

11.5 Analyzing equity 4–7 Analysis11.6 Preference shares alternatives 5, 6 Analysis11.7 Reporting effects of transactions 4, 7 Analysis11.8 Computing book value 4–7 Analysis, communication11.9 Treasury shares transactions 9 Analysis, communication11.10 Effects of share splits 8 Communication, judgment11.11 Treasury shares presentation 9 Communication, judgment11.12 Real World: Star Cruises Limited 4 Analysis, communication

Authorized share capital11.13 Ordinary shares and treasury shares 4, 9 Analysis, communication

11.14 Treasury shares and share split 8, 9 Analysis

OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL THINKING CASES

Objectives

Dividends on ordinary and preference shares

Dividends on ordinary and preference shares

Learning Objective

s1–3

Dividends on preference & ordinary shares

© The McGraw-Hill Companies, Inc., 2010Overview

11.15 Real World: adidas AG 4, 7

Reading an annual report

Analysis, communication, research

© The McGraw-Hill Companies, Inc., 2010Overview (p.2)

Problems Learning

Sets A, B Topic Objectives Skills

11.1 A,B Reporting shareholders’ equity 4, 5, 6 Analysis, communication11.2 A,B Reporting shareholders’ equity 4, 5, 6 Analysis, communication11.3 A,B Reporting shareholders’ equity 4, 5, 6 Analysis, communication11.4 A,B Comprehensive equity problem 4, 5 Analysis11.5 A,B Analysis of equity 4, 5 Analysis11.6 A,B Comprehensive equity analysis 1–7

11.7 A,B Par, book, and market values 4, 7 Communication, judgment11.8 A,B 4, 5, 7, 9 Analysis, communication

11.9 A,B 4, 5, 7, 8, 9

Critical Thinking Cases 11.1 5, 7 Communication, judgment

11.2 7 Communication

11.3 1, 2, 3 Communication, judgment

11.4 1, 2, 3

Analytical, communication, group

Comprehensive equity with treasury shares transactions

Comprehensive equity with treasury shares transactions and share splits

Analytical, communication, judgment

Factors affecting market prices of preference and ordinary shares

Real World: Japan Airlines Corporation, HSBC, GlaxoSmithKline

Factors affecting market prices of ordinary shares

Selecting a form of business organization

Securities & Futures Commission

Communication, judgment, technology

(Ethics, fraud & corporate governance)

A6

: A

A10

:

A14

:

© The McGraw-Hill Companies, Inc., 2010Description Problems

DESCRIPTIONS OF PROBLEMS ANDCRITICAL THINKING CASES

Problems (Sets A and B)11.1 A,B Robbinsville Press/Septa Limited 20 Easy

11.2 A,B Waller Publications/Banner Publications 20 Easy

11.3 A,B Manhattan Transport Company/Ray Beam Limited 25 Medium

11.4 A,B Barnes Communications Limited/Markup Limited 35 Medium

11.5 A,B Smithfield Products/Manor Limited 35 Strong

11.6 A,B Parsons Limited/Toasty Corporation 35 Medium

11.7 A,B Techno Corporation/Brain Corporation 15 Easy

Below are brief descriptions of each problem and case. These descriptions are accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time estimates assume use of the partially filled-in working papers.

A short problem requiring the completion of the shareholders’ equity section of a corporate balance sheet. Includes preference share dividends and conceptual issues pertaining to the market price of preference shares.

A second short problem requiring the completion of the shareholders’ equity section of a corporate balance sheet. Includes preference share dividends and conceptual issues pertaining to dividends in arrears.

A more difficult problem requiring the completion of the shareholders’ equity section of a corporate balance sheet. Includes preference share dividends and conceptual issues pertaining to equity versus debt financing.

A short but comprehensive problem on corporations. Includes journal entries for issuance of ordinary shares and preference shares. Also includes dividends on preference shares, closing entries, and the preparation of the shareholders’ equity section of a corporate balance sheet.

A more difficult problem involving distinction among par values, book values, and market values.

Analysis of the shareholders’ equity of a publicly owned corporation. Includes a discussion of why a business may opt to become publicly owned and the reasons why the dividend yields on preference shares vary.

A straightforward discussion of the relationships (if any) among par value, book value, and market value per share. A company has a book value 6,500 times greater than its par value, and a market value 65,000 times as high. Fun problem that makes a point.

© The McGraw-Hill Companies, Inc., 2010Desc. of Cases

Problems (continued)11.8 A,B Feller Corporation/Tin Corporation

15 Medium

11.9 A,B Herndon Industries/Parker Industries30 Strong

Critical Thinking Cases11.1 15 Medium

11.2 Factors Affecting the Market Prices of Ordinary Shares 25 Strong

11.3 Selecting a Form of Organization

11.4 S.F.C. Enforcement Division 20 EasyEthics, Fraud & Corporate Governance

A shareholders’ equity problem involving share capital from treasury share transactions. Requires the computation of book value per share and reporting for the statement of cash flows.

A comprehensive equity problem involving treasury shares transactions in two different years, preference and ordinary share transactions, book value calculations, and an understanding of share splits.

Factors Affecting the Market Prices of Preference and Ordinary Shares

Students are asked to explain whether the prices of preference shares, ordinary shares, and convertible preference shares are likely to rise or fall if profitability increases dramatically and interest rates rise slightly. A problem that stimulates lively classroom discussion.

Students are to explain the reason for changes in the market prices of shares of various real companies. A difficult problem that is very thought-provoking.

Interview; No time estimate

Students are to interview the owners of two small businesses with different forms of organization and find out why the particular form was selected—and if they have any misgivings.

Students do an internet search to locate the website of the Securities & Futures Commission and respond to questions about the S.F.C.

© The McGraw-Hill Companies, Inc., 2010Desc. of Cases

*Supplemental Topic, “Special Types of Liabilities.”

© The McGraw-Hill Companies, Inc., 2010Q1-5

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1.

2. a.

b.

c.

d.

3.

4.

5.

Large corporations are often said to be publicly owned because they are literally owned by the general public. The shares of many large corporations is actively traded on organized stock exchanges, such as the Singapore Exchange. Anyone may purchase an ownership interest in such corporations, even if that interest is but a single share. Many large corporations have hundreds of thousands, even millions, of individual shareholders.

Owners’ liability for debts of the business. Sole proprietors are personally liable for the debts of the business. A corporation, however, is responsible for its own debts; the shareholders of a corporation are not personally liable for the debts of the business entity. Thus, the amount of money that a shareholder might lose by investing in a corporation is limited to the amount of his or her investment.

Transferability of ownership interest. A sole proprietor generally must sell his or her entire interest in the business. This creates a new business owned by a new sole proprietor. Shares in a corporation are freely transferable.

Continuity of existence. A sole proprietorship is terminated upon sale or abandonment by the owner and upon that person’s death or incapacitation. Corporations continue in existence regardless of changes in ownership.

Federal taxation on income. A corporation is subject to federal income tax on its income, and shareholders are also subject to a personal income tax on any amounts they receive as dividends. A sole proprietorship is not a taxable entity, but the owner must pay personal taxes on the income earned by the business, whether or not it is actually withdrawn by the owner.

There are three basic rights: (1) the right to vote, (2) the right to share in dividends when declared, and (3) the right to share in assets upon liquidation.

A preference share is typically entitled to cumulative preference to a limited amount of dividends and to a prior claim against assets in case of liquidation; in return, it usually has no voting power.

The term double taxation refers to the fact that the profit of a corporation may be taxed on two separate occasions. First, the profit of a corporation is subject to corporate income taxes, which must be paid by the corporation. Second, if the corporation distributes its earnings as dividends to shareholders, the shareholders must pay personal income taxes on the amounts they receive. This double taxation of profit is one of the principal disadvantages of the corporate form of business organization.

Capital of a corporation represents the amount invested by shareholders and is generally not available for dividends. Retained earnings represents the cumulative amount of profit not distributed to shareholders as dividends. The distinction between share capital and retained earnings is useful because it shows how much of the total shareholders’ equity represents investments by the owners and how much has been accumulated through profitable operations since the company started in business.


6.

7. a.

b.

8.

9.

10. a.

b.

c.

d.

11.

Par value represents the legal capital per share, that is, the amount below which shareholders’ equity cannot be reduced except by losses. The primary significance of par value is that a corporation cannot declare a dividend if this action would reduce total shareholders’ equity below the par value of the outstanding shares.

Par value is not an indication of a fair market price for an ordinary share. The market price of the share is determined by such factors as the profitability and solvency of the issuing company, interest rates, the amount of dividends paid by the share, and general market conditions. The market price of a share may be above or below its par value.

Cumulative means that unpaid dividends on preference shares are carried forward and must be fully paid before any dividends can be paid on ordinary shares.

Convertible means that each preference share may be returned to the corporation in exchange for a given number of ordinary share under specified conditions.

Noncumulative preference share is entitled to dividends only if and when they are declared. If noncumulative preference dividends had not been declared for several years, it would be possible to declare only the current year’s dividends on preference share and then declare a dividend on ordinary shares. Noncumulative preference shares does not have the protection afforded by the cumulative requirements that any dividends in arrears must be paid before dividends can be paid on ordinary shares. This means a weak form of dividend preference, and as a result the noncumulative feature is not attractive to most investors.

(a) Cash is classified as an asset; (b) Organization Costs typically are classified as an expense; (c) Preference Shares, (d) Retained Earnings, and (e) Share premium are all classified as shareholders’ equity accounts; (f) Income Taxes Payable is classified as a liability.

Share transfer agent. A bank or trust company retained by a corporation to maintain records of share ownership and transfers.

Shareholders subsidiary ledger. A record kept by a corporation showing the number of shares owned by each shareholder.

Underwriter. An investment banking company that undertakes to sell new corporate shares to investors. The underwriter usually guarantees the corporation a specified price, and plans to make a profit by selling to individual investors at a slightly higher price.

Share registrar. An independent fiscal agent, usually a large bank, retained by acorporation to control the issuance of share certificates and provide assurance againstoverissuance.

Book value per share represents the amount of net assets (or shareholders’ equity) associated with each ordinary share. It is determined by dividing the total shareholders’ equity in the corporation, less the amount assigned to preference shares (par value, or liquidation value if given, plus dividends in arrears) by the number of ordinary shares outstanding. Book value does not represent the amount ordinary shareholders would receive in the event of liquidation. If a corporation were liquidated, many assets would be sold at prices different from their carrying values in the accounting records. The resulting gains or losses would cause shareholders’ equity to change accordingly.


12.

13. a.

b.

14.

15.

16.

17.

To compute book value per ordinary share for a company with both preference shares and ordinary shares outstanding, the starting point is total shareholders’ equity, including both preference and ordinary shares and all other elements of share capital. Deduct from this total the preference shares at its assigned amount (par value or liquidation value, if given) and any dividends in arrears. The remainder is the equity of the ordinary shareholders. Divide this amount by the number of ordinary shares outstanding to arrive at book value (or net assets) per ordinary share.

When a corporation obtains a bank loan there is no effect upon book value per ordinary share. Assets and liabilities both increase by the amount of the loan. Net assets, therefore, are unchanged.

Declaration of a dividend reduces book value per share. Total assets are not affected by the declaration of a dividend, but liabilities are increased. Net assets (shareholders’ equity), therefore, are decreased.

A change in the market price of IBM’s outstanding shares has no effect upon IBM’s balance sheet. These shares belong to IBM’s shareholders, not to IBM. Therefore, a change in the market value of these shares has no effect upon the recorded amounts of IBM’s assets, liabilities, or shareholders’ equity. IBM’s share capital accounts will continue to show the amount received by IBM at the time the ordinary share was issued. This historical amount is not affected by subsequent changes in market price.

When you ask a sharebroker to purchase shares for you, the shares is purchased on a secondary market—in this case the Singapore Exchange, because that is where Singapore Airlines shares are traded. On a secondary market, you are purchasing the shares from another investor. The transaction will have no effect on the financial statements of Singapore Airlines.

The purpose of a share split is to reduce the per-share market price of the company’s shares down to a more appropriate “trading range”—that is, a price that is appealing to a greater number of potential investors.

Treasury shares are corporate shares that has been issued and then reacquired by the issuing company.

One reason for acquiring treasury shares is to have shares available to issue to officers and employees under profit-sharing agreements, shares options, or bonus plans. Purchases of treasury shares may also be intended to support the market price of the shares or to increase earnings per share.

Treasury shares are not asset; it represents a reduction in the amount of shareholders’ investment in the corporation. For this reason the cost of the treasury shares are reported in the balance sheet as a reduction of the shareholders’ equity.


18.

19.

Transaction/activity Direction of changeSale of share capital IncreasePurchase of treasury shares DecreaseSale of treasury shares IncreaseShare split None*

20.

The purpose of this rule is to protect corporate creditors, for whom shareholders’ equity represents the margin of safety against loss from a shrinkage of asset values. The restriction of retained earnings for dividend purposes to the extent of the cost of treasury shares assures creditors that the shareholders’ equity of a corporation will not, as a result of the purchase of treasury shares, be reduced below the amount of share capital. If this restriction were not imposed, a corporation might distribute assets equal to the entire amount of its retained earnings as dividends, and then distribute additional assets in payment for its own shares, thereby reducing the net assets of the corporation below the amount of the share capital or even below the amount of stated (legal) capital.

The major types of transactions and activities that change the amount of issued and fully paid capital and the direction of that change are as follows:

*A share split increases the number of shares and lowers the market price of that share, but does not affect the total amount of share capital.

No definitive answer can be given to this question because a case can be made for having preference shares and for not having preference shares. Similarly, if preference shares are included in the capital structure, a case can be made for different features, primarily whether the dividend is cumulative or not. Following are comments under different assumptions about the desirability of preference shares.

Include preference shares—Preference shares offer investors an opportunity to invest on what may be a more predictable and secure basis than ordinary share. While dividends are not guaranteed, they are more predictable than on ordinary share, particularly for a new company. Some investors may be willing to invest in preference shares while they would not be willing to accept the greater uncertainty and risk of ordinary share. This may be a factor in designing the company’s capital structure in light of the capital requirements of the new company.

Do not include preference shares—The presence of preference shares may make ordinary shares less attractive in light of the dividend preference of preference shares. Once the company is up and running, preference shares may be undesirable in terms of the long-term capital structure of the company.

Features of preference shares—Assuming preference shares are included in the capital structure, the most important decision is whether the dividend is cumulative. If the dividend is cumulative, the preference shares are more attractive to investors, but it detracts from the attractiveness of the ordinary shares. The lack of the cumulative feature may make preference shares a relatively weak investment alternative and effectively defeat the purpose of including preference shares in the capital structure.

© The McGraw-Hill Companies, Inc., 2010BE11.1,2,3,4

B.Ex. 11.1 Ordinary shares (10,000 shares @ $10) $100,000Share premium (10,000 shares @ $3) 30,000 Retained earnings 75,000 Total shareholders' equity $205,000

B.Ex. 11.2 Preference shares (1,000 shares @ $100) $100,000Ordinary shares (10,000 shares @ $25) 250,000Share premium: Preference shares (1,000 shares @ $10) 10,000 Ordinary shares (10,000 shares @ $2) 20,000Retained earnings 100,000 Total shareholders' equity $480,000

B.Ex. 11.3

100,000 shares x $100 par value x 6% dividend rate x 3 years = $1,800,000

B.Ex. 11.4 Total dividend declared $200,000Dividend requirements for preference shares: 10,000 shares x $100 par x 6% x 2 years 120,000Dividends available for ordinary shares $80,000

B.Ex. 11.5 Total dividend declared $120,000Dividend requirements for noncumulative preference shares: 10,000 x $100 par x 8% x 1 year 80,000Dividends available for ordinary shares $40,000Dividends per share on ordinary shares: $40,000/100,000 shares $0.40

10,000 x $100 par x 8% x 4 years = $320,000

Dividends on arrears on preference shares for three years are calculated as follows:

The amount of dividends in arrears must be disclosed in the financial statements, but they are not formally included as a liability in the balance sheet until declared by the Board of Directors of the company.

If the preference shares is cumulative, the entire dividend goes to preference shares and the ordinary shareholders will receive none of the $120,000 dividends declared. In fact, satisfaction of the full claim of the preference sharesholders in this case will require $320,000, determined as follows:

© The McGraw-Hill Companies, Inc., 2010BE11.6,7,8,9,10

B.Ex. 11.6

($1,000,000 + $750,000 + $600,000)/100,000 shares = $23.50

B.Ex. 11.7$11,550,000

Less: Preference shares at par value $4,000,000Dividends in arrears (40,000 shares x $5) 200,000 4,200,000Amount attributable to ordinary shares $7,350,000Book value per ordinary share:

$7,350,000/500,000 shares $14.70

B.Ex. 11.8

B.Ex. 11.9 Ordinary shares (100,000 shares @ $10) $1,000,000 Share premium

(100,000 shares @ $15) 1,500,000$2,500,000

Less: Treasury shares (10,000 shares x $55) (550,000) Total shareholders' equity $1,950,000

B.Ex. 11.10 Ordinary shares (1,000,000 shares @ $25) $25,000,000 Share premium on ordinary shares

(1,000,000 shares @ $5) 5,000,000 Share premium on treasury shares

[70,000 shares x ($55 - $50)] 350,000$30,350,000

Less: Treasury shares (30,000 shares x $50) 1,500,000 Total shareholders' equity $28,850,000

The book value on ordinary shares are calculated by adding all shareholders' equity accounts together and dividing by the number of ordinary shares outstanding:

This amount does not reflect the current market value of the shares. Instead, it reflects a per-share amount of the assets, less liabilities, included in the company's balance sheet.

Total shareholders' equity ($4,000,000 + $5,000,000 + $800,000 + $1,750,000)

The share split will double the number of shares outstanding from 100,000 to 200,000. It will reduce the market price of the shares to approximately half of its current price: $50 x 1/2 = $25. The split will have no impact on the total shareholders' equity attributable to ordinary shares. While the number of shares will double, the par value will be reduced to half, or $5 per share, leaving the total shareholders' equity attributable to ordinary shares unchanged.

© The McGraw-Hill Companies, Inc., 2010E11.1,2

SOLUTIONS TO EXERCISES

Ex. 11.1 a. (1) Organizing the scuba diving school as a sole proprietorship.Advantages:(a) Easy to form(b) No double taxation on distributed earningsDisadvantages:(a) Personal liability of owner for debts of the business(b) Business ceases with death of owner

(2) Organizing the scuba diving school as a corporation.Advantages:(a) No personal liability of owners for debts of the business(b) Readily transferable ownership shares(c) Continuous existenceDisadvantages:(a) Double taxation on distributed earnings(b) Greater regulation

b.

Ex. 11.2 a. Double taxationb. Market valuec.

d. Ordinary sharese.

f. Publicly owned corporationg. Issued and fully paid capitalh. Retained earningsi.

j. None (The price of preference shares varies inversely with interest rates.)

A corporation would probably be the better form of organization because of the characteristic of limited liability of the owners. Potentially, a scuba diving student could be seriously injured in the class. With the sole proprietorship form of organization, your personal assets would be at risk to pay for the person’s injuries, after you exhausted any insurance coverage and assets that the business might have.

None (Retained earnings is not an amount of cash; it is an element of owners’ equity.)

None (Dividends in arrears are prior years’ dividends owed to holders of cumulative preference shares.)

None (Book value is ordinary shareholders’ equity divided by the number of ordinary shares outstanding.)

© The McGraw-Hill Companies, Inc., 2010E11.3,4,5

Ex. 11.3 a. Shareholders’ equity:Preference shares, $100 par value,5,000 shares authorized, 2,500 shares issued and outst $ 250,000 Ordinary shares, $2 stated value, 100,000 shares authorized,70,000 shares issued and outstanding……………… 140,000Share premium:

Preference shares …………………………………………… 7,500Ordinary shares ……………………………………………… 770,000

Total issued and fully paid capital …………………… $ 1,167,500 Retained earnings ……………………………………………………… 382,000

Total shareholders’ equity ………………………………… $ 1,549,500

b.

Ex. 11.4 a. Total dividends paid in third year ……………………………… $376,000 Dividends on 9% noncumulative preference shares:

Current year’s dividend ($50 x .09 x 40,000) … 180,000Total paid on 9% noncumulative preferen $180,000

Dividends on 12% noncumulative preference shares:Current year’s dividend ($100 x .12 x 8,000) 96,000 276,000

Dividends on ordinary shares in third year ………………………… $100,000

b. Dividends per share:Preference shares, 9% noncum. ($180,000 ¸ 40,000 s $ 4.50 per sharePreference shares, 12% noncum. ($96,000 ¸ 8,000 share $ 12.00 per shareOrdinary shares ($100,000 ¸ 400,000 shares) …… $ 0.25 per share

c.

Ex. 11.5 a.

b.

c.

d. $35,000,000 legal capital ($15,000,000 preference, plus $20,000,000 ordinary)

No. The market value of a corporation’s shares have no effect on the amount in the financial statements. Share capital is recorded at the amount for which it was originally issued.

The shareholders’ equity section of the balance sheet reports no share premium. Thus, the preference shares must have been issued at their respective par values ($50 per share for the 9% noncumulative preference shares, and $100 per share for the noncumulative preference shares).

150,000 shares ($15,000,000 total par value, divided by $100 par value per share)

$1,050,000 ($15,000,000 total par value x 7% or 150,000 x $100 x 7%)

$16 [($20 million par value + $44 million share premium) ¸ 4,000,000 shares issued]

$79,000,000 total issued and fully paid capital ($35,000,000 legal capital, plus $44,000,000 share premium)


e. Total shareholders’ equity ………………………………… $ 143,450,000 Less: Par value of preference shares (150,000 shares x 15,000,000Equity of ordinary shareholders ………………………………… $ 128,450,000 Ordinary shares outstanding …………………………………… 4,000,000

$32.11

f.

Ex. 11.6 Annual dividends on the preference shares are $14,000 (7,000 × $25 × 8%)

Total dividend ……………………………………………………Amount to preference shares …………………………………Amount to ordinary shares ………………………………………

Ex. 11.7 Net Cash Flow Current Shareholders’ (from Any

Event Assets Equity Profit Source)a. I I NE Ib. NE NE NE NEc. D D NE D

Book value per share ($128.45 million ¸ 4 million shares) …………………………..

No. Changes in the market value of shares do not directly affect a corporation’s financial position and are not reflected in the equity section of the balance sheet.

$50,000 (14,000)$36,000


Ex. 11.8 a. Net assets (shareholders’ equity):Preference shares ……………………………………………………….. $ 200,000 Ordinary shares, $5 par, 60,000 shares issued …………………… 300,000 Share premium ………………………………………………………… 452,800

Total issued and fully paid capital ………………… $ 952,800 Less: Deficit …………………………………………………………… 146,800 Total net assets (shareholders’ equity) ……………………………… $ 806,000

b. Book value per ordinary share:Total shareholders’ equity (from part a) ……………………… $ 806,000 Less: Claims of preference sharesholders ($200,000 plus

dividends in arrears, $16,000) …………………… 216,000 Equity of ordinary shareholders ……………………………… $ 590,000 Number of ordinary shares outstanding …………………………… 60,000

$ 9.83

c.

Ex. 11.9 a. Feb. 10 Treasury Shares ……………………… 425,000Cash ………………………………………………… 425,000

June 4 Cash ……………………………………… 198,000Treasury Shares ……………… 150,000 Share premium: ……………………Treasury Shares……………………. 48,000

Dec. 22 Cash ……………………………………… 88,000Share premium: Treasury Shares …………………………………… 12,000

Treasury Shares …………… 100,000

b. Restriction of retained earnings for treasury shares owned at year-end:

c.

Book value per share ($590,000 ¸ 60,000 shares)

No. The book value per share represents the shareholders’ share of the net book value of the corporation’s assets, not the assets’ liquidation values. The shareholders may receive more or less than the book value per share if the corporation is liquidated, depending primarily on the amounts at which the corporation’s assets are sold.

Purchased 17,000 shares of treasury shares at $25 per share.

Sold 6,000 shares of treasury shares, cost $150,000, for $33 per share.

Sold 4,000 shares of treasury shares, cost $100,000, for $22 per share.

$175,000 (7,000 shares still owned x $25 per share cost)

No, a restriction on retained earnings does not affect the total amount of retained earnings reported in the balance sheet. A restriction of retained earnings is disclosed, but does not reduce the total amount of retained earnings of a company. The restriction on retained earnings simply limits the amount of dividends the corporation can pay as long as it holds treasury shares.

© The McGraw-Hill Companies, Inc., 2010E11.10-12

Ex. 11.10 a.

b.

c.

Ex. 11.11 a.

b.

Ex. 11.12 a.

b.

Had the shares been split 2-for-1, it would begin trading at approximately $40 per share immediately after the split ($80 ¸ 2 = $40).

Had the shares been split 4-for-1, it would begin trading at approximately $20 per share immediately after the split ($80 ¸ 4 = $20).

When the market price of a corporation’s ordinary shares appreciate in value significantly, as it had in the case of Fido Corporation, it may become too expensive for many investors. Thus, the decision to split the company’s shares were probably made with the intent of making it more affordable to investors.

Companies sometimes purchase their own ordinary shares to help boost the market price per share. This practice is not generally considered unethical, given that information pertaining to the purchase is fully disclosed in the company’s financial statements. Furthermore, if the company acquires a significantly large amount of its outstanding shares, the event would be reported in the financial press.

For a company to classify its treasury shares as a short-term investment is not appropriate. When treasury shares is purchased, the corporation is actually reducing its assets (cash), and eliminating part of its shareholders’ equity. For this reason, treasury shares should not appear in the balance sheet as a current asset.

Carnival Corporation could sell approximately 1,336 million additionalshares. This figure is determined by subtracting the number of issued shares from the number of authorized shares 1,960 million – 624 million = 1,336million.

Authorized, but unissued, shares do not represent an asset of the company. At some time in the future they may result in an increase in assets if they are issued for cash or other assets, but until that time they simply represent the potential for future increases in assets. They are not included in the company’s balance sheet, other than through disclosure of the numbers of authorized and issued shares. This permits the reader of the financial statements to calculate the number of authorized, but unissued shares, as was done above.

© The McGraw-Hill Companies, Inc., 2010E11.13

Ex. 11.13 a. Cash (550,000 x $12)……………………………… 6,600,000Ordinary shares (550,000 x $10)…………… 5,500,000

1,100,000

Cash (40,000 x $110)……………………………… 4,400,000Preference Shares (40,000 x $100)…………… 4,000,000

400,000

Treasury Stock/Ordinary (40,000 x $60)…………. 2,400,000Cash…………………………………………… 2,400,000

b. Shareholders' Equity:

$4,000,000

$ 5,500,000

Share premium:Preference shares 400,000Ordinary shares 1,100,000

Total issued and fully paid capital $11,000,000

Less: Treasury (ordinary) shares at cost, 40,000 shares (2,400,000)

Total shareholders' equity $8,600,000

Share Premium on ordinary shares………………………………………….

Share Premium on Preference Shares…………………………………………..

Note: No entry is required to record the authorization to issue preference and ordinary shares.

Preference shares, 6%, $100 par value, 50,000 shares authorized, 40,000 shares issued and outstanding

Ordinary shares, $10 par value, 1,000,000 shares authorized, 550,000 shares issued


Ex. 11.14 a. $1,000,000

Share premium on ordinary shares 800,000

Share premium on treasury shares Transactions 30,000

Total Issued and fully paid capital $1,830,000

Retained earnings 120,000

Total issued and fully paid capital and retained earnings $1,950,000

Less: Treasury shares (300,000)

Total shareholders' equity $1,650,000

Calculations:Share premium on ordinary shares:

100,000 shares x ($18 - $10) = $800,000Share premium on treasury shares:

10,000 shares x ($23 - $20) = $30,000Treasury shares:

15,000 shares x $20 = $300,000

b.

Ordinary Shares, $10 par value, 200,000 shares authorized, 100,000 shares issued

After a 2:1 share split is distributed, the par value of the ordinary shares will be reduced to half ($10 x 1/2 = $5) and all of the share numbers will double. The 2:1 split has no effect on the total figures for ordinary shares, share premium, retained earnings, treasury shares, or total shareholders' equity.


Ex. 11.15

a.

b.

c.

The number of issued and fully paid up ordinary shares can be read in the note 26 to adidas' financial statements but it is not enclosed. The share capital in the balance sheet cannot indicate the par value of the share capital. adidas in fact issued about 209 million no-par-value bearer shares. Issued and fully paid up shares represents the number of shares that the company has issued and bought by its shareholders.

The amount of authorized share capital can be be read in the note 26 to adidas' financial statement but it is not enclosed. adidas' authorized share capital is about €304 million. Authorized shares or authroized share capital are the number of shares or the amount of share capital specified in the company’s articles of incorporation. It represents the maximum number of shares that the company is authorized to issue by its state of incorporation.

€3,771 million. This amount is not how much the outstanding shares is actually worth. The total shareholders’ equity figure represents the amount invested in the company by owners over time, plus the amount of earnings retained in the company. The amount reported is an historical concept that may or may not bear a close relationship to the shares's current market value.

© The McGraw-Hill Companies, Inc., 2010P11.1A

SOLUTIONS TO PROBLEMS SET A20 Minutes, Easy PROBLEM 11.1A

ROBBINSVILLE PRESSa.

ROBBINSVILLE PRESSPartial Balance Sheet

December 31, 2009Shareholders' equity Preference shares, $100 par value,

authorized 100,000 shares, issued and outstanding $ 1,000,000 10,000 shares

Ordinary shares, $1 par value, authorized 500,000 shares issued and outstanding 170,000 shares 170,000 Share premium: Ordinary shares 2,380,000

Total issued and fully paid capital $ 3,550,000 Retained earnings* 255,000

Total shareholders' equity $ 3,805,000

*Computation of retained earnings at December 31, 2009:

Profit for the four-year period 2006-2009 $ 1,085,000 Less: Preference share dividends ($80,000 per year for four yea $ 320,000 Ordinary share dividends ($0.75 x 170,000 shares x 4 year 510,000 830,000 Retained earnings, December 31, 2009 $ 255,000

b. There are no dividends in arrears at December 31, 2009. We know this because ordinary dividends were paid in each of the four years that the company was in existence. Ordinary shareholders could not have received dividends in each year of the company’s existence had any dividends been in arrears on the preference shares.


20 Minutes, Easy PROBLEM 11.2AWALLER PUBLICATIONS

a.WALLER PUBLICATIONS

Partial Balance SheetDecember 31, 2009

Shareholders' equity 10% cumulative preference shares, $100 par value,

authorized, issued, and outstanding 20,000 shares $ 2,000,000 Ordinary shares, $1 par value, authorized 1 million shares, issued and outstanding 300,000 shares 300,000 Share premium: ordinary shares 5,700,000




Profit for the five-year period 2004-2008 $ 4,460,000 Less: Preference share dividends ($200,000 x 5 years) $ 1,000,000 Ordinary share dividends ($1 x 300,000 shares x 5 yea 1,500,000 2,500,000 Retained earnings, December 2008 $ 1,960,000

Less: Net loss of 2009 1,750,000 Retained earnings, December 31, 2009 $ 210,000

b. Note to financial statements:Since the corporation sustained a loss of $1,750,000 the directors recommended that no dividends shall be paid for the year 2009.


25 Minutes, Medium PROBLEM 11.3AMANHATTAN TRANSPORT COMPANY

a.MANHATTAN TRANSPORT COMPANY


Shareholders' equity 8% noncumulative preference shares, $100 par, 5,000

shares authorized, issued, and outstanding $ 500,000 $9 noncumulative preference shares, no-par value, 10,000 shares

authorized, 5,000 shares issued and outstanding 512,000 Ordinary shares, $2 par, 200,000 shares authorized, 100,000 shares issued and outstanding 200,000 Share premium: Ordinary shares 600,000




Retained earnings at Dec. 31, 2007 $ 170,000 Add: Profit for 2008 and 2009 890,000

Profit for four-year period $ 1,060,000 Less: Dividends paid on 8% preference shares:

2008 (8% x $100 x 5,000 shares = $40,000) $ 40,000 2009 (8% x $100 x 5,000 shares = $40,000) 40,000 (80,000) Dividends on $9 preference shares:

2008 ($9 x 5,000 shares) $ 45,000 2009 ($9 x 5,000 shares) 45,000 (90,000)

Dividends on ordinary shares:2008 ($0.50 x 100,000 shares) $ 50,000 2009 ($1.60 x 100,000 shares) 160,000 (210,000)

Retained earnings, December 31, 2009 $ 680,000

b.

1.

2.

3. Increasing the amount of debt on a balance sheet can adversely affect financial ratios.

A corporation might decide to use preference shares rather than debt to finance operations for any of the following reasons (only 2 required):

Dividends do not have to be paid each year and do not become a legal obligation of the corporation until they are declared. Interest on debt is a legal obligation of the corporation and must be paid each year.

Debt must be repaid at some future date. To be a permanent source of capital, debt must be periodically refinanced. Preference shares generally does not mature.


35 Minutes, Medium PROBLEM 11.4A BARNES COMMUNICATIONS LIMITED a.

General Journal

20__ Jan 6 Cash 280,000

Ordinary Shares 40,000 Share Premium: Ordinary Shares 240,000

at $14 per share.

7 Organization Costs Expense 7,000 Ordinary Shares 1,000 Share Premium: Ordinary Shares 6,000

Issued 500 shares of ordinary shares to Barnes inexchange for services relating to formation of the

shares) = $14 per share.

### Cash 250,000 Preference Shares 250,000 Issued 2,500 shares of $100 par value, 10%,preference shares at par value.

4 Land 225,000 Ordinary Shares 30,000 Share Premium: Ordinary Shares 195,000

for land valued at $225,000 (15,000 shares x $15).

Nov ### Dividends (Preference Shares) 25,000 Dividends Payable 25,000

To record declaration of annual dividends of $10 per share on 2,500 preference shares outstanding.Payable Dec. 20.

Dec ### Dividends Payable 25,000 Cash 25,000

To record payment of dividend declared Nov. 15.

### Income Summary Retained Earnings 147,200 To close the Income Summary account for the 147,200 year.

### Retained Earnings 25,000 Dividends 25,000

To close the Dividends account.

Issued 20,000 shares of $2 par value ordinary shares

corporation. Implied issuance price ($7,000 ÷ 500

June

Issued 15,000 shares of ordinary shares in exchange


© The McGraw-Hill Companies, Inc., 2010P11.4A (p.2)

PROBLEM 11.4ABARNES COMMUNICATIONS LIMITED (concluded)

b.BARNES COMMUNICATIONS LIMITED

Partial Balance SheetDecember 31, 20___

Shareholders' equity Preference shares, $100 par, authorized

50,000 shares, issued and outstanding 2,500 shares $ 250,000 Ordinary shares, $2 par, authorized 400,000 shares, issued and outstanding 35,500 shares 71,000 Share premium: Ordinary shares 441,000

Total issued and fully paid capital $ 762,000 Retained earnings* 122,200

Total shareholders' equity $ 884,200

*Computation of retained earnings at December 31, 20__:

Retained earnings at January 1, 20__ $ - Add: Profit in 20__ 147,200 Less: Preference dividends in 20__ (25,000)Retained earnings at December 31, 20__. $ 122,200

© The McGraw-Hill Companies, Inc., 2010P11.4A (p.2)


35 Minutes, Strong PROBLEM 11.5ASMITHFIELD PRODUCTS

a. Par value of all preference shares outstanding $ 2,400,000 Par value per share of preference shares $ 100

Number of preference shares outstanding ($2,400,000 ÷ $100) 24,000

b. Dividend requirement per preference share (7 1/2% x $100) $ 7.50 Number of preference shares outstanding (a) 24,000 Annual preference shares dividend requirement ($7.50 x 24,000 shares) $ 180,000

c. Par value of all ordinary shares outstanding $ 900,000 Par value per ordinary share $ 2 Number of ordinary shares outstanding ($900,000 ÷ $2 per share) 450,000

d. Par value of all ordinary shares issued $ 900,000 Share premium: Ordinary 8,325,000

Total issuance price of all ordinary shares $ 9,225,000 Number of ordinary shares issued (c) 450,000 Average issuance price per ordinary share ($9,225,000 ÷ 450,000 shares) $ 20.50

e. Par value of preference shares $ 2,400,000 Par value of ordinary shares 900,000 Total legal capital $ 3,300,000

f. Total legal capital (e) $ 3,300,000 Add: Share premium: Ordinary shares 8,325,000

Total issued and fully paid capital $ 11,625,000

g. Total shareholders’ equity $ 14,220,000 Less: Par value of preference shares [24,000 shares (a) x $100 per shar 2,400,000

Equity of ordinary shareholders $ 11,820,000 Number of ordinary shares outstanding (c) 450,000

$ 26.27

h. Retained earnings, beginning of the year $ 717,500 Add: Profit for the year 3,970,000

Subtotal $ 4,687,500 Less: Retained earnings, end of the year 2,595,000

Total dividends paid during the year $ 2,092,500 Less: Dividends on preference shares (part b) 180,000

Total dividends on ordinary shares $ 1,912,500 Number of ordinary shares outstanding 450,000

Dividends per ordinary share ($1,912,500 ¸ 450,000) $ 4.25

Book value per share ($11,820,000 ¸ 450,000 shares)


35 Minutes, Medium PROBLEM 11.6APARSONS LIMITED CORPORATION

In Thousands (Except for Per Share Amounts) a. Par value of all ordinary shares outstanding $ 6,819

Par value per share 0.50 Number of shares outstanding ($6,819/$0.50) 13,638

b. Dividend requirement per preference share $ 17.20

Number of preference shares outstanding 345 Annual dividends paid to preference sharesholders ($17.20 x 345) $ 5,934

c. Par value of preference shares $ 86,250

Par value of ordinary shares 6,819 Share premium 87,260 Total issued and fully paid capital $ 180,329

d. Total shareholders’ equity $ 237,592

Less: Preference shares par value = ($250 x 345 shares) 86,250 Equity of ordinary shareholders $ 151,342 Number of ordinary shares outstanding 13,638 Book value per share ($151,342/13,638 shares) $ 11.10

© The McGraw-Hill Companies, Inc., 2010P11.6A(p.2)

PROBLEM 11.6A PARSONS LIMITED (concluded)

e.

f.

g.

The basic advantage of being publicly owned is that the corporation has the opportunity to raise large amounts of equity from many investors. Some publicly owned corporations have millions of shareholders, including pension funds, mutual funds, and other corporations. Private corporations are usually unable to raise the large amounts of capital available to publicly owned corporations.

A major advantage to the shareholders of a publicly owned corporation is that theirequity investments are highly liquid assets, immediately salable at quoted marketprices.

The primary disadvantages of being publicly owned are the increased governmental regulations and financial reporting requirements.

The term convertible means that at the option of the preference shareholder, each preference share can be converted into a specified number of ordinary shares. To evaluate the value of this conversion feature, the shareholder must know into how many shares of ordinary each preference share can be converted. This information is disclosed in the notes accompanying the corporation’s financial statements.

At $248 per share, Parson's preference share has a dividend yield of 6.9% ($17.20 ¸ $248). In comparison, an 8%, $50 par preference selling at $57 has a dividend yield of 7% [(8% x $50 par) ¸ $57].

The dividend yield on preference shares indicates how much investors value certainfeatures of the shares. The lower the yield, the more investors favor the shares. Ahigher yield means that investors demand a higher return to induce them to purchasethe shares.

The two principal factors that cause one preference share to yield less than another are: (1) the appearance of greater ability to pay the preference dividends each year, and (2) special features that appeal to investors, such as Parson’s conversion feature, cumulative dividends, or a high call price.


15 Minutes, Easy PROBLEM 11.7A TECHNO CORPORATION

a.

b.

Par value is the legal capital per share—the amount by which shareholders’ equity cannot be reduced except by losses. Thus, par value may be viewed as a minimum cushion of equity capital existing for the protection of creditors.

Book value per share is equal to the net assets represented by each ordinaryshare. Book value is a historical cost concept, representing the amounts invested bythe shareholders, plus the amounts earned and retained by the corporation. Bycomparing book value with current market value, shareholders may gain insight intowhether management has increased or diminished the value of the resourcesentrusted to their care.

The market value of a share is established in the marketplace. It represents the per-share price at which willing sellers can and will sell shares to willing buyers. Market value is related primarily to investors’ future expectations of the company’s performance, rather than to historical amounts.

The company’s par value—one-tenth of a cent per share—is quite low. However, thecorporation can set par value at any level that it chooses; the amount of par value hasno direct effect upon either book value or market value. It does mean, however, thatthe amount of the company’s legal capital—serving as a cushion for creditors—is quite low. Another reason for the small par value is the possibility of share splits in the past.

The fact that book value per share ($6.50) is far above par value indicates either that (1) the shares initially was issued at a price far above par value, or (2) that the company has retained substantial amounts of earnings. Even if there had been share splits in prior years, the total dollar amount of book value would not have been affected.

The market value of $65 is 10 times book value. This implies that investors believe that management and product lines make the company worth far more than the amounts of capital historically invested.

The very low par value offers little protection to the company’s creditors. On the other hand, a market value of many times book value implies that little cushion is required for creditors’ claims to be secure. If the company performs as its market price implies that it will, its earnings and cash flows should make the creditors’ positions quite secure. Earnings and cash flows are far more relevant to a company’s debt-paying ability than is the cushion provided by par value.


15 Minutes, Medium PROBLEM 11.8AFELLER CORPORATION

a.

Shareholders’ equity:

Ordinary shares, $1 par, 50,000 shares authorized, issu $ 50,000 outstandingShare premium: Ordinary shares 350,000 Share premium: Treasury shares 5,000


Total shareholders’ equity $ 590,000

*Computation of retained earnings at Dec. 31, 2009: Profit in 2007 $ 82,000 Profit in 2008 25,000 Profit in 2009 78,000 Retained earnings, Dec. 31, 2009 $ 185,000

b.

c.

The company’s book value per share is $11.80 ($590,000 total shareholders’ equity ¸ 50,000 shares outstanding).

The treasury shares purchase of $35,000 in 2008 was reported as a financing cash outflow in the statement of cash flows for that year. The reissue of the treasury shares for $40,000 in the following year was reported as a financing cash inflow in the 2009 statement of cash flows.


30 Minutes, Strong PROBLEM 11.9AHERNDON INDUSTRIES

a. Shareholders’ equity:

10% preference shares, $100 par, cumulative, authorized, issued, and outstanding 30,000 shares $ 3,000,000 Ordinary shares, $10 par, 200,000 shares authorized, 120,000 shares issued, of which 10,000 shares are held in treasury 1,200,000 Share premium: Ordinary shares 720,000 Share premium: Treasury shares* 50,000

Total issued and fully paid capital $ 4,970,000 Retained earnings** 1,925,000

Subtotal $ 6,895,000 Less: Treasury shares (10,000 shares x $20 cost per share) 200,000

Total shareholders’ equity at Dec. 31, 2009 $ 6,695,000

*Computation of share premium on treasury shares:

per share

per sharePremium per share reissued: $5 per share ($25 - $20) Total issued and fully paid capital on treasury shares: $50,000 ($5 per share x 10,000 shares reissued)

**Computation of retained earnings at Dec. 31, 2009: Profit (for years 2005–2009) $ 3,700,000 Less: Preference dividend (for years 2005–2009)

$100 x 10% x 30,000 shares x 5 years $ 1,500,000 Less: Ordinary dividends

2005–2006: 120,000 shares outstanding x $0.50 x 2 yrs 120,000 2007–2008: 100,000 shares outstanding x $0.50 x 2 yrs 100,000 2009: 110,000 shares outstanding x $0.50 55,000 1,775,000

Retained earnings, Dec. 31, 2009 $ 1,925,000

b.

c.

Purchase price per share: $400,000 ÷ 20,000 shares = $20

Reissue price per share: $250,000 ÷ 10,000 shares = $25

The company’s book value per share is approximately $33.59 ($6,695,000 total shareholders’ equity - $3,000,000 of preference shares book value = $3,695,000; $3,695,000 ¸ 110,000 shares outstanding = $33.59).

Had the company decided to split its ordinary shares 3-for-1 on December 31, 2009, the market value would have fallen to approximately $10 per share ($30 ¸ 3). The par value would have been reduced to $3.33 ($10 ÷ 3), and the number of shares outstanding would have increased to 330,000 shares (110,000 x 3).

© The McGraw-Hill Companies, Inc., 2010P11.1B

SOLUTIONS TO PROBLEMS SET B20 Minutes, Easy PROBLEM 11.1B

SEPTA LIMITEDa.

SEPTA LIMITEDPartial Balance Sheet

December 31, 2009Shareholders' equity 10% noncumulative preference shares, $100 par value, callable

at $110, authorized 1,000 shares, issued and out- $ 50,000 standing 500 shares

Ordinary shares, $1 par value, authorized 200,000 shares Issued and outstanding 80,000 shares 80,000 Share premium: Ordinary shares 1,120,000

Total issued and fully paid capital $ 1,250,000 Retained earnings* 1,652,000



Profit for the four-year period 2006-2009 $ 1,800,000 Less: Preference share dividends ($5,000 per year for four years) $ 20,000 Ordinary share dividends ($0.40 x 80,000 shares x 4 years) 128,000 148,000 Retained earnings, December 31, 2009 $ 1,652,000

b. The market price of preference shares usually decreases as interest rates increase. Thus, at December 31, 2009, the market price of Septa's preference shares was probably lower than its call price of $110 (in fact, it may actually have fallen below its original price of $100 per share.


20 Minutes, Easy PROBLEM 11.2B BANNER PUBLICATIONSa.

BANNER PUBLICATIONSPartial Balance Sheet

December 31, 2009Shareholders' equity 10% noncumulative preference shares, $100 par value,

authorized, issued, and outstanding 10,000 shares $ 1,000,000 Ordinary shares, $1 par value, authorized 1 million shares, issued and outstanding 400,000 shares 400,000 Share premium: ordinary shares $ 5,600,000

Total issued and fully paid capital 7,000,000 Retained earnings* 900,000



Profit for the five-year period 2004-2008 $ 4,100,000 Less: Preference share dividends ($100,000 x 5 years) $ 500,000 Ordinary share dividends ($.80 x 400,000 shares x 5 y 1,600,000 2,100,000 Retained earnings, December 2008 $ 2,000,000

Less: Loss of 2009 1,100,000 Retained earnings, December 31, 2009 $ 900,000

b. Note to financial statements:Since the company sustained a loss in 2009, the directors recommended that no dividends shall be paid.


25 Minutes, Medium PROBLEM 11.3BRAY BEAM LIMITED

a.RAY BEAM LIMITED


Shareholders' equity 10% noncumulative preference shares, $100 par value, 10,000

shares authorized, issued, and outstanding $6 noncumulative preference shares, no-par value, 8,000 shares

authorized, 5,000 shares issued and outstandingOrdinary shares, $1 par, 260,000 shares authorized, 130,000 shares issued and outstandingShare premium: Ordinary shares

Total issued and fully paid capitalRetained earnings*

Total shareholders' equity


Retained earnings at Dec. 31, 2007Add: Profit for 2008 and 2009

Profit for four-year periodLess: Dividends paid on 10% preference shares:

2008 (10% x $100 x 10,000 shares = $100,000) 100,000 2009 (10% x $100 x 10,000 shares = $100,000) 100,000 Dividends on $6 preference shares:

2008 ($6 x 5,000 shares) $ 30,000 2009 ($6 x 5,000 shares) 30,000

Dividends on ordinary shares: 2008 ($0.90 x 130,000 shares) $ 117,000 2009 ($2.00 x 130,000 shares) 260,000

Retained earnings, December 31, 2009

b.

1.

2.

3. Increasing the amount of debt on a balance sheet can adversely affect financial ratios.

A corporation might decide to use preference shares rather than debt to finance operations for any of the following reasons (only 2 required):

Dividends do not have to be paid each year and do not become a legal obligation of the corporation until they are declared. Interest on debt is a legal obligation of the corporation and must be paid each year.



PROBLEM 11.3BRAY BEAM LIMITED

RAY BEAM LIMITEDPartial Balance Sheet

December 31, 2009 $ 1,000,000 320,000 130,000 1,820,000 $ 3,270,000 1,193,000 $ 4,463,000 $ 530,000 1,400,000 $ 1,930,000

(200,000)

(60,000)

(377,000) $ 1,293,000

Increasing the amount of debt on a balance sheet can adversely affect financial ratios.

A corporation might decide to use preference shares rather than debt to finance operations for any of

Dividends do not have to be paid each year and do not become a legal obligation of the corporation until they are declared. Interest on debt is a legal obligation of the



35 Minutes, Medium PROBLEM 11.4B MARKUP LIMITED a.

General Journal

20__ Jan 7 Cash 300,000

Ordinary Shares 30,000 Share Premium: Ordinary Shares 270,000

at $10 per share.

### Organization Costs Expense 12,000 Ordinary Shares 1,000 Share Premium: Ordinary Shares 11,000

Issued 1,000 shares of ordinary shares to Deal inexchange for services relating to formation of the

shares) = $12 per share.

### Cash 400,000 5% Preference Shares 400,000 Issued 4,000 shares of $100 par value, 5%,noncumulative preference shares at par value.

July 5 Land 120,000 Ordinary Shares 10,000 Share Premium: Ordinary Shares 110,000

for land valued at $120,000 (10,000 shares x $12).

Nov ### Dividends (Preference Shares) 20,000 Dividends Payable 20,000

To record declaration of annual dividends of $5per share on 4,000 preference shares outstanding.Payable Dec. 11.

Dec ### Dividends Payable 20,000 Cash 20,000

To record payment of dividend declared Nov. 25.

### Income Summary Retained Earnings 810,000 To close the Income Summary account for the 810,000 year.

### Retained Earnings 20,000 Dividends (Preference Shares) 20,000

Issued 30,000 shares of $1 par value ordinary shares

corporation. Implied issuance price ($12,000 ÷ 1,000

Issued 10,000 shares of ordinary shares in exchange


To close the Dividends account.

© The McGraw-Hill Companies, Inc., 2010P11.4B (p.2)

20 Minutes, Easy PROBLEM 11.4BRKUP LIMITED (concluded)

b.MARKUP LIMITED

Partial Balance SheetDecember 31, 20__

Shareholders' equity 5% cumulative preference shares, $100 par, authorized

100,000 shares, issued and outstanding 4,000 shares $ 400,000 Ordinary shares, $1 par, authorized 100,000 shares, issued and outstanding 41,000 shares 41,000 Share premium: Ordinary shares 391,000



*Computation of retained earnings at December 31, 20__:

Retained earnings at January 1, 20__ $ - Add: Profit in 20__ 810,000 Less: Preference dividends in 20__ (20,000)Retained earnings at December 31, 20__. $ 790,000

© The McGraw-Hill Companies, Inc., 2010P11.4B (p.2)


35 Minutes, Strong PROBLEM 11.5BMANOR LIMITED

a. Par value of all preference shares outstanding $ 4,400,000 Par value per share of preference shares $ 100

Number of preference shares outstanding ($4,400,000 ÷ $100) 44,000

b. Dividend requirement per share of preference shares (10% x $100) $ 10 Number of preference shares outstanding (a) 44,000 Annual preference shares dividend requirement ($10 x 44,000 shares) $ 440,000

c. Par value of all ordinary shares outstanding $ 3,400,000 Par value per ordinary share $ 2 Number of ordinary share outstanding ($3,400,000 ÷ $2 per share) 1,700,000

d. Par value of all ordinary shares issued $ 3,400,000 Share premium: Ordinary 6,800,000

Total issuance price of all ordinary shares $ 10,200,000 Number of ordinary shares issued (c) 1,700,000 Average issuance price per ordinary share ($10,200,000 ÷ 1,700,000 shares) $ 6

e. Par value of preference shares $ 4,400,000 Par value of ordinary shares 3,400,000 Total legal capital $ 7,800,000

f. Total legal capital (e) $ 7,800,000 Add: Share premium: Ordinary shares $ 6,800,000 Donated capital 400,000

Total issued and fully paid capital $ 15,000,000

g. Total shareholders’ equity $ 18,160,000 Less: Par value of preference shares [44,000 shares (a) x $100 per shar 4,400,000

Equity of ordinary shareholders $ 13,760,000 Number of ordinary shares outstanding (c) 1,700,000

$ 8.09

h. Retained earnings, beginning of the year $ 1,200,000 Add: Profit for the year 4,800,000

Subtotal $ 6,000,000 Less: Retained earnings, end of the year 3,160,000

Total dividends paid during the year $ 2,840,000 Less: Dividends on preference shares (part b) 440,000

Total dividends on ordinary shares $ 2,400,000 Number of ordinary shares outstanding 1,700,000

Dividends per ordinary share ($2,400,000 ¸ 1,700,000) $ 1.41

Book value per share ($13,760,000 ¸ 1,700,000 shares)



35 Minutes, Medium PROBLEM 11.6BTOASTY CORPORATION

In Thousands (Except for Per Share Amounts) a. Par value of all ordinary shares outstanding $ 9,600

Par value per share $ 3 Number of shares outstanding ($9,600/$3) 3,200

b. Dividend requirement per share of preference shares $ 10

Numbers of preference shares outstanding 250 Annual dividends paid to preference sharesholders ($10 x 250) $ 2,500

c. Par value of preference shares $ 50,000

Par value of ordinary shares $ 9,600 Share premium 76,800 Total issued and fully paid capital $ 136,400

d. Total shareholders’ equity $ 187,000

Less: Preference shares par value = ($200 x 250 shares) 50,000 Equity of ordinary shareholders $ 137,000 Number of ordinary shares outstanding 3,200

$ 42.81 Book value per share ($137,000 ÷ 3,200 shares)

© The McGraw-Hill Companies, Inc., 2010P11.6B(p.2)

PROBLEM 11.6B TOASTY CORPORATION (concluded)

e.

f.

g.

The basic advantage of being publicly owned is that the corporation has the opportunity to raise large amounts of equity capital from many investors. Some publicly owned corporations have millions of shareholders, including pension funds, mutual funds, and other corporations. Private corporations are usually unable to raise the large amounts of capital available to publicly owned corporations.

A major advantage to the shareholders of a publicly owned corporation is that theirequity investments are highly liquid assets, immediately salable at quoted marketprices.

The primary disadvantages of being publicly owned are the increased governmental regulations and financial reporting requirements.

The term convertible means that at the option of the preference sharesholder, each preference share can be converted into a specified number of ordinary shares. To evaluate the value of this conversion feature, the shareholder must know into how many shares of ordinary each preference share can be converted. This information is disclosed in the notes accompanying the corporation’s financial statements.

At $190 per share, Toasty’s preference has a dividend yield of 5.26% ($10 ¸ $190). In comparison, a 6%, $50 par preference selling at $52 has a dividend yield of 5.77% [(6% ´ $50 par) ¸ $52].

The dividend yield on preference shares indicates how much investors value certainfeatures of the shares. The lower the yield, the more investors favor the shares. Ahigher yield means that investors demand a higher return to induce them to purchasethe shares.

The two principal factors that cause one preference to yield less than another are: (1) the appearance of greater ability to pay the preference dividends each year, and (2) special features that appeal to investors, such as Toasty’s conversion feature, cumulative dividends, or a high call price.


15 Minutes, Easy PROBLEM 11.7B BRAIN CORPORATION

a.

b.

Par value is the legal capital per share—the amount by which shareholders’ equity cannot be reduced except by losses. Thus, par value may be viewed as a minimum cushion of equity capital existing for the protection of creditors.

Book value per share is equal to the net assets represented by each ordinary share. Book value is a historical cost concept, representing the amounts invested bythe shareholders, plus the amounts earned and retained by the corporation. Bycomparing book value with current market value, shareholders may gain insight intowhether management has increased or diminished the value of the resourcesentrusted to their care.

The market value of a share is established in the marketplace. It represents the per-share price at which willing sellers can and will sell shares of the share to willing buyers. Market value is related primarily to investors’ future expectations of the company’s performance, rather than to historical amounts.

The company’s par value—five cents per share—is quite low. However, thecorporation can set par value at any level that it chooses; the amount of par value hasno direct effect upon either book value or market value. It does mean, however, thatthe amount of the company’s legal capital—serving as a cushion for creditors—is quite low. Another reason for the small par value is the possibility of share splits in prior years.

The fact that book value per share ($10.00) is far above par value indicates either that (1) the share initially was issued at a price far above par value, or (2) that the company has retained substantial amounts of earnings. Even if there had been share splits in prior years, the total dollar amount of book value would not have been affected.

The market value of $96 is 9.6 times book value. This implies that investors believe that management and product lines make the company worth far more than the amounts of capital historically invested.

The very low par value offers little "cushion" to the company’s creditors. On the other hand, a market value of many times book value implies that little cushion is required for creditors’ claims to be secure. If the company performs as its market price implies that it will, its earnings and cash flows should make the creditors’ positions quite secure. Earnings and cash flows are far more relevant to a company’s debt-paying ability than is the cushion provided by par value.


15 Minutes, Medium PROBLEM 11.8BTIN CORPORATION

a.

Shareholders’ equity:

Ordinary shares, $3 par, 50,000 shares authorized, issu $ 150,000 outstanding

Share premium: Ordinary shares 350,000 Share premium: Treasury shares 10,000


Total shareholders’ equity $ 840,000

*Computation of retained earnings at Dec. 31, 2009: Profit in 2007 $ 150,000 Profit in 2008 80,000 Profit in 2009 100,000 Retained earnings, Dec. 31, 2009 $ 330,000

b.

c.

The company’s book value per share is $16.80 ($840,000 total shareholders’ equity ¸ 50,000 shares outstanding).

The treasury shares purchase of $30,000 in 2008 was reported as a financing cash outflow in the statement of cash flows for that year. The reissue of the treasury shares for $40,000 in the following year was reported as a financing cash inflow in the 2009 statement of cash flows.


30 Minutes, Strong PROBLEM 11.9BPARKER INDUSTRIES

a. Shareholders’ equity:

6% preference shares, $100 par, authorized and issued and outstanding 10,000 shares $ 1,000,000 Ordinary shares, $20 par, 100,000 shares authorized, 80,000 shares issued, of which 400 shares are held in treasury 1,600,000 Share premium: Ordinary shares 1,200,000 Share premium: Treasury shares* 6,000

Total issued and fully paid capital $ 3,806,000 Retained earnings** 3,261,440

Subtotal 7,067,440 Less: Treasury shares (400 shares x $40 cost per share) 16,000

Total shareholders’ equity at Dec. 31, 2009 $ 7,051,440

*Computation of share premium on treasury shares:

per share

per sharePremium per share reissued: $10 per share ($50 - $40) Total issued and fully paid capital on treasury shares: $6,000 ($10 per share x 600 shares reissued)

**Computation of retained earnings at Dec. 31, 2009: Profit (for years 2005–2009) $ 3,800,000 Less: Preference dividend (for years 2005–2009)

$100 x 6% x 10,000 shares x 5 years 300,000 Less: Ordinary dividends

2005–2006: 80,000 shares outstanding x $0.60 x 2 yrs $ 96,000 2007–2008: 79,000 shares outstanding x $0.60 x 2 yrs 94,800 2009: 79,600 shares outstanding x $0.60 47,760 238,560

Retained earnings, Dec. 31, 2009 $ 3,261,440

b.

c.

Purchase price per share: $40,000 ÷ 1,000 shares = $40

Reissue price per share: $30,000 ÷ 600 shares = $50

The company’s book value per share is approximately $76.02 ($7,051,440 total shareholders’ equity - $1,000,000 of preference shares book value = $6,051,440; $6,051,440 ¸ 79,600 shares outstanding = $76.02).

Had the company decided to split its ordinary share 2-for-1 on December 31, 2009, the market value would have fallen to approximately $28 per share ($56 ÷ 2). The par value would have been reduced to $10.00 ($20 ÷ 2), and the number of shares outstanding would have increased to 159,200 shares (79,600 x 2).

© The McGraw-Hill Companies, Inc., 2010Case 11.1

SOLUTIONS TO CRITICAL THINKING CASES

15 Minutes, Medium CASE 11.1FACTORS AFFECTING THE MARKET PRICES

OF PREFERENCE AND ORDINARY SHARES

a.

b.

c.

The market price of the 10%, $100 par value preference shares may be expected to decline gradually as long-term interest rates rise. The market price of preference shares tends to vary inversely with the level of interest rates.

If ADM’s profitability increases dramatically, the market price of its ordinary shareprobably will rise significantly. The improved profitability of the company may lead tolarger increases in the dividends paid to ordinary shareholders than the 5 and 10 centincreases of prior years. The market price of ordinary share is strongly affected by suchfactors as the company’s expected future earnings and the probable rate of futureordinary share dividends.

The market price of the 7%, $100 par value convertible preference shares should rise approximately in proportion to the increase in the market value of the ordinary share. This issue of preference shares is already deriving much of its market value from its conversion feature, as indicated by the fact that its market price ($125) exceeds the market price of ADM’s 10% preference shares ($90), which pays a higher dividend.

The current market price of the convertible preference shares is too high to be explained by its $7 per year dividend, and it is approximately three times the current market price of the ordinary share. Therefore, each share of this preference shares probably is convertible into about three shares of ordinary share. As the market price of the ordinary share increases, the market price of the convertible preference should also increase to remain approximately equal in value to three shares of ordinary share.


25 Minutes, Strong CASE 11.2 FACTORS AFFECTING THE MARKET PRICES

a.

b.

c.

OF ORDINARY SHARES

The value of an ordinary share is based on investors’ expectations about future earnings and cash flows of the business. Thus, the increase in the price of the shares of Japan Airlines Corporation resulted from an decrease in investors’ expectations about future earnings of the company based on bankruptcy rumors.

The fall in the price of HSBC’s ordinary shares probably is based on two factors. The increase in the default risk signals a general increase in interest rates which will affect the required yield on all investments. Since investors will demand a higher yield on their investments, share and bond prices may suffer an overall decline.

As a financial institution, this increase in the defaults has additional significance to HSBC. The increase in the discount rate increases HSBC’s financial strength, which will reduce its profit, at least in the short run. This reduction in expectations about future earnings will further reduce the bank’s share price.

The close down of research center signaled to the market that GlaxoSmithKline may be having problems with its investment in research and development. Therefore, investors are reducing their expectations of the company’s future earnings and increasing their assessments of the risk of the business. This caused the share price to drop.


Group assignment: CASE 11.3No time estimate SELECTING A FORM OF ORGANIZATION

We do not provide comprehensive solutions for group problems that involve interviews. But the following items normally come to light in our classes.

• Students may find that many people entered a business without giving much thought to the form of entity.

• Among the “unforeseen complications” that often come to light are the problems when partners do not see eye to eye, and the costs and complications resulting from the corporation being a taxable entity.

• The normal reason why a business may change its form of entity is to attract morecapital.

• Some students may encounter professional corporations, which often are used by one or more members of a partnership. These professional corporations are intended to limit the individuals’ personal liability—although they require the individual to carry “malpractice” insurance and do not exonerate them from liability for some types of professional misconduct. They may also encounter S corporations, which, for tax purposes, are treated as unincorporated organizations.


20 Minutes, Medium CASE 11.4S.F.C. ENFORCEMENT DIVISION

ETHICS, FRAUD & CORPORATE GOVERNANCE(a)

The six divisions and two departments of the Securities and Futures Commission are:

Corporate FinanceEnforcementPolicy, China & Investment ProductsSupervision of MarketsCorporate AffairsLegal ServicesLicensingIntermediaries Supervision

(b)

(c) The publication is "Does price information tell all?" under monthly focus on February 2010.

(d)

The Enforcement Division inquires possible irregularities of stock and derivative markets, recommends disciplinary action when appropriate and prevent unlawful or improper activities.

Investor has to pay attention to the timeliness of market data and cross check different financial ratios through the latest financial reports and announcements. In addition to price information, investors should also look at other corporate actions that also affect the price movements of stocks.

The recent market manipulation verdicts have sent the a clear message to all market participants that market manipulation is a serious offence and that perpetrators could be prosecuted and sent to jail for such actions. It is imperative that all market participants operate with fairness and integrity on the markets.

Documents

Chapter 11 Solutions Manual