MANAGEMENT DECISIONS AND FINANCIAL

ACCOUNTING REPORTS Baginski & Hassell

Electronic presentation adaptation byDr. Barbara L. Hassell & Dr. Harold O. Wilson

Chapter 2

FINANCING DECISIONS— Introduction and Equity Decisions

• Characteristics that distinguish debt from equity

• Hybrid securities

• Theoretical determinants of capital structure

• Financing decisions– equity securities

• Dividends

Distinguishing Debt & Equity

• Voting privileges– Common stockholders vote & elect the

Board of Directors.

– Debt holders do not vote!– Preferred stockholders do not vote!

Distinguishing Debt & Equity

• Claims in corporate dissolution, or in other times of stress:

– Debt holders have first claim!– Preferred stockholders have a secondary claim.– Common stockholders have THE residual claim.

BANKERS COME FIRST!

Distinguishing Debt & Equity

• Claims against future cash flows– Debt holders have contractual claims against

future cash flows• Interest payments• Principal payments

Stockholders have no such contractual claims.

Preferred vs. Common Stock

Preferred stockholders receive a dividend preference IF dividends are declared.• Should preferred dividends be “skipped” in

any given year, and the shares have a “cumulative” feature (the normal condition), footnotes to financial statements indicate what is known as…

dividends in arrears—but there is still no legal liability to declare & pay dividends to preferred shareholders.

Hybrid SecuritiesHybrid securities have some debt features and

some equity features:– The preferred stock dividend, if any, is a rate

based on par value--a debt-like feature.– Convertible debt has an option to convert to

common stock--an equity-like feature. – Debt issued with detachable stock warrants

means the investor-lender acquires both debt and equity (warrants) securities for one price.

Theoretical Determinants of Capital Structure

• Capital Structure: the mix of debt and equity used to finance assets or projects.

• What constitutes optimal capital structure (OCS) is one of the most important aspects of corporate finance.

• Important variables in OCS decisions include…

• Tax considerations: Interest expense (as on bonds) is tax deductible, but there is “no such account as dividends expense.” Dividend payments are distributions of profits, and are not tax deductible.

Debt service considerations: The pressure & stress of meeting [fixed] Principal & Interest payments may increases the likelihood of financial distress; dividend payments are somewhat flexible.

– Superior management information may be assumed to be possessed by management, as compared to potential stockholder’s information; this might reduce the capital expected to be obtained in IPOs, etc.

– Perceived importance of control may be viewed by some existing shareholders as diluted, when new shares are issued. to existing shareholders.• The cost of equity issued might be thought

to increase---to compensate “old” owners for some loss of control.

FINANCING DECISIONS: Equity Securities

• Common stock issued for cash.

• Common stock issued for non-cash consideration.

• Preferred stock issued.

• Stock subscriptions issued.

• Stock options issued.

• Stock rights issued.

• Donations.

Common (or Preferred) Stock Issued for Cash

• Transaction recognized at fair market value:– Cash, net of transaction costs, increases.– Common/Preferred stock account

increases (for par value, by law), OR for the cash proceeds if the state has allowed “no par” issuances.

Additional paid in capital increases if the net cash proceeds exceeds the par value.

Common/Preferred Stock issued for Cash

• Facts: Ajaxx, Inc., is authorized to issue 50,000,000 shares of $2 par, common stock, and issues [IPO] at $10 each, 1,000,000 shares. Assume transaction costs are $50,000.

• What is the transaction’s impact on the financial statements?

Partial Balance Sheet (000s)

Assets

Cash ($10,000,000 - $50,000) $9,950

Stockholders’ Equity

Common stock, $2 par, 50,000,000 shares authorized, 1,000,000 shares issued and outstanding $2,000

Additional paid-in capital 7,950

$9,950

Common/Preferred Stock Issued for Non-Cash Consideration

• Non-cash consideration (e.g., property or services)

• Transaction recognized at FMV (which may be difficult to ascertain).– Asset/expense increases [by the clearer of

FMV of what is received or surrendered].– Common/Preferred stock account increases

for par value of shares issued.– Additional paid-in capital [likely] increases.

• Exum, Inc., issues 800,000 shares of $1 par common stock, in exchange for property with a fair market value of $7,800,000, and incurs $100,000 in transactions costs.

• What is the impact of the transaction on the financial statements?

Balance Sheet Effects (000s)Assets

Property ($7,800,000 - $100,000) $7,700

Stockholders’ Equity

Common stock (800,000 shares, $1 par)

800

Additional paid-in capital 6,900

$7,700

Stock Subscriptions

• Stock Subscriptions Receivable: A corporation accepts an order for capital stock, with the shares to be delivered at a future date for a predetermined price.

The agreement is an executory contract (both parties agree to perform in the future).

Stock Subscription Details

• The corporation records…– Subscription receivable, at subscription price.– Common stock subscribed, a temporary equity

account, at par value.– Additional paid-in capital, a permanent

account, at subscription price minus par value.

The Common Stock Subscribed account is replaced by Common Stock when the payment check clears the bank!

Observations…

– Future uncertainty exists regarding collectibility of receivable.• Treat Subscriptions receivable as a contra

equity account [the SEC treatment].

– Minimal uncertainty … treat the Subscriptions Receivable as an asset.

CORPORATE STOCK RIGHTS

Stock rights may be issued pursuant to common stockholders’ preemptive right.

• Common shareholders normally possess a preemptive right--enables current shareholders to maintain a proportional ownership in the corporation when additional shares are to be issued.

Note: Stock options are deferred to a later chapter.

Example… Assume a corporation, for no

consideration, issues stock rights that may be redeemed, with cash, for new shares.

• The firm receives no assets at time of issuance; thus, the issuance does not affect financial statements.

• Financial statements are affected only if the holders of the stock rights elect to exercise them.

ASSETS DONATED TO CORPORATE ENTITIES

• A donation received by a corporation from a governmental entity is recorded as contributed capital:– Donated asset is recorded at its

FMV.– “Paid-in capital – donations” is

credited!

UNCLE SAM?

Example – Land!

• In return for agreeing to build a factory in Greenwood, Indiana, the city of Greenwood donated land having a reliable appraisal at $3,000,000 to the Chan Co., Inc.

• What is the Balance Sheet effect?

Balance Sheet Effect of Land Donation

$3,000,000Donated Capital

Stockholders’ Equity

$3,000,000Land

Assets

DIVIDENDS ON STOCK

Dates of importance• Date of declaration• Date of record• Date of issuance

Types• Cash• Script• Property

STOCK DIVIDENDS

–Small, 20%

»Accounted for at FMV on date of declaration

–Midrange, > 20% but < 25%

–Large, 25%

»Accounted for at par value on date of declaration

STOCK MATH!

Par value of shares is adjusted so that the total par value of the stock outstanding after the stock split is the same as before the stock split.

CON’T

Example Problems: Stock Dividends and Stock Splits

Facts: On Dec. 1, the Williams Co. had 10,000,000 shares of $10 par common stock authorized, with 4,000,000 shares issued and outstanding, having received (on average) $25 per share for it. On Dec. 1, the firm retained earnings account showed $18 million.

The FMV of the common stock was $30 per share.

Before Stock Dividend or Stock Split

(1) 4,000,000 shares x ($25 - $10 par)

$218,000,000Total stockholders’ equity

118,000,000Retained earnings

60,000,000Additional paid in capital (1)

$ 40,000,000

Common stock, $10 par, 10,000,000 shares authorized; 4,000,000 shares issued and outstanding

Stockholders’ equity

“Small” Stock Dividend

• On December 1, Williams declared a 3% stock dividend to be distributed on December 21.

• The combined effect of the declaration and distribution on Williams’ December 31 financial statements is as follows:

After 3% Stock Dividend

$218,000,000Total stockholders’ equity

114,400,000Retained earnings (3)

62,400,000Additional paid in capital (2)

$ 41,200,000

Common stock, $10 par, 10,000,000 shares authorized; 4,120,000 shares issued and outstanding (1)

Supplemental Calculations

Note: Total stockholders’ equity is the same before and after the stock dividend

120,000 shares x $30 fair market value = $3,600,000, and $118,000,000 - $3,600,000 = $114,400,000

(3)

120,000 shares x ($30 fair market value - $10 par value) = $2,400,000, and $60,000,000 + $2,400,000 = $62,400,000

(2)

4,000,000 shares x 3% = 120,000 shares;

120,000 shares x $10 par = $1,200,000, and $40,000,000 + $1,200,000 = $41,200,000

(1)

“Large” Stock Dividend

• On December 1, Williams declared a 40% stock dividend to be distributed on December 21.

• The combined effect of the declaration and distribution on Williams’ December 31 financial statements is as follows:

After 40% Stock Dividend

$218,000,000Total stockholders’ equity

102,000,000Retained earnings (3)

60,000,000Additional paid in capital (2)

$ 56,000,000

Common stock, $10 par, 10,000,000 shares authorized; 5,600,000 shares issued and outstanding (1)

Supplemental Calculations

Note: Total stockholders’ equity is the same before and after the stock dividend

$118,000,000 - $16,000,000 par value of the shares issued = $102,000,000

(3)

No change from before dividend situation(2)

4,000,000 shares x 40% = 1,600,000 shares x $10 par = $16,000,000; and $40,000,000 + $16,000,000 = $56,000,000

(1)

Stock Split (back at Dec. 1)

• On December 1, Williams declared a 2:1 stock split to be distributed on December 21.

• Note: If the stock market reacted “perfectly,” the new FMV should be $15 per share.

• The combined effect of the declaration and distribution on Williams’ December 31 financial statements is as follows:

After 2:1 Stock Split

$218,000,000Total stockholders’ equity

118,000,000Retained earnings

60,000,000Additional paid in capital

$ 40,000,000

Common stock, $5 par, 10,000,000 shares authorized; 8,000,000 shares issued and outstanding

$17

Note: Total stockholders’ equity per books, is the same before and after the stock split, as are the amounts for common stock and additional paid in capital.

Par value was reduced from $10 to $5, and the number of shares issued and outstanding doubled from 4,000,000 shares to 8,000,000 shares.

“Imperfect” Timing?

Hopefully, the stock market reacted IMPERFECTLY, and the FMV dropped, maybe to only $17 per share—an optimistic public! In this case, the shareholders are RICHER with no cost to the corporation!

TIMING IS EVERYTHING!

End of Chapter 2