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CHAPTER 11 SHAREHOLDERS' EQUITY: CAPITAL

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


Brief Exercises B. Ex. 11.1 B. Ex. 11.2 B. Ex. 11.3 B. Ex. 11.4 B. Ex. 11.5 B. Ex. 11.6 B. Ex. 11.7 B. Ex. 11.8 B. Ex. 11.9 B. Ex. 11.10 Learning Objectives 4 4 5 5 5 7 7 8 4, 9 4, 9 Learning Objectives 13 19 4, 5 4, 5 47 5, 6 4, 7 47 9 8 9 4

Topic Shareholders' equity Shareholders' equity Dividends on preference shares Dividends on ordinary and preference shares Dividends on ordinary and preference shares Book value Book value Share split Treasury shares Treasury shares

Skills Analysis Analysis Analysis, communication Analysis Analysis, communication Analysis, communication Analysis Analysis, communication Analysis Analysis

Exercises 11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9 11.10 11.11 11.12

Topic Form of organization Accounting terminology Prepare equity section Dividends on preference & ordinary shares Analyzing equity Preference shares alternatives Reporting effects of transactions Computing book value Treasury shares transactions Effects of share splits Treasury shares presentation Real World: Star Cruises Limited Authorized share capital Ordinary shares and treasury shares Treasury shares and share split Real World: adidas AG Reading an annual report

Skills Analysis, communication Analysis Analysis, communication Analysis, communication Analysis Analysis Analysis Analysis, communication Analysis, communication Communication, judgment Communication, judgment Analysis, communication

11.13 11.14 11.15

4, 9 8, 9 4, 7

Analysis, communication Analysis Analysis, communication, research

The McGraw-Hill Companies, Inc., 2010 Overview

Reading an annual report

The McGraw-Hill Companies, Inc., 2010 Overview

Problems Sets A, B 11.1 A,B 11.2 A,B 11.3 A,B 11.4 A,B 11.5 A,B 11.6 A,B 11.7 A,B 11.8 A,B 11.9 A,B

Topic Reporting shareholders equity Reporting shareholders equity Reporting shareholders equity Comprehensive equity problem Analysis of equity Comprehensive equity analysis Par, book, and market values Comprehensive equity with treasury shares transactions Comprehensive equity with treasury shares transactions and share splits

Learning Objectives 4, 5, 6 4, 5, 6 4, 5, 6 4, 5 4, 5 17 4, 7 4, 5, 7, 9 4, 5, 7, 8, 9

Skills Analysis, communication Analysis, communication Analysis, communication Analysis Analysis Analytical, communication, group Communication, judgment Analysis, communication Analytical, communication, judgment

Critical Thinking Cases 11.1 Factors affecting market prices of preference and ordinary shares 11.2 Real World: Japan Airlines Corporation, HSBC, GlaxoSmithKline Factors affecting market prices of ordinary shares Selecting a form of business organization Securities & Futures Commission (Ethics, fraud & corporate governance)

5, 7

Communication, judgment

Communication

11.3 11.4

1, 2, 3 1, 2, 3

Communication, judgment Communication, judgment, technology

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

DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASES


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.

Problems (Sets A and B)


11.1 A,B Robbinsville Press/Septa Limited 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. Waller Publications/Banner Publications 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. Manhattan Transport Company/Ray Beam Limited 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. Barnes Communications Limited/Markup Limited 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. Smithfield Products/Manor Limited A more difficult problem involving distinction among par values, book values, and market values. Parsons Limited/Toasty Corporation 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. Techno Corporation/Brain Corporation 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. 20 Easy

11.2 A,B

20 Easy

11.3 A,B

25 Medium

11.4 A,B

35 Medium

11.5 A,B

35 Strong

11.6 A,B

35 Medium

11.7 A,B

15 Easy

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

Problems (continued)
11.8 A,B Feller Corporation/Tin Corporation 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. 11.9 A,B Herndon Industries/Parker Industries 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. Factors Affecting the Market Prices of Ordinary Shares 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. Selecting a Form of Organization Students are to interview the owners of two small businesses with different forms of organization and find out why the particular form was selectedand if they have any misgivings. S.F.C. Enforcement Division Ethics, Fraud & Corporate Governance Students do an internet search to locate the website of the Securities & Futures Commission and respond to questions about the S.F.C. 15 Medium

30 Strong

Critical Thinking Cases


11.1 15 Medium

11.2

25 Strong

11.3

Interview; No time estimate

11.4

20 Easy

*Supplemental Topic, Special Types of Liabilities.

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

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS


1. 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. 2. a. 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. b. 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. c. Continuity of existence. A sole proprietorship is terminated upon sale or abandonment by the owner and upon that persons death or incapacitation. Corporations continue in existence regardless of changes in ownership. d. 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. 3. 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. 4. 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. 5. 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.

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

6. 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. 7. a. b. 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.

8. 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 years 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. 9. (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. 10. a. b. c. 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 a corporation to control the issuance of share certificates and provide assurance against overissuance.

d.

11. 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.

The McGraw-Hill Companies, Inc., 2010 Q6-11

12. 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. 13. a. 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. b. 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. 14. A change in the market price of IBMs outstanding shares has no effect upon IBMs balance sheet. These shares belong to IBMs shareholders, not to IBM. Therefore, a change in the market value of these shares has no effect upon the recorded amounts of IBMs assets, liabilities, or shareholders equity. IBMs 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. 15. When you ask a sharebroker to purchase shares for you, the shares is purchased on a secondary marketin 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. 16. The purpose of a share split is to reduce the per-share market price of the companys shares down to a more appropriate trading rangethat is, a price that is appealing to a greater number of potential investors. 17. 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.

The McGraw-Hill Companies, Inc., 2010 Q12-17

18. 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.

19. 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: Transaction/activity Direction of change Sale of share capital Increase Purchase of treasury shares Decrease Sale of treasury shares Increase Share split None* *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. 20. 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 sharesPreference 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 companys capital structure in light of the capital requirements of the new company. Do not include preference sharesThe 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 sharesAssuming 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., 2010 Q18-20

B.Ex. 11.1

Ordinary shares (10,000 shares @ $10) Share premium (10,000 shares @ $3) Retained earnings Total shareholders' equity Preference shares (1,000 shares @ $100) Ordinary shares (10,000 shares @ $25) Share premium: Preference shares (1,000 shares @ $10) Ordinary shares (10,000 shares @ $2) Retained earnings Total shareholders' equity

$100,000 30,000 75,000 $205,000 $100,000 250,000 10,000 20,000 100,000 $480,000

B.Ex. 11.2

B.Ex. 11.3

Dividends on arrears on preference shares for three years are calculated as follows: 100,000 shares x $100 par value x 6% dividend rate x 3 years = $1,800,000 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.

B.Ex. 11.4

Total dividend declared Dividend requirements for preference shares: 10,000 shares x $100 par x 6% x 2 years Dividends available for ordinary shares Total dividend declared Dividend requirements for noncumulative preference shares: 10,000 x $100 par x 8% x 1 year Dividends available for ordinary shares Dividends per share on ordinary shares: $40,000/100,000 shares

$200,000 120,000 $80,000 $120,000 80,000 $40,000 $0.40

B.Ex. 11.5

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

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

B.Ex. 11.6

The book value on ordinary shares are calculated by adding all shareholders' equity accounts together and dividing by the number of ordinary shares outstanding: ($1,000,000 + $750,000 + $600,000)/100,000 shares = $23.50 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.

B.Ex. 11.7

Total shareholders' equity ($4,000,000 + $5,000,000 + $800,000 + $1,750,000) Less: Preference shares at par value $4,000,000 Dividends in arrears (40,000 shares x $5) 200,000 Amount attributable to ordinary shares Book value per ordinary share: $7,350,000/500,000 shares

$11,550,000 4,200,000 $7,350,000 $14.70

B.Ex. 11.8

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.

B.Ex. 11.9

Ordinary shares (100,000 shares @ $10) Share premium (100,000 shares @ $15) Less: Treasury shares (10,000 shares x $55) Total shareholders' equity

$1,000,000 1,500,000 $2,500,000 (550,000) $1,950,000 $25,000,000 5,000,000 350,000 $30,350,000 1,500,000 $28,850,000

B.Ex. 11.10

Ordinary shares (1,000,000 shares @ $25) Share premium on ordinary shares (1,000,000 shares @ $5) Share premium on treasury shares [70,000 shares x ($55 - $50)] Less: Treasury shares (30,000 shares x $50) Total shareholders' equity

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

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 earnings Disadvantages: (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 existence Disadvantages: (a) Double taxation on distributed earnings (b) Greater regulation b. 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 persons injuries, after you exhausted any insurance coverage and assets that the business might have.

Ex. 11.2

a. Double taxation b. Market value c. None (Retained earnings is not an amount of cash; it is an element of owners equity.) d. Ordinary shares e. None (Dividends in arrears are prior years dividends owed to holders of cumulative preference shares.) f. Publicly owned corporation g. Issued and fully paid capital h. Retained earnings i. None (Book value is ordinary shareholders equity divided by the number of ordinary shares outstanding.) j. None (The price of preference shares varies inversely with interest rates.)

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

Ex. 11.3

a.

Shareholders equity: Preference shares, $100 par value, 5,000 shares authorized, 2,500 shares issued and outstanding $ 250,000 Ordinary shares, $2 stated value, 100,000 shares authorized, 70,000 shares issued and outstanding 140,000 Share premium: Preference shares 7,500 Ordinary shares 770,000 Total issued and fully paid capital $ 1,167,500 Retained earnings . 382,000 Total shareholders equity . $ 1,549,500

b. No. The market value of a corporations shares have no effect on the amount in the financial statements. Share capital is recorded at the amount for which it was originally issued. Ex. 11.4 a. Total dividends paid in third year .. $376,000 Dividends on 9% noncumulative preference shares:
Current years dividend ($50 x .09 x 40,000) . 180,000 Total paid on 9% noncumulative preference shares $180,000 Dividends on 12% noncumulative preference shares: Current years 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 shares) .. $ 4.50 per share Preference shares, 12% noncum. ($96,000 8,000 shares) .. $ 12.00 per share

Ordinary shares ($100,000 400,000 shares) c.

$ 0.25 per share

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)

Ex. 11.5

a.

b. $1,050,000 ($15,000,000 total par value x 7% or 150,000 x $100 x 7%) c. $16 [($20 million par value + $44 million share premium) 4,000,000 shares issued]

d. $35,000,000 legal capital ($15,000,000 preference, plus $20,000,000 ordinary) $79,000,000 total issued and fully paid capital ($35,000,000 legal capital, plus $44,000,000 share premium)

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

e.

Total shareholders equity $ 143,450,000 Less: Par value of preference shares (150,000 shares x $100) 15,000,000 Equity of ordinary shareholders .. $ 128,450,000 Ordinary shares outstanding .. 4,000,000 $32.11 Book value per share ($128.45 million 4 million shares) .. No. Changes in the market value of shares do not directly affect a corporations financial position and are not reflected in the equity section of the balance sheet.

f.

Ex. 11.6

Annual dividends on the preference shares are $14,000 (7,000 $25 8%) Total dividend . $50,000 Amount to preference shares (14,000) Amount to ordinary shares .. $36,000

Ex. 11.7 Event a. b. c. Current Assets I NE D Shareholders Equity I NE D Profit NE NE NE

Net Cash Flow (from Any Source) I NE D

The McGraw-Hill Companies, Inc., 2010 E11.6,7

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 Book value per share ($590,000 60,000 shares) c. No. The book value per share represents the shareholders share of the net book value of the corporations 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 corporations assets are sold.

Ex. 11.9

a. Feb. 10

Treasury Shares . 425,000 Cash Purchased 17,000 shares of treasury shares at $25 per share.

425,000

June

4 Cash 198,000 Treasury Shares Share premium: . Treasury Shares.. Sold 6,000 shares of treasury shares, cost $150,000, for $33 per share. Cash . 88,000 Share premium: Treasury Shares 12,000 Treasury Shares . Sold 4,000 shares of treasury shares, cost $100,000, for $22 per share.

150,000 48,000

Dec. 22

100,000

b. Restriction of retained earnings for treasury shares owned at year-end: $175,000 (7,000 shares still owned x $25 per share cost) c. 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., 2010 E11.8,9

Ex. 11.10

a. Had the shares been split 2-for-1, it would begin trading at approximately $40 per share immediately after the split ($80 2 = $40). b. Had the shares been split 4-for-1, it would begin trading at approximately $20 per share immediately after the split ($80 4 = $20). c. When the market price of a corporations 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 companys shares were probably made with the intent of making it more affordable to investors.

Ex. 11.11

a. 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 companys financial statements. Furthermore, if the company acquires a significantly large amount of its outstanding shares, the event would be reported in the financial press. b. 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.

Ex. 11.12

a. Carnival Corporation could sell approximately 1,336 million additional shares. This figure is determined by subtracting the number of issued shares from the number of authorized shares 1,960 million 624 million = 1,336 million. b. 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 companys 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., 2010 E11.10-12

Ex. 11.13

a. Cash (550,000 x $12) Ordinary shares (550,000 x $10) Share Premium on ordinary shares. Cash (40,000 x $110) Preference Shares (40,000 x $100) Share Premium on Preference Shares.. Treasury Stock/Ordinary (40,000 x $60). Cash Note: No entry is required to record the authorization to issue preference and ordinary shares.

6,600,000 5,500,000 1,100,000 4,400,000 4,000,000 400,000 2,400,000 2,400,000

b. Shareholders' Equity: 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 Share premium: Preference shares Ordinary shares Total issued and fully paid capital Less: Treasury (ordinary) shares at cost, 40,000 shares Total shareholders' equity

$4,000,000

$ 5,500,000

400,000 1,100,000 $11,000,000 (2,400,000) $8,600,000

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

Ex. 11.14

a. Ordinary Shares, $10 par value, 200,000 shares authorized, 100,000 shares issued Share premium on ordinary shares Share premium on treasury shares Transactions Total Issued and fully paid capital Retained earnings Total issued and fully paid capital and retained earnings Less: Treasury shares Total shareholders' equity Calculations: Share premium on ordinary shares: 100,000 shares x ($18 - $10) = $800,000 Share premium on treasury shares: 10,000 shares x ($23 - $20) = $30,000 Treasury shares: 15,000 shares x $20 = $300,000

$1,000,000

800,000 30,000 $1,830,000 120,000 $1,950,000 (300,000) $1,650,000

b. 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.

The McGraw-Hill Companies, Inc., 2010 E11.14

Ex. 11.15

a. 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. b. 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 companys articles of incorporation. It represents the maximum number of shares that the company is authorized to issue by its state of incorporation. c. 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., 2010 E11.15

20 Minutes, Easy a.

SOLUTIONS TO PROBLEMS SET A PROBLEM 11.1A ROBBINSVILLE PRESS


ROBBINSVILLE PRESS Partial Balance Sheet December 31, 2009

Shareholders' equity Preference shares, $100 par value, authorized 100,000 shares, issued and outstanding 10,000 shares Ordinary shares, $1 par value, authorized 500,000 shares issued and outstanding 170,000 shares Share premium: Ordinary shares Total issued and fully paid capital Retained earnings* Total shareholders' equity

$ 1,000,000

170,000 2,380,000 $ 3,550,000 255,000 $ 3,805,000

*Computation of retained earnings at December 31, 2009: Profit for the four-year period 2006-2009 Less: Preference share dividends ($80,000 per year for four years) $ Ordinary share dividends ($0.75 x 170,000 shares x 4 years) Retained earnings, December 31, 2009

$ 1,085,000 320,000 510,000 $ 830,000 255,000

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 companys existence had any dividends been in arrears on the preference shares.

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

20 Minutes, Easy a.

PROBLEM 11.2A WALLER PUBLICATIONS


WALLER PUBLICATIONS Partial Balance Sheet December 31, 2009

Shareholders' equity 10% cumulative preference shares, $100 par value, authorized, issued, and outstanding 20,000 shares Ordinary shares, $1 par value, authorized 1 million shares, issued and outstanding 300,000 shares Share premium: ordinary shares Total issued and fully paid capital Retained earnings* Total shareholders' equity

2,000,000 300,000 5,700,000 8,000,000 210,000 8,210,000

$ $

*Computation of retained earnings at December 31, 2009: Profit for the five-year period 2004-2008 Less: Preference share dividends ($200,000 x 5 years) $ Ordinary share dividends ($1 x 300,000 shares x 5 years) Retained earnings, December 2008 Less: Net loss of 2009 Retained earnings, December 31, 2009

$ 1,000,000 1,500,000 $ $

4,460,000 2,500,000 1,960,000 1,750,000 210,000

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.

The McGraw-Hill Companies, Inc., 2010 P11.2A

25 Minutes, Medium a.

PROBLEM 11.3A MANHATTAN TRANSPORT COMPANY


MANHATTAN TRANSPORT COMPANY Partial Balance Sheet December 31, 2009

Shareholders' equity 8% noncumulative preference shares, $100 par, 5,000 shares authorized, issued, and outstanding $9 noncumulative preference shares, no-par value, 10,000 shares authorized, 5,000 shares issued and outstanding Ordinary shares, $2 par, 200,000 shares authorized, 100,000 shares issued and outstanding Share premium: Ordinary shares Total issued and fully paid capital Retained earnings* Total shareholders' equity

500,000 512,000 200,000 600,000 1,812,000 640,000 2,452,000

$ $

*Computation of retained earnings at December 31, 2009: Retained earnings at Dec. 31, 2007 Add: Profit for 2008 and 2009 Profit for four-year period Less: Dividends paid on 8% preference shares: 2008 (8% x $100 x 5,000 shares = $40,000) 2009 (8% x $100 x 5,000 shares = $40,000) Dividends on $9 preference shares: 2008 ($9 x 5,000 shares) 2009 ($9 x 5,000 shares) Dividends on ordinary shares: 2008 ($0.50 x 100,000 shares) 2009 ($1.60 x 100,000 shares) Retained earnings, December 31, 2009 $ 40,000 40,000 45,000 45,000 50,000 160,000

$ $

170,000 890,000 1,060,000

(80,000)

$ $

(90,000) (210,000) 680,000

b.

A corporation might decide to use preference shares rather than debt to finance operations for any of the following reasons (only 2 required): 1. 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. 2. 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. 3. Increasing the amount of debt on a balance sheet can adversely affect financial ratios.

The McGraw-Hill Companies, Inc., 2010 P11.3A

35 Minutes, Medium

PROBLEM 11.4A BARNES COMMUNICATIONS LIMITED


General Journal

a.

20__ Jan 6 Cash Ordinary Shares Share Premium: Ordinary Shares Issued 20,000 shares of $2 par value ordinary shares at $14 per share. 7 Organization Costs Expense Ordinary Shares Share Premium: Ordinary Shares Issued 500 shares of ordinary shares to Barnes in exchange for services relating to formation of the corporation. Implied issuance price ($7,000 500 shares) = $14 per share. ## Cash Preference Shares Issued 2,500 shares of $100 par value, 10%, preference shares at par value. June 4 Land Ordinary Shares Share Premium: Ordinary Shares Issued 15,000 shares of ordinary shares in for land valued at $225,000 (15,000 shares x $15). Nov ## Dividends (Preference Shares) Dividends Payable To record declaration of annual dividends of $10 per share on 2,500 preference shares outstanding. Payable Dec. 20. ## Dividends Payable Cash To record payment of dividend declared Nov. 15. ## Income Summary Retained Earnings To close the Income Summary account for the year. ## Retained Earnings Dividends To close the Dividends account.

280,000 40,000 240,000

7,000 1,000 6,000

250,000 250,000

225,000 30,000 195,000

25,000 25,000

Dec

25,000 25,000

147,200 147,200

25,000 25,000

The McGraw-Hill Companies, Inc., 2010 P11.4A

The McGraw-Hill Companies, Inc., 2010 P11.4A

PROBLEM 11.4A BARNES COMMUNICATIONS LIMITED (concluded)


b.
BARNES COMMUNICATIONS LIMITED Partial Balance Sheet December 31, 20___ Shareholders' equity Preference shares, $100 par, authorized 50,000 shares, issued and outstanding 2,500 shares Ordinary shares, $2 par, authorized 400,000 shares, issued and outstanding 35,500 shares Share premium: Ordinary shares Total issued and fully paid capital Retained earnings* Total shareholders' equity

250,000 71,000 441,000 762,000 122,200 884,200

$ $

*Computation of retained earnings at December 31, 20__: Retained earnings at January 1, 20__ Add: Profit in 20__ Less: Preference dividends in 20__ Retained earnings at December 31, 20__.

$ $

147,200 (25,000) 122,200

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

35 Minutes, Strong

PROBLEM 11.5A SMITHFIELD PRODUCTS

a.

Par value of all preference shares outstanding Par value per share of preference shares Number of preference shares outstanding ($2,400,000 $100) Dividend requirement per preference share (7 1/2% x $100) Number of preference shares outstanding (a) Annual preference shares dividend requirement ($7.50 x 24,000 shares) Par value of all ordinary shares outstanding Par value per ordinary share Number of ordinary shares outstanding ($900,000 $2 per share) Par value of all ordinary shares issued Share premium: Ordinary Total issuance price of all ordinary shares Number of ordinary shares issued (c) Average issuance price per ordinary share ($9,225,000 450,000 shares) Par value of preference shares Par value of ordinary shares Total legal capital Total legal capital (e) Add: Share premium: Ordinary shares Total issued and fully paid capital
Total shareholders equity Less: Par value of preference shares [24,000 shares (a) x $100 per share] Equity of ordinary shareholders Number of ordinary shares outstanding (c) Book value per share ($11,820,000 450,000 shares) Retained earnings, beginning of the year Add: Profit for the year Subtotal Less: Retained earnings, end of the year Total dividends paid during the year Less: Dividends on preference shares (part b) Total dividends on ordinary shares Number of ordinary shares outstanding Dividends per ordinary share ($1,912,500 450,000)

$ $

2,400,000 100 24,000 7.50 24,000 180,000 900,000 2 450,000 900,000 8,325,000 9,225,000 450,000 20.50 2,400,000 900,000 3,300,000 3,300,000 8,325,000 11,625,000 14,220,000 2,400,000 11,820,000 450,000 26.27 717,500 3,970,000 4,687,500 2,595,000 2,092,500 180,000 1,912,500 450,000 4.25

b.

$ $ $ $

c.

d.

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $

e.

f.

g.

h.

The McGraw-Hill Companies, Inc., 2010 P11.5A

35 Minutes, Medium

PROBLEM 11.6A PARSONS LIMITED CORPORATION


In Thousands (Except for Per Share Amounts) $ 6,819 0.50 13,638 $ $ $ $ $ $ $ 17.20 345 5,934 86,250 6,819 87,260 180,329 237,592 86,250 151,342 13,638 11.10

a.

Par value of all ordinary shares outstanding Par value per share Number of shares outstanding ($6,819/$0.50) Dividend requirement per preference share Number of preference shares outstanding Annual dividends paid to preference sharesholders ($17.20 x 345) Par value of preference shares Par value of ordinary shares Share premium Total issued and fully paid capital Total shareholders equity Less: Preference shares par value = ($250 x 345 shares) Equity of ordinary shareholders Number of ordinary shares outstanding Book value per share ($151,342/13,638 shares)

b.

c.

d.

The McGraw-Hill Companies, Inc., 2010 P11.6A

PROBLEM 11.6A PARSONS LIMITED (concluded)


e. 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 their equity investments are highly liquid assets, immediately salable at quoted market prices. The primary disadvantages of being publicly owned are the increased governmental regulations and financial reporting requirements. f. 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 corporations 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 certain features of the shares. The lower the yield, the more investors favor the shares. A higher yield means that investors demand a higher return to induce them to purchase the 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 Parsons conversion feature, cumulative dividends, or a high call price.

g.

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

15 Minutes, Easy

PROBLEM 11.7A TECHNO CORPORATION

a.

Par value is the legal capital per sharethe 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 by the shareholders, plus the amounts earned and retained by the corporation. By comparing book value with current market value, shareholders may gain insight into whether management has increased or diminished the value of the resources entrusted 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 companys performance, rather than to historical amounts.

b.

The companys par valueone-tenth of a cent per shareis quite low. However, the corporation can set par value at any level that it chooses; the amount of par value has no direct effect upon either book value or market value. It does mean, however, that the amount of the companys legal capitalserving as a cushion for creditorsis 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 companys 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 companys debt-paying ability than is the cushion provided by par value.

The McGraw-Hill Companies, Inc., 2010 P11.7A

15 Minutes, Medium

PROBLEM 11.8A FELLER CORPORATION

a.

Shareholders equity:
Ordinary shares, $1 par, 50,000 shares authorized, issued, and outstanding

50,000 350,000 5,000 405,000 185,000 590,000

Share premium: Ordinary shares Share premium: Treasury shares Total issued and fully paid capital Retained earnings* Total shareholders equity

$ $

*Computation of retained earnings at Dec. 31, 2009: Profit in 2007 Profit in 2008 Profit in 2009 Retained earnings, Dec. 31, 2009

$ $

82,000 25,000 78,000 185,000

b. c.

The companys 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.

The McGraw-Hill Companies, Inc., 2010 P11.8A

30 Minutes, Strong

PROBLEM 11.9A HERNDON INDUSTRIES

a. Shareholders equity: 10% preference shares, $100 par, cumulative, authorized, issued, and outstanding 30,000 shares Ordinary shares, $10 par, 200,000 shares authorized, 120,000 shares issued, of which 10,000 shares are held in treasury Share premium: Ordinary shares Share premium: Treasury shares* Total issued and fully paid capital Retained earnings** Subtotal Less: Treasury shares (10,000 shares x $20 cost per share) Total shareholders equity at Dec. 31, 2009

3,000,000

$ $ $

1,200,000 720,000 50,000 4,970,000 1,925,000 6,895,000 200,000 6,695,000

*Computation of share premium on treasury shares: Purchase price per share: $400,000 20,000 shares = $20 per share Reissue price per share: $250,000 10,000 shares = $25 per share Premium 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 20052009) Less: Preference dividend (for years 20052009) $100 x 10% x 30,000 shares x 5 years Less: Ordinary dividends
20052006: 120,000 shares outstanding x $0.50 x 2 yrs 20072008: 100,000 shares outstanding x $0.50 x 2 yrs

$ $ 1,500,000 120,000 100,000 55,000 $

3,700,000

2009: 110,000 shares outstanding x $0.50 Retained earnings, Dec. 31, 2009

1,775,000 1,925,000

b.

The companys 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).

c.

The McGraw-Hill Companies, Inc., 2010 P11.9A

20 Minutes, Easy a.

SOLUTIONS TO PROBLEMS SET B PROBLEM 11.1B SEPTA LIMITED


SEPTA LIMITED Partial Balance Sheet December 31, 2009

Shareholders' equity 10% noncumulative preference shares, $100 par value, callable at $110, authorized 1,000 shares, issued and outstanding 500 shares Ordinary shares, $1 par value, authorized 200,000 shares Issued and outstanding 80,000 shares Share premium: Ordinary shares Total issued and fully paid capital Retained earnings* Total shareholders' equity

50,000

$ $

80,000 1,120,000 1,250,000 1,652,000 2,902,000

*Computation of retained earnings at December 31, 2009: Profit for the four-year period 2006-2009 Less: Preference share dividends ($5,000 per year for four years) Ordinary share dividends ($0.40 x 80,000 shares x 4 years) Retained earnings, December 31, 2009

$ $ 20,000 128,000 $

1,800,000 148,000 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.

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

20 Minutes, Easy a.

PROBLEM 11.2B BANNER PUBLICATIONS


BANNER PUBLICATIONS Partial Balance Sheet December 31, 2009

Shareholders' equity 10% noncumulative preference shares, $100 par value, authorized, issued, and outstanding 10,000 shares Ordinary shares, $1 par value, authorized 1 million shares, issued and outstanding 400,000 shares Share premium: ordinary shares Total issued and fully paid capital Retained earnings* Total shareholders' equity

$ $

1,000,000 400,000 5,600,000 7,000,000 900,000 7,900,000

*Computation of retained earnings at December 31, 2009: Profit for the five-year period 2004-2008 Less: Preference share dividends ($100,000 x 5 years) $ Ordinary share dividends ($.80 x 400,000 shares x 5 years) Retained earnings, December 2008 Less: Loss of 2009 Retained earnings, December 31, 2009

$ 500,000 1,600,000 $ $

4,100,000 2,100,000 2,000,000 1,100,000 900,000

b.

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

The McGraw-Hill Companies, Inc., 2010 P11.2B

25 Minutes, Medium a.
RAY BEAM LIMITED Partial Balance Sheet December 31, 2009 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 outstanding Ordinary shares, $1 par, 260,000 shares authorized, 130,000 shares issued and outstanding Share premium: Ordinary shares Total issued and fully paid capital Retained earnings* Total shareholders' equity

PROBLEM 11.3B RAY BEAM LIMITED

*Computation of retained earnings at December 31, 2009: Retained earnings at Dec. 31, 2007 Add: Profit for 2008 and 2009 Profit for four-year period Less: Dividends paid on 10% preference shares: 2008 (10% x $100 x 10,000 shares = $100,000) 2009 (10% x $100 x 10,000 shares = $100,000) Dividends on $6 preference shares: 2008 ($6 x 5,000 shares) 2009 ($6 x 5,000 shares) Dividends on ordinary shares: 2008 ($0.90 x 130,000 shares) 2009 ($2.00 x 130,000 shares) Retained earnings, December 31, 2009 100,000 100,000 $ $ 30,000 30,000 117,000 260,000

b.

A corporation might decide to use preference shares rather than debt to finance operations for any of the following reasons (only 2 required): 1. 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. Increasing the amount of debt on a balance sheet can adversely affect financial ratios.

2. 3.

The McGraw-Hill Companies, Inc., 2010 P11.3B

PROBLEM 11.3B RAY BEAM LIMITED

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

finance operations for any of

ome a legal obligation of the egal obligation of the

ent source of capital, debt must es not mature.

ersely affect financial ratios.

The McGraw-Hill Companies, Inc., 2010 P11.3B

35 Minutes, Medium

PROBLEM 11.4B MARKUP LIMITED


General Journal

a.
20__ Jan 7 Cash Ordinary Shares Share Premium: Ordinary Shares Issued 30,000 shares of $1 par value ordinary shares at $10 per share. ## Organization Costs Expense Ordinary Shares Share Premium: Ordinary Shares Issued 1,000 shares of ordinary shares to Deal in exchange for services relating to formation of the corporation. Implied issuance price ($12,000 1,000 shares) = $12 per share. ## Cash 5% Preference Shares Issued 4,000 shares of $100 par value, 5%, noncumulative preference shares at par value. July 5 Land Ordinary Shares Share Premium: Ordinary Shares Issued 10,000 shares of ordinary shares in for land valued at $120,000 (10,000 shares x $12). Nov ## Dividends (Preference Shares) Dividends Payable To record declaration of annual dividends of $5 per share on 4,000 preference shares outstanding. Payable Dec. 11. ## Dividends Payable Cash To record payment of dividend declared Nov. 25. ## Income Summary Retained Earnings To close the Income Summary account for the year. ## Retained Earnings Dividends (Preference Shares) To close the Dividends account. 20,000 20,000 120,000 10,000 110,000 400,000 400,000 12,000 1,000 11,000

300,000 30,000 270,000

Dec

20,000 20,000

810,000 810,000

20,000 20,000

The McGraw-Hill Companies, Inc., 2010 P11.4B

The McGraw-Hill Companies, Inc., 2010 P11.4B

20 Minutes, Easy b.

PROBLEM 11.4B MARKUP LIMITED (concluded)


MARKUP LIMITED Partial Balance Sheet December 31, 20__

Shareholders' equity 5% cumulative preference shares, $100 par, authorized 100,000 shares, issued and outstanding 4,000 shares Ordinary shares, $1 par, authorized 100,000 shares, issued and outstanding 41,000 shares Share premium: Ordinary shares Total issued and fully paid capital Retained earnings* Total shareholders' equity

400,000 41,000 391,000 832,000 790,000 1,622,000

$ $

*Computation of retained earnings at December 31, 20__: Retained earnings at January 1, 20__ Add: Profit in 20__ Less: Preference dividends in 20__ Retained earnings at December 31, 20__.

$ $

810,000 (20,000) 790,000

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

35 Minutes, Strong

PROBLEM 11.5B MANOR LIMITED

a.

Par value of all preference shares outstanding Par value per share of preference shares Number of preference shares outstanding ($4,400,000 $100) Dividend requirement per share of preference shares (10% x $100) Number of preference shares outstanding (a) Annual preference shares dividend requirement ($10 x 44,000 shares) Par value of all ordinary shares outstanding Par value per ordinary share Number of ordinary share outstanding ($3,400,000 $2 per share) Par value of all ordinary shares issued Share premium: Ordinary Total issuance price of all ordinary shares Number of ordinary shares issued (c)
Average issuance price per ordinary share ($10,200,000 1,700,000 shares)

$ $

4,400,000 100 44,000 10 44,000 440,000 3,400,000 2 1,700,000 3,400,000 6,800,000 10,200,000 1,700,000 6 4,400,000 3,400,000 7,800,000 7,800,000 6,800,000 400,000 15,000,000 18,160,000 4,400,000 13,760,000 1,700,000 8.09 1,200,000 4,800,000 6,000,000 3,160,000 2,840,000 440,000 2,400,000 1,700,000 1.41

b.

$ $ $ $

c.

d.

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

e.

Par value of preference shares Par value of ordinary shares Total legal capital Total legal capital (e) Add: Share premium: Ordinary shares Donated capital Total issued and fully paid capital
Total shareholders equity Less: Par value of preference shares [44,000 shares (a) x $100 per share] Equity of ordinary shareholders Number of ordinary shares outstanding (c) Book value per share ($13,760,000 1,700,000 shares) Retained earnings, beginning of the year Add: Profit for the year Subtotal Less: Retained earnings, end of the year Total dividends paid during the year Less: Dividends on preference shares (part b) Total dividends on ordinary shares Number of ordinary shares outstanding Dividends per ordinary share ($2,400,000 1,700,000)

f.

g.

h.

The McGraw-Hill Companies, Inc., 2010 P11.5B

35 Minutes, Medium

PROBLEM 11.6B TOASTY CORPORATION


In Thousands (Except for Per Share Amounts) $ 9,600 $ 3 3,200 $ $ $ $ $ $ $ $ 10 250 2,500 50,000 9,600 76,800 136,400 187,000 50,000 137,000 3,200 42.81

a.

Par value of all ordinary shares outstanding Par value per share Number of shares outstanding ($9,600/$3) Dividend requirement per share of preference shares Numbers of preference shares outstanding Annual dividends paid to preference sharesholders ($10 x 250) Par value of preference shares Par value of ordinary shares Share premium Total issued and fully paid capital Total shareholders equity Less: Preference shares par value = ($200 x 250 shares) Equity of ordinary shareholders Number of ordinary shares outstanding Book value per share ($137,000 3,200 shares)

b.

c.

d.

The McGraw-Hill Companies, Inc., 2010 P11.6B

PROBLEM 11.6B TOASTY CORPORATION (concluded)


e. 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 their equity investments are highly liquid assets, immediately salable at quoted market prices. The primary disadvantages of being publicly owned are the increased governmental regulations and financial reporting requirements. f. 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 corporations financial statements. At $190 per share, Toastys 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 certain features of the shares. The lower the yield, the more investors favor the shares. A higher yield means that investors demand a higher return to induce them to purchase the 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 Toastys conversion feature, cumulative dividends, or a high call price.

g.

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

15 Minutes, Easy

PROBLEM 11.7B BRAIN CORPORATION

a.

Par value is the legal capital per sharethe 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 by the shareholders, plus the amounts earned and retained by the corporation. By comparing book value with current market value, shareholders may gain insight into whether management has increased or diminished the value of the resources entrusted 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 companys performance, rather than to historical amounts.

b.

The companys par valuefive cents per shareis quite low. However, the corporation can set par value at any level that it chooses; the amount of par value has no direct effect upon either book value or market value. It does mean, however, that the amount of the companys legal capitalserving as a cushion for creditorsis 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 companys 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 companys debt-paying ability than is the cushion provided by par value.

The McGraw-Hill Companies, Inc., 2010 P11.7B

15 Minutes, Medium

PROBLEM 11.8B TIN CORPORATION

a.
Shareholders equity:
Ordinary shares, $3 par, 50,000 shares authorized, issued, and

150,000 350,000 10,000 510,000 330,000 840,000

outstanding Share premium: Ordinary shares Share premium: Treasury shares Total issued and fully paid capital Retained earnings* Total shareholders equity

$ $

*Computation of retained earnings at Dec. 31, 2009: Profit in 2007 Profit in 2008 Profit in 2009 Retained earnings, Dec. 31, 2009

$ $

150,000 80,000 100,000 330,000

b. c.

The companys 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.

The McGraw-Hill Companies, Inc., 2010 P11.8B

30 Minutes, Strong

PROBLEM 11.9B PARKER INDUSTRIES

a.
Shareholders equity: 6% preference shares, $100 par, authorized and issued and outstanding 10,000 shares Ordinary shares, $20 par, 100,000 shares authorized, 80,000 shares issued, of which 400 shares are held in treasury Share premium: Ordinary shares Share premium: Treasury shares* Total issued and fully paid capital Retained earnings** Subtotal Less: Treasury shares (400 shares x $40 cost per share) Total shareholders equity at Dec. 31, 2009

*Computation of share premium on treasury shares: Purchase price per share: $40,000 1,000 shares = $40 per share Reissue price per share: $30,000 600 shares = $50 per share
Premium 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 20052009) Less: Preference dividend (for years 20052009) $100 x 6% x 10,000 shares x 5 years Less: Ordinary dividends
20052006: 80,000 shares outstanding x $0.60 x 2 yrs 20072008: 79,000 shares outstanding x $0.60 x 2 yrs

2009: 79,600 shares outstanding x $0.60 Retained earnings, Dec. 31, 2009

96,000 94,800 47,760

b.

The companys 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).

c.

The McGraw-Hill Companies, Inc., 2010 P11.9B

PROBLEM 11.9B ARKER INDUSTRIES

1,000,000

1,600,000 1,200,000 6,000 3,806,000 3,261,440 7,067,440 16,000 7,051,440

3,800,000 300,000

238,560 3,261,440

($7,051,440 total shareholders 40; $6,051,440 79,600 shares

n December 31, 2009, the market 2). The par value would have tstanding would have increased

The McGraw-Hill Companies, Inc., 2010 P11.9B

SOLUTIONS TO CRITICAL THINKING CASES


15 Minutes, Medium

CASE 11.1 FACTORS AFFECTING THE MARKET PRICES OF PREFERENCE AND ORDINARY SHARES

a. 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. b. If ADMs profitability increases dramatically, the market price of its ordinary share probably will rise significantly. The improved profitability of the company may lead to larger increases in the dividends paid to ordinary shareholders than the 5 and 10 cent increases of prior years. The market price of ordinary share is strongly affected by such factors as the companys expected future earnings and the probable rate of future ordinary share dividends. c. 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 ADMs 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.

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

25 Minutes, Strong

CASE 11.2 FACTORS AFFECTING THE MARKET PRICES OF ORDINARY SHARES

a.

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.

b. The fall in the price of HSBCs 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 HSBCs financial strength, which will reduce its profit, at least in the short run. This reduction in expectations about future earnings will further reduce the banks share price. c. 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 companys future earnings and increasing their assessments of the risk of the business. This caused the share price to drop.

The McGraw-Hill Companies, Inc., 2010 Case 11.2

Group assignment: No time estimate

CASE 11.3 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 more capital. 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 liabilityalthough 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.

The McGraw-Hill Companies, Inc., 2010 Case 11.3

20 Minutes, Medium

CASE 11.4 S.F.C. ENFORCEMENT DIVISION ETHICS, FRAUD & CORPORATE GOVERNANCE

(a) The six divisions and two departments of the Securities and Futures Commission are: Corporate Finance Enforcement Policy, China & Investment Products Supervision of Markets Corporate Affairs Legal Services Licensing Intermediaries Supervision (b) The Enforcement Division inquires possible irregularities of stock and derivative markets, recommends disciplinary action when appropriate and prevent unlawful or improper activities. (c) The publication is "Does price information tell all?" under monthly focus on February 2010.

(d) 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.

The McGraw-Hill Companies, Inc., 2010 Case 11.4