MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

Baginski & Hassell

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 arrearsbut there is still no legal liability to declare & pay dividends to preferred shareholders.

Hybrid Securities
Hybrid 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 increase 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 stockholders 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. 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 transactions impact on the financial statements?

Partial Balance Sheet Assets Cash ($10,000,000 - $50,000) Stockholders Equity Common stock, $2 par, 50,000,000 shares authorized, 1,000,000 shares issued and outstanding Additional paid-in capital

(000s)

$9,950

$2,000 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. What is the impact of the transaction on the financial statements?

Balance Sheet Effects

Assets Property ($7,800,000) Stockholders Equity Common stock (800,000 shares, $1 par)

(000s)
$7,800

800 Additional paid-in capital 7,000 $7,800

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 check clears the bank and the stock is issued!

Observations
Future uncertainty exists regarding collectibility of receivable.
Treat Subscriptions Receivable as a contra equity account [the SECs 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 which 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: UNCLE SAM? Donated asset is recorded at its FMV. Paid-in capital: donations is credited.

Example Land
In return for agreeing to build a factory in Greenwood, Indiana, the city of Greenwood donated land having a reliable appraisal of $3,000,000 to the Chan Co., Inc. What is the Balance Sheet effect?

Balance Sheet Effect of Land Donation

Assets: Land Stockholders Equity: Donated Capital $3,000,000 $3,000,000

DIVIDENDS ON STOCK
Dates of importance
Date of declaration Date of record Date of issuance

Types
Cash Scrip Property

STOCK DIVIDENDS
Small 20% Accounted for at FMV on date of declaration Midrange > 20% but < 25% GAAP is ambiguous; state law may govern treatment Large 25% Accounted for at par value on date of declaration

STOCK SPLITS
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.
CONT

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 $118 million. The FMV of the common stock was $30 per share.

Before Stock Dividend or Stock Split

Stockholders equity Common stock, $10 par, 10,000,000 shares authorized; 4,000,000 shares issued and outstanding Additional paid in capital (1) Retained earnings Total stockholders equity (1) 4,000,000 shares ($25 - $10 par)

$ 40,000,000 60,000,000 118,000,000 $218,000,000

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

Common stock, $10 par, 10,000,000 shares authorized; 4,120,000 shares issued and outstanding (1) Additional paid in capital (2) Retained earnings (3) Total stockholders equity

$ 41,200,000 62,400,000 114,400,000 $218,000,000

Supplemental Calculations
(1) 4,000,000 shares 3% = 120,000 shares 120,000 shares $10 par = $1,200,000 $40,000,000 + $1,200,000 = $41,200,000 (2) 120,000 shares ($30 Mkt value - $10 par value) = $2,400,000; $60,000,000 + $2,400,000 = $62,400,000 (3) 120,000 shares $30 fair market value = $3,600,000; $118,000,000 - $3,600,000 = $114,400,000 Note: Total stockholders equity is the same before and after the stock dividend

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

Common stock, $10 par, 10,000,000 shares authorized; 5,600,000 shares issued and outstanding (1) Additional paid in capital (2) Retained earnings (3) Total stockholders equity

$ 56,000,000 60,000,000 102,000,000 $218,000,000

Supplemental Calculations
(1) 4,000,000 shares 40% = 1,600,000 shares $10 par = $16,000,000; $40,000,000 + $16,000,000 = $56,000,000 (2) No change from before dividend situation (3) $118,000,000 - $16,000,000 par value of the shares issued = $102,000,000 Note: Total stockholders equity is the same before and after the stock dividend

Stock Split (December 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

Common stock, $5 par, 10,000,000 shares authorized; 8,000,000 shares issued and outstanding Additional paid in capital Retained earnings Total stockholders equity

$ 40,000,000 60,000,000 118,000,000 $218,000,000

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 (instead of $15; half of what it was before the split)! In this case, the shareholders are RICHER with no cost to the corporation! TIMING IS EVERYTHING!

End of Chapter 2