CHAPTER 11 - SHAREHOLDERS EQUITY PROBLEM SOLUTIONS
Assessing Your Recall
11.1
The forms of business organization that have limited legal liability as a benefit
are:
Corporations
Limited Partnership
The forms of business organization that are exempt from corporate taxation
(i.e. the income is only taxed once at the personal level) are:
Sole-proprietorships
Partnerships
Limited partnerships
11.2
The purpose of the partnership agreement is to specify how the partners share in
the profits and losses of the business, how they share in the assets and liabilities
upon dissolution of the partnership, and how they distinguish their roles as
owners, employees, and creditors.
11.3
The articles of incorporation specify the type of business, the operating structure
and the officers of the business, and the structure of the share capital of the
business. They specify the authorized classes and numbers of shares. The only
major significant item for the accounting system is the specification of the
different classes of share.
11.4
Common shares carry a basic set of rights. The rights are to share proportionately
(based on the number of shares that are held) in:
1) Profits and losses – This is the shareholder’s share of the success of the
corporation.
2) Management of the Corporation – The shareholders exercise their right to
management typically by voting their shares in the election of the Board of
Directors and other issues.
3) Assets upon liquidation – If the corporation decides to go out of business, the
shareholders share in whatever assets are left after creditors are paid.
4) Subsequent issues of shares – This right ensures that shareholders will not
have their percentage ownership diluted by the issuance of new shares. This is
only a right if it is written into the Articles of Incorporation when the
corporation is first formed.
11.5
Preferred shares differ from common shares in that they are given a preference
with regard to dividends. Preferred shares must be paid dividends first before
common shares are entitled to receive dividends. Preferred shares also have
different rights from the basic rights of the common shares. Typically the
preferred shares are non-voting or carry a lesser right to vote (for instance, a half a
1
vote per share). If the corporation decides to liquidate, preferred shareholders
usually have a claim on assets prior to the claim of common shareholders. There
are many other features of preferred shares that are different from common shares.
See question 11.6 for a list.
11.6
a) Participating - This feature means that preferred shares get to share in
dividends declared to common shares above the level of preferred dividends
specified. For instance, if preferred shareholders get a 5% dividend and an 8%
dividend is declared to common shares, the preferred shares would be entitled to
receive an extra 3% dividend.
b) Cumulative – This feature means that if a preferred dividend goes undeclared
in one year it is the first dividend that must be declared in the second year (if one
is declared at all). The preferred dividends therefore accumulate and any
undeclared preferred dividends are referred to as dividends in arrears.
c) Convertible – This feature allows the preferred shareholder to convert the
preferred shares into common shares, based on a ratio specified in the articles of
incorporation. This feature is exercisable at the discretion of the preferred
shareholder.
d) Redeemable – The feature allows the corporation to buy back or redeem the
preferred shares at a price set in the articles of incorporation. This feature is
exercisable at the discretion of management.
11.7
Authorized shares are the maximum number of shares the corporation is permitted
to issue. Issued shares are the shares the corporation has actually sold to
shareholders. Outstanding shares are the shares owned by shareholders, excluding
treasury shares owned by the corporation.
11.8
Dividends are declared by a vote of the Board of Directors. On the date of
declaration the dividends become a legal obligation of the corporation and an
entry should be made on the accounting system to record the decrease in retained
earnings and the increase in dividends payable. In the declaration a date of record
will be specified which is the date on which the share must be owned in order to
receive the dividend. If the share is sold after the date of record the new owner
will not receive the dividend. No accounting entry is made at the date of record.
Payment date is the date at which the corporation writes a cheque to pay the
shareholder (as of the date of record). The corporation should make an entry to
the account to record the decrease in cash and the decrease in dividends payable.
11.9
Property dividends are satisfied through the transfer of property, rather than
through the transfer of cash. These are not used often because the property
transferred might not be separable into equal units, making it difficult for each
shareholder to get a proportionate amount based on the number of shares he or she
holds.
2
11.10 A stock dividend is the issuance of additional shares to shareholders with no
proceeds from the shareholders. Economically there is no value to these shares in
that the corporation has neither received nor paid out any cash flows. It does
mean that there are additional shares outstanding that represent ownership in the
corporation and you would expect that the share price in the market would decline
to adjust to the new issuance. The distinction between a relatively large and small
stock dividend can be made to indicate that for relatively large stock dividends the
presumption is that the market price will adjust for the issuance and the additional
shares that are issued should be valued as close to zero as possible. Since the
corporation must at least record the shares at market value, zero is the value that is
used in most large stock dividends. Relatively small stock dividends presume that
the share price does not adjust to the new issuance and the value of the shares
given to shareholders is best represented by the current market price of the shares
issued. The shares issued in a relatively small stock dividend are therefore
measured at the current market price of the shares.
11.11 A 100% stock dividend and a 2 for 1 split have the same economic effect on the
corporation. Twice as many shares will be outstanding after the transaction as
before. There is no change in total shareholders’ equity under either method.
11.12 Companies issue stock options to employees as an incentive to work to increase
the market value of the corporation. If employees are also shareholders, they may
work harder to make the corporation a success. The exercise price of the option is
typically set at a value slightly above the current market value of the shares to
provide the necessary incentive. Typically these types of options have no effects
on the financial statements at the date they are issued because they are not
instantly valuable (because the exercise price is higher than the current shares
price). The only effect they have is when they are exercised and the corporation
has to issue shares to satisfy the options. This causes more shares to be
outstanding and could dilute the earnings per share number. For this reason the
fully diluted earnings per share calculation incorporates the shares that can
potentially have a future dilutive effect due to shares options.
11.13 Corporations might issue stock dividends rather than cash dividends simply
because they may not have sufficient cash on hand to pay for a cash dividend.
Shareholders will receive a similar benefit with stock dividends as with cash
dividends as they will be able to sell the shares received on the market to receive
cash.
11.14 The price/earnings ratio indicates to users the market price of a share
compared to the book earnings per share. The ratio thus reflects the importance,
as reflected in the market price, of one dollar of earnings in a company.
3
11.15 The common shareholders’ return is a function of the residual value after creditors
and preferred shareholders claims have been satisfied. The return on
shareholders’ equity is limited to the return to common
shareholders, because amounts attributable to preferred shareholders are deducted
from the numerator and denominator of the ratio. That is, preferred dividends are
deducted from net income and the preferred equity is excluded from shareholders’
equity.
Applying Your Knowledge
11.16 a) A dental practice of five dentists is likely to be a partnership. The earnings of
the organization will depend on the individual client base of each of the dentists.
They would therefore probably prefer to receive earnings in relation to their
efforts. A partnership works best for this.
b) A chain of clothing stores in which all of the stores are owned by the same
company would probably be a corporation. Expansion from one location to
another usually requires more capital than one individual can raise. Issuing shares
to other investors (forming a corporation) is an efficient way of raising additional
capital. Individual shops might be owned locally as sole proprietorships operating
under license from the company that owns the idea for the chain (the license is
called a franchise).
c) A paint and body shop owned by one person is likely to be a sole
proprietorship. The owner would probably manage the shop and a sole
proprietorship is easy to establish.
d) A lumber company operating in British Columbia is likely to be corporation.
The resources required to establish a lumber company would likely be more than
one person could raise. Issuing shares to other investors (forming a corporation) is
an efficient way of raising the necessary capital.
e) A family-owned farm is likely to be a partnership among the three brothers. A
partnership would allow each of the brothers to have an equal say in the
operations of the farm.
f) A lobster fisher is likely to be a sole proprietorship. The fisher would manage
the operation and would want an organizational structure that is easy to set up and
manage.
11.17 a) A hairstyling salon is likely to be a sole proprietorship. The resources required
to establish the salon are probably within the means of one person. Additional
investors would be needed only if additional salons were going to be established.
b) A local investment firm consisting of four financial advisors is likely to be a
partnership. The earnings of the organization will depend on the individual client
base of each of the financial advisors. They would therefore probably prefer to
receive earnings in relation to their efforts. A partnership works best for this.
4
c) A potash company is likely to be a corporation. The capital necessary to
establish the company would require resources from many individuals and/or
organizations. A corporation would be the best mechanism for recognizing the
investments of each of the participants.
d) A real estate development company is likely to be a corporation. The capital
necessary to establish the company would require resources from many
individuals. A corporation would be the best mechanism for recognizing the
investments of each of the participants.
e) The big accounting firms are partnerships, although most are limited liability
partnerships to mitigate the risk of litigation. The earnings of the organization will
depend on the individual client base of each of the accountants. They would
therefore probably prefer to receive earnings in relation to their efforts. A
partnership works best for this.
f) A car dealership owned by mother and son is likely to be a partnership. A
partnerships would enable each of them to have a say in the management of the
business and to share in its earnings.
11.18 a) Operating as a sole proprietorship does not require coordination with other
owners and there is no confusion as to who profits if the business is financially
successful and who loses if it is not. Albert would not need to negotiate with
others about who will undertake which duties and which responsibilities will be
assumed by whom. He also may be able to focus more easily on the types of
services he would like to provide. He will however, be limited to his own
personal resources when it comes to raising new capital.
b) The corporate form of organization provides certain protection for personal
assets because of its limited liability feature. Also, it normally is easier to raise
larger amounts of capital to purchase equipment or facilities in which to operate
using the corporate form. However, as a new and unproven business person, he
may have difficulty raising large amounts of capital. There may also be tax
advantages in that he will be taxed at the corporate rate which could be lower then
his personal income tax rate. Once he is established as a corporation he could
raise capital by issuing shares to others which would expand his potential new
capital base.
c) Many customers are likely to be indifferent about the form of business. If given
a preference, they might prefer an incorporated business, because a corporation
has a separate existence from the owner and can thus continue to operate into the
indefinite future. This might be important for a software company, because
customers are more comfortable that an incorporated company is going to be
around in the future to satisfy warranties and support its products.
d) If Albert anticipates rapid growth in his business, the corporate form of
organization is most appropriate because it is easier for him to raise capital
through the issuance of shares. Capital is likely to be required to finance the
expansion that he anticipates.
5
11.19 a) Operating as a sole proprietorship does not require coordination with other
owners and there is no confusion as to who profits if the business is financially
successful and who loses if it is not. Janice would not need to negotiate with
others about who will undertake which duties and which responsibilities will be
assumed by whom. She also may be able to focus more easily on the types of
services she would like to provide. She will however, be limited to her own
personal resources when it comes to raising new capital.
b) The corporate form of organization provides certain protection for personal
assets because of its limited liability feature, although complete protection
typically is not available in personal service fields. Also, it normally is easier to
raise larger amounts of capital to purchase equipment or facilities in which to
operate using the corporate form. However, as a new and unproven business
person, she may have difficulty raising large amounts of capital. There may also
be tax advantages in that she will be taxed at the corporate rate which could be
lower then his personal income tax rate. Once she is established as a corporation
she could raise capital by issuing shares to others which would expand his
potential new capital base.
c) Beginning as a sole proprietorship and then expanding into a partnership means
that Janice can maintain complete control until her planned expansions require
partners. Also, if the expansion does not turn out as planned, she need not
transfer the business into a partnership.
d) Many customers are likely to be indifferent about the form of business. If
given a preference, they might prefer an unincorporated business. They may have
more confidence in her work if they feel she is personally liable for all of her
actions.
e) If Janice wants to maintain control as the business expands, the sole
proprietorship is the preferred form of organization. The trade-off, however, is
that she it limited to her personal resources when it comes to raising capital to
finance the expansion. If substantial capital is required for expansion and
maintaining control is a concern, then the corporate form of organization would
be preferred rather than the partnership. If Janice maintains more than half of the
voting shares in a corporation, she has control. In a partnership, it might be more
difficult for Janice to maintain control over decision-making.
11.20 a) Information on the number of common and preferred shares authorized to be
issued will be reported in the shareholders’ equity section of the balance sheet.
No journal entry is made until actual shares are issued.
b) The following journal entry will be recorded when the common shares are
sold:
A-Cash (100,000 x $15)
SE-Common shares (100,000 x $15)
1,500,000
1,500,000
6
Common shares outstanding will increase by $15 per share. Total shareholders’
equity will increase by $1,500,000.
c) The following journal entry will be recorded when the preferred shares are
sold:
A-Cash (20,000 x $45)
SE-Preferred shares (20,000 x $45)
900,000
900,000
Preferred shares outstanding will increase by $45 per share. Total shareholders’
equity will increase by $900,000.
d) The following journal entry will be recorded when the preferred dividend is
declared:
SE-Preferred dividends declared (20,000 x $5)
L-Preferred dividends payable (20,000 x $5)
100,000
100,000
Dividends declared is a temporary account reported as a reduction in retained
earnings. Retained earnings and total shareholders’ equity will decrease by
$100,000 because of the preferred dividend.
e) The following journal entry will be recorded when the common dividend is
declared:
SE-Dividends declared (100,000 x $0.20)
L-Dividends payable (100,000 x $0.20)
20,000
20,000
Dividends declared is a temporary account reported as a reduction in retained
earnings. Retained earnings and total shareholders’ equity will decrease by
$20,000 because of the dividend.
f) The following journal entries will be recorded when the dividends are paid:
L-Preferred dividends payable
A-Cash
L-Dividends payable
A-Cash
100,000
100,000
20,000
20,000
Because the decrease in liabilities is the same as the decrease in assets, these
entries do not affect shareholders’ equity. Shareholders’ equity decreases only
when the dividends are declared.
g) Retained earnings will increase by $290,000 and total shareholders’ equity will
increase by $290,000.
11.21a) No journal entry
b) A-Cash
SE-Common shares
c) A-Cash
SE-Preferred shares
1,080,000
1,080,000
450,000
450,000
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d) SE-Preferred dividends declared
A-Cash
37,500
e) SE-Dividends declared
L-Dividends payable
67,500
f) SE-Income summary
SE-Retained earnings
240,000
37,500
67,500
240,000
g) L-Dividends payable
A-Cash
67,500
h) SE-Stock dividends declared
SE-Common shares
(90,000 x 2% x $15)
27,000
67,500
27,000
11.22 a) A-Cash
SE-Common shares
250,000
b) A-Cash
SE-Preferred shares
350,000
250,000
350,000
c) SE-Preferred dividends declared
L-Preferred dividends payable
20,000
d) L-Preferred dividends payable
A-Cash
20,000
e) SE-Common shares
SE-Retained earnings
A-Cash
12,500
12,500
f) SE-Income summary
SE-Retained earnings
11.23a) A-Cash
20,000
20,000
25,000
120,000
120,000
750,000
SE-Common shares
b) SE-Preferred dividends declared
A-Cash
c) SE-Stock dividends declared
SE-Stock dividends issuable
((750,000 + 50,000 ) x 10% x $18)
One month after declaration:
SE-Stock dividends issuable
SE-Common shares
d) SE-Dividends declared
L-Dividends payable
((750,000 + 50,000 + 80,000) x $1.50)
750,000
50,000
50,000
1,440,000
1,440,000
1,440,000
1,440,000
1,320,000
1,320,000
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e) SE-Income summary
SE-Retained earnings
2,350,000
2,350,000
9
11.24 a) No entry is needed. The corporation may make a memorandum entry, which is
just a notation that the stock split has occurred and the number of shares has been
changed.
b) SE-Stock dividends declared
SE-Stock dividends issuable
(80,000 x 10% x $30)
240,000
c) SE-Stock dividends issuable
SE-Common shares
240,000
d) SE-Common shares1
SE-Retained earnings
A-Cash
50,000
230,000
1
240,000
240,000
280,000
(($5 x 40,000) + $240,000) / (40,000 + 40,000 + 8,000) = $5 per share
11.25 a) Journal entries
a) A-Cash
SE-Common shares
b) SE-Preferred dividends declared
A-Cash
(10,000 x $8 x 1/2 )
c) SE-Preferred shares
A-Cash
SE-Contributed surplus
d) SE-Income summary
SE-Retained earnings
b) Shareholders’ equity, December 31, 20x2
Common shares
Contributed surplus
Retained earnings
Total shareholders’ equity
1,400,000
1,400,000
40,000
40,000
3,000,000
1,030,000
1,970,000
966,000
966,000
$ 7,220,000
1,970,000
6,364,000
$15,554,000
c) When the preferred shares were issued, a stated dividend of $8 per share might
have been necessary in order to secure such financing. Due to changes in the risk
of the firm, financing might be cheaper for the company, and as a result, it is
beneficial for it to redeem the preferred shares and issue common shares. Because
the redemption price is less than the issue price, the company also increases its
shareholders’ equity through the redemption. Once the preferred shares are
redeemed, the company can issue more dividends to the common shareholder.
11.26 a) SE-Stock dividends declared
135,000
10
SE-Common shares
(45,000 x 5% x $60)
135,000
b) No entry is needed. The corporation may make a memorandum entry, which is
just a notation that the stock split has occurred and the number of shares has been
changed. There are now 90,000 shares outstanding.
11.27
Shareholders’ Equity:
Common shares1
Retained earnings (deficit)
Total shareholders’ equity
1
$1,820,000
(47,000)
$1,773,000
(50,000 x $30) + (10,000 x $32) = $1,820,000
11.28 a) Distribution of cash dividend:
Preferred shares (10,000 x $1)
Common shares ($30,000 - $10,000)
$10,000
$20,000
b) and c)
Common shares increased due to the issuance of 20,000 shares at $7.05 per share
during 2002. This is evident from the fact that the number of shares issued
increased from 180,000 to 200,000 during the year, while common shares
increased from $305,000 to $446,000.
Retained earnings increased due to the earnings for 2002. Because dividends of
$30,000 decreased retained earnings, net income must have been $110,000
($510,000 - $430,000 + $30,000).
11.29 a) Ending balance in common shares (in thousands):
$7,500 + (10 x $32) + (5 x $25) =
b) Net income (in thousands)
$3,750 + net income - $750 - $100
Net income =
=
$7,945
$4,400
$1,500
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11.30 a) No journal entry.
b) A-Cash
SE-Common shares
1,875,000
c) A-Land
A-Equipment
A-Inventory
A-Building
A-Accounts receivable
SE-Common shares
SE-Preferred shares
500,000
250,000
200,000
500,000
50,000
d) A-Cash
SE-Preferred shares
2,500,000
1,875,000
500,000
1,000,000
2,500,000
e) No journal entry.
f) SE-Preferred dividends declared
L-Preferred dividends payable
[(10,000 + 25,000) x $10 x 2 years]
700,000
f) SE-Stock dividends declared
SE-Stock dividends issuable
[(75,000 + 20,000) x 10% x $72)
684,000
SE-Stock dividends issuable
SE-Common shares
700,000
684,000
684,000
684,000
11.31 a) 8,600 common shares were issued.
8,600 = ($380,000 / $50) outstanding + 1,000 canceled
b) 5,000 preferred shares were issued.
5,000 = $250,000 / $50
c) Net income = $188,000
Beginning retained earnings + net income - dividends = Ending retained
earnings
$0 + net income - (5,000 x $4) - (7,600 x $5) = $130,000
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11.32
Darby Ltd.
Income Statement
Year Ending December 31, 20x1
Revenues
Cost of Goods Sold
Gross Margin
Operating expenses:
Wage expense
Amortization expense
Miscellaneous expense
Operating income
Interest expense
Net Income
$2,240,000
925,700
1,314,300
$340,800
145,000
220,900
706,700
607,600
42,000
$ 565,600
Darby Ltd.
Statement of Retained Earnings
Year Ending December 31, 20x1
Retained earnings, January 1
Net income
Less:
Cash dividends declared, Preferred shares
Common shares
Retained earnings, December 31
$4,239,500
565,600
(167,000)
(252,600)
$4,385,500
Based on the above information, it would appear that Darby Ltd. should be able to
continue the dividends on common shares. Net income was $565,600 and the
total preferred and common dividends were $419,600. However, the dividend
payout ratio for common shares is somewhat high at 63.4% [common dividends
$252,600 / (net income $565,600 - preferred dividends $167,000)]. Darby must
also generate enough cash to continue to pay dividends. While information on
cash flows is not presented, amortization expense of $145,000 was included in
the computation of net income thereby raising the possibility of $710,600
($565,600 + $145,000) of cash generated from operations.
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Management Perspective Problems
11.33 The share issuance benefits the bank’s position as a creditor because the assets of
the company increase as a result. Since the claims of creditors must be satisfied
prior to the claims of shareholders, the additional assets that result from the share
issuance offer the bank more assurance that its loan is protected. This greater
assurance or comfort is manifested in a lesser debt/equity ratio. Negative
outcomes from the perspective of the bank include the possibility that the
company is in trouble, or needs cash to finance high-risk projects.
11.34 The price/earnings ratio is important because it relates the market price of a share to
the actual earnings of a company. This ratio indicates the risk that shareholders bear
through investing in common shares, because a high price/earnings ratio means that
the market price is based on anticipated earnings rather than actual earnings. If the
company does not perform or expand at the expected rate, a correction in the market
price occurs.
11.35 Investment bankers assist companies in issuing shares or public debt, and help the
companies design the shares or bonds so that these financial assets are attractive
to investors. When a company goes public, or issues shares on a stock market for
the first time, the investment banker also ensures that the operations of the
company are legitimate in order to protect investors.
11.36 a) Shareholders’ equity, December 31, 2002
Common shares, 1,000,000 shares authorized,
1
440,000 issued and outstanding
Retained earnings
Total shareholders’ equity
1
$3,390,000
3,370,000
$6,760,000
Stock dividend: 100,000 x 10% x $89 = $890,000
Total shares outstanding prior to split =
100,000 Dec. 31, 2001 + 10,000 stock dividend = 110,000
Total shares outstanding after split = 110,000 x 4 = 440,000
Cash dividend = 440,000 x $1 = $440,000
Retained earnings = $2,345,000 + $2,355,000 - $890,000 - $440,000 =
$3,370,000
b) The stock dividend has the effect of transferring $890,000 from retained
earnings to common shares, so it does not effect total shareholders’ equity. The
cash dividend reduces both retained earnings and total shareholders’ equity in the
amount of $440,000.
14
c) The company might declare a stock dividend because it is short of cash but
does not want to upset shareholders through not declaring a dividend. Another
possible reason is that the company wants to capitalize a portion of its retained
earnings, so that it is no longer available for dividend distribution. These reasons
are generally strong enough to justify declaration of a stock dividend.
d) Companies usually split their shares in order to make them more marketable
for investors to purchase. Because the share price of Bonanza has been
increasing, splitting the shares means that a larger number of shares is
outstanding, and the per share price falls in proportion to the increase in shares.
Thus, splitting the shares helps the company to target a broader group of investors.
Splitting shares in order to increase their marketability is a good reason to declare
a stock split.
e) As a shareholder, your wealth increases if the company declares a 10% stock
dividend because the market price is not expected to fully adjust for the increase
in outstanding shares. You may be able to sell your additional shares for close to
the old market price. The stock split, however, does not increase your wealth
because the market price per share is expected to fall in proportion to the increase
in the number of outstanding shares. In the 4 for 1 stock split, you own four times
as many shares after the split as compared to before the split, but the market price
per share is about one fourth of the old price. The reduction in the cash dividend
is expected because the number of shares outstanding has quadrupled. Thus, as a
shareholder, you are better off this year as compared to last year, because the per
share dividend did not fall in proportion to the 4 for 1 stock split.
11.37 a) If you were to purchase its shares, your prospects of receiving a dividend are
slight, because although earnings per share has been increasing more than 15% in
recent years, the expenditures in capital assets indicate that the company is
growing, and is likely to reinvest its earnings. Your reasoning that the company
can declare a $2 or $3 dividend without making a dent in retained earnings
overlooks the fact that cash is required to pay out the dividend. At the current
time, the company can declare a maximum $0.25 dividend before exhausting its
current cash balance. In addition, the $50,000 cash on hand is likely required to
settle current liabilities as these fall due.
b) During the next 5 years, your prospects of getting a dividend are much higher,
because the company is likely to be generating a reasonable return on the capital
assets its has purchased, and might no longer need funds for reinvestment and
growth. In general, mature companies are more likely to declare dividends than
growth companies, because mature companies generate cash that is not required to
finance expansion.
c) If Cascade were to enter into such a loan agreement, the prospects of getting a
dividend are less, because the company would be concerned about meeting the
debt covenant. Paying out a dividend decreases the assets of Cascade, and
increases the risk that long-term debt to equity exceeds 2 to 3. With the additional
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long-term debt, the long-term debt to equity ratio would be 2.2 to 3 ($4,500 /
$6,184) which already exceeds the 2 to 3 ratio stipulated.
11.38 a) You would expect to receive $1,640 from your purchase of 2,000 shares.
Computation of dividend received:
Total expected dividend ($3,600,000 x 40%)
Preferred dividends:
Arrears on Class B (50,000 x $6)
Current year, Class A (20,000 x $1)
Current year, Class B (50,000 x $6)
Available for common shares
Common shares outstanding
Common dividends per share
Common shares to be purchased
Dividend on 2,000 common shares
$1,440,000
(300,000)
(20,000)
(300,000)
$820,000
1,000,000
0.82
x 2,000
$ 1,640
b) You would expect to receive $2,240 from your purchase of 2,000 common
shares if the Class B preferred shares are noncumulative.
Total expected dividend ($3,600,000 x 40%)
Preferred dividends:
Current year, Class A (20,000 x $1)
Current year, Class B (50,000 x $6)
Available for common shares
Common shares outstanding
Common dividends per share
Common shares to be purchased
Dividend on 2,000 common shares
$1,440,000
(20,000)
(300,000)
$1,120,000
1,000,000
1.12
x 2,000
$ 2,240
16
11.39
a)
Ratios for Stanley:
1.
Return on assets = Net income / Total assets
=
$928,000 / $9,843,000
=
9.4%
2.
Return on long-term capital = Net income / (Long-term debt + Shareholders’
equity)
=
$928,000 / ($2,500,000 + $6,831,000)
=
9.9%
3.
Return on common shareholders’ equity
= (Net income - preferred dividends) / (Shareholders’ equity – preferred
shares)
= ($928,000 - $80,000) / ($6,831,000 - $1,000,000)
= 14.5%
b) Return on common equity without the debt financing
= (Net income + after-tax interest - preferred dividends) / (shareholders’ equity +
interest – preferred shares)
= ($928,000 + $135,000 - $80,000) / ($6,831,000 + $2,500,000 +
$135,000 – $1,000,000)
= 11.6%
Stanley’s return on common equity decreases if the company uses more common
shares and less long-term debt, indicating the company earns more on the money
invested in operating assets than it pays out in interest on money borrowed
through long-term debt. The company management is successfully using debt to
increase the return to shareholders. Debt increases the return to shareholders
when the company earns more on the money borrowed than it must pay in interest.
On the other hand, if interest exceeds the earnings on the money borrowed, the
return on common equity decreases as the level of debt is increased.
c) Return on common equity without the preferred shares
= Net income / Shareholders’ equity
=
$928,000 / $6,831,000
=
13.6%
This is lower than the 14.5% return computed on common equity with the
preferred shares outstanding. The 8% return ($80,000 / $1,000,000) paid to
preferred shareholders is less than the return earned overall; thus, a reduction of
preferred shares and an increase in common shares reduces the rate of return to
common shareholders. The company management is successfully using the
preferred shares to increase the return to common shareholders. However, if the
overall rate of return were to drop below 8%, the required payment of preferred
dividends would reduce the return to common equity.
17
Reading and Interpreting Published Financial Statements
11.40 a) A-Cash
SE-Common shares
900,000
b) A-Cash
SE-Common shares
2,600,000
900,000
2,600,000
c) The balance in the common shares account as at December 29, 1996 is $448.3
million.
d) Number of shares outstanding, January 3, 1998
Shares issued pursuant to stock options
Number of shares outstanding, January 3, 1999
105,959,504
124,460
106,083,964
e) Shares outstanding December 29, 1996
105,610,910
f) Return on shareholders’ equity = Net income / Average shareholders’ equity
= $146.4 / [($1,164.3 + $1,042.4) / 2]
= 13.3%
11.41 a) A stock option is an offer made to employees and executives in which they
can purchase a specified number of shares at a specified price during a specified
future period. The purpose of the stock option is to encourage employees and
executive to work to improve the company such that the future purchase price of
the shares is exceed by the market price. If employees exercise options, they
would be able to immediately sell the shares on the market for a profit if the
market price exceeded the option price.
When new shares are being issued by a company, it will often give its current
shareholders the first option to buy the new shares. It does this by giving them a
warrant. Each warrant entitles the holder to purchase a specified number of shares
at a specified price. The shareholders have a fixed amount of time to exercise the
warrant before the company attempts to sell the shares on the open market.
b) The options are held by the employee or executive and the warrants are held
by the shareholders.
c) The options would have been issued to encourage employees and executives to
work to make the company a success. The warrants would have been issued to
facilitate a new issuance of a shares.
d) By February 28,1999, the first set of stock options and the warrants described
in Note 8 had already expired. They, therefore, were not included in the following
calculation:
1,250,000 x $.10 =
$125,000
1,250,000 x $.10 =
125,000
250,000 x $.10 =
25,000
Total
$275,000
e) $275,000 x 10% = $27,500
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H. Jager could earn an additional $27,500 in net income if it had the additional
$275,000 to use to earn income.
f) Number of shares outstanding on Feb. 28, 1999 = $2,095,402 / .06 =
34,923,367
Number of shares outstanding after the exercise of the stock options = 34,923,367
+ 2,750,000 = 37,673,367
New net income = $2,095,402 + $27,500 = $2,122,902
Revised EPS = $2,122,002 / 37,673,367 = $.06
The EPS does not change.
g) Return on shareholders’ equity =
$2,095,402 / (($3,895,152 - $285,683)+ $820,987)/2 = 94.6%
11.42
a) A-Cash
SE-Common shares
14,768
14,768
The additional shares were issued due to the exercise of stock options. The shares were
issued at a price of
$5.58 [($67,655 - $52,887) / (124,904,630 - 122,259,630)].
b) Minimum:
$3.81 x 1,159,200 =
$3.75 x 553,000
$4.00 x 1,014,900
$6.63 x 1,101,100
$14.13 x 3,073,000
$17.65 x 35,000
Maximum:$6.00 x 1,159,200=
$4.75 x 553,000
$5.63 x 1,014,900
$8.85 x 1,101,100
$20.48 x 3,073,000=
$17.65 x 35,000
$ 4,416,552
=
=
=
=
=
$ 6,955,200
=
=
=
62,935,040
=
2,073,750
4,059,600
7,300,293
43,421,490
617,750
$ 61,889,435
2,626,750
5,713,887
9,744,735
617,750
$ 88,593,362
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c) The following accounts change in the pro forma balance sheet:
Assets
Cash and short-term investments
$189,765
Shareholders’ Equity
Capital stock
$129,544
The changes in the pro forma balance sheet are an increase in both cash and shortterm investments and capital stock in the amount of $61,889 thousand.
d) Return on shareholders’ equity = $80,658 /[($445,033 + $356,781) / 2]
=
20.1%
11.43 a) A-Cash
SE-Common shares
7,558
7,558
b) Number of shares outstanding Dec. 31, 1998
Share purchase options
Maximum number of common shares
45,314,156
2,885,000
48,199,156
c) Assets: Cash would increase by the amount paid for the new shares.
Liabilities: No change
Equities: common shares would increase by the amount paid.
Revenues: no effect
Expenses: no effect
d) ROE = $2,205 / [($107,630 + $97,867) / 2]
= 2.1%
11.44 a) A-Cash
SE-Bonuses expense
SE-Common shares
279,945
22,500
b) A-Cash
SE-Bonuses expense
SE-Common shares
18,233,188
254,800
302,445
18,487,988
c) Average issue price per share
1998
Private placements
Exercise of options
Exercise of warrants
For bonuses
$0.15
$0.40
$0.45
1997
$2.17
$0.25
$1.55
$2.60
The average prices received for each type of placement are different because the
shares are issued for different reasons. The amounts received for shares placed
privately are likely to approximate market value. Amounts received for the
options and warrants are, in general, less because these options and warrants were
20
granted to officers and employees for incentive purposes when the shares traded at
a lower amount. The amounts received vary substantially over the two years.
d) It is likely that the prices received for the private placements best reflect
Queenstake’s operating success and prospects as these transactions are the easiest
to quantify. The amounts received for options and warrants are predetermined
and do not indicate any assessment of value.
Beyond the Book
11.45Answers to this question will depend on the company selected.
CASE
11.46Manonta Sales Company
Expected Income Statement for 19x9: ($ in thousands)
Earnings before income taxes (increase 10%)
Plus interest on debt saved
Adjusted earnings before income taxes
Income taxes (40%)
Expected net income
Current number of shares
To be issued on conversion
Expected number of shares
Expected Earnings per share
Expected market price per share (multiple of 22)
Current market price (multiple of 20)
% decrease
$27,500
7,440
34,940
(13,976)
$20,964
15,000,000
9,300,000
24,300,000
$ 0.86
$18.92
$20.00
5.4%
Decision: Sell
21
Critical Thinking Question
11.47 General Comments
The purpose of this question is to make the students think about executive
compensation, which will likely include stock options. Students are expected to
think about the several different types of benefits that may be included, and to
think about the effects each of the different benefits may have on executive
actions.
Solution Outline
a) Salary: Level of salary would have no direct impact on the actions of
executives as long as the salary paid was comparable to that paid to executives in
other comparable companies. The expectation of higher salaries as a reward for
good performance may encourage executives to work harder.
b) Perks: Perks are there to be enjoyed, so they would likely encourage
executives to take time to enjoy them, perhaps to the detriment of their work.
They may not be conducive to hard work. Like salary, the perks would need to be
comparable to perks offered in other comparable companies.
c) Bonuses based on net income: These will encourage executives to achieve a
higher reported net income. This may be beneficial if they try to achieve this by
increasing sales, but may be detrimental if the executives achieve higher net
income by reducing maintenance, cutting service to customers, using longer
amortization periods, and deciding not to undertake research and development.
d) Bonuses based on gross sales: These may be beneficial or harmful. They
would be beneficial if the executives achieved higher sales by producing better
products or entering more markets. They would be harmful if the higher sales
were achieved by reducing prices substantially or by selling to customers who
were a poor credit risk.
e) Stock option plans: These would encourage executives to achieve higher stock
prices, which usually occurs with higher reported net incomes and with the
likelihood of future growth and profits. These may be harmful to the company if
the executives attempt to manipulate the stock market prices with improper
trading or false information.
The design of a good executive compensation plan is very difficult and usually
includes a mixture of high salary, some perks, bonuses based on reported net
income, and stock option plans.
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