Chapter 11 Management Issues Related to Contributed Capital Copyright © Cengage Learning. All rights reserved. 11–1 What is Contributed Capital? Investments by stockholders, called contributed capital, is one of the major means of financing for a corporation Copyright © Cengage Learning. All rights reserved. 11–2 What Is a Corporation? An entity having separate legal rights, privileges, and liabilities distinct from those of its owners. The result of a body of persons who have requested and been granted a charter by the state, recognizing the entity. Copyright © Cengage Learning. All rights reserved. 11–3 Corporate Form of Business Advantages Disadvantages Separate legal entity More government regulation Limited liability Double taxation Ease of raising capital Limited liability Ease of transferring stock Separation of ownership and control Lack of mutual agency Continuous existence Centralized authority Professional management Copyright © Cengage Learning. All rights reserved. 11–4 Using Equity Financing Stock Certificate Shows units of ownership in a corporation A stock certificate is issued to the owner Stockholder can transfer ownership at will Independent registrars and transfer agents are often used to keep track of stockholders’ records Copyright © Cengage Learning. All rights reserved. 11–5 Par Value An arbitrary amount assigned to each share of stock Usually bears little or no relationship to the market value or book value of shares Constitutes the legal capital of the corporation Legal capital – The number of shares issued times the par value – The minimum amount that can be reported as contributed capital Copyright © Cengage Learning. All rights reserved. 11–6 Initial Public Offering (IPO) The initial offering of capital stock Underwriter May be used to act as intermediary between the corporation and investing public for an IPO Guarantees the sale of the stock for a fee The corporation records the net proceeds of the offering Copyright © Cengage Learning. All rights reserved. 11–7 Costs to Start a Corporation? Start-up and Organization Costs A corporation’s life normally is not known, so these costs are expensed as incurred. State incorporation fees Attorneys’ fees Cost of printing stock certificates Accountants’ fees related to registering the firm’s stock Copyright © Cengage Learning. All rights reserved. 11–8 Dividends Distribution among stockholders of the assets that a corporation’s earnings have generated Stockholders receive these assets, usually cash, in proportion to the number of shares they own Copyright © Cengage Learning. All rights reserved. Board of directors has sole authority to declare dividends Decision to declare dividends affected by cash flows, pending lawsuits, economic situation, or debt levels. 11–9 Dividend Dates Date of Declaration Board of directors formally declares that the corporation is going to pay a dividend Copyright © Cengage Learning. All rights reserved. 11–10 Dividend Dates Date of Declaration Date of Record Board of Persons who directors formally own the stock declares that the on the record corporation is date will going to pay a receive the dividend dividend Copyright © Cengage Learning. All rights reserved. 11–11 Dividend Dates Date of Declaration Date of Record Board of Persons who directors formally own the stock declares that the on the record corporation is date will going to pay a receive the dividend dividend Copyright © Cengage Learning. All rights reserved. Payment Date Date on which the dividend is paid to the stockholders of record 11–12 Evaluating Dividend Policies Dividends Yield Ratio Tells investors how much they can expect to receive in dividends expressed as a percentage of the market price per share Dividends Yield Microsoft Dividends per Share Market Price per Share $0.40 1.4% $27.87 Copyright © Cengage Learning. All rights reserved. 11–13 Return on Equity Most important ratio associated with stockholders’ equity Compensation of top executives often tied to return on equity Return on Equity = Net Income Average Stockholders’ Equity Google = $4,203,720 ($22,689,679 + $17,039,840) / 2 = 21.2% Copyright © Cengage Learning. All rights reserved. 11–14 Price/Earnings (P/E) Ratio A measure of investors’ confidence in a company’s future Market Price per Share Price Earnings (P/E) Ratio Earnings per Share Microsoft $27.87 16 times $1.74 Because the market price is 16 times earnings, investors are paying a good price in relation to earnings. They do so in the expectation that this software company will continue to be successful Hwk E 3, Example Review problem pg 592-594 Copyright © Cengage Learning. All rights reserved. 11–15 Stock Option Plans Give employees the right to purchase stock in the future at a fixed price A means of both motivating and compensating employees On date of grant: estimate fair value of options Copyright © Cengage Learning. All rights reserved. Amount in excess of exercise price is recorded as compensation expense over the grant period 11–16 Stockholders’ Equity Three basic components: Contributed Stockholders’ investments capital Retained earnings Earnings since corporation’s inception, less any losses, dividends, or transfers to contributed capital Treasury stock Shares of its own stock that the corporation has bought back on the open market Copyright © Cengage Learning. All rights reserved. 11–17 Contributed Capital Common Stock Preferred Stock Basic form of stock that a corporation issues Also called residual equity, which means that if the corporation is liquidated, the claims of all creditors and usually those of preferred stockholders rank ahead of the claims of common stockholders Gives owners preference over common stockholders, usually in terms of receiving dividends and in terms of claims to assets if the corporation is liquidated Hwk E 5 Copyright © Cengage Learning. All rights reserved. 11–18 Relationship of Shares Copyright © Cengage Learning. All rights reserved. 11-19 11–19 Authorized, Issued, and Outstanding Shares Authorized shares: Maximum number that the corporation’s charter allows it to issue Stockholders’ Equity Contributed capital Issued shares: Sold or transferred to stockholders Preferred stock, $50 par value, 1,000 shares authorized, issued, and outstanding Common stock, $5 par value, 30,000 shares authorized, 20,000 shares issued, 18,000 shares outstanding Additional paid-in capital Total contributed capital $50,000 $100,000 50,000 150,000 $200,000 Outstanding shares: Shares issued and still in circulation (unlike treasury stock) Copyright © Cengage Learning. All rights reserved. 11–20 What Are the Characteristics of Preferred Stock? One or more of the following: Preference as to dividends Convertibility Rights to assets on liquidation Callable option Copyright © Cengage Learning. All rights reserved. 11–21 Dividend Preference Preferred stockholders must ordinarily receive a certain amount of dividends before common stockholders receive anything No guarantee of ever receiving dividends Consequences of not declaring an annual dividend depends on whether the preferred stock is cumulative or noncumulative Cumulative Noncumulative Dividend amount per share accumulates from year to year; Company must pay the whole amount before it pays any dividends on common stock Copyright © Cengage Learning. All rights reserved. Company is under no obligation to make up the missed dividend in future years 11–22 Dividends in Arrears Dividends not paid to cumulative preferred stock in the year they are due A corporation has 20,000 shares of $100 par, 5 percent cumulative preferred stock, its first year of operations outstanding. If the corporation pays no dividends in 2011, its first year of operations, preferred dividends in arrears at the end of the year would amount to $100,000. (20,000 shares × $100 × .05) If the corporation’s board declares dividends in 2012, the corporation must pay preferred stockholders the dividends in arrears plus their current year’s dividends before paying any dividends to common stockholders. Copyright © Cengage Learning. All rights reserved. 11–23 Dividends in Arrears Illustrated January 1, 2011: A corporation issued 20,000 shares of $10 par, 6 percent cumulative preferred stock and 100,000 shares common stock. The board of directors declared a $6,000 dividend to preferred stockholders after the first year of operations. 2011 dividends due preferred stockholders ($200,000 x .06) Less 2011 dividends declared to preferred stockholders 2011 preferred stock dividends in arrears $12,000 6,000 $6,000 In 2012, the board of directors declared a $24,000 dividend to be distributed to preferred and common stockholders. How much of the $24,000 can be given to common stockholders and how much belongs to preferred stockholders? Copyright © Cengage Learning. All rights reserved. 11–24 Dividends in Arrears Illustrated (cont’d) 2012 declaration of dividends Less 2011 preferred stock dividends in arrears Available for 2012 dividends Less 2012 dividends due preferred stockholders ($200,000 x .06) Remainder available to common stockholders $24,000 6,000 $ 18,000 12,000 $ 6,000 Record the journal entry for the declaration of the dividend: Dec. 31 Dividends 24,000 Dividends Payable Declared a $18,000 cash dividend to preferred stockholders and a $6,000 cash dividend to common stockholders 24,000 Hwk E 9-10; Example SE 6 & 7 Copyright © Cengage Learning. All rights reserved. 11–25 Convertible Preferred Stock Stockholder’s may exchange their shares of preferred stock for shares of common stock at a ratio stated in the company’s preferred stock contract Copyright © Cengage Learning. All rights reserved. 11–26 Convertible Preferred Stock Illustrated A company issued 1,000 shares of 8 percent, $100 par value convertible preferred stock for $100 per share. Each share can be converted into 5 shares of the company’s common stock at any time. The market value of the common stock is now $15 per share and, in the past, the owner of common stock could expect dividends of $1 per share per year. Per Share Dividends $1 Stock Market Value Common $15 Preferred if converted to common 75 (5 shares x $15) Convertible preferred 100 5 ( 5 shares x $1) 8 At this point, the preferred stockholder receives more in dividends by keeping the preferred shares and is more likely to receive dividends than the common stockholders. Copyright © Cengage Learning. All rights reserved. 11–27 Convertible Preferred Stock Illustrated (cont’d) A few years later, the dividends paid to common stockholders increase to $3 per share and market value is $30 per share. Stock Common Preferred if converted to common Convertible Preferred Market Value $30 Per Share Dividends $3 150 (5 shares x $30) 100 15 ( 5 shares x $3) 8 At this point, the market value of each share of convertible preferred stock is equivalent to $150 and converting to common would increase dividend payments from $8 per share to the equivalent of $15. Copyright © Cengage Learning. All rights reserved. 11–28 Callable Preferred Stock Can be redeemed or retired at the option of the issuing corporation at a price stated in the preferred stock contract The call price is usually higher than the par value of the stock Reasons to call stock – A desire to pay lower dividends – Because the corporation has enough profits to retire preferred stock Copyright © Cengage Learning. All rights reserved. 11–29 Issuance of Common Stock -Par Value Par value is the amount per share that is recorded in a corporation’s capital stock accounts Nocek Corporation is authorized to issue 10,000 shares of $10 par value common stock. The company issues 5,000 shares at $12 per share on January 1, 2010. Jan. 1 Cash 60,000 Common Stock Additional Paid-in Capital Issued 5,000 shares of $10 par value common stock for $12 per share Copyright © Cengage Learning. All rights reserved. 50,000 10,000 11–30 Par Value Stock (continued) Balance Sheet Presentation Stockholders’ Equity Section Contributed capital Common stock, $10 par value, 10,000 shares authorized, 5,000 shares issued and outstanding Additional paid-in capital Total contributed capital Retained earnings Total stockholders’ equity Copyright © Cengage Learning. All rights reserved. $50,000 10,000 $60,000 — $60,000 11–31 No-Par Stock Nocek Corporation is authorized to issue 20,000 shares of no-par common stock. Suppose the company issues 5,000 shares at $15 per share on January 1, 2010. Jan. 1 Cash 75,000 Common Stock Issued 5,000 shares of no-par common stock for $15 per share Assume Nocek’s board puts a $10 stated value on its no-par stock. It issues 5,000 shares at $15 per share on January 1, 2010. Jan. 1 Cash 75,000 Stated value of stock can be any value set by the board unless the state specifies a minimum amount. 75,000 Common Stock Additional Paid-in Capital Issued 5,000 shares of no-par value common stock with $10 stated value for $15 per share 50,000 25,000 Hwk E11; Example SE8 Copyright © Cengage Learning. All rights reserved. 11–32 Issuance of Stock for Noncash Assets Companies may issue stock for services or assets like buildings or land Record the transaction at the fair market value of what the corporation is giving up (stock) If fair market value of the stock cannot be determined, use the fair market value of the assets or services received Board of directors has the right to determine the fair value of the property Copyright © Cengage Learning. All rights reserved. 11–33 Issuance of Stock for Noncash Assets When Nocek Corporation was formed on January 1, 2010, its attorney agreed to accept 200 shares of its $10 par value common stock for services rendered. At the time the stock was issued, its market value could not be determined. For similar services, the attorney would have billed $3,000. Jan. 1 Start-up and Organization Expense Common Stock Additional Paid-in Capital Issued 200 shares of $10 par common stock for attorney’s services 3,000 2,000 1,000 Hwk E12; Example SE9 Copyright © Cengage Learning. All rights reserved. 11–34 Treasury Stock Why do more than 67 percent of large companies repurchase their own stock? Use the stock for employee stock option plans Want to maintain a favorable market for their stock Want to increase earnings per share or stock price per share Want to have additional shares of stock available for purchasing other companies Attempt to prevent hostile takeovers Copyright © Cengage Learning. All rights reserved. 11–35 Purchase of Treasury Stock Illustrated On Sept. 15, Amber Corporation purchases 2,000 shares of its common stock on the market for $50 per share. When treasury stock is purchased, it is usually recorded at cost: Sept. 15 Treasury Stock, Common Cash Acquired 2,000 shares of the company’s common stock for $50 per share Copyright © Cengage Learning. All rights reserved. 100,000 100,000 11–36 Purchase of Treasury Stock Illustrated (cont’d) Balance Sheet Presentation Stockholders’ Equity Section Contributed capital Common stock, $5 par value, 200,000 shares authorized, 60,000 shares issued, 58,000 shares outstanding Additional paid-in capital Total contributed capital Retained earnings Total contributed capital and retained earnings Less treasury stock, common (1,000 shares at cost) Total stockholders’ equity $300,000 60,000 $360,000 1,800,000 $2,160,000 100,000 $2,060,000 Notice that the number of shares issued, and therefore legal capital, has not changed even though the number of shares outstanding has decreased. Copyright © Cengage Learning. All rights reserved. 11–37 Sale of Treasury Stock At cost Above cost Debit Cash Credit Treasury Stock, Common Debit Cash for proceeds Credit Treasury Stock, Common for cost Credit Paid-in Capital, Treasury Stock for amount over cost Copyright © Cengage Learning. All rights reserved. 11–38 Sale of Treasury Stock Below Cost Dec. 15: Amber Corporation sells 1,200 shares of its treasury stock for $42 per share. (Cost was $50 per share.) Dec. 15 Cash Paid-in Capital, Treasury Stock Retained Earnings Treasury Stock, Common Sold 1,200 shares of the treasury stock for $42 per share; cost was $50 per share When treasury shares are sold below cost, the difference is deducted from Paid-in Capital, Treasury Stock Copyright © Cengage Learning. All rights reserved. 50,400 9,600 1,600 60,000 If the Paid-in Capital, Treasury Stock account cannot absorb the full amount of the difference, or doesn’t exist, Retained Earnings absorbs the remainder. 11–39 Retirement of Treasury Stock Treasury stock is retired when the company determines that it will not reissue stock it has purchased If acquisition price < original contributed capital Credit Paid-In Capital, Retirement of Stock If acquisition price > original contributed capital Debit Retained Earnings Hwk E13-14; Example SE10-11 Copyright © Cengage Learning. All rights reserved. 11–40