chapter 11 - shareholders’ equity - initial set...

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:

CorporationsLimited 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-proprietorshipsPartnershipsLimited 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.

1

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 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

2

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.

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

3

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.

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

4

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.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

5

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.

11.19 a) Operating as a sole proprietorship does not require coordination with other owners and there is no confusion as to

6

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.

7

b) The following journal entry will be recorded when the common shares are sold:

A-Cash (100,000 x $15) 1,500,000SE-Common shares (100,000 x $15) 1,500,000

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) 900,000SE-Preferred shares (20,000 x $45)

900,000Preferred 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) 100,000L-Preferred dividends payable (20,000 x $5) 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) 20,000L-Dividends payable (100,000 x $0.20) 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 100,000A-Cash 100,000

L-Dividends payable 20,000A-Cash 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.

8

g) Retained earnings will increase by $290,000 and total shareholders’ equity will increase by $290,000.

11.21a) No journal entryb) A-Cash 1,080,000

SE-Common shares 1,080,000c) A-Cash 450,000

SE-Preferred shares 450,000d) SE-Preferred dividends declared 37,500

A-Cash 37,500e) SE-Dividends declared 67,500

L-Dividends payable 67,500f) SE-Income summary 240,000

SE-Retained earnings 240,000 g) L-Dividends payable 67,500

A-Cash 67,500h) SE-Stock dividends declared 27,000

SE-Common shares 27,000(90,000 x 2% x $15)

11.22 a) A-Cash 250,000SE-Common shares 250,000

b) A-Cash 350,000SE-Preferred shares 350,000

c) SE-Preferred dividends declared 20,000L-Preferred dividends payable 20,000

d) L-Preferred dividends payable 20,000A-Cash 20,000

e) SE-Common shares 12,500SE-Retained earnings 12,500

A-Cash 25,000f) SE-Income summary 120,000

SE-Retained earnings 120,000

11.23a) A-Cash 750,000 SE-Common shares 750,000

b) SE-Preferred dividends declared 50,000A-Cash 50,000

c) SE-Stock dividends declared 1,440,000SE-Stock dividends issuable 1,440,000

9

((750,000 + 50,000 ) x 10% x $18)One month after declaration:SE-Stock dividends issuable 1,440,000

SE-Common shares 1,440,000d) SE-Dividends declared 1,320,000

L-Dividends payable 1,320,000 ((750,000 + 50,000 + 80,000) x $1.50)

e) SE-Income summary 2,350,000SE-Retained earnings 2,350,000

10

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 240,000SE-Stock dividends issuable 240,000

(80,000 x 10% x $30) c) SE-Stock dividends issuable 240,000

SE-Common shares 240,000d) SE-Common shares1 50,000

SE-Retained earnings 230,000A-Cash 280,000

1(($5 x 40,000) + $240,000) / (40,000 + 40,000 + 8,000) = $5 per share

11.25 a) Journal entriesa) A-Cash 1,400,000

SE-Common shares 1,400,000b) SE-Preferred dividends declared 40,000

A-Cash 40,000 (10,000 x $8 x 1/2 )

c) SE-Preferred shares 3,000,000A-Cash 1,030,000SE-Contributed surplus 1,970,000

d) SE-Income summary 966,000SE-Retained earnings 966,000

b) Shareholders’ equity, December 31, 20x2Common shares $ 7,220,000Contributed surplus 1,970,000Retained earnings 6,364,000 Total shareholders’ equity $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

11.26 a) SE-Stock dividends declared 135,000SE-Common shares 135,000

(45,000 x 5% x $60)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 $1,820,000Retained earnings (deficit) (47,000) Total shareholders’ equity $1,773,0001 (50,000 x $30) + (10,000 x $32) = $1,820,000

11.28 a) Distribution of cash dividend:Preferred shares (10,000 x $1) $10,000Common shares ($30,000 - $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) = $7,945

b) Net income (in thousands)$3,750 + net income - $750 - $100 = $4,400Net income = $1,500

12

11.30 a) No journal entry.b) A-Cash 1,875,000

SE-Common shares 1,875,000c) A-Land 500,000

A-Equipment 250,000A-Inventory 200,000A-Building 500,000A-Accounts receivable 50,000

SE-Common shares 500,000SE-Preferred shares 1,000,000

d) A-Cash 2,500,000SE-Preferred shares 2,500,000

e) No journal entry.f) SE-Preferred dividends declared 700,000

L-Preferred dividends payable 700,000 [(10,000 + 25,000) x $10 x 2 years]

f) SE-Stock dividends declared 684,000SE-Stock dividends issuable 684,000

[(75,000 + 20,000) x 10% x $72) SE-Stock dividends issuable 684,000

SE-Common shares 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 = $188,000Beginning retained earnings + net income - dividends = Ending retained earnings$0 + net income - (5,000 x $4) - (7,600 x $5) = $130,000

13

11.32 Darby Ltd.

Income StatementYear Ending December 31, 20x1

Revenues $2,240,000Cost of Goods Sold 925,700 Gross Margin 1,314,300Operating expenses: Wage expense $340,800 Amortization expense 145,000 Miscellaneous expense 220,900 706,700 Operating income 607,600Interest expense 42,000 Net Income $ 565,600

Darby Ltd.Statement of Retained EarningsYear Ending December 31, 20x1

Retained earnings, January 1 $4,239,500Net income 565,600Less:Cash dividends declared, Preferred shares (167,000)Common shares (252,600) Retained earnings, December 31 $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.

14

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, 1440,000 issued and outstanding $3,390,000Retained earnings 3,370,000Total shareholders’ equity $6,760,000 1 Stock dividend: 100,000 x 10% x $89 = $890,000Total shares outstanding prior to split = 100,000 Dec. 31, 2001 + 10,000 stock dividend = 110,000Total shares outstanding after split = 110,000 x 4 = 440,000Cash dividend = 440,000 x $1 = $440,000Retained earnings = $2,345,000 + $2,355,000 - $890,000 - $440,000 = $3,370,000

15

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. 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

16

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 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%) $1,440,000Preferred dividends:

Arrears on Class B (50,000 x $6) (300,000)Current year, Class A (20,000 x $1) (20,000)Current year, Class B (50,000 x $6) (300,000)

Available for common shares $820,000Common shares outstanding 1,000,000Common dividends per share 0.82Common shares to be purchased x 2,000Dividend on 2,000 common shares $ 1,640b) 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%) $1,440,000Preferred dividends:

Current year, Class A (20,000 x $1) (20,000)Current year, Class B (50,000 x $6) (300,000)

Available for common shares $1,120,000Common shares outstanding 1,000,000Common dividends per share 1.12Common shares to be purchased x 2,000Dividend on 2,000 common shares $ 2,240

17

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

19

were to drop below 8%, the required payment of preferred dividends would reduce the return to common equity.

Reading and Interpreting Published Financial Statements


b) A-Cash 2,600,000SE-Common shares 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 105,959,504

Shares issued pursuant to stock options 124,460 Number of shares outstanding, January 3, 1999 106,083,964

e) Shares outstanding December 29, 1996 105,610,910f) 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.

20

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 = $125,0001,250,000 x $.10 = 125,000250,000 x $.10 = 25,000Total $275,000e) $275,000 x 10% = $27,500 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 = 34,923,367Number of shares outstanding after the exercise of the stock options = 34,923,367 + 2,750,000 = 37,673,367New net income = $2,095,402 + $27,500 = $2,122,902Revised EPS = $2,122,002 / 37,673,367 = $.06The EPS does not change.g) Return on shareholders’ equity = $2,095,402 / (($3,895,152 - $285,683)+ $820,987)/2 = 94.6%


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 = $ 4,416,552

$3.75 x 553,000 = 2,073,750$4.00 x 1,014,900 = 4,059,600$6.63 x 1,101,100 = 7,300,293$14.13 x 3,073,000= 43,421,490$17.65 x 35,000 = 617,750

$ 61,889,435

Maximum:$6.00 x 1,159,200= $ 6,955,200$4.75 x 553,000 = 2,626,750$5.63 x 1,014,900 = 5,713,887$8.85 x 1,101,100 = 9,744,735$20.48 x 3,073,000= 62,935,040$17.65 x 35,000 = 617,750

$ 88,593,362

21

c) The following accounts change in the pro forma balance sheet:

AssetsCash and short-term investments $189,765Shareholders’ EquityCapital stock $129,544The changes in the pro forma balance sheet are an increase in both cash and short-term 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%


b) Number of shares outstanding Dec. 31, 1998 45,314,156 Share purchase options 2,885,000 Maximum number of common shares 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 279,945 SE-Bonuses expense 22,500

SE-Common shares 302,445b) A-Cash 18,233,188

SE-Bonuses expense 254,800SE-Common shares 18,487,988

c) Average issue price per share1998 1997

Private placements $2.17Exercise of options $0.15 $0.25Exercise of warrants $0.40 $1.55For bonuses $0.45 $2.60

22

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 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

11.45 Answers to this question will depend on the company selected.

CASE

11.46 Manonta Sales CompanyExpected Income Statement for 19x9: ($ in thousands)

Earnings before income taxes (increase 10%) $27,500Plus interest on debt saved 7,440Adjusted earnings before income taxes 34,940Income taxes (40%) (13,976)

Expected net income $20,964Current number of shares 15,000,000To be issued on conversion 9,300,000Expected number of shares 24,300,000Expected Earnings per share $ 0.86Expected market price per share (multiple of 22) $18.92Current market price (multiple of 20) $20.00% decrease 5.4%

Decision: Sell

23

Critical Thinking Question

11.47 General CommentsThe 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 Outlinea) 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.

24

chapter 11 - shareholders’ equity - initial set...

Documents