Financial Accounting Ch 7-8

Deciding on the Debt-Equity Mix:

- Basic approach - select a suitable mix. - Utilize at least some hybrid investment instruments

Advantages of financing with debt:

- Interest portion of debt payments are tax deductible to the company. - No loss of control. - No direct claims on future profits. - Finite life. - Adds discipline to management.

Legal capital

- Is the amount of capital that, under state law, must remain invested in the corporation (i.e., not taken out as a dividend or used to buy back shares from shareholders). - Many states have laws providing that the maximum amount available for dividends (or share buy-backs) is equal to assets, minus liabilities, minus legal capital. - Legal capital serves as a "cushion" for creditors.

Disadvantages of financing with equity*:

- Loss of control. - Obligation to share in profits. - Potentially infinite life. - Securities law requirements (sometimes). - Fiduciary duties owed to equity holders. *Assume that equity, for purposes of this slide, means a tradition pure-equity based instrument- i.e., voting common stock.

Disadvantages of financing with debt:

- Loss of financing flexibility. - Agency costs inflate the cost of debt. - Bankruptcy costs inflate the cost of debt.

What advantage is there to obtaining financing using bonds compared to getting a loan from a bank?

-larger amount of money -longer period of time -lower interest rate

bonds

A certificate issued by a government or private company which promises to pay back with interest the money borrowed from the buyer of the certificate.

Stock Dividend

A corporation's distribution of additional shares of its own stock to its stockholders without the receipt of any payment in return

Estimated Liabilities

A known obligation of an uncertain amount, but one that can be reasonably estimated.

What is a mortgage?

A mortgage is a long-term liability that gives the lender a claim against property if the borrower does not make payments.

adjusting entry

An adjusting entry is required to record liabilities incurred to date but not previously recorded.

What is the difference between how bonds are repaid compared to other forms of financing that require installment payments?

Bonds - periodic payments of interest & principal repaid at the maturity date Installment payments - part interest and part principal over the life of the loan

Explain the difference between stock dividends and cash dividends.

Cash dividends distribute cash to the corporation's shareholders. Stock dividends distribute additional shares of stock to the corporation's shareholders.

What is the difference between common stock and preferred stock?

Common stock represents ownership in the corporation - right to vote for the board of directors - right to receive dividends - right to share in assets at liquidation - preemptive right to acquire more shares when the corporation issues more stock Preferred shareholders are not actual owners and usually cannot vote. - have preferential rights to dividends and assets at liquidation.

What are the two sections of the shareholders' equity section of the balance sheet? Explain what each section reports.

Contributed Capital - proceeds from the sale of stock or other contributions made by owners Retained Earnings - the portion of the corporation's net income that it has retained in the business

What are dividends in arrears?

Dividends in arrears are unpaid dividends on cumulative preferred stock from prior years.

Of all the financial ratios you have studied, which is the only one that is required by U.S. GAAP to be reported in the financial statements? On which financial statement will it appear?

EPS is the only one reported in the financial statements. It appears on the income statement.

Known (definitely determinable) Liabilities:

Exist where the business has an existing liability for which it can identify the creditor, the EXACT amount of the debt and the date the obligations must be paid or performed.

current liability

Expected to be paid within one year or the company's operating cycle, whichever is longer.

Long-Term Liabilities

Expected to not be paid within one year or the company's operating cycle, whichever is longer.

Classified Balance Sheet

Groups together similar assets and similar liabilities, using a number of standard classifications and sections.

Why issue stock dividend?

Low on Cash To decrease per share market price of stock

Large Stock Dividend (>25%)

No effect on income No effect on equity No effect on assets

Small Stock Dividend (<25%)

No effect on income No effect on equity No effect on assets

What is the difference between paid-in capital in general and additional paid-in capital on the balance sheet?

Paid-in-Capital - sub-section of stockholders' equity which includes the proceeds from the sale of stock Additional-Paid-in-Capital - an account which is credited for the proceeds from the sale of stock in excess of par Paid-in capital = Capital Stock + Additional Paid-in Capital

Explain how par value affects the issuance of common stock and preferred stock.

Par value is an arbitrary amount and does not determine the price at which a share of stock sells.

Are dividends expenses of a corporation? Explain why or why not.

Per GAAP, dividends are not an expense They are a distribution of the firm's income to the owners

Contingent Liabilities

Potential obligations that depend on future events, but arise out of past transactions or events.

Explain the difference between the stated rate and the effective rate of interest on a bond.

Stated interest rate - determines the cash (interest) payment of the bond Effective interest rate - market rate of interest that investors actually demand

Cost of Debt

The "cost of debt" to a company is equal to the interest rate of the debt, adjusted for the "tax shield" created by the interest payments. Cost of Debt = Int. Rate x (1 - Marginal Tax Rate)

proceeds (of bond)

The amount of cash the bond issuer collects from the bondholders when the bonds are issued

Shares Authorized

The maximum number of shares permitted to be issued, as stated in the corporation's charter.

Shares Outstanding

The portion of shares issued that remain in the hands of shareholders.

Shares Issued

The shares actually sold to shareholders.

What are the two main sources of financing for a business?

The two main sources of financing for a business are debt and equity.

What are the two primary ways for a company to finance its business?

The two primary ways for a company to finance a business are debt and equity.

Would treasury stock be considered authorized, issued, or outstanding? Explain your answer.

Treasury stock is authorized and issued, but not outstanding.

Explain financial leverage.

Use of debt to increase earnings If a company earns more with the money it borrows than it has to pay to borrow the money, then it is called "positive financial leverage."

6. On January 1, Sonata Company issued 10-year bonds with a face value of $400,000 and a stated rate of 10%. The cash proceeds from the bond issue amounted to $354,120. Sonata Company will pay interest to the bondholders annually. How much cash will Sonata pay the bondholders on the first payment date? a. $40,000 b. $48,000 c. $35,412 d. $42,494

a

7. Refer to the information in multiple-choice question 6. How did the market interest rate compare to the stated rate on the date the bonds were issued? a. The market rate is higher than the stated rate. b. The market rate is lower than the stated rate. c. Both rates are the same. d. It cannot be determined.

a

capital structure

a firm's mix of debt and equity financing

preferred stock

a nonvoting share of ownership in a corporation that pays a fixed dividend

1. Partco hired a secretary for $900 a week. The secretary's first paycheck had 20% withheld for income taxes, 6.2% for social security, and 1.45% for Medicare taxes. What is Partco's total expense (including payroll tax expense) related to this payment? a. $68.85 b. $968.85 c. $651.15 d. $720.00

b

10. Positive financial leverage means that a company a. has more debt than equity. b. earns more with borrowed money than the cost of borrowing it. c. has the correct amount of debt. d. has more equity than debt.

b

2. All of the following are current liabilities except a. salaries payable. b. mortgage payable. c. unearned revenue. d. accounts payable.

b

actual bond payments

based on the face value & stated interest

1. Which of the following does not affect retained earnings? a. Net income for the period b. Dividends declared for common shareholders c. Repayment of the principal of a loan d. All of the above affect retained earnings.

c

What is treasury stock and why might a company acquire it?

corporation's own stock that it has repurchased to use in employee benefit plans to prevent takeovers to increase earnings per share

What is the difference between cumulative and noncumulative preferred stock?

cumulative - unpaid dividends in arrears must be paid before the common shareholders can receive any dividends noncumulative - unpaid dividends in arrears are lost to the preferred shareholders (Preferred shareholders of any kind must be paid before the common shareholders in any given year)

2. Preferred stock is stock that is a. traded above the price of common stock. b. issued and later repurchased. c. bought and sold to smooth a company's earnings. d. given priority over common stock for dividends.

d

What are the three dates corporations consider when issuing a dividend?

declaration date record date distribution date

What is the effect of a stock dividend on a company's financial statements?

decreases Retained Earnings increases Common Stock and Additional Paid-in-Capital net effect on stockholders' equity is zero

What effect does the purchase of treasury stock have on a company's financial statements?

decreases cash decreases stockholders' equity on the balance sheet

What is the cost of bankruptcy?

direct = Attorney fees, accounting fees, filing fees, trustee fees, etc. indirect = Lost customers, damaged relations with suppliers, damage to reputation, lower morale, etc.

underwriter

firm that buys an issue of securities from a company and resells it to the public

What is a stock split and what effect does it have on a company's shareholders' equity?

increases the number of shares outstanding decreases the par value per share of the stock proportionately

How is return on equity calculated? What does this ratio measure?

net income (minus any preferred dividends) / average common stockholders' equity measures the return earned on invested capital

Explain how earnings per share (EPS) is calculated. What does this ratio measure?

net income (minus any preferred dividends) / weighted ave # of common shares outstanding EPS is a measure of profitability

Amortization schedule

provides a summary of the cash interest payments, interest expense, and changes in carrying value for debt instruments.

"Straight-Line Method"

spreads the discount or premium equally across the interest payment periods.

How are the interest payments associated with a bond calculated?

stated interest rate x principal amount of the bond

When is a bond issued at a discount?

stated rate < market rate

When is a bond issued at a premium?

stated rate > market rate

What is another name for the face value of a bond?

stated value or par value

Advantages of financing with equity*:

- No certain payment obligations. - Lower agency costs. - Investors are often a good source of advise and contacts. *Assume that equity, for purposes of this slide, means a tradition pure-equity based instrument- i.e., voting common stock.

par value

- is a nominal value per share of capital stock specified in the corporate charter and appearing on the fact of the stock certificate. - has no relationship to the market value of the stock. - serves as the basis for "legal capital."

Reasons for issuing Preferred Stock

1) to raise capital without sacrificing control 2) to boost the return earned by common stockholders through financial leverage 3) to appeal to investors who may believe the common stock is too risky or that the expected return on such stock is too low.

What is the difference between a definitely determinable (known) liability and an estimated liability? Give an example of each.

A definitely determinable liability is one that can be measured exactly such as an account payable or a note payable. An estimated liability is a liability whose amount is not certain such as liabilities under a warranty agreement.

return on equity

Net Income (minus preferred dividends) / Average common shareholders' equity

Treasury Stock

Previously issued shares that have been repurchased by the Company.

When installment loan payments on a mortgage are made, the amount paid reduces cash. What other two items on the financial statements are affected?

Reduce principal (balance in liabilities (notes payable) decreases on the balance sheet) Interest expense (reported on the income statement)

4. Liabilities are often estimated because a. the related expense needs to be recorded to match the appropriate revenues. b. it gives managers a way to manage assets. c. they are usually not disclosed until they are settled. d. the related assets are already recorded.

a

8. Bonds issued with a stated interest rate that is higher than the prevailing market rate are issued at a. a premium. b. a discount. c. par. d. It cannot be determined.

a

annuity

a series of equal cash receipts or cash payments over equally spaced intervals of time

3. The amount a company owes its employees for current work done is a. shown on the balance sheet as pension liability. b. shown as a current liability. c. called postretirement benefits on the balance sheet. d. not shown on the balance sheet.

b

3. Treasury stock is a. a company's own stock that it has repurchased and added to its short-term trading securities (current assets) as an investment. b. a company's own stock that is considered issued but not outstanding. c. a company's own stock that may be used to "manage" earnings—it could be sold for a gain when the price of the stock increases to help a company meet its earnings forecast. d. booked as an increase to assets and a decrease to shareholders' equity when it is purchased.

b

5. Advanced Music Technology, Inc., estimated that its warranty costs would be $900 for items sold during the current year, an amount it considers significant. During the year Advanced paid $750 to repair merchandise that was returned by customers. What is the amount of warranty expense for the current year? a. $750 b. $900 c. $150 d. Cannot be determined

b

5. The purchase of treasury stock will a. increase assets and shareholders' equity. b. decrease assets and shareholders' equity. c. have no effect on assets or shareholders' equity. d. decrease assets but have no effect on shareholders' equity.

b

7. The number of shares of stock designated as issued on the year-end balance sheet are those shares that a. were issued during the year. b. have been issued during the firm's life. c. are authorized to be issued. d. have been repurchased during the year.

b

9. A $1,000 bond with a stated rate of 8% is issued when the market rate is 10%. How much interest will the bondholders receive each year for the annual interest payments? a. $100 b. $80 c. $20 d. $800

b

9. The payment of dividends is a. required by corporate law. b. determined by the firm's board of directors. c. related in amount to the firm's earnings per share. d. determined by the Securities and Exchange Commission.

b

10. Return on equity measures how well a firm is using a. owners' original contributions to the firm. b. creditors' investment in the firm. c. shareholders' total investment in the firm, both contributed and earned. d. its assets.

c

4. The two major components of shareholders' equity are a. preferred stock and common stock. b. contributed capital and paid-in capital. c. contributed capital and retained earnings. d. common stock and treasury stock.

c

8. When treasury stock is reissued for more than the company paid to buy it, the difference is a. a gain that will increase the firm's income. b. included in sales revenue for the period. c. added to an additional paid-in capital account. d. given to the current shareholders as a dividend.

c

6. If a company purchased 50 shares of its own stock for $10 per share and later sold it for $12 per share, the company would a. record a gain of $2 per share. b. record an increase to retained earnings of $100. c. show a gain on the sale. d. show an increase of $100 of paid-in capital.

d

What are the two ways that shareholders can make money on an investment in a corporation's stock?

receiving dividends or selling the stock at a higher price than its cost

To what does the term capital structure refer?

relative amounts of debt and equity used to finance the firm

retained earnings

the accumulated earnings from a firm's profitable operations that were reinvested in the business and not paid out to stockholders in dividends

dividend

the distribution of a corporation's earnings to shareholders

Stock Split

the division of a single share of stock into more than one share - decreases par value of stock - increases number of outstanding shares - no change in stockholders' equity

market rate (of bond)

the interest rate an investor could earn in an equally risky investment

financial leverage

the use of borrowed funds to increase earnings

How is the debt-to-equity ratio calculated, and what does this ratio measure?

total liabilities ------------------------------- shareholders' equity compares creditors' claims with owners' claims to assets of the firm.

debt-to-equity ratio

total liabilities/total equity. An indication of solvency