Accounting II - Chapter 13 - Planning Equity Financing

Rate of return on assets (formula)

Income before interest and taxes / Total assets

Debt financing arises when...

a company obtains funds (cash) in exchange for a liability to repay the borrowed funds

Companies often issue preferred stock with one or more of the following five features:

(1) cumulative (2) participating (3) callable (4) redeemable (5) convertible

Times Interest Earned Ratio (formula)

(Earnings before interest and taxes) / Interest expense

What are the three dates related to dividends?

1. Date of declaration 2. Date of record 3. Date of payment

What are the three important advantages of sole proprietorships and partnerships?

1. Ease of formation 2. Income is only taxed once 3. Sole proprietors and partners are more likely to manage the business and be involved in its operations

In a partnership, what are the five commonly used methods for the allocation of earnings?

1. Fixed ratio 2. Ratio of capital account balances 3. Salary allowances and some determination of allocation of any remainder 4. Interest allowance on capital balances and some determination of allocation of any remainder 5. Combination of salary and interest allowance and some determination of allocation of any remainder

What are the three major advantages of corporations?

1. Limited liability 2. Ability to raise large amounts of capital by selling its stock 3. Unlimited life

From what three sources do companies acquire funds?

1. Owners' contributions 2. Earnings generated by the company's operating activities 3. Debt

What are two disadvantages of sole proprietorships and partnerships?

1. Risk associated with unlimited liability, that is, owners can lose not only what they invested in the company, but also their personal assets. 2. Inability to raise large amounts of equity capital

What are two disadvantages of corporations?

1. Time and money it takes to become incorporated and maintain corporate status 2. Double taxation

Cash Dividend

A cash dividend is a cash distribution paid by sending checks to shareholders as of a certain date. The advantage of cash dividends is that most investors prefer this type of distribution. The disadvantage of cash dividends is that they reduce a source of equity financing.

Reverse Stock Split

A reverse stock split occurs when a corporation calls in its old shares and replaces them with a reduced number of shares with a higher par value.

Stock Split

A stock split occurs when a corporation calls in its old shares of stock and issues a larger number of new shares of stock in their place

Convertible Preferred Stock

Convertible preferred stock gives shareholders the right to convert (exchange) preferred shares for other forms of capital, as stated in the corporate charter, at the option of the preferred shareholder. Preferred stock is normally convertible into common stock, although occasionally it is convertible into debt instruments.

Dividends in Arrears

If a corporation does not pay dividends in a given year, the next time dividends are paid, all the preferred dividends skipped in prior years plus the preferred dividend due for the current year must be paid before the common shareholders can receive any dividends.

Return on Owners' Equity Ratio (ROE) (formula)

Net income / Owners' equity

Participating Preferred Stock

Participating preferred stock allows preferred shareholders the right to receive an amount in excess of the stated dividend rate or amount. After common shareholders have received a dividend, any dividend remaining is shared between preferred and common shareholders.

Redeemable Preferred Stock

Redeemable preferred stock is similar to callable preferred stock except it gives the shareholder the option to turn in (redeem) the stock for cash at the shareholder's option. If the shareholder no longer wishes to hold preferred stock, he or she can redeem or sell the stock to the corporation for a predetermined price per share.

Retired Shares

Retired shares are repurchased (or converted) issued shares that the corporation will never reissue. When shares are retired, both the number of shares issued and outstanding are decreased.

Some corporations have different classes of common stock. What is usually the difference between them?

The difference between the classes of stock (Class A common stock, Class B common stock) involves the voting rights associated with each class of stock and is described in the corporation's charter and bylaws.

Legal Capital

The legal capital of the corporation is the portion of shareholders' equity required by state law to be retained for the protection of the corporation's creditors. In many states itis calculated by multiplying the par value times the number of shares of stock issued.

Market Value

The market value of a share of stock is the price agreed to by an unrelated willing buyer and seller. Rising stock prices reflect increasing investor confidence in future profitability, while declining prices indicate erosion of their confidence in the company's future profitability.

Companies enter into stock splits for a variety of reasons. What's the most common?

The most common reason is to lower the market price of the company's stock to make the price more affordable to a wider group of potential investors.

Why would a company do a reverse stock split?

The most common reason is to increase the selling price of the stock. Many stock exchanges require that the stock sell for a certain minimum amount or the stock will be delisted.

Times Interest Earned Ratio (definition)

The times interest earned ratio measures a company's ability to service its debt by comparing earnings before deducting interest and taxes to the amount of interest expense for the period. Planners use the times interest earned ratio to determine whether the interest on new debt will put the company at risk of not meeting its interest obligations.

What are some marked differences between preferred stock and common stock?

Upon liquidation of the corporation, the preferred shareholders are paid before the common shareholders. In addition, preferred shareholders are entitled to receive dividends before common shareholders receive dividends. Preferred stock may include additional features (cumulative, participating, redeemable, convertible). In exchange for these preferences, preferred shareholders usually give up the right to vote, and the dividends they receive are usually limited to a set amount per share of stock.

Stock Dividend

When a corporation issues a stock dividend. it distributes additional shares of the corporation's stock to existing shareholders. Stock dividends have no effect on the assets of the company because each shareholder receives more shares of stock rather than corporate assets. Although each investor has more shares as a result of a stock dividend, his or her percentage interest in the corporation does not change. When planning a stock dividend, management must be aware that as the size of the stock dividend increases, the market price of the outstanding shares will decrease.

Financial Leverage

a financing strategy designed to increase the rate of return on owners' investment by generating a greater return on borrowed funds than the cost of using the funds.

Equity financing

a means for companies to obtain funds in exchange for an ownership interest in the company.

Dividend Reinvestment Program (DRIP)

a program that allows current shareholders to use their cash dividends to buy more shares of the company's stock

Cumulative Preferred Stock

accumulates unpaid dividends over time.

Par Value

an arbitrary value assigned to shares of capital stock; this value is approved by the state in which the business is incorporated

A corporation issues what two classes of stock?

common and preferred

What rights do common shareholders have?

common shareholders have the right to vote on significant events that effect the corporation, they elect members of the board of directors, the right to declared dividends, the right to residual assets upon liquidation of the corporation, the right to dispose of the shares by sale or gift, and the preemptive right.

Common stock

common stock is a basic ownership unit of a corporation

What are the two financing categories?

equity and debt

Preemptive right

gives common shareholders the right to maintain their percentage interest in the corporation when it issues new shares of common stock. The trend today is for most large corporations to eliminate the preemptive right.

Callable Preferred Stock

gives the corporation the right to repurchase its preferred stock at a stipulated price. If the corporation decides it wants lo reduce the number of shares of preferred stock or eliminate all preferred shareholders. it can call or buy hack some or all of the preferred stock.

Return on Owners' Equity Ratio (ROE) (definition)

measures the return per dollar of owners' equity of the company.

Companies raise equity funds when...

owners acquire a financial interest in the company and when management elects to reinvest the company's earnings that would otherwise be distributed to the owners in the company.

Preferred stock dividends are stated in either ______________________ or _______________________.

predetermined dollar amounts; as a percentage of par value

Preferred Stock

represents an ownership interest in a corporation with special privileges or preferences as to liquidation and dividends.

When planning whether to issue preferred or common stock, the ________________________________ ratio is used.

return on common equity

Treasury Stock

shares of a corporation's issued stock that the corporation has repurchased and intends to reissue at a later date. the corporation is not buying an asset; rather, it is reducing its shareholders' equity by reducing the munber of shares outstanding

Date of Declaration

the date on which the board of directors announces its decision to pay a dividend

Date of Record

the date on which the secretary of the corporation examines the stock ownership transfer book to determine who is officially registered as a shareholder of the corporation and, therefore, eligible to receive the corporation's dividends

Date of Payment

the date that the company pays the dividends to shareholders of record

Importance of debt-to-equity ratio and its formula

the debt-to-equity ratio measures the relationship between the amount of debt and the amount of owners' equity used to finance the company. Recall the debt-to-equity ratio is calculated as total liabilities divided by total owners' equity. A debt-to-equity ratio of 1 means that equal amounts of debt and owners' equity finance the company. The larger the debt-to-equity ratio, the greater the amount of debt used to finance the company and, therefore, the greater the financial risk.

Property Dividend

the distribution of specific non-cash assets. such as inventory or investments in other corporations' securities, to shareholders

Issued Shares

the number of authorized shares a corporation has sold to shareholders

Outstanding Shares

the number of shares issued less the number of shares of treasury stock held by the corporation

Financial risk

the risk of debt financing. The chance that a company will default on its debt.

Authorized Shares

the total number of shares the state has approved for a corporation to sell

Companies strive to have times interest earned ratios that are...

well above 1.