POA学习整理-11：Reporting and Analyzing Stockholder’s Equity
Section 1: The Corporate Form of Organization
Characteristics of a Corporation
Separate Legal Existence
The corporation acts under its own name rather than in the name of its stockholders.
Limited Liability of Stockholders
Creditors ordinarily have recourses only to corporate assets to satisfy their claims, and have no legal claim on the personal assets of the stockholders unless fraud has occurred.
Transferable ownership rights
The transfer of ownership rights among stockholders normally has no effect on the operating activities of the corporation. Nor does it affect the corporation’s asset, liabilities and total stockholder’s equity.
Ability to Acquire Capital
It is relatively easy to obtain capital through the issuance of stock.
Continuous Life
The life of a corporation is stated in its charter. The life may be perpetual or it may be limited to a specific number of years. If it is limited, the period of existence can be extended through renewal of the charter.
Corporation Management
Stockholders elect a board of directors. The board formulates the operating policies and select officers to execute policy and to perform daily management functions. The president is the chief executive officer (CEO), has direct responsibility for managing the business. The chief accounting officer is the controller. Responsibilities include: (1) maintaining the accounting records and an adequate system of internal control and (2) preparing financial statement, tax returns, and internal reports. The treasurer has custody of the corporation’s funds and is responsible for maintaining the company’s cash position.
Government Regulations
A corporation is subject to numerous state and federal regulations. Most publicly held corporations are required to make extensive disclosure of their financial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports. When a corporate stock is listed and traded on organized securities markets, the corporation must comply with the reporting requirements of these exchanges.
Additional Taxes
Corporations pay federal and state income taxes and stockholders are required to pay taxes on cash dividends. Double taxation: once at the corporate level and again at the individual level.
Forming a Corporation
A corporation is formed by grant of a state charter. It is incorporated in only one state. Corporations engaged in interstate commerce must also obtain a license from each state in which they do business.
Stockholder rights
When a corporation has only one class of stock, it is identified as common stock. Proof of stock ownership is evidenced by a printed or engraved form known as stock certificate.
Stockholders have the right to:
(1) Vote in election of board of directors at annual meeting a vote on actions that require stockholder approval.
(2) Share the corporate earnings through receipt of dividends
(3) Keep the same percentage ownership when new shares of stock are issued.
(4) Share in assets upon liquidation in proportion to their holdings. This is called a residual claim because owners are paid with assets that remain after all claims have been paid.
Section 2: Stock Issue Considerations
Authorized Stock
The amount of stock that a corporation is authorized to sell is indicated in its charter. The authorization of common stock does not result in a formal accounting entry. If all authorized stock is sold, then a corporation must obtain consent of the state to amend its charter before it can issue additional shares.
Issuance of Stock
A corporation can directly or indirectly issue common stock. Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation.
Par and No-par Value Stocks
Par value stock is capital stock that has been assigned a value per share in the corporate charter, and it does not indicate a stock’s market value. No-par value stock is capital stock that has not been assigned a value in the corporate charter. No-par value stock is quite common today. In many states the board of directors is permitted to assign a stated value to the no-par shares.
Accounting for Common Stock Issues
The stockholder’s equity section of a corporation’s balance sheet includes: (1) paid-in (contributed) capital and (2) retained earnings (earned capital). The issuance of common stock affects only paid-in capital accounts.
When the issuance of common stock for cash is recorded, the par value of the shares is credited to common stock, and the portion of the proceeds that is above or below par value is recorded in a separate paid-in capital account.
(1) 如果只按照par value发行股票，只有一个entry记录。
Cash 1,000
Common Stock 1,000
(2) 如果发行股票不按照par value而是市场价格，, 一个记录par value 那部分的钱，一个记录多余的或者缺少的钱
Cash 5,000
Common Stock 1,000
Paid-in Capital in Excess of Par Value 4,000
Some companies issue no-par stock with a stated value. For accounting purpose, the stated value is treated in the same fashion as the par value. If a company issues no-par stock that does not have a stated value, then the full amount received is credited to the Common Stock account. In such a case, there is no need for the Paid-in Capital in Excess of Stated Value account.
Section 3: Accounting for Treasury Stock
Treasury stock is a corporation’s own stock that has been issued, fully paid for, reacquired by the corporation and held in its treasury for future use.
A corporation may acquire treasury stock for various reasons:
(1) To reissue the shares to officers and employees under bonus and stock compensation plans.
(2) To increase trading of the company’s stock in the securities market in the hope of enhancing its market value by signaling that management believes the stock is underpriced.
(3) To have additional shares available for use in acquiring other companies.
(4) To reduce the number of shares outstanding and thereby increase earnings per share.
Purchase of Treasury Stock
Under the cost method, treasury stock is increased (debited) by the price paid to acquire the shares. Treasury stock decreases by the same amount when the shares are later sold.
(1) Before purchase of treasury stock, the stockholders’ equity section is:
Stockholders’ equity
Paid-in capital
Common stock, $5 par value, 100,000 shares
Issued and outstanding $500,000
Retained earnings 200,000
Total stockholders’ equity $700,000
(2) After acquiring 4,000 shares of its stock at $8 per share:
Treasury stock $32,000
Cash $32,000
Stockholders’ equity
Paid-in capital
Common stock, $5 par value, 100,000 shares
Issued and 96,000 outstanding $500,000
Retained earnings 200,000
Total pain-in capital and retained earnings 700,000
Less: Treasury stock (4,000 shares) 32,000
Total stockholders’ equity $668,000
注意：(1) the original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change. (2) Both the number of shares issued (100,000) and the number in the treasury (4,000) are disclosed. The difference is the number of shares of stock outstanding (96,000).
Section 4: Preferred Stock
Preferred stock has contractual provisions that give it preference or priority over common stock in certain areas. Typically, preferred stockholders have a priority in relation to (1) dividends and (2) assets in the event of liquidation. The entries are similar to the entries for common stock.
A company issues 10,000 shares of $10 par value preferred stock for $12 cash per share.
Cash 120,000
Preferred stock 100,000
Paid-in Capital in Excess of Par Value – Preferred stock 20,000
Dividend Preferences
Preferred stockholders have the right to share in the distribution of corporate income before common stockholders. For preferred stock, the per share dividend amount is stated as a percentage of the par value of the stock or as a specified amount.
Cumulative dividend means that preferred stockholders must be paid both current year dividends and any unpaid prior-year dividends before common stockholders receive dividends. Preferred dividends not declared in a given period are called dividends in arrears借金、遅れ. Dividends cannot be paid to common stockholders while any preferred stock dividend is in arrears. Dividends in arrears are not considered a liability. No obligation exists until the board of directors formally “declares” that the corporation will pay a dividend. The amount of dividends in arrears should be disclosed in the notes to the F/S.
Liquidation Preference
The preference to assets may be for the par value of the shares or for a specified liquidating value.
Section 5: Dividends
Dividend is a distribution by a corporation to its stockholders on a pro rata basis比例してPro rata means that if you own 10% of the common shares, you will receive 10% of the dividend. Dividend can take four forms: cash, property, script (promissory note to pay cash), or stock. Dividends are generally reported quarterly as a dollar amount per share.
Cash Dividends
A cash dividend is a pro rata distribution of cash to stockholders. It must have the following:
(1) Retained earnings. Payment of dividends from retained earnings is legal in all states. In many states, payment of dividends from legal capital is prohibited. However, payment of dividends from paid-in capital in excess of par is legal in some states.
(2) Adequate cash.
(3) Declared dividends. Dividends do not accrue like interest on a note payable, and they are not a liability until they are declared.
Accounting for Cash Dividends
Accounting entries are required on the declaration date and the payment date of dividends.
On the declaration date, a cash dividend commits the corporation to a binding legal obligation.
Dec 1 Retained Earnings (or Cash Dividends Declared) 50,000
Dividends Payable 50,000
注意：instead of RE, the account Dividend can be used. RE增减方向与avenue相同. Dividend增减方向与assets相同。
On the payment date,
Jan 20 Dividend Payable 50,000
Cash 50,000
注意：payment of dividend reduces both current assets and current liabilities, but it has no effect on stockholders’ equity. The cumulative effect of the declaration and payment of a cash dividend on a company’s F/S is to decrease both stockholders’ equity and total assets.
Stock Dividends
A stock dividend results in a decrease in retained earnings and an increase in paid-in capital. Unlike a cash dividend, a stock dividend doesn’t decrease total stockholders’ equity or total assets. Investors are not receiving anything they didn’t already own. They own more shares of stock, but their ownership interest has not changed.
The accounting profession recommends the directors assign the fair market value per share for small stock dividend (less than 20% - 25%). The amount to be assigned for a large stock dividend (greater than 20% - 25%) is not specified，however, par or stated value per share is normally assigned.
Stock dividends change the composition of stockholders’ equity, total stockholders’ equity remains the same. Stock dividends also have no effect on the par or stated value per share, but the number of shares outstanding increases.
Stock Splits
A stock split results in a reduction in the par or stated value per share. The purpose of a stock split is to increase the marketability of the stock by lowering its market value per share, in turn, makes it easier for the corporation to issue additional stock. A stock split does not have any effect on paid-in capital, retained earnings, and total stockholders’ equity. However, the number of shares outstanding increases. It is not necessary to journalize a stock split.
Section 6: Retained Earnings
Retained earnings are net income (loss) that is retained in the business. Some companies identified a debit balance (增加为credit, 减少为debit) in retained earnings as a deficit.
Beginning of the balance + Net income (loss) – Dividends = Ending balance
Retained Earnings Restrictions
The balance in retained earnings is generally available for dividend declarations. Retained earnings restrictions make a portion of the balance currently unavailable for dividends. These are generally disclosed in the notes to the financial statements.
Section7: Financial Statement Presentation
Balance Sheet Presentation
In the stockholders’ equity section, paid-in capital and retained earnings are reported. Within paid-in capital, two classifications are recognized: (1) capital stock, which consists of preferred and common stock. Information about the par value, shares authorized, shares issued and shares outstanding is reported for each class of stock. (2) Additional paid-in capital, which includes the excess of amount paid in over par or stated value and paid-in capital from treasury stock.
Stockholders’ equity
Paid-in capital
Capital stock
9% preferred stock, $100 par value, cumulative,
10,000 shares authorized, 6,000 shares issued
And outstanding $ 600,000
Common stock, no par, $5 stated value,
500,000 share authorized, 400,000 shares
Issued, and 390,000 outstanding 2,000,000
Total capital stock 2,600,000
Additional paid-in capital
In excess of par value – preferred stock $ 30,000
In excess of stated value – common stock 1,050,000
Total additional paid-in capital 1,080,000
Total paid-in capital 3,680,000
Retained earnings (see Note R) 1,160,000
Total paid-in capital and retained earnings 4,840,000
Less: Treasury stock – common stock (10,000 shares) (80,000)
Total stockholders’ equity $4,760,000
Statement of Cash Flows Presentation
Information regarding cash inflows and outflows during the year that resulted from equity transactions is reported in the “financing activities” section of the statement of cash flows. Such as Issuances of common stock, Purchases of common stock, and Payment of dividends.
Section 8: Measuring Corporate Performance
Dividend Record
Payout ratio – profitability
Payout Ratio = Cash Dividends Declared on Common Stock / Net Income
Payout ratio measures the percentage of earnings distributed in the form of cash dividends to common stockholders. Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business.
Earnings Performance
Return on common stockholders’ equity – profitability
ROCSE = Net Income – Preferred Stock Dividends / Average Common Stockholders’ Equity
This ratio shows how many dollars of net income were earned for each dollar invested by common stockholders. The higher is the better. From common stockholder’ perspective, higher percentage suggests strong earnings performance.
Debt versus Equity Decision
Issue bond or sell common stock
Disadvantage of bond financing:
The company locks in fixed payments that must be made in good times and bad. Interest must be paid on a periodic basis, and the principal (face value) of the bonds must be paid at maturity.
Advantages of bond financing:
1. Stockholder control is not affected.
2. Tax saving result. Bond interest is deductible for tax purpose; dividends on stock are not.
3. Return on common stockholders’ equity may be higher.
The following example is to illustrate the potential effect of debt financing on the return on common stockholders’ equity.
S company plans to finance $5 million. Currently has 100,000 shares of common stock outstanding issued at $25 per share. Tax rate is 30%.
(A) Issue 200,000 shares of common stock at price of $25 per share.
(B) Issue $5 million of 12% bonds at face value.
Plan A Plan B
Income before interest and taxes $1,500,000 $1,500,000
Interest (12% x $5,000,000) - 600,000
Income before income tax 1,500,000 900,000
Income tax expense (30%) 450,000 270,000
Net income $1,050,000 $630,000
Common stockholders’ equity $7,500,000 $2,500,000
Return on common stockholders’ equity 14% 25.2%
Characteristics of a Corporation
Separate Legal Existence
The corporation acts under its own name rather than in the name of its stockholders.
Limited Liability of Stockholders
Creditors ordinarily have recourses only to corporate assets to satisfy their claims, and have no legal claim on the personal assets of the stockholders unless fraud has occurred.
Transferable ownership rights
The transfer of ownership rights among stockholders normally has no effect on the operating activities of the corporation. Nor does it affect the corporation’s asset, liabilities and total stockholder’s equity.
Ability to Acquire Capital
It is relatively easy to obtain capital through the issuance of stock.
Continuous Life
The life of a corporation is stated in its charter. The life may be perpetual or it may be limited to a specific number of years. If it is limited, the period of existence can be extended through renewal of the charter.
Corporation Management
Stockholders elect a board of directors. The board formulates the operating policies and select officers to execute policy and to perform daily management functions. The president is the chief executive officer (CEO), has direct responsibility for managing the business. The chief accounting officer is the controller. Responsibilities include: (1) maintaining the accounting records and an adequate system of internal control and (2) preparing financial statement, tax returns, and internal reports. The treasurer has custody of the corporation’s funds and is responsible for maintaining the company’s cash position.
Government Regulations
A corporation is subject to numerous state and federal regulations. Most publicly held corporations are required to make extensive disclosure of their financial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports. When a corporate stock is listed and traded on organized securities markets, the corporation must comply with the reporting requirements of these exchanges.
Additional Taxes
Corporations pay federal and state income taxes and stockholders are required to pay taxes on cash dividends. Double taxation: once at the corporate level and again at the individual level.
Forming a Corporation
A corporation is formed by grant of a state charter. It is incorporated in only one state. Corporations engaged in interstate commerce must also obtain a license from each state in which they do business.
Stockholder rights
When a corporation has only one class of stock, it is identified as common stock. Proof of stock ownership is evidenced by a printed or engraved form known as stock certificate.
Stockholders have the right to:
(1) Vote in election of board of directors at annual meeting a vote on actions that require stockholder approval.
(2) Share the corporate earnings through receipt of dividends
(3) Keep the same percentage ownership when new shares of stock are issued.
(4) Share in assets upon liquidation in proportion to their holdings. This is called a residual claim because owners are paid with assets that remain after all claims have been paid.
Section 2: Stock Issue Considerations
Authorized Stock
The amount of stock that a corporation is authorized to sell is indicated in its charter. The authorization of common stock does not result in a formal accounting entry. If all authorized stock is sold, then a corporation must obtain consent of the state to amend its charter before it can issue additional shares.
Issuance of Stock
A corporation can directly or indirectly issue common stock. Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation.
Par and No-par Value Stocks
Par value stock is capital stock that has been assigned a value per share in the corporate charter, and it does not indicate a stock’s market value. No-par value stock is capital stock that has not been assigned a value in the corporate charter. No-par value stock is quite common today. In many states the board of directors is permitted to assign a stated value to the no-par shares.
Accounting for Common Stock Issues
The stockholder’s equity section of a corporation’s balance sheet includes: (1) paid-in (contributed) capital and (2) retained earnings (earned capital). The issuance of common stock affects only paid-in capital accounts.
When the issuance of common stock for cash is recorded, the par value of the shares is credited to common stock, and the portion of the proceeds that is above or below par value is recorded in a separate paid-in capital account.
(1) 如果只按照par value发行股票，只有一个entry记录。
Cash 1,000
Common Stock 1,000
(2) 如果发行股票不按照par value而是市场价格，, 一个记录par value 那部分的钱，一个记录多余的或者缺少的钱
Cash 5,000
Common Stock 1,000
Paid-in Capital in Excess of Par Value 4,000
Some companies issue no-par stock with a stated value. For accounting purpose, the stated value is treated in the same fashion as the par value. If a company issues no-par stock that does not have a stated value, then the full amount received is credited to the Common Stock account. In such a case, there is no need for the Paid-in Capital in Excess of Stated Value account.
Section 3: Accounting for Treasury Stock
Treasury stock is a corporation’s own stock that has been issued, fully paid for, reacquired by the corporation and held in its treasury for future use.
A corporation may acquire treasury stock for various reasons:
(1) To reissue the shares to officers and employees under bonus and stock compensation plans.
(2) To increase trading of the company’s stock in the securities market in the hope of enhancing its market value by signaling that management believes the stock is underpriced.
(3) To have additional shares available for use in acquiring other companies.
(4) To reduce the number of shares outstanding and thereby increase earnings per share.
Purchase of Treasury Stock
Under the cost method, treasury stock is increased (debited) by the price paid to acquire the shares. Treasury stock decreases by the same amount when the shares are later sold.
(1) Before purchase of treasury stock, the stockholders’ equity section is:
Stockholders’ equity
Paid-in capital
Common stock, $5 par value, 100,000 shares
Issued and outstanding $500,000
Retained earnings 200,000
Total stockholders’ equity $700,000
(2) After acquiring 4,000 shares of its stock at $8 per share:
Treasury stock $32,000
Cash $32,000
Stockholders’ equity
Paid-in capital
Common stock, $5 par value, 100,000 shares
Issued and 96,000 outstanding $500,000
Retained earnings 200,000
Total pain-in capital and retained earnings 700,000
Less: Treasury stock (4,000 shares) 32,000
Total stockholders’ equity $668,000
注意：(1) the original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change. (2) Both the number of shares issued (100,000) and the number in the treasury (4,000) are disclosed. The difference is the number of shares of stock outstanding (96,000).
Section 4: Preferred Stock
Preferred stock has contractual provisions that give it preference or priority over common stock in certain areas. Typically, preferred stockholders have a priority in relation to (1) dividends and (2) assets in the event of liquidation. The entries are similar to the entries for common stock.
A company issues 10,000 shares of $10 par value preferred stock for $12 cash per share.
Cash 120,000
Preferred stock 100,000
Paid-in Capital in Excess of Par Value – Preferred stock 20,000
Dividend Preferences
Preferred stockholders have the right to share in the distribution of corporate income before common stockholders. For preferred stock, the per share dividend amount is stated as a percentage of the par value of the stock or as a specified amount.
Cumulative dividend means that preferred stockholders must be paid both current year dividends and any unpaid prior-year dividends before common stockholders receive dividends. Preferred dividends not declared in a given period are called dividends in arrears借金、遅れ. Dividends cannot be paid to common stockholders while any preferred stock dividend is in arrears. Dividends in arrears are not considered a liability. No obligation exists until the board of directors formally “declares” that the corporation will pay a dividend. The amount of dividends in arrears should be disclosed in the notes to the F/S.
Liquidation Preference
The preference to assets may be for the par value of the shares or for a specified liquidating value.
Section 5: Dividends
Dividend is a distribution by a corporation to its stockholders on a pro rata basis比例してPro rata means that if you own 10% of the common shares, you will receive 10% of the dividend. Dividend can take four forms: cash, property, script (promissory note to pay cash), or stock. Dividends are generally reported quarterly as a dollar amount per share.
Cash Dividends
A cash dividend is a pro rata distribution of cash to stockholders. It must have the following:
(1) Retained earnings. Payment of dividends from retained earnings is legal in all states. In many states, payment of dividends from legal capital is prohibited. However, payment of dividends from paid-in capital in excess of par is legal in some states.
(2) Adequate cash.
(3) Declared dividends. Dividends do not accrue like interest on a note payable, and they are not a liability until they are declared.
Accounting for Cash Dividends
Accounting entries are required on the declaration date and the payment date of dividends.
On the declaration date, a cash dividend commits the corporation to a binding legal obligation.
Dec 1 Retained Earnings (or Cash Dividends Declared) 50,000
Dividends Payable 50,000
注意：instead of RE, the account Dividend can be used. RE增减方向与avenue相同. Dividend增减方向与assets相同。
On the payment date,
Jan 20 Dividend Payable 50,000
Cash 50,000
注意：payment of dividend reduces both current assets and current liabilities, but it has no effect on stockholders’ equity. The cumulative effect of the declaration and payment of a cash dividend on a company’s F/S is to decrease both stockholders’ equity and total assets.
Stock Dividends
A stock dividend results in a decrease in retained earnings and an increase in paid-in capital. Unlike a cash dividend, a stock dividend doesn’t decrease total stockholders’ equity or total assets. Investors are not receiving anything they didn’t already own. They own more shares of stock, but their ownership interest has not changed.
The accounting profession recommends the directors assign the fair market value per share for small stock dividend (less than 20% - 25%). The amount to be assigned for a large stock dividend (greater than 20% - 25%) is not specified，however, par or stated value per share is normally assigned.
Stock dividends change the composition of stockholders’ equity, total stockholders’ equity remains the same. Stock dividends also have no effect on the par or stated value per share, but the number of shares outstanding increases.
Stock Splits
A stock split results in a reduction in the par or stated value per share. The purpose of a stock split is to increase the marketability of the stock by lowering its market value per share, in turn, makes it easier for the corporation to issue additional stock. A stock split does not have any effect on paid-in capital, retained earnings, and total stockholders’ equity. However, the number of shares outstanding increases. It is not necessary to journalize a stock split.
Section 6: Retained Earnings
Retained earnings are net income (loss) that is retained in the business. Some companies identified a debit balance (增加为credit, 减少为debit) in retained earnings as a deficit.
Beginning of the balance + Net income (loss) – Dividends = Ending balance
Retained Earnings Restrictions
The balance in retained earnings is generally available for dividend declarations. Retained earnings restrictions make a portion of the balance currently unavailable for dividends. These are generally disclosed in the notes to the financial statements.
Section7: Financial Statement Presentation
Balance Sheet Presentation
In the stockholders’ equity section, paid-in capital and retained earnings are reported. Within paid-in capital, two classifications are recognized: (1) capital stock, which consists of preferred and common stock. Information about the par value, shares authorized, shares issued and shares outstanding is reported for each class of stock. (2) Additional paid-in capital, which includes the excess of amount paid in over par or stated value and paid-in capital from treasury stock.
Stockholders’ equity
Paid-in capital
Capital stock
9% preferred stock, $100 par value, cumulative,
10,000 shares authorized, 6,000 shares issued
And outstanding $ 600,000
Common stock, no par, $5 stated value,
500,000 share authorized, 400,000 shares
Issued, and 390,000 outstanding 2,000,000
Total capital stock 2,600,000
Additional paid-in capital
In excess of par value – preferred stock $ 30,000
In excess of stated value – common stock 1,050,000
Total additional paid-in capital 1,080,000
Total paid-in capital 3,680,000
Retained earnings (see Note R) 1,160,000
Total paid-in capital and retained earnings 4,840,000
Less: Treasury stock – common stock (10,000 shares) (80,000)
Total stockholders’ equity $4,760,000
Statement of Cash Flows Presentation
Information regarding cash inflows and outflows during the year that resulted from equity transactions is reported in the “financing activities” section of the statement of cash flows. Such as Issuances of common stock, Purchases of common stock, and Payment of dividends.
Section 8: Measuring Corporate Performance
Dividend Record
Payout ratio – profitability
Payout Ratio = Cash Dividends Declared on Common Stock / Net Income
Payout ratio measures the percentage of earnings distributed in the form of cash dividends to common stockholders. Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business.
Earnings Performance
Return on common stockholders’ equity – profitability
ROCSE = Net Income – Preferred Stock Dividends / Average Common Stockholders’ Equity
This ratio shows how many dollars of net income were earned for each dollar invested by common stockholders. The higher is the better. From common stockholder’ perspective, higher percentage suggests strong earnings performance.
Debt versus Equity Decision
Issue bond or sell common stock
Disadvantage of bond financing:
The company locks in fixed payments that must be made in good times and bad. Interest must be paid on a periodic basis, and the principal (face value) of the bonds must be paid at maturity.
Advantages of bond financing:
1. Stockholder control is not affected.
2. Tax saving result. Bond interest is deductible for tax purpose; dividends on stock are not.
3. Return on common stockholders’ equity may be higher.
The following example is to illustrate the potential effect of debt financing on the return on common stockholders’ equity.
S company plans to finance $5 million. Currently has 100,000 shares of common stock outstanding issued at $25 per share. Tax rate is 30%.
(A) Issue 200,000 shares of common stock at price of $25 per share.
(B) Issue $5 million of 12% bonds at face value.
Plan A Plan B
Income before interest and taxes $1,500,000 $1,500,000
Interest (12% x $5,000,000) - 600,000
Income before income tax 1,500,000 900,000
Income tax expense (30%) 450,000 270,000
Net income $1,050,000 $630,000
Common stockholders’ equity $7,500,000 $2,500,000
Return on common stockholders’ equity 14% 25.2%
