Shareholders' Equity: Chapter 11 PDF

Chapter 11 – Shareholders’ Equity Chapter Objectives – Be able to: 1. describe the characteristics of debt and that of equity 2. describe the components of Shareholders’ Equity 3. account for stock issuance and repurchase (Treasury Stock) 4. explain stock dividends and stock splits 5. discuss Other...

Chapter 11 – Shareholders’ Equity Chapter Objectives – Be able to: 1. describe the characteristics of debt and that of equity 2. describe the components of Shareholders’ Equity 3. account for stock issuance and repurchase (Treasury Stock) 4. explain stock dividends and stock splits 5. discuss Other Comprehensive Income items 6. describe basic and diluted EPS 1  How to Finance a Corporation  Borrow  Examples: Notes, bonds, leases  The debt holders are legally entitled to repayment of the interest and principal  Issue Equity  Common and preferred stock  The shareholders have various rights, limited liability, and a residual interest in the corporate assets  Internally generated cash 2  Debt versus Equity Debt Equity Formal legal contract No legal contract Fixed maturity date No fixed maturity date Fixed periodic payments Discretionary dividends Security in case of default Residual asset interest No voice in management Voting rights - common Interest expense deductibleDividends not deductible Double taxation 3  Pfizer’s Stockholders’ Equity The stockholders’ equity section of Pfizer’s balance sheet contains two sections: 4  Contributed Capital  Represents  Cumulative cash inflows received from the issuance of various classes of stock  Less the net cash paid out to repurchase a company’s own stock from the market  Includes  Two classes of stock  Common stock  Preferred stock  Additional paid-in capital (also labeled as Paid-in capital in excess of par) 5  Earned Capital Represents:  Retained earnings—Cumulative profits and losses of the company less any dividends to shareholders  Other comprehensive income (OCI)—Changes to equity which are not part of income and not reflected in retained earnings 6  Retained Earnings  Represents the cumulative profit that has been retained by the company  Increased by net income  Decreased by net losses  Decreased by dividends to shareholders  Affected by a handful of other events 7  Common Stock  The primary ownership unit in a company  Common shareholders have voting rights  Par value  An arbitrary value often assigned to each share of stock  Specified in the corporate charter at the time the corporation is formed  Specifies the allocation of proceeds from stock issuances between common stock and additional paid-in capital on the balance sheet 8  Numbers of Shares of Stock Authorized Shares  The upper limit on the number of shares that the corporation can issue  Established in the articles of incorporation  Can be increased by affirmative shareholder vote Issued Shares  Actual number of shares that have been issued to shareholders Outstanding Shares  Number of issued shares less the number of shares repurchased as treasury stock 9  Preferred Stock  Generally has some preference, or priority, with respect to common stock  Typical preferences  Dividend preference - Preferred shareholders receive dividends on their shares before common shareholders  Liquidation preference - If a company fails, assets sold in liquidation go first to pay debtors, next to preferred shareholders, and finally to common stockholders 10  Accounting for Stock Issuances  Used to obtain cash and other assets for use in the business  Creates an increase in assets and stockholders’ equity  Common or preferred stock account increases by Par value × Number of shares sold  Additional paid-in capital account increases by Remainder of issue price  No effect on the income statement The first issuance of stock by a company is called an initial public offering or IPO 11  Stock Issuance Example Phelps Swimming, Inc. issued 500 shares of $1 par value common stock at $15 per share. Cash 7,500 Common stock 500 Additional Paid-in Capital 7,000 Cash Common Stock 7,500 500 Additional Paid-in Capital 7,000 12  Stock Repurchase (Treasury Stock)  How it works - A company buys its own stock from investors at the market price  Reasons for repurchase  To reduce the number of shares outstanding in order to increase the value of possible undervalued stock (Sends a positive signal to the market that affects share price favorably)  To offset the dilutive effects of an employee stock option program 13  Accounting for Treasury Stock  Never results in a gain or loss on the income statement  Difference between the cost of the stock and the resale price is an adjustment to additional paid-in capital  Treasury stock account is a contra stockholders’ equity account, deducted from total stockholders’ equity on the balance sheet 14  Treasury Stock Purchase Example Phelps Swimming, Inc. repurchased 100 shares of its own common stock for $22 per share. Treasury stock 2,200 Cash 2,200 Treasury Stock Cash 2,200 2,200 15  Treasury Stock Reissue Example Phelps Swimming, Inc. reissued 80 shares of the treasury shares for $24 per share. 80 x $24 per share = $1,920 Cash 1,920 Treasury stock 1,760 Additional Paid-in Capital 160 Cash Treasury Stock 1,920 1,760 Additional Paid-in Capital 160 16  Cash Dividends  Reasons for dividend payments vary  Most paid in cash  Most are paid quarterly  Pfizer’s dividend policy as stated in its 2020 annual report: Dividends on Common Stock In December 2020, our BOD declared a first-quarter dividend of $0.39 per share, payable on March 5, 2021, to shareholders of record at the close of business on January 29, 2021. The first-quarter 2021 cash dividend will be our 329th consecutive quarterly dividend. Our current and projected dividends provide a return to shareholders while maintaining sufficient capital to invest in growing our business. Our dividends are not restricted by debt covenants. While the dividend level remains a decision of Pfizer’s BOD and will continue to be evaluated in the context of future business performance, we currently believe that we can support future annual dividend increases, barring significant unforeseen events… Not all companies pay dividends 17  Cash Dividend Example Phelps Swimming declared and paid a quarterly cash dividend of $780 Retained earnings 780 Cash 780 Retained Earnings Cash 780 780 No effect on profit 18  Stock Dividends and Splits  Additional shares of stock distributed to shareholders  Stock dividends  Retained earnings is reduced  Contributed capital is increased  Stock splits  No financial statement effects 19  Other Comprehensive Income  Includes:  Foreign currency adjustments  Unrealized gains and losses on Available-for-sale securities and derivatives  Adjustments to pension and other benefit plans  Displayed separately in the Shareholders’ Equity section of the Balance Sheet as Other Comprehensive Income (OCI) 20  Earnings per Share (EPS)  Reported on the face of the income statement  At least one and potentially two EPS amounts are required 1 Always required 2 Required with complex capital structures 21  Complex Capital Structure  Exists if dilutive securities are outstanding, including:  Securities that can be converted into shares of common stock that would reduce/dilute earnings per share upon conversion  Three primary types  Stock options  Convertible debt  Convertible preferred stock Requires Diluted EPS be calculated and reported in addition to Basic EPS 22  Calculating EPS Basic EPS Earnings available for common shareholders Weighted average number of common shares outstanding Why are preferred dividends and noncontrolling interests subtracted?  EPS is the amount of income per common share available for dividend payment to common shareholders. Diluted EPS Earnings available for common shareholders + Add-backs Avg. number of Shares of convertible securities & stock common shares + options assumed to be converted 23  Basic EPS Example Phelps Swimming reported net income totaling $8,000 for 20X9 and paid $1,000 in preferred dividends and $3,000 in common dividends. At the beginning of 20X9, there were 8,000 common shares outstanding. At April 1, Phelps purchased 800 treasury shares. Earnings available for common shareholders Basic EPS = Weighted avg. number of common shares outstanding = $8,000 – $1,000 = $0.95 per share [8,000 × 3/12] + [7,200 × 9/12] 24  Diluted EPS Example Phelps Swimming reported net income totaling $8,000 for 20X9 and paid $1,000 in preferred dividends and $3,000 in common dividends. The preferred stock is convertible into 2,400 shares of common stock. Diluted EPS = Earnings available for common shareholders + Add-backs Avg. number of Shares of convertible securities & stock common shares + options assumed to be converted $8,000 = = $0.82 per share [8,000 × 3/12] + [7,200 × 9/12] + 2,400 The possible conversion ‘dilutes’ earnings per share from $0.95 to $0.82 per share 25  Pfizer’s EPS The EPS section of Pfizer’s income statement for the years ending December 31, 2020 and 2019 shows both basic and diluted EPS 26