Equity Financing

debt financing

• loans; repay, with interest

• liable for amount of loan

• relationship ends with repayment

equity financing

• no responsibility to repay

• investor takes risk

• investor rewarded by company’s future success

2 categories of equity

1. contributed capital

2. retained earnings

contributed capital

the amount that owners have contributed through the purchase of stock

• capital stock

retained earnings

the net income earned by the company not paid out as dividends

2 types of capital stock

1. preferred stock

2. common stock

preferred stock

• has dividend preference, means if a dividend is paid the preferred stockholders must be paid in full before common stockholders can receive a dividend

• the preferred stock dividend is set at a fixed percentage

• preferred stockholders typically do not have voting rights

common stock

• common stockholders have voting privileges

  • election of board of directors

  • vote on significant activities of management

• dividend rates are determined by the board of directors based on the corporations profitability

• receive dividends after preferred stockholders

par value

a monetary amount assigned to each class of stock for accounting purposes only

• has no relationship to market value

• accounting rule:

  • when stock is sold to owners, the stock amount is only recorded at par value — excess of the selling price of stock over the par value is recorded in the equity account called paid-in capital

stock income statement impact

NONE, transactions involving our own stock never affect the income statement

stock balance sheet impact

increase assets (by cash received) and increase equity (common stock & paid-in capital)

stock cash flow impact

proceeds from issuance are a financing inflow

3 types of shares in each class of stock

1. authorized shares

2. issued shares

3. outstanding shares

authrorized shares

the total number of shares of stock that the company is allowed to set to the public

issues shares

the total number of shares that have been sold to the public

outstanding shares

the total number of shares that are actually in the hands of stockholders

treasury stock

a corporations own stock that had been issued but was subsequently re-acquired

why we re-acquire stock

• to reduce the shares outstanding and thus increase the market value per share

• to remove shares from the market to avoid a hostile takeover

• to use in employee stock option programs

• to give cash back to existing shareholders

characteristics of treasury stock

• when reacquired, recorded in treasury stock account

• results in a decrease to stockholders’ equity on the balance sheet

• classified as a contra-equity account, normal balance is a debit

• considered issued stock but not outstanding stock

  • no voting rights & cannot receive dividends

• recorded at its reacquisition cost, not at par value

dividends

distributions to the owners of a corporation

cash dividends

cash distributions of earnings to stockholders

characteristics of cash dividends

• dividends must be declared by the board of directors before they can be paid

• the corporation is not legally required to declare dividends

• dividends are not an expense and thus do not impact net income, rather dividends are paid out of net income

• classified as a contra-equity, normal balance is a debit

• once a dividend is declared, a liability is created

preferred stock dividend equation

par value per share x %

total preferred stock dividend

par value per share x % x outstanding shares

3 important dates relating to dividends

1. date of declaration

2. date of record

3. date of payment

date of declaration

the date the corporations board of directors formally decides to pay a dividend to stockholders

• RE is reduced & liability is established

• income and cash flow statement not affected

• balance sheet: liabilities increased, equity decreases

date of record

the date which stockholders must own stock in order to receive the declared dividend

• financial statements and company’s accounting records (journal & ledger), no impact on date of record

date of payment

the date on which a corporation pays dividends to its stockholders

• income statement not affected

• statement of cash flows will show financing outflow

• balance sheet: assets decreased, liabilities decreased

cumulative preferred stock

preferred stockholders must be paid both current and prior years unpaid dividends before common stockholders receive any dividends

dividends in arrears

prior years unpaid preferred stock dividends

• does not represent actual liabilities, thus not recorded in the accounts, but must be disclosed in the financial accounts

financial statements relating to stockholders’ equity

1. return on equity (ROE)

2. earnings per share (EPS)

3. price earnings ratio (P/E ratio)

return on equity (ROE)

measures the amount of profit earned per dollar of invested capital

• higher is better

ROE equation

net income / average equity = ROE

(equity 1/1 + equity 12/31) / 2 = average equity

earnings per share (EPS)

measures the amount of net income associated with each share of common stock

• higher is better

EPS equation

(net income - preferred stock dividends) / common shares outstanding

price earnings ratio (P/E ratio)

measures investors’ expectations regarding the growth potential and earnings stability of a company

• higher is better, as high P/E ratios are associated with firms for which strong growth is predicted in the future

P/E ratio equation

market price per share of stock / earnings per share