Equity Financing No responsibility to pay Investors take risk Investors rewarded by company s future success Equity Financing Debt Financing Relationships end with payments Loans repay with interest Liable for amount of loan Two Categories of Equity purchase of stock o Capital stock dividends Two Types of Capital Stock 1 Preferred Stock Contributed capital the amount that owners have contributed through the Retained Earnings the net income earned by the company not paid out as o Has dividend preference means if a dividend is paid the preferred stockholders must be paid in full before common stockholders can receive a dividend o The preferred stock dividend is set at a fixed percentage o Preferred stockholders typically do not have voting rights 2 Common Stock o Common Stockholders have voting privileges Election of board of directors Vote on significant activities of management o Dividend rates are determined by the board of directors based on the corporation s profitability o Receive dividends after preferred stockholders Both stocks are accounted for in the same way Par value a monetary amount assigned to each class of stock for accounting purposes only o Has no relationship to market value o Accounting rules When stock is sold to owners stockholders the stock account is only recorded at par value The excess of the selling price of the stock over the par value is recorded on equity account called paid in capital Example 1 o NO effect on net income Each class of stock has 3 types of shares 1 Authorized shares the total number of shares of stock that the company is allowed to sell to the public 2 Issued shares the total number of shares that have been sold in public 3 Outstanding shares the total number of shares actually in the hands owned of stockholders Difference between issued and outstanding shares The difference represents shares that were once sold but we re bought back by the company treasury stock Treasury stock is a corporation s own stock that had been issued but was subsequently reacquired Why reacquire shares o To reduce shares and increase the market value per share o Market price is low o Avoid hostile takeover o Use in employee stock option programs o Give cash back to shareholders o Increase earnings per share Treasury stock o Results in a decrease to total stockholder s equity on the balance sheet o Classified as a contra equity account o Normal balance is a debt o No voting rights o Can t receive dividends o Is recorded at its reacquisition cost not at par value o No gains or losses are ever recorded Example 2 What happens if shares are re issued o Depends on the relationship between the re issue price and the reacquisition cost o Re issuance of treasury stock reissue price reacquisition price o Record the excess in the equity account paid in capital treasury o When treasury stock is re issued always remove the treasury stock from the balance sheet at its reacquisition cost Example 2 Re issuance of treasury stock re issue price reacquisition cost Reduce paid in capital treasury by debiting the account for the difference However the account cannot be debited for more than its balance If a deficit still exists after debiting the paid in capital a treasury account reduce retained earnings for the remaining deficit Retained earnings the net income earned by the company not paid out as dividends Dividends distribution to owners of corporation Cash dividends cash distribution of earnings to stockholders Characteristics of Cash Dividend 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 classified as an expense and thus do not impact net income rather dividends are paid out of net income Dividends are classified as a contra equity account because they reduce equity dividend stockholders Example 3 Preferred stock Cash dividends require sufficient cash and retained earnings to cover the dividends Normal balance of dividends account is a debit Once a dividend is declared a liability is declared Dividend paid to preferred stockholders is set at a fixed percentage Preferred stock dividend Total preferred stock dividend par value per share percent per share dividend par value per share percent number of shares outstanding 3 important dates relating to dividends 1 Date of declaration date board of directors formally decides to pay a 2 Date of record the date which a stockholder must own the stock in order to receive the declared dividend 3 Date of payment date on which a corporation pays dividends to its o Dividends are only paid on outstanding shares o No dividends are played on treasury stock o Most is cumulative preferred stockholders must be paid both current and prior years unpaid dividends before common stockholders can receive any dividends Dividends in arrears o Not a liability o Not in financial statements but the notes with financial statements prior years unpaid preferred stock dividends Example 4 Example 5 1 Return on equity measures amount of profit earned per dollar of invested Financial statement ratios relating to equity capital o Net income average equity o The fundamental measure of overall company performance o Higher is better 2 Earnings per share measures net income associated with each share of common stock o Net income preferred stock dividends of common shares outstanding o Higher the better o Tells investor how much of the company s net income belongs to an investor 3 Profit equity ratio measures investor s expectations regarding potential growth and earning stability for a company o Market price per share earnings per share o Higher is better o Allows for meaningful comparisons of earnings across firm