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Financial Statement Analysis & Valuation Third Edition. Peter D. Mary Lea Gregory A. Xiao-Jun Easton McAnally Sommers Zhang. Module 8: Equity Recognition and Owner Financing. Stockholders’ Equity. Total stockholders’ equity is divided into two components:
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Financial Statement Analysis & Valuation Third Edition Peter D. Mary Lea Gregory A. Xiao-Jun Easton McAnally Sommers Zhang
Stockholders’ Equity Total stockholders’ equity is divided into two components: Contributed capital - proceeds received by the issuing company from original stock issuances, net of the amounts paid to repurchase shares of the issuer’s stock from its investors. Earned capital - Retained earnings and accumulated other comprehensive income (AOCI). In addition, many companies report an equity account called noncontrolling interest, which reflects the equity of minority shareholders.
Types of Stock There are two classes of stock: Preferred Stock Common Stock Preferred stock preferences: Dividend preference – preferred shareholders receive dividends on their shares before common shareholders do. Liquidation preference –preferred shareholders receive payment in full before common shareholders in liquidation.
Preferred Stock Privileges Conversion privileges – a conversion privilege allows preferred stockholders to convert their shares into common shares at a predetermined conversion ratio. Participation feature – allows preferred shareholders to share ratably with common stockholders in dividends.
Fortune Brands’ Convertible Preferred Stock Holders of convertible preferred are entitled to $2.67 dividends per share. Each share of convertible preferred stock is entitled to 3/10 of a vote per share. Holders of convertible preferred have a preference in liquidation over common shareholders amounting to $30.50. Each share of convertible preferred is convertible into 6.601 shares of common stock. Fortune Brands has an option to redeem each share at a price of $30.50; upon redemption, the preferred shareholder will receive that cash amount and will surrender that share to the company.
Aon’s Common Stock Par value of $1 per share. Aon has authorized the issuance of 750 million shares. To date, Aon’s management has issued (sold) 385.9 million shares of stock. Aon has repurchased 53.6 million shares from its shareholders. The number of outstanding shares is equal to the issued shares less treasury shares. There were 332.3 million (385.9 million – 53.6 million) shares outstanding at the end of 2010.
Sale of Stock Illustrated To illustrate, assume that AON issues 100,000 shares of its $1 par value common stock at a market price of $43 cash per share: • Cash increases by $4,300,000 (100,000 shares @ $43 per share) • Common stock increases by the par value of shares sold (100,000 shares @ $1 par value = $100,000) • Additional paid-in capital increases by the $4,200,000 difference between the issue proceeds and par value ($4,300,000 - $100,000)
Repurchase of Stock Illustrated To illustrate, assume that 3,000 common shares of AON previously issued for $43 are repurchased for $40:
Repurchase of Stock Illustrated Now assume that these 3,000 shares are subsequently resold for $42 cash per share:
Accounting for Dividends: Cash Dividends Aon declares and pays a cash dividend of $10 million:
Preferred and Common Dividends Assume that a company has 15,000 shares of $50 par value, 8% preferred stock outstanding and 50,000 shares of $5 par value common stock outstanding. During its first three years in business, the company declares $20,000 dividends in the first year, $260,000 of dividends in the second year, and $60,000 of dividends in the third year. If the preferred stock is cumulative, the total amount of dividends paid to each class of stock in each of the three years follows:
Small Stock Dividends Illustrated Assume that a company has 1 million shares of $5 par common stock outstanding. It then declares a small stock dividend of 15% of the outstanding shares when the market price of the stock is $30 per share. This small stock dividend has the following financial statement effects:
Large Stock Dividends Illustrated To illustrate the effect of a large stock dividend, assume that the company now declares a large stock dividend of 70% of the outstanding shares when the market price of the stock is $30 per share ($5 par value). The large stock dividend will have the following effects on the balance sheet:
Noncontrolling Interest Noncontrolling interest represents the equity of noncontrolling (minority) shareholders who only have a claim on the net assets of one or more of the subsidiaries in the consolidated entity. If the company acquires less than 100% of the subsidiary, it must include 100% of the subsidiary’s assets, liabilities, revenues and expenses in its consolidated balance sheet and income statement, but now there are two groups of shareholders that have a claim on the net assets and earnings of the subsidiary company: The parent company, and The noncontrolling shareholders (those shareholders who continue to own shares of the subsidiary company).
Analysis and Interpretation of Noncontrolling Interest The return on equity (ROE) computation is usually performed from the perspective of the parent company’s shareholders. Consequently, the numerator is usually the net income attributable to the parent company shareholders and the denominator includes only the equity of the parent company’s shareholders (excluding noncontrolling interest equity).
Equity Carve Outs Corporate divestitures have become increasingly common as companies seek to increase shareholder value through partial or total divestiture of operating units. In general, these equity carve outs are motivated by the notion that consolidated financial statements often obscure the performance of individual business units, thus complicating their evaluation by market analysts.
Equity Carve Outs: Conoco’s Sell-Off Conoco received $4.6 billion in cash, which it reported as a component of cash flows from investing activities in its statement of cash flows. The Syncrude joint venture was reported on Conoco’s balance sheet at $1.75 billion on the date of sale. Conoco’s gain on sale equaled the proceeds ($4.6 billion) less the carrying amount of the business sold ($1.75 billion), or $2.85 billion which Conoco rounds to $2.9 billion in the footnote referenced above. Conoco subtracts the gain on sale in computing net cash flows from operating activities to remove the gain from net income; cash proceeds are reported as a cash inflow in the investing section.
Equity Carve Outs: BMY’s Split-off of Mead Johnson • The Treasury Stock account on Bristol-Myers’ balance sheet increased (became more negative) by $6.9 billion (269 million shares x $25.70 per share), which reduced equity by $6.9 billion. • This reduction was offset, however, by the recognition of a gain on the exchange amounting to $7.2 billion after tax. • This split-off was affected by a tender offer with Bristol-Myers shareholders. Consequently, it is a non pro rata exchange and is, therefore, valued at market value with a resulting gain. • The net effect on equity is minimal, but the income statement reports a substantial gain for that year.
Global Accounting Under IFRS, accounting for equity is similar to that under U.S. GAAP. Following are a few terminology differences:
Global Accounting U.S. GAAP has a more narrow definition of liabilities than IFRS. Therefore, more items are classified as liabilities under IFRS. For example, some preferred shares are deemed liabilities under IFRS and equity under GAAP. Treasury stock transactions are sometimes difficult to identify under IFRS because companies are not required to report a separate line item for treasury shares on the balance sheet. Instead treasury share transactions reduce share capital and share premium.
