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Equity Accounts

The authorized share capital of the Alfred Cake Company is 100,000 shares. The equity is currently shown in the company`s books as follows:

Common stock ($1.00 par value) $ 60,000

Additional paid-in capital 10,000

Retained earnings 30,000

Common equity 100,000

Treasury stock (2,000 shares) 5,000

Net common equity 95,000

a. How many shares are issued?

b. How many are outstanding?

c. How many more shares can be issued without the approval of shareholders?

2. Equity Accounts.

a. Look back at problem 1. Suppose that the company issues 10,000 shares at $5 a share. Which of the above figures would change?

b. What would happen to the company`s books if instead it bought back 1,000 shares at $5 per share?

3. Financing Terms. Fill in the blanks by choosing the appropriate term from the following list: lease, funded, floating-rate, eurobond, convertible, subordinated, call, sinking fund, prime rate, private placement, public issue, senior, unfunded, eurodollar rate, warrant,

debentures, term loan.

a. Debt maturing in more than 1 year is often called _________ debt.

b. An issue of bonds that is sold simultaneously in several countries is traditionally called a(n) _________.

c. If a lender ranks behind the firm`s general creditors in the event of default, the loan is said to be _________.

d. In many cases a firm is obliged to make regular contributions to a(n) _________, which is then used to repurchase bonds.

e. Most bonds give the firm the right to repurchase or _________ the bonds at specified prices.

f. The benchmark interest rate that banks charge to their customers with good to excellent credit is generally termed the _________.

g. The interest rate on bank loans is often tied to short-term interest rates. These loans are usually called _________ loans.

h. Where there is a(n) _________, securities are sold directly to a small group of institutional investors. These securities cannot be resold to individual investors. In the case of a(n) _________, debt can be freely bought and sold by individual investors.

i. A long-term rental agreement is called a(n) _________.

j. A(n) _________ bond can be exchanged for shares of the issuing corporation.

k. A(n) _________ gives its owner the right to buy shares in the issuing company at a predetermined price.

4. Financing Trends. True or false? Explain.

a. In several recent years, nonfinancial corporations in the United States have repurchased more stock than they have issued.

b. A corporation pays tax on only 30 percent of the common or preferred dividends it receives from other corporations.

c. Because of the tax advantage, a large fraction of preferred shares is held by corporations.

5. Preferred Stock. In what ways is preferred stock like long-term debt? In what ways is it like common stock?

6. Voting for Directors. If there are 10 directors to be elected and a shareholder owns 90 shares, indicate the maximum number of votes that he or she can cast for a favorite candidate under

a. majority voting

b. cumulative voting

7. Voting for Directors. The shareholders of the Pickwick Paper Company need to elect five directors. There are 400,000 shares outstanding. How many shares do you need to own to ensure that you can elect at least one director if the company has

a. majority voting

b. cumulative voting

Hint: How many votes in total will be cast? How many votes are required to ensure that at least one-fifth of votes are cast for your choice?

8. Equity Accounts. Look back at Table 5.8.

a. Suppose that Heinz issues 10 million shares at $55 a share. Rework Table 5.8 to show the company`s equity after the issue.

b. Suppose that Heinz subsequently repurchased 500,000 shares at $60 a share. Rework part (a) to show the effect of the further change.

9. Equity Accounts. Common Products has just made its first issue of stock. It raised $2 million by selling 200,000 shares of stock to the public. These are the only shares outstanding. The par value of each share was $1.50. Fill in the following table:

Common shares (par value) ________

Additional paid-in capital ________

Retained earnings ________

Net common equity $2,500,000

10. Protective Covenants. Why might a bond agreement limit the amount of assets that the firm can lease?

11. Bond Yields. Other things equal, will the following provisions increase or decrease the yield to maturity at which a firm can issue a bond?

a. A call provision

b. A restriction on further borrowing

c. A provision of specific collateral for the bond

d. An option to convert the bonds into shares

12. Income Bonds. Income bonds are unusual. Interest payments on such bonds may be skipped or deferred if the firm`s income is insufficient to make the payment. In what way are these bonds like preferred stock? Why might a firm choose to issue an income bond instead of preferred stock?

13. Preferred Stock. Preferred stock of financially strong firms sometimes sells at lower yields than the bonds of those firms. For weaker firms, the preferred stock has a higher yield. What might explain this pattern?

1 Par value of common shares must be $1 ГЧ 100,000 shares = $100,000. Additional paid-in capital is ($15 Ј $1) ГЧ 100,000 = $1,400,000. Since book value is $4,500,000, retained earnings must be $3,000,000. Therefore, the accounts look like this:

2 Book value is $10 million. At a discount rate of 10 percent, the market value of the firm ought to be $2 million ГЧ 20-year annuity factor at 10% = $17 million, which exceeds book value. At a discount rate of 20 percent, market value falls to $9.7 million, which is below

book value.

3 The corporation`s after-tax yield on the bonds is 10% Ј (.35 ГЧ 10%) = 6.5%. The after-tax yield on the preferred is 8% Ј [.35 ГЧ (.30 ГЧ 8%)] = 7.16%. The preferred stock provides the higher after-tax rate despite its lower before-tax rate. For the individual, the tax rate on both the preferred and the bond is equal to 35 percent, so the investment with the higher beforetax rate also provides the higher after-tax rate.

4 Because the coupon on floating-rate debt adjusts periodically to current market conditions, the bondholder is less vulnerable to changes in market yields. The coupon rate paid by the bond is not locked in for as long a period of time. Therefore, prices of floaters should be less sensitive to changes in market interest rates.

5 The callable bond will sell at a lower price. Investors will not pay as much for the callable bond since they know that the firm may call it away from them if interest rates fall. Thus they know that their capital gains potential is limited, which makes the bond less valuable. If both bonds are to sell at par value, the callable bond must pay a higher coupon rate as compensation to the investor for the firm`s right to call the bond.

6 The extra debt makes it more likely that the firm will not be able to make good on its promised payments to its creditors. If the new debt is not junior to the already-issued debt, then the original bondholders suffer a loss when their bonds become more susceptible to default risk. A protective covenant limiting the amount of new debt that the firm can issue would have prevented this problem. Investors, having witnessed the problems of the RJR bondholders, generally demanded the covenant on future debt issues.

7 Capital markets provide liquidity for investors. Because individual stockholders can always lay their hands on cash by selling shares, they are prepared to invest in companies that retain earnings rather than pay them out as dividends. Well-functioning capital markets allow the firm to serve all its stockholders simply by maximizing value. Capital markets also provide managers with information. Without this information, it would be very difficult to determine opportunity costs of capital or to assess financial performance.