Financing Decisions (Introduction and Equity Decisions)1

Chapter 2

Financing Decisions (Introduction and Equity Decisions)

Notes to Instructor

In the first part of the chapter, we introduce the topics of financing decisions (debt and equity), and optimal capital structure (the optimal mix of debt and equity). Then, we discuss activities related to equity securities (Chapter 3 deals with debt-related activities). We also discuss hybrid securities (those with both equity and debt characteristics).

You should start with the basic accounting equation, A = L + OE, and note that all assets are financed either by owners (Chapter 2) or creditors (Chapter 3). In Chapter 2, we discuss how corporations raise cash (and sometimes other assets) in exchange for equity instruments. We also discuss dividends, the major cost associated with equity financing. After completing this chapter, students should understand the basic vocabulary associated with and the effects of equity transactions.

When discussing dividends, it is useful to note that:

  • Certain dividends require the eventual distribution of corporate assets (e.g., cash and property); but a stock dividend does not require the distribution of assets but rather the issuance of capital stock.
  • Certain dividends result in a charge to retained earnings because they are deemed to be asset distributions financed by net income (e.g., cash and property); but a liquidating dividend is charged to paid-in capital because it is deemed to be an asset distribution financed by owner contributions.

Eli Lilly Financial Statements. Beginning with this chapter, each chapter and module throughout the text contains an end-of-chapter problem asking the students to access the Eli Lilly 2001 financial statements and use them in answering the problem. The Lilly financial statements are available at our Web site ( Please advise your students to visit the Web site and download and print the financial statements so that students will have a copy for reference throughout this course. We strongly urge you to assign the Lilly problem at the end of every chapter/module. By completing these problems, over the course of the semester students will become very familiar with the GAAP-based financial statements of a major company.

PowerPoint slides are provided on disk to adopting instructors and are available at the text Web site ( for both instructors and students from adopting schools.

Check Figures. The following check figures are provided for computational problems.

1. (1) Common stock: par value of shares issued = $65,000; (2) preferred stock: paid-in capital in excess of par = $27,000; 2. Advertising expense = $80,000; 3. Market value of land = $189,000; 4. Dividends in arrears = $225,000; 5. No financial statement effect; 6. Revenue from donations = $375,000; 7. Dividend = $80,000; 8. Retained earnings decreases $1,200,000; 9. Retained earnings decreases $65,800; 10. (a) Retained earnings decreases $45,000 (b) Retained earnings decreases $90,000 (c) No effect on balance sheet; 11. Retained earnings decreases $1,500,000; 13. (a) Retained earnings decreases $36,000 (b) Equity per share = $18.04; 15. Ending retained earnings = $567,750; 16. Retained earnings decreases $6,000,000; 17. (c) at December 31, 2001, Lilly had 1,123,348,749 shares outstanding.

Chapter OutlineChapter 2: Financing Decisions (Introduction and Equity Decisions)

A.Financing Decisions—Introduction

1.Contractual Characteristics that Distinguish Debt from Equity

a.Claims of Debt Holders in a Corporate Dissolution

b.Voting Privileges

c.Claims to Future Cash Flows

d.The Final, Liquidating Payment

2.Hybrid Securities

a.Typical Preferred Stock

b.Convertible Preferred Stock

c.Convertible Debt

d.Bonds Issued with Detachable Warrants

3.Theoretical and Practical Determinants of Capital Structure

a.Tax Savings of Debt

b.Costs of Financial Distress

c.Agency Costs

d.Superior Management Information

e.Underwriting Costs

f.Perceived Importance of Control

B.Financing Decisions—Equity Issues

1.Cash-Based Equity Transactions

2.Noncash Contributions by Investors

a.Investor Provides Property

b.Investor Provides Services

3.Corporate Issuance of Preferred Stock

4.Corporate Issuance of Stock Options

5.Corporate Issuance of Rights

6.Corporate Issuance of Nothing in Exchange for Assets (Donations)

C.Dividends

1.Cash Dividends

2.Property Dividends

3.Stock Dividends and Stock Splits

a.Small Stock Dividends

b.Midrange Stock Dividends

c.Large Stock Dividends and Stock Splits

d.General Rules to Follow

D.The External Decision Makers’ Perspective

1.Danger! Earnings and Book Value Management

2.Southwest Airlines Equity Financing Decisions

F.Chapter Summary

G.EOC—Key Terms and Assignments (Questions, Short Problems, Analytical and Comprehensive Problems, CFA Exam and Other Multiple-Choice Problems)

Chapter 2: Learning Objectives Matched with End-of-Chapter Assignments
Learning Objectives (LO)
1.Identify characteristics that distinguish debt from equity.
2.Describe the characteristics of hybrid securities.
3.Describe the determinants of capital structure.
4.Account for the various forms of equity issues.
5.Account for the various forms of dividend distributions.
6.Explain how external decision makers view owners’ equity.
LO /
Questions / Short
Problems / Analytical and
Comprehensive Problems / CFA Exam and Other
Multiple-Choice Problems
1 / Q1
2 / Q2, 16 / 21
3 / Q3, 4, 8, 15 / 17 / 21, 22
4 / Q5–13, 17, 18 / 1–3, 5–9 / 12, 15, 17
5 / Q19–26 / 4, 7–10, 11 / 13, 15–17 / 18–20, 23
6 / 14 / 24
Note: A particular problem can relate to more than one learning objective.