E11.13Shareholders’ Equity Transactions.

Transaction / Effect on Total Shareholders’ Equity / Accounts Affected / Impact
1. / 1. / Increase / 1. / Retained earnings / Increase
2. / 2. / Increase / 2. / Common stock, at par / Increase
3. / 3. / Decrease / 3. / Additional paid-in-capital
Retained earnings / Increase
Decrease
4. / 4. / No effect / 4. / Retained earnings
Common stock at par
Additional paid-in-capital / Decrease
Increase
Increase
5. / 5. / Decrease / 5. / Treasury stock / Increase
6. / 6. / No effect / 6. / No accounts affected / N/A

Each of these three equity transactions is likely to be associated with a share price value increase, although for different reasons. A repurchase of shares reduces the number of shares outstanding, and consequently, should lead to a share price increase. A stock dividend and forward stock split, however, increase the number of shares outstanding, and consequently, should be associated with a proportionate share price decline. Available research, however, indicates that the capital market views free-share distributions as signals from company management indicating that the future operating performance of the company is likely to be better than anticipated; and as a consequence, the share price tends to drift upward following the announcement of these two equity-related events.

E11.15Accounting for Shareholders’ Equity Transactions.

Transaction / Common Stock
at $1 Par / Additional
Paid-in-Capital / Preferred
Stock, No-Par / Retained
Deficit / Treasury
Stock
Beg. Balance / $100,000 / $1,200,000 / $800,000 / $(600,000) / $(250,000)
1. / +80,000
2. / -220,000
3. / +10,000 / +90,000 / -100,000
4. / -- / -- / -- / -- / --
5. / +15,000 / +285,000 / -300,000
$125,000 / $1,575,000 / $500,000 / $(840,000) / $(250,000)

The capital market response to a preferred stock conversion into common stock can be both positive and negative. On the one hand, converting the preferred shares into common will free up cash flow to be used to support operations or to increase the common stock dividend—preferred stock usually pays a higher dividend than common stock. On the other hand, adding additional common shares to the number of shares outstanding may drive the share price down—that is, the event may be price dilutive! Another concern is that the cost of equity on common shares is usually higher than the cost of capital associated with preferred shares. In short, it is unclear how the market will weigh each of these factors and impound them into the new common share price

E11.21Contrasting the Contributed Capital of a Firm with Treasury Stock. The ratio of treasury stock (TS) divided by contributed capital indicates the portion of a firm’s contributed capital (CC) that is outstanding:

Cisco Systems / Intel / Microsoft
(TS ÷ CC) / 1.00 / 1.38 / 0.13

Each of the above three companies have active stock repurchase plans, in part to offset the dilutive effect of the many employee stock options. A ratio 1.0 or greater (e.g., Cisco and Intel) indicates that the firm has repurchased treasury shares at least equivalent to the value of the firm’s contributed capital. In the case of Intel, it has repurchased shares valued at 138 percent of its contributed capital. Thus, for Intel, while there are shares outstanding, the book value of those shares in terms of the contributed capital is effectively negative (i.e., the value of treasury shares exceeds the value of contributed capital).

P11.26Accounting for Share Transactions.

1.

Shares outstanding (beginning) / 6,100,000
Effect of 2-for-1 stock split / +6,100,000
Total before 10% dividend / 12,200,000
+ new dividend shares / 1,220,000
Total before repurchase / 13,420,000
-treasury shares / (200,000)
Shares outstanding / 13,220,000

2.Par value = $.005

3.

4.Shareholders’ equity (in thousands):

Original Total: / $130,046
Stock split / -0-
Stock dividend / -0-
Treasury stock / (3,000)
New Total / $127,046

5. Each of these three events is likely to be associated with a share price increase, although for different reasons. Since a treasury stock purchase reduces the number of shares outstanding, the value of the remaining outstanding shares should increase. In the case of the stock dividend and forward stock split, although the number of outstanding shares increase and the share price should fall proportionately, the share price often drifts upward following the announcement of these free share distributions because they are often a precursor to improved future corporate performance. In short, the free share distributions are often a signal to the capital market about future good news regarding the company.