MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell
Chapter 5 FINANCIAL DECISIONS: Reducing Outstanding Equity and Debt
FINANCING DECISIONS (Reducing Outstanding Equity and Debt) • Topics • Identify conditions leading to reduction of equity financing • Identify methods of equity reduction • Review of Statement of Owners’ Equity • Identify conditions leading to reduction of debt financing • Identify methods of debt reduction
Reasons for Reducing Equity Financing • Available free cash flow is used to pay dividends • Corporation desires to shift the mix of debt and equity financing • Stock buy-backs can be used as a signal of higher future earnings expectations • Repuchase to support stock price
Methods of Equity Reduction • Liquidating dividends • Retire common stock • Purchase treasury stock
Liquidating Dividends • Normally, regular dividends are limited to the amount of free and unappropriated retained earnings. • Regular dividends are considered a return on capital. • “Dividend distributions” that are greater than the free and unappropriated retained earnings are designated as a liquidating dividends. • Liquidating dividends are considered a return of capital. • What is the debit after retained earnings hits zero?
Retire Common Stock • When common stock shares are acquired and retired … • The par value and original premium over par value are written off. • Any “economic gain/loss” is credited/charged directly to the premium account, if any, in the stockholders’ equity section. • The shares revert to the status of unissued.
The following two slides indicate the “before & after” balance sheet of Beneish Co. that acquired and retired (cancelled) 10,000 shares of its common stock (for $56 per share.)
SUPP0RTING COMPUTATIONS: Beneish realizes $40,000 “economic gain” on combination of two transactions, issuing stock and retiring stock: • Originally received 10,000 shares × $60 (average price) = $600,000 • Repurchase price was $560,000 • Economic gain = $40,000
Common stock decreases $100,000: 10,000 shares × $10 par • Additional [original] paid in capital in excess of par decreases by $500,000: 10,000 shares × $50 premium in original issuance • Additional paid-in capital from retirement of stock increases by the $40,000 “economic gain” If a net “economic loss” had resulted, the loss would be charged either to additional paid-in capital, if any, or to retained earnings, likely dependent on state law.
Purchase of Treasury Stock • Treasury Stock: A corporation’s own stock which has been reacquired, but not retired, with the intent of holding it temporarily and reissuing it later. • Two methods of accounting for treasury stock: cost method (predominant) and par method(not illustrated here) Treasury stock is contra-equity and is reported as such in the balance sheet. (Not an asset!)
The following two slides indicate the “before & after” balance sheet of Shane Co. that acquired 50,000 shares of treasury stock for $40 per share (presumably in the open market).
REISSUE SHARES: Assume Shane reissued 20,000 of the 50,000 treasury shares (which were acquired at $40 per share) at $42 per share.
Results: • Shane realizes a $40,000 “economic gain:” 20,000 shares × ($42 reissue price - $40 repurchase price). • The “economic gain” increases additional paid-in capital because no “outsiders” were involved. • Both cash and stockholders’ equity increase by $840,000 (20,000 shares × $42).
Statement of Owners’ Equity The Statement of Owners’ Equity reconciles the beginning balances to the ending balances of each component of stockholders’ equity.It is an analysis(not a schedule). A template for the a corporate statement is as follows:
Items appearing in the Statement of Stockholders’ Equity covered in Chapters 2-5 include: • Net income • Issue common stock • Dividends (cash, property, stock, liquidating) • Stock splits • Treasury stock transactions • Retirement of common stock
Reasons for Reducing Debt Financing • Market conditions favor “refunding existing debt” • If interest rates fall substantially, firms are able to issue debt at current market rates and repurchase and retire high interest rate debt issued previously. • Strategic planning results in reallocating debt and equity financing (e.g., to reach a target ratio of debt to equity).
Methods of Debt Reduction • Normal payments • Early extinguishment of debt • Call or open market purchase • Conversion into common stock • Troubled debt • Settlements • Modifications of terms
Early Extinguishment of Debt • FASB Statement #145 (2002) • Previously all early extinguishment were accounted for as extraordinary items • Most early debt extinguishments result from risk-management decisions • Don’t meet the “unusual and infrequent” test • Pre-2002 extinguishments will continue to be shown as extraordinary in comparative financial statements
Troubled Debt: Settlement • Assume here that settlement only occurs if debtor has an economic gain and creditor an economic loss (the typical scenario). • Usually, debt is settled by either transferring assets to the lender and/or issuing stock to the lender. • If assets are to be transferred • they must first be written up/down to FMV, resulting in an ordinary gain/loss on revaluation • excess of the carrying value of the debt over FMV of assets given or stock issued is an ordinary gain on debt settlement
Troubled Debt: Settlement Example Mufasa Co. owed First National Bank a $5,000,000 note payable plus accrued interest of $90,000. In complete settlement of the debt, Mufasa ... • transferred to First National Bank land with a book value of $750,000 (FMV = $1,200,000), and • issued to First National Bank 700,000 shares of $1 par common (FMV = $5 per share).
SOLUTION • Mufasa would write up the land by $450,000 (up to FMV) and recognize a gain on revaluation. • Mufasa would record a $390,000 gain on the debt settlement Debt owed $5,090,000 FMV of land 1,200,000 FMV of stock 3,500,0004,700,000 390,000
Troubled Debt: Modification of Terms • The accounting depends on comparison of the pre-modification debt carrying value and the total future cash flows under the modified debt agreement: • Pre-modification carrying value< total future cash flows • New effective interest rate is computed using new future cash flows • Debtor records no gain (because the net interest rate still calculates as positive)
Pre-modification carrying value > total future cash flows • Debtor records gainon restructuring equal to the excess of pre-modification carrying value over total future cash flows • New effective interest rate = 0 or calculates to a negative A “negative” rate calculation would simply mean that the principal amount is to be adjusted and a 0% rate used in the bookkeeping.
Troubled Debt: Modification of Terms Example, Situation 1 Situation 1: On January 1, 2004, the Mufasa Co. owed First National $5,000,000 plus accrued interest of $90,000 on a 7.2%, $5,000,000 note payable due December 31, 2008. First National agrees to restructure the note as follows: Principal reduced to $4,500,000 due December 31, 2008; accrued interest of $90,000 waived; stated interest rate reduced to 6% to be paid annually on December 31 of each year.
Pre-modificationcarrying value = $5,090,000 (total payoff needed) Total of future cash payments as modified = $5,850,000 ($4,500,000 + 5 interest payments of $270,000) The “real” interest rate remains positive (although interest cost is reduced); thus, no gain recognition.
RESULT: Mufasa records no gain because future cash flows $5,850,000 > pre-modification carrying value $5,090,000 New effective interest rate of 3.13% must be computed: • n = 5 • present value = $5,090,000 • future value = $4,500,000 • interest payment (ordinary annuity) = $270,000 • i = ? = 3.13%
Troubled Debt: Modification of Terms Example, Situation 2 Situation 2. On January 1, 2004, the Mufasa Co. owed First National $5,000,000 plus accrued interest of $90,000 on a 7.2%, $5,000,000 note payable due December 31, 2008. First National agrees to restructure the note as follows: principal reduced to $4,000,000 due December 31, 2008; accrued interest of $90,000 waived; stated interest rate reduced to 4% to be paid annually on December 31 of each year.
Pre-modificationcarrying value = $5,090,000 (total payoff needed) Total of future cash payments as modified = $4,800,000 ($4,000,000 + 5 interest payments of $160,000) The “real” interest rate is negative (principal reduced so much that interest rate is below zero); thus, a gain on restructuring is recognized.
Result: Mufasa records an extraordinary gain because $4,800,000 < $5,090,000 Gain = $5,090,000 – $4,800,000 = $290,000 The note’s carrying value is reduced from $5,090,000 to $4,800,000 and all future payments are principal New effective interest rate = 0% n = 5 present value = $4,800,000 (after modification) future value = $4,000,000 interest payment (ordinary annuity) = $160,000 i = ? = 0%