a. An accounting measure? Owners’ equity represents the amount of a company’s assets not offset by liabilities, hence owned by the firm’s investors. Mathematically, owners’ equity equals assets minus liabilities.
b. A legal concept? Owners’ equity represents the legal ownership of the business, the investment of those with the authority to hire (or be) the firm’s management and set company policy.
c. An investment concept? Owners’ equity identifies that some people have contributed money to the firm and represents one measure of the value of the money they have invested.
d. A value claim concept? Owners’ equity indicates that there is a person or group of people who have the last claim to the income produced by the company and to any residual value should the firm dissolve.
e. A risk concept? Owners’ equity represents a class of contributors to the company who bear a relatively high amount of risk in return for potentially high returns.
a. Authorized shares – the total number of shares a company can issue as approved by the government.
b. Issued shares – the total number of shares sold to investors at any time in the past.
c. Outstanding shares – the number of shares currently in the hands of investors.
d. Treasury shares – the number of issued shares not currently in the hands of investors having been repurchased by the company and “held in the company’s treasury.”
a. Par value – the maximum capital contribution required from investors for each share.
b. Book value – the accounting value for each share; total owners’ equity divided by the number of shares outstanding.
c. Market value – the price of each share in the financial marketplace reflecting investors forecasts of future cash flows the company will produce.
d. Liquidation value – the value investors would receive for each share if the company were dissolved and its assets sold.
Everyone will rank the six benefits in their own order of preference, although most people will put income near the top of the list. In the order presented in this chapter, the six benefits are:
(1) Income – the right to a proportional share of the company’s income, either paid out as a dividend or retained and reinvested in the business.
(2) Control – the right to vote on company affairs, in particular the election of directors, the selection of external auditors, and proposed amendments to the company’s charter or by-laws.
(3) Information – the right to “inspect the company’s books,” usually satisfied by providing stockholders with summary financial statements and commentary in the company’s annual and quarterly reports.
(4) Freedom to sell – the ability to sell ownership in the company to anyone else at any time without the need for approval.
(5) Limited liability – freedom from legal responsibility for company errors beyond the amount of the money invested in the company.
(6) Residual claim – the right to a proportional share of any value remaining after all other claimants have been satisfied, particularly in bankruptcy.
What is the difference between primary and fully diluted earnings per share?
Primary earnings per share (EPS) is calculated by dividing a corporation’s reported net income by the average number of shares outstanding during the year. It is a measure of a company’s per-share performance as it actually happened. Fully diluted earnings per share measures what would have happened to EPS if all options on the company’s stock had been exercised at the beginning of the year, increasing the average number of outstanding shares and possibly changing net income. For example, if a company’s outstanding convertible bonds had been exchanged for common stock, interest expense would have been reduced and the number of outstanding shares would have increased. Both measures must be reported with a company’s income statements under GAAP accounting rules.
In what way does a proxy give significant power to a corporation’s management?
A proxy is a combination absentee ballot and assignment of vote. Proxies are solicited by management prior to a corporation’s annual meeting. One reason is to ensure that a majority of shares are represented at the annual meeting, either in person or by proxy, thus constituting a quorum and permitting the meeting to take place. However, in a widely-held company, it is normal for only a small percentage of stockholders to attend the annual meeting; the vast majority of shares are represented by proxies. This gives power to management in two ways.
First, the proxy form is usually printed to favor management. For yes-no-abstain votes, the proxy typically identifies management’s preferred outcomes, often in large bold type.
For the election of directors, the typical proxy only gives shareholders two choices:
(1) vote for all of management’s preferred candidates, or
(2) vote for all of management’s preferred candidates except those whose names the shareholder writes into a small space on the proxy. With these limited, awkward alternatives, it is difficult for management’s candidates to lose.
Second, collecting proxies permits management to cast a majority of the votes on any issue not listed on the proxy that comes before the meeting. Management has total control of these issues and while dissenting shareholders may speak out, they cannot change management’s position.
Is there any advantage to having preemptive rights as a stockholder? Is there any disadvantage?
There are two advantages to a corporation’s stockholders of having preemptive rights. The primary advantage is the ability to maintain a proportional ownership of the corporation should it issue additional shares of common stock in order to maintain control. In addition, it is less costly to issue new shares to existing shareholders than to new shareholders since the services of an investment banker are not required. This lowers the company’s cost of equity, and hence its cost of capital, increasing the firm’s value. Management can keep this extra value within the company or can distribute it to shareholders in the form of a discounted price on the newly issued shares (in which case the rights may be used or sold to other investors for their cash value). There is no particular disadvantage to preemptive rights other than that a stockholder who elects to use them to purchase additional shares must come up with the necessary amount of cash.
If a stockholder could literally inspect the company’s books, a company’s competitors could buy a few shares and use their new relationship as a stockholder to obtain confidential competitive information. Also, a constant stream of stockholders passing through a company’s offices and going through its records could create quite a disruption to its business. Instead, stockholders are entitled to regular financial reports according to standard accounting formats, an obligation discharged through the formal annual report and 10K form (the non-glossy annual report required to be filed with the Securities and Exchange Commission).
When would a stockholder be willing to purchase a class of common stock that did not have full shareholders’ rights?
Not all shareholders’ rights are of equal value to all shareholders. Some shareholders value one or more of the rights of ownership so highly that they are willing to give up other shareholder rights to secure the ones they value most.
- For example, when venture capitalists invest in a startup business, the company’s managers often get stock with control but limited income (“founder’s shares”) while the venture capitalists get shares with income but limited control.
Also, some shareholders are prohibited by law or regulation from owning one or more of the traditional shareholder rights.
- For example, a charity or foundation which owns a substantial amount of the stock of any one company will attract the scrutiny of the IRS which will wonder whether it was set up to evade taxes while maintaining control of the company.
Such a charity or foundation might prefer stock with all the income and residual value rights but with limited or no voting power to avoid threatening its tax-exempt status.
Why is preferred stock often called a hybrid between bonds and common stock?
Preferred stock is often considered a hybrid between bonds and common stock because it contains a mixture of many of the characteristics of each. Among the examples given in the chapter:
(1) Like a bond: preferred stock has a face or maturity or par value, it pays its holder a fixed amount each year, it normally has no voting privileges, it has priority above common stock in liquidation, it may contain a call feature or be convertible to common stock, the issue may require a sinking fund for its retirement, and it may contain indenture provisions.
(2) Like common stock: preferred stock normally does not have a fixed maturity, it pays a dividend, it may contain voting power, it has priority after all debt in liquidation, and dividends may adjust with the company’s income.