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Chapter 11.

Equity Financing and Shareholders Equity

Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses


Difficulty Rating for Exercises and Problems:

Easy: E11.13; E11.14


Medium: E11.15; E11.17; E11.19; E11.20
P11.24: P11.25; P11.26; P11.27; P11.32; P11.33
Difficult: E 11.16; E11.18; E11.21; E11.22; E11.23
P11.28; P11.29; P11.30; P11.31

QUESTIONS

Q11.1 Book Value versus Market Capitalization. Market capitalization refers to a


companys current fair value, calculated by multiplying its current share price
times the number of shares outstanding. A companys book value, on the other
hand, refers to the total assets of the firm less its total liabilities (i.e., the
balance sheet value of its shareholders equity).

Home Depots market capitalization of $105 billion reflects the capital markets
assessment of the firm based on what the market expects to transpire with
respect to the firms future operations; it is the markets assessment of the
firms current value as a function of its expectations about Home Depots future
operating performance. The companys book value is not a forward-looking
measure of value but rather is a reflection of a firms historical performance.
Thus, while market capitalization is based on expectations about the future,
book value is based on actual past events. Since Home Depots market
capitalization is almost six times its book value, the capital market appears to
believe that the companys future is brighter than its past.

Q11.2 Free Share Distributions. It is appropriate to label stock dividends and stock
splits as free share distributions for two reasons. First, in both a stock split
and a forward stock dividend, shareholders end up with a greater number of
shares which are distributed free of charge to shareholders (i.e., there is no
purchase price associated with the new shares). Second, the value of the newly
distributed shares is zero; that is, the total cost basis of a shareholders
investment in a company is unchanged by a stock dividend or stock split. The
cost basis of each individual share declines as a result of the greater number of
outstanding shares, as does the market value per share, but no wealth is
transferred from the company to its shareholders in either of these share
transactions.

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-1
Q11.3 Dividend-in-Arrears. Dividends-in-arrears are reported as a contingent liability
in the footnotes, rather than as a real liability on the balance sheet, because
there is no legal obligation to pay dividends-in-arrears. A liability is created only
after a companys board of directors reinstitutes a dividend. At that time, the
contingent liability to pay the previously missed preferred stock dividends
becomes a real liability and is then recorded on the balance sheet as a current
liability. Thus, all dividends-in-arrears must first be paid before any current
dividends may be distributed. In general, the presence of dividends-in-arrears is
a signal of past, and possibly current, financial distress.

Q11.4 Multiple Classes of Voting Rights. A two-class stock structure found in many
family-centered businesses allows the members of the founding family to sell
shares in the business while maintaining a disproportionate level of control over
the business. The two-class stock structure is, for example, typical of the
newspaper industry (e.g., The Washington Post, Dow Jones & Co., and Viacom
Inc., have multiple class structures). A representative of Morgan Stanley,
quoted in The Wall Street Journal article, explained why the firm opposed the
two-class structure:
Declassifying the share structure will foster a culture of
accountability that will ultimately benefit all shareholders, by
improving financial and operational performance and closing the
gap between the market price of the stock and its intrinsic value.
Thus, Morgan Stanleys motivation appears to be two-fold:
1. Increase the share value of the Class A shares.
2. Foster accountability and governance.
A useful discussion concerns why the elimination of the Times Class B shares
would cause the value of the Class A shares to increase.

Q11.5 Oversubscribed Initial Public Offering. Given the large oversubscription to its
IPO, Reliance Petroleum has a number of options:
1. Increase the number of shares offered for sale in the IPO, assuming
that there are additional authorized but unissued shares available.
2. Maintain the IPO offering at 1.8 million shares but raise the IPO share
price above the estimated range of 57 to 62 rupees to capture some of
the excess demand via a price increase.
3. Some combination of Option 1 (volume increase) and Option 2 (price
increase).

Assuming that 25 percent of the company will be worth $2.5 billion to $2.7
billion under the current IPO plan, the implicit value of 100 percent of the
company would be $10 billion to $10.8 billion.

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11-2 Financial Accounting for Executives & MBAs, 3 rd Edition
Q11.6 Stock Splits and Share Prices. Lowes share price had increased about 42
percent over the past year, driving the price from $70 per share to $99 per
share. The companys board of directors must believe that they can attract
additional buying interest by reducing the price to the low $30s. (At $99 per
share, the post-split price would fall to about $33 per share.) As expected, the
announcement of a forward stock split generated about a two percent increase
in share price in after-hours trading. In general, a forward stock split is
interpreted by the capital market as positive news, suggesting that
management believes that there is still further upside potential in the companys
share price, in part because of the additional buying interest potentially created
by the lower share price, but also in part because of further expected
improvement in future operating revenue and operating income.

Q11.7 Dividend Reductions. Most public companies set their dividend policy after
first assessing their capacity to generate excess future discretionary operating
cash flow. Since a change in dividend policy (either an increase or decrease) is
an important signal about a firms future financial health, these changes are
carefully monitored by the capital market and usually induce significant share
price reactions. Cutting a dividend would normally cause a significant share
price reduction; however, in the case of The Mills Corporation, the decision
appears to have been already priced into its share price as news of the
announcement led to an increase in share price, probably for two reasons.
First, analysts may have been expecting a steeper dividend cut than the
company actually announced. Second, the announcement may have signaled
the market that The Mills Corporation was finally taking positive steps to correct
its operational problems.

Q11.8 Dividend Payout Ratio. The dividend payout ratio indicates the percentage of
current net income paid to shareholders in the form of a dividend. Generally,
high-growth companies have a low or zero dividend payout ratio because these
companies use their operating income to fund their future growth. Mature or
low-growth companies generally pay high dividends, and hence, have a high
dividend payout policy. Mature companies pay large dividends as a way to
attract and retain investors. By definition, mature companies are unlikely to
show large share price appreciation, and thus, investors must be attracted to
such firms through their dividend payouts. Individual investors in search of
regular income flows (e.g., retired persons) are likely to prefer companies like
Procter & Gamble or Pfizer, to companies like Intel or Cisco, which pay no
dividends.

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-3
Q11.9 Cost of Employee Stock Options. Yahoos news announcement contained
several positive pieces of information, and hence, the markets positive reaction
to the news. First, the companys revenues were up 30 percent over the prior
year. Revenue is the key driver of share price, and this is illustrated here.
Second, the impact of expensing employee stock options on earnings per share
was only $0.04 per share, and this amount was somewhat less than the market
had probably expected. (A useful discussion point here is: Do employee stock
options represent a wealth transfer from shareholders to employees? If the
student consensus is yes, then it is easier to obtain student support for the
expensing of stock options.)

Should employee stock options be expensed? Are they part of an employees


compensation? Do the options cost the firm and its shareholders anything? Is
there a wealth transfer from shareholders to employees? Given the potential
dilutive effect of stock options on earnings per share and share price, the
answer is clearly yes; however, there is always the possibility that the options
will become worthless and expire without being exercised, which is an
argument against immediate expensing.

Q11.10 Directors Compensation. Critics of the Coca Cola directors compensation


plan fear that the scheme could make the directors too fixated on earnings and
less inclined to question risky or unethical decisions by company executives.
According to Professor John Coffee, a corporate-governance specialist from
Columbia University;

It will give the board a strong incentive not to look too closely at
the numbers. It puts directors on the same side as management.

In short, the new plan could change the role of the board of directors from being
a watchdog to being a cheerleader.

In reply to criticism of the plan, a Coke spokesperson observed:

1. Most of Cokes directors are independently wealthy, and thus, are


unlikely to see the $175,000 fee as critical to their lifestyle. (This, of
course, is unlikely to be true at many corporations; in short, the new plan
may work at Coke, but probably not at many other companies.)

2. Under Sarbones-Oxley, there is a system of checks and balances in


place to maintain the quality and integrity of the numbers.

Cambridge Business Publishers, 2014


11-4 Financial Accounting for Executives & MBAs, 3 rd Edition
Q11.11 Special Dividends: Return on Capital or Return of Capital. A special
dividend is considered to be a return of capital, and thus, is tax-free, if a
company is currently posting operating losses and has zero or negative
retained earnings for income tax purposes. Since a firm may report positive
earnings or have a positive balance in retained earnings for accounting
purposes, but not for income tax purposes, it is possible for a special dividend
to receive tax-free distribution status (in whole or in part) despite the favorable
performance reported for accounting purposes.

Q.11.12 (Ethics Perspective) Stakeholder Theory and Shareholder Wealth


Maximization. Stakeholder theory attempts to determine which groups are
stakeholders in a corporation and thus deserve managements attention. In
other words, it attempts to determine who or what really counts. It can certainly
be argued that without knowing who or what really counts, management will not
be successful in maximizing shareholder value.

Peter Drucker, the management guru, stated that the purpose of business is to
create and keep a customer. From this concept it follows that the well-being of
the other stakeholders of a business should cascade from that focus. The logic
behind this is that if the customer is satisfied in terms of quality, price, etc., they
will continue to demand the product. This, in turn, is necessary for healthy and
sustainable financial rewards for the company. Further, the proper treatment of
employees, the community, and the environment should all factor into how the
customer views a company and its products and services. Ultimately
stakeholder theory and shareholder maximization appear intertwined rather
than being competing theories.

(Note: This answer was based on the writings of Bill Bramer and Leak Emkin.)

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-5
EXERCISES

E11.13 Shareholders Equity Transactions.


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

E11.14 Accounting for Shareholders Equity Transactions.


Common Additional Retained Treasury
Transaction Stock Paid-in-Capital Earnings Stock
Beginning Balance $600,000 $89,400,000 $32,000,000 $(7,500,000)
1. +6,000,000
2. -1,500,000
3. -950,000
4. -0- -0- -0- -0-
Ending Balance $600,000 $89,400,000 $36,500,000 $(8,450,000)

Stockholders Equity
12/31
Common stock $ 600,000
Additional paid-in-capital 89,400,000
Retained earnings 36,500,000
Treasury stock (8,450,000)
Total shareholders equity $ 118,050,000

Cambridge Business Publishers, 2014


11-6 Financial Accounting for Executives & MBAs, 3 rd Edition
E11.15 Accounting for Shareholders Equity Transactions.
Common Additional Preferred
Stock Paid-in- Stock, Retained Treasury
Transaction at $1 Par Capital No-Par Deficit 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 dividendpreferred 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

E11.16 Dividend Yield and Dividend Payout.


Yr 1 Yr 2 Yr 3
Dividend Payout 3.7% 6.3% 11.3%

Dividend Yield 0.25% 0.42% 0.76%

WTWM is paying an increasing percentage of its earnings out in the form of


dividends, and the relationship between dividends and share price is also
increasing. Basically, WTWMs dividend doubled over the first two years and
again from Year 2 to Year 3, yet its share price increased only 18.8 percent and
10.5 percent over these same time periods, respectively. Calculating the
companys price-to-earnings ratio reveals that share price is tracking earnings
at a fairly constant multiple of 15 times earnings. Hence, as we would expect,
(i.e., since increasing earnings are a necessary-but-not-sufficient condition for
an increasing dividend), WTWMs share price is tracking earnings more closely
than its dividend.

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-7
E11.17 Accounting for Stock Dividends and Stock Splits.
Additional Shares
Common Paid-in- Retained Outstandin Par
Transaction Stock Capital Earnings g Value
Beg. Balance $100,000 $300,000 $1,400,000 100,000 $1.00
1. +10,000 +140,000 -150,000 10,000
110,000 440,000 1,250,000 110,000 1.00
2. -- -- -- 55,000
110,000 440,000 1,250,000 165,000 0.66667
3. 22,000 968,000 -990,000 33,000
132,000 1,408,000 260,000 198,000 0.66667
4. -- -- -- 198,000 0.33333
396,000 0.33333

Shares outstanding: 396,000


Par value per share: $0.33333
Shareholders equity:
Common stock, par value = $0.33333 $ 132,000
Additional paid-in-capital 1,408,000
Retained earnings 260,000
Treasury stock (600,000)
Other comprehensive income 200,000
Total shareholders equity $1,400,000

E11.18 Interpreting the Foreign Currency Translation Adjustment Account. Home


Depot reported a negative balance in the Foreign Currency Translation
Adjustment account (CTA) for Year 1 because the U.S. dollar has appreciated
(on a net basis) against the foreign currencies for those countries in which
Home Depot maintains operations. The amount of the negative balance (i.e.,
$124 million) reflects the unrealized loss that would be realized if Home Depot
sold its foreign operations and repatriated the proceeds from the sale back into
U.S. dollars. Beginning in Year 2, the U.S. dollar depreciated (on a net basis)
sufficiently against those foreign currencies to cause the CTA to swing from an
unrealized loss to an unrealized gain of $109 million. The depreciation of the
U.S. dollar continued in Year 3, driving the CTA to a net unrealized gain of $172
million. These amounts do not appear either on Home Depots income
statement or its statement of cash flow because the amounts remain unrealized
(i.e., they are non-cash-flow amounts and not yet realized). Since the amounts
are unrealized, they are not subject to income taxation.

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11-8 Financial Accounting for Executives & MBAs, 3 rd Edition
E11.19 Analyzing the Net Unrealized Gain on Available-for-Sale Securities. Smith
& Sons, Inc. reports a net unrealized loss of $9.324 billion in Year 1 because
the market value of its portfolio of available-for-sale securities had fallen below
its cost basis by $9.324 billion. Between Year 1 and Year 2, there was a
significant recovery in value for the companys portfolio as reflected by the
revision of the account balance from a negative $9.324 billion to a positive
$47.23 billion. In essence, Smith & Sons portfolio experienced a $56.554 billion
swing in market value. Some of those gains were lost in Year 3, as the portfolio
value dropped $27.992 billion to an unrealized gain of $19.238 billion. These
unrealized gains and losses are noncash valuation changes, and thus, do not
appear on either the firms income statement or its statement of cash flow.

E11.20 Adjusting Conversion Ratios for Stock Splits and Stock Dividends.
Convertible Convertible
Preferred Stock Debenture
Original conversion ratio 3-to-1 46-to-1
Revised conversion ratio after
o 10% stock dividend 3.3-to-1 50.6-to-1
o 2:1 stock split 6.6-to-1 101.2 to 1

It is appropriate to recalibrate the conversion ratio for convertible preferred


stock and convertible debentures to protect these investor groups from the
dilutive effect associated with stock dividends and forward stock splits. Little
value would be attached to the conversion options if investors could be
subsequently disadvantaged by the dilutive effects of stock dividends or stock
splits.

E11.21 Contrasting the Contributed Capital of a Firm with Treasury Stock. The
ratio of treasury stock (TS) divided by contributed capital indicates the portion
of a firms 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 firms 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).

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-9
E11.22 Analyzing Shareholders Equity.
1. Cash dividends paid = $3.793 billion.

2. Value of exercised employee stock options = $1.017 billion. The shares


were issued from treasury stock.

3. Value of converted subordinated debentures = $369 million. The


issued shares came from treasury stock.

4. Treasury stock repurchases = $1.717 billion.

5. The currency translation account declined by $415 million because the


U.S. dollar appreciated.

E11.23 Analyzing Shareholders Equity.


1. Convertible preferred stock declined by $24. This decline could have
resulted from (1) a conversion to common stock or (b) a retirement of the
preferred stock.

2. Common stock increased by $1, along with a $524 increase in APIC,


and could have resulted from:
Conversion of preferred stock into common
Sale of common stock (unlikely)
Exercise of employee stock options

3. Employee trust benefit declined by $306 due to increased funding by


Pfizer.

4. Treasury stock increased by $3,775 due to share repurchases.

5. Retained earnings increased by $2,116 due to net earnings, net of any


dividends paid.

6. Other comprehensive income declined by $1,799 due to (1) an


increase in the value of the U.S. dollar or (b) a decline in the value of
available-for-sale securities.

Cambridge Business Publishers, 2014


11-10 Financial Accounting for Executives & MBAs, 3 rd Edition
PROBLEMS

P11.24 Accounting for Share Transactions.


The Mann Corporation
Common 8% No-par 8% No-par Balance
Shares Preferred Preferre Preferred Preferred Sheet
Transaction (in thousands) IPO IPO d IPO Dividend Dividend Totals
Assets
Cash 10,000 10,500 5,500 (800) (500) 24,700
Shareholders Equity
Common Stock 1,000 1,000
APIC Common 9,000 9,000
$100 Preferred Stock 10,000 10,000
APIC-Preferred 500 500
$5 Conv. Preferred 5,500 5,500
Retained Earnings (800) (500) (1,300)
Total Shareholders Equity 24,700

P11.25 Accounting for Share Transactions.


1 a Initial public offering 10,000,000 shares
. .
10% stock dividend 1,000,000
11,000,000
3-for-1 stock split 22,000,000
33,000,000
Share repurchase (500,000)
Dec. 31, 2015 shares outstanding 32,500,000

b Par value
.
At IPO $1.00
After 3-for-1 stock split $1/3 = $0.333

2.
The Mayfair Corporation
Initial Balance
Transaction Public Stock Stock Share Cash Sheet
(in thousands) Offering Dividend Split* Repurchase Dividend Totals
Assets
Cash 30,000 (7,500) (3,250) 19,250
Shareholders Equity no
entry
Ordinary shares 10,000 1,000 11,000
APIC 20,000 5,000 25,000
Retained earnings (6,000) (3,250) (9,250)
Treasury stock (7,500) (7,500)
Total Shareholders Equity 19,250
Cambridge Business Publishers, 2014
Solutions Manual, Chapter 11 11-11
* No financial effect: par value declines from $1 to $0.333 while shares outstanding
increase from 11 million to 33 million

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11-12 Financial Accounting for Executives & MBAs, 3 rd Edition
P11.26 Accounting for Share Transactions.
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 = $0.005

3.
CompX International
Stock Stock Share Balance Sheet
Transaction Split* Dividend Repurchase Totals
Assets
Cash no (3,000,000) (3,000,000)
Shareholders Equity entry
Common stock 6,100 6,100
APIC 24,393,900 24,393,900
Retained earnings (24,400,000) (24,400,000)
Treasury stock (3,000,000) (3,000,000)
Total Shareholders Equity (3,000,000)
* No financial effect: par value declines from $.01 to $0.005 while shares outstanding
increase from 6.1 million to 12.2 million

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.

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-13
P11.27 Stock Dividends.
1. Shares outstanding increase by 125,000 (i.e., 25% x 500,000 shares).
Retained earnings decline by $3,725,000 (i.e., $30 par value x 125,000
shares).
Common stock at par increases by $125,000.
Additional Paid-in-capital increases by $3,625,000.

2. Shares outstanding increase by 100,000 (i.e., 20% x 500,000 shares).


Retained earnings decline by $3.0 million (i.e.100,000 shares x $30 per
share).
Note: A 20 percent stock dividend would, in an efficient market, cause the
share price to decline to $25 (i.e., $30 x 5/6).
Common stock at par increases by $100,000 (i.e., $1 par value x 100,000
shares).
APIC increases by $2.9 million (i.e., a plug figure).

3. A small stock dividend, in and of itself, would not make the shareholders
happy because the stock price adjusted for the stock dividend will fall
leaving the shareholders with their wealth unchanged. However, typically
share prices increase after the announcement of a stock dividend because
they are thought to provide information to the market that a firms future
prospects look promising.

4. The company should declare a 25 percent stock dividend. If the firm


declares a 20 percent stock dividend, RE would be reduced to $100,000
($3,100,000 less $3,000,000), which would allow the company to only
dividends of $100,000.

5. The company issued either a 100 percent stock dividend or a 2-for-1 stock
split and chose to account for the dividend/split by capitalizing additional
paid-in-capital instead of adjusting the par value or capitalizing retained
earnings.

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11-14 Financial Accounting for Executives & MBAs, 3 rd Edition
P11.28 Convertible Preferred Stock: A Redemption.
1. Redemption
Account Financial Effects
Preferred stock Declines by the amount of its book value
(not reported in problem)
Cash Declines by 52.45 million euros(i.e., 1
million shares @ 52.45 euros per share) for
the share repurchase
Declines by 160,000 euros (i.e., 1 million
shares @ 0.16 euros) for the accrued
dividend
Retained earnings Declines by 160,000 euros for the accrued
dividend
Declines by the difference between the
cash paid for redemption and the book
value of the preferred shares.

Conversion
Account Financial Effects
Preferred stock Declines by the amount of its book value
(not reported in problem)
Common stock, Increases by 1 million euros (i.e., 1 million
1 euro par value shares @ 1 euro per share)
APIC Increases by the difference (a plug figure)
between the book value of the preferred
shares and 1million euros (i.e., par value of
common shares issued)

2. A rational investor would prefer the conversion of preferred shares into


common shares:
Market value of 100 preferred shares: 5,245 euros (i.e., 100 shares @ 52.45
euros)
Market value of 196.08 common shares = 6,397.11 euros (i.e., 196.08
shares @ 32.6250 euros.
The common shares could be resold for 6,397.11 euros, which exceeds the
cash value of 5,245 euros.

3. Given the current convertibility of the preferred shares into common, it is


surprising that the spread (i.e., 6,397.11 - 5,245 = 1,152.11) between the
value of the two securities is so large. One explanation is low liquidity (i.e.,
low available float) on the preferred shares. In any case, most managers
would prefer to preserve their cash flow, and thus, would prefer the
conversion option to the redemption option.
Cambridge Business Publishers, 2014
Solutions Manual, Chapter 11 11-15
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11-16 Financial Accounting for Executives & MBAs, 3 rd Edition
P11.29 Analyzing Shareholders Equity. 2004 shareholders equity transactions:
1. $1.924 billion in common stock was issued, either (a) for M&A transactions
or (b) for the exercise of stock options or stock purchase plans by
employees.

2. Common stock repurchases totaled $4.632 billion (i.e., $1.714 million plus
$2.918 billion), probably to offset the dilutive share price effect of the
issuance of common shares under the employee stock option and stock
purchase plans. Note: It is unclear why Microsoft accounts for $1.714
million in share repurchases under common stock and the remaining $2.918
billion under Retained Earnings.

3. Stock-based compensation expense of $2.244 billion. Beginning in 2004,


Microsoft switched from the issuance of employee stock options (because
such options would need to be expensed beginning in 2005) to the issuance
of stock grants. The $2.244 billion is the before-tax value of the stock grants
given to Microsoft employees in 2012.

4. Net income of $16.978 billion was earned by the company.

5. Other Comprehensive Income:


a. The fair market value of the companys derivative securities used
for hedging purposes (e.g., to manage foreign currency, interest rate,
and credit risk) increased by $882 million (i.e., $627 + $255).
b. The fair market value of the companys available-for-sale
investments declined by $1.444 billion (i.e., $1,054 + $390), reflecting
a declining share market.
c. The cumulative foreign currency translation account declined by
$687 million (i.e., $381 + $306), reflecting an appreciation of the U.S.
dollar against the foreign currencies in which Microsoft does
business.

6. Issuance of a common stock dividend of $6.721 billion.

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-17
P11.30 Other Comprehensive Income: Calculating the Cumulative Foreign
Currency Translation Adjustment.
1. Translate the income statement.
Australian Exchange U.S.
Dollar Rate Dollar
Sales $1,148,000 0.76 $872,480
Operating expenses (781,200) 0.76 (593,712)
Income tax expense (186,200) 0.76 (141,512)
Net income $180,600 $137,256

2. Translate the balance sheet.


Australian Exchang U.S.
Dollar e Dollar
Rate
Cash 63,000 0.78 49,140
Accounts receivable 103,600 0.78 80,808
Inventory 140,000 0.78 109,200
Property & equipment, net 462,000 0.78 360,360
Total 768,600 599,508
Liabilities 336,000 0.78 262,080
Common stock 42,000 25,830 1)
Retained earnings 390,600 311,206 2)
Translation adjustment -- 392 3)
Total 768,600 599,508
1)
See translated value of common stock in problem.
2)
$173,950 + $137,256 = $311,206.
3)
Plug: $ 599,508 $ 262,080 $25,830 $ 311,206 =$ 392.

Reconciliation of Retained Earnings:


Retained earnings (Jan. 1, U.S. dollars) $173,950
Net income (translated, see income statement) 137,256
$311,206

3. Reconciliation of Cumulative Foreign Currency Translation Adjustment


Account:
Balance, Jan. 1 $(10,780)
Adjustment for beginning net assets, with increase in
exchange rate from $0.75 to $0.78: A$252,000 x $0.03 7,560
Adjustment for net income, with increase in exchange rate
from average of $0.76 to $0.78: A$180,600 x $0.02 3,612
Balance, Dec. 31 $392

The U.S. dollar depreciated against the Australian dollar during the year,
making the translated value of Grahams net assets in Australia worth more.

Cambridge Business Publishers, 2014


11-18 Financial Accounting for Executives & MBAs, 3 rd Edition
The unrealized gain will be realized on Grahams parent-company income
statement when the Australian subsidiary is sold.

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-19
P11.31 Analyzing Shareholders Equity.
1. $54.60 ($6,170 113)

2. Less than 100 percent of the subsidiarys outstanding shares are


owned by Wal-Mart.

3. Appreciated

4. $44.69 ($89 3/8 2)

5. The companys stock price experienced a substantial run-up in the


previous year up 85 percent to $89 3/8 and Wal-Mart wanted to return
the share price to a normal trading range of about $40 - $50 per share.

6. Change in retained earnings = -$33,128


Number of shares issued = 20% * 2,224 = 444.80
Market price = $89 3/8 * 1/1.2 = $74.48
Market value of new shares = 444.8 * $74.48 = $33,129

Cambridge Business Publishers, 2014


11-20 Financial Accounting for Executives & MBAs, 3 rd Edition
CORPORATE ANALYSIS

CA11.32 The Procter and Gamble Company.


a. Outstanding equity shares:
2012 2011
Convertible Class A preferred stock
stated value = $1.00
authorized shares = 600 million
outstanding shares = N/A $1,195 $1,234
Common stock
stated value = $1.00
authorized shares = 10 billion
outstanding shares = 4,008.4 million
(shares issued: 2012 4008.4; 2011 4007.9) 4,008 4,008

b. Financing Policy
2012 2011
Total debt total assets 51.6% 50.8%
Total shareholders equity total assets 48.4% 49.2%
Total 100.0% 100.0%
Weighted-average cost of debt: short-term 0.6% 0.9%
Cost of debt: long-term 3.3% 3.4%
(see footnote no. 5)
Cost of equity (using CAPM) 6.19%
re = 1.78 + 0.31(16.00 1.78) = 6.19%

P&G is principally debt financed, although the absolute amount of debt


declined from 2011 to 2012 ($70.353 billion to $68.209 billion). The use of
debt financing actually increased by 0.8% from 2011 to 2012, due to a
decrease of $6.110 billion in total assets over the same time period.

P&Gs short-term cost of debt decreased by a third, while its long-term cost
of borrowing remained almost flat.

c. Treasury shares repurchased in 2012:


Quantity: 61,826 thousand shares
Aggregate repurchase price: $4.024 billion

Cambridge Business Publishers, 2014


Solutions Manual, Chapter 11 11-21
d. Shares issued in 2012 under the employee stock option plan: 39,546
shares.
According to Note 6, diluted weighted average common shares in 2012
is 2.941 billion with a diluted EPS of $3.66; 2011diluted weighted
average common shares is 3.002 billion with a diluted EPS of $3.93.
Outstanding stock options not included in diluted EPS (footnote 2 in Note
5) is .067 billion in 2012 and .093 billion in 2011. This reduces 2012
diluted EPS to $3.58, an $0.08 reduction in diluted EPS; and this
reduces 2011 diluted EPS to $3.81, a $0.12 reduction in diluted EPS.

CA11.33 Internet-based Analysis. No solution is provided since any solution would


be unique to the company selected.

CA11.34 IFRS Financial Statements. LVMH Moet Hennessey-Louis Vuitton S.A.


a. LVMH equity account U.S. GAAP equivalent

(a) Share capital (a) Common stock at par


(b) Share premium account (b) Paid-in-capital in excess
(c) Treasury shares and LVMH-share (c) Treasury stock
settled derivatives
(d) Cumulative translation adj. (d) Cumulative translation adj.
(e) Revaluation reserves (e) NA
(f) Other reserves (f) Retained earnings
(g) Net profit, group share (g) Retained earnings
(h) Equity, group share (h) Retained earnings
(i) Minority interest (i) Noncontrolling interest

b. The accounts most likely to have been impacted to reflect the 2,819
euros include the asset accounts land and financial investments.

Cambridge Business Publishers, 2014


11-22 Financial Accounting for Executives & MBAs, 3 rd Edition

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