Stockholders' Equity: Classes of Capital Stock

Read this chapter, which introduces long-term bonds, their value, how they compare with stock. Some companies expand using stock, while some use debt (bonds). The example exercises refer to Appendix A, which is included here.

Selling (issuing) bonds

A company seeking to borrow millions of dollars generally is not able to borrow from a single lender. By selling (issuing) bonds to the public, the company secures the necessary funds.

Usually companies sell their bond issues through an investment company or a banker called an underwriter. The underwriter performs many tasks for the bond issuer, such as advertising, selling, and delivering the bonds to the purchasers. Often the underwriter guarantees the issuer a fixed price for the bonds, expecting to earn a profit by selling the bonds for more than the fixed price.

When a company sells bonds to the public, many purchasers buy the bonds. Rather than deal with each purchaser individually, the issuing company appoints a trustee to represent the bondholders. The trustee usually is a bank or trust company. The main duty of the trustee is to see that the borrower fulfills the provisions of the bond indenture. A bond indenture is the contract or loan agreement under which the bonds are issued. The indenture deals with matters such as the interest rate, maturity date and maturity amount, possible restrictions on dividends, repayment plans, and other provisions relating to the debt. An issuing company that does not adhere to the bond indenture provisions is in default. Then, the trustee takes action to force the issuer to comply with the indenture.

Bonds may differ in some respects; they may be secured or unsecured bonds, registered or unregistered (bearer) bonds, and term or serial bonds. We discuss these differences next.

Certain bond features are matters of legal necessity, such as how a company pays interest and transfers ownership. Such features usually do not affect the issue price of the bonds. Other features, such as convertibility into common stock, are sweeteners designed to make the bonds more attractive to potential purchasers. These sweeteners may increase the issue price of a bond.

Secured bonds: A secured bond is a bond for which a company has pledged specific property to ensure its payment. Mortgage bonds are the most common secured bonds. A mortgage is a legal claim (lien) on specific property that gives the bondholder the right to possess the pledged property if the company fails to make required payments.

Unsecured bonds: An unsecured bond is a debenture bond, or simply a debenture. A debenture is an unsecured bond backed only by the general creditworthiness of the issuer, not by a lien on any specific property. A financially sound company can issue debentures more easily than a company experiencing financial difficulty.

Registered bonds: A registered bond is a bond with the owner's name on the bond certificate and in the register of bond owners kept by the bond issuer or its agent, the registrar. Bonds may be registered as to principal (or face value of the bond) or as to both principal and interest. Most bonds in our economy are registered as to principal only. For a bond registered as to both principal and interest, the issuer pays the bond interest by check. To transfer ownership of registered bonds, the owner endorses the bond and registers it in the new owner's name. Therefore, owners can easily replace lost or stolen registered bonds.

Unregistered (bearer) bonds: An unregistered (bearer) bond is the property of its holder or bearer because the owner's name does not appear on the bond certificate or in a separate record. Physical delivery of the bond transfers ownership.

Coupon bonds: A coupon bond is a bond not registered as to interest. Coupon bonds carry detachable coupons for the interest they pay. At the end of each interest period, the owner clips the coupon for the period and presents it to a stated party, usually a bank, for collection.

Term bonds and serial bonds: A term bond matures on the same date as all other bonds in a given bond issue. Serial bonds in a given bond issue have maturities spread over several dates. For instance, one-fourth of the bonds may mature on 2011 December 31, another one-fourth on 2012 December 31, and so on.

Callable bonds: A callable bond contains a provision that gives the issuer the right to call (buy back) the bond before its maturity date. The provision is similar to the call provision of some preferred stocks. A company is likely to exercise this call right when its outstanding bonds bear interest at a much higher rate than the company would have to pay if it issued new but similar bonds. The exercise of the call provision normally requires the company to pay the bondholder a call premium of about USD 30 to USD 70 per USD 1,000 bond. A call premium is the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity date.

Convertible bonds: A convertible bond is a bond that may be exchanged for shares of stock of the issuing corporation at the bondholder's option. A convertible bond has a stipulated conversion rate of some number of shares for each USD 1,000 bond. Although any type of bond may be convertible, issuers add this feature to make risky debenture bonds more attractive to investors.

Bonds with stock warrants: A stock warrant allows the bondholder to purchase shares of common stock at a fixed price for a stated period. Warrants issued with long-term debt may be nondetachable or detachable. A bond with nondetachable warrants is virtually the same as a convertible bond; the holder must surrender the bond to acquire the common stock. Detachable warrants allow bondholders to keep their bonds and still purchase shares of stock through exercise of the warrants.

Junk bonds: Junk bonds are high-interest rate, high-risk bonds. Many junk bonds issued in the 1980s financed corporate restructurings. These restructurings took the form of management buyouts (called leveraged buyouts or LBOs), hostile takeovers of companies by outside parties, or friendly takeovers of companies by outside parties. In the early 1990s, junk bonds lost favor because many issuers defaulted on their interest payments. Some issuers declared bankruptcy or sought relief from the bondholders by negotiating new debt terms.

Several advantages come from raising cash by issuing bonds rather than stock. First, the current stockholders do not have to dilute or surrender their control of the company when funds are obtained by borrowing rather than issuing more shares of stock. Second, it may be less expensive to issue debt rather than additional stock because the interest payments made to bondholders are tax deductible while dividends are not. Finally, probably the most important reason to issue bonds is that the use of debt may increase the earnings of stockholders through favorable financial leverage.

Favorable financial leverage: A company has favorable financial leverage when it uses borrowed funds to increase earnings per share (EPS) of common stock. An increase in EPS usually results from earning a higher rate of return than the rate of interest paid for the borrowed money. For example, suppose a company borrowed money at 10 percent and earned a 15 percent rate of return. The 5 percent difference increases earnings.

Exhibit 42 provides a more comprehensive example of favorable financial leverage. The two companies in the illustration are identical in every respect except in the way they are financed. Company A issued only capital stock, while Company B issued equal amounts of 10 percent bonds and capital stock. Both companies have USD 20,000,000 of assets, and both earned USD 4,000,000 of income from operations. If we divide income from operations by assets (USD 4,000,000/USD 20,000,000), we see that both companies earned 20 percent on assets employed. Yet B's stockholders fared far better than A's. The ratio of net income to stockholders' equity is 18 percent for B, while it is only 12 percent for A.

Assume that both companies issued their stock at the beginning of 2010 at USD 10 per share. B's USD 1.80 EPS are 50 percent greater than A's USD 1.20 EPS. This EPS difference probably would cause B's shares to sell at a substantially higher market price than A's shares. B's larger EPS would also allow a larger dividend on B's shares.

Company B in Exhibit 42 is employing financial leverage, or trading on the equity. The company is using its stockholders' equity as a basis for securing funds on which it pays a fixed return. Company B expects to earn more from the use of such funds than their fixed after-tax cost. As a result, Company B increases its rate of return on stockholders' equity and EPS.

Companies A and B
Condensed Statements Balance Sheets
2010 December 31

Company A Company B
Total assets $20,000,000 $20,000,000
Bonds payable, 10% $10,000,000
Stockholders' equity (capital stock) $20,000,000 10,000,000
Total equities $20,000,000 $20,000,000
Income statements
For the year ended 2010 December 31
Income from operations $4,000,000 $4,000,000
Interest expense 1,000,000
Income before federal income taxes $4,000,000 $3,000,000
       Deduct: Federal income taxes (40%) 1,600,000 1,200,000
Net income $2,400,000 $1,800,000
Number of common shares outstanding 2,000,000 1,000,000
Earnings per share (EPS) (Net income/Number of common shares outstanding) $1.20 $1.80
Rate of return on assets employed (Income from Operations/Total assets; both companies $4,000,000/$20,000,000) 20% 20%
Rate of return on stockholders' equity (Net income/Stockholders' equity):
       Company A ($2,400,000/$20,000,000) 12%
       Company B ($1,800,000/$10,000,000) 18%

Exhibit 42: Favorable financial leverage

Several disadvantages accompany the use of debt financing. First, the borrower has a fixed interest payment that must be met each period to avoid default. Second, use of debt also reduces a company's ability to withstand a major loss. For example, assume that instead of having net income, both Company A and Company B in Exhibit 42 sustain a net loss in 2010 of USD 11,000,000. At the end of 2010, Company A will still have USD 9,000,000 of stockholders' equity and can continue operations with a chance of recovery. Company B, on the other hand, would have negative stockholders' equity of USD 1,000,000 and the bondholders could force the company to liquidate if B could not make interest payments as they came due. The result of sustaining the loss by the two companies is as follows:

Companies A and B
Condensed Statements Balance Sheets
2010 December 31

Company A Company B
Stockholders' equity:    
Paid-in capital:
Common stock
$20,000,000 $10,000,000
Retained earnings
Total  stockholders' equity $0,000,000 $(1,000,000)

A third disadvantage of debt financing is that it also causes a company to experience unfavorable financial leverage when income from operations falls below a certain level. Unfavorable financial leverage results when the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage. In the previous example, if income from operations fell to USD 1,000,000, the rates of return on stockholders' equity would be 3 percent for A and zero for B, as shown in this schedule:

Companies A and B
Partial Balance Sheets
2010 December 31

Company A Company B
Income from operations $1,000,000 $1,000,000
Interest expense 1,000,000
Income before federal income taxes $1,000,000 $ -0-
      Deduct: Federal income taxes (40%) 400,000 -0-
Net income 600,000 $ -0-
Rate of return on stockholders' equity:
      Company A ($600,000/$20,000,000) 3%
      Company B ($0/$10,000,000) 0%

The fourth disadvantage of issuing debt is that loan agreements often require maintaining a certain amount of working capital (Current assets - Current liabilities) and place limitations on dividends and additional borrowings.

When a company issues bonds, it incurs a long-term liability on which periodic interest payments must be made, usually twice a year. If interest dates fall on other than balance sheet dates, the company must accrue interest in the proper periods. The following examples illustrate the accounting for bonds issued at face value on an interest date and issued at face value between interest dates.

Bonds issued at face value on an interest date Valley Company's accounting year ends on December 31. On 2010 December 31, Valley issued 10-year, 12 percent bonds with a USD 100,000 face value, for USD 100,000. The bonds are dated 2010 December 31, call for semiannual interest payments on June 30 and December 31, and mature on 2020 December 31. Valley made the required interest and principal payments when due. The entries for the 10 years are as follows:

On 2010 December 31, the date of issuance, the entry is:

2010 Dec. 31 Cash (+A) 100,000
Bonds payable (+L) 100,000
To record bonds issued at face value.

On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020 June 30), the entry would be:

Each year June 30 And Dec.31 Bond Interest Expense ($100,000 x 0.12 x ½) (-SE) 100,000
Cash (-A) 6,000
To record periodic interest payment.

On 2020 December 31, the maturity date, the entry would be:

2020 Dec. 31 Bond interest expense (-SE) 6,000
Bonds payable (-L) 100,000
Cash (-A) 106,000
To record final interest and bond redemption payment.

Note that Valley does not need adjusting entries because the interest payment date falls on the last day of the accounting period. The income statement for each of the 10 years 2010-2018 would show Bond Interest Expense of USD 12,000 (USD 6,000 X 2); the balance sheet at the end of each of the years 2010-2018 would report bonds payable of USD 100,000 in long-term liabilities. At the end of 2019, Valley would reclassify the bonds as a current liability because they will be paid within the next year.

The real world is more complicated. For example, assume the Valley bonds were dated 2010 October 31, issued on that same date, and pay interest each April 30 and October 31. Valley must make an adjusting entry on December 31 to accrue interest for November and December. That entry would be:

2010 Dec. 31 Bond interest expense ($100,000 x 0.12 x 2/12) (-SE) 2,000
Bond interest payable (+L) 2,000
To accrue two month's interest expense.

The 2011 April 30, entry would be:

2011 Apr. 30 Bond interest expense ($100,000 x 0.12 x (4/12)) (-SE) 4,000
Bond interest payable (-L) 2,000
Cash (-A) 6,000
To record semiannual interest payment.

The 2011 October 31, entry would be:

2011 Oct. 31 Bond interest expense (-SE) 6,000
Cash (-A) 6,000
To record semiannual interest payment.

Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest. The firm would report the USD 2,000 Bond Interest Payable as a current liability on the December 31 balance sheet for each year.

Bonds issued at face value between interest dates Companies do not always issue bonds on the date they start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price "plus accrued interest". The issuer must pay holders of the bonds a full six months' interest at each interest date. Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first six months' interest check.

Using the facts for the Valley bonds dated 2010 December 31, suppose Valley issued its bonds on 2011 May 31, instead of on 2010 December 31. The entry required is:

2011 May 31 Cash (+A) 105,000
Bonds payable (+L) 100,000
Bond interest payable ($100,000 x 0.12 x (5/12)) (+L) 5,000
To record bonds issued at face value plus accrued interest.

This entry records the USD 5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable.

The entry required on 2011 June 30, when the full six months' interest is paid, is:

2011 June 30 Bond Interest Expense ($100,000 x 0.12 x (1/12)) (-SE) 1,000
Bond interest payable (-L) 5,000
Cash (-A) 6,000
To record bond interest payment

This entry records USD 1,000 interest expense on the USD 100,000 of bonds that were outstanding for one month. Valley collected USD 5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.