Accounting: Chapter 3

Organizations need _____________ to be able to buy land, buildings, equipment, and supplies

Resources

The money needed to acquire these \n assets is referred to as the organization’s

Capital

The choices made with respect to obtaining \n resources determine the ________________ of the firm: i.e., their debt-to-equity ratio

Capital Structure

The capital structure of the organization represents the __________________ of the balance sheet: liabilities and stockholders’ equity

right-hand side

The returns must be ______________ of the cost \n of capital used to acquire assets to create \n shareholder value

in excess

Creates internal “______________” for projects \n to clear

hurdle rate

A company’s cost of capital is a function of their

(1) cost of __________ capital \n (2) cost of ________ capital \n (3) capital _______________

1. Equity

2. Debt

3. Structure

The riskier an investment is, the greater the \n _____________ demanded by investors.

Return

For example, a low-risk borrower is likely to be \n able to borrow money at a __________ interest \n rate than would a high-risk borrower.

Lower

Similarly, there is a __________________ trade-off in equity returns.

risk-return

Investments in risky stocks are expected to earn \n ____________ returns than investments in low-risk stocks, and stocks are priced accordingly.

higher

The higher _____________ rate of return is \n compensation for accepting greater uncertainty in returns.

expected

Why? Investors’ demand for greater returns on risky stocks _______________ the company’s expected future returns to a lower present value.

discount

Equity investors’ expected _____________ is \n the cost of equity capital

rate of return

Equity securities are riskier than debt \n securities

Cost of equity capital > Cost of debt capital

Equity holders expect to earn a certain rate of \n return, like debt holders receive interest, and \n this is a real cost that influences __________ \n ____________

managers’ actions

KEY: Equity isn’t “free” money – you must expect to pay back ______________ with “interest” (like w/ debt)

Equity Holders

Disappointing investors makes it harder for the company \n to raise _________________ in the future – and also affects a CEO’s reputation and future career opportunities

More capital

Through _____________ funds

Internal

Through ________________

Creditors

Through equity __________

Investors

The “pecking order hypothesis”

states that firms \n follow this preferred order of financing

Common stock is the ____________ ownership unit in a company

\n primary

Common stockholders:

own a ________________ on the corporation’s assets

\n have the right to vote to elect the board of directors

\n are entitled to a ________________ share of \n distributions (such as dividends)

\n can freely sell their ownership interest

Residual claim;

Proportionate

Common stockholders hope to benefit from \n ______________ and/or increases in the _________ _______________

dividends; value of the stock

Issuing additional shares of stock ___________ the ownership share of all ____________ owners

dilutes; stock

Equity increases your ________________ of capital

cost

Cost of debt is ___________ than cost of equity

lower

Tax benefit of debt \n Interest is tax-deductible, ____________ \n payments are not

dividend

Loss of ___________ with equity \n Common stockholders have perpetual voting \n rights \n Control only transfers to debtors under threat of \n ____________

control; bankruptcy

Equity issuances dilute __________ ownership \n shares

existing

\n Debt increases __________ risk, as debt payments are mandatory

default

\n Debt covenants and/or large amounts of mandatory payments can limit scope of _____________ opportunities

investment

_____________ preference

Dividend

Preferred shareholders receive dividends on their shares before common shareholders

\n ______________ preference

Liquidation

If the company were to fail, funds from assets sold in liquidation go first to pay debtors, next to preferred shareholders, and finally to common stockholders

“Mezzanine” financing (debt-equity _________) \n

Unlike debt, does not increase risk of bankruptcy

Hybrid

\n Call feature: Provides the issuer the right, but not obligation, to repurchase the \n preferred shares at a ___________________

specified price

Conversion feature:

Allows preferred shareholders to convert their shares into common \n shares at their option at a predetermined ____________________

\n Yields a higher price than if not convertible

\n Imposes a cost on common shareholders

conversion ratio

\n Nonvoting shares

Most preferred shares have no voting rights

Give employees the right to purchase shares \n of stock at a ___________________ price

predetermined

Vesting period \n Period of time during which the employee may \n _________________________ the stock option

not exercise

\n Fair value of each stock option grant must be \n recognized as an ______________ on the \n income statement over the vesting period

expense

\n More than half of CEO compensation is now \n comprised of _________________

stock options

Cash dividends

Most are paid quarterly \n Not all companies pay dividends

\n Trend over time towards _____________ over dividends

repurchases

Strong ______________ value

A firm’s stock price substantially increases (decreases) upon the announcement of an increase (decrease) in dividend payout (i.e., when the dividend changes)

What this means: dividend decisions convey information held by the firm’s insiders but not publicly known

signaling

(1) pay a 10% ____________ on common stock or \n (2) use the same amount of cash to _____________ some of its shares. Let’s further imagine that you own 10 shares of stock, and do not have any pressing liquidity needs.

All things equal, do these provide ______________ to you?

Dividend

Repurchase

Equal Value

KEY: Value of cash in hand vs. Value of \n _____________ of an asset

Appreciation

Now let’s say you do have liquidity needs and prefer cash. Are these things still identical? Why isn’t the dividend clearly better?

Yes. You can always __________ 1 share of your stock – providing the same cash as the dividend would have – and your remaining shares 9 shares are as __________ as the 10 shares after a dividend payment.

Equity payouts (____________________ \n to shareholders) come in two forms

Returning Value

Dividends (direct; cash in hand)

Stock repurchases (indirect; appreciation \n in value)

Long-term trend towards ________________

Tax advantages to shareholders in the U.S. \n

Capital gains versus ordinary income \n

Advantages to managers holding stock options

repurchases

Issuing vs. repurchasing equity shares

Companies tend to issue new shares at high prices (which sends a ________________ signal to the market) and repurchase shares at low prices (which sends a _____________ signal)

negative; positive

\n A company buys its ________________ from \n investors at the market price

own stock

Reasons for repurchase:

To ______________ the number of shares outstanding in order to increase stock price (anti-dilutive)

reduce

Reasons for repurchase: Sends a positive signal to the market that management views stock as ___________________ Impact of signal favorably impacts share price

undervalued

To offset the _____________ effects of an employee stock option program

dilutive

\n Stock dividends: additional shares of \n stock _________________ to \n shareholders on a ratable basis

distributed

No effect on the % _____________ by \n each investor

owned

Stock split is similar in ____________ to a \n stock dividend

substance

A typical stock split is 2-for-1:

the company distributes one additional share for each share owned by the stockholders (so no effect on the % owned)

Some evidence of a positive signaling value

signaling

___________________ benefit: makes you feel \n like you have more

psychological

Stock split: reduces stock price to a more \n reasonable ________________, perhaps opens \n up some possible investors

trading range