Notes

So far, we saw that a firm can use three types of financing to make its investments and carry on its business operations, POT (Packed Order Theory):

• Internal Resources (namely profits generated in the past that were not distributed as dividends);
• Debt (notes payable, bonds, loans and debentures);
• Equity Financing.

These 3 ways of financing are in order which means that the firm will arrive to ask for equity as a last step, only after having already used/checked the two ways before it. That's because equity is the most expensive way of financing for a firm, and that is related to the risk that shareholders are ready to take in exchange of a premium.

In order to understand how much of financing comes from the equity we have to check the capital structure of the firm, and in particular the mix of debt and equity used to finance its investments. Therefore, by computing Financial Leverage Ratio = Stockholders' Equity / Total Assets, (as we'll see , in the case of Kellogg's this ratio is 17.8%).

This chapter is focused on Equity Financing.

A firm like Kellogg's, in 2018 reported a total stockholders' equity in the balance sheet of 3159$. The stockholders' equity includes both the retained earnings (that is the profits generated by the firm in the past and reinvested in the company) and the common equity (that is the money provided by company's owners). Moreover, as the financial statements of Kellogg's are consolidated financial statements, there is also a separate indication of equity belonging to minorities.

If you consider the total assets of Kellogg's (17780$), we can see that 82.2% of the assets are financed through debt financing and just 17.8% is financed through equity and internal resources.

As Kellogg's is a corporation (rather than a partnership or sole proprietorship), the equity (namely its ownership) is divided in a number of pieces called shares. Each share gives the owner two rights:

• Voting Rights, rights to vote in the stockholders' meetings and, hence, influence company's decisions.
• Cash Flow Rights, cash flow rights comprise:
  • The right to receive dividends, namely receive a proportional share of the distributed profits (notice that the share of dividends is proportional to the amount of equity provided by the shareholder).
  • At the end of the life of the company (case of failure or liquidation), the company pays back a cash amount to shareholders that it is proportional to the initial contribution. This is the so-called residual claim of shareholders. In the case of failure, owners are paid after everyone else (suppliers, banks, etc.). This makes equity investments riskier than lending. This is the reason why the profits that are not distributed in form of dividends are included in firm's stockholders' equity as shareholders have a residual claim over them.

Shares differ depending on the type of rights that they provide. In particular, we can distinguish between:

• Common Shares, they provide both rights. Yet, we can have different classes depending on whether they provide more/less voting and cash flow rights. For instance, in the case of family firms, family owners hold shares that provide more voting rights than cash flow right as the family wants to influence more the corporate activities.
• Preferred Shares, they are distinct from the common shares. In this case, equity holders will receive dividends and will be paid back before the others. Usually, they don't carry voting rights.

A corporation having both types of shares has a Dual Class Structure. (Lyft vs Uber).

The different rights provided by the shares are reflected in different prices that owners pay for them.

In the case of private firms, the price of the shares is privately negotiated. In the case of listed firms, the price is determined on the stock market where the shares are traded. In US, the major stock market is the New York Stock Exchange (NYSE) but it is not the only one. Other two relevant stock markets are the NASDAQ (specialized for high-tech companies) and OTC (specialized for start-up companies). Kellogg's for example is traded on the NYSE.

When shares are traded in the markets and therefore the prices changes according to Demand&Supply, the Balance Sheet is not affected. The only situation in which the Balance Sheet and the Statement of Stockholders' Equity are affected is in case of issuance of new shares.

When a firm decides to sell its shares in the stock market, it makes an IPO (Initial Public Offering). New shares are issued and sold in the market at a given price. At the moment of IPO, the firm has to provide the past financial statements and the expected ones so that investors can decide to buy or not the shares. In US, the document containing all these information is the form S-1.

After the initial IPO, the firm can decide to issue new shares in the market as it needs more capital to make its investments. In this case, we have a SEO (Seasoned Equity Offerings) where new shares are issued and traded in the market. Note that the firm can decide to trade all its shares or just part of them.

The maximum number of shares that a company can issue is the authorized number of shares. (In the case of Kellogg's, authorized shares are equal to 1.000.000.000).

The issued shares is the total number of shares that have been issued and sold. (In the case of Kellogg's, the issued shares are equal to 420.666.780)

However, the shares that have been sold in the market may have been purchased by investors or by the firm itself. The firm can decide to purchase its own shares when it has low growth opportunities and the management thinks that the firm itself is the best investment. The shares that the company repurchases are separately identified as treasury stock. In the case of Kellogg's, the number of shares that has been repurchased is 76.801.314 and the treasury stock is 4551. Shares that have been repurchased are considered as issued shares but not outstanding (that is the total number of shares of stock that are owned by stockholders on any particular date) as they are not owned by shareholders but by the firm. This is the reason why they are reported with a negative sign as they do not represent financial resources provided by external subjects towards which the firm has obligations (that is, dividend payment and residual claim).

Thus, the number of shares held by stockholders is the difference between the issued shares and the treasury stock. In the case of Kellogg's, this number is 343.865.466 and it represents the number of shares outstanding of Kellogg's namely the number of shares owned by Kellogg's shareholders.

Giving that, in discussing the journal entries relative to stockholders' equity, we will focus on:

• Issuance of (new) shares
• Stock repurchase
• Payment of dividends

Notice that all these transactions have implications for the balance sheet and the statement of stockholders' equity when all changes in stockholders' equity are recorded.

Starting from the Issuance of (new) shares. We previously mentioned the IPO and the SEO as cases of issuances of new shares. These are particular cases where new shares are issued and sold in the stock market. However, when the firm started its activities, the owner of the firm invested an initial amount of capital to start the business. That amount is included in the common equity, but it is also included in the corporate chapter.

In particular, in the corporate chapter, the company indicates the legal capital namely the capital that will not be touched throughout the life of the firm in order to avoid instances of low capitalization. The legal capital is determined by multiplying the number of shares authorized included in the corporate chapter by the par value namely the nominal value per share established in the corporate chapter. The legal capital is the permanent amount of capital that owners cannot withdraw before the bankruptcy. In the case of Kellogg's, the par value is 0.25$. All changes in common equity are determined by multiplying the existing par value by the number of new shares issued (unless a modification in the corporate charter occurs). Most states require stock to have a par value. The original purpose of this requirement was to protect creditors by specifying a permanent amount of capital that owners could not withdraw before a bankruptcy, which would leave creditors with something in the event that a company did not succeed.

Nevertheless, in subsequent issuance of new shares, the price asked for the new shares can be:

• Price equal to the Par Value, in this case, we recognize an increase in cash and an increase in the common equity for an amount equal to price (which is equal to the par value) multiplied by the number of new shares issued.
• Price higher than the Par Value, in this case, we record an increase in cash equal to the number of new shares issued multiplied by the price. Moreover, we will credit the common equity account by an amount equal to the number of shares multiplied by the Par Value. The difference between the cash received and the increase in common equity will credit the so-called "Additional paid-in capital" account. The "Additional paid-in capital" is one of the components of stockholders' equity (in addition to the common equity, retained earnings and treasury stock) representing the value of the shares issued exceeding Kellogg's par value.
• Price lower than the Par Value, in this case, the firm sells its shares for a price lower than its par value. Thus, we recognize an increase in cash equal to the number of shares multiplied by the price. At the same time, we credit the common equity account for an amount equal to the number of shares multiplied by the par value, as increases in common equity cannot be recognized at a value lower than the par value unless we modify the corporation charter. However, as we charged a price lower than the par value and, hence, we received less cash that the actual increase in common equity, we will debit the "Discount on common equity" account for the difference. The discount on common equity account is a contra-equity to be reported in the balance sheet as an indirect reduction in common equity. Remember that, common equity can be "reduced" only if there is a change in the corporation charter changing the number of authorized shares or the par value. Likewise, the legal capital namely the permanent capital can be withdrawn only in exceptional cases.

Note that the firm's new shares can be purchase by existing shareholders as well as new shareholders. Shareholders can be investors, funds, government but also employees of the firm. In certain cases, firms offer firms' shares as a form of compensation to employees and managers.

As we previously discussed, the company can also decide to repurchase its own shares. In this case, we have a stock repurchase.

There are several reasons why the company decides to repurchase its stock from existing stockholders. A common reason is to provide employees bonus plans based on firms' shares and avoid dilution effect. When the company repurchases its stock from existing shareholders, the shares that have been repurchased are held by the corporation and have no voting or cash flow rights.

Even if the company purchases its own shares, the treasury stock is not reported as an asset as the firm cannot own itself. Instead, the treasury stock will be included in the balance sheet as a component of the stockholders' equity with a negative sign. Indeed, the treasury shares are shares issued but not outstanding. Thus, it will appear in the balance sheet as a separate account of the stockholders' equity and, in particular, as a contra-equity account.

What happens when the firm sells the repurchased shares?

• If the price is higher than that paid at the moment of repurchase, then cash is increased, treasury stock is reduced and the difference between the two is compensated increasing the additional paid-in capital.
• If the price is lower than that paid at the moment of repurchase, cash is increased, treasury stock is reduced and the difference between the two is compensated decreasing the additional paid-in capital.

One of the rights provided by shares is the right to periodically receive dividends. Shareholders invest into the firm because they expect to gain a return from their investment. Such return has two forms:

• Stock Price Appreciation (difference between the price paid for obtaining the share and the price at which shares are sold).
• Dividends

Firms have diverse dividend policies: some firms regularly distribute dividends while others are less likely to do so (Apple).

The decision to distribute dividends or not is quite sticky over time and it depends on firms' characteristics and strategies. For instance, high-tech firms are less likely to pay dividends as they will use the profits generated to make the new investments and keep their growth.

Nevertheless, the dividend policy of the firm is a relevant factor that investors consider when they have to decide in which firm they want to invest. Indeed, some investors prefer firms that regularly pay dividends as they assure a steady income. Others may prefer capital gains.

In the case of Kellogg's, the firm regularly paid dividends as you can see from the statement of stockholders' equity and from the Kellogg's website.

Kellogg's declared its latest dividend on 21 February 2020. The announcement points out the dividend policy of Kellogg's characterized by frequent dividend payments. In the announcement, there are 3 relevant dates:

• February 21, 2020. This is the declaration date namely the date when the board of directors officially approves the dividend. Note that when the dividend is declared, the company has a legal obligation to pay that dividend. The corporation will make a journal entry to record this decision. In particular, it will recognize a reduction in retained earnings and a new liability (dividend payable) is created.
• March 3, 2020. This is the date of record namely it is the date on which the company prepares the list of shareholders who will receive the dividend payment. For this date, no journal entry is required.
• March 16, 2020. This is the date of payment namely the date when the dividend will be paid for cash. The corporation will make a journal entry to recognize the decrease in cash and the settlement of the liability towards the shareholders.

Thus, the dividend payment leads to a decrease in cash and a decrease in retained earnings. Hence, in order to pay the cash dividend, the firm needs to have:

• Enough retained earnings namely the company needs to generate net income now and/or in the past. If the firm is not able to generate profits, no dividend can be distributed.
• Sufficient cash. The availability of cash is fundamental for the firm to pay dividends as the lack of cash does not allow the firm to settle its obligation towards the shareholders.