Management Of Shareholders Equity

Introduction

Shareholders’ equity is the interest of the shareholders, or owners, in the assets of a company, and at any time is the cumulative net result of past transactions affecting this segment of the balance sheet. This equity is created initially by the owner’s investment in the entity, and may be increased from time to time by additional investments, as well as by net earnings. It is reduced by distributions of the equity to the owners (usually as dividends). Further, it may also decrease if the enterprise is unprofitable. When all liabilities are satisfied, the balance the residual belongs to the owners.

Basic accounting concepts govern the accounting for shareholders’ equity as a whole, for each class of shareholder, and for the various segments of the equity interest, such as capital stock, contributed capital, or earned capital. This chapter does not deal with the accounting niceties regarding the ownership interest. It is assumed the controller is well grounded in such proper treatment, or will become so. The concerns relate to the shareholders’ interest as a total and not any special accounting segments.

Importance Of Shareholders Equity

As previously stated, capital structure is composed of all long term obligations and shareholders’ equity in a sense, the “permanent” capital. Some would describe the capital structure of the enterprise as the cornerstone of financial policy. Such policy must be so planned that it will command respect from investors far into the future. But of the two basic elements, it is the shareholders’ equity that is critical. This equity must provide a margin of safety to protect the senior obligations. Stated another way, in most instances, without the shareholders’ equity, no senior obligations could be issued. It is for this reason, among others, that proper management of the equity is of paramount importance. In a sense, the controller, together with other members of financial management, must safeguard the long-term financial interests of not only the shareholders but also the providers of long-term credit, to say nothing of the sources of short-term capital such as commercial banks and suppliers. This is accomplished, in part, by properly planning and controlling the equity base of the enterprise.

Role Of The Controller

Given the importance of shareholders’ equity and the need to manage it prudently, what should be the role of the controller? In a general sense, as one of the principal financial officers of the corporation, the controller must properly account for the shareholders’ equity, providing those analyses and recommending those actions that are consistent with enhancing shareholder value over the long term. The task would require attention to these specific actions :

>	Properly accounting for the shareholders’ equity in accordance with generally accepted accounting principles (GAAP). This includes the historical analysis of the source of the equity and the segregation of the cumulative equity by class of shareholder.
>	Preparing the appropriate reports on the status and changes in shareholders’ equity as required by agencies of the U.S. government (e.g., Securities and Exchange Commission), by management, and by credit agreements and other contracts
>	Making the necessary analyses to assist in planning the most appropriate source (debt or shareholders’ equity) of new funds, and the timing and amount required of each.
>	As appropriate, maintaining in proper and economical form the capital stock records of the individual shareholders, with the related meaningful analysis (by nature of Owner individual, institution, and so forth by geographic area, by size of holding, etc.) or assuring that it is done. (In larger firms, a separate department or an outside service might perform these functions.)
>	Periodically making the required analysis, reporting on, and making recommendations or observations on such matters as :
	-	Dividend policy
	-	Dividend reinvestment plans
	-	Stock splits or dividends
	-	Stock repurchase
	-	Capital structure
	-	Trend and outlook for earnings per share
	-	Cost of capital for the company and industry
	-	Tax legislation as it affects shareholders
	-	Price action of the market price of the stock, and influences on it

Plainly, there is a grassland of financial subjects on which the controller can graze and in due course make useful suggestions.

Before a discussion of specifics about the planning phases regarding shareholders’ equity, some interesting relationships should be understood :

-	Rate of growth in equity as related to the return on equity (ROE)
-	Growth in earnings per share as related to ROE
-	Cost of capital
-	Dividend payout ratio
-	Relationship of long term debt to equity

Growth Of Equity As A Source Of Capital

As a company grows, it usually requires additional funds to finance working capital and plant and equipment, as well as for other purposes. Of course, it could issue additional shares of stock, but this might dilute earnings per share for a time or perhaps raise questions of control. Another alternative is to borrow long-term funds. Some managements may wish to do neither. As a result, the remaining source of long-term capital (excluding some assets sales, etc.) is the growth in retained earnings. But such a method is typically a slow way to gain additional capital. The rate of growth of equity is germane to establishing target rates of return on equity, selecting sources of capital, and monitoring dividend policy.

Return On Equity As Related To Growth In Earnings Per Share

Another facet of the shareholders’ equity role is the relationship of the ROE to the rate of annual increase in earnings per share (EPS). This connection is often not understood even by some financial executives. Basically, the rate of return on shareholders’ equity, when adjusted for the payout ratio, produces the rate of growth per year in EPS.

Growth In Earnings Per Share

Prudent financial planning will consider the impact of decisions on EPS. Management is concerned with the growth in EPS since one of its tasks is to enhance shareholder value. And continual increases in EPS each year will raise shareholder value through its recognition in a higher P/E ratio and usually a rising dividend payment. Moreover, the growth in EPS is one of the measures of management as viewed by the financial community, including financial analysts.

Given the importance of EPS, financial officers should bear in mind that the EPS will increase as a result of any one of these actions :

-	The plow-back of some share of earnings, even as long as the rate of return on equity remains just constant
-	An actual increase in the rate of return earned on shareholders’ equity
-	Repurchase of common shares as long as the rate of return on equity does not decrease
-	Use of prudent borrowing
-	Acquisition of a company whose stock is selling at a lower P/E than the acquiring company
-	Sale of shares of common stock above the book value of existing shares, assuming the ROE is maintained

Cost Of Capital

Investors are willing to place funds at risk in the expectation of recovering such capital and making a reasonable return. Some individuals or companies might prefer to invest in a practically risk free security, such as U.S. government bonds; others will assume greater risks but expect a correspondingly higher rate of return. Cost of capital, then, may be defined as the rate of return that must be paid to investors to induce them to supply the necessary funds (through the particular instrument under discussion). Thus, the cost of a bond would be represented by the interest payments plus the recovery of the bond purchase price, perhaps plus some capital gains. The cost of common shares issued would be represented by the dividend paid plus the appreciation of the stock. Capital will flow to those markets where investors expect to receive a rate of return consistent with their assessment of the financial and other risks, and a rate that is competitive with alternative investments.

Knowledge of the cost of capital is important for two reasons :

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The financial manager must know what the cost of capital is and offer securities that provide a competitive rate, in order to be able to attract the required funds to the business.

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In making investment decisions, such as for plant and equipment, the financial manager must secure a return that is, on average, at least as high as the cost of capital. Otherwise, there is no reason to make an investment that yields only the cost or less. The manager is expected to gain something for the shareholder. Hence, the cost of capital theoretically sets the floor as the minimum rate of return before any investment should even be considered.

Prudent management of the shareholders’ equity, then, involves :

-	Attempting to finance the company so as to achieve the optimum capital structure, and, hence, a reasonable cost of capital
-	Properly determining the cost of capital, and employing such knowledge in relevant investment decisions

Components Of Cost Of Capital

Before determining the amount of a company’s cost of capital, it is necessary to determine its components. The following two sections describe in detail how to arrive at the cost of capital for these components. The weighted average calculation that brings together all the elements of the cost of capital is then described in the “Calculating the Weighted Cost of Capital” Section.

 The first component of the cost of capital is debt. This is a company’s commitment to return to a lender both the interest and principal on an initial or series of payments to the company by the lender. This can be short-term debt, which is typically paid back in full within one year, or long-term debt, which can be repaid over many years, with either continual principal repayments, large repayments at set intervals, or a large payment when the entire debt is due, which is called a balloon payment. All these forms of repayment can be combined in an infinite number of ways to arrive at a repayment plan that is uniquely structured to fit the needs of the individual corporation.

 The second component of the cost of capital is preferred stock. This is a form of equity that is issued to stockholders and that carries a specific interest rate. The company is obligated to pay only the stated interest rate to shareholders at stated intervals, but not the initial payment of funds to the company, which it may keep in perpetuity, unless it chooses to buy back the stock. There may also be conversion options, so that a shareholder can convert the preferred stock to common stock in some predetermined proportion. This type of stock is attractive to those companies that do not want to dilute earnings per share with additional common stock, and that also do not want to incur the burden of principal repayments. Though there is an obligation to pay shareholders the stated interest rate, it is usually possible to delay payment if the funds are not available, though the interest will accumulate and must be paid when cash is available.

 The third and final component of the cost of capital is common stock. A company is not required to pay anything to its shareholders in exchange for the stock, which makes this the least risky form of funding available. Instead, shareholders rely on a combination of dividend payments, as authorized by the Board of Directors (and which are entirely at the option of the Board  authorization is not required by law), and appreciation in the value of the shares. However, since shareholders indirectly control the corporation through the Board of Directors, actions by management that depress the stock price or lead to a reduction in the dividend payment can lead to the firing of management by the Board of Directors. Also, since shareholders typically expect a high return on investment in exchange for their money, the actual cost of these funds is the highest of all the components of the cost of capital.

As will be discussed in the next two sections, the least expensive of the three forms of funding is debt, followed by preferred stock and common stock. The main reason for the differences between the costs of the three components is the impact of taxes on various kinds of interest payments. This is of particular concern when discussing debt, which is covered in the next section.

Calculating The Cost Of Debt

This section covers the main factors to consider when calculating the cost of debt, and also notes how these factors must be incorporated into the final cost calculation. We also note how the net result of these calculations is a form of funding that is less expensive than the cost of equity, which is covered in the next section.

 

Calculating The Cost Of Equity

This section shows how to calculate the cost of the two main forms of equity, which are preferred stock and common stock. These calculations, as well as those from the preceding section on the cost of debt, are then combined in the following section to determine the weighted cost of capital.

 

Calculating The Weighted Cost Of Capital

Now that we have derived the costs of debt, preferred stock, and common stock, it is time to assemble all three costs into a weighted cost of capital. This section is structured in an example format, showing the method by which the weighted cost of capital of the Canary Corporation is calculated. Following that, there is a short discussion of how the cost of capital can be used.

Dividend Policy

Dividend policy is a factor to be considered in the management of shareholders’ equity in that :

-	Cash dividends paid are the largest recurring charge against retained earnings for most U.S. corporations.
-	The amount of dividends paid, which reduces the amount of equity remaining, will have an impact on the amount of long-term debt that can be prudently issued in view of the long-term debt to equity ratio that usually governs financing.
-	Dividend payout is an influence on the reception of new stock issues.
-	Dividend policy is an element in most loan and credit agreements with restrictions on how much may be paid.

To Pay or Not to Pay Cash Dividends?

If a company has discontinued cash dividends, for whatever reason, or if a corporation has never paid a cash dividend, then most readers would appreciate the desirability of discussing whether cash dividends should be paid. However, even if cash dividends are now being disbursed, the question should be considered

Dividend payments are determined by a number of influences, including :

-	The need for additional capital for expansion or other reasons
-	Cash flow of the enterprise
-	Industry practice
-	Shareholders’ expectations

Dividend payment practices send a message to the financial community, and investors and analysts accept the pattern as an indication of future payments. Hence, when a dividend payment rate is set, a dividend reduction should be avoided if at all possible. Dividend payment patterns may follow any one of several, such as :

-	A constant or regular quarterly payment
-	A constant pattern with regularly recurring increases perhaps the same quarter each year
-	A constant pattern with irregular increases
-	A constant pattern with period extras so as to avoid committing to regular increases In planning, any erratic pattern should be avoided.

Long Term Debt Ratios 

There are two principal ratios used by rating agencies and the financial marketplace in judging the debt worthiness (or the value of equity) of an enterprise :

1.	Ratio of long-term debt to equity
2.	Ratio of long-term debt to total capitalization.

Other Transactions Affecting Shareholders Equity

In the management of shareholders’ equity, any actions that are expected to impact this element of the financial statements should be reflected in the plans the annual plan or the long range plan, as may be appropriate. While earnings and dividends have been discussed, there are a host of other transactions that might be involved, including :

-	Repurchase of common shares
-	Conversion of preferred shares or convertible debentures
-	Dividend reinvestment programs
-	Exercise of stock options
-	New issues of shares
-	Special write-offs or adjustments

Before approving any such actions or agreements on such matters, the management should consider their impact on debt capacity, especially where debt ratios already are high.

Long Term Equity Planning

For those entities with a practical financial planning system, the long term planning sequence might be something like this :

-	The company financial management has determined, or determines, what is an acceptable capital structure and gets the agreement of management and the board of directors.
-	As a step in the long-range financial planning, the amount of funds required in excess of those available is determined by year, in an approximate amount.
-	Based on the needs over several years, the desired capital structure, the relative cost of each segment of capital (debt or equity), the cost of each debt issue, and any constraints imposed by credit agreements, or the judgment of management, the long term fund requirements are allocated between long-term debt and equity.
-	For the annual business plan, any actions deemed necessary in the first year of the long range plan are incorporated with the other usual annual transactions to form the equity budget for the year.

Other Suggestions in Managing the Capital Structure

The “Long-Term Equity Planning” Section provides guidance in allocating required funds annually between debt and equity. The disposition depends on the urgency of attaining a given preferred capital structure, or meeting debt indenture constraints, or other limitations. But managing the capital structure involves more than allocating the new capital needs between debt and equity. It also includes watching for signals that funding problems are slowly (or faster) developing, as well as providing safeguards against unwarranted action by the suppliers of funds.

Short Term Plan For Shareholders Equity 

In terms of management of shareholders’ equity, the emphasis should be on planning  especially long-term planning so as to achieve the proper capital structure and use it as the basis for prudent borrowing. Additionally, the many other aspects already discussed need to be reviewed, and policies and practices developed or continued that will enhance the shareholders’ value.

 

Other Considerations

Dividend Reinvestment Programs

A supplementary facet of dividend policy is the question of offering a dividend reinvestment plan to investors. Under such a plan, shareholders may invest their cash dividends in the common stock of the company sometimes at market price, usually with no brokerage fee, and sometimes at a discount, that is, 5% of the market price. Many dividend investment marketing plans utilize shares purchased in the open market. Others permit the issue of original shares directly by the company.

 

Stock Dividends and Stock Splits

This chapter is not intended to be a treatise on the types of stocks that may be issued or their advantages or disadvantages, and the many related subjects. However, the controller should be aware of the accounting treatment of stock dividends as well as stock splits and the arguments for and against the issuance of such designated shares.

Basically, the New York Stock Exchange has ruled that the issuance of 25 % or less of stock is a stock dividend and that the issuance of more than 25 % is a stock split. Both are essentially paper transactions that do not change the total equity of the company but do increase the number of pieces or shares. However, depending on state law, the accounting treatment may differ. Thus a stock split may not change retained earnings; only the par or stated value is changed. A stock dividend may cause the paid-in-capital accounts and retained earnings to be modified (but not the total equity). The controller should be aware of the pros and cons, the expense involved, and the procedure for issuance of dividends, or splits, or reverse splits.

Repurchase of Common Shares

Another subject to be considered by the financial management is the repurchase of common shares. Conceptually, a company is enfranchised to invest capital in the production of goods or services. Hence it should not knowingly invest in projects that will not provide a sufficiently high rate of return to adequately compensate the investors for the risk assumed. In other words, the enterprise should not invest simply because funds or capital are available. Business management should identify sufficiently profitable projects that are consistent with corporate strategy, determine the capital required, and make the investment. Hence shareholders might interpret the purchase of common stock as the lack of available investment opportunities. To some, the purchase of company stock is not an “investment” but a return of capital. It is “disfinancing.

 

Capital Stock Record

An administrative concern in the management of shareholders’ equity relates to the maintenance of necessary capital stock records. In the larger companies, the stock ledgers and

transfer records are kept by the transfer agent. The information relative to payment of dividends on outstanding shares, for example, is secured from this source. Quite often, the database is contained on computer files, and any number of sortings can produce relevant data regarding ownership :

-	Geographic dispersion
-	Nature of owners (individual, institution, etc.)
-	History and timing of purchases
-	Market price activity
-	Volume of sales and the like