Page 105 - DCOM201_ACCOUNTING_FOR_COMPANIES_I

Accounting for Companies-I

Notes  Stockholders’ equity decreases from $500,000 to $300,000 — a reduction of 40 percent.
 Leverage increases from 200 percent ($1 million total debt divided by $500,000
equity) to 333 percent ($1 million debt divided by $300,000 equity). This assumes
that no additional capital was borrowed to finance the stock repurchase. If that were
necessary, the debt-to-equity ratio would have risen even higher.
Effect on Remaining Owners
The remaining stockholders increase their ownership percentages. Since 20,000 shares are
in treasury, a stockholder owning 10,000 of the remaining 80,000 shares will now own 12.5
percent of the corporation (10,000 shares divided by 80,000). Before the purchase, this
stockholder owned 10 percent (10,000 shares divided by 100,000). The percentage ownership
position of all stockholders will increase by 25 percent.

Book value per share declines from $5 to $3.75–$300,000 pro forma (after repurchase)
stockholders’ equity position divided by 80,000 shares. The proforma decline in book
value occurs because the buy-back price of $10 per share was double the previous book
value per share of $5 ($500,000 stockholders’ equity divided by 100,000 shares). That’s why
other minority stockholders may not be in favor of the transaction – unless they also are
given the right to sell shares back to the company on the same terms.

Based on last year’s net income of $75,000, earnings per share would increase from $0.75 to
$0.94 ($75,000 net income divided by 80,000 shares). But note that if debt is used to finance
the stock purchase, pretax income (and net income) should be adjusted downward to
reflect the resulting interest expense. Company cash is being used for nonproductive
purposes. This may significantly impact the company’s future growth and its profitability
and, as explained below, can negatively impact the company’s borrowing ability.
Finally, the tax basis of each share of stock owned by the remaining shareholders remains
unchanged despite the fact that the value of each share has risen due to the lower number
of shares outstanding. When the remaining shareholders sell their shares, as if the entire
company were sold, the taxable gain will be greater than it would have been had the
buyout of the 20 percent owner been effected by a direct purchase from the shareholders.
Such a purchase would have required the shareholders to use personal funds to effect the
purchase, but a step-up in the basis of the stock would have occurred and the tax owed in
a subsequent sale would be less.
Effect on Company’s Value
Since $200,000 is purchasing 20 percent of this company, the value placed on the business
is $1 million ($200,000 divided by .20). In terms of fundamental valuation methods, this $1
million value represents:

 A price-earnings multiple (P/E) of 13.3 times last year’s net income of $75,000.
 2.0 times stockholders’ equity of $500,000 before the stock repurchase.
 3.3 times stockholders’ equity of $300,000 after the stock repurchase.

This value analysis is presented to give you additional information to help you in deciding
whether or not to effect the buyout. You also will have to determine the value of the
company going forward. For example, if this company were projecting net income of
$150,000 next year, the $1 million value would represent a P/E multiple of only 6.7. This
alone could justify the stock repurchase, particularly if the company’s growth continues
on course.
Contd...

98 LOVELY PROFESSIONAL UNIVERSITY