Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 11 Stockholders’ Equity: Capital Stock and Dividends 505

earnings per share would increase from $1.46 in the base case to $1.58 ($840,000 ÷

530,000 shares, rounded). This increase in earnings per share is termed accretion.

The second column shows the earnings per share from issuing bonds. In addition

to the $180,000 return on investment, the bond interest expense of $150,000 (10% 

$1,500,000) must be deducted from the EBIT before deducting taxes. The net income

after deducting taxes would be $750,000. With bond financing, the number of common

shares outstanding would remain unchanged. Thus, the earnings would be $1.50 per

share ($750,000 ÷ 500,000 shares). As can be seen in this example, the bond alternative

avoids dilution.^6 For bond financing, the EPS will fall below the no financing option

(third column) whenever the return on investment is less than the interest on the

bonds. Thus, firms would not borrow money to invest in projects with investment

returns less than the interest rate.

ACCOUNTING FOR DIVIDENDS

When a board of directors declares a cash dividend, it authorizes the distribution of a

portion of the corporation’s cash to stockholders. When a board of directors declares

a stock dividend, it authorizes the distribution of a portion of its stock. In both cases,

the declaration of a dividend reduces the retained earnings of the corporation.^7

Cash Dividends

A cash distribution of earnings by a corporation to its shareholders is called a cash

dividend. Although dividends may be paid in the form of other assets, cash dividends

are the most common form.

$15 per Share

Common Stock 10% Bond No

Financing Financing Financing

Earnings before interest and

taxes—base case (EBIT) $1,220,000 $1,220,000 $1,220,000

Return on investment

(12%$1,500,000) 180,000 180,000 —

Interest on bonds

(10%$1,500,000) — (150,000) —

Earnings before taxes $1,400,000 $1,250,000 $1,220,000

Income tax (@40%) 560,000 500,000 488,000

Net income $ 840,000 $ 750,000 $ 732,000

Base number of shares outstanding 500,000 500,000 500,000

Plus additional shares issued 100,000

Total shares outstanding 600,000 500,000 500,000

Earnings per share (EPS) $ 1.40 $ 1.50 $ 1.46

Exhibit 5

Common Stock and

Bond Financing

Alternatives on

Earnings per Share

Describe the financial
statement effects of cash
dividends and stock
dividends.

7

6 A bond or other security that avoids dilution is also called “antidilutive.”

7 In rare cases, when a corporation is reducing its operations or going out of business, a dividend may be

a distribution of paid-in capital. Such a dividend is called a liquidating dividend.