Common Equity Others | Corporate Finance | Part 2 | Section B | Episode 15 | CMA USA

Welcome back to CMA USA Exam Coach, your trusted study companion on your journey to CMA success. In the previous episode, we discussed common shares, their features, valuation, dividend models, and the cost of equity. Today, in this new episode, we are moving one step ahead and exploring other equity items that are part of a company's capital structure, but are often overlooked. So, what are we going to cover in this episode? We'll begin by understanding what other equity items are and how they differ from common shares. We'll take a closer look at important components such as treasury stock, retained earnings, additional paid-in capital, dividend, dividend policy, and stock split, stock right, warrants, and ADRs, finally benefit, and limitation of common shares. We'll learn what each of these items represents on the balance sheet and how they impact a company's financial position and shareholder value. By the end of this lesson, you'll be able to identify, explain, and evaluate each equity component in detail, all of which are crucial for your CMA USA Exam and real-world financial analysis. So, let's get started and build a strong foundation in equity accounting beyond just common shares. Before we dive deep into the details, let's quickly review the key equity items that are usually reported on the equity section of a company's balance sheet. These include common shares, preference shares, retained earnings, additional paid-in capital, often abbreviated as APIC, and treasury stock. These are the standard equity components you'll find in most corporate financial statements. We've already covered preference shares and common shares in our previous lessons, including their features, valuation models, and how they affect ownership and income distribution. Now, in this episode, we'll begin by understanding treasury stock and then move on to other important components like retained earnings and additional paid-in capital. Let's start with treasury stock, what it means, why companies buy back their own shares, and how it is reported in the financial statements. Now let's explore a crucial yet often misunderstood equity item, treasury stock. Treasury stock refers to the company's own shares that were once issued to investors, but later repurchased by the company from the open market. These shares are held by the company itself, and they are not considered outstanding shares anymore. That's why we call treasury stock a contra-equity account. It works in the opposite direction of common shares. While issuing new shares increases shareholders' equity, buying back shares reduces it. Let's take a quick look at the accounting entries to understand this clearly. When a company issues shares, the entry is debit to cash or bank, credit to common stock, and any amount received above the par value is credited to additional paid-in capital or APIC. But when the company buys back its own shares, the entry is debit to treasury stock and credit to cash based on the repurchase price. Now let's understand why companies repurchase their own shares and why treasury stock exists in the first place. There are several strategic reasons for a share buyback. First, to reduce the number of shares outstanding. When fewer shares are in circulation, metrics like earnings per share, or EPS, often improve, making the stock more attractive to investors. Second, to increase the market price of shares. By reducing supply, the company can influence demand and push the price higher, especially if the stock is currently undervalued. Third, to return excess cash to shareholders in a tax-efficient way. Instead of paying out dividends, the company may buy back shares as a form of indirect shareholder benefit. Fourth, companies may repurchase shares to meet the requirements of employee stock option plans or stock-based compensation. If the shares are perceived as undervalued, the company might buy them back to signal confidence in its own future prospects. And finally, treasury shares may also be used for stock dividends or to be reissued in the future for acquisitions, mergers, or other financing needs. But it's important to remember a few key facts. Treasury shares do not receive dividends because the company cannot pay itself. They also do not carry voting rights, so they don't influence board decisions or corporate resolutions. And most importantly, they are not counted as outstanding shares. That means they are excluded from calculations such as EPS, dividend per share, and market capitalization. In conclusion, treasury stock is not an asset. It is a contra-equity account that plays a major role in a company's financial and strategic planning. It represents previously-issued shares that are now temporarily held by the company for a variety of business and financial reasons. Now let's move on to another important equity item known as additional paid-in capital, or simply APIC. Additional paid-in capital represents the excess amount paid by investors over the par value of a company's shares. It is part of shareholders' equity and is often seen when a company issues shares at a price higher than their par value. Let me explain this with a simple scenario. Suppose a company issues common shares with a par value of $1 but sells them for $5 each. The extra $4 received from investors, over and above the par value, is recorded as additional paid-in capital. The journal entry for this would look like debit to cash for the total amount received, credit to common stock for the par value multiplied by the number of shares, and credit to APIC for the remaining balance, which is the premium over par. This APIC amount is reported separately under the equity section of the balance sheet, usually right below common stock. It's important to understand that APIC represents capital that shareholders have contributed to the company, but it is not tied to operating profits or retained earnings. It is purely based on initial investment during share issuance. Also note, once shares are issued, the APIC amount stays fixed. It doesn't change with stock price movements in the market. If the share price goes up or down after issuance, it affects market capitalization, but not the APIC on the books. Another important point, APIC is only created when new shares are issued by the company. If investors buy shares from other investors in the secondary market, no APIC is created. It only applies to primary market transactions where the company directly receives the funds. To sum up, additional paid-in capital reflects the confidence investors have in the company, because they are willing to pay more than the nominal value of the shares. It strengthens the company's equity position and is a useful source of funding, especially in the early stages of growth. Let's take a closer look at retained earnings, a very important component of shareholders' equity. Retained earnings represent the accumulated portion of net income that a company has chosen not to distribute as dividends to shareholders. Instead, these earnings are retained or kept within the company to be reinvested in the business, used to pay down debt or held as a reserve for future needs. Each year, when a company prepares its income statement, the final figure at the bottom, net income or net loss, flows into retained earnings at the end of the financial year. This happens through a closing journal entry that transfers the net profit or loss from the income summary to the retained earnings account in the equity section of the balance sheet. If the company earns a profit, that amount increases retained earnings. If the company experiences a loss, the retained earnings balance is reduced. And when losses accumulate over multiple years, the company may even show a negative retained earnings balance, which is often referred to as an accumulated deficit. Retained earnings continue to accumulate year over year, building a history of the company's earnings that have been reinvested rather than paid out. This accumulation reflects the company's long-term profitability and financial health. Now, it's important to understand that although retained earnings belong to the shareholders, they are not distributed automatically. The company's board of directors must formally approve any distribution in the form of dividends. Only then can a portion of the retained earnings be used to pay dividends to the shareholders. These dividends may be in the form of cash dividends or stock dividends, and both will result in a reduction of retained earnings. For cash dividends, retained earnings are reduced by the cash amount paid out. For stock dividends, retained earnings are reduced by the fair value or par value of the additional shares issued, depending on the accounting policy. Let's now quickly understand the basic equation for Retained earnings equals opening retained earnings plus net income, or loss for the current period, minus cash dividends, minus stock dividends. This equation simply shows how the retained earnings balance is updated each year. We begin with the opening balance of retained earnings, which is the amount carried forward from the previous year. To this, we add the net income for the current year if the company made a profit, or subtract the net loss if the company had a loss. Then we subtract any dividends declared during the year. This includes both cash dividends and stock dividends because both reduce the portion of profits retained in the company. The result is the closing retained earnings, which appears in the equity section of the balance sheet. So this formula helps us track how much profit the company has kept after rewarding shareholders, and how it builds up or reduces over time based on performance and dividend policies. So in summary, retained earnings are the cumulative profits that remain in the company after dividend payments, and they serve as an essential source of funding for future growth, stability, and shareholder value. They grow when the company is profitable and shrink when there are losses or when dividends are declared. In our next slide, we'll take a deep dive into dividends, how they are declared, paid, and how they impact the company's financial statements. In the previous slide, we learned how retained earnings are accumulated and adjusted each year based on a company's net income and dividend payments. Now, it's time to explore the next set of important equity-related topics. In this new section, we will be discussing three key concepts, dividends, dividend policy, and stock splits. These are essential topics, not only from an exam point of view, but also to help you understand how companies return value to their shareholders and how these actions impact the financial statements. Each of these topics will be discussed in detail in the upcoming slides, with clear explanations, formulas, and practical examples to support your learning. So let's begin by first understanding the concept of dividends. Let's now begin our discussion on dividends, a fundamental concept in corporate finance and a key component of shareholder returns. So what exactly is a dividend? A dividend is a portion of the company's profits, a share of the success that the business chooses to distribute to its shareholders. It's a way of saying, thank you for believing in us, here's your share of our growth. Dividends are not mandatory. They are voluntary, declared by the board of directors, and they come only after the company has met its obligations and decided how much of the profit to keep for future growth. Now, let's dive into the two main types of dividends, cash dividends and stock dividends. First, we have the cash dividend. This is the classic, most common form. If a company earns well and has healthy cash flow, it may distribute part of its profit directly to shareholders in the form of cash. For example, if you own 100 shares and the dividend declared is $1 per share, you get a cool $100 in your account. Simple, satisfying. But remember, this reduces the company's cash reserves and also decreases retained earnings. Then comes the stock dividend, a non-cash reward. Instead of giving you money, the company gives you more shares. If you owned 100 shares and there's a 10% stock dividend, you now own 110 shares. While your total ownership percentage may not change, the number of shares increases and each share's price adjusts accordingly. Stock dividends are often used when companies want to reward shareholders but prefer to conserve cash for operations or investments. Now that we understand dividends, let's talk about the dividend policy, the company's official approach to distributing profits. A company doesn't just wake up one morning and decide to pay dividends. This decision is driven by a strategic framework known as dividend policy. A sound dividend policy answers critical questions like, should we pay dividends at all? How much should we pay? Should we keep it consistent or link it to profits? The ultimate goal? To maximize shareholder wealth. You see, when dividends are paid regularly and sustainably, investors feel secure. Confidence in the company increases. And this confidence is reflected in the share price, which rises. So yes, a good dividend policy can literally boost the market value of the company. But several factors influence the dividend policy. First, profitability. A company must have sufficient and consistent earnings to pay dividends. Second, cash availability. Profits on paper don't always mean cash in hand. A company needs liquidity to distribute dividends. Third, future growth needs. If there are lucrative investment opportunities, the company might retain profits instead of paying them out. Fourth, earnings stability. Companies with steady earnings tend to maintain stable dividends. Fifth, legal and contractual restrictions. Laws and loan agreements might limit dividend payments. And sixth, tax considerations. The taxation system in a country may affect whether dividends are preferred over capital gains. So to sum it up, dividends are a key part of shareholder return. The decision to distribute them is not just financial, but strategic and aligned with the company's long-term vision. Next, we're going to learn about some important dates related to dividends. Key milestones that every CMA student, investor, and corporate finance professional must understand. Let's start with a brief introduction. When it comes to dividends, it's important to understand that management does not have the authority to declare a dividend on its own. The power to declare dividends lies exclusively with the board of directors. During a formal board meeting, if they find that the company has sufficient retained earnings and liquidity, the board may approve and declare a dividend. Now let's walk through the four important dates that follow this decision. First, the declaration date. This is the date when the board of directors officially announces the dividend. On this date, the company makes a legal commitment to pay the dividend. It also records a liability in the books, reducing retained earnings and increasing dividends payable. This is the starting point of the entire dividend process. Next is the ex-dividend date. This is a critical date from an investor's perspective. The ex-dividend date is the cut-off date that determines who qualifies to receive the dividend. If an investor purchases the stock on or after the ex-dividend date, they will not receive the upcoming dividend. Only those who own the stock before this date will be eligible. This is because trades take two business days to settle, and we'll see why that matters in the next point. Third, the record date. This is the date on which the company will check its records to determine the list of shareholders eligible to receive the dividend. Only those whose names appear on the company's shareholder register on the record date will get the dividend. Now you can see why the ex-dividend date comes before the record date. It allows time for the stock transaction to settle and the buyer's name to be recorded. Finally, the payment date. This is the day the company actually distributes the dividend to the shareholders, either by direct deposit, check, or crediting it to their brokerage accounts. So to recap, the declaration date is when the board announces the dividend. The ex-dividend date is the last day to buy the stock and still receive the dividend. The record date determines who is officially entitled to receive the dividend, and the payment date is when the money is actually paid out. These four dates define the timeline of a dividend, and understanding them is essential for both investors and finance professionals. Let's walk through the accounting treatment of dividends, focusing on the journal entries for both cash dividends and stock dividends, using simple examples. We'll begin with cash dividends. Let's assume a company declares a cash dividend of $1 per share, and it has 10,000 shares outstanding. That means the total dividend to be distributed is $10,000. Now, at the time of declaration, the company records the following journal entry. Retained earnings will be debited by $10,000, and dividends payable will be credited by $10,000. This entry is made to reflect the obligation created to pay the dividend in the future. The company is reducing its retained earnings and creating a liability. Then, when the dividend is actually paid to the shareholders, we make the second journal entry. Dividends payable is debited by $10,000 to remove the liability, and cash is credited by $10,000 to reflect the outflow of funds. This completes the accounting for a cash dividend. Now, let's look at stock dividends. Let's say a company declares a 10% stock dividend. It has 10,000 shares outstanding. That means it will issue 1,000 new shares as a dividend. Assume the market value per share is $15. So, the total value of the stock dividend will be 1,000 shares multiplied by $15, which equals $15,000. At the time of declaration, the company will debit retained earnings by $15,000. It will credit common stock dividend distributable by $1,000, which represents the par value of the 1,000 new shares to be issued. Let's assume the par value per share is $1. The remaining amount, which is $14,000, is credited to additional paid-in capital, or APIC. This represents the excess of the market value over the par value. This entry reflects the reduction in retained earnings and the commitment to issue new shares. Later, when the company actually issues the new shares, it will debit common stock dividend distributable by $1,000 and credit common stock by $1,000. This final step moves the amount from a temporary holding account into the permanent equity account for common stock. And that's how we account for both cash dividends and stock dividends. Remember, cash dividends reduce both retained earnings and cash, while stock dividends reduce retained earnings and increase the equity in the form of common stock and APC. Again, if the company declares a dividend on December 30th and the payment is scheduled for January 25th of the next year, the accounting entry to debit retained earnings and recognize the dividend payable must still be recorded in December itself. This is because the obligation to pay the dividend arises on the declaration date, not the payment date. Now let's talk about property dividend, another form of dividend distribution made by a company. Unlike cash dividends or stock dividends, a property dividend is paid not in cash or shares, but in the form of non-cash assets. This could include real estate, inventory, or investments in other companies. Basically, any non-cash item the company owns and chooses to distribute to its shareholders. Why would a company issue a property dividend? There are several reasons. It might want to conserve cash, or perhaps it holds assets that are not strategic anymore and wants to return value to shareholders through those assets. Let's take a simple example to understand this better. Imagine a company holds shares in another listed company worth $50,000. Instead of selling those shares for cash, the company decides to directly distribute them to its own shareholders as a dividend. This action is called a property dividend. One important point. Before distributing the asset, the company must first adjust the asset to fair market value and recognize any gain or loss in its books. This is different from cash or stock dividends, which don't usually involve such revaluation. So, property dividends are a less common but perfectly valid way of rewarding shareholders, especially when cash flow is tight or when the company wants to offload non-core assets. Now let's understand liquidating dividends. A liquidating dividend is not a regular dividend paid from profits. Instead, it is a return of capital to shareholders. That means the company is giving back part of the money that the shareholders originally invested. This usually happens when a company is winding down its operations, selling off assets, or returning excess capital that it no longer needs. It's often seen during partial or full liquidation of a business. Unlike a normal dividend, a liquidating dividend reduces the contributed capital on the company's balance sheet. It is not considered income for the investor, but rather a reduction in their investment. Let's look at a simple example. Suppose a company decides to shut down a division and sells the related assets. From the proceeds, it returns $20 per share to its shareholders. Since this money is not coming from profits or retained earnings, but from the capital itself, it is called a liquidating dividend. And one key point, liquidating dividends are not sustainable. They are typically one-time events and signal that the company is either restructuring or closing parts of its business. So, while it might feel like a it's actually the company returning part of their original investment. Now let's explore the important concept of dividend policy. Dividend policy refers to a company's strategic decision on how much profit to distribute to shareholders as dividends, and how much to retain for reinvestment in the business. Every company must choose a dividend policy that aligns with its long-term goals, cash flow situation, and the expectations of There are four main types of dividend policies that we need to understand. First, we have the residual dividend policy. This policy is based on the idea that dividends should be paid only after all profitable investment opportunities are funded. In simple words, the company retains earnings to finance new projects, and if anything is left, that portion is distributed as dividends. This policy helps maintain a strong internal source but may result in irregular dividends for shareholders. Next, there is the stable dividend policy. Under this approach, the company aims to pay a consistent and predictable dividend, regardless of earnings fluctuations. For example, it might pay $2 per share every year, even if profits go up or down. This policy builds investor confidence and is especially popular among income-focused investors who value stability. Third, we have the constant payout ratio policy. Here, the company pays a fixed percentage of its net earnings as dividends every year. For example, it might declare that 40% of its profits will be paid as dividends. As profits grow or shrink, the dividend amount will also vary. This policy maintains a strong link between performance and payout but results in fluctuating dividend income. And finally, there is the irregular dividend policy. In this case, the company pays dividends only when it feels comfortable, with no fixed schedule or ratio. This policy is often used by companies with volatile earnings or uncertain cash flows, such as startups or cyclical businesses. While it gives flexibility to the business, it may create uncertainty for investors. So, to summarize, dividend policy is all about balance. It must satisfy the needs of the company and, at the same time, provide fair value to shareholders. Next, we will discuss about stock split. A stock split is a corporate action where a company increases the number of its outstanding shares by issuing more shares to existing shareholders. This is done in a specific ratio, such as 2 for 1, 3 for 1, or even higher. However, while the number of shares increases, the total value of the investment remains the same because the price per share is adjusted accordingly. Let's take a simple example to understand how a stock split works. Imagine you currently hold 100 shares of a company and each share is priced at $50. That means your total investment value is 100 shares multiplied by $50, which gives you $5,000. Now, the company announces a 2 for 1 stock split. What does that mean? It means for every 1 share you currently own, you will now receive 2 shares. So, your 100 shares will become 200 shares. But what about the price? After the split, the price of each share will adjust automatically to reflect the increase in share quantity. So, instead of $50, the new share price will be $25. Let's do the math again. You now own 200 shares and each share is worth $25. 200 times 25 equals $5,000. So, even though the number of shares you hold has doubled, the total value of your investment has not changed. It remains exactly the same. That's the key takeaway. A stock split increases the number of shares but does not increase the total value of your investment. It simply makes shares more affordable and accessible to investors, especially retail investors. Now, why would a company do a stock split? There are several reasons. The main reason is to make the stock more affordable and attractive to small investors. When a stock price becomes too high, say several hundred dollars, it may become less accessible. A stock split lowers the price per share and can improve market liquidity, which means easier buying and selling in the market. It can also create positive market sentiment, making the company appear confident about its future prospects. Another point to note is that stock splits often involve adjustments to stock dividends. Since the number of shares has changed, companies need to recalculate stock dividends proportionately. Now, let's look at the opposite situation called a reverse stock split. In a stock split, a company reduces the number of outstanding shares and increases the share price proportionately. For example, in a one-for-five reverse split, every five shares you own are consolidated into one new share. If you owned 100 shares at two dollars each, after a reverse split, you would have 20 shares priced at ten dollars each. Again, the total value remains the same. Companies usually carry out reverse stock splits when the share price has dropped very low, often below the minimum required for stock exchange listing. It is a way to boost the per share price, improve the company's image, and sometimes avoid delisting. To summarize, stock splits and reverse splits are non-cash corporate actions that do not change the overall value of your investment, but adjust the number of shares and price per share to support liquidity, affordability, and compliance. Now we are going to explore some special types of equity instruments that companies use for strategic purposes, stock rights, warrants, and ADRs, or American Depository Receipts. These instruments may sound complex, but don't worry, we'll break them down in a simple, structured, and practical way. Let's begin with preemptive rights. Preemptive rights are special privileges given to existing shareholders. These rights allow them to purchase additional shares of the company, typically at a discounted price, before the are offered to the public. Why do companies issue preemptive rights? Well, when a company wants to raise more capital by issuing new shares, they may offer these rights to existing shareholders first. This gives current investors the chance to maintain their proportional ownership in the company. Think of it this way, if you already own 5% of a company and the company is about to issue more shares, your ownership would be diluted. But with preemptive rights, you get the first opportunity to buy more shares so you can keep your 5% stake. Let's understand preemptive rights with a simple numerical example. Suppose there is a company with two million shares currently outstanding. One of the shareholders, Mr. A, owns 20,000 shares out of those two million. Now, the company decides to issue 500,000 new shares and offers these shares to existing shareholders through a preemptive rights offering. So, how many of the new shares is Mr. A entitled to? First, we calculate Mr. A's ownership percentage in the company. He owns 20,000 shares out of two million total shares. That's 20,000 divided by two million, which equals 0.01 or 1% ownership. Since Mr. A owns 1% of the company, he has the right to purchase 1% of the new shares being issued. So, he is entitled to 1% of 500,000, which equals 5,000 new shares. This means if he wants to maintain his 1% ownership in the company, Mr. A can buy 5,000 of the newly issued shares under the rights offer. This is how preemptive rights work. They protect existing shareholders from dilution and give them the opportunity to maintain their ownership percentage in the company. Now, let's discuss stock rights. Stock rights, also called subscription rights or rights offerings, are special rights issued by a company to its existing shareholders. These rights give shareholders the opportunity to purchase additional shares of the company, usually at a discounted price, before the company offers them to the public. Here's how it works. Suppose a company wants to raise additional capital by issuing new shares. Instead of directly offering the shares to the public, the company first gives its existing shareholders a chance to buy the new shares through what is called a rights offering. For each share they already own, shareholders receive a certain number of stock rights. These rights can be used to purchase a specific number of new shares, often at a price lower than the current market price. Let's say you receive one right for every share you own, and you need five rights to buy one new share. This allows you to buy new shares at a lower cost. This helps the company raise funds and rewards loyal shareholders. Stock rights are typically short term, meaning they have an expiration date. If you do not use your rights within that time frame, they will expire and become worthless. Now, what can you do with these rights? There are typically three things an investor can do with a stock right. First, the investor can exercise the right. That means they can purchase the additional shares at the specified price, usually a price lower than the current market value. This helps them maintain their proportional ownership in the company. Second, the investor can sell the right. Since stock rights are often transferable, the investor can sell them in the open market to someone else who wants to purchase shares at the lower price. This is a way to gain some financial benefit without spending money to buy more shares. And third, the investor can choose to do nothing and simply let the right expire. If the investor doesn't find value in exercising or selling the right, maybe because the offer price is close to or higher than the market price, the right can expire unused after a specific expiration date. Now, before we move on, let's clear up a common confusion. The difference between stock rights and preemptive rights. At first glance, both sound very similar because both give shareholders a chance to buy more shares. But here's the key distinction. Preemptive right is a permanent legal right. It's part of your ownership as a shareholder. It means that whenever the company issues new shares, you have the legal right to maintain your proportional ownership by buying a proportionate number of new shares. It's a built-in right that exists unless the company's charter says otherwise. On the other hand, stock rights, also called rights offerings, are temporary and they are issued at the discretion of the company. It's a short-term opportunity to buy new shares, usually at a discount, and it lasts only for a specific time period. It's more of a fundraising tool used when the company decides to raise capital. So remember, preemptive right is an ongoing shareholder protection, while stock right is a short-term offer for new shares. They serve similar purposes but are not the same thing. Let's start with a very important and foundational concept in understanding stock rights. When a company issues rights to its existing shareholders, it is essentially giving them the first opportunity to buy additional shares, usually at a discounted price, before these shares are offered to the general public. But here comes the key question. How many of these rights are needed to buy one new share? Let's break it down step by step using a simple, practical example. Imagine a company that currently has five million common shares already issued and outstanding in the market. Now this company wants to raise new capital. Specifically, it wants to raise 100 million dollars by issuing additional common shares. To make the offer attractive to investors, these new shares will be offered at a discounted price of $40 per share, even though the current market price of the share is $50. Here's an important detail. For every share currently owned, the shareholder will receive one right. This is commonly referred to as a one-for-one rights issue. So the question becomes, how many rights would a shareholder need to buy just one of these new discounted shares? Let's calculate that step by step. First, how many new shares is the company planning to issue? The company wants to raise 100 million dollars and each new share is going to be sold at $40. To find the number of new shares, we divide 100 million dollars by $40 per share. The result is 2.5 million new shares. So the company will issue 2.5 million new shares as part of this rights offering. Next, how many rights will be issued in total? Remember, each existing shareholder receives one right for every share they already hold. Since the company currently has 5 million shares outstanding, that means 5 million shares times one right per share equals 5 million rights issued. So now, there are 5 million rights distributed among shareholders. How many rights are needed to buy one new share? This is the key question we are solving. We know that 5 million rights are issued and the company is offering 2.5 million new shares. So, to find out how many rights are needed to buy one new share, we divide 5 million rights by 2.5 million new shares. The answer is 2 rights per new share. That means a shareholder needs to use 2 rights to purchase one new discounted share. To summarize, the company is offering 5 million rights and plans to issue 2.5 million new shares. It takes 2 rights to buy one new share at $40. This 2 to 1 ratio, or 2 rights for one share, is very important because it forms the basis for calculating the value of a right, which we will learn in the next slide. Stay tuned, as next we will understand how much a single right is worth before the X rights date. Now that we understand what a stock right is, the next question is, does the right itself have any value? Let's think about our example to find out. In our example, we are able to buy the new shares at $40 each, but the current market price is $50. This means that if we buy a share for $40 using our rights, we could potentially sell it immediately in the market for $50. That sounds like a $10 profit, right? So, one might think that the value of the right is $10. But it's not exactly that simple. Remember, to buy one new share, we need to give up 2 rights. So, does that mean the value of each right is $10? Actually, no. To understand the real value of a right, we need to calculate it carefully. The profit from buying the share below market price has to be spread across the number of rights required to purchase that share. In other words, the value of the right is related to the difference between the market price and the subscription price, divided by the number of rights needed to buy one share. Before we dive into the calculation, there is an important concept we need to understand. The difference between rights being on and rights being x. This will help us understand when the rights have value and when they don't. We will explain the idea of right on and x right in the next slide. For now, just remember that the value of a right depends on these conditions. So, in this slide, we have seen that the right does have value because it lets us buy shares below market price, but the exact value is not simply the difference in prices. We will learn how to calculate it next. Before we learn how to calculate the value of a stock right, we need to understand two very important terms, right on and x right. These terms describe the status of a share when rights are being issued and traded during a rights offering. Let's go step by step. When a company announces a rights issue, it gives existing shareholders the option to buy additional shares, usually at a discounted price. But these rights are not always permanently attached to the shares. Whether or not the rights come with the shares depends on the timing of the trade, and that's where the concepts of right on and x right come into play. Let's first understand what right on means. When a share is said to be trading right on, it means the rights are still attached to the shares. So, if an investor buys the shares during this period, before the x right date, the buyer will receive both the shares and the rights. The seller transfers the rights along with the shares. That's why the share price during this period is slightly higher, because it includes the value of the share plus the value of the attached right. Now let's talk about x right. When the share starts trading x right, which happens on a specific date set by the company, the rights are no longer included when someone buys the share. In this case, the rights are detached or separated from the share. So, if a shareholder sells their shares after the x right date, the buyer will receive only the shares, not the rights. The seller keeps the rights, and the price of the share typically drops slightly to reflect that the right is no longer included. So, to clarify it again, right on means selling the share with the right attached. x right means selling the share without the right. The right is now separated and can be traded or exercised separately if it is tradable. Understanding this difference is very important, especially when calculating the value of the right, because whether the share includes the right or not will affect how we determine its actual worth. Now that we understand what right on means, let's move forward and learn how to calculate the value of a right when the shares are trading right on, that is, when the right is still attached to the share. There is a simple formula we use to calculate the value of a right in this case. Value of right equals P0 minus Pn divided by r plus 1. Let's break this formula down. P0 stands for the current market price of the share. This is the price of the share while the right is still attached. Pn is the subscription or exercise price. This is the price at which the new shares are being offered to existing shareholders. r is the number of rights required to purchase one new share. Now let's apply this formula using our example. The current market price, P0, is $50. The subscription price, Pn, is $40. And we have already calculated that two rights are required to purchase one new share, so r is equal to 2. Plugging all of these into the formula, value of right equals 50 minus 40 divided by 2 minus 1. Value of right equals 10 divided by 3. That gives us approximately $3.33. So what does this number actually mean? It means that each right is worth $3.33 when the share is still trading right on. Because by holding the rights, the shareholder is getting access to a discount, buying a share for $40 that is currently worth $50. But that $10 benefit is shared across three parts, the two rights and one new share, which is why we divide by 3. This value of the right, $3.33, is already included in the current market price of the share. That's why the market price remains at 50 during the write-on period. Now, we've just calculated the value of one right using the formula. Value of right equals P0 minus Pn divided by r plus 1. And we got the answer as $3.33. But wait a minute. In our example, we need two rights to buy one new share. So a student might wonder, does that mean the total benefit we're getting is two rights times $3.33, which equals $6.66? Let's clarify. Yes, it's absolutely correct that to buy one new share, the shareholder must submit two rights. So if each right is worth $3.33, the total value of the two rights together is approximately $6.66. But here's the important point. That's the total value of the benefit the shareholder is gaining by using those two rights to buy one new share at the discounted price. Let's see how this works logically. The market price of the share is $50. The shareholder is allowed to buy the new share at the discounted price of $40 using two rights. That means they are saving $10 in total. This $10 benefit is shared among the three components involved, the two rights and the $40 of cash the shareholder is paying. So when we calculate the value of one right using the formula is $3.33. That value tells us the worth of each right, assuming we need two rights plus $40 to get a share worth 50. Therefore, yes, to buy one new share, you'll need to give up two rights, which together are worth This reflects the portion of the $10 discount that is attributed to the rights themselves. The remaining portion, $3.33, is the gain from the money paid, which is part of the deal too. In summary, the value of one right is $3.33. The value of two rights, which are required to buy one share, is $6.66. And the total benefit of the transaction is $10, which is the difference between This is a key insight in rights valuation and will help you fully understand how rights create value for existing shareholders. Before we wrap up, it's important to remember that the value of the right we just calculated is theoretical. In real world markets, the actual trading price of the right may vary due to several reasons. For example, market demand and supply. If many investors want to buy or sell the rights, the price may fluctuate. Investor expectations. If the company's future performance looks promising, the rights may trade at a higher value. Time remaining before expiry. As the expiration date of the rights approaches, their value may decline. Overall market conditions, changes in the stock market, interest rates, or economic outlook can also affect the rights trading price. So while the formula gives us a good estimate for educational and planning purposes, the real trading value of the right can be higher or lower depending on these external factors. It's always important to treat this calculated value as a benchmark, not a guaranteed price. Now that we've understood how to calculate the value of a stock right when the share is trading with the right attached, also known as right on, let's now understand what happens when the share starts trading X right. In X right trading, the right and the share are separated. This means if someone buys the share now, they no longer get the right along with it. The right becomes a separate security and can be bought or sold on its own. So what is the value of a right in this situation? We use a slightly different formula. The value of a right is equal to the difference between the market price of the share and the subscription price, divided by the number of rights required to purchase one new share. Let's apply this to our ongoing example. The market price of the share before going X right was $50. The subscription price is $40. Two rights are needed to buy one new share. Using the formula, the value of the right is calculated as the difference between 50 and 40, divided by 2, which gives $5. However, when the right is detached from the share, the market adjusts the share price downward to reflect that it no longer includes the right. Let's assume that after going X right, the share price drops to $46.66. The right, which is now trading separately, has a value of $3.33. If a shareholder wants to recreate the original combined value of the right on share, they would hold the X right share worth $46.66 and the right worth $3.33. Together, these add up to $50, which matches the original share price when it was trading with the right. This tells us that nothing is lost or gained during the transition from right on to X right. The total value remains the same, it's just now split between the share and the separate right. You might remember that during right on trading, the shareholder pays $40 in cash to buy the new share and gives up two rights, each worth $3.33. So the value given up is $40 plus $6.66, which equals $46.66. In X right trading, the shareholder still pays $40 to buy the new share, but now they buy the two rights separately in the market. Each right costs $3.33, so two rights will cost $6.66. The total cost is the same, $46.66. When the new share is acquired for $40 and is worth $50 in the market, the total benefit to the investor is still $10. But this $10 benefit is now split between the X right share, which has dropped in value, and the right, which is trading independently. This confirms that the value of the right, when calculated correctly, ensures that investors are neither advantaged nor disadvantaged when the stock moves from right on to X right. It's simply a matter of how the value is distributed. Let's now talk about something very useful for global investors, ADRs or American Depository Receipts. An American Depository Receipt is a financial instrument that allows investors in the United States to invest in foreign companies without dealing with foreign stock exchanges or currencies. In simple words, it's a way for American investors to buy shares of non-American companies, but in their own country, in U.S. dollars, and through U.S. stock markets. Here's how it works. Imagine there's a company based in India, Japan, or Germany, and that company wants to attract investors from the United States. What they can do is issue American Depository Receipts. These ADRs represent shares in the foreign company, but instead of being traded in their home country, they are traded on American stock exchanges like the New York Stock Exchange or NASDAQ. To make this possible, a U.S. bank steps in. That bank buys the actual shares of the foreign company and holds them in custody. Then, it issues ADRs in the U.S. market, each one representing a certain number of those foreign shares. For the American investor, buying an ADR is almost like buying a U.S. company stock. It's traded in dollars, pays dividends in dollars, and follows U.S. trading rules. This makes life much easier for American investors. They don't need to worry about foreign exchange rates, different tax systems, or language barriers. Everything is handled through the ADR, just like a normal U.S. investment. So, in summary, ADRs make it simple for American investors to invest in international companies, and they help foreign companies gain access to the large U.S. investor base. Let's now understand a simple and common benefit many companies offer to their employees, something called an employee stock option. An employee stock option is a way for a company to reward and motivate its employees by giving them a chance to become part owners of the company. Instead of just giving a regular salary, the company offers an additional benefit, the right to buy company shares at a price that is lower than the current market price. Let's say the current market price of the company stock is $50. The company may offer its employees the option to buy shares at only $30. This means the employee is getting a $20 discount on each share. So, if an employee is allowed to buy 1,000 shares at $30 each, and the current market price is $50, they are already getting shares worth $50,000 by paying only $30,000. That's a direct benefit of $20,000. This benefit is not given to everyone in the market, only to employees. It's a reward for their hard work and loyalty. It also gives them a reason to help the company grow, because as the company becomes more successful, its stock price increases and the value of their stock options goes up as well. Employee stock options help build a strong connection between the employee's efforts and the company's performance. When the company does well, the employee benefits directly. In short, it's a win-win situation. The employee gets a valuable benefit and the company gains a motivated and committed team. Now let's explore the concept of A financial instrument that might seem a bit technical at first, but is actually quite straightforward once you understand the basics. A warrant is a type of financial security that gives the holder the right to buy a company's shares at a fixed price, known as the exercise price, within a specific time period. It's somewhat similar to an option, but there are a few key differences. Warrants are usually issued by the company itself, not traded between investors like standard options. Also, when someone exercises a warrant, the company issues new shares, so this can actually increase the total number of shares outstanding. Let's simplify this with an example. Imagine a company issues a warrant that allows you to buy its stock at $20. If the market price of the stock rises to $30, you can use your warrant to buy at $20 and either keep or sell at $30, earning a profit of $10 per share. Now, there are different types of warrants and it's important to understand the differences. First, we have detachable warrants. These are often issued along with bonds or preferred shares. A detachable warrant means it can be separated from the bond or the preferred share and traded independently. So, an investor can sell the bond and keep the warrant or sell the warrant and keep the bond. Each can move separately in the market. Second, we have non-detachable warrants. These are attached to the bond or preferred share and cannot be traded separately. In this case, the investor must either keep both together or sell them together. You cannot trade the warrant without the associated security. And finally, we have standalone warrants. These are not attached to any bond or preferred share. They're issued on their own and they work just like options. You simply purchase the warrant directly and it gives you the right to buy shares at a fixed price during a set period. Warrants are often used by companies to make their bonds or preferred shares more attractive. They act as a sweetener, giving investors an added incentive to invest. In summary, a warrant is a tool that gives you a right to buy company shares at a fixed price. And depending on how it's issued, it could be detachable, non-detachable or standalone. Let's now wrap up this topic by understanding the advantages and limitations of issuing common shares, but this time from the perspective of the entity, that is, the company itself. When a company issues common shares, it is raising capital by selling ownership in the business to investors. This has some very clear advantages. One major advantage is that the company does not have to repay this capital. Unlike loans or bonds, common equity does not come with a fixed repayment obligation. This helps the company manage its cash flows better, especially in the early stages or during periods of uncertainty. Another key benefit is that there is no fixed interest or dividend that must be paid. Dividends on common shares are not mandatory. This gives the company flexibility in managing its profits. They can reinvest earnings into growth instead of paying them out. Also, by issuing shares, a company improves its debt-to-equity ratio, which can make it easier to get loans in the future. A healthy balance between debt and equity signals financial stability to banks and investors. However, issuing common shares also has some limitations. First, by selling shares, the company is diluting its ownership. That means the original owners or existing shareholders now own a smaller percentage of the business. This can reduce their control over decision making. Second, issuing new shares can reduce earnings per share, which may negatively impact the stock price and investor perception. And finally, as common shareholders are last in line during liquidation, raising capital through equity can sometimes be more expensive than debt because investors expect higher returns to compensate for the higher risk. So, while common shares are a flexible and powerful way to raise capital, companies must consider the long-term impact on ownership, control, and cost. Before we wind up, let's quickly review what we've learned in this episode. We started with treasury stock, understanding what it means, why companies buy back their own shares, and its impact on shareholders' equity. Then, we explored retained earnings, how profits are accumulated over time and used for dividends or reinvestment. We discussed additional paid-in capital, or APIC, how it arises from issuing shares above their par value. We took a deep dive into dividends, dividend policy, and stock splits, understanding how companies reward shareholders and adjust share structure. We also explored stock rights, warrants, and ADRs, learning how these instruments provide flexibility and opportunity to investors. And finally, we wrapped up with the benefits and limitations of common stock, looking at what shareholders gain and what risks they face. Make sure to practice the questions from your CMA USA materials and read your textbook for deeper understanding. Remember, the more you practice, the more confident you become. Thank you so much for watching. Stay focused, stay motivated, and I'll see you in the next episode of CMA USA Exam Coach, your trusted study companion. Take care and happy learning!