Suppose you have wondered how businesses get the finances necessary to sustain their phenomenal market share and physical supremacy rise. In that case, you should know several methods they might use. To expand, some businesses take out expensive loans with high-interest rates, while others issue capital stock, which offers finance without incurring debt.
This article defines and explains capital stock and its functions, demonstrates how the value of a capital stock is determined and addresses some commonly asked topics about the capital stock.
What Does Capital Stock Mean?
When individuals invest in a company's success in exchange for a portion of its ownership, they have capital stock.
Capital stock, which comprises common and preferred stock, may only be issued by the firm and is typically used to obtain funds for corporate expansion and operation. Additionally, corporations can issue stock to pay for assets such as land, infrastructure, or equipment. Investors purchase capital stock in search of returns (dividends). A corporation may issue more shares of capital stock over time or repurchase the shares presently owned by shareholders.
Capital stock may be subdivided into two major categories. U.S.-based firms primarily issue common stock, but only a tiny minority of corporations issue preferred stock. The standard and preferred stock values are utilized to compute dividend payments. A firm can offer capital stock to raise funding for business development. Investors, who want price appreciation and dividends, can purchase issued shares or swap them for assets, such as operationally necessary equipment.
How the value of capital stock is recorded depends on whether the stock has a stated (par) value. The par value of a common share is the monetary amount ascribed to it. In the shareholders' equity column of a company's balance sheet, the dollar amount received in return for shares of capital stock is reflected as paid-in capital. Investors' extra payments over the par value are recorded as additional paid-in capital. Due to its holders' preference over common stockholders in dividend payments and liquidation, preferred stock is mentioned first.
The proportion of corporate ownership held by each investor is determined by the amount of capital stock issued to that investor. For instance, if there are 20,000 shares of capital stock and an investor has 10,000 shares, he controls fifty percent of the business. The number of outstanding shares issued to investors is not always identical to the number of authorized or available shares. The capital stock that a business is legally allowed to issue is known as authorized shares. In contrast, outstanding shares have already been issued and are still circulated among shareholders.
The common stock balance is computed by multiplying the nominal or par value of the common stock by the number of outstanding common stock shares. The nominal value of a firm's stock is an arbitrary value allocated for balance sheet reasons when the company issues new shares; it is often $1 or less. It has nothing to do with the market price.
Tips
The number of common stock and preferred shares that a business may issue is known as capital stock, and it is shown on the balance sheet under shareholders' equity.
The quantity of capital stock is the maximum number of outstanding shares a corporation can ever have.
Capital stock issuance enables a corporation to raise funds without incurring debt.
The disadvantages of issuing capital stock are that the corporation loses control and the outstanding shares lose value.
How to Determine Capital Stock's Value
The dollar value of a firm's stock is usually one penny or less and is arbitrarily ascribed for balance sheet reporting reasons when the company issues share capital. The par value and the market price are unrelated. Use the following equation to determine the value of the capital stock:
Value of capital stock equals (Par value per share)x(Number of shares issued)
Illustration of Capital Stock
A business may issue and sell up to 5 million shares of stock if it has a $5 million fundraising cap and a $1 par value per stock. Under shareholders' equity, the stock's par value and sale price difference are noted as additional paid-in capital.
If the stock sells for $10, $5 million will be recorded as paid-in capital, while the remaining $45 million will be considered extra.
Consider Apple (AAPL), which has 12.6 million authorized shares with a par value of $0.0001. This amount represents its capital stock. Apple had issued 4,283,939 shares and has 4,443,236 outstanding as of June 27, 2020.
Why is Capital Stock So Important?
The capital stock is how a corporation gets funds for commercial expansion. An investor can purchase a company's stock with the expectation of receiving dividends. Companies can also issue the stock for business-related assets such as land, buildings, and equipment.
The amount of capital stock provided to investors and shareholders determines the proportion of the firm that each individual owns. If there are 10,000 shares of capital stock and an investor holds 5,000 shares, he owns fifty percent of the firm.
How Is Capital Stock Valued?
Typically, the value of a capital stock is the sum of its paid-in capital based on par value and additional paid-in capital.
For accounting considerations, a corporation often sets the par value of its common stock significantly below the offering price when it goes public. The par value is a nominal amount to demonstrate that the shares are accounted for in shareholders' equity and to satisfy a state government's requirement that shares cannot be sold below their par value. On the other hand, the par value of the preferred stock might differ from that of common stock since dividends paid to preferred stockholders are determined based on the par value. Nonetheless, for certain corporations, the par value of a common and preferred stock is the same. In all other circumstances, preferred shares lack a par value.
Known as paid-in capital more than par value, additional paid-in capital is the difference between what investors pay for a company's stock at market value and its par value at the time of its first public offering. Typically, additional paid-in capital is employed to offset the stock's par value. However, some corporations publish stock at par value and do not declare extra paid-in capital since they have neither issued nor repurchased stock. Some corporations distinguish between contributed capital (paid-in capital) and extra paid-in capital, while others may merge the two into a single entry.
When a firm decides to sell additional shares (through a follow-on offering or secondary offering) or repurchase stock, the capital stock quantity changes and is reported for the corresponding period. When a corporation sells new shares to raise cash, existing common shareholders' value and voting rights are diluted.
The corporation can set away repurchased common shares as treasury shares, which can be shown as a different, negative line item under shareholders' equity because it is regarded as a counter equity account (against paid-in stock).
Treasury stock is issued stock that a firm has repurchased. This stock is no longer counted among outstanding shares and can be used for employee pay (stock options, grants, etc.). Treasury stock maintains a component of issued shares but has restrictions such as no voting rights and no dividend entitlement. Treasury shares are recorded as a counter equity account in the shareholders' equity part of the balance sheet if a corporation repurchases shares from the open market.
Pros and Cons of Capital Stock
Pros
The benefits of issuing capital stock include the following:
The capacity to finance future expansion without incurring debt. Instead of taking out an expensive loan (which would appear as a liability on the firm's public financial papers), the company can fund its expansion by selling capital stock.
The amount of cash raised by selling stock may be more than the amount received if the firm had taken out a bank loan (plus, they avoid paying the interest on the bank loan).
By issuing stock, a firm can profit from the experience and resources of its investors, who are skilled business people. Since these investors own a portion of the firm, they have a financial interest in its success and an incentive to contribute their skills and resources to promote profitability.
Cons
There might be downsides to issuing stock. Examples include:
They are giving up a portion of the company's stock. Through the sale of capital stock to investors, the corporation gives away a portion of its ownership.
They are diluting share value. The more the company's issuance of capital stock, the lower the per-share value.
As a corporation continues to raise funds via stock issuing, the owners and founders may lose majority control at some point.
The quantity of available shares is limited, and investors will not be able to buy company shares in the future.
In order to get investors to commit capital, the corporation must guarantee dividend payments. If a corporation has pledged to pay dividends but fails to do so, its reputation and stock price may suffer.
Capital Stock on Balance Sheet
The value of the capital stock would not appear in the asset or liability sections of the balance sheet. Instead, the information about the value of the capital stock, extra paid-in capital, and retained earnings will be contained in a separate section on equity. Any amount received by investors exceeding the capital stock's par value is recorded as extra paid-in capital and is shown separately. As the term implies, retained earnings are the company's retained earnings. And they are not distributed as dividends to shareholders for reinvestment in their primary business or debt repayment.
In the past, it was common practice for legislatures to mandate that firms issue stock with a par value. States desired corporations to maintain reserve money for creditors in case of insolvency. Par value is the minimal amount of cash that cannot be lawfully removed from a firm, for example, to pay shareholder dividends. In response to this rule, corporations set the par value of common stock certificates to one cent or less. Barnes & Noble recorded a par value of one-tenth of a cent for its common stock on its balance sheet dated April 30, 2011. Numerous states have abandoned par value entirely. Other states retain the par value practice, even though it provides minimal protection for creditors.
Capital Surplus Account
Many "par value states" require firms to maintain a separate account for shares sold more than their par value. This is typically referred to as the "capital surplus" account. If a company sold 1 million shares of common stock to investors for $10 per share and each share had a par value of one penny, the company would report a cash asset of $10 million. In the shareholders' equity section, the company would record $10,000 in the "common stock" account — 1,000,000 shares multiplied by $0.001 — and $9,990,000 in the "capital surplus" account. In "no par value states," the $10 million would be reported in the common stock account under shareholders' equity.
Treasury Stock
Treasury Stock is stock that firms have repurchased on the open market. Treasury shares are significant since they are approved and issued but not outstanding. Legally, corporations cannot possess stock in their organizations. Consequently, and because treasury stock is not outstanding, it is recognized as a reduction in the capital stock of a firm. It is listed as a "contra" account on a balance sheet. Instead of debiting cash and crediting common stock, a treasury stock transaction is recorded as a credit to cash and debit, or reduction, to common stock.
Par Value vs. Market Value
Par value is an arbitrary value ascribed by businesses if they allocate a value to shares of stock they issue. On the other hand, market value is a value in the actual world that reflects the stock price agreed upon by interested buyers and sellers in open market transactions. After issuance to original investors, who then sell their shares to other parties on stock exchanges or in other open-market transactions, capital stock obtains market value.
Capital Stock FAQs
In the case of a company's liquidation, preferred investors have a higher priority than common stockholders. Preferred investors will get their share of the distribution before common stockholders and receive dividends first.
What is the meaning of par value?
The par value is the lowest value that cannot be utilized to pay dividends to shareholders. Companies responded to this government-implemented law by lowering the par value of their common stock certificates to one cent or less. Par value is not market value. Par value, the value attributed to shares of stock sold by firms, is arbitrary (for those that assign a value at all).
In contrast, market value is the real-world value of a stock's open-market price. When issued shares of capital stock are sold to third parties on the open market, only then do they acquire a market value.
What is surplus capital?
A record of the amount of paid-in capital over and above the stock's par value was historically known as capital surplus. As a result, the total sale price will be broken down into two categories: the amount received above par and the par value of the issued stock.
What is an organization's charter?
A corporate charter usually referred to as a "charter" or "articles of incorporation," is a legal instrument used to establish a corporation. It is submitted to the state government, where the business is incorporated. It describes the company's location, whether it will be for-profit or nonprofit, the membership of its board of directors, and its ownership structure. This is also where a corporation will indicate how much authorized stock it intends to utilize.
What is a corporate kit?
A corporate kit contains the corporate charter, shareholder meeting minutes, benefit plan papers, the stock register, and the stock certificate book of a corporation.
What are preferred shares?
Prior to common stockholders receiving dividends, preferred stockholders receive their dividends. In exchange for this priority, preferred stockholders will typically never receive dividends above the stated amount. For instance, a stockholder who owns 100 shares of a company's 9 percent preferred stock with a par value of $100 will receive an annual dividend of $900 before common stockholders receive their cash dividend payments for that year. In most cases, the preferred stockholder will never be paid more than $9 per share, regardless of the company's profitability.
When the inflation rate increases, the preferred stock tends to lose value. As dividends paid on preferred stock are often fixed indefinitely, the stock's market value moves typically in the opposite direction of inflation. If the inflation rate falls, the value of the preferred stock may grow accordingly, but not above the call price.
What occurs when the corporation repurchases its capital stock?
Treasury stock refers to the repurchased shares of stock by businesses. Treasury stock is approved and issued but is not regarded as outstanding. Legally, corporations are not permitted to possess shares of their stock. On the balance sheet, treasury stock is therefore shown as a drop in capital stock.
What is the stock market?
Share trading is the process of shareholders purchasing and selling shares. This trade has no effect on the firm's financial documents until the corporation repurchases the shares, in which case they become treasury stock.
How do you define a share?
A single part of capital stock is a share, and the per-share value is the par value a corporation sets for its stock.
How are outstanding shares defined?
Outstanding shares have been distributed to investors but do not belong to the corporation. In other words, outstanding shares equal total shares minus shares held in the company's treasury.
What is a stock account?
A stock registry lists all shareholders' contact information, the number of shares they possess, and the unique identifier for each share.
What are treasury shares?
Treasury stock consists of shares repurchased from investors by a corporation. Once a stock is repurchased, the corporation has the option to cancel, reissue, or retain it.
Final Thoughts
A company's capital stock demonstrates its robust financial health. The more it is, the better, as it reduces reliance on external debt. However, this does not imply that a company with more outstanding debt on its balance sheet is a secure investment. Different financial professionals have divergent views on a firm's optimal combination of stock and debt.
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