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Chapter 11
Reporting and Interpreting Shareholders’ Equity
ANSWERS TO QUESTIONS
1. A corporation is a separate legal entity (authorized by law to operate as if it were an individual). It is owned by a number of persons and/or entities whose ownership is evidenced by shares of common shares. Its primary advantage is the ease of participation in its ownership. This is related to the corporation’s: (a) transferability of ownership, (b) limited liability to the owners, and (c) the ability to sell ownership in small quantities, which can accumulate to large amounts of resources.
2. The advantages of equity financing are (1) equity does not have to be repaid, whereas debt must be repaid or refinanced and (2) dividends are optional, but interest on debt must be paid.
The advantages of debt financing are (1) there is no change in shareholder control when debt financing is used whereas the additional issuance of shares dilutes the control of existing shareholders, and (2) interest expense is tax deductible whereas dividends are not tax deductible.
3. General Motors might have proposed the exchange of debt for equity to gain more flexibility in its future cash outflows. Debt typically requires periodic payment of interest until its mandatory principal repayment at maturity. On the other hand, equity does not require payment of dividends and equity does not require mandatory repayment.
The bondholders might have rejected this proposal because they had acquired the bonds with an expectation of periodic cash payments. Also, bondholders have a higher priority than shareholders should the company go out of business and have its assets liquidated and distributed to creditors and shareholders.
4. (a) Authorized common shares—the maximum number of shares that can be sold and issued as specified in the charter of the corporation.
(b) Issued common shares—the total number of shares that have been issued by the corporation at a particular date....