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Equity Theories Essay

1025 words - 5 pages

ScenarioExamine the following document:Revenues: $1,000,000Operating Expenses:- Cost of goods sold: $400,000- Depreciation: $100,000- Salaries and wages: $200,000Bond interest (8% debentures sold at a maturity value of $1,000,000 $80,000Dividends declared on 6% preferred stock (par value $500,000) $30,000Dividends declared of $5 per share on common stock (20,000 shares outstanding) $100,000Based on this information you are to complete the following tasks:1. Determine the income under each of the following equity theories:- Proprietary theory- Entity theory (orthodox view)- Entity theory (unorthodox view)- Residual theory2. Would any of your answers change if the preferred stock is ...view middle of the document...

, 2004, p. 144)There is somewhat of a paradox considering the treatment of debt and equity costs. On the one hand we can argue that both interest and dividends are in fact distributions of income to providers of capital (Wolk et al., 2004, p. 145) and as such are not deducted when calculating income, but also it could be argued, because of the firm and owners being separate entities, that owner's equity truly belongs to the firm, even considering the claims of stockholders (Wolk et al., 2004, p. 145), in which case interest and dividends would both be deductions in calculating income.Orthodox ViewThe orthodox view refers to considering interest and dividends as distribution of income to providers of capital. Shareholder and other providers of capital are treated equally. This would result in the following income:Exhibit 2Both debt and equity costs are not deducted from revenues.Unorthodox ViewThe unorthodox view refers to the scenario where we consider owner's equity to truly belong to the firm and both debt costs and equity costs are deductions for the purpose of calculating income. The income in our example would be calculated as follows:Exhibit 3Residual TheoryAccording to the VentureLine Glossary "RESIDUAL EQUITY THEORY is the theory that common stockholders are considered to be the real owners of the business, i.e., Assets - Liabilities - Preferred Stock = Common Stock (VentureLine, 2005a).Assets - Specific Equities (including liabilities and preferred stock) = Residual EquityThe claims of one group of stakeholders are superseded by all others: the common stock holders. Those are considered the residual equity holders. Interest and preferred dividends are deductions, but not common dividends (Wolk et al., 2004, p. 146).Our income calculation would be as follows:Exhibit 4Preferred StockWould any of our results change if the...

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