What Is Capital Stock? (Definition, Types And Examples)
Updated 28 September 2022
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Companies use various means to raise money for development activities and to grow their business. Capital stock, also known as authorised stock, comprises stocks that a company can issue legally. If you work in finance, you can benefit from learning about authorised stock and how to calculate its value. In this article, we discuss what capital stock is, examine its types, outline its advantages and limitations and share how to calculate it using a few examples.
What Is Capital Stock?
The capital stock of a company comprises stocks that the company issues to investors and shareholders to finance its business operations and expand its market share. By investing in that company, an investor gets this stock in the form of shares, which denotes a unit of ownership in a company. Companies record this information in the equity section of their balance sheet. Investors may invest in a company for the following reasons:
Capital appreciation: If a company performs well, its stock value appreciates over time. This results in a profit for the investors who bought a company's stocks at a lower amount.
Dividends: At the end of each quarter, companies distribute some of their earnings to their stockholders. As a company grows and generates more revenue, the value of the dividends increases.
Voting: Voting shares allow stockholders the right to vote on matters concerning policymaking and other critical decisions.
Related: What Are Shares Outstanding? (Definition And Calculation)
Why Do Companies Issue Stock?
Companies issue stocks for the following reasons:
Paying off their debt
Investing in research and development activities
Buying new equipment
Expanding into different regions
Launching new products
Building new infrastructure such as warehouses
Acquiring other companies
Related: What Is Capital Structure? (With Types And Ways To Use It)
Types Of Authorised Stock
The types of authorised stock include:
Common stocks, also known as ordinary stock, refer to a stockholder's partial ownership of a company. When stockholders hold the common stock, it gives them the right to vote on crucial decisions at a company's annual meeting, such as the appointment of the corporate director, policy changes and other matters specific to the company. If a stockholder cannot attend the annual meeting, the voting power rests with a company's representative who votes in place of the stockholder. When stockholders hold common stock, they may also receive dividends from a company's profits.
Common stocks can yield higher rates of return for stockholders, but they are highly volatile and carry market risk. The value of a company may decline over a period because of various reasons, such as performance, inability to generate revenue for an extended period and failure to pay the debt. This may cause a drop in the share price, which results in a loss. If a company goes bankrupt, the common stocks lose their value and the shareholders do not receive dividends. This can cause financial loss.
Related: What Is Acquisition Financing? (With Types And Examples)
Preferred stocks, also known as preferred shares, represent a stockholder's ownership in a company. In contrast to common stocks, stockholders with preferred stocks have no voting rights in a company's decisions. The rate of return on preferred stocks is lower compared to common stocks. A company pays a fixed percentage of dividend to preferred stockholders throughout the maturity life. Since preferred stockholders have no voting rights, the dividend rates are much higher than common stocks to attract more investors.
With preferred stocks, stockholders have priority over a company's income compared to holders of common stock. In the case of bankruptcy, a company pays its preferred stockholders before common stockholders. Compared to common stock, this makes it a more secure form of investment, with low risk and lower earning potential.
Related: What Is A Stock Option? (With Definition, Types And Benefits)
Advantages Of Issuing Stock
Here are some advantages of issuing stocks:
Reducing debt: By issuing stock, a company can raise enough capital to finance its operations without debt. The company may also use the money raised to repay its earlier debts and become debt-free.
Performing acquisitions: In acquisition through equity, a company can provide its stakeholders with the common stock of the acquired company, which they can sell for cash.
Attracting more investors: Upon issuing common stock, a company can attract more investors, as it allows buying and selling of its shares. Companies can do this through an initial public offering (IPO) and a secondary price offering.
Improving credit rating: Rating agencies issue credit ratings indicating a company's financial strength. When a company receives a large amount of capital by issuing stocks, agencies are more likely to provide a higher credit rating.
Related: What Is Growth Equity? (With Definition, Pros, Cons And FAQs)
Limitations Of Issuing Stock
Here are some limitations to issuing stocks:
Loss of ownership: By issuing stocks and selling them to investors, a company eventually loses some of its ownership to investors.
Dividend payments: Companies require paying monthly or quarterly dividends to their stakeholders. In case of default, they require paying back the stockholders by liquidating their assets.
Potential for a takeover: If a stakeholder purchases a majority of the shares, they can take control of all the company's decisions. The goal of the stakeholder is to achieve at least 51% ownership of the company's stocks.
Loss of control: A company that issues stock transfers control to outside parties. Having a stake in the company allows shareholders to vote on specific issues and influence decision-making.
Loss of value: While selling more stock can increase capital, issuing more stock dilutes the value of the current shares, unless the company increases its market value. This drop in the stock's value may negatively impact the confidence of the investors.
Related: Top 10 Careers In Stock Market (With Duties And Salary)
How To Calculate The Value Of Capital Stock
Follow these steps if you want to calculate the value of the authorised stock issued by a company:
1. Calculate the number of shares issued
A company can issue common and preferred stocks to raise capital. Make a note of the number of shares issued in each type. You can find this information on a company's balance sheet. Review this example:
A company wishes to raise capital to pay off its debts and use a portion of it to buy machinery and a warehouse. It issues 4000 common and 5000 preferred shares available to the public via a trading platform.
Related: What Is A Stockbroker? A Complete Guide
2. Note the par value
The par value for a stock is the amount that a company sets for its per-share value. This is the minimum amount at which investors can buy the company's stocks. Many companies may decide to issue their stock without a par value. This information is available on the stock certificate. Continuing the previous example:
The company issues 4000 common shares at a par value of ₹430 and 5000 preferred shares at a par value of ₹345.
Related: What Is A Shareholder? (With Rights And Responsibilities)
3. Obtain the value of the stock
Here is the formula to calculate the value of the issued stock:
Capital stock = number of shares issued x par value per share
Continuing the previous example, multiply 4000 by 430 and 5000 by 345. Add the values to obtain the value of the issued stock. Adding ₹17,20,000 and ₹17,25,000 gives ₹34,45,000, which is the value of the issued stock.
Related: What Is A Balance Sheet? (With Template And Example)
Here is an example of calculating the value of the stock:
Global AI wants to raise capital to invest in new hardware, storage centres and development activities. It decides to issue 4000 common shares at a par value of ₹95 and 5000 preferred shares at a par value of ₹80.
Number of common shares issued = 4000
Number of preferred shares issues = 5000
Par value of common shares = ₹95
Par value of preferred shares = ₹80
*Value of stock = 4000 x ₹95 + 5000 x ₹80 = ₹7,80,000*
Global AI can use this value for its financial reporting purposes.
Please note that none of the companies, institutions or organisations mentioned in this article are associated with Indeed.
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