Question

(Preemptive Rights and Dilution of Ownership) Wallace Computer Company is a small, closely-held corporation. Eighty percent of the stock is held by Derek Wallace, president. Of the remainder, 10% is held by members of his family and 10% by Kathy Baker, a former officer who is now retired. The balance sheet of the company at June 30, 2017, was substantially as shown below.

Asset

Current assets \(22,000

Equipment (net) 450,000

\)472,000

Liabilities and Stockholders’ Equity

Current liabilities \(50,000

Common stock 250,000

Retained earnings 172,000

\)472,000

Additional authorized common stock of \(300,000 par value had never been issued. To strengthen the cash position of the company, Wallace issued common stock with a par value of \)100,000 to himself at par for cash. At the next stockholders’ meeting, Baker objected and claimed that her interests had been injured.

Instructions

1. Which stockholder’s right was ignored in the issue of shares to Derek Wallace?
2. How may the damage to Baker’s interests be repaired most simply?
3. If Derek Wallace offered Baker a personal cash settlement and they agreed to employ you as an impartial arbitrator to determine the amount, what settlement would you propose? Present your calculations with sufficient explanation to satisfy both parties.

Short answer

Wallace Computer Company should investigate the idea of dilution of ownership interests and take any required remedial steps to compensate current shareholders for this dilution impact.

Step-by-step solution

Meaning of Preemptive Rights

Preemptive Rights are the rights given to existing shareholders to purchase newly issued shares before the share is offered to others. This right helps to protect the dilution of existing shareholders’ shares.

Explaining the stockholders’ right that was ignored in the shares to Derek Wallace.

Here, one of the important preemptive rights was ignored, to share proportionately in any new stock of the same class.

Determining the damage to Baker’s interests be repaired most simply

Derek Wallace purchased a $100,000 par value stock. The initial cost of his ownership was $200,000. As a result, he raised his shareholding by 50%. This imbalance can be remedied by issuing Ms. Baker at par shares equal to 50% of her current holdings or by purchasing shares equal to 50% of their holdings, allowing all shareholders to retain the same proportionate stake as before the issue of extra shares.

Explaining the type of settlement that should be initiated.

As there is no information given with respect to the fair value of stock, an estimate should be taken for a fair value that could be developed based on market transactions that involve comparable assets.

Alternatively, discounted projected cash flow might be utilized to estimate fair value. In this closely held corporation, and in the lack of credible fair value data, the book value may be utilized to calculate the cash settlement amount.

Showing calculation to support the opinion

Book value of Ms. Baker’s capital stock, June 30 2017 before Issuance of additional shares, $\left(\frac{25}{250}\times \$422,000\right)$ Less: Book value after issuance of additional shares to Derek Wallace $\left(\frac{25}{350}\times \$522,000\right)$	$42,200 37,286
Loss in book value and amount of cash settlement	$4,914