Updated July 19, 2023
Definition of Premium on Stock
Any extra amount of money that the investor of the company can pay to it for purchasing the stock of a company, up and above the par value or face value of the stock is called the Premium on stock and the same is calculated by deducting the par value of the stock from its issuing price.
Explanation
Every stock of the company has a par value which is also called as stated value or face value of the stock, which is generally the minimum value of the stock and is very low. It is the extra amount that the investor of the company can pay to the company up and above the par value of the stock. The share value is indicated by the stock.
For a particular company, the stock also shows the expectations from the market. For making the investors ready to pay more than the par value of a share, the company should exceed the market expectation using a premium on stock. The company should also keep the investors motivated or interested in the future prospects of the company to make them ready to pay up and above the par value of the stock. The premium received on the stock is generally recorded in the account called a “Securities Premium Account” or “Stock Premium Account”. This account appears on the liabilities side of the balance sheet under “Shareholders equity”.
Example of Premium of Stock
Let’s take the example of Mr. Tom who is running the business of the hotel. The hotel is situated in the most demanding area. The hotel is running very well and it can be said that the hotel has a bright future in terms of its financial growth. Mr. Tom proposed to issue the additional 3,000 shares of stock at the rate of $10 each stock to new investors. The issue of additional shares stock to the new investors is proposed to raise the additional capital for expanding the projects in the future or also to expand the services of the hotel in other areas too. As the hotel is running very well, and the future of the financial growth of the hotel seems bright, it is found that investors are ready to pay $40 per share. Here, the premium on the stock is calculated as:
Solution:
Calculation of Premium on issue of the new stock to investors of the company
|
Particulars |
Value |
| No. of shareholders | 4 |
| Proposed no.of additional issue of stock | 3,000 |
| Par value of the additional stock to be issued | $10 |
| Price of share stock, the investor is ready to pay(Issue price)] | $40 |
| Par value of stock= | $30 |
Where,
Premium on Stock Options
The premium on the stock is the price paid to the seller by the buyer for the purchase of the options contract or the price which is paid by the buyer to the seller to acquire the option is called the Premium on stock options or simply the income received by the trader from the other party for selling the option contract is called Premium on stock options. There are various forces determining the stock options like time remaining, Volatility, and the market price. Intrinsic Value and the time value are the two components of the option premium.
Disadvantages
Following are the disadvantages are:
- The process of earning a premium on stock is a complex task. There requires a lot of observation and analysis consistently to understand the business of the company and to earn profits. It is very difficult for beginners to have technical analysis in the stock. The beginners should be able to understand the volatility analysis also, which is not an easy task. Understanding all the strategies and processes requires a lot of time and observation.
- Every company has multiple classes of common shares like class A shares and class B shares. The investor has lower trading volumes and voting rights considering these classes of shares.
- Generally, the common stock is issued by the company to raise money for strategic and operational reasons. Ownership stakes can be monetized by the Owners and employees of the company. The shares of the company can be used by the company as currency in mergers & acquisitions. So, there is a loss of control of external shareholders.
- The earning of the stock includes many regulatory fillings as well as communications with the shareholders. This requires a thorough knowledge of by-laws and rules.
- Due to all the above reason, a lot of additional costs is also involved.
Important Points Related to Premium on Stock
- The amount received in advance as a premium amount on the stock should be adjusted in the share allotment account. The nominal value of shares should be adjusted first in case of advance money received and the remaining balance left out should be transferred to the securities premium account/Stock Premium account
- The balance in the stock premium account cannot be used for any general purposes. There are specific and exclusive purposes mentioned in the by-laws of the company for which the stock premium account balance can be utilized.
- The equity-related expenses like fees of the underwriters can be paid from a stock premium account.
- The premium received on stock cannot be utilized for the distribution of dividends to the shareholders of the company.
- The Operating losses of the company also cannot be set off with the amount of premium received on the stock.
- It can be utilized for the issue of bonus shares to the shareholders of the company. Also, the expenses for the issue of new shares can also be incurred from the balance of the stock.
Conclusion
It is the extra amount received by the company over its face value at the time of the issue of the shares. This account appears on the liabilities side of the balance sheet. Under the liabilities section, the securities Premium account appears under “Shareholders equity”. It does not appear in the income statement or profit and loss account. There are various specific purposes, for which the balance in the stock premium account/securities premium account can be utilized.
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