Final answer:
When a corporation repurchases its debt, its capitalization decreases option (b) but the market value of its common stock may or may not change. In the case of Acme Bank selling bonds to the Fed, its reserves increased, allowing it to extend new loans, which changed its balance sheet but not its equity.
Step-by-step explanation:
When a corporation repurchases its debt, the financial statement items are affected in the following ways:
- If the corporation repurchases its debt, then its capitalization generally decreases because the total amount of debt and equity financing is reduced.
- The market value of common stock may or may not change; this depends on market perception and the reasons behind the debt repurchase. Sometimes, the action can be viewed positively if the market interprets it as a sign of financial strength, potentially leading to an increase in stock price, but it is not a direct consequence of the debt repurchase itself.
In a hypothetical example with Acme Bank, if the Fed conducts an open market purchase by buying $10 million in Treasury bonds from the bank, here is how the balance sheet changes:
Before the purchase, Acme's balance sheet listed $30 million in reserves, $50 million in bonds, and $50 million in loans as assets, with $300 million in deposits and $30 million in equity as liabilities.
After selling $10 million in bonds to the Fed, Acme's reserves increased by $10 million. This additional reserve can then potentially be turned into new loans. This action does not directly affect Acme's equity or the deposit amount.
However, as the bank creates additional loans with its new reserves, the balance sheet expands on the asset side (with the increase in loans) and the liability side (with a corresponding increase in deposits).