Chapter 17 Mc GrawHillIrwin Common and Preferred Stock

Chapter 17 Mc. Graw-Hill/Irwin Common and Preferred Stock Financing Copyright © 2011 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Outline • Common stockholders – Rights and privileges • Cumulative voting and its characteristics • Rights offering • Poison pills and other regulatory provisions • Preferred stock 17 -2

Common Stock • Represents the ultimate ownership of a firm • Though stockholders directly control the business, it is practically wielded by management on an everyday basis 17 -3

Preferred Stock • Plays a secondary role in financing the corporate enterprise • Represents a hybrid security by combining some of the features of debt and common stock • Preferred stockholders do not have an ownership interest in the firm • They have a priority to claim dividends over common stockholders 17 -4

Common Stockholders – Rights • Three key rights: – Residual claim to income – Voting right – Right to purchase new shares 17 -5

Common Stockholders’ Claim to Income • Common stockholders have a residual claim to income regardless of payment of dividends or retention by the firm • They do not have a legal or enforceable claim to dividends • A firm may have several classes of common stock outstanding that carry different rights to dividends and income 17 -6

Institutional Ownership of U. S. Companies 17 -7

The Voting Right • Common stockholders have the right to: – Vote in the election of board of directors – Vote on all other major issues – Assign a proxy or “power to cast their ballot” • Companies can have different classes of common stock with unequal voting rights 17 -8

Cumulative Voting • Majority voting – Stockholders owning above 50% of common stock may elect all of the directors • Cumulative voting – Stockholders with less than 50% interest may elect some of the directors 17 -9

Cumulative Voting Process • To determine the number of shares needed to elect a given number of directors under this method of voting: • If the number of minority shares outstanding under cumulative voting is known, the number of directors that can be elected can be determined: 17 -10

The Right to Purchase New Shares • A corporate charter containing preemptive right provision requires: – Holders of common stock must be given the first option to buy new shares • This ensures that management cannot subvert the position of present stockholders • Stockholders may choose to sell their rights, rather than exercise them in the purchase of new shares • A corporate that does not include preemptive right provision can include “rights offering” in its charter 17 -11

The Use of Rights in Financing • Used by many U. S. companies and is popular as fund raising method in Europe • Questions to consider: – How many rights should be necessary to purchase one new share of stock? – What is the monetary value of these rights? 17 -12

Monetary Value of a Right • When a rights offering is announced a stock initially trades “rights-on” – Acquiring a right toward a future purchase of the stock – The value of the right when a stock is trading rights-on is: R = (M 0 – S) ÷ (N + 1) Where: M 0= market value – rights-on; S = subscription price; N = number of rights required to purchase a new share of stock • Ex-rights: Buying shares with no right toward future purchase – The value of the right when a stock is trading at ex-right is: R = (Me – S) ÷ N Where: Me= market value – ex-rights 17 -13

Effect of Rights on Stockholders Position Option 1: • Suppose Stockholder A owns 9 shares before the rights offering and has $30 in cash. His holdings would appear as: • If he receives and exercises 9 rights to buy one new share at $30: 17 -14

Effect of Rights on Stockholders Position (cont’d) Option 2: • Sell rights in the market and stay with his position of owning only nine shares and holding cash. The outcome would be: • If a stockholder neither exercises his rights nor sells the rights, he would be at a loss as the total value of his holdings would come down as shown below: 17 -15

Desirable Features of Rights Offering • The position of the current stockholders is protected in regard to voting rights and claims to earnings • Use of rights offerings gives the firm a built-in market for new security issues • It may also generate more interest in the market than a straight public issue • Stock purchased through a rights offering carries lower margin requirements – Margin requirement is the cash or equity that must be deposited with brokerage house or bank, with a balance fund eligible for borrowing 17 -16

Poison Pills • A rights offering made to existing shareholders of a company – Allows existing shareholders to buy additional shares of the stock at a very low price – Used to avoid a takeover – Makes hostile takeovers very expensive and unattractive 17 -17

American Depository Receipts • Certificates that have a legal claim on an ownership interest in a foreign company’s common stock – Also referred to as American Depository Shares (ADSs) – Allows foreign shares to be traded in the United States much like common stock 17 -18

Advantages of ADRs for the U. S. Investor • Annual reports and financial statements are presented in English according to GAAP • Dividends are paid in dollars and are more easily collected • Considered to be: – More liquid – Less expensive – Easier to trade than buying foreign companies’ stock directly on that firm’s home exchange 17 -19

Drawbacks of ADRs for the U. S. Investor • ADRs are also traded in their own country subjecting investors to currency risk • Infrequent reporting of financial results • Information lag due to the time for translation of reports into English 17 -20

Preferred Stock Financing • An intermediate or hybrid form of security • Lacks the desirable characteristics of debt and common stock – Merely entitled to receive a stipulated dividend – Receive payment of dividends before common stockholders – Rights to annual dividends is not mandatory for corporations 17 -21

Justification for Preferred Stock • May be issued to achieve a balance in capital structure • A means of expanding the capital base without: – Diluting the common stock ownership position – Incurring contractual debt obligations • A drawback is that dividend payments are not tax-deductible 17 -22

Investor Interest • Primary purchasers of preferred stock are corporate investors, insurance companies, and pension funds – Under the tax law, the corporate investor must need to add only 30% of preferred or common dividends received from another corporation, to its taxable income – By contrast, all the interest of bonds are taxable to the recipient except for municipal bond interest 17 -23

Summary of Tax Considerations • Tax considerations for preferred stock work in two opposite directions: – They make the after-tax cost of debt cheaper than preferred stock to the issuing corporation • Interest is deductible to the payer – Tax considerations generally make the receipt of preferred dividends more valuable than bond interest • Since 70% of the dividend is exempt from taxation 17 -24

Provisions Associated with Preferred Stock • The following stipulations and provisions define preferred stockholder’s claim to income and assets – Cumulative dividends – Conversion feature – Call feature – Participation provision – Floating rate – Auction rate preferred stock – Par value 17 -25

Cumulative Dividends • Cumulative preferred stock have a cumulative claim to dividends – If preferred stock dividends are not paid in any one year, they accumulate and must be paid in total before common stockholders can receive dividends – This feature makes a corporation aware of its obligations to preferred stockholders • A financial recapitalization may occur if a financially troubled firm has missed a number of dividend payments – Under this arrangement, preferred stockholders receive new securities in place of the dividend that is unpaid 17 -26

Conversion Feature • Allows a company to convert preferred stock into a specified number of shares of common stock • Allows a company to force conversion from convertible preferred stock into convertible debt – Company can take advantage of falling interest rates, or – Company can prefer to change the preferred dividends into tax-deductible interest payments 17 -27

Call Feature • Allows corporations for the retirement of security before maturity – At some small premium over par, at the discretion of the corporation • A preferred issue carrying a call provision will be accorded a slightly higher yield than a similar issue without this feature 17 -28

Participation Provision • A small percentage of preferred stock issues are participating preferreds – They may participate over and above the quoted yield – If the common stock dividend equals the preferred stock dividend: • The two classes of securities may share equally in additional payouts 17 -29

Floating Rate • Floating rate preferred stocks have dividends adjustable in nature • Dividend is changed based on the current market conditions – Investors can minimize the risk of price changes – Investors can take advantage of tax benefits associated with preferred stock corporate ownership – The price stability makes it equivalent to a safe short-term investment 17 -30

Auction Rate Preferred Stock • Also known as Dutch auction preferred stock – The stock is issued to the bidder willing to accept the lowest yield and then to the next lowest bidder, and so on until all the preferred stock is sold • Long-term in nature, behaves like a short-term security – The auction periods vary for each issue, re-auctioned at a subsequent bidding – This is much like the Treasury bill auction – Allows investors to keep up with the changing interest rates in the short-term market – Allows corporate investors to invest at short-term rates and get tax-benefits as well 17 -31

Par Value • Par value of preferred stock is set at the anticipated market value at the time of the issue – Establishes the amount due to preferred stockholders in the event of liquidation – Determines the base against which the percentage or dollar return on preferred stock is computed 17 -32

Comparing Features of Common, Preferred Stock and Debt • Highest return and risk is associated with common stock • Preferred stock generally pays a lower return – Due to the 70% tax exemption status for corporate purchasers • Increasingly high return requirement on debt, based on: – The presence or absence of security provision – The priority of claims on unsecured debts 17 -33

Features of Alternative Security Issues 17 -34

Risk and Expected Return for Various Security Classes 17 -35