Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Common and Preferred Stock Financing 17

1-2 Chapter 17 - Outline Common Stock The Voting Right Rights Offering “Rights-on” and “Ex-rights” Poison Pill Preferred Stock Provisions Associated with Preferred Stock Risk and Expected Return Summary and Conclusions PPT 17-2

1-3 Common Stock Stockholders - Ultimate owners of a firm Legally, stockholder directly controls the business –A large creditor may have the power to exert pressure on the firm to meet certain financial performance standards

1-4 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 –Stockholders do not have an ownership interest in the firm –Stockholders have a priority of claims to dividends superior to that of common stockholders

1-5 Common Stockholders’ Claim to Income Common stockholders have a residual claim to income –These funds can be paid out as dividends or retained 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

1-6 Institutional Ownership of U.S. Companies

1-7 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 –Such as “founders’ shares” Bondholders and preferred stockholders may vote: –If a corporate agreement has been violated

1-8 The Voting Right Proxy: –assigning shareholders’ right to vote to another individual Majority Voting: –all directors must be elected by at least 51% of the vote –doesn’t allow minority shareholders representation on the board of directors Cumulative Voting: –a shareholder’s votes can all be used to elect 1 person –allows minority shareholders representation on board PPT 17-4

1-9 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:

1-10 The Right to Purchase New Shares Holders of common stock must be given the first option to buy new shares –Ensures that management cannot subvert the position of present stockholders

1-11 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? Rights required Stockholders may choose to sell their rights, rather than exercise them in the purchase of new shares

1-12 The Use of Rights in Financing (cont’d) What is the monetary value of these rights? –Monetary value of a right – two terms –When a rights offering is announced a stock initially trades rights-on The value of the right when a stock is trading rights-on is: Alternate formula: Where: M o = market value – right-on; S = subscription price; N = number of rights required to purchase a new share of stock; M e = market value when trading ex-rights. –Ex-rights – when you buy a share there is no right towards future purchase

1-13 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:

1-14 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: As indicated, whether you choose to exercise a rights or not, the stock will still go down a lower value.

1-15 Three options when presented with a rights offering Exercise the rights; no net gain or loss sell the rights; no net gain or loss allow the rights to lapse; a loss will be incurred due to the dilution of existing shares that is not offset by value of unsold or unexercised rights.

1-16 Poison Pills A rights offering made to existing shareholders of a company –Used to avoid a takeover –Makes hostile takeovers very expensive and unattractive –Allows existing shareholders the right to buy additional shares of the stock at a very low price

1-17 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

1-18 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

1-19 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 translation of reports into English

1-20 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 for annual dividends is not mandatory for corporations Firm may forgo the preferred dividends when deemed necessary

1-21 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 interest payments are not tax-deductible

1-22 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 of another corporation, to its taxable income –By contrast, all the interest of bonds are taxable to the recipient except for municipal bond interest

1-23 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 Since 70% of the dividend is exempt from taxation

1-24 Cumulative Dividends Cumulative preferred stock have a cumulative claim to 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

1-25 Conversion Feature Preferred stock may be convertible to a specified number of shares of common stock –Allows the company to force conversion from convertible preferred stock into convertible debt, –Allows company to take advantage of falling interest rates, OR –Allows company to change the preferred dividends into tax-deductible interest payments

1-26 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

1-27 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

1-28 Floating Rate Dividends are adjustable in nature - floating rate preferred stock –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

1-29 Dutch Auction Preferred Stock Short-term in nature –The security matures every seven weeks and is re-auctioned at a subsequent bidding –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

1-30 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, is based on: –The presence or absence of security provision –The priority of claims on unsecured debts

1-31 Common Stock Belongs to common shareholders through voting rights and residual claim to income None Lowest claim of any security holder Highest Preferred Stock Limited rights when dividends are missed Must receive payment before common shareholder Bondholders and creditors must be satisfied first Moderate Bonds Limited rights under default in interest payments Contractual obligation Highest claim Lowest 1.Ownership and control of the firm 2.Obligation to provide return 3.Claim to assets in bankruptcy 4.Cost of distribution PPT17-13 Features of alternative security issues

1-32 Common Stock Highest risk, highest return (at least in theory) Not deductible Dividend to another corporation is usually tax exempt Special tax treatment with dividend tax credit Preferred Stock Moderate risk, moderate return Not deductible Same as common stock Bonds Lowest risk, moderate return Tax deductible Cost = Interest payment  (1 – Tax rate) Interest usually fully taxable 5.Risk-return trade-off 6.Tax status of payment by corporation 7.Tax status of payment to recipient PPT17-14 Features of alternative security issues

1-33 Risk and Expected Return for Various Security Classes