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

17-2 Chapter Outline Privileges of a common stockholder. Cumulative voting and its characteristics. Rights offering. Poison pills and other regulatory provisions. Preferred stock.

17-3 Common Stock Stockholders - ultimate owners of a firm. Legally, stockholder directly controls the business. –Large creditor may have the power to exert pressure on the firm to meet certain standards.

17-4 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 have a priority of claims to dividends. –Stockholders do not have an ownership interest in the firm.

17-5 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.

17-6 Institutional Ownership of U.S. Companies

17-7 The Voting Right Common stockholders have the right to: –Vote in the election of broad 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. –Like founders shares. Bondholders and preferred stockholders may vote: –If a corporate agreement has been violated.

17-8 Cumulative Voting Majority voting –Possible for stockholders owning above 50% of common stock. Cumulative voting –Stockholders with less than 50% interest may select some of the board members.

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 Holders of common stock must be given the first option to buy new shares. –Ensures that management cannot subvert the position of stockholders.

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

17-12 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. –Ex-rights – when you buy a share there is no right towards future purchase.

17-13 Effect of Rights on Stockholders Position Assume 100 people own shares of stock in a corporation and decide to sell new shares to themselves at 25% below current value. 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 new shares at #30:

17-14 Effect of Rights on Stockholders Position (cont’d) Second alternative: 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.

17-15 Desirable Features of Rights Offering Current position of the current stockholders is protected in regard 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.

17-16 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

17-17 American Depository Receipts Certificates that have a legal claim on an ownership interest in a foreign company’s common stock. –Referred to as American Depository Shares (ADSs). –Allows foreign shares to be traded in the United States 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 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 for annual dividends is not mandatory for corporations. Firm may forgo the preferred dividends when deemed necessary.

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. Interest 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 of another corporation, to its taxable income. –All the interest of binds are taxable to the recipient except for municipal bond interest.

17-23 Before-Tax Yields on Moodys Utility Bonds and Preferred Stock

17-24 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.

17-25 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.

17-26 Conversion Feature Preferred stock may be convertible to a specified number of common stock. –Allows the company to force to conversion from convertible preferred stock into convertible debt. –Allows company to take advantage of falling interest rates. –Allows company to change the preferred dividends into tax-deductible interest payments.

17-27 Call Feature Preferred stock, allows for the retirement of security before maturity. –At some small premium over par, if the corporation chooses so. 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 Dividend 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.

17-30 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.

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, is 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