Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 17 Common and Preferred Stock Financing Block, Hirt, and Danielsen Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Common stockholders – rights and privileges Cumulative voting characteristics Rights offering Poison pills and other regulatory provisions Preferred stock Chapter Outline 17-2

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Represents ultimate firm ownership Stockholders directly control business — in practice management controls on daily basis Common Stock 17-3

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Plays secondary role in financing corporate enterprise Represents hybrid security by combining features of debt and common stock Preferred stockholders have no ownership interest in firm Priority claim on dividends over common stockholders Preferred Stock 17-4

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Three key rights Residual claim to income Voting right Right to purchase new shares Common Stockholders – Rights 17-5

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Common stockholders have residual claim to income regardless of payment of dividends or retention by firm No legal or enforceable claim to dividends Firm may have several classes of common stock outstanding that carry different rights to dividends and income Common Stockholders’ Claim to Income 17-6

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Institutional Ownership of U.S. Companies Company NameInstitutional Ownership (%)Institutional Ownership in Shares Motorola Solutions Inc ,242,374 Lockheed Martin Corp ,027,852 eBay Inc ,107,664,142 Panera Bread Co ,623,105 Kellogg Co ,143,160 Wal-Mart Stores Inc ,671,198,763 Hewlett-Packard Co ,550,275,883 Bristol-Myers Squibb Co ,195,000,588 Amazon.com Inc ,567,732 PepsiCo Inc ,107,344,418 3M Co ,795,895 Microsoft Corp ,897,651,856 Walt Disney Co ,268,812,986 Johnson & Johnson ,918,676,067 EI du Pont de Nemours & Co ,388,751 Coca-Cola Co ,879,468,739 International Business Machines Corp ,824,582 Procter & Gamble Co ,639,216,073 General Electric Co ,904,284,425 Exxon Mobil Corp ,339,511,

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Common stockholders have right to Vote in election of board of directors Vote on all other major issues Assign proxy or “power to cast their ballot” Companies can have different classes of common stock with unequal voting rights Voting Right 17-8

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Majority voting Stockholders owning above 50% of common stock may elect all directors Cumulative voting Stockholders with less than 50% interest may elect some directors Cumulative Voting 17-9

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Cumulative Voting Process To determine number of shares needed to elect given number of directors under this method of voting If number of minority shares outstanding under cumulative voting known, number of directors to be elected can be determined 17-10

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Corporate charter containing preemptive right provision requires Holders of common stock must be given first option to buy new shares Ensures management cannot subvert position of present stockholders Stockholders may choose to sell rights rather than exercise them in purchase of new shares Corporation that does not include preemptive right provision can include “rights offering” in charter Right to Purchase New Shares 17-11

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Used by many U.S. companies, popular fund- raising method in Europe Questions to consider How many rights necessary to purchase one new share? Monetary value of rights? Use of Rights in Financing 17-12

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. When rights offering announced stock initially trades “rights-on” Right value when stock trades rights-on R = (M 0 – S) ÷ (N + 1) Where: M 0 = market value – rights-on; S = subscription price; N = number of rights required to purchase new share of stock Ex-rights— buying shares with no right toward future purchase Right value when stock trades at ex-right R = (M e – S) ÷ N Where: M e = market value – ex-rights Monetary Value of a Right 17-13

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Option 1 Stockholder A owns 9 shares before rights offering and has $30 cash If receives and exercises 9 rights to buy one new share at $30 Effect of Rights on Stockholder's Position 17-14

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Option 2 Sell rights in market and stay with position of owning only nine shares and holding cash If stockholder neither exercises rights nor sells rights, total value of holdings would come down Effect of Rights on Stockholder's Position (cont’d) 17-15

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Position of current stockholders protected in regard to voting rights and claims to earnings Use of rights offerings gives firm built-in market for new security issues May also generate more market interest than straight public issue Stock purchased through rights offering carries lower margin requirements Margin requirement — cash or equity that must be deposited with brokerage house or bank, with balance of fund eligible for borrowing Desirable Features of Rights Offering 17-16

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Rights offering made to existing shareholders of company Allows existing shareholders to buy additional shares of stock at very low price Used to avoid takeover Makes hostile takeovers very expensive and unattractive Poison Pills 17-17

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Certificates that have legal claim on ownership interest in foreign company’s common stock Also referred to as American Depository Shares (ADSs) Allows foreign shares to be traded in United States much like common stock American Depository Receipts 17-18

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Annual reports and financial statements presented in English according to GAAP Dividends paid in dollars and more easily collected Considered to be More liquid Less expensive Easier to trade than buying foreign companies’ stock directly on firm’s home exchange Advantages of ADRs for the U.S. Investor 17-19

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. ADRs also traded in own country subjecting investors to currency risk Infrequent reporting of financial results Information lag due to time for translation of reports into English Drawbacks of ADRs for U.S. Investor 17-20

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Intermediate or hybrid form of security Lacks desirable characteristics of debt and common stock Entitled to receive only stipulated dividend Receive payment of dividends before common stockholders Rights to annual dividends not mandatory for corporations Preferred Stock Financing 17-21

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. May be issued to achieve capital structure balance Means of expanding capital base without Diluting common-stock-ownership position Incurring contractual debt obligations Drawback — dividend payments not tax- deductible Justification for Preferred Stock 17-22

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Primary purchasers of preferred stock are corporate investors, insurance companies, and pension funds Corporate investor must add only 30% of preferred or common dividends received from another corporation to taxable income All bond interest taxable to recipient except for municipal bond interest Investor Interest 17-23

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Tax considerations for preferred stock work in two opposite directions Make after-tax cost of debt cheaper than preferred stock to issuing corporation Interest deductible to payer Tax considerations generally make receipt of preferred dividends more valuable than bond interest Since 70% of dividend exempt from taxation Summary of Tax Considerations 17-24

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. These 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 Provisions Associated with Preferred Stock 17-25

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Cumulative preferred stock have cumulative claim to dividends If dividends not paid in any one year, they accumulate and must be paid in total before common stockholders can receive dividends Makes corporation aware of obligations to preferred stockholders Financial recapitalization may occur if financially troubled firm has missed number of dividend payments Preferred stockholders receive new securities in place of unpaid dividend Cumulative Dividends 17-26

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Allows company to convert preferred stock into specified number of common stock shares Allows company to force conversion from convertible preferred stock into convertible debt Can take advantage of falling interest rates Can change preferred dividends into tax- deductible interest payments Conversion Feature 17-27

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Allows corporations to retire security before maturity At some small premium over par, at discretion of corporation Preferred-issue-carrying-call provision receives slightly higher yield than similar issue without feature Call Feature 17-28

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Small percentage of preferred stock issues are participating preferred May participate over and above quoted yield If common stock dividend equals preferred stock dividend Two security classes may share equally in additional payouts Participation Provision 17-29

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Floating-rate-preferred stocks have adjustable dividends Dividend changes based on current market conditions Investors can minimize risk of price changes Investors get tax benefits Price stability makes equivalent to safe short-term investment Floating Rate 17-30

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Also known as Dutch auction preferred stock Issued to bidder willing to accept lowest yield, then to next lowest bidder, so on until all preferred stock sold Long-term in nature, behaves like short-term security Auction periods vary for each issue, re-auctioned at subsequent bidding Much like Treasury bill auction Allows investors to keep up with changing interest rates in short-term market Allows corporate investors to invest at short-term rates and get tax-benefits Auction Rate Preferred Stock 17-31

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Par value of preferred stock set at anticipated market value at time of issue Establishes amount due to preferred stockholders in event of liquidation Determines base against which percentage or dollar return on preferred stock computed Par Value 17-32

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Highest return and risk associated with common stock Preferred stock generally pays lower return Due to 70% tax exemption for corporate purchasers Increasingly high return requirement on debt, based on Presence or absence of security provision Priority of claims on unsecured debts Comparing Features of Common, Preferred Stock and Debt 17-33

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Features of Alternative Security Issues 17-34

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Risk and Expected Return for Various Security Classes 17-35