Chapter 7 Equity: Preferred and Common Stock

Investing in Stock Acquiring ownership (equity) in a corporation Residual claim Riskier than debt from investors’ perspective

“Agency” Assumptions Management represents the owners Management is the agent of the owners The “agency” problem - possible conflicts of interest

Types of Stock Preferred stock Common stock Common stock is the residual claim

Features of Preferred Stock Fixed dividend payments Payment from earnings Not a legal obligation Cumulative preferred stock Non-cumulative preferred stock Arrearage

Comparisons of Bonds and Preferred Stock Both make fixed payments Bonds are riskier than preferred stock –from the issuing company’s perspective Preferred stock is riskier than bonds –from the investor’s perspective Interest is a tax-deductible expense Preferred dividends are not tax deductible

Analysis of Preferred Stock Based on the capacity of the company to pay the dividend Times-dividend-earned ratio –Earnings after taxes / preferred dividend payment Earnings per preferred share –Earnings after taxes / number of preferred shares

Rights of Common Stockholders Voting authority to elect a board of directors Cumulative voting Preemptive rights and rights offerings

Cash Dividends Distribution from earnings The payout ratio Regular quarterly dividends Extra dividends and irregular dividends Impact of taxation

Distribution of Dividends Date of record Stock trading ex dividend Ex dividend date Distribution date

The Stock Dividend Does not affect proportionate ownership Does not affect assets Does not affect liabilities Does not affect total equity

The Stock Dividend Dilution of existing shares Price adjusts for a stock dividend A 10% stock dividend –Causes a $20 stock price to fall to $18.18 ($20/1.1)

The Stock Split Does not affect proportionate ownership Does not affect assets Does not affect liabilities Does not affect total equity

The Stock Split Does affect the stock's price A 2 for 1 stock split –Causes a $80 stock price to decline to $40 ($80/2)

Dividend Reinvestment Plans Cash dividends used to purchase additional shares Additional cash contributions may be allowed Expenses often paid by the firm Are automatic; an easy means to save

Stock Repurchases Corporations with cash may reduce the number of existing shares through buy back programs The decrease in outstanding shares may –Increase earnings per share –Increase the price of the stock

Stock Repurchases and Capital Gains Stockholders do not have to sell their shares Sales are –Realized capital gains and –Subject to capital gains taxation