Chapter
17
McGraw-Hill/Irwin
Common and
Preferred Stock
Financing
Copyright © 2011 by The McGraw-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 = (M0 – S) ÷ (N + 1)
Where: M0= 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