15.1
Assuming that the common shares have no par value:
Before the issue After the issue
Common shares
2,500,000@1.6$/share
Retained earnings
$4,000,000 Common shares
Surplus
$195,000,000 Retained earnings
$4,004,800
$133,200
$195,000,000
$199,138,000 Total $199,000,000 Total
New Book value per share is 199,138,000/2,503,000shares=$79.56/share
New Market–to–Book ratio is $46/$79.56=0.578
15.2 Assuming that 100 shares are repurchased at $46 per share and cancelled:
Before the purchase After the purchase
Common shares
2,500,000@1.6$/share
Retained earnings
$4,000,000 Common shares
2’499’900@1.6$/share
$195,000,000 Retained earnings
$3,999,840
$194,995,560
Total $199,000,000 Total $198,995,400
Alternatively, if the shares are not cancelled and remain as Treasury Stock, the accounts would be as follows:
After the purchase
Common shares
2,500,000@1.6$/share
Treasury Stock
Retained earnings
$4,000,000
(4,600)
$195,000,000
Total $198,995,400
15.3 Corporate bonds yields are usually higher. Corporations may receive dividends on preferred stock tax free, so they are willing to accept a lower pretax yield. Other corporations and institutions are the big investors in preferred stock.
15.4 The following table summarizes the main difference between debt and equity.
Debt
Repayment is an obligation of the firm Yes
Grants ownership of the firm
Provides a tax shield
No
Yes
Equity
No
Yes
No
Answers to End–of–Chapter Problems B–209

Liquidation will result if not paid Yes No
When corporations try to create a debt security that is really equity, they are trying to obtain the tax benefits of debt while eliminating its bankruptcy costs.
Preferred stock is like an “equity bond” because:
1.
Preferred holders receive a stated dividend.
2.
In case of liquidation, preferred holders are senior to common shareholders.
3.
Often, preferreds carry credit ratings.
4.
Preferreds are sometimes convertible into common shares.
5.
Preferreds are often callable.
6.
Preferreds may have a sinking fund.
7.
Preferred may have an adjustable dividend.
15.5 Babel will finance initially with internal funds and if necessary, resort to external funds – first debt and lastly common stock.
For example, suppose 80% could be generated internally:
.80 ($14,000,000) = $11,200,000 internal funds
.20 ($14,000,000) = 2,800,000, external funds, most likely debt.
15.6 a. In order to create the equity statement , first find the components:
Common stock = 325,000 shares outstanding x $5.90
= $1,917,500
Retained earnings = previous retained earnings + Net income – Dividends
= $3,545,000 + $360,000 – ($360,000)(0.21)
= 3,829,400
Now, putting it all together:
Shareholders’ equity
Common stock (Authorized $750,000; issued and outstanding 325,000)
Retained earnings
Total b.
Shareholders’ equity
Common stock (Authorized $750,000; issued and outstanding 360,000
Deficit
Retained earnings
Total
$1,917,500
3,829,400
$5,746,900
$2,124,000
(66,500)
3,829,400
$5,886,900
Answers to End–of–Chapter Problems B–210

15.7 a. b.
Under straight voting, one share equals one vote. Thus, to ensure the election of one director you must hold a majority of the shares. Since 2.5 million shares are outstanding, you must hold more than 1,250,000 shares (i.e. At least 1,250,001 shares) to have a majority of votes.
Cumulative voting is often more easily understood through a story. Remember that your goal is to elect one board member of the nine who will be chosen today. Suppose the firm has 36 shares outstanding. You own 4 of the shares and one other person owns the remaining 32 shares. Under cumulative voting, the total number of votes equals the number of shares times the number of directors being elected, (36)(9) = 324. Therefore, you have 36 votes and the other stockholder has 288 votes.
Also, suppose the other shareholder does not wish to have your favorite candidate on the board. If that is true, the best you can do to try to ensure electing one member is to place all of your votes on your favorite candidate. To keep your candidate off the board, the other shareholder must have enough votes to elect all nine members who will be chosen. If the other shareholder splits her votes evenly across her nine favorite candidates, then ten people, your one favorite and her nine favorites, will all have the same number of votes.
There will be a tie! If she does not split her votes evenly (for example 37 36 36 36 36 36
35 36 36 ) then your candidate will win a seat. To avoid a tie and assure your candidate of victory, you must have 37 votes which means you must own more than 4 shares.
Notice what happened. If nine board members will be elected and you want to be certain that one of your favorite candidates will win, you must have more than one–ninth of the shares.
That is, if the percentage of the shares you must have to win is N , then:
N

1
( number of members being elected
 number you want to select )
.
Also notice that the number of shares you need does not change if more than one person owns the remaining shares. If several people owned the remaining 288 shares they could form a coalition and vote together.
To view cumulative voting more rigorously:
1) let V = the Total Number of votes
= the number of shares times the number of directors being elected
= 2,500,000 x 9
= 22,500,000
2) Let N be the number of shares you need. The number of shares necessary is
9 N

V

9 N
9 N

9
22 , 500 , 000

9 N
9
N

250 , 000
Answers to End–of–Chapter Problems B–211

3) You will need more than 250,000 shares i.e 250,001or more shares.
15.8 She can be certain to have one of her candidate friends elected under the cumulative voting rule.
Modifying the equations in the previous question for percentages, let N be the percentage of shares needed, and V = 6 x 100%. Then,
6 N
N

600%
6

14.29%

6 N
Alternatively, you can find this as : the lowest percentage of shares she needs to own to elect at least one out of 6 candidates is higher than 1/7 = 14.29%.
Either way, her current ownership of 32% is more than enough to ensure one seat.
If the voting rule is staggered as described in the question, she would need to own more than
1/4=25% of the shares to elect one out of the three candidates for certain. In this case, she would still have enough shares.
15.9 Examples of securities will be limited only by the students' imaginations.
Problems that might be encountered with regulatory bodies such as CCRA and the appropriate securities commission will have to be overcome. The security will have to fill a need that is not currently addressed to be perceived as valuable to investors.
15.10 To determine the net after–tax receipt by investors in income trust:
Income
Corporate income tax
$34,456,750
0
Amount distributed to investor $34,456,750
Amount included in income $34,456,750
Personal income tax (44%)
Investor’s net receipt
15,160,970
$19,295,780
To determine the total tax paid to government if we have a corporation instead, we determine tax paid by a corporation, then the tax paid by investors:
Corporation
Income $34,456,750
Corporate income tax (36%) 12,404,430
Amount distributed to investor $22,052,320
Investors
Amount included in income $22,052,320
Personal income tax (44%)
Investor’s net receipt
9,703,020.8
$12,349,299.2
Total tax paid = 12,404,430+9,703,020.8 = $22,107,450.8
Answers to End–of–Chapter Problems B–212

15.11 a & b. Compare the investor’s net receipt if dividends are paid versus what would be received from an income trust distribution:
Income
Dividends
$576,879.00
Income trust distributions
$576,879.00
Corporate income tax (35%)
Amount distributed
201,907.65
374,971.35
0
$576,879.00
Tax on dividends (22%) 82,493.69
Tax on interest income (46%)
Investors’ net receipt $292,477.65
236,520.39
$340,358.61
It appears that investors would benefit from the conversion. For each unit held upon conversion, an investor would lose ($340,358.61– $292,477.65)/7,000 = $6.84.
For an investor holding 1,000 units the loss would be = 1,000 ($6.84) = $6,840. c. The indifferent corporate tax rate to restructure into an income trust is determined as follows :
$576,879 (1–T
Tc ≈.244 c
)(1–.22) = $340,358.61
15.12 After–tax yield on the bonds is 3.89% = 6.6% x (1–.41). The investor seeks 5.39% in after–tax yield on preferreds (3.89 + 1.5).
Using the information in Table 1A2–Chapter 1, before–tax yield on preferred shares r = 5.39/ [l –1.45(.41 – 0.19 – 0.0716)]
= 5.39/0.78482
= 6.86%
Note the gross up and dividend tax credit reduces the impact of the tax liability.
15.13 Enbridge’s current share price was found to be $41.00 per share. Using this information, the following has been provided for illustrative purposes only. (If you found the share price in the S&P database remember that the price of the share is in US dollars, but the Shareholder’s Equity is reported in
Canadian dollars.) a. If the company issues 8 million shares at $41.00 per share, the common shares will increase by $328 million and the Shareholder’s Equity account will be as follows:
Share Capital $ ( thousands)
Preferred securities
Commons shares ( 2,416,100 + 54,943)
Surplus (18,300+273,057)
125,000
2,471,043
291,357
Answers to End–of–Chapter Problems B–213

b.
Retained earnings
Foreign currency translation adjustment
Reciprocal shareholding
Total shareholders’ equity
2,322,700
–135,800
–135,700
4,938,600
If the company buys back these shares instead, then the total price of the shares is 2.6 million shares times $41.00 per share which is $106.6 million.
The book value per share before the repurchase was $13.10 per share calculated as follows:
$4,610,600,000 / 351,800,000 shares outstanding. Therefore, the $106.6 million will be allocated as follows:
Common shares 2.6 million x $13.03
Retained earnings for the difference
Total
$ 34,060,000
72,540,000
$106,600,000
The share repurchase would be shown in the Shareholders’ equity as follows:
Share Capital $ ( thousands)
Preferred securities
Commons shares ( 2,416,100 – 34,060)
Contributed Surplus
Retained earnings (2,322,700 – 72,540)
Foreign currency translation adjustment
Reciprocal shareholding
Total shareholders’ equity
125,000
2,382,040
18,300
2,250,160
–135,800
–135,700
4,504,000
Answers to End–of–Chapter Problems B–214