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Understanding Stock Financing in Business Organizations

Learn about common financing structures including Sole Proprietorships, Partnerships, and Corporations. Discover how agency problems are tackled, shareholders' rights, dilution of shares, and the impact of rights offerings on old shareholders. Gain insights into the value and pricing of rights in stock offerings.

kimberley-edwards
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Understanding Stock Financing in Business Organizations

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  1. Chapter 17 Common and Preferred Stock Financing

  2. Business Organization • Sole Proprietorship – No separation of person assets from business assets and business profit taxed as personal income (unlimited liability) • Partnership – partners share the profit and liability of the organization personally (unlimited liability); can limit risk exposure through limited partnership • Corporation – Limited liability and impersonal identity; easily transferred ownership; taxed at corporate rates; separation of management & ownership (shareholders)

  3. Managers as the agent of the shareholders • Small shareholders have little control over management – little say • Managers may put their interests above stockholders • Insufficient corporate governance e.g.directors are recommended by the management; stockholders are rubber seal • Agency problem – managers won’t work for the owners unless it is in their own best interests

  4. How to solve agency problem • Goal alignment of the managers & owners • Make the mangers the owners • Tie compensation to share price - e.g. stock options, bonuses based on share price • Strengthen corporate governance – e.g. appoint outside directors • Takeover and replacement of management

  5. Shareholders’ Rights • Residual claim to income – amount remained after the creditors and preferred shareholders; dividends or retained earning; no legal or enforceable claim to dividends • The voting rights – on major issues such as director election, CEO appointment, etc • The right to purchase new shares – Preemptive RightProvision in corporate charter allows existing shareholdersto maintain the percentage of ownership, voting power and claim to earnings

  6. The Voting Right • Majority voting – holders of majority (> 50%) of stock can elect all directors • Cumulative voting – allow minority (<50%) shareholders to elect some of the directors; stockholder can cast one vote for each share of stock owned times the number of directors to be elected

  7. Right to Purchase New Shares • Difference between initial public offerings (IPO or non-seasonal offerings) and seasonal offerings • In both cases, the company will set the initial price at a discount • Share price rises in the first case but very often falls in the latter case • Reason - in the latter case, there is a dilution of the value of existing outstanding shares

  8. Dilution of Shares • Assume there are 9M outstanding shares currently, each share has a market value of $40. • The company decides to issue another 1M new shares at a price of $30 • The total number of outstanding shares becomes 9M + 1M = 10M with a total value of 9Mx40 + 1Mx30 = 390 M • New value for each share = 390 M/ 10 M = $39

  9. Right Offerings • Each old stockholder receives one right for each share owned • Needs to combine several rights and pay the subscription price to buy one new share • How many rights should be necessary to purchase one new share? • What is the value of these rights?

  10. Right Offerings cont’ • Given the followings • Market value of existing share $40/share • Share outstanding 9 M • Current equity in total $360 M • Additional funds required $30 M • Subscription price $30/share • New share issued 1 M

  11. How many rights are needed? • The ratio of old to new shares is 9 to 1, hence old shareholder needs to combine 9 shares (or rights) to buy one new share • Number of rights required = number of outstanding shares/ number of new shares to be issued • In addition, the old shareholder has to pay a subscription price of $30 for each new share

  12. What’s the value of each right? • New value of the share after dilution = $39 per share • Acquisition costs = 9 rights + $30 • Hence 9 rights = $39 - $30 = $9 • Each right = $1 • Rights may not sell at this theoretical value due to the investors’ expectation and market short-term condition

  13. Figure 17-1(p.665) Time line during rights offering

  14. Rights-on share price (Mo) R = (Mo – S)/ (N+1) S = subscription price N = number of rights required to purchase one new share Ex-rights share price (Me) R = (Me – S)/ N Infact Me = Mo - R Formulae for Right Pricing

  15. Before and After Right Offerings • Before: 9 old shares at $40 = $360 • Cash = 30 • Total = 390 • After: exercise the rights • 10 shares at $39(diluted value) = $390 Cash = 0 Total = 390

  16. After Right Offerings cont’ • Case 1: selling the rights • 9 shares at $39 (diluted value) = $351 • Proceeds from sale of rights = 9 • Cash = 30 • Total = 390 • Case 2: neither exercise nor sell the rights • 9 shares at $39 = $351 • Cash = 30 • Total = 381

  17. Effect of Rights on Old Shareholders • Exercise the rights; no net gain or loss • Sell the rights; no net gain or loss • Allow the rights to lapse; a loss due to the dilution of existing shares • Remember to exercise or sell the rights upon seasonal offerings

  18. Advantage of Rights Offerings Financing • Protects stockholder’s voting position and claim on earnings • Existing shareholders provide a built-in market for new issues • Distribution costs are lower • The false appearance of a bargain may create more interest in the company stock

  19. Poison Pill • A right offering to prevent the company from being acquired by hostile buyer • Once the hostile buyer accumulates a certain percentage of the common stock (say 20%), the other shareholders will receive rights to purchase additional shares at very low prices • This will dilute the hostile buyer’s ownership percentage as well as the share value

  20. Preferred Stock Financing • From the corporate perspective, preferred stock contributes to capital structure balance by • Expanding the capital base without diluting common stock or incurring contractual obligations • Unlike interest payment on debt, preferred stock dividends are not tax deductible

  21. Preferred Stock Financing cont’ • From investor perspective, institutional investors may receive the preferred stock dividends tax free (Legislation changed) • For small individual investors, they may enjoy dividend tax credit

  22. Possible features for Preferred Shares • Cumulative dividends - dividends may accumulate but must be paid before dividends on common shareholders • Participation provision - receives higher than the quoted yield when company makes exceptional profit • Convertible - may convert into common shares • Callable - company has option to call back • Retractable - investor has option to redeem • Floating rate - preferred yield adjust to market condition

  23. Alternative Security Financing • Corporate Bonds • Preferred Stock • Common Stock • Table 17-1 & 2

  24. Table 17-1Features of alternative security issues

  25. Table 17-1 cont’Features of alternative security issues

  26. Required rate of return Corporate issues Common stock Subordinated debentures Senior unsecured debt Secured debt Long-term government securities Treasury bills (short term) Savings account Risk to investor Figure 17-2Risk and expected return for various securities

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