Common and Preferred Stock Financing

1. Common and Preferred Stock Financing 17

2. Chapter Outline • Privileges of a common stockholder. • Cumulative voting and its characteristics. • Rights offering. • Poison pills and other regulatory provisions. • Preferred stock.

3. Common Stock • Stockholders - ultimate owners of a firm. • Legally, stockholder directly controls the business. • Large creditor may have the power to exert pressure on the firm to meet certain standards.

4. 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. • Stockholders have a priority of claims to dividends. • Stockholders do not have an ownership interest in the firm.

5. Common Stockholders’ Claim to Income • Common stockholders have a residual claim to income. • These funds can be paid out as dividends or retained 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.

6. Institutional Ownership of U.S. Companies

7. The Voting Right • Common stockholders have the right to: • Vote in the election of broad 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. • Like founders shares. • Bondholders and preferred stockholders may vote: • If a corporate agreement has been violated.

8. Cumulative Voting • Majority voting • Possible for stockholders owning above 50% of common stock. • Cumulative voting • Stockholders with less than 50% interest may select some of the board members.

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:

10. The Right to Purchase New Shares • Holders of common stock must be given the first option to buy new shares. • Ensures that management cannot subvert the position of stockholders.

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? • Rights required. • Stockholders may choose to sell their rights, rather than exercise them in the purchase of new shares.

12. The Use of Rights in Financing (cont’d) • What is the monetary value of these rights? • Monetary value of a right – two terms. • When a rights offering is announced a stock initially trades rights-on. • The value of the right when a stock is trading rights-on is: Alternate formula: Where: Mo= market value – right-on; S = subscription price; N = number of rights required to purchase a new share of stock. • Ex-rights – when you buy a share there is no right towards future purchase.

13. Effect of Rights on Stockholders Position • Assume 100 people own shares of stock in a corporation and decide to sell new shares to themselves at 25% below current value. • 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 new shares at #30:

14. Effect of Rights on Stockholders Position (cont’d) • Second alternative: • Sell rights in the market and stay with his position of owning only nine shares and holding cash. The outcome would be: • As indicated, whether you choose to exercise a rights or not, the stock will still go down a lower value.

15. Desirable Features of Rights Offering • Current position of the current stockholders is protected in regard 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.

16. Poison Pills • A rights offering made to existing shareholders of a company. • Used to avoid a takeover. • Makes hostile takeovers very expensive and unattractive. • Allows existing shareholders the right to buy additional shares of the stock at a very low price

17. American Depository Receipts • Certificates that have a legal claim on an ownership interest in a foreign company’s common stock. • Referred to as American Depository Shares (ADSs). • Allows foreign shares to be traded in the United States like common stock.

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.

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 translation of reports into English.

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 for annual dividends is not mandatory for corporations. • Firm may forgo the preferred dividends when deemed necessary.

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. • Interest payments are not tax-deductible.

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 of another corporation, to its taxable income. • All the interest of binds are taxable to the recipient except for municipal bond interest.

23. Before-Tax Yields on Moodys Utility Bonds and Preferred Stock

24. 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. • Since 70% of the dividend is exempt from taxation.

25. Cumulative Dividends • Cumulative preferred stock have a cumulative claim to 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.

26. Conversion Feature • Preferred stock may be convertible to a specified number of common stock. • Allows the company to force to conversion from convertible preferred stock into convertible debt. • Allows company to take advantage of falling interest rates. • Allows company to change the preferred dividends into tax-deductible interest payments.

27. Call Feature • Preferred stock, allows for the retirement of security before maturity. • At some small premium over par, if the corporation chooses so. • A preferred issue carrying a call provision will be accorded a slightly higher yield than a similar issue without this feature.

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.

29. Floating Rate • Dividend are adjustable in nature - floating rate preferred stock. • 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.

30. Dutch Auction Preferred Stock • Short-term in nature. • The security matures every seven weeks and is re-auctioned at a subsequent bidding. • Allows investors to keep up with the changing interest rates in the short-term market.

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.

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, is based on: • The presence or absence of security provision. • The priority of claims on unsecured debts.

33. Features of Alternative Security Issues

34. Risk and Expected Return for Various Security Classes