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Chapte r McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Common and Preferred Stock Financing 1 7

Common and Preferred Stock Financing

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Common and Preferred Stock Financing. 17. Chapter Outline. Privileges of a common stockholder. Cumulative voting and its characteristics. Rights offering. Poison pills and other regulatory provisions. Preferred stock. Common Stock. Stockholders - ultimate owners of a firm. - PowerPoint PPT Presentation

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Page 1: Common and  Preferred Stock  Financing

Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Common and Preferred Stock Financing17

Page 2: 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.

Page 3: Common and  Preferred Stock  Financing

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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.

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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.

Page 5: Common and  Preferred Stock  Financing

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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.

Page 6: Common and  Preferred Stock  Financing

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Institutional Ownership of U.S. Companies

Page 7: Common and  Preferred Stock  Financing

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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.

Page 8: Common and  Preferred Stock  Financing

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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.

Page 9: Common and  Preferred Stock  Financing

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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:

Page 10: Common and  Preferred Stock  Financing

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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.

Page 11: Common and  Preferred Stock  Financing

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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.

Page 12: Common and  Preferred Stock  Financing

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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.

Page 13: Common and  Preferred Stock  Financing

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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:

Page 14: Common and  Preferred Stock  Financing

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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.

Page 15: Common and  Preferred Stock  Financing

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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.

Page 16: Common and  Preferred Stock  Financing

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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

Page 17: Common and  Preferred Stock  Financing

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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.

Page 18: Common and  Preferred Stock  Financing

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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.

Page 19: Common and  Preferred Stock  Financing

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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.

Page 20: Common and  Preferred Stock  Financing

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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.

Page 21: Common and  Preferred Stock  Financing

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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.

Page 22: Common and  Preferred Stock  Financing

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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.

Page 23: Common and  Preferred Stock  Financing

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Before-Tax Yields on Moodys Utility Bonds and Preferred Stock

Page 24: Common and  Preferred Stock  Financing

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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.

Page 25: Common and  Preferred Stock  Financing

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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.

Page 26: Common and  Preferred Stock  Financing

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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.

Page 27: Common and  Preferred Stock  Financing

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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.

Page 28: Common and  Preferred Stock  Financing

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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.

Page 29: Common and  Preferred Stock  Financing

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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.

Page 30: Common and  Preferred Stock  Financing

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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.

Page 31: Common and  Preferred Stock  Financing

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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.

Page 32: Common and  Preferred Stock  Financing

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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.

Page 33: Common and  Preferred Stock  Financing

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Features of Alternative Security Issues

Page 34: Common and  Preferred Stock  Financing

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Risk and Expected Return for Various Security Classes