Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 17 Common and Preferred Stock Financing Block, Hirt, and Danielsen Copyright ©

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

17Common and Preferred Stock Financing

Block, Hirt, and Danielsen

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


• Common stockholders – rights and privileges• Cumulative voting characteristics• Rights offering• Poison pills and other regulatory provisions• Preferred stock

Chapter Outline

17-2


• Represents ultimate firm ownership• Stockholders directly control business — in

practice management controls on daily basis

Common Stock

17-3


• Plays secondary role in financing corporate enterprise

• Represents hybrid security by combining features of debt and common stock

• Preferred stockholders have no ownership interest in firm• Priority claim on dividends over common

stockholders

Preferred Stock

17-4


• Three key rights• Residual claim to income• Voting right• Right to purchase new shares

Common Stockholders – Rights

17-5


• Common stockholders have residual claim to income regardless of payment of dividends or retention by firm

• No legal or enforceable claim to dividends• Firm may have several classes of common

stock outstanding that carry different rights to dividends and income

Common Stockholders’ Claim to Income

17-6


Institutional Ownership of U.S. Companies

Company Name Institutional Ownership (%) Institutional Ownership in Shares

Motorola Solutions Inc. 91.35 256,242,374

Lockheed Martin Corp. 91.17 295,027,852

eBay Inc. 85.60 1,107,664,142

Panera Bread Co. 83.30 23,623,105

Kellogg Co. 79.37 284,143,160

Wal-Mart Stores Inc. 79.47 2,671,198,763

Hewlett-Packard Co. 78.85 1,550,275,883

Bristol-Myers Squibb Co. 72.39 1,195,000,588

Amazon.com Inc. 70.77 320,567,732

PepsiCo Inc. 71.59 1,107,344,418

3M Co. 70.21 485,795,895

Microsoft Corp. 70.07 5,897,651,856

Walt Disney Co. 70.71 1,268,812,986

Johnson & Johnson 69.59 1,918,676,067

EI du Pont de Nemours & Co. 67.28 627,388,751

Coca-Cola Co. 64.20 2,879,468,739

International Business Machines Corp. 62.47 705,824,582

Procter & Gamble Co. 59.95 1,639,216,073

General Electric Co. 55.92 5,904,284,425

Exxon Mobil Corp. 50.68 2,339,511,998

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• Common stockholders have right to• Vote in election of board of directors• Vote on all other major issues• Assign proxy or “power to cast their ballot”

• Companies can have different classes of common stock with unequal voting rights

Voting Right

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• Majority voting• Stockholders owning above 50% of common stock

may elect all directors

• Cumulative voting• Stockholders with less than 50% interest may elect

some directors

Cumulative Voting

17-9


Cumulative Voting Process

• To determine number of shares needed to elect given number of directors under this method of voting

• If number of minority shares outstanding under cumulative voting known, number of directors to be elected can be determined

17-10


• Corporate charter containing preemptive right provision requires• Holders of common stock must be given first option to buy

new shares• Ensures management cannot subvert position of

present stockholders• Stockholders may choose to sell rights rather than

exercise them in purchase of new shares• Corporation that does not include preemptive right

provision can include “rights offering” in charter

Right to Purchase New Shares

17-11


• Used by many U.S. companies, popular fund-raising method in Europe

• Questions to consider• How many rights necessary to purchase one new

share?• Monetary value of rights?

Use of Rights in Financing

17-12


• When rights offering announced stock initially trades “rights-on”• Right value when stock trades rights-on

R = (M0 – S) ÷ (N + 1)Where: M0= market value – rights-on; S = subscription price; N = number of rights required to purchase new share of stock

• Ex-rights— buying shares with no right toward future purchase• Right value when stock trades at ex-right

R = (Me – S) ÷ N Where: Me= market value – ex-rights

Monetary Value of a Right

17-13


Option 1• Stockholder A owns 9 shares before rights offering and has $30 cash

• If receives and exercises 9 rights to buy one new share at $30

Effect of Rights on Stockholder's Position

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Option 2• Sell rights in market and stay with position of owning only nine shares and

holding cash

• If stockholder neither exercises rights nor sells rights, total value of holdings would come down

Effect of Rights on Stockholder's Position (cont’d)

17-15


• Position of current stockholders protected in regard to voting rights and claims to earnings

• Use of rights offerings gives firm built-in market for new security issues

• May also generate more market interest than straight public issue

• Stock purchased through rights offering carries lower margin requirements• Margin requirement — cash or equity that must be

deposited with brokerage house or bank, with balance of fund eligible for borrowing

Desirable Features of Rights Offering

17-16


• Rights offering made to existing shareholders of company• Allows existing shareholders to buy additional

shares of stock at very low price• Used to avoid takeover• Makes hostile takeovers very expensive and

unattractive

Poison Pills

17-17


• Certificates that have legal claim on ownership interest in foreign company’s common stock• Also referred to as American Depository Shares

(ADSs)• Allows foreign shares to be traded in United States

much like common stock

American Depository Receipts

17-18


• Annual reports and financial statements presented in English according to GAAP

• Dividends paid in dollars and more easily collected

• Considered to be• More liquid• Less expensive• Easier to trade than buying foreign companies’

stock directly on firm’s home exchange

Advantages of ADRs for the U.S. Investor

17-19


• ADRs also traded in own country subjecting investors to currency risk

• Infrequent reporting of financial results• Information lag due to time for translation of

reports into English

Drawbacks of ADRs for U.S. Investor

17-20


• Intermediate or hybrid form of security• Lacks desirable characteristics of debt and

common stock• Entitled to receive only stipulated dividend• Receive payment of dividends before common

stockholders• Rights to annual dividends not mandatory for

corporations

Preferred Stock Financing

17-21


• May be issued to achieve capital structure balance

• Means of expanding capital base without• Diluting common-stock-ownership position• Incurring contractual debt obligations

• Drawback — dividend payments not tax-deductible

Justification for Preferred Stock

17-22


• Primary purchasers of preferred stock are corporate investors, insurance companies, and pension funds• Corporate investor must add only 30% of

preferred or common dividends received from another corporation to taxable income

• All bond interest taxable to recipient except for municipal bond interest

Investor Interest

17-23


• Tax considerations for preferred stock work in two opposite directions• Make after-tax cost of debt cheaper than

preferred stock to issuing corporation• Interest deductible to payer

• Tax considerations generally make receipt of preferred dividends more valuable than bond interest

• Since 70% of dividend exempt from taxation

Summary of Tax Considerations

17-24


• These 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

Provisions Associated with Preferred Stock

17-25


• Cumulative preferred stock have cumulative claim to dividends• If dividends not paid in any one year, they accumulate and

must be paid in total before common stockholders can receive dividends

• Makes corporation aware of obligations to preferred stockholders

• Financial recapitalization may occur if financially troubled firm has missed number of dividend payments• Preferred stockholders receive new securities in place of

unpaid dividend

Cumulative Dividends

17-26


• Allows company to convert preferred stock into specified number of common stock shares

• Allows company to force conversion from convertible preferred stock into convertible debt• Can take advantage of falling interest rates• Can change preferred dividends into tax-

deductible interest payments

Conversion Feature

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• Allows corporations to retire security before maturity• At some small premium over par, at discretion of

corporation

• Preferred-issue-carrying-call provision receives slightly higher yield than similar issue without feature

Call Feature

17-28


• Small percentage of preferred stock issues are participating preferred• May participate over and above quoted yield• If common stock dividend equals preferred stock

dividend• Two security classes may share equally in additional

payouts

Participation Provision

17-29


• Floating-rate-preferred stocks have adjustable dividends

• Dividend changes based on current market conditions• Investors can minimize risk of price changes• Investors get tax benefits• Price stability makes equivalent to safe short-term

investment

Floating Rate

17-30


• Also known as Dutch auction preferred stock• Issued to bidder willing to accept lowest yield, then to next

lowest bidder, so on until all preferred stock sold• Long-term in nature, behaves like short-term security

• Auction periods vary for each issue, re-auctioned at subsequent bidding

• Much like Treasury bill auction• Allows investors to keep up with changing interest rates in

short-term market• Allows corporate investors to invest at short-term rates

and get tax-benefits

Auction Rate Preferred Stock

17-31


• Par value of preferred stock set at anticipated market value at time of issue• Establishes amount due to preferred stockholders

in event of liquidation• Determines base against which percentage or

dollar return on preferred stock computed

Par Value

17-32


• Highest return and risk associated with common stock

• Preferred stock generally pays lower return• Due to 70% tax exemption for corporate

purchasers• Increasingly high return requirement on debt,

based on• Presence or absence of security provision• Priority of claims on unsecured debts

Comparing Features of Common, Preferred Stock and Debt

17-33


Features of Alternative Security Issues

17-34


Risk and Expected Return for Various Security Classes

17-35

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Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 17 Common and Preferred Stock Financing Block, Hirt, and Danielsen Copyright ©