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Chapter 17: Common and Preferred Stock Financing
Chapter 17
Common and Preferred Stock Financing
Discussion Questions
17-1.
Why has corporate management become increasingly sensitive to the
desires of large institutional investors?
Corporate management has become increasingly sensitive to the desires of
large institutional investors because they fear these shareholders may side
with corporate raiders in voting their shares in mergers or takeovers
attempt.
17-2.
Why might a corporation use a special category such as founders’ stock in
issuing common stock?
Founders’ stock may carry special voting rights that allow the original
founders to maintain voting privileges in excess of their proportionate
ownership.
17-3.
What is the purpose of cumulative voting? Are there any disadvantages to
management?
The purpose of cumulative voting is to allow some minority representation
on the board of directors. A possible disadvantage to management is that
minority stockholders can challenge their actions.
17-4.
How does the preemptive right protect stockholders from dilution?
The preemptive right provides current stockholders with a first option to
buy new shares. In this fashion, their voting right and claim to earnings
cannot be diluted without their consent.
17-5.
If common stockholders are the owners of the company, why do they have
the last claim on assets and a residual claim on income?
The actual owners have the last claim to any and all funds that remain. If
the firm is profitable, this could represent a substantial amount. Thus, the
residual claim may represent a privilege as well as a potential drawback.
Generally, other providers of capital may only receive a fixed amount.
Chapter 17: Common and Preferred Stock Financing
17-6.
During a rights offering, the underlying stock is said to sell “rights-on” and
“ex-rights.” Explain the meaning of these terms and their significance to
current stockholders and potential stockholders.
When a rights offering is announced, a stock initially trades rights-on, that
is, if you buy the stock you will also acquire a right toward future purchase
of stock.
After a certain period of time (say four weeks), the stock goes ex-rights;
thus when you buy the stock you no longer get a right toward future
purchase of stock.
The significance to current and future stockholders is that they must decide
if they wish to use or sell the right when the stock is trading rights-on. The
stock will go down by the appropriate value of the right when the stock
moves to an ex-rights designation.
17-7.
Why might management use a poison pill strategy?
A poison pill may help management defend itself against a potential
takeover attempt. When another company attempts to acquire the firm, the
poison pill allows current stockholders to acquire additional shares at a
very low price. This increases the shares outstanding and makes it more
difficult for the potential acquiring company to successfully complete the
merger.
17-8.
Preferred stock is often referred to as a hybrid security. What is meant by
this term as applied to preferred stock?
Preferred stock is a “hybrid” or intermediate form of security possessing
some of the characteristics of debt and common stock. The fixed amount
provision is similar to debt, but the noncontractual obligation is similar to
common stock. Though the preferred stockholder does not have an
ownership interest in the firm, the priority of claim is higher than that of
the common stockholder.
Chapter 17: Common and Preferred Stock Financing
17-9.
What is the most likely explanation for the use of preferred stock from a
corporate viewpoint?
Most corporations that issue preferred stock do so to achieve a balance in
their capital structure. It is a means of expanding the capital base of the
firm without diluting the common stock ownership position or incurring
contractual debt obligations.
17-10.
Why is the cumulative feature of preferred stock particularly important to
preferred stockholders?
With the cumulative feature, if preferred stock dividends are not paid in
any one year, they accumulate and must be paid in total before common
stockholders can receive dividends. Even though preferred stock
dividends are not a contractual obligation as is true of interest on debt, the
cumulative feature tends to make corporations very aware of obligations
to preferred stockholders. Preferred stockholders may even receive new
securities for forgiveness of missed dividend payments.
17-11.
A small amount of preferred stock is participating. What would your
reaction be if someone said common stock is also participating?
The participation privileges of a few preferred stock issues mean that
preferred stockholders may receive a payout over and above the quoted
rate when the corporation enjoys a particularly good year. This is very
similar to the situation with common stock and one can certainly say that
common stock is a participation-type security.
17-12.
What is an advantage of floating rate preferred stock for the risk-averse
investor?
There is less price volatility than with regular preferred stock.
Chapter 17: Common and Preferred Stock Financing
17-13.
Put an X by the security that has the feature best related to the following
considerations. You may wish to refer to Table 17-3.
a. Ownership and control of the firm
b. Obligation to provide return
c. Claims to assets in bankruptcy
d. High cost of distribution
e. Highest return
f. Highest risk
g. Tax-deductible payment
h. Payment partially tax-exempt
to corporate recipient
Common
Stock
Preferred
Stock
Bonds
a. Owners and control of the
firm
X
b. Obligation to provide
return
X
c. Claims to assets in
bankruptcy
X
d. Highest cost of
distribution
X
e. Highest return
X
f. Highest risk
X
g. Tax deductible
payment
X
h. Payment partially tax
exempt to corp. recipient
X
X
Chapter 17
Problems
1. Residual claims to earnings (LO1) Diploma Mills has $30 million in earnings, pays $4.25
million in interest to bondholders, and $2.95 million in dividends to preferred stockholders.
a. What are the common stockholders’ residual claims to earnings?
b. What are the common stockholders’ legal, enforceable claims to dividends?
Chapter 17: Common and Preferred Stock Financing
17-5
Diploma Mills
(in millions)
a. Earnings $30.00
–Interest 4.25
2. Residual claims to earnings (LO1) Text-Messaging Inc. has $72 million in earnings and
is considering paying $8.35 million in interest to bondholders and $6.65 million in
dividends to preferred stockholders.
a. What are the bondholders contractual claims to payment? (You may wish to review
Table 17-3).
b. What are the preferred stockholders immediate contractual claims to payment? What
privilege do they have?
17-2. Solution:
Text-Messaging, Inc.
a. The bondholders have a legal contractual claim of
$8.35 million.
Chapter 17: Common and Preferred Stock Financing
17-6
3. Person pill (LO4) Steele Pipe Co. has 13,800,000 shares outstanding. The stock is
currently selling at $68 per share. If an unfriendly outside group acquired 25 percent of the
shares, existing stockholders will be able to buy new shares at 30 percent below the
currently existing stock price.
a. How many shares must the unfriendly outside group acquire for the poison pill to go
into effect?
b. What will be the new purchase price for the existing stockholders?
17-3. Solution:
Steele Pipe Co.
a. 13,800,000 Total shares
4. Cumulative voting (LO2) Russell Stover Jr. wishes to know how many shares are
necessary to elect 4 directors out of 11 directors up for election for the Tasty Candy
Company board. There are 75,000 shares outstanding. (Use Formula 17–1 on page 538 to
determine the answer.)
17-4. Solution:
Tasty Candy Company
(Number of directors desired) ×
(Total number of shares outstanding)
Shares required = +1
Total number of directors to be elected +1
=
4 × 75,000 300,000
+ 1 = + 1
11 + 1 12
= 25,000 + 1 = 25,001 shares
Chapter 17: Common and Preferred Stock Financing
17-7
5. Cumulative voting (LO2) Dr. Phil wishes to know how many shares are necessary to elect
6 directors out of 15 directors up for election for the board of the Winfrey Publishing
Company. There are 400,000 shares outstanding. (Use Formula 17–1 on page 538 to
determine the answer.)
17-5. Solution:
Winfrey Publishing Company
(Number of directors desired) ×
(Total number of shares outstanding)
Shares required = +1
Total number of directors to be elected +1
=
6 × 400,000 2,400,000
+ 1 = + 1
15 + 1 16
= 150,000 + 1 = 150,001 shares
6. Cumulative voting (LO2) Mr. R.C. Cola owns 7,001 shares of the Softdrinks, Inc. There
are 10 seats on the company board of directors, and the company has a total of 77,000
shares outstanding. Softdrinks, Inc., utilizes cumulative voting.
17-6. Solution:
Softdrinks, Inc
(Shares owned 1)−
Number of directors
that can be elected
(Total number of directors to be elected) + 1
=Total number of shares outstanding
(7,001 1) (10 1) 7,000 11 77,000
77,000 77,000 77,000 director
− +
===
= 1 director
Chapter 17: Common and Preferred Stock Financing
17-8
7. Cumulative voting (LO2) Betsy Ross owns 918 shares in the Hanson Fabrics Company.
There are 13 directors to be elected. Thirty-one thousand shares are outstanding. The firm
has adopted cumulative voting.
a. How many total votes can be cast?
b. How many votes does Betsy control?
c. What percentage of the total votes does she control?
17-7. Solution:
Hanson Fabrics Company.
Votes = Number of shares × number of directors to be elected
8. Dissident stockholder group and cumulative voting (LO2) The Beasley Corporation has
been experiencing declining earnings, but has just announced a 50 percent salary increase
for its top executives. A dissident group of stockholders wants to oust the existing board of
directors. There are currently 11 directors and 30,000 shares of stock outstanding.
Mr. Wright, the president of the company, has the full support of the existing board. The
dissident stockholders control proxies for 10,001 shares. Mr. Wright is worried about
losing his job.
a. Under cumulative voting procedures, how many directors can the dissident
stockholders elect with the proxies they now hold? How many directors could they
elect under majority rule with these proxies?
b. How many shares (or proxies) are needed to elect six directors under cumulative voting?
17-8. Solution:
Chapter 17: Common and Preferred Stock Financing
17-9
Beasley Corporation
a. Number of
directors
that can be
elected
(10,001 1) (11 1) 120,000 4
30,000 30,000
− +
= = =
Four directors can be elected by the dissident stockholders
under cumulative voting.
b.
(Number of directors desired)
(Total number of shares outstanding)
Shares Required = 1
Total number of directors to be elected +1 +
6 30,000 180,000
1 1 15,001 shares
11 1 12
= + = + =
+
9. Dissident stockholder group and cumulative voting (LO2) Midland Petroleum is
holding a stockholders’ meeting next month. Ms. Ramsey is the president of the company
and has the support of the existing board of directors. All 11 members of the board are up
for reelection. Mr. Clark is a dissident stockholder. He controls proxies for 40,001 shares.
Ms. Ramsey and her friends on the board control 60,001 shares. Other stockholders, whose
loyalties are unknown, will be voting the remaining 19,998 shares. The company uses
cumulative voting.
a. How many directors can Mr. Clark be sure of electing?
b. How many directors can Ms. Ramsey and her friends be sure of electing?
c. How many directors could Mr. Clark elect if he obtains all the proxies for the
uncommitted votes? (Uneven values must be rounded down to the nearest whole
number regardless of the amount.) Will he control the board?
(Shares owned 1)
(Total number of directors to be elected) +1
=Total number of shares outstanding
−
Chapter 17: Common and Preferred Stock Financing
17-10
17-9. Solution:
Midland Petroleum
a. Number of
directors
that can be
elected
(40,001 1) (11 1) 480,000 4
120,000 120,000
− +
= = =
b.
(60,001 1) (11 1) 60,000 12
120,000 120,000
− +
=
720,000 6 directors
120,000
==
6 directors.
17-9. (Continued)
c. Shares owned = shares owned and proxies of other voters
(40,001 19,998 1) 12 59,998 12
120,000 120,000
+ −
==
719,976 5.9998 5 directors (rounded down)
120,000
= = =
(Shares owned 1)
(Total number of directors to be elected) + 1
=Total number of shares outstanding
−
