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Chapter 17: Common and Preferred Stock Financing
17-21
Robbins Petroleum Company
a. $6.50 per share × 850,000 shares × 4 years =
$22,100,000 × 90% = $19,890,000 compensation
b. $875.54
21. Preferred stock dividends in arrears and valuing common stock (LO5) Enterprise
Storage Company has $400,000 shares of cumulative preferred stock outstanding, which
has a stated dividend of $4.75. It is six years in arrears in its dividend payments.
a How much in total dollars is the company behind in its payments?
b. The firm proposes to offer new common stock to the preferred stockholders to wipe
out the deficit.
The common stock will pay the following dividends over the next four years:
D1 ................ $1.25
D2 ................ 1.50
D3 ................ 1.75
D4 ................ 2.00
The company anticipates earnings per share after four years will be $4.05 with a P/E ratio
of 12.
The common stock will be valued as the present value of future dividends plus the present
value of the future stock price after four years. The discount rate used by the investment
banker is 10 percent. Round to two places to the right of the decimal point. What is the
calculated value of the common stock?
c. How many shares of common stock must be issued at the value computed in part b to
eliminate the deficit (arrearage) computed in part a? Round to the nearest whole number.
17-21. Solution:
Chapter 17: Common and Preferred Stock Financing
17-22
Enterprise Storage Company
a. $4.75 per share × 400,000 shares × 6 years = $ 11,400,000
dividends in arrears.
b. Stock Price
Present value of common stock dividends
PV factor Present
Amount at 10% Value
17-21. (Continued)
Present value of future stock price
1. Stock price = P/E × EPS
2. PV of stock price (4 years in the future)
PV factor Present
Amount at 10% Value
Current value of the common stock
Chapter 17: Common and Preferred Stock Financing
c.
22. Borrowing funds to purchase preferred stock (LO5) The treasurer of Kelly Bottling
Company (a corporation) currently has $100,000 invested in preferred stock yielding 8
percent. He appreciates the tax advantages of preferred stock and is considering buying
$100,000 more with borrowed funds. The cost of the borrowed funds is 10 percent. He
suggests this proposal to his board of directors. They are somewhat concerned by the fact
that the treasurer will be paying 2 percent more for funds than the company will be carning
on the investment. Kelly Bottling is in a 34 percent tax bracket, with dividends taxed at
15 percent.
a. Compute the amount of the aftertax income from the additional preferred stock if it is
purchased.
b. Compute the aftertax borrowing cost to purchase the additional preferred stock. That
is, multiply the interest cost times (1 – T).
c. Should the treasurer proceed with his proposal?
d. If interest rates and dividend yields in the market go up six months after a decision to
purchase is made, what impact will this have on the outcome?
17-22. Solution:
Kelly Bottling Company
a. Preferred Stock................... $100,000
Dividend yield .................... 8%
b. Loan ................................... $100,000
Number of shares
Of common stock
to eliminate the
deficit
$11,400,000
Deficit
commonstockvalue $38.25
(2,980,039shares) 2,980,039
==
==
Chapter 17: Common and Preferred Stock Financing
17-24
17-22. (Continued)
c. Yes, the return exceeds the cost.
the borrowing cost could go up.
Note the dangers of these problems could be overcome by
23. Floating rate preferred stock (LO5) Barnes Air Conditioning, Inc., has two classes of
preferred stock: floating rate preferred stock and straight (normal) preferred stock. Both
issues have a par value of $100. The floating rate preferred stock pays an annual dividend
yield of 6 percent, and the straight preferred stock pays 7 percent. Since the issuance of the
two securities, interest rates have gone up by 2 percent for each issue. Both securities will
pay their year-end dividend today.
a. What is the price of the floating rate preferred stock likely to be?
b. What is the price of the straight preferred stock likely to be? Refer back to Chapter 10
and use Formula 10–4 to answer this question.
17-23. Solution:
Barnes Air Conditioning, Inc.
a. The floating rate preferred stock should be trading at very
Chapter 17: Common and Preferred Stock Financing
17-25
P
P
P
D$7
P $77.78
K .09
= = =
COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Crandall Corporation (rights offering and the impact on shareholders ) (LO3) The Crandall
Corporation currently has 100,000 shares outstanding that are selling at $50 per share. It needs to
raise $900,000. Net income after taxes is $500,000. Its vice-president of finance and its
investment banker have decided on a rights offering, but are not sure how much to discount the
subscription price from the current market value. Discounts of 10 percent, 20 percent, and 40
percent have been suggested. Common stock is the sole means of financing for the Crandall
Corporation.
a. For each discount, determine the subscription price, the number of shares to be issued, and
the number of rights required to purchase one share. (Round to one place after the decimal
point where necessary.)
b. Determine the value of one right under each of the plans. (Round to two places after the
decimal point.)
c. Compute the earnings per share before and immediately after the rights offering under a
10 percent discount from the market price.
d. By what percentage has the number of shares outstanding increased?
e. Stockholder X has 100 shares before the rights offering and participated by buying 20 new
shares. Compute his total claim to earnings both before and after the rights offering (that is,
multiply shares by the earnings per share figures computed in part c).
f. Should Stockholder X be satisfied with this claim over a longer period of time?
CP 17-1. Solution:
Crandall Corp.
a. 10% discount-subscription price equals $45.
Required funds $900,000
Number of new shares = 20,000
Subscription price $45
==
Chapter 17: Common and Preferred Stock Financing
17-26
Old shares 100,000
Number of rights to purchase one share = 5
New shares 20,000
==
CP17-1. (Continued)
20% discount-subscription price equals $40
Required funds $900,000
Number of new shares = 22,500
Subscription price $40
==
Old shares 100,000
Number of rights to purchase one share = 4.4
New shares 22,500
==
40% discount-subscription price equals $30
Required funds $900,000
Number of new shares = 30,000
Subscription price $30
==
Old shares 100,000
Number of rights to purchase one share = 3.3
New shares 30,000
==
b.
oMS
R= N+1
−
Chapter 17: Common and Preferred Stock Financing
10%
$50 45 $5
R = $.83
5 1 6
−==
+
20%
$50 40 $10
R = $1.85
4.4 1 5.4
−==
+
40%
$50 30 $20
R = $4.65
3.3 1 4.3
−==
+
CP17-1. (Continued)
c. EPS before rights offering = net income/old shares
EPS after rights offering = net income/(old + new shares)
d. 20% increase in shares outstanding (100,000 to 120,000)
should increase.
COMPREHENSIVE PROBLEM
Comprehensive Problem 2.
Chapter 17: Common and Preferred Stock Financing
17-28
Electro Cardio Systems, Inc. (poison pill strategy) (LO4) Dr. Robert Grossman founded
Electro Cardio Systems, Inc., (ECS) in 2001. The principal purpose of the firm was to engage in
the research and development of heart pump devices. Although the firm did not show a profit
until 2006, by 2010 it reported aftertax earnings of $1,200,000. The company had gone public in
2004 at $10 a share. Investors were initially interested in buying the stock because of its future
prospects. By year-end 2010, the stock was trading at $42 per share because the firm had made
good on its promise to produce lifesaving heart pumps and, in the process, was now making
reasonable earnings. With 850,000 shares outstanding, earnings per share were $1.41.
Dr. Grossman and the members of the board of directors were initially pleased when another
firm, Parker Medical Products, began buying their stock. John Parker, the chairman and CEO of
Parker Medical Products, was thought to be a shrewd investor and his company’s purchase of
50,000 shares of ECS was taken as an affirmation of the success of the firm.
However, when Parker bought another 50,000 shares, Dr. Grossman and members of the
board of directors of ECS became concerned that John Parker and his firm might be trying to take
over ECS.
Upon talking to her attorney, Dr. Grossman was reminded that ECS had a poison pill
provision that took effect when any outside investor accumulated 25 percent or more of the shares
outstanding. Current stockholders, excluding the potential takeover company, were given the
privilege of buying up to 500,000 shares of ECS at 80 percent of current market value. Thus, new
shares would be restricted to friendly interests.
The attorney also found that Dr. Grossman and “friendly” members of the board of directors
currently owned 175,000 shares of ECS.
a. How many more shares would Parker Medical Products need to purchase before the poison
pill provision would go into effect? Given the current price of ECS stock of $42, what would
be the cost to Parker to get up to that level?
b. ECS’s ultimate fear was that Parker Medical Products would gain over a 50 percent interest
in ECS’s outstanding shares. What would be the additional cost to Parker to get 50 percent
(plus 1 share) of the stock outstanding of ECS at the current market price of ECS stock? In
answering this question, assume Parker had previously accumulated the 25 percent position
discussed in a.
c. Now assume Parker exceeds the number of shares you computed in part b and gets all the way
up to accumulates 625,000 shares of ECS. Under the poison pill provision, how many shares
must “friendly” shareholders purchase to thwart a takeover attempt by Parker? What will be
the total cost? Keep in mind that friendly interests already own 175,000 shares of ECS and to
maintain control, they must own one more share than Parker.
d. Would you say the poison pill is an effective deterrent in this case? Is the poison pill in the
best interest of the general stockholders (those not associated with the company)?
Chapter 17: Common and Preferred Stock Financing
17-29
CP 17-2. Solution:
Electro Cardio Systems, Inc.
a. If Parker owns 25 percent of the shares outstanding of ECS, the
poison pill will go into effect.
b. To get a 50% + 1 share interest in ECS, Parker would need to own
425,000 (1/2 of 850,000) + 1 share. The number is 425,001.
Since Parker has already acquired 212,500 shares of ECS, it would
need to buy 212,501 more shares.
c. One more share than Parker would necessitate an ownership of
625,001 shares.
Chapter 17: Common and Preferred Stock Financing
17-30
CP17-2. (Continued)
Because under the poison pill provision, they can buy at 80% of
current market value, the total cost of the 450,001 shares would be
$15,120,033.
d. Yes, the poison pill is an effective deterrent in this case. Since the
poison pill provision allows up to 500,000 additional shares to be
Quite likely, the poison pill is not in the best interest of the general
shareholders. Without the poison pill, ECS is more likely to be a
merger takeover candidate. Often a price is offered well in excess of
