978-1259277160 Chapter 17 Lecture Note

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Common and Preferred Stock Financing

Author’s Overview

The first part of the chapter gives the student a clear view of the changing nature of stock

ownership through increasing institutional participation and the declining importance of

individual stock ownership. The residual nature of common stock as compared to other

securities is examined as well as cumulative voting and rights offerings. We also stress the

various classes of common stock that exist, such as voting and non-voting and founders stock.

Preferred stock should be introduced as a hybrid form of security. The unusual tax features of

preferred stock are compared to debt by highlighting the non-tax deductibility of preferred

dividends to the paying corporation and the partial tax-exempt nature of preferred dividends to

corporate owners. The cumulative nature of preferred stock is also important to the discussion,

with lesser recognition given to the conversion, call, and participating features (some of these

topics have been covered under the discussion of debt).

Chapter Concepts

LO1. Common stockholders are the owners of the corporation and therefore have a claim to

undistributed income, the right to elect the board of directors, and other privileges.

LO2. Cumulative voting provides minority stockholders with the potential for some

representation on the board of directors.

LO3. A rights offering gives current stockholders a first option to purchase new shares.

LO4. Poison pills and other similar provisions may make it difficult for outsiders to take over

a corporation against management’s wishes.

LO5. Preferred stock is an intermediate type of security that falls somewhere between debt

and common stock.

Annotated Outline and Strategy

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I. Introduction

A. Although management controls the corporation on a daily basis, ultimate control

of the firm resides in the hands of the stockholders.

B. Common stockholders poses three key rights: the residual claim to income, the

right to vote and elect the board of directors, and the right to purchase new

shares to maintain their ownership percentage.

Perspective 17-1: The introduction tells a story of TowerJazz headquartered in Israel and the

journey of losses and fundraising through common stock sales. It emphasizes the importance of

common stock and access to capital markets and is a good introduction to risk taking by

investors in small firms.

II. Common Stockholders’ Claim to Income

A. Common stockholders have a residual claim on the income stream; the amount

remaining after creditors and preferred stockholders have been satisfied belongs

to the owners (common stockholders) whether paid in dividends or retained.

B. Institutional investors such as pension, mutual funds, exchange traded funds,

insurance companies, and bank managed trust funds control a large share of the

voting power.

C. A corporation may have several classes of common stock that differ in regard

to voting rights and claim on the earnings stream.

PPT Institutional Ownership of U.S. Companies (Table 17-1)

III. The Voting Right

A. Owners of common stock have the right to vote on all major issues including

election of the board of directors.

Perspective 17-2: The voting right is important, and the Ford family provides an interesting

example of “founders’ stock” for students.

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B. Majority voting: holders of majority of stock can elect all directors.

C. In some firms such as Ford Motor Company, different classes of stock are

entitled to elect a specified percentage of the board of directors.

D. Cumulative voting makes it possible for minority stockholders who own less

than 50 percent of the stock to elect some of the directors.

1. The stockholder can cast one vote for each share of stock owned times

the number of directors to be elected.

2. The following formula may be employed to determine the number of

shares needed to elect a given number of directors under cumulative

voting.

3. Restated, if we know the number of minority shares outstanding under

cumulative voting and wish to determine the number of directors that can

be elected, we use the formula:

Number of directors (Shares owned 1) (Number of directors to be elected + 1)

that can be elected Total number of shares outstanding

– ´

Finance in Action: Morningstar Raises Hewlett-Packard’s Stewarship Rating from “Poor:

to “Standard”

This box discusses how corporate boards of directors are responsible for the major strategic

decisions of a company. According to Morningstar, a financial analysis firm, HP senior

management and the board failed to provide consistent quality leadership for the company.

After a new CEO, Meg Whitman was hired the situation improved and the rating was upgraded.

This comprehensive box can be tied back to Chapter 1 and the section on corporate governance.

IV. The Right to Purchase New Shares

A. The stockholder may have the right to maintain his percentage of ownership, voting

power, and claim to earnings through the preemptive right provision which

requires that existing stockholders be given the first option to purchase new

shares. Rights offerings are more common in European markets than in the U.S.

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Number of Total number of

Shares directors desired shares outstanding

= + 1

required Total number of directors to be elected + 1

Perspective 17-3: The Ericsson offering in August of 2002 is an example of a major rights

offering. See Table 17-2 for other examples.

B. The Use of Rights in Financing

1. Even if the preemptive right provision is not required, the corporation

may finance through a rights offering.

2. Each stockholder receives one right for each share of stock owned, and is

allowed to buy new shares of stock at a reduced price (below market

value) plus the required number of rights/share.

3. The number of rights required to purchase a new share equals the ratio of

shares outstanding to the new shares issued.

Number of rights required Number of shares outstanding

to purchase one new share Number of shares to be issued

4. Rights have market value since they entitle the holder to purchase shares

of stock at less than market price.

a. Rights Required: Initially, after the rights offering announcement,

stock trades “rights-on.” The formula for the value of a right

during the rights-on period is:

M0 = Market value of stock, rights-on

S = Subscription price

N = Number of rights required to purchase a new share of

stock

b. Monetary Value of a Right: After a certain period, the right no

longer trades with the stock but may be bought and sold

separately. On the “ex-rights” date the stock price falls by the

theoretical value of a right. The ex-rights value of a right is:

Me = Market value of stock, ex-rights

Perspective 17-4: Rights provide a first option to purchase new shares but do not make the

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( )

( 1)

M S

–

( )

M S

–

stockholder wealthier.

5. Existing stockholders usually do not have a monetary gain from a rights

offering. The gain from purchasing shares at less than market price is

eliminated by dilution of previously owned shares.

6. A stockholder has three options when presented with a rights offering.

a. Exercise the rights; no net gain or loss

b. Sell the rights; no net gain or loss

c. Allow the rights to lapse; a loss will be incurred due to the

dilution of existing shares that is not offset by value of unsold or

unexercised rights.

C. Desirable features of rights offerings

1. Protects stockholders’ voting position and claim on earnings

2. Existing stockholders provide a built-in market for new issues;

distribution costs are lower

3. May create more interest in stock than a straight offering

4. Lower margin requirements

Finance in Action: HSBC Holdings Plc. Rights Offering

HSBC Holdings Plc. also know as Hong Kong Shanghai Banking Corporation, is Europe’s

biggest bank with a worldwide presence. This box describes how they used a $17.7 billion

rights offering in March of 2009 to bail themselves out of the financial crisis. This is one of the

largest rights offerings in history.

D. Poison Pills

1. A “poison pill” is a rights offering made to existing shareholders of a

company with the sole purpose of thwarting an acquisition attempt by

another company. The increased number of shares may dilute the

ownership percentage of the firm pursuing the takeover.

2. Some investors feel that a poison pill strategy is contrary to the goal of

maximizing the wealth of the owners.

V. American Depository Receipts (ADRs)

A. ADRs are shares of foreign stock held in trust by U.S. Banks that issues a claim

on these trust receipts. There are over 3725 ADRs or GDRs (global deposit

receipts) listed on U.S. Exchanges and over-the-counter markets. See Table 17-3

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for the list of regions and markets.

B. ADRs allow foreign companies to raise funds in U.S. markets and provide

investors with English annual reports using U.S. GAAP accounting.

C. The example of ADRs gives the professor yet another chance to emphasize how

important international markets are to both U.S. and foreign firms.

VI. Preferred Stock Financing

A. Characteristics of preferred stock

1. Stipulated that dividends must be paid before dividends on common stock

but are not guaranteed or required.

2. Dividends are not tax-deductible to the corporation and are paid after

taxes just like common stock diviends.

B. Preferred stock contributes to capital structure balance by expanding the capital

base without diluting common stock or incurring contractual obligations.

C. Primary purchasers of preferred stock are corporate investors, insurance

companies and pension funds. One advantage these investors have is that 70

percent of dividend income received by corporations is exempt from taxation

whereas interest received is fully taxable.

VII. Provisions Associated with Preferred Stock

A. Cumulative dividends

B. Conversion feature

C. Call feature

D. Participation provision

E. Floating rate

F. Auction Rate Preferred Stock

G. Par value

VIII. Comparing Features of Common and Preferred Stock and Debt: As the level of risk

increases, so does the return.

PPT Features of Alternative Security Issues (Table 17-4)

PPT Risk and Expected Return for Various Security Classes (Figure 17-1)

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Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 26, Midsouth Exploration Company (Preferred Stock)

Case 27, Alpha Biogenetics (Poison Pill)

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