17-1
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 nonvoting 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
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.
17
17-2
Annotated Outline and Strategy
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
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.
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.
B. Majority voting: holders of majority of stock can elect all directors.
17-3
C. In some firms such as Ford Motor Company, different classes of stock are entitled to
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
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
−
PPT Rights Offerings Big and Small (Table 17-2)
Finance in Action: Hewlett Packard Corporate Governance, Stewardship and Facebook
Inc.
This box illustrates that corporate governance refers to the way a company is managed by the
board of directors. Good governance includes information transparency so that stockholders and
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.
Number of Total number of
Shares directors desired shares outstanding
required Total number of directors to be elected + 1
17-4
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
3. The number of rights required to purchase a new share equals the ratio of
shares outstanding to the new shares issued.
to purchase one new share =Number of shares outstanding
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
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:
0
( )
( 1)
MS
RN
−
=+
()
e
MS
RN
−
=
17-5
Perspective 17-4: Rights provide a first option to purchase new shares but do not make the
stockholder wealthier.
5. Existing stockholders usually do not have a monetary gain from a rights
6. A stockholder has three options when presented with a rights offering.
a. Exercise the rights; no net gain or loss
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
4. Lower margin requirements
Finance in Action: HSBC Holdings Plc. Rights Offering
1. A “poison pill” is a rights offering made to existing shareholders of a
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 issue a claim on
these trust receipts. There are over 3725 ADRs or GDRs (global deposit receipts)
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listed on U.S. exchanges and over-the-counter markets. See Table 17-3 for the
American Depository Shares (Receipts) for nine regions in January 2018.
PPT Depository (Table 17-3)
VI. Preferred Stock Financing
A. Characteristics of preferred stock
1. Stipulated that dividends must be paid before dividends on common stock but
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,
VII. Provisions Associated with Preferred Stock
A. Cumulative dividends
B. Conversion feature
C. Call feature
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)
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 27, Alpha Biogenetics (Poison Pill)