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Common andPreferred StockFinancing

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Figure 17-1Time line during rights offering

PPT 17-1

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Beforetax and aftertax yields on corporate debentures andpreferred shares

Beforetax debenture yield . . . . . . . . . . . . . 5.34 percent

Federal tax (29%) . . . . . . . . . . . . . . . . . . . (1.55)

Provincial tax (44% of federal tax) . . . . . (0.68)

Aftertax debenture yield . . . . . . . . . . . . . . 3.11 percent

Beforetax preferred yield . . . . . . . . . . . . . . 4.50 percent

Gross up (25%) . . . . . . . . . . . . . . . . . . . . . . 5.63

Federal tax (29% of grossed-up amount) . 1.63

Tax credit (13 1/3% of grossed-up amount) .75

Net federal tax . . . . . . . . . . . . . . . . . . . . . . . (0.88)

Provincial tax (44% of federal tax) . . . . . . (0.39)

Aftertax preferred yield . . . . . . . . . . . . . . . . 3.23 percent

PPT 17-2

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CommonStock

Belongs to commonshareholders throughvoting rights andresidual claim to income

None

Lowest claim of anysecurity holder

Highest

PreferredStock

Limited rights whendividends are missed

Must receive paymentbefore commonshareholder

Bondholders andcreditors must besatisfied first

Moderate

BondsLimited rightsunder default ininterest payments

Contractualobligation

Highest claim

Lowest

1. Ownershipand controlof the firm

2. Obligationto providereturn

3. Claim toassets inbankruptcy

4. Cost ofdistribution

PPT17-3

Table 17-1aFeatures of alternative security issues

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CommonStock

Highest risk, highestreturn (at least intheory)

Not deductible

Dividend to anothercorporation is usuallytax exempt

Special tax treatment with dividend tax credit

PreferredStock

Moderate risk,moderate return

Not deductible

Same as commonstock

BondsLowest risk,moderate return

Tax deductibleCost = Interestpayment ××××(1 – Tax rate)

Interest usuallyfully taxable

5. Risk-returntrade-off

6. Tax status ofpayment bycorporation

7. Tax status ofpayment torecipient

PPT17-3

Table 17-1bFeatures of alternative security issues

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Required rate of return

Savings account

Treasury bills (short term)

Long-term government securities

Secured debt

Senior unsecured debt

Subordinated debentures

Common stock

Corporate issues

Risk to investor

PPT17-4

Figure 17-2Risk and expected return for various security classes

•Preferred stock

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Chapter 17 - Outline LT 17-1

• Common Stock

• The Voting Right

• Rights Offering

• “Rights-on” and “Ex-rights”

• Poison Pill

• Preferred Stock

• Provisions Associated with Preferred Stock

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Common Stock LT 17-2

• Common shareholders own the corporation and have ultimate control

• They have a residual (leftover) claim to all corporate income that is notpaid out to others

• Common shareholders have the right to vote on all major issues,including election of the board of directors

• Practically, management controls the corporation on a daily basis

• Management is most sensitive to the holders of large blocks of shares,

– such as the founding family, mutual funds, pension funds,insurance companies, trust companies

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The Voting Right LT 17-3

Proxy:

– a right to vote given to someone else’s (absentshareholder’s) vote

Majority Voting:

– all directors must be elected by at least 51% of the vote

– doesn’t allow minority shareholders representation onthe board of directors

Cumulative Voting:

– a shareholder’s votes can all be used to elect 1 person

– allows minority shareholders representation on board

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Rights Offering LT 17-4

Rights Offering:

– gives current shareholders a first option to purchasenew shares (called a preemptive right provision)

– allows existing shareholders the same amount of controlthey have initially

– shareholder receives 1 right for each share of stockowned

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“Rights-on” and “Ex-rights” LT 17-5

“Rights-on”

– if you buy the stock, you will also acquire a righttoward a future purchase of the stock

– occurs when a rights offering is initially announced

“Ex-rights”

– when you buy the stock you no longer get a righttoward future purchase of the stock

– occurs after a certain period of time

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Poison Pill LT 17-6

Poison Pill:

– a rights offering made to existing shareholders of acompany in order to make it more difficult for anothercompany to acquire it

– allows existing shareholders the right to buy additionalshares of the stock at a very low price

– makes hostile takeovers very expensive and unattractive

– often introduced by management to protect their owninterests

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Preferred Stock LT 17-7

Preferred Stock:

– a hybrid security combining characteristics of both debtand common stock

– has a fixed dividend that must be paid before dividendson common stock

– dividends are not tax deductible to a company

– provides the company with a balance in its capitalstructure

– primary purchasers are corporate investors, insurancecompanies, and pension funds

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Provisions Associated withPreferred Stock LT 17-8

Cumulative Dividends:

– if not paid in one year, dividends accumulate and mustbe paid in total before common shareholders

Conversion Feature:

– preferred stock may be converted into common stock atthe option of the holder

Call Feature:

– company has option to redeem stock

Retractable Feature:

– investor has option to redeem stock

Floating Rate Dividend:

– company adjusts dividend to market conditions