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17

Common and Preferred Stock Financing

LEARNING OBJECTIVES

The ultimate ownership of the firm resides in common stock, whether it is in the form of all outstanding shares of a closely held corporation or one share of IBM. In terms of legal distinctions, it is the common stockholder alone who directly controls the business. While control of the company is legally in the shareholders’ hands, it is practically wielded by management on an everyday basis. It is also important to realize that a large creditor may exert tremendous pressure on a firm to meet certain standards of financial performance, even though the creditor has no voting power.

Small, growing companies often operate at a loss until they reach critical mass. Start-up biotech firms frequently fall in this category along with small technology companies competing with the big guys like Intel and Qualcomm. TowerJazz is one such tech company. TowerJazz is headquartered in Israel with its subsidiary Jazz Semiconductor Inc. located in the United States and its wholly owned subsidiary, TowerJazz Japan, Ltd., in Japan. TowerJazz operates three fabrication facilities in Japan through a joint venture with Panasonic. These companies operate collectively under the brand name TowerJazz and trade on the NASDAQ stock exchange under the ticker symbol TSEM. The company fabricates integrated circuits for more than 200 customers worldwide in industries such as automotive, defense, medical, and aerospace. Their foundries fabricate semiconductors like radio frequency chips used in cell phones.

According to S&P Capital IQ, TSEM lost money from 2009 (−$10.65 per share) to 2013 (−$2.72 per share) and finally turned an aftertax profit of $0.07 per share in 2014. In fact 2014 was a breakout year for TowerJazz with record revenues of $828 million, a 64 percent increase over 2013. The ending cash balance on December 31, 2014, was $187 million.

TowerJazz would not have gotten to this point in its corporate life without the ability to sell common stock in public markets like NASDAQ. It is very expensive to operate and build foundries, and it takes a critical mass and high utilization rate within the foundries to make money. To get to this point TSEM had to continually sell new stock to finance its operations that were losing money. The company sold 35 million shares in 2008, 39 million shares in 2009, and 66.5 million shares in 2010.

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By 2012 the stock was trading for less than $1. NASDAQ has a rule that a stock cannot stay listed if it continuously trades under $1. If a company can’t get its stock price above $1 within 180 days and keep it there for 30 days, the stock will be delisted; in other words, it can no longer be traded on NASDAQ.

By August 2012, shares of TSEM had ballooned from 125 million in 2008 to over 330 million, and the stock price was trading at $0.52. On August 2 TowerJazz had a 1 for 15 reverse split, reducing the number of shares to about 22 million. The share price closed at $9.01 on August 6, the day the reverse split became effective. By March 2015 the stock was trading at more than $16 per share and had hit a high of $18.20 on March 3. We should point out that during 2013, TSEM share count increased by another 25.4 million shares as the company converted some capital notes into stock and warrants and stock options were exercised.

Without investors willing to take a risk on companies like TowerJazz, these small companies would not have a chance to mature and become profitable. The ability to sell common stock to balance debt in the capital structure makes the stock markets important to corporations.

In this chapter, we will also look closely at preferred stock. Preferred stock plays a secondary role in financing the corporate enterprise. It represents a hybrid security, combining some of the features of debt and common stock. Though preferred stockholders do not have an ownership interest in the firm, they do have a priority of claims to dividends that is superior to that of common stockholders.

To understand the rights and characteristics of the different means of financing, we shall examine the powers accorded to shareholders under each arrangement. In the case of common stock, everything revolves around three key rights: the residual claim to income, the voting right, and the right to purchase new shares. We shall examine each of these in detail and then consider the rights of preferred stockholders.

Common Stockholders’ Claim to Income

All income that is not paid out to creditors or preferred stockholders automatically belongs to common stockholders. Thus we say they have a residual claim to income. This is true regardless of whether these residual funds are actually paid out in dividends or retained in the corporation. A firm that earns $10 million before capital costs and pays $1 million in interest to bondholders and an equal amount in dividends to preferred stockholders will have $8 million available for common stockholders.1 Perhaps half of that will be paid out as common stock dividends. The balance will be reinvested in the business for the benefit of stockholders, with the hope of providing even greater income, dividends, and price appreciation in the future.

Of course, it should be pointed out that the common stockholder does not have a legal or enforceable claim to dividends. Whereas a bondholder may force the corporation into bankruptcy for failure to make interest payments, the common stockholder must accept circumstances as they are or attempt to change management if a new dividend policy is desired.

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Occasionally a company will have several classes of common stock outstanding that carry different rights to dividends and income. For example, Google, Facebook, and Ford Motor Company have two separate classes of common stock that differentiate the shares of the founders from other stockholders and grant preferential rights to founders’ shares.

Although there are over 90 million common stockholders in the United States, increasingly ownership is being held by large institutional interests, such as pension funds, mutual funds, or bank trust departments, rather than individual investors. As would be expected, management has become more sensitive to these large stockholders who may side with corporate raiders in voting their shares for or against merger offers or takeover attempts (these topics are covered in Chapter 20).

Table 17-1 presents a list of major companies with high percentages of common stock owned by institutional investors at the beginning of 2015. ExxonMobil is at the bottom of the list with a 58.99 percent institutional ownership while Motorola Solutions is now 94.33 percent owned by institutions. Large companies are institutional favorites, perhaps because the sheer size of the shares outstanding allows for large trades and a high level of liquidity.

Table 17-1   Institutional ownership of U.S. companies

The Voting Right

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Because common stockholders are the owners of a firm, they are accorded the right to vote in the election of the board of directors and on all other major issues. Common stockholders may cast their ballots as they see fit on a given issue, or assign a proxy, or “power to cast their ballot,” to management or some outside contesting group. As mentioned in the previous section, some corporations have different classes of common stock with unequal voting rights.

There is also the issue of “founders’ stock.” Perhaps the Ford Motor Company is the biggest and best example of such stock. Class B shares were used to differentiate between the original founders’ shares and those shares sold to the public. The founders wanted to preserve partial control of the company while at the same time raise new capital for expansion. The regular common stock (no specific class) has one vote per share and is entitled to elect 60 percent of the board of directors, and the Class B shares have one vote per share but are entitled, as a class of shareholders, to elect 40 percent of the board of directors. Class B stock is reserved solely for Ford family members or their descendants, trusts, or appointed interests. The Ford family has a very important position in Henry Ford’s company without owning more than about 3½ percent of the current outstanding stock. Both common and Class B stockowners share in dividends equally, and no stock dividends may be given unless to both common and Class B stockholders in proportion to their ownership.

While common stockholders and the different classes of common stock that they own may, at times, have different voting rights, they do have a vote. Bondholders and preferred stockholders may vote only when a violation of their corporate agreement exists and a subsequent acceleration of their rights takes place. For example, Continental Illinois Corporation was on the edge of bankruptcy in 1984, and failed to pay dividends on one series of preferred stock for five quarters from July 1, 1984, to September 30, 1985. The preferred stockholder agreement stated that failure to pay dividends for six consecutive quarters would result in the preferred stockholders being able to elect two directors to the board to represent their interests. Continental Illinois declared a preferred dividend in November 1985 and paid all current and past dividends on the preferred stock, thus avoiding the special voting privileges for preferred stockholders. In 1994, Continental was bought by Bank of America.

Cumulative Voting

The most important voting matter is the election of the board of directors. As indicated in Chapter 1, the board has primary responsibility for the stewardship of the corporation. If illegal or imprudent decisions are made, the board can be held legally accountable. Furthermore, members of the board of directors normally serve on a number of important subcommittees of the corporation, such as the audit committee, the long-range financial planning committee, and the salary and compensation committee. The board may be elected through the familiar majority rule system or by cumulative voting. Under majority voting, any group of stockholders owning over 50 percent of the common stock may elect all of the directors. Under cumulative voting, it is possible for those who hold less than a 50 percent interest to elect some of the directors. The provision for some minority interests on the board is important to those who, at times, wish to challenge the prerogatives of management.

The type of voting has become more important to stockholders and management with the threat of takeovers, leveraged buyouts, and other challenges to management’s control of the firm. In many cases, large minority stockholders, seeking a voice in the operations and direction of the company, desire seats on the board of directors. To further their goals, several have gotten stockholders to vote on the issue of cumulative voting at the annual meeting.

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How does this cumulative voting process work? A stockholder gets one vote for each share of stock he or she owns, times one vote for each director to be elected. The stockholder may then accumulate votes in favor of a specified number of directors.

Assume there are 10,000 shares outstanding, you own 1,001, and nine directors are to be elected. Your total votes under a cumulative election system are:

Let us assume you cast all your votes for the one director of your choice. With nine directors to be elected, there is no way for the owners of the remaining shares to exclude you from electing a person to one of the top nine positions. If you own 1,001 shares, the majority interest could control a maximum of 8,999 shares. This would entitle them to 80,991 votes.

These 80,991 votes cannot be spread thinly enough over nine candidates to stop you from electing your one director. If they are spread evenly, each of the majority’s nine choices will receive 8,999 votes (80,991/9). Your choice is assured 9,009 votes as previously indicated. Because the nine top vote-getters win, you will claim one position. Note that candidates do not run head-on against each other (such as Place A or Place B on the ballot), but rather that the top nine candidates are accorded directorships.

To determine the number of shares needed to elect a given number of directors under cumulative voting, the following formula is used:

The formula reaffirms that in the previous instance, 1,001 shares would elect one director.

If three director positions out of nine are desired, 3,001 shares are necessary.

Note that, with approximately 30 percent of the shares outstanding, a minority interest can control one-third of the board. If instead of cumulative voting a majority rule system were utilized, a minority interest could elect no one. The group that controlled 5,001 or more shares out of 10,000 would elect every director.

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Finance in ACTION Managerial Morningstar Raises Hewlett-Packard’s Stewardship Rating from “Poor” to “Standard”

Morningstar is a financial advisory service headquartered in Chicago and a company that provides stock and mutual fund ratings on thousands of companies. The following paragraph from their service defines their definition of “stewardship grades”:

Our corporate Stewardship Rating represents our assessment of management’s stewardship of shareholder capital, with particular emphasis on capital allocation decisions. Analysts consider companies’ investment strategy and valuation, financial leverage, dividend and share buyback policies, execution, compensation, related party transactions, and accounting practices. Corporate governance practices are only considered if they’ve had a demonstrated impact on shareholder value. Analysts assign one of three ratings: “Exemplary,” “Standard,” and “Poor.” Analysts judge stewardship from an equity holder’s perspective. Ratings are determined on an absolute basis. Most companies will receive a Standard rating, and this is the default rating in the absence of evidence that managers have made exceptionally strong or poor capital allocation decisions.

With this in mind, let’s explore some of the facts surrounding Morningstar’s “poor” rating for Hewlett-Packard (HP).

Corporate boards may appear to be removed from the everyday workings of a corporation with the press focusing on the chief executive officer (CEO) as the main driver of a company’s success. However, corporate boards play a vital role in representing the owners of the corporation and are elected by the shareholders. Perhaps the most important job is choosing a new CEO. This is one area where HP seems to have failed too many times. Board members also deal with high-level decisions, which can be anything from choosing the auditor to evaluating large acquisitions and mergers or a new business line. They are supposed to act as an independent check on management, ensuring that corporate executives keep the interests of the shareholders in mind.

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After several scandals involving corporate governance in the early 2000s, emphasis has been focused on boards and good corporate governance practices. Important criteria are emphasized, such as the number of executives on the board relative to independent board members. Many advocates for independent boards of directors push for the separation of the chairman of the board and CEO roles. HP has tried both models and still has had trouble making good decisions. Investors will discount a company’s share price if the board is perceived as anything less than competent or independent. Consistent turnover of both executives and board members is viewed as a sign of instability and lack of leadership.

HP has generally been viewed as suffering from bad stewardship over the past decade. Several scandals involving management have been blamed on the hiring decisions and conduct of HP’s board members. In 2005, Carly Fiorina was asked to resign by the board and walked away with $42.6 million in severance pay and stock grants. In 2006, HP’s non-executive chairman Patricia Dunn was removed after she hired private investigators to illegally obtain phone records of board members. She was replaced as chairman by Mark Hurd, the CEO at that time. But in 2009, Mark Hurd was forced to step down as CEO after a scandal involving falsified expense reports and a sexual harassment claim by a former contractor. Leo Apotheker, the former CEO of SAP, replaced Hurd only to be removed 11 months later due to conflicts with the board over HP’s long-term strategy. He walked away with $25 million in severance and stock grants. The last three CEOs and chairmen who have been terminated or resigned under pressure have received over $83 million in severance and stock grants. This has not gone over well with stockholders.

Another area where the board has been faulted has been Hewlett-Packard’s consistent mismanagement of its merger and acquisition activity. HP’s board has a history of approving inflated purchase prices for acquisitions such as Compaq Computer, Electronic Data Systems, and Palm. In August 2011, during Leo Apotheker’s stint as chairman and CEO, the board approved a $10 billion purchase of Autonomy Corp. plc. A little over a year later, HP recorded an $8.8 billion non-cash expense against earnings to write down goodwill and intangibles. This write-off was mostly related to the Autonomy purchase and accounting irregularities that were not discovered during the acquisition process. These and other factors have led to a high degree of board turnover, with 7 of its 12 directors being replaced or resigning in 2011 under the new CEO and chairman Meg Whitman, who was previously responsible for running eBay quite successfully. She has succeeded in improving the corporate governance and decision making process at HP, and this accounts for Morningstar’s improved rating.

All of this activity has not been lost on shareholders. HP’s share price hit a high of $54.75 in April of 2010 and fell to a low of $11.35 in November of 2012 for a loss of 79 percent. With Whitman in charge, the stock price hit a high of $40 in early January 2015.

Sources: “Morningstar Equity Analyst Report,” Morningstar, May 21, 2015. Standard & Poor’s Stock Report, February 3, 2013, pp.1–10. http://money.cnn.com/2011/09/22/technology/hp_leo_apotheker_severance/index.htm. http://finance.yahoo.com/news/key-moments-hewlett-packards-recent-history-204439968-finance.html.

As a restatement of the problem: 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 this formula:

Plugging 3,001 shares into the formula, we show:

If the formula yields an uneven number of directors, such as 3.3 or 3.8, you always round down to the nearest whole number (i.e., 3).

It is not surprising that 22 states require cumulative voting in preference to majority rule, that 18 consider it permissible as part of the corporate charter, and that only 10 make no provision for its use. Such consumer-oriented states as California, Illinois, and Michigan require cumulative voting procedures.

Delaware does not require cumulative voting and is viewed as having a legal system that is lenient on corporations; it should come as no surprise that many companies are legally registered in the State of Delaware.

The Right to Purchase New Shares

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In addition to a claim to residual income and the right to vote for directors, the common stockholders may also enjoy a privileged position in the offering of new securities. If the corporate charter contains a preemptive right provision, holders of common stock must be given the first option to purchase new shares. While only two states specifically require the use of preemptive rights, most other states allow for the inclusion of a rights offering in the corporation charter.

The preemptive right provision ensures that management cannot subvert the position of present stockholders by selling shares to outside interests without first offering them to current shareholders. If such protection were not afforded, a 20 percent stockholder might find his or her interest reduced to 10 percent through the distribution of new shares to outsiders. Not only would voting rights be diluted, but proportionate claims to earnings per share would be reduced.

The Use of Rights in Financing

Many corporations also engage in a preemptive rights offering to tap a built-in market for new securities—the current investors. Rights offerings are not only used by many U.S. companies, but are especially popular as a fund-raising method in Europe. It is quite common in European markets for companies to ask their existing shareholders to help finance expansion.

For example, Telephon A.B. Ericsson, a Swedish company, had a $3 billion rights offering in August 2002 to raise new funds. The collapse of the Internet bubble in 2000 caused a huge decline in sales and earnings, and Ericsson was in need of new capital. What better place to look for equity capital than the existing stockholders. If they already believe in the company and own shares, they might be willing to ante up more money to keep the company alive. This also happened in 2009 in the banking crisis. Many banks were short of their required capital requirements and needed new infusions of equity capital. The American banks relied mostly on secondary offerings available to anyone while the European banks relied on rights offerings. In Table 17-2, we feature three European banks that raised a total of $56.7 billion of new equity through rights offerings. Also included are smaller rights offerings from Sweden, Singapore, Spain, and the United States.

Most rights offerings are successful in getting shareholders to exercise their rights to buy new shares. When all the shares are not exercised by shareholders, the investment banker in charge of the offering exercises the rest and sells them in the open market. Additionally, the number of shares a shareholder can buy is conditional on the number of shares he or she owns, and there is a ratio of new shares to shares already owned. This is shown in the table in the fourth column of Table 17-2, and one can see that there is no standard ratio. In the Royal Bank of Scotland rights offering, for every 18 shares a stockholder owned, he or she could buy 11 new shares, while for Banco Popular Español SA, a shareholder could buy 1 new share for every 3 shares owned.

Usually the investment banker in charge of the rights offering will price the new shares at a discount to the price of the existing shares. The price of the new shares is stated on the announcement day, and the underpricing is expressed as the offering price of the new shares compared to the market price of the shares traded on the market on the day of the announcement. The more the shares are underpriced, the more likely it is that the rights will be exercised. The underpricing is shown in column five.

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To illustrate the use of rights, let’s take a look at a hypothetical company, Watson Corporation, which has 9 million shares outstanding and a current market price of $40 per share (the total market value is $360 million). Watson needs to raise $30 million for new plant and equipment and will sell 1 million new shares at $30 per share.2 As part of the process, it will use a rights offering in which each old shareholder receives a first option to participate in the purchase of new shares.

Table 17-2   Rights offerings big and small

Sources: Bloomberg, Globe Newswire, PR Newswire, 123Jump.com, Morningstar, Standard & Poor’s, and corporate websites.

Each old shareholder will receive one right for each share of stock owned and may combine a specified number of rights plus $30 cash to buy a new share of stock. Let us consider these questions:

1. How many rights should be necessary to purchase one new share of stock?

2. What is the monetary value of these rights?

Rights Required Since 9 million shares are currently outstanding and 1 million new shares will be issued, the ratio of old to new shares is 9 to 1. On this basis, the old stockholder may combine nine rights plus $30 cash to purchase one new share of stock.

A stockholder with 90 shares of stock would receive an equivalent number of rights, which could be applied to the purchase of 10 shares of stock at $30 per share. As indicated later in the discussion, stockholders may choose to sell their rights, rather than exercise them in the purchase of new shares.

Monetary Value of a Right Anything that contributes toward the privilege of purchasing a considerably higher priced stock for $30 per share must have some market value. Consider the following two-step analysis.

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Nine old shares sold at $40 per share, or for $360; now one new share will be introduced for $30. Thus we have a total market value of $390 spread over 10 shares. After the rights offering has been completed, the average value of a share is theoretically equal to $39.3

The rights offering thus entitles the holder to buy a stock that should carry a value of $39 (after the transactions have been completed) for $30. With a differential between the anticipated price and the subscription price of $9 ($39 − $30) and nine rights required to participate in the purchase of one share, the value of a right in this case is $1.

Formulas have been developed to determine the value of a right under any circumstance. Before they are presented, let us examine two new terms that will be part of the calculations—rights-on and ex-rights. 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 a future purchase of the stock. After a certain period (say four weeks), the stock goes ex-rights—when you buy the stock, you no longer get a right toward the future purchase of stock. Consider the following:

Once the ex-rights period is reached, the stock will go down by the theoretical value of the right. The remaining value ($39) is the ex-rights value. Though there is a time period remaining between the ex-rights date (April 1) and the end of the subscription period (April 30), the market assumes the dilution has already occurred. Thus the ex-rights value reflects the same value as can be expected when the new, underpriced $30 stock issue is sold. In effect, it projects the future impact of the cheaper shares on the stock price.

The formula for the value of the right when the stock is trading rights-on is:

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where

Using Formula 17-3 we determined that the value of a right in the Watson Corporation offering was $1. An alternative formula giving precisely the same answer is:

The only new term is Me, the market value of the stock when the shares are trading ex-rights. It is $39. We show:

These are all theoretical relationships, which may be altered somewhat in reality. If there is great enthusiasm for the new issue, the market value of the right may exceed the initial theoretical value (perhaps the right will trade for 1.375).

Effect of Rights on Stockholder’s Position

At first glance, a rights offering appears to bring great benefits to stockholders. But is this really the case? Does a shareholder really benefit from being able to buy a stock that is initially $40 (and later $39) for $30? Don’t answer too quickly!

Think of it this way: Assume 100 people own shares of stock in a corporation and one day decide to sell new shares to themselves at 25 percent below current value. They cannot really enhance their wealth by selling their own stock more cheaply to themselves. What is gained by purchasing inexpensive new shares is lost by diluting existing outstanding shares.

Take the case of Stockholder A, who owns nine shares before the rights offering and also has $30 in cash. His holdings would appear as follows:

If he receives and exercises nine rights to buy one new share at $30, his portfolio will contain:

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Clearly he is no better off. A second alternative would be for him to sell his rights in the market and stay with his position of owning only nine shares and holding cash. The outcome is:

As indicated previously, whether he chooses to exercise his rights or not, the stock will still go down to a lower value (others are still diluting). Once again, his overall value remains constant. The total value received for the rights ($9) exactly equals the extent of dilution in the value of the original nine shares.

The only foolish action would be for the stockholder to regard the rights as worthless securities. He would then suffer the pains of dilution without the offset from the sale of the rights.

Empirical evidence indicates this careless activity occurs 2 to 3 percent of the time.

Desirable Features of Rights Offerings

You may ask, If the stockholder is no better off in terms of total valuation, why undertake a rights offering? There are a number of possible advantages.

As previously indicated, by giving current stockholders a first option to purchase new shares, the firm protects the stockholders’ current position in regard to voting rights and claims to earnings. Of equal importance, the use of a rights offering gives the firm a built-in market for new security issues. Because of this built-in base, distribution costs are likely to be lower than under a straight public issue in which investment bankers must underwrite the full risk of distribution.4

Also, a rights offering may generate more interest in the market than would a straight public issue. There is a market not only for the stock but also for the rights. Because the subscription price is normally set 15 to 25 percent below current value, there is the “nonreal” appearance of a bargain, creating further interest in the offering.

A last advantage of a rights offering over a straight stock issue is that stock purchased through a rights offering carries lower margin requirements. The margin requirement specifies the amount of cash or equity that must be deposited with a brokerage house or a bank, with the balance of funds eligible for borrowing. Though not all investors wish to purchase on margin, those who do so prefer to put down a minimum amount. While normal stock purchases may require a 50 percent margin (half cash, half borrowed), stock purchased under a rights offering may be bought with as little as 25 percent down, depending on the current requirements of the Federal Reserve Board.

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HSBC Holdings Plc. Rights Offering Finance in ACTION Global

HSBC Holdings Plc. is Europe’s biggest bank with a worldwide presence. It is also known as Hong Kong Shanghai Banking Corporation, and while it was originally focused in Asia, now Europe accounts for over 50 percent of its assets, Hong Kong and Asia Pacific about 25 percent, and North America 20 percent, with Latin America about 5 percent. The credit crisis of 2007–2009 put tremendous pressure on HSBC’s capital ratios. HSBC had set aside loan loss reserves of $53 billion during 2007–2009 to cover investments in U.S. subprime debt and direct exposure to loans packaged into securitized financings, but it needed more equity capital. European banks like the U.S. banks found it difficult to sell their high-risk assets, and many like HSBC, Royal Bank of Scotland, UBS of Switzerland, Bank America, Citibank, and others were forced to either write down their assets or sell them at fire-sale prices. This caused their capital ratios to shrink below the required limit of 6 percent.

The solution was to find equity capital in the form of common stock and preferred stock. Common stock was high-risk equity without a guaranteed dividend and was considered tier 1 capital, while preferred stock was considered tier 2 capital. Total capital had to equal a minimum of 6 percent with tier 1 capital (common stock and common shareholder equity) equaling a minimum of 4 percent. Most banks and investors wanted ratios well above 6 percent in the uncertain economy with more potential losses from bank loans and investments looming on the horizon. In the United States, the U.S. government bought several hundred billion dollars of preferred stock in many banks to bolster their capital, and banks like Bank of America, Citigroup, and others also sold common stock through secondary offerings. As Table 17-2 shows, in Europe, banks used rights offerings to raise capital.

HSBC did not want to borrow from the British Government, so on March 2, 2009, it announced a rights offering intended to raise approximately $17.7 billion dollars through the sale of 5.06 billion shares of common stock. The rights offering was successful, and 97 percent of the shares were sold to existing stockholders with the investment bankers exercising the 3 percent that was left over. Before the rights offering, HSBC’s tier 1 capital ratio was 8.3 percent; after the rights offering, the ratio jumped to 9.8 percent, which was at the upper end of the 7.5 to 10.0 percent target HSBC liked to maintain. The big question after the offering was “Did they raise enough capital?” With continued losses expected over the next several years, was this new infusion of equity enough to cover future loan losses, or would earnings from operations be enough to cover any future losses? What did the market think about this?

HSBS trades in the United States as an ADR (American Depository Receipt). When the bank announced the offering on March 2, 2009, the price of its ADR in the United States was $28.25, and by November 2009 the stock had more than doubled to $64.42. This would indicate that the market thought their rights offering and very high capital ratio had minimized the risk from future losses. The stock price drifted down to $35.75 in 2011 and recovered to $54 per share by June of 2013. You might want to check on the stock price to see how HSBC is doing. The ticker symbol is HBC.

Poison Pills

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During the last two decades, a new wrinkle was added to the meaning of rights when firms began receiving merger and acquisition proposals from companies interested in acquiring voting control of the firm. The management of many firms did not want to give up control of the company, and so they devised a method of making the firm very unattractive to a potential acquisition-minded company. As you can tell from our discussion of voting provisions, for a company using majority voting, a corporate raider needs to control only slightly over 50 percent of the voting shares to exercise total control. Management of companies considered potential takeover targets began to develop defensive tactics in fending off these unwanted takeovers. One widely used strategy is called the poison pill.

A poison pill may be a rights offer made to existing shareholders of Company X with the sole purpose of making it more difficult for another firm to acquire Company X. Most poison pills have a trigger point. When a potential buyer accumulates a given percentage of the common stock (for example, 25 percent), the other shareholders may receive rights to purchase additional shares from the company, generally at very low prices. If the rights are exercised by shareholders, this increases the total shares outstanding and dilutes the potential buyer’s ownership percentage. Poison pill strategies often do not have to be voted on by shareholders to be put into place. At International Paper Company, however, the poison pill issue was put on the proxy ballot and 76 percent of the voting shareholders sided with management to maintain the poison pill defense. This was surprising because many institutional investors are opposed to the pill. They believe it lowers the potential for maximizing shareholder value by discouraging potential high takeover bids.

American Depository Receipts

American Depository Receipts (ADRs) are certificates that have a legal claim on an ownership interest in a foreign company’s common stock. The shares of the foreign company are purchased and put in trust in a foreign branch of a major U.S. bank. The bank, in turn, receives and can issue depository receipts to the American shareholders of the foreign firm. These ADRs (depository receipts) allow foreign shares to be traded in the United States much like common stock. ADRs have been around for a long time and are sometimes referred to as American Depository Shares (ADS).

Since foreign companies want to tap into the world’s largest capital market, the United States, they need to offer securities for sale in the United States that can be traded by investors and have the same liquidity features as U.S. securities. ADRs imitate common stock traded on the New York Stock Exchange. Foreign companies such as HSBC Holdings (English), Nestlé (Swiss), Heineken (Dutch), and Sony (Japanese) that have common stock trading on their home exchanges in London, Zurich, Amsterdam, and Tokyo also issue ADRs in the United States.

An American investor (or any foreign investor) can buy American Depository Shares of foreign companies from around the world on the New York Stock Exchange, the NASDAQ Stock Market, or the American Stock Exchange. Table 17-3 shows the American Depository Shares (Receipts) for nine regions in March 2015. The table includes Global Depository Receipts (GDRs), which are patterned after ADRs but can be issued by international companies and traded globally rather than just on U.S. markets.

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There are many advantages to American Depository Shares for the U.S. investor. The annual reports and financial statements are presented in English according to generally accepted accounting principles. Dividends are paid in dollars and are more easily collected than if the actual shares of the foreign stock were owned. Although ADRs are considered to be more liquid, less expensive, and easier to trade than buying foreign companies’ stock directly on that firm’s home exchange, there are some drawbacks.

Table 17-3   Foreign company listings on U.S. exchanges and over-the-counter—American and global depository receipts

Source: http://www.adrbnymellon.com/dr_search_by_country.jsp, March 11, 2015

Even though the ADRs are traded in the U.S. market in dollars, they are still traded in their own countries in their local currencies. This means that the investor in ADRs is subject to a foreign currency risk if the exchange rates between the two countries change. Also, most foreign companies do not report their financial results as often as U.S. companies. Furthermore, there is an information lag as foreign companies need to translate their reports into English. By the time the reports are translated, some of the information has already been absorbed in the local markets and by international traders.

Preferred Stock Financing

Having discussed bonds in Chapter 16 and common stock in this chapter, we are prepared to look at an intermediate or hybrid form of security known as preferred stock. You may question the validity of the term preferred, for preferred stock does not possess any of the most desirable characteristics of debt or common stock. In the case of debt, bondholders have a contractual claim against the corporation for the payment of interest and may throw the corporation into bankruptcy if payment is not forthcoming. Common stockholders are the owners of the firm and have a residual claim to all income not paid out to others. Preferred stockholders are merely entitled to receive a stipulated dividend and, generally, must receive the dividend before the payment of dividends to common stockholders. However, their right to annual dividends is not mandatory for the corporation, as is true of interest on debt, and the corporation may forgo preferred dividends when this is deemed necessary.

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For example, XYZ Corporation might issue 7 percent preferred stock with a $100 par value. Under normal circumstances, the corporation would pay the $7 per share dividend. Let us also assume it has $1,000 bonds carrying 6.8 percent interest and shares of common stock with a market value of $50, normally paying a $1 cash dividend. The 6.8 percent interest must be paid on the bonds. The $7 preferred dividend has to be paid before the $1 dividend on common stock, but both may be waived without threat of bankruptcy. The common stockholder is the last in line to receive payment, but the common stockholder’s potential participation is unlimited. Instead of getting a $1 dividend, the investor may someday receive many times that much in dividends and also capital appreciation in stock value.

Justification for Preferred Stock

Because preferred stock has few unique characteristics, why might the corporation issue it and, equally important, why are investors willing to purchase the security?

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.

Even here, there may be a drawback. While interest payments on debt are tax-deductible, preferred stock dividends are not. Thus the interest cost on 6.8 percent debt may be only 4.5 to 5 percent on an aftertax cost basis, while the aftertax cost on 7 percent preferred stock would be the stated amount. A firm issuing the preferred stock may be willing to pay the higher aftertax cost to assure investors it has a balanced capital structure, and because preferred stock may have a positive effect on the costs of the other sources of funds in the capital structure.

Investor Interest Primary purchasers of preferred stock are corporate investors, insurance companies, and pension funds. To the corporate investor, preferred stock offers a very attractive advantage over bonds. The tax law provides that any corporation that receives either preferred or common dividends from another corporation must add only 30 percent of such dividends to its taxable income. Thus 70 percent of such dividends are exempt from taxation. On a preferred stock issue paying a 7 percent dividend, only 30 percent would be taxable. By contrast, all the interest of bonds is taxable to the recipient except for municipal bond interest.

Assume a bond is paying 5.61 percent interest in 2014. Since interest on bonds receives no preferential tax treatment for the corporate investor, the aftertax bond yield must be adjusted by the investing corporation’s marginal tax rate.

In this example, we shall use a tax rate of 35 percent.

The corporate bondholder will receive 3.65 percent as an aftertax yield.

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Now let’s look at preferred stock, which was paying 4.25 percent in 2014. For preferred stock, the adjustment includes the advantageous 30 percent tax provision. Also under current tax laws, the tax rate on dividends is only 15 percent. The computation for aftertax return for preferred stock is as follows:

The aftertax yield on preferred stock is clearly higher than the aftertax bond yield (4.06 percent versus 3.65 percent) due to the higher initial yield and the tax advantages.

Summary of Tax Considerations Tax considerations for preferred stock work in two opposite directions. First, they make the aftertax cost of debt cheaper than preferred stock to the issuing corporation because interest is deductible to the payer. Second, tax considerations generally make the receipt of preferred dividends more valuable than corporate bond interest to corporate investors because 70 percent of the dividend is exempt from taxation.

Provisions Associated with Preferred Stock

A preferred stock issue contains a number of stipulations and provisions that define the stockholder’s claim to income and assets.

1. Cumulative Dividends Most issues represent cumulative preferred stock and have a cumulative claim to dividends. That is, 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. If preferred stock carries a $10 cash dividend and the company does not pay dividends for three years, preferred stockholders must receive the full $30 before common stockholders can receive anything.

The cumulative dividend feature makes a corporation very aware of its obligation to preferred stockholders. When a financially troubled corporation has missed a number of dividend payments under a cumulative arrangement, there may be a financial recapitalization of the corporation in which preferred stockholders receive new securities in place of the dividend that is in arrears (unpaid). Assume the corporation has now missed five years of dividends under a $10-a-year obligation and the company still remains in a poor cash position. Preferred stockholders may be offered $50 or more in new common stock or bonds as forgiveness of the missed dividend payments. Preferred stockholders may be willing to cooperate in order to receive some potential benefit for the future.

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2. Conversion Feature Like certain forms of debt, preferred stock may be convertible into common shares. Thus $100 in preferred stock may be convertible into a specified number of shares of common stock at the option of the holder. One new wrinkle on convertible preferreds is the use of convertible exchangeable preferreds that allow the company to force conversion from convertible preferred stock into convertible debt. This can be used to allow the company to take advantage of falling interest rates or to allow the company to change preferred dividends into tax-deductible interest payments when it is to the company’s advantage to do so. The topic of convertibility is discussed at length in Chapter 19, “Convertibles, Warrants, and Derivatives.”

3. Call Feature Also, preferred stock, like debt, may be callable; that is, the corporation may retire the security before maturity at some small premium over par. This, of course, accrues to the advantage of the corporation and to the disadvantage of the preferred stockholder. A preferred issue carrying a call provision will be accorded a slightly higher yield than a similar issue without this feature. The same type of refunding decision applied to debt obligations in Chapter 16 could also be applied to preferred stock.

4. Participation Provision A small percentage of preferred stock issues are participating preferreds; that is, they may participate over and above the quoted yield when the corporation is enjoying a particularly good year. Once the common stock dividend equals the preferred stock dividend, the two classes of securities may share equally in additional payouts.

5. Floating Rate Beginning in the 1980s, some preferred stock issuers made the dividend adjustable in nature, and this stock is classified as floating rate preferred stock. Typically the dividend is changed on a quarterly basis, based on current market conditions. Because the dividend rate changes only quarterly, there is still some possibility of a small price change between dividend adjustment dates. Nevertheless, it is less than the price change for regular preferred stock.

Investors that participate in floating rate preferred stock do so for two reasons: to minimize the risk of price changes and to take advantage of potential tax benefits associated with preferred stock corporate ownership. The price stability actually makes floating rate preferred stock the equivalent of a safe short-term investment even though preferred stock is normally thought of as long term in nature.

6. Auction Rate Preferred Stock Auction rate preferred stock is sometimes referred to as Dutch auction preferred stock, and is similar to floating rate preferred stock. Though it is actually a long-term security, it behaves like a short-term one. The auction rate preferred dividend is reset through a periodic auction that keeps the dividend yield consistent with current market conditions. The auction periods vary for each issue and can be 7, 14, 28, 49, or 91 days with some issues being reset semiannually or annually. The concept of a Dutch auction means the stock is issued to the bidder willing to accept the lowest yield and then to the next lowest bidder, and so on until all the preferred stock is sold. This is much like the Treasury bill auction held by the U.S. Treasury on a regular basis. This auction process at short-term intervals allows investors to keep up with the changing interest rates in the short-term market. Some corporate investors prefer to buy Dutch auction preferred stock because it allows them to invest at short-term rates and take advantage of the tax benefits available to them with preferred stock investments.

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This type of security works well as long as there are participants at the auction willing to bid on the securities. If there are no bidders, the rate stays the same, and investors are stuck with the return until another auction can be held. One of the consequences of the financial crisis was that the auction rate securities market dried up on February 7, 2008. The auction rate market froze as large institutional investors such as Citigroup, Morgan Stanley, and Merrill Lynch failed to bid. These banks couldn’t afford to take risks on buying assets that could become illiquid, and by not bidding they created an illiquid market that many short-term investors depended upon for liquidity. This problem continued throughout 2008 and into 2009 as investors were stuck holding assets that could not be sold. Several lawsuits were filed by states, municipalities, pension funds, and by the Securities and Exchange Commission. Eventually many institutions agreed to buy back or redeem the securities at par. For all practical purposes, this market is frozen for now; maybe over time with new protections, it might recover.

7. Par Value A final important feature associated with preferred stock is par value. Unlike the par value of common stock, which is often only a small percentage of the actual value, the par value of preferred stock is set at the anticipated market value at the time of issue. The par value establishes the amount due to preferred stockholders in the event of liquidation. Also, the par value of preferred stock determines the base against which the percentage or dollar return on preferred stock is computed. Thus 10 percent preferred stock would indicate $10 a year in preferred dividends if the par value were $100, but only $5 annually if the par value were $50.

Comparing Features of Common and Preferred Stock and Debt

In Table 17-4, we compare the characteristics of common stock, preferred stock, and bonds. You should consider the comparative advantages and disadvantages of each.

In terms of the risk-return features of these three classes of securities and also of the other investments discussed earlier in Chapter 7, we might expect the risk-return patterns depicted in Figure 17-1. The lowest return is obtained from savings accounts, and the highest return and risk are generally associated with common stock. In between, we note that short-term instruments generally, though not always, provide lower returns than longer-term instruments. We also observe that government securities pay lower returns than issues originated by corporations because of the lower risk involved. Next on the scale after government issues is preferred stock. This hybrid form of security may pay a lower return than even well-secured corporate debt instruments because of the 70 percent tax-exempt status of preferred stock dividends to corporate purchasers. Thus the focus of preferred stock is not just on risk-return trade-offs but also on aftertax return.5

Next we observe increasingly high return requirements on debt, based on the presence or absence of security provisions and the priority of claims on unsecured debt. At the top of the scale is common stock. Because of its lowest priority of claim in the corporation and its volatile price movement, it has the highest demanded return.

Though extensive research has tended to validate these general patterns, short-term or even intermediate-term reversals have occurred, in which investments with lower risk have outperformed investments at the higher end of the risk scale.

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Table 17-4   Features of alternative security issues

Figure 17-1   Risk and expected return for various security classes

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SUMMARY

Common stock ownership carries three primary rights or privileges. First, there is a residual claim to income. All funds not paid out to other classes of securities automatically belong to the common stockholder; the firm may then choose to pay out these residual funds in dividends or to reinvest them for the benefit of common stockholders.

Because common stockholders are the ultimate owners of the firm, they alone have the privilege of voting. To expand the role of minority stockholders, many corporations use a system of cumulative voting, in which each stockholder has voting power equal to the number of shares owned times the number of directors to be elected. By cumulating votes for a small number of selected directors, minority stockholders are able to have representation on the board.

Common stockholders may also enjoy a first option to purchase new shares. This privilege is extended through the procedure known as a rights offering. A shareholder receives one right for each share of stock owned and may combine a certain number of rights, plus cash, to purchase a new share. While the cash or subscription price is usually somewhat below the current market price, the stockholder neither gains nor loses through the process.

A poison pill represents a rights offer made to existing shareholders of a company with the sole purpose of making it more difficult for another firm or outsiders to take over a firm against management’s wishes. Most poison pills have a trigger point tied to the percentage ownership in the company that is acquired by the potential suitor. Once the trigger point is reached, the other shareholders (the existing shareholders) have the right to buy many additional shares of company stock at low prices. This automatically increases the total number of shares outstanding and reduces the voting power of the firm wishing to acquire the company.

A hybrid, or intermediate, security, falling between debt and common stock, is preferred stock. Preferred stockholders are entitled to receive a stipulated dividend and must receive this dividend before any payment is made to common stockholders. Preferred dividends usually accumulate if they are not paid in a given year, though preferred stockholders cannot initiate bankruptcy proceedings or seek legal redress if nonpayment occurs.

Finally, common stock, preferred stock, bonds, and other securities tend to receive returns over the long run in accordance with risk, with corporate issues generally paying a higher return than government securities.

REVIEW OF FORMULAS

1. 

2. 

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3. 

R is the value of a right

M0 is the market value of the stock—rights-on (stock carries a right)

S is the subscription price

N is the number of rights required to purchase a new share of stock

4. 

R is the value of a right

Me is the market value of stock—ex-rights (stock no longer carries a right)

S is the subscription price

N is the number of rights required to purchase a new share of stock

LIST OF TERMS

common stock 543

residual claim to income 544

proxy 545

founders’ shares 546

majority voting 546

cumulative voting 546

preemptive right 549

rights offering 550

rights-on 552

ex-rights 552

margin requirement 554

poison pill 556

American Depository Receipts 556

preferred stock 557

cumulative preferred stock 559

convertible exchangeable preferreds 559

participating preferreds 560

floating rate preferred stock 560

auction rate preferred stock 560

DISCUSSION QUESTIONS

1. Why has corporate management become increasingly sensitive to the desires of large institutional investors? (LO17-1)

2. Why might a corporation use a special category such as founders’ stock in issuing common stock? (LO17-1)

3. What is the purpose of cumulative voting? Are there any disadvantages to management? (LO17-2)

4. How does the preemptive right protect stockholders from dilution? (LO17-3)

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? (LO17-1)

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. (LO17-3)

7. Why might management use a poison pill strategy? (LO17-4)

8. Preferred stock is often referred to as a hybrid security. What is meant by this term as applied to preferred stock? (LO17-5)

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9. What is the most likely explanation for the use of preferred stock from a corporate viewpoint? (LO17-5)

10. Why is the cumulative feature of preferred stock particularly important to preferred stockholders? (LO17-2)

11. A small amount of preferred stock is participating. What would your reaction be if someone said common stock is also participating? (LO17-4)

12. What is an advantage of floating rate preferred stock for the risk-averse investor? (LO17-4)

13. Put an X by the security that has the feature best related to the following considerations. You may wish to refer to Table 17-4. (LO17-1 & 17-5)

PRACTICE PROBLEMS AND SOLUTIONS

Cumulative voting

(LO17-2)

1.

a. George Kelly wishes to elect 5 of the 13 directors on the Data Processing Corp. board. There are 98,000 shares of the company’s stock outstanding. How many shares will be required to accomplish this goal?

b. Jennifer Wallace owns 60,001 shares of stock in the Newcastle Corp. There are 12 directors to be elected with 195,000 shares outstanding. How many directors can Jennifer elect?

Rights offering

(LO17-3)

2. Dunn Resources has issued rights to its shareholders. The subscription price is $60. Four rights are needed along with the subscription price of $60 to buy one new share. The stock is selling for $72 rights-on.

a. What is the value of one right?

b. After the stock goes ex-rights, what will the new stock price be?

Solutions

1.

a. 

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b. 

2.

a. 

b. The market value of the stock ex-rights (after the effect of the rights offering) is equal to M0 (the market value before the rights offering) minus the value of a right (R).

PROBLEMS

 Selected problems are available with Connect. Please see the preface for more information.

Basic Problems

Residual claims to earnings

(LO17-1)

1. Folic Acid Inc. has $20 million in earnings, pays $2.75 million in interest to bondholders, and pays $1.80 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?

Residual claims to earnings

(LO17-1)

2. Time Watch Co. has $46 million in earnings and is considering paying $6.45 million in interest to bondholders and $4.35 million to preferred stockholders in dividends.

a. What are the bondholders’ contractual claims to payment? (You may wish to review Table 17-4.)

b. What are the preferred stockholders’ immediate contractual claims to payment? What privilege do they have?

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Poison pill

(LO17-4)

3. Katie Homes and Garden Co. has 10,640,000 shares outstanding. The stock is currently selling at $52 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?

Cumulative voting

(LO17-2)

4. Mr. Meyers wishes to know how many shares are necessary to elect 5 directors out of 14 directors up for election in the Austin Power Company. There are 150,000 shares outstanding. (Use Formula 17-1 to determine the answer.)

Cumulative voting

(LO17-2)

5. Dr. Phil wishes to know how many shares are necessary to elect 6 directors out of 14 directors up for election for the board of the Winfrey Publishing Company. There are 340,000 shares outstanding. (Use Formula 17-1 to determine the answer.)

Cumulative voting

(LO17-2)

6. Carl Hubbell owns 6,001 shares of the Piston Corp. There are 12 seats on the company board of directors, and the company has a total of 78,000 shares of stock outstanding. The Piston Corp. utilizes cumulative voting.

Can Mr. Hubbell elect himself to the board when the vote to elect 12 directors is held next week? (Use Formula 17-2 to determine if he can elect one director.)

Cumulative voting

(LO17-2)

7. Betsy Ross owns 927 shares in the Hanson Fabrics Company. There are 15 directors to be elected, and 33,500 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?

Dissident stockholder group and cumulative voting

(LO17-2)

8. 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 14 directors and 32,500 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 15,001 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 nine directors under cumulative voting?

Dissident stockholder group and cumulative voting

(LO17-2)

9. 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 12 members of the board are up for reelection. Mr. Clark is a dissident stockholder. He controls proxies for 34,001 shares. Ms. Ramsey and her friends on the board control 44,001 shares. Other stockholders, whose loyalties are unknown, will be voting the remaining 24,998 shares. The company uses cumulative voting.

a. How many directors can Mr. Clark be sure of electing?

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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?

d. If nine directors were to be elected, and Ms. Ramsey and her friends had 60,001 shares and Mr. Clark had 40,001 shares plus half the uncommitted votes, how many directors could Mr. Clark elect?

Strategies under cumulative voting

(LO17-2)

10. Mr. Michaels controls proxies for 40,000 of the 75,000 outstanding shares of Northern Airlines. Mr. Baker heads a dissident group that controls the remaining 35,000 shares. There are seven board members to be elected and cumulative voting rules apply. Michaels does not understand cumulative voting and plans to cast 100,000 of his 280,000 (40,000 × 7) votes for his brother-in-law, Scott. His remaining votes will be spread evenly between three other candidates.

How many directors can Baker elect if Michaels acts as described? Use logical numerical analysis rather than a set formula to answer the question. Baker has 245,000 votes (35,000 × 7).

Intermediate Problems

Different classes of voting stock

(LO17-1)

11. Rust Pipe Co. was established in 1994. Four years later the company went public. At that time, Robert Rust, the original owner, decided to establish two classes of stock. The first represents Class A founders’ stock and is entitled to 9 votes per share. The normally traded common stock, designated as Class B, is entitled to one vote per share. In late 2010, Mr. Stone, an investor, was considering purchasing shares in Rust Pipe Co. While he knew the founders’ shares were not often present in other companies, he decided to buy the shares anyway because of a new technology Rust Pipe had developed to improve the flow of liquids through pipes.

Of the 1,450,000 total shares currently outstanding, the original founder’s family owns 51,825 shares. What is the percentage of the founder’s family votes to Class B votes?

Rights offering

(LO17-3)

12. Boles Bottling Co. has issued rights to its shareholders. The subscription price is $45 and four rights are needed along with the subscription price to buy one of the new shares. The stock is selling for $55 rights-on.

a. What would be the value of one right?

b. If the stock goes ex-rights, what would the new stock price be?

Procedures associated with a rights offering

(LO17-3)

13. Computer Graphics has announced a rights offering for its shareholders. Carol Stevens owns 1,400 shares of Computer Graphics stock. Four rights plus $54 cash are needed to buy one of the new shares. The stock is currently selling for $66 rights-on.

a. What is the value of a right?

b. How many of the new shares could Carol buy if she exercised all her rights? How much cash would this require?

c. Carol doesn’t know if she wants to exercise her rights or sell them. Would either alternative have a more positive effect on her wealth?

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Investing in rights

(LO17-3)

14. Todd Winningham IV has $4,800 to invest. He has been looking at Gallagher Tennis Clubs Inc. common stock. Gallagher has issued a rights offering to its common stockholders. Six rights plus $48 cash will buy one new share. Gallagher’s stock is selling for $66 ex-rights.

a. How many rights could Todd buy with his $4,800? Alternatively, how many shares of stock could he buy with the same $4,800 at $66 per share?

b. If Todd invests his $4,800 in Gallagher rights and the price of Gallagher stock rises to $70 per share ex-rights, what would his dollar profit on the rights be? (First compute profit per right.)

c. If Todd invests his $4,800 in Gallagher stock and the price of the stock rises to $70 per share ex-rights, what would his total dollar profit be?

d. What would be the answer to part b if the price of Gallagher’s stock falls to $40 per share ex-rights instead of rising to $70?

e. What would be the answer to part c if the price of Gallagher’s stock falls to $40 per share ex-rights?

Effect of rights on stockholder position

(LO17-3)

15. Mr. and Mrs. Anderson own two shares of Magic Tricks Corporation’s common stock. The market value of the stock is $58. The Andersons also have $46 in cash. They have just received word of a rights offering. One new share of stock can be purchased at $46 for each two shares currently owned (based on two rights).

a. What is the value of a right?

b. What is the value of the Andersons’ portfolio before the rights offering? (Portfolio in this question represents stock plus cash.)

c. If the Andersons participate in the rights offering, what will be the value of their portfolio, based on the diluted value (ex-rights) of the stock?

d. If they sell their two rights but keep their stock at its diluted value and hold onto their cash, what will be the value of their portfolio?

Advanced Problems

Relation of rights to EPS and the price-earnings ratio

(LO17-3)

16. Walker Machine Tools has 5.5 million shares of common stock outstanding. The current market price of Walker common stock is $52 per share rights-on. The company’s net income this year is $17.5 million. A rights offering has been announced in which 550,000 new shares will be sold at $46.50 per share. The subscription price plus 5 rights is needed to buy one of the new shares.

a. What are the earnings per share and price-earnings ratio before the new shares are sold via the rights offering?

b. What would the earnings per share be immediately after the rights offering? What would the price-earnings ratio be immediately after the rights offering? (Assume there is no change in the market value of the stock, except for the change when the stock begins trading ex-rights.) Round all answers to two places after the decimal point.

Aftertax comparison of preferred stock and other investments

(LO17-5)

17. The Omega Corporation has some excess cash that it would like to invest in marketable securities for a long-term hold. Its vice president of finance is considering three investments (Omega Corporation is in a 35 percent tax bracket and the tax rate on dividends is 20 percent). Which one should she select based on aftertax return: (a) Treasury bonds at a 10 percent yield; (b) corporate bonds at a 13 percent yield; or (c) preferred stock at an 11 percent yield?

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Preferred stock dividends in arrears

(LO17-5)

18. National Health Corporation (NHC) has a cumulative preferred stock issue outstanding, which has a stated annual dividend of $8 per share. The company has been losing money and has not paid preferred dividends for the last five years. There are 350,000 shares of preferred stock outstanding and 650,000 shares of common stock.

a. How much is the company behind in preferred dividends?

b. If NHC earns $13,500,000 in the coming year after taxes but before dividends, and this is all paid out to the preferred stockholders, how much will the company be in arrears (behind in payments)? Keep in mind that the coming year would represent the sixth year.

c. How much, if any, would be available in common stock dividends in the coming year if $13,500,000 is earned as explained in part b?

Preferred stock dividends in arrears

(LO17-5)

19. Robbins Petroleum Company is four years in arrears on cumulative preferred stock dividends. There are 690,000 preferred shares outstanding, and the annual dividend is $6.50 per share. The vice president of finance sees no real hope of paying the dividends in arrears. She is devising a plan to compensate the preferred stockholders for 80 percent of the dividends in arrears.

a. How much should the compensation be?

b. Robbins will compensate the preferred stockholders in the form of bonds paying 12 percent interest in a market environment in which the going rate of interest is 8 percent for similar bonds. The bonds will have a 10-year maturity. Using the bond valuation table in Chapter 16 (Table 16-2), indicate the market value of a $1,000 par value bond.

c. Based on market value, how many bonds must be issued to provide the compensation determined in part a? (Round to the nearest whole number.)

Preferred stock dividends in arrears and valuing common stock

(LO17-5)

20. Enterprise Storage Company has $440,000 shares of cumulative preferred stock outstanding, which has a stated dividend of $7.75. 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:

The company anticipates earnings per share after four years will be $4.09 with a P/E ratio of 10.

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 14 percent. Round to two places to the right of the decimal point. What is the calculated value of the common stock?

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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.

Borrowing funds to purchase preferred stock

(LO17-5)

21. The treasurer of Kelly Bottling Company (a corporation) currently has $150,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying $150,000 more with borrowed funds. The cost of the borrowed funds is 13 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 5 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 35 percent tax bracket, with dividends taxed at 20 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?

Floating rate preferred stock

(LO17-5)

22. 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 4 percent, and the straight preferred stock pays 5 percent. Since the issuance of the two securities, interest rates have gone up by 2.50 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.

COMPREHENSIVE PROBLEM

Crandall Corporation

(Rights offering and the impact on shareholders)

(LO17-3)

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.

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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?

COMPREHENSIVE PROBLEM

Electro Cardio Systems Inc.

(Poison pill strategy)

(LO17-4)

Dr. Robert Grossman founded Electro Cardio Systems Inc. (ECS) in 2001. The principal purpose of the firm was to engage in research and development of heart pump devices. Although the firm did not show a profit until 2006, by 2010 it reported after-tax 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 heart pump research 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 his 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 new 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 question a.

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c. Now assume that Parker exceeds the number of shares you computed in part b and gets all the way up to accumulating 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)?

WEB EXERCISE

1. 3M (Minnesota Mining & Manufacturing Co.) was listed in Table 17-1 as one of the companies having a large percentage of institutional ownership. Institutional ownership represents stock held by nonindividuals such as pension funds, mutual funds, or bank trust departments. Let’s learn more about the company.

Go to 3M’s website, www.3m.com, and follow these steps: Scroll to the bottom of the page and click “Investor Relations.” Click on “Stock Information” under “Investing in 3M.”

2. Scroll down and write down the following:

a. Recent price

b. “52-week high”

c. “52-week low”

d. “52-week price percent change”

e. “Average Daily Volume last 10 days”

3. Return to the prior page and click on “Financial Information” and then click “Ratios” in the middle of the page. The average firm in 3M’s industry of diversified chemicals has the following ratios. How does 3M compare?

Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for.

1Tax consequences related to interest payments are ignored for the present.

2If this were not a rights offering, the discount from the current market price would be much smaller. The new shares might sell for $38 or $39.

3A number of variables may intervene to change the value. This is a “best” approximation.

4Though investment bankers generally participate in a rights offering as well, their fees are less because of the smaller risk factor.

5In a strict sense, preferred stock does not belong on the straight line because of its unique tax characteristics.