Common and Preferred Stock Financing

1
Chapter 17

• Common and Preferred Stock Financing

2
Business Organization

• Sole Proprietorship No separation of person
  assets from business assets and business profit
  taxed as personal income (unlimited liability)
• Partnership partners share the profit and
  liability of the organization personally
  (unlimited liability) can limit risk exposure
  through limited partnership
• Corporation Limited liability and impersonal
  identity easily transferred ownership taxed at
  corporate rates separation of management
  ownership (shareholders)

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Managers as the agent of the shareholders

• Small shareholders have little control over
  management little say
• Managers may put their interests above
  stockholders
• Insufficient corporate governance e.g.directors
  are recommended by the management stockholders
  are rubber seal
• Agency problem managers wont work for the
  owners unless it is in their own best interests

4
How to solve agency problem

• Goal alignment of the managers owners
• Make the mangers the owners
• Tie compensation to share price - e.g. stock
  options, bonuses based on share price
• Strengthen corporate governance e.g. appoint
  outside directors
• Takeover and replacement of management

5
Shareholders Rights

• Residual claim to income amount remained after
  the creditors and preferred shareholders
  dividends or retained earning no legal or
  enforceable claim to dividends
• The voting rights on major issues such as
  director election, CEO appointment, etc
• The right to purchase new shares Preemptive
  Right Provision in corporate charter allows
  existing shareholders to maintain the percentage
  of ownership, voting power and claim to earnings

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The Voting Right

• Majority voting holders of majority (gt
  50) of stock can elect all directors
• Cumulative voting allow minority (lt50)
  shareholders to elect some of the directors
  stockholder can cast one vote for each share of
  stock owned times the number of directors to be
  elected

7
Right to Purchase New Shares

• Difference between initial public offerings (IPO
  or non-seasonal offerings) and seasonal offerings
• In both cases, the company will set the initial
  price at a discount
• Share price rises in the first case but very
  often falls in the latter case
• Reason - in the latter case, there is a dilution
  of the value of existing outstanding shares

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Dilution of Shares

• Assume there are 9M outstanding shares currently,
  each share has a market value of 40.
• The company decides to issue another 1M new
  shares at a price of 30
• The total number of outstanding shares becomes 9M
  1M 10M with a total value of 9Mx40 1Mx30
  390 M
• New value for each share 390 M/ 10 M 39

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Right Offerings

• Each old stockholder receives one right for each
  share owned
• Needs to combine several rights and pay the
  subscription price to buy one new share
• How many rights should be necessary to purchase
  one new share?
• What is the value of these rights?

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Right Offerings cont

• Given the followings
• Market value of existing share 40/share
• Share outstanding 9 M
• Current equity in total 360 M
• Additional funds required 30 M
• Subscription price 30/share
• New share issued 1 M

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How many rights are needed?

• The ratio of old to new shares is 9 to 1, hence
  old shareholder needs to combine 9 shares (or
  rights) to buy one new share
• Number of rights required number of outstanding
  shares/ number of new shares to be issued
• In addition, the old shareholder has to pay a
  subscription price of 30 for each new share

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Whats the value of each right?

• New value of the share after dilution 39 per
  share
• Acquisition costs 9 rights 30
• Hence 9 rights 39 - 30 9
• Each right 1
• Rights may not sell at this theoretical value due
  to the investors expectation and market
  short-term condition

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Figure 17-1(p.665) Time line during rights
offering
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Formulae for Right Pricing

• Rights-on share price (Mo)
• R (Mo S)/ (N1)
• S subscription price
• N number of rights required to purchase one new
  share

• Ex-rights share price (Me)
• R (Me S)/ N
• Infact Me Mo - R

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Before and After Right Offerings

• Before 9 old shares at 40 360
• Cash 30
• Total 390
• After exercise the rights
• 10 shares at 39(diluted value) 390
  Cash 0
  Total 390

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After Right Offerings cont

• Case 1 selling the rights
• 9 shares at 39 (diluted value) 351
• Proceeds from sale of rights 9
• Cash 30
• Total 390
• Case 2 neither exercise nor sell the rights
• 9 shares at 39 351
• Cash 30
• Total 381

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Effect of Rights on Old Shareholders

• Exercise the rights no net gain or loss
• Sell the rights no net gain or loss
• Allow the rights to lapse a loss due to the
  dilution of existing shares
• Remember to exercise or sell the rights upon
  seasonal offerings

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Advantage of Rights Offerings Financing

• Protects stockholders voting position and claim
  on earnings
• Existing shareholders provide a built-in market
  for new issues
• Distribution costs are lower
• The false appearance of a bargain may create more
  interest in the company stock

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Poison Pill

• A right offering to prevent the company from
  being acquired by hostile buyer
• Once the hostile buyer accumulates a certain
  percentage of the common stock (say 20), the
  other shareholders will receive rights to
  purchase additional shares at very low prices
• This will dilute the hostile buyers ownership
  percentage as well as the share value

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Preferred Stock Financing

• From the corporate perspective, preferred stock
  contributes to capital structure balance by
• Expanding the capital base without diluting
  common stock or incurring contractual obligations
• Unlike interest payment on debt, preferred stock
  dividends are not tax deductible

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Preferred Stock Financing cont

• From investor perspective, institutional
  investors may receive the preferred stock
  dividends tax free (Legislation changed)
• For small individual investors, they may enjoy
  dividend tax credit

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Possible features for Preferred Shares

• Cumulative dividends - dividends may accumulate
  but must be paid before dividends on common
  shareholders
• Participation provision - receives higher than
  the quoted yield when company makes exceptional
  profit
• Convertible - may convert into common shares
• Callable - company has option to call back
• Retractable - investor has option to redeem
• Floating rate - preferred yield adjust to market
  condition

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Alternative Security Financing

• Corporate Bonds
• Preferred Stock
• Common Stock
• Table 17-1 2

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Table 17-1Features of alternative security
issues
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Table 17-1 contFeatures of alternative security
issues
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Figure 17-2Risk and expected return for various
securities