Preferred Stock & Common Stock

Chapter Structure

Preferred Stock

Common Stock

Topic Layout – Preferred Stocks

Basic Terms Features of Preferred Stocks

Cumulative Dividend Feature Participating Feature Voting Rights Retirement of Bonds

Call Provision Sinking Fund Conversion

Use in Financing

Basic Terms - Preferred Stocks

Preferred Stocks− Preferred stock is a hybrid form of financing,

combining feature of debt and common stock.− Like bonds, preferred stock has a par value and a

dividend, that must be paid before dividends can be paid on the common stock.

− However, if the preferred dividend is not earned, the directors can omit it without throwing the company into bankruptcy.

Basic Terms - Preferred Stocks

Dividend − The dividend paid on preferred stocks are fixed, in

terms of the rate at which it is paid.− Holders of the preferred stocks must receive a

dividend (in the case of an ongoing firm) before holders of common shares are entitled to anything.

− Although preferred stock has a fixed payment like bonds, which is at the discretion of the board of directors and a failure to make this payment will not lead to bankruptcy

Basic Terms - Preferred Stocks

Par Value − Preferred shares have a stated par value.− In case of liquidation the claim of preferred stock

holders is restricted to the par value of the preferred stock.

− The claim of preferred stockholder’s on assets comes after that of creditors but before that of common stockholders.

Features of Preferred Stocks

Cumulative Dividend Feature− A requirement that all cumulative unpaid dividends on the

preferred stock be paid before a dividend may be paid on the common stock.

− For example, if the board of directors omits a $6 preferred dividend for two years, it must pay preferred shareholders $12 per share ($100 par value) before any dividend can be paid to common shareholders.

− The corporation does not have to make up the dividend even if it is profitable, as long as the firm has no plans to pay dividends to common shareholders.

Features of Preferred Stocks

Participating Feature− Preferred stock where the holder is allowed to participate in

increasing dividends if the common stockholders receive increasing dividends.

− Preferred stockholders have a prior claim on income and an opportunity for additional return if the dividends to common stockholders exceed a certain amount.

− A 6% participating preferred issue ($100 par) allows holders to share equally in any dividend in excess of $6. A $7 common dividend results in an extra $1 dividend to the participating preferred shareholders.

Features of Preferred Stocks

Voting Rights− Preferred stockholders are not normally given a voice in

management unless the company is unable to pay preferred stock dividends during a specified period.

− If such a situation presents itself, the class of preferred stockholders would be entitled to elect a specified number of directors.

− Any situation in which the company defaults under restrictions in the agreement (similar to bond indenture) may lead to voting power for preferred shareholders.

− Preferred shareholders cannot force the immediate repayment of obligations (like debt obligations).

Features of Preferred Stocks

Retirement of Preferred Stocks− Call Provision -- almost all issues carry a call provision

because of the infinite maturity. It is often a cheaper method of retirement than open market purchases, inviting tenders, or an exchange of securities.

− Sinking Fund -- like bonds, many preferred issues provide for this method of retirement.

− Conversion -- certain issues are convertible into common stock at the option of the preferred stockholder. Used most frequently in the acquisition of other companies (the transaction is not taxable to the shareholders of the acquired firm).

Use in Financing

The corporate issuer uses irregularly because the preferred dividend is not tax deductible. Utilities use more frequently as the preferred dividend can be accounted for when setting customer rates.

The corporate investor is attracted to preferred stock as generally 70% of dividends can be excluded from taxes.

Flexibility in paying dividends and an infinite maturity (similar to a perpetual loan) are significant advantages to the corporate issuer.

The after-tax cost of preferred financing is greater than that of long-term debt financing to the corporate issuer.

Common Stock

Securities that represent the ultimate ownership (and risk) position in a corporation.

In event of liquidation, these stockholders have a residual claim over the assets.

Their claim is limited to amount recovered from the asset of the company.

Common stocks has no maturity date.

Basic Terms – Common Stocks

Authorized Shares−

Issued Shares−

Outstanding Shares −

Basic Terms – Common Stocks

Par Value− It is the face value of stock.− It is merely a recorded figure in the corporate charter and is of little

economic consequence. − Stock should never be issued below par value as shareholders

would be legally liable for any discount from par if the firm is liquidated.

− Common stock that is authorized without par value (no-par stock) is carried on the books at the original market price or at some assigned (or stated) value.

− The difference between the issuing price and the par or stated value is additional paid-in capital.

Basic Terms – Common Stocks

Par Value (Example)

FunFinMan, Inc.FunFinMan, Inc.

Common stock ($1 par value;100,000 100,000 shares shares issued and outstanding) $ 100,000

Additional paid-in capital 400,000Retained earnings 650,000Total shareholders’ equity $1,150,000$1,150,000

The par value of FunFinMan, Inc., is $1 per share. This value is not likely to change over time from normal day-to-

day operations.

Basic Terms – Common Stocks

Book Value− It is the shareholders’ equity − It is total assets minus liabilities and preferred stock

divided by the number of shares outstanding.

Liquidating Value− The value per share if the firm’s assets are sold

separately from the operating organization.− This value may be less (or greater) than book value.

Rarely are the two values identical.

Basic Terms – Common Stocks

Book Value (Example)

FunFinMan, Inc.FunFinMan, Inc.

Common stock ($1 par value;100,000 100,000 shares shares issued and outstanding) $ 100,000

Additional paid-in capital 400,000Retained earnings 650,000Total shareholders’ equity $1,150,000$1,150,000

The book value book value (per share) of FunFinMan, Inc.,FunFinMan, Inc., is determined by dividing total shareholderstotal shareholders’’ equity equity ($1,150,000) by the shares outstanding (100,000100,000), which yields a book value of $11.50 per book value of $11.50 per shareshare. This value is not likely to change over time from normal day-to-day operations.

Basic Terms – Common Stocks

Market Value− The current price at which the stock is currently

trading.− This value is usually greater than book value (per

share), but can occasionally be less than book value (per share) for firms that have been, are or expected to be in financial difficulties. Rarely are the two values identical.

− Market value (per share) may be difficult to obtain from thinly traded securities.

Rights of Common Shareholders

Right to Income - entitled to share in the earnings of the company only if cash dividends are paid (via approval by the board of directors).

Right to Purchase New Share (Maybe) Income - the corporate charter of state statute may provide current shareholders with a preemptive right, which requires that these shareholders be first offered any new issue of common stock or an issue that can be converted into common stock.

Rights of Common Shareholders

Voting Right - because the shareholders are owners of the firm, they are entitled to elect the board of directors.− Shareholders are generally geographically widely

dispersed.− Two methods of voting:

(1) in person or (2) by proxy

ProxyProxy -- A legal document giving one person authority to act for another.

Rights of Common Shareholders

Voting Right (Cont…)− SEC regulates the solicitation of proxies and requires

companies to disseminate information to their shareholders through proxy mailings.

− Most shareholders, if satisfied with company performance, sign proxies in behalf of management.

− Voting Procedure - The board of directors are elected under either:

1. Majority-rule Voting -- a method of electing corporate directors, where each common share held carries one vote for each director position that is open; also called statutory votingstatutory voting.

Rights of Common Shareholders

Voting Right (Cont…)

2. 2. Cumulative VotingCumulative Voting -- a method of electing corporate directors, where each common share held carries as many votes as there are directors to be elected and each shareholder may accumulate these votes and cast them in any fashion for one or more particular directors.

Rights of Common Shareholders

Voting Procedure Example

Under Majority-rule Voting: You may cast 100 votes (1 per share) for each of the 9 director positions open for a maximum of 100 votes per position.

Under Cumulative Voting: You may cast 900 votes (100 votes x 9 positions) for a single position or divide the votes amongst the 9 open positions in any manner you desire.

You are a shareholder of FunFinMan, Inc. You own 100 shares and there are 10 director positions to be

filled.

Rights of Common Shareholders

Voting Procedure - Minimum Votes to Elect a Director Under Cumulative Voting (Cont…)

For example, to elect 3 directors out of 9 director positions at FunFinMan, Inc., (100,000 voting shares outstanding) would require 30,001* voting shares30,001* voting shares.

*(100,000 shares) x (3 directors) 10

Total number ofvoting shares

Specific number ofdirectors sought

Total number of directors to be elected + 1

X+ 1

Rights of Common Shareholders

Voting Procedure - Minimum Votes to Elect a Director Under Cumulative Voting − Notice that slightly over 30% of total voting shares are

necessary to guarantee the election of three of the nine director positions -- less than a majority.

− Management can reduce the influence of minority shareholders by reducing the number of directors or staggering the election terms of directors so fewer positions are open at each vote.

− Reducing the number of directors up for election from 9 to 4 would increase the votes necessary to elect 3 directors to 60,001 shares (twice as many)!

Dual - Class Common Stock

Two classes of common stock, usually designated Class A and Class B.

Class A is usually the weaker voting or nonvoting class, and Class B is usually the stronger.

This is used to retain control for founders, management, or some other specific group.

For example, 80,000 shares of Class A at $20/share and 200,000 shares of Class B at $2/share. Class A puts up 80% of the funds, but Class B has over 70% of the votes.

Usually Class B takes a lower claim to dividends and assets than Class A for this voting control.