CHAPTER

SEVENTEEN

Common and
Preferred Stock
Financing

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Figure 17-1
Time line during rights offering

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Beforetax and aftertax yields on corporate debentures and

preferred shares
Beforetax debenture yield . . . . . . . . . . . . .

5.34 percent

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

(1.55)

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

(0.68)

Aftertax debenture yield . . . . . . . . . . . . . .

3.11 percent

Beforetax preferred yield . . . . . . . . . . . . . .

4.50 percent

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

5.63

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

1.63

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

.75

Net federal tax . . . . . . . . . . . . . . . . . . . . . . .

(0.88)

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

(0.39)

Aftertax preferred yield . . . . . . . . . . . . . . . .

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3.23 percent
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Table 17-1a
Features of alternative security issues

Common
Preferred
Stock
Bonds
Stock
Limited rights when Limited rights
1. Ownership Belongs to common
dividends are missed under default in
and control shareholders through
interest payments
of the firm voting rights and
residual claim to income

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2. Obligation None
to provide
return

Must receive payment Contractual

before common
obligation
shareholder

Lowest claim of any

3. Claim to
security holder
assets in
bankruptcy

Bondholders and
creditors must be
satisfied first

Highest claim

Highest
4. Cost of
distribution

Moderate

Lowest

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Table 17-1b
Features of alternative security issues

Common
Stock
5. Risk-return Highest risk, highest
trade-off
return (at least in
theory)

Preferred
Stock
Moderate risk,
moderate return

6. Tax status of Not deductible

payment by
corporation

Not deductible

Tax deductible
Cost = Interest
payment
(1 Tax rate)

7. Tax status of Dividend to another

payment to
corporation is usually
tax exempt
recipient
Special tax treatment
with dividend tax credit

Same as common
stock

Interest usually
fully taxable

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Bonds
Lowest risk,
moderate return

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

Co

rp

t
a
r
o

ue
iss

s
Common stock
Subordinated debentures

Senior unsecured debt

Secured debt

Long-term government securities

Treasury bills (short term)

Preferred stock

Savings account
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Risk to investor
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Chapter 17 - Outline

LT 17-1

Common Stock
The Voting Right
Rights Offering
Rights-on and Ex-rights
Poison Pill
Preferred Stock
Provisions Associated with Preferred Stock

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Common Stock

LT 17-2

Common shareholders own the corporation and have ultimate control

They have a residual (leftover) claim to all corporate income that is not
paid out to others

Common shareholders have the right to vote on all major issues,

including election of the board of directors

Practically, management controls the corporation on a daily basis

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

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

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The Voting Right

LT 17-3

Proxy:
a right to vote given to someone elses (absent
shareholders) vote
Majority Voting:
all directors must be elected by at least 51% of the vote
doesnt allow minority shareholders representation on
the board of directors

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Cumulative Voting:
a shareholders votes can all be used to elect 1 person
allows minority shareholders representation on board
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Rights Offering

LT 17-4

Rights Offering:
gives current shareholders a first option to purchase
new shares (called a preemptive right provision)
allows existing shareholders the same amount of control
they have initially
shareholder receives 1 right for each share of stock
owned

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Rights-on and Ex-rights

LT 17-5

Rights-on
if you buy the stock, you will also acquire a right
toward a future purchase of the stock
occurs when a rights offering is initially announced
Ex-rights
when you buy the stock you no longer get a right
toward future purchase of the stock
occurs after a certain period of time
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Poison Pill

LT 17-6

Poison Pill:
a rights offering made to existing shareholders of a
company in order to make it more difficult for another
company to acquire it
allows existing shareholders the right to buy additional
shares of the stock at a very low price
makes hostile takeovers very expensive and unattractive
often introduced by management to protect their own
interests
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Preferred Stock

LT 17-7

Preferred Stock:
a hybrid security combining characteristics of both debt
and common stock
has a fixed dividend that must be paid before dividends
on common stock
dividends are not tax deductible to a company
provides the company with a balance in its capital
structure
primary purchasers are corporate investors, insurance
companies, and pension funds
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Provisions Associated with

Preferred Stock

LT 17-8

Cumulative Dividends:
if not paid in one year, dividends accumulate and must
be paid in total before common shareholders
Conversion Feature:
preferred stock may be converted into common stock at
the option of the holder
Call Feature:
company has option to redeem stock
Retractable Feature:
investor has option to redeem stock
Floating Rate Dividend:
company adjusts dividend to market conditions
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