Chapter 10

financial
Management
- Part One
“Common and Preferred Stocks”

– Chapter Ten
1
Chapter 10 Common and Preferred Stocks
“Common and Preferred Stocks are two common
means of raising long term finance that are
available to joint stock companies and both possess
their own personalities to serve the investors.”
Financial Management Part One

2
Learning Objectives
Need for long term finance and alternatives available to meet them
Role of common stock to meet long term finance needs.
Rights enjoyed by a common stockholder.
Common stock has certain advantages and a few shortcomings.
Features of preferred stock.
Classes in which preference stock is available
Salient features of common stock, preferred stock and long term debt instruments

3
10.01 Introduction
When an investor pays any company money in return for

part ownership, the corporation issues a certificate of
ownership interest to the stockholder. This certificate is
known as a stock certificate, capital stock, or stock. (Today
all shares or stock are in electronic form).
It is the evidence of an ownership interest, and not a loan,

and it does not come with due date or maturity. So the
stockholder owns the stock indefinitely. If stockholders
want to sell their stock, they must find a buyer through the
services of a stockbroker who arranges for the transaction
on the stock exchange.

4
10.01 Introduction
Nowhere on the stock certificate is it indicated what the
stock is worth (or what price was paid to acquire it).
In a market of buyers and sellers, the current value of any

stock fluctuates moment-by-moment.
It has value on its face that indicates what proportion in

total ownership the owner enjoys. Total common stock
consists of a certain amount (` One crore) divided into a
certain number of shares (` twenty lacs) of face value that
is indicated in the share certificate (`Five).

5
10.01 Introduction
Nowhere on the stock certificate is it indicated what the
stock is worth (or what price was paid to acquire it).
In a market of buyers and sellers, the current value of any

stock fluctuates moment-by-moment.
It has value on its face that indicates what proportion in

total ownership the owner enjoys. Total common stock
consists of a certain amount (` One crore) divided into a
certain number of shares (` twenty lacs) of face value that
is indicated in the share certificate (`Five).

6
10.01 Introduction
A corporation's accounting records are involved in stock
transactions only when the corporation is issuing shares as
per its prospectus. Sale and purchase of shares on
exchanges have no effect in records of the corporation.
As per section 2(46) of the Indian Companies Act 1956,

"share" means share in the share capital of a company, and
includes stock except where a distinction between stock
and shares is expressed or implied.
Preferred stock is a hybrid source of long term financing
with some characteristics of equity and some of the long
term debt.

7
10.02 Categories of Equity Capital
10.02.01 Share Capital
Some investors may have large ownership interests in a

given corporation, while others own a very small part. To
keep track of each investor's ownership interest,
corporations use a unit of measurement referred to as a
"share" (or "share of stock"). The number of shares that an
investor owns is printed on the investor's stock certificate
(which is now in an electronic form).
Public corporations have their equity distributed over a
number of shareholders, who enjoy the rewards and bear
the risks. Risk is restricted to the initial amount they paid to
buy stocks.
8
L & T Limited
Distribution of Shareholding as on March 31, 2015:
No. of Shares Shareholders Shareholding % Number %
Up to 500 7, 81,280 91.51 6, 58, 86,346 7.09
501 – 1000 39,256 4.60 2, 78, 31,827 2.99
1001 – 2000 18,171 2.13 2, 55, 51,969 2.75
2001 – 3000 5,663 0.66 1, 40, 84,226 1.51

9
Distribution of Shareholding as on March 31, 2015: contd.
No. of Shares Shareholders Shareholding Number %

%
3001 – 4000 2,425 0.28 84, 38,946 0.91
4001 – 5000 1,511 0.18 68, 17, 391 0.73
5001 – 10000 2,836 0.33 1, 96, 83,512 2.12
10001 & ABOVE 2,682 0.31 76, 12, 67,844 81.90
TOTAL 8, 53,824 100.00 92, 95, 62,061 100.00

10
10.02.02 Authorized Share Capital
When a business entity applies for incorporation to the

Registrar of Companies, its application will specify the classes
(or types) of stock, the par value of the stock, and the number
of shares it is authorized to issue. This constitutes authorized
capital of the company (` One crore consisting of twenty lac
shares of five rupees each).
When its articles of incorporation are prepared, the business
entity will often request authorization to issue a larger
number of shares than what is immediately needed. This way,
the business entity avoids the inconvenience of having to go
back to the Registrar if and when more shares are needed to
raise more capital.
11
10.02.03 Issued Share Capital
When a corporation sells some of its authorized shares, the

shares are described as "issued." The number of issued
shares is often considerably less than the number of
authorized shares.
Corporations issue (or sell) shares of stock in order
to obtain cash from investors,
to acquire another company (the new shares are given
to the owners of the other company in exchange for
their ownership interest),
or to acquire certain assets or services, and as an
incentive/reward for key staff of the corporation.

12
10.02.03 Issued Share Capital
The "par value" of a share of stock is sometimes defined as

the legal capital of a corporation. The par value of common
stock is usually a very small insignificant amount that was
required by state laws many years ago. Because of those
existing laws whenever a share of stock is issued, the par
value is recorded in a separate stockholders' equity account
in the general ledger. Any proceeds that exceed the par value
are credited to equity premium account.
This required accounting allows you to determine the number
of issued shares by dividing the balance in the par value
account in the balance sheet by the par value per share.

13
10.02.04 Subscribed Capital and Paid-up Capital
If a share of stock has been issued i.e. offered to the public

for subscription, and has not been reacquired by the
corporation, it is said to be "outstanding." The number of
outstanding or subscribed shares is always less than (or equal
to) the number of issued shares. The number of issued shares
is always less than (or equal to) the authorized number of
shares.
The actual amount paid by the investors against the number

of shares they had subscribed constitutes paid up capital.
Typically the issued, subscribed and paid up capital of a
corporation are the same.
14
10.02.05 Share Capital Values
When you examine the data published by corporates about

common stock in their published year end accounts you will
come across various terms as
€ Par Value
€ Issue Value or Price
€ Book Value
€ Market Value

15
10.02.05 Share Capital Values - € Par Value
Par Value:
The par value of an equity share is

the one which is indicated in the
memorandum of association of the
corporation. It is also reflected in the
body of the share certificate issued
to the equity holder.

16
10.02.05 € Issue Value or Price
Initially new corporations entering the stock market for the

first time, issue their shares at a par value. At that stage they
have just started the business activity and need long term
finance to run operations by installing fixed assets.
Later established firms with excellent earnings enter the
capital market for seeking long term finance for expansion as
well as to liquidate (costly) long term debts.
These business entities wish to seek returns on their financial
achievements and hence issue equity at prices higher than
the par value. These are known as Issue prices.
17
** The difference between

issue price and par value of
the share is known as
share premium.

18
Investors are prepared to pay premium in view of the past

financial record of the corporation that assures them of long
term returns.
Investors were so impressed with financial performance of
Indigo airlines that they overwhelmingly responded to this
initial public offer and the issue was oversubscribed (the
quantity of shares for which investors subscribed was in
multiples of what was offered).
When these shares were traded on exchanges the price was
15% over the issue price providing the investors best returns.
19
€ Book Value
The book value of an equity share is equal a sum of paid-up
equity capital and reserves and surplus divided by number of
outstanding shares of the corporation.
Larsen Toubro Ltd. Balance Sheet 2014- 15.
Paid up capital ` 185.9 crores

Reserve and Surplus ` 36898.7 crores
Total ` 37084.6 crores
Outstanding shares 929,562,061
Book value per share ` 398. 78
This book value increases as the corporation starts earning

profits and creating reserves.
20
€ Book Value
The fact that this successful giant corporation is adding to the shareholders’ value is indicated by the
increase in its book value over last ten years from ` 55.67 to a whopping ` 398.78 as under.
2014-15 2013-14 2012-13 2011-12 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06
398.78 362.95 317.09 274.35 238.96 202.46 141.54 108.63 67.43 55.67

21
€ Book Value
This increase in book value goes a long way to prove that the
corporation is living to its vision statement below which
states that it is committed to enhance shareholder value.

22
€ Market value
The market value of an equity share is the day today changing
price at which it is traded in the market known as stock
exchange.
For a company to have its shares traded on an exchange it has
get them listed (registered) on that exchange.
In India most shares are actively traded on the National and
Bombay Stock Exchanges (NSE and BSE).
Market prices of all listed shares are displayed on line by
these exchanges.

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Month National Stock Exchange Prices
2014 High Low Month Close
April 1,388.50 1,242.00 1,294.10

May 1,627.35 1,251.20 1,545.50
June 1,776.60 1,539.00 1,701.70
July 1,765.90 1,499.30 1,502.90
August 1,557.90 1,440.00 1,526.50
September 1,632.70 1,431.65 1,458.25
October 1,663.50 1,401.00 1,655.45
November 1,692.90 1,593.50 1,639.35
December 1,655.00 1,450.20 1,494.65
2015
January 1,750.00 1,485.55 1,700.55
February 1,799.90 1,532.15 1,768.10
March 1,893.80 1,613.45 1,719.65

24
€ Market value
The last table once again indicates how shareholders benefit

from the rise in market prices of the L & T shares in which
they decided to invest.
These market prices in addition to the past financial
performance of the company depend on many factors like
current earnings, growth prospects, risk and company size.
These prices are further governed by external factors like
state of the industry, national economy and mood prevailing
on the stock exchanges both domestic as well as
international.
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10.03 Rights of Equity Holders
Equity holders enjoy many rights:
Right to Income
Right to Vote
convertible
debentures Right to Acquire
New Shares
Right to Bonus Shares

26
10.03.01 Right to Income

All incoming cash flow is utilized by business entities to pay
out for its expenses and its creditors. If it has issued
preference stock then the preference stockholders have a
claim on the balance.
Thereafter the residual income belongs to equity holders.

Whether it is distributed to stakeholders by way of dividends
or retained as reserves in the company does not affect their
claim.
It is just a matter of timing.

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Total Receipts
Less
Expenses.
Dividend to Preference Shares
= Balance owned by equity share holders
It is either distributed as dividends
or
Retained as reserves

28

In the fiscal 2014 – 15 ITC Ltd. reported net profit after tax
(PAT) of ` 3,711 crores which was available to equity holders.
Out of this amount ` 601 crores was distributed as dividends, `

153.80 crores paid as tax on dividends and rest transferred to
reserves and surplus. ITC paid income tax on dividends as
shareholders receive dividend tax free
These cumulative reserves accounted for ` 20,261.70 crores.
This surplus is for re-investment in the business for the
benefit of equity holders; with the hope of providing even
greater income, dividends and price appreciation in the
future.
29

This right to income is not legal and cannot be enforced in
courts of law. Declaration of dividends is entirely a
prerogative of the ITC Ltd. Board of Directors and if they
declare fewer dividends or skip them altogether in any year
shareholders do not have any recourse to legal action.
This needs to be contrasted with the rights of long term
lenders and bond holders who on non-payment of interest
can force ITC Ltd into bankruptcy.
Equity owners have to accept circumstances about dividends
as they are or attempt to change the management if a revised
dividend policy is desired. They, then, need to exercise their
right “to vote” explained in 10.03.02.
30

All companies do not show spectacular results; they fail to
perform successfully in each consecutive year. This results in
depreciation of their book as well as market value.
The latest trend indicates that many individuals prefer to
invest indirectly through financial institutes and mutual
funds.
Thus about 37% shares of L & T Ltd of are held by
LIC of India 15, 55, 22,285 16.73
L&T Employees Foundation 11, 16, 06,174 12.01
Unit Trust of India 7, 59, 25,962 8.17

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10.03.02 Right to Vote

Equity holders being owners of the joint stock company
exercise their right to vote and appoint a Board of Directors
to manage operations of the company.
Directors to this board are elected in the annual general body

meeting. The directors serve on different committees that
look after Risk Management, Corporate Social Responsibility,
Employee Administration and Welfare, Internal Audit etc.
Shareholders are also required to vote on resolutions on all

significant financial matters presented in this meeting.

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10.03.03 Poison Pills
In the last two decades a new wrinkle was added to the

meaning of rights of equity shareholders. Many business
families are able to manage large joint stock companies with
shareholding of about 20% - 25%.
These families in control of the corporation often perceive a
threat from another business unit which is gradually acquiring
more and more of their company’s share capital to gain
control of the company from these families.
To thwart these attacks these families have provided new
thrust to the rights of the shareholders.

33

When the acquisition minded group is observed to be in
possession of about say 15% of the equity capital the present
management arranges for sale of preference shares or
debentures that get converted into equity.
When the acquisition minded group is about to possess more
than 20% of the capital the present management of the
company announces conversion of the above preference
shares or debentures into equity. This step increases total
paid up capital of the company and thereby significantly
reduces the percentage of shares held by the acquisition
minded group which does not get any additional shares.

34

35
10.03.04 Right to Acquire New Shares

Equity holders have one more right of a privileged position in
the offer of fresh shares of the company. This preemptive
right permits existing equity shareholders to maintain their
proportional ownership.
When company issues additional shares to public the total
paid up capital increases and their existing share holding
proportion in total capital decreases unless correspondingly
more shares are acquired by them.
The company law requires to reserve a portion of the
additional shares for existing share holders, so that if they
purchase shares from this quota their proportion in the total
paid capital remains constant.
36

37

In addition to right on
residual income,
right to vote in the shareholders’ meetings
equity holders have one more right of a privileged position in
the offer of fresh shares of the company.
This preemptive right permits existing equity shareholders to
maintain their proportional ownership permanently.
If their company issues additional shares to public the total
paid up capital increases but with existing share holding their
proportion in total capital decreases.

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If the equity holders wish to maintain that proportion,

correspondingly more shares have to be acquired by them.
The company law, therefore, requires corporations to reserve
a certain part/quota of the additional shares being offered to
the public for existing shareholders, so that if they purchase
shares from this quota, their proportion in the total paid
capital remains constant.
This type of public
offering of shares
is known as
“Rights Issue.”
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10.03.05 Right to Bonus Shares

Every year, profit-making companies reward shareholders.
They do so by distributing a (usually increasing) portion of
profits to shareholders.
This we know is called dividend.
Sometimes, however, the company may announce bonus
shares – additional shares for all existing shareholders
without requiring any payment from them – in other words
for free. This is also called ‘stock dividend’.
As part of a bonus issue, the company uses its surplus
reserve to convert it into share capital.

40
Normally a company can use its surplus money in multiple
ways –
reinvest into the company,
distribute the cash as dividends or
issue more shares as a bonus.
The last two aim at giving back money to the shareholders. As
a result, investors usually rejoice when a company announces
a bonus share issue. After all, they are getting extra shares of
the company for free.
The increased number of shares
an opportunity to earn extra dividends.
41
A bonus share issue indicates that the company is confident
about the business’s capacity to generate value for a larger
capital owned by investors.
It also helps boost trading of the shares in the stock market as
more number of shares is traded. Further the (temporary?)
drop in the share price after bonus issue can attract small
investors into the share market.
Next, while issuing more shares, the company avoids paying
the ‘dividend distribution tax’. This helps reduce costs for the
company as well as stockholders.

42
Like in earlier years, Infosys issued bonus shares along with
the usual dividend payment in 2014. The IT major has a large
cash reserve of around ` 30, 000 crores. Investors have been
asking the company to use the cash – either for acquisitions
or return it to shareholders.
This amount could have been used for expansion or
purchasing a new company – either of which could help
improve its profitability. This acquisition is a continuous
process for this profitable company. But it also arranges
bonus issues. This shows the company values giving back to
shareholders more and does not foresee better use for the
money lying idle.
43

After any company announces a bonus issue the actual
distribution happens not immediately but at a later date. Like
the dividend distribution, there is a particular date on which
the new changes are incorporated.
This day is called the ‘Record’ date. If you already have the
shares on the record date, you will be eligible to get the
bonus shares.
Until the ‘Record’ date, price of the stock usually rises as
more investors want to be eligible for the extra stocks.
However, it may not be so if the company is underperforming
or it has poor fundamentals.
44
The day after the bonus is distributed, the share price is
adjusted. This is called the ex-bonus price. So, if the company
has issued a 1:1 bonus share, then the price of the shares will
fall to nearly half of its original price.
Share’s price is a reflection of the company’s value in the
market. A bonus does not change the share’s inherent value.
So, the prices of the shares fall temporarily. One study
observed that of the top thirty companies which announced
bonus issues between January 2001 and July 2010 the share
price of twenty one companies rose till the record date. Also,
stocks of twenty four companies rose in the year after the
record date.
45
We must also know how different the bonus issue is from a
stock-split. On the face of it, a bonus share issue is
remarkably similar to a stock split – the number of shares a
person holds increases while the price falls in tandem.
However, there are some differences. Firstly, every share has
a face value. It could be Rs 1, 5 or 10. In a stock split, the face
value of the share falls. So, if your shares had a face value of
Rs 10 before a 1:1 stock split, you would now have two shares
with a face value of Rs 5. This is not so in a bonus stock issue.
There you will hold two shares with a face value of Rs 10. This
means, you get a greater piece of the surplus available for
distribution to shareowners.

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10.04 Common Stock – Benefits and Drawbacks
First Benefits
When common stocks are issued to meet long term needs of an organization, earnings can be
retained to meet further financial requirements as there is no compulsion on management to declare
dividend and divert a part of earnings to shareholders.
Similarly, unlike long term debts, common stock does not have any maturity date on which the
shares have to be redeemed. Common stock is a permanent fund.
Higher common stock base allows managers to get larger amount of debts at lower interest rates.
This advantage accrues from the fact for lenders larger common stock offers a cushion.
47
Investors do not have to pay the income tax on dividends they receive.
. Now Drawbacks
However company has to pay dividend distribution tax (15% in the year 2015) with surcharge and
cess. Plus unlike interest on long term debt, dividends can be distributed only out of after tax earnings of
the business entity. Interest paid is a tax deductible expense but not dividends.

48
The cost of equity capital is high as rate of return expected by shareholders is greater than the one
expected by long term lenders.
Underwriting commission, brokerage costs and issue expenses cause high cost for issue of equity as
compared to other long term debts.
Equity stock holders can be obstacles in management of the company if they organize themselves
and challenge management decisions by voting against the resolutions put up by the board of directors
during shareholders’ meetings.

49
10.05 Preferred Stock – Features
Preferred stock is a hybrid form of long term finance available
to corporations. It has some characteristics of equity and
some of the long term debts. The term preferred attached to
this category of financial instrument is very questionable as it
does not possess desirable characteristics of either equity or
debt.
Common stockholders have claim on residual income while
bond or long term security holders have a contractual claim
on the company for their interest payments and refund of the
principal. They can put the company into bankruptcy if these
not arranged per schedules. No such privilege exists for
preference stockholders.
50
Central Government Act
Section 85(1) in the Companies Act, 1956
(1) " Preference share capital" means, with reference to any company limited by shares, whether
formed before or after the commencement of this Act, that part of the share capital of the company
which fulfills both the following requirements, namely:-
(a) that as respects dividends, it carries or will carry a preferential right to be paid a fixed amount or
an amount calculated at a fixed rate, which may be either free of or subject to income- tax; and
(b) that as respects capital, it carries or will carry, on a winding up or repayment of capital, a
preferential right to be repaid the amount of the capital paid up or deemed to have been paid up.

51
Common stock holders are the owners of the company and as

such have a right on residual income while preferred
stockholders are entitled to a fixed amount of dividend and
must receive it before the payment of dividends to common
stock holders is arranged.
But this right of preference stockholders to dividend is not
mandatory as is the case with interest on long term debt
instruments.
Dividends on preferred stocks can be skipped if the board of
directors feels that the earnings of the year are inadequate.
52

53
10.06 Preferred Stock - Classification
10.06.01 Classification Based on Income.
a) Non-cumulative Preference Stock.

As stated earlier preference stockholders have priority for
claim on dividends. Unless dividends are declared the
company cannot declare dividends on common stock. At the
same time there is no compulsion on the board of directors
to declare dividend whenever earnings are available. The
board can very well invest all the earnings back in business.
Distribution of dividends thus is a priority of the management
alone.
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a) Non-cumulative Preference Stock.

Dividends when declared are at the rate specified at the time
of issue of the preference stock and this rate does not
change. In case in any year dividend is not declared
preference shareholders’ loss is permanent as there is no
provision to pay earlier year’s dividends for this category of
preference stock. (Hence non-cumulative).
A Company ensures that dividends on preference stocks are
declared each year so as not to lose its credit standing in the
market.
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b) Cumulative Preference Stock

For this class of stock, if dividend is not declared in any year, it
does not lapse. Unpaid dividend is carried over and holders
have a claim of unpaid dividends on future earnings of the
company. Until this accumulated dividend amount is paid the
company cannot declare dividend on common stock. Thus
due to inadequate earnings a company does not pay dividend
on 10% Cumulative Preference Stock for, say, three years,
preference shareholder has to receive ` Thirty before common
stockholder can receive any dividend.

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b) Cumulative Preference Stock

In case a company is unable to declare a dividend on its
cumulative preference shares for a long time, it is common
for the company to recapitalize itself. It then offers fresh
common or preference stocks against unpaid dividends.
These shares are attractive to investors as they earn a steady
flow of income without any dilution in value of their initial
investment.
For companies they offer additional source of finance, so long
as there are no unpaid dividends.
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10.06.02 Classification Based on Maturity
a) Irredeemable Preference Stock

Normally preference stocks along with common stocks have
no maturity.
The company has no obligation to repay the capital amount
to stockholders unless there is a liquidation of the business
entity.
Therefore, both the stocks are a permanent source of finance
for the enterprise.

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b) Redeemable Preference Stock

However, the Articles of Association can be framed to permit
redemption or calling back of preference stocks at
management’s discretion. The terms and conditions under
which these stacks can be recalled have to be specified in the
company’s Articles of Association. Redemption is arranged in
a manner that provides premium to the stockholders.
Redemption can take place out of accumulated profits or out
of sale proceeds of assets and property of the company. Such
redemption can also be arranged through issue of fresh issue
of common stock.
59

Redeemable preferred stock contains a call option that allows
the issuer to forcibly redeem the shares on or after a
specified call date.
You call shares by canceling them and paying a preset price
plus any dividends due. Issuers value the call option because
it allows them to replace preferred shares with lower yielding
ones if interest rates fall. You are under no obligation to call
the shares if interest rates remain steady or rise. In latter case
You continue to pay dividends at same earlier lower rate.
60

Because call options favor issuers, redeemable preferred
stock will raise less money than will equivalent shares without
the call option. Further, such redeemable preference shares
could be allotted to foreign investors without offering them
any voting rights or control in respect of the Indian company.
There is a prescribed limit on the maximum dividend that can
be paid, so preference shares could not work as an
instrument for unfettered outflow of the profits of Indian
companies.

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c) Convertible Preference Stock

Convertible preferred stock is defined as a stock that includes
an option for the holder to convert the preferred shares into
a fixed number of common shares, usually any time after a
predetermined date. Usually the stock certificate specifies
that the preference share of ` One Hundred is convertible
into say ten shares of ` Ten each any time after, say, three
years. Until the price of common stock is below the par value
of ` Ten the investor is not interested in conversion. But once
the common stock trades at a premium the stockholder
stands to benefit by opting for the conversion.

62

Under a circular (New Circular) dated 8 June 2007 issued by
the Reserve Bank of India (RBI), it has revised its guidelines
pertaining to issue of preference shares to foreign investors.
After revision, only those preference shares that are fully and
mandatorily convertible into equity shares within a specified
time will be considered as a part of the investee company’s
share capital—and only such preference shares will be issued
to foreign investors under the automatic approval route (that
is, without requiring permission from the ministry of
commerce).

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Foreign investments in non-convertible,

optionally convertible or partially
convertible preference shares are now
considered to be debt finance, that is, akin
to a loan, and are required to conform to
the stringent guidelines relating to external
commercial borrowings (ECBs).

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10.07 Preference Stock – Benefits and Drawbacks
p) Benefits:
The board of directors has flexibility in decision about payment of dividends to preference
shareholders. There is no compulsion, like in case of interest on long term debt, to arrange
payments every year.
There is again no compulsion to set aside a part of earnings into a sinking fund for redemption of
preference stock. Redemption can be delayed without any adverse financial consequences.

65
Being a part of a net worth of the company issue of preference stock enhances company’s
c creditworthiness.
Since preference shares do not carry (in normal circumstances) any voting rights as a result with
issue of preference stock there is no dilution of control.
Issue of preference stock does not call for any mortgage of company’s assets which remain
available for raising debt as and when required.

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q) Drawbacks
Preference stock as a source of long term finance is very expensive vis-à-vis debt capital as
dividends have to be paid from after tax earnings and not as a tax deductible expense.
Dividend payments need to be arranged each year, even though not mandatory, as skipping
dividend in any year has adverse effects on company’s creditworthiness.
Dividends on common equity capital cannot be declared unless dividend is paid on preference
stock in that year.
If dividends are skipped for a certain years preference stockholders acquire voting rights and
thereby cause dilution of control.

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10.08 Common Stock, Preferred Stock & Debt Instruments
Feature Common Stock Preferred Stock Debt Instruments

Ownership Control Full control through Limited control when Limited control in case
voting right and claim dividends are skipped of interest default/s
on residual income
Claim to income None Must receive dividends Must pay per

before common contractual obligations.
stockholders
Claim to assets in case Lowest / last Next to debt holders First claim
of bankruptcy
Cost of distribution Highest Moderate Lowest

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10.08 Common Stock, Preferred Stock & Debt Instruments
Feature Common Stock Preferred Stock Debt Instruments
Risk / Return Highest risk and hence Moderate risk and fixed Lowest risk and fixed
highest return return return
Tax burden on company Dividends paid out of Dividends paid out of Interest paid as an
after tax earnings after tax earnings expense as charge to
earnings
Tax burden on investor Dividends received are Dividends received are Interest received is
tax free. tax free taxable.

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10.09 Summary
When an investor pays any company money in return for part

ownership in it, the company issues a certificate of ownership
interest to the stockholder. This certificate is known as a stock
certificate, capital stock, or stock.
Of course these days all stock records are handled
electronically. Most large public corporations have their
equity distributed over a large number of shareholders to
ensure control over the company continues with its
promoters. They together enjoy the rewards and bear the
risks of ownership.

70
10.09 Summary
It must be noted here that their liability, unlike the liability of

a proprietor or a partner of a business unit, is limited to the
amount they paid to get the shares in their name.
When a business entity applies for incorporation to the
Registrar of Companies, its application will specify the classes
(or types) of stock, the par value of the stock, and the number
of shares it is authorized to issue. This constitutes authorized
capital of the company. Companies ask for a larger amount of
authorized capital to avoid any revision when the need for
capital increases with the growth of the business.

71
10.09 Summary
When a corporation sells some of its authorized shares, the

shares are described as "issued." The number of issued
shares is often considerably less initially than the number of
authorized shares. The value of issued shares constitutes
company’ subscribed capital.
If a share of stock has been issued i.e. offered to the public
for subscription, and has not been reacquired by the
corporation, it is said to be "outstanding." Value of such
shares when fully subscribed constitutes company’s paid up
capital.

72
10.09 Summary
Value indicated on the share certificate is its face or par

value. Shares are often issued at a premium, face value plus
such premium is termed paid up value.
After satisfying the claims of all others, value of assets with
the company that belongs to common stockholders when
divided by number of fully paid shares provides you with the
book value of the common stock.
The prices at which the shares are bought and sold on stock
exchange are termed its market value.

73
10.09 Summary
All cash inflows are utilized by business entities to pay for its
expenses and creditors. If it has issued preference stock then
the preference stockholders have a claim on the balance.
Thereafter equity holders have sole right on the residual
income. A company can retain this net balance as reserves to
meet company’s future requirements of long term finance or
distribute it to equity holders as dividends. They enjoy
another right to vote on resolutions at the AGM. This right
provides them with a control over the company in proportion
to the number of shares owned.

74
10.09 Summary
Common stockholders have one more right of a privileged

position in the offer of fresh shares of the company.
When the company wants to meet its long term finance
requirements by issue of fresh equity capital, it has to offer it
first to its existing shareholders.
This offer is termed ‘Rights Issue’.
By participating in the rights issue stockholders can further
increase their gains.

75
10.09 Summary
Every year, profit-making companies reward

shareholders by distributing a portion of profits to
shareholders and balance is retained as reserves in
business.
When reserves get built up and they are no more
required for long term finance, companies
distribute them to common stockholders through
issue of bonus (free) shares again in proportion to
shares owned by stockholders.

76
10.09 Summary
The major advantages of common stock as source of long

term finance are
1 The funds are available forever and there is no
contractual obligation to pay the investors.
2 Dividends can be paid when surplus earnings are
available.
3 Common stock increases the net worth of the company
and along with it company’s creditworthiness.

77
10.09 Summary
The current income tax provisions call for tax free dividends
at the hands of stockholders.
However company has to pay dividend distribution tax (15%
in the year 2015) with surcharge and cess.
The cost of equity capital is high as rate of return expected by
shareholders is greater than the one expected by long term
lenders. Underwriting commission, brokerage costs and issue
expenses cause high cost for issue of equity as compared to
other long term debts.

78
10.09 Summary
Preferred stock is a hybrid form of long term finance available

to corporations. It has some characteristics of equity and
some of the long term debts.
Preferred stockholders are entitled to a fixed amount of
dividend and must receive it before the payment of dividends
to common stock holders is arranged.
Even though normally preference stockholders do not possess
any voting rights at the stockholders meeting, there are
certain exceptional circumstances when they are empowered
to vote.
79
10.09 Summary
Preference stock is classified as
a) Non-cumulative Preference Stock ( if dividend is skipped

in any year it is lost forever);
b) Cumulative Preference Stock (unpaid dividends are

carried forward for payment in later years);
c) Irredeemable Preference Stock (stock cannot be paid

back);

80
10.09 Summary
Preference stock is classified as
d) Redeemable Preference Stock ( company has right to pay

back the capital and eliminate its dividend liability); and
e) Convertible Preference Stock ( company can convert

preference shares into common stock);

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financial

“Common and Preferred Stocks”

“Common and Preferred Stocks are two common

means of raising long term finance that are

available to joint stock companies and both possess

their own personalities to serve the investors.”

Financial Management Part One

Role of common stock to meet long term finance needs.

Rights enjoyed by a common stockholder.

Common stock has certain advantages and a few shortcomings.

Features of preferred stock.

Classes in which preference stock is available

Financial Management Part One

When an investor pays any company money in return for

It is the evidence of an ownership interest, and not a loan,

Financial Management Part One

In a market of buyers and sellers, the current value of any

It has value on its face that indicates what proportion in

Financial Management Part One

In a market of buyers and sellers, the current value of any

It has value on its face that indicates what proportion in

Financial Management Part One

As per section 2(46) of the Indian Companies Act 1956,

Financial Management Part One

Some investors may have large ownership interests in a

No. of Shares Shareholders Shareholding % Number %

Up to 500 7, 81,280 91.51 6, 58, 86,346 7.09

501 – 1000 39,256 4.60 2, 78, 31,827 2.99

1001 – 2000 18,171 2.13 2, 55, 51,969 2.75

2001 – 3000 5,663 0.66 1, 40, 84,226 1.51

Financial Management Part One

Distribution of Shareholding as on March 31, 2015: contd.

No. of Shares Shareholders Shareholding Number %

4001 – 5000 1,511 0.18 68, 17, 391 0.73

5001 – 10000 2,836 0.33 1, 96, 83,512 2.12

10001 & ABOVE 2,682 0.31 76, 12, 67,844 81.90

TOTAL 8, 53,824 100.00 92, 95, 62,061 100.00

Financial Management Part One

When a business entity applies for incorporation to the

When a corporation sells some of its authorized shares, the

Financial Management Part One

The "par value" of a share of stock is sometimes defined as

Financial Management Part One

If a share of stock has been issued i.e. offered to the public

The actual amount paid by the investors against the number

10.02.05 Share Capital Values

When you examine the data published by corporates about

€ Issue Value or Price

Financial Management Part One

10.02.05 Share Capital Values - € Par Value

The par value of an equity share is

Financial Management Part One

10.02.05 € Issue Value or Price

Initially new corporations entering the stock market for the

10.02.05 € Issue Value or Price

** The difference between

Financial Management Part One

10.02.05 € Issue Value or Price

Investors are prepared to pay premium in view of the past

Paid up capital ` 185.9 crores

This book value increases as the corporation starts earning

Financial Management Part One

Financial Management Part One

Financial Management Part One