Chapter 8: Common Stock, Preferred

Stock, and Issuance of Securities

Common stock:
The stock that’s holder has ownership
claim, management participation
right, voting right and residual claim
in the distribution of income and
liquidation value is known as common
stock.
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CS, PS and Issuance of Securities

Basic features of common stock:

i. Type of security-equity security
ii. Prerogatives-claim and control
iii. Retirement provision
iv. Advantages to the issuer
v. Disadvantages to the issuer

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Characteristics of CS
 Type of Security-the CS holders must put up initial
equity money to start a business so CS holders
represent ownership of the company and it is
perpetual security i.e. it will exist as long as the firm
exists. Over time total equity funds come from the
initial sale of shares to start the business, subsequent
sales of additional shares as authorized by the board
of directors and retained earnings.
Authorized shares- a firm’s charter specifies this
number
Issued shares- total shares that are sold to investor
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Characteristics of CS
Outstanding shares- the shares that are actually held
by investors
Treasury stock- the difference between the number
issued and the number outstanding or the shares
repurchased by the firm
Prerogatives of CS holders
1. Claim- they are residual claimant. In case of income
it is through the dividend paid by the firm. The firm
must first pay its operating expenses, followed by
interest and taxes and if PS outstanding then PS
dividend and then the residual will go to CS holder.
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Characteristics of CS
However the firm is not obligated to pay out earnings
as dividends it may decide to retain part or all the
earning for investment purposes.
Asset Claims- in case of termination due to failure
CS have residual claim i.e. after the claim of other
parties are satisfied.
Control Prerogatives- control of routine operations of
the firm rests on management but major decisions
like issuing new CS or making major investment are
approved by the board of directors who again are
elected by CS holders.
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Characteristics of CS
 Voting rights- They have the right to vote for the
board of directors who work on behalf of the CS
holders. The board of directors act as representative
of the CS holders. If a common stock holder is not
present in the annual meeting they do not lose the
voting right but they can use proxies. A proxy is a
written authorization that empowers another to vote
for the signer. If the stockholder believe that the
candidates proposed by the firms management will
do little for the firms benefit then the stockholders
together may elect directors not nominated by the
firm.
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Advantages of CS Financing
 The firm is not bound to pay dividend
especially when cash flow levels are low
 It does not have any maturity date so no
obligation to redeem it but is case of debt it
has particular maturity date and if the firm
can not meet its redemption obligation on
that date it will be forced into bankruptcy
 Addition of CS to the firm’s capital structure
enhances the future borrowing capacity of
the firm 3-7
Disadvantages of CS Financing
 As new shares are sold old owners may
feel this control dilution
 Earning per share will be reduced as
more shares are now outstanding
 The dividend received by common stock
holders is not exempted from tax
payment

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 CS, PS and Issuance of Securities

Preferred stock:
The stock that’s holder has not
ownership claim, management
participation right, voting right but
has preferential claim in the
distribution of income and liquidation
value before common stockholders is
known as preferred stock.
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CS, PS and Issuance of Securities

Basic features of Preferred stock:

i. Type of security-hybrid security
ii. Prerogatives-claim and control
iii. Retirement provision
iv. Advantages to the issuer
v. Disadvantages to the issuer

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Features of PS
 Priority status- it has relatively seniority
position it has a prior claim on the firm’s
income and they also have a prior claim if the
firm is dissolved. For priority in claim they
give up voting rights. However their claim
must be met after creditors’ (bond holders).
It is a safer investment than CS.
 Fixed Income status- their dividend are
contractually stipulated. They are stated as
par value of each preferred share.
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Features of PS
Say divided is 5% and par value is $50 per
share then dividend is $2.50 per share.
Cumulative dividend- if the firm fails to pay
dividend a cumulative dividend feature
requires all dividend known as arrearages
must be paid before CS dividends are paid.
Retirement provision- though no fixed
maturity date but provisions may be included
in the agreement to provide retirement of an
outstanding issue. 3-12
Features of PS
 Convertibility- it can be converted into CS.
 Call Feature- it allows the firm to buy back
the preferred at a call price stipulated when
the preferred is first sold. The call price is set
above the initial sale price of the preferred
creating a call premium which is the
difference between the call price and the face
value. Usually the firm agrees not to call the
preferred for at least 2 or 3 years after the
issue.
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Advantages of PS
 Leverage with no default risk- PS dividend are
fixed obligation and thus create financial
leverage but if the firm omits a dividend the
PS holder can not force the firm into
bankruptcy.
 Cash Flow Flexibility- because its dividend can
be legally omitted if necessary and the firm
has the option to retire PS when it has
sufficient financial resources.
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Advantages of PS
 Preservation of Shareholder Control- issuing
PS increases equity base but as it carries no
voting rights it does not dilute the control
position of current CS owners.
 Tax advantages in Merger and Acquisitions-
If CS holder of a company being acquired sell
their stock for cash they will incur capital gain
tax on the difference between price received
and the original cost but if the acquiring firm
issue them convertible PS it is exempted form3-15
tax.
Disadvantages of PS
 Its dividend are not tax deductible like debt
interest payments.
 Because PS is like debt in its fixed payment
feature but lacks debt’s tax deductibility,
many firms consider PS to be one of the
worst kinds of financing available. If tax rate
is 34% then the cost $1 interest expense
after tax is $0.66 whereas for $1PS it is $1
dividend after tax.
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Necessities of new security
 When the firm requires long term external
financing it must choose between debt and
equity financing. Again in equity financing
though both CS and PS financing are
available most CS are sold. If the firms capital
structure is optimum then the firm may try to
keep it optimum may selling a combination of
securities over time. However if the interest
rate are unusually low the firm may opt for
debt financing, but then again the risk factor
comes in. 3-17
Methods of Selling Shares
 Underwriting Method
 Best Effort Method
 Shelf Registration
 Right Issue Method
 Private Placement

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 CS, PS and Issuance of Securities

The general process of a typical common

stock underwriting operation:
1. Underwriter Selection 2. Advice and Counsel
3. Registration 4. Syndicate Formation
5. Price Setting 6. Fee Distribution
7. Price Stabilization 8. Quiet and Lock-up
Periods

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Underwriting Method of selling
shares
 The investment bank acts initially underwrites
are all the shares at a certain price and
bears all the risk. Later it sales the share to
different individuals and organizations at a
certain price. Its income is the difference
purchase and selling price.
 Investment bank gives all sorts of advice to
the issuing companies’, like what is the right
time to issue, how sensitive is the share to
current market conditions etc.
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Underwriting Process…
 The investment bank also provides
assistance regarding different
administrative works.
 It is the responsibility of the investment
bank to distribute the shares among
different groups.

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Methods of Selling Shares
 Best Effort Method- under this method the
investment bank does not underwrites but
agrees to sale the shares as many as they
can and then return the shares that they fail
to sale. The risk of not selling is borne by
issuer. Small riskier firm does this.
 Self registration- under this the company
issuing share usually get approval of the
number of shares to be sold within a specific
period of time( usually 2 years), later it
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underwrites the amount needed.
Method of Selling Shares
 Right Issue Method- before selling share to
the public it is offered to the companies
existing shareholders. If they purchase share
then it is called right issue method.
 Private Placement- under this method
companies sale share to small group of
particular investors. Sometimes investment
banker are appointed to act as a middle man
between the companies and the investors.
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 CS, PS and Issuance of Securities

 Preemptive rights offerings – It grants

existing shareholders the right to buy some
proportion of the new shares issued at a price
below market value. The price at which the
new shares can be purchased is called the
subscription price. The value of right can be
determined by calculating the difference
between the price of a share before the rights
offering and the price of a share after the
rights offering. That is, 3-24
 CS, PS and Issuance of Securities

Value of a right = Price before rights offering –

Price after rights offering or Share price on
rights – Share price ex rights.

Example, capitalization of a company is

Tk.600000 against 30000 shares with Tk.20
per share price. Now the company issues right
shares in the ratio of 3:1 for Tk.17 per share.
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CS, PS and Issuance of Securities

Number of shares is 40000 and

capitalization is Tk.770000. After rights issue
price per share is Tk.19.25
(Tk.770000/40000). So, value of a right is
Tk.0.75 (Tk.20-Tk.19.25).

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Advantages and
Disadvantages of Rights Issue
 The stockholder control position is protected.
The right privilege protects proportionate
ownership position.
 The flotation cost is low because there is no
underwriting fee.
 The primary disadvantages is it create losses
to forgetful stockholders. So firms avoid this
by selling the right of the negligent
shareholders at the end of the sale period
and remitting the proceeds to them. 3-27
Flotation Cost
 Underwriter’s spread- the investment banker
purchase of securities and what they offer
these securities for to the public.
(Gross sales proceeds- Net Sales)/ Gross
sales proceeds
Co. ‘X’ issued 950,000 shares of CS by
underwriter . The underwriter paid Co. ‘X” Tk.
74,908,153 and sold the securities for Tk.
77,187,500
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Flotation Costs….
 Underwriter’s spread= Tk.77,187,500-
Tk.74,908,153/ Tk. 77,187,500=
.02953= 2.953%
 The flotation cost decreases as the size
of the issue increases

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