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Chapter 17. Common and Preferred Stock Financing. Business Organization. Sole Proprietorship – No separation of person assets from business assets and business profit taxed as personal income (unlimited liability)

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chapter 17

Chapter 17

Common and Preferred Stock Financing

business organization
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)
managers as the agent of the shareholders
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 won’t work for the owners unless it is in their own best interests
how to solve agency problem
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
shareholders rights
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 RightProvision in corporate charter allows existing shareholdersto maintain the percentage of ownership, voting power and claim to earnings
the voting right
The Voting Right
  • Majority voting – holders of majority (> 50%) of stock can elect all directors
  • Cumulative voting – allow minority (<50%) 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
right to purchase new shares
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
dilution of shares
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
right offerings
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?
right offerings cont
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
how many rights are needed
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
what s the value of each right
What’s 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
formulae for right pricing
Rights-on share price (Mo)

R = (Mo – S)/ (N+1)

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

Formulae for Right Pricing
before and after right offerings
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
after right offerings cont
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
effect of rights on old shareholders
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
advantage of rights offerings financing
Advantage of Rights Offerings Financing
  • Protects stockholder’s 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
poison pill
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 buyer’s ownership percentage as well as the share value
preferred stock financing
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
preferred stock financing cont
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
possible features for preferred shares
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
alternative security financing
Alternative Security Financing
  • Corporate Bonds
  • Preferred Stock
  • Common Stock
  • Table 17-1 & 2
figure 17 2 risk and expected return for various securities

Required rate of return

Corporate issues

Common stock

Subordinated debentures

Senior unsecured debt

Secured debt

Long-term government securities

Treasury bills (short term)

Savings account

Risk to investor

Figure 17-2Risk and expected return for various securities