Chapter 17: Common and Preferred Stock Financing
Chapter 17
Common and Preferred Stock Financing
Discussion Questions
17-1.
Why has corporate management become increasingly sensitive to the desires of large institutional investors?
Corporate management has become increasingly sensitive to the desires of large institutional investors because they fear these shareholders may side with corporate raiders in voting their shares in mergers or takeover attempts.
Why might a corporation use a special category such as founders’ stock in issuing common stock?
Founders’ stock may carry special voting rights that allow the original founders to maintain voting privileges in excess of their proportionate ownership.
What is the purpose of cumulative voting? Are there any disadvantages to management?
The purpose of cumulative voting is to allow some minority representation on the board of directors. A possible disadvantage to management is that minority stockholders can challenge their actions.
How does the preemptive right protect stockholders from dilution?
The preemptive right provides current stockholders with a first option to buy new shares. In this fashion, their voting right and claim to earnings cannot be diluted without their consent.
If common stockholders are the owners of the company, why do they have the last claim on assets and a residual claim on income?
The actual owners have the last claim to any and all funds that remain. If the firm is profitable, this could represent a substantial amount. Thus, the residual claim may represent a privilege as well as a potential drawback. Generally, other providers of capital may only receive a fixed amount.
17-2.
17-3.
17-4.
17-5.
Chapter 17: Common and Preferred Stock Financing
17-6.
17-7.
17-8.
During a rights offering, the underlying stock is said to sell “rights-on” and “ex-rights.” Explain the meaning of these terms and their significance to current stockholders and potential stockholders.
When a rights offering is announced, a stock initially trades rights-on, that is, if you buy the stock you will also acquire a right toward future purchase of stock.
After a certain period of time (say four weeks), the stock goes ex-rights; thus when you buy the stock you no longer get a right toward future purchase of stock.
The significance to current and future stockholders is that they must decide if they wish to use or sell the right when the stock is trading rights-on. The stock will go down by the appropriate value of the right when the stock moves to an ex-rights designation.
Why might management use a poison pill strategy?
A poison pill may help management defend itself against a potential
takeover attempt. When another company attempts to acquire the firm, the poison pill allows current stockholders to acquire additional shares at a very low price. This increases the shares outstanding and makes it more difficult for the potential acquiring company to successfully complete the merger.
Preferred stock is often referred to as a hybrid security. What is meant by this term as applied to preferred stock?
Preferred stock is a “hybrid” or intermediate form of security possessing some of the characteristics of debt and common stock. The fixed amount provision is similar to debt, but the noncontractual obligation is similar to common stock. Though the preferred stockholder does not have an
ownership interest in the firm, the priority of claim is higher than that of the common stockholder.
Chapter 17: Common and Preferred Stock Financing
17-9.
17-10.
17-11.
17-12.
What is the most likely explanation for the use of preferred stock from a corporate viewpoint?
Most corporations that issue preferred stock do so to achieve a balance in their capital structure. It is a means of expanding the capital base of the firm without diluting the common stock ownership position or incurring contractual debt obligations.
Why is the cumulative feature of preferred stock particularly important to preferred stockholders?
With the cumulative feature, if preferred stock dividends are not paid in any one year, they accumulate and must be paid in total before common stockholders can receive dividends. Even though preferred stock dividends are not a contractual obligation, as is true of interest on debt, the
cumulative feature tends to make corporations very aware of obligations to preferred stockholders. Preferred stockholders may even receive new securities for forgiveness of missed dividend payments.
A small amount of preferred stock is participating. What would your reaction be if someone said common stock is also participating?
The participation privileges of a few preferred stock issues mean that
preferred stockholders may receive a payout over and above the quoted rate when the corporation enjoys a particularly good year. This is very similar to the situation with common stock and one can certainly say that common stock is a participation-type security.
What is an advantage of floating rate preferred stock for the risk-averse investor?
There is less price volatility than with regular preferred stock.
Chapter 17: Common and Preferred Stock Financing
17-13.
Put an X by the security that has the feature best related to the following considerations. You may wish to refer to Table 17-4.
a. Ownership and control of the firm b. Obligation to provide return c. Claims to assets in bankruptcy d. High cost of distribution e. Highest return f. Highest risk
g. Tax-deductible payment
h. Payment partially tax-exempt to corporate recipient Common Stock X X X X X Preferred Stock X Bonds X X X
a. Owners and control of the firm b. Obligation to provide return c. Claims to assets in bankruptcy d. Highest cost of distribution e. Highest return f. Highest risk g. Tax deductible payment h. Payment partially tax-exempt to corporate recipient
Chapter 17: Common and Preferred Stock Financing
Chapter 17
Problems
1.
Residual claims to earnings (LO17-1) Folic Acid Inc. has $20 million in earnings, pays $2.75 million in interest to bondholders, and $1.80 million in dividends to preferred stockholders. a. b.
What are the common stockholders’ residual claims to earnings?
What are the common stockholders’ legal, enforceable claims to dividends?
17-1. Solution:
Folic Acid Inc.
(in millions)
a. Earnings $20.00
– Interest 2.75 – Preferred stock dividends 1.80 Common stockholders residual claim to earnings $15.45 b. None. The common stockholders have no legal, enforceable
claim to dividends. The corporation may choose to pay dividends, but it is not a legal obligation.
Chapter 17: Common and Preferred Stock Financing
2.
Residual claims to earnings (LO17-1) Time Watch Co. has $46 million in earnings and is considering paying $6.45 million in interest to bondholders and $4.35 million to preferred stockholders in dividends. a. b.
What are the bondholders’ contractual claims to payment? (You may wish to review Table 17-4.)
What are the preferred stockholders’ immediate contractual claims to payment? What privilege do they have?
17-2. Solution:
Time Watch Co.
a. The bondholders have a legal contractual claim of
$6.45 million. b. The preferred stockholders do not have an immediate
contractual claim to payment of dividends.
However, they must receive payment before the common stockholders receive anything.
3.
Poison pill (LO17-4) Katie Homes and Garden Co. has 10,640,000 shares outstanding. The stock is currently selling at $52 per share. If an unfriendly outside group acquired 25 percent of the shares, existing stockholders will be able to buy new shares at 30 percent below the currently existing stock price. a. b.
How many shares must the unfriendly outside group acquire for the poison pill to go into effect?
What will be the new purchase price for the existing stockholders?
17-3. Solution:
Katie Homes and Garden Co.
a. 10,640,000 Total shares 25% Trigger point 2,660,000 Number of shares to trigger the poison pill b. $52 30% $36.40
Current stock price
Reduction to current stockholders Price to existing stockholders
Chapter 17: Common and Preferred Stock Financing
4.
Cumulative voting (LO17-2) Mr. Meyers wishes to know how many shares are necessary to elect 5 directors out of 14 directors up for election in the Austin Power Company. There are 150,000 shares outstanding. (Use Formula 17-1 to determine the answer.)
17-4. Solution:
Austin Power Company
=
= 50,000 + 1 = 50,001 shares
5.
Cumulative voting (LO17-2) Dr. Phil wishes to know how many shares are necessary to elect 6 directors out of 14 directors up for election for the board of the Winfrey Publishing Company. There are 340,000 shares outstanding. (Use Formula 17-1 to determine the answer.)
17-5. Solution:
Winfrey Publishing Company
(Number of directors desired)? (Total number of shares outstanding)Shares required = +1
Total number of directors to be elected +16?40,0002,040,000= +1=+1
14+115Chapter 17: Common and Preferred Stock Financing
= 136,000 + 1 = 136,001 shares
6.
Cumulative voting (LO17-2) Carl Hubbell owns 6,001 shares of the Piston Corp. There are 12 seats on the company board of directors, and the company has a total of 78,000 shares of stock outstanding. The Piston Corp. utilizes cumulative voting.
Can Mr. Hubbell elect himself to the board when the vote to elect 12 directors is held next week? (Use Formula 17-2 to determine if he can elect one director.)
17-6. Solution:
Piston Corporation
= 1 director
Yes, Mr. Hubbell can elect himself to the board.
7.
Cumulative voting (LO17-2) Betsy Ross owns 927 shares in the Hanson Fabrics
Company. There are 15 directors to be elected. Thirty-three thousand five hundred shares are outstanding. The firm has adopted cumulative voting. a. b. c.
How many total votes can be cast? How many votes does Betsy control?
What percentage of the total votes does she control?
17-7.
Solution:
Hanson Fabrics Company
Votes = Number of shares × Number of directors to be elected a. 33,500 × 15 b. 927 × 15
= 502,500 votes = 13,905 votes
Chapter 17: Common and Preferred Stock Financing
c. 13,905/502,500 = 2.77%
8.
Dissident stockholder group and cumulative voting (LO17-2) The Beasley Corporation has been experiencing declining earnings, but has just announced a 50 percent salary
increase for its top executives. A dissident group of stockholders wants to oust the existing board of directors. There are currently 14 directors and 32,500 shares of stock outstanding. Mr. Wright, the president of the company, has the full support of the existing board. The dissident stockholders control proxies for 15,001 shares. Mr. Wright is worried about losing his job. a.
Under cumulative voting procedures, how many directors can the dissident
stockholders elect with the proxies they now hold? How many directors could they elect under majority rule with these proxies?
b. How many shares (or proxies) are needed to elect nine directors under cumulative voting?
17-8.
Solution:
Beasley Corporation
a.
Number of directors that can be elected
(Shares owned?1)?(Total number of directors to be elected+1) =Total number of shares outstanding
Six directors can be elected by the dissident stockholders under cumulative voting.
None would be elected by the dissidents under majority rule because the existing board controls over 50 percent of the shares. b. (Number of directors desired)?
(15,001?1)?(14?1)225,000???6
32,50032,500Chapter 17: Common and Preferred Stock Financing
(Total number of shares outstanding)Shares Required=?1Total number of directors to be elected +1 9?32,500292,500?1??1?19,501 shares ?14?115
9.
Dissident stockholder group and cumulative voting (LO17-2) Midland Petroleum is holding a stockholders’ meeting next month. Ms. Ramsey is the president of the company and has the support of the existing board of directors. All 12 members of the board are up for reelection. Mr. Clark is a dissident stockholder. He controls proxies for 34,001 shares. Ms. Ramsey and her friends on the board control 44,001 shares. Other stockholders, whose loyalties are unknown, will be voting the remaining 24,998 shares. The company uses cumulative voting. a. b. c. d.
How many directors can Mr. Clark be sure of electing?
How many directors can Ms. Ramsey and her friends be sure of electing? How many directors could Mr. Clark elect if he obtains all the proxies for the uncommitted votes? (Uneven values must be rounded down to the nearest whole number regardless of the amount.) Will he control the board?
If nine directors were to be elected, and Ms. Ramsey and her friends had 60,001 shares and Mr. Clark had 40,001 shares plus half the uncommitted votes, how many directors could Mr. Clark elect?
17-9.
Solution:
Midland Petroleum
a.
Number of directors that can be elected
(Shares owned?1)?(Total number of directors to be elected + 1) =Total number of shares outstanding
(34,001?1)?(12?1)442,000??? 4
103,000103,000Mr. Clark can be assured of electing four directors.
(44,001?1)?(12?1)44,000?13b. ?103,000103,000Chapter 17: Common and Preferred Stock Financing
572,000??5 directors 103,000Ms. Ramsey and her friends can be assured of electing five directors.
c. Shares owned = Shares owned and proxies of other voters
(34,001?24,998?1)?1358,998?13 ??103,000103,000766,974??7.4463?7 directors (rounded down) 103,000
He can only elect seven directors. Yes, Mr. Clark will control the board. d.
(40,001?9,999?1)?(9?1)49,999?10 ?120,000120,000499,990??4.17?4 directors (rounded down) 120,000
Chapter 17: Common and Preferred Stock Financing
10. Strategies under cumulative voting (LO17-2) Mr. Michaels controls proxies for 40,000 of
the 75,000 outstanding shares of Northern Airlines. Mr. Baker heads a dissident group that controls the remaining 35,000 shares. There are seven board members to be elected and cumulative voting rules apply. Michaels does not understand cumulative voting and plans to cast 100,000 of his 280,000 (40,000 × 7) votes for his brother-in-law, Scott. His remaining votes will be spread evenly between three other candidates.
How many directors can Baker elect if Michaels acts as described in the preceding paragraph? Use logical numerical analysis rather than a set formula to answer the question. Baker has 245,000 votes (35,000 × 7).
17-10. Solution:
Northern Airlines
Mr. Michaels controls 280,000 votes (40,000 shares × 7 directors).
Mr. Baker controls 245,000 votes (35,000 shares × 7 directors). If Mr. Michaels casts 100,000 votes for Scott, this will leave 60,000 votes (180,000/3) for each of the other three candidates that he favors.
Mr. Baker could elect four of seven directors with less than one half of the votes because of Mr. Michaels’ error in voting. This is true because Mr. Baker could cast 61,250 votes for each of the four directors of his choice (245,000/4 = 61,250).
Chapter 17: Common and Preferred Stock Financing
11. Different classes of voting stock (LO17-1) Rust Pipe Co. was established in 1994. Four
years later, the company went public. At that time, Robert Rust, the original owner,
decided to establish two classes of stock. The first represents Class A founders’ stock and is entitled to nine votes per share. The normally traded common stock, designated as Class B, is entitled to one vote per share. In late 2010, Mr. Stone, an investor, was considering purchasing shares in Rust Pipe Co. While he knew founders’ shares were not often present in other companies, he decided to buy the shares anyway because of a new technology Rust Pipe had developed to improve the flow of liquids through pipes.
Of the 1,450,000 total shares currently outstanding, the original founder’s family owns 51,825 shares. What is the percentage of the founder’s family votes to Class B votes?
17-11. Solution:
Rust Pipe Company
Founder’s family votes = Shares owned × 9 = 51,825 ×9 = 466,425 Class B votes
= Total shares – founder’s family shares = 1,450,000 – 51,825 = 1,398,175
Founder抯 family votes466,425??33.36%
Class B votes1,398,175
12. Rights offering (LO17-3) Boles Bottling Co. has issued rights to its shareholders. The
subscription price is $45 and four rights are needed along with the subscription price to buy one of the new shares. The stock is selling for $55 rights-on.
a. b.
What would be the value of one right?
If the stock goes ex-rights, what would the new stock price be?
Chapter 17: Common and Preferred Stock Financing
17-12. Solution:
Boles Bottling Co.
Mo?Sa. R?
N?1
b. $55.00 – $2.00 = –$53.00
The stock price will decrease by the amount of the right’s value.
13. Procedures associated with a rights offering (LO17-3) Computer Graphics has
announced a rights offering for its shareholders. Carol Stevens owns 1,400 shares of Computer Graphics stock. Four rights plus $54 cash are needed to buy one of the new shares. The stock is currently selling for $66 rights-on.
a. b. c.
What is the value of a right?
How many of the new shares could Carol buy if she exercised all her rights? How much cash would this require?
Carol doesn’t know if she wants to exercise her rights or sell them. Would either alternative have a more positive effect on her wealth?
17-13. Solution:
Computer Graphics
Mo?Sa. R?
N?1$66?$54$12???$2.40 value per right
4?15Chapter 17: Common and Preferred Stock Financing
b. Carol owns 1,400 shares, so she would receive 1,400 rights.
1,400 rights/4 rights per share = 350 hares 350 Shares × $54 Subscription price = $18,900
c. Neither exercising the rights nor selling them would have any effect on the stockholder’s wealth (all things being equal).
14. Investing in rights (LO17-3) Todd Winningham IV has $4,800 to invest. He has been
looking at Gallagher Tennis Clubs Inc. common stock. Gallagher has issued a rights offering to its common stockholders. Six rights plus $48 cash will buy one new share. Gallagher’s stock is selling for $66 ex-rights.
a. b. c. d. e.
How many rights could Todd buy with his $4,800? Alternatively, how many shares of stock could he buy with the same $4,800 at $66 per share?
If Todd invests his $4,800 in Gallagher rights and the price of Gallagher stock rises to $70 per share ex-rights, what would his dollar profit on the rights be? (First compute profit per right.)
If Todd invests his $4,800 in Gallagher stock and the price of the stock rises to $70 per share ex-rights, what would his total dollar profit be?
What would be the answer to part b if the price of Gallagher’s stock falls to $40 per share ex-rights instead of rising to $70?
What would be the answer to part c if the price of Gallagher’s stock falls to $40 per share ex-rights?
17-14. Solution:
Gallagher Tennis Clubs Inc. (Todd Winningham IV)
Me?Sa. R?
N$66?$48??$3 per right
6Chapter 17: Common and Preferred Stock Financing
$4,800 investment/$3 per right = 1,600 rights $4,800 investment/$66 per share = 73 shares
b. ($70 – $48)/6 = $3.67 per right value $3.67 per right value – $ 3.00 = $.67 profit per right $.67 × 1,600 rights = $1,072 total profit on rights c. ($70 – $66) $4 × 73 shares
d. ($40 – $48)/6 = –$1; the right’s value = 0
Todd would lose his entire $4,800 investment.
= $26 loss per share
= –$1,898
= $4 profit per share
= $292 total dollar profit on the stock
e. ($40 – $66) –$26 × $73
Tom would lose $1,898 on his $4,800 investment.
Chapter 17: Common and Preferred Stock Financing
15. Effect of rights on stockholder position (LO17-3) Mr. and Mrs. Anderson own two
shares of Magic Tricks Corporation’s common stock. The market value of the stock is $58. The Andersons also have $46 in cash. They have just received word of a rights offering. One new share of stock can be purchased at $46 for each two shares currently owned (based on two rights). a. b. c.
d.
17-15.
What is the value of a right?
What is the value of the Andersons’ portfolio before the rights offering? (Portfolio in this question represents stock plus cash.)
If the Andersons participate in the rights offering, what will be the value of their portfolio, based on the diluted value (ex-rights) of the stock?
If they sell their two rights but keep their stock at its diluted value and hold onto their cash, what will be the value of their portfolio?
Solution:
Magic Tricks Corp. (The Andersons)
a. R?Mo?SN?1
?$58?$462?1?$12$3?$4
b. Portfolio value
Stock 2 × $58 = $116 Cash
46 Total portfolio value
$162
c. First compute diluted value:
Diluted value = Market value ex-rights
Me = Mo – R = $58 – $4 = $54
or Chapter 17: Common and Preferred Stock Financing
2 old shares sold at $58 per share 1 new share will sell at $46 Total value of 3 shares
$116
46 $162
Average value of 1 share (Market value ex-rights) = $54 Portfolio value Stock 3 × $54 = Cash Total portfolio value d. Portfolio value Stock 2 × $54 = Proceeds from sale of 2 rights (2 × $4) Cash Total portfolio value
16. Relation of rights to EPS and the price-earnings ratio (LO17-3) Walker Machine Tools
has 5.5 million shares of common stock outstanding. The current market price of Walker common stock is $52 per share rights-on. The company’s net income this year is $17.5 million. A rights offering has been announced in which 550,000 new shares will be sold at $46.50 per share. The subscription price plus five rights is needed to buy one of the new shares.
a. b.
What are the earnings per share and price-earnings ratio before the new shares are sold via the rights offering?
What would the earnings per share be immediately after the rights offering? What would the price-earnings ratio be immediately after the rights offering? (Assume there is no change in the market value of the stock, except for the change when the stock begins trading ex-rights.) Round all answers to two places after the decimal point.
$162 0 $162 $108
8 46 $162
Chapter 17: Common and Preferred Stock Financing
17-16. Solution:
Walter Machine Tools
a. $17.5 million earnings/5.5 million shares = $3.18 earnings
per share
$52 market price/$3.18 earnings per share = 16.35 price-earnings ratio b. 5.5 million original shares + 550,000 new shares =
6,050,000 shares
$17.5 million earnings ?$2.89earningsper share 6,050,000 sharesMo?S$52?$46.50$5.50R????$.92
N?15?16$52 per share – $.92 = $51.08
$51.08 market price per share?17.67 price-earnings ratio
$2.89 earnings per share17. Aftertax comparison of preferred stock and other investments (LO17-5) The Omega
Corporation has some excess cash it would like to invest in marketable securities for a long-term hold. Its vice president of finance is considering three investments (Omega Corporation is in a 35 percent tax bracket and the tax rate on dividends is 20 percent). Which one should she select based on aftertax return: (a) Treasury bonds at a 10 percent yield; (b) corporate bonds at a 13 percent yield; or (c) preferred stock at an 11 percent yield?
Chapter 17: Common and Preferred Stock Financing
17-17. Solution:
Omega Corporation
a. Treasury bonds 10% × (1 – .35) = 10% × .65 = 6.50% b. Corporate bonds 13% × (1 – .35) = 13% × .65 = 8.45% c. Preferred stock 70 percent of the dividend is excluded
from corporate taxes so only 30 percent is taxable. The tax rate on dividends is 20 percent. We subtract the taxes from the yield.
18. Preferred stock dividends in arrears (LO17-5) National Health Corporation (NHC) has a
cumulative preferred stock issue outstanding, which has a stated annual dividend of $8 per share. The company has been losing money and has not paid preferred dividends for the last five years. There are 350,000 shares of preferred stock outstanding and 650,000 shares of common stock.
a. b.
How much is the company behind in preferred dividends?
If NHC earns $13,500,000 in the coming year after taxes but before dividends, and this is all paid out to the preferred stockholders, how much will the company be in arrears (behind in payments)? Keep in mind that the coming year would represent the sixth year.
How much, if any, would be available in common stock dividends in the coming year if $13,500,000 is earned as explained in part b?
11% – (11% × .30) (.20) 11% – (3.30%) (.20) 11% – .66% = 10.34%
The preferred stock should be selected because it provides the highest aftertax return.
c.
Chapter 17: Common and Preferred Stock Financing
17-18. Solution:
National Health Corp.
a. $8 per share × 350,000 shares × 5 years = $14,000,000
dividends in arrears b.
$14,000,000 original dividends in arrears + ($8 ×
350,000) next year’s preferred dividends – $13,500,000 profit paid out in dividends
$14,000,000 + $2,800,000 – $13,500,000 = $3,300,000 still in arrears
c. No common stock dividends can be paid until all the
preferred dividends are paid to the cumulative preferred stockholders.
19. Preferred stock dividends in arrears (LO17-5) Robbins Petroleum Company is four
years in arrears on cumulative preferred stock dividends. There are 690,000 preferred shares outstanding, and the annual dividend is $6.50 per share. The vice president of finance sees no real hope of paying the dividends in arrears. She is devising a plan to compensate the preferred stockholders for 80 percent of the dividends in arrears.
a. b.
How much should the compensation be?
Robbins will compensate the preferred stockholders in the form of bonds paying 12 percent interest in a market environment in which the going rate of interest is 8 percent for similar bonds. The bonds will have a 15-year maturity. Using the bond valuation table in Chapter 16 (Table 16-2), indicate the market value of a $1,000 par value bond.
Based on market value, how many bonds must be issued to provide the compensation determined in part a? (Round to the nearest whole number.)
c.
Chapter 17: Common and Preferred Stock Financing
17-19. Solution:
Robbins Petroleum Company
a. $6.50 per share × 690,000 shares × 4 years = $17,940,000 × 80% = $14,352,000 compensation b. $1345.52
c. Compensation/Bond value =
= 10,667 shares
20. Preferred stock dividends in arrears and valuing common stock (LO17-5) Enterprise Storage Company has $440,000 shares of cumulative preferred stock outstanding, which has a stated dividend of $7.75. It is six years in arrears in its dividend payments.
a. b.
How much in total dollars is the company behind in its payments?
The firm proposes to offer new common stock to the preferred stockholders to wipe out the deficit.
The common stock will pay the following dividends over the next four years:
D1 ............... $1.15 D2 ............... 1.25 D3 ............... 1.35 D4 ............... 1.45
The company anticipates earnings per share after four years will be $4.09 with a P/E ratio of 10.
The common stock will be valued as the present value of future dividends plus the present value of the future stock price after four years. The discount rate used by the investment banker is 14 percent. Round to two places to the right of the decimal point. What is the calculated value of the common stock? c.
How many shares of common stock must be issued at the value computed in part b to eliminate the deficit (arrearage) computed in part a? Round to the nearest whole number.
Chapter 17: Common and Preferred Stock Financing
17-20. Solution:
Enterprise Storage Company
a. $7.75 per share × 440,000 shares × 6 years = $ 20,460,000 dividends in arrears b. Stock Price
Present value of common stock dividends
Amount
PV Factor at 14%
Present Value
D1 $1.15 .877 $1.01 D2 1.25 .769 .96 D3 1.35 .675 .91 D4 1.45 .592 .86 $3.74
Present value of future stock price
1. Stock price = P/E × EPS $40.90 = 10 × $4.09
2. PV of stock price (four years in the future)
PV of common stock dividends PV of stock price
Value of common stock
$3.74 24.21 $27.95
Amount $40.90
PV Factor at 14% .592
Present Value $24.21
Current value of the common stock
Chapter 17: Common and Preferred Stock Financing
c. Number of shares
$20,460,000of common stock Deficit?? to eliminate the commonstockvalue$27.95 deficit
?(732,021 shares)?732,021
21. Borrowing funds to purchase preferred stock (LO17-5) The treasurer of Kelly Bottling
Company (a corporation) currently has $150,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying $150,000 more with borrowed funds. The cost of the borrowed funds is 13 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 5 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 35 percent tax bracket, with dividends taxed at 20 percent. a. Compute the amount of the aftertax income from the additional preferred stock if it is
purchased.
b. Compute the aftertax borrowing cost to purchase the additional preferred stock. That
is, multiply the interest cost times (1 – T).
c. Should the treasurer proceed with his proposal? d. If interest rates and dividend yields in the market go up six months after a decision to
purchase is made, what impact will this have on the outcome?
17-21. Solution:
Kelly Bottling Company
a. b.
Preferred stock .................... $150,000 Dividend yield ..................... 8% Dividend .............................. $ 12,000 Taxable income (35%) ........ 3,600 Tax rate (20%) .................... 720 Aftertax income................... $11,280 ($12,000 – $720) Loan ..................................... $150,000 Interest expense ................... 13% Interest ................................. $ 19,500 × (1 – T) ............................... 65% Chapter 17: Common and Preferred Stock Financing
Aftertax borrowing cost. ..... $ 12,675
c. No, the return does not exceed the cost.
d. The outcome could become quite unfavorable for two reasons. The increase in dividend yield would lower the value of the $150,000 portfolio. Also, interest rates generally are not fixed on a loan of this nature. Thus, the borrowing cost could go up.
Note the dangers of these problems could be overcome by buying floating-rate preferred stock. The market value of the portfolio would be fixed, and preferred stock yields and interest rates would, in all likelihood, move up and down together.
22. Floating-rate preferred stock (LO17-5) Barnes Air Conditioning Inc. has two classes of
preferred stock: floating rate preferred stock and straight (normal) preferred stock. Both issues have a par value of $100. The floating-rate preferred stock pays an annual dividend yield of 4 percent, and the straight preferred stock pays 5 percent. Since the issuance of the two securities, interest rates have gone up by 2.50 percent for each issue. Both securities will pay their year-end dividend today.
a. b.
What is the price of the floating-rate preferred stock likely to be?
What is the price of the straight preferred stock likely to be? Refer back to Chapter 10 and use Formula 10-4 to answer this question.
17-22. Solution:
Barnes Air Conditioning Inc.
a. The floating rate preferred stock should be trading at very
close to the par value of $100 per share since interest rates will adjust to current market conditions rather than price. b. Based on Formula 10-4, the price of straight preferred stock
will be:
Chapter 17: Common and Preferred Stock Financing
DP$5PP???$66.67
KP.075
COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Crandall Corporation (rights offering and the impact on shareholders ) (LO17-3) The
Crandall Corporation currently has 100,000 shares outstanding that are selling at $50 per share. It needs to raise $900,000. Net income after taxes is $500,000. Its vice president of finance and its investment banker have decided on a rights offering, but are not sure how much to discount the subscription price from the current market value. Discounts of 10 percent, 20 percent, and 40 percent have been suggested. Common stock is the sole means of financing for the Crandall Corporation.
a. For each discount, determine the subscription price, the number of shares to be issued, and
the number of rights required to purchase one share. (Round to one place after the decimal point where necessary.) b. Determine the value of one right under each of the plans. (Round to two places after the
decimal point.) c. Compute the earnings per share before and immediately after the rights offering under a
10 percent discount from the market price. d. By what percentage has the number of shares outstanding increased?
e. Stockholder X has 100 shares before the rights offering and participated by buying 20 new
shares. Compute his total claim to earnings both before and after the rights offering (that is, multiply shares by the earnings per share figures computed in part c). f.
Should Stockholder X be satisfied with this claim over a longer period of time?
CP 17-1. Solution:
Crandall Corp.
a. A 10 percent discount-subscription price equals $45.
Required funds$900,000Number of new shares=??20,000
Subscription price$45Chapter 17: Common and Preferred Stock Financing
Old shares100,000Number of rights to purchase one share=??5New shares20,000
CP17-1. (Continued)
A 20 percent discount-subscription price equals $40.
Required funds$900,000Number of new shares =??22,500
Subscription price$40Old shares100,000Number of rights to purchase one share=??4.4
New shares22,500
A 40 percent discount-subscription price equals $30.
Required funds$900,000Number of new shares =??30,000
Subscription price$30Number of rights to purchase one share=
Old shares100,000??3.3New shares30,000Mo?Sb. R?
N?1Chapter 17: Common and Preferred Stock Financing
10% $50?45$5R=??$.835?1620% $50?40$10R=??$1.854.4?15.440% $50?30$20R=??$4.653.3?14.3CP17-1. (Continued)
c. EPS before rights offering = Net income/Old shares $500,000/100,000 = $5.00
EPS after rights offering = Net income/(Old + New shares) $4.17 = $500,000/(100,000 + 20,000)
d. A 20 percent increase in shares outstanding (100,000 to 120,000) e. Before 100 shares × $5.00 = $500 After 120 shares × $4.17 = $500 (rounded)
f. No, he would expect greater earnings. He and others have put
additional capital into the corporation so total claims to earnings should improve. Invested capital has increased from $5,000,000 to $5,900,000. He earned $500 before he put $900 more (20 shares × $45) of additional funds in the corporation. Over time, earnings should increase.
COMPREHENSIVE PROBLEM
Comprehensive Problem 2.
Chapter 17: Common and Preferred Stock Financing
Electro Cardio Systems Inc. (poison pill strategy) (LO17-4) Dr. Robert Grossman founded Electro Cardio Systems Inc. (ECS) in 2001. The principal purpose of the firm was to engage in the research and development of heart pump devices. Although the firm did not show a profit until 2006, by 2010 it reported aftertax earnings of $1,200,000. The company had gone public in 2004 at $10 a share. Investors were initially interested in buying the stock because of its future prospects. By year-end 2010, the stock was trading at $42 per share because the firm had made good on its promise to produce lifesaving heart pumps and, in the process, was now making reasonable earnings. With 850,000 shares outstanding, earnings per share were $1.41.
Dr. Grossman and the members of the board of directors were initially pleased when another firm, Parker Medical Products, began buying their stock. John Parker, the chairman and CEO of Parker Medical Products, was thought to be a shrewd investor and his company’s purchase of 50,000 shares of ECS was taken as an affirmation of the success of the firm.
However, when Parker bought another 50,000 shares, Dr. Grossman and members of the
board of directors of ECS became concerned that John Parker and his firm might be trying to take over ECS.
Upon talking to her attorney, Dr. Grossman was reminded that ECS had a poison pill
provision that took effect when any outside investor accumulated 25 percent or more of the shares outstanding. Current stockholders, excluding the potential takeover company, were given the privilege of buying up to 500,000 shares of ECS at 80 percent of current market value. Thus new shares would be restricted to friendly interests.
The attorney also found that Dr. Grossman and “friendly” members of the board of directors currently owned 175,000 shares of ECS.
a. How many more shares would Parker Medical Products need to purchase before the poison
pill provision would go into effect? Given the current price of ECS stock of $42, what would be the cost to Parker to get up to that level? b. ECS’s ultimate fear was that Parker Medical Products would gain over a 50 percent interest
in ECS’s outstanding shares. What would be the additional cost to Parker to get 50 percent (plus 1 share) of the stock outstanding of ECS at the current market price of ECS stock? In answering this question, assume Parker had previously accumulated the 25 percent position discussed in a. c. Now assume that Parker exceeds the number of shares you computed in part b and gets all the
way up to accumulating 625,000 shares of ECS. Under the poison pill provision, how many shares must “friendly” shareholders purchase to thwart a takeover attempt by Parker? What will be the total cost? Keep in mind that friendly interests already own 175,000 shares of ECS and to maintain control, they must own one more share than Parker. d. Would you say the poison pill is an effective deterrent in this case? Is the poison pill in the
best interest of the general stockholders (those not associated with the company)?
Chapter 17: Common and Preferred Stock Financing
CP 17-2. Solution:
Electro Cardio Systems Inc.
a. If Parker owns 25 percent of the shares outstanding of ECS, the
poison pill will go into effect.
Since there are 850,000 shares outstanding, the trigger point is at 212,500 shares. This means Parker would have to buy 112,500 additional shares to go with its current ownership of 100,000. The cost of 112,500 additional shares of ECS common stock at its current price of $42 per share would be $ 4,725,000.
b. To get a 50 percent + 1 share interest in ECS, Parker would need to
own 425,000 (one-half of 850,000) + 1 share. This number is 425,001.
Since Parker has already acquired 212,500 shares of ECS, it would need to buy 212,501 more shares.
At a stock price of $42 per share, this would represent an additional cost of $8,925,042.
212,501 Additional shares $42 Stock price $8,925,042 Additional cost
This would be in addition to the $4,725,000 in part a. c. One more share than Parker would necessitate an ownership of
625,001 shares.
Since “friendly” interests of ECS already own 175,000 shares, this would mean they would need to acquire 450,001 additional shares.
Chapter 17: Common and Preferred Stock Financing
CP17-2. (Continued)
Because under the poison pill provision, they can buy at 80 percent of current market value, the total cost of the 450,001 shares would be $15,120,033.
450,001 $33.60 $15,120,033
Additional shares Cost per share* Total cost
*$42 × 80% (poison pill provision) = $33.60
d. Yes, the poison pill is an effective deterrent in this case. Since the poison pill provision allows up to 500,000 additional shares to be purchased by “friendly” interests, the “friendly” interests are assured of always owning more than 625,000 shares. Their total potential is 675,000 shares (175,000 shares currently owned plus 500,000 under the poison pill plan).
Quite likely, the poison pill is not in the best interest of the general shareholders. Without the poison pill, ECS is more likely to be a merger takeover candidate. Often, a price is offered well in excess of current market value for a takeover candidate. For example, ECS, with a current price of $42, might be offered $60 or $70 per share in a takeover tender offer. General stockholders would certainly benefit from such an offer.
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