Fabozzi Frank, Peterson Pamela. Financial Management and Analysis Workbook

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SolCh15 Page 370 Tuesday, December 16, 2003 9:30 AM

CHAPTER

371

Common Stock

FILL IN THE BLANKS

Answers

1. stock; common, preferred; shares, certiﬁcates; shareholders, stockhold-

ers; return, dividends, cash

2. common; liability, shares, ownership, classiﬁed, voting, buy

3. shares, authorized; not; issued, actually, fewer, authorized; left, out-

standing, issued; retired, treasury

4. Common, elect, directors, vote, merger, authorize, vote, amendments;

classes, votes, percentages; controlling, retain

5. Cumulative, minority; cumulative, accumulate, pile, seats, gover-

nance, smaller

6. one, entire; classiﬁed, staggered; advantage, continuity; experienced,

one year

7. additional, common, rights, rights, existing, maintain, holding

8. directors, dividend, obligation; cash; shares, property

9. reinvest, shares, dividend, DRP, shareholders, dividends, additional,

cash; additional, outstanding, issued

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372 SOLUTIONS

10. split; divides, existing, more, portion, same; reverse, raises, reducing

11. dividend, decision, cash; no, growth, payout, low regular, periodic;

Irrelevance, Bird, Tax-Preference, Signaling, Agency

12. repurchasing, cash, taxes; Cash, ordinary; repurchase, capital, price;

higher, gains, lower

SHORT ANSWER QUESTIONS

Answers

1. Shareholders do not actually purchase a piece of the company per se,

instead they buy the right to future income and are allowed to be

involved in the ﬁrm’s activities and decision making.

2. Preferred stockholders are given preference over common stock-

holders. This means that the company must give income to the pre-

ferred shareholders before the common shareholders. The same is

true of dividends. Also, while dividends are not guaranteed to com-

mon shareholders, they are to preferred shareholders. Common

shareholders have voting rights, whereas preferred shareholders do

not. However, only when ﬁrms halt dividend payment, can preferred

shareholders receive some temporary voting rights.

3. Common equity is created through residual ownership in a ﬁrm. This

residual ownership is created by issuing shares of stock, protecting

and maintaining of the ﬁrms earnings, and reinvesting of earnings

back into the ﬁrm, meeting creditor obligations, and paying any

required dividends to preferred shareholders. Any remaining earnings

may either be kept by the ﬁrm or paid out to common shareholders in

the form of dividends.

4. A publicly held corporation is one whose shares of stock are traded in

ﬁnancial markets. Publicly held ﬁrms are subject to scrutiny and must

meet the disclosure requirements set forth by the SEC. Because of this

scrutiny and disclosure, public ﬁrms can raise outside capital easier

than other types of ﬁrms because they are fairly transparent.

A privately held corporation is one whose shares are not traded

in ﬁnancial markets. If a private ﬁrm has less than 500 shareholders

SolCh16 Page 372 Tuesday, December 16, 2003 9:31 AM

Common Stock 373

or less than $3 million of assets, registering with the SEC is optional.

In general, a private ﬁrm is not required to disclose any information

to the public or to the SEC. A private corporation can issue stock to a

select few. These types of privately held ﬁrms are also called closely

held ﬁrms. Ownership and management is selective, which also

means that the shareholders in these ﬁrms are not well diversiﬁed as

they are but a few holding much of one company. Because transpar-

ency is lacking with these ﬁrms, raising capital is difﬁcult.

5. Reasons a company would pay a stock dividend:

■

As a signal of information, such as to reveal good news about the

ﬁrm’s future prospects and not have to spend cash to do so.

■

To reduce the price of the stock. Overvalued stocks are subject to

higher costs and the payment of a dividend reduces the price of the

stock, on average, by the amount of the dividend.

6. The board of directors makes the dividend payment decisions.

Dividend Date Time Line:

■

Declaration date: The day the board of directors meets and decides

on the dividend.

■

Record date: The date speciﬁed by the board such that any share-

holders who are on record as owning shares on this date are eligible

to receive the dividend.

■

Ex-dividend date: The date, established by the ﬁnancial markets as

four business days prior to the record date, that determines who

receives the dividend (whoever purchased and held on to the shares

prior to this date) and who does not (whoever buys the shares on or

after this date).

■

Payment date: The date the dividend checks are mailed.

7. Reasons for a reverse stock split:

■

To raise the price to improve trading and reduce investors’ trans-

action costs for trading in the stock, especially in light of ﬂat

commissions which assess the same fees no matter the price of the

stock. So theoretically, an investor could pay more for the trans-

action fees than for the actual stock purchased.

■

To raise the price up from a penny stock because penny stocks are

viewed negatively.

■

As a way to privatize a ﬁrm.

SolCh16 Page 373 Tuesday, December 16, 2003 9:31 AM

374 SOLUTIONS

8. Reasons a company would repurchase its own stock:

■

To inexpensively distribute cash to shareholders. Shareholders bene-

ﬁt from the tax treatment of capital gains over dividends.

■

To reduce the number of shares outstanding in order to improve

earnings per share.

■

To reduce the equity in order to readjust the debt-to-equity ratio.

This means that the ﬁrm has greater ﬁnancial leverage, which

increases the value of the ﬁrm.

■

To creatively and painlessly reduce total dividend payments. The

reduction in shares implies a total dividend reduction because the

same amount of dividends per share can be paid but for fewer

shares.

■

To minimize agency costs by reducing any cash the management can

consume as perquisites.

■

To put the ﬁrm on a diet. Sometimes ﬁrms become too large and

unmanageable. When cash is paid out, the value of the ﬁrm is

reduced.

■

To maximize shareholder wealth. If the ﬁrm has no proﬁtable invest-

ment opportunities, then it is better to pay funds to the shareholders

than to invest in negative NPV projects.

A company would repurchase its own stock using the following

methods:

■

A tender offer

■

Open-market purchases

■

A targeted share repurchase

PROBLEMS

Answers

1. a.

Dividends per share

Common stock dividends

Number of common shares outstanding

------------------------------------------------------------------------------------------------------ -

$550,000

1,300,000

--------------------------

$0.42==

SolCh16 Page 374 Tuesday, December 16, 2003 9:31 AM

Common Stock 375

2. a. Market value = Price per share

× Number of shares owned

= $275

× 300 = $82,500

b. After the 3 for 1 stock split, the number of stocks you own has tri-

pled to 900 shares. However the price per share then adjusts accord-

ingly and is approximately $91.67 per share. The market value is

still the same: $275/3

× 900 = $82,500.

After the 15% stock dividend, you own 300

× 1.15 = 345

shares. The market value of your investment is still $82,500 as

now the shares are worth $275/1.15 = $239.13 per share.

3. Under the ordinary voting procedure, you may cast some or all 500

votes for Ms. W. because one share equals one vote. Under the cumu-

lative voting procedure, you may cast some or all of 500

× 4 = 2000

votes for Ms. W.

Dividends payout

Common stock dividends

Available earnings

----------------------------------------------------------------- -

$550,000

$2,400,000

----------------------------- -

0.23 23%===

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SolCh16 Page 376 Tuesday, December 16, 2003 9:31 AM

CHAPTER

377

Preferred Stock

FILL IN THE BLANKS

Answers

1. preferred; Preferred, income, common; preferred, common; priority,

preferred

2. preferred; preferred, ﬁrst, common; dividends, cash, shares; pre-

ferred, quarterly, ﬁxed, ﬂoating

3. Fixed, percentage, ﬁxed; variable, adjustable-rate, quarterly, reset;

perpetual, collar; issuer, costs, limited, investor, return, lower

4. auction, periodically; Remarketed, agent, tendered, offering; investor,

resets, auction, remarketed

5. cumulative, dividend, before, common; noncumulative, not, forgot-

ten, future; cumulative; arrearage, arrears; cumulative

6. conversion, conversion, common, preferred, common; price, ratio,

value, common; preferred, premium

7. Callable, buy, shareholder; price; price, set, change, schedule; greater,

stated

8. obligation, bondholders, creditors, assurance, sinking; trustee, funds,

retire, sinking; preferred, dividend

SolCh17 Page 377 Tuesday, December 16, 2003 9:31 AM

378 SOLUTIONS

9. features, package; attractive, cost; issuer, call, investor, conversion;

returns, risk, ﬂexibility, costs

SHORT ANSWER QUESTIONS

Answers

1. No longer are only common shareholders allowed to share in the earn-

ings of a ﬁrm. Participating preferred stock allows preferred sharehold-

ers to share as well. The sharing of earnings is conducted one of two

ways, either in addition to the already stated preferred dividend or it

can ﬂuctuate along with the dividend for the common stock.

There are very few participating preferred stock issues because:

■

Originally created as a substitute for debt, preferred stock was ini-

tially used by ﬁrms in failing health. Therefore the cash in hand, by

way of dividend, is better than taking a chance on a sick ﬁrm’s

future earnings that may never materialize.

■

If a ﬁrm has participating preferred stock, it reduces the beneﬁts to

common shareholders because regardless of ﬁrm health, common

shareholders are always the last to receive anything. However in

good times, while the common shareholder is still the last to receive,

there is at least more to receive after obligations (bondholders and

preferred shareholders) are paid.

2. Convertible preferred stock and mandatory preferred stock both give

the shareholder the right to exchange the preferred shares for com-

mon shares. Convertible preferred stock can convert at a predeter-

mined rate of exchange while mandatory preferred stock must

convert within a speciﬁed period of time.

The issuer’s perspective on mandatory convertible preferred is

that it is beneﬁcial because the ﬁrm is freed from its requirement to

pay preferred dividends. For the investor, the time limitation on con-

version is a cost as the preferred shareholder forfeits the dividend in

place of a less proﬁtable and ﬁxed investment.

3. Yes, there are contingent voting rights attached to preferred stock. This

means that the right to vote is invoked only when dividends have not

been paid for some time. However, this right to vote is very limited.

SolCh17 Page 378 Tuesday, December 16, 2003 9:31 AM

Preferred Stock 379

4. To convert preferred stock into common stock requires investors to

consider:

■

The uncertainty of the common stock dividend

■

The certainty of the preferred dividend

■

The unlimited common stock price appreciation

■

The limited preferred stock price appreciation

5. Advantages to issuing preferred stock:

■

To raise capital in outside markets

■

To maintain voting concentration for common shareholders

■

Preferred is cheaper and less risky

■

Preferred dividends are not taxes

Disadvantages to issuing preferred stock:

■

Preferred stockholders have a claim on income and assets.

■

Preferred shares have historically been issued by unhealthy ﬁrms.

PROBLEMS

Answers

1. Dividend for one year = 1,100,000

× $100

× 8% = $8,800,000

Arrearage after four years = $8,800,000

× 4 = $35,200,000

2. Conversion value = 500

× 25

× Market price of common share

Conversion value = 500

× 25

× $30 = $375,000

3. Dividends per share = 0.0975($80) = $7.80 per share, per year

Total dividends = $7.80($3,000,000/80) = $292,500 per year

SolCh17 Page 379 Tuesday, December 16, 2003 9:31 AM