3 15.1 Common Stock: Some terms (1) Common stockholders are owners of the corporation and assume the ultimate risk associated with the ownershipDifferent terms of ValuePar value - stated face value of shareTypically in Canada, stocks do not have a par valueBook-value - net worth of firm from balance sheet- limited economic significanceMarket value - going-concern value - current investor expectations about firm’s future prospectsReplacement value - current costs of replacing assets of the firmMarket value / book value (M/B) M/B is usually > 1positive NPV projectsinflation has driven the value of assets above what they originally costTobin’s Q - market value of assets / replacement value of assets
4 Common stock: Some terms (2) Share capital structureauthorized shares - approved by shareholders - no legal limit on no. of authorized sharesissued shares - shares actually soldcontributed surplus (aka additional paid-in capital):selling price - parretained earnings
5 Example: Share capital structure of RBC (1) RBC (TSE/NYSE: RY), 2006 Annual ReportQuestion: Find authorized shares, outstanding shares, and Tobin’s Q for RBC FY 2006.
6 Shareholder Rights (1) Easy transfer of shares Limited liability Residual claimants—DividendsDividends at board’s discretionDividends paid by firm - taxableDividends received by investors - partial tax shelterDividends received by corporations-100% tax shelterElect directors who hire managementMost important control mechanism of shareholders
7 Shareholder Rights (2) Voting rights straight voting -one vote per share for each position50% + can control boardminority freeze-outcumulative voting - permits minority participation; no. of votes = no. of shares * no. of positions on board; cumulate votes and cast for any positionproxy votingDelegate vote to another party by proxy
8 Proxy fight: Hewllet vs. Fiorina 2002 Acquistion of Compaq by HPHewllet and Packard families, controlling 18% of equity, opposed to it;Proxy fights to get shareholder supportMost expensive proxy fightsApproved by 51% of the votes.“ Whew. After a rancorous eight-month proxy fight, a three-day trial in Delaware, countless speeches, a blizzard of regulatory filings, and a bitter boardroom squabble, Hewlett-Packard on Friday completed the largest technology merger in history by acquiring Compaq Computer.”-from CNET.com
9 Dual-class share is a common scene in North America Dual-class of sharesunequal voting rights (subordinate voting / restricted voting / multiple voting)Examples:Google: Each of the class-B shares reserved for Google insiders (founders and top executives) would carry 10 votes, while ordinary class-A shares sold to the public would get just one vote.Ford: The Ford family controls 40% of shareholder voting power with only about 4% of the total equity in the company.Bombardier: (see text p. 426) founder’s family has about 2/3 of the votes, but only 22% of the shares.Empirical evidence suggests that shares with superior voting rights are worth more than those with inferior voting rights.
11 Example: Straight vs. cumulative voting The shareholders of the ABC company need to elect seven new directors. There are two million shares outstanding. How many shares do you need to be certain that you elect at least one director ifIf ABC has straight voting:2. If ABC has cumulative votingSuppose you have x shares-votes that you cast on 1 candidate (“concentrate”) > the 7th largest vote excluding your candidate.Thumb rule for your one candidate:Does it work?Suppose you have 250,001 shares, then you have votes.Your opponents have shares and votes.You choose one director with votes. If the others choose seven different people with say votes each, your choice will prevail.
12 15.2 Long-term DebtDebt is not an ownership interest in the firm—creditors do not (usually) have voting powerCreditors protect themselves via the loan contract (indenture)Interest payments are considered a cost of doing business and are fully tax deductible by the corporationUnpaid debt is a liability. If it is not paid, creditors can legally claim the assets of the firmSome securities blur the line between debt and equity:hybrid securities that look like equity but are called debt (basic idea is to obtain the tax advantages of debt while eliminating potential costs of bankruptcy)
13 Long-term debt cont’dAmong the features usually listed in the bond indenture areamount of issue, date of issue, maturity, par valueannual coupon, dates of coupon paymentssecuritysinking funds, call provisionscovenantsDebt securities are usually called notes, bonds, or debenturesa note is normally some form of unsecured “short” term debt (e.g. with a maturity less than 7 years)a debenture is unsecured debtin legal terms, a bond is secured by a mortgage on corporate propertyin practice, “bond” refers to both secured and unsecured debt
14 Cont’d repayment provisions: bonds can be repaid at maturity or earlier through the use of a sinking fundsome bonds are callable (the issuer has the right to pay a contractually specified amount to retire the debt prior to the stated maturity date)there are also extendible bonds (the issuer has the right to extend the maturity to a later date) and retractable bonds (the holder has the right to shorten the maturity to an earlier date)seniority indicates preference in position over other lenderssubordinated debt —in case of default, holders of subordinated debt must give preference to other specified creditors who are paid firstnote that debt cannot be subordinated to equity
15 Is it Debt or Equity? Feature Equity Debt Income tax status default and prioritymanagement controlmaturity
16 Related knowledge: Gov’t bonds Treasury bills - maturity < 1 year - no couponsTreasury notes - medium maturity yrs - semi-annual couponsTreasury bonds - maturity > 10 years - semi-annual coupons
17 Yields and rates on Financial Post, Sept. 14, 2007
18 Yield comparison of bonds with repayment provisions > or < ?Regular BondCallable BondExtendable BondRetractable Bond
20 15.3 Preferred Shares Perpetual dividends, usually fixed Dividends not contractually guaranteed - cumulative or noncumulativeForm of equity financingNo final repayment dateClaims of preferred shareholders ahead of common stockholders but behind creditorsNo voting rights - some voting rights if dividend skippedPreferred more risky than debt but less risky than common stock (Return?)For firm, payment of preferred dividends is not tax-deductibleDividend received by a firm tax-deductible100% of the dividends firms receive are exempt from income taxesExtra features: callable / retractable / convertible preferred shares
22 15.4 Patterns of Long -Term Financing Pecking order theory: internal cash then debt then equity
23 Review Questions 1. Why are preferred shares issued? Tax reasons Low-tax companies can make little use of the tax deduction on interest. They can issue preferred shares and enjoy lower financing costs since preferred dividends are significantly lower than interest payments.Non-tax reasonsRegulated public utilities can pass the tax disadvantage of issuing preferred shares on their customers.Firms issuing preferred shares can avoid the threat of bankruptcy that might otherwise exist if debt were relied on.Issuing preferred shares may be a means of raising equity without surrendering control.
24 Canadian Dividend Tax: (Appendix 1A, p28 Canadian Dividend Tax: (Appendix 1A, p28. Note that tax codes keep changing.)An investor pays tax at a marginal combined federal-provincial rate of 40.16% (29% federal % provincial). Suppose that dividend is taxed as in Appendix 1A.Long-term corporate bonds currently yield 6%. Because preferred shares issued by the same corporation are riskier, the investor seeks an increase in after-tax yield (for preferred over bonds) of 1%. If a preferred share issue is as attractive as a bond issued by the same company, what dividend yield (before tax) must the preferred shares have for the investor to be indifferent?
25 Solution to RQ 2Step 1: after-tax yield of preferred = 1% + after-tax yield of bondAfter-tax bond yield:After-tax preferred yield:Step 2: Before-tax preferred yield = AT yield / (1-Net dividend tax rate)Step 3: Net dividend rate work sheetDividend of $1Gross up at 45%Federal tax rate: 29%Less federal dividend tax credit (19%)Federal tax payableOntario Provincial tax at 11.16%Less dividend tax credit: 7.16%Total tax rate: