McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-0
Chapter Outline
Common Stock
Corporate Long-Term Debt: The Basics
Preferred Stock
Patterns of Financing
Recent Trends in Capital Structure
Summary and Conclusions
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-1
Common Stock
• Par and No-Par Stock
• Authorized versus Issued Common Stock
• Capital Surplus
• Retained Earnings
• Market Value, Book Value, and Replacement Value
• Shareholders’ Rights
• Dividends
• Classes of Stock
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
Par and No-Par Stock
• The stated value on a stock certificate is called the
par value.
– Par value is an accounting value, not a market value.
– The total par value (the number of shares multiplied by
the par value of each share) is sometimes called the
dedicated capital of the corporation.
• Some stocks have no par value.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-3
Authorized vs. Issued Common Stock
• The articles of incorporation must state the number
of shares of common stock the corporation is
authorized to issue.
• The board of directors, after a vote of the
shareholders, may amend the articles of
incorporation to increase the number of shares.
– Authorizing a large number of shares may worry
investors about dilution because authorized shares can be
issued later with the approval of the board of directors but
without a vote of the shareholders.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-4
Capital Surplus
• Usually refers to amounts of directly contributed
equity capital in excess of the par value.
– For example, suppose 1,000 shares of common stock
having a par value of $1 each are sold to investors for $8
per share. The capital surplus would be
($8 – $1) × 1,000 = $7,000
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-5
Retained Earnings
• Not many firms pay out 100 percent of their
earnings as dividends.
• The earnings that are not paid out as dividends are
referred to as retained earnings.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-6 Market Value, Book Value, and
Replacement Value
• Market Value is the price of the stock multiplied by
the number of shares outstanding.
– Also known as Market Capitalization
• Book Value
– The sum of par value, capital surplus, and accumulated
retained earnings is the common equity of the firm,
usually referred to as the book value of the firm.
• Replacement Value
– The current cost of replacing the assets of the firm.
• At the time a firm purchases an asset, market value,
book value, and replacement value are equal.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-7
Shareholders’ Rights
• The right to elect the directors of the corporation by
vote constitutes the most important control device
of shareholders.
• Directors are elected each year at an annual meeting
by a vote of the holders of a majority of shares who
are present and entitled to vote.
– The exact mechanism varies across companies.
• The important difference is whether shares are to be
voted cumulatively or voted straight.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-8
Cumulative versus Straight Voting
• The effect of cumulative voting is to permit
minority participation.
– Under cumulative voting, the total number of votes that
each shareholder may cast is determined first. Usually,
the number of shares owned or controlled by a
shareholder is multiplied by the number of directors to be
elected. Each shareholder can distribute these votes as he
wishes over one or more candidates.
• Straight voting works like a . political election.
– Shareholders have as many votes as shares and each
position on the board has its own election.
– A tendency to freeze out minority shareholders.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-9
Cumulative vs. Straight Voting: Example
• Imagine a firm with two shareholders: Mr. Smith
and Ms. Wesson.
– Mr. Smith owns 60% of the firm ( = 600 shares) and Ms.
Wesson 40% ( = 400 shares).
– There are three seats up for election on the board.
• Under straight voting, Mr. Smith gets to pick all
three seats.
• Under cumulative voting, Ms. Wesson has 1,200
votes ( = 400 shares × 3 seats) and Mr. Smith 1,800
votes.
• Ms. Wesson can elect at least one board member.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-10
Proxy Voting
• A proxy is the legal grant of authority by a
shareholder to someone else to vote his or her
shares.
• For convenience, the actual voting in large public
corporations is usually done by proxy.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-11
Dividends
• Unless a dividend is declared by the board of
directors of a corporation, it is not a liability of the
corporation.
– A corporation cannot default on an undeclared dividend.
• The payment of dividends by the corporation is not
a business expense.
– Therefore, they are not tax-deductible.
• Dividends received by individual shareholders are
for the most part considered ordinary income by the
IRS and are fully taxable.
– There is an intra-corporate dividend exclusion.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-12
Classes of Stock
• When more than one class of stock exists, they are
usually created with unequal voting rights.
• Many companies issue dual classes of common
stock. The reason has to do with control of the firm.
• Lease, McConnell, and Mikkelson found the market
prices of stocks with superior voting rights to be
about 5 percent higher than the prices of otherwise-
identical stocks with inferior voting rights.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-13
Corporate Long-Term Debt: The Basics
• Interest versus Dividends
• Is It Debt or Equity?
• Basic Features of Long-Term Debt
• Different Types of Debt
• Repayment
• Seniority
• Security
• Indenture
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-14
Interest versus Dividends
• Debt is not an ownership interest in the firm.
Creditors do not usually have voting power.
• The corporation’s payment of interest on debt is
considered a cost of doing business and is fully tax-
deductible. Dividends are paid out of after-tax
dollars.
• Unpaid debt is a liability of the firm. If it is not
paid, the creditors can legally claim the assets of the
firm.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-15
Is It Debt or Equity?
• Some securities blur the line between debt and
equity.
• Corporations are very adept at creating hybrid
securities that look like equity but are called debt.
– Obviously, the distinction is important at tax time.
– A corporation that succeeds is creating a debt security
that is really equity obtains the tax benefits of debt while
eliminating its bankruptcy costs.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-16
Basic Features of Long-Term Debt
• The bond indenture usually lists
– Amount of Issue, Date of Issue, Maturity
– Denomination (Par value)
– Annual Coupon, Dates of Coupon Payments
– Security
– Sinking Funds
– Call Provisions
– Covenants
• Features that may change over time
– Rating
– Yield-to-Maturity
– Market price
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-17
Different Types of Debt
• A debenture is an unsecured corporate debt,
whereas a bond is secured by a mortgage on the
corporate property.
• A note usually refers to an unsecured debt with a
maturity shorter than that of a debenture, perhaps
under 10 years.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-18
Repayment
• Long-term debt is typically repaid in regular
amounts over the life of the debt. The payment of
long-term debt by installments is called
amortization.
• Amortization is usually arranged by a sinking fund.
Each year the corporation places money into a
sinking fund, and the money is used to buy back the
bonds.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-19
Seniority
• Seniority indicates preference in position over other
lenders.
• Some debt is subordinated. In the event of default,
holders of subordinated debt must give preference
other specified creditors who are paid first.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-20
Security
• Security is a form of attachment to property.
– It provides that the property can be sold in event of
default to satisfy the debt for which the security is given.
– A mortgage is used for security in tangible property.
– Debentures are not secured by a mortgage.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-21
Indenture
• The written agreement between the corporate debt
issuer and the lender.
• Sets forth the terms of the loan:
– Maturity
– Interest rate
– Protective covenants.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-22
Preferred Stock
• Represents equity of a corporation, but is different
from common stock because it has preference over
common in the payments of dividends and in the
assets of the corporation in the event of bankruptcy.
• Preferred shares have a stated liquidating value,
usually $100 per share.
• Preferred dividends are either cumulative or
noncumulative.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-23
Is Preferred Stock Really Debt?
• A good case can be made that preferred stock is
really debt in disguise.
– The preferred shareholders receive a stated dividend.
– In the event of liquidation, the preferred shareholders are
entitled to a fixed claim.
• Unlike debt, preferred stock dividends cannot be
deducted as interest expense when determining
taxable corporate income.
• Most preferred stock in the . is held by corporate
investors.
– They get a 70-percent income tax exemption.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-24
The Preferred-Stock Puzzle
• There are two offsetting tax effects to consider in
evaluating preferred stock:
1. Dividends are not deducted from corporate income in
computing the tax liability of the issuing corporation.
2. When a corporation buys preferred stock, 70 percent of
the dividends received are exempt from corporate
taxation.
• Most agree that 2) does not fully offset 1). Given
that preferred stock offers less flexibility to the
issuer than common stock, some have argued that
preferred stock should not exist.
• Yet it does.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-25
Patterns of Financing
• Internally generated cash flow dominates as a
source of financing, typically between 70 and 90%.
• Firms usually spend more than they generate
internally—the deficit is financed by new sales of
debt and equity.
• Net new issues of equity are dwarfed by new sales
of debt.
• This is consistent with the pecking order hypothesis.
• Firms in other countries rely to a greater extent than
. firms on external equity.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-26
The Long-Term Financial Deficit (1999)
Sources of Cash Flow
(100%)
Internal cash
flow (retained
earnings plus
depreciation)
70%
Long-term
debt and
equity 30%
Uses of Cash Flow
(100%)
Capital
spending
80%
Net
working
capital plus
other uses
20%
Internal
cash flow
External
cash flow
Financial
deficit
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-27
Recent Trends in Capital Structure
• This important question is difficult to answer
definitively.
• Which are best: book or market values?
– In general, financial economists prefer market values.
– However, many corporate treasurers may find book
values more appealing due to the volatility of market
values.
• Whether we use book or market values, debt ratios
for . non-financial firms have been below 50
percent of total financing.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-28
Summary and Conclusions
• The basic sources of long-term financing are:
– Long-Term Debt
– Common Stock
– Preferred Stock
• Common shareholders have voting rights, limited
liability, and a residual claim on the corporation.
• Bondholders have a contractual claim against the
corporation.
• Preferred stock has some of the features of debt and
equity.
• Firms need financing—most of it is generated
internally.
