Equity in the Secondary Market: Common and Preferred Stock

3 Equity in the Secondary Market: Common and Preferred Stock............................................... Terms You Need to Know Adjustable preferred American depositary receipts (ADRs) Book-entry method Class Common stock Conversion parity Conversion ratio Convertible preferred Cum dividend Cum rights Cumulative preferred Cumulative voting Dividend Ex date Ex dividend Ex rights Market value Par value Participating preferred Preemptive right Preferred stock Proxy Record date Registrar Regular-way settlement (T+3) Reverse split Rights offering Shareholder of record Shareholder rights Standby commitment Statutory voting Stock split (or forward split) Street name Subscription price Transfer agent Voting trust certificates (VTCs) Warrant (or subscription warrant) Concepts You Need to Understand Classes and kinds of common stock How foreign stocks are traded in the United States Basic rights When and how shareholders can vote Preemptive right and rights offerings Rules that govern the distribution of dividends Important dates for dividend calculations How stock prices are affected by the declaration of dividends Rights of preferred shareholders The relationship between interest rates and preferred stock prices How some preferred stock can be converted into common stock The purpose of subscription warrants

50 Chapter... 3 The Fundamentals of Common Stock The secondary market is the scene of most securities trading. Many kinds of securities trade there, from corporate bonds, government bonds, and municipal bonds, to options and more recent financial inventions such as derivatives. Equities are the most common way for corporations to raise capital. This chapter looks at the features of common and preferred equity stock including the rights of shareholders, the process of declaring dividends, what distinguishes subscription rights from subscription warrants, and the characteristics of convertible preferred stock. Common stock gives shareholders an equity, or ownership position in a corporation. One of the chief characteristics of common stock is that it pays a variable dividend or none at all depending on the decision of the company s board of directors. A dividend is a periodic payment (either in cash or stock) made by the company to owners of its common or preferred stock. The corporate charter authorizes that a certain number of common shares be issued and assigns them an arbitrary par value. For common stock, par value is usually very low, often only one dollar. The par value of preferred stock, on the other hand, is very important. Why So Cheap? The par value of common stock is not low for purely arbitrary reasons. States often tax corporations based on the par value of their common stock. The market value of common stock is determined wherever the stock is traded. Market prices reflect investors knowledge and beliefs about a whole range of factors, including the company s present and future profitability, the likelihood of dividend payments, the health of the industry, and even the growth prospects for the entire economy. Types of Common Stock In some instances a corporation might choose to issue various classes of stock to help a select group of shareholders maintain control of the company. A family-owned business that is going public, for example, might issue class A common stock to family members and class B to the public. This classification

... Equity in the Secondary Market: Common and Preferred Stock 51 method has fallen out of favor in recent years, and Congress has reviewed proposals to prohibit it altogether. The NYSE rarely lists companies employing this kind of two-tier structure, although the American Stock Exchange continues to do so. The differences between class A and class B stock can be found in their respective prospectuses. Categories of Common Stock Investors and broker-dealers distinguish stocks according to their historical performance in the marketplace and the issuing company s track record. A few of the more frequent labels are: Blue chip Stock of a big, well-known company with a long history of profits and regular dividend payments. Coca-Cola and Ford Motor Company belong to this group. Income Stock of companies that have good records of paying relatively high and stable dividends. Telephone companies, electric utilities, and banks are often considered income stocks. Growth Stock of a company that is expanding rapidly by investing in its own growth with profits that otherwise might have become dividend payments. In the 1980s and 1990s, the technology sector featured many growth stocks. Investors in the secondary market have several kinds of common stock to choose from. In addition, they might want to consider purchasing shares in overseas companies. The easiest way to accomplish this is through American depositary receipts. American Depositary Receipts American depositary receipts (ADRs) are certificates representing shares of foreign companies. ADRs are traded in U.S. markets, whereas the actual securities remain in the vault of a U.S. bank branch in the company s home country. Holders of ADRs enjoy all the rights of common stock owners except for voting and preemptive rights. For the foreign firm, ADRs present an opportunity to tap into the vast U.S. capital market while avoiding the time and expense of registering with the SEC. Instead, the U.S. bank that is holding the securities (in its overseas branch) handles all SEC compliance.

52 Chapter... 3 How Dividends Are Paid to the Owners of ADRs The foreign corporation pays dividends to the U.S. bank that is holding its securities. The bank then converts the dividends into dollars and pays the owners of the ADRs in the United States. Where are ADRs traded? Sponsored ADRs are bought and sold on one of the major exchanges (AMEX or the NYSE), whereas nonsponsored ADRs can be found on the OTC market. In the case of a sponsored ADR, the issuing company works with one U.S. depositary bank and sends its American shareholders annual financial reports in English. The issuing companies of nonsponsored ADRs, on the other hand, play no direct role in the receipts creation. Nonsponsored ADRs are packaged and sold by banks or brokerdealers on their own initiative. Because the company does not participate, nonsponsored ADRs can have more than one depositary bank. All shareholders, whether of ADRs or domestic stocks, have certain rights. Generally, these rights consist of sharing in the growth and profitability of the company, and having a voice in how the company is managed. Common Shareholder Rights Although the specific rights and privileges of common stock shareholders can vary with each corporation s charter or bylaws, they all have the right to: Receive dividends (when the company declares them) Receive a certificate of stock ownership Transfer their securities (sell their stock) Inspect the company s financial records, plus the minutes of shareholder meetings Vote either in person or by proxy on certain corporate matters Maintain their proportionate share of the company s outstanding stock (known as the preemptive right) Partake in the division of company assets if the company is liquidated Who decides when shareholders receive a dividend? The board of directors determines whether a dividend will be declared and, if so, how large it is.

... Equity in the Secondary Market: Common and Preferred Stock 53 When companies decide to declare dividends, they usually make payments quarterly. The Process of Paying Dividends Dividends can be paid in cash or stock. Companies might issue stock dividends in order to conserve cash for expansion or other purposes. For the shareholder, the advantage of stock dividends is that, unlike cash dividends, taxes are not owed until the shares are sold. Stock dividends are usually stated as a percentage of outstanding shares, and the price of the common stock is reduced accordingly. EXAMPLE: An investor owns 100 shares of Triple Platinum Records, Inc., which are trading at $50. The company declares a 10% stock dividend. After the distribution, the shareholder now has 110 shares, each worth $45.50. (There are now 10% more shares of stock outstanding, or 1.1 times as many as before the stock dividend. Fifty dollars divided by 1.1 equals $45.45.) The Right of Transfer Common stock is a negotiable security: owners can sell their shares to anyone. Among other things, this means that corporations face a challenge keeping track of their shareholders. Usually they hire an outside firm to act as a transfer agent, which maintains records of all shareholder names and addresses. A registrar, also an outside firm, makes sure that the corporation does not issue more shares than its charter authorizes. Shareholders can give their brokers permission to keep their stocks in street name the name of the broker. This simplifies the transfer process after stock sales. Shareholders have a right to receive stock certificates as evidence of ownership. Some corporations, however, use the book-entry method, whereby the registrar records purchases and sales, but no certificates change hands. Shareholders of a corporation have the right to review company records. In practice, this means that they can read the company s annual reports, known as Form 10-Ks, as well as its quarterly reports (Form 10-Qs), both of which must be filed with the SEC. The SEC views the filing of annual reports as a fundamental requirement of publicly traded companies. A company that fails to file a 10-K not only compromises its reputation with investors, but also triggers an SEC investigation and risks being delisted by the exchange on which it trades.

54 Chapter... 3 Shareholders Influence on Company Decisions Holders of common stock have the right to vote on many of the matters that affect their ownership interest. These include: Membership on the board of directors Stock splits and reverse stock splits The issuing of convertible securities (securities that can be converted into common stock) Shareholders do not vote on whether a corporation: Declares a dividend Declares a rights offering If shareholders cannot be present when matters affecting their ownership interest are to be decided usually at the company s annual meeting they have the right to vote by proxy. On such issues, the corporation is required to send ballots (proxies) to its shareholders. Shareholders mark their choices and return them to the corporation, where their votes are counted. The Voting Process Shareholder voting can be conducted on either a statutory or cumulative basis. In broad terms, the two methods are similar: shareholders get one vote per share, times the number of items on the ballot. If three board positions are to be filled, for example, a person with 100 shares has 300 votes. The difference between statutory and cumulative voting comes into play in cases such as these, where there are multiple choices for a single ballot item. Under statutory voting, shareholders cast votes equal to the number of shares they own for each open position on the board. The 100-share owner can vote 100 times for each of the three openings. Cumulative voting allows the shareholder to distribute his or her votes among the choices. Thus, the stock owner can place 150 votes for one candidate, 150 for a second, and none for the third. EXAMPLE: An investor owns 100 shares of Satellite Technologies, which is electing six directors. The company uses statutory voting. The investor has 600 total votes (100 shares 6 directors), but cannot cast more than 100 votes for any one candidate.

... Equity in the Secondary Market: Common and Preferred Stock 55 BioGen Corp, which employs cumulative voting, is also electing six directors. An investor who owns 100 shares of BioGen has 600 votes (the same as the Satellite Technologies investor), but can apportion them as he or she sees fit, even giving them all to one director. Cumulative voting is advantageous to smaller shareholders, enabling them to amass their votes on a single candidate or policy option. Perhaps that is why statutory voting remains much more common. In addition to electing members of the board of directors, shareholders are often asked to approve splits of the company s stock. The Stock Split A stock split multiplies the number of a company s outstanding shares by whatever ratio the company chooses. The market price of the stock drops accordingly. So, if a company s stock were selling at $30 per share, and it carried out a 3:1 split, there becomes three times as many shares outstanding after the split, each priced at $10. Companies use stock splits to make their shares more affordable to investors. EXAMPLE: WorldScape stock is selling at $110 a share. The company wants to attract new investors and declares a 2:1 split. The number of outstanding shares doubles and the price per share drops by half. An investor with 1,000 shares now owns 2,000, each priced at $55. If WorldScape had declared a 4:1 split, the same investor would have 4,000 shares, each priced at $27.50. Note, however, that the total market value of the investor s shares remains the same in either scenario: $110,000. Par value is the value arbitrarily assigned to common stock by the corporation. Market value is the price investors are currently willing to pay for the stock. Although ownership interest is not affected by splits, shareholder approval is required. Why? Because stock splits change the par value of a company s stock. They might also increase the number of outstanding shares beyond the amount currently authorized in the corporate charter. Either of these changes requires an amendment of the charter and thus stockholder approval.

56 Chapter... 3 Different Kinds of Stock Splits Stock splits are sometimes called forward splits to distinguish them from reverse splits. A reverse split increases the price of each share, while reducing the number of shares in circulation. Companies generally use reverse splits when they think their share price is too low to inspire investor confidence. By declaring a reverse split, companies can elevate the market price of their shares, creating an impression of higher value. EXAMPLE: Test Right Corp. has nine million outstanding shares selling at $10 a share. Trading has been slack, so the company declares a 1:3 reverse split. Now the company has only three million shares outstanding, each selling at $30. An investor who owned 90 shares of the original stock now has only 30 shares, but the total value of his shares is unchanged: $900. Not everything that changes the number of a company s outstanding shares requires stockholder approval. A company can issue new shares without such approval because shareholders are protected by their preemptive right, which they can exercise through a rights offering. Rights Offering A rights offering gives stockholders the opportunity to purchase new shares of a corporation before those shares are made available to the public. Shareholders preemptive right, the privilege of existing shareholders to maintain their proportionate ownership in the company, is triggered whenever a company issues new stock through a rights offering. In a rights offering, shareholders can purchase new shares at a price less than the current market price. This lower price is known as the subscription price. Shareholders usually receive one right for each share they own, but the number of rights necessary to buy a new share, the subscription ratio, is determined by the corporation. For example, the corporation might decide that 20 rights are required to buy one new share at the subscription price. Rights are generally valid for 30 days and are transferable. (In some offerings, rights are valid only for two weeks; in others, for as long as three months.) When a company stages a rights offering, it often negotiates a standby commitment with an investment banker, who agrees to purchase any unsubscribed shares and sell them to the public.

... Equity in the Secondary Market: Common and Preferred Stock 57 Performing a Rights Offering After deciding to issue new shares, a corporation places an announcement in major business newspapers. The notice states the subscription ratio and price, the current market price of the stock, and the following deadlines: Record date Date by which any transfer of shares must be completed in order for the new shareholder to receive rights. Distribution date Date that shareholders of record receive the rights. Expiration date Date the rights are no longer valid. Any investor who has completed the purchase of shares in a corporation by the record date becomes a shareholder of record. Shares traded from the date of the announcement through the record date are traded cum rights, which means with the rights attached. After the record date, shares trade ex rights, which means without the rights attached. The time between the distribution date and the expiration date is called the standby period. After the standby period, an investment banker with a standby commitment must purchase whatever portion of the issue that remains. EXAMPLE: Based on the announcement below, a shareholder with 100 shares of Java Express stock will receive 100 rights from the company on May 28. With a subscription ratio of 5-1, that shareholder can purchase 20 new shares of Java Express, at a total cost of $480 (20 new shares times $24 per share). Companies frequently retain a rights agent to handle the mechanics of the rights offering. The stockholder who wants to exercise his or her preemptive right must notify the Java Express rights agent, plus mail a check for $480, by June 29 for 20 new shares. Java Express Corporation Santa Monica, California Java Express Announces Rights Distribution The Board of Directors of Java Express Corporation is planning a rights distribution to stock holders of record on May 4, 1998. Stockholders will receive one right for each share owned. The rights will be distributed May 28, 1998. Under the terms of the offer, five rights are necessary to subscribe to one new share at a price of $24 per share. The offer expires midnight of June 29, 2006. The current market price of Java Express stock is $30.

58 Chapter... 3 Shareholders, of course, are not obligated to purchase new shares with their rights. Rights are transferable, so holders can decide to sell their rights in the marketplace. Shareholders thus need to calculate the market value of their rights. Determining the Value of a Right market price subscription price = value of right number of rights required + 1 So the value of a Java Express right mentioned in the previous example is 30 24 5 + 1 6 = = $1 per right 6 Rights offerings are important for investors who own shares in a healthy company. But investors with holdings in an ailing corporation also have legal rights. Shareholder Rights During Bankruptcy As part-owners of a corporation, stockholders are entitled to their proportionate share of the company s assets in the event of bankruptcy or liquidation (provided that assets are available). Shareholders, however, are not the first group to be paid in a liquidation. Common stockholders are compensated after banks and the owners of the corporation s bonds and preferred stock otherwise known as senior securities have been paid. In a liquidation, a stockholder s liability is limited to the loss of his or her investment. Limited liability is one of the cornerstones of corporate structure. Of course, companies make every effort to avoid bankruptcy. To mitigate its financial difficulties, a corporation might recall its common stock and replace it with voting trust certificates. EXAMPLE: Jefferson Adams paid $1 million for a 10% ownership position in Presidential Hotels, Inc. The company unfortunately goes bankrupt. After liquidating its assets, Presidential still has outstanding debt of $50 million. Mr. Adams, however, is not responsible for paying 10% of that debt (or $5 million). He only loses his original investment of $1 million. Voting Trust Certificates The board of directors of a financially distressed company can replace shareholders common stock with voting trust certificates (VTCs). Shareholders

... Equity in the Secondary Market: Common and Preferred Stock 59 retain all their rights except the right to vote. Those voting rights are given to a group of trustees appointed by the board of directors to turn the company around. VTCs thus concentrate decision-making power in the hands of the appointed trustees, giving them more freedom to take the steps necessary to put the company back on track. If the trustees are successful in saving the company, the common shares are returned to the shareholders (along with their voting rights). VTCs are traded just like common stock. Although companies do not receive any money from the trading of their stock in the secondary market, they do want their stock to perform well. One way a company can inspire investor confidence is by regularly distributing dividends. When Companies Declare a Dividend As with rights offerings, when a company decides to pay a dividend, certain dates become important. A dividend announcement might read as follows: Megahit Studios Hollywood, California Board Announces Dividend The Board of Directors of Megahit Studios today declared a dividend of 75 cents per share to stockholders of record on Monday, April 20, 2006. The dividend will be paid on May 4, 2006. Megahit thus has established the Declaration date (April 6) Date on which the company announced the dividend Record date (April 20) Date by which any transfer of shares must be completed in order for a shareholder to be eligible for the dividend Payment date (May 4) Date the corporation will pay the dividend Who is eligible to receive dividends? Only shareholders of record on April 20, the record date in this case, receive a dividend. The buying and selling of stocks is usually completed through regular-way settlement, in which a transaction settles three business days after the trade date (or T+3). So to buy Megahit Studios stock cum dividend (with the dividend), an investor has to purchase the stock on or before Wednesday, April 15. The following day, Thursday, April 16, is known as the ex date because investors who buy

60 Chapter... 3 Megahit on that date or later will not have enough time to settle their trades before the record date of Monday, April 20. These investors thus buy the stock ex dividend (without the dividend). The ex-dividend date is important for another reason: on this date the company s stock price is adjusted downward by the exchange on which it is listed. Stock Adjustment on the Ex-Dividend Date On the ex-dividend date, the stock opens at a price reduced by the amount of the dividend to be paid. For example, if Megahit stock closed at $50 per share on April 15, the stock will open at $49.25 on the morning of April 16 to account for the 75-cent dividend. This adjustment prevents traders from making riskless profits. If there were no reduction, a trader could buy the stock for $50 on April 15 (becoming a shareholder of record for April 20), sell it for $50 on April 16 (going off the record on April 21), and receive the dividend an essentially risk-free profit of 75 cents per share. The price adjustment eliminates that profit. As mentioned earlier, price adjustments are made for stock dividends as well. Common stock is not the only type of stock that a company can issue. Under some circumstances, corporations might choose to issue preferred stock. Preferred stock has noticeably different rights and characteristics from common stock. The Fundamentals of Preferred Stock Preferred stock is a hybrid security that combines characteristics of common stock and bonds. Like common stock, preferred stock is a unit of ownership in a public corporation. Like bonds, preferred stock is a fixed-income security: it pays a set dividend that is determined at the time it is issued. Typically it has a par value of $100, and the dividend is stated as a percentage of this par value. For example, 6% preferred stock pays a dividend of $6 per year, or $1.50 per quarter. Preferred stock has limited potential for capital growth compared to common stock. Because the dividends received by preferred stockholders are fixed at the outset, the value of preferred stock is affected more by interest rate fluctuations than by the company s performance. In contrast, common

... Equity in the Secondary Market: Common and Preferred Stock 61 stockholders can benefit from higher dividend payments when a company is successful with the market value of their stock climbing accordingly. More often than not, preferred stock is an investment choice of other corporations that are seeking better returns on their cash reserves. Current U.S. tax law allows corporations that own 20% or more of an issuer s preferred stock to deduct 80% of the dividend payments received. A corporation that owns less than 20% of an issuer s preferred stock can still deduct 70% of the dividend payments. On the other hand, any interest income earned by the same corporations on their bond investments is taxable. Dividends on preferred stock are paid before dividends on common stock. As mentioned earlier, preferred stockholders also precede common stockholders in receiving a distribution from a company s liquidation, making preferred stock a senior security much like a bond. There are drawbacks to preferred stock, however. Preferred stockholders usually do not have voting rights. Nor do they have preemptive rights, because even if the corporation issues more stock, the preferred stock s rate of return is not affected. What determines the market value of preferred stock? Because preferred stock earns a fixed return, its value in the marketplace is affected by interest rate movements. When preferred stock is issued, its dividend rate is set to be competitive with the existing market rate of interest. Thus, an inverse relationship exists between interest rate movements and the market value of preferred stock. If interest rates climb above the fixed rate offered by the preferred, its market price declines. If interest rates fall below the preferred stock s rate of return, the price of the stock increases. Calculating the Market Value of Preferred Stock To determine what an existing share of preferred stock is worth after a change in interest rates, investors use a simple formula: market income market value = market yield Of course, there are factors other than interest rates that influence a preferred stock s attractiveness. Investors must also consider the features of different types of preferred stock.

62 Chapter... 3 Other Types of Preferred Stock The most common varieties of preferred stock include Callable preferred Stock that the issuer can call (buy back) if interest rates fall. This allows the company to issue new preferred stock at a lower rate. Callable preferred typically pays a higher dividend rate because of the call feature. Participating preferred Stock giving the preferred shareholder the right to participate in any special dividends paid by the company. For example, after an especially lucrative year, a company might announce an additional year-end dividend of $2. Participating preferred stockholders receive the extra dividend along with common stock owners. This type of stock is quite rare. Cumulative preferred Stock requiring that any dividend payments in arrears be paid before the company pays dividends to common shareholders. If a company has missed three consecutive quarterly dividends on an 8% preferred stock and wants to pay a $1 dividend on its common stock in the fourth quarter, it must first pay a total dividend of $8 to preferred stockholders. See Table 3.1 for a schedule of dividend payments for cumulative preferred stock. Table 3.1 Cumulative Preferred Stock Dividend Payment Schedule First Quarter Second Quarter Third Quarter Fourth Quarter 8% cumulative $2 missed $2 missed $2 missed $8 must be preferred paid before paid common stock dividend Common stock None None None $1 paid after payment of cumulative dividend Adjustable preferred Stock with a dividend rate that is reset every six months to match movements in market interest rates. Convertible preferred Stock that can be converted into shares of common stock. Convertible preferred generally pays a lower dividend rate because of the conversion feature. Also, because any conversion dilutes the ownership interest of existing common stock owners, a company must get shareholder approval before issuing this type of security.

... Equity in the Secondary Market: Common and Preferred Stock 63 How Does Preferred Stock Become Common Stock? Owners of convertible preferred stock can exchange their shares for common stock according to a set conversion price, which determines the conversion ratio: par value of preferred stock conversion price = number of common shares received EXAMPLE: Cyclops Vision, Inc., convertible preferred stock ($100 par value) is convertible at $40. The conversion ratio is thus 2 1 /2:1. One share of the preferred stock can be converted into 2 1 /2 shares of Cyclops common stock. The conversion feature becomes valuable when the price of common stock is equal to or greater than the preferred stock s price, divided by the conversion ratio. EXAMPLE: Cyclops preferred stock, which is trading at $93, can be converted at $40. The conversion ratio (par value divided by conversion price) is 2 1 /2:1. To find the threshold for profitable conversion, divide $93 by 2.5. The answer, $37.20, is the price of conversion parity. At this level, preferred stock can be converted for common stock of equal value. If the market price of Cyclops common stock trades at $34, the company s convertible preferred stock will trade at $85, regardless of what interest rates are doing, in order to achieve parity with the common stock. An investor wanting to know whether a convertible preferred share is more valuable than the corresponding shares of common stock can use this formula: parity price of preferred stock = conversion ration market price of common stock EXAMPLE: An investor wants to know if she should convert her Cyclops preferred stock. The preferred stock is trading at $95; the common stock at $36 1 /2. Parity price of preferred stock = conversion ratio market price of common stock = 2.5 $36.50 = $91.25 At current market prices, the investor will probably want to hold on to her Cyclops preferred.

64 Chapter... 3 The conversion feature is one of several features that companies use to make preferred stock more attractive to investors. Companies can also issue warrants along with their preferred stock. Subscription Warrants Warrants (or subscription warrants) give investors the chance to buy a company s common stock at a specified price, at some point in the future. Often they are packaged with a bond or preferred stock, as a sweetener, to make the fixed-income security more attractive to investors. Warrants are freely transferable and are traded on the major exchanges or over the counter, depending on where the underlying stock is listed. Warrants resemble rights offerings because they permit investors to buy stock at a set price. They differ from rights in two important ways: Whereas rights generally have terms of 30 to 60 days, warrants commonly last for many years or even for perpetuity. (Warrants also often include initial waiting periods, during which they cannot be exercised.) Warrants have a subscription price that is higher than the stock s market price. Warrants, therefore, have a low value at the outset; they increase in value when the market price of the company s stock climbs above the subscription price or when investors expect it to. EXAMPLE: B. Mulligan Publishers, Inc., issues a warrant with its new preferred stock. The warrant has a subscription price of $40, whereas Mulligan s common stock is selling at $30. The current value of the warrant is $2. If the stock s market price rises to $45, however, the value of the warrant increases to at least $5. It might sell for much more than $5, depending on how investors judge the prospects of the company and its stock. Companies sometimes give warrants to their top executives as an incentive to improve the company s performance and drive up the price of its stock. If the price of the common stock rises above the subscription price, an executive can then exercise his or her warrants for a substantial profit. See Table 3.2 for an example of executive warrants and rights schedule.

... Equity in the Secondary Market: Common and Preferred Stock 65 Table 3.2 Warrants and Rights Schedule Warrants Rights Term Long (often 5 years) or perpetual Short (weeks) Waiting period Yes No Subscription price Higher than current market price Lower than current market price Value Low at outset; increases if stock Immediate value price rises above subscription price Transferable Yes Yes Traded on exchanges Yes Yes Availability All investors Shareholders of record

66 Chapter... 3 Exam Prep Questions 1. Why do companies typically set the par value of common stock at a low arbitrary value? A. Many states tax common stock a taxable corporate asset on the basis of the stock s par value. B. Stockholders can deduct the difference between par and market value on their income tax statements. C. A low par value makes it easier for the company to issue additional shares. D. Low par value enables a company to issue inexpensive long-term warrants to its executives. 2. Which of the following are rights of common-stock owners? I. To receive dividends II. To receive a stock certificate III. To stand second in seniority to bondholders for a claim on the company s assets in the event of a liquidation IV. To maintain proportionate ownership in a company when it issues additional stock A. I and II B. I, II, and III C. I, II, and IV D. I, II, III, and IV 3. Argus Co. shares are trading at $60 when it declares a 10% stock dividend. Harold Cross, who owns 100 shares: A. Receives a $600 dividend B. Owns 110 shares worth $54.55 each C. Owns 100 shares worth $66 each D. Receives 10 additional shares valued at $60 each 4. Harry Green owns 300 shares of DDT, Inc., which uses the cumulative method of voting. What is the maximum number of votes that Green can cast for one candidate when stockholders vote to fill three open positions on the DDT board? A. 100 B. 300 C. 900 D. 1,200

... Equity in the Secondary Market: Common and Preferred Stock 67 5. Which procedures favor investors with smaller holdings over investors with larger holdings? I. Statutory voting rights II. Cumulative voting rights III. Forward stock splits IV. Reverse stock splits A. I B. II C. II and III D. I and IV 6. Which are true about rights offerings? I. Companies price rights above the market price of their existing shares. II. Companies price rights below the market price of their existing shares. III. Through rights offerings, existing shareholders have the choice of maintaining proportionate ownership in a company. IV. Companies can use rights to dilute the holdings of existing owners. A. I B. II C. I and IV D. II and III 7. Zyxon Corporation declares a rights distribution with a subscription price of $30 and a subscription ratio of 10:1. When Zyxon trades at $34, what is the market value of rights to purchase 20 shares of Zyxon? A. $6,000 B. $800 C. $72.72 D. $680

68 Chapter... 3 8. Millenium Corporation has petitioned the courts for bankruptcy protection to attempt a restructuring. Millenium s board appoints a group of trustees and issues voting trust certificates (VTCs), replacing its outstanding stock. Existing shareholders: I. Retain all of their common-stock rights. II. Might eventually get their common shares back. III. Cannot sell their holdings. IV. Lose their voting rights to the appointed trustees. A. I B. II and III C. II and IV D. III and IV 9. Tuscarora Light and Gas issues 100,000 shares of 6.4% preferred stock at $100 par value. Megabyte Corp. buys 30,000 shares of the Tuscarora preferred. Assuming that the utility makes all scheduled dividend payments, what amount must Megabyte claim as taxable dividend income on the preferred each year? A. $48,000 B. $38,400 C. $192,000 D. $57,600 10. Last year, Rocky Falls Power issued 7% preferred stock at a par value of $100. Since then, interest rates have risen from about 7% to about 9%. The Rocky Falls preferred stock now: A. Trades at about par B. Trades at about 78 C. Trades at about 128 D. Pays a 9% dividend 11. Logical Decisions, Inc. (LDI), has omitted payment of the last two dividends on its 6.6% cumulative preferred stock, a one million share issue with a par value of $100. Based on strong sales of its new database software, the LDI board decides to pay a $1.40 dividend in the next quarter to owners of its five million outstanding shares of common stock. What sum does LDI s treasurer set aside to pay the quarter s dividends? A. $7 million B. $10.3 million C. $11.95 million D. $8.4 million

... Equity in the Secondary Market: Common and Preferred Stock 69 12. The common stock of Online Auctions, Inc., trades at $23. The company s convertible preferred shares, issued at a par of $100 with a conversion ratio of 4:1, trade at parity with the common stock at: A. 92 B. 25 C. 48 D. 100 13. Jordan purchased 1,000 shares of Virex common stock when the biotech firm went public with an offering price of 12. Each share had one warrant attached that gave the holder the right to purchase the stock at 35. Virex now trades at 38. What is the minimum market value of Jordan s warrants? A. $105,000 B. $78,000 C. $3,000 D. $72,000 14. Which of the following are true about warrants? I. Warrants often exist in perpetuity. II. Companies use warrants as an incentive to attract investors in common-stock offerings. III. Investors must use European-style execution to exercise warrants. IV. Warrants issued by NYSE-listed companies trade over the counter. A. I B. I, II, and IV C. I, II, and III D. I and II 15. Regular-way settlement for preferred-stock transactions occurs on: A. The same day B. The next day C. T+3 D. T+5

70 Chapter... 3 Exam Prep Answers 1. The correct answer is A. Many corporations set the par value of their stock at an arbitrary and low level because states have historically taxed this asset on the basis of its par value. 2. The correct answer is C. Shareholders of common stock have the right to receive dividends, to take physical delivery of the stock from the transfer agent, and to maintain their proportionate ownership by exercising the preemptive right. Owners of common stock stand last in seniority for a claim on assets of a liquidating firm. 3. The correct answer is B. After the stock dividend, Cross owns 110 shares of Argus at 54.55. Argus issues its shareholders 10% additional shares; the exchange on which Argus is listed adjusts the stock s price downward to keep the value of the shares unchanged. 4. The correct answer is C. Using cumulative voting, Green can pool the 900 votes to which his 300 shares entitle him, and he can distribute them as he desires among the three candidates for the board. 5. The correct answer is C. Cumulative voting rights and forward stock splits best serve the interest of small investors. Cumulative voting gives smaller shareholders the capability to apportion their voting in favor of candidates they prefer. A forward stock split lowers a stock s price, making its shares more affordable to smaller investors. 6. The correct answer is D. Corporations price the shares in rights offerings below the market price of their existing shares to provide current shareholders with the chance to protect themselves, at a discount, from dilution of their ownership. 7. The correct answer is C. The market value of a right is market price subscription price number of rights required + 1 One Zyxon right thus equals $34 $30 10 + 1 = $0.3636 Two hundred rights, at the subscription ratio of 10:1, enable an investor to purchase 20 shares, so 200 $.3636 = $72.72. 8. The correct answer is C. The Millenium shareholders retain all of their rights except their voting rights. They can still sell their holdings, now in the form of VTCs, which trade just as common stock does. Or, if the trustees turn the company around, they can wait for the board to return their shares of common stock, along with their voting rights.

... Equity in the Secondary Market: Common and Preferred Stock 71 9. The correct answer is B. Corporations that own more than 20% of another company s preferred stock can claim an 80% exemption on the dividend income they earn from the preferred. Megabyte earns $192,000 a year from the Tuscarora preferred (30,000 0.064 $100 = $192,000). Because 80% of this amount is exempt from taxation, Megabyte must claim $38,400 as dividend income subject to taxation ($192,000 0.20 = $38,400). 10. The correct answer is B. Because the market value of preferred stock moves inversely to interest rates, investors can calculate the approximate market value of preferred stock by dividing the fixed income they receive each year by the current level of interest rates. As interest rates have risen to 9%, the Rocky Falls preferred stock, issued at par when interest rates (and thus its dividend) were 7%, now trades at $77.78 ($7 0.09 = $77.78). 11. The correct answer is C. Cumulative preferred stockholders are entitled to receive all dividends they have missed before the company pays any common-stock dividend. LDI has to pay the cumulative preferred shareholders the two quarters of omitted dividends, or $3.3 million (1 million $100 0.066 2 = $3.3 million), plus the next quarter s cumulative preferred dividend of $1.65 million. The common stock dividend equals $7 million ($1.40 5 million = $7 million). The total dividend bill equals $11.95 million. 12. The correct answer is A. The parity price of convertible preferred stock equals the conversion ratio multiplied by the current market price of the common stock. The parity price of the Online Auctions convertible is thus $23 4, or $92. 13. The correct answer is C. A warrant s market value equals at least the difference between the price of the underlying stock and the subscription price. As Jordan owns 1,000 warrants, and the underlying Virex stock trades three dollars above his subscription price, his warrants are worth a minimum of $3,000. If investors believe that the underlying Virex stock has significant upside potential, the warrants might trade at a premium to this minimum value. 14. The correct answer is D. Warrants, often issued by unproven companies as an inexpensive way to attract additional investors in a new stock issue, generally exist in perpetuity. Because warrants trade on the exchange where the issuing company s underlying stock is listed, the warrants issued by an NYSE-listed stock trade on the Big Board. Investors can exercise warrants any time after the initial waiting period if one exists for the life of the security. 15. The correct answer is C. Regular-way settlement for all corporate issues, including preferred stock, is T+3.