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Assignment Content 1. Top of Form About Your Signature Assignment Harrod’s Sporting Goods Case Study is designed to align with specific program student learning outcome(s) in your program. Program St
15 Investment Banking Public and Private Placement LEARNING OBJECTIVES LO 15-1 Investment bankers are intermediaries between corporations in need of funds and the investing public. They also provide important advice. LO 15-2 Investment bankers, rather than corporations, normally take the risk of successfully distributing corporate securities and for this there are costs involved. LO 15-3 Distribution of new securities may involve dilution in earnings per share. LO 15-4 Corporations turn to investment bankers when making the critical decision about whether to go public (distribute their securities in the public markets) or stay private. LO 15-5 Leveraged buyouts rely heavily on debt in the restructuring of a corporation. In 2014 the IPO (initial public offering) market made a comeback. Alibaba, a Chinese Internet company, set a new record with a $25 billion offering, and other companies you may recognize, like Spotify, Dropbox, and J. Crew, also had initial public offerings of their common stock. Two hundred seventy-five companies came to market in 2014, the most since 2000. They raised a total of $85 billion, with Alibaba accounting for 29 percent of that amount. Table 15-1 lists the 10 largest equity IPOs of 2014. Table 15-1 Top equity IPOs in 2014 Source: Dealogic, Page 474 In 2012 Facebook was the IPO poster child and on its way to over a billion users when it went public. The issue price of $38 per share valued the company at $104 billion, the largest valuation ever for a newly listed public company. The company’s share of the proceeds was $16 billion, and the rest went to existing shareholders. Facebook’s initial public offering (IPO) was one of 94 that occurred in 2012, but this followed the worst environment in modern times for companies wishing to go public. As a worldwide financial crisis took hold in 2008, companies were forced to shelve plans for raising new capital through IPOs. By one count, only 21 companies went public in 2008. Even the revived IPO market of 2012 looks weak when compared to the hot IPO market of the 1990s. Between 1993 and 1999, on average more than 460 companies went public every year. In particular, during the late 1990s investors seemed to go wild over companies that had anything to do with the Internet. It seemed that if a company ended its name with “.com” or was connected to the Internet because of its business model, it could easily raise capital without having any cash flow or earnings. Investors were willing to pay high prices for stocks based on expectations that one day the companies would make large profits. Sometimes things worked out well., the Internet book company, became a public company in 1998, as did eBay, the Internet auction company. Actually, eBay was one of those rare Internet companies that made money, and the demand for shares of its initial public offering was 10 times greater than the shares available for sale. Goldman Sachs, its managing investment banker, priced the shares at $18 per share for the 3.5 million shares available for sale on the day of the offering. The opening price for eBay common stock was $53.50 per share. It never traded at its anticipated offering price of $18. Amazon and eBay are examples of two winners. Amazon’s stock price soared to new highs and split (2:1) three times, so an initial investor would have multiple shares for each share purchased. When Amazon peaked out at $113 in late 1999, an original investor had earned a 7,533 percent return in less than two years. Then, as the Internet stock bubble collapsed, the price of Amazon’s stock fell by more than 95 percent to $5.50 per share in late 2001. By July 2015, Amazon’s stock traded for over $435.00. It had recovered all of the earlier decline almost four times over. eBay was another highly successful Internet business, and because of stock splits an original investor would have 24 shares of eBay today for each original share purchased. After accounting for splits, the stock traded as high as $765 per original share ($18) by March 2000. Then the stock’s price fell by 79 percent before the end of that year. However, eBay continued to be a successful business, and its price eventually recovered to rise to new highs. Both Amazon and eBay had business strategies that worked. Although they were overpriced in 1999, their business met real market needs, and the companies continued to grow. Eventually their stock prices recovered. In contrast, many other Internet-based “new economy” companies failed or were acquired at low prices by other firms. Sometimes investors think that all they have to do is buy IPOs and they will get rich. Unfortunately it doesn’t always work out that way. Many companies that went public during the Internet bubble of the late 1990s and 2000 crashed and burned, losing investors their total investment. So while we marvel at the success of companies like Alibaba, we never seem to hear about the failures of 2014 such as MOL Global, Sysorex Global Holdings, Viggle, or Eclipse Resources, companies that all lost close to 80 percent of their issue price within 12 months of their public offerings. So did the investment banker misprice these issues, or did their projections turn out to be wrong? What does an investment banker actually do for a company in an initial public offering? Keep reading. The Role of Investment Banking Page 475 The investment banker is the link between the corporation in need of funds and the investor. As a middleman, the investment banker is responsible for designing a security offering and selling the securities to the public. The investment banking fraternity has long been thought of as an elite group—with appropriate memberships in the country club, the yacht club, and other such venerable institutions. However, several changes have occurred in the investment banking industry over the last decade. Investment Banking Competition Competition has become the new way of doing business, in which the fittest survive and prosper, while others drop out of the game. Raising capital has become an international proposition, and firms need to be very large to compete. This concentration of capital allows large firms to take additional risks and satisfy the needs of an increasingly hungry capital market. There have been international consolidations under way for some time, with foreign banks buying U.S. firms and U.S. banks buying foreign firms. The high level of global concentration is shown in Table 15-2 with the top 10 global investment bankers listed by revenue generated. The top 10 investment bankers accounted for 51.9 percent of the total revenue generated. Table 15-2 Global ranking of investment bankers, 2014 Source: Dealogic, Enumeration of Functions As a middleman in the distribution of securities, the investment banker has a number of key roles. These functions are described next. Underwriter In most cases, the investment banker is a risk taker. The investment banker will contract to buy securities from the corporation and resell them to other security dealers and the public. By giving a “firm commitment” to purchase the securities from the corporation, the investment banker is said to underwrite any risks that might be associated with a new issue. While the risk may be fairly low in handling a bond offering for ExxonMobil or General Electric in a stable market, such may not be the case in selling the shares of a lesser-known firm in a volatile market environment. Page 476 Though most large, well-established investment bankers would not consider managing a public offering without assuming the risk of distribution, smaller investment houses may handle distributions for relatively unknown corporations on a “best-efforts,” or commission, basis. Some issuing companies even choose to sell their own securities directly. Both the “best-efforts” and “direct” methods account for a relatively small portion of total offerings. Market Maker During distribution and for a limited time afterward, the investment banker may make a market in a given security—that is, engage in the buying and selling of the security to ensure a liquid market. The investment banker may also provide research on the firm to encourage active investor interest. Advisor The investment banker may advise clients on a continuing basis about the types of securities to be sold, the number of shares or units for distribution, and the timing of the sale. A company considering a stock issuance to the public may be persuaded, in counsel with an investment banker, to borrow the funds from an insurance company or, if stock is to be sold, to wait for two more quarters of earnings before going to the market. The investment banker also provides important advisory services in the area of mergers and acquisitions, leveraged buyouts, and corporate restructuring. Agency Functions The investment banker may act as an agent for a corporation that wishes to place its securities privately with an insurance company, a pension fund, or a wealthy individual. In this instance, the investment banker will shop around among potential investors and negotiate the best possible deal for the corporation. Page 477 Table 15-3 illustrates the revenue generated for each product serviced by investment bankers. So we can see that the revenues generated by the equity markets, the debt markets, and the merger and acquisition markets for 2014 were all in the $21 billion range and that syndicated lending accounted for more than $17 billion. Each category has a subheading with the respective amounts listed. We can see that follow-on offerings in the secondary equity markets generated more revenue than equity IPOs. Under the debt heading, investment-grade bonds generated more revenue than high-yield bonds, but notice that high-yield bonds (junk bonds) are quite a significant slice of the debt pie. Investment bankers love to advise on mergers and acquisitions because they are profitable and don’t entail as much risk as initial public offerings. An interesting fact is that even though the investment banking markets are global, three U.S. firms dominate the revenue generated, with Morgan Stanley leading in three categories, Goldman Sachs in one, and JPMorgan in six. Table 15-3 Top IB earners by product, 2014 Dealogic Revenue analytics are employed where fees are not disclosed. Source: Dealogic, The Distribution Process The actual distribution process requires the active participation of a number of parties. The principal or managing investment banker, often referred to as the bookrunner, will call on other investment banking houses to share the burden of risk and to aid in the distribution. To this end, they will form an underwriting syndicate comprising as few as 2 or as many as 100 investment banking houses. In Figure 15-1 we see a typical case in which a hypothetical firm, the Maxwell Corporation, wishes to issue 250,000 additional shares of stock with Bank of America Merrill Lynch as the managing underwriter and an underwriting syndicate of 15 firms. Figure 15-1 Distribution process in investment banking Page 478 The underwriting syndicate will purchase shares from the Maxwell Corporation and distribute them through the channels of distribution. Syndicate members will act as wholesalers in distributing the shares to brokers and dealers who will eventually sell the shares to the public. Large investment banking houses may be vertically integrated, acting as underwriter-dealer-brokers and capturing all fees and commissions. The Spread The underwriting spread represents the total compensation for those who participate in the distribution process. If the public or retail price is $21.50 and the managing investment banker pays a price of $20.00 to the issuing company, we say there is a total spread of $1.50. The $1.50 may be divided among the participants, as indicated in Figure 15-2. Figure 15-2 Allocation of underwriting spread Note that the lower a party falls in the distribution process, the higher the price for shares. The managing investment banker pays $20, while dealers pay $20.75. Also, the farther down the line the securities are resold, the higher is the potential profit. If the managing investment banker resells to dealers, he makes 75 cents per share; if he resells to the public, he makes $1.50. The total spread of $1.50 in the present case represents approximately 7 percent of the offering price ($1.50/$21.50). Generally, the larger the dollar value of an issue, the smaller the spread is as a percentage of the offering price. Percentage figures on underwriting spreads for U.S. corporations are presented in Table 15-4. This table illustrates that the smaller the issue, the higher the fees percentagewise, and also that equity capital is more expensive than debt capital. The higher equity spreads reflect the fact that there is more uncertainty with common stock than for other types of capital. Since the Maxwell Corporation stock issue is for $5.375 million (250,000 shares × $21.50), the 7 percent spread is in line with SEC figures in Table 15-4. It should be noted that the issuer bears not only the “give-up” expense of the spread in the underwriting process but also out-of-pocket costs related to legal and accounting fees, printing expenses, exchange listing fees, and so forth. As indicated in Table 15-5, when the spread plus the out-of-pocket costs are considered, the total cost of a small issue is high but decreases as the issue size increases. Of course substantial benefits may still be received. Page 479 Table 15-4 Underwriting compensation as a percentage of proceeds Spread Size of Issue ($ millions) Common Stock Debt Under 0.5   11.3%  7.4% 0.5–0.9 9.7 7.2 1.0–1.9 8.6 7.0 2.0–4.9 7.4 4.2 5.0–9.9 6.7 1.5 10.0–19.9 6.2 1.0 20.0–49.9 4.9 1.0 50.0 and over 2.3 0.8 Source: Securities and Exchange Commission data. Table 15-5 Total costs to issue stock (percentage of total proceeds) *Out-of-pocket cost of debts is approximately the same. Source: Securities and Exchange Commission data. Pricing the Security Because the syndicate members purchase the stock for redistribution in the marketing channels, they must be careful about the pricing of the stock. When a stock is sold to the public for the first time (i.e., the firm is going public), the managing investment banker will do an in-depth analysis of the company to determine its value. The study will include an analysis of the firm’s industry, financial characteristics, and anticipated earnings and dividend-paying capability. Based on valuation techniques that the underwriter deems to be appropriate, a price will be tentatively assigned and will be compared to that enjoyed by similar firms in a given industry. If the industry’s average price-earnings ratio is 20, the firm is likely to be priced near this norm. Anticipated public demand will also be a major factor in pricing a new issue. Page 480 Finance in ACTION Managerial Warren Buffett’s Bailout of Goldman Sachs At the peak of the recent financial crisis, Goldman Sachs turned to Warren Buffett’s Berkshire Hathaway Inc. to bail it out of trouble. After Bear Stearns and Lehman Brothers collapsed at the start of the global financial crisis, Goldman Sachs found itself short of capital. Fortunately, Warren Buffett stood ready with billions to invest. Warren Buffett’s Berkshire Hathaway bought $5 billion of Goldman Sachs Series G preferred stock yielding a 10 percent guaranteed annual return. Along with the preferred stock came warrants to buy an additional $5 billion of common stock, or more precisely, 43.5 million shares of Goldman Sachs at $115 per share. Before Buffett closed the deal on September 23, 2008, Goldman Sachs (ticker symbol GS) traded for $113. After the announcement the stock rose to $129.95 and closed on the day at $125.05. Just by investing $5 billion, the value of Buffett’s warrants rose by $10 per share, or $435 million. Buffett’s investment didn’t end Goldman’s troubles completely. Over the next two months, financial markets kept getting worse, and Goldman Sachs stock fell as low as $54.54 per share. As the financial crisis bottomed out and the government stabilized the markets, bank and investment bank stock prices increased. The Goldman Sachs stock price hit a high of $193.60 towards the end of 2009, and by June of 2013, it traded at $165 per share. Berkshire Hathaway had until October 1, 2013, to purchase the 43.5 million shares. By March of 2013, it was clear to Goldman Sachs that the company didn’t need another $5 billion from Buffett through the exercise of the 43.5 million shares of stock, so instead they agreed to a swap. Goldman would subtract the $115 strike price from the average market price 10 days prior to October 1 and give Buffett the value in shares. This was advantageous for Buffett because he didn’t have to come up with $5 billion in cash, and instead he received 13.06 million shares or 2.8 percent ownership in Goldman Sachs. As of July 2015 those shares were worth approximately $2.7 billion, not a bad return on top of a 10 percent annual dividend payment of $500 million over five years. The great majority of the issues handled by investment bankers are, however, additional issues of stocks or bonds for companies already trading publicly. When additional shares are to be issued, the investment bankers will generally set the price at slightly below the current market value. This process, known as underpricing, will help ensure a receptive market for the securities. At times, an investment banker also will underwrite the sale of large blocks of stock for existing stockholders, rather than for the company. When holders of these blocks wish to sell too many shares for normal channels to handle, the investment banker will manage the sale and underprice the stock below current market prices. This process is known as a secondary offering. Secondary offerings occur after an IPO, also known as a primary offering, in which securities are sold to the public for the first time. Secondary offerings often combine shareholder blocks with additional shares being issued directly by the company. Table 15-3 refers to secondary offerings in the category “Follow-on.” A secondary offering can also occur without shareholder blocks being included. Three of the largest equity offerings ever were secondary offerings that occurred in December 2009. Several banking giants (Citigroup, Bank of America, and Wells Fargo) raised over $52 billion in new capital to pay back the U.S. government for bailout funding received the previous year. These banks wished to avoid restrictions on their activities that the government had imposed until repayments were made. Page 481 Debt versus Equity Offerings Students are often surprised that debt offerings outnumber equity offerings in number and dollar amounts. Perhaps it is because we are bombarded with daily Dow Jones updates in the financial press that stock seems to take preference over bonds. Table 15-6 however shows that for 2014 and 2013, debt offerings were more than three times equity offerings. In 2014 $6.325 trillion of debt was issued globally while $935 billion of equity was issued. There were 20,728 debt offerings and 5,464 equity offerings. But referring back to Table 15-3, you can see that investment banking revenue from debt and equity was almost equal, which magnifies the point that equity is more profitable to the investment banker because there is more risk involved in an equity IPO than in a debt IPO. Table 15-6 Global debt and equity capital markets bookrunner rankings Source: Dealogic, Dilution A problem a company faces when issuing additional securities is the actual or perceived dilution of earnings effect on shares currently outstanding. In the case of the Maxwell Corporation, the 250,000 new shares may represent a 10 percent increment to shares currently in existence. Perhaps the firm had earnings of $5 million on 2,500,000 shares before the offering, indicating earnings per share of $2. With 250,000 new shares to be issued, earnings per share will temporarily slip to $1.82 ($5,000,000 ÷ 2,750,000). The proceeds from the sale of new shares may well be expected to provide the increased earnings necessary to bring earnings back to at least $2. While financial theory dictates that a new equity issue should not be undertaken if it diminishes the overall wealth of current stockholders, there may be a perceived time lag in the recovery of earnings per share as a result of the increased shares outstanding. For this reason, there may be a temporary weakness in a stock when an issue of additional shares is proposed. In most cases this is overcome with time. Page 482 Market Stabilization Another problem may set in when the actual public distribution begins—namely, unanticipated weakness in the stock or bond market. Since the sales group normally has made a firm commitment to purchase stock at a given price for redistribution, it is essential that the price of the stock remain relatively strong. Syndicate members, committed to purchasing the stock at $20 or better, could be in trouble if the sale price falls to $19 or $18. The managing investment banker is generally responsible for stabilizing the offering during the distribution period and may accomplish this by repurchasing securities as the market price moves below the initial public offering price. The period of market stabilization usually lasts two or three days after the initial offering, but it may extend up to 30 days for difficult-to-distribute securities. In a very poor market environment, stabilization may be virtually impossible to achieve. Consider Facebook’s initial public offering on Friday, May 18, 2012. The initial IPO price was set at $38 by the lead underwriter, Morgan Stanley. The offering was a big news event, and many small investors rushed into the stock in the first minutes of trading. The stock was extremely volatile on the first day of trading, but the stock price never fell below the offering price because Morgan Stanley was actively buying shares when the price hit $38. Figure 15-3 shows that the price fell to $38 during the morning when Morgan Stanley apparently intervened. The price fell back to $38 later in the day as price support activities held the price above $38 at the close. Figure 15-3 Facebook share price on the first day of trading Page 483 Facebook’s price quotes near the end of the first trading day show the magnitude of the price support. In Figure 15-4, notice that there is a bid for almost 10 million shares of Facebook stock at exactly $38 per share. This is almost certainly a bid by Morgan Stanley attempting to support the price at that level. To put the size of this support into perspective, it was not unusual for the bid size to be less than 5,000 shares in later transactions. Figure 15-4 Facebook closing quotes on May 18, 2012 On Monday, May 21, the price support was removed and the price fell to $34. By September, the price had collapsed to a low of $17.55. Investors who understood that the underwriter was only temporarily supporting the price were probably able to avoid these early losses. Manipulation of prices in security markets is normally illegal. Market stabilization or underwriter price support is a rare exception to the general market manipulation prohibition. Temporary market stabilization is accepted by the Securities and Exchange Commission as necessary for smoothly functioning new-issue markets. Aftermarket The investment banker is also interested in how well the underwritten security behaves after the distribution period because the banker’s ultimate reputation rests on bringing strong securities to the market. This is particularly true of initial public offerings. Page 484 Exhaustive research shows that initial public offerings tend to perform well in the immediate aftermarket. Between 1980 and 2012 there were more than 7,700 initial public offerings in the United States. The average first-day return for these stocks was 18 percent. In many countries, the initial aftermarket returns are even higher. In China, initial aftermarket returns have averaged more than 160 percent. Studies covering over 22,000 non-U.S. IPOs from 38 other countries show initial returns that average more than40 percent. In fact, IPOs are underpriced in every country where stocks are publicly traded. After the issuance, initial public offerings appear to lose their luster. Over the first three years of trading, excluding the first-day price jump, IPO returns are approximately 7 percent lower than those of similar firms. The typical IPO is a good deal for investors who purchase shares from the underwriter at the offering price, but after the first day of trading most companies underperform the market for several years. Shelf Registration The Securities and Exchange Commission also allows a filing process called shelf registration under SEC Rule 415. Shelf registration permits large companies, such as IBM or Citigroup, to file one comprehensive registration statement that outlines the firm’s financing plans for up to the next two years. Then, when market conditions seem appropriate, the firm can issue the securities without further SEC approval. Future issues are thought to be sitting on the shelf, waiting for the appropriate time to appear. Shelf registration is at variance with the traditional requirement that security issuers file a detailed registration statement for SEC review and approval every time they plan a sale. Whether investors are deprived of important “current” information as a result of shelf registration is difficult to judge. While shelf registration was started on an experimental basis by the SEC in 1982, it has now become a permanent part of the underwriting process. Shelf registration has been most frequently used with debt issues, with relatively less utilization in the equity markets (corporations do not wish to announce equity dilution in advance). Shelf registration has contributed to the concentrated nature of the investment banking business, previously discussed. The strong firms are acquiring more and more business and, in some cases, are less dependent on large syndications to handle debt issues. Only investment banking firms with a big capital base and substantial expertise are in a position to benefit from this registration process. The Gramm–Leach–Bliley Act Repeals the Glass–Steagall Act The Glass–Steagall Act, passed after the great crash of 1929 and bank runs of the early 1930s, required U.S. banks to separate their commercial banking operations and investment banking operations into two different entities. Banks like J.P. Morgan were forced to sell off Morgan Stanley. Congress took this position because they thought the risk of the securities business impaired bank capital and put the banking system at risk of default. As global financial markets grew, it became clear that U.S. commercial and investment banks were at a competitive disadvantage against large European and Japanese banks, who were not hobbled by these restrictions. Foreign banks were universal banks and could offer traditional banking services as well as insurance, securities brokerage, and investment banking. Page 485 In 1999 the U.S. Congress passed the Gramm–Leach–Bliley Act, which repealed Depression-era laws that had separated banking, brokerage, insurance, and investment banking. Now banks may engage in all these activities. The Federal Reserve and the Treasury, however, still have the power to impose restrictions on the activities of banks. Recently the Fed and Treasury have been concerned that banks’ investments into risky venture capital companies may impair their capital. The Fed has effectively banned some banks from participating in this merchant banking activity unless they set aside reserves equal to 50 percent of their capital. This allows the strong banks to participate in the venture capital market but forces the weak ones to sit on the sidelines. Economists (and politicians) currently argue over whether repeal of Glass–Steagall was a major cause of the banking crisis in 2008, but most agree that inadequate regulatory oversight was the main cause. The Dodd–Frank law enacted in 2010 included the Volcker Rule, named for a former Federal Reserve Chairman Paul Volcker. The rule is intended to restrict banks from making certain risky investments that the repeal of Glass–Steagall allowed. The Volcker Rule has been criticized as a watered-down version of the old Glass–Steagall restrictions. Public versus Private Financing Our discussion to this point has assumed the firm was distributing stocks or bonds in the public markets (as explained in Chapter 14). However, many companies, by choice or circumstance, prefer to remain private—restricting their financial activities to direct negotiations with bankers, insurance companies, and so forth. Let us evaluate the advantages and the disadvantages of public placement versus private financing and then explore the avenues open to a privately financed firm. Advantages of Being Public First of all, the corporation may tap the security markets for a greater amount of funds by selling securities to the public. With over 90 million individual stockholders in the country, combined with thousands of institutional investors, the greatest pool of funds is channeled toward publicly traded securities. Furthermore, the attendant prestige of a public security may be helpful in bank negotiations, executive recruitment, and the marketing of products. Some corporations listed on the New York Stock Exchange actually allow stockholders a discount on the purchase of their products. Stockholders of a heretofore private corporation may also sell part of their holdings if the corporation decides to go public. A million-share offering may contain 500,000 authorized but unissued corporate shares and 500,000 existing stockholder shares. The stockholder is able to achieve a higher degree of liquidity and to diversify his or her portfolio. A publicly traded stock with an established price may also be helpful for estate planning. Finally, going public allows the firm to play the merger game, using marketable securities for the purchase of other firms. A public company can purchase another firm using its own stock as currency, whereas a private firm might be forced to buy using cash. The high visibility of a public offering may even make the acquiring firm a potential recipient of attractive offers for its own securities. (This may not be viewed as an advantage by firms that do not wish to be acquired.) Disadvantages of Being Public The company must make all information available to the public through SEC and state filings. Not only is this tedious, time-consuming, and expensive, but also important corporate information on profit margins and product lines must be divulged. The CEO (chief executive officer) and the CFO (chief financial officer) must adapt to being public relations representatives to all interested members of the securities industry. Page 486 Another disadvantage of being public is the tremendous pressure for short-term performance placed on the firm by security analysts and large institutional investors. Quarter-to-quarter earnings reports can become more important to top management than providing a long-run stewardship for the company. A capital budgeting decision calling for the selection of Alternative A—carrying a million dollars higher net present value than Alternative B—may be discarded in favor of the latter because Alternative B adds two cents more to next quarter’s earnings per share. In a number of cases, the blessings of having a publicly quoted security may become quite the opposite. Although a security may have had an enthusiastic reception in a strong “new-issues” market, such as that of 1967–68, 1981–83, or 1998–99, a dramatic erosion in value may later occur, causing embarrassment and anxiety for stockholders and employees. As was evidenced in Tables 15-4 and 15-5, there can be a high cost to going public. For small firms, the underwriting spread and the out-of-pocket costs can run in the 15–18 percent range. Moreover, after going public the firm faces higher compliance costs because of various public disclosure requirements. In response to the collapse of Enron Corporation and its accounting firm, Arthur Andersen and Co., Congress passed the Sarbanes–Oxley Act of 2002 which created several costly new requirements. Public Offerings A Classic Example—Rosetta Stone Goes Public A classic example of an IPO is that of Rosetta Stone Inc., which went public on April 16, 2009. The company offers self-study language software for over 30 languages. Prior to the offering, the company filed a registration statement with the SEC that included a prospectus that was distributed to potential investors. Every public offering must be preceded by a prospectus that offers details about the company and the offering. The front page of Rosetta Stone’s prospectus is shown in Figure 15-5. As shown in the figure, 6.25 million shares (top of page) were offered to the public at a price of $18 per share (middle of page). Underwriting commissions were $1.26 per share, exactly 7 percent of the offer price. Also, the company received only half of the remaining proceeds. The other half went to shareholders who sold part of their interest in the company. Table 15-7 on page 488 shows the out-of-pocket costs that Rosetta Stone incurred. Members of the underwriting syndicate are shown along the bottom of Figure 15-5. Morgan Stanley was the lead underwriter with William Blair & Company listed as a co-lead. The other members of the syndicate are listed below these underwriters. On the whole, the features shown in Figure 15-5 are all very standard for primary offerings. The day of the offering, Rosetta Stone’s shares began trading on the NYSE at $23 and closed at $25.12, for a first-day gain of more than 39 percent ($25 – $18)/$18. This is a good example of the first-day underpricing that frequently accompanies IPOs. Over the next several months, the price of Rosetta Stone continued to climb, and the stock traded for almost $31 per share on August 10, 2009. After the stock market closed on that day, Rosetta Stone announced that it had filed another registration statement with the SEC for a secondary offering of its common stock. Most of the stock to be sold in the secondary offering would come from two shareholders who owned large stakes prior to the IPO, not from new stock issued by the company. Because very little of the stock would be newly issued, dilution would not be a problem. Nevertheless, the financial markets interpreted this news negatively. If two large insiders believed the stock should be sold at this price, then perhaps the market price was too high. Page 487 Figure 15-5 Rosetta Stone’s prospectus Source: The Wall Street Journal, Tuesday, December 21, 1999, C7, © 1999 Dow Jones & Co. Inc. All Rights Reserved Worldwide. Page 488 Table 15-7 Out-of-pocket costs for Rosetta Stone IPO Amount Paid SEC registration fee $          6,819 FINRA filing fee 12,719 Initial NYSE listing fee 157,500 Legal fees and expenses 700,000 Accounting fees and expenses 2,000,000 Printing expenses 250,000 Transfer agent and registrar fees and expenses 10,000 Miscellaneous expenses      346,982 Total $3,484,020 Source: Rosetta Stone prospectus. Over the next week, Rosetta Stone’s price fell to $20 per share, a 35 percent drop in one week. On August 17, the firm announced that the secondary offering was canceled. The stock price immediately stabilized, and the stock rose in value to over $22 per share by the end of the month. Figure 15-6 shows Rosetta Stone’s stock price performance and the S&P 500 Index return during all of 2009. Figure 15-6 2009 stock returns for Rosetta Stone and S&P 500 Index Source: Yahoo! Inc., Page 489 This narrative offers several general observations about IPOs and secondary offerings. IPOs are typically underpriced and have high first-day returns. Consistent with Rosetta Stone’s original plan, secondary offerings frequently occur after a stock has risen significantly in value. Often the stockholders sell because they want to diversify their portfolio, but the market generally interprets secondary offerings as a sign that company managers or insiders view the stock as overvalued, and the share price declines when the offering is announced. However, Rosetta Stone’s decline was larger than most. Private placement Private placement refers to the selling of securities directly to insurance companies, pension funds, and wealthy individuals, rather than through the security markets. This financing device may be employed by a growing firm that wishes to avoid or defer an initial public stock offering or by a publicly traded company that wishes to incorporate private funds into its financing package. Private placements exceed 50 percent of all long-term corporate debt outstanding. The advantages of private placement are worthy of note. First, there is no lengthy, expensive registration process with the SEC. Second, the firm has greater flexibility in negotiating with one or a handful of insurance companies, pension funds, or bankers than is possible in a public offering. Because there is no SEC registration or underwriting, the initial costs of a private placement may be considerably lower than those of a public issue. However, the interest rate on bonds is usually higher to compensate the investor for holding a less liquid obligation. Going Private and Leveraged Buyouts Throughout the years, there have always been some public firms going private. In the 1970s, a number of firms gave up their public listings to be private, but these were usually small firms. Management figured it could save several hundred thousand dollars a year in annual report expenses, legal and auditing fees, and security analysts meetings—a significant amount for a small company. In the 1980s, 1990s, and mid-2000s, however, very large corporations began going private and not just to save several hundred thousand dollars. More likely they had a long-term strategy in mind. There are basically two ways to accomplish going private. In the most frequent method, a publicly owned company is purchased by a private company or a private equity fund. Private equity funds typically are partnerships formed specifically to buy companies. An alternative avenue for going private is for a company to repurchase all publicly traded shares from stockholders. Both methods have been in vogue and are usually accomplished through the use of a leveraged buyout. In a leveraged buyout, either the management or some other investor group borrows the needed cash to repurchase all the shares of the company. After the repurchase, the company has substantial debt and heavy interest expense. Usually management of the private company must sell assets to reduce the debt load, and a corporate restructuring occurs, wherein divisions and products are sold and assets redeployed into new, higher-return areas. As specialists in the valuation of assets, investment bankers try to determine the “breakup value” of a large company. This is its value if all its divisions were divided up and sold separately. Over the long run, these strategies can be rewarding, and these companies may again become publicly owned. For example, Beatrice Foods went private in 1986 for $6.2 billion. One year later, it sold various pieces of the company—Avis, Coke Bottling, International Playtex, and other assets worth $6 billion—and still had assets left valued at $4 billion for a public offering. Page 490 Finance in ACTION Managerial Tulip Auctions and the Google IPO While traditional investment banking relies on institutional relationships, there is a move afoot to do some initial public offerings on the Internet using auctions. Most individual investors (especially those with less than million-dollar accounts) find it very difficult to acquire shares in a traditional IPO. Shares are typically allocated to mutual funds, pension funds, and other institutional investors who have connections with the investment bankers. Often, these institutions are repeat customers who participate in most of an underwriter’s offerings. While this is obviously bad for small investors, firms that are going public also have concerns with the traditional distribution system. They wonder whose interest the underwriter is looking out for. Are they looking out for the issuer? Or is the banker looking out for the interests of the institutional investors who are the banker’s repeat customers? In 1998, William Hambrecht founded WR Hambrecht & Co., which helped pioneer U.S. stock auctions. Hambrecht’s Open IPO® auctions are based on the method developed to auction Dutch tulip bulbs in the 17th century. In a “Dutch” auction, prices are determined after all prospective buyers have placed bids. Then one price is set for all buyers. That price is the highest price at which all the securities can be sold to the bidders. No investor pays more than his bid price, but many will receive securities at a price that is less than their bid. Dutch auctions are commonly used to sell U.S. Treasury securities, and about 150 auctions of Treasuries are held each year. One of the attractive features of Dutch auctions is that connections don’t matter. Mom-and-Pop investors can compete for shares alongside big institutional investors. In August 2004, Google Inc. went public using a variation on the Dutch auction. Google’s IPO was, by far, the largest auction-based offering ever. The auction rules ensured that small investors could participate because orders as small as 5 shares were accepted. In traditional IPOs, allocations of less than 100 shares are rare, although most deals have no official minimum. Google’s IPO did not go off without a hitch. The company originally estimated a selling range between $108 and $135 per share, but the eventual issue price was only $85 per share. Noting this fact, many Wall Street bankers and professional investors declared the IPO auction a failure. Of course, there is no evidence that a traditional IPO would have yielded a higher initial selling price, and Google paid underwriting fees of only 2.8 percent, which is less than the norm. On the first day of trading, Google’s price rose in the aftermarket to $100.34, an 18 percent gain that is about average for IPOs. By January 2009, Google’s price had risen above $600 per share. In 2005, Chicago investment research firm Morningstar Inc. chose to go public using Hambrecht’s OpenIPO system. However, traditional Wall Street underwriters strongly discouraged Morningstar from using the auction format. After all, the traditional underwriting method is extremely profitable for underwriters and institutional investors. Institutional investors clearly did not receive preferential treatment in the Morningstar IPO. Investment behemoth Fidelity Investments received no shares in the IPO. Its $17.50 bid for 2.2 million Morningstar shares was too low. The auction clearing price was set at $18.50. Morningstar paid underwriting fees of less than 2 percent of the offering proceeds, much less than would be expected in a traditional offering. Internet-based auctions may eventually capture a significant share of the underwriting market, but that time is probably still far off. However, not all leveraged buyouts have worked as planned. Because they are based on the heavy use of debt, any shortfall in a company’s performance after the buyout can prove disastrous. Page 491 It should be further pointed out that the impetus to going private was once again stimulated in 2002 by the Sarbanes–Oxley Act, which greatly increased the reporting requirements and potential liability for publicly traded companies. This was especially true for smaller companies where the financial burden of reporting was a significant expense. Many of these decided to go private. International Investment Banking Deals Privatization Beginning in the 1980s and continuing to date, governments around the world have privatized companies previously owned by the state. The word “privatization” can be confusing, because in the United States we refer to many companies as “publicly owned” when they are actually owned by private investors. So-called “public” companies like General Electric, Intel, and Boeing are not owned by the government. They are owned by private individuals, mutual funds, pension funds, and other investors. This has been a common practice in the United States for over 100 years. However, in many countries—especially socialist and communist countries—the auto industry, steel industry, aerospace industry, and virtually all other major industries have been owned by the state. The process of privatization involves investment bankers taking companies public, but instead of selling companies formerly owned by individuals, the companies sold had been previously owned by governments. Although Britain privatized its state-owned steel industry in the 1950s, in many respects, the privatization of British Telecom in 1984 was the first significant effort to turn state-owned businesses into private companies. Subsequently, a wave of privatizations swept Western Europe, Latin America, and the more capitalist countries of Asia. With the collapse of the USSR, many of the former communist countries such as Poland, Hungary, and the Czech Republic began to privatize their industries with public offerings of common stock. In recent years, China and Russia have joined the push toward reducing government ownership of assets. In 2007, three of the world’s four largest public stock offerings involved the privatization of petroleum and coal companies in China and a government-owned bank in Russia. Around the world, governments continue to own a wealth of assets. Consider the United States, a country with a tradition of private ownership. The federal and state governments still own 88 percent of Alaska’s land, over 320 million acres. Almost all of the roads in the United States are owned by state, local, and federal governments. There may be good reasons for state ownership of these assets, but as the public demands more services from the government, a huge source of potential cash could be tapped by the privatization of some of these assets. In 2006 Indiana effectively privatized the Indiana East-West Toll Road by leasing the road to a Spanish-Australian partnership, which now operates it. The road needed to be upgraded, and the Indiana government balked at spending taxpayer money on a toll road when other needs were deemed to be more pressing. In many other countries, the fraction of wealth owned by the state is much higher than in the United States. It can be expected that governments around the world will continue to privatize government businesses and assets. SUMMARY Page 492 The investment banker acts as an intermediary between corporations in need of funds and investors having funds, such as the investing public, pension funds, and mutual funds, to name a few. Of course the investment banker charges a fee to the corporation selling securities, and the fee is based on the size of the offering, the risk associated with the company, and whether the security is equity or debt. The role of the investment banker is critical to the distribution of securities in the U.S. economy. The investment banker serves as an underwriter or the risk taker by purchasing securities from the issuing corporation and redistributing them to the public; he or she may continue to maintain a market in the distributed securities after they have been sold to the public. The investment banking firm can also help a company sell a new issue on a “best-efforts” basis. As corporations become larger and more global, they need larger investment banks, and this has caused consolidation in the investment banking industry. A few large investment banks that are able to take down large blocks of securities and compete in international markets now dominate the industry. Investment bankers also serve as important advisors to corporations by providing advice on mergers, acquisitions, foreign capital markets, and leveraged buyouts, and also on resisting hostile takeover attempts. The fees earned for this advice can be substantial. The advantages of selling securities in the public markets must be weighed against the disadvantages. While going public may give the corporation and major stockholders greater access to funds, as well as additional prestige, these advantages quickly disappear in a down market. Furthermore the corporation must open its books to the public and orient itself to the short-term emphasis of investors. Companies may decide to go from public to private. This trend was evident in the late 1980s, 1990s, and mid-2000s with many large companies going private through leveraged buyouts. However, a number of these companies again publicly distributed their shares a year or two later, generating large profits for their owners in the process. LIST OF TERMS investment banker 474 underwrite 475 “best-efforts” basis 476 agent 476 managing investment banker 477 bookrunner 477 underwriting syndicate 477 underwriting spread 478 underpricing 480 dilution of earnings 481 market stabilization 482 aftermarket 483 shelf registration 484 public placement 485 private placement 489 going private 489 leveraged buyout 489 restructuring 489 privatization 491 Page 493 DISCUSSION QUESTIONS 1. In what way is an investment banker a risk taker? (LO15-2) 2. What is the purpose of market stabilization activities during the distribution process? (LO15-1) 3. Discuss how an underwriting syndicate decreases risk for each underwriter and at the same time facilitates the distribution process. (LO15-2) 4. Discuss the reason for the differences between underwriting spreads for stocks and bonds. (LO15-2) 5. What is shelf registration? How does it differ from the traditional requirements for security offerings? (LO15-1) 6. Discuss the benefits accruing to a company that is traded in the public securities markets. (LO15-4) 7. What are the disadvantages to being public? (LO15-4) 8. If a company were looking for capital by way of a private placement, where would it look for funds? (LO15-1) 9. How does a leveraged buyout work? What does the debt structure of the firm normally look like after a leveraged buyout? What might be done to reduce the debt? (LO15-5) 10. How might a leveraged buyout eventually lead to high returns for a company? (LO15-5) 11. What is privatization? (LO15-5) PRACTICE PROBLEMS AND SOLUTIONS Dilution effect of new issue (LO15-3) 1. Dawson Motor Company has 6 million shares outstanding with total earnings of $12 million. The company is considering issuing 1.5 million new shares. a. What will be the immediate dilution in earnings per share? b. If the new shares can be sold at $25 per share and the proceeds will earn 12 percent, will there still be dilution? Based on the new EPS, should the new shares be issued? Underwriting costs (LO15-2) 2. Gallagher Corp. will issue 300,000 shares at a retail (public) price of $40. The company will receive $37.90 per share and incur $160,000 in out-of-pocket expenses. a. What is the percentage spread? b. What percentage of the total value of the issue (based on the retail price) are the out-of-pocket costs? Solutions 1. a. Earnings per share before the stock issue: Page 494 Earnings per share after the stock issue: b. New income = 12% × (1.5 million shares × $25) = 12% × 37,500,000      = $4,500,000 Total income = $12,000,000 + $4,500,000 = $16,500,000 Earnings per share based on the additional income included in total income: There is no longer dilution. Earnings per share will grow from the initial amount of $2.00 to $2.20. The new shares should be issued. 2. a.  b.  PROBLEMS  Selected problems are available with Connect. Please see the preface for more information. Basic Problems Dilution effect of stock issue (LO15-3) 1. Louisiana Timber Company currently has 5 million shares of stock outstanding and will report earnings of $9 million in the current year. The company is considering the issuance of 1 million additional shares that will net $40 per share to the corporation. a. What is the immediate dilution potential for this new stock issue? b. Assume the Louisiana Timber Company can earn 11 percent on the proceeds of the stock issue in time to include it in the current year’s results. Should the new issue be undertaken based on earnings per share? Dilution effect of stock issue (LO15-3) Page 495 2. The Hamilton Corporation Company has 4 million shares of stock outstanding and will report earnings of $6,910,000 in the current year. The company is considering the issuance of 1 million additional shares that can only be issued at $30 per share. a. Assume the Hamilton Corporation Company can earn 7.0 percent on the proceeds. Calculate the earnings per share. b. Should the new issue be undertaken based on earnings per share? Dilution effect of stock issue (LO15-3) 3. American Health Systems currently has 6,400,000 shares of stock outstanding and will report earnings of $10 million in the current year. The company is considering the issuance of 1,700,000 additional shares that will net $30 per share to the corporation. a. What is the immediate dilution potential for this new stock issue? b. Assume that American Health Systems can earn 9 percent on the proceeds of the stock issue in time to include them in the current year’s results. Calculate earnings per share. Should the new issue be undertaken based on earnings per share? Dilution effect of stock issue (LO15-3) 4. Using the information in Problem 3, assume that American Health Systems’ 1,700,000 additional shares can only be issued at $18 per share. a. Assume that American Health Systems can earn 6 percent on the proceeds. Calculate earnings per share. b. Should the new issue be undertaken based on earnings per share? Dilution and pricing effect of stock issue (LO15-3) 5. Jordan Broadcasting Company is going public at $50 net per share to the company. There also are founding stockholders that are selling part of their shares at the same price. Prior to the offering, the firm had $26 million in earnings divided over 11 million shares. The public offering will be for 5 million shares; 3 million will be new corporate shares and 2 million will be shares currently owned by the founding stockholders. a. What is the immediate dilution based on the new corporate shares that are being offered? b. If the stock has a P/E of 30 immediately after the offering, what will the stock price be? c. Should the founding stockholders be pleased with the $50 they received for their shares? Underwriting spread (LO15-2) 6. Solar Energy Corp. has $4 million in earnings with 4 million shares outstanding. Investment bankers think the stock can justify a P/E ratio of 21. Assume the underwriting spread is 5 percent. What should the price to the public be? Underwriting spread (LO15-2) 7. Tiger Golf Supplies has $25 million in earnings with 7 million shares outstanding. Its investment banker thinks the stock should trade at a P/E ratio of 31. Assume there is an underwriting spread of 7.8 percent. What should the price to the public be? Underwriting spread (LO15-2) 8. Assume Sybase Software is thinking about three different size offerings for issuance of additional shares. Page 496 Size of Offer Public Price Net to Corporation a. 1.1 million $30 $27.50 b. 7.0 million $30 28.44 c. 28.0 million $30 29.15 What is the percentage underwriting spread for each size offer? Underwriting spread (LO15-2) 9. Walton and Company is the managing investment banker for a major new underwriting. The price of the stock to the investment banker is $23 per share. Other syndicate members may buy the stock for $24.25. The price to the selected dealers group is $24.80, with a price to brokers of $25.20. Finally, the price to the public is $29.50. a. If Walton and Company sells its shares to the dealer group, what will the percentage return be? b. If Walton and Company performs the dealer’s function also and sells to brokers, what will the percentage return be? c. If Walton and Company fully integrates its operation and sells directly to the public, what will its percentage return be? Underwriting spread (LO15-2) 10. The Wrigley Corporation needs to raise $44 million. The investment banking firm of Tinkers, Evers & Chance will handle the transaction. a. If stock is utilized, 2,300,000 shares will be sold to the public at $20.50 per share. The corporation will receive a net price of $19 per share. What is the percentage underwriting spread per share? b. If bonds are utilized, slightly over 43,700 bonds will be sold to the public at $1,009 per bond. The corporation will receive a net price of $994 per bond. What is the percentage of underwriting spread per bond? (Relate the dollar spread to the public price.) c. Which alternative has the larger percentage of spread? Is this the normal relationship between the two types of issues? Secondary offering (LO15-2) 11. Kevin’s Bacon Company Inc. has earnings of $9 million with 2,100,000 shares outstanding before a public distribution. Seven hundred thousand shares will be included in the sale, of which 400,000 are new corporate shares, and 300,000 are shares currently owned by Ann Fry, the founder and CEO. The 300,000 shares that Ann is selling are referred to as a secondary offering, and all proceeds will go to her. The net price from the offering will be $16.50, and the corporate proceeds are expected to produce $1.8 million in corporate earnings. a. What were the corporation’s earnings per share before the offering? b. What are the corporation’s earnings per share expected to be after the offering? Market stabilization and risk (LO15-2) 12. Becker Brothers is the managing underwriter for a 1.45-million-share issue by Jay’s Hamburger Heaven. Becker Brothers is “handling” 10 percent of the issue. Its price is $27 per share, and the price to the public is $28.95.Page 497 Becker also provides the market stabilization function. During the issuance, the market for the stock turns soft, and Becker is forced to purchase 50,000 shares in the open market at an average price of $27.50. It later sells the shares at an average value of $27.20. Compute Becker Brothers’ overall gain or loss from managing the issue. Underwriting costs (LO15-2) 13. Trump Card Co. will issue stock at a retail (public) price of $32. The company will receive $29.20 per share. a. What is the spread on the issue in percentage terms? b. If the firm demands receiving a new price only $2.20 below the public price suggested in part a, what will the spread be in percentage terms? c. To hold the spread down to 2.5 percent based on the public price in part a, what net amount should Trump Card Co. receive? Underwriting costs (LO15-2) 14. Winston Sporting Goods is considering a public offering of common stock. Its investment banker has informed the company that the retail price will be $16.85 per share for 550,000 shares. The company will receive $15.40 per share and will incur $180,000 in registration, accounting, and printing fees. a. What is the spread on this issue in percentage terms? What are the total expenses of the issue as a percentage of total value (at retail)? b. If the firm wanted to net $15.99 million from this issue, how many shares must be sold? Intermediate Problems P/E ratio for new public issue (LO15-2) 15. Richmond Rent-A-Car is about to go public. The investment banking firm of Tinkers, Evers & Chance is attempting to price the issue. The car rental industry generally trades at a 20 percent discount below the P/E ratio on the Standard & Poor’s 500 Stock Index. Assume that index currently has a P/E ratio of 25. The firm can be compared to the car rental industry as follows: Richmond Car Rental Industry Growth rate in earnings per share 15% 10% Consistency of performance Increased earnings 4 out of 5 years Increased earnings 3 out of 5 years Debt to total assets 52% 39% Turnover of product Slightly below average Average Quality of management High Average Assume, in assessing the initial P/E ratio, the investment banker will first determine the appropriate industry P/E based on the Standard & Poor’s 500 Index. Then a half point will be added to the P/E ratio for each case in which Richmond Rent-A-Car is superior to the industry norm, and a half point will be deducted for an inferior comparison. On this basis, what should the initial P/E be for the firm? Dividend valuation model for new public issue (LO15-1) Page 498 16. The investment banking firm of Einstein & Co. will use a dividend valuation model to appraise the shares of the Modern Physics Corporation. Dividends (D1) at the end of the current year will be $1.64. The growth rate (g) is 8 percent and the discount rate (Ke) is 13 percent. a. What should be the price of the stock to the public? b. If there is a 7 percent total underwriting spread on the stock, how much will the issuing corporation receive? c. If the issuing corporation requires a net price of $31.30 (proceeds to the corporation) and there is a 7 percent underwriting spread, what should be the price of the stock to the public? (Round to two places to the right of the decimal point.) Comparison of private and public debt offering (LO15-1) 17. The Landers Corporation needs to raise $1.60 million of debt on a 20-year issue. If it places the bonds privately, the interest rate will be 10 percent. Twenty thousand dollars in out-of-pocket costs will be incurred. For a public issue, the interest rate will be 9 percent, and the underwriting spread will be 2 percent. There will be $120,000 in out-of-pocket costs. Assume interest on the debt is paid semiannually, and the debt will be outstanding for the full 20-year period, at which time it will be repaid. For each plan, compare the net amount of funds initially available—inflow—to the present value of future payments of interest and principal to determine net present value. Assume the stated discount rate is 12 percent annually. Use 6 percent semiannually throughout the analysis. (Disregard taxes.) Advanced Problems Features associated with a stock distribution (LO15-3) 18. Midland Corporation has a net income of $19 million and 4 million shares outstanding. Its common stock is currently selling for $48 per share. Midland plans to sell common stock to set up a major new production facility with a net cost of $21,120,000. The production facility will not produce a profit for one year, and then it is expected to earn a 13 percent return on the investment. Stanley Morgan and Co., an investment banking firm, plans to sell the issue to the public for $44 per share with a spread of 4 percent. a. How many shares of stock must be sold to net $21,120,000? (Note: No out-of-pocket costs must be considered in this problem.) b. Why is the investment banker selling the stock at less than its current market price? c. What are the earnings per share (EPS) and the price-earnings ratio before the issue (based on a stock price of $48)? What will be the price per share immediately after the sale of stock if the P/E stays constant? d. Compute the EPS and the price (P/E stays constant) after the new production facility begins to produce a profit. e. Are the shareholders better off because of the sale of stock and the resultant investment? What other financing strategy could the company have tried to increase earnings per share? Dilution and rates of return (LO15-3) Page 499 19. The Presley Corporation is about to go public. It currently has aftertax earnings of $7,200,000, and 2,100,000 shares are owned by the present stockholders (the Presley family). The new public issue will represent 800,000 new shares. The new shares will be priced to the public at $25 per share, with a 5 percent spread on the offering price. There will also be $260,000 in out-of-pocket costs to the corporation. a. Compute the net proceeds to the Presley Corporation. b. Compute the earnings per share immediately before the stock issue. c. Compute the earnings per share immediately after the stock issue. d. Determine what rate of return must be earned on the net proceeds to the corporation so there will not be a dilution in earnings per share during the year of going public. e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 5 percent increase in earnings per share during the year of going public. Dilution and rates of return (LO15-3) 20. Tyson Iron Works is about to go public. It currently has aftertax earnings of $4,400,000, and 4,200,000 shares are owned by the present stockholders. The new public issue will represent 500,000 new shares. The new shares will be priced to the public at $25 per share with a 3 percent spread on the offering price. There will also be $280,000 in out-of-pocket costs to the corporation. a. Compute the net proceeds to Tyson Iron Works. b. Compute the earnings per share immediately before the stock issue. c. Compute the earnings per share immediately after the stock issue. d. Determine what rate of return must be earned on the net proceeds to the corporation so there will not be a dilution in earnings per share during the year of going public. e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 10 percent increase in earnings per share during the year of going public. Aftermarket for new public issue (LO15-4) 21. I. B. Michaels has a chance to participate in a new public offering by Hi-Tech Micro Computers. His broker informs him that demand for the 700,000 shares to be issued is very strong. His broker’s firm is assigned 25,000 shares in the distribution and will allow Michaels, a relatively good customer, 1.3 percent of its 25,000 share allocation. The initial offering price is $30 per share. There is a strong aftermarket, and the stock goes to $32 one week after issue. The first full month after issue, Mr. Michaels is pleased to observe his shares are selling for $33.50. He is content to place his shares in a lockbox and eventually use their anticipated increased value to help send his son to college many years in the future. However, one year after the distribution, he looks up the shares in The Wall Street Journal and finds they are trading at $28.50. a. Compute the total dollar profit or loss on Mr. Michaels’s shares one week, one month, and one year after the purchase. In each case, compute the profit or loss against the initial purchase price. b. Also compute this percentage gain or loss from the initial $30 price. c. Why might a new public issue be expected to have a strong aftermarket? Leveraged buyout (LO15-5) Page 500 22. The management of Mitchell Labs decided to go private in 2002 by buying in all 2.80 million of its outstanding shares at $24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for $10.75 million, the fiber technology division for $8.45 million, and the synthetic products division for $20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it reentered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share. a. What was the initial cost to Mitchell Labs to go private? b. What is the total value to the company from (1) the proceeds of the divisions that were sold, as well as (2) the current value of the 2.80 million shares (based on current earnings and an anticipated P/E of 15)? c. What is the percentage return to the management of Mitchell Labs from the restructuring? Use answers from parts a and b to determine this value. COMPREHENSIVE PROBLEM Bailey Corporation (Impact of new public offering) (LO15-4) The Bailey Corporation, a manufacturer of medical supplies and equipment, is planning to sell its shares to the general public for the first time. The firm’s investment banker, Robert Merrill and Company, is working with Bailey Corporation in determining a number of items. Information on the Bailey Corporation follows: BAILEY CORPORATIONIncome StatementFor the Year 20X1 Sales (all on credit) $42,680,000 Cost of goods sold 32,240,000 Gross profit $10,440,000 Selling and administrative expenses 4,558,000 Operating profit $ 5,882,000 Interest expense 600,000 Net income before taxes 5,282,000 Taxes 2,120,000 Net income $ 3,162,000 Page 501 BAILEY CORPORATIONBalance SheetAs of December 31, 20X1 Assets Current assets: Cash $      250,000 Marketable securities 130,000 Accounts receivable 6,000,000 Inventory      8,300,000 Total current assets $14,680,000 Net plant and equipment    13,970,000 Total assets $28,650,000 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $   3,800,000 Notes payable      3,550,000 Total current liabilities $  7,350,000 Long-term liabilities     5,620,000 Total liabilities $12,970,000 Stockholders’ equity: Common stock (1,800,000 shares at $1 par) $  1,800,000 Capital in excess of par 6,300,000 Retained earnings     7,580,000 Total stockholders’ equity $15,680,000 Total liabilities and stockholders’ equity $28,650,000 a. Assume that 800,000 new corporate shares will be issued to the general public. What will earnings per share be immediately after the public offering? (Round to two places to the right of the decimal point.) Based on the price-earnings ratio of 12, what will the initial price of the stock be? Use earnings per share after the distribution in the calculation. b. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000, what will net proceeds to the corporation be? c. What return must the corporation earn on the net proceeds to equal the earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet? d. Now assume that, of the initial 800,000 share distribution, 400,000 belong to current stockholders and 400,000 are new shares, and the latter will be added to the 1,800,000 shares currently outstanding. What will earnings per share be immediately after the public offering? What will the initial market price of the stock be? Assume a price-earnings ratio of 12, and use earnings per share after the distribution in the calculation. Page 502 e. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000, what will net proceeds to the corporation be? f. What return must the corporation now earn on the net proceeds to equal earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet? WEB EXERCISE 1. Initial public offerings (IPOs) were covered in the chapter. Let’s take a closer look at two actual issues. Go to For the first two issues under “Latest Pricings,” do the following steps all the way through, one company at a time. Use the menu in the left margin to navigate the IPO. 2. a. Click on and write down the company name. b. Write a short paragraph about what the company does or its products. c. Scroll down and record the date the company went public. d. Write down the actual offer price. e. Write down the offering amount (mil.). f. Record the name of the lead underwriter. Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for.
Assignment Content 1. Top of Form About Your Signature Assignment Harrod’s Sporting Goods Case Study is designed to align with specific program student learning outcome(s) in your program. Program St
17 Common and Preferred Stock Financing LEARNING OBJECTIVES LO 17-1 Common stockholders are the owners of the corporation and therefore have a claim to undistributed income, the right to elect the board of directors, and other privileges. LO 17-2 Cumulative voting provides minority stockholders with the potential for some representation on the board of directors. LO 17-3 A rights offering gives current stockholders a first option to purchase new shares. LO 17-4 Poison pills and other similar provisions may make it difficult for outsiders to take over a corporation against management’s wishes. LO 17-5 Preferred stock is an intermediate type of security that falls somewhere between debt and common stock. The ultimate ownership of the firm resides in common stock, whether it is in the form of all outstanding shares of a closely held corporation or one share of IBM. In terms of legal distinctions, it is the common stockholder alone who directly controls the business. While control of the company is legally in the shareholders’ hands, it is practically wielded by management on an everyday basis. It is also important to realize that a large creditor may exert tremendous pressure on a firm to meet certain standards of financial performance, even though the creditor has no voting power. Small, growing companies often operate at a loss until they reach critical mass. Start-up biotech firms frequently fall in this category along with small technology companies competing with the big guys like Intel and Qualcomm. TowerJazz is one such tech company. TowerJazz is headquartered in Israel with its subsidiary Jazz Semiconductor Inc. located in the United States and its wholly owned subsidiary, TowerJazz Japan, Ltd., in Japan. TowerJazz operates three fabrication facilities in Japan through a joint venture with Panasonic. These companies operate collectively under the brand name TowerJazz and trade on the NASDAQ stock exchange under the ticker symbol TSEM. The company fabricates integrated circuits for more than 200 customers worldwide in industries such as automotive, defense, medical, and aerospace. Their foundries fabricate semiconductors like radio frequency chips used in cell phones. According to S&P Capital IQ, TSEM lost money from 2009 (−$10.65 per share) to 2013 (−$2.72 per share) and finally turned an aftertax profit of $0.07 per share in 2014. In fact 2014 was a breakout year for TowerJazz with record revenues of $828 million, a 64 percent increase over 2013. The ending cash balance on December 31, 2014, was $187 million. TowerJazz would not have gotten to this point in its corporate life without the ability to sell common stock in public markets like NASDAQ. It is very expensive to operate and build foundries, and it takes a critical mass and high utilization rate within the foundries to make money. To get to this point TSEM had to continually sell new stock to finance its operations that were losing money. The company sold 35 million shares in 2008, 39 million shares in 2009, and 66.5 million shares in 2010. Page 544 By 2012 the stock was trading for less than $1. NASDAQ has a rule that a stock cannot stay listed if it continuously trades under $1. If a company can’t get its stock price above $1 within 180 days and keep it there for 30 days, the stock will be delisted; in other words, it can no longer be traded on NASDAQ. By August 2012, shares of TSEM had ballooned from 125 million in 2008 to over 330 million, and the stock price was trading at $0.52. On August 2 TowerJazz had a 1 for 15 reverse split, reducing the number of shares to about 22 million. The share price closed at $9.01 on August 6, the day the reverse split became effective. By March 2015 the stock was trading at more than $16 per share and had hit a high of $18.20 on March 3. We should point out that during 2013, TSEM share count increased by another 25.4 million shares as the company converted some capital notes into stock and warrants and stock options were exercised. Without investors willing to take a risk on companies like TowerJazz, these small companies would not have a chance to mature and become profitable. The ability to sell common stock to balance debt in the capital structure makes the stock markets important to corporations. In this chapter, we will also look closely at preferred stock. Preferred stock plays a secondary role in financing the corporate enterprise. It represents a hybrid security, combining some of the features of debt and common stock. Though preferred stockholders do not have an ownership interest in the firm, they do have a priority of claims to dividends that is superior to that of common stockholders. To understand the rights and characteristics of the different means of financing, we shall examine the powers accorded to shareholders under each arrangement. In the case of common stock, everything revolves around three key rights: the residual claim to income, the voting right, and the right to purchase new shares. We shall examine each of these in detail and then consider the rights of preferred stockholders. Common Stockholders’ Claim to Income All income that is not paid out to creditors or preferred stockholders automatically belongs to common stockholders. Thus we say they have a residual claim to income. This is true regardless of whether these residual funds are actually paid out in dividends or retained in the corporation. A firm that earns $10 million before capital costs and pays $1 million in interest to bondholders and an equal amount in dividends to preferred stockholders will have $8 million available for common stockholders.1 Perhaps half of that will be paid out as common stock dividends. The balance will be reinvested in the business for the benefit of stockholders, with the hope of providing even greater income, dividends, and price appreciation in the future. Of course, it should be pointed out that the common stockholder does not have a legal or enforceable claim to dividends. Whereas a bondholder may force the corporation into bankruptcy for failure to make interest payments, the common stockholder must accept circumstances as they are or attempt to change management if a new dividend policy is desired. Page 545 Occasionally a company will have several classes of common stock outstanding that carry different rights to dividends and income. For example, Google, Facebook, and Ford Motor Company have two separate classes of common stock that differentiate the shares of the founders from other stockholders and grant preferential rights to founders’ shares. Although there are over 90 million common stockholders in the United States, increasingly ownership is being held by large institutional interests, such as pension funds, mutual funds, or bank trust departments, rather than individual investors. As would be expected, management has become more sensitive to these large stockholders who may side with corporate raiders in voting their shares for or against merger offers or takeover attempts (these topics are covered in Chapter 20). Table 17-1 presents a list of major companies with high percentages of common stock owned by institutional investors at the beginning of 2015. ExxonMobil is at the bottom of the list with a 58.99 percent institutional ownership while Motorola Solutions is now 94.33 percent owned by institutions. Large companies are institutional favorites, perhaps because the sheer size of the shares outstanding allows for large trades and a high level of liquidity. Table 17-1   Institutional ownership of U.S. companies Company Name Institutional Ownership (%) Institutional Ownership in Shares Motorola Solutions Inc. 94.33   227,076,675 Lockheed Martin Corp. 94.25   297,440,687 eBay Inc. 94.18 1,139,564,832 Hewlett-Packard Co. 89.84 1,641,841,229 Walmart Stores Inc. 83.05 2,676,952,631 Bristol-Myers Squibb Co. 82.71 1,371,918,018 Kellogg Co. 82.08   291,406,830 Microsoft Corp. 81.13 6,655,712,703 EI du Pont de Nemours & Co. 79.01   715,319,624 3M Co. 78.19   501,079,402 PepsiCo Inc. 78.05 1,168,166,106 Johnson & Johnson 75.77 2,120,764,813 Walt Disney Co. 73.58 1,250,497,713 Apple Inc. 69.67 4,058,010,812 Coca-Cola Co. 69.61 3,048,820,127 Inc. 69.40   322,262,348 Procter & Gamble Co. 68.79 1,857,696,445 International Business Machines Corp. 66.00   653,174,614 General Electric Co. 62.46 6,272,679,212 ExxonMobil Corp. 58.99 2,497,907,990 The Voting Right Page 546 Because common stockholders are the owners of a firm, they are accorded the right to vote in the election of the board of directors and on all other major issues. Common stockholders may cast their ballots as they see fit on a given issue, or assign a proxy, or “power to cast their ballot,” to management or some outside contesting group. As mentioned in the previous section, some corporations have different classes of common stock with unequal voting rights. There is also the issue of “founders’ stock.” Perhaps the Ford Motor Company is the biggest and best example of such stock. Class B shares were used to differentiate between the original founders’ shares and those shares sold to the public. The founders wanted to preserve partial control of the company while at the same time raise new capital for expansion. The regular common stock (no specific class) has one vote per share and is entitled to elect 60 percent of the board of directors, and the Class B shares have one vote per share but are entitled, as a class of shareholders, to elect 40 percent of the board of directors. Class B stock is reserved solely for Ford family members or their descendants, trusts, or appointed interests. The Ford family has a very important position in Henry Ford’s company without owning more than about 3½ percent of the current outstanding stock. Both common and Class B stockowners share in dividends equally, and no stock dividends may be given unless to both common and Class B stockholders in proportion to their ownership. While common stockholders and the different classes of common stock that they own may, at times, have different voting rights, they do have a vote. Bondholders and preferred stockholders may vote only when a violation of their corporate agreement exists and a subsequent acceleration of their rights takes place. For example, Continental Illinois Corporation was on the edge of bankruptcy in 1984, and failed to pay dividends on one series of preferred stock for five quarters from July 1, 1984, to September 30, 1985. The preferred stockholder agreement stated that failure to pay dividends for six consecutive quarters would result in the preferred stockholders being able to elect two directors to the board to represent their interests. Continental Illinois declared a preferred dividend in November 1985 and paid all current and past dividends on the preferred stock, thus avoiding the special voting privileges for preferred stockholders. In 1994, Continental was bought by Bank of America. Cumulative Voting The most important voting matter is the election of the board of directors. As indicated in Chapter 1, the board has primary responsibility for the stewardship of the corporation. If illegal or imprudent decisions are made, the board can be held legally accountable. Furthermore, members of the board of directors normally serve on a number of important subcommittees of the corporation, such as the audit committee, the long-range financial planning committee, and the salary and compensation committee. The board may be elected through the familiar majority rule system or by cumulative voting. Under majority voting, any group of stockholders owning over 50 percent of the common stock may elect all of the directors. Under cumulative voting, it is possible for those who hold less than a 50 percent interest to elect some of the directors. The provision for some minority interests on the board is important to those who, at times, wish to challenge the prerogatives of management. The type of voting has become more important to stockholders and management with the threat of takeovers, leveraged buyouts, and other challenges to management’s control of the firm. In many cases, large minority stockholders, seeking a voice in the operations and direction of the company, desire seats on the board of directors. To further their goals, several have gotten stockholders to vote on the issue of cumulative voting at the annual meeting. Page 547 How does this cumulative voting process work? A stockholder gets one vote for each share of stock he or she owns, times one vote for each director to be elected. The stockholder may then accumulate votes in favor of a specified number of directors. Assume there are 10,000 shares outstanding, you own 1,001, and nine directors are to be elected. Your total votes under a cumulative election system are: Number of shares owned 1,001 Number of directors to be elected       9 Number of votes 9,009 Let us assume you cast all your votes for the one director of your choice. With nine directors to be elected, there is no way for the owners of the remaining shares to exclude you from electing a person to one of the top nine positions. If you own 1,001 shares, the majority interest could control a maximum of 8,999 shares. This would entitle them to 80,991 votes. Number of shares owned (majority)   8,999 Number of directors to be elected         9 Number of votes (majority) 80,991 These 80,991 votes cannot be spread thinly enough over nine candidates to stop you from electing your one director. If they are spread evenly, each of the majority’s nine choices will receive 8,999 votes (80,991/9). Your choice is assured 9,009 votes as previously indicated. Because the nine top vote-getters win, you will claim one position. Note that candidates do not run head-on against each other (such as Place A or Place B on the ballot), but rather that the top nine candidates are accorded directorships. To determine the number of shares needed to elect a given number of directors under cumulative voting, the following formula is used: The formula reaffirms that in the previous instance, 1,001 shares would elect one director. If three director positions out of nine are desired, 3,001 shares are necessary. Note that, with approximately 30 percent of the shares outstanding, a minority interest can control one-third of the board. If instead of cumulative voting a majority rule system were utilized, a minority interest could elect no one. The group that controlled 5,001 or more shares out of 10,000 would elect every director. Page 548 Finance in ACTION Managerial Morningstar Raises Hewlett-Packard’s Stewardship Rating from “Poor” to “Standard” Morningstar is a financial advisory service headquartered in Chicago and a company that provides stock and mutual fund ratings on thousands of companies. The following paragraph from their service defines their definition of “stewardship grades”: Our corporate Stewardship Rating represents our assessment of management’s stewardship of shareholder capital, with particular emphasis on capital allocation decisions. Analysts consider companies’ investment strategy and valuation, financial leverage, dividend and share buyback policies, execution, compensation, related party transactions, and accounting practices. Corporate governance practices are only considered if they’ve had a demonstrated impact on shareholder value. Analysts assign one of three ratings: “Exemplary,” “Standard,” and “Poor.” Analysts judge stewardship from an equity holder’s perspective. Ratings are determined on an absolute basis. Most companies will receive a Standard rating, and this is the default rating in the absence of evidence that managers have made exceptionally strong or poor capital allocation decisions. With this in mind, let’s explore some of the facts surrounding Morningstar’s “poor” rating for Hewlett-Packard (HP). Corporate boards may appear to be removed from the everyday workings of a corporation with the press focusing on the chief executive officer (CEO) as the main driver of a company’s success. However, corporate boards play a vital role in representing the owners of the corporation and are elected by the shareholders. Perhaps the most important job is choosing a new CEO. This is one area where HP seems to have failed too many times. Board members also deal with high-level decisions, which can be anything from choosing the auditor to evaluating large acquisitions and mergers or a new business line. They are supposed to act as an independent check on management, ensuring that corporate executives keep the interests of the shareholders in mind. Page 549 After several scandals involving corporate governance in the early 2000s, emphasis has been focused on boards and good corporate governance practices. Important criteria are emphasized, such as the number of executives on the board relative to independent board members. Many advocates for independent boards of directors push for the separation of the chairman of the board and CEO roles. HP has tried both models and still has had trouble making good decisions. Investors will discount a company’s share price if the board is perceived as anything less than competent or independent. Consistent turnover of both executives and board members is viewed as a sign of instability and lack of leadership. HP has generally been viewed as suffering from bad stewardship over the past decade. Several scandals involving management have been blamed on the hiring decisions and conduct of HP’s board members. In 2005, Carly Fiorina was asked to resign by the board and walked away with $42.6 million in severance pay and stock grants. In 2006, HP’s non-executive chairman Patricia Dunn was removed after she hired private investigators to illegally obtain phone records of board members. She was replaced as chairman by Mark Hurd, the CEO at that time. But in 2009, Mark Hurd was forced to step down as CEO after a scandal involving falsified expense reports and a sexual harassment claim by a former contractor. Leo Apotheker, the former CEO of SAP, replaced Hurd only to be removed 11 months later due to conflicts with the board over HP’s long-term strategy. He walked away with $25 million in severance and stock grants. The last three CEOs and chairmen who have been terminated or resigned under pressure have received over $83 million in severance and stock grants. This has not gone over well with stockholders. Another area where the board has been faulted has been Hewlett-Packard’s consistent mismanagement of its merger and acquisition activity. HP’s board has a history of approving inflated purchase prices for acquisitions such as Compaq Computer, Electronic Data Systems, and Palm. In August 2011, during Leo Apotheker’s stint as chairman and CEO, the board approved a $10 billion purchase of Autonomy Corp. plc. A little over a year later, HP recorded an $8.8 billion non-cash expense against earnings to write down goodwill and intangibles. This write-off was mostly related to the Autonomy purchase and accounting irregularities that were not discovered during the acquisition process. These and other factors have led to a high degree of board turnover, with 7 of its 12 directors being replaced or resigning in 2011 under the new CEO and chairman Meg Whitman, who was previously responsible for running eBay quite successfully. She has succeeded in improving the corporate governance and decision making process at HP, and this accounts for Morningstar’s improved rating. All of this activity has not been lost on shareholders. HP’s share price hit a high of $54.75 in April of 2010 and fell to a low of $11.35 in November of 2012 for a loss of 79 percent. With Whitman in charge, the stock price hit a high of $40 in early January 2015. Sources: “Morningstar Equity Analyst Report,” Morningstar, May 21, 2015. Standard & Poor’s Stock Report, February 3, 2013, pp.1–10. As a restatement of the problem: If we know the number of minority shares outstanding under cumulative voting and wish to determine the number of directors that can be elected, we use this formula: Plugging 3,001 shares into the formula, we show: If the formula yields an uneven number of directors, such as 3.3 or 3.8, you always round down to the nearest whole number (i.e., 3). It is not surprising that 22 states require cumulative voting in preference to majority rule, that 18 consider it permissible as part of the corporate charter, and that only 10 make no provision for its use. Such consumer-oriented states as California, Illinois, and Michigan require cumulative voting procedures. Delaware does not require cumulative voting and is viewed as having a legal system that is lenient on corporations; it should come as no surprise that many companies are legally registered in the State of Delaware. The Right to Purchase New Shares Page 550 In addition to a claim to residual income and the right to vote for directors, the common stockholders may also enjoy a privileged position in the offering of new securities. If the corporate charter contains a preemptive right provision, holders of common stock must be given the first option to purchase new shares. While only two states specifically require the use of preemptive rights, most other states allow for the inclusion of a rights offering in the corporation charter. The preemptive right provision ensures that management cannot subvert the position of present stockholders by selling shares to outside interests without first offering them to current shareholders. If such protection were not afforded, a 20 percent stockholder might find his or her interest reduced to 10 percent through the distribution of new shares to outsiders. Not only would voting rights be diluted, but proportionate claims to earnings per share would be reduced. The Use of Rights in Financing Many corporations also engage in a preemptive rights offering to tap a built-in market for new securities—the current investors. Rights offerings are not only used by many U.S. companies, but are especially popular as a fund-raising method in Europe. It is quite common in European markets for companies to ask their existing shareholders to help finance expansion. For example, Telephon A.B. Ericsson, a Swedish company, had a $3 billion rights offering in August 2002 to raise new funds. The collapse of the Internet bubble in 2000 caused a huge decline in sales and earnings, and Ericsson was in need of new capital. What better place to look for equity capital than the existing stockholders. If they already believe in the company and own shares, they might be willing to ante up more money to keep the company alive. This also happened in 2009 in the banking crisis. Many banks were short of their required capital requirements and needed new infusions of equity capital. The American banks relied mostly on secondary offerings available to anyone while the European banks relied on rights offerings. In Table 17-2, we feature three European banks that raised a total of $56.7 billion of new equity through rights offerings. Also included are smaller rights offerings from Sweden, Singapore, Spain, and the United States. Most rights offerings are successful in getting shareholders to exercise their rights to buy new shares. When all the shares are not exercised by shareholders, the investment banker in charge of the offering exercises the rest and sells them in the open market. Additionally, the number of shares a shareholder can buy is conditional on the number of shares he or she owns, and there is a ratio of new shares to shares already owned. This is shown in the table in the fourth column of Table 17-2, and one can see that there is no standard ratio. In the Royal Bank of Scotland rights offering, for every 18 shares a stockholder owned, he or she could buy 11 new shares, while for Banco Popular Español SA, a shareholder could buy 1 new share for every 3 shares owned. Usually the investment banker in charge of the rights offering will price the new shares at a discount to the price of the existing shares. The price of the new shares is stated on the announcement day, and the underpricing is expressed as the offering price of the new shares compared to the market price of the shares traded on the market on the day of the announcement. The more the shares are underpriced, the more likely it is that the rights will be exercised. The underpricing is shown in column five. Page 551 To illustrate the use of rights, let’s take a look at a hypothetical company, Watson Corporation, which has 9 million shares outstanding and a current market price of $40 per share (the total market value is $360 million). Watson needs to raise $30 million for new plant and equipment and will sell 1 million new shares at $30 per share.2 As part of the process, it will use a rights offering in which each old shareholder receives a first option to participate in the purchase of new shares. Table 17-2   Rights offerings big and small Sources: Bloomberg, Globe Newswire, PR Newswire,, Morningstar, Standard & Poor’s, and corporate websites. Each old shareholder will receive one right for each share of stock owned and may combine a specified number of rights plus $30 cash to buy a new share of stock. Let us consider these questions: 1. How many rights should be necessary to purchase one new share of stock? 2. What is the monetary value of these rights? Rights Required Since 9 million shares are currently outstanding and 1 million new shares will be issued, the ratio of old to new shares is 9 to 1. On this basis, the old stockholder may combine nine rights plus $30 cash to purchase one new share of stock. A stockholder with 90 shares of stock would receive an equivalent number of rights, which could be applied to the purchase of 10 shares of stock at $30 per share. As indicated later in the discussion, stockholders may choose to sell their rights, rather than exercise them in the purchase of new shares. Monetary Value of a Right Anything that contributes toward the privilege of purchasing a considerably higher priced stock for $30 per share must have some market value. Consider the following two-step analysis. Page 552 Nine old shares sold at $40 per share, or for $360; now one new share will be introduced for $30. Thus we have a total market value of $390 spread over 10 shares. After the rights offering has been completed, the average value of a share is theoretically equal to $39.3 Nine old shares sold at $40 per share $360 One new share will sell at $30 per share   30 Total value of 10 shares $390 Average value of one share $  39 The rights offering thus entitles the holder to buy a stock that should carry a value of $39 (after the transactions have been completed) for $30. With a differential between the anticipated price and the subscription price of $9 ($39 − $30) and nine rights required to participate in the purchase of one share, the value of a right in this case is $1. Average value of one share $39 Subscription price   30 Differential $  9 Rights required to buy one share Value of a right $  1 Formulas have been developed to determine the value of a right under any circumstance. Before they are presented, let us examine two new terms that will be part of the calculations—rights-on and ex-rights. 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 a future purchase of the stock. After a certain period (say four weeks), the stock goes ex-rights—when you buy the stock, you no longer get a right toward the future purchase of stock. Consider the following: Once the ex-rights period is reached, the stock will go down by the theoretical value of the right. The remaining value ($39) is the ex-rights value. Though there is a time period remaining between the ex-rights date (April 1) and the end of the subscription period (April 30), the market assumes the dilution has already occurred. Thus the ex-rights value reflects the same value as can be expected when the new, underpriced $30 stock issue is sold. In effect, it projects the future impact of the cheaper shares on the stock price. The formula for the value of the right when the stock is trading rights-on is: Page 553 where M0 = Market value—rights-on, $40 S = Subscription price, $30 N = Number of rights required to purchase a new share of stock; in this case, 9 Using Formula 17-3 we determined that the value of a right in the Watson Corporation offering was $1. An alternative formula giving precisely the same answer is: The only new term is Me, the market value of the stock when the shares are trading ex-rights. It is $39. We show: These are all theoretical relationships, which may be altered somewhat in reality. If there is great enthusiasm for the new issue, the market value of the right may exceed the initial theoretical value (perhaps the right will trade for 1.375). Effect of Rights on Stockholder’s Position At first glance, a rights offering appears to bring great benefits to stockholders. But is this really the case? Does a shareholder really benefit from being able to buy a stock that is initially $40 (and later $39) for $30? Don’t answer too quickly! Think of it this way: Assume 100 people own shares of stock in a corporation and one day decide to sell new shares to themselves at 25 percent below current value. They cannot really enhance their wealth by selling their own stock more cheaply to themselves. What is gained by purchasing inexpensive new shares is lost by diluting existing outstanding shares. Take the case of Stockholder A, who owns nine shares before the rights offering and also has $30 in cash. His holdings would appear as follows: Nine old shares at $40 $360 Cash    30  Total value $390 If he receives and exercises nine rights to buy one new share at $30, his portfolio will contain: Ten shares at $39 (diluted value) $390 Cash      0  Total value $390 Page 554 Clearly he is no better off. A second alternative would be for him to sell his rights in the market and stay with his position of owning only nine shares and holding cash. The outcome is: Nine shares at $39 (diluted value) $351 Proceeds from sale of nine rights Cash    30  Total value $390 As indicated previously, whether he chooses to exercise his rights or not, the stock will still go down to a lower value (others are still diluting). Once again, his overall value remains constant. The total value received for the rights ($9) exactly equals the extent of dilution in the value of the original nine shares. The only foolish action would be for the stockholder to regard the rights as worthless securities. He would then suffer the pains of dilution without the offset from the sale of the rights. Nine shares at $39 (diluted value) $351 Cash    30  Total value $381 Empirical evidence indicates this careless activity occurs 2 to 3 percent of the time. Desirable Features of Rights Offerings You may ask, If the stockholder is no better off in terms of total valuation, why undertake a rights offering? There are a number of possible advantages. As previously indicated, by giving current stockholders a first option to purchase new shares, the firm protects the stockholders’ current position in regard to voting rights and claims to earnings. Of equal importance, the use of a rights offering gives the firm a built-in market for new security issues. Because of this built-in base, distribution costs are likely to be lower than under a straight public issue in which investment bankers must underwrite the full risk of distribution.4 Also, a rights offering may generate more interest in the market than would a straight public issue. There is a market not only for the stock but also for the rights. Because the subscription price is normally set 15 to 25 percent below current value, there is the “nonreal” appearance of a bargain, creating further interest in the offering. A last advantage of a rights offering over a straight stock issue is that stock purchased through a rights offering carries lower margin requirements. The margin requirement specifies the amount of cash or equity that must be deposited with a brokerage house or a bank, with the balance of funds eligible for borrowing. Though not all investors wish to purchase on margin, those who do so prefer to put down a minimum amount. While normal stock purchases may require a 50 percent margin (half cash, half borrowed), stock purchased under a rights offering may be bought with as little as 25 percent down, depending on the current requirements of the Federal Reserve Board. Page 555 HSBC Holdings Plc. Rights Offering Finance in ACTION Global HSBC Holdings Plc. is Europe’s biggest bank with a worldwide presence. It is also known as Hong Kong Shanghai Banking Corporation, and while it was originally focused in Asia, now Europe accounts for over 50 percent of its assets, Hong Kong and Asia Pacific about 25 percent, and North America 20 percent, with Latin America about 5 percent. The credit crisis of 2007–2009 put tremendous pressure on HSBC’s capital ratios. HSBC had set aside loan loss reserves of $53 billion during 2007–2009 to cover investments in U.S. subprime debt and direct exposure to loans packaged into securitized financings, but it needed more equity capital. European banks like the U.S. banks found it difficult to sell their high-risk assets, and many like HSBC, Royal Bank of Scotland, UBS of Switzerland, Bank America, Citibank, and others were forced to either write down their assets or sell them at fire-sale prices. This caused their capital ratios to shrink below the required limit of 6 percent. The solution was to find equity capital in the form of common stock and preferred stock. Common stock was high-risk equity without a guaranteed dividend and was considered tier 1 capital, while preferred stock was considered tier 2 capital. Total capital had to equal a minimum of 6 percent with tier 1 capital (common stock and common shareholder equity) equaling a minimum of 4 percent. Most banks and investors wanted ratios well above 6 percent in the uncertain economy with more potential losses from bank loans and investments looming on the horizon. In the United States, the U.S. government bought several hundred billion dollars of preferred stock in many banks to bolster their capital, and banks like Bank of America, Citigroup, and others also sold common stock through secondary offerings. As Table 17-2 shows, in Europe, banks used rights offerings to raise capital. HSBC did not want to borrow from the British Government, so on March 2, 2009, it announced a rights offering intended to raise approximately $17.7 billion dollars through the sale of 5.06 billion shares of common stock. The rights offering was successful, and 97 percent of the shares were sold to existing stockholders with the investment bankers exercising the 3 percent that was left over. Before the rights offering, HSBC’s tier 1 capital ratio was 8.3 percent; after the rights offering, the ratio jumped to 9.8 percent, which was at the upper end of the 7.5 to 10.0 percent target HSBC liked to maintain. The big question after the offering was “Did they raise enough capital?” With continued losses expected over the next several years, was this new infusion of equity enough to cover future loan losses, or would earnings from operations be enough to cover any future losses? What did the market think about this? HSBS trades in the United States as an ADR (American Depository Receipt). When the bank announced the offering on March 2, 2009, the price of its ADR in the United States was $28.25, and by November 2009 the stock had more than doubled to $64.42. This would indicate that the market thought their rights offering and very high capital ratio had minimized the risk from future losses. The stock price drifted down to $35.75 in 2011 and recovered to $54 per share by June of 2013. You might want to check on the stock price to see how HSBC is doing. The ticker symbol is HBC. Poison Pills Page 556 During the last two decades, a new wrinkle was added to the meaning of rights when firms began receiving merger and acquisition proposals from companies interested in acquiring voting control of the firm. The management of many firms did not want to give up control of the company, and so they devised a method of making the firm very unattractive to a potential acquisition-minded company. As you can tell from our discussion of voting provisions, for a company using majority voting, a corporate raider needs to control only slightly over 50 percent of the voting shares to exercise total control. Management of companies considered potential takeover targets began to develop defensive tactics in fending off these unwanted takeovers. One widely used strategy is called the poison pill. A poison pill may be a rights offer made to existing shareholders of Company X with the sole purpose of making it more difficult for another firm to acquire Company X. Most poison pills have a trigger point. When a potential buyer accumulates a given percentage of the common stock (for example, 25 percent), the other shareholders may receive rights to purchase additional shares from the company, generally at very low prices. If the rights are exercised by shareholders, this increases the total shares outstanding and dilutes the potential buyer’s ownership percentage. Poison pill strategies often do not have to be voted on by shareholders to be put into place. At International Paper Company, however, the poison pill issue was put on the proxy ballot and 76 percent of the voting shareholders sided with management to maintain the poison pill defense. This was surprising because many institutional investors are opposed to the pill. They believe it lowers the potential for maximizing shareholder value by discouraging potential high takeover bids. American Depository Receipts American Depository Receipts (ADRs) are certificates that have a legal claim on an ownership interest in a foreign company’s common stock. The shares of the foreign company are purchased and put in trust in a foreign branch of a major U.S. bank. The bank, in turn, receives and can issue depository receipts to the American shareholders of the foreign firm. These ADRs (depository receipts) allow foreign shares to be traded in the United States much like common stock. ADRs have been around for a long time and are sometimes referred to as American Depository Shares (ADS). Since foreign companies want to tap into the world’s largest capital market, the United States, they need to offer securities for sale in the United States that can be traded by investors and have the same liquidity features as U.S. securities. ADRs imitate common stock traded on the New York Stock Exchange. Foreign companies such as HSBC Holdings (English), Nestlé (Swiss), Heineken (Dutch), and Sony (Japanese) that have common stock trading on their home exchanges in London, Zurich, Amsterdam, and Tokyo also issue ADRs in the United States. An American investor (or any foreign investor) can buy American Depository Shares of foreign companies from around the world on the New York Stock Exchange, the NASDAQ Stock Market, or the American Stock Exchange. Table 17-3 shows the American Depository Shares (Receipts) for nine regions in March 2015. The table includes Global Depository Receipts (GDRs), which are patterned after ADRs but can be issued by international companies and traded globally rather than just on U.S. markets. Page 557 There are many advantages to American Depository Shares for the U.S. investor. The annual reports and financial statements are presented in English according to generally accepted accounting principles. Dividends are paid in dollars and are more easily collected than if the actual shares of the foreign stock were owned. Although ADRs are considered to be more liquid, less expensive, and easier to trade than buying foreign companies’ stock directly on that firm’s home exchange, there are some drawbacks. Table 17-3   Foreign company listings on U.S. exchanges and over-the-counter—American and global depository receipts Region or Country Total Australia & New Zealand 265 Central and Eastern Europe 348 Continental Europe 700 Latin America 272 Middle East/n. Africa/the Gulf 147 North Asia 988 South Asia 509 Sub-Saharan Africa 124 United Kingdom & Ireland  372 Total 3725 Source:, March 11, 2015 Even though the ADRs are traded in the U.S. market in dollars, they are still traded in their own countries in their local currencies. This means that the investor in ADRs is subject to a foreign currency risk if the exchange rates between the two countries change. Also, most foreign companies do not report their financial results as often as U.S. companies. Furthermore, there is an information lag as foreign companies need to translate their reports into English. By the time the reports are translated, some of the information has already been absorbed in the local markets and by international traders. Preferred Stock Financing Having discussed bonds in Chapter 16 and common stock in this chapter, we are prepared to look at an intermediate or hybrid form of security known as preferred stock. You may question the validity of the term preferred, for preferred stock does not possess any of the most desirable characteristics of debt or common stock. In the case of debt, bondholders have a contractual claim against the corporation for the payment of interest and may throw the corporation into bankruptcy if payment is not forthcoming. Common stockholders are the owners of the firm and have a residual claim to all income not paid out to others. Preferred stockholders are merely entitled to receive a stipulated dividend and, generally, must receive the dividend before the payment of dividends to common stockholders. However, their right to annual dividends is not mandatory for the corporation, as is true of interest on debt, and the corporation may forgo preferred dividends when this is deemed necessary. Page 558 For example, XYZ Corporation might issue 7 percent preferred stock with a $100 par value. Under normal circumstances, the corporation would pay the $7 per share dividend. Let us also assume it has $1,000 bonds carrying 6.8 percent interest and shares of common stock with a market value of $50, normally paying a $1 cash dividend. The 6.8 percent interest must be paid on the bonds. The $7 preferred dividend has to be paid before the $1 dividend on common stock, but both may be waived without threat of bankruptcy. The common stockholder is the last in line to receive payment, but the common stockholder’s potential participation is unlimited. Instead of getting a $1 dividend, the investor may someday receive many times that much in dividends and also capital appreciation in stock value. Justification for Preferred Stock Because preferred stock has few unique characteristics, why might the corporation issue it and, equally important, why are investors willing to purchase the security? 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. Even here, there may be a drawback. While interest payments on debt are tax-deductible, preferred stock dividends are not. Thus the interest cost on 6.8 percent debt may be only 4.5 to 5 percent on an aftertax cost basis, while the aftertax cost on 7 percent preferred stock would be the stated amount. A firm issuing the preferred stock may be willing to pay the higher aftertax cost to assure investors it has a balanced capital structure, and because preferred stock may have a positive effect on the costs of the other sources of funds in the capital structure. Investor Interest Primary purchasers of preferred stock are corporate investors, insurance companies, and pension funds. To the corporate investor, preferred stock offers a very attractive advantage over bonds. The tax law provides that any corporation that receives either preferred or common dividends from another corporation must add only 30 percent of such dividends to its taxable income. Thus 70 percent of such dividends are exempt from taxation. On a preferred stock issue paying a 7 percent dividend, only 30 percent would be taxable. By contrast, all the interest of bonds is taxable to the recipient except for municipal bond interest. Assume a bond is paying 5.61 percent interest in 2014. Since interest on bonds receives no preferential tax treatment for the corporate investor, the aftertax bond yield must be adjusted by the investing corporation’s marginal tax rate. In this example, we shall use a tax rate of 35 percent. Aftertax bond yield = Before-tax bond yield × (1 − Tax rate) 5.61% (1 − 0.35) 3.65% The corporate bondholder will receive 3.65 percent as an aftertax yield. Page 559 Now let’s look at preferred stock, which was paying 4.25 percent in 2014. For preferred stock, the adjustment includes the advantageous 30 percent tax provision. Also under current tax laws, the tax rate on dividends is only 15 percent. The computation for aftertax return for preferred stock is as follows: Aftertax preferred yield = Before-tax preferred stock yield × [1 − (Tax rate)(0.30)] 4.25% × [1 − (0.15)(0.30)] 4.25% × (1 − 0.045) 4.25% × (0.955) 4.06% The aftertax yield on preferred stock is clearly higher than the aftertax bond yield (4.06 percent versus 3.65 percent) due to the higher initial yield and the tax advantages. Summary of Tax Considerations Tax considerations for preferred stock work in two opposite directions. First, they make the aftertax cost of debt cheaper than preferred stock to the issuing corporation because interest is deductible to the payer. Second, tax considerations generally make the receipt of preferred dividends more valuable than corporate bond interest to corporate investors because 70 percent of the dividend is exempt from taxation. Provisions Associated with Preferred Stock A preferred stock issue contains a number of stipulations and provisions that define the stockholder’s claim to income and assets. 1. Cumulative Dividends Most issues represent cumulative preferred stock and have a cumulative claim to dividends. That is, 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. If preferred stock carries a $10 cash dividend and the company does not pay dividends for three years, preferred stockholders must receive the full $30 before common stockholders can receive anything. The cumulative dividend feature makes a corporation very aware of its obligation to preferred stockholders. When a financially troubled corporation has missed a number of dividend payments under a cumulative arrangement, there may be a financial recapitalization of the corporation in which preferred stockholders receive new securities in place of the dividend that is in arrears (unpaid). Assume the corporation has now missed five years of dividends under a $10-a-year obligation and the company still remains in a poor cash position. Preferred stockholders may be offered $50 or more in new common stock or bonds as forgiveness of the missed dividend payments. Preferred stockholders may be willing to cooperate in order to receive some potential benefit for the future. Page 560 2. Conversion Feature Like certain forms of debt, preferred stock may be convertible into common shares. Thus $100 in preferred stock may be convertible into a specified number of shares of common stock at the option of the holder. One new wrinkle on convertible preferreds is the use of convertible exchangeable preferreds that allow the company to force conversion from convertible preferred stock into convertible debt. This can be used to allow the company to take advantage of falling interest rates or to allow the company to change preferred dividends into tax-deductible interest payments when it is to the company’s advantage to do so. The topic of convertibility is discussed at length in Chapter 19, “Convertibles, Warrants, and Derivatives.” 3. Call Feature Also, preferred stock, like debt, may be callable; that is, the corporation may retire the security before maturity at some small premium over par. This, of course, accrues to the advantage of the corporation and to the disadvantage of the preferred stockholder. A preferred issue carrying a call provision will be accorded a slightly higher yield than a similar issue without this feature. The same type of refunding decision applied to debt obligations in Chapter 16 could also be applied to preferred stock. 4. Participation Provision A small percentage of preferred stock issues are participating preferreds; that is, they may participate over and above the quoted yield when the corporation is enjoying a particularly good year. Once the common stock dividend equals the preferred stock dividend, the two classes of securities may share equally in additional payouts. 5. Floating Rate Beginning in the 1980s, some preferred stock issuers made the dividend adjustable in nature, and this stock is classified as floating rate preferred stock. Typically the dividend is changed on a quarterly basis, based on current market conditions. Because the dividend rate changes only quarterly, there is still some possibility of a small price change between dividend adjustment dates. Nevertheless, it is less than the price change for regular preferred stock. Investors that participate in floating rate preferred stock do so for two reasons: to minimize the risk of price changes and to take advantage of potential tax benefits associated with preferred stock corporate ownership. The price stability actually makes floating rate preferred stock the equivalent of a safe short-term investment even though preferred stock is normally thought of as long term in nature. 6. Auction Rate Preferred Stock Auction rate preferred stock is sometimes referred to as Dutch auction preferred stock, and is similar to floating rate preferred stock. Though it is actually a long-term security, it behaves like a short-term one. The auction rate preferred dividend is reset through a periodic auction that keeps the dividend yield consistent with current market conditions. The auction periods vary for each issue and can be 7, 14, 28, 49, or 91 days with some issues being reset semiannually or annually. The concept of a Dutch auction means the stock is issued to the bidder willing to accept the lowest yield and then to the next lowest bidder, and so on until all the preferred stock is sold. This is much like the Treasury bill auction held by the U.S. Treasury on a regular basis. This auction process at short-term intervals allows investors to keep up with the changing interest rates in the short-term market. Some corporate investors prefer to buy Dutch auction preferred stock because it allows them to invest at short-term rates and take advantage of the tax benefits available to them with preferred stock investments. Page 561 This type of security works well as long as there are participants at the auction willing to bid on the securities. If there are no bidders, the rate stays the same, and investors are stuck with the return until another auction can be held. One of the consequences of the financial crisis was that the auction rate securities market dried up on February 7, 2008. The auction rate market froze as large institutional investors such as Citigroup, Morgan Stanley, and Merrill Lynch failed to bid. These banks couldn’t afford to take risks on buying assets that could become illiquid, and by not bidding they created an illiquid market that many short-term investors depended upon for liquidity. This problem continued throughout 2008 and into 2009 as investors were stuck holding assets that could not be sold. Several lawsuits were filed by states, municipalities, pension funds, and by the Securities and Exchange Commission. Eventually many institutions agreed to buy back or redeem the securities at par. For all practical purposes, this market is frozen for now; maybe over time with new protections, it might recover. 7. Par Value A final important feature associated with preferred stock is par value. Unlike the par value of common stock, which is often only a small percentage of the actual value, the par value of preferred stock is set at the anticipated market value at the time of issue. The par value establishes the amount due to preferred stockholders in the event of liquidation. Also, the par value of preferred stock determines the base against which the percentage or dollar return on preferred stock is computed. Thus 10 percent preferred stock would indicate $10 a year in preferred dividends if the par value were $100, but only $5 annually if the par value were $50. Comparing Features of Common and Preferred Stock and Debt In Table 17-4, we compare the characteristics of common stock, preferred stock, and bonds. You should consider the comparative advantages and disadvantages of each. In terms of the risk-return features of these three classes of securities and also of the other investments discussed earlier in Chapter 7, we might expect the risk-return patterns depicted in Figure 17-1. The lowest return is obtained from savings accounts, and the highest return and risk are generally associated with common stock. In between, we note that short-term instruments generally, though not always, provide lower returns than longer-term instruments. We also observe that government securities pay lower returns than issues originated by corporations because of the lower risk involved. Next on the scale after government issues is preferred stock. This hybrid form of security may pay a lower return than even well-secured corporate debt instruments because of the 70 percent tax-exempt status of preferred stock dividends to corporate purchasers. Thus the focus of preferred stock is not just on risk-return trade-offs but also on aftertax return.5 Next we observe increasingly high return requirements on debt, based on the presence or absence of security provisions and the priority of claims on unsecured debt. At the top of the scale is common stock. Because of its lowest priority of claim in the corporation and its volatile price movement, it has the highest demanded return. Though extensive research has tended to validate these general patterns, short-term or even intermediate-term reversals have occurred, in which investments with lower risk have outperformed investments at the higher end of the risk scale. Page 562 Table 17-4   Features of alternative security issues Figure 17-1   Risk and expected return for various security classes Page 563 SUMMARY Common stock ownership carries three primary rights or privileges. First, there is a residual claim to income. All funds not paid out to other classes of securities automatically belong to the common stockholder; the firm may then choose to pay out these residual funds in dividends or to reinvest them for the benefit of common stockholders. Because common stockholders are the ultimate owners of the firm, they alone have the privilege of voting. To expand the role of minority stockholders, many corporations use a system of cumulative voting, in which each stockholder has voting power equal to the number of shares owned times the number of directors to be elected. By cumulating votes for a small number of selected directors, minority stockholders are able to have representation on the board. Common stockholders may also enjoy a first option to purchase new shares. This privilege is extended through the procedure known as a rights offering. A shareholder receives one right for each share of stock owned and may combine a certain number of rights, plus cash, to purchase a new share. While the cash or subscription price is usually somewhat below the current market price, the stockholder neither gains nor loses through the process. A poison pill represents a rights offer made to existing shareholders of a company with the sole purpose of making it more difficult for another firm or outsiders to take over a firm against management’s wishes. Most poison pills have a trigger point tied to the percentage ownership in the company that is acquired by the potential suitor. Once the trigger point is reached, the other shareholders (the existing shareholders) have the right to buy many additional shares of company stock at low prices. This automatically increases the total number of shares outstanding and reduces the voting power of the firm wishing to acquire the company. A hybrid, or intermediate, security, falling between debt and common stock, is preferred stock. Preferred stockholders are entitled to receive a stipulated dividend and must receive this dividend before any payment is made to common stockholders. Preferred dividends usually accumulate if they are not paid in a given year, though preferred stockholders cannot initiate bankruptcy proceedings or seek legal redress if nonpayment occurs. Finally, common stock, preferred stock, bonds, and other securities tend to receive returns over the long run in accordance with risk, with corporate issues generally paying a higher return than government securities. REVIEW OF FORMULAS 1.  2.  Page 564 3.  R is the value of a right M0 is the market value of the stock—rights-on (stock carries a right) S is the subscription price N is the number of rights required to purchase a new share of stock 4.  R is the value of a right Me is the market value of stock—ex-rights (stock no longer carries a right) S is the subscription price N is the number of rights required to purchase a new share of stock LIST OF TERMS common stock 543 residual claim to income 544 proxy 545 founders’ shares 546 majority voting 546 cumulative voting 546 preemptive right 549 rights offering 550 rights-on 552 ex-rights 552 margin requirement 554 poison pill 556 American Depository Receipts 556 preferred stock 557 cumulative preferred stock 559 convertible exchangeable preferreds 559 participating preferreds 560 floating rate preferred stock 560 auction rate preferred stock 560 DISCUSSION QUESTIONS 1. Why has corporate management become increasingly sensitive to the desires of large institutional investors? (LO17-1) 2. Why might a corporation use a special category such as founders’ stock in issuing common stock? (LO17-1) 3. What is the purpose of cumulative voting? Are there any disadvantages to management? (LO17-2) 4. How does the preemptive right protect stockholders from dilution? (LO17-3) 5. If common stockholders are the owners of the company, why do they have the last claim on assets and a residual claim on income? (LO17-1) 6. 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. (LO17-3) 7. Why might management use a poison pill strategy? (LO17-4) 8. Preferred stock is often referred to as a hybrid security. What is meant by this term as applied to preferred stock? (LO17-5) Page 565 9. What is the most likely explanation for the use of preferred stock from a corporate viewpoint? (LO17-5) 10. Why is the cumulative feature of preferred stock particularly important to preferred stockholders? (LO17-2) 11. A small amount of preferred stock is participating. What would your reaction be if someone said common stock is also participating? (LO17-4) 12. What is an advantage of floating rate preferred stock for the risk-averse investor? (LO17-4) 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. (LO17-1 & 17-5) PRACTICE PROBLEMS AND SOLUTIONS Cumulative voting (LO17-2) 1. a. George Kelly wishes to elect 5 of the 13 directors on the Data Processing Corp. board. There are 98,000 shares of the company’s stock outstanding. How many shares will be required to accomplish this goal? b. Jennifer Wallace owns 60,001 shares of stock in the Newcastle Corp. There are 12 directors to be elected with 195,000 shares outstanding. How many directors can Jennifer elect? Rights offering (LO17-3) 2. Dunn Resources has issued rights to its shareholders. The subscription price is $60. Four rights are needed along with the subscription price of $60 to buy one new share. The stock is selling for $72 rights-on. a. What is the value of one right? b. After the stock goes ex-rights, what will the new stock price be? Solutions 1. a.  Page 566 b.  2. a.  R = Value of a right M0 = Market value rights-on. This is the value before the effect of the right offering, $72. S = Subscription price $60. N = Number of rights necessary to purchase a new share 4. R = b. The market value of the stock ex-rights (after the effect of the rights offering) is equal to M0 (the market value before the rights offering) minus the value of a right (R). Me = M0 − R Me = Market value of the stock ex-rights M0 = $72 R = $2.40 Me = $72 − $2.40 = $69.60 PROBLEMS  Selected problems are available with Connect. Please see the preface for more information. Basic Problems Residual claims to earnings (LO17-1) 1. Folic Acid Inc. has $20 million in earnings, pays $2.75 million in interest to bondholders, and pays $1.80 million in dividends to preferred stockholders. a. What are the common stockholders’ residual claims to earnings? b. What are the common stockholders’ legal, enforceable claims to dividends? Residual claims to earnings (LO17-1) 2. 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. What are the bondholders’ contractual claims to payment? (You may wish to review Table 17-4.) b. What are the preferred stockholders’ immediate contractual claims to payment? What privilege do they have? Page 567 Poison pill (LO17-4) 3. 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. How many shares must the unfriendly outside group acquire for the poison pill to go into effect? b. What will be the new purchase price for the existing stockholders? Cumulative voting (LO17-2) 4. 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.) Cumulative voting (LO17-2) 5. 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.) Cumulative voting (LO17-2) 6. 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.) Cumulative voting (LO17-2) 7. Betsy Ross owns 927 shares in the Hanson Fabrics Company. There are 15 directors to be elected, and 33,500 shares are outstanding. The firm has adopted cumulative voting. a. How many total votes can be cast? b. How many votes does Betsy control? c. What percentage of the total votes does she control? Dissident stockholder group and cumulative voting (LO17-2) 8. 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? Dissident stockholder group and cumulative voting (LO17-2) 9. 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. How many directors can Mr. Clark be sure of electing? Page 568 b. How many directors can Ms. Ramsey and her friends be sure of electing? c. 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? d. 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? Strategies under cumulative voting (LO17-2) 10. 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? Use logical numerical analysis rather than a set formula to answer the question. Baker has 245,000 votes (35,000 × 7). Intermediate Problems Different classes of voting stock (LO17-1) 11. 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 9 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 the 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? Rights offering (LO17-3) 12. 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. What would be the value of one right? b. If the stock goes ex-rights, what would the new stock price be? Procedures associated with a rights offering (LO17-3) 13. 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. What is the value of a right? b. How many of the new shares could Carol buy if she exercised all her rights? How much cash would this require? c. 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? Page 569 Investing in rights (LO17-3) 14. 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. 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? b. 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.) c. 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? d. 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? e. What would be the answer to part c if the price of Gallagher’s stock falls to $40 per share ex-rights? Effect of rights on stockholder position (LO17-3) 15. 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. What is the value of a right? b. What is the value of the Andersons’ portfolio before the rights offering? (Portfolio in this question represents stock plus cash.) c. 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? d. 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? Advanced Problems Relation of rights to EPS and the price-earnings ratio (LO17-3) 16. 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 5 rights is needed to buy one of the new shares. a. What are the earnings per share and price-earnings ratio before the new shares are sold via the rights offering? b. 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. Aftertax comparison of preferred stock and other investments (LO17-5) 17. The Omega Corporation has some excess cash that 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? Page 570 Preferred stock dividends in arrears (LO17-5) 18. 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. How much is the company behind in preferred dividends? b. 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. c. 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? Preferred stock dividends in arrears (LO17-5) 19. 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. How much should the compensation be? b. 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 10-year maturity. Using the bond valuation table in Chapter 16 (Table 16-2), indicate the market value of a $1,000 par value bond. c. Based on market value, how many bonds must be issued to provide the compensation determined in part a? (Round to the nearest whole number.) Preferred stock dividends in arrears and valuing common stock (LO17-5) 20. 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. How much in total dollars is the company behind in its payments? b. 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? Page 571 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. Borrowing funds to purchase preferred stock (LO17-5) 21. 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? Floating rate preferred stock (LO17-5) 22. 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. What is the price of the floating rate preferred stock likely to be? b. 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. COMPREHENSIVE PROBLEM 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. Page 572 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? COMPREHENSIVE PROBLEM 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 research and development of heart pump devices. Although the firm did not show a profit until 2006, by 2010 it reported after-tax 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 heart pump research 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 his 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 new 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 question a. Page 573 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)? WEB EXERCISE 1. 3M (Minnesota Mining & Manufacturing Co.) was listed in Table 17-1 as one of the companies having a large percentage of institutional ownership. Institutional ownership represents stock held by nonindividuals such as pension funds, mutual funds, or bank trust departments. Let’s learn more about the company. Go to 3M’s website,, and follow these steps: Scroll to the bottom of the page and click “Investor Relations.” Click on “Stock Information” under “Investing in 3M.” 2. Scroll down and write down the following: a. Recent price b. “52-week high” c. “52-week low” d. “52-week price percent change” e. “Average Daily Volume last 10 days” 3. Return to the prior page and click on “Financial Information” and then click “Ratios” in the middle of the page. The average firm in 3M’s industry of diversified chemicals has the following ratios. How does 3M compare? a. Price to earnings (P/E) 21.0x b. Price to sales 2.4x c. Price to book 5.0x d. Net profit margin 15.0% e. Current ratio 1.1x Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for. 1Tax consequences related to interest payments are ignored for the present. 2If this were not a rights offering, the discount from the current market price would be much smaller. The new shares might sell for $38 or $39. 3A number of variables may intervene to change the value. This is a “best” approximation. 4Though investment bankers generally participate in a rights offering as well, their fees are less because of the smaller risk factor. 5In a strict sense, preferred stock does not belong on the straight line because of its unique tax characteristics.
Assignment Content 1. Top of Form About Your Signature Assignment Harrod’s Sporting Goods Case Study is designed to align with specific program student learning outcome(s) in your program. Program St
Assignment Content Top of Form About Your Signature Assignment Harrod’s Sporting Goods Case Study is designed to align with specific program student learning outcome(s) in your program. Program Student Learning Outcomes are broad statements that describe what students should know and be able to do upon completion of their degree. Signature/Benchmark Assignments are graded with a grading guide or an automated rubric that allows the University to collect data that can be aggregated across a location or college/school and used for course/program improvements.  Review the Week 5 Case Study. Complete the required activities 1 to 8 in Microsoft® Word or Microsoft® Excel®. Submit the assignment. Bottom of Form

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