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Unformatted text preview: Chapter 14: Long-Term Financing: An Introduction 14.1 a. b. Common Stock Account $135,430 = 67,715 shares Par Value $2 Net capital from the sale of shares = Common Stock + Capital Surplus Net capital = $135,430 + $203,145 = $338,575 Therefore, the average price is $338,575 / 67,715 = $5 per share Alternate solution: Average price = Par value + Average capital surplus = $2 + $203,145 / 67,715 = $5 per share = c. Book value = Assets - Liabilities = Equity = Common stock + Capital surplus + Retained earnings = $2,708,600 Therefore, book value per share is $2,708,600 / 67,715= $40. 14.2 a. Common stock = (Shares outstanding ) x (Par value) = 500 x $1 = $500 Total = $150,500 Common stock (1500 shares outstanding, $1 par) Capital surplus* Retained earnings Total * Capital Surplus = Old surplus + Surplus on sale = $50,000 + ($30 - $1) x 1,000 =$79,000 $1,500 79,000 100,000 $180,500 b. 14.3 a. Shareholders' equity Common stock ($5 par value; authorized 500,000 shares; issued and outstanding 325,000 shares) Capital in excess of par* Retained earnings** Total $1,625,000 195,000 3,794,600 $5,614,600 *Capital surplus = 12% of Common Stock = (0.12) ($1,625,000) = $195,000 **Retained earnings = Old retained earnings + Net income - Dividends = $3,545,000 + $260,000 - ($260,000)(0.04) = 3,794,600 Answers to End-of-Chapter Problems B-137 b. Shareholders' equity Common stock ($5 par value; authorized 500,000 shares; issued and outstanding 350,000 shares) Capital in excess of par* Retained earnings Total $1,750,000 170,000 3,794,600 $5,714,600 *Capital surplus is reduced by the below par sale, i.e. $195,000 - ($1)(25,000) = $170,000 14.4 a. Under straight voting, one share equals one vote. Thus, to ensure the election of one director you must hold a majority of the shares. Since two million shares are outstanding, you must hold more than 1,000,000 shares to have a majority of votes. Cumulative voting is often more easily understood through a story. Remember that your goal is to elect one board member of the seven who will be chosen today. Suppose the firm has 28 shares outstanding. You own 4 of the shares and one other person owns the remaining 24 shares. Under cumulative voting, the total number of votes equals the number of shares times the number of directors being elected, (28) (7) = 196. Therefore, you have 28 votes and the other stockholder has 168 votes. Also, suppose the other shareholder does not wish to have your favorite candidate on the board. If that is true, the best you can do to try to ensure electing one member is to place all of your votes on your favorite candidate. To keep your candidate off the board, the other shareholder must have enough votes to elect all seven members who will be chosen. If the other shareholder splits her votes evenly across her seven favorite candidates, then eight people, your one favorite and her seven favorites, will all have the same number of votes. There will be a tie! If she does not split her votes evenly (for example 29 28 28 28 28 28 27) then your candidate will win a seat. To avoid a tie and assure your candidate of victory, you must have 29 votes which means you must own more than 4 shares. Notice what happened. If seven board members will be elected and you want to be certain that one of your favorite candidates will win, you must have more than oneeighth of the shares. That is, the percentage of the shares you must have to win is more than b. 1 . (The number of members being elected + The number you want to select)
Also notice that the number of shares you need does not change if more than one person owns the remaining shares. If several people owned the remaining 168 shares they could form a coalition and vote together. Thus, in the Unicorn election, you will need more than 1/(7+1) = 12.5% of the shares to elect one board member. You will need more than (2,000,000) (0.125) = 250,000 shares. Cumulative voting can be viewed more rigorously. Use the facts from the Unicorn election. Under cumulative voting, the total number of votes equals the number of B-138 Answers to End-of-Chapter Problems shares times the number of directors being elected, 2,000,000 x 7 = 14,000,000. Let x be the number of shares you need. The number of shares necessary is
7x > 14,000,000 - 7x ==> x > 250,000. You will need more than 250,000 shares. 7 14.5 She can be certain to have one of her candidate friends be elected under the cumulative voting rule. The lowest percentage of shares she needs to own to elect at least one out of 6 candidates is higher than 1/7 = 14.3%. Her current ownership of 17.3% is more than enough to ensure one seat. If the voting rule is staggered as described in the question, she would need to own more than 1/4=25% of the shares to elect one out of the three candidates for certain. In this case, she will not have enough shares. 14.6 a. You currently own 120 shares or 28.57% of the outstanding shares. You need to control 1/3 of the votes, which requires 140 shares. You need just over 20 additional shares to elect yourself to the board. b. You need just over 25% of the shares, which is 250,000 shares. At $5 a share it will cost you $2,500,000 to guarantee yourself a seat on the board. 14.7 The differences between preferred stock and debt are: a. The dividends of preferred stock cannot be deducted as interest expenses when determining taxable corporate income. From the individual investor's point of view, preferred dividends are ordinary income for tax purposes. From corporate investors, 80% of the amount they receive as dividends from preferred stock are exempt from income taxes. b. c. In liquidation, the seniority of preferred stock follows that of the debt and leads that of the common stock. There is no legal obligation for firms to pay out preferred dividends as opposed to the obligated payment of interest on bonds. Therefore, firms cannot be forced into default if a preferred stock dividend is not paid in a given year. Preferred dividends can be cumulative or non-cumulative, and they can also be deferred indefinitely. 14.8 Some firms can benefit from issuing preferred stock. The reasons can be: a. Public utilities can pass the tax disadvantage of issuing preferred stock on to their customers, so there is substantial amount of straight preferred stock issued by utilities. b. Firms reporting losses to the IRS already don't have positive income for tax deduction, so they are not affected by the tax disadvantage of dividend vs. interest payment. They may be willing to issue preferred stock. c. Firms that issue preferred stock can avoid the threat of bankruptcy that exists with debt financing because preferred dividends are not legal obligation as interest payment on corporate debt. 14.9 a. The return on non-convertible preferred stock is lower than the return on corporate bond for two reasons: i. Corporate investors receive 80% tax deductibility on dividends if they hold the stock. Therefore, they are willing to pay more for the stock; that lowers its return. Answers to End-of-Chapter Problems B-139 b. ii. Issuing corporations are willing and able to offer higher returns on debt since the interest on the debt reduces their tax liabilities. Preferred dividends are paid out of net income, hence they provide no tax shield. Corporate investors are the primary holders of preferred stock since, unlike individual investors, they can deduct 80% of the dividend when computing their tax liability. Therefore, they are willing to accept the lower return which the stock generates. Debt Yes No Yes Yes Equity No Yes No No 14.10 The following table summarizes the main difference between debt and equity. Repayment is an obligation of the firm Grants ownership of the firm Provides a tax shield Liquidation will result if not paid Companies often issue hybrid securities because of the potential tax shield and the bankruptcy advantage. If the IRS accepts the security as debt, the firm can use it as a tax shield. If the security maintains the bankruptcy and ownership advantages of equity, the firm has the best of both worlds. 14.11 The trends in long-term financing in the United States were presented in the text. If Cable Company follows the trends, it will probably use 80% internal financing, net income of the project plus depreciation less dividends, and 20% external financing, long term debt and equity. B-140 Answers to End-of-Chapter Problems ...
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