Unformatted text preview: Common Stock
“Where your treasure is, there will
your heart be also.”
—Matthew 6:21 Vonage Tanks after Its IPO
Vonage Holdings Corporation issued 31.2 million shares of common stock
on May 24, 2006, in its initial public offering (IPO). The issue price was
$17 per share. The price of this stock dropped by 30% on the first day of
public trading. In July of 2009 the stock’s price was way below $1.
Vonage is a provider of telephone service over the Internet. It uses VOIP
(voice over Internet protocol) to deliver its service. The company likes to tout
its lower cost telephone service but the company was surely not happy that
the stock market viewed its common stock as cheap. The investment bankers
involved in the underwriting of this new stock issue include Deutsche Bank
Securities, Citigroup Global Markets, and UBS Securities.
Usually, stock sold in an initial public offering goes up in price when it
begins trading in the stock market. As we see here, this is not always the
case. Investors often try to get access to new shares from the investment
bankers in an attempt to make a quick buck. As we can see here, you should
be careful what you ask for. In this chapter we examine the use of common
stock as a source of capital for a firm. Sources: http://www.macworld.com/news/2006/06/05/vonage/index.php?lsrc=mwrss, 6/11/06; http://www.internetnews.
com/bus-news/article.php/3611221, 6/11/06. 440 © Scott Rothstein (http://www.fotolia.com/p/4000) Chapter Overview Learning Objectives In this chapter we explore the characteristics and types of common stock, types
of common stock owners, and the pros and cons of issuing stock to raise capital.
Then we investigate how firms issue common stock. Finally, we examine rights
and warrants, and their risk and return features. The Characteristics of Common Stock
As we learned in Chapter 2, common stock is a security that represents an equity
claim on a firm. Having an equity claim means that the one holding the security
(the common stockholder) is an owner of the firm, has voting rights, and has a
claim on the residual income of the firm. Residual income is income left over
after other claimants of the firm have been paid. Residual income can be paid out
in the form of a cash dividend to common stockholders, or it can be reinvested
in the firm. Reinvesting this residual income increases the market value of the
common stock due to the new assets acquired or liabilities reduced.
Corporations sometimes have different classes of stockholders. For example, a
corporation’s charter may provide for a certain class of stockholders to have greater
voting rights than other classes. Or one class of stock may receive its dividends
based on the performance of only a certain part of the company. 441 After reading this chapter,
you should be able to: 1. Describe the characteristics
of common stock. 2. Explain the disadvantages
and advantages of equity
financing. 3. Explain the process of
issuing new common stock. 4 Describe the features of
rights and warrants. 442 Part IV Long-Term Financing Decisions Figure 15-1 Stock
Certificate for 288 Shares
of Central Jersey Bankcorp
Common Stock Interactive Module
Go to www.textbookmedia.
com and find the free
companion material for this
book. Follow the instructions
there. See how stockholders
exercise their control over a
company. Google, for example, has two different classes of stock. Class A shares are owned
by the general public and have one vote for each share. Class B shares, available to
the founders and top executives of the company, have ten votes per share. (There is no
consistent standard about which designation, A or B, has the greater voting rights and
which designation the lesser.)
A relatively new special class of stock is sometimes created when a company that
has long been in one line of business expands into a new, often riskier line. The company
will then issue a new class of common stock that represents a claim only on the new
business. This stock is called target stock because its value is targeted toward specific
(nontraditional) assets. In 1995, for example, Qwest Communications International (one
of the Baby Bells spun off in the AT&T divestiture) issued target stock to finance its
venture in cellular, cable, and other nontelephone businesses. The idea is that a different
kind of stockholder is likely to be attracted to the newer, nontraditional businesses than
the stockholder interested in “plain old telephone service” (POTS).
All classes of stock have values that are determined when those stocks are traded
from one investor to another at the various stock exchanges and in the over-the-counter
market, as was described in Chapter 2. The market takes into account the characteristics
of a given class and values each class accordingly. Figure 15-1 shows a certificate of
ownership for 288 shares of the common stock of Central Jersey Bancorp.
Common stockholders are paid dividends determined by the ability and willingness
of the firm to pay. This dividend decision is made by the board of directors of the
corporation. Residual income not paid out to the common stockholders in the form of
dividends is reinvested in the firm. It benefits the common stockholders there as well
(because they are the owners of the corporation).
All corporations issue stock reflecting the owners’ claims. But some corporations
are privately owned, whereas others are owned by members of the general public. The
rules for private and public corporations differ, as we see next. Chapter 15 Common Stock Stock Issued by Private Corporations
Private corporations (also known as closely held corporations) are so called because
their common stock is not traded openly in the marketplace. Private corporations do
not report financial information to the government through the Securities and Exchange
Commission. (Tax returns, of course, are filed with the IRS, but this information is
confidential.) Privately held corporations are usually small, and the stockholders are often
actively involved in the management of the firm. The corporate form of organization is
attractive to many small firms because the owners face only limited liability.
Stock Issued by Publicly Traded Corporations
AT&T. McDonald’s. Motorola. These are just some examples of well-known publicly
traded corporations. A publicly traded corporation is a corporation whose common
stock can be bought by any interested party and that must release audited financial
statements to the public. It is typically run by a professional management team, which
likely owns only a tiny fraction of the outstanding shares of common stock.
The professional management team that handles the operations of the firm reports
to a group called the board of directors. The board of directors, in turn, is elected
by the common stockholders to represent their interests. The board is an especially
important body for large public corporations because management typically owns such
a small percentage of the firm. The agency problem discussed in Chapter 1 described
the conflict of interest that can occur when those who run a firm own very little of it.
The common stockholders elect the board members, and the board members oversee
the management of the company.
Members of the board of directors have a fiduciary responsibility to the common
stockholders who elected them. Fiduciary responsibility is the legal duty to act in the
best interests of the person who entrusted you with property or power. When stockholders
elect board members to represent them, they entrust the board members with the
management of their company. Those board members owe it to common stockholders
to act in the common stockholders’ interest. Stockholders may vote directly on some
major issues, such as a proposal to merge or liquidate the company.
Institutional Ownership of Common Stock
Much of the common stock of publicly traded corporations is owned by institutional
investors—financial institutions that invest in the securities of other companies. Money
management firms handling pension fund money, bank trust departments, insurance
companies, mutual funds, and the like are major common stockholders. The link between
ownership and control is likely to be a loose one in such cases because the individual
shareholder is several layers away from the corporation. For instance, a worker may
have a claim on a pension fund that is managed by a money management firm that has
invested funds in another company’s common stock.
In recent years many institutional investors have begun to take a more active role in
overseeing the companies in which they own common stock. Institutional investors usually
have substantial amounts of funds, so they can buy a large number of shares of stock and
become major shareholders. As a result, they can exercise more control than widely dispersed
individual investors. Fidelity Investments, for example, a large mutual fund company, has been
seeking seats on the board of directors of companies in which Fidelity is a major shareholder.
Institutional investors have been accused by some of contributing to the financial
crisis. Since these institutions hold most of the publicly traded stock they have most of
the votes. Should they have done a better job electing directors who properly oversee 443 444 Part IV Long-Term Financing Decisions management of the companies that failed? Surely success by managers needs to be
rewarded. Isn’t the other side of that coin that failure should be punished? How often
do you hear about a CEO of a large publicly traded corporation getting a large severance
package just has that company has been run into the ground? Merrill Lynch got a lot
of publicity in late 2007 when it offered its retiring CEO a severance package in the
ballpark of $200 million after the company posted dismal financial results. Legislators
and regulators are likely to look closely at executive compensation practices in the
coming years. This is a very controversial area of business and institutional investors
find themselves right in the middle of it.
In this section, we investigated common stock characteristics, including classes of
stock for stock issued by private and public corporations. We also looked at institutional
ownership of common stock. Next, we examine the voting rights of common stockholders. Voting Rights of Common Stockholders
Common stockholders have power to vote according to the number of shares they own.
The general rule is “one vote per share.” A stockholder or stockholder group holding more
than 50 percent of the voting shares has a majority interest in the firm. The stockholder or
group of stockholders that owns enough voting shares to control the board and operations
of the firm has a controlling interest in the firm. The stockholder or stockholder group
gains control when it elects a majority of its supporters to the board of directors.
In practice, a group can gain control with much less than 50 percent of the voting
shares. This can happen if the remaining voting shares are widely distributed among
many thousands of stockholders (each of whom owns a tiny percentage of the outstanding
voting shares) who do not act in concert with each other. Many firms are controlled
by groups of common stockholders owning as little as 5 percent or 10 percent of the
voting shares, sometimes less. Proxies
In large publicly traded corporations, the typical shareholder is likely to be uninterested
in the details of the company’s operations. It is not worth going to the stockholders’
meeting in another part of the country if you hold only a few hundred shares. Such
stockholders will typically allow others to vote their shares for them by proxy. This
means that another group—usually the management of the company, but sometimes a
group opposing management—will vote the shares for the stockholder who has given
his or her proxy.
To give permission to another to vote your shares, you sign a card sent out by the
group seeking this permission. In contested votes, in which several competing groups
may solicit shareholder proxies, each group may send out a card of a different color.
Board of Directors Elections
Corporate elections typically use one of two different sets of voting rules to fill seats
on the board of directors. These are majority voting and cumulative voting rules. Under
majority voting rules, a given number of seats are to be filled in a given election. The
number of voting shares held, plus proxy votes held, represents the number of votes a
person may cast for a given candidate. If multiple seats are contested say, for example,
five—then the five candidates receiving the most votes are awarded seats on the board.
The person receiving the greatest number of votes wins that seat. With majority voting, Chapter 15 Common Stock whoever controls the majority of the votes will get their candidates elected to every
seat to be filled.
Under cumulative voting rules, the votes cast by a given stockholder may be allocated
differently among different candidates for the board. If there are five seats to be filled in
the election, the top five vote getters among all the candidates win those seats. Votes are
cast—one vote per share times the number of seats being contested—for as many or as
few candidates as a voter wishes. For example, if there were five seats to be filled with
cumulative voting rules, and if a person were voting 100 shares, that shareholder would
cast 500 votes that could be allocated to one, two, three, four, or five board candidates.
This means that stockholders with shares and proxies for less than a majority of the
number of voting shares can “accumulate” their votes by casting them all for only a
few candidates (even casting all votes for one candidate).
Cumulative voting makes it more likely that those shareholders with less than a
majority of the voting shares will get some representation on the board. With majority
voting rules, minority stockholders would get outvoted by the majority stockholders in
each of these separate elections.
Suppose Burgerworld Corporation has a ten-member board, and terms for three of
the ten members are expiring. The firm uses cumulative voting rules. Seven candidates
are competing for the right to fill these three seats. There are 100,000 voting shares of
common stock outstanding for Burgerworld. This means that 300,000 total votes will
be cast (100,000 shares × 3 contested seats = 300,000 total votes).
The stockholders are divided into two camps of differing corporate management
philosophy. The majority group controls 60 percent of the voting shares, whereas the
minority group of common stockholders controls the other 40 percent. One of the seven
candidates was nominated by the minority group. The minority stockholder group knows
that with only 40 percent of the votes, they have no hope of winning two or three of
the three seats contested. Does the minority group of stockholders have enough voting
power to get their one candidate on the board?
The majority stockholders would like to get three of their people elected to the
three seats available. If they want to succeed, they will have to spread their 180,000
votes (60 percent of 300,000) among their three favorite candidates. Spreading the votes
evenly among their preferred candidates, each candidate supported by the majority
group would receive 60,000 votes (180,000 ÷ 3 = 60,000). If the minority stockholders
cast all their votes for their candidate, that person will receive 120,000 (300,000 total
– 180,000 majority votes = 120,000 minority votes) votes and win a seat on the board.
The formula for determining the number of directors that a stockholder group could
elect, given the number of voting shares they control, is shown next in Equation 15-1.
The Number of Directors Who Can Be Elected under Cumulative Voting Rules NUM DIR =
where: (SHARES CONTROLLED − 1) × (TOT NUM DIR T.B.E. + 1) (15-1)
TOT NUM VOTING SHARES NUM DIR = umber of directors who can be elected by
a given group SHARES CONTROLLED = he number of voting shares controlled by
a given group TOT NUM DIR T.B.E. = otal number of directors to be elected
T TOT NUM VOTING SHARES = otal number of voting shares in the election
T 445 446 Part IV Long-Term Financing Decisions Using the number of shares owned by the minority stockholders described in our
Burgerworld example (40,000 of 100,000 shares outstanding), we can calculate the
number of directors that this minority group could elect. Recall that the number of
directors to be elected is three. The calculations follow:
NUM DIR = (40, 000 − 1) × (3 + 1)
100, 000 = 1.60 This group can elect one of their people to the board out of the three to be elected.
Note that we rounded down to get the answer. Because people cannot be divided, the
minority group can’t elect .6 (60 percent) of a person to the board.
The formula for determining the number of shares needed by a given group to elect
a given number of directors is shown next in Equation 15-2.
The Number of Shares Needed to Elect a Given
Number of Directors under Cumulative Voting Rules
NUM DIR DESIRED × TOT NUM VOTING SHARES NUM VOTING SHARES NEEDED =
TOT NUM DIR T.B.E. + 1 where: (15-2)
NUM DIR DESIRED = N umber of directors a given group of
stockholders desires to elect TOT NUM VOTING SHARES = otal number of voting shares in the election
T TOT NUM DIR T.B.E. = otal number of directors to be elected in
the election For example, to calculate the number of voting shares needed to elect two of the
three directors in the election described earlier, we could plug in the appropriate numbers
into Equation 15-2. The calculation is shown next:
NUM VOTING SHARES NEEDED = 2 × 100, 000
3 + 1 = 50, 001 We find that a group would need control of 50,001 voting shares to guarantee
the election of two of the three directors in this election. This number is equivalent to
150,003 votes spread evenly between two director candidates. This would be 75,001.5
votes per candidate (50,001 voting shares × 3 total directors to be elected ÷ 2 directors
sought to be elected). The other shareholders, holding 49,999 voting shares, would have
the remaining 149,997 votes (49,999 voting shares × 3 total directors to be elected). If
these 149,997 votes were divided between two candidates, that would be only 74,998.5
votes per candidate.
In this section, we reviewed the voting rights of common stockholders. We examine
the advantages and disadvantages of equity financing next. Chapter 15 Common Stock The Pros and Cons of Equity Financing
Selling new common stock has advantages and disadvantages for a corporation. Some
disadvantages include dilution of power and earnings per share of existing stockholders,
flotation costs, and possible unfavorable market perceptions about the firm’s financial
prospects. The advantages of a new stock issue include additional capital for the firm,
lower risk, and the potential to borrow more in the future. Disadvantages of Equity Financing
Selling new common stock is like taking in new partners (although we are referring to a
corporation rather than to a partnership). When you sell new common stock, you must
share the profits and the power with the new stockholders. When new common stock is
issued, the ownership position of the existing common stockholders is diluted because
the number of shares outstanding increases.
The dilution may result in a lower earnings per share for a profitable company.
Losses, of course, would be shared, too, resulting in a lower negative earnings per
share figure for a money-losing company. The voting power of the existing common
stockholders would also be diluted. Firms concerned with losing control through diluted
voting power, often avoid raising funds through a stock issue.
Also, when new common stock is sold, flotation costs are incurred. As we discussed
in Chapter 9, flotation costs are fees paid to investment bankers, lawyers, and others
when new securities are issued. The flotation costs associated with new common stock
issues are normally much higher than those associated with debt.
Another reason that common stock issues are often a last resort for many corporations
is because of signaling effects. Signaling is a message a firm sends, or investors infer,
about a financial decision.
It is reasonable to suggest that the internal corporate managers have better insight
about a firm’s future business prospects than the average outside investor. If we accept
this proposition as true, then we would not expect a company to sell additional shares of
common stock to the general public unless its managers know that the future prospects
for the company are worse than is generally believed. How do we know this? Equity
financing is expensive and often used as a last resort. The inference drawn by investors
who agree with this view is that a corporation issuing new stock wants more “partners”
with whom to share future bad times. A company that expected good times would attempt
to preserve the benefits for the current owners alone. Instead of issuing new stock, then,
the firm would issue more debt securities.
Management may issue new common stock even though the future financial
prospects for the firm are bright. However, if the market believes otherwise, the price
of the common stock will drop when the new common stock is issued.
Advantages of Equity Financing
Why would any corporation issue new stock? One big reason is that corporations
do not pay interest (and are not legally obligated to pay any dividends) to common
stockholders. Unlike interest payments on debt, dividends can be skipped without
incurring legal penalties. Interest payments on debt reduce a firm’s earnings, whereas
dividend payments to stockholders do not. 447 448 Part IV Long-Term Financing Decisions Some firms choose equity financing because they do not like borrowing. Some
business people view being “in debt” as undesirable. They avoid it if possible and pay
off unavoidable debts as soon as possible. Companies whose managers and owners hold
this view will tend to favor equity financing.
A final reason that firms choose equity instead of debt financing is that the firm may
have so much debt that borrowing more may be difficult or too expensive. Suppose, for
example, that the “normal” ratio of debt to assets in your firm’s industry is 20 percent,
and your firm’s debt to assets ratio is 40 percent. If this is the case, lenders may be
reluctant to lend your firm any more money at an affordable interest rate; your firm
might be forced to issue stock to raise funds. In this situation a new stock issue could
bring the firm’s debt ratios down to more normal industry levels. This would make it
easier for the firm to borrow in the future.
In this section we described the pros and cons of a new stock issue. We turn to the
process of issuing common stock next. Issuing Common Stock
When a firm wishes to raise new equity capital, it must first decide whether to try to
raise the capital from the firm’s existing stockholders or to seek new investors. Private
companies usually raise additional equity capital by selling new shares to existing
common stockholders. This generally satisfies these stockholders because they continue
to exercise complete control over the firm. However, when a large amount of equity
capital must be raised, the existing stockholders may find that their only recourse is to
sell shares of the firm’s stock to the general public. A firm that sells its private shares of
stock to the general public “goes public.” The issuance of common stock to the public
for the first time is known as an initial public offering (IPO). Figure 15-2 describes
the LogMeIn Corporation IPO.
Institutional investors are major buyers of new equity issues. Investment bankers
who try to sell initial shares typically prefer to sell large blocks of shares to institutional
investors, as opposed to selling many small blocks of shares to individual investors.
The institutional investors do well because a new issue is generally sold for 10 percent
to 20 percent below value to ensure that the new shares are sold. Figure 15-2 IPO of
LogMeIn Corporation On July 1, 2009 LogMeIn
Corporation, a networking and
connectivity sofware company, went
public by offering 6.6875 million
shares of common stock at $16
a share. The company trades on
the Nasdaq with the ticker symbol
LOGM. J.P. Morgan Securities, Inc.
was the lead manager for the IPO.
Investors were apparently eager to buy the stock, as its price instantly
went to $20 when the market
opened, and it finished the trading
day at $20.02, up 25% from its
initial offering price. Chapter 15 Common Stock The Function of Investment Bankers
When a corporation does decide to sell stock to the public, its first step is to contact an
investment bank to handle the issue. Some of the names of investment banking firms that
a corporation might contact would include J.P. Morgan, Morgan Stanley, Dean Witter,
Merrill Lynch, Goldman Sachs, and Credit Suisse First Boston, to mention only a few.
Investment bankers handle all the details associated with pricing the stock and
marketing it to the public. A potential investor in a new security must be given a
prospectus. A prospectus is a disclosure document that describes the security and the
issuing company. Investment bankers typically announce a new issue and the availability
of the prospectus in a large boxed-in ad called a tombstone ad. It is so named because
the large box with large print identifying the new issue looks like a tombstone. Figure
15-3 shows a tombstone ad for 5,462,500 shares of Geocities Corporation common stock.
Underwriting versus Best Efforts Investment bankers take on the job of marketing
a firm’s stock to the public on one of two bases: underwriting or best efforts. When an
investment banker underwrites a stock issue, it means the investment banker agrees to
buy a certain number of shares from the issuing company at a certain price. Usually,
a group of investment bankers will form a temporary alliance called a syndicate when
underwriting a new security issue. The head of the investment banking syndicate is
known as the manager. The manager has the primary responsibility for advising the
security issuer. Extra fees are collected for this advice. It is up to the syndicate to sell
the shares to the public at whatever price it can get. An underwriting poses the least
risk to the firm whose stock is being issued. This is because the firm gets the stock
issue proceeds from the investment bankers all at once, up front. However, because the
investment bankers bear the risk that they might not be able to sell the firm’s shares at
the price they expect, they charge a rather substantial fee for underwriting.
A cheaper alternative to underwriting is called a best efforts offering. In this
arrangement, the investment banker agrees to use its “best efforts” to sell the issuing
company’s shares at the desired price, but it makes no firm promises to do so. If the
shares can only be sold at a lower price than was expected, then the issuing firm must
either issue more shares to make up the difference or be satisfied with lower proceeds
from the stock issue. Not surprisingly, the fees investment bankers charge for marketing
stock on a best efforts basis are considerably less than those they charge for underwriting. Pricing New Issues of Stock
When new shares of stock in a company are to be sold to the public, someone must
decide at what price to offer them for sale. This is not a significant problem when the
company’s shares are already publicly traded. The new shares are simply sold at the
same price as the old shares, or perhaps a little lower.1 However, if the company is going
public, there is no previous market activity to establish what the shares are worth. In this
situation the investment banker, in conjunction with the issuing company’s managers,
must put a price on the shares and hope that the market will agree that the price represents
fair value. This is a daunting task indeed, and frequently investment bankers and firm
managers miss the mark. Often an IPO stock will fluctuate wildly in price after it is
issued. Table 15-1 shows five initial public offerings and stock prices after the IPO.
The figures in Table 15-1 show the differing fortunes of these five initial public
There is usually a little dilution (downward movement) in the price of a company’s common stock when new shares are sold. 1 449 450 Part IV Long-Term Financing Decisions 5,462,00 Shares G E O C I T I E S® Common Stock
(par value $0.001 per share) Price $17 Per Share Upon request, a copy of the Prospectus describing these securities and the business of the
Company may be obtained within any State from any Underwriter who may legally
distribute it within such State. The securities are offered only by means of the Prospectus
and this announcement is neither an offer to sell nor solicitation of an offer to buy. Goldman, Sachs & Co.
Donaldson, Lufkin & Jenrette
Hambrecht & Quist
BancBost Robertson Stephens Inc.BT Alex, BrownEveren Securities, Inc.
Merrill Lynch & Co. Figure 15-3
Tombstone Ad for
Common Stock Dain Rauscher Wessels E* Trade Securities a division of Dain Rauscher Incorporated Edward D. Jones & Co., L.P. Needham & Company, Inc. Sutro & Co. IncorporatedTucker AnthonyVolpe Brown Whelan & Company
Incorporated Valuing the Stock of a Company That Is Not Publicly Traded Before investment
bankers offer a company’s stock for sale to the public, they must have some idea of
how the public will value the stock to predict the new issue market price. The trouble
is, when a company’s stock has not been sold to anyone before, it is perilously difficult
to say how much it is worth.
Suppose you have been creating oil paintings for a few years and have become pretty
good at it. One day the art club you belong to has a show, and one of your paintings is Chapter 15 Common Stock Table 15-1 Recent Prices of Five Initial Public Offerings (IPOs) IPO Date Stock Initial Price Price on
July 6, 2009 June 2006 LogMeIn $ 16 $ 9.70
1 May 2006 Vonage Holdings Corporation $17 $ 0.36 May 2006 Corel Corporation $16 $ 2.48 May 2006 Burger King Holdings, Inc. $17 $ 7.18
1 March 2006 Sealy Corp $16 $ 1.60 Source: Yahoo.com (http://finance.yahoo.com) included. When you deliver the painting to the gallery, you are asked what sale price
you wish posted on the painting. Now you face the same question firms and investment
bankers face. How much is the painting worth? How much can you get for it?
Naturally, you want to sell the painting for as high a price as possible, but the
potential buyers want to pay as low a price as possible. If you post too high an asking
price, no one will buy your painting and you will leave empty handed. If you post too
low a price, however, someone will snatch it up and may well resell it to someone else
for a substantial profit. You can see that if you had previously sold a number of similar
paintings you would have an idea of what to ask for this one. The first painting you try
to sell is the one that presents the pricing problem.
In Chapter 12, we presented some of the methods that companies and investment
bankers use to estimate the market value of a company’s stock. These methods include
calculating the present value of expected cash flows, multiplying earnings per share by
the appropriate P/E ratio, the book value approach, and the liquidation value approach. Rights and Warrants
Rights and warrants are securities issued by a corporation that allow investors to buy
new common stock. They originate in different ways and have somewhat different
characteristics, as explained in the following sections. Preemptive Rights
When some companies plan to issue new stock, they establish procedures to protect
the ownership interest of the original stockholders. The existing stockholders are given
securities that allow them to preempt other investors in the purchase of new shares.
This security is called a preemptive right. A preemptive right, sometimes referred
to simply as a right, gives the holder the option to buy additional shares of common
stock at a specified price (the subscription price) until a given expiration date. Current
stockholders who do not wish to exercise their rights can sell them in the open market.
The Number of Rights Required to Buy a New Share Suppose that Right Stuff
Corporation has 100,000 shares of common stock currently outstanding. An additional 451 452 Part IV Long-Term Financing Decisions 20,000 shares of common stock are to be sold to existing shareholders by means of a
rights offering. Because one right is sent out to existing shareholders for each share held,
100,000 rights must be sent out. There are five shares of common stock outstanding
for each new share to be sold (100,000/20,000 = 5). Five rights are therefore needed,
along with the payment of the subscription price, to purchase a new share of common
stock through the rights offering.
The Value of a Right We know that five rights are required to buy a new share of Right
Stuff Corporation’s common stock through the rights offering. To determine the value
of each right, we must also know the subscription price and the market price of Right
Stuff’s common stock.
This information, along with our knowledge of the number of rights required to buy
a new share, will allow us to estimate the value of one of these rights.2
Suppose that the current market price of Right Stuff Corporation’s common stock
is $65 and that the subscription price is set at $50. This means that you are saving $15
($65 – $50 = $15) when you send in your five rights to receive one of the new shares
(known as “exercising your rights”). This means that each right would be worth $3 ($15
÷ 5 = $3) before dilution effects are considered.
The approximate value of a right can be determined by two formulas. The formula
used depends on the status of the stock as it trades in the marketplace, relative to
the timing of the issuance of the rights. Timing is the key to determining which
approximation formula to use.
Rights are generally sent out several weeks after the announcement of the rights
offering is made. This initial period is called the rights-on period, and the stock is said
to trade rights-on during this time. This means that if the common stock is purchased
during the rights-on period, the investor will receive the forthcoming rights.
At the opening of trading on the day following the rights-on period, the stock is
said to be trading ex-rights. This means that the purchaser buys the stock without (ex
is Latin for “without”) receiving the entitlement to the preemptive rights if the purchase
is on or after the ex-rights date.
Trading Rights-On If the stock is trading rights-on, then we calculate the approximate
market value of the right as depicted in Equation 15-3:
Approximate Value of a Right, Stock Trading Rights-On
R = M0 − S
N + 1 (15-3) where: R = pproximate market value of a right
A M0 = arket price of the common stock, selling rights-on
M S = ubscription price
S N = umber of rights needed to purchase one of the new shares of common
stock The actual pricing of a right is somewhat more complicated than what we are presenting here. A right is an option to buy
the new stock at the specified subscription price. Option pricing is discussed in the following section on warrants. The rights
valuation presented here should be considered an approximation only. 2 Chapter 15 Common Stock Table 15-2 Right Valuation with Stock Selling Rights-On M0, Market Price of the Common Stock, Rights-On $65 S, Subscription Price $50 N, Number of Rights Required to Purchase One New Share R, Approximate Market Price of One Right: 5
$65 − $50
5 + 1
6 = $2.50 We call R the approximate market value of the right because rights are securities that
can be traded just like stock and bonds. Once the rights are sent to the existing common
stockholders (those who bought the stock before it “went ex-rights”), the rights can be
traded in the marketplace at the option of the owner. The actual market price of the
right may be slightly different than shown in the formulas presented here because of
the option characteristics of the rights, which are discussed later.
Table 15-2 shows the calculation of the approximate market value of a Right Stuff
Corporation right. This is the value of the right as determined by the rights-on formula,
We see from the calculations in Table 15-2 that the market value of the Right Stuff
right is $2.50, given a market price of common stock of $65, a subscription price of
$50, and five rights required to purchase one new share.
Selling Ex-Rights To find the approximate value of the right when the stock is selling
ex-rights, the ex-rights formula must be used. This formula is presented as follows in
Approximate Value of a Right, Stock Trading Ex-Rights
R = Mx − S
N (15-4) where: R = Approximate market value of a right Mx = Market price of the common stock, selling ex-rights S = Subscription price N = umber of rights needed to purchase one of the new shares of common
stock When the common stock begins trading ex-rights, the entitlement to the forthcoming
rights is lost. Thus, the price of the common stock in the marketplace will drop by the
value of the right now lost on the ex-rights date (other factors held constant).
Suppose Right Stuff Corporation common stock begins selling ex-rights today.
When the opening bell rings on the exchange, the price of Right Stuff common stock
will drop by the amount of the value of the right that has been lost. Holding other factors 453 454 Part IV Long-Term Financing Decisions constant (no news overnight to otherwise affect the value of the common stock), the
price of the common stock will drop by $2.50 from $65 to $62.50.
Table 15-3 shows the calculation of the approximate market value of the right when
the common stock is selling ex-rights, using Equation 15-4.
When the common stock is selling ex-rights, Equation 15-4 gives the approximate
market value of a right. The equation reflects the loss of the entitlement of the rights,
$2.50 in our example. Warrants
A warrant is a security that gives its owner the option to buy a certain number of
shares of common stock from the issuing company, at a certain exercise price, until a
specified expiration date. The corporation benefits from issuing warrants because the
issue raises funds. It also creates the possibility of a future increase in the company’s
number of common stock shares. The investor values warrants because of the option
to buy the company’s stock.
Warrants are similar to rights except they are sold to investors instead of given away
to existing shareholders. They typically have longer maturities than rights and are often
issued with bonds as part of a security package.
Warrant Valuation Warrants have value only until the expiration date, at which time
they become worthless. Before a warrant expires, its value depends on how the price of
the common stock compares to the warrant’s exercise price—the price the firm sets for
exercising the right to buy common stock shares—and on other factors, described next.
To value warrants, investors must be able to find the exercise value. The exercise
value is the amount saved by purchasing the common stock by exercising the warrant
rather than buying the common stock directly in the open market. If there is no saving,
the exercise value is zero.
The formula for calculating the exercise value of a warrant is described in Equation
15-5 as follows:
The Exercise Value of a Warrant XV = (M – XP) × # (15-5) where: XV = Exercise value of a warrant M = Market price of the stock XP = Exercise price of a warrant # = umber of shares that may be purchased if the warrant is
exercised Suppose that the McGuffin Corporation warrant entitles the investor to purchase
four shares of common stock, at an exercise price of $50 per share, during the next
three years. If the current common stock price is $60, the exercise value according to
Equation 15-5 follows: XV = (M – XP) × # = ($60 – $50) × 4 = $40 Chapter 15 Common Stock Table 15-3 Right Valuation with Stock Selling Ex-Rights Mx, Market Price of the Common Stock, Ex-Rights $62.50 S, Subscription Price $50 N, Number of Rights Required to Purchase One New Share R, Approximate Market Price of One Right: 5
$62.50 − $50
5 = $2.50 Our calculations show that the exercise value is $40.
If the market price of the common stock price were $50 or less, the exercise value
of the warrant would be zero. This is because you would have an option to buy the
common stock at a price that is no better than the regular market price of the stock. You
would have no reason to exercise the warrant, and a rational investor would not do so.
Note that the time remaining until the expiration of the warrant does not affect the
exercise value. For the McGuffin Corporation warrants, the investor saves $10/share on
four shares of common stock, creating an exercise value of $40.
As long as there is still time remaining until expiration, the actual market price of
a warrant will be greater than the exercise value. The difference between the market
price and the exercise value is called the warrant’s time value. Warrants have time value
because if the price of the common stock goes up, the exercise value increases with
leverage and without limit (because of the fixed exercise price). If, on the other hand,
the price of the common stock falls, the exercise value cannot dip below zero. Once the
common stock price is at or below the exercise price, no further damage can be done
to the exercise value.
The exercise value is zero if the common stock price is at or below the exercise
value, but it can never be negative. Table 15-4 shows the exercise value for a McGuffin
Corporation warrant for different possible stock values.
No matter how much below $50 the market price of the common stock goes, the
exercise value stays at zero. As the stock value goes above $50, however, the exercise
value increases at a much faster rate than the corresponding increase in the stock price.
The difference between the potential benefit if the stock price increases (unlimited and
leveraged) and the potential loss (limited) is what gives a warrant its time value.
Because of this time value, warrants are seldom exercised until they near maturity,
even when the exercise value is high. This is because if a warrant is exercised, only the
exercise value is realized. If the warrant is sold to another investor, the seller realizes
the exercise value plus the time value. The time value approaches zero as the expiration
date nears. A warrant approaching its expiration date, having a positive exercise value,
would be exercised by the investor before the value goes to zero on the expiration date.
The greater the volatility of the stock price, and the greater the time to expiration,
the greater the market value of the warrant. If the stock price is volatile, the stock
price could easily increase. This would give the warrant owner the benefit of an even
greater increase due to leverage. If the common stock price decreases, no more than the 455 456 Part IV Long-Term Financing Decisions Table 15-4 McGuffin Corporation Warrant Exercise Value
Market Price of Common Stock Exercise
Price Number of
Value $100 $50 4 $200 $ 90 $50 4 $160 $ 80 $50 4 $120 $ 70 $50 4 $ 80 $ 60 $50 4 $ 40 $ 50 $50 4 $ 0 $ 40 $50 4 $ 0 $ 30 $50 4 $ 0 $ 20 $50 4 $ 0 price paid can be lost. The more time left before expiration, the better the chance for
a major stock price change, up or down. Again, the warrant value upside is substantial
if the stock price moves up, and the downside potential is limited if the stock price
decreases. The asymmetry of the warrant’s upside and downside potential gives the
warrant greater value.
Option pricing has many applications in finance. We can apply the principles
described here for warrant pricing to certain types of capital budgeting and even common
stock valuation. What if a proposed capital budgeting project gives us an option to
undertake future projects that are tied to the first? Common stock has unlimited upside
price potential, coupled with limited downside risk, just like a warrant. These are issues
you may explore further in other finance courses. What’s Next
In this chapter we examined types and traits of common stock, and the advantages
and disadvantages of issuing common stock. We also explored rights and warrants. In
Chapter 16, we will look at how a corporation determines the amount of cash dividends
to pay and the timing of those dividend payments. Summary
1. escribe the characteristics of common stock.
Common stock is a security that represents an ownership claim on a corporation. The
shareholders are entitled to the residual income of the firm, resulting in a high-risk
position relative to other claimants and a relatively high-return potential. Common
stock may come in different classes with different voting rights or dividend payments.
The professional management team that handles the operations of the firm reports
to the board of directors. The board of directors, in turn, is elected by the common
stockholders to represent their interests. Because the stockholders have entrusted
the board to represent their interests, board members have a fiduciary duty to act on Chapter 15 Common Stock stockholders’ behalf. Stockholders usually vote according to the number of shares held.
The two main types of voting rules are the majority voting rules, under which candidates
run for specific seats, and the cumulative voting rules, under which all the candidates
run against each other but do not run for a particular seat.
2. xplain the disadvantages and advantages of equity financing.
Disadvantages of equity financing include the dilution of existing shareholder power
and control, flotation costs incurred when new common stock is sold, and the negative
signal investors often perceive (rightly or wrongly) when new common stock is sold.
Equity financing has several advantages. It reduces the risk of a firm because common
stockholders, as opposed to debtors, have no contractual entitlement to dividends. Equity
financing can also increase the ability to borrow in the future.
3. xplain the process of issuing new common stock.
Once a firm decides that the benefits outweigh the costs of issuing stock, the firm almost
always seeks the help of an investment banking firm. The investment banker usually
underwrites the new issue, which means that it purchases the entire issue for resale
to investors. Sometimes the investment banker will try to find investors for the new
common stock without a guarantee to the issuing company that the stock will be sold.
This arrangement is known as a best efforts offering.
4. escribe the features of rights and warrants.
Rights are securities given to existing common stockholders that allow them to purchase
additional shares of stock at a price below market value. Corporations issue rights to
safeguard the power and control of existing shareholders in the event of a new stock
issue. Warrants are securities that give the holder the option to buy a certain number of
shares of common stock of the issuing company at a certain price for a specified period
of time. Warrants have high-return potential because if the stock price increases, the
value of the warrant increases at a much higher rate due to leverage. The downside risk
of a warrant is limited because the maximum loss potential is the price of the warrant.
As a result of the high-return and low-risk potential, warrants have time value that is
greatest when the stock price is volatile and the time to maturity is great. Equations Introduced in This Chapter
The Number of Directors Who Can Be Elected under Cumulative
NUM DIR = where: (SHARES CONTROLLED - 1) × (TOT NUM DIR T.B.E. + 1)
TOT NUM VOTING SHARES NUM DIR = umber of directors who can be elected by a
given group SHARES CONTROLLED = he number of voting shares controlled by a
TOT NUM DIR T.B.E. = otal number of directors to be elected
T TOT NUM VOTING SHARES = otal number of voting shares in the election
T 457 458 Part IV Long-Term Financing Decisions Equation 15-2.
The Number of Shares Needed to Elect a Given Number of
Directors under Cumulative Voting Rules:
NUM VOTING SHARES NEEDED = where: NUM DIR DESIRED × TOT NUM VOTING SHARES
TOT NUM DIR T.B.E. + 1 NUM DIR DESIRED = umber of directors a given group of
stockholders desires to elect TOT NUM VOTING SHARES = otal number of voting shares in the
election TOT NUM DIR T.B.E. = otal number of directors to be elected
in the election Equation 15-3.
Approximate Value of a Right, Stock Trading Rights-On:
R = where: M0 − S
N + 1 R = Approximate market value of a right
M0 = Market price of the common stock, selling rights-on S = Subscription price N = umber of rights needed to purchase one of the new shares of
common stock Equation 15-4. Approximate Value of a Right, Stock Trading Ex-Rights:
R = where: Mx − S
N R = Approximate market value of a right
Mx = Market price of the common stock, selling ex-rights S = Subscription price N = umber of rights needed to purchase one of the new shares of
common stock Equation 15-5.
The Exercise Value of a Warrant:
XV = (M – XP) × #
where: XV = Exercise value of a warrant M = Market price of the stock XP = Exercise price of a warrant # = umber of shares that may be purchased if the warrant
is exercised Chapter 15 Common Stock 459 Self-Test
ST-1. hat is residual income and who has a claim
on it? W
ST-3. hat does it mean when a company’s common
stock is said to be trading ex-rights? ST-2. s a new common stock issue usually perceived
as a good or bad signal by the market? Explain. ST-4. f a company’s common stock is selling at
$80 per share and the exercise price is $60 per
share, what would be the exercise value of a
warrant that gives its holder the right to buy
10 shares at the exercise price? Review Questions
1. What are some of the government requirements
imposed on a public corporation that are not
imposed on a private, closely held corporation?
2. How are the members of the board of directors of
a corporation chosen and to whom do these board
members owe their primary allegiance?
3. What are the advantages and the disadvantages of a
new stock issue? 4. hat does an investment banker do when
underwriting a new security issue for a corporation?
5. ow does a preemptive right protect the interests of
6. xplain why warrants are rarely exercised unless
the time to maturity is small.
7. nder what circumstances is a warrant’s value
high? Explain. Build Your Communication Skills
CS-1. eview a financial publication, such as
The Wall Street Journal, for a tombstone
advertisement. Contact one of the investment
banking firms you see listed in a tombstone ad
announcing a new issue. Request a prospectus
for that new issue. Once you receive the
prospectus, write a report describing its key
elements and what those elements reveal about
the new security and its issuer. CS-2. Research a company that is having a contested
stockholder vote. You will find notice of such a
vote in business publications, such as The Wall
Street Journal. Different groups will typically
run their own advertisements soliciting proxies
so those groups can vote the shares of other
stockholders. Analyze the positions of the
opposing sides, break into small groups, and
debate the direction the company should take
on the issue in contention. 460 Part IV Long-Term Financing Decisions Problems
Sonny owns 20,000 shares of common stock in QuickFix Company. The
company has 1 million shares of common stock outstanding at a market
value of $50 per share. What percentage of the firm is owned by Sonny? the company issues 500,000 new shares at $50 per share to new stockholders,
how does Sonny’s ownership change?
Terence Mann is considering buying some shares of common stock of
an initial public offering by NewAge Communications Corporation. The
privately held company is going public by issuing 2 million new shares at
$20 per share. Terence gathered the following information about NewAge: Total assets: $ 00 illion (historical cost)
m Total liabilities: $ 50 illion (market value
3 illion (5 million shares after IPO)
m Number of shares retained by pre-IPO owners outstanding $ Estimated liquidation value: $ 50 million
2 Estimated replacement value of assets: $ 00 illion
m Expected dividend in one year: $ Expected dividend growth rate: 2 per share
The required rate of return for Terence from a share of common stock for this
type of company is 13 percent.
Compare the selling price of the stock with its value as obtained from different
valuation methods. Would you recommend that Terence buy the stock?
Danali Corporation has 2,500,000 shares of common stock outstanding.
Danali has a 15-member board, and five will leave at the end of this year.
There are nine candidates for these five open seats. The minority group
of stockholders controls 45 percent of the shares, and the majority group
controls the other 55 percent. What is the maximum number of directors who
definitely can be elected by each of the following under cumulative voting
rules? a. The minority group b. The majority group
Using the information in the previous problem, how many voting shares
would be needed to elect the specified directors? a. 1 director b. 3 directors c. 5 directors 461 Chapter 15 Common Stock 15-5.
Alliances are shifting, and Danali Corporation (described in the previous two
problems) now has 35 percent of the voting shares controlled by the minority
group and 65 percent by the majority. a.
How many directors can now be elected for the minority group? b.
How many voting shares would be needed if the minority group wanted
two directors under the revised group breakdown? Ownership Claim Valuation of IPO 15-6.
Iowa Corn Corporation has nine board members. Three of these seats are up
for election every three years. What is the length of the term served by each
The stockholders of Blue Sky, Inc. are divided into two camps of different
corporate management philosophy. The majority group controls 65 percent
and the minority group controls 35 percent of the voting shares. The total
number of shares of common stock outstanding is 1 million. The total
number of directors to be elected in the near future is four. What is the
maximum number of directors the minority group can possibly elect,
assuming that the company follows cumulative voting procedures?
Ms. O’Niel owns 26,000 shares of Tri Star Corporation out of 200,000
shares of common stock outstanding. The board has seven members, and all
seven seats are up for election now. Ms. O’Niel has long wanted to serve as a
member of the board. Assuming that the company follows cumulative voting
procedures, can Ms. O’Niel get herself elected to the board on the strength
of her own votes?
The Rainbow Corporation had traditionally been a constant dollar-dividend
paying company, with the board enjoying the support of retired investors
holding 65 percent of the voting shares. A dissident group of high-salaried
young investors holding 30 percent of the voting shares prefers reinvestment
of earnings to save personal taxes and, hence, wants to elect board members
supportive of its cause. The company has 600,000 shares of common stock
outstanding and the board has 13 members—all to be reelected shortly. a.
How many directors can the young stockholders elect under (i) cumulative voting rules? (ii) majority voting rules? b.
What percentage of voting shares and/or proxies must the dissident group
have to be able to elect 7 out of the 13 board members?
Fargo Corporation has 500,000 shares of common stock currently
outstanding. The company plans to sell 50,000 more shares of common
stock to the existing shareholders through a rights offering. How many rights
will it take to buy one share?
15-11. company with 2 million shares of common stock currently outstanding
is planning to sell 500,000 new shares to its existing shareholders through
a rights issue. Current market price of a share is $65, and the subscription
price is $55. If the stock is selling rights-on, calculate the value of a right. Number of Directors Number of Voting Shares
Needed 462 Part IV Long-Term Financing Decisions Number of Directors 15-12.
Use the same information given in problem 15-11. Now calculate the value
of a right if the stock is selling ex-rights. Term of Board Members Cumulative Voting Cumulative Voting Dissident Group and Cumulative Voting Rights Offering Value of Rights 15-13.
Fillsulate Products, a manufacturer of refractory powders, is about to declare
a rights issue. The subscription price is $65. Seven rights in addition to
the subscription price are required to buy one new share of stock. Rightson market price of the stock is $77. Calculate the value of one right. Also
calculate the new stock price once it goes ex-rights.
Johnny Rocco owns 700 shares of stock of East-West Tobacco Company,
which is offering a rights issue to its existing shareholders. To buy one new
share of stock, Johnny will need four rights plus $60. Rights-on market price
of the stock is $72. a. Calculate the value of a right. b. What is the maximum number of new shares Johnny can buy? c.
How much would he have to spend if he decides to buy all the new stock
he can? d. f he decides not to buy the new stock, how much would he be able to sell
his rights for?
Kelsery Products is planning on selling 300,000 new shares to existing
stockholders through a rights issue. The company currently has 1,500,000
outstanding shares at a market price of $40 and a subscription price of $25.
The stock is selling rights-on. What is the value of one right?
Using the data from problem 15-15, calculate the value of one right if the
stock is selling ex-rights.
Armand Goldman owns 60 shares of East Asia Shipping Company stock and
has $750 in cash for investment. The company has offered a rights issue in
which purchasing a new stock would require four rights plus $50 in cash.
Current market value of the stock is $62. a.
Calculate the value of a right if the stock is selling rights-on. b.
Should Armand participate in the rights offering by buying as many
shares as he can, or sell his rights and keep the shares he already owns at
a diluted value?
The current market price of a share of common stock of SkyHigh, Inc. is
$100. The company had issued warrants earlier to its new bond investors
that gave the investors an option to buy five shares of common stock at
an exercise price of $85. Calculate the exercise value of a warrant. What
happens to the exercise value of the warrant if the stock price changes to: a. $110? b. $80? 463 Chapter 15 Common Stock 15-19.
The current market price of Digicomm’s common stock is $40 per share. The
company has 600,000 common shares outstanding. To finance its growing
business, the company needs to raise $2 million. Due to its already high debt
ratio, the only way to raise the funds is to sell new common stock. Alvin C.
York, the vice president of finance of Digicomm, has decided to go ahead
with a rights issue, but he is not sure at what price the existing shareholders
would be willing to buy a share of new stock. Digicomm’s investment
banker has suggested that an analysis based on a wide range of possible
prices be carried out, and the subscription prices agreed upon were $36, $33,
$29, and $26 per share of new stock. Digicomm’s net income for the year is
Based on the preceding information, Mr. York has asked you to carry out the
following analysis: a. each of the possible subscription prices, calculate the number of
shares that would have to be issued and the number of rights required to
buy one share of new stock. b. each of the possible subscription prices, calculate the earnings per
share immediately before and immediately after the rights offering. c.
Guy Hamilton owns 10,000 shares of Digicomm stock. For each of the
possible subscription prices, calculate the maximum number of new
shares Guy would be able to buy. Under each of these cases, calculate
Guy’s total claim to earnings before and after the offering. Value of Rights Value of Rights Rights Offering Rights Value (Rights-On) Answers to Self-Test ST-1. esidual income is income that is left over after all claimants, except for
common stockholders, have been paid. This leftover income belongs to
the common stockholders, who receive this income either in the form of a
dividend or by having it reinvested in the corporation that they own.
ST-2. he market usually infers bad news when new common stock is issued.
Investors ask themselves why the current owners would want to share their
profits with new owners if management expected good news ahead. The
market often infers (rightly or wrongly) that there must be bad news coming
that the management of the firm wants to “share” with new stockholders.
New stock issued is, therefore, usually perceived as a negative signal.
ST-3. stock is selling ex-rights when the purchase of that stock no longer carries
with it entitlement to the rights that are soon to be sent out to stockholders.
ST-4. $80 stock price – $60 exercise price) × 10 shares purchased per warrant =
$200 exercise value of the warrant Rights Value (Ex-Rights) C hallenge Problem Warrants ...
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