Chapter 13: Stockholders' Equity, Earnings and Dividends
Common and Preferred Stock
All corporations have common stock. Common stock provides the following rights to shareholders:
sell or transfer any of their shares
buy additional newly issued shares in a proportion equal to the percentage of shares they already own (called the preemptive right),
receive a dividend when declared,
receive a portion of any money left over after paying all debts in a liquidation, and
one vote for every share of stock.
It is important to note that shareholders cannot take money out of the business whenever they want like owners could in a sole proprietorship or partnership. Shareholders receive earnings of the company in the form of dividends which must be declared by the board of directors.
There is some terminology we need to get familiar with for stock. These include:
Authorized shares: Authorized share are the total number of shares we are allowed to sell as specified in the corporate charter.
Issued shares: Issued shares are the total number of share we have given out to shareholders.
Outstanding shares: Outstanding shares are the total number of shares currently held by shareholders. Issues and outstanding shares will be different if the company has treasury stock, which we will discuss later.
Par value: Random value assigned to each share of stock in the corporate charter.
No par value: A par value was not assigned to each share of stock in the corporate charter.
Stated value: No par value stock (meaning no value was assigned to stock in the charter) but the board of directors voted and determined a value for each share of stock.
Market value: Current value of a share of stock as determined by the stock exchange.
All corporations have common stock. Another type of stock some corporations may have is preferred stock. Preferred stock has the same rights and terminology associated with common stock with a few differences. Preferred stock is guaranteed a specific amount or rate of dividends each year when dividends are declared. Preferred stockholders may give up their right to vote.
Types of preferred stock
When a corporation issues both preferred and common stock, the preferred stock may be:
Noncumulative preferred stock is preferred stock on which the right to receive a dividend expires whenever the dividend is not declared. This means that if the company does not declare dividends this year they do not have to pay preferred shareholders the guaranteed dividend amount.
Cumulative preferred stock is preferred stock for which the right to receive a basic dividend accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock. This means if the company does not declare dividends this year, the amount owed from this year will rollover to next year. Preferred shareholders must receive all dividends owed before common shareholders can get a dividend.
Convertible preferred stock is preferred stock that is convertible into common stock of the issuing corporation. Many preferred stocks do not carry this special feature; they are nonconvertible. Holders of convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common stock of the same corporation.
Callable preferred stockmeans that the corporation can inform nonconvertible preferred stockholders that they must surrender their stock to the company. Also, convertible preferred stockholders must either surrender their stock or convert it to common shares. Most preferred stocks are callable at the option of the issuing corporation. Preferred shares are usually callable at par value plus a small premium of 3 or 4 % of the par value of the stock. This call premium is the difference between the amount at which a corporation calls its preferred stock for redemption and the par value of the preferred stock.
Why would a corporation call in its preferred stock? Corporations call in preferred stock for many reasons: (1) the outstanding preferred stock may require a 12 per cent annual dividend at a time when the company can secure capital to retire the stock by issuing a new 8 per cent preferred stock; (2) the issuing company may have been sufficiently profitable to retire the preferred stock out of earnings; or (3) the company may wish to force conversion of its convertible preferred stock because the cash dividend on the equivalent common shares is less than the dividend on the preferred shares.
We will discuss how noncumulative and cumulative preferred stock affects cash dividends in the next unit.
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