Prefered Stok and Common Stock

Chapter 20
Preferred Stock, and

Common Stock
20.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Preferred Stock
and Its Features
Preferred Stock – A type of stock that
promises a (usually) fixed dividend, but at
the discretion of the board of directors.
Basic Terms
Par Value
Dividend Rate
Maturity
Cumulative
Dividends Feature
Cumulative Dividends Feature – A requirement
that all cumulative unpaid dividends on the
preferred stock be paid before a dividend may
be paid on the common stock.
• For example, if the board of directors omits a $6
preferred dividend for two years, it must pay preferred
shareholders $12 per share ($100 par value) before any
dividend can be paid to common shareholders.
• The corporation does not have to make up the dividend
even if it is profitable, as long as the firm has no plans
to pay dividends to common shareholders.
Participating Feature
Participating Preferred Stock – Preferred stock where
the holder is allowed to participate in increasing
dividends if the common stockholders receive
increasing dividends.
• Preferred stockholders have a prior claim on income
and an opportunity for additional return if the
dividends to common stockholders exceed a certain
amount.
• A 6% participating preferred issue ($100 par) allows
holders to share equally in any dividend in excess of
$6. A $7 common dividend results in an extra $1
dividend to the participating preferred shareholders.
Voting Rights in
Special Situations
• Preferred stockholders are not normally given a
voice in management unless the company is unable
to pay preferred stock dividends during a specified
period.
• If such a situation presents itself, the class of
preferred stockholders would be entitled to elect a
specified number of directors.
• Any situation in which the company defaults under
restrictions in the agreement (similar to bond
indenture) may lead to voting power for preferred
shareholders.
• Preferred shareholders cannot force the immediate
repayment of obligations (like debt obligations).
Retirement of
Preferred Stock
• Call Provision – almost all issues carry a call provision
because of the infinite maturity. It is often a cheaper
method of retirement than open market purchases,
inviting tenders, or an exchange of securities.
• Sinking Fund – like bonds, many preferred issues
provide for this method of retirement.
• Conversion – certain issues are convertible into
common stock at the option of the preferred
stockholder. Used most frequently in the acquisition of
other companies (the transaction is not taxable to the
shareholders of the acquired firm).
Use of Preferred
Stock in Financing
• The corporate issuer uses irregularly because the
preferred dividend is not tax deductible. Utilities use
more frequently as the preferred dividend can be
accounted for when setting customer rates.
• The corporate investor is attracted to preferred stock as
generally 70% of dividends can be excluded from taxes.
• Money market preferred stock (MMP) is a floating-
rate preferred stock with the dividend rate set at
auction every 49 days - attractive to corporations.
• Flexibility in paying dividends and an infinite maturity
(similar to a perpetual loan) are significant advantages to
the corporate issuer.
• The after-tax cost of preferred financing is greater than
that of long-term debt financing to the corporate issuer.
Common Stock
and Its Features
Common Stock – Securities that

represent the ultimate ownership (and
risk) position in a corporation.
Basic Terms
Authorized Shares
Issued Shares
Outstanding Shares
Types of
Common Stock Value
A. Par Value – The face value.
• It is merely a recorded figure in the corporate charter
and is of little economic consequence.
• Stock should never be issued below par value as
shareholders would be legally liable for any discount
from par if the firm is liquidated.
• Common stock that is authorized without par value
(no-par stock) is carried on the books at the original
market price or at some assigned (or stated) value.
• The difference between the issuing price and the par
or stated value is additional paid-in capital.
Example of Value
FunFinMan, Inc.
Common stock ($1 par value; 100,000
shares issued and outstanding) $ 100,000
Additional paid-in capital 400,000
Retained earnings 650,000
Total shareholders’ equity $1,150,000
The par value of FunFinMan, Inc., is $1 per share.

This value is not likely to change over time from
normal day-to-day operations.
Types of
Common Stock Value
B. Book Value (per share) – Shareholders’ equity
(as listed on the balance sheet) divided by the
number of shares outstanding.
C. Liquidating Value (per share) – The value per

share if the firm’s assets are sold separately
from the operating organization.
• This value may be less (or greater) than
book value. Rarely are the two values
identical.
Example of Book
Value (per share)
FunFinMan, Inc.
Common stock ($1 par value; 100,000
shares issued and outstanding) $ 100,000
Additional paid-in capital 400,000
Retained earnings 650,000
Total shareholders’ equity $1,150,000
The book value (per share) of FunFinMan, Inc., is

determined by dividing total shareholders’ equity
($1,150,000) by the shares outstanding (100,000),
which yields a book value of $11.50 per share. This
value is not likely to change over time from normal
day-to-day operations.
Types of
Common Stock Value
D. Market Value (per share) – The current price
at which the stock is currently trading.
• This value is usually greater than book
value (per share), but can occasionally be
less than book value (per share) for firms
that have been, are or expected to be in
financial difficulties. Rarely are the two
values identical.
• Market value (per share) may be difficult to
obtain from thinly traded securities.
Types of
Common Stock Value
D. Market Value (per share) – continued.
• Typically, the shares of new

companies are traded in the over-the-
counter (OTC) market, where dealers
maintain an inventory of the stock to
provide additional liquidity.
Rights of
Common Shareholders
• Right to Income – entitled to share in the earnings of the
company only if cash dividends are paid (via approval
by the board of directors).
• Right to Purchase New Shares (Maybe) – the corporate
charter of state statute may provide current
shareholders with a preemptive right, which requires
that these shareholders be first offered any new issue
of common stock or an issue that can be converted into
common stock.
• Voting Rights – because the shareholders are owners of
the firm, they are entitled to elect the board of directors.
Voting Rights
• Shareholders are generally geographically widely
dispersed.
• Two methods of voting: (1) in person or (2) by proxy
Proxy – A legal document giving one person(s)
authority to act for another.
• SEC regulates the solicitation of proxies and
requires companies to disseminate information to
their shareholders through proxy mailings or via the
Internet effective July 2007.
• Most shareholders, if satisfied with company
performance, sign proxies in behalf of management.
Proxy Contest
• Occurs usually when disagreement between
management and an outside or minority party
• Non-management group will register its proxy
statement with the SEC and will often send an
alternative proxy request to shareholders
• Management, due to corporate resources and
organization, is generally favored to win
• eProxies are expected to provide a more cost-
effective mechanism for non-management groups to
communicate with shareholders and possibly reduce
the management advantage.
Voting Procedures
The board of directors are elected under either:
• Plurality voting – a method of electing corporate
directors, where each common share held carries
one vote for each director position that is open; the
highest vote count wins the open director position.
Does not consider “withheld” or “against” votes.
• Cumulative voting – a method of electing corporate
directors, where each common share held carries
as many votes as there are directors to be elected
and each shareholder may accumulate these votes
and cast them in any fashion for one or more
20.18
particular directors.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Voting Procedures
A growing election method:
• Majority or Modified Plurality voting – a method of
electing corporate directors, where each common
share held carries one vote for each director
position that is open; a majority of all votes cast
must be received to be elected.
• Common in Europe and gaining popularity due to
advocacy groups in the United States
• Must receive a majority of “for” plus “against” plus
“withheld” votes cast
• Approximately two-thirds of S&P500 have adopted by Nov
2007 versus only 16% in Feb 2006
Voting
Procedures Example
You are a shareholder of FunFinMan, Inc. You
own 100 shares and there are 9 director
positions to be filled.
• Under majority-rule voting: You may cast 100 votes
(1 per share) for each of the 9 director positions
open for a maximum of 100 votes per position.
• Under cumulative voting: You may cast 900 votes
(100 votes x 9 positions) for a single position or
divide the votes amongst the 9 open positions in
any manner you desire.
Minimum Votes to Elect
a Director – Cumulative
Total number of Specific number of

voting shares X directors sought
+1
Total number of directors to be elected + 1
• For example, to elect 3 directors out of 9 director

positions at FunFinMan, Inc., (100,000 voting shares
outstanding) would require 30,001 voting shares.
• (100,000 shares) x (3 directors) + 1 = 30,001 shares
10
Minimum Votes to Elect
a Director – Cumulative
• Notice that slightly over 30% of total voting shares
are necessary to guarantee the election of three
of the nine director positions – less than a
majority.
• Management can reduce the influence of minority
shareholders by reducing the number of directors
or staggering the election terms of directors so
fewer positions are open at each vote.
• Reducing the number of directors up for election
from 9 to 4 would increase the votes necessary to
elect 3 directors to 60,001 shares (twice as many)!
Dual-Class
Common Stock
Dual-class Common Stock – Two classes of common
stock, usually designated Class A and Class B. Class
A is usually the weaker voting or nonvoting class, and
Class B is usually the stronger.
• This is used to retain control for founders,
management, or some other specific group.
• For example, 80,000 shares of Class A at $20/share
and 200,000 shares of Class B at $2/share. Class A
puts up 80% of the funds, but Class B has over 70%
of the votes.
• Usually Class B takes a lower claim to dividends
and assets than Class A for this voting control.

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Chapter 20

Preferred Stock, and

Common Stock – Securities that

The par value of FunFinMan, Inc., is $1 per share.

C. Liquidating Value (per share) – The value per

The book value (per share) of FunFinMan, Inc., is

• Typically, the shares of new

Total number of Specific number of

• For example, to elect 3 directors out of 9 director

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