Corporate

Finance
Questions and Practice problems_Chapter 15

Chapter 15:
Concept questions (page 490 textbook): 2, 6, 12, 13
Questions and Problems (page 491 textbook): 1, 4

Answers:
Concept questions:
2. The differences between preferred stock and debt are:
a. The dividends on preferred stock cannot be deducted as interest expense when
determining taxable corporate income. From the individual investor’s point of view,
preferred dividends are ordinary income for tax purposes. For corporate investors, 70%
of the amount they receive as dividends from preferred stock are exempt from income
taxes.
b. In case of liquidation (at bankruptcy), preferred stock is junior to debt and senior to
common stock.
c. 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 (of course,
indefinitely deferring the dividends might have an undesirable effect on the market
value of the stock).
6. There are two benefits. First, the company can take advantage of interest rate declines by
calling in an issue and replacing it with a lower coupon issue. Second, a company might
wish to eliminate a covenant for some reason. Calling the issue does this. The cost to the
company is a higher coupon. A put provision is desirable from an investor’s standpoint, so
it helps the company by reducing the coupon rate on the bond. The cost to the company is
that it may have to buy back the bond at an unattractive price.
12. When a company has dual class stock, the difference in the share classes are the voting
rights. Dual share classes allow minority shareholders to retain control of the company
even though they do not own a majority of the total shares outstanding. Often, dual share
companies were started by a family, and then taken public, but the founders want to retain
control of the company.
13. The statement is true. In an efficient market, the callable bonds will be sold at a lower price
than that of the non-callable bonds, other things being equal. This is because the holder of
callable bonds effectively sold a call option to the bond issuer. Since the issuer holds the
right to call the bonds, the price of the bonds will reflect the disadvantage to the
bondholders and the advantage to the bond issuer (i.e., the bondholder has the obligation
to surrender their bonds when the call option is exercised by the bond issuer.)

Questions and Problems:
1. Straight voting: Total cost = $18,275,043
 Cumulative voting: Total cost = $4,568,793
4. Percent of stock needed = 14.29%. Her nominee is guaranteed election.
If the elections are staggered, the percentage of the company’s stock needed is 33.33%. Her
nominee is no longer guaranteed election.