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Chapter 22

22- Chapter 22

Equity 22-

      22-

CHAPTER 22 

Equity 
 
 

QUESTIONS 

    1. In what way can owners' equity been seen as:

    a.  An accounting measure?  Owners' equity represents the amount of a company's assets not offset by liabilities, hence owned by the firm's investors.  Mathematically, owners' equity equals assets minus liabilities.

    b.  A legal concept?  Owners' equity represents the legal ownership of the business, the investment of those with the authority to hire (or be) the firm's management and set company policy.

    c.  An investment concept?  Owners' equity identifies that some people have contributed money to the firm and represents one measure of the value of the money they have invested.

    d.  A value claim concept?  Owners' equity indicates that there is a person or group of people who have the last claim to the income produced by the company and to any residual value should the firm dissolve.

    e.  A risk concept?  Owners' equity represents a class of contributors to the company who bear a relatively high amount of risk in return for potentially high returns. 

      2. Distinguish among the following common stock concepts:

      a.  Authorized shares � the total number of shares a company can issue as approved by the government.

      b.  Issued shares � the total number of shares sold to investors at any time in the past.

      c.  Outstanding shares � the number of shares currently in the hands of investors.

      d.  Treasury shares � the number of issued shares not currently in the hands of investors having been repurchased by the company and “held in the company's treasury.” 

        3. Distinguish among the following common stock concepts:

        a.  Par value � the maximum capital contribution required from investors for each share.

        b.  Book value � the accounting value for each share; total owners' equity divided by the number of shares outstanding.

        c.  Market value � the price of each share in the financial marketplace reflecting investors forecasts of future cash flows the company will produce.

        d.  Liquidation value � the value investors would receive for each share if the company were dissolved and its assets sold. 
         

          4. What are six benefits to owning common stock?  Rank them in order of importance to you.  Everyone will rank the six benefits in their own order of preference, although most people will put income near the top of the list.  In the order presented in this chapter, the six benefits are:

          (1) Income � the right to a proportional share of the company's income, either paid out as a dividend or retained and reinvested in the business.

          (2) Control � the right to vote on company affairs, in particular the election of directors, the selection of external auditors, and proposed amendments to the company's charter or by-laws.

          (3) Information � the right to “inspect the company's books,” usually satisfied by providing stockholders with summary financial statements and commentary in the company's annual and quarterly reports.

          (4) Freedom to sell � the ability to sell ownership in the company to anyone else at any time without the need for approval.

          (5) Limited liability � freedom from legal responsibility for company errors beyond the amount of the money invested in the company.

          (6) Residual claim � the right to a proportional share of any value remaining after all other claimants have been satisfied, particularly in bankruptcy. 

            5. What is the difference between primary and fully diluted earnings per share?  Primary earnings per share (EPS) is calculated by dividing a corporation's reported net income by the average number of shares outstanding during the year.  It is a measure of a company's per-share performance as it actually happened.  Fully diluted earnings per share measures what would have happened to EPS if all options on the company's stock had been exercised at the beginning of the year, increasing the average number of outstanding shares and possibly changing net income.  For example, if a company's outstanding convertible bonds had been exchanged for common stock, interest expense would have been reduced and the number of outstanding shares would have increased.  Both measures must be reported with a company's income statements under GAAP accounting rules. 

              6. In what way does a proxy give significant power to a corporation's management?  A proxy is a combination absentee ballot and assignment of vote.  Proxies are solicited by management prior to a corporation's annual meeting.  One reason is to ensure that a majority of shares are represented at the annual meeting, either in person or by proxy, thus constituting a quorum and permitting the meeting to take place.  However, in a widely-held company, it is normal for only a small percentage of stockholders to attend the annual meeting; the vast majority of shares are represented by proxies.  This gives power to management in two ways.  First, the proxy form is usually printed to favor management.  For yes-no-abstain votes, the proxy typically identifies management's preferred outcomes, often in large bold type.  For the election of directors, the typical proxy only gives shareholders two choices: (1) vote for all of management's preferred candidates, or (2) vote for all of management's preferred candidates except those whose names the shareholder writes into a small space on the proxy.  With these limited, awkward alternatives, it is difficult for management's candidates to lose.  Second, collecting proxies permits management to cast a majority of the votes on any issue not listed on the proxy that comes before the meeting.  Management has total control of these issues and while dissenting shareholders may speak out, they cannot change management's position. 

                7. Is there any advantage to having preemptive rights as a stockholder?  Is there any disadvantage?  There are two advantages to a corporation's stockholders of having preemptive rights.  The primary advantage is the ability to maintain a proportional ownership of the corporation should it issue additional shares of common stock in order to maintain control.  In addition, it is less costly to issue new shares to existing shareholders than to new shareholders since the services of an investment banker are not required.  This lowers the company's cost of equity, and hence its cost of capital, increasing the firm's value.  Management can keep this extra value within the company or can distribute it to shareholders in the form of a discounted price on the newly issued shares (in which case the rights may be used or sold to other investors for their cash value).  There is no particular disadvantage to preemptive rights other than that a stockholder who elects to use them to purchase additional shares must come up with the necessary amount of cash. 

                  8. Why can't a stockholder “inspect the company's books”?  If a stockholder could literally inspect the company's books, a company's competitors could buy a few shares and use their new relationship as a stockholder to obtain confidential competitive information.  Also, a constant stream of stockholders passing through a company's offices and going through its records could create quite a disruption to its business.  Instead, stockholders are entitled to regular financial reports according to standard accounting formats, an obligation discharged through the formal annual report and 10K form (the non-glossy annual report required to be filed with the Securities and Exchange Commission). 

                    9. When would a stockholder be willing to purchase a class of common stock that did not have full shareholders' rights?  Not all shareholders' rights are of equal value to all shareholders.  Some shareholders value one or more of the rights of ownership so highly that they are willing to give up other shareholder rights to secure the ones they value most.  For example, when venture capitalists invest in a startup business, the company's managers often get stock with control but limited income (“founder's shares”) while the venture capitalists get shares with income but limited control.  Also, some shareholders are prohibited by law or regulation from owning one or more of the traditional shareholder rights.  For example, a charity or foundation which owns a substantial amount of the stock of any one company will attract the scrutiny of the IRS which will wonder whether it was set up to evade taxes while maintaining control of the company.  Such a charity or foundation might prefer stock with all the income and residual value rights but with limited or no voting power to avoid threatening its tax-exempt status. 
                     
                     

                      10. Why is preferred stock often called a hybrid between bonds and common stock?  Preferred stock is often considered a hybrid between bonds and common stock because it contains a mixture of many of the characteristics of each.  Among the examples given in the chapter:

                      (1) Like a bond: preferred stock has a face or maturity or par value, it pays its holder a fixed amount each year, it normally has no voting privileges, it has priority above common stock in liquidation, it may contain a call feature or be convertible to common stock, the issue may require a sinking fund for its retirement, and it may contain indenture provisions.

                      (2) Like common stock: preferred stock normally does not have a fixed maturity, it pays a dividend, it may contain voting power, it has priority after all debt in liquidation, and dividends may adjust with the company's income. 

                        11. Is there any difference in value between cumulative and non-cumulative preferred stock?  Why, or why not?  While the difference is minimal in financially healthy companies, there is a significant difference in companies in financial distress.  A company with outstanding cumulative preferred stock cannot pay dividends on its common stock unless all past dividends on the preferred issue have been fully paid.  Financially healthy companies routinely pay all preferred dividends; to the preferred shareholders of these firms, the cumulative feature adds little value to the issue because it is highly unlikely that it will ever be invoked.  However, companies in financial distress often are cash poor and elect to suspend preferred dividends in order to conserve their cash.  To the preferred shareholders of these firms, the cumulative feature is critical to maintaining any value to the preferred shares at all. 

                          12. Why do companies issue warrants?  Companies issue warrants for at least three reasons: (1) as the mechanism for conveying preemptive rights to their shareholders (“stock subscription warrants”), (2) as incentive compensation for employees (“employee stock options”), and (3) as extra compensation for lenders and preferred stockholders (“sweeteners,” “kickers”). 

                            13. Why do companies issue convertible bonds?  Companies issue convertible bonds for at least four reasons: (1) to minimize the interest rate on their debt since the conversion feature forms part of the lenders' value, (2) to raise funds in a poor stock market that will eventually become equity at a much better share price, (3) to create financial leverage for a period of time which then disappears upon the bonds' conversion, and (4) to use and then automatically free up debt capacity. 

                              14. What is the relationship of a warrant and a convertible bond to a call option? Both a warrant and a convertible bond contain a call option.  A warrant is a call option.  The holder of the warrant can force the company to deliver a specified number of shares of its stock to be paid for with cash.  Warrants differ from other call options only in that they are issued by the company whose stock can be called.  A convertible bond is the combination of a bond and a call option.  The bond's owner can force the company to deliver a specified number of shares of its stock to be paid for with the bond.  And, like a warrant, the option is granted by the company whose stock can be called. 

                                15. Under what circumstances can a company successfully force conversion of a convertible bond?  Under what circumstances will the company fail?  Since holders of convertible bonds generally have no reason ever to convert the bonds to stock, companies often use a call feature to force conversion.  Bondholders will convert their bonds in response to a call if the value of the stock to be received upon conversion exceeds the proceeds from the call.  This will be the case if the stock has risen sufficiently since the bond was issued.  On the other hand, if the company's stock price has not increased very much so that the value to be received upon conversion is less than the proceeds from the call, bondholders will simply submit to the call and the company will find itself paying out cash instead of issuing new stock. 
                                 

                                PROBLEMS 

                                SOLUTION PROBLEM 221 

                                (a) Issued shares  =  the 6 million that have been sold to the public. 

                                (b) Authorized but not issued shares

                                            =  10 million authorized  6 million issued  =  4 million 

                                (c) Outstanding shares  =  the 5 million in the hands of investors today. 

                                (d) Treasury shares  =  6 million issued  5 million outstanding  =  1 million
                                 

                                SOLUTION PROBLEM 222 

                                (a) Authorized but not issued shares

                                            =  40 million authorized  25 million issued  =  15 million 

                                (b) Outstanding shares  =  25 million issued  7 million repurchased  =  18 million  

                                (c) Treasury shares  =  the 7 million that have been repurchased by the company. 

                                  (d) With 18 million shares outstanding, a 2 for 1 split would require issuing another 18 million shares.  This would raise the number of shares outstanding to 36 million, within the 40 million shares authorized.  Therefore, no additional authorization is required.

                                SOLUTION PROBLEM 223 

                                  (a) The shareholder's obligation is the par value of $2.50.  Since only $1.00 has been paid, the remaining obligation is $2.50  1.00  =  $1.50 

                                  (b) This shareholder has already satisfied the obligation of $2.50.  Remaining obligation  =  $0 

                                  (c) Book value per share = Total owners' equity = $96 million =  $8.00

                                                    Shares outstanding 12 million 

                                  (d) Earnings per share =              Net income             = $25 million  = $2.17

                                                    Average shares outstanding 11.5 million 
                                   

                                  SOLUTION PROBLEM 224 

                                    (a) The shareholder's obligation is the par value of $1.00.  Since only $0.40 has been paid, the remaining obligation is $1.00  0.40  =  $0.60 

                                    (b) This shareholder has already satisfied the obligation of $1.00.  Remaining obligation  =  $0 

                                    (c) Book value per share = Total owners' equity = $100 million =  $4.00

                                                      Shares outstanding   25 million 

                                    (d) Earnings per share =              Net income             = $75 million = $3.13

                                                      Average shares outstanding  24 million 
                                     

                                    SOLUTION PROBLEM 225 

                                    With 2 directors' seats up for vote, each share has two votes, so the investor who owns 50,000 shares has 100,000 votes. 

                                      (a) Under a majority voting system, she must spread the two votes held by each share across two different candidates.  Since only one vote from each share can be cast for herself, the maximum number of votes she can cast for herself is 50,000

                                        (b) Under a cumulative system, she can cast both votes from each share for herself for a maximum of   2 � 50,000  =  100,000 

                                        With 5 seats up for vote, each share has 5 votes, so her 50,000 shares have 250,000 votes in total. 

                                        (c) Still 50,000

                                        (d) 5 � 50,000  =  250,000 
                                         

                                        SOLUTION PROBLEM 226 

                                        With 3 directors' seats up for vote, each share has 3 votes, so the investor who owns 150,000 shares has   3 � 150,000  =  450,000 votes. 

                                          (a) Under a majority voting system, he must spread the 3 votes held by each share across 3 different candidates.  Since only one vote from each share can be cast for himself, the maximum number of votes he can cast for himself is 150,000

                                          (b) Under a cumulative system, he can cast all three votes from each share for himself for a maximum of   3 � 150,000  =  450,000 

                                          With 7 seats up for vote, each share has 7 votes, so his 150,000 shares have  7 � 150,000  =  1,050,000 votes in total 

                                          (c) Still 150,000

                                          (d) 7 � 150,000  =  1,050,000 
                                           

                                          SOLUTION PROBLEM 227 

                                          (a) You own 1000 of the 25 million shares outstanding:

                                                          1,000       = .00004 = 0.004%

                                                      25,000,000 

                                          (b) You are entitled to a proportionate share of the new issue:

                                                      0.004% � 5 million new shares  =  200 shares 

                                          (c) The 5% discount translates to:

                                                      $30  5%($30)  =  $30  1.50  =  $28.50 

                                          (d) You will purchase 200 shares at $28.50 each.

                                                      200 � $28.50  =  $5,700 
                                           
                                           

                                          SOLUTION PROBLEM 228 

                                          (a) You own 500 shares of the 50 million shares outstanding:

                                                            500       = .00001 = 0.001%

                                                      50,000,000 

                                          (b) You are entitled to a proportionate share of the new issue:

                                                      0.001% � 15 million new shares  =  150 shares 

                                          (c) The 4% discount translates to:

                                                      $75  4%($75)  =  $75  3  =  $72.00 

                                            (d) If you do not purchase the new shares, your percentage ownership will decline from the present 0.001% to:

                                                              500 shares          =       500       = .00000769 = 0.000769%

                                                      50 million + 15 million  65,000,000 
                                           

                                          SOLUTION PROBLEM 229 

                                          Organize the data in a table similar to the one in the Ford Motor Company example in the chapter.  Let X  =  number of votes given each class A share. 

                                                                shares    � votes/share = total votes

                                                Class A   5,000,000 X   5,000,000X

                                                Class B 25,000,000 1 25,000,000 

                                                                        25,000,000 + 5,000,000X 

                                          The voting power of the class A shares is therefore:

                                                      5,000,000X  =    X 

                                                25,000,000 + 5,000,000X 5 + X 

                                          (a) 30% voting power

                                                         X    = .30

                                                      5 + X

                                                      X = .30(5 + X) = 1.5 + .3X

                                                      .7X = 1.5

                                                      X = 1.5/.7 = 2.14 votes / share 
                                           
                                           
                                           
                                           

                                          (b) 40% voting power

                                                         X    = .40

                                                      5 + X

                                                      X = .40(5 + X) = 2 + .4X

                                                      .6X = 2

                                                      X = 2/.6 = 3.33 votes / share 

                                          (c) 50% voting power

                                                         X    = .50

                                                      5 + X

                                                      X = .50(5 + X) = 2.5 + .5X

                                                      .5X = 2.5

                                                      X = 2.5/.5 = 5 votes / share 

                                          (d) 60% voting power

                                                         X    = .60

                                                      5 + X

                                                      X = .60(5 + X) = 3 + .6X

                                                      .4X = 3

                                                      X = 3/.4 = 7.5 votes / share 
                                           

                                          SOLUTION PROBLEM 2210 

                                          The dividend paid to Class B shareholders is:

                                                2 million shares � $1.00  =  $2,000,000 

                                          (a) 5%

                                                      5% � $2,000,000  =  $100,000

                                                and: $100,000/500,000 shares  =  $0.20 / share 

                                          (b) 10%

                                                      10% � $2,000,000  =  $200,000

                                                and: $200,000/500,000 shares  =  $0.40 / share 

                                          (c) 20%

                                                      20% � $2,000,000  =  $400,000

                                                and: $400,000/500,000 shares  =  $0.80 / share 

                                          (d) 35%

                                                      35% � $2,000,000  =  $700,000

                                                and: $700,000/500,000 shares  =  $1.40 / share

                                          SOLUTION PROBLEM 2211 

                                          (a) $12, as stated in the title of the issue. 

                                          (b) 14% � $100 par value  =  $14 

                                          (c) (1) Amount by which common dividend exceeds $5: $7  5  =  $2

                                                (2) Preferred dividend: $10 + 2 � $0.25  =  $10 + 0.50  =  $10.50 

                                            (d) Since the common dividend at $7 exceeds $6, the preferred dividend will increase to $7 to equal the common dividend. 
                                             

                                            SOLUTION PROBLEM 2212 

                                            (a) $13, as stated in the title of the issue. 

                                            (b) 11% � $100 par value  =  $11 

                                            (c) (1) Amount by which common dividend exceeds $8: $12  8  =  $4

                                                  (2) Preferred dividend: $8 + 4 � $0.60  =  $8 + 2.40  =  $10.40 

                                              (d) Since the common dividend at $12 exceeds the $8 threshold, the preferred dividend will increase to $12 to equal the common dividend. 
                                               

                                              SOLUTION PROBLEM 2213 

                                              (a) 1 year's arrearages  =  $12 per share 

                                              (b) 3 years' arrearages  =  3 � $12  =  $36 per share 

                                              (c) 5 years' arrearages  =  5 � $12  =  $60 per share 

                                                (d) If the preferred stock is not cumulative, missed dividends are lost, and no payment is due nor required. 
                                                 

                                                SOLUTION PROBLEM 2214 

                                                (a) Each preferred share is owed: $14 � 10 years  =  $140

                                                      In total, this comes to: $140 � 100,000 shares  =  $14,000,000

                                                  (b) Total outlay  =  the $14 million due the preferred shareholders plus the common dividend which would be:

                                                            $0.50 � 3 million shares  =  $1,500,000

                                                      so the total is:

                                                            $14,000,000 + 1,500,000  =  $15,500,000 

                                                (c) They would receive 10 shares of common stock which would give them a cash dividend of:

                                                            10 shares @ $0.50  =  $5.00

                                                     plus 25% ownership of the company (since they would own 1 million of now 4 million outstanding shares).  In return they would give up their preferred stock and any further claim on the $140 arrearages. 

                                                  (d) (1) zero  non-cumulative preferred has no arrearages

                                                        (2) $1,500,000  the common dividend only

                                                        (3) There would be no need for an exchange offering with no arrearages 
                                                   

                                                  SOLUTION PROBLEM 2215 

                                                    (a) When the stock price is below or equal to the warrant's exercise price, there is no benefit to using the warrant, and its minimum value is $0.  For stock prices above the warrant's exercise price, the minimum value of the warrant is the difference between stock price and exercise price which equals the savings from using the warrant to buy the stock. 

                                                                Minimum value

                                                          Stock price     of warrant 

                                                          $10 $0

                                                            15   0

                                                            20   0

                                                            25   0

                                                            30 30  25  =  $5

                                                            35 35  25  =  10

                                                            40 40  25  =  15

                                                            45 45  25  =  20

                                                            50 50  25  =  25 
                                                     
                                                     
                                                     
                                                     
                                                     
                                                     

                                                    (b) 
                                                     
                                                     
                                                     

                                                      (c) With six months until expiration, the warrants' value (upper line on graph) will exceed the minimum value taking into account investors' expectations of stock price movement during the remaining 6 months.  If the stock price increases, the warrant might provide a greater savings when used to buy the stock. 

                                                        (d) The holder will send in the warrant plus $25 and receive a share of stock.  The company will issue the share and increase its cash account and owners' equity by the $25. 
                                                         

                                                        SOLUTION PROBLEM 2216 

                                                          (a) When the stock price is below or equal to the warrant's exercise price, there is no benefit to using the warrant, and its minimum value is $0.  For stock prices above the warrant's exercise price, the minimum value of the warrant is the savings from using the warrant to buy stock.  For this warrant, which is redeemable for 5 shares, the savings is 5 times the difference between the stock price and the warrant's exercise price. 
                                                           

                                                                      Minimum value

                                                                Stock price          of warrant 

                                                                $20 $0

                                                                  30   0

                                                                  40   0

                                                                  50   0

                                                                  60 5(60  50) =  $50

                                                                  70 5(70  50) =  $100

                                                                  80 5(80  50) =  $150

                                                                  90 5(90  50) =  $200

                                                                100 5(100  50) =  $250 

                                                          (b) 
                                                           
                                                           

                                                            (c) The holder will send in the warrant plus $250 ($5 savings per share on 5 shares) and receive 5 shares of stock.  The company will issue the 5 shares and increase its cash account and owners' equity by the $250. 

                                                            (d) Nothing.  At this stock price, the warrant's value is $0, and it will expire unused. 
                                                             

                                                            SOLUTION PROBLEM 2217 

                                                            (a) Calculate the value of a bond if submitted in response to the call:

                                                                        108% � $1,000  =  $1,080

                                                                  Calculate the value if converted: 40 shares � $30  =  $1,200

                                                                  Bondholders will convert their bond to stock to obtain the greater value. 

                                                              (b) The firm will simply issue the new shares and retire the bonds, making the appropriate change on its balance sheet.  No money will change hands. 

                                                              (c) Calculate the value of a bond if submitted in response to the call:

                                                                          108% � $1,000  =  $1,080

                                                                    Calculate the value if converted: 40 shares � $20  =  $800

                                                                    Bondholders will submit to the call to obtain the greater value. 

                                                                b(d) The company will pay out $1,080 per bond and remove the bonds payable from its balance sheet. 
                                                                 

                                                                SOLUTION PROBLEM 2218 

                                                                (a) Calculate the value of a bond if submitted in response to the call:

                                                                            107% � $1,000  =  $1,070

                                                                      Calculate the value if converted: 50 shares � $23  =  $1,150

                                                                      Bondholders will convert their bond to stock to obtain the greater value. 

                                                                  (b) The firm will issue new shares and retire the bonds, making the appropriate change on its balance sheet.  No money will change hands. 

                                                                  (c) Calculate the value of a bond if submitted in response to the call:

                                                                              107% � $1,000  =  $1,070

                                                                        Calculate the value if converted: 50 shares � $17  =  $850

                                                                        Bondholders will submit to the call to obtain the greater value. 

                                                                    (d) The company will pay out $1,070 per bond and remove the bonds payable from its balance sheet. 


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