Borrowing funds to purchase preferred stock

(LO17-5)

21. The treasurer of Kelly Bottling Company (a corporation) currently has $150,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying $150,000 more with borrowed funds. The cost of the borrowed funds is 13 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 5 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 35 percent tax bracket, with dividends taxed at 20 percent.

a. Compute the amount of the aftertax income from the additional preferred stock if it is purchased.

b. Compute the aftertax borrowing cost to purchase the additional preferred stock. That is, multiply the interest cost times (1 − T).

c. Should the treasurer proceed with his proposal?

d. If interest rates and dividend yields in the market go up six months after a decision to purchase is made, what impact will this have on the outcome?

Floating rate preferred stock

(LO17-5)

22. Barnes Air Conditioning Inc. has two classes of preferred stock: floating rate preferred stock and straight (normal) preferred stock. Both issues have a par value of $100. The floating rate preferred stock pays an annual dividend yield of 4 percent, and the straight preferred stock pays 5 percent. Since the issuance of the two securities, interest rates have gone up by 2.50 percent for each issue. Both securities will pay their year-end dividend today.

a. What is the price of the floating rate preferred stock likely to be?

b. What is the price of the straight preferred stock likely to be? Refer back to Chapter 10 and use Formula 10-4 to answer this question.

COMPREHENSIVE PROBLEM

Crandall Corporation

(Rights offering and the impact on shareholders)

(LO17-3)

The Crandall Corporation currently has 100,000 shares outstanding that are selling at $50 per share. It needs to raise $900,000. Net income after taxes is $500,000. Its vice president of finance and its investment banker have decided on a rights offering but are not sure how much to discount the subscription price from the current market value. Discounts of 10 percent, 20 percent, and 40 percent have been suggested. Common stock is the sole means of financing for the Crandall Corporation.

a. For each discount, determine the subscription price, the number of shares to be issued, and the number of rights required to purchase one share. (Round to one place after the decimal point where necessary.)

b. Determine the value of one right under each of the plans. (Round to two places after the decimal point.)

c. Compute the earnings per share before and immediately after the rights offering under a 10 percent discount from the market price.

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d. By what percentage has the number of shares outstanding increased?

e. Stockholder X has 100 shares before the rights offering and participated by buying 20 new shares. Compute his total claim to earnings both before and after the rights offering (that is, multiply shares by the earnings per share figures computed in part c).

f. Should Stockholder X be satisfied with this claim over a longer period of time?

COMPREHENSIVE PROBLEM

Electro Cardio Systems Inc.

(Poison pill strategy)

(LO17-4)

Dr. Robert Grossman founded Electro Cardio Systems Inc. (ECS) in 2001. The principal purpose of the firm was to engage in research and development of heart pump devices. Although the firm did not show a profit until 2006, by 2010 it reported after-tax earnings of $1,200,000. The company had gone public in 2004 at $10 a share. Investors were initially interested in buying the stock because of its future prospects. By year-end 2010, the stock was trading at $42 per share because the firm had made good on its promise to produce lifesaving heart pumps and, in the process, was now making reasonable earnings. With 850,000 shares outstanding, earnings per share were $1.41.

Dr. Grossman and the members of the board of directors were initially pleased when another firm, Parker Medical Products, began buying their stock. John Parker, the chairman and CEO of Parker Medical Products, was thought to be a shrewd investor and his company’s purchase of 50,000 shares of ECS was taken as an affirmation of the success of the heart pump research firm.

However, when Parker bought another 50,000 shares, Dr. Grossman and members of the board of directors of ECS became concerned that John Parker and his firm might be trying to take over ECS.

Upon talking to his attorney, Dr. Grossman was reminded that ECS had a poison pill provision that took effect when any outside investor accumulated 25 percent or more of the shares outstanding. Current stockholders, excluding the potential takeover company, were given the privilege of buying up to 500,000 new shares of ECS at 80 percent of current market value. Thus new shares would be restricted to friendly interests.

The attorney also found that Dr. Grossman and “friendly” members of the board of directors currently owned 175,000 shares of ECS.

a. How many more shares would Parker Medical Products need to purchase before the poison pill provision would go into effect? Given the current price of ECS stock of $42, what would be the cost to Parker to get up to that level?

b. ECS’s ultimate fear was that Parker Medical Products would gain over a 50 percent interest in ECS’s outstanding shares. What would be the additional cost to Parker to get 50 percent (plus 1 share) of the stock outstanding of ECS at the current market price of ECS stock? In answering this question, assume Parker had previously accumulated the 25 percent position discussed in question a.

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c. Now assume that Parker exceeds the number of shares you computed in part b and gets all the way up to accumulating 625,000 shares of ECS. Under the poison pill provision, how many shares must “friendly” shareholders purchase to thwart a takeover attempt by Parker? What will be the total cost? Keep in mind that friendly interests already own 175,000 shares of ECS and to maintain control, they must own one more share than Parker.

d. Would you say the poison pill is an effective deterrent in this case? Is the poison pill in the best interest of the general stockholders (those not associated with the company)?

WEB EXERCISE

1. 3M (Minnesota Mining & Manufacturing Co.) was listed in Table 17-1 as one of the companies having a large percentage of institutional ownership. Institutional ownership represents stock held by nonindividuals such as pension funds, mutual funds, or bank trust departments. Let’s learn more about the company.

Go to 3M’s website, www.3m.com, and follow these steps: Scroll to the bottom of the page and click “Investor Relations.” Click on “Stock Information” under “Investing in 3M.”

2. Scroll down and write down the following:

a. Recent price

b. “52-week high”

c. “52-week low”

d. “52-week price percent change”

e. “Average Daily Volume last 10 days”

3. Return to the prior page and click on “Financial Information” and then click “Ratios” in the middle of the page. The average firm in 3M’s industry of diversified chemicals has the following ratios. How does 3M compare?

Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for.

1Tax consequences related to interest payments are ignored for the present.

2If this were not a rights offering, the discount from the current market price would be much smaller. The new shares might sell for $38 or $39.

3A number of variables may intervene to change the value. This is a “best” approximation.

4Though investment bankers generally participate in a rights offering as well, their fees are less because of the smaller risk factor.

5In a strict sense, preferred stock does not belong on the straight line because of its unique tax characteristics.