Poison Pills

During the last two decades, a new wrinkle was added to the meaning of rights when firms began receiving merger and acquisition proposals from companies interested in acquiring voting control of the firm. The management of many firms did not want to give up control of the company, and so they devised a method of making the firm very unattractive to a potential acquisition-minded company. As you can tell from our discussion of voting provisions, for a company using majority voting, a corporate raider needs to control only slightly over 50 percent of the voting shares to exercise total control. Management of companies considered potential takeover targets began to develop defensive tactics in fending off these unwanted takeovers. One widely used strategy is called the poison pill.

A poison pill may be a rights offer made to existing shareholders of Company X with the sole purpose of making it more difficult for another firm to acquire Company X. Most poison pills have a trigger point. When a potential buyer accumulates a given percentage of the common stock (for example, 25 percent), the other shareholders may receive rights to purchase additional shares from the company, generally at very low prices. If the rights are exercised by shareholders, this increases the total shares outstanding and dilutes the potential buyer’s ownership percentage. Poison pill strategies often do not have to be voted on by shareholders to be put into place. At International Paper Company, however, the poison pill issue was put on the proxy ballot and 76 percent of the voting shareholders sided with management to maintain the poison pill defense. This was surprising because many institutional investors are opposed to the pill. They believe it lowers the potential for maximizing shareholder value by discouraging potential high takeover bids.

American Depository Receipts

American Depository Receipts (ADRs) are certificates that have a legal claim on an ownership interest in a foreign company’s common stock. The shares of the foreign company are purchased and put in trust in a foreign branch of a major U.S. bank. The bank, in turn, receives and can issue depository receipts to the American shareholders of the foreign firm. These ADRs (depository receipts) allow foreign shares to be traded in the United States much like common stock. ADRs have been around for a long time and are sometimes referred to as American Depository Shares (ADS).

Since foreign companies want to tap into the world’s largest capital market, the United States, they need to offer securities for sale in the United States that can be traded by investors and have the same liquidity features as U.S. securities. ADRs imitate common stock traded on the New York Stock Exchange. Foreign companies such as HSBC Holdings (English), Nestlé (Swiss), Heineken (Dutch), and Sony (Japanese) that have common stock trading on their home exchanges in London, Zurich, Amsterdam, and Tokyo also issue ADRs in the United States.

An American investor (or any foreign investor) can buy American Depository Shares of foreign companies from around the world on the New York Stock Exchange, the NASDAQ Stock Market, or the American Stock Exchange. Table 17-3 shows the American Depository Shares (Receipts) for nine regions in March 2015. The table includes Global Depository Receipts (GDRs), which are patterned after ADRs but can be issued by international companies and traded globally rather than just on U.S. markets.

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There are many advantages to American Depository Shares for the U.S. investor. The annual reports and financial statements are presented in English according to generally accepted accounting principles. Dividends are paid in dollars and are more easily collected than if the actual shares of the foreign stock were owned. Although ADRs are considered to be more liquid, less expensive, and easier to trade than buying foreign companies’ stock directly on that firm’s home exchange, there are some drawbacks.

Table 17-3   Foreign company listings on U.S. exchanges and over-the-counter—American and global depository receipts

Source: http://www.adrbnymellon.com/dr_search_by_country.jsp, March 11, 2015

Even though the ADRs are traded in the U.S. market in dollars, they are still traded in their own countries in their local currencies. This means that the investor in ADRs is subject to a foreign currency risk if the exchange rates between the two countries change. Also, most foreign companies do not report their financial results as often as U.S. companies. Furthermore, there is an information lag as foreign companies need to translate their reports into English. By the time the reports are translated, some of the information has already been absorbed in the local markets and by international traders.

Preferred Stock Financing

Having discussed bonds in Chapter 16 and common stock in this chapter, we are prepared to look at an intermediate or hybrid form of security known as preferred stock. You may question the validity of the term preferred, for preferred stock does not possess any of the most desirable characteristics of debt or common stock. In the case of debt, bondholders have a contractual claim against the corporation for the payment of interest and may throw the corporation into bankruptcy if payment is not forthcoming. Common stockholders are the owners of the firm and have a residual claim to all income not paid out to others. Preferred stockholders are merely entitled to receive a stipulated dividend and, generally, must receive the dividend before the payment of dividends to common stockholders. However, their right to annual dividends is not mandatory for the corporation, as is true of interest on debt, and the corporation may forgo preferred dividends when this is deemed necessary.

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For example, XYZ Corporation might issue 7 percent preferred stock with a $100 par value. Under normal circumstances, the corporation would pay the $7 per share dividend. Let us also assume it has $1,000 bonds carrying 6.8 percent interest and shares of common stock with a market value of $50, normally paying a $1 cash dividend. The 6.8 percent interest must be paid on the bonds. The $7 preferred dividend has to be paid before the $1 dividend on common stock, but both may be waived without threat of bankruptcy. The common stockholder is the last in line to receive payment, but the common stockholder’s potential participation is unlimited. Instead of getting a $1 dividend, the investor may someday receive many times that much in dividends and also capital appreciation in stock value.

Justification for Preferred Stock

Because preferred stock has few unique characteristics, why might the corporation issue it and, equally important, why are investors willing to purchase the security?

Most corporations that issue preferred stock do so to achieve a balance in their capital structure. It is a means of expanding the capital base of the firm without diluting the common stock ownership position or incurring contractual debt obligations.

Even here, there may be a drawback. While interest payments on debt are tax-deductible, preferred stock dividends are not. Thus the interest cost on 6.8 percent debt may be only 4.5 to 5 percent on an aftertax cost basis, while the aftertax cost on 7 percent preferred stock would be the stated amount. A firm issuing the preferred stock may be willing to pay the higher aftertax cost to assure investors it has a balanced capital structure, and because preferred stock may have a positive effect on the costs of the other sources of funds in the capital structure.

Investor Interest Primary purchasers of preferred stock are corporate investors, insurance companies, and pension funds. To the corporate investor, preferred stock offers a very attractive advantage over bonds. The tax law provides that any corporation that receives either preferred or common dividends from another corporation must add only 30 percent of such dividends to its taxable income. Thus 70 percent of such dividends are exempt from taxation. On a preferred stock issue paying a 7 percent dividend, only 30 percent would be taxable. By contrast, all the interest of bonds is taxable to the recipient except for municipal bond interest.

Assume a bond is paying 5.61 percent interest in 2014. Since interest on bonds receives no preferential tax treatment for the corporate investor, the aftertax bond yield must be adjusted by the investing corporation’s marginal tax rate.

In this example, we shall use a tax rate of 35 percent.

The corporate bondholder will receive 3.65 percent as an aftertax yield.

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Now let’s look at preferred stock, which was paying 4.25 percent in 2014. For preferred stock, the adjustment includes the advantageous 30 percent tax provision. Also under current tax laws, the tax rate on dividends is only 15 percent. The computation for aftertax return for preferred stock is as follows:

The aftertax yield on preferred stock is clearly higher than the aftertax bond yield (4.06 percent versus 3.65 percent) due to the higher initial yield and the tax advantages.

Summary of Tax Considerations Tax considerations for preferred stock work in two opposite directions. First, they make the aftertax cost of debt cheaper than preferred stock to the issuing corporation because interest is deductible to the payer. Second, tax considerations generally make the receipt of preferred dividends more valuable than corporate bond interest to corporate investors because 70 percent of the dividend is exempt from taxation.

Provisions Associated with Preferred Stock

A preferred stock issue contains a number of stipulations and provisions that define the stockholder’s claim to income and assets.