REVIEW OF FORMULAS
REVIEW OF FORMULAS
R is the value of a right
M0 is the market value of the stock—rights-on (stock carries a right)
S is the subscription price
N is the number of rights required to purchase a new share of stock
4.
R is the value of a right
Me is the market value of stock—ex-rights (stock no longer carries a right)
S is the subscription price
N is the number of rights required to purchase a new share of stock
LIST OF TERMS
common stock 543
residual claim to income 544
proxy 545
founders’ shares 546
majority voting 546
cumulative voting 546
preemptive right 549
rights offering 550
rights-on 552
ex-rights 552
margin requirement 554
poison pill 556
American Depository Receipts 556
preferred stock 557
cumulative preferred stock 559
convertible exchangeable preferreds 559
participating preferreds 560
floating rate preferred stock 560
auction rate preferred stock 560
DISCUSSION QUESTIONS
1. Why has corporate management become increasingly sensitive to the desires of large institutional investors? (LO17-1)
2. Why might a corporation use a special category such as founders’ stock in issuing common stock? (LO17-1)
3. What is the purpose of cumulative voting? Are there any disadvantages to management? (LO17-2)
4. How does the preemptive right protect stockholders from dilution? (LO17-3)
5. If common stockholders are the owners of the company, why do they have the last claim on assets and a residual claim on income? (LO17-1)
6. During a rights offering, the underlying stock is said to sell “rights-on” and “ex-rights.” Explain the meaning of these terms and their significance to current stockholders and potential stockholders. (LO17-3)
7. Why might management use a poison pill strategy? (LO17-4)
8. Preferred stock is often referred to as a hybrid security. What is meant by this term as applied to preferred stock? (LO17-5)
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9. What is the most likely explanation for the use of preferred stock from a corporate viewpoint? (LO17-5)
10. Why is the cumulative feature of preferred stock particularly important to preferred stockholders? (LO17-2)
11. A small amount of preferred stock is participating. What would your reaction be if someone said common stock is also participating? (LO17-4)
12. What is an advantage of floating rate preferred stock for the risk-averse investor? (LO17-4)
13. Put an X by the security that has the feature best related to the following considerations. You may wish to refer to Table 17-4. (LO17-1 & 17-5)
PRACTICE PROBLEMS AND SOLUTIONS
Cumulative voting
(LO17-2)
1.
a. George Kelly wishes to elect 5 of the 13 directors on the Data Processing Corp. board. There are 98,000 shares of the company’s stock outstanding. How many shares will be required to accomplish this goal?
b. Jennifer Wallace owns 60,001 shares of stock in the Newcastle Corp. There are 12 directors to be elected with 195,000 shares outstanding. How many directors can Jennifer elect?
Rights offering
(LO17-3)
2. Dunn Resources has issued rights to its shareholders. The subscription price is $60. Four rights are needed along with the subscription price of $60 to buy one new share. The stock is selling for $72 rights-on.
a. What is the value of one right?
b. After the stock goes ex-rights, what will the new stock price be?
Solutions
1.
a.
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b.
2.
a.
| R = | Value of a right |
| M0 = | Market value rights-on. This is the value before the effect of the right offering, $72. |
| S = | Subscription price $60. |
| N = | Number of rights necessary to purchase a new share 4. |
| R = |
b. The market value of the stock ex-rights (after the effect of the rights offering) is equal to M0 (the market value before the rights offering) minus the value of a right (R).
| Me = | M0 − R |
| Me = | Market value of the stock ex-rights |
| M0 = | $72 |
| R = | $2.40 |
| Me = | $72 − $2.40 = $69.60 |
PROBLEMS
Selected problems are available with Connect. Please see the preface for more information.
Basic Problems
Residual claims to earnings
(LO17-1)
1. Folic Acid Inc. has $20 million in earnings, pays $2.75 million in interest to bondholders, and pays $1.80 million in dividends to preferred stockholders.
a. What are the common stockholders’ residual claims to earnings?
b. What are the common stockholders’ legal, enforceable claims to dividends?
Residual claims to earnings
(LO17-1)
2. Time Watch Co. has $46 million in earnings and is considering paying $6.45 million in interest to bondholders and $4.35 million to preferred stockholders in dividends.
a. What are the bondholders’ contractual claims to payment? (You may wish to review Table 17-4.)
b. What are the preferred stockholders’ immediate contractual claims to payment? What privilege do they have?
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Poison pill
(LO17-4)
3. Katie Homes and Garden Co. has 10,640,000 shares outstanding. The stock is currently selling at $52 per share. If an unfriendly outside group acquired 25 percent of the shares, existing stockholders will be able to buy new shares at 30 percent below the currently existing stock price.
a. How many shares must the unfriendly outside group acquire for the poison pill to go into effect?
b. What will be the new purchase price for the existing stockholders?
Cumulative voting
(LO17-2)
4. Mr. Meyers wishes to know how many shares are necessary to elect 5 directors out of 14 directors up for election in the Austin Power Company. There are 150,000 shares outstanding. (Use Formula 17-1 to determine the answer.)
Cumulative voting
(LO17-2)
5. Dr. Phil wishes to know how many shares are necessary to elect 6 directors out of 14 directors up for election for the board of the Winfrey Publishing Company. There are 340,000 shares outstanding. (Use Formula 17-1 to determine the answer.)
Cumulative voting
(LO17-2)
6. Carl Hubbell owns 6,001 shares of the Piston Corp. There are 12 seats on the company board of directors, and the company has a total of 78,000 shares of stock outstanding. The Piston Corp. utilizes cumulative voting.
Can Mr. Hubbell elect himself to the board when the vote to elect 12 directors is held next week? (Use Formula 17-2 to determine if he can elect one director.)
Cumulative voting
(LO17-2)
7. Betsy Ross owns 927 shares in the Hanson Fabrics Company. There are 15 directors to be elected, and 33,500 shares are outstanding. The firm has adopted cumulative voting.
a. How many total votes can be cast?
b. How many votes does Betsy control?
c. What percentage of the total votes does she control?
Dissident stockholder group and cumulative voting
(LO17-2)
8. The Beasley Corporation has been experiencing declining earnings but has just announced a 50 percent salary increase for its top executives. A dissident group of stockholders wants to oust the existing board of directors. There are currently 14 directors and 32,500 shares of stock outstanding. Mr. Wright, the president of the company, has the full support of the existing board. The dissident stockholders control proxies for 15,001 shares. Mr. Wright is worried about losing his job.
a. Under cumulative voting procedures, how many directors can the dissident stockholders elect with the proxies they now hold? How many directors could they elect under majority rule with these proxies?
b. How many shares (or proxies) are needed to elect nine directors under cumulative voting?
Dissident stockholder group and cumulative voting
(LO17-2)
9. Midland Petroleum is holding a stockholders’ meeting next month. Ms. Ramsey is the president of the company and has the support of the existing board of directors. All 12 members of the board are up for reelection. Mr. Clark is a dissident stockholder. He controls proxies for 34,001 shares. Ms. Ramsey and her friends on the board control 44,001 shares. Other stockholders, whose loyalties are unknown, will be voting the remaining 24,998 shares. The company uses cumulative voting.
a. How many directors can Mr. Clark be sure of electing?
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b. How many directors can Ms. Ramsey and her friends be sure of electing?
c. How many directors could Mr. Clark elect if he obtains all the proxies for the uncommitted votes? (Uneven values must be rounded down to the nearest whole number regardless of the amount.) Will he control the board?
d. If nine directors were to be elected, and Ms. Ramsey and her friends had 60,001 shares and Mr. Clark had 40,001 shares plus half the uncommitted votes, how many directors could Mr. Clark elect?
Strategies under cumulative voting
(LO17-2)
10. Mr. Michaels controls proxies for 40,000 of the 75,000 outstanding shares of Northern Airlines. Mr. Baker heads a dissident group that controls the remaining 35,000 shares. There are seven board members to be elected and cumulative voting rules apply. Michaels does not understand cumulative voting and plans to cast 100,000 of his 280,000 (40,000 × 7) votes for his brother-in-law, Scott. His remaining votes will be spread evenly between three other candidates.
How many directors can Baker elect if Michaels acts as described? Use logical numerical analysis rather than a set formula to answer the question. Baker has 245,000 votes (35,000 × 7).
Intermediate Problems
Different classes of voting stock
(LO17-1)
11. Rust Pipe Co. was established in 1994. Four years later the company went public. At that time, Robert Rust, the original owner, decided to establish two classes of stock. The first represents Class A founders’ stock and is entitled to 9 votes per share. The normally traded common stock, designated as Class B, is entitled to one vote per share. In late 2010, Mr. Stone, an investor, was considering purchasing shares in Rust Pipe Co. While he knew the founders’ shares were not often present in other companies, he decided to buy the shares anyway because of a new technology Rust Pipe had developed to improve the flow of liquids through pipes.
Of the 1,450,000 total shares currently outstanding, the original founder’s family owns 51,825 shares. What is the percentage of the founder’s family votes to Class B votes?
Rights offering
(LO17-3)
12. Boles Bottling Co. has issued rights to its shareholders. The subscription price is $45 and four rights are needed along with the subscription price to buy one of the new shares. The stock is selling for $55 rights-on.
a. What would be the value of one right?
b. If the stock goes ex-rights, what would the new stock price be?
Procedures associated with a rights offering
(LO17-3)
13. Computer Graphics has announced a rights offering for its shareholders. Carol Stevens owns 1,400 shares of Computer Graphics stock. Four rights plus $54 cash are needed to buy one of the new shares. The stock is currently selling for $66 rights-on.
a. What is the value of a right?
b. How many of the new shares could Carol buy if she exercised all her rights? How much cash would this require?
c. Carol doesn’t know if she wants to exercise her rights or sell them. Would either alternative have a more positive effect on her wealth?
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Investing in rights
(LO17-3)
14. Todd Winningham IV has $4,800 to invest. He has been looking at Gallagher Tennis Clubs Inc. common stock. Gallagher has issued a rights offering to its common stockholders. Six rights plus $48 cash will buy one new share. Gallagher’s stock is selling for $66 ex-rights.
a. How many rights could Todd buy with his $4,800? Alternatively, how many shares of stock could he buy with the same $4,800 at $66 per share?
b. If Todd invests his $4,800 in Gallagher rights and the price of Gallagher stock rises to $70 per share ex-rights, what would his dollar profit on the rights be? (First compute profit per right.)
c. If Todd invests his $4,800 in Gallagher stock and the price of the stock rises to $70 per share ex-rights, what would his total dollar profit be?
d. What would be the answer to part b if the price of Gallagher’s stock falls to $40 per share ex-rights instead of rising to $70?
e. What would be the answer to part c if the price of Gallagher’s stock falls to $40 per share ex-rights?
Effect of rights on stockholder position
(LO17-3)
15. Mr. and Mrs. Anderson own two shares of Magic Tricks Corporation’s common stock. The market value of the stock is $58. The Andersons also have $46 in cash. They have just received word of a rights offering. One new share of stock can be purchased at $46 for each two shares currently owned (based on two rights).
a. What is the value of a right?
b. What is the value of the Andersons’ portfolio before the rights offering? (Portfolio in this question represents stock plus cash.)
c. If the Andersons participate in the rights offering, what will be the value of their portfolio, based on the diluted value (ex-rights) of the stock?
d. If they sell their two rights but keep their stock at its diluted value and hold onto their cash, what will be the value of their portfolio?
Advanced Problems
Relation of rights to EPS and the price-earnings ratio
(LO17-3)
16. Walker Machine Tools has 5.5 million shares of common stock outstanding. The current market price of Walker common stock is $52 per share rights-on. The company’s net income this year is $17.5 million. A rights offering has been announced in which 550,000 new shares will be sold at $46.50 per share. The subscription price plus 5 rights is needed to buy one of the new shares.
a. What are the earnings per share and price-earnings ratio before the new shares are sold via the rights offering?
b. What would the earnings per share be immediately after the rights offering? What would the price-earnings ratio be immediately after the rights offering? (Assume there is no change in the market value of the stock, except for the change when the stock begins trading ex-rights.) Round all answers to two places after the decimal point.
Aftertax comparison of preferred stock and other investments
(LO17-5)
17. The Omega Corporation has some excess cash that it would like to invest in marketable securities for a long-term hold. Its vice president of finance is considering three investments (Omega Corporation is in a 35 percent tax bracket and the tax rate on dividends is 20 percent). Which one should she select based on aftertax return: (a) Treasury bonds at a 10 percent yield; (b) corporate bonds at a 13 percent yield; or (c) preferred stock at an 11 percent yield?
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Preferred stock dividends in arrears
(LO17-5)
18. National Health Corporation (NHC) has a cumulative preferred stock issue outstanding, which has a stated annual dividend of $8 per share. The company has been losing money and has not paid preferred dividends for the last five years. There are 350,000 shares of preferred stock outstanding and 650,000 shares of common stock.
a. How much is the company behind in preferred dividends?
b. If NHC earns $13,500,000 in the coming year after taxes but before dividends, and this is all paid out to the preferred stockholders, how much will the company be in arrears (behind in payments)? Keep in mind that the coming year would represent the sixth year.
c. How much, if any, would be available in common stock dividends in the coming year if $13,500,000 is earned as explained in part b?
Preferred stock dividends in arrears
(LO17-5)
19. Robbins Petroleum Company is four years in arrears on cumulative preferred stock dividends. There are 690,000 preferred shares outstanding, and the annual dividend is $6.50 per share. The vice president of finance sees no real hope of paying the dividends in arrears. She is devising a plan to compensate the preferred stockholders for 80 percent of the dividends in arrears.
a. How much should the compensation be?
b. Robbins will compensate the preferred stockholders in the form of bonds paying 12 percent interest in a market environment in which the going rate of interest is 8 percent for similar bonds. The bonds will have a 10-year maturity. Using the bond valuation table in Chapter 16 (Table 16-2), indicate the market value of a $1,000 par value bond.
c. Based on market value, how many bonds must be issued to provide the compensation determined in part a? (Round to the nearest whole number.)
Preferred stock dividends in arrears and valuing common stock
(LO17-5)
20. Enterprise Storage Company has $440,000 shares of cumulative preferred stock outstanding, which has a stated dividend of $7.75. It is six years in arrears in its dividend payments.
a. How much in total dollars is the company behind in its payments?
b. The firm proposes to offer new common stock to the preferred stockholders to wipe out the deficit. The common stock will pay the following dividends over the next four years:
| D1 | $1.15 |
| D2 | 1.25 |
| D3 | 1.35 |
| D4 | 1.45 |
The company anticipates earnings per share after four years will be $4.09 with a P/E ratio of 10.
The common stock will be valued as the present value of future dividends plus the present value of the future stock price after four years. The discount rate used by the investment banker is 14 percent. Round to two places to the right of the decimal point. What is the calculated value of the common stock?
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c. How many shares of common stock must be issued at the value computed in part b to eliminate the deficit (arrearage) computed in part a? Round to the nearest whole number.
