Download par value - McGraw Hill Higher Education

14-0
Chapter Fourteen
Long-Term Financing:
An
Corporate Finance
Ross Westerfield Jaffe
Introduction


14
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-1
Chapter Outline
14.1 Common Stock
14.2 Corporate Long-Term Debt: The Basics
14.3 Preferred Stock
14.4 Patterns of Financing
14.5 Recent Trends in Capital Structure
14.6 Summary and Conclusions
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-2
14.1 Common Stock
•
•
•
•
•
•
•
•
Par and No-Par Stock
Authorized versus Issued Common Stock
Contributed Surplus
Retained Earnings
Market Value, Book Value, and Replacement Value
Shareholders’ Rights
Dividends
Classes of Stock
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-3
Par and No-Par Stock
• The stated value on a stock certificate is called the
par value.
– Par value is an accounting value, not a market value.
– The total par value (the number of shares multiplied by
the par value of each share) is sometimes called the
dedicated capital of the corporation.
• Some stocks have no par value.
– Typically in Canada, there is no particular par value
assigned to stock.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-4
Authorized vs. Issued Common Stock
• The articles of incorporation must state the number
of shares of common stock the corporation is
authorized to issue.
• The board of directors, after a vote of the
shareholders, may amend the articles of
incorporation to increase the number of shares.
– Authorizing a large number of shares may worry
investors about dilution because authorized shares can be
issued later with the approval of the board of directors but
without a vote of the shareholders.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-5
Contributed Surplus
• Usually refers to amounts of directly contributed
equity capital in excess of the par value.
– For example, suppose 1,000 shares of common stock
having a par value of $1 each are sold to investors for $8
per share. The contributed surplus would be
($8 – $1) × 1,000 = $7,000
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-6
Retained Earnings
• Not many firms pay out 100-percent of their
earnings as dividends.
• The earnings that are not paid out as dividends are
referred to as retained earnings.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-7
Market Value, Book Value, and Replacement
Value
• Market Value is the price of the stock multiplied by
the number of shares outstanding.
– Also known as Market Capitalization
– Common stocks of Canadian corporations trade on
Canadian stock exchanges (TSE, MSE, ASE, VSE) and
U.S. stock exchanges (NYSE, NASDAQ).
• Book Value
– The sum of par value, contributed surplus, accumulated
retained earnings, and adjustments to equity is the
common equity of the firm, usually referred to as the
book value of the firm.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-8
Market Value, Book Value, and Replacement
Value (continued)
Example: TransCanada Pipelines Limited
Shareholder’s Equity at Book Value, 2000
(in $ thousands)
Common stock and other
shareholders’ equity
Retained earnings
Contributed surplus
Foreign exchange adjustment
Total shareholders’ equity
McGraw-Hill Ryerson
$5,898,000
414,000
263,000
13,000
$6,588,000
© 2003 McGraw–Hill Ryerson Limited
14-9
Market Value, Book Value, and Replacement
Value (continued)
• Replacement Value
– The current cost of replacing the assets of the firm.
• At the time a firm purchases an asset, market value,
book value, and replacement value are equal.
– The market-to-book ratio of common stock and Tobin’s Q
(market value of assets / replacement value of assets) are
indicators of the success of the firm.
– If these ratios are greater than one, then this indicates that
the firm has done well with its investment decisions.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-10
Shareholders’ Rights
• The right to elect the directors of the corporation by
vote constitutes the most important control device
of shareholders.
• Directors are elected each year at an annual meeting
by a vote of the holders of a majority of shares who
are present and entitled to vote.
– The exact mechanism varies across companies.
• The important difference is whether shares are to be
voted cumulatively or voted straight.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-11
Cumulative versus Straight Voting
• The effect of cumulative voting is to permit
minority participation.
– Under cumulative voting, if there are N directors up for
election, then 1/(N+1) percent of the stock plus one share
will guarantee you a seat.
– With cumulative voting, the more seats that are up for
election at one time, the easier it is to win one.
• Straight voting works like a U.S. political election.
– Shareholders have as many votes as shares and each
position on the board has its own election.
– A tendency to freeze out minority shareholders.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-12
Cumulative vs. Straight Voting: Example
• Imagine a firm with two shareholders:
Mr. MacDonald and Ms. Laurier.
– Mr. MacDonald owns 60% of the firm ( = 600 shares)
and Ms. Laurier 40% ( = 400 shares).
– There are three seats up for election on the board.
• Under straight voting, Mr. MacDonald gets to pick
all three seats.
• Under cumulative voting, Ms. Laurier has 1,200
votes ( = 400 shares × 3 seats) and Mr. MacDonald
1,800 votes.
• Ms. Laurier can elect at least one board member.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-13
Proxy Voting
• A proxy is the legal grant of authority by a
shareholder to someone else to vote his or her
shares.
• For convenience, the actual voting in large public
corporations is usually done by proxy, e.g. BCE Inc.
• If shareholders are not satisfied with management,
an outside group of shareholders can try to obtain as
many votes as possible via proxy.
• Proxy battles are often led by large pension funds
like the Ontario Teachers’ Pension Board or the
Caisse de Dépôt.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-14
Dividends
• Unless a dividend is declared by the board of
directors of a corporation, it is not a liability of the
corporation.
– A corporation cannot default on an undeclared dividend.
• The payment of dividends by the corporation is not
a business expense.
– Therefore, they are not tax-deductible.
• Dividends received by individual shareholders are
partially sheltered by a dividend tax credit.
(Appendix of Chapter 1)
• There is a pension for Canadian corporations to
avoid the double taxation of dividends.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-15
Classes of Shares
• When more than one class of share exists, they are
usually created with unequal voting rights.
• Many companies issue dual classes of common
stock. The reason has to do with control of the firm.
– Amoako-Adu and Smith show that firms going public
with dual classes of shares in Canada are often family
controlled.
• Lease, McConnell, and Mikkelson found the market
prices of U.S. stocks with superior voting rights to
be about 5-percent higher than the prices of
otherwise-identical stocks with inferior voting
rights.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-16
14.2 Corporate Long-Term Debt: The Basics
•
•
•
•
•
•
•
•
Interest versus Dividends
Is It Debt or Equity?
Basic Features of Long-Term Debt
Different Types of Debt
Repayment
Seniority
Security
Indenture
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-17
Interest versus Dividends
• Debt is not an ownership interest in the firm.
Creditors do not usually have voting power.
• The device used by creditors to protect themselves
is the loan contract (i.e., indenture).
• The corporation’s payment of interest on debt is
considered a cost of doing business and is fully taxdeductible. Dividends are paid out of after-tax
dollars.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-18
Interest versus Dividends (continued)
• Unpaid debt is a liability of the firm. If it is not
paid, the creditors can legally claim the assets of the
firm.
– One of the costs of issuing debt is the possibility of
financial failure.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-19
Is It Debt or Equity?
• Some securities blur the line between debt and
equity.
• Corporations are very adept at creating hybrid
securities that look like equity but are called debt.
– Obviously, the distinction is important at tax time.
– A corporation that succeeds in creating a debt security
that is really equity obtains the tax benefits of debt while
eliminating its bankruptcy costs.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-20
Basic Features of Long-Term Debt
• The bond indenture usually lists
–
–
–
–
–
–
–
Amount of Issue, Date of Issue, Maturity
Denomination (Par value)
Annual Coupon, Dates of Coupon Payments
Security
Sinking Funds
Call Provisions
Covenants
• Features that may change over time
– Rating
– Yield-to-Maturity
– Market Price
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-21
Different Types of Debt
• A debenture is an unsecured corporate debt,
whereas a bond is secured by a mortgage on the
corporate property.
• A note usually refers to an unsecured debt with a
maturity shorter than that of a debenture, perhaps
under seven years.
• Debentures and bonds are long-term debt, i.e.,
payable more than one year from the date they are
originally issued.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-22
Repayment
• Bonds can be repaid at maturity or earlier through
the use of a sinking fund.
• A sinking fund is an account managed on behalf of
the issuer by a bond trustee for the purpose of
retiring all or part of the bonds prior to their stated
maturity.
• Debt may be extinguished before maturity through a
call provision giving the firm the right to pay a
specific amount to retire the debt before the stated
maturity date.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-23
Seniority
• Seniority indicates preference in position over other
lenders.
• Some debt is subordinated. In the event of default,
holders of subordinated debt must give preference
to other specified creditors who are paid first.
• Debt cannot be subordinated to equity.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-24
Security
• Security is a form of attachment to property.
– It provides that the property can be sold in event of
default to satisfy the debt for which the security is given.
– A mortgage is used for security in tangible property.
For example, debt can be secured by mortgages on plant
and equipment.
– Debentures are not secured by a mortgage.
– If mortgaged property is sold in the event of default,
debenture holders will obtain something only if the
mortgage bondholders have been fully satisfied.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-25
Indenture
• The written agreement between the corporate debt
issuer and the lender.
• Sets forth the terms of the loan:
– Maturity
– Interest rate
– Protective covenants
Examples:
- restrictions on further indebtedness,
- a maximum on the amount of dividends that
can be paid,
- a minimum level of working capital.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-26
14.3 Preferred Shares
• Represents equity of a corporation, but is different
from common stock because it has preference over
common in the payments of dividends and in the
assets of the corporation in the event of bankruptcy.
• Preferred shares have a stated liquidating value.
For example, CIBC “$2.25 preferred” translates into
a dividend yield of 9% of the stated $25 value.
• Preferred dividends are either cumulative or
noncumulative.
• Firms may have an incentive to delay preferred
dividends, since preferred shareholders receive no
interest on the cumulated dividends.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-27
Is Preferred Stock Really Debt?
• A good case can be made that preferred stock is
really debt in disguise.
– The preferred shareholders receive a stated dividend.
– In the event of liquidation, the preferred shareholders are
entitled to a fixed claim.
• Some preferred shares have adjustable dividends.
An example is the CARP (cumulative, adjustable
rate, preferred).
• In Canada, corporate investors have an incentive to
hold preferred shares issued by other corporations,
since 100% of the dividends they receive are
exempt from income taxes.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-28
The Preferred Shares and Taxes
•
•
•
•
In Canada, a tax loophole encourages corporations
that are lightly taxed to issue preferred shares.
Low-tax companies can make little use of the tax
deduction on interest.
They can issue preferred shares and enjoy lower
financing costs since preferred dividends are
significantly lower than interest payments.
There are several reasons beyond taxes why
preferred shares are issued:
–
Regulated public utilities can pass the tax disadvantage
of issuing preferred shares on their customers.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-29
The Preferred Shares and Taxes (continued)
– Firms issuing preferred shares can avoid the threat of
bankruptcy that might otherwise exist if debt were relied
on.
– Issuing preferred shares may be a means of raising equity
without surrendering control.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-30
14.4 Patterns of Financing
• For Canadian firms, internally generated cash flow
dominates as a source of financing.
• Firms usually spend more than they generate
internally—the gap is financed by new sales of debt
and equity.
• Net new issues of equity are dwarfed by new sales
of debt.
• This is consistent with the pecking order hypothesis.
• Leverage ratios for Canadian firms are considerably
higher than they were in the 1960s.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
14-31
The Long-Term Financial Gap
Uses of Cash Flow
(100%)
Sources of Cash Flow
(100%)
Capital
spending
Internal cash
flow (retained
earnings plus
depreciation)
68.3%
Net
working
capital plus
other uses
McGraw-Hill Ryerson
Internal
cash flow
Financial
deficit
Long-term
debt and
equity 31.7%
External
cash flow
© 2003 McGraw–Hill Ryerson Limited
14-32
14.6 Summary and Conclusions
• The basic sources of long-term financing are:
– Long-Term Debt
– Common Stock
– Preferred Stock
• Common shareholders have voting rights, limited
liability, and a residual claim on the corporation.
• Bondholders have a contractual claim against the
corporation.
• Preferred stock has some of the features of debt and
equity.
• Firms need financing—most of it is generated
internally.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited