equity in the secondary market: common and preferred stock · 50 chapter 3..... the fundamentals of...

Equity in the SecondaryMarket: Common andPreferred StockTerms You Need to Know

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✓ Adjustable preferred✓ American depositary

receipts (ADRs)✓ Book-entry method✓ Class✓ Common stock✓ Conversion parity✓ Conversion ratio✓ Convertible preferred✓ Cum dividend✓ Cum rights✓ Cumulative preferred✓ Cumulative voting✓ Dividend

✓ Ex date✓ Ex dividend✓ Ex rights✓ Market value✓ Par value✓ Participating preferred✓ Preemptive right✓ Preferred stock✓ Proxy✓ Record date✓ Registrar✓ Regular-way settlement

(T+3)✓ Reverse split

✓ Rights offering✓ Shareholder of record✓ Shareholder rights✓ Standby commitment✓ Statutory voting✓ Stock split (or forward

split)✓ Street name✓ Subscription price✓ Transfer agent✓ Voting trust certificates

(VTCs)✓ Warrant (or subscription

warrant)

Concepts You Need to Understand✓ Classes and kinds of common stock✓ How foreign stocks are traded in the United States✓ Basic rights✓ When and how shareholders can vote✓ Preemptive right and rights offerings✓ Rules that govern the distribution of dividends✓ Important dates for dividend calculations✓ How stock prices are affected by the declaration of dividends✓ Rights of preferred shareholders✓ The relationship between interest rates and preferred stock prices✓ How some preferred stock can be converted into common stock✓ The purpose of subscription warrants

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The Fundamentals of CommonStockThe secondary market is the scene of most securities trading. Many kinds ofsecurities trade there, from corporate bonds, government bonds, and munic-ipal bonds, to options and more recent financial inventions such as deriva-tives. Equities are the most common way for corporations to raise capital.This chapter looks at the features of common and preferred equity stock—including the rights of shareholders, the process of declaring dividends, whatdistinguishes subscription rights from subscription warrants, and the charac-teristics of convertible preferred stock.

Common stock gives shareholders an equity, or ownership position in a corpo-ration. One of the chief characteristics of common stock is that it pays a vari-able dividend—or none at all—depending on the decision of the company’sboard of directors. A dividend is a periodic payment (either in cash or stock)made by the company to owners of its common or preferred stock. The cor-porate charter authorizes that a certain number of common shares be issuedand assigns them an arbitrary par value. For common stock, par value is usu-ally very low, often only one dollar. The par value of preferred stock, on theother hand, is very important.

Why So Cheap? The par value of common stock is not low for purely arbitrary rea-sons. States often tax corporations based on the par value of their common stock.

The market value of common stock is determined wherever the stock is trad-ed. Market prices reflect investors’ knowledge and beliefs about a wholerange of factors, including the company’s present and future profitability, thelikelihood of dividend payments, the health of the industry, and even thegrowth prospects for the entire economy.

Types of Common StockIn some instances a corporation might choose to issue various classes of stockto help a select group of shareholders maintain control of the company. A fam-ily-owned business that is going public, for example, might issue class A com-mon stock to family members and class B to the public. This classification

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method has fallen out of favor in recent years, and Congress has reviewed pro-posals to prohibit it altogether. The NYSE rarely lists companies employingthis kind of two-tier structure, although the American Stock Exchange contin-ues to do so. The differences between class A and class B stock can be found intheir respective prospectuses.

Categories of Common StockInvestors and broker-dealers distinguish stocks according to their historicalperformance in the marketplace and the issuing company’s track record. Afew of the more frequent labels are:

➤ Blue chip—Stock of a big, well-known company with a long history ofprofits and regular dividend payments. Coca-Cola and Ford MotorCompany belong to this group.

➤ Income—Stock of companies that have good records of paying relative-ly high and stable dividends. Telephone companies, electric utilities, andbanks are often considered income stocks.

➤ Growth—Stock of a company that is expanding rapidly by investing inits own growth with profits that otherwise might have become dividendpayments. In the 1980s and 1990s, the technology sector featured manygrowth stocks.

Investors in the secondary market have several kinds of common stock tochoose from. In addition, they might want to consider purchasing shares inoverseas companies. The easiest way to accomplish this is through Americandepositary receipts.

American Depositary ReceiptsAmerican depositary receipts (ADRs) are certificates representing shares of foreigncompanies. ADRs are traded in U.S. markets, whereas the actual securitiesremain in the vault of a U.S. bank branch in the company’s home country.Holders of ADRs enjoy all the rights of common stock owners except for vot-ing and preemptive rights. For the foreign firm, ADRs present an opportunityto tap into the vast U.S. capital market while avoiding the time and expense ofregistering with the SEC. Instead, the U.S. bank that is holding the securities(in its overseas branch) handles all SEC compliance.

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How Dividends Are Paid to the Owners ofADRsThe foreign corporation pays dividends to the U.S. bank that is holding itssecurities. The bank then converts the dividends into dollars and pays theowners of the ADRs in the United States.

Where are ADRs traded? Sponsored ADRs are bought and sold on one ofthe major exchanges (AMEX or the NYSE), whereas nonsponsored ADRscan be found on the OTC market. In the case of a sponsored ADR, the issu-ing company works with one U.S. depositary bank and sends its Americanshareholders annual financial reports in English. The issuing companies ofnonsponsored ADRs, on the other hand, play no direct role in the receipts’creation. Nonsponsored ADRs are packaged and sold by banks or broker-dealers on their own initiative. Because the company does not participate,nonsponsored ADRs can have more than one depositary bank.

All shareholders, whether of ADRs or domestic stocks, have certain rights.Generally, these rights consist of sharing in the growth and profitability ofthe company, and having a voice in how the company is managed.

Common Shareholder RightsAlthough the specific rights and privileges of common stock shareholderscan vary with each corporation’s charter or bylaws, they all have the right to:

➤ Receive dividends (when the company declares them)

➤ Receive a certificate of stock ownership

➤ Transfer their securities (sell their stock)

➤ Inspect the company’s financial records, plus the minutes of shareholdermeetings

➤ Vote—either in person or by proxy—on certain corporate matters

➤ Maintain their proportionate share of the company’s outstanding stock(known as the preemptive right)

➤ Partake in the division of company assets if the company is liquidated

Who decides when shareholders receive a dividend? The board of directorsdetermines whether a dividend will be declared and, if so, how large it is.

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When companies decide to declare dividends, they usually make paymentsquarterly.

The Process of Paying DividendsDividends can be paid in cash or stock. Companies might issue stock divi-dends in order to conserve cash for expansion or other purposes. For theshareholder, the advantage of stock dividends is that, unlike cash dividends,taxes are not owed until the shares are sold. Stock dividends are usually stat-ed as a percentage of outstanding shares, and the price of the common stockis reduced accordingly.

EXAMPLE: An investor owns 100 shares of Triple Platinum Records,Inc., which are trading at $50. The company declares a 10% stock divi-dend. After the distribution, the shareholder now has 110 shares, eachworth $45.50. (There are now 10% more shares of stock outstanding, or1.1 times as many as before the stock dividend. Fifty dollars divided by 1.1equals $45.45.)

The Right of TransferCommon stock is a negotiable security: owners can sell their shares to any-one. Among other things, this means that corporations face a challenge keep-ing track of their shareholders. Usually they hire an outside firm to act as atransfer agent, which maintains records of all shareholder names and address-es. A registrar, also an outside firm, makes sure that the corporation does notissue more shares than its charter authorizes. Shareholders can give theirbrokers permission to keep their stocks in street name—the name of the bro-ker. This simplifies the transfer process after stock sales.

Shareholders have a right to receive stock certificates as evidence of owner-ship. Some corporations, however, use the book-entry method, whereby theregistrar records purchases and sales, but no certificates change hands.

Shareholders of a corporation have the right to review company records. Inpractice, this means that they can read the company’s annual reports, knownas Form 10-Ks, as well as its quarterly reports (Form 10-Qs), both of whichmust be filed with the SEC. The SEC views the filing of annual reports as afundamental requirement of publicly traded companies. A company that failsto file a 10-K not only compromises its reputation with investors, but alsotriggers an SEC investigation and risks being delisted by the exchange onwhich it trades.

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Shareholders Influence on CompanyDecisionsHolders of common stock have the right to vote on many of the matters thataffect their ownership interest. These include:

➤ Membership on the board of directors

➤ Stock splits and reverse stock splits

➤ The issuing of convertible securities (securities that can be convertedinto common stock)

Shareholders do not vote on whether a corporation:

➤ Declares a dividend

➤ Declares a rights offering

If shareholders cannot be present when matters affecting their ownershipinterest are to be decided—usually at the company’s annual meeting—theyhave the right to vote by proxy. On such issues, the corporation is required tosend ballots (proxies) to its shareholders. Shareholders mark their choicesand return them to the corporation, where their votes are counted.

The Voting ProcessShareholder voting can be conducted on either a statutory or cumulative basis.In broad terms, the two methods are similar: shareholders get one vote pershare, times the number of items on the ballot. If three board positions areto be filled, for example, a person with 100 shares has 300 votes. The differ-ence between statutory and cumulative voting comes into play in cases suchas these, where there are multiple choices for a single ballot item. Understatutory voting, shareholders cast votes equal to the number of shares theyown for each open position on the board. The 100-share owner can vote 100times for each of the three openings. Cumulative voting allows the share-holder to distribute his or her votes among the choices. Thus, the stock ownercan place 150 votes for one candidate, 150 for a second, and none for thethird.

EXAMPLE: An investor owns 100 shares of Satellite Technologies,which is electing six directors. The company uses statutory voting. Theinvestor has 600 total votes (100 shares × 6 directors), but cannot castmore than 100 votes for any one candidate.

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BioGen Corp, which employs cumulative voting, is also electing six direc-tors. An investor who owns 100 shares of BioGen has 600 votes (the sameas the Satellite Technologies investor), but can apportion them as he orshe sees fit, even giving them all to one director.

Cumulative voting is advantageous to smaller shareholders, enabling them toamass their votes on a single candidate or policy option. Perhaps that is whystatutory voting remains much more common.

In addition to electing members of the board of directors, shareholders areoften asked to approve splits of the company’s stock.

The Stock SplitA stock split multiplies the number of a company’s outstanding shares bywhatever ratio the company chooses. The market price of the stock dropsaccordingly. So, if a company’s stock were selling at $30 per share, and it car-ried out a 3:1 split, there becomes three times as many shares outstandingafter the split, each priced at $10. Companies use stock splits to make theirshares more affordable to investors.

EXAMPLE: WorldScape stock is selling at $110 a share. The companywants to attract new investors and declares a 2:1 split. The number of out-standing shares doubles and the price per share drops by half. An investorwith 1,000 shares now owns 2,000, each priced at $55. If WorldScape haddeclared a 4:1 split, the same investor would have 4,000 shares, eachpriced at $27.50. Note, however, that the total market value of theinvestor’s shares remains the same in either scenario: $110,000.

Par value is the value arbitrarily assigned to common stock by the corporation.Market value is the price investors are currently willing to pay for the stock.

Although ownership interest is not affected by splits, shareholder approval isrequired. Why? Because stock splits change the par value of a company’sstock. They might also increase the number of outstanding shares beyondthe amount currently authorized in the corporate charter. Either of thesechanges requires an amendment of the charter and thus stockholderapproval.

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Different Kinds of Stock SplitsStock splits are sometimes called forward splits to distinguish them fromreverse splits. A reverse split increases the price of each share, while reducingthe number of shares in circulation. Companies generally use reverse splitswhen they think their share price is too low to inspire investor confidence.By declaring a reverse split, companies can elevate the market price of theirshares, creating an impression of higher value.

EXAMPLE: Test Right Corp. has nine million outstanding shares sellingat $10 a share. Trading has been slack, so the company declares a 1:3reverse split. Now the company has only three million shares outstanding,each selling at $30. An investor who owned 90 shares of the original stocknow has only 30 shares, but the total value of his shares is unchanged:$900.

Not everything that changes the number of a company’s outstanding sharesrequires stockholder approval. A company can issue new shares without suchapproval because shareholders are protected by their preemptive right,which they can exercise through a rights offering.

Rights OfferingA rights offering gives stockholders the opportunity to purchase new shares ofa corporation before those shares are made available to the public.Shareholders’ preemptive right, the privilege of existing shareholders to main-tain their proportionate ownership in the company, is triggered whenever acompany issues new stock through a rights offering.

In a rights offering, shareholders can purchase new shares at a price less thanthe current market price. This lower price is known as the subscription price.Shareholders usually receive one right for each share they own, but the num-ber of rights necessary to buy a new share, the subscription ratio, is deter-mined by the corporation. For example, the corporation might decide that20 rights are required to buy one new share at the subscription price. Rightsare generally valid for 30 days and are transferable. (In some offerings, rightsare valid only for two weeks; in others, for as long as three months.)

When a company stages a rights offering, it often negotiates a standby com-mitment with an investment banker, who agrees to purchase any unsub-scribed shares and sell them to the public.

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Performing a Rights OfferingAfter deciding to issue new shares, a corporation places an announcement inmajor business newspapers. The notice states the subscription ratio andprice, the current market price of the stock, and the following deadlines:

➤ Record date—Date by which any transfer of shares must be completedin order for the new shareholder to receive rights.

➤ Distribution date—Date that shareholders of record receive the rights.

➤ Expiration date—Date the rights are no longer valid.

Any investor who has completed the purchase of shares in a corporation bythe record date becomes a shareholder of record. Shares traded from the dateof the announcement through the record date are traded cum rights, whichmeans with the rights attached. After the record date, shares trade ex rights,which means without the rights attached.

The time between the distribution date and the expiration date is called the“standby period.” After the standby period, an investment banker with astandby commitment must purchase whatever portion of the issue thatremains.

EXAMPLE: Based on the announcement below, a shareholder with 100shares of Java Express stock will receive 100 rights from the company onMay 28. With a subscription ratio of 5-1, that shareholder can purchase20 new shares of Java Express, at a total cost of $480 (20 new shares times$24 per share). Companies frequently retain a rights agent to handle themechanics of the rights offering. The stockholder who wants to exercisehis or her preemptive right must notify the Java Express rights agent, plusmail a check for $480, by June 29 for 20 new shares.

Java Express CorporationSanta Monica, California

Java Express Announces Rights Distribution

The Board of Directors of Java Express Corporation is planning a rightsdistribution to stock holders of record on

May 4, 1998. Stockholders will receive one right for each share owned.The rights will be distributed May 28, 1998.

Under the terms of the offer, five rights are necessary to subscribe to onenew share at a price of $24 per share. The offer expires midnight of June29, 2006. The current market price of Java Express stock is $30.

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Shareholders, of course, are not obligated to purchase new shares with theirrights. Rights are transferable, so holders can decide to sell their rights in themarketplace. Shareholders thus need to calculate the market value of theirrights.

Determining the Value of a Right

So the value of a Java Express right mentioned in the previous example is

Rights offerings are important for investors who own shares in a healthycompany. But investors with holdings in an ailing corporation also have legalrights.

Shareholder Rights During BankruptcyAs part-owners of a corporation, stockholders are entitled to their propor-tionate share of the company’s assets in the event of bankruptcy or liquida-tion (provided that assets are available). Shareholders, however, are not thefirst group to be paid in a liquidation. Common stockholders are compen-sated after banks and the owners of the corporation’s bonds and preferredstock—otherwise known as senior securities—have been paid.

In a liquidation, a stockholder’s liability is limited to the loss of his or herinvestment. Limited liability is one of the cornerstones of corporate struc-ture. Of course, companies make every effort to avoid bankruptcy. To miti-gate its financial difficulties, a corporation might recall its common stock andreplace it with voting trust certificates.

EXAMPLE: Jefferson Adams paid $1 million for a 10% ownership posi-tion in Presidential Hotels, Inc. The company unfortunately goes bank-rupt. After liquidating its assets, Presidential still has outstanding debt of$50 million. Mr. Adams, however, is not responsible for paying 10% of thatdebt (or $5 million). He only loses his original investment of $1 million.

Voting Trust CertificatesThe board of directors of a financially distressed company can replace share-holders’ common stock with voting trust certificates (VTCs). Shareholders

30 – 245 + 1

66

$1 per right= =

market price – subscription price

number of rights required + 1value of right =

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retain all their rights except the right to vote. Those voting rights are givento a group of trustees appointed by the board of directors to turn the com-pany around. VTCs thus concentrate decision-making power in the hands ofthe appointed trustees, giving them more freedom to take the steps necessaryto put the company back on track. If the trustees are successful in saving thecompany, the common shares are returned to the shareholders (along withtheir voting rights). VTCs are traded just like common stock.

Although companies do not receive any money from the trading of theirstock in the secondary market, they do want their stock to perform well. Oneway a company can inspire investor confidence is by regularly distributingdividends.

When Companies Declare aDividendAs with rights offerings, when a company decides to pay a dividend, certaindates become important. A dividend announcement might read as follows:

Megahit StudiosHollywood, California

Board Announces Dividend

The Board of Directors of Megahit Studios today declared a dividend of75 cents per share to stockholders of record on Monday, April 20, 2006.The dividend will be paid on May 4, 2006.

Megahit thus has established the

➤ Declaration date (April 6)—Date on which the company announced thedividend

➤ Record date (April 20)—Date by which any transfer of shares must becompleted in order for a shareholder to be eligible for the dividend

➤ Payment date (May 4)—Date the corporation will pay the dividend

Who is eligible to receive dividends? Only shareholders of record on April20, the record date in this case, receive a dividend. The buying and selling ofstocks is usually completed through regular-way settlement, in which a trans-action settles three business days after the trade date (or T+3). So to buyMegahit Studios stock cum dividend (with the dividend), an investor has topurchase the stock on or before Wednesday, April 15. The following day,Thursday, April 16, is known as the ex date because investors who buy

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Megahit on that date or later will not have enough time to settle their tradesbefore the record date of Monday, April 20. These investors thus buy thestock ex dividend (without the dividend).

The ex-dividend date is important for another reason: on this date the com-pany’s stock price is adjusted downward by the exchange on which it is listed.

Stock Adjustment on the Ex-Dividend DateOn the ex-dividend date, the stock opens at a price reduced by the amountof the dividend to be paid. For example, if Megahit stock closed at $50 pershare on April 15, the stock will open at $49.25 on the morning of April 16to account for the 75-cent dividend.

This adjustment prevents traders from making riskless profits. If there wereno reduction, a trader could buy the stock for $50 on April 15 (becoming ashareholder of record for April 20), sell it for $50 on April 16 (going off therecord on April 21), and receive the dividend—an essentially risk-free profitof 75 cents per share. The price adjustment eliminates that profit. As men-tioned earlier, price adjustments are made for stock dividends as well.Common stock is not the only type of stock that a company can issue. Undersome circumstances, corporations might choose to issue preferred stock.Preferred stock has noticeably different rights and characteristics from com-mon stock.

The Fundamentals of PreferredStockPreferred stock is a hybrid security that combines characteristics of commonstock and bonds. Like common stock, preferred stock is a unit of ownershipin a public corporation. Like bonds, preferred stock is a fixed-income secu-rity: it pays a set dividend that is determined at the time it is issued. Typicallyit has a par value of $100, and the dividend is stated as a percentage of thispar value. For example, 6% preferred stock pays a dividend of $6 per year, or$1.50 per quarter.

Preferred stock has limited potential for capital growth compared to com-mon stock. Because the dividends received by preferred stockholders arefixed at the outset, the value of preferred stock is affected more by interestrate fluctuations than by the company’s performance. In contrast, common

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stockholders can benefit from higher dividend payments when a company issuccessful—with the market value of their stock climbing accordingly.

More often than not, preferred stock is an investment choice of other cor-porations that are seeking better returns on their cash reserves. Current U.S.tax law allows corporations that own 20% or more of an issuer’s preferredstock to deduct 80% of the dividend payments received. A corporation thatowns less than 20% of an issuer’s preferred stock can still deduct 70% of thedividend payments. On the other hand, any interest income earned by thesame corporations on their bond investments is taxable.

Dividends on preferred stock are paid before dividends on common stock. Asmentioned earlier, preferred stockholders also precede common stockhold-ers in receiving a distribution from a company’s liquidation, making pre-ferred stock a senior security much like a bond.

There are drawbacks to preferred stock, however. Preferred stockholdersusually do not have voting rights. Nor do they have preemptive rights,because even if the corporation issues more stock, the preferred stock’s rateof return is not affected.

What determines the market value of preferred stock? Because preferredstock earns a fixed return, its value in the marketplace is affected by interestrate movements. When preferred stock is issued, its dividend rate is set to becompetitive with the existing market rate of interest.

Thus, an inverse relationship exists between interest rate movements and the mar-ket value of preferred stock. If interest rates climb above the fixed rate offered by thepreferred, its market price declines. If interest rates fall below the preferred stock’srate of return, the price of the stock increases.

Calculating the Market Value of PreferredStockTo determine what an existing share of preferred stock is worth after achange in interest rates, investors use a simple formula:

Of course, there are factors other than interest rates that influence a pre-ferred stock’s attractiveness. Investors must also consider the features of dif-ferent types of preferred stock.

market income

market yieldmarket value =

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Other Types of Preferred StockThe most common varieties of preferred stock include

➤ Callable preferred—Stock that the issuer can call (buy back) if interestrates fall. This allows the company to issue new preferred stock at alower rate. Callable preferred typically pays a higher dividend ratebecause of the call feature.

➤ Participating preferred—Stock giving the preferred shareholder theright to participate in any “special” dividends paid by the company. Forexample, after an especially lucrative year, a company might announcean additional year-end dividend of $2. Participating preferred stockhold-ers receive the extra dividend along with common stock owners. Thistype of stock is quite rare.

➤ Cumulative preferred—Stock requiring that any dividend payments inarrears be paid before the company pays dividends to common share-holders. If a company has missed three consecutive quarterly dividendson an 8% preferred stock and wants to pay a $1 dividend on its commonstock in the fourth quarter, it must first pay a total dividend of $8 to pre-ferred stockholders. See Table 3.1 for a schedule of dividend paymentsfor cumulative preferred stock.

Table 3.1 Cumulative Preferred Stock Dividend Payment Schedule

First Quarter Second Quarter Third Quarter Fourth Quarter

8% cumulative $2 missed $2 missed $2 missed $8 must be preferred paid before paid

common stock dividend

Common stock None None None $1 paid afterpayment ofcumulative dividend

➤ Adjustable preferred—Stock with a dividend rate that is reset every sixmonths to match movements in market interest rates.

➤ Convertible preferred—Stock that can be converted into shares ofcommon stock. Convertible preferred generally pays a lower dividendrate because of the conversion feature. Also, because any conversiondilutes the ownership interest of existing common stock owners, a com-pany must get shareholder approval before issuing this type of security.

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How Does Preferred Stock BecomeCommon Stock?Owners of convertible preferred stock can exchange their shares for commonstock according to a set conversion price, which determines the conversionratio:

EXAMPLE: Cyclops Vision, Inc., convertible preferred stock ($100 parvalue) is convertible at $40. The conversion ratio is thus 21/2:1. One shareof the preferred stock can be converted into 21/2 shares of Cyclops com-mon stock.

The conversion feature becomes valuable when the price of common stockis equal to or greater than the preferred stock’s price, divided by the conver-sion ratio.

EXAMPLE: Cyclops preferred stock, which is trading at $93, can be con-verted at $40. The conversion ratio (par value divided by conversionprice) is 21/2:1. To find the threshold for profitable conversion, divide $93by 2.5. The answer, $37.20, is the price of conversion parity. At this level,preferred stock can be converted for common stock of equal value. If themarket price of Cyclops common stock trades at $34, the company’s con-vertible preferred stock will trade at $85, regardless of what interest ratesare doing, in order to achieve parity with the common stock.

An investor wanting to know whether a convertible preferred share is morevaluable than the corresponding shares of common stock can use this for-mula:

parity price of preferred stock = conversion ration × market price of commonstock

EXAMPLE: An investor wants to know if she should convert her Cyclopspreferred stock. The preferred stock is trading at $95; the common stockat $361/2.

Parity price of preferred stock = conversion ratio × market price of com-mon stock

= 2.5 × $36.50

= $91.25

At current market prices, the investor will probably want to hold on to herCyclops preferred.

par value of preferred stock

conversion pricenumber of common shares received =

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The conversion feature is one of several features that companies use to makepreferred stock more attractive to investors. Companies can also issue war-rants along with their preferred stock.

Subscription WarrantsWarrants (or subscription warrants) give investors the chance to buy a compa-ny’s common stock at a specified price, at some point in the future. Oftenthey are packaged with a bond or preferred stock, as a “sweetener,” to makethe fixed-income security more attractive to investors. Warrants are freelytransferable and are traded on the major exchanges or over the counter,depending on where the underlying stock is listed.

Warrants resemble rights offerings because they permit investors to buystock at a set price. They differ from rights in two important ways:

➤ Whereas rights generally have terms of 30 to 60 days, warrants com-monly last for many years or even for perpetuity. (Warrants also ofteninclude initial waiting periods, during which they cannot be exercised.)

➤ Warrants have a subscription price that is higher than the stock’s marketprice. Warrants, therefore, have a low value at the outset; they increasein value when the market price of the company’s stock climbs above thesubscription price—or when investors expect it to.

EXAMPLE: B. Mulligan Publishers, Inc., issues a warrant with its newpreferred stock. The warrant has a subscription price of $40, whereasMulligan’s common stock is selling at $30. The current value of the war-rant is $2. If the stock’s market price rises to $45, however, the value of thewarrant increases to at least $5. It might sell for much more than $5,depending on how investors judge the prospects of the company and itsstock.

Companies sometimes give warrants to their top executives as an incentive toimprove the company’s performance and drive up the price of its stock. If theprice of the common stock rises above the subscription price, an executivecan then exercise his or her warrants for a substantial profit. See Table 3.2 foran example of executive warrants and rights schedule.

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Table 3.2 Warrants and Rights Schedule

Warrants Rights

Term Long (often 5 years) or perpetual Short (weeks)

Waiting period Yes No

Subscription price Higher than current market price Lower than currentmarket price

Value Low at outset; increases if stock Immediate value price rises above subscription price

Transferable Yes Yes

Traded on exchanges Yes Yes

Availability All investors Shareholders of record

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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 366

Exam Prep Questions1. Why do companies typically set the par value of common stock at a

low arbitrary value?❑ A. Many states tax common stock—a taxable corporate asset—on the

basis of the stock’s par value.❑ B. Stockholders can deduct the difference between par and market value

on their income tax statements.❑ C. A low par value makes it easier for the company to issue additional

shares.❑ D. Low par value enables a company to issue inexpensive long-term war-

rants to its executives.

2. Which of the following are rights of common-stock owners?I. To receive dividendsII. To receive a stock certificateIII. To stand second in seniority to bondholders for a claim on thecompany’s assets in the event of a liquidationIV. To maintain proportionate ownership in a company when it issuesadditional stock❑ A. I and II❑ B. I, II, and III❑ C. I, II, and IV❑ D. I, II, III, and IV

3. Argus Co. shares are trading at $60 when it declares a 10% stock div-idend. Harold Cross, who owns 100 shares:❑ A. Receives a $600 dividend❑ B. Owns 110 shares worth $54.55 each❑ C. Owns 100 shares worth $66 each❑ D. Receives 10 additional shares valued at $60 each

4. Harry Green owns 300 shares of DDT, Inc., which uses the cumula-tive method of voting. What is the maximum number of votes thatGreen can cast for one candidate when stockholders vote to fill threeopen positions on the DDT board?❑ A. 100❑ B. 300❑ C. 900❑ D. 1,200

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5. Which procedures favor investors with smaller holdings overinvestors with larger holdings?I. Statutory voting rightsII. Cumulative voting rightsIII. Forward stock splitsIV. Reverse stock splits❑ A. I❑ B. II❑ C. II and III❑ D. I and IV

6. Which are true about rights offerings?I. Companies price rights above the market price of their existingshares.II. Companies price rights below the market price of their existingshares.III. Through rights offerings, existing shareholders have the choice ofmaintaining proportionate ownership in a company.IV. Companies can use rights to dilute the holdings of existing owners.❑ A. I❑ B. II❑ C. I and IV❑ D. II and III

7. Zyxon Corporation declares a rights distribution with a subscriptionprice of $30 and a subscription ratio of 10:1. When Zyxon trades at$34, what is the market value of rights to purchase 20 shares ofZyxon?❑ A. $6,000❑ B. $800❑ C. $72.72❑ D. $680

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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 368

8. Millenium Corporation has petitioned the courts for bankruptcy pro-tection to attempt a restructuring. Millenium’s board appoints agroup of trustees and issues voting trust certificates (VTCs), replacingits outstanding stock. Existing shareholders:I. Retain all of their common-stock rights.II. Might eventually get their common shares back.III. Cannot sell their holdings.IV. Lose their voting rights to the appointed trustees.❑ A. I❑ B. II and III❑ C. II and IV❑ D. III and IV

9. Tuscarora Light and Gas issues 100,000 shares of 6.4% preferredstock at $100 par value. Megabyte Corp. buys 30,000 shares of theTuscarora preferred. Assuming that the utility makes all scheduleddividend payments, what amount must Megabyte claim as taxable div-idend income on the preferred each year?❑ A. $48,000❑ B. $38,400❑ C. $192,000❑ D. $57,600

10. Last year, Rocky Falls Power issued 7% preferred stock at a par valueof $100. Since then, interest rates have risen from about 7% to about9%. The Rocky Falls preferred stock now:❑ A. Trades at about par❑ B. Trades at about 78❑ C. Trades at about 128❑ D. Pays a 9% dividend

11. Logical Decisions, Inc. (LDI), has omitted payment of the last twodividends on its 6.6% cumulative preferred stock, a one million shareissue with a par value of $100. Based on strong sales of its new data-base software, the LDI board decides to pay a $1.40 dividend in thenext quarter to owners of its five million outstanding shares of com-mon stock. What sum does LDI’s treasurer set aside to pay the quar-ter’s dividends?❑ A. $7 million❑ B. $10.3 million❑ C. $11.95 million❑ D. $8.4 million

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12. The common stock of Online Auctions, Inc., trades at $23. The com-pany’s convertible preferred shares, issued at a par of $100 with a con-version ratio of 4:1, trade at parity with the common stock at:❑ A. 92❑ B. 25❑ C. 48❑ D. 100

13. Jordan purchased 1,000 shares of Virex common stock when thebiotech firm went public with an offering price of 12. Each share hadone warrant attached that gave the holder the right to purchase thestock at 35. Virex now trades at 38. What is the minimum marketvalue of Jordan’s warrants?❑ A. $105,000❑ B. $78,000❑ C. $3,000❑ D. $72,000

14. Which of the following are true about warrants?I. Warrants often exist in perpetuity.II. Companies use warrants as an incentive to attract investors incommon-stock offerings.III. Investors must use European-style execution to exercise warrants.IV. Warrants issued by NYSE-listed companies trade over the counter.❑ A. I❑ B. I, II, and IV❑ C. I, II, and III❑ D. I and II

15. Regular-way settlement for preferred-stock transactions occurs on:❑ A. The same day❑ B. The next day❑ C. T+3❑ D. T+5

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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 370

Exam Prep Answers1. The correct answer is A. Many corporations set the par value of their

stock at an arbitrary and low level because states have historicallytaxed this asset on the basis of its par value.

2. The correct answer is C. Shareholders of common stock have theright to receive dividends, to take physical delivery of the stock fromthe transfer agent, and to maintain their proportionate ownership byexercising the preemptive right. Owners of common stock stand lastin seniority for a claim on assets of a liquidating firm.

3. The correct answer is B. After the stock dividend, Cross owns 110shares of Argus at 54.55. Argus issues its shareholders 10% additionalshares; the exchange on which Argus is listed adjusts the stock’s pricedownward to keep the value of the shares unchanged.

4. The correct answer is C. Using cumulative voting, Green can poolthe 900 votes to which his 300 shares entitle him, and he can distrib-ute them as he desires among the three candidates for the board.

5. The correct answer is C. Cumulative voting rights and forward stocksplits best serve the interest of small investors. Cumulative votinggives smaller shareholders the capability to apportion their voting infavor of candidates they prefer. A forward stock split lowers a stock’sprice, making its shares more affordable to smaller investors.

6. The correct answer is D. Corporations price the shares in rightsofferings below the market price of their existing shares to providecurrent shareholders with the chance to protect themselves, at a dis-count, from dilution of their ownership.

7. The correct answer is C. The market value of a right is

One Zyxon right thus equals

Two hundred rights, at the subscription ratio of 10:1, enable aninvestor to purchase 20 shares, so 200 × $.3636 = $72.72.

8. The correct answer is C. The Millenium shareholders retain all oftheir rights except their voting rights. They can still sell their hold-ings, now in the form of VTCs, which trade just as common stockdoes. Or, if the trustees turn the company around, they can wait forthe board to return their shares of common stock, along with theirvoting rights.

$34 – $3010 + 1

$0.3636=

market price – subscription price

number of rights required + 1

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9. The correct answer is B. Corporations that own more than 20% ofanother company’s preferred stock can claim an 80% exemption onthe dividend income they earn from the preferred. Megabyte earns$192,000 a year from the Tuscarora preferred (30,000 × 0.064 × $100= $192,000). Because 80% of this amount is exempt from taxation,Megabyte must claim $38,400 as dividend income subject to taxation($192,000 × 0.20 = $38,400).

10. The correct answer is B. Because the market value of preferred stockmoves inversely to interest rates, investors can calculate the approxi-mate market value of preferred stock by dividing the fixed incomethey receive each year by the current level of interest rates. As inter-est rates have risen to 9%, the Rocky Falls preferred stock, issued atpar when interest rates (and thus its dividend) were 7%, now trades at$77.78 ($7 ÷ 0.09 = $77.78).

11. The correct answer is C. Cumulative preferred stockholders are enti-tled to receive all dividends they have missed before the companypays any common-stock dividend. LDI has to pay the cumulative pre-ferred shareholders the two quarters of omitted dividends, or $3.3million (1 million × $100 × 0.066 ÷ 2 = $3.3 million), plus the nextquarter’s cumulative preferred dividend of $1.65 million. The com-mon stock dividend equals $7 million ($1.40 × 5 million = $7 million).The total dividend bill equals $11.95 million.

12. The correct answer is A. The parity price of convertible preferredstock equals the conversion ratio multiplied by the current marketprice of the common stock. The parity price of the Online Auctionsconvertible is thus $23 × 4, or $92.

13. The correct answer is C. A warrant’s market value equals at least thedifference between the price of the underlying stock and the subscrip-tion price. As Jordan owns 1,000 warrants, and the underlying Virexstock trades three dollars above his subscription price, his warrantsare worth a minimum of $3,000. If investors believe that the under-lying Virex stock has significant upside potential, the warrants mighttrade at a premium to this minimum value.

14. The correct answer is D. Warrants, often issued by unproven compa-nies as an inexpensive way to attract additional investors in a newstock issue, generally exist in perpetuity. Because warrants trade onthe exchange where the issuing company’s underlying stock is listed,the warrants issued by an NYSE-listed stock trade on the Big Board.Investors can exercise warrants any time after the initial waiting peri-od—if one exists—for the life of the security.

15. The correct answer is C. Regular-way settlement for all corporateissues, including preferred stock, is T+3.

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