Chapter 20: The Features of Stock combined votes must be large enough to

exceed the majoritys per seat voting capacity.

Equity
Preemptive Rights
A firms sources of finance are either debt or
equity. Preemptive rights- the right to maintain their
Equity- represents ownership in a firm. proportionate ownership in the firm.
- Represents a residual claim - New share in a rights offering must be
- Riskier than debt because of being the offered initially to the existing
residual claim. stockholders.
Stock- represents equity in a corporation Rights offering- sale of new securities to
2 types of stocks: stockholders by offering them the option to
1) Preferred Stock- has a preferred or purchase new shares.
superior position. Although preemptive rights are required in
2) Common Stock- represents the final some states for incorporation, their importance
claim on a corporations earnings and has diminished. The rationale was that issuing
assets. new shares through rights offering was more
Management decisions are consistent with expensive than selling the shares to the
owners goals since managers have a fiduciary general public through underwriting.
responsibility to the corporate owners.
Owners must monitor managerial decisions and Dividend Policy
reduce the potential conflict between
managers and owners: After a corporation has earned profits:
1) Developing a structure of chain of 1) Retain and increase earnings
commands 2) Distribute cash dividends
2) System of removal of harmful Equity:
employees 1) Stock outstanding- issued stocks
3) System of rewards for performance 2) Additional paid-in capital- funds paid in
Agency Costs- expenditures that owners must excess of the stocks par value when
bear to ensure that management acts in the the shares are initially sold.
best interest of the owners. 3) Retained Earnings- accumulated
Creditors also have similar costs, since owners earnings of the firm that have not been
and managers can take actions that reduce the distributed (if negative, cumulative
safety of the debt. deficit)
-represent an investment in the firm by
Common Stock CS
-part of the stockholders contribution
Common stock- represents the residual claim to firm
on the assets and earnings of a corporation. Total Equity- sum of the entries and represents
- Receives earnings that have accrued after the stockholders total contribution to the firm.
expenses, interest and preferred stock The distribution of dividends doesnt affect
dividends are paid. paid-in capital.
Common Stockholders receive all the rights of The impact of the dividend policy on the firms
ownership, including the option to vote the balance sheet depends whether:
shares. 1) Distributes the earnings
- Elect a board of directors that selects the -equity is not increased
2) Retains and acquires more assets
firms management
-retained earnings increased
- Stockholders > Board of Directors >
3) Retains and retires the debt
Management -retained earnings increased also
For publicly held corporations, stockholders are The decision concerning the distribution of
usually widely dispersed, while the firms board earnings is in relation to the stockholders
and management generally form a cohesive wants and satisfies these wants. (dividends or
unit in which the board supports the capital gain)
management. However, the stockholders position is
Professional money managers often press unaffected by the dividend policy of the firm.
corporate executives to achieve higher Instead, transaction costs affect it.
earnings and returns. If not achieved:
1) Replacement of management Impact of Transaction Costs
2) Acquisition of the corporation by
another firm
If the corporations stockholders desire
The threat of a change in management
dividends, then there may be a net cost saving
encourages the board to pursue strategies that
from the distribution of earnings and the
increase the value of the firms stocks.
flotation of new shares.
2 methods of voting:
If they seek capital gains, then there may be a
1) Traditional Method- 1 share, 1 vote, 1
net cost saving from retaining the earnings.
candidate
2) Cumulative Voting- encourages If they want cash, they could sell part of their
minority representation by permitting holdings, in which case they bear the expense.
stockholders to cast all their shares for
one candidate.
Impact of Taxation
Although cumulative voting can help a minority
Dividends are subject to federal income taxes,
group obtain representation, the total of its
while profits from security sales are subject to
federal capital gains taxes.
 Argument in favor of capital gains: 1) The number of new shares issued
- Dividends are taxed when they are through the stock dividend
received; that tax on capital gains is 2) The market price of the stock
deferred until the shares are sold. No increase in assets, only recapitalization
The stock dividend does not increase your
The Firms Need for Funding wealth but does increase the number of share
you own.
The fluctuations in the firms cash needs can Dilution- reduction in earnings per share as the
have an impact on the desirability of result of issuing additional shares.
distributing cash dividends as well as the firms The stock dividend DOES NOT increase the
capacity to pay the dividend. ability of the firm to grow. Hence, the decision
In cyclical industries: During periods of to pay stock dividend does not increase the
economic prosperity their earnings tend to firms cash, it is the decision not to pay the
expand, which would permit higher dividend. cash dividend that conserves the cash.
However, they may prefer to retain the
earnings to help finance the firms operations Stock Splits
during economic slowdown and stagnation.
Inflation also affect dividend policy, since there Stock Split- recapitalization achieved by
will be a need for more funds to finance higher changing the number of shares outstanding
prices. - Lowers the price of the stock and makes it
If management seeks to maximize the wealth more accessible to investors.
- Alters only the equity section, but no
of the stockholders, the dividend decision
changes in the additional paid-in capital,
depends on who has the better use for the
RE, or total equity.
money- the stockholders of the firm.
Reverse Splits- reduce the number of shares
and raise the price of the stock.
Cash Dividends Price after the split= price before the split x
reciprocal of the terms of the split
Payout Ratio- cash dividend divided by the A lower selling price increases the
earnings per share. marketability of the shares. This increased
The stability of dividends coupled with marketability and interest may cause the value
fluctuations in earnings means that the amount of the stock to appreciate.
of earnings retained varies each year and A lower priced stock (higher number of shares)
management has decided to maintain a stable may rise more that the higher priced stock.
dividend at the expense of stable increases in (E.g. gain of P5 per stock. 100 shares=P500,
RE. 200 shares= P1000)
Even If the amount of the dividend is stable, A reason to prefer higher priced stock (lower
fluctuations in exchange rates imply that the number of shares) is that brokerage firms tend
amount of the dividend received varies with to charge commission based on the number of
each payment. shares.
The unwillingness to cut dividends has resulted
in a tendency for management to raise Dividend Reinvestment Plans
dividends only when it is certain that the
higher level of earnings can be maintained. DRIPs- permit the stockholders to have cash
Date of record- books of the corporation are dividends reinvested in additional shares
closed, day on which an investor must own instead of receiving cash.
stock in order to receive the dividend payment. In most plans a bank collects the cash
Ex-record- stock purchases exclusive of any dividends and offers the stockholders the
dividend payment. (2 working days before the option of making additional contributions and
date of record) purchases the stock in the secondary market.
Settlement date of purchase- 3 working days Since the bank purchases a large block of
Pay date or Distribution date- day on which shares, there will be a reduction in the per-
dividend is paid to stockholders. (several share commission cost.
weeks after the record date) Another type is that the company issues new
When a stock goes ex div, its price is adjusted shares of stock, and the money goes directly to
downward for the dividend. the company. The brokerage fees are
The change in the stocks price from the circumvented, thus, the entire amount of the
previous days trading is figured form the cash dividend is used to purchase shares with
adjusted price. the issuing cost paid by the company.
Most important advantage to investors of
Stock Dividends dividend reinvestment plans is the forced
savings.
Stock Dividends- distribution form earnings
paid in additional shares of stock. Repurchase of Stock
- Alter the entries on the equity section, but
they have no impact on the firms asset Stock repurchases decrease the number of
and liabilities. shares outstanding. Since the earnings will be
- Do not affect the companys earning spread over fewer shares, the earning per
capacity. share should increase, leading to a higher
- Transfers amounts from retained earnings stock price in the future.
to common stock and additional paid-in May be viewed as an alternative to paying cash
capital. dividend, thus the firm offers to repurchase it
The amount transferred depends on:
stocks. If the stockholders believe that the retention of the shares, they do not have to sell
firms potential is sufficient to warrant them.