Stocks (equity) and Bonds (debt)
Debt and equity are broad categories of firm liabilities. Key distinguishing features of debt and equity are :
- Whether asset yields are a legal obligation or discretionary
- Whether asset owners can vote to choose directors - Priority in sharing values in liquidation - The tax deductibility of payments to asset owners
Stocks and Bonds (continued)
Various financial instruments are also used in practice : Common stock can have different voting rights Preferred stock, that has precedence in payment of dividends and in liquidation, has some “debt-like” features Long-term debt, that is unsecured or subordinated, has some “equity-like” features Debt, that receives interest payment conditional on corporate income, also resembles the discretionary dividend yield of equity
Trends in Financing Patterns (US Industrial firms)
Internally generated cash flow has dominated as a source of financing, and the proportion of internal financing has grown. (Table 1) External financing has been dominated by borrowing. (Figure 1) During 1984-1990, new issues of equity were negative as firms repurchased stock, largely through increased borrowing. Nevertheless, during 1977-1992, the market value of firm’s equity increased more than 500% compared to only 350% for debt. Internal financing tends to be higher in recessions or periods of slower growth in the economy (1979, 1982, 1991) Firms in the US use more internal financing than do firms in other comparable countries. (Figure 2)
Only firms in the US retired stocks in the 1980’s
Table 1 : Historical U.S. Financing Patterns (percent), 1979 to 1992
Figure 1: Sources of financing for U.S. industrial firms
Figure 2: International Financing Patterns, 1990-1992
These assets represent ownership shares that have no special preferences in bankruptcy or rights to dividends. Dividend payment is at the discretion of the board of directors, but once declared is a legal liability that can force bankruptcy. Dividends are “double-taxed” -- except a corporate owner is taxed on only 30% of receipts.
Table 2 : Definitions of some share value concepts
Term Par value Definition Face value of share: it can only be distributed to shareholders upon liquidation (the number of shares issued) * (their current market price) (initial market value of the firm’s shares) – (their par value) (net income) – (dividends paid out to shareholders) (par value) + (capital surplus) + (accumulated retained earnings)
Market value Capital surplus Retained earnings Common equity book value
Voting of Shareholders
Shareholders elect directors who select executive officers. Votes may decide mergers. A proxy is a legal grant of authority for someone else to vote an owner’s shares.
Under cumulative voting for directors : votes ? ?shares controlled?? ?number of directors to be elected?
Under cumulative voting, votes can be distributed to over one or more candidates. Under straight voting, votes for each candidate equal the shares owned.
Voting of Shareholders (continued)
Although cumulative voting assists minority shareholders, election can be staggered so that only one director is elected at a time. Stocks with superior voting rights sell at a premium, particularly in a takeover battle. Preferred stocks usually do not have voting rights, but may do if dividends are skipped.
Example : Problem 14.4
Shareholders of unicorn Co. need to elect 7 new directors. There are 2 million shares outstanding. How many shares do you need to be certain that you can elect one director? [Straight voting case] One share is one vote, so you need at least 1,000,001 (= 2,000,000/2 + 1) votes. [Cumulative voting case] Let X be the number of shares needed to guarantee a candidate comes at least 7th.
votes ? ?votes per share?? ?shares? ? 7 ? 2,000,000 ? 14,000,000
Then, solve 7x ? 14,000,000 ? 7x ? x ? 250,000 7
Hence, you need at least 250,001 shares.
Debt is a contractual obligation of a firm, although it can be subordinated to other debt. Often debt is secured with a mortgage on tangible property which must be used to repay the secured debt. The debt contract or indenture specifies : ? maturity date, interest rate, interest payment frequency, and repayment schedule ? whether, or when, debt may be called and if so at what premium relative to par value ? restrictions on future indebtedness ? a maximum level of dividends that can be paid ? a minimum level of working capital to be maintained
Creditors can claim the firm’s assets if principal and interest are not paid on time Interest payments on debt are tax-deductible. However, debt increases the risk of a costly bankruptcy.
The principal, face or par value is usually dominated in units of $1000. Hence debt “selling at 90” could be bought for $900.
Interest is generally expressed as a fraction of par value. For example, 7% debt at a par value of $1000 would pay $70 interest payment annually, usually in semi-annual installments of $35.
Different broad categories of debt : ? ? ? ? a bond is secured by a mortgage on company property a debenture is unsecured by specified property a note is a short-term obligation, usually under seven years unfunded debt is due in less than one year and is a current liability ? funded debt is payable more than one year from when issued ? debt with no specific maturity is called consol
Has a preference, stated as a liquidating value and a (maximum) dividend payment, in the event of liquidation. Skipped cumulative dividends are carried forward (without interest) to be paid before common stock holders receive anything. Holders of preferred stock usually don’t vote, but may be given voting rights if preferred dividends have not been paid.
Preferred dividends are not tax deductible. However, since 70% of preferred dividends received by corporations are tax exempt, preferred stocks are often bought by other corporations.
Preferred Stock (continued)
Preferred stock does not impose a tax penalty on companies reporting losses to IRS. On the other hand, the deductibility of interest payments on debt would be “wasted”. Unlike straight debt, preferred stock cannot force bankruptcy.