4.2 Stock Flashcards
Advantages of common stock to the issuer include
- Common stock does not require a fixed dividend
- There is no fixed maturity date for repayment of the capital
- The sale of common stock increase the creditworthiness of the firm by providing more equity
- Common stock is frequently more attractive to investors than debt because it grows in value with the success of the firm. The higher the common stock value, the more advantageous equity financing is compared with debt financing.
Disadvantages of common stock to the issuer include
- Cash dividends on common stock are not tax-deductible by the corporation, and so must be paid out of after-tax profits.
- Control (voting rights) is usually diluted as more common stock is sold. (While this aspect is disadvantageous to existing shareholders, management of the corporation may view it as an advantage.)
- New common stock sales dilute earnings per share available to existing shareholders.
- Underwriting costs are typically higher for common stock issues.
- Too much equity may raise the average cost of capital of the firm above its optimal level.
- Inflation may increase the yields of new bond issues and decrease demand for common stock. Moreover, higher interest costs reduce funds available for dividends.
Advantages of preferred stock to the issuer include
- It is a form of equity and therefore builds the creditworthiness of the firm.
- Control is still held by common shareholders.
- Superior earnings of the firm are usually still reserved for the common shareholders.
Disadvantages of preferred stock to the issuer include
- Cash dividends on preferred stock are not deductible as a tax expense and are paid with after-tax income. The result is a substantially greater cost relative to bonds.
- In periods of economic difficulty, accumulated unpaid dividends (called dividends in arrears) may create major managerial and financial problems for the firm.
The par value of a common stock represents
A. The estimated market value of the stock when it was issued.
B. The liability ceiling of a shareholder when a company undergoes bankruptcy proceedings.
C. The total value of the stock that must be entered in the issuing corporation’s records.
D. A theoretical value of $100 per share of stock with any differences entered in the issuing corporation’s records as discount or premium on common stock.
B. The liability ceiling of a shareholder when a company undergoes bankruptcy proceedings.
Par value represents a stock’s legal capital. It is an arbitrary value assigned to stock before it is issued. Par value represents a shareholder’s liability ceiling because, as long as the par value has been paid in to the corporation, the shareholders obtain the benefits of limited liability.
Which one of the following rights is ordinarily sacrificed by the holders of preferred stock in exchange for other preferences received over common shareholders?
A. The right to vote for members of the board of directors and in other matters requiring a vote.
B. The right to share in the residual assets of the company upon liquidation.
C. The right to share in the periodic earnings of the company through the receipt of dividends.
D. The right to accrue dividend payments in arrears when payments are not made for a period of time.
A. The right to vote for members of the board of directors and in other matters requiring a vote.
Unlike common stockholders, preferred stockholders are not usually entitled to voting rights. Preferred stockholders sacrifice voting rights in exchange for other preferences over common stockholders.
The following excerpt was taken from a company’s financial statements: “ . . . 10% convertible participating . . . $10,000,000.” What is most likely being referred to?
A. Bonds.
B. Common stock.
C. Stock options.
D. Preferred stock.
D. Preferred stock.
Preferred shareholders have priority over common shareholders in the assets and earnings of the enterprise. If preferred dividends are cumulative, any past preferred dividends must be paid before any common dividends. Preferred stock may also be convertible into common stock, and it may be participating. For example, 10% fully participating preferred stock will receive additional distributions at the same rates as other shareholders if dividends paid to all shareholders exceed 10%.
In general, it is more expensive for a company to finance with equity capital than with debt capital because
A. Long-term bonds have a maturity date and must therefore be repaid in the future.
B. Investors are exposed to greater risk with equity capital.
C. Equity capital is in greater demand than debt capital.
D. Dividends fluctuate to a greater extent than interest rates.
B. Investors are exposed to greater risk with equity capital.
Providers of equity capital are exposed to more risk than are lenders because the firm is not obligated to pay them a return. Also, in case of liquidation, creditors are paid before equity investors. Thus, equity financing is more expensive than debt because equity investors require a higher return to compensate for the greater risk assumed.
The equity section of a Statement of Financial Position is presented below.
Preferred stock, $100 par: $12,000,000
Common stock, $5 par: 10,000,000
Paid-in capital in excess of par: 18,000,000
Retained earnings: 9,000,000
Net worth: $49,000,000
The common shareholders have preemptive rights. If an additional 400,000 shares of common stock are issued at $6 per share, a current holder of 20,000 shares of common stock must be given the option to buy
A. 1,000 additional shares.
B. 3,774 additional shares.
C. 4,000 additional shares.
D. 3,333 additional shares.
C. 4,000 additional shares.
Common shareholders usually have preemptive rights, which means they have first right to purchase any new issues of stock in proportion to their current ownership percentages. The purpose of a preemptive right is to allow stockholders to maintain their current percentages of ownership. Given that the corporation had 2,000,000 shares outstanding ($10,000,000 ÷ $5 par), an investor with 20,000 shares has a 1% ownership. Thus, this investor must be allowed to purchase 4,000 (400,000 shares × 1%) of the additional shares.
A financial manager usually prefers to issue preferred stock rather than debt because
A. Payments to preferred stockholders are not considered fixed payments.
B. The cost of fixed debt is less expensive since it is tax deductible even if a sinking fund is required to retire the debt.
C. The preferred dividend is often cumulative, whereas interest payments are not.
D. In a legal sense, preferred stock is equity; therefore, dividend payments are not legal obligations.
D. In a legal sense, preferred stock is equity; therefore, dividend payments are not legal obligations.
For a financial manager, preferred stock is preferable to debt because dividends do not have to be paid on preferred stock, but failure to pay interest on debt could lead to bankruptcy. Thus, preferred stock is less risky than debt. However, debt has some advantages over preferred stock, the most notable of which is that interest payments are tax deductible. Preferred stock dividends are not.
Which one of the following situations would prompt a firm to issue debt, as opposed to equity, the next time it raises external capital?
A. High breakeven point.
B. Significant percentage of assets under capital lease.
C. Low fixed-charge coverage.
D. High effective tax rate.
D. High effective tax rate.
The interest paid on indebtedness is deductible for tax purposes; dividends paid to equity holders is not. Thus, a firm with a high effective tax rate would prefer to issue debt, which would create an additional tax benefit.
Preferred stock may be retired through the use of any one of the following except a
A. Conversion
B. Refunding
C. Sinking fund
D. Call provision
B. Refunding
Preferred stock is equity. Only debt can be refunded.
All of the following are characteristics of preferred stock except that
A. It usually has no voting rights.
B. It may be converted into common stock.
C. Its dividends are tax deductible to the issuer.
D. It may be callable at the option of the corporation.
C. Its dividends are tax deductible to the issuer.
Dividends on stock, whether common or preferred, are not deductible for tax purposes.
