Stock and Dividends* Flashcards
What is common stock?
Owners of common stocks are shareholders of the corporation. This Equity ownership involves risk because there’s no guaranty of return and the owners are last in priority in a liquidation.
What rights do holders of common stock have?
Voting rights. They can select the corporation’s board of directors and vote on resolutions.
What are preemptive rights?
Rights to common shareholders for purchasing future stock issuances in proportion to their ownership so their ownership percentage is not diluted.
What are advantages to issue common stocks?
- No required fixed dividend payment to stockholders
- No fixed maturity date for repayment of capital
- Sale of common stock increases a corporations’ creditworthiness by providing equity
What are disadvantages to issue common stocks?
- Cash dividends are not tax deductible by the corporation (paid out of after-tax profits)
- Higher underwriting costs
- Too much equity may raise the average cost of capital above optimal level (equity has higher return to investors than debt so more equity means higher cost to pay to investors)
Why is common stock more attractive than debt to investors?
Common stock grows in value with the success of the corporation.
What happens when more common stocks are sold?
- Control (voting rights) is usually diluted. This may be a disadvantage to existing shareholders but advantage to the management of the corporation.
- Earnings per share is diluted for existing shareholders.
What is a common stock’s par value?
It represents legal capital. It is the value assigned to stock before the stock is issued. It also represents the maximum liability to shareholders.
What is preferred stock?
It’s a hybrid of debt and equity. It has a fixed charge and increases leverage, but payment of dividends is not a legal obligation. Shareholders of preferred stocks have priority in assets and earnings over common shareholders.
What is accumulation of dividends?
Preferred dividends in arrears must be paid before any common dividends can be paid.
What are participating and non-participating preferred stocks?
Participating preferred stock may participate with common in excess earnings of the company. However, the non-participating stock will only receive the stated percentage on the face of the stock.
What is par value for preferred stock?
It’s the liquidation value. Preferred dividend is calculated as a percentage of the par value.
What is redeemable preferred stock?
It can be repurchased by issuer at a given time or at the option of the holder or otherwise at a time not controlled by the issuer.
What is a call provision for preferred stock?
The issuer may repurchase and pay a call premium after the noncallable period has passed.
What are advantages to issue preferred stock?
- It’s a form of equity so it builds creditworthiness of the corporation
- Control is held by common shareholders
- Superior earnings are reserved for the common shareholders
What are disadvantages to issue preferred stock?
- Cash dividends paid are not tax deductible; thus, its cost is greater than bonds
- Accumulated unpaid dividends (dividends in arrears) may create managerial and financial problem for the corporation
What’s the tax implication to holders of preferred stocks vs bonds?
Holding preferred stock provides corporation major tax advantage because at least 70% of the dividends received is tax deductible, but bond interest received is taxable.
What is a dividend policy?
It determines what portion of net income is distributed to shareholders as dividends and what portion is retained or reinvestment. The most important factor to consider is future planned use of cash.
Why do corporation normally maintain a stable level of dividend payout?
- Profits may fluctuate so not raising the dividend when profits are high can help sustain payout since shareholders have expectation of receiving payout.
- Stock usually sells at a higher price shareholders receive that receiving dividends as less risky.
What is signaling hypothesis?
A change in dividend policy is a signal to the market regarding management’s forecast of future earnings.
How do legal restrictions influence dividend policy?
- Dividends usually cannot be paid out of paid-in capital so a corporation must have retained earnings before payout can be made.
- Restrictive covenants in bond and other debt agreements often limits the dividends a corporation can declare.
How does cash position influence dividend policy?
Cash must be available before a dividend can be paid regardless of a corporation’s earnings record. Earnings may be tied up in receivables or inventories.
How does growth rate influence dividend policy?
Faster growth rate means a corporation needs financing from retained earnings and thus a lower dividend payout.
How do tax positions of shareholders influence dividend policy?
- Shareholders who are in high tax brackets may want to forgo dividends in exchange for future capital gains or wait to receive dividends in future when they are in lower tax brackets.
- Accumulated earnings tax is assessed on a corporation if it has accumulated retained earnings beyond reasonably expected needs.
