Equity

Question 1

What are the advantages of common stock to an issuer?

Answer 1

The following are advantages of issuing common stock:

1. Common stock does not require a fixed dividend; dividends are paid from profits when available
2. There is no fixed maturity date for repayment of the capital
3. The sale of common stock increases the creditworthiness of the firm by providing more equity
4. 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

Question 2

What are disadvantages of common stock to an issuer?

Answer 2

The following are disadvantages of issuing common stock:

1. Cash dividends on common stock are not tax-deductible and so must be paid out of after-tax profits
2. 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)
3. New common stock sales dilute earnings per share available to existing shareholders
4. Underwriting costs are typically higher for common stock issues
5. Too much equity may raise the average cost of capital of the firm above its optimal level

Question 3

What are advantages of preferred stock to an issuer?

Answer 3

The following are advantages of issuing preferred stock:

1. It is a form of equity and therefore builds the creditworthiness of the firm
2. Control is still held by common shareholders
3. Superior earnings of the firm are usually still reserved for the common shareholders

Question 4

What are disadvantages of preferred stock to an issuer?

Answer 4

The following are disadvantages of issuing preferred stock:

1. 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
2. In periods of economic difficulty, accumulated unpaid dividends (called dividends in arrears) may create major managerial and financial problems for the firm

Question 5

What are typical provisions of preferred stock issues?

Answer 5

The following are typical provisions of preferred stock issues:

1. Priority in assets and earnings
2. Accumulation of dividends
3. Convertibility
4. Participation
5. Par value
6. Redeemability
7. Voting rights
8. Callability
9. Maturity

Question 6

What are priority in assets and earnings provisions pertaining to preferred stock?

(Typical provisions of preferred stock issues)

Answer 6

Priority in assets and earnings - If the firm goes bankrupt, the preferred shareholders have priority over common shareholders

Question 7

What are accumulation of dividends pertaining to preferred stock?

(Typical provisions of preferred stock issues)

Answer 7

Accumulation of dividends - If preferred dividends are cumulative, dividends in arrears must be paid before any common dividends can be paid

Question 8

What is convertibility pertaining to preferred stock?

Typical provisions of preferred stock issues

Answer 8

Convertibility - Preferred stock issues may be convertible into common stock at the option of the shareholder

Question 9

What is participation pertaining to preferred stock?

Typical provisions of preferred stock issues

Answer 9

Participation - Preferred stock may participate with common in excess earnings of the company

For example, 8% participating preferred stock might pay a dividend each year greater than 8% when the corporation is extremely profitable, but nonparticipating preferred stock will receive no more than is stated on the face of the stock

Question 10

What is par value pertaining to preferred stock?

Typical provisions of preferred stock issues

Answer 10

Par value - Par value is the liquidation value and a percentage of par equals the preferred dividend

Question 11

What is redeemability pertaining to preferred stock?

Typical provisions of preferred stock issues

Answer 11

Redeemability - Some preferred stock may be redeemed at a given time or at the option of the holder or otherwise at a time not controlled by the issuer. This feature makes preferred stock more nearly akin to debt, particularly in the case of transient preferred stock, which must be redeemed within a short time (i.e. 5 to 10 years)

The SEC requires a separate presentation of redeemable preferred, nonredeemable preferred and common stock

Question 12

What are voting rights pertaining to preferred stock?

Typical provisions of preferred stock issues

Answer 12

Voting rights - these may be conferred if preferred dividends are in arrears for a stated period

Question 13

What is callability pertaining to preferred stock?

Typical provisions of preferred stock issues

Answer 13

Callability - the issuer may have the right to repurchase the stock. For example, the stock may be noncallable for a stated period, after which it may be called if the issuer pays a called if the issuer pays a call premium (an amount exceeding par value)

Question 14

What is maturity pertaining to preferred stock?

Typical provisions of preferred stock issues

Answer 14

Maturity - preferred stock may have a sinking fund that allows for the purchase of a given annual percentage of the outstanding shares