CHAPTER 14 LONG-TERM FINANCING: AN INTRODUCTION

Size: px

Start display at page:

Download "CHAPTER 14 LONG-TERM FINANCING: AN INTRODUCTION"

Loraine Hood
6 years ago
Views:

1 CHAPTER 14 B- 1 CHAPTER 14 LONG-TERM FINANCING: AN INTRODUCTION Answers to Concepts Review and Critical Thinking Questions 1. The differences between preferred stock and debt are: a. The dividends on preferred stock cannot be deducted as interest expense when determining taxable corporate income. From the individual investor s point of view, preferred dividends are ordinary income for tax purposes. From corporate investors, 70% of the amount they receive as dividends from preferred stock are exempt from income taxes. b. In case of liquidation (at bankruptcy), preferred stock is junior to debt and senior to common stock. c. There is no legal obligation for firms to pay out preferred dividends as opposed to the obligated payment of interest on bonds. Therefore, firms cannot be forced into default if a preferred stock dividend is not paid in a given year. Preferred dividends can be cumulative or non-cumulative, and they can also be deferred indefinitely (of course, indefinitely deferring the dividends might have an undesirable effect on the market value of the stock). 2. Some firms can benefit from issuing preferred stock. The reasons can be: a. Public utilities can pass the tax disadvantage of issuing preferred stock on to their customers, so there is substantial amount of straight preferred stock issued by utilities. b. Firms reporting losses to the IRS already don t have positive income for any tax deductions, so they are not affected by the tax disadvantage of dividends versus interest payments. They may be willing to issue preferred stock. c. Firms that issue preferred stock can avoid the threat of bankruptcy that exists with debt financing because preferred dividends are not a legal obligation like interest payments on corporate debt. 3. The return on non-convertible preferred stock is lower than the return on corporate bonds for two reasons: 1) Corporate investors receive 70 percent tax deductibility on

2 CHAPTER 14 B- 2 dividends if they hold the stock. Therefore, they are willing to pay more for the stock; that lowers its return. 2) Issuing corporations are willing and able to offer higher returns on debt since the interest on the debt reduces their tax liabilities. Preferred dividends are paid out of net income, hence they provide no tax shield. Corporate investors are the primary holders of preferred stock since, unlike individual investors, they can deduct 70 percent of the dividend when computing their tax liabilities. Therefore, they are willing to accept the lower return that the stock generates.

3 CHAPTER 14 B The following table summarizes the main difference between debt and equity: Debt Equity Repayment is an obligation of the firm Yes No Grants ownership of the firm No Yes Provides a tax shield Yes No Liquidation will result if not paid Yes No Companies often issue hybrid securities because of the potential tax shield and the bankruptcy advantage. If the IRS accepts the security as debt, the firm can use it as a tax shield. If the security maintains the bankruptcy and ownership advantages of equity, the firm has the best of both worlds. 5. The trends in long-term financing in the United States were presented in the text. If Cable Company follows the trends, it will probably use about 80 percent internal financing net income of the project plus depreciation less dividends and 20 percent external financing, long-term debt and equity. 6. It is the grant of authority by a shareholder to someone else to vote his or her shares. 7. Preferred stock is similar to both debt and common equity. Preferred shareholders receive a stated dividend only, and if the corporation is liquidated, preferred stockholders get a stated value. However, unpaid preferred dividends are not debts of a company and preferred dividends are not a tax deductible business expense. 8. A company has to issue more debt to replace the old debt that comes due if the company wants to maintain its capital structure. There is also the possibility that the market value of a company continues to increase (we hope). This also means that to maintain a specific capital structure on a market value basis the company has to issue new debt, since the market value of existing debt generally does not increase as the value of the company increases (at least by not as much). 9. Internal financing comes from internally generated cash flows and does not require issuing securities. In contrast, external financing requires the firm to issue new securities.

4 CHAPTER 14 B The three basic factors that affect the decision to issue external equity are: 1) The general economic environment, specifically, business cycles. 2) The level of stock prices, and 3) The availability of positive NPV projects. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. a. Since the common stock entry in the balance sheet represents the total par value of the stock, simply divide that by the par per share: Shares outstanding = 165,320 / 0.50 Shares outstanding = 330,640

5 CHAPTER 14 B- 5 b. Capital surplus is the amount received over par, so capital surplus plus par gives you the total dollars received. In aggregate, the solution is: Net capital from the sale of shares = Common Stock + Capital Surplus Net capital from the sale of shares = 165, ,876,145 Net capital from the sale of shares = 3,041,025 Therefore, the average price is: Average price = 3,041,465 / 330,640 Average price = 9.20 per share Alternatively, you can do this per share: Average price = Par value + Average capital surplus Average price = ,876,145 / 330,460 Average price = 9.20 per share c. The book value per share is the total book value of equity divided by the shares outstanding, or: Book value per share = 5,411,490 / 330,640 Book value per share = a. The common stock account is the shares outstanding times the par value per share, or: Common stock = 500( 2) Common stock = 1,000 So, the total equity account is: Total equity = 1, , ,000 Total equity = 1,001,000 b. The capital surplus on the sale of the new shares of stock is the price per share above par times the shares sold, or:

6 CHAPTER 14 B- 6 Capital surplus on sale = ( 30 2)(5,000) Capital surplus on sale = 140,000 So, the new equity accounts will be: Common stock, 2 par value 5,500 shares outstanding 11,000 Capital surplus 390,000 Retained earnings 750,000 Total 1,151,000

7 CHAPTER 14 B a. First, we will find the common stock account value, which is the shares outstanding times the par value, or: Common stock = 410,000( 元 5) Common stock = 元 2,050,000 The capital surplus account is the amount paid for the stock over par value. Since the stock was sold at an average premium of 30 percent to par value, the average stock price when sold was: Average stock price when sold = 元 5(1.30) Average stock price = 元 6.50 So, the capital surplus is: Capital surplus = (Average sale price Par)(Number of shares) Capital surplus = ( 元 )(410,000) Capital surplus = 元 615,000 And the new retained earnings balance will be: Retained earnings = Previous retained earnings + Net income Dividends Retained earnings = 元 3,545, ,000 ( 元 650,000)(0.30) Retained earnings = 元 4,000,000 So, the equity accounts will be: Common stock, 元 5 par value 元 2,050,000 Capital surplus 615,000

8 CHAPTER 14 B- 8 Retained earnings 4,000,000 Total 元 6,665,000 b. The only account that will change is the capital surplus account. The new capital surplus will be: Capital surplus = Previous capital surplus, + Surplus from sale of new issues Capital surplus = 元 615,000 + (Sales price Par value)(number of shares sold) Capital surplus = 元 615,000 + ( 元 4 5)(25,000) Capital surplus = 元 590,000 Note that because the stock was sold for less than par value, the additional capital surplus from the sale of the stock is negative. So, the new equity accounts will be: Common stock, 元 5 par value 元 2,050,000 Capital surplus 590,000 Retained earnings 4,000,000 Total 元 6,664, If the company uses straight voting, the board of directors is elected one at a time. You will need to own one-half of the shares, plus one share, in order to guarantee enough votes to win the election. So, the number of shares needed to guarantee election under straight voting will be: Shares needed = (500,000 shares / 2) + 1 Shares needed = 250,001 And the total cost to you will be the shares needed times the price per share, or: Total cost = 250,001 10,572

9 CHAPTER 14 B- 9 Total cost = 2,643,010,572 If the company uses cumulative voting, the board of directors are all elected at once. You will need 1/(N + 1) percent of the stock (plus one share) to guarantee election, where N is the number of seats up for election. So, the percentage of the company s stock you need is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (7 + 1) Percent of stock needed =.1250 or 12.50% So, the number of shares you need to purchase is: Number of shares to purchase = (500, ) + 1 Number of shares to purchase = 62,501 And the total cost to you will be the shares needed times the price per share, or: Total cost = 62,501 10,572 Total cost = 660,760, If the company uses cumulative voting, the board of directors are all elected at once. You will need 1/(N + 1) percent of the stock (plus one share) to guarantee election, where N is the number of seats up for election. So, the percentage of the company s stock you need is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (3 + 1) Percent of stock needed =.25 or 25% So, the number of shares you need is: Number of shares to purchase = (2,500.25) + 1 Number of shares to purchase = 626 So, the number of additional shares you need to purchase is: New shares to purchase =

10 CHAPTER 14 B- 10 New shares to purchase = If the company uses cumulative voting, the board of directors are all elected at once. You will need 1/(N + 1) percent of the stock (plus one share) to guarantee election, where N is the number of seats up for election. So, the percentage of the company s stock you need is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (3 + 1) Percent of stock needed =.25 or 25% So, the number of shares you need to purchase is: Number of shares to purchase = (2,000,000.25) + 1 Number of shares to purchase = 500,001 And the total cost will be the shares needed times the price per share, or: Total cost = 500,001 Rs.420 Total cost = Rs.210,000, Under cumulative voting, she will need 1/(N + 1) percent of the stock (plus one share) to guarantee election, where N is the number of seats up for election. So, the percentage of the company s stock she needs is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (8 + 1) Percent of stock needed =.1111 or 11.11% Her nominee is guaranteed election. If the elections are staggered, the percentage of the company s stock needed is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (4 + 1) Percent of stock needed =.20 or 20% Her nominee is no longer guaranteed election.

CHAPTER 19 DIVIDENDS AND OTHER PAYOUTS

CHAPTER 19 DIVIDENDS AND OTHER PAYOUTS Answers to Concepts Review and Critical Thinking Questions 1. Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid. Dividend