Sinking Funds Because there is no legal obligation to pay the preferred dividend and
Sinking Funds Because there is no legal obligation to pay the preferred dividend and
because bondholders and other creditors get the first crack at a firm’s income and liquidation rights, preferred shareholders want some assur- ance they will receive preferred stock dividends. A corporation can pro- vide this assurance in the form of a sinking fund provision. In fact, almost all preferred stock has a sinking fund provision.
As we discussed in Chapter 15 in the context of long-term debt, a sinking fund is like a savings account. The corporation deposits funds with a trustee, who uses these funds to periodically retire preferred stock, buying it from shareholders at a specified price, the sinking fund call price. The trustee acquires these shares by either buying them in the open market—calling up a broker and buying the shares—or calling in the preferred stock at a specified sinking fund call price. The amount of
FINANCING DECISIONS
the periodic retirement is predetermined, which may be specified in terms of the number of shares or the percentage of total shares to be retired each year. By retiring preferred stock periodically, the firm is bet- ter able to meet the dividend payments on the remaining preferred shares.
Packaging Features
A corporation may combine any of the features we just described into its preferred stock. If they hope to sell their preferred shares, they must pack- age them in a way that is attractive to investors and at a reasonable cost.
Features that give the issuer flexibility, such as a call feature, intro- duce uncertainty for investors. Investors do not know when (or if) the firm will call in the issue. Because investors do not like risk, they will demand a greater return on callable preferred shares to compensate them for the additional risk implicit in its uncertainty. Providing a greater return increases the issuer’s cost.
Features that give the investor something of additional value, such as a conversion feature, lower the issuers’ cost. Investors are willing to accept a lower return in exchange for convertibility. And if investors are willing to accept a lower return, the issuer’s cost of capital is lower.
And like common stock, dividends received by corporations are par- tially excluded from taxation. And because most of the investors in pre- ferred stock are corporations, the dividend received deduction lowers the return demanded by investors, lowering the issuing corporation’s cost of financing.
Packaging a new issue of preferred stock requires considering inves- tors’ need for greater returns and lower risk and the issuer’s need for greater flexibility and lower costs.
CORPORATE USE OF PREFERRED STOCK Preferred stock is generally considered the Wall Street wallflower. Seldom
issued, preferred stock is usually associated with financially troubled firms. Recently, several major U.S. companies issued preferred stock as a source of additional equity capital. Examples of preferred stock issues in the 1990s include Ford Motor Company, RJR Nabisco Holdings, Kmart, and General Motors. These issues did not do much to change preferred stock’s image, since these companies issued preferred stock at times when they were cash-poor or on the brink of a debt downgrade.
Why would a company issue preferred stock? One advantage of using preferred stock as a source of capital is that, in general, the firm must pay
Preferred Stock
only a fixed amount in dividends, leaving the upside potential in earnings to be reaped by common shareholders. Another advantage is that the vot- ing control of common shareholders is not diluted, as it would be if com- mon shares were issued. Still another advantage is the cost of preferred stock. Preferred stock is considered less risky than common stock, there- fore its cost to the issuer should be less than that of common stock. Rela- tive to issuing debt, preferred stock is more expensive since the interest paid on debt is deductible for tax purposes and the dividends paid on pre- ferred stock is not deductible.
Mitigating this cost somewhat is the fact that a large portion (cur- rently 70%) of the dividends received by corporate owners of preferred stock is excluded from taxable income, which therefore reduces the yields that corporate investors demand on the stock For example, if Corporation A owns the preferred stock of Corporation B, then only $30 of each $100 that A receives in dividends from B will be taxed at A’s marginal tax rate. The purpose of this provision is to mitigate the effect of the double taxation of corporate earnings. There are two implica- tions of this tax treatment of preferred stock dividends. First, the major buyers of preferred stock are the treasurers of corporations seeking tax- advantaged investments. Second, the cost of preferred stock issuance is lower than it would be in the absence of the tax provision, because the tax benefits are passed through to the issuer by the willingness of buyers to accept a lower dividend rate.
A disadvantage of preferred stock, relative to common stock, is that it has a claim on income and assets of the firm that is senior to that of common shareholders. The firm must pay the dividends owed preferred shareholders before it pays dividends to common shareholders.
Another disadvantage of using preferred stock as a source of capital is the connotation associated with these issuing firms. Historically, pre- ferred stock issuances have been made by firms that were in financial difficulty. This is confirmed by looking at what happens to a firm’s com- mon stock price when it announces an issue of preferred stock: The price of the issuer’s common shares tends to go down. For example, when RJR Nabisco Holdings announced a planned offering of $2 billion of preferred stock in 1994, its common stock price fell 8.5%. A portion of this fall in price may be attributed to the possible dilution of existing common shares since the planned preferred shares are convertible. However, the common stock price drop may also be attributed to the relatively high dividend yield needed to convince investors to buy the preferred stock and to the message conveyed by the firm that it was unable to successfully offer new common shares directly to the public.
FINANCING DECISIONS
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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