CSC Volume 1 (ch8) PDF

Preview

Summary

Download CSC Volume 1 (ch8) PDF

Description

CSC Volume One Chapter 8 Equity Securities: Common and Preferred Shares Common Shares  Common shareholders are the owners of a company and initially provide the equity capital to start the business  If the venture prospers, the shareholders benefit from the growth in value of their original investment and the flow of dividend income  On the other hand, if the business fails, the common shareholders may lose their entire investment 

This possibility of total loss explains why common share capital is sometimes referred to as venture or risk capital

Position on asset claims in case of bankruptcy Dividends

Evidence of Ownership

Clearing and Settlement

Trading Units





SUMMARY of COMMON SHARES As part owner of the business, the common shareholder is in relative weak position, as senior creditors (such as banks), bond and debenture holders and preferred shareholders all have prior claims on the earnings and assets of the company. Unlike debt interest, common share dividends are payable at the discretion of the Board of Directors. There is no guarantee of dividend income. Shares are most often registered in street certificate form, meaning they are registered in the name of the securities firm rather than the beneficial owner. This increases the negotiability of the shares, making them more readily transferable to a new owner. Clearing and Depository Services Inc. (CDS) offers computer-based systems to replace certificates as evidence of ownership in securities transactions. This system almost eliminates the need to handle securities physically. Stocks trade in uniform lot sizes on stock exchanges. The usual unit of trading(standard trading unit) for most stocks is 100 shares. A group of shares traded in less than a standard trading unit is called an odd lot.

Rights and Advantages of Common Share Ownership 1. Potential for Capital Appreciation  As companies earn profits year after year, whatever money is not paid out to shareholders in the form of dividends will remain in the company as retained earnings  Since retained earnings from part of common equity, a growth in retained earnings will add to the value of shareholders’ equity Rights and Advantages of Common Share Ownership (cont’d) 1

2. Right to Receive Dividends Paid by the Company  A company’s net earnings after preferred dividends are available for distribution as common share dividends  Dividend policy is determined by the Board of Directors, who are guided primarily by the goals of the company, the size of the company, the industry in which it participates, and the financial position of the company.  Regular Dividend – some companies paying common share dividends designate a specified amount that will be paid each year. The term “regular” indicates to investors that payments will be maintained, barring a major collapse in earnings.  Extra Dividend – some companies may also pay an extra dividend on the common shares, usually at the end of the company’s fiscal year. The extra is a “bonus” paid in addition to the regular dividend, but the term extra cautions investors not to assume that the payment will be repeated the following year.  Ex-Dividend – a purchaser of these shares will not receive the dividend that has just been declared. When a stock is actively traded, the record of shareholders is continually changing and for convenience, the company names a date known as the dividend record date. The ex-dividend date is set at the 2nd business day before the dividend record date. For Example: The Board of Directors of ABC Inc. voted to pay on July 2, 2015 to shareholders of record at the close of business on June 13, 2015 a dividend of $0.75 per each share of common stock. The transfer books will not be closed. Payment will be made in Canadian funds. The purpose of the interval between June 13 and July 2 is to give the company time to prepare the dividend cheques for mailing to recorded shareholders. During this interval, a purchaser of these shares will not receive the dividend that has just been declared and the stock is said to be ex-dividend. 





Dividend Record Date – for convenience, the company names a date known as the dividend record date. All shareholders recorded as of this date will be entitled to the dividend. The dividend record date is usually 2-4 weeks in advance of the payment date in order to allow time for cheque preparation. Cum-Dividend – means the reverse, trades during this period result in the purchasers receiving the declared dividend. The last day a stock trades cum dividend is 3rd business day before the dividend record date.

Rights and Advantages of Common Share Ownership (cont’d)

2

Dividend Reinvestment Plans – in such a plan, the company diverts the shareholders’ dividends to the purchase of additional shares of the company. Reinvested dividends are taxable to the shareholder as ordinary cash dividends even though the dividends are not received as cash.  Stock Dividends – sometimes the dividend may be in the form of additional stock rather than cash. Often such dividends are paid from time to time by a rapidly growing company that needs to retain a high degree of earnings to finance future growth. 3. Voting Privileges  Voting rights are important feature; however, many companies have 2 or 3 different types of shares, often designated as Class A or B.  Restricted Shares – are shares, which have the right to participate to an unlimited degree in the earnings of a company and in its assets on liquidation, but do not have full voting rights. There 3 categories of restricted shares:  Non Voting  Subordinate Voting –shares in a company which has another class of shares which have greater voting rights on a per share basis; and  Restricted Voting – shares that have a limit on the number or percentage of shares that may be voted by a person, company or group 4. Favourable Tax Treatment  The federal government offers a dividend tax credit that makes the purchase of dividend-paying shares of taxable Canadian companies relatively attractive for persons in lower tax brackets  The current exemption from tax of 50% of capital gains  Stock savings plans (Labour Sponsored Funds) entitle residents of some provinces to deduct up to specified annual amounts from (or obtain a tax credit for) the cost of certain stocks purchased in their respective provinces during the year  Tax on foreign dividends – no similar preferential treatment is applicable to foreign dividends or dividends from non-taxable Canadian corporations  Capital Loss – arises from the sale of a capital property for less than its cost. Capital losses can be used to reduce any capital gains that have been earned, but generally cannot be used to reduce any other income. 



Rights and Advantages of Common Share Ownership (cont’d)

3

5. Marketability  The right to buy or sell common shares in the open market at any time is an attractive feature and a relatively simple matter with few legal formalities  Stock Splits – the common shares of a prospering corporation can rise substantially in price over time. Most companies believe it is good corporate strategy to keep the market price of their shares in a popular price range, say $10-$20, and use a stock split or subdivision to bring a high-priced stock into this range.  Reverse Splits or Consolidations – can occur with the result that each shareholder’s total shareholdings in a company are reduced. The total dollar value of the holdings should theoretically not be affected. Reverse splits occur most frequently when a company’s shares have fallen in value to a level that is unattractive to investors with large amounts of capital

PREFERRED SHARES Overview  A company can raise funds by selling ownership in itself to investors  These funds would form the equity portion of a company’s capital structure  In return, the investors would receive shares in the company, representing their degree of ownership  Their investment would be tied directly to the fortunes of the company  As the company earned profits and retained some or all of them, its equity value would grow  This increases the net asset value of each common share and makes them more attractive to investors  Growing profits could also mean an increase in dividends paid out to shareholders, which would also enhance the appeal of the shares  As the company’s shares became attractive to new investors, they would bid up in price, providing a potential gain to existing shareholders  All corporations, whether public or private, listed or unlisted, issue common shares  In addition, some companies issue preferred shares  A preferred share is entitled to a fixed amount of equity, determined when the share is first issued  A series of profitable years will increase the equity value of common shares, as retained earnings and therefore common equity grow, but will have no effect on the equity value of preferred shares  Common shares are bought by those looking to profit from the ongoing success of the issuer  Preferred shares appeal to those wanting steady dividend income and a place in line ahead of the common shareholders should the company dissolve Characteristics of Preferred Shares  Preferred’s Position

4

Typically the preferred shareholder occupies a position between that of the company’s creditors and that of the common shareholder  If a company’s ability to pay interest and dividends deteriorates because of lower earnings, the preferred shareholder is “in the middle”  The investor is better protected than the common shareholders but junior to the claims of debtholders (bond and debenture holders are also creditors)  Some companies issue more than one class of preferred stock and when this occurs each class is separately identified Preference as to Assets  Preferred shares are usually given a prior claim to assets ahead of the common shares in the event of winding up or dissolution of a company  Claims of creditors and debtholders rank ahead of preferred shareholder claims and the common shareholder has to be content with anything that is left after all creditor, debtholder and preferred shareholder claims have been met Preference as to Dividends  Preferred shares are usually entitled to a fixed dividends expressed either as a percentage of the par or stated value, or as a stated amount of dollars and cents  Dividends are paid from earnings, current or past  However, unlike interest on a debt security, dividends are not obligatory and are payable only if declared by the Board of Directors  If the Board of Directors omits the payment of a preferred dividend, there is very little the preferred shareholder can do about it  The charters of some companies provide that no dividends are paid to common shareholders until the preferred’s have received full payment of dividends to which they are entitled  Failure to declare an anticipated preferred dividend has unfavourable repercussions, weakens investor confidence, the general credit and future borrowing power of the company suffer The Importance of Dividends  Although greater risk is involved in owning preferred and common shares compared to owning debt securities, the pre-tax yield from preferred and common shares is normally below the yields available from debt investments  This is due to the tax treatment of interest received versus dividends received  When a company pays interest on its debt, the interest is paid with the company’s pre-tax dollars because interest is considered a tax deductible cost of doing business  When bond or debenture holders receive interest, it is treated as taxable income in their hands  When a company pays dividends on its shares, the dividends are paid with after-tax dollars because dividends, being a share of a company’s profits, are not considered a tax-deductible cost of doing business  When shareholders receive dividends, the dollars involved have already been subject to tax in the company’s hands prior to payout  To alleviate double taxation, shareholders of Canadian companies receive tax relief through the dividend tax credit 







5

 

The gross-up and tax credit system results in individual Canadian investors paying less tax on eligible dividend income than on the same amount of interest income Since most preferred shares can be considered fixed income securities, they do not offer, from an investment standpoint, the same potential for capital gain that common shares provide



Why Do Companies Issue Preferred Shares?  Preferred Issue or Debt Issue?  From a company’s viewpoint, preferreds do not create the demands that a debt issue creates  Preferreds do not usually have a maturity date, which may come at a financially awkward time, although some may have a purchase fund  If a preferred dividend payment is omitted, no assets are seized by preferred shareholders  Because of the stringent legalities involved, a company will go to great lengths to avoid missing an interest or principal payment  Dividends are never omitted without good reason, such as, to preserve working capital in an emergency, a company’s directors may decide to omit a preferred dividend without jeopardizing the company’s solvency



Who Buys Preferred Shares?  Preferred shares are bought largely by income-oriented investors to take advantage of the dividend tax credit  Institutional investors are attracted to the preferential tax treatment as well  If the institutional investor is not concerned with taxes (i.e., pension funds) they would buy bonds

Features of Preferred Shares  Cumulative  Unpaid dividends accumulate or pile in what is known as “arrears”  All arrears of cumulative preferred dividends must be paid before common dividends are paid or before the preferred shares are redeemed  No interest is paid on arrears  Non-Cumulative  The shareholder is entitled to payment of a specified dividend in any year, only when declared  When a non-cumulative preferred dividend is passed, arrears do not accrue and the preferred shareholder is not entitled to “catch-up” payments if dividends resume

Features of Preferred Shares (continued)  Callable (or Redeemable Feature)

6

Issuers of preferred shares frequently reserve the right to call or redeem preferred issues  A call feature is a convenience to the issuer, rather than to the purchaser  As with callable corporate debt, called preferreds usually provide for payment of a small premium above the amount per share asset entitlement fixed by the charter, as compensation to the investor whose shares are being called in  This premium is usually on a sliding scale, falling to zero  Accepted practice is for the issuer to give 30 days’ notice of intention to redeem  It is usual to give the issuing company the ability to buy shares for cancellation on the open market or through invitations for tenders addressed to all holders  The price paid under these circumstances generally must not exceed the par value of the preferred shares plus the premium provided for redemption by call Non-Callable  Preferred shares cannot be called or redeemed as long as the issuing company is in existence  This feature is restrictive from the issuer’s standpoint, in that it freezes a part of the capital structure for the life of the company  This feature is rarely built into the terms of Canadian preferreds Voting Privileges  Virtually all preferred shares are non-voting so long as preferred dividends are paid on schedule  However, once a stated number of preferred dividends have been omitted, it is common practice to assign voting privileges to the preferred Purchase Fund  The company agrees to retire, through purchases in the open market, a specified amount of preferred shares each year if stock is available at or below a stipulated price  However, if the purchase fund is not able to buy enough shares in the open market, no redemption is implemented  Is advantageous to preferred shareholders because it means that if the price of the shares declines in the market to or below a stipulated price, the fund will make every effort to buy specified amounts of shares for redemption 







Features of Preferred Shares (continued)  Sinking Fund

7

    

Is widely used in the terms of new debt issues, its use is less prevalent with preferred issues Under a sinking a fund the company annually sets aside a stipulated percentage of net earnings, or a fixed sum, to gradually retire the entire preferred issue over a period of years The sinking fund purchases stock for redemption on the open market if shares are available at or below a stipulated price However, if purchase efforts are unsuccessful, the required number of shares are called by lot for purchase by the sinking fund Shareholders whose stock is called turn in a specified amount of stock & receive a fixed price per share, usually the par value or stated value per share plus accrued and unpaid dividends

Types of Preferreds  Fixed Rate (or Straight) Preferreds  These are preferred shares with normal preferences as to asset and dividend entitlement ahead of the common shares  Pay a fixed dividend rate, and therefore, the shares trade in the market on a yield basis  As with the market price of bonds and debentures, if interest rates rise, the market price of straight preferreds will fall, and if interest rates decline the market price will rise  Advantages and Disadvantages from the Purchaser’s standpoint  Greater safety than common shares through preference to dividend and asset entitlements  A tax advantage to individuals through the dividend tax credit and to public corporation which receive preferred dividends from taxable Canadian companies on a tax-exempt basis  Less safety than a debt investment since dividends are not a legal obligation  A fixed dividend which will not be increased  No voting privileges (unless a stated number of dividend payments are in arrears)  No maturity date, unlike a debt investment  Poorer marketability than common shares because there are usually fewer shares than common outstanding; and  Limited appreciation potential compared to common shares

Types of Preferreds (continued)  Convertible Preferreds

8

     

Are similar to convertible bonds and debentures because they enable the holder to convert the preferred into some other class of shares (usually common) at a predetermined price(s) and for a stated period of time Conversion terms are set when the preferred is created and normally specify the number of common shares into which each preferred is convertible The preferred price is set at a modest premium (perhaps 10%-15%) above its converted value The purpose of the premium is to discourage an early conversion, which would defeat the purpose of the convertible offering Virtually all conversion privileges expire after a stated period of time, usually 5-12 years from date of issue For example: Inco Ltd. 5.5% Convertible Preferred, Series E, convertible into 1.19474 common share per one preferred share a conversion price of US $41.85.  As the price of the common shares nears the preferred’s current conversion price, the market price of the convertible will rise accordingly  When this occurs, the preferred is described as selling off the common stock and the market action of the preferred will reflect the market action of the common  Assume the common shares of Inco were trading at US $55.00, therefore, the preferred shares can be converted into 1.19474 of these common shares 1. They would be worth US $65.71 ($55 X 1.19474) 2. The preferreds could be expected to sell for at least US $65.71  Usually, however, the convertible preferred will sell at a premium above the price it might be expected to sell at, based on the conversion terms  This premium can be expressed as a dollar amount or ...