CHAPTER 4: CORPORATE STOCK

Learning Objectives:
1. Define corporate stock and stock financing
2. Enumerate and explain the advantages of common stock financing
3. Recall varieties of common stock
4. Differentiate Common Stock and Preferred Stock

Corporations issue stock to raise money for capital or operating expenses, such
as purchasing new equipment or buying advertising. When an investor
purchases a share of corporate stock, he owns a fractional portion of that
company.
Corporate stock is an equity security issued by a corporation. It is an instrument
that signifies an ownership position, or equity, in a corporation, and represents a
claim on its proportionate share in the corporation's assets and profits.

Different Types of Stocks

There are two main types of stocks: common stock and preferred stock.
1. Common Stock
Common stock represents ownership in a company and a claim (dividends) on a
portion of profits. Investors get one vote per share to elect the board members,
who oversee the major decisions made by management. Common stocks entail
the most risk. If a company goes bankrupt and liquidates, the common
shareholders will not receive money until the creditors, bondholders, and
preferred shareholders are paid.

Advantages of Common Stock Financing

 Common stock is the source of permanent capital.
 Common stock does not legally obligate the firm to pay dividend.
 Common stock financing increases the borrowing capacity of the company.
 Common stock is easily marketable than debt and preferred stock.
Varieties of Common Stock
 Classified common stock;
 Deferred stock;
 Voting trust certificate;
 Guaranteed stock; and
 Debenture stock
Classified Common Stock. This can either be Class A and Class B.
Companies subject to the 60 percent minimum local equity rule simplify their
approach by assigning 60 percent of its common stock as Class A stockholders
that can be owned only by nationals. The remaining 40 percent are classified as
Class B and may be owned by foreigners.
Preferred Stock. This is a minor type of issue generally issued to founders,
promoters, or managers as bonus for their efforts in getting the corporation
started.
Voting Trust Certificate. These certificates are given to trustees of a
corporation to ensure that the voting power remains in certain hands for a period
of time.
Guaranteed Stocks. The payment of dividends is guaranteed by another
corporation. This happens when a corporation purchases or leases the property
of another.
Debenture Stock. Debentures are transferable. It is an unsecured financial
instrument in raising capital through borrowing.

2. Preferred Stock
Preferred shares investors are usually guaranteed a fixed dividend forever. This
is different than common stock, which has variable dividends that are never
guaranteed. In the event of liquidation preferred shareholders are paid off before
the common shareholder. Preferred stock may also be callable, meaning that the
company has the option to purchase the shares from shareholders at anytime for
any reason.

Differences Between Common Stock and Preferred Stock

Two classes of corporate stock shares are fundamentally different:
common stock and preferred stock.
Here are two basic differences:
 Preferred stockholders are promised (but not guaranteed) a certain amount of
cash dividends each year, but the corporation makes no such promises to its
common stockholders. Each year, the board of directors must decide how much,
if any, cash dividends to distribute to its common stockholders.
 Common stockholders have the most risk. A business that ends up in deep
financial trouble is obligated to pay off its liabilities first, and then its preferred
stockholders. By the time the common stockholders get their turn, the business
may have no money left to pay them.
Neither of these points makes common stock seem too attractive. But
consider the following points:
 Preferred stock shares usually are promised a fixed (limited) dividend per year
and typically don’t have a claim to any profit beyond the stated amount of
dividends. (Some corporations issue participating preferred stock, which gives
the preferred stockholders a contingent right to more than just their basic amount
of dividends.)
 Preferred stockholders generally don’t have voting rights, unless they don’t
receive dividends for one period or more. In other words, preferred stock
shareholders usually do not participate in electing the corporation’s board of
directors or vote on other critical issues facing the corporation.

Common stock represents a bundle of rights and powers. They include:

 the right to receive dividend payments typically from earnings -- if authorized
by the board of directors
 the power to sell the stock (liquidity rights) and realize capital gains on public
trading markets or in private transactions—if there are willing buyers
 the right to receive consideration in a merger or other fundamental transaction
-- if approved by the board and the shareholders
 the right to vote to elect directors and to approve fundamental transactions
(mergers, sale of assets, amendments to articles, dissolutions)
 the right to receive a proportionate distribution of assets on corporate

Liquidation -- if the board and shareholders approve a dissolution Shareholders

are often said to have a residual claim to the income and assets of the business.
Financially, they stand last in line behind corporate creditors, such as
bondholders, short-term lenders, banks, trade creditors. When a company is
unable to pay its debts, and the company is forced into bankruptcy, shareholders
receive nothing.
There are other kinds of ownership interests. For example, preferred stock has a
prior and often fixed claim to dividends and distributions, but typically lacks the
power to elect directors or vote on fundamental corporate transactions. Often
seen as a hybrid between debt and common stock, preferred has characteristics
of both. Similar to debt, preferred stock offers a fixed dividend, but usually no
voting rights unless the company stops paying dividends. Similar to equity,
preferred has no maturity and the firm does not go bankrupt if it cannot pay
dividends.

Stock Financing
Stock financing is an activity undertaken by a firm when they desire to raise
funds for the long-term financing requirements of the firm. The objective of stock
financing is to increase equity capital. Stock finance is a mechanism which
releases working capital from stock such as finished goods or raw materials,
which works by lenders purchasing stock from a seller on behalf of the buyer.
One of the biggest advantages of common stock from the issuing company's
perspective is the absence of required payments. Debt financing requires a
business to make interest and principal payments on a specified schedule.
Common stock has no such requirements.

The advantages of using stock financing are:

 Common stock does not obligate the firm to make fixed payments to
stockholders,
 Common stock carries no fixed maturity date,
 Common stock increases the creditworthiness of the firm thus increasing the
future availability of debt at a lower cost,
 Common stock can often be sold more easily than debt if the firm’s prospects
look potentially good but risky, and
 Financing with common stock serves as a reserve of borrowing capacity.

The disadvantages of common stock financing to the corporation:

 Issuing common stock extends voting rights and perhaps even control, to new
stockholders,
 Common stock gives new stockholders the right to a percentage of profits
rather than to a fixed payment in the case of creditors,
 The cost of underwriting and distributing common stock is high,
 If common stock is sold to the point where the equity ratio exceeds that in the
optimal capital structure, a firm’s average cost of capital will increase and its
stock price will not be maximized, and
 Dividends paid to stockholders are not tax deductible as is interest paid to
creditors.