Corporate Finance

Questions and Practice problems_Chapter 15

Chapter 15:
Concept questions (page 490 textbook): 2, 6, 12, 13
Questions and Problems (page 491 textbook): 1, 4
Answers:
Concept questions (page 490 textbook):
2: What are the differences between preferred stock and debt?
The differences between preferred stock and debt are:
1. 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. For corporate investors, 70%
of the amount they receive as dividends from preferred stock are exempt from income
taxes.
2. In case of liquidation (at bankruptcy), preferred stock is junior to debt and senior to
common stock.
3. 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).
6: A company is contemplating a long-term bond issue. It is debating whether to include a
call provision. What are the benefits to the company from including a call provision? What
are the costs? How do these answers change for a put provision?
There are two benefits. First, the company can take advantage of interest rate declines by calling
in an issue and replacing it with a lower coupon issue. Second, a company might wish to
eliminate a covenant for some reason. Calling the issue does this. The cost to the company is a
higher coupon. A put provision is desirable from an investor's standpoint, so it helps the
company by reducing the coupon rate on the bond. The cost to the company is that it may have to
buy back the bond at an unattractive price.
12: Several publicly traded companies have issued more than one class of stock. Why might
a company issue more than one class of stock?
When a company has a dual class stock, the difference in the share classes are the voting rights.
Dual share classes allow minority shareholders to retain control of the company even though
they do not own a majority of the total shares outstanding. Often, dual share companies were
started by a family, and then taken public, but the founders want to retain control of the
company.
13: Do you agree or disagree with the following statement: In an efficient market, callable
and noncallable bonds will be priced in such a way that there will be no advantage or
disadvantage to the call provision. Why?

The statement is true. In an efficient market, the callable bonds will be sold at a lower price than
that of the non-callable bonds, other things being equal. This is because the holder of callable
bonds effectively sold a call option to the bond issuer. Since the issuer holds the right to call the
bonds, the price of the bonds will reflect the disadvantage to the bondholders and the advantage
to the bond issuer (i.e., the bondholder has the obligation to surrender their bonds when the call
option is exercised by the bond issuer.)

Questions and Problems (page 491 textbook):

1: The shareholders of the Stackhouse Company need to elect seven new directors. There
are 850,000 shares outstanding currently trading at $43 per share. You would like to serve
on the board of directors; unfortunately no one else will be voting for you. How much will
it cost you to be certain that you can be elected if the company uses straight voting? How
much will it cost you if the company uses cumulative voting?

How much will it cost you to be certain that you can be elected if the company uses straight
voting?

% needed > 1/(1+1) =50%

#Shares needed > 50% *(850000 shares = 425000)

So 425001 shares are minimum

Total cost = 425001 × $43 = $18275043

How much will it cost you if the company uses cumulative voting?

% needed > 1 / (N + 1) = 1 / (7 + 1) = 12.5%

#Shares needed > = (850000 × 12.5%) = 106250

106251 shares are minimum

Total cost = 110,001 × $43 = $5,280,048

4: Candle box Inc. is going to elect six board members next month. Betty Brown owns 17.4
percent of the total shares outstanding. How confident can she be of having one of her
candidate friends elected under the cumulative voting rule? Will her friend be elected for
certain if the voting procedure is changed to the staggering rule, under which shareholders
vote on two board members at a time?

What percentage of stock is needed to have one of her friends elected under the cumulative
voting rule?

Percent of stock needed = 1 / (N + 1) = 1 / (6 + 1)= 14.29%

What percentage of stock is needed to have one of her friends elected under the staggered
cumulative voting rule under which shareholders vote on two board members at a time?

Percent of stock needed = 1 / (N + 1) = 1 / (2 + 1) = 33.33%