Chapter 7

Common stock: characteristics, valuation, and issuance

Common Stock

Common stock (C/S) is the permanent long-term financing of the firm

Represents the true residual ownership of the firm

Balance Sheet Accounts Associated With C/S

Par value of C/SContributed capital in excess of par

Additional paid in capitalCapital surplus

Retained earnings ( R/E )Book value / share = equity

# of shares outstanding

Rights of Common Stockholders

Dividend rightsAsset rightsPreemptive rightsVoting rights

Voting for the Board of Directors

Majority voting requires more than 50% of the votes to elect a director

Cumulative voting Shareholders may concentrate votes on a

few candidates

Proxy - signing over your voting rights to someone else

Features of C/SC/S classes

Voting and nonvoting

Specific ownership

Stock dividends Transfer from R/E

account to the C/S and additional paid-in capital accounts

Stock repurchases Disposition of excess

cash Financial

restructuring Future corporate

needs Reduction of

takeover risk

Stock splitsReverse stock splits

C/S Advantages and Disadvantages

AdvantagesFlexibleReduced financial leverageLower cost of capital

DisadvantagesDiluted EPS Expensive

Investment Banking

Long-range financial planningTiming of security issuesPurchase of securitiesMarketing of securitiesArrangement of private loans and

leasesNegotiation of mergers

How Are Securities Sold?Public cash offering

Selling securities through investment bankers to the public

Private or direct placement Placing a security issue with one or more large

investorsRights offering

Selling C/S to existing stockholdersStandby underwriting

Investment banker purchases shares not sold to rights holder

Other Issuance Costs

Management timeUnderpricing new equity Stock price declinesIncentives“Green shoe” option

Registration RequirementsSec act of 1933 & sec exchange act of

1934Any interstate security issue over $1.5

million and having a maturity > 270 days is required to register issue with the SEC

Provide all buyers of the new security with a final copy of the prospectus

Shelf registration

Valuation of C/S

Capitalized value of the stock’s expected stream of cash flow during holding period

uncertain

DividendsDividends Not constantNot constant Expected to grow over timeExpected to grow over time

Capital gain or lossCapital gain or loss

Dividend Valuation Models

Zero growthG = 0

Constant growth dividend Ke > g

Dt = D0 ( 1 + g )t

Above-normal growth Multiple growth rates

Zero Growth

e0 k

DP

Constant Growth

g

e

10 k

DP

gP

Dk

0

1e

Above Normal Growth

1. Find the PV of the dividends during the above-normal growth period ( if two or more above -normal growth periods continue with the PV of the second)

2a. Find the value of the C/S at the end of the above-normal growth period

2b. Discount the answer in 2a to the present time

3. Sum steps 1 and 2b to find p0

Valuing Small FirmsNature of businessHistory of businessEconomic outlookDividend paying

capacity Industry

Earnings capacityBook valueFinancial conditionMajority or minority

interestVoting or nonvoting