CH-17-21 Common and Preferred Stock Financing – Foundations of Financial Management : Chapter Notes

This Document Contains Chapters 17 to 21 Chapter 17 Common and Preferred Stock Financing Author's Overview The first part of the chapter gives the student a clear view of the changing nature of share ownership through increasing institutional participation and the declining importance of individual share ownership. The residual nature of common stock as compared to other securities is examined as well as cumulative voting, rights offerings and the various classes of common stock. Preferred stock should be introduced as a hybrid form of security. The unusual tax features of preferred stock are compared to debt by highlighting the non-tax deductibility of preferred dividends to the paying corporation and the tax-exempt nature of preferred dividends to corporate owners. Individuals receive preferential tax treatment. The cumulative nature of preferred stock is also important to the discussion, with lesser recognition given to the conversion, call, and participating features (some of these topics have been covered under the discussion of debt). Learning Objectives 1. Outline the rights of shareholders as owners of the corporation. 2. Briefly describe cumulative voting as a method to potentially give minority shareholders representation on the board of directors. Calculate the number of shares required to elect a director. 3. Characterize a rights offering as a method used to raise funds for the firm and calculate values of rights, shares, and shareholder wealth during the rights-offering process. 4. Describe poison pills and other provisions that make it difficult for outsiders to gain control of the corporation against management wishes. 5. Characterize preferred shares as a type of security somewhere between debt and common stock. 6. Calculate the different tax treatment and resulting aftertax income from preferred dividends as compared to bond interest. 7. Differentiate the features of various securities in a risk-return framework. Annotated Outline and Strategy I. Common Stock and Common Shareholders A. Directly or indirectly through mutual funds about 50 percent of Canadians own shares. B. Although management controls the corporation on a daily basis, ultimate control of the firm resides in the hands of the shareholders. C. Management has become increasingly sensitive to the growing institutional ownership of common stock. Mutual funds, pension funds, insurance companies and bank trust accounts are examples of financial institutions that in combination own a large percentage of many leading corporations. II. Common shareholders’ claim to income A. Common shareholders have a residual claim on the income stream; the amount remaining after creditors and preferred shareholders have been satisfied belongs to the owners (common shareholders) whether paid in dividends or retained. There is no legal claim to dividends. B. A corporation may have several classes of common stock that differ in regard to voting rights and claim on the earnings stream (e.g. Telus, Bombardier). Finance in Action: A Claim to Income and a Right to Vote? Ballard is examined from the point of view of a claim to income without positive earnings. Shaw is examined in light of special voting rights. www.ballard.com www.shaw.ca III. The Voting Right A. Owners of common stock have the right to vote on all major issues including election of the board of directors. B. Majority voting: holders of the majority of shares can elect all directors. Perspective 17-1: The voting right is a very important issue and the Canadian Tire Corporation provides an interesting example for students. The FIA also is of note. C. In some firms, different classes of stock are entitled to elect a specified percentage of the board of directors. D. Cumulative voting: possibility for minority shareholders (own less than 50 percent of stock) to elect some of the directors. 1. The shareholder can cast one vote for each share of stock owned times the number of directors to be elected. 2. The following formula may be employed to determine the number of shares needed to elect a given number of directors under cumulative voting. (17-1; page 558) 3. By staggering directors’ terms, with only a few elected each year, minority interests can be denied board representation. E. The type of voting process has become more important to both shareholders and management because of challenges to management’s control of the firm. F. The majority of Canadians do not own shares directly. However through large and growing mutual and pension funds, Canadians indirectly have a large stake in corporate Canada and its performance. IV. The Right to Purchase New Shares A. The shareholder may have the right to maintain his percentage of ownership, voting power, and claim to earnings through the preemptive right provision which requires that existing shareholders be given the first option to purchase new shares. B. Financing through rights offerings. 1. Even if the preemptive right provision is not required, the corporation may finance through a rights offering. 2. Each shareholder receives one right for each share of stock owned, and is allowed to buy new shares of stock at a reduced price (below market value) plus the required number of rights/share. 3. The number of rights required to purchase a new share equals the ratio of shares outstanding to the new shares issued. Number of rights required = Number of shares outstanding to purchase one new share Number of shares to be issued 4. Rights have market value since they entitle the holder to purchase shares of stock at less than market price. PPT 10 of 24 Time line during rights offering (Figure 17-1) a. Initially, after the rights offering announcement, stock trades "rights on." The formula for the value of a right during the rights on period is: (17-3; page 561) P0 = Market value of stock, rights on S = Subscription price N = Number of rights required to purchase a new share of stock b. After a certain period, the right no longer trades with the stock but may be bought and sold separately. On the ‘ex rights’ date the stock price falls by the theoretical value of a right. The ex rights value of a right is: (17-4; page 562) Pe = Market value of stock, ex rights 5. Existing shareholders usually do not have a monetary gain from a rights offering. The gain from purchasing shares at less than market price is eliminated by dilution of previously owned shares. 6. A shareholder has three options when presented with a rights offering. a. Exercise the rights; no net gain or loss b. Sell the rights; no net gain or loss c. Allow the rights to lapse; a loss will be incurred due to the dilution of existing shares that is not offset by value of unsold or unexercised rights. Finance in Action: Funds for a Small Business A comparison of a share and rights issue at a smaller Canadian company is examined. C. Desirable features of rights offerings 1. Protects shareholders' voting position and claim on earnings 2. Existing shareholders provide a built in market for new issues; distribution costs are lower 3. May create more interest in stock than a straight offering 4. Lower margin requirements D. American Depository Receipts (ADRs) 1. ADRs are shares of foreign stock held in trust by U.S. Banks that issue a claim on these trust receipts. 2. ADRs allow foreign companies to raise funds in U.S. markets, the world’s largest capital market, and provide investors with annual reports using U.S. GAAP accounting. Finance in Action: ADRs or Shares? Over 510 foreign companies are listed on the NYSE with the vast majority traded as ADRs. www.nyse.com E. Poison Pills 1. A ‘poison pill’ is a rights offering made to existing shareholders of a company with the sole purpose of thwarting an acquisition attempt by another company. The increased number of shares may dilute the ownership percentage of the firm pursuing the takeover. 2. Some investors feel that a poison pill strategy is contrary to the goal of maximizing the wealth of the owners. Finance in Action: An Expensive Pill to Swallow Clarica and Sun Life merged in 2002 but established excessive ‘break fees’ that made suggested were a poison pill in effect. www.sunlife.com V. Preferred Stock A. Characteristics of preferred stock 1. Stipulated dividends must be paid before dividends on common stock but are not guaranteed or required. 2. Dividends are not tax deductible. B. Preferred stock contributes to capital structure balance by expanding the capital base without diluting common stock or incurring contractual obligations. Under the Bank Act preferred stock qualifies for capital adequacy tests for Canadian banks. C. Primary purchasers of preferred stock are corporate investors, insurance companies and pension funds. Dividend income received by corporations in most cases is exempt from taxation. To the individual investor the dividend tax credit reduces the amount of tax payable on dividend income. Bond interest is usually fully taxable. Preferreds are of greater significance in Canadian markets than U.S. markets. PPT 18 of 24 Before-tax and aftertax yields on corporate debentures and preferred shares (Page 566) D. Provisions associated with preferred stock 1. Cumulative dividends 2. Conversion feature (including convertible exchangeable preferreds) 3. Call feature 4. Retractable feature (bondholder option) 5. Participation provision 6. Floating rate 7. Par value 8. Dutch auction preferred stock VI. Income Trusts A new operating company, with the claims from debt and equity, held by a Trust was formed for advantageous tax treatment (since reduced by Government). With risk similar to equity claims, the Trust enjoys an income stream from mature assets. Finance in Action: The Fall of Income Trusts? These innovative securities with their unique features were cut short by government action. VII. Comparing Features of Common and Preferred Stock and Debt PPT 20 & 21 of 24 Features of alternative security issues (Table 17-1) PPT 22 of 24 Risk and expected return for various security classes (Figure 17-2) Summary Listing of Suggested PowerPoint Slides PPT 10 Time line during rights offering (Figure 17-1) PPT 18 Beforetax and aftertax yields: debentures and preferred shares (page 566) PPT 20 & 21 Features of alternative security issues (Table 17-1) PPT 22 Risk and expected return for various security classes (Figure 17-2) PowerPoint Presentation The Chapter 17 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 24 frames. Chapter 18 Dividend Policy and Retained Earnings Author's Overview How does a corporation determine the amount of dividends to be paid? Consideration is given to the marginal principle of retained earnings with the associated emphasis on dividends as a passive variable in the decision-making process. Few students would accept the theory that a corporation sets its dividend payment entirely on the basis of whether the corporation or shareholder can make a higher return on the funds. Therefore the passive approach to dividends is seen as a good but incomplete theory that must be supplemented with further considerations. Other relevant functions of dividends such as resolution of uncertainty, information content (Gordon, Solomon, etc.), and investor preferences are discussed. Legal requirements, cash position of the firm, access to capital markets, and the like are also presented. The corporate life-cycle curve is included to relate growth to dividend policy. Additional material is also provided on dividend payment procedures and dividend reinvestment plans. Stock repurchase as an alternative to the cash dividend has received increasing attention in the literature and in the popular press and makes a good ending discussion point. Learning Objectives 1. Justify management’s decision criteria as to whether internally generated funds should be reinvested or paid out as dividends. 2. Describe a dividend payment as a passive decision or active decision based on investor preference and the informational content of dividends. Also, calculate dividend payout ratios and dividend yields. 3. Outline the many factors to be considered in dividend policy. Also, calculate aftertax income from dividends and calculate share prices based on earnings multiples. 4. Outline the life cycle and growth of dividends. 5. Outline dividend payment procedures. 6. Distinguish the impact of stock splits and stock dividends on the position of the shareholders. Also, calculate the changes in the balance sheet that result. 7. Discuss the reasons for a share repurchase. 8. Explain a dividend reinvestment plan. Annotated Outline and Strategy I. Dividend Theories A. The marginal principle of retained earnings suggests earnings should be retained as long as the rate earned is expected to exceed a shareholder's rate of return on the distributed dividend. Therefore dividends become a passive or residual decision. Finance in Action: Dividends or Reinvestment In 1989, Inco Ltd. paid a special dividend of over $1 billion because it had no other capital investments it considered appropriate. The TSX seemed to do the same with its $5 a share dividend in 2003. www.tmx.com B. The residual dividend theory assumes a lack of preference for dividends by investors. There is much disagreement as to investors' preference for dividends or retention of earnings. C. Irrelevance of dividends argument 1. The homemade dividend argument suggests dividend policy is irrelevant to firm valuation (page 583 - 584). PPT 8 of 24 Homemade dividends (Figure 18-1) D. Relevance of dividends arguments 1. Resolves uncertainty 2. Information content 3. Payout ratios suggest firms view dividends as relevant (Table 18-1; page 615) Finance in Action: Pay Those Dividends The experiences are highlighted for several firms: TransCanada Pipelines, Telus, Microsoft, and BP that have cut their dividends or started paying them. www.transcanada.com TRP www.telus.com T www.bp.com BP PPT 11 of 24 Earnings and dividends of selected Canadian companies (Table 18-1) E. Dividend yields for Canadian traded companies (Table 18-2; page 587). Dividends/ market share price II. Dividend Stability A. Growth firms with high rates of return usually pay relatively low dividends. B. Mature firms follow a relatively high payout policy. C. The stable dividend policy followed by Canadian corporations indicates that corporate management feels that shareholders have a preference for dividends. PPT 12 of 24 Corporate earnings and dividends (all industries) (Figure 18-2) Perspective 18-1: Figure 18-2 highlights the residual nature of retained earnings for the economy as a whole as companies preserve dividend payouts. This macro data may not support the theory as applied to individual firms. III. Other Factors Influencing Dividend Policy A. Legal rules: laws have been enacted protecting corporate creditors by forbidding distribution of the firm's capital in the form of dividends. Dividends are also prohibited if the firm will become insolvent as a result. B. Cash position: the firm must have cash available regardless of the level of past or current earnings in order to pay dividends. C. Access to capital markets: the easier the access to capital markets, the more able the firm is to pay dividends rather than retain earnings. Some large firms have borrowed to maintain dividend payments. D. Desire for control 1. Small, closely held firms may limit dividends to avoid restrictive borrowing provisions or the need to sell new stock. 2. Established firms may feel pressure to pay dividends to avoid shareholders' demand for change of management. E. Tax position of shareholders (clientele effect) 1. High tax bracket shareholders may prefer retention of earnings. 2. Lower tax bracket individuals, institutional investors, and corporations receiving dividends prefer higher dividend payouts. 3. Shareholder preferences for dividends or capital gains foster investor behavior called the clientele effect. High tax bracket investors often invest in growth-oriented firms that pay no or low dividends. Low tax bracket investors often purchase stocks with high dividend payouts. 4. The dividend tax credit lowers the effective tax rate on dividend income. PPT 14 of 24 Dividend tax credit (page 590) IV. Life Cycle Growth and Dividends PPT 16 of 24 Life cycle growth and dividend policy (Figure 18-3) A. The corporate growth rate in sales is a major influence on dividends. B. A firm's dividend policy will usually reflect the firm's stage of development. 1. Stage I: small firm, initial stage of development – no dividends. 2. Stage II: successful firm, growing demand for products and increasing sales, earn¬ings and assets – stock dividends followed later by cash dividends. 3. Stage III: cash dividends rise as asset expansion slows and external funds are more readily available – stock dividends and stock splits also common. 4. Stage IV: the firm reaches maturity and maintains a stable sales growth rate and cash dividends tend to be 40 – 60 percent of earnings. Perspective 18-2: The life cycle curve is a very important concept and the impact of growth on cash flow can be tied back into cash forecasting in Chapter 4, and external and internal funds in Chapter 14. The particular life cycle curve we use is different than the one used in marketing classes in that it divides the growth phase into two parts: growth (accelerating growth) and expansion (decelerating growth). This is an important distinction for corporate dividend policy. The FIA on Microsoft ties in the lifecycle. V. Dividend Payment Procedures A. Dividends are usually paid quarterly. B. Three key dividend dates: 1. Dividend record date: the date the corporation examines its books to determine who is entitled to a cash dividend. 2. Ex dividend date: two business days prior to the holder of record date. If an investor buys a share of stock after the second day prior to the holder of record date, the investor's name would not appear on the firm's books. 3. Payment date: approximate date of mailing of dividend checks. 4. Time line (page 592, Figure 18-4). VI. Stock Dividends and Stock Splits A. Stock dividends: an additional distribution of shares, typically about 10 percent of outstanding amount. 1. An accounting transfer is required at fair market from retained earnings. The remainder of the stock dividend is transferred to the common stock account. PPT 19 of 24 XYZ Corporation's financial position before stock dividend (Table 18-4) XYZ Corporation's financial position after stock dividend (Table 18-5) 2. Unless total cash dividends increase, the shareholder does not benefit from a stock dividend. 3. Use of stock dividends a. Informational content: retention of earnings for reinvestment b. Camouflage inability to pay cash dividends 4. Tax legislation requires that stock dividends be taxable as if they were regular cash dividends. B. Stock split: a distribution of stock that increases the total shares outstanding by 20 25 percent or more. PPT 21 of 24 XYZ Corporation before and after stock split (Table 18-6) 1. Accounting transfer from retained earnings is not required. The number of shares increases proportionately. 2. Benefits to shareholders, if any, are difficult to identify. 3. Primary purpose is to lower stock price into a more popular trading range. Finance in Action: Microsoft and Stock Splits An investment of $158 in 1987 would have been worth $810,432 in 2004. www.microsoft.com VII. Repurchase of Stock A. Alternative to payment of dividends 1. Most often used when firm has excess cash and inadequate investment opportunities. 2. With the exception of a lower capital gains tax (in certain circumstances) the shareholder would be as well off with a cash dividend. B. Other reasons for repurchase 1. Management may deem that stock is selling at a very low price and is the best investment available. 2. Use for stock options or as part of a tender offer in a merger or acquisition. 3. To reduce the possibility of being "taken over." 4. Strategic goals including tighter control. 5. Evidence of superior returns. Finance in Action: Timing the Buyback TD Bank sold TD Waterhouse to the public and bought it back two years later at less than 40 percent of the sale price. www.tdbank.ca TD VIII. Dividend Reinvestment Plans (DRIPs) A. Begun during the 1970s, plans provide investors with an opportunity to buy additional shares of stock with the cash dividend paid by the company. B. Types of plans 1. The company sells authorized but unissued shares. The stock is often sold at a discount since no investment or underwriting fees have to be paid. This plan provides a cash flow to the company. 2. The company's transfer agent buys shares of stock in the market for the shareholder. This plan does not provide a cash flow to the firm but is a service to the shareholder. C. Plans usually allow shareholders to supplement dividends with cash payments up to $1,000 per month in order to increase purchase of stock. Summary Listing of Suggested PowerPoint Slides PPT 8 Homemade dividends (Figure 18-1) PPT 11 Earnings and dividends of selected Canadian corporations (Table 18-1) PPT 13 Corporate earnings and dividends (all industries) (Figure 18-2) PPT 16 Dividend tax credit (page 590) PPT 17 Life cycle growth and dividend policy (Figure 18-3) PPT 19 XYZ Corporation's financial position before stock dividend (Table 18-4) XYZ Corporation's financial position after stock dividend (Table 18-5) PPT 21 XYZ Corporation before and after stock split (Table 18-6) PowerPoint Presentation The Chapter 18 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 24 frames. Chapter 19 Derivatives, Convertibles and Warrants Author's Overview Because the material in the chapter can be viewed from a corporate finance and investments perspective, the student's interest in the chapter is usually quite high. A light overview of forwards, futures and options is given before moving to corporate issued securities. The student is given an in- depth exposure to convertibles, with primary attention devoted to valuation procedures. There is also material on the usefulness, advantages, and disadvantages of convertibles to the corporation. Many real world examples are included in the text and can be woven into the lecture. Accounting considerations are covered using step-by-step procedures for computing fully diluted earnings per share. The discussion of warrants parallels many of the points considered under convertibles. The topic of leverage, as it applies to warrants, also is appropriately introduced at this point and provides valuable background material for the student who progresses to subsequent courses in investments. Learning Objectives 1. Distinguish between and outline the uses of forwards, futures, and options. 2. Calculate the hedge on futures and the values of call and put options. 3. Characterize the securities offered by a corporation that are convertible into common shares at the option of the investor and are a means of raising funds. 4. Examine the benefits of a convertible security including a fixed rate of return and the potential for capital appreciation. 5. Calculate the conversion value of a convertible security. 6. Describe warrants and compare them to convertible securities. 7. Calculate the intrinsic value and the speculative premium on a warrant. 8. Show how convertible securities and warrants impact on earnings per share as reported on the income statement. Annotated Outline and Strategy I. Introduction A. Derivatives are contracts that give the holder the right to buy or sell a particular commodity or asset, at an established price, at some time in the future. B. Derivatives allow the holder to reduce or hedge their risk from the volatile price changes of commodities, foreign exchange, and interest rates. The derivatives markets are huge. See also chapters 8 and 21. Finance in Action: The Derivatives Market A brief survey of the size of the established and over-the-counter derivatives markets, as well as some of the more spectacular losses. www.bis.org C. Derivatives take the form of forwards, futures, or options. Derivatives are side bets on the performance of corporations, commodities and other assets. Options are available on corporation shares, but are sold through exchanges independently of the firm. D. Convertibles, warrants, and rights (from chapter 17) are options issued by corporations to raise money. Finance in Action: Derivatives for Bob’s Farming Operation Forwards, futures, and options are illustrated in a straightforward and uncomplicated manner through the operations of a rancher/ farmer in Southern Alberta. II. Forwards A. Forwards are customized contracts that fix the price of some commodity for delivery at a specified place and a specified time in the future. B. The use of a forward is demonstrated with a simple example. PPT 9 of 38 Forward (page 614) Finance in Action: A Brief History of Derivatives An interesting look at how the derivatives market has developed over two milleniums. www.cboe.com www.tmx.com www.m-x/accueil_en.php www.cmegroup.com www.theice.com www.globalderivatives.nyx.com III. Futures A. Futures are standardized contracts that fix the price of some commodity for delivery at a specified place and a specified time in the future. B. Futures are available on commodities, interest rates, market indexes, and currencies and are often sold through exchanges. C. The use of a future is demonstrated with a simple example. PPT 10 of 38 Future (page 617) IV. Options A. A beginning knowledge of options requires understanding a few key terms. PPT 11 of 38 Option terms (page 618) PPT 12 of 38 Option participants (Figure 19-1) (page 618) B. Options are standardized contracts that fix the price of some commodity for delivery at a specified place and a specified time in the future. Unlike forwards and futures, options can expire. The holder does not have to exercise it. C. The use of a call option is demonstrated with a simple example. The market price relationships are illustrated in Figure 19-2. PPT 13 & 14 of 38 Call option (pages 619) PPT 15 of 38 Market price relationships for a call option (Figure 19-2) D. The use of a put option is demonstrated with a simple example. The market price relationships are illustrated in Figure 19-3. PPT 16 & 17 of 38 Put option (page 621) PPT 18 of 38 Market price relationships for a put option (Figure 19-3) E. Options versus futures for hedging is discussed, and the options issued the corporation are introduced. Finance in Action: Weather Derivatives An interesting look at a new derivative used to reduce the risk that firms face in dealing with mother nature. V. Convertible Securities A. A convertible is a fixed income security, bond, or preferred stock that can be converted at the option of the holder into common stock. (The chapter focuses on convertible bonds.) Convertible securities are only a small percentage of Canadian capital market activity. B. Convertible terminology 1. Conversion ratio: number of shares of common stock into which the security may be converted. 2. Conversion price: face value of bond divided by the conversion ratio. 3. Conversion value: conversion ratio times the market price per share of common stock. 4. Conversion premium: market value of convertible bond minus the conversion value. 5. Pure bond value: the value of the convertible bond as a straight bond; the present value of the annual interest payment and maturity payment discounted at the market rate of interest. 6. Face value = Conversion value  Conversion ratio (19-1; page 623) C. Value of a convertible bond 1. At issue, investors pay a conversion premium and the price of the convertible exceeds both the pure bond value and the conversion value. 2. If the market price of the common stock exceeds the conversion price, the market value of the bond will rise above its par value to the conversion value or higher. 3. The convertible bond's value is limited on the downside by its pure bond value, which is considered the ‘floor value.’ PPT 24 of 38 Price movement pattern for a convertible bond (Figure 19-4) Perspective 19-1: While Figure 19-3 is understandable to anyone with previous exposure to convertible bonds, students often get confused about where the data come from for plotting the lines. A common mistake is an inability to remember the label on the horizontal axis. PPT 25 of 38 Pricing pattern for convertible debentures outstanding, Sept 2011 (FIA page 625) D. Is this Fool’s Gold? Disadvantages to the Investor 1. All downside risk is not eliminated. When the conversion value is very high, the investor is subject to much downward price movement. 2. The pure bond value will fall if interest rates rise. 3. Interest rates on convertibles are less than on non-convertible straight bonds of the same risk. 4. Convertibles are usually subject to the call provision. E. Advantages to the Corporation 1. Lower interest rate than a straight bond. 2. May be only means of gaining access to the capital market. 3. Enables the sale of stock at higher than market price. Perspective 19-2: After covering all the advantages and disadvantages of convertibles from both the investor's viewpoint and corporate viewpoint, the student should examine the tradeoffs that are made by both parties. Probe students' understanding of why a security like this exists and how it affects the capital structure. F. Forcing conversion 1. Conversion may be forced if the company calls the convertible when the conversion value exceeds the call price. 2. Conversion is encouraged by a ‘step up’ provision in the conversion price. 3. The convertible bond’s value is limited on the downside by its pure bond value. Finance in Action: To Convert or Not to Convert? Magna called its convertible debentures shortly before a market downturn. www.magna.com G. Convertible preferred shares: FIA on page 629 identifies two outstanding convertible preferred issues with attractive dividend yields. VI. Accounting Considerations with Convertibles (and Warrants) A. Dilution effects of convertible securities on earnings per share are reflected in financial reports through diluted earnings per share. B. Currently earnings per share must be reported as if common shares related to conversion had occurred at the beginning of the accounting period. (19-2; page 626) 1. Numerator adjustment includes dividends payable on convertible preferred shares, aftertax interest on convertible debt. 2. Denominator adjustment includes all common shares outstanding and equivalent shares of all convertible preferreds and bonds and common shares issued if rights, warrants and options exercised and then the proceeds used to repurchase share at the market price. VII. Warrants A. A warrant is an option to buy a stated number of shares of stock at a specified price over a given period. 1. Sweetens a debt issue 2. Usually detachable 3. Speculative; value dependent on market movement of stock PPT 29 of 38 Relationships determining warrant prices, October 2011 (Table 19-2) B. Valuation of warrant 1. Applying this formula, the minimum value of a warrant may be found: I = (M - E)  N (19-3; page 629) Where: I = Intrinsic value of a warrant (minimum value M = Market value of a common stock E = Exercise price of a warrant N = Number of shares each share entitles the holder to purchase 2. Intrinsic value can not be negative. 3. The actual price of the warrant may substantially exceed the formula value due to the speculative nature of warrants. The amount above the intrinsic value is a speculative premium. S = (W – I) (19-4; page 629) Where: S = Speculative premium W = Warrant price PPT 31 of 38 Market price relationships for a warrant (Figure 19-5) C. Use of warrants for corporate financing: 1. Enhances a debt issue 2. Add on in a merger or acquisition 3. Cannot be forced with a call, but option price is sometimes ‘stepped up’ 4. Equity base expands when warrants are exercised but the underlying debt remains D. Potential dilution of earnings per share upon exercise of warrants must be disclosed in financial reports. VIII. Use of Warrants in Corporate Finance A. Warrants are effective in growth companies where free cash flow is limited. Warrants keep the cost of debt down and allow for future cash infusion if and when the warrants are exercised. Summary Listing of Suggested PowerPoint Slides PPT 9 Forward (page 614) PPT 10 Future (page 617) PPT 11 Option terms (page 618) PPT 12 Option participants (Figure 19-1) (page 618) PPT 13 & 14 Call option (pages 619) PPT 15 Market price relationships for a call option (Figure 19-2) PPT 16 & 17 Put option (page 621) PPT 18 Market price relationships for a put option (Figure 19-3) PPT 24 Price movement pattern for a convertible bond (Figure 19-4) PPT 25 Pricing pattern for convertible debentures outstanding, Sept 2011 (FIA page 625) PPT 29 Relationships determining warrant prices, October 2011 (Table 19-2) PPT 31 Market price relationships for a warrant (Figure 19-5) PPT 35 Distinguishing rights, warrants, and convertible securities (Table 19-4) PowerPoint Presentation The Chapter 19 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 38 frames. Chapter 20 External Growth Through Mergers Author's Overview The discussion of mergers and acquisitions brings together a number of topics discussed earlier in the text. Again we look at earnings per share growth, price-earnings ratios, shareholder wealth maximization, and portfolio considerations. Most students enjoy hearing about unfriendly takeovers, proxy battles, White Knights, poison pills and various defensive strategies. A central consideration in the chapter is the effect of differential P/E ratios on postmerger earnings per share. Once this concept is understood, the student should be encouraged to consider why P/E ratios may differ for the acquiring firm and the merger candidate. At least one major variable affecting P/E ratios is the possibility of different future growth rates. The short-term impact on earnings per share can be very different from the long-term effect. Of greater importance, the student is forced to consider what the impact of these short and long-term effects will be on the postmerger valuation. Another important consideration is the portfolio effect associated with the merger. The price movement pattern associated with mergers is also worthy of consideration. Not only is the material of interest to students who relate well to investment oriented subjects, but it is also an important consideration to corporate financial management. The premium offered and the associated price movement may determine management's strategy in regard to accepting or fighting a proposal. This is particularly relevant when unfriendly offers for undervalued assets are commonplace. Learning Objectives 1. Explain some defensive measures taken to avoid an unfriendly takeover. 2. Analyze the motives for mergers and divestitures, including financial considerations and the desire to increase operating efficiency. Also, perform an NPV analysis of a merger proposal. 3. Explain acquisition through cash purchases or by one company exchanging its shares for another company's shares. 4. Evaluate the impact of the merger on earnings per share and share value. 5. Characterize the diversification benefits of a merger. 6. Outline the reasons for using a holding company. Annotated Outline and Strategy I. The International and Canadian Merger Environment A. Heavy merger activity returned at the end of the 1990s fueled by low interest rates, changing regulations, competition and evolving technology. B. The 1960s and 1970s saw mergers attempting to achieve the benefits of diversification. The 1980s saw divestiture activity, particularly in Canada as a result of the National Energy Program. The 1990s saw strategic positioning and convergence of technology firms. After 2008 mergers were driven by cash hordes. PPT 6 of 23 Largest mergers and acquisitions (Table 20-1) C. Divestitures are a component of this topic. In the 1990s we saw Governments selling off crown corporations. Finance in Action: Canada! Part of the Action Canada has always seen its’ share of merger and acquisition activity, often from outside interests. Sometimes the acquisitions have been stopped by the Federal Government or for technical reasons. PPT 7 of 23 Largest mergers and acquisitions in Canada (Table 20-2) II. Negotiated versus Tender Offers A. Friendly versus unfriendly mergers 1. Most mergers are friendly and the officers and directors of the involved companies negotiate the terms. 2. During the 1970s and 1980s, takeover tender offers occurred frequently and often were opposed by the management of candidate firms. The Air Canada attempted takeover by Onex in late 1999 would be a good example. B. Unfriendly takeover attempts have resulted in additions to the investment community’s vocabulary. 1. Saturday Night Special: a surprise offer made right before the market closes for the weekend. 2. Leveraged takeover: the acquiring firm negotiates a loan based on the target company's assets (particularly a target company with large cash balances). C. Actions by target companies to avoid unwanted takeovers. Known sometimes as applying shark repellent. 1. White Knight arrangements. 2. Selling crown jewels. 3. Targeted repurchase of shares. 4. Voting in golden parachutes. 5. Taking on more debt. Avoiding large cash balances. 6. Adopting poison pills or other shareholders’ rights plans. 7. Moving corporate offices to jurisdictions with protective provisions against takeovers. 8. Buying the other firm first (a Pacman defense). D. Many mergers cause a domino effect resulting in further mergers. E. The Canadian Government regulates large takeovers that lessen competition and fair pricing. Finance in Action: Let’s Make a Deal Open Text made a hostile takeover offer for Accelio, while Sun Life made a friendly offer for Clarica in 2002. III. Motives for Business Combinations Finance in Action: No to Foreign Acquisition! In 2008 the Canadian Government stepped in to prevent the takeover of MacDonald, Dettwiler and Associates Ltd. The Government also stopped the takeover of Potash by BHP Billiton. A. Business combinations may be either mergers or consolidations. 1. Merger: A combination of two or more companies in which the resulting firm maintains the identity of the acquiring company. 2. Consolidation: Two or more companies combined into an entirely new entity. B. Financial motives 1. Risk reduction as a result of the portfolio effect a. Lower required rate of return by investors. b. Higher value of the firm. 2. Improved financing posture: a. Greater access to financial markets to raise debt and equity capital b. Attract more prestigious investment dealers to handle financing c. Strengthen cash position and/or improve debt/equity ratio 3. Obtain a tax loss carry-forward 4. Synergism: 2 + 2 = 5. C. Non-financial motives 1. Expand management and marketing capabilities. 2. Acquire new products. 3. Ego of management D. Motives of selling shareholders 1. Desire to receive acquiring firm's stock, which may have greater acceptability in the market. 2. Provides opportunity to diversify their holdings. 3. Gain on sale of stock at an attractive price. 4. Avoid the bias against smaller businesses. IV. Terms of Exchange Perspective 20-1: Mergers recall valuation models (chapter 10), cost of capital (chapter 11) and capital budgeting (chapter 12). Concepts of growth and value are relevant as are future benefits derived from the acquired company. See page 652. A. Cash purchases 1. Capital budgeting decision: NPV of a purchase equals the present value of cash inflows including anticipated synergistic benefits minus cash outlays. The tax shield benefit from any tax loss carry-forward is included. B. Stock for stock exchange 1. Emphasizes the impact of the merger on earnings per share. 2. If the P/E ratio of the acquiring firm is greater than the P/E ratio of the acquired firm, there will be an immediate increase in earnings per share. 3. Shareholders of the acquired firm are usually more concerned with market value exchanged than earnings, dividends, or book value exchanged. PPT 16 & 17 of 23 Financial data on potential merging firms (Table 20-3) and Postmerger earnings per share (Table 20-4) C. In addition to the immediate impact on earnings per share, the acquiring firm must be concerned with the long run impact of the merger on market value. 1. An acquired firm may have a low P/E ratio because its future rate of growth is expected to be low. In the long run, the acquisition may reduce the acquiring firm's earnings per share and its market value. 2. The acquisition of a firm with a higher P/E ratio causes an immediate reduction in earnings per share. In the long run, however, the higher growth rate of the acquired firm may cause earnings per share and the market value of the acquiring company to be greater than if the merger did not take place. D. Determinants of earnings per share impact of a merger: 1. Exchange ratio 2. Relative growth rates 3. Relative sizes of the firms V. Market Value Maximization Ultimately it is the market value of the share price that is the goal of a merger and this should be the test of the success of a merger or acquisition. A. The portfolio effect can affect market value 1. If a merger decreases the risk assessment of the acquiring firm, its market value will rise even if the earnings per share remain constant. Perspective 20-2: The portfolio effect pertaining to mergers reinforces concepts in Chapter 13. Issue of earnings correlation and synergy can be discussed and, if possible, present a current merger situation with potential benefits. PPT 19 of 23 Risk reduction portfolio benefits (Figure 20-1) 2. A merger may accomplish two types of risk reduction: a. Business risk reduction may result from acquiring a firm that is influenced by an opposite set of factors in the business cycle. b. Financial risk reduction may result from a lower use of debt in the post merger financial structure of the acquiring firm. VI. Accounting Considerations in Mergers and Acquisitions A. A merger is treated as a purchase of assets on the books of the acquiring firm. B. Purchase of assets 1. Necessary when the tender offer is in cash, bonds, preferred stock, or common stock with restricted rights. 2. Any excess of over fair value is recorded as goodwill and written off for accounting purposes only as impaired. 3. Of goodwill, 75% can be considered eligible capital expenditures and amortized a with a CCA rate of 7 percent. C. Exchange of shares or cash 1. The exchange of stock is usually a tax free exchange. 2. In the 1970s and 1980s, many proposed and actual mergers were purchases. Shareholders of the acquired firm were often disenchanted with the stock market in general and preferred cash to an exchange of stock. The 1990s saw a return to share exchanges, probably because investors were willing to accept shares that were valued higher in the equity markets of the 90s. 3. Although purchases tend to raise earnings per share, the cash required has a substantial capital cost associated with it. Perspective 20-3: The instructor can bring up the conflict between efficient market theory and premiums paid for acquired companies. Stocks trading in the market are priced by buyers and sellers close to the previous equilibrium price while stocks priced in a merger offer are priced significantly away from the prevailing equilibrium price as the company making the merger offer seeks a controlling interest. VII. Premium Offers and Stock Price Movements A. The average premium paid over market value in mergers or acquisitions has been in the 5 50 percent range. B. High merger premiums are related to the belief that replacement value exceeds market value. C. Acquired companies apparently have superior risk adjusted returns, but it is uncertain whether or not the acquiring firms achieve superior results. D. Merger arbitrageurs (ARBS) have influenced the merger market, by buying potential takeover companies in hopes of selling when a higher takeover price is announced. E. The market for corporate control may act to align management with the shareholder goal of wealth maximization. VIII. Holding Companies A. A holding company has control over one or more other companies. B. Advantages of holding companies: 1. Offers unusual opportunities for leverage 2. The isolation of legal risks 3. Dividends paid between companies are usually tax free C. Disadvantages of holding companies. 1. A poor year by one or more companies may result in a very poor year for the holding company as well. 2. Coordinating the management of multiple companies is often expensive and difficult. Finance in Action: Refocusing Strategies One of Canada’s great holding companies, Brascan, sought a sharper corporate strategy in the early 2000s. www.brookfield.com BAM.A Summary Listing of Suggested PowerPoint Slides PPT 6 Largest mergers and acquisitions (Table 20-1) PPT 7 Largest mergers and acquisitions in Canada (Table 20-2) PPT 16 & 17 Financial data on potential merging firms (Table 20-3) and Postmerger earnings per share (Table 20-4) PPT 19 Risk reduction portfolio benefits (Figure 20-1) PowerPoint Presentation The Chapter 20 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 23 frames. Chapter 21 International Financial Management Author's Overview The instructor should stress the importance of international financial management (and international trade) to the class. Data demonstrating Canada’s exceptional openness to the forces of trade should be emphasized. Factors leading to a more integrated world economy can be mentioned. The students can easily appreciate the everyday events that bring the world closer together. The nature of the international firm can be described, along with the many forms entry into a foreign country can take. The increased risks of foreign investment can be identified. An important point is that international finance has the same elements as domestic financial management only the issues tend to be more involved. The firm must not only make a profit on a transaction, but consider currency fluctuations. Inflation, interest rates, balance of payments, and government policies impact on foreign exchange rates. Spot and forward exchange rates can be illustrated. The foreign exchange market hedge, the money market hedge, and the currency futures market hedge are discussed as means to manage foreign exchange risk. Increasingly students must understand how to conduct business across international borders. Transferring funds internationally, the Euromarket, government institutions facilitating trade financing, and international equity markets are all part of international trade. Learning Objectives 1. Identify reasons for a foreign investment decision (later analyze). 2. Examine the effects of exchange and political risk on the foreign investment decision 3. Assess the effects of exchange rates on the firm’s profitability and cash flow. 4. Characterize the factors influencing exchange rates. 5. Utilize spot, cross and forward rates and compute forward premiums and discounts. 6. Evaluate techniques to hedge or reduce foreign exchange risk. 7. Explain the purposes and nature of the multinational operations of the corporation. 8. Outline potential ways to finance international operations. Annotated Outline and Strategy I. The Scope A. Trade: 1. Canada is a significant player in international trade (30% of GDP), particularly with the United States. (Free Trade Agreement) 2. Integration of economic, technological and political systems: a. Post World War II rebuilding programs b. European Common Market (ECM or EU) c. Political and social changes 3. International balance of payments for Canada moved from surplus to deficit, with services and interest payments always in deficit. PPT 8 of 30 Canada’s international balance of payments, current account, 2010 (Figure 21-4) B. Capital Investment: 1. There is more investment in Canada than Canada investment abroad, although the tide has turned somewhat. Canadians tend to invest in longer-term assets (equities, direct investment) while investment from abroad tends to be in debt instruments (bonds, deposits). PPT 9 of 30 Canada’s international investment position, 2010 (Figure 21-5) 2. Canadian investment abroad is primarily in the United States PPT 10 of 30 Canada’s investment abroad by region, 2010 (assets) (Figure 21-6) C. Reasons for Capital Investment (a special capital budgeting case): 1. Higher potential returns (resource availability, lower production costs, lower wages, lower taxes, better market access) 2. Strategic advantages PPT 14 of 23 Risk reduction from international diversification (Figure 21-8) 3. Diversification: less correlation with existing assets lowers risk although there are significant hindrances II. The Risks A. Foreign Exchange Risk: The monetary value of an international transaction or investment will fluctuate over time. Finance in Action: The Birth and Perhaps Death of a New Currency – The Euro! In 1999 the Euro came into existence for electronic transactions. By 2002 paper and coin Euros were available. By 2012 the future existence of the Euro was being questioned www.ecb.int Perspective 21-1: The instructor may wish to use Table 21-1 to illustrate foreign exchange rates and how they change over time. B. Exchange Rates: To facilitate international trade, currencies must be exchanged. For example, an importer may have to swap the domestic currency for the currency desired by the exporter in order to pay for goods or services. PPT 17 of 23 Selected currencies and exchange rates (Table 21-1) C. Exchange Rate Exposure: Exchange risk is the possibility of experiencing a gain or loss in an international transaction due to a change in foreign exchange rates. 1. Three types of foreign exchange risk exposure: a. Economic exposure identifies market value of net investment subject to change in economic value due to currency fluctuation. b. Accounting or translation exposure: depends upon accounting rules established by CICA accounting recommendations. This is often an unrealized gain or loss. c. Transaction exposure: the foreign exchange gains and losses resulting from international transactions, when foreign funds are converted to Canadian dollars. D. Political Risk: 1. The structure of the foreign government and/or those in control may change many times during the lengthy period necessary to recover an investment. "Unfriendly" changes may result in: a. Foreign exchange restriction b. Foreign ownership limitations c. Blockage of repatriation of earnings d. Expropriation of foreign subsidiary's assets 2. Safeguards against political risk. a. A thorough investigation of the country's political stability b. Joint ventures with local (foreign) companies c. Joint ventures with multiple companies representing multiple countries d. Insurance through the federal government agency, the Export Development Corporation (EDC) Finance in Action: Whiskey is Risky! In the mid-1990s Seagram was allowed to enter the liquor business in India. It found the early going tougher than it expected as several unique cultural, political, and technical risks were encountered. III. Exchange Rate Management A. Factors affecting exchange rates: 1. Supply of and demand for the currencies of the various countries 2. The degree of central bank intervention 3. Inflation rate differentials (Purchasing Power Parity Theory) 4. Interest rate differentials (Interest Rate Parity Theory). Finance in Action: Interest Rate in Other Countries: Are They Any Better? This example taken from the financial pages of a newspaper demonstrates a swap deposit, interest parity theory, and the integration of world financial markets. Although interest rates may look better in another country they turn out to be remarkably similar through the forward covered rate. This is the interest rate parity theory. (Page 679). http://fx.sauder.ubc.ca 5. Balance of payments 6. Government policies 7. Other factors: a. Capital market movements b. Changes in supply of and demand for the products and services of individual countries c. Labour disputes d. Political turmoil B. Many variables affect currency exchange rates. The importance of each variable or set of variables will change as economics and political conditions change throughout the world. C. Spot Rates, Forward Rates, and Cross Rates Perspective 21-2: There are a number of easily understood examples in the text on spot and forward rates, as well as cross rates. 1. Spot rate: the exchange rate between currencies with immediate delivery. 2. Forward rate: the rate of exchange between currencies when delivery will occur in the future. (21-1; page 682) 3. Cross rate: the exchange rate between currencies such as Euro and British Pound based on their exchange rate with another currency such as Canadian Dollars. D. Hedging (risk reduction) techniques to minimize transaction exposure: 1. Forward Hedging in the forward exchange market: the recipient (seller) of foreign currency in an international transaction sells a forward contract to assure the amount that will be received in domestic currency. 2. Hedging in the money market: the recipient borrows foreign currency in the amount to be received and then immediately converts to domestic currency. When the receivable is collected, the loan is paid off. 3. Hedging in the currency futures market: futures contracts in foreign currencies began trading in the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME) on May 16, 1972. 4. Hedging in the currency options market: options contracts on foreign currencies are traded on the CME. Finance in Action: Devaluation and Deflation The problems in Argentina and Japan in 2002 are identified. http://fx.sauder.ubc.ca IV. The Multinational Corporation (MNC) A. Basic forms of MNC: 1. Exporter: exportation to foreign markets of domestically produced products 2. Licensing Agreement: the granting of a license to an independent local (in the foreign country) firm to use the "exporting" firm's technology 3. Joint Venture: cooperative business operation with a firm (or firms) in the foreign country 4. Fully Owned Foreign Subsidiary B. International Environment versus Domestic Environment: 1. More risky: in addition to normal business risks, the MNC is faced with foreign exchange risk and political risk. The portfolio risk of the parent company, however, may be reduced if foreign and domestic operations are not correlated 2. Potentially more profitable 3. More complex: the laws, customs, and economic environment of the host country may vary in many respects: a. Rates of inflation b. Tax rules c. Structure and operation of financial institutions d. Financial policies and practices e. Work habits and wages of labourers V. Financing International Business Operations A. Letters of credit: in order to reduce the risk of non-payment, an exporter may require an importer to furnish a letter of credit. The letter of credit is normally issued by the importer's bank and guarantees payment to the exporter upon delivery of the merchandise if the specified conditions are met. B. Export credit insurance: the Export Development Corporation may provide insurance against non-payment by foreign customers. C. Funding of transactions 1. Export Development Corporation: facilitates the financing of Canadian exports through several programs. 2. Loans from the parent company or sister affiliate. a. Parallel loans: an arrangement where two parent firms in different countries each make a loan to the affiliate of the other parent. The procedure eliminates foreign exchange risk. PPT 25 & 26 of 30 A parallel loan arrangement (Figure 21-10) and A fronting loan arrangement (Figure 21-11) b. Fronting loans: loans from a parent firm to a foreign subsidiary via a bank located in the foreign country. 3. Eurocurrency loans: loans from foreign banks that are denominated in dollars. a. There are many participants in the Eurodollar market from throughout the world particularly the U.S., Canada, Western Europe and Japan. b. Lower borrowing costs and greater credit availability have enabled these markets to become an important source of short-term funding. c. The lending rate is based on the London Interbank Offered Rate (LIBOR). d. Lending in the Eurodollar market is almost exclusively done by commercial banks. Large Euro-currency loans are frequently syndicated and managed by a lead bank. Finance in Action: Rating the Countries Moody’s Bond Rating Service rates the sovereign debt of countries. www.moodys.com 4. Eurobond market: long-term funds may be secured by issuing Eurobonds. These bonds are sold throughout the world but are denominated primarily in U.S. dollars, Euros, Swiss francs and Japanese yen. a. Disclosure requirements are less stringent. b. Registration costs are lower. c. Some tax advantages exist. d. Caution must be exercised because of the exposure to foreign exchange risk. 5. International equity markets: selling common stock to residents of a foreign country provides financing and also reduces political risk. See Figure 14-2 on page 466. a. Multinational firms list their shares on major stock exchanges around the world. b. Marketing securities internationally requires firms to adjust their procedures. For example, chartered banks have a dominant role in the securities business throughout Europe. 6. International Finance Corporation (IFC): the IFC was established in 1956 and is unit of the World Bank. Its objective is to promote economic development to member countries of the World Bank. a. A multinational firm may be able to raise equity capital by selling partial ownership to the IFC. b. The IFC decides to participate in the venture on the basis of profitability and the potential benefit to the host country. c. Once the venture is well established, the IFC frees up its capital by selling its ownership interest. VI. Global Cash Management A. Government restrictions, volatile interest rates, differing inflation rates, technological constraints, and other variables increase the complexity of managing cash globally. B. Successful participation in the international business environment requires cohesive, coordinated financial management. VII. Appendix 21A: Cash Flow Analysis and the Foreign Investment Decision A. Cash Flow Analysis B. Tax Factors C. Foreign Exchange Considerations D. Present Value Analysis E. The Risk Factor PPT 28 of 30 Cash flow analysis of a foreign investment (Table 21A-1) Perspective 21-3: The appendix represents a reasonably complicated consideration of a foreign investment decision by a corporation. Summary Listing of Suggested PowerPoint Slides PPT 5 World’s leading merchandise exporters, 2009 (Figure 21-1) PPT 6 World’s leading merchandise importers, 2009 (Figure 21-2) PPT 7 Canada’s 2007 merchandise exports and imports by region (Figure 21-3) PPT 8 Canada’s international balance of payments, current account, 2010 (Figure 21-4) PPT 9 Canada’s international investment position, 2010 (Figure 21-5) PPT 10 Canada’s investment abroad by region, 2010 (assets) (Figure 21-6) PPT 14 Risk reduction from international diversification (Figure 21-8) PPT 17 Selected currencies and exchange rates (Table 21-1) PPT 25 & 26 A parallel loan arrangement (Figure 21-10) and A fronting loan arrangement (Figure 21-11) PPT 28 Cash Flow Analysis of a Foreign Investment (Table 21A-1) PowerPoint Presentation The Chapter 21 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 30 frames. Instructor Manual for Foundations of Financial Management Canadian Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015