3.1Types of Equity Securities

Firms obtain equity capital either internally by earning money and retaining it within

the firm or externally by issuing new equity securities. There are three different

kinds of equity that a firm can issue: (1) common stock, (2) preferred stock, and

(3)warrants.

Common Stock

Common stockis a share of ownership in a corporation that usually entitles its hold-

ers to vote on the corporation’s affairs. The common stockholders of a firm are gener-

ally viewed as the firm’s owners. They are entitled to the firm’s profits after other con-

tractual claims on the firm are satisfied and have the ultimate control over how the firm

is operated.³

Some firms have two classes of common stock (dual-class shares), usually called

class Aand class B, which differ in terms of their votes per share. Dual-class com-

monstockis largely confined to firms that are majority controlled by some person or

group. Such firms include Ford Motor, Reader’s Digest, Smucker’s, the Washington

Post Group, and Adolph Coors. These firms were family-owned firms until they grew

too large to be financed by the family alone. Because the families did not want to give

up control, they created two classes of common stock, with one class having more votes

per share than the other class. In these situations, family members will usually own the

majority of the shares with the greater voting power. Although only a limited number

of U.S. firms have more than one class of common stock, multiple classes of stock

with different voting rights are popular outside the United States. The stocks in a

number of countries outside the United States are divided into Aand B classes, with

¹In reality, however, managers may be more influenced by bankers and other debt holders with whom

they must deal on a day-to-day basis than by shareholders with whom they have much less contact.

Isssues relating to who controls corporations will be discussed in more detail in Chapter 18.

²In this way, the U.S. tax code favors debt over equity financing. The tax advantages of debt versus

equity financing will be discussed in great detail in Chapters 13, 14, and 15.

³As Chapter 18 discusses, it is often difficult for stockholders to exercise their control.

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Strategy, Second Edition

70Part IFinancial Markets and Financial Instruments

foreigners restricted to holding the B shares, which often have no voting rights. In some

cases, the B shares have voting rights, but not enough to permit foreigners to control

the firm.

Preferred Stock

Preferred stockis a financial instrument that gives its holders a claim on a firm’s earn-

ings that must be paid before dividends on its common stock can be paid. Preferred

stock also is a senior claim in the event of reorganization or liquidation,which is the

sale of the assets of the company. However, the claims of preferred stockholders are

always junior to the claims of the firm’s debt holders. Preferred stock is used much

less than common stock as a source of capital. The biggest issuers of preferred stock

have historically been electric utilities which have been allowed to claim the dividends

as an expense when setting electricity rates. Because of tax advantages, financial insti-

tutions recently have become big issuers of new kinds of preferred stock that are

described below.

Preferred stock is like debt in that its dividend is fixed at the time of sale. In

some cases, preferred stock has a maturity date much like a bond. In other cases,

preferred stock is more like common stock in that it never matures. Preferred shares

are almost always cumulative:If the corporation stops paying dividends, the unpaid

dividends accumulate and must be paid in full before any dividends can be paid to

common shareholders. At the same time, a firm generally cannot be forced into bank-

ruptcy for not paying its preferred dividends.⁴The voting rights of preferred stock

differ from instrument to instrument. Preferred stockholders do not always have

voting rights, but they often obtain voting rights when the preferred dividends are

suspended.

Convertible Preferred.Convertible preferred stockis similar to the convertible

debt instruments described in Chapter 2. These instruments have the properties of pre-

ferred stock prior to being converted, but can be converted into the common stock of

the issuer at the preferred shareholder’s discretion. In addition to the standard features

of preferred stock, convertible preferred stock specifies the number of common shares

into which each preferred share can be converted.

Adjustable-Rate Preferred.About half the preferred stock issued in the 1990s was

some variant of adjustable-rate preferred stock, an instrument that was invented in

the 1980s. This kind of preferred stock goes by various acronyms, including ARPS

(adjustable-rate preferred stock), DARTS (Dutch auction rate stock), APS (auction pre-

ferred stock), and RP(remarketed preferred). In each form of adjustable-rate preferred

stock, the dividend is adjusted quarterly (sometimes monthly) by an amount determined

by the change in some short-term interest rate. Most of the adjustable-rate preferred

stock is sold by financial institutions seeking deposits and is bought by corporate finan-

cial managers seeking a tax-advantaged investment for short-term funds. The tax advan-

tage arises because, as of 1997, U.S. corporations may exclude from taxable income

70 percent of the dividends received from the preferred or common shares of another

domestic corporation.⁵Leveraged municipal bond funds also use this type of preferred

stock as a source of capital.

⁴For the newer kinds of preferred stock, discussed below, preferred shareholders can sometimes force

the firm into bankruptcy.

⁵We will discuss this in greater detail in Chapter 15.

Grinblatt166Titman: Financial	I. Financial Markets and	3. Equity Financing	© The McGraw166Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 3

Equity Financing

71

MIPS.One of the biggest advantages of preferred stock is that it allows corporations

to issue a debtlike security without lowering the ratings on their existing debt. How-

ever, in contrast to a debt security with its tax-deductible interest, preferred stock has

the disadvantage that its dividends are not tax deductible. In response to the desire for

a security that provides the best of debt and preferred equity, investment bankers have

developed a security they call either MIPS (monthly income preferred securities) or

trust preferred securities.

Texaco’s Monthly Income Preferred Securities (MIPS)

In October 1993 Goldman Sachs and Texaco brought the first MIPS issue to market.

Monthly income preferred securities (MIPS)combine features of debt and equity. Like

equity, they pay dividends, they can be perpetual, the dividends can be deferred if there are

cash flow problems, and they aren’t counted as debt on the firm’s balance sheet. Like debt,

however, they carry a fixed payment, they are rated by the rating agencies, and the pay-

ments to investors are classified as tax-deductible interest. The cash flows can be dividends

to investors and interest to the firm through a special tax trick in which a wholly owned

financing subsidiary is created that issues the preferred stock and then loans the proceeds

to the parent company. The interest payments are passed back to the subsidiary, which records

these payments as dividends to investors who are classified as partners of the subsidiary. This

convoluted arrangement allowed Texaco to issue MIPS at their A-rated dividend yield of

6.875 percent but to have an after-tax financing rate of approximately 4.6 percent per year.

Source: Reprinted by permission of The Wall Street Journal,©1995 Dow Jones & Company, Inc. All Rights

Reserved Worldwide.

Akey distinction between a MIPS and a typical preferred security is that the MIPS

can defer the dividends for only five years while standard preferred stock can defer the

dividends indefinitely. Unlike standard preferred stock, MIPS can force the firm into

bankruptcy for failure to pay the dividend on this instrument. The Internal Revenue

Service (IRS) has ruled that this distinction is sufficient to make the dividends on MIPS

tax deductible, which in turn implies that corporate holders of these instruments are

taxed on the entire dividend.⁶

Warrants

There are several other equity-related securities that firms issue to finance their oper-

ations. Firms sometimes issue warrants, which are long-term call options on the issu-

ing firm’s stock. Call options⁷give their holders the right to buy shares of the firm at

a prespecified price for a given period of time. These options are often included as part

of a unit offering, which includes two or more securities offered as a package. For

example, firms might try to sell one common share and one warrant as a unit. Schultz

(1990) suggested that this kind of unit offering serves as a form of staged financing in

which investors have an option to either invest more in the firm if it is successful or

to shut it down by refusing to invest at the option’s prespecified price. Warrants also

are often bundled with a firm’s bond and preferred stock offerings.