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economic significance.1
Value of The price at which new shares are sold to investors almost always exceeds par value.
PAR VALUE
security shown on certificate. The difference is entered into the company™s accounts as additional paid-in capital, or
capital surplus. For example, if Heinz sold an additional 100,000 shares at $50 a share,
the par value of the common stock would increase by 100,000 — $.25 = $25,000 and ad-
ADDITIONAL PAID-IN
ditional paid-in capital would increase by 100,000 — ($50 “ $.25) = $4,975,000. You can
CAPITAL Difference
between issue price and par see from this example that the funds raised from the stock issue are divided between par
value of stock. Also called value and additional paid-in capital. Since the choice of par value in the first place was
capital surplus. immaterial, so is the allocation between par value and additional paid-in capital.

TABLE 5.8
Common shares ($.25 par value per share) $108
Book value of common
Additional paid-in capital 278
stockholders™ equity of H. J.
Retained earnings 3,853
Heinz Company, April 28,
Treasury shares at cost (2,435)
1999 (figures in millions)
Net common equity 1,803


Note:
Authorized shares
Issued shares, of which 431
Outstanding shares 358
Treasury shares 72



1 Because some states do not allow companies to sell new shares below par value, par value is generally set
at a low figure. Some companies even issue shares with no par value, in which case the stock is listed in the
accounts at an arbitrarily determined figure.
496 SECTION FIVE


Besides buying new stock, shareholders also indirectly contribute new capital to the
firm whenever profits that could be paid out as dividends are instead plowed back into
the company. Table 5.8 shows that the cumulative amount of such retained earnings is
RETAINED EARNINGS
$3,853.
Earnings not paid out as
Heinz™s books also show the amount that the company has spent in the past on re-
dividends.
purchasing its own stock. The repurchase of the 72 million shares cost Heinz $2,435
million. This is money that has in effect been returned to shareholders.
The sum of the par value, additional paid-in capital, and retained earnings, less re-
purchased stock, is known as the net common equity of the firm. It equals the total
amount contributed directly by shareholders when the firm issued new stock and indi-
rectly when it plowed back part of its earnings.



Generic Products has had one stock issue in which it sold 100,000 shares to the public
Self-Test 1
at $15 per share. Can you fill in the following table?

Common shares ($1.00 par value per share) ________
Additional paid-in capital ________
Retained earnings ________
Net common equity $4,500,000




BOOK VALUE VERSUS MARKET VALUE
We discussed the distinction between book and market value earlier, but it bears
repeating.


Book value is a backward-looking measure. It tells us how much capital the
firm has raised from shareholders in the past. It does not measure the value
that investors place on those shares today. The market value of the firm is
forward-looking; it depends on the future dividends that shareholders expect
to receive.


Heinz™s common equity has a book value of $1,803 million. With 358 million shares
outstanding, this translates to a book value of $1,803/358 = $5.04 per share. But in April
1999 Heinz shares were priced at about $49 each. So the total market value of the com-
mon stock was 358 million shares — $49 per share = $17.5 billion, nearly 10 times the
book value.
Market value is usually greater than book value. This is partly because inflation has
driven the value of many assets above what they originally cost. Also, firms raise capi-
tal to invest in projects with present values that exceed initial cost. These positive-NPV
projects made the shareholders better off. So we would expect the market value of the
firm to be higher than the amount of money put up by the shareholders.
However, sometimes projects do go awry and companies fall on hard times. In this
case, market value can fall below book value.
An Overview of Corporate Financing 497



No-name News can be established by investing $10 million in a printing press. The
Self-Test 2
newspaper is expected to generate a cash flow of $2 million a year for 20 years. If the
cost of capital is 10 percent, is the firm™s market or book value greater? What if the cost
of capital is 20 percent?



DIVIDENDS
Shareholders hope to receive a series of dividends on their investment. However, the
company is not obliged to pay any dividend and the decision is up to the board of di-
rectors.
Because dividends are discretionary, they are not considered to be a business ex-
pense. Therefore, companies are not allowed to deduct dividend payments when they
calculate their taxable income.


STOCKHOLDERS™ RIGHTS
Stockholders have the ultimate control of the company™s affairs. Occasionally compa-
nies need shareholder approval before they can take certain actions. For example, they
need approval to increase the authorized capital or to merge with another company.

On most other matters, shareholder control boils down to the right to vote on
appointments to the board of directors.

The board usually consists of the company™s top management as well as outside di-
rectors, who are not employed by the firm. In principle, the board is elected as an agent
of the shareholders. It appoints and oversees the management of the firm and meets to
vote on such matters as new share issues. Most of the time the board will go along with
the management, but in crisis situations it can be very independent. For example, when
the management of RJR Nabisco announced that it wanted to take over the company,
the outside directors stepped in to make sure that the company was sold to the highest
bidder.


VOTING PROCEDURES
In most companies stockholders elect directors by a system of majority voting. In this
MAJORITY VOTING
case each director is voted on separately and stockholders can cast one vote for each
Voting system in which each
share they own. In some companies directors are elected by cumulative voting. The di-
director is voted on
rectors are then voted on jointly and the stockholders can, if they choose, cast all their
separately.
votes for just one candidate. For example, suppose there are five directors to be elected
and you own 100 shares. You therefore have a total of 5 — 100 = 500 votes. Under ma-
CUMULATIVE VOTING
jority voting you can cast a maximum of 100 votes for any one candidate. With a cu-
Voting system in which all the
mulative voting system you can cast all 500 votes for your favorite candidate. Cumula-
votes one shareholder is
tive voting makes it easier for a minority group of the stockholders to elect a director to
allowed to cast can be cast
represent their interests. That is why minority groups devote so much effort to cam-
for one candidate for the
paigning for cumulative voting.
board of directors.
On many issues a simple majority of the votes cast is enough to carry the day, but
there are some decisions that require a “supermajority” of, say, 75 percent of those
498 SECTION FIVE


eligible to vote. For example, a supermajority vote is sometimes needed to approve a
merger. This requirement makes it difficult for the firm to be taken over and therefore
helps to protect the incumbent management.
Shareholders can either vote in person or appoint a proxy to vote. The issues on
which they are asked to vote are rarely contested, particularly in the case of large, pub-
licly traded firms. Occasionally, however, there are proxy contests in which outsiders
PROXY CONTEST
compete with the firm™s existing management and directors for control of the corpora-
Takeover attempt in which
tion. But the odds are stacked against the outsiders, for the insiders can get the firm to
outsiders compete with
pay all the costs of presenting their case and obtaining votes.
management for
shareholders™ votes.
CLASSES OF STOCK
Most companies issue just one class of common stock. Sometimes, however, a firm may
have two or more classes outstanding, which differ in their right to vote or receive div-
idends. Suppose that a firm needs fresh capital but its present stockholders do not want
to give up control of the firm. The existing shares could be labeled class A, and then
class B shares could be issued to outside investors. The class B shares could have lim-
ited voting rights, although they would probably sell for less as a result.


CORPORATE GOVERNANCE IN THE
UNITED STATES AND ELSEWHERE
Heinz™s shareholders own the company but they don™t manage it. Management is dele-
gated to a team of professional managers. Each shareholder owns only a small fraction
of Heinz™s shares and can exert little influence on the way the company is run. If share-
holders do not like the policies the management team pursues, they can try to vote in
another board of directors who will bring about a change in policy. But such attempts
are rarely successful, and the shareholders™ simplest solution is to sell the shares.
The separation between ownership and management in major United States corpo-
rations creates a potential conflict between shareholders (the principals who own the
company) and managers (their agents who make the decisions). We noted earlier sev-
eral mechanisms that have evolved to mitigate this conflict:
• Shareholders elect a board of directors, which then appoints the managers, oversees
them, and on occasion fires them.
• Managers™ remuneration is tied to their performance.
• Poorly performing companies are taken over and the management is replaced by a
new team.
These principles of corporate governance do not apply worldwide. The United
States, Canada, Britain, Australia, and other English-speaking countries all have
broadly similar systems, but other countries do not. In Japan industrial and financial
companies are often linked together in a group, called a keiretsu. For example, the Mit-
subishi keiretsu contains 29 core companies, including two banks, two insurance com-
panies, an automobile manufacturer, a steel producer, and a cement company. Members
of the keiretsu are tied together in several ways. First, managers may sit on the boards
of directors of other group companies, and a “president™s council” of chief executives
meets regularly. Second, each company in the group holds shares in many of the other
companies. And third, companies generally borrow from the keiretsu™s bank or from
elsewhere within the group. These links may have several advantages. Companies can
obtain funds from other members of the group without the need to reveal confidential
An Overview of Corporate Financing 499


information to the public, and if a member of the group runs into financial heavy
weather, its problems can be worked out with other members of the group rather than
in the bankruptcy court.
The more stable and concentrated shareholder base of large Japanese corporations
may make it easier for them to resist pressures for short-term performance and allow
them to focus on securing long-term advantage. But the Japanese system of corporate
governance also has its disadvantages, for the lack of market discipline may promote a
too-cozy life and allow lagging or inefficient Japanese corporations to put off painful
surgery.
Keiretsus are found only in Japan. But large companies in continental Europe are
linked in some similar ways. For example, banks and other companies often own or con-
trol large blocks of shares and can push hard for changes in the management or strat-
egy of poorly performing firms. (Banks in the United States are prohibited from large
or permanent holdings of the stock of nonfinancial corporations.) Thus oversight and
control are entrusted largely to banks and other corporations. Hostile takeovers of
poorly performing companies are rare in Germany and virtually impossible in Japan.

For large corporations, separation of ownership and control is seen the world
over. In the United States, control of large public companies is exercised
through the board of directors and pressure from the stock market. In other
countries the stock market is less important, and control shifts to major
stockholders, typically banks and other companies.




Preferred Stock
Usually when investors talk about equity or stock, they are referring to common stock.
But Heinz has also issued $200,000 of preferred stock, and this too is part of the com-
PREFERRED STOCK
pany™s equity. The sum of Heinz™s common equity and preferred stock is known as its
Stock that takes priority over
net worth.
common stock in regard to
For most companies preferred stock is much less important than common stock.
dividends.
However, it can be a useful method of financing in mergers and certain other special sit-
uations.
Book value
NET WORTH
Like debt, preferred stock promises a series of fixed payments to the investor and
of common stockholders™
with relatively rare exceptions preferred dividends are paid in full and on time. Never-
equity plus preferred stock.
theless, preferred stock is legally an equity security. This is because payment of a pre-
ferred dividend is almost invariably within the discretion of the directors. The only ob-
ligation is that no dividends can be paid on the common stock until the preferred
dividend has been paid.2 If the company goes out of business, the preferred stockhold-
ers get in the queue after the debtholders but before the common stockholders.
Preferred stock rarely confers full voting privileges. This is an advantage to firms
that want to raise new money without sharing control of the firm with the new share-
holders. However, if there is any matter that affects their place in the queue, preferred
stockholders usually get to vote on it. Most issues also provide the holder with some
voting power if the preferred dividend is skipped.
Companies cannot deduct preferred dividends when they calculate taxable income.
2 These days this obligation is usually cumulative. In other words, before the common stockholders get a cent,
the firm must pay any preferred dividends that have been missed in the past.

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