What is a dual-class common stocks? Why do firms typically issue dual classes of common stocks? As an Investor, would you support, or oppose issuance of dual class securities? Why? Answer in 3 paragraphs. Make sure to cite your external research work.
236 Part 2 Securities Markets
STOCK MARKET SECURITIES
Two types of corporate stock exist: common stock and preferred stock. While all public
corporations issue common stock, many do not offer preferred stock. The market value
of preferred stock outstanding is only about 1 percent of the value of common stock
outstanding.
Common Stock
Common stock is the fundamental ownership claim in a public or private corporation. Many characteristics of common stock differentiate it from other types of financial securi-
ties (e.g., bonds, mortgages, preferred stock). These include (1) discretionary dividend
payments, (2) residual claim status, (3) limited liability, and (4) voting rights. These char-
acteristics are described next.
Dividends. While common stockholders can potentially receive unlimited dividend pay- ments if the firm is highly profitable, they have no special or guaranteed dividend rights.
The payment and size of dividends are determined by the board of directors of the issuing
firm (who are elected by the common stockholders). Unlike interest payments on debt,
a corporation does not default if it misses a dividend payment to common stockholders.
Thus, common stockholders have no legal recourse if dividends are not received, even if
a company is highly profitable and chooses to use these profits to reinvest in new projects
and firm growth. In fact, many firms pay no dividends, but instead reinvest all of their net
earnings in the firm. For example, in 2013, 95 of the firms listed in the S&P 500 Index (see
below) paid no dividends.
Another drawback with common stock dividends, from an investor’s viewpoint, is that
they are taxed twice—once at the firm level (at the corporate tax rate, by virtue of the fact
that dividend payments are not tax deductible from the firm’s profits or net earnings) and
once at the personal level (at the personal income tax rate). Investors can partially avoid
this double taxation effect by holding stocks in growth firms that reinvest most of their
earnings to finance growth rather than paying larger dividends. Generally, earnings growth
leads to stock price increases. Thus, stockholders can sell their stock for a profit and pay
capital gains taxes rather than ordinary income taxes on dividend income. Under current
tax laws, capital gains tax rates are lower than ordinary income tax rates. For example, in
the 2010s, ordinary income tax rates ranged from 15 percent to 39 percent of an individ-
ual’s taxable income. Long-term (a 12-month or longer investment horizon) capital gains
tax rates were capped at 20 percent.
The return to a stockholder over a period t – 1 to t can be written as:
R t = P t − P t − 1
__ P t − 1
- D t
__ P t − 1
where
P t = Stock price at time t D t = Dividends paid over time t – 1 to t
P t − P t − 1
__ P t − 1
= Capital gain over time t – 1 to t
D t
__ P t − 1
= Return from dividends over time t – 1 to t
In the context of the return equation, the reinvestment of earnings (rather than payment
of dividends) affects both return components: capital gains and dividends. By reinvest-
ing earnings (rather than paying dividends), the dividend component of returns, D t / P t – 1 , decreases. However, the reinvestment of earnings generally results in a relatively larger
increase in the capital gains component, ( P t – P t – 1 )/ P t – 1 .
LG 8-1
common stock
The fundamental ownership
claim in a public or private
corporation.
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Chapter 8 Stock Markets 237
Residual Claim. Common stockholders have the lowest priority claim on a corpora- tion’s assets in the event of bankruptcy—they have a residual claim. Only after all senior claims are paid (i.e., payments owed to creditors such as the firm’s employees, bond hold-
ers, the government (taxes), and preferred stockholders) are common stockholders entitled
to what assets of the firm are left. For example, the bankruptcy of Washington Mutual
Bank in 2008 left its shareholders with nothing. The residual claim feature associated with
common stock makes it riskier than bonds as an investable asset.
Limited Liability. One of the most important characteristics of common stock is its lim- ited liability feature. Legally, limited liability implies that common stockholder losses are limited to the amount of their original investment in the firm if the company’s asset value
falls to less than the value of the debt it owes. That is, the common stockholders’ personal
wealth held outside their ownership claims in the firm are unaffected by bankruptcy of the
corporation—even if the losses of the firm exceed its total common stock ownership
claims. In contrast, sole proprietorship or partnership stock interests mean the stockholders
may be liable for the firm’s debts out of their total private wealth holdings if the company
gets into financial difficulties and its losses exceed the stockholders’ ownership claims in
the firm. This is the case of “unlimited” liability.
Voting Rights. A fundamental privilege assigned to common stock is voting rights. While common stockholders do not exercise control over the firm’s daily activities (these
activities are overseen by managers hired to act in the best interests of the firm’s com-
mon stockholders and bond holders), they do exercise control over the firm’s activities
indirectly through the election of the board of directors. Stockholders also vote on major
changes pertaining to the firm, (e.g., mergers and dividend changes). For example, in
residual claim
In the event of liquidation,
common stockholders have
the lowest priority in terms of
any cash distribution.
limited liability
No matter what financial dif-
ficulties the issuing corporation
encounters, neither it nor its
creditors can seek repay-
ment from the firm’s common
stockholders. This implies that
common stockholders’ losses
are limited to the original
amount of their investment.
EXAMPLE 8–1 Payment of Dividends versus Reinvestment of Earnings
A corporation has after- (corporate) tax earnings that would allow a $2 dividend per share
to be paid to its stockholders. If these dividends are paid, the firm will be unable to invest
in new projects, and its stock price, currently $50 per share, probably will not change. The
return to the firm’s stockholders in this case is:
R t = $50 − $50
_ $50
- $2
__ $50
= 4%
Suppose a stockholder bought the stock at the beginning of the year (at $50) and sold it
at the end of the year (at $50). The stockholder’s ordinary income tax rate is 30 percent
and the capital gains tax rate is 20 percent. (The capital gains tax rate depends on several
things, including the holding period of the investment, the investor’s income level, and any
tax-code changes made during the holding period.) The return to the stockholder in this
case is all in the form of ordinary income (dividends). Thus, the after-tax rate of return to
the stockholder is 4%(1 – 0.30) = 2.8%.
Alternatively, rather than pay dividends, the firm can use the earnings to invest in new
projects that will increase the overall value of the firm such that the stock price will rise to
$52 per share. The return to the firm’s stockholders in this case is:
R t = $52 − $50
_ $50
- $0
__ $50
= 4%
Further, the return to the stockholder is all in the form of capital gains and is taxed at a rate
of 20 percent. Thus, the after-tax rate of return to the stockholder is 4% (1 – 0.20) = 3.2%.
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238 Part 2 Securities Markets
July 2013, Dell was forced to delay a vote on founder Michael Dell’s plan to take the
slumping computer maker private. The vote was scheduled at a special shareholders meet-
ing at the company’s headquarters in Texas. Dell called the meeting to order and then
quickly adjourned it without a formal vote. The vote was postponed due to a lack of share-
holder support for the proposal. The lack of support and vote delay presented a significant
setback for Michael Dell. The meeting and the vote were rescheduled for a week later but
had to be postponed a second time due to a continued lack of shareholder support.
The typical voting rights arrangement is to assign one vote per share of common
stock. However, some corporations are organized as dual-class firms, in which two classes of common stock are outstanding, with different voting and/or dividend rights
assigned to each class. For example, inferior voting rights have been assigned by (1) limit-
ing the number of votes per share on one class relative to another (e.g., Berkshire Hatha-
way Class B shares are entitled to 1/10,000th vote per share, while Class A shares are
entitled to one vote per share), (2) limiting the fraction of the board of directors that one
class can elect relative to another (e.g., WhiteWave Food Company Class B common stock
is entitled to 10 votes with respect to the election and removal of directors and one vote
with respect to all other matters, while Class A common stockholders get one vote per
share on all matters), or (3) a combination of these two (e.g., the Molson Coors Brewing
Company allows holders of Class B common stock the right to elect three directors to the
Molson Coors board of directors and the right to one vote per share on other specified
transactional actions, while the right to vote for all other activities remains exclusively
with Class A common stock). To offset the reduced voting rights, inferior class shares are
often assigned higher dividend rights. For example, no dividends are paid on the Class B
common shares of Berkshire Hathaway unless equal or greater dividends are paid on the
Class A stock.
Shareholders exercise their voting rights, electing the board of directors by casting
votes at the issuing firm’s annual meeting or by mailing in a proxy vote (see below). Two
methods of electing a board of directors are generally used: cumulative voting and
straight voting. Cumulative voting is required by law in some states (e.g., Arizona and
Illinois) and is authorized in others. With cumulative voting, all directors up for elec- tion, as nominated by the shareholders and selected by a committee of the board, are
voted on at the same time. The number of votes assigned to each stockholder equals the
number of shares held multiplied by the number of directors to be elected. A shareholder
may assign all of his or her votes to a single candidate for the board or may spread them
over more than one candidate. The candidates with the highest number of total votes are
then elected to the board. Cumulative voting permits minority stockholders to have some
real say in the election of the board of directors, since less than a majority of the votes
can affect the outcome.
dual-class firms
Two classes of common stock
are outstanding, with differen-
tial voting rights assigned to
each class.
cumulative voting
All directors up for election are
voted on at the same time.
The number of votes assigned
to each stockholder equals
the number of shares held
multiplied by the number of
directors to be elected.
EXAMPLE 8–2 Cumulative Voting of a Board of Directors
Suppose a firm has 1 million shares of common stock outstanding and three directors
up for election. With cumulative voting, the total number of votes each shareholder
may cast equals the number of shares owned multiplied by the number of directors to
be elected. Thus, the total number of votes available is 3,000,000 ( = 1 million shares
outstanding × 3 directors).
If there are four candidates for the three board positions, the three candidates with the
highest number of votes will be elected to the board and the candidate with the fewest total
votes will not be elected. In this example, the minimum number of votes needed to ensure
election is one-fourth of the 3 million votes available, or 750,000 votes. If one candidate
receives 750,000, the remaining votes together total 2,250,000. No matter how these votes
are spread over the remaining three director candidates, it is mathematically impossible for
each of the three to receive more than 750,000. This would require more than 3 × 750,000 votes, or more than the 2,250,000 votes that remain.
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Chapter 8 Stock Markets 239
With straight voting, the vote on the board of directors occurs one director at a time.
Thus, the number of votes eligible for each director is the number of shares outstanding.
Straight voting results in a situation in which an owner of over half the voting shares can
elect the entire board of directors. The state of Delaware allows only straight voting of
directors, unless a company specifically affirmatively “opts in” to cumulative voting in its
certificate of incorporation. Because of the advantages of straight voting to large stock-
holders (often corporate insiders or institutional investors), over 50 percent of all publicly
traded corporations are incorporated in Delaware.
Proxy Votes. Most shareholders do not attend annual meetings. Most corporations antic- ipate this and routinely mail proxies to their stockholders prior to the annual meeting. A
completed proxy returned to the issuing firm allows stockholders to vote by absentee bal- lot or authorize representatives of the stockholders to vote on their behalf. It is estimated
that, on average, less than 30 percent of the total possible votes are cast at corporate meet-
ings. However, use of the Internet may increase this number in the future. By the 2010s,
virtually all U.S. firms were putting proxy statements online and allowing votes to be cast
via the Internet. The entire documentation delivery process can be electronically auto-
mated with the use of services such as Computershare or Automatic Data Processing’s
(ADP’s) ProxyVote. Official documentation is delivered in electronic form to sharehold-
ers, who log onto the system with a control number or personal identification number and
vote for or against the resolutions presented.
Preferred Stock
Preferred stock is a hybrid security that has characteristics of both bonds and common stock. Preferred stock is similar to common stock in that it represents an ownership interest in
the issuing firm, but like a bond it pays a fixed periodic (dividend) payment. Preferred stock
is senior to common stock but junior to bonds. Therefore, preferred stockholders are paid
only when profits have been generated and all debt holders have been paid (but before com-
mon stockholders are paid). Like common stock, if the issuing firm does not have sufficient
profits to pay the preferred stock dividends, preferred stockholders cannot force the firm into
proxy
A voting ballot sent by a
corporation to its stockholders.
When returned to the issuing
firm, a proxy allows stockhold-
ers to vote by absentee ballot
or authorizes representatives
of the stockholders to vote on
their behalf.
LG 8-2
preferred stock
A hybrid security that has
characteristics of both bonds
and common stock.
For example, if candidate 1 receives 750,000 votes, and votes for the other three can-
didates are spread as follows:
Candidate 2 = 2 million votes
Candidate 3 = 150,000 votes
Candidate 4 = 100,000 votes
for a total of 3 million votes cast, candidates 1, 2, and 3 are elected to the board. Alternatively,
votes for the other three candidates can be spread as:
Candidate 3 = 751,000 votes
Candidate 2 = 750,000 votes
Candidate 4 = 749,000 votes
Again, candidates 1, 2, and 3 are elected. Indeed, any distribution of the remaining
2,250,000 votes will ensure that candidate 1 is one of the top three vote getters and will be
elected to the board. The number of shares needed to elect p directors, N p , is
N p = [( p × Number of votes available)/(Number of directors to be elected + 1)] + 1
or, in our example, to ensure the election of candidates 1 and 2, a stockholder would need
N p = [(2 × 3,000,000)/(3 + 1)] + 1 = 1,500,001 shares
and these would be split as 750,001 for candidate 1 and 750,000 for candidate 2.
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