Foundations of Financial Management: An Analysis (part 67)

What we really want to do is what we are really meant to do. When we do what we are meant to do, money comes to us, doors open for us, we feel useful, and the work we do feels like play to us. 

Julia Cameron

Common and Preferred Stock Financing

(part C)

by

Charles Lamson

American Depository Receipts

American Depository Receipts (ADRs) are certificates that have a legal claim on an ownership interest in a foreign company's common stock. The shares of the foreign company are purchased and put in trust in a foreign branch of a major U.S. bank. The bank, in turn, receives and can issue depository receipts to the American shareholders of the foreign firm. These ADRs (depository receipts) allow foreign shares to be traded in the United States much like common stock. ADRs have been around for a long time and they are sometimes referred to as American Depository Shares (ADSs).

Since foreign companies want to tap into the world's largest capital market, the United States, they need to offer securities for sale in the United States that can be traded by investors and have the same liquidity features as U.S. securities. An American investor (or any foreign investor) can buy American Depository Shares of several hundred foreign companies listed on the New York Stock Exchange or the over-the-counter Nazdaq market. 

There are many advantages to American Depository Shares for the U.S. investor. The annual reports and financial statements are presented in English according to generally accepted accounting principles. Dividends are paid in dollars and are more easily collected than if the actual shares of the foreign stock were owned. Although ADRs are considered to be more liquid, less expensive, and easier to trade than buying foreign companies' stock directly on that firm's home exchange, there are some drawbacks.

Even though the ADRs are traded in the US market in dollars, they are still traded in their own country in their local currency. This means that the investor in ADRs is subject to a foreign currency risk if the exchange rates between the two countries change. Also, most foreign companies do not report their financial results as often as U.S. companies. Furthermore, there is an information lag as foreign companies need to translate their reports into English. By the time the reports are translated, some of the information has already been absorbed at the local markets and by International traders,

Preferred Stock Financing

Preferred stock is an intermediate or hybrid form of security. You may question the validity of the term preferred, for preferred stock does not possess any of the most desirable characteristics of debt or common stock. In the case of debt, bondholders have a contractual claim against the corporation for the payment of interest and may throw the corporation into bankruptcy if payment is not forthcoming. Common stockholders are the owners of the firm and have a residual claim to all income not paid out to others. Preferred stockholders are merely entitled to receive a stipulated dividend and, generally, must receive the dividend before the payment of dividends to common stockholders. However, their right to annual dividends is not mandatory for the corporation, as is true of interest on debt, and the corporation may forgo preferred dividends when this is deemed necessary.

For example, XYZ Corporation might issue 9 percent preferred stock with a $100 par value. Under normal circumstances, the corporation would pay the $9 per share dividend. Let us also assume it has $1,000 bonds carrying 9.2 percent interest and shares of common stock with a market value of $50, normally paying a $1 cash dividend. The 9.2 percent interest must be paid on the bonds. The $9 preferred dividend has to be paid before the $1 dividend on common stock, but both may be waived without threat of bankruptcy. The common stockholder is the last in line to receive payment, but the stockholders potential participation is unlimited. Instead of getting a $1 dividend, the investor may someday receive many times that much in dividends and also capital appreciation in stock value.

Justification for Preferred Stock

Because preferred stock has a few unique characteristics, why might the corporation issue it and, equally important, why are investors willing to purchase the security?

Most corporations that issue preferred stock do so to achieve a balance in their capital structure. It is a means of expanding the capital base of the firm without diluting the common stock ownership position or incurring contractual debt obligations.

Even here, there may be a drawback. While interest payments on debt are tax-deductible, preferred stock dividends are not. Thus, the interest cost on 10 percent debt may be only 6.5 to 7 percent on an aftertax cost basis, while the after-tax cost on 10 percent preferred stock would be the stated amount. A firm issuing the preferred stock may be willing to pay the higher aftertax cost to assure investors it has a balanced capital structure, and because preferred stock may have a positive effect on the costs of the other sources of funds in the capital structure.

Investor Interest Primary purchasers of preferred stock are corporate investors, insurance companies, and pension funds. To the corporate investor, preferred stock offers a very attractive advantage over bonds. The tax law provides that any corporation that receives either preferred or common dividends from another corporation must add only 30 percent of such dividends to its taxable income. Thus, 70 percent of such dividends are exempt from taxation. On a preferred stock issue paying a 10 percent dividend, only 30 percent would be taxable. By contrast, all the interest of bonds is taxable to the recipient except for municipal bond interest.

Summary of Tax Considerations Tax considerations for preferred stock work in two opposite directions. First, they make the aftertax cost of debt cheaper than preferred stock to the issuing corporation because interest is deductible to the payer. (This is true even though the quoted rate may be higher.) Second, tax considerations generally make the receipt of preferred dividends more valuable than the corporate bond interest to corporate investors because 70 percent of the dividend is exempt from taxation. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 514-518*

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