csc3 inv products ch 8

CSI Global Education Inc.

Investment Products

CHAPTER 8: Equity Securities: Common and Preferred Shares

2CSI Global Education Inc.

Chapter Highlights The purchase of common or preferred shares represents an

‘ownership’ stake in the company. The return on the investment is tied to how well the company

does. With an investment in a corporate bond, volatility in interest rates

can have a big impact on the value of the investment. However, as a ‘creditor’ of the company bondholders are given

first priority in the event of bankruptcy.


Common Shares

Why do investors purchase common shares?

What are some of the main reasons for selecting this type of investment?


Common Share Rights & Advantages

• Potential for capital appreciation

• The right to dividends

• Favourable tax treatment for dividends and capital gains

• Voting privileges

• Limited liability

• Marketability


Dividends

• Not a contractual obligation until announced

• Record Date

– recorded shareholders on this date receive the dividend

• Cum Dividend

– if buy stock will receive dividend

– up to 3rd business day before record date

• Ex Dividend

– if buy stock will not receive dividend

– 2nd business day before record date


DividendsRegular Dividends

• payment of the dividend is maintained, barring changes to the firm’s finances/operations

Extra Dividends

• a bonus paid in addition to the regular dividend

• does not imply this extra payment will be made regularly

Stock Dividends

• in the form of additional stock rather than cash

• typically paid by rapidly growing companies

• treated as regular dividends for tax purposes


Dividends

• DRIP (Dividend Reinvestment Plan)

– dividends are used to purchase additional stock in the company and not paid as cash

– taxable same as cash dividend

– shareholders benefit by saving on commission to purchase the underlying stock

– benefit from dollar cost averaging


Restricted Shares

Shares which have the right to participate to an unlimited degree in the earnings of a company and in its assets on liquidation, but do not have full voting rights.

There are three categories of restricted or special shares:

• Non-voting

• Subordinate voting

• Restricted voting

Can you describe how they differ?


Restricted Shares (continued)

• Non-voting – shares that are not voting, except perhaps in certain limited circumstances.

• Subordinate voting – shares which carry a right to vote, where there is another class of shares outstanding that carry a greater voting right on a per share basis.

• Restricted voting – shares which carry a right to vote, subject to a limit or restriction on the number or percentage of shares that may be voted by a person, company or group.


Stock Splits & Consolidations

Stock Split

• To reduce price to a popular trading range.

• Investor owns 100 shares with a current share price of $40.

• Company announces a 2:1 split.

– 2 new shares for every 1 old share

– investor now holds 200 shares

– price adjusted to $20 a share

Impact on the investor’s proportionate ownership?


Stock Splits & Consolidations

Consolidation or Reverse Split

• To raise market price & improve a company’s ability to refinance

• 1:10 reverse split when price is 40¢

• Investor owns 1,000 shares

– 1 new share for every 10 old shares

– now hold only 100 shares

– price adjusted to $4

Impact on investor’s proportionate ownership?


Stock QuoteHigh Low Stock Div. High Low Close Change Volume

12.55 9.25 BEC .50 10.65 10.25 10.35 +.50 6,000

High – 52 week high of $12.55 per share

Low – 52 week low of $9.25 per share

BEC – Name of the company

Div. – Paid $0.50 in dividends in last 52 weeks

High – Day high of $10.65 per share

Low – Day low of $10.25

Closed – Last trade was made at $10.35

Change – The closing price was $0.50 higher than the previous

trading day’s closing trade price

Volume – 6,000 common shares traded that day


Preferred Shares

Why are they called Preferred Shares?

• Dividends must be paid before common share dividends.

• In cases of business failure, preferreds rank ahead of common shareholders.


Why Issue Preferred Shares?

Over Debt

• No “contractual obligations” to pay dividends

• No maturity date

• Greater flexibility for company

Over Common

• Preferred shareholders are only entitled to a “fixed” return(no dilution of earnings)

• No dilution of control – most are non-voting


Why Preferreds as an Investment?

• Cash flows – tax advantaged dividends

• Preference in dividends and assets on wind-ups

Dangers

• Purchasing power risk

• Increases in interest rates

• Dividends could be passed over

• The company could fail


Preferred Share Features

• Par value

• Maturity Date no maturity date

• Voting Rights non-voting if dividends paid on schedule

• Cumulative

– unpaid dividends accumulate in arrears

– preferred dividend arrears must be paid

– before common dividends paid

• Redeemable/Call Feature

• Sinking/Purchase Fund


Types of Preferreds

Retractable

• creates a “maturity” date

• investor can force company to buy back at a specified time & price

Convertible

• right to convert to common shares at specified time & price

Variable Rate

• dividend fluctuates with changes in interest rates

Foreign Pay

• dividend payable in foreign currency


Preferred Features – Convertibles

Advantages

• potential capital gain on the common

• security of preferred

• higher yield than common

Disadvantages

• lower yield than straight preferred

• price volatility if “selling off the common


Preferred Features – Retractables

Advantages

• retraction date

• desirable as market rates rise (can reinvest proceeds at a higher rate)

• price less volatile as approach retraction date

Disadvantages

• retraction privilege expires


Preferred Features – Variable

Advantages

• protection against interest rate increases

• price less volatile

Disadvantages

• dividends will decrease if interest rates fall


Preferred Features – Foreign Pay

Advantages

• if strong currency, foreign exchange gains

• possibly, receive income in currency of residence

Disadvantages

• foreign exchange risk if currency value declines


Other Types of Preferreds

• COPrS (Canadian Originated Preferred Securities)

• Preferreds with warrants

• Deferred preferreds

• Split shares

• Participating preferreds


Canadian Originated Preferred Securities• COPrS are long term (49 years) junior subordinate fixed income

instruments

• Quarterly distributions treated as interest for tax purposes

• Trade “cum dividend” – i.e. accrued interest is paid out not accumulated

• Traded on exchanges

Other:

• Can defer payments up to 5 years

• Shows up as equity on the balance sheet

• Non-callable for first 5 years



Deferred Shares:

• Pays no dividend until a future maturity date.

• Dividends compound without having to pay annual taxes.

• The ‘dividend premium’ is not eligible for the dividend tax credit.

• At maturity the accrued dividends are treated as interest income.

• If sold prior, it is treated as a capital gain (or loss).



Split Shares:

Share that have two components – equity dividend share and capital share.

Equity shares trade on yields but may share in dividends.

The maturity value of both are determined by the value of the underlying stock.


Convertible Securities Exercise

A $25 par value preferred share pays $2.50 in dividends and can be converted into 2 common shares.

Interest rates in the market for similar risk securities have a 9% yield.

The common currently trades at $10 a share, while the preferreds trade at $32 a share.



What is the conversion value of the preferreds?

2 shares at $10 a share = $20

This is the value of the common stock that the preferreds can be converted into



If the common share price rises to $15, and interest rates do not change, what is the conversion value? Will this impact the ‘pure’ value of the preferreds?

Conversion value

= 2 shares × $15 = $30



With the common at $15 and the preferreds at $32, what is the conversion cost premium?

$32 – (2 shares × $15) = $2

Or $2/$30 = .06667 (6.67%)

The premium reflects the fact that the preferreds currently sell above the conversion value of the common.



If the dividend yield on the common shares is 5% and 7.8%on the preferreds, what is the payback period?

Pay back premium = 6.67/(7.8 – 5) = 2.38 years


Convertible Securities

Rule:

“Convertible securities trade at the higher of eithertheir conversion value or their pure investment value.”

csc3 inv products ch 8

Economy & Finance

convertible securities exercise

investors proportionate ownership

stock splits

time

buy stock

interest rates

common shares

business day