Chapter 9 – Corporate Financial Structure

Corporate Finances:  Key Terms

• Security:  a share, participation, or other interest in property or an enterprise of the issuer or an obligation of the issuer
• Equity Security:  a security representing ownership interest in an enterprise (often called a share)
• Equity Capital:  capital received by a corporation in return for issuance of stock
• Debt Security:  a security representing an obligation of the corporate issuer (often called a bond)
• Debt Capital:  money received by a corporation in return for issuing debt securities
• Bondholder:  one to whom a debt is owed by a corporation
• Dividend:  a distribution of corporate profits
• Types of Stock
  • Common Stock:  Ordinary stock of a corporation having no special privileges
  • Preferred Stock:  Stock in a corporation that carries certain rights and privileges
• Types of Rights
  • Voting rights
  • Distribution rights
    • Cumulative distribution—must be paid once a corporation has funds to do so
    • Noncumulative distribution—does not accumulate; lost if it cannot be paid
  • Liquidation rights
  • Conversion rights—right to convert preferred stock into some other form of equity security, usually common stock
  • Redemption rights—right to compel a stockholder or a corporation to sell or buy stock back
    • Call—rights of corporation to require shareholders to sell stock back to the corporation
    • Put—right of shareholder to require corporation to buy stock from shareholders

Comparison of Common and Preferred Stock

• Voting Rights
  • Common Stock – Usually one vote per share
  • Preferred Stock – Voting rights may or may not exist; articles will specify.  Voting rights are somewhat rare
• Distribution Rights 
  • Common Stock – No right to distributions; distributions declared in discretion of board and corporation must be solvent
  • Preferred Stock -Distributions are usually “guaranteed” and may be cumulative
• Liquidation Rights 
  • Common Stock – Shareholders receive assets after distribution to creditors and then preferred shareholders
  • Preferred Stock -Shareholders receive assets after creditors and before common shareholders
• Conversion Rights
  • Common Stock -No conversion rights
  • Preferred Stock -Shareholders may have right to convert their preferred shares into some other type of shares
• Redemption Rights
  • Common Stock – No redemption rights
  • Preferred Stock -Shareholders may be forced to sell their stock back to corporation or to compel corporation to purchase their stock at agreed-upon price

Unsecured debt

• Unsecured debt:  Debt for which no collateral is pledged
• The corporation’s obligation will be set forth in a loan agreement in a simple document called a promissory note.

Secured debt

• Secured debt:  Money borrowed by a corporation backed by collateral that can be seized in the event of nonpayment.
• The document evidencing the corporation’s obligation to repay—often called a bond—will specify the principal amount due, the interest required, the date of repayment, the property pledged to secure repayment of the loan, and any other rights to the bondholder or lender.

Comparison of Equity and Debt Securities

• Equity Securities
  • Shareholder is an owner of the corporation and is entitled to vote and receive distributions, if earnings permit
  • Issuance of shares produces cash for the corporation
  • Issuance of shares dilutes power of existing shareholders but costs the corporation nothing
  • If corporation is insolvent, no distributions will be paid to any shareholder
  • Corporation may not deduct distributions paid to shareholders

  • In the event of liquidation, shareholders receive assets after outside creditors/bondholders

• Debt Securities
  • Creditor or bondholder is an outside creditor of the corporation and is entitled to timely repayment of the debt
  • Borrowing money produces cash for the corporation
  • Borrowing money does not dilute the power of existing shareholders but money borrowed must be repaid
  • Creditor or bondholder will be entitled to periodic payments of interest and principal or repayment of the debt
  • Corporation may deduct interest paid to creditors and bondholders and reduce taxable income

  • In event of liquidation, creditors and bondholders receive assets before shareholders

Double taxation

• Corporations are subject to double taxation. 
• Corporations pay tax at specified corporate rates on income
• When net profits are distributed to shareholders, the shareholders pay income tax on distributions received at the applicable tax rates

Avoiding double taxation

• Electing S corporation status
• Debt financing: elect to obtain funds through debt financing, because interest paid to creditors is a deductible corporate expense
  • Thin capitalization:  a corporation whose debts are disproportionately high to its equity
  • Accumulated earnings tax:  tax penalty imposed on corporation that retain earnings beyond reasonable business needs
• Tax inversions—reincorporating a U.S. company in a country with lower tax rate to reduce U.S. taxes

Key Features of Corporate Finances

• To raise money, corporations will issue stock (equity securities), which show ownership interest in the corporation or bonds (debt securities), which are loans to the corporation.
• Shares issued by a corporation must be authorized by the articles.
• The par value of a share is the lowest price for which it can be sold.

Key Features of Corporate Finances

• If stock has no par value, it can be sold for whatever amount the directors determine is in the best interest of the corporation.
• Corporations may have more than one class of stock.
• “Common” stock is ordinary stock of the corporation and usually has voting rights, distribution rights, and liquidation rights.

Key Features of Corporate Finances

• “Preferred” stock has some sort of right or preference other classes do not have, often as to cumulating dividends, conversion, or redemption.
• Debt securities may be unsecured, in which case, in the event of a default, the creditor simply sues to recover the amount lent to the corporation.
• Debt securities may be secured by real estate or personal property; in the event of a default the creditor can recover the property pledged as security or collateral.

Key Features of Corporate Finances

• Debt securities may have favorable redemption terms or conversion terms.
• Corporations are said to be subject to “double taxation”; the corporation pays tax on money it earns, and shareholders then pay tax on distributions made to them.  Interest paid on bonds is a deductible expense for a corporation.