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As we have seen, a company can raise funds by selling ownership
in itself to investors.These funds would form the equity portion of
a companys capital structure. In return,the investors would receive
shares in the company, representing their degree of owner-ship.
Their investment would be tied directly to the fortunes of the
company. As the companyearned profits and retained some or all of
them, its equity value would grow. This increases thenet asset
value of each common share and makes them more attractive to
investors. Growingprofits could also mean an increase in dividends
paid out to shareholders, which would alsoenhance the appeal of the
shares. As the companys shares became attractive to new
investors,they would be bid up in price, providing a potential gain
to existing shareholders.
Conversely, a series of losses could eat away at retained
earnings and thereby reduce the equityvalue of the shares. A
company without profits would be unlikely to increase its
dividends. Itwould be more inclined to cut them to conserve cash.
These events would probably cause adecline in the share price and
in the value of the shareholders investment.
All corporations, whether public or private, listed or unlisted,
issue common shares. In addition,some companies issue preferred
shares. A common share is entitled to a proportion of a compa-nys
equity relative to the total number of common shares. It will have
a varying equity worth asthe companys equity and number of
outstanding shares varies.
A preferred share is entitled to a fixed amount of equity,
determined when the share is firstissued. A series of profitable
years will increase the equity value of common shares, as
retainedearnings and therefore common equity grow, but will have no
effect on the equity value of pre-ferred shares. The two types of
shares appeal to two distinct types of investors. Common sharesare
bought by those looking to profit from the ongoing success of the
issuer. Preferred sharesappeal to those wanting steady dividend
income and a place in line ahead of the common share-holders should
the company dissolve.
The stock market is a leading indicator of the direction of the
business cycle. Exchanges andother financial institutions create
indexes to track the movement of these markets. These indexesare
discussed at the end of this chapter.
A. COMMON SHARESCommon shareholders are the owners of a company
and initially provide the equity capital tostart the business.
If the venture prospers, the shareholders benefit from the
growth in value of their originalinvestment and the flow of
dividend income. The prospect of a small investment growing tomany
times its original value attracts many investors to common
shares.
On the other hand, if the business fails, the common
shareholders may lose their entire invest-ment. This possibility of
total loss explains why common share capital is sometimes referred
toas venture or risk capital.
Although part owner of the business, the common shareholder is
in a relatively weak position, assenior creditors (such as banks),
bond and debenture holders and preferred shareholders all haveprior
claims on the earnings and assets of the company. Unlike debt
interest, dividends are
Chapter 6
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payable at the discretion of the Board of Directors. In many
companies dividend pay-ments are a routine matter and can be
regularly anticipated by shareholders. For compa-nies in cyclical
industries, there is less certainty. Some companies reinvest all
earnings inthe business; others lack sufficient earnings to pay
dividends.
For many years, a purchaser of common shares was given a
certificate with the companyname and number of shares engraved on
it. Some of these certificates were quite elabo-rately done, with
an illustration relating to the companys business. For the most
part,the securities industry has moved away from a paper-based
system of ownership.Instead, street certificates are registered in
the name of a securities firm rather than theowner of the shares.
This procedure is often followed because, like a bond in
bearerform, a share certificate in street name is negotiable, that
is, readily transferable to a newowner.
The Canadian Depository for Securities Limited offers
computer-based systems toreplace certificates as evidence of
ownership in securities transactions. This systemalmost eliminates
the need to handle securities physically.
B. RIGHTS AND ADVANTAGES OF COMMON SHARE OWNERSHIP
The following are some of the benefits of owning common
shares:
Potential for capital appreciation;
The right to receive any common share dividends paid by the
company;
Voting privileges including the right to elect directors, to
approve financial state-ments, and auditors reports, and vote on
other important issues;
Favourable tax treatment in Canada of dividend income and
capital gains;
Marketability shareholdings can easily be increased, decreased
or sold for mostpublic companies;
The right to receive copies of the annual and quarterly reports,
and other mandato-ry information pertaining to the companys
affairs;
The right to examine certain company documents such as the
by-laws and registerof shareholders at specified times;
The right to question management at shareholders meetings;
and
Limited liability.
1. Capital Appreciation
For many investors the prospect of capital appreciation is the
main attraction of com-mon shares. Stocks have proven over time
that such an attraction is justified, althoughnot all common shares
fulfil this expectation, and even those that do will not
necessarilyincrease in value every year.
As companies earn profits year after year, whatever money is not
paid out to sharehold-ers in the form of dividends will remain in
the company as retained earnings. Sinceretained earnings form part
of common equity, a growth in retained earnings will add tothe
value of shareholders equity. Assuming a fairly constant number of
shares outstand-ing, the amount of equity that belongs to each
share will increase. Since investors relatethe price they are
willing to pay to a shares equity or book value, a higher equity
pershare value will lead to a willingness on the part of investors
to pay more to acquirethese shares.
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Annual growth in the size of a companys profits also makes its
shares attractive toinvestors. Anticipation that this growth will
continue will increase the earnings multiple(i.e., the
price/earnings ratio) that investors will be willing to pay for the
stock.Increased earnings can lead also to an increase in the
dividend rate. Since yield is anoth-er factor that investors take
into account when evaluating stocks, dividend growth canlead to
stock price increases.
There are many other factors, both within the company and
externally, that can affect acompanys stock price, and careful
analysis and selection are required to ensure a prof-itable
investment. Analysis of these factors is covered in Chapter 8.
2. Dividends
A companys net earnings after the payment of preferred dividends
are available:
For distribution as common share dividends;
As funds to be kept by the company as retained earnings and
reinvested in the busi-ness; or
As a combination of the preceding.
Companies vary widely in the percentage of earnings they pay to
common shareholders.Payout ratios vary greatly from one industry to
another. Mature companies, such asbanks, may pay out a substantial
percentage of their earnings as dividends to sharehold-ers. While
growing companies such as those in the technology field may need to
keep ahigh proportion of earnings within the company to fund the
large amount of researchand development that are crucial to their
success. Dividend policy is determined by theBoard of Directors who
are guided primarily by the goals set for the company.
To maintain its operations and finance future growth
opportunities, most companieswill retain a portion of earnings each
year. In the long run this policy may work to thebenefit of
shareholders if it results in increased earnings.
Reductions or omissions of dividends do occur, particularly in
poor economic times,and, although they may be temporary, they do
emphasize the risks of common shareinvestment.
Restrictions in the trust deed of outstanding bond issues or
preferred covenants oftenrequire that working capital be maintained
at a certain level before dividends can bepaid on the common
shares.
a) Regular and Extra Dividends
Some companies paying common share dividends designate a
specified amount that willbe paid each year as a regular dividend.
The term regular indicates to investors that pay-ments will be
maintained barring a major collapse in earnings.
Some companies may also pay an extra dividend on the common
shares, usually at theend of the companys fiscal year. The extra is
a bonus paid in addition to the regularpayout but the term extra
cautions investors not to assume that the payment will berepeated
the following year. If the companys earnings are maintained, the
extra may berepeated. However, directors can omit the extra at
their discretion just as they can withregular dividends.
In calculating an indicated annual yield for a common stock, it
is accepted practice toinclude extra dividends if there is strong
evidence that the extra dividend will be paidagain. However, when
factors such as declining earnings suggest the extra will not
berepeated, then the indicated yield is best calculated on the
regular indicated dividend.
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b) Declaring and Claiming Dividends
Unlike interest on debt, dividends on common shares are not a
contractual obligation.The Board of Directors decides whether to
pay a dividend, the amount and paymentdate. An announcement is made
in advance of the payment date. Companies may paydividends
quarterly, semi-annually or annually.
If the shares are registered in the name of the owner, dividend
payment cheques aremailed directly to the owner. For shares
registered in street certificate form, dividendpayments are made to
the securities firm whose name appears on the certificate.
Thedividends are then credited to the accounts of the firms clients
who own the shares.
c) Ex-Dividend/Cum Dividend
Many companies place advertisements in financial newspapers
announcing the declara-tion of a dividend. Exhibit 6.1shows a
typical dividend announcement.
EXHIBIT 6.1
Notice of Dividend
NOTICE is hereby given that a dividend has been declared on the
capital stock of the Company as follows:
Common Shares . . . . . . . . . . . . .$1.50 per share
The dividend will be payable July 2, 20** to shareholders of
record at the close of business on the13th day of June, 20**.The
transfer books will not be closed. Payment will be made in Canadian
funds:
By Order of the Board
K. C. JONESSecretary.
Vancouver, June 2, 20**
The purpose of the interval between June 13 and July 2 is to
give the company time toprepare the dividend cheques for mailing to
recorded shareholders. During this intervala purchaser of these
shares will not receive the dividend that has just been declared
andthe stock is said to be ex-dividend.
When a stock is actively traded, the record of shareholders is
continually changing. Forconvenience, the company names a date
known as the dividend record date. All share-holders, recorded as
of this date will be entitled to the dividend. The dividend
recorddate is usually two to four weeks in advance of the payment
date in order to allow timefor cheque preparation.
To determine whether the seller or the buyer is entitled to the
dividend when a saletakes place around the time of the dividend
payment, the stock exchange names an ex-dividend date. On and after
this date, the stock sells ex dividend; that is, the sellerretains
the dividend and the buyer is not entitled to it. The ex dividend
date is set at thesecond business day before the dividend record
date. Since trades settle on the third busi-ness day after a trade,
a purchaser of shares two days before the record date would nothave
the trade settle until the day after the record date, and would
therefore not be ashareholder of record for purposes of receiving
the dividend. Exhibit 6.2 provides anexample of how the shares
trade.
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EXHIBIT 6.2
Trading Ex- and Cum Dividend
Using the dates in Exhibit 6.1, and assuming that all are
business days, the shares wouldtrade as follows:
Date Traded Date Settled Ex- or Cum Dividend
June 9 June 12 Cum Dividend
June 10 June 13 Cum Dividend
June 11 June 16 Ex-dividend
June 12 June 17 Ex-dividend
June 13 June 18 Ex-dividend
June 16 June 19 Ex-dividend
The major Canadian stock exchanges publish dividend
announcements in their dailyreleases to securities firms in the
following form:
Share- ExWhen Holders Dividend
Payment Payable of Record* Date
A Company .25 June 15 May 14 May 12
B Company .50 August 5 July 15 July 13
*or Dividend Record Date
Stocks going ex dividend sometimes start trading at a price
reduced by the exact amountof the dividend. Securities firms
holding open orders to buy or open stop orders to sellautomatically
reduce such orders by the amount of the dividend when the stock
starts totrade ex dividend (unless otherwise advised). Open sell
orders and open stop orders tobuy are not reduced. An open order is
a type of order that is usually entered at a speci-fied price to
buy or sell a security and is held open until executed or
cancelled. Adjustingopen orders is a standard approach used within
the securities industry.
These same general principles apply when a security is quoted
ex-rights (explained inChapter 7).
The person who buys the stock on the day that it goes ex
dividend does not get thedeclared dividend, but will of course
receive subsequent dividends as long as the sharesare held.
The expression cum dividend means the reverse. Trades during
this period result in thepurchasers receiving the declared
dividend. The last day a stock trades cum dividend isthe third
business day before the dividend record date; in other words, it is
the daybefore the first ex dividend date.
d) Dividend Reinvestment Plans
Some major companies give their preferred and common
shareholders the option ofparticipating in an automatic dividend
reinvestment plan. In such a plan, the companydiverts the
shareholders dividends to the purchase of additional shares of the
company.Reinvested dividends are taxable to the shareholder as
ordinary cash dividends eventhough the dividends are not received
as cash.
Share purchases in most dividend reinvestment plans are made on
the open marketunder the direction of a trustee. Participating
shareholders are periodically sent a state-
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ment showing the number of shares, including fractional shares
in some cases, boughtunder the plan and at what price. BCE Inc. and
Enerplus Resources Fund are examplesof major companies offering
dividend reinvestment plans.
Since under a reinvestment plan the company uses authorized
dividends to purchaseadditional shares in bulk, a saving in
commission is achieved. An individual shareholdertrying to buy the
same small number of shares would normally pay a higher
commis-sion, particularly if odd lots were involved.
In effect, a dividend reinvestment plan is an automatic savings
plan which solves theproblem of reinvesting small amounts of cash.
Participating shareholders acquire a gradu-ally increasing share
position in the company and because purchases by the plan aremade
regularly, the advantages of dollar cost averaging are obtained.
The provision insome plans for crediting participating shareholders
with applicable fractions of shares isunique. Normally fractions of
shares cannot be purchased in the market by a shareholder.
Some companies offer variations on this type of reinvestment
plan and permit share-holders to make additional cash contributions
to the plan, perhaps up to a fixed amount(e.g., $1,000 to $3,000
per quarter). Another variation is to apply the funds for
rein-vestment to the purchase of unissued treasury shares at a
specified discount from theprevailing open market price.
e) Stock Dividends
Sometimes the dividend may be in the form of additional stock
rather than cash. Oftensuch dividends are paid from time to time by
a rapidly growing company that needs toretain a high degree of
earnings to finance future growth. The advantage to the compa-ny is
that cash is conserved for expansion purposes while shareholders
receive additionalshares, which can be sold if they require the
cash. These stock dividends would berecorded on the Statement of
Retained Earnings in the same fashion as cash dividends.
Since stock dividends are treated as regular cash dividends for
tax purposes, manyinvestors, given the option, elect to receive
dividends in cash.
3. Voting Privileges
Voting rights are an important feature of common shares. Through
the right to vote atthe annual meeting and at special or general
meetings, shareholders exercise their rightsas owners to control
the destiny of the corporation. They elect the directors who
guideand control the business operations of the corporation through
its officers. Many mat-ters of an unusual, non-recurring nature,
such as the sale, merger or liquidation of thebusiness and the
amendment of the charter must receive shareholder approval
beforeaction is taken.
However, many companies have two or even three different types
of shares, often desig-nated as Class A or B. Because all classes
may not have voting rights and may differ inother respects such as
dividend entitlement, it is important to know their respective
fea-tures.
a) Restricted Shares
Restricted shares are shares which have the right to participate
to an unlimited degreein the earnings of a company and in its
assets on liquidation, but do not have full vot-ing rights. There
are three categories of restricted or special shares:
Non-voting shares which have no right to vote, except perhaps in
certain limitedcircumstances;
Subordinate voting shares which carry a right to vote, where
there is another classof shares outstanding that carry a greater
voting right on a per share basis; and
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Restricted voting shares which carry a right to vote, subject to
a limit or restrictionon the number or percentage of shares that
may be voted by a person, company orgroup.
Beginning in 2004, the Toronto Stock Exchange and TSX Venture
Exchange beganidentifying stock listings by the type of
non-conventional voting structure that eachsecurity offers. These
voting structures are:
NV non-voting shares.
SV subordinate-voting shares.
RV restricted-voting shares.
For example: Power Corporation currently has an issue of
subordinated common sharesoutstanding. These shares are listed
under the symbol POW.SV on the TSX.
In recent years the number of companies issuing restricted
shares has increased substan-tially. Some investors have become
concerned and have resisted reorganizations whichinvolve the
creation of restricted shares.
Canadian securities regulators have introduced policies
regarding these shares. InOntario, for example, the details of
these policies are set out in Ontario SecuritiesCommission Policy
1.3. Investment Advisors should be able to identify restricted
sharesand understand the implications of the differences in the
voting rights of such shares inorder to advise their clients
properly.
b) Rights and Benefits of Restricted Shares
Like common shares, restricted shares participate in the
earnings of a company and in itsassets on winding up or
liquidation. While being subject to the same risks as holders
ofcommon shares, holders of restricted shares may have little or no
voice in the affairs ofthe company. Many of the rights and remedies
available to shareholders under corporateand securities law are
conditional upon the shares carrying voting rights. Under
corporatelaw, these rights include requisitioning of shareholders
meetings and initiation of share-holder proposals, election of
directors, approval of financial statements, confirmation ofby-law
amendments, and, in many circumstances, prior approval of
fundamental changesin the business, operations or capital of the
company. Examples of fundamental changesinclude the sale of
substantially all the assets and increases in the authorized
capital.
Reference should be made to a companys charter, the notes to
financial statements inthe annual report and the governing
corporate statute to determine the rights and bene-fits attached to
particular classes of restricted shares.
c) Stock Exchange Regulations Regarding Restricted Shares
The stock exchanges have urged companies having or issuing
restricted shares to put inplace provisions to ensure that the
holders of restricted shares are treated fairly.
Some of the regulations published by the stock exchanges and
securities commissions are:
Restricted shares must be identified by the appropriate
restricted share term;
Disclosure documents such as information circulars, annual
reports and financialstatements which are sent to voting
shareholders must be sent to holders of restrict-ed shares and must
describe the restrictions on the voting rights of the
restrictedshares;
Restricted shares must be identified in the financial press with
a code;
Dealer and advisor literature must properly describe restricted
shares;
Trade confirmations must identify restricted shares as such;
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Holders of restricted shares must be given notice of, be invited
to attend and bepermitted to speak at shareholders meetings;
and
Minority approval is required for any corporate action, which
would result in thecreation of new restricted shares.
Advisors should be aware of the protection offered to restricted
shareholders, as theextent of such protection may vary.
4. Tax Treatment
The tax system in Canada provides some benefits to investors
holding common shares.
A dividend tax credit is available that makes the purchase of
dividend-paying sharesof taxable Canadian companies relatively
attractive compared to interest payingsecurities;
The current exemption from tax of 50% of capital gains provides
investors with atax inducement to buy shares; and
Stock savings plans entitle residents of some provinces to
deduct up to specifiedannual amounts from (or obtain a tax credit
for) the cost of certain stocks pur-chased in their respective
provinces during the year.
a) Dividends from Taxable Canadian Corporations
Although greater risk is involved in owning common and preferred
shares compared toowning debt securities, the pre-tax yield from
common and preferred shares is normallybelow the yields available
from debt investments. This is due to the tax treatment ofinterest
received versus dividends received.
When a company pays interest on its debt, the interest is paid
with the companys pre-tax dollars because interest is considered a
tax-deductible cost of doing business. Whenbond or debenture
holders receive interest, it is treated as taxable income in their
hands.
When a company pays dividends on its shares, the dividends are
paid with after-tax dol-lars because dividends, being a share of a
companys profits, are not considered a tax-deductible cost of doing
business. When shareholders receive dividends, the dollarsinvolved
have already been subject to tax in the companys hands prior to
payout. Toalleviate double taxation, shareholders of Canadian
companies receive tax relief throughthe dividend tax credit.
This procedure is applicable to dividends received from resident
taxable Canadian cor-porations. No similar preferential treatment
is applicable to interest income, foreign div-idends or dividends
from nontaxable Canadian corporations. The taxpayer is required
togross-up the amount of the dividend by 25%. For example, if an
individual receives a$160 dividend, it would be reported for tax
purposes as $200 (125% of $160) in netincome. The additional $40 is
referred to as the gross-up and the $200 is known as thetaxable
amount of dividend.
The taxpayer calculates net income using the $200 amount, and
can then claim a creditin the amount of:
13.33% of the taxable amount of dividend
or
13.33% x $200 = $27
All provinces and territories provide a dividend tax credit as
well. Examples of this cal-culation are shown in greater detail in
Chapter 13, Financial Planning and Taxation.
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b) Minimizing Taxable Income on After-Tax Yield of
Investments
Dividends from taxable Canadian corporations (but not foreign
corporations) are sub-ject to less tax than interest. At the lower
tax brackets, these dividends are more taxeffective. Accordingly, a
shift of investments from interest paying investments into
divi-dend-paying Canadian stocks may reduce taxes and improve
after-tax yield.
c) Tax on Foreign Dividends
Individuals who receive dividends from non-Canadian sources
usually receive a netamount from these sources, as taxes are
usually deducted at source. Such investors maybe allowed a
deduction from the Canadian income tax otherwise payable. The
allowablecredit is essentially the lesser of the foreign tax paid
and the Canadian tax payable onthe foreign income, subject to
certain adjustments. Details on foreign tax deductions areavailable
from the Canada Revenue Agency (CRA).
d) Capital Gains and Losses
Investors are taxed on any capital gains or losses earned from
their investments.Basically, a capital gain arises from the sale
(or the deemed sale) of a capital property formore than its cost. A
capital loss arises from the sale of a capital property for less
thanits cost. Any capital gains earned must be reported and 50% of
the gain must be includ-ed in income for that year and taxed at the
investors marginal tax rate. Capital lossescan be used to reduce
any capital gains that have been earned, but generally cannot
beused to reduce any other income. The taxation of capital gains
and losses are covered inmore detail in Chapter 13.
5. Marketability
The right to buy or sell common shares in the open market at any
time is an attractivefeature and a relatively simple matter with
few legal formalities.
When a company first sells its shares to investors, the proceeds
from the sale go to thecompany. When these outstanding shares are
subsequently sold by their holders, theselling price is paid to the
seller of the shares and not to the corporation. Shares,
there-fore, may be transferred from one owner to another without
affecting the operations ofthe company or its finances. From the
companys point of view, the effect of a sale issimply that a new
name appears on its list of shareholders.
6. Stock Splits and Consolidations
a) Stock Splits
The common shares of a prospering corporation can rise
substantially in price overtime. Most companies believe it is good
corporate strategy to keep the market price oftheir shares in a
popular price range, say $10 $20, and use a stock split or
subdivisionto bring a high-priced stock into this range.
The mechanics of a stock split are straightforward. First, the
companys directors passand submit a by-law for approval by a vote
of the voting common shareholders at a spe-cial meeting. Depending
on the current market price of the shares, the split could be onany
basis such as two new shares for one old share; or three new for
one old; or even tenfor one.
When a split becomes effective, the market price of the new
shares reflects the basis ofthe split. For example, in a
four-for-one split, the market price of shares selling at
$100(pre-split basis) will sell somewhere in the $25 range after
the split. An investor whoowned 1,000 shares of the company would
now own 4,000 shares.
When a split is first announced, the initial effect on the
market price of the stock maybe bullish. There can be a modest
surge in the price of the shares on increased volume.
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Dividend increases, often announced at the same time, contribute
to the initial bullishimpact. The effect of a split on the shares
market price after the initial flurry dependson several important
factors such as the companys earnings trend and the stage of
theequity cycle (described later).
Although investor aversion to purchases of odd-lots of
high-priced shares is usually citedas the main reason for splits,
commissions on odd-lot trading may also be a factor. Thelonger-term
results of a split may be to broaden the distribution of a companys
shares,increase marketability and, thus, facilitate equity
financing if required in the future.
While stock splits are associated with active and buoyant stock
markets and are general-ly viewed in a positive light, the split
itself does not affect the dollar value of a compa-nys equity, nor
the value of a shareholders stake. Equity per share would be
reduced, asthe total number of shares outstanding would increase;
but the equity section of the bal-ance sheet would remain
unchanged. Each individual shareholder would own moreshares, but
there would be a greater number of total shares outstanding, so
proportion-ate ownership would stay the same. Exhibit 6.3
illustrates the impact a stock split hason the financial structure
of the company and its shareholders.
EXHIBIT 6.3
Effect of Stock SplitA company announces a 4 for 1 stock
split.
Before the stock split After the stock split
# of shares outstanding 1,000,000 4,000,000
Approximate market price per share $100 $25
Capitalization of company $100,000,000 $100,000,000
# of shares owned by investor 50,000 200,000
Dollar value of Shares owned by Investor A $ 5,000,000 $
5,000,000
Investor As proportionate ownership in company 5% 5%
b) Reverse Splits or Consolidations
Reverse stock splits or consolidations can occur with the result
that each shareholderstotal shareholdings in a company are reduced.
If a reverse split of one new share for fourold was implemented
after shareholder approval, a shareholder owning 100 shares ofstock
would own only 25 new shares after the split. The total dollar
value of the hold-ings should theoretically not be affected. If the
shares were selling at $0.25 before thesplit, the new shares would
probably trade near $1.00 per share.
Reverse splits occur most frequently when a companys shares have
fallen in value to alevel that is unattractive to investors with
large amounts of capital. They are utilizedwhen a company is in
danger of being delisted by a stock exchange as the companysshare
price has fallen below the exchanges minimum share price rule.
For example, in March 2003, the price of the common shares of
Aventura Energy Inc.had fallen to $0.41. This price level was so
low that it discouraged purchases by institu-tional investors who
had policies of avoiding shares with low prices. The
companyresponded by implementing a 1 for 10 reverse split that
raised the price to more than$4.00 per share.
A reverse split raises the market price of the new shares and
can put the company in abetter position to raise new capital.
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7. Reading Stock Quotations
In the financial press, stocks are listed in alphabetical order.
Quotes sometimes appear intwo separate sections: high, low and
closing prices for stocks that traded during the dayunder review
and bid and ask quotations for stocks that didnt trade.
There are two kinds of stocks traded during the day under
review: those that are listedand thus traded on the stock
exchanges, and the unlisted stocks that trade on the
over-the-counter market.
A typical quotation for stocks traded in Canada during the day
under review is shownhere:
52 weeks
High Low Stock Div. High Low Close Change Volume12.55 9.25 BEC
.50 10.65 10.25 10.35 +.50 6,000
This type of quotation is complex but very useful and may vary
in format among finan-cial newspaper quotation sections. This
quotation means that:
BEC common has traded as high as $12.55 per share and as low as
$9.25 duringthe last 52 weeks;
BEC common has paid dividends totalling $0.50 per share during
the last 52 weeks(sometimes an indicated dividend rate may be shown
if the company pays regulardividends and has recently increased a
dividend payment). Unlisted stocks tend notto pay dividends,
therefore this column is omitted from TSX Venture Exchange
andUnlisted tables; and
During the day under review, BEC common shares traded as high as
$10.65 and aslow as $10.25. The last trade of the day in this stock
was made at $10.35 and theclosing trade price was $0.50 higher than
the previous trading days closing tradeprice. A total of 6,000 BEC
common shares traded that day.
Some financial publications give additional information about
the stock, including theyield, price earnings ratio and the
earnings per share.
Market prices used in stock quotations apply to trades in board
lot sizes of the stockand exclude commission expense for trades in
listed stocks. Financial publications gen-erally provide
information on how to read their quotations. To understand a stock
quo-tation, note any code or symbol attached to a quotation and
read the appropriate expla-nation of the code or symbol.
Quotations for stocks that didnt trade during the day under
review might read as fol-lows:
Issue Bid Ask LastXYZ 11.45 12 11.45
This quotation means that the best bid (the highest price a
prospective buyer was will-ing to pay) was $11.45 and the best
asking price (the lowest price a potential selleroffered to accept)
was $12 for each XYZ common share. The most recent trade in
XYZcommon shares took place at $11.45. Bear in mind that the bid
and ask figures do notrepresent actual trade prices, since no
trades took place during the day.
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C. PREFERRED SHARESShares can have a number of designations
including common, ordinary, subordinated,Class A, and preferred. In
recent years the name given to shares has become less helpfulin
determining the attributes attached to the shares. It is necessary
to go beyond thename to determine the true characteristics of a
companys shares. The notes to a compa-nys audited financial
statements can be useful in this regard.
In this chapter, references to preferred shares apply to all
shares not classified as com-mon or restricted shares.
1. The Preferreds Position
Typically the preferred shareholder occupies a position between
that of the companyscreditors and that of the common shareholder.
Preferred shareholders are usually enti-tled to a fixed dividend
payable out of retained earnings, subject to the discretion of
theBoard of Directors.
If a companys ability to pay interest and dividends deteriorates
because of lower earn-ings, the preferred shareholder is in the
middle. The investor is better protected thanthe common
shareholders but junior to the claims of the debtholders. It is
important tokeep in mind that bond and debenture holders are
creditors, while preferred sharehold-ers rank afterwards and are
part owners along with common shareholders.
Some companies issue more than one class of preferred stock and
when this occurs eachclass is separately identified. (Note that in
this example, and the ones that follow, refer-ence is sometimes
made to preference shares. These shares generally hold the same
mean-ing as preferred shares, but can rank ahead of the different
classes of preferred sharesthat a company has outstanding.)
Example: Argus Corporation Limited has four preferred share
issues outstanding: a$2.50 Series Class A Preference; a $2.60
Series Class A Preference; a 1962 Series Class BPreference; and a
Class C Participating Preference.
If various outstanding preferred share issues rank equally as to
asset and dividend enti-tlement, the shares are described as
ranking pari passu.
Example: TELUS Communications Inc. has one class of 6%
Preference Shares and 8classes of preferred shares outstanding. The
6% Preference Shares have priority as toasset and dividend
entitlement ahead of the 8 classes of preferred shares. However,
the 8classes of preferred shares rank pari passu as to asset and
dividend entitlement after the6% Preference Shares.
2. Preference as to Assets
Preferred shares are usually given a prior claim to assets ahead
of the common shares inthe event of winding up or dissolution of a
company. Claims of creditors and debthold-ers rank ahead of
preferred shareholder claims and the common shareholder has to
becontent with anything that is left after all creditor, debtholder
and preferred shareholderclaims have been met.
This preference as to assets clause is found in most preferred
share issues. Since preferredshareholders usually have no claim on
earnings beyond the fixed dividend, it is fair thattheir position
is buttressed by a prior claim on assets ahead of the common
shares.
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In the event of the winding up or dissolution of the issuing
company, preferred share-holders are entitled to funds up to a
stated amount after creditors and debtholders havebeen paid in
full.
Example: Dofasco Inc.s Class A Preferred Shares Series A are
entitled in the event of liq-uidation, dissolution, winding up,
etc., if voluntary, to $101; or, if involuntary, to $100;in each
case plus accrued and unpaid dividends.
3. Preference as to Dividends
Preferred shares are usually entitled to a fixed dividend
expressed either as a percentageof the par or stated value, or as a
stated amount of dollars and cents.
Example: TransCanada Pipelines Limiteds 5.6% First Preferred
shares pay a fixed annualdividend of $2.80 per share.
Dividends are paid from earnings current or past. However,
unlike interest on a debtsecurity, dividends are not obligatory and
are payable only if declared by the Board ofDirectors. If the Board
omits the payment of a preferred dividend, there is very little
thepreferred shareholders can do about it. However, the charters of
some companies pro-vide that no dividends are paid to common
shareholders until preferred shareholdershave received full payment
of dividends to which they are entitled.
While directors have the right to defer the declaration of
preferred dividends indefinite-ly, in practice dividends are paid
if justified by earnings. Failure to declare an
anticipatedpreferred dividend has unfavourable repercussions.
Besides weakening investor confi-dence, the general credit and
future borrowing power of the company suffer.
Since most preferred shares can be considered fixed income
securities, they do not offer,from an investment standpoint, the
same potential for capital gain that common sharesprovide. Should
interest rates decline, the preferred will increase in price, much
like abond; but good corporate earnings will have no effect on the
dividend rate or equityallocation. Thus, the dividend rate is of
prime importance to the preferred shareholder.
4. Features Of Preferred Shares
a) Introduction
While the description of the rights of a debtholder is found in
the trust deed or inden-ture, those of a preferred shareholder are
found in the charter of the company. A com-pany wishing to issue
preferred shares must apply to make the necessary changes to
itscharter, unless the existing charter provides for issuance of
preferred shares at the discre-tion of the directors.
After deciding to issue preferred shares, the directors meet
with the companys under-writers to determine the type of preferred
to issue and the specific features to include.The features
described in this section could be built into any of the types of
preferredshares just described. Some features strengthen the
issuers position, others protect thepurchasers position. The final
selection represents a compromise in that the new issuewill offer
safeguards to the buyer without unduly restricting the issuer.
b) Cumulative and Non-cumulative
Most Canadian preferred shares have a cumulative dividend
feature built into their terms.
Cumulative Feature
With a cumulative feature, if a companys Board of Directors
votes not to pay one ormore preferred dividends when due, the
unpaid dividends accumulate or pile up inwhat is known as arrears.
All arrears of cumulative preferred dividends must be paidbefore
common dividends are paid or before the preferred shares are
redeemed.
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If a companys financial condition weakens because of a decline
in earnings, the direc-tors may reluctantly decide to omit a
preferred dividend. This will likely cause a declinein the
preferreds market price. If the dividend is cumulative, the shares
assume a specu-lative aspect which will become more pronounced if
subsequent dividends are passed,causing the dollar amount of the
arrears to grow. Later, if the companys earningsimprove or if
losses change to profit, some investors may buy the preferred on
specula-tion that dividends will resume. If a partial or complete
repayment of arrears material-izes, payment is made to the
preferred shareholders owning shares at the time of repay-ment. No
payments are made to preferred shareholders who previously sold
their stock,and no interest is paid on arrears.
Non-cumulative Feature
On non-cumulative preferreds, the shareholder is entitled to
payment of a specified divi-dend in any year, only when
declared.
When a non-cumulative preferred dividend is passed, arrears do
not accrue and the pre-ferred shareholder is not entitled to
catch-up payments if dividends resume. For thisreason the dividend
position of non-cumulative preferred shares is very weak.
Investors should determine if a cumulative feature is present
before purchasing a preferred.
c) Callable and Non-callable
Callable or Redeemable Feature
Issuers of preferred shares frequently reserve the right to call
or redeem preferred issuesat a stated time and at a stated price. A
call feature is a convenience to the issuer, ratherthan to the
purchaser.
As with callable corporate debt, callable preferreds usually
provide for payment of asmall premium above the amount of per share
asset entitlement fixed by the charter, ascompensation to the
investor whose shares are being called in.
The company will typically try to buy shares for cancellation on
the open market orthrough invitations for tenders addressed to all
holders. The price paid under these cir-cumstances generally must
not exceed the par value of the preferred shares plus the pre-mium
provided for redemption by call.
Non-callable Feature
Non-callable preferred shares cannot be called or redeemed as
long as the issuing com-pany is in existence. This feature is
restrictive from the issuers standpoint, in that itfreezes a part
of the capital structure for the life of the company. The feature
is, there-fore, rarely built into the terms of Canadian preferreds.
It is advantageous to the pur-chaser since the investment cannot be
redeemed.
d) Voting Privileges
Virtually all preferred shares are non-voting so long as
preferred dividends are paid onschedule. However, once a stated
number of preferred dividends have been omitted, it iscommon
practice to assign voting privileges to the preferred.
Issuing companies may consider a non-voting feature advantageous
since it ensures thepreferred shareholders have no say in running
the companys affairs so long as dividendrequirements are met.
However, preferred shareholders are usually given a vote on
matters affecting the qualityof their security. For example, if the
company intended to increase the amount of pre-ferred stock
authorized, the preferred shareholders would have to approve the
new issue.
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Sometimes, the approval of holders of a stated percentage of the
preferred shares out-standing must be obtained before funded debt
is created.
e) Purchase Funds and Sinking Funds
Purchase and Sinking Funds
Many redeemable Canadian preferred shares have a purchase fund
or a sinking fundbuilt into their terms. These features are similar
to those found in bonds and debenturesdiscussed in Chapter 5. A
purchase fund is advantageous to preferred shareholdersbecause it
means that if the price of the shares declines in the market to or
below a stip-ulated price, the fund will make every effort to buy
specified amounts of shares forredemption. Consequently, a
preferred share issue with a purchase fund has potentialbuilt-in
market support through the funds purchasing efforts each year.
Example: Domtars cumulative preferred Series B shares include a
purchase fund whichstipulates that beginning in April 1992, the
company will make all reasonable efforts toannually purchase 1% of
the outstanding shares in that year at a maximum price of $25per
share.
As a preferred share purchase or sinking fund operates, the
total of outstanding pre-ferred shares of a particular issue
gradually decreases. As shares become scarcer, mar-ketability
becomes thinner. However, the market price of the preferred will
show firm-ness or improvement as the purchase or sinking fund bids
for shares up to the stipulatedprice. Over time, as the funds
gradually reduce the total number of preferred shares out-standing,
the position of the remaining shareholders is strengthened. Annual
preferreddividend requirements are reduced, allowing more net
earnings for the common shares.
5. Special Protective Provisions
Underwriters encourage companies creating new preferreds to
build in specified protec-tive provisions to safeguard the position
of the preferred shareholder and make the issuemore saleable. A
description of several protective provisions follows:
a) Restrictions on Common Dividends
To protect the preferred shareholders, specific provisions can
be created to restrict thecircumstances under which common
dividends are paid. A working capital clause isdesigned to ensure
that the companys financial position will not be seriously
weakenedif dividends are paid on the common shares. For example,
the working capital clause ofone company is worded as follows:
No dividends shall at any time be declared or paid or set apart
for the common shares or anyshares or any part thereof when the
payment of such dividends would reduce the workingcapital of the
company as herein defined after such dividend has been paid to an
amount lessthan $500,000.
Terms can specify that no dividends will be paid to common
shareholders if preferredshare purchase or sinking fund payments
are in arrears.
b) Right to Vote in Event of Arrears
Many Canadian preferreds have a protective provision whereby
preferred shareholdersare entitled to vote when preferred dividends
and/or purchase or sinking fund paymentsare a stated number of
payments in arrears.
Since the number of preferred shares outstanding is usually far
less than the number ofcommon shares outstanding, any voting
privileges given to the preferred shareholdersrarely affect control
of the company. To ensure that the preferred shareholders have
at
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least one seat on the board of directors, some companies specify
the number of directorswho shall be elected by the preferred
shareholders as a group.
c) Restrictions on Further Preferred Issues
This clause restricts future issues of preferred shares that are
senior or equal to the pre-ferred shares presently outstanding.
Issuance of such shares is usually prohibited withoutthe prior
approval of the preferred shareholders. However, in most cases,
approval neednot be obtained if certain conditions are met. The
most common requirement is thatnet earnings over a stated period of
time (usually the previous 12 months) must cover(usually at least
two times) the annual dividend requirements on the issued and
pro-posed-to-be-issued preferreds.
d) Restrictions on Sale of Assets
Sometimes the affirmative vote of two-thirds of the preferred
shares outstanding isrequired before a company is allowed to sell,
transfer or lease its property, or consolidateor merge with another
corporation where securities rank prior to or in parity with
theexisting companys preferred shares.
e) Restrictions on Change of Terms
The provisions and terms included in preferred share covenants
are typically written in away that makes it very difficult for a
company to change them. Usually clear preferredshareholder approval
is required before a proposed change is implemented.
6. Why Do Companies Issue Preferred Shares?
In comparison with debt, preferred shares are usually more
expensive for a companybecause dividends paid are not a
tax-deductible expense. However, when all considera-tions are
weighed, there may be sufficient advantages to justify a new
preferred shareissue.
a) Preferred Issue or Debt Issue?
From a companys viewpoint, preferreds do not create the demands
that a debt issue cre-ates. Preferreds do not usually have a
maturity date, which may come at a financiallyawkward time,
although some may have a purchase fund. If a preferred dividend
pay-ment is omitted, no assets are seized by preferred
shareholders.
Because of the stringent legalities involved, a company will go
to great lengths to avoidmissing an interest or principal payment.
However, the company has flexibility in decid-ing whether or not to
declare a preferred dividend. Dividends are never omitted
withoutgood reason. But to preserve working capital in an
emergency, a companys directorsmay decide to omit a preferred
dividend without jeopardizing the companys solvency.
A corporation will choose to issue preferreds rather than debt
if:
It is not feasible for it to market a new debt issue. Existing
assets may already beheavily mortgaged;
Market conditions are temporarily unreceptive to new debt
issues;
The company has enough short and long-term debt outstanding,
i.e., its debt/equi-ty ratio is high. Preferreds will increase the
equity component;
The directors are reluctant to assume the legal obligations to
pay interest and prin-cipal; or
The directors decide that paying preferred dividends will not be
onerously expen-sive. The company has a low apparent tax rate,
which means it is less of a burden topay dividends from after-tax
profits.
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b) Preferred Shares vs. Common Shares
When a company has decided it will not or cannot issue bonds or
debentures, it mayfind conditions are not favourable for selling
common shares. The stock market may befalling or inactive, or
business prospects may be uncertain. However, in such
circum-stances preferred shares might be marketed as a compromise
acceptable to both the issu-ing company and investors. Preferreds
also offer the advantage of avoiding the dilutionof equity that
results from a new issue of common shares.
7. Who Buys Preferred Shares?
Preferred shares are bought largely by income-oriented
investors. Today, conservativeindividual investors, seeking income,
purchase preferred shares to take advantage of thepreviously
mentioned dividend tax credit. Institutional investors are
attracted to thepreferential tax treatment of preferreds as well.
If the institutional investor is not con-cerned with taxes, such as
a pension fund, they will typically invest in bonds.
Canadian companies also purchase preferred shares as an income
investment. Dividendspaid by one resident taxable Canadian company
to a similar company are not taxable inthe hands of the receiving
company. This is not the case with debt interest. WhenCanadian
Company One purchases a debt issue of Canadian Company Two, the
inter-est received by Company One is fully taxable in Company Ones
hands.
D. TYPES OF PREFERREDS1. Fixed Rate (or Straight) Preferreds
These are preferred shares with normal preferences as to asset
and dividend entitlementahead of the common shares. Straight
preferreds may have any or all of the featuresdescribed previously.
Since straight preferreds pay a fixed dividend rate, the shares
tradein the market on a yield basis. As with the market price of
bonds and debentures, ifinterest rates rise, the market price of
straight preferreds will fall, and if interest ratesdecline the
market price of straight preferreds will rise.
From the standpoint of the purchaser, straight preferred shares
provide:
Greater safety than common shares through preference to dividend
and asset enti-tlements;
A tax advantage to individuals through the dividend tax credit
and to public corpo-rations which receive preferred dividends from
taxable Canadian companies on atax-exempt basis;
Less safety than a debt investment since dividends are not a
legal obligation;
A fixed dividend rate which will not be increased;
No voting privileges (unless a stated number of dividend
payments are in arrears);
No maturity date, unlike a debt investment;
Poorer marketability than common shares because there are
usually fewer preferredshares than common outstanding; and
Limited appreciation potential compared to common shares. The
price at which thepreferred could be redeemed by the issuer will
limit any appreciation that mightoccur as a result of a decline in
interest rates.
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2. Convertible Preferreds
a) General Description
Convertible preferreds are similar to convertible bonds and
debentures because theyenable the holder to convert the preferred
into some other class of shares (usually com-mon) at a
predetermined price(s) and for a stated period of time. More
recently, pre-ferred shares have been issued where both the holder
and the issuer have conversionprivileges.
Conversion terms are set when the preferred is created and
normally specify the numberof common shares into which each
preferred is convertible. The preferred price is set ata modest
premium (perhaps 10% 15%) above its converted value. The purpose of
thepremium is to discourage an early conversion, which would defeat
the purpose of theconvertible offering. Virtually all conversion
privileges expire after a stated period oftime, usually five to 12
years from the date of issue.
Example: Power Financial Corporation, 4.70% Non-Cumulative
Preferred Shares, SeriesJ are convertible by the holder on a
minimum of 65 days notice beginning July 31, 2013and on the last
day of January, April, July and October of each year into
commonshares. The conversion rate is determined by dividing $25,
plus declared and unpaiddividends to the date of conversion, by the
greater of (i) $3 and (ii) 95% of the weight-ed average trading
price of the common shares on the TSX for the 20 trading days
end-ing on the last trading day occurring on or before the fourth
day immediately prior tothe date of conversion. These shares are
also convertible by the company beginningApril 30, 2009 under
various terms.
Usually the convertible preferred will sell at a premium above
the price it might beexpected to sell at, based on the conversion
terms. This premium can be expressed as adollar amount or as a
percentage. Expressing the premium as a percentage makes
com-parisons between preferreds easier. The premium on the
preferred shares is usually offsetby their higher yield compared to
the underlying common shares. Over a period ofyears, the preferreds
higher yield will pay back to the investor the premium requiredto
purchase it.
Table 6.1 illustrates a hypothetical example of a convertible
preferred share. As the priceof the common shares approaches the
preferreds current conversion price the marketprice of the
convertible preferred will rise accordingly. When the price of the
commonshares rises above the conversion price, the preferred is
selling off the common stockand the market action of the preferred
will reflect the market action of the common.
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TABLE 6.1
Example of Conversion Cost Premium and PaybackPreferred Market
Price Pre-tax Yield Conversion Cost Years to RepayIssue Preferred
Common Preferred Common Difference Premium Premium
ABC Corp.Cumulative Redeemable Convertible $62.50 $18.50 3.2%
1.5% +1.70 12.61% 7.42 yearsClass A Preferred, Series 2 (Div.
$0.2775)(Each Series 2 preferred is convertible into 3 common
shares at any time.)
Sample calculation (excluding commission) of a conversion cost
premium using ABC Corp.
1. To buy one ABC Corp. Series 2 preferred share that could be
converted into 3 common shares costs $62.50
2. To buy 3 common shares would cost $55.50 (3 x $18.50)
3. Therefore, the conversion cost dollar premium is $62.50
$55.50 = $7.00.As a percent of the common share price, the premium
is:
4. Years to pay back premium from the convertibles higher
dividend stream:
b) Selecting Convertible Preferreds
Generally speaking, investors look for convertible preferreds
with low premiums andshort payback periods. However, it is
necessary to go beyond the simple numbers incomparing these
preferreds. A low premium may signal that the prospects for the
under-lying common are poor. In that case, the conversion feature
of the preferred would noteven be worth its low premium. A high
premium is a result of popularity with investors,who have bid up
the preferreds price. Is their optimism justified? If the common
sharesdo well, the preferred will turn out to be a good investment
despite its premium.
Most convertible preferreds are redeemable, which gives the
issuer the power to force aconversion into the underlying shares
when the market price of the preferred rises abovethe redemption
price. To force a conversion, management announces the redemption
ofthe preferred at the call price as at a certain date. Convertible
preferred shareholdersconvert their shares into common to avoid
having them redeemed for less than theircurrent value. A forced
conversion is implemented only if management decides there isan
advantage to retiring the preferred by issuing new common
shares.
Once a convertible preferred is exercised it is not possible to
convert back. No commis-sion is charged on conversion and no
capital gain or capital loss is incurred until thesubsequent
sale(s) of shares received from the conversion.
If the underlying common shares are split, the conversion terms
are adjusted automati-cally on the basis of the larger number of
new underlying shares.
Convertible preferreds are issued either in markets where a
straight preferred is difficultto sell or in a situation where a
high level of dividend coverage is lacking. Because of theadded
benefit of a conversion feature, the dividend on a convertible is
often less thanthat of a comparable straight preferred.
% .. .
. premiumconvertible yield common yield
=
=12 61
3 20 1 5012 6611 70
7 42.
.= years
$ .$ .
. %7 0055 50
100 12 61 =
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c) Implications for Investors
From the standpoint of the purchaser, convertible preferred
shares:
Provide a two-way security. The holder is in a more secure
position than the com-mon shareholder and yet can realize a capital
gain if the market price of the com-mon rises sufficiently;
Usually provide a higher yield than the underlying common
shares;
Provide the right to obtain common shares through conversion
without paying acommission;
Usually provide a lower yield than a comparable straight
preferred;
Are vulnerable to a decline in price if selling off the common
and the price of thecommon declines;
Sometimes convert into less (or more) than a board lot of common
shares which inturn may be a little more difficult to sell than a
board lot; and
Revert to a straight preferred when the conversion period
expires if conversion hasnot taken place.
3. Retractable Preferreds
a) General Description
While most preferred shares are redeemable, there is no
assurance that redemption willoccur because the call privilege
rests with the company. A retractable preferred share-holder, on
the other hand, can force the company to buy back the retractable
preferredon a specified date(s) and at a specified price(s). Some
are issued with two or moreretraction dates. The principle of
retraction or pulling back is identical to that describedin Chapter
5 for retractable bonds and debentures. The holder of a retractable
preferredcan create a maturity date for the preferred by exercising
the retraction privilege andtendering the shares to the issuer for
redemption. The term soft retractable preferredrefers to those
retractables where the redemption value may be paid in cash or in
com-mon shares, generally at the election of the issuer.
Example: Brascan Corp., Series 5, floating rate Preference
Shares are retractable on thefirst of each March, June, September,
and December at $25 per share.
b) Implications for Investors
From the standpoint of the purchaser, retractable preferred
shares:
Provide a predetermined date(s) and price(s) to tender shares
for retraction. Theshorter the time interval to the retraction
date, the less vulnerable is the stocks mar-ket price to increases
in interest rates. Whereas a straight preferred will decline
inprice if interest rates rise, a retractable preferred will not
fall significantly below itsretraction price as the retraction date
approaches;
Provide a capital gain if purchased at a discount from the
retraction price and sub-sequently tendered at the retraction
price;
Will sell above the retraction price and at least as high as the
call price if interestrates decline sufficiently;
Do not retract automatically. The retraction privilege will
expire, if no action istaken by the holder during the election
period(s); and
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Become straight preferred shares if not retracted when the
election period(s) expires.If this occurs in a period of high or
rising interest rates, the stocks market value willdecline. The
shares will sell on a straight yield basis after the retraction
privilegeexpires.
c) How to Calculate Annual Pre-Tax Yield for A Retractable
Preferred
If a preferred can be purchased below its retraction price, a
capital gain will occur if thepreferred is later retracted.
Alternatively, if a preferred is purchased above its
retractionprice, a capital loss will occur if the preferred is
later retracted (which is a less likely situ-ation). The pre-tax
yield should factor in this gain or loss, much as a bond yield
calcula-tion factors in the difference between a bonds purchase
price and its redemption ormaturity value. The approximate yield to
maturity calculation given for bonds inChapter 5 can therefore be
used here. The after-tax yield will vary, depending on the taxrates
of the province.
Example: Suppose a 7% $100 p.v. retractable preferred is
purchased at $98.75 and isretractable at the holders option at $100
in 4 years and 2 months time.
Numerator: annual dividend income ($7.00) + [annualized capital
gain (100 98.75) 4.17]
Denominator: (98.75 + 100) 2
4. Variable or Floating Rate Preferreds
a) General Description
Identical in concept to variable or floating rate debentures,
variable rate preferreds paydividends in amounts that fluctuate to
reflect changes in interest rates. If interest ratesrise, so will
dividend payments and vice versa.
Example: The Thompson Corp. Variable Rate Cumulative Redeemable,
Series II areentitled to cumulative preferential cash dividends.
The annual dividend rate is 70% ofthe prime rate. The dividend rate
is set on the last business day of the preceding month.
Variable rate preferreds are issued:
During periods in the market when a straight preferred is hard
to sell and the issuerhas rejected making the issue convertible
(because of potential dilution of equity) orretractable (because
holders could force redemption on a specified date);
When the issuer believes interest rates will not go much higher
than they are at thedate of issuance of the new issue. The company,
in any event, is prepared to pay ahigher dividend if interest rates
rise. Of course, if interest rates decline, the issuerwill pay a
smaller dividend (subject in most cases to a guaranteed minimum
rate);and
When the issuer may be trying to match the nature of the firms
assets.
Some preferred shares may have delayed variable rate features.
Known as delayedfloaters, fixed-reset or fixed floaters, these
shares entitle the holder to a fixed dividendfor a predetermined
period of time after which the dividend becomes variable.
Example: Extendicare Inc., Floating Rate Cumulative, Redeemable
Class 1 Preference,Series 2. The issue pays 71% of the prime
rate.
7 3099 375
100 7 35..
. % =
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b) Implications for Investors
From the standpoint of the purchaser, variable rate preferreds
provide:
Higher income if interest rates rise, but lower income if
interest rates fall;
A variable amount of annual income that is difficult to predict
accurately but whichwill reflect prevailing interest rate levels;
and
An investment with a market price less responsive to changes in
interest rates com-pared to the market prices of straight preferred
shares. The dividend payout of avariable rate preferred is tied to
changes in interest rates on a predetermined basis.Accordingly the
preferreds market price is less sensitive to changes in interest
rates.
5. Foreign-pay Preferreds
Most Canadian preferreds pay dividends in Canadian funds.
However, it is possible fora company to create and issue preferreds
with dividends and certain other featurespayable in or related to
foreign funds. These are known as foreign-pay preferreds.
Example: Bank of Montreal 5.95% Non-cumulative Class B
Preferred, Series 10 sharespay an annual dividend of US$1.4875.
The key factor to selecting a foreign-pay preferred is the
desirability of receiving divi-dends in a currency other than
Canadian funds. There is additional risk in the form offoreign
currency risk. If the foreign currency increases in value compared
to theCanadian dollar, your dividend will increase. If, however,
the Canadian dollar increasesin value compared to the foreign
currency, your dividend will decrease in value whenyou convert it
to Canadian funds.
One of the advantages of this type of preferred share is that,
although the dividend isreceived in a foreign currency, because it
is paid by a Canadian company, the dividend iseligible for the
dividend tax credit.
Typically, it is the sophisticated investors, wishing to
diversify the currencies received intheir portfolios, who are the
logical buyers of foreign-pay preferreds. Another type ofinvestor
who may benefit a foreign-pay preferred is the person who maintains
a resi-dence in another country and wants to receive a cash flow in
the currency of that coun-try (for example, a Canadian who spends
part of the year in Florida).
6. Canadian Originated Preferred Securities (COPrS)
Canadian Originated Preferred Securities (COPrS) were introduced
to the Canadianmarket in March 1999 (they are a trademark of
Merrill Lynch). COPrS are long-termjunior subordinated debt
instruments issued by Canadian corporations. These hybridsecurities
offer features that resemble both long-term corporate bonds (debt),
and pre-ferred shares (equity). Similar to debt instruments, COPrS
quarterly distributions aretreated as regular interest income for
taxation purposes. Similar to preferred shares,COPrS trade cum
dividend (an ex-date is declared) in that accrued interest is
notadded to the market price. COPrS rank ahead of common and
preferred shares and jun-ior to senior and other subordinated debt
of the corporation. COPrS trade on listedstock exchanges and trade
like preferred shares.
On most issues, the COPrS issuer has the right to defer payment
for up to 20 consecu-tive quarterly periods. Deferred interest will
accrue, but not compound. Most issues areredeemable by the issuer
at a redemption price equal to 100% of the principal amountof the
securities to be redeemed plus accrued and unpaid interest. Yields
tend to bemuch higher on COPrS than on comparable fixed income
instruments.
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Because payments from COPrS are treated as interest income, for
tax purposes, the pay-ments do not receive the preferential
dividend tax treatment. This makes them particu-larly suitable for
inclusion in non-taxable accounts, such as an RRSP.
Example: Shaw Communications Inc. 8.875% COPrS, due September
28, 2049redeemable on and after October 17, 2005 on minimum 30 and
maximum 60 daysnotice at $25 per share. The company has the right
to defer, at any time and from timeto time, subject to certain
conditions payments of interest on the securities by extendingthe
interest payment period on the securities for a period of up to 20
consecutive quar-terly periods.
7. Other Types of Preferreds
New products are constantly being introduced to the marketplace.
Many of these newproducts are custom made for the issuer or the
buyer (usually institutional). There areother types of preferreds
that are not as common as those mentioned above but dotrade, such
as participating preferreds, or deferred preferreds. The investor
and the advi-sor must always investigate the security, in order to
confirm the features of that particu-lar issue.
Many preferreds may have special designations in their
description, such as Class A orClass B, Series I or Series II.
These designations could mean only that the two pre-ferreds were
issued at different times, but in all other respects, the issues
are identical.The term Class A shares may be used to identify a
special class of preferred share withdifferent characteristics from
other outstanding preferred shares from the same issuer,such
as:
Voting rights;
Example: Dofasco Inc.s Class A preferred shares are non-voting
but rank ahead of allother outstanding classes of non-voting
preferred shares as to asset and dividend entitle-ment.
To distinguish shares which may receive a cash dividend from
Class B shares whichmay receive a stock dividend; and
To identify restricted shares.
a) Participating Preferreds
Participating preferred shares have certain rights to a share in
the earnings of the com-pany over and above their specified
dividend rate.
Example: Argus Corporation Limited Class C Participating
Preferred Shares participateequally with the common shares in any
dividends paid in any fiscal year, after $0.30 pershare has been
paid on each preferred and common share. The shareholder can also
par-ticipate in any distribution of assets.
b) Preferred Issues with Warrants
The addition of a bonus or sweetener of common share warrants,
as part of a new pre-ferred issue, is another method of improving
the issues saleability. The two securitiestogether are called a
unit. In some cases, the warrants are readily detachable,
enablingthe preferred shareholder to sell part or all of the
warrants and retain the preferredshares. A variation is to defer
issuing the warrants to preferred shareholders until a speci-fied
date in the future. This in turn encourages retention of the
shares.
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c) Auction Preferreds
Auction preferreds offer a dividend rate determined by an
auction between the holderand the issuer. The rate may be based on
the number of orders to hold, sell or buy andtypically offer a
reset minimum and maximum dividend rate.
d) Deferred Preferreds
Deferred preferred shares pay no dividend until a future preset
maturity date. On thematurity date, the holder is paid a cumulative
amount equal to the dividends thatwould have been received had the
investor purchased a preferred share that paid a regu-lar annual
dividend. If held to redemption, the accrued dividends are fully
taxable asinterest income. If sold prior to redemption, the income
is treated as a capital gain (orloss). This feature allows
investors to defer taxes paid on income earned until a laterdate.
These preferreds are attractive to investors who do not have an
immediate need forregular income. The shares are also attractive
for investors who want to receive com-pounded growth in a
registered account, such as an RRSP, as taxes are deferred to a
laterperiod.
e) Split Shares
Split shares (also known as structured preferreds or equity
dividend shares) are com-mon shares that have been structured to
create two classes of securities which are splitinto an equity
component (preferred shares) and a capital component (capital
shares).The preferred shareholders receive only the dividends from
the underlying commonshares, while the capital shareholders have
the potential to generate capital gains fromthe underlying common
shares.
The equity dividend shares trade like bonds and preferreds,
based on yields, but theycan benefit from increases in dividends
paid on the underlying common stock. Thematurity values of these
shares are dependent upon the value of the underlying commonshares.
It is possible, therefore, to lose a portion of ones principal at
maturity if thecommon shares decline substantially in price. Most
structured preferreds areredeemable. If the shares are redeemed
early, the investor will lose the stream of divi-dend income.
Example: TD Split Shares. The preferred shareholders receive
quarterly dividend pay-ments that are funded from the dividends
received on Toronto-Dominion Bank com-mon shares and, if necessary,
with proceeds from the sale of TD Bank shares. The capi-tal shares
provide holders with a leveraged investment, whereby the value of
the invest-ment is linked to changes in the market price of the
Toronto-Dominion Bank commonshares. Both the preferred and capital
shares are listed and publicly trade on the TSX.
E. CASH AND MARGIN ACCOUNTS1. Cash Accounts
A securities transaction through a member firm must be made in
either a cash accountor a margin account.
Cash Accounts: Clients with regular cash accounts are expected
to make full paymentfor purchases or full delivery for sales on or
before the settlement date which is pre-scribed by industry rules
and specified in the contract. The normal settlement dateis
prescribed as the following business days after the transaction
date:
Government of Canada Treasury bills Same day as the transaction
takes place;
Most debt securities maturing up to 3 years (see Table 5.10 in
Chapter 5 forexceptions) Two business days after; and
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All other securities Three business days after.
Margin Accounts: In contrast, margin accounts are for clients
who wish to buyand/or sell securities on credit and initially pay
only part of the full price of thetransaction. In such cases, the
member firm lends the remainder of the transactionprice to the
client, charging interest on the loan.
It is important to recognize the difference between cash
accounts and margin accounts.When a client opens a cash account,
the member does not grant credit and the explicitunderstanding is
that the client will settle on the settlement date. On the other
hand,when a client opens a margin account, it is on the explicit
understanding that the mem-ber is granting credit based on the
market value and quality of the securities held longand/or short in
the account. A long position represents actual ownership in a
security.For example, an investor who is long 100 shares of Bell
Canada owns 100 shares of BellCanadas stock. In contrast, a short
position is created when an investor sells a securitythat he or she
does not own.
a) Cash Account Rules Summary
In most cases, a firms computerized accounting system will flag
settlement dates forclients transactions. The computer will also
keep track of the dates when accountsbecome overdue and the amounts
of capital that must be maintained by the member tocarry these
overdue accounts. At a certain point, the account will become
restricted andtrading activity will no longer be permitted until
the account is settled.
Members may adopt more stringent rules to minimize the amount of
capital being un-profitably tied up in carrying delinquent cash
accounts. IAs must know industry andtheir own firms requirements as
well as acceptable methods of settling both normal cashaccount
transactions and those where restrictions have later been
imposed.
b) Free Credit Balances
Free credit balances are uninvested funds held in client
accounts that the member firmmay use as a financing source for its
business. These funds are, however, payable ondemand to their
clients. The exchanges and the IDA require that every statement
ofaccount given or sent to a customer by a member contain the
following written notice:
Any free credit balances represent funds payable on demand
which, although properly record-ed in our books, are not segregated
and may be used in the conduct of our business.
2. Margin Accounts
The word margin refers to the amount of funds the investor must
personally provide.The margin plus the amount provided by the
member firm together make up the totalamount required to complete
the transaction. There are two different types of
marginpositions:
A long margin position allows the investor to partially finance
the purchase of secu-rities by borrowing money from the dealer.
A short margin position allows the investor to sell securities
short by arranging forthe dealer to borrow securities to cover the
short position.
Not every investment firm allows margin accounts, and those that
do are required toobtain an authorized Margin Account Agreement
Form from a potential margin clientbefore business is
transacted.
Interest on the margin loan is calculated daily on the debit
balance in the account andcharged monthly. Member firms usually
charge margin clients interest based on therates members are
charged on loans made to them by the chartered banks.
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a) Long Margin Accounts
The amount of credit which a member may extend to customers on
the purchase ofsecurities (both listed and unlisted) is strictly
regulated and enforced. Examiners con-duct spot checks in addition
to regular field examinations to ensure that members keepclients
accounts properly margined.
Table 6.2 shows the maximum loan values which IDA member firms
may extend forlong positions in equity securities listed on any
recognized exchange in Canada or theU.S., the Tokyo Stock Exchange
(First Section) or the London Stock Exchange.
TABLE 6.2
Maximum Loan Values
On listed equities selling: Maximum Loan Values
Securities Eligible for Reduced Margin 70% of market value
at $2.00 and over 50% of market value
at $1.75 to $1.99 40% of market value
at $1.50 to $1.74 20% of market value
under $1.50 No loan value
Securities that meet specific price risk and liquidity risk
measures at each calendar quar-ter-end will be eligible for reduced
margin. Each quarter, the IDA will publish a List ofSecurities
Eligible for Reduced Margin.
The maximum loan values of 40% and 20% on listed securities
selling between $1.99and $1.50 (which means the client is required
to put up margin of at least 60% and80% respectively, and more if
the price has dropped since the initial transaction) aredesigned to
reduce the scale of additional margin calls in a falling
market.
Clients with margin accounts should avoid the practice of
margining close to prevailingprice limits (i.e., keeping a minimum
amount of margin on deposit in the account).Where additional funds
or securities with excess loan value are on deposit, a cushion
ofprotection is provided against the inconvenience of having to
respond to a margin callafter a minor adverse price fluctuation. It
also reduces the possibility that the dealer willbe forced to sell
out (or buy in) the margin account in the event of a drastically
adverseprice fluctuation.
The exchanges prohibit one member from accepting transfers from
another member ofany under-margined account, unless that member
holds sufficient funds or collateral tothe credit of the account to
margin it when it is taken over.
b) Margining Long Positions in Listed Equities
When a long position is established on margin, sufficient funds
(or securities with excessloan value) must be in the account to
cover the purchase. The member firm lends someof these funds to the
client, with the client being responsible for the balance.
Thus,margin is the amount put up by the client (not the amount
borrowed or loaned), andthe minimum margin required equals the
initial cost of the transaction minus the mem-bers loan. The
following are some examples of margin transactions; in all cases,
com-missions are excluded from the calculations.
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Example of a Margin Transaction in a Listed Equity(which is not
eligible for reduced margin)
Assume a client buys 1,000 shares of listed ABC Company on
margin when it sells for $1.95 per share:
Total cost to buy ABC shares . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,950
(A)
Less: Member's maximum loan(40% of $1.95 x 1,000) . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . $ 780
Equals: Margin (which is put up by the client) . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . $ 1,170 (B)
(i) Example of a Margin CallAssume the price of ABCs shares
declines to $1.60
Original cost of ABC shares (A above) . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . $ 1,950
Less: Member's revised maximum loan(20% of $1.60 x 1,000) . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . $ 320
Equals: Gross margin requirement . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,630
Less: Clients original margin deposit (B above) . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . $ 1,170
Equals: Net margin deficiency(for which a margin call is issued
to the client) . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . $ 460
(ii) Example of Excess Margin in AccountAssume this time the
price of ABCs shares instead of declining from $1.95 to $1.60 had
increased from $1.95 to $2.25
Original cost of ABC shares (A above) . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . $ 1,950
Less: Member's revised maximum loan(50% of $2.25 x 1,000) . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . $ 1,125
Equals: Gross margin requirement . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . $ 825
Less: Clients original margin deposit (B above) . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . $ 1,170
Equals: Excess margin in account . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 345
The $345 can be used as margin toward the purchase of another
security, or withdrawnfrom the account. It is not, however, an idle
amount of cash that can be removed with-out consequence. The client
is still borrowing money from the member firm, on whichinterest
will be charged. If the excess margin is left in the account, the
amount bor-rowed would still be (1,950 $1,170) the $780 lent
initially by the dealer. What haschanged is the amount of money the
dealer is willing to lend: because the collateralvalue of the
shares has increased, the member will now lend $1,125 instead of
$780. Bywithdrawing the $345 margin surplus, the client will be
borrowing (and paying intereston) this larger amount.
F. SHORT SELLING OF EQUITIES 1. What is Short Selling?
Short selling is defined as the sale of securities that the
seller does not own.
Profits are made whenever the initial sale price exceeds the
subsequent purchase cost.With long positions, an investor purchases
a security and then holds it in the hope ofselling it later at a
higher price. With short selling, the order of the transactions
isreversed. The investor sells the security first, and then waits
in the hope of buying itback later at a lower price. Since the
seller does not own the securities sold, the seller ineffect
creates a deficit or short position where he or she owes
securities, and the subse-quent purchase covers or repays this
deficit.
Short selling is generally carried out in the belief that the
price of a stock is going to fall.
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The short seller feels bearish towards a particular security and
sells it short, hoping tobuy it back later at a lower price. If the
sale is made at a higher price than the subse-quent purchase, the
investor has made a profit.
However, short selling is not done only by speculators in
anticipation of a price drop. Itis also done by arbitrageurs and
hedgers, as well as by strategists using combinations ofsecurities
positions such as convertibles and various derivatives products,
such as putand call options, together with short positions.
2. How is Short Selling Done?
A client wishing to short a security would first contact his or
her IA and declare theintention to sell short. The IAs firm would
then lend the securities to be shorted to theclient, and the client
would sell them into the market in the same manner as a
longposition would be sold. The proceeds of the short sale are then
deposited in the clientsaccount, and the client is required to
deposit enough margin into the account, in addi-tion to the sale
proceeds, to bring the account balance up to the required
minimum.
As an example, if an investor sells a stock short at $10.00 per
share, the investor wouldhave to put up margin of $5.00 per share.
Since the investor is putting up less moneythan the full value of
the securities being sold, the element of leverage exists for all
shortsales. In fact, short selling is the mirror image of
purchasing shares on margin.Therefore, short selling can be
somewhat more risky than purchasing an outright longposition, and
such basic precautions as stop buy orders (see Part H) should be
consid-ered.
After the short position is established, the investor then waits
for an opportune momentto cover the sale with a purchase at a lower
price. Of course, since the price could alsorise and lead to
losses, regular monitoring of the position is advisable. A client
maydecide to enter a stop buy order to reduce the risk of loss.
When the short seller finally purchases the stock originally
sold short, the stock isreturned to the lender. Alternatively, the
ultimate lender of the shorted security may askthat the security be
returned. If no other lender can be found, the seller will be
forcedto buy back the security at whatever the current price is,
regardless of whether thei