True & False 1. The preemptive right gives current stockholders the right to pur
ID: 2767348 • Letter: T
Question
True & False
1. The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value.
2. If a firm’s stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight.
3. The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.
4. According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period.
Explanation / Answer
1.
Pre-emptive right is a written agreement which provide some special right to some special stock holders. There are some stock holders who have initially invested huge money, when the company was at initiation staze. By investing such money they have taken high risk as it was not certain how the company will perform in future. In such cases, they are rewarded by this right.
As per this right they are offered the purchase of shares before the shares are offered to the public. If this right is not there, then such shareholders can loss their percentage holding on the company subsequent to the issue of new shares. Such dilution of percentage holding will make them to loose control on the company including dilution of voting right. So it protects their position in the company.
In case of subsequent issue of shares, existing shareholders are first offered the right to buy them on proprtional basis. Remembere it is a right, not an obligation. After such right offer, subsequently remaining stocks are issued to the public. So it will give existing stockholders to protect their right/holding in the company.
Thus statement 1 is true. It gives right to protect stockholders against both dilution of control and dilution of value.
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2.
This statement is not true. It is a right to have proprtionate new share before they are issued to public. It protects the holding of existing shareholders in the companys stock. It is not true that by using this right shareholders can call a meeting to vote to replace the management.
Thus statement 2 is false.
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3.
Cash flow on common stock is difficult to estimate than Bond. As you know, bonds are issued for taking loan. Usually periodic interest is paid on them at coupon rate. On maturity the principal is returned at a price specified in the agreement. Thus future cash flows on bond are very specific and clearly indicated in the terms and conditions of the bond.
It is not possible for common stock. The owner of a common stock is the owner of the company. So instead of intererst, they are eligible to get share of profit known as 'dividend'. This dividend is payable only whern-
1. Company has adequate residual earnings to pay off dividend. Here residual earinig is the balance left after satisfying all obligations including interest payment, tax etc.
2. A company may have adequate residuals but its liquidity position is very week. In such a situation, company may refuse to declare dividend.
3. Company may rerquire huge money to invest. So istead of paying dividend, company may retain it. Thus cash flow for common stock is very undertain as it depends upon many factors. Also it is not legally compulsory to declare a specific rate of dividend.
Answer: Thus statement 3 is correct.
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4. Valuation of common stock is based on cash flows. It is the sum of present value of future expected cash flows from the stock owership. Usually cash flow here is dividend, that stockholders will get on issue of stock. It is uncetain. Therefore, two common methods are followed. In first method, dividend per annum is assumed constant. In second mathod, dividend is assumed to grow at a constant rate.
Discount rate used in the valuation of common stock is the cost of equity. It is the minimum required rate of return, that firm should earn to satisfy its stockholders. It does not depend upon the growth rate in the dividend. It depends upon opportunity cost of investing in other similar risk category firm, degree of risk associated etc.
So statement 4 is not true.
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