Text 3 Types of Securities

A company wishing to raise funds will issue or sell not only common stock but also preferred stock and bonds (debentures). There is a certain difference between these 3 types.

Common stock is shares of ownership in a corporation. As owners of the firm, common stockholders stand to make good profits when the firm is successful, but will sustain losses when business is poor.

Common stockholders are often named the residual owners. They are so named because they have the right to residual earnings of the corporation. If a corporation were to go bankrupt, the common stockholders would be the last to receive any proceeds from the sale of the corporation’s property. This is because all other creditors, bondholders, and preferred stockholders must be paid first. What is left is considered residual earnings. Common stockholders are paid out of these residual earnings if dividends are declared by the board of directors.

Some investors prefer to give up the chance of a higher return in exchange for greater security in the event of low earnings or losses. One way to tap capital held by such people is to offer them preferred stock (or preferential -British English).

Preferred stock is, like common stock, a share in the ownership of the company but instead of equal participation in the profits, preferred shares carry fixed annual dividends that must be paid before dividends can be declared on a common stock. There are many different types of preferred stock but most are cumulative. That is, if the fixed preferred dividends are not paid in a given year, they accumulate, and all arrears must be paid before any dividends can be declared on common stock.

In exchange for this preferred dividend position, preferred stockholders give up the chance of participating in management. Nevertheless, they are still owners. They have no claim on the firm, in the event of liquidation they must wait, like other owners, until all creditors are paid off. If any ownership equity remains after the creditors are paid, the preferred stockholders are entitled to recover their equity before the common stockholders.

Bonds/Debentures. Lending to companies is often in the forms of bonds or debentures, loans with special conditions. One condition is that the borrower must have collateral or security: that is, if the borrower can not repay the loan, the lender can take equipment or property, and sell it in order to get the money back. This may be an asset which was bought with the loan. Some corporations borrow money for long periods by issuing bonds. Bonds are corporate IOYs that promise to pay a specified annual rate of interest and to repay the borrowed principal (a sum of money) on a specified date.

Bond interest and principal are contractual claims against the firm and must be paid whether the firm makes profit or not. If payments are not made on time, the bondholders can sue the firm to collect.

The use of bonds makes it possible for a firm to borrow large amounts of money from a number of small creditors on a long-term basis. Instead of a series of bonds for a number of separate debts, a company may create one fund of bonds and issue certificates for particular divisions of the fund. In simpler words, it breaks up the debt into small units, just as issuing stock breaks up the ownership equity. Certain kinds of firms, most notably public utilities, raise more of their capital by bonds than by stocks.

In many ways, a bondholder is as much an investor as a shareholder. But a shareholder is a member of the company whereas a bondholder is a creditor, whatever the similarities or dissimilarities between the rights and obligations of the two.

Whereas the articles of association can be varied, the rights of bondholders are fixed by the contract of loan and any attempted variation of them by the company (other than under a compromise or arrangement) will be a breach of contract.

The law governing the transfer of the securities held by shareholders and bondholders is basically similar, apart from the fact that bonds must be transferred as a whole (therefore there is no need to certify transfers of them) and are generally transferable without limitation. In other respects, the law differs.

Assignment to text 4:

1. Read the text and write down all the key terms.

2. Answer the following questions:

· What is a dividend?

· What is retained earnings?

· What can the shareholders benefit from?

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