Business Associations
Professor Pratt
Unit 4
The dividend equivalence of a pro rata redemption
Example
ABCDE Corp. has 2 classes of stock; 5% $100 par value cumulative preferred stock and
common stock. There are 1,000 shares of preferred stock outstanding. The annual
cumulative dividend on each share of preferred is $5.
A, B, C, D, and E each own 100 shares of the common stock of ABCDE Corp. The net
asset value of ABCDE Corp. is $50,000. The common shares are worth $100 per share
($50,000/500 shares), so each common shareholder holds shares worth $10,000 ($100 per
share value times 100 shares).
If the corporation could distribute a $1,000 dividend to each of the common shareholders,
the net asset value of the corporation would be $45,000 ($50,000 net asset value less
$5,000 distributed as a dividend) and the common shares would be worth $90 per share
($45,000/500 shares). Each of the common shareholders would have $10,000 worth of
assets ($1,000 dividend plus 100 shares of stock worth $90 per share). The corporation,
however, cannot make a dividend distribution to the common shareholders without first
paying the $5,000 cumulative preferred dividend owed to the preferred shareholders.
What if, instead, the corporation could redeem 10% of the common stock pro rata?
Assume that each of the common shareholders would sell 10 of their shares to the
corporation in exchange for $1,000. After the redemption, the net asset value of the
corporation would be $45,000 ($50,000 net asset value less $5,000 distributed in the
redemption) and the common shares would be worth $100 per share (45,000/450 shares).
Each of the common shareholders would have $10,000 worth of assets ($1,000
redemption plus 90 shares of stock worth $100 per share).
Regardless of whether the distribution to the common shareholders is structured as a
redemption or a dividend, each common shareholder would, after the distribution, have
(1) $1000 of cash, and (2) ABCDE Corp. stock worth $9,000 (20% of a corporation
worth $45,000). (In the case of the dividend, each shareholder would own 100 shares of
a stock worth $90 per share. In the case of the redemption, each shareholder would own
90 shares of a stock worth $100 per share.)
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