Holding companies

A holding company is a company that owns a big large percentage of common stock shares of a company or group of companies to exercise voting control over such business or businesses. Such voting control includes control over operations, management and boards of directors. Holding companies originated in 1889 in New Jersey, USA. New Jersey was the first state that made it legal to form a company with the single purpose of owning stocks in other companies.

The companies controlled by a holding company are called subsidiaries and holding company itself is called a parent company of such subsidiaries. If a holding company owns all the shares of the subsidiary than such subsidiary is called a wholly owned subsidiary.

The purpose of a holding company is usually only to own shares in other companies. However, if a holding company also runs the business operations then it is called a holding-operating company.

Liability of the holding company is limited to the value of the stock it has in particular companies. Acquiring control over the business via a holding company is much easier than to do so via leveraged buyouts or mergers.

Advantages of holding companies

One of the advantages of holding company includes isolation of risks.This occurs because each organization the holding company controls operates independently. If one of the organizations fails or becomes involved in a lawsuit then other organizations are not affected. This also allows the holding company to take on bigger risks at individual subsidiaries.

There are some exceptions to this. In certain circumstances the parent company may feel responsible for rectifying the problems in particular subsidiaries to maintain its reputation. Lenders may also require guarantee from the holding company when lending to subsidiaries. Therefore, this advantage is not always relevant for holding companies.

Holding companies are also able to control many assets with fractional ownership. Holding companies control a large amount of assets with a relatively small percentage of ownership and therefore relatively small investment. The percentage of shares required to obtain voting control differs from situation to situation. In smaller organizations it may be around 30%. However, if the holding company wants to obtain the voting control of a large company with widely distributed shares, than even 10-20% of the outstanding stock may be enough to have such control.

Disadvantages of holding companies

One of the disadvantages of holding company is double taxation. In the United States, if the holding company wants to obtains tax consolidation benefits such as tax free dividends than it needs to own at least 80% of the subsidiaries to do so. If it owns from 20% to 80% than it needs to pay taxes on 20% of the dividends received from the subsidiaries. If it owns below 20% than it needs to pay taxes on 30% of dividends received from subsidiaries. Such disadvantage is not relevant to mergers as no double taxation occurs in mergers.

Another disadvantage of holding companies is costly administration. This occurs because each subsidiary is maintained as a separate entity and therefore no economies of scale are possible as in the case of a merger.

A further disadvantage of holding companies is increased risk. If a holding company finances investments through debt than it needs to service the debt. If one or more of subsidiaries are not able to distribute dividends due to economic downturn or any other reasons then the holding company may not be in a position to be able to service debt and may be forced into bankruptcy.

It is also easier to request dissolution of the holding company if it is found guilty in breaking antitrust laws.

Another disadvantage is that due to the availability of voting control, the holding company may ignore interests of the minority shareholders.

 

Finding the Market Price Ratio of Exchange

When the acquiring company knows the ratio of exchange, it can be used to find the market price ratio of exchange. The market price rate of exchange is found as follows:

(MP of acquiring company * ratio of exchange)/ MP of the target company

Where: MP refers to the market price per share.

The market price ratio of exchange indicates how much of market price per share of the acquiring firm is exchanged for every $1.00 of the market price per share of the target company.

It is normal for the market price ratio of exchange to be above 1. This is an indication that the acquiring company pays a premium above the market price to acquire a target company.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s market price is $60 and BCD’s market price is $55. However, during merger negotiations, ABC agreed to a 1.5 ratio of exchange where it valued BCD’s shares at $90.

Find the market price per share in the ABC/BCD merger.

Solution:

(60*1.5)/55=1.6

This means that ABC gives $1.6 of its market price in exchange for every dollar of the BCD’s market price.

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Stock splits and reverse stock splits

Organizations undertake stock splits when it is perceived within the firm that shares of the company are traded at a too high price and this may slow down trading activity. If a stock split is undertaken, the market value of shares can slightly increase. Such increase tends to be maintained as long as dividends after the split also increase.

If a firm undertakes a 2 for 1 split than 2 new shares will be given in exchange for every 1 old share. The stock split does not affect the organizational capital structure.

Organizations can also do reverse stock splits when firm wants to increase the share price. Increase in share price may help to enhance trading of a shares activity. This occurs because unsophisticated investors tend to equate low priced stocks to low quality investments.

If firm undertakes a 1 for 2 split, one new share will be exchanged for 2 old shares.

Declaring and payment of dividends

The board of directors determines whether or not dividends will be declared for the current financial period. Such decisions are made during semi-annual or quarterly meetings of the board of directors.

If a decision to distribute dividends is made, it will be paid to all shareholders whose names are listed as shareholders on the record date.

Due to time that it takes for new shareholders to be listed, dividends are only paid out to those shareholders who acquired shares of the firm earlier than two business days before the record date.

Two business days prior to record date, along with usual fluctuations of the market, the stock price starts selling as ex dividend and drops by an amount close to the declared dividend. The payment date of the dividend usually occurs few weeks after the record date.

Test yourself:

ABC Company declared a quarterly dividend of $0.5 per share on 15th of November. You purchased 800 shares of ABC on 1st of November and 15% tax is applicable to any dividends received. Determine whether you are eligible to receive dividends and, if so, how much will you receive after tax is taken into account.

Solution:

The dividends were declared on 15th of November. Since you purchased stock on 1st of November, you are eligible to receive the dividends. Your before tax dividends amount to $400 (=800*$0.5). Your after-tax dividends amount to $340 (=$400*(1-.15)).

Dividend reinvestment plans (DRIPs) – many firms offer dividend reinvestment plans which allow current stockholders to use dividends to acquire more shares at about five percent below the market price of the firm’s shares.

This allows company to avoid under pricing and flotation costs involved in issuing new shares and shareholders also benefit due to lower prices per share. This arrangement makes obtainment of additional shares more attractive for current stockholders.

Dividend relevance and irrelevance

Whether dividend policy affects the share price and, therefore, a value of the firm is still an unresolved issue. Residual theory of dividends, the dividend irrelevance theory proposed by Merton H. Miller and Franco Modigliani, and dividend relevance theory proposed by Myron J. Gordon and John Lintner, provide different viewpoints on the issue and are briefly discussed in the next set of articles.