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Home , Common stock

 Answers to Concepts in Review

1. A common is an investment that represents ownership in a corporate form of business. Each share represents a fractional ownership interest in the firm. The key attribute of this investment is that it enables to participate in the profits of the firm. As residual owners of the company, common stockholders are entitled to income and a prorated share of the firm’s earnings after all other obligations of the firm have been met. They have no guarantee they will ever receive any return on their investment.

2. One important investment attribute of common is that they enable investors to participate in the profits of the firm, and as such, they can offer attractive return opportunities. Another attribute is the versatility of the security—it can be used to meet just about any type of investment objective. In addition, as investments go, common stocks are fairly simple and straightforward, so they’re easy to understand (though that certainly doesn’t mean they’re easy to value). They are easy to buy and sell, and the transactions costs are modest. Moreover, price and information is widely disseminated in the news and financial media.

3. The has been very volatile over the past 20 years. A bull market was followed by a bubble that became a bear market, turned bullish, and was followed by a significant decline in share prices. Although stocks provided average annual returns of around 11% from 1953–2002, there was a significant sell-off in October 1987. While the first half of the 1990s witnessed returns that were slightly below average, average annual returns during the second half of the decade were 26%. The 2000s have been a real roller coaster ride. The decade began with a bear market that resulted in one of the few three-year stretches with negative annual returns. Although stocks have generated rates of return around 10% per year over the past 50 years, the average annual return over the 2001 through 2010 period was a dismal –1%. Although the Dow Jones Industrial Average was off a harsh 38% during the first portion of the 2000s, the ’s 77% drop was twice as nasty. By December 2006, the Dow Jones Industrial Average was within 2% of its early 2000 high. However, the Nasdaq was still languishing at over 50% below its all-time high close of 5,049. Then came the market surge that led to an all-time high Dow Jones Industrial Average of 14,164 on October 9, 2007. From that point, it dropped over 50% to 7,062 on February 27, 2009. Then from March 2009 through the end of 2011, the major market indexes more than doubled from their low points. After a strong start in 2012, the indexes again fell sharply late in the year on worries over Europe, the “fiscal cliff” and other issues. (Of course, the instructor should get the most recent information about these key indexes.)

4. While they don’t provide the “bang” that capital gains do, are an important source of return to stockholders. Dividend returns are always positive, although the dividend has been under 2.5% during the past decade. Capital gains have ranged from 38.32% in 1975 to –27.57% in 1974. Over the past 50 years, dividends have accounted for a little less than 50% of the average annual total return from stocks. There’s no question that capital gains provide the really big returns, though they also lead to wider swings in year-to-year yields. Dividends, in contrast, provide an element of stability and tend to shore up returns in off years. Currently, dividends are taxed at 5% and 15% rates, the same as capital gains. With interest rates on safe, -term investments close to 0 since late 2008, many investors have showed renewed interest in quality stocks with dividend yields of 2% to 5% as a way to generate a reliable, growing stream of income.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 6

5. The major advantage of common stock ownership is the return it offers. Because stockholders are entitled to participate in the prosperity of a firm, there is almost no limit to a stock’s capital gains potential. In addition, many stocks provide regular current income in the form of annual dividends—and for most income-producing stocks, those dividends tend to grow over time, adding even more to the stockholder’s return. Common stocks are also highly liquid and easily transferable, their transaction costs are relatively low, market information is readily available, and unit price is nominal. The risky nature of common stocks is the most significant disadvantage of common stock ownership. As residual owners of the firm, no return is guaranteed. Furthermore, prices are subject to wide swings, making valuation difficult. Finally, the sacrifice in current income is a disadvantage relative to other investments (like bonds, for instance) that pay higher and more certain returns. The principal risks to stockholders include: business and financial risk, purchasing power risk, and of course, market risk. Business risk is related to the kind of business the company is in and deals with both sales and the amount of variability in the firm’s earnings. Financial risk is associated with the mix of debt and equity financing. The more debt (financial leverage) the firm uses, the greater the likelihood that it will default on its principal and interest payments—which in turn will have a negative impact on the stock. Purchasing power risk refers to the possibility that stock returns may not keep pace with inflation. Market risk is caused by factors independent of the firm that affect the return on the firm’s common stock. Such things as economic fluctuations, threat of war, and political factors affect market risk and, therefore, can have a bearing on the market price of a stock. The market itself has an impact on the price performance of a stock—which, of course, is what is all about (i.e., a stock’s beta is a measure of the extent to which the stock reacts to the market).

6. A occurs when a firm announces its intention to increase the number of shares of stock outstanding by exchanging a specified number of new shares for each outstanding share of stock.

Most stock splits are executed with a view to lowering the price of the stock and enhancing its trading appeal. If the stock split is not accompanied by an increase in the level of dividends, stock prices will fall to account for the split. Thus, a $100 stock will fall to $50 after a 2-for-1 split. If the split accompanies good news about future earnings and dividends the stock price may rise after adjusting for the split.

7. Stock spin-offs involve conversion of one of a firm’s subsidiaries to a stand-alone company by distribution of stock in that new company to existing . For example, Kraft Foods recently spun off its snack food operations into a separate company from consumer staples, and the pharmaceutical giant Bristol-Myer Squibb had a very successful spin-off of its subsidiary Mead Johnson, best known for baby formulas. Investors have shares in both the old and the new firm, allowing them to keep those they want to hold and sell the others. For a number of complex reasons, spin-offs often result in increased value for the shareholders.

8. a. Firms do not “issue” ; these are simply shares of common stock that have been issued and subsequently repurchased by the issuing firm. This is generally done because the firm views the stock as an attractive investment; perhaps the price is unusually low. Most treasury stock is later reissued by the firm and used for such purposes as mergers and acquisitions, employee stock plans, or for payment of stock dividends. Treasury stock is not a form of classified stock. Classification of common stock simply breaks common stock into different classes or groups. Each class has different voting rights and/or dividend obligations. For example, class A stock might designate nonvoting shares that receive preferential dividends, while class B stock might designate voting shares with lower dividends. Some classes pay stock dividends to appeal to individuals interested in capital gains; other classes pay higher cash dividends that attract income-seeking investors.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 6

b. Common stock can be bought or sold in round or odd lots. A round lot is 100 shares of stock, or multiples of 100 shares. An odd lot is a transaction involving less than 100 shares. c. The of a stock is its stated or face value and exists primarily for accounting purposes. Many stocks are issued with no par value. It is a relatively useless number. The liquidation value of a stock is an estimate of the market value of the firm’s assets, if sold at auction, less the liabilities and outstanding. While this measure of value is vitally important to the high-stakes LBO and takeover artists, it is very difficult to determine and is generally of little interest to the typical individual who tends to view the firm as a going concern. d. is an accounting measure of the amount of stockholder’s equity in the firm. Book value indicates the amount of stockholder funds used to finance the firm. Investment value, perhaps the most important measure for a stockholder, indicates what value investors place on the stock. Investment value is based on the expectations of the risk and return patterns of a stock: The returns come from dividends and capital gains, and the risk is based on the exposure to holding the stock. Because stock prices are determined by thousands of investors agreeing to buy or sell at the same price, investment value is unlikely to differ greatly from market value.

9. An odd-lot differential is the additional transactions costs an investor must pay to an odd-lot dealer to trade in odd lots. The differential can be as high as 10 to 25 cents per share over and above normal commission fees. These costs can be avoided by trading in round lots, or units of 100 shares. a. Odd-lot differential added to fees b. No differential added c. Odd-lot differential added to fees

10. The question on the amount of dividends to be paid is decided by the firm’s . The directors evaluate the firm’s operating results and financial conditions to determine whether dividends should be paid and, if so, in what amount.

During a board of directors meeting, a variety of factors are considered in making the investment decision. These include: a. The firm’s current earnings or profits are considered a vital link in the dividend decision. b. The board also looks at the firm’s growth prospect. Firms with good investment opportunities pay less dividends, using the retained earnings, instead, for new investment. c. The board also considers the firm’s cash to make sure it has sufficient liquidity to meet a cash dividend of a given size. d. The board also ensures that it is meeting all legal and contractual constraints that might be imposed by loans. e. The board also makes an effort to meet the dividend expectations of its shareholders; failure to meet these expectations can lead to disastrous results in the stock market. Investors have a particularly negative view of dividend reductions, which are usually accompanied by falling stock prices.

11. The ex-dividend date (which occurs two business days prior to the date of record) determines who is eligible to receive the declared dividend when the stock is sold. If the stock is sold on or after the ex-dividend date, the owner (seller) receives the dividend; if it is sold prior to the ex-dividend date, the new (buyer) receives the dividend. Thus, if the stock is sold on the ex-dividend date, the seller receives the dividend—going “ex-dividend” means the buyer is not entitled to the dividend since the stock is being sold “without” the dividend.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 6

12. Cash dividends are simply dividend payments made to the stockholder in cash. This form of dividend represents something of value. A stock dividend is an issue of new shares expressed and distributed as a percentage of each shareholder’s existing shares. It really has no value since the market responds to stock dividends by adjusting the market price accordingly. As an example, consider a stock that is trading at $50 per share; if the issuing firm declared a 10% stock dividend, the price of this stock would drop by 9.1% to $45.45 ($50/1.1). Thus, an investor who held 100 shares before the stock dividend would hold 110 shares after, but the total market value of these shares would be basically the same: $50  100  $45.45  110.

When a stock dividend is declared by the firm, additional shares of the stock are issued to existing shareholders. Stock dividends may be used as a substitute for cash dividends, but they have no value because the stock prices adjust to the stock dividend accordingly. Stock splits occur when the firm gives shareholders new shares in exchange for each share they own. The central difference between stock dividends and stock splits is that dividends are additional issues and stock splits are exchanges.

In a 200% stock dividend, the investor receives additional shares equaling 200% of existing shares (i.e., 100 shares already owned  200%  200 new shares distributed in addition to the original 100). In a 3-for-1 stock split, the investor receives three new shares for each existing share (100  3  300 shares held after split).

13. Firms with dividend reinvestment plans (DRPs) allow shareholders to automatically reinvest their dividends into additional shares of the firm. DRPs provide investors with a convenient and inexpensive way to accumulate capital without paying brokerage commissions. Despite these cost savings, the dividends paid through DRPs are taxable as ordinary income in the year they are received, just as if they had been received in cash.

14. a. Blue chips are common stocks of very high quality that have a and proven record of earnings and dividends. They offer respectable dividend yields and modest growth potential. They are often viewed as long-term investments, have low risks, and provide modest but dependable rates of return. b. Income stocks are issues that have a long and sustained record of higher than average dividends. These are ideal for investors who desire high current income with little risk. Unlike other types of income securities (bonds, for instance), holders of income stocks can expect the amount of dividends they receive to increase regularly over time. One disadvantage with these stocks is their generally low to modest growth potential. In recent years interest rates have remained extremely low so that many stocks have dividend yields exceeding the return on high-quality debt instruments. c. Mid-cap stocks are stocks with capitalization value between $1 billion and $4–$5 billion. Mid-caps offer investors attractive return opportunities—they have the sizzle of small-cap stocks without the high price volatility. They also provide characteristics of the big, established stocks. This mid-cap range is probably most appropriate for investors willing to tolerate a bit more risk and price volatility than large stocks. One type of mid-cap stock, a “baby blue chip,” has all the characteristics of a regular blue chip, except for size. d. American depositary receipts (ADRs) are negotiable instruments issued by American . Each ADR represents a specific number of shares of stock in a specific foreign company. They are used as a way to purchase foreign stocks and are traded on U.S. exchanges (for example, the NYSE) or in the OTC markets; they trade just like shares of American stocks. Beyond the simplified trading, the investment merits of an ADR are a function of the investment merits of the foreign company that issued the stock, as well as the value of the dollar relative to the of the foreign company.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 6

e. IPOs are initial public offerings of primarily small, relatively new companies. As the name suggests, these stocks are offered to the public for the first time. IPOs offer a chance to earn phenomenal capital gains. At the same time, it is very likely that investing in IPO stocks might result in a loss. As such, these should be considered only by experienced and knowledgeable investors. IPOs must be considered to be highly risky investments. f. Tech stocks are issued by companies in the technology sector. Issuing firms produce everything from computers to Internet content. They typically are growth stocks or speculative stocks because they pose considerable risk to the investor. This sector has done extremely well in good times and depreciated significantly in bear markets.

15. Income stocks generally have limited capital gains potential because they pay out large amounts of their earnings in dividends; in essence, little of their income is plowed back into the company to finance growth. Returns from income stocks come mostly from current income rather than capital gains, a distinction favored by many investors. This does not mean these stocks are unprofitable; most, in fact, are highly profitable, with excellent long-term future prospects.

16. Approximately 35% of the world equity market is in U.S. stocks. For the most part, the U.S. stock market has been one of the best places to invest over the past 25 years. However, the United States seldom finished on top. Thus, to achieve greater returns on their portfolio in a given year, investors should also consider foreign markets. Furthermore, if the foreign currency appreciates relative to the U.S. dollar investors will have an additional profit in dollar terms.

The U.S. investor can either invest directly in foreign markets or indirectly by buying American depository receipts (ADRs). All things considered, American investors are probably better off with ADRs because they avoid many logistical problems and high transaction costs that arise with direct investing. ADRs are dollar-denominated and are about as easy to buy/trade as U.S. stocks.

17. A quality-conscious investor would probably do best with a simple and conservative buy-and-hold strategy. With this strategy, the investor purchases income, quality, and blue chip stocks and watches them grow over time. On the other hand, if an investor is willing to tolerate a lot of risk, an aggressive stock management strategy is the most appropriate. Here, the investor aggressively trades in and out of the various types of quality stocks in an attempt to earn above-average return from both dividends and capital gains. An individual’s investment approach depends upon whether common stock is viewed primarily as a storehouse of value, way to accumulate capital, or source of income.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 6