Answers to Concepts in Review 1. A common stock is an equity 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 security is that it enables investors to participate in the profits of the firm. As residual owners of the company, common stockholders are entitled to dividend 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 stocks 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 market information is widely disseminated in the news and financial media. 3. The stock market 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 Nasdaq’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, dividends are an important source of return to stockholders. Dividend returns are always positive, although the dividend yield 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, short-term fixed income 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 volatility 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 beta 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 stock split 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 shareholders. 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” treasury stock; 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 option 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 par value 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 preferred stock 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 investor who tends to view the firm as a going concern. d. Book value 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.