HB 311 1st Edition Lecture 8 Current Lecture Institutional Characteristics of Common Stock Corporate Organization and Control Controlled by Board of Directors elected by stockholders Board appoints top management who then appoint middle lower management Board consists of top management and outside members major stockholders top executives at other firms former presidents etc In widely held corporations top management is effectively in control of the firm because no stockholder group has enough power to remove them Preemptive Rights If firm issues new shares existing shareholders have right to purchase pro rata share of new issue Common but not required by law Voting Rights and Issues Each share of common stock has one vote in the election of directors which is usually cast by proxy A proxy fight occurs if parties with conflicting interests solicit proxies at the same time Stockholders Claim on Income and Assets Stockholders have claim on the firm s net income What is not paid out as dividends is retained Retained Earnings for investment in new projects Leads to future growth These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Common stockholders are last in line to receive income or assets and bear more risk than other investors However residual interest is large when firm does well Preferred Stock Preferred stock is often referred to as a hybrid between common stock and bonds because No maturity date like common stock Fixed dividend payment similar to bond interest payment Example 100 preferred issue offering a dividend of 10 is referred to as 10 preferred issue Characteristics of Preferred Stock Cumulative Feature Common dividends can t be paid unless the dividends on cumulative preferred are current Preferred stock never returns principal like a bond does upon maturity Preferred stockholders cannot force a firm into bankruptcy like bondholders Preferred stockholders received preferential treatment over common stockholders in the event of bankruptcy but have a lower priority than bondholders Preferred stockholders do not have voting rights like common stockholders do Dividend payments to preferred stockholders are not tax deductible to the firm Valuation of Preferred Stock There is no growth rate in preferred stock dividends so growth rate equals 0 The dividend at time 1 is the same as the dividend at time 0 so there is usually no time period associated with the numerator Valuation is that of a perpetuity Securities Analysis Securities analysis is the art and science of selecting investments Fundamental analysis looks at a company and its business to forecast value Technical analysis bases value on the pattern of past prices and volumes The Efficient Market Hypothesis says information moves so rapidly in financial markets that price changes occur immediately so it is impossible to consistently beat the market to bargains Options and Warrants Option gives the option holder the temporary right to buy or sell an asset from another party at a fixed price For instance a company may be interested in building a new factory on a tract of land but it is still unsure if it wants to build the factory However it plans to make a final decision in six months The company could buy an option contract giving it the right to buy the land at a fixed price by the end of the six months If the company pursues the factory project it would exercise the option If the company decided not to go ahead with the factory project it would not have to exercise the option But what if the value of the land had risen substantially above the price fixed by the option it could exercise the option and sell the land for a profit thus benefiting even though it didn t own the land during the period of the option Stock Options Stock options are purchased to speculate on stock price movements Can be traded in financial markets Call option call an option to buy a stock Put option put an option to sell stock Known as a derivative derives its value from the price of an underlying security Call Option Basic call option Gives owner the right to buy stock at a fixed price called the exercise or strike price for a specified time period Usually 3 6 or 9 months Option expires at the end of the time period Price of the option is less than the price of the underlying stock The more volatile the stock s price the more attractive the option The stock s price is more likely to exceed the strike price before the option expires The longer the time until expiration the more attractive the option The stock s price is more likely to exceed the strike price before the option expires The Call Option Writer The option writer is the person who creates the contract Agrees to sell the stock at the strike price if the option is exercised The original writer must stand ready to deliver on the contract regardless of how many times the option is sold Call writer hopes stock price will remain the same Intrinsic Value A call option s intrinsic value is the difference between the underlying stock s current price and the option s strike price If the option is out of the money then the intrinsic value is zero Option will always sell for intrinsic value or above Difference between option s intrinsic value and price is known as time value Options and Leverage Financial leverage Technique that amplifies return on investment Improves positive returns and worsens negative returns Options offer leveraging potential due to the lower price at which you can buy an option compared to the price of the underlying stock The higher the price of the option the less the leverage potential Options That Expire Option investing is risky because options expire after a limited time If the option was purchased out of the money and the stock price never exceeds the strike price prior to the expiration date the option will expire worthless Resulting in a 100 loss As the expiration date approaches an option s time value approaches zero Trading in Options Options can be bought and sold at any time prior to expiration Chicago Board Options Exchange CBOE is the largest oldest and best known options exchange Price volatility in the options market As the price of the underlying stock changes the price of the option changes but by a greater relative movement due to the lower price of the option compared to the stock Options are rarely exercised before expiration If the call option