HB 311 1st EditionLecture 8Current LectureInstitutional 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 lawVoting 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 timeStockholders’ 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 growthThese 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 wellPreferred 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 issueCharacteristics 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 theevent 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 firmValuation 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 perpetuitySecurities 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 bargainsOptions and Warrants• Option gives the option holder the temporary right to buy (or sell) an asset from anotherparty 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 landduring the period of the optionStock 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 securityCall 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 expiresThe 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 sameIntrinsic 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 valueOptions 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 potentialOptions 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 zeroTrading 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