Chapter 11: Common StocksChapter 12 – Analyzing Common StockChapter 13 – Mutual Funds: Professionally Managed PortfoliosFIN3244 – FINAL EXAM STUDY GUIDEChapter 11: Common StocksI. What Stocks Have to Offeri. Enable investors to participate in the profits of a firmii. (11) Become residual owners of the company1. Residual owner – their claim is subordinate to the claims of other investors, such as lenders2. Company must fulfill all other financial obligations for investors to profit3. No guarantee that they will receive any return on their investmentII. The Appeal of Common Stocksi. The allure of common stocks is the prospect that they will increase in value over time and generate significant capital gainsii. Dividends provide a periodic income stream but are pale in comparison to capital gainsIII. Putting Stock Price Behavior in Perspectivei. The behavior of stock prices are usually in line with the behavior of the market ii. Market decline is much less common than market increaseiii. From 1956-2008 the Dow was down for the year only 17 timesiv. From 1982-to early 2000 the DJIA grew at an annual rate of 17%IV. (1) From Stock Prices to Stock Returnsi. Stock returns take into account both price behavior and dividend incomeii. Two basic sources of return1. Dividends 2. Capital Gainsiii. Capital gains generally provides the bigger gains or losses on return ofstockiv. Stocks generally earn positive total returns over long periods of timev. Investing in stock does not come without riskV. A Real Estate Bubble Goes Bust and So Does the Marketi. Some of the biggest investors of home mortgages were commercial and investment banks1. Their stock price dropped when mortgages could not be repaid2. Lehman Brothers, filed for bankruptcy in September 2008a. Sparked free fall in stock marketVI. (3) (12) The Pros and Cons of Stock Ownershipa. The Advantage of Stock Ownershipi. They offer substantial return opportunitiesii. Stocks typically outperform corporate bonds1. In last century high grade corporate bonds earned annual returns that were about half as large as the returns on commonstocksiii. Provide investors protection from inflationiv. They are easy to buy and sellv. The unit cost of a share of common stock is with reach of most financial investorsb. The Disadvantagesi. Stocks are subject to various types of risk1. Business and financial risk2. Purchasing power risk3. Market risk4. Event riskii. The earnings and general performance of stocks are subject to wide swingsiii. The sacrifice current income in hopes of attaining capital gains returnsVII. Basic Characteristics of Common Stocksi. Are often referred to as equity securities or equity capitalii. The value of all traded and OTC stocks in mid-2009 was more than $12 trillionb. Issuing New Sharesi. Most widely used procedure is a public offeringii. (4) Can also issue shares through a rights offering1. Rights offering – existing stockholders are given the first opportunity to buy the new issuea. A stock right gives the shareholder the right to purchasenew shares of the company’s stock in proportion to his or her current ownership positionc. Stock Spin-Offsi. Spin-Off – occurs when a company gets rid of one of its subsidiaries ordivisionsii. Creates a new stand-alone company and then distributes stock in that company to its existing shareholdersd. (14) Stock Splitsi. Stock split – a firm merely announces that it will increase the number of shares outstanding by exchanging a specified number of new sharesfor each outstanding share of common stockii. In a 2-1 stock split two new shares are exchanged for each old shareiii. Company uses stock split when it wants to enhance its stock’s trading appeal by lowering market valueiv. For a 2-for-1 stock split we divide the original price per share by the ration of new shares to old1. In a 2-for-1, 200 shares of $100 would become 400 shares of $502. In a 3-for-2, 200 shares of $100 would become 300 shares of $67e. (15) Treasury Stocki. Treasury Stock – are simply shares of stock that have been issued and subsequently repurchased by issuing firmii. Firms repurchase their own stock when they view it as undervalued in the market place1. Used to reduce the number of shares outstandingiii. Treasury stock can be used at a later date for a number of reasonsf. Classified Common Stocki. Classified common stock – each of which entitles holders to different privileges and benefits, each class of common stock is different and has its own valueVIII. Buying and Selling Stocksi. Monitoring current price as well as transactions costs is important because of the impact they can have on investment returnsb. Reading the Quotesi. Investors in the stock market have come to rely on a highly efficient information systems that quickly disseminates market prices to the publicc. Transaction Costsi. (5) A round lot is 100 shares of stock or multiples there of ii. An odd lot is a transaction involving fewer than 100 shares1. Higher fees associated with odd lot transactions2. Requires odd lot dealer3. Results in odd-lot differential a. Usually $.10 - $.25iii. The major cost is the brokerage fee paid by both the buyer and the seller at time of transactionIX. (6) (16) Common stock valuesa. Par Valuei. Par value – refers to the stated, or face, value of a stock1. Relatively uselessb. Book Valuei. Book value – an accounting measure, represents the amount of stockholder’s equity in a firmii. Indicates the amount of stockholders funds used to finance the firmiii. Most stocks have market prices that are well above their book valuec. Market Valuei. Market value – it is simply the prevailing market price of an assetii. Indicates how the market participants as a whole have assessed the worth of a share of stockiii. Market Capitalization = market price x number of shares outstandingd. Investment Valuei. Investment value – is probably the most important measure for a stockholder, indicates the worth investors place on stock, what they think the stock should be trading forii. Investment value is calculated by assessing the risk and return for a given stockiii. The value represents the maximum price an investor should be willing to pay for the issueX. (2) Common Stock Dividendsi. Capital gains provide a much bigger source of return than dividends, at least over the long haulii. Taxed at the same rate as capital gains (15%)XI. The Dividend Decisioni. Directors evaluate the firm’s
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