FIN3244 FINAL EXAM STUDY GUIDE Chapter 11 Common Stocks I What Stocks Have to Offer i Enable investors to participate in the profits of a firm ii 11 Become residual owners of the company 1 Residual owner investors such as lenders their claim is subordinate to the claims of other 2 Company must fulfill all other financial obligations for investors to profit 3 No guarantee that they will receive any return on their investment i The allure of common stocks is the prospect that they will increase in value over time and generate significant capital gains ii Dividends provide a periodic income stream but are pale in comparison to II The Appeal of Common Stocks capital gains market III Putting Stock Price Behavior in Perspective i The behavior of stock prices are usually in line with the behavior of the ii Market decline is much less common than market increase iii From 1956 2008 the Dow was down for the year only 17 times iv From 1982 to early 2000 the DJIA grew at an annual rate of 17 IV 1 From Stock Prices to Stock Returns i Stock returns take into account both price behavior and dividend income ii Two basic sources of return 1 Dividends 2 Capital Gains iii Capital gains generally provides the bigger gains or losses on return of stock iv Stocks generally earn positive total returns over long periods of time v Investing in stock does not come without risk A Real Estate Bubble Goes Bust and So Does the Market V i Some of the biggest investors of home mortgages were commercial and investment banks 1 Their stock price dropped when mortgages could not be repaid 2 Lehman Brothers filed for bankruptcy in September 2008 a Sparked free fall in stock market VI 3 12 The Pros and Cons of Stock Ownership a The Advantage of Stock Ownership i They offer substantial return opportunities ii Stocks typically outperform corporate bonds 1 In last century high grade corporate bonds earned annual returns that were about half as large as the returns on common stocks iii Provide investors protection from inflation iv They are easy to buy and sell v The unit cost of a share of common stock is with reach of most financial investors b The Disadvantages i Stocks are subject to various types of risk 1 Business and financial risk 2 Purchasing power risk 3 Market risk 4 Event risk ii The earnings and general performance of stocks are subject to wide swings iii The sacrifice current income in hopes of attaining capital gains returns VII Basic Characteristics of Common Stocks i Are often referred to as equity securities or equity capital ii The value of all traded and OTC stocks in mid 2009 was more than 12 trillion Issuing New Shares b i Most widely used procedure is a public offering ii 4 Can also issue shares through a rights offering 1 Rights offering opportunity to buy the new issue existing stockholders are given the first a A stock right gives the shareholder the right to purchase new shares of the company s stock in proportion to his or her current ownership position occurs when a company gets rid of one of its subsidiaries or c Stock Spin Offs i Spin Off divisions ii Creates a new stand alone company and then distributes stock in that company to its existing shareholders d 14 Stock Splits a firm merely announces that it will increase the number of i Stock split shares outstanding by exchanging a specified number of new shares for each outstanding share of common stock ii In a 2 1 stock split two new shares are exchanged for each old share iii Company uses stock split when it wants to enhance its stock s trading iv For a 2 for 1 stock split we divide the original price per share by the ration appeal by lowering market value of new shares to old VIII Buying and Selling Stocks 1 2 In a 2 for 1 200 shares of 100 would become 400 shares of 50 In a 3 for 2 200 shares of 100 would become 300 shares of 67 e 15 Treasury Stock i Treasury Stock subsequently repurchased by issuing firm are simply shares of stock that have been issued and ii Firms repurchase their own stock when they view it as undervalued in the market place 1 Used to reduce the number of shares outstanding iii Treasury stock can be used at a later date for a number of reasons f Classified Common Stock i Classified common stock privileges and benefits each class of common stock is different and has its own value each of which entitles holders to different i Monitoring current price as well as transactions costs is important because of the impact they can have on investment returns i Investors in the stock market have come to rely on a highly efficient information systems that quickly disseminates market prices to the public b Reading the Quotes c Transaction Costs 5 A round lot is 100 shares of stock or multiples there of i ii An odd lot is a transaction involving fewer than 100 shares 1 Higher fees associated with odd lot transactions 2 Requires odd lot dealer 3 Results in odd lot differential a Usually 10 25 iii The major cost is the brokerage fee paid by both the buyer and the seller at IX time of transaction 6 16 Common stock values a Par Value i Par value refers to the stated or face value of a stock 1 Relatively useless b Book Value i Book value an accounting measure represents the amount of stockholder s equity in a firm Indicates the amount of stockholders funds used to finance the firm ii iii Most stocks have market prices that are well above their book value c Market Value i Market value ii it is simply the prevailing market price of an asset Indicates how the market participants as a whole have assessed the worth of a share of stock iii Market Capitalization market price x number of shares outstanding d Investment Value i ii is probably the most important measure for a Investment value stockholder indicates the worth investors place on stock what they think the stock should be trading for Investment value is calculated by assessing the risk and return for a given stock iii The value represents the maximum price an investor should be willing to X 2 Common Stock Dividends pay for the issue i Capital gains provide a much bigger source of return than dividends at least over the long haul ii Taxed at the same rate as capital gains 15 XI The Dividend Decision i Directors evaluate the firm s operating results and financial condition to determine whether dividends should be paid and if so what amount b Corporate Versus Market Factors i Profits are considered a vital link in the dividend decision ii Annual earnings of a firm are usually measured
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