Finance Study Guide Chapter 11 Common Stock Common Stock represents a person s ownership of a firm Residual ownership gives the entitlement to dividends as a share of the firm s earnings Dividends are an important source of income with stocks but do not provide the bang that capital gains do Dividends represent stability and can provide returns in off years No guarantee of receiving dividends Attributes of Common Stock 1 It has high returns 2 It is versatile 3 Simpler than other investments 4 NOT easy to value 5 Highly liquid 6 Easy to buy with low Transaction costs 3 Annual Dividends tend to grow over time Advantages of Common Stock 1 High returns 2 Unlimited potential of CG 4 Highly liquid 5 Low prices Disadvantages of Common Stock 1 Risky 2 No guarantee of dividends 3 Opportunity costs Stock Split firms increases outstanding shares by exchanging new shares for existing shares Enhance trade appeal Trade Range Theory by reducing price Shows stock is not overpriced Signaling Theory showing a firm believes its stock is undervalued Attention getting events Viewed as POSITIVE events Firms that split stocks have abnormal returns the following years Stock Spin Off conversion of firms division to a stand alone by distributing stock in a new company to existing shareholders Investors keep shares in old brand while being given new company shares Investors can do what they wish with the stocks Treasury Stock stock that a firm has repurchased Done when a firm views itself as an attractive investment Most treasury stock is later reissued NOT classified stock Classified stock common stock that is groups separately based on higher dividend rates or different voting rights in the company Par Value the face value of a stock Exists for accounting purposes Market value the of outstanding shares times the price per share Book value the accounting measure of stockholders equity in a firm Shows how much stockholder funds are financing the firm Investment value value that an investor places on a stock also known as intrinsic value Shows the MAX price an investor is willing to pay for a stock Boards of directors make dividend decisions based on 1 Current profits 2 Growth prospects 3 Cash position liquidity 4 Legal and contracts 5 Dividend expectations to shareholders Ex dividend date determines who is eligible to receive a dividend If stock is sold on or after the seller receives dividend If the stock is sold before the buyer receives it The stock price falls by the amount of the dividend on the ex dividend date Going ex dividend means the buyer is not entitled to the dividend because the stock is being sold without it Cash dividend dividend paid in cash Considered to have greater value than stock dividends Dividend paid in stock market value of stock stays the same but the investor receives the dividend in the form of more shares Dividend reinvestment plan DRIP allows the investor to automatically reinvest in shares These are a form of Stock Split After dividends the firms stock price decreases No brokerage commissions But taxed like cash personal income Income stocks limited capital gains because they pay most of their earnings in the form of dividends Most income stocks are highly profitable Chapter 13 Mutual Funds Mutual Fund represents ownership in a managed portfolio of securities Revolves around diversification Reduced overall risk without reducing average return Open ended investments Advantages of Mutual Funds 1 Diversification 2 Professionally managed 3 Mutual funds handle all paperwork and reinvest dividends Disadvantages of Mutual Funds 1 Can be expensive with load funds or 12 b 1 fees 2 Lower returns than the market index generally 3 High expenses reduce investor returns Open ended investment 1 Contains unlimited of shares 2 Bought and sold directly from Mutual Fund 3 Most common type of mutual fund Close ended investment 1 Fixed number of shares 2 More rare than open ended investments 3 Trade in secondary market 4 Listed on the NYSE 1 Open ended but trade like stocks 2 Less regulated 3 No capital gains but give dividends 4 Tax efficient 5 payment in kind creation unit instead of cash Exchange Traded Funds hybrid of mutual funds and close ended funds Hedge Funds 1 Sell shares in professionally manages portfolio 2 PRIVATE limit investors to accredited people 3 Manager is a general partner while investors are limited partners 4 Limit partners to less than 100 5 No SEC regulations Load Funds funds that charge commission to purchase shares No load fund does not charge commission and has higher return 12 b 1 fund annual fee of 25 to 1 on mutual funds Can be a no load fund if less than 25 Back end load fee that investor pays when he sells fund shares Create incentive for stock holders to retain their shares for long periods of time because the fee disappears within 3 5 years Fees and commission can be found on a fund s prospectus SEC sets rules but the funds can also have their own specific rules Automatic reinvestment plan enables fund owners to keep capital fully invested Let s investors earn fully compounded rates of return Avoided brokerage costs and front end loads Mutual funds generally mimic the market but it depends on which sector of funds the mutual fund managers
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