CHAPTER 6: ANSWERS TO CONCEPTS IN REVIEW

CHAPTER 6: ANSWERS TO CONCEPTS IN REVIEW 6.1 A common stock is an equity investment that represents ownership in a corporate form of business. Each share represents a fractional ownership interest in the firm. The key attribute of this investment security is that it enables investors to participate in the profits of the firm. As residual owners of the company, common stockholders are entitled to dividend income and a prorated share of the firm s earnings after all other obligations of the firm have been met. They have no guarantee they will ever receive any return on their investment. 6.2 One important investment attribute of common stocks is that they enable investors to participate in the profits of the firm and as such, they can offer attractive return opportunities. Another attribute is the versatility of the security it can be used to meet just about any type of investment objective. In addition, as investment vehicles go, common stocks are fairly simple and straightforward, so they re easy to understand (though that certainly doesn t mean they re easy to value). They are easy to buy and sell, and the transactions costs are modest. Moreover price and market information is widely disseminated in the news and financial media. 6.3 The stock market has been very good to investors over the past 15 years. Stocks have produced an average annual return of nearly 18%, which is substantially higher than the average annual return of 12% over a 50-year period. This market run, which began in the August of 1982, has seen the Dow soar more than 10-fold, making it one of the biggest advances of all time. But investors had to go through some hair-raising experiences during this run. On October 19 1987, the Dow fell by 508 points or 23% in a single day! And it took about 2 1/2 years for the market to recover from this crash. Similarly on October 27, 1997 the Dow fell by 554 points or 7%, but the market recovered all of its losses within two weeks. These volatile periods remind the investors of the risks involved in investing in the stock market. (Instructors can use Fig 6.1. to highlight the trend in stock movements. Instructors may emphasise that Log Scale DJIA is a much better indicator of trends as it measures the rate of change in the market. Instructors may also point out that these figures reflect the general behavior of the market as a whole, not necessarily that of individual stocks.) 6.4 Market breadth mean how broadly the market is moving, that is, are stocks overall trading in volume not just one sector like communications or one type of stock like large caps. Lack of market breadth became a problem when a relatively small number of stocks pushed market averages higher while many other companies did not move much if at all in prices. Consequently, some indexes were not truly representative of the overall market activity. 6.5 While they don t provide the bang that capital gains do, dividends are an important source of return to stockholders. Over the past 50 years, dividends have accounted for a little less than 50% of the average annual total return from stocks. This trend has been quite different in the past 10 years. Dividends have accounted for only about 3% of the total average annual returns of 18%, due to the strong bull market. There s no question that capital gains provide the really big returns, though they also lead to wider swings in year-to-year yields. Dividends, in contrast, provide an element of stability and tend to shore up returns in off years. 6.6 The major advantage of common stock ownership is the returns it offers. Because stockholders are entitled to participate in the prosperity of a firm, there is almost no limit to a stock s capital Fundamentals of Investing, by Gitman and Joehnk 1

gains potential. In addition, many stocks provide regular current income in the form of annual dividends and for most income-producing stocks, those dividends tend to grow over time, adding even more to the stockholder s return. Common stocks are also highly liquid and easily transferable; their transaction costs are relatively low, market information is readily available, and unit price is nominal. The risky nature of common stocks is the most significant disadvantage of common stock ownership. As residual owners of the firm, no return is guaranteed. Furthermore, prices are subject to wide swings, making valuation difficult. Finally, the sacrifice in current income is a disadvantage relative to other investments (like bonds, for instance) that pay higher and more certain returns. The principal risks to stockholders include: business and financial risk, purchasing power risk, and, of course, market risk. Business risk is related to the kind of business the company is in and deals with both sales volatility and the amount of variability in the firm s earnings. Financial risk is associated with the mix of debt and equity financing. The more debt (financial leverage) the firm uses, the greater the likelihood that it will default on its principal and interest payments which in turn will have a negative impact on the stock. Purchasing power risk refers to the possibility of price increases and the corresponding decline in the value of the dollars invested in common stock. Market risk is caused by factors independent of the firm that affect the return on the firm s common stock. Such things as economic fluctuations, threat of war, and political factors affect market risk and therefore can have a bearing on the market price of a stock. The market itself has an impact on the price performance of a stock which, of course, is what beta is all about (i.e., a stock s beta is a measure of the extent to which the stock reacts to the market). 6.7 A stock split occurs when a firm announces its intention to increase the number of shares of stock outstanding by exchanging a specified number of new shares for each outstanding share of stock. Most stock splits are executed with a view to lowering the price of the stock and enhancing its trading appeal. If the stock split is not accompanied by an increase in the level of dividends, stock prices will fall to account for the split. Thus, a $100 stock will fall to $50 after a 2 for 1 split. If the company had changed its dividend rate say, by increasing dividends the stock price will rise after adjusting for the split. In the above case, the stock price will end up above $50 per share, depending on the size of the dividend increase. Thus, other things being equal, a change (increase) in the dividend rate will have a positive impact on the stock s price, after adjusting for the stock split. 6.8 Stock spin-offs involve conversion of one of firm's subsidiaries to a stand alone company by distribution of stock in that new company to existing shareholders. For e.g. Pepsico spun off its restaurant operations - Pizza Hut, KFC, and Taco Bell - into a new company called Tricon Global Restaurants. Spin-offs have been very successful in the pre-1995 era, beating the S&P 500 index by 18.5%. In the post-1995 era, their performance has been marginally better than the market index, mainly due to increasing investor interest in these companies. Spin-offs might be a good idea because the new company might be less bureaucratic and more entrepreneurial than the parent. Given incentives such as stock options, new management can find ways to improve corporate performance; thus improving stock returns. 6.9 a. Firms do not issue treasury stock; these are simply shares of common stock that have been issued and subsequently repurchased by the issuing firm. This is generally done because the Fundamentals of Investing, by Gitman and Joehnk 2

firm views the stock as an attractive investment; perhaps the price is unusually low. Most treasury stock is later reissued by the firm and used for such purposes as mergers and acquisitions, employee stock option plans, or for payment of stock dividends. Treasury stock is not a form of classified stock. Classification of common stock simply breaks common stock into different classes or groups. Each class has different voting rights and/or dividend obligations. For example, class A stock might designate nonvoting shares that receive preferential dividends, while class B stock might designate voting shares with lower dividends. Some classes pay stock dividends to appeal to individuals interested in capital gains; other classes pay higher cash dividends that attract income-seeking investors. b. Common stock can be bought or sold in round or odd lots. A round lot is 100 shares of stock, or multiples of 100 shares. An odd lot is a transaction involving less than 100 shares. c. The par value of a stock is its stated or face value and exists primarily for accounting purposes. Many stocks are issued with no par value. It is a relatively useless number. The liquidation value of a stock is an estimate of the market value of the firm s assets, if sold at auction, less the liabilities and preferred stock outstanding. While this measure of value is vitally important to the high-stakes LBO and take-over artists, it is very difficult to determine and is generally of little interest to the typical individual investor who tends to view the firm as a going concern. d. Book value is an accounting measure of the amount of stockholder's equity in the firm. Book value indicates the amount of stockholder funds used to finance the firm. Investment value, perhaps the most important measure for a stockholder, indicates what value investors place on the stock. Investment value is based on the expectations of the risk and return patterns of a stock: the returns come from dividends and capital gains, and the risk is based on the exposure to holding the stock. 6.10 An odd-lot differential is the additional transactions costs an investor must pay to an odd-lot dealer to trade in odd lots. The differential can be as high as 12.5 to 25 cents per share over and above normal commission fees. These costs can be avoided by trading in round lots, or units of 100 shares. a. odd-lot differential added to fees b. no differential added c. odd-lot differential added to fees 6.11 The question on the amount of dividends to be paid is decided by the firm's board of directors. The directors evaluate the firm's operating results and financial conditions to determine whether dividends should be paid and, if so, in what amount. During a Board of Directors meeting, a variety of factors are considered in making the investment decision. These include: a) The firm s current earnings or profits are considered a vital link in the dividend decision. b) The Board also looks at the firm s growth prospect. Firms with good investment opportunities pay less dividends; using the retained earnings for new investment. c) The Board also considers the firm's cash position to make sure it has sufficient liquidity to meet a cash dividend of a given size. Fundamentals of Investing, by Gitman and Joehnk 3

d) The Board also ensures that it is meeting all legal and contractual constraints that might be imposed by loans. e) The Board also makes an effort to meet the dividend expectations of its shareholders; failure to meet these expectations can lead to disastrous results in the stock market. 6.12 The ex-dividend date (which occurs three business days prior to the date of record) determines who is eligible to receive the declared dividend when the stock is sold. If the stock is sold on or after the ex-dividend date, the owner (seller) receives the dividend; if it is sold prior to the ex-dividend date, the new shareholder (buyer) receives the dividend. Thus, if the stock is sold on the ex-dividend date, the seller receives the dividend going ex-dividend means the buyer is not entitled to the dividend since the stock is being sold without the dividend. 6.13 Cash dividends are simply dividend payments made to the stockholder in cash. This form of dividend represents something of value. A stock dividend is an issue of new shares expressed and distributed as a percentage of each shareholder s existing shares. It really has no value, since the market responds to stock dividends by adjusting the market price accordingly. As an example, consider a stock that is trading at $50 per share; if the issuing firm declared a 10 percent stock dividend, the price of this stock would drop by 10 percent to approximately $45. Thus, an investor who held 100 shares before the stock dividend would hold 110 shares after, but the total market value of these shares would be basically the same: $50 x 100 = $45 x 110 (actually the post-dividend price would have to be $45.45 for the two market values to be identical). When a stock dividend is declared by the firm, additional shares of the stock are issued to existing shareholders. Stock dividends may be used as a substitute for cash dividends, but they have no value because the stock prices adjusts to the stock dividend accordingly. Stock splits occur when the firm gives shareholders new shares in exchange for each share they own. The central difference between stock dividends and stock splits is that dividends are additional issues and stock splits are exchanges. In a 200 percent stock dividend, the investor receives additional shares equaling 200 percent of existing shares equaling 200 percent of existing shares (i.e., 100 shares already owned x 200% = 200 new shares distributed in addition to the original 100). In a 2 for 1 stock split, the investor receives 2 new shares for each existing share (100 x 2 = 200 shares held after split). 6.14 Firms with dividend reinvestment plans (DRPs) allow shareholders to automatically reinvest their dividends into additional shares of the firm. DRPs provide investors with a convenient and inexpensive way to accumulate capital without paying brokerage commissions. Despite these cost savings, the dividends paid through DRPs are taxable as ordinary income in the year they are received, just as if they had been received in cash. 6.15 a. Blue chips are common stocks of very high quality that have a long and proven record of earnings and dividends. They offer respectable dividend yields and modest growth potential. They are often viewed as long-term investment vehicles, have low risks, and provide modest but dependable rates of return. b. Income stocks are issues that have a long and sustained record of higher than average dividends. These are ideal for investors who desire high current income with little risk. Unlike other types of income securities (bonds, for instance), holders of income stocks can expect the amount of dividends they receive to increase regularly over time. One disadvantage with these stocks is their generally low to modest growth potential. Fundamentals of Investing, by Gitman and Joehnk 4

c. Mid-cap stocks are stocks with capitalization value between $750 million to $3-$4 billion. Mid-caps offer investors attractive return opportunities they have the sizzle of small-cap stocks without the high price volatility. They also provide characteristics of the big, established stocks. This mid-cap range is probably most appropriate for investors willing to tolerate a bit more risk and price volatility than large stocks. One type of mid-cap stock, a baby blue chip, has all the characteristics of regular blue chip, except for size. d. American Depository Receipts (ADRs) are negotiable instruments issued by American banks. Each ADR represents a specific number of shares of stock in a specific foreign company. They are used as a way to purchase foreign stocks and are traded on U.S. exchanges (for example, the NYSE) or in the OTC markets; they trade just like shares of American stocks. Beyond the simplified trading, the investment merits of an ADR are a function of the investment merits of the foreign company that issued the stock, as well as the value of the dollar relative to the currency of the foreign company. e. IPOs are initial public offerings of primarily small, relatively new companies. As the na me suggests, these stocks are offered to the public for the first time. (Note: The stock in big, well-known companies that went private through LBOs can also be reissued to the public. When that occurs, the shares are issued much like any other IPO except that it s a much bigger new issue.) IPOs offer a chance to earn phenomenal capital gains. At the same time, it is very likely that investing in IPO stocks might result in a loss. As such, these should be considered only by experienced and knowledgeable investors. IPOs must be considered to be highly risky investments. 6.16 Income stocks generally have limited capital gains potential because they pay out large amounts of their earnings in dividends; in essence, little of their income is plowed back into the company to finance growth. Returns from income stocks come mostly from current income rather than capital gains, a distinction favored by many investors. This does not mean these stocks are unprofitable; most, in fact, are highly profitable, with excellent long-term future prospects. 6.17 Only 40 percent of the world equity market is in U.S. stocks. For the most part, the U.S. stock market has not been able to match the performance of some of the foreign markets over the last decade. Thus, to achieve greater returns on their portfolio, investors should also consider foreign markets. The U.S. investor can either invest directly in foreign markets or indirectly by buying American Depository Receipts (ADRs). All things considered, American investors are probably better off with ADRs because they avoid many logistical problems that arise with direct investing. ADRs are dollar-denominated and are about as easy to buy/trade as U.S. stocks. 6.18 Yes, currency exchange rates can have a big impact on security returns. This is because money that's invested overseas is typically converted to a local currency and then later converted back to dollar. If the dollar is weakening, then the local currency can buy more dollars when the money is concerted later. For example, assume that the market in India gives a return of 10%. If a U.S. investor invested $100 in an Indian market today and current exchange rate is Rs. 40/$, then he has invested Rs. 4000 in India. In one year, his investment is worth Rs. 4,400. For the U.S. investor, the return in U.S. dollars depends on the exchange rate at which Rs. 4,400 is converted. If the rupee appreciates to Rs. 30/dollar, his investment is worth $ 146.66 or a return of 46.66%. Fundamentals of Investing, by Gitman and Joehnk 5

If the Rupee depreciates to Rs. 50/$, his investment is worth $88 or a loss of 12%. Hence exchanges rates are crucial! Once exchange rates are factored out, the US market outperformed the overseas markets. US markets yield a return of 470% between 1985 and 1995 while the overseas markets yielded 193% in the same period. 6.19 A quality conscious investor would probably do best with a simple and conservative buy-and hold strategy. With this strategy, the investor purchases income, quality, and blue chip stocks, and watches them grow over time. On the other hand, if an investor is willing to tolerate a lot of risk, an aggressive stock management strategy is the most appropriate. Here the investor aggressively trades in and out of the various types of quality stocks in order to earn above average return from both dividends and capital gains. Fundamentals of Investing, by Gitman and Joehnk 6