FIN3244 Chapter 11

Book value versus investment value

Book value indicates the amount of stockholder funds used to finance the firm. Investment value indicates what value an investor places on the stock based on expectations of the risk and return.

MV(share)

Current market price of last stock trade

Classified Common Stock: (2 benefits/privileges)

Different classes have different privileges & benefits 1. Voting rights (1 vote per share) 2. Dividend amounts & payment schedules

Stock Price Behavior

Directional; Economy and Stock Prices move together In general, stocks earn positive returns over long periods of time

Stock dividends

paid in additional stock shares NO REAL VALUE (book) Taxes deferred until shares are sold (Capital gains tax: long & short term)

Ex-dividend date

(2-3 days before date of record). determines who is eligible to receive the declared dividend Sold on or after date, stock sells without dividend. Allows time for bookkeeping. ***stock price falls by dividend amount***

Book Value

Amount of firm's equity belonging to stockholders' (the owners of the firm)

Income Stock. why limited capital gains potential?

An income stock is an equity security that pays regular, often steadily increasing dividends they pay out large amounts of their earnings in dividends and re-invest less of their earnings into the finance growth of the firm. = Returns come from div (current income), and not capital gains

MV(firm)

= (share price) x (# common shares outstanding) === Firm's MARKET CAPITALIZATION = changes moment to moment

Board of Directors

1 vote for C/S Represent shareholders and oversee company decisions 1. hiring/firing CEO

Why do firms repurchase shares? (2)

1. Belief that stock is undervalued (price will rise in future) 2. Way to return profits to shareholders (capital gains as opposed to dividends) (1 time only, holders don't expect more) Firm investing in itself because it thinks its a good buy

Stock Ownership Advantages (4)

1. Best probability for highest returns 2. Good inflation hedge 3. Highly liquid 4. Transaction costs relatively small

Two ways shareholders don't lose money from issuance of equity capital

1. Can buy lower price offering before public 2. Sell rights to buy Both offset loss in value of their existing shares

Foreign Market Return Risk

1. Due to exchange rates 2. Know less about whats going on in the countries 3. Accounting different 4. Political turmoil

Dividend Considerations (5) (whether or not to pay dividends)

1. EPS/current profits 2. Growth opportunities (do they need $ for expansion?) 3. Cash position (sufficient liquidity) 4. Contractual obligations? (restricted covenants) 5. Div expectations of shareholders

Results of rights offering (3)

1. Firm acquires more equity capital 2. Number of shares outstanding increases 3. Decrease of stock price to existing shareholders TO MAINTAIN EXISTING OWNERSHIP %

Why don't firm's issue C/S (2)

1. Firms too small 2. Family or privately controlled (Still C/S, just not public)

Possible uses of treasury stock (3)

1. In the course of a Merger/Acquisition 2. Companies pay other companies with shares of their own stock 3. May use as stock options for management/employees

Stock Split:

Specified # of 'new' shares (more) exchanged for 'old' shares Have more shares than you began with 1 share @ 1.00 to 2 shares @ .50

Cash dividends

1. Most common type 2. Tend to rise over time: as firm's earnings increase 3. Meets investor expectations Mature firms: less opportunities from new growth

Stock Spin-Off: Why? (2)

1. No longer a good fit (Chipotle-McDonalds) 2. More profitable on its own Might drag down parent company or not recognize its full potential (lack funding or management attention) 3. Don't have to issue an IPO

Why are costs relatively small per transaction for Stock? (2)

1. Price & market info easily obtainable 2. Unit cost per stock share relatively low: (Lets small investors invest) versus commercial paper w/ min $100,000 investment

Name some of the more important attributes of common stock

1. Profits (return) 2. Versatility 3. Simple & Straightforward 4. Liquid 5. Low Transaction Costs 6. Easy to get information

Publicly traded C/S (2)

1. Readily available to the general public 2. Listed firms are subject to SEC regs.

Stock Ownership Disadvantages (4)

1. Volatile: Can be wide swings in earnings & performance (great upside, serious downside) 2. Subject to many types of risk (internal & external) & greater risk than debt investments (uncertainty) 2. Hard to predict the future (Future value of firm, stock market, economy) 3. Hard to analyze data even when right 4. Sacrifice current income

Reinvested dividends (DRIPs):

Allow shareholders to automatically reinvest their dividends into additional firm shares. Typically, no brokerage commissions 1. Convenient 2. Inexpensive Taxed as is it was cash dividend

Declaration date

Announcement

Stock repurchase (buyback): Impact on share price?

Announcement Actual occurrence

Book Value Formula

BV = (Firm's assets) - (Firm's liabilities + preferred stock)

When is lowering dividends more acceptable?

Bad economic times, shareholders understand its lower for all firms

Why would an investor hold a certain stock?

Believe that a firm's earnings will grow CEO job to maximize shareholder wealth Less growth as firms mature b/c they no longer need all its profits to pursue investment opportunities = if not using $ to grow firm, CEO must pay shareholders

Stock repurchase (buyback): Creates?

Buy back shares of own stock @ market price = Decreases # outstanding shares = Treasury Stock = "Retire" the stock to their treasury

Selling Stock Dividends

Can sell at MV and its basically a cash dividend Make investors wonder who the company isn't paying dividends in cash = Cash problems = stock price down = dividends worth less

Total Stock Returns formula

Capital Gains + Current Income === (Selling price - buying price) + Dividends

Stock: Internal Risks

Come from the firm itself; Management, the product, etc.

Dividends paid out? Special Dividend

Companies don't pay dividends until they think they can pay them consistently overtime Special Dividend = one time only, stockholders shouldn't expect to receive it again

Stock: External Risks

Company has no control over Oil prices, terrorism, etc. SYSTEMATIC RISK = affects ALL STOCKS

Capital Gains vs. Dividends

Dividend: 1. Returns less volatile than capital gains returns (more stable) 2. Dividends can offset cap losses or boost cap gains 3. Cant have negative return Capital Gains: 1. Majority of returns come from capital gains (Main source of returns for shareholders) 2. Only time you know what your capital gains will be is when you actually sell 3. Can have negative capital gains (loss) ~~~~~~ Despite capital gains unquestionably providing higher returns than dividends, capital gains are responsible for the wide swings in year-to-year total stock returns. Dividends, in contrast, provide an element of stability and tend to shore-up returns in off-years.

Effect of a Spin-Off

Firm gets smaller = DOES NOT CHANGE # C/S OUTSTANDING IN PARENT COMPANY = Existing share price MV FALLS = But, creates a brand new company = New firm stock distributed to existing shareholders based on % of shares in parent company

Stock Spin-Off:

Firm sells-off division/subsidiary which becomes a stand-alone company

Why Stock Split?

Firms that split their stock tend to have 10% abnormally positive return over the next year Nothing happens to existing shareholders market value

Dividend Reinvestment

Dividends offset capital losses and boost capital gains DIVIDENDS GROW OVERTIME **Assume the dividends are reinvested when received = Holdings are increased = More future dividends (like the compounding of interest)

Rights offering

Existing stockholders have 1st chance to buy 'new' issue shares (Proportionate to current firm ownership) Rights have value---can be sold Price ALWAYS set BELOW EXISTING SHARE PRICE **** if nothing is done/bought, price of stock will fall = Existing shareholders lose money = allows for selling of rights (makes up for difference in drop in share price

C/S: Equity capital

Funds the firm receives from the sale of stock SALE OF STOCK IN THE PRIMARY MARKET

Investing in Foreign Stocks

Globalization of financial markets is growing 1. U.S. equity market represents ~ 35% of world equity markets (worlds largest equity) 2. 6 countries = 80% of world equity market 3. Non-U.S. market returns: partly due to currency exchange rates

Reasons for Stock Classes

Help founders of corporation maintain control of the firm overtime Stock classes w/ multiple votes per share are issued to certain individuals/family members

Stocks: Why are they an inflation hedge?

Inflation = loss of purchasing power. With stock, the firms can raise prices to compensate for inflation. Meaning they have good change to maintain stock prices ex. Stockholder w/ fixed salary is hurt by inflation but will get higher returns on their investments = hedge against inflation

Who loses money through seasoned offerings?

Investors who do nothing; don't buy/sell rights Its important to investors with large share of C/S to buy & maintain ownership position

C/S Disadvantage

RISKY NATURE returns are not guaranteed and debt holders have first claim to a firm's assets stock prices are subject to wide swings that make valuation difficult Important: Sacrifice of current income (ex. would be making interest $ if bonds instead)

Restricted Covenants

Limits a firms dividend payments unless profits exceed a certain smount

Payment date

Mailing date of dividend checks

Stocks: Best probability of returns

Of all asset classes (bonds, real estate, etc) Returns 2x the size of corporate bonds ALSO MOST RISKY

Trading Range Theory

People get used to/comfortable trading a stock in a given price range (ex. $20-$60) At some point, 1. the price of the stock becomes too high 2. people get nervous about the run up and start to sell, which the company doesn't want So, the company decides to split the stock to cut the price in half = 2 shares of $30

Investment Value (Intrinsic value)

Price an investor believes a firm should trade at What they think it's worth (different for different people) If you think a firms intrinsic value > what its currently selling for, you would BUY It is the maximum price the investor will be willing to pay for the share.

What is meant by the statement that holders of common stock are the residual owners of the firm?

Residual: remaining after the greater part or quantity has gone. common stockholders are entitled to dividend income (if paid) and a prorated share of the firm's earnings *after all other obligations of the firm have been met* Investors have no guarantee that they will ever receive any return on their investment.

Dividends

Return of profit to owners of the firm (shareholders) Pay out only if profits stable so that they will continue to pay them out in future years Board of Directors make all dividend decisions

Why do shareholders invest in dividend paying firms?

See them as lower risk than rapidly growing firms BOD doesn't initiate dividend payments until they have a $$$ cushion in reserve Older, established companies

Date of record

Shareholders registered by close of business day receive declared dividends

Issue with Stock Repurchase

Since people know that when a repurchase is going to occur, and that it raises prices, why wouldn't they run out and buy shares before the company does it? To solve, company authorizes a DOLLAR VALUE of shares to be repurchased OVER PERIOD TIME = May or may not go through with it "if price is reasonable" (even though they announced it)

Preferred Stock

Stated fixed dividend rate (like bonds) Dividends paid before those of common stock (also have to make up payments missed before C/S sees any) Paid first if firm gets into financial trouble = Slightly safer/less risky than C/S

Treatment of dividends

Stock Div = Capital Gains DRIPS = current income

Effect of a stock buyback

Stock Price Rises

Stock Split & Trade Range Theory

Stock Split: Enhance the stock's trading appeal (Trading Range Theory) since it makes stock shares more affordable to small investors while also lessening the likelihood that they will view the stock as overpriced due simply to a higher cost per share.

Stocks: Why are they highly liquid?

Stocks listed on a reputable exchange already have high enough liquidity to be sold there = Easy to find other people to buy/sell = Always at a fair price (part of what liquidity means) = Wouldn't be a transaction if prices were unfair = Determined by the marketplace

C/S Advantage

The return; capital gains have unlimited potential Annual current income thru Dividends

Signaling Theory

When a company announces that its going to split its stock, it is a BIG DEAL (positive, investors like this) = By splitting their stock, the company believes that their stock is UNDERVALUED/UNDERPRICED = Use the stock split to call attention to themselves = result in the re-examination of a firm

Common Stock Details

Together, C/S own the company Each share entitles owner to an equal ownership position ==Equal vote ==Equal voice in management These C/S have little control over CEOs and Moral Hazard