FIN 3244 Ch.11 Review Q&A

What are dividend reinvestment plans and what benefits do they offer investors? Are there disadvantages?

Firms with dividend reinvestment plans (DRIPs) allow shareholders to automatically reinvest their dividends into additional firm shares. DRIPs provide investors with a convenient and inexpensive way to accumulate stock shares without paying brokerage commissions. Dividends paid into DRIPs, however, are taxed as ordinary personal income in the year received; just as if they'd been received as cash.

Par value versus market value.

The par value of stock is its stated or face value and exists primarily for accounting purposes. Many stocks are issued with no par value. A firm's market value is equal to the number of common shares outstanding multiplied by the price of a stock share. It is literally, the price 'the market' places on a firm at some point in time.

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

A common stock is an equity investment that represents fractional ownership in a firm. It lets investors participate in the firm's profits. As residual owners of the company, 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 (liabilities). Investors have no guarantee that they will ever receive any return on their investment.

whats a stock split? how does it affect the market value of a stock share? how do you think the stock price would be affected?

A stock split occurs when a firm announces its intention to increase the number of common shares of stock outstanding by exchanging a specified number of new shares for each existing share. Stock splits are executed to lower the price per share of a stock. This may 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. Stock splits can also send a message (Signaling Theory) to the market that the firm believes its stock is undervalued. This is because stock splits are attention-getting events in the business world and often result in the re-examination of a firm. Stock prices fall proportionately to account for the split. Thus, a $100 stock will fall to $50 after a 2 for 1 split. Stock splits are viewed positively by the market. Studies show that despite stock splits being merely cosmetic (no value change), on average, firms that split their shares tend to have abnormal returns for the following year.

Book value versus investment value.

Book value is an accounting measure of the amount of stockholder's equity in a firm. Book value indicates the amount of stockholder funds used to finance the firm. Investment value indicates what value an investor places on the stock. It is often referred to as a firm's 'intrinsic' value. Investment value is based on expectations of the risk and return. It can vary with different investors since different investors can come to different conclusions about the value of a stock share. It is the maximum price the investor will be willing to pay for the share.

What is the difference between a cash dividend and a dividend paid-in-stock? Which would be more valuable to you? How does a dividend paid-in-stock compare to a stock split? Explain.

Cash dividends are simply dividend payments made to stockholders in the form of cash. They are a return to owners of part of the firm's profits. Cash dividends represent something of value since shareholders physically receive cash although the price of stock falls by the dividend amount on the ex-dividend day. A dividend paid-in-stock is an issue of new shares expressed and distributed as a percentage of each shareholder's existing shares. As with cash dividends, the market responds to these dividends by adjusting the market stock price accordingly. As an example, a stock trading at $50 per share that declares a 10% dividend paid-in-stock would drop its stock price to $45.45 ($50/1.10). Thus, an investor holding 100 shares before the stock dividend would hold 110 shares afterward. But, the total market value of these shares would be the same, assuming all other things remain equal: $50 100 = $45.45 110. Dividends paid-in-stock substitute for cash dividends. In both instances, when dividends are paid, the firm's stock price adjusts downward proportionately so that the market value of the firm doesn't change. Stock splits occur when a firm exchanges new shares for existing shares owned. In essence, dividends paid-in-stock are a form of stock split, but they are viewed differently by the market. Stock splits are considered positive events whereas dividends paid-in-stock may cause investor concern. Stock splits tend to raise investors' expectations of future firm profits resulting in abnormal returns for stock-splitting firms.

How important are dividends as a source of return to common stock? What about capital gains? Which is more important to total return? Which causes wider swings in total return?

Dividends are an important source of return to stockholders even though they don't have the "bang" of capital gains. Dividend returns are never negative, although they can be zero. Capital gains have ranged from -27.57% (1974) to +38.32% (1975). 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.

Treasury stock versus classified stock.

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 firm views the stock (of itself) as an attractive investment. 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. 'Classified' stock simply groups common stock into groups according to different voting rights and/or dividend obligations each group may have. For example, Class A stock might designate nonvoting shares that receive higher dividend rates, while Class B stock might designate shares with more votes than other shares.

Why do most income stocks offer only limited capital gains potential? Does this mean that the outlook for continued profitability is also limited? Explain.

Income stocks generally have limited capital gains potential because 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 from income stocks come mostly from current income rather than capital gains. This does not mean that these stocks are unprofitable. Most, in fact, are highly profitable and have excellent long-term future prospects.

important attributes of common stock

One important attribute of common stock is that it lets investors participate in a firm's profits, thus offering them the possibility of attractive return opportunities. Another attribute of stock is its versatility. It can be used to meet different investment objectives. Relative to many investments, common stock is fairly simple and straightforward, making it easier to understand. Note: this does NOT mean that stock is easy to value. Stocks tend to be liquid, making it easy to buy and sell them. Their transaction costs are modest. Moreover, price and market information concerning firms is widely disseminated in the news and by the financial media.

What is a spin-off? In general terms, explain how a spin-off works. Are these spin-offs of value to investors?

Stock spin-offs involve the conversion of a firm's subsidiary or division to a stand-alone company by distributing stock in the new company to existing shareholders. For example, PepsiCo spun off its restaurant operations—Pizza Hut, KFC, and Taco Bell—into a new company called Tricon Global Restaurants (now called Yum Brands). Investors keep shares in their old firm while being given shares in the new firm. Investors are free to keep shares of both firms, sell both firms, or sell one of the firms and keep the other.

Briefly explain how the dividend decision is made. What corporate and market factors are important in deciding whether, and in what amount, to pay dividends?

The amount of dividends to be paid is decided by the firm's board of directors. The directors evaluate the firm's operational and financial conditions in determining whether dividends should be paid and, if so, in what amount. A variety of factors are incorporated into the board's final decision. These include: (a) The firm's current earnings or profits. (b) The firm's growth prospects. Firms with good investment opportunities tend to retain their earnings to use for new investments and, thus, tend to pay little, if any, dividends. (c) The firm's cash position. The board tries to insure that the firm has sufficient liquidity to meet a cash dividend of a given size. (d) All legal and contractual constraints imposed by loans (Conditions and amounts of dividend payment can be restricted by debt contracts.) (e) The dividend expectations of its shareholders. Failure to meet these expectations can lead to disastrous results in the stock market.

Why is the ex-dividend date important to stockholders? If a stock is sold on the ex-dividend date, who receives the dividend - the buyer or the seller? Explain.

The ex-dividend date (which occurs two or three business days prior to the date of record) determines who is eligible to receive the declared dividend. If a stock is sold on or after the ex-dividend date, and before or on the date of record, the previous owner (the seller) receives the declared dividend. If the stock is sold prior to the ex-dividend date, the new shareholder (buyer) receives the declared dividend. Going "ex-dividend" means the buyer is not entitled to the dividend since the stock is being sold "without" it.

What are some of the advantages and disadvantages of owning common stock? What are the major types of risk to which stockholders are exposed?

The major advantage of common stock ownership is the returns it offers. Because stockholders are entitled to participate in the prosperity of a firm, capital gains have unlimited potential. In addition, many stocks provide regular current income in the form of annual dividends. For most income-producing stocks, dividends tend to grow over time, further increasing a stockholder's return. Listed common stocks are also highly liquid and easily transferable. Their transaction costs are relatively low, market information is readily available, and the price per share is typically within reach of small (retail) investors. The risky nature of common stocks is the most significant disadvantage of ownership. As residual owners of the firm, returns are not guaranteed and debt holders have first claim to a firm's assets. Furthermore, stock prices are subject to wide swings that make valuation difficult. Finally, the sacrifice of current income by stockholders is a disadvantage relative to other investments [debt securities (bonds that pay interest, for instance example.)]