Chapter 4 - Equity Securities
Charles bought 100 shares of STC at $15 on May 25 and gives the stock to Bruce on August 14 when the market price is $20. Since the market price on the day the gift is made is higher than Charles' cost. Bruce's cost basis for the stock is _____. On the other hand, if the market price on August 14 was $12, then Bruce's cost basis would be _____.
$15, $12.
On July 30, Joe's uncle purchased 100 shares of TPA stock of $15 but subsequently passed away on August 18 when the market value of TPA was $22. If Joe inherits the TPA stock, he will have a cost basis in the stock of _____. Although his uncle owned the stock for less than one month, Joe's holding period is considered long term.
$22.
An investor with $5,000 in long term gains and $10,000 in short term losses will net these two results and be left with a $5,000 short term loss. The investor will then deduct _____, which is the maximum of losses that may be used in the current tax year as a deduction, from their ordinary income and carry forward the remaining _____ loss to the next tax year.
$3,000, $2,000.
What is a leveraged buyout?
A leveraged buyout is defined as the acquisition of a company by primarily using debt to finance the purchase. The assets of the acquired company are generally used as collateral for the borrowed funds. This type of acquisition allows the acquiring company, which is referred to as a private equity firm, to make the purchase without using much of its own equity.
What is a penny stock?
A penny stock is an unlisted equity security that has a bid price below $5 per share.
What is statutory voting?
A shareholder is given one vote, per share owned, per voting issue.
What is a warrant?
A warrant is another type of equity security that may be issued by corporations. Like rights, warrants give the holder the ability to buy the issuer's common stock at the subscription price in the future. However, unlike stock rights that have a relatively short life, warrants have a maturity that's often set years in the future. Another way that warrants differ from stock rights is that a warrant's subscription price is usually set at a price that's higher than the current market price of the stock. Therefore, if a stock's value increases to where it is above the subscription price, the holder of the warrant will be in a position to realize a profit.
Who are affiliated directors?
Affiliated directors are senior executives of the corporation, such as the CEO and the president, who also serve on the board of directors.
What is limited liability?
Although a corporation is owned by its shareholders, the business is considered a separate person under the law and, therefore, shareholders generally are not held personally responsible for the corporation's debts.
What is the right to receive dividends?
Although not guaranteed, companies will often pay out some of their profits to common and preferred shareholders in the form of dividends.
What is an over the counter (OTC) equity security?
An OTC equity security is generally defined as any equity that's not listed or traded on a national securities exchange.
What is a participating preferred stock?
An investor who purchases participating preferred stock may receive a higher dividend if the company is doing well and its common dividends exceed a specified amount. For example, if the stock is a 5% preferred but participating to 8%, it will normally pay a 5% dividend but could receive up to 8% if the common stock dividends reach a specified level.
Common versus preferred stock
Both common and preferred stock have ownership stake in the company. Preferred stock is more likely to receive regular dividend payments, has higher priority in the event of bankruptcy, and is issued with a specific dividend rate. Common stock has greater potential for capital appreciation and typically has voting rights.
Why do companies typically issue warrants in connection with an offering of stocks or bonds?
By including the warrants, investors are given an added incentive to purchase these issues.
What are the two basic methods used by corporations to raise money?
Debt financing and equity financing.
What are derivative securities?
Derivative securities are special types of investments that track the value of common stock or some other underlying asset. Examples are rights, warrants, and options.
How are dividends from foreign securities taxed?
Dividends and interest paid to a US investor on foreign securities, such as American Depositary Receipts (ADRs), may be subject to a withholding tax by the country from which they were paid.
What are electronic communication networks (ECNs)
ECNs are market centers that allow for the quoting and trading of exchange listed securities. They provide electronic systems for bringing buyers and sellers together. They charge subscribers a fee for using their system and act in only an agency, not principal, capacity.
What is a sponsored ADR?
For a sponsored ADR, the company whose stock underlies the ADR pays a depositary bank to issue ADR shares in the US. This sponsorship permits the company to raise capital in the US and list the ADR on the NYSE or Nasdaq. Many of the largest ADRs are sponsored.
What is an unsponsored ADR?
For an unsponsored ADR, the company doesn't pay for the cost associated with trading in the US. Unsponsored ADRs trade in the over the counter market and are usually quoted on the OTC Bulletin Board (OTCBB) or the Pink Marketplace.
What is a treasury stock?
For various reasons, many corporations may ultimately reacquire some of their issued shares. When stock is issued and subsequently repurchased by the company, it's referred to as treasury stock. As long as the stock remains in the treasury, it has no voting rights and doesn't receive dividends.
What is a cumulative preferred stock?
If a corporation fails to pay the full dividend on its preferred stock and the preferred stock is cumulative, then all the preferred dividends that are in arrears or owed must be paid before the common stockholders may receive dividends. Most preferred stock is cumulative.
What is a non-cumulative preferred stock?
If preferred stock is non-cumulative, the dividends in arrears are not paid to stockholders. Instead, only the current year's dividend must be paid before common stock dividends may be paid.
What is an intrinsic value?
If the stock's market price rises above the warrant's subscription price, then the warrant has intrinsic value. For example, if the stock's market price is $33 and the warrant's subscription price is $30, then the warrant has intrinsic value of $3.
What is equity financing?
In contrast to bondholders, investors who purchase stock become part owners of the corporation. Unlike when bonds are issued, the corporation is not required to pay interest on these equity securities and there is no maturity date. If a company prospers, shareholders can expect to share in its profits in the form of dividends and an increase in the value of their shares. However, if a company fails, shareholders are more likely than other investors to lose their entire investment. This is due to the fact that bondholders have a higher claim against the company's assets at liquidation.
What are issued shares?
Issued shares represent the amount of stock that has actually been sold by the corporation.
What is an outstanding stock?
Issued stock - treasury stock = outstanding stock.
What is the wash sale zone?
Purchase allowed <- 30 days <- sale at a loss -> 30 days -> purchase allowed. In the wash sale zone, any purchase of the security will trigger a wash sale.
What are examples of shareholder rights?
Right to evidence of ownership, right of transfer, right of inspection, right to vote, right to receive dividends.
Summary of rights.
Rights are issued to existing common stockholders, priced below current market value, have a short term maturity (30-45 days), and their purpose is to allow existing stockholders to maintain their proportionate interest in a company.
What is cumulative voting?
Shareholders are able to multiply the number of shares that they own by the number of voting issues. Cumulative voting tends to favor the minority shareholders.
What is the right to evidence of ownership?
Shareholders have the right to receive one or more stock certificates as proof of ownership.
What are restricted shares?
Shares that are ineligible for transfer.
What is a spin off transaction?
Spin off transactions occur when a parent company distributes shares of a subsidiary company to the parent company's shareholders. They are used by sellers in the hopes that the combined valuation that the market assigns to the two separate companies will be greater than that of the single combined entity.
How are stock splits taxed?
Stock splits and stock dividends receive the same tax treatment. The shares received from either action are not taxable at the time of receipt. The only action required is for the investor to adjust his per share cost basis in the security. A gain or loss will result from any subsequent sale of the shares. With a forward stock split, the number of shares owned will increase and the cost basis per share will decrease and vice versa.
What is the right of inspection?
Stockholders have the right to inspect certain books and records of the company, including the stockholders' list and the minutes of stockholders' meetings.
What is wash sale?
The IRS doe snot allow an investor to claim a deduction for a capital loss on an investment if he purchases "substantially the same security" prior and within 30 days of the sale.=
What are the two sources in which prices of OTC equities may be obtained?
The OTC Bulletin Board (OTCBB) and the OTC Markets Group Pink Marketplace.
What are preemptive rights?
When a corporation intends to issue additional shares of stock, a rights offering may be conducted to provide current shareholders with the opportunity to buy the shares before they're offered to the public. In doing so, the current shareholders are able to maintain their proportionate ownership interest in the company.
What is debt financing?
When an issuer sells bonds (debt), it's borrowing money from the investors who buy the bonds. The funds are borrowed for a predetermined period with interest being paid over the course of the loan. bondholders have no ownership interest in the corporation and no influence in its management.
What is the cost basis of inherited securities?
When securities are inherited, the recipient's cost basis is equal to the market value of the securities at the time of the deceased's death. Regardless of the deceased's actual holding period, the recipient's holding period is considered long term.
What is a stock split?
A stock split is a decision by a company's board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders. For example, in a 2-for-1 stock split, an additional share is given for each share held by a shareholder.
What is the right to vote?
Common stockholders may attend annual shareholder meetings and vote on important issues including the election of members to the board of directors and whether the company should merge with or acquire another company. Shareholders also vote on stock splits but not on cash and stock dividends.
Widget Inc. has 1,000,000 shares of outstanding stock and plans to issue an additional 1,000,000 shares to the public. An investor who currently owns 100,000 shares will receive _____ rights. These rights will allow her to purchase the shares at the subscription price that is below the current market value of the stock, and maintain her 10% ownership in the company. If she doesn't exercise her rights within a certain period, the rights will expire.
100,000.
XYZ Corporation is holding an election for its board of directors. There are three seats but five potential candidates available. With three seats available, this represents three voting issues. If shareholders are required to use statutory voting, an investor who owns 1,000 shares is able to cast a maximum of 1,000 votes to three of the five candidates. On the other hand, if cumulative voting is required, an investor who owns 1,000 shares is able to cast _____ votes in any manner that she chooses, which is a significant benefit if she really favors one of the five candidates.
3,000
An investor bought stock at $24 per share and later sold the stock at $21 per share - claiming a $3 loss per share. If, within _____ days, the investor buys the same stock at $23, the $3 loss will be disallowed and his new cost basis will be $23 + $3 = $26.
30.
What is a callable preferred stock?
A company that issues callable preferred stock has the right to repurchase the stock at a specified price at some time in the future.
What is a tender offer?
A tender offer occurs when an entity offers to buy a corporation's shares, typically for the purpose of acquiring control of the company.
What are American Depositary Receipts (ADRs)?
ADRs represent claims to foreign securities with the actual shares being held by US banks abroad.
What is common stock?
Common stock is the basic unit of corporate ownership, the most widely issued type of stock, the first type of stock that a corporation issues.
What is corporate dividend exclusion when it comes to taxation?
Corporations are given preferential tax treatment on any dividends that they receive from other corporations. i.e. ABC Corporation owns 1,000 shares of ATT, which is less than 20% of the company), and receives dividends of $2,000. Since the dividend qualifies for the corporate dividend exclusion, $1000 ($2,000 x 50%) will be tax free. The corporation will be taxed on only the remaining $1,000
What is a convertible preferred stock?
Investors who purchase convertible preferred stock are able to convert the par value (face value) of the preferred stock into a predetermined number of common shares at a specified price (stated conversion price).
What is the subscription price?
It is the preset exercise price for a rights offering, a warrant, or an option.
How is market capitalization found?
It's found by multiplying the current market price of the stock by the number of outstanding shares.
What are listed securities?
Listed securities are securities that are eligible for trading on either the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotation (Nasdaq) system.
What are the two different voting methods?
Statutory and cumulative.
How are stock dividends taxed?
Stock dividends are not taxable at the time of receipt because, although the shareholder is receiving more shares, they will have a reduced basis per share. With stock dividends, the taxable event occurs when the acquired shares are eventually sold. i.e. Ms. Black originally purchased 100 shares of stock at $11 for a cost basis of $1,100 total cost but then received a 10% stock dividend. Due to the stock dividend, her cost per share is adjusted by dividing the original total cost of $1,100 by the new total number of shares of 110. This results in a new cost basis of $10 per share ($1,100/110 shares). The gain or loss from any subsequent sales is calculated by using the new cost basis of $10 per share. Therefore, if 50 shares were later sold at a price of $15 per share, Ms. Black will have a profit of $5 per share ($15 - $10) for a total gain of $250 (50 shares x $5).
What is the right of transfer?
Stockholders have the right to freely transfer their shares by selling them, giving them away, or bequeathing them to heirs.
What is the basic structure of a corporation?
The shareholders of the company elect a board of directors who are responsible for overseeing the company. The board of directors, in turn, appoints the company's senior managers who run the company.
Summary of warrants.
Warrants are issued to purchasers of the issuer's preferred stock or bonds, priced above current market value, have a long term maturity, and its purpose is to act as a sweetener attached to the issuance of stocks or bonds to encourage a purchase.
Mr. Jones has executed the following transactions in the same year: On May 1, he bought 100 shares of XYZ at $60. On September 1, he bought 100 shares of XYZ at $90. On October 15, he sold 100 shares of XYZ at $89. For Mr. Jones to be able to apply the October 15 sale of 100 XYZ at $89 to this September 1 purchase at $90, which creates a $100 loss, the sell order ticket must be marked "versus purchase of September 1, 20XX." If not designated, the IRS will automatically apply the October 15 sale to the May 1 purchase due to _____, thereby creating a $2,900 capital gain.
first in, first out (FIFO).
If an investor has a $12,000 short term capital gain and a $7,000 long term capital loss, the result is a net $5,000 capital gain which will be taxed at the _____ rate.
short term.
