1. Stock Markets
Chapter 8
Dr. Lakshmi Kalyanaraman

2. Chapter Overview
description of equity or stock securities and the markets in which they trade.
description of the different types of corporate stock.
how they are sold to the public and then traded; first in primary markets and then in secondary markets.
the major stock market indexes.
Form of markets.
Dr. Lakshmi Kalyanaraman

3. Stock Markets
Allows suppliers of funds (investors) to efficiently and cheaply transfer funds to users of funds (corporations and government) in exchange for financial claims
Dr. Lakshmi Kalyanaraman

4. Stock Market Securities – Corporate Stock
Common stock and preferred stock
All public corporations offer common stock but many do not offer preferred stock
Both offer two part rate of return
Capital gains if the stock appreciates in price over time
Periodic dividend payments
Dr. Lakshmi Kalyanaraman

5. Stock Returns Pt = stock price at time t
Dt = dividends paid over time t – 1 to t
(Pt – Pt – 1) / Pt – 1 = capital gain over time t – 1 to t
Dt / Pt – 1 = return from dividends paid over time t – 1 to t
Dr. Lakshmi Kalyanaraman

6. Stock Returns
Suppose you owned a stock over the last year. You originally bought the stock for $40 and just sold it for $45. The stock also paid an annual dividend of $4 on the last day of the year. What is your return on this investment?
Capital gains = ($45-$40)/40 = 12.5%
Dividend income = 4/40 = 10%
Return = 12.5% + 10% = 22.5%
Dr. Lakshmi Kalyanaraman

7. Common Stock
Fundamental ownership claim in a public or private corporation
Characteristics
1. Discretionary dividend payments
2. Residual claim status
3. Limited liability
4. Voting rights
Dr. Lakshmi Kalyanaraman

8. Dividends Unlimited if firm highly profitable
No guaranteed dividend rights even if firm profitable, growing firms
Corporation does not default if dividends are missed and common stock holders have no legal recourse (not like interest payment on debt)
Profitable firm may reinvest profits
Payment and size decided by Board of directors elected by shareholders
Taxed twice – firm level and personal level
Dr. Lakshmi Kalyanaraman

9. Reinvestment of earnings
Affects both components of return
Dividend, Dt/Pt-1, decreases
Capital gains , (Pt – Pt-1)/Pt-1, increases
What is the impact of non-payment of dividends on stock returns?
Dr. Lakshmi Kalyanaraman

10. DOUBLE TAXATION ISSUE
Investors can partially avoid this double taxation effect by holding stocks in growth firms that reinvest most of their earnings to finance growth rather than paying larger dividends.
earnings growth leads to stock price increases. And stockholders can sell their stock for a profit and pay capital gains taxes rather than ordinary income taxes on dividend income.
Under current tax laws, capital gains tax rates are lower than ordinary income tax rates.
The capital gains tax rate depends on several things, including the holding period of the investment, the investor’s income level, and any tax-code changes made during the holding period.
Dr. Lakshmi Kalyanaraman

11. Capital gains = ($50-$50)/50 = 0% Dividend income = 2/50 = 4%
A corporation has after- (corporate) tax earnings that would allow a $2 dividend per share to be paid to its stockholders. If these dividends are paid, the firm will be unable to invest in new projects, and its stock price, currently $50 per share, probably would not change. The return to the firm’s stockholders in this case is:
Capital gains = ($50-$50)/50 = 0%
Dividend income = 2/50 = 4%
Return = 0%+ 4% = 4%
Dr. Lakshmi Kalyanaraman

12. Suppose a stockholder bought the stock at the beginning of the year (at $50) and sold it at the end of the year (at $50). The stockholder’s ordinary income tax rate is 30 percent and the capital gains tax rate is 20 percent.) The return to the stockholder in this case is all in the form of ordinary income (dividends). Thus, the after-tax rate of return to the stockholder is:
4%(1-0.30) = 2.8%
Dr. Lakshmi Kalyanaraman

13. Capital gains = ($52-$50)/50 = 4% Dividend income = 0/50 = 0%
Alternatively, rather than pay dividends, the firm can use the earnings to invest in new projects that will increase the overall value of the firm such that the stock price will rise to $52 per share. The return to the firm’s stockholders in this case is:
Capital gains = ($52-$50)/50 = 4%
Dividend income = 0/50 = 0%
Return = 4%+ 0% = 4%
the return to the stockholder is all in the form of capital gains and is taxed at 20%.
after-tax rate of return to the stockholder is
4% (1 - 􏰀0.20) =􏰁 3.2%.
Dr. Lakshmi Kalyanaraman

14. Residual Claims
In the event of bankruptcy, they have residual claim: In the event of liquidation, common stockholders have the lowest priority in terms of any cash distribution. After all senior claims are paid:
Creditors such as employees
Bondholders
Government for taxes
Preferred stockholders
Common stockholders
Hence, common stock is riskier than bonds
Dr. Lakshmi Kalyanaraman

15. Limited Liability limited liability
No matter what financial difficulties the issuing corporation encounters, neither it nor its creditors can seek repayment from the firm’s common stockholders. This implies that common stockholders’ losses are limited to the original amount of their investment.
Losses limited to original investment if firm’s assets fall less than debt in case of corporation
Unlike sole proprietorship and partnership ownership interests – Unlimited liability
Shareholders’ wealth outside ownership claims unaffected
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16. Voting Rights
No control over firm’s daily activities – overseen by managers in the interest of stockholders and bond holders
Common stockholders control the firm’s activities indirectly by exercising their voting rights in the election of the board of directors
Normally one vote per share of common stock.
Dr. Lakshmi Kalyanaraman

17. Dual class firms
Have two classes of common shares outstanding, with different voting rights assigned to each class.
One class has limited number of votes per share than the other
For example, class A may have one-tenth vote per share while class B one vote per share
Or Class A may elect 20% of board and class B 80%
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18. Cumulative Voting
In straight voting, election for one director at a time
In cumulative voting, all directors up for election voted at the same time
Number of votes = Number of shares held × Number of directors to be elected
A shareholder may assign all votes to a single candidate or may spread over more than one
Candidates with highest total votes get elected
Dr. Lakshmi Kalyanaraman

19. Proxy Votes By shareholders not attending the meeting
Proxy returned to the issuing firm allows shareholders to vote by absentee ballot or authorize a representative to vote on their behalf
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20. Preferred Stock Hybrid between bond and common stock
Like common stock represents ownership right
Like bond carries a fixed periodic (dividend) payment
Senior to common stock but junior to bonds
preferred stockholders are paid only when profits have been generated and all debt holders have been paid (but before common stockholders are paid)
In case of insufficient profits and missing dividends, no bankruptcy can be forced
Dr. Lakshmi Kalyanaraman

21. Preferred Stock
Generally does not have voting rights unless dividend payments are missed
Dividends only in case of profits
Cumulative vs. noncumulative
Cumulative – missed dividends go into arrears and must be paid before any common stock dividends
Noncumulative – missed dividends do not go into arrears and never paid
Dr. Lakshmi Kalyanaraman

22. Preferred Stock
Nonparticipating – dividend fixed regardless of profits
Participating – dividends more in exceptionally profitable years
Dr. Lakshmi Kalyanaraman

23. Advantages to Corporation
Corporations find preferred stock beneficial as a source of funds because, unlike coupon interest on a bond issue, dividends on preferred stock can be missed without fear of bankruptcy proceedings.
Dr. Lakshmi Kalyanaraman

24. Drawbacks of Preferred Stocks
if a preferred dividend payment is missed, new investors may be reluctant to make investments in the firm. Thus, firms are generally unable to raise any new capital until all missed dividend payments are paid on preferred stock
Dr. Lakshmi Kalyanaraman

25. Primary Markets
Markets in which corporations raise funds through new issues of securities – both ownership and debt securities
Government raises funds through issue of debt securities
Dr. Lakshmi Kalyanaraman

26. Primary Markets Most of the time through investment banks
Corporations raise funds through new issues of securities
Before common stock can be, shares must be authorized by a majority vote of both the board of directors and the firm’s existing common stockholders
Most of the time through investment banks
Investment banks act as distribution agents in best efforts underwriting
Underwriter does not guarantee a price to the issuer
Acts as a distribution agent for a fee
Risk of sale on corporation
Dr. Lakshmi Kalyanaraman

27. Primary Markets
Investment banks act as principals in firm commitment underwriting
Guarantees a price to the corporation for the newly issued securities
Underwriter buys the whole stock from the issuer for a guaranteed price called net proceeds
Resells them to investors at a higher price called the gross proceeds
Dr. Lakshmi Kalyanaraman

28. Primary Markets
Underwriter’s spread = Gross proceeds – Net proceeds
Underwriter’s compensation for risk and expenses is underwriter’s spread
Gross proceeds – price at which the investment bank sells the stock to investors
Net proceeds – guaranteed price at which the investment bank purchases the stock from the issuer
Dr. Lakshmi Kalyanaraman

29. Primary Markets
A syndicate is a group of investment banks working in concert to issue stock;
Originating house - the lead underwriter who negotiates with the issuing company on behalf of the syndicate
Shares of stock issued through a syndicate of invest- ment banks spreads the risk associated with the sale of the stock among several investment banks.
A syndicate also results in a larger pool of potential outside investors, increasing the probability of a successful sale and widening the scope of the investor base
Dr. Lakshmi Kalyanaraman

30. Primary Markets
An initial public offering (IPO) is the first public issue of financial instruments by a firm
A seasoned offering is the sale of additional securities by a firm whose securities are already traded in secondary markets
preemptive rights give existing stockholders right in which new shares must be offered to them and give them ability to maintain their proportional ownership
Dr. Lakshmi Kalyanaraman

31. This means that before a seasoned offering of stock can be sold to outsiders, the new shares must first be offered to existing shareholders in such a way that they can maintain their proportional ownership in the corporation
A “rights offering” generally allows existing stockholders to purchase shares at a price slightly below the market price
Dr. Lakshmi Kalyanaraman

32. Primary Markets
Public sale – stock issue offered to general investing public
Private placement – stock sold to a limited number of large investors
Dr. Lakshmi Kalyanaraman

33. Primary Markets
A red herring prospectus is a preliminary version of the prospectus that describes a new security issue
Shelf registration allows firms to offer multiple issues of stock over a two-year period with only one registration statement
Dr. Lakshmi Kalyanaraman

34. Secondary Stock Markets
Stocks once issued are traded
Bought and sold by investors
Securities brokers – intermediaries
The U.S. has three major stock markets
the New York Stock Exchange Euro next (NYSE Euro next)
the National Association of Securities Dealers Automated Quotation (NASDAQ)
the American Stock Exchange (AMEX)
Dr. Lakshmi Kalyanaraman

35. Secondary Market Transactions
Market order
Is when an investor makes a market order through a broker to buy or sell an investment immediately at the best available current price. Market order is the default option and is likely to be executed because it does not contain restrictions on the price or the time frame in which the order can be executed.
It provides immediate liquidity.
Limit order – to transact at a specified price
Left with a specialist to be executed
Dr. Lakshmi Kalyanaraman

36. Market efficiency
the current market price of a stock equals the present value of its expected future dividends (or the fair market value of the security).
When market traders determine that a stock is undervalued ( the current price of the stock is less than its fair present value), they will purchase the stock, thus driving its price up.
when market traders determine that a stock is overvalued (i.e., its current price is greater than its fair present value), they will sell the stock, resulting in a price decline.
Dr. Lakshmi Kalyanaraman

37. Market Efficiency
The degree to which financial security prices adjust to “news” and the degree (and speed) with which stock prices reflect information about the firm and factors that affect firm value is referred to as market efficiency
It has three measures:
weak form
semistrong form
strong form
Dr. Lakshmi Kalyanaraman

38. Weak form
Current stock prices reflect all historic price and volume information so investors cannot use past price information to make excess return.
Old news and trends are already impounded in historic prices and are of no use in predicting today’s or future stock prices
Investors cannot make more than fair return by using information based on historic price movements
However, with public and private information, investors can make more than fair return
Dr. Lakshmi Kalyanaraman

39. Semistrong form
As public information arrives about a company, it is immediately impounded
Investors cannot make more than fair return using public news releases
Since historic information is a subset of all public information, hence already reflected on share prices
However, with private information, investors can make more than fair return
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40. Strong form Stock prices reflect both public and private information
There is no set of information that allows investors to make more than fair return
Insider trading – laws prohibit investors from trading on the basis of private information.
Dr. Lakshmi Kalyanaraman