1. Stocks Economics 71a: Spring 2007 Mayo, chapter 10 Lecture notes 4.1

2. Goals  Stock basics  Historical stock performance

3. Common Stock  Ownership of piece of a firm  Key parts Voting rights (control) Dividends Right to assets Limited liability

4. 1. Voting and Control  Voting rights In proportion to share holdings Annual meetings Proxy  Firm control Shareholders elect Board of Directors Oversee management Sometimes difficult to remove

5. Voting Methods  Traditional Everyone votes on each candidate Like regular election  Cumulative One vote per board position  5 members - get 5 votes per share Can cast all votes for one candidate Increases power of minority voting blocks  Can group all votes for one candidate

6. 2. Dividends  Payments to shareholders from firm Usually cash  Usually paid quarterly  Firm sets amounts  Dividends paid after all other obligations are met  Amount can be zero

7. Dividend Timing  Declaration date (June 3rd)  Ex-dividend date (June 16)  Date of record (June 18)  Payment date (June 30)  Key date: Ex-dividend date Purchase before: get dividend Purchase after: no dividend

8. Dividend Decisions  Profits of the firm (earnings) Shareholders (dividends) Retained earnings (investment)  Payout ratio = (dividends)/earnings  Dividend yield = (dividends per share)/(price per share)

9. Does Dividend Policy Matter?  Example: Assets - Liabilities = 100 = Shareholder equity Shares = 100, price per share = 100/100 = 1 Earnings = 10 1. Pay out earnings as dividends 10/100 = 0.1 per share 2. Hold earnings as cash  Value of the firm goes from 100 to 110 (A-L)  Price per share goes to 110/100 = 1.10  Shareholders gain 0.1 per share

10. Does Dividend Policy Matter?  In theory, No  In real life, Yes Worry about firm investing funds wisely Worry about firm running off with funds Stock may not be priced correctly

11. Dividend Reinvestment  Firm allows you to buy stock with dividends  No fees or commissions  Sometimes below market prices

12. What is a Stock Return?  Stock held from time t to t+1  Pays dividend during this time of d(t+1)  Why is this sensible? Increase of 1 dollar after investment t to t+1

13. Two Parts to a Stock Return = (capital gain) + (dividend yield)

14. Numerical Example  Price(last year) = 100 (per share)  Price(today) = 110  Dividend = 3 (per share)

15. 3. Rights to Assets  Shareholders have rights to residual assets in a bankruptcy case  Value distributed after other obligations met Bills Tax payments Bond holders  Often this can be zero

16. 4. Limited Liability  Liabilities of shareholders are limited  Not responsible for amounts firm owes  Or lawsuits against the firm  What does this mean? If you buy a stock for $10, the most you can lose is $10

17. Preferred Stock (Debt like)  Fixed, promised dividend Similar to interest payments on debt Cumulative basis: missed dividends must be paid  No voting rights (usually)  Call option Firm can buy back

18. Bankruptcy Priorities  Bills owed and tax payments  Debt holders  Preferred stock holders  Common stock holders

19. Issuing and Increasing Shares  Initial Public Offering (IPO) at start  New issues (issue more shares) “Dilution” Rights offering Stock options  Stock spin-offs Spin off subsidiaries  Stock splits 2 for 1 split  Stock dividends

20. Stock Splits  Example: 2-1 split Number of shares increases by 2 Price falls by 1/2 Dividend reduced by 1/2  No real impact  Why? Lower price, more investors  Reverse split: 1-2 split Increase price, why??

21. Reducing Shares  Buy back shares (share repurchase) Treasury stock Reverse dilution

22. Stock Dividends  Pay dividends with shares of stock  Similar to stock split  No change for investors More shares Price goes down

23. Tax Treatments  Firm Interest payments on debt are tax deductible Dividend payments are not Example  (Profits – debt interest payments)  Pay taxes on this amount This gives a tax advantage to the firm for using debt financing

24. Tax Treatments  Individual Investors Capital gains (lower rates) Dividends (some at lower rates)  2003 tax law change  Before 2003 dividends taxed at higher rates

25. Goals  Stock basics  Historical stock performance

26. Goals  Stock basics  Historical stock performance

27. Real Portfolio Values (Inflation Adjusted, dividends reinvested)

28. Total Portfolios (log scale)

29. Dividend Comparison

30. Real Portfolio Values (Inflation Adjusted)

33. Long Term Annual Returns (1/28-6/2005) Dividends Reinvested Raw ReturnsInflation Adjusted Stocks12.4%9.2% Corp Bonds6.3%3.2% Gov’t Bonds5.8%2.8% TBills3.8%0.7%

34. Goals  Stock basics  Historical stock performance