978-0077861667 Chapter 8 Lecture Note Part 1

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1.1.1.1.1Chapter Eight

Stock Markets

1.1.1.2 I. Chapter Outline

1. The Stock Markets: Chapter Overview

2. Stock Market Securities

a. Common Stock

b. Preferred Stock

3. Primary and Secondary Stock Markets

a. Primary Stock Markets

b. Secondary Stock Markets

c. Stock Market Indexes

4. Stock Market Participants

5. Other Issues Pertaining to Stock Markets

a. Economic Indicators

b. Market Efficiency

c. Stock Market Regulations

6. International Aspects of Stock Markets

Appendix 8A: The Capital Asset Pricing Model (available on Connect or from your

McGraw-Hill representative)

Appendix 8B: Event Study Tests (available on Connect or from your McGraw-Hill

representative)

II. Learning Goals

1. Identify the major characteristics of common stock.

2. Identify the major characteristics of preferred stock.

3. Examine the process by which common stock is used in primary markets.

4. Describe the major secondary stock markets.

5. Examine the process by which a trade takes place in the stock markets.

6. Identify the major stock market indexes.

7. Know who the major stock market participants are.

8. Explain the three forms of market efficiency.

9. Describe the major characteristics of international stock markets.

1.1.1.3 III. Chapter in Perspective

In this chapter the readers are introduced to the major characteristics of stock securities and their

primary and secondary markets. Fully underwritten offers and rights offers are discussed.

Registration requirements and the shelf registration procedure are presented. Exchange trading

is contrasted with the OTC market, and the specialist function is introduced. Various types of

stock orders are discussed and online trading is briefly covered. The expansion of stock holdings

by the public due to the bull markets of the 1990s and the major demographics of stock

ownership are presented. The three forms of market efficiency are introduced. Recent ethical

failures on Wall Street are discussed as well. The effects of foreign exchange movements on

dollar rates of return and the benefits of international diversification are illustrated. Finally, two

brief appendices cover the capital asset pricing model and event study methodology respectively.

1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students

Common stock Syndicate

Residual claim Originating house

Limited liability Preemptive rights

Dual class firms Red herring proxy

Cumulative voting Shelf registration

Proxy Secondary stock markets

Preferred stock Trading post

Nonparticipating and participating preferred stock Designated Market Makers

Cumulative and non-cumulative preferred stock Market order

Primary markets Limit order

Net proceeds Market efficiency

Gross proceeds Random walk hypothesis

Underwriter’s spread Spinning

Market microstructure Flash trading

Naked access Dark pools

Stub quotes

1.1.1.5 V. Teaching Notes

1. The Stock Markets: Chapter Overview

Common stock securities represent the owner’s equity in the firm. U.S. stock values peaked in

2007 at $26.4 trillion before falling to $13.9 trillion in March 2009. In 2013 the value was $28.4

trillion outstanding. Common stocks are residual claims, because nothing is paid to common

stockholders until all other claims have been satisfied. Because common stock represents

ownership, the stockholders are usually entitled to vote for the firm’s board of directors

(hereafter board). The board oversees the firm’s daily operations. Because of the dramatic

growth in stock prices during the 1990s, common stocks became one of the most widely held and

followed securities in the country. The extreme volatility of stock prices during the crisis is

likely to reduce the breadth of stock holdings among individual investors, at least for a while.

The market value of preferred stock is only about 1% of the market value of common stock.

2. Stock Market Securities

A stockholder’s return is the sum of the dividend yield and capital gain yield. The annual capital

gain yield on common stocks can be positive or negative, but during the 1990s it was abnormally

high by historical standards while common stock dividend yields were abnormally low. Large

dollar amounts of stock were issued during the years 1996-2000. Stock markets were generally

weaker in 2001, particularly after the September 11 terrorist attacks and they remained weak in

2002. The slowing economy and the many scandals involving firms such as Adelphia, Citigroup,

Enron, Arthur Anderson, Global Crossing/Qwest, IMClone, Merrill Lynch, Tyco International,

Goldman Sachs and WorldCom reduced investor confidence in accounting data, corporate

leadership and in the stock market. The passage of the Sarbanes-Oxley Act of 2002 was

designed to help restore public confidence in stock investments. The act and related rules

changes of the NYSE instituted a public oversight board of accounting standards, increased the

independence of the board of directors from management, and required boards to promulgate

codes of ethics and a culture of ethics at publicly traded firms. The markets recovered in the mid

2000s but the number of IPOs remained far lower than in the ‘go-go’ 1990s with IPOs virtually

ceasing during the financial crisis and not recovering until 2012.

Stock Return Calculations

The pre-tax holding period return (HPR) on a stock may be found as:

BuyBuy

BuySell

Dividend

HPR 





= Capital gain yield + Dividend yield

Suppose an investor buys 10 shares of stock priced at $55.10 and sells the stock one year later

for $56.30 after collecting a $0.30 dividend per share. What was the investor’s pre-tax holding

period return?

%.%.%.

.$.$

HPR 72254182

1055

300

1055

10553056 





If dividend income is taxed at a 28% rate and capital gains are taxed at 20%, what was the

investor’s after tax holding period return?

HPRA-T = [2.18% x (1 – 20%)] +[0.54% x (1- 28%)] = 2.13%

a. Common Stock

Common stock is a claim to ownership of a corporation. Partnerships and proprietorships do not

have common stock.

Dividends

Dividend payments are not a legal liability of the corporation (until declared). They are normally

declared quarterly by the board. Unlike interest payments, dividends are not tax deductible to

the issuing company. Dividends paid to investors are taxed as ordinary income at rates up to

39%. Long term capital gain tax rates are capped at 20%. Ceteris paribus, taxable investors

would prefer a $1 capital gain to a $1 dividend.

Teaching Tip: For an investor in the 28% ordinary income tax bracket who faces a 20% capital

gains tax, it takes $1.11 in dividend income to give the same after tax benefit of $1 in capital

gains. $1.11 = $1(1-0.2) / (1-0.28)

In theory, a firm should pay dividends only when it has no positive NPV projects remaining in

which it may invest (residual theory of dividends). In practice, investors seem to prefer a

constant or growing dividend payment. The consistent quarterly dividend payment probably

does two things. First, it allows investors to self-select themselves into choosing firms with

different payout levels according to their desired level of taxable income (clientele effect).

Second, the quarterly dividend forces management to pay out cash on a consistent basis to

owners, a requirement that helps assure stockholders that managers are acting in shareholders’

interests (bonding effect). About 19% of S&P firms do not currently pay a dividend.

Residual claim

Common stockholders are paid only after all other claims are satisfied.

Limited Liability

A stockholder can lose only the amount invested in the stock. The stockholder’s private assets

cannot be seized to satisfy debts of the corporation.

Teaching Tip: The limited liability feature of stock implies that common stock can be thought of

as a call option on the firm’s value with an exercise price equal to the firm’s debt. If the value of

the firm is less than the value of the debt at maturity of the debt, the stockholders do not exercise

their claim on the firm (bankruptcy ensues). As with any call option, the value of the option can

rise if the riskiness of the firm increases. This type of analysis can be used to introduce agency

costs and explain problems that bondholders may face with financially distressed firms.

Voting Rights

Voting rights typically accrue to common stockholders, but some firms have created dual class

firms with different voting rights. Usually in these dual class issues a controlling stockholder

has attempted to raise additional equity capital without diluting their own control by issuing

shares with no or only limited voting rights. Investors should be aware that their risk may be

higher in these situations and takeovers beneficial to existing stockholders will be less likely to

occur. Sometimes the limited voting shares are granted a higher dividend priority to offset this

risk.

Cumulative Voting: In this procedure all directors up for election are voted on at once. For

instance, if there are three positions available on the board and four candidates are running, the

top three vote winners in a single election will be elected to the board. Each shareholder is

assigned one vote per share held times the number of directors up for election. The shareholder

may then cast all of his/her votes for one director or spread them among different directors.

Under cumulative voting minority stockholders have a greater chance to affect the composition

of the board of directors.

Straight Voting: With straight voting each candidate for the board is elected individually. In

straight voting a majority shareholder can always elect the entire board. Control is often possible

with less than a 50% majority because less than 40% of possible votes are typically cast at

corporate meetings. Stockholders can allow someone else to vote their shares by signing a

proxy statement and Internet proxy voting is now beginning to grow. Internet based voting is

an encouraging trend. Far too many shareholders do not vote their shares, nor respond to

challenges to management by active shareholders. Consequently, most shareholder initiatives

are defeated unless they have management’s support regardless of the merits of the initiative.

Unfortunately the default is straight voting for companies chartered in Delaware. The initiation

charter must specify cumulative voting in Delaware. This is a major reason why about 50% of

firms are incorporated in Delaware.

Cumulative Voting versus Straight Voting Example

One can calculate the number of shares needed (Np) to elect p board members under cumulative

voting. If there are k directors up for election under cumulative voting a minority shareholder

would have to own or control [1 / (k+1) * # shares outstanding] +1 to ensure that the shareholder

will be able to elect one board member (p = 1).1 Under straight voting a shareholder would have

to own or control 50% of shares outstanding + 1 share (assuming that all shares are voted). For

example if there are 1 million shares outstanding and there are k = 4 director spots up for election

with cumulative voting. The minority shareholder must own or control Np = [((1 / (4+1)) * 1

million] + 1 = 200,001 shares to ensure board representation. Under straight voting the

shareholder would have to own or control 50% + 1 = 500,001 shares. In the latter case the

shareholder would elect the entire board winning in each of 4 separate elections.

b. Preferred Stock

Preferred stock has some features similar to common stock and some features similar to bonds.

For instance, preferred stock represents an ownership claim in the firm and it is a residual claim

in the event of bankruptcy, senior only to common stock. Preferred stock normally pays a fixed

dividend amount. The dividend is fixed like the coupon on a bond, but preferred stockholders

cannot sue the corporation for non-payment of the dividend. Like common dividends, preferred

dividends are not tax deductible to the firm.

Teaching Tip: At times preferred stock dividend yields have been quite favorable compared to

current yields on bonds and certainly dividend yields on stocks, but an investor in preferreds

should not expect any capital gains. In the low interest rate, poor stock performance

environment of the early 2000s, high yield preferreds were one of the few standard financial

assets to earn a reasonable rate of return.

Types of preferred stock

Nonparticipating preferred stock (typical): The dividend is not affected by the firm’s

profitability.

Participating preferred stock: The preferred stockholders may receive a special dividend if

corporate profits are high enough in a given year.

Cumulative preferred stock (typical): If one or more preferred dividends are missed, no

common dividends may be paid until the preferred dividends in arrears are first paid. Under

1 See Essentials of Corporate Finance, Ross, Westerfield, and Jordan, Chapter 7.

the government’s Capital Purchase Program (a part of TARP) the government injected capital

into firms and received cumulative preferred stock in return paying a 5% cumulative

dividend for five years then a 9% dividend.

Non-cumulative preferred stock: Preferred dividend payments in arrears do not impair the

payment of common dividends.

Teaching Tip: The majority of firms do not issue preferred stock. They are typically a higher

cost source of funds than debt and do not carry the tax deduction for the issuing firm. A

corporate investor (not issuer) in another company’s preferred stock can exclude 70% of any

dividends earned from taxable income, increasing the preferred’s after tax yield relative to other

securities. The supposed advantage of the ability to skip dividend payments on preferred stock is

somewhat illusory since it is more difficult and costly for a firm to raise additional capital from

any source if it has a poor record of payment on its existing claims. Preferred stock does not

normally have voting rights so it may be a way for firms to raise equity capital without fear of

changing voting control.