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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
P
Dividend
P
PP
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.
