CHAPTER 8
STOCK
Teaching Guides for Questions and Problems in the Text
QUESTIONS
8-1. If an investor buys IBM stock, the maximum amount that can be lost is limited to the
amount invested. If IBM were to fail and declare bankruptcy, its stockholders would not be
8-2. a. The pre-emptive right is the right of stockholders to maintain their proportionate
ownership in the firm. If the firm seeks to raise more funds through the sale of common
b. Cumulative voting is a means by which a minority may obtain representation on the
c. The board of directors is elected by the corporation’s stockholders and acts on the behalf
8-3. Management tends to increase cash dividends after earnings have increased, and it
believes the higher earnings will be maintained. Since the reluctance to cut dividends
encourages management to follow a conservative policy on dividend increments. Management
8-4. Stockholders, who own stock on the date of record, receive the dividend. Since it takes
three days for settlement, the investor must own the stock three days prior to the record date
8-5. Dividend reinvestment plans permit investors to acquire additional shares before the
dividends are received. Thus the funds cannot be spent (i.e., the investor is forced to save). In
8-6. Cash dividends are paid in cash while stock dividends are paid in additional shares. Both
stock dividends and stock splits alter the number of shares outstanding and the stock’s price.
Stock dividends and stock splits do not alter the firm’s assets, liabilities, total equity, or
8-7. a. No tax advantages are associated with dividend reinvestment plans. The investor has
b. Stock dividends are not subject to income tax. The price of the stock adjusts for the
c. Stock splits are not subject to income tax. The price of the stock adjusts for the split and the
d. Stock repurchases result in capital gains and the gains only apply to the individual selling
8-8. Preferred stock like common stock represents ownership, but unlike common stock
8-9. The payment of preferred stock dividends is not a legal obligation of the firm, but
there is an implied understanding that, if possible, the firm will make the payments. If the
8-10. a. Cross-section analysis compares a firm to other firms over a period of time.
Time-series analysis compares a firm’s financial statements over a period of time.
b. The current ratio includes all current assets relative to current liabilities:
Current ratio: Current assets/Current liabilities.
The quick ratio subtracts inventory from current assets:
c. Turnover ratios indicate how rapidly a firm’s assets flow through the firm. Receivables
turnover indicate how long it takes to collect receivable. If accounts receivables increase
without a corresponding increase in sales, the average collection period is lengthened (days
d. Profit margins measure earnings to sales after expenses. The gross profit deducts the cost
of the goods sold. Operating deducts all operating expenses, and the net profit margin
e. The difference between the return on assets and the return on equity is the base. Return
f. Debt to total assets measures to proportion of a firm’s assets that are financed by debt.
Debt to equity expresses debt relative to equity. Both are measures of financial leverage.
g. Times-interest-earned and times-dividend-earned are coverage ratios.
Times-interest-earned indicates the extent to which a firm’s operating income (EBIT)
exceeds its interest expense. Interest is paid after other expenses, so interest payments are
8-11. The statement of cash flow helps the financial analyst determine the ability of the
firm to generate cash. The statement has three essential components: operating activities,
investment activities, and financing activities. It starts by converting accrual income to a
8-12. This question asks the student to compare the financial ratios of three firms in the same
PROBLEMS
8-1. a. The dividend yield is 5 percent ($2/$40 = 5 percent), so the number of shares in the
b. In this part, the price of the stock rises while the dividend remains $2, so each year the
c. In Part c, both the price of the stock and the dividend increase but at different rates. From
the investor’s perspective, this case is obviously the best since the investor experiences both
increasing dividends and an increasing stock price.
The calculations for each year are as follows:
1. a.
End of Price of Total Per Share Dividend Shares Bought
Year Stock Shares Dividend Reinvested Through Reinvested
Owned
Dividend
s
(Beginning of
the year)
0 40 2.000
1 40 100.000 2.000 200.00 5.000
2 40 105.000 2.000 210.00 5.250
Beginning Year 11: 6515.58
b.
End of Price of Total Per Share Dividend Shares Bought
Year Stock Shares Dividend Reinvested Through Reinvested
Owned
Dividend
s
(Beginning of
the year)
0 40.00 2.000
c.
End of Price of Total Per Share Dividend Shares Bought
Year Stock Shares Dividend Reinvested Through Reinvested
Owned
Dividend
s
0 40.00 2.000
1 42.40 100.000 2.060 206.00 4.858
2 44.94 104.858 2.122 222.49 4.950
8-2. a. Cash and retained earnings decline by $1,000,000 to $19,000,000 and $97,500,000.
The other entries are unaffected.
b. 100,000 shares are issued with a value of $1,300,000. $1,300,000 is subtracted from
retained earnings, which becomes $97,200,000. The other entries in the equity section of the
balance sheet become:
c. and d. Stock splits only affect the number of shares outstanding and the par value. After a
three-for-one split the entry for common stock is
8-3. a. New balance sheet after the three-for-one stock split:
Assets $30,000,000 Liabilities $14,000,000
b. New balance sheet after the 10 percent stock dividend:
Assets $30,000,000 Liabilities $14,000,000
8-4. An investor in debt instruments is primarily concerned with the firm’s capacity to pay
the interest and make the principal repayment. Emphasis will be placed on liquidity ratios
and times-interest-earned. Emphasis may also be placed on the turnover of current assets,
since such turnover generates the cash to make the creditor’s payments.
Current ratio:
There has been a decline in the current ratio.
Quick ratio:
There has been little change in the quick ratio.
Inventory turnover (using average inventory):
Inventory turnover has increased.
Days Sales Outstanding (Average collection period):
Days sales outstanding has dramatically improved.
Times-interest-earned: 20X0: $90,000/$20,000 = 4.5
Times-interest-earned has improved.
With the exception of the slight decline in the current ratio, there has been no change that
indicates deterioration in the creditor’s position. The creditor’s position has probably
improved.
8-6. The firm wants to achieve the industry average given its level of sales. Thus:
Industry average = Sales/Average inventory
8-7. Average collection period = Accounts receivable
Sales per day
8-8. Operating profit margin = EBIT/Sales
8-9. EBIT $10,000
8-10. With debt financing With preferred stock
financing
Notice that since the preferred stock dividends are paid after taxes, earnings per common
share are lower than when debt financing is used.
8-11. This problem serves as a review of financial ratios by having the student compare the
Times-interest-earned:
earnings before interest and taxes = $1,460 = 4.97
interest expense $294
Investment Assignment (Part 3)
In this part, the student is asked if any of the stocks that he or she has selected meet specified
criteria based on ratios. Students are often more interested in growth stocks or name stocks
that they know. Often these do not have the fundamental associated with value stocks. You
can use this assignment to generate a discussion of growth versus value.
Teaching Guides for the Financial Advisor’s Investment Case: Strategies to Increase Equity
1. In this problem management wants to acquire more funds to help finance expansion. One
possibility is selling new stock, but this raises the question of diluting the current
Two other alternatives are suggested: (1) institute a dividend reinvestment plan that sells new
shares to stockholders who reinvest their dividends and (2) substitute a stock dividend for the
cash dividend. The stock dividend will not dilute the existing stockholders’ position since
2. The amount of money raised by the substituting the stock dividend for the cash dividend
will be the amount by which the cash dividend is reduced. If the cash dividend is eliminated,
If the dividend reinvestment plan is adopted, the amount of cash raised depends on the amount
of participation in the plan. Even if a large number of stockholders participate, the amount
3. The stock dividend will reduce the price of the stock by the amount of the dividend, as the
market adjusts for the additional shares. The dividend reinvestment plan will probably have no
4. Both the dividend reinvestment plan and the distribution of the stock dividend will have
some administrative costs. However, they may also generate some cost savings from not
5. Stock splits only alter the number of shares and the price of the stock adjusts accordingly. A
6. If the cash dividend were raised, that would reduce retained earnings. Unless all
stockholders participated in the dividend reinvestment plan, increasing the dividend must
7. The problem specifies four possibilities.
1. Raising new equity by issuing additional shares has a major advantage in that by using
an underwriting through an investment banker, the firm is guaranteed of raising a specified
2. Completely eliminating the dividend would raise $3.74 x 12,000,000 = $44,880,000.
Unless this amount is sufficient for the desired investments, future cash dividends would also
3. The dividend reinvestment plan will raise even less cash than eliminating the dividend.
4. The stock dividend is, in effect, being used as a smoke screen. It is the failure to pay a
cash dividend, and not the stock dividend that is saving the cash. Many investors realize that