Question

a. Define the two major types of corporate stock. Discuss the characteristics of each of the two types. How does an investor realise a return on a stock investment?

b. “Shareholders of corporate stock may have claims to a company’s assets and income.” Discuss and analyse this quote.

c. Using the Dividend Valuation Model, calculate the following: What is the value of a common stock that paid a $1.50 dividend at the end of the last year and is expected to pay a cash dividend in the future. Dividends are expected to grow at 7% annually and the investor’s required rate of return is 11%.

Answer 1

(a)

There are two main types of stocks: common stock and preferred stock.

Common Stock

Common stock is, well, common. When people talk about stocks in general they are most likely referring to this type. In fact, the majority of stock issued is in this form. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders, and preferred shareholders are paid.

Preferred Stock

Preferred stock represents some degree of ownership in a company but usually doesn't come with the same voting rights. (This may vary depending on the company.) With preferred shares investors are usually guaranteed a fixed dividend forever. This is different than common stock, which has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at anytime for any reason (usually for a premium).

Charecteristick of Common Stock

Common stocks have many unique and popular characteristics; this is why its very popular investment all over the world.

Common Stocks Represent Ownership of a Company
A piece of stock represents a portion of ownership of a company. That means, when you hold a portion of the company’s total stocks, you are one of the owners of the company.
For example, if a company has 1000 shares traded in the market and you hold 100 shares of that company, then you are the owner of one-tenth of that company.

The Voting Rights of Common Stock Holders
As a common stockholder of a company enlisted in the stock market, you have the capability of casting the vote while selecting directors’ board. This privilege gives you the right to select the most efficient person for the company. Sometimes, shareholders express their opinion in the major decision making for the company by voting e.g. mergers & acquisition etc.

The Value of Common Stocks
The value of the common stocks is not concrete. That means the value fluctuates time to time. The value of the common stock is backed by the value of the main company.

Capability of Receiving Periodic Dividends
The dividend is the most important part of a common stock. The image, capability, or attracting investors vastly depend on the dividend declaration capability. As a common stockholder, you have the rights or capability of receiving the periodic dividend.

Characteristic of Limited Liability in Common Stocks
When it is about the liability of the ownership, you have the limited liability. In simple words, the portion you have purchased from the stock market is actually your total liability.
For example, you are holding 10 shares of a company which has 100 shares trading in the market. So, if the company goes bankrupt, the maximum amount you can lose is the value of 10 shares.

Profitt and Risks Relation
The profitt and risk relation is high in the case of common stock. That means, when the risk is high for a specific stock, the return will be high as well. Conversely, if the risk is low, the possible return will be low as well.

Tax Exemptions (Indirect)
It is an indirect characteristic that is dependent on the decision of the government. In some countries, the income from the common stocks is not taxable. So, the money you earn from stock trading or investment is tax exempted.

Chances of Losing Everything in the Case of Bankruptcy
When it becomes bankrupt, there is a big chance that you do lose everything. That is because the stock price may go to the value at zero. And if there is nothing left after paying the preferred stockholders, you cannot get anything as there is nothing left.

Right to have Capital Gain
When you buy a stock, the price may go up or down. This is one of the primary characteristics of common stocks. In this case, you do have the right to sell the share to others and lock your prot. As there is an appreciation in the capital, it is called capital gain.

Volatility of Common Stocks
As the stock is traded in the market by the traders and investors, different people allocate different value for the same stock. So, the price of the stock becomes very volatile. In the morning you are seeing a price may not be the same price in the evening.

Uncertain Return
There is uncertainty in the return of stock investment as the value is dependent on many factors such as company earning, taxes, industry factors, or macroeconomic factors.

Charecteristic of Preferref Stock

Dividend Payment Priority
It is the most attractive characteristic of preferred stock. Preferred shares pay dividends annually which is a fixed percentage of stock’s purchase price. Corporation has to pay to the preferred stockholders before anyone else. However, if the company does not have any earnings then it is not applicable to pay dividends to anyone.

Cumulative Dividend Payments
Preferred dividend payment can be either cumulative or non-cumulative system. This system should be considered in the beginning of investing in preferred stocks. The cumulative dividend payment is if a company fails to pay one year’s dividend to the preferred stockholders then the company should pay the dividends in the second year with adding the prior year.

Fixed Rate of Dividend
Preferred stock has a fixed rate of dividend. It is specified as a percentage of the par value.

Less Riskier than Common Stock
Preferred stocks are less risky than common stocks. In the case of bankruptcy or liquidation, companies pay preferred stockholders before the common stockholders.

Claims on Income and Assets
In the event of bankruptcy, preferred stockholders’ claims get priority over the common stockholders. Preferred stockholders can claim on income and assets of the company before anyone else.

Convertible Feature
Some preferred stocks issues have a convertible feature that allows preferred stockholders to exchange their preferred shares into common shares. The terms of a convertible feature are already set when preferred shares are being issued. In these terms, the conversion ratio and conversion prices are included. Conversion ratio includes the number of the common stocks the preferred stockholders will get for exchanging each preferred stock.

Callable Features
The issuer has the right to call in the shares at par value after a set date. The issuers tend to call when the interest rates have fallen. New preferred shares can be issued at a current lower price after excluding the old high rates.

Redeemable
some preferred stocks are redeemable by giving the right to the company to buy back them at a fixed date and price.

Dividends: the dividend of the company is paid before paying the common stock holders. It ensures that the investment is less risky than investing in common stocks.

Higher Claim: the preferred stocks have a higher claim on the company’s asset. If the company goes for a bankruptcy, the preferred stock holders are paid rst from the remaining assets.

Return on stock

Common Stock : Investor can earn via dividend and capital gain in case of sale of stock in stock price appreciation.

Preferref Stock : Investor can earn via predecided dividend ans appreciation of stock value.

(b)

Claim to Income

In the cases of bankruptcy and dividend distribution, preferred stock shareholders will receive assets before common stock shareholders.

• Common stock and preferred stock are both forms of equity ownership but carry different rights and claims to income.
• Preferred stock shareholders will have claim to assets over common stock shareholders in the case of company liquidation.
• Preferred stock also has first right to dividends.

• Preferred Stock: Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.
• Common stock: Common stock is a form of equity and type of security. Common stock shareholders are at the bottom of the line when it comes to dividends and receiving compensation in the case of bankruptcy.

Preferred stock may or may not have a fixed liquidation value (or par value) associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued. Preferred stock has a claim on liquidation proceeds of a stock corporation equal to its par (or liquidation) value, unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim.

Both types of stock can have a claim to income in the form of capital appreciation as well. As company value increases based on market determinants, the value of equity held in this company also will increase. This translates to a return on investment to shareholders. This will be different to common stock shareholders and preferred stock shareholders because of the different prices and rewards based on holding these different kinds of shares. In turn, should market forces decrease, the value of equity held will decrease as well, reflecting a loss on investment and, therefore, a decrease on the value of any claims to income for shareholders.

(c) Using the Gordon growth model

Stock value = Dividend per share / (Required Rate of Return – Dividend Growth Rate)

= [$1.50 x (1+0.07)] / (0.11 - 0.07)

   = $1.605 / 0.04

Stock value = $40.125