Question

1. Define the two major types of corporate stock. Discuss the characteristicsof each of the two types. How does an investor realise a returnon a stock investment?

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

3. Using the Dividend Valuation Model, calculate the following: What is the value of a common stockthat 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

Sol 1

Corporate Stock basically means an ownership  in a business entity. A company may require funds for its future growth or for its capital expenditure, and therfore can raise funds from investors. Corporate stock consists of shares which give ownership to the investors. Shares of corporate stock can be purchased and sold in two different ways:

1. Single private transaction : means buying/ selling to a single private purchaser, or

2. Regulated stock exchange : a platform through which purchasers can buy shares.

A company can raise as many shares as it wants. As the business starts to grow, or in case of splitting up of shares the shares' value increases, thereby increasing the shareholder's wealth.

There are mainly two types of corporate stock:

a) Common Stock : As a widely used type of stock, the characteristics of common stock include:

i) Voting Rights: these shares are allowed voting rights i.e whenever a shareholders' meeting is held, shareholders holding common stock are eligible to take decisions via voting.

ii) High return on investment: The return on investment is also high in this type of stock.

iii) Varying Dividends:  The dividend on common stock is not guranteed and may also vary.

  

b) Preferred Stock: characteristics of preferred stock include:

i) No Voting Rights: unlike the common stock, preferred stock do not contain any voting rights.  . This type of investmet is suitable for those who are just looking to profit off of the growth of the business without having anything to do with the operations.

ii) Guaranteed Dividends: Preferred stock typically guarantees a set amount per dividend in perpetuity.

iii) Preferred over common stock: In case of a financial event , for example liquidation or winding up of a company, a preferred stock would stand first in ranking in terms of eligibility for payment before common stockhoders.

Return on Investment can be realised in two ways:

i) Capital appreciation: It refers to a situation whrere  the value of a share increases. The appreciation can be due to many reasons such as increase in market share, or investors hope to earn more return from investment etc.

ii) Dividend Income: Varying or otherwise, a dividend income adds to the value of share. appreciating its value and thus the investor ends up realising his return on investment.

Sol 2:

“Shareholders of corporate stock may have claims to a company’s assets and income.” : This quote suggests about the ownership rights the shareholders of common as well as preferred stock carry. However, as discussed earlier, each of them carry different ownership and income rights. Preferred stock shareholders will have claim to assets over common stock shareholders in the case of company liquidation.Also, Preferred stock also has first and guaranteed right to dividends. Additionally. at the time of new shares to be issued to the public, current shareholders have the right to buy shares before they're offered to new shareholders.

Sol 3:

As per the Dividend Valuation Model, value of common stock:
Price=	Expected dividend
	(Rate of return- growth rate)
=	1.5(1+.07)
	(0.11-0.07)
=	40.125 $