4.2 Stock

Question 1

Advantages of common stock to the issuer include

Answer 1

• Common stock does not require a fixed dividend
• There is no fixed maturity date for repayment of the capital
• The sale of common stock increase the creditworthiness of the firm by providing more equity
• Common stock is frequently more attractive to investors than debt because it grows in value with the success of the firm. The higher the common stock value, the more advantageous equity financing is compared with debt financing.

Question 2

Disadvantages of common stock to the issuer include

Answer 2

• Cash dividends on common stock are not tax-deductible by the corporation, and so must be paid out of after-tax profits.
• Control (voting rights) is usually diluted as more common stock is sold. (While this aspect is disadvantageous to existing shareholders, management of the corporation may view it as an advantage.)
• New common stock sales dilute earnings per share available to existing shareholders.
• Underwriting costs are typically higher for common stock issues.
• Too much equity may raise the average cost of capital of the firm above its optimal level.
• Inflation may increase the yields of new bond issues and decrease demand for common stock. Moreover, higher interest costs reduce funds available for dividends.

Question 3

Advantages of preferred stock to the issuer include

Answer 3

• It is a form of equity and therefore builds the creditworthiness of the firm.
• Control is still held by common shareholders.
• Superior earnings of the firm are usually still reserved for the common shareholders.

Question 4

Disadvantages of preferred stock to the issuer include

Answer 4

• Cash dividends on preferred stock are not deductible as a tax expense and are paid with after-tax income. The result is a substantially greater cost relative to bonds.
• In periods of economic difficulty, accumulated unpaid dividends (called dividends in arrears) may create major managerial and financial problems for the firm.

Question 5

The par value of a common stock represents

A. The estimated market value of the stock when it was issued.
B. The liability ceiling of a shareholder when a company undergoes bankruptcy proceedings.
C. The total value of the stock that must be entered in the issuing corporation’s records.
D. A theoretical value of $100 per share of stock with any differences entered in the issuing corporation’s records as discount or premium on common stock.

Answer 5

B. The liability ceiling of a shareholder when a company undergoes bankruptcy proceedings.

Par value represents a stock’s legal capital. It is an arbitrary value assigned to stock before it is issued. Par value represents a shareholder’s liability ceiling because, as long as the par value has been paid in to the corporation, the shareholders obtain the benefits of limited liability.