(48) Overview of Equity Securities

Question 1

LOS 48: Describe the benefit of cumulative share voting.

Answer 1

Cumulative voting allows minority shareholders to gain representation on the board because they can use all of their votes for specific board members.

Question 2

LOS 48. a: Describe characteristics of types of equity securities. Common shareholders

Answer 2

Common shareholders have a residual claim on firm assets and govern the corporation through voting rights. Common shares have variable dividends which the firm is under no legal obligation to pay.

Question 3

LOS 48. a: Describe characteristics of types of equity securities. Callable common shares

Answer 3

Callable common shares allow the firm the right to repurchase the shares at a prespecified price.

Question 4

LOS 48. a: Describe characteristics of types of equity securities. Puttable common shares

Answer 4

Puttable common shares give the shareholder the right to sell the shares back to the firm at a pre-specified price.

Question 5

LOS 48. a: Describe characteristics of types of equity securities. Preferred stock

Answer 5

Preferred stock typically does not mature, does not have voting rights, and has dividends that are fixed in amount but are not contractual obligation of the firm.

Question 6

LOS 48. a: Describe characteristics of types of equity securities. Cumulative preferred shares

Answer 6

Cumulative preferred shares require any dividends that were missed in the past (dividends in arrears) to be paid before common shareholders receive any dividends.

Question 7

LOS 48. a: Describe characteristics of types of equity securities. Participating preferred shares

Answer 7

Participating preferred shares receive extra dividends if firm profits exceed a prespecified level and a value greater than the par value if the firm is liquidated.

Question 8

LOS 48. a: Describe characteristics of types of equity securities. Convertible preferred stock

Answer 8

Convertible preferred stock can be converted to common stock at a pre-specified conversion ratio.

Question 9

LOS 48. b: Describe differences in voting rights and other ownership characteristics among different equity classes.

Answer 9

Some companies’ equity shares are divided into different classes, such as Class A and Class B shares. Different classes of common equity may have different voting rights and priority in liquidation.

Question 10

LOS 48. c: Distinguish between public and private equity securities.

Answer 10

Compared to publicly traded firms, private equity firms have:

• lower reporting costs
• greater ability to focus on long-term prospects, and;
• potentially greater return for investors once the firm goes public

However, private equity investments are illiquid, firm financial disclosures may be limited, and corporate governance may be weaker.

Question 11

LOS 48. d: Describe methods for investing in non-domestic equity securities.

Answer 11

Investors who buy foreign stock directly on a foreign stock exchange receive a return denominated in a foreign currency, must abide by the foreign stock exchange’s regulations and procedures, and may be faced with less liquidity and less transparency than is available in the investor’s domestic markets. Investors can often avoid these disadvantages by purchasing depository receipts for the foreign stock that trade on their domestic exchanges.

Question 12

LOS 48. d: Describe methods for investing in non-domestic equity securities. What are ‘global depository receipts’?

Answer 12

Global depository receipts are issued outside the United States and outside the issuer’s home country. They are most often denominated in U.S. Dollars.

Question 13

LOS 48. d: Describe methods for investing in non-domestic equity securities. What are ‘American depository receipts’?

Answer 13

American depository receipts are denominated in U.S. dollars and are traded on U.S. exchanges.

Question 14

LOS 48. d: Describe methods for investing in non-domestic equity securities. What are ‘global registered shares’?

Answer 14

Global registered shares are common shares of a firm that trade in different currencies on stock exchanges throughout the world.

Question 15

LOS 48. d: Describe methods for investing in non-domestic equity securities. What are ‘baskets of listed depository receipts’?

Answer 15

Baskets of listed depository receipts are exchange-traded funds that invest in depository receipts.

Question 16

LOS 48. e: Compare the risk and return characteristics of different types of equity securities. What do equity investor returns consist of?

Answer 16

Equity investor returns consist of:

• dividends
• capital gains or losses from changes in share price, and;
• any foreign exchange gains or losses on shares traded in a foreign currency.

Compounding of reinvestment dividends has been an important part of any equity investor’s long-term return.

Question 17

LOS 48. e: Compare the risk and return characteristics of different types of equity securities. Preferred stock vs. common stock.

Answer 17

Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend to investors; preferred stockholders must receive dividends before common stock dividends can be paid; and preferred stockholders have a claim equal to par value if the firm is liquidated.

Question 18

LOS 48. e: Compare the risk and return characteristics of different types of equity securities. Puttable shares vs. callable shares

Answer 18

Puttable shares are the least risky and callable shares are the most risky.

Question 19

LOS 48. e: Compare the risk and return characteristics of different types of equity securities. Cumulative preferred shares vs. non-cumulative preferred shares

Answer 19

Cumulative preferred shares are less risky than non-cumulative preferred shares, as any dividends missed must be paid before a common stock dividend can be paid.

Question 20

LOS 48. f: Explain the role of equity securities in the financing of a company’s assets.

Answer 20

Equity securities provide funds to a firm to buy productive assets, to buy other companies, or to offer to employees as compensation. Equity securities provide liquidity that may be important when the firm must raise additional funds.

Question 21

LOS 48. g: Distinguish between the market value and book value of equity securities.

Answer 21

The book value of equity is the difference between the financial statement value of the firm’s assets and liabilities. Positive retained earnings increase the book value of equity. Book values reflect the firm’s past operating and financing choices.

The market value of equity is the share price multiplied by the number of shares outstanding. Market value reflects investors’ expectations about the timing, amount, and risk of the firm’s future cash flows.

Question 22

LOS 48. h: Compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return.

Answer 22

The accounting return on equity (ROE) is calculated as the firm’s net income divided by the book value of common equity. ROE measures whether management is generating a return on common equity but is affected by the firm’s accounting methods.

The firm’s cost of equity is the minimum rate of return that investors in the firm’s equity require. Investors’ required rates of return are reflected in the market prices of the firm’s shares.