Chapter 1a

Question 1

What is a stock?

Answer 1

ownership stake in a company

Question 2

What is a share of stock?

Answer 2

a share in the ownership of the company

Question 3

What does that mean: % of outstanding stock you own?

Answer 3

% of the company you own

Question 4

Outstanding stock

Answer 4

number of shares issued by a company that are actually owned by someone (or by another company)

Question 5

Primary Financial Markets

Answer 5

Original Sale of securities: Transaction takes places directly between issuer and investor.
• Ex.: Your small corporation from Example 1 decides to bring on a 3rd member, and you sell 5000 directly to him

Question 6

Secondary Financial Markets

Answer 6

Sale of securities after the original sale: Transaction takes place between investors, transferring of ownerships
• Ex.: You buy 10 shares of Amazon as in Example 2 through your online brokerage account. You are actually buying the shares from an another investor who wants to sell their shares, not from Amazon.

Question 7

Two types of primary markets transactions of corporations

Answer 7

• public offerings: involves selling securities to the GENERAL public (need to be registered at SEC)
• private placements: a negotiated sale involving a SPECIFIC buyer (no need to register at SEC)

Question 8

How does companies sell stocks?

Answer 8

Small companies: The owners themselves find an investor willing to buy the shares, negotiate a price, and the investor pays the company directly for the stock

Large companies: Companies that meet certain size requirements can have their stock listed on an exchange (NYSE, etc.); They are selling it to brokerage firms who sell it again to investors

Question 9

Why issue stocks?

Answer 9

Pro:
• Unlike when the company incurs debt, it does not have to pay money back to purchasers of stock
– More favorable effect on liquidity, since debt payments do not have to be made
• Easier for good companies to attract investors who want an ownership stake, and thus the chance to make ongoing, higher returns

Contra:
• Current owners are giving up a piece of their stake in the company
• Equity investors usually require a higher potential return than bond investors, thus initial stock selling prices must reflect this
• Dividends are not tax-deductible, unlike interest payments on loans or bonds (Double Taxation)

Question 10

What are the features of common stocks?

Answer 10

• Voting Rights
• Proxy voting
• Classes of stock – same rights for all members
• Directly related to other rights of general stocks (dividends paid, remaining assets after liquidation, Preemptive right – first shot at new stock issue to maintain proportional ownership if desired)

Question 11

What is a common stock?

Answer 11

First, with common stock, not even the promised cash flows are known in advance. Second, the life of the investment is essentially forever because common stock has no maturity. Third, there is no way to easily observe the rate of return that the market requires.

• common stock have voting rights

Question 12

cumulative voting (voting rights)

Answer 12

A procedure in which a shareholder may cast all votes for one member of the board of directors.
If cumulative voting is permitted, the total number of votes that each shareholder may cast is determined first. This is usually calculated as the number of shares multiplied by the number of directors to be elected.

Question 13

straight voting (voting rights)

Answer 13

A procedure in which a shareholder may cast all votes for each member of the board of directors.
The only way to guarantee a seat is to own 50 percent plus one share.

Question 14

proxy voting

Answer 14

A grant of authority by a shareholder allowing another individual to vote his or her shares (Usual for large public corporations)

Question 15

classes of stocks

Answer 15

Example Google:
Share A - 1 vote
Share B - 10 votes

Question 16

Types of liabilities

Answer 16

Current (Short-term):
– Accounts Payable (money the company owes to vendors)
– Loans Outstanding (typically to banks)
– Current portion of Long-term Debt (payable in next 12 months)

Long-term:
In this class, ‘Long-Term Liabilities’ will always mean bonds
outstanding

Question 17

What is a bond?

Answer 17

• contact between a borrower and investor
• repaying a set amount of money at a specified date in the future, and usually make interest payments to the holder
• Bonds can be traded between investors the same way as
  stocks

Question 18

Why issue a bond?

Answer 18

Pro:
• Selling bonds does not force current owners to give up management or ownership control of the company
• Unlike stock, bonds have a limited life
• Since the company can deduct interest payments from
income for tax purposes, the cost to the company of
issuing and holding debt in the form of bonds is typically
lower than that of stock

Contra:
• Usually, periodic interest payments must be made. This
reduces the company’s liquidity, and can even force the
company into bankruptcy.
• Unlike stockholders, the company is obligated to make a
payment to bondholders at a specified period of time
• May be harder to sell bonds than stock in certain
circumstances

Question 19

Difference between Debt and Equity

Answer 19

• Debt
– Not an ownership interest
– Creditors do not have voting rights
– Interest is considered a cost of doing business and is tax
deductible
– Creditors have legal recourse if interest or principal payments are missed
– Excess debt can lead to financial distress and bankruptcy

• Equity
– Ownership interest
– Common stockholders vote for the board of directors
and other issues
– Dividends are not considered a cost of doing business and are not tax deductible
– Dividends are not a liability of the firm, and stockholders
have no legal recourse if dividends are not paid
– An all equity firm can not go bankrupt merely due to debt since it has no debt

Question 20

mutual funds

Answer 20

• Mutual funds pool money from many investors to buy
  individual securities:
  • Easier for individual investors to gain exposure to certain
  companies, as well as to diversify their holdings, than trying to purchase individual securities on their own
  • Mutual fund managers charge a fee for this service
  – Usually mutual funds focus on one type of security, and have a particular focus within that security type

Question 21

Other financial instruments

Answer 21

• Options
• Futures
• Real Estate
• Commodities
• Hedge Funds