Introduction to Stocks

Question 1

All of the following statements concerning common stock are correct, EXCEPT:

1) Owners of common stock are entitled to dividends declared by the board of directors.
2) Owners of common stock have a right to vote either in person or by proxy at annual meetings.
3) Owners of a share class with disproportionate voting power can be sued for debts of the business.
4) Companies have the right to either lower or raise dividend rates on common shares.

Answer 1

3) Owners of a share class with disproportionate voting power can be sued for debts of the business.

– Common stock owners cannot be sued for debts of the business even if they own a class of shares of disproportionate voting power.

Question 2

If preferred stock is cumulative:
1) Unpaid dividends of one period must be carried forward and paid in subsequent periods.
2) The yearly dividend rate must be adjusted upward if previous dividends have not been paid.
3) Dividends must be paid on an equal basis with common stock , as long as earnings permit.
4) Dividends cannot be declared and paid if they are not earned.

Answer 2

1) Unpaid dividends of one period must be carried forward and paid in subsequent periods.

– With cumulative preferred stock, dividends accumulate; that is, a missed dividend and the current dividend must both be paid prior to dividends being paid to common shareholders.

Question 3

Jessica owns 10 shares of ACME Tools, Inc. stock at $50 per share. The stock splits 2 for 1. What would be the number of shares Jessica owns after the split and total value of Jessica’s investment?

1) 5 shares at a total value of $1,000
2) 5 shares at a total value of $500
3) 20 shares at a total value of $1,000
4) 20 shares at a total value of $500

Answer 3

4) 20 shares at a total value of $500

– Share amount will double due to the stock split. However, since share price is halved, total stock value will not change after the split.

Question 4

Which of the following firm ratios will change after a stock split?

1) Price to Earnings ratio
2) Return on Equity ratio
3) Earnings per Share ratio
4) Gross Margin ratio

Answer 4

3) Earnings per Share ratio

– Earnings will not change after a stock split. However, shares outstanding will double after a stock split.

Question 5

Common stocks have voting rights that give shareholders the power to do which of the following EXCEPT:

1) Vote by proxy
2) Elect the board of directors
3) Vote of major company issues
4) Vote on everyday management decisions

Answer 5

4) Vote on everyday management decisions

– Voting rights allow shareholders to elect the board of directors, vote on major company issues and vote by proxy when not available to be present at shareholder meetings. Everyday management decisions are left to the management of the company.

Question 6

On which of the following exchanges would you most likely find a technology stock like Google?

1) Nasdaq
2) AMEX
3) Boston Stock Exchange
4) NYSE
5) Chicago Exchange

Answer 6

1) Nasdaq

– The Nasdaq lists many of the U.S.’s high tech stocks. The NYSE only allows large established companies in its membership. AMEX companies are smaller than the NYSE. Boston and Chicago stock exchanges cater to more of the local companies.

Question 7

Which of the following statements concerning the Standard and Poor’s 500 Index are correct?

1) The S&P 500 index only includes companies listed in the U.S.
2) The S&P index is a capitalization-weighted index.
3) A company listed in the S&P 500 can’t be listed on pink sheets or traded over the counter.

(1) and (3) only
(1) and (2) only
(2) and (3) only
(1), (2) and (3) only

Answer 7

(1), (2) and (3) only

– All three of these statements regarding the S&P 500 Index are correct.

Question 8

Carl ended the year with a total investment in McDonald’s of $7,000 (100 shares x the $70 market price of the stock). McDonald’s has just announced a 3-for-2 stock split, payable May 30th. If the market price of the stock does not change (except for the split effect), which of the following best represents Carl’s McDonald’s holdings on May 30th?

1) Total investment $4,667 (100 shares x $46.67)
2) Total investment $7,000 (150 shares x $46.67)
3) Total investment $10,500 (150 shares x $70)
4) Total investment $7,000 (120 shares x $58.33)

Answer 8

2) Total investment $7,000 (150 shares x $46.67)

– For a stock split, the shares outstanding are multiplied by the multiplication factor (in this example, 1.5), and the market price of the stock is divided by the multiplication factor.

Question 9

Roy met with his financial planner who discussed the benefits of investing in common stocks. Which of the following statements about common stocks is not correct?

1) Stocks provide high current income relative to other asset classes
2) Stocks generate better returns over the long term
3) Stocks are affected by several risks including interest rate risk
4) Some company specific risk can be diversified by investing in a variety of companies.

Answer 9

1) Stocks provide high current income relative to other asset classes

– Typically, common stocks outperform other investments over the long term. Usually, a common stock’s total return comes from capital appreciation (or depreciation) rather than from dividends. The company specific factors that contribute to the risk of common stocks can be diversified through investing in various companies. Stock price movements can be affected by a number of factors beyond interest rates.

Question 10

Common stock

Answer 10

Common stock represents ownership (equity) in a publicly traded corporation. Holders of common stock exercise control by electing a board of directors and voting on certain corporate matters. Common shareholders have lowest priority in terms of claims to the company’s earnings and assets. A company must make interest payments on debt instruments and preferred stock dividends before common stock dividends will be paid. In the event of liquidation, common shareholders have rights to the company’s assets only after bondholders, preferred shareholders and other creditors have been paid in full.

Question 11

Right to a Stock Certificate

Answer 11

• When investors buy common stock, they can obtain certificates as proof of their ownership. However, it is worth noting that many investors now hold their shares with a brokerage firm.

Question 12

Voting Rights

Answer 12

• Stockholders own the corporation. They are entitled to elect the firm’s board of directors, vote in person or by mail on major issues that affect the corporation, and delegate their vote(s) via proxy if not interested in voting.

Question 13

Right to Buy and Sell

Answer 13

• Shareholders have the right to buy additional shares or to sell their shares whenever and to whomever they choose.

Question 14

Preemptive Right

Answer 14

• The preemptive right grants existing stockholders the right-of-first-refusal on any new stock the corporation issues. This means that existing investors are guaranteed the right to maintain their previous fraction of total outstanding shares and prevents dilution of ownership control.

Question 15

Right to Information

Answer 15

• The Securities Act of 1933 requires U.S. issuers to make full disclosure of all relevant information to any interested party. Publicly traded corporations in the U.S. are required to send their stockholders quarterly and annual financial reports. Stockholders may also demand additional information, such as minutes from the board of directors meetings, lists of stockholders and detailed financial reports.

Question 16

Right to Receive Cash Dividends

Answer 16

• Boards of directors typically discuss the question of whether to pay cash dividends, and, if so, how much.

Question 17

Shares pay cash dividends and are sold to the public to raise capital, but investors might have zero or diminished voting power.

Answer 17

Class A Shares

Question 18

Voting stock held by management that is entitled to zero or reduced cash dividends. The top managers of the corporation usually take Class B stock as payment for founding, merging, or reorganizing the corporation. Voting power, combined with its management authority, can give top executives of a corporation total control of the firm without investing any money.

Answer 18

Class B Shares

Question 19

Stock Value - Par Value

Answer 19

When a corporation is first chartered, it is authorized to issue up to a stated number of shares of common stock, each of which has a specified par value. The par value is typically lower than the initial sales price of the stock. The difference may be carried separately on the corporation’s books under stockholders’ equity. This is capital contributed in excess of par value or paid-in capital.

The par value of the stock is carried in a separate account, generally titled simply as common stock, with an amount that is equal to the number of shares outstanding times the par value per share. For an equity security, par is usually a very small amount that bears no relationship to its market price, except for preferred stock, in which case par is used to calculate dividend payments.

Question 20

Stock Value - Book Value

Answer 20

Book value is calculated by dividing the net worth of a company by the number of shares outstanding.

The sum of the cumulative retained earnings and other entries such as common stock and capital contributed in excess of par value, under stockholder’s equity is the book value of the equity.

The book value per share is obtained by dividing the book value of the equity by the number of shares outstanding

Question 21

The percentage of net earnings not paid out in dividends but retained by the company to be reinvested in its core business or to pay debt.

Answer 21

Cumulative retained earnings

Question 22

Difference between initial sale price of stock and its par value

Answer 22

Capital contributed in excess of par

Question 23

Par value of the common stock

Answer 23

Common stock

Question 24

Book value of the equity

Answer 24

Cumulative retained earnings + Capital contributed in excess of par + Common stock

Calculating the book value begins with identifying the portion of profit kept for company use.
Then any additional amount that was obtained at the IPO price above par.
Finally, the par value of all of the outstanding common stock shares is added.
The total value of the company on the books includes the retained earnings, the par value of shares, and the capital in excess.

Question 25

Bid-Ask spread

Answer 25

The difference between ask price and bid price known as the bid-ask spread and often represents a profit to the market maker or broker.

Ask price (price at which the market maker is willing to sell the stock).
Bid price (price at which the market maker is willing to buy the stock).

Question 26

Preferred Stocks

Answer 26

Preferred stock is a form of equity investment that receives only a stipulated dividend. Owners of preferred stocks have a right to a company’s earnings before common stock shareholders. Payments on preferred stocks are called dividends and do not qualify as a tax-deductible expense for the issuing corporation. Preferred dividends are stated as a percent and are required to be paid to shareholders before common stock shareholders receive any dividends. There are various provisions protecting the preferred stockholders against potentially harmful actions. Many issues of preferred stock are callable at a stated redemption price.

Question 27

Price-weighted index

Answer 27

The Dow Jones Industrial is a price-weighted index. To calculate a price weighted index:

Add all the prices of the stocks that are included in the index.
Then divide this sum by a constant (the divisor) in order to calculate an average price.
The divisor is adjusted whenever there is a stock split in order to avoid giving misleading indications of the market’s direction. The original divisor was 30.

However, as stocks undergo stock splits or pay stock dividends, the divisor must decrease in order to keep the index from changing in value before and after the event. As of 2021, the divisor was .15198707565833.

Question 28

Standard & Poor’s 500 Stocks Composite

Answer 28

Standard & Poor’s Corporation is a financial information company that developed its first stock market indicator in 1923. The prices of 233 stocks were compiled by hand and used to create 26 industry indices. By 1941, the list of 233 stocks had grown to 416 stocks, and they were used to create 72 industrial indices. In 1957, the sample of 416 stocks was expanded to 500 stocks, and they were used to create the Standard & Poor’s 500 Stock Composite Index, which was retabulated by computer every minute throughout each trading day.

The S&P 500 is a much broader representation of large companies. It is more representative of diversified common stock investing in the U.S. than the DJIA.

Question 29

Value Weighting

Answer 29

In this method, the prices of the stocks in the index are multiplied by their respective number of shares outstanding and then added up in order to arrive at a figure equal to the aggregate market value for that day. This figure is then divided by the corresponding figure for the day that the index was started, with the resulting value being multiplied by an arbitrarily determined beginning index value.

There are no special procedures needed to handle stock splits, because the resulting increased number of shares for a company is automatically used after a split in calculating its market value.

The S&P 500 employs a market-value weighting system that assigns each security a weight that is proportional to the market value of all that issue’s outstanding shares. Such market value weights correspond to the investment opportunities that exist in the U.S. stock market. This characteristic makes the S&P 500 a useful standard of comparison for evaluating the performance of other U.S. common stock investments.