Stock and Dividends*

Question 1

What is common stock?

Answer 1

Owners of common stocks are shareholders of the corporation. This Equity ownership involves risk because there’s no guaranty of return and the owners are last in priority in a liquidation.

Question 2

What rights do holders of common stock have?

Answer 2

Voting rights. They can select the corporation’s board of directors and vote on resolutions.

Question 3

What are preemptive rights?

Answer 3

Rights to common shareholders for purchasing future stock issuances in proportion to their ownership so their ownership percentage is not diluted.

Question 4

What are advantages to issue common stocks?

Answer 4

1. No required fixed dividend payment to stockholders
2. No fixed maturity date for repayment of capital
3. Sale of common stock increases a corporations’ creditworthiness by providing equity

Question 5

What are disadvantages to issue common stocks?

Answer 5

1. Cash dividends are not tax deductible by the corporation (paid out of after-tax profits)
2. Higher underwriting costs
3. Too much equity may raise the average cost of capital above optimal level (equity has higher return to investors than debt so more equity means higher cost to pay to investors)

Question 6

Why is common stock more attractive than debt to investors?

Answer 6

Common stock grows in value with the success of the corporation.

Question 7

What happens when more common stocks are sold?

Answer 7

1. Control (voting rights) is usually diluted. This may be a disadvantage to existing shareholders but advantage to the management of the corporation.
2. Earnings per share is diluted for existing shareholders.

Question 8

What is a common stock’s par value?

Answer 8

It represents legal capital. It is the value assigned to stock before the stock is issued. It also represents the maximum liability to shareholders.

Question 9

What is preferred stock?

Answer 9

It’s a hybrid of debt and equity. It has a fixed charge and increases leverage, but payment of dividends is not a legal obligation. Shareholders of preferred stocks have priority in assets and earnings over common shareholders.

Question 10

What is accumulation of dividends?

Answer 10

Preferred dividends in arrears must be paid before any common dividends can be paid.

Question 11

What are participating and non-participating preferred stocks?

Answer 11

Participating preferred stock may participate with common in excess earnings of the company. However, the non-participating stock will only receive the stated percentage on the face of the stock.

Question 12

What is par value for preferred stock?

Answer 12

It’s the liquidation value. Preferred dividend is calculated as a percentage of the par value.

Question 13

What is redeemable preferred stock?

Answer 13

It can be repurchased by issuer at a given time or at the option of the holder or otherwise at a time not controlled by the issuer.

Question 14

What is a call provision for preferred stock?

Answer 14

The issuer may repurchase and pay a call premium after the noncallable period has passed.

Question 15

What are advantages to issue preferred stock?

Answer 15

1. It’s a form of equity so it builds creditworthiness of the corporation
2. Control is held by common shareholders
3. Superior earnings are reserved for the common shareholders

Question 16

What are disadvantages to issue preferred stock?

Answer 16

1. Cash dividends paid are not tax deductible; thus, its cost is greater than bonds
2. Accumulated unpaid dividends (dividends in arrears) may create managerial and financial problem for the corporation

Question 17

What’s the tax implication to holders of preferred stocks vs bonds?

Answer 17

Holding preferred stock provides corporation major tax advantage because at least 70% of the dividends received is tax deductible, but bond interest received is taxable.

Question 18

What is a dividend policy?

Answer 18

It determines what portion of net income is distributed to shareholders as dividends and what portion is retained or reinvestment. The most important factor to consider is future planned use of cash.

Question 19

Why do corporation normally maintain a stable level of dividend payout?

Answer 19

1. Profits may fluctuate so not raising the dividend when profits are high can help sustain payout since shareholders have expectation of receiving payout.
2. Stock usually sells at a higher price shareholders receive that receiving dividends as less risky.

Question 20

What is signaling hypothesis?

Answer 20

A change in dividend policy is a signal to the market regarding management’s forecast of future earnings.

Question 21

How do legal restrictions influence dividend policy?

Answer 21

1. Dividends usually cannot be paid out of paid-in capital so a corporation must have retained earnings before payout can be made.
2. Restrictive covenants in bond and other debt agreements often limits the dividends a corporation can declare.

Question 22

How does cash position influence dividend policy?

Answer 22

Cash must be available before a dividend can be paid regardless of a corporation’s earnings record. Earnings may be tied up in receivables or inventories.

Question 23

How does growth rate influence dividend policy?

Answer 23

Faster growth rate means a corporation needs financing from retained earnings and thus a lower dividend payout.

Question 24

How do tax positions of shareholders influence dividend policy?

Answer 24

1. Shareholders who are in high tax brackets may want to forgo dividends in exchange for future capital gains or wait to receive dividends in future when they are in lower tax brackets.
2. Accumulated earnings tax is assessed on a corporation if it has accumulated retained earnings beyond reasonably expected needs.

Question 25

What is residual theory of dividends?

Answer 25

The residual amount of earnings paid as dividends depends on the available investment opportunities and the debt-equity ratio at which cost of capital is minimized. Rational investors may prefer reinvestment of retained earnings when the return exceeds other investments with equal risk. Corporations may prefer to pay dividends when investment opportunities are poor and the use of internal equity financing would move the company away from ideal capital structure.

Question 26

What is date of declaration?

Answer 26

The date when board of directors formally vote to declare a dividend. On this date, the dividend becomes a liability of the corporation.

Question 27

What is date of record?

Answer 27

The date when the corporation determines the shareholders who will receive declared dividends.

Question 28

What is ex-dividend date?

Answer 28

The date established by the stock exchanges (i.e. 2 business days before date of record) The period between ex-dividend date and date of record gives stock exchanges time to process transactions.

Question 29

Who is entitled declared dividends?

Answer 29

An investor who buys stock before the ex-dividend date will receive the dividend. An investor who buys on or after the ex-dividend date (but before date of record) will not receive dividends. Usually a stock will drop price by the amount of dividend on ex-dividend date because the new investors won’t receive it.

Question 30

What is date of distribution?

Answer 30

The date when dividend is actually paid (checks are in mail to the investors). It is usually 2 to 4 weeks after date of record.

Question 31

What is stock dividend?

Answer 31

Issuance of additional shares by transferring of a sum from the retained earnings account to a paid-in capital account. It’s usually used by growing companies who needs retained earnings in the business.

Question 32

What is stock split?

Answer 32

The existing shares are divided into more shares so that the market price per share is reduced. There’s no accounting entries required.

Question 33

What is reverse stock split?

Answer 33

It reduces the number of shares outstanding and thus increases the market price per share.

Question 34

What are advantages of issuing stock splits?

Answer 34

1. The lower market price per share will induce small investors, thus the demand for the stock will be higher. That leads to a slightly higher price per share and will benefit current shareholders
2. More shares means larger the number of shareholders, who are usually good customers of the company’s products
3. It can be a publicity gesture because shareholders may believe they receive something of value. They will have a better opinion of the company.

Question 35

What is a share repurchase?

Answer 35

It’s when a corporation buys back its own stock back on the open market. These shares are called treasury shares.

Question 36

What are the motives for share repurchase?

Answer 36

1. Mergers
2. Share options
3. Dividends
4. Tax advantages to shareholders
5. Increased earnings per share or other ratios
6. Prevention of hostile takeover
7. Elimination of a particular ownership interest