CHAPTER 10: Equity Markets

Answers to End-of-Chapter Questions

1. Describe the major differences between common stock and preferred stock.

Under many state laws, there are no differences unless noted in the stock issue specifications.
Usually there are considerable differences between a company's preferred and common in
these areas:

a. Considering maturity, equity does not mature, but preferred stock often has a written plan
for retirement or an option to retire is retained by the issuing firm.
b. Preferred stock has a "preferred" position in the claim on the income flow of the firm.
Preferred stock dividends, usually a fixed rate relative to par value, are paid ahead of
common stock dividends. If cumulative, prior dividends must be paid in their entirety
before common stockholders receive a dividend. If participating, preferred and
common may participate in earnings levels formally prescribed. In all cases, the board of
directors decides the payment of dividends to equity.
c. In liquidation, preferred stocks have a prior claim on the liquidated assets of the firm
ahead of common stocks.
d. Preferred stockholders usually give up voting rights for their prior claim on the income
stream and assets of the firm.
e. Preferred stock investors are mostly tax-paying financial corporations that have generous
deduction on dividends received on equity shares. Casualty insurance companies are
major investors in preferred stock.

2. Why are convertible securities more attractive to investors than simply holding a firm's
preferred stock or corporate bonds?

Convertibles provide a prior claim if the common equity does not perform. If the stock
appreciates, the convertibles may participate in the good fortune of the company. The
tradeoff is a lower coupon or preferred rate than regular bonds or preferred stocks.

3. Rowell Inc. has 100 million shares of common stock outstanding and the company is
electing seven directors by means of cumulative voting. If a group of minority
shareholders controls 31 million shares, how many directors is the group certain of
electing? If straight voting was used, how many directors would the group be certain of
electing?

The number of directors they may elect under cumulative voting is determined by the
following formula:

# of Directors Elected
Shares Owned - 1 # ofDirectors Elected 1
Total Voting Shares

31,000,000 1 7 1 248
100,000,000
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The minority shareholders may elect 2 directors by cumulating their votes. With straight or
majority voting, with only 31% of the shares, the minority shareholder group will not elect
any directors.

4. Weber Corporation has 10 million shares of a preferred stock issue outstanding that
pays a cumulative $6 annual dividend on a quarterly basis. However, due to poor
profitability the company has not paid the preferred stock dividend for the last five
quarters. The company also has 20 million shares of common stock outstanding.
Weber Corporations profitability has improved recently and the board of directors
believes that the company can pay $100 million in dividends next quarter. How much
of a dividend can the company pay on its common stock?

Of the $100 million available for total dividends, the preferred stock is cumulative so that
dividend arrearages must be paid before any dividend may be paid to common stocks.

Preferred Dividends
Quarterly preferred dividend = $6.00/4 = $1.50
Accumulated preferred dividend to be paid first = $1.50 * 5 = $7.50/share
Total preferred dividends to be paid = $7.50 * 10 million shares = $75 million

Before paying a common dividend, the current quarters preferred dividend must be paid.

Amount due to preferred stockholders = $1.50 * $10 million = $15 million

Common Dividends
Amount available for common stockholders = $10 million
Common dividends per share = $10 million/20 million shares = $0.50 per share

5. Arbuckle Corporation is selling two million shares of common stock in its initial public
offering (IPO). The companys investment banker, Jones Securities, will offer the stock
to the public at $15 per share and charge Arbuckle Corporation an underwriting
spread of 7 percent. What will be the gross proceeds from the IPO? What will be
Arbuckle Corporations net proceeds from the offering? How much will Jones
Securities earn for conducting the offering?

Gross proceeds from the IPO = $15 * 2 million = $30 million.

Underwriting spread = 7% * 30,000,000 = $2.1 million
Net amount available to Arbuckle Corporation = $27.9 million
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6. List and explain the factors affecting underwriter spread.

Several factors tend to affect the size of the underwriter spread - the difference in the gross
proceeds and net proceeds from the sale, and the amount tended the issuing company. The
underwriter spread is inversely related to the size of the offering; directly related to the
degree of risk associated with the market price of the security; and shelf registrations tend to
have lower spreads compared to ordinary offerings.

7. Define the following terms as they relate to secondary markets: Depth, breadth, and
resiliency.

A security traded in a market with considerable breadth, depth, and resiliency will tend to be
fairly priced and trade narrowly around a central value. Breadth relates the number of
diverse traders in the market; depth exists when there are considerable limit orders above
and below the current price; and resiliency exists if a high volume of new orders respond to a
price change, bringing the security back to fair value. In such conditions, liquidity is high,
price trading ranges narrow, and a constant market exists. The T-bills market is a good
example, as is the market for a high volume stock.

8. List and explain the factors affecting bid-ask spreads.

Dealers earn revenue by selling (ask) a security at a price above that paid (bid). The bid/ask
spread (%) compensates for inventory costs, price risk, investor services, and liquidity
services. The bid/ask spread is a function of the price of the issue (-), the size of the issue (-),
the size of the transaction (+), the frequency of transactions (-), the extent to which new
information traders are in the market (+).

9. How did the introduction of NASDAQ in 1971 affect price discovery in secondary
markets? Explain.

Prior to 1971 daily pink sheets disclosed dealers "in the market" and their prices. Usually
dated, the NASDAQ system provides an electronic pink sheet of who trades at what price.

10. Briefly describe the role of the NYSE specialists. How does this role differ from that of
a dealer?

The stock specialists makes a continuous market at the stock trading post for his/her own
account and maintains the limit price order book, executing trades for others at different
prices.

11. Explain the difference between a market order and a limit order.

A market order is an order to buy or sell at the best price available at the time. A limit order
is an order to buy or sell at a designated price or better price.
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12. Lance Garrison and Jennifer Stock have both decided to buy 100 shares of
WWW.COM, a hot Internet stock. The market price is $240 per share when Lance
places a market order and Jennifer places a limit order at $230 per share. One week
later, the price of WWW.com is $305 per share after having increased steadily since
Lance and Jennifer placed their orders. How much profit has Lance made? How much
profit has Jennifer made?

Lance has done very well and Jennifer is out of luck. Lance made $305 - $240 = $65 * 100 =
$6500 while Jens limit order is still in the specialists order book, not yet executed.

13. Winters Hi-Hook Inc., a golf club manufacturer, is currently paying a dividend of $0.50
per share. The dividend is expected to grow at a 20% rate for the next two years and at
a 3% rate thereafter (forever). What is the value of the stock if the required rate of
return is 14%?

D1 = D0 (1 + g) = $0.50 (1.20) = $0.60

D2 = D1 (1 + g) = $0.60 (1.20) = $0.72
D3 = D2 (1 + g) = $0.72 (1.03) = $0.74
P2 = D3/(r - g) = $0.74/(0.14 - 0.03) = $0.74/0.11 = $6.73
P0 = [D1/(1 + r)] + [D2/(1 + r)2] + [P2/(1 + r)2]
= [$0.60/(1.14)] + [$0.72/(1.14)2] + [$6.73/(1.14)2] = $0.526 + $0.554 + $5.179 = $6.26

14. Kaes Power Company promises to maintain dividends of $5 per share on its preferred
stock, indefinitely. The stock currently sells at $37.50 per share. What is the required
return on the stock?

g = 0 P0 = D0/r r = D0/P0 = $5/$37.50 = 13.3%

15. Chastains Gardening Supplies, Inc. is a young start-up company. It plans to pay no
dividends over the next five years because it needs to reinvest all earnings in the firm to
finance growth. The firm then plans to begin dividends of $3 per share, which are
anticipated to grow at 10% per year for three years, and 6% per year in perpetuity
beyond that. If the required return on Chastains stock is 15%, what should be today's
stock price?

D6 = $3
D7 = D6 (1 + g) = $3 (1.10) = $3.3
D8 = D7 (1 + g) = $3.3 (1.10) = $3.63
D9 = D8 (1 + g) = $3.63 (1.06) = $3.85
P8 = D9/(r - g) = $3.85/(0.15 - 0.06) = $3.85/0.09 = $42.78
P0 = [D6/(1 + r)6] + [D7/(1 + r)7] + [D8/(1 + r)8] +]
= [$3/(1.15)6] + [$3.3/(1.15)7] + [$3.63/(1.15)8] + [$42.78/(1.15)8]
= $2.785 + $3.025 + $3.287 + $38.733= $47.83
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16. You purchase 100 shares of Adams Trading Company stock today for $22.50 per share.
At the end of one year, you collect a dividend of $2.75 and then sell the stock at $24.50
per share. What is your total return on the stock? What is the dividend yield? What is
the capital gains yield?

Return = Dividend Yield + Capital Gains Yield

r = (D1/P0) + P/P = ($2.75/$22.50) + ($2/$22.50) = 12.2% + 8.8% = 21%

17. Farrell Motors stock has a beta of 1.3. If the market risk premium is 8.5% and the
risk-free rate is 4%, what is the expected return of the stock according to the Security
Market Line?

The expected rate of return is the sum of the risk-free rate plus the market risk premium
times beta or 4% + 8.5% (1.3) = 14.4%. The market return is 12% (4% + 8.5%); Farrell
Motors' beta is 30% higher than the market, so their required rate of return is higher.

18. The market's required return on Gitche Gumee Oil Company stock is currently 13.8
per cent. If the expected return on the market portfolio is 12.6 per cent and the risk-
free rate is 3.5 per cent, what is the beta of Gitche Gumee stock?

The required return of Gitche Gumme Oil exceeds the return on the market portfolio,
indicating a beta above one. The market risk premium = 12.6% - 3.5% = 9.1% times a beta
plus the risk-free rate of 3.5% is Gitche's RRR of 13.8. Solving for beta, 13.8% = 3.5% +
Beta (9.1%) Beta = 1.13

19. Explain the difference between systematic and unsystematic risk. Explain how beta
captures systematic risk.

Unsystematic risk is the diversifiable risk portion of the total risk of a stock. A properly
diversified portfolio eliminates the unsystematic, specific, diversifiable risk, leaving the
investor facing the systematic risk of the portfolio. Beta is a measure of the variability of the
stock relative to the market portfolio.

20. You have decided to create stock market indexes using three representative stocks. At
the end of day one, stock X has a price of $20 per share and 20 million shares
outstanding, stock Y has a price of $25 per share and 50 million shares outstanding, and
stock Z has a price of $35 per share and 40 million shares outstanding. You are going to
calculate a price-weighted index. You have decided that the beginning value of each
index at the end of day one will be 100. What is the value of each index at the end of
day two if stock Xs price is $23 per share, stock Ys price is $22 per share, and stock
Zs price is $36 per share?
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Day 1 Day 2
Shares Price Market Value Price Market Value
Outstanding ($ Millions) ($ Millions)
Stock X 20,000,000 $20 $400 $23 $460
Stock Y 50,000,000 $25 $1,250 $22 $1,100
Stock Z 40,000,000 $35 1,400 $36 $1,440
TOTAL $80 $3,050 $81 $3,000

Price-Weighted Index:

With a desired base of 100 the divisor will be 80/100 = 0.8. On day two the index moves to
81/0.8 = 101.25, up 1.25% for the day.

Market Value Weighted Index:

With a desired base of 100 the divisor will be 3,050/100 = 30.50. On day two the index
moves to 3,000/30.50 = 98.36, down 1.64% for the day.