Chapter Eight

Stock Markets

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserv

 Overview of Stock Markets

 Stock

Stock markets
markets allow
allow suppliers
suppliers of of funds
funds to to
efficiently
efficiently and
and cheaply
cheaply get get equity
equity funds
funds toto public
public
corporations
corporations (users
(users ofof funds).
funds).
 In

In exchange,
exchange, the the fund
fund users
users (firms)
(firms) give
give the
the
fund
fund suppliers
suppliers ownership
ownership rights
rights inin the
the firm
firm as
as
well
well as
as cash
cash flows
flows in
in the
the form
form of
of dividends.
dividends.

McGraw-Hill/Irwin 8-2
 Overview of Stock Markets

 Stockholders

Stockholders are
are the
the legal
legal owners
owners of
of aa
corporation
corporation
 have

have aa right
right to
to share
share inin the
the firm’s
firm’s profits
profits (e.g.,
(e.g.,
through
through dividends,
dividends, after
after the
the payment
payment of of interest
interest
to
to bond
bond holders
holders andand taxes)
taxes)
 are

are residual
residual claimants
claimants
 have

have limited
limited liability
liability
 have

have voting
voting rights
rights (e.g.,
(e.g., to
to elect
elect board
board of of
directors)
directors)

McGraw-Hill/Irwin 8-3
 Overview of Stock Markets

 Primary

Primary stock
stock markets
markets allow
allow suppliers
suppliers of
of funds
funds to
to
raise
raise equity
equity capital
capital
 Secondary

Secondary stock
stock markets
markets are are the
the most
most closely
closely
watched
watched and
and reported
reported of
of all
all financial
financial markets
markets
 Stock

Stock market
market movements
movements areare sometimes
sometimes seen
seen as
as
predictors
predictors ofof economic
economic activity
activity andand performance.
performance.
 Most

Most individuals
individuals ownown stocks
stocks either
either directly
directly or
or
indirectly
indirectly through
through pension
pension fundfund and
and mutual
mutual fund
fund
investments
investments

McGraw-Hill/Irwin 8-4
 Common Stock

 Common

Common stock
stock is
is the
the fundamental
fundamental ownership
ownership
claim
claim in
in aa public
public or
or private
private corporation
corporation
 Common

Common stockstock characteristics:
characteristics:
 Dividends

Dividends are
are discretionary
discretionary and
and are
are thus
thus not
not
guaranteed
guaranteed
 unlike

unlike interest
interest payments
payments on
on debt,
debt, aa corporation
corporation does
does
not
notdefault
defaultififititmisses
missesaadividend
dividendpayment
paymentto tocommon
common
stockholders.
stockholders.
 common

commonstock
stockdividends
dividendsare
aredouble
doubletaxed
taxed

McGraw-Hill/Irwin 8-5
 Common Stock

In

In theory,
theory, aa firm
firm should
should pay
pay dividends
dividends only
only
when
when itit has
has no no positive
positive NPV
NPV projects
projects
remaining
remaining inin which
which itit may
may invest
invest (residual
(residual
theory
theory of
of dividends).
dividends).
In

In practice,
practice, investors
investors seem
seem to to prefer
prefer aa
constant
constant or
or growing
growing dividend
dividend payment.
payment.

McGraw-Hill/Irwin 8-6
 Common Stock

The

The consistent
consistent quarterly
quarterly dividend
dividend payment
payment
probably
probably does
does two
two things.
things.
 First,

First, itit allows
allows investors
investors to
to self-select
self-select themselves
themselves
into
into choosing
choosing firms
firms with
with different
different payout
payout levels
levels
according
according to
to their
their desired
desired level
level of
of taxable
taxable income
income
(clientele
(clientele effect).
effect).

McGraw-Hill/Irwin 8-7
 Common Stock

 Second,

Second, the
the quarterly
quarterly dividend
dividend forcesforces
management
management to to pay
pay out
out cash
cash onon aa consistent
consistent
basis
basis to
to owners,
owners, aa requirement
requirement that
that helps
helps assure
assure
stockholders
stockholders that that managers
managers are are acting
acting inin
shareholders’
shareholders’interests
interests (bonding
(bonding effect).
effect).

McGraw-Hill/Irwin 8-8
 Common Stock characteristics

 Common

Common stockholders
stockholders have
have the
the lowest
lowest priority
priority
claim
claim in
in the
the event
event of
of bankruptcy
bankruptcy (i.e.,
(i.e., aa residual
residual
claim)
claim)
 Only

Only after
after all
all senior
senior claims
claims are
are paid
paid (i.e.,
(i.e., payments
payments
owed
owed to
to creditors
creditors such
such as
as the
the firm’s
firm’s employees,
employees, bond
bond
holders,
holders, the
the government
government (taxes),
(taxes), and
and preferred
preferred
stockholders)
stockholders) are
are common
common stockholders
stockholders entitled
entitled to
to
what
whatassets
assetsof ofthe
thefirm
firmare
areleft.
left.

McGraw-Hill/Irwin 8-9
 Common Stock characteristics

 Limited

Limited liability
liability implies
implies that that common
common
stockholders
stockholders can can lose
lose no
no more
more than
than their
their original
original
investment
investment
 Common

Common stockholders
stockholders control
control the
the firm’s
firm’s activities
activities
indirectly
indirectly by
by exercising
exercising their
their voting
voting rights
rights in
in the
the
election
election of
of the
the board
board ofof directors
directors

McGraw-Hill/Irwin 8-10
 Common Stock Voting Rights

 Two

Two methods
methods of of electing
electing aa board
board of
of directors
directors
are
are generally
generally used:
used: cumulative
cumulative voting
voting and
and
straight
straight voting.
voting.
 With

With cumulative
cumulative voting,
voting, the
the number
number ofof votes
votes
assigned
assigned to to each
each stockholder
stockholder equals
equals thethe
number
number of of shares
shares held
held multiplied
multiplied by
by the
the number
number
of
of directors
directors toto be
be elected
elected

McGraw-Hill/Irwin 8-11
 Stock Returns


 The
Thereturns
returnson
onaastock
stockover
overone
oneperiod
period(R
(Rt)t)can
canbe
bedivided
divided
into
intocapital
capitalgains
gainsand
anddividend
dividendreturns:
returns:

Pt  Pt  1 Dt
Rt  
Pt  1 Pt  1
PPt ==stock
stockprice
priceat
attime
timett
t
DDt ==dividends
dividendspaid
paidover
overtime
timett––11to
tott
t
(P
(Pt t––PPt t––11))//PPt t––11==capital
capitalgain
gainover
overtime
timett––11to
tott
DDt //PPt – 1 ==return
returnfrom fromdividends
dividendspaid
paidover
overtime
timett––11to
tott
t t–1

McGraw-Hill/Irwin 8-12
 Stock Returns


 Suppose
Supposean aninvestor
investorbuys
buys10
10shares
sharesof ofstock
stockpriced
pricedatat$55.10
$55.10
and
andsells
sellsthe
thestock
stockone
oneyear
yearlater
laterfor
for$56.30
$56.30after
aftercollecting
collectingaa
$0.30
$0.30dividend
dividendperpershare.
share. What
Whatwaswasthe
theinvestor’s
investor’spre-tax
pre-tax
holding
holdingperiod
periodreturn?
return?

$56.30  $55.10 $0.30

HPR    2.18%  .54%  2.72%
$55.10 $55.10

McGraw-Hill/Irwin 8-13
 Stock Returns


 IfIfdividend
dividendincome
incomeisistaxed
taxedat
ataa28%
28%rate
rateand
andcapital
capitalgains
gainsare
are
taxed
taxedat at20%,
20%,what
whatwas
wasthe
theinvestor’s
investor’safter-tax
after-taxholding
holdingperiod
period
return?
return?

HPR A  T 2.18%(1  20%)   0.54%(1  28%)  2.13%

McGraw-Hill/Irwin 8-14
 Common Stock

 Payment

Payment of
of dividends
dividends versus
versus reinvestment
reinvestment of
of
earnings:
earnings:
A

Acorporation
corporation has
has after-tax
after-tax earnings
earnings that
that would
would
allow
allow aa $2$2 dividend
dividend per
per share
share toto be
be paid
paid toto its
its
stockholders.
stockholders.
 IfIf these

these dividends
dividends areare paid,
paid, the
the firm
firm will
will be
be unable
unable
to
to invest
invest in
in new
new projects,
projects, and
and its
its stock
stock price,
price,
currently
currently $50 $50 per
per share,
share, probably
probably would
would notnot
change.
change.

McGraw-Hill/Irwin 8-15
 Common Stock

 The

The return
return to
to the
the firm’s
firm’s stockholders
stockholders in
in this
this case
case
is:
is:

 Suppose

Suppose aa stockholder
stockholder bought
bought the
the stock
stock at
at the
the
beginning
beginning ofof the
the year
year (at
(at $50)
$50) and
and sold
sold itit at
at the
the
end
end of
of the
the year
year (at
(at $50).
$50).
 The

The stockholder’s
stockholder’s ordinary
ordinary income
income tax tax rate
rate isis
30%
30% and
and the
the capital
capital gains
gains tax
tax rate
rate is
is 20%.
20%.

McGraw-Hill/Irwin 8-16
 Common Stock

The

The return
return to
to the
the stockholder
stockholder in
in this
this case
case is
is
all
all in
in the
the form
form ofof ordinary
ordinary income
income (dividends).
(dividends).
The
The after-tax
after-tax rate
rate ofof return
return to
to the
the stockholder
stockholder
is
is 4%(1
4%(1 -- .30).30) == 2.8%.
2.8%.
Alternatively,

Alternatively, rather
rather than
than pay
pay dividends,
dividends, the the
firm
firm can
can use
use the
the earnings
earnings to to invest
invest inin new
new
projects
projects thatthat will
will increase
increase thethe overall
overall value
value ofof
the
the firm
firm such
such that
that the
the stock
stock price
price will
will rise
rise to
to
$52
$52 perper share.
share.

McGraw-Hill/Irwin 8-17
 Common Stock

The

The return
return to
to the
the firm’s
firm’s stockholders
stockholders in
in this
this
case
case is:
is:

In
In this
this case,
case, the
the return
return toto the
the stockholder
stockholder is is all
all in
in
the
the form
form ofof capital
capital gains
gains andand is is taxed
taxed at
at aa
rate
rate ofof 20%.
20%.
The
The after-tax
after-tax rate
rate of
of return
return toto the
the stockholder
stockholder is is
4%
4% (1 (1 -.20)
-.20) == 3.2%.
3.2%.
McGraw-Hill/Irwin 8-18
 Primary Stock Markets

 Before

Before common
common stock
stock can
can bebe issued
issued by by aa
corporation,
corporation, shares
shares must
must bebe authorized
authorized by by aa
majority
majority vote
vote of
of both
both the
the board
board of
of directors
directors and
and
the
the firm’s
firm’s existing
existing common
common stockholders.
stockholders.
 Once

Once authorized,
authorized, newnew shares
shares of of stock
stock are
are
distributed
distributed to to existing
existing and
and new
new investors
investors
through
through aa primary
primary market
market sale
sale with
with the
the help
help of
of
investment
investment banks.
banks.
 Once

Once issued,
issued, thethe stocks
stocks are
are traded
traded inin
secondary
secondary stock
stock markets
markets

McGraw-Hill/Irwin 8-19
 Primary Stock Markets

 Primary

Primary markets
markets are are markets
markets inin which
which
corporations
corporations raise
raise funds
funds through
through new
new issues
issues of
of
stock,
stock, most
most ofof the
the time
time through
through investment
investment
banks
banks

McGraw-Hill/Irwin 8-20
 Primary Stock Markets

 Investment

Investment banks
banks act
act as
as distribution
distribution agents
agents inin
best
best efforts
efforts underwriting
underwriting
 Investment

Investment banks
banks act
act asas principals
principals in
in firm
firm
commitment
commitment underwriting
underwriting
gross
gross proceeds
proceeds –– net net proceeds
proceeds ==
underwriter’s
underwriter’s spread
spread

McGraw-Hill/Irwin 8-21
 Dutch or Uniform Price Auction

 Buyers:

Buyers:
 Bid

Bidaaprice
priceand
andnumber
numberof
of shares
shares
 Seller:

Seller:
 Work

Workdown
downthethelist
list of
of bidders
bidders
 Determine the highest price at

Determine the highest price at which
which they
they can
can sell
sell the
the
desired
desirednumber
number of
of shares
shares
 All

All successful
successful bidders
bidders pay
pay the
the same
same price
price
per
per share.
share.
 Encourages

Encourages aggressive
aggressive bidding
bidding

McGraw-Hill/Irwin 8-22
 Dutch or Uniform Price Auction

Bidder Quantity Bid

A 500 $20
The company wants to sell B 400 18
1,500 shares of stock. C 250 16
D 350 15
E 200 12

The firm will sell

1,500 shares at Bidder Quantity Bid Σ Qty
A 500 $20 500
$15 per share.
B 400 18 900
Bidders A, B, C, C 250 16 1,150
and D will get D 350 15 1,500
shares. E 200 12 1,700

McGraw-Hill/Irwin 8-23
 Primary Stock Markets

A

A syndicate
syndicate is is aa group
group ofof investment
investment banks
banks
working
working in in concert
concert to to issue
issue stock;
stock; the
the lead
lead
underwriter
underwriter isis the
the originating
originating house
house
 Syndicate

Syndicate spreads
spreads the the risk
risk associated
associated with
with the
the
sale
sale of
of the
the stock
stock among
among several
several investment
investment
banks.
banks.
A

A syndicate
syndicate alsoalso results
results inin aa larger
larger pool
pool ofof
potential
potential outside
outside investors,
investors, increasing
increasing thethe
probability
probability ofof aa successful
successful sale
sale and
and widening
widening
the
the scope
scope ofof the
the investor base..
investor base
McGraw-Hill/Irwin 8-24
 Primary Stock Markets

 An

An initial
initial public
public offering
offering (IPO)
(IPO) isis the
the first
first
public
public issue
issue of
of financial
financial instruments
instruments byby aa firm
firm
A

A seasoned
seasoned offering
offering is is the
the sale
sale of
of additional
additional
securities
securities byby aa firm
firm whose
whose securities
securities are
are already
already
publicly
publicly traded
traded
 Corporate

Corporate stocks
stocks may
may initially
initially be
be issued
issued through
through
either
either aa public
publicsale
sale or
or aa private
privateplacement
placement

McGraw-Hill/Irwin 8-25
 Primary Stock Markets

 Preemptive

Preemptive rights
rights give
give existing
existing stockholders
stockholders
the
the ability
ability to to maintain
maintain theirtheir proportional
proportional
ownership
ownership
A A rights
rights offering
offering allows
allows existing
existing shareholders
shareholders
to
to purchase
purchase aa pro-rata
pro-rata portion
portion of of the
the new
new
issue
issue at
at aa slightly
slightly favorable
favorable price.
price.
 “Rights”
“Rights” are
are given
given to
to the
the shareholders:
shareholders:
Specify

Specify number
number of
of shares
shares that
that can
can be
be purchased
purchased
Specify purchase price

Specify purchase price
Specify

Specify time
time frame
frame

McGraw-Hill/Irwin 8-26
 The Value of a Right

 The

The price
price specified
specified in in aa rights
rights offering
offering is
is
generally
generally less
less than
than the
the current
current market
market price
price
 The

The share
share price
price will
will adjust
adjust based
based on on the
the number
number
of
of new
new shares
shares issued
issued
 The

The value
value of
of the
the right
right is
is the
the difference
difference between
between
the
the old
old share
share price
price and
and thethe “new”
“new” share
share price
price

McGraw-Hill/Irwin 8-27
 Rights Offering Example

 Suppose

Suppose aa company
company wants
wants to
to raise
raise $10
$10 million.
million.
 The

The subscription
subscription price
price is
is $20.
$20.
 The

The current
current stock
stock price
price is
is $25.
$25.
 The

The firm
firm currently
currently has
has 5,000,000
5,000,000 shares
shares
outstanding.
outstanding.
1. How
1. How many
many shares
shares must
must be be issued?
issued?
2. How
2. How many
many rights
rights will
will itit take
take to
to
purchase
purchase one one share?
share?
3. What
3. What isis the
the value
value of
of one
one right?
right?
McGraw-Hill/Irwin 8-28
 Rights Offering Example

1.
1. How
How many
many shares
shares must
must be
be issued?
issued?
Shares
Sharesissued
issued== 10,000,000/20
10,000,000/20== 500,000
500,000
2.
2. How
How many
many rights
rights will
will itit take
take to
to
purchase
purchase one
one share?
share?
Rights
Rightsneeded
needed== 5,000,000/500,000
5,000,000/500,000== 10
10
3.
3. What
What is
is the
the value
value of
of one
one right?
right?
Total
Totalinvestment
investment == 10*25
10*25++ 2020== 270
270
Price
Priceper
per share
share== 270270// 11
11== 24.55
24.55
Value
Valueofof aaright
right == 25
25––24.55
24.55== .45
.45

McGraw-Hill/Irwin 8-29
 Primary Stock Markets

A

A red
red herring
herring prospectus
prospectus is is aa preliminary
preliminary
version
version of
of the
the prospectus
prospectus that
that describes
describes aa new
new
security
security issue and distributed
issue and distributed to to potential
potential
equity
equity buyers.
buyers.
 An

An official
official or
or final
final prospectus
prospectus that
that will
will be
be printed
printed
upon
upon SECSEC registration
registration of of the
the issue
issue and
and makes
makes
up
up the
the bulk
bulk of
of the
the registration
registration statement.
statement.
 Shelf

Shelf registration
registration allows
allows firms
firms to
to offer
offer multiple
multiple
issues
issues ofof stock
stock over
over aa two-year
two-year period
period with
with only
only
one
one registration
registration statement
statement

McGraw-Hill/Irwin 8-30
 IPO Cost – Example

 The

The XYZ
XYZ Co.
Co. has
has just
just gone
gone public
public under
under aa firm
firm
commitment
commitment agreement.
agreement. XYZ XYZ received
received $32$32 for for
each
each ofof the
the 4.1
4.1 million
million shares
shares sold.
sold. The
The initial
initial
offering
offering price
price was
was $34.40
$34.40 perper share,
share, andand the
the stock
stock
rose
rose to
to $41
$41 per
per share
share in in the
the first
first few
few minutes
minutes of of
trading.
trading.
 XYZ

XYZ paid
paid $905,000
$905,000 in in legal
legal and
and other
other direct
direct costs
costs
and
and $250,000
$250,000 in in indirect
indirect costs.
costs.
 What

What was
was the
the flotation
flotation costcost as
as aa percentage
percentage of of
funds
funds raised?
raised?

McGraw-Hill/Irwin 8-31
 IPO Cost – Example

 Net

Net amount
amount raised
raised == (4,100,000
(4,100,000 shares)($32)
shares)($32) –– 905,000
905,000
––250,000
250,000== $130,045,000
$130,045,000
 Total

Total direct
direct costs
costs == $905,000
$905,000 ++ (($34.40–
(($34.40– 32)
32) ××
(4,100,000
(4,100,000shares)
shares) == $10,745,000
$10,745,000
 Total

Total indirect
indirect costs
costs == $250,000
$250,000 ++ ($41
($41 –– 34.40)
34.40) ××
(4,100,000
(4,100,000shares)
shares) == $27,310,000
$27,310,000
 Total

Totalcosts
costs== $10,745,000
$10,745,000++ 27,310,000
27,310,000== $38,055,000
$38,055,000
 The

The flotation
flotation costs
costs asas aa percentage
percentage of
of the
the amount
amount raised
raised
isisthe
thetotal
totalcost
cost divided
dividedby bythe
theamount
amount raised,
raised, or:
or:
 Flotation

Flotation cost
cost percentage
percentage == $38,055,000
$38,055,000 // $130,045,000
$130,045,000
== 29.26%
29.26%

McGraw-Hill/Irwin 8-32