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CHAPTER 9 CHARACTERISTICS OF COMMON STOCKS AND PREFERRED STOCKS ANSWERS TO END OF CHAPTER QUESTIONS: 1. Common stock is a considered a residual form of ownership because claims of common stockholders on the firm’s earnings and assets are considered only after all other claims have been paid. For example, the net earnings that accrue to shareholders are the residual earnings after paying out all operating expenses (including salaries to employees and purchases of raw materials), interest expenses to debt holders and other creditors, taxes to the government, and dividends to preferred stockholders. In similar fashion, if a firm declares bankruptcy and decides to liquidate its assets, the claim of common stockholders against the assets of the firm comes last after claims of employees, governments (e.g., taxes owed to federal and state government agencies), debt holders, other general creditors (e.g., suppliers of raw materials) and preferred stockholders have been satisfied. 2. For common stock, par value typically is a low figure of little significance. Book value is common stockholders’ equity divided by the number of common shares issued and outstanding. The market value per share of common stock is the price at which the stock trades for on the exchange. 3. Stockholder rights often include the following: Dividend rights - right to share equally on a per share basis in any dividend distributions. Asset rights - in the event of liquidation, the right to assets that remain after the obligations to creditors have been satisfied. Voting rights - the right to vote on stockholder matters, such as the election of the board of directors. Preemptive rights - the right to share proportionately in any new stock sold. Common stocks of very few firms in the U.S. stock have this right. 4. The valuation of common stock is more complicated than the valuation of bonds and preferred stocks due to the following factors: • Common stock returns can take two different forms--cash dividend payments and/or increases in the stock price. • Common stock dividend payments normally are expected to grow and not remain constant. Hence the relatively simple annuity and perpetuity formulas used in the valuation of bonds and preferred stocks are generally not applicable to common stocks. • The future returns from common stocks (i.e., cash dividends and/or price appreciation) are more uncertain than the returns from bonds and preferred stocks. 5. The financial decisions of the firm affect both expected future dividend payments of the firm ( D 1 , D 2 ,...) as well as the (marginal) investor's required rate of return ( k e ).
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This note was uploaded on 05/01/2008 for the course FIN 3113 taught by Professor Titus-piersma during the Spring '08 term at Oklahoma State.

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