Answers to Chapter 9 Questions
This is because stock market movements are sometimes seen as predictors of economic
activity in a country. This is also because corporate stocks may be the most widely held of all
financial securities. Most individuals own stock securities either directly through stock purchases
or indirectly through pension fund and mutual fund investments, and thus their economic wealth
fluctuates closely with the market.
While common stockholders can potentially receive unlimited dividend payments if the firm is
highly profitable, they have no special or guaranteed dividend rights. Rather, the payment and
size of dividends is determined by the board of directors of the issuing firm. Further, unlike
interest payments on debt, a corporation does not default if it misses a dividend payment to
common stockholders. Thus, common stockholders have no legal recourse if dividends are not
received, even if a company is highly profitable and chooses to use these profits to reinvest in
new projects and firm growth.
Another characteristic of common stock dividends, from an investor’s viewpoint, is that
they are taxed twice
once at the firm level (at the corporate tax rate) and once at the personal
level (at the personal income tax rate). Investors can partially avoid this double taxation effect by
holding stocks in growth firms that reinvest most of their earnings to finance growth rather than
paying larger dividends.
Common stockholders have the lowest priority claim on a corporation’s assets in the event of
bankruptcy. That is, they have a residual claim. Only after all senior claims are paid (i.e.,
payments owed to creditors, bondholders, and preferred stockholders) are common stockholders
entitled to what assets of the firm are left, i.e., the residual. The residual claim feature associated
with common stock makes it riskier than debt or bonds as an investable asset.
Dual-class firms are corporations in which two classes of common stock are outstanding with
differential voting rights assigned to each class in various ways. For example, inferior voting
rights have been assigned by i) limiting the number of votes per share on one class relative to
another, ii) limiting the fraction of the board of directors which one class could elect relative to
another, or iii) a combination of these two. To offset the reduced voting rights, inferior class
shares are often assigned higher dividend rights. Dual-class firms have often been used in
corporations owned and controlled by a single family or group turning to the public market to
raise capital through the issue of new shares. To retain voting control over the firm, the family or
group issues the dual classes of stock, keeping the high voting stock for themselves and selling
the limited voting shares to the public. In all other respects the shares of the two classes are often
identical. Because dual-classes of stock have often been used by a small group (i.e., family
managers) to entrench themselves in the firm, dual-class firms are controversial.