Preferred stock 

is often called a hybrid security because it has some characteristics that are typical
of debt and others that are typical of common equity. The following table lists several characteristics
of preferred stock. Determine which of these characteristics are consistent with debt securities and
which are consistent with common stock.

Companies that have preferred stock outstanding promise to pay a stated dividend for an infinite
period. Preferred stock is treated like a perpetuity if the payments last forever. Preferred stocks are
considered to be a hybrid of a stock and a bond. For example, one of the major differences between
preferred shares and bonds is that the issuing companies can suspend the payment of their preferred
dividends without throwing the company into bankruptcy.
However, similar to bonds, preferred stockholders receive a fixed payment—their dividend—before the
company’s residual earnings are paid out to its common stockholders and, as with common stock,
preferred stockholders can benefit from an appreciation in the value of the firm’s stock securities.

Equity, or common stock, trades on stock markets all around the world. Because of globalization, the
lines between equity markets are being blurred. In many cases, multinational firms sell equity in
foreign equity markets. In other words, they sell stock on exchanges outside of their home country.
Stocks of companies that retain most, if not all, of their earnings each year to help fund growth
opportunities are referred to as growth stocks. These stocks tend to pay little or no dividends
because the firm is using its earnings to grow the company.
Stocks that produce returns that are based primarily on dividends are traditionally called income
stocks. Mature firms tend to have few investment opportunities so they simply distribute their
earnings back to stockholders in the form of large, consistent dividends.
A preemptive right is a provision in a corporate charter or bylaws that allows common stockholders
to maintain their ownership percentage by purchasing additional shares of any new stock issues. This
right allows the current shareholders to purchase additional shares in a new stock issue in proportion
to their existing holdings before the new shares are offered to other investors. This right, which is not
an obligation, allows the existing shareholders to protect their proportional ownership in the firm.
A proxy is an instrument that allows common stockholders to transfer their voting rights to a second
party. It is common for common stockholders to transfer their voting rights to the management of the
firm; however, if earnings and performance are down, an outside group might solicit the proxies in an
effort to overthrow management and take control of the business. This kind of battle is known as a
proxy fight.
If a foreign multinational firm issues stock in another country besides its home country or in the U.S.,
its shares are referred to as Euro stock. London happens to be in Europe, but the “Euro” distinction
has nothing to do with the continent the stock trades in. If a Japanese firm’s stock traded in Korea or
India, it would still be considered a Euro stock. The name comes from the fact that outside the U.S.,
Europe used to have the only other large, stable, and well-organized stock markets, and so early in
the international trade of stock, it was the European markets that attracted the stock of companies
from other nations, especially from the U.S.
A stock issued by a foreign company that is traded in the U.S. is called a Yankee stock.
An American depository receipt (ADR) is a certificate that represents ownership in stocks of
foreign companies that trade on U.S. exchanges. ADRs are not shares of common stock; instead, they
are a claim upon the shares of stock held in trust by the bank issuing the ADR.

o meet specific requirements for a certain group of shareholders, companies issue different classes of
common shares. These classes of common shares are given a special designation, such as Class A and
Class B, and are called classified stock.
Founders’ shares are the stocks that the founders of the company own. They usually have special
voting rights and restricted dividends for a specified number of years. Companies that have these
classes of shares are said to have a dual-class share structure, which gives special voting rights to
the founders of the company.
Many companies use a dual-class share structure by issuing classified shares. Classified shares allow
the company’s founders to maintain control and to have special voting rights so that they get more
decision-making liberty without owning a majority of common shares.
Different firms have classified shares for different purposes. Classified shares are often designed to
provide specific shareholder control to a certain class of shareholders, usually the owners, founders,
executives, and key insiders of the firm. Classified shares give a certain class special voting rights—
also called super voting rights—in which each share in the class has more votes per share than
shares in other classes. (Source: “Dish Network 2010 Annual Report,” Dish Network Investor
Relations,
Increasing dividends may not always increase the stock price, because less
earnings may be invested back into the firm and that impedes growth.
if increasing dividends results in the company not having enough funds for
reinvestment, then value of the company may go down, since value of a stock
is the present value of all expected cash-flows from holding the stock. But, if
the company is paying dividend from free cash flows, then the payment of the
dividend will not negatively affect the value of the stock.
In summary, paying a dividend will not always increase the stock price,
and will not always decrease the stock price.
t’s true that dividends are in the numerator of the equation, and all else being equal, an increase in
dividends would cause P0P0 to increase. However, a firm can’t simply increase its dividends without
affecting other factors. Firms face the fundamental decision of paying out earnings as dividends or
retaining them for future investment. If a firm increases its dividends, it is retaining less earnings for
future investment.
Therefore, an increase in current dividends might jeopardize future dividends—that is, the dividend
growth rate might decrease. There are two competing forces here: Higher dividends increase stock
prices, but lower growth rates decrease stock prices. A firm’s specific situation will determine whether
a dividend increase will raise the stock price.
Thus, the correct statement in the options given is “Increasing dividends may not always increase the
stock price, because less earnings may be invested back into the firm and that impedes growth.”
The stock’s dividends are expected to grow at a constant rate of 6.00% per year, but the stock’s price
also will increase by 6.00% per year. Remember that for a constant growth stock the expected
dividend growth rate equals the expected stock price growth rate and the expected capital gains yield.
Because both dividends and the stock price are expected to increase at a constant rate of 6.00%, the
dividend yield is expected to remain constant.
If a stock is in equilibrium, its intrinsic value or stock price (as calculated in the preceding question)
equals its current stock price. A stock’s expected dividend yield (DY) equals its expected dividend
one year from now divided by the current stock price, which can be calculated as follows:
Dividend yield (DY)Dividend yield (D
 =  =  D1P0D1P0
Y)
Therefore, the dividend yield on Super’s stock is 4.73%. That is:
DYSuperDYSupe
 =  =  $2.23$47.15$2.23$47.15
r
 =  =  4.73%4.73%
Now, using the standard constant growth stock formula, the stock price one year from today will be
the expected dividend in the following year (D2D2) divided by the difference between the stock’s
required return and its expected dividend growth rate (rsrs - g). Therefore, to calculate the expected
dividend in year 2:
D2D2  =  =  D0×(1+g)2D0×1+g2
 =  =  D1×(1+g)D1×1+g
 =  =  $2.23×(1+0.0315)$2.23×1+0.0315
 =  =  $2.30 per share$2.30 per share
Now use D2D2 to solve for the expected stock price one year from now (P1P1):
P1P1  =  =  D2rs−gD2rs−g
 =  =  $2.300.0788−0.0315$2.300.0788−0.0315
 =  =  $48.63 per share$48.63 per share
You also could have solved for P1P1 using its current price and its expected dividend growth rate.
Remember that a constant growth stock’s expected dividend growth rate equals its expected stock
price growth rate and its expected capital gains yield (the expected change in price over the next
year). Solve as follows:
P1P1  =  =  P0×(1+g)P0×1+g
 =  =  $47.15×(1+0.0315)$47.15×1+0.0315
 =  =  $48.63 per share$48.63 per share
Thus, Super’s stock price one year from now will be $48.63 per share.
Another approach to calculate Super’s stock price one year from today is to use capital gains yield. A
stock’s expected capital gains yield (CGY) equals its expected change in price over the next year
divided by its current stock price. The calculation is as follows:
CGYCG
 =  =  P1−P0P0P1−P0P0
Y
Therefore:
CGYSuperCGYSupe
 =  =  $48.63−47.1547.15$48.63−47.1547.15
r
 =  =  0.0314=3.14%0.0314=3.14%
Thus, the capital gain on Super’s stock in one year will be 3.14%.
Remember that the required rate of return on a stock is equal to the sum of its expected dividend
yield and expected capital gains yield.
r̂sr̂s =  = Expected Rate of ReturnExpected Rate of Return
Expected Dividend Yield+Expected Capital Gains YieldExpected Dividend Yield+Expected Capital Gains 
 =  = 
Yield
If you add 4.73% and 3.14%, you’ll get 7.87%. Thus, if markets are in equilibrium, the expected rate
of return will be equal to the rate of return on a stock (̂r̂s=rsr̂s=rs).

Use the constant growth model to calculate the appropriate values to complete the following
statements about Super Carpeting Inc.:

• If Super’s stock is in equilibrium, the current expected dividend yield on the stock will
beError! Filename not specified.4.73%   per share.
• Super’s expected stock price one year from today will beError! Filename not specified.$48.63
per share.
• If Super’s stock is in equilibrium, the current expected capital gains yield on Super’s stock
will beError! Filename not specified.3.14%   per share.