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 CHAPTER 8
STOCK

Teaching Guides for Questions and Problems in the Text

QUESTIONS

1. If an investor buys IBM stock, the maximum amount that

can be lost is limited to the amount invested. If IBM were to
fail and declare bankruptcy, its stockholders would not be
liable for its debts. The investor's liability is limited to
the amount paid for the stock (i.e., each individual investor
has limited liability).

2. a. The pre-emptive right is the right of stockholders to

maintain their proportionate ownership in the firm. If the
firm seeks to raise more funds through the sale of common
stock, these shares must initially be offered to existing
stockholders. If these stockholders buy the additional
shares, their proportionate ownership is maintained.

b. Cumulative voting is a means by which a minority may

obtain representation on the corporation's board of
directors. It permits an investor to cast all of his or her
votes for one candidate instead of having to spread those
votes for each seat. Thus, if an investor owns 100 shares and
the corporation has five seats, the investor may cast the
entire 500 votes for one candidate instead of casting 100
votes for a candidate for each of the five seats.

c. The board of directors is elected by the corporation's

stockholders and acts on the behalf of the stockholders. The
board selects and employs the firm's management and
establishes the firm's policies. In reality, members of the
board may be handpicked by management (or at least the CEO),
in which case it could be argued that the board may not act
in the best interests of the stockholders. (Increased use of
outside directors may lead to increased responsiveness to
stockholders.)

3. Management tends to increase cash dividends after earnings

have increased, and it believes the higher earnings will be
maintained. Since the reluctance to cut dividends encourages
management to follow a conservative policy on dividend
increments. Management may continue to maintain cash dividends
even when earnings decline if the firm has the funds and
management believes the decline in earnings will be temporary.
93
Prior to 2008-2009, dividend cuts were often interpreted as a
sign of financial weakness, and management generally desires to
avoid this implication of a dividend cut. During 2008-2009,
dividend cuts, however, became so prevalent that the negative
connotation disappeared and dividends became an indication of
prudence.

4. Stockholders, who own stock on the date of record, receive

the dividend. Since it takes three days for settlement, the
investor must own the stock three days prior to the record date
to be eligible to receive the dividend. The ex-dividend day is
the first day of trading exclusive of the dividend. Investors
who purchase the stock on the ex-dividend day do not receive
the dividend. The distribution date establishes when the
dividends are to be received by stockholders.

5. Dividend reinvestment plans permit investors to acquire

additional shares before the dividends are received. Thus the
funds cannot be spent (i.e., the investor is forced to save).
In addition, some plans have no fees and commissions in which
case the plans are completely paid for by the firms as a
service to stockholders. Even those plans with fees permit the
stockholder to acquire additional shares at a lower commission
cost than is available through brokerage firms.

6. Cash dividends are paid in cash while stock dividends are

paid in additional shares. Both stock dividends and stock
splits alter the number of shares outstanding and the stock's
price. Stock dividends and stock splits do not alter the firm's
assets, liabilities, total equity, or earning capacity. The
difference between a stock dividend and a stock split is
essentially the difference in how accountants alter the equity
section of a firm’s balance sheet.

7. a. No tax advantages are associated with dividend

reinvestment plans. The investor has to pay the tax on
dividends that are reinvested.

b. Stock dividends are not subject to income tax. The price

of the stock adjusts for the dividend and the investor’s cost
basis is allocated over the original shares and the new shares.

c. Stock splits are not subject to income tax. The price of

the stock adjusts for the split and the investor’s cost basis
94
is allocated over the original shares and the new shares.

d. Stock repurchases result in capital gains and the gains

only apply to the individual selling the stock and not all of
the corporation’s stockholders. The individual does not have to
sell the shares back to the firm, so the tax may be deferred
until the shares are ultimately sold.

8. Preferred stock like common stock represents ownership,

but unlike common stock the amount of the dividend is usually
fixed and must be paid prior to dividend payments to common
stock. Preferred stock rarely has the right to vote the
shares. Preferred stock is frequently perpetual; however,
many preferred stocks are subject to mandatory sinking funds
and must be retired. Such preferred stocks are more similar
to long-term bonds than to common stock.

9. The payment of preferred stock dividends is not a legal

obligation of the firm, but there is an implied understanding
that, if possible, the firm will make the payments. If the
firm skips a dividend payment and the preferred stock is
cumulative, the passed dividends accumulate and must be paid
before the firm may pay dividends to its common stockholders.
As long as these skipped dividends have not been paid, the
preferred stock is said to be in arrears.

10. a. Cross-section analysis compares a firm to other firms

over a period of time. Time-series analysis compares a firm’s
financial statements over a period of time.

b. The current ratio includes all current assets relative

to current liabilities:
Current ratio: Current assets/Current liabilities.
The quick ratio subtracts inventory from current assets:
Quick ratio: (Current assets - inventory)/Current liabilities

The reason for excluding inventory from current assets is

that inventory may not be readily sold and may not contribute
to the firm's liquidity. (An alternative approach is to
include only cash, cash equivalents, and accounts receivable
in the numerator. The two definitions are identical unless
the firm has other current assets such as prepaid expenses.)

Liquidity ratios measure the firm's capacity to meet its

current obligations as they come due. In effect, the ratios
assume that if a firm has current assets, it will be able to
95
pay off current liabilities on a timely basis.

c. Turnover ratios indicate how rapidly a firm’s assets

flow through the firm. Receivables turnover indicate how long
it takes to collect receivable. If accounts receivables
increase without a corresponding increase in sales, the
average collection period is lengthened (days sales
outstanding increases) and turnover declines. It takes longer
for the firm to receive cash from its credit sales.

Inventory turnover indicates how long it takes to sell

inventory. If inventory increases without a corresponding
increase in sales, turnover declines. It takes long to sell
inventory.

Fixed asset turnover indicate how long it takes to turnover

plant and equipment. Essentially it indicates how much in
fixed asset the firm is carrying in order to generate sales.

Since activity ratios show how rapidly assets flow through

the firm, they like liquidity ratios give an indication of
the firm's capacity to meet its current obligations as they
come due. More rapid turnover generates the cash to meet
current liabilities on a timely basis.

d. Profit margins measure earnings to sales after

expenses. The gross profit deducts the cost of the goods
sold. Operating deducts all operating expenses, and the net
profit margin deducts interest and taxes.

Computing all three ratios lets the analyst determine if

differences in net income are the result of differences in
cost of goods sold, operations, interest expense, or taxes.

e. The difference between the return on assets and the

return on equity is the base. Return on assets indicates who
much the firm earns on every $1 in assets. Return on equity
indicates how much the firm earns on every $1 in equity.

A high return on equity indicates the firm is earning a large

return for investors. While a high return on equity may be
indicative of superior performance, a high return on equity
could be achieved through the excessive use of financial
leverage, which increases the investor's risk exposure. If
the debt ratio indicates an acceptable level of financial
leverage, a high return on equity is an indicator of superior
performance. While superior performance may suggest
purchasing the stock, the ratio does not indicate the price
at which the stock should be purchased and does not indicate
96
if it is under or overvalued.

f. Debt to total assets measures to proportion of a

firm’s assets that are financed by debt. Debt to equity
expresses debt relative to equity. Both are measures of
financial leverage. (The debt ratio may also be defined as
long-term debt to assets instead of total debt to assets. The
possibility of differences in definitions raises a major
question concerning comparing the numerical values of ratios
obtained from different sources.)

Usage of debt financing is one of the sources of

diversifiable, unsystematic risk (i.e., financial risk).
While increased use of debt financing may result in higher
earnings per share (EPS), the higher EPS may not produce a
higher stock price if investors believe that the higher EPS
are insufficient to compensate for the additional risk.

g. Times-interest-earned and times-dividend-earned are

coverage ratios. Times-interest-earned indicates the extent
to which a firm's operating income (EBIT) exceeds its
interest expense. Interest is paid after other expenses, so
interest payments are made out of operating income. Time-
dividend-earned uses earnings since dividends are paid from
earnings and after all expenses including interest and taxes
are made. Both ratios indicate the safety of the interest and
dividend payments and are primarily of interest to investors
in fixed income securities.

11. The statement of cash flow helps the financial analyst

determine the ability of the firm to generate cash. The
statement has three essential components: operating
activities, investment activities, and financing activities.
It starts by converting accrual income to a cash basis by
making adjustments to account for non-cash expenses. The
statement isolates the firm's sources and uses of cash from
its operating, investing, and financial actions. An increase
in an asset and a decrease in liabilities or equity consume
cash while a decrease in an asset and an increase in
liabilities or equity generate cash.

12. This question asks the student to update the ratio

analysis of Hershey’s financial statements to determine if
there have been any changes in the company’s financial
condition. To do this, the student must obtain the Hershey’s
financial statements, which are readily available from Hershey
or many of the sites provided in the text.

97
13. This question essentially repeats Question #12 except that
it permits the student to determine which firms to compare.

PROBLEMS

1. a. The dividend yield is 5 percent ($2/$40 = 5 percent), so

the number of shares in the dividend reinvestment plan will
grow annually by 5 percent.

b. In this part, the price of the stock rises while the

dividend remains $2, so each year the number of shares
purchases declines.
c. In Part c, both the price of the stock and the dividend
increase but at different rates. From the investor’s
perspective, this case is obviously the best since the investor
experiences both increasing dividends and an increasing stock
price.

The calculations for each year are as follows:

1. a.
Per
End of Price of Total Share Dividend Shares Bought
Year Stock Shares Dividend Reinvested Through Reinvested
Owned Dividends
(Beginning of
the year)

0 40 2.000
1 40 100.000 2.000 200.00 5.000
2 40 105.000 2.000 210.00 5.250
3 40 110.250 2.000 220.50 5.513
4 40 115.763 2.000 231.53 5.788
5 40 121.551 2.000 243.10 6.078
6 40 127.628 2.000 255.26 6.381
7 40 134.010 2.000 268.02 6.700
8 40 140.710 2.000 281.42 7.036
9 40 147.746 2.000 295.49 7.387
10 40 155.133 2.000 310.27 7.757
Value of Stock 162.889 62.889
Beginning Year 11: 6515.58

b.
Per
End of Price of Total Share Dividend Shares Bought
98
 Year Stock Shares Dividend Reinvested Through Reinvested
Owned Dividends
(Beginning of
the year)

0 40.00 2.000
1 42.40 100.000 2.000 200.00 4.717
2 44.94 104.717 2.000 209.43 4.660
3 47.64 109.377 2.000 218.75 4.592
4 50.50 113.969 2.000 227.94 4.514
5 53.53 118.482 2.000 236.96 4.427
6 56.74 122.909 2.000 245.82 4.332
7 60.15 127.241 2.000 254.48 4.231
8 63.75 131.473 2.000 262.95 4.124
9 67.58 135.597 2.000 271.19 4.013
10 71.63 139.610 2.000 279.22 3.898
Value of Stock 143.508 43.508
Beginning Year 11: 10280.03

c.
Per
End of Price of Total Share Dividend Shares Bought
Year Stock Shares Dividend Reinvested Through Reinvested
Owned Dividends

0 40.00 2.000
1 42.40 100.000 2.060 206.00 4.858
2 44.94 104.858 2.122 216.01 4.806
3 47.64 109.665 2.185 225.91 4.742
4 50.50 114.407 2.251 235.68 4.667
5 53.53 119.074 2.319 245.29 4.582
6 56.74 123.656 2.388 254.73 4.489
7 60.15 128.145 2.460 263.98 4.389
8 63.75 132.534 2.534 273.02 4.282
9 67.58 136.817 2.610 281.84 4.171
10 71.63 140.987 2.688 290.43 4.054
Value of Stock 145.042 45.042
Beginning Year 11: 10389.91

99
2. a. Cash and retained earnings decline by $1,000,000 to
$19,000,000 and $97,500,000. The other entries are unaffected.

b. 100,000 shares are issued with a value of $1,300,000.

$1,300,000 is subtracted from retained earnings, which becomes
$97,200,000. The other entries in the equity section of the
balance sheet become:
Common stock $11,000,000
($10 par; 1,100,000 shares outstanding)
Paid-in capital 300,000

The stock dividend transfers $1,300,000 from retained earnings

to common stock ($1,000,000 increase). A new account, paid-in
capital of $300,000, is created.

c. and d. Stock splits only affect the number of shares

outstanding and the par value. After a three-for-one split the
entry for common stock is
Common stock $10,000,000
($3.33 par; 3,000,000 shares outstanding)

After a one-for-two reverse split common stock entries are

Common stock $10,000,000
($20 par; 500,000 shares outstanding)

The total amount under common stock remains $10,000,000 in both

cases.

3. a. New balance sheet after the three-for-one stock split:

Assets $30,000,000 Liabilities $14,000,000
Preferred stock 1,000,000
Common stock 1,200,000
($4 par, 300,000 shares
outstanding)
Paid-in capital 1,800,000
Retained earnings 12,000,000
New price of the stock: $20

b. New balance sheet after the 10 percent stock dividend:

Assets $30,000,000 Liabilities $14,000,000
Preferred stock 1,000,000
Common stock 1,320,000
($12 par, 110,000 shares
outstanding)
Paid-in capital 2,280,000
Retained earnings 11,400,000

New price of the stock: $54.55

The total value of the shares was $6,000,000 (i.e., 100,000 x
100
$60). The new value of a share is $6,000,000/110,000 = $54.55.)

4. This problem requires the student to calculate the

various ratios and compare them with the given industry
averages.

Current ratio:
current assets = $82,000 = 2
current liabilities $41,000

Quick ratio (acid test):

current assets minus inventory = $40,000 = 0.98
current liabilities $41,000

Inventory turnover:
sales = $100,000 = 2.4
average inventory ($42,000 + $40,000)/2
or
cost of goods sold = $60,000 = 1.5
average inventory ($42,000 + 40,000)/2

Receivables turnover:
annual credit sales
accounts receivable
or
annual sales = $100,000 = 3.3
accounts receivable $30,000

(Credit sales are not given; first definition of receivables

turnover cannot be computed.)

Average collection period:

receivables = $30,000 = 108 days
sales per day $100,000/360

Operating profit margin:

earnings before interest and taxes = $25,000 = 25%
sales $100,000

Net profit margin:

earnings after taxes = $16,800 = 16.8%
sales $100,000

Return on assets:
earnings after taxes = $16,800 = 9.8%
total assets $172,000

Return on equity:
earnings after taxes = $16,800 = 14.5%
equity $116,000
101
Return on investment:
earnings x sales = $16,800 x $100,000 = 9.8%
sales assets $100,000 $172,000

Debt/net worth:
debt = $56,000 = 48.3%
equity $116,000

Debt ratio:
debt = $56,000 = 32.6%
total assets $172,000

Times-interest-earned:
earnings before interest and taxes = $25,000 = 5.0
interest expense $5,000

Strengths:

The current ratio, acid test, and inventory are comparable to

the industry averages, and the operating profit margin
exceeds the industry average. In general, the firm is
performing acceptably.

Weaknesses:

There are two basic weaknesses. One is the slow collection of

accounts receivable which are taking, on the average, 108
days to collect while the industry average is about 75 days.
The firm is also using more debt financing than the industry
(32.6 percent versus 25 percent for the industry). This
increased debt financing may be financing the increased
investment in accounts receivable. If the firm can collect
its accounts receivable more rapidly, then it will be able to
pay off some of its liabilities and thus reduce its debt
ratio.
The increased usage of debt may also explain why the net
profit margin is below the industry average. Since the
operating profit margin is comparable to the industry, the
lower net profit margin can not be explained by the firm's
operations. Either interest expense or higher taxes must be
the source of the lower net profit margin. If the lower net
profit margin is the result of increased interest expense,
then this is probably the result of carrying too many
accounts receivable.

5. An investor in debt instruments is primarily concerned

with the firm's capacity to pay the interest and make the
principal repayment. Emphasis will be placed on liquidity
102
ratios and times-interest-earned. Emphasis may also be placed
on the turnover of current assets, since such turnover
generates the cash to make the creditor's payments.

Current ratio:
2008: $5,000 + 125,000 + 200,000$ = 1.9
$175,000

2009: $7,000 + 130,000 + 190,000 = 1.5

$210,000

2010: $15,000 + 152,000 + 200,000 = 1.6

$225,000

There has been a decline in the current ratio.

Quick ratio:
2008: $5,000 + 125,000 = 0.7
$175,000

2009: $7,000 + 130,000 = 0.8

$175,000

2010: $18,000 + 152,000 = 0.8

$225,000

There has been little change in the quick ratio.

Inventory turnover (using average inventory):

2009: $1,500,000 = 7.7
($200,000 + 190,000)/2

2010: $1,700,000 = 8.7

($190,000 + 200,000)/2

Inventory turnover has increased.

Days Sales Outstanding (Average collection period):

2008: $125,000 = 45
$1,000,000/360

2009: $130,000 = 31
$1,500,000/360

2010: $152,000 = 32
$1,700,000/360

Days sales outstanding has dramatically improved.

103
Times-interest-earned: 2008: $90,000/$20,000 = 4.5
2009: $145,000/$23,000 = 6.3
2010: $170,000/$27,000 = 6.3
Times-interest-earned has improved.

With the exception of the slight decline in the current

ratio, there has been no change that indicates deterioration
in the creditor's position. The creditor's position has
probably improved.

6. Debt/Net worth: $700,000/$300,000 = 2.3

Debt ratio (Debt/Total assets):

$700,000/($700,000 + $300,000) = 0.7 = 70%

7. The firm wants to achieve the industry average given its

level of sales. Thus:
Industry average = Sales/Average inventory
4 = $500,000/X
X = $125,000

Since the firm's inventory is $200,000, the reduction in

inventory will be $200,000 - $125,000 = $75,000.

8. Average collection period = Accounts receivable

Sales per day

To determine what the firm's accounts receivable should be to

be comparable to the industry, solve the following equation:

40 = X/[($42,791,000/360)]

X = $4,754,556

9. Operating profit margin = EBIT/Sales

Firm A: $150,000/$1,000,000 = 15%

Firm B: $150,000/$1,000,000 = 15%

Net profit margin = Net earnings/Sales

Firm A: $80,000/$1,000,000 = 8%
Firm B: $45,000/$1,000,000 = 4.5%

104
 Return on equity = Earnings/Equity

Firm A: $80,000/$300,000 = 26.7%

Firm B: $45,000/$100,000 = 45%

Both firms have the same operating profit margins; the

difference in the net profit margin is the result of Firm B
paying more interest. The firms have the same amount of total
assets but their equity differ ($300,000 for A but only
$100,000 for B). Thus firm B uses more debt financing. While
this requires paying more interest and results in lower total
earnings, it may also increase the return on equity.

10. EBIT $10,000

Interest 2,000
EBT 8,000
Taxes (30 percent) 2,400
Earnings (available to $ 5,600
pay preferred stock
dividends)
Times-dividend-earned: $5,600/$2,000 = 2.8

11. With debt financing With preferred stock

financing
EBIT $500,000 $500,000
Interest 100,000
EBT 400,000 500,000
Taxes 120,000 150,000
Earnings 280,000 350,000
Preferred dividends 100,000
Earnings available $280,000 $250,000
to common stock

Earnings per common $2.80 $2.50

share

Notice that since the preferred stock dividends are paid

after taxes, earnings per common share are lower than when
debt financing is used.

Investment Assignment (Part 3)

In this part, the student is asked if any of the stocks that he

or she has selected meet specified criteria based on ratios.
Students are often more interested in growth stocks or name
105
stocks that they know. Often these do not have the fundamental
associated with value stocks. You can use this assignment to
generate a discussion of growth versus value.

106
Teaching Guides for the Financial Advisor’s Investment Case:
Strategies to Increase Equity

1. In this problem management wants to acquire more funds to

help finance expansion. One possibility is selling new stock,
but this raises the question of diluting the current
stockholders' equity and the possibility of reducing the price
of the stock. Another alternative is to borrow the funds. This
raises the question of capital structure and whether additional
debt will also require additional equity financing and hence
dilute the current stockholders' position. (You may use this
question to introduce or tie in the concept of an optimal
capital structure that is discussed in courses on corporate
finance.)

Two other alternatives are suggested: (1) institute a dividend

reinvestment plan that sells new shares to stockholders who
reinvest their dividends and (2) substitute a stock dividend
for the cash dividend. The stock dividend will not dilute the
existing stockholders' position since each stockholder will
receive the additional shares. Stockholders who do not
participate in the reinvestment plan will see their
proportionate ownership reduced as new shares are issued to the
participating stockholders.

2. The amount of money raised by the substituting the stock

dividend for the cash dividend will be the amount by which the
cash dividend is reduced. If the cash dividend is eliminated,
the cash raised is $3.74 x 1,200,000 = $4,488,000. (Be certain
to point out that the cash raised in the result of eliminating
the cash dividend and not the result of distributing the stock
dividend.)

If the dividend reinvestment plan is adopted, the amount of

cash raised depends on the amount of participation in the plan.
Even if a large number of stockholders participate, the amount
raised may be modest since large financial institutions that
hold the stock will probably not participate. If one third of
the shares participate, the amount of cash raised is
($3.74)(.33)(1,200,000) = $1,481,100.

The amount of funds raised by issuing new shares will depend on

the price of the stock and the number of shares sold. The same
also applies to issuing debt. The amount raised will depend on
the amount of debt issued.

107
3. The stock dividend will reduce the price of the stock by the
amount of the dividend, as the market adjusts for the
additional shares. The dividend reinvestment plan will probably
have no impact on the price of the stock. While the price of
the stock will decline when the stock goes ex dividend, that
decline is not the result of the dividend reinvestment plan.
The price of the stock may fall if the firm issues new shares
as a result of the possible dilution, and the price could fall
as a result of issuing debt if the firm is perceived as being
riskier from the increased use of debt financing.

4. Both the dividend reinvestment plan and the distribution of

the stock dividend will have some administrative costs.
However, they may also generate some cost savings from not
having to distribute cash dividends. There is no information in
the problem to determine whether either will result in a net
increase in costs. Issuing new stock will also have the costs
associated with registering the shares with the SEC and the
underwriting discount. Issuing new debt would also have these
expenses if the debt were sold to the general public. Some of
the expenses could be reduced through the private placement of
the securities.

5. Stock splits only alter the number of shares and the price
of the stock adjusts accordingly. A stock split will not help
raise additional equity financing.

6. If the cash dividend were raised, that would reduce retained

earnings. Unless all stockholders participated in the dividend
reinvestment plan, increasing the dividend must reduce funds
available for reinvestment. (Point out that if all stockholders
participated in the reinvestment plan, the plan would be
unnecessary since retaining all earnings would have the same
impact and avoid the costs associated with administrating the
plan and the taxes associated with receiving the dividends.)

7. The problem specifies four possibilities.

1. Raising new equity by issuing additional shares has a

major advantage in that by using an underwriting through an
investment banker, the firm is guaranteed of raising a
specified amount of money. The position of current stockholders
is diluted (unless they buy the new shares), but if management
is able to earn a sufficient return on the new funds, the value
of the stock may rise instead of falling.

108
 2. Completely eliminating the dividend would raise $3.74 x
1,200,000 = $4,488,000. Unless this amount is sufficient for
the desired investments, future cash dividends would also have
to be deferred. In addition, it is uncertain how the market
will react to the cut. If a substantial number of stockholders
hold the shares for the dividend income, the elimination of
cash dividends will probably lead to a lower stock price.

3. The dividend reinvestment plan will raise even less cash

than eliminating the dividend. This may be offset by offering
stockholders the option to buy additional shares. In any event,
the amount of money to be raised by this method may be both
modest and uncertain.

4. The stock dividend is, in effect, being used as a smoke

screen. It is the failure to pay a cash dividend, and not the
stock dividend that is saving the cash. Many investors realize
that the stock dividend does not increase the firm's assets or
equity. Thus, stock dividends by themselves cannot help raise
the desired funds.

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