Question

CHAPTER 7 QUESTIONS 1. What is equity? What are some characteristics of equity? a. Explain the following statement: "Whereas a bond contains a promise to pay interest, common stock provides an expectation but no promise of dividends." b. What is the significance of the par value of a preferred stock? Of a common stock? 2. How are stock prices determined? 3. How are stock returns determined? What two components are included in a stock's return? 4. What factors affect stock prices? Explain. 5. What alternative techniques do investors use to value stocks? Why?

Answer 1

1. Equity represents the stake that the shareholders have in a company. The equity can be calculated by subtracting the assets from the liabilities.

The characteristics of equity are :

• the equity holders have voting rights.
• They have the right to dividend: they are paid dividend in the case of excess profits but there is no guarantee that dividends will be paid every year.
• right to income : the equity holders have a right over the residual income of the company.
• Claim on assets : the equity holders have a right to claim on the residual assets of the company. In the event of liquidation, they can claim the assets which is left after paying the debt holders and the preference share holders.

a. The equity holders expect that dividends will be paid to them but there is no guarantee. A company is not obligated to pay dividend to equity holders. They can reinvest the earnings if there are growth opportunities available. In the case of bonds, they are guaranteed to receive the principal and interest payments and there cannot be any defaults.

b. Par value is the amount appearing on the share certificate. It has no connection with the market value of the share.Par value is the face value of bond.

Par value of preference stock, is the amount on which the dividend is calculated.So, if the par value is $1000 and the dividend is 5%, the dividend to be paid is $50.

2. The stock prices is determined , after a company goes public after the IPO by the forces of supply and demand.

3. The total stock returns = (P1- PO + Dividends)/ Po * 100

The total stock returns = dividends paid + stock price appreciation divided by the original price.

4. The factors affecting the stock prices are :

• Supply and demand for the stock.
• The economic conditions in the market.
• The dividends paid.
• The management of the company.
• The changes in the interest rates.

5. The alternative methods to value stocks is the Price/ earnings ratio and price/ sales ratio. It is the simple and easy method to value stocks.