CHAPTER - I

Money market securities, such as bank accounts, savings accounts, CDs, money market
mutual
funds, Treasury bills, and commercial paper, offer safety of principal and low rates of return.
Short-term objectives such as building an emergency fund and saving for short-term purchases
within the year fall into this category of investments. Returns from these securities often do
not cover inflation and taxes.

Investments that provide a steady stream of income with higher rates of return than money
market
securities include bonds and preferred stock. The tradeoff in seeking higher levels of return
from bonds and preferred stock is the possible loss of principal. Investors looking to fund
objectives with
one- to five-year time horizons use bonds with matching maturities to their time horizons to
earn higher rates of return than money market securities.

Generally, the yields on dividend-paying stocks tend to be lower than the yields of
bonds.

Stock investments are suitable to fund investors’ longer-term objectives (with a time horizon
of greater than five years), such as building a retirement fund.

Lowrisk investments (money market securities) guarantee principal but

provide low returns in the form of income. Fixed-income securities
(bonds and preferred stock) provide higher levels of income but
carry a risk of loss of principal in the event of default for bonds or
having to sell preferred stock at a lower price than the purchase
price. Common stocks offer the greatest total return (capital growth
and income) over long periods of time but carry a higher risk of
loss of principal over short periods of time. Your personal circumstances
(age, marital status, number of dependents, net worth, and
income) determine your tolerance for risk as a guide to your choice
of investments.

In general, the younger you are, the greater can be your allocation
toward capital growth investments (common stocks and real
estate). The closer you are to retirement, the greater should be your
allocation to bonds and money market securities, which provide
income, and the smaller should be your allocation to stocks, which
provide growth to the portfolio.

Financial planners use this rule of thumb method for determining the percentage to
allocate to stocks:
Percentage amount to allocate to stocks = 100 – your age
For example, if you are 65 years old, you would allocate 35 percent to stocks and
divide up the balance to other investment asset classes (bonds and money market
securities). This is the starting point to your plan, where the categories will be
adjusted for your financial circumstances and risk tolerance.

A diversified stock portfolio includes stocks from different sectors of the economy
(technology, energy, health care, consumer, industrial, financial, auto, basic materials,
manufacturing, and utilities) whose returns are not directly related. An investor following an
active strategy uses fundamental and technical analysis to assemble stocks to buy that are
undervalued and then sells them when they become overvalued and replaces them with new
undervalued stocks. Irrespective of whether you are an active or passive investor, you
need to even out the risk of loss by having a diversified portfolio. In other words,
you should not have all your eggs in one basket.
Stocks provide returns in the form of dividends and capital appreciation. Historically, returns
from stocks have been greater than the returns received from bonds and money market
securities over long time horizons (seven-plus years). Investing in stocks provides growth to an
investment portfolio in addition to any dividend income.

Stocks provide a store of value. Buying and holding appreciated stocks in a portfolio is a tax-
efficient way to increase wealth in that if the holding period is longer than a year before selling
a stock, the capital gain is taxed at a maximum of 15 percent at the federal level. Gains from
stocks held for less than a year are taxed at your marginal tax bracket, which could
be as high as 35 percent.

Dividend income from qualified stocks is taxed at lower rates than interest from
bonds and money market securities.

CHAPTER – II

CHARACTERISTICS OF COMMON STOCK

Common stockholders are the residual owners of the corporation because they have
voting rights and bear the ultimate risk associated with ownership.
In bankruptcy, common stockholders are last in line (after bondholders and
preferred stockholders) for claims on assets.
Shareholders’ liability is limited to the amount of their investments (limited
liability).
With regard to claims on earnings, common stockholders are entitled to receipt of
dividends only after all the corporation’s obligations have been met.
Shareholders receive dividends only when a company’s board of directors declares a
dividend.

A charter of incorporation is a document that the company files with the state when forming a
corporation.

Corporations use either the majority voting procedure (also known as the statutory method) or
the cumulative voting procedure. In the majority voting procedure, shareholders are allowed
one vote
for each share held for each director’s position. Under the majority voting procedure, the
number of votes a shareholder has equals the number of shares he or she holds. The majority
of votes cast determines the issue or the director elected.

In the cumulative voting procedure, shareholders are entitled to a total number of

votes equal to the total number of shares owned multiplied by the number of
directors being elected. Shareholders can cast all their votes for a single candidate
or split them as they see fit. Cumulative voting gives increased weight to minority
shareholders, enabling them to elect at least one director.

Preemptive rights allow shareholders to maintain their constant percentage of a company’s

outstanding stock by being given the first chance to purchase newly issued stock in proportion
to their existing percentage ownership of stock. Not all corporations provide preemptive rights
in their charters. For example, if a shareholder owns 10 percent of a company’s stock,
that shareholder is entitled to purchase 10 percent of new shares being offered. To
put it another way, existing shareholders have the first right of refusal in
purchasing new shares. Certificates called rights are issued to the shareholders,
giving them the option to purchase a stated number of new shares at a specific
price during a specific period. These rights can be exercised (which allows the
purchase of new common stock at below-market price), sold, or allowed to expire.
If the receipt of dividends is important to you, you need to be
aware of these four dates:
Date of declaration is the date on which the board of directors declares dividends.
Date of record is the date that determines which shareholders are entitled to receive the
dividends. Only shareholders owning shares of the company on the date of record are entitled
to receive dividends. If shares are purchased after the record date, the owners are not entitled
to receive the dividends.
Ex-dividend date is two business days before the date of record. Stocks traded on the ex-
dividend date do not include the dividend. When common stock is bought, the settlement
takes three business days to be completed. Thus, if the record date for a company’s dividend
is Friday, the ex-dividend date is the preceding Wednesday. Investors who buy these shares on
Tuesday (the day before the 16 ex-dividend date) receive the dividend because the transaction
is recorded in the ownership books for that company in three working days.
Payment date is the date on which the company pays the dividends.

Shareholders who rely on income from their investments generally purchase the stocks of
companies that have a history of paying regular dividends from their earnings. These
companies tend to be older and well established; their stocks are referred to as income
stocks or blue-chip stocks.

Young companies that are expanding generally retain their earnings; their stocks are referred
to as growth stocks. Growth stocks appeal to investors who are more interested in capital
appreciation.

The importance of dividends lies in their tax benefits. In 2003, federal tax rates on
qualified dividends were lowered to a maximum rate of 15 percent if held for the required
length of time. This lowered tax rate makes investing in dividend-paying stocks more
advantageous from a tax point of view than many taxable bonds, where interest is taxed at the
taxpayer’s marginal rate, which can be as high as 35 percent.

A company might declare extra dividends in addition to regular dividends. An extra dividend
is an additional, nonrecurring dividend paid over and above the regular dividends by the
company. Rather than battle to maintain a higher amount of regular dividends, companies with
fluctuating earnings pay out
additional dividends when their earnings warrant it.

Types of Dividends

Cash dividends
Stock dividends and stock splits
Property dividends
Special distributions, extra dividends, spin-offs and split-offs

Stock Split Vs Stock Dividends

The only difference between a stock split and a stock dividend is technical. From an accounting
point of view, a stock dividend of greater than 25 percent is recorded as a stock split. A 100
percent stock dividend is the same as a two-for-one stock split. Acompany might split its stock
because the price is too high, and with a lower price the company’s stock becomes more
marketable. The following example illustrates what happens when a company declares a two-
for-one stock split. If at the time of the split the company has 1 million shares outstanding and
the price of the stock is $50, after the split the company will have 2 million shares outstanding,
and the stock will trade at $25 per share. Someone who owns 100 shares before the split (with
a value of $50 per share) would own 200 shares after the split with a value of approximately
$25 per share (50 _ 2). On January 16, 2003, Microsoft Corporation announced a two-for-one
stock split that took effect on February 18, 2003. Before the split, Microsoft closed at $48.30
per share. On the morning of the split, it opened at $24.15 per share. An investor with 100
shares before the split would have had 200 shares after the split.
Reverse Split

Occasionally, companies announce reverse splits, which reduce the number of shares and
increase the share price. A reverse split is a proportionate reduction in the number of shares
outstanding without
affecting the company’s assets or earnings. When a company’s stock has fallen in price, a
reverse split raises the price of the stock to a respectable level. Another reason for raising the
share price is to meet the minimum listing requirements of the exchanges and the Nasdaq
market. For example, a stock trading in the $1 range would trade at $10 with a 1-for-10
reverse split. The number of shares outstanding
would be reduced by 10 times after the split. On November 19, 2002, AT&T had a reverse
stock split of one-for-five shares. See Table 2–3 for a discussion of whether there are any
advantages to
stock dividends and stock splits

Advantages to Stock Dividends and Stock Splits

If shareholder wealth is not increased through stock dividends and stock splits, why do
companies go to the trouble and expense of issuing them? The first advantage for the issuing
company is a conservation of cash. By substituting stock dividends for cash dividends, a
company can conserve its cash or use it for other investment opportunities. If the company
successfully invests its retained earnings in business ventures, the stock price is bid up,
benefiting shareholders. Consequently, shareholders are better off receiving stock dividends,
but there are costs associated with the issue of stock dividends. Shareholders pay the cost of
issuing new shares, the transfer fees, and the costs of revising the company’s record of
shareholders. Advocates of stock dividends and stock splits believe that a stock price never
falls in exact proportion to the increase in shares. For example, in a two-for-one stock split, the
stock price might fall less than 50 percent, which means that shareholders are left with a
higher total value. This conclusion has not been verified by most academic studies. When the
price of the stock is reduced because of the split, the stock might become more attractive to
potential investors because of its lower price. The increased marketability of the stock might
push up the price if the company continues to do well financially; stockholders benefit in the
long run by owning more shares of a company whose stock price continues to increase. Stock
dividends and stock splits do not increase stockholder wealth from the point of view of the
balance sheet. Cash dividends, however, directly increase a shareholder’s monetary wealth
and reduce the company’s cash and reinvestment dollars