Part Three
Investing in Common Stocks
Part Three Includes
Chapter 6
Common Stocks
Chapter 7
Analyzing Common Stocks
Chapter 8
Stock Valuation
Chapter 9
Market Price Behavior
Chapter 6
Common Stocks

Outline
Learning Goals
I.
What Stocks Have to Offer
A) The Appeal of Common Stocks
B) Putting Stock Price Behavior into Perspective
C) From Stock Prices to Stock Returns
D) The Dow, the S&P, and the Nasdaq
1. Comparative Performance of the Three Market Measures
2. Bulls, Bubbles, and Bears
E) The Pros and Cons of Stock Ownership
1. The Advantages of Stock Ownership
2. The Disadvantages
Concepts in Review
II.
Basic Characteristics of Common Stock
A) Common Stock as a Corporate Security
1. Issuing New Shares
2. Stock Spin-Offs
3. Stock Splits
4. Treasury Stock
5. Classified Common Stock
B) Buying and Selling Stocks
1. Reading the Quotes
2. Transaction Costs
C) Common Stock Values
1. Par Value
2. Book Value
3. Market Value
4. Investment Value
Concepts in Review
Chapter 6
III. Common Stock Dividends
A) The Dividend Decision
1. Corporate Versus Market Factors
2. Some Important Dates
B) Types of Dividends
1. Cash
2. Stock Dividends
C) Dividend Reinvestment Plans
Concepts in Review
IV. Types and Uses of Common Stock
A) Types of Stocks
1. Blue Chips Stocks
2. Income Stocks
3. Growth Stocks
4. Tech Stocks
5. Speculative Stocks
6. Cyclical Stocks
7. Defensive Stocks
8. Mid-Cap Stocks
9. Small-Cap Stocks
B) Investing in Foreign Stocks
1. Comparative Returns
2. Going Global: Direct Investments
3. Going Global with ADR’s
4. Putting Global Returns in Perspective
5. Measuring Global Returns
6. Currency Exchange Rates
C) Alternative Investment Strategies
1. Buy-and-Hold
2. Current Income
3. Quality Long-Term Growth
4. Aggressive Stock Management
5. Speculation and Short-Term Trading
Concepts in Review
Common Stocks
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Summary
Putting Your Investment Know-How to the Test
Discussion Questions
Problems
Case Problems
6.1 Sara Decides to Take the Plunge
6.2 Wally Wonders Whether There’s a Place for Dividends
Excel with Spreadsheets
Trading Online with OTIS

Key Concepts
1.
The investment appeal of common stock.
2.
Historical returns in the stock market.
3.
Basic issue characteristics of common stock, including the advantages and disadvantages of
ownership.
4.
Stock quotations and transaction costs.
5.
Different types of stock offerings and common stock values.
6.
Transaction costs of buying and selling stocks.
7.
The importance of dividends to stocks and stock valuation, including how dividend decisions are
made, types of dividends, and dividend policies.
8.
The kinds of common stocks and their investment merits.
9.
Investing in foreign stocks, including the impact of currency exchange rates in returns to U.S.
stockholders.
10. Uses of common stocks as investment vehicles, and the strategies that can be employed to meet
various investment goals.

Overview
This chapter is one of four that examines common stocks as an investment vehicle. Common stocks are
one of the most interesting of investment vehicles, and this chapter provides an essential foundation to the
students’ understanding of equity securities; as such, the instructor should plan to cover it in detail.
Chapter 6
1.
2.
Common Stocks
105
Several characteristics of common stocks make them an important investment vehicle: (1) Common
stocks provide an attractive ownership feature in addition to income potential. (2) Common
stockholders lay claim to all the residual profits of the firm. (The instructor should explain the
meaning of residual profits.) (3) Owners of common stock do not receive all the residual profits as
income, but only that part of profits declared as dividends. (4) Because a wide variety of common
stocks may be purchased, the investor may choose from a broad spectrum of risk-return
combinations.
Because of widespread misunderstandings, it’s important to put stock returns into perspective.
Students seem to have all sorts of ideas about how stock perform, so it’s best to address this issue
early on in the discussion. Table 6.1 provides over 50 years (1950–2002) of annual returns and
holding period returns. Spend some time on: historical returns in the stock market; how these can be
used as a benchmark of performance; and the relative importance of dividends and capital gains to
total stock returns. While discussing historical returns, it’s the perfect time to discuss the market
crashes of October 1987 & October 1997 and their causes. Students appreciate information about
stock returns since the book was published. It is good to bring information about the recent returns on
the Dow, S&P, and Nasdaq indexes to class.
3.
The following features of common stocks presented in the text should be discussed in detail in class:
ownership rights, rights offerings, kinds of issues, deferred equity securities, stock splits, treasury
stock, and classified common stock. The costs incurred in making common stock transactions of
different sizes should also be mentioned.
4.
The alternative ways of defining the value of common stock are: par value, book value, market value,
and investment value. The meaning and usefulness of each of these value measures to the investor
should be discussed in class. Current copies of stock quotes can be weaved into the discussion of
market value.
5.
The dividend decision of a firm is important to the investor and to the firm, so the following aspects
of dividends should be highlighted: how the dividend decision is made; important dates that affect
dividends; tax effects of different types of dividends; and the basic principles behind the creation of
and participation in dividend reinvestment plans. Examples of earnings per share (EPS) and dividend
yield computations should be worked out in class. Current common stock yields can be compared to
bond yields and local savings account yields.
6.
In the latter part of the chapter, common stocks are classified into different types, based on different
features. These types are blue chips, income stocks, growth stocks, speculative stocks, cyclical
stocks, defensive stocks, mid-cap, and small-cap stocks. The instructor should indicate the risk-return
characteristics of each type. The instructor should also outline the steps involved in investing in
foreign stocks, with special emphasis on ADRs and the impact of currency exchange on total return.
7.
Finally, the alternative strategies that investors can follow when using stocks should be explained,
and the instructor should emphasize that investors choose different types of stocks according to their
investment objectives.

Answers to Concepts in Review
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1.
A common stock is an equity investment that represents ownership in a corporate form of business.
Each share represents a fractional ownership interest in the firm. The key attribute of this investment
security is that it enables investors to participate in the profits of the firm. As residual owners of the
company, common stockholders are entitled to dividend income and a prorated share of the firm’s
earnings after all other obligations of the firm have been met. They have no guarantee they will ever
receive any return on their investment.
2.
One important investment attribute of common stocks is that they enable investors to participate in
the profits of the firm and as such, they can offer attractive return opportunities. Another attribute is
the versatility of the security—it can be used to meet just about any type of investment objective. In
addition, as investment vehicles go, common stocks are fairly simple and straightforward, so they’re
easy to understand (though that certainly doesn’t mean they’re easy to value). They are easy to buy
and sell, and the transactions costs are modest. Moreover price and market information is widely
disseminated in the news and financial media.
3.
The stock market has been very volatile over the past 15 years. A bull market, was followed by a
bubble, that became a bear market, and once again appears to be quite bullish. Although stocks
provided average annual returns of around 11% from 1953–2002, there was a significant sell-off in
October 1987. While the first half of the 1990’s witnessed returns that were slightly below average,
average annual returns during the second half of the decade were 26%. Then came a bear market that
resulted one of the few three-year stretches with negative annual returns. However, by December of
2003, the stock market had rebounded off of the 2002 lows, and the Dow Jones Industrial Average
once again reached 10,000. In early 2004, the Dow Jones Industrial Average stood at 10,700.
The Nasdaq index showed even more volatility than the Dow. Over the entire 1990 to mid-2003
period the Dow outperformed both the S&P and Nasdaq. The Dow also had less of a loss during the
period from 2000 to mid-2003.
(Instructors may also point out that these figures reflect the general behavior of the market as a
whole, not necessarily that of individual stocks.)
4.
While they don’t provide the “bang” that capital gains do, dividends are an important source of return
to stockholders. Dividend returns are always positive, although the dividend yield recently has been
under 2.5 percent. Capital gains have ranged from 43.96 percent in 1954 to –27.57% in 1974. Over
the past 50 years, dividends have accounted for a little less than 50% of the average annual total
return from stocks. There’s no question that capital gains provide the really big returns, though they
also lead to wider swings in year-to-year yields. Dividends, in contrast, provide an element of
stability and tend to shore up returns in off years. Currently, dividends are taxed at five percent and
fifteen percent rates, the same as capital gains.
5.
The major advantage of common stock ownership is the returns it offers. Because stockholders are
entitled to participate in the prosperity of a firm, there is almost no limit to a stock’s capital gains
potential. In addition, many stocks provide regular current income in the form of annual
dividends—and for most income-producing stocks, those dividends tend to grow over time, adding
even more to the stockholder’s return. Common stocks are also highly liquid and easily transferable;
their transaction costs are relatively low, market information is readily available, and unit price is
nominal. The risky nature of common stocks is the most significant disadvantage of common stock
ownership. As residual owners of the firm, no return is guaranteed. Furthermore, prices are subject to
wide swings, making valuation difficult. Finally, the sacrifice in current income is a disadvantage
relative to other investments (like bonds, for instance) that pay higher and more certain returns.
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The principal risks to stockholders include: business and financial risk, purchasing power risk, and, of
course, market risk. Business risk is related to the kind of business the company is in and deals with
both sales volatility and the amount of variability in the firm’s earnings. Financial risk is associated
with the mix of debt and equity financing. The more debt (financial leverage) the firm uses, the
greater the likelihood that it will default on its principal and interest payments—which in turn will
have a negative impact on the stock. Purchasing power risk refers to the possibility of price increases
and the corresponding decline in the value of the dollars invested in common stock. Market risk is
caused by factors independent of the firm that affect the return on the firm’s common stock. Such
things as economic fluctuations, threat of war, and political factors affect market risk and therefore
can have a bearing on the market price of a stock. The market itself has an impact on the price
performance of a stock—which, of course, is what beta is all about (i.e., a stock’s beta is a measure of
the extent to which the stock reacts to the market).
6.
A stock split occurs when a firm announces its intention to increase the number of shares of stock
outstanding by exchanging a specified number of new shares for each outstanding share of stock.
Most stock splits are executed with a view to lowering the price of the stock and enhancing its trading
appeal. If the stock split is not accompanied by an increase in the level of dividends, stock prices will
fall to account for the split. Thus, a $100 stock will fall to $50 after a 2 for 1 split. If the company had
changed its dividend rate—say, by increasing dividends—the stock price will rise after adjusting for
the split. In the above case, the stock price will end up above $25 per share, depending on the size of
the dividend increase. Thus, other things being equal, a change (increase) in the dividend rate will
have a positive impact on the stock’s price, after adjusting for the stock split.
7.
Stock spin-offs involve conversion of one of firm’s subsidiaries to a stand alone company by
distribution of stock in that new company to existing shareholders. For e.g. Pepsico spun off its
restaurant operations—Pizza Hut, KFC, and Taco Bell—into a new company called Tricon Global
Restaurants (now called Yum Brands). Investors have shares in both the old and new firm, allowing
them to keep those divisions they want to hold and selling the other.
8.
(a) Firms do not “issue” treasury stock; these are simply shares of common stock that have been
issued and subsequently repurchased by the issuing firm. This is generally done because the firm
views the stock as an attractive investment; perhaps the price is unusually low. Most treasury
stock is later reissued by the firm and used for such purposes as mergers and acquisitions,
employee stock option plans, or for payment of stock dividends. Treasury stock is not a form of
classified stock. Classification of common stock simply breaks common stock into different
classes or groups. Each class has different voting rights and/or dividend obligations. For
example, class A stock might designate nonvoting shares that receive preferential dividends,
while class B stock might designate voting shares with lower dividends. Some classes pay stock
dividends to appeal to individuals interested in capital gains; other classes pay higher cash
dividends that attract income-seeking investors.
(b) Common stock can be bought or sold in round or odd lots. A round lot is 100 shares of stock, or
multiples of 100 shares. An odd lot is a transaction involving less than 100 shares.
(c) The par value of a stock is its stated or face value and exists primarily for accounting purposes.
Many stocks are issued with no par value. It is a relatively useless number. The liquidation value
of a stock is an estimate of the market value of the firm’s assets, if sold at auction, less the
liabilities and preferred stock outstanding. While this measure of value is vitally important to the
high-stakes LBO and take-over artists, it is very difficult to determine and is generally of little
interest to the typical individual investor who tends to view the firm as a going concern.
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(d) Book value is an accounting measure of the amount of stockholder’s equity in the firm. Book
value indicates the amount of stockholder funds used to finance the firm. Investment value,
perhaps the most important measure for a stockholder, indicates what value investors place on the
stock. Investment value is based on the expectations of the risk and return patterns of a stock: the
returns come from dividends and capital gains, and the risk is based on the exposure to holding
the stock.
9.
An odd-lot differential is the additional transactions costs an investor must pay to an odd-lot dealer to
trade in odd lots. The differential can be as high as 10 to 25 cents per share over and above normal
commission fees. These costs can be avoided by trading in round lots, or units of 100 shares.
(a) odd-lot differential added to fees
(b) no differential added
(c) odd-lot differential added to fees
10. The question on the amount of dividends to be paid is decided by the firm’s board of directors. The
directors evaluate the firm’s operating results and financial conditions to determine whether
dividends should be paid and, if so, in what amount.
During a Board of Directors meeting, a variety of factors are considered in making the investment
decision. These include:
(a) The firm’s current earnings or profits are considered a vital link in the dividend decision.
(b) The Board also looks at the firm’s growth prospect. Firms with good investment opportunities
pay less dividends; using the retained earnings for new investment.
(c) The Board also considers the firm’s cash position to make sure it has sufficient liquidity to meet
a cash dividend of a given size.
(d) The Board also ensures that it is meeting all legal and contractual constraints that might be
imposed by loans.
(e) The Board also makes an effort to meet the dividend expectations of its shareholders; failure to
meet these expectations can lead to disastrous results in the stock market.
11. The ex-dividend date (which occurs two business days prior to the date of record) determines who is
eligible to receive the declared dividend when the stock is sold. If the stock is sold on or after the exdividend date, the owner (seller) receives the dividend; if it is sold prior to the ex-dividend date, the
new shareholder (buyer) receives the dividend. Thus, if the stock is sold on the ex-dividend date, the
seller receives the dividend—going “ex-dividend” means the buyer is not entitled to the dividend
since the stock is being sold “without” the dividend.
12. Cash dividends are simply dividend payments made to the stockholder in cash. This form of dividend
represents something of value. A stock dividend is an issue of new shares expressed and distributed as
a percentage of each shareholder’s existing shares. It really has no value, since the market responds to
stock dividends by adjusting the market price accordingly. As an example, consider a stock that is
trading at $50 per share; if the issuing firm declared a 10 percent stock dividend, the price of this
stock would drop by 10 percent to $45.45 ($50/1.1). Thus, an investor who held 100 shares before the
stock dividend would hold 110 shares after, but the total market value of these shares would be
basically the same: $50  100  $45.45  110.
When a stock dividend is declared by the firm, additional shares of the stock are issued to existing
shareholders. Stock dividends may be used as a substitute for cash dividends, but they have no value
because the stock prices adjusts to the stock dividend accordingly. Stock splits occur when the firm
gives shareholders new shares in exchange for each share they own. The central difference between
stock dividends and stock splits is that dividends are additional issues and stock splits are exchanges.
Chapter 6
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In a 200 percent stock dividend, the investor receives additional shares equaling 200 percent of
existing shares (i.e., 100 shares already owned  200%  200 new shares distributed in addition to the
original 100). In a 3-for-1 stock split, the investor receives 3 new shares for each existing share
(100  3  300 shares held after split).
13. Firms with dividend reinvestment plans (DRPs) allow shareholders to automatically reinvest their
dividends into additional shares of the firm. DRPs provide investors with a convenient and
inexpensive way to accumulate capital without paying brokerage commissions. Despite these cost
savings, the dividends paid through DRPs are taxable as ordinary income in the year they are
received, just as if they had been received in cash.
14. (a) Blue chips are common stocks of very high quality that have a long and proven record of
earnings and dividends. They offer respectable dividend yields and modest growth potential.
They are often viewed as long-term investment vehicles, have low risks, and provide modest but
dependable rates of return.
(b) Income stocks are issues that have a long and sustained record of higher than average dividends.
These are ideal for investors who desire high current income with little risk. Unlike other types of
income securities (bonds, for instance), holders of income stocks can expect the amount of
dividends they receive to increase regularly over time. One disadvantage with these stocks is
their generally low to modest growth potential.
(c) Mid-cap stocks are stocks with capitalization value between $1 billion and $4–$5 billion.
Mid-caps offer investors attractive return opportunities—they have the sizzle of small-cap stocks
without the high price volatility. They also provide characteristics of the big, established stocks.
This mid-cap range is probably most appropriate for investors willing to tolerate a bit more risk
and price volatility than large stocks. One type of mid-cap stock, a “baby blue chip,” has all the
characteristics of regular blue chip, except for size.
(d) American Depository Receipts (ADRs) are negotiable instruments issued by American banks.
Each ADR represents a specific number of shares of stock in a specific foreign company. They
are used as a way to purchase foreign stocks and are traded on U.S. exchanges (for example, the
NYSE) or in the OTC markets; they trade just like shares of American stocks. Beyond the
simplified trading, the investment merits of an ADR are a function of the investment merits of
the foreign company that issued the stock, as well as the value of the dollar relative to the
currency of the foreign company.
(e) IPOs are initial public offerings of primarily small, relatively new companies. As the name
suggests, these stocks are offered to the public for the first time. IPOs offer a chance to earn
phenomenal capital gains. At the same time, it is very likely that investing in IPO stocks might
result in a loss. As such, these should be considered only by experienced and knowledgeable
investors. IPOs must be considered to be highly risky investments.
(f) Tech stocks are issued by companies in the technology sector. Issuing firms produce everything
from computers to Internet content. They typically are growth stocks or speculative stocks,
because they pose considerable risk to the investor. This sector has done extremely well in good
times and depreciated significantly in bear markets.
15. Income stocks generally have limited capital gains potential because they pay out large amounts of
their earnings in dividends; in essence, little of their income is plowed back into the company to
finance growth. Returns from income stocks come mostly from current income rather than capital
gains, a distinction favored by many investors. This does not mean these stocks are unprofitable;
most, in fact, are highly profitable, with excellent long-term future prospects.
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16. Less than 50 percent of the world equity market is in U.S. stocks. For the most part, the U.S. stock
market has been one of the best places to invest over the past two decades. However, the U.S.
finished first in only one year during the 1980–2002 period. Thus, to achieve greater returns on their
portfolio in a given year, investors should also consider foreign markets. Furthermore, the appreciated
value of a foreign currency relative to the U.S. dollar would enhance foreign equity returns.
The U.S. investor can either invest directly in foreign markets or indirectly by buying American
Depository Receipts (ADRs). All things considered, American investors are probably better off with
ADRs because they avoid many logistical problems that arise with direct investing. ADRs are dollardenominated and are about as easy to buy/trade as U.S. stocks.
17. A quality conscious investor would probably do best with a simple and conservative buy-and hold
strategy. With this strategy, the investor purchases income, quality, and blue chip stocks, and watches
them grow over time. On the other hand, if an investor is willing to tolerate a lot of risk, an aggressive
stock management strategy is the most appropriate. Here the investor aggressively trades in and out of
the various types of quality stocks in order to earn above average return from both dividends and capital
gains. An individual’s investment approach depends upon whether common stock is viewed primarily as
a storehouse of value, way to accumulate capital, or source of income.

Suggested Answers to Investing in Action Questions
Anatomy of a Market Meltdown (p. 238)
(a) What factors contributed to the 2000 market meltdown?
(b) What steps can you take to protect yourself in the future?
Answers:
(a) Factors leading up to the meltdown included:
(1) Unsustainable annual average returns of 26% during the prior five years,
(2) Investors eagerly buying shares in new technology companies, without regard to track records,
products, or profits,
(3) Individuals investing with the expectation that there would not be another recession, and
(4) Extra money being pumped into the economy by the Federal Reserve to guard against any year2000 computer problems.
Then in early 2000:
(1) The Federal Reserve raised interest rates,
(2) Business investment in technology decreased,
(3) Lower sales at Dell and the antitrust suit against Microsoft worried investors,
(4) The September 11, 2001 terrorist bombings and stock market closure for a week following
terrorist bombings,
(5) Corporate scandals at Enron eroded investor confidence and brought into question the validity of
numbers produced by Arther Andersen and others,
(6) Subsequent terrorist threats and anxiety arising from the looming war in Iraq caused the markets
to drop even farther, and
(7) Simply the fear that matters could get even worse pushed investors to give up (even if it meant
taking a loss) and move their money into bonds.
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(b) Diversifying allows you to spread out the risk that a unique firm or industry event will have a
devastating impact on your investment. You have to analyze the track record, products and profits of
firms before investing. Investors will want to reallocate their portfolio, even if it means selling
winners so that their wealth is not a closely tied to the success of a single firm. It also is good to
include both stock and bonds in your portfolio. The surge of interest in bonds and falling interest rates
as the economy stagnated drove prices of these securities upward.
In International Investing, Currencies can Make or Break You (p. 268)
(a) How does a strengthening dollar erode returns from non-U.S. investments?
(b) Is the dollar currently weak or strong, and what does this mean for investors?
Answers:
(a) If the dollar strengthens between the time the investor buys and sells the stock, the local currency buys
fewer dollars at the time of the sale. If foreign currency values decline by more than the rate of return
in the foreign currency, positive foreign returns may net out to a negative return for the U.S. investor.
(b) Due to the varying relationship of the U.S. dollar with foreign currencies, instructors will have to get
current information. Also, instructors may locate instances where the U.S. dollar is appreciating
relative to one currency, but depreciating relative to another.

Suggested Answers to Ethics in Investing Questions
Boards of Directors: Who Do They Represent? (at Web site)
Should company directors be required to own the stock of companies they represent?
Answer:
The sad reality of many corporate boards is that they are filled with outside directors, who have little or no
financial interest in a company they are suppose to oversee. Rather than requiring directors to put their
money at stake to buy company stock, corporations often granted them free stock options instead.
Unfortunately, these options were often treated as perks and giveaways and did little to align directors’
financial interests with that of the stockholders as many recent corporate scandals have indicated. One
possible solution to this problem, and to provide directors with incentives to own company stock, would
be matching grants where companies would establish a fund to match the director’s own purchase of
shares.

Suggested Answers to Discussion Questions
1.
(a) Returns during the 1970’s were only one third of those earned during the 1980’s. There were four
declines during the 1970’s, but only two during the 1980’s. Average returns during the 1990’s
were the highest of any decade, at 18.3%. Furthermore, there was only one year with a decline,
1990, during the period from 1990–1999. In both the 1980’s and 1990’s, there were seven years
with during which the Dow Jones Industrial Average rose by over ten percent. By contrast, the
stock market fell in each of the full years since 1999 reported in Table 6.1, and averaged a loss
of 4.3%.
(b) All three measures of stock market performance had an average positive rate of return exceeding
18% during the 1990s. During the portion of the 2000s available, all three indexes had a loss of at
least 5%. While the Nasdaq market rose the most on average during the 1990s, it also declined
the most during the 2000–2003 period. The Nasdaq Composite is more volatile during the period
covered by Figure 6.2.
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(c) There is a wide difference in the average annual rates of return, between the first half of 1990s
and the second half. From 1990–1994, the Dow Jones Industrial Average’s average rate of return
was 10.26%, while in the 1995–1999 period the average rate of return was 27.03%. A better
indicator of future returns may be the average annual rate of return for the past fifty years, as
presented in Table 6.2, which is 10.7 percent. Obviously, there is quite a range in actual returns
around this average.
2.
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
Wednesday, April 9
189.12
6.8%
15 The ratio of the daily market price to the current earnings
189.12
$6.00/share
254.00, 150.50
75,500
–3.88, 193.00
3.
Answers will vary with each student.
4.
(a) A combination of growth and value stock in a 50–50 weighting such as Microsoft for growth and
a public utility for value (income). Another appropriate approach would be a total-return
approach, that seeks to high rates of growth in dividend income or capital gains. A buy-and-hold
strategy invested in a portfolio of large growth companies would also be appropriate.
(b) Those with smaller amounts to invest are better off to focus on quality long-term growth and less
on aggressive stock management. If she were more risk averse, we may want to allocate more
value than growth to the weighting such as 75–25 or 60–40.
5.
The three sources of return to U.S. investors from foreign stocks are the share of profit payments in
the form of dividends, the capital gain as the value of the stock increases in market price and the
appreciation of the foreign currency against the U.S.$. Currency exchange rates are critical, small
foreign rates of return are elevated as the value of the U.S.$ declines. It is best to buy foreign
currencies after the dollar has appreciated relative to those currencies and sell when the dollar has
declined relative to the foreign currency.
(a) British pounds have appreciated in value as compared to the U.S.$ giving greater returns to the
U.S. investor who holds pounds. Australian dollars have depreciated against the U.S.$ as well as
the Mexican peso giving the investor who holds these currencies less return.
(b) ADRs are not directly affected by exchange rate changes since they trade in the U.S. financial
markets in U.S.$. But since the underlying asset is a foreign stock denominated in a foreign
currency, the change in exchange rates will eventually impact the price of the ADRs in U.S.$s.
6.
(a) A buy-and-hold strategy is a long-term program that seeks capital growth with as well as
preservation of capital, a well-balanced combination of growth and value stocks are most
appropriate.
(b) A current-income portfolio focuses on the current dividend yield of stocks. Safety of principal
and stability of income are vital, while capital gains have secondary importance. The benefits of
this strategy have increased with the decline in dividend tax rates.
(c) Long-term total return would emphasize more growth stock as well as a lesser percentage in
value stocks. Beyond the current dividend yield, attention would be paid to the anticipated
dividend growth rate.
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(d) Aggressive stock management would call for a frequent rebalancing of the portfolio weights to
represent the latest economic condition in the markets. These investors would hold a greater
portion of their wealth in small-cap issues, speculative tech stocks, foreign shares, and ADRs.

Solutions to Problems
1.
If a $50 stock splits 5 for 2, the new price of a share immediately after the split would be $20. Using
the approach noted in the chapter, we have:
[$50/(5/2)]  $20.
If an investor owned 200 shares before the split, he would own 500 shares afterward:
200  5/2  500 shares.
The market value of his holdings, however, would be unchanged:
2.
Before the split:
200 shares  $50  $10,000
After the split:
500 shares  $20  $10,000
Commissions on trades. The investor began with $20,000 and made $1,000 on his trade of stock. This
totals $21,000. His balance, however, is $20,900. Therefore, Item 4 should be:
Commissions on Trades
3.
– $100.00.
Book value  Total assets – Total debt – Preferred stock
For Kracked Pottery:
= $2,500,000  $1,800, 000  $200, 000
 $500, 00
Book value
Book value per share =
Book value
Number of shares of common stock outstanding
For Kracked Pottery:
Book value per share 
4.
$500, 000
 $10 per share
50, 000
Market Capitalization  share price  number of shares outstanding.
$25  250,000,000  $6,250,000,000
5.
(a) Earnings per share (EPS) 
Net profits after taxes  Preferred dividends
Number of shares of common stock outstanding
For Med Tech Co.:
EPS 
$15,800, 000  $1, 000, 000
2, 500, 000
 $5.92
114
Gitman/Joehnk • Fundamentals of Investing, Ninth Edition
(b) Dividend yield 
Cash dividends per share
Market price per share
For Med Tech Co.:
Dividend yield 
(c) Dividend payout ratio 
$2
 3.33%
$60
Dividends per share
EPS
For Med Tech Co.:
Dividend payout ratio 
$2
 33.8%
$5.92
6.
Initial Investment  200  $50 
Sales Proceeds  200  $55 
Dividends  $0.25  4  200 
Total Proceeds  $200  $11,000 
Net Proceeds Before Tax 
Tax @ 15%  0.15  $1,200
Net Proceeds After Tax  $1,200 – $180 
7.
$10,000
$11,000
$200
$11,200
$1,200
$180
$1,020
(a) Book value  Total assets – Total debt – Preferred stock
For Truly Good Coffee:
Book value  $240M – $115M – $25M  $100M
Which is equal to common stockholders’ equity.
Book Value
(b) Book value per share 
Number of shares of common stock outstanding
For Truly Good Coffee:
Book value per share 
$100, 000, 000
 $10 per share
10, 000, 000
(c) Earnings per share (EPS) 
Net profits after taxes  Preferred dividends
Number of shares of common stock outstanding
For Truly Good Coffee:
EPS 
(d) Dividend payout ratio 
$22, 500, 000  $2, 000, 000
 $2.05 per share
10, 000, 000 shares
Dividends per share
Earning per share
For Truly Good Coffee:
Dividend payout ratio 
$0.75
 36.59%
$2.05
Chapter 6
(e) Dividend yield on common stock 
Common Stocks
115
Cash dividends per share
Market price per share
For Truly Good Coffee:
$0.75
 3.0%
$25.0
Preferred dividends per share
(f) Dividend yield on preferred stock 
Market price of preferred share
Dividend yield on CS

For Truly Good Coffee:
Dividend yield on PS

$2.00
 6.5%
$30.75
8.
$0.28  4  $1.12 per annum in dividends. $1.12/$28  4%.
9.
Earnings per share are $900M/$900M  $1.00.
Dividends per share  $0.90.
Payout ratio
 $0.90/$1.00  90%.
10. (a) If Colin sells his stock on March 20th, he will be selling after the stock’s ex-dividend date (which
will occur on March 19th) and, therefore, he will be the holder of record and is entitled to receive
the dividend of $100 ($.50  200 shares).
(b) Colin will be credited with $100 that will be used in the dividend reinvestment plan to purchase
more of the company’s stock. A 5 percent discount on the $40 share price is $2.00, so the
purchase price would be $38 per share ($40  $2); thus, Colin will be able to purchase
2.632 shares of common stock ($100/$38). Unfortunately, Colin will have to pay taxes on the
$100, since it’s still treated as a cash dividend.
11. The dividends paid under the two systems would be as follows:
Year
2000
2001
2002
2003
2004
Total Dividends
EPS
$1.40
2.10
1.00
3.25
0.80
Dividends Paid
40% Payout Regular Dividend
Ratio
of $1 per share
$0.56
$1.00
0.84
1.00
0.40
1.00
1.30
1.00
0.32
1.00
$3.42
$5.00
Total dividends are highest with regular dividends of $1 per share. Also, note how dividend
payments fluctuate with the fixed payout ratio procedure.
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Gitman/Joehnk • Fundamentals of Investing, Ninth Edition
12. There is no set solution to this problem, since the answer will vary with the companies selected by the
student. The students should be encouraged (required?) to actually compute the requested
information, rather than simply look up the numbers in something like Value Line. To compute the
latest B/V per share, EPS, dividend payout ratio, and dividend yield, the student will have to refer to a
couple of different sources to come up with the necessary input (e.g., Mergent or S&P for balance
sheet and income statement information, and The Wall Street Journal or Barron’s for dividends and
prices). Several Internet sites can also be employed.
Chapter 6
13. (a) Holding Period Return (HPR) 
Common Stocks
117
Ending price  Beginning price  Current income
Beginning Price
(1)
(2)
(3)
Ending
Year
2000
2001
2002
2003
2004
Beginning
Price
$54.00
74.25
81.00
91.25
128.75
Capital
Price
$42.50
54.00
74.25
81.00
91.25
(4)
Current
Gain
(1) – (2)
$11.50
20.25
6.75
10.25
37.50
(5)
(6)
Annual
Income
$0.82
1.28
1.64
1.91
2.30
Return
(3)  (4)
$12.32
21.53
8.39
12.16
39.80
HPR
(5)/(2)
28.99%
39.87
11.30
15.01
43.62
Over the five-year period, on average Engulf and Devour has returned 27.76% per year. This is
well above the average return on the stock market over the same period.
14. (a) Ignoring the currency effect:
(1) Total return to Siemens AG:
Ending Value in Euros  Dividends in Euros
1
Beginning Value in DM
60e  1.5e

1
53.25e
 0.1549 or 15.49%

(2) Total return to Swisscom:

Ending Value in Sf + Dividends in Sf
1
Beginning Value in Sf
760 Sf  15 Sf
1
715 Sf
 0.0839 or 8.39%

Ignoring the currency effect, Siemens promises the higher total return. Based on total returns in
foreign currency form, it is the better investment.
(b) Note: The Euro depreciated, while the Swiss franc appreciated. Considering the currency effect:
(1) Total return to Siemens in U.S. dollars:
Exchange Rate at
Ending Value in Euros and Dividends in Euros End of Period

1
Beginning Value in Euros
Exchange Rate at
Beginning of Period
60.0e  1.5e 0.9852

1
53.25e
1.1080
 (1.1549) (0.8892)  1  0.027 or 2.7%

118
Gitman/Joehnk • Fundamentals of Investing, Ninth Edition
(2) Total return to Swisscom in U.S. dollars:
760 Sf  15 Sf 0.85

1
715 Sf
0.75
 0.2284 or 22.84%

Exchange rates worked against the German investment because the higher returns were offset by
an appreciation in the dollar relative to the euro. Conversely, the dollar depreciated relative to the
Swiss franc, yielding an even higher total return on the Swiss stock. Given exchange rates, select
the stock issued by Swisscom.
15. If the stock falls by 50%, Bob’s stock would be worth $12,500 ($25,000/2). To get back to $25,000,
the stock would have to increase by 100%.
16. (a) You should buy Eurodollars. You expect that the euro will become more valuable in six months,
such that the cost of one dollar will go from 1.02 Euros to 0.8941 Euros in six months.
(b) At a rate of 1.02 Euros/Dollar, $10,000 will buy 10,200 Euros. At a rate of 0.8941 Euros/Dollar,
10,200 Euros will buy $11,408.12. Profit is $11,408.12 – $10,000  $1,408.12.

Solutions to Case Problems
Case 6.1
Sara decides to take the plunge
The purpose of this case is to provide the student with the opportunity to identify investment needs,
establish investment goals, and design an investment program.
(a) Since Sara is so successful, she can easily provide for the necessities of life. Other than a minimum
savings account to meet emergency needs, her savings should not be held for the long haul in these
accounts. Keeping money tied up in low yielding savings accounts is costly, since the lower yields
mean much slower growth of capital—in short, Sara will end up with a lot less money than if she’d
put it into something with a higher return (like stocks). As an aside, Sara should make sure that any
money she keeps in savings (i.e., for emergency purposes) is put into higher yielding short-term
vehicles such as money funds, short-term CD’s, or MMDA’s. Although common stocks involve more
risk and may not be a perfect hedge against inflation, they will generally earn higher returns than basic
savings accounts and as such, Sara should seriously consider putting some of her money into stocks
(or some other form of equity security). Because of the positive effects that such investments have on
the long-run accumulation of capital, equity securities should be a part of most portfolios, especially
for younger people.
(b) Because of her high current income, Sara does not need investments to provide income now. She does
need securities for capital accumulation and as a store of value (protect loss in purchasing power due
to inflation)
1. North Atlantic Swimsuit Company (NASS) might meet Sara’s needs, but it is a highly speculative
stock. The capital accumulation and storage of value benefits from this security are difficult to
predict. Certainly Sara’s income and personal position justify some risk, but probably not as her
only investment. If she purchases NASS, she needs to be able to monitor the firm closely. She
should be prepared to sell if its growth prospects suddenly dim. And she should purchase other,
less risky securities as well.
2. Town and Country Computer best fills these needs. It is a classic growth firm: long record of
growth, quality firm, excellent prospects. The modest dividend is unimportant now, and the stock
should provide for storage of value as well as capital accumulation.
Chapter 6
Common Stocks
119
3. Southeastern Public Utility Company does not meet Sara’s needs; it has a high current dividend
and low growth prospects. Without at least average growth, the stock cannot serve as a store of
value, since inflation will cause the value of the investment to fall. On the other hand, given the
recent changes in the tax laws for dividends, this stock could represent a decent growth
opportunity if the dividends are reinvested. This would also provide some income in the event
her employment situation changes.
4. International Gold Mines may serve as a source of capital accumulation, but its price volatility
makes it questionable as a store of value. Certainly its defensive characteristics make it attractive
during periods of high inflation when the price of gold is increasing. However, when inflation
moderates, it may fail to provide the spectacular performance it has had in inflationary times. A
key here should be Sara’s expectations concerning inflation. If she expects inflation to accelerate
at a high rate, this stock may suit her.
Of the four options, Town and Country best serves her needs, and Southeastern Utilities is least
attractive. The other two, more speculative stocks, fall in between with their appeal a function of
their long-term growth prospects (NASS) and expectations about inflation (International Gold
Mines).
(c) Sara should follow a buy-and-hold or a quality long-term growth strategy. A high-income strategy
does not fit her needs; she does not have the expertise to handle aggressive stock management
(although her investment advisor might help her here); and the speculative, short-term strategy does
not match her requirements or abilities. Given her new entry into the area of investments, she should
probably begin with the buy-and-hold strategy and plan to adopt a quality long-term growth strategy
as she develops a better understanding of the market and if she has the time to devote to investment
management. Through such a program, common stocks should enable her to enjoy long-term growth
in capital. For Sara, common stocks are an ideal investment vehicle since they should provide the type
of investment return (capital gain) she is (or should be) seeking. One of the key attributes of common
stock is its potential for capital appreciation, and this is precisely what Sara should go after.
Case 6.2 Wally Wonders Whether There’s A Place for Dividends
This case illustrates the common practice of changing investment vehicles in reaction to market changes.
This case should allow students to experience some of the steps involved in following an investment
strategy, as it demonstrates that during an economic downswing, even an investor interested in long-term
growth may have something to gain by going after stocks that offer attractive dividend yields.
(a) Wally’s existing plan is one of long-term growth, obtained by investing in quality issues. Given his
high income and the limited time he has to devote to his security holdings, this strategy (of quality
growth) seems appropriate for him.
(b) 1. Expected dividends for Hydro-Electric:
Year
2004
2005
2006
2007
2008
(1)
Expected EPS
$3.25
3.40
3.90
4.40
5.00
(2)
Expected
Dividend Payout Ratio
40%
40
45
45
45
(3)
(1)  (2)
Expected Dividend
$1.30
1.36
1.76
1.98
2.25
120
Gitman/Joehnk • Fundamentals of Investing, Ninth Edition
2. Wally could purchase 100 shares of Hydro-Electric stock ($6,000 investment/$60 per share).
Expected returns would be a function of dividends and capital gains. First, dividend income over
the five years would be:
Year
2004
2005
2006
2007
2008
Dividends
per Share
$1.30
1.36
1.76
1.98
2.25

100 Shares

100


100


100


100


100


Total dividends for 5 years:
Total
$130
136
176
198
225
$865
Now, assuming he can sell the stock for $80 per share in five years, his 100 shares will bring
$8,000 and his capital gains would be: $8,000 – $6,000  $2,000.
Therefore:
Total return
 Total dividends  Capital gains
 $865  $2,000
 $2,865
3. If Wally joins the company’s Dividend Reinvestment Plan, he can obtain shares at reduced prices
and hence can achieve his goal of capital appreciation.
Wally will obtain additional shares as follows:
(1)
(2)
(3)
(4)
No. of Shares
Held at
Beginning
Dividends
Total
Year
of Year
per Share Dividends
2004
100.00
$1.30
$130.00
2005
102.60
1.36
139.54
2006
105.14
1.76
185.05
2007
108.22
1.98
214.28
2008
111.52
2.25
250.92
Number of additional shares purchased through the DRP
Number of shares bought originally
(5)
(6)
Purchase
Price
per Share
$50
55
60
65
70
No. of Shares
Purchased
(4)  (5)
2.60
2.54
3.08
3.30
3.58
15.10
100.00
Total
115.10
Using the Dividend Reinvestment Plan, Wally would have accumulated 15.10 additional shares,
for a total of 115.10 shares by the end of 2008. With the stock trading at $80 on December 31,
2008, his shares would be worth 115.10  $80  $9,208.
Note: The figure shown in column (2) is the number of shares held at the beginning of the year;
this number will increase each year with the dividends reinvested. This increases the total
dividends received each year. Compare this answer with 2(b). Thus, dividend reinvestment plans
have a cascading effect.
Chapter 6
Common Stocks
121
(c) Wally would not be going to a different investment strategy if he buys the shares of Hydro-Electric; he
would merely be changing the thrust of it. This is a common strategy used by aggressive investors
following a long-term growth program. Of course, when conditions change, Wally would go back to
investing in long-term growth stocks. In that sense, his trading would be increased. However, since the
number of trades should not be too many, this should not be a serious drain on his time.

Outside Project
Chapter 6: Just What Kind of Stock Is It, Anyway?
The text describes a number of different types of common stocks: blue chips, income stocks, growth
stocks, speculative, cyclical, defensive, and small cap stocks. Each type can be characterized by their
sensitivity to the economy, which is an important market factor and which may be measured by the beta of
the company. They may also be characterized by their dividend yield. High yielding companies have fewer
investment opportunities, so they pay higher dividends and investors expect more of their return in the
form of dividends. The purpose of this project is to see if betas and dividend yields do, indeed, behave as
expected for the various types of stocks identified above.
Value Line publishes betas and dividend yields for about 1700 companies. Using the companies listed in
the text, and other similar companies that you can identify in Value Line, find the betas and dividend
yields for five companies in each of the seven (7) stock categories defined above (i.e., find the betas and
dividend yields for 5 blue chips, 5 income stocks, 5 growth companies, 5 speculative stocks, 5 cyclicals,
5 defensive, and 5 small cap stocks). Next, calculate the average beta and average dividend yield for each
type of stock—that is, find the average beta and dividend yield for the 5 blue chip stocks, then find the
average beta and dividend yield for the 5 income stocks, etc. Now, what conclusions can you draw about
risk and return based on your observations for each type of stock? (Note: Be sure your information is
current.