Answers to Chapter 9 Questions

1. This is because stock market movements are sometimes seen as predictors of economic activity in a country. This is also because corporate stocks may be the most widely held of all financial securities. Most individuals own stock securities either directly through stock purchases or indirectly through pension fund and mutual fund investments, and thus their economic wealth fluctuates closely with the market.

2. While common stockholders can potentially receive unlimited dividend payments if the firm is highly profitable, they have no special or guaranteed dividend rights. Rather, the payment and size of dividends is determined by the board of directors of the issuing firm. Further, unlike interest payments on debt, a corporation does not default if it misses a dividend payment to common stockholders. Thus, common stockholders have no legal recourse if dividends are not received, even if a company is highly profitable and chooses to use these profits to reinvest in new projects and firm growth. Another characteristic of common stock dividends, from an investor’s viewpoint, is that they are taxed twice(once at the firm level (at the corporate tax rate) and once at the personal level (at the personal income tax rate). Investors can partially avoid this double taxation effect by holding stocks in growth firms that reinvest most of their earnings to finance growth rather than paying larger dividends.

3. Common stockholders have the lowest priority claim on a corporation’s assets in the event of bankruptcy. That is, they have a residual claim. Only after all senior claims are paid (i.e., payments owed to creditors, bondholders, and preferred stockholders) are common stockholders entitled to what assets of the firm are left, i.e., the residual. The residual claim feature associated with common stock makes it riskier than