Abaarso Tech University

COURSE : FINANCIAL INSTITUION &

MARKETS
Instructor: Abdihakim Abdillahi
Credit Hour: 3 hrs
CHAPTER THREE: Stock Markets
Email: abdi.177@hotmail.com
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• When a firm is created, its founders typically invest their
own money in the business.
• The founders may also invite some family or friends to
invest equity in the business. This is referred to as private
equity because the business is privately held and the owners
can not sell their shares to the public.
• The founders of many firms dream of going public someday
so that they can obtain a large amount of financing to
support the firm’s growth. They may also hope to “cash out”
by selling their original equity investment to others.
• Normally, however, a firm’s owners do not consider going
public until they want to sell at least $50 million in stock.

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Even if a firm wants to sell at least $50 million of stock to
the public, it may not have a long enough history of stable
business performance that it can raise money from a large
number of investors. Private firms that need a large equity
investment but are not yet in a position to go public may
attempt to obtain funding from a venture capital (VC)
fund.
Such funds receive money from wealthy investors and from
pension funds that are willing to maintain the investment for
a long-term period, such as 5 or 10 years. These investors
are not allowed to withdraw their money before a specified
deadline 4
• Stock markets allow suppliers of funds to
efficiently and cheaply get equity funds to
public corporations (users of funds).
• In exchange, the fund users (firms) give the
fund suppliers ownership rights in the firm as
well as cash flows in the form of dividends.
• Thus, corporate stock or equity serves as a
source of financing for firms, in addition to debt
financing or retained earnings financing.
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Common stock is the fundamental ownership claim in a public or
private corporation.
Many characteristics of common stock differentiate it from other types
of financial securities (e.g., bonds, mortgages, preferred stock).

These include :

1. Discretionary dividend payments,

2. Residual claim status,
3. Limited liability, and
4. Voting rights.

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• While common stockholders can potentially
receive unlimited dividend payments if the firm is
highly profitable, they have no special or
guaranteed dividend rights. The payment and size
of dividends are determined by the board of
directors of the issuing firm (who are elected by
the common stockholders).

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• Another drawback with common stock dividends, from
an investor’s viewpoint, is that they are taxed twice—
once at the firm level (at the corporate tax rate, by virtue
of the fact that dividend payments are not tax deductible
from the firm’s profits or net earnings) 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.
• Generally, earnings growth leads to stock price increases
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• Common stockholders have the lowest
priority claim on a corporation’s assets in
the event of bankruptcy—they have a
residual claim.
• Only after all senior claims are paid (i.e.,
payments owed to creditors such as the
firm’s employees, bond holders, the
government (taxes), and preferred
stockholders) are common stockholders
entitled to what assets of the firm are left9
• Limited liability: implies that common
stockholder losses are limited to the amount of
their original investment in the firm if the
company’s asset value falls to less than the
value of the debt it owes.
• That is, the common stockholders’ personal
wealth held outside their ownership claims in
the firm are unaffected by bankruptcy of the
corporation

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• In contrast, sole proprietorship or partnership
stock interests mean the stockholders may be
liable for the firm’s debts out of their total
private wealth holdings if the company gets
into financial difficulties and its losses
exceed the stockholders’ ownership claims in
the firm.
• This is the case of “unlimited” liability.
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• A fundamental privilege assigned to
common stock is voting rights. While
common stockholders do not exercise
control over the firm’s daily activities (these
activities are overseen by managers hired to
act in the best interests of the firm’s
common stockholders and bond holders),
• They do exercise control over the firm’s
activities indirectly through the election of
the board of directors. 12
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• Shareholders exercise their voting rights, electing the
board of directors by casting votes at the issuing firm’s
annual meeting or by mailing in a proxy vote..
• One of the methods of electing a board of directors are
generally used:
1. Cumulative voting

 Cumulative voting: With cumulative voting, all

directors up for election, as nominated by the
shareholders and selected by a committee of the board,
are voted on at the same time 13
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 Preferred Stock Drawbacks
1. The first drawback: is that, if a preferred
dividend payment is missed, new investors may
be reluctant to make investments in the firm.
Thus, firms are generally unable to raise any new
capital until all missed dividend payments are
paid on preferred stock
2. preferred stock: dividends affects the net profit
available to common stockholders of the firm.

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 Types of Preferred Stock
• Typically, preferred stock is nonparticipating and
cumulative.
1. Non-participating preferred stock: means
that the preferred stock dividend is fixed
regardless of any increase or decrease in the
issuing firm’s profits.
2. Cumulative preferred stock: means that any
missed dividend payments go into arrears and
must be made up before any common stock
dividends can be paid.
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• In contrast, participating preferred stock means
that actual dividends paid in any year may be greater
than the promised dividends. In some cases, if the
issuing firm has an exceptionally profitable year,
preferred stockholders may receive some of the high
profits in the form of an extra dividend payment.

• If preferred stock is noncumulative,

missed dividend payments do not go into arrears and
are never paid.

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SECTION II

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 1. Capital markets
• Capital markets provide funds for long term use.
• There is no strict definition of ‘long term’ but the
original maturity of the debts will usually be
more than five years.
• The main instruments which are traded in these
markets are bonds and equities or company
shares.
– Many bonds are issued with a projected life of more
than twenty years, while a company’s shares have no
specified maturity but continue for as long as the
firm exists.
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• A capital market is -
a market for securities (debt or equity), where business
enterprises (companies) and governments
can raise long-term funds.

It is defined as a market in which money is provided for

periods longer than a year, as the raising of short-term
funds takes place on other markets (the money market).
The capital market includes the stock market (equity
securities) and the bond market (debt).

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• Capital markets may be classified as: primary
markets and secondary markets
• In primary markets, new stock or bond issues
are sold to investors via a mechanism known
as underwriting.
• In the secondary markets, existing securities
are sold and bought among investors or
traders, usually on a securities exchange, over-
the-counter, or elsewhere.

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 IPO
• A primary market sale may be a first-time issue by
a private firm going public (i.e., allowing its
equity, some of which was held privately by
managers and venture capital investors, to be
publicly traded in stock markets for the first
time). These first-time issues are also referred to
as initial public offerings (IPOs).

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• corporate stocks may initially be
issued through either a public sale
(where the stock issue is offered to
the general investing public) or a
private placement (where stock is
sold privately to a limited number of
large investors).
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• This means that before a seasoned offering of
stock can be sold to outsiders, the new shares
must first be offered to existing shareholders
in such a way that they can maintain their
proportional ownership in the corporation.
• NOTE: (i.e., the issuing firm avoids
the expense of an underwritten
offering).
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