S uppose you buy a new car that costs $20,000 and you pay cash for it.

S uppose you buy a new car that costs $20,000 and you pay cash for it.

You will own it completely. The value of your investment in the car— your equity—is the value of the car, $20,000. If, instead, you pay 10% in cash and finance the rest with a car loan, your equity is 10% of the value of the car, or $2,000. Your equity in the car is the value of the car, less any debt obligation. As you pay off your debt or as the car changes in value, your equity in the car changes also.

If you joined together with your roommate to buy the car, each put- ting up $10,000 in cash, you own 50% of the equity in the car and your roommate owns 50%. By sharing ownership, you are sharing the equity.

Like the equity in your car, the equity of a corporation is the value of its ownership. We refer to the equity of a corporation as stock.

A corporation’s stock may be divided into two major types—com- mon stock and preferred stock (discussed in Chapter 17). Both may be split into smaller classes of stock. And each of these classes is split into smaller pieces called shares. This smallest unit of ownership, one share, is represented by a stock certificate. Owners of these shares are referred to as shareholders or stockholders. As a shareholder you are not buying something that is tangible (other than the stock certificate itself), but rather you are buying rights: rights to income, rights to have a say in the corporation’s activities, and so on.

Preferred stock and common stock have different rights. Preferred shareholders are given preference over common shareholders: They have rights to receive income ahead of common shareholders. You see, shareholders receive part of the return on their investment from divi- dends, which are periodic cash payments from the corporation. Divi- dends promised to preferred shareholders must be paid before common shareholders can receive any dividends.

FINANCING DECISIONS

If the firm is liquidated—that is, the business operations stopped— the assets are sold and the proceeds of the sale are distributed to credi- tors and owners. Preferred shareholders are given preference over com- mon shareholders when liquidation proceeds are distributed among the owners. Preferred shareholders receive the liquidation value of their shares before common shareholders can receive anything.

Common stock is the residual ownership of a corporation, residual meaning that creditors and preferred shareholders have the right to the income and assets of a corporation before common shareholders can receive anything. Common shareholders get what is left over.

In this chapter, we take a closer look at the specific features of com- mon stock. In particular, we examine the characteristics of these shares, a firms’ dividend policy (in theory and in practice), and stock repurchases. We take a close look at preferred stock in Chapter 17. We put all the financing pieces—long-term debt, common stock, and preferred stock— together in our discussion of capital structure in Chapter 18.