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day. Shares commonly are traded in round lots of 100 shares each. Investors who wish to trade
in smaller “odd lots” generally must pay higher commissions to their stockbrokers. The last,
or closing, price of $37.25 was up $.10 from the closing price of the previous day.

Preferred Stock
Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay preferred stock
to its holder a fixed stream of income each year. In this sense, preferred stock is similar to an Nonvoting shares in a
infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not give the corporation, usually
holder voting power regarding the firm™s management. paying a fixed stream
of dividends.
Preferred stock is an equity investment, however. The firm retains discretion to make the
dividend payments to the preferred stockholders: It has no contractual obligation to pay those
dividends. Instead, preferred dividends are usually cumulative; that is, unpaid dividends cu-
mulate and must be paid in full before any dividends may be paid to holders of common stock.
In contrast, the firm does have a contractual obligation to make the interest payments on the
debt. Failure to make these payments sets off corporate bankruptcy proceedings.
Preferred stock also differs from bonds in terms of its tax treatment for the firm. Because
preferred stock payments are treated as dividends rather than as interest on debt, they are not
tax-deductible expenses for the firm. This disadvantage is largely offset by the fact that cor-
porations may exclude 70% of dividends received from domestic corporations in the compu-
tation of their taxable income. Preferred stocks, therefore, make desirable fixed-income
investments for some corporations.
Even though preferred stock ranks after bonds in terms of the priority of its claim to the as-
sets of the firm in the event of corporate bankruptcy, preferred stock often sells at lower yields
than corporate bonds. Presumably this reflects the value of the dividend exclusion, for risk
considerations alone indicate that preferred stock ought to offer higher yields than bonds. In-
dividual investors, who cannot use the 70% exclusion, generally will find preferred stock
yields unattractive relative to those on other available assets.
Corporations issue preferred stock in variations similar to those of corporate bonds. Pre-
ferred stock can be callable by the issuing firm, in which case it is said to be redeemable. It
also can be convertible into common stock at some specified conversion ratio. A relatively re-
cent innovation in the market is adjustable-rate preferred stock, which, like adjustable-rate
mortgages, ties the dividend rate to current market interest rates.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

42 Part ONE Elements of Investments

Stock Market Indexes
The daily performance of the Dow Jones Industrial Average is a staple portion of the
evening news report. While the Dow is the best-known measure of the performance of the
stock market, it is only one of several indicators. Other more broadly based indexes are
computed and published daily. In addition, several indexes of bond market performance
are widely available.
The ever-increasing role of international trade and investments has made indexes of foreign
financial markets part of the general news. Thus, foreign stock exchange indexes such as the
Nikkei Average of Tokyo and the Financial Times index of London have become household

Dow Jones Averages
The Dow Jones Industrial Average (DJIA) of 30 large, “blue-chip” corporations has been com-
puted since 1896. Its long history probably accounts for its preeminence in the public mind.
(The average covered only 20 stocks until 1928.)
Originally, the DJIA was calculated as the simple average of the stocks included in the in-
dex. So, if there were 30 stocks in the index, one would add up the value of the 30 stocks and
divide by 30. The percentage change in the DJIA would then be the percentage change in the
average price of the 30 shares.
This procedure means that the percentage change in the DJIA measures the return (exclud-
ing any dividends paid) on a portfolio that invests one share in each of the 30 stocks in the in-
dex. The value of such a portfolio (holding one share of each stock in the index) is the sum of
the 30 prices. Because the percentage change in the average of the 30 prices is the same as the
percentage change in the sum of the 30 prices, the index and the portfolio have the same per-
centage change each day.
An average computed
The Dow measures the return (excluding dividends) on a portfolio that holds one share of
by adding the prices
each stock, so it is called a price-weighted average. The amount of money invested in each
of the stocks and
company represented in the portfolio is proportional to that company™s share price.
dividing by a “divisor.”

Consider the data in Table 2.4 for a hypothetical two-stock version of the Dow Jones Average.
Stock ABC sells initially at $25 a share, while XYZ sells for $100. Therefore, the initial value
2.2 EXAMPLE of the index would be (25 100)/2 62.5. The final share prices are $30 for stock ABC and
$90 for XYZ, so the average falls by 2.5 to (30 90)/2 60. The 2.5 point drop in the in-
dex is a 4% decrease: 2.5/62.5 .04. Similarly, a portfolio holding one share of each stock
would have an initial value of $25 $100 $125 and a final value of $30 $90 $120,
for an identical 4% decrease.
Notice that price-weighted averages give higher-priced shares more weight in determining
the performance of the index. For example, although ABC increased by 20% while XYZ fell
by only 10%, the index dropped in value. This is because the 20% increase in ABC repre-
sented a smaller price gain ($5 per share) than the 10% decrease in XYZ ($10 per share).
The “Dow portfolio” has four times as much invested in XYZ as in ABC because XYZ™s price
is four times that of ABC. Therefore, XYZ dominates the average.

You might wonder why the DJIA is now (in mid-2002) at a level of about 8,500 if it is sup-
posed to be the average price of the 30 stocks in the index. The DJIA no longer equals the av-
erage price of the 30 stocks because the averaging procedure is adjusted whenever a stock
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

2 Global Financial Instruments

Initial Value of Final Value of
TA B L E 2.4 Initial Final Shares Outstanding Stock Outstanding Stock
Data to construct Stock Price Price (millions) ($ million) ($ million)
stock price indexes
ABC $25 $30 20 $500 $600
XYZ 100 90 1 100 90
Total $600 $690

Initial Value of Final Value of
TA B L E 2.5 Initial Final Shares Outstanding Stock Outstanding Stock
Data to construct Stock Price Price (millions) ($ million) ($ million)
stock price indexes
after a stock split ABC $25 $30 20 $500 $600
XYZ 50 45 2 100 90
Total $600 $690

splits, pays a stock dividend of more than 10%, or when one company in the group of 30 in-
dustrial firms is replaced by another. When these events occur, the divisor used to compute the
“average price” is adjusted so as to leave the index unaffected by the event.
For example, if XYZ were to split two for one and its share price to fall to $50, we would
not want the average to fall, as that would incorrectly indicate a fall in the general level of
market prices. Following a split, the divisor must be reduced to a value that leaves the average
unaffected by the split. Table 2.5 illustrates this point. The initial share price of XYZ, which
was $100 in Table 2.4, falls to $50 if the stock splits at the beginning of the period. Notice that
the number of shares outstanding doubles, leaving the market value of the total shares unaf-
fected. The divisor, d, which originally was 2.0 when the two-stock average was initiated,
must be reset to a value that leaves the “average” unchanged. Because the sum of the postsplit
stock prices is 75, while the presplit average price was 62.5, we calculate the new value of d
by solving 75/d 62.5. The value of d, therefore, falls from its original value of 2.0 to 75/62.5
1.20, and the initial value of the average is unaffected by the split: 75/1.20 62.5.
At period-end, ABC will sell for $30, while XYZ will sell for $45, representing the same
negative 10% return it was assumed to earn in Table 2.4. The new value of the price-weighted
average is (30 45)/1.20 62.5. The index is unchanged, so the rate of return is zero, greater
than the 4% return that would be calculated in the absence of a split. The relative weight of
XYZ, which is the poorer-performing stock, is reduced by a split because its price is lower; so
the performance of the average is higher. This example illustrates that the implicit weighting
scheme of a price-weighted average is somewhat arbitrary, being determined by the prices
rather than by the outstanding market values (price per share times number of shares) of the
shares in the average.
Because the Dow Jones averages are based on small numbers of firms, care must be taken
to ensure that they are representative of the broad market. As a result, the composition of the
average is changed every so often to reflect changes in the economy. The last change took
place on November 1, 1999, when Microsoft, Intel, Home Depot, and SBC Communications
were added to the index, and Chevron, Goodyear Tire & Rubber, Sears, Roebuck, and Union
Carbide were dropped. The nearby box presents the history of the firms in the index since
1928. The fate of many companies once considered “the bluest of the blue chips” is striking
evidence of the changes in the U.S. economy in the last 75 years.
In the same way that the divisor is updated for stock splits, if one firm is dropped from the
average and another firm with a different price is added, the divisor has to be updated to leave
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

How the 30 Stocks in the Dow Jones Industrial Average
Have Changed since Oct. 1, 1928

Oct. 1, 1928 1929 1930s 1940s 1950s 1960s 1970s 1980s 1990s Nov. 1, 1999

Alcoa* (™99)
Wright Aeronautical Curtiss-Wright (™29) Hudson Motor (™30) Aluminum Co. of
Coca-Cola (™32) America (™59)
National Steel (™35)

Allied Signal* (™85) Honeywell*
Allied Chemical & Dye

North American Johns-Manville (™30) Amer. Express (™82) American Express

Victor Talking Machine Natl Cash Register IBM (˜32) AT&T
(™29) AT&T (™39)

International Nickel Inco Ltd.* (™76) Boeing (™87) Boeing
International Harvester Navistar (™86) Caterpillar (™91) Caterpillar

Citigroup* (™98)
Westinghouse Electric Travelers Group (™97)

Texas Gulf Sulphur Intl. Shoe (™32) Owens-Illinois (™59) Coca-Cola (™87) Coca-Cola
United Aircraft (™33)
National Distillers (™34)

American Sugar Borden (™30) DuPont
DuPont (™35)

American Tobacco (B) Eastman Kodak (™30) Eastman Kodak
Standard Oil (N.J.) Exxon (™72)

General Electric General Electric

General Motors General Motors

Texaco* (™59)
Texas Corp. Hewlett-Packard (™97) Hewlett-Packard

Home Depot†
Sears Roebuck

Chrysler IBM (™79) IBM

Atlantic Refining Goodyear (™30)

Paramount Publix Loew™s (™32) Intl. Paper (™56) International Paper

Bethlehem Steel Johnson & Johnson Johnson & Johnson

General Railway Signal Liggett & Myers (™30) McDonald™s (™85) McDonald™s
Amer. Tobacco (™32)

Esmark* (™73)
Mack Trucks Drug Inc. (™32) Swift & Co. (™59) Merck
Corn Products (™33) Merck (™79)

Union Carbide

American Smelting Anaconda (™59) Minn. Mining (™76) Minn. Mining (3M)

Primerica* (™87)
American Can J.P Morgan (™91)
. J.P Morgan
Postum Inc. General Foods (™29) Philip Morris (™85) Philip Morris

Nash Motors United Air Trans. (™30) Procter & Gamble
Procter & Gamble (™32)

Goodrich Standard Oil (Calif) (™30) Chevron* (™84) SBC Communications
Radio Corp. Nash Motors (™32) United Tech. (™75) United Technologies
United Aircraft (™39)

Woolworth Wal-Mart Stores (™97) Wal-Mart Stores
U.S. Steel USX Corp. (™86) Walt Disney (™91) Walt Disney

Note: Year of change shown in (); * denotes name change, in some cases because of their shared industry, but the other three incoming stocks are
designated alphabetically next to a departing stock.
following a takeover or merger. To track changes in the components,
begin in the column for 1928 and work across. For instance, American SOURCE: From The Wall Street Journal, October 27, 1999. Reprinted by
Sugar was replaced by Borden in 1930, which in turn was replaced by Du permission of Dow Jones & Company, Inc. via Copyright Clearance
Pont in 1935. Unlike past changes, each of the four new stocks being Center, Inc. © 1999. Dow Jones & Company, Inc. All Rights Reserved
added doesn™t specifically replace any of the departing stocks; it™s simply a Worldwide.


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