Über die Autorin bzw. den Autor

Jeffrey B. Little has been a registered investment analyst, serving as senior analyst at a major Wall Street firm and as a vice president of the prominent investment counsel firm, T. Rowe Price Associates.
Lucien Rhodes is a respected financial journalist with several years experience as a senior analyst and portfolio manager in both commercial and investment banking.

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UNDERSTANDING WALL STREET

The McGraw-Hill Companies, Inc.

Contents

Chapter One

Introduction

Every business day, billions of shares of stock are bought and sold. How did these shares originate, and how are their prices determined? For shares to be traded from one person to another, a company must be created. How does it begin? Where does the money come from?

In this chapter, The NewBrite Lighting Company is born and its officers confront the problems that all successful corporations must solve. Directors are elected, shares are issued, profits are reinvested in the business, and dividends are declared. In the process, the reader will see capitalism at work and will gain an appreciation for a great system that has produced the most advanced economy in the world.

The NewBrite Lighting Company

Johnston W. "Jack" Campbell, a young inventor, has just created a brighter, more efficient LED lighting fixture with a superior design. Encouraged by his family and friends, he decides to turn his hobby of improving lights into a full-time business rather than sell his patents to a large lighting company.

Although Jack has savings that could be put into the venture, the amount is far short of the total capital necessary. He estimates that the total cost for the factory, machinery, and initial money required for product inventory to be approximately $2 million.

These "assets" (the factory, machinery, inventory, and remaining capital) would be used to produce the units and maintain the new business. The more fixtures Jack can produce using these assets, the more profitable the business would be.

Jack has calculated that if he could make and sell at least 100,000 units annually, it would cost about $20 to manufacture each unit. In addition, he estimates the sales and marketing expenses for each fixture to be roughly $10.

Since each new lighting fixture would be sold to his customers at the competitive price of $35, his profit (before paying federal, state, and local taxes) would be exactly $5 per unit.

Jack believes that his new enterprise would be beneficial in several ways. Thousands would enjoy using the lights, many people in his community would be earning a living by making and selling the fixtures, and the company would contribute to the welfare of his community, state, and country through the payment of taxes. If Jack could, indeed, manufacture and sell 100,000 light fixtures, this activity would no longer be a hobby; it would be a sizable business.

Now Jack faces a major problem. Where will he get almost $2 million for the factory, machinery, and working capital? He is unable to borrow such a large amount without collateral.

Jack decides to find other investors, frequently called "venture capitalists," who might also see the potential for his idea and be willing to risk some capital to get the venture started.

To interest others, Jack must divide his new business into smaller pieces to give the investors some ownership. Jack realizes, too, that relinquishing some ownership means that he would no longer be entitled to all the profits. However, he is willing to do this to secure the help of others.

After exploring the advantages and disadvantages of the various legal forms of business, he decides to establish a "corporation." The principal reason for choosing a corporation rather than a partnership or any other form is financial liability. Jack learned that no matter which legal structure is used, creditors always have first claim on the assets if the business fails. However, a corporation, as a legal entity, limits the financial risk of the owners to the amount of capital invested. In other words, stockholders owning shares in a corporation are not liable for more than they invest.

Jack forms the corporation under the laws of his state, names it "The NewBrite Lighting Company," and selects a few individuals to act as the board of directors until the first annual meeting of stockholders. At that time, the board of directors will be formally elected by the stockholders.

The directors decide to "issue" 250,000 shares of stock of the 400,000 total possible shares authorized by the company's founding charter (when the company was organized, this number was determined to be the most appropriate for the company's needs). The 250,000 shares are divided between Jack and the venture capitalists in proportion to their agreedupon ownership, determined by the contributions of each. Jack still owns a meaningful amount because of his importance to the company, his fixture patents, and his initial capital. Now it can be said that he and the venture capitalists are, indeed, "stockholders in common."

Each stockholder is a part owner of the company, with the extent of ownership depending upon the number of shares held (someone who holds 50 of the total 250,000 shares issued owns 1/5,000 of the entire company, whereas a person who owns 10,000 shares owns 1/25 of the company). The remaining 150,000 shares could be issued by the directors at a later date if the company finds it necessary. However, at the present time, the ownership of the company is divided into 250,000 pieces. In other words, there are 250,000 shares outstanding of 400,000 shares authorized.

The members of the board of directors, including Jack, are elected by all the stockholders to oversee the affairs of the company. Each share outstanding, according to the company's charter, is entitled to an equal vote in the annual election of the directors.

The NewBrite Lighting Company is now a "private" corporation owned solely by its small group of founders. However, later they might allow the public to participate. If so, stock would be sold to these new investors through the company's "Initial Public Offering" (or "IPO"). But, first, the company needs to establish a "track record" before "going public."

Most of the initial $2 million has been contributed in the form of "equity capital" by the venture capitalists. To raise the remaining capital, the company decides to go into debt. If the corporation were to borrow this money, expecting to repay it in a relatively short period of time, a bank could be approached for a loan. If it needs the money for a longer time period, a few years or more, the company might consider selling bonds.

The NewBrite Lighting Company, being a young, unproven business, would probably be unable to issue bonds backed solely by its word or good name (bonds of this type are called "debentures"). Lenders are usually reluctant to loan money to a new firm without security. Consequently, the company might be asked to put up some property as collateral (bonds of this type are often called "mortgage bonds").

Although The NewBrite Lighting Company would have to pay interest on the money it borrows, present holders would not have to give up any of their ownership, as Jack did when the new stock was issued for equity capital.

On the other hand, the lenders (the bondholders) do have first claim on the company's property if the company fails to repay the debt (such a failure is called a "default").

The Importance of Profits Why would Jack and his associates risk their personal savings to build a factory to manufacture the lights? They could have deposited their money into a bank account rather than investing in the new enterprise. The money would have been safe, and the bank would have paid them interest. Why would anybody be willing to risk...