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STOCKS AND THEIR VALUATION CHAPTER 9

(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

Note that there is some overlap between the T/F and the multiple choice questions, as some T/F statements are used in the MC questions. See the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines. Multiple Choice: True/False (9-1) Proxy 1

.

F G

Answer: a

EASY

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. a. True b. False

(9-1) Preemptive right 2

.

F G

Answer: a EASY

The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value. a. True b. False

(9-1) Preemptive right 3

.

F G

Answer: b

EASY

If a firm's stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight. a. True b. False

(9-2) Classified stock 4

.

F G

Answer: a

EASY

Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting control. a. True b. False

(9-2) Founders' shares 5

.

F G

Answer: a

EASY

Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock.

a. True b. False (9-4) Total stock returns 6

.

F G

Answer: b

EASY

The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. a. True b. False

(9-4) Common stock cash flows 7

.

F G

Answer: a

EASY

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. a. True b. False

(9-4) Stock valuation 8

.

F G

Answer: b

EASY

According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock. a. True b. False

(9-4) Marginal investor and price 9

.

F G

Answer: a

EASY

When a new issue of stock is brought to market, it is the marginal investor who determines the price at which the stock will trade. a. True b. False

(9-5) Constant growth model 10

.

F G

Answer: a

EASY

The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities. a. True b. False

(9-6) Nonconstant growth model 11

.

F G

According to the nonconstant growth model discussed discount rate used to find the present value of the during the initial growth period is the same as the to find the PVs of cash flows during the subsequent period.

Answer: a

EASY

in the textbook, the expected cash flows discount rate used constant growth

a. True b. False (9-7) Corporate valuation model

F G

Answer: b

EASY

12

.

The corporate valuation model can be used only when a company doesn't pay dividends. a. True b. False

(9-7) Corporate valuation model 13

.

F G

Answer: b

EASY

The corporate valuation model cannot be used unless a company pays dividends. a. True b. False

(9-7) Free cash flows and valuation 14

.

F G

Answer: a

EASY

Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the firm’s total corporate value. a. True b. False

(9-8) Preferred stock 15

.

F G

Answer: b

EASY

Preferred stock is a hybrid--a sort of cross between a common stock and a bond--in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond. a. True b. False

(9-8) Preferred stock 16

.

F G

Answer: a

EASY

From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer's standpoint, these risk relationships are reversed: bonds are the most risky for the firm, preferred is next, and common is least risky. a. True b. False

Multiple Choice: Conceptual Some of the questions require calculations. (9-5) Constant growth model 17

.

C G

Answer: c

EASY

Which of the following statements is CORRECT? a. The constant growth model is often appropriate for evaluating startup companies that do not have a stable history of growth but are expected to reach stable growth within the next few years. b. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock’s dividend yield is also 5%. c. The stock valuation model, P0 = D1/(rs - g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

e. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time.

(9-5) Required return 18

.

Answer: c

EASY

the stock is experiencing supernormal growth. the stock should be sold. the stock is a good buy. management is probably not trying to maximize the price per share. dividends are not likely to be declared.

(9-1) Preemptive right .

C G

If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the investor thinks a. b. c. d. e.

20

EASY

increase. decrease. fluctuate less than before. fluctuate more than before. possibly increase, possibly decrease, or possibly remain constant.

(9-5) Required return .

Answer: e

An increase in a firm’s expected growth rate would cause its required rate of return to a. b. c. d. e.

19

C G

C G

Answer: d

MEDIUM

The preemptive right is important to shareholders because it a. allows managers to buy additional shares below the current market price. b. will result in higher dividends per share. c. is included in every corporate charter. d. protects the current shareholders against a dilution of their ownership interests. e. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.

(9-2) Classified stock 21

.

C G

Answer: e

MEDIUM

Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks fall into one of three classes: A, B, and C. b. All common stocks, regardless of class, must have the same voting rights. c. All firms have several classes of common stock. d. All common stock, regardless of class, must pay the same dividend. e. Some class or classes of common stock are entitled to more votes per share than other classes.

(9-5) Required return 22

.

C G

a. b. c. d. e.

A 10% $25 7%

These These These These These

two two two two two

stocks stocks stocks stocks stocks

B 12% $40 9%

should have the same price. must have the same dividend yield. should have the same expected return. must have the same expected capital gains yield. must have the same expected year-end dividend.

(9-5) Required return .

MEDIUM

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Required return Market price Expected growth

23

Answer: b

C G

Answer: e

MEDIUM

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Price Expected growth Expected return

A $25 7% 10%

B $40 9% 12%

a. The two stocks should have the same expected dividend. b. The two stocks could not be in equilibrium with the numbers given in the question. c. A's expected dividend is $0.50. d. B's expected dividend is $0.75. e. A's expected dividend is $0.75 and B's expected dividend is $1.20. (9-5) Dividend yield and g 24

.

C G

Answer: a

MEDIUM

Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? a. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B’s. b. Stock B must have a higher dividend yield than Stock A. c. Stock A must have a higher dividend yield than Stock B. d. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B’s. e. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B.

(9-5) Dividend yield and g 25

.

C G

Answer: b

MEDIUM

Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? a. The two stocks must have the same dividend per share. b. If one stock has a higher dividend yield, it must also have a lower dividend growth rate. c. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. d. The two stocks must have the same dividend growth rate. e. The two stocks must have the same dividend yield.

(9-5) Dividend yield and g 26

.

C G

Answer: a

MEDIUM

Which of the following statements is CORRECT, assuming stocks are in equilibrium? a. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield. b. Assume that the required return on a given stock is 13%. If the stock’s dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well. c. A stock’s dividend yield can never exceed its expected growth rate. d. A required condition for one to use the constant growth model is that the stock’s expected growth rate exceeds its required rate of return. e. Other things held constant, the higher a company’s beta coefficient, the lower its required rate of return.

(9-5) Declining constant growth stk. 27

.

C G

Answer: e

MEDIUM

A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT? a. The company’s current stock price is $20. b. The company’s dividend yield 5 years from now is expected to be 10%. c. The constant growth model cannot be used because the growth rate is negative. d. The company’s expected capital gains yield is 5%. e. The company’s expected stock price at the beginning of next year is $9.50.

(9-5) Constant growth model 28

.

C G

Answer: a

MEDIUM

Which of the following statements is CORRECT? a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. b. Two firms with the same expected dividend and growth rate must also have the same stock price. c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock’s dividend yield is also 5%. e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

(9-5) Constant growth model 29

.

C G

The expected return on the stock is 5% a year. The stock’s dividend yield is 5%. The price of the stock is expected to decline in the future. The stock’s required return must be equal to or less than 5%. The stock’s price one year from now is expected to be 5% above the current price.

(9-5) Constant growth model .

MEDIUM

If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. b. c. d. e.

30

Answer: e

C G

Answer: a

MEDIUM

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Price Expected growth (constant) Required return

A $25 10% 15%

B $25 5% 15%

a. Stock A's expected dividend at t = 1 is only half that of Stock B. b. Stock A has a higher dividend yield than Stock B. c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. d. Since Stock A’s growth rate is twice that of Stock B, Stock A’s future dividends will always be twice as high as Stock B’s. e. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist.

(9-5) Constant growth model 31

.

C G

Answer: c

MEDIUM

Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Price Expected growth (constant) Required return

X $30 6% 12%

Y $30 4% 10%

a. Stock X has a higher dividend yield than Stock Y. b. Stock Y has a higher dividend yield than Stock X. c. One year from now, Stock X’s price is expected to be higher than Stock Y’s price. d. Stock X has the higher expected year-end dividend. e. Stock Y has a higher capital gains yield. (9-5) Constant growth model 32

.

C G

a. b. c. d. e.

The The The The The

stock’s stock’s stock’s stock’s stock’s

required expected expected expected expected

$3.00 $50 6.0%

return is 10%. dividend yield and growth rate are equal. dividend yield is 5%. capital gains yield is 5%. price 10 years from now is $100.00.

(9-5) Constant growth model .

MEDIUM

Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT? Expected dividend, D1 Current Price, P0 Expected constant growth rate

33

Answer: b

C G

Answer: b

MEDIUM

Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Price Expected dividend yield Required return a. b. c. d. e.

X $25 5% 12%

Y $25 3% 10%

Stock Y pays a higher dividend per share than Stock X. Stock X pays a higher dividend per share than Stock Y. One year from now, Stock X should have the higher price. Stock Y has a lower expected growth rate than Stock X. Stock Y has the higher expected capital gains yield.

(9-5) Constant growth model 34

.

C G

The The The The The

stock’s dividend yield is 7%. stock’s dividend yield is 8%. current dividend per share is $4.00. stock price is expected to be $54 a share one year from now. stock price is expected to be $57 a share one year from now.

(9-5) Constant growth model and CAPM .

a. b. c. d. e.

Stock Stock Stock Stock Stock

Answer: b

MEDIUM

A 1.10 7.00%

B 0.90 7.00%

A must have a higher stock price than Stock B. A must have a higher dividend yield than Stock B. B’s dividend yield equals its expected dividend growth rate. B must have the higher required return. B could have the higher expected return.

(9-7) Corporate valuation model .

C G

Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Beta Constant growth rate

36

MEDIUM

The expected return on Natter Corporation’s stock is 14%. The stock’s dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? a. b. c. d. e.

35

Answer: d

C G

Answer: b

MEDIUM

Which of the following statements is NOT CORRECT? a. The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends. b. The corporate valuation model discounts free cash flows by the required return on equity. c. The corporate valuation model can be used to find the value of a division. d. An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements. e. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or continuing, value.

(9-7) Corporate valuation model 37

.

C G

Answer: a

MEDIUM

Which of the following statements is CORRECT? a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital. b. To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the weighted average cost of capital. c. To implement the corporate valuation model, we discount projected net income at the weighted average cost of capital. d. To implement the corporate valuation model, we discount projected free cash f...