FINB 314 Ch 7 - Testbank PDF

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CHAPTER 7—VALUATION OF STOCKS AND CORPORATIONS TRUE/FALSE 1. 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. ANS: T OBJ: LO: 7-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Proxy KEY: Bloom’s: Knowledge

2. 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. ANS: T OBJ: LO: 7-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Preemptive right KEY: Bloom’s: Knowledge

3. 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. ANS: F OBJ: LO: 7-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Preemptive right KEY: Bloom’s: Knowledge

4. 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. ANS: T OBJ: LO: 7-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Classified stock KEY: Bloom’s: Knowledge

5. 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. ANS: T OBJ: LO: 7-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Founders' shares KEY: Bloom’s: Knowledge

6. The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. ANS: F OBJ: LO: 7-4 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Total stock returns KEY: Bloom’s: Knowledge

7. 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.

ANS: T OBJ: LO: 7-4 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Common stock cash flows KEY: Bloom’s: Knowledge

8. 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. ANS: F OBJ: LO: 7-4 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Value: investment horizon KEY: Bloom’s: Knowledge

9. 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. ANS: T OBJ: LO: 7-4 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Marginal investor and price KEY: Bloom’s: Knowledge

10. 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. ANS: T OBJ: LO: 7-5 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Constant growth model KEY: Bloom’s: Knowledge

11. According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. ANS: T OBJ: LO: 7-6 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Nonconstant growth model KEY: Bloom’s: Knowledge

12. Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. ANS: T OBJ: LO: 7-7 LOC: TBA 13. dividends. ANS: F OBJ: LO: 7-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Free cash flows and valuation KEY: Bloom’s: Knowledge The corporate valuation model cannot be used unless a company doesn't pay PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Corporate valuation model KEY: Bloom’s: Knowledge

14. Free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. ANS: T OBJ: LO: 7-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Free cash flows and valuation KEY: Bloom’s: Knowledge

15. 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. ANS: F Preferred dividends don't normally grow, and they are not guaranteed. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds LOC: TBA TOP: Preferred stock KEY: Bloom’s: Knowledge 16. 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. ANS: T OBJ: LO: 7-9 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Preferred stock KEY: Bloom’s: Knowledge

MULTIPLE CHOICE

a. b. c. d. e.

ANS: OBJ: LOC: MSC: NOT:

a. b. c. d. e. ANS: OBJ: LOC: MSC:

17. Which of the following statements is CORRECT? 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%. 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. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years. B PTS: 1 DIF: Difficulty: Easy LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Constant growth model KEY: Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer. 18. If a firm's expected growth rate increased then its required rate of return would decrease. fluctuate less than before. fluctuate more than before. possibly increase, possibly decrease, or possibly remain constant. increase. D PTS: 1 DIF: Difficulty: Easy LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Required return KEY: Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual

NOT: Question may require calculations to find the correct answer. 19. You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that you think a. the stock should be sold. b. the stock is a good buy. c. management is probably not trying to maximize the price per share. d. dividends are not likely to be declared. e. the stock is experiencing supernormal growth. ANS: OBJ: LOC: MSC: NOT:

B PTS: 1 DIF: Difficulty: Easy LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Required return KEY: Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

e.

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

ANS: OBJ: LOC: MSC: NOT:

C PTS: 1 DIF: Difficulty: Moderate LO: 7-1 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Preemptive right KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

a. b. c. d.

21. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks, regardless of class, must have the same voting rights. b. All firms have several classes of common stock. c. All common stock, regardless of class, must pay the same dividend. d. Some class or classes of common stock are entitled to more votes per share than other classes. e. All common stocks fall into one of three classes: A, B, and C. ANS: OBJ: LOC: MSC: NOT:

a. b. c. d.

D PTS: 1 DIF: Difficulty: Moderate LO: 7-2 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Classified stock KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer. 22. Which of the following statements is CORRECT? Two firms with the same expected dividend and growth rates must also have the same stock price. 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. 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%. 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 takes into consideration the capital gains investors expect to earn on a stock.

ANS: E Statement e is true, because the expected growth rate is also the expected capital gains yield. All the other statements are false. PTS: NAT: LOC: MSC: NOT:

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Constant growth model KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

23. 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 dividend yield 5 years from now is expected to be 10%. b. The constant growth model cannot be used because the growth rate is negative. c. The company's expected capital gains yield is 5%. d. The company's expected stock price at the beginning of next year is $9.50. e. The company's current stock price is $20. ANS: D Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so P1 must be $10(0.95) = $9.50. Therefore, answer d is correct, while the others are all false. PTS: NAT: LOC: MSC: NOT:

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Declining constant growth KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

24. 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. The stock's dividend yield is 5%. b. The price of the stock is expected to decline in the future. c. The stock's required return must be equal to or less than 5%. d. The stock's price one year from now is expected to be 5% above the current price. e. The expected return on the stock is 5% a year. ANS: D Statement d is true, because the stock price is expected to grow at the dividend growth rate. PTS: NAT: LOC: MSC: NOT:

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Constant growth stock KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

25. 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

A 10%

B 12%

Market price Expected growth a. b. c. d. e.

$25 7%

$40 9%

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

ANS: A The following calculations show that answer a is correct. The others are all wrong.

Expected return Expected growth Dividend yield PTS: NAT: LOC: MSC: NOT:

A 10% 7% 3%

B 12% 9% 3%

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Expected and required returns KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

26. 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. b. c. d. e.

A $25 7% 10%

B $40 9% 12%

The two stocks could not be in equilibrium with the numbers given in the question. A's expected dividend is $0.50. B's expected dividend is $0.75. A's expected dividend is $0.75 and B's expected dividend is $1.20. The two stocks should have the same expected dividend.

ANS: D The following calculations show that answer d is correct. The others are all wrong.

Price Expected growth Expected return

A $25 7% 10%

B $40 9% 12%

A = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $0.75 B = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $1.20 PTS: NAT: LOC: MSC: NOT:

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Expected and required returns KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

27. 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. b. c. d. e.

A $25 10% 15%

B $25 5% 15%

Stock A has a higher dividend yield than Stock B. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. 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. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist. Stock A's expected dividend at t = 1 is only half that of Stock B.

ANS: E Statement e is correct, because if both stocks have the same price and the same required return, and A's growth rate is twice that of B, then A's dividend and dividend yield must be half that of B. This point is illustrated with the following example.

Price g r Div. Yield = r − g = D1 = P(Div Yield) = PTS: NAT: LOC: MSC: NOT:

A $25 10% 15% 5% $1.25

B $25 5% 15% 10% $2.50

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Expected and required returns KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

28. 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 a. b. c. d. e.

X $30 6% 12%

Y $30 4% 10%

Stock Y has a higher dividend yield than Stock X. One year from now, Stock X's price is expected to be higher than Stock Y's price. Stock X has the higher expected year-end dividend. Stock Y has a higher capital gains yield. Stock X has a higher dividend yield than Stock Y.

ANS: B The correct answer is statement b. Both prices are currently the same, but X's price should grow at 6% vs. 4% for Y, so X's price should be higher a year from now.

PTS: NAT: LOC: MSC: NOT:

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Expected and required returns KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

29. 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

$3.00

Current Price, P0

$50

Expected constant growth rate a. b. c. d. e.

6.0%

The stock's expected dividend yield and growth rate are equal. The stock's expected dividend yield is 5%. The stock's expected capital gains yield is 5%. The stock's expected price 10 years from now is $100.00. The stock's required return is 10%.

ANS: A The correct answer choice is a. One could quickly calculate the dividend yield and see that it equals the growth rate, but here are some numbers that provide more information. D1

$3.00

P0 g PTS: NAT: LOC: MSC: NOT:

D1/P0

6.0%

$50.00 rX 6.0%

12.0%

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Expected and required returns KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

30. 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 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. Stock Y pays a higher dividend per share than Stock X.

ANS: A Dividend = Yield × Price:

X dividend = $1.25

Y dividend = $0.75

Stock X has a dividend yield of 5% versus a yield of 3% for Y. Since they both have the same stock

price, X must pay a higher dividend. PTS: NAT: LOC: MSC: NOT:

1 DIF: Difficulty: Moderate OBJ: LO: 7-5 BUSPROG: Analytic STA: DISC: Stocks and bonds TBA TOP: Expected and required returns KEY: Bloom’s: Analysis TYPE: Multiple Choice: ...