FM12 Ch 08 Test Bank PDF

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CHAPTER 8 STOCKS, STOCK VALUATION, AND STOCK MARKET EQUILIBRIUM True/False Easy: (8.1) Proxy 1

Answer: a

.

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. A proxy can be an important tool relating to control of the firm.

a. b.

True False (8.1) Preemptive right

2

Answer: a

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

a. b.

True False Answer: b

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. b.

True False Answer: a

EASY

.

When a corporation's shares are owned by a few individuals who are associated with the firm's management, we say that the stock is "closely held."

a. b.

True False (8.1) Public company

5

EASY

.

(8.1) Closely held stock 4

EASY

.

(8.1) Preemptive right 3

EASY

Answer: a

EASY

.

A publicly owned corporation is a company whose shares are held by the investing public, which may include other corporations as well as institutional investors.

a. b.

True False

Chapter 8: Stocks, Equilibrium

True/False

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(8.2) Classified stock 6

Answer: a

.

Classified stock differentiates different 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. b.

True False (8.2) Founders' shares

7

Answer: a

.

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. b.

True False (8.4) Total stock returns

8

Answer: b

EASY

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. b.

True False

.

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stocks only have residual claims against the company.

a. b.

True False

(8.4) Common stock cash flows 9

EASY

Answer: a

(8.4) Stock valuation 10

Answer: b

EASY

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. b.

True False (8.5) Constant growth model

11

Answer: a

EASY

.

The constant growth DCF model used to evaluate the prices of common stocks is essentially the same as the model used to find the price of perpetual preferred stock or any other perpetuity.

a. b.

True False

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True/False

Chapter 8: Stocks, Equilibrium

(8.7) Nonconstant growth model 12

Answer: a

EASY

.

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.

a. b.

True False (8.11) Marginal investor and price

13

Answer: a

.

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. b.

True False (8.12) Efficient markets hypothesis

14

Answer: b

EASY

EASY

.

If security markets were truly strong-form efficient, one could never earn a realized return on a stock greater than the marginal investor's expected (and required) rate of return on the stock.

a. b.

True False

Medium: (8.1) Proxy fight 15

Answer: b

MEDIUM

.

A proxy fight generally is a battle between management and a group of stockholders who want to install a new management team that will operate the firm differently, or possibly break it up or sell it. Under most companies' bylaws, the dissident group must obtain 80% or more of the votes in order to prevail.

a. b.

True False (8.11) Stock market equilibrium

16

Answer: b

MEDIUM

.

If two firms have the same current dividend and the same expected dividend growth rate, their stocks must sell at the same current price or else the market will not be in equilibrium.

a. b.

True False

Chapter 8: Stocks, Equilibrium

True/False

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Multiple Choice: Conceptual Easy: (8.4) Required return 17

Answer: e

EASY

.

An increase in a firm’s expected growth rate would normally cause its required rate of return to

a. b. c. d. e.

Increase. Decrease. Fluctuate less than before. Remain constant. Possibly increase, possibly decrease, or possibly have no effect. (8.4) Required return

18

Answer: c

EASY

.

If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that

a. b. c. d.

The investor thinks The investor thinks The investor thinks The investor thinks price per share. The investor thinks

e.

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 dividends are not likely to be declared.

(8.5) Constant growth model 19

Answer: c

EASY

.

Which of the following statements is CORRECT?

a.

The constant growth model is often appropriate to evaluate start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next year or so. 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 5%. The stock valuation model, P0 = D1/(rs - g), can be used for firms that have expected negative, but constant, growth rates. 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.

b.

c. d. e.

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Conceptual Questions

Chapter 8: Stocks, Equilibrium

(8.12) Efficient markets hypothesis 20

Answer: b

EASY

.

Which of the following statements is CORRECT?

a.

Semistrong-form market efficiency implies that as soon as any public or private information comes into being it is incorporated into stock prices. Weak-form market efficiency implies that recent trends in stock prices are of no use in predicting future stock prices. Market efficiency implies that all stocks should have the same expected return. According to strong-form market efficiency, insiders would find it possible to consistently earn abnormal returns in the stock market even if they have superior knowledge about the company. Studies of the Efficient Markets Hypothesis suggest that neither the weak-form nor the semi-strong forms of efficiency hold, especially for larger companies. However, the market appears to be strong-form efficient because institutional traders make abnormal profits.

b. c. d.

e.

(8.12) Efficient markets hypothesis 21

Answer: e

EASY

.

Which of the following statements is CORRECT?

a.

The Efficient Markets Hypothesis suggests that the market does not price stocks fairly; hence, managers should make decisions based on the premise that firms' stocks are undervalued or overvalued. An individual who has information about past stock prices would be able to profit from this information if weak-form market efficiency exists. An individual who has inside information about a publicly traded company should be able to profit from this information if strong-form market efficiency exists. For the Efficient Markets Hypothesis to hold true, every individual investor must be "rational." Semistrong-form market efficiency means that stock prices reflect all public, but not necessarily all private, information.

b. c.

d. e.

(8.12) Efficient markets hypothesis 22

Answer: c

EASY

.

Most studies of stock market efficiency suggest that the stock market is highly efficient in the weak form and reasonably efficient in the semistrong form. (This is true.) Based on these findings, which of the following statements is CORRECT?

a.

Information disclosed in companies’ most recent annual reports can be used to consistently beat the market. The stock price for a company has been increasing for the past 6 months. Based on this information, it must be true that the stock price will also increase during the current month. Information you read in The Wall Street Journal today cannot be used to select stocks that will consistently beat the market. Stock prices will respond whenever financial information is released to the public. It does not matter whether this financial information had been expected or not. Managers who have inside information that is not available to the public cannot consistently earn abnormal returns, i.e., returns that are higher than those predicted by the SML.

b.

c. d.

e.

Chapter 8: Stocks, Equilibrium

Conceptual Questions

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Easy/Medium: (8.4) Required return 23

Answer: b

EASY/MEDIUM

.

Stock A has a required return of 10% and a price of $25, and its dividend is expected to grow at a constant rate of 7% per year. Stock B has a required return of 12% and a price of $40, and its dividend is expected to grow at a constant rate of 9% per year. Which of the following statements is CORRECT?

a.

If the stock market price. The two stocks have If the stock market expected return. The two stocks have The two stocks have

b. c. d. e.

were efficient, these two stocks would have the same the same dividend yield. were efficient, these two stocks would have the same the same expected capital gains yield. the same expected year-end dividend.

Medium: (8.1) Preemptive right 24

Answer: d

MEDIUM

.

The preemptive right is important to shareholders because it

a. b. c. d.

Allows managers to buy additional shares below the current market price. 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.

e.

(8.2) Classified stock 25

Answer: e

MEDIUM

.

Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?

a. b. c. d. e.

All common stocks fall into one of three classes: A, B, and C. All common stocks, regardless of class, must have the same voting rights. All firms have several classes of common stock. All common stock, regardless of class, must pay the same dividend. Some class or classes of common stock may be entitled to more votes per share than other classes. (8.4) Dividend yield and g

26

Answer: a

MEDIUM

.

Stocks A and B have the same price, 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. Stock B must have a higher dividend yield than Stock A. Stock A must have a higher dividend yield than Stock B. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B’s. Stock A must have both a higher dividend yield and a higher capital

b. c. d. e.

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Conceptual Questions

Chapter 8: Stocks, Equilibrium

gains yield than Stock B. (8.5) Declining constant growth stock 27

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’s expected and required rate of return is 15%, which of the following statements is CORRECT?

a. b. c.

The company’s current stock price is $20. The company’s dividend yield 5 years from now is expected to be 10%. The constant growth model cannot be used because the growth rate is negative. The company’s expected capital gains yield is 5%. The company’s stock price next year is expected to be $9.50.

d. e.

(8.5) Constant growth: dividend yield and g 28

Answer: b

MEDIUM

.

If two constant growth stocks have the same price and the same required rate of return, which of the following statements is CORRECT?

a. b.

The two stocks must have the same dividend per share. If one stock has a higher dividend yield, it will also have a lower dividend growth rate. The two stocks have the same dividend growth rate. The two stocks have the same dividend yield. The stock with the higher dividend yield will have the higher dividend growth rate.

c. d. e.

(8.5) Constant growth: dividend yield and g 29

Answer: a

MEDIUM

.

Which of the following statements is CORRECT?

a.

The dividend yield on a constant growth stock must be equal to the stock's expected total return less its expected capital gains return. 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. A stock’s dividend yield can never exceed its expected growth rate. 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. Other things held constant, the higher a company’s beta coefficient, the lower its required rate of return.

b.

c. d. e.

(8.5) Constant growth model 30

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. Two firms with the same expected dividend and growth rate must also have the same stock price. It is appropriate to use the constant growth model to estimate stock value even if the 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

b. c. d.

e.

Chapter 8: Stocks, Equilibrium

Conceptual Questions

Page 277

dividends, discounted at the dividend growth rate. (8.5) Constant growth model 31

Answer: e

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?

a. b. c. d. e.

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. (8.5) Constant growth model

32

Answer: a

MEDIUM

.

Stocks A and B have the same required return and the same price, $25. Stock A’s dividend is expected to grow at a constant rate of 10% per year, while Stock B’s dividend is expected to grow at a constant rate of 5% per year. Which of the following statements is CORRECT?

a. b. c.

Stock A's expected dividend at t = 1 is only half that of Stock B. 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 passes 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 exists.

d. e.

(8.5) Constant growth model 33

Answer: c

MEDIUM

.

Stocks X and Y sell at the same price. Stock X has a required return of 12% while Y's required return is 10%. Stock X’s dividend is expected to grow at a constant rate of 6% a year, while Stock Y’s dividend is expected to grow at a constant rate of 4%. If the market is in equilibrium so that expected returns equal required returns, which of the following statements is CORRECT?

a. b. c.

Stock X has a higher dividend yield than Stock Y. 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.

d. e.

(8.5) Constant growth model 34

Answer: b

MEDIUM

.

Stock X is expected to pay a dividend of $3.00 at the end of the year, i.e., D1 = $3.00, and that dividend is expected to grow at a constant rate of 6% a year. The stock currently trades at a price of $50 a share. Assume that the stock is in equilibrium, that is, the stock’s price equals its intrinsic value. Which of the following statements is CORRECT?

a. b. c.

The stock’s required return is 10%. The stock’s expected dividend yield and growth rate are equal. The stock’s expected dividend yield is 5%.

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Conceptual Questions

Chapter 8: Stocks, Equilibrium

d. e. 35

The stock’s expected capital gains y...