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10.3 Information, Competition, and Stock Prices
1) If you value a stock using a range of stock valuation methods and these valuations
indicate a stock price that is greater than its actual market price, it is most likely that the
stock is under-valued.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
2) In an eicient market, investors will only ind positive-NPV trading opportunities if they
have some form of competitive advantage over other investors.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
3) Valuation models use the relationship between share value, future cash lows, and the
cost of capital to estimate these quantities for a given irm. Realistically, for a publicly
traded irm, what can we reliably use such models to determine?
I. the irm's future cash lows
II. the irm's cost of capital
III. the irm's market price
A) I only
B) II only
C) III only
D) I and II
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
17
4) Praetorian Industries will pay a dividend of $2.50 per share this year and has an equity
cost of capital of 8%. Praetorian's stock is currently trading at $84 per share. By comparing
Praetorian with similar irms, an investor expects that its dividends will grow by up to 5%
per year. What is the best next step that the investor should take regarding Praetorian's
stock?
A) Sell any Praetorian stock that she owns.
B) Short Praetorian's stock.
C) Revise Praetorian's equity cost of capital.
D) Revise her estimate of Praetorian's dividend growth.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
5) On a certain date, Kastbro has a stock price of $37.50, pays a dividend of $0.64, and has
an equity cost of capital of 8%. An investor expects the dividend rate to increase by 6% per
year in perpetuity. He then sells all stocks that he owns in Kastbro. Given Kastbro's share
price, was this a reasonable action?
A) No, since the constant dividend growth rate gives a stock estimate of $37.50.
B) No, since the constant dividend growth rate gives a stock estimate greater than $37.50.
C) Yes, since the constant dividend growth rate gives a stock estimate greater than $37.50.
D) No, since the diference between his calculated stock price and the actual stock price
most likely indicates that his estimate of dividend growth rate was incorrect.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
6) Which of the following is the best statement of the eicient markets hypothesis?
A) Investors with information that a stock had a positive net present value (NPV) will buy it,
while investors with information that a stock had a negative net present value (NPV) will
sell it.
B) Investor's decisions are dependent on complete current information of a irm's cash
lows and accurate predictions of future cash lows.
C) Competition between investors works to make the net present value (NPV) of all trading
opportunities zero.
D) A share's price is the aggregate of the information of many investors.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
18
7) Carbondale Oil announces that a well that it has sunk in a new oil province has shown
the existence of substantial oil reserves. The exploitation of these reserves is expected to
increase Carbondale's free cash low by $100 million per year for eight years. If investors
had not been expecting this news, what is the most likely efect on Carbondale's stock price
upon the announcement, given that Carbondale has 80 million shares outstanding, no debt,
and an equity cost of capital of 11%?
A) no efect
B) rise by $5.15
C) rise by $6.43
D) rise by $7.72
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
8) Advanced Chemical Industries is awaiting the verdict from a court case over whether it
is liable for the clean-up of wastes on a disused factory site. If it is liable, this will result in
a reduction of its free cash low by $11 million per year for ten years. If it is not liable,
there will be no efect. On the close of trading the day before the announcement of the
verdict, Advanced Chemicals was trading at $20 per share. Most investors calculate that
there is a 100% chance that Advanced Chemicals will have a verdict returned against them.
One investor, Jo, has performed extensive research into the outcome of the trial and
estimates that there is no chance Advanced Chemicals will have a verdict returned against
them. Given that Advanced Chemicals has 40 million shares outstanding and an equity cost
of capital of 6% with no debt, Jo's estimate of the value of a share of Advanced Chemicals
would be how much more than the market price?
A) $2.02
B) $20.81
C) $21.01
D) $21.62
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
19
9) Aerelon Airways, a commercial airline, sufers a major crash. As a result, passengers are
considered to be less likely to choose Aerelon as their carrier, and it is expected free cash
lows will fall by $15million per year for ive years. If Aerelon has 55 million shares
outstanding, an equity cost of capital of 10%, and no debt, by how much would Aerelon's
shares be expected to fall in price as a result of this accident?
A) $0.93
B) $1.03
C) $1.14
D) $1.34
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
10) Which of the following should be done by a manager wishing to raise his stock's price?
I. Focus on maximizing the present value (PV) of the free cash low.
II. Focus on accounting earnings.
III. Focus on inancial policy.
A) I only
B) II only
C) I and II
D) II and II
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
11) On a particular day, a mining company reveals that, due to new extraction technology,
the extractable yield from several of its nickel/lead mines has risen by 15%. Which of the
following is the LEAST likely consequence of such an announcement?
A) The price of the stock would rise.
B) Investors would determine that the estimates of the irm's value on the date prior to the
announcement were too high.
C) Investors would increase their forecast of future cash lows in that irm.
D) Investors would revise their estimates of the net present value (NPV) of the irm.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
20
12) What are the implications of the eicient markets hypothesis for corporate managers
regarding accounting earnings?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
10.4 Individual Biases and Trading
1) Individual investors trade conservatively, given the diiculty of inding over-valued and
under-valued stocks.
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
2) Individual investors who grow up and live during a time of high stock returns are more
likely to invest in stocks.
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
3) Individual investors' tendency to trade too much based on the mistaken belief that they
can pick winners and losers better than investment professionals is known as ________.
A) the disposition efect
B) the investor attention hypothesis
C) the investor overconidence hypothesis
D) the excessive trading costs hypothesis
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
21
4) A study of trading behavior of individual investors at a discount brokerage found that
individual investors ________.
A) trade very actively, despite the fact that their performance is actually worse because of
trading costs
B) trade very conservatively, despite the fact that their performance is actually worse
because of trading costs
C) trade very actively, partly because their performance is better than the professionals'
due to low trading costs
D) trade very conservatively, partly because their performance is better than the
professionals' due to low trading costs
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
5) Disposition efect is the tendency of individual investors to ________.
A) trade too much based on the mistaken belief that they can pick winners and losers
better than investment professionals
B) buy stocks that have been in the news, advertised more, have very high trading volume,
or recently had extreme (high or low) returns
C) put too much weight on their own experience rather than considering historical
evidence
D) hold on to stocks that have lost value and sell stocks that have risen in value since the
time of purchase
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
22
