978-0134083285 Chapter 8 Part 1

Unlock access to all the studying documents.

View Full Document

Foundations of Finance, 9e (Keown/Martin/Petty)

Chapter 8 The Valuation and Characteristics of Stock

Learning Objective 8.1

1) Preferred stock is referred to as a hybrid security because it has many characteristics of both common

stock and bonds.

Keywords: Preferred Stock, Hybrid Security

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

2) Because most preferred stocks are perpetuities, their value can be determined by dividing the annual

dividend by an investor‘s required return.

Keywords: Preferred Stock, Perpetuity, Intrinsic Value

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

3) In terms of risk, preferred stock is safer than common stock because it has a prior claim on assets and

income.

Keywords: Preferred Stock, Common Stock, Risk

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

4) A call provision entitles a company to repurchase its preferred stock from holders at stated prices over

a given time period.

Keywords: Preferred Stock, Call Provision

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

5) For a given constant required rate of return, the greatest portion of a preferred stockholder’s return

comes from increases in the price of preferred stock.

Keywords: Preferred Stock, Capital Gain

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

6) The amount of the preferred stock dividend is generally fixed either as a dollar amount or as a

percentage of the par value.

Keywords: Preferred Stock Dividend

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

7) Preferred stock is riskier than long-term debt because its claim on assets and income come after those

of bonds.

Keywords: Claims on Income, Preferred Stock, Long-term Debt

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

8) A call provision allows the issuing firm the opportunity to avoid rising interest rates by calling

investors and asking for more cash.

Keywords: Call Provision

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

9) Although under normal operating conditions preferred shareholders do not have voting rights,

protective provision generally allow for voting rights in the event of nonpayment of preferred dividends.

Keywords: Preferred Stock, Protective Provisions

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

10) If a firm does not have enough money to pay any common stock dividends, it is technically in default

to the common shareholders.

Keywords: Common Stock Dividends, Default

Learning Obj.: L.O. 8.1

AACSB: Analytical Thinking

11) The use of a call provision in addition to a sinking fund can effectively create a maturity date for

preferred stock.

Keywords: Preferred Stock, Call Provision, Sinking Fund, Maturity Date

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

12) The upper limit on common stock dividends, which is set by the SEC, is generally equal to the sum of

dividends paid on the company‘s preferred stock.

Keywords: Dividends, Common Stock

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

13) A sinking-fund provision allows for the retirement of a portion of preferred stock each year.

Keywords: Sinking Fund, Preferred Stock

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

14) Two approaches that allow for the retirement of preferred stock are call provisions and sinking fund

provisions.

Keywords: Preferred Stock, Call Provision, Sinking Fund Provision

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

15) A company‘s market capitalization is generally greater than its book value, in part due to its

reputation for being able to deliver growth, attract top talent, and avoid ethical mistakes.

Keywords: Reputation, Book Value, Market Capitalization

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

16) Preferred stock is less risky than common stock, but more risky than debt.

Keywords: Preferred Stock, Debt, Common Stock, Required Return

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

17) Preferred stock and common stock issued by the same firm will have the same required return

because the riskiness of the firm’s cash flows is the same for both securities.

Keywords: Preferred Stock, Common Stock, Required Return

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

18) Preferred stock valuation usually treats the preferred stock as a

A) capital asset.

B) perpetuity.

C) common stock.

D) long-term bond.

Keywords: Preferred Stock, Perpetuity

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

19) Preferred stock is similar to a bond in the following way:

A) Preferred stock always contains a maturity date.

B) Both investments provide a stated income stream.

C) Both contain a growth factor similar to common stock.

D) Both provide interest payments.

Keywords: Preferred Stock, Bonds

Learning Obj.: L.O. 8.1

AACSB: Analytical Thinking

20) Cumulative preferred stock

A) requires dividends in arrears to be carried over into the next period.

B) has a right to vote cumulatively.

C) has a claim to dividends before bonds.

D) has a higher required return than common stock.

Keywords: Cumulative Preferred Stock

Learning Obj.: L.O. 8.1

AACSB: Analytical Thinking

21) How is preferred stock similar to bonds?

A) Dividend payments to preferred shareholders (much like bond interest payments to bondholders) are

tax deductible.

B) Investors can sue the firm if preferred dividend payments are not paid (much like bondholders can sue

for non-payment of interest payments).

C) Preferred stockholders receive a dividend payment (much like interest payments to bondholders) that

is usually fixed.

D) Preferred stock is not like bonds in any way.

Keywords: Preferred Stock, Bonds

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

22) Most preferred stocks have a feature that requires all past unpaid preferred dividend payments be

paid before any common stock dividends can be paid. What is the name of this feature?

A) participating

B) cumulative

C) provisional

D) convertible

Keywords: Preferred Stock, Cumulative, Dividends

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

23) Many preferred stocks have a provision that entitles a company to repurchase its preferred stock from

their holders at stated prices over a given time period. What is the name of this provision?

A) cumulative

B) putable

C) callable

D) convertible

Keywords: Callable Preferred Stock

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

24) Many preferred stocks have a feature that requires a firm to periodically set aside an amount of

money for the retirement of its preferred stock. What is the name of this feature?

A) convertible

B) callable

C) cumulative

D) sinking fund

Keywords: Preferred Stock, Sinking Fund

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

25) Preferred stock differs from common stock in that

A) preferred stock usually has a maturity date.

B) preferred stock investors have a higher required return than common stock investors.

C) preferred stock dividends are fixed.

D) common stock investors have a required return and preferred stock investors do not.

Keywords: Preferred Stock, Dividends

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

26) How is preferred stock similar to common stock?

A) Preferred dividend payments usually have unlimited growth potential.

B) Investors cannot sue a corporation for the non–payment of dividends.

C) Both preferred and common stockholders have voting control of a firm.

D) Preferred stock dividends and common stock dividends are fixed.

Keywords: Preferred Stock, Common Stock

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

27) What provisions are available to protect a preferred stockholder?

Keywords: Preferred Stock, Protective Provisions

Learning Obj.: L.O. 8.1

AACSB: Reflective Thinking

Learning Objective 8.2

1) ABC Corp. 5% preferred stock with a par value of $100 and a market price of $125 will pay an annual

dividend this year of $12 per share.

Keywords: Preferred Stock, Dividends, Par Value

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

2) The YTD% shown in Wall Street Journal stock quotes stands for the stock’s dividend yield and is

calculated by dividing the amount of the dividend by the stock’s opening price on the first day of the

year.

Keywords: Dividend Yield, Stock Quotes

Learning Obj.: L.O. 8.2

AACSB: Reflective Thinking

3) A preferred stock that pays an annual dividend of $10, has a par value of $100, and has a required

return of 5% will be valued at $200.

Keywords: Preferred Stock, Valuation

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

4) Public perception and reputation do not affect stock prices, which are strictly a function of dividends

and required returns.

Keywords: Stock Valuation Reputation

Learning Obj.: L.O. 8.2

AACSB: Reflective Thinking

5) Maynard Inc. preferred stock pays an annual dividend of $7 per share. Which of the following

statements is true for an investor with a required return of 9%?

A) The value of the preferred stock is $7 because the dividend is fixed at $7 each year .

B) The value of the preferred stock is $63.00 per share.

C) The value of the preferred stock is $77.78 per share.

D) The value of the preferred stock is $6.30 per share because of the 9% required return.

Keywords: Preferred Stock Valuation

Learning Obj.: L.O. 8.2

AACSB: Reflective Thinking

6) Which of the following statements concerning preferred stock is MOST correct?

A) Preferred stock is valued the same as zero coupon bonds because the cash flow patterns are similar.

B) If a corporation issues 4% preferred stock with a par value of $100, the dividend will increase by 4%

per year.

C) Preferred stock dividends are typically the same each year, allowing a preferred stock to be valued as a

perpetuity.

D) Preferred stock dividends are calculated as a percentage of common stock dividends, although the

preferred stock dividends must be paid first.

Keywords: Preferred Stock Valuation, Dividends, Perpetuity

Learning Obj.: L.O. 8.2

AACSB: Reflective Thinking

7) Stimpson Inc. preferred stock pays a $.50 annual dividend. What is the value of the stock if your

required rate of return is 10%?

A) $.05

B) $.50

C) $5.00

D) $50.00

Keywords: Preferred Stock

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

8) Whistle Corp. has a preferred stock that pays a dividend of $2.40. If you are willing to purchase the

stock at $11, what is your required rate of return? (Round your answer to the nearest .1% and assume that

there are no transaction costs.)

A) 21.8%

B) 11.0%

C) 9.1%

D) 20.1%

Keywords: Preferred Stock, Required Return

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

9) What is the value of a preferred stock that pays a $5.55 dividend to an investor with a required rate of

return of 10%?

A) $22.22

B) $27.83

C) $45

D) $55.50

Keywords: Preferred Stock Valuation

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

10) How is preferred stock affected by a decrease in the required rate of return?

A) The value of a share of preferred stock increases.

B) The dividend increases.

C) The dividend decreases.

D) The dividend yield increases.

Keywords: Preferred Stock Valuation, Required Return

Learning Obj.: L.O. 8.2

AACSB: Reflective Thinking

11) Bacon Signs Company preferred stock pays a perpetual annual dividend of 4.5% of its $100 par value.

If investors’ required rate of return on this stock is 12%, what is the value per share?

A) $37.50

B) $31.82

C) $8.50

D) $45.00

Keywords: Preferred Stock Valuation, Perpetual Dividend

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

12) LTM, Inc. has an issue of preferred stock whose par value is $1,000. The preferred stock pays a 4.5%

dividend. If investors require a 5.5% rate of return for these shares, what price should the preferred stock

sell for?

A) $611.11

B) $508.33

C) $409.09

D) $818.18

Keywords: Preferred Stock Valuation

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

13) Studio 55, Inc. has an issue of preferred stock that pays a dividend of $4.00. The preferred

stockholders require a rate of return on this stock of 9%. At what price should the preferred stock sell for?

Round off to the nearest $0.10.

A) $36.00

B) $44.40

C) $62.50

D) $88.80

Keywords: Preferred Stock Valuation

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

14) Lithium Lakes Industries preferred stock has a par value of $100 and pays a dividend of $6.00 per

share. It presently sells for $87 per share. What do investors require as a rate of return on this stock?

Round off to the nearest .10%.

A) 14.5%

B) 9.3%

C) 6.9%

D) 6.0%

Keywords: Preferred Stock, Required Return

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

15) Glacier Inc. preferred stock has a 5% stated dividend percentage, and a $100 par value. What is the

value of the stock if your required rate of return is 6% per year?

A) $83.33

B) $94.05

C) $100.00

D) $30.00

Keywords: Preferred Stock Valuation

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

16) If Neal O’Danny preferred stock pays an annual dividend of $2.80, and investors require a 9% return,

what is the value of O’Danny’s preferred stock today?

Keywords: Preferred Stock Valuation

Learning Obj.: L.O. 8.2

AACSB: Analytical Thinking

Learning Objective 8.3

1) The market price of a firm’s common stock equals the sum of all equity accounts as reported in its

balance sheet (common stock + paid-in capital + retained earnings) divided by the number of shares

outstanding.

Keywords: Market Value of Equity

Learning Obj.: L.O. 8.3

AACSB: Reflective Thinking