Financial Management: Core Concepts, 4e (Brooks)
Chapter 7 Stocks and Stock Valuation
1) Stocks are different from bonds because ________.
A) stocks, unlike bonds, are major sources of funds
B) stocks, unlike bonds, represent residual ownership
C) stocks, unlike bonds, give owners legal claims to payments
D) bonds, unlike stocks, represent voting ownership
2) Stocks differ from bonds because ________.
A) bond cash flows are known while stock cash flows are uncertain
B) firms pay bond cash flows prior to paying taxes while stock cash flows are after tax
C) the ending par value of a bond is known at purchase while the ending value of a share of stock
is unknown at purchase
D) All of the above
3) Bonds are different from stocks because ________.
A) bonds promise fixed payments for the length of their maturity
B) bonds give payments only after other owners are paid
C) bonds do not have maturity dates
D) bonds promise growth in earnings
4) Which of the statements below is FALSE?
A) The profits for common stock owners come before payment to employees, suppliers,
government, and creditors.
B) Shareholders elect the board of directors, which ultimately selects the management team that
runs the day-to-day operations of the company.
C) Stock is a major financing source for public companies.
D) Common stock’s ownership claim on the assets and cash flow of a company is often referred
to as a residual claim.
5) Which of the statements below is FALSE?
A) For common stock, there is no maturity date and the promised cash flow is not stated on the
asset, but is determined at a later date by the board of directors.
B) An equity claim is a claim to all the assets and cash flows of a company once debt claimants
have been paid.
C) Like a bond, common stock entitles the owner to some of the cash flow of a company.
D) Bond ownership gives the right to participate in the management of the company.
6) Which of the statements below is TRUE?
A) The profits for common stock owners come after payment to the employees, suppliers,
government, and creditors.
B) Shareholders elect the board of directors, which ultimately selects the bondholder team that
runs the day-to-day operations of the company.
C) Stock is a minor financing source for public companies.
D) Stockholders are paid before debt holders (bondholders) if a company fails.
7) Which of the statements below is FALSE?
A) Common stock usually carries the right to participate in the management of the firm through
the right to vote for the members of the Board of Directors and for changes to the charter and
bylaws of the company.
B) Shareholders with super voting right shares have multiple votes per share – a fact that
increases their influence and control over the company.
C) Some firms issue several classes of common stock, and these classes may have unequal
voting rights.
D) The standard of one vote for each share cannot be altered.
8) There are two typical ways to alter the one vote-one share standard. One way is ________.
A) to have companies buy back nonvoting common stock
B) to not have companies pay dividends
C) to have companies issue classes of stock whereby one or more classes have super voting
rights
D) to not have companies issue bonds
9) A typical practice of many companies is to distribute part of the earnings to shareholders
through ________.
A) quarterly stock splits
B) quarterly cash dividends
C) semiannual cash dividends
D) annual stock dividends
10) Which of the statements below is FALSE?
A) The payment of cash dividends to shareholders is a deductible expense for the company.
B) Unlike coupon payments on bonds, which are treated as an interest expense of the firm,
common stock dividends are considered a return of capital to shareholders and not an expense of
the firm.
C) For the shareholder, receipt of dividends is a taxable event.
D) A typical practice of many companies is to distribute part of the earnings to shareholders
through cash dividends.
11) Which of the statements below is FALSE?
A) If an investor purchases 20% of the initial issue of the company, the investor then owns 20%
of the company, given the one vote-one share norm.
B) After an initial offering, the company can sell more shares to the public at a later date. If the
investor who originally purchased 20% does not purchase 20% of the subsequent issue, his or her
ownership is diluted below 20%.
C) A preemptive right enables one to maintain one’s proportional level of ownership.
D) A preemptive right is never particularly valuable to shareholders with large ownership
percentages.
12) Common stock is a vehicle for selling ownership and another way to raise money for
operations, expansion, or other business needs.
13) Like a bond, common stock provides no specific promise of when and how much you will
receive.
14) A privilege that allows current shareholders to buy a fixed percentage of all futures issues
before they are offered to the public is called a primary right.
15) Even though a company sets a limit on the number of shares it will sell, before selling any of
them, the company must receive authorization to market the shares from the Securities and
Exchange Commission (SEC).
16) The shares that are available for public purchase and subsequent trading in a secondary
market such as the NYSE or NASDAQ are the issued shares of the company.
17) Describe two basic rights that stock ownership gives.
18) Define treasury shares, distinguishing between treasury shares and outstanding shares. Is a
company limited in treasury shares that it may own? Briefly explain.
1) The ________ is the market of first sale in which companies first sell their authorized shares
to the public.
A) primary market
B) secondary market
C) both primary and secondary markets
D) Nasdaq market
2) You can think of the ________ as the “used stock” market because these shares have been
owned or “used” previously.
A) secondary market
B) primary market
C) NYSE market
D) initial public offering market
3) Which of the statements below is FALSE?
A) Selling of shares is the selling of ownership in the company.
B) A company is said to go “public” when it opens up its ownership structure to the general
public through the sale of common stock.
C) Companies choose to sell stock to attract permanent financing through equity ownership of
the company.
D) Most companies have the resident expertise to complete an initial public offering (IPO) or
first public equity issue.
4) The hiring process for an investment banker can happen in two ways. Which of the below is
one of these ways?
A) Randomly choose an investment banking firm from a list of underwriting firms.
B) Pick a desirable investment banking firm, usually basing the choice on the reputation and
history of the banker in its particular industry.
C) Have the primary government regulator of your industry choose the best investment banking
firm for your company.
D) Solicit advice from a government agency and use it as your primary guide in choosing an
investment banker.
5) Part of the negotiation with the investment banker during the selection process has to do with
how the investment banker will be compensated for taking the company public. One of these two
standard compensation packages involves ________.
A) a firm-commitment approach, in which the investment banker essentially buys the entire
stock issue from the company at several prices
B) a best efforts approach, in which the investment banker pledges to do his or her best to sell the
shares and will take a small percentage of the sale of each stock
C) a best efforts approach, in which the investment banker essentially buys the entire stock issue
from the company at one price and then sells the issue at the auction for a higher price
D) a firm-commitment approach, in which the investment banker pledges to do his or her best to
sell the shares and will take a small percentage of the sale of each stock
6) Which of the statements below is FALSE?
A) The secondary market, or “used stock” market, provides a place for current common
stockholders to sell their stock or acquire more stock or for new stockholders to acquire stock for
the first time.
B) Both the NYSE and the NYSE MKT LLC (previously known as the AMEX) are physical
trading locations with trading floors. In order to complete a trade (the selling or buying of
shares), orders must be processed at trading posts on the floor of the exchange.
C) Immediately after the public auction of common stock, the stock begins trading in the
secondary market.
D) Trading on the NYSE is accomplished through a set of registered dealers who are connected
by a computer network.
7) Which of the statements below is TRUE?
A) Buying of shares is the selling of ownership in the company.
B) A company is said to go “private” when it opens up its ownership structure to the general
public through the sale of common stock.
C) Private companies can go public by choosing to sell stock to attract permanent financing
through equity ownership of the company.
D) Most companies have the resident expertise to complete an initial public offering (IPO), or
first public equity issue.
8) In the United States, there are three well known secondary stock markets. Which of the below
is NOT one of these?
A) The New York Stock Exchange (NYSE)
B) The Chicago Stock Exchange (CSE)
C) The National Association of Securities Dealers and their trading system NASDAQ (National
Association of Securities Dealers Automated Quotation System)
D) The New York Stock Exchange MKT LLC (formerly the AMEX)
9) Which of the following statements is TRUE?
A) The dealers of stock are not allowed to make money on the difference between what they buy
the stock for and what they sell it for.
B) A bear market is a prolonged rising market, one in which stock prices in general are
increasing.
C) The ask price is the price at which a dealer is willing to sell, and the bid price is the price at
which a dealer is willing to buy.
D) A bull market is a prolonged declining market, one in which stock prices in general are
decreasing.
10) There are two major markets for the sale of stock: the primary market and the secondary
market.
11) A bull market is a prolonged declining market.
12) With best efforts compensation, the investment banker essentially buys the entire stock issue
from the company at one price and then sells the issue at auction for a higher price.
13) Both the NYSE and the NYSE MKT LLC (formerly the AMEX) are physical trading
locations with trading floors.
14) Most companies do not have the resident expertise to complete an initial public offering
(IPO), so they hire an investment banker to help accomplish the sale. Describe three significant
tasks that an investment banker provides.
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7.3 Stock Valuation
1) The value of a financial asset is the ________.
A) present value of all of the future cash flows that will be received
B) sum of all previous cash flows received
C) future value of just the capital gains but not the dividends
D) present value of just the capital gains but not the dividends
2) You want to invest in a stock that pays $4.00 annual cash dividends for the next three years.
At the end of the three years, you will sell the stock for $35.00. If you want to earn 9% on this
investment, what is a fair price for this stock if you buy it today?
A) $41.37
B) $37.15
C) $24.75
D) $18.91
3) You want to invest in a stock that pays $2.00 annual cash dividends for the next four years. At
the end of the four years, you will sell the stock for $27.00. If you want to earn 11% on this
investment, what is a fair price for this stock if you buy it today?
A) $21.45
B) $23.99
C) $27.90
D) $25.42
4) You want to invest in a stock that pays $1.50 annual cash dividends for the next six years. At
the end of the six years, you will sell the stock for $18.50. If you want to earn 7.5% on this
investment, what is a fair price for this stock if you buy it today?
A) about $18.45
B) about $15.29
C) about $22.45
D) about $19.03
5) If we know the dividend stream, the future price of the stock, the future selling date of the
stock, and the required return, we can price stocks just as we priced ________.
A) annuities
B) perpetuities
C) bonds
D) preferred stocks
6) In regards to the fact that the pricing of stocks is more difficult than the pricing of bonds,
which of the below statements is FALSE?
A) Cash dividends, unlike coupons for bonds, typically change from year to year.
B) The ending price of the stock at any point in time is not fixed like the par value of the
principal.
C) Because a stock has no maturity date, the number of its payments are unknown.
D) A stock’s final sale is fixed in time on its maturity date.
7) Craftwell Inc. pays a $0.75 dividend every quarter and will maintain this policy forever. What
price should you pay for one share of common stock if you want an annual return of 10.5% on
your investment?
A) $28.57
B) $29.17
C) $30.02
D) $30.94
8) Giant Motorcycles Inc. pays a $0.77 preferred dividend every quarter and will maintain this
policy forever. What price should you pay for one share of preferred stock if you want an annual
return of 9.25% on your investment?
A) $33.04
B) $35.27
C) $31.96
D) $33.30
9) A corporation is scheduled to produce a line of products for the next ten years and then go out
of business. The firm will pay an annual dividend of $1.75 for only those ten years. What is the
present value of a share for this company if we want an 8% annual return on the stock?
A) $11.74
B) $12.97
C) $14.97
D) $15.97
10) You buy a stock for which you expect to receive an annual dividend of $2.10 for the ten
years that you plan on holding it. After 10 years, you expect to sell the stock for $26.15. What is
the present value of a share for this company if you want an 8% return?
A) $7.72
B) $15.97
C) $26.20
D) $31.41
11) ________ means that the percentage increase in the dividend is the same each year.
A) Constant growth
B) Inconsistent growth
C) No growth
D) A constant cash flow
12) Why would we want to assume a constant growth to dividends if we seldom see a firm with
this type of pattern?
A) The answer is that we really want to estimate a series of future dividends and can only do this
if we have a growth rate.
B) The answer is that we do not need to estimate future capital gains and can only do this if we
have a growth rate.
C) The answer is that we really want to estimate a series of past dividends and can only do this if
we have a growth rate.
D) The answer is that we really want to estimate the past capital gains and can only do this if we
have a growth rate.
13) Which of the statements below is FALSE?
A) In estimating the current price using the constant growth dividend model, we let g be the
growth rate of the dividend stream and r be the rate of return required by the potential buyer of
the stock.
B) Constant growth means that the percentage increase in the dividend is the same each year.
C) Div0 refers to the dividends that have just been paid to the current owner of the stock.
D) One unlikely dividend pattern is to raise or grow dividends by a fixed amount at fixed
intervals.
14) Wallboard Inc, plans to pay a dividend in one year (Div1) of $0.80, the dividend growth rate
(g) is expected to be 6%, and the required rate of return (r) for the firm’s stock is 10%. What is
the stock price, according to the constant growth dividend model?
A) $20.80
B) $30.80
C) $20.00
D) $15.00
15) The most recent dividend (Div0) from Wallboard Inc, is $0.80, the dividend growth rate (g)
is expected to be 6.25%, and the required rate of return (r) on the firm’s stock is 10%. What is the
stock price according to the constant growth dividend model?
A) $22.67
B) $23.47
C) $21.85
D) $20.80
16) Bartlett Batteries Inc. just paid an annual dividend of $1.12. If you expect a constant growth
rate of 4% and have a required rate of return of 13%, what is the current stock price according to
the constant growth dividend model?
A) $12.44
B) $12.94
C) $13.46
D) There is not enough information to answer this question.
17) The constant growth dividend model requires that ________.
A) the return rate r is greater than the growth rate g of the dividend stream
B) the return rate g is greater than the growth rate r of the dividend stream
C) the return rate r is lesser than the growth rate g of the dividend stream
D) we set g = 0 if the return rate r is greater than the growth rate g of the dividend stream