Chapter 08 – Stocks, Stock Markets, and Market Efficiency
101. What price would an individual be willing to pay today for a stock that is expected to sell
for $100 two years from now and which pays an annual dividend that is $6.00? Assume the
individual has a discount rate of 8% (0.08).
102. What price would an individual would be willing to pay for a stock that currently pays a
$5.00 annual dividend if the individual expects the dividend to grow by 4% (0.04) per year
and the individual has a discount rate of 6.0% (0.06)?
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
103. After one year, a company will pay $20 in dividends. It commits to paying $21 two years
from the current date. This growth rate in dividends is expected to continue indefinitely. The
interest rate is 8%. Compute the current price of this stock, using the dividend-discount
model.
104. Identify the ways in which a bondholder’s rights differ from those of a stockholder. In
what ways do they differ when a firm is bankrupt?
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
105. This is a two-part question: We have a firm that needs $1000 to obtain a new machine
for its business. It can either issue stock or bonds, or some combination of both. If it issues
bonds it will have to pay $8.00 in interest for every $100 borrowed. Finally, assume the
company will earn $150 in good years and $75 in bad years, with equal probability. The first
part of the question is to (a) determine the payment to the equity holders under the following
three scenarios: (i) the first is the firm uses 0% debt financing; (ii) the second is the firm uses
50% debt financing, and (iii) the third finds the firm using 80% debt financing.
The second part of the question is to (b) determine the expected equity return (%) under each
scenario.
106. You make a $1,000 investment in the stock of ABC Inc. Over the next year the
investment decreases by 60%. What percentage increase do you need in the following year on
your holding to be back to $1,000?
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
107. The investment you made in a mutual fund one year ago lost 50% of its value over the
past year. What percentage increase is needed in the fund to restore your portfolio to the level
it was one year ago?
108. After one year, a company will pay $5 in dividends. It commits to paying $5.30 two
years from the current date. This growth rate for dividends is expected to continue
indefinitely. The U.S. Treasury bond yield is 8% and the equity-risk premium is equal to
2.5%. Compute the required stock return and current price of this stock, using the dividend-
discount model.
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
109. Considering the return an investor requires from a stock, what are the two components
that make up that return? Briefly explain each of these components.
110. Discuss the effects on the current price of a stock from each of the following: a) An
increase in the growth rate of the dividend; b) A decrease in the risk-free interest rate; c) An
increase in the equity-risk premium; and finally d) A decrease in the annual dividend.
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
111. Why does the theory of efficient markets imply that stock price movements are
unpredictable?
112. Is the Efficient Markets Hypothesis (EMH) responsible for the financial crisis of 2007–
2009?
113. What possibilities exist to explain the claim made by many professional money
managers that they can exceed the average stock market return year after year?
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
114. From the perspective of the theory of efficient markets, explain why it may be difficult
for professional money managers who have an exceptional year to continuously outperform
the market average.
115. You hear someone claim that stocks are less risky than bonds. What possible evidence
could this person offer for such a claim?
116. Use the five issues an investor should consider when purchasing stock to explain the
popularity of mutual funds.
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
117. Explain how a well-functioning stock market contributes to the efficiency of the
economy.
118. From information presented in Chapter 8, you should be able to identify at least two
reasons an investor may want to consider an index fund over a managed (mutual) fund. What
are these reasons?
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
119. Discuss the inefficiencies that can be caused by stock market bubbles, especially
focusing on firms and consumers.
Essay Questions
120. Do the voting rights possessed by common stockholders ensure that managers and
directors have the same objectives as stockholders? Explain.
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
121. If you understood the discussion of the characteristics of common stocks, you should be
able to explain the following statement: One of the benefits from stock ownership is the
unlimited upside potential and the limited downside. What does this statement mean?
122. XYZ Inc. announces plans to finance the expansion of the firm by issuing hundreds of
millions of dollars of bonds. Discuss how the current stockholders of XYZ Inc. will feel about
this plan.
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
123. Discuss how changes in economic conditions are likely to affect the equity-risk premium
and stock prices. Considering the risks associated with investing in stocks (over short periods
of time), what types of investments would you expect investors to buy during an economic
recession?
124. You are a top Treasury official for a developing country who has been asked for advice
on how to best open the nation’s stock market to foreign investment. Previously, the
government did not permit foreigners to purchase domestic stock. Now, the government has a
plan to create two markets: one for domestic residents and one for foreign investment. What
are the potential drawbacks of this system, compared to allowing both domestic and foreign
investors to trade in the same market? What are the larger implications for economic
efficiency? How might the government be able to address these issues?
Chapter 08 – Stocks, Stock Markets, and Market Efficiency
125. Discuss whether the economy would be more or less efficient if public corporations
issued fewer shares of stock.