Chapter 11
The Stock Market
◼ Multiple Choice Questions
1. (I) A share of common stock in a firm represents an ownership interest in that firm. (II) A share of
preferred stock is as much like a bond as it is like common stock.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
2. Preferred stockholders hold a claim on assets that has priority over the claims of
(a) both common stockholders and bondholders.
(b) neither common stockholders nor bondholders.
(c) common stockholders, but after that of bondholders.
(d) bondholders, but after that of common stockholders.
3. (I) Preferred stockholders hold a claim on assets that has priority over the claims of common
stockholders, but after that of bondholders. (II) Firms issue preferred stock in far greater amounts
than common stock.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
4. (I) Preferred stockholders hold a claim on assets that has priority over the claims of common
stockholders. (II) Bondholders hold a claim on assets that has priority over the claims of preferred
stockholders.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
136 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
5. (I) Firms issue common stock in far greater amounts than preferred stock. (II) The total volume of
stock issued is much less than the volume of bonds issued.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
6. The riskiest capital market security is
(a) preferred stock.
(b) common stock.
(c) corporate bonds.
(d) Treasury bonds.
7. Organized exchanges account for about _________ percent of the total dollar volume of domestic
stock shares traded.
(a) 30
(b) 45
(c) 60
(d) 70
8. Organized exchanges account for about _________ percent of the total dollar volume of domestic
stocks traded.
(a) 60
(b) 70
(c) 80
(d) 90
9. (I) The largest of the organized stock exchanges in the United States is the New York Stock
Exchange. (II) To be listed on the NYSE, a firm must have a minimum of $100 million dollars in
market value or $10 million in revenues.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
10. To list on the NYSE, a firm must
(a) have earnings of at least $100 million for each of the last three years.
(b) have at least $500 million of market value and $100 million of revenue.
(c) have a total of $100 million in market value of publicly traded shares.
(d) meet all of the above requirements.
(e) meet (a) and (b) of the above requirements.
Chapter 11 The Stock Market 137
11. Securities not listed on one of the exchanges trade in the over-the-counter market. In this exchange,
dealers “make a market” by
(a) buying stocks for inventory when investors want to sell.
(b) selling stocks from inventory when investors want to buy.
(c) doing both of the above.
(d) doing neither of the above.
12. The most active stock exchange in the world is the
(a) Nikkei Stock Exchange.
(b) London Stock Exchange.
(c) Shanghai Stock Exchange.
(d) New York Stock Exchange.
13. Which of the following statements about trading operations in an organized exchange are correct?
(a) Floor traders all deal in a wide variety of stocks.
(b) In most trades, specialists match buy and sell orders.
(c) In most trades, specialists buy for or sell from their own inventories.
(d) The SuperDOT system is used to expedite large trades of over 100,000 shares.
14. Which of the following is not an advantage of Electronic Communications Networks (ECNs)?
(a) All unfilled orders are available for review by ECN traders.
(b) Transactions costs are lower for ECN trades.
(c) Trades are made and confirmed faster.
(d) ECNs work well for thinly traded stocks.
15. Which of the following statements is false regarding Electronic Communications Networks (ECNs)?
(a) Archipelago and Instinet are two examples of ECNs.
(b) Competition from ECNs has forced NASDAQ to cut its fees.
(c) Traders benefit from lower trading costs and faster service.
(d) ECNs allow institutional investors, but not individuals, to trade after hours.
16. A basic principle of finance is that the value of any investment is
(a) the present value of all future net cash flows generated by the investment.
(b) the undiscounted sum of all future net cash flows generated by the investment.
(c) unrelated to the future net cash flows generated by the investment.
(d) unrelated to the degree of risk associated with the future net cash flows generated by the
investment.
138 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
17. A stock currently sells for $25 per share and pays $0.24 per year in dividends. What is an investor’s
valuation of this stock if she expects it to be selling for $30 in one year and requires 15 percent
return on equity investments?
(a) $30.24
(b) $26.30
(c) $26.09
(d) $27.74
18. A stock currently sells for $30 per share and pays $1.00 per year in dividends. What is an investor’s
valuation of this stock if he expects it to be selling for $37 in one year and requires 12 percent return
on equity investments?
(a) $38
(b) $33.50
(c) $34.50
(d) $33.93
19. In the one-period valuation model, a stock’s value will be higher
(a) the higher is its expected future price.
(b) the lower is its dividend.
(c) the higher is the required return on investments in equity.
(d) all of the above.
20. In the one-period valuation model, a stock’s value falls if the _________ rises.
(a) dividend
(b) expected future price
(c) required return on equity
(d) current price
21. In the generalized dividend valuation model a stock’s value depend only on
(a) its future dividend payments and its future price.
(b) its future dividend payments and the required return on equity.
(c) its future price and the required return on investments on equity.
(d) its future dividend payments.
22. Which of the following is not an element of the Gordon growth model of stock valuation?
(a) the stock’s most recent dividend paid.
(b) the expected constant growth rate of dividends.
(c) the required return on investments in equity.
(d) the stock’s expected future price.
Chapter 11 The Stock Market 139
23. According to the Gordon growth model, what is an investor’s valuation of a stock whose current
dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10 percent over a
long period of time and the investor’s required return is 11 percent?
(a) $110
(b) $100
(c) $11
(d) $10
(e) $5.24
24. According to the Gordon growth model, what is an investor’s valuation of a stock whose current
dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10 percent over a
long period of time and the investor’s required return is 15 percent?
(a) $20
(b) $11
(c) $22
(d) $7.33
(e) $4.40
25. Holding other things constant, a stock’s value will be highest if its dividend growth rate is
(a) 15 percent
(b) 10 percent
(c) 5 percent
(d) 2 percent
26. Holding other things constant, a stock’s value will be highest if its most recent dividend is
(a) $2.00
(b) $5.00
(c) $0.50
(d) $1.00
27. Holding other things constant, a stock’s value will be highest if the investor’s required return on
investments in equity is
(a) 20 percent
(b) 15 percent
(c) 10 percent
(d) 5 percent
140 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
28. Suppose the average industry PE ratio for auto parts retailers is 20. What is the current price of Auto
Zone stock if the retailer’s earnings per share are projected to be $1.85?
(a) $21.85
(b) $37
(c) $10.81
(d) $9.25
29. Which of the following is true regarding the Gordon growth model?
(a) Dividends are assumed to grow at a constant rate forever.
(b) The dividend growth rate is assumed to be greater than the required return on equity.
(c) Both (a) and (b).
(d) Neither (a) nor (b).
30. The PE ratio approach to valuing stock is especially useful for valuing
(a) privately held firms.
(b) firms that don’t pay dividends.
(c) both (a) and (b).
(d) neither (a) nor (b).
31. The PE ratio approach to valuing stock is especially useful for valuing
(a) publicly held corporations.
(b) firms that regularly pay dividends.
(c) both (a) and (b).
(d) neither (a) nor (b).
32. A weakness of the PE approach to valuing stock is that it is
(a) difficult to estimate the constant growth rate of a firm’s dividends.
(b) difficult to estimate the required return on equity.
(c) difficult to predict how much a firm will pay in dividends.
(d) based on industry averages rather than firm-specific factors.
33. A firm is expected to pay a dividend of $1.00 next year and the dividend is expected to grow at a
constant rate of 4 percent over time. Some investors have required returns on investments in equity
of 12 percent, some 10 percent, and some 8 percent. The market price of this firm’s stock will be
slightly above
(a) $25
(b) $18
(c) $16.67
(d) $12.50
Chapter 11 The Stock Market 141
34. (I) The market price of a security at a given time is the highest value any investor puts on the
security. (II) Superior information about a security increases its value by reducing its risk.
(a) (I) is true, (II) is false.
(b) (I) is false, (II) is true.
(c) Both are true.
(d) Both are false.
35. The main cause of fluctuations in stock prices is changes in
(a) tax laws.
(b) errors in technical stock analysis.
(c) daily trading volume in stock markets.
(d) information available to investors.
(e) total household wealth in the economy.
36. Stock values computed by valuation models may differ from actual market prices because it is
difficult to
(a) estimate future dividend growth rates.
(b) estimate the risk of a stock.
(c) forecast a stock’s future dividends.
(d) all of the above are true.
37. The 2001 terrorist attacks and the Enron financial scandal caused anticipated dividend growth to
_________, investors’ required return on equity to _________, and stock prices to _________.
(a) decreases; increase; decrease
(b) decrease; increase; increase
(c) increase; decrease; decrease
(d) increase; decrease; increase
38. Which of the following is not an objective of the Securities and Exchange Commission?
(a) maintain integrity of the securities markets
(b) advise investors about which particular stocks are good buys
(c) require firms to provide specific information to investors
(d) regulate major participants in securities markets
142 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
◼ True/False
1. More stock trading in the U.S. occurs in over-the-counter markets rather than on organized
exchanges.
2. In over-the-counter markets, dealers increases the liquidity of thinly traded securities.
3. Electronic Communications Networks apply technology to make organized exchanges more
efficient and speedy.
4. All stocks pay dividends, as that is the only way an investor can profit from holding stock.
5. Common stock is the riskiest corporate security, followed by preferred stock and then bonds.
6. The Enron financial scandal increased uncertainty about the quality of accounting information and
as a result increased required return on investment in stocks.
7. The Dow Jones Industrial Average is the broadest and best indicator of the stock market’s
day-to-day performance.
8. The Securities and Exchange Commission requires firms to submit various documents to increase
the flow of information to investors but does not verify the accuracy of that information.
9. About half of new equity issues are preferred stock.
10. A stock’s market value will be higher the higher is its expected dividend stream.
11. The Gordon growth model assumes that a stock’s dividend grows at a constant rate forever.
12. A stock’s market value will be higher the higher is the investor’s required rate of return.
Chapter 11 The Stock Market 143
◼ Essay
1. How do corporate stocks differ from bonds?
2. How do common stocks differ from preferred stock?
3. How do over-the-counter markets differ from organized exchanges?
4. What is the role of specialists on a stock exchange?
5. What are the advantages and disadvantages of Electronic Communications Networks (ECNs) for
trading stocks?
6. What is the role of the required return on equity investments in stock valuation models?
7. Using the Gordon growth model, explain why the 2001 terorist attacks and the Enron financial
scandal caused stock prices to decline.
8. What are American Depository Receipts (ADRs)?
9. What are the objectives of the Securities and Exchange Commission?