Principles of Managerial Finance, Brief, 7e (Gitman)
Chapter 7 Stock Valuation
7.1 Differentiate between debt and equity.
1) Unlike creditors, equityholders are owners of the firm.
2) Unlike equityholders, creditors are owners of the firm.
3) Holders of equity have claims on both income and assets that are secondary to the claims of
creditors.
4) The tax deductibility of interest lowers the cost of debt financing, thereby causing the cost of
debt financing to be lower than the cost of equity financing.
5) Interest paid to bondholders is tax deductible.
6) Dividends paid to stockholders is tax deductible.
7) Which of the following is an advantage for a firm to issue common stock over long-term debt?
A) the cost of equity financing is less than the cost of debt financing
B) the primary claim of equityholders on income and assets in the event of liquidation
C) no maturity date on which the par value of the issue must be repaid
D) the tax deductibility of dividends which lowers the cost of equity financing
8) Which of the following is a difference between common stock and bonds?
A) Bondholders have a voice in management; common stockholders do not.
B) Bondholders have a senior claim on assets and income relative to stockholders.
C) Stocks have a stated maturity but bonds do not.
D) Dividend paid to stockholders is tax-deductible but interest paid to bondholders are not.
9) Holders of equity capital ________.
A) own the firm
B) receive interest payments
C) receive guaranteed income
D) have loaned money to the firm
10) Because equityholders are the last to receive any distribution of assets as a result of
bankruptcy proceedings, they expect ________.
A) fixed dividend payments
B) greater returns from their investment in the firm’s stock
C) all profits to be paid out in dividends
D) warrants to be attached to the stock issue
11) If bankruptcy were to occur, ________ would have the first claim on assets.
A) preferred stockholders
B) unsecured creditors
C) equity stockholders
D) secured creditors
7.2 Discuss the features of both common and preferred stock.
1) The market value of common stock is related to its par value because both are sensitive to the
reactions of investors to new information.
2) Common stockholders are often referred to as residual claimants.
3) Common stock can be either privately owned by private investors or publicly owned by public
investors.
4) The market value of common stock is completely unrelated to its par value.
5) The par value on a common stock is used as a basis for determining its fixed dividend.
6) The number of authorized shares of common stock is always greater than or equal to the
number of outstanding shares of common stock.
7) The number of outstanding shares of common stock is always greater than or equal to the
number of authorized shares of common stock.
8) Supervoting shares of common stock provide shareholders with ten times the voting power of
ordinary shares of common stock.
9) Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, currently dividends are
subject to a maximum tax rate of 8 percent.
10) Treasury stocks held within the corporation do not have voting rights but have a claim on
assets in liquidation.
11) Preferred stock is a special form of stock having a fixed periodic dividend that must be paid
prior to payment of any interest to outstanding bonds.
12) In the case of liquidation, bondholders are paid first, followed by preferred stockholders,
followed by common stockholders.
13) In the case of liquidation, common stockholders are paid first, followed by preferred
stockholders, followed by bondholders.
14) Preferred stock has characteristics of debt since it provides a fixed periodic cash payment.
15) The amount of the claim of preferred stockholders in liquidation is normally equal to the
market value of the preferred stock.
16) Cumulative preferred stocks are preferred stocks for which all passed (unpaid) dividends in
arrears must be paid along with the current dividend prior to the payment of dividends to
common stockholders.
17) Because preferred stock is a form of ownership and has no maturity date, its claims on
income and assets are secondary to those of the firm’s creditors.
18) No-par preferred stock has no stated face value, but its annual dividend is stated as a
percentage of the market value.
19) A preferred stockholder is sometimes referred to as a residual owner, since in essence he or
she receives what is left—the residual—after all other claims on the firm’s income and assets
have been satisfied.
20) A call feature is a feature that allows preferred stockholders to change each share into a
stated number of shares of common stock.
21) Although preferred stock provides added financial leverage in much the same way as bonds,
it differs from bonds in that the issuer can pass a dividend payment without suffering the
consequences that result when an interest payment is missed on a bond.
22) Preferred stockholders are often referred to as residual claimants.
23) Which of the following typically applies to common stock but not to preferred stock?
A) par value
B) dividend yield
C) legally considered as equity in the firm
D) voting rights
24) Which of the following is true of common stocks?
A) The common stock of a corporation can be either privately or publicly owned.
B) Firms often issue common stock with no par value.
C) Preemptive rights often result in a dilution of ownership.
D) A firm’s corporate charter indicates the rate at which dividends are paid.
25) Which of the following is true of equity?
A) equityholders do not have voting rights.
B) It does not mature, so repayment is not required.
C) It is a temporary form of financing for a firm.
D) Equity financing is obtained from creditors.
26) Equity capital can be raised through ________.
A) the money market
B) the NYSE bond market
C) the stock market
D) a private placement with an insurance company
27) Common stockholders are sometimes referred to as ________.
A) non preemptive right holders
B) managers
C) creditors
D) residual owners
28) Which of the following is true of common stock?
A) It is often considered quasi-debt due to fixed payment obligation.
B) It has less restrictive covenants than debt.
C) It gives the holder voting rights which permit selection of the firm’s directors.
D) Its holders have priority over preferred stockholders in the event of liquidation of assets.
29) A proxy statement is a statement transferring ________.
A) the ownership of a bondholder to another party
B) the votes of a bondholder to the another party
C) the votes of a stockholder to another party
D) the ownership of a stockholder to another party
30) Which of the following is typically a feature of common stock?
A) Most common stocks are callable.
B) Most common stocks are cumulative.
C) Common stocks have a maturity value.
D) Common stocks may or may not pay dividends.
31) ADRs are ________.
A) securities, backed by American depositary shares (ADSs), that permit U.S. investors to hold
shares of non-U.S. companies and trade them in U.S. markets
B) securities, backed by Securities Exchange Commission (SEC), that permit all investors to
hold shares of U.S. companies and trade them in U.S. markets
C) securities, backed by American depositary shares (ADSs), that permit non-U.S. investors to
hold shares of U.S. companies and trade them in U.S. markets
D) securities, backed by Securities Exchange Commission (SEC), that permit U.S. investors to
hold shares of non-U.S. companies and trade them in international markets
32) ________ are promised a fixed periodic dividend that must be paid prior to paying any
common stock dividends.
A) Preferred stockholders
B) Common stockholders
C) Bondholders
D) Creditors
33) Dividends in arrears that must be paid to the preferred stockholders before payment of
dividends to common stockholders are ________.
A) cumulative
B) nonparticipating
C) participating
D) convertible
34) An 8 percent preferred stock with a market price of $110 per share and a $100 par value pays
a cash dividend of ________.
A) $4.00
B) $8.00
C) $8.80
D) $80.00
35) From a corporation’s point of view, a disadvantage of issuing preferred stock is ________.
A) that it increases financial leverage
B) that it has to give fixed payments as well as voting rights to the holders
C) its excellent merger security
D) that the dividends are not tax-deductible
36) Which of the following is a disadvantage of issuing preferred stock from the common
stockholders’ perspective?
A) There is a seniority of preferred stockholder’s claim over common stockholders.
B) The preferred stockholders have superior voting rights in the selection of board of directors.
C) The preferred stockholders are always paid a higher proportion of dividend payments.
D) Issuance of preferred stocks will result in a higher risk, to the disadvantage of common
stockholders.
37) The cost of preferred stock is ________.
A) lower than the cost of long-term debt
B) higher than the cost of common stock
C) higher than the cost of long-term debt and lower than the cost of common stock
D) lower than the cost of convertible long-term debt and higher than the cost of common stock
38) Preferred stock is characterized by ________.
A) voting rights
B) maturity date
C) quasi-debt nature
D) preemptive rights
39) A firm has issued cumulative preferred stock with a $100 par value and a 12 percent annual
dividend. For the past two years, the board of directors has decided not to pay a dividend. At the
end of the current year, the preferred stockholders must be paid ________ prior to paying the
common stockholders.
A) $ 0/share
B) $12/share
C) $24/share
D) $36/share
40) A firm has an outstanding issue of 1,000 shares of preferred stock with a $100 par value and
an 8 percent annual dividend. The firm also has 5,000 shares of common stock outstanding. If
the stock is cumulative and the board of directors has passed the preferred dividend for the prior
two years, how much must the preferred stockholders be paid prior to paying dividends to
common stockholders at the end of third year?
A) $ 8,000
B) $16,000
C) $24,000
D) $25,000
41) A violation of preferred stock restrictive covenants usually permits preferred shareholders to
________.
A) force the company into bankruptcy
B) suit against the shareholders
C) force the retirement of the preferred stock at or above its par value
D) force the company to repurchase the shares at a stated amount below par
42) Which of the following is true of preferred stocks?
A) Preferred stock with a conversion feature allows holders to change each share into a stated
number of shares of common stock.
B) Like bonds, preferred stocks are due for payment on a fixed maturity date along with interest.
C) Restrictive covenants of preferred stocks include provisions about listing of stocks on the
securities exchange and determining the price of stock.
D) A firm’s bond indenture indicates how many authorized preferred shares and bonds it can
issue.
43) Preferred stockholders ________.
A) do not have preference over common stockholders in the case of liquidation
B) have preference over bondholders in the case of liquidation
C) do not have preference over bondholders in the case of liquidation
D) have preference over creditors in the case of liquidation
44) Which of the following is usually a right of a preferred stockholder?
A) right to convert shares to common stock on demand
B) preemptive right to participate in the issuance of new common shares
C) right to receive dividend payments before any dividends are paid to common stockholders
D) right to sue company in bankruptcy proceedings if promised preferred dividends are not paid
45) Which of the following is typically a feature of preferred stocks?
A) They are settled prior to common stocks during liquidation.
B) They are mostly noncumulative in nature.
C) They are paid dividends that grow at a constant rate.
D) They carry voting rights and have maturity date.
46) Identify whether the key characteristic describes common stock (CS) or preferred stock (PS).
________ 1. Source of financing which places minimum constraints on the firm
________ 2. Used by young firms receiving investment funds from venture capital firms
________ 3. Potential dilution of earnings and voting power
________ 4. Fixed financial obligation
________ 5. Increases the firm’s borrowing power
________ 6. May have cumulative and participating features
________ 7. May be convertible into another type of security
________ 8. Last to receive earnings or distribution of assets in the event of bankruptcy
________ 9. Frequently includes a call feature
47) Edward Accounting Services has an outstanding issue of 1,000 shares preferred stock with a
$100 par value, an 9 percent annual dividend, and 5,000 shares of common stock outstanding. If
the stock is cumulative and the board of directors has passed the preferred dividend for the last
two years, how much must preferred stockholders be paid prior to paying dividends to common
stockholders?
1) The claims of the equityholders on a firm’s assets have priority over the claims of creditors
because the equityholders are the owners of the firm.
2) Preemptive rights allow common stockholders to maintain their proportionate ownership in
the corporation when new issues are made.
3) Stock rights allow stockholders to purchase additional shares of stock in direct proportion to
the number of shares they own.
4) A common stockholder has no guarantee of receiving any cash inflows, but receives what is
left after all other claims on the firm’s income and assets have been satisfied.
5) Preemptive rights allow existing shareholders to maintain voting control and protect
themselves against the dilution of their ownership.
6) Treasury stock generally does not have voting rights, does not earn dividends, and does not
have a claim on assets in liquidation.
7) Treasury stock is generally reclassified as class B common stock and has voting rights.
8) Firms occasionally repurchase stock in order to alter capital structure or to increase the returns
to the owners.
9) Dilution of ownership occurs when a new stock issue results in each present stockholder
having a larger number of shares and, thus, a claim to a larger part of the firm’s earnings than
previously.
10) Corporate venture capital funds are subsidiaries of financial institutions, particularly banks,
set up to help young firms grow and, it is hoped, become major customers of the institutions.
11) Small business investment companies (SBICs) are corporations chartered by the federal
government that can borrow at attractive rates from the U.S. Treasury and use the funds to make
venture capital investments in private companies.
12) Angel capitalists or angels are wealthy individual investors who do not operate as a business
but invest in early-stage companies in exchange for a portion of equity.