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Chapter 7 – Socks (Equity) – Characteristics and Valuation
1. American depository receipts (ADRs) are foreign stocks listed on a domestic exchange.
a. True
b. False
2. Founders’ shares is a type of classified stock where the shares are owned by the firm’s founders and they retain the
sole voting rights to those shares but have restricted dividends for a specified time period.
a. True
b. False
3. A publicly owned corporation is simply a company whose shares are held by the investing public, which may include
other corporations and institutions.
a. True
b. False
4. After a new issue is brought to market it is the marginal investor who determines the price at which the stock will
trade.
a. True
b. False
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
5. A stock’s par value is equal to the market value of the stock on the last day of the fiscal year for a firm.
a. True
b. False
6. The book value per share is computed by taking the sum of common stock, additional paid in capital, and retained
earnings and dividing the number by the number of shares outstanding.
a. True
b. False
7. A proxy fight is an attempt by a group to gain control of a firm by convincing its stockholders to give the group the
authority to vote their shares in order to elect a new management team.
a. True
b. False
8. A preemptive right is a provision in the corporate charter or by laws that gives common stockholders the right to
purchase on a pro rata basis new issues of common stock.
a. True
b. False
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
9. Preemptive rights are important to stockholders because they provide protection against a dilution of value when new
shares are issued.
a. True
b. False
10. One advantage of using common stock as a source of funds is that common stock does not legally obligate the firm
to make payments to stockholders.
a. True
b. False
11. One advantage of common stock as a source of funds is that the underwriting and distribution costs of common
stock are usually much lower than those for debt.
a. True
b. False
12. From a social welfare perspective, common stock is a desirable form of financing in part because it involves no fixed
charge payments. Its inclusion in a firm‘s capital structure makes the firm less vulnerable to the consequences of
unanticipated declines in sales and earnings than if only debt were available.
a. True
b. False
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
13. When a firm issues new equity, market pressure applies first to the new shares issued and then to existing shares.
Subsequent to the new issue, the value of the new shares will rise to the equilibrium price of the old shares.
a. True
b. False
14. When management controls more than 50% of the shares of the firm, they must be concerned with the potential of a
proxy fights than can lead to takeovers of the firm and the replacement of management.
a. True
b. False
15. The constant growth model used for evaluating the price of a share of common stock can also be used to find the
price of perpetual preferred stock or any other perpetuity.
a. True
b. False
16. According to the textbook model, under conditions of nonconstant growth, the discount rate utilized to find the
present value of the expected cash flows will be the same for the initial growth period as for the normal growth
period.
a. True
b. False
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
17. According to the basic stock valuation model, the value an investor assigns to a share of stock is dependent upon the
length of time the investor plans to hold the stock.
a. True
b. False
18. Other things held constant, P/E ratios are higher for firms with high growth prospects. At the same time, P/E‘s are
lower for riskier firms, other things held constant. These two factors, growth prospects and riskiness, may either be
offsetting or reinforcing as P/E determinants.
a. True
b. False
19. The net income that firm earns can either be paid out to shareholders as
as ____.
a. interest; additional paid-in capital
b. dividends; retained earnings
c. shares; capital stock.
d. capital gains; additional paid-in capital
e. interest; retained earnings
or can be reinvested in the company
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
20. In international markets, excluding stocks sold in the United States, what is any stock that is traded in a country other
than the issuing company’s home country called?
a. ADRs
b. Yankee stock
c. Euro stock
d. Class A stock
e. Preferred stock
21. Shareholders exert control of the management of the firm by
a. electing board members who can replace management.
b. directly replacing management with themselves.
c. buying shares in an IPO at a discounted price.
d. running the daily operations of the firm.
e. None of the above.
22. Stock owned by the organizers of the firm who have sole voting rights is
a. preferred stock.
b. common equity.
c. founders’ shares.
d. convertible equity.
e. retained earnings.
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
23. Certificates representing ownership in stocks of foreign companies, which are held in a trust bank located in the
country the stock is traded are called .
a. Certificates of Ownership
b. Foreign Stock Funds
c. Mutual Funds
d. American Depository Receipts
e. Investment Bankers
24. Velcraft Company has 20,000,000 shares of common stock authorized, but to date, has only 12,000,000 shares
outstanding, each with a $1.00 par value. The company has $24,000,000 in additional paid-in capital and retained
earnings are $96,000,000. What is Velcraft’s current book value per share?
a. $1.00
b. $3.00
c. $11.00
d. $6.60
e. $9.00
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
25. Blow Glass Corporation has 100,000 shares of stock outstanding, each with a par value of $2.50 per share. Blow
Glass also has another 400,000 shares of stock that are shelf registered. Blow Glass has retained earnings of
$9,000,000 and additional paid–in capital of $1,000,000. What is Blow Glass‘s book value per share?
a. $90.00
b. $100.00
c. $27.50
d. $102.50
e. $92.50
26. Scubapro Corporation currently has 500,000 shares outstanding and plans to issue 200,000 more shares in a seasoned
equity offering. The current shareholders have preemptive rights on any new issue of stock by Scubapro
Corporation. An investor with 20,000 shares who exercises his preemptive rights on the new stock issue will have
the right to buy how many stocks?
a. 200,000 shares
b. 120,000 shares
c. 80,000 shares
d. 12,000 shares
e. 8,000 shares
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
27. Micromain Company has 10,000,000 shares of common stock authorized and 8,000,000 shares outstanding, each with
a $1.00 par value. The firm’s additional paid-in capital account has a balance of $18,000,000. The previous year’s
retained earnings account was $124,000,000. In the year just ended, Micromain generated net income of $16,000,000
and the firm has a dividend payout ratio of 40 percent. What will Micromain’s book value per share be when based
on the final year–end balance sheet?
a. $20.75
b. $15.00
c. $15.96
d. $19.95
e. $18.75
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
28. Nahanni Treasures Corporation is planning a new common stock issue of five million shares to fund a new project.
The increase in shares will bring to 25 million the number of shares outstanding. Nahanni’s long-term growth rate is 6
percent, and its current required rate of return is 12.6 percent. The firm just paid a $1.00 dividend and the stock sells
for $16.06 in the market. On the announcement of the new equity issue, the firm‘s stock price dropped. Nahanni
estimates that the company’s growth rate will increase to 6.5 percent with the new project, but since the project is
riskier than average, the firm’s cost of capital will increase to 13.5 percent. Using the DDM constant growth model,
what is the change in the equilibrium stock price?
a. −$1.77
b. −$1.06
c. −$0.85
d. −$0.66
e. −$0.08
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
29. Mesmer Analytic, a biotechnology firm, floated an initial public offering of 2,000,000 shares at a price of $5.00 per
share. The firm’s owner/managers held 60 percent of the company‘s $1.00 par value authorized and issued stock
following the public offering. One month after the IPO, the firm’s board of directors declared a one-time dividend of
$0.50 per share payable to all stockholders, meaning that the owner/managers would receive an immediate dividend,
in part out of the pockets of the new public stockholders. What was the book value per share of the firm before and
after the special dividend was paid?
a. $2.60; $2.10
b. $2.60; $2.60
c. $2.60; $2.30
d. $1.60; $1.10
e. $1.60; $1.00
30. When using the Dividend Discount Model, assuming that growth (g) will remain constant, the dividend yield is a good
measure of the required return on a common stock under which of the following circumstances?
a. g = 0
b. g > 0
c. g < 0
d. Under no circumstances.
e. Answers a and b are both correct.
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
31. If the expected rate of return on a stock exceeds the required rate,
a. The stock is experiencing supernormal growth.
b. The stock should be sold.
c. The company is probably not trying to maximize price per share.
d. The stock is a good buy.
e. Dividends are not being declared.
32. Which of the following statements is correct?
a. The constant growth DDM model can be used to value a stock only if the stock’s dividends are expected to
grow forever at a constant rate which is less than the required rate of return on the stock.
b. If the growth rate is negative, the constant growth DDM model cannot be used.
c. The constant growth DDM model may be written as r0 = D0/P0 + g.
d. The constant growth DDM model may be written as P0 = D0/(r + g).
e. The constant growth DDM model may be written as P0 = D0/(r − g).
33. Alpha‘s preferred stock currently has a market price equal to $80 per share. If the dividend paid on this stock is $6
per share, what is the required rate of return investors are demanding from Alpha’s preferred stock?
a. 7.5%
b. 13.3%
c. 6.0%
d. $6.00
e. None of the above is a correct answer.
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
34. Ms. Manners Catering (MMC) has paid a constant $1.50 per share dividend to its common stockholders for the past
25 years. MMC expects to continue this policy for the next two years, and then begin to increase the dividend at a
constant rate equal to 2 percent per year into perpetuity. Investors require a 12 percent rate of return to purchase
MMC‘s common stock. What is the market value of MMC‘s common stock?
a. $14.73
b. $15.00
c. $15.58
d. $15.30
e. $12.20
35. A share of perpetual preferred stock pays an annual dividend of $6 per share. If investors require a 12 percent rate
of return, what should be the price of this preferred stock?
a. $57.25
b. $50.00
c. $62.38
d. $46.75
e. $41.64
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
36. A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is currently $50,
what is the simple annual rate of return?
a. 12%
b. 18%
c. 20%
d. 23%
e. 28%
37. A share of preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00 for this preferred
stock, what is your simple (not effective) annual rate of return?
a. 10%
b. 8%
c. 6%
d. 12%
e. 14%
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
38. The last dividend on Spirex Corporation’s common stock was $4.00, and the expected growth rate is 10 percent. If
you require a rate of return of 20 percent, what is the highest price you should be willing to pay for this stock?
a. $44.00
b. $38.50
c. $40.00
d. $45.69
e. $50.00
39. You are trying to determine the appropriate price to pay for a share of common stock. If you purchase this stock,
you plan to hold it for 1 year. At the end of the year you expect to receive a dividend of $5.50 and to sell the stock
for $154. The appropriate rate of return for this stock is 16 percent. What should be the current price of this stock?
a. $137.50
b. $150.22
c. $162.18
d. $98.25
e. $175.83
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
40. A share of common stock has a current price of $82.50 and is expected to grow at a constant rate of 10 percent. If
you require a 14 percent rate of return, what is the current dividend on this stock?
a. $3.00
b. $3.81
c. $4.29
d. $4.75
e. $6.13
41. The last dividend paid by Klein Company was $1.00. Klein’s growth rate is expected to be a constant 5 percent for 2
years, after which dividends are expected to grow at a rate of 10 percent forever. Klein’s required rate of return on
equity (rs) is 12 percent. What is the current price of Klein’s common stock?
a. $21.00
b. $33.33
c. $42.25
d. $50.16
e. $58.75
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
42. You are given the following data:
(1) The risk-free rate is 5 percent.
(2) The required return on the market is 8 percent.
(3) The expected growth rate for the firm is 4 percent.
(4) The last dividend paid was $0.80 per share.
(5) Beta is 1.3.
Now assume the following changes occur:
(1) The inflation premium drops by 1 percent.
(2) An increased degree of risk aversion causes the required return on the market to go to 10
percent after adjusting for the changed inflation premium.
(3) The expected growth rate increases to 6 percent.
(4) Beta rises to 1.5.
What will be the change in price per share, assuming the stock was in equilibrium before the changes?
a. +$12.11
b. −$4.87
c. +$6.28
d. −$16.97
e. +$2.78
CFIN4
Chapter 7 – Socks (Equity) – Characteristics and Valuation
43. You are considering an investment in the common stock of Cowher Corp. The stock is expected to pay a dividend of
$2 per share at the end of the year (i.e., D1 = $2.0 ). The stock has a beta equal to 1.2. The risk-free rate is 6
percent. The market risk premium is 5 percent. The stock’s dividend is expected to grow at some constant rage, g.
The stock currently sells for $40 a share. Assuming the market is in equilibrium, what does the market believe the
stock price will be at the end of three years? (In other words, what is P3?)
a. $40.00
b. $42.35
c. $45.67
d. $46.31
e. $49.00
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
44. A firm expects to pay dividends at the end of each of the next four years of $2.00, $1.50, $2.50, and $3.50. If growth
is then expected to level off at 8 percent, and if you require a 14 percent rate of return, how much should you be
willing to pay for this stock?
a. $67.81
b. $22.49
c. $58.15
d. $31.00
e. $43.97