CHAPTER 9: STOCKS AND THEIR VALUATION
1.
A proxy is a document giving one party the authority to act for another party, including the power to vote
shares of
common stock. Proxies can be important tools relating to control of firms.
a.
True
b.
False
2.
The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares
issued by
the firm. This right helps protect current stockholders against both dilution of control and dilution of
value.
a.
True
b.
False
3.
If a firm’s stockholders are given the preemptive right, this means that stockholders have the right to call for a
meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to
seek
a change in management through a proxy fight.
a.
True
b.
False
4.
Classified stock differentiates various classes of common stock, and using it is one way companies can meet
special
needs such as when owners of a start–up firm need additional equity capital but don’t want to relinquish
voting
control.
a.
True
b.
False
5.
Founders’ shares are a type of classified stock where the shares are owned by the firm’s founders, and they
generally have more votes per share than the other classes of common stock.
a.
True
b.
False
6.
The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is
purchased and sold.
a.
True
b.
False
7.
The cash flows associated with common stock are more difficult to estimate than those related to bonds
because
stock has a residual claim against the company versus a contractual obligation for a bond.
a.
True
b.
False
8.
According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is
dependent on the length of time he or she plans to hold the stock.
a.
True
b.
False
9.
When a new issue of stock is brought to market, it is the marginal investor who determines the price at which
the
stock will trade.
a.
True
b.
False
10.
The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the
model
used to find the price of perpetual preferred stock or other perpetuities.
a.
True
b.
False
11.
According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present
value of the expected cash flows during the initial growth period is the same as the discount rate used to find
the
PVs of cash flows during the subsequent constant growth period.
a.
True
b.
False
12.
The corporate valuation model can be used only when a company doesn’t pay dividends.
a.
True
b.
False
13.
The corporate valuation model cannot be used unless a company pays dividends.
a.
True
b.
False
14.
Projected free cash flows should be discounted at the firm’s weighted average cost of capital to find the firm’s
total
corporate value.
a.
True
b.
False
15.
Preferred stock is a hybrid—a sort of cross between a common stock and a bond—in the sense that it pays
dividends that normally increase annually like a stock but its payments are contractually guaranteed like
interest on a
bond.
a.
True
b.
False
16.
From an investor’s perspective, a firm’s preferred stock is generally considered to be less risky than its
common
stock but more risky than its bonds. However, from a corporate issuer’s standpoint, these risk
relationships are
reversed: bonds are the most risky for the firm, preferred is next, and common is least risky.
a.
True
b.
False
17.
If a stock’s expected return as seen by the marginal investor exceeds this investor’s required return, then the
investor
will buy the stock until its price has risen enough to bring the expected return down to equal the
required return.
a.
True
b.
False
18.
If a stock’s market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell
the
stock until its price has fallen down to the level of the investor’s estimate of the intrinsic value.
a.
True
b.
False
19.
For a stock to be in equilibrium, two conditions are necessary: (1) The stock’s market price must equal its
intrinsic
value as seen by the marginal investor and (2) the expected return as seen by the marginal investor
must equal this
investor’s required return.
a.
True
b.
False
20.
Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock’s market
price
equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as
seen by
the marginal investor equal this investor’s required return? If either of these conditions, but not
necessarily both,
holds, then the stock is said to be in equilibrium.
a.
True
b.
False
21.
Which of the following statements is CORRECT?
a.
The constant growth model is often appropriate for evaluating start-up companies that do not have a stable
history of growth but are expected to reach stable growth within the next few years.
b.
If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%,
this implies that the stock’s dividend yield is also 5%.
c.
The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to
decline at a constant rate, i.e., to grow at a negative rate.
d.
The price of a stock is the present value of all expected future dividends, discounted at the dividend growth
rate.
e.
The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain
constant over time.
22.
An increase in a firm’s expected growth rate would cause its required rate of return to
a.
increase.
b.
decrease.
c.
fluctuate less than before.
d.
fluctuate more than before.
e.
possibly increase, possibly decrease, or possibly remain constant.
23.
If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the
investor thinks
a.
the stock is experiencing supernormal growth.
b.
the stock should be sold.
c.
the stock is a good buy.
d.
management is probably not trying to maximize the price per share.
e.
dividends are not likely to be declared.
24.
If markets are in equilibrium, which of the following conditions will exist?
a.
Each stock’s expected return should equal its realized return as seen by the marginal investor.
b.
Each stock’s expected return should equal its required return as seen by the marginal investor.
c.
All stocks should have the same expected return as seen by the marginal investor.
d.
The expected and required returns on stocks and bonds should be equal.
e.
All stocks should have the same realized return during the coming year.
25.
The preemptive right is important to shareholders because it
a.
allows managers to buy additional shares below the current market price.
b.
will result in higher dividends per share.
c.
is included in every corporate charter.
d.
protects the current shareholders against a dilution of their ownership interests.
e.
protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.
26.
Companies can issue different classes of common stock. Which of the following statements concerning stock
classes is CORRECT?
a.
All common stocks fall into one of three classes: A, B, and C.
b.
All common stocks, regardless of class, must have the same voting rights.
c.
All firms have several classes of common stock.
d.
All common stock, regardless of class, must pay the same dividend.
e.
Some class or classes of common stock are entitled to more votes per share than other classes.
27.
Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium,
which of the following statements is CORRECT?
A
B
Required return
10%
12%
Market price
$25
$40
Expected growth
7%
9%
a.
These two stocks should have the same price.
b.
These two stocks must have the same dividend yield.
c.
These two stocks should have the same expected return.
d.
These two stocks must have the same expected capital gains yield.
e.
These two stocks must have the same expected year-end dividend.
28.
Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium,
which of the following statements is CORRECT?
A
B
Price
$25
$40
Expected growth
7%
9%
Expected return
10%
12%
a.
The two stocks should have the same expected dividend.
b.
The two stocks could not be in equilibrium with the numbers given in the question.
c.
A’s expected dividend is $0.50.
d.
B’s expected dividend is $0.75.
e.
A’s expected dividend is $0.75 and B’s expected dividend is $1.20.
29.
Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return.
Which of the following statements is CORRECT?
a.
If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than
Stock
B’s.
b.
Stock B must have a higher dividend yield than Stock A.
c.
Stock A must have a higher dividend yield than Stock B.
d.
If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than
Stock
B’s.
e.
Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B.
30.
Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return.
Which of the following statements is CORRECT?
a.
The two stocks must have the same dividend per share.
b.
If one stock has a higher dividend yield, it must also have a lower dividend growth rate.
c.
If one stock has a higher dividend yield, it must also have a higher dividend growth rate.
d.
The two stocks must have the same dividend growth rate.
e.
The two stocks must have the same dividend yield.
31.
Which of the following statements is CORRECT, assuming stocks are in equilibrium?
a.
The dividend yield on a constant growth stock must equal its expected total return minus its expected capital
gains yield.
b.
Assume that the required return on a given stock is 13%. If the stock’s dividend is growing at a constant rate
of 5%, its expected dividend yield is 5% as well.
c.
A stock’s dividend yield can never exceed its expected growth rate.
d.
A required condition for one to use the constant growth model is that the stock’s expected growth rate
exceeds its required rate of return.
e.
Other things held constant, the higher a company’s beta coefficient, the lower its required rate of return.
32.
A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at
a
rate of 5% a year forever (g = −5%). If the company is in equilibrium and its expected and required rate of
return is
15%, which of the following statements is CORRECT?
a.
The company’s current stock price is $20.
b.
The company’s dividend yield 5 years from now is expected to be 10%.
c.
The constant growth model cannot be used because the growth rate is negative.
d.
The company’s expected capital gains yield is 5%.
e.
The company’s expected stock price at the beginning of next year is $9.50.
33.
Which of the following statements is CORRECT?
a.
The constant growth model takes into consideration the capital gains investors expect to earn on a stock.
b.
Two firms with the same expected dividend and growth rate must also have the same stock price.
c.
It is appropriate to use the constant growth model to estimate a stock’s value even if its growth rate is never
expected to become constant.
d.
If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of
5%, this implies that the stock’s dividend yield is also 5%.
e.
The price of a stock is the present value of all expected future dividends, discounted at the dividend growth
rate.
34.
If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is
CORRECT? The stock is in equilibrium.
a.
The expected return on the stock is 5% a year.
b.
The stock’s dividend yield is 5%.
c.
The price of the stock is expected to decline in the future.
d.
The stock’s required return must be equal to or less than 5%.
e.
The stock’s price one year from now is expected to be 5% above the current price.
35.
Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium,
which of the following statements is CORRECT?
A
B
Price
$25
$25
Expected growth (constant)
10%
5%
Required return
15%
15%
a.
Stock A’s expected dividend at t = 1 is only half that of Stock B.
b.
Stock A has a higher dividend yield than Stock B.
c.
Currently the two stocks have the same price, but over time Stock B’s price will pass that of A.
d.
Since Stock A’s growth rate is twice that of Stock B, Stock A’s future dividends will always be twice as
high
as Stock B’s.
e.
The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist.
36.
Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium,
which of the following statements is CORRECT?
X
Y
Price
$30
$30
Expected growth (constant)
6%
4%
Required return
12%
10%
a.
Stock X has a higher dividend yield than Stock Y.
b.
Stock Y has a higher dividend yield than Stock X.
c.
One year from now, Stock X’s price is expected to be higher than Stock Y’s price.
d.
Stock X has the higher expected year-end dividend.
e.
Stock Y has a higher capital gains yield.
37.
Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which
of the
following statements is CORRECT?
Expected dividend, D1 $3.00
Current Price, P0 $50
Expected constant growth rate 6.0%
a.
The stock’s required return is 10%.
b.
The stock’s expected dividend yield and growth rate are equal.
c.
The stock’s expected dividend yield is 5%.
d.
The stock’s expected capital gains yield is 5%.
e.
The stock’s expected price 10 years from now is $100.00.
38.
Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium,
which of the following statements is CORRECT?
X
Y
Price
$25
$25
Expected dividend yield
5%
3%
Required return
12%
10%
a.
Stock Y pays a higher dividend per share than Stock X.
b.
Stock X pays a higher dividend per share than Stock Y.
c.
One year from now, Stock X should have the higher price.
d.
Stock Y has a lower expected growth rate than Stock X.
e.
Stock Y has the higher expected capital gains yield.
39.
The expected return on Natter Corporation’s stock is 14%. The stock’s dividend is expected to grow at a
constant
rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT?
a.
The stock’s dividend yield is 7%.
b.
The stock’s dividend yield is 8%.
c.
The current dividend per share is $4.00.
d.
The stock price is expected to be $54 a share one year from now.
e.
The stock price is expected to be $57 a share one year from now.
40.
Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%.
Assuming
the stock market is efficient and the stocks are in equilibrium, which of the following statements is
CORRECT?
A
B
Beta
1.10
0.90
Constant growth rate
7.00%
7.00%
a.
Stock A must have a higher stock price than Stock B.
b.
Stock A must have a higher dividend yield than Stock B.
c.
Stock B’s dividend yield equals its expected dividend growth rate.
d.
Stock B must have the higher required return.
e.
Stock B could have the higher expected return.
41.
Which of the following statements is NOT CORRECT?
a.
The corporate valuation model can be used both for companies that pay dividends and those that do not pay
dividends.
b.
The corporate valuation model discounts free cash flows by the required return on equity.
c.
The corporate valuation model can be used to find the value of a division.
d.
An important step in applying the corporate valuation model is forecasting the firm’s pro forma financial
statements.
e.
Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon,
or continuing, value.
42.
Which of the following statements is CORRECT?
a.
To implement the corporate valuation model, we discount projected free cash flows at the weighted average
cost of capital.
b.
To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the
weighted average cost of capital.
c.
To implement the corporate valuation model, we discount projected net income at the weighted average cost
of capital.
d.
To implement the corporate valuation model, we discount projected free cash flows at the cost of equity
capital.
e.
The corporate valuation model requires the assumption of a constant growth rate in all years.
43.
Which of the following statements is CORRECT?
a.
Preferred stockholders have a priority over bondholders in the event of bankruptcy to the income, but not to
the proceeds in a liquidation.
b.
The preferred stock of a given firm is generally less risky to investors than the same firm’s common stock.
c.
Corporations cannot buy the preferred stocks of other corporations.
d.
Preferred dividends are not generally cumulative.
e.
A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing
corporation.
44.
Which of the following statements is CORRECT?
a.
A major disadvantage of financing with preferred stock is that preferred stockholders typically have
supernormal voting rights.
b.
Preferred stock is normally expected to provide steadier, more reliable income to investors than the same
firm’s common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax
expected return on the common stock.
c.
The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to
purchase (on a pro rata basis) new issues of preferred stock.
d.
One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received
represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax
free.
e.
One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax
deductible to the issuer.
45.
For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its
current
level, then
a.
the expected future return must be less than the most recent past realized return.
b.
the past realized return must be equal to the expected return during the same period.
c.
the required return must equal the realized return in all periods.
d.
the expected return must be equal to both the required future return and the past realized return.
e.
the expected future return must be equal to the required return.
46.
Which of the following statements is CORRECT?
a.
If a company has two classes of common stock, Class A and Class B, the stocks may pay different
dividends,
but under all state charters the two classes must have the same voting rights.
b.
The preemptive right gives stockholders the right to approve or disapprove of a merger between their
company and some other company.
c.
The preemptive right is a provision in the corporate charter that gives common stockholders the right to
purchase (on a pro rata basis) new issues of the firm’s common stock.
d.
The stock valuation model, P0 = D1/(rs − g), cannot be used for firms that have negative growth rates.
e.
The stock valuation model, P0 = D1/(rs − g), can be used only for firms whose growth rates exceed their
required return.
47.
The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is
CORRECT?
a.
If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the
higher expected growth rate.
b.
If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains
yield than Stock X.
c.
If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then
Stock Y must sell for a higher price.
d.
The stocks must sell for the same price.
e.
Stock Y must have a higher dividend yield than Stock X.
48.
A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%,
and
the expected constant growth rate is g = 6.4%. What is the stock’s current price?
a.
$17.39
b.
$17.84
c.
$18.29
d.
$18.75
e.
$19.22
49.
A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth
rate is
g = 4.0%. What is the current stock price?
a.
$23.11
b.
$23.70
c.
$24.31
d.
$24.93
e.
$25.57
50.
A share of common stock just paid a dividend of $1.00. If the expected long-run growth rate for this stock is
5.4%,
and if investors’ required rate of return is 11.4%, what is the stock price?
a.
$16.28
b.
$16.70
c.
$17.13
d.
$17.57
e.
$18.01
51.
If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $26.00, what is the stock’s expected dividend yield for
the
coming year?
a.
4.12%
b.
4.34%
c.
4.57%
d.
4.81%
e.
5.05%
52.
If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the stock’s expected dividend yield for the
coming
year?
a.
4.42%
b.
4.66%
c.
4.89%
d.
5.13%
e.
5.39%
53.
If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock’s expected capital gains yield for
the
coming year?
a.
6.50%
b.
6.83%
c.
7.17%
d.
7.52%
e.
7.90%
54.
If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock’s expected total return for the
coming
year?
a.
7.54%
b.
7.73%
c.
7.93%
d.
8.13%
e.
8.34%
55.
If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the stock’s expected total return for the
coming year?
a.
8.37%
b.
8.59%
c.
8.81%
d.
9.03%
e.
9.27%
56.
Gay Manufacturing is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The
stock
sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at
some
constant rate, g, forever. What is the equilibrium expected growth rate?
a.
6.01%
b.
6.17%
c.
6.33%
d.
6.49%
e.
6.65%
57.
Reddick Enterprises’ stock currently sells for $35.50 per share. The dividend is projected to increase at a
constant
rate of 5.50% per year. The required rate of return on the stock, rs, is 9.00%. What is the stock’s
expected price 3
years from today?
a.
$37.86
b.
$38.83
c.
$39.83
d.
$40.85
e.
$41.69
58.
Whited Inc.’s stock currently sells for $35.25 per share. The dividend is projected to increase at a constant rate
of
4.75% per year. The required rate of return on the stock, rs, is 11.50%. What is the stock’s expected price 5
years
from now?
a.
$40.17
b.
$41.20
c.
$42.26
d.
$43.34
e.
$44.46