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Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 8 The Valuation and Characteristics of Stock
8.1 Learning Objective 1
1) Preferred stock is referred to as a hybrid security because it has many characteristics of both
common stock and bonds.
2) Because most preferred stocks are perpetuities, their value can be determined by dividing the
annual dividend by an investor’s required return.
3) In terms of risk, preferred stock is safer than common stock because it has a prior claim on
assets and income.
4) Public perception and reputation do not affect stock prices, which are strictly a function of
dividends and required returns.
5) A call provision entitles a company to repurchase its preferred stock from holders at stated
prices over a given time period.
6) For a given constant required rate of return, the greatest portion of a preferred stockholder’s
return comes from increases in the price of preferred stock.
7) The amount of the preferred stock dividend is generally fixed either as a dollar amount or as a
percentage of the par value.
8) Preferred stock is riskier than long-term debt because its claim on assets and income come
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after those of bonds.
9) A call provision allows the issuing firm the opportunity to avoid rising interest rates by calling
investors and asking for more cash.
10) Although under normal operating conditions preferred shareholders do not have voting
rights, protective provision generally allow for voting rights in the event of nonpayment of
preferred dividends.
11) If a firm does not have enough money to pay any common stock dividends, it is technically
in default to the common shareholders.
12) The use of a call provision in addition to a sinking fund can effectively create a maturity date
for preferred stock.
13) The upper limit on common stock dividends, which is set by the SEC, is generally equal to
the sum of dividends paid on the company’s preferred stock.
14) A sinking-fund provision allows for the retirement of a portion of preferred stock each year.
15) Two approaches that allow for the retirement of preferred stock are call provisions and
sinking fund provisions.
16) A company’s market capitalization is generally greater than its book value, in part due to its
reputation for being able to deliver growth, attract top talent, and avoid ethical mistakes.
17) Preferred stock valuation usually treats the preferred stock as a
A) capital asset.
B) perpetuity.
C) common stock.
D) long-term bond.
18) Preferred stock is similar to a bond in the following way
A) preferred stock always contains a maturity date.
B) both investments provide a stated income stream.
C) both contain a growth factor similar to common stock.
D) both provide interest payments.
19) Cumulative preferred stock
A) requires dividends in arrears to be carried over into the next period.
B) has a right to vote cumulatively.
C) has a claim to dividends before bonds.
D) has a higher required return than common stock.
20) How is preferred stock similar to bonds?
A) Dividend payments to preferred shareholders (much like bond interest payments to
bondholders) are tax deductible.
B) Investors can sue the firm if preferred dividend payments are not paid (much like bondholders
can sue for non-payment of interest payments).
C) Preferred stockholders receive a dividend payment (much like interest payments to
bondholders) that is usually fixed.
D) Preferred stock is not like bonds in any way.
21) Most preferred stocks have a feature that requires all past unpaid preferred dividend
payments be paid before any common stock dividends can be paid. What is the name of this
feature?
A) Participating
B) Cumulative
C) Provisional
D) Convertible
22) Many preferred stocks have a provision that entitles a company to repurchase its preferred
stock from their holders at stated prices over a given time period. What is the name of this
provision?
A) Cumulative
B) Putable
C) Callable
D) Convertible
23) Many preferred stocks have a feature that requires a firm to periodically set aside an amount
of money for the retirement of its preferred stock. What is the name of this feature?
A) Convertible
B) Callable
C) Cumulative
D) Sinking fund
8.2 Learning Objective 2
1) XYZ Corp 8% preferred stock with a par value of $100 and a market price of $150 will pay an
annual dividend this year of $12 per share.
2) The YLD% shown in Wall Street Journal stock quotes stands for the stock’s dividend yield
and is calculated by dividing the amount of the dividend by the stock’s opening price on the first
day of the year.
3) A preferred stock that pays an annual dividend of $10, has a par value of $100, and has a
required return of 5% will be valued at $200.
4) Keyes Corporation preferred stock pays an annual dividend of $7 per share. Which of the
following statements is true for an investor with a required return of 9%?
A) The value of the preferred stock is $7 because the dividend is fixed at $7 each year .
B) The value of the preferred stock is $63.00 per share.
C) The value of the preferred stock is $77.78 per share.
D) The value of the preferred stock is $6.30 per share because of the 9% required return.
5) Which of the following statements concerning preferred stock is most correct?
A) Preferred stock is valued the same as zero coupon bonds because the cash flow patterns are
similar.
B) If a corporation issues 4% preferred stock with a par value of $100, the dividend will increase
by 4% per year.
C) Preferred stock dividends are typically the same each year, allowing a preferred stock to be
valued as a perpetuity.
D) Preferred stock dividends are calculated as a percentage of common stock dividends, although
the preferred stock dividends must be paid first.
6) Nuray Corp. preferred stock pays a $.50 annual dividend. What is the value of the stock if
your required rate of return is 10%?
A) $.05
B) $.50
C) $5.00
D) $50.00
7) Bell Corp. has a preferred stock that pays a dividend of $2.40. If you are willing to purchase
the stock at $11, what is your required rate of return (round your answer to the nearest .1% and
assume that there are no transaction costs)?
A) 21.8%
B) 11.0%
C) 9.1%
D) 20.1%
8) What is the value of a preferred stock that pays a $4.50 dividend to an investor with a required
rate of return of 10%?
A) $22.22
B) $27.83
C) $45
D) $55.50
9) How is preferred stock affected by a decrease in the required rate of return?
A) The value of a share of preferred stock increases.
B) The dividend increases.
C) The dividend decreases.
D) The dividend yield increases.
10) Casino Games Company preferred stock pays a perpetual annual dividend of 3.5% of its
$100 par value. If investors’ required rate of return on this stock is 11%, what is the value per
share?
A) $35.00
B) $31.82
C) $7.97
D) $3.18
11) CMT, Inc. has an issue of preferred stock whose par value is $500. The preferred stock pays
a 4.5% dividend. If investors require a 5.5% rate of return for these shares, what price should the
preferred stock sell for?
A) $611.11
B) $508.33
C) $409.09
D) $81.82
12) Department 65 has an issue of preferred stock that pays a dividend of $4.00. The preferred
stockholders require a rate of return on this stock of 9%. At what price should the preferred stock
sell for? Round off to the nearest $0.10.
A) $36.00
B) $44.40
C) $62.50
D) $88.80
13) Positive Tronics Industries preferred stock has a par value of $100 and pays a dividend of
$6.00 per share. It presently sells for $87 per share. What do investors require as a rate of return
on this stock? Round off to the nearest .10%.
A) 14.5%
B) 9.3%
C) 6.9%
D) 6.0%
14) Yanti Corp. preferred stock has a 5% stated dividend percentage, and a $100 par value. What
is the value of the stock if your required rate of return is 6% per year?
A) $83.33
B) $94.05
C) $100.00
D) $30.00
15) If Neal O’Danny preferred stock pays an annual dividend of $2.80, and investors require a
9% return, what is the value of O’Danny’s preferred stock today?
8.3 Learning Objective 3
1) The market price of a firm’s common stock equals the sum of all equity accounts as reported
in its balance sheet (common stock + paid-in capital + retained earnings) divided by the number
of shares outstanding.
2) Historically, price appreciation, or capital gains yield, has accounted for a greater portion of
returns on common stocks than dividend payments.
3) Preferred stock is less risky than common stock, but more risky than debt.
4) Cumulative voting is advantageous to minority shareholders because it may allow them to
elect a member of the board of directors.
5) Shareholders, as owners of the corporation, face unlimited liability for the corporation’s debts,
while bondholders, as creditors, may only lose the value of their investment if the company goes
bankrupt.
6) Common stock cannot be worth less than its book value.
7) Convertibility is a common feature of common stock; it allows the common stockholders to
convert their common shares into preferred shares or into bonds.
8) Common stockholders demand a return on the price paid for their common stock, but since
retained earnings on the balance sheet are merely “on paper” they do not require a return on
earnings that have been retained.
9) The common stock of a constant-growth firm is valued in the same manner as its preferred
stock.
10) Common stock does not mature.
11) Bondholders and preferred stockholders can be viewed as creditors, whereas the common
stockholders are the true owners of the firm.
12) If a common stockholder cannot personally attend the meeting of shareholders then their
votes are lost.
13) Under cumulative voting a 10% shareholder will likely be able to elect 10% of the board of
directors.
14) Under majority voting a majority (>50%) shareholder will just be able to elect a simple
majority of the board of directors.
15) Under majority voting a majority (>50%) shareholder will be able to elect the entire board of
directors.
16) Preferred stock and common stock issued by the same firm will have the same required
return because the riskiness of the firm’s cash flows is the same for both securities.
17) In theory, shareholders select the board of directors, but in reality, management effectively
selects the directors.
18) Limited liability for a corporation’s common shareholders is a protective provision that aids
the corporation in raising funds.
19) If a shareholder cannot attend the corporation’s annual meeting, the shares may still be voted
using
A) the preemptive right.
B) a proxy.
C) majority voting rules.
D) the cumulative voting right.
20) Minority shareholders have a greater chance of electing a member to the board of directors if
the company uses
A) cumulative voting.
B) majority voting.
C) minority voting.
D) proxy voting.
21) Preferred stock differs from common stock in that
A) preferred stock usually has a maturity date.
B) preferred stock investors have a higher required return than common stock investors.
C) preferred stock dividends are fixed.
D) common stock investors have a required return and preferred stock investors do not.
22) How is preferred stock similar to common stock?
A) Preferred dividend payments usually have unlimited growth potential.
B) Investors cannot sue a corporation for the non-payment of dividends.
C) Both preferred and common stockholders have voting control of a firm.
D) Preferred stock dividends and common stock dividends are fixed.
23) Which of the following is not true regarding common stock?
A) Dividends, unlike interest payments, are not tax deductible.
B) Common stock, unlike bond principal, does not mature.
C) Common stockholders are owners of the firm, whereas bondholders are creditors.
D) Dividend payments, like interest payments, are fixed.
24) Consider the following four types of payments that could be made by a normal operating
firm: interest, common dividends, income taxes, and preferred dividends. Compared to the other
payments mentioned, where would you rank common dividend payments in terms of the order of
payment if the firm is liquidating?
A) First
B) Second
C) Third
D) Fourth
25) Assume that a firm had such serious financial problems that it was about to be liquidated
after a bankruptcy. All of the firm’s assets are about to be sold in order to pay the following
claims against the firm: bondholders, preferred stockholders, common stockholders, and federal
income taxes. Of the claims mentioned, what priority would common stockholders have?
A) First
B) Second
C) Third
D) Fourth
26) What provision entitles the common shareholder to maintain a proportionate share of
ownership in a firm?
A) the cumulative feature
B) the convertible feature
C) the proportionality clause
D) the preemptive right
27) Which of the following features, or benefits, belong to a firm’s common stockholders?
A) limited liability
B) ownership of the firm
C) voting rights
D) all of the above
28) Who bears the greatest risk of loss of value if a firm should fail?
A) bondholders
B) preferred stockholders
C) common stockholders
D) All of the above bear equal risk of loss.
8.4 Learning Objective 4
1) The most relevant form of growth for valuing a firm’s common stock is internal growth.
2) Because common stock represents a residual interest in the corporation, the value of common
stock is equal to the total firm value less the firm’s outstanding debt.
3) An investor’s required rate of return for a common stock can be estimated by summing the
stock’s dividend yield and annual growth rate, assuming the growth rate is constant over time.
4) Given the constant growth dividend valuation model, the expected percentage growth in value
of a stock is equal to the capital gains yield for that stock.
5) If the expected growth rate for dividends is zero, then the value of common stock will be
equal to the current dividend.
6) A common stock with an expected dividend growth rate of zero would be valued in the same
way as preferred stock, that is, the expected dividend divided by the required return.
7) In general, common stock and preferred stock are both valued by calculating the present value
of all expected future cash flows, using the required return as the discount rate.
8) The stock valuation model D1/(rcs – g) requires the stock to grow at a rate greater than the
required return; otherwise, the stock is worthless.
9) The retention ratio is equal to 1 minus the dividend payout ratio.
10) A firm can increase the growth rate of common stockholders’ investment in the firm by
retaining more earnings or increasing return on equity.
11) Common stock valuation can be based on the present value of future dividends or
alternatively on the present value of the firm’s future quarterly net income.
12) The change in the value of a corporation’s common stock as the result of growth is the same
regardless of whether the growth is the result of internal growth or the infusion of new capital.
13) United Financial Corp had a return on equity of 15%. The corporation’s earnings per share
was $6.00, its dividend payout ratio was 40% and its profit-retention rate was 60%. If these
relationships continue, what will be United Financial Corp’s internal growth rate?
A) 6.0%
B) 8.6%
C) 9.0%
D) 15.6%