CHAPTER 8
STOCK VALUATION
Answers to Concepts Review and Critical Thinking Questions
1. The value of any investment depends on the present value of its cash flows; i.e., what investors will
actually receive. The cash flows from a share of stock are the dividends.
2. Investors believe the company will eventually start paying dividends (or be sold to another company).
3. In general, companies that need the cash will often forgo dividends since dividends are a cash expense.
Young, growing companies with profitable investment opportunities are one example; another example is a
company in financial distress. This question is examined in depth in a later chapter.
4. The general method for valuing a share of stock is to find the present value of all expected future dividends.
The dividend growth model presented in the text is only valid (i) if dividends are expected to occur forever,
that is, the stock provides dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs
forever. A violation of the first assumption might be a company that is expected to cease operations and
5. The common stock probably has a higher price because the dividend can grow, whereas it is fixed on the
preferred. However, the preferred is less risky because of the dividend and liquidation preference, so it is
possible the preferred could be worth more, depending on the circumstances.
6. The two components are the dividend yield and the capital gains yield. For most companies, the capital
gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay
dividends, the dividend yields are rarely over five percent and are often much less.
7. Yes. If the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate
and the capital gains yield are the same.
8. In a corporate election, you can buy votes (by buying shares), so money can be used to influence or even
determine the outcome. Many would argue the same is true in political elections, but, in principle at least,
no one has more than one vote.
9. It wouldn’t seem to be. Investors who don’t like the voting features of a particular class of stock are under
no obligation to buy it.
10. Investors buy such stock because they want it, recognizing that the shares have no voting power.
Presumably, investors pay a little less for such shares than they would otherwise.
