Chapter 8
Stocks, Stock Markets, and Market Efficiency
Conceptual and Analytical Problems
1. Explain why being a residual claimant makes stock ownership risky. (LO1)
Answer: Stockholders do not receive dividends unless all of the firm’s creditors have
bankrupt, stockholders lose their entire investment.
2. Do individual shareholders have an effective say in corporate governance matters?
(LO1)
Answer: In principle, shareholders have a say on corporate affairs. They elect
members of the company’s board of directors and can vote on important issues raised
impact of a small shareholder is limited. In addition, while shareholders vote to elect
directors, managers, rather than owners, often control the overall board.
3. Consider the following information on the stock market in a small economy. (LO2)
Company Shares
Outstanding
Price,
beginning
of year
Price, end
of year
a. Compute a price-weighted stock price index for the beginning of the year and the
end of the year. What is the percentage change?
b. Compute a value-weighted stock price index for the beginning of the year and the
end of the year. What is the percentage change?
Answer:
a. For a price-weighted index, we find the cost of buying one share of each company
change is 1.6%.
b. The percentage change in a value-weighted index is given by percentage change
4. To raise wealth and stimulate private spending, suppose the central bank lowers
Jones Industrial Average or the S&P 500? Why? (LO2)
Answer: Since the S&P 500 is a value-weighted index, it tracks the value of owning
each of the stocks in the index. As such, it does not measure wealth.
5. Suppose you see evidence that the stock market is efficient. Would that make you
your first job? (LO4)
Answer: Efficient markets suggest that all relevant information is incorporated into
stock prices, and that changes in prices on a particular day reflect that day’s “news.”
knowledge of the historical long-run performance of a diversified portfolio of stocks.
6. Professor Siegel argues that investing in stocks for retirement may be less risky than
investing in bonds. Would you recommend this approach to an individual in his or her
early 60s? (LO4)
Answer: The closer an individual is to retirement, the less time for a portfolio to
exposed to equities.
7. How do venture capital firms, which specialize in identifying and financing
promising but high-risk businesses, help the economy grow? (LO5)
Answer: New companies often have difficulty finding financing to put their plans into
action. Venture capital firms specialize (say, in one particular industry) in identifying
marketplace. The resulting shift of resources to more productive activities boosts
incomes and economic growth.
8. *What are the advantages of holding stock in a company versus holding bonds issued
by the same company? (LO1)
Answer: Stocks represent a share of ownership in the company and give the holder a
share in the future profits of the company. If the company, for example, makes a
company. The right to vote at annual meetings is another advantage of holding stock
rather than bonds in a company.
9. If Professor Siegel is correct that stocks are less risky than bonds, then the risk
warranted by the fundamentals. Compare the result to the current S&P 500 level, and
comment on it. (LO4)
Answer:
If the current dividend is $70, the risk-free rate is 2.5 percent and the growth rate of
is: P = $70(1.01) / (0.025 – 0.01) = $4,713.33
On January 3, 2017, the S&P 500 was at $2,257.83. This suggests either that the
10. *Why is a booming stock market not always a good thing for the economy? (LO5)
Answer: If stock prices are rising for reasons that are not related to economic
leading to increased demand for certain goods and services that cannot be sustained
when the stock market readjusts.
11. The financial press tends to become excited when the Dow Jones Industrial Average
rises or falls sharply. After a particularly steep rise or fall, newspapers may publish
days in stock market history, how would you do it, and why? (LO2)
Answer: This type of reporting can be misleading because it ignores the level of the
changes is the best solution.
12. You are thinking about investing in stock in a company which paid a dividend of $10
in the market is $200 a share, should you buy it? (LO3)
Answer: Yes. Using the dividend discount model, you are willing to pay:P =
13. *Consider again the stock described in Problem 12. What might account for the
difference in the market price of the stock and the price you are willing to pay for the
stock? (LO3)
Answer: The difference could reflect the fact that you require a lower risk premium
pushing the price below the fundamental value.
14. You are trying to decide whether to buy stock in Company X or Company Y. Both
companies need $1000 capital investment and will earn $200 in good years (with
10% interest must be paid.
Construct a table showing the expected value and standard deviation of the equity
return for each of the companies. (You could use Table 8.3 as a guide.) Based on this
table, in which company would you buy stock? Explain your choice. (LO3)
Answer:
% equity % bonds Pay on
bonds
Pay to
equity
holders
Equity
return
Expected
Value
Standard
Deviatio
n
(Remember, the expected value of the equity return is calculated as a % of 500 – the
amount put into equity.)
Which company you choose depends on your attitude toward risk. If you are willing
company X.
15. Your brother has a $1,000 and a one-year investment horizon and asks your advice
investment strategy to gain exposure to the stock market you might suggest he
consider? (LO4)
Answer: You should explain that the return on his investment will depend on the
dividend he may be paid and the movement in the stock price over the year. You
invest his $1000 in a mutual fund, thus spreading the risk over a portfolio of stocks.
16. Given that many stock market indices across the world fell and rose together during
the financial crisis of 2007-2009, do you think investing in global stock markets is an
effective way to reduce risk? Why or why not? (LO2)
Answer: While it is true that movements in stock market indices across the world
have become more highly correlated over time, as long as they are not perfectly