Deck 7: Stocks and Their Valuation

Question 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.

Answer 1

True

Question 2

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.

Answer 2

True

Question 3

If a stock's market price exceeds its intrinsic value as seen by the
1.
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.

Answer 3

True

Question 4

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.

Question 5

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.

Question 6

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.

Question 7

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.

Question 8

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.

Question 9

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.

Question 10

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.

Question 11

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.

Question 12

The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold.

Question 13

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.

Question 14

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.

Question 15

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.

Question 16

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.

Question 17

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.

Question 18

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.

Question 19

Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

Question 20

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.

Question 21

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.

Question 22

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.

Question 23

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.

Question 24

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?

Question 25

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.

Question 26

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.

Question 27

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 returns.

Question 28

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 rates 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.

Question 29

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.

Question 30

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) 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.

Question 31

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

Question 32

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 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%.

Question 33

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 returns must be equal to the required return.

Question 34

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.

Question 35

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) Increase the dividend payout ratio for the upcoming year.
B) Increase the percentage of debt in the target capital structure.
C) Increase the proposed capital budget.
D) Reduce the amount of short-term bank debt in order to increase the current ratio.

Question 36

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.

Question 37

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?

Question 38

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.

Question 39

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?

Question 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? Problems
Most of these problems are straightforward and only moderately difficult. However, a few of the later ones are relatively difficult and should be used primarily on take-home exams for students with some experience with Excel. Problems with * in the topic line are nonalgorithmic.

Question 41

Huang Company's last dividend was $1.25. The dividend growth rate is expected to be constant at 15% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If the firm's required return (rs) is 11%, what is its current stock price?

A) $30.57
B) $31.52
C) $32.49
D) $33.50
E) $34.50

Question 42

Agarwal Technologies was founded 10 years ago. It has been profitable for the last 5 years, but it has needed all of its earnings to support growth and thus has never paid a dividend. Management has indicated that it plans to pay a $0.25 dividend 3 years from today, then to increase it at a relatively rapid rate for 2 years, and then to increase it at a constant rate of 8.00% thereafter. Management's forecast of the future dividend stream, along with the forecasted growth rates, is shown below. Assuming a required return of 11.00%, what is your estimate of the stock's current value?

A) $ 9.94
B) $10.19
C) $10.45
D) $10.72
E) $10.99

Question 43

Ackert Company's last dividend was $1.55. The dividend growth rate is expected to be constant at 1.5% for 2 years, after which dividends are expected to grow at a rate of 8.0% forever. The firm's required return (rs) is 12.0%. What is the best estimate of the current stock price?

A) $37.05
B) $38.16
C) $39.30
D) $40.48
E) $41.70

Question 44

Savickas Petroleum's stock has a required return of 12%, and the stock sells for $40 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% per year for the next 4 years, so D4 = $1.00(1.30)⁴ = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of X% per year forever. What is the stock's expected constant growth rate after t = 4, i.e., what is X?

A) 5.17%
B) 5.44%
C) 5.72%
D) 6.02%
E) 6.34%

Question 45

Sorenson Corp.'s expected year-end dividend is D1 = $1.60, its required return is rs = 11.00%, its dividend yield is 6.00%, and its growth rate is expected to be constant in the future. What is Sorenson's expected
59)
Stock price in 7 years, i.e., what is

A) $37.52
B) $39.40
C) $41.37
D) $43.44
E) $45.61 Pˆ7 ?

Question 46

The Ramirez Company's last dividend was $1.75. Its dividend growth rate is expected to be constant at 25% for 2 years, after which dividends are expected to grow at a rate of 6% forever. Its required return (rs) is 12%. What is the best estimate of the current stock price?

A) $41.58
B) $42.64
C) $43.71
D) $44.80
E) $45.92

Question 47

Carter's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return?

A) 8.03%
B) 8.24%
C) 8.45%
D) 8.67%
E) 8.89%

Question 48

Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 25% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company's last dividend, D0, was
$1)25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock?

A) $26.77
B) $27.89
C) $29.05
D) $30.21
E) $31.42