Chapter 7 Homework Questions

Suppose that a stock is priced at ​$75. Given that a potential buyer has a required rate of return on equity investments of 7​%, the expected dividend for next year when the constant rate of growth of dividends is 5% is ​$_______.

$1.50 75 x (0.07-0.05) = 1.50 D1=P0×(ke−g) D1​ = dividends paid a year from today g ​= expected constant growth rate in dividends ke​ = required return on an investment in equity P0​ = price paid for the stock

Suppose that a stock is expected to pay a ​$1 dividend at the end of this year and that your required return on equity investments is 11​%. Using a​ one-period model of stock price​ determination, if you expect to sell a stock you buy today a year later for ​$16.0​, you will be willing to pay for the stock the amount ​$__________.

$15.32

According to the Gordon growth model of stock price​ determination, at what price should a stock sell for if the required return on equity investments is​ 12%, the stock will pay a dividend of​ $1.80 next​ year, and dividends are expected to grow at a constant rate of​ 3%?

$20 1.8/(0/12-0.09) = 20

How much would you pay for a share of stock paying a dividend ​(cash payout ​C) of ​$4 to be paid in one​ year, a known selling price in one year ​(​P) of ​$25​, and expected return ​(R) of similar assets of 8​%?

$26.85 R = [(Pt+1) - Pt + C]/(Pt)]

Using the​ one-period model of stock price​ determination, at what price should a stock sell for if the required return on equity investments is​ 8%, the stock pays a dividend of​ $0.50 next​ year, and the stock is expected to sell next year for​ $30?

$28.24

Using the​ one-period valuation model of stock​ prices, if a share of stock pays an annual dividend of ​$2​, you require a 13.0​% return on equity​ investments, and if you believe that you can sell the stock next year for ​$40​, then you would be willing to pay for the stock the amount ​$________.

$37.16

Suppose that the price a stock is bought for is ​$130. Based on the​ one-period valuation model of stock​ prices, if the stock is sold a year later at the price ​$140 and the required rate of return on the equity investments is 14​%, then the dividend paid out for the stock is ​$_____. Suppose that the price a stock was bought for was higher than the one above. Holding every other variable the​ same, this implies that the dividend paid out for the stock is: __________.

$8.20 (130 x (1 + (14/100)) - 140 = 8.20 Also higher

Suppose that the average growth rate of the economy has been 1%. Given a forecast of 4% growth this​ year, if rational expectations​ hold, then the expected forecast error is ______%

0%

Suppose that a stock paid a dividend of ​$2 this year and that your required return on equity investments is 8​%. Using the Gordon growth​ model, if you expect the dividends to grow at 6​%, you will be willing to pay for the stock the amount ​$________.

106.00 (2 x(1+6/100))/ (8/100 - 6/100) = 106 P0 = (D x(1+g))/(ke-g) D = dividends paid today g = expected constant growth rate in dividends ke = required return on an investment in equity P0 = price paid for the stock

Using the Gordon growth model of stock price​ determination, if a share of stock will pay a ​$1 dividend next year​, dividends are expected to grow 4​%, and people require an 11​% return on equity​ investments, then the price of the stock is ​$_____.

14.29 1/((11/100) - (4/100)) = 14.29 P0 = D1/ (ke-g) D1​ = dividends paid a year from today g ​ = expected constant growth rate in dividends ke​ = required return on an investment in equity P0​ = price paid for the stock

What is the annual growth rate in the value of the dollar if we expect this value to rise​ 2% next​ (and every)​ week? Is such a change possible if our expectations are​ rational?

180% ((1.02)^52 - 1) x 100 = 180% No This expected change in the value of the dollar would imply that there is a huge unexploited profit opportunity​ (over a​ 100% expected return at an annual​ rate). Since rational expectations rule out unexploited profit​ opportunities, such a big expected change in the exchange rate could not exist.

Currently a share of stock is paying a dividend​ (cash payout C​) of ​$4.00 to be paid in exactly one year and has a known selling price in one year ​(P) of ​$25.00. The expected return​ (R) of similar assets is 8.0​%, and the current market price is​ $24.00. What is the total rate of return ​(R*) on this​ asset? Based on this information, you would expected the price of this stock to ________.

20.8% R* = [(Pt+1)-Pt + C]/Pt Increase

Given that the price a stock is bought for is ​$90. Based on the​ one-period valuation model of stock​ prices, if the stock is sold a year later at the price ​$130 after receiving a dividend of ​$2​, then the required rate of return on equity investments is _____% Now, suppose that the price of the stock above was bought instead for​ $115. Then, required rate of return on equity investments then ____________

46.7% ((130+2)/(90) - 1 = 46.7 Decreased

Suppose that a certain stock is being sold for ​$70. If the expected dividend for next period is ​$3 and the rate of growth of the dividend is 22%, then the required rate of return on equity investments of the buyer of the stock is equal to ________%.

6.3% ((3/70) + (2/100)) x 100 = 6.3% (D1/P0)+g D1​ = dividends paid a year from today g ​= expected constant growth rate in dividends ke​ = required return on an investment in equity P0​ = price paid for the stock

Interest rates have been at 4​% for the past four years. The economy goes into a recession causing the Fed chairperson to announce an expansionary monetary policy with an interest rate target of 3.0%. You forecast interest rates for next year to be 4​%. This is an example of applying the theory of ______________.

Adaptive expectations

If​ John, Jennifer,​ Arthur, and Lisa are the only prospective buyers of a​ stock, and they have the discount rates 10​%, 15​%, 6% and 13​%, ​respectively, then the buyer who will be able to obtain the stock is

Arthur The investor with the lowest perceived risk​ (and therefore, the lowest discount​ rate) is willing to pay the most for the stock.

John values ABC stock at​ $10 per share. Susan values it at​ $15 per​ share, and Bill values it at​ $20 per share. In a​ free-market auction, the individual who ends up buying the item is _______.

Bill In a​ free-market auction, the individual who values the good the most gets the good in the end. This is true with stocks.

Identify the cash flows available to an investor in stock.

Dividends and capital gains

Which of the following is not considered to be a candidate for observed excessive volatility in stock​ prices?

Extreme fluctuations in the fundamental value of a given stock.

f your broker has been right in her five previous buy and sell​ recommendations, you should continue to listen to her advice. Is this statement true or​ false?

False, although your broker has done well in the​ past, efficient market theory suggests that she has probably been lucky

'Forecasters' predictions of inflation are notoriously​ inaccurate, so their expectations of inflation cannot be 'rational.' This statement is:

False, as expectations can be highly inaccurate and still be rational

"If most participants in the stock market do not follow what is happening to monetary​ aggregates, prices of common stocks will not fully reflect information about​ them." Is this statement true or​ false?

False, as full information can be gained with only some participants eliminating unexploited profit opportunities.

​'Human fear is the source of stock market​ crashes, so these crashes indicate that expectations in the stock market cannot be​ rational.' Is this statement true or​ false?

False, as rational expectations theory does not rule out large changes in stock prices as a result of fears on the part of the investing public

Suppose a change in the way a variable moves such that it is much larger than before. If adaptive expectations accurately represent how people form​ expectations, then the difference between the variable and its expected value is ___________.

Greater than zero

A share of stock in DuWop Corporation pays an annual dividend of ​$4. From the list of individuals​ below, calculate the value each person is likely to place on a share of this stock. ​(Round your responses to the nearest​ penny.) If the current market price is ​$25 and these three individuals are representative of the market as a​ whole, this share price is likely to ______________.

Hannah Required return: 12% Expected Growth in Dividends: 4% OFFER PRICE: $52 Henry Required return: 12% Expected Growth in Dividends: 4% OFFER PRICE: $82.40 Heather Required return: 12% Expected Growth in Dividends: 4% OFFER PRICE: $106.00 RISE

If a forecaster spends hours every day studying data to forecast interest​ rates, but his expectations are not as accurate as predicting that​ tomorrow's interest rates will be identical to​ today's interest​ rate, which of the following is​ true?

He could improve the accuracy of his forecasts

Define how the market price of a share of DuWop stock is likely to react to each of the following​ changes: If DuWop announces an increase in the annual​ dividend, ​Div, the price of a share of DuWop will _____________. If investors develop a greater aversion to risk or view DuWop stock as having greater​ risk, ​k, the share price will ____________. If investors expect an increase in the​ growth, g​, of earnings and dividends over the next 5​ years, the price of a share of DuWop will _____________.

Increase Decrease increase

A share of stock in​ Pria-Utang Corporation pays an annual dividend of ​$5. The current market price is ​$75. From the list of individuals​ below, identify who is likely to be a buyer or a seller of this stock. ​(Each person currently owns 100​ shares.)

Janey Required return: 10% Expected Growth in Dividends: 6% BUY Jimmy Required return: 12% Expected Growth in Dividends: 2% SELL Jonny Required return: 20% Expected Growth in Dividends: 5% SELL P0 = PVshare = (Div 1)/(ke - g)

A share of stock in Bodah Corporation pays an annual dividend of ​$5. The current market price is ​$50. From the list of individuals​ below, identify who is likely to be a buyer or a seller of this stock. ​(Each person currently owns 100​ shares.)

Kate Required return: 5% Expected Growth in Dividends: 0% BUY Keith Required return: 8% Expected Growth in Dividends: 0% BUY Kyle Required return: 15% Expected Growth in Dividends: 0% SELL

If higher money growth is associated with higher future​ inflation, and if announced money growth turns out to be extremely high but is still less than the market​ expected, what do you think would happen to​ long-term bond​ prices?

Long term bond prices will increase

'Anytime it is snowing when Joe Commuter gets up in the​ morning, he misjudges how long it will take him to drive to work. When it is not​ snowing, his expectations of the driving time are perfectly accurate. Considering that it snows only once every ten years where Joe​ lives, Joe's expectations are almost always perfectly​ accurate.' This statement is _____________ because​ Joe's expectations could still be improved by accounting for a snowfall in his forecasts.

Not rational

Which of the following is an argument in favor of the efficient market hypothesis​?

Over the long​ term, stock prices follow a random walk and do resemble their underlying fundamental value.

​"An efficient market is one in which no one ever profits from having better information than the​ rest." Why is this statement​ false?

People with better information make the market more efficient by exploiting​ profit-making opportunities.

What basic principle of finance can be applied to the valuation of any investment​ asset?

Present value

The current price Pt of a share of DuWop​ (a publicly traded​ company) is​ $25. Which of the following price movements​ (in the next time​ period, Pt+1​) is consistent with a random walk?

Pt+1 is​ $28 with a probability of 0.50 and Pt+1 is​ $24 with a probability of 0.50. ​ EV​ = ​0.25(minus−​$3) ​+ 0.75(+$1)

The current price of DuWop​ (a publicly traded​ company) is​ $25. The following rules describe the random-walk behavior of price movements in the​ future: 1. Gains and losses are equally likely​ (i.e., pr​(gain) ​= pr​(loss) ​= 0.50​). 2. Gains are equal to ​$2. 3. Losses are equal to ​$1. Calculate the likely​ (expected) value of the price of this stock for the next three periods. ​ You observe in time period 3 that the​ price, Pt+3​, of DuWop is equal to​ $31. Does this imply that this particular stock does not follow a random​ walk?

Pt: $25 Pt+1: $25.50 Pt+2: $26.00 Pt+3: $26.50 EV​ = prob[gain]($25​ + gain)​ + ​prob[loss]($25−​loss) No

The efficient market hypothesis is an application of the theory of

Rational expectations

Which of the following statements about rational expectations is not true​?

Rational expectations theory suggests that forecast errors of expectations are sizable and can be predicted.

If monetary policy becomes more transparent about the future course of interest​ rates, how would that affect stock​ prices, if at​ all?

Stock prices will​ increase, as the risk and required return on the investment will be reduced.

After careful​ analysis, you have determined that a​ firm's dividends should grow at 5​%, on​ average, in the foreseeable future. The​ firm's last dividend was ​$0.50. Compute the current price of this​ stock, assuming the required return is 10%.

The current stock price is $10.50

A company has just announced a 4​-for-1 stock​ split, effective immediately. Prior to the​ split, the company had a market value of ​$5 billion with 75 million shares outstanding. Assuming that the split conveys no new information about the​ company, what is the value of the​ company, the number of shares​ outstanding, and price per share after the​ split? If the actual market price immediately following the split is ​$19.00 per​ share, what does this tell us about market​ efficiency?

The market value of the company is $5 billion The number of shares after the split is 300 million (75 million shares x 4 = 300 million) The new price per share is $16.67 ($5 billion/300 million) Market efficiency is uncertain. The price could indicate both market efficiency or failure depending on whether or not the stock split actually conveyed information about the company.

The current price of a stock is ​$97.49. If dividends are expected to be ​$0.80 per share for the next five ​years, and the required return is 55​%, then what should the price of the stock be in 5 years when you plan to sell​ it? If the dividend and required return remain the​ same, and the stock price is expected to increase by ​$1 five years from​ now, does the current stock price also increase by ​$1?

The price 5 years from now will be ​$120 No, the current stock price will not increase by ​$1 because the future stock price is discounted by the required return.

Compute the price of a share of stock that pays a ​$2.00 per year dividend and that you expect to be able to sell in one year for ​$20, assuming you require a 20​% return.

The price of the share is $18.33

If the public expects a corporation to lose​ $5 per share this quarter and it actually loses​ $4, which is still the largest loss in the history of the​ company, what does the efficient market hypothesis say will happen to the price of the stock when the​ $4 loss is​ announced?

The stock price will be revised upward.

Suppose that the Fed engages in an contractionary monetary​ policy, which raises interest rates. Which of the following statements best describes the impact of this event on the stock​ market?

There will be an increase in the required rate of return on equities, a decrease in the growth rate, and stock prices will fall

If stock prices did not follow a random walk, which of the following statements would be​ true?

There would be unexploited profit opportunities in the market and expectations would not be rational

Which of the following is not true regarding the pricing of​ assets?

Those with the most wealth pay the highest price for assets

Foreign exchange​ rates, like stock​ prices, should follow a random walk because changes in the exchange rate are unpredictable.

True

Can a person with rational expectations​, given new information about the search technology​ industry, expect the price of a share of Google to rise by​ 10% in the next​ month?

Yes, if this information is such that expectations of growth prospects or desired yields justify such a change.

Suppose that increases in the money supply lead to a rise in stock prices. Should you go out and buy​ stocks?

You should not buy stocks because the rise in the money supply is publicly available information that will be already incorporated into stock prices

The following are associated with an increase in the required rate of return on the equity investment except

an increase in the current price of the stock.

If the dividend of a stock​ decreases, then according to the Gordon Growth​ Model, holding everything else​ constant, the price of the stock will ____________________.

decrease

If you read in the Wall Street Journal that the​ "smart money" on Wall Street expects stock prices to​ fall, you​ should:

not sell all of your stocks because this is publicly available information and is already reflected in stock prices.

There are many faults associated with adaptive expectations except that

past data do not help predict future values of variables.

Stock market analysts might prepare a forecast of the​ next-period stock price Pt+1 as​ follows: Pt+1 ​= (Pt + Pt−1 + Pt−2 + Pt−3)/4, a process known as a moving average. This technique is part of what is​ called:

technical analysis.

Monetary policy affects stock prices through the following except

the changes in the price level