Finance 300 Exam 2

common class A stock

1 share gets 1 vote

three features of NASDAQ

1. computer network and no physical location where trading takes place 2. multiple market maker system (OTC with dealers who buy/sell for their own inventories) 3. second largest stock market in the US in terms of total dollar volume of trading

reasons common stock is more difficult to value than a bond

1. life of investment is forever 2. no easy way to observe the rate of return the market requires 3. promised cash flows aren't known in advance

other rights of shareholders (3)

1. share proportionately in dividends paid 2. right to share proportionately in assets remaining after liabilities have been paid in liquidation 3. right to vote on stockholder matters of great importance, like mergers

NYSE personnel

1366 exchange members

discount rate or expected total return R

D1/P0 + g D1/P0 called dividend yield g called capital gains yield, rate at which stock price grows

electronic communications networks (ECNs)

NASDAQ websites that allow investors to trade directly with one another, allow individual investors to enter orders

order flow

NYSE largest stock market in the world, refers to the flow of customer orders to buy and sell stocks, usually a billion shares change hands in a day

nonconstant growth formula

P0 = D1/(1+R)^1 + D2/(1+R)^2 + Pt/(1+R)^t Pt = [Dt x (1+g)]/(R-g)

constant growth formula

P0 = D1/(R-g)

two stage growth formula

P0 = D1/(R-g1) x [1-[(1+g1)/(1+R)]^t] + Pt/((1+R)^t) Pt = D0 x (1+g1)^t x (1+g2)/(R-g2)

zero growth stock formula

P0=D/R

dividends are paid out of...

aftertax profits (not deductible for corporate tax purposes)

broker

brings buyers and sellers together but does not maintain inventory

preemptive right

company that wishes to sell stock must first offer it to existing stockholders before the general public

disadvantages of NPV

complicated and requires discount rate

DMMs (specialists)

dealers in a particular kind of stock, promote market liquidity by ensuring there is always a buyer and seller available

staggering/classified boards

directors are placed into different classes with terms that expire at different times, makes more difficult for minority to elect director because there are fewer directors to be elected at one time, makes takeover more difficult because more difficult to vote majority of new directors

floor broker

executes trade for customers, emphasis on getting the best price possible

assumptions behind dividend growth/constant growth model

g must be less than r g has to be constant forever rate has to hold forever

proxy

grant of authority by a shareholder to someone else to vote his/her shares

disadvantages of payback rule

ignores TVM conventional projects only requires arbitrary cutoff

supplemental liquidity providers (SLPs)

investment firms that agree to be active participants in stocks assigned to them, don't operate on the floor of the stock exchange

NASDAQ levels of information access

level 1: designed to provide timely, accurate source of price quotations, freely available over the internet level 2: allows users to view price quotes from NASDAQ market makers (inside quotes: highest bid quotes and lowest asked quotes), available on the internet for a small fee level 3: for use of market makers only, allows dealers to enter or change price quote information

dealer

maintains inventory and stands ready to buy and sell at any time

disadvantages of PI

may lead to incorrect decisions in comparisons of mutually exclusive investments because it ignores scale

disadvantages of discounted payback

may reject positive NPV investments conventional projects only biased toward long term projects ignores cash flows beyond arbitrary point

payback rule: 1. adjust for TVM? 2. adjust for risk? 3. info on creating value?

no sort of (ignores cash flows past date, cash flows far out very uncertain) no

general rule to director elections

one share, one vote

cumulative voting

permits minority participation, each shareholder gets their shares x # directors being elected, can't split up shares

profitability index (PI)

present value of future cash flows/initial investment

benchmark PE ratio

price per share/earnings per share (benchmark)

benchmark PS ratio

price per share/sales per share (benchmark)

stock valuation using multiples formula

pt = benchmark PE ratio x EPSt pt = benchmark price sales ratio x sales per sharet (used when firm has negative EPS)

IRR is

the required return that results in a zero NPV when it is used as the discount rate, works on two conditions: 1. conventional cash flows 2. project must be independent

when g and r are not close

very price sensitive

IRR: 1. account for TVM? 2. account for risk of cash flows? 3. provide indication about increase in value?

yes yes no

PI test: 1. account for TVM? 2. account for risk of cash flows? 3. indicate increase in value?

yes yes no

discounted payback rule: 1. account for TVM? 2. account for risk of cash flows? 3. provide info about increase in value?

yes yes no

NPV: 1. adjust for TVM? 2. adjust for risk? 3. info on creating value?

yes yes yes