FINANCE 331 TEST 3

When stockholders assign their right to vote to another party, this is called

A proxy. Proxy fights occur when a dissident group of stockholders solicits proxies in competition with the firm's management. If the dissident group obtains a majority of the proxies, then it can gain control of the board of directors and oust existing management.

Which of the following statements is correct?

Both the SML and a company's position on it change over time due to changes in interest rates, investors' aversion to risk, and individual companies' betas.

A preemptive right gives stockholders 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.

FALSE A preemptive right is used to maintain shareholder positions if new shares are issued.

If a stock has a beta of zero, it will be riskless when held in isolation.

FALSE A zero beta stock could be made riskless if it were combined with enough other zero beta stocks, but it would still have diversifiable risk and be risky when held in isolation.

An investor using the DCF stock valuation model would assign a value based on the length of time he or she plans to hold the stock.

FALSE The investor needs to consider the value during the holding period as well as the price at which the share will be sold to someone else.

To find the total return on a share of stock, find the dividend yield and subtract any commissions paid when the stock is purchased and sold.

FALSE Total return is dividend yield plus capital appreciation.

The preemptive right is important to shareholders because it:

Protects the current shareholders against a dilution of their ownership interests.

Assume that a company's dividends are expected to grow at a rate of 25% per year for 5 years and then to slow down and to grow at a constant rate of 5% thereafter. The required (and expected) total return, rs, is expected to remain constant at 12%. Which of the following statements is correct?

Right now, it would be easier (require fewer calculations) to find the dividend yield expected in Year 7 than the dividend yield expected in Year 3.

Which of the following statements about stock classes is CORRECT?

Some classes of common stock are entitled to more votes per share than other classes.

In order to prevent dilution of control or dilution of value, shareholders use preemptive rights to purchase, on a pro rata basis, any new shares issued by the firm.

TRUE A preemptive right is used to maintain shareholder positions if new shares are issued.

A document that gives one party the authority to act for another party is a proxy. This includes the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

TRUE A proxy is used by shareholders to vote their common shares.

Because stock has a residual claim rather than a contractual obligation, the cash flows associated with common stock are more difficult to estimate than those related to bonds.

TRUE Bonds are paid before common stock, and it is difficult to estimate what will be left over.

Classified stock is the differentiation of different shares of common stock. It gives companies a way to meet special needs such as when owners of a start-up firm need additional equity capital but do not want to relinquish voting control.

TRUE Classified stock is a way to differentiate shares of common stock that have different privileges.

Because most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets, the relevant risk of each asset should be measured in terms of its effect on the risk of the firm's stockholders.

TRUE Corporate managers need to look at returns for shareholders, not the effects on a market portfolio.

To find the firm's total corporate value, discount projected free cash flows at the firm's weighted average cost of capital.

TRUE Corporate value is based on cash flows discounts at the weighted average cost of capital.

Two investors each hold a portfolio, which is their only asset. Mr. Luca's portfolio has a beta of minus 2.0, while Ms. Johnson's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then Mr. Luca and Ms. Johnson face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0.

TRUE Correct. Both portfolios would be twice as risky as a portfolio of average stocks. Their risks would decline if they added b = 1.0 stocks, as those stocks would move the portfolios' betas toward 1.0.

The type of classified stock where the shares are owned by the firm's founders is called founder's shares. With founders' shares, shareholders generally have more votes per share than with other classes of common stock.

TRUE Founders' shares are a common type of classified stock that are used to differentiate shares of common stock that have different privileges.

The marginal investor determines the price at which a new issue of stock will trade when it is brought to market.

TRUE The marginal trade is the one that closes the IPO and sets the price of trading.

If investors expected inflation to increase in the future, and they also became more risk averse, what could be said about the change in the Security Market Line (SML)?

The SML would shift up and the slope would increase. The increase in inflation would cause the SML to shift up, and more risk-averse investors would cause the slope to increase.

In a portfolio of three different stocks, which of the following could not be true?

The beta of the portfolio is less than the beta of each of the individual stocks. WEIGHTED AVG

Which of the following assumptions would cause the constant growth stock valuation model to be invalid? The constant growth model is given below:

The required rate of return is less than the growth rate.