Managerial Finance CH 8 & 9

You can estimate the value of a company's stock using models such as the corporate valuation model and the dividend discount model. Which of the following companies would you choose to evaluate if you were using the discounted dividend model to estimate the value of the company's stock? A company that has been distributing a portion of their earnings every quarter for the past six years. A company that is in a high-growth stage and plans to retain all its earnings for the next few years to support its growth.

A company that has been distributing a portion of their earnings every quarter for the past six years.

A financial planner is examining the portfolios held by several of her clients. Which of the following portfolios is likely to have the smallest standard deviation (smallest risk)? A portfolio containing only Microsoft stock. A portfolio consisting of about three randomly selected stocks from different sectors. A portfolio containing Microsoft, Apple, and Google stock.

A portfolio consisting of about three randomly selected stocks from different sectors.

Based on your understanding of stock prices and intrinsic values, which of the following statements is true? The intrinsic value of a stock is based only on perceived investor returns. A stock's market price is often based on investors' perceived risk in the company.

A stock's market price is often based on investors' perceived risk in the company.

Which of the following 2 statements accurately describes the relationship between earnings and dividends when all other factors are held constant? Long-run earnings growth will decrease when firms retain earnings and reinvest them in the business. Retaining a higher percentage of earnings will result in a lower growth rate. All else being equal, growth in dividends requires growth in earnings. Retaining a higher percentage of earnings will result in a higher growth rate.

All else being equal, growth in dividends requires growth in earnings. Retaining a higher percentage of earnings will result in a higher growth rate.

Which of the following statements is true? Classified shares are not issued with the purpose of providing super voting rights to a certain class of investors. Classified shares have super voting rights, which give more control to a certain class of investors.

Classified shares have super voting rights, which give more control to a certain class of investors.

Higher-beta stocks are expected to have lower required returns. True or False

False

The market risk component of the total portfolio risk can be reduced by randomly adding stocks to the portfolio. True or False

False

The risk in a portfolio will increase if more stocks that are negatively correlated with other stocks are added to the portfolio. True or False

False

Based on your understanding of P/E ratios, in which of the following situations would the average trailing P/E ratio (current price divided by earnings per share over the previous 12 months) of the S&P 500 Index be higher? Forecast earnings for S&P 500 companies are expected to fall in the future. Forecast earnings for S&P 500 companies are expected to rise in the future.

Forecast earnings for S&P 500 companies are expected to rise in the future. (earnings expected to rise means price will increase)

Which kind of stock is most affected by changes in risk aversion? (In other words, which stocks see the biggest change in their required returns?) Low-beta stocks Medium-beta stocks All stocks affected the same, regardless of beta High-beta stocks

High-beta stocks

Which of the following statements is true? Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth. Increasing dividends will always decrease the stock price, because the firm is depleting internal funding resources. Increasing dividends will always increase the stock price.

Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.

The SML helps determine the level of risk aversion among investors. The higher the level of risk aversion, the (flatter/steeper) the slope of the SML. (beta aka risk on the x-axis & expected return on the y-axis)

Steeper (risk averse individual: need significant increase in expected return for a slight increase in risk)

preemptive right

Stockholders' right to maintain their proportionate interest in a corporation with any additional shares issued. (So that stock dilution does not occur.)

Which of the following describe the reason(s) why maximization of intrinsic stock value benefits society?

Successful companies benefit consumers. Most people have an important stake in the stock market. Stock price maximization requires efficient, low-cost businesses. Successful companies hire more employees.

Which of the following statements is true about the constant growth model? The constant growth model can be used if a stock's expected constant growth rate is less than its required return. The constant growth model can be used if a stock's expected constant growth rate is more than its required return.

The constant growth model can be used if a stock's expected constant growth rate is less than its required return. (r must be less than g because can't divide by 0)

Which of the following statements is true about the constant growth model? The constant growth model implies that dividend growth remains constant from now to infinity. The constant growth model implies that dividends remain constant from now to a certain terminal year.

The constant growth model implies that dividend growth remains constant from now to infinity.

Which of the following statements will always hold true? The constant growth valuation formula is not appropriate to use for zero growth stocks. It will never be appropriate for a rapidly growing start-up company that pays no dividends at present, but is expected to pay dividends at some point in the future, to use the constant growth valuation formula. The constant growth valuation formula is not appropriate to use unless the company's growth rate is expected to remain constant in the future.

The constant growth valuation formula is not appropriate to use unless the company's growth rate is expected to remain constant in the future.

All else held constant, what happens to the SML line when inflation increases by 2%?

The slope of the SML line stays the same and the y-intercept increases by 2.

A stock that is more volatile than the market will have a beta of more than 1.0. True or False

True

If markets are in equilibrium, the expected rate of return will be equal to the required rate of return on a stock. True or False

True

If the company should liquidate, creditors receive payments before preferred shareholders and common shareholders. True or False

True

Preferred stockholders are entitled to receive a fixed dividend before the dividends can be paid to common stockholders. True or False

True

Stock A's beta is 1.0; this means that the stock moves in the same direction and magnitude as the market. True or False

True

When using a constant growth model to analyze a stock, if an increase in the growth rate occurs while the required return remains the same, this will lead to an increased value of the stock. True or False

True (because this leads to a smaller number in the denominator: P1 = D2/(r-g))

A portfolio's risk is NOT equal to the weighted average of the individual stocks' standard deviations. True or False

True because the correlation between the asset returns also affects the portfolio standard deviation.

Goodwin has been very successful, but it hasn't paid a dividend yet. It circulates a report to its key investors containing the following statement: "Goodwin has yet to record a profit (positive net income)." Is this statement a possible explanation for why the firm hasn't paid a dividend yet? Yes or No

Yes

Goodwin has been very successful, but it hasn't paid a dividend yet. It circulates a report to its key investors containing the following statement: "Investors prefer the deferred tax liability that capital gains offer over dividends." Is this statement a possible explanation for why the firm hasn't paid a dividend? Yes or No

Yes

stock dilution

company issues new shares and it results in a decrease of ownership per share and the price of each share goes down

A stock is in equilibrium if its required return _______ its expected return.

equals

In some cases, individuals who start a business have special voting rights that help them exercise more control over the firm. They own a special class of stock called _______ shares.

founders' (a type of common stock); Companies that have these classes of shares are said to have a dual-class share structure, which gives special voting rights to the founders of the company.

Suppose instead of replacing Atteric Inc.'s stock with Transfer Fuels Co.'s stock, Brandon considers replacing Atteric Inc.'s stock with the equal dollar allocation to shares of Company X's stock that has a higher beta than Atteric Inc. If everything else remains constant, the required return from the portfolio would...

increase

Suppose that there is high unemployment, which causes interest rates to fall, which in turn pulls the preferred stock's yield to 8.84%. The value of the preferred stock will: increase or decrease

increase (formula: P = D/r and r decreases so P increases)

If the risk-free return (inflation) increases by 2 percentage points, the required rate of return:

increases the same 2 percentage points for all securities

Suppose each stock in Andre's portfolio has a correlation coefficient of 0.4 (ρ = 0.4) with each of the other stocks. If the weighted average of the risk of the individual securities (as measured by their standard deviations) included in the partially diversified four-stock portfolio is 35%, the portfolio's standard deviation (σpσp) most likely is (less than/equal to/greater than) 35%.

less than; Because the stocks within the portfolio are not perfectly correlated (ρ < 1), the portfolio benefits from diversification. Hence, the portfolio's standard deviation must be less than the weighted average of the risk of the individual securities. The weighted average of risk of the individual securities is 35%, so the portfolio's standard deviation must be less than 35%.

Least amount of market risk means...

lowest beta

Least amount of stand-alone risk means...

lowest standard deviation

If a stock's required return is greater than it's expected return, the stock is...

overvalued

A stock's contribution to the market risk of a well-diversified portfolio is called (systematic/unsystematic/relevant) risk. According to the Capital Asset Pricing Model (CAPM), this risk can be measured by a metric called the beta coefficient, which calculates the degree to which a stock moves with the movements in the market. Choose 2 synonyms to fill in the blank.

systematic/relevant

Beta

the degree to which a stock moves with the movements in the market

Beta of a portfolio =

the summation of the weight of each stock x its respective individual beta

If the risk-free return (inflation) increases by 2 percentage points, then for the security market line:

the y-intercept changes and the slope remains the same

If a stock's required return is less than it's expected return, the stock is...

undervalued

Suppose, based on the earnings consensus of stock analysts, Brandon expects a return of 13.50% from the portfolio with the new weights. Does he think that the required return as compared to expected returns is undervalued, overvalued, or fairly valued? (required return is 12%)

undervalued