Ch. 8&9

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? All common stocks fall into one of three classes: A, B, and C . All common stocks, regardless of class, must have the same voting rights. All common stocks, regardless of class, must pay the same dividend. Some classes of common stock are entitled to more votes per share than other classes. All firms have several classes of common stock.

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

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.

In a portfolio of three different stocks, which of the following could not be true? The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. The beta of the portfolio is equal to the beta of one of the individual stocks. The riskiness of the portfolio is less than the riskiness of each stock held in isolation. The beta of the portfolio is less than the beta of each of the individual stocks. The beta of the portfolio is greater than the beta of one or two of the individual stocks.

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

Which of the following assumptions would cause the constant growth stock valuation model to be invalid? The constant growth model is given below: P-hat The required rate of return is less than the growth rate. The required rate of return is above 30%. The growth rate is negative. None of the above assumptions would invalidate the model. The growth rate is zero.

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

Which of the following statements is NOT CORRECT? a. The total return is equal to the dividend yield plus the capital gains yield. b. The dividend yield, the capital gains yield, and the total return are three key components of the Discounted Dividend Model. c. The capital gains yield is calculated as the dollar amount of the year's dividend payments divided by the current stock price. d. The dividend yield is the percentage of how much of the stock's return is received as dividends. e. The capital gains yield is the annual percentage of a stock's change in price.

c. The capital gains yield is calculated as the dollar amount of the year's dividend payments divided by the current stock price.

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

false, still have diversifiable risk and be risky when held in isolation

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

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.

Which of the following statements is correct? The SML relates required returns to firms' market risk. The slope and intercept of this line can be controlled by the financial manager. The slope of the SML is determined by the value of beta. If you plotted the returns of a given stock against those of the market, and if you found that the slope of the regression line was negative, then the CAPM would indicate that the risk-free rate of return on the stock should be less than the required rate of return for a well-diversified investor, assuming that the observed relationship is expected to continue on into the future. If investors become less risk averse, the slope of the Security Market Line will increase. 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.

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.

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.

Your sister-in-law, a stockbroker at Invest Inc., is trying to sell you a stock with a current market price of $25. The stock's last dividend (D0) was $2.00, and earnings and dividends are expected to increase at a constant growth rate of 10%. Your required return on this stock is 20%. From a strict valuation standpoint, you should:

Not buy the stock; it is overvalued by $3.00.

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

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

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

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

True

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

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.

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.

Which of the following statements is NOT CORRECT? a. The discount rate, or required rate of return, used in the discounted dividend model reduces the values of future dividend payments to calculate their present values—which are used in arriving at the value of the stock price today. b. For the discounted dividend model, you need to know the firm's dividend payments, the dividend growth rate, and the discount rate, or required rate of return. In addition, the model assumes that the firm will only be around for a finite period. The model cannot handle the assumption that there are an infinite number of dividend payments. c. The discounted dividend model calculates what the value of the stock price today should be, so we can then compare that value to the stock's current market price to determine whether to purchase, sell, or hold the stock. d. The discounted dividend model deals with a fundamental question in finance—the value or worth of a stock e. To arrive at an estimate of the growth rate used in the discounted dividend model that determines how much dividends are expected to change each year, one looks at the company's history and likely future performance.

b. For the discounted dividend model, you need to know the firm's dividend payments, the dividend growth rate, and the discount rate, or required rate of return. In addition, the model assumes that the firm will only be around for a finite period. The model cannot handle the assumption that there are an infinite number of dividend payments.

Which of the following statements is CORRECT? a. The realized rate of return is denoted simply as a lower-case r. It represents a statistical calculation of what will happen with the stock's future return. b. The required rate of return is denoted simply as a lower-case r with a straight line on top. This rate of return doesn't represent speculation about a stock's future return but represents the actual return you receive from the stock. c. The required return represents the return an investor requires to invest in the stock; the expected return is based on a statistical calculation of what will happen with the future value of the stock; and the realized rate of return is the actual, historic return earned on the stock. d. The actual values of the expected rate of return, the required rate of return, and the realized rate of return must be identical for financial markets to operate.

c. The required return represents the return an investor requires to invest in the stock; the expected return is based on a statistical calculation of what will happen with the future value of the stock; and the realized rate of return is the actual, historic return earned on the stock.

The preemptive right is important to shareholders because it

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

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

proxy

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

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, hose stocks would move the portfolios' betas toward 1.0