Chapter 7

According to the Gordon Growth​ Model, the price of stocks depend on the following except A. required return on investments B. expected constant growth rate in dividends C. return on Treasure bills D. the most recent dividend paid When your required return on an equity investment increases​, then according to the Gordon Growth Model you will be willing to pay ▼ the same more less for the investment. Suppose that a stock is expected to pay a $2 dividend next​ year, that the dividend is expected to grow at 3​% per​ year, and that your required return on this equity investment is 8​%. Using the Gordon growth​ model, the price you would be willing to pay for the stock is $_______. (Round your response to the nearest two decimal​ place.)

#10 Screenshot CH 7 C. return on Treasure bills Less 2/ (.08-.03) = $40

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 8​% return on equity​ investments, then the price of the stock is $________.

#11 Screenshot CH 7 $25

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 5​%, you will be willing to pay for the stock the amount $__________. (Round your response to the nearest two decimal​ places.)

#11 Screenshot CH 7 Stock Amount $70

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%? A.$18 B.$20 C.$12 D.​$15

#11 Screenshot CH7 $20

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 2​%, then the required rate of return on equity investments of the buyer of the stock is equal to _______ ​%.

#12 Screenshot CH 7 #12 in notebook 6.3%

A share of stock in Bodah 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.

#13 Screenshot CH7 #13 in notebook

A share of stock in​ Pria-Utang Corporation pays an annual dividend of $5. The current market price is $60. From the list of individuals​ below, identify who is likely to be a buyer or a seller of this stock.

#14 Screenshot CH 7 #14 in notebook

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.

#15 Screenshot CH 7

How much would you pay for a share of stock paying a dividend ​(cash payout ​C) of ​$8 to be paid in one​ year, a known selling price in one year ​(​P) of ​$40​, and expected return ​(R) of similar assets of 5​%? You would pay ​$nothing. ​(Round your response to the nearest​ penny.)

#25 in notebook CH 7

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 expect the price of this stock to ________________.

#26 in notebook CH7 Increase

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: You observe in time period 3 that the​ price, Upper P Subscript t plus 3Pt+3​, of DuWop is equal to​ $31. Does this imply that this particular stock does not follow a random​ walk?

#27 Screenshot CH7 #27 in notebook CH7 No Each outcome is equally likely. Just as it is possible to flip three heads in a row on a​ coin, it is possible that this stock will experience three successive gains.

With no​ dividend, and assuming the 2020 price was perfectly​ predicted, the required return is

#35 Screenshot CH 7

The current price of a stock is $100.51. If dividends are expected to be $0.80 per share for the next five years, and the required return is 6%, 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 six years from​ now, does the current stock price also increase by $1​?

#5 Screenshot CH 7 ​No, the current stock price will not increase by $1 because the future stock price is discounted by the required return.

Using the​ one-period valuation model of stock​ prices, if a share of stock pays an annual dividend of $3​, you require a 15.0​% return on equity​ investments, and if you believe that you can sell the stock next year for $55​, then you would be willing to pay for the stock the amount

#6 Screenshot CH 7 Just as in part​ a, the​ price, in​ dollars, that the stock will be bought for given that the buyer has information as described is given by 50.43(55+3)/(1+(15.0/100))=50.43

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? A. $27.78 B. $30 C. $28.24 D. $30.50

#6 Screenshot CH 7 The​ price, in​ dollars, that the stock will be bought for after one year is given by (30+0.05)/(1+.08) = $28.24

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 9%. Using a​ one-period model of stock price​ determination, if you expect to sell a stock you buy today a year later for $17.00​, solve for the one year​ stock-holding.

#6 Screenshot CH 7 The​ price, in​ dollars, that the stock will be bought for given that the buyer has information as described is given by 16.51(17.0+1)/(1+(9/100))= 16.51

Given that the price a stock is bought for is $110. Based on the​ one-period valuation model of stock​ prices, if the stock is sold a year later at the price $120 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

#7 Screenshot CH 7 The required rate of​ return, in​ percentage, is therefore equal to (120+2)/ 110= 1.1090 - 1 = .1090% x 100 = 10.9

Suppose that the price a stock is bought for is $120. Based on the​ one-period valuation model of stock​ prices, if the stock is sold a year later at the price $130 and the required rate of return on the equity investments is 12​%, then the dividend paid out for the stock is $________. (Round your response to the nearest​ penny.) 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 Screenshot CH 7 Solve for the dividend paid out for the stock. ​(Round your response to the nearest whole​ number.) D = (120 x (1+.12)) - 130 ​= $4.4 Also higher; an increase in dividends paid out increases the price of the stocks.

After careful​ analysis, you have determined that a​ firm's dividends should grow at 15​%, on​ average, in the foreseeable future. The​ firm's last dividend was $1.00. Compute the current price of this​ stock, assuming the required return is 20​%.

$21 #4 in notebook CH 7

Compute the price of a share of stock that pays a $1.50 per year dividend and that you expect to be able to sell in one year for $25​, assuming you require a 10​% return.

$24.09 #3 in notebook CH 7

Suppose that the average growth rate of the economy has been 3%. Given a forecast of 3​% growth this​ year, if rational expectations​ hold, then the expected forecast error is _____​%.

0% The expected forecast​ error, under rational​ expectations, is zero.

​Now, suppose that the price of the stock above was bought instead for​ $115. Then, required rate of return on equity investments then

A decrease in the risk evaluation of the stock results to both an increase in the price of the stock and a decrease in the required rate of return on that stock.

Bubble

A situation in which the price of an asset differs from its fundamental market value.

​"An efficient market is one in which no one ever profits from having better information than the​ rest." Why is this statement​ false? A. People with better information make the market more efficient by exploiting​ profit-making opportunities. B. If markets follow a​ "random walk," then there will never be an opportunity to make profits. C. Acting on better information is not allowed by market regulators or organized exchanges. D. An efficient market is one where share prices never change.

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

What does the stronger view of the efficient market hypothesis​ imply? A. Security prices can be used by managers to assess their cost of capital B. A security's price only reflects a fraction of available information about the market value of the security. C. An inefficient capital market. D. An investment can be compared to another, but market prices do not reflect the actual value.

A. Security prices can be used by managers to assess their cost of capital

Which of the following does not explain why survey data is​ unreliable? A. Survey data is easier to collect in financial markets when compared to other markets. B. Respondents seldom have an incentive to respond truthfully. C. Survey responses may differ from actual economic decisions made by the respondents. D. Survey evidence may be a poor guide to actual market behavior.

A. Survey data is easier to collect in financial markets when compared to other markets.

The following are associated with an increase in the required rate of return on the equity investment except A. an increase in the current price of the stock. B. a​ one-time increase in the constant growth rate. C. a decrease in the current price of the stock. D. an increase in the dividend paid.

A. an increase in the current price of the stock. An increase in the current price of a stock is associated with a lower required rate of return on equity investments.

Stock market bubbles A. does not prove that the efficient market hypothesis is incorrect. B. occur when stock prices move directly with the fundamental value of the stock. C. should be able to be predicted by stock analysts. D. cannot occur if market participants are rational.

A. does not prove that the efficient market hypothesis is incorrect. D. can occur if market participants are rational. Stock market bubbles can occur even if market participants are rational.

​'Forecasters' predictions of inflation are notoriously​ inaccurate, so their expectations of inflation cannot be rational. This statement​ is: A. false, as expectations can be highly inaccurate and still be rational B. true, as a forecast is optimal if it is the best possible forecast even if the forecast errors are large C. false, as inaccurate forecasts are never rational D. true, as optimal forecasts are not necessarily accurate

A. false, as expectations can be highly inaccurate and still be rational

If you read in the Wall Street Journal that the​ "smart money" on Wall Street expects stock prices to​ fall, you​ should: A. not sell all of your stocks because this is publicly available information and is already reflected in stock prices. B. not sell all of your stocks because the Wall Street Journal is not a reputable publication. C. sell all of your stocks like the experts because you can earn a better return on your investment. D. sell all of your stocks like the experts because you will benefit from this information when you sell your stocks.

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

The efficient market hypothesis implies​ that: A. prices in markets like the stock market are unpredictable. B. market crashes and bubbles cannot occur. C. a​ security's price reflects little information about the future value of the security. D. investors can outperform a​ buy-and-hold strategy.

A. prices in markets like the stock market are unpredictable.

If​ John, Jennifer,​ Arthur, and Lisa are the only prospective buyers of a​ stock, and they have the discount rates 9​%, 15​%, 7​% and 12​%, ​respectively, then the buyer who will be able to obtain the stock is ▼ Lisa Arthur Jennifer John

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

Which of the following statements about market bubbles is​ accurate? A. Bubbles represent irrational behavior because asset prices are higher than their fundamental​ value, but investors continue to hold these assets anyway. B. Bubbles can occur when investors buy an asset above its fundamental price in the belief that someone else will buy the asset for a higher price in the future. C. Loss​ aversion, investor​ overconfidence, and social contagion often lead to decreases in market bubbles. D. With market​ bubbles, unexploited profit opportunities may​ exist, adding further proof to the stronger view of market efficiency.

B. Bubbles can occur when investors buy an asset above its fundamental price in the belief that someone else will buy the asset for a higher price in the future.

Identify the cash flows available to an investor in stock. A. Retained earnings. B. Dividends and capital gains. C. Corporate profits. D. Net income after taxes.

B. Dividends and capital gains.

Which of the following is true regarding the pricing of​ assets? A. The price is set by the buyer who can least take advantage of the asset. B. Other things being the same, the price is set by buyers with the most amount of information regarding the stock. C. Those with the most wealth pay the highest price for assets. D. The price is set by the buyer willing to pay the lowest price.

B. Other things being the same, the price is set by buyers with the most amount of information regarding the stock. Several facts can be said about asset pricing.​ First, the price is set by the buyer willing to pay the highest price.​ Second, other things being the​ same, the price is set by buyers with the most amount of information regarding the stock.​ Lastly, the price is set by the buyer who can best take advantage of the asset.

Which of the following is an argument in favor of the efficient market hypothesis​? A. Mean reversion of stock prices. B. Over the long​ term, stock prices follow a random walk and do resemble their underlying fundamental value. C. Observed behavior in reaction to the​ "January effect." D. Excessive volatility in stock prices as observed in 1987 and​ 2000-2001.

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

Evidence from studies in behavioral finance suggests that A. social​ contagion, not​ overconfidence, causes bubbles. B. investors are overconfident so they buy and sell too often. C. investors do not fear losing money so they engage in too much short selling. D. investment fads cause stock prices to be undervalued most of the time.

B. investors are overconfident so they buy and sell too often. C. investment fads cause stock prices to be overvalued most of the time. Overconfidence and social contagion​ (fads) provide an explanation for stock market bubbles.

According to the Generalized Dividend​ Model, the final sales price of a stock depends on the following except the A. number of periods. B. price of the stock in the last period. C. required return on investments in equity. D. dividend payments.

B. price of the stock in the last period.

Which of the following statements about rational expectations is not true​? A. Rational expectations are different from adaptive expectations. B. Rational expectations are identical to optimal forecasts. C. Rational expectations theory suggests that forecasts errors of expectations are sizable and can be predicted. D. Rational expectations may not be may not be accurate.

C. Rational expectations theory suggests that forecasts 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? A. Stock prices will remain​ unchanged, as increased transparency will not affect investment decisions. B. Stock prices will decrease because investors are now aware of stock prices and​ won't overpay. C. Stock prices will​ increase, as the risk and required return on the investment will be reduced. D. Stock prices will be​ unaffected, as stock prices and transparent monetary policy are unrelated.

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

If stock prices did not follow a random walk, which of the following statements would be​ true? A. If large changes in a stock price could be​ predicted, then the optimal forecast of the stock return would be equal to the equilibrium return for that stock B. Unexploited profit opportunities would never exist C. There would be unexploited profit opportunities in the market and expectations would not be rational D. Very small changes in stock prices could not be​ predicted, and the optimal forecast of returns would not be equal to the equilibrium return

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

Suppose that increases in the money supply lead to a rise in stock prices. Should you go out and buy​ stocks? A. You should buy stocks because the increase in the money supply should increase stock prices B. You should not buy stocks because bonds are always a better investment than stocks C. You should not buy stocks because the rise in the money supply is publicly available information that will be already incorporated into stock prices D. You should buy stocks because you can expect to earn more than the equilibrium return on stocks by acting on the money supply information

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

What basic principle of finance can be applied to the valuation of any investment​ asset? A. Cash flow analysis B. Internal rate of return C. Price-earnings ratio D. Present value

D. Present value

If a company called Advanced Technologies has yet to pay a dividend on its​ stock, the generalized dividend model predicts that the​ company's stock may still have value because A. all companies that have any physical assets have value. B. all companies are legally required to pay dividends within ten years of the initial public offering of stock. C. the required return on investment for high technology companies is zero. D. people expect Advanced Technologies to pay dividends in the future.

D. people expect Advanced Technologies to pay dividends in the future.

Define how the market price of a share of DuWop stock is likely to react to each of the following​ changes: If investors develop a greater aversion to risk or view DuWop stock as having greater​ risk, ​k, the share price will ▼ remain unchanged increase decrease.

Decrease

Efficient Market Hypothesis

Efficient Market Hypothesis The application of the theory of rational expectations to financial markets.

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 ▼ John Susan 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. Bill

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 ▼ remain unchanged increase decrease.

Increase

Define how the market price of a share of DuWop stock is likely to react to each of the following​ changes: 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 ▼ remain unchanged increase decrease.

Increase

Dividends

Periodic payments made by equities to shareholders.

Cash flows Short sales Arbitrage Dividends ▼ are the selling of borrowed shares of stock that must be replaced at a later​date, thus betting that the stock price will go down.

Short sales Short sale is the act of selling borrowed shares of stock that must be replaced at a later​ date, thus betting that the stock price will go down.

The efficient markets theory does not hold if crashes are ▼

predictable As long as crashes and bubbles are not​ predictable, the efficient markets theory will hold.

The efficient market hypothesis is an application of the theory of

rational expectations