FINA CH 6

Efficient Market Hypothesis

(EMH) is a theory describing the behavior of an assumed "perfect" market in which securities are in equilibrium, security prices fully reflect all available information and react swiftly to new information, and because stocks are fully and fairly priced, investors need not waste time looking for mispriced securities.

market efficiency

- Because the flow of new information is almost constant, stock prices fluctuate, continuously moving toward a new equilibrium that reflects the most recent information available. This general concept is known as market efficiency

The main vote that shareholders have:

- Elect the board of directors [the committee that hires, evaluates, and monitors the senior managers of the firm] shareholders also vote on major decisions about the firm, such as approving mergers and acquisitions

Dividend

Cash flows generated by the assets of the firm are often paid to the shareholder by a cash payment - the dividend

5. What are the possible patterns for future dividends? Check all that apply. - grow at a constant rate - constant over time - plaid - grow at a changing rate - decrease at a constant rate

- grow at a constant rate - constant over time - grow at a changing rate - decrease at a constant rate

16. What are the characteristics of preferred stock? - may carry some voting rights, but generally not as many voting rights as common stock - preferred stockholders are usually paid after common stockholders - don't have voting right - all debts must be paid before to bondholders before preferred stockholders are paid - fixed dividend payment

- may carry some voting rights, but generally not as many voting rights as common stock - don't have voting right -all debts must be paid before to bondholders before preferred stockholders are paid - fixed dividend payment

dividend yield capital gain

- measures how much the dividend is, as a percent of the price D1/P0 - The increase in the stock price over time

3. What do companies do with excess cash flows generated by their operations? - Pay CEO salary - reinvest in the firm - cash payment in a form of dividend to shareholders - make loan payments

- reinvest in the firm - cash payment in a form of dividend to shareholders

Preferred Stock

- represents a hybrid security, in that it has some characteristics like common stock and some characteristics that make it like debt - generally makes a fixed dividend payment (like the interest payment on a bond) but with no maturity date (like common stock) - if a firm fails to make a dividend payment to preferred stockholders, it is not considered to be a default - Preferred stockholders usually do not have voting rights - all debts must be paid before to bondholders before preferred stockholders are paid, but preferred stockholders are usually paid before common stockholders.

preemptive right

- right to buy additional shares - In order to maintain their voting power, shareholders often get the first chance to buy any additional shares that the firm may issue, before they are sold to the public

37. A share of preferred stock pays a dividend of $6 and has a discount rate of 3.3%. What is the price?

181.82

12. What is the estimate of Walmart's long term growth assuming the constant growth period started in 2014 when the dividend per share was $1.89? Answer in % terms w/o the % sign.

2.12 (dividend per share in 2020) 1.89(given dividend per share in 2014) 2.12/1.89 - 1 = 12.17% (1+.1217)^(1/6) - 1 The average annual dividend growth rate 2014 - 2020 = 1.93

36. A stock will pay no dividends for the next 5 years. Then it will pay a dividend of $4.82 growing at 4.56%. The discount rate is 6%. What should be the current stock price?

250.12

7. A preferred stock's price is $ 36.28 with an expected return of 16.47 %. What is the expected dividend amount? (Enter the answer in dollar format without $ sign or thousands comma -> 3519.23 and not $3,519.23 or 3,519.23)

36.28 = D / 0.1647 D = 36.28*0.1647 = 5.98

20. Mackenzie Bezos, the ex-wife of founder Jeff Bezos, owns a large number of Amazon's shares. Using the Bloomberg quote data in 6.4, what is the market value of Mrs. Bezos Amazon holdings? in Billions w/o $ sign.

48.26 her share percentage & Market Capitalization

33. Which of the following statements is correct about a stock currently selling for $50 per share that has 16% expected return and a 10% expected capital appreciation? Its expected dividend exceeds the actual dividend It is expected to pay $3 in annual dividends It is expected to pay $8 in annual dividends Its expected return will exceed the actual return

50 = D / (.16 - .10) D = 50(.06) = 3 It is expected to pay $3 in annual dividends

35. Your company is estimated to make dividends payments of $2.2 next year, $3.8 the year after, and $4.8 in the year after that. The dividends will then grow at a constant rate of 6% per year. If the discount rate is 13% then what is the current stock price?

58.62

10. A stock costs $66.84 and will pay a dividend of $8.08 that will grow at 2.8% per year. What is the dividend yield? (Enter the answer in % format without % sign -> 20.51 and not 20.51% or 0.2051)

66.84 = 8.08 / (r-.028) r = (8.08/66.84) + .028 = 0.148886 = 14.89% r = (D1/P0) + g (8.08/66.84) + .028

23. Large and active stock markets are not very efficient because they do not react to relevent market news. (TF)

F

24. Manager of actively managed funds are investment professional who typically beat the market. (TF)

F

21. The efficient-market hypothesis (Links to an external site.) (EMH) is a theory describing the behavior of an assumed "perfect" market in which securities are in equilibrium, security prices fully reflect all available information and react swiftly to new information, and yet stocks are not fully and fairly priced, so investors will not waste time looking for mispriced securities (TF)

F they are fully and fairly priced

1. Match the following concepts Proxy Voting Board of Directors Preemptive right straight-line voting cumulative voting

im lazy

prospect theory

is closely related to regret theory and suggests that people express a different degree of emotion toward gains than losses.

39. Matching those following investor behaviors theories

lazy

40. Match the investment types

lazy

14. Your company is estimated to make dividends payments of $2.6 next year, $4 the year after, and $4.5 in the year after that. The dividends will then grow at a constant rate of 5% per year. If the discount rate is 11% then what is the current stock price? (Enter the answer in dollar format without $ sign or thousands comma -> 3519.23 and not $3,519.23 or 3,519.23)

npv(11,0,[2.6,4,((4.5*1.05)/(0.11-0.05))+4.5]) 66.46

15. A stock will pay no dividends for the next 5 years. Then it will pay a dividend of $4 growing at 4%. The discount rate is 12%. What should be the current stock price? (Enter the answer in dollar format without $ sign or thousands comma -> 3519.23 and not $3,519.23 or 3,519.23)

npv(12,0,[0,0,0,0,0,((4*1.04)/(.12-.04))+4]) 28.37

28. In the formula r=D 1 P 0 + g, what does g represent? the interest payment from a bond the dividend yield from a preferred stock the expected price appreciation yield from a common stock the expected dividend yield from a common stock

the expected price appreciation yield from a common stock

Anchoring

the tendency of investors to place more value on recent or even irrelevant information. Anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions. Once an anchor is set, other judgments are made by adjusting away from that anchor, and there is a bias toward interpreting other information around the anchor. ------------------------------------EX car dealer offers to sell you a car for $30,000 and you start to negotiate from that price rather than the $25,000 average price for cars of the same age, make, and model. The dealer succeeded in "anchoring" you to $30,000 rather than the more relevant $25,000. (Anchor = 30k)

Confirmation bias

the tendency to interpret new evidence as confirmation of one's existing beliefs or theories.

27. You are considering investing in a firm The dividend on the company's stock has not changed in the past ten years and most likely will not change in the foreseeable future. In this case, the most appropriate stock valuation model would be the _________ model. zero growth constant growth negative dividend growth growing perpetuity

zero

32. Campbell Soup stock currently sells for $40.16 per share and is expected to pay a year-end dividend of $4.92. If Campbell's constant growth rate is 2.06%, calculate the expected rate of return.

P = D / (r - g) (r - g) = D / P r = (D/P) + g = (4.92/40.16) + .0206 = 14.31%

31. ABC Inc. will pay a dividend of $3.13 per share on its common stock at the end of this year. If the expected long-term growth rate for this company is 2.94% and investors require a 9.47% rate of return, what is the price of ABC Inc. stock?

P = D / (r - g) P = 3.13 / (.0947 - .0294) = 47.93

Price of preferred stock P =

P = D / r - EX Suppose a share of preferred stock sells for $90 and pays a dividend of $4.50 each period. What is the discount rate? 4.50 / 90 = 5% --------------------------------------- - EX A share of preferred stock sells for $50 and has a discount rate of 8%. How much is the dividend? 50*.08 = $4 ------------------------------------------ - EX A share of preferred stock pays a dividend of $6.00 and has a discount rate of 12%. What is the price? 6 / .12 = $50

29. A stock is expected to pay dividends of $ 15 per share for the foreseeable future. If the appropriate discount rate is 2.9 % then what should be the price of this stock?

P = D / r = 15 / .029 = 517.24

18. A share of preferred stock sells for $28.14 and has a discount rate of 8.42%. How much is the dividend? (Enter the answer in dollar format without $ sign or thousands comma -> 3519.23 and not $3,519.23 or 3,519.23)

P =D / r 28.14 = D / .0842 D = 28.14 * .0842 = 2.37

17. Suppose a share of preferred stock sells for $41.62 and pays a dividend of $2.63 each period. What is the discount rate? (Enter the answer in % format without % sign -> 20.51 and not 20.51% or 0.2051)

P =D / r 41.62 = 2.63 / r r = 2.63/41.62 = 6.32%

19. A share of preferred stock pays a dividend of $2.98 and has a discount rate of 10.2%. What is the price? (Enter the answer in dollar format without $ sign or thousands comma -> 3519.23 and not $3,519.23 or 3,519.23)

P =D / r P = 2.98 / .102 = 29.22

13. What is the value of Walmart stock per share if the required return is 7% and the above growth rate is (rounded to 2 decimal places)? Use the growth rate to estimated the 2021 dividend. Dollar terms without the $ sign and to 2 decimals.

P0 = D0 / (r-g) D0 given in statement as 2.12 D1 = 2.12*(1+.0193) = 2.16 = 2.16 / (.07-.0193) 42.60

dividends grow at a constant rate PV of a growing perpetuity

P0 = D1 / (r-g) - D1 is the dividend paid at the end of the first time period - r is the discount rate - g is the growth rate ------------- EX A stock will pay a dividend of $4.00 per share, which is expected to grow at 5% per period. The discount rate is 8%. What should be the current price? P0 = 4 / (.08-.05) = 4 / .03 = 133.33 --------------EX A stock just paid dividend of $4.00 per share, which is expected to grow at 5% per period. The discount rate is 8%. What should be the current price? Bc it was just paid we need to find D1. D1 = D0(1+g) = 4(1.05) = 4.20 P0 = 4.20/.03 = 140.00

A stock costs $25 and will pay a dividend of $5.00 that will grow at 2% per year. What is the expected return? What is the dividend yield? A stock costs $25 and will pay a dividend of $5.00. If the discount rate is 30% then what is the expected growth rate?

P0 = D1 / (r-g) (r-g) = D1/P0 r = (D1/P0) + g r = (5/25) + .02 = .2 + .02 = .22 = 22% ------------------------- P0 = D1 / (r-g) g = r - (D1/Po) g = .3 - (5/25) = .3 - .2 = .1 = 10%

11. Loser Inc. will pay a dividend of $4.36 per share on its common stock at the end of this year. If the expected long-term growth rate for this company is -1.82% and investors require a 8.74% rate of return, what is the price of ABC Inc. stock?

PV = D / (r-g) = 4.36 / (.0874 + .0182) = 41.28789 = 41.29

6. A stock is expected to pay dividends of $ 3.67 per share for the foreseeable future. If the appropriate discount rate is 16.21 % then what should be the price of this stock? (Enter the answer in dollar format without $ sign or thousands comma -> 3519.23 and not $3,519.23 or 3,519.23)

PV = D/r = 3.67/0.1621 = 22.64

8. A stock will pay a dividend of $ 9.33 per share, which is expected to grow at 2.6 % per period. The discount rate is 15.53%. What should be the current price? (Enter the answer in dollar format without $ sign or thousands comma -> 3519.23 and not $3,519.23 or 3,519.23)

PV = D1/ (r-g) = 9.33 / (.1553 - .026) = 72.16

38. Which of the following is a true statement regarding publicly traded stocks and bonds? - Market interest rates and bond prices move in the same direction. - The price of a stock is greater than the present value of all future dividends. - A share of common stock is generally easier to value in practice than a bond. - The constant dividend growth model can be used to value stocks only if the dividend growth rate remains constant.

The constant dividend growth model can be used to value stocks only if the dividend growth rate remains constant.

Nonconstant Dividend Growth Rate Stock Valuation

- Estimate dividends for the next couple time periods - Assume dividends grow at a constant rate after you can no longer estimate the precise dividend amounts. Use that constant growth rate to estimate the price at this point in the future. Because we are estimating the stock price at a point in the future, we require a generalized version of the formula for a growing perpetuity PV = (Di+1)+)/(r-g) Pi is the stock price in time period I, and Di+1 is the dividend at the end of time period i. - Use the cash flow functions on the calculator to compute the NPV of the estimated dividends and the estimate of the future stock price. The future stock price represents all of the dividends that would occur from that point on. Together, the dividends and the future stock price give us a way to compute the PV of all future dividends. This PV of all future dividends gives us the expected stock price now, at time=0.

couple of differences between bond and stock

- First, there is usually no principal amount or maturity date for a stock. Therefore, dividend payments are like perpetuities that continue indefinitely. This means that they do not have maturity (N) or future values (FV) for the TVM calculations. - Second, dividend payments are not constant over time. They tend to change over time, usually by increasing. Because the dividends change over time we do not have a fixed PMT and cannot compute a stock's value as an annuity. Unlike bonds then, we cannot use the TVM annuity formulas to calculate stock values.

share of stock

- When investors contribute money in exchange for ownership, the security that is issued to reflect their ownership is a share of stock - gives its owner some voting rights over the actions of the firm, - as well as a claim on assets the firm may have after all other debts have been paid.

Constant Dividend Stock Valuation [Annual Examples]

- simplest case of valuing a stock is when the dividends are constant. That is, the dividends are at a fixed dollar amount and they continue forever at that amount. - PV = D/r - ---------Ex. A stock is expected to pay dividends of $4.00 per share for the foreseeable future. If the appropriate discount rate is 8% then what should be the price of this stock? Solution: Using the formula above, we would have: PV = 4/.08 = $50.00 - ----------Ex. A stock is expected to pay dividends of $4.00 per share for the foreseeable future. If the price is $45.00 then what is the implied discount rate? 45 = 4 / r r = 4/45 = 8.89% Expected return is 8.89% - -----------EX. A stock costs $40.00 and has an expected return of 6%. What is the expected dividend amount? 40 = D / 0.06 D = 40 * 0.06 = 2.4

The rules for voting in a corporation

- straight-line voting, each candidate for the board of directors is elected by a majority vote. This method tends to favor large blockholders at the expense of small shareholders - cumulative voting system, board seats are awarded in proportion to the votes received. Therefore, if a small block of voters represents 10% of shareholders, they will be able to elect 10% of the board members. The cumulative voting arrangement tends to favor minority shareholders.

When a firm needs to raise cash in order to pay for projects, the choice can be simplified to two options:

- the owners can contribute their own money, referred to as equity, (stock) - or the firm can borrow the money, referred to as debt. (bond)

Constant Dividend Stock Valuation [not annual]

A stock is expected to pay dividends of $4.00 per share each quarter for the foreseeable future. If the appropriate discount rate is 8% per year then what should be the price of this stock? .08/4 = .02 PV = 4 / .02 = 200 A stock is expected to pay dividends of $4.00 per share each quarter for the foreseeable future. If the price is $200.00 then what is the implied discount rate? 200 = 4/r r = 4/200 = .02 .02*4 = .08 = 8%

proxy voting

Allowing someone else to vote one's shares

22. What do you think Apple's stock will be in three months? If your valuation is based on where the stock is today, you could be exhibiting what irrational behavior? herding regret timeliness Anchoring confirmation

Anchoring

26. In addition to voting, shareholders also have a claim on the firm's assets, after all debts have been paid. (TF)

T

4. The value of a share of stock should be the present value of all future cash flows payable to shareholders, discounted at a rate that accounts for risk. (TF)

T

Dividends

In addition to voting, shareholders also have a claim on the firm's assets, after all debts have been paid. The cash flows can either be paid immediately to shareholders as a cash payment called a dividend, or the cash flows can be reinvested in the firm in order to pay more dividends in the future. the value of a share of stock should be the present value of these dividends to be paid to shareholders. The discount rate used to compute the present value should reflect the risk of dividend payments. The discount rate used on stock valuation is also called the return.

9. A stock just paid a dividend of $ 0.93 per share, which is expected to grow at 1.8% per period. The discount rate is 6.54%. What should be the current price? (Enter the answer in dollar format without $ sign or thousands comma -> 3519.23 and not $3,519.23 or 3,519.23)

Just Paid so we need to calculate D1 D1 = D0 (1+g) = 0.93(1.018) = 0.9467 PV = D1 / (r-g) = 0.9467/(0.0654-.018) = 19.97

Herding

Some investors rationalize their decision to buy certain stocks with "everyone else is doing it."

2. In straight-line voting, each candidate for the board of directors is elected by a majority vote. Therefore, any voting block which controls 51% of the votes will be able to elect all board members. Straight-line voting tends to favor large blockholders at the expense of small shareholders. (TF)

T

25. QUIZ START The main vote that shareholders have is to elect the Board of Directors (TF)

T

Dividend Discount Model, the Dividend Growth Model, or the Gordon Growth Model

The procedure of computing stock values by computing the PV of expected dividends --------------THREE STEPS--------------- 1. Estimate the expected future dividends. There are three patterns for future dividends: a. Dividends are constant over time. b. The dividends grow or shrink at a constant rate. c. The dividends grow or shrink at a changing rate. 2. Estimate the discount rate (we will be given the discount rate for now). 3. Use the dividends from step 1 as your CFs and the discount rate from step 2. Compute the present value. This is the stock's expected price.

Mutual funds

are investments that pool an investor's money together with other investors to purchase shares of a collection of stocks, bonds, or other securities, referred to as a portfolio, that might be difficult to recreate for individual investors. Mutual funds are overseen by portfolio managers (Links to an external site.) who are highly trained, professional investors. Actively managed mutual fund portfolio managers attempt to earn higher returns than the market by buying undervalued stocks and selling overvalued stocks.

34. A stock's ______ is found by dividing the stock's annual dividend by its closing price. current yield coupon rate yield to maturity cost of capital investors' required rate of return

current yield

Regret theory

deals with the emotional reaction people experience after realizing they have made an error in judgment. The anticipation of negative emotions leads to sub-optimal or irrational decisions. Fear of regret can lead investors to become extremely risk-averse or motivate them to be risk-seekers (less risk-averse) and take excessive risks. When risk aversion increases for many investors market prices tend to fall. Conversely, when risk aversion decreases market prices increase.

30. Common stock can be valued using the perpetuity formula if the: dividends are not expected to grow growth rate in dividends is not constant discount rate is expected to remain constant investor does not intend to sell the stock

dividends are not expected to grow

Behavioral Finance

growing body of research that focuses on investor behavior and its impact on investment decisions and stock prices. "behaviorists" argue that understanding human behavior and biases helps us to understand markets.