Finance 300 Exam 2
common class A stock
1 share gets 1 vote
three features of NASDAQ
1. computer network and no physical location where trading takes place 2. multiple market maker system (OTC with dealers who buy/sell for their own inventories) 3. second largest stock market in the US in terms of total dollar volume of trading
reasons common stock is more difficult to value than a bond
1. life of investment is forever 2. no easy way to observe the rate of return the market requires 3. promised cash flows aren't known in advance
other rights of shareholders (3)
1. share proportionately in dividends paid 2. right to share proportionately in assets remaining after liabilities have been paid in liquidation 3. right to vote on stockholder matters of great importance, like mergers
NYSE personnel
1366 exchange members
discount rate or expected total return R
D1/P0 + g D1/P0 called dividend yield g called capital gains yield, rate at which stock price grows
electronic communications networks (ECNs)
NASDAQ websites that allow investors to trade directly with one another, allow individual investors to enter orders
order flow
NYSE largest stock market in the world, refers to the flow of customer orders to buy and sell stocks, usually a billion shares change hands in a day
nonconstant growth formula
P0 = D1/(1+R)^1 + D2/(1+R)^2 + Pt/(1+R)^t Pt = [Dt x (1+g)]/(R-g)
constant growth formula
P0 = D1/(R-g)
two stage growth formula
P0 = D1/(R-g1) x [1-[(1+g1)/(1+R)]^t] + Pt/((1+R)^t) Pt = D0 x (1+g1)^t x (1+g2)/(R-g2)
zero growth stock formula
P0=D/R
dividends are paid out of...
aftertax profits (not deductible for corporate tax purposes)
broker
brings buyers and sellers together but does not maintain inventory
preemptive right
company that wishes to sell stock must first offer it to existing stockholders before the general public
disadvantages of NPV
complicated and requires discount rate
DMMs (specialists)
dealers in a particular kind of stock, promote market liquidity by ensuring there is always a buyer and seller available
staggering/classified boards
directors are placed into different classes with terms that expire at different times, makes more difficult for minority to elect director because there are fewer directors to be elected at one time, makes takeover more difficult because more difficult to vote majority of new directors
floor broker
executes trade for customers, emphasis on getting the best price possible
assumptions behind dividend growth/constant growth model
g must be less than r g has to be constant forever rate has to hold forever
proxy
grant of authority by a shareholder to someone else to vote his/her shares
disadvantages of payback rule
ignores TVM conventional projects only requires arbitrary cutoff
supplemental liquidity providers (SLPs)
investment firms that agree to be active participants in stocks assigned to them, don't operate on the floor of the stock exchange
NASDAQ levels of information access
level 1: designed to provide timely, accurate source of price quotations, freely available over the internet level 2: allows users to view price quotes from NASDAQ market makers (inside quotes: highest bid quotes and lowest asked quotes), available on the internet for a small fee level 3: for use of market makers only, allows dealers to enter or change price quote information
dealer
maintains inventory and stands ready to buy and sell at any time
disadvantages of PI
may lead to incorrect decisions in comparisons of mutually exclusive investments because it ignores scale
disadvantages of discounted payback
may reject positive NPV investments conventional projects only biased toward long term projects ignores cash flows beyond arbitrary point
payback rule: 1. adjust for TVM? 2. adjust for risk? 3. info on creating value?
no sort of (ignores cash flows past date, cash flows far out very uncertain) no
general rule to director elections
one share, one vote
cumulative voting
permits minority participation, each shareholder gets their shares x # directors being elected, can't split up shares
profitability index (PI)
present value of future cash flows/initial investment
benchmark PE ratio
price per share/earnings per share (benchmark)
benchmark PS ratio
price per share/sales per share (benchmark)
stock valuation using multiples formula
pt = benchmark PE ratio x EPSt pt = benchmark price sales ratio x sales per sharet (used when firm has negative EPS)
IRR is
the required return that results in a zero NPV when it is used as the discount rate, works on two conditions: 1. conventional cash flows 2. project must be independent
when g and r are not close
very price sensitive
IRR: 1. account for TVM? 2. account for risk of cash flows? 3. provide indication about increase in value?
yes yes no
PI test: 1. account for TVM? 2. account for risk of cash flows? 3. indicate increase in value?
yes yes no
discounted payback rule: 1. account for TVM? 2. account for risk of cash flows? 3. provide info about increase in value?
yes yes no
NPV: 1. adjust for TVM? 2. adjust for risk? 3. info on creating value?
yes yes yes