Basic Stock Valuation Exam Study Guide: Chapter 8, Exams of Business Economics

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CHAPTER 8:BASIC STOCK VALUATION

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1. A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.53 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Proxy KEYWORDS: Bloom’s: Knowledge
2. The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.53 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preemptive right KEYWORDS: Bloom’s: Knowledge
3. If a firm's stockholders are given the preemptive right, this means that stockholders have 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. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.53 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preemptive right KEYWORDS: Bloom’s: Knowledge

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a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.54 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Classified stock KEYWORDS: Bloom’s: Knowledge

5. Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.54 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Founders' shares KEYWORDS: Bloom’s: Knowledge
6. The expected total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected otal stock returns KEYWORDS: Bloom’s: Knowledge
7. The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock

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has a residual claim against the company versus a contractual obligation for a bond. a. True b. False

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a. True b. False ANSWER: True POINTS: 1

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DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant growth model KEYWORDS: Bloom’s: Knowledge

11. Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.56 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flows and valuation KEYWORDS: Bloom’s: Knowledge
12. The free cash flow valuation model cannot be used unless a company doesn't pay dividends. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.56 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model KEYWORDS: Bloom’s: Knowledge
13. Free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy

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LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flows and valuation KEYWORDS: Bloom’s: Knowledge

14. Preferred stock is a hybrid⎯ a sort of cross between a common stock and a bond⎯ in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond. a. True b. False ANSWER: False RATIONALE: Preferred dividends don't normally grow, and they are not guaranteed. POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.59 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Knowledge
15. From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer's standpoint, these risk relationships are reversed: Bonds are the most risky for the firm, preferred is next, and common is least risky. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.59 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Knowledge
16. Which of the following statements is CORRECT? a. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. b. The stock valuation model, P 0 = D 1 /(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. c. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. d. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain

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constant over time. e. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years.

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ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy

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LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-

NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

19. You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that you think a. the stock should be sold. b. the stock is a good buy. c. management is probably not trying to maximize the price per share. d. dividends are not likely to be declared. e. the stock is experiencing supernormal growth. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.
20. The preemptive right is important to shareholders because it a. will result in higher dividends per share. b. is included in every corporate charter. c. protects the current shareholders against a dilution of their ownership interests. d. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate. e. allows managers to buy additional shares below the current market price. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.53 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA

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21. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks, regardless of class, must have the same voting rights. b. All firms have several classes of common stock. c. All common stock, regardless of class, must pay the same dividend. d. Some class or classes of common stock are entitled to more votes per share than other classes. e. All common stocks fall into one of three classes: A, B, and C. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.54 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Classified stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.
22. Which of the following statements is CORRECT? a. Two firms with the same expected dividend and growth rates must also have the same stock price. b. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. c. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. ANSWER: e RATIONALE: Statement e is true, because the expected growth rate is also the expected capital gains yield. All the other statements are false. POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual

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NOTES: Question may require calculations to find the correct answer.

23. Which of the following statements is CORRECT? a. Two firms with the same expected free cash flows and growth rates must also have the same value of

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OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

25. If a stock's dividend is expected to grow at a constant rate of 5% a year, which of the following statements is

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CORRECT? The stock is in equilibrium. a. The stock's dividend yield is 5%. b. The price of the stock is expected to decline in the future. c. The stock's required return must be equal to or less than 5%. d. The stock's price one year from now is expected to be 5% above the current price. e. The expected return on the stock is 5% a year. ANSWER: d RATIONALE: Statement d is true, because the stock price is expected to grow at the dividend growth rate. POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

26. If a company’s free cash flows are expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. The company’s stock's dividend yield is 5%. b. The value of operations is expected to decline in the future. c. The company's WACC must be equal to or less than 5%. d. The company’s value of operations one year from now is expected to be 5% above the current price. e. The expected return on the company’s stock is 5% a year. ANSWER: d RATIONALE: Statement d is true, because the value of operations is expected to grow at the free cash flow growth rate. POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.60 - LO: 8- NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant free cash flow growth stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.
27. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium,