Valuation of Stocks

Which is true and false?

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.
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.
3. Classified stock differentiates various classes of common stock, and using it is one way companies can meet special
needs such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting
control.
4. 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.
5. Founders' shares is a type of classified stock where the shares are owned by the firm's founders, and they retain the
sole voting rights to those shares but have restricted dividends for a specified time period.
6. The cash flows associated with common stock are more difficult to estimate than those related to bonds because
stock has a residual claim against the company versus a contractual obligation for a bond.
7. When a new issue of stock is brought to market, it is the marginal investor who determines the price at which the
stock will trade.
8. According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present
value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs
of cash flows during the subsequent constant growth period.
9. Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its
operations.
10. 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.
11. If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor
will buy the stock until its price has risen enough to bring the expected return down to equal the required return.
12. If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock
until its price has fallen down to the level of the investor's estimate of the intrinsic value.
13. For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic
value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this
investor's required return.
14. A publicly owned corporation is simply a company whose shares are held by the investing public, which may include
other corporations and institutions.
15. After a new issue is brought to market it is the marginal investor who determines the price at which the stock will
trade.
16. The book value per share is computed by taking the sum of common stock, additional paid in capital, and retained
earnings and dividing the number by the number of shares outstanding.
17. A proxy fight is an attempt by a group to gain control of a firm by convincing its stockholders to give the group the
authority to vote their shares in order to elect a new management team.
18. A preemptive right is a provision in the corporate charter or by laws that gives common stockholders the right to
purchase on a pro rata basis new issues of common stock.
19. Preemptive rights are important to stockholders because they provide protection against a dilution of value when
new shares are issued.
20. One advantage of using common stock as a source of funds is that common stock does not legally obligate the firm to
make payments to stockholders.
21. From a social welfare perspective, common stock is a desirable form of financing in part because it involves no fixed
charge payments. Its inclusion in a firm's capital structure makes the firm less vulnerable to the consequences of
unanticipated declines in sales and earnings than if only debt were available.
22. Other things held constant, P/E ratios are higher for firms with high growth prospects. At the same time, P/E's are
lower for riskier firms, other things held constant. These two factors, growth prospects and riskiness, may either be
offsetting or reinforcing as P/E determinants.
23. The stock valuation model, P0 = D1/(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.
24. If markets are in equilibrium, each stock’s expected return should equal its required return as seen by the marginal
investor.
25. 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.
26. The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased
and sold.
27. According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent
on the length of time he or she plans to hold the stock.
28. 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.
29. Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal
its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the
marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds,
then the stock is said to be in equilibrium.
30. A stock's par value is equal to the market value of the stock on the last day of the fiscal year for a firm.
31. One advantage of common stock as a source of funds is that the underwriting and distribution costs of common stock
are usually much lower than those for debt.
32. When a firm issues new equity, market pressure applies first to the new shares issued and then to existing shares.
Subsequent to the new issue, the value of the new shares will rise to the equilibrium price of the old shares.
33. When management controls more than 50% of the shares of the firm, they must be concerned with the potential of
a proxy fights than can lead to takeovers of the firm and the replacement of management.
34. The constant growth model used for evaluating the price of a share of common stock can also be used to find the price
of perpetual preferred stock or any other perpetuity.
35. According to the textbook model, under conditions of nonconstant growth, the discount rate utilized to find the
present value of the expected cash flows will be the same for the initial growth period as for the normal growth period.
36. According to the basic stock valuation model, the value an investor assigns to a share of stock is dependent upon the
length of time the investor plans to hold the stock.
37. 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%.
38. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.
39. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant
over time.
40. 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.

MULTIPLE CHOICE. Identify the letter of the choice that best completes the statement or answers the questions.

41. If a firm’s expected growth rate increased then its required rate of return would [A] decrease. [B] fluctuate less than
before. [C] fluctuate more than before [D] possibly increase, possibly decrease, or possibly remain constant. [E]
increase.
42. 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.
43. 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.
44. Companies can issue different classes of common stock. Which of the following statements concerning stock classes
is most 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.
45. Which of the following statements is most 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.
46. A stock is expected to pay a year-end dividend of P2.00, i.e., D1 = P2.00. The dividend is expected to decline at a rate
of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%,
which of the following statements is most correct? [A] The company’s dividend yield 5 years from now is expected to
be 10%. [B] The constant growth model cannot be used because the growth rate is negative. [C] The company’s
expected capital gains yield is 5%. [D] The company’s expected stock price at the beginning of next year is P9.50. [E]
The company’s current stock price is P20.
47. If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is most
correct? The stock is in equilibrium if [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.
48. Stock X has the following data: Assuming the stock market is efficient and the stock is in equilibrium, which of the
following statements is most correct?
Expected dividend, D1 P 3.00
Current Price, P0 P 50
Expected constant growth rate 6.0%
[A] The stock’s expected dividend yield and growth rate are equal. [B] The stock’s expected dividend yield is 5%. [C]
The stock’s expected capital gains yield is 5%. [D] The stock’s expected price 10 years from now is P100.00. [E] The
stock’s required return is 10%.
49. Merrell Enterprises’ stock has an expected return of 14%. The stock’s dividend is expected to grow at a constant rate
of 8%, and it currently sells for P50 a share. Which of the following statements is most correct? [A] The stock’s dividend
yield is 8%. [B] The current dividend per share is P4.00. [C] The stock price is expected to be P54 a share one year from
now. [D] The stock price is expected to be P57 a share one year from now. [E] The stock’s dividend yield is 7%.
50. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which
of the following statements is most correct? [A] Stock B must have a higher dividend yield than Stock A. [B] Stock A
must have a higher dividend yield than Stock B. [C] If Stock A has a higher dividend yield than Stock B, its expected
capital gains yield must be lower than Stock B’s. [D] Stock A must have both a higher dividend yield and a higher capital
gains yield than Stock B. [E] If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be
higher than Stock B’s.
51. Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which
of the following statements is most correct? [A] If one stock has a higher dividend yield, it must also have a lower
dividend growth rate. [B] If one stock has a higher dividend yield, it must also have a higher dividend growth rate. [C]
The two stocks must have the same dividend growth rate. [D] The two stocks must have the same dividend yield. [E]
The two stocks must have the same dividend per share.
52. Which of the following statements is most correct, assuming stocks are in equilibrium? [A] Assume that the required
return on a given stock is 13%. If the stock’s dividend is growing at a constant rate of 5%, its expected dividend yield
is 5% as well. [B] A stock’s dividend yield can never exceed its expected growth rate. [C] A required condition for one
to use the constant growth model is that the stock’s expected growth rate exceeds its required rate of return. [D]
Other things held constant, the higher a company’s beta coefficient, the lower its required rate of return. [E] The
dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.
53. Which of the following statements is most correct? [A] The preferred stock of a given firm is generally less risky to
investors than the same firm’s common stock. [B] Corporations cannot buy the preferred stocks of other corporations.
[C] Preferred dividends are not generally cumulative. [D] A big advantage of preferred stock is that dividends on
preferred stocks are tax deductible by the issuing corporation. [E] Preferred stockholders have a priority over
bondholders in the event of bankruptcy to the income, but not to the proceeds in a liquidation.
54. Which of the following statements is most correct? [A] Preferred stock is normally expected to provide steadier, more
reliable income to investors than the same firm’s common stock, and, as a result, the expected after-tax yield on the
preferred is lower than the after-tax expected return on the common stock. [B] The preemptive right is a provision in
all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of
preferred stock. [C] One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends
received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax
free. [D] One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax
deductible to the issuer. [E] A major disadvantage of financing with preferred stock is that preferred stockholders
typically have supernormal voting rights.
55. The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is most correct?
[A] If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield
than Stock X. [B] If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate,
then Stock Y must sell for a higher price. [C] The stocks must sell for the same price. [D] Stock Y must have a higher
dividend yield than Stock X. [E] If the market is in equilibrium, and if Stock Y has the lower expected dividend yield,
then it must have the higher expected growth rate.