Question 1

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.

Accepted Answer

Preferred dividends don't normally grow, and they are not guaranteed.

Question 2

Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

Accepted Answer

This statement is true. Discounting projected free cash flows at the firm's weighted average cost of capital is a common method used to calculate the value of a company's operations. This is known as the discounted cash flow (DCF) valuation approach.

Question 3

If a firm's expected growth rate increased then its required rate of return would

Accepted Answer

The required rate of return could react in various ways to an increase in a firm's expected growth rate. It might increase if investors demand a higher return for the perceived higher risk associated with growth. It could decrease if the growth is seen as reducing risk or improving the firm's financial outlook. Or, it might remain constant if the market had already anticipated this growth or if other factors offset the impact of growth on required returns.

Question 4

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.

Accepted Answer

The nonconstant growth model assumes that the discount rate remains the same throughout the entire period of analysis, both during the initial nonconstant growth phase and the subsequent constant growth phase. This is because the discount rate reflects the risk of the overall investment, not the growth rate of dividends or cash flows.

Question 5

According to the basic FCF 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.

Accepted Answer

The basic Free Cash Flow (FCF) stock valuation model calculates the value of a share of stock based on the present value of the company's expected future free cash flows, independent of the investor's holding period.

Question 6

The constant growth dividend model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities.

Accepted Answer

Both the constant growth dividend model for common stocks and the model for perpetual preferred stocks or other perpetuities involve calculating the present value of future cash flows using a constant growth rate and a discount rate. Therefore, they are conceptually similar.

Question 7

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.

Accepted Answer

The expected total return on a share of stock refers to the dividend yield plus any capital gains or losses when the stock is sold. Commission fees are not factored into the expected total return calculation.

Question 8

Which of the following statements is CORRECT?

Accepted Answer

The answer of Which of the following statements is CORRECT?
...

Question 9

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.

Accepted Answer

The statement is accurate. The preemptive right allows current stockholders to maintain their proportional ownership in the company by giving them the opportunity to purchase new shares before they are offered to the general public. This helps prevent dilution of control and dilution of value for existing shareholders.

Question 10

You,in analyzing a stock,find that its expected return exceeds its required return.This suggests that you think

Accepted Answer

If the expected return exceeds the required return, it means that the market is undervaluing the stock and it is likely to generate higher returns than what it is currently priced at. This would suggest that the stock is a good buy.

Question 11

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.

Accepted Answer

This statement is true because bondholders have a contractual right to receive interest payments and the return of their principal, whereas stockholders only receive a return on their investment if the company is profitable and chooses to distribute dividends or if they sell their shares at a higher price than they purchased them for. The variability in these outcomes makes it more difficult to estimate the cash flows associated with common stock.

Question 12

The free cash flow valuation model cannot be used unless a company doesn't pay dividends.

Accepted Answer

The free cash flow valuation model can still be used for companies that pay dividends, but the dividends paid out must be subtracted from the free cash flow in order to calculate the company's intrinsic value.

Question 13

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.

Accepted Answer

This statement is true. Classified stock allows for different classes of common stock, which can include different voting rights, dividend preferences, and more. This can be useful for start-up firms who want to raise equity capital without giving up voting control.

Question 14

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.

Accepted Answer

This statement is true. A proxy allows one party to vote on behalf of another party, which can be important in situations where a shareholder is unable or unwilling to attend a company's annual meeting to vote their shares in person. Proxies can also be used in proxy contests or other situations where different parties are competing for control of a company.

Question 15

Which of the following statements is CORRECT?

Accepted Answer

The answer of Which of the following statements is CORRECT?
...

Question 16

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.

Accepted Answer

Founders' shares typically have greater voting rights than other classes of common stock.

Question 17

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.

Accepted Answer

From an investor's perspective, bonds are considered less risky because they have a higher claim on assets and earnings than preferred or common stock, and interest payments are obligatory. Preferred stock comes next as it often has fixed dividends and priority over common stock in asset liquidation, but lacks voting rights. Common stock is riskiest for investors due to its residual claim on assets and variable dividends. Conversely, for the issuing firm, common stock is least risky because dividends are not obligatory and can be suspended in financial distress without risking bankruptcy. Preferred stock carries moderate risk for the issuer due to fixed dividend requirements, which are less stringent than bond interest obligations but more binding than common stock dividends. Bonds are the riskiest for the issuer because they require regular interest payments and the principal must be repaid at maturity, increasing the firm's bankruptcy risk if it fails to meet these obligations.

Question 18

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.

Accepted Answer

The statement is incorrect. The preemptive right refers to the right of existing stockholders to maintain their percentage ownership in the company by having the right to purchase newly issued shares before they are offered to the public. It has nothing to do with the ability to call for a meeting to vote to replace management. Without the preemptive right, existing stockholders would not have the opportunity to purchase the newly issued shares and could potentially have their ownership stake diluted. Dissident stockholders seeking a change in management would still need to go through a proxy fight regardless of whether the company has a preemptive right or not.

Question 19

The preemptive right is important to shareholders because it

Accepted Answer

The preemptive right allows current shareholders to maintain their percentage ownership in the company by having the first right to purchase any new shares issued by the company. This protects them against a dilution of their ownership interests.

Question 20

Free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

Accepted Answer

Free cash flows represent the cash available to all providers of capital (equity and debt), so they should be discounted at the firm's weighted average cost of capital (WACC), which represents the average cost of funds from all capital providers. This approach ensures that the valuation reflects the opportunity cost of all capital providers and that the value of operations includes the value of debt and equity.

Quiz 8: Basic Stock Valuation

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.

Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

If a firm's expected growth rate increased then its required rate of return would

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.

According to the basic FCF 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.

The constant growth dividend model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities.

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.

Which of the following statements is CORRECT?

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.

You,in analyzing a stock,find that its expected return exceeds its required return.This suggests that you think

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.

The free cash flow valuation model cannot be used unless a company doesn't pay dividends.

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.

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.

Which of the following statements is CORRECT?

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.

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.

The preemptive right is important to shareholders because it

Free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.