Question 1

If a firm's stockholders are given the preemptive right,then they can call for a meeting to vote to replace the management.Without the preemptive right,dissident stockholders have to seek a change in management through a proxy fight.

Accepted Answer

The preemptive right refers to a shareholder's right to maintain their percentage ownership of a company by purchasing newly issued shares before they are offered to the public. It does not give them the ability to call for a meeting to vote to replace management. Dissident stockholders can seek a change in management through a proxy fight regardless of whether or not they have the preemptive right.

Question 2

Founders' shares,a type of classified stock owned by the firm's founders,generally have more votes per share than the other classes of common stock.

Accepted Answer

Founders' shares often have multiple votes per share compared to other common stock, giving the founders greater control over important company decisions.

Question 3

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 his or her required return.

Accepted Answer

In equilibrium, the market price of a stock should reflect its intrinsic value and the expected return should equal the required return. This is because any deviation from either of these conditions would result in investors making trades that would eventually correct the discrepancy and bring the stock back to equilibrium.

Question 4

The constant growth DCF 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 DCF model and the perpetuity model rely on the assumption of steady, perpetual cash flows, making them conceptually similar in their approach to determining fair value.

Question 5

The 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 total return on a share of stock includes both capital gains/losses and dividend yield, not just the dividend yield alone. Commission paid when the stock is purchased and sold is not included in the calculation of total return.

Question 6

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 can give someone else the authority to vote on behalf of another party, which can be important in the context of controlling a company.

Question 7

Preferred stock is a hybrid-a 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 8

If a stock's expected return as seen by the marginal investor exceeds his or her 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.

Accepted Answer

This statement is known as the equilibrium principle and is a fundamental concept in finance. When the expected return of a stock exceeds the required return, investors will demand the stock, driving up the price and lowering the expected return until it is equal to the required return. Conversely, if the expected return is lower than the required return, investors will sell the stock, causing the price to fall and the expected return to increase until it reaches equilibrium with the required return.

Question 9

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

Accepted Answer

This is the correct method for calculating a firm's total corporate value using discounted cash flow analysis. The weighted average cost of capital represents the cost of financing the firm's operations, and therefore is an appropriate discount rate to use when determining the present value of its future cash flows.

Question 10

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

Common stock does not have a set or guaranteed payment schedule like bonds do, making their cash flows more uncertain and difficult to estimate. Additionally, stockholders do not have a contractual obligation to be paid dividends or to have their principal amount returned. They only receive payments after bondholders and other stakeholders are paid first. This residual claim status makes common stock inherently riskier, but also potentially more lucrative due to the possibility of higher returns.

Question 11

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.

Accepted Answer

The basic DCF (Discounted Cash Flow) stock valuation model calculates the present value of expected future cash flows, independent of the investor's intended holding period. It focuses on the intrinsic value of the stock based on its future cash flows, not on the investor's personal investment horizon.

Question 12

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 priority over stocks in case of liquidation and often provide a fixed income. Preferred stocks are riskier than bonds but less risky than common stocks because they typically offer fixed dividends and have priority over common stocks in asset liquidation. However, from a corporate issuer's standpoint, bonds are the most risky because they require fixed interest payments regardless of the company's financial situation, increasing the financial burden. Preferred stocks are next in terms of risk due to dividend obligations, which are typically fixed but can be suspended in financial distress without the company facing bankruptcy. Common stocks are considered the least risky for the issuer since dividends are not obligatory and can be adjusted based on the company's performance.

Question 13

Classified stock differentiates various classes of common stock.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 companies to create different classes of common stock with varying rights and privileges, such as voting rights and dividend preferences. This can help companies meet specific financing or ownership needs. One example is when founders of a start-up company want to raise additional capital but maintain control over the decision-making process, they may issue a class of non-voting stock to new investors.

Question 14

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 a single discount rate is used throughout the entire valuation process, both for the initial period of nonconstant growth and the subsequent period of constant growth, to discount all expected cash flows to their present values.

Question 15

Two conditions are used to determine whether 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 his or her required return? If either of these conditions,but not necessarily both,holds,then the stock is said to be in equilibrium.

Accepted Answer

If one condition holds,then the other must also hold.

Question 16

When a new issue of stock is brought to market,the marginal investor determines the price at which the stock will trade.

Accepted Answer

The marginal investor is the one who is willing and able to buy or sell at the current market price, and their actions determine the price at which the stock will trade. Therefore, when a new issue of stock is brought to market, the price will be determined by the marginal investor.

Question 17

The corporate valuation model cannot be used unless a company pays dividends.

Accepted Answer

The corporate valuation model can be used even if a company does not pay dividends, as long as there is a reliable estimate of future cash flows.

Question 18

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 preemptive right allows existing stockholders to maintain their proportional ownership in a company by purchasing new shares before they are offered to the general public. This helps protect their control and value in the company.

Question 19

The corporate valuation model can be used only when a company doesn't pay dividends.

Accepted Answer

The corporate valuation model can be used for companies that pay dividends as well as those that do not, but it requires the estimation of the cost of equity using other methods such as the dividend discount model or capital asset pricing model.

Question 20

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.

Accepted Answer

This is the principle of market competition known as the "law of one price," which suggests that prices will eventually adjust to reflect the true value of an asset. When a stock's market price exceeds its intrinsic value (as determined by the marginal investor), sellers will be motivated to sell until the price falls to an equilibrium level that reflects the true value of the asset.

Quiz 9: Stocks and Their Valuation