Question 1

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 stock dividends are not contractually guaranteed like bond interest payments, and they do not normally increase annually like common stock dividends might. Preferred dividends are typically fixed and can be suspended by the company's board of directors without the company facing bankruptcy.

Question 2

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

A proxy is a legal document that allows someone to represent another person or entity, typically in the context of voting rights for shares of common stock. Proxies can be important tools for those seeking to exercise control over a firm, as they allow for strategic voting and decision-making.

Question 3

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 both dividend-paying and non-dividend-paying companies.

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 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 determines the value of a stock based on the present value of its future cash flows, not on how long an investor plans to hold it.

Question 6

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 is known as the principle of equilibrium in finance. If the expected return on a stock is higher than the required return (i.e. the investor's minimum acceptable rate of return), investors will buy the stock, driving up its price and lowering its expected return until it is in line with the required return. Similarly, if the expected return is lower than the required return, investors will sell the stock, driving down its price and increasing its expected return until it is in line with the required return.

Question 7

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

Accepted Answer

The corporate valuation model can still be used for companies that do not pay dividends. In such cases, the model would calculate the present value of the expected future cash flows from the company, including any potential future dividends or other distributions to shareholders.

Question 8

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

For a stock to be in equilibrium, both conditions mentioned in the statement must be satisfied. So, the statement is true.

Question 9

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

For a stock to be in equilibrium, both conditions must hold: the stock's market price must equal its intrinsic value as perceived by the marginal investor, and the expected return on the stock must equal the marginal investor's required return.

Question 10

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 often considered to be the one whose buying or selling decision will most significantly impact the stock price, and they determine the price at which the stock will trade.

Question 11

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 must seek a change in management through a proxy fight.

Accepted Answer

The statement is incorrect. The preemptive right relates to the ability of existing shareholders to maintain their proportionate ownership in the company by subscribing to new shares before they are offered to the general public. It has nothing to do with the ability to call for a meeting to vote on replacing management. Dissident stockholders can still call for a meeting and seek a change in management through a proxy fight, regardless of whether or not there is a preemptive right.

Question 12

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 accurately describes the preemptive right.

Question 13

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 refers to the sum of any capital gains or losses (the difference between the purchase price and the sale price) as well as any dividends received. It does not factor in any commissions paid when the stock is purchased and sold.

Question 14

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 based on the principle of efficient markets, which suggests that in a perfectly efficient market, the price of a stock will quickly adjust to reflect all available information, including its intrinsic value. If the market price exceeds the intrinsic value, the marginal investor (i.e. the investor whose decision to buy or sell will cause the price to move) will sell the stock, which will drive the price down until it is once again equal to or below the investor's estimate of the intrinsic value.

Question 15

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

This is true. Both the constant growth DCF model for common stocks and the perpetuity model assume that cash flows will continue indefinitely and therefore calculate the present value of cash flows using a discount rate and a growth rate. The only difference is that the constant growth DCF model for common stocks takes into consideration future dividends and their growth, while the perpetuity model assumes a fixed cash flow amount that will be paid out indefinitely.

Question 16

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 represents ownership in a company and the cash flows associated with it are based on the company's profitability and dividends, which are not guaranteed or contractual obligations like bond payments. This makes estimating future cash flows associated with common stock more difficult.

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, preferred stock is less risky than common stock because preferred shareholders have priority over common shareholders in receiving dividends and assets in the event of liquidation. However, it's riskier than bonds because bondholders are paid before both types of stockholders. From the issuer's standpoint, bonds are the most risky because they come with fixed interest payments that the company must make regardless of its financial situation, increasing the risk of financial distress. Preferred stock is next because, although it typically has fixed dividends, these can be suspended in times of financial difficulty without the company facing bankruptcy. Common stock is considered the least risky for the issuer because there are no obligations to pay dividends, providing more flexibility in financial management.

Question 18

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 typically have more voting rights than other classes of common stock, giving the founders greater control over the company's decisions.

Question 19

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 statement is true. Discounting projected free cash flows at the firm's weighted average cost of capital is a common method used to determine the present value of the firm's future cash flows and therefore its total corporate value.

Question 20

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

Classified stock is a type of common stock that differentiates various classes based on their voting rights and dividend payments. It can be used by companies to meet specific needs, such as allowing owners of a start-up firm to raise additional equity capital without losing voting control.

Quiz 10: Stocks and Their Valuation