Chapter 7 - Stock Valuation

7.1 Differentiate between debt and equity.

1) Unlike creditors, equityholders are owners of the firm.

Answer: TRUE

2) Unlike equityholders, creditors are owners of the firm.

Answer: FALSE

3) Holders of equity have claims on both income and assets that are secondary to the claims of creditors.
Answer: TRUE

4) The tax deductibility of interest lowers the cost of debt financing, thereby causing the cost of debt financing
to be lower than the cost of equity financing.
Answer: TRUE

5) Interest paid to bondholders is tax deductible.

Answer: TRUE

6) Dividends paid to stockholders is tax deductible.

Answer: FALSE

7) Which of the following is an advantage for a firm to issue common stock over long-term debt?
A) the cost of equity financing is less than the cost of debt financing
B) the primary claim of equityholders on income and assets in the event of liquidation
C) no maturity date on which the par value of the issue must be repaid
D) the tax deductibility of dividends which lowers the cost of equity financing
Answer: C

8) Which of the following is a difference between common stock and bonds?

A) Bondholders have a voice in management; common stockholders do not.
B) Bondholders have a senior claim on assets and income relative to stockholders.
C) Stocks have a stated maturity but bonds do not.
D) Dividend paid to stockholders is tax-deductible but interest paid to bondholders are not.
Answer: B

9) Holders of equity capital ________.

A) own the firm
B) receive interest payments
C) receive guaranteed income
D) have loaned money to the firm
Answer: A

10) Because equityholders are the last to receive any distribution of assets as a result of bankruptcy proceedings,
they expect ________.
A) fixed dividend payments
B) greater returns from their investment in the firm's stock
C) all profits to be paid out in dividends
D) warrants to be attached to the stock issue
Answer: B
11) If bankruptcy were to occur, ________ would have the first claim on assets.
A) preferred stockholders
B) unsecured creditors
C) equity stockholders
D) secured creditors
Answer: D

7.2 Discuss the features of both common and preferred stock.

1) The market value of common stock is related to its par value because both are sensitive to the reactions of
investors to new information.
Answer: FALSE

2) Common stockholders are often referred to as residual claimants.

Answer: TRUE

3) Common stock can be either privately owned by private investors or publicly owned by public investors.
Answer: TRUE

4) The market value of common stock is completely unrelated to its par value.
Answer: TRUE

5) The par value on a common stock is used as a basis for determining its fixed dividend.
Answer: FALSE

6) The number of authorized shares of common stock is always greater than or equal to the number of
outstanding shares of common stock.
Answer: TRUE

7) The number of outstanding shares of common stock is always greater than or equal to the number of
authorized shares of common stock.
Answer: FALSE

8) Supervoting shares of common stock provide shareholders with ten times the voting power of ordinary shares
of common stock.
Answer: FALSE

9) Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, currently dividends are subject to a
maximum tax rate of 8 percent.
Answer: FALSE

10) Treasury stocks held within the corporation do not have voting rights but have a claim on assets in
liquidation.
Answer: FALSE

11) Preferred stock is a special form of stock having a fixed periodic dividend that must be paid prior to
payment of any interest to outstanding bonds.
Answer: FALSE

12) In the case of liquidation, bondholders are paid first, followed by preferred stockholders, followed by
common stockholders.
Answer: TRUE

13) In the case of liquidation, common stockholders are paid first, followed by preferred stockholders, followed
by bondholders.
Answer: FALSE

14) Preferred stock has characteristics of debt since it provides a fixed periodic cash payment.
Answer: TRUE

15) The amount of the claim of preferred stockholders in liquidation is normally equal to the market value of the
preferred stock.
Answer: FALSE

16) Cumulative preferred stocks are preferred stocks for which all passed (unpaid) dividends in arrears must be
paid along with the current dividend prior to the payment of dividends to common stockholders.
Answer: TRUE

17) Because preferred stock is a form of ownership and has no maturity date, its claims on income and assets
are secondary to those of the firm's creditors.
Answer: TRUE

18) No-par preferred stock has no stated face value, but its annual dividend is stated as a percentage of the
market value.
Answer: FALSE

19) A preferred stockholder is sometimes referred to as a residual owner, since in essence he or she receives
what is left—the residual—after all other claims on the firm's income and assets have been satisfied.
Answer: FALSE

20) A call feature is a feature that allows preferred stockholders to change each share into a stated number of
shares of common stock.
Answer: FALSE

21) Although preferred stock provides added financial leverage in much the same way as bonds, it differs from
bonds in that the issuer can pass a dividend payment without suffering the consequences that result when an
interest payment is missed on a bond.
Answer: TRUE

22) Preferred stockholders are often referred to as residual claimants.

Answer: FALSE

23) Which of the following typically applies to common stock but not to preferred stock?
A) par value
B) dividend yield
C) legally considered as equity in the firm
D) voting rights
Answer: D

24) Which of the following is true of common stocks?

A) The common stock of a corporation can be either privately or publicly owned.
B) Firms often issue common stock with no par value.
C) Preemptive rights often result in a dilution of ownership.
D) A firm's corporate charter indicates the rate at which dividends are paid.
Answer: A

25) Which of the following is true of equity?

A) equityholders do not have voting rights.
B) It does not mature, so repayment is not required.
C) It is a temporary form of financing for a firm.
D) Equity financing is obtained from creditors.
Answer: B

26) Equity capital can be raised through ________.

A) the money market
B) the NYSE bond market
C) the stock market
D) a private placement with an insurance company
Answer: C

27) Common stockholders are sometimes referred to as ________.

A) non preemptive right holders
B) managers
C) creditors
D) residual owners
Answer: D

28) Which of the following is true of common stock?

A) It is often considered quasi-debt due to fixed payment obligation.
B) It has less restrictive covenants than debt.
C) It gives the holder voting rights which permit selection of the firm's directors.
D) Its holders have priority over preferred stockholders in the event of liquidation of assets.
Answer: C

29) A proxy statement is a statement transferring ________.

A) the ownership of a bondholder to another party
B) the votes of a bondholder to the another party
C) the votes of a stockholder to another party
D) the ownership of a stockholder to another party
Answer: C

30) Which of the following is typically a feature of common stock?

A) Most common stocks are callable.
B) Most common stocks are cumulative.
C) Common stocks have a maturity value.
D) Common stocks may or may not pay dividends.
Answer: D
31) ADRs are ________.
A) securities, backed by American depositary shares (ADSs), that permit U.S. investors to hold shares of non-
U.S. companies and trade them in U.S. markets
B) securities, backed by Securities Exchange Commission (SEC), that permit all investors to hold shares of U.S.
companies and trade them in U.S. markets
C) securities, backed by American depositary shares (ADSs), that permit non-U.S. investors to hold shares of
U.S. companies and trade them in U.S. markets
D) securities, backed by Securities Exchange Commission (SEC), that permit U.S. investors to hold shares of
non-U.S. companies and trade them in international markets
Answer: A

32) ________ are promised a fixed periodic dividend that must be paid prior to paying any common stock
dividends.
A) Preferred stockholders
B) Common stockholders
C) Bondholders
D) Creditors
Answer: A

33) Dividends in arrears that must be paid to the preferred stockholders before payment of dividends to
common stockholders are ________.
A) cumulative
B) nonparticipating
C) participating
D) convertible
Answer: A

34) An 8 percent preferred stock with a market price of $110 per share and a $100 par value pays a cash
dividend of ________.
A) $4.00
B) $8.00
C) $8.80
D) $80.00
Answer: B

35) From a corporation's point of view, a disadvantage of issuing preferred stock is ________.
A) that it increases financial leverage
B) that it has to give fixed payments as well as voting rights to the holders
C) its excellent merger security
D) that the dividends are not tax-deductible
Answer: D

36) Which of the following is a disadvantage of issuing preferred stock from the common stockholders'
perspective?
A) There is a seniority of preferred stockholder's claim over common stockholders.
B) The preferred stockholders have superior voting rights in the selection of board of directors.
C) The preferred stockholders are always paid a higher proportion of dividend payments.
D) Issuance of preferred stocks will result in a higher risk, to the disadvantage of common stockholders.
Answer: A
37) The cost of preferred stock is ________.
A) lower than the cost of long-term debt
B) higher than the cost of common stock
C) higher than the cost of long-term debt and lower than the cost of common stock
D) lower than the cost of convertible long-term debt and higher than the cost of common stock
Answer: C

38) Preferred stock is characterized by ________.

A) voting rights
B) maturity date
C) quasi-debt nature
D) preemptive rights
Answer: C

39) A firm has issued cumulative preferred stock with a $100 par value and a 12 percent annual dividend. For
the past two years, the board of directors has decided not to pay a dividend. At the end of the current year, the
preferred stockholders must be paid ________ prior to paying the common stockholders.
A) $ 0/share
B) $12/share
C) $24/share
D) $36/share
Answer: D

40) A firm has an outstanding issue of 1,000 shares of preferred stock with a $100 par value and an 8 percent
annual dividend. The firm also has 5,000 shares of common stock outstanding. If the stock is cumulative and the
board of directors has passed the preferred dividend for the prior two years, how much must the preferred
stockholders be paid prior to paying dividends to common stockholders at the end of third year?
A) $ 8,000
B) $16,000
C) $24,000
D) $25,000
Answer: C

41) A violation of preferred stock restrictive covenants usually permits preferred shareholders to ________.
A) force the company into bankruptcy
B) suit against the shareholders
C) force the retirement of the preferred stock at or above its par value
D) force the company to repurchase the shares at a stated amount below par
Answer: C

42) Which of the following is true of preferred stocks?

A) Preferred stock with a conversion feature allows holders to change each share into a stated number of shares
of common stock.
B) Like bonds, preferred stocks are due for payment on a fixed maturity date along with interest.
C) Restrictive covenants of preferred stocks include provisions about listing of stocks on the securities
exchange and determining the price of stock.
D) A firm's bond indenture indicates how many authorized preferred shares and bonds it can issue.
Answer: A

43) Preferred stockholders ________.

A) do not have preference over common stockholders in the case of liquidation
B) have preference over bondholders in the case of liquidation
C) do not have preference over bondholders in the case of liquidation
D) have preference over creditors in the case of liquidation
Answer: C

44) Which of the following is usually a right of a preferred stockholder?

A) right to convert shares to common stock on demand
B) preemptive right to participate in the issuance of new common shares
C) right to receive dividend payments before any dividends are paid to common stockholders
D) right to sue company in bankruptcy proceedings if promised preferred dividends are not paid
Answer: C

45) Which of the following is typically a feature of preferred stocks?

A) They are settled prior to common stocks during liquidation.
B) They are mostly noncumulative in nature.
C) They are paid dividends that grow at a constant rate.
D) They carry voting rights and have maturity date.
Answer: A

46) Identify whether the key characteristic describes common stock (CS) or preferred stock (PS).
________ 1. Source of financing which places minimum constraints on the firm
________ 2. Used by young firms receiving investment funds from venture capital firms
________ 3. Potential dilution of earnings and voting power
________ 4. Fixed financial obligation
________ 5. Increases the firm's borrowing power
________ 6. May have cumulative and participating features
________ 7. May be convertible into another type of security
________ 8. Last to receive earnings or distribution of assets in the event of bankruptcy
________ 9. Frequently includes a call feature
Answer:
1. CS
2. PS
3. CS
4. PS
5. CS
6. PS
7. PS
8. CS
9. PS

7.3 Describe the process of issuing common stock, including venture capital, going public, and the investment
banker.

1) The claims of the equityholders on a firm's assets have priority over the claims of creditors because the
equityholders are the owners of the firm.
Answer: FALSE

2) Preemptive rights allow common stockholders to maintain their proportionate ownership in the corporation
when new issues are made.
Answer: TRUE
3) Stock rights allow stockholders to purchase additional shares of stock in direct proportion to the number of
shares they own.
Answer: TRUE

4) A common stockholder has no guarantee of receiving any cash inflows, but receives what is left after all other
claims on the firm's income and assets have been satisfied.
Answer: TRUE

5) Preemptive rights allow existing shareholders to maintain voting control and protect themselves against the
dilution of their ownership.
Answer: TRUE

6) Treasury stock generally does not have voting rights, does not earn dividends, and does not have a claim on
assets in liquidation.
Answer: TRUE

7) Treasury stock is generally reclassified as class B common stock and has voting rights.
Answer: FALSE

8) Firms occasionally repurchase stock in order to alter capital structure or to increase the returns to the owners.
Answer: TRUE

9) Dilution of ownership occurs when a new stock issue results in each present stockholder having a larger
number of shares and, thus, a claim to a larger part of the firm's earnings than previously.
Answer: FALSE

10) Corporate venture capital funds are subsidiaries of financial institutions, particularly banks, set up to help
young firms grow and, it is hoped, become major customers of the institutions.
Answer: FALSE

11) Small business investment companies (SBICs) are corporations chartered by the federal government that
can borrow at attractive rates from the U.S. Treasury and use the funds to make venture capital investments in
private companies.
Answer: TRUE

12) Angel capitalists or angels are wealthy individual investors who do not operate as a business but invest in
early-stage companies in exchange for a portion of equity.
Answer: TRUE

13) Venture capitalists invest in promising early-stage companies in exchange for a portion of the firm's equity.
Answer: FALSE

14) American Depositary Receipts (ADRs) are claims issued by U.S. banks representing ownership of shares of
a foreign company's stock held on deposit by the U.S. bank in the foreign market and issued in dollars to U.S.
investors.
Answer: FALSE Test Bank Incorrect – AnswerL TRUE

15) A prospectus is another term for a firm's annual report showing the firm's prospects for the coming year.
Answer: FALSE

16) A prospectus is a portion of the security registration statement that describes the key aspects of the issue, the
issuer, and its management and financial position.
Answer: TRUE

17) An underwritten issue of common stock is one in which a firm purchases insurance to cover unexpected
losses suffered by shareholders.
Answer: FALSE

18) Regarding the tax treatment of payments to securities holders, it is true that ________.
A) interest and preferred stock dividends are not tax-deductible, while common stock dividends are tax
deductible
B) interest and preferred stock dividends are tax-deductible, while common stock dividends are not tax-
deductible
C) common stock dividends and preferred stock dividends are tax-deductible, while interest is not tax-
deductible
D) common stock dividends and preferred stock dividends are not tax-deductible, while interest is tax-
deductible
Answer: D

19) Which of the following is a marketable security?

A) mutual funds
B) treasury bill
C) provident fund
D) forward contracts
Answer: B

20) Which of the following is true of outstanding shares?

A) A firm cannot sell more shares than the outstanding shares mentioned in the charter.
B) Authorized shares become outstanding shares when they are issued or sold to investors.
C) Outstanding shares are indicated in a firm's corporate charter.
D) Outstanding shares are the shares repurchased by the firm.
Answer: B

21) Shares of stock currently owned by a firm's shareholders are called ________.
A) authorized shares
B) issued shares
C) outstanding shares
D) treasury shares
Answer: C

22) If a firm has class A and class B common stock outstanding, it means that ________.
A) each class receives a different dividend
B) the par value of each class is different
C) the dividend paid to one of the classes is tax deductible by the corporation
D) one of the classes is probably nonvoting stock
Answer: D

23) Common stockholders expect to earn a return by receiving ________.

A) semiannual interest
B) fixed periodic payments
C) dividends
D) annual interest
Answer: C

24) The purpose of nonvoting common stock is to ________.

A) limit the voting power of the management
B) allow the minority interest to elect one director
C) raise capital without giving up any voting control
D) give preference on distribution of earnings to those shareholders who own the stock
Answer: C

25) A proxy statement gives shareholders the right ________.

A) of one vote for each share owned
B) to give up their vote to another party
C) to maintain their proportionate ownership in the corporation when new common stock is issued
D) to sell their share of stock at a premium
Answer: B

26) A proxy battle is the attempt by ________.

A) the creditors of a bankrupt corporation to seize assets of the corporation
B) the management to dismiss the board of directors for their incapability to manage the operations
C) a nonmanagement group to unseat the existing management and gain control of the firm
D) the employees to form trade unions to influence decisions on behalf of members
Answer: C

27) The attempt by a nonmanagement group to gain control of the management of a firm by soliciting a
sufficient number of proxy votes is called a ________.
A) hostile takeover
B) bankruptcy proceeding
C) proxy battle
D) management buyout
Answer: C

28) Which of the following is true of par value of a common stock?

A) It is determined on the basis of the stock's market value.
B) It is an arbitrary value established for legal purposes in a firm's corporate charter.
C) It indicates the market value at which the stock was originally sold.
D) It allows stockholders to purchase additional shares at a price below the market price.
Answer: B

29) A firm issued 5,000 shares of $1 par-value common stock, receiving proceeds of $20 per share. The amount
recorded for the paid-in capital in excess of par account is ________.
A) $5,000
B) $95,000
C) $100,000
D) $0
Answer: B

30) A firm issued 10,000 shares of $2 par-value common stock, receiving proceeds of $40 per share. The
amount recorded for the paid-in capital in excess of par account is ________.
A) $420,000
B) $380,000
C) $400,000
D) $800,000
Answer: B

31) A firm issued 10,000 shares of no par-value common stock, receiving proceeds of $40 per share. The
amount recorded is ________.
A) $0 in the Common Stock account
B) $0 in the Paid-in Capital in Excess of Par account
C) $400,000 in the Common Stock account
D) $400,000 in the Paid-in Capital in Excess of Par account
Answer: C

32) ________ are financial instruments that allow stockholders to purchase additional shares at a price below
the market price, in direct proportion to their number of owned shares.
A) Rights offering
B) Treasury stocks
C) Preemptive rights
D) Proxy statements
Answer: A

33) Which of the following is true of a common stock?

A) It gives voting rights which permit determination of the amount of dividend receivable.
B) It gives claims on income and assets which are superior to the claims of creditors of the firm.
C) Dividends on commonstock are fully tax-deductible.
D) There is no fixed dividend payment obligation for the company.
Answer: D

34) Stock rights provide the stockholder with ________.

A) the right to purchase additional shares in direct proportion to their number of owned shares
B) the right to elect the board of directors
C) cumulative voting privileges over the preference stockholders
D) the opportunity to receive extraordinary earnings
Answer: A

35) The preemptive right gives shareholders the right ________.

A) to caste one vote for each share owned at the annual meeting of the company
B) to give up their vote to another party if they do not attend the annual meeting
C) to maintain their proportionate ownership in the corporation when new common stock is issued
D) to sell their share of stock at a premium in the event of liquidation
Answer: C

36) A firm has the balance sheet accounts, Common Stock and Paid-in Capital in Excess of Par, with values of
$10,000 and $250,000, respectively. The firm has 10,000 common shares outstanding. If the firm had a par
value of $1, the stock originally sold for ________.
A) $24/share
B) $25/share
C) $26/share
D) $30/share
Answer: C

37) A firm has the balance sheet accounts, Common Stock and Paid-in Capital in Excess of Par, with values of
$40,000 and $500,000, respectively. The firm has 40,000 common shares outstanding. If the firm had a par
value of $1, the stock originally sold for ________.
A) $11.50/share
B) $12.50/share
C) $13.50/share
D) $15.50/share
Answer: C

38) A(n)________ is hired by a firm to find prospective buyers for its new stock or bond issue.
A) securities analyst
B) trust officer
C) commercial loan officer
D) investment banker
Answer: D

39) Which of the following is true of securities analysts?

A) They raise initial external equity finance privately for firms.
B) They are primarily involved in underwriting of securities.
C) They find prospective buyers for new stocks or bonds issue.
D) They use a variety of models and techniques to value stocks.
Answer: D

40) In a ________, new shares are sold to the existing shareholders.

A) private placement
B) public offering
C) rights offering
D) direct placement
Answer: C

41) Treasury stock refers to the ________.

A) sale of stock at a price greater than the par value
B) stock issued by the US government
C) repurchase of outstanding stock
D) authorization of additional shares of stock by the board of directors
Answer: C

42) Which of the following is an attribute of investment bankers?

A) They make long-term investments for banking institutions.
B) They bear the risk of selling a security issue.
C) They act as middlemen between the issuer and the banker.
D) They provide the issuer with advice relating to the amounts of dividend to be paid.
Answer: B

43) Which of the following is true of the issuance of nonvoting common stock?
A) It is issued in the event of a hostile takeover to preserve the interests of existing owners.
B) It helps the corporation to raise capital through the sale of common stock, without giving up its voting
control.
C) It helps the existing stockholders to automatically transfer their voting rights to new stockholders without
any legal proceeding.
D) It tends to result in the dilution of voting rights of current stockholders.
Answer: B
44) A group formed by an investment banker to share the financial risk associated with underwriting new
securities is called a(n) ________.
A) underwriting syndicate
B) selling group
C) investment banking consortium
D) broker pool
Answer: A

7.4 Understand the concept of market efficiency and basic stock valuation using zero-growth, constant-growth,
and variable-growth models.

1) Investors purchase a stock when they believe that it is undervalued and sell when they feel that it is
overvalued.
Answer: TRUE

2) In an efficient market, the expected return and the required return are equal.
Answer: TRUE

3) In an efficient market, stock prices adjust quickly to new public information.

Answer: TRUE

4) In an inefficient market, stock prices adjust quickly to new public information.

Answer: FALSE

5) In an inefficient market, securities are typically in equilibrium, which means that they are fairly priced and
that their expected returns equal their required returns.
Answer: FALSE

6) In an efficient market, securities are typically in equilibrium, which means that they are fairly priced and that
their expected returns equal their required returns.
Answer: TRUE

7) To a buyer, an asset's value represents the minimum price that he or she would pay to acquire it.
Answer: FALSE

8) If the expected return is less than the required return, investors will sell the asset, because it is not expected to
earn a return commensurate with its risk.
Answer: TRUE

9) If the expected return were above the required return, investors would buy an asset, driving its price up and
its expected return down.
Answer: TRUE

10) Efficient-market hypothesis is the theory describing the behavior of an assumed "perfect" market in which
securities are typically in equilibrium, security prices fully reflect all public information available and react
swiftly to new information, and, because stocks are fairly priced, investors need not waste time looking for
mispriced securities.
Answer: TRUE

11) If a market is truly efficient, investors should not waste their time trying to find and capitalize on mispriced
securities.
Answer: TRUE

12) Behavioral finance is a growing body of research that focuses on investor behavior and its impact on
investment decisions and stock prices.
Answer: TRUE

13) The constant growth model is an approach to dividend valuation that assumes a constant future dividend.
Answer: FALSE

14) The constant growth model is an approach to dividend valuation that assumes that dividends grow at a
constant rate indefinitely.
Answer: TRUE

15) Rational buyers and sellers use their assessment of an asset's risk and return to determine its value. Relative
to this concept, which of the following is true?
A) To a buyer the asset's value represents the minimum price that he or she would pay to acquire it.
B) To a seller the asset's value represents the maximum sale price.
C) To a buyer the asset's value represents the maximum price that he or she would pay to acquire it.
D) To a seller the asset's value represents the price at which he acquired the asset.
Answer: C

16) According to the efficient market hypothesis, prices of actively traded stocks ________.
A) can be under- or over-valued in an efficient market
B) can only be under-valued in an efficient market
C) do not differ from their true values in an efficient market
D) can only be over-valued in an efficient market
Answer: C

17) If expected return is less than required return on an asset, rational investors will ________.
A) buy the asset, which will drive the price up and cause expected return to reach the level of the required return
B) sell the asset, which will drive the price down and cause the expected return to reach the level of the required
return
C) sell the asset, which will drive the price up and cause the expected return to reach the level of the required
return
D) buy the asset, since price is expected to increase
Answer: B

18) If the expected return is above the required return on an asset, rational investors will ________.
A) buy the asset, which will drive the price up and cause expected return to reach the level of the required return
B) buy the asset, which will drive the price down and cause the expected return to reach the level of the required
return
C) sell the asset, which will drive the price up and cause the expected return to reach the level of the required
return
D) sell the asset, since price is expected to decrease
Answer: A
19) Which of the following is true of efficient-market hypothesis?
A) Securities are typically in disequilibrium, meaning they are fairly priced and their expected returns are more
than their required returns.
B) Insider trading scandals have proven that stocks are not fully and fairly priced; as a result, it would be
worthwhile for investors should spend time searching for mispriced (over- or under-valued) stocks.
C) At any point in time, security prices fully reflect all internal information available about the firm and its
securities, and these prices are insensitive to new information.
D) Since stocks are fully and fairly priced, it follows that investors should not waste their time trying to find and
capitalize on miss-priced (undervalued or overvalued) securities.
Answer: D

20) Preferred stock is valued as if it were a ________.

A) fixed-income obligation
B) bond
C) perpetuity
D) common stock
Answer: C

21) A firm has an issue of preferred stock outstanding that has a stated annual dividend of $4. The required
return on the preferred stock has been estimated to be 16 percent. The value of the preferred stock is ________.
A) $64
B) $16
C) $25
D) $50
Answer: C

22) A firm has to pay a dividend of $1.20 per share till perpetuity, a zero growth rate of dividends, and a
required return of 10 percent. The value of the firm's preferred stock is ________.
A) $120
B) $10
C) $12
D) $100
Answer: C

23) A firm has an issue of preferred stock outstanding that has a par value of $100 and a 4% dividend. If the
current market price of the preferred stock is $50, the yield on the preferred stock is ________.
A) 4.00%
B) 6.00%
C) 8.00%
D) 12.00%
Answer: C

24) The ________ is utilized to value preferred stock.

A) capital asset pricing model
B) arbitrage pricing model
C) zero-growth model
D) Black-Scholes model
Answer: C

25) In the Gordon model, the value of a common stock is the ________.
A) net value of all assets which are liquidated for their exact accounting value
B) actual amount each common stockholder would expect to receive if the firm's assets are sold
C) present value of a non-growing dividend stream
D) present value of a constant growing dividend stream
Answer: D

26) Emmy Lou, Inc. has an expected dividend next year of $5.60 per share, a growth rate of dividends of 10
percent, and a required return of 20 percent. The value of a share of Emmy Lou, Inc.'s common stock is
________.
A) $28.00
B) $56.00
C) $22.40
D) $18.67
Answer: B

27) A firm has experienced a constant annual rate of dividend growth of 9 percent on its common stock and
expects the dividend per share in the coming year to be $2.70. The firm can earn 12 percent on similar risk
involvements. The value of the firm's common stock is ________.
A) $22.50/share
B) $9/share
C) $90/share
D) $30/share
Answer: C

28) You are planning to purchase the stock of Ted's Sheds Inc. and you expect it to pay a dividend of $3 in 1
year, $4.25 in 2 years, and $6.00 in 3 years. You expect to sell the stock for $100 in 3 years. If your required
return for purchasing the stock is 12 percent, how much would you pay for the stock today?
A) $75.45
B) $77.24
C) $81.52
D) $85.66
Answer: C

29) Smith Corporation's common stock is expected to pay a dividend of $3.00 forever and currently sells for
$21.42. What is the required rate of return?
A) 10%
B) 12%
C) 13%
D) 14%
Answer: D

30) Julian is considering purchasing the stock of Pepsi Cola because he really loves the taste of Pepsi. What
should Julian be willing to pay for Pepsi today if it is expected to pay a $2 dividend in one year and he expects
dividends to grow at 5 percent indefinitely? Julian requires a 12 percent return to make this investment.
A) $28.57
B) $29.33
C) $31.43
D) $43.14
Answer: A

31) Harry Corporation's common stock currently sells for $180 per share. Harry just paid a dividend of $10.18
and dividends are expected to grow at a constant rate of 6 percent forever. If the required rate of return is 12
percent, what will Harry Corporation's stock sell for one year from now?
A) $190.64
B) $187.04
C) $195.40
D) $179.84
Answer: A

32) Tangshan China Company's stock is currently selling for $80.00 per share. The expected dividend one year
from now is $4.00 and the required return is 13 percent. What is Tangshan's dividend growth rate assuming that
dividends are expected to grow at a constant rate forever?
A) 8%
B) 9%
C) 10%
D) 11%
Answer: A

33) Tangshan China's stock is currently selling for $160.00 per share and the firm's dividends are expected to
grow at 5 percent indefinitely. Assuming Tangshan China's most recent dividend was $5.50, what is the required
rate of return on Tangshan's stock?
A) 7.3%
B) 8.4%
C) 9.5%
D) 10.6%
Answer: B

34) Daniel Custom Cycles' common stock currently pays no dividends. The company plans to begin paying
dividends beginning 3 years from today. The first dividend will be $3.00 and dividends will grow at 5 percent
per year thereafter. Given a required return of 15 percent, what would you pay for the stock today?
A) $25.33
B) $18.73
C) $29.86
D) $22.68
Answer: D

35) Jia's Fashions recently paid a $2 annual dividend. The company is projecting that its dividends will grow by
20 percent next year, 12 percent annually for the two years after that, and then at 6 percent annually thereafter.
Based on this information, how much should Jia's Fashions common stock sell for today if her required return is
10.5%?
A) $54.90
B) $60.80
C) $59.16
D) $69.30
Answer: C

7.5 Discuss the free cash flow valuation model and the book value, liquidation value, and price/earnings (P/E)
multiple approaches.

1) The free cash flow valuation model can be used to determine the value of an entire company as the present
value of its expected free cash flows discounted at the firm's weighted average cost of capital.
Answer: TRUE
2) The free cash flow valuation model is based on the same principle as the P/E valuation approach; that is, the
value of a share of stock is the present value of future cash flows.
Answer: FALSE

3) The free cash flow valuation model is based on the same principle as dividend valuation models; that is, the
value of a share of stock is the present value of future cash flows.
Answer: TRUE

4) In valuation of common stock, the price/earnings multiple approach is considered superior to the use of book
or liquidation values since it considers expected earnings.
Answer: TRUE

5) The common stock book value model ignores a firm's expected earnings potential and generally lacks any
true relationship to the firm's value in the marketplace.
Answer: TRUE

6) The liquidation value per share of common stock is the amount per share of common stock that would be
received if all of a firm's assets were sold for their accounting value and the proceeds remaining were divided
among common stockholders.
Answer: FALSE

7) The book value per share of common stock is the amount per share of common stock that would be received
if all of a firm's assets were sold for their accounting value and the proceeds remaining were divided among
common stockholders.
Answer: TRUE

8) Ted Corporation expects to generate free-cash flows of $200,000 per year for the next five years. Beyond that
time, free cash flows are expected to grow at a constant rate of 5 percent per year forever. If the firm's average
cost of capital is 15 percent, the market value of the firm's debt is $500,000, and Ted has a half million shares of
stock outstanding, what is the value of Ted stock?
A) $2.43
B) $3.43
C) $1.43
D) $0.00
Answer: A

9) Patrick Company expects to generate free-cash of $120,000 per year forever. If the firm's required return is
12 percent, the market value of debt is $300,000, the market value of preferred stock is $70,000, and the
company has 100,000 shares of stock outstanding. What is the value of Patrick's stock?
A) $6.30
B) $10.00
C) $7.00
D) $9.70
Answer: A

10) Tangshan China's stock is currently selling for $160.00 per share and the firm's dividends are expected to
grow at 5 percent indefinitely. In addition, Tangshan China's most recent dividend was $5.50. If the expected
risk free rate of return is 3 percent, the expected market premium is 4 percent, and Tangshan has a beta of 1.2,
Tangshan's stock would be ________.
A) overvalued because the market price is higher than the resulting share value
B) undervalued because the market price is less than the resulting share value
C) overvalued because the resulting share value is higher than the market value
D) undervalued because the resulting share value is less than the market value
Answer: B

11) Tangshan China's stock is currently selling for $160.00 per share and the firm's dividends are expected to
grow at 5 percent indefinitely. In addition, Tangshan China's most recent dividend was $5.50. If the expected
risk free rate of return is 3 percent, the expected market return is 8 percent, and Tangshan has a beta of 1.2,
Tangshan's stock would be ________.
A) overvalued because the market price is higher than the resulting share value
B) undervalued because the market price is less than the resulting share value
C) overvalued because the resulting share value is higher than the market value
D) undervalued because the resulting share value is less than the market value
Answer: A

12) ________ is the value of a firm's ownership in the event that all assets are sold for their exact accounting
value and the proceeds remaining after paying all liabilities (including preferred stock) are divided among
common stockholders.
A) Liquidation value
B) Book value
C) The P/E multiple
D) The present value of the common stock
Answer: B

13) ________ is the actual amount each common stockholder would expect to receive if a firm's assets are sold
for their market value, creditors and preferred stockholders are repaid, and any remaining money is divided
among the common stockholders.
A) Liquidation value
B) Book value
C) The P/E multiple
D) The present value of the dividends
Answer: A

14) ________ is a guide to a firm's value if it is assumed that investors value the earnings of a given firm in the
same way they do the average firm in the industry.
A) Liquidation value
B) Book value
C) The P/E multiple
D) The present value of the dividends
Answer: C

15) Which of the following valuation methods is superior to others in the list since it considers expected
earnings?
A) liquidation value
B) book value
C) P/E multiple
D) present value of the interest
Answer: C

16) The use of the ________ is especially helpful in valuing firms that are not publicly traded.
A) liquidation value
B) book value
C) P/E multiple
D) present value of the dividends
Answer: C

17) The current price of DEF Corporation stock is $26.50 per share. Earnings next year should be $2 per share
and it should pay a $1 dividend. The P/E multiple is 15 times on average. What price would you expect for
DEF's stock in the future?
A) $13.50
B) $15.00
C) $26.50
D) $30.00
Answer: D

18) At year end, Tangshan China Company balance sheet showed total assets of $60 million, total liabilities
(including preferred stock) of $45 million, and 1,000,000 shares of common stock outstanding. Based on this
information, Tangshan's book value per share of common stock is ________.
A) $105
B) $10.50
C) $15
D) $150
Answer: C

19) At year end, Tangshan China Company balance sheet showed total assets of $60 million, total liabilities
(including preferred stock) of $45 million, and 1,000,000 shares of common stock outstanding. If Tangshan
could sell its assets for $52.5 million, Tangshan's liquidation value per share of common stock is ________.
A) $15
B) $7.50
C) $52.50
D) $75
Answer: B

20) At year end, Tangshan China Company balance sheet showed total assets of $60 million, total liabilities
(including preferred stock) of $45 million, and 1,000,000 shares of common stock outstanding. Next year,
Tangshan is projecting that it will have net income of $1.5 million. If the average P/E multiple in Tangshan's
industry is 15, what should be the price of Tangshan's stock?
A) $15.00
B) $22.50
C) $52.50
D) $75.00
Answer: B

7.6 Explain the relationships among financial decisions, return, risk, and the firm's value.

1) Any action taken by a financial manager that increases risk will also increase the required return.
Answer: TRUE

2) An action on the part of a firm that increases the level of expected cash flows without a corresponding
increase in risk should reduce share value; an action that reduces the level of expected cash flows without a
corresponding decline in risk should increase share value.
Answer: FALSE
3) Assuming that economic conditions remain stable, any management action that would cause current and
prospective stockholders to raise their dividend expectations should decrease a firm's value.
Answer: FALSE

4) The required return can be affected by changes in the risk free rate, even if the risk premium remains
constant.
Answer: TRUE

5) If the risk-free rate decreases due to a shift in government policy, the required return goes up.
Answer: FALSE

6) Milton Glasses recently paid a dividend of $1.70 per share, is currently expected to grow at a constant rate of
5%, and has a required return of 11%. Milton Glasses has been approached to buy a new company. Milton
estimates if it buys the company, its constant growth rate would increase to 6.5%, but the firm would also be
riskier, therefore increasing the required return of the company to 12%. Should Milton go ahead with the
purchase of the new company?
A) Yes, because the value of the Milton Co. will increase by $3.17 per share.
B) Yes, because the value of the Milton Co. will increase by $2.56 per share.
C) Yes, because the value of the Milton Co. will increase by $4..59 per share.
D) No, because the value of the Milton Co. will decrease by $3.17 per share.
Answer: A