Foundations of Finance, 7e (Keown/Martin/Petty)Chapter 8 The Valuation and Characteristics of Stock 8.1 Learning Objective 11) Preferred stock is referred to as a hybrid security because it has many characteristics of both common stock and bonds.Answer:!"#$eywords:Preferred %tock& 'ybrid %ecurityAA(%):!ef*ective thinking ski**s+) )ecause most ,referred stocks are ,er,etuities& their va*ue can be determined by dividing the annua* dividend by an investor-s re.uired return.Answer:!"#$eywords:Preferred %tock& Per,etuity& /ntrinsic 0a*ueAA(%):!ef*ective thinking ski**s1) /n terms of risk& ,referred stock is safer than common stock because it has a ,rior c*aim on assets and income. Answer:!"#$eywords:Preferred %tock& (ommon %tock& !isk AA(%):!ef*ective thinking ski**s2) Pub*ic ,erce,tion and re,utation do not affect stock ,rices& which are strict*y a function of dividends and re.uired returns. Answer:3AL%#$eywords:%tock 0a*uation !e,utationAA(%):!ef*ective thinking ski**s4) A ca** ,rovision entit*es a com,any to re,urchase its ,referred stock from ho*ders at stated ,rices over a given time ,eriod. Answer:!"#$eywords:Preferred %tock& (a** Provision AA(%):!ef*ective thinking ski**s5) 3or a given constant re.uired rate of return& the greatest ,ortion of a ,referred stockho*der-s return comes from increases in the ,rice of ,referred stock.Answer:3AL%#$eywords:Preferred %tock& (a,ita* 6ainAA(%):!ef*ective thinking ski**s7) he amount of the ,referred stock dividend is genera**y fi8ed either as a do**ar amount or as a ,ercentage of the ,ar va*ue. Answer:!"#$eywords:Preferred %tock 9ividendAA(%):!ef*ective thinking ski**s1(o,yright : +;11 Pearson #ducation& /nc.8) Preferred stock is riskier than *ongarket (a,ita*i?ation AA(%):!ef*ective thinking ski**s17) Preferred stock va*uation usua**y treats the ,referred stock as aA) ca,ita* asset.)) ,er,etuity.() common stock.9) *ong& /nc. has an issue of ,referred stock whose ,ar va*ue is G4;;. he ,referred stock ,ays a 2.4F dividend. /f investors re.uire a 4.4F rate of return for these shares& what ,rice shou*d the ,referred stock se** for@A) G511.11)) G4;8.11() G2;=.;=9) G81.8+Answer:($eywords:Preferred %tock 0a*uationAA(%):Ana*ytic ski**s1+) 9e,artment 54 has an issue of ,referred stock that ,ays a dividend of G2.;;. he ,referred stockho*ders re.uire a rate of return on this stock of =F. At what ,rice shou*d the ,referred stockse** for@ !ound off to the nearest G;.1;.A) G15.;;)) G22.2;() G5+.4;9) G88.8;Answer:)$eywords:Preferred %tock 0a*uationAA(%):Ana*ytic ski**s11) Positive ronics /ndustries ,referred stock has a ,ar va*ue of G1;; and ,ays a dividend of G5.;; ,er share. /t ,resent*y se**s for G87 ,er share. Bhat do investors re.uire as a rate of return on this stock@ !ound off to the nearest .1;F.A) 12.4F)) =.1F() 5.=F9) 5.;FAnswer:($eywords:Preferred %tock& !e.uired !eturnAA(%):Ana*ytic ski**s12) Danti (or,. ,referred stock has a 4F stated dividend ,ercentage& and a G1;; ,ar va*ue. Bhat is the va*ue of the stock if your re.uired rate of return is 5F ,er year@A) G81.11)) G=2.;4() G1;;.;;9) G1;.;;Answer:A$eywords:Preferred %tock 0a*uationAA(%):Ana*ytic ski**s7(o,yright : +;11 Pearson #ducation& /nc.14) /f Jea* O-9anny ,referred stock ,ays an annua* dividend of G+.8;& and investors re.uire a =F return& what is the va*ue of O-9anny-s ,referred stock today@Answer:0, K 9ivL! K G+.8;L.;= K G11.11$eywords:Preferred %tock 0a*uationAA(%):Ana*ytic ski**s8.1 Learning Objective 11) he market ,rice of a firm-s common stock e.ua*s the sum of a** e.uity accounts as re,orted in its ba*ance sheet Acommon stock M ,aidarket 0a*ue of #.uityAA(%):!ef*ective thinking ski**s+) 'istorica**y& ,rice a,,reciation& or ca,ita* gains yie*d& has accounted for a greater ,ortion of returns on common stocks than dividend ,ayments.Answer:!"#$eywords:9ividends& !eturns on (ommon %tock& Price A,,reciationAA(%):!ef*ective thinking ski**s1) Preferred stock is *ess risky than common stock& but more risky than debt.Answer:!"#$eywords:Preferred %tock& 9ebt& (ommon %tock& !e.uired !eturnAA(%):!ef*ective thinking ski**s2) (umu*ative voting is advantageous to minority shareho*ders because it may a**ow them to e*ect a member of the board of directors.Answer:!"#$eywords:(umu*ative 0oting& >inority %hareho*dersAA(%):!ef*ective thinking ski**s4) %hareho*ders& as owners of the cor,oration& face un*imited *iabi*ity for the cor,oration-s debts& whi*e bondho*ders& as creditors& may on*y *ose the va*ue of their investment if the com,any goes bankru,t.Answer:3AL%#$eywords:%hareho*ders& (reditors& Limited Liabi*ityAA(%):!ef*ective thinking ski**s5) (ommon stock cannot be worth *ess than its book va*ue.Answer:3AL%#$eywords:(ommon %tock& )ook 0a*ueAA(%):!ef*ective thinking ski**s8(o,yright : +;11 Pearson #ducation& /nc.7) (onvertibi*ity is a common feature of common stockN it a**ows the common stockho*ders to convert their common shares into ,referred shares or into bonds.Answer:3AL%#$eywords:(onvertibi*ityAA(%):!ef*ective thinking ski**s8) (ommon stockho*ders demand a return on the ,rice ,aid for their common stock& but since retained earnings on the ba*ance sheet are mere*y Oon ,a,erO they do not re.uire a return on earnings that have been retained.Answer:3AL%#$eywords:!e.uired !eturn& !etained #arningsAA(%):!ef*ective thinking ski**s=) he common stock of a constantode*& Preferred %tockAA(%):!ef*ective thinking ski**s1;) (ommon stock does not mature.Answer:!"#$eywords:(ommon %tock& >aturity 9ateAA(%):!ef*ective thinking ski**s11) )ondho*ders and ,referred stockho*ders can be viewed as creditors& whereas the common stockho*ders are the true owners of the firm.Answer:!"#$eywords:(ommon %tock& Preferred %tock& )ondsAA(%):!ef*ective thinking ski**s1+) /f a common stockho*der cannot ,ersona**y attend the meeting of shareho*ders then their votes are *ost. Answer:3AL%#$eywords:0oting !ights& (ommon %tockAA(%):!ef*ective thinking ski**s11) "nder cumu*ative voting a 1;F shareho*der wi** *ike*y be ab*e to e*ect 1;F of the board of directors.Answer:!"#$eywords:(umu*ative 0oting& )oard of 9irectorsAA(%):!ef*ective thinking ski**s=(o,yright : +;11 Pearson #ducation& /nc.12) "nder majority voting a majority AP4;F) shareho*der wi** just be ab*e to e*ect a sim,*e majority of the board of directors.Answer:3AL%#$eywords:>ajority 0oting& )oard of 9irectorsAA(%):!ef*ective thinking ski**s14) "nder majority voting a majority AP4;F) shareho*der wi** be ab*e to e*ect the entire board ofdirectors.Answer:!"#$eywords:>ajority 0oting& )oard of 9irectorsAA(%):!ef*ective thinking ski**s15) Preferred stock and common stock issued by the same firm wi** have the same re.uired return because the riskiness of the firm-s cash f*ows is the same for both securities.Answer:3AL%#$eywords:Preferred %tock& (ommon %tock& !e.uired !eturnAA(%):!ef*ective thinking ski**s17) /n theory& shareho*ders se*ect the board of directors& but in rea*ity& management effective*y se*ects the directors.Answer:!"#$eywords:)oard of 9irectors& Agency Prob*emsAA(%):!ef*ective thinking ski**s18) Limited *iabi*ity for a cor,oration-s common shareho*ders is a ,rotective ,rovision that aids the cor,oration in raising funds.Answer:!"#$eywords:Limited Liabi*ity AA(%):!ef*ective thinking ski**s1=) /f a shareho*der cannot attend the cor,oration-s annua* meeting& the shares may sti** be voted usingA) the ,reem,tive right.)) a ,ro8y.() majority voting ru*es.9) the cumu*ative voting right.Answer:)$eywords:Pro8yAA(%):!ef*ective thinking ski**s1;(o,yright : +;11 Pearson #ducation& /nc.+;) >inority shareho*ders have a greater chance of e*ecting a member to the board of directors ifthe com,any usesA) cumu*ative voting.)) majority voting.() minority voting.9) ,ro8y voting.Answer:A$eywords:(umu*ative 0otingAA(%):Ana*ytic ski**s+1) Preferred stock differs from common stock in thatA) ,referred stock usua**y has a maturity date.)) ,referred stock investors have a higher re.uired return than common stock investors.() ,referred stock dividends are fi8ed.9) common stock investors have a re.uired return and ,referred stock investors do not.Answer:($eywords:Preferred %tock& 9ividendsAA(%):!ef*ective thinking ski**s++) 'ow is ,referred stock simi*ar to common stock@A) Preferred dividend ,ayments usua**y have un*imited growth ,otentia*.)) /nvestors cannot sue a cor,oration for the nonode*& (a,ita* 6ains Die*dAA(%):!ef*ective thinking ski**s4) /f the e8,ected growth rate for dividends is ?ero& then the va*ue of common stock wi** be e.ua* to the current dividend. Answer:3AL%#$eywords:(onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s5) A common stock with an e8,ected dividend growth rate of ?ero wou*d be va*ued in the same way as ,referred stock& that is& the e8,ected dividend divided by the re.uired return.Answer:!"#$eywords:Preferred %tock& (onstant 6rowth 9ividend 0a*uation >ode*AA(%):!ef*ective thinking ski**s7) /n genera*& common stock and ,referred stock are both va*ued by ca*cu*ating the ,resent va*ueof a** e8,ected future cash f*ows& using the re.uired return as the discount rate.Answer:!"#$eywords:(ommon %tock& Preferred %tock& 0a*uation& Present 0a*ue& !e.uired !eturnAA(%):!ef*ective thinking ski**s11(o,yright : +;11 Pearson #ducation& /nc.8) he stock va*uation mode* 91LArcs < g) re.uires the stock to grow at a rate greater than the re.uired returnN otherwise& the stock is worth*ess.Answer:3AL%#$eywords:(onstant 6rowth (ommon %tock 0a*uation >ode*AA(%):!ef*ective thinking ski**s=) he retention ratio is e.ua* to 1 minus the dividend ,ayout ratio. Answer:!"#$eywords:!etention !atio& 9ividend Payout !atioAA(%):!ef*ective thinking ski**s1;) A firm can increase the growth rate of common stockho*ders- investment in the firm by retaining more earnings or increasing return on e.uity.Answer:!"#$eywords:6rowth !ate& (ommon %tock& !etained #arnings& !eturn on #.uityAA(%):!ef*ective thinking ski**s11) (ommon stock va*uation can be based on the ,resent va*ue of future dividends or a*ternative*y on the ,resent va*ue of the firm-s future .uarter*y net income. Answer:3AL%#$eywords:(ommon %tock& 0a*uation& 9ividends& Jet /ncomeAA(%):!ef*ective thinking ski**s1+) he change in the va*ue of a cor,oration-s common stock as the resu*t of growth is the same regard*ess of whether the growth is the resu*t of interna* growth or the infusion of new ca,ita*.Answer:3AL%#$eywords:9ividend 0a*uation >ode*& /nterna* 6rowth AA(%):!ef*ective thinking ski**s11) "nited 3inancia* (or, had a return on e.uity of 14F.he cor,oration-s earnings ,er share was G5.;;& its dividend ,ayout ratio was 2;F and its ,rofitode*AA(%):!ef*ective thinking ski**s+1) Jogrowth (or,oration e8,ects their dividend to stay at G;.4; ,er share each year into the foreseeab*e future. herefore&A) the stock wi** be va*ued at G;.4; times the number of years an investor ,*ans to kee, it.)) the va*ue of the stock can be estimated as G;.4; divided by an investor-s re.uired rate of return.() the va*ue of the stock can not be determined using the dividend va*uation mode* because the growth rate is ?ero.9) the va*ue of the stock is ,ositive on*y if the re.uired return is negativeAnswer:)$eywords:(onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s+2) A financia* ana*yst e8,ects $acie(o. to ,ay a dividend of G+ ,er share one year from today& adividend of G1 ,er share in years two& and estimates the va*ue of the stock at the end of year two to be G++. /f your re.uired return on $acie(o stock is 12 F& what is the most you wou*d be wi**ing to ,ay for the stock today if you ,*an to se** the stock in two years@A) G+;.==)) G+5.74() G+5.=;9) G+7.;;Answer:A$eywords:%tock 0a*uation& Present 0a*ueAA(%):Ana*ytic ski**s+4) $i*sheimer (om,any just ,aid a dividend of G4 ,er share. 3uture dividends are e8,ected to grow at a constant rate of 7F ,er year. Bhat is the va*ue of the stock if the re.uired return is 15F@A) G11.22)) G44.45() G4=.229) G54.87Answer:($eywords:(onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s17(o,yright : +;11 Pearson #ducation& /nc.+5) #mery (om,any just ,aid a dividend yesterday of G+.+4 ,er share. he com,any-s stock is current*y se**ing for G5; ,er share& and the re.uired rate of return on #mery (om,any stock is 15F. Bhat is the growth rate e8,ected for #mery (om,any dividends assuming constant growth@ A) =.27F)) =.8=F() 1;.87F9) 11.81FAnswer:9$eywords:(onstant 6rowth 9ividend 0a*uation >ode*& 6rowth !ateAA(%):Ana*ytic ski**s+7) HQ% (or,oration has ,referred stock which ,aid an annua* dividend in +;;= of G4 ,er share. HQ% a*so has common stock which ,aid a dividend in +;;= of G4. Bhich of the fo**owing statements is most correct concerning HQ% stock@A) he ,rice of the ,referred stock shou*d e.ua* the ,rice of the common stock since the dividends are the same.)) he ,rice of the common stock cou*d be higher than the ,rice of the ,referred stock if the common stock dividends are e8,ected to grow in the future.() he ,rice of the ,referred stock is e8,ected to be higher than the ,rice of the common stock because the re.uired return on ,referred stock is higher than the re.uired return on common stock.9) /f the re.uired return on the ,referred stock is the same as the re.uired return on the common stock& then the ,rice of ,referred stock shou*d e.ua* the ,rice of the common stock if markets areefficient.Answer:)$eywords:Preferred %tock 0a*uation& (ommon %tock 0a*uationAA(%):!ef*ective thinking ski**s+8) "sing the dividend va*uation method& an ana*yst determines the va*ue of (om,any A-s stock to be G1; and the va*ue of (om,any )-s stock to be G12. )ased on this information& which of the fo**owing statements is most accurate@A) (om,any ) must be riskier than (om,any A& and risk re.uires a reward. )) Other things being e.ua*& if (om,any A and (om,any ) have the same firm va*ue& (om,any ) must have more debt& thus *everaging its returns for the benefit of shareho*ders.() Other things being e.ua*& if (om,any A and (om,any ) have the same firm va*ue& (om,any A may have more shares of stock outstanding than (om,any ).9) (om,any )-s re.uired rate of return is higher than (om,any A-s re.uired return.Answer:($eywords:3ree (ash 3*ow 0a*uationAA(%):!ef*ective thinking ski**s18(o,yright : +;11 Pearson #ducation& /nc.+=) A** of the fo**owing affect the va*ue of a share of common stock e8ce,t:A) the do**ar amount of the dividends.)) investors- re.uired rate of return.() the future growth rate for dividends.9) the stock and ,aidode*AA(%):Ana*ytic ski**s12) Li*y (o.,aid a dividend of G4.+4 on its common stock yesterday. he com,any-s dividends are e8,ected to grow at a constant rate of 8.4F indefinite*y. he re.uired rate of return on this stock is 14.4F. Dou observe a market ,rice of G78.4; for the stock. %hou*d you ,urchase this stock@A) Jo& the market ,rice is above the intrinsic va*ue of the stock. )) Des& the market ,rice is be*ow the intrinsic va*ue of the stock. () Jo& the growth rate in dividends is too far be*ow the re.uired return.9) Des& but on*y if you can kee, the stock for at *east 4 years.Answer:)$eywords:(onstant 6rowth 9ividend 0a*uation >ode*AA(%):!ef*ective thinking ski**s14) Ba**ace /ndustries ,aid a dividend of G1.54 on its common stock yesterday. he dividends ofBa**ace /ndustries are e8,ected to grow at =F ,er year indefinite*y. /f the risk free rate is 1F andinvestors- risk ,remium on this stock is 8F& estimate the va*ue of Ba**ace /ndustries stock + years from now.A) G1;5.82)) G1;;.21() G=1.819) G42.71Answer:A$eywords:(onstant 6rowth 9ividend 0a*uation >ode*& !e.uired !eturn& !isk 3ree !ate& !isk PremiumAA(%):Ana*ytic ski**s15) 6reen*and Air*ines has net income of G+ mi**ion this year. he book va*ue of 6reen*and Air*ines common e.uity is G8 mi**ion do**ars. he com,any-s dividend ,ayout ratio is 5;F and ise8,ected to remain this way. Bhat is 6reen*and Air*ines- interna* growth rate@A) 5F)) =F() 1;F9) 14FAnswer:($eywords:%ustainab*e 6rowth !ateAA(%):Ana*ytic ski**s+;(o,yright : +;11 Pearson #ducation& /nc.17) )erberich (or,oration net income this year is G8;;&;;;. he com,any genera**y retains 14Fof net income for reinvestment. he com,any-s common e.uity current*y has a book va*ue of G4&;;;&;;;. hey just ,aid a dividend of G1.17& and the re.uired rate of return on this stock is 1+F. (om,ute the va*ue of this stock if dividends are e8,ected to continue growing indefinite*y at the com,any-s interna* growth rate.A) G++.51)) G11.2+() G14.519) G2.14Answer:A$eywords:/nterna* 6rowth !ate& (onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s18) (hambers (or,oration-s !O# is +;F. heir dividend ,ayout ratio is 7;F. he *ast dividend& just ,aid& was G+.;;. /f dividends are e8,ected to grow by the com,any-s interna* growth rate indefinite*y& what is the current va*ue of (hambers common stock if its re.uired return is 18F@A) G17.57)) G15.8=() G12.=+9) G11.4+Answer:A$eywords:/nterna* 6rowth !ate& (onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s1=) Hohnstown %u,,*y (or,oration stock is current*y se**ing for G48.;;. /t is e8,ected to ,ay a dividend of G4.;; at the end of the year. 9ividends are e8,ected to grow at a constant rate of 7.4F indefinite*y. (om,ute the re.uired rate of return on Hohnstown %u,,*y (or,oration stock.A) 1+.28F)) 14.54F() 11.52F9) 15.1+FAnswer:9$eywords:(onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s2;) >odem 9eve*o,ment& /nc. ,aid a dividend of G4.;; ,er share on its common stock yesterday. 9ividends are e8,ected to grow at a constant rate of 2F for the ne8t two years& at which ,oint the stock is e8,ected to se** for G45.;;. /f investors re.uire a rate of return on >odem-s common stock of 18F& what shou*d the stock se** for today@A) G4;.++)) G28.41() G22.759) G2;.++Answer:)$eywords:9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s+1(o,yright : +;11 Pearson #ducation& /nc.21) /f you e8,ect Jo9iv (or,oration to se** for G74 ,er share in three years whi*e ,aying no dividends a*ong the way& and if your re.uired rate of return is 15F ,er year& how much is the stock worth today@A) G2+.58)) G28.;4() G41.1;9) G72.52Answer:)$eywords:(ommon %tock 0a*uation& Present 0a*ueAA(%):Ana*ytic ski**s2+) (reamy (ustard common stock is current*y se**ing for G7=.;;. /t just ,aid a dividend of G2.5; and dividends are e8,ected to grow at a rate of 4F indefinite*y. Bhat is the re.uired rate of return on (reamy (ustard-s stock@A) 11.11F)) 11.75F() 1+.+F9) 12.+1FAnswer:A$eywords:!e.uired !eturn& (onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s21) >odem 9eve*o,ment& /nc. ,aid a dividend of G4.;; ,er share on its common stock yesterday. 9ividends are e8,ected to grow at a constant rate of 1;F for the ne8t two years& at which ,oint the dividends wi** begin to grow at a constant rate indefinite*y./f the stock is se**ingfor G4; today and the re.uired return is 14F& what it the e8,ected annua* dividend growth rate after year two@A) 1.154F)) 1.878F() 2.445F9) 4.;;;FAnswer:A$eywords:(onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s22) / %age& whose common stock is current*y se**ing for G1+ ,er share& is e8,ected to ,ay a G1.8;dividend& and se** for G12.2; one year from now. Bhat are the dividend yie*d& growth rate& and tota* rate of return& res,ective*y@A) 14F +;F14F)) 1;F 4F14F() 14F 1+F +7F9) +;F 14F14FAnswer:A$eywords:9ividend Die*d& 6rowth !ate& ota* !ate of !eturnAA(%):Ana*ytic ski**s++(o,yright : +;11 Pearson #ducation& /nc.24) %hara >ise**e (o. just ,aid a dividend of G1.54 A9;) on its common stock. his com,any-s dividends are e8,ected to grow at a constant rate of 1F indefinite*y. /f the re.uired rate of return on this stock is 11F& com,ute the current va*ue ,er share of %hara >ise**e stock.A) G+;.51)) G+1.+2() G14.;;9) G44.;;Answer:)$eywords:(onstant 6rowth 9ividend 0a*uation >ode*AA(%):Ana*ytic ski**s25) Dou observe 6o*den 3*ashes (ommon %tock se**ing for G2;.;; ,er share. he ne8t dividend is e8,ected to be G2.;;& and is e8,ected to grow at a 4F annua* rate forever. /f your re.uired rateof return is 1+F& shou*d you ,urchase the stock@A) Des& because the ,resent va*ue of the e8,ected future cash f*ows is greater than G2;.)) Jo& because the ,resent va*ue of the e8,ected future cash f*ows is *ess than G2;.() Des& because the ,resent va*ue of the e8,ected future cash f*ows is *ess than G2;.9) Jo& because the ,resent va*ue of the e8,ected future cash f*ows is greater than G2;.Answer:A$eywords:(ommon %tock 0a*uation& !e.uired !eturnAA(%):!ef*ective thinking ski**s27) JewAge& /nc. ,aid a dividend yesterday of G+ ,er share. JewAge management e8,ects the dividend to increase ne8t year to G1 annua**y. /f the dividend is e8,ected to stay at G1 ,er year for the foreseeab*e future& what is the va*ue of the stock to an investor with a re.uired rate of return of 1;F@A) G7.4;)) G1;.;;() G1+.;;9) G4;.;;Answer:)$eywords:9ividend 0a*uation >ode*& Eero 6rowthAA(%):Ana*ytic ski**s28) '. H. (or,.-s common stock ,aid G+.4; in dividends *ast year A9;). 9ividends are e8,ected togrow at a 1+