Module 5 Conceptuals

Which of the following statements is not (or least) correct?

• The constant growth model can be used to evaluate zero growth stocks, such as preferred stock.

• An alternative method of finding the price per share is to use free cash flows and the firm’s cost of capital to determine an “enterprise” or firm value. Subtracting the value of the debt and other liabilities will leave us with the value of the firm’s equity. If we then divide this value by the number of shares outstanding, this should give us the appropriate price per share.

• The investors’ expected rate of return on common stock is equal to an expected dividend yield plus an expected capital gains yield. The expected capital gains yield is also the expected growth rate of the stock’s price and, if the stock is a constant growth stock, it is also the expected growth rate of the firm’s dividend.

• If markets were shown to be semi-strong-form efficient, then this would indicate that there is no value to either technical or fundamental analysis of stocks.

• In order to use the constant growth model to evaluate the price of a share of common stock, we must assume that the investor’s required rate of return will be less than the long-run constant growth rate.

Select the statement that is most correct.

• Long-run sustainable growth is a function of the firm’s retention rate and its return on equity. The firm’s retention rate, when added to its dividend payout rate, must always sum to zero.

• The stockholders have the first claim on the firm’s earnings and on specific assets in the event of the firm’s default on their commitments. Therefore, these securities provide the least risk to investors

• Most academic research clearly shows that markets are weak, semi-strong, and strong form efficient.

• Investors like dividends that grow over time. If a firm can take actions that will increase the growth rate of dividends, then the price of the stock will automatically increase.

• Markets are in equilibrium when supply is equal to demand. This is also where investors’ required rates of return are equal to expected rates of return.

Select the statement that is most correct.

• Markets are said to be weak, semi-strong, and strong-form efficient if no one, except insiders, is able to earn abnormal returns (that is, beat the market) on a consistent basis.

• If two, constant growth stocks have the same required rate of return, but where the price of Stock A is greater than the price of Stock B, then Stock A must have a lower dividend yield.

• To find the current price of a supernormal growth stock, we must value both the dividends during the supernormal period as well as the price at the end of the supernormal period (equivalent to the value of the remaining dividend stream out to infinity), where both have been discounted to the present.

• Not only is the market value of a company equal to the expected future free cash flows discounted at the pre-tax cost of debt, but the value of the firm will increase as long as the firm’s basic earnings power (BEP) is greater than the cost of the firm’s debt.

• If stock prices are in equilibrium, then investing in the stock is the same as investing in a positive NPV project. That is, the expected return on the stock will be greater than the required rate of return on the stock.

If two constant growth stocks have the same required rate of return and the same price, which of the following statements is most correct?

• The two stocks must have the same per-share dividend.

• The stock with the higher dividend yield will have a higher dividend growth rate.

• The two stocks must have the same dividend growth rate.

• The stock with the higher dividend yield will have a lower dividend growth rate.

• The two stocks must have the same dividend yield.

Select the statement that is most correct.

• Risk aversion implies that some securities will go unpurchased in the market even if a large risk premium is paid to investors.

• The constant growth model used for evaluating the price of a share of common stock may also be used to find the price of perpetual preferred stock or any other perpetuity.

• Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification, we know that Portfolio B will have the lower market risk; that is, Portfolio B will have the lower beta.

• According to the basic stock valuation model, the value an investor assigns to a share of stock is dependent upon the length of time the investor plans to hold the stock.

• Even if the correlation between the returns on two different securities is perfectly positively correlated, if the securities are combined in the correct unequal proportions, the resulting portfolio can have less risk than either security held alone.

Stocks A and B have the same required rate of return and the same expected yearend dividend (D1). Stock A’s dividend is expected to grow at a constant rate of 10 percent per year, while Stock B’s dividend is expected to grow at a constant rate of 5 percent per year. Which of the following statements is most correct?

• The two stocks should sell at the same price.

• Stock A has a higher dividend yield than Stock B.

• Currently Stock B has a higher price, but over time Stock A will eventually have a higher price.

• Statements B and C are correct.

• None of the statements above is correct.

Select the statement that is most correct.

• Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events.

• Portfolio diversification reduces the variability of returns on an individual stock.

• When company-specific risk has been diversified the inherent risk that remains is market risk, which is constant for all securities in the market.

• A stock with a beta of -1.0 has zero market risk.

• The SML relates required returns to the firms’ market risk. The slope and intercept of this line cannot be controlled by the financial manager.

Which of the following statements is incorrect (least correct)?

• Theoretically, the price of a share of stock will decline by the present value of the dividend given up when the stock goes ex dividend.

• If a share of stock is growing at a constant rate, then the growth rate of dividends should be equal to the growth rate of price (capital appreciation). In addition, if the stock price is in a state of equilibrium, then this growth rate should also be equal to the investors’ required rate of return minus the expected dividend yield.

• The price sensitivity of a share of common stock increases with the time remaining until it matures

• The preemptive right is important because it protects existing shareholders against dilution of their ownership interests.

• To evaluate theoretical changes in dividend policy we assume that capital budgeting (investing) and capital structure (financing) decisions have already been made. Thus, increasing a dividend is accomplished by issuing new equity and decreasing a dividend is accomplished by repurchasing existing equity.