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FINANCE - Chapter 8 Reading Assignment

Terms in this set (43)

Which of these descriptions apply to common stock? Select all that apply.
- a security that provides voting privileges
- A financial security which provides guaranteed dividend payments
- An equity security that offers ownership benefits in a corporation
- A security that provides the potential for its owner to receive both dividends and capital gains
a security that provides voting privileges
an equity security that offers ownership benefits in a corporation
a security that provides the potential for its owner to receive both dividends and capital gains
reason:
common stockholders elect the board of directors and vote on key issues concerning the corporation
common stockholders are the residual owners of a corporation
common stockholders have the potential to receive dividends and capital gains

- common stock dividends are not guaranteed. Stockholders have the potential for earning dividends and capital gains.
Which of these is the key service provided by stock exchanges that attracts investors?
- liquidity
- trading volume reports
- research information
- ticker symbols
Liquidity

- while some investors monitor the trading volume, it is liquidity that attracts investors to the stock market
- Full-service brokers provide research information
- Ticker symbols aid in the trading process
A stock quote displays the last price as 28.13, down 0.10. What was the previous day's closing price?
$28.23
Reason:
Prior day's close = $28.13 + $0.10 = $28.23
A ______________ symbol is the unique code for a company on a stock exchange. It consists of one to five letters.
Ticker
Which of these characteristics apply to the New York Stock Exchange (NYSE)? Select all that apply.
- physical trading floor
- brokers
- specialists
- no actual trading floor
physical trading floor
brokers
specialists
Reason:
the NYSE has a physical trading floor
Brokers are floor traders who act as agents and execute trades by matching buy and sell orders
Specialists operate at trading posts located on a trading floor and manage the trading process for their assigned stocks

- NASDAQ is an electronic exchange that has no trading floor. The NYSE does have a physical trading floor.
Which of these apply to publicly-issued common stock? Select all that apply.
- value determined on the stock exchanges
- valueless security unless dividends are currently being paid
- stock value depends on the issuer's business success
- ownership position
Value determined on the stock exchanges
Stock Value depends on the issuer's business success
Ownership Position
Reason:
The value of publicly-issued stock is determined on the stock exchanges
The value of a stock is based on the business success of the issuer
Common stock represents a residual ownership position

- Stocks receive value from capital appreciation as well as from dividends
If you purchase shares of stock on NASDAQ, who is the most likely seller of those shares?
- specialist
- broker
- individual investor
- dealer
Dealer

- specialists operate on a trading floor, which NASDAQ does not have
- a buy order is filled on NASDAQ by the dealer who offers the best price
How important is the liquidity provided by stock exchanges to the equity markets?
Very important
Reason: the liquidity provided by the stock exchanges is crucial to the equity markets as this liquidity provides confidence to investors.
True or false: The value of a firm as measured by its market capitalization is solely dependent upon the market value of the firm's stock.
False
Reason:
Market capitalization depends on both the market price per share and the number of shares outstanding
A stock quote shows a P/E of 18. How is the ratio defined?
P/E ratio as shown in a stock quote = Current stock price / Last four quarters of earnings
Which one of the following characteristics most applies to a discount brokerage firm?
Investors place trades on the firm's internet site
- full-services brokerage firms charge high commissions, offer advice, and conduct research; discount brokerage firms charge low commission
__________________ located around the perimeter of the floor of the stock exchange, act as agents for those buying and selling stocks
brokers
Which of these is correct?
- dealers are willing to purchase stocks at the ask price
- dealers are willing to sell stocks at the ask price
- investors earn the spread
- investors buy stocks at the bid price
Dealers are willing to sell stocks at the ask price

- dealers buy at the bid and sell at the ask
- dealers earn the spread between the bid and ask prices
- investors buy at the ask and sell at the bid
Which one of these is a factor that has minimum requirements which a firm must meet to be listed on the NYSE?
- number of employees
- number of stockholders
- number of corporate directors
- dividends per share
Number of stockholders
Reason:
to be listed on the NYSE, a firm must meet the minimum requirement for the total number of stockholders.
Mary placed an order to purchase 100 shares of ABC stock at the going price. The order was filled as soon as it reached the floor of the exchange. What type of order did Mary place?
Market Buy Order
Reason:
She placed a market buy order as she was willing to pay the going price.
What term best describes the trading process used by NASDAQ?
Multiple Market Maker System
Reason:
NASDAQ uses a multiple market maker, or multiple dealer, system of electronic trading

- Brokers are used to execute trades on physical trading floors.
- Specialists are used to manage the trading of stocks on a physical trading floor.
- Trading on NASDAQ is all completed electronically. Face-to-face trading occurs on physical trading floors.
What is the definition of market capitalization?
Current stock price times number of shares outstanding
Just before the market closes, ABC stock is selling for $43 a share, so you place a market sell order for 300 shares. The order reaches the trading floor after the market closes for the day. The next morning, ABC stock opens at a price of $28 a share. What happens to your order?
The order is executed at a price of $28 a share

- this illustrates the disadvantage of a market order
Which of these services should you expect to receive from a full-service brokerage firm? Select all that apply.
- guaranteed rates of returns on equity securities
- in-depth research on individual stocks
- low transaction costs
- investment advice
In-depth research on individual stocks
Investment Advice
Reason:
In exchange for their high commissions, full-service brokerage firms conduct research and offer investment advice

- Full-service brokerage firms charge high commissions in exchange for their services
- Equity securities do not provide guaranteed rates of return
True or False: A dealer will buy stock from an investor at the ask price
False
Reason:
Dealers buy at the bid and sell at the ask.
Investors buy at the ask and sell at the bid.
Investors buy at the ______ and sell at the __________
Investors buy at the ask and sell at the bid
Which statements are correct? Select all that apply.
- A limit sell order will only execute at the limit price or higher.
- A limit buy order will execute as soon as the market price reaches or exceeds the limit price.
- A market order will execute immediately, regardless of the price.
- A limit sell order may never be executed.
A limit sell order will only execute at the limit price or higher
A market order will execute immediately, regardless of the price
A limit sell order may never be executed

Reason:
Market orders will execute immediately at the going market price
If the market price never reaches the limit price, the limit order will not be executed

- Limit buy orders will only execute at the limit price or lower
Which one of these defines the current value of a stock?
- Discounted value of a future stock price
- Summation of future dividends and the future stock price
- Compounded value of both the future dividends and the future stock price
- Discounted value of both the future dividends and the future stock price
Discounted value of both the future dividends and the future stock price

Reason:
The current value of a stock equals the present value, or discounted value, of both the future dividends and the future stock price
What is the disadvantage of a market order?
- the execution price is unknown in advance
- the order executes immediately
- the order may not execute
- the execution will occur only if the specified price is obtained
The execution price is unknown in advance

- Executing immediately is an advantage of a market order.
- Market orders execute immediately at the best price available
Which one of these best defines the dividend discount model?
- A method of valuing a stock based on a fixed dividend amount
- A stock valuation method based on the present value of all future dividends
- A method of valuing a stock by limiting the number of future dividends that are to be discounted
- A stock valuation method based on the present value of future dividends and an expected future stock price
A stock valuation method based on the present value of all future dividends

- the dividend discount model can handle both constant and varying dividends
- the DDM values a stock as the present value of all future dividends, even when the number of dividend payments is infinite
Which one of the following characteristics most applies to a discount brokerage firm?
- In-depth stock research
- investors place trades on the firm's internet site
- buy and sell advice offered to clients
- high commissions
Investors place trades on the firm's internet site

- all the other characteristics apply to full-service brokerage firms
A stock just paid its annual dividend of $1.20. Future dividends are expected to increase by 2 percent annually and the discount rate is 9 percent. Which of these is the correct formula for computing the current stock price?
P0 = ($1.20 × 1.02)/(0.09 - 0.02)
Which of these are correct?
- Investors earn the spread.
- Dealers are willing to sell stocks at the ask price.
- Dealers are willing to purchase stocks at the ask price.
- Investors buy stocks at the bid price.
Dealers are willing to sell stocks at the ask price

Reason:
Dealers earn the spread between the bid and ask prices
Dealers buy at the BID and sell at the ASK
Investors buy at the ASK and sell at the BID
A preferred stock has which of these characteristics?
- residual ownership claim
- owned primarily by individual investors
- guaranteed voting rights
- zero dividend growth
Zero dividend growth

Reasoning:
- Common stock is a residual ownership claim. Preferred stock has preference over common stock
- Preferred stock is largely owned by other companies due to the corporate tax break on dividend income
- Preferred stock generally does not carry any voting rights unless the dividends are not being paid
How is the discount rate used to value a stock related to the expected return on the stock? Assume the stock price fairly reflects the stock's value.
- The discount rate should exceed the expected rate of return.
- The discount rate should equal the expected rate of return.
- The discount rate should be less than the expected rate of return.
- The discount should be equal to or less than the expected rate of return.
The discount rate should equal the expected rate of return

Reasoning:
- If the stock price represents fair value, then the discount rate should equal the expected rate of return
Which one of these applies to stock valuation?
- The value of a stock today is determined by the stock's historical values.
- The value of a stock today is based on guaranteed future cash flows.
- The value of a stock today equals the discounted value of the future expected cash flows.
- The value of a stock can be computed with certainty.
The value of a stock today equals the discounted value of the future expected cash flows

Reasoning:
- The value of a stock cannot be computed with certainty since the stock's future dividends and price are uncertain.
- The current value of a stock is based on the discounted value of the stock's expected future dividends and an expected future price
What is the best definition of the variable-growth rate stock valuation method?
- Stock valuation method used when a firm has variable earnings but a constant dividend rate of growth
- Stock valuation method used when a firm is expected to go out of business
- Stock valuation method used when a firm's current growth rate is expected to change in the future
- Stock valuation method used when a firm is expected to pay totally irregular dividends into infinity
Stock valuation method used when a firm's current growth rate is expected to change in the future

Reasoning:
- the variable growth rate formula assumes dividends increase at one rate for a period of time and then increase at a second rate into infinity
- the variable growth rate formula assumes dividends are paid indefinitely but increase at two different rates
What is the key premise upon which the dividend discount model is based?
All future cash flows from a stock are dividend payments.

Reasoning:
- Dividend payments can be for a set number of years or can be theoretically infinite. Either way, dividends represent the only source of future cash flows in the DDM
- Dividends can either be constant or can vary
- Dividend payments can be infinite and represent the only source of future cash flows in the DDM
True or False: A P/E is a measure of relative value
True
Reasoning:
P/E ratios are used to compare one firm's stock value to another firm's stock value
A firm just paid an annual dividend of $1.40 and increases that dividend by 2 percent each year. How do you find the price of the firm's stock at year 4 if the discount rate is 13 percent?
P4 = ($1.40 × 1.025)/(0.13 - 0.02)

Reasoning:
To find the price at time 4, use the dividend at time 5. The $1.40 was just paid so it is D0.
Which one of these generally applies to preferred stock?
- Higher dividend yields than common stock issued by the same issuer
- Constant stock price
- Principal repaid at maturity
- Stock prices that are directly related to market interest rates
Higher dividend yields than common stock issued by the same issuer

Reasoning:
- The value of preferred stock will change in response to changes in the discount rate. Preferred stock generally has a higher dividend yield than a common stock as its estimated rate of return is based solely on its dividend yield
- Preferred stock is an equity security that does not have to be repaid like a debt security.
- Preferred stock prices and interest rates are inversely related.
How is the discount rate used to evaluate a security related to the security's level of risk?
The higher the level of risk, the higher the discount rate needs to be.
What is the primary purpose of the P/E valuation formula?
- estimate a firm's future earnings
- estimate future dividends
- estimate the future price of a stock
- determine the appropriate P/E for a firm
Estimate the future price of a stock
Which of these are basic assumptions of a variable growth rate valuation? Select all that apply.
- g1 can be negative, positive, or equal to zero
- g2 < i
- g1 must be a sustainable rate of growth
- g1 applies to a designated number of years
g1 can be negative, positive, or equal to zero
g2 < i
g1 applies to a designated number of years

Reasoning:
- If you review the formula, you can see that a positive, negative, or zero stage one growth rate will work. However, g2 must be < i.
- The first growth rate does not have to be sustainable in the long-term but the second growth rate must be sustainable.
- The first growth rate must apply to a limited number of years while the second growth rate applies into infinity.
Which of these is a correct interpretation of a P/E ratio?
- The stock with the lowest P/E has the highest rate of growth.
- The stock with the lowest P/E has the lowest current price per dollar of earnings.
- The stock with the highest P/E has the lowest current price per dollar of earnings.
- The stock with the highest P/E has the highest stock price.
The stock with the lowest P/E has the lowest current price per dollar of earnings
What does it mean when a P/E is designated as a trailing P/E?
- The earnings used in the P/E calculation were for a period greater than 12 months.
- The price used in the P/E calculation was last year's price.
- Both the price and the earnings used in the P/E calculation were last year's values.
- The earnings used in the P/E calculation were for the past four quarters.
The earnings used in the P/E calculation were for the past four quarters

Reasoning:
Trailing P/E = Current stock price/Per-share earnings for the last 12 months
If you want to estimate a future price, Pn, using the P/E valuation formula, you should use the estimated earnings for which year?
Year n

Reasoning:
The P/E ratio and the earnings should be for the same year as the price.
Pn = (P/E)n × En.
Which one of these statements is correct?
- The trailing P/E includes investor's expectations of future profits.
- Investors generally use the trailing P/E.
- A forward P/E is less accurate than a trailing P/E.
- Media outlets generally report the forward P/E.
A forward P/E is less accurate than a trailing P/E

Reasoning:
- The forward P/E includes investor expectations while the trailing P/E is based on historical performance. The forward P/E is less accurate than the trailing P/E.
- Investors tend to use the forward P/E even though it is less accurate than the trailing P/E.
- Forward earnings estimates are less accurate than actual past earnings, thus a forward P/E is less accurate than a trailing P/E.
- The media uses the trailing P/E, which is more accurate than the forward P/E.
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