chapter 7

Question 1

what are the 2 expected cash flows from someone who owns a stock?

Answer 1

the dividends the firm pays out
the price of the sold share in the future

Question 2

according to the law of one price, what does the current price of a stock reflect?

Answer 2

the expected future dividend and stock price

Question 3

what is the “equity cost of capital”?

Answer 3

the expected return of other investments with equivalent risk

Question 4

since it it difficult to estimate future dividends of a stock, what do we do to make it more simple?

Answer 4

we simplify the problem by assuming that dividends will grow at a constant rate ‘g’ forever

Question 5

what are the 2 things a firm can do to maximize their share price?

Answer 5

the firm can increase the level of its dividend payments

they can increase their growth rate

Question 6

what is the trade off that firms have when trying to maximize their share price?

Answer 6

investing in higher growth may mean using cash that could be used to pay dividends and this could negatively impact future growth

Question 7

what is the dividend payout rate?

Answer 7

the fraction of earnings that the firm pays as dividends each year

Question 8

what are the 3 ways a firm can increase its dividends?

Answer 8

increasing their earnings

increasing their dividend payout rate

reducing the number of shares outstanding (increasing EPS)

Question 9

how can companies reduce the number of shares outstanding?

Answer 9

the firm can buy back existing shares from investors

Question 10

what are the 2 ways a firm can use their earnings?

Answer 10

to pay dividends

retain and reinvest them

Question 11

what is the retention rate?

Answer 11

the fraction of current earnings that the firm retains

Question 12

what does the decision whether to retain more earnings and reduce the current dividend depend on?

Answer 12

depends on the profitability of the firms investment

Question 13

when will cutting the firms dividend to increase investment raise the stock price?

Answer 13

it will only raise the stock price if the new investments have a positive NPV

Question 14

what is share repurchase?

Answer 14

when a firm uses excess cash to buy back its own stock

Question 15

why would the dividend discount model be adjusted?

Answer 15

because that model assumes that firms distribute all cash to shareholders through dividend payments

Question 16

what is the total payout model?

Answer 16

a model that values all of the firms equity rather than just a single share and discounts the total dividends paid and shares repurchased

Question 17

what is the method of comparables?

Answer 17

a way that estimates the value of the firm based on the values of similar firms or investments

Question 18

what is a valuation multiple?

Answer 18

a ratio of the value to a measure of the firms size

Question 19

what are the 2 most common valuation multiples?

Answer 19

P/E ratio
EV/ EBIT or EV/EBITDA

Question 20

what are the estimates of stock prices made up of?

Answer 20

all of the different information of investors and the trading of a stock adds to the aggregate information of many investors

Question 21

if your estimate is very different than the market price, what might you want to do?

Answer 21

you might want to reconsider how you arrived at your estimate

Question 22

what is the efficient market hypothesis?

Answer 22

a theory that implies that all stock are fairly priced given all information that is currently available to investors

Question 23

how does the efficient market hypothesis impact all positive-NPV opportunities?

Answer 23

it eliminates them

Question 24

under the efficient market hypothesis, how does new information impact the price of a stock?

Answer 24

it will immediately change the price of the stock to reflect the new information through the buying and selling actions ion investors

Question 25

is the efficient market hypothesis always correct?

Answer 25

no it is just an approximation that would hold in an ideal situation and not a perfect description of how stock markets work