Chapter 9

Question 1

Facts About Common Stock

Answer 1

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Management’s goal: Maximize the stock price

Question 2

Intrinsic Value and Stock Price

Answer 2

• In equilibrium we assume that a stock’s price equals its intrinsic value
• Outsiders estimate intrinsic value to help determine which stocks are attractive to buy and/or sell
• Stocks with a price below (above) its intrinsic value are undervalued (overvalued)

Question 3

Discounted Dividend Model

Answer 3

• Value of stock is PV of future dividends expected to be generated by the stock
• p0=D1/(1+r)^s

Question 4

Constant Growth Rate

Answer 4

• Expected to grow at a constant rate forever
• D1=D0(1+g)^1
• D2=D1(1+g)^2
• Dt=D0(1+g)^t

Question 5

D0

Answer 5

Dividend today

Question 6

If g > rs…

Answer 6

The constant growth formula leads to a negative stock price, which does not make sense

Question 7

(rm-rrf)

Answer 7

Market risk premium

Question 8

Beta

Answer 8

Risk of investment

Question 9

Beta=1.0

Answer 9

Stock moves with the market

Question 10

Beta>1.0

Answer 10

More volatile

Question 11

Beta<1.0

Answer 11

Less volatile

Question 12

Dividend Yield

Answer 12

D1/P0

Question 13

Capital Gains Yield

Answer 13

(P1-P0)/P0

Question 14

Total Return (Rs)

Answer 14

Dividend Yield+Capital Gains Yield

Question 15

If g=0, the dividend stream is a…

Answer 15

• Perpetuity

- PMT/r

Question 16

Horizon Date

Answer 16

The date when the growth rate becomes constant; no longer necessary to forecast individual dividends

Question 17

Corporate Valuation Model

Answer 17

Value of entire firm equals present value of firm’s free cash flow

Question 18

Issues Regarding Corporate Valuation Model

Answer 18

• Often preferred to the discounted dividend model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast
• Similar to discounted dividend model, assumes at some point free cash flow will grow at a constant rate
• Horizon value (HVN) represents value of firm’s operations at the point that growth becomes constant

Question 19

Preferred Stock

Answer 19

• Hybrid security
• Preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders
• Companies can omit preferred dividend payments without fear of pushing the firm into payments without fear of pushing the firm into bankruptcy