FIN 3310: Chapter 7

Considering the economic value added (EVA) of a firm, which of the following should increase the firm's value?

Considering the economic value added (EVA) of a firm, which of the following should increase the firm's value?

EVA > 0

• When EVA is greater than zero, the firm's value should increase because its operating earnings exceed the amount that must be paid to investors who have provided the funds that the firm uses to finance its assets. See 7-3: Other Stock Valuation Methods

Which of the following represents the minimum legal financial obligation of a common stockholder if a firm is liquidated and additional funds are needed to repay its debt?

The par value of the common stock

• Legally, the par value of a common stock represents a stockholder's minimum financial obligation in the event the corporation is liquidated and its debts are repaid. See 7-1: Types of Equity

If a firm wants to be able to redeem some of its preferred stock at some date after issue, it must _____.

incorporate a call provision in the preferred stock issue

• A call provision gives the issuing corporation the right to call in the preferred stock for redemption. See 7-1: Types of Equity

Which of the following provisions/features allows the firm to repurchase and retire a given percentage of its preferred stock each year?

Sinking fund

• Most newly issued preferred stocks have sinking funds that call for the repurchase and retirement of a given percentage of the preferred stock each year. By including a call provision with a sinking fund, a firm essentially adds a maturity option to a preferred stock issue. See 7-1: Types of Equity

If the expected rate of return on a stock exceeds the required rate, it means that the _____.

Stock is a good buy

• An investor should buy a stock only if the expected rate of return is equal to or greater than the required rate of return; that is, a stock is considered a good investment. See 7-2: Stock Valuation—The Dividend Discount Model (DDM)

Certificates that represent ownership in stocks of foreign companies and are held in trusts at banks located in the countries where the stocks are traded are called _____.

American depository receipts

• American depository receipts (ADRs) are certificates that represent ownership in stocks of foreign companies and are held in trust by banks located in the countries where the stocks are traded. See 7-1: Types of Equity

A shareholder can transfer the right to vote to another person by means of an instrument known as _____.

proxy

• Stockholders of large corporations can appear at the annual meeting and vote in person, but in most cases they transfer their right to vote to a second party by means of an instrument known as a proxy. See 7-1: Types of Equity

A share of a preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00 for this preferred stock, what is the simple (not effective) annual rate of return?

10%

• The annual rate of return of the preferred stock = ($0.50 × 4) / $20 = 10% See 7-2: Stock Valuation—The Dividend Discount Model (DDM)

On January 1 of the current year, the price of a stock is $42.50, whereas on December 31 of the current year, the price of the stock is $48.78. Determine the capital gain yield of the stock.

14.78%

• Capital gains yield = Capital gain/Beginning price = ($48.78 − $42.50)/$42.50 = $6.28/$42.50 = 14.78% See 7-2: Stock Valuation—The Dividend Discount Model (DDM)

Which of the following securities is eligible for a cumulative dividend?

Preferred stock

• A protective feature on a preferred stock that requires preferred dividends that were not paid in the previous years to be disbursed before any common stock dividends can be paid is known as a cumulative dividend. See 7-1: Types of Equity

Stocks that produce returns that are based primarily on dividends are traditionally called _____.

income stocks

• Stocks that produce returns that are based primarily on dividends are traditionally called income stocks because dividend payments represent income to investors. See 7-1: Types of Equity

A firm’s _____ is determined by subtracting the costs associated with both the debt and the equity that the firm uses from its after-tax operating income?

economic value added (EVA)

• The change in a firm's economic value, or its economic value added (EVA), is determined by decreasing its after-tax operating income by the costs associated with both the debt and the equity issued by the firm. See 7-3: Other Stock Valuation Methods

Which of the following types of securities is referred to as a hybrid security?

Preferred stock

• Preferred stock is often referred to as a hybrid security because it is similar to bonds (debt) in some respects, but similar to common stock in other respects. See 7-1: Types of Equity

Which of the following is true of American depository receipts?

American depository receipts provide U.S. investors with the ability to invest in foreign companies with less complexity and difficulty than might otherwise be possible.

• American depository receipts provide U.S. investors with the ability to invest in foreign companies with less complexity and difficulty than might otherwise be possible. See 7-1: Types of Equity

Nahanni Treasures Corporation is planning a new common stock issue of five million shares to fund a new project. The increase in shares will bring the number of shares outstanding to 25 million. Nahanni's long-term growth rate is 6 percent, and its current required rate of return is 12.6 percent. The firm just paid a $1.00 dividend, and the stock sells for $16.06 in the market. On the announcement of the new equity issue, the firm's stock price dropped. Nahanni estimates that the company's growth rate will increase to 6.5 percent with the new project, but as the project is riskier than average, the firm's required return on stock will increase to 13.5 percent. Using the constant growth dividend discount model, what is the change in the equilibrium stock price?

–$0.85

• Value of the constant growth stock before the new equity issue = [D₀ (1 + g)] ÷ (r_s – g) = [$1 × (1 + 0.06)] ÷ (0.126 – 0.06) = $16.06

  Value of the constant growth stock after the new equity issue = [D₀ (1 + g)] ÷ (r_s – g) = [$1 × (1 + 0.065)] ÷ (0.135 – 0.065) = $15.21

  Change in price = $15.21 – $16.06 = –$0.85

  See 7-2: Stock Valuation—The Dividend Discount Model (DDM)

The amount in excess of par value that a company must pay when it repurchases a security is known as the _____.

call premium

• A call provision gives the issuing corporation the right to call in the preferred stock for redemption. The amount in excess of par value that a company must pay when it calls a security is known as a call premium. See 7-1: Types of Equity

Which of the following is a feature of a preferred stock?

Preferred stockholders have a higher priority claim to distributions made by the firm than common stockholders.

• Preferred stockholders have a higher priority claim to distributions made by the firm than common stockholders. However, if the firm is highly successful, the common stockholders do not share that success with preferred stockholders because their dividend payment is fixed. See 7-1: Types of Equity

Which of the following is true about the change in a stock price?

If investors demand higher returns to invest in stocks, then stock prices should fall.

• Stock prices move opposite to the changes in rates of return, but they move in the same direction as changes in cash flows expected from the stock in the future. See 7-4: Changes in Stock Prices

The price-earnings (P/E) ratio gives an indication of _____.

the payback period of a stock

• The P/E ratio is the current market price of a stock divided by the earnings per share. It gives an indication of how long it would take to payback the per share stock price from current earnings per share. See 7-3: Other Stock Valuation Methods

A share of a preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is currently $50, what is the simple annual rate of return?

20%

• The annual rate of return of the preferred stock = ($2.50 × 4) / $50 = 20% See 7-2: Stock Valuation—The Dividend Discount Model (DDM)

Excluding stocks traded in the United States, a stock that is traded in a country other than the issuing company's home country is called a ________.

Euro stock

• With the exception of stocks traded in the United States, any stock that is traded in a country other than the issuing company's home country is called a Euro stock. See 7-1: Types of Equity

Common stockholders have the right to _____.

vote for the changes in a firm's charter

• The common stockholders have the right to elect the firm's directors, who in turn appoint the officers who manage the business. Stockholders also vote on shareholders' proposals, mergers, and changes in the firm's charter. See 7-1: Types of Equity

What is another name for the par value of a preferred stock?

Liquidation value

• Usually, a preferred stock has a par value or its equivalent under some other name, such as liquidation value or liquidation preference. See 7-1: Types of Equity

A firm expects to pay dividends at the end of each of the next four years of $2.00, $1.50, $2.50, and $3.50. If growth is then expected to level off at 8 percent, and if you require a 14 percent rate of return, how much should you be willing to pay for this stock? (Round intermediate calculations to two decimal places.)

$43.96

• An investor will be willing to pay an amount calculated by taking the present value of all the dividends until the end of year 4 and the present value of the market price of the stock at the end of year 4. Present value of the market price of the stock at the end of year 4 = $3.50 × (1 + 0.08) / (0.14 − 0.08) = $63.00

  Price an investor will be willing to pay for the stock = $2.00/(1 + 0.14)¹ + $1.50/(1 + 0.14)² + $2.50/(1 + 0.14)³ + $3.50/(1 + 0.14)⁴ + $63.00/(1 + 0.14)⁴ = $1.75 + $1.15 + $1.69 + $2.07 + $37.30 = $43.96; Therefore, an investor will be willing to pay $43.96 for this stock See 7-2: Stock Valuation—The Dividend Discount Model (DDM)

How can a firm effectively incorporate a maturity provision within a preferred stock issue?

By including a call provision

• A call provision gives the issuing corporation the right to call in the preferred stock for redemption, which essentially incorporates a maturity in the preferred stock issue. See 7-1: Types of Equity