Chapter 9 Stock Markets

True/False Questions

1. A type of absentee ballot that allows a representative to vote on behalf of the

stockholder is called a proxy.

Answer: True Page: 250 Level: Easy

2. An order to buy shares of stock at a specified price or better is called a limit order.

Answer: True Page: 261 Level: Easy

3. The NYSE defines the simultaneous buying and selling of 15 or more different stocks
with a total value of at least $1 million dollars to be block trading and such trades are
subject to trading curbs.

Answer: False Page: 262 Level: Easy

4. A long term investor in a high marginal tax bracket will normally prefer a dollar of
capital gain to a dollar of dividend yield.

Answer: True Page: 247 Level: Easy

5. In the event of bankruptcy a firm's janitor must be paid all the salary owed him before
stockholders receive anything.

Answer: True Page: 247 Level: Easy

6. At year end a firm has assets of $100 and debts due of $120. In this situation the
stockholders must pay an additional $20 out of their own pocket.

Answer: False Page: 247 Level: Medium

7. In cumulative voting, a stockholder who owns 51% of the shares can be assured of the
ability to elect the entire board of directors.

Answer: False Page: 249 Level: Medium

8. During the quiet period, the firm may not release any information about the firm to the
public.

Answer: False Page: 256 Level: Medium

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 9. Preferred stockholders have a claim senior to common stock but junior to bondholders.

Answer: True Page: 251 Level: Easy

10. A market order is normally executed in 15 minutes or less but the buyer has three days
to actually pay for the stock.

Answer: True Page: 261 Level: Medium

11. The market in which firms sell new securities to raise cash is called the secondary
market.

Answer: False Page: 252-253, 257-258 Level: Medium

12. Preferred stock where the firm cannot pay a preferred dividend unless a common stock
divided is also paid is termed cumulative preferred stock.

Answer: False Page: 251 Level: Easy

13. Dual class stock refers to firms with both common and preferred stock outstanding.

Answer: False Page: 248 Level: Medium

14. If the stock markets are weak form efficient, stock prices reflect all historic public
information about a firm.

Answer: True Page: 275 Level: Medium

15. IPOs are sometimes sold via a rights offering.

Answer: False Page: 255 Level: Medium

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Multiple Choice Questions

16. You buy a stock for $14 per share and sell it for $18 after you collect a $1.00 per share
dividend. Your pre-tax capital gain yield is _____ and your pre-tax dividend yield is
_____.
A) 28.57%; 7.14%
B) 35.71%; 0.00%
C) 21.42%; 5.55%
D) 22.22%; 5.55%
E) 27.78%; 6.32%

Answer: A Page: 246-247 Level: Medium

17. Common stocks typically have which of the following that bonds do not have:
I. Voting rights
II. Fixed cash flows
III. Set maturity date
IV. Tax deductibility of cash flows to investors

A) I only
B) I, II and IV only
C) II, III and IV only
D) IV only
E) I, II, III and IV

Answer: A Page: 247 Level: Easy

18. You buy a stock for $10 per share and sell it for $12 after holding it for slightly over a
year and collecting a $0.50 per share dividend. Your ordinary income tax rate is 28%
and your capital gains tax rate is 20%. Your after-tax rate of return is _______.
A) 18.1%
B) 19.6%
C) 25.0%
D) 20.2%
E) 17.4%

Answer: B Page: 247 Level: Medium

Rationale: [(($12-$10)x(1-0.20)) + ($0.50x(1-0.28))] / $10 = $1.96 / $10 = 19.6%

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19. An investor has a 38% ordinary income tax rate and a 20% long term capital gains tax
rate. The investor holds stock in a firm that could pay its usual $1 per share dividend
or reinvest the cash in the firm. The stock price is currently $25 per share. If the firm
does not pay the dividend the share price will rise. If it pays the dividend the share
price will stay the same. By how much must the share price rise if the dividend is not
paid in order to make the investor indifferent between receiving the dividend or not?
A) $2.00
B) $0.59
C) $1.55
D) $1.97
E) $2.50

Answer: C Page: 247-248 Level: Difficult

Rationale: 2 * (1- 0.38) = Change in share price * (1- 0.20)

20. With _________ voting, all directors up for election are voted on by the shareholders
at the same time in one general election.
A) Straight
B) Participating
C) Nonparticipating
D) Proxy
E) Cumulative

Answer: E Page: 249 Level: Medium

21. If all preferred dividend payments that have been missed must be paid before any
common stock dividend can be paid the preferred stock is called _____ preferred
stock.
A) Cumulative
B) Participating
C) Nonparticipating
D) Voting
E) Dual class

Answer: A Page: 251 Level: Easy

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22. In 2004 about 20% of the shares of the top one hundred non-U.S. companies (ranked
by sales) were owned by U.S. residents. Most of these stocks were held in the form of
_________________.
A) Foreign direct investment
B) ADRs
C) Proxies
D) GRDs
E) Brady bonds

Answer: B Page: 280 Level: Medium

23. If the net proceeds are greater than the gross proceeds in an underwritten offering
A) The investment banker made a profit on the spread
B) The issuing company underpriced its securities
C) The issue fails to occur
D) The SEC rescinds the issue
E) None of the above

Answer: E Page: 253 Level: Difficult

24. The preemptive right is designed to

A) Allow management to diffuse stock ownership any voting power
B) Allow managers to preempt a stock offering if they do not like the terms of the
deal
C) Allow existing shareholders the right to sell their existing shares before the new
offer
D) Allow existing shareholders to buy shares of the new offering if they desire
E) None of the above

Answer: D Page: 255 Level: Medium

25. The NASDAQ automatic order execution system for individual traders placing buy or
sell orders of 1000 or fewer shares is called the
A) ECN Network
B) SOE System
C) NASDAQ/AMEX Joint Program
D) Instinet Network
E) E*Trade Online Program

Answer: B Page: 265 Level: Easy

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26. The preliminary version of a security offer that is circulated to potential buyers before
SEC approval (registration) is obtained is called a
A) Final prospectus
B) Shelf registration statement
C) Due diligence draft
D) Waiting period offer
E) Red herring prospectus

Answer: E Page: 256 Level: Easy

27. A shelf registration allows firms the opportunity to avoid the normal _____ day
waiting period by allowing preregistration of securities for up to _____ years.
A) 20 day; 2 years
B) 10 day; 1 year
C) 15 day; 3 years
D) 20 day; 1 year
E) 30 day; 2 year

Answer: A Page: 257 Level: Medium

28. Which of the following is/are true about specialists?

I. Investment banks generally cannot be specialists
II. Specialists are used by the NASDAQ system
III. Market and limit orders are transacted at specialist posts, but the specialist's
'own account' orders are executed elsewhere
IV. Specialists help maintain continuous trading

A) I, II and III only

B) I and IV only
C) II, III and IV only
D) I only
E) III only

Answer: B Page: 259 Level: Medium

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29. When all the directors up for election are voted on at the same time the procedure is
called
A) Dual class voting
B) Straight voting
C) Limited liability voting
D) Proxy voting
E) Cumulative voting

Answer: E Page: 249 Level: Easy

30. A stock has a P/E ratio of 95. If earnings don't grow the investor must wait how long
to recover their investment?
A) 20 years
B) 45 years
C) 60 years
D) 95 years
E) None of the above

Answer: D Page: 263-264 Level: Medium

31. In terms of volume of trading and market value of firms traded the ________ is the
largest U.S. stock market. In terms of number of firms traded the ___________ is the
largest in the U.S.
A) NYSE; NYSE
B) NASDAQ; NYSE
C) NYSE; AMEX
D) NYSE; NASDAQ
E) NASDAQ; AMEX

Answer: D Page: 266 Level: Medium

32. On the NASDAQ system, the inside quotes are the

A) Lowest ask and lowest bid
B) Lowest bid and highest ask
C) Highest bid and highest ask
D) Highest bid and lowest ask
E) None of the above

Answer: D Page: 265 Level: Medium

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33. NYSE listing has traditionally benefited a firm by
A) Improving the stock's price
B) Generating increased publicity for the firm
C) Providing easier access to primary market capital
D) B and C only
E) A, B and C

Answer: E Page: 266 Level: Medium

34. Which of the following indices are value-weighted?

I. NYSE Composite
II. S&P500
III. NASDAQ Composite
IV. Dow Jones Industrial Average

A) I, II, III and IV

B) I only
C) II only
D) II, III and IV only
E) I, II and III only

Answer: E Page: 269-270 Level: Easy

35. The largest single type of holder of common stock ($) is

A) Pension funds
B) Households
C) Mutual funds
D) Brokers and dealers
E) Life insurance firms

Answer: B Page: 272 Level: Easy

36. A firm is using cumulative voting and five director spots are up for election. There are
2.4 million shares outstanding. How many shares must a minority owner own or
control to ensure that he or she can gain control of one seat on the board of directors?
A) 400,001
B) 1,200,001
C) 555,001
D) 650,001
E) None of the above

Answer: A Page: 250,267-271 Level: Medium

Rationale: ((1/(5+1))*2.4 million + 1

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37. If no information (publicly available or not) can be consistently used to predict stock
price changes then the market is
A) weak form efficient
B) semi-strong form efficient
C) semi-strong form inefficient
D) strong form efficient
E) strong form inefficient

Answer: D Page: 275 Level: Medium

38. Suppose that over the last ten to fifteen years significantly large numbers of investors
have been able to earn abnormal returns from using the firm's publicly available
financial information to forecast growth in earnings and dividends. This would be
evidence that the markets are not
I. weak form efficient
II. semi-strong form efficient
III. strong form efficient

A) I only
B) I and II only
C) III only
D) II and III only
E) I, II and III

Answer: B Page: 275 Level: Difficult

39. In a ___________ offering the firm preregisters with SEC any securities it wishes to
sell over the next two years.
A) Rights
B) Full underwritten
C) General cash
D) Shelf
E) Best efforts

Answer: D Page: 257 Level: Easy

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40. The stamp on a prospectus accompanying a new issue that indicates the issue has not
yet been approved for sale by the SEC is called the
A) green hornet
B) seal of approval
C) red herring
D) eagle stamp
E) Reg FD

Answer: C Page: 256 Level: Easy

41. The NYSE specialists are charged with

I. trading for their own account
II. ensuring public limit orders are executed
III. facilitating processing public market orders

A) I only
B) I and II only
C) II and III only
D) I and III only
E) I, II and III

Answer: E Page: 260-261 Level: Medium

42. The age group that holds the most stock is the ____________ group.
A) Under 35
B) 35-44
C) 45-64
D) 65 and older

Answer: C Page: 272 Level: Easy

43. The electronic based market for less actively traded U.S. securities is the
A) ADR market
B) OTC Bulletin Board
C) Pink Sheet stocks
D) NYSE Low Volume Market
E) ECN Market

Answer: B Page: 265 Level: Easy

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 44. Computerized markets that automatically match buyers and sellers orders and are used
primarily by institutions traders are called
A) OTC bulletin boards
B) SPIDRS
C) Index Markets
D) ECNs
E) Specialists

Answer: D Page: 266 Level: Easy

45. The process of allocating shares in an IPO to certain customers in exchange for
additional business or other perks is called
A) Spinning
B) Laddering
C) Biased analyst reporting (BAR)
D) Front running
E) Short dealing

Answer: A Page: 253,277 Level: Easy

Rationale: The term 'spinning' is not used in the text.

Short Answer Questions

46. Data shows that only 11 of 27 recessions prior to 1990 were preceded by a decline in
stock prices. Although stocks are a leading economic indicator, what are some reasons
why a stock price decline might not indicate an upcoming recession?

Answer: Stock prices might drop because equity risk premiums temporarily rise,
depressing stock prices without foreshadowing lower growth. It may also be that
current stock prices are overly optimistic about future growth, when the over optimism
is corrected, stock prices fall, sometimes sharply. This may occur even if no change in
underlying economic growth takes place. One might also observe slower growth than
expected that does not result in a recession. More succinctly, expectations may change
more rapidly than actual economic growth rates. Page: 273 Level: Medium

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47. What are weak form, semi-strong form and strong form efficiency? Does one form of
efficiency imply another?

Answer: Weak form efficiency implies that past price and trading information is
contained in today's stock price and is of no value to an investor. Semi-strong
efficiency implies that an investor cannot use any publicly available information to
predict tomorrow's price change. Strong form efficiency implies that public and inside
information is of no value in predicting tomorrow's price change. Strong form
efficiency implies that the markets are also weak and semi-strong form efficient.
Likewise, semi-strong from efficiency implies that the markets are also weak form
efficient. Page: 274-278 Level: Medium

48. Answer the following questions concerning the given stock quote:

What was the dividend yield? What was the most recent four quarters of earnings per
share? Valued at the closing price, what was the total dollar volume of shares traded?
What was the stock price at the beginning of the year?

Answer: The dividend yield = 1.72%

The most recent four quarters of earnings per share = $23.30 / EPS = 35 ; EPS = $0.67
Valued at the close, the total $ volume of shares traded = $23.30 *
4123 * 100 = $9,606,590
The stock price at the beginning of the year was ($23.30 - Pbegin) /
Pbegin = -0.153 ;
Pbegin = $23.30 / (1 - 0.153) = $27.51 Page: 263-264 Level: Difficult

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49. Investment bankers have recently engaged in unethical practices related to IPOs and
stock research. Describe what has been happening and discuss why these practices
hurt the overall economy.

Answer: Bankers have engaged in spinning and laddering. Spinning (a term not used
in the text) is allocating shares of a hot IPO to favored customers in exchange for
receiving investment banking business from the customer's firm later on. (Laddering
(also not in the text) is allocating IPO shares to firms who agree to buy more in the
aftermarket in an attempt to increase the price over the short run, increasing gains to
original purchasers.) Investment banking firms have also publicly disseminated overly
optimistic research reports in order to facilitate gaining and assisting underwriting
business. These practices reduce investor confidence in purchasing IPOs (and in
secondary market purchases of securities). Reduced investment results in lower share
prices and higher cost of capital for firms. With higher capital costs, corporate
investment and economic growth is reduced. Page: 253, 277 Level: Medium

50. What are the advantages and disadvantages of foreign investing? How does an ADR
help overcome the disadvantages?

Answer: International investing can reduce risk by generating additional

diversification benefits. These benefits have been small lately because the U.S. has
dominated the rest of the world in economic performance, but this is not likely to
continue indefinitely. International investing also introduces foreign exchange risk,
information risk and sovereign risk, as well as trading and tax complexities. The
ADRs limit foreign exchange risk and other trading complexities. Foreign firms are
also required to meet U.S. disclosure requirements when ADRs are issued.
Page: 280 Level: Medium

51. As a small (minority) stockholder would you prefer to have cumulative voting or
straight voting shares? As a majority shareholder?

Answer: Cumulative voting gives a small shareholder a better chance of electing a

given board member because they don't have to own (or control by proxy) a majority
of shares. As a controlling stockholder you can ensure that you will always be able to
elect the entire board of your choice if you have straight voting.
Page: 248-250 Level: Medium

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52. When would preferred stock be a better investment choice than common stock or
bonds?

Answer: Preferred stocks have higher yields than bonds and much higher dividend
yields than stocks. One will not get capital gains with preferred stock however. Thus
if steady high pretax yields are desired, with little or no chance of capital gains, and a
tax sheltered investment vehicle such as an IRA is available, preferred may be an ideal
choice. Page: 251-252 Level: Medium

53. What are ECNs? How are they changing trading in the traditional markets?

Answer: ECNs are electronic communication networks. These computerized trading

systems automatically match buy and sell orders. Since they are electronic, ECNs
allow for extended trading hours. As fewer humans and physical overhead are
required, ECNs provide a potentially cheaper trading platform than the exchanges.
Institutions use ECNs to solicit trading interest on large blocks of shares. The rule
changes requiring publishing all quotes form different markets mean that ECN market
share is likely to grow at the expense of the NYSE and NASDAQ (hence a rationale
for the mergers between NYSE and Archipelago and NASDAQ and Instinet).
Page: 266 Level: Medium

54. In what major ways do stocks differ from bonds?

Answer:
Stocks have the following characteristics:
1. Discretionary cash flows (dividend payments). The board of directors may choose
to pay or not to pay a dividend.
2. Residual claim in the event of bankruptcy
3. No maturity date, thus there is no guarantee of a return of your principle.
4. Voting rights. As a stockholder you are part owner of the company and have a
voice in company decisions.
5. Stock markets are deeper and more actively traded than bond markets.
Page: 247 Level: Difficult

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55. A firm desires to sell stock to the public. The underwriter charges $0.4 million in fees
and offers to buy 6 million shares from the firm at a price of $19 per share. In
addition, registration and audit fees total $145,000, and marketing and miscellaneous
fees add up to another $65,000. The underwriter expects to earn gross proceeds per
share of $21. What is the issuing firm's out of pocket dollar transaction cost to issue
the stock? Immediately after the stock was issued, the stock price rose to $23. What
is the issuing firm's opportunity cost? What is the total issuance cost, including
opportunity costs, as a percentage of the total funds available to the issuing firm?

Answer:
Out of pocket cost = $400,000 + $145,000 + $65,000 = $610,000
Opportunity cost = 6 million shares * ($23 - $19) = $24,000,000
Actual funds available to firm: 6 million * $19 = $114 million - $610,000 =
$113,390,000
Percentage cost = ($24,000,000 + $610,000) / $113,390,000 = 21.7%
Page: 252-255 Level: Difficult

56. What are the major effects of the Sarbanes-Oxley Act (SO) of 2002 on the stock
markets? What else has the NYSE done to improve corporate governance?

Answer:
The SO Act * Created an independent auditing oversight board under the SEC
 Increased penalties for corporate wrongdoing
 Required more extensive accounting disclosure
 Increased ability of aggrieved shareholders to seek recourse from management
The NYSE changed listing requirements to ensure
 Listed firms have a majority of independent directors
 Boards institute and implement codes of ethics for the board and top management
 Require shareholder approval of equity based compensation plans
 Require CEOs to annually certify the information given to stockholders.
Page: 277 Level: Difficult

57. Describe recent ethical breaches at the NYSE involving specialists. Why do you think
these have occurred?

Answer: NYSE specialists have allegedly routinely executed their own orders ahead of
orders from the public, a process called 'front running' (the term is not in the text).
The NYSE was apparently either unable or unwilling to stop these and other practices.
One or more specialists have also engaged in market manipulation, procuring
information from corporate executives before the information was made public. These
violations have occurred more frequently as specialists' profit margins have declined
due to increasing competition and automation. Page: 278 Level: Medium

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