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 Chapter 7: Common Stock

Name:

TRUE/FALSE. Write ‘T’ if the statement is true and ‘F’ if the statement is false.

1) Common stock provides the investor a residual claim on both the firm’s assets and
the firm’s cash flow.

2) The most typical common stock maturity is 20 years.

3) Common stock’s residual claim on assets implies owners have a prior claim on assets
before other claim holders are paid.

4) In the case of corporate bankruptcy, common stock’s residual claim becomes

especially valuable.

5) The lack of a fixed common stock dividend provides the corporation greater
flexibility versus the use of bonds or preferred stock.

6) Investors view common stock as a riskier investment than bonds or preferred stock.

7) The costs involved with issuing common stock are much lower than the costs
involved with issuing bonds and preferred stock.

8) Valuing common stock is less difficult and more precise than valuing bonds.

9) The valuation of common stock with zero growth is similar to the valuation of
preferred stock.

10) Everything else being the same, the higher a firm’s earnings growth, the lower the
value of its common stock.

MULTIPLE CHOICE. Choose the one alternative that best completes the
statement or answers the question.

11) Typically a corporation’s board of directors would not make which one of the
following decisions?
A) compensation for the president of the corporation
B) who can purchase the corporation’s common stock
C) determine long-term corporate policy
D) decide whether to build a new $1 billion casino or not

12) Why is valuing common stock more difficult than valuing bonds?
A) Common stock is a long-term security and a bond is a short-term security.
 B) Because bonds have more seniority than common stocks.
C) Because common stock is less risky to the investor than a bond.
D) It is more difficult to forecast future common stock cash flows than bond cash
flow.

13) If a corporation has two classes of common stock, what is typically unique about the
second or class B common stock?
A) It has superior voting rights.
B) It has inferior dividend payments.
C) It has no voting rights.
D) It has superior dividend payments.

14) Everything else being the same, the greater an investor’s required rate of return, what
is true of the value of common stock?
A) It is worth more.
B) It is worth less.
C) The impact on value could be up or down.
D) The value will not change.

15) Into which two parts is a firm’s earnings divided?

A) dividends and debt repayments
B) dividends and tax payments
C) dividends and addition to retained earnings
D) dividends and interest payments

16) Which of the following is not a defining feature of common stock?

A) a residual claim on assets
B) voting rights
C) a residual claim on cash flows
D) a fixed return

17) Which of the following is true for corporate stockholders?

A) They elect the chief executive officer.
B) They elect the board of directors.
C) They determine the dividend through a ballot to each stockholder.
D) They determine the maturity through a ballot to each stockholder.

18) Which of the following is true the longer a common stock investor’s expected
holding period?
A) The current value of the common stock is greater.
B) The current value of the common stock is lower.
C) The investor’s holding period has no impact on the current value of common
stock.
D) None of the above.
19) Why do investors require a higher expected rate of return on common stock than on
bonds?
A) Common stock is a riskier investment than bonds.
B) Common stock is a lower risk investment than bonds.
C) Common stock has a shorter maturity than bonds.
D) Dividends are considered taxable income, but interest is not.

20) Why is common stock financing lower risk to the firm than financing with bonds?
A) The lack of a fixed dividend provides the firm greater flexibility versus the
interest cost of a bond.
B) Common stock typically has a shorter maturity than bonds.
C) Although common stock dividends are typically fixed, they are usually lower
than the interest on bonds.
D) The sinking fund feature on common stock lowers its risk.

21) Wiley & Jose’s Corporation currently pays a $1.50 common stock dividend.
Dividends are expected to grow at a 3% rate into the foreseeable future. What is the
value of Wiley & Jose’s common stock to an investor requiring a 14% rate of return?
A) $11.04
B) $51.50
C) $13.64
D) $14.05

22) Keong is considering an investment in Leong’s Bar & Grille Corporation. Keong is
planning to buy the stock today, hold it for 2 years, and then expects to sell the stock
for $30 at the end of 2 years. Keong expects the first dividend to be $1.00 and the
second dividend to be $1.30. If Keong requires a 15% rate of return, what is the
value of Leong’s Bar & Grille common stock to Keong today?
A) $21.58
B) $23.55
C) $24.54
D) $23.67

23) Jabbar Hotels Incorporated currently pays a $3.00 common stock dividend.
Dividends have been growing at a 5% annual rate and are expected to continue
growing a this rate into the foreseeable future. What is the current value of Jabbar
Hotels common stock to an investor requiring a 12% rate of return?
A) $26.25
B) $45.00
C) $63.00
D) $42.86

24) Lapidus Restaurants Incorporated currently pays a $5.00 common stock dividend.
The dividend is expected to remain at $5.00 and not expected to grow in the future.
What is the current value of Lapidus Restaurants common stock to an investor
requiring an 11% rate of return?
 A) $100.00
B) $83.33
C) $50.45
D) $45.45

25) Mehmet is considering an investment in Cho’s Korean Restaurant. Mehmet is

planning to buy the stock today, hold it for 3 years, and then expects to sell the stock
for $40 at the end of 3 years. Mehmet expects the first dividend to be $1.00, the
second dividend to be $1.50, and the third dividend to be $2.25. If Mehmet requires
a 17% rate of return, what is the value of Cho’s Korean Restaurant to Mehmet
today?
A) $28.33
B) $26.93
C) $13.24
D) $24.70

26) Dolci’s Theme Parks currently pays a $1.00 common stock dividend. Dividends
have been growing at a 5% annual rate and are expected to continue growing at this
rate for the next 2 years. Thereafter the growth rate is expected to be 0% for the
foreseeable future. What is the current value of Dolci common stock to an investor
requiring a 16% rate of return?
A) $6.03
B) $9.55
C) $6.85
D) $6.56

27) Gourrier Sleepy Motels currently pays a $2.00 common stock dividend. Dividends
have been growing at a 3% annual rate and are expected to continue growing at this
rate for the next 4 years. Thereafter the growth rate is expected to be 0% for the
foreseeable future. What is the current value of Gourrier common stock to an
investor requiring a 12% rate of return?
A) $18.44
B) $17.17
C) $22.89
D) $17.01

28) Gongoras Gorgeous Hotels currently pays a $1.80 common stock dividend.
Dividends have been recently growing at a 10% annual rate and are expected to
continue growing at this rate for the next 2 years. Thereafter the growth rate is
expected to be 4% for the foreseeable future. What is the current value of Gongoras
common stock to an investor requiring an 18% rate of return?
A) $14.14
B) $11.00
C) $14.86
D) $13.09
29) Casey’s Sports Books currently pays a $2.30 common stock dividend. Dividends
have been recently growing at a 12% annual rate and are expected to continue
growing at this rate for the next 3 years. Thereafter the growth rate is expected to be
5% for the foreseeable future. What is the current value of Casey’s common stock to
an investor requiring an 14% rate of return?
A) $28.98
B) $32.11
C) $18.40
D) $28.62

30) Bednar’s Bed & Breakfasts, Incorporated currently pays a $3.10 common stock
dividend. Dividends have been recently growing at a 15% annual rate and are
expected to continue growing at this rate for the next 2 years. Then dividends are
expected to continue growing at a 10% rate for another 2 years (years 3 and 4) and
thereafter the growth rate is expected to be 5% for the foreseeable future. What is
the current value of Casey’s common stock to an investor requiring an 13% rate of
return?
A) $47.87
B) $52.47
C) $27.42
D) $44.56
 ANSWER KEY—Chapter 7: Common Stock

1) TRUE 16) D
2) FALSE 17) B
3) FALSE 18) C
4) FALSE 19) A
5) TRUE 20) A
6) TRUE 21) D
7) FALSE 22) C
8) FALSE 23) B
9) TRUE 24) D
10) F 25) A
11) B 26) C
12) D 27) A
13) A 28) C
14) B 29) B
15) C 30) B