Money Banking and Financial Markets 5th Edition Cecchetti Test Bank

Chapter 08
Stocks, Stock Markets and Market Efficiency
Multiple-Choice Questions
1. A share of common stock represents a(n):

a. claim from a lender against a borrower.
b. share in the company's debts.
c. share of ownership of the company.
d. unlimited liability to the owner of the stock.
Ans: C
Difficulty: 01 Easy
Learning Objective: 08-01
AACSB: Reflective Thinking
Blooms: Remember
Topic: The Essential Characteristics of Common Stock
2. Two characteristics that make owning stock attractive are:

a. unlimited liability and first claim on assets.
b. share prices are relatively inexpensive and are transferable.
c. each share represents a large percentage of ownership and dividends are fixed.
d. dividends are paid before any other distributions are made and stocks are transferable.
Ans: B
Difficulty: 01 Easy
Blooms: Understand
3. Voting rights in a corporation are held by the:

a. board of directors.
b. preferred stockholders.
c. corporate bondholders.
d. common stockholders.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
1
© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4. The fact that common stockholders are residual claimants means the stockholders:
a. have a claim against the revenue that remains after everyone else is paid.
b. receive their dividends before any other residuals are paid.
c. are paid any past due dividends before other claims are paid.
d. are paid before the bondholders but after any taxes are paid.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
5. If a public corporation goes bankrupt and does not have enough assets to pay off all creditors:
a. the stockholders are personally liable for the balance.
b. the fact that stockholders are residual claimants means they may have to pay in additional
capital to cover the obligations.
c. the stockholders receive any dividends due before the other creditors are paid.
d. the stockholders cannot lose more than their investment.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
6. The concept of limited liability says a stockholder of a corporation:

a. is liable for the corporation's liabilities, but nothing more.
b. cannot receive dividends that exceed his/her investment.
c. cannot lose more than his/her investment.
d. is only responsible for any taxes that the corporation may owe but not its other debts.
Ans: C
Difficulty: 01 Easy
Blooms: Understand
7. Which of the following statements is most correct?

a. Stockholders have limited liability and have no control over corporate leadership.
b. Stockholders can dislodge the managers of the corporation but not the board of directors.
c. Stockholders have unlimited liability and can dislodge members of the board of directors.
d. Stockholders can dislodge members of the board and have limited liability.
Ans: D
2
Difficulty: 02 Medium
Blooms: Understand
8. Which of the following is not a feature of common stock?

a. Stockholders receive regular fixed payments on their shares.
b. Stockholders have limited liability.
c. Stock holders are residual
claimants. d. Stockholders have voting
rights. Ans: A
Difficulty: 01 Easy
Blooms: Understand
9. What do bondholders and stockholders have in common?

a. Both are claimants.
b. Both have voting rights.
c. Both are shareholders in the company.
d. Both receive fixed payments on their securities each year.
Ans: A
Blooms: Understand
10. Which of the following statements is most correct?

a. Managers, directors, and stockholders almost always share the same interest.
b. Managers' and directors' interests often conflict with stockholders' interest.
c. Managers and stockholders have the same interests, but this usually conflicts with the interests
of directors.
d. Directors and stockholders have the same interests, but this usually conflicts with the interests
of managers.
Ans: B
Blooms: Understand
3
11. Which of the following stock price indexes is a price-weighted index?
a. Dow Jones Industrial Average
b. Standard & Poor's 500 Index
c. Nasdaq
d. Wilshire 5000
Ans: A
Difficulty: 01 Easy
Blooms: Remember
Topic: Measuring the Level of the Stock Market
12. An index number is valuable because:

a. the level of every index number itself provides critical information.
b. it is more stable than the data it reflects.
c. it provides a meaningful measurement scale to calculate percentage changes.
d. it does not require any calculations to compute percentage changes.
Ans: C
Blooms: Understand
13. The Dow Jones Industrial Average is:

a. an index made up of the stock prices of the 100 largest corporations in the U.S.
b.an index that measures the value of purchasing 100 shares in each of the corporations that
make up the index.
c. the average price of stock in 30 of the largest companies in the U.S.
d. the broadest measure of stock market performance.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
14. The Dow Jones Industrial Average is a:

a. simple average.
b. price-weighted index.
c. value-weighted index.
d. total-value index.
Ans: B
4
Difficulty: 01 Easy
Blooms: Remember
15. The Dow Jones Industrial Average:

a. gives equal weight to a change in the price of the stock of any company in the index.
b. reflects that a 10% increase in a share of stock selling for $30 will have the same effect on the
index as a 10% increase in the price of a stock selling for $60.
c. is a value-weighted index.
d. gives greater weight to shares with higher prices.
Ans: D
Blooms: Remember
16. If the Dow Jones Industrial Average is currently at 10,000 and the price of one stock
included in the index increases by $10, the Dow Jones Industrial Average will:
a. not change; it is a value-weighted index.
b. increase by 10.0%.
c. increase by 1.0%.
d. increase by 0.1%.
Ans: D
Difficulty: 03 Hard
AACSB: Knowledge Application
Blooms: Apply
17. If the Dow Jones Industrial Average is at 10,205 and it is up 4% from the previous day, what
was the index at the close of the market the previous day?
a. 10,201.0
b. 9,805.0
c. 9,812.5
d. 9800. 0
Ans: C
Difficulty: 03 Hard
Blooms: Apply
5
18. The stocks that make up the Dow Jones Industrial Average:
a. are dominated by the automobile industry.
b. are the same ones that were originally used to construct the index.
c. are not a broad measure of the market since they do not include any technology companies.
d. have changed as the structure of the economy has changed.
Ans: D
Difficulty: 01Easy
Blooms: Remember
19. If each company that made up the Dow Jones Industrial Average increased the number of
their shares outstanding by 10%, but the share prices did not change, the value of the index
would:
a. not change.
b. increase by 10%.
c. increase, but by less than 10%.
d. decrease since there are more shares outstanding.
Ans: A
Blooms: Understand
20. The Standard & Poor's 500 Index differs from the Dow Jones Industrial Index because:
a. it takes into account the stock prices of 500 of the largest firms, which is less than the DJIA.
b. it is a price-weighted index, where the DJIA is a value-weighted index.
c. larger firms are less important in the S&P 500 than in the DJIA.
d. it takes into account the prices of more stocks and it uses a different weighting scheme.
Ans: D
Blooms: Understand
6
21. The Standard & Poor's 500 Index:
a. gives more weight to large companies than small companies.
b. actually includes more than 500 of the largest corporations in the U.S.
c. is a price-weighted index.
d. assigns equal weight to all the prices of all the stocks in the index.
Ans: A
Blooms: Understand
22. Considering the S&P 500 Index, if each company's stock price increased by 10%:
a. the weights in the index would remain the same.
b. the companies with the most shares outstanding would have even greater weight after the
increase.
c. the companies with fewer shares would gain more weight at the expense of the companies
with greater shares.
d. the weights in the index would change to reflect the percentage changes in the prices of the
various stocks.
Ans: A
Blooms: Understand
23. Which of the following statements is not true?

a. A value-weighted index is a better index to use to reflect changes in the economy's overall
wealth.
b. A price-weighted index is a better index to use to reflect the average change in the price of a
typical share of stock.
c. The Dow Jones Industrial Average is a price-weighted index.
d. The S&P 500 is a price-weighted index.
Ans: D
Blooms: Understand
7
© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
24. The Nasdaq Composite Index is:
a. a value-weighted index.
b. a price-weighted index.
c. made up of over 5000 companies traded on the NYSE.
d. made of mainly older firms and is heavily weighted by manufacturing.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
25. The Nasdaq Composite Index is:

a. made up of over 50,000 firms traded on the Over-the-Counter market.
b. a price-weighted index.
c. made up of mainly newer firms, and heavily influenced by technology and internet
companies.
d. the most broadly based index in use.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
26. The most broadly based stock index in use is the:

a. Nasdaq Composite Index.
b. Wilshire 5000.
c. Dow Jones Industrial Average.
d. Standard and Poor's 500 Index.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
8
27. When studying world stock indexes, we observe that:
a. the S&P 500 is largest in terms of index value.
b. most of the world's indexes are price-weighted.
c. the indexes are very comparable.
d. the indexes are comparable but only in percentage terms.
Ans: D
Blooms: Understand
28. When comparing stock indexes around the world we:

a. find that a given percentage change across all indexes has the same value.
b. observe that they always move together.
c. can see that the numeric change in indices allows investors to make easy comparisons of value.
d. can examine their respective movements if we look at them as percentage changes.
Ans: D
Blooms: Understand
29. People differ on the method by which stock should be valued. Some people are chartists,
others behavioralists. The basic difference between these groups is:
a. chartists rely on astrological charts to predict stock values, behavioralists rely on psychology.
b. behavioralists are finance based, chartists study charts of investor psychology.
c. chartists study charts of stock prices; behavioralists focus on investor psychology and behavior.
d. chartists and behavioralists are the same in their approach; essentially there aren't any differences.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
Topic: Valuing Stocks
9
30. The dividends that stockholders receive are:
a. fixed by contract and paid annually.
b. distributions from profits.
c. paid before all other obligations of the company are met.
d. always equal to the average amount of interest paid to a bond holder, adjusting for the
value of the holdings.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
31. You start with a $1,000 portfolio; it loses 50% over the next year, the following year it gains
50% in value. At the end of two years your portfolio is worth:
a. $1,000.
b. $500.
c. $750.
d. $950.
Ans: C
Difficulty: 03 Hard
Blooms: Apply
32. You start with a portfolio valued at $500. Over the next twelve months it loses 40%; the
following year it has a gain of 30%. At the end of two years your portfolio is worth:
a. $390.
b. $450.
c. $300.
d. $410.
Ans: A
Difficulty: 03 Hard
Blooms: Apply
10
33. You have a portfolio valued at $1,000. Over the next twelve months it loses 75% of its value.
What return does the portfolio need to earn over the following twelve months to restore the
portfolio to its original value?
a. 75%
b. 200%
c. 300%
d. 25%
Ans: C
Difficulty: 03 Hard
Blooms: Apply
34. You have a portfolio valued at $10,000. Over the next twelve months it loses 50% of its
value. What return does the portfolio need to earn over the following twelve months to be
restored to its original value?
a. 100%
b. 50%
c. 200%
d. 25%
Ans: A
Difficulty: 03 Hard
Blooms: Apply
35. The dividend-discount model of stock valuation:

a. is an application of the net present value formula.
b. takes the net present value of expected dividends and add it to the future sale price of the
stock.
c. takes the net present value of the expected future price of the stock and adds the annual
dividend.
d. takes the annual dividend, adds it to the expected future selling price and divides by the
number of years to get the current price.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
11
36. A stock has an annual dividend of $10.00 and it is expected not to grow. It is believed the
stock will sell for $100 one year from now, and an investor has a discount (interest) rate of 6%
(0.06). The dividend discount model predicts the stock's current price should be:
a. $94.67
b. $116.00
c. $103.77
d. $106.60
Ans: C
Difficulty: 03 Hard
Blooms: Apply
37. A stock has a current annual dividend of $6.00 per year and it is expected to grow by 3%
(0.03) a year. It is expected that two years from now the stock will sell for $90.00 a share. If the
interest rate is 5% (0.05), the dividend-discount model predicts the stock's current price should
be:
a. $94.90
b. $93.29
c. $101.30
d. $94.30
Ans: B
Difficulty: 03 Hard
Blooms: Apply
38. A stock currently does not pay an annual dividend. An investor expects this policy to remain
in force. She believes, however, the stock of this company will sell for $110.00 per share four
years from now. If she has an interest (discount) rate of 7% (0.07), the dividend discount model
predicts the current price of this stock should be:
a. you cannot apply the model to this example since it requires a dividend be offered.
b. $82.00
c. $83.92
d. $86.35
Ans: C
Difficulty: 03 Hard
Blooms: Apply
12
39. Next year, the price of a stock is expected to be $2,200 and the stock will pay a $55 dividend.
The interest rate is 10%. Based on the dividend-discount model, what is the current price of this
stock?
a. $1,980
b. $2,000
c. $2,050
d. $2,035
Ans: C
Difficulty: 03 Hard
Blooms: Apply
40. The price of a stock is currently $750 and the stock will pay a $43 dividend. The interest rate
is 7.5%. Based on the dividend-discount model, what is the expected price of this stock for next
year?
a. $651.17
b. $657.67
c. $691.17
d. $763.25
Ans: D
Difficulty: 03 Hard
Blooms: Apply
41. A company currently pays a dividend of $4.00 per share. It expects the growth rate of the
dividend to be 3% (0.03) annually. If the interest rate is 6% (0.06) what does the dividend-
discount model predict the current price of the stock should be?
a. $103.33
b. it doesn't, you need an expected future selling price to use the model.
c. $ 137.33
d. $66.67
Ans: C
Difficulty: 03 Hard
Blooms: Apply
13
42. A company currently pays an annual dividend of $6.50 per share. It expects the growth rate
of the dividend will be 2.5% (0.025) annually. If the interest (discount) rate is 5% (0.05) what
does the dividend-discount model predict the current price of the stock should be?
a. It doesn't, you need an expected future price to use the model
b. $257.50
c. $130.00
d. $266.50
Ans: D
Difficulty: 03 Hard
Blooms: Apply
43. The dividend-discount model predicts that stock prices:

a. should be high when dividends are high.
b. will be high when interest rates are high.
c. will be higher when the growth rate of dividends is low.
d. should be high when dividends are low.
Ans: A
Blooms: Understand
44. Suppose that the current dividend for a stock is Dtoday, the expected dividend growth rate is r,
and the interest rate is i. If we ignore risk, which of the following represents the dividend-
discount model formula for the fundamental price of a stock?
a. Dtoday / (i + g)
b. (i + g) / Dtoday
c. Dtoday (1 + g) / (i - g)
d. Dtoday / (i - g)
Ans: C
Blooms: Understand
14
45. A share of stock resembles a consol in all of the following ways except that the:
a. share of stock does not have a maturity date.
b. annual dividend the stock pays resembles the coupon on a consol.
c. prices of both can be computed using a variation of the net present value formula.
d. are both residual claims.
Ans: D
Blooms: Understand
46. As the corporation uses more debt financing, which of the following holds true for the
stockholders?
a. The expected return to the stockholders decreases and the standard deviation of that return
decreases.
b. The expected return to the stockholders increases and the standard deviation of the return
decreases.
c. The expected return to the stockholders increases and the standard deviation of the return
increases.
d. The expected return to the stockholders decreases and the standard deviation of the return
increases.
Ans: C
Blooms: Understand
47. The fact that many corporations use debt financing as well as equity financing creates all of
the following except:
a. the opportunity for a greater expected return for the stockholders.
b. greater risk for the stockholders.
c. leverage for the stockholders.
d. consistently lower debt-to-equity ratios.
Ans: D
Blooms: Understand
15
48. Without the stockholders' limited liability, the risk from the use of leverage would:
a. be significantly less.
b. be significantly greater.
c. still be the same.
d. be irrelevant.
Ans: B
Blooms: Understand
49. Consider the effect of business cycles on bondholders versus stockholders. We expect that
business cycles will affect:
a. bondholders and stockholders about the same.
b. bondholders more since the amount they receive depends on profits.
c. stockholders more since they are residual claimants.
d. bondholders more since they do not have any claim to property.
Ans: C
Blooms: Understand
50. In the event of bankruptcy, stockholders:

a. are paid before bondholders.
b. receive at least their initial investment due to limited liability.
c. could lose more than their initial investment.
d. are the last to be paid and could end up losing what they have invested.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
16
51. As a company issues more debt:
a. its leverage decreases.
b. the share of financing from equity increases.
c. the expected return to equity holders falls.
d. risk increases
Ans: D
Blooms: Understand
52. All other things equal, a decrease in the equity risk premium leads to a(n):
a. increase in the required return on stock.
b. decrease in the present value of stock.
c. increase in the price of equity shares.
d. decrease in dividend growth.
Ans: C
Blooms: Understand
53. The basic dividend-discount model is a bit of an oversimplification for valuing stocks
because it:
a. ignores expected dividend growth.
b. ignores the value of future dividends.
c. ignores the risk involved in holding stocks.
d. cannot handle stocks that do not pay dividends.
Ans: C
Blooms: Understand
17
© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution
in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
54. The required stock return an investor seeks can best be represented by which of the
following?
a. Risk Premium - Risk-free Return
b. Risk-free Return × Risk Premium
c. (Risk-free Return + Risk Premium)/(1 + i)
d. Risk-free Return + Risk Premium
Ans: D
Blooms: Understand
55. Which of the following will cause an increase in the current price of a stock?
a. A decrease in the risk-free return

b. A decrease in the current dividend
c. A decrease in the dividend growth rate
d. Both an increase in the risk-free return or an increase in the current dividend
Ans: A
Blooms: Understand
56. If a company reports that it is going to have a difficult time meeting its debt obligations,
you would expect the Ptoday:
a. to fall since the risk-free return will rise.

b. to rise since the Dtoday will likely fall.
c. to fall since the risk premium will likely rise.
d. to remain about the same until the Dtoday actually changes.
Ans: C
18
© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution
in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Blooms: Apply
57. Suppose there is a reduction of the return provided on U.S. Treasury bonds. We should
expect the current price of stocks to:
a. increase since the risk-free return is now lower.

b. decrease since U.S. Treasury bonds are safer.
c. increase since the risk premium on the stocks will increase.
d. stay the same; there is no effect on stock prices from this reduction.
Ans: A
AACSB: Analytical Thinking
Blooms: Analyze
58. The impact from rapid dividend growth on a stock's current price will be:
a. negative, since the company is paying out profits to stockholders.

b. positive since rapid dividend growth causes stockholders to expect higher future dividends.
c. zero; only current dividends are used to determine the current price of a stock.
d. positive, but only if the corporation does not have any debt.
Ans: B
Blooms: Analyze
59. The theory of efficient markets assumes that:

a. prices of bonds, but not stocks, reflect all available information.
b. the prices of all financial instruments reflect all available information.
c. stock prices are relatively rigid because it takes a while for information to efficiently move
through the market.
d. the best approach to determining stock prices is to follow the chartists.
19
Ans: B
Difficulty: 01 Easy
Blooms: Remember
60. The theory of efficient markets implies:

a. stock prices should be highly unpredictable.
b. the price at which stocks currently trade only reflect past information.
c. expectations do not play a role in stock prices because this isn't real information.
d. the chartists are in fact correct that there are patterns in stock prices.
Ans: A
Blooms: Understand
61. The theory of efficient markets means

a. professional fund managers should be able to consistently beat the market average.
b. a professional fund manager should really not expect to beat the market average consistently.
c. a professional fund manager who beats the market average one year should be expected to beat
the market average the next year.
d. a professional fund manager who beats the market average one year should be expected to not
beat the market average the next year.
Ans: B
Blooms: Understand
62. The theory of efficient markets:

a. rules out high returns due to chance.
b. says insider information makes markets less efficient.
c. allows for higher than average returns if the investor takes higher than average risk.
d. assumes people have equal luck.
Ans: C
20
Blooms: Understand
63. The notion that stock prices reflect all current available information:
a. makes the risk of holding stocks greater.
b. indicates that mutual fund managers will not, on average, outperform market averages.
c. says stock prices should be more rigid than they are.
d. makes it easier to predict the movements in the price of a stock.
Ans: B
Blooms: Understand
64. People who claim to have the ability to accurately predict the future prices of stocks:
a. are strong advocates of the theory of efficient markets.
b. should be looked at with skepticism, unless they have information not available to others.
c. are unusually lucky, and should be listened to intently.
d. are always psychologists.
Ans: B
Difficulty: 03 Hard
Blooms: Analyze
65. In the first calendar quarter a company issues a surprising report saying that it expects profits to
rise in the fourth quarter. The theory of efficient markets says we should expect the price of the
company's stock to:
a. rise in the fourth quarter when the higher profits are actually seen.
b. fall immediately as stockholders will be disappointed about having to wait until the fourth
quarter for higher profits.
c. rise immediately on the expectation of higher profits in the future.
d. rise around the third quarter since this information will take time to disseminate.
Ans: C
Blooms: Analyze
21
66. According to the theory of efficient markets:
a. investors use rules of thumb to make choices about which stocks to buy and sell.
b. investors are able to use forecasts based on the dividend-discount model to generate above-
average returns.
c. a portfolio manager who charges no commission should not, on average, outperform an
individual investor with access to the same funds.
d. the stock price should remain constant.
Ans: C
Difficulty: 03 Hard
Blooms: Analyze
67. According to the theory of efficient markets, mutual fund managers may be expected to earn
above-average returns if they:
a. take on less risk.
b. have access to illegal, private information.
c. participate in efficient markets.
d. have learned from investing in the same stocks repeatedly.
Ans: B
Blooms: Understand
68. Stocks appear to present risk, yet many people have substantial parts of their wealth invested
in them. This behavior could be explained by:
a. people are irrational in their investment behavior, only focusing on positive outcomes.
b. people are not very risk-averse and do not require a risk premium for stocks.
c. investing in stocks over the long run is not as risky as short-term holdings of stocks
d. people are not efficient users of information.
Ans: C
Blooms: Understand
Topic: Investing in Stocks for the Long Run
22
69. Professor Jeremy Siegel, of the University of Pennsylvania, did research showing that:
a. owning stocks over the long run produces returns below the risk-free return.
b. if an investor owns stocks for a very short time the risk is greater than if the stocks are held for
a long time.
c. the return on the S&P 500 for a 25-year period often produces returns below zero.
d. bonds really are less risky to hold over the long term.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
70. Professor Jeremy Siegel, of the University of Pennsylvania, conducted research that showed
that:
a. over the long run, stocks have been less risky than bonds.
b. over the long run, bonds have been less risky than stocks.
c. over the long run, bonds frequently outperform stocks.
d. investors should only own stocks for short periods of time to maximize returns.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
71. Mutual funds are characterized by the fact that they all:
a. have the same management fee set by regulation.
b. require the same minimum investment of $10,000.
c. provide some degree of diversification.
d. provide the same degree of liquidity.
Ans: C
Blooms: Remember
72. Management fees for mutual funds are:

a. fixed by regulation.
b. fixed by regulation and can vary by the size of the fund. c.
usually a percentage of the gains the fund achieves.
23
d. usually a percentage of the funds under management.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
73. Management fees for mutual funds are:

a. different across funds and can significantly impact the return to an investor. b.
fixed by regulation.
c. fixed by regulation but can vary by the size of the fund.
d. usually a percentage of the return achieved by fund managers.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
74. Index funds are often preferred to other mutual funds because:
a. they offer greater diversification. b.
they are managed better.
c. they have greater liquidity.
d. on average they have lower management fees.
Ans: D
Blooms: Understand
75. When stock prices reflect fundamental values:

a. all investors will have positive returns.
b. the allocation of resources will be more efficient.
c. all companies will have an easier task of obtaining financing for investment projects. d.
the overall level of the stock market should move higher.
Ans: B
Blooms: Understand
24
76. The fact that returns from the stock market are less volatile over long-periods of time
suggests that:
a. investors are more risk averse over the long run. b.
stock markets are efficient.
c. people get comfortable with the stocks they own.
d. stock market bubbles have become more common.
Ans: B
Blooms: Understand
77. Stock market bubbles are:

a. the increase in a stock's price resulting from reported higher profits by a firm.
b. persistent and expanding gaps between stocks' actual prices and the prices warranted by the
fundamentals.
c. synonymous to stock market crashes.
d. those periods of time when the overall level of the stock market is rising at a slow rate
reflecting market fundamentals.
Ans: B
Blooms: Understand
78. Stock market bubbles typically lead to all of the following except:
a. an efficient allocation of resources. b.
stock market crashes.
c. patterns of volatile returns from the stock market.
d. gaps between actual stock prices and those warranted by the fundamentals.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
79. Which of the following could cause a stock market bubble?

a. Changes in the real interest rate
b. Better enforcement of insider trading laws
25
c. Investor euphoria
d. Changes in dividends
Ans: C
Difficulty: 01 Easy
Blooms: Remember
80. Why are stock market bubbles costly for the economy?
a. They imply that the actual stock price is equal to the fundamental value of the stock. b.
They hurt consumers more than corporations.
c. They lead to a reduction in real investment in both the short-term and long-term. d.
They lead to a misallocation of resources in both the short-term and long-term. Ans: D
Blooms: Understand
81. Companies whose stocks increase the most during a stock market bubble will:
a. have a difficult time raising investment capital. b.
tend to under-invest.
c. usually rebound faster once the bubble bursts.
d. find it difficult to put their capital to profitable use after the bubble bursts. Ans:
D
Blooms: Understand
82. The stock market bubble of the late 1990s and early 2000s:
a. saw internet and computer technology companies over-invest.
b. saw an efficient allocation of resources toward the high-growth computer/internet sector.
c. was a good example of the theory of efficient markets.
d. was an example that not all bubbles burst.
Ans: A
26
Blooms: Understand
83. Stock market bubbles impact consumers by:

a. encouraging greater consumption and greater saving.
b. encouraging greater consumption and less saving.
c. encouraging more work and delaying retirement.
d. resulting in less investment in home ownership and more into stocks.
Ans: B
Blooms: Understand
84. Some good did come from the internet bubble of the late 1990s. One good thing was that:
a. people learned they should not invest in dotcom companies.
b. start-up companies found they could bypass venture capitalists and raise funds directly from
the capital markets.
c. stock market bubbles do not have to result in an inefficient allocation of resources.
d. the theory of efficient markets doesn't always hold and consistently better-than-market returns
are achievable.
Ans: B
Blooms: Understand
85. The Nasdaq Composite Index:

a. is made of of mainly newer, smaller firms.
b. is a price-weighted index.
c. is made up of over 5000 companies traded on the NYSE.
d. is made of mainly older firms and is heavily weighted by manufacturing.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
27
Short Answer Questions
86. Explain why being a residual claimant can increase the risk from owning stocks.
Ans: The stockholders, being residual claimants, get what is left after everyone else has been
paid. While this can be substantial during good years, it also means that during bad years the
stockholders may get nothing, and if the corporation does poorly for a number of years, the
stockholders' investment can be lost.
Blooms: Understand
87. Does the concept of limited liability make owning stocks more or less attractive? Explain.
Ans: Limited liability makes owning stocks (equities) more attractive. Basically, limited liability
says an investor can only lose what he/she paid for the stock (invested) in the first place. This
clearly makes stock ownership more attractive.
Blooms: Understand
88. Explain why the willingness to purchase stocks is influenced heavily by shareholders' legal
rights with respect to control of the corporation.
Ans: Shareholders' legal rights include the ability to elect and dislodge the board of directors of a
corporation. The board can also dislodge managers and officers who are performing poorly. The
ability of stockholders to influence these choices enhances the attractiveness of owning shares and
therefore increases the willingness of individuals to purchase stocks.
Blooms: Understand
89. Why isn't the actual level of an index, for example the Dow Jones Industrial Average, very
useful on its own?
Ans: For many indexes, the real value is to be able to compute percentage changes in the index
over time. For example, the level of the consumer price index by itself conveys little
information, but percentage changes in the CPI allow us to measure the rate of inflation.
Similarly, in the case of the Dow Jones Industrial Average, the percentages changes are useful in
measuring the performance of the stocks (on average) that make up this index.
28
Blooms: Understand
90. You have a price-weighted index made up of two stocks, A and B. The price of A equals
$30 and the price of B equals $70. What is the current value of this index? Also, what will be the
percentage change in the index resulting from a 10 % increase only in the price of A? A 10%
increase only in the price of B?
Ans: The current value of the index is 50. This is determined by taking the current stock prices
and dividing by two, similar to the construction of the DJIA. If the price of A increases by 10%
this raises A's price to $33 and the value of the index to 51.5, or an increase of 3%. If only the
price of stock B increases by 10%, the price of B will rise to $77, and the index will have a value
of 53.5, or an increase of 7%.
Difficulty: 03 Hard
Blooms: Apply
91. Why does the Dow Jones Industrial Average have a value over 15,000 when the 30 stocks
that make up the index all have values less than $200 per share?
Ans: The DJIA accounts for stock splits over the years, which are reflected in the average but not
in the current price of the stock, and the companies included in the index change periodically.
Blooms: Understand
92. The Standard & Poor's 500 Index differs from the DJIA in at least two major respects. What
are the two major differences?
Ans: The S&P 500 Index differs from the DJIA in (1) that the S&P 500 is constructed from the
500 largest firms in the U.S. economy, where the DJIA uses 30 of the largest firms. Also, (2) the
S&P is a value-weighted index, meaning it reflects the total value of owning the entirety of the
500 firms. By contrast, in the DJIA the higher priced stocks carry more weight because it is a
price-weighted average. The S&P 500 gives more weight to the larger firms than the DJIA does.
Blooms: Understand
29
93. You have a value-weighted index made up of two companies. One company, we will call A,
has a stock price of $25 per share and there are 10,000 shares outstanding. The other company, we
will call B, has a stock price of $100 per share and has 1000 shares outstanding. What will be the
percentage change in the index from a 10% increase in the share price of company A? What will be
the percentage change in the index from a 10% increase in the share price of company B?
Ans: The value of company A is $250,000, which we obtain by taking the share price of $25 and
multiplying that by 10,000 shares outstanding. The value of company B is $100,000, which we
obtain by taking the share price of $1000 and multiplying by 1000 shares outstanding. A 10%
increase in the share price of A results in a market value of $275,000, which is a 10% increase.
The index however is constructed from the value of both companies, and the total value increases
from $350,000 to $375,000, or 7.14%. When the share price of B increases by 10%, the new
market value of the entire company is $110,000, ($110 × 1000), this increases the value of the
index to $360,000 from $350,000, or 2.86%.
Difficulty: 03 Hard
Blooms: Analyze
94. Compare/contrast the Nasdaq Composite Index with the Dow Jones Industrial Average.
Ans: The Nasdaq is a value-weighted index, where the DJIA is a price-weighted index. Also, the
Nasdaq is made up of many smaller, newer companies, recently dominated by technology and
internet companies, where the DJIA includes 30 of the largest firms in the U.S.
Blooms: Understand
95. Why must caution be employed in comparing stock indexes across countries?
Ans: Since stock indexes are made up of different companies and can be composed in different
ways, comparing indexes in terms of their levels is really useless, much as it really is of little
value to just look at the level of various indexes. What can be important and interesting is to
compare percentage changes in the various indexes and to see how they correlate or move
together.
Blooms: Understand
30
96. Briefly explain the different focus of valuing stocks taken by behavioralists, chartists, and
fundamentalists.
Ans: The behavioralists estimate the value of stocks based on their perceptions of investor
psychology and behavior. Chartists look for patterns in the price movements of a stock. And
others focus on the financial statements, where they determine a stock's fundamental value from
current assets and estimates of future profitability.
Blooms: Understand
97. Many small companies currently pay no dividends to their shareholders. Based on the
dividend discount model, how is it possible for these stocks to sell for a positive price?
Ans: According to the dividend discount model, the current price is equal to the present value of
future dividends to be paid on the stock. Therefore, while these small companies don't currently
pay dividends, investors may still buy stocks in these companies based on the expectation that
they will pay dividends in the future.
Blooms: Analyze
98. What price would an individual be willing to pay today for a stock he/she expects can be
sold for $200 one year from now, if the individual has a discount rate of 6% (.06) and the stock
pays an annual dividend of $7.50?
Ans: We can use the following formula to determine the price of the stock today:
Based on the information provided in the question, the Dnextyear = $7.50; the Pnext year = $200;
and the i = 0.06. With these values plugged into the equation, we determine the Ptoday to be
$195.75.
Blooms: Apply
31
99. What price would an individual be willing to pay today for a stock that is expected to sell
for $100 two years from now and which pays an annual dividend that is $6.00? Assume the
individual has a discount rate of 8% (0.08).
Ans: We can use the formula from the chapter to determine the price of the stock today:
Based on the information provided in the question; the D next year and Din two years will = $6.00. The Pin
two years will = $100.00 and i = (0.08) Ptoday will be $96.43.
Blooms: Apply
100. What price would an individual would be willing to pay for a stock that currently pays a
$5.00 annual dividend if the individual expects the dividend to grow by 4% (0.04) per year and
the individual has a discount rate of 6.0% (0.06)?
Ans: We can calculate the Ptoday by using equation 8 from the chapter: The equation,
where i is the discount rate, or in this case 0.06; g is the growth rate of the dividend, or in this
case 0.04; and the Dtoday is the current dividend of $5.00. Inserting these values into the
equation we solve for Ptoday and obtain $260.00
Blooms: Apply
101. After one year, a company will pay $20 in dividends. It commits to paying $21 two years from
the current date. This growth rate in dividends is expected to continue indefinitely. The interest rate
is 8%. Compute the current price of this stock, using the dividend-discount model.
Ans: First, we need to compute the growth rate of dividends, g. This is equal to 5% = ($21 -
$20)/$20.
Now, we can compute the price of the stock:
Ptoday = Dtoday(1 + g)/(i - g)
Ptoday = $20(1 + 0.05)/(0.08 - 0.05)
Ptoday = $700
Difficulty: 03 Hard
32
Blooms: Apply
102. Identify the ways in which a bondholder's rights differ from those of a stockholder. In what
ways do they differ when a firm is bankrupt?
Ans: Bondholders are not owners of the company, meaning that they are not entitled to a share of
the firm's profits, nor are they involved in the voting of the firm's managers. Stockholders are the
company's owners, so they are entitled to these things. If a firm is bankrupt, then its creditors
must be paid first. That is, the stockholders are residual claimants. They collect any remaining
assets once the bondholders (and other lenders) are paid. While the stockholders are owners of
the firm, their liability is limited in that the bondholders cannot collect losses from the
stockholders beyond the value of the company.
Blooms: Understand
103. This is a two-part question: We have a firm that needs $1000 to obtain a new machine for
its business. It can either issue stock or bonds, or some combination of both. If it issues bonds it
will have to pay $8.00 in interest for every $100 borrowed. Finally, assume the company will
earn $150 in good years and $75 in bad years, with equal probability. The first part of the
question is to (a) determine the payment to the equity holders under the following three
scenarios: (i) the first is the firm uses 0% debt financing; (ii) the second is the firm uses 50%
debt financing, and (iii) the third finds the firm using 80% debt financing.
The second part of the question is to (b) determine the expected equity return (%) under each
scenario.
Ans: The payment to the equity holders and the expected return are as follows, (i) for 0% debt
financing, the payment is $75 - $150; with an expected return of 11.25%; (ii) with 50% debt
financing the payment to equity holders will be $35 - $110; with an expected return of 14.5%;
and finally, (iii) with 80% debt financing, the payment to the equity holders will be $11 - $86;
with an expected return of 24.25%.
Difficulty: 03 Hard
Blooms: Apply
104. You make a $1,000 investment in the stock of ABC Inc. Over the next year the investment
decreases by 60%. What percentage increase do you need in the following year on your holding
to be back to $1,000?
Ans: We can employ the formula from the text: 100·
33
Using this formula, where d is the initial decline in the investment (60), the answer is 150%.
Blooms: Apply
105. The investment you made in a mutual fund one year ago lost 50% of its value over the past
year. What percentage increase is needed in the fund to restore your portfolio to the level it was
one year ago?
Ans: We can employ the formula from the text: 100·
Using this formula, where d is the initial decline in the investment (50), the answer is 100%.
Blooms: Apply
106. After one year, a company will pay $5 in dividends. It commits to paying $5.30 two years
from the current date. This growth rate for dividends is expected to continue indefinitely. The
U.S. Treasury bond yield is 8% and the equity-risk premium is equal to 2.5%. Compute the
required stock return and current price of this stock, using the dividend-discount model.
Ans: The required stock return is 10.5%. To find the price of the stock, we need to compute the
growth rate of dividends: 6% = ($5.3-$5)/$5. Now, we can compute the current price of the
stock:
Ptoday = Dtoday(1 + g)/(rf + rp - g)
Ptoday = $5(1 + 0.06)/(0.105 - 0.06)
Ptoday = $117.78
Difficulty: 03 Hard
Blooms: Apply
34
107. Considering the return an investor requires from a stock, what are the two components that
make up that return? Briefly explain each of these components.
Ans: We saw in the chapter; that the required stock return (i) = risk-free return (rf) + risk premium
(rp). The risk-free return is the interest rate the investor could earn on say a U.S. Treasury bond.
The risk premium is the compensation the investor requires due to
the fact that the future selling price of the stock is uncertain
Blooms: Understand
108. Discuss the effects on the current price of a stock from each of the following:
a) An increase in the growth rate of the dividend;
b) A decrease in the risk-free interest rate;
c) An increase in the equity-risk premium; and finally
d) A decrease in the annual dividend.
Ans: We can use the dividend-discount model to think through our answers:
where Dtoday is the current dividend; rf is the risk-free rate; rp is the risk premium; g is growth
rate of the dividend; we are measuring the impact on Ptoday. From the formula we see that an
increase in g will cause Ptoday to increase. In addition, a decrease in rf will also cause Ptoday to
increase. An increase in rp on the other hand will reduce Ptoday as will a decrease in the annual
dividend.
AACSB: Analytical Thinking Blooms:
Analyze
109. Why does the theory of efficient markets imply that stock price movements are
unpredictable?
Ans: If people could accurately forecast price movements in stocks, they would immediately act
on those forecasts, which would cause the price of the stocks to move today. When markets are
efficient, the price at which a stock currently trades reflects all available information, so the
future price movements are unpredictable.
Blooms: Analyze
35
110. Is the efficient markets hypothesis (EMH) responsible for the financial crisis of 2007-
2009?
Ans: Hardly. The hypothesis does not claim that the market price is always right. On the
contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is
not at all easy to say whether they are too high or too low. The fact that the best and brightest on
Wall Street made so many mistakes shows how hard it is to beat the market.
Blooms: Analyze
111. What possibilities exist to explain the claim made by many professional portfolio
managers that they can exceed the average stock market return year after year?
Ans: As the chapter points out there are four possibilities; 1) the managers have private or insider
information, which is illegal; 2) They are lucky; 3) They are taking on more risk which will
provide a higher return in some years but can also lead to lower than average returns for other
years; and 4) markets are not efficient.
Blooms: Understand
112. From the perspective of the theory of efficient markets, explain why it may be difficult for
professional portfolio managers who have an exceptional year to continuously outperform the
market average.
Ans: A professional money manager who has an exceptional year will attract a lot of attention
and money. The attention may be in the form of other professional managers who will copy the
actions of the successful manager. The additional money will require the manager to put these
funds to use which, due to the law of diminishing marginal returns, will also make it more
difficult to duplicate the return.
Blooms: Analyze
36
113. You hear someone claim that stocks are less risky than bonds. What possible evidence
could this person offer for such a claim?
Ans: Professor Jeremy Siegel's research points out that when held for the long run stocks are less
risky than if held for a very short time. In fact, Professor Siegel's research points out that
between the years 1871 and 1992 there was no 30-year period when bonds outperformed stocks.
Blooms: Understand
114. Use the five issues an investor should consider when purchasing stock to explain the
popularity of mutual funds.
Ans: (1) Affordability, (2) liquidity, (3) diversification, (4) management, and (5) costs are the
five issues that need to be considered, and mutual funds address these in one way or another.
Many mutual funds can be opened with relatively small amounts, they usually allow for
investors to sell their positions and withdraw their investment. Mutual funds are designed to
provide more diversification than what most individual investors could hope to achieve on their
own. Most are managed by professional managers and they provide different fees or costs for
these management services.
Blooms: Understand
115. Explain how a well-functioning stock market contributes to the efficiency of the economy.
Ans: If the prices of stocks reflect fundamental values, the resource allocation mechanism of the
stock market works well. With accurate signals investment resources flow to their most socially
beneficial uses.
Blooms: Understand
116. Identify at least two reasons an investor may want to consider an index fund over a managed
(mutual) fund. What are these reasons?
Ans: (1) Managed funds or mutual funds tended to perform worse than index funds. Also (2) the
fees for managed funds tend to run about 1.5% a year compared to 0.5% or less for index funds.
The lower fees, even at the same return, would provide an investor with a much higher return
over the long run.
37
Blooms: Understand
117. Discuss the inefficiencies that can be caused by stock market bubbles, especially focusing
on firms and consumers.
Ans: Stock market bubbles can lead to the inefficient allocation of investment funds. Those
companies that are positively affected by the bubble and see their stock prices increase will find
it relatively less expensive to raise funds and consequently may over-invest. On the other hand,
those firms who are not the object of stockholder euphoria will find it more expensive to attract
funds and as a result may under-invest. For consumers, the bubbles can lead to increased wealth
for some individuals who as a result may consume more, save less, buy expensive automobiles,
homes, vacations etc. These individuals may even work less or retire early. When the bubble
bursts these individuals are left trying to adjust, which can be not only inefficient but traumatic.
Also, the companies that geared up to provide these luxury goods are left to adjust. So the result
is the bubbles and their subsequent bursts result in real investment and spending that is
inefficient.
Blooms: Analyze
Essay Questions
118. Do the voting rights possessed by common stockholders ensure that managers and directors
have the same objectives as stockholders? Explain.
Ans: Not necessarily. Stockholders are usually interested in receiving the highest return possible
and may even desire the firm to take additional risk if it means higher compensation. The
managers and directors on the other hand may prefer job security and look at the increased risk
as decreasing this job security if the results are poor, so may steer away from opportunities that
stockholders would welcome. In fact, stockholders may not even be aware of the opportunities
because managers and directors do not present them. Also managers and directors may have their
own interests in the sense that they prefer to manage a "larger" firm, feeling it increases their
own individual influence and power. As a result they may propose mergers or acquisitions, or
additional layers of management which may not be in the best interest of the stockholders. In
economics, this is known as the principal-agent conflict and is the focus of significant research in
economics and management.
Blooms: Analyze
38
119. If you understood the discussion of the characteristics of common stocks, you should be
able to explain the following statement: One of the benefits from stock ownership is the
unlimited upside potential and the limited downside. What does this statement mean?
Ans: The common stockholders are residual claimants. This means that the most they can lose is
their original investment, which pertains to the limited downside. The company could perform
poorly, so poorly in fact that it could go bankrupt leaving many liabilities unpaid. For the
common stockholders though, their losses are limited to their original investment. On the other
hand, if the company is hugely successful, once the other liabilities are paid all, of the residuals
belong to the common stockholders. This means that the dividends and or the future price of the
stock will rise. There isn't a cap as to how large this potentially could be; it depends on the
management and the success of the company. Stockholders do not face a ceiling on potential
returns, which is the reason why the upside potential can be called "unlimited."
Blooms: Analyze
120. XYZ Inc. announces plans to finance the expansion of the firm by issuing hundreds of
millions of dollars of bonds. Discuss how the current stockholders of XYZ Inc. will feel about
this plan.
Ans: The common stockholders may have mixed feelings about this announcement. On one
hand, they may applaud the proposal because (as we saw in the chapter), the use of leverage by a
firm can increase the expected return to equity, which are the stockholders. On the other hand,
the stockholders are residual claimants, so the increased use of bonds means the company is
required to honor its liabilities to the bondholders (interest payments) before any profits are
distributed to the stockholders. If the expansion proves to be profitable it can certainly turn out to
be a good decision for the stockholders who may see the higher return from leverage. On the other
hand, if the company's estimate or forecast is wrong and the expansion does not prove profitable,
the stockholders will see a lower return than they would have without the expansion. This reflects
the trade-off presented by leverage discussed in the chapter. The expected return is increased but
so is the standard deviation of that return (risk).
Difficulty: 03 Hard
Blooms: Analyze
121. Discuss how changes in economic conditions are likely to affect the equity-risk premium
and stock prices. Considering the risks associated with investing in stocks (over short periods of
time), what types of investments would you expect investors to buy during an economic
recession?
39
Ans: If investors expect a recession, it is likely this will lead to an increase in the equity-risk
premium. The potential losses associated with stocks are greater during economic downturns, so
investors will have a higher required return on stock. All other things equal, this will lead to a
decrease in stock prices. During an economic recession, U.S. Treasury securities are relatively
more attractive than stocks, so we would expect that investors would purchase more of them
relative to equity shares. Recall that stockholders are residual claimants. With bankruptcy more
likely during a recession, the expected losses associated with being a residual claimant are
higher.
Blooms: Analyze
Topic: The Stock Market’s Role in the Economy
122. You are a top Treasury official for a developing country who has been asked
for advice on how to best open the nation's stock market to foreign investment.
Previously, the government did not permit foreigners to purchase domestic stock.
Now, the government has a plan to create two markets: one for domestic residents
and one for foreign investment. What are the potential drawbacks of this system,
compared to allowing both domestic and foreign investors to trade in the same
market? What are the larger implications for economic efficiency? How might the
government be able to address these issues?
Ans: The creation of two distinct markets will allow for a situation where the prices
of the same stock may be different in the two markets. From an efficiency
perspective, this is not a good thing. Ideally, those investors who value the stock
most should have access to purchase the stock, regardless of which market they are
located in. This separation of the two markets could lead to a misallocation of
resources. One way to deal with this misallocation is to allow companies the option
of issuing the number of shares that will allow them to equate the prices in both
markets. Difficulty: 03 Hard
Blooms: Analyze
123. Discuss whether the economy would be more or less efficient if public
corporations issued fewer shares of stock.
Ans: The economy would probably be less efficient. If corporations needed to raise
the same amount of capital but did so using fewer shares, the share prices would
increase. The result would be fewer participants in the equity markets and less
liquidity in the market which will decrease efficiency since stocks would be less
attractive. Also, with low share prices many more people participate in the stock
market which means a larger source of funds for companies seeking financing and
basic principles of economics tells us that the greater the supply, everything else
constant, the lower the price. And finally, with many more participants in the stock
40
market we have a market that performs closer to the competitive market model
where no one participant can exert considerable influence over the price. The
increased competition leads to not only greater efficiency due to lower prices, but a
better flow of information that allocates resources to their most efficient use.
Blooms: Analyze
41
42
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Chapter 08

Stocks, Stock Markets and Market Efficiency

1. A share of common stock represents a(n):

2. Two characteristics that make owning stock attractive are:

3. Voting rights in a corporation are held by the:

6. The concept of limited liability says a stockholder of a corporation:

7. Which of the following statements is most correct?

8. Which of the following is not a feature of common stock?

9. What do bondholders and stockholders have in common?

10. Which of the following statements is most correct?

12. An index number is valuable because:

13. The Dow Jones Industrial Average is:

14. The Dow Jones Industrial Average is a:

15. The Dow Jones Industrial Average:

23. Which of the following statements is not true?

25. The Nasdaq Composite Index is:

26. The most broadly based stock index in use is the:

28. When comparing stock indexes around the world we:

35. The dividend-discount model of stock valuation:

43. The dividend-discount model predicts that stock prices:

50. In the event of bankruptcy, stockholders:

a. A decrease in the risk-free return

a. to fall since the risk-free return will rise.

a. increase since the risk-free return is now lower.

a. negative, since the company is paying out profits to stockholders.

59. The theory of efficient markets assumes that:

60. The theory of efficient markets implies:

61. The theory of efficient markets means

62. The theory of efficient markets:

72. Management fees for mutual funds are:

73. Management fees for mutual funds are:

75. When stock prices reflect fundamental values:

77. Stock market bubbles are:

79. Which of the following could cause a stock market bubble?

83. Stock market bubbles impact consumers by:

85. The Nasdaq Composite Index:

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