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Discussion 1 – Organizational Forms of Business
Go to TeachMeFinance.com – and
read topics:
· Probability Distribution, Probability Distribution – Taking a Weighted Average
· Stock Valuation, Stock Valuation – The Present Value of Preferred Stock, Common Stock and the Gordon Growth Formula
This week’s discussion will focus on financial fraud and the implications on consumers and the financial markets.
Select ONE of the TWO topics below for your weekly discussion topic:
1) Research and discuss the Bernie Madoff Ponzi scheme. What does this story tell you about human nature? Discuss the role of the regulatory agencies and the reasons for not detecting the fraud? Analyze the impact of this type of fraud on the U.S. economy.
https://www.businessinsider.com/how-bernie-madoffs-ponzi-scheme-worked-2014-7
2) Research and discuss the Theranos scandal involving Elizabeth Holmes and Ramesh Balwani. What does this story tell you about human nature? Make sure to discuss how regulatory agencies and investors were not able to detect the fraud? Discuss how this type of fraud could impact consumer confidence.
https://www.smh.com.au/business/companies/blood-fraud-and-money-led-to-theranos-ceo-s-fall-from-grace-20180315-p4z4f8.html
https://leocontent.umgc.edu/content/umuc/tus/finc/finc331/2228/modules/finc330/m2-
module-2/s3-commentary.html#IV
Module 2: Financial Securities
Valuation and Characteristics of Stocks
In this section, we continue to use the previously developed concept of security valuation and
apply it to the second of the two principal securities—equities. Specifically, we will address the
characteristics and valuation of the two primary equities, preferred stock and common stock. We
begin by discussing the definition, characteristics, and valuation of preferred stock and conclude
by examining the definition, characteristics, and valuation of common stock.
The Characteristics and Valuation of Preferred Stock
Many consider preferred stock to be a hybrid security with characteristics of both common stock
and bonds. Preferred stock is similar to common stock in that it has no fixed repayment date, and
the firm is not obligated to pay dividends. Preferred stock is similar to bonds in that the periodic
payment amount is fixed. Preferred stock is normally issued by established, publicly traded firms
to raise capital without diluting the current investors’ common stock ownership. Because of the
flexibility of terms, preferred stock is also frequently used in the initial private financing of
startup companies.
Preferred Stock Characteristics
The following is a list of the significant characteristics of preferred stock as compared to the
other two securities, common stock and bonds.
• Preferred stock does not provide the preferred stockholder a claim to ownership or voting
rights in the firm.
• Preferred stock does entitle the stockholder to priority over the common stockholders in
claims on the firm’s assets in the event of bankruptcy.
• Preferred stockholders receive periodic dividends instead of interest, however, unlike
with bond interest, failure to pay the dividends is not a cause for bankruptcy.
• Multiple classes of preferred stock can be issued with each class having different
characteristics.
• Preferred stock normally carries a cumulative feature that requires that all past unpaid
preferred stock dividends must be paid in full before any common stock dividends can be
issued.
• Preferred stock may contain other varied protective and incentive provisions that are
designed to protect the investor’s investment.
• Preferred stock may contain a provision that allows it to be converted to a predetermined
number of shares of common stock (convertible preferred).
https://leocontent.umgc.edu/content/umuc/tus/finc/finc331/2228/modules/finc330/m2-module-2/s3-commentary.html#IV
https://leocontent.umgc.edu/content/umuc/tus/finc/finc331/2228/modules/finc330/m2-module-2/s3-commentary.html#IV
• Most preferred stocks are perpetuities (nonmaturing), however, retirement features are
frequently included. Two common retirement features are:
o callable provision, which allows preferred stock to be called at the issuer’s
request and retired, like a bond
o sinking fund provision, which requires the firm periodically to repurchase and
retire a set amount of the preferred stock
Preferred Stock Valuation
According to the general valuation theory, the value of preferred stock is equal to the sum of all
the cash flows generated from the investment, discounted by the investor’s required rate of
return. Because the only cash flow generated from preferred stock is the dividend payment, the
value of a preferred stock equals the present value of all the future preferred stock dividends.
Because a preferred stock is normally nonmaturing, and the dividends are expected to be paid in
equal amounts each year in perpetuity, the value of the preferred stock can be determined simply
by dividing the annual dividend by the required rate of return:
Vps = annual dividend/required rate of return
Vps = D/kps
where:
Vps = value of the preferred stock
D = annual dividend
kps = required rate of return
The Characteristics and Valuation of Common Stock
Common stock is the unique security that provides the investor a part ownership of a
corporation. It has no maturity date and entitles the common stockholder to common stock
dividends and a share in any appreciation of the firm’s stock value. On the downside, in the event
of bankruptcy and liquidation, the common stockholders have last claim on the assets of the firm,
after all creditors, bondholders, and preferred stockholders. Corporations issue common stock to
raise long-term capital without incurring the disadvantages of legal obligations to pay interest,
principal, or dividends.
Common Stock Characteristics
The following is a list of the significant characteristics of common stock as related to the other
two securities, preferred stock and bonds.
1. Common stockholders have the right to the residual income and assets of the corporation
after all bondholders, other debts, and preferred stockholders have been paid.
2. Common stockholders have the right to elect the corporation’s board of directors.
3. Common stockholders’ personal liability as owners of the corporation is limited to the
amount of their investment in the company (their original common stock investment
amount).
4. The issuance of additional new shares of common stock can dilute the percent of
ownership of the current common stockholders.
Common Stock Valuation
According to the general valuation theory, the value of common stock is equal to the sum of all
the cash flows generated from the investment, discounted by the investors’ required rate of
return. Because the only cash flow generated from common stock until sold is the dividend
payment, the value of a common stock equals the present value of all the future preferred stock
dividends.
In general, a common stockholder also receives a return on her or his common stock in one of
two ways:
1. an increase in market value, which is caused by a higher stock price—normally because
of higher actual or expected generated earnings, or
2. by common stock dividends, which are expected to increase with higher corporate
earnings
To calculate the value of a common stock (Vcs), we must discount all future expected dividends
(D1, D2, D2, …Dn) to the present at the stockholders’ required rate of return, kcs. Now because the
amount of the annual dividends is not fixed and is typically expected to increase with higher
corporate earnings, we require a new assumption for the future dividend amount. One simplified
assumption, which would apply to many growing companies, is to assume that the dividend
amount is increasing by a constant growth rate each year. With this assumption, we can
determine the common stock value as follows:
Vcs = D1/(kcs – g) + D2/(kcs – g) + D3(kcs – g) + — + Dn/(kcs – g)
The above common stock cash stream can be shown algebraically to reduce to the following
equation when g, the annual growth rate is a constant:
Vcs = D1/(kcs – g)
Interpreting the above formula, we see the common stock value is equal to the next expected
dividend in year 1 (D1)(divided by the net of the required rate of return (kcs), minus the growth
rate (g).
This formula can also be written to use the last issued (previous, dividend) D, and the annual
growth rate g:
Vcs = D(1 + g)/(Kcs – g)
where:
D1 = D(1 + g) = the next expected dividend
D0 = last or most recent dividend
g = annual growth rate
Vcc = value of common stock
Carefully note the relationship between the last issued (previous) dividend (Do) and the next
(expected) dividend D1 = D(1 + g).
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Introduction to
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Understanding Return
Portfolio Considerations
The Impact of News of Expected Returns
Risk
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Introduction to
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Diversification
Understanding the Security Market Line
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Expected Return
•
Variance
Understanding Return
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• In order to make investment decisions, investors often estimate the expected
return of a potential investment.
• Expected value is a concept that the helps investors assess the value of a
potential investment based on different future outcomes and a probability for each
outcome.
• Once you have categories for different scenario’s, along with probabilities and
returns in each scenario, you then calculate your expected return by multiplying
each probability by it’s respective outcome and adding these all together.
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• Any investment should be made taking time considerations and risk tolerance into
account. If there is a specific deadline for when the investment needs to be
matured (i.e. to generate retirement income, pay for a down payment on a house,
college tuition) then caution is required.
• Three different asset classes — stocks, bonds, money markets — range from
aggressive, to moderate, to conservative. An investment that is aggressive
typically features a higher expected return, but also a higher variance.
• Variance is calculated by calculating an expected return and summing a weighted
average of the squared deviations from the mean return.
Variance
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•
Portfolio Diversification and Weighting
•
Implications for Expected Returns
• Implications for Variance
Portfolio Considerations
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• Diversification is the idea of spreading a portfolio across different classes of
investments with a target weight attached to each class.
• Modern portfolio theory is the idea that for any investment objective, there is an
optimal mix of investments that can maximize expected return subject to a
specific risk threshold.
• Systemic risk is the risk that applies to a particular market or industry. It cannot be
diversified away. Specific risk is the risk that applies to one particular investment
within a market and it can be diversified away.
Portfolio Diversification and Weighting
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• Asset allocation is a theory of designing a portfolio that achieves a weighting
scheme with a target mix of different asset classes that is suitable to the time
frame and risk tolerance of the investor.
• The principals that support the theory of asset allocation are the cyclical nature of
investments within a particular class of assets and weaker or even negative
correlations that often exist across asset classes.
• When you re-balance your portfolio after it has deviated from the original target
mix, you are selling classes that have relatively appreciated in order to buy those
which have relatively depreciated.
• If you believe that markets go in cycles, you should believe in selling assets that
have relatively appreciated and buying those which have relatively depreciated.
Implications for Expected Returns
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• Portfolio managers often target a mix of assets across different categories that
maximize potential return and limit specific risk.
• Portfolio managers choose from many more classes of assets than the two that
have been used primarily for this chapter.
• With historical data, powerful software and a proficient financial analyst, a
correlation matrix can be produced that helps portfolio managers make
investment decisions that will limit the portfolio’s overall risk and exposure to
market downturns.
Implications for Variance
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•
Surprises and Returns
•
Announcements, News, and Returns
The Impact of News of Expected Returns
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• Surprise announcements that come from a company, its competition, or a supplier
or customer can affect the long run value of a stocks and bonds related to that
company.
• These announcements will often concern earnings, stages in a product
development cycle (FDA approval of a drug) or corporate structure changes (the
acquisition of a competitor) and can move a company’s outlook positively or
negatively.
• When the news is generally seen as positive, a company’s equity and debt
become more valuable on the secondary market, and its stock price will rise and
the effective yield on its debt instruments will fall.
Surprises and Returns
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• A company that is publicly traded must announce its earnings reports quarterly.
When the report matches analysts’ expectations, the stock’s price will not be
greatly affected. When it announces a report that is unexpected, it can affect the
stock price of a competitor or supplier as well.
• Beta is a metric used to signal the risk in a particular stock. Stocks with high beta
values fluctuate more on a day-to-day basis than those with lower beta values.
• Analysts constantly assess the health of public companies to assess the value of
its equity and debt instruments, and their outlook affects stock and bond prices in
secondary markets.
Announcements, News, and Returns
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Volatility begets volatility
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•
Types of Risk
•
Measuring Risk
Risk
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• Financial risk is associated to the chances that an investor might lose value in an
investment. It is separated into different sources of dec
line.
• Often the risks interact with each other and ultimately shock causes panic. Many
of the worst market crashes have been a result of widespread speculation and not
the devaluation of that asset itself.
• In the market crash of 2008, investors feared that some home owners would
default. It triggered a chain of events that shocked the whole world and left many
people in bad financial situations.
Types of Risk
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• The general progression in the risk-return spectrum is: short-term debt, long-term
debt, property, high-yield debt, and equity.
• When a firm makes a capital budgeting decision, they will wish, as a bare
minimum, to recover enough to pay the increased cost of goods due to inflation.
• Risk aversion is a concept based on the behavior of firms and investors while
exposed to uncertainty to attempt to reduce that uncertainty.
• Beta is a measure firms can use in order to determine an investment’s return
sensitivity in relation to overall market risk.
Measuring Risk
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•
Calculating Expected Portfolio Returns
•
Portfolio Risk
• Beta Coefficient for Portfolios
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• To calculate the expected return of a portfolio, you need to know the expected
return and weight of each asset in a portfolio.
• The figure is found by multiplying each asset’s weight with its expected return,
and then adding up all those figures at the end.
• These estimates are based on the assumption that what we have seen in the past
is what we can expect in the future, and ignores a structural view on the market.
Calculating Expected Portfolio Returns
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• Portfolios that are efficient investments are those that effectively diversify the
underlying risk away and price their investment efficiently.
• Portfolio risk takes into account the risk and weight of each individual position and
also the co-variances across different positions.
• To calculate the risk of a portfolio, you need each asset’s variance along with a
matrix of cross-asset correlations.
Portfolio Risk
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• In individual stocks, a beta coefficient compares how much a particular stock
fluctuates in value on a day-to-day basis.
• A beta coefficient for a portfolio of assets measures how that portfolio value
changes compared to a benchmark, like the S&P 500. A value of 1 suggests that
it fluctuates as much as the index and in the same direction.
• A beta coefficient of less than 1 suggests a portfolio that fluctuates less than the
benchmark. A negative beta is an indication that a portfolio moves in the opposite
direction of its benchmark.
Beta Coefficient for Portfolios
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•
Impact of Diversification on Risk and Return: Unsystematic Risk
•
Impact of Diversification on Risk and Return: Systematic Risk
Diversification
Introduction to Risk and Return > Diversification
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• Diversification is not putting all your eggs in one basket.
• Diversification relies on the lack of a tight positive relationship among the assets’
returns, and works even when correlations are near zero or somewhat positive.
• The debate over active vs passive management is one that takes on the limits to
diversification.
Impact of Diversification on Risk and Return: Unsystematic Risk
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An empirical example relating diversification to
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• Diversification is a technique for reducing risk that relies on the lack of a tight
positive relationship among the returns of various types of assets.
• The role of diversification is to narrow the range of possible outcomes.
• Unsystematic risk does not factor into an investment’s risk premium, since this
type of risk can be diversified away.
Impact of Diversification on Risk and Return: Systematic Risk
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The Security Market Line
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•
Expected Risk and Risk Premium
•
Defining the Security Market Line
• Impact of the SML on the Cost of Capital
Understanding the Security Market Line
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• In return for undertaking risk, investors expect to be compensated in such as a
way as to reasonably reward them.
• Systemic risk is the risk associated with an entire financial system or entire
market. It cannot be diversified away.
• Unsystematic risk is risk to which only specific classes of securities or industries
are vulnerable, and with proper grouping of assets it can be reduced or even
eliminated.
• Beta is a number describing the correlated volatility of an asset in relation to the
volatility of the benchmark that said asset is being compared to — usually the
market as expressed in an index.
• The term risk premium refers to the amount by which an asset’s expected rate of
return exceeds the risk-free interest rate.
Expected Risk and Risk Premium
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Beta
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• The security market line is the theoretical line on which all capital investments lie.
Investors want higher expected returns for more risk.
• On a graph, the line has risk on its horizontal axis (independent variable) and
expected return on the vertical axis (dependent variable).
• Assuming a linear relationship between risk and return, the assumption is that the
y-intercept is the return on a risk-free investment (the risk free rate), and the slope
is the premium on risk in terms of expected returns.
• Given two investments with the same expected return, investors would always
choose less risk. Someone with opposite preferences might better be called a
gambler.
Defining the Security Market Line
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The equation that defines the security market
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• The security market line is a hypothetical concept that suggests that investors
require compensation in the form of expected returns for the risk the investment
exposes them to.
• A capital investment below the security market wouldn’t be efficiently priced to the
buyer of the investment. A higher return or lower price would be required, both
increasing the cost of capital.
• A capital investment above the security market line wouldn’t be efficiently priced
for the seller or whomever raises the capital. A lower return or higher price would
be necessary to justify this cost of capital for the company.
Impact of the SML on the Cost of Capital
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Appendix
Key terms
• beta In finance, the Beta (β) of a stock or portfolio is a number describing the correlated volatility of an asset in relation to the
volatility of the benchmark that said asset is being compared to.
• beta Average sensitivity of a security’s price to overall securities market prices.
• capital asset pricing model In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate
required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset’s non-
diversifiable risk.
• Co-Variance In probability theory and statistics, co-variance is a measure of how much two random variables change together.
• Correlation Matrix A matrix that shows a set of correlations between two random variables over a number of observations.
• diversifiable risk the potential for loss which can be removed by investing in a variety of assets
• expected return The expected return of a potential investment can be computed by computing the product of the probability of a
given event and the return in that case and adding together the products in each discrete scenario.
• expected value The expected value of a random variable is the weighted average of all possible values that this random
variable can take on.
• inflation An increase in the general level of prices or in the cost of living.
• line of credit source of debt extended to a government, business or individual by a bank or other financial institution
• market risk the potential for loss due to movements in prices in a system of exchange
• market risk premium the amount by which expected rate of return of the exchange system exceeds the risk-free interest rate
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Introduction to Risk and Return
• mergers and acquisitions Mergers and acquisitions (M&A) is an aspect of corporate strategy, corporate finance, and
management dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help
an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other
child entity, or using a joint venture.
• Normalized variable In statistics, a normalized variable is one that is calculated using a ratio of itself and some benchmark
figure. Normalized figures tend to be smaller than the original values.
• portfolio The group of investments and other assets held by an investor.
• risk The potential (conventionally negative) impact of an event, determined by combining the likelihood of the event occurring
with the impact, should it occur.
• Risk free rate Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
• security market line Security market line (SML) is the representation of the capital asset pricing model. It displays the expected
rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta).
• standard deviation The standard deviation of an investment is obtained by taking the square root of the variance. It has a more
straightforward meaning than variance. It tells you that in a given year, you can expect an investment’s return to be one
standard deviation above or below the average rate of return.
• Strategic Asset Allocation The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal
balance between expected risk and return for a long-term investment horizon.
• systematic risk The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as
its beta.
• systematic risk systematic or non-diversifiable risk is a term given to the portion of risk in a portfolio that cannot be diversified
away by holding a pool of individual assets and therefore commands a return in excess of the risk-free-rate.
• systemic risk Refers to the risk common to all securities which cannot be diversified away.
• treasury bill Treasury bills (or T-Bills) mature in one year or less. They do not pay interest prior to maturity; instead they are sold
at a discount of the par value to create a positive yield to maturity.
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• Unsystematic risk Unsystematic or diversifiable risk is a term given to the portion of risk in a portfolio that can be diversified
away by holding a pool of individual assets.
• Variable Rate Mortgage A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan
with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on
the credit markets.
• variance In finance, variance is a term used to measure the degree of risk in an investment. It is calculated by finding the
average of the squared deviations from the mean rate of return.
• weighted average In statistics, a weighted average is an average that takes each object and calculates the product of its weight
and its figure and sums all of these products to produce one average. It is implied that all the individual weights add to 1.
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Introduction to Risk and Return
Volatility begets volatility
Data shown is from the period of Jan. 1990-Sep. 2009. Volatility is measured as the standard deviation of S&P 500 one-day returns over a month’s
period.
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An empirical example relating diversification to risk reduction
In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3,290
securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal
amounts held in each included asset, for various values of n. Their results are summarized in the following table. It can be seen that most of the gains
from diversification come for n≤30.
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The Security Market Line
This is an example of a security market line graphed. The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and
the slope is the premium that the market charges for risk.
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The Security Market Line
The location of a financial instrument above, below, or on the security market line will lead to consequences for a company’s cost of capital.
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Average Returns for Different Weighting Schemes
Different returns are expected for different asset allocations given historical averages
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The equation that defines the security market line.
Look at the equation and remember that old formula of a line: y = mx + b. In this case it looks rearranged, like y = b + mx, but the real question is what do
the slope and y-intercept actually represent?
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How much do investors want to pay to have to take the good with the bad?
Calculating variance is a 3 step process once expected return has been calculated. Calculate deviations from mean (blue), square the deviations
(yellow), multiply the squared deviation by its original probability (orange). Get brownie points by taking the square root of that number and interpret its
meaning in the form of a sentence.
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Variance of any portfolio
The formula shows that the overall variance in a portfolio is the sum of each individual variance along with the cross-asset correlations.
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Care to roll the dice?
Is a bet that doesn’t always pay out, but pays out big when it does a good bet? Is playing the lottery a good bet? Would it be a good bet if tickets were
only $0.10 instead of $1.00?
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The Security Market Line
Diversification theory says that the only risk that earns a risk premium is that which can’t be diversified away.
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World countries Standard & Poor’s ratings
An example of the credit ratings prescribed by Standard & Poor’s as a result of their respective long-term liability analysis for debt issued at the national
government level. Countries issue debt to build national infrastructure. Look how expensive it is to raise capital for such projects based on geographic
region.
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Inflation
Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.
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Illustration of Modern Portfolio Theory
Diversifying asset classes can reduce portfolio variance without diminishing expected return
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A Fruitful Portfolio
How would you calculate the expected return on this
portfolio?
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Calculating Beta
Two hypothetical portfolios; what do you think each Beta value is?
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Diversified Portfolio
Asset classes and their weightings for a particular portfolio
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Beta
Beta is a measure that relates the rate of return of an asset, ra, with the rate of return of a benchmark, rb.
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Introduction to Risk and Return
An investment portfolio has a 30% chance of earning $125,000 in
a year, a 40% chance of earning $50,000, a 15% chance of
earning nothing and 15% chance of losing $20,000. What is its
expected return?
A) $62,000
B) $54,500
C) $38,750
D) $50,000
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Introduction to Risk and Return
An investment portfolio has a 30% chance of earning $125,000 in
a year, a 40% chance of earning $50,000, a 15% chance of
earning nothing and 15% chance of losing $20,000. What is its
expected return?
A) $62,000
B) $54,500
C) $38,750
D) $50,000
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Introduction to Risk and Return
You have $20,000. You plan on purchasing a house in one year,
but you will need to have $22,500 for the downpayment. Which of
the following is a good investment opportunity to ensure you have
the money necessary to make your downpayment in a year?
A) A portfolio with an expected return of $24,000 and a standard
deviation of 10%.
B) A portfolio with an expected return of $30,000 and a standard
deviation of 15%.
C) A portfolio with an expected return of $27,000 and a standard
deviation of 20%.
D) All of these options would be a good investment.
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Introduction to Risk and Return
You have $20,000. You plan on purchasing a house in one year,
but you will need to have $22,500 for the downpayment. Which of
the following is a good investment opportunity to ensure you have
the money necessary to make your downpayment in a year?
A) A portfolio with an expected return of $24,000 and a standard
deviation of 10%.
B) A portfolio with an expected return of $30,000 and a standard
deviation of 15%.
C) A portfolio with an expected return of $27,000 and a standard
deviation of 20%.
D) All of these options would be a good investment.
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Introduction to Risk and Return
What factors should be considered when weighting an investment
portfolio?
A) The time frame of the investment.
B) The investor’s risk tolerance.
C) All of these answers.
D) The specific risks of the individual securities.
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Introduction to Risk and Return
What factors should be considered when weighting an investment
portfolio?
A) The time frame of the investment.
B) The investor’s risk tolerance.
C) All of these answers.
D) The specific risks of the individual securities.
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Introduction to Risk and Return
A portfolio has $70,000 of bonds and $30,000 of stock. The bonds
are 80% likely to have a 10% return and 20% likely to have a 0%
return. The stock is 50% likely to have a 20% return and 50%
likely to have a 10% loss. What is the expected return?
A) 5.9%
B) 2.9%
C) 13%
D) 7.1%
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Introduction to Risk and Return
A portfolio has $70,000 of bonds and $30,000 of stock. The bonds
are 80% likely to have a 10% return and 20% likely to have a 0%
return. The stock is 50% likely to have a 20% return and 50%
likely to have a 10% loss. What is the expected return?
A) 5.9%
B) 2.9%
C) 13%
D) 7.1%
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Introduction to Risk and Return
The adequately diversify your portfolio, you need to do more than
just own a variety of securities. Which of the following is a
necessary component of a well-diversified portfolio that has a low
variance?
A) The component securities have small or negative correlation
coefficients.
B) The portfolio’s components are in a variety of asset classes, such as
commodities and derivatives.
C) The portfolio is reviewed and rebalanced based on updated
projections and new information.
D) All of these answers.
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Introduction to Risk and Return
The adequately diversify your portfolio, you need to do more than
just own a variety of securities. Which of the following is a
necessary component of a well-diversified portfolio that has a low
variance?
A) The component securities have small or negative correlation
coefficients.
B) The portfolio’s components are in a variety of asset classes, such as
commodities and derivatives.
C) The portfolio is reviewed and rebalanced based on updated
projections and new information.
D) All of these answers.
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Introduction to Risk and Return
A potential merger is announced between Company A and B.
Which of the following is a potential response to that
announcement?
A) Company A’s stock is downgraded, because analysts believe the
merger signals A is financially weak.
B) All of these answers.
C) Company A’s stock is upgraded because analysts believe the merger
will increase its marketshare.
D) Nothing happens because analysts picked up on signals prior to the
announcement that the merger would occur.
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Introduction to Risk and Return
A potential merger is announced between Company A and B.
Which of the following is a potential response to that
announcement?
A) Company A’s stock is downgraded, because analysts believe the
merger signals A is financially weak.
B) All of these answers.
C) Company A’s stock is upgraded because analysts believe the merger
will increase its marketshare.
D) Nothing happens because analysts picked up on signals prior to the
announcement that the merger would occur.
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Introduction to Risk and Return
In which of the following ways can technical analysts use a
company’s announcements, news and returns to determine
whether to buy the company’s stock?
A) They can review the company’s press releases to analyze its
competitive advantages.
B) They can use the returns to study the company’s growth patterns and
stock price fluctuations.
C) They can review the company’s press releases to evaluate the
company’s managerial competence.
D) All of these answers.
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Introduction to Risk and Return
In which of the following ways can technical analysts use a
company’s announcements, news and returns to determine
whether to buy the company’s stock?
A) They can review the company’s press releases to analyze its
competitive advantages.
B) They can use the returns to study the company’s growth patterns and
stock price fluctuations.
C) They can review the company’s press releases to evaluate the
company’s managerial competence.
D) All of these answers.
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Introduction to Risk and Return
A company issues a bond with the provision that it may pay off the
debt early. This bond is subject to which type of
risk?
A) Prepayment risk.
B) Model risk.
C) Interest rate risk.
D) All of the above.
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Introduction to Risk and Return
A company issues a bond with the provision that it may pay off the
debt early. This bond is subject to which type of risk?
A) Prepayment risk.
B) Model risk.
C) Interest rate risk.
D) All of the above.
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Introduction to Risk and Return
A relatively new tech company issues a bond that is publicly
traded. The company is based in the US and pays interest in
dollars. The potential investor lives in the UK. Which of the
following risks does the investor face if he buys the bond?
A) Market risk.
B) Foreign investment risk.
C) Credit risk.
D) All of these answers.
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Introduction to Risk and Return
A relatively new tech company issues a bond that is publicly
traded. The company is based in the US and pays interest in
dollars. The potential investor lives in the UK. Which of the
following risks does the investor face if he buys the bond?
A) Market risk.
B) Foreign investment risk.
C) Credit risk.
D) All of these answers.
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Introduction to Risk and Return
Using the Value at Risk methodology, an investment advisor says
that she is 90% sure that her investment portfolio will not lose
more than $250,000 in a given day. Based on that description,
which of the following statements is true?
A) It is 90% sure that the portfolio will not earn more than $250,000 in a
given day.
B) Investors should expect to see losses 1 out of every 10 days.
C) The portfolio will lose more than $250,000 every month.
D) All of these answers.
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Introduction to Risk and Return
Using the Value at Risk methodology, an investment advisor says
that she is 90% sure that her investment portfolio will not lose
more than $250,000 in a given day. Based on that description,
which of the following statements is true?
A) It is 90% sure that the portfolio will not earn more than $250,000 in a
given day.
B) Investors should expect to see losses 1 out of every 10 days.
C) The portfolio will lose more than $250,000 every month.
D) All of these answers.
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Introduction to Risk and Return
A portfolio has a 95% certainty that it won’t lose more than
$50,000 in a given day. On the big loss days, there is a 30%
chance the portfolio will lose $50,000 and a 70% chance it will
lose $75,000. What is the portfolio’s expected shortfall?
A) ES_0.05 = $57,500
B) ES_0.05 = $67,500
C) ES_0.95 = $67,500
D) ES_0.95 =$57,500
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Introduction to Risk and Return
A portfolio has a 95% certainty that it won’t lose more than
$50,000 in a given day. On the big loss days, there is a 30%
chance the portfolio will lose $50,000 and a 70% chance it will
lose $75,000. What is the portfolio’s expected shortfall?
A) ES_0.05 = $57,500
B) ES_0.05 = $67,500
C) ES_0.95 = $67,500
D) ES_0.95 =$57,500
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Introduction to Risk and Return
A portfolio is composed of 30% stock, 20% bonds, and 50%
mutual funds. The stock is expected to have a 10% return, the
bonds a 5% return and the mutual funds a 7% return. What is the
expected return of the portfolio?
A) 7.3%
B) 7%
C) 8.1%
D) 7.5%
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Introduction to Risk and Return
A portfolio is composed of 30% stock, 20% bonds, and 50%
mutual funds. The stock is expected to have a 10% return, the
bonds a 5% return and the mutual funds a 7% return. What is the
expected return of the portfolio?
A) 7.3%
B) 7%
C) 8.1%
D) 7.5%
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Introduction to Risk and Return
A portfolio is composed of 80% stock and 20% bonds. The
variance of stock is 170 and the variance of bonds is 140. The
covariance is 30. What is the portfolio’s variance?
A) 114
B) 119
C) 101
D) 168
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Introduction to Risk and Return
A portfolio is composed of 80% stock and 20% bonds. The
variance of stock is 170 and the variance of bonds is 140. The
covariance is 30. What is the portfolio’s variance?
A) 114
B) 119
C) 101
D) 168
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Introduction to Risk and Return
Over a period of three days, a company stock increased by 4%,
decreased by _______%, then increased by 6%. During that
same period, the Dow Jones increased by _______%, decreased
by 1% , and then increased by 3%. What is the company’s beta?
A) -2
B) 2
C) 0.5
D) -0.5
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Introduction to Risk and Return
Over a period of three days, a company stock increased by 4%,
decreased by _______%, then increased by 6%. During that
same period, the Dow Jones increased by _______%, decreased
by 1% , and then increased by 3%. What is the company’s beta?
A) -2
B) 2
C) 0.5
D) -0.5
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Introduction to Risk and Return
Under the capital asset pricing model (CAPM), what beta value is
considered risky?
A) A beta equal to 0
B) A beta above 1
C) A beta between 0 and 1
D) None of these
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Introduction to Risk and Return
Under the capital asset pricing model (CAPM), what beta value is
considered risky?
A) A beta equal to 0
B) A beta above 1
C) A beta between 0 and 1
D) None of these
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Introduction to Risk and Return
Which of the following accurately describes unsystemic risk?
A) Unsystemic risk can be diversified away.
B) All of these answers.
C) Unsystemic risk is correlated to investing in only one company or
security.
D) A company losing a lawsuit which creates a massive legal liability is an
example of unsystemic risk.
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Introduction to Risk and Return
Which of the following accurately describes unsystemic risk?
A) Unsystemic risk can be diversified away.
B) All of these answers.
C) Unsystemic risk is correlated to investing in only one company or
security.
D) A company losing a lawsuit which creates a massive legal liability is an
example of unsystemic risk.
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Introduction to Risk and Return
Which of the following statements accurately describes systemic
risk?
A) By diversifying your stock portfolio, you can minimize systemic risk.
B) Systemic risk is what provides a stock its “risk premium.”
C) An example of a systemic risk is if you own stock in a company that
has liquidity problems.
D) All of these answers.
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Introduction to Risk and Return
Which of the following statements accurately describes systemic
risk?
A) By diversifying your stock portfolio, you can minimize systemic risk.
B) Systemic risk is what provides a stock its “risk premium.”
C) An example of a systemic risk is if you own stock in a company that
has liquidity problems.
D) All of these answers.
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Introduction to Risk and Return
A stock has a beta of 0.75 in relation to the Dow Jones Industrial
Index. Today, the Dow Jones increased by 2%. Based on its beta,
predict what happened to the stock’s price.
A) The stock’s price increased by less than 2%.
B) The stock’s price increased by 2%.
C) The stock’s price increased by more than 2%.
D) The stock’s price decreased by less than 2%.
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Introduction to Risk and Return
A stock has a beta of 0.75 in relation to the Dow Jones Industrial
Index. Today, the Dow Jones increased by 2%. Based on its beta,
predict what happened to the stock’s price.
A) The stock’s price increased by less than 2%.
B) The stock’s price increased by 2%.
C) The stock’s price increased by more than 2%.
D) The stock’s price decreased by less than 2%.
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Introduction to Risk and Return
Which of the following statements regarding the Security Market
Line (SML) is true?
A) The x-intercept of the SML is equal to the risk-free interest rate.
B) The SML graphs unsystematic risk
C) The slope of the SML is equal to the market risk premium and reflects
the risk-return trade off.
D) All of these answers.
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Introduction to Risk and Return
Which of the following statements regarding the Security Market
Line (SML) is true?
A) The x-intercept of the SML is equal to the risk-free interest rate.
B) The SML graphs unsystematic risk
C) The slope of the SML is equal to the market risk premium and reflects
the risk-return trade off.
D) All of these answers.
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Introduction to Risk and Return
A company’s security is priced above the security market line.
Which of the following statements regarding that security is true?
A) This isn’t an attractive market situation for a potential investor looking
to purchase the security.
B) This is not an attractive market situation for the company issuing the
security.
C) The security is fairly priced for the amount of expected return.
D) All of these answers.
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Introduction to Risk and Return
A company’s security is priced above the security market line.
Which of the following statements regarding that security is true?
A) This isn’t an attractive market situation for a potential investor looking
to purchase the security.
B) This is not an attractive market situation for the company issuing the
security.
C) The security is fairly priced for the amount of expected return.
D) All of these answers.
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Attribution
• Wikipedia. “Fundamental analysis.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Fundamental_analysis
• Wikipedia. “Technical analysis.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Technical_analysis
• Wiktionary. “beta.” CC BY-SA 3.0 http://en.wiktionary.org/wiki/beta
• Wikipedia. “Fundamental analysis.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Fundamental_analysis
• Wikipedia. “Technical analysis.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Technical_analysis
• Wikipedia. “Public company.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Public_company
• Wikipedia. “mergers and acquisitions.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/mergers%20and%20acquisitions
• Wikibooks. “Real Estate Financing and Investing/Understanding Return and Risk.” CC BY-SA 3.0
http://en.wikibooks.org/wiki/Real_Estate_Financing_and_Investing/Understanding_Return_and_Risk#Risk_and_the_Risk-
Return_Trade_Off
• Wikipedia. “Beta (finance).” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Beta_(finance)
• Wikipedia. “Interest.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Interest
• Wikipedia. “Risk aversion.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_aversion
• Wiktionary. “inflation.” CC BY-SA 3.0 http://en.wiktionary.org/wiki/inflation
• Wiktionary. “systematic risk.” CC BY-SA 3.0 http://en.wiktionary.org/wiki/systematic+risk
• Wikipedia. “Risk-return spectrum.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk-return_spectrum
• Wikipedia. “Security market line.” CC BY-SA 3.0 http://en.wikipedia.org/wiki/Security_market_line
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Stock Valuation
Defining Stock
Types of Stock
Rules and Rights of Common and
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Valuing the Corporation
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Ownership Nature of Stock
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Control and Preemption
Defining Stock
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• The stock (capital stock) of a company or business entity is equal to the original
capital paid into the business by its
founders.
• Stock serves as a security for creditors and investors in the business. While it
may fluctuate in value, it is different from the assets and property of a business.
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Ownership Nature of Stock
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• Shareholders gain certain rights with regards to a business entity when
purchasing stock. These include being able to sell shares, voting rights and
dividends.
• Shareholders have the right of preemption, meaning they have the first chance at
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• Even if shareholders do have the option of using their preemptive right, they do
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Control and Preemption
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Common Stock
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Types of Stock
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• Common stock is a form of equity ownership. It is a type of security that is also
known as a voting share or an ordinary share.
• Common stock shareholders will not receive assets after bankruptcy unless the
bondholders, other creditors, and preferred shareholders are paid first. Common
shareholders also do not get dividends unless preferred shareholders receive
them first.
• Common shareholders do receive voting rights. Some shareholders may also be
able to exercise preemptive rights.
Common Stock
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• Preferred Stock is a security which has characteristics of both equity and debt
securities.
• Preferred Stock shareholders have rights to dividends and assets (in the case of
bankruptcy) before Common Stock shareholders.
• Preferred stockholders have a number of rights which will vary based on the
business entity, but generally do not carry voting rights.
Preferred Stock
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Claim to Income
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Voting Right
• Purchasing New Shares
• Preferred Stock Rules and Rights
• Provisions of Preferred Stock
• Comparing Common Stock, Preferred Stock, and Debt
Rules and Rights of Common and Preferred Stock
Stock Valuation > Rules and Rights of Common and Preferred Stock
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• Common stock and preferred stock are both forms of equity ownership but carry
different rights and claims to income.
• Preferred stock shareholders will have claim to assets over common stock
shareholders in the case of company liquidation.
• Preferred stock also has first right to dividends.
Claim to Income
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• Common stock shareholders can generally vote on issues, such as members of
the board of directors, stock splits, and the establishment of corporate objectives
and policy.
• While having superior rights to dividends and assets over common stock,
generally preferred stock does not carry voting rights.
• Many of the voting rights of a shareholder can be exercised at annual general
body meetings of companies. An annual general meeting is a meeting that official
bodies, and associations involving the general public, are often required by law to
hold.
Voting Right
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• New share purchase is an important indicator of current shareholder belief in the
health of the company and long term prospects for growth.
• Current Shareholders will often have preemptive rights that give them the right to
purchase newly issued company shares before they go on sale to the general
public.
• New shares can be purchased on exchanges, which offer a platform for the
financial marketplace.
Purchasing New Shares
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• Preferred stock generally does not carry voting rights, but this may vary from
company to
company.
• Preferred stock can gain cumulative dividends, convertibility to common stock,
and callability.
• The rights that come with ownership of preferred stock are detailed in a
“Certificate of Designation”.
Preferred Stock Rules and Rights
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• If a preferred share has cumulative dividends, then it contains the provision that
should a company fail to pay out dividends at any time at the stated rate, then the
issuer will have to make up for it as time goes on.
• Convertible preferred stock can be exchanged for a predetermined number of
company common
stock shares.
• Often times companies will keep the right to call or buy back preferred shares at a
predetermined price.
• Participating preferred issues offer holders the opportunity to receive extra
dividends if the company achieves predetermined financial goals.
• Sometimes, dividends on preferred shares may be negotiated as floating; they
may change according to a benchmark interest-rate index.
Provisions of Preferred Stock
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• Common stock and preferred stock fall behind debt holders as creditors that
would receive assets in the case of company liquidation.
• Common stock and preferred stock are both types of equity ownership. They
receive rights of ownership in the company, such as voting and dividends.
• Debt holders often receive a bond for lending and while this does not give the
ownership rights of being a stockholder, it does create a superior claim to a
company’s assets in the case of liquidation.
Comparing Common Stock, Preferred Stock, and Debt
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A bond from the Dutch East India Company
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•
Market Actors
•
NYSE
• NASDAQ
• Market Reporting
Stock Markets
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• Pension funds are important shareholders of listed and private
companies.
• Insurance companies are generally classified as either mutual or proprietary
companies.
• A mutual fund is a type of professionally-managed collective investment vehicle
that pools money from many investors to purchase securities.
• An index fund or index tracker is a collective investment scheme (usually a mutual
fund or exchange-traded fund) that aims to replicate the movements of an index
of a specific financial market, or a set of rules of ownership that are held constant,
regardless of market conditions.
• An exchange-traded fund (ETF) is an investment fund traded on stock exchanges,
much like stocks.
• A hedge fund is an fund that can undertake a wider range of investment and
trading activities than other funds. It is generally only open to certain types of
investors specified by regulators.
Market Actors
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• The origin of the NYSE can be traced to May 17, 1792, when the Buttonwood
Agreement was signed by 24 stockbrokers outside of 68 Wall Street in New York
under a buttonwood tree on Wall Street.
• The New York Stock Exchange (sometimes referred to as “the Big Board”)
provides a means for buyers and sellers to trade shares of stock in companies
registered for public trading.
• The New York Stock Exchange is open for trading Monday through Friday from
9:30 am to 4:00 pm ET, with the exception of holidays declared by the NYSE in
advance.
• Traders can gather around the appropriate post. There, a specialist broker acts as
an auctioneer in an open outcry auction market environment to bring buyers and
sellers together and to manage the actual auction.
• To be listed on the New York Stock Exchange, a company must have issued at
least a million shares of stock worth $100 million and must have earned more
than $10 million over the last three years.
NYSE
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• NASDAQ was founded in 1971 by the National Association of Securities Dealers
(NASD), who divested themselves of it in a series of sales in 2000 and 2001.
• NASDAQ quotes are available at three levels: Level 1 shows the highest bid and
lowest offer; Level 2 shows all public quotes of market makers; Level 3 is used by
the market makers and allows them to enter their quotes and execute orders.
• NASDAQ has a pre-market session from 7:00am to 9:30am, a normal trading
session from 9:30am to 4:00pm, and a post-market session from 4:00pm to
8:00pm (all times in ET).
• Three market tiers are NASDAQ Capital Market – Small Cap, NASDAQ Global
Market – Mid Cap, NASDAQ Global Select Market – Large Cap.
NASDAQ
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• The is a tool used by investors and financial managers to describe the market and
to compare the return on specific investments.
• An index is a mathematical construct, so it may not be invested in directly.
• A ‘world’ or ‘global’ stock market index includes (typically large) companies without
regard for where they are domiciled or traded.
• A ‘national’ index represents the performance of the stock market of a given
nation—and by proxy, reflects investor sentiment on the state of its
economy.
• Stock market indices provide invaluable information for investors and
accountants.
Market Reporting
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•
Expected Dividends, No Growth
•
Expected Dividends and Constant Growth
• Relationship Between Dividend Payments and the Growth Rate
• Understanding Future Stock Value
• Valuing Nonconstant Growth Dividends
Stock Valuation
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• Companies generally either retain earnings for investment, or distribute them as
dividend, according to their growth strategy.
• Clientele effects suggests that different dividend levels attract different types of
investors.
• Value investors look for indications that a stock is undervalued. High dividends
are one indication of undervaluation.
• Knowing a firm’s cost of capital is needed in order to make better decisions.
Managers make capital budgeting decisions while capital providers make
decisions about lending and investment.
Expected Dividends, No Growth
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• Companies are constantly changing, as well as the economy. Solely using
historical growth rates to predict the future is not an acceptable form of valuation.
Calculating the future growth rate requires personal investment research.
• A generalized version of the Walter model (1956), SPM considers the effects of
dividends, earnings growth, as well as the risk profile of a firm on a stock’s value.
• The Gordon model or Gordon’s growth model is the best known of a class of
discounted dividend models. It assumes that dividends will increase at a constant
growth rate (less than the discount rate) forever.
Expected Dividends and Constant Growth
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• Investors take into account how much capital is distributed to investors, and
conversely how much capital is kept from investors.
• Investors hope that firms will use retained earnings to either maximize their
current operations or invest in such as a way as to lead to higher profits.
• Some firms are unable to distribute earnings, since their funds are tied up in
maintenance, repairs, et cetera.
• On the other hand, some companies can retain earnings and put that money back
to work – i.e., invest in growth opportunities.
Relationship Between Dividend Payments and the Growth Rate
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• Earnings Per Share is the total net income of the company divided by the number
of shares outstanding; the Profits/Earnings ratio is the stock price divided by the
annual EPS figure.
• Return on Invested Capital measures how much money the company makes each
year per dollar of invested capital and approximates the expected level of growth;
Return on Assets measures the company’s ability to make money from its assets.
• To measure Market Capitalization (the value of all of a company’s stock), multiply
the current stock price by the fully diluted shares outstanding; Enterprise Value is
equal to the total value the company is trading for on the stock market.
• Enterprise Value (EV) to earnings before interest, taxes, depreciation and
amortization (EBITDA) is one of the best measurements of whether or not a
company should be valued as cheap or expensive.
Understanding Future Stock Value
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• Limited high-growth approximation: When a stock has a significantly higher
growth rate than its peers, it is sometimes assumed that the earnings growth rate
will be sustained for a short time (say, 5 years), and then the growth rate will
revert to the mean.
• Implied Growth Models: One can use the Gordon model or the limited high-growth
period approximation model to impute an implied growth estimate.
• Imputed growth acceleration ratio: Subsequently, one can divide this imputed
growth estimate by recent historical growth rates.
Valuing Nonconstant Growth Dividends
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• Valuing the Corporation
•
Discounted Dividend vs. Corporate Valuation
Valuing the Corporation
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• Income approaches include Discount or capitalization rates, Capital Asset Pricing
Model (CAPM), Modified Capital Asset Pricing Model, and Weighted average cost
of capital (“WACC”).
• The asset approach to business valuation is based on the principle of substitution:
no rational investor will pay more for the business assets than the cost of
procuring assets of similar economic utility.
• The market approach to business valuation is rooted in the economic principle of
competition: in a free market the supply and demand forces will drive the price of
business assets to a certain equilibrium.
Valuing the Corporation
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• P = D1 / ( r – g ). P is the current stock price, g is the constant growth rate in
perpetuity expected for the dividends, r is the constant cost of equity for that
company, and D1 is the value of the next year’s dividends.
• The equation can also be understood to generate the value of a stock such that
the sum of its dividend yield (income) plus its growth (capital gains) equals the
investor’s required total return.
• There are also problems with the model, such as the presumption of a steady and
perpetual growth rate less than the cost of capital may not be reasonable.
Discounted Dividend vs. Corporate Valuation
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Appendix
Key terms
• bond A bond is an instrument of indebtness of the bond issuers toward the bond holders.
• bond A bond is an instrument of indebtness of the bond issuers toward the bond holders.
• break-even Break-even (or break even) is the point of balance between making either a profit or a loss.
• Callable shares Shares which can be bought back by the issuer at a predetermined price.
• capital gains Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.
• clientele The body or class of people who frequent an establishment or purchase a service, especially when considered as
forming a more-or-less homogeneous group of clients in terms of values or habits.
• closed-end Closed-end funds (or closed-ended funds) are mutual funds with a fixed number of shares (or units). Unlike open-
end funds, new shares/units are not created by managers, to meet demand from investors, but the shares can only be
purchased (and sold) in the market.
• Common stock Common stock is a form of equity and type of security. Common stock shareholders are at the bottom of the
line when it comes to dividends and receiving compensation in the case of bankruptcy.
• Common stock Common stock is a form of equity and type of security. Common stock shareholders are at the bottom of the
line when it comes to dividends and receiving compensation in the case of bankruptcy.
• Common stock Common stock is a form of corporate equity ownership, a type of security.
• Common stock Shares of an ownership interest in the equity of a corporation or other entity with limited liability. Holders of this
type of stock are entitled to dividends. Importantly, the financial rights for holders of this type of stock are junior to preferred
stock and liabilities.
• Common stock Common stock is a form of equity and type of security. Common stock shareholders are at the bottom of the
line when it comes to dividends and receiving compensation in the case of bankruptcy.
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Stock Valuation
• Convertible preferred stock Convertible preferred stock can be exchanged for a predetermined number of company common
stock shares.
• corporation a group of individuals, created by law or under authority of law, having a continuous existence independent of the
existences of its members, and powers and liabilities distinct from those of its members
• Cumulative Dividends Condition where owners of certain shares will receive accumulated dividends in the case a company
cannot pay out dividends at the stated rate at the stated time.
• DCF models Valuation using discounted cash flows is a method for determining the current value of a company using future
cash flows adjusted for time value. The future cash flow set is made up of the cash flows within the determined forecast period
and a continuing value that represents the cash flow stream after the forecast period.
• discounted cash flow In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using
the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)–
the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or
price of the cash flows in question.
• dividend Dividends are payments made by a corporation to its shareholder members.
• Dutch auction an event to buy or sell that starts at a high price that is gradually reduced by the auctioneer until someone is
willing to buy
• equity The residual claim or interest to investors in assets after all liabilities are paid. If liability exceeds assets, negative equity
exists and can be purchased through stock.
• FINRA In the United States, the Financial Industry Regulatory Authority, Inc., or FINRA, is a private corporation that acts as a
self-regulatory organization (SRO). FINRA is the successor to the National Association of Securities Dealers, Inc. (NASD).
Though sometimes mistaken for a government agency, it is a non-governmental organization that performs financial regulation
of member brokerage firms and exchange markets. The government organization which acts as the ultimate regulator of the
securities industry, including FINRA, is the Securities and Exchange Commission.
• GAAP Generally Accepted Accounting Principles refer to the standard framework of guidelines, conventions, and rules
accountants are expected to follow in recording, summarizing, and preparing financial statements in any given jurisdiction.
• Gordon Growth Model Gordon Growth Model is also called the dividend discount model (DDM), which is a way of valuing a
company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.
• liquidation liquidation is the process by which a company (or part of a company) is brought to an end, and the assets and
property of the company redistributed
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Stock Valuation
• market capitalization The total market value of the equity in a publicly traded
entity.
• Miller-Modigliani hypothesis The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern
thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in
the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a
firm is unaffected by how that firm is financed.
• NASDAQ The National Association of Securities Dealers Automated Quotations; this is an electronic stock market.
• net asset value Net asset value (NAV) is the value of an entity’s assets less the value of its liabilities, often in relation to open-
end or mutual funds, since shares of such funds registered with the U.S.
• open-end An open-end(ed) fund is a collective investment scheme which can issue and redeem shares at any time.
• Preemption The right of a shareholder to purchase newly issued shares of a business entity before they are available to the
general public so as to protect individual ownership from dilution.
• Preemption The right of a shareholder to purchase newly issued shares of a business entity before they are available to the
general public so as to protect individual ownership from dilution.
• preemptive right a contractual ability to acquire certain property newly coming into existence before it can be offered to any
other person or entity
• Preferred Stock Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher
ranking than common stock.
• Preferred Stock Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher
ranking than common stock.
• Preferred Stock Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher
ranking than common stock.
• Preferred Stock Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher
ranking than common stock.
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Stock Valuation
• Preferred Stock Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher
ranking than common stock.
• risk premium A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the
known return on a risk-free asset, or the expected return on a less risky asset, in order to induce an individual to hold the risky
asset rather than the risk-free asset.
• secondary market The financial market in which previously issued financial instruments such as stock, bonds, options, and
futures are bought and sold.
• shareholder A shareholder legally owns at least one share of stock in a company, and has rights with regards to the company
because of this
• Stock The stock of a company represents the original capital paid into the business by its founders. It serves as a security for
investors.
• Stock Exchange A form of exchange that provides services for stock brokers and traders to trade stocks, bonds and other
securities.
• Voting rights Rights which are generally associated with common stock shareholders in regards to business entity matters (
such as electing the board of directors or establishing corporate policy)
• weighted average An arithmetic mean of values biased according to agreed weightings.
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Stock Valuation
Stock Valuation
Stock valuation involves many methods.
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Valuation
Business Valuation include different methods.
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Your Dividend
DDM can be used to calculate a constant growth company.
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Shareholder Meeting
This scene from “The Office” humorously illustrates a shareholder meeting, where the shareholder can exercise their right to vote on company issues or
question company directors.
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CAPM
CAPM formula
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A bond from the Dutch East India Company
A bond is a financial security that represents a promise by a company or government to repay a certain amount, with interest, to the bondholder.
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Investing trade-offs
Value investors trade growth for dividends.
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Dividend
The portion of the net income not paid to investors is left for the growth of a company.
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Exchanges
New shares can be traded on exchanges such as the Nasdaq, but will usually be offered to current shareholders before being put on sale to the general
public.
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1903 stock certificate of the Baltimore and Ohio Railroad
Ownership of shares is documented by the issuance of a stock certificate and represents the shareholder’s rights with regards to the business entity.
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Shareholder Meeting
This scene from “The Office” humorously illustrates a shareholder meeting, where the shareholder can exercise their right to vote on company issues or
question company directors.
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NASDAQ
NASDAQ is the second-largest stock exchange market in the world, as of 2012.
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1903 stock certificate of the Baltimore and Ohio Railroad
Preferred and common stock both carry rights of ownership, but represent different classes of equity ownership.
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VOC stock
Preferred stock is a security ( a little more modern that this stock from the VOC or Dutch East India Company) that carries certain rights which designate
it from common stock or debt.
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New York Stock Exchange
Stocks can be bought and sold on exchanges, like the New York Stock Exchange shown above.
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Dow Jones Crashes
DJIA drops signifying recession.
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Bond
Preferred Stocks are considered a hybrid security with properties of both stocks and bonds, but are subordinate to bonds when it comes to rights of claim
to company assets.
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Stock dividend
Discounted dividend method can be used to value a company.
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Historical dividend information for Franklin Automobile Company
Dividends are one of the privileges of stock ownership, and preferred shares get more rights to them than common shares do.
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Dividend
DCF model can be used to calculate nonconstant growth dividends.
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Stock Market
Different kinds of investors are active in stock market.
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NYSE Trading Floor
Buyers and sellers meet and engage in face-to-face transactions at the NYSE, which is an auction-style secondary market.
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Stock Valuation
Which of the following statements regarding what stock in a
company represents is
true?
A) Stock represents the original capital invested in the business by its
founders.
B) Ownership of stock represents a stake of ownership in the business
entity.
C) All of these statements.
D) Stock is valued according to market demand and overall business
health.
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Stock Valuation
Which of the following statements regarding what stock in a
company represents is true?
A) Stock represents the original capital invested in the business by its
founders.
B) Ownership of stock represents a stake of ownership in the business
entity.
C) All of these statements.
D) Stock is valued according to market demand and overall business
health.
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Stock Valuation
Which of the following statement accurately describes a
shareholder’s preemption rights?
A) The right to vote on directors.
B) The right to acquire certain property coming into existence, such as
stock, before anyone else.
C) The right to purchase new shares issued by the company.
D) The right to claim a company’s remaining assets after a liquidation.
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Stock Valuation
Which of the following statement accurately describes a
shareholder’s preemption rights?
A) The right to vote on directors.
B) The right to acquire certain property coming into existence, such as
stock, before anyone else.
C) The right to purchase new shares issued by the company.
D) The right to claim a company’s remaining assets after a liquidation.
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Stock Valuation
Which of the following benefits is NOT associated with common
stock?
A) The right to vote on corporate objectives and policy.
B) Preemptive rights.
C) Guaranteed dividends.
D) The right to vote on who gets to sit on the company’s Board of
Directors.
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Stock Valuation
Which of the following benefits is NOT associated with common
stock?
A) The right to vote on corporate objectives and policy.
B) Preemptive rights.
C) Guaranteed dividends.
D) The right to vote on who gets to sit on the company’s Board of
Directors.
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Stock Valuation
Which of the following features is generally NOT associated with
preferred stock?
A) Voting rights.
B) Preference in dividends.
C) Convertability to common stock.
D) Callability at the option of the corporation.
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Stock Valuation
Which of the following features is generally NOT associated with
preferred stock?
A) Voting rights.
B) Preference in dividends.
C) Convertability to common stock.
D) Callability at the option of the corporation.
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Stock Valuation
Which of the following statements about a preferred stockholder’s
rights to the company’s income is NOT true?
A) When a business is liquidated, preferred shareholders receive funds
equal to the stock’s par value.
B) A preferred stock’s par value represents the original investment when
the shares were issued.
C) Dividends to common and preferred shareholders are paid at the
same time.
D) The price of both common and preferred shares are subject to market
determinants.
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Stock Valuation
Which of the following statements about a preferred stockholder’s
rights to the company’s income is NOT true?
A) When a business is liquidated, preferred shareholders receive funds
equal to the stock’s par value.
B) A preferred stock’s par value represents the original investment when
the shares were issued.
C) Dividends to common and preferred shareholders are paid at the
same time.
D) The price of both common and preferred shares are subject to market
determinants.
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Stock Valuation
Which of the following statements regarding voting rights is NOT
true?
A) Generally each share of common stock equals one vote.
B) Preferred stock generally does not carry voting rights.
C) Shareholders generally get to vote on who is part of the corporate
Board of Directors.
D) Corporate shareholders are prohibited from casting their vote online.
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Stock Valuation
Which of the following statements regarding voting rights is NOT
true?
A) Generally each share of common stock equals one vote.
B) Preferred stock generally does not carry voting rights.
C) Shareholders generally get to vote on who is part of the corporate
Board of Directors.
D) Corporate shareholders are prohibited from casting their vote online.
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Stock Valuation
Which of the following is a reason a shareholder may buy more
shares in a company?
A) All of these answers.
B) To prevent the shareholder’s percentage of ownership in the company
from being diluted.
C) The shareholder believes the company is a good investment.
D) The shareholder wishes to maintain his ownership position in the
company.
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Stock Valuation
Which of the following is a reason a shareholder may buy more
shares in a company?
A) All of these answers.
B) To prevent the shareholder’s percentage of ownership in the company
from being diluted.
C) The shareholder believes the company is a good investment.
D) The shareholder wishes to maintain his ownership position in the
company.
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Stock Valuation
Which of the following is generally NOT a right granted to owners
of preferred shares?
A) Callability.
B) Convertibility to common shares.
C) Variable dividend amounts.
D) Preference with regards to receiving dividends.
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Stock Valuation
Which of the following is generally NOT a right granted to owners
of preferred shares?
A) Callability.
B) Convertibility to common shares.
C) Variable dividend amounts.
D) Preference with regards to receiving dividends.
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Stock Valuation
A company sells preferred stock with the provision that the
company can repurchase the shares from the shareholder at a
predetermined price. Which of the following describes this stock?
A) Callable preferred stock.
B) Participating preferred stock.
C) Convertible preferred stock.
D) All of these answers.
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Stock Valuation
A company sells preferred stock with the provision that the
company can repurchase the shares from the shareholder at a
predetermined price. Which of the following describes this stock?
A) Callable preferred stock.
B) Participating preferred stock.
C) Convertible preferred stock.
D) All of these answers.
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Stock Valuation
A company goes bankrupt and its assets are to be divided
between its shareholders and debtholders. Which of the following,
from highest priority to lowest, is the correct order of how the
company’s assets should be divided?
A) Bondholders, preferred shareholders, common shareholders.
B) Bondholders, common shareholders, preferred shareholders.
C) Preferred shareholders, bondholders, common shareholders.
D) Preferred shareholders, common shareholders, bondholders.
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Stock Valuation
A company goes bankrupt and its assets are to be divided
between its shareholders and debtholders. Which of the following,
from highest priority to lowest, is the correct order of how the
company’s assets should be divided?
A) Bondholders, preferred shareholders, common shareholders.
B) Bondholders, common shareholders, preferred shareholders.
C) Preferred shareholders, bondholders, common shareholders.
D) Preferred shareholders, common shareholders, bondholders.
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Stock Valuation
Which of the following is NOT an actor in the stock market?
A) Issuers.
B) Intermediaries.
C) Government regulators.
D) Index fund.
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Stock Valuation
Which of the following is NOT an actor in the stock market?
A) Issuers.
B) Intermediaries.
C) Government regulators.
D) Index fund.
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Stock Valuation
Which of the following statements regarding the New York Stock
Exchange is true?
A) The NYSE is a primary market due to its market capitalization.
B) To be listed on the NYSE, a company must have issued 10 million
shares worth $100 million.
C) The NYSE is an auction market.
D) The NYSE has held true to its traditions and is not automated.
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Stock Valuation
Which of the following statements regarding the New York Stock
Exchange is true?
A) The NYSE is a primary market due to its market capitalization.
B) To be listed on the NYSE, a company must have issued 10 million
shares worth $100 million.
C) The NYSE is an auction market.
D) The NYSE has held true to its traditions and is not automated.
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Stock Valuation
Which of the following statements regarding the NASDAQ is true?
A) The NASDAQ is known as the primary blue-chip stock market,
catering mostly to established companies.
B) The NASDAQ was popular with brokerages because it lowered stock
spreads.
C) All of these answers.
D) The NASDAQ was the world’s first electronic stock market.
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Stock Valuation
Which of the following statements regarding the NASDAQ is true?
A) The NASDAQ is known as the primary blue-chip stock market,
catering mostly to established companies.
B) The NASDAQ was popular with brokerages because it lowered stock
spreads.
C) All of these answers.
D) The NASDAQ was the world’s first electronic stock market.
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Stock Valuation
Which of the following statements regarding stock indexes is true?
A) A global index measures investor sentiment on the state of a national
economy.
B) An investor can invest directly in a stock index.
C) All of these answers.
D) A stock market index is computed using the prices of selected stocks.
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Stock Valuation
Which of the following statements regarding stock indexes is true?
A) A global index measures investor sentiment on the state of a national
economy.
B) An investor can invest directly in a stock index.
C) All of these answers.
D) A stock market index is computed using the prices of selected stocks.
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Stock Valuation
After reviewing its prospects for the coming year, a company
determines that it has no potential projects for the upcoming year
that would exceed its hurdle rate. What should the company do
with its profits from the current year?
A) Liquidate the company and distribute all of the profits and assets to its
investors.
B) Retain the profits as savings for profitable projects in upcoming years.
C) Distribute the majority of the profits to its investors as a dividend.
D) Invest the profits in the projects anyway and hope that these new
product lines exceed expectations.
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Stock Valuation
After reviewing its prospects for the coming year, a company
determines that it has no potential projects for the upcoming year
that would exceed its hurdle rate. What should the company do
with its profits from the current year?
A) Liquidate the company and distribute all of the profits and assets to its
investors.
B) Retain the profits as savings for profitable projects in upcoming years.
C) Distribute the majority of the profits to its investors as a dividend.
D) Invest the profits in the projects anyway and hope that these new
product lines exceed expectations.
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Stock Valuation
A company a constant growth rate of 3%. The company’s risk
adjusted discount rate is 5%. The company has a $2 dividend.
What is the per share value of the stock?
A) $105
B) $51.50
C) $52.50
D) $103
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Stock Valuation
A company a constant growth rate of 3%. The company’s risk
adjusted discount rate is 5%. The company has a $2 dividend.
What is the per share value of the stock?
A) $105
B) $51.50
C) $52.50
D) $103
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Stock Valuation
Which of the following statements regarding capital distributions
and investor preferences is correct?
A) Investors seeking higher capital growth may prefer a lower payout
ratio.
B) All of these answers.
C) Firms that require new capital to continue operations have limited
growth potential.
D) Investors seeking high current income and limited capital growth
prefer high dividend payout ratios.
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Stock Valuation
Which of the following statements regarding capital distributions
and investor preferences is correct?
A) Investors seeking higher capital growth may prefer a lower payout
ratio.
B) All of these answers.
C) Firms that require new capital to continue operations have limited
growth potential.
D) Investors seeking high current income and limited capital growth
prefer high dividend payout ratios.
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Stock Valuation
Which of the following statements correctly defines a stock
valuation method?
A) The PEG Ratio is the Forward P/E ratio divided by the expected
earnings growth rate.
B) A company’s market cap equals tits outstanding stock times its stock
price plus the company’s debt.
C) Return on Invested Capital equals the pro forma net income divided
by the company’s total assets.
D) Price to Earnings equals a company’s earnings divided by the number
of outstanding shares.
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Stock Valuation
Which of the following statements correctly defines a stock
valuation method?
A) The PEG Ratio is the Forward P/E ratio divided by the expected
earnings growth rate.
B) A company’s market cap equals tits outstanding stock times its stock
price plus the company’s debt.
C) Return on Invested Capital equals the pro forma net income divided
by the company’s total assets.
D) Price to Earnings equals a company’s earnings divided by the number
of outstanding shares.
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Stock Valuation
Which of the following is a known limitation associated with
valuing a company with dividends that have a nonconstant growth
rate?
A) An analyst can justify any valuation by fine-tuning the growth/discount
assumptions.
B) The models are sensitive to the differences between the dividend
growth and discount factors.
C) All of these answers.
D) The valuation is based on company comparisons and requires
analysis beyond a simple calculation.
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Stock Valuation
Which of the following is a known limitation associated with
valuing a company with dividends that have a nonconstant growth
rate?
A) An analyst can justify any valuation by fine-tuning the growth/discount
assumptions.
B) The models are sensitive to the differences between the dividend
growth and discount factors.
C) All of these answers.
D) The valuation is based on company comparisons and requires
analysis beyond a simple calculation.
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Stock Valuation
Which of the following statements regarding corporate valuation
approaches is true?
A) The income approaches rely on using discount rates to determine a
company’s value.
B) A downside of the asset-based approach of valuing a company is that
it is not objective.
C) The weighted average cost of capital is an approach used to find the
value of a business.
D) One of the variables in the Capital Asset Pricing Model is the cost of
equity.
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Stock Valuation
Which of the following statements regarding corporate valuation
approaches is true?
A) The income approaches rely on using discount rates to determine a
company’s value.
B) A downside of the asset-based approach of valuing a company is that
it is not objective.
C) The weighted average cost of capital is an approach used to find the
value of a business.
D) One of the variables in the Capital Asset Pricing Model is the cost of
equity.
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Stock Valuation
A company has cost of equity of 8% and a dividend growth rate of
3%. Its dividends for next year is $2.20 per share. What should
the stock’s price be?
A) $44.00
B) $4.40
C) $0.22
D) $27
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Stock Valuation
A company has cost of equity of 8% and a dividend growth rate of
3%. Its dividends for next year is $2.20 per share. What should
the stock’s price be?
A) $44.00
B) $4.40
C) $0.22
D) $27
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Attribution
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