Tutorial Questions #5

ECON7200

1. Why might the efficient market hypothesis be less likely to hold when fundamentals

suggest stocks should be at a lower level?

2. Compute the price of a share of stock that pays a $5 per year dividend and that you

expect to be able to sell in one year for $20, assuming you require a 20% return.

3. The current price of a stock is $55.68. If dividends are expected to be $0.80 per share for

the next five years, and the required return is 6%, then what should the price of the stock

be in 5 years when you plan to sell it? If the dividend and required return remain the

same, and the stock price is expected to increase by $1 five years from now, does the

current stock price also increase by $1? Why or why not?

4. A company has just announced a 3-for-1 stock split, effective immediately. Prior to the

split, the company had a market value of $5 billion with 100 million shares outstanding.

Assuming the split conveys no new information about the company, what are the value of

the company, the number of shares outstanding, and the price per share after the split? If

the actual market price immediately following the split is $17.00 per share, what does this

tell us about market efficiency?

5. What basic principle of finance can be applied to the valuation of any investment asset?

6. What are the two main sources of cash flows for a stockholder? How reliably can these

cash flows be estimated? Compare the problem of estimating stock cash flows to the

problem of estimating bond cash flows. Which security would you predict to be more

volatile?

7. Some economists think that central banks should try to prick bubbles in the stock market

before they get out of hand and cause later damage when they burst. How can monetary

policy be used to prick a market bubble? Explain using the Gordon growth model.

MCQs

1. Using the one-period valuation model, assuming a year-end dividend of $0.11, an expected

sales price of $110, and a required rate of return of 10%, the current price of the stock would

be

A) $110.11.

B) $121.12.

C) $100.10.

D) $100.11.

2. Using the Gordon growth formula, if D1 is $2.00, ke is 12% or 0.12, and g is 10% or 0.10,

then the current stock price is

A) $20.

B) $50.

C) $100.

D) $150.

3. Using the Gordon growth model, if D1 is $.50, ke is 7%, and g is 5%, then the present

value of the stock is

A) $2.50.

B) $25.

C) $50.

D) $46.73.

4. Economists have focused more attention on the formation of expectations in recent years.

This increase in interest can probably best be explained by the recognition that

A) Expectations influence the behavior of participants in the economy and thus have a major

impact on economic activity.

B) Expectations influence only a few individuals, have little impact on the overall economy,

but can have important effects on a few markets.

C) Expectations influence many individuals, have little impact on the overall economy, but

can have distributional effects.

D) Models that ignore expectations have little predictive power, even in the short run.

5. ________ and ________ may provide an explanation for stock market bubbles.

A) Overconfidence; social contagion

B) Underconfidence; social contagion

C) Overconfidence; social isolationism

D) Underconfidence; social isolationism

6. A stockholder's ownership of a company's stock gives her the right to

A) vote and be the primary claimant of all cash flows.

B) vote and be the residual claimant of all cash flows.

C) manage and assume responsibility for all liabilities.

D) vote and assume responsibility for all liabilities.

7. Information plays an important role in asset pricing because it allows the buyer to more

accurately judge

A) liquidity.

B) risk.

C) capital.

D) policy.

8. Increased uncertainty resulting from the global financial crisis ________ the required

return on investment in equity.

A) raised

B) lowered

C) had no impact on

D) decreased

9. If expectations of the future inflation rate are formed solely on the basis of a weighted

average of past inflation rates, then economists would say that expectation formation is

A) irrational.

B) rational.

C) adaptive.

D) reasonable.

10. If expectations are formed rationally, then individuals

A) will have a forecast that is 100% accurate all of the time.

B) change their forecast when faced with new information.

C) use only the information from past data on a single variable to form their forecast.

D) have forecast errors that are persistently low.