FM11 Ch 07 Instructors Manual

FM11 Ch 07 Instructors Manual - Chapter 7 Stocks and Their...

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Chapter 7 Stocks and Their Valuation ANSWERS TO END-OF-CHAPTER QUESTIONS 7-1 a. A proxy is a document giving one person the authority to act for another, typically the power to vote shares of common stock. If earnings are poor and stockholders are dissatisfied, an outside group may solicit the proxies in an effort to overthrow management and take control of the business, known as a proxy fight. A takeover is an action whereby a person or group succeeds in ousting a firm’s management and taking control of the company. The preemptive right gives the current shareholders the right to purchase any new shares issued in proportion to their current holdings. The preemptive right may or may not be required by state law. When granted, the preemptive right enables current owners to maintain their proportionate share of ownership and control of the business. It also prevents the sale of shares at low prices to new stockholders which would dilute the value of the previously issued shares. Classified stock is sometimes created by a firm to meet special needs and circumstances. Generally, when special classifications of stock are used, one type is designated “Class A”, another as “Class B”, and so on. Class A might be entitled to receive dividends before dividends can be paid on Class B stock. Class B might have the exclusive right to vote. Founders’ shares are stock owned by the firm’s founders that have sole voting rights but restricted dividends for a specified number of years. b. Some companies are so small that their common stocks are not actively traded; they are owned by only a few people, usually the companies’ managers. Such firms are said to be closely held corporations. In contrast, the stocks of most larger companies are owned by a large number of investors, most of whom are not active in management. Such companies are said to be publicly owned corporations. c. The secondary market deals with trading in previously issued, or outstanding, shares of established, publicly owned companies. The company receives no new money when sales are made in the secondary market. The primary market handles additional shares sold by established, publicly owned companies. Companies can raise additional capital by selling in this market. Going public is the act of selling stock to the public at large by a closely held corporation or its principal stockholders, and this market is often termed the initial public offering (IPO) market. d. Intrinsic value ( 0 P ˆ ) is the present value of the expected future cash flows. The market price (P 0 ) is the price at which an asset can be sold. Answers and Solutions: 7 - 1
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e. The required rate of return on common stock, denoted by r s , is the minimum acceptable rate of return considering both its riskiness and the returns available on other investments. The expected rate of return, denoted by s r , is the rate of return expected on a stock given its current price and expected future cash flows. If the stock is in equilibrium, the required rate of return will equal the expected rate of
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FM11 Ch 07 Instructors Manual - Chapter 7 Stocks and Their...

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