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FM12 Ch 08 Solutions Manual - Chapter 8 Stocks Stock...

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Chapter 8 Stocks, Stock Valuation, and Stock Market Equilibrium ANSWERS TO END-OF-CHAPTER QUESTIONS 8 5 -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. The stock in such firms is said to be closely held. 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 stock is said to be publicly owned stock. c. 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: 8 5 - 1
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d. 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 return. The realized (actual) rate of return, denoted by s r , is the rate of return that was actually realized at the end of some holding period. Although expected and required rates of return must always be positive, realized rates of return over some periods may be negative.
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