ch09sm - Chapter 9 Stock Valuation Critical Thinking...

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Page 1 of 18 Chapter 9 Stock Valuation Critical Thinking Questions 9.1 Why does the market price of a security vary from the true equilibrium price? Let us start by first defining the market equilibrium price of a security as the price that equates the demand for a security with the supply of the security. The role of the security markets is to bring buyers and sellers together in the most efficient way such that securities are bought and sold at the true equilibrium price. In reality, however, barriers of various kinds including the geographic separation of the two parties make the market price of a security slightly different than the true equilibrium price. The more efficient the market place, the smaller the deviation between the two. 9.2 Why are investors and managers concerned about market efficiency? The role of secondary markets is to bring buyers and sellers together. Ideally, we would like security markets to be as efficient as possible. Markets are efficient when current market prices of securities traded reflect all available information relevant to the security. If this is the case, security prices will be near or at their equilibrium price. The more efficient the market, the more likely this is to happen. This makes it easier for managers to price the securities close to the equilibrium price. What investors are most concerned about is having complete information regarding a security’s current price and where that price information can be obtained. Efficient markets allow them to trade at prices that are closer to the true equilibrium price than otherwise possible. Thus, both investors who provide funds and managers (firms) who raise money are concerned when high transaction costs lead to inefficient markets. 9.3 Why are common stockholders considered to be more at risk than the holders of other types of securities? In the hierarchy of lenders of funds to a firm, common stockholders have the most to lose. In the event of a firm becoming bankrupt, the law requires that creditors of different types, including bondholders, be paid off first. Next, preferred stockholders are paid off. Finally, common stockholders receive their investment if any funds are still available. Thus, common stockholders receive their money back last and are placed at most risk. This feature of common equity is referred to as residual claim . 9.4 How can individual stockholders avoid double taxation?
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Page 2 of 18 Double taxation refers to the fact that in the United States a firm’s income is taxed first and then any dividends paid to investors get taxed at the personal tax rate. Thus, investors pay taxes twice. Some investors who desire to get around this problem try to invest in growth firms that do not pay out dividends but instead reinvest in the firm. This allows the firms to grow with internal capital and leads to the firm’s value growing faster. Stockholders benefit from rising stock prices and can sell some or all of their holdings
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This note was uploaded on 05/06/2011 for the course FIN 300 taught by Professor Olander during the Spring '08 term at ASU.

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ch09sm - Chapter 9 Stock Valuation Critical Thinking...

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