CHAPTER 7 – Valuing Stocks

CHAPTER 7 – Valuing Stocks

Questions

1. As owners, what rights and advantages do shareholders obtain?

They are able to participate in the economic growth of publicly traded firms without having to manage business entities directly. They have the right to residual cash flows of corporate profits and often receive some of these cash flows through dividends. In addition, shareholders vote on the members for board of directors and other proposals for the company. Shareholder capital losses are capped in that they can only lose their initial investment. Stocks are very liquid and investors can enjoy this liquidity in both their entrance into the stock market and their exit from it.

2. Describe how being a residual claimant can be very valuable.

Residual claimant’s are able to delegate the operations of the firm to professional managers, enjoying the possibly vast gains in value that can be created by some firms over time.

3. Obtain a current quote of McDonald’s (MCD) from the Internet. Describe what has changed since the quote in Figure 8.1.

As of November 23, 2007, MCD’s stock price had increased in value to $57.72 per share. MCD experienced a modest loss from July 11, 2007 reaching a trough in mid-August 2007 at approximately $47.50 per share. Since that time, it has generally trended upward through the Fall of 2007.

4. Get the trading statistics for the three main U.S. stock exchanges. Compare the trading activity to that of Table 8.1.

The table below reflects trading activity on the three main U.S. stock exchanges for November 26, 2007. Trading volume was particularly high this day compared to the July 11, 2007 activity reflected in Table 8.1. Continued concerns over the home mortgage crises built into a selling frenzy in the markets with the DJIA plummeting 240 points on this day. Volume was also up due to this trading day immediately following the Thanksgiving holiday weekend, since markets were closed the previous Thursday and only light trading volume was experienced in the lightly attended trading session the day after Thanksgiving.

ADVANCES & DECLINES

	NYSE	AMEX	NASDAQ
Advancing Issues	834 (24%)	451 (33%)	782 (25%)
Declining Issues	2,565 (74%)	824 (60%)	2,248 (72%)
Unchanged Issues	64 (2%)	96 (7%)	104 (3%)
Total Issues	3,463	1,371	3,134
New Highs	45	48	54
New Lows	340	128	286
Up Volume	463,831,873 (13%)	102,173,146 (13%)	339,948,056 (17%)
Down Volume	3,149,651,823 (86%)	667,962,524 (86%)	1,599,678,727 (82%)
Unchanged Volume	38,646,084 (1%)	8,138,296 (1%)	8,948,642 (0%)
Total Volume	3,652,129,7801	778,273,9661	1,948,575,4251

5. Why might the Standard & Poor’s 500 Index be a better measure of stock market performance than the Dow Jones Industrial Average? Why is the DJIA more popular than the S&P 500?

The S&P 500 is a broad market index that includes stocks of the 500 largest US firms from ten sectors of the economy. It captures 80% of the overall stock market capitalization and is a good proxy for what is occurring in the overall stock market. The DJIA has been used for a longer period, since the mid-1880’s, and represents the activity of the 30 largest corporations in the US, covering 30% of the stock market. Its popularity arises from it being the first index used by the media.

6. Explain how it is possible for the DJIA to increase one day while the Nasdaq Composite decreases during the same day.

The components of the DJIA and the Nasdaq Composite index are mostly different companies. The DJIA includes the 30 industry leaders across all sectors of the economy. The Nasdaq is comprised of predominantly technology related firms and emits a noisy signal of technology performance on any given day.

Problems

7-1 Stock Index Performance On January 16, 2007, the Dow Jones Industrial Average set a new high. The index closed at 12,582.59, which was up 26.51 that day. What was the return (in percent) of the stock market that day?

FV = PV × (1 + i)

12,582.59 = (12,582.59-26.51) × (1 + i)

i = (12,582.59/12,556.08)-1 = 0.2111%

7-2 Stock Index Performance On January 16, 2007, the Standard & Poor’s 500 Index reached the highest it had been since 2000. The index closed at 1,431.90, which was up 1.17 that day. What was the return (in percent) of the stock market that day?

FV = PV × (1 + i)

1,431.90 = (1,431.9-1.17) × (1 + i)

i = (1.431.90/1,430.73)-1 = 0.08178%

7-3 Buying Stock with Commissions At your discount brokerage firm, it costs $8.95 per stock trade. How much money do you need to buy 200 shares of Pfizer, Inc. (PFE), which trades at $27.22?

($27.22/share × 200 shares) + $8.95 = $5,452.95

7-4 Buying Stock with Commissions At your discount brokerage firm, it costs $9.50 per stock trade. How much money do you need to buy 300 shares of Time Warner, Inc. (TWX), which trades at $22.62?

($22.62/share × 300 shares) + $9.50 = $6,795.50

7-5 Selling Stock with Commissions At your full-service brokerage firm, it costs $120 per stock trade. How much money do you receive after selling 150 shares of Nokia Corporation (NOK), which trades at $20.13?

($20.13/share × 150 shares) - $120 = $2,899.50

7-6 Selling Stock with Commissions At your full-service brokerage firm, it costs $135 per stock trade. How much money do you receive after selling 250 shares of International Business Machines (IBM), which trades at $96.17?

($96.17/share × 250 shares) - $135 = $23,907.50

7-7 Buying Stock with a Market Order You would like to buy shares of Sirius Satellite Radio (SIRI). The current ask and bid quotes are $3.96 and $3.93 respectively. You place a market buy-order for 500 shares that executes at these quoted prices. How much money did it cost to buy these shares?

($3.96/share × 500 shares) = $1,980.00

7-8 Buying Stock with a Market Order You would like to buy shares of Coldwater Creek, Inc. (CWTR). The current ask and bid quotes are $20.70 and $20.66 respectively. You place a market buy-order for 200 shares that executes at these quoted prices. How much money did it cost to buy these shares?

($20.70/share × 200 shares) = $4,140.00

7-9 Selling Stock with a Limit Order You would like to sell 200 shares of WorldSpace, Inc. (WRSP). The current ask and bid quotes are $4.66 and $4.62 respectively. You place a limit sell-order at $4.65. If the trade executes, how much money do you receive from the buyer?

($4.65/share × 200 shares) = $930.00

7-10 Selling Stock with a Limit Order You would like to sell 100 shares of eCollege.com (ECLG). The current ask and bid quotes are $15.33 and $15.28 respectively. You place a limit sell-order at $15.31. If the trade executes, how much money do you receive from the buyer?

($15.31/share ×100 shares) = $1,531.00

7-11 Value of a Preferred Stock A preferred stock from Duquesne Light Company (DQUPRA) pays $2.10 in annual dividends. If the required return on the preferred stock is 5.4 percent, what’s the value of the stock?

Use equation 7-6, noting that for preferred stock, the growth rate g equals zero:

7-12 Value of a Preferred Stock A preferred stock from Hecla Mining Co. (HLPRB) pays $3.50 in annual dividends. If the required return on the preferred stock is 6.8 percent, what is the value of the stock?

Use equation 7-6, noting that for preferred stock, the growth rate g equals zero:

7-13 P/E Ratio and Stock Price Ultra Petroleum (UPL) has earnings per share of $1.56 and a P/E ratio of 32.48. What’s the stock price?

Use equation 7-10:

7-14 P/E Ratio and Stock Price JP Morgan Chase Co. (JPM) has earnings per share of $3.53 and a P/E ratio of 13.81. What is the price of the stock?

Use equation 7-10:

7-15 Value of Dividends and Future Price A firm is expected to pay a dividend of $1.35 next year and $1.50 the following year. Financial Analysts believe the stock will be at their price target of $75 in two years. Compute the value of this stock with a required return of 11.5 percent.

Use equation 7-3:

7-16 Value of Dividends and Future Price A firm is expected to pay a dividend of $2.05 next year and $2.35 the following year. Financial Analysts believe the stock will be at their price target of $110 in two years. Compute the value of this stock with a required return of 12 percent.

Use equation 7-3: