CHAPTER 10

TRUE/FALSE QUESTIONS

(T) 1. The Dow Jones Industrial Average is a price-weighted index.

(F) 2. The NASDAQ is a stock exchange with a physical location

(F) 3. The secondary market for capital market securities is important because it provides funds
directly to deficit spending units.

(F) 4. Primary capital market securities provide marketability and possibilities for investors to
alter the riskiness of their portfolios.

(F) 5. High frequency trading is designed to help market trades by individual investors.

(F) 6. Limited liability of stockholders protects them from losses on their stock portfolio.

(T) 7. The New York Stock Exchange is an example of a secondary market.

(T) 8. A wide spread between the bid and ask quotes of a security dealer represents high costs to
trade.

(T) 9. At the NYSE, limit orders are usually entered into the specialist’s limit order book.

(F) 10. Preferred stocks have more variable prices than common stock.

(T) 11. A market with breadth has a large number of diverse investors.

(T) 12. The underwriter's spread is typically inversely related to the size of the primary offering.

(F) 13. Preferred stockholders have the same voting rights as common shareholders.

(F) 14. Common stockholders enjoy limited liability, which means any losses in stock value are
covered by the company.

(F) 15. Common and preferred stock dividends are paid out of pre-tax earnings.

(F) 16. A publicly traded company issuing additional shares of common stock does it through an
IPO.

(T) 17. Convertible preferred stock can be exchanged into common stock at a predetermined
ratio.

(T) 18. Shelf registration permits a corporation to preregister several types of security issues and
sell them at any time within the subsequent two years.

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(T) 19. Among financial institutions, mutual funds are the largest holders of corporate equity
securities.

(F) 20. The most common method of selling stock to the public is through a rights offering.

(F) 21. Equity capital can be raised through the money market and the NYSE bond market.

(T) 22. A proxy is an absentee ballot that allows a representative to vote on behalf of the
stockholder.

(F) 23. Preferred stockholders have a claim junior to common stock but senior to bondholders.

(T) 24. The typical underwriter’s spread on an IPO is about 7 percent.

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 MULTIPLE-CHOICE QUESTIONS

(c) 1. Which of the following is not an example of capital market securities?

a. common stocks
b. convertible bonds
c. commercial paper
d. mortgages

(c) 2. Which of the following is not a characteristic of common stock?

a. residual claim on income and assets
b. limited liability
c. cumulative dividends
d. dual-class stock

(c) 3. Dual class stock is generally designed to

a. provide bigger dividends to majority owners.
b. help minority owners obtain board representation.
c. protect the voting rights of managing owners.
d. Improve marketability of the shares.

(b) 4. Managers help maintain control of the firm by asking shareholders to

a. forego dividend payments.
b. allow managers to vote stockholders’ shares by proxy.
c. ignore the cumulative nature of dividends.
d. sell their shares to managers.

(d) 5. The equity primary capital market is used to

a. borrow long term.
b. change ownership of existing shares.
c. update prices of stock.
d. obtain funds in exchange for company ownership.

(c) 6. The term shareholder equity means

a. a right to cumulative dividends.
b. a contractual relationship with a corporation.
c. an ownership claim.
d. a prior claim on income and assets.

(a) 7. Which of the following terms is not associated with common stock?
a. contractual cash flows
b. residual
c. ownership
d. limited liability

(b) 8. Security exchanges provide a valuable function in that they

a. raise funds for company owners.
b. increase the marketability of securities.
c. provide a legal way to gamble.
d. supply money to deficit spending units.

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(d) 9. Regulators provide a valuable function for the capital markets because they
I. try to keep the market participants honest.
II. try to prevent excessive speculation from destabilizing the market.
III. limit the ability to trade on inside information.
a. I only
b. I and III only
c. II and III only
d. I, II and III

(b) 10. A shareholder in a troubled corporation is not likely to lose his/her

a. money invested in the stock.
b. personal assets.
c. dividends declared.
d. par value.

(d) 11. Which of the following is not true about American Depository Receipts (ADRs)?
a. ADRs are claims issued by U.S. financial intermediaries (FIs) on shares in
foreign companies, with the shares held in custody by the FIs for investors.
b. ADRs are issued in the U.S. and are denominated in U.S. dollars. All cash flows
to the investor are in dollars.
c. An ADR enhances a company’s visibility, status and profile in the U.S. and
internationally among investors.
d. An ADR decreases the foreign firm’s U.S. liquidity (and potentially total global
issuer liquidity).

(a) 12. Which of the following statements is true?

a. Electronically linking equity dealers and exchange markets is slowly leading
toward a national market system.
b. Dark pools are designed to assist individual investors to sell their stock.
c. HFT refers to after-hours trading of stocks by mutual funds.
d. Electronic trading has eliminated bid-ask spreads.

(d) 13. The _________ sector is the single largest surplus sector that invests in the equity market
a. mutual fund
b. banking
c. pension fund
d. household

(c) 14. A stock purchased at $40 at the beginning of the year paid $10 in dividends and was sold
for a net price of $42 at the end of the year. The total annual return is
a. 25%
b. 100%
c. 30%
d. 40%
e. 12%

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(c) 15. The sale of securities via an investment banker by a corporation raising
equity funds from the public for the first time is called
a. a seasoned offering.
b. a secondary offering.
c. an initial public offering.
d. a best efforts offering.

(d) 16. Which of the following terms is associated with secondary equity markets?
a. seasoned equity offering
b. initial public offering
c. underwriter’s spread
d. dealers’ bid-ask spread
e. shelf registration

(c) 17. Which of the following is a market participant in the primary equity markets?
a. broker
b. specialist
c. underwriter
d. dealer

(a) 18. Sampson Corporation, through its investment banker, First Ohio Securities, recently sold
200,000 shares of common stock to the public, grossing $7.4 million. Issuing
expenses paid by Sampson totaled $200,000, and the underwriter's spread was $3
per share. How much net financing did Sampson Corporation raise in the deal?
a. $6.6 million
b. $7.2 million
c. $6.4 million
d. $7.0 million
e. $6.8 million

(b) 19. The underwriter's spread (%) is

a. directly related to the size of the primary offering.
b. directly related to the riskiness of the issue.
c. greater when the shelf registration process is used.
d. smaller for stocks than for bonds.

(d) 20. The New York Stock Exchange is all of the following except a/an
a. auction market
b. exchange
c. secondary market
d. a dealer based market

(a) 21. Which of the four types of secondary markets listed below involves considerable costs
and no third party?
a. direct search
b. brokered
c. dealer
d. auction

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(b) 22. Which of the four types of secondary markets listed below achieves economies of scale in
search costs but does not guarantee that orders will be executed promptly?
a. direct search
b. brokered
c. dealer
d. auction

(c) 23. Which of the four types of secondary markets listed below minimizes liquidity risk, but
a bid ask spread must be paid?
a. direct search
b. brokered
c. dealer
d. auction

(d) 24. Which of the four types of secondary markets listed below has low search costs, low
liquidity risk, and the best chance of executing at the best price?
a. direct search
b. brokered
c. dealer
d. auction

(b) 25. A stock dealer has a bid of $17.00 and an ask of $17.25. An investor buys and then sells
the stock at these quotes. The investor’s transaction cost per dollar invested is
_____.
a. 1.47%
b. 1.45%
c. 1.42%
d. 1.40%

(a) 26. You would expect the bid-ask spread for equity securities to be _______ for more
frequently traded stocks and _______ for stocks which have more traders with
inside information.
a. less; more
b. less; less
c. more; more
d. more; less

(c) 27. The over-the-counter market trades ______ stocks than exchanges, and exchanges tend
to list ________ companies.
a. fewer; smaller
b. fewer; larger
c. more; larger
d. more; smaller

(d) 28. Which of the following is a typical reason to list a stock on an exchange such as the
NYSE rather than using NASDAQ?
a. limited trading in the stock
b. small issue size
c. to reduce listing fees
d. having a large number of public shareholders

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(c) 29. Which of the following is not associated with the over-the-counter market for stocks?
a. NASDAQ
b. limited trading interest
c. auction market
d. dealer market

(b) 30. The NASDAQ system provides price input capability for
a. brokers.
b. dealers.
c. stock-trading customers of dealers.
d. the Securities and Exchange Commission.

(c) 31. The daily pink sheets of the OTC market were replaced
a. by the emerging dealer market.
b. by the brokers relaying information to their customers.
c. by the OTC Pink market.
d. when the NASD required that dealers be registered.

(b) 32. Which of the following is not one of three major sources of active bids and offerings in a
stock issue at a stock trading post on an exchange?
a. floor brokers handling customer orders.
b. limit price orders held by floor brokers.
c. the specialists making trades for his/her own account.
d. the specialist executing limit price orders.

(c) 33. An order to the New York Stock Exchange to buy or sell at the best price available is
called
a. a limit order.
b. a stop order.
c. a market order.
d. a GTC order.

(a) 34. Which of the following is not a result of advances in technology and competition in
equity markets?
a. higher transaction costs
b. the development of a national market system
c. 24-hour trading of some stocks
d. globalization of equity markets

(d) 35. Which of the following statements is/are true about secondary market transactions?
I. Dark pools are a means to reduce search costs
II. A broker may bring buyers and sellers together, charging a commission.
III.A dealer may sell and buy securities using his or her own inventory, therefore
reducing search costs.
IV. An auction market allocates the selling shares to the highest bidder.
a. I and II only
b. II and III only
c. II, III and IV only
d. I, II, III and IV

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(c) 36. In response to competition from foreign stock exchanges, U.S. stock exchanges have
a. shortened their trading hours to decrease the volatility of stock prices.
b. implemented after-hours discussion sessions between floor brokers and
customers.
c. expanded electronic after-hour trading for stocks.
d. listed fewer stocks to compete with foreign stock exchanges.

(e) 37. The primary federal regulator of stock markets is

a. the Federal Reserve.
b. the Federal National Securities Corporation.
c. the National Association of Securities Dealers (NASD).
d. the Securities Investor Protection Corporation.
e. the Securities and Exchange Commission.

(b) 38. The federal legislation that made the Securities and Exchange Commission responsible
for the broad oversight of securities markets was
a. The Securities Act of 1933.
b. The Securities Exchange Act of 1934.
c. The Investment Company Act of 1940.
d. The National Securities Company Act of 1932.

(b) 39. Convertible preferred stock is usually convertible to ________ at the ________ option.
a. a bond; investor’s
b. common stock; investor’s
c. a convertible bond; company’s
d. cash; company’s

(a) 40. Convertible bonds typically ______ when the company’s stock increases in value.
a. increase in value
b. decrease in value
c. have the same value
d. may increase or decrease in value

(d) 41. If a stock’s price drops in value by 10% the price of the company’s convertible bond will
a. increase in value by more than 10%.
b. decrease in value by more than 10%
c. increase in value by less than 10%
d. decrease in value by less than 10%

(b) 42. In 2015 the top three holders of U.S. equity securities by percent were
a. households, private pension funds and insurers.
b. households, mutual funds, and foreign investors.
c. exchange traded funds, federal pension funds and foreign investors.
d. mutual funds, insurers and private pension funds.

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(b) 43. A primary stock offering where existing stockholders are given the chance to purchase
the new seasoned offering is called a/an
a. IPO
b. rights offering
c. best efforts offering
d. fully underwritten general cash offer
e. private placement

(d) 44. In a fully underwritten offering a firm sells 1 million shares of stock through a fully
underwritten offering. Their banker charged a $2.45 spread and sold the stock to the
public at a price of $35 per share. The issuing firm also pays $250,000 in other direct
costs to complete the sale. What is the firm’s net proceeds per share from the sale?
a. $35.00
b. $33.55
c. $32.55
d. $32.30
e. $31.75

(a) 45. In a given year there are typically a larger dollar amount of
a. debt private placements than equity private placements.
b. public equity issues than public debt issues.
c. convertible debt issues than standard debt issues.
d. primary market issues than secondary market trading.

(c) 46. The process where firms can seek cash directly from investors over the Internet is called
a. shelf registration.
b. Rule 144 offerings.
c. crowdfunding.
d. JOBS Kickstarters.

(c) 47. Which of the following is true concerning shelf offerings?

a. Only debt securities can be offered via a shelf offering.
b. Shelf offerings avoid the costly registration process.
c. Shelf offerings allow firms to preregister securities for two years.
d. Shelf offerings give investors the option of when to buy the security.
e. Shelf offerings are only allowed for private placements.

(b) 48. A new offering allows under the JOBS Act creates less onerous registration requirements
for certain smaller offerings. Offerings that are between $20 and $50 million and
require audited financials and the firm to file annual reports with the SEC are called
_______ offerings.
a. Tier I
b. Tier II
c. Tier III
d. Tier IV

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(a) 49. Which of the following is not found in a typical online stock quote?
a. current yield
b. price
c. dividend yield
d. recent price range
e. P/E ratio

(b) 50. In a stock market quote the dividend yield is found as the
a. capital gain minus the dividend.
b. annualized dividend divided by the stock price.
c. total annual return on the stock.
d. quarterly dividend times the stock price.

(d) 51. At the beginning of year one, the stock market index had a value of 225.4. Two years
later the value was 298. What was the average annual rate of return on the index
portfolio?
a. 28.6%
b. 30.0%
c. 36.3%
d. 15.0%
e. 14.3%

(c) 52. Stocks XX, YY, and ZZ, initially priced at $35, $65, and $72, respectively, comprise a
price-weighted index with a base value of 100. One year later the stocks above
were valued at $40, $69, and $87, respectively. What was the value of the index at the
end of year one?
a. 88
b. 100
c. 114
d. 124
e. 196

(a) 53. Which of the followings statements is correct?

a. The stock market does a poor job of predicting economic recessions.
b. The stock market does a good job of predicting economic recessions.
c. Economic recessions always precede poor stock market performance.
d. Positive stock market returns are not possible during economic recessions.

(a) 54. Formosan Freedom Co. is currently priced at $42.50 per share and it is expected to sell
for 6% more next year. The stock will pay an annual dividend per share of $1.10
next year. The expected return on this stock is
a. 8.59%
b. 7.65%
c. 6.00%
d. 2.59%

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(c) 55. Suppose MBI Co. is expected to pay a $0.60 dividend per share next year. Wall Street
analysts project the stock will sell for $35.75 in one year. You have been earning
11.5% on your other investments and you believe this one should give you the same
return. What is the most you can pay for MBI today in order for you to earn your
required return?
a. $35.15
b. $31.64
c. $32.60
d. $31.27

(d) 56. The current price of Fukushima Power Co. stock is $32.50 per share. Earnings
next year should be $2.5 per share and it should pay a $ 1 dividend. The P/E
multiple is 15 times on average in this industry. What price would you
expect for the firm’s stock in the future if you believe the P/E multiple
approach is correct?
a. $13.5
b. $22.50
c. $26.50
d. $37.50

(a) 57. You sell your old car to a person in the next town by placing an ad on the Internet service
George’s List. This is an example of a/an
a. direct search market.
b. auto exchange market.
c. dealer market.
d. broker market.

(d) 58. Since your grandmother supports your tuition at college, she wants to make sure
it is worthy to invest in your education. She is wondering if you can tell her the
key differences between common stock and bonds. Which of the
following is NOT accurate?
a. interest paid to bondholder is tax-deductible but dividends paid to
stockholders are not.
b. bonds have a stated maturity but stock does not.
c. bonds are long-term debt instruments, while stock is long-term equity
capital.
d. common stockholders have a senior claim on assets and income relative to
bondholders.

(c) 59. All of the following features may be characteristics of perpetual preferred stock EXCEPT
a. convertible
b. callable
c. tax-deductible dividends
d. no maturity date

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(d) 60. You buy a share of the common stock of game maker Dzenga Wooden Puzzle Games.
The stock is popular right now and it has a P/E ratio of 95. The firm’s earnings
and dividends per share are both $1.55 per share. If Dzenga’s earnings don’t grow in
the future, how long can you expect to wait until you recover the cost of your
investment?
a. 47.5 years
b. 61.3 years
c. 82.7 years
d. 95.0 years

(d) 61. If you own a portfolio of small company stocks, you may to compare your portfolio’s
performance to which one of the following indices?
a. S&P 500
b. Dow Jones Industrial Average
c. Russell 1000
d. Russell 2000

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 ESSAY QUESTIONS

1. Explain what shelf registration is and how it can help companies to reduce their costs.

Answer: Shelf registration permits an issuer to register a certain quantity of securities with the
SEC and sell them over a period of time rather than all at once. Thus, the issuer is able to save
money and time through a single registration.

2. List and briefly describe the four types of secondary equity markets.

Answer: Direct search involves buyers and sellers seeking each other directly. Brokered markets
feature brokers, middlemen who bring buyers and sellers together. Dealer markets are
characterized by the presence of dealers, market participants who “make market” in certain
securities, therefore eliminating the need for time-consuming searches for trading partners.
Auction markets provide centralized locations and procedures for trading securities, which
eliminates not only search costs but also bargaining for a favorable price.

3. Describe how limit orders whose prices are not close to current market prices are handled at
NYSE.

Answer: When a limit order carries a price that is not close to the current market price, the broker
handling the order enters it into the specialist’s limit order book. The order is then executed by
the specialist if and when the stock price hits the specified limit.

4. What are the advantages of investing in American Depository Receipts (ADRs) compared to
direct investment into foreign equities?

Answer: ADRs make international diversification easier. First, they are dollar-denominated
claims that pay dividends in dollars. Second, ADR trading is done in accordance with American
securities laws. Finally, ADRs are more marketable (i.e., easier to trade) for U.S. investors than
direct investments into foreign stocks.

5. What are the pros and cons of high frequency trading (HFT) and dark pools? Do they improve
market efficiency? Explain.

Answer: The positive side of HFT and dark pools includes the ability to help institutions process
large purchases and sales of stock without impacting liquidity or causing temporary price moves
based on the size of the transaction. In this sense HFTs and dark pools reduce the cost of direct
search and minimize the impact on the broader market and thus improve the efficient operations
of the markets. The down side, as witnessed in the Knight Capital debacle and the so called
‘Flash Crash,’ clearly shows that these activities can actually disrupt markets if things go wrong.
The automated trading in large numbers of orders can quickly cause major price moves that could
result in a market panic. It may also erode investor confidence in the markets as trading is
occurring and the price is revealed only after the trade occurs. In addition, certain pool operators
have been accused of not treating all pool participants equally. The bottom line is that efficiency
will be reduced if there is excess volatility and if normal posted market prices are perceived as
not truly representative of the current trade value of a security.

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6. Why do you think stock prices increased in late 2016, particularly after the election of
Donald Trump?

Answer: Stock prices are a forward indicator of economic performance. Throughout much of
2016 the economy was already starting to grow more quickly than it had in the past, although
concerns about problems in Europe, China and some emerging markets had limited growth in the
U.S. and global economy. While no one can say for certain what was behind the increase in stock
prices late in the year, it is likely that the election of Donald Trump with a more pro-business
approach to governing increased confidence in stock investors that the economy and corporate
earnings would grow in the future. This would explain the rising stock prices at the time.

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 APPENDIX QUESTIONS

(T) 1. A stock which is expected to pay a $4 dividend next year, growing constantly at 6%, and
is priced to yield a required return of 18% should be selling for $33.33 if
it is priced correctly.

(F) 2. The market rate of return on a $100 par value preferred stock, priced at $90, paying an
$8.00 annual dividend, is 8 per cent.

(F) 3. Systematic risk can be significantly reduced through diversification.

(T) 4 If the stock markets are semi-strong efficient, stock prices reflect all historic and
current public information about a firm but prices do not reflect inside
information.

(b) 5. What is the value of a stock expected to pay a constant $5 dividend each year forever, if
the market required rate of return is 18%?
a. $90
b. $28
c. $36
d. $23

(d) 6. A stock just paid an annual dividend of $2. The dividends are expected to grow at 20%
per year over each of the next three years and 5% per year thereafter. What is the
value of the stock if the required rate of return is 12%?
a. $34.29
b. $36.49
c. $39.84
d. $43.80
e. $58.74

(c) 7. Ace Corporation preferred stock pays an 8% dividend on a par value of $50 and is
currently selling at $47.50. What is required rate of return on the stock?
a. 7.5%
b. 8%
c. 8.4%
d. 12.5%
e. 16%

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(b) 8. What is the estimated value of a stock, which paid a $5 dividend this year, expects
dividends to grow at 6 per cent, and requires a 20 per cent return?
a. $35.71
b. $37.86
c. $25.00
d. $20.38
e. $26.50

(b) 9. What is the required rate of return on a stock if the risk-free rate is 7%, the return on the
market portfolio is 15%, and the beta is 1.5?
a. 12 %
b. 19%
c. 22.5%
d. 29.5%
e. 33%

(d) 10. If the risk-free rate is 7%, the return on the market portfolio is 15%, and the beta is 1.5,
what is the value of the stock if the current dividend (D0) is $1.20 and it is expected to
grow at a constant rate of 6% per year?
a. $6.30
b. $6.70
c. $9.20
d. $9.80
e. $20.00

(a) 11. A stock currently trading at $50 expects to pay a $4.50 dividend this year. The dividends
and stock price have been growing at 8% per year for 10 years. What is the expected
total return on the stock this year?
a. 17%
b. 18%
c. 20%
d. 9%
e. 15%

(c) 12. Investors in well diversified stock portfolios are concerned about ________ risk.
a. specific stock
b. unsystematic
c. systematic
d. diversifiable

(c) 13. Stocks with beta values of one

a. will have very predictable rates of return.
b. will have little risk compared to the market portfolio.
c. have had return variability similar to the market.
d. have had a constant rate of return.

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(b) 14. The security market line shows
a. the amount of risk demanded for each unit of return.
b. the return for each level of systematic risk.
c. the sum of the systematic and unsystematic risks.
d. the total risk/return tradeoff over time.

(a) 15. The slope of the security market line is

a. the market risk premium.
b. beta
c. the risk-free rate
d. the return on the market portfolio.

(a) 16. The most recently paid dividend divided by the current stock price of Tahitian Travels is
4.8%. The company just paid a $2.10 dividend. The dividend will be $2.205 in
next year. The dividend growth rate is expected to remain constant at the
current level. What is the required rate of return on stock of Tahitian
Travels?
a. 10.04 percent
b. 16.07 percent
c. 21.88 percent
d. 43.75 percent

(b) 17. Suppose MBC Co. recently paid a $2 annual dividend. The company is projecting
that its dividends will grow by 20 percent next year, 12 percent annually for the
two years after that, and then at 6 percent annually. Based on this
information, how much should the company’s common stock sell for today if
the required return is 10.5%?
a. $50.90
b. $59.16
c. $66.60
d. $77.50

1. Explain why unsystematic risk is ignored when appropriate levels of return are computed.

Answer: Unsystematic risk is unique to each security. As investors diversify their portfolios,
unsystematic risk is reduced and eventually eliminated. Because it is easy to diversify across
different stocks, investors take advantage of it. Investors who diversify face less risk and are thus
willing to pay a higher price for a stock. As a consequence, securities are priced according to their
systematic risk, not their unsystematic risk.

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