Answers to End-of-Chapter Questions Chapter 1
When you purchase a stock, you expect to receive dividends plus capital gains. Not all stocks pay dividends immediately, but those corporations that do, typically pay dividends quarterly. Capital gains (losses) are received when the stock is sold. Stocks are risky, so you would not be certain that your expectations would be met—as you would if you had purchased a U.S. Treasury security, which offers a guaranteed payment every 6 months plus repayment of the purchase price when the security matures.
No, the stocks of different companies are not equally risky. A company might operate in an industry that is viewed as relatively risky, such as biotechnology—where millions of dollars are spent on R&D that may never result in profit. A company might also be heavily regulated and this could be perceived as increasing its risk. Other factors that could cause a company’s stock to be viewed as relatively risky include: heavy use of debt financing vs. equity financing, stock price volatility, and so on.
If investors are more confident that Company A’s cash flows will be closer to their expected value than Company B’s cash flows, then investors will drive the stock price up for Company A. Consequently, Company A will have a higher stock price than Company B.
No, all corporate projects are not equally risky. A firm’s investment decisions have a significant impact on the riskiness of the stock. For example, the types of assets a company chooses to invest in can impact the stock’s risk—such as capital intensive vs. labor intensive, specialized assets vs. general (multipurpose) assets—and how they choose to finance those assets can also impact risk.
A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data. It can be estimated but not measured precisely. A stock’s current price is its market price—the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stock’s “true long-run value” is more closely related to its intrinsic value rather than its current price.
Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are indifferent between buying or selling a stock. If a stock is in equilibrium then there is no fundamental imbalance, hence no pressure for a change in the stock’s price. At any given time, most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or overvalued.
If the three intrinsic value estimates for Stock X were different, I would have the most confidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and different analysts with different data and different views of the future will form different estimates of the intrinsic value for any given stock. However, a firm’s managers have the best information about the company’s future prospects, so managers’ estimates of intrinsic value are generally better than the estimates of outside investors.
If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there is no pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the two be equal; however, intrinsic value is a long-run concept. Management’s goal should be to maximize the firm’s intrinsic value, not its current price. So, maximizing the intrinsic value will maximize the average price over the long run but not necessarily the current price at each point in time. So, stockholders in general would probably expect the firm’s market price to be under the intrinsic value—realizing that if management is doing its job that current price at any point in time would not necessarily be...
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