AHIP Business Finance Exam 2 Notes
(Chapter 7) 2024
The cash flows from owning a share of stock come in the form of... - ANS future dividends.
As the owner of shares of common stock in a corporation, you have various rights, including: -
ANS the right to vote to elect corporate directors.
Voting in corporate elections can be either: - ANS 1. Cumulative
2. Straight
Most voting is done by... - ANS proxy.
Proxy battles... - ANS break out when competing sides try to gain enough votes to have their
candidates for the board elected.
Someone seeks after a bunch of investors' proxy votes so they can take control of the project
In addition to common stock, some corporations have issued... - ANS preferred stock.
Preferred stockholders must... - ANS be paid first, before common stockholders can receive
anything.
Preferred stock has a... - ANS fixed dividend.
The two biggest stock markets in the United States - ANS NYSE
NASDAQ
Why does the value of a share of stock depend on dividends? - ANS The value of any
investment depends on its cash flows; i.e., what investors will actually receive. The
cash flows from a share of stock are the dividends.
A substantial percentage of the companies listed on the NYSE and the NASDAQ don't pay
dividends, but investors are nonetheless willing to buy shares in them. How is this possible
given your answer to the previous question? - ANS Investors believe the company will
eventually start paying dividends (or be sold to another company).
Referring to the previous questions, under what circumstances might a company choose not to
pay dividends? - ANS In general, companies that need the cash will often forgo dividends since
dividends are a cash expense. Young, growing companies with profitable investment
, opportunities are one example; another example is a company in financial distress. This
question is examined in depth in a later chapter.
Under what two assumptions can we use the dividend growth model presented in the chapter to
determine the value of a share of stock? Comment on the reasonableness of these
assumptions. - ANS The general method for valuing a share of stock is to find the present value
of all expected future dividends. The dividend growth model presented in the text is only valid (i)
if dividends are expected to occur forever; that is, the stock provides dividends in perpetuity, and
(ii) if a constant growth rate of dividends occurs forever. A violation of the first assumption might
be a company that is expected to cease operations and dissolve itself some finite number of
years from now. The stock of such a company would be valued by the methods of this chapter
by applying the general method of valuation. A violation of the second assumption might be a
start-up firm that isn't currently paying any dividends, but is expected to eventually start making
dividend payments some number of years from now. This stock would also be valued by the
general dividend valuation method of this chapter.
Suppose a company has a preferred stock issue and a common stock issue. Both have just
paid a $2 dividend. Which do you think will have a higher price, a share of the preferred or a
share of the common? - ANS The common stock probably has a higher price because the
dividend can grow, whereas it is fixed on the preferred. However, the preferred is less risky
because of the dividend and liquidation preference, so it is possible the preferred could be worth
more, depending on the circumstances.
Based on the dividend growth model, what are the two components of the total return on a
share of stock? Which do you think is typically larger? - ANS The two components are the
dividend yield and the capital gains yield. For most companies, the capital gains yield is larger.
This is easy to see for companies that pay no dividends. For companies that do pay dividends,
the dividend yields are rarely over five percent and are often much less.
In the context of the dividend growth model, is it true that the growth rate in dividends and the
growth rate in the price of the stock are identical? - ANS The dividend growth model makes the
implicit assumption that the stock price will grow at the same constant rate as the dividend.
What this means is that if the cash flows on an investment grow at a constant rate through time,
the value of that investment grows at the same rate as the cash flows.
Is it possible for a company to pay dividends when it has a negative net income for the year?
Could this happen for longer periods? - ANS For a particular year, this can (and often does)
happen. Going back to the cash flow identity, the dividend payments depend on operating cash
flow, capital spending, the change in net working capital, and the cash flow to creditors. The firm
could have positive operating cash flow with negative earnings, sell fixed assets, reduce net
working capital, or raise cash from creditors in order to pay dividends. While this is possible in
the short term, as a practical matter over the longer term, the company would probably need to
have a positive net income (at least on average) in order to maintain a dividend.
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