Chapter 10 The Stock Market and the Efficient Market Hypothesis

10.1 Multiple Choice

1) A basic principle of finance is that the value of any investment is A) the present value of all future net cash flows generated by the investment. B) the undiscounted sum of all future net cash flows generated by the investment. C) unrelated to the future net cash flows generated by the investment. D) unrelated to the degree of risk associated with the future net cash flows generated by the investment. Answer: A

6) In the generalized dividend valuation model a stocks value depend only on A) its future dividend payments and its future price. B) its future dividend payments and the required return on equity. C) its future price and the required return on investments on equity. D) its future dividend payments. Answer: B 7) Which of the following is not an element of the Gordon growth model of stock valuation? A) the stocks most recent dividend paid B) the expected constant growth rate of dividends. C) the required return on investments in equity. D) the stocks expected future price. Answer: D 8) According to the Gordon growth model, what is an investors valuation of a stock whose current dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10 percent over a long period of time and the investors required return is 11 percent? A) $100 B) $9.09 C) $10 D) $4.76 Answer: A 9) According to the Gordon growth model, what is an investors valuation of a stock whose current dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10 percent over a long period of time and the investors required return is 15 percent? A) $6.67 B) $10 C) $20 D) $4 Answer: C 10) Holding other things constant, a stocks value will be highest if its dividend growth rate is A) 15 percent B) 10 percent C) 5 percent D) 2 percent Answer: A

2) A stock currently sells for $25 per share and pays $0.24 per year in dividends. What is an investors valuation of this stock if she expects it to be selling for $30 in one year and requires 15 percent return on equity investments? A) $30.24 B) $26.30 C) $26.09 D) $27.74 Answer: B

3) A stock currently sells for $30 per share and pays $1.00 per year in dividends. What is an investors valuation of this stock if he expects it to be selling for $37 in one year and requires 12 percent return on equity investments? A) $38 B) $33.50 C) $34.50 D) $33.93 Answer: D

4) In the one-period valuation model, a stocks value will be higher A) the higher is its expected future price. B) the lower is its dividend. C) the higher is the required return on investments in equity. D) all of the above. Answer: A

5) In the one-period valuation model, a stocks value falls if the ______ rises. A) dividend B) expected future price C) required return on equity D) current price Answer: C

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11) Holding other things constant, a stocks value will be highest if its most recent dividend is A) $2.00 B) $5.00 C) $0.50 D) $1.00 Answer: B

17) A weakness of he PE approach to valuing stock is that A) it is difficult to estimate the constant growth rate of a firms dividends. B) it is difficult to estimate the required return on equity. C) it is difficult to predict how much a firm will pay in dividends. D) it is based on industry averages rather than firm-specific factors. Answer: D 18) A firms current dividend is $1.00 per year and is expected to grow at a constant rate of 4 percent over time. Some investors have required returns on investments in equity of 12 percent, some 10 percent, and some 8 percent. The market price of this firms stock will be slightly above A) $25 B) $12.50 C) $16.67 D) $18 Answer: C 19) The market price of a security represents the highest value any investor puts on the security. (II) Superior information about a security increases its value by reducing its risk. A) (I) is true, I(I) is false. B) (I) is false, I(I) is true. C) Both are true. D) Both are false. Answer: B 20) The main cause of fluctuations in stock prices is changes in A) tax laws. B) errors in technical stock analysis. C) daily trading volume in stock markets. D) information available to investors. E) total household wealth in the economy. Answer: C 21) Stock values computed by valuation models may differ from actual market prices because A) it is difficult to estimate future dividend growth rates. B) it is difficult to estimate the risk of a stock. C) it is difficult to forecast a stocks future dividends. D) all of the above are true. Answer: D

12) Holding other things constant, a stocks value will be highest if the investors required return on investments in equity is A) 20 percent B) 15 percent C) 10 percent D) 5 percent Answer: D

13) Suppose the average industry PE ratio for auto parts retailers is 20. What is the current price of Auto Zone stock if the retailers earnings per share are projected to be $1.85? A) $21.85 B) $37 C) $10.81 D) $9.25 Answer: B

14) Which of the following is true regarding the Gordon growth model? A) Dividends are assumed to grow at a constant rate forever. B) The dividend growth rate is assumed to be greater than the required return on equity. C) Both (A) and (B). D) Neither (A) nor (B). Answer: A

15) The PE ratio approach to valuing stock is especially useful for valuing A) privately held firms. B) firms that dont pay dividends. C) both (A) and (B). D) neither (A) nor (B). Answer: C

16) The PE ratio approach to valuing stock is especially useful for valuing A) publicly held corporations. B) firms that regularly pay dividends. C) both (A) and (B). D) neither (A) nor (B). Answer: D

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22) According to the efficient market hypothesis, the current price of a financial security A) is the discounted net present value of future interest payments. B) is determined by the highest successful bidder. C) fully reflects all available relevant information. D) is a result of none of the above. Answer: C

23) The efficient market hypothesis A) is based on the assumption that prices of securities fully reflect all available information. B) holds that the expected return on a security equals the equilibrium return. C) both (A) and (B). D) neither (A) nor (B). Answer: C

27) Another way to state the efficient market hypothesis is that in an efficient market, A) unexploited profit opportunities will never exist as market participants, such as arbitrageurs, ensure that they are instantaneously dissipated. B) unexploited profit opportunities will not exist for long, as market participants will act quickly to eliminate them. C) every financial market participant must be well informed about securities. D) only (A) and (C) of the above. Answer: B 28) A situation in which the price of an asset differs from its fundamental market value is called A) an unexploited profit opportunity. B) a bubble. C) a correction. D) a mean reversion. Answer: B 29) A situation in which the price of an asset differs from its fundamental market value A) indicates that unexploited profit opportunities exist. B) indicates that unexploited profit opportunities do not exist. C) need not indicate that unexploited profit opportunities exist. D) indicates that the efficient market hypothesis is fundamentally flawed. Answer: C 30) Studies of mutual fund performance indicate that mutual funds that outperformed the market in one time period A) usually beat the market in the next time period. B) usually beat the market in the next two subsequent time periods. C) usually beat the market in the next three subsequent time periods. D) usually do not beat the market in the next time period. Answer: D

24) If the optimal forecast of the return on a security exceeds the equilibrium return, then A) the market is inefficient. B) an unexploited profit opportunity exists. C) the market is in equilibrium. D) only (A) and (B) of the above are true. E) only (B) and (C) of the above are true. Answer: D

25) According to the efficient market hypothesis A) one cannot expect to earn an abnormally high return by purchasing a security. B) information in newspapers and in the published reports of financial analysts is already reflected in market prices. C) unexploited profit opportunities abound, thereby explaining why so many people get rich by trading securities. D) all of the above are true. E) only (A) and (B) of the above are true. Answer: E

26) Another way to state the efficient market condition is that in an efficient market, A) unexploited profit opportunities will be quickly eliminated. B) unexploited profit opportunities will never exist. C) arbitrageurs guarantee that unexploited profit opportunities never exist. D) both (A) and (C) of the above occur. Answer: A

31) The efficient market hypothesis suggests that allocating your funds in the financial markets on the advice of a financial analyst A) will certainly mean higher returns than if you had made selections by throwing darts at the financial page. B) will always mean lower returns than if you had made selections by throwing darts at the financial page. C) is not likely to prove superior to a strategy of making selections by throwing darts at the financial page. D) is good for the economy. Answer: C

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32) Ivan Boesky, the most successful of the so-called arbs in the 1980s, was able to outperform the market on a consistent basis, indicating that A) securities markets are not efficient. B) unexploited profit opportunities were abundant. C) investors can outperform the market with inside information. D) only (B) and (C) of the above. Answer: D 39) The advantage of a "buy-and-hold strategy" is that A) net profits will tend to be higher because there will be fewer brokerage commissions. B) losses will eventually be eliminated. C) the longer a stock is held, the higher will be its price. D) only (B) and (C) of the above are true. Answer: A 40) The efficient market hypothesis suggests that A) investors should not try to outguess the market by constantly buying and selling securities. B) investors do better on average if they adopt a "buy and hold" strategy. C) buying into a mutual fund is a sensible strategy for a small investor. D) all of the above are sensible strategies. E) only (A) and (B) of the above are sensible strategies. Answer: D

38) Which of the following types of information will most likely enable the exploitation of a profit opportunity? A) Financial analysts' published recommendations B) Technical analysis C) Hot tips from a stockbroker D) None of the above Answer: D

33) To say that stock prices follow a "random walk" is to argue that A) stock prices rise, then fall. B) stock prices rise, then fall in a predictable fashion. C) stock prices tend to follow trends. D) stock prices are, for all practical purposes, unpredictable. Answer: D

34) To say that stock prices follow a "random walk" is to argue that A) stock prices rise, then fall, then rise again. B) stock prices rise, then fall in a predictable fashion. C) stock prices tend to follow trends. D) stock prices cannot be predicted based on past trends. Answer: D

35) Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets theory, A) a waste of time B) profitably employed by all financial analysts. C) the most efficient rules to employ. D) consistent with the random walk hypothesis. Answer: A

36) Tests used to rate the performance of rules developed in technical analysis conclude that A) technical analysis outperforms the overall market. B) technical analysis far outperforms the overall market, suggesting that stockbrokers provide valuable services. C) technical analysis does not outperform the overall market. D) technical analysis does not outperform the overall market, suggesting that stockbrokers do not provide services of any value. Answer: C

41) Sometimes one observes that the price of a company's stock falls after the announcement of favorable earnings. This phenomenon is A) clearly inconsistent with the efficient market hypothesis. B) consistent with the efficient market hypothesis if the earnings were not as high as anticipated. C) consistent with the efficient market hypothesis if the earnings were not as low as anticipated. D) the result of none of the above. Answer: B 42) Important implications of the efficient market hypothesis include which of the following? A) Future changes in stock prices should, for all practical purposes, be unpredictable. B) Stock prices will respond to announcements only when the information in these announcements is new. C) Sometimes a stock price declines when good news is announced. D) all of the above. E) only (A) and (B) of the above. Answer: D

37) Which of the following types of information will most likely enable the exploitation of a profit opportunity? A) Financial analysts' published recommendations B) Technical analysis C) Hot tips from a stockbroker D) Insider information Answer: D

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8) In an efficient market, abnormal returns are not possible even using inside information. Answer: FALSE 9) It is probably a good use of an investor's time to watch as many shows featuring technical analysts as possible. Answer: FALSE

43) Although the verdict is not yet in, the available evidence indicates that, for many purposes, the efficient market hypothesis is A) a good starting point for analyzing expectations. B) not a good starting point for analyzing expectations. C) too general to be a useful tool for analyzing expectations. D) none of the above. Answer: A

10.3 Essay
1) How is it possible that a firm can announce a record breaking loss, yet its stock price rise when the announcement is made? 2) What is the optimal investment strategy according to the efficient market hypothesis? Why? 3) Explain what the market reaction will be in an efficient market if a firm announces a fully anticipated filing for bankruptcy. 4) Explain how the market's reaction to a mispriced security will lead to the correct pricing of all securities. 5) What is the role of the required return on investments in equity in stock valuation models?

44) The efficient market hypothesis suggests that A) investors should purchase no-load mutual funds which have low management fees. B) investors can use the advice of technical analysts to outperform the market. C) investors let too many unexploited profit opportunities go by if they adopt a "buy and hold" strategy. D) only (A) and (B) of the above are sensible strategies. Answer: A

10.2 True/False

1) Evidence that stock prices sometimes fall when a firm announces good news contradicts the efficient market hypothesis. Answer: FALSE

2) If the security markets are truly efficient, there is no need to pay for help selecting securities. Answer: TRUE

3) Evidence that a mutual fund has performed extraordinarily well in the past contradicts the efficient market hypothesis. Answer: FALSE

4) In an efficient market, every stock is a good choice. Answer: TRUE

5) Technical analysts look at historical prices for information to project future prices. Answer: TRUE

6) The evidence suggests technical analysts are not superior stock pickers. Answer: TRUE

7) If the markets are efficient, the optimal investment strategy will be to buy and hold so as to minimize transaction costs. Answer: TRUE

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