Chapter 10 The Stock Market and the Efficient Market Hypothesis 6) In the generalized dividend valuation model a stocks

vidend 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.
10.1 Multiple Choice C) its future price and the required return on investments on equity.
D) its future dividend payments.
1) A basic principle of finance is that the value of any investment is Answer: B
A) the present value of all future net cash flows generated by the investment.
7) Which of the following is not an element of the Gordon growth model of stock
B) the undiscounted sum of all future net cash flows generated by the investment.
valuation?
C) unrelated to the future net cash flows generated by the investment.
A) the stocks most recent dividend paid
D) unrelated to the degree of risk associated with the future net cash flows
B) the expected constant growth rate of dividends.
generated by the investment.
C) the required return on investments in equity.
Answer: A
D) the stocks expected future price.
2) A stock currently sells for $25 per share and pays $0.24 per year in dividends. Answer: D
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? 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
A) $30.24
constant rate of 10 percent over a long period of time and the investors required
B) $26.30
return is 11 percent?
C) $26.09
A) $100
D) $27.74
B) $9.09
Answer: B
C) $10
3) A stock currently sells for $30 per share and pays $1.00 per year in dividends. D) $4.76
What is an investors valuation of this stock if he expects it to be selling for $37 in Answer: A
one year and requires 12 percent return on equity investments?
A) $38 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
B) $33.50
constant rate of 10 percent over a long period of time and the investors required
C) $34.50 return is 15 percent?
D) $33.93
A) $6.67
Answer: D B) $10
4) In the one-period valuation model, a stocks value will be higher C) $20
A) the higher is its expected future price. D) $4
B) the lower is its dividend. Answer: C
C) the higher is the required return on investments in equity. 10) Holding other things constant, a stocks value will be highest if its dividend growth
D) all of the above. rate is
Answer: A A) 15 percent
5) In the one-period valuation model, a stocks value falls if the ______ rises. B) 10 percent
A) dividend C) 5 percent
B) expected future price D) 2 percent
C) required return on equity Answer: A
D) current price
Answer: C

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11) Holding other things constant, a stocks value will be highest if its most recent 17) A weakness of he PE approach to valuing stock is that
dividend is A) it is difficult to estimate the constant growth rate of a firms dividends.
A) $2.00 B) it is difficult to estimate the required return on equity.
B) $5.00 C) it is difficult to predict how much a firm will pay in dividends.
C) $0.50 D) it is based on industry averages rather than firm-specific factors.
D) $1.00 Answer: D
Answer: B
18) A firms current dividend is $1.00 per year and is expected to grow at a constant
12) Holding other things constant, a stocks value will be highest if the investors rate of 4 percent over time. Some investors have required returns on investments in
required return on investments in equity is equity of 12 percent, some 10 percent, and some 8 percent. The market price of this
A) 20 percent firms stock will be slightly above
B) 15 percent A) $25
C) 10 percent B) $12.50
D) 5 percent C) $16.67
Answer: D D) $18
Answer: C
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 19) The market price of a security represents the highest value any investor puts on the
be $1.85? security. (II) Superior information about a security increases its value by reducing
A) $21.85 its risk.
B) $37 A) (I) is true, I(I) is false.
C) $10.81 B) (I) is false, I(I) is true.
D) $9.25 C) Both are true.
Answer: B D) Both are false.
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. 20) The main cause of fluctuations in stock prices is changes in
B) The dividend growth rate is assumed to be greater than the required return on A) tax laws.
equity. B) errors in technical stock analysis.
C) Both (A) and (B). C) daily trading volume in stock markets.
D) Neither (A) nor (B). D) information available to investors.
Answer: A E) total household wealth in the economy.
Answer: C
15) The PE ratio approach to valuing stock is especially useful for valuing
A) privately held firms. 21) Stock values computed by valuation models may differ from actual market
B) firms that dont pay dividends. prices because
C) both (A) and (B). A) it is difficult to estimate future dividend growth rates.
D) neither (A) nor (B). B) it is difficult to estimate the risk of a stock.
Answer: C C) it is difficult to forecast a stocks future dividends.
D) all of the above are true.
16) The PE ratio approach to valuing stock is especially useful for valuing Answer: D
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 27) Another way to state the efficient market hypothesis is that in an efficient market,
A) is the discounted net present value of future interest payments. A) unexploited profit opportunities will never exist as market participants, such as
B) is determined by the highest successful bidder. arbitrageurs, ensure that they are instantaneously dissipated.
C) fully reflects all available relevant information. B) unexploited profit opportunities will not exist for long, as market participants
D) is a result of none of the above. will act quickly to eliminate them.
Answer: C C) every financial market participant must be well informed about securities.
D) only (A) and (C) of the above.
23) The efficient market hypothesis Answer: B
A) is based on the assumption that prices of securities fully reflect all available
information. 28) A situation in which the price of an asset differs from its fundamental market value
B) holds that the expected return on a security equals the equilibrium return. is called
C) both (A) and (B). A) an unexploited profit opportunity.
D) neither (A) nor (B). B) a bubble.
Answer: C C) a correction.
D) a mean reversion.
24) If the optimal forecast of the return on a security exceeds the equilibrium return, Answer: B
then
A) the market is inefficient. 29) A situation in which the price of an asset differs from its fundamental market value
B) an unexploited profit opportunity exists. A) indicates that unexploited profit opportunities exist.
C) the market is in equilibrium. B) indicates that unexploited profit opportunities do not exist.
D) only (A) and (B) of the above are true. C) need not indicate that unexploited profit opportunities exist.
E) only (B) and (C) of the above are true. D) indicates that the efficient market hypothesis is fundamentally flawed.
Answer: D Answer: C

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
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
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 38) Which of the following types of information will most likely enable the exploitation
outperform the market on a consistent basis, indicating that of a profit opportunity?
A) securities markets are not efficient. A) Financial analysts' published recommendations
B) unexploited profit opportunities were abundant. B) Technical analysis
C) investors can outperform the market with inside information. C) Hot tips from a stockbroker
D) only (B) and (C) of the above. D) None of the above
Answer: D Answer: D
33) To say that stock prices follow a "random walk" is to argue that 39) The advantage of a "buy-and-hold strategy" is that
A) stock prices rise, then fall. A) net profits will tend to be higher because there will be fewer brokerage
B) stock prices rise, then fall in a predictable fashion. commissions.
C) stock prices tend to follow trends. B) losses will eventually be eliminated.
D) stock prices are, for all practical purposes, unpredictable. C) the longer a stock is held, the higher will be its price.
Answer: D D) only (B) and (C) of the above are true.
Answer: A
34) To say that stock prices follow a "random walk" is to argue that
A) stock prices rise, then fall, then rise again. 40) The efficient market hypothesis suggests that
B) stock prices rise, then fall in a predictable fashion. A) investors should not try to outguess the market by constantly buying and
C) stock prices tend to follow trends. selling securities.
D) stock prices cannot be predicted based on past trends. B) investors do better on average if they adopt a "buy and hold" strategy.
Answer: D C) buying into a mutual fund is a sensible strategy for a small investor.
D) all of the above are sensible strategies.
35) Rules used to predict movements in stock prices based on past patterns are, E) only (A) and (B) of the above are sensible strategies.
according to the efficient markets theory, Answer: D
A) a waste of time
B) profitably employed by all financial analysts. 41) Sometimes one observes that the price of a company's stock falls after the
C) the most efficient rules to employ. announcement of favorable earnings. This phenomenon is
D) consistent with the random walk hypothesis. A) clearly inconsistent with the efficient market hypothesis.
Answer: A B) consistent with the efficient market hypothesis if the earnings were not as high
as anticipated.
36) Tests used to rate the performance of rules developed in technical analysis conclude C) consistent with the efficient market hypothesis if the earnings were not as low
that as anticipated.
A) technical analysis outperforms the overall market. D) the result of none of the above.
B) technical analysis far outperforms the overall market, suggesting that Answer: B
stockbrokers provide valuable services.
C) technical analysis does not outperform the overall market. 42) Important implications of the efficient market hypothesis include which of the
D) technical analysis does not outperform the overall market, suggesting that following?
stockbrokers do not provide services of any value. A) Future changes in stock prices should, for all practical purposes, be
Answer: C unpredictable.
B) Stock prices will respond to announcements only when the information in
37) Which of the following types of information will most likely enable the exploitation these announcements is new.
of a profit opportunity? C) Sometimes a stock price declines when good news is announced.
A) Financial analysts' published recommendations D) all of the above.
B) Technical analysis E) only (A) and (B) of the above.
C) Hot tips from a stockbroker Answer: D
D) Insider information
Answer: D

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43) Although the verdict is not yet in, the available evidence indicates that, for many 8) In an efficient market, abnormal returns are not possible even using inside
purposes, the efficient market hypothesis is information.
A) a good starting point for analyzing expectations. Answer: FALSE
B) not a good starting point for analyzing expectations.
C) too general to be a useful tool for analyzing expectations. 9) It is probably a good use of an investor's time to watch as many shows featuring
D) none of the above. technical analysts as possible.
Answer: A Answer: FALSE

44) The efficient market hypothesis suggests that

A) investors should purchase no-load mutual funds which have low
management fees. 10.3 Essay
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 1) How is it possible that a firm can announce a record breaking loss, yet its stock
"buy and hold" strategy. price rise when the announcement is made?
D) only (A) and (B) of the above are sensible strategies.
Answer: A 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.
10.2 True/False
4) Explain how the market's reaction to a mispriced security will lead to the correct
1) Evidence that stock prices sometimes fall when a firm announces good news pricing of all securities.
contradicts the efficient market hypothesis.
5) What is the role of the required return on investments in equity in stock valuation
Answer: FALSE models?
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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