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Personal Finance: Turning Money into Wealth, 7e (Keown)

Chapter 12 Investing in Stocks


12.1 Why Consider Stocks?
1) Limited liability associated with stock ownership means that shareholders can only lose the
amount of money they have invested in the company.
Answer: TRUE
Diff: 1
Topic: Limited Liability
AACSB: Diverse and Multicultural Work Environments
2) A company's dividend distribution can be in the form of cash or additional stock.
Answer: TRUE
Diff: 1
Topic: Dividends
AACSB: Information Technology
3) The market price of the stock is a reflection of the potential earnings per share of the firm.
Answer: TRUE
Diff: 2
Topic: Earnings per Share
AACSB: Diverse and Multicultural Work Environments
4) Some firms have negative earnings per share numbers.
Answer: TRUE
Diff: 2
Topic: Earnings per Share
AACSB: Diverse and Multicultural Work Environments
5) Some companies distribute earnings per share in the form of dividends and some retain these
earnings for future investment in the firm.
Answer: TRUE
Diff: 2
Topic: Earnings per Share
AACSB: Diverse and Multicultural Work Environments
6) The dividend yield is calculated by dividing the earnings per share by the market price of the
stock.
Answer: FALSE
Diff: 2
Topic: Dividends
AACSB: Information Technology

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7) The dividend yield tells investors how much in the way of a return they would receive if the
stock price and the dividend level remain constant.
Answer: TRUE
Diff: 2
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
8) In the event of a corporate bankruptcy, bondholder's claims are paid before shareholders'
claims are paid.
Answer: TRUE
Diff: 2
Topic: Claims on Assets
AACSB: Diverse and Multicultural Work Environments
9) Common stockholders not only have the right to elect the board but also must approve day-today decisions of the chief executive officer.
Answer: FALSE
Diff: 2
Topic: Voting Rights
AACSB: Diverse and Multicultural Work Environments
10) Stock splits increase the number of the shares you own, but decrease the value of your total
holdings with the company.
Answer: FALSE
Diff: 1
Topic: Stock Split
AACSB: Analytical Thinking
11) Publicly traded stocks listed on a major exchange are not very liquid investments.
Answer: FALSE
Diff: 1
Topic: Liquidity
AACSB: Diverse and Multicultural Work Environments
12) Every company must pay dividends as a portion of the company's profits to its stockholders.
Answer: FALSE
Diff: 1
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
13) According to your text, over time, investing in stocks generally outperforms most other
investments.
Answer: TRUE
Diff: 2
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments
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14) Holding several types of stock can greatly reduce the risk in your portfolio.
Answer: TRUE
Diff: 2
Topic: Risk
AACSB: Analytical Thinking
15) Common stockholders have a superior claim on a company's assets over creditors and
bondholders.
Answer: FALSE
Diff: 2
Topic: Claims on Assets
AACSB: Diverse and Multicultural Work Environments
16) A stock split is a tactic by a corporation to manipulate the market price of its stock.
Answer: TRUE
Diff: 2
Topic: Stock Split
AACSB: Diverse and Multicultural Work Environments
17) A proxy is a legal agreement a stockholder signs to allow someone else to vote for him or her
at the corporation's annual meeting.
Answer: TRUE
Diff: 2
Topic: Voting Rights
AACSB: Information Technology
18) When a corporation engages in a stock repurchase, each remaining shareholder owns a
smaller proportion of the firm.
Answer: FALSE
Diff: 2
Topic: Stock Repurchase
AACSB: Diverse and Multicultural Work Environments
19) A firm may decide that the price per share for its stock is getting too high for the smaller
investor so the company "splits the stock."
Answer: TRUE
Diff: 2
Topic: Stock Split
AACSB: Diverse and Multicultural Work Environments
20) When a corporation repurchases its own stock, it does so in the secondary markets.
Answer: TRUE
Diff: 3
Topic: Stock Repurchase
AACSB: Diverse and Multicultural Work Environments

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21) Returns on stocks can come in the form of capital appreciation.


Answer: TRUE
Diff: 2
Topic: Returns
AACSB: Diverse and Multicultural Work Environments
22) Capital appreciation refers to an increase in the selling price of your shares of stock.
Answer: TRUE
Diff: 3
Topic: Stock Investment Strategies
AACSB: Information Technology
23) You cannot benefit from capital appreciation until you actually sell your stock.
Answer: TRUE
Diff: 2
Topic: Stock Investment Strategies
AACSB: Diverse and Multicultural Work Environments
24) Both capital gains and dividends are guaranteed with common stock.
Answer: FALSE
Diff: 3
Topic: Dividends
AACSB: Information Technology
25) Dividends are paid regardless if the company makes a profit.
Answer: FALSE
Diff: 3
Topic: Dividends
AACSB: Information Technology
26) While you can't be assured of what you will get when you sell your stock, you will most
likely not have difficulty selling it.
Answer: TRUE
Diff: 3
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments
27) Income stocks are stocks that have a very high capital appreciation potential.
Answer: FALSE
Diff: 1
Topic: Classification of Common Stock
AACSB: Information Technology

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28) Growth stocks are issued by companies that have exhibited sales and earnings growth well
above their industry average.
Answer: TRUE
Diff: 1
Topic: Classification of Common Stock
AACSB: Information Technology
29) Most of the stocks listed in the Dow Jones Industrials have high P/E ratios and are classified
as speculative stocks.
Answer: FALSE
Diff: 1
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
30) A growth stock is known for its high dividend yields.
Answer: FALSE
Diff: 1
Topic: Classification of Common Stock
AACSB: Information Technology
31) When the economy slumps, the earnings of cyclical stocks drop; when the economy
recovers, so do their earnings.
Answer: TRUE
Diff: 2
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
32) Microsoft is an example of a company whose common stock is considered to be a growth
stock.
Answer: TRUE
Diff: 2
Topic: Classification of Common Stock
AACSB: Information Technology
33) Income stocks pay relatively low dividends, and offer a high potential for capital
appreciation.
Answer: FALSE
Diff: 2
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
34) Speculative stocks are often traded through the OTC Bulletin Board.
Answer: TRUE
Diff: 2
Topic: Classification of Common Stock
AACSB: Information Technology
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35) Proctor and Gamble is an example of a blue-chip stock.


Answer: TRUE
Diff: 2
Topic: Classification of Common Stock
AACSB: Information Technology
36) Defensive stocks frequently perform better during economic downturns.
Answer: TRUE
Diff: 2
Topic: Classification of Common Stock
AACSB: Information Technology
37) Stocks reduce risk by portfolio rebalancing.
Answer: FALSE
Diff: 1
Topic: Classification of Common Stock
AACSB: Information Technology
38) Berkshire Hathaway's "A" stock has never split. As a result, in mid-2014 one share of the
stock was selling at a price of more than $190,000 per share.
Answer: TRUE
Diff: 2
Topic: Stocks
AACSB: Reflective Thinking
39) Coca-Cola is an example of a red-chip stock.
Answer: FALSE
Diff: 2
Topic: Classification of Common Stock
AACSB: Information Technology
40) You have just purchased 10 shares of a stock selling at $50 per share. Since that time, the
company was found to be in violation of several environmental laws and has several major
lawsuits outstanding. Which of the following statements is most correct?
A) You could lose up to your $500 investment.
B) You could lose more than your $500 investment.
C) You cannot lose your investment based on the actions of the company.
D) By owning stock in the company, you have also technically violated the law.
E) None of the above
Answer: A
Diff: 2
Topic: Limited Liability
AACSB: Diverse and Multicultural Work Environments

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41) Which of the following statements is most correct regarding the general relationship between
stocks and interest rates?
A) There is no relationship between interest rates and stock prices.
B) As interest rates increase, stock prices should also increase.
C) As interest rates increase, stock prices should decrease.
D) Stock prices are negatively exponentially related to interest rate increases.
E) None of the above
Answer: C
Diff: 1
Topic: Stock Valuation
AACSB: Diverse and Multicultural Work Environments
42) ________ are a company's distribution of its profits in the form of cash or stock to its
owners.
A) Dividends
B) Coupon interest payments
C) Equity payments
D) Shareholder divestments
E) None of the above
Answer: A
Diff: 1
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
43) When a company buys back its own common stock it is engaging in a
A) stock split.
B) stock reissue.
C) stock repurchase.
D) stock repo.
E) none of the above.
Answer: C
Diff: 1
Topic: Stock Repurchase
AACSB: Diverse and Multicultural Work Environments
44) A ________ increases the number of stock shares outstanding by replacing each existing
share of stock with a stated number of new shares.
A) dividend reinvestment
B) stock split
C) stock repurchase
D) stock reissue
E) none of the above
Answer: B
Diff: 1
Topic: Stock Split
AACSB: Diverse and Multicultural Work Environments
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45) The net income of the firm is $4 million dollars. The firm will pay $500,000 in dividends to
the preferred shareholders. There are currently 1 million shares of common stock outstanding.
What are the earnings per share for this firm?
A) $4.00
B) $3.50
C) $4.50
D) $3.00
Answer: B
Diff: 1
Topic: Earnings per Share
AACSB: Analytical Thinking
46) The firm will pay an annual dividend this year of $2 per share. The current market price of
the stock is $40.00 per share. The book value of this stock is $24.00 per share. The earnings per
share for this firm is $5.75. What is the current dividend yield of this stock?
A) 14.38%
B) 8.33%
C) 23.9%
D) 5%
Answer: D
Diff: 1
Topic: Earnings per Share
AACSB: Analytical Thinking
47) Your investment goal is to receive a stream of income from your investment. Which of the
following would be important information to determine whether a particular stock purchase
would suit your plan?
A) The earnings per share
B) The market-to-book ratio
C) The book value
D) The dividend yield
Answer: D
Diff: 3
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
48) A(n) ________ is a legal agreement signed by a stockholder allowing someone else to vote
on his or her behalf at the corporation's annual meeting.
A) voting contract
B) agency contact
C) contingency contract
D) proxy
E) none of the above
Answer: D
Diff: 1
Topic: Voting Rights
AACSB: Information Technology
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49) The ________ date is the date the stock begins trading without dividend, meaning that if you
buy it after this date you will not get the dividend for that year.
A) payment date
B) declaration date
C) ex-dividend date
D) reinvestment date
E) maturity date
Answer: C
Diff: 1
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
50) The ________ is the date on which the board of directors announces the amount of the
dividend.
A) announcement date
B) declaration date
C) dividend date
D) ex-dividend date
E) maturity date
Answer: B
Diff: 1
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
51) You purchased 100 shares of Quantex at $150 per share for a total investment of $15,000.
After your purchase the stock had a 3 for 1 split. How many shares do you now own and how
much is your original investment now worth?
A) 100 shares and $150 dollars
B) 300 shares and $15,000 dollars
C) 100 shares and $45,000 dollars
D) 300 shares and $45,000 dollars
Answer: B
Diff: 3
Topic: Stock Split
AACSB: Analytical Thinking

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52) Nathan noticed that a company that has great potential just declared a ________ because its
stock price was getting too high for the small investor to buy the stock. The company will
substitute more shares for the existing shares of stock without increasing the market value of the
firm.
A) dividend yield
B) stock repurchase
C) claim on income
D) stock split
E) stock splice
Answer: D
Diff: 2
Topic: Stock Split
AACSB: Diverse and Multicultural Work Environments
53) You are really keen on stocks. However, you do not like stocks with regard to ________.
This means that if a company you have invested in goes bankrupt, the creditors are paid first and
you will be out of luck.
A) claim on income
B) limited liability
C) claims on assets
D) voting rights
E) claims on dividends
Answer: C
Diff: 2
Topic: Claims on Assets
AACSB: Diverse and Multicultural Work Environments
54) Common stockholders are entitled to elect the company's board of directors. Usually one
share of stock is equal to ________ vote(s).
A) one
B) two
C) 100
D) 1,000
Answer: A
Diff: 2
Topic: Stocks
AACSB: Information Technology

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55) What are proxy fights?


A) Proxy fights are when two rival companies want the same voters.
B) Proxy fights are battles for proxy votes between rival groups of share holders in separate
companies.
C) Proxy fights are battles for proxy votes between rival groups of share holders in the same
company.
D) Proxy fights are when shareholders fight over who will cast their votes.
E) There is no such thing as a proxy fight.
Answer: C
Diff: 3
Topic: Stock Investment Strategies
AACSB: Analytical Thinking
56) The dividend yield on a share of common stock is
A) available at most large companies.
B) the amount of annual dividends divided by the market price of the stock.
C) the taxes you pay on the reinvested dividends.
D) all of the above.
E) only A and B.
Answer: B
Diff: 3
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
57) The book value of a company is calculated by
A) adding the price per share to the dividends paid.
B) subtracting its price per share from the dividends paid.
C) subtracting the value of all the firm's assets from the value of its liabilities.
D) subtracting the value of all the firm's liabilities from the value of its assets.
Answer: D
Diff: 2
Topic: Investment Information
AACSB: Information Technology
58) A proxy vote means
A) filling out a voting form and having a representative turn it in for you.
B) requesting that your vote be deferred until a later date.
C) giving a representative the right to vote in your place.
D) none of the above.
Answer: C
Diff: 2
Topic: Voting Rights
AACSB: Information Technology

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59) What point marks the purchase of common stock without a right to a declared dividend?
A) Dividend payout date
B) Declaration date
C) Ex-dividend date
D) Cut-off point
E) End of fiscal year
Answer: C
Diff: 1
Topic: Dividends
AACSB: Information Technology
60) As a shareholder in Titanic Shipping, Inc., James Blue is one of the many actual owners. In
case of the bankruptcy of the corporation, his liability would be limited to
A) his ownership percentage of the actual loss.
B) the amount of his investment.
C) nothing at all.
D) what is left after selling the stock and subtracting the debt.
Answer: B
Diff: 2
Topic: Limited Liability
AACSB: Diverse and Multicultural Work Environments
61) Which feature of common stock ownership allows a stockholder to share in the company's
earnings after the creditors are paid?
A) Limited liability
B) Claim on income
C) Claims on assets
D) Voting rights
Answer: B
Diff: 2
Topic: Claims on Assets
AACSB: Diverse and Multicultural Work Environments
62) Returns from shares of stock come in the form of
A) stock splits.
B) capital appreciation.
C) dividends.
D) All of the above are correct.
E) Only B and C are correct.
Answer: E
Diff: 2
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments

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63) Dividends
A) are always paid, regardless of the company's profitability.
B) are always paid when the company makes a profit.
C) are never paid to common stockholders; only preferred stockholders receive them.
D) None of the above is true.
Answer: D
Diff: 2
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments
64) Abby previously owned 200 shares of NEWAGE stock at $25 per share. Today the company
split the stock in a 3:1 split. Now what is the value of Abby's stock?
A) $5,000
B) $6,000
C) $2,500
D) $200
Answer: A
Diff: 2
Topic: Stocks
AACSB: Analytical Thinking
65) Which of the following investment options is not affected by a change in the market rates of
interest?
A) Common stocks
B) Corporate bonds
C) Government bonds
D) None of the above is correct; all are affected.
Answer: D
Diff: 3
Topic: Stocks
AACSB: Analytical Thinking
66) Figure 13.1 in your textbook compares the returns on various investments over the period
1951-2010. Which of the following is shown to exceed the inflation rate by the widest margin?
A) Common stocks
B) Government bonds
C) Treasury bills
D) Mutual funds
Answer: A
Diff: 1
Topic: Risk
AACSB: Diverse and Multicultural Work Environments

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67) Which of the following makes common stocks more risky than corporate bonds when both
are issued by the same company?
A) Claims on income
B) Unlimited liability
C) Claims on assets
D) All of the above are correct.
E) Only A and C are correct.
Answer: E
Diff: 1
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments
68) Suppose that a company feels that the price of its stock is more than the average small
investor can afford. To lower the price the company could engage in a
A) stock split.
B) stock repurchase.
C) proxy vote.
D) All of the above are correct.
Answer: A
Diff: 2
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments
69) The dividend yield tells investors which of the following?
A) What their portfolio is worth on the open market
B) How much in the way of a return they would receive if the stock price and the dividend level
remain constant
C) When the company will be releasing dividends
D) How much in total the company has available to pay out in dividends
E) none of the above
Answer: B
Diff: 3
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
70) Greg Jewell read about several companies that were performing relatively well despite the
current recession. Stocks like these, that in some cases actually perform better during downturns
in the economy, are called ________ stocks.
A) cyclical
B) speculative
C) defensive
D) growth
E) seasonal
Answer: C
Diff: 2
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
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71) If you purchase stock of big companies like Proctor & Gamble, General Electric, and Texaco
you would be buying shares of ________ stocks.
A) blue-chip
B) true-blue
C) mini-caps
D) speculative
Answer: A
Diff: 2
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
72) Deborah recently purchased a stock that is considerably more risky than a typical stock. It
has exhibited a high degree of earnings variability. This is an example of a(n) ________ stock.
A) speculative
B) blue-chip
C) income
D) mid-cap
Answer: A
Diff: 1
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
73) If you were to purchase common stocks issued by large, nationally known companies with
sound financial histories with solid dividend and growth records you would own what are called
A) best-bet stocks.
B) blue-chip stocks.
C) performance stocks.
D) long-run performance stocks.
E) none of the above.
Answer: B
Diff: 1
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments

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74) Because of her children's immediate financial needs, your aunt Marsha has decided to switch
some of her money to high-grade utility company stocks. Her reasoning is that these ________
stocks generally pay relatively high dividends that she will be able to give to her children as they
need assistance.
A) growth
B) blue-chip
C) income
D) cyclical
E) safe
Answer: C
Diff: 2
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
75) As compared to growth stocks, income stocks pay ________ dividends with ________
growth in earnings.
A) relatively high; relatively high
B) the same; relatively high
C) relatively high; relatively little
D) relatively high; moderate
E) relatively high; the same
Answer: C
Diff: 3
Topic: Classification of Common Stock
AACSB: Analytical Thinking
76) For an investor who is retired, which category of stocks would be more appropriate for a
portion of their portfolio?
A) Blue-chip stocks
B) Income stocks
C) Growth stocks
D) All of the above are correct.
E) Only A and B are correct.
Answer: E
Diff: 3
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments

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77) Brenda is a 25 year old investor who recently graduated from college and has a successful
career, which type of stock should represent a good portion of her portfolio?
A) Growth stocks
B) Defensive stocks
C) Income stocks
D) Risk-free stocks
Answer: A
Diff: 3
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
78) Large-caps, mid-caps, and small-caps refer to the size of the firm issuing the stock, more
specifically, to its
A) book value.
B) market value.
C) dividend.
D) capacity for growth.
Answer: B
Diff: 3
Topic: Classification of Common Stock
AACSB: Information Technology
79) Which stock index will have the largest representation of small-, mid- and large -cap stocks?
A) DJIA
B) S&P 500
C) Wilshire 5000
D) None of the above
Answer: C
Diff: 3
Topic: Stock Index
AACSB: Information Technology
80) Berkshire Hathaway's "A" stock has never split. As a result, in mid-2014 one share of its
stock was selling at a price of more than ________ per share.
A) $190
B) $1,900
C) $19,000
D) $190,000
Answer: D
Diff: 2
Topic: Stocks
AACSB: Reflective Thinking

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81) Explain the common stock features and rights as though you are speaking to a novice.
Answer: Common stocks have limited liability; that is, if the company goes bankrupt your
liability is limited to the amount of your investment. The claim on income is not certain because
the corporation is not obligated to pay any dividends. Dividends are paid only after all debt and
other obligations have been paid, such as reinvesting the leftover earnings back into the
company. On the other hand, if the company has a booming year the stockholders will make a
bundle.
Should a company go bankrupt, the creditors have claim on its assets before the stockholders do,
and therefore the stockholders may be out of luck. Stockholders are entitled to elect the
company's officers and sometimes vote on policy. The number of votes depends upon the number
of shares owned. When a firm thinks its stock price is too high for the smaller investor, the
officers will "split" it into more shares. Sometimes a firm will repurchase shares so that each
stockholder will own a larger proportion of the firm.
Common stock has book value, a return (dividend yield), earnings per share, and a market-tobook ratio.
Diff: 2
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments
82) Explain the purpose and value of the dividend yield ratio.
Answer: The dividend yield ratio is a tool that allows investors to compare the potential income
return on various investment opportunities. For example, a share with a dividend yield of 3%
would produce the same amount of income as a CD with a 3% yield. Investors with an income
investment goal would value the dividend yield a lot.
Diff: 2
Topic: Dividends
AACSB: Diverse and Multicultural Work Environments
83) What factors can effect the market price of a stock?
Answer: There are many factors that can effect the market value of a firm's stock price. The
price of the stock reflects the firm's potential to earn profits. Anything that increases the chances
of the firm making higher profits is most likely to cause the market price of the stock to rise.
Examples such as lower market rates of interest, lower production costs, successful price
increases, new and innovative products, increase in market share, favorable tax breaks or
government regulations. Anything that reduces or hinders the firm's ability to make profits will
negatively effect the market price of the stock. Examples include rising market rates of interests,
rising energy costs, rising costs of production, fading popularity or obsolete products, bad
publicly, losing market share to competition, unfavorable taxes or newer, tougher government
regulations.
Diff: 3
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments

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84) Is a positive stock split good for the current share holders?
Answer: Yes, for the most part a positive stock split is a bullish signal to the market about the
success and growth of the profit potential for the firm. When a firm's profits are rising, the
demand for their stock increases causing the market price of the stock to increase. When the
share price gets to high then the company can effectively lower the share price by doing a stock
split. Since a stock split increases the number of shares shareholders own, then they will
eventually end up with more dividends and capital gains if the company continues to prosper.
The market price of the stock effects the liquidity of the stock also. It is much easier to sell stock
at $40 per share than $120 per share since more people can afford the lower price.
Diff: 3
Topic: Stock Split
AACSB: Analytical Thinking
85) Differentiate between the general classifications of common stock.
Answer: Blue-chip stocks are issued by large, nationally known companies with sound financial
histories and solid dividend and growth records, such as IBM. Growth stocks have shown sales
and earnings growth well above their industry average. Income stocks are usually issued by more
mature firms that pay relatively high dividends with little increase in earnings.
Speculative stocks have much more variability and risk than do typical stocks. It is difficult to
forecast their direction for investment purposes. Cyclical stocks move with the economy, up with
recoveries and down with slumps. Defensive stocks are not as affected by swings in the economy
and they are not hurt as much in slumps.
Diff: 2
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments
86) Discuss the relationship between growth stocks and income stocks and their P/E ratios.
Answer: A growth stock is a company that is actively growing and expanding. This growth
requires a lot of capital so they seldom pay much in dividends, if any. Instead they plow their
earnings back into the growth of the company. A fast growing company leads to the potential for
fast growing earnings per share. When the market thinks this growth company has good earnings
growth, they bid the share price up accordingly representing higher P/E ratios.
Most income stocks are from companies who are relatively large and mature in their industries.
Since they are not in an active growth mode, then they don't need to retain earnings and can
instead pay them out to the shareholders in the form of high dividends. Because they are not
expected to have a lot of growth in earnings, then the market does not bid up their market price
resulting in relatively low P/E ratios.
Diff: 3
Topic: Classification of Common Stock
AACSB: Diverse and Multicultural Work Environments

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87) Discuss four reasons to invest in stocks.


Answer: Over time, common stocks outperform all other investments. Although stocks aren't
guaranteed to give you any return, they usually give you a worthwhile return.
Stocks reduce risk through diversification. When you include in your portfolio different types
of investments that don't move (that is, the rate of return doesn't fluctuate) perfectly together over
time, you're able to reduce the risk in your portfolio. Stocks don't move in the same manner as
other investments such as bonds, and each stock moves in its own way. Holding stock from
multiple industries can greatly reduce your risk.
Stocks are liquid. You can't be assured of the price you'll get when you want to sell your stock,
but you won't have difficulty selling it. The secondary markets for common stock are extremely
well developed, and as such, you will be able to sell your stock with minimum transaction
costswhenever you want.
The growth in your investment is determined by more than just interest rates.With some
investments, the potential for price appreciation is largely a function of interest rates going down.
But with common stock, the value isn't a slave to interest rates.
Diff: 3
Topic: Stocks
AACSB: Analytical Thinking
12.2 Stock Indexes and Quotes
1) A stock market index is a measure of the performance of a group of stocks that represent the
market or a sector of the market.
Answer: TRUE
Diff: 1
Topic: Stocks
AACSB: Diverse and Multicultural Work Environments
2) The Dow Jones Industrial Average is based on the movement of 500 stocks, primarily from the
NYSE.
Answer: FALSE
Diff: 1
Topic: Stock Index
AACSB: Diverse and Multicultural Work Environments
3) When investors talk about movements in the market, they generally refer to the Russell 1000.
Answer: FALSE
Diff: 1
Topic: Stock Index
AACSB: Diverse and Multicultural Work Environments
4) During a "bear market" stocks prices typically fall.
Answer: TRUE
Diff: 1
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments
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5) The only time to buy stocks is in a bull market and the only times to sell stocks is during a
bear market.
Answer: FALSE
Diff: 1
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments
6) The S&P 500 is a much broader index than the Dow.
Answer: TRUE
Diff: 3
Topic: Stock Valuation
AACSB: Diverse and Multicultural Work Environments
7) The stocks tracked by the Dow represent over 50% of the market value of the NYSE.
Answer: FALSE
Diff: 3
Topic: Stock Listing
AACSB: Diverse and Multicultural Work Environments
8) Movement in the stock market indexes determines whether it is a bear or bull market.
Answer: TRUE
Diff: 2
Topic: Stock Index
AACSB: Diverse and Multicultural Work Environments
9) Because the Dow Jones Index Average is based on the movement of 500 large, wellestablished stocks, many investors believe it reflects price movements for large firms rather than
for the general market.
Answer: FALSE
Diff: 2
Topic: Stock Index
AACSB: Analytical Thinking
10) The term "bear" stems from the fact that bears raise their paws upward when they attack.
Answer: FALSE
Diff: 1
Topic: Market Movements
AACSB: Analytical Thinking

21
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11) The Dow Jones Industrial Average has been an index since what year?
A) 1796
B) 1896
C) 1996
D) 2006
Answer: B
Diff: 2
Topic: Stock Index
AACSB: Information Technology
12) A stock market characterized by increasing prices is termed a(n) ________ market.
A) bull
B) bear
C) animal
D) none of the above
Answer: A
Diff: 1
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments
13) A ________ is a measure of the performance of a group of stocks that represent the market or
a sector of the market.
A) stock market index
B) stock grouping
C) market composite
D) portfolio return
E) none of the above
Answer: A
Diff: 1
Topic: Stock Index
AACSB: Information Technology
14) A stock market characterized by ________ prices is termed a bear market.
A) falling
B) rising
C) steady
D) none of the above
Answer: A
Diff: 1
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments

22
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15) If you are very optimistic about the ability of firms to earn profits today and in the immediate
future, what type of investor philosophy do you exhibit?
A) Animalistic
B) Bullish
C) Bearish
D) Psychic
Answer: B
Diff: 2
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments
16) The S&P 500
A) is the oldest and most widely quoted of the stock indexes.
B) is a narrower index than the DOW.
C) includes some stocks from the OTC market.
D) all of the above
Answer: C
Diff: 2
Topic: Stock Index
AACSB: Information Technology
17) The ________ is a common stock indicator, consisting of 30 large industrial firms, and is
used to indicate how well stocks have done.
A) DAIA
B) CMIA
C) DJIA
D) SPFA
E) none of the above
Answer: C
Diff: 1
Topic: Stock Index
AACSB: Information Technology
18) Jessica wanted to gauge stock performance in general. She found a useful tool that measured
the stock prices of 30 large industrial firms, called the
A) Dow Jones Industrial Average.
B) Standard & Poor's Index.
C) Value Line Survey.
D) Moody's Index.
E) none of the above.
Answer: A
Diff: 1
Topic: Stock Index
AACSB: Information Technology

23
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19) If you wanted information about how the entire stock market is performing, which index
would provide you with information on virtually all types and sizes of companies?
A) Dow Jones Industrials
B) S&P 500
C) NASDAQ 100
D) Wilshire 5000
Answer: D
Diff: 1
Topic: Stock Index
AACSB: Information Technology
20) When you got home after work, you saw on the news that the S&P was down by 20 points.
Which of the following is true?
A) All of your stocks' market prices must have declined by 20 points.
B) Some of your stocks' market prices may have increased.
C) Some of your stocks' market prices may have decreased.
D) Both B and C are correct.
Answer: D
Diff: 1
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments
21) You are looking at the stock quotes in your newspaper and you see that your stock closed up
5% yesterday. Where would you look to see how it has been doing over the last year?
A) Prior day's close
B) P/E ratio
C) 52-week high and low
D) Market cap
Answer: C
Diff: 1
Topic: Stock Listing
AACSB: Information Technology
22) All of the following are stock market indexes except
A) the Dow Jones Industrial Average.
B) the Standard & Poor's 500.
C) the Russell 100.
D) the Wilshire 5000.
Answer: C
Diff: 3
Topic: Earnings per Share
AACSB: Information Technology

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23) The DJIA weights stocks based on


A) the size of the company.
B) their place alphabetically.
C) their relative prices.
D) none of the above.
Answer: C
Diff: 3
Topic: Stock Index
AACSB: Diverse and Multicultural Work Environments
24) Because the DJIA weights stocks based on their relative prices, when a high priced stock
moves a small amount on the DJIA, it has a(n) ________ impact on the index.
A) limited
B) inordinately large
C) insignificant
D) minute
Answer: B
Diff: 3
Topic: Stock Index
AACSB: Diverse and Multicultural Work Environments
25) Because the Dow Jones Index Average is based on the movement of only ________ large,
well-established stocks, many investors believe it reflects price movements for large firms rather
than for the general market.
A) 30
B) 50
C) 100
D) 500
Answer: A
Diff: 2
Topic: Stock Index
AACSB: Analytical Thinking
26) The letters or characters that represent a stock is known as the stock's
A) ticker.
B) code.
C) acronym.
D) share.
Answer: A
Diff: 3
Topic: Stocks
AACSB: Information Technology

25
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27) Compare and contrast the Dow Jones Industrial Average and Standard & Poor's 500-Stock
Index.
Answer: The Dow attempts to gauge the well-being of the stock market based on the
performance of 30 large industrial firms. Many investors think it reflects price movements for
large firms rather than for the general market. It weights stocks based upon their relative prices,
neglecting other factors that would be indicative. Nonetheless, it does a relatively good job of
reflecting market movements.
The S & P 500 is a much broader index because it is based on the movements of 500 stocks. It is
probably a better representative of movements in the overall market.
Diff: 2
Topic: Stock Index
AACSB: Diverse and Multicultural Work Environments
28) What is the importance of the P/E Ratio to investors?
Answer: The P/E ratio is a measure of risk and the growth potential of the EPS of the firm. A
low P/E ratio signifies that the company is fairly mature or weak and the market is not pricing in
very much earnings growth potential into this stock. An average P/E ratio signals that this firm is
a healthy firm in a healthy industry and this firm has the potential for average or normal earnings
growth. A P/E ratio above the average P/E ratio signals that the market is very optimistic about
above average EPS growth potential and that this stock could provide healthy capital gains.
Possibly it is a new firm with a new innovative product and its EPS are fairly small right now but
this firm has the potential to explode in sales and profits causing the market value of the stock to
explode also. However, many times a company with a high P/E ratio doesn't work out so well
and the stock crashes much faster than it rose in value. High P/E stocks are very speculative and
risky and not appropriate for important investing goals such as retirement.
Diff: 2
Topic: Earnings per Share
AACSB: Diverse and Multicultural Work Environments
12.3 Valuation of Common Stock
1) The price/earnings ratio is an indication of how much investors are willing to pay for a dollar
of the company's earnings.
Answer: TRUE
Diff: 1
Topic: Stock Valuation
AACSB: Information Technology
2) The discounted dividends valuation model states that the value of a share of stock is the
present value of its future dividends.
Answer: TRUE
Diff: 1
Topic: Stock Valuation
AACSB: Information Technology

26
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3) Technical analysis is a stock valuation technique that incorporates expected future earnings of
the company, the riskiness of the companies cash flows, and interest rates in the markets in
determining the current value of the stock.
Answer: FALSE
Diff: 1
Topic: Stock Valuation
AACSB: Information Technology
4) Earnings per share is a ratio that describes the amount of net income less preferred stock
dividends available to the common shareholders.
Answer: TRUE
Diff: 1
Topic: Earnings per Share
AACSB: Information Technology
5) Technical analysis focuses on supply and demand, using charts and computer programs to
project stock trends.
Answer: TRUE
Diff: 3
Topic: Stocks
AACSB: Information Technology
6) According to your text, there is very little validation in using technical analysis as an investing
tool.
Answer: TRUE
Diff: 3
Topic: Stock Valuation
AACSB: Information Technology
7) The P/E ratio approach is a type of fundamental analysis.
Answer: TRUE
Diff: 3
Topic: Earnings per Share
AACSB: Information Technology
8) When the market becomes too bullish, the average P/E ratio will fall.
Answer: FALSE
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking

27
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9) A technical analysis is the framework for analyzing a security in which you look at a firm's
internal strengths and weaknesses and external opportunities and threats in order to gain an
understanding of what the future holds for that firm and its stock.
Answer: FALSE
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking
10) A stock currently selling for $105 with estimated earnings per share of $5.25 would have a
P/E ratio of
A) 10.
B) 12.
C) 20.
D) 28.
E) 30.
Answer: C
Diff: 3
Topic: Ratios
AACSB: Analytical Thinking
11) The P/E ratio of a stock is 20, and its earnings per share is $5.25. What is the current selling
price of the stock?
A) $20
B) $75
C) $100
D) $105
Answer: D
Diff: 3
Topic: Ratios
AACSB: Analytical Thinking
12) Your friend has recommended that you purchase stock in company XYZ. It is expected to
pay a $4 dividend, and has historically grown at 5%. If the required rate of return is 12%, what is
the estimated value of a share of XYZ stock?
A) $23.53
B) $33.34
C) $57.14
D) $80.00
Answer: C
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking

28
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13) You are considering purchasing one of two stocks. Stock A is expected to pay a $2.50
dividend, and has historically grown at 6%. Stock B is expected to pay a $3.00 dividend and has
historically grown at 4%. Both are the same risk, and you desire to earn a 16% return. Which of
the following is true?
A) You should buy Stock A, since its estimated price is higher than Stock B.
B) You should buy Stock B, since its estimated price is higher than Stock A.
C) You should buy Stock A, since its estimated price is lower than Stock B.
D) You should buy Stock B, since its estimated price is lower than Stock A.
E) You should buy either Stock A or B, since the estimated prices are the same.
Answer: E
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking
14) You are considering the purchase of a stock with a current market price of $50.25 per share.
It is expected to pay a dividend of $5.25 next year. Historically the stock has grown at 5%, and
based on its risk, you desire to earn a 15% return. Which of the following is true?
A) Buy the stock, since your estimated price is higher than the market price.
B) Buy the stock, since your estimated price is lower than the market price.
C) Do not buy the stock, since your estimated price is lower than the market price.
D) Do not buy the stock, since your estimated price is higher than the market price.
E) None of the above are true statements
Answer: A
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking
15) ComChip is a computer chip manufacturer whose stock is selling at $50 per share. Next
year's net earnings, minus the preferred stock dividends, is estimated to be $200,000. The
company currently has 100,000 shares of common stock outstanding. What is the firm's P/E
ratio?
A) 50.00
B) 45.80
C) 25.00
D) 27.78
Answer: C
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking

29
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16) ComChip is a computer chip manufacturer. Its stock is selling at $50 per share and earnings
are $2 per share. What is the stock's P/E ratio?
A) 50.00
B) 45.80
C) 25.00
D) 27.78
E) 22.50
Answer: C
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking
17) A stock currently sells for $100 per share, and has earnings of $2.00 per share. What is the
stock's P/E ratio?
A) 50.00
B) 25.00
C) 5.00
D) 1.00
Answer: A
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking
18) The ratio of the annual dividend to the market price of the stock is called the
A) retention ratio.
B) plowback ratio.
C) current ratio.
D) dividend yield.
E) none of the above.
Answer: D
Diff: 1
Topic: Dividends
AACSB: Information Technology
19) Using the stock valuation formula calculate the value of a share of stock if it is expected to
pay $5 in dividends, in addition the dividends are expected to grow at a rate of 4 percent forever,
and the investor's required rate of return is 12 percent.
A) $18.75
B) $39.75
C) $62.50
D) $68.50
Answer: C
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking

30
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20) Using the stock valuation formula calculate the value of a share of stock if it is expected to
pay $15 in dividends, in addition the dividends are expected to grow at a rate of 8 percent
forever, and the investor's required rate of return is 10 percent.
A) $6.50
B) $7.50
C) $12.00
D) $14.50
Answer: B
Diff: 1
Topic: Stock Valuation
AACSB: Analytical Thinking
21) Your dad said that he was curious to know why there is so much fluctuation in the value of
common stocks. In 1997 the prospects for Sun Industries became more uncertain and investors
began to view it as a more risky investment than they had previously. To compensate for this
added risk, investors increased their required rate of return on Sun Industries stock, resulting in a
decline in its market value. This explains the factor of
A) earnings growth and stock valuation.
B) interest rates and stock valuation.
C) risk and stock valuation.
D) supply and demand.
E) dividend strength and stock valuation.
Answer: C
Diff: 3
Topic: Stock Valuation
AACSB: Diverse and Multicultural Work Environments
22) A SWOT analysis
A) is a good way of breaking down a firm's capabilities and gaining a better understanding of
what the future may hold for the firm.
B) focuses on strengths, weaknesses, opportunities, and threats.
C) is designed to better understand a firm's strategies and whether or not the strategies are
sustainable.
D) both A and C.
Answer: D
Diff: 2
Topic: Stock Investment Strategies
AACSB: Analytical Thinking

31
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23) For several years you have been using charts and computer programs to project trends in the
stock market. You are engaging in what type of analysis?
A) Dollar cost averaging
B) Technical
C) Fundamental
D) Price/Earnings
E) None of the above
Answer: B
Diff: 1
Topic: Stock Investment Strategies
AACSB: Analytical Thinking
24) Your father-in-law's stockbroker examines future earnings and dividends, the expected level
of interest rates, and the firm's risk to provide a basis for buy-sell recommendations. This
stockbroker uses the ________ approach to stock valuation.
A) financial statement analysis
B) earnings analysis
C) expectations method
D) fundamental analysis
E) none of the above
Answer: D
Diff: 1
Topic: Stock Valuation
AACSB: Information Technology
25) Louise Rogers knows that several factors affect the price of a share of common stock. The
one that says there is an inverse relationship between interest rates and the value of a share of
common stock is the ________ factor.
A) risk and stock valuation
B) interest rates and stock valuation
C) earnings growth and stock valuation
D) interest rates and risk valuation
E) interest rates and earnings growth valuation
Answer: B
Diff: 2
Topic: Stock Valuation
AACSB: Diverse and Multicultural Work Environments

32
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26) Your mother-in-law's stockbroker focuses on supply and demand, and uses charts and
computer programs to identify and make buy-sell recommendations. She is using the ________
method.
A) descriptive analysis
B) visual hedging
C) technical analysis
D) push and shove
E) none of the above
Answer: C
Diff: 1
Topic: Stock Valuation
AACSB: Analytical Thinking
27) Fundamental analysis looks at which of the following?
A) Future earnings
B) Dividends
C) Expected levels of interest rates
D) The firm's risk
E) All of the above
Answer: E
Diff: 2
Topic: Dividends
AACSB: Analytical Thinking
28) The discounted dividends valuation model of common stock assumes that dividends will
grow at a constant rate forever. This method tells us that the (dividend next year) divided by the
(required rate of return - growth rate) yields the
A) discounted dividend.
B) dividend growth rate.
C) value of the common stock.
D) value of the earnings.
E) value of the P/E ratio.
Answer: C
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking

33
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29) Marian read in a financial magazine that the discounted dividends valuation model of
common stock defines the value of a share of common stock as the ________ value of the
infinite stream of future ________.
A) future; growth
B) future; earnings
C) dividend; earnings
D) present; dividends
E) present; earnings
Answer: D
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking
30) This equation, dividends next year/required rate of return minus growth rate tells us the
stock's
A) dividend yield.
B) earnings per share.
C) value.
D) growth potential.
E) book-to-price ratio.
Answer: C
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking
31) The ________ the firm's earnings growth rate, the ________ the firm's P/E ratio and the
________ the investor's required rate of return, the ________ the P/E ratio.
A) higher; higher; higher; higher
B) higher; higher; higher; lower
C) higher; higher; lower; lower
D) higher; lower; lower; lower
E) lower; lower; lower; lower
Answer: B
Diff: 3
Topic: Stock Valuation
AACSB: Analytical Thinking

34
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32) This approach is used regularly by security analysts to measure a stock's relative value, or
how much investors are willing to pay for a dollar of the company's earnings. It is found by
dividing the price per share by the earnings per share and is called the
A) P/E ratio.
B) technical industry analysis.
C) fundamental analysis.
D) discounted dividends valuation.
E) market-to-price ratio.
Answer: A
Diff: 3
Topic: Stock Valuation
AACSB: Diverse and Multicultural Work Environments
33) The following equation, (net income - preferred stock dividends)/number of shares of
common stock outstanding, allows us to calculate the ________ and this information is necessary
to calculate the ________ ratio.
A) dividend yield; dividend
B) earnings per share; P/E
C) market-to-book ratio; book-to-market
D) stock growth: P/E
E) price-to-book ratio; market-to-book
Answer: B
Diff: 3
Topic: Earnings per Share
AACSB: Analytical Thinking
34) Which one of the popular common stock valuation methods focuses on supply and demand
and uses a computer and charts to identify and project price trends for a stock or for the market
as a whole?
A) Fundamental analysis approach
B) Technical analysis approach
C) Price/earnings ratio approach
D) Market analysis approach
E) Industry analysis approach
Answer: B
Diff: 2
Topic: Stock Valuation
AACSB: Information Technology
35) What are the three factors that explain why stock values fluctuate?
Answer: As interest rates rise, the value of the stock decreases. As the stock's risk increases, so
does the investor's required rate of return. As earnings grow, so does the company's capacity to
pay dividends. This earnings growth is viewed as a cause of dividend increases and stock prices.
Diff: 1
Topic: Stock Valuation
AACSB: Diverse and Multicultural Work Environments
35
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36) Distinguish between the technical analysis and fundamental approaches of valuation of
common stock.
Answer: Technical analysis takes a number of forms, including the interpretation of computer
programs, charts, graphs, and mathematical calculations of tracking patterns, all aimed at
spotting some trend or direction for stocks. This is no longer a useful approach because it
encourages moving in and out of the market rather than buying and holding stocks.
A fundamental analysis determines the value of a share of stock by focusing on such factors as
future earnings and dividends, expected levels of interest rates, and the firm's risk. An example is
the Price/Earnings Ratio which is a measure of a stock's relative value, found by dividing the
price per share by the earnings per share. The higher the ratio the better.
Diff: 2
Topic: Stock Valuation
AACSB: Analytical Thinking
37) Why is using the P/E ratio a very popular valuation tool?
Answer: Many investors use the P/E ratio because it helps to compare the stock's growth
potential relative to other firms. When you purchase a stock, you are not really buying the
company as it stands today. You are actually buying the earnings potential in the future. A
healthy, well run company will have innovative products and growing market share leading to
growing EPS. It is the EPS in the future that you are actually buying today. The P/E ratio
communicates how the market feels about the future prospects of the firm.
The P/E ratio also communicates a level of risk. When a stock is 'priced to perfection' with a high
P/E ratio, then the firm had better live up to these lofty expectations for future growth. Any bad
news such as disappointing earnings growth or slowing sales growth or competitive or regulatory
pressures can cause these stocks to plummet in value to match the new, reduced expectations for
earnings growth.
Diff: 3
Topic: Stock Valuation
AACSB: Information Technology
12.4 Stock Investment Strategies
1) A buy-and-hold investment strategy means that an investor's gains will be taxed as short-term
capital gains.
Answer: FALSE
Diff: 1
Topic: Stock Investment Strategies
AACSB: Analytical Thinking

36
Copyright 2016 Pearson Education, Inc.

2) The acronym DRIP stands for


A) Dividends, Returns, Interest, and Profits.
B) Dividend Rates and Income Potential.
C) Dividend Reinvestment Plan.
D) Dividend Risk and Income Potential.
Answer: C
Diff: 2
Topic: Dividends
AACSB: Analytical Thinking
3) You have just discovered one reason not to invest in stocks. What do you think it is?
A) Stocks reduce risk through diversification.
B) Your tolerance of risk is low.
C) Over time, common stocks outperform all other investments.
D) Stocks are liquid.
E) Growth is determined by more than just interest rates.
Answer: B
Diff: 2
Topic: Risk
AACSB: Reflective Thinking
4) The experts say that a person under the age of 40 should have a majority of their retirement
money invested in the stock markets. What is the reason for this?
A) On average, common stocks provide a higher return on investment than other investment
options.
B) Younger people have enough time ahead of them to ride out any dramatic market movements.
C) Younger people generally don't have enough money to invest in other options.
D) All of the above are correct.
E) Only A and B are correct.
Answer: E
Diff: 3
Topic: Risk and Return Go Hand in Hand
AACSB: Reflective Thinking
5) A buy-and-hold investment strategy
A) avoids timing the market.
B) minimizes transaction costs.
C) postpones capital gains taxes.
D) means your gains will be taxed as long-term capital gains.
E) all of the above.
Answer: E
Diff: 3
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments

37
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6) Which of the following questions should potential investors answer before investing?
A) Is this a good price for the stock?
B) Is this firm in a position that will allow profitability in the future?
C) Are this firm's strengths and weaknesses likely to get better or worse?
D) Are this firm's threats and opportunities likely to get better or worse?
E) All of the above
Answer: E
Diff: 2
Topic: Stock Investment Strategies
AACSB: Analytical Thinking
7) Discuss three reasons why dollar-cost averaging is an important concept to investors.
Answer: If you buy stock over an extended period, it's less likely that all your money will be
invested right before a market crash.
Dollar-cost averaging keeps you from trying to "time the market" in an attempt to wait for the
lowest possible price before buying. Identifying the lowest price is virtually impossible to do,
although admittedly, it is awfully tempting to try.
Most importantly, dollar-cost averaging forces disciplined investing. If you are regularly
investing in stocks, the practice becomes part of your budgeting and planning process.
Diff: 2
Topic: Stock Investment Strategies
AACSB: Analytical Thinking
8) What are the four basic investment questions a potential investor should answer before
investing?
Answer: Value: Is this a good price for the stock?
Quality: Is this firm in a position that will allow profitability in the future?
Strengths and Weaknesses: Are this firm's strengths and weaknesses likely to get better or worse?
Threats and Opportunities: Are this firm's threats and opportunities likely to get better or worse?
Diff: 2
Topic: Stock Investment Strategies
AACSB: Reflective Thinking
9) How do the three common investment strategies differ? Which is good if you want to avoid
being killed rather than make a killing in the market?
Answer: Dollar cost averaging occurs when you buy a fixed dollar amount of stock at specified
intervals to level out the ups and downs of prices. It is the best strategy for avoiding being killed
rather than to make a killing. The buy-and-hold idea aims at avoiding timing the market,
minimizes brokerage fees and costs, postpones capital gains taxes, and is simple to carry out.
A dividend reinvestment plan allows you to accumulate wealth by automatically reinvesting
dividends (rather than spend them) without any brokerage fees. Without reinvesting the
dividends, your wealth will be limited to the stock's capital gains.
Diff: 2
Topic: Stock Investment Strategies
AACSB: Analytical Thinking
38
Copyright 2016 Pearson Education, Inc.

10) Briefly describe the SWOT analysis.


Answer: The SWOT analysis is a framework for analyzing a firm or its common stock. The
analysis forces you to consider a firm's internal strengths and weaknesses and external
opportunities and threats. A benefit of the analysis is that it allows you to better anticipate
changes that might occur in the company.
Diff: 2
Topic: Stock Investment Strategies
AACSB: Analytical Thinking
12.5 Risks Associated with Common Stocks
1) When all stocks move in the same direction, diversification among stocks works just as well
as ever.
Answer: FALSE
Diff: 2
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments
2) For investors with a long time in front of them, market volatility is not of great concern today.
Answer: TRUE
Diff: 2
Topic: Market Movements
AACSB: Reflective Thinking
3) In the short run, market variability or volatility creates potential risk.
Answer: TRUE
Diff: 2
Topic: Market Movements
AACSB: Diverse and Multicultural Work Environments
4) By using the risk evaluation tool called beta, you can measure the movement of your
individual stock compared to the S&P 500.
Answer: TRUE
Diff: 2
Topic: Risk
AACSB: Diverse and Multicultural Work Environments
5) If your stock's beta was greater than 1.0 that indicates that your stock is more susceptible to
movements in the market.
Answer: TRUE
Diff: 2
Topic: Stock Valuation
AACSB: Diverse and Multicultural Work Environments

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6) If your portfolio is very diversified then the beta is of no use to you.


Answer: FALSE
Diff: 2
Topic: Risk
AACSB: Information Technology
7) Beta is the measure of how responsive a stock is to changes in the market portfolios, like the
S&P 500.
Answer: TRUE
Diff: 2
Topic: Diversification
AACSB: Information Technology
8) According to the risk-return relationship, commercial paper usually has a higher risk and
return than long-term corporate bonds.
Answer: FALSE
Diff: 2
Topic: Principle 8: Risk and return go hand in hand
AACSB: Analytical Thinking
9) You and a group of your friends have been discussing your portfolios at the company water
cooler. Your discussion has centered on how your stocks are moving up or down in price relative
to the market as a whole. Each stock's ________ is likely the best measure of the relationship.
A) relative index
B) beta
C) alpha
D) delta
E) none of the above
Answer: B
Diff: 1
Topic: Risk
AACSB: Information Technology
10) Because every company is almost certain to experience a bad year or two, holding on to
stock for only one year
A) is not a very sound investment decision.
B) is a very sound investment decision.
C) is a good idea for those who may need to liquidate their investment quickly.
D) diversifies one's portfolio risk.
Answer: A
Diff: 2
Topic: Risk
AACSB: Diverse and Multicultural Work Environments

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11) Compared to other investment options, we can safely say that investing in stocks
A) has equal risk.
B) has greater risk.
C) has less risk.
D) is not worth the risk.
Answer: B
Diff: 1
Topic: Risk
AACSB: Diverse and Multicultural Work Environments
12) In October 2008, most of the major stock indices around the world plummeted in value. The
most likely cause for these dramatic events were
A) non-systematic risk.
B) variable betas.
C) systematic risk.
D) None of the above are correct.
Answer: C
Diff: 3
Topic: Risk
AACSB: Diverse and Multicultural Work Environments
13) What would you expect to be associated with a company whose stock has a high beta?
A) A high potential return
B) A high dividend yield
C) A large market capitalization
D) All of the above are correct.
E) All but C are correct.
Answer: A
Diff: 3
Topic: Risk
AACSB: Analytical Thinking
14) The phrase ________ is sadly appropriate for the actions of some people, as they perceive
that investment success rests in making frequent transactions.
A) "playing the market"
B) "timing the market"
C) "go big or lose your home"
D) "buy low, sell high"
Answer: A
Diff: 2
Topic: Investment Information
AACSB: Reflective Thinking

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15) Discuss the concept of using beta for investing in stocks.


Answer: Beta is a mathematical process to quantify or identify an individual stock's risk relative
to the overall stock market risk. It is a coefficient that amplifies or magnifies the individual
stock's potential price movements relative to the overall market's price movements. If a stock has
a beta of 1.5, then this tells us that if the average or typical stock increased by 10% then this
stock should average a 15% increase in its market price. Beta is a function of risk. For investors
with a low propensity for risk they should avoid stocks with high beta coefficients. Investors
with a willingness to speculate should look for high beta stocks to invest in, realizing that they
may lose all or most of their investment.
Diff: 3
Topic: Risk
AACSB: Diverse and Multicultural Work Environments
16) Can you explain the risk-return trade-off with common stocks?
Answer: Stocks have more risk than other investments, but at the same time have more potential
return associated with them. By diversifying your portfolio, you reduce the risk of downs ruining
your ups. By diversifying you can diversify away some risk and by holding for the long term
they can become even less risky.
Diff: 2
Topic: Risk and Return Go Hand in Hand
AACSB: Diverse and Multicultural Work Environments

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Copyright 2016 Pearson Education, Inc.