Ch5 Test Bank + Answers The Stock Market Is Smarter Than You

Chapter: Chapter 05: The Stock Market Is Smarter Than You Think

True/False

1. Changes in expectations will rarely have a larger impact on realized total returns to shareholders (TRS) than actual performance over periods longer than a year or one operating cycle.

Response: []

Multiple Choice

2. Noise-trader risk is caused by:

a) Program trading.

b) Systematic risk being greater than idiosyncratic risk.

c) Idiosyncratic risk being greater than systematic risk.

d) Traders making bets on short-term price movements without reference to fundamental valuations.

Response: []

3. Which of the following criteria do noise traders make bets on?

I. Short-term price movements.

II. Fundamental valuations.

III. Investing only in emerging markets.

a) I and II.

b) II and III.

c) I only.

d) II only.

Response: []

4. Which of the following are impediments to short selling?

I. Beta risk.

II. Bubble risk.

III. Noise-trader risk.

IV. Short-selling constraints.

a) I and II only.

b) I, II, and IV only.

c) II and III only.

d) III and IV only.

Response: []

5. Which of the following is most accurate concerning the bounds on a stock’s price set by informed investors and/or the volatility of the stock within those bounds?

a) As long as the price is within the bounds, the volatility will always be relatively low.

b) Share prices can be significantly volatile within the bounds but only when new information about a company has been revealed; otherwise, volatility will be relatively low.

c) The bounds are set by mechanical traders and are fairly constant over time.

d) Share prices can be significantly volatile within the bounds even at times when no new information about a company has been revealed.

Response: []

True/False

6. Random deviations from intrinsic value can occur in stock prices, but managers are best off assuming that the market will correctly reflect the intrinsic value of their decisions.

Response: []

Multiple Choice

7. Which of the following characterize noise traders?

I. They do not care about intrinsic value.

II. They are always in the minority.

III. They can move price outside the bounds of intrinsic value.

IV. They trade on small events.

a) I and II only.

b) I, III, and IV only.

c) II, III, and IV only.

d) II and IV only.

Ans. [b]

Response: []

8. Over the past five years, the highest share price for Techno Inc., a 15-year-old software company, was around $750, and its lowest price was around $250, while for ConsumerCo, a consumer products firm with a 50-year history, share prices ranged from $85 down to $60 over the same period. Which of the following are the most likely reasons for these stock market reactions?

I. The stock market is reflecting emotions more than fundamentals.

II. Swings in prices reflect changes in expectations of Techno Inc.

III. The range in expectations for Techno Inc. is likely greater than for ConsumerCo.

a) I only.

b) I and III.

c) II and III.

d) I, II, and III.

Response: []

True/False

9. Having only fundamental investors among a company’s shareholders is the most ideal situation.

Response: [With only fundamental investors, the stock would not be as liquid, as investors would take a long time to scrutinize each bit of information before acting on it.]

Multiple Choice

10. What is the impact on a company’s share price of trading done by noise traders?

a) Noise traders buy and sell a great deal, their volume of trading is high, and the long-term effect on share price is low.

b) Noise traders buy and sell a great deal, their volume of trading is high, and the long-term effect on share price is high.

c) Noise traders buy and sell a small amount, their volume of trading is low, and the long-term effect on share price is low.

d) Noise traders set the boundaries for a stock’s intrinsic value.

Ans. [a]

Response: []

11. Which of the following are properties that should lead to firms having higher value in the stock market?

I. Higher P/E.

II. First-in, first-out (FIFO) accounting.

III. Higher growth.

IV. ROIC greater than the cost of capital.

a) I and II only.

b) I, II, and III only.

c) III and IV only.

d) II, III, and IV only

Ans [c]

True/False

12. Individual company deviations from fundamental values are rarer than market deviations from fundamental values.

Response: [Individual company deviations from fundamental values are more common than market deviations from fundamental values.]

Multiple Choice

13. In comparing growth stocks and value stocks with respect to growth rates and the return on capital, the results from the article by T. Koller and B. Jiang titled “The Truth about Growth and Value Stocks” (2007) found which of the following?

a) Growth stocks had a higher average growth rate but a lower median return on capital.

b) Growth stocks had both a higher average growth rate and a higher median return on capital.

c) Growth stocks did not have a higher average growth rate or a higher median return on capital.

d) Growth stocks did not have a higher average growth rate but did have a higher median return on capital.

Response: []

True/False

14. Long-term price-to-earnings (P/E) ratios in the U.S. stock market of around 15 times are consistent with long-term expected stock returns of around 6 to 7 percent a year in real terms

Response: [Assuming a constant growth rate in earnings and a constant return on capital, the returns to shareholders are composed of a cash yield plus the growth rate in earnings. If the P/E gravitates to 15, then the earnings yield is 1/15 or 6.7 percent. If half of this is paid out to shareholders, then the cash yield is 3.35 percent. If corporate profits continue to grow at 3 to 3.5 percent per year, then summing these two components yields about a 6.5 percent average return.]

15. Growth stocks have higher expectations for earnings growth and consistently have been found to have earnings growth significantly higher than value stocks.

Response: [Despite having higher expectations for earnings growth, it has been found that earnings growth does not significantly differ between stocks classified as growth or value by agencies such as Standard & Poor’s.]

Multiple Choice

16. Which of the following is/are way(s) that short-term market deviations from a particular company’s intrinsic value might play a role in the decisions of the managers?

I. When making acquisitions, a manager might pay with shares instead of cash when the stock market overprices the shares relative to intrinsic value.

II. If the multiples in a particular sector are too high, a manager of a firm that owns a subsidiary in that industry might consider divesting the subsidiary.

III. If the multiples in a particular sector are too low, a manager of a firm that owns a subsidiary in that industry might consider divesting the subsidiary.

IV. When making acquisitions, a manager might pay with cash instead of shares when the stock market overprices the shares relative to intrinsic value.

a) I and II.

b) I and III.

c) III and IV.

d) IV only.

Ans. [a]

Response: []

True/False

17. Both the 2001 bubble and the 2007 bubble were valuation bubbles.

Response: []

Multiple Choice

18. In the 1999 stock bubble, most of the large-capitalization companies with high P/Es were clustered in all of the following sectors EXCEPT:

a) Utilities.

b) Technology.

c) Media.

d) Telecommunications.

Ans. [a]

Response: []

True/False

19. If investors focused on earnings, a move from FIFO to LIFO would increase the share price, but it generally does the opposite because of the decrease in cash flows.

Response: [Switching from FIFO to LIFO usually lifts share price because it increases cash flow. Firms switching to FIFO have seen their share prices fall.]

20. Researchers have found that the stock market is very concerned with earnings volatility and requires companies to meet analyst expectations.

Response: []

21. Empirical evidence shows that managers can effectively manage share price by focusing on EPS and meeting analysts’ estimated earnings.

Response: []

22. Empirical research shows that goodwill impairments have no impact on a company’s share price at the time of the impairment.

Response: []

23. Investors care about goodwill impairment only if the adjustment reflects lower-than-expected benefits from the acquisition that have not already been reflected in the stock price.

Response: []

Multiple Choice

24. Which of the following are ways the managers of firms may try to meet earnings forecasts and have been proven to have an impact on share price?

I. Deferring divestments.

II. Gradually providing new information to lead analysts.

III. Offering customer incentives without immediate costs.

IV. Accounting adjustments such as capitalizing costs and R&D.

a) I and II only.

b) I and III only.

c) II and IV only.

d) III and IV only.

Response: [Investors tend to see through accounting adjustments and attempts to avoid surprises. Investors do recognize that customer incentives without immediate costs to the firm will lead to costs in the future, and the price will react negatively.]

25. Voluntary option expensing has been found to have which of the following effects?

a) A negative impact on share price.

b) A positive impact on share price.

c) No impact on share price.

d) A positive impact if LIFO accounting is used and a negative effect if FIFO accounting is used.

Ans. [c]

Response: []

26. An analysis of 50 European companies that began reporting using U.S. GAAP over the period 1997 to 2004 found which of the following?

I. Earnings under GAAP were generally lower than earnings under the home country’s rules.

II. The differences in earnings under the two regimes were all less than 10 percent.

III. The stocks of the 50 companies generally reacted positively when the disclosures were made.

IV. Executives had concerns over the impact of reporting under U.S. GAAP.

a) I and II only.

b) I, II, and III only.

c) I, III, and IV only.

d) II, III, and IV only.

Ans. [c]

Response: []

27. With respect to the cash flow volatility and earnings volatility of a certain firm, which of the following is most accurate concerning their effects on ratios of market value to capital?

a) Cash flow volatility is more likely to diminish the ratios than earnings volatility is.

b) Earnings volatility is more likely to diminish the ratios than cash flow volatility is.

c) Neither of these types of volatility has been proven to have a negative effect on ratios of market value to capital.

d) Both types of volatility have a negative effect on ratios of market value to capital, but it is not clear which has the stronger effect.

Response: [It is not certain that earnings volatility will affect the value of a firm, but cash flow volatility is very likely to have an effect.]

True/False

28. Managers should focus on issuing guidance on their likely EPS in the next quarter because it leads to higher valuations, lower share price volatility, and improved liquidity.

Response: [Studies have found no evidence that issuing EPS guidance accomplishes these goals. Managers might better accomplish these goals by providing investors with a broad set of operational measures such as volume targets, revenue targets, and initiatives to reduce costs.]

Multiple Choice

29. Academic research has found that share prices of companies that are removed from a major stock index:

a) Trend down until significant news arrives to reverse the trend.

b) Do not experience any abnormal returns either in the short term or in the long term.

c) Drop immediately and then begin trading normally.

d) Drop immediately, but the decline is usually reversed within one or two months.

Ans. [d]

30. Which of the following are valid reasons that cross-listing might actually improve a company’s stock performance?

I. Improved corporate governance.

II. Trading in multiple time zones.

III. Access to an increased number of investors.

IV. Affirmation effect of being listed in more than one developed market.

a) I, II, and IV only.

b) I and III only.

c) II and III only.

d) II, III, and IV only.

Ans. [b]

Response: []

31. Which of the following are valid reasons that a firm’s stock split can be followed by an increase in the value of the shares of that firm?

I. Signaling.

II. Liquidity.

III. More shares outstanding.

IV. Self-selection.

a) I and IV only.

b) II and III only.

c) II, III, and IV only.

d) None of these.

Ans. [a]

Response: []

32. Which is most accurate concerning the behavior of a stock’s return after a stock split relative to companies whose stock has not split?

a) Compared to companies whose stock has not recently split, the stock prices of companies whose stock has recently split are less sensitive to improvements in performance.

b) Compared to companies whose stock has not recently split, the stock prices of companies whose stock has recently split are significantly more sensitive to improvements in performance.

c) Compared to companies whose stock has not recently split, the stock prices of companies whose stock has recently split are about equally sensitive to improvements in performance.

d) Compared to companies whose stock has not recently split, the stock prices of companies whose stock has recently split are more sensitive to improvements in performance, but the difference is not significant.

Response: [The stock split builds in positive expectations for the stock price; therefore, improvements in performance of a company whose stock has recently split have little or no impact on the behavior of the stock.]

True/False

33. Managers should assess whether their company’s share price has deviated more than 5 percent from its fundamental value on a weekly basis and, if it has, take appropriate action such as issuing or buying back shares.

Response: [Managers should look to the long-term behavior of a company’s share price, not whether it is 5 or 10 percent undervalued this week.]