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Practice Problems 301

PRACTICE PROBLEMS
1 Which of the following is not a characteristic of common equity?
A It represents an ownership interest in the company.
B Shareholders participate in the decision-making process.
C The company is obligated to make periodic dividend payments.
2 The type of equity voting right that grants one vote for each share of equity
owned is referred to as:
A proxy voting.
B statutory voting.
C cumulative voting.
3 All of the following are characteristics of preference shares except:
A They are either callable or putable.
B They generally do not have voting rights.
C They do not share in the operating performance of the company.
4 Participating preference shares entitle shareholders to:
A participate in the decision-making process of the company.
B convert their shares into a specified number of common shares.
C receive an additional dividend if the company’s profits exceed a pre-
determined level.
5 Which of the following statements about private equity securities is incorrect?
A They cannot be sold on secondary markets.
B They have market-determined quoted prices.
C They are primarily issued to institutional investors.
6 Venture capital investments:
A can be publicly traded.
B do not require a long-term commitment of funds.
C provide mezzanine financing to early-stage companies.
7 Which of the following statements most accurately describes one difference
between private and public equity firms?
A Private equity firms are focused more on short-term results than public
firms.
B Private equity firms’ regulatory and investor relations operations are less
costly than those of public firms.
C Private equity firms are incentivized to be more open with investors about
governance and compensation than public firms.
8 Emerging markets have benefited from recent trends in international markets.
Which of the following has not been a benefit of these trends?
A Emerging market companies do not have to worry about a lack of liquidity
in their home equity markets.
B Emerging market companies have found it easier to raise capital in the mar-
kets of developed countries.

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302 Reading 36 ■ Overview of Equity Securities

C Emerging market companies have benefited from the stability of foreign

exchange markets.
9 When investing in unsponsored depository receipts, the voting rights to the
shares in the trust belong to:
A the depository bank.
B the investors in the depository receipts.
C the issuer of the shares held in the trust.
10 With respect to Level III sponsored ADRs, which of the following is least likely
to be accurate? They:
A have low listing fees.
B are traded on the NYSE, NASDAQ, and AMEX.
C are used to raise equity capital in US markets.
11 A basket of listed depository receipts, or an exchange-traded fund, would most
likely be used for:
A gaining exposure to a single equity.
B hedging exposure to a single equity.
C gaining exposure to multiple equities.
12 Calculate the total return on a share of equity using the following data:
Purchase price: $50
Sale price: $42
Dividend paid during holding period: $2
A –12.0%
B –14.3%
C –16.0%
13 If a US-based investor purchases a euro-denominated ETF and the euro subse-
quently depreciates in value relative to the dollar, the investor will have a total
return that is:
A lower than the ETF’s total return.
B higher than the ETF’s total return.
C the same as the ETF’s total return.
14 Which of the following is incorrect about the risk of an equity security? The risk
of an equity security is:
A based on the uncertainty of its cash flows.
B based on the uncertainty of its future price.
C measured using the standard deviation of its dividends.
15 From an investor’s point of view, which of the following equity securities is the
least risky?
A Putable preference shares.
B Callable preference shares.
C Non-callable preference shares.
16 Which of the following is least likely to be a reason for a company to issue
equity securities on the primary market?
A To raise capital.
B To increase liquidity.
C To increase return on equity.
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Practice Problems 303

17 Which of the following is not a primary goal of raising equity capital?

A To finance the purchase of long-lived assets.
B To finance the company’s revenue-generating activities.
C To ensure that the company continues as a going concern.
18 Which of the following statements is most accurate in describing a company’s
book value?
A Book value increases when a company retains its net income.
B Book value is usually equal to the company’s market value.
C The ultimate goal of management is to maximize book value.
19 Calculate the book value of a company using the following information:
Number of shares outstanding 100,000
Price per share €52
Total assets €12,000,000
Total liabilities €7,500,000
Net Income €2,000,000

A €4,500,000.
B €5,200,000.
C €6,500,000.
20 Which of the following statements is least accurate in describing a company’s
market value?
A Management’s decisions do not influence the company’s market value.
B Increases in book value may not be reflected in the company’s market value.
C Market value reflects the collective and differing expectations of investors.
21 Calculate the return on equity (ROE) of a stable company using the following
data:
Total sales £2,500,000
Net income £2,000,000
Beginning of year total assets £50,000,000
Beginning of year total liabilities £35,000,000
Number of shares outstanding at the end of the 1,000,000
year
Price per share at the end of the year £20

A 10.0%.
B 13.3%.
C 16.7%.
22 Holding all other factors constant, which of the following situations will most
likely lead to an increase in a company’s return on equity?
A The market price of the company’s shares increases.
B Net income increases at a slower rate than shareholders’ equity.
C The company issues debt to repurchase outstanding shares of equity.
23 Which of the following measures is the most difficult to estimate?
A The cost of debt.
B The cost of equity.
C Investors’ required rate of return on debt.
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304 Reading 36 ■ Overview of Equity Securities

24 A company’s cost of equity is often used as a proxy for investors’:

A average required rate of return.
B minimum required rate of return.
C maximum required rate of return.
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Solutions 305

SOLUTIONS
1 C is correct. The company is not obligated to make dividend payments. It is at
the discretion of the company whether or not it chooses to pay dividends.
2 B is correct. Statutory voting is the type of equity voting right that grants one
vote per share owned.
3 A is correct. Preference shares do not have to be either callable or putable.
4 C is correct. Participating preference shares entitle shareholders to receive an
additional dividend if the company’s profits exceed a pre-determined level.
5 B is correct. Private equity securities do not have market-determined quoted
prices.
6 C is correct. Venture capital investments can be used to provide mezzanine
financing to companies in their early stage of development.
7 B is correct. Regulatory and investor relations costs are lower for private equity
firms than for public firms. There are no stock exchange, regulatory, or share-
holder involvements with private equity, whereas for public firms these costs
can be high.
8 C is correct. The trends in emerging markets have not led to the stability of
foreign exchange markets.
9 A is correct. In an unsponsored DR, the depository bank owns the voting rights
to the shares. The bank purchases the shares, places them into a trust, and then
sells shares in the trust—not the underlying shares—in other markets.
10 A is correct. The listing fees on Level III sponsored ADRs are high.
11 C is correct. An ETF is used to gain exposure to a basket of securities (equity,
fixed income, commodity futures, etc.).
12 A is correct. The formula states Rt = (Pt – Pt–1 + Dt)/Pt–1. Therefore, total
return = (42 – 50 + 2)/50 = –12.0%.
13 A is correct. The depreciated value of the euro will create an additional loss in
the form of currency return that is lower than the ETF’s return.
14 C is correct. Some equity securities do not pay dividends, and therefore the
standard deviation of dividends cannot be used to measure the risk of all equity
securities.
15 A is correct. Putable shares, whether common or preference, give the investor
the option to sell the shares back to the issuer at a pre-determined price. This
pre-determined price creates a floor for the share’s price that reduces the uncer-
tainty of future cash flows for the investor (i.e., lowers risk relative to the other
two types of shares listed).
16 C is correct. Issuing shares in the primary (and secondary) market reduces a
company’s return on equity because it increases the total amount of equity capi-
tal invested in the company (i.e., the denominator in the ROE formula).
17 C is correct. Capital is raised to ensure the company’s existence only when it is
required. It is not a typical goal of raising capital.
18 A is correct. A company’s book value increases when a company retains its net
income.
19 A is correct. The book value of the company is equal to total assets minus total
liabilities, which is €12,000,000 – €7,500,000 = €4,500,000.
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306 Reading 36 ■ Overview of Equity Securities

20 A is correct. A company’s market value is affected by management’s decisions.

Management’s decisions can directly affect the company’s book value, which can
then affect its market value.
21 B is correct. A company’s ROE is calculated as (NIt/BVEt–1). The BVEt–1
is equal to the beginning total assets minus the beginning total liabilities,
which equals £50,000,000 – £35,000,000 = £15,000,000. Therefore, ROE =
£2,000,000/£15,000,000 = 13.3%.
22 C is correct. A company’s ROE will increase if it issues debt to repurchase out-
standing shares of equity.
23 B is correct. The cost of equity is not easily determined. It is dependent on
investors’ required rate of return on equity, which reflects the different risk
levels of investors and their expectations about the company’s future cash flows.
24 B is correct. Companies try to raise funds at the lowest possible cost. Therefore,
cost of equity is used as a proxy for the minimum required rate of return.