Review Questions: Chapter 1-5

1)  Which of the following is not considered a “stakeholder”?

  1. A firm supplier
  2. A firm customer
  3. A stockholder in the firm

d.  A firm in the same industry (competitor)

  1. In fact, all of the above are stakeholders

2)  Why do some feel that maximizing “stakeholder” wealth is not a sustainable goal, in the long-run?

A)  If stakeholder wealth-maximization is done at the expense of stockholders, the stock price will be lower than it could be. This makes the firm a likely takeover target

B)  Other firms in the same industry may have lower expenses because they are paying lower wages, donating less to community projects (etc). Assuming these firms do not support those “stakeholder” interests that are not also in the stockholders’ best interests, these competitors can charge lower prices for their products – thus gaining market share over the firm that pursues (non-optimal) stakeholder policies.

3)  Why do most economists believe all profitable firms must pay dividends (or disburse profits), eventually?

In a competitive economy, profitable firms will exhaust positive NPV investment opportunities eventually. If a firm finds profitable projects over a sustained period, other firms will enter the market and compete for these investments. Further, if a firm retains all of their profits, their assets will increase in value over time – producing successively larger cash flows that must then be re-invested in new projects. Therefore, to fail to pay dividends (ever) implies that firms must find increasingly larger positive NPV investments over time. This is unlikely – absent conditions that create a monopoly for the firm.

4)  Under what circumstance is the objective of “minimizing risk” inconsistent with the goal of “maximizing shareholder wealth”?

Low risk projects generally come with expectations of lower cash flows. While low risk projects may lower the firm’s beta (and lower “r”, the discount rate of dividends in the stock price formulas) – such projects will also tend to lower the future expected dividends. Therefore, it is not clear whether such projects will increase stock price, thus maximizing stockholder wealth. (At issue is whether the decrease in the future expected dividends will be more than offset by a decrease in the dividend’s discount rate, r.)

5)  When is the formula “price = PV of future expected dividends” the same as Div1 / (r-g)

When dividends are expected to grow at a constant rate.

6)  Why is the term “Pn/(1+r)n” omitted from the formula “Price = PV of future expected dividends” when n goes to infinity?

Because the PV of the price goes to 0 as n goes to infinity.

The long-winded explanation:

Pn = P0 (1+gp)n

Assume gp is the stock price growth rate. In other words, gp is the expected rate of stock price appreciation, over time. Therefore,

Pn = P0 (1+gp)n

Investors receive returns in the form of dividends and stock price appreciation, so the required rate of return on the stock (r) =

r = rate of stock-price appreciation + dividend yield

= (∆P + D1)/P

= ∆P/P + D1/P

= gp + D1/P

Therefore, r must be greater than the rate of stock price appreciation, gp, (in the long run) if we expect the firm to pay dividends (eventually).

Recall Pn = P0 (1+gp)n

If we replace Pn with what it is equal to (from above):


PV of Pn = P0 (1+gp)n / (1+r)n

We showed, above, that for firms expected to pay dividends, r must be greater than the rate of stock price appreciation, gp. When both the numerator and denominator of a fraction are raised to the same power (in this case, n), and n gets very large (goes to infinity), the value of the fraction goes to 0 if the number raised to the power of “n” in the denominator is greater than that in the numerator. Since we showed that (1+r) > (1+gp) for stocks expected to pay dividends, the PV of Pn must go to 0 as n goes to infinity, since (1+gp)n / (1+r)n goes to 0.