Chapter Nine Valuation of Common Stocks This chapter contains 47 multiple choice questions,17 short problems,and 9 longer problems. Multiple Choice 1.In a quote listing of stocks,the is defined as the annualized dollar dividend divided by the stock's price,and is usually expressed as a percentage. (a)cash dividend (b)dividend payout (c)dividend coverage (d)dividend yield Answer:(d) 2.According to the discounted-dividend model,the price of a share of stock is the value of all expected dividends per share,discounted at the market capitalization rate. (a)present;current (b)present:future (c)future:future (d)future;current Answer:(b) 3.The value of common stock is determined by which of the following expected cash flows? (a)dividends and interest payments (b)dividends and maturity value of stock (c)dividends and net cash flows from operations of the firm (d)interest payments and maturity value Answer:(c) 9-1
9-1 Chapter Nine Valuation of Common Stocks This chapter contains 47 multiple choice questions, 17 short problems, and 9 longer problems. Multiple Choice 1. In a quote listing of stocks, the ________ is defined as the annualized dollar dividend divided by the stock’s price, and is usually expressed as a percentage. (a) cash dividend (b) dividend payout (c) dividend coverage (d) dividend yield Answer: (d) 2. According to the discounted-dividend model, the price of a share of stock is the ________ value of all expected ________ dividends per share, discounted at the market capitalization rate. (a) present; current (b) present; future (c) future; future (d) future; current Answer: (b) 3. The value of common stock is determined by which of the following expected cash flows? (a) dividends and interest payments (b) dividends and maturity value of stock (c) dividends and net cash flows from operations of the firm (d) interest payments and maturity value Answer: (c)
4.The is the expected rate of return that investors require in order to be willing to invest in the stock (a)market capitalization rate (b)risk-adjusted discount rate (c)cost of debt (d)a and b Answer:(d) 5.The of dividends is the most basic assumption underlying the discounted dividend model. (a)industry average (b)non-constant growth (c)constant growth (d)variability Answer:(c) 6. BHM stock is expected to pay a dividend of $2.50 a year from now,and its dividends are expected to grow by 6%per year thereafter.What is the price of a BHM share if the market capitalization rate is 7%per year? (a)$250.00 (b)$192.31 (c)$25.00 (d)$19.23 Answer:(c) 7.IOU stock is expected to pay a dividend of $1.67 a year from now,and its dividends are not expected to grow in the foreseeable future.If the market capitalization rate is 7%,what is the current price of a share of IOU stock? (a)$11.69 (b)$23.86 (c)$116.90 (d)$238.60 Answer:(b) 9-2
9-2 4. The ________ is the expected rate of return that investors require in order to be willing to invest in the stock. (a) market capitalization rate (b) risk-adjusted discount rate (c) cost of debt (d) a and b Answer: (d) 5. The ________ of dividends is the most basic assumption underlying the discounted dividend model. (a) industry average (b) non-constant growth (c) constant growth (d) variability Answer: (c) 6. BHM stock is expected to pay a dividend of $2.50 a year from now, and its dividends are expected to grow by 6% per year thereafter. What is the price of a BHM share if the market capitalization rate is 7% per year? (a) $250.00 (b) $192.31 (c) $25.00 (d) $19.23 Answer: (c) 7. IOU stock is expected to pay a dividend of $1.67 a year from now, and its dividends are not expected to grow in the foreseeable future. If the market capitalization rate is 7%, what is the current price of a share of IOU stock? (a) $11.69 (b) $23.86 (c) $116.90 (d) $238.60 Answer: (b)
8.GMATS stock is currently selling for $34.50 a share.The current dividend for this stock is $1.60 and dividends are expected to grow at a constant rate of 10%per year thereafter.What must be the market capitalization rate for a share of GMATS stock? (a)4.90% (b)5.36% (c)14.64% (d)15.10% Answer:(d) 9.Avacor stock is expected to pay a dividend of $1.89 a year from now,and its dividends are expected to grow at a constant rate of 5%per year thereafter.If the market capitalization rate is 14%per year,what is the current price of a share of Avacor stock? (a)$13.50 (b)$18.90 (c)$21.00 (d)$37.80 Answer:(c) 10.GRITO stock is currently selling for $46.10 a share.If the company is expected to pay a dividend of $5.60 a year from now and dividends are not expected to grow thereafter,what is the market capitalization rate for a share of GRITO stock? (a)7.56% (b)8.23% (c)10.50% (d)12.15% Answer:(d) 11.In the DDM model,if D and k are held constant,what will happen to the price of a stock if the constant growth rate gets higher? (a)the price of the stock will be higher (b)the price of the stock will hold constant (c)the price of the stock will be lower (d)it cannot be determined from the information given Answer:(a) 9-3
9-3 8. GMATS stock is currently selling for $34.50 a share. The current dividend for this stock is $1.60 and dividends are expected to grow at a constant rate of 10% per year thereafter. What must be the market capitalization rate for a share of GMATS stock? (a) 4.90% (b) 5.36% (c) 14.64% (d) 15.10% Answer: (d) 9. Avacor stock is expected to pay a dividend of $1.89 a year from now, and its dividends are expected to grow at a constant rate of 5% per year thereafter. If the market capitalization rate is 14% per year, what is the current price of a share of Avacor stock? (a) $13.50 (b) $18.90 (c) $21.00 (d) $37.80 Answer: (c) 10. GRITO stock is currently selling for $46.10 a share. If the company is expected to pay a dividend of $5.60 a year from now and dividends are not expected to grow thereafter, what is the market capitalization rate for a share of GRITO stock? (a) 7.56% (b) 8.23% (c) 10.50% (d) 12.15% Answer: (d) 11. In the DDM model, if D1 and k are held constant, what will happen to the price of a stock if the constant growth rate gets higher? (a) the price of the stock will be higher (b) the price of the stock will hold constant (c) the price of the stock will be lower (d) it cannot be determined from the information given Answer: (a)
12.The relation between earnings and dividends in any period is (a)Dividends =Earnings/Net New Investment (b)Dividends=Earnings x Net New Investment (c)Dividends=Earnings Net New Investment (d)Dividends Earnings-Net New Investment Answer:(d) 13.Consider a firm called Nowhere Corporation,whose earnings per share are $12.The firm invests an amount each year that is just sufficient to replace the production capacity that is wearing out,and so the new investment is zero.The firm pays out all its earnings as dividends.Calculate the price of a share of Nowhere Corporation stock,give that k=14%. (a)$168.00 (b)$166.67 (c)$85.71 (d)$82.40 Answer:(c) 14.Consider a firm called SureBet Corporation.SureBet reinvests 55%of its earnings each year into new investments that earn a rate of return of 17%per year.Currently,SureBet Corporation has earnings per share of $12 and pays out 45%or $5.40 as dividends.Calculate the growth rate of earnings and dividends. (a)7.65% (b)8.50% (c)9.35% (d)24.75% Answer:(c) 15.What adds value to the current price of a share of stock is (a)growth per se (b)tax advantages (c)investment opportunities that earn rates of return >k (d)all of the above Answer:(c) 9-4
9-4 12. The relation between earnings and dividends in any period is ________. (a) Dividends = Earnings/Net New Investment (b) Dividends = Earnings x Net New Investment (c) Dividends = Earnings + Net New Investment (d) Dividends = Earnings – Net New Investment Answer: (d) 13. Consider a firm called Nowhere Corporation, whose earnings per share are $12. The firm invests an amount each year that is just sufficient to replace the production capacity that is wearing out, and so the new investment is zero. The firm pays out all its earnings as dividends. Calculate the price of a share of Nowhere Corporation stock, give that k = 14%. (a) $168.00 (b) $166.67 (c) $85.71 (d) $82.40 Answer: (c) 14. Consider a firm called SureBet Corporation. SureBet reinvests 55% of its earnings each year into new investments that earn a rate of return of 17% per year. Currently, SureBet Corporation has earnings per share of $12 and pays out 45% or $5.40 as dividends. Calculate the growth rate of earnings and dividends. (a) 7.65% (b) 8.50% (c) 9.35% (d) 24.75% Answer: (c) 15. What adds value to the current price of a share of stock is ________. (a) growth per se (b) tax advantages (c) investment opportunities that earn rates of return > k (d) all of the above Answer: (c)
16.In order to evaluate the stock of Beltran Inc.,an analyst uses the constant growth discounted dividend model.Expected earnings of $12 per share is assumed,as are an earnings retention rate of 70%and an expected rate of return on future investments of 17%per year.If the market capitalization rate is 14%per year,calculate the price for a share of Beltran stock. (a)$171.43 (b)$367.35 (c)$400.00 (d)$857.14 Answer:(a) 17.In order to evaluate the stock of The Rendell-Vine Corporation,an analyst uses the constant growth discounted dividend model.Expected earnings of $12 per share is assumed,as are an earnings retention rate of 70%and an expected rate of return on future investments of 17% per year.If the market capitalization rate is 14%per year,what is the implied net present value of future investments? (a)$314.29 (b)$281.64 (c)$171.43 (d)$85.72 Answer:(d) 18.In order to evaluate the stock of Toys'R'Me,an analyst uses the constant growth discounted dividend model.Expected earnings of $14 per share is assumed,as are an earnings retention rate of 60%and an expected rate of return on future investments of 17%per year.If the market capitalization rate is 15%per year,what is the implied net present value of future investments? (a)$23.34 (b)$70.00 (c)$93.34 (d)$116.67 Answer:(a) 19.Firms with consistently high P/E multiples are interpreted to have either relatively market capitalization rates or relatively present value of value-added investments. (a)low;low (b)high;high (c)high;low (d)low;high Answer:(d) 9-5
9-5 16. In order to evaluate the stock of Beltran Inc., an analyst uses the constant growth discounted dividend model. Expected earnings of $12 per share is assumed, as are an earnings retention rate of 70% and an expected rate of return on future investments of 17% per year. If the market capitalization rate is 14% per year, calculate the price for a share of Beltran stock. (a) $171.43 (b) $367.35 (c) $400.00 (d) $857.14 Answer: (a) 17. In order to evaluate the stock of The Rendell-Vine Corporation, an analyst uses the constant growth discounted dividend model. Expected earnings of $12 per share is assumed, as are an earnings retention rate of 70% and an expected rate of return on future investments of 17% per year. If the market capitalization rate is 14% per year, what is the implied net present value of future investments? (a) $314.29 (b) $281.64 (c) $171.43 (d) $85.72 Answer: (d) 18. In order to evaluate the stock of Toys’R’Me, an analyst uses the constant growth discounted dividend model. Expected earnings of $14 per share is assumed, as are an earnings retention rate of 60% and an expected rate of return on future investments of 17% per year. If the market capitalization rate is 15% per year, what is the implied net present value of future investments? (a) $23.34 (b) $70.00 (c) $93.34 (d) $116.67 Answer: (a) 19. Firms with consistently high P/E multiples are interpreted to have either relatively ________ market capitalization rates or relatively ________ present value of value-added investments. (a) low; low (b) high; high (c) high; low (d) low; high Answer: (d)
20.In a "frictionless"financial environment,the shareholders wealth is the dividend policy the firm adopts. (a)increased by (b)decreased by (c)not affected by (d)determined by Answer:(c) 21.Ina the company pays cash to buy shares of its stock in the stock market,thereby reducing the number of shares outstanding. (a)cash dividend (b)share repurchase (c)stock split (d)a and b Answer:(b) 22.Stock splits and stock dividends the number of shares of stock outstanding (a)decrease (b)do not alter (c)increase (d)aor b Answer:(c) 23.SureBet Corporation has total assets with a market value of $15 million:$3 million in cash and $12 million in other assets.The market value of its debt is $3 million;of its equity $12 million.There are 1,000,000 shares of SureBet common stock outstanding,each with a market price of $12.If SureBet distributes a cash dividend of $1.50 per share,the market value of its assets and of its equity by (a)increases;$1.5 million (b)increases;$10.5 million (c)decreases;$1.5 million (d)decreases;$10.5 million Answer:(c) 9-6
9-6 20. In a “frictionless” financial environment, the shareholders wealth is ________ the dividend policy the firm adopts. (a) increased by (b) decreased by (c) not affected by (d) determined by Answer: (c) 21. In a ________ the company pays cash to buy shares of its stock in the stock market, thereby reducing the number of shares outstanding. (a) cash dividend (b) share repurchase (c) stock split (d) a and b Answer: (b) 22. Stock splits and stock dividends ________ the number of shares of stock outstanding. (a) decrease (b) do not alter (c) increase (d) a or b Answer: (c) 23. SureBet Corporation has total assets with a market value of $15 million: $3 million in cash and $12 million in other assets. The market value of its debt is $3 million; of its equity $12 million. There are 1,000,000 shares of SureBet common stock outstanding, each with a market price of $12. If SureBet distributes a cash dividend of $1.50 per share, the market value of its assets and of its equity ________ by ________. (a) increases; $1.5 million (b) increases; $10.5 million (c) decreases; $1.5 million (d) decreases; $10.5 million Answer: (c)
24.SureBet Corporation has total assets with a market value of $15 million:$3 million in cash and $12 million in other assets.The market value of its debt is $3 million;of its equity $12 million.There are 1,000,000 shares of SureBet common stock outstanding,each with a market price of $12.If SureBet repurchases shares worth $2.4 million,the resulting number of shares outstanding is with a price per share of (a)200,000,$15 (b)200,000:$12 (c)800,000:$15 (d)800,000:$12 Answer:(d) 25."Frictions"that can cause a firm's dividend policy to have an effect on the wealth of shareholders include: (a)regulations (b)taxes (c)cost of external finance (d)all of the above Answer:(d) 26.Outside investors may interpret an increase in a corporation's cash dividend as sign. (a)a positive sign (b)a negative sign (c)an indifferent sign (d)bor c Answer:(a) 27.From the perspective of a shareholder with regard to personal taxation,it is always for the corporation to pay out cash by (a)better;cash dividends (b)worse;cash dividends (c)worse;share repurchases (d)it varies according to the situation Answer:(b) 9-7
9-7 24. SureBet Corporation has total assets with a market value of $15 million: $3 million in cash and $12 million in other assets. The market value of its debt is $3 million; of its equity $12 million. There are 1,000,000 shares of SureBet common stock outstanding, each with a market price of $12. If SureBet repurchases shares worth $2.4 million, the resulting number of shares outstanding is ________ , with a price per share of ________. (a) 200,000; $15 (b) 200,000; $12 (c) 800,000; $15 (d) 800,000; $12 Answer: (d) 25. “Frictions” that can cause a firm’s dividend policy to have an effect on the wealth of shareholders include: (a) regulations (b) taxes (c) cost of external finance (d) all of the above Answer: (d) 26. Outside investors may interpret an increase in a corporation’s cash dividend as ________ sign. (a) a positive sign (b) a negative sign (c) an indifferent sign (d) b or c Answer: (a) 27. From the perspective of a shareholder with regard to personal taxation, it is always ________ for the corporation to pay out cash by ________. (a) better; cash dividends (b) worse; cash dividends (c) worse; share repurchases (d) it varies according to the situation Answer: (b)
28.An increase in a corporation's cash dividend is most likely to (a)decrease the price of its stock (b)increase the price of its stock (c)have no impact on the price of its stock (d)decrease trading activity of its stock Answer:(b) 29.Raising cash by issuing new stock is to the corporation than raising cash by foregoing the payments of dividends. (a)is less costly (b)is more costly (c)is no different (d)just as costly Answer:(b) 30.Gough Fraser is considering purchasing the stock of ASIOA Companies,which he plans to hold indefinitely.ASIOA just paid an annual dividend of $2.50 and the price of the stock is $48 per share.The earnings and dividends of the company are expected to grow forever at a rate of 6 percent per year.What annual rate of return does Gough expect on his investment? (a)10.58% (b)11.21% (c)11.52% (d)12.46% Answer:(c) 31.Beazley Inc.just paid a dividend of $3.00 per share.This dividend is expected to grow at a supernormal rate of 15 percent per year for the next two years.It is then expected to grow at a rate of 6 percent per year forever.The appropriate discount rate for Beazley's stock is 17 percent.What is the price of the stock? (a)$17.64 (b)$27.27 (c)$33.78 (d)$46.15 Answer:(c) 9-8
9-8 28. An increase in a corporation’s cash dividend is most likely to ________. (a) decrease the price of its stock (b) increase the price of its stock (c) have no impact on the price of its stock (d) decrease trading activity of its stock Answer: (b) 29. Raising cash by issuing new stock is ________ to the corporation than raising cash by foregoing the payments of dividends. (a) is less costly (b) is more costly (c) is no different (d) just as costly Answer: (b) 30. Gough Fraser is considering purchasing the stock of ASIOA Companies, which he plans to hold indefinitely. ASIOA just paid an annual dividend of $2.50 and the price of the stock is $48 per share. The earnings and dividends of the company are expected to grow forever at a rate of 6 percent per year. What annual rate of return does Gough expect on his investment? (a) 10.58% (b) 11.21% (c) 11.52% (d) 12.46% Answer: (c) 31. Beazley Inc. just paid a dividend of $3.00 per share. This dividend is expected to grow at a supernormal rate of 15 percent per year for the next two years. It is then expected to grow at a rate of 6 percent per year forever. The appropriate discount rate for Beazley’s stock is 17 percent. What is the price of the stock? (a) $17.64 (b) $27.27 (c) $33.78 (d) $46.15 Answer: (c)
32.Beazley Corporation would like to raise $100,000,000 by issuing preferred stock.The preferred stock will have a par value of $1,000 per share and pay a dividend of $72 per year. If the required rate of return for this stock is 16 percent,how many shares of preferred stock must Beazley issue? (a)450 (b)16,000 (c)222,222 (d)265,332 Answer:(c) 33.If you use the constant dividend growth model to value a stock,which of the following is certain to cause you to increase your estimate of the current value of the stock? (a)Decreasing the required rate ofreturn for the stock (b)Decreasing the estimate of the amount of next year's dividend (c)Decreasing the expected dividend growth rate (d)All of the above Answer:(a) 34.The constant dividend growth model may be used to find the price of a stock in all of the following situations except when: (a)g<k (b)k<g (c)g=0 (d)k≠g Answer:(b) 35.CarsonCorp just paid an annual dividend of $3.00.Dividends are expected to grow at a constant rate forever.The price of the stock is currently $63.00.The required rate of return for this stock is 15 percent.What is the expected growth rate of CarsonCorp's dividend? (a)5.00% (b)5.48% (c)6.33% (d)10.00% Answer:(a) 9-9
9-9 32. Beazley Corporation would like to raise $100,000,000 by issuing preferred stock. The preferred stock will have a par value of $1,000 per share and pay a dividend of $72 per year. If the required rate of return for this stock is 16 percent, how many shares of preferred stock must Beazley issue? (a) 450 (b) 16,000 (c) 222,222 (d) 265,332 Answer: (c) 33. If you use the constant dividend growth model to value a stock, which of the following is certain to cause you to increase your estimate of the current value of the stock? (a) Decreasing the required rate of return for the stock (b) Decreasing the estimate of the amount of next year’s dividend (c) Decreasing the expected dividend growth rate (d) All of the above Answer: (a) 34. The constant dividend growth model may be used to find the price of a stock in all of the following situations except when: (a) g < k (b) k < g (c) g = 0 (d) k ≠ g Answer: (b) 35. CarsonCorp just paid an annual dividend of $3.00. Dividends are expected to grow at a constant rate forever. The price of the stock is currently $63.00. The required rate of return for this stock is 15 percent. What is the expected growth rate of CarsonCorp’s dividend? (a) 5.00% (b) 5.48% (c) 6.33% (d) 10.00% Answer: (a)
36.The common stock of Century Inc.is expected to pay a dividend of $2.00 one year from today.After that the dividend is expected to grow at a rate of 10 percent per year for two years and then at a rate of 5 percent per year forever.If the required rate of return for this stock is 15 percent what is the current price? (a)$12.00 (b)$18.29 (c)$21.69 (d)$25.40 Answer:(c) 37.A firm's common stock is trading at $80 per share.In the past the firm has paid a constant dividend of $6 per share.However,the company has just announced new investments that the market did not know about.The market expects that with these new investments,the dividends should grow at 4%per year forever.Assuming that the discount rate remains the same,what will be the price of the stock after the announcement? (a)$94.50 (b)$156.00 (c)$171.43 (d)$178.29 Answer:(d) 38.If the model below is to give a reasonable valuation of a stock,which of the following possible situations must be excluded? Po=Di/(r-g) (a)There is no growth. (b)The growth rate exceeds the required rate of return. (c)The required rate of return is exceptionally high. (d)Growth is constant. Answer:(b) 39.According to the constant growth model of stock valuation,capital appreciation in common stock is a direct result of (a)growth in future dividends (b)a reduction in the required rate of return (c)growth in corporate assets (d)a growth rate that exceeds the required rate of return Answer:(a) 9-10
9-10 36. The common stock of Century Inc. is expected to pay a dividend of $2.00 one year from today. After that the dividend is expected to grow at a rate of 10 percent per year for two years and then at a rate of 5 percent per year forever. If the required rate of return for this stock is 15 percent what is the current price? (a) $12.00 (b) $18.29 (c) $21.69 (d) $25.40 Answer: (c) 37. A firm’s common stock is trading at $80 per share. In the past the firm has paid a constant dividend of $6 per share. However, the company has just announced new investments that the market did not know about. The market expects that with these new investments, the dividends should grow at 4% per year forever. Assuming that the discount rate remains the same, what will be the price of the stock after the announcement? (a) $94.50 (b) $156.00 (c) $171.43 (d) $178.29 Answer: (d) 38. If the model below is to give a reasonable valuation of a stock, which of the following possible situations must be excluded? P0 = D1/(r – g) (a) There is no growth. (b) The growth rate exceeds the required rate of return. (c) The required rate of return is exceptionally high. (d) Growth is constant. Answer: (b) 39. According to the constant growth model of stock valuation, capital appreciation in common stock is a direct result of ________. (a) growth in future dividends (b) a reduction in the required rate of return (c) growth in corporate assets (d) a growth rate that exceeds the required rate of return Answer: (a)