Equity

Question 1

An argument against using the price to cash flow (P/CF) valuation approach is that:
A) cash flows are not as easy to manipulate or distort as EPS and book value.
B) price to cash flow ratios are not as volatile as price-to-earnings (P/E) multiples.
C) non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash charges as an estimate.

Answer 1

C) non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash charges as an estimate.

Items affecting actual cash flow from operations are ignored when the EPS plus non-cash charges estimate is used. For example, non-cash revenue and net changes in working capital are ignored. Both remaining responses are arguments in favor of using the price to cash flow approach.

Question 2

The primary reason for a firm to issue equity securities is to:
A) improve its solvency ratios.
B) increase publicity for the firm’s products.
C) acquire the assets necessary to carry out its operations.

Answer 2

C) acquire the assets necessary to carry out its operations.

While issuing equity securities can improve a company’s solvency ratios and increase the firm’s visibility with the public, the primary reason to issue equity is to raise the capital needed to acquire operating assets.

Question 3

Given the following information, compute price/sales.
- Book value of assets = $550,000.
- Total sales = $200,000.
- Net income = $20,000.
- Dividend payout ratio = 30%.
- Operating cash flow = $40,000.
- Price per share = $100.
- Shares outstanding = 1,000.
- Book value of liabilities = $500,000.

A) 0.50X.
B) 2.50X.
C) 2.00X.

Answer 3

A was correct!

Market value of equity = ($100)(1000) = $100,000
Price / Sales = $100,000 / $200,000 = 0.5X

Question 4

When a company’s return on equity (ROE) is 12% and the dividend payout ratio is 60%, what is the implied sustainable growth rate of earnings and dividends?
A) 4.0%.
B) 4.8%.
C) 7.8%.

Answer 4

B) 4.8%.

g = ROE × retention ratio = ROE × (1 – payout ratio) = 12 (0.4) = 4.8%

Question 5

An investor is considering acquiring a common stock that he would like to hold for one year. He expects to receive both $1.50 in dividends and $26 from the sale of the stock at the end of the year. What is the maximum price he should pay for the stock today to earn a 15 percent return?
A) $23.91.
B) $27.30.
C) $24.11.

Answer 5

A was correct!

By discounting the cash flows for one period at the required return of 15% we get: x = (26 + 1.50) / (1+.15)1
(x)(1.15) = 26 + 1.50
x = 27.50 / 1.15
x = $23.91

Question 6

A high growth rate would be consistent with:

A) a high dividend payout rate.
B) a high ROE.
C) a low retention rate.

Answer 6

B) a high ROE.

Since g = retention rate * ROE, or (1 - payout ratio) * ROE, the only choice that would result in a higher g is a higher ROE. A low ROE, or a high dividend payout rate (which is the same as a low retention rate) would result in a low growth rate.

Question 7

Utilizing the infinite period dividend discount model, all else held equal, if the required rate of return (Ke) decreases, the model yields a price that is:
A) increased, due to a smaller spread between required return and growth.
B) reduced, due to increased spread between growth and required return.
C) reduced, due to the reduction in discount rate.

Answer 7

A was correct!

The denominator of the single-stage DDM is the spread between required return Ke, and expected growth rate, g. The smaller the denominator, all else held equal, the larger the computed value.

Question 8

According to the earnings multiplier model, which of the following factors is the least important in estimating a stock’s price-to-earnings ratio? The:
A) estimated required rate of return on the stock.
B) expected dividend payout ratio.
C) historical dividend payout ratio.

Answer 8

C) historical dividend payout ratio.

P/E = (D1/E1)/(k - g)
where:
D1/E1 = the expected dividend payout ratio
k = estimated required rate of return on the stock
g = expected growth rate of dividends for the stock
The P/E is most sensitive to movements in the denominator.

Question 9

A company has 6% preferred stock outstanding with a par value of $100. The required return on the preferred is 8%. What is the value of the preferred stock?
A) $75.00.
B) $92.59.
C) $100.00.

Answer 9

A was correct!

The annual dividend on the preferred is $100(.06) = $6.00. The value of the preferred is $6.00/0.08 = $75.00.

Question 10

An argument against using the price-to-earnings (P/E) valuation approach is that:

A) research shows that P/E differences are significantly related to long-run average stock returns.
B) earnings can be negative.
C) earnings power is the primary determinant of investment value.

Answer 10

B) earnings can be negative.

Negative earnings render the P/E ratio useless. Both remaining factors increase the usefulness of the P/E approach.

Question 11

Assume that a stock paid a dividend of $1.50 last year. Next year, an investor believes that the dividend will be 20% higher and that the stock will be selling for $50 at year-end. Assume a beta of 2.0, a risk-free rate of 6%, and an expected market return of 15%. What is the value of the stock?
A) $45.00.
B) $40.32.
C) $41.77.

Answer 11

C) $41.77.

Using the Capital Asset Pricing Model, we can determine the discount rate equal to 0.06 + 2(0.15 – 0.06) = 0.24. The dividends next year are expected to be $1.50 × 1.2 = $1.80. The present value of the future stock price and the future dividend are determined by discounting the expected cash flows at the discount rate of 24%: (50 + 1.8) / 1.24 = $41.77.

Question 12

Declining prices that result from the development of substitute products are most likely to characterize an industry in the:
A) shakeout stage.
B) mature stage.
C) decline stage.

Answer 12

C) decline stage.

The decline stage of the industry life cycle is often characterized by declining prices as substitute products or global competition emerge, or as a result of decreasing demand due to societal changes.

Question 13

Pearl River Heavy Industries shows the following information in its financial statements:

Total Assets: HK$146,000,000
Total Liabilities: HK$87,000,000
Net Income: HK$27,000,000
Price per Share: HK$312
Shares Outstanding: 200,000

The equity securities of Pearl River have a:
A) book value of HK$62,400,000.
B) book value of HK$59,000,000.
C) market value of HK$146,000,000.

Answer 13

) book value of HK$59,000,000.
Book value = Total assets − total liabilities = 146,000,000 − 87,000,000 = HK$59,000,000
Market value of equity = Market price per share × shares outstanding = HK$312 × 200,000 = HK$62,400,000

Question 14

The constant-growth dividend discount model would typically be most appropriate in valuing a stock of a:
A) moderate growth, “mature” company.
B) rapidly growing company.
C) new venture expected to retain all earnings for several years.

Answer 14

A was correct!

Remember, the infinite period DDM has the following assumptions:
- The stock pays dividends and they grow at a constant rate.
- The constant growth rate, g, continues for an infinite period.
- k must be greater than g. If not, the math will not work.
If any one of these assumptions is not met, the model breaks down. The infinite period DDM doesn’t work with growth companies. Growth companies are firms that currently have the ability to earn rates of return on investments that are currently above their required rates of return. The infinite period DDM assumes the dividend stream grows at a constant rate forever while growth companies have high growth rates in the early years that level out at some future time. The high early or supernormal growth rates will also generally exceed the required rate of return. Since the assumptions (constant g and k > g) don’t hold, the infinite period DDM cannot be used to value growth companies

Question 15

Using the one-year holding period and multiple-year holding period dividend discount model (DDM), calculate the change in value of the stock of Monster Burger Place under the following scenarios. First, assume that an investor holds the stock for only one year. Second, assume that the investor intends to hold the stock for two years. Information on the stock is as follows:
- Last year’s dividend was $2.50 per share.
- Dividends are projected to grow at a rate of 10.0% for each of the next two years.
- Estimated stock price at the end of year 1 is $25 and at the end of year 2 is $30.
- Nominal risk-free rate is 4.5%.
- The required market return is 10.0%.
- Beta is estimated at 1.0.
The value of the stock if held for one year and the value if held for two years are:

Year one	Year two A)	$25.22   	$29.80

B) $25.22 $35.25

C) $27.50 $35.25

Answer 15

A was correct!

Question 16

An analyst studying Albion Industries determines that the average EV/EBITDA ratio for Albion’s industry is 10. The analyst obtains the following information from Albion’s financial statements:
EBITDA = £11,000,000
Market value of debt = £30,000,000
Cash = £1,000,000
Based on the industry’s average enterprise value multiple, what is the equity value of Albion Industries?
A) £110,000,000.
B) £81,000,000.
C) £80,000,000.

Answer 16

B) £81,000,000.
Enterprise value = Average EV/EBITDA × company EBITDA = 10 × £11,000,000 = £110,000,000
Enterprise value = Equity value + debt − cash
Equity value = Enterprise value − debt + cash = £110,000,000 − £30,000,000 + £1,000,000 = £81,000,000

Question 17

If a preferred stock that pays a $11.50 dividend is trading at $88.46, what is the market’s required rate of return for this security?
A) 13.00%.
B) 11.76%.
C) 7.69%.

Answer 17

A was correct!
From the formula: ValuePreferred Stock = D / kp, we derive kp = D / ValuePreferred Stock = 11.50 / 88.46 = 0.1300, or 13.00%.

Question 18

A company’s payout ratio is 0.45 and its expected return on equity (ROE) is 23%. What is the company’s implied growth rate in dividends?
A) 10.35%.
B) 12.65%.
C) 4.16%.

Answer 18

B) 12.65%.

Growth Rate = (ROE)(1 – Payout Ratio) = (0.23)(0.55) = 12.65%

Question 19

Calculate the value of a common stock that last paid a $2.00 dividend if the required rate of return on the stock is 14 percent and the expected growth rate of dividends and earnings is 6 percent. What growth model is an example of this calculation?

Value of stock - Growth model
A) $26.50 Supernormal growth

B) $25.00 Gordon growth

C) $26.50 Gordon growth

Answer 19

C) $26.50 Gordon growth

$2(1.06)/0.14 - 0.06 = $26.50.
This calculation is an example of the Gordon Growth Model also known as the constant growth model.

Question 20

A firm pays an annual dividend of $1.15. The risk-free rate (RF) is 2.5%, and the total risk premium (RP) for the stock is 7%. What is the value of the stock, if the dividend is expected to remain constant?
A) $25.00.
B) $16.03.
C) $12.10.

Answer 20

C) $12.10.

If the dividend remains constant, g = 0.
P = D1 / (k-g) = 1.15 / (0.095 - 0) = $12.10

Question 21

Which of the following statements about the constant growth dividend discount model (DDM) in its application to investment analysis is least accurate? The model:
A) can’t be applied when g > K.
B) is best applied to young, rapidly growing firms.
C) is inappropriate for firms with variable dividend growth.

Answer 21

B) is best applied to young, rapidly growing firms.
The model is most appropriately used when the firm is mature, with a moderate growth rate, paying a constant stream of dividends. In order for the model to produce a finite result, the company’s growth rate must not exceed the required rate of return.

Question 22

If the payout ratio increases, the P/E multiple will:
A) decrease, if we assume that the growth rate remains constant.
B) always increase.
C) increase, if we assume that the growth rate remains constant.

Answer 22

C) increase, if we assume that the growth rate remains constant.

When payout ratio increases, the P/E multiple increases only if we assume that the growth rate will not change as a result.

Question 23

Other things equal, which of the following types of stock has the most risk from the investor’s perspective?
A) Callable preferred share.
B) Putable common share.
C) Callable common share.

Answer 23

C) Callable common share.

Callable shares have more risk than putable shares because the issuer can exercise the call option (which limits the investor’s potential gains) while the investor can exercise the put option (which limits the investor’s potential losses, assuming the firm is able to meet its obligation). Preferred shares have less risk for the investor than common shares because preferred shares have a higher priority claim on the firm’s assets in the event of liquidation, and because preferred dividends typically must be paid before common dividends may be paid.

Question 24

Which of the following statements concerning security valuation is least accurate?
A) A stock with a dividend last year of $3.25 per share, an expected dividend growth rate of 3.5%, and a required return of 12.5% is estimated to be worth $36.11.
B) A stock to be held for two years with a year-end dividend of $2.20 per share, an estimated value of $20.00 at the end of two years, and a required return of 15% is estimated to be worth $18.70 currently.
C) A stock with an expected dividend payout ratio of 30%, a required return of 8%, an expected dividend growth rate of 4%, and expected earnings of $4.15 per share is estimated to be worth $31.13 currently.

Answer 24

A was correct!

Question 25

Assume that the expected dividend growth rate (g) for a firm decreased from 5% to zero. Further, assume that the firm's cost of equity (k) and dividend payout ratio will maintain their historic levels. The firm's P/E ratio will most likely: A) decrease. B) become undefined. C) increase.

Answer 25

A was correct! The P/E ratio may be defined as: Payout ratio / (k - g), so if k is constant and g goes to zero, the P/E will decrease.

Question 26

A firm has an expected dividend payout ratio of 50 percent, a required rate of return of 18 percent, and an expected dividend growth rate of 3 percent. The firm’s price to earnings ratio (P/E) is: A) 3.33. B) 6.66. C) 2.78.

Answer 26

A was correct! P/E = .5 / (18%-3%) = 3.33.

Question 27

A stock has the following elements: last year’s dividend = $1, next year’s dividend is 10% higher, the price will be $25 at year-end, the risk-free rate is 5%, the market premium is 5%, and the stock’s beta is 1.2. Part 1) What happens to the price of the stock if the beta of the stock increases to 1.5? It will: A) increase. B) remain unchanged. C) decrease.

Answer 27

C) decrease. When the beta of a stock increases, its required return will increase. The increase in the discount rate leads to a decrease in the PV of the future cash flows

Question 28

A stock has the following elements: last year’s dividend = $1, next year’s dividend is 10% higher, the price will be $25 at year-end, the risk-free rate is 5%, the market premium is 5%, and the stock’s beta is 1.2. Part 2) What will be the current price of the stock with a beta of 1.5? A) $23.51. B) $23.20. C) $20.23.

Answer 28

B) $23.20. k = 5 + 1.5(5) = 12.5% P0 = (1.1 / 1.125) + (25 / 1.125) = $23.20

Question 29

Assume a company has earnings per share of $5 and this year paid out 40% in dividends. The earnings and dividend growth rate for the next 3 years will be 20%. At the end of the third year the company will start paying out 100% of earnings in dividends and earnings will increase at an annual rate of 5% thereafter. If a 12% rate of return is required, the value of the company is approximately: A) $92.92. B) $102.80. C) $55.69.

Answer 29

B) $102.80.

Question 30

An equity valuation model that values a firm based on the market value of its outstanding debt and equity securities, relative to a firm fundamental, is a(n): A) asset-based model. B) market multiple model. C) enterprise value model.

Answer 30

C) enterprise value model. An enterprise value model relates a firm’s enterprise value (the market value of its outstanding equity and debt securities minus its cash and marketable securities holdings) to its EBITDA, operating earnings, or revenue.

Question 31

A firm’s earnings are most likely to be cyclical if: A) most of the firm’s costs depend on its level of output. B) the firm produces luxury items. C) the firm operates in a growth industry.

Answer 31

B) the firm produces luxury items. Producers of luxury items tend to have cyclical earnings because consumers typically decrease their purchases of these items during economic recessions. The earnings of firms with high percentages of variable costs are not as likely to be cyclical as those of firms with high percentages of fixed costs (i.e., high operating leverage). A growth industry has demand that is strong enough that earnings remain relatively unaffected by the business cycle.

Question 32

One advantage of price/sales (P/S) multiples over price to earnings (P/E) and price-to-book value (PBV) multiples is that: A) P/S is easier to calculate. B) Regression shows a strong relationship between stock prices and sales. C) P/S can be used for distressed firms.

Answer 32

C) P/S can be used for distressed firms. Unlike the PBV and P/E multiples, which can become negative and not meaningful, the price/sales multiple is meaningful even for distressed firms (that may have negative earnings or book value).

Question 33

Assuming that a company's return on equity (ROE) is 12% and the required rate of return is 10%, which of the following would most likely cause the company's P/E ratio to rise? A) The inflation rate falls. B) The firm's ROE falls. C) The firm's dividend payout rises.

Answer 33

A was correct!

Question 34

Johnson Company shuts down and is liquidated. Bob Smith owns 100 common shares of Johnson, but has a lower priority of claims than Al Jones, who also owns 100 common shares. Smith most likely owns: A) non-participating shares. B) non-cumulative shares. C) Class B shares.

Answer 34

C) Class B shares. Some firms have different classes of common stock (e.g., Class A and Class B shares). These classes may be distinguished by factors such as voting rights and priority in the event of liquidation. Participating and non-participating, cumulative and non-cumulative refer to characteristics of preferred stock

Question 35

All else equal, an increase in a company’s growth rate will most likely cause its P/E ratio to: A) decrease. B) either increase or decrease. C) increase.

Answer 35

C) increase. Increase in g: As g increases, the spread between ke and g, or the P/E denominator, will decrease, and the P/E ratio will increase.

Question 36

Which of the following statements regarding price multiples is most accurate? A) An advantage of the price/sales ratio is that it is meaningful even for distressed firms. B) A disadvantage of the price/book value ratio is that it is not an appropriate measure for firms that primarily hold liquid assets. C) A rationale for using the price/cash flow ratio is that there is only one clear definition of cash flow.

Answer 36

A was correct! The P/S ratio is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for the P/E and P/BV ratios, which can be negative. In the P/BV ratio book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Analysts use several different definitions of cash flow (CFO, adjusted CFO, FCFE, EBITDA, etc.) to calculate P/CF ratios. When earnings are negative, the P/E ratio is meaningless.

Question 37

The price to book value ratio (P/BV) is a helpful valuation technique when examining firms: A) with older assets compared to those with newer assets. B) that hold primarily liquid assets. C) with the same stock prices.

Answer 37

B) that hold primarily liquid assets. P/BV analysis works best for firms that hold primarily liquid assets.

Question 38

A firm’s cost of equity capital is least accurately described as the: A) minimum rate of return investors require to invest in the firm’s equity securities. B) ratio of the firm’s net income to its average book value. C) expected total return on the firm’s equity shares in equilibrium.

Answer 38

B) ratio of the firm’s net income to its average book value. The ratio of the firm’s net income to its average book value is the firm’s return on equity, which can be greater than, equal to, or less than the firm’s cost of equity. Cost of equity for a firm can be defined as the expected equilibrium total return in the market on its equity shares, or as minimum rate of return that investors require as compensation for the risk of the firm’s equity securities.

Question 39

For relative valuation, a peer group is best described as companies: A) in a similar sector or industry classification. B) with similar business activities and competitive factors. C) at a similar stage of the industry life cycle.

Answer 39

B) with similar business activities and competitive factors. An analyst should form peer groups of companies that have similar business activities, drivers of demand and costs, and access to capital. Companies in the same industry or sector and companies at the same stage of the industry life cycle are not necessarily comparable for equity valuation purposes

Question 40

According to the earnings multiplier model, a stock’s P/E ratio (P0/E1) is affected by all of the following EXCEPT the: A) required return on equity. B) expected dividend payout ratio.

Answer 40

C) expected stock price in one year. According to the earnings multiplier model, the P/E ratio is equal to P0/E1 = (D1/E1)/(ke - g). Thus, the P/E ratio is determined by: - The expected dividend payout ratio (D1/E1). - The required rate of return on the stock (ke). - The expected growth rate of dividends (g).

Question 41

Gwangwa Gold, a South African gold producer, has as its primary asset a mine which is shown on the balance sheet with a value of R100 million. An analyst estimates the market value of this mine to be 90% of book value. The company’s balance sheet shows other assets of R20 million and liabilities of R40 million, and the analyst feels that the book value of these items reflects their market values. Using the asset-based valuation approach, what should the analyst estimate the value of the company to be? A) R80 million. B) R110 million. C) R70 million.

Answer 41

C) R70 million. Market value of assets = 0.9(R100 million) + R20 million = R110 million Market value of liabilities = R40 million Estimated net value of company = R110 million − R40 million = R70 million.

Question 42

Industry analysis is most likely to provide an analyst with insight about a company’s: A) competitive strategy. B) financial performance. C) pricing power.

Answer 42

C) pricing power. Industry analysis provides a framework for an analyst to understand a firm in relation to its competitive environment, which determines how much pricing power a firm has. Competitive strategy and financial performance are aspects of company analysis.

Question 43

One advantage to using the price/book value (P/B) ratio over using the price/earnings (P/E) ratio is that P/B can be used when: A) earnings or cash flows are negative. B) stock markets are volatile. C) the firm is in a slow growth phase.

Answer 43

A was correct! When earnings are negative, P/E ratios cannot be used but P/B ratios can be used. The firm's rate of growth and the volatility of markets do not suggest advantages of using P/B ratios rather than P/E ratios.

Question 44

Which of the following industries is most likely to operate in a fragmented market? A) Pharmaceuticals. B) Oil services. C) Confections.

Answer 44

B) Oil services. Most areas of the oil services industry are characterized by many small competitors. The confections and pharmaceutical industries each have a small number of very large firms

Question 45

The following data pertains to a common stock: - It will pay no dividends for two years. - The dividend three years from now is expected to be $1. - Dividends are expected to grow at a 7% rate from that point onward. If an investor requires a 17% return on this stock, what will they be willing to pay for this stock now? A) $ 7.30. B) $10.00. C) $ 6.24.

Answer 45

A was correct! time line = $0 now; $0 in yr 1; $0 in yr 2; $1 in yr 3. P2 = D3/(k - g) = 1/(.17 - .07) = $10 Note the math. The price is always one year before the dividend date. Solve for the PV of $10 to be received in two years. FV = 10; n = 2; i = 17; compute PV = $7.30

Question 46

An argument against using the price-to-sales (P/S) valuation approach is that: A) P/S ratios are not as volatile as price-to-earnings (P/E) multiples. B) sales figures are not as easy to manipulate or distort as earnings per share (EPS) and book value. C) P/S ratios do not express differences in cost structures across companies.

Answer 46

C) P/S ratios do not express differences in cost structures across companies. P/S ratios do not express differences in cost structures across companies. Both remaining responses are advantages of the P/S ratios, not disadvantages.

Question 47

The preferred stock of the Delco Investments Company has a par value of $150 and a dividend of $11.50. A shareholder’s required return on this stock is 14%. What is the maximum price he would pay? A) $150.00. B) $54.76. C) $82.14.

Answer 47

C) $82.14. Value of preferred = D / kp = $11.50 / 0.14 = $82.14

Question 48

An equity security that requires the firm to pay any scheduled dividends that have been missed, before paying any dividends to common equity holders, is a: A) participating preference share. B) convertible preference share. C) cumulative preference share.

Answer 48

C) cumulative preference share. Cumulative preference shares (cumulative preferred stock) must receive any dividends in arrears before the firm may pay any dividends to common shareholders.

Question 49

Day and Associates is experiencing a period of abnormal growth. The last dividend paid by Day was $0.75. Next year, they anticipate growth in dividends and earnings of 25% followed by negative 5% growth in the second year. The company will level off to a normal growth rate of 8% in year three and is expected to maintain an 8% growth rate for the foreseeable future. Investors require a 12% rate of return on Day. Part 1) What is the approximate amount that an investor would be willing to pay today for the two years of abnormal dividends? A) $1.62. B) $1.83. C) $1.55.

Answer 49

C) $1.55. First find the abnormal dividends and then discount them back to the present. $0.75 × 1.25 = $0.9375 × 0.95 = $0.89. D1 = $0.9375; D2 = $0.89. At this point you can use the cash flow keys with CF0 = 0, CF1 = $0.9375 and CF2 = $0.89. Compute for NPV with I/Y = 12. NPV = $1.547. Alternatively, you can put the dividends in as future values, solve for present values and add the two together.

Question 50

Which of the following statements concerning security valuation is least accurate? A) The best way to value a company with no current dividend but who is expected to pay dividends in three years is to use the temporary supernormal growth (multistage) model. B) A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on equity of 12%, and a 15% required return is worth $18.24. C) The best way to value a company with high and unsustainable growth that exceeds the required return is to use the temporary supernormal growth (multistage) model.

Answer 50

B) A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on equity of 12%, and a 15% required return is worth $18.24. A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on new investment of 12%, and a 15% required return is worth $20.64. The growth rate is (1 – 0.40) × 0.12 = 7.2%. The expected dividend is then ($1.50)(1.072) = $1.61. The value is then (1.61) / (0.15 – 0.072) = $20.64.

Question 51

Which of the following is NOT an assumption of the constant growth dividend discount model (DDM)? A) The growth rate of the firm is higher than the overall growth rate of the economy. B) Dividend payout is constant. C) ROE is constant.

Answer 51

A was correct! Other assumptions of the DDM are: dividends grow at a constant rate and the growth rate continues for an infinite period.

Question 52

Use the following information and the dividend discount model to find the value of GoFlower, Inc.’s, common stock. - Last year’s dividend was $3.10 per share. - The growth rate in dividends is estimated to be 10% forever. - The return on the market is expected to be 12%. - The risk-free rate is 4%. - GoFlower’s beta is 1.1. A) $121.79. B) $34.95. C) $26.64.

Answer 52

A was correct! The required return for GoFlower is 0.04 + 1.1(0.12 – 0.04) = 0.128 or 12.8%. The expect dividend is ($3.10)(1.10) = $3.41. GoFlower’s common stock is then valued using the infinite period dividend discount model (DDM) as ($3.41) / (0.128 – 0.10) = $121.79.

Question 53

The required rate of return on equity used as an input to the dividend discount model is influenced by each of the following factors EXCEPT: A) the stock's appropriate risk premium. B) the expected inflation rate. C) the stock's dividend payout ratio.

Answer 53

C) the stock's dividend payout ratio. A stock’s required rate of return is equal to the nominal risk-free rate plus a risk premium. The nominal risk-free rate is approximately equal the real risk-free rate plus expected inflation.

Question 54

Which of the following is least likely an advantage of using price/sales (P/S) multiple? A) P/S multiples are more reliable because sales data cannot be distorted by management. B) P/S multiples provide a meaningful framework for evaluating distressed firms. C) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation analysis.

Answer 54

A was correct! Accounting data on sales is used to calculate the P/S multiple. The P/S multiple is thought to be more reliable because sales figures are not as easy to manipulate as the earnings and book value, both of which are significantly affected by accounting conventions. However, it is not true that "sales data cannot be distorted by management" because aggressive revenue recognition practices can influence reported sales.

Question 55

Assuming a discount rate of 15%, a preferred stock with a perpetual dividend of $10 is valued at approximately: A) $1.50. B) $66.67. C) $8.70.

Answer 55

B) $66.67. The formula for the value of preferred stock with a perpetual dividend is: D / kp, or 10.0 / 0.15 = $66.67.

Question 56

Given the following information, compute the implied dividend growth rate. - Profit margin = 10.0% - Total asset turnover = 2.0 times - Financial leverage = 1.5 times - Dividend payout ratio = 40.0% A) 4.5%. B) 12.0%. C) 18.0%.

Answer 56

C) 18.0%. Retention ratio equals 1 – 0.40, or 0.60. Return on equity equals (10.0%)(2.0)(1.5) = 30.0%. Dividend growth rate equals (0.60)(30.0%) = 18.0%.

Question 57

A firm has an expected dividend payout ratio of 50%, a required rate of return of 12% and a constant growth rate of 6%. If earnings for the next year are expected to be $4.50, the value of the stock today is closest to: A) $39.75. B) $33.50. C) $37.50.

Answer 57

C) $37.50. Expected dividend = $4.50 × 0.50 = $2.25 Value today = $2.25 / (0.12 − 0.06) = $37.50

Question 58

An analyst gathered the following data: - An earnings retention rate of 40%. - An ROE of 12%. - The stock's beta is 1.2. - The nominal risk free rate is 6%. - The expected market return is 11%. Assuming next year's earnings will be $4 per share, the stock’s current value is closest to: A) $33.32. B) $26.67. C) $45.45.

Answer 58

A was correct! Dividend payout = 1 − earnings retention rate = 1 − 0.4 = 0.6

Question 59

An analyst gathered the following information about a company: - The stock is currently trading at $31.00 per share. - Estimated growth rate for the next three years is 25%. - Beginning in the year 4, the growth rate is expected to decline and stabilize at 8%. - The required return for this type of company is estimated at 15%. - The dividend in year 1 is estimated at $2.00. The stock is undervalued by approximately: A) $6.40. B) $15.70. C) $0.00.

Answer 59

A was correct! The high “supernormal” growth in the first three years and the decrease in growth thereafter signals that we should

Question 60

The competitive forces identified by Michael Porter include: A) threat of substitute products and rivalry among suppliers. B) rivalry among existing competitors and bargaining power of buyers. C) bargaining power of existing competitors and threat of new entrants.

Answer 60

B) rivalry among existing competitors and bargaining power of buyers. Porter’s five competitive forces are: (1) rivalry among existing competitors; (2) threat of new entrants; (3) threat of substitute products; (4) bargaining power of buyers; (5) bargaining power of suppliers.

Question 61

A firm has an expected dividend payout ratio of 48 percent and an expected future growth rate of 8 percent. What should the firm's price to earnings ratio (P/E) be if the required rate of return on stocks of this type is 14 percent and what is the retention ratio of the firm? P/E ratio - Retention ratio A) 6.5 52% B) 6.5 48% C) 8.0 52%

Answer 61

C) 8.0 52% P/E = (dividend payout ratio)/(k - g) P/E = 0.48/(0.14 - 0.08) = 8 The retention ratio = (1 - dividend payout) = (1 - 0.48) = 52%