Chapter 4 The Value of Common Stocks
Multiple Choice Questions
1.If the Vol. 100s is reported as 10,233 in the Wall Street Journal quotation, then the trading volume for that day of trading is:
A)10,233 shares
B)102,330 shares
C)1,023,300 shares
D)10,233,000 shares
Answer: C
Type: Medium
Page: 60
Response: Trading volume = 10,233 * 100 = 1,023,300
2.The dividend yield reported as Yld. % in The Wall Street Journal quotation is calculated as follows:
A)(dividends / hi)
B)(dividends / lo)
C)(dividends / close)
D)None of the above
Answer: C
Type: Medium
Page: 60
3.The Wall Street Journal quotation for a company has the following values: Div: 2.28, PE: 19, Close: 75.30. Calculate the dividend pay out ratio for the company.
A)58%
B)12%
C)75%
D)None of the above
Answer: A
Type: Difficult
Page: 60
Response: EPS = (75.30)/19 = 3.9631 dividend payout = 2.28/3.9631 = 0.5753= 58%
4.If the Wall Street Journal Quotation for a company has the following values close: 26.00; Net chg: =+1.00; then the closing price for the stock for the previous trading day was?
A)$26
B)$25
C)$27
D)None of the above.
Answer: B
Type: Medium
Page: 60
Response: Previous closing = today's closing net chg. = 26.00-1.00= $25.00
5.The value of a common stock today depends on:
A)Number of shares outstanding and the number of shareholders
B)The Wall Street analysts
C)The expected future dividends and the discount rate
D)Present value of the future earnings per share
Answer: C
Type: Easy
Page: 62
6.Super Computer Company's stock is selling for $100 per share today. It is expected that this stock will pay a dividend of 5 dollars per share, and then be sold for $120 per share at the end of one year. Calculate the expected rate of return for the shareholders.
A)20%
B)25%
C)10%
D)15%
Answer: B
Type: Easy
Page: 62
Response: r = (120+5-100)/100 = 25%
7.PC Company stockholders expect to receive a year-end dividend of $10 per share and then be sold for $122 dollars per share. If the required rate of return for the stock is 20%, what is the current value of the stock?
A)$100
B)$122
C)$132
D)$110
Answer: D
Type: Medium
Page: 62
Response: P = (122+10)/1.2 = 110
8.Macrohard Company expects to pay a dividend of $6 per share at the end of year one, $8 per share at the end of year two and then be sold for $136 per share. If the required rate on the stock is 20%, what is the current value of the stock?
A)$100
B)$105
C)$110
D)$120
Answer: B
Type: Medium
Page: 62
Response: P = (6/1.2)+(8+136)/(1.2^2) = 105
9.The constant dividend growth formula P0 = D1/(r-g) assumes:
A)The dividends are growing at a constant rate g forever.
B)r > g
C)g is never negative.
D)Both A and B
Answer: D
Type: Medium
Page: 64
10.Casino Co. is expected to pay a dividend of $6 per share at the end of year one and these dividends are expected to grow at a constant rate of 8% per year forever. If the required rate of return on the stock is 20%, what is current value of the stock today?
A)$30
B)$50
C)$100
D)$54
Answer: B
Type: Medium
Page: 64
Response: P = (6/(0.2-0.08) = 50
11.WorldTour Co. has just now paid a dividend of $6 per share (Do), the dividends are expected to grow at a constant rate of 5% per year forever. If the required rate of return on the stock is 15%, what is the current value on stock, after paying the dividend?
A)$63
B)$56
C)$40
D)$48
Answer: A
Type: Medium
Page: 64
Response: P = (6*1.05)/(0.15 0.05) = 63
12.The required rate of return or the market capitalization rate is estimated as follows:
A)Dividend yield + expected rate of growth in dividends
B)Dividend yield - expected rate of growth in dividends
C)Dividend yield / expected rate of growth in dividends
D)(Dividend yield) * (expected rate of growth in dividends)
Answer: A
Type: Difficult
Page: 65
13.Mcom Co. is expected to pay a dividend of $4 per share at the end of year one and the dividends are expected to grow at a constant rate of 4% forever. If the current price of the stock is $25 per share calculated the required rate of return or the market capitalization rate for the firms' stock.
A)4%
B)16%
C)20%
D)None of the above.
Answer: C
Type: Medium
Page: 65
Response: r = (4/25) + 0.04 = 20%
14.Dividend growth rate for a stable firm can be estimated as:
A)Plow back rate * the return on equity (ROE)
B)Plow back rate / the return on equity (ROE)
C)Plow back rate +the return on equity (ROE)
D)Plow back rate - the return on equity (ROE)
Answer: A
Type: Difficult
Page: 66
15.MJ Co. pays out 60% of its earnings as dividends. Its return on equity is 20%. What is the stable dividend growth rate for the firm?
A)3%
B)5%
C)8%
D)12%
Answer: C
Type: Difficult
Page: 66
Response: g = (1 - 0.6)*20 = 8%
16.Michigan Motor Company is currently paying a dividend of $1.50 per year. The dividends are expected to grow at a rate of 20% for the next three years and then a constant rate of 6 % thereafter. What is the expected dividend per share in year 5?
A)$2.59
B)$2.00
C)$2.91
D)$1.50
Answer: C
Type: Medium
Page: 69
Response: D5 = (1.5) * (1.2^3) * (1.06^2) = 2.91
17.Great Lakes Co. is currently paying a dividend of $2.20 per share. The dividends are expected to grow at 25% per year for the next four years and then grow 5% per year thereafter. Calculate the expected dividend in year 6.
A)$5.37
B)$2.95
C)$5.92
D)$8.39
Answer: A
Type: Medium
Page: 69
Response: Div6=2.2 * (1.25^4) * (1.05^2) = 5.92
18.Y2K Technology Corporation has just paid a dividend of $0.40 per share. The dividends are expected to grow at 30% per year for the next two years and at 5% per year thereafter. If the required rate of return in the stock is 15% (APR), calculate the current value of the stock.
A)$1.420
B)$6.33
C)$5.63
D)None of the above
Answer: B
Type: Difficult
Page: 69
Response: Po = [(0.4 *1.3)/1.15] + [(0.4 * 1.3^2)/(1.15^2)] + [(0.4 * 1.3^2*1.06)/((1.15^2 * (0.15 0.05))] = $6.33
19.The NetTech Co. has just paid a dividend of $1 per share. The dividends are expected to grow at 20% per year for the next three years and at the rate of 5% per year thereafter. If the required rate of return on the stock is 15%(APR), what is the current value of the stock?
A)$18.14
B)$15.20
C)$12.51
D)None of the above
Answer: B
Type: Difficult
Page: 69
Response: P = (1.2/1.15) + (1.44/1.15^2) + (1.728/1.15^3) + (1.8144/((1.15^3) * (0.15 0.05)) = 15.20
20.Lake Co. has paid a dividend $2 per share out of earnings of $4 per share. If the book value per share is $25, what is the expected growth rate in dividends (g)?
A)16%
B)12%
C)8%
D)4%
Answer: C
Type: Difficult
Page: 72
Response: g = (1 0.5) (4/25) = 0.08 or 8%
21.Lake Co. has paid a dividend $2 per share out of earnings of $4 per share. If the book value per share is $25 and is currently selling for $30 per share, calculate the required rate of return on the stock. (Use the calculated g from the previous problem to answer this question.)
A)7.2%
B)15.2%
C)14.7%
D)16.6%
Answer: B
Type: Difficult
Page: 72
Response: g = (1 0.5)(4/25) = 0.08 or 8%; [(2*1.08)/30] + 0.08 = 15.2 %.
22.Lake Co. has paid a dividend $3 per share out of earnings of $5 per share. If the book value per share is $40, what is the expected growth rate in dividends?
A)12.5%
B)8%
C)5%
D)3%
Answer: C
Type: Difficult
Page: 72
Response: g = (1 (5/40) = .05 or 5%;
23.Lake Co. has paid a dividend $3 per share out of earnings of $5 per share. If the book value per share is $40 and the share value is 52.50 per share, calculate the required rate of return on the stock. (Use the calculated 'g' from the previous problem to answer this question)
A)11%
B)12%
C)5%
D)6%
Answer: A
Type: Difficult
Page: 72
Response: g = (1 0.6) (5/40) = .05 or 5%; [(3*1.05)/52.50] + 0.05 = 0.11 = 11%.
24.The growth rate in dividends can be thought of as a sum of two parts. They are:
A)ROE and the Retention Ratio.
B)Dividend yield and growth rate in dividends
C)ROA and ROE
D)Book value per share and EPS
Answer: A
Type: Medium
Page: 72
25.The value of the stock:
A)Increases as the dividend growth rate increases
B)Increases as the required rate of return decreases
C)Increases as the required rate of return increases
D)Both A and B
Answer: D
Type: Difficult
Page: 72
26.Company X has a P/E ratio of 10 and a stock price of $50 per share. Calculate earnings per share of the company.
A)$5 per share
B)$10 per share
C)$0.20 per share
D)$6 per share
Answer: A
Type: Medium
Page: 74
Response: EPS = 50/10 = $5
27.Companies with higher expected growth opportunities usually sell for:
A)Lower P/E ratio
B)Higher P/E ratio
C)A price that is independent of P/E ratio
D)A price that the dependent upon the payment ratio
Answer: B
Type: Medium
Page: 74
28.Which of the following formulas regarding earnings to price ratio is true:
A)EPS/Po = r[1+(PVGO/Po]
B)EPS/Po = r[1 - (PVGO/Po)]
C)EPS/Po = [r+(PVGO/Po)]
D)EPS/Po =[r(1+(PVGO/Po)]/r
Answer: B
Type: Difficult
Page: 74
29.Woe Co. is expected to pay a dividend or $4.00 per share out of earnings of $7.50 per share. If the required rate of return on the stock is 15% and dividends are growing at a current rate of 10% per year, calculate the percent value of the growth opportunity for the stock (PVGO).
A)$80
B)$50
C)$30
D)$26
Answer: C
Type: Difficult
Page: 74
Response: No growth value = 7.5/0.15 = 50; Po = 4/ (0.15-0.1) = 80; PVGO = 80-50 = 30
30.Parcel Corporation is expected to pay a dividend of $5 per share next year, and the dividends pay out ratio is 50%. If the dividends are expected to grow at a constant rate of 8% forever and the required rate of return on the stock is 13%, calculate the present value of the growth opportunity.
A)$23.08
B)$64.10
C)$100
D)None of the above
Answer: A
Type: Difficult
Page: 74
Response: EPS= (5/0.5)=$10; No Growth Value = 10/0.13 = 76.92; Growth Value = 5/(0.13-0.08) = 100; PVGO = 100-76.92 = 23.08
31.A high proportion of the value a growth stock comes from:
A)Past dividend payments
B)Past earnings
C)PVGO (Present Value of the Growth Opportunities)
D)Both A and B
Answer: C
Type: Medium
Page: 74
32.Generally high growth stocks pay:
A)High dividends
B)Low or no dividends
C)Erratic dividends
D)Both A and C
Answer: B
Type: Medium
Page: 74
33.The following stocks are examples of growth stocks except:
A)Wal-Mart
B)Dell Computer
C)Microsoft
D)Chubb
Answer: D
Type: Medium
Page: 74
34.The following stocks are examples of income stocks except:
A)Exxon Mobil
B)Wal-Mart
C)Chubb
D)Kellogg
E)All of the above
Answer: B
Type: Easy
Page: 74
35.Which of the following stocks are growth stocks?
A)Dell Computer
B)AT&T
C)Duke Power
D)Exxon
E)None of the above
Answer: A
Type: Easy
Page: 74
36.Which of the following stocks are income stocks?
A)Duke Power
B)Dell Computer
C)Microsoft
D)Wal-Mart
E)None of the above
Answer: A
Type: Easy
Page: 74
37.The relationship between P/E ratio and market capitalization rate can be described by the following statements:
A)EPS/Po measures r, only if PVGO = 0
B)High P/E ratios indicate low r
C)There is no reliable association between the P/E ratio and r
D)A and C above
Answer: D
Type: Easy
Page: 75
38.Universal Air is a no growth firm and has two million shares outstanding. It is expected to earn a constant 20 million per year on its assets. If all earnings are paid out as dividends and the cost of capital is 10%, calculate the current price per share for the stock.
A)$200
B)$100
C)$150
D)$50
Answer: B
Type: Medium
Page: 77
Response: EPS = DPS = 20/2 = $10 per share = Po = 10/0.1 = 100
39.Which of the following statements regarding free cash flow is true?
A)Free cash flow is always positive
B)Free cash flow is always negative
C)Free cash flow is the net cash flow to the shareholders after paying for future investments
D)None of the above
Answer: C
Type: Medium
Page: 77
40.Discounted cash flow formulas work for the valuation of:
A)Stocks with constant dividend growth
B)Businesses
C)Stocks with super normal dividend growth
D)All of the above
Answer: D
Type: Medium
Page: 77
41.The value of a business is given by:
A)PV = PV(free cash flows)
B)PV = PV(free cash flows) + PV (horizon value)
C)PV(free cash flows) – PV(horizon value)
D)None of the above
Answer: B
Type: Medium
Page: 77
42.The present value of free cash flow is $5 million and the present value of the horizon value is $10 million. Calculate the present value of the business.
A)$5 million
B)$10 million
C)$15 million
D)None of the above
Answer: C
Type: Medium
Page: 77
Response: PV(business) = 5 + 10 = 15
True/False Questions
TF43.The New York Stock Exchange is the only stock market in the US.
Answer: False
Type: Easy
Page: 60
TF44.Shareholders receive cash from the firm in the form of dividends and capital gains.
Answer: False
Type: Difficult
Page: 61
TF45.The return that is expected by investors from a common stock is often called its market capitalization rate.
Answer: True
Type: Medium
Page: 61
TF46.At each point in time, all securities in an equivalent-risk class are priced to offer the same expected return.
Answer: True
Type: Difficult
Page: 62
TF47.The constant growth formula for stock valuation does not work for firms with negative growth (declining) rates in dividends.
Answer: False
Type: Difficult
Page: 64
TF48.The market capitalization equals the dividend yield plus the growth rate in dividends for a constant dividend growth stock.
Answer: True
Type: Medium
Page: 65
TF49.The value of a share of common stock is equal to the discounted stream of free cash flow per share.
Answer: True
Type: Difficult
Page: 69
TF50.The value of a share of common stock is equal to the discounted stream of earnings per share.
Answer: False
Type: Medium
Page: 69
TF51.There is a strong relationship between a stock's price-earnings (P/E) ratio and its capitalization rate.
Answer: False
Type: Medium
Page: 70
TF52.Discounted cash flow approach can be used to value ongoing businesses.
Answer: True
Type: Medium
Page: 76
Essay Questions
53.Explain the term "primary market."
Type: Easy
Page: 59
Answer:
When new shares of common stocks are sold in the market to raise capital, it is called a primary market transaction. A good example of a primary market transaction is the IPO (Initial Public Offering).
54.Explain the term "secondary market."
Type: Easy
Page: 59
Answer:
When already issued stocks are traded in the market, it is called a secondary market transaction. Most transactions in the stock market are secondary market transactions.
55.Briefly explain the term "market capitalization rate."
Type: Medium
Page: 61
Answer:
The rate of return expected by the investors in common stocks is called the market capitalization rate. For a constant growth stock it is the dividend yield plus the growth rate in dividends.
56.Discuss the general principle in the valuation of a common stock.
Type: Medium
Page: 62
Answer:
The value of a common stock is the present value of all the dividends received by owning the stock discounted at the market capitalization rate. This is called the discounted cash flow (DCF) method.
57.Discuss the term "price-earnings (P/E) ratio."
Type: Medium
Page: 70
Answer:
The P/E ratio is a widely used financial indicator, but is also quite ambiguous. Generally, a high P/E ratio indicates that the investors think a firm has good growth potential. The P/E ratio is helpful in evaluating shocks. It is the ratio of current market price and earnings of a stock.
58.Discuss the problems inherent in the valuation of a business.
Type: Difficult
Page: 75
Answer:
The main problems are estimating future cash flows for the next several years, and estimating the horizon value. The latter is quite difficult and is a significant proportion of the total estimated value of the firm. Generally, the discounted cash flow approach is applied for the valuation. There are other methods like using the market to book ratio and the P/E ratio.
Chapter 5 Why Net Present Value Leads to Better Investment Decisions than Other Criteria
Multiple Choice Questions
1.The following measures are used by firms when making capital budgeting decisions except:
A)Payback period
B)Internal rate of return
C)Net present value
D)P/E ratio
Answer: D
Type: Easy
Page: 91
2.Which of the following investment rules does not use the time value of the money concept?
A)The payback period
B)Internal rate of return
C)Net present value
D)All of the above use the time value concept
Answer: A
Type: Easy
Page: 93
3.Suppose a firm has a $500 million in excess cash. It could:
A)Invest the funds in projects with positive NPVs
B)Pay high dividends to the shareholders
C)Buy another firm
D)All of the above
Answer: D
Type: Easy
Page: 93
4.Which of the following investment rules has value additivity property?
A)The payback period method
B)The internal rate of return method
C)The book rate of return method
D)Net present value method
E)All of the above have value additivity property
Answer: D
Type: Difficult
Page: 93
5.If the net present value of project A is +$80, and of project B is +$60, then the net present value of the combined project is:
A)+$80
B)+$60
C)+$140
D)None of the above
Answer: C
Type: Easy
Page: 93
Response: NPV(A +B) = 80 + 60 = 140
6.If the NPV of project A is +$100, and that of project B is -$50 and that of project C is +$20, what is the NPV of the combined project?
A)$100
B)-$50
C)$120
D)$70
Answer: D
Type: Easy
Page: 93
Response: NPV(A+B+C) = 100 + 20 = 70
7.You are given a job to make a decision on project X, which is composed of three independent projects A, B, and C which have NPVs of +$50, -$20 and +$100, respectively. How would you go about making the decision about whether to accept or reject the project?
A)Accept the firm's joint project as it has a positive NPV
B)Reject the joint project
C)Break up the project into its components: accept A and C and reject B
D)None of the above
Answer: C
Type: Difficult
Page: 93
8.If the NPV of project A is +$50 and that of project B is -$60, than the NPV of the combined project is:
A)+$50
B)+$60
C)-$10
D)None of the above.
Answer: C
Type: Easy
Page: 93
Response: NPV(A+B) = 50 - 60 = 10
9.The net present value of a project depends upon:
A)forecasted cash flows and opportunity cost of capital
B)manager's tastes and preferences
C)company's choice of accounting method
D)all of the above
Answer: A
Type: Medium
Page: 93
10.The payback period rule:
A)Varies the cut-off point with the interest rate
B)Determines a cut-off point so that all projects accepted by the NPV rule will be accepted by the payback period rule.
C)Requires an arbitrary choice of a cut-off point
D)Both A and C
Answer: C
Type: Medium
Page: 94
11.The payback period rule accepts all projects for which the payback period is:
A)Greater than the cut-off value
B)Less than the cut-off value
C)Is positive
D)An integer
Answer: B
Type: Easy
Page: 94
12.Which of the following investment rules may not use all possible cash flows in its calculations?
A)Payback period.
B)NPV
C)IRR
D)All of the above