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Chapter 04

The Value of Common Stocks

Multiple Choice Questions

1. The major secondary market for GE shares is:

A. London Stock Exchange.

B. New York Stock Exchange.

C. Nasdaq.

D. Tokyo Stock Exchange.

2. Assume General Electric (GE) has about 10.3 billion shares outstanding and the stock price is $37.10. Also, assume the P/E ratio is about 18.3. Calculate the approximate market capitalization for GE.

A. $679 billion

B. $188 billion

C. $382 billion

D. $103 billion

3. The following are foreign companies that are traded on the New York Stock Exchange:

I) Toyota; II) Brazil Telecom; III) Canadian Pacific; IV) Tata Motors; V) General Electric

A. I, II, and III only

B. I, II, III, and IV only

C. I, II, III, and V only

D. all of the given companies

4. The dividend yield reported on finance.yahoo.com is calculated as follows:

A. (dividend/year-high stock price).

B. (dividend/year-low stock price).

C. (dividend/closing stock price).

D. (dividends/earnings).

5. A Wall Street Journal quotation for a company has the following values: Div: $1.12, PE: 18.3, Close: $37.22. Calculate the approximate dividend payout ratio for the company.

A. 18%

B. 35%

C. 45%

D. 55%

6. If a Wall Street Journal quotation for a company has the following values: close, 55.14; net change: = +1.04; then the closing price for the stock for the previous trading day was?

A. $56.18

B. $54.10

C. $55.66

D. $53.02

7. The exchange-traded fund (ETF) that tracks the Nasdaq 100 index is called:

A. SPDR.

B. DIAMONDS.

C. QQQQ.

D. NDAQQ.

8. The following are auction markets EXCEPT:

A. New York Stock Exchange.

B. London Stock Exchange.

C. Tokyo Stock Exchange.

D. Nasdaq.

9. The following is an example of a dealer market:

A. New York Stock Exchange.

B. London Stock Exchange.

C. Tokyo Stock Exchange.

D. Nasdaq.

10. In which of the following stock exchanges are there specialists who act as auctioneers?

A. New York Stock Exchange

B. London Stock Exchange

C. Tokyo Stock Exchange

D. Frankfurt Stock Exchange

11. In which of the following exchanges does a computer act as the auctioneer?

I) New York Stock Exchange; II) London Stock Exchange; III) Tokyo Stock Exchange; IV) Frankfurt Stock Exchange

A. I, II, III, and IV

B. I, III, and IV only

C. I, II, and III only

D. II, III, and IV only

12. Super Computer Companys stock is selling for $100 per share today. It is expected thatat the end of one yearit will pay a dividend of $6 per share and then be sold for $114 per share. Calculate the expected rate of return for the shareholders.

A. 20%

B. 15%

C. 10%

D. 25%

13. The valuation of a common stock today primarily depends on:

A. the number of shares outstanding and the number of its shareholders.

B. its expected future dividends and its discount rate.

C. Wall Street analysts.

D. the present value of its future earnings per share and its discount rate.

14. CK Company stockholders expect to receive a year-end dividend of $5 per share and then immediately sell their shares for $115 dollars per share. If the required rate of return for the stock is 20%, what is the current value of the stock?

A. $132

B. $122

C. $100

D. $110

15. Deluxe Company expects to pay a dividend of $2 per share at the end of year 1, $3 per share at the end of year 2, and then be sold for $32 per share at the end of year 2. If the required rate of return on the stock is 15%, what is the current value of the stock?

A. $28.20

B. $32.17

C. $32.00

D. $29.18

16. Casino Inc. expects to pay a dividend of $3 per share at the end of year 1 (D1) and these dividends are expected to grow at a constant rate of 6% per year forever. If the required rate of return on the stock is 18%, what is the current value of the stock today?

A. $25

B. $50

C. $100

D. $54

17. The constant dividend growth formula P0 = Div1/(r g) assumes:

I) that dividends grow at a constant rate g, forever; II) r > g; III) g is never negative

A. I only

B. II only

C. I and II only

D. III only

18. Will Co. is expected to pay a dividend of $2 per share at the end of year 1(D1), and the dividends are expected to grow at a constant rate of 4% forever. If the current price of the stock is $20 per share, calculate the expected return or the cost of equity capital for the firm.

A. 10%

B. 4%

C. 14%

D. 20%

19. World-Tour Co. has just now paid a dividend of $2.83 per share (D0); its dividends are expected to grow at a constant rate of 6% per year forever. If the required rate of return on the stock is 16%, what is the current value of the stock, after paying the dividend?

A. $70

B. $56

C. $30

D. $48

20. One can estimate the expected rate of return or the cost of equity capital 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).

21. One can estimate the dividend growth rate for a stable firm 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).

22. MJ Co. pays out 60% of its earnings as dividends. Its return on equity is 15%. What is the stable dividend growth rate for the firm?

A. 9%

B. 5%

C. 6%

D. 15%

23. Michigan Co. just paid a dividend of $2.00 per share. Analysts expect future dividends to grow at 20% per year for the next four years and then grow at 6% per year thereafter. Calculate the expected dividend in year 5.

A. $4.15

B. $2.95

C. $4.40

D. $3.81

24. Otobai Motor Company just paid a dividend of $1.40. Analysts expect its dividend to grow at a rate of 18% for the next three years and then a constant rate of 5% thereafter. What is the expected dividend per share at the end of year 5?

A. $2.35

B. $2.54

C. $2.91

D. $1.50

25. The In-Tech Co. just paid a dividend of $1 per share. Analysts expect its dividend to grow at 25% per year for the next three years and then 5% per year thereafter. If the required rate of return on the stock is 18%, what is the current value of the stock?

A. $12.97

B. $11.93

C. $15.20

D. $15.78

26. R&D Technology Corporation just paid a dividend of $0.50 per share. Analysts expect its dividend to grow at 24% per year for the next two years and then 8% per year thereafter. If the required rate of return in the stock is 16%, calculate the current value of the stock.

A. $1.11

B. $7.71

C. $8.82

D. $10.38

27. Ocean Co. just paid a dividend of $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%

28. Seven-Seas Co. just paid a dividend of $3 per share out of earnings of $5 per share. If its book value per share is $40 and its market price is $52.50 per share, calculate the required rate of return on the stock.

A. 12%

B. 11%

C. 5%

D. 6%

29. River Co. just paid a dividend of $2 per share out of earnings of $4 per share. If its book value per share is $25 and its stock is currently selling for $40 per share, calculate the required rate of return on the stock.

A. 15.2%

B. 7.2%

C. 14.7%

D. 13.4%

30. Lake Co. just paid a dividend of $3 per share out of earnings of $5 per share. If its book value per share is $40, what is the expected growth rate in dividends?

A. 7.5%

B. 8%

C. 12.5%

D. 5%

31. The growth rate in dividends is a function of two ratios. They are:

A. ROA and ROE.

B. dividend yield and growth rate in stock price.

C. ROE and the plowback ratio.

D. book value per share and EPS.

32. 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. $6 per share

B. $10 per share

C. $0.20 per share

D. $5 per share

33. Which of the following formulas regarding the earnings-to-price ratio is true?

A. EPS/P0 = r[1 + PVGO/P0]

B. EPS/P0 = r[1 PVGO/P0]

C. EPS/P0 = [r + PVGO/P0]

D. EPS/P0 = [1 + r + PVGO/P0)]/r

34. Generally high growth stocks pay:

A. low or no dividends.

B. high, steadily growing dividends.

C. erratic dividends.

D. decreasing dividends.

35. A high proportion of the value of a growth stock typically comes from:

A. past dividend payments.

B. past earnings.

C. PVGO (present value of growth opportunities).

D. both A and B.

36. Summer Co. expects to pay a dividend of $4.00 per shareone year from nowout of earnings of $7.50 per share. If the required rate of return on the stock is 15% and its dividends are growing at a constant rate of 10% per year, calculate the present value of growth opportunities for the stock (PVGO).

A. $80

B. $30

C. $50

D. $26

37. Parcel Corporation expects to pay a dividend of $5 per share next year, and the dividend payout ratio is 50%. If 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 growth opportunities.

A. $100.00

B. $76.92

C. $23.08

D. $69.54

38. Which of the following stocks is an income stock?

A. Dow Chemicals

B. Starbucks

C. Facebook

D. Google

39. Goodyear is an example of:

A. a growth stock.

B. an income stock.

C. a high dividend stock.

D. a low plowback stock.

40. Universal Air is a no-growth firm and has two million shares outstanding. It expects to earn a constant $20 million per year on its assets. If it has no debt, all earnings are paid out as dividends, and the cost of capital is 10%, calculate the current price per share of the stock.

A. $200

B. $150

C. $100

D. $50

41. A firm forecasts a projects net cash flows ($millions) in years 1 thru 4 as $120, $130, $135, and $137, respectively. If the project ends at the end of the fourth year, what is the horizon value of the project? Assume that the company had a historical growth rate of 3% and has a discount rate of 10%.

A. $0.00

B. $1.37

C. $1.96

D. $4.87

42. A company forecasts growth of 6% for the next five years and 3% thereafter. Given last years free cash flow was $100, what is its horizon value if the company cost of capital is 8%?

A. $0

B. $1,672

C. $2,000

D. $2,676

43. Galaxy Air, previously a no-growth firm, has two million shares outstanding. Until now, it consistently earned $20 million per year on its assets. (It has no debt and pays out all earnings as dividends. Its cost of capital is 10%.) Due to its newly appointed CEO, Galaxy Air is now able to squeeze out 1% annual growth by plowing back 5% of earnings. Calculate its stock price per share.

A. $200.00

B. $106.61

C. $100.00

D. $110.10

44. Ottocell Motor Company just paid a dividend of $1.40. Analysts expect its dividend to grow at a rate of 10% next year, 8% for the following two years, and then a constant rate of 5% thereafter. What is the expected dividend per share at the end of year 5?

A. $2.08

B. $1.98

C. $1.80

D. $0.99

True / False Questions

45. The New York Stock Exchange is the only stock market in the U.S.

True False

46. Most of the trading on the NYSE is in ordinary common stocks.

True False

47. The return that is expected by investors from a common stock is also called its market capitalization rate, or cost of equity capital.

True False

48. All securities in an equivalent risk class are priced to offer the same expected return.

True False

49. The only payoff to the owners of common stocks is in the form of cash dividends.

True False

50. The constant growth formula for stock valuation does not work for a firm with a negative growth rate (i.e., a declining growth rate) in its dividend.

True False

51. The cost of equity capital equals the dividend yield minus the growth rate in dividends for a constant dividend growth stock.

True False

52. It is not possible to value a firm that has a supernormal (variable) growth rate for the first few years of its life.

True False

53. A large percentage of the total value of a growth stock comes from the present value of its growth opportunities.

True False

54. One can use the discounted cash-flow formulas that are used to value common stocks in order to value entire businesses.

True False

55. An investor who uses a limit order instructs his brokerage firm to buy a limited quantity of shares at the best available price.

True False

56. An investor who uses a market order instructs her brokerage firm to buy a given quantity of shares at the best available price.

True False

57. For most firms, market value is usually greater than book value.

True False

58. A stocks price is based on the expected present value, at the market capitalization rate, of all the stocks future earnings.

True False

Essay Questions

59. Explain the term primary market.

60. Explain the term secondary market.

61. Briefly explain the major types of exchanges prevalent in the U.S.

62. Briefly explain the term market capitalization rate.

63. Discuss the general principle at work in valuing a common stock.

64. Briefly explain the assumptions associated with the constant dividend growth formula.

65. Discuss the term price-earnings (P/E) ratio.

66. Briefly explain how the formulas that are used for valuing common stocks can also be used to value businesses.

67. Briefly explain why Microsoft experienced a significant drop in price when it announced its first ever, regular dividend along with huge profits.

Chapter 04 The Value of Common Stocks Answer Key

Multiple Choice Questions

1. The major secondary market for GE shares is:

A. London Stock Exchange.

B. New York Stock Exchange.

C. Nasdaq.

D. Tokyo Stock Exchange.

Type: Easy

2. Assume General Electric (GE) has about 10.3 billion shares outstanding and the stock price is $37.10. Also, assume the P/E ratio is about 18.3. Calculate the approximate market capitalization for GE.

A. $679 billion

B. $188 billion

C. $382 billion

D. $103 billion

Market capitalization = (10.3)(37.10) = $382.13 billion.

Type: Medium

3. The following are foreign companies that are traded on the New York Stock Exchange:

I) Toyota; II) Brazil Telecom; III) Canadian Pacific; IV) Tata Motors; V) General Electric

A. I, II, and III only

B. I, II, III, and IV only

C. I, II, III, and V only

D. all of the given companies

Type: Easy

4. The dividend yield reported on finance.yahoo.com is calculated as follows:

A. (dividend/year-high stock price).

B. (dividend/year-low stock price).

C. (dividend/closing stock price).

D. (dividends/earnings).

Type: Medium

5. A Wall Street Journal quotation for a company has the following values: Div: $1.12, PE: 18.3, Close: $37.22. Calculate the approximate dividend payout ratio for the company.

A. 18%

B. 35%

C. 45%

D. 55%

PE ratio = price per share/earnings per share; Earnings per share = (37.22)/18.3 = 2.03; Dividend payout = 1.12/2.03 = 0.55 = 55%.

Type: Difficult

6. If a Wall Street Journal quotation for a company has the following values: close, 55.14; net change: = +1.04; then the closing price for the stock for the previous trading day was?

A. $56.18

B. $54.10

C. $55.66

D. $53.02

Previous closing = todays closing net chg. = 55.14 1.04 = $54.10.

Type: Medium

7. The exchange-traded fund (ETF) that tracks the Nasdaq 100 index is called:

A. SPDR.

B. DIAMONDS.

C. QQQQ.

D. NDAQQ.

Type: Easy

8. The following are auction markets EXCEPT:

A. New York Stock Exchange.

B. London Stock Exchange.

C. Tokyo Stock Exchange.

D. Nasdaq.

Type: Easy

9. The following is an example of a dealer market:

A. New York Stock Exchange.

B. London Stock Exchange.

C. Tokyo Stock Exchange.

D. Nasdaq.

Type: Easy

10. In which of the following stock exchanges are there specialists who act as auctioneers?

A. New York Stock Exchange

B. London Stock Exchange

C. Tokyo Stock Exchange

D. Frankfurt Stock Exchange

Type: Medium

11. In which of the following exchanges does a computer act as the auctioneer?

I) New York Stock Exchange; II) London Stock Exchange; III) Tokyo Stock Exchange; IV) Frankfurt Stock Exchange

A. I, II, III, and IV

B. I, III, and IV only

C. I, II, and III only

D. II, III, and IV only

Type: Medium

12. Super Computer Companys stock is selling for $100 per share today. It is expected thatat the end of one yearit will pay a dividend of $6 per share and then be sold for $114 per share. Calculate the expected rate of return for the shareholders.

A. 20%

B. 15%

C. 10%

D. 25%

r = (114 + 6 100)/100 = 20%.

Type: Easy

13. The valuation of a common stock today primarily depends on:

A. the number of shares outstanding and the number of its shareholders.

B. its expected future dividends and its discount rate.

C. Wall Street analysts.

D. the present value of its future earnings per share and its discount rate.

Type: Easy

14. CK Company stockholders expect to receive a year-end dividend of $5 per share and then immediately sell their shares for $115 dollars per share. If the required rate of return for the stock is 20%, what is the current value of the stock?

A. $132

B. $122

C. $100

D. $110

P = (115 + 5)/1.20 = 100.

Type: Medium

15. Deluxe Company expects to pay a dividend of $2 per share at the end of year 1, $3 per share at the end of year 2, and then be sold for $32 per share at the end of year 2. If the required rate of return on the stock is 15%, what is the current value of the stock?

A. $28.20

B. $32.17

C. $32.00

D. $29.18

P0 = (2/1.15) + [(3 + 32)/(1.15^2)] = $28.20.

Type: Medium

16. Casino Inc. expects to pay a dividend of $3 per share at the end of year 1 (D1) and these dividends are expected to grow at a constant rate of 6% per year forever. If the required rate of return on the stock is 18%, what is the current value of the stock today?

A. $25

B. $50

C. $100

D. $54

P0 = Div1/(r g) = (3/(0.18 0.06)) = 25.

Type: Medium

17. The constant dividend growth formula P0 = Div1/(r g) assumes:

I) that dividends grow at a constant rate g, forever; II) r > g; III) g is never negative

A. I only

B. II only

C. I and II only

D. III only

Type: Medium

18. Will Co. is expected to pay a dividend of $2 per share at the end of year 1(D1), and the dividends are expected to grow at a constant rate of 4% forever. If the current price of the stock is $20 per share, calculate the expected return or the cost of equity capital for the firm.

A. 10%

B. 4%

C. 14%

D. 20%

r = [(D1/P0 ) + g] = (2/20) + 0.04 = 14%.

Type: Medium

19. World-Tour Co. has just now paid a dividend of $2.83 per share (D0); its dividends are expected to grow at a constant rate of 6% per year forever. If the required rate of return on the stock is 16%, what is the current value of the stock, after paying the dividend?

A. $70

B. $56

C. $30

D. $48

P0 = (2.83 1.06)/(0.16 0.06) = 30.

Type: Medium

20. One can estimate the expected rate of return or the cost of equity capital 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).

Type: Medium

21. One can estimate the dividend growth rate for a stable firm 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).

Type: Difficult

22. MJ Co. pays out 60% of its earnings as dividends. Its return on equity is 15%. What is the stable dividend growth rate for the firm?

A. 9%

B. 5%

C. 6%

D. 15%

g = (1 0.60) 15 = 6%.

Type: Difficult

23. Michigan Co. just paid a dividend of $2.00 per share. Analysts expect future dividends to grow at 20% per year for the next four years and then grow at 6% per year thereafter. Calculate the expected dividend in year 5.

A. $4.15

B. $2.95

C. $4.40

D. $3.81

Div6 = (2.00) (1.20^4) (1.06) = 4.40.

Type: Medium

24. Otobai Motor Company just paid a dividend of $1.40. Analysts expect its dividend to grow at a rate of 18% for the next three years and then a constant rate of 5% thereafter. What is the expected dividend per share at the end of year 5?

A. $2.35

B. $2.54

C. $2.91

D. $1.50

D5 = (1.40) (1.18^3) (1.05^2) = 2.54.

Type: Medium

25. The In-Tech Co. just paid a dividend of $1 per share. Analysts expect its dividend to grow at 25% per year for the next three years and then 5% per year thereafter. If the required rate of return on the stock is 18%, what is the current value of the stock?

A. $12.97

B. $11.93

C. $15.20

D. $15.78

P = (1.25/1.18) + (1.5625/1.18^2) + (1.9531/1.18^3) + (2.0508/(0.18 0.05))/(1.18^3) = 12.97.

Type: Difficult

26. R&D Technology Corporation just paid a dividend of $0.50 per share. Analysts expect its dividend to grow at 24% per year for the next two years and then 8% per year thereafter. If the required rate of return in the stock is 16%, calculate the current value of the stock.

A. $1.11

B. $7.71

C. $8.82

D. $10.38

P0 = [(0.5 1.24)/1.16] + [(0.5 1.24^2)/(1.16^2)] + [(0.5 1.24^2 1.08)/(0.16 0.08)/(1.16^2))] = $8.82.

Type: Difficult

27. Ocean Co. just paid a dividend of $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%

Sustainable growth = ROE plowback ratio;

Payout ratio = 50%; Plowback ratio = 50%; g = (1 0.5)(4/25) = 0.08, or 8%.

Type: Difficult

28. Seven-Seas Co. just paid a dividend of $3 per share out of earnings of $5 per share. If its book value per share is $40 and its market price is $52.50 per share, calculate the required rate of return on the stock.

A. 12%

B. 11%

C. 5%

D. 6%

g = (1 0.6) (5/40) = .05, or 5%; r = [(3 1.05)/52.50] + 0.05 = 0.11 = 11%.

Type: Difficult

29. River Co. just paid a dividend of $2 per share out of earnings of $4 per share. If its book value per share is $25 and its stock is currently selling for $40 per share, calculate the required rate of return on the stock.

A. 15.2%

B. 7.2%

C. 14.7%

D. 13.4%

g = (1 0.5)(4/25) = 0.08, or 8%; r = [(2 1.08)/40] + 0.08 = 13.4%.

Type: Difficult

30. Lake Co. just paid a dividend of $3 per share out of earnings of $5 per share. If its book value per share is $40, what is the expected growth rate in dividends?

A. 7.5%

B. 8%

C. 12.5%

D. 5%

g = (1 3/5)(5/40) = .05, or 5%.

Type: Difficult

31. The growth rate in dividends is a function of two ratios. They are:

A. ROA and ROE.

B. dividend yield and growth rate in stock price.

C. ROE and the plowback ratio.

D. book value per share and EPS.

Type: Medium

32. 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. $6 per share

B. $10 per share

C. $0.20 per share

D. $5 per share

EPS = 50/10 = $5.

Type: Medium

33. Which of the following formulas regarding the earnings-to-price ratio is true?

A. EPS/P0 = r[1 + PVGO/P0]

B. EPS/P0 = r[1 PVGO/P0]

C. EPS/P0 = [r + PVGO/P0]

D. EPS/P0 = [1 + r + PVGO/P0)]/r

Type: Difficult

34. Generally high growth stocks pay:

A. low or no dividends.

B. high, steadily growing dividends.

C. erratic dividends.

D. decreasing dividends.

Type: Medium

35. A high proportion of the value of a growth stock typically comes from:

A. past dividend payments.

B. past earnings.

C. PVGO (present value of growth opportunities).

D. both A and B.

Type: Medium

36. Summer Co. expects to pay a dividend of $4.00 per shareone year from nowout of earnings of $7.50 per share. If the required rate of return on the stock is 15% and its dividends are growing at a constant rate of 10% per year, calculate the present value of growth opportunities for the stock (PVGO).

A. $80

B. $30

C. $50

D. $26

No growth value = 7.5/0.15 = 50; P0 = 4.00/(0.15 0.10) = 80; PVGO = 80 50 = 30.

Type: Difficult

37. Parcel Corporation expects to pay a dividend of $5 per share next year, and the dividend payout ratio is 50%. If 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 growth opportunities.

A. $100.00

B. $76.92

C. $23.08

D. $69.54

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.

Type: Difficult

38. Which of the following stocks is an income stock?

A. Dow Chemicals

B. Starbucks

C. Facebook

D. Google

Type: Easy

39. Goodyear is an example of:

A. a growth stock.

B. an income stock.

C. a high dividend stock.

D. a low plowback stock.

Type: Easy

40. Universal Air is a no-growth firm and has two million shares outstanding. It expects to earn a constant $20 million per year on its assets. If it has no debt, all earnings are paid out as dividends, and the cost of capital is 10%, calculate the current price per share of the stock.

A. $200

B. $150

C. $100

D. $50

EPS = DPS = 20,000,000/2,000,000 = $10 per share; P0 = 10/0.10 = $100/share.

Type: Medium

41. A firm forecasts a projects net cash flows ($millions) in years 1 thru 4 as $120, $130, $135, and $137, respectively. If the project ends at the end of the fourth year, what is the horizon value of the project? Assume that the company had a historical growth rate of 3% and has a discount rate of 10%.

A. $0.00

B. $1.37

C. $1.96

D. $4.87

If the project terminates, there is no horizon value.

Type: Medium

42. A company forecasts growth of 6% for the next five years and 3% thereafter. Given last years free cash flow was $100, what is its horizon value if the company cost of capital is 8%?

A. $0

B. $1,672

C. $2,000

D. $2,676

The future value at five years of the free cash flow is expected to equal 100 1.065 = 133.82. The horizon value = 133.82/(.08 .03) = 2,676.

Type: Difficult

43. Galaxy Air, previously a no-growth firm, has two million shares outstanding. Until now, it consistently earned $20 million per year on its assets. (It has no debt and pays out all earnings as dividends. Its cost of capital is 10%.) Due to its newly appointed CEO, Galaxy Air is now able to squeeze out 1% annual growth by plowing back 5% of earnings. Calculate its stock price per share.

A. $200.00

B. $106.61

C. $100.00

D. $110.10

(1 .05) EPS1 = DPS1 = (20 .95 1.01)/2 = $9.60 per share; P0 = 9.60/(0.10 0.01) = $106.61/share.

Type: Medium

44. Ottocell Motor Company just paid a dividend of $1.40. Analysts expect its dividend to grow at a rate of 10% next year, 8% for the following two years, and then a constant rate of 5% thereafter. What is the expected dividend per share at the end of year 5?

A. $2.08

B. $1.98

C. $1.80

D. $0.99

D5 = (1.40) (1.10) (1.08^2) (1.05^2) = 1.98.

Type: Medium

True / False Questions

45. The New York Stock Exchange is the only stock market in the U.S.

FALSE

Type: Easy

46. Most of the trading on the NYSE is in ordinary common stocks.

TRUE

Type: Easy

47. The return that is expected by investors from a common stock is also called its market capitalization rate, or cost of equity capital.

TRUE

Type: Medium

48. All securities in an equivalent risk class are priced to offer the same expected return.

TRUE

Type: Difficult

49. The only payoff to the owners of common stocks is in the form of cash dividends.

FALSE

Type: Difficult

50. The constant growth formula for stock valuation does not work for a firm with a negative growth rate (i.e., a declining growth rate) in its dividend.

FALSE

Type: Difficult

51. The cost of equity capital equals the dividend yield minus the growth rate in dividends for a constant dividend growth stock.

FALSE

Type: Medium

52. It is not possible to value a firm that has a supernormal (variable) growth rate for the first few years of its life.

FALSE

Type: Medium

53. A large percentage of the total value of a growth stock comes from the present value of its growth opportunities.

TRUE

Type: Medium

54. One can use the discounted cash-flow formulas that are used to value common stocks in order to value entire businesses.

TRUE

Type: Difficult

55. An investor who uses a limit order instructs his brokerage firm to buy a limited quantity of shares at the best available price.

FALSE

Type: Easy

56. An investor who uses a market order instructs her brokerage firm to buy a given quantity of shares at the best available price.

TRUE

Type: Easy

57. For most firms, market value is usually greater than book value.

TRUE

Type: Easy

58. A stocks price is based on the expected present value, at the market capitalization rate, of all the stocks future earnings.

FALSE

Type: Medium

Essay Questions

59. Explain the term primary market.

When new shares of common stocks are first sold to investorsusually in an IPO (initial public offering)in order to raise capital, it is called a primary market transaction.

Type: Easy

60. Explain the term secondary market.

When already issued stocks are traded in the market, it is called a secondary market transaction. Most transactions in the stock market (e.g., trades on the NYSTE) are secondary market transactions.

Type: Easy

61. Briefly explain the major types of exchanges prevalent in the U.S.

There are two types of exchanges prevalent in the U.S. They are auction markets and dealer markets. The New York Stock Exchange is an example of an auction market. Here specialists can act as auctioneers and match up would-be buyers and sellers. However, even on the NYSE, most trades are made electronically. The Nasdaq is an example of a dealer market. In the case of a dealer market, all trades take place between a group of dealers and investors. Dealer markets are also active in trading many other types of financial instruments such as bonds.

Type: Medium

62. Briefly explain the term market capitalization rate.

The rate of return expected by the investors in common stocks is called the market capitalization rate. It is also called the cost of equity capital. For a constant growth stock it equals the dividend yield plus the expected growth rate in dividends.

Type: Medium

63. Discuss the general principle at work in valuing a common stock.

The value of a common stock is the expected present value of all the dividends received by owning the stock, discounted at the market capitalization rate, or the cost of equity. This is the discounted cash flow (DCF) method.

Type: Medium

64. Briefly explain the assumptions associated with the constant dividend growth formula.

There are two important assumptions that are necessary for the formula to work correctly. The first assumption is that the expected growth rate of dividends is constant. The second assumption is that the discount rate is greater than the expected growth rate in dividends.

Type: Difficult

65. Discuss the term price-earnings (P/E) ratio.

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. It is the ratio of current market price and earnings of a stock. However, a high P/E ratio can result from very low earnings.

Type: Medium

66. Briefly explain how the formulas that are used for valuing common stocks can also be used to value businesses.

The formulas that are used to value common stocks can also be used to value entire businesses. In the case of businesses, free cash flows generated by the businesses are discounted. Typically, a two-stage DCF model is used. Free cash flows are forecasted out to a horizon and discounted to present value. Then a horizon value is forecasted, discounted, and added to the present value of free cash flows. The sum is the value of the business. This may look easy in theory but is quite complicated in practice.

Type: Difficult

67. Briefly explain why Microsoft experienced a significant drop in price when it announced its first ever, regular dividend along with huge profits.

Under the concept of PVGO, Microsoft was converting from a company with significant growth to a company with no growth. An increase in the dividend for a growth company is often a sign of reduced growth. Thus, the market would have reacted negatively to the news.

Type: Difficult

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