Chapter 4.pdf

Chapter 04 - The Value of Common Stocks

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. none of the above

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 market capitalization for GE. (Approximately) A. $679 billion B. $188 billion C. $382 billion D. None of the above

3. The following are foreign companies that are traded on the New York Stock Exchange: I) Toyota, II) Brasil Telecom, III) Nokia, IV) Endesa, 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 are foreign companies

4. If the Volume is reported in 100s as 292,059 in the Wall Street Journal quotation, then the trading volume for that day of trading is: A. 292,059 shares B. 2,920,590 shares C. 29,205,900 shares D. 292,059,000 shares

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Chapter 04 - The Value of Common Stocks

5. 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

6. The Wall Street Journal quotation for a company has the following values: Div: $1.12, PE: 18.3, Close: $37.22. Calculate the dividend pay out ratio for the company (Approximately). A. 18% B. 55% C. 45% D. None of the above

7. If the Wall Street Journal Quotation for a company has the following values close: 55.14; Net chg: = + 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. None of the above.

8. The exchange-traded fund (EFT) that tracks the Nasdaq 100 index is called: A. SPDR B. DIAMONDS C. QQQQ D. None of the above

9. The following are auction markets except: A. New York Stock Exchange B. London Stock Exchange C. Tokyo Stock Exchange D. Nasdaq

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Chapter 04 - The Value of Common Stocks

10. The following is an example of a dealer market: A. New York Stock Exchange B. London Stock Exchange C. Tokyo Stock Exchange D. Nasdaq

11. In which of the following stock exchange specialists act as the auctioneers: A. New York Stock Exchange B. London Stock Exchange C. Tokyo Stock Exchange D. Frankfurt Stock Exchange

12. In which of the following exchanges a computer acts 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

13. Super Computer Company's stock is selling for $100 per share today. It is expected that this stock will pay a dividend of 6 dollars per share, and then be sold for $114 per share at the end of one year. Calculate the expected rate of return for the shareholders. A. 20% B. 15% C. 10% D. 25%

14. The value of a common stock today depends on: A. Number of shares outstanding and the number of shareholders B. The expected future dividends and the discount rate C. The Wall Street analysts D. Present value of the future earnings per share

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Chapter 04 - The Value of Common Stocks

15. CK Company stockholders expect to receive a year-end dividend of $5 per share and then be sold 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. $100 B. $122 C. $132 D. $110

16. 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. If the required rate on the stock is 15%, what is the current value of the stock? A. $28.20 B. $32.17 C. $32.00 D. None of the given answers

17. Casino Inc. is expected 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 current value of the stock today? A. $25 B. $50 C. $100 D. $54

18. The constant dividend growth formula P0 = Div1/(r - g) assumes: I) the dividends are growing 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

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Chapter 04 - The Value of Common Stocks

19. 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. None of the above.

20. World-Tour Co. has just now paid a dividend of $2.83 per share (D0); the 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 on stock, after paying the dividend? A. $30 B. $56 C. $70 D. $48

21. The expected rate of return or the cost of equity capital 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)

22. 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)

23. 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%

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Chapter 04 - The Value of Common Stocks

24. Michigan Co. is currently paying a dividend of $2.00 per share. The dividends are expected to grow at 20% per year for the next four years and then grow 6% per year thereafter. Calculate the expected dividend in year 5. A. $4.15 B. $2.95 C. $4.40 D. $3.81

25. Otobai Motor Company is currently paying a dividend of $1.40 per year. The dividends are expected 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 in year 5? A. $2.35 B. $2.54 C. $2.91 D. $1.50

26. The In-Tech Co. has just paid a dividend of $1 per share. The dividends are expected to grow at 25% 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 18%(APR), what is the current value of the stock? A. $12.97 B. $11.93 C. $15.20 D. None of the above

27. R&D Technology Corporation has just paid a dividend of $0.50 per share. The dividends are expected to grow at 24% per year for the next two years and at 8% per year thereafter. If the required rate of return in the stock is 16% (APR), calculate the current value of the stock. A. $1.11 B. $7.71 C. $8.82 D. None of the above

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Chapter 04 - The Value of Common Stocks

28. Ocean 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%

29. Seven-Seas 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 market price is 52.50 per share, calculate the required rate of return on the stock. A. 12% B. 11% C. 5% D. 6%

30. River 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 $40 per share, calculate the required rate of return on the stock. A. 15.2% B. 7.2% C. 14.7% D. 13.4%

31. 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. 7.5% B. 8% C. 12.5% D. 5%

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Chapter 04 - The Value of Common Stocks

32. The growth rate in dividends is a function of two ratios. They are: A. ROA and ROE. B. Dividend yield and growth rate in dividends. C. ROE and the Retention Ratio. D. Book value per share and EPS.

33. 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

34. 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

35. Generally high growth stocks pay: A. Low or no dividends B. High dividends C. Erratic dividends D. Both A and C

36. A high proportion of the value of 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

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Chapter 04 - The Value of Common Stocks

37. Summer 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 present value of the growth opportunity for the stock (PVGO). A. $80 B. $30 C. $50 D. $26

38. 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. $100 B. $76.92 C. $23.08 D. None of the above

39. Which of the following stocks is (are) an income stock(s)? A. Dow Chemicals B. Starbucks C. Microsoft D. None of the above

40. The following stocks are examples of income stocks except: A. Cummins, Inc. B. Dow Chemicals C. Starbucks D. All of the above are income stocks

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Chapter 04 - The Value of Common Stocks

41. Which of the following stocks is/are a growth stock(s)? A. Unilever B. Cummins, Inc C. Starbucks D. All of the above are growth stocks

42. The following stocks are examples of growth stocks except: A. Scottish Power B. e2v Technologies C. Microsoft D. Starbucks

43. 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. $150 C. $100 D. $50

44. A firm forecasts of cash flows ($millions) in years 1 thru 4 to be $120, $130, 135, and $137, respectively. If the project ends at the end of the fourth year, what is the horizon value given the company has historical growth of 3% and a discount rate of 10%? (answers in $millions) A. $0 B. $1.37 C. $1.96 D. $4.87

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Chapter 04 - The Value of Common Stocks

45. A company forecasts growth of 6% for 5 years and 3% thereafter. Given last year's cash flow was $100, what is the horizon value if the company cost of capital is 8%? A. $0 B. $1,672 C. $2,000 D. $2,676

True / False Questions

46. It is more likely than not that a high tech growth company which reports record earnings and announces its first ever dividend will have the stock price of the firm drop. True False

47. An increase in PVGO will almost always coincide with a decrease in dividends. True False

48. The New York Stock Exchange is the only stock market in the US. True False

49. Most of the trading on the NYSE is in ordinary common stocks. True False

50. 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

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

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Chapter 04 - The Value of Common Stocks

52. The only payoff to the owners of common stocks is in the form cash dividends. True False

53. The constant growth formula for stock valuation does not work for firms with negative growth (declining) rates in dividends. True False

54. The cost of equity equals the dividend yield minus the growth rate in dividends for a constant dividend growth stock. True False

55. It is not possible to value a firm with supernormal (variable) growth rate for the first few years of its life. True False

56. A large percentage of the total value of a growth stock comes from the growth opportunity. True False

57. Everyone regards Microsoft as an income stock and Cummins as a growth stock. True False

58. The discounted-cash-flow formulas that is used to value common stocks can also be used to value entire businesses. True False

Essay Questions

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Chapter 04 - The Value of Common Stocks

59. Explain the term "primary market."

60. Explain the term "secondary market."

61. Briefly explain the major types of exchanges prevalent in the USA.

62. Briefly explain the term "market capitalization rate."

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Chapter 04 - The Value of Common Stocks

63. Discuss the general principle in the valuation of 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.

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Chapter 04 - The Value of Common Stocks

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

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Chapter 04 - The Value of Common Stocks

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. none of the above

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 market capitalization for GE. (Approximately) A. $679 billion B. $188 billion C. $382 billion D. None of the above 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) Brasil Telecom, III) Nokia, IV) Endesa, 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 are foreign companies

Type: Easy

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Chapter 04 - The Value of Common Stocks

4. If the Volume is reported in 100s as 292,059 in the Wall Street Journal quotation, then the trading volume for that day of trading is: A. 292,059 shares B. 2,920,590 shares C. 29,205,900 shares D. 292,059,000 shares Trading volume = 292059 * 100 = 29,205,900

Type: Easy

5. 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

Type: Medium

6. The Wall Street Journal quotation for a company has the following values: Div: $1.12, PE: 18.3, Close: $37.22. Calculate the dividend pay out ratio for the company (Approximately). A. 18% B. 55% C. 45% D. None of the above EPS = (37.22)/18.3 = 2.03; dividend payout = 1.12/2.03 = 0.55 = 55%

Type: Difficult

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Chapter 04 - The Value of Common Stocks

7. If the Wall Street Journal Quotation for a company has the following values close: 55.14; Net chg: = + 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. None of the above. Previous closing = today's closing net chg. = 55.14 - 1.04 = $54.10

Type: Medium

8. The exchange-traded fund (EFT) that tracks the Nasdaq 100 index is called: A. SPDR B. DIAMONDS C. QQQQ D. None of the above

Type: Easy

9. The following are auction markets except: A. New York Stock Exchange B. London Stock Exchange C. Tokyo Stock Exchange D. Nasdaq

Type: Easy

10. 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

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Chapter 04 - The Value of Common Stocks

11. In which of the following stock exchange specialists act as the auctioneers: A. New York Stock Exchange B. London Stock Exchange C. Tokyo Stock Exchange D. Frankfurt Stock Exchange

Type: Medium

12. In which of the following exchanges a computer acts 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

13. Super Computer Company's stock is selling for $100 per share today. It is expected that this stock will pay a dividend of 6 dollars per share, and then be sold for $114 per share at the end of one year. 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

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Chapter 04 - The Value of Common Stocks

14. The value of a common stock today depends on: A. Number of shares outstanding and the number of shareholders B. The expected future dividends and the discount rate C. The Wall Street analysts D. Present value of the future earnings per share

Type: Easy

15. CK Company stockholders expect to receive a year-end dividend of $5 per share and then be sold 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. $100 B. $122 C. $132 D. $110 P = (115 + 5)/1.2 = 100

Type: Medium

16. 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. If the required rate on the stock is 15%, what is the current value of the stock? A. $28.20 B. $32.17 C. $32.00 D. None of the given answers P0 = (2/1.15) + [(3 + 32)/(1.15^2)] = $28.20

Type: Medium

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Chapter 04 - The Value of Common Stocks

17. Casino Inc. is expected 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 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

18. The constant dividend growth formula P0 = Div1/(r - g) assumes: I) the dividends are growing 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

19. 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. None of the above. r = [(D1/P0 ) + g] = (2/20) + 0.04 = 14%

Type: Medium

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Chapter 04 - The Value of Common Stocks

20. World-Tour Co. has just now paid a dividend of $2.83 per share (D0); the 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 on stock, after paying the dividend? A. $30 B. $56 C. $70 D. $48 P0 = (2.83 * 1.06)/(0.16 - 0.06) = 30

Type: Medium

21. The expected rate of return or the cost of equity capital 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)

Type: Medium

22. 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)

Type: Difficult

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Chapter 04 - The Value of Common Stocks

23. 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

24. Michigan Co. is currently paying a dividend of $2.00 per share. The dividends are expected to grow at 20% per year for the next four years and then grow 6% per year thereafter. Calculate the expected dividend in year 5. A. $4.15 B. $2.95 C. $4.40 D. $3.81 Div6 = (2.0) * (1.20^4) * (1.06) = 4.40

Type: Medium

25. Otobai Motor Company is currently paying a dividend of $1.40 per year. The dividends are expected 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 in year 5? A. $2.35 B. $2.54 C. $2.91 D. $1.50 D5 = (1.4) * (1.18^3) * (1.05^2) = 2.54

Type: Medium

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Chapter 04 - The Value of Common Stocks

26. The In-Tech Co. has just paid a dividend of $1 per share. The dividends are expected to grow at 25% 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 18%(APR), what is the current value of the stock? A. $12.97 B. $11.93 C. $15.20 D. None of the above P = (1.25/1.18) + (1.5625/1.18^2) + (1.9531/1.18^3) + (2.0508/((1.18^3) * (0.18 - 0.05)) = 12.97

Type: Difficult

27. R&D Technology Corporation has just paid a dividend of $0.50 per share. The dividends are expected to grow at 24% per year for the next two years and at 8% per year thereafter. If the required rate of return in the stock is 16% (APR), calculate the current value of the stock. A. $1.11 B. $7.71 C. $8.82 D. None of the above Po = [(0.5 * 1.24)/1.16] + [(0.5 * 1.24^2)/(1.16^2)] + [(0.5 * 1.24^2 * 1.08)/((1.16^2 * (0.16 - 0.08))] = $8.82

Type: Difficult

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

Type: Difficult

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Chapter 04 - The Value of Common Stocks

29. Seven-Seas 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 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

30. River 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 $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

31. 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. 7.5% B. 8% C. 12.5% D. 5% g = (1 - 3/5)(5/40) = .05 or 5%.

Type: Difficult

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Chapter 04 - The Value of Common Stocks

32. The growth rate in dividends is a function of two ratios. They are: A. ROA and ROE. B. Dividend yield and growth rate in dividends. C. ROE and the Retention Ratio. D. Book value per share and EPS.

Type: Medium

33. 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

34. 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

Type: Difficult

35. Generally high growth stocks pay: A. Low or no dividends B. High dividends C. Erratic dividends D. Both A and C

Type: Medium

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Chapter 04 - The Value of Common Stocks

36. A high proportion of the value of 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

Type: Medium

37. Summer 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 present value of the growth opportunity for the stock (PVGO). A. $80 B. $30 C. $50 D. $26 No growth value = 7.5/0.15 = 50; Po = 4/(0.15 - 0.1) = 80; PVGO = 80 - 50 = 30

Type: Difficult

38. 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. $100 B. $76.92 C. $23.08 D. None of the above 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

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Chapter 04 - The Value of Common Stocks

39. Which of the following stocks is (are) an income stock(s)? A. Dow Chemicals B. Starbucks C. Microsoft D. None of the above

Type: Easy

40. The following stocks are examples of income stocks except: A. Cummins, Inc. B. Dow Chemicals C. Starbucks D. All of the above are income stocks

Type: Easy

41. Which of the following stocks is/are a growth stock(s)? A. Unilever B. Cummins, Inc C. Starbucks D. All of the above are growth stocks

Type: Easy

42. The following stocks are examples of growth stocks except: A. Scottish Power B. e2v Technologies C. Microsoft D. Starbucks

Type: Medium

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Chapter 04 - The Value of Common Stocks

43. 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. $150 C. $100 D. $50 EPS = DPS = 20/2 = $10 per share = Po = 10/0.1 = 100

Type: Medium

44. A firm forecasts of cash flows ($millions) in years 1 thru 4 to be $120, $130, 135, and $137, respectively. If the project ends at the end of the fourth year, what is the horizon value given the company has historical growth of 3% and a discount rate of 10%? (answers in $millions) A. $0 B. $1.37 C. $1.96 D. $4.87 If the project terminates, there is no horizon value.

Type: Medium

45. A company forecasts growth of 6% for 5 years and 3% thereafter. Given last year's cash flow was $100, what is the 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 5 years of 100 is 133.82. The horizon value = 133.82/(.08 - .03)

Type: Difficult

True / False Questions

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Chapter 04 - The Value of Common Stocks

46. It is more likely than not that a high tech growth company which reports record earnings and announces its first ever dividend will have the stock price of the firm drop. TRUE

Type: Difficult

47. An increase in PVGO will almost always coincide with a decrease in dividends. TRUE

Type: Difficult

48. The New York Stock Exchange is the only stock market in the US. FALSE

Type: Easy

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

Type: Easy

50. 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

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

Type: Difficult

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Chapter 04 - The Value of Common Stocks

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

Type: Difficult

53. The constant growth formula for stock valuation does not work for firms with negative growth (declining) rates in dividends. FALSE

Type: Difficult

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

Type: Medium

55. It is not possible to value a firm with supernormal (variable) growth rate for the first few years of its life. FALSE

Type: Medium

56. A large percentage of the total value of a growth stock comes from the growth opportunity. TRUE

Type: Medium

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Chapter 04 - The Value of Common Stocks

57. Everyone regards Microsoft as an income stock and Cummins as a growth stock. FALSE

Type: Medium

58. The discounted-cash-flow formulas that is used to value common stocks can also be used to value entire businesses. TRUE

Type: Difficult

Essay Questions

59. Explain the term "primary market." 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).

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 are secondary market transactions.

Type: Easy

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Chapter 04 - The Value of Common Stocks

61. Briefly explain the major types of exchanges prevalent in the USA. There are two types of exchanges that are prevalent in the USA. They are auction markets and dealer markets. The New York Stock Exchange is an example of an auction market. Here specialists act as auctioneers and match up would-be buyers and sellers. 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 the 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 is the dividend yield plus the growth rate in dividends.

Type: Medium

63. Discuss the general principle in the valuation of a common stock. 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 or the cost of equity. This is called 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. First assumption is that the growth rate in dividends is constant. The second assumption is that the discount rate is greater than the growth rate in dividends.

Type: Difficult

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Chapter 04 - The Value of Common Stocks

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.

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 form 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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