Chapter 7 Stock Valuation

7.1 Stock Basics

1) The ownership in a corporation is divided into shares of stock, which carry rights to share in the profits of the firm
through future dividend payments.
Answer: TRUE

2) What are dividend payments?

A) payments made to a company by investors for a share of the ownership of that company
B) incremental increases in the value of the stock held by an investor due to rises in share price
C) the difference between the original cost price of a share and the price an investor receives when that share is sold
D) a part share of the profits or earnings of a company paid to each shareholder on the basis of the number of
shares they hold
Answer: D

Use the figure for the question(s) below.

3) The above screen shot from Google
Finance shows basic stock information for
PepsiCo. If you owned 2000 shares of
PepsiCo for the period shown, how much
would you have earned in dividend
payments?
A) $108.33
B) $120.00
C) $760.00
D) $860.00
Answer: D
Explanation: D) 2000 × .43 = $860

Use the figure for the question(s) below.

4) The above screen shot from Google

Finance shows the basic stock
information for Logitech International SA
(USA). What is Logitech International SA
(USA)'s ticker symbol?
A) LIS
B) LOGITECH
C) LOG
D) LOGI
Answer: D
5) The above screen shot from Google
Finance shows the basic stock
information for Logitech International SA
(USA) after the close of business on
August 22, 2008. What is the difference
between the opening and closing price of
the stock on this date?
A) $0.49
B) $0.27
C) $0.24
D) $0.03
Answer: C
Explanation: C) $26.30 - $26.06 = $0.24
Use the figure for the question(s) below.

6) The above screen shot from Google

Finance shows the basic stock
information for Kraft Foods Inc. after
the close of the stock market on May
30, 2008. What is the highest that the
stock has traded at in the last 12
months?
A) $32.44
B) $32.48
C) $32.99
D) $35.29

Answer: D

Use the figure for the question(s)

7) The above screen shot above from

Google Finance shows the price history of
Progenics, a pharmaceutical company. In
the time period shown, Progenics released
information that an intravenously-
administered formulation of their leading
product had failed in a Phase III clinical
trial. In which of the months shown in the
price history is this most likely to have
occurred?
A) February 2008
B) March 2008
C) April 2008
D) May 20008
Answer: B

7.2 The Mechanics of Stock Trades

1) A floor broker is a person at the NASDAQ with a trading license who represents orders on the floor.
Answer: FALSE

2) You placed an order to purchase stock where you specified the maximum price you were willing to pay. This type of
order is known as a:
A) maximum order.
B) limit order.
C) floor order.
D) market order.
Answer: B
3) A "round lot" consists of how many shares?
A) 1
B) 10
C) 100
D) 1000
Answer: C
7.3 The Dividend-Discount Model
1) The Valuation Principle states that the value of a stock is equal to the present value (PV) of both the dividends and
future sale price of that stock which the investor will receive.
Answer: TRUE

2) OwenInc has a current stock price of $14.50 and is expected to pay a $0.85 dividend in one year. If OwenInc's equity
cost of capital is 12%, what price would OwenInc's stock be expected to sell for immediately after it pays the dividend?
A) $12.18
B) $13.65
C) $15.29
D) $15.39
Answer: D
N=1, I=12, PV=14.50 then FV = 16.24; FV- dividend=16.24 - 0.85 = $15.39

3) Which of the following situations is a potential source of cash flows for a shareholder of a certain stock?
I. The investor may be able to sell the shares at a future date.
II. The firm in which the shares are held might pay out cash to shareholders in the form of dividends.
III. The firm in which the shares are held might increase the value of its shares by reducing the total number of shares
outstanding.
A) I only
B) II only
C) I and II
D) II and III
Answer: C

4) Coolibah Holdings is expected to pay dividends of $1.20 every six months for the next three years. If the current
price of Coolibah stock is $22.40, and Coolibah's equity cost of capital is 16%, what price would you expect Coolibah's
stock to sell for at the end of three years?
A) $26.74
B) $28.82
C) $29.34
D) $31.36
Answer: A.Using a financial calculator, PV = -22.4, PMT = 1.2, n = 6, I = 8; calculate FV = 26.74.

5) Matilda Industries pays a dividend of $2.25 per share and is expected to pay this amount indefinitely. If Matilda's
equity cost of capital is 12%, which of the following would be expected to be closest to Matilda's stock price?
A) $12.25
B) $14.65
C) $18.75
D) $21.98
Answer: C Explanation: C) PV0 = 2.25 / 0.12 = $18.75

6) Jumbuck Exploration has a current stock price of $2.00 and is expected to sell for $2.10 in one year's time,
immediately after it pays a dividend of $0.26. Which of the following is closest to Jumbuck Exploration's equity cost of
capital?
A) 9%
B) 12%
C) 18%
D) 22%
Answer: C Explanation: C) 0.26 + 2.10 = 2.36; cost of capital = 0.36 / 2 = 18%

7) A stock is bought for $22.00 and sold for $26.00 one year later, immediately after it has paid a dividend of $1.50.
What is the capital gain rate for this transaction?
A) 0.27%
B) 4.00%
C) 15.00%
D) 18.18%
Answer: D Explanation: D) (26 - 22) / 22 = 18.18% capital gain rate doesn’t count in dividend

8) Credenza Industries is expected to pay a dividend of $1.20 at the end of the coming year. It is expected to sell for
$62.00 at the end of the year. If its equity cost of capital is 8%, what is the expected capital gain from the sale of this
stock at the end of the coming year?
A) $3.48
B) $4.86
C) $14.28
D) $58.52
Answer: A Explanation: A) (1.2 + 62) / 1.08 = 58.5185; 62 - 58.5185 = $3.48

9) The Busby Corporation had a share price at the start of the year of $26.20, paid a dividend of $0.56 at the end of the
year, and had a share price of $29.00 at the end of the year. Which of the following is closest to the rate of return of
investments in companies with equal risk to The Busby Corporation for this period?
A) 5%
B) 7%
C) 9%
D) 13%
Answer: D Explanation: D) 29.56 - 26.20 = 3.36; 3.36 / 26.2 = 12.82%; rounded up to 13%

10) Valorous Corporation will pay a dividend of $1.80 per share at this year's end and a dividend of $2.40 per share at
the end of next year. It is expected that the price of Valorous' stock will be $44 per share after two years. If Valorous has
an equity cost of capital of 8%, what is the maximum price that a prudent investor would be willing to pay for a share
of Valorous stock today?
A) $39.27
B) $40.22
C) $41.45
D) $42.40
Answer: C Explanation: C) Using a financial calculator, CF0 = 0, CF1 = 1.8, CF2 = (44 + 2.4) = 46.4;
calculate NPV at I = 8%, equals $41.45.

11) A stock is expected to pay $0.80 per share every year indefinitely. If the current price of the stock is $18.90, and the
equity cost of capital for the company that released the shares is 6.4%, what price would an investor be expected to pay
per share five years into the future?
A) $12.50
B) $20.43
C) $21.23
D) $22.65
Answer: A explanation: A) P0 = 0.8 / 0.064 = $12.50

12) A stock is expected to pay $1.25 per share every year indefinitely and the equity cost of capital for the company is
7.5%. What price would an investor be expected to pay per share ten years in the future?
A) $16.67
B) $25.01
C) $33.34
D) $41.68
Answer: A Explanation: A) P0 = 1.25 / 0.075 = $16.67

13) Rylan Industries is expected to pay a dividend of $5.20 year for the next four years. If the current price of Rylan
stock is $32.63, and Rylan's equity cost of capital is 14%, what price would you expect Rylan's stock to sell for at the
end of the four years?
A) $29.52
B) $55.11
C) $25.58
D) $80.70
Answer: A Explanation: A) Using a financial calculator, PV = -32.63, PMT = 5.2, n = 4, I = 14; Calculate FV = 29.52

14) A stock is expected to pay $3.20 per share every year indefinitely and the equity cost of capital for the company is
10%. What price would an investor be expected to pay per share next year?
A) $8.00
B) $16.00
C) $24.00
D) $32.00
Answer: D Explanation: D) P0 = 3.20 / 0.10 = $32.00

7.4 Estimating Dividends in the Dividend-Discount Model

1) A firm can either pay its earnings out to its investors or it can keep them and reinvest them.
Answer: TRUE

2) Which of the following is NOT a way that a firm can increase its dividend?
A) by increasing its retention rate
B) by decreasing its shares outstanding
C) by increasing its earnings (net income)
D) by increasing its dividend payout rate
Answer: A

3) Which of the following statements is FALSE regarding profitable and unprofitable growth?
A) If a firm wants to increase its share price, it must cut its dividend and invest more.
B) If the firm retains more earnings, it will be able to pay out less of those earnings, which means that the firm will
have to reduce its dividend.
C) A firm can increase its growth rate by retaining more of its earnings.
D) Cutting the firm's dividend to increase investment will raise the stock price if, and only if, the new investments have
a positive net present value (NPV).
Answer: A
Explanation: A) This will only increase the share price if the reinvested money is invested in positive-NPV projects.

4) Which of the following statements is FALSE?

A) Estimating dividends, especially for the distant future, is difficult.
B) A firm can only pay out its earnings to investors or reinvest their earnings.
C) Successful young firms often have high initial earnings growth rates.
D) According to the constant dividend growth model, the value of the firm depends on the current dividend level,
divided by the equity cost of capital plus the grow rate.
Answer: D
Explanation: D) According to the constant dividend growth model, the value of the firm depends on the current
dividend level, divided by the equity cost of capital adjusted by the growth rate.

5) Which of the following statements is FALSE?

A) We cannot use the general dividend-discount model to value the stock of a firm with rapid or changing
growth.
B) As firms mature, their growth slows to rates more typical of established companies.
C) The dividend-discount model values the stock based on a forecast of the future dividends paid to shareholders.
D) The simplest forecast for the firm's future dividends states that they will grow at a constant rate, i.e., forever.
Answer: A Explanation: A) A multistage model can be used.

6) Which of the following statements is FALSE?

A) A common approximation is to assume that in the long run, dividends will grow at a constant rate.
B) The dividend each year is the firm's earnings per share (EPS) multiplied by its dividend payout rate.
C) There is a tremendous amount of uncertainty associated with any forecast of a firm's future dividends.
D) During periods of high growth, it is not unusual for firms to pay out 100% of their earnings to shareholders
in the form of dividends.
Answer: D
Explanation: D) During periods of high growth, it is not unusual for these firms to retain 100% of their earnings to
exploit profitable investment opportunities.

7) Which of the following statements is FALSE?

A) As firms mature, their earnings exceed their investment needs and they begin to pay dividends.
B) Total return equals earnings multiplied by the dividend payout rate.
C) Cutting the firm's dividend to increase investment will raise the stock price if, and only if, the new investments have
a positive net present value (NPV).
D) We cannot use the constant dividend growth model to value the stock of a firm with rapid or changing growth.
Answer: B

8) Which of the following formulas is INCORRECT?

A) g = retention rate × return on new investment
B) Divt = EPSt × Dividend Payout Rate
Di
C) P0 = 1
rE  g
Di
1
D) rE = P
-g
0
Answer: D
Di
1
Explanation: D) rE = P
+g
0

9) Which of the following formulas is INCORRECT?

earnings
t
A) Divt = shares outstanding
× Dividend Payout Rate
t
Di
B) PN = N
rE  g
C) earnings growth rate = retention rate x return on new investment
Di Di Di 1 Di
D) P0 = 1 + 2 + ... + N + × N 1
2 N (1  rE ) N rE  g
1  rE (1  rE ) (1  rE )

Answer: B Explanation: B) PN =

10) NoGrowth Industries presently pays an annual dividend of $1.50 per share and it is expected that these dividend
payments will continue indefinitely. If NoGrowth's equity cost of capital is 12%, then the value of a share of
NoGrowth's stock is closest to:
A) $10.00
B) $15.00
C) $14.00
D) $12.50
Answer: D Explanation: D) P0 = Div1 / (rE - g) = $1.50 / (0.12 - 0) = $12.50

11) Von Bora Corporation (VBC) is expected to pay a $2.00 dividend at the end of this year. If you expect VBC's
dividend to grow by 5% per year forever and VBC's equity cost of capital is 13%, then the value of a share of VBS
stock is closest to:
A) $25.00
B) $40.00
C) $15.40
D) $11.10
Answer: A Explanation: A) P0 = Div1 / (rE - g) = 2.00 / (0.13 - 0.05) = $25.00

12) Luther Industries has a dividend yield of 4.5% and and a cost of equity capital of 12%. Luther Industries' dividends
are expected to grow at a constant rate indefinitely. The growth rate of Luther's dividends are closest to:
A) 7.5%
B) 5.5%
C) 16.5%
D) 12%
Answer: A Explanation: A) rE = Div1 / P0 + g 0.12 = 0.045 + g, so g = 0.075

13) The Sisyphean Company's common stock is currently trading for $25.00 per share. The stock is expected to pay a
$2.50 dividend at the end of the year and the Sisyphean Company's equity cost of capital is 14%. If the dividend payout
rate is expected to remain constant, then the expected growth rate in the Sisyphean Company's earnings is closest to:
A) 8%
B) 6%
C) 4%
D) 2%
Answer: C Explanation: C) P0 = Div1 / (rE - g) = 25.00 = 2.50 / (0.14 - g), so g = 0.04

14) You expect KT industries (KTI) will have earnings per share of $3 this year and expect that they will pay out $1.50
of these earnings to shareholders in the form of a dividend. KTI's return on new investments is 15% and their equity
cost of capital is 12%. The expected growth rate for KTI's dividends is closest to:
A) 6.0%
B) 7.5%
C) 4.5%
D) 3.0%
Answer: B
Explanation: B) g = retention rate × return on new investment = (3.00 - 1.50) / 3.00 × 0.15 = 0.075 or 7.5%

15) You expect KT industries (KTI) will have earnings per share of $3 this year and expect that they will pay out $1.50
of these earnings to shareholders in the form of a dividend. KTI's return on new investments is 15% and their equity
cost of capital is 12%. The value of a share of KTI's stock is closest to:
A) $39.25
B) $20.00
C) $33.35
D) $12.50
Answer: C Explanation: C) g = retention rate × return on new investment = (3.00 - 1.50) / 3.00 × 0.15 = 0.075 or 7.5%
P0 = Div1 / (rE - g) = 1.50 / (0.12 - 0.075) = 33.33

16) JRN Enterprises just announced that it plans to cut its dividend from $2.50 to $1.50 per share and use the extra
funds to expand its operations. Prior to this announcement, JRN's dividends were expected to grow at 4% per year and
JRN's stock was trading at $25.00 per share. With the new expansion, JRN's dividends are expected to grow at 8% per
year indefinitely. Assuming that JRN's risk is unchanged by the expansion, the value of a share of JRN after the
announcement is closest to:
A) $25.00
B) $15.00
C) $31.25
D) $27.50
Answer: A Explanation: A) Two steps. Step 1: Solve for rE:
rE = Div1 / P0 + g = 2.50 / 25.00 + 0.04 = 0.14 or 14%
Step 2: Solve for new stock price:
P0 = Div1 / (rE - g) = 1.50 / (0.14 - 0.08) = 25.00
17) You expect that Bean Enterprises will have earnings per share of $2 for the coming year. Bean plans to retain all of
its earnings for the next three years. For the subsequent two years, the firm plans on retaining 50% of its earnings. It
will then retain only 25% of its earnings from that point forward. Retained earnings will be invested in projects with an
expected return of 20% per year. If Bean's equity cost of capital is 12%, then the price of a share of Bean's stock is
closest to:
A) $17.00
B) $10.75
C) $27.75
D) $43.50
Answer: C
C) Year Earnings Dividends g

1 $2.00 $0.00 20% P0 = 1.73 / (1.12)4 + 1.90 / 1.125 + (3.14 / (0.12 - 0.05)) / 1.125 = 27.63
2 $2.40 $0.00 20% Each g is calculated as the 20% return on the projects × the retention ratio.
3 $2.88 $0.00 20%

4 $3.46 $1.73 10% 18) Avril Synchronistics will pay a dividend of $1.30 per share this year. It is
5 $3.80 $1.90 10% expected that this dividend will grow by 5% each year in the future. What will
6 $4.18 $3.14 5% be the current value of a single share of Avril's stock if the firm's equity cost of
capital is 14%?
A) $9.23
B) $9.28
C) $14.44
D) $15.16
Answer: C Explanation: C) P0 = 1.3/(0.14 - 0.05) = $14.44

19) Spacefood Products will pay a dividend of $2.40 per share this year. It is expected that this dividend will grow by
3% per year each year in the future. What will be the current value of a single share of Spacefood's stock if the firm's
equity cost of capital is 10%?
A) $24.00
B) $23.97
C) $30.22
D) $34.29
Answer: D Explanation: D) P0 = 2.4/(0.10 - 0.03) = $34.29

20) Gremlin Industries will pay a dividend of $1.80 per share this year. It is expected that this dividend will grow by
4% per year each year in the future. The current price of Gremlin's stock is $22.40 per share. What is Gremlin's equity
cost of capital?
A) 11%
B) 12%
C) 14%
D) 16%
Answer: B Explanation: B) Cost of capital = 1.8 / 22.40 + 0.04 = 12%

21) A company has stock which costs $42.00 per share and pays a dividend of $2.50 per share this year. The company's
cost of equity is 8%. What is the expected annual growth rate of the company's dividends?
A) 2%
B) 4%
C) 8%
D) 11%
Answer: A Explanation: A) Growth rate = 0.08 - 2.5 / 42 = 2%

22) Which of the following is NOT a method by which a company can increase its dividend payments?
A) It can issue more shares.
B) It can increase its earnings.
C) It can decrease the number of shares outstanding.
D) It can increase its dividend payout rate.
Answer: A

23) Jumbo Transport, an air-cargo company, expects to have earnings per share of $2.50 in the coming year. It decides
to retain 20% of these earnings in order to lease new aircraft. The return on this investment will be 25%. If its equity
cost of capital is 12%, what is the expected share price of Jumbo Transport?
A) $16.67
B) $19.23
C) $24.75
D) $28.57
Dividend per share DPS= Earnings per share EPS x (1- 20%) =2.5 × 0.8 = 2.
Retention rate = (EPS-DPS)/ EPS= (2.5-2)/2.5=2%
g = retention rate x return on investment =0.2 × 0.25 = 0.05
P0 = DPS/ ( r-g) = 2 / (0.12 - 0.05) = $28.57

24) Sunnyfax Publishing pays out all its earnings and has a share price of $38. In order to expand, Sunnyfax Publishing
decides to cut its dividend from $3.00 to $2.00 per share and reinvest the retained funds. Once the funds are reinvested,
they are expected to grow at a rate of(wrong=return on investment) 12%. If the reinvestment does not affect Sunnyfax's
equity cost of capital, what is the expected share price as a consequence of this decision?
A) $33.33
B) $40.00
C) $50.00
D) $60.00
Answer: C Explanation: C) cost of capital = 3/38 = 0.08; g = 0.33 × 0.12 = 0.04; P0 = 2 / (0.08 -0.04) = $50

25) Kirkevue Industries pays out all its earnings as dividends and has a share price of $24. In order to expand, Kirkevue
announces it will cut its dividend payments from $2.00 to $1.80 per share and reinvest the retained funds. What is the
growth rate that should be achieved on the reinvested funds to keep the equity cost of capital unchanged?
A) 0.83%
B) 15.33%
C) 18.23%
D) 17.97%
Explanation: A) re1 = 2/24 = 8.33%; re2 = 1.8/24 = 7.5%; growth rate = 8.33 - 7.5 = 0.83%

26) Sinclair Pharmaceuticals, a small drug company, develops a vaccine that will protect against Helicobacter pylori, a
bacteria that is the cause of a number of diseases of the stomach. It is expected that Sinclair Pharmaceuticals will
experience extremely high growth over the next three years and will reinvest all of its earnings in expanding the
company over this time. Earnings were $1.20 per share before the development of the vaccine and are expected to grow
by 40% per year for the next three years. After this time, it is expected growth will drop to 5% and stay there for the
expected future. Four years from now Sinclair will pay dividends that are 75% of its earnings. If its equity cost of
capital is 10%, what is the value of a share of Sinclair Pharmaceuticals today?
A) $33.33
B) $38.96
C) $48.30
D) $52.00
Answer: B Explanation: B) E3 = $3.29s D3 = 2.470
E4 = $3.4574; D4 = $2.5931; P3 = 2.5931 / (0.10 - 0.05) = 49.392;
P0 = (49.392 + 2.470) / (1.10)^3 = $38.96

7.5 Limitations of the Dividend-Discount Model

1) Forecasting dividends requires forecasting the firm's future earnings.
Answer: TRUE

2) Stocks that do not pay a dividend must have a value of $0. Answer: FALSE
7.6 Share Repurchases and the Total Payout Model
1) Sultan Services has 1.2 million shares outstanding. It expects earnings at the end of the year of $5.6 million. Sultan
pays out 60% of its earnings in total - 40% paid out as dividends and 20% used to repurchase shares. If Sultan's
earnings are expected to grow by 7% per year, these payout rates do not change, and Sultan's equity cost of capital is
9%, what is Sultan's share price?
A) $22.40
B) $56.00
C) $93.33
D) $140.00
Answer: D Explanation: D) P0 = (0.6 × 5.6) / (0.09 - 0.07) = $168 million; per share = 168 / 1.2 = $140

2) Which of the following models can be used to value a firm without explicitly forecasting that firm's dividends, share
repurchases, or its use of debt?
I. Dividend-discount model
II. Total payout model
III. Discounted free cash flow model
A) I only
B) II only
C) III only
D) II and III
Answer: C

3) Valence Electronics has 217 million shares outstanding. It expects earnings at the end of the year of $760 million.
Valence pays out 40% of its earnings in total15% paid out as dividends and 25% used to repurchase shares. If
Valence's earnings are expected to grow by 6% per year, these payout rates do not change, and Valence's equity cost of
capital is 8%, what is Valence's share price?
A) $10.51
B) $24.40
C) $56.60
D) $70.05
Answer: D Explanation: D) P0 = (0.4 × 760) / (0.08 - 0.06) = $15,200 million; per share = 15,200 / 217 =$70.05

4) Chittenden Enterprises has 632 million shares outstanding. It expects earnings at the end of the year to be $940
million. The firm's equity cost of capital is 10%. Chittenden pays out 30% of its earnings in total: 20% paid out as
dividends and 10% used to repurchase shares. If Chittenden's earnings are expected to grow at a constant 4% per year,
what is Chittenden's share price?
A) $4.96
B) $3.36
C) $7.44
D) $14.88
Answer: C Explanation: C) P0 = (0.3 × $940) / (0.10 - 04) =$4,700 million; per share = $4,700/632 =$7.44

5) Aaron Inc. has 316 million shares outstanding. It expects earnings at the end of the year to be $602 million. The
firm's equity cost of capital is 11.5%. Aaron pays out 50% of its earnings in total: 30% paid out as dividends and 20%
used to repurchase shares. If Aaron's earnings are expected to grow at a constant 6% per year, what is Aaron's share
price?
A) $8.66
B) $17.32
C) $25.98
D) $34.64
Answer: B
Explanation: B) P0 = (0.5 × $602) / (0.115 -.06) =$5,473 million; per share = $5,473/316 =$17.32