Chapter 10: Valuation & Rates of Return

Calculate the present value of the bonds principal payment for a $5,000, 10 year bond with a stated rate of 10%, compounded annually, and a yield of 12%? Round to the nearest whole dollar. $3,791 $1,610 $1,928 $30,723

$1,610 Explanation: Using the formula in the book, the table factor at a discount/market rate of 12% =.321973236. Multiply $5,000 principal payment by the table factor of.321973236 = 1,609.87. Round up to 1,610.00. Using a Financial Calculator: FV = $5,000 I/Y = 12% N = 10 PMT = 0 CPT PV = $1,609.87 = $1,610 rounded

What is the present value of interest payments for $5,000, 10 year bond with a stated coupon rate of 12% and a market rate of 10%? (Round to the nearest whole dollar) $3,652 $3,687 $30,723 $3,791

$3,687 Explanation: To determine the annuity (interest payments) multiply $5,000 by 12% stated rate = $600. Using the formula in the book, the present value factor at a discount/market rate of 10% = 6.144567106. Multiply $600 interest payment by the table factor of 6.144567106 = 3,686.74. Round up to 3,687.

The growth rate for the firm's common stock is 7%. The firm's preferred stock is paying an annual dividend of $3. What is the preferred stock price if the required rate of return is 8%? $37.50 $3.00 None of these options $50.00

$37.50 Explanation PP = Dividend/Required return = $3.00 / 0.08 = $37.50

Calculate the present value of $5,000, 10 year bonds with a stated rate of 12% and a market rate of 10%? Round to the nearest whole dollar. $5,614 $50,723 $3,686 $3,791

$5,614 Explanation: To determine the annuity (interest payments) multiply $5,000 by 12% stated rate = $600. Using the formula in the book, the table factor at a discount/market rate of 10% = 6.144567106. Multiply $600 interest payment by the table factor of 6.144567106 = 3,686.74. The present value of the principal payment of $5,000/(1+10%)10 = $1,927.72. Present value of bond = $3,686.74 + $1,927.72 = $5,614.46, or $5,614.

What is the present value of principal payment for $1,000, 5 year bond with a stated coupon rate of 8% and a market rate of 10%? $3,791 $1,685 $614 $621

$621 Explanation: To determine the single principal payment at maturity go to the PV of $1 table and find the table factor associated with 5 periods at a 10% discount/market rate =.621. Multiply $1,000 principal payment by the table factor of.621 = 621.00 Using a Financial Calculator: FV = $1,000 I/Y = 10% PMT = 0 N = 5 CPT PV = $620.92 = $621 rounded

A 5-year zero-coupon bond was issued with a $1,000 par value to yield 8%. What is the approximate market value of the bond? Use time value of money table in Appendix B. $275 $681 $597 $482

$681 Explanation PV = FV × PVIF Using PV of $1 table to find the PV of the principal: i = 8%, n = 5 years. Factor = 0.681 × 1000 = $681.

An issue of common stock has just paid a dividend of $2.00. Its growth rate is equal to 4%. If the required rate of return is 7%, what is its current price? $19.04 $80.00 $69.33 None of these options are correct

$69.33 Explanation D1 = D0 (1 + g) = $2.00 (1 + 0.04) = $2.08 PO = D1 / (Ke − g) = $2.08 / (0.07 − 0.04) = $69.33

Calculate the present value of the bond's interest payments. The interest payments are $200 annually for 6 years at a discount rate of 6%. Use the formula method to calculate the present value. $984.40 $985.50 $983.15 $983.46

$983.46 Explanation: use table (PVAF) find 6 yrs 6% multiply 200*4.91

What is the reward to financial managers who use capital efficiently? -Higher profits -A lower required return -Lower costs -A lower present value

-A lower required return

Which of the following financial assets is likely to have the highest required rate of return based on risk? -Corporate bond -Common stock -Certificate of deposit -U.S. Treasury bill

-Common stock

The required return by investors is directly influenced by all of the following except: -Risk -Dividends -Inflation -U.S. Treasury rates

-Dividends

The market allocates capital to firms based on all of the following except: -Higher risk requires lower returns due to higher expectations -The level of efficiency -Expected returns -The degree of past performance

-Higher risk requires lower returns due to higher expectations

Which of the following does NOT influence the yield to maturity for a security? -Historic yields -Business risk -Required real rate of return -Risk free rate

-Historic yields

The price of a bond is based on which cash flow(s)? Select all that apply -Interest payments -Principal payment at maturity -The future values -The amount received for the bond

-Interest payments -Principal payment at maturity

The return measure that an investor demands for giving up current use of funds, without adjusting for purchasing power changes or the real rate of return, is the -risk premium. -inflation premium. -dividend yield. -discount rate.

-Risk premium

What factors influence the bondholder's or investor's required rate of return? Select all that apply -Risk premium -Real rate of return -Amount of investment -Inflation premium

-Risk premium -Real rate of return -Inflation premium

Doug has been approached by his broker to purchase a $1,000 bond for $795. He believes the bond should yield 8%. The bond pays a 5% annual coupon rate and has 10 years left until maturity. What should Doug's analysis of the bond indicate to him? Use annual analysis. Use time value of money tables in Appendix B and Appendix D. -The bond is undervalued; he should purchase it. -The bond is undervalued; he should not purchase it. -The bond is overvalued; he should purchase it. -The bond is overvalued; he should not purchase it.

-The bond is undervalued; he should purchase it.

Will an increase in inflation have a larger impact on the price of a bond or preferred stock? -The bond. -The preferred stock. -The impact will be the same. -Inflation doesn't affect either the bond or the preferred stock price.

-The preferred stock.

Preferred stock has all but which of the following characteristics? -Preferred lacks the full ownership privilege of common stock. -A fixed dividend payment that carries a higher precedence than common stock dividends. -No stated maturity. -The same binding contractual obligation as debt.

-The same binding contractual obligation as debt.

Cash flows are discounted at Y. What does Y represent? -Time value of money -Market position -Yield to maturity -Valuation concept

-Yield to maturity

A higher interest rate (discount rate) would -reduce the price of corporate bonds. -reduce the price of preferred stock. -reduce the price of common stock. -all of these options are true.

-all of these options are true.

The market allocates capital to companies based on -expected returns. -all of these options are true. -risk. -efficiency.

-all of these options are true.

A bond that has a "yield to maturity" greater than its coupon interest rate will sell for a price -at par. -below par. -that is equal to the face value of the bond plus the value of all interest payments. -above par.

-below par.

The value of stocks and bonds is based on the present value of the future -cash flows -revenues only -costs only -value table factor

-cash flows

Valuation concepts can be applied to: Select all that apply -retained earnings -common stock -preferred stock -bonds

-common stock -preferred stock -bonds

The required rate of return is also known as the _____ rate? -lower-of-market -discount -interest -present

-discount

Stock valuation models are dependent upon -expected dividends, future dividend growth, and an appropriate discount rate. -past dividends, flotation costs, and bond yields. -historical dividends, historical growth, and an appropriate discount rate. -All of these options are true.

-expected dividends, future dividend growth, and an appropriate discount rate.

What needs to be known to determine the current value of a financial asset. Select all that apply -future cash flows -price of the asset -discount rate -future value factor

-future cash flows -discount rate

If a company's stock price (P0) goes up, and nothing else changes, Ke (the required rate of return) should -go up. -go down. -remain unchanged. -More information is needed for an answer.

-go down.

If the interest rate stated on the bond is equal to the yield to maturity (discount rate), the bonds will sell for -less than par value (a discount) -more than par value (a premium) -par value

-par value

A common stock that pays a constant dividend can be valued as if it were -a corporate bond. -a discount bond. -a stock paying a growing dividend. -preferred stock.

-preferred stock.

The price at which a bond sells for is equal to the present value of the Select all that apply -principal -interest payments -yield to maturity -required rate of return

-principal -interest payments

The dividend valuation model stresses the -importance of earnings per share. -importance of dividends and legal rules for maximum payment. -relationship of dividends to market prices. -relationship of dividends to earnings per share.

-relationship of dividends to market prices.

The _____ rate of return depends on the market's perceived level of risk associated with a security. -formal -required -risky -market

-required

Y, in the bond market, represents the required rate of return for bonds of a given _____ and maturity. -amount -risk -return -rate

-risk

The market allocates capital to companies based on Select all that apply -risk -expected returns -efficiency -lowest costs

-risk -expected returns -efficiency

The price of a bond can be determined using a formula. Choose the term(s) from the list below that are involved in pricing a bond. Select all that apply -take the present value of the principal payment at maturity -take the future value of the principal payment at maturity -take the sum of the future values of the interest payments -take the sum of the present values of the interest payments

-take the present value of the principal payment at maturity -take the sum of the present values of the interest payments

The longer the time to maturity -the greater the bond price increase from an increase in interest rates. -the less the bond price increase from an increase in interest rates. -the greater the bond price increase from a decrease in interest rates. -the less the bond price decrease from a decrease in interest rates.

-the greater the bond price increase from a decrease in interest rates.

If the yield to maturity on a bond is greater than the coupon rate, you can assume -the sales price is above par. -risk premiums have decreased. -the sales price is below par. -interest rates have decreased.

-the sales price is below par.

The price of preferred stock may react strongly to a change in Kp (required rate of return) because -preferred stock may be cumulative. -preferred stock dividends have to be paid before common stock dividends. -there is no maturity date. -corporate recipients of preferred stock dividends may receive a partial tax exemption.

-there is no maturity date.

The value of a common stock is based on its -past performance. -historic dividends. -current earnings. -value of future benefits to the holder.

-value of future benefits to the holder.

To determine the price of a bond, the interest payments and the principal must be discounted by the ________ -future value -yield to maturity -interest payments -bonds stated interest rate

-yield to maturity

Historically, the real rate of return demanded by investors has been about _____? 6 to 10 percent 2 to 3 percent 3 to 5 percent 1 to 2 percent

2 to 3 percent

BioScience Inc. will pay a common stock dividend of $3.20 at the end of the year (D1). The required return on common stock (Ke) is 14 percent. The firm has a constant growth rate (g) of 9 percent. Compute the current price of the stock (P0). (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Current price: $64.00 Explanation P0= D1 / (Ke − g) = $3.20 / (0.14 − 0.09) = $64.00

T/F: "Business risk" relates to the inability of the firm to meet its debt obligations as they come due.

False

T/F: An increase in the yield of a bond compared to the coupon rate would be associated with an increase in the price of a bond.

False

T/F: As time to maturity increases, bond price sensitivity decreases.

False

T/F: Preferred stock may not have the same ownership privileges as common stock, but preferred stock offers a fixed dividend stream supported by a binding contractual obligation.

False

T/F: The present value of the interest payments and principal payment should be discounted at the coupon rate.

False

T/F: The yield to maturity is always equal to the coupon rate of a bond.

False

T/F: There is a negative correlation between risk and the return investors demand.

False

True/False: "Business risk" relates to the inability of the firm to meet its debt obligations as they come due.

False

True/False: A stock that has a high required rate of return because of its risky nature will usually have a high P/E ratio.

False

True/False: Firms with an expectation for great potential tend to trade at low P/E ratios.

False

True/False: In estimating the market value of a bond, the coupon rate should be used as the discount rate.

False

Which of the following regarding preferred stock is true? -If the price decreases, the required rate of return has decreased. -If the required rate of return increases, the price decreases. -If the required rate of return increases, the price increases. -The price in the market remains at par.

If the required rate of return increases, the price decreases.

Which of the following is not one of the components included in the required rate of return on a bond? -Risk premium -Real rate of return -Inflation premium -Market yield

Market Yield

Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 15 percent. This return was in line with the required returns by bondholders at that point as described below: Real rate of return 4% Inflation premium 6 Risk premium 5 Total return 15% Assume that five years later the inflation premium is only 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years remaining until maturity. Compute the new price of the bond. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)

New price of the bond: $1,224.08 Explanation First compute the new required rate of return (yield to maturity): Current yield to maturity= Real rate of return + Inflation premium + Risk premium = 4% + 3 + 5 = 12% Then, use this value to find the price of the bond. Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.15 × $1,000) × ({1 − [1 / (1.12)20]} / 0.12)] + [$1,000 / 1.1220] = $1,224.08

Media Bias Inc. issued bonds 10 years ago at $1,000 per bond. These bonds had a 40-year life when issued and the annual interest payment was then 12 percent. This return was in line with the required returns by bondholders at that point in time as described below: Real rate of return 2% Inflation premium 5 Risk premium 5 Total return 12% Assume that 10 years later, due to good publicity, the risk premium is now 2 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 30 years remaining until maturity. Compute the new price of the bond. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)

New price of the bond: $1,307.88 Explanation First compute the new required rate of return (yield to maturity): Required return= Real rate + Inflation premium + Risk premium = 2% + 5 + 2 = 9% Then, use this value to find the price of the bond. Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.12 × $1,000) × ({1 − [1 / (1.09)^30]} / 0.09)] + [$1,000 / 1.0930] = $1,308.21

Analogue Technology has preferred stock outstanding that pays a $9 annual dividend. It has a price of $76. What is the required rate of return (yield) on the preferred stock? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Rate of return: 11.84% Explanation Original price: Kp= Dp / Pp = $9 / $76 = 0.1184, or 11.84%

T/F: Most bonds promise both a periodic return and a lump-sum payment.

True

T/F: Preferred stock would be valued the same as a common stock with a zero dividend growth rate.

True

T/F: The discount rate depends on the market's perceived level of risk associated with an individual security.

True

T/F: The price of a bond is equal to the present value of all future interest payments added to the present value of the principal.

True

T/F: The price-earnings ratio is another tool used to measure the value of common stock.

True

T/F: The required rate of return is the rate of return the investor demands for giving up the current use of the funds on a noninflation-adjusted basis.

True

T/F: The valuation of a financial asset is based on the concept of determining the present value of future cash flows that this financial asset will accumulate.

True

True/False: An increase in inflation will cause a bond's required return to rise.

True

True/False: By using different discount rates, the market allocates capital to companies based on their risk, efficiency, and expected returns.

True

True/False: Even though the IRS tries to minimize occurrences, small business owners often intermingle business and personal expenses in order to minimize taxable income.

True

True/False: High-risk corporate bonds are referred to as junk bonds.

True

True/False: Historically, the real rate of return has been about 2% to 3%.

True

True/False: The further the yield to maturity of a bond moves away from the bond's coupon rate, the greater the price-change effect will be.

True

True/False: The market-determined required rate of return is the appropriate discount rate used in valuation calculations.

True

True/False: The price of preferred stock is determined by dividing the fixed dividend payment by the required rate of return.

True

True/False: A 10-year bond pays 6% annual interest in semi-annual payments. The current market yield to maturity is 4%. The appropriate interest factors used to calculate the sales price of this bond should be in the TVM tables under 2% for 20 periods.

True Explanation i = 4% / 2 = 2%, n = 10 × 2 = 20

Stilley Resources bonds have 4 years left to maturity. Interest is paid annually, and the bonds have a $1,000 par value and a coupon rate of 5 percent. If the price of the bond is $841.51, what is the yield to maturity? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Yield to maturity: 10.00% Explanation Calculator Solution: N: 4 I/Y: CPT I/Y 10 PV: −841.51 PMT: 50 FV: 1,000 Answer: 10%

Essex Biochemical Co. has a $1,000 par value bond outstanding that pays 15 percent annual interest. The current yield to maturity on such bonds in the market is 17 percent. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. Compute the price of the bonds for the maturity dates: (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)

a. 30 years Bond Price: $883.41 b. 20 years Bond Price: $887.44 c. 4 years Bond Price: $945.14 Explanation a.30 years to maturity: Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.15 × $1,000) × ({1 − [1 / (1.17)^30]} / 0.17)] + [$1,000 / 1.1730] = $883.41 b.20 years to maturity: Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.15 × $1,000) × ({1 − [1 / (1.17)^20]} / 0.17)] + [$1,000 / 1.1720] = $887.44 c.4 years to maturity: Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.15 × $1,000) × ({1 − [1 / (1.17)^4]} / 0.17)] + [$1,000 / 1.174] = $945.14

Midland Oil has $1,000 par value bonds outstanding at 8 percent interest. The bonds will mature in 25 years. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. Compute the current price of the bonds if the present yield to maturity is: (Do not round intermediate calculations. Round your final answers to 2 decimal places. Assume interest payments are annual.)

a. 7% Bond Price: $1,116.54 b. 10% Bond Price: $818.46 c. 13% Bond Price: $633.50 Explanation a. 7 percent yield to maturity: Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.08 × $1,000) × ({1 − [1 / (1.07)^25]} / 0.07)] + [$1,000 / 1.0725] = $1,116.54 b.10 percent yield to maturity: Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.08 × $1,000) × ({1 − [1 / (1.10)^25]} / 0.10)] + [$1,000 / 1.1025] = $818.46 c.13 percent yield to maturity: Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.08 × $1,000) × ({1 − [1 / (1.13)^25]} / 0.13)] + [$1,000 / 1.1325] = $633.50

Martin Office Supplies paid a $3 dividend last year. The dividend is expected to grow at a constant rate of 7 percent over the next four years. The required rate of return is 14 percent (this will also serve as the discount rate in this problem). Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods. a. Compute the anticipated value of the dividends for the next four years. (Do not round intermediate calculations. Round your final answers to 2 decimal places.) b. Calculate the present value of each of the anticipated dividends at a discount rate of 14 percent. (Do not round intermediate calculations. Round your final answers to 2 decimal places.) c. Compute the price of the stock at the end of the fourth year (P4). (Do not round intermediate calculations. Round your final answer to 2 decimal places.) d. Calculate the present value of the year 4 stock price at a discount rate of 14 percent. (Do not round intermediate calculations. Round your final answer to 2 decimal places.) e. Compute the current value of the stock. (Do not round intermediate calculations. Round your final answer to 2 decimal places.) f. Use the formula given below to show that it will provide approximately the same answer as part e. (Do not round intermediate calculations. Round your final answer to 2 decimal places.) P0=D1/Ke − g g. If current EPS were equal to $5.32 and the P/E ratio is 10% higher than the industry average of 8, what would the stock price be? (Do not round intermediate calculations. Round your final answer to 2 decimal places.) h. By what dollar amount is the stock price in part g different from the stock price in part f? (Do not round intermediate calculations. Round your final answer to 2 decimal places. i. With regard to the stock price in part f, indicate which direction it would move if: (1) D1 increases: (2)Ke increases: (3) g increases:

a. Anticipated value D1= $3.21 D2= $3.43 D3= $3.67 D4= $3.93 b. PV of Dividends D1= $2.82 D2= $2.64 D3= $2.48 D4= $2.33 Total= 10.27 c. Stock price at Year 4: $60.14 d. Present value of Year 4 stock price: $35.61 e. Current value: $45.88 f. Current value: $45.86 g. Stock price: $46.82 h. Amount: $0.96 i: (1) D1 increases: Stock price increases (2)Ke increases: Stock price decreases (3) g increases: Stock price increases Explanation a.D1 = $3.00(1.07) = $3.21D2 = $3.21(1.07) = $3.43D3 = $3.43(1.07) = $3.68D4 = $3.68(1.07) = $3.93 b. D1 = ($3.00 × 1.07^1) / 1.14^1 = $2.82 D2 = ($3.00 × 1.07^2) / 1.14^2 = $2.64 D3 = ($3.00 × 1.07^3) / 1.14^3 = $2.48 D4 = ($3.00 × 1.07^4) / 1.14^4 = $2.33 Total PV of dividends= $2.82 + 2.64 + 2.48 + 2.33 = $10.27 c. P4= D5 / (Ke − g) = [D0 × (1 + g)^5] / (Ke − g) = ($3 × 1.075) / (0.14 − 0.07) = $60.11 You can also compute P4 using D4: P4= D5 / (Ke − g) = [D4 × (1 + g)] / (Ke − g) = ($3.93 × 1.07) / (0.14 − 0.07) = $60.07 The difference between the two answers is due to rounding. d. PV of Year 4 price= $60.11 / 1.14^4 = $35.59 e. Current stock value= PV of dividends + PV of Year 4 stock price = $10.27 + 35.59 = $45.86 f. P0= D1 / (Ke − g) = $3.21 / (0.14 − 0.07) = $45.86 g. Price= P/E × EPS = (1.1 × 8) × $5.32 = $46.82 h. Difference in prices= $46.82 − 45.86 = $0.96

You are called in as a financial analyst to appraise the bonds of Olsen's Clothing Stores. The $1,000 par value bonds have a quoted annual interest rate of 10 percent, which is paid semiannually. The yield to maturity on the bonds is 10 percent annual interest. There are 15 years to maturity. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. a. Compute the price of the bonds based on semiannual analysis. (Do not round intermediate calculations. Round your final answer to 2 decimal places.) b. With 10 years to maturity, if yield to maturity goes down substantially to 8 percent, what will be the new price of the bonds? (Do not round intermediate calculations. Round your final answer to 2 decimal places.)

a. Bond price: $1,000.00 b. New bond price: $1,135.90 Explanation a. Price= A × ({1 − [1 / (1 + i)^n]} / i) + FV / (1 + i)^n = [(0.10 × $1,000) / 2] × [(1 − {1 / [1 + (0.10 / 2)]^15 × 2}) / (0.10 / 2)] + $1,000 / [1 + (0.10 / 2)]^15 × 2 = $1,000.00 b. Price= A × ({1 − [1 / (1 + i)^n]} / i) + FV / (1 + i)^n = [(0.10 × $1,000) / 2] × [(1 − {1 / [1 + (0.08 / 2)]^10 × 2}) / (0.08 / 2)] + $1,000 / [1 + (0.08 / 2)]^10 × 2 = $1,135.90

Jim Busby calls his broker to inquire about purchasing a bond of Disk Storage Systems. His broker quotes a price of $1,180. Jim is concerned that the bond might be overpriced based on the facts involved. The $1,000 par value bond pays 14 percent interest, and it has 25 years remaining until maturity. The current yield to maturity on similar bonds is 12 percent. a. Compute the new price of the bond. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.) b. Do you think the bond is overpriced?

a. New price of the bond: $1,157.62 b. yes Price= [A × ({1 − [1 / (1 + i)^n]} / i)] + [FV / (1 + i)^n] = [(0.14 × $1,000) × ({1 − [1 / (1.12)^25]} / 0.12)] + [$1,000 / 1.1225] = $1,156.86 b.When the quoted price exceeds your computed price, the bond is overvalued. When the quoted price is less than your computed price, the bond is undervalued.

A firm pays a $1.50 dividend at the end of year one (D1), has a stock price of $155 (P0), and a constant growth rate (g) of 10 percent. a. Compute the required rate of return (Ke). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) Indicate whether each of the following changes will increase or decrease the required rate of return (Ke). (Each question is separate from the others. That is, assume only one variable changes at a time.) No actual numbers are necessary. b. If the dividend payment increases: c. If the expected growth rate increases: d. If the stock price increases:

a. Rate of return: 10.97% b. Dividend yield: Increases Required rate of return: Increases c. Required rate of return: Increases d. Dividend yield: Decreases Required rate of return: Decreases Explanation a. Ke= D1 / P0 + g = $1.50 / $155 + 0.10 = 0.1097, or 10.97%

An increase in the riskiness of a particular security would NOT affect -the risk premium for that security. -the premium for expected inflation. -the total required return for the security. -investors' willingness to buy the security.

the premium for expected inflation.

What is the reward to financial managers who use capital efficiently? -A lower required return -Higher profits -A lower present value -Lower costs

-A lower required return

True/False: The "risk premium" is primarily concerned with business risk, financial risk, and inflation risk.

False

True/False: The drawback of the future stock value procedure is that it does not consider dividend income.

False

True/False: The fact that small businesses are usually illiquid does not affect their valuation process.

False

True/False: The inflation premium is based on past and current inflation levels.

False

True/False: The total required rate of return is equal to the real rate of return plus the inflation premium.

False

True/False: When a bond trades at a discount to par, the yield to maturity on the bond will exceed the required return.

False

The preferred stock of Denver Savings and Loan pays an annual dividend of $5.70. It has a required rate of return of 6 percent. Compute the price of the preferred stock. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Price: $95.00 Explanation Pp= Dp / Kp = $5.70 / 0.06 = $95.00

True/False: The variable growth model is most useful for firms in emerging industries.

True

True/False: Valuation of a common stock with no dividend growth potential is treated in the same manner as preferred stock.

True

True/False: When inflation rises, bond sales prices fall.

True

True/False: When inflation rises, preferred stock prices fall.

True

Justin Cement Company has had the following pattern of earnings per share over the last five years: Year Earnings per Share 20X1 $5.00 20X2 5.30 20X3 5.62 20X4 5.96 20X5 6.32 The earnings per share have grown at a constant rate (on a rounded basis) and will continue to do so in the future. Dividends represent 40 percent of earnings. a. Project earnings and dividends for the next year (20X6). (Round the growth rate to the nearest whole percent. Do not round any other intermediate calculations. Round your answers to 2 decimal places.) b. If the required rate of return (Ke) is 13 percent, what is the anticipated stock price (P0) at the beginning of 20X6? (Round the growth rate to the nearest whole percent. Do not round any other intermediate calculations. Round your answer to 2 decimal places.)

a. 20x6 Earnings: 6.70 Dividend: 2.68 b. Anticipated stock price: $38.28 Explanation a.Earnings growth rate:20X1-20X2: ($5.30 − 5.00) / $5.00 = 0.06, or 6%20X2-20X3: ($5.62 − 5.30) / $5.30 = 0.06, or 6%20X3-20X4: ($5.96 − 5.62) / $5.62 = 0.06, or 6%20X4-20X5: ($6.32 − 5.96) / $5.96 = 0.06, or 6% 20X6 Earnings= 20X5 Earnings × (1 + g) = $6.32 × 1.06 = $6.70 20X6 Dividends= 0.40 × 20X6 Earnings = 0.40 × $6.70 = $2.68 b. P0= D1 / (Ke − g) = $2.68 / (0.13 − 0.06) = $38.28

X-Tech Company issued preferred stock many years ago. It carries a fixed dividend of $12.00 per share. With the passage of time, yields have soared from the original 10 percent to 17 percent (yield is the same as required rate of return). a. What was the original issue price? (Do not round intermediate calculations. Round your answer to 2 decimal places.) b. What is the current value of this preferred stock? (Do not round intermediate calculations. Round your answer to 2 decimal places.) c. If the yield on the Standard & Poor's Preferred Stock Index declines, how will the price of the preferred stock be affected? -The price of preferred stock will increase. -The price of preferred stock will decrease.

a. Original issue price: $120.00 b. Current value: $70.59 c: The price of preferred stock will increase. Explanation a. Original price: Pp= Dp / Kp = $12.00 / 0.10 = $120.00 b. Current value: Pp= Dp / Kp = $12.00 / 0.17 = $70.59 c. The price of preferred stock will increase as yields decline. Since preferred stock is a fixed income security, its price is inversely related to yields as would be true with bond prices. The present value of an income stream has a higher present value as the discount rate declines, and a lower present value as the discount rate increases.

A bond provides an ____________ _____________ which is a stream of interest payments of equal amount for a period of time.

annuity stream

The valuation of a financial asset is based on determining the _____ value of future cash flows. -present -return -market -future

present