Fin 334 Ch. 8
10) Which of the following are key inputs to determining the value of an asset? I. the required rate of return II. future cash flows III. current stock price IV. timing of future cash flows A) I and II only B) I and III only C) I, II and IV only D) II, III and IV only
Answer: C
12) GLOO stock's P/E ratio is 45 at a time when the market's P/E ratio is 15. GLOO's realtive P/E ratio is A) 30. B) -30. C) 3. D) .33.
Answer: C
11) The major forces behind earnings per share are A) return on assets and book value. B) return on assets and total asset turnover. C) return on equity and the equity multiplier. D) return on equity and book value.
Answer: D
9) The rate of dividend growth can be estimated by multiplying the return on equity rate by the dividend payout ratio.
Answer: FALSE
the lower the dividend payout, the higher the P/E 8.2 Learning Goal 2 1) A relative P/E ratio greater than 1 indicates that a company may be undervalued.
Answer: FALSE
11) High P/E ratios can be expected when investors expect A) a high rate of growth in earnings. B) low earnings. relative to market prices. C) high interest rates. D) a bear market.
Answer: A
12) The dividends-and-earnings (D&E) approach to stock valuation and the variable-growth DVM approach are similar in that both approaches A) are present-value based. B) consider dividends only and ignore the future selling price of the stock. C) consider the future selling price of the stock but ignore future dividends. D) use the historical dividend growth rate as the key input figure.
Answer: A
14) Stephanie is an investor who believes that the real key to a company's future stock price lies in its future earnings. When investing in a company, she carefully studies its future earnings potential, and sells a company's stock at the first sign of any trouble. This information indicates that Della would correctly be classified as A) a growth investor. B) a value investor. C) a buy-and-hold investor. D) an index investor.
Answer: A
20) When using the constant-growth dividend valuation model, which of the following will lower the value of the stock? A) An increase in the required rate of return. B) A decrease in the required rate of return. C) An increase in the dividend payout ratio. D) An increase in the growth rate of the dividends.
Answer: A
23) ABC Company stock currently has a market value equivalent to its intrinsic value. Marco perceives that ABC Company is increasing its level of risk and therefore Marco increases his required rate of return on ABC stock. This change in the required rate of return A) will reduce the intrinsic value of ABC stock to Marco. B) will increase the intrinsic value of ABC stock to Marco. C) will change the intrinsic value but the direction of the change cannot be determined. D) is a signal to Marco that he should buy more ABC Company stock.
Answer: A
24) In applying the variable-growth dividend valuation model to a company's stock, analysts frequently define the growth rate, g, as equal to A) ROE multiplied by the firm's retention rate. B) ROE divided by the dividend payout ratio. C) the dividend payout ratio multiplied by the firm's retention rate. D) P/E multiplied by the dividend payout ratio.
Answer: A
28) In general, the higher the retention ratio A) the higher the future growth rate of the company. B) the higher the dividends per share of common stock. C) the higher the future debt-equity ratio. D) the lower the future book value per share.
Answer: A
29) Martin's Inc. is expected to pay annual dividends of $2.50 a share for the next three years. After that, dividends are expected to increase by 3% annually. What is the current value of this stock to you if you require a 9% rate of return on this investment? A) $39.47 B) $40.11 C) $41.81 D) $42.92
Answer: A
5) The price-to-cash-flow method of stock valuation generally A) uses EBITDA as the cash flow value. B) relies on historical cash flows. C) produces a cash flow multiple that is greater than the P/E multiple. D) applies the P/E multiple to the cash flow per share value.
Answer: A
6) P/E ratios could rise even as earnings fall if A) earnings fall at a faster rate than stock prices. B) earnings fall at a slower rate than stock prices. C) investors expect lower stock prices to be permanent. D) investors expect lower earnings to be permanent.
Answer: A
7) The intrinsic value of a stock provides a purchase price for the stock A) that is reasonable given the associated level of risk. B) which will assuredly yield the anticipated capital gain. C) which will guarantee the expected rate of return. D) that is always below the market value but yet yields the expected rate of return.
Answer: A
8) The risk-free rate of return is 4.2 percent, the expected market return is 9 percent, and the beta for Lea, Inc. is 1.12. What is Lea's required rate of return? A) 9.58% B) 10.08% C) 13.70% D) 14.28%
Answer: A
8) The value of a stock is a function of A) future returns. B) historic dividend growth rate. C) most recent earnings per share. D) past returns.
Answer: A
10) Which of the following contributes to high P/E ratios A) High dividend payout ratios B) High rate of earnings growth C) Periods of high inflation D) High debt ratios
Answer: B
11) In the price/earnings approach to stock valuation, A) historical stock prices are utilized. B) forecasted EPS are typically used. C) the P/E ratio is computed by multiplying the stock price by the earnings per share. D) the market P/E ratio, adjusted by beta, is used to value individual stocks.
Answer: B
12) An investor should purchase a stock when A) the market price exceeds the intrinsic value. B) the expected rate of return equals or exceeds the required return. C) the capital gains rate is less than the required return and no dividends are paid. D) the market price is greater than the justified price.
Answer: B
12) Lindell, Inc. has 8% , $100 par value preferred stock outstanding. To earn 12% on an investment in this stock, you need to purchase the shares at a per share price of A) $9.60. B) $66.67. C) $96.00. D) $150.00.
Answer: B
13) Which one of the following is a correct equation to calculate earnings per share? A) (ROA)(book value per share) B) (profit margin)(total asset turnover)(equity multiplier)(book value per share) C) (profit margin)(equity multiplier)(book value per share) D) (profit margin)(book value per share)
Answer: B
15) According to the price/earnings approach to stock valuation, if the dividend growth rate is expected to drop or if the required return goes up, the net effect is a A) higher P/E ratio. B) lower P/E ratio. C) higher stock price. D) higher retention rate.
Answer: B
17) The common stock of Jennifer's Furniture Outlet is currently selling at $32.60 a share. The company adheres to a 60% dividend payout ratio and has a P/E ratio of 19. There are 21,000 shares of stock outstanding. What is the amount of the annual net income for the firm? A) $21,619 B) $36,032 C) $48,327 D) $60,053
Answer: B
27) The variable-growth dividend valuation model A) develops the value of a stock using the future value of dividends minus a rate of capital gain growth. B) is valuable because it accounts for the general growth patterns of most companies. C) is invalid if at any point in time the growth rate exceeds the required rate of return. D) assumes the rate of dividend growth will vary indefinitely.
Answer: B
8) Zephyr Inc. sells wind based systems for generating electricity. The company pays no dividends, but you estimate the stock will be worth $50 per share 5 years from now and you require a 15% rate of return for stock investments of this type. What price should you be willing to pay for this stock? A) $12.50 B) $24.86 C) $43.48 D) $57.50
Answer: B
9) If the market multiple is 23.0 and the P/E ratio of a company is 27.4, then the stock's relative P/E is A) 0.84. B) 1.19. C) 3.21. D) 4.40.
Answer: B
9) Ivonne has bought shares of RIO, Inc. stock for $25.00 per share. She expects a 1.00 dividend at the end of this year. After 2 years, she expects to receive a dividend of $1.25 and to sell the stock for $28.75. What is Ivonne's required rate of return? A) 4.0% B) 11.6% C) 15.2% D) 24.0%
Answer: B
10) The current annual sales of Flower Bud, Inc. are $178,000. Sales are expected to increase by 4% next year. The company has a net profit margin of 5% which is expected to remain constant for the next couple of years. There are 10,000 shares of common stock outstanding. The market multiple is 16.4 and the relative P/E of the firm is 1.21. What is the expected market price per share of common stock for next year? A) $15.18 B) $17.66 C) $18.37 D) $19.29
Answer: C
13) Which of the following approaches to stock valuation is not based on a multiple of some figure from the financial statements? A) the price to cash flow approach B) the price to sales approach C) the dividends-and-earnings approach D) the price to earnings approach
Answer: C
14) A company that wants to maintain both a constant growth rate in dividends and a constant payout ratio will have to A) grow earnings faster than dividends. B) increase assets at the same rate as dividends. C) grow earnings at the same rate as dividends. D) increase stockholders' equity at the same rate as dividends.
Answer: C
14) The Highlight Company has a book value of $56.50 per share, and is currently trading at a price of $59.00 per share. You are interested in investing in Highlight, and have just used a present-value based stock valuation model to calculate a present (intrinsic) value of $55.00 per share for Highlight's stock. Assuming that your calculations are correct you should A) buy the stock, because the current market price per share is higher than the present value. B) buy the stock, because the book value per share is greater than the present value. C) not buy the stock, because the present value is less than the market price per share. D) buy the stock, because the book value and the current trading price are very close to one another in value.
Answer: C
14) Which one of the following is is most likely to increase the price of a stock? A) rapid growth in sales. B) rapid growth in dividends. C) rapid growth in earnings. D) rapid increases in bond interest rates.
Answer: C
15) Michelak's Maritime Industries has relatively stable earnings and pays an annual dividend of $2.50 per share. This dividend has remained constant over the past few years and is expected to remain constant for some time to come. If you want to earn 12% on an investment in the common stock of Michelak's, how much should you pay to purchase each share of stock? A) $12.50 B) $18.88 C) $20.83 D) $25.00
Answer: C
16) Markhem Enterprises is expected to earn $1.34 per share this year. The company has a dividend payout ratio of 40% and a P/E ratio of 18. What should one share of common stock in Markhem Enterprises be selling for in the market? A) $9.65 B) $14.47 C) $24.12 D) $33.77
Answer: C
18) What is the required rate of return on a common stock that is expected to pay a $0.75 annual dividend next year if dividends are expected to grow at 2 percent annually and the current stock price is $8.59? A) 8.73% B) 8.91% C) 10.73% D) 11.38%
Answer: C
19) The constant-growth dividend valuation model is best suited for use with A) stocks of new or emerging companies. B) small-cap stocks within growing industries. C) the stocks of mature, dividend-paying companies. D) the stocks of cyclical companies.
Answer: C
21) Newton, Inc. just paid an annual dividend of $0.95 . Their dividends are expected to increase by 4% annually. Newton Company stock is selling for $11.54 a share. What is the capitalization rate on this stock? A) 8.23% B) 12.2% C) 12.6% D) 13.9%
Answer: C
26) Which of the following statements concerning the constant-growth dividend valuation model is (are) correct? I. One simple method of estimating the dividend growth rate is to analyze the historical pattern of dividends. II. The expected total return equals the return from capital gains plus the return from dividends paid. III. The model is applicable to growth firms with initially high growth rates. IV. The intrinsic value calculated using this method can change from one investor to another if their risk-return payoffs differ. A) I and IV only B) II and III only C) I, II, and IV only D) I, II and III only
Answer: C
30) One common method of estimating the growth rate of dividends is to A) randomly assign an annual growth rate of 4% to the latest dividend amount. B) multiply the return on assets by the dividend payout ratio. C) multiply the return on equity by the firm's retention rate. D) multiply the return on equity by the dividend payout ratio.
Answer: C
6) For which one of the following situations will the price to sales valuation model work but the dividend and cash flow models will not? A) mature firm with minimal growth opportunities B) water-powered electric utility company C) newly-formed biotechnology company with negative earnings D) top-performing firm in a mature industry
Answer: C
6) Which of the following statements concerning the dividends-and-earnings (D&E) approach to stock valuation are true? I. The D&E valuation method works just as well for non-dividend paying stocks as it does for dividend-paying stocks. II. The current value of a stock using the D&E method is equal to the expected selling price of the stock plus the present value of the future dividends. III. The D&E approach considers earnings per share and the price/earnings ratio. IV. The D&E considers a finite investment period. A) I and II only B) III and IV only C) I, III and IV only D) I, II and III only
Answer: C
7) EBITDA is an acronym for A) Earnings Based Information, Total Development Approach. B) Ernst, Bostwick, Davenport, Innes Approach. C) Earnings Before Interest, Taxes, Depreciation, and Amortization. D) Earnings Before Interest, Taxes, Dividends, and Asset replacement.
Answer: C
7) Even if a company does not officially follow a fixed-dividend policy, dividend payments are A) extremely difficult to predict. B) very volatile and subject to economic conditions. C) fairly stable from one time period to another. D) directly tied to a company's P/E ratio.
Answer: C
7) The single most important issue in the stock valuation process is a company's A) past earnings record. B) historic dividend growth rate. C) expected future returns. D) capital structure.
Answer: C
7) The single most important variable in the dividends-and-earnings approach is the A) rate of growth. B) applicable beta. C) appropriate P/E multiple. D) amount of the future dividends.
Answer: C
GHI 1.2 , 13%, and JKL 2, 22%. Which of these stocks should not be purchased? A) ABC B) DEF C) GHI D) JKL
Answer: C
10) An internal rate of return (IRR) is the discount rate that A) represents the minimal rate required to create a positive net present value. B) is the minimal rate of return an investor will accept. C) provides an investor with their required return. D) produces a present value of future benefits equal to the market price of a stock.
Answer: D
11) The subjective approach to determining a required rate of return for a stock includes I. the rate of return on a long-term bond. II. a risk premium for the perceived business risk of the asset. III. a risk premium for assuming the risk of the market. IV. the desired rate of return of the individual investor. A) I and III only B) II and IV only C) I, II and IV only D) I, II and III only
Answer: D
11) Which of the following characteristics appeal to so-called value investors? I. high P/E ratios. II. low debt to equity ratios III. high cash flow relative to price IV. high book value relative to market price. A) I and II only B) I and III only C) I, II and IV only D) II, III and IV only
Answer: D
12) Which of the following will most directly influence a company's market value? A) The state of the economy. B) The book value of its assets. C) The use of financial leverage. D) Its future cash flows.
Answer: D
13) James is willing to settle for a 10% rate of return on EG stock at a time when investors, on average, are requiring an 11% rate of return on the same stock. Which of the following will happen? A) James will be have to pay more for the stock than he was willing to pay. B) Investors with different required rates of return will pay different prices for the stock. C) James will not be able to buy the stock unless the price changes. D) James will be happy to buy the stock for less than he was willing to pay.
Answer: D
13) William is the type of stock market investor who focuses on factors such as a company's book value, debt load, return on equity, and cash flow. In searching for stock investments, he looks at a company's historical performance and attempts to find undervalued stocks. This information indicates that Sam is the type of investor known as A) a growth investor. B) a premium investor. C) an earnings investor. D) a value investor.
Answer: D
15) Over the last year, a firm's earnings per share increased from $1.20 to $1.40, its dividends per share increased from $0.50 to $0.60, and its share price increased from $21 to $24. The firm maintained a relative P/E of 1.10 over the entire time period. Given this information, it follows that the A) stock experienced an increase in its P/E ratio. B) company had a decrease in its dividend payout ratio. C) current P/E of the overall market is 26.4. D) overall market P/E is declining.
Answer: D
16) Winifred, Inc. paid $1.64 as an annual dividend per share last year. The company is expected to increase their annual dividends by 3% each year. How much should you pay to purchase one share of this stock if you require a 9% rate of return on this investment? A) $18.22 B) $18.77 C) $27.33 D) $28.15
Answer: D
17) One stock valuation model holds that the value of a share of stock is a function of its future dividends, and that the dividends will increase at an annual rate which will remain unchanged over time. This stock valuation model is known as the A) approximate yield model. B) holding period return model. C) dividend reinvestment model. D) constant growth dividend valuation model.
Answer: D
22) The Frisco Company just paid $2.20 as its annual dividend. The dividends have been increasing at a rate of 4% annually and this trend is expected to continue. The stock is currently selling for $63.60 a share. What is the rate of return on this stock? A) 3.46% B) 3.60% C) 7.46% D) 7.60%
Answer: D
25) A company has an annual dividend growth rate of 5% and a retention rate of 40%. The company's dividend payout ratio is A) 35%. B) 40%. C) 45%. D) 60%.
Answer: D
5) The Merry Co. has current annual sales of $350,000 and a net profit margin of 6%. Sales are expected to increase by 5% annually while the profit margin is expected to remain constant. What is the projected after-tax earnings for two years from now? A) $19,294 B) $22,050 C) $23,100 D) $23,153
Answer: D
8) A firm with a price to sales ratio of 1 would usually be considered A) overvalued. B) correctly valued. C) near bankruptcy. D) undervalued.
Answer: D
8) Whisper numbers are A) officially published forecast numbers provided by company management. B) the official released estimates prepared by financial analysts. C) generally less accurate than the released estimates by analysts. D) generally higher than the released analysts' forecasts.
Answer: D
9) Which of the following variables affect the P/E ratio? I. capital structure of a firm II. amount of dividends paid III. inflation rate IV. earnings rate of growth A) I, II and III only B) I, II and IV only C) I, III and IV only D) I, II, III and IV
Answer: D
15) Explain how the time value of money concept is used in stock valuation. Answer: The intrinsic value of a stock is based on the current discounted value of all future dividends plus the discounted value of the sale price of the stock at a future point in time. 8.4 Learning Goal 4 1) Overall, professional analysts have an outstanding record of predicting changes in market direction before they happen.
Answer: FALSE
2) As a company's beta rises, the required return on the stock should fall, all other things being equal.
Answer: FALSE
2) The P/E approach is too complicated to be widely used in practice.
Answer: FALSE
3) Companies with high P/E ratios tend to also have high dividend payout ratios.
Answer: FALSE
3) If the annual dividend on a stock never changes, its price will never change.
Answer: FALSE
4) A temporary decline in earnings per share usually results in a temporary reduction of dividends.
Answer: FALSE
4) Generally speaking, the higher the Price-to-Sales ratio, the better.
Answer: FALSE
4) The greater the perceived risk of an asset, the lower the expected rate of return.
Answer: FALSE
5) Most stocks trade at five to seven times their book values.
Answer: FALSE
5) The dividend valuation model estimates the value of a share of stock as the future value of all dividends.
Answer: FALSE
6) One of the easiest aspects of the dividend valuation model (DVM) is specifying the appropriate growth rate for a firm's dividends over time.
Answer: FALSE
9) Tureves S.A. is a French biotechnology company that has developed promising therapies for hair loss, obesity, and wrinkled skin. Sales have doubled in each of the last three years, but so far, the company has yet to turn a profit. Which common procedures would be most, and least appropriate to value Tureves' ADRs.
Answer: Such a speculative company would be extremely difficult to value, but price-to-sales would be the best method, and price-to-cash-flow might be of some help. Since there are no dividends or earnings, dividend valuation and price to earnings methods would not be helpful.
1) The primary reason an investor should look at the past performance of a company is to gain insight into the future direction and profitability of the firm.
Answer: TRUE
10) The rate of growth can exceed the required return during the variable-growth period without invalidating the variable growth dividend valuation model.
Answer: TRUE
16) How can you determine the current value of a non-dividend paying stock? Answer: There are several methods you can use such as the dividends-and-earnings approach, price/earnings approach, price to cash flow, price to sales, or the price to book ratio method. 8.6 Learning Goal 6 1) The constant growth dividend valuation model works best for mature companies with a long record of paying dividends.
Answer: TRUE
2) If net income rises, but the number of shares outstanding remains the same, EPS will rise.
Answer: TRUE
2) Neither the P/E approach nor the dividends-and-earnings approach rely on dividends as the key input into the valuation of a stock.
Answer: TRUE
2) The approach to stock valuation which holds that the value of a share of stock is a function of its future dividends is known as the dividend valuation model (DVM).
Answer: TRUE
2) The key to the future behavior of a company lies in the sales growth and the net profit margin.
Answer: TRUE
3) A drawback to the Price- to- Cash-Flow method of valuation is that there is no generally accepted cash flow measure.
Answer: TRUE
3) The common-size income statement expresses every item on the income statement as a percentage of sales.
Answer: TRUE
3) There is no assurance that the actual rate of return on an asset will be similar to the projected rate of return.
Answer: TRUE
3) When an investor multiplies future estimated earnings per share by a price/earnings ratio to compute the value of a stock that investor is using the price/earnings approach to valuation.
Answer: TRUE
31) WaterCo is a manufacturer of boat parts and has been in business only a few years. Its board of directors decided to start paying a dividend to help boost the attractiveness of its stock. The dividend will be $0.50 per share next year. After that dividends will increase by 4 percent per year. The company has a beta of 1.6. The market rate of return is 8% and the T-bill rate is 3%. Should you purchase shares in this firm at the current market price of $6.98 per share? Answer: Required rate of return = 3% + [1.6 (8% - 3%)] = 3% + [1.6 (5%)] = 11.0% The value of a share using the constant growth dividend valuation model = $0.50/(0.11 - 0.04) = $7.14. Yes, you should buy the stock as it is currently priced at $6.98 per share while the intrinsic value is $7.14 per share. 32) The common stock of Peachtree Paper, Inc., is currently selling for $40 a share. A dividend of $2.00 per share was just paid. You are estimating that this dividend will grow at a constant rate of 10%. (a) Using the constant growth DVM model, what is your required rate of return if $40 is a reasonable trading price? (Show all work.) (b) If Peachtree Papers is a new company that produces a relatively unknown product, is the constant growth model a good valuation method for a potential investor to use? Justify your answer. Answer: (a) Required rate of return r = [$2.00(1.10)/$40] + 0.10 r = 15.50% (b) No, it is not. The constant growth DVM is suited only for mature companies with strong track records. It is unlikely that the firm can continue increasing their dividends by 10% annually over the long term. 8.5 Learning Goal 5 1) A stock's internal rate of return (IRR) is the discount rate that cause the present value of future dividends to equal the price of the stock.
Answer: TRUE
4) High price/sales multiples go with high profit margins.
Answer: TRUE
4) Higher rates of growth and lower debt levels contribute to higher P/E ratios.
Answer: TRUE
4) The dividend valuation model (DVM) is very sensitive to the growth rate (g) being used, because it affects both the model's numerator and its denominator.
Answer: TRUE
5) The price of a stock with a low relative P/E will tend to be more volatile than the price of a stock with a high relative P/E.
Answer: TRUE
5) The required rate of return denotes the minimum rate of return an investor should expect.
Answer: TRUE
6) The estimated price of a stock in the future is important because it includes the projected capital gain on the stock.
Answer: TRUE
6) The intrinsic value of an asset equals the present value of all future cash flows at a given discount rate.
Answer: TRUE
7) The intrinsic value of a zero-growth stock is simply the capitalized value of its annual dividends.
Answer: TRUE
8) One method of estimating the dividend growth rate is to calculate the discount rate that equates today's dividend with the dividend paid ten years ago.
Answer: TRUE
8.3 Learning Goal 3 1) Risk is brought into the stock valuation process through the required rate of return.
Answer: TRUE
