FIN3400 Ch 8 SMARTBOOK

A stock just paid an annual dividend of $0.70. The dividend is expected to increase by 10 percent per year for the next three years and by 2 percent per year thereafter. What is the current price at a discount rate of 9 percent?

$12.62 Rationale: P0 = $0.70(1.1)1.09$0.70(1.1)1.09 + $0.70(1.1)21.092$0.70(1.1)21.092 + $0.70(1.1)3+$0.70(1.1)3(1.02)0.09−0.021.093$0.70(1.1)3+$0.70(1.1)3(1.02)0.09-0.021.093 = $12.62

A preferred stock is currently selling for $68 a share. What must be the dividend if the interest rate is 7%?

$4.76 Rationale: Div = P X i

Assume you are computing P0, which is the current price of a stock. What discount factor will you use to discount the dividend in year 3?

(1 + i)^3

Which of these characteristics apply to the New York Stock Exchange (NYSE)? Select all that apply.

-Brokers Rationale: Brokers are floor traders who act as agents and execute trades by matching buy and sell orders. -Specialists Rationale: Specialists operate at trading posts located on a trading floor and manage the trading process for their assigned stocks. -Physical trading floor Rationale: The NYSE has a physical trading floor.

Which of these accurately recaps dividend growth estimations and limitations as they apply to the dividend growth model? Select all that apply.

-Dividends can grow quickly in the short-run but cannot exceed the overall economic growth rate over the long-run. -Dividend growth can be estimated based on historical data, dividend trends, or analyst's forecasts.

Which of these are current trends related to stock trading? Select all that apply.

-Exchanges are relying more on electronic trading and less on open-outcry. Rationale: Electronic trading is replacing open-outcry systems, which may eventually disappear all together. -Exchanges are becoming more global in nature. Rationale: Exchanges are merging across international borders. -International trading of securities is rising. Rationale: International trading of both U. S. and non-U. S. securities is increasing.

Which of these firms are considered to be incorrectly priced? Select all that apply.

-Low growth, high P/E Rationale: These stocks may be overpriced. A low-growth stock should have a low P/E. -High growth, low P/E Rationale: These stocks may be underpriced. A high-growth stock should have a high P/E.

Which of these apply to publicly-issued common stock? Select all that apply.

-Ownership position Rationale: Common stock represents a residual ownership position. -Value determined on the stock exchanges Rationale: The value of publicly-issued stock is determined on the stock exchanges. Stock value depends on the issuer's business success Rationale: The value of a stock is based on the business success of the issuer.

Which of these characteristics apply to the American Stock Exchange but not to NASDAQ? Select all that apply.

-Physical trading floor Rationale: AMEX has a physical trading floor. NASDAQ does not. -One designated market maker overseeing the process for an individual stock on a trading floor Rationale: Instead of one designated market maker overseeing the process for an individual stock on a trading floor, Nasdaq's system uses multiple market makers, or dealers.

Which of these applies to the valuation of a preferred stock? Select all that apply.

-Preferred dividends are assumed to be a constant dollar amount. -Preferred dividend payments are assumed to be infinite.

How can a preferred stock be valued? Select all that apply.

-Preferred stock can be valued using the constant-growth model. Rationale: Preferred stock can be valued using the constant-growth model with a growth rate of zero. -Preferred stock can be valued as a perpetuity, PV = PMT/i Rationale: Preferred stock is a perpetuity. The dividend is the PMT and the discount rate per period is i.

For a two stage variable growth stock, the stock's value is based on which of the following?

-Present value of each dividend during the second growth stage -Present value of each dividend during the first growth stage

Which of these are basic assumptions of a variable growth rate valuation? Select all that apply.

-g2 < i -g1 applies to a designated number of years Rationale: The first growth rate must apply to a limited number of years while the second growth rate applies into infinity. -g1 can be negative, positive, or equal to zero Rationale: If you review the formula, you can see that a positive, negative, or zero stage one growth rate will work. However, g2 must be < i.

A stock has a dividend yield of 1.4 percent. What is the expected return if the growth rate is 4 percent? What if the growth rate is 8 percent?

5.4 percent; 9.4 percent Rationale: Expected return = 1.4% + 4% = 5.4%; Expected return = 1.4% + 8% = 9.4%

A stock has an expected rate of return of 10.6 percent based on a 9 percent rate of growth. What will the expected rate of return be if analysts revise the firm's growth rate to 7.5 percent?

9.1 percent Rationale: Dividend yield = 10.6% - 9% = 1.6%; Expected rate of return = 1.6% + 7.5% = 9.1%

What is the key difference between a floor broker on AMEX and a dealer on NASDAQ?

A dealer buys and sells only from his own inventory while a floor broker executes trades both for himself and others.

Which one of these statements is correct?

A forward P/E is less accurate than a trailing P/E. Rationale: Forward earnings estimates are less accurate than actual past earnings, thus a forward P/E is less accurate than a trailing P/E.

What is the primary disadvantage of a limit order?

A limit order may not execute.

Approximately how much of a decline occurred in the NASDAQ Composite index in the two and a half years following its peak in March of 2000?

Approximately 78 percent Rationale: From March 2000 to October 2002, the NASDAQ Composite lost approximately 78 percent of it value.

Yesterday, Beth placed a limit sell order on ABC stock at $36. The market price ranged from $34.80 to $35.50 yesterday. This morning, ABC opened at $36.50 a share. What is the status of Beth's order?

Beth sold her shares for $36.50, which illustrates an advantage of limit orders.

Which one of these is true?

Both the S&P 500 and the NASDAQ Composite indexes are based on market capitalization. Rationale: Both the S&P 500 and the NASDAQ Composite are based on market capitalization. Market capitalization equals the stock price times the number of shares outstanding.

Assume an industry is growing at an average rate of 3.2 percent annually. Given four companies in this industry and their rates of growth, which company's stock would be classified as a growth stock?

Company A; 3.5 percent

Which of the following are two of the four key factors listed in the textbook that affect the value of a stock?

Current market interest rates and overall stock market conditions

A stock quote shows a P/E of 18. How is the ratio defined?

Current stock price/Last four quarters of earnings

If you purchase shares of stock on NASDAQ, who is the most likely seller of those shares?

Dealer

Assume a preferred stock pays a constant annual dividend. Which of these is a correct computation of the dividend yield? Select all that apply.

Dividend yield = D/P0 Dividend yield = D0/P0 Dividend yield = D1/P0

Which one of these is the oldest stock index?

Dow Jones Industrial Average (DJIA)

In a stock valuation formula, what does the symbol D1 represent?

Estimated dividend in time period 1, or next year's dividend when solving for the current price

True or false: A growth stock is considered to be a bargain stock.

False Rationale: A value stock is considered to be a bargain stock.

True or false: A dealer will buy stock from an investor at the ask price.

False Rationale: Dealers buy at the bid and sell at the ask. Investors buy at the ask and sell at the bid.

True or false: The value of a firm as measured by its market capitalization is solely dependent upon the market value of the firm's stock.

False Rationale: Market capitalization depends on both the market price per share and the number of shares outstanding.

What is the basic assumption of the constant-growth model?

If the dividend amount changes each year, it does so by a constant percentage.

Which one of the following characteristics most applies to a discount brokerage firm?

Investors place trades on the firm's Internet site

How is the dividend yield on a constant-dividend preferred stock defined?

Last four quarters of dividend income/Current stock price

Which of these is the key service provided by stock exchanges that attracts investors?

Liquidity

Which of these indicates a value stock?

Low P/E, high growth

Which one of the following is the key financial market feature that must be present if investors are to be attracted to equity securities?

Market liquidity

Marcos owns 1,500 shares of ABC stock which he purchased at $44 a share. The stock has been steadily decreasing in value and he wants to cut his losses now as he expects the stock price to decline further. Which type of order should Marcos place?

Market sell order for 1,500 shares Rationale: Marcos wants to sell, not buy.

Which one of these is a factor that has minimum requirements which a firm must meet to be listed on the NYSE?

Number of stockholders

A stock just paid an annual dividend of $1.10. The dividend is expected to increase by 10 percent per year for the next two years and then increase by 2 percent per year thereafter. The discount rate is 14 percent. Which of these correctly computes the current stock price?

P0 = $1.10(1.1)1.14$1.10(1.1)1.14 + $1.10(1.1)2+$1.10(1.1)2(1.02)0.14−0.021.142

A stock is expected to pay a dividend of $1.42 next year and increase that amount by 3 percent annually thereafter. The discount rate is 12 percent. How do you compute the current price?

P0 = $1.42/(0.12 - 0.03)

A firm just paid its annual dividend of $1.80 and expects to increase that dividend each year. The discount rate is 11 percent. Which one of these correctly identifies an error when computing the current value of this firm's stock?

P0 = $1.80/(0.11 - 0.025); The value of D1 is incorrect as $1.80 equals D0.

A firm just paid its annual dividend of $1.80 and expects to increase that dividend each year. The discount rate is 11%. Which one of these correctly identifies an error when computing the current value of this firm's stock?

P0 = $2.02/(0.11 - 0.12); The growth rate exceeds it limitation for using this formula.

A stock is expected to pay a dividend of $2 in year 2, $3 in year 3, and sell for $40 at the end of year 3. The discount rate is 11 percent. Which one of these is the correct formula for computing the current stock price?

P0 = $2/1.11^2 + [($3 + $40)/1.11^3]

A stock just paid its annual dividend of $1.20. Future dividends are expected to increase by 2 percent annually and the discount rate is 9 percent. Which of these is the correct formula for computing the current stock price?

P0 = ($1.20 × 1.02)/(0.09 - 0.02)

A stock is expected to pay annual dividends of $1.20 and sell for $42.60 three years from today. Which of these is the correct formula for computing the value of the stock today if the discount rate is 9 percent?

P0 = ($1.20/1.09) + ($1.20/1.09^2) + [($1.20 + $42.60)/1.09^3]

A firm just paid an annual dividend of $1.40 and increases that dividend by 2 percent each year. How do you find the price of the firm's stock at year 4 if the discount rate is 13 percent?

P4 = ($1.40 × 1.02^5)/(0.13 - 0.02)

The overall rate of growth for a firm and its industry is 3.5 percent. Which of these combinations of dividend growth rates are acceptable when computing the current value of the firm's stock?

Short-run growth = 15 percent; Long-run growth = 3 percent

What is the definition of a growth stock?

Stock of a company with above-average rates of increases in revenues, earnings, and/or dividends

Which one of these best summarizes stock valuation?

Stock valuation is an estimate of a stock's value given a certain set of assumptions.

Which one of these statements is correct?

The DJIA, S&P 500, and NASDAQ Composite tend to be positively related. Rationale: All three indexes tend to move in the same general direction, although by different amounts.

The textbook lists four key factors that affect the market value of a firm's common stock. Which of these is one of those four factors?

The company's future growth prospects

What does it mean when a P/E is designated as a trailing P/E?

The earnings used in the P/E calculation were for the past four quarters.

What is the disadvantage of a market order?

The execution price is unknown in advance.

Yesterday, Trevor placed a limit buy order at a price of $35 on 100 shares of ABC stock. Since the order was placed, the market price of ABC stock has ranged from $35.10 to $36.30 a share. What is the status of Trevor's order?

The order has not executed.

You own 500 shares of ABC stock. The stock has been declining in price and is now selling for $30 a share. You decide to sell all your shares and place a limit sell order at a price of $30 a share. When you order reaches the trading desk, the market price has declined to $29 a share. The next day the price falls to $18 a share. What is the status of your order?

The order has not executed. You still own 500 shares. Rationale: Your limit order has not executed. It will not execute unless the price increases to $30 or more.

Just before the market closes, ABC stock is selling for $43 a share, so you place a market sell order for 300 shares. The order reaches the trading floor after the market closes for the day. The next morning, ABC stock opens at a price of $28 a share. What happens to your order?

The order is executed at a price of $28 a share. Rationale: This illustrates the disadvantage of a market order.

Which one of these is an advantage of a market order?

The order will execute immediately.

What is the key advantage of a limit order?

The order will only execute at the limit price or better.

Which one of these is the primary basis for a stock's value?

The profitability and success of the issuer

A preferred stock is currently selling for $68 a share. What will happen to the stock price if market interest rates increase?

The stock price will decrease.

Why do you have to use the dividend at time n + 1 to compute the terminal price in the two-stage growth valuation model?

The terminal price is the time n price. The dividend used to compute a price must always be one time period ahead of the price.

A young firm has a P/E of 36 as compared to its industry average P/E of 21. Which one of these is the best explanation for the firm's higher P/E?

The young firm may be expected to grow faster than its industry.

What is the purpose of the terminal price that is used in conjunction with a variable-growth rate stock valuation formula?

To replace all of the dividends paid in stage 2

Which one of these is most apt to disappear as a part of the stock trading process if current trends continue?

Trading posts Rationale: Trading posts are an integral part of floor trading. If floor trading continues to be replaced by electronic trading, then trading posts will disappear.

True or false: Stock valuation can really only be meaningfully viewed from a long-term perspective.

True

Which of these is a limitation that applies to the constant-growth dividend model?

g < i

A stock just paid an annual dividend of $0.40 per share. The firm expects to increase the dividend by 20 percent per year for the next four years and 3 percent per year thereafter. The discount rate is 11 percent. Which one of these is correct regarding the two-stage growth formula?

g2 = 0.03

Which of the following are expressions of value of a company's underlying success?

growth dividends large residual cash flows

A stock just announced that its next annual dividend will be $1.02 and it expects to increase that dividend by 2.5 percent annually. The stock is currently selling for $28 a share. How do you compute the expected rate of return?

i = ($1.02/$28) + 0.025

Lew's increases its annual dividend by 2 percent annually. The last dividend paid was $1.42 and the stock price is $46. How is the expected rate of return computed?

i = [($1.42 × 1.02)/$46] + 0.02