Intermediate Finance, Chapter 6

A market participant who buys and sells securities from inventory is called a:

Dealer

According to finance professionals, which one of these factors has the biggest impact on a firm's PE ratio?

Growth opportunities

What is the primary role of a designated market maker (DMM)?

Providing a two-sided market

A stock that pays a constant annual dividend will have a market price that:

decreases when the market rate of return increases

The EV/EBITDA ratio has an advantage over the PE ratio in situations where comparisons are being made of firms that vary based on their:

degree of leverage

What is the maximum price an investor should pay for the common stock of a firm that has no growth opportunities but pays an annual dividend of $1.85? The market rate of return on similar securities is 14.5 percent.

$1.85/.145 = $12.76

Differential growth refers to a firm that increases its dividend by:

varying rates over a period of time

Which one of the following transactions occurs in the primary market

D. Initial sale of JKL stock by JKL to Jamie

Electronic communications networks (ECNs

D. act to increase liquidity in the financial markets.

The owner of preferred stock

D. is entitled to a distribution of income prior to the common shareholders.

Ernst Electrical increases its annual dividend by 2.2 percent annually. The stock commands a market rate of return of 15 percent and sells for $26.60 a share. What is the expected amount of the next dividend?

$26.60 = D1/(.15 - .022) D1 = Answer $3.40

Wislow Brothers common stock sells for $28.20 a share and pays an annual dividend that increases by 1.5 percent annually. The market rate of return on this stock is 11.3 percent. What is the amount of the last dividend paid

$28.20 = (D0 × 1.015)/(.113 - .015) D0 = Answer $2.72

Shares of ABBO stock are currently selling for $29.06 a share. The last annual dividend paid was $1.50 a share and dividends increase at a constant rate. If the market rate of return is 10 percent, what is the dividend growth rate?

$29.06 = [$1.50 × (1 + g)]/(.10 - g) g = Answer .0460, or 4.60%

In a liquidation, the owners of 6 percent preferred stock are generally entitled to a liquidation payment of _____ a share as long as there is sufficient funds available

100

Which one of the following statements concerning dealers and brokers in the financial markets is correct?

A. A broker never assumes ownership of the securities being traded.

What is the primary business of the NYSE

Attract and process order flow

A stock report contains the following information: P/E 21.4, closing price 28.16, dividend 1.10, net chg .06, and an ask of 28.22 × 300. Which one of the following statements is correct given this information?

B. The closing price on the previous trading day was $28.10.

Greener Grass Co. pays a constant annual dividend of $1 a share and has 1,000 shares of common stock outstanding. The company:

B. must still declare each dividend before it becomes an actual company liability.

The Yarn Outlet has net income of $42,000 for the year with 12,000 shares of stock outstanding. Big Knitter is a similar firm with similar growth opportunities and it has 7,000 shares of stock outstanding with a market price of $13.30 a share and earnings per share of $.95. What is the estimated value of the Yarn Outlet?

Big Tree PE = $13.30/$.95 = 14 Tall Tree Timber estimated value = 14 × $42,000 = $588,000

Tall Tree Timber has net income of $167,000 for the year with 60,000 shares of stock outstanding. Big Trees is a similar firm with similar growth opportunities and it has 75,000 shares of stock outstanding with a market price of $32.20 a share and earnings per share of $1.60. What is the estimated value of Tall Tree Timber?

Big Tree PE = $32.20/$1.60 = 20.125 Tall Tree Timber estimated value = 20.125 × $167,000 = $3,360,875

In a stock market report, the open price represents the

C. first trade of the day.

The rate at which a stock's price is expected to appreciate (or depreciate) is called the _____ yield.

Capitol gains

Which one of these represents the portion of a stock's rate of return that is attributable to the growth rate of the dividends?

Capitol gains yield

Lester's Diner just paid an annual dividend of $.24 a share and plans on increasing this amount by 2 percent annually. What is the expected dividend for Year 6?

D6 = $.24 (1.02)6 = Answer $.27

Janlea Co. had total net earnings of $127,000 this past year and paid out 30 percent of those earnings in dividends. There are 100,000 shares of stock outstanding at a current market price of $11.62 a share. If the dividend growth rate is 5.6 percent, what is the required rate of return?

Dividend per share = (.3 × $127,000)/100,000 = $.381 R = $.381/$11.62 + .056 = .0888, or 8.88%

Shares of a common stock offer an expected total return of 12 percent. What is the dividend yield if the dividend increases by 3 percent annually?

Dividend yield = 12% - 3% = Answer 9%

Corporate dividends:

E. are taxed at the personal level even though they are paid from aftertax income.

NASDAQ has which one of these features?

Multiple market maker system

Duncan Street Mills is an all-equity firm with 28,000 shares of stock outstanding. The firm expects sales of $400,000 next year. Sales are expected to grow by 5 percent for the following two years and then level off to a constant 3 percent growth rate. Net cash flow varies in direct proportion to sales and is currently equal to 15 percent of sales. The required return for this firm is 16 percent. What is the estimated current value of one share of stock?

Net cash flowYear 1 = .15 × $400,000 = $60,000 Terminal valueYear 3 = ($60,000 × 1.052 × 1.03)/(.16 - .03) = $524,111.54 Total firm value = $60,000/1.16 + ($60,000 × 1.05)/1.162 + [($60,000 × 1.052) + $524,111.54]/1.163 = $476,698.99 Price per share = $476,698.99/28,000 = Answer $17.02

Hanover Inc. is an all-equity firm with 35,000 shares of stock outstanding. The firm expects sales of $750,000 next year. Sales are expected to grow by 10 percent the following year and then level off to a constant 4 percent growth rate. Net cash flow varies in direct proportion to sales and is currently equal to 17 percent of sales. The required return for this firm is 14 percent. What is the estimated current value of one share of stock?

Net cash flowYear 1 = .17 × $750,000 = $127,500 Terminal valueYear 2 = ($127,500 × 1.10 × 1.04)/(.14 - .04) = $1,458,600 Current firm value = $127,500/1.14 + [($127,500 × 1.10) + $1,458,600]/1.142 = $1,342,105.26 Price per share = $1,342,105.26/35,000 = $38.35

Poplar Trees Inc. has 65,000 shares of stock outstanding and each share receives one vote for each open seat on the board of directors. There are five open seats at this time. How many shares must you own if the firm uses straight voting to guarantee your personal election to the board?

Number of shares required = (.5 × 65,000) + 1 = 32,501 shares

Denver Machinery has 234,000 shares of stock outstanding and each share receives one vote for each open seat on the board of directors. There are three open seats at this time. How many shares must you own if the firm uses cumulative voting to guarantee your personal election to the board?

Number of shares required = [234,000/(3 + 1)] + 1 = 58,501 shares

A securities market primarily comprised of dealers who buy and sell for their own inventories is generally referred to as a(n) ______ market.

Over-the-counter

ALP Inc. has decided to issue preferred stock with an annual dividend of $4 a share. Similar stocks are currently yielding 11 percent. What price should the firm expect to receive for each new share issued?

P = $4/.11 = $36.36

Sharpe General Stores is declining so it has announced that it will pay annual dividends of $.80, $.50, and $.50 over the next three years, respectively. The following year, the firm will close and pay a final dividend of $13.80 a share. If you have a required return of 14.5 percent, what is one share of this stock worth to you today?

P0 = $.80/1.145 + $.50/1.1452 + $.50/1.1453 + $13.80/1.1454 = $9.44

New Tours last annual dividend was $2 a share. The company plans to lower the dividend by $.50 each year for the next three years. In Year 5, it will pay a final liquidating dividend of $22 a share. If the required return is 16 percent, what is the current per share value of this stock?

P0 = $1.50/1.16 + $1/1.162 + $.50/1.163 + $22/1.165 P0 = Answer $12.83

The ELL common stock pays an annual dividend of $1.90 a share and is committed to maintaining a constant dividend. How much are you willing to pay for one share of this stock if your required return is 11 percent?

P0 = $1.90/.11 P0 = $17.27

Webster preferred stock pays an annual dividend of $7.50 a share. What is the maximum price you should pay today to purchase this stock if you desire a rate of return of 12.25 percent

P0 = $7.50/.1225 = $61.22

Blasco just paid an annual dividend of $1.24 a share. What is one share of this stock worth to you if the dividends increase by 2 percent annually and you require a rate of return of 12 percent?

P0 = [$1.24 × (1 + .02)]/(.12 - .02) P0 = $12.65

Tyler Industries stock traditionally provides a rate of return of 14.2 percent. The company just paid an annual dividend of $1.65 a share and recently announced it will commence increasing its dividends by 3.5 percent each year. For this stock to return its traditional rate, what should the market price of this stock be?

P0 = [$1.65 × (1 + .035)]/(.142 - .035) P0 = Answer $15.96

Last week, Railway Cabooses paid its annual dividend of $1.20 a share. The company has been reducing its dividends by 6 percent each year. What is one share of stock worth at a required return of 14 percent?

P0 = {$1.20 × [1 + (-.06)]}/[.14 - (-.06)] = $5.64

Doctors-On-Call, a newly formed medical group, just paid a dividend of $.50 a share. The dividends are expected to increase by 20 percent a year for the next two years and then increase by 3 percent annually thereafter. What is the current value of a share if the appropriate discount rate is 12 percent?

P2 = ($.50 × 1.22 × 1.03)/(.12 - .03) = $8.24 P0 = ($.50 × 1.2)/1.12 + [($.50 × 1.22) + $8.24]/1.122 = $7.68

The voting procedure where you must own 50 percent plus one of the outstanding shares of stock to guarantee that you will win a seat on the board of directors is called _____ voting.

straight

A stock you are interested in paid a dividend of $1 per share last year. The anticipated growth rate in dividends and earnings is 25 percent for the next two years before settling down to a constant 5 percent growth rate. The discount rate is 12 percent. What is the current value of the stock?

P2 = ($1 × 1.252 × 1.05)/(.12 - .05) = $23.44 P0 = ($1 × 1.25)/1.12 + [($1 × 1.252) + $23.44]/1.122 = $21.05

Nu-Tech stock's last annual dividend was $1.10 a share. Dividends are expected to increase by 25 percent for the next two years and then increase at a constant 4 percent annually. The required return on this high-risk stock is 18.5 percent. What is the current value of one share?

P2 = ($1.10 × 1.252 × 1.04)/(.185 - .04) = $12.33 P0 = ($1.10 × 1.25)/1.185 + [($1.10 × 1.252) + $12.33]/1.1852 = $11.16

Mario's is going to pay $1, $2.50, and $5 a share over the next three years, respectively. After that, the company plans to pay annual dividends of $1.25 per share indefinitely. If your required return is 13 percent, how much are you willing to pay for one share today?

P3 = $1.25/.13 = $9.62 P0 = $1/1.13 + $2.50/1.132 + ($5 + 9.62)/1.133 = $12.97

Midtown Enterprises paid its first annual dividend yesterday in the amount of $.28 a share. The company plans to double each annual dividend payment for the next three years. After that, it will pay a constant $1.50 per share dividend indefinitely. What is one share of this stock worth today if the market rate of return on similar securities is 11.5 percent?

P3 = $1.50/.115 = $13.04 P0 = $.56/1.115 + $1.12/1.1152 + ($2.24 + 13.04)/1.1153 P0 = Answer $12.43

Nu-Tek, Inc. is expecting a period of intense growth, so it has decided to retain more of its earnings to help finance that growth. As a result, it is going to reduce its annual dividend by 20 percent a year for the next three years. After that it will maintain a constant dividend of $1.60 a share. Last year, the annual dividend was $2.60 a share. What is the market value of this stock if the required rate of return is 13 percent?

P3 = $1.60/.13 = $12.31 P0 = ($2.60 × .80)/1.13 + ($2.60 × .802)/1.132 + [($2.60 × .803) + $12.31]/1.133 = $12.60

Dille Inc. pays no dividend at the present time. In Years 2 and 3, the firm will pay annual dividends of $3 a share. After that, it will pay a constant $1 a share dividend indefinitely. What is this stock worth at a required return of 15 percent?

P3 = $1/.15 = $6.67 P0 = $3/1.152 + ($3 + 6.67)/1.153 = Answer $8.62

The Extreme Reaches Corp. last paid a $1.50 per share annual dividend. The company is planning on paying $3, $5, $7.50, and $10 a share over the next four years, respectively. After that the dividend will be a constant $2.50 per share per year. What is the current price of this stock if the rate of return is 14 percent?

P4 = $2.50/.14 = $17.86 P0 = $3/1.14 + $5/1.142 + $7.50/1.143 + ($10 + 17.86)/1.144 P0 = Answer $28.03

Felix Pet Foods plans to pay an annual dividend of $.75 next year, increase the dividend by 12 percent for the following three years, and then increase the dividend by 2 percent annually thereafter. The required rate of return is 12.5 percent. What is this stock worth per share today?

P4 = ($.75 × 1.123 × 1.02)/(.125 - .02) = $10.24 P0 = $.75/1.125 + ($.75 × 1.12)/1.1252 + ($.75 × 1.122)/1.1253 + [($.75 × 1.123) + $10.24]/1.1254 P0 = $9.04

XanEx is a new firm that just paid an annual dividend of $1 a share. The firm plans to increase its dividend by 20 percent a year for the next four years and then decrease the growth rate to 5 percent annually. If the required rate of return is 10.25 percent, what is one share of this stock worth today?

P4 = ($1 × 1.24 × 1.05)/(.1025 - .05) = $41.47 P0 = ($1 × 1.2)/1.1025 + ($1 × 1.22)/1.10252] + ($1 × 1.23)/1.10253 + [($1 × 1.24) + $41.47]/1.10254 P0 = Answer $33.04

Wilton's Market just announced its next annual dividend will be $1.50 a share with future dividends increasing by 1.8 percent annually. How much will one share of this stock be worth five years from now if the required return is 15.5 percent?

P5 = ($1.50 × 1.0185)/(.155 - .018) = Answer $11.97

Which one of the following statements concerning preferred stock is correct

Preferred shareholders may be granted voting rights if preferred dividend payments remain unpaid

A _____ is a form of equity security that has a stated liquidating value

Preferred stock

The market in which new securities are originally sold to investors is called the _____ market

Primary

The voting procedure where a shareholder grants authority to another individual to vote his/her shares is called _____ voting.

Proxy

The preferred stock of Eastern Shores pays an annual dividend of $6.50 and sells for $42.19 a share. What is the dividend yield?

R = $6.50/$42.19 = .1541, or 15.41%

Dirt Bikes just announced that its next annual dividend will be $1.42 a share and that all future dividends are expected to increase by 2.5 percent annually. What is the market rate of return if this stock is currently selling for $14.11 a share?

R = ($1.42/$14.11) + .025 R = Answer .1256, or 12.56%

The Vinyard recently paid a $2.38 annual dividend on its common stock. This dividend increases at 1.75 percent per year and currently sells for $40.15 a share. What is the rate of return?

R = [($2.38 × 1.0175)/$40.15] + .0175 R = Answer .0778, or 7.78%

Which one of these formulas is used to estimate a firm's growth rate

Retention ratio X ROE

Lew, an individual investor, sold 100 shares of Global Tech stock on Monday. Janice, another individual investor, purchased those shares but never met Lew. You know for certain that this trade occurred in which market?

Secondary market

The total return on a stock is equal to

the capital gains yield plus the dividend yield

The underlying assumption of the dividend growth model is that a stock is worth

the present value of the future income provided by that stock

Westside Motors has expected earnings after taxes for Year 4 of $122,000 and has 25,000 outstanding shares. The current value of the firm's earnings for the next four years, Years 1 through 4, is $391,600. The comparable PE for the firm is 8.2. What is the estimated value of one share of this stock if the required rate of return is 15 percent?

Terminal valueYear 4 = $122,000 × 8.2 = $1,000,400 Current firm value = $391,600 + 1,000,400 = $1,392,000 Price per share = $1,392,000/25,000 = $55.68

Dixie Down has expected earnings after taxes for Year 5 of $385,000 and has 60,000 outstanding shares. The current value of the firm's earnings for the next five years, Years 1 through 5, is $567,000. The comparable PE for the firm is 11.4. What is the estimated value of one share of this stock if the required rate of return is 16 percent

Terminal valueYear 5 = $385,000 × 11.4 = $4,389,000 Current firm value = $567,000 + 4,389,000 = $4,956,000 Price per share = $4,956,000/60,000 = $82.60

A stock quote shows a last price of 32.13, a P/E of 17, and a net change of -.23. Based on this information, which one of the following statements is correct?

The earnings per share are equal to 1/17th of $32.13.

Dixie Mart has 75,000 shares of stock outstanding. The firm expects to earn net income of $268,000 next year with annual increases of 4.5 percent per year thereafter. The firm also expects to pay out 40 percent of its net income in dividends and share repurchases. The required return is 12 percent. What is its share price?

Total PV = (.40 × $268,000)/(.12 - .045) = $1,429,333.33 Price per share = $1,429,333.33/75,000 = $19.06

Feltwater Furniture has 120,000 shares of stock outstanding. The firm expects to earn net income of $325,000 next year with annual increases of 3 percent per year thereafter. The firm also expects to pay out 75 percent of its net income in dividends and share repurchases. The required return is 14 percent. What is its share price?

Total PV = (.75 × $325,000)/(.14 - .03) = $2,215,909.09 Price per share = $2,215,909.09/120,000 = $18.47

Theo owns 13,400 of the 85,000 outstanding shares of BBE Inc. The shares sell for $22.40. Each share is granted one vote for each open seat on the board of directors. Currently, there are three open seats. Theo wants to be on the board and is assuming that no one, other than himself, will vote for him. How much additional money, if any, must he invest in BBE to guarantee his election if the firm uses a straight voting system?

Total number of shares needed = (.5 × 85,000) + 1 = 42,501 shares Additional shares needed = 42,501 - 13,400 = 29,101 shares Additional cost to purchase shares = 29,101 × $22.40 = $651,862.40

Khloe owns ten percent of KLK Clothing which has a total of 112,000 shares of stock outstanding. Each share receives one vote for each open seat on the board. The next election will select four new directors. The market price per share is $48. How much does Khloe need to spend, if any, to guarantee her election to the board if the firm has a cumulative voting policy?

Total number of shares needed = [112,000/(1 + 4)] + 1 = 22,401 shares Additional shares needed = 22,401 - (.1 × 112,000) = 11,201 shares Additional investment needed = 11,201 × $48 = $537,648

The free cash flow model, as compared to other models, tends to be most helpful when valuing a share of stock in:

a non-dividend paying firm that has external financing needs

Multiple classes of stock are primarily created to:

allow certain shareholders to retain control of a firm

A dealer will buy at the ____ price and sell at the _____ price.

bid; ask

An agent who arranges security transactions among investors without maintaining an inventory is called a:

broker

Denver Wool is owned by a group of shareholders who all vote independently and who all want personal control over the firm. There are three open seats and Don is one of six contenders. If straight voting is utilized and Don is a current shareholder, then he:

can only be assured of his election if he owns sufficient shares to control the entire election

Based on the dividend growth model, an increase in investors' overall level of required returns will:

cause the market values of all stocks to decrease, all else held constant

The voting procedure whereby shareholders may cast all of their votes for one member of the board is called _____ voting.

cumulative

JJ Companies will pay an annual dividend of $2.10 a share on its common stock next year. Last week, the company paid a dividend of $2 a share. The company adheres to a constant rate of growth dividend policy. What will one share of this stock be worth ten years from now if the applicable discount rate is 9 percent?

g = ($2.10 - 2.00)/$2.00 = .05 P10 = ($2.10 × 1.0510)/(.09 - .05) P10 = Answer $85.52

Snider's Hardwoods adheres to a 40 percent dividend payout policy and has a return on assets of 11.3 percent. The firm's debt-equity ratio is .45. What is the firm's rate of growth?

g = (1 - .40) × [.113 × (1 + .45)] = .0983, or 9.83%

Grenville common stock had a 12.25 percent rate of return last year. The fixed annual dividend is $.65 a share, which equates to a dividend yield of 1.6 percent. What was the rate of price appreciation on the stock?

g = 12.25% - 1.6% = 10.65%

Jack owns shares of stock in Boynton Foods and wants to be elected to the company's board of directors. There are 10,000 shares of stock outstanding and each share is granted one vote for each open position on the board. Presently, the company is voting to elect two new directors. Jack can be assured of his election:

if cumulative voting applies and he owns one-third of the shares, plus one additional share

Alto stock pays an annual dividend of $1.10 a share and has done so for the past six years. No changes in the dividend amount are expected. The relevant market rate of return is 7.8 percent. Given this, one share of this stock:

is valued as a perpetuity

Assume you are using the total payout method for determining the price of a share of stock. When computing the total present value, the total payout is divided by the:

required rate of return minus the net income rate of growth