Chapter 7

The two main types of stock are:

Common and Preferred

The control issues involved in running a firm are known as:

Corporate governance

Which of the following is a typical characteristic of preferred stock?

Dividends in arrears Cumulative dividends A higher payoff claim in case of bankruptcy

Common stock guarantees an equal stream of future cash flows.

F

If we do an analysis and determine a company is really good, this means it is also a good investment.

F

Investing in a good, stable company is always a good investment.

F

Like debt, stock has a maturity or expiration date.

F

Most corporations in the US issue preferred stock.

F

Preferred stock is reserved for established companies like utilities and is not used for new start-up ventures.

F

Common stock shareholders (in the aggregate) have all of the following rights except:

Highest claims position in a liquidation case

Preferred stock is often called a _______ security because it has some characteristics of debt and some of equity.

Hybird

If a company neglects paying dividends to a preferred stockholder in year one but they pay the set dividend in year two, they must do the following:

Pay year one preferred dividend before paying any common stockholder dividends

To pick a good stock:

Pick a company that is undervalued

Stockholders own the remaining earnings after operations are paid for and creditors are paid making equity a _________ claim.

Residual

Common stock represents ownership in the firm.

T

Some types of equity give the owner the right to vote on company matters.

T

Stock and equity mean the same thing in finance.

T

We can value stocks like debt by discounting all future cash flows to the present value.

T

Which of the following is true for preferred stockholders?

They will have dividend priority over common stockholders

One of your friends is recommending a stock if it sells for more than $165.00 per share. The growth rate is 4% and the latest dividend was $6. You are expecting an 11% return. Why should you buy or not buy the stock?

nswer: Do not buy—the calculated price is too low. (6.00 * 1.04) / (.110 - .040) = 89.14

What is the value of a preferred stock where the dividend rate is 15 percent on a $100 par value? The appropriate discount rate is 12 percent.

Answer: $125.00 D = $15 kps = 12% V0 = 15/.12 = $125

You have purchased 1000 shares of Omega Corporation for $11 per share. You require a 35 percent return for investing in start-up companies. How much must the dividend be in order to reach your required rate of return?

Answer: $3.85 Using the perpetuity equation, solve for D. D = V0 * kps D = 11 * .35

You are considering purchasing a stock that recently paid a dividend of $2.10 and is expected to grow at the average industry rate of 3 percent a year. What would you pay for this stock if you require a 10 percent return on your investments?

Answer: $30.90 Using the Gordon Growth Model, we compute V0. Remember to grow the dividend! V0 =(2.1*1.03)/(.10-.03)

Calculate the value of a preferred stock that pays a dividend of $5 per share and your required rate of return is 14 percent.

Answer: $35.71 D = $5.00 kps = 14% V0 = 5.00/.14

Snapp Corporation is expecting to pay a dividend of $3.25 to their common stockholders this year. If your required rate of return is 10 percent and the expected price of Snapp in one year is $40, what would you be willing to pay for the stock today?

Answer: $39.32 This problem can be solved with a calculator/Excel function or the equation. With calculator/Excel: FV = ($3.25+$40), I/Y = 10%, n = 1, compute PV = $39.32 With the equation: D1 = $3.25 V1 = $40.00 Rate = 10% V0 = (3.25+40)/(1+.10) = $39.32

FredCo preferred stock pays a constant dividend of $3.55 to their shareholders. If your required rate of return on investments is 9 percent, what would you be willing to pay for FredCo stock?

Answer: $39.44 Using the perpetuity equation, compute V0. V0 = D/kps V0 = 3.55/.09

XYZ motors paid a $2.75 dividend last year. At a constant growth rate of 8 percent, what is the value of the common stock if the investors require a 14 percent rate of return?

Answer: $49.50 D0 = $2.75 g = 8% kcs = 14% V0 = (2.75 * 1.08)/(.14-.08) = $49.50

You are considering purchasing Quarry Diamonds stock. They have promised to pay dividends of $2.50, $3.00, and $3.50 over the next three years. Dividends will grow at 5% after that indefinitely. How much are you willing to pay for the stock if your required rate of return is 11%?

Answer: $52.03 Discount Rate = 11% g = 5% D1 = $2.50 D2 = 3.00 D3 = 3.50 PV of D1 = 2.50/1.111 = 2.25 PV of D2 = 3.00/1.112 = 2.43 PV of D3 = 3.50/1.113 = 2.56 (Can also be calculated on your calculator using TVM function) Stage 2 (3.50*1.05)/(.11-.05) = 61.25 PV = 61.25/1.113 = 44.79 V0 = 2.25 + 2.43 + 2.56 + 44.79 = 52.03

You are looking to purchase Ordway common stock at $55 per share, hold it one year, and sell after a dividend of $3 is paid. What would the stock price need to be in order to satisfy your required rate of return of 15 percent?

Answer: $60.25 V0 = $55.00 D1 = $3.00 Rate = 15% (V1-55+3)/55 = .15, Solve for V1

If you require a 10 percent return on your money, and ABC stock is currently selling at $55, what would you have to sell this stock at in one year to earn your required return? Assume no dividends are paid and annual compounding.

Answer: $60.50 We can solve this problem with a financial calculator/Excel function or the equation. With calculator/Excel function: PV = 55, I/Y = 10%, n = 1, solve for FV = $60.50. Using the equation, we solve for P1. P1 = P0*(1+ks) P1 = 55*(1.10)

You are interested in buying a preferred stock and want to know what the rate of return is. The stock is selling for $85 and pays a dividend today of $2.25. What is the rate of return?

Answer: .0265 2.25 / 85.00 = .0265 or 2.65% (Preferred stock has no growth.)

The company expected to pay a dividend of $13.85 at the end of the year. Management has estimated growth at 2.75%, and the stock is currently selling for $290. What is the expected rate of the return for this investment?

Answer: .0753 (13.85 / 290) + .0275 = .0753 or 7.53%

If a common stock is worth $75 and the growth rate is 5% with a dividend expected to pay $2 in a year's time, what is the expected rate of return?

Answer: .0767 (2.00 / 75.00) + .05 = .0767

A stock sells for $87 one year from now, giving a total return of 8%. What is the dividend if the stock was originally purchased for $82?

Answer: 1.56 D = Vo * (1+r) - V1 Dividend step by step: 82.00 * 1.08 = 88.56, 88.56 -87.00 = 1.56 dividend

ABC's common stock currently sells for $36.68 per share. The company's executives anticipate a growth rate of 6 percent and a future dividend of $1.75. What is your expected rate of return?

Answer: 10.77% V0 = $36.68 g = 6% D1 = $1.75 kcs = 6% + (1.75/36.68) = 10.77%

Honeydwell's common stock just paid a dividend of $1.95. Dividends are expected to grow at a 5 percent annual rate forever. If Honeydwell's stock is currently selling at $25.45, what is the stock's expected rate of return?

Answer: 13.05% V0 = $25.45 D0 = $1.95 g = 5% 25.45 = (1.95*1.05)/( kcs-5%), solve for kcs

What is the rate of return for a stock purchased for $89, sold in a year for $100, paying a dividend during that time of $2.75?

Answer: 15.45% R = (V1 + D) / Vo Rate of return step by step: 100.00 + 2.75 = 102.75 / 89.00 = 1.1545 Less 1 = 15.45 %

You can buy a stock today at $39 that is expected to pay a $3.25 dividend at the end of one year. If you think that you can sell it for $45 after the dividend is paid, what would be your return?

Answer: 23.72% Using the holding period return equation, we can solve for the rate of return. ks = [(P1 + D1)/P0]- 1 ks = [(45 + 3.25)/39] - 1

An investor wishes to know what the value of a common stock is if it pays a dividend of $6 today. The company's growth rate is 4.5% and the investor expects the stock to earn 7%. What is the value of the common stock?

Answer: 250.80 (6 * 1.045) / (.07 - .045) = 250.80

If you are looking for a return of at least 10%, what would you invest in a company given that it just paid a dividend of $1.80 and estimates a growth rate of 3%?

Answer: 26.49 Vo = ((1.80 * 1.03) /(.10 - .03) = 26.49

A company just paid a dividend of $2.30 per share to its shareholders. It estimates that future growth will be at 2%. What is the value of the stock if you are looking for an 8% return on your investment?

Answer: 39.10 (2.30 * 1.02) / (.08 - .02) = 39.10

The common stock of Zed Corporation is selling for $32.84. The stock expects to pay a dividend of $2.94 per share next year. The expected rate of return on Zed's stock is 13 percent. What is Zed's estimated growth rate?

Answer: 4.05 % Using the Gordon Growth Model: V0=D1/(r-g), we can solve for g. g = r - (D1/V0) g = 13% - (2.94/32.84)

What would a dividend have to be if the investor buys a stock for $110, expects to sell the stock in a year for $120, and expects an annual return of 13%?

Answer: 4.30 D = Vo * (1+r) - V1 Dividend step by step: 110 * 1.13 = 124.30 124.30 - 120.00 = 4.30

Tom purchased stock from HAL Corporation one year ago for $179.00. He recently received one dividend payment in the amount of $5.05 and then sold the stock for $182.00. What is Tom's return?

Answer: 4.5% Using the holding period return equation, we can solve for our return. ks = [(P1 + D1)/P0]- 1 ks = [(182+5.05)/179] - 1

An investor wishes to know the value of preferred stock when the dividend is $3 per share and the expected rate of return is 6.5%.

Answer: 46.15 3.00 / .065 = 46.15

What would an investor be willing to pay for a stock today if the value in a year would be $55 with a dividend of $2.24 per share, and the investor wants to make 9% on the investment?

Answer: 52.51 Vo = V1 + D / (1 + r) Stock Price Today step by step: 55.00 + 2.24 = 57.24 57.24 / 1.09 = 52.51

You own 175 shares of Rain's preferred stock, which currently sells for $45 per share and pays annual dividends of $2.90 per share. What is your expected return?

Answer: 6.44% Using the perpetuity equation, we compute kps = D/V kps = 2.90/45

What does a stock have to sell for one year in the future if it currently sells for $75, has a planned dividend of $1.87 a share, and has an expected return of 14%?

Answer: 83.63 V1 = Vo * (1+r) - D where Vo = stock price today, V1 = stock price in 1 yr, r = rate of return, D = dividend. Stock in the future step by step: 75 * .14 = 10.50 10.50 - 1.87 = 8.63 75 + 8.63 = 83.63 stock price in one year

Jennie purchased $10,000 worth of Techno Corp's stock at $50/share. She held this stock for one year. After receiving a dividend of $2.00/share, she sold it for $52.50/share. What is her rate of return?

Answer: 9% D1 = $2.00 V0 = $50.00 V1 = 52.50 Rate = (52.50+2.00)/50.00 - 1 = .09

Unlike bonds which are fixed-return securities, stocks are ___________________ securities.

Variable return

Stocks are:

Variable-return securities