Finance Test III ~ Chapter 9 'Stocks And Their Valuation'

(T/F) The corporate valuation model can be used only when a company doesn't pay dividends.

False

(T/F) Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting control.

True

(T/F) For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

True

(T/F) Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock.

True

(T/F) From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer's standpoint, these risk relationships are reversed: bonds are the most risky for the firm, preferred is next, and common is least risky.

True

(T/F) If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

True

(T/F) Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the firm's total corporate value.

True

(T/F) The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.

True

85. Huang Company's last dividend was $1.25. The dividend growth rate is expected to be constant at 15% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If the firm's required return (rs) is 11%, what is its current stock price? a. $30.57 b. $31.52 c. $32.49 d. $33.50 e. $34.50

d. $33.50

54. If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock's expected total return for the coming year? a. 7.54% b. 7.73% c. 7.93% d. 8.13% e. 8.34%

e. 8.34% RATIONALE: D1 $1.25 g 5.5% P0 $44.00 Total return = rs = D1/P0 + g 8.34%

46. Which of the following statements is CORRECT? a. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights. b. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. c. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. d. The stock valuation model, P0 = D1/(rs − g), cannot be used for firms that have negative growth rates. e. The stock valuation model, P0 = D1/(rs − g), can be used only for firms whose growth rates exceed their required return.

ANSWER: C- The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. RATIONALE: Statement a is false—a number of companies have different classes of stock with different voting rights. Statement b is simply false. Statement c is true. Statements d and e are false, because the constant growth model can be used anytime as long as the constant growth rate is less than the required return (even if the growth rate is negative).

47. The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is CORRECT? a. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate. b. If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X. c. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price. d. The stocks must sell for the same price. e. Stock Y must have a higher dividend yield than Stock X.

ANSWER: a If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate. RATIONALE: Since X has the lower required return, if Y has a lower dividend yield it must have a higher expected growth rate.

Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? a. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's. b. Stock B must have a higher dividend yield than Stock A. c. Stock A must have a higher dividend yield than Stock B. d. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B's. e. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B.

ANSWER: a RATIONALE: Statement a is true, because if the required return for Stock A is higher than that of Stock B, and if the dividend yield for Stock A is lower than Stock B's, the growth rate for Stock A must be higher to offset this.

33. Which of the following statements is CORRECT? a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. b. Two firms with the same expected dividend and growth rate must also have the same stock price. c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

ANSWER: a RATIONALE: Statement a is true, because the expected growth rate is also the expected capital gains yield. All the other statements are false.

35. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $25 Expected growth (constant) 10% 5% Required return 15% 15% a. Stock A's expected dividend at t = 1 is only half that of Stock B. b. Stock A has a higher dividend yield than Stock B. c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. d. Since Stock A's growth rate is twice that of Stock B, Stock A's future dividends will always be twice as high as Stock B's. e. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist.

ANSWER: a Stock A's expected dividend at t = 1 is only half that of Stock B. RATIONALE: Statement a is correct, because if both stocks have the same price and the same required return, and A's growth rate is twice that of B, then A's dividend and dividend yield must be half that of B. This point is illustrated with the following example. A B Price $25 $25 g 10% 5% r 15% 15% Div. Yield = r − g = 5% 10% D1 = P(Div Yield) = $1.25 $2.50

40. Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Beta 1.10 0.90 Constant growth rate 7.00% 7.00% a. Stock A must have a higher stock price than Stock B. b. Stock A must have a higher dividend yield than Stock B. c. Stock B's dividend yield equals its expected dividend growth rate. d. Stock B must have the higher required return. e. Stock B could have the higher expected return

ANSWER: b Stock A must have a higher dividend yield than Stock B. RATIONALE: Statement b is true, because Stock A has a higher required return but the stocks have the same growth rate, so Stock A must have the higher dividend yield. Here are some calculations to demonstrate the point. rRF beta RPM rStock A 6.40% + 1.10 × 6.00% = 13.00% B 6.40% + 0.90 × 6.00% = 11.80% Div. Yld. g rStock A D1/P0 + 7.00% = 13.00% D1/P0 = r − g = 6.00% B D1/P0 + 7.00% = 11.80% D1/P0 = r − g = 4.80%

24. If markets are in equilibrium, which of the following conditions will exist? a. Each stock's expected return should equal its realized return as seen by the marginal investor. b. Each stock's expected return should equal its required return as seen by the marginal investor. c. All stocks should have the same expected return as seen by the marginal investor. d. The expected and required returns on stocks and bonds should be equal. e. All stocks should have the same realized return during the coming year.

ANSWER: b RATIONALE: Statement b is true, because if the expected return does not equal the required return, then markets are not in equilibrium and buying/selling will occur until the expected return equals the required return.

27. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Required return 10% 12% Market price $25 $40 Expected growth 7% 9% a. These two stocks should have the same price. b. These two stocks must have the same dividend yield. c. These two stocks should have the same expected return. d. These two stocks must have the same expected capital gains yield. e. These two stocks must have the same expected year-end dividend.

ANSWER: b RATIONALE: The following calculations show that answer b is correct. The others are all wrong. A B Expected return 10% 12% Expected growth 7% 9% Dividend yield 3% 3%

37. Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT? Expected dividend, D1 $3.00 Current Price, P0 $50 Expected constant growth rate 6.0% a. The stock's required return is 10%. b. The stock's expected dividend yield and growth rate are equal. c. The stock's expected dividend yield is 5%. d. The stock's expected capital gains yield is 5%. e. The stock's expected price 10 years from now is $100.00.

ANSWER: b The stock's expected dividend yield and growth rate are equal. RATIONALE: The correct answer choice is b. One could quickly calculate the dividend yield and see that it equals the growth rate, but here are some numbers that provide more information. D1 $3.00 D1/P0 6.0% P0 $50.00 rX 12.0%

88. Your boss, Sally Maloney, treasurer of Fred Clark Enterprises (FCE), asked you to help her estimate the intrinsic value of the company's stock. FCE just paid a dividend of $1.00, and the stock now sells for $15.00 per share. Sally asked a number of security analysts what they believe FCE's future dividends will be, based on their analysis of the company. The consensus is that the dividend will be increased by 10% during Years 1 to 3, and it will be increased at a rate of 5% per year in Year 4 and thereafter. Sally asked you to use that information to estimate the required rate of return on the stock, rs, and she provided you with the following template for use in the analysis. (must be changed to force Calculated Price to equal Year 0 Dividend growth rate (insert correct values) 10% 10% 10% 5% 5% Calculated dividends (D0 has been paid) $1.00 HV3 = P3 = D4/(rs - g4). Find using Estimated rs. ? ? ? ? ? ? Total CFs ? ? ? PVs of CFs when discounted at Estimated rs ? ? ? Calculated Price = P0 = Sum of PVs = $0.00 A positive number will be here when dividends are estimated. The Calculated Price will equal the Actual Market Price once the correct rs has been found. Sally told you that the growth rates in the template were just put in as a trial, and that you must replace them with the analysts' forecasted rates to get the correct forecasted dividends and then the estimated HV. She also notes that the estimated value for rs, at the top of the template, is also just a guess, and you must replace it with a value that will cause the Calculated Price shown at the bottom to equal the Actual Market Price. She suggests that, after you have put in the correct dividends, you can manually calculate the price, using a series of guesses as to the Estimated rs. The value of rs that causes the calculated price to equal the actual price is the correct one. She notes, though, that this trial-and-error process would be quite tedious, and that the correct rs could be found much faster with a simple Excel model, especially if you use Goal Seek. What is the value of rs? a. 11.84% b. 12.21% c. 12.58% d. 12.97% e. 13.36%

ANSWER: d. 12.97% RATIONALE: Finding the discount rate when we know the dividends and the actual stock price is complicated if the growth rate is not constant, and an iterative solution is required. Estimated rs = 12.97% Actual Market Price, P0: $15.00

32. A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = −5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT? a. The company's current stock price is $20. b. The company's dividend yield 5 years from now is expected to be 10%. c. The constant growth model cannot be used because the growth rate is negative. d. The company's expected capital gains yield is 5%. e. The company's expected stock price at the beginning of next year is $9.50.

ANSWER: e RATIONALE: Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so P1 must be $10(0.95) = $9.50. Therefore, answer e is correct, while the others are all false.

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $40 Expected growth 7% 9% Expected return10%12% a. The two stocks should have the same expected dividend. b. The two stocks could not be in equilibrium with the numbers given in the question. c. A's expected dividend is $0.50. d. B's expected dividend is $0.75. e. A's expected dividend is $0.75 and B's expected dividend is $1.20.

ANSWER: e RATIONALE: The following calculations show that answer e is correct. The others are all wrong. A B Price $25 $40 Expected growth 7% 9% Expected return 10% 12% A = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $0.75 B = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $1.20

34. If a stock's dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. The expected return on the stock is 5% a year. b. The stock's dividend yield is 5%. c. The price of the stock is expected to decline in the future. d. The stock's required return must be equal to or less than 5%. e. The stock's price one year from now is expected to be 5% above the current price.

ANSWER: e The stock's price one year from now is expected to be 5% above the current price. RATIONALE: Statement e is true, because the stock price is expected to grow at the dividend growth rate.

39. The expected return on Natter Corporation's stock is 14%. The stock's dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? a. The stock's dividend yield is 7%. b. The stock's dividend yield is 8%. c. The current dividend per share is $4.00. d. The stock price is expected to be $54 a share one year from now. e. The stock price is expected to be $57 a share one year from now.

ANSWER:d The stock price is expected to be $54 a share one year from now. RATIONALE: P1 = P0(1 + g) = $54. Therefore, d is correct. All the other answers are false. P1 = $54.00

80. Rebello's preferred stock pays a dividend of $1.00 per quarter, and it sells for $55.00 per share. What is its effective annual (not nominal) rate of return? a. 6.62% b. 6.82% c. 7.03% d. 7.25% E. 7.47%

E. 7.47% Periods per year = 4 Pref. quarterly dividend $1.00 Preferred stock price $55.00 Eff % required return = (1 + (Qt Div/P))N − 1 = 7.47%

(T/F) Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.

False

73. Kale Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 11.0% and FCF is expected to grow at a rate of 5.0% after Year 2, what is the firm's total corporate value, in millions? Year 1 2 Free cash flow −$50 $100 a. $1,456 b. $1,529 c. $1,606 d. $1,686 e. $1,770

a. $1,456 First, find the horizon, or continuing, value: HV2 = FCF2(1 + g)/(WACC − g) = $100(1.05)/(0.11 − 0.05) = $1,750.00 Then find the PV of the free cash flows and the horizon value: Total corporate value = −$50/(1.11) + ($100 + $1,750)/(1.11)2 = $1,456.46

67. Sorenson Corp.'s expected year-end dividend is D1 = $1.60, its required return is rs = 11.00%, its dividend yield is 6.00%, and its growth rate is expected to be constant in the future. What is Sorenson's expected stock price in 7 years, i.e., what is ? a. $37.52 b. $39.40 c. $41.37 d. $43.44 e. $45.61

a. $37.52 RATIONALE: Next expected dividend = D1 = $1.60 Required return 11.0% Dividend yield = D1/P0 = 6.0% Find the growth rate: g = rs − yield = 5.0% Find P0 = D1/(rs − g) = $26.67 Years in the future 7 $37.52

69. Misra Inc. forecasts a free cash flow of $35 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5.5% thereafter. If the weighted average cost of capital (WACC) is 10.0% and the cost of equity is 15.0%, what is the horizon, or continuing, value in millions at t = 3? a. $821 b. $862 c. $905 d. $950 e. $997

a. $821 RATIONALE: FCF3 $35.00 g 5.5% WACC 10.0% FCF4 = FCF3(1 + g) = $36.9250 HV3 = FCF4/(WACC − g) = $820.56

53. If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock's expected capital gains yield for the coming year? a. 6.50% b. 6.83% c. 7.17% d. 7.52% e. 7.90%

a. 6.50% RATIONALE: D1 $1.50 g 6.5% P0 $56.00 Capital gains yield = g = 6.50%

31. Which of the following statements is CORRECT, assuming stocks are in equilibrium? a. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield. b. Assume that the required return on a given stock is 13%. If the stock's dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well. c. A stock's dividend yield can never exceed its expected growth rate. d. A required condition for one to use the constant growth model is that the stock's expected growth rate exceeds its required rate of return. e. Other things held constant, the higher a company's beta coefficient, the lower its required rate of return.

a. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.

65. Goode Inc.'s stock has a required rate of return of 11.50%, and it sells for $25.00 per share. Goode's dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D0? a. $0.95 b. $1.05 c. $1.16 d. $1.27 e. $1.40

b. $1.05 RATIONALE: Stock price $25.00 Required return 11.50% Growth rate 7.00% P0 = D1/(rs − g), so D1 = P0(rs − g) = $1.1250 Last dividend = D0 = D1/(1 + g) $1.05

89. Wall Inc. forecasts that it will have the free cash flows (in millions) shown below. If the weighted average cost of capital is 14% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the firm's total corporate value, in millions? Year 1 2 3 Free cash flow −$20.00 $48.00 $54.00 a. $2,650.00 b. $2,789.47 c. $2,928.95 d. $3,075.39 e. $3,229.16

b. $2,789.47

66. Francis Inc.'s stock has a required rate of return of 10.25%, and it sells for $57.50 per share. The dividend is expected to grow at a constant rate of 6.00% per year. What is the expected year-end dividend, D1? a. $2.20 b. $2.44 c. $2.69 d. $2.96 e. $3.25

b. $2.44 RATIONALE: Stock price $57.50 Required return 10.25% Growth rate 6.00% P0 = D1/(rs − g), so D1 = P0(rs − g) Expected dividend = D1 = P0(rs − g) = $2.44

72. Kedia Inc. forecasts a negative free cash flow for the coming year, FCF1 = −$10 million, but it expects positive numbers thereafter, with FCF2 = $25 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14.0%, what is the firm's total corporate value, in millions? a. $200.00 b. $210.53 c. $221.05 d. $232.11 e. $243.71

b. $210.53 RATIONALE: First, find the horizon, or continuing, value at t = 2: HV2 = FCF2(1 + g)/(WACC − g) = $25(1.04)/(0.14 − 0.04) = $26.0/0.10 = $260.00 Then find the PV of the free cash flows and the horizon value: Total corporate value = −$10/(1.14)1 + ($25 + $260)/(1.14)2 Total corporate value = −$8.772 + $219.298 = $210.53

76. Based on the corporate valuation model, Gay Entertainment's total corporate value is $1,200 million. The company's balance sheet shows $120 million of notes payable, $300 million of long-term debt, $50 million of preferred stock, $180 million of retained earnings, and $800 million of total common equity. If the company has 30 million shares of stock outstanding, what is the best estimate of its price per share? a. $21.90 b. $24.33 c. $26.77 d. $29.44 e. $32.39

b. $24.33

83. The Ramirez Company's last dividend was $1.75. Its dividend growth rate is expected to be constant at 25% for 2 years, after which dividends are expected to grow at a rate of 6% forever. Its required return (rs) is 12%. What is the best estimate of the current stock price? a. $41.58 b. $42.64 c. $43.71 d. $44.80 e. $45.92

b. $42.64

52. If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the stock's expected dividend yield for the coming year? a. 4.42% b. 4.66% c. 4.89% d. 5.13% e. 5.39%

b. 4.66% RATIONALE: D0 $2.25 g 3.5% P0 $50.00 D1 = D0(1 + g) = $2.329 Dividend yield = D1/P0 = 4.66%

Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? a. The two stocks must have the same dividend per share. b. If one stock has a higher dividend yield, it must also have a lower dividend growth rate. c. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. d. The two stocks must have the same dividend growth rate. e. The two stocks must have the same dividend yield.

b. If one stock has a higher dividend yield, it must also have a lower dividend growth rate.

44. Which of the following statements is CORRECT? a. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights. b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm's common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock. c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock. d. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free. e. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer.

b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm's common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock.

41. Which of the following statements is NOT CORRECT? a. The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends. b. The corporate valuation model discounts free cash flows by the required return on equity. c. The corporate valuation model can be used to find the value of a division. d. An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements. e. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or continuing, value.

b. The corporate valuation model discounts free cash flows by the required return on equity.

43. Which of the following statements is CORRECT? a. Preferred stockholders have a priority over bondholders in the event of bankruptcy to the income, but not to the proceeds in a liquidation. b. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock. c. Corporations cannot buy the preferred stocks of other corporations. d. Preferred dividends are not generally cumulative. e. A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing corporation.

b. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock.

59. Mooradian Corporation's free cash flow during the just-ended year (t = 0) was $150 million, and its FCF is expected to grow at a constant rate of 5.0% in the future. If the weighted average cost of capital is 12.5%, what is the firm's total corporate value, in millions? a. $1,895 b. $1,995 c. $2,100 d. $2,205 e. $2,315

c. $2,100 RATIONALE: FCF0 $150 g 5.0% WACC 12.5% FCF1 = FCF 0(1 + g) = $157.50 Total corporate value = FCF1/(WACC − g) = $2,100.00

77. Based on the corporate valuation model, the total corporate value of Chen Lin Inc. is $900 million. Its balance sheet shows $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of its stock price per share? a. $22.03 b. $24.48 c. $27.20 d. $29.92 e. $32.91

c. $27.20

82. Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 25% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company's last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock? a. $26.77 b. $27.89 c. $29.05 d. $30.21 e. $31.42

c. $29.05

71. You have been assigned the task of using the corporate, or free cash flow, model to estimate Petry Corporation's intrinsic value. The firm's WACC is 10.00%, its end-of-year free cash flow (FCF1) is expected to be $75.0 million, the FCFs are expected to grow at a constant rate of 5.00% a year in the future, the company has $200 million of long-term debt and preferred stock, and it has 30 million shares of common stock outstanding. What is the firm's estimated intrinsic value per share of common stock? a. $40.35 b. $41.82 c. $43.33 d. $44.85 e. $46.42

c. $43.33

70. You must estimate the intrinsic value of Noe Technologies' stock. The end-of-year free cash flow (FCF1) is expected to be $27.50 million, and it is expected to grow at a constant rate of 7.0% a year thereafter. The company's WACC is 10.0%, it has $125.0 million of long-term debt plus preferred stock outstanding, and there are 15.0 million shares of common stock outstanding. What is the firm's estimated intrinsic value per share of common stock? a. $48.64 b. $50.67 c. $52.78 d. $54.89 e. $57.08

c. $52.78 $27.50 Constant growth rate 7.0% WACC 10.0% Debt & preferred stock $125 Shares outstanding 15 Total firm value = FCF1/(WACC − g) = Less: Value of debt & preferred $916.67 −$125.00 Value of equity $791.67 Number of shares 15 Value per share = Equity value/Shares = $52.78

If in the opinion of a given investor a stock's expected return exceeds its required return, this suggests that the investor thinks a. the stock is experiencing supernormal growth. b. the stock should be sold. c. the stock is a good buy. d. management is probably not trying to maximize the price per share. e. dividends are not likely to be declared.

c. the stock is a good buy.

86. Agarwal Technologies was founded 10 years ago. It has been profitable for the last 5 years, but it has needed all of its earnings to support growth and thus has never paid a dividend. Management has indicated that it plans to pay a $0.25 dividend 3 years from today, then to increase it at a relatively rapid rate for 2 years, and then to increase it at a constant rate of 8.00% thereafter. Management's forecast of the future dividend stream, along with the forecasted growth rates, is shown below. Assuming a required return of 11.00%, what is your estimate of the stock's current value? Year 0 1 2 3 4 5 6 Growth rate NA NA NA NA 50.00% 25.00% 8.00% Dividends $0.000 $0.000 $0.000 $0.250 $0.375 $0.469 $0.506 a. $ 9.94 b. $10.19 c. $10.45 d. $10.72 e. $10.99

d. $10.72

78. Based on the corporate valuation model, Morgan Inc.'s total corporate value is $300 million. The balance sheet shows $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock's price per share?' a. $12.00 b. $12.64 c. $13.30 d. $14.00 e. $14.70

d. $14.00

50. A share of common stock just paid a dividend of $1.00. If the expected long-run growth rate for this stock is 5.4%, and if investors' required rate of return is 11.4%, what is the stock price? a. $16.28 b. $16.70 c. $17.13 d. $17.57 e. $18.01

d. $17.57 RATIONALE: Last dividend (D0) $1.00 Long-run growth rate 5.4% Required return 11.4% D1 = D0(1 + g) = $1.054 P0 = D1/(rs − g) $17.57

60. Suppose Boyson Corporation's projected free cash flow for next year is FCF1 = $150,000, and FCF is expected to grow at a constant rate of 6.5%. If the company's weighted average cost of capital is 11.5%, what is the firm's total corporate value? a. $2,572,125 b. $2,707,500 c. $2,850,000 d. $3,000,000 e. $3,150,000

d. $3,000,000 RATIONALE: FCF1 $150,000 g 6.50% WACC 11.50% Total corporate value = FCF1/(WACC − g) = $3,000,000

81. Nachman Industries just paid a dividend of D0 = $1.32. Analysts expect the company's dividend to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The required return on this low-risk stock is 9.00%. What is the best estimate of the stock's current market value? a. $41.59 b. $42.65 c. $43.75 d. $44.87 e. $45.99

d. $44.87

75. Based on the corporate valuation model, Wang Inc.'s total corporate value is $750 million. Its balance sheet shows $100 million notes payable, $200 million of long-term debt, $40 million of common stock (par plus paid-in-capital), and $160 million of retained earnings. What is the best estimate for the firm's value of equity, in millions? a. $386 b. $406 c. $428 d. $450 e. $473

d. $450

51. If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $26.00, what is the stock's expected dividend yield for the coming year? a. 4.12% b. 4.34% c. 4.57% d. 4.81% e. 5.05%

d. 4.81% RATIONALE: D1 $1.25 g 4.7% P0 $26.00 Dividend yield = D1/P0 = 4.81%

The preemptive right is important to shareholders because it a. allows managers to buy additional shares below the current market price. b. will result in higher dividends per share. c. is included in every corporate charter. d. protects the current shareholders against a dilution of their ownership interests. e. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.

d. protects the current shareholders against a dilution of their ownership interests.

61. Molen Inc. has an outstanding issue of perpetual preferred stock with an annual dividend of $7.50 per share. If the required return on this preferred stock is 6.5%, at what price should the stock sell?

e. $115.38 RATIONALE: Preferred dividend $7.50 Required return 6.5% Preferred price = DP/rP = $115.38

49. A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth rate is g = 4.0%. What is the current stock price? a. $23.11 b. $23.70 c. $24.31 d. $24.93 e. $25.57

e. $25.57 RATIONALE: D0 $1.50 rs 10.1% g 4.0% D1 = D0(1 + g) = $1.56 P0 = D1/(rs − g) $25.57

74. Ryan Enterprises forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13.0%, and the FCFs are expected to continue growing at a 5.0% rate after Year 3. What is the firm's total corporate value, in millions? Year 1 2 3 FCF −$15.0 $10.0 $40.0 a. $314.51 b. $331.06 c. $348.48 d. $366.82 e. $386.13

e. $386.13

57. Reddick Enterprises' stock currently sells for $35.50 per share. The dividend is projected to increase at a constant rate of 5.50% per year. The required rate of return on the stock, rs, is 9.00%. What is the stock's expected price 3 years from today? a. $37.86 b. $38.83 c. $39.83 d. $40.85 e. $41.69

e. $41.69 RATIONALE: Stock price $35.50 Growth rate 5.50% Years in the future 3 P3 = P0(1 + g)3 = $41.69

58. Whited Inc.'s stock currently sells for $35.25 per share. The dividend is projected to increase at a constant rate of 4.75% per year. The required rate of return on the stock, rs, is 11.50%. What is the stock's expected price 5 years from now? a. $40.17 b. $41.20 c. $42.26 d. $43.34 e. $44.46

e. $44.46 RATIONALE: Growth rate 4.75% Years in the future 5 Stock price $35.25 P5 = P0(1 + g)5 = $44.46

87. Savickas Petroleum's stock has a required return of 12%, and the stock sells for $40 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% per year for the next 4 years, so D4 = $1.00(1.30)4 = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of X% per year forever. What is the stock's expected constant growth rate after t = 4, i.e., what is X? a. 5.17% b. 5.44% c. 5.72% d. 6.02% e. 6.34%

e. 6.34%

56. Gay Manufacturing is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate? a. 6.01% b. 6.17% c. 6.33% d. 6.49% e. 6.65%

e. 6.65% RATIONALE: Expected dividend (D1) $1.25 Stock price $32.50 Required return 10.5% Dividend yield 3.85% Growth rate = rs − D1/P0 = 6.65%

79. Carter's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return? a. 8.03% b. 8.24% c. 8.45% d. 8.67% e. 8.89%

e. 8.89% RATIONALE: Pref. quarterly dividend $1.00 Annual dividend = Qtrly dividend × 4 = $4.00 Preferred stock price $45.00 Nom. required return = Annual dividend/Price = 8.89%

55. If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the stock's expected total return for the coming year? a. 8.37% b. 8.59% c. 8.81% d. 9.03% e. 9.27%

e. 9.27% RATIONALE: D0 $1.75 g 3.6% P0 $32.00 D1 = D0(1 + g) = $1.81 Total return = rs = D1/P0 + g 9.27%

26. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks fall into one of three classes: A, B, and C. b. All common stocks, regardless of class, must have the same voting rights. c. All firms have several classes of common stock. d. All common stock, regardless of class, must pay the same dividend. e. Some class or classes of common stock are entitled to more votes per share than other classes.

e. Some class or classes of common stock are entitled to more votes per share than other classes.

An increase in a firm's expected growth rate would cause its required rate of return to a. increase. b. decrease. c. fluctuate less than before. d. fluctuate more than before. e. possibly increase, possibly decrease, or possibly remain constant.

e. possibly increase, possibly decrease, or possibly remain constant.

45. For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then

e. the expected future return must be equal to the required return.

48. A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price? a. $17.39 b. $17.84 c. $18.29 d. $18.75 e. $19.22

ANSWER: c $18.29 RATIONALE: D1 $0.75 rs 10.5% g 6.4% P0 = D1/(rs − g) $18.29

36. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $30 $30 Expected growth (constant) 6% 4% Required return 12% 10% a. Stock X has a higher dividend yield than Stock Y. b. Stock Y has a higher dividend yield than Stock X. c. One year from now, Stock X's price is expected to be higher than Stock Y's price. d. Stock X has the higher expected year-end dividend. e. Stock Y has a higher capital gains yield.

ANSWER: c One year from now, Stock X's price is expected to be higher than Stock Y's price. RATIONALE: The correct answer is statement c. Both prices are currently the same, but X's price should grow at 6% vs. 4% for Y, so X's price should be higher a year from now.

(T/F) Which of the following statements is CORRECT? a. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years. b. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. c. The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. e. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time.

C The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.

(T/F) According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock.

False

(T/F) If a firm's stockholders are given the preemptive right,this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight

False

(T/F) Preferred stock is a hybrid—a sort of cross between a common stock and a bond—in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond.

False

(T/F) The corporate valuation model cannot be used unless a company pays dividends.

False

(T/F) The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold.

False

(T/F) The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value

True

(T/F) When a new issue of stock is brought to market, it is the marginal investor who determines the price at which the stock will trade.

True

(T/F) The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities

True

(T/F) A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms

True

(T/F) According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period.

True

(T/F) If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return.

True

64. Schnusenberg Corporation just paid a dividend of D0 = $0.75 per share, and that dividend is expected to grow at a constant rate of 6.50% per year in the future. The company's beta is 1.25, the required return on the market is 10.50%, and the risk-free rate is 4.50%. What is the company's current stock price? a. $14.52 b. $14.89 c. $15.26 d. $15.64 e. $16.03

a. $14.52 RATIONALE: D0 $0.75 b 1.25 rRF 4.5% rM 10.5% g 6.5% D1 = D0(1 + g) = $0.7988 rs = rRF + b(rM − RRF) = 12.0% P0 = D1/(rs − g) $14.52

63. The Isberg Company just paid a dividend of $0.75 per share, and that dividend is expected to grow at a constant rate of 5.50% per year in the future. The company's beta is 1.15, the market risk premium is 5.00%, and the risk-free rate is 4.00%. What is the company's current stock price, P0? a. $18.62 b. $19.08 c. $19.56 d. $20.05 e. $20.55

a. $18.62 RATIONALE: D0 $0.75 b 1.15 rRF 4.0% RPM 5.0% g 5.5% D1 = D0(1 + g) = $0.7913 rs = rRF + b(RPM ) = 9.75% P0 = D1/(rs − g) $18.62

62. The Francis Company is expected to pay a dividend of D1 = $1.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 6.00% per year in the future. The company's beta is 1.15, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the company's current stock price? a. $28.90 b. $29.62 c. $30.36 d. $31.12 e. $31.90

a. $28.90 RATIONALE: D1 $1.25 b 1.15 rRF 4.00% RPM 5.50% g 6.00% rs = rRF + b(RPM ) = 10.33% P 0 = D1/(rs − g) $28.90

84. Ackert Company's last dividend was $1.55. The dividend growth rate is expected to be constant at 1.5% for 2 years, after which dividends are expected to grow at a rate of 8.0% forever. The firm's required return (rs) is 12.0%. What is the best estimate of the current stock price? a. $37.05 b. $38.16 c. $39.30 d. $40.48 e. $41.70

a. $37.05

42. Which of the following statements is CORRECT? a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital. b. To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the weighted average cost of capital. c. To implement the corporate valuation model, we discount projected net income at the weighted average cost of capital. d. To implement the corporate valuation model, we discount projected free cash flows at the cost of equity capital. e. The corporate valuation model requires the assumption of a constant growth rate in all years.

a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital.

68. Gupta Corporation is undergoing a restructuring, and its free cash flows are expected to vary considerably during the next few years. However, the FCF is expected to be $65.00 million in Year 5, and the FCF growth rate is expected to be a constant 6.5% beyond that point. The weighted average cost of capital is 12.0%. What is the horizon (or continuing) value (in millions) at t = 5? a. $1,025 b. $1,079 c. $1,136 d. $1,196 e. $1,259

e. $1,259 RATIONALE: CF5 $65.00 g 6.5% WACC 12.0% FCF6 = FCF5(1 + g) = $69.2250 HV5 = FCF6/(WACC − g) = $1,258.64