FIN CH 7

Assuming everything else remains unchanged, how does a firmʹs decision to increase its dividend-payout ratio affect its growth rate?

Increasing dividend-payout ratio will decrease the retention rate, thereby decreasing the growth rate.

A stock is expected to pay $1.25 per share every year indefinitely and the equity cost of capital for the company is 8.4%. What price would an investor be expected to pay per share ten years in the future?

A) $14.88 A) P0 = $1.25 / 0.084 = $14.88

JRN Enterprises just announced that it plans to cut its dividend from $3.00 to $1.50 per share and use the extra funds to expand its operations. Prior to this announcement, JRNʹs dividends were expected to grow indefinitely at 4% per year and JRNʹs stock was trading at $25.50 per share. With the new expansion, JRNʹs dividends are expected to grow at 8% per year indefinitely. Assuming that JRNʹs risk is unchanged by the expansion, the value of a share of JRN after the announcement is closest to ________.

A) $19.32 A) Two steps. Step 1: Solve for rE: rE = Div1 / P0 + g = $3.00 /$25.50 + 0.04 = 0.15765 or 15.77% Step 2: Solve for new stock price: P0 = Div1 / (rE - g) = $1.50 /(0.15765 - 0.08) = $19.32

Rylan Industries is expected to pay a dividend of $5.70 year for the next four years. If the current price of Rylan stock is $31.27 , and Rylanʹs equity cost of capital is 12%, what price would you expect Rylanʹs stock to sell for at the end of the four years?

A) $21.96 A) Using a financial calculator, PV = -31.27 , PMT = 5.70, n = 4, I = 12; Calculate FV = $21.9

Coolibah Holdings is expected to pay dividends of $1.20 every six months for the next three years. If the current price of Coolibah stock is $22.60 , and Coolibahʹs equity cost of capital is 18%, what price would you expect Coolibahʹs stock to sell for at the end of three years?

A) $28.87 A) Using a financial calculator, PV = -$22.60 , PMT = $1.20, n = 6, I = 18% / 2; calculate FV = $28.87 .

Credenza Industries is expected to pay a dividend of $1.70 at the end of the coming year. It is expected to sell for $62 at the end of the year. If its equity cost of capital is 9%, what is the expected capital gain from the sale of this stock at the end of the coming year?

A) $3.56 A) P0 using the capital gain rate formula = ($1.70 + $62) / (1 + 0.09) = $58.44 ; Capital gain = P1 - P0 = $62 - $58.44 = $3.56

Von Bora Corporation (VBC) is expected to pay a $3.00 dividend at the end of this year. If you expect VBCʹs dividend to grow by 6% per year forever and VBCʹs equity cost of capital to be 13%, then the value of a share of VBS stock is closest to ________.

A) $42.86 A) P0 = Div1 / (rE - g) = $3.00 / (0.13 - 0.06) = $42.86

A stock is expected to pay $0.70 per share every year indefinitely. If the current price of the stock is $18.90 , and the equity cost of capital for the company that released the shares is 7.9%, what price would an investor be expected to pay per share five years into the future?

A) $8.86 A) P0 = $0.70 / 0.079 = $8.86

A company has stock which costs $41.50 per share and pays a dividend of $2.50 per share this year. The companyʹs cost of equity is 7%. What is the expected annual growth rate of the companyʹs dividends?

A) 0.98%

Kirkevue Industries pays out all its earnings as dividends and has a share price of $27. In order to expand, Kirkevue announces it will cut its dividend payments from $2.15 to $1.75 per share and reinvest the retained funds. What is the growth rate that should be achieved on the reinvested funds to keep the equity cost of capital unchanged?

A) 1.48%

Luther Industries has a dividend yield of 4.5% and a cost of equity capital of 10%. Luther Industriesʹ dividends are expected to grow at a constant rate indefinitely. The growth rate of Lutherʹs dividends is closest to ________.

A) 5.5% A) rE = Div1 / P0 + g 0.1 = 0.045 + g, so g = 5.5%

Which of the following statements is FALSE regarding profitable and unprofitable growth?

A) If a firm wants to increase its share price, it must diversify.

Which of the following will NOT increase a companyʹs dividend payments?

A) It can issue more shares

Which of the following is a limitation of the dividend-discount model?

A) It cannot handle negative growth rates.

Which of the following statements is FALSE of the dividend-discount model?

A) We cannot use the dividend-discount model to value the stock of a firm with rapid or changing growth.

Which of the following is NOT a way that a firm can increase its dividend?

A) by increasing its retention rate

Aaron Inc. has 321 million shares outstanding. It expects earnings at the end of the year to be $641 million. The firmʹs equity cost of capital is 11%. Aaron pays out 50% of its earnings in total: 30% paid out as dividends and 20% used to repurchase shares. If Aaronʹs earnings are expected to grow at a constant 7% per year, what is Aaronʹs share price?

B) $24.96 B) P0 = (0.5 × $641 million) / (0.11 - 0.07) = $8012.5 million; Price per share = $8012.5 million / 321 million = $24.96

Sinclair Pharmaceuticals, a small drug company, develops a vaccine that will protect against Helicobacter pylori, a bacteria that is the cause of a number of diseases of the stomach. It is expected that Sinclair Pharmaceuticals will experience extremely high growth over the next three years and will reinvest all of its earnings in expanding the company over this time. Earnings were $1.10 per share before the development of the vaccine and are expected to grow by 40% per year for the next three years. After this time, it is expected that growth will drop to 5% and stay there for the expected future. Four years from now Sinclair will pay dividends that are 75% of its earnings. If its equity cost of capital is 12%, what is the value of a share of Sinclair Pharmaceuticals today?

B) $25.78

Gremlin Industries will pay a dividend of $1.90 per share this year. It is expected that this dividend will grow by 4% per year each year in the future. The current price of Gremlinʹs stock is $23.50 per share. What is Gremlinʹs equity cost of capital?

B) 12%

You expect KT industries (KTI) will have earnings per share of $5 this year and expect that they will pay out $1.25 of these earnings to shareholders in the form of a dividend. KTIʹs return on new investments is 13% and their equity cost of capital is 15%. The expected growth rate for KTIʹs dividends is closest to ________.

B) 9.8% B) g = Retention rate × Return on new investment = ($5 - $1.25 ) / $5 × 0.13 = 0.0975 or 9.8%

Which of the following models directly values all of the firmʹs equity, rather than a single share? I. Dividend-discount model II. Total payout model III. Discounted cash flow model

B) II only

The above screen shot above from Google Finance shows the price history of Progenics, a pharmaceutical company. In the time period shown, Progenics released information that an intravenously-administered formulation of their leading product had failed in a Phase III clinical trial. In which of the months shown in the price history is this most likely to have occurred?

B) March 2008

Which of the following formulas is INCORRECT?

B) PN = (rE - g) × DivN+1

Which of the following statements is FALSE?

B) Total return equals earnings multiplied by the dividend payout rate.

You placed an order to purchase stock where you specified the maximum price you were willing to pay. This type of order is known as a ________.

B) limit order

The above screen shot from Google Finance shows the basic stock information for Logitech International SA (USA) after the close of business on August 22, 2008. What is the difference between the opening and closing price of the stock on this date?

C) $0.24 C) $26.30 - $26.06 = $0.24

Matilda Industries pays a dividend of $2.10 per share and is expected to pay this amount indefinitely. If Matildaʹs equity cost of capital is 9%, which of the following would be closest to Matildaʹs stock price?

C) $23.33 C) PV0 = $2.10 / 0.09 = $23.33

Valorous Corporation will pay a dividend of $1.75 per share at this yearʹs end and a dividend of $2.35 per share at the end of next year. It is expected that the price of Valorousʹ stock will be $41 per share after two years. If Valorous has an equity cost of capital of 9%, what is the maximum price that a prudent investor would be willing to pay for a share of Valorous stock today?

C) $38.09 C) Using a financial calculator, CF0 = 0,CF1 = 1.75,CF2 = (41 + 2.35) = 43.35 ; calculate NPV at I = 9%, equals $38.09 .

You expect that Bean Enterprises will have earnings per share of $2 for the coming year. Bean plans to retain all of its earnings for the next three years. For the subsequent two years, the firm plans on retaining 50% of its earnings. It will then retain only 25% of its earnings from that point forward. Retained earnings will be invested in projects with an expected return of 20% per year. If Beanʹs equity cost of capital is 10%, then the price of a share of Beanʹs stock is closest to ________.

C) $41.36

Sunnyfax Publishing pays out all its earnings and has a share price of $37. In order to expand, Sunnyfax Publishing decides to cut its dividend from $3.00 to $2.00 per share and reinvest the retained funds. Once the funds are reinvested, they are expected to grow at a rate of 13%. If the reinvestment does not affect Sunnyfaxʹs equity cost of capital, what is the expected share price as a consequence of this decision?

C) $52.38

You expect KT industries (KTI) will have earnings per share of $5 this year and expect that they will pay out $2.50 of these earnings to shareholders in the form of a dividend. KTIʹs return on new investments is 14% and their equity cost of capital is 11%. The value of a share of KTIʹs stock today is closest to ________.

C) $62.50 C) g = Retention rate × Return on new investment = ($5 - $2.50 )/$5 × 0.14 = 0.07 or 7% P0 = Div1 / (rE - g) = $2.50 / (0.11 - 0.07) = $62.50

Chittenden Enterprises has 643 million shares outstanding. It expects earnings at the end of the year to be $960 million. The firmʹs equity cost of capital is 9%. Chittenden pays out 30% of its earnings in total: 20% paid out as dividends and 10% used to repurchase shares. If Chittendenʹs earnings are expected to grow at a constant 3% per year, what is Chittendenʹs share price?

C) $7.47 C) P0 = (0.3 × $960 million) / (0.09 - 0.03) = $4800 million; Price per share = $4800 million / 643 million = $7.47

Avril Synchronistics will pay a dividend of $1.20 per share this year. It is expected that this dividend will grow by 3% each year in the future. What will be the current value of a single share of Avrilʹs stock if the firmʹs equity cost of capital is 16%?

C) $9.23

The Sisyphean Companyʹs common stock is currently trading for $25.50 per share. The stock is expected to pay a $2.80 dividend at the end of the year and the Sisyphean Companyʹs equity cost of capital is 10%. If the dividend payout rate is expected to remain constant, then the expected growth rate in the Sisyphean Companyʹs earnings is closest to ________.

C) -0.98% C) P0 = Div1 / (rE - g) = $25.50 = $2.80 / (0.1 - g),so g = -0.0098 or -0.98%

A round lot consists of how many shares?

C) 100

Jumbuck Exploration has a current stock price of $3.00 and is expected to sell for $3.15 in one yearʹs time, immediately after it pays a dividend of $0.28 . Which of the following is closest to Jumbuck Explorationʹs equity cost of capital?

C) 14.33% C) $0.28 + $3.15 - $3.00 = $0.43 ; cost of capital = $0.43 /$3.00 = 14.33%

Which of the following will be a source of cash flows for a shareholder of a certain stock? I. Sale of the shares at a future date II. The firm in which the shares are held paying out cash to shareholders in the form of dividends III. The firm in which the shares are held increasing the total number of shares outstanding through a stock split

C) I and II

Growth Industries presently pays an annual dividend of $1.20 per share and it is expected that these dividend payments will continue indefinitely. If NoGrowthʹs equity cost of capital is 10%, then the value of a share of NoGrowthʹs stock is closest to ________.

D) $12.00 D) P0 = Div1 / (rE - g) = $1.20 / (0.1 - 0) = $12.00

Owen Inc. has a current stock price of $15.00 and is expected to pay a $0.80 dividend in one year. If Owenʹs equity cost of capital is 12%, what price would its stock be expected to sell for immediately after it pays the dividend?

D) $16.00 D) (1 + 0.12) × $15.00 = $16.80 ; $16.80 - $0.80 = $16.00

Jumbo Transport, an air-cargo company, expects to have earnings per share of $2.00 in the coming year. It decides to retain 10% of these earnings in order to lease new aircraft. The return on this investment will be 25%. If its equity cost of capital is 11%, what is the expected share price of Jumbo Transport?

D) $21.18

A stock is expected to pay $2.60 per share every year indefinitely and the equity cost of capital for the company is 11%. What price would an investor be expected to pay per share next year?

D) $23.64 D) P0 = $2.60 / 0.11 = $23.64

Spacefood Products will pay a dividend of $2.40 per share this year. It is expected that this dividend will grow by 5% per year each year in the future. What will be the current value of a single share of Spacefoodʹs stock if the firmʹs equity cost of capital is 12%?

D) $34.29

The above screen shot from Google Finance shows the basic stock information for Kraft Foods Inc. after the close of the stock market on May 30, 2008. What is the highest that the stock has traded at in the last 12 months?

D) $35.29

Sultan Services has 1.2 million shares outstanding. It expects earnings at the end of the year of $6.0 million. Sultan pays out 60% of its earnings in total: 40% paid out as dividends and 20% used to repurchase shares. If Sultanʹs earnings are expected to grow by 5% per year, these payout rates do not change, and Sultanʹs equity cost of capital is 10%, what is Sultanʹs share price?

D) $60.00 D) P0 = (0.6 × $6.0 million) / (0.1 - 0.05) = $72 million; P0 = $72 million / 1.2 million = $60.00

The above screen shot from Google Finance shows basic stock information for PepsiCo. If you owned 1600 shares of PepsiCo for the period shown, how much would you have earned in dividend payments?

D) $688.00 D) 1600 × $0.43 = $688.00

Valence Electronics has 213 million shares outstanding. It expects earnings at the end of the year of $800 million. Valence pays out 40% of its earnings in total15% paid out as dividends and 25% used to repurchase shares. If Valenceʹs earnings are expected to grow by 7% per year, these payout rates do not change, and Valenceʹs equity cost of capital is 9%, what is Valenceʹs share price?

D) $75.12 D) P0 = (0.4 × $800 million) / (0.09 - 0.07) = $16,000 million; Price per share = $16,000 million / 213 million = $75.12

The Busby Corporation had a share price at the start of the year of $26.10 , paid a dividend of $0.59 at the end of the year, and had a share price of $29.50 at the end of the year. Which of the following is closest to the rate of return of investments in companies with equal risk to The Busby Corporation for this period?

D) 15% D) $29.50 + $0.59 - $26.10 = $3.99 ; $3.99 / $26.10 = 15.29 %; rounded to 15%

A stock is bought for $23.00 and sold for $27.00 one year later, immediately after it has paid a dividend of $1.50. What is the capital gain rate for this transaction?

D) 17.39% D) Capital gain rate = (P1 - P0) / P0 = ($27.00 - $23.00 ) / $23.00 = 17.39%

Which of the following statements is FALSE?

D) According to the constant dividend growth model, the value of the firm depends on the current dividend level, divided by the equity cost of capital plus the grow rate.

Which of the following statements is FALSE about dividend payout and growth?

D) During periods of high growth, it is not unusual for firms to pay out 100% of their earnings to shareholders in the form of dividends

The above screen shot from Google Finance shows the basic stock information for Logitech International SA (USA). What is Logitech International SA (USA)ʹs ticker symbol?

D) LOGI

What are dividend payments?

D) a share of the profits paid to each shareholder on the basis of the number of shares they hold

Which of the following formulas is INCORRECT?

D) rE = (Div1 / P0) - g

What role do dividends play in stock investing?

Dividends are periodic payments given out by the firm to shareholders. It is not necessary for a firm to declare dividends, but mature firms tend to pay out dividends.

A floor broker is a person at the NASDAQ with a trading license who represents orders on the floor.

FALSE

Stocks that do not pay a dividend must have a value of $0.

FALSE

What is the relationship between the growth rate and the cost of equity implied in the dividend-discount model?

For the dividend-discount model equation to be viable, the growth rate should be smaller than the cost of equity because the model becomes meaningless if the growth rate is equal to or greater than the cost of equity.

What is a major assumption about growth rate in the dividend-discount model?

It is assumed that the growth rate used in the dividend-discount model be constant in the future.

How can the dividend-discount model handle changing growth rates?

Most firms have high growth rate during the early part of their existence, which gradually tapers to the steady-state growth rate. We cannot apply the formula during the period while the growth rate is changing. We can only apply it once the growth rate has stabilized to a constant rate.

A firm can either pay its earnings to its investors, or it can keep them and reinvest them.

TRUE

Forecasting dividends requires forecasting the firmʹs earnings, dividend payout rate, and future share count.

TRUE

The Valuation Principle states that the value of a stock is equal to the present value (PV) of both the dividends and future sale price of that stock which the investor will receive.

TRUE

The ownership in a corporation is divided into shares of stock, which carry rights to a share in the profits of the firm through future dividend payments.

TRUE

Can the dividend-discount model handle negative growth rates?

Yes, the dividend-discount model can handle negative growth rates. The model works as long as growth rate is smaller than the cost of equity and negative growth rate is smaller than the cost of equity.