FIN/370 CHAPTER 8

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

$12.62

51. A firm is expected to have net earnings of $1,480,000 three years from now. There are 500,000 shares of stock outstanding. The firm's current P/E ratio is 18 and it is expected to remain at that level. What is the firm's expected stock price for year 3?

$53.28 Formula: P3 = 18 x (1,480,000 / 500,000)

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

(1 + i)3

4. Which statements are correct? Select all that apply.

-A limit sell order will only execute at the limit price or higher. -A market order will execute immediately, regardless of the price. -A limit sell order may never be executed.

20. Which of these descriptions apply to common stock?

-A security that provides the potential for its owner to receive both dividends and gains -An equity security that offers ownership benefits in a corporation -A security that provides voting privileges.

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

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

35. Why are dividends an important part of a common stock's rate of return?

-Dividends increase the return for stocks with capital gains and reduce the loss for stocks with capital losses. -Dividends tend to be more stable than capital gains.

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

-Exchanges are becoming more global in nature. -Exchanges are relying more on electronic trading and less on open outcry -International trading of securities is rising

37. Which of these services should you expect to receive from a full-service brokerage firm?

-Investment advice -In-depth research on individual stocks

48. Which of these firms are considered to be incorrectly priced?

-Low growth high P/E -High growth low P/E

26. Which of these characteristics apply to the New York Stock Exchange (NYSE)

-Market maker (Specialist) -Physical trading floor -Brokers

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

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

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

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

45. What is the primary disadvantage of a limit order?

A limit order may not execute.

7. What is the key premise upon which the dividend discount model is based?

All future cash flows from a stock are dividend payments.

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

Approximately 78 percent

15. How is the discount rate used to value a stock related to the expected return on the stock?

Assume the stock price failry reflects the stock's value. The discount rate should equal the expected rate of return.

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

Current stock price / last four quarters of earnings.

2. What is the definition of market capitalization?

Current stock price times number of shares outstanding

41. Which of these is correct?

Dealers are willing to sell stocks at the ask price.

36. Which one of these defines the current value of stock?

Discounted value of both the future dividends and the future stock price.

50. What is the primary purpose of the P/E valuation formula?

Estimate the future price of a stock

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

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

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

Last four quarters of dividend income/current stock price

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

Liquidity

49. Which of these indicates a value stock?

Low P/E, high growth

18. Mary placed an order to purchase 100 shares of ABC at the going price. The order was filled as soon as it reached the floor of the exchange. What type of order did Mary place?

Market buy order

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

Market liquidity

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

Market sell order for 1,500 shares

1. Which of these terms best describes the trading process used by NASDAQ?

Multiple market maker system

40. Which of these indexes is the most technology-oriented?

NASDAQ Composite

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

P0 - $2 / 1.112 + [($3 + $40) / 1.113]

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

P0 = $1.42 / (0.12 - 0.03)

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

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

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

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

34. What is the definition of a growth stock?

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

31. Which one of these best summarizes stock valuation?

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

3. Which one of these statements is correct?

The DIJA, S&P 500, and NASDAQ Composite tend to be positively related.

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

The company's future growth prospects

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

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

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

The order has not executed. You still own 500 shares.

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

The order is executed at a price of $28 a share.

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

The profitability and success of the issuer

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

The stock price will decrease

24. Which of these is a correct interpretation of a P/E ratio?

The stock with the lowest P/E has the lowest current price per dollar of earnings.

30. Which one of these applies to stock valuation?

The value of a stock today equals the discounted value of the future expected cash flows.

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

To replace all of the dividends paid in stage 2

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

What if the growth rate is 8 percent? 5.4 percent; 9.4 percent

11. A preferred stock has which of these characteristics?

Zero dividend growth

21. Which of these are basic assumptions of a variable growth rate valuation?

g1 applies to a designated number of years g2 < i g1 can be negative positive or equal to zero

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

g2=0.03

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

i=(($1.42 x 1.02)/$46)+0.02