Finance Chapter 7 Practice Problems

Stock rights provide the stockholder with ________.

the right to purchase additional shares in direct proportion to their number of owned

Equity capital can be raised through ________.

the stock market

Smith Corporation's common stock is expected to pay a dividend of $3.00 forever and currently sells for $21.42. What is the required rate of return?

14%

Which of the following is a disadvantage of issuing preferred stock from the common stockholders' perspective?

There is a seniority of preferred stockholder's claim over common stockholders.

Which of the following is true of a common stock

There is no fixed dividend payment obligation for the company.

Which of the following is true of efficient-market hypothesis?

Since stocks are fully and fairly priced, it follows that investors should not waste their time trying to find and capitalize on miss-priced (undervalued or overvalued) securities.

A firm has to pay a dividend of $1.20 per share till perpetuity, a zero growth rate of dividends, and a required return of 10 percent. The value of the firm's preferred stock is ________.

$12

A firm has the balance sheet accounts, Common Stock and Paid-in Capital in Excess of Par, with values of $40,000 and $500,000, respectively. The firm has 40,000 common shares outstanding. If the firm had a par value of $1, the stock originally sold for ________.

$13.50/share

At year end, Tangshan China Company balance sheet showed total assets of $60 million, total liabilities (including preferred stock) of $45 million, and 1,000,000 shares of common stock outstanding. Based on this information, Tangshan's book value per share of common stock is ________.

$15

Harry Corporation's common stock currently sells for $180 per share. Harry just paid a dividend of $10.18 and dividends are expected to grow at a constant rate of 6 percent forever. If the required rate of return is 12 percent, what will Harry Corporation's stock sell for one year from now?

$190.64

Ted Corporation expects to generate free-cash flows of $200,000 per year for the next five years. Beyond that time, free cash flows are expected to grow at a constant rate of 5 percent per year forever. If the firm's average cost of capital is 15 percent, the market value of the firm's debt is $500,000, and Ted has a half million shares of stock outstanding, what is the value of Ted stock?

$2.43

At year end, Tangshan China Company balance sheet showed total assets of $60 million, total liabilities (including preferred stock) of $45 million, and 1,000,000 shares of common stock outstanding. Next year, Tangshan is projecting that it will have net income of $1.5 million. If the average P/E multiple in Tangshan's industry is 15, what should be the price of Tangshan's stock?

$22.50

Daniel Custom Cycles' common stock currently pays no dividends. The company plans to begin paying dividends beginning 3 years from today. The first dividend will be $3.00 and dividends will grow at 5 percent per year thereafter. Given a required return of 15 percent, what would you pay for the stock today?

$22.68

A firm has an outstanding issue of 1,000 shares of preferred stock with a $100 par value and an 8 percent annual dividend. The firm also has 5,000 shares of common stock outstanding. If the stock is cumulative and the board of directors has passed the preferred dividend for the prior two years, how much must the preferred stockholders be paid prior to paying dividends to common stockholders at the end of third year?

$24,000

A firm has an issue of preferred stock outstanding that has a stated annual dividend of $4. The required return on the preferred stock has been estimated to be 16 percent. The value of the preferred stock is ________.

$25

A firm has the balance sheet accounts, Common Stock and Paid-in Capital in Excess of Par, with values of $10,000 and $250,000, respectively. The firm has 10,000 common shares outstanding. If the firm had a par value of $1, the stock originally sold for ________.

$26/share

Julian is considering purchasing the stock of Pepsi Cola because he really loves the taste of Pepsi. What should Julian be willing to pay for Pepsi today if it is expected to pay a $2 dividend in one year and he expects dividends to grow at 5 percent indefinitely? Julian requires a 12 percent return to make this investment.

$28.57

The current price of DEF Corporation stock is $26.50 per share. Earnings next year should be $2 per share and it should pay a $1 dividend. The P/E multiple is 15 times on average. What price would you expect for DEF's stock in the future?

$30.00

A firm has issued cumulative preferred stock with a $100 par value and a 12 percent annual dividend. For the past two years, the board of directors has decided not to pay a dividend. At the end of the current year, the preferred stockholders must be paid ________ prior to paying the common stockholders

$36/share

A firm issued 10,000 shares of $2 par-value common stock, receiving proceeds of $40 per share. The amount recorded for the paid-in capital in excess of par account is ________.

$380,000

A firm issued 10,000 shares of no par-value common stock, receiving proceeds of $40 per share. The amount recorded is ________.

$400,000 in the Common Stock account

Emmy Lou, Inc. has an expected dividend next year of $5.60 per share, a growth rate of dividends of 10 percent, and a required return of 20 percent. The value of a share of Emmy Lou, Inc.'s common stock is ________.

$56.00

Jia's Fashions recently paid a $2 annual dividend. The company is projecting that its dividends will grow by 20 percent next year, 12 percent annually for the two years after that, and then at 6 percent annually thereafter. Based on this information, how much should Jia's Fashions common stock sell for today if her required return is 10.5%?

$59.16

Patrick Company expects to generate free-cash of $120,000 per year forever. If the firm's required return is 12 percent, the market value of debt is $300,000, the market value of preferred stock is $70,000, and the company has 100,000 shares of stock outstanding. What is the value of Patrick's stock?

$6.30

At year end, Tangshan China Company balance sheet showed total assets of $60 million, total liabilities (including preferred stock) of $45 million, and 1,000,000 shares of common stock outstanding. If Tangshan could sell its assets for $52.5 million, Tangshan's liquidation value per share of common stock is ________.

$7.50

An 8 percent preferred stock with a market price of $110 per share and a $100 par value pays a cash dividend of ________.

$8.00

You are planning to purchase the stock of Ted's Sheds Inc. and you expect it to pay a dividend of $3 in 1 year, $4.25 in 2 years, and $6.00 in 3 years. You expect to sell the stock for $100 in 3 years. If your required return for purchasing the stock is 12 percent, how much would you pay for the stock today?

$81.52

A firm has experienced a constant annual rate of dividend growth of 9 percent on its common stock and expects the dividend per share in the coming year to be $2.70. The firm can earn 12 percent on similar risk involvements. The value of the firm's common stock is ________.

$90/share

A firm issued 5,000 shares of $1 par-value common stock, receiving proceeds of $20 per share. The amount recorded for the paid-in capital in excess of par account is ________.

$95,000

Smith, Inc. stock currently sells for $75 per share. The firm has total assets of $1,000,000 and total liabilities, including preferred stock, of $350,000. If the firm has 10,000 shares of common stock outstanding, (a) what is the book value of each share of common stock? (b) is the stock overvalued or undervalued in the marketplace? (c) what is the reason(s) for your answer in (b)?

(a) Book value per share = ($1,000,000-$350,000)/(10,000) = $65 per share (b) Overvalued (c) Market value of the assets is greater than the book value.

Ria's Doll Company has an outstanding preferred issue of stock with a par value of $100 and an annual dividend of 10 percent (of par). Similar risk preferred stocks are yielding an 11.5 percent annual rate of return. (a) What is the current value of the outstanding preferred stock? (b) What will happen to price as the risk-free rate increases? Explain.

(a) Current value of the outstanding preferred stock = $100 × 0.10 / 0.115 = $86.96 (b) As the risk-free rate increases, the required rate of return will increase and the price will drop

Tangshan China Company's stock is currently selling for $80.00 per share. The expected dividend one year from now is $4.00 and the required return is 13 percent. What is Tangshan's dividend growth rate assuming that dividends are expected to grow at a constant rate forever?

8%

A firm has an issue of preferred stock outstanding that has a par value of $100 and a 4% dividend. If the current market price of the preferred stock is $50, the yield on the preferred stock is ________.

8.00%

Tangshan China's stock is currently selling for $160.00 per share and the firm's dividends are expected to grow at 5 percent indefinitely. Assuming Tangshan China's most recent dividend was $5.50, what is the required rate of return on Tangshan's stock?

8.4%

The Oxford Heating Company has been very successful in the past four years. Over these years, it paid common stock dividend of $4 in the first year, $4.20 in the second year, $4.41 in the third year, and its most recent dividend was $4.63. The company wishes to continue this dividend growth indefinitely. What is the value of the company's stock if the required rate of return is 12 percent?

Answer: Constant growth rate, g = ($4.63 / $4.00) 1 / 3 - 1 = 0.04996, g = 5% P = D5 / (r - g) = 4.63 (1 + 0.05) / (0.12 - 0.05) = $69.45

The Bradshaw Company's most recent dividend was $6.75. The historical dividend payment by the company shows a constant growth rate of 5 percent per year. What is the maximum you would be willing to pay for a share of its common stock if your required rate of return is 8 percent?

Answer: D1 = $6.75 × (1 + 0.05) = $7.0875 P = D1 / (r - g) = $7.0875 / (0.08 - 0.05) = $236.25

Ted has 10 shares of Grand Company. Based on the company's dividend policy, Ted will receive a total of $450 a year in perpetuity. What is the value of each share if the rate of interest is 8 percent?

Answer: Dividend per share = $450 / 10 = $45 P = D / r = 45 / 0.08 = $562.50

Which of the following is true of outstanding shares?

Authorized shares become outstanding shares when they are issued or sold to investors.

Which of the following is a difference between common stock and bonds?

Bondholders have a senior claim on assets and income relative to stockholders.

China Imports currently has 2,000 shares of common stock outstanding. The firm has assets of $200,000 and total liabilities including preferred stock of $75,000. Calculate the book value per share of China Imports common stock

Book value per share = (200,000-$75,000)/(2000) = $62.50 per share

Which of the following is typically a feature of common stock?

Common stocks may or may not pay dividends

Based on analysis of the company and expected industry and economic conditions, China Imports is expected to earn $4.60 per share of common stock next year. The average price/earnings ratio for firms in the same industry is 8. Calculate the estimated value of a share of China Imports common stock

Estimated value of share price = $4.60 × 8 = $36.80 per share

Which of the following is true of equity?

It does not mature, so repayment is not required

Which of the following is true of common stock ?

It gives the holder voting rights which permit selection of the firm's directors.

Which of the following is true of the issuance of nonvoting common stock?

It helps the corporation to raise capital through the sale of common stock, without giving up its voting control

Which of the following is true of par value of a common stock?

It is an arbitrary value established for legal purposes in a firm's corporate charter.

________ is the actual amount each common stockholder would expect to receive if a firm's assets are sold for their market value, creditors and preferred stockholders are repaid, and any remaining money is divided among the common stockholders

Liquidation value

Smith has current assets of $800,000, which can be liquidated at 90 percent of book value. Total liabilities, including preferred stock, equal $270,000. The firm has 15,000 shares of common stock outstanding. What is the liquidation value per share of common stock?

Liquidation value per share = ($800,000*90%-$270,000)/15,000 = $30 per share

Aunt Tilly's Fur Company has been experiencing several years of financial difficulty and, thus, has considered maintaining its dividend payment at $2.50 indefinitely. What is the value of its common stock if the required rate of return is 8.5 percent

P = D / r = $2.50 / 0.085 = $29.41

The board of directors of Ride World, Inc. has declared $5.00 common stock dividend and accepted a plan to freeze the dividend at $5 per year indefinitely. What is the value of the Ride World's common stock if the required rate of interest is 15 percent?

P = D / r = $5 / 0.15 = $33.33

Jia's Kitchen Stuff has recently sold 1,000 shares of preferred stock. What is the value of the stock assuming 10 percent required rate of return and a preferred dividend of $6.75

P = D / r = $6.75 / 0.10 = $67.50

Tina's Medical Equipment Company paid $2.25 common stock dividend last year. The company's policy is to allow its dividend to grow at 5 percent per year indefinitely. What is the value of the stock if the required rate of return is 8 percent?

P = D1 / (r - g) = $2.25 × (1 + 0.05) / (0.08 - 0.05) = $78.75

In response to the stock market's reaction to its dividend policy, the Nico's Toy Company has decided to increase its dividend payment at a rate of 4 percent per year. The firm's most recent dividend is $3.25 and the required rate of interest is 9 percent. What is the maximum you would be willing to pay for a share of the stock?

P = D1 / (r - g) = 3.25 × (1 + 0.04) / (0.09 - 0.04) = $67.60

The use of the ________ is especially helpful in valuing firms that are not publicly traded.

P/E multiple

Which of the following valuation methods is superior to others in the list since it considers expected earnings?

P/E multiple

Which of the following is true of preferred stocks?

Preferred stock with a conversion feature allows holders to change each share into a stated number of shares of common stock.

________ are promised a fixed periodic dividend that must be paid prior to paying any common stock dividends

Preferred stockholders

Ride World has estimated the market value of its assets to be $1,250,000. What is the value of Ride World's common stock if it has $900,000 in liabilities, $50,000 in preferred stock, and 7,500 shares of common stock outstanding?

Stock price = ($1,250,000 - $900,000 - $50,000) / 7,500 = $40

Karina's Caribbean Foods had total assets as recorded on its balance sheet are $1,500,000. What is the value of the Karina's common stock if it has $950,000 in liabilities, and 7,500 shares of common stock outstanding?

Stock price = ($1,500,000 - $950,000) / 7,500 = $73.33

Due to growing demand for computer software, the Shine Company has had a very successful year and expects its earnings per share to grow by 25 percent to reach $5.50 for this year. Estimate the price of the company's common stock assuming the industry's price/earning ratio is 12.

Stock price = (P/E × E) = 12 × $5.50 = $66

________ is a guide to a firm's value if it is assumed that investors value the earnings of a given firm in the same way they do the average firm in the industry.

The P/E multiple

Edward Accounting Services has an outstanding issue of 1,000 shares preferred stock with a $100 par value, an 9 percent annual dividend, and 5,000 shares of common stock outstanding. If the stock is cumulative and the board of directors has passed the preferred dividend for the last two years, how much must preferred stockholders be paid prior to paying dividends to common stockholders?

The amount to be paid to preferred stockholders prior to paying dividends to common stockholders = Cumulative preferred dividends + Current year preferred dividend = $9,000 × 2 + $9,000 = $27,000

Which of the following is true of common stocks?

The common stock of a corporation can be either privately or publicly owned.

Uncle Tim's Inventions has an expected dividend next year of $3.60 and a required return of 12 percent. Assuming the dividends will be paid indefinitely, calculate the value of a share of common stock assuming a zero growth rate of dividends.

The value of a share of common stock = ($3.60/0.12)= $30

Angel recently purchased a block of 100 shares of Hayley's Optical common stock for $6,000. The stock is expected to provide an annual cash flow of dividends of $400 indefinitely. Assuming a discount rate of 8 percent, how does the price Angel paid compare to the value of the stock?

The value of the stock is = ($400/0.08) = $5,000

Which of the following is typically a feature of preferred stocks?

They are settled prior to common stocks during liquidation.

Which of the following is an attribute of investment bankers?

They bear the risk of selling a security issue.

Which of the following is true of securities analysts?

They use a variety of models and techniques to value stocks

Rational buyers and sellers use their assessment of an asset's risk and return to determine its value. Relative to this concept, which of the following is true?

To a buyer the asset's value represents the maximum price that he or she would pay to acquire it.

Which of the following is a marketable security?

Treasury bill

According to the efficient market hypothesis, prices of actively traded stocks ________.

do not differ from their true values in an efficient market

Milton Glasses recently paid a dividend of $1.70 per share, is currently expected to grow at a constant rate of 5%, and has a required return of 11%. Milton Glasses has been approached to buy a new company. Milton estimates if it buys the company, its constant growth rate would increase to 6.5%, but the firm would also be riskier, therefore increasing the required return of the company to 12%. Should Milton go ahead with the purchase of the new company?

Yes, because the value of the Milton Co. will increase by $3.17 per share

A proxy battle is the attempt by ________.

a nonmanagement group to unseat the existing management and gain control of the firm

Preferred stockholders ________.

do not have preference over bondholders in the case of liquidation

________ is the value of a firm's ownership in the event that all assets are sold for their exact accounting value and the proceeds remaining after paying all liabilities (including preferred stock) are divided among common stockholders

book value

If the expected return is above the required return on an asset, rational investors will ________.

buy the asset, which will drive the price up and cause expected return to reach the level of the required return

Regarding the tax treatment of payments to securities holders, it is true that ________.

common stock dividends and preferred stock dividends are not tax-deductible, while interest is tax-deductible

Dividends in arrears that must be paid to the preferred stockholders before payment of dividends to common stockholders are ________.

cumulative

Common stockholders expect to earn a return by receiving ________.

dividends

A violation of preferred stock restrictive covenants usually permits preferred shareholders to ________.

force the retirement of the preferred stock at or above its par value

Because equityholders are the last to receive any distribution of assets as a result of bankruptcy proceedings, they expect ________.

greater returns from their investment in the firm's stock

The cost of preferred stock is ________.

higher than the cost of long-term debt and lower than the cost of common stock.

A(n)________ is hired by a firm to find prospective buyers for its new stock or bond issue

investment banker

Which of the following is an advantage for a firm to issue common stock over long-term debt?

no maturity date on which the par value of the issue must be repaid

If a firm has class A and class B common stock outstanding, it means that ________.

one of the classes is probably nonvoting stock

Shares of stock currently owned by a firm's shareholders are called ________.

outstanding shares

Tangshan China's stock is currently selling for $160.00 per share and the firm's dividends are expected to grow at 5 percent indefinitely. In addition, Tangshan China's most recent dividend was $5.50. If the expected risk free rate of return is 3 percent, the expected market return is 8 percent, and Tangshan has a beta of 1.2, Tangshan's stock would be ________.

overvalued because the market price is higher than the resulting share value

Holders of equity capital ________.

own the firm

Preferred stock is valued as if it were a ________.

perpetuity

In the Gordon model, the value of a common stock is the ________.

present value of a constant growing dividend stream

The attempt by a nonmanagement group to gain control of the management of a firm by soliciting a sufficient number of proxy votes is called a ________.

proxy battle

Preferred stock is characterized by ________.

quasi-debt nature

The purpose of nonvoting common stock is to ________.

raise capital without giving up any voting control

Treasury stock refers to the ________.

repurchase of outstanding stock

Common stockholders are sometimes referred to as ________.

residual owners

Which of the following is usually a right of a preferred stockholder?

right to receive dividend payments before any dividends are paid to common stockholders

In a ________, new shares are sold to the existing shareholders.

rights offering

________ are financial instruments that allow stockholders to purchase additional shares at a price below the market price, in direct proportion to their number of owned shares

rights offering

If bankruptcy were to occur, ________ would have the first claim on assets

secured creditors

ADRs are ________.

securities, backed by American depositary shares (ADSs), that permit U.S. investors to hold shares of non-U.S. companies and trade them in U.S. markets

If expected return is less than required return on an asset, rational investors will ________.

sell the asset, which will drive the price down and cause the expected return to reach the level of the required return

From a corporation's point of view, a disadvantage of issuing preferred stock is ________.

that the dividends are not tax-deductible

A proxy statement is a statement transferring ________.

the votes of a stockholder to another party

A proxy statement gives shareholders the right ________.

to give up their vote to another party

The preemptive right gives shareholders the right ________.

to maintain their proportionate ownership in the corporation when new common stock is issued

Tangshan China's stock is currently selling for $160.00 per share and the firm's dividends are expected to grow at 5 percent indefinitely. In addition, Tangshan China's most recent dividend was $5.50. If the expected risk free rate of return is 3 percent, the expected market premium is 4 percent, and Tangshan has a beta of 1.2, Tangshan's stock would be ________.

undervalued because the market price is less than the resulting share value

A group formed by an investment banker to share the financial risk associated with underwriting new securities is called a(n) ________.

underwriting syndicate

Which of the following typically applies to common stock but not to preferred stock?

voting rights

The ________ is utilized to value preferred stock

zero-growth model