Ch. 7: Part 2

Estimates of the terminal price generally account for a _______ proportion of a stock's value than estimates of the present value of forecasted dividends up until the horizon date.

greater

A firm that is experiencing rapid ____________ may see its free cash flow be zero or negative since it is reinvesting all of its earnings into new investments.

growth

A low P/E ratio generally means that a firm has:

high dividend payouts

Plowed back earnings will add to firm value when they are expected to earn:

higher than the rate of return that investors require

Stock repurchases are an attractive alternative to dividends because:

investors interpret dividends as repeated cash distributions

Free cash flow may be _________ for rapidly growing businesses that are reinvesting all of their earnings into new investments.

negative

Companies that grow rapidly for several years before settling down to a stable growth rate should use the ___________ for stock valuation.

non-constant growth model

Behavioral finance has shown that most investors are _________ in their ability to pick stocks that will offer superior returns.

overconfident

The fraction of earnings paid out as dividends is a firm's:

payout ratio

A stock that pays out a perpetual stream of constant dividends can be valued as a(n) _________.

perpetuity

The fraction of earnings reinvested in the firm is called the:

plowback ratio

The expected rate of return for a stock whose next dividend is "DIV1", that has a required rate of return "r" and expects to grow its future dividends at a rate of "g" is ________.

r = (DIV1/P0) + g

A firm hosts its quarterly investment call. News about the firm's earnings will be reflected in the firm's stock price within:

seconds or minutes

The type of market efficiency that asserts that investors cannot earn superior returns through a study of information available to other investors is:

semi-strong form efficiency

The total value of a firm's stock is $23.75 per share. The value of the firm's assets in place is $12 per share. What is the firm's present value of growth opportunities (PVGO)?

$11.75 Rationale: Value of assets in place + PVGO = total value of stock; therefore $12 + PVGO = $23.75. PVGO = $23.75 - 12= $11.75

Smithfield Hams is forecasted to pay a dividend of $1.50 for the following year and expects dividends to grow at a rate of 3 percent into the future. If investors require an 11 percent rate of return from Smithfield, what should its current share price be?

$18.75 Rationale: $1.50/(.11 - .03) = $18.75

Vandalay Industries is an established company in a mature industry. They currently pay an annual dividend of $2.50 per share and expect to continue to do so indefinitely. If investors require a 12 percent return on stock of this risk, what should Vandalay's current share price be?

$20.83 Rationale: $2.50/0.12 = $20.83

Robco is an established company in a mature industry. They currently pay an annual dividend of $28 per share and expect to continue to do so indefinitely. If investors require a 12 percent return on stock of this risk, what should Robco's current dividend be?

$3.36 Rationale: $28*0.12 = $3.36

Using the dividend discount model for a no-growth stock, what is the value of a stock that pays a $3 dividend and has a discount rate of 10%?

$30 Rationale: Value of a no-growth stock = DIV1/r = $3/.1=$30

Helena Handbaskets expects to pay a dividend of $0.50 at year end and expects that dividend to grow at a rate of 6 percent per year thereafter. If investors require a 15 percent return on Helena's stock, what should the current share price be?

$5.56 Rationale: $0.50/(0.15-0.06)=$5.56

A firm has $2 million in earnings. It has a plowback ratio of 75%. How much will the firm pay out in dividends to shareholders?

$500,000 Rationale: If the firm's plowback ratio is 75%, then its payout ratio is 25%. It will pay out $2 million x.25 = $500,000

A firm has $1 million in earnings. It has a payout ratio of 40%. How much will the firm plow back into the firm?

$600,000 Rationale: If the payout ratio is 40%, the plowback ratio will be 60%, which means the firm will plow back $1 million x.6= $600,000

A firm has a payout ratio of.3, plowback ratio of.7 and a return on equity of .13. What is the firm's growth rate?

9.1% Rationale: Growth rate = plowback ratio x ROE =.7 x.13=.091 or 9.1%

The price of a share of stock adjusts to significant new information typically over the course of what time frame?

A few seconds to minutes

Which of the following correctly describes the horizon year?

The last year of non-constant growth. The year after which constant dividend growth is achieved.

If ROE and the plowback ratio are held constant, then which of the following figures will increase at the sustainable growth rate?

Book equity Earnings Dividends

A firm's present value of growth opportunities (PVGO) can be defined as the net present value of the firm's:

expected future investments

If the firm uses repurchases instead of dividends to distribute returns to shareholders, how would the dividend discount model be modified to accommodate this?

Discount free cash flows instead of dividends, then divide by number of shares to get share value.

Which dividend is used to calculate the horizon price, at time H?

DivH+1

The plowback ratio is defined as the:

fraction of earnings retained by the firm

If you value the whole firm by applying the dividend discount model to ____________, then you can find the share price by dividing the value of the firm by the current number of shares outstanding.

free cash flow

Statisticians have shown that the correlation coefficient between market movements in successive weeks is:

effectively zero

A(n) ________ market is one in which prices reflect all available information.

efficient

A high P/E ratio generally means that a firm has:

good growth opportunities

A stock's price is increasing in which of following variables?

Growth Rate Dividend

If a stock has a required return of "r", its next dividend is expected to be "DIV1", and its dividends are expected to grow at a constant rate "g" thereafter, then its current share price "P0" can be determined by __________.

P0=DIV1/(r-g)

To determine a firm's sustainable growth rate, which three figures must remain constant?

Plowback ratio Long-term debt ratio Return on equity

If a company earns a constant return on equity and plows back a constant proportion of earnings, then its growth rate, g, is:

ROE x plowback ratio

True or false: A constant growth can never exceed the required return.

True

True or false: An efficient market absorbs new information immediately, thereby making it very difficult to detect undervalued stocks and to beat the market consistently.

True

True or false: a market "bubble" is characterized by stock prices that are at levels in excess of what would be justified by expected dividends and earnings. In short, the market is seriously overpriced for some class of stocks.

True

In a market where stocks are fairly valued, stock prices follow:

a random walk

The field of behavioral finance shows that _________ caused investors to pile more and more money into tech companies, causing the dot-com bubble.

attitudes toward risk

A ____________ is characterized by prices that are at levels in excess of what would be justified economically.

bubble

In the constant growth dividend discount model, the expected return is equal to:

dividend yield + growth rate

The random walk of stock prices dictates that a stock's price on any given day:

do not depend on previous stock price movement

If a firm's ROE is held constant, then ________ will grow in direct proportion to equity.

earnings per share

Plowed back earnings may result in ______ and _______ growth, but it will not increase ______ if that money is expected to earn only the return that investors require.

earnings, dividend, stock price

Using the discounted cash flow valuation formula, Rocky's Restaurant Group is valued at $42.13 per share. The firm's CFO expects the firm to grow 4% per year until the horizon date 12 years hence. Rocky's CFO recalculates growth at 5% per year. How will this change in growth affect the firm's valuation?

share price will increase by more than 1% Rationale: Even a small change in growth estimates can greatly affect valuation estimates using the discounted cash flow valuation formula.

In addition to paying a dividend, a firm can return cash to its equity investors through a:

stock repurchase

The type of market efficiency that asserts that no investor, including firm insiders, can earn superior returns is:

strong form efficiency

The firm's growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant is the firm's __________________.

sustainable growth rate

The constant-growth formula does not work when there is a case of:

temporary rapid growth

The tendency for stock price increases to persist for 6-9 months and then to revert is an anomaly to the efficient market hypothesis called:

the momentum factor

Investors who buy stock in an IPO and receive an immediate gain followed by a longer term loss are experiencing an anomaly to the efficient market hypothesis called:

the new-issue puzzle

The payout ratio is defined as:

the proportion of earnings to be paid out as dividends

Successive week returns on the NY Composite Index show no significant relationship between returns; however, when you move to successive months,

the relationship remains unchanged

The terminal value is defined as __________.

the stock price at the start of the year in which constant dividend growth begins

The type of market efficiency that asserts that investors cannot make superior returns by searching for patterns in past returns is _______.

weak form efficiency