FIN 3320 Chapter 9 Moore

Stability Inc. has maintained a dividend rate of $4 per share for many years. The same rate is expected to be paid in future years. If investors require a 12% rate of return on similar investments, determine the present value of the company's stock.

$33.33 This is a zero growth stock, or perpetuity: P0= D/rs = $4.00/0.12 = $33.33

The Canning Company has been hard hit by increased competition. Analysts predict that earnings (and dividends) will decline at a rate of 5% annually into the foreseeable future. If Canning's last dividend (D0) was $2.00, and investors' required rate of return is 15%, what will be Canning's stock price in 3 years?

$8.15

Lucas Laboratories' last dividend was $1.50. Its current equilibrium stock price is $15.75, and its expected growth rate is a constant 5%. If the stockholders' required rate of return is 15%, what is the expected dividend yield and expected capital gains yield for the coming year?

10% ; 5% The dividend yield is D(1+g)/P = $1.50(1.05)/$15.75 = 10%. The capital gains yield is (P(1+g) - P)/P = ($16.5375 - $15.75)/$15.75 = g = 5%

Hanebury Manufacturing Company (HMC) has preferred stock outstanding with a par value of $50. The stock pays a quarterly dividend of $1.25 and has a current price of $71.43. What is the nominal annual rate of return on the preferred stock?

7% Nominal annual rate of return = $5.00/$71.43 = 7% Periodic rate of return = $1.25/$71.43 = 1.75% Nominal annual rate of return = 1.75% x 4 = 7%

Hanebury Manufacturing Company (HMC) has preferred stock outstanding with a par value of $50. The stock pays a quarterly dividend of $1.25 and has a current price of $71.43. What is the effective annual rate of return on the preferred stock?

7.19% Nominal annual rate of return = INOM = (4 x $1.25)/$71.43 = 7% EAR = (1 + INOM/4)4 - 1 = (1 + 0.07/4)4 - 1 = (1.0175)4 - 1 = 1.0719 - 1 = 0.0719 = 7.19%

A preemptive right gives stockholders 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 A preemptive right is used to maintain shareholder positions if new shares are issued.

A document that gives one party the authority to act for another party is a proxy. This includes the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

False A proxy is used by shareholders to vote their common shares.

An investor using the DCF stock valuation model would assign a value based on the length of time he or she plans to hold the stock.

False The investor needs to consider the value during the holding period as well as the price at which the share will be sold to someone else.

To find the total return on a share of stock, find the dividend yield and subtract any commissions paid when the stock is purchased and sold.

False total return is dividend yield plus capital appreciation.

Your sister-in-law, a stockbroker at Invest Inc., is trying to sell you a stock with a current market price of $25. The stock's last dividend (D0) was $2.00, and earnings and dividends are expected to increase at a constant growth rate of 10%. Your required return on this stock is 20%. From a strict valuation standpoint, you should:

Not buy the stock; it is overvalued by $3.00. P0= D(1+g)/(r-g) = $2.00(1.10)/(0.20-0.10) = $22.00. As the stock is currently selling for $25.00, the stock is not in equilibrium and is overvalued by $3.00

The preemptive right is important to shareholders because it:

Protects the current shareholders against a dilution of their ownership interests.

When stockholders assign their right to vote to another party, this is called

Proxy

Assume that a company's dividends are expected to grow at a rate of 25% per year for 5 years and then to slow down and to grow at a constant rate of 5% thereafter. The required (and expected) total return, rs, is expected to remain constant at 12%. Which of the following statements is correct?

Right now, it would be easier (require fewer calculations) to find the dividend yield expected in Year 7 than the dividend yield expected in Year 3. We know that after Year 5, the stock will have a constant growth rate, and the capital gains yield will be equal to that growth rate. We also know that the total return is expected to be constant. Therefore, we could find the expected dividend yield in Year 7 simply by subtracting the growth rate from the total return: Yield = 12% - 5% = 7% in Year 7. The other statements are all false. This could be confirmed by thinking about how the dividend growth rate starts high, ends up at the constant growth rate, and must lie between these two rates and be declining between Years 1 and 5. The average growth rate in dividends during Years 1 through 5 will be (25 + 5)/2 = 15%, which is above rs = 12%, so statements c and d must be false.

Which of the following statements about stock classes is CORRECT?

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

Which of the following assumptions would cause the constant growth stock valuation model to be invalid? The constant growth model is given below:

The required rate of return is less than the growth rate. If this equation is used in situations when rs is less than g, the results will be both wrong and meaningless.

Because stock has a residual claim rather than a contractual obligation, the cash flows associated with common stock are more difficult to estimate than those related to bonds.

True

Classified stock is the differentiation of different shares of common stock. It gives companies a way to meet special needs such as when owners of a start-up firm need additional equity capital but do not want to relinquish voting control.

True

In order to prevent dilution of control or dilution of value, shareholders use preemptive rights to purchase, on a pro rata basis, any new shares issued by the firm.

True

The marginal investor determines the price at which a new issue of stock will trade when it is brought to market.

True

The type of classified stock where the shares are owned by the firm's founders is called founder's shares. With founders' shares, shareholders generally have more votes per share than with other classes of common stock.

True

To find the firm's total corporate value, discount projected free cash flows at the firm's weighted average cost of capital.

True