Exercises on equity valuation 1. The _________ is the fraction of earnings reinvested in the firm.

A) dividend payout ratio B) retention rate C) plowback ratio D) A and C E) B and C Answer: E Difficulty: Easy Rationale: Retention rate, or plowback ratio, represents the earnings reinvested in the firm. The retention rate, or (1 - plowback) = dividend payout. 2. The Gordon model A) is a generalization of the perpetuity formula to cover the case of a growing perpetuity. B) is valid only when g is less than k. C) is valid only when k is less than g. D) A and B. E) A and C. Answer: D Difficulty: Easy Rationale: The Gordon model assumes constant growth indefinitely. Mathematically, g must be less than k; otherwise, the intrinsic value is undefined.

3.You wish to earn a return of 13% on each of two stocks, X and Y. Stock X is expected to pay a dividend of $3 in the upcoming year while Stock Y is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The intrinsic value of stock X ______. A) cannot be calculated without knowing the market rate of return B) will be greater than the intrinsic value of stock Y C) will be the same as the intrinsic value of stock Y D) will be less than the intrinsic value of stock Y E) none of the above is a correct answer. Answer: D Difficulty: Easy Rationale: PV0 = D1/(k-g); given k and g are equal, the stock with the larger dividend will have the higher value. 4.You wish to earn a return of 11% on each of two stocks, C and D. Stock C is expected to pay a dividend of $3 in the upcoming year while Stock D is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The intrinsic value of stock C ______. A) will be greater than the intrinsic value of stock D B) will be the same as the intrinsic value of stock D C) will be less than the intrinsic value of stock D D) cannot be calculated without knowing the market rate of return E) none of the above is a correct answer. Answer: C Difficulty: Easy Rationale: PV0 = D1/(k-g); given k and g are equal, the stock with the larger dividend will have the higher value. 5. You wish to earn a return of 12% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $2 in the upcoming year. The expected growth rate of dividends is 9% for stock A and 10% for stock B. The intrinsic value of stock A _____. A) will be greater than the intrinsic value of stock B B) will be the same as the intrinsic value of stock B C) will be less than the intrinsic value of stock B D) cannot be calculated without knowing the rate of return on the market portfolio. E) none of the above is a correct statement. Answer: C Difficulty: Easy Rationale: PV0 = D1/(k-g); given that dividends are equal, the stock with the higher growth rate will have the higher value. You wish to earn a return of 10% on each of two stocks, C and D. Each of the stocks is expected to pay a dividend of $2 in the upcoming year. The expected growth rate of dividends is 9% for stock C and 10% for stock D. The intrinsic value of stock C _____. A) will be greater than the intrinsic value of stock D B) will be the same as the intrinsic value of stock D C) will be less than the intrinsic value of stock D D) cannot be calculated without knowing the rate of return on the market portfolio. E) none of the above is a correct statement. Answer: C Difficulty: Easy Rationale: PV0 = D1/(k-g); given that dividends are equal, the stock with the higher growth rate will have the higher value.

6.

7. High Speed Company has an expected ROE of 15%. The dividend growth rate will be ________ if the firm follows a policy of paying 50% of earnings in the form of dividends. A) 3.0% B) 4.8% C) 7.5% D) 6.0%

E)

none of the above

Answer: C Difficulty: Easy Rationale: 15% X 0.50 = 7.5%. 8. A preferred stock will pay a dividend of $2.75 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 10% on this stock. Use the constant growth DDM to calculate the intrinsic value of this preferred stock. A) $0.275 B) $27.50 C) $31.82 D) $56.25 E) none of the above Answer: B Difficulty: Moderate Rationale: 2.75 / .10 = 27.50 9.You are considering acquiring a common stock that you would like to hold for one year. You expect to receive both $0.75 in dividends and $16 from the sale of the stock at the end of the year. The maximum price you would pay for the stock today is _____ if you wanted to earn a 12% return. A) $23.91 B) $14.96 C) $26.52 D) $27.50 E) none of the above Answer: B Difficulty: Moderate Rationale: .12 = (16 - P + 0.75) / P; .12P = 16 - P + 0.75; 1.12P = 16.75; P = 14.96. Use the following to answer questions 10-12: Sure Tool Company is expected to pay a dividend of $2 in the upcoming year. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. Analysts expect the price of Sure Tool Company shares to be $22 a year from now. The beta of Sure Tool Company's stock is 1.25. 10. The market's required rate of return on Sure's stock is _____. A) 14.0% B) 17.5% C) 16.5% D) 15.25% E) none of the above Answer: C Difficulty: Moderate Rationale: 4% + 1.25(14% - 4%) = 16.5%. 11. What is the intrinsic value of Sure's stock today? A) $20.60 B) $20.00 C) $12.12 D) $22.00 E) none of the above Answer: A Difficulty: Difficult Rationale: k = .04 + 1.25 (.14 - .04); k = .165; .165 = (22 - P + 2) / P; .165P = 24 - P; 1.165P = 24 ; P = 20.60. If Sure's intrinsic value is $21.00 today, what must be its growth rate? A) 0.0% B) 10% C) 4% D) 6% E) 7% Answer: E Difficulty: Difficult Rationale: k = .04 + 1.25 (.14 - .04); k = .165; .165 = 2/21 + g; g = .07

12.

13. Midwest Airline is expected to pay a dividend of $7 in the coming year. Dividends are expected to grow at the rate of 15% per year. The risk-free rate of return is 6% and the expected return on the market portfolio is 14%. The stock of Midwest Airline has a beta of 3.00. The return you should require on the stock is ________. A) 10% B) 18% C) 30% D) 42% E) none of the above Answer: C Difficulty: Moderate Rationale: 6% + 3(14% - 6%) = 30%.

14. High Tech Chip Company is expected to have EPS in the coming year of $2.50. The expected ROE is 12.5%. An appropriate required return on the stock is 11%. If the firm has a plowback ratio of 70%, the growth rate of dividends should be A) 5.00% B) 6.25% C) 6.60% D) 7.50% E) 8.75% Answer: E Difficulty: Easy Rationale: 12.5% X 0.7 = 8.75%. 15. Sunshine Corporation is expected to pay a dividend of $1.50 in the upcoming year. Dividends are expected to grow at the rate of 6% per year. The risk-free rate of return is 6% and the expected return on the market portfolio is 14%. The stock of Sunshine Corporation has a beta of 0.75. The intrinsic value of the stock is _______. A) $10.71 B) $15.00 C) $17.75 D) $25.00 E) none of the above Answer: D Difficulty: Moderate Rationale: 6% + 0.75(14% - 6%) = 12%; P = 1.50 / (.12 - .06) = $25. 16. J.C. Penney Company is expected to pay a dividend in year 1 of $1.65, a dividend in year 2 of $1.97, and a dividend in year 3 of $2.54. After year 3, dividends are expected to grow at the rate of 8% per year. An appropriate required return for the stock is 11%. The stock should be worth _______ today. A) $33.00 B) $40.67 C) $77.53 D) $66.00 E) none of the above Answer: C Difficulty: Difficult Rationale: Calculations are shown in the table below. Yr Dividend PV of Dividend @ 11% 1 $1.65 $1.65/(1.11) = $1.4865 2 $1.97 $1.97/(1.11)2 = $1.5989 3 $2.54 $2.54/(1.11)3 = $1.8572 Sum $4.94 P3 = $2.54 (1.08) / (.11-.08) = $91.44; PV of P3 = $91.44/(1.08)3 = $72.5880; PO = $4.94 + $72.59 = $77.53. 17. Exercise Bicycle Company is expected to pay a dividend in year 1 of $1.20, a dividend in year 2 of $1.50, and a dividend in year 3 of $2.00. After year 3, dividends are expected to grow at the rate of 10% per year. An appropriate required return for the stock is 14%. The stock should be worth _______ today. A) $33.00 B) $39.86 C) $55.00 D) $66.00 E) $40.68 Answer: E Difficulty: Difficult Rationale: Calculations are shown in the table below. Yr Dividend PV of Dividend @ 14% 1 $1.20 $1.20/1.14 = $1.0526 2 $1.50 $1.50/(1.14)2 = $1.1542 3 $2.00 $2.00/(1.14)3 = $1.3499 Sum $3.56 P3 = 2 (1.10) / (.14-.10) = $55.00; PV of P3 = $55/(1.14)3 = $37.12; PO = $3.56 + $37.12 = $40.68.