14) A company that wants to maintain both a constant growth rate in dividends and a constant
payout ratio will have to
A) grow earnings faster than dividends.
B) increase assets at the same rate as dividends.
C) grow earnings at the same rate as dividends.
D) increase stockholders’ equity at the same rate as dividends.
15) Michelak’s Maritime Industries has relatively stable earnings and pays an annual dividend of
$2.50 per share. This dividend has remained constant over the past few years and is expected to
remain constant for some time to come. If you want to earn 12% on an investment in the
common stock of Michelak’s, how much should you pay to purchase each share of stock?
A) $12.50
B) $18.88
C) $20.83
D) $25.00
16) Winifred, Inc. paid $1.64 as an annual dividend per share last year. The company is expected
to increase their annual dividends by 3% each year. How much should you pay to purchase one
share of this stock if you require a 9% rate of return on this investment?
A) $18.22
B) $18.77
C) $27.33
D) $28.15
17) One stock valuation model holds that the value of a share of stock is a function of its future
dividends, and that the dividends will increase at an annual rate which will remain unchanged
over time. This stock valuation model is known as the
A) approximate yield model.
B) holding period return model.
C) dividend reinvestment model.
D) constant growth dividend valuation model.
18) What is the required rate of return on a common stock that is expected to pay a $0.75 annual
dividend next year if dividends are expected to grow at 2 percent annually and the current stock
price is $8.59?
A) 8.73%
B) 8.91%
C) 10.73%
D) 11.38%
19) The constant-growth dividend valuation model is best suited for use with
A) stocks of new or emerging companies.
B) small-cap stocks within growing industries.
C) the stocks of mature, dividend-paying companies.
D) the stocks of cyclical companies.
20) When using the constant-growth dividend valuation model, which of the following will
lower the value of the stock?
A) An increase in the required rate of return.
B) A decrease in the required rate of return.
C) An increase in the dividend payout ratio.
D) An increase in the growth rate of the dividends.
21) Newton, Inc. just paid an annual dividend of $0.95 . Their dividends are expected to increase
by 4% annually. Newton Company stock is selling for $11.54 a share. What is the capitalization
rate on this stock?
A) 8.23%
B) 12.2%
C) 12.6%
D) 13.9%
22) The Frisco Company just paid $2.20 as its annual dividend. The dividends have been
increasing at a rate of 4% annually and this trend is expected to continue. The stock is currently
selling for $63.60 a share. What is the rate of return on this stock?
A) 3.46%
B) 3.60%
C) 7.46%
D) 7.60%
23) ABC Company stock currently has a market value equivalent to its intrinsic value. Marco
perceives that ABC Company is increasing its level of risk and therefore Marco increases his
required rate of return on ABC stock. This change in the required rate of return
A) will reduce the intrinsic value of ABC stock to Marco.
B) will increase the intrinsic value of ABC stock to Marco.
C) will change the intrinsic value but the direction of the change cannot be determined.
D) is a signal to Marco that he should buy more ABC Company stock.
24) In applying the variable-growth dividend valuation model to a company’s stock, analysts
frequently define the growth rate, g, as equal to
A) ROE multiplied by the firm’s retention rate.
B) ROE divided by the dividend payout ratio.
C) the dividend payout ratio multiplied by the firm’s retention rate.
D) P/E multiplied by the dividend payout ratio.
25) A company has an annual dividend growth rate of 5% and a retention rate of 40%. The
company’s dividend payout ratio is
A) 35%.
B) 40%.
C) 45%.
D) 60%.
26) Which of the following statements concerning the constant-growth dividend valuation model
is (are) correct?
I. One simple method of estimating the dividend growth rate is to analyze the historical pattern
of dividends.
II. The expected total return equals the return from capital gains plus the return from dividends
paid.
III. The model is applicable to growth firms with initially high growth rates.
IV. The intrinsic value calculated using this method can change from one investor to another if
their risk-return payoffs differ.
A) I and IV only
B) II and III only
C) I, II, and IV only
D) I, II and III only
27) The variable-growth dividend valuation model
A) develops the value of a stock using the future value of dividends minus a rate of capital gain
growth.
B) is valuable because it accounts for the general growth patterns of most companies.
C) is invalid if at any point in time the growth rate exceeds the required rate of return.
D) assumes the rate of dividend growth will vary indefinitely.
28) In general, the higher the retention ratio
A) the higher the future growth rate of the company.
B) the higher the dividends per share of common stock.
C) the higher the future debt-equity ratio.
D) the lower the future book value per share.
29) Martin’s Inc. is expected to pay annual dividends of $2.50 a share for the next three years.
After that, dividends are expected to increase by 3% annually. What is the current value of this
stock to you if you require a 9% rate of return on this investment?
A) $39.47
B) $40.11
C) $41.81
D) $42.92
30) One common method of estimating the growth rate of dividends is to
A) randomly assign an annual growth rate of 4% to the latest dividend amount.
B) multiply the return on assets by the dividend payout ratio.
C) multiply the return on equity by the firm’s retention rate.
D) multiply the return on equity by the dividend payout ratio.
31) WaterCo is a manufacturer of boat parts and has been in business only a few years. Its board
of directors decided to start paying a dividend to help boost the attractiveness of its stock. The
dividend will be $0.50 per share next year. After that dividends will increase by 4 percent per
year. The company has a beta of 1.6. The market rate of return is 8% and the T-bill rate is 3%.
Should you purchase shares in this firm at the current market price of $6.98 per share?
32) The common stock of Peachtree Paper, Inc., is currently selling for $40 a share. A dividend
of $2.00 per share was just paid. You are estimating that this dividend will grow at a constant
rate of 10%.
(a) Using the constant growth DVM model, what is your required rate of return if $40 is a
reasonable trading price? (Show all work.)
(b) If Peachtree Papers is a new company that produces a relatively unknown product, is the
constant growth model a good valuation method for a potential investor to use? Justify your
17
Copyright © 2011 Pearson Education, Inc.
8.5 Learning Goal 5
1) A stock’s internal rate of return (IRR) is the discount rate that cause the present value of future
dividends to equal the price of the stock.
2) Neither the P/E approach nor the dividends-and-earnings approach rely on dividends as the
key input into the valuation of a stock.
3) When an investor multiplies future estimated earnings per share by a price/earnings ratio to
compute the value of a stock that investor is using the price/earnings approach to valuation.
4) High price/sales multiples go with high profit margins.
5) Most stocks trade at five to seven times their book values.
6) Which of the following statements concerning the dividends-and-earnings (D&E) approach to
stock valuation are true?
I. The D&E valuation method works just as well for non-dividend paying stocks as it does for
dividend-paying stocks.
II. The current value of a stock using the D&E method is equal to the expected selling price of
the stock plus the present value of the future dividends.
III. The D&E approach considers earnings per share and the price/earnings ratio.
IV. The D&E considers a finite investment period.
A) I and II only
B) III and IV only
C) I, III and IV only
D) I, II and III only
7) The single most important variable in the dividends-and-earnings approach is the
A) rate of growth.
B) applicable beta.
C) appropriate P/E multiple.
D) amount of the future dividends.
8) Zephyr Inc. sells wind based systems for generating electricity. The company pays no
dividends, but you estimate the stock will be worth $50 per share 5 years from now and you
require a 15% rate of return for stock investments of this type. What price should you be willing
to pay for this stock?
A) $12.50
B) $24.86
C) $43.48
D) $57.50
9) Ivonne has bought shares of RIO, Inc. stock for $25.00 per share. She expects a 1.00 dividend
at the end of this year. After 2 years, she expects to receive a dividend of $1.25 and to sell the
stock for $28.75. What is Ivonne’s required rate of return?
A) 4.0%
B) 11.6%
C) 15.2%
D) 24.0%
10) An internal rate of return (IRR) is the discount rate that
A) represents the minimal rate required to create a positive net present value.
B) is the minimal rate of return an investor will accept.
C) provides an investor with their required return.
D) produces a present value of future benefits equal to the market price of a stock.
11) In the price/earnings approach to stock valuation,
A) historical stock prices are utilized.
B) forecasted EPS are typically used.
C) the P/E ratio is computed by multiplying the stock price by the earnings per share.
D) the market P/E ratio, adjusted by beta, is used to value individual stocks.
12) The dividends-and-earnings (D&E) approach to stock valuation and the variable-growth
DVM approach are similar in that both approaches
A) are present-value based.
B) consider dividends only and ignore the future selling price of the stock.
C) consider the future selling price of the stock but ignore future dividends.
D) use the historical dividend growth rate as the key input figure.
13) Which of the following approaches to stock valuation is not based on a multiple of some
figure from the financial statements?
A) the price to cash flow approach
B) the price to sales approach
C) the dividends-and-earnings approach
D) the price to earnings approach
14) The Highlight Company has a book value of $56.50 per share, and is currently trading at a
price of $59.00 per share. You are interested in investing in Highlight, and have just used a
present-value based stock valuation model to calculate a present (intrinsic) value of $55.00 per
share for Highlight’s stock. Assuming that your calculations are correct you should
A) buy the stock, because the current market price per share is higher than the present value.
B) buy the stock, because the book value per share is greater than the present value.
C) not buy the stock, because the present value is less than the market price per share.
D) buy the stock, because the book value and the current trading price are very close to one
another in value.
15) According to the price/earnings approach to stock valuation, if the dividend growth rate is
expected to drop or if the required return goes up, the net effect is a
A) higher P/E ratio.
B) lower P/E ratio.
C) higher stock price.
D) higher retention rate.
16) How can you determine the current value of a non-dividend paying stock?
1) The constant growth dividend valuation model works best for mature companies with a long
record of paying dividends.
2) The P/E approach is too complicated to be widely used in practice.
3) A drawback to the Price– to– Cash-Flow method of valuation is that there is no generally
accepted cash flow measure.
4) Generally speaking, the higher the Price-to-Sales ratio, the better.
5) The price–to–cash-flow method of stock valuation generally
A) uses EBITDA as the cash flow value.
B) relies on historical cash flows.
C) produces a cash flow multiple that is greater than the P/E multiple.
D) applies the P/E multiple to the cash flow per share value.
6) For which one of the following situations will the price to sales valuation model work but the
dividend and cash flow models will not?
A) mature firm with minimal growth opportunities
B) water-powered electric utility company
C) newly-formed biotechnology company with negative earnings
D) top-performing firm in a mature industry
7) EBITDA is an acronym for
A) Earnings Based Information, Total Development Approach.
B) Ernst, Bostwick, Davenport, Innes Approach.
C) Earnings Before Interest, Taxes, Depreciation, and Amortization.
D) Earnings Before Interest, Taxes, Dividends, and Asset replacement.
8) A firm with a price to sales ratio of 1 would usually be considered
A) overvalued.
B) correctly valued.
C) near bankruptcy.
D) undervalued.
9) Tureves S.A. is a French biotechnology company that has developed promising therapies for
hair loss, obesity, and wrinkled skin. Sales have doubled in each of the last three years, but so
far, the company has yet to turn a profit. Which common procedures would be most, and least
appropriate to value Tureves’ ADRs.