B) In the method of comparables, we estimate the value of the firm based on the value of other,
comparable firms or investments that we expect will generate very similar cash flows in the future.
C) Consider the case of a new firm that is identical to an existing publicly traded company. If these firms
will generate identical cash flows, the Law of One Price implies that we can use the value of the existing
company to determine the value of the new firm.
D) A valuation multiple is a ratio of some measure of the firm’s scale to the value of the firm.
29) Which of the following statements is FALSE?
A) The most common valuation multiple is the price–earnings ratio.
B) You should be willing to pay proportionally more for a stock with lower current earnings.
C) A firm’s price–earnings ratio is equal to the share price divided by its earnings per share.
D) The intuition behind the use of the price–earnings ratio is that when you buy a stock, you are in a sense
buying the rights to the firm’s future earnings, and differences in the scale of firms’ earnings are likely
to persist.
30) Which of the following statements is FALSE?
A) We can estimate the value of a firm’s shares by multiplying its current earnings per share by the
average price–earnings ratio of comparable firms.
B) For valuation purposes, the trailing price–earnings ratio is generally preferred, since it is based on
actual not expected earnings.
C) Forward earnings are the expected earnings over the coming 12 months.
D) Trailing earnings are the earnings over the previous 12 months.
31) Which of the following statements is FALSE?
A) Because the enterprise value represents the entire value of the firm before the firm pays its debt, to form
an appropriate multiple, we divide it by a measure of earnings or cash flows after interest payments are
made.
B) We can compute a firm’s price–earnings ratio by using either trailing earnings or forward earnings with
the resulting ratio called the trailing price–earnings or forward price–earnings.
C) It is common practice to use valuation multiples based on the firm’s enterprise value.
D) Using a valuation multiple based on comparables is best viewed as a “shortcut” to the discounted cash
flow method of valuation.
SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.
32) Which is the best valuation technique when using comparables?
TRUE/FALSE. Write ‘T’ if the statement is true and ‘F’ if the statement is false.
33) If you value a stock using a range of stock valuation methods and these valuations indicate a stock price that
is greater than its actual market price, it is most likely that the stock is under–valued.
34) In an efficient market, investors will only find positive–NPV trading opportunities if they have some form of
competitive advantage over other investors.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
35) Valuation models use the relationship between share value, future cash flows, and the cost of capital to
estimate these quantities for a given firm. Realistically, for a publicly traded firm, what can we reliably use
such models to determine?
I. the firm’s future cash flows
II the firm’s cost of capital
III the firm’s stock price
A) I only
B) II only
C) III only
D) I and II
36) Praetorian Industries will pay a dividend of $2.50 per share this year and has an an equity cost of capital of
8%. Praetorian’s stock is currently trading at $84 per share. By comparing Praetorian with similar firms, an
investor expects that its dividends will grow by up to 5% per year. What is the best next step that the
investor should take regarding Praetorian’s stock?
A) Sell any Praetorian stock that she owns.
B) Short Praetorian’s stock.
C) Revise Praetorian’s equity cost of capital.
D) Revise her estimate of Praetorian’s dividend growth.
37) On a certain date, Hasbro has a stock price of $37.50, pays a dividend of $0.64, and has an equity cost of
capital of 8%. An investor expects the dividend rate to increase by 6% per year in perpetuity. He then sells all
stocks that he owns in Hasbro. Given Hasbro’s share price, was this a reasonable action?
A) No, since the constant dividend growth rate gives a stock estimate of $37.50.
B) No, since the constant dividend growth rate gives a stock estimate greater than $37.50.
C) Yes, since the constant dividend growth rate gives a stock estimate greater than $37.50.
D) No, since the difference between his calculated stock price and the actual stock price most likely
indicates that his estimate of dividend growth rate was incorrect.
38) Which of the following is the best statement of the efficient markets hypothesis?
A) Investors with information that a stock had a positive net present value (NPV) will buy it, while
investors with information that a stock had a negative net present value (NPV) will sell it.
B) Investor’s decisions are dependent on complete current information of a firm’s cash flows and accurate
predictions of future cash flows.
C) Competition between investors works to make the net present value (NPV) of all trading opportunities
zero.
D) A share’s price is the aggregate of the information of many investors.
39) Carbondale Oil announces that a wildcat well that it has sunk in a new oil province has shown the existence
of substantial oil reserves. The exploitation of these reserves is expected to increase Carbondale’s free cash
flow by $100 million per year for eight years. If investors had not been expecting this news, what is the most
likely effect on Carbondale‘s stock price upon the announcement, given that Carbondale has 80 million
shares outstanding, no debt, and an equity cost of capital of 10%?
A) no effect
B) rise by $5.78
C) rise by $6.67
D) rise by $8.30
40) Advanced Chemical Industries is awaiting the verdict from a court case over whether it is liable for the
clean–up of wastes on a disused factory site. If it is liable, this will result in a reduction of its free cash flow by
$12 million per year for ten years. If it is not liable, there will be no effect. On the close of trading the day
before the announcement of the verdict, Advanced Chemicals was trading at $20 per share. Most investors
calculate that there is a 100% chance that Advanced Chemicals will have a verdict returned against them.
One investor, Jo, has performed extensive research into the outcome of the trial and estimates that there is no
chance Advanced Chemicals will have a verdict returned against them. Given that Advanced Chemicals has
60 million shares outstanding and an equity cost of capital of 8% with no debt, Jo’s estimate of the value of a
share of Advanced Chemicals would be how much more than the market price?
A) $1.34
B) $20.46
C) $20.68
D) $20.96
41) Aerelon Airways, a commercial airline, suffers a major crash. As a result, passengers are considered to be less
likely to choose Aerelon as their carrier, and it is expected free cash flows will fall by $20 million per year for
five years. If Aerelon has 65 million shares outstanding, an equity cost of capital of 12%, and no debt, by how
much would Aerelon’s shares be expected to fall in price as a result of this accident?
A) $0.98
B) $1.11
C) $1.28
D) $1.45
42) If a manager wishes to raise his stock’s price, he should do which of the following?
I. Focus on maximizing the present value (PV) of the free cash flow.
II Focus on accounting earnings.
III. Focus on financial policy.
A) I only
B) II only
C) I and II
D) II and II
43) On a particular day, a mining company reveals that, due to new extraction technology, the extractable yield
from several of its nickel/lead mines has risen by 15%. Which of the following is the LEAST likely
consequence of such an announcement?
A) The price of the stock would rise due to the pressure to buy
B) Investors would determine that the estimates of the firm’s value on the date prior to the announcement
were too high.
C) Investors would increase their forecast of future cash flows in that firm.
D) Investors would revise their estimates of the net present value (NPV) of the firm.
SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.
44) What are the implications of the efficient markets hypothesis for corporate managers regarding accounting
earnings?
TRUE/FALSE. Write ‘T’ if the statement is true and ‘F’ if the statement is false.
45) Individual investors trade conservatively, given the difficulty of finding over– and under–valued stocks.
46) Individual investors who grow up and live during a time of high stock returns are more likely to invest in
stocks.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
47) Individual investors’ tendency to trade too much based on the mistaken belief that they can pick winners and
losers better than investment professionals is known as:
A) the disposition effect.
B) the investor attention hypothesis.
C) the investor overconfidence hypothesis.
D) the excessive trading costs hypothesis.
48) A study of trading behavior of individual investors at a discount brokerage found that individual investors:
A) trade very actively, despite the fact that their performance is actually worse because of trading costs.
B) trade very conservatively, despite the fact that their performance is actually worse because of trading
costs.
C) trade very actively, partly because their performance is better than the professionals’ because of low
trading costs.
D) trade very conservatively, partly because their performance is better than the professionals’ because of
low trading costs.
49) Which of the following tendencies of individual investors is called the disposition effect?
A) The tendency to trade too much based on the mistaken belief that they can pick winners and losers
better than investment professionals.
B) The tendency to buy stocks that have been in the news, advertised more, have very high trading
volume, or recently had extreme (high or low) returns.
C) The tendency to put too much weight on their own experience rather than considering historical
evidence.
D) The tendency to hold on to stocks that have lost value and sell stocks that have risen in value since the
time of purchase.
