CHAPTER 7—VALUATION OF STOCKS AND CORPORATIONS
TRUE/FALSE
1. A proxy is a document giving one party the authority to act for another party, including the power to
vote shares of common stock. Proxies can be important tools relating to control of firms.
2. The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new
shares issued by the firm. This right helps protect current stockholders against both dilution of control
and dilution of value.
3. If a firm’s stockholders are given the preemptive right, this means that stockholders have 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.
4. Classified stock differentiates various classes of common stock, and using it is one way companies can
meet special needs such as when owners of a start-up firm need additional equity capital but don’t want
to relinquish voting control.
5. Founders’ shares are a type of classified stock where the shares are owned by the firm’s founders, and
they generally have more votes per share than the other classes of common stock.
6. The total return on a share of stock refers to the dividend yield less any commissions paid when the
stock is purchased and sold.
7. The cash flows associated with common stock are more difficult to estimate than those related to
bonds because stock has a residual claim against the company versus a contractual obligation for a
bond.
8. According to the basic DCF stock valuation model, the value an investor should assign to a share of
stock is dependent on the length of time he or she plans to hold the stock.
9. When a new issue of stock is brought to market, it is the marginal investor who determines the price at
which the stock will trade.
10. The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar
to the model used to find the price of perpetual preferred stock or other perpetuities.
11. According to the nonconstant growth model discussed in the textbook, the discount rate used to find
the present value of the expected cash flows during the initial growth period is the same as the
discount rate used to find the PVs of cash flows during the subsequent constant growth period.
12. Projected free cash flows should be discounted at the firm’s weighted average cost of capital to find the
value of its operations.
13. The corporate valuation model cannot be used unless a company doesn’t pay dividends.
14. Free cash flows should be discounted at the firm’s weighted average cost of capital to find the value of
its operations.
15. Preferred stock is a hybrid⎯a sort of cross between a common stock and a bond⎯in the sense that it
pays dividends that normally increase annually like a stock but its payments are contractually
guaranteed like interest on a bond.
16. From an investor’s perspective, a firm’s preferred stock is generally considered to be less risky than its
common stock but more risky than its bonds. However, from a corporate issuer’s standpoint, these risk
relationships are reversed: Bonds are the most risky for the firm, preferred is next, and common is least
risky.
MULTIPLE CHOICE
17. Which of the following statements is CORRECT?
a.
If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a
constant rate of 5%, this implies that the stock’s dividend yield is also 5%.
b.
The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends
are expected to decline at a constant rate, i.e., to grow at a negative rate.
c.
The price of a stock is the present value of all expected future dividends, discounted at the
dividend growth rate.
d.
The constant growth model cannot be used for a zero growth stock, where the dividend is
expected to remain constant over time.
e.
The constant growth model is often appropriate for evaluating start-up companies that do
not have a stable history of growth but are expected to reach stable growth within the next
few years.
18. If a firm’s expected growth rate increased then its required rate of return would
a.
decrease.
b.
fluctuate less than before.
c.
fluctuate more than before.
d.
possibly increase, possibly decrease, or possibly remain constant.
e.
increase.
19. You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that
you think
a.
the stock should be sold.
b.
the stock is a good buy.
c.
management is probably not trying to maximize the price per share.
d.
dividends are not likely to be declared.
e.
the stock is experiencing supernormal growth.
20. The preemptive right is important to shareholders because it
a.
will result in higher dividends per share.
b.
is included in every corporate charter.
c.
protects the current shareholders against a dilution of their ownership interests.
d.
protects bondholders, and thus enables the firm to issue debt with a relatively low interest
rate.
e.
allows managers to buy additional shares below the current market price.
21. Companies can issue different classes of common stock. Which of the following statements
concerning stock classes is CORRECT?
a.
All common stocks, regardless of class, must have the same voting rights.
b.
All firms have several classes of common stock.
c.
All common stock, regardless of class, must pay the same dividend.
d.
Some class or classes of common stock are entitled to more votes per share than other
classes.
e.
All common stocks fall into one of three classes: A, B, and C.
22. Which of the following statements is CORRECT?
a.
Two firms with the same expected dividend and growth rates must also have the same
stock price.
b.
It is appropriate to use the constant growth model to estimate a stock’s value even if its
growth rate is never expected to become constant.
c.
If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a
constant rate of 5%, this implies that the stock’s dividend yield is also 5%.
d.
The price of a stock is the present value of all expected future dividends, discounted at the
dividend growth rate.
e.
The constant growth model takes into consideration the capital gains investors expect to
earn on a stock.
23. A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to
decline at a rate of 5% a year forever (g = −5%). If the company is in equilibrium and its expected and
required rate of return is 15%, which of the following statements is CORRECT?
a.
The company’s dividend yield 5 years from now is expected to be 10%.
b.
The constant growth model cannot be used because the growth rate is negative.
c.
The company’s expected capital gains yield is 5%.
d.
The company’s expected stock price at the beginning of next year is $9.50.
e.
The company’s current stock price is $20.
24. If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following
statements is CORRECT? The stock is in equilibrium.
a.
The stock’s dividend yield is 5%.
b.
The price of the stock is expected to decline in the future.
c.
The stock’s required return must be equal to or less than 5%.
d.
The stock’s price one year from now is expected to be 5% above the current price.
e.
The expected return on the stock is 5% a year.
25. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium, which of the following statements is CORRECT?
A
B
Required return
10%
12%
Market price
$25
$40
Expected growth
7%
9%
a.
These two stocks must have the same dividend yield.
b.
These two stocks should have the same expected return.
c.
These two stocks must have the same expected capital gains yield.
d.
These two stocks must have the same expected year-end dividend.
e.
These two stocks should have the same price.
A
B
Expected return
10%
12%
Expected growth
Dividend yield
26. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium, which of the following statements is CORRECT?
A
B
Price
$25
$40
Expected growth
7%
9%
Expected return
10%
12%
a.
The two stocks could not be in equilibrium with the numbers given in the question.
b.
A’s expected dividend is $0.50.
c.
B’s expected dividend is $0.75.
d.
A’s expected dividend is $0.75 and B’s expected dividend is $1.20.
e.
The two stocks should have the same expected dividend.
A
B
Price
$25
$40
Expected growth
27. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium, which of the following statements is CORRECT?
A
B
Price
$25
$25
Expected growth (constant)
10%
5%
Required return
15%
15%
a.
Stock A has a higher dividend yield than Stock B.
b.
Currently the two stocks have the same price, but over time Stock B’s price will pass that
of A.
c.
Since Stock A’s growth rate is twice that of Stock B, Stock A’s future dividends will
always be twice as high as Stock B’s.
d.
The two stocks should not sell at the same price. If their prices are equal, then a
disequilibrium must exist.
e.
Stock A’s expected dividend at t = 1 is only half that of Stock B.
Price
$25
$25
g
10%
5%
r
15%
15%
Div. Yield = r − g =
28. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium, which of the following statements is CORRECT?
X
Y
Price
$30
$30
Expected growth (constant)
6%
4%
Expected return
10%
12%
Required return
12%
10%
a.
Stock Y has a higher dividend yield than Stock X.
b.
One year from now, Stock X’s price is expected to be higher than Stock Y’s price.
c.
Stock X has the higher expected year-end dividend.
d.
Stock Y has a higher capital gains yield.
e.
Stock X has a higher dividend yield than Stock Y.
29. Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium,
which of the following statements is CORRECT?
Expected dividend, D1
$3.00
Current Price, P0
$50
Expected constant growth rate
6.0%
a.
The stock’s expected dividend yield and growth rate are equal.
b.
The stock’s expected dividend yield is 5%.
c.
The stock’s expected capital gains yield is 5%.
d.
The stock’s expected price 10 years from now is $100.00.
e.
The stock’s required return is 10%.
$3.00
6.0%
g
6.0%
30. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in
equilibrium, which of the following statements is CORRECT?
X
Y
Price
$25
$25
Expected dividend yield
5%
3%
Required return
12%
10%
a.
Stock X pays a higher dividend per share than Stock Y.
b.
One year from now, Stock X should have the higher price.
c.
Stock Y has a lower expected growth rate than Stock X.
d.
Stock Y has the higher expected capital gains yield.
e.
Stock Y pays a higher dividend per share than Stock X.
31. Merrell Enterprises’ stock has an expected return of 14%. The stock’s dividend is expected to grow at a
constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is
CORRECT?
a.
The stock’s dividend yield is 8%.
b.
The current dividend per share is $4.00.
c.
The stock price is expected to be $54 a share one year from now.
d.
The stock price is expected to be $57 a share one year from now.
e.
The stock’s dividend yield is 7%.
32. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of
return. Which of the following statements is CORRECT?
a.
Stock B must have a higher dividend yield than Stock A.
b.
Stock A must have a higher dividend yield than Stock B.
c.
If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must
be lower than Stock B’s.
d.
Stock A must have both a higher dividend yield and a higher capital gains yield than Stock
B.
e.
If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must
be higher than Stock B’s.
33. Two constant growth stocks are in equilibrium, have the same price, and have the same required rate
of return. Which of the following statements is CORRECT?
a.
If one stock has a higher dividend yield, it must also have a lower dividend growth rate.
b.
If one stock has a higher dividend yield, it must also have a higher dividend growth rate.
c.
The two stocks must have the same dividend growth rate.
d.
The two stocks must have the same dividend yield.
e.
The two stocks must have the same dividend per share.
34. Which of the following statements is CORRECT, assuming stocks are in equilibrium?
a.
Assume that the required return on a given stock is 13%. If the stock’s dividend is growing
at a constant rate of 5%, its expected dividend yield is 5% as well.
b.
A stock’s dividend yield can never exceed its expected growth rate.
c.
A required condition for one to use the constant growth model is that the stock’s expected
growth rate exceeds its required rate of return.
d.
Other things held constant, the higher a company’s beta coefficient, the lower its required
rate of return.
e.
The dividend yield on a constant growth stock must equal its expected total return minus
its expected capital gains yield.
35. Which of the following statements is NOT CORRECT?
a.
The corporate valuation model discounts free cash flows by the required return on equity.
b.
The corporate valuation model can be used to find the value of a division.
c.
An important step in applying the corporate valuation model is forecasting the firm’s pro
forma financial statements.
d.
Free cash flows are assumed to grow at a constant rate beyond a specified date in order to
find the horizon, or terminal, value.
e.
The corporate valuation model can be used both for companies that pay dividends and
those that do not pay dividends.
36. Which of the following statements is CORRECT?
a.
The preferred stock of a given firm is generally less risky to investors than the same firm’s
common stock.
b.
Corporations cannot buy the preferred stocks of other corporations.
c.
Preferred dividends are not generally cumulative.
d.
A big advantage of preferred stock is that dividends on preferred stocks are tax deductible
by the issuing corporation.
e.
Preferred stockholders have a priority over bondholders in the event of bankruptcy to the
income, but not to the proceeds in a liquidation.
37. Which of the following statements is CORRECT?
a.
Preferred stock is normally expected to provide steadier, more reliable income to investors
than the same firm’s common stock, and, as a result, the expected after-tax yield on the
preferred is lower than the after-tax expected return on the common stock.
b.
The preemptive right is a provision in all corporate charters that gives preferred
stockholders the right to purchase (on a pro rata basis) new issues of preferred stock.
c.
One of the disadvantages to a corporation of owning preferred stock is that 70% of the
dividends received represent taxable income to the corporate recipient, whereas interest
income earned on bonds would be tax free.
d.
One of the advantages to financing with preferred stock is that 70% of the dividends paid
out are tax deductible to the issuer.
e.
A major disadvantage of financing with preferred stock is that preferred stockholders
typically have supernormal voting rights.
38. Which of the following statements is CORRECT?
a.
The preemptive right gives stockholders the right to approve or disapprove of a merger
between their company and some other company.
b.
The preemptive right is a provision in the corporate charter that gives common
stockholders the right to purchase (on a pro rata basis) new issues of the firm’s common
stock.
c.
The stock valuation model, P0 = D1/(rs − g), cannot be used for firms that have negative
growth rates.
d.
The stock valuation model, P0 = D1/(rs − g), can be used only for firms whose growth rates
exceed their required returns.
e.
If a company has two classes of common stock, Class A and Class B, the stocks may pay
different dividends, but under all state charters the two classes must have the same voting
rights.
39. The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements
is CORRECT?
a.
If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower
expected capital gains yield than Stock X.
b.
If Stock X and Stock Y have the same current dividend and the same expected dividend
growth rate, then Stock Y must sell for a higher price.
c.
The stocks must sell for the same price.
d.
Stock Y must have a higher dividend yield than Stock X.
e.
If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then
it must have the higher expected growth rate.
40. Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is
6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following
statements is CORRECT?
A
B
Beta
1.10
0.90
Constant growth rate
7.00%
7.00%
a.
Stock A must have a higher dividend yield than Stock B.
b.
Stock B’s dividend yield equals its expected dividend growth rate.
c.
Stock B must have the higher required return.
d.
Stock B could have the higher expected return.
e.
Stock A must have a higher stock price than Stock B.
41. A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs =
10.5%, and the expected constant growth rate is g = 6.4%. What is the stock’s current price?
a.
$17.39
b.
$17.84
c.
$18.29
d.
$18.75
e.
$19.22
42. A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant
growth rate is g = 4.0%. What is the current stock price?
a.
$23.11
b.
$23.70
c.
$24.31
d.
$24.93
e.
$25.57
43. A share of Lash Inc.’s common stock just paid a dividend of $1.00. If the expected long-run growth
rate for this stock is 5.4%, and if investors’ required rate of return is 11.4%, what is the stock price?
a.
$16.28
b.
$16.70
c.
$17.13
d.
$17.57
e.
$18.01
44. Franklin Corporation is expected to pay a dividend of $1.25 per share at the end of the year (D1 =
$1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is
expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate?
a.
6.01%
b.
6.17%
c.
6.33%
d.
6.49%
e.
6.65%
45. $35.50 per share is the current price for Foster Farms’ stock. The dividend is projected to increase at a
constant rate of 5.50% per year. The required rate of return on the stock, rs, is 9.00%. What is the
stock’s expected price 3 years from today?
a.
$37.86
b.
$38.83
c.
$39.83
d.
$40.85
e.
$41.69
46. Kelly Enterprises’ stock currently sells for $35.25 per share. The dividend is projected to increase at a
constant rate of 4.75% per year. The required rate of return on the stock, rs, is 11.50%. What is the
stock’s expected price 5 years from now?
a.
$40.17
b.
$41.20
c.
$42.26
d.
$43.34
e.
$44.46
47. If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $26.00, what is the stock’s expected dividend
yield for the coming year?
a.
4.12%
b.
4.34%
c.
4.57%
d.
4.81%
e.
5.05%
48. If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the stock’s expected dividend yield
for the coming year?
a.
4.42%
b.
4.66%
c.
4.89%
d.
5.13%
e.
5.39%
49. If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock’s expected capital gains
yield for the coming year?
a.
6.50%
b.
6.83%
c.
7.17%
d.
7.52%
e.
7.90%
50. If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock’s expected total return for
the coming year?
a.
7.54%
b.
7.73%
c.
7.93%
d.
8.13%
e.
8.34%
51. If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the stock’s expected total return
for the coming year?
a.
8.37%
b.
8.59%
c.
8.81%
d.
9.03%
e.
9.27%
52. Barnette Inc.’s free cash flows are expected to be unstable during the next few years while the
company undergoes restructuring. However, FCF is expected to be $50 million in Year 5, i.e., FCF at t
= 5 equals $50 million, and the FCF growth rate is expected to be constant at 6% beyond that point. If
the weighted average cost of capital is 12%, what is the horizon value (in millions) at t = 5?
a.
$719
b.
$757
c.
$797
d.
$839
e.
$883
53. Gere Furniture forecasts a free cash flow of $40 million in Year 3, i.e., at t = 3, and it expects FCF to
grow at a constant rate of 5% thereafter. If the weighted average cost of capital is 10% and the cost of
equity is 15%, what is the horizon value, in millions at t = 3?
a.
$840
b.
$882
c.
$926