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Chapter 7 – Socks (Equity) – Characteristics and Valuation
45. Eastern Auto Parts’ last dividend was D0 = $0.50, and the company expects to experience no growth for the next 2
years. However, Eastern will grow at an annual rate of 5 percent in the third and fourth years, and, beginning with
the fifth year, it should attain a 10 percent growth rate which it should sustain thereafter. Eastern has a required rate
of return of 12 percent. What should be the present price per share of Eastern common stock?
a. $19.26
b. $31.87
c. $30.30
d. $20.83
e. $19.95
46. The Satellite Building Company has fallen on hard times. Its management expects to pay no dividends for the next 2
years. However, the dividend for Year 3, D3, will be $1.00 per share, and the dividend is expected to grow at a rate
of 3 percent in Year 4, 6 percent in Year 5, and 10 percent in Year 6 and thereafter. If the required return for
Satellite is 20 percent, what is the current equilibrium price of the stock?
a. $0
b. $5.26
c. $6.34
d. $12.00
e. $13.09
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
47. A share of stock has a dividend of D0 = $5. The dividend is expected to grow at a 20 percent annual rate for the
next 10 years, then at a 15 percent rate for 10 more years, and then at a long-run normal growth rate of 10 percent
forever. If investors require a 10 percent return on this stock, what is its current price?
a. $100.00
b. $82.35
c. $195.50
d. $212.62
e. The data given in the problem are internally inconsistent, i.e., the situation described is impossible in that no
equilibrium price can be produced.
48. You are considering the purchase of a common stock that just paid a dividend of $2.00. You expect this stock to
have a growth rate of 30 percent for the next 3 years, then to have a long-run normal growth rate of 10 percent
thereafter. If you require a 15 percent rate of return, how much should you be willing to pay for this stock?
a. $71.26
b. $97.50
c. $82.46
d. $79.15
e. $62.68
49. DAA’s stock is selling for $15 per share. The firm’s income, assets, and stock price have been growing at an annual
15 percent rate and are expected to continue to grow at this rate for 3 more years. No dividends have been declared
as yet, but the firm intends to declare a dividend of D3 = $2.00 at the end of the last year of its supernormal growth.
After that, dividends are expected to grow at the firm’s normal growth rate of 6 percent. The firm’s required rate of
return is 18 percent. The stock is
a. Undervalued by $3.03.
b. Overvalued by $3.03.
c. Correctly valued.
d. Overvalued by $2.25.
e. Undervalued by $2.25.
50. Berg Inc. has just paid a dividend of $2.00. Its stock is now selling for $48 per share. The firm is half as risky as the
market. The expected return on the market is 14 percent, and the yield on U.S. Treasury bonds is 11 percent. If the
market is in equilibrium, what rate of growth is expected?
a. 13%
b. 10%
c. 4%
d. 8%
e. −2%
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
51. You have a chance to purchase a perpetual security that has a stated annual payment (cash flow) of $50. However,
this is an unusual security in that the payment will increase at an annual rate of 5 percent per year; this increase is
designed to help you keep up with inflation. The next payment to be received (your first payment, due in 1 year) will
be $52.50. If your required rate of return is 15 percent, how much should you be willing to pay for this security?
a. $350
b. $482
c. $525
d. $556
e. $610
52. Suppose you are willing to pay $30 today for a share of stock which you expect to sell at the end of one year for
$32. If you require an annual rate of return of 12 percent, what must be the amount of the annual dividend which you
expect to receive at the end of Year 1?
a. $2.25
b. $1.00
c. $1.60
d. $3.00
e. $1.95
53. Carlson Products, a constant growth company, has a current market (and equilibrium) stock price of $20.00.
Carlson‘s next dividend, D1, is forecasted to be $2.00, and Carlson is growing at an annual rate of 6 percent. Carlson
has a beta coefficient of 1.2, and a required rate of return on the market is 15 percent. As Carlson’s financial
manager, you have access to insider information concerning a switch in product lines which would not change the
growth rate, but would cut Carlson’s beta which would not change the growth rate, but would cut Carlson’s beta
coefficient in half. If you buy the stock at the current market price, what is your expected percentage capital gain?
a. 23%
b. 33%
c. 43%
d. 53%
e. There would be a capital loss.
54. Given the following information, calculate the expected capital gains yield for Chicago Bears Inc.: beta = 0.6; rM =
15%; rRF = 8%; = $2.00; P0 = $25.00. Assume the stock is in equilibrium and exhibits constant growth.
a. 3.8%
b. 0%
c. 8.0%
d. 4.2%
e. None of the above.
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
55. Over the past few years, Swanson Company has retained, on the average, 70 percent of its earnings in the business.
The future retention rate is expected to remain at 70 percent of earnings, and long-run earnings growth is expected
to be 10 percent. If the risk-free rate, rRF, is 8 percent, the expected return on the market, rM
, is 12 percent,
Swanson‘s beta is 2.0, and the most recent dividend, D0, was $1.50, what is the most likely market price and P/E
ratio (P0/E1) for Swanson’s stock today?
a. $27.50; 5.0x
b. $33.00; 6.0x
c. $25.00; 5.0x
d. $22.50; 4.5x
e. $45.00; 4.5x
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
56. Yesterday BrandMart Supplies paid its common stockholders a dividend equal to $3 per share. BrandMart expects
to pay a $5 per share one year from today. After the $5 dividend is paid, the company expects its growth rate will
remain constant at 4 percent per year forever. If BrandMart‘s investors demand a 12 percent rate of return, what
should be the current market price of the company’s stock?
a. $62.50
b. $65.00
c. $62.27
d. $37.50
e. None of the above is correct.
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
57. Philadelphia Corporation’s stock recently paid a dividend of $2.00 per share (D0 = $2), and the stock is in equilibrium.
The company has a constant growth rate of 5 percent and a beta equal to 1.5. The required rate of return on the
market is 15 percent, and the risk-free rate is 7 percent. Philadelphia is considering a change in policy which will
increase its beta coefficient to 1.75. If market conditions remain unchanged, what new constant growth rate will
cause the common stock price of Philadelphia to remain unchanged?
a. 8.85%
b. 18.53%
c. 6.77%
d. 5.88%
e. 13.52%
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
58. Hard Hat Construction‘s stock is currently selling at an equilibrium price of $30 per share. The firm has been
experiencing a 6 percent annual growth rate. Last year’s earnings per share, E0, were $4.00, and the dividend payout
ratio is 40 percent. The risk-free rate is 8 percent, and the market risk premium is 5 percent. If systematic risk (beta)
increases by 50 percent, and all other factors remain constant, by how much will the stock price change? (Hint: Use
four decimal places in your calculations.)
a. −$7.33
b. +$7.14
c. −$15.00
d. −$15.22
e. +$22.63
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
59. The Hart Mountain Company has recently discovered a new type of kitty litter which is extremely absorbent. It is
expected that the firm will experience (beginning now) an unusually high growth rate (20 percent) during the period
(3 years) it has exclusive rights to the property where the raw material used to make this kitty litter is found.
However, beginning with the fourth year the firm’s competition will have access to the material, and from that time
on the firm will achieve a normal growth rate of 8 percent annually. During the rapid growth period, the firm’s
dividend payout ratio will be relatively low (20 percent) in order to conserve funds for reinvestment. However, the
decrease in growth in the fourth year will be accompanied by an increase in dividend payout to 50 percent. Last
year’s earnings were E0 = $2.00 per share, and the firm‘s required return is 10 percent. What should be the current
price of the common stock?
a. $66.50
b. $87.96
c. $71.53
d. $61.78
e. $93.50
60. NYC Company has decided to make a major investment. The investment will require a substantial early cash
outflow, and inflows will be relatively late. As a result, it is expected that the impact on the firm’s earnings for the
first 2 years will cause a negative growth of 5 percent annually. Further, it is anticipated that the firm will then
experience 2 years of zero growth, after which it will begin a positive annual sustainable growth of 6 percent. If the
firm‘s required return is 10 percent and its last dividend, D0, was $2 per share, what should be the current price per
share?
a. $32.66
b. $47.83
c. $53.64
d. $38.47
e. $42.49
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
61. Club Auto Parts‘ last dividend, D0, was $0.50, and the company expects to experience no growth for the next 2
years. However, Club will grow at an annual rate of 5 percent in the third and fourth years, and, beginning with the
fifth year, it should attain a 10 percent growth rate which it will sustain thereafter. Club has a required rate of return
of 12 percent. What should be the price per share of Club stock at the beginning of the third year, P2?
a. $19.98
b. $25.06
c. $31.21
d. $19.48
e. $27.55
62. Modular Systems Inc. just paid dividend D0, and it is expecting both earnings and dividends to grow by 0 percent in
Year 2, by 5 percent in Year 3, and at a rate of 10 percent in Year 4 and thereafter. The required return on Modular
is 15 percent, and it sells at its equilibrium price, P0 = $49.87. What is the expected value of the next dividend? (Hint:
Set up and solve an equation with the unknown.)
a. It cannot be estimated without more data.
b. $1.35
c. $1.85
d. $2.35
e. $2.85
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
63. Laserclok Corporation paid a dividend for 50 years until it experienced financial difficulty three years ago, at which ti
dividend payment was suspended (that is, a dividend has not been paid during the past three years). The company is
much stronger financially, but Laserclok does not expect to pay a dividend for the next five years. Beginning six year
today, the company will pay a dividend equal to $2.10, which is 5 percent greater than the last dividend paid three yea
After the dividend payments start again, Laserclok expects the dividend to continue to be paid and to grow at a const
of 5 percent. If the appropriate market rate for investments similar to Laserclok’s stock is 15 percent, at what price sh
the stock currently be selling in the financial markets?
a. $21.00
b. $10.44
c. $14.00
d. There is not enough information to answer the question.
e. None of the above.
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
64. Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for 1 year, 5 percent
the next year, then 6 percent for the following year, and then the growth rate is expected to be a constant 7 percent
thereafter. The required rate of return on equity (ks) is 10 percent. What is the current price of the common stock?
a. $53.45
b. $60.98
c. $64.49
d. $67.47
e. $69.21
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
65. Garcia Inc. has a current dividend of $3.00 per share (D0 = $3.00). Analysts expect that the dividend will grow at a
rate of 25 percent a year for the next three years, and thereafter it will grow at a constant rate of 10 percent a year.
The company’s cost of equity capital is estimated to be 15 percent. What is the current stock price of Garcia Inc.?
a. $75.00
b. $88.55
c. $95.42
d. $103.25
e. $110.00
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
66. Worldwide Inc., a large conglomerate, has decided to acquire another firm. Analysts are forecasting a period (2
years) of extraordinary growth (20 percent), followed by another 2 years of unusual growth (10 percent), and finally
a normal (sustainable) growth rate of 6 percent annually. If the last dividend was D0 = $1.00 per share and the
required return is 8 percent, what should the market price be today?
a. $93.70
b. $72.76
c. $99.66
d. $98.57
e. $68.87
67. Assume that the average firm in your company‘s industry is expected to grow at a constant rate of 5 percent, and its
dividend yield is 4 percent. You company is about as risky as the average firm in the industry, but it has just
developed a line of innovative new products which leads you to expect that its earnings and dividends will grow at a
rate of 40 percent. (i.e., = D0 ((1 + g) = D0 (1.40)) this year and 25 percent the following year, after which
growth should match the 5 percent industry average rate. The last dividend paid (D0) was $2. What is the value per
share of your firm’s stock?
a. $42.60
b. $82.84
c. $91.88
d. $101.15
e. $110.37
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
68. Assume that you would like to purchase 100 shares of preferred stock that pays an annual dividend of $6 per share.
However, you have limited resources now, so you cannot afford the purchase price. In fact, the best that you can do
now is to invest your money in a bank account earning a simple interest rate of 6 percent, but where interest is
compounded daily (assume a 365–day year). Because the preferred stock is riskier, it has a required annual rate of
return of 12 percent (assume that this rate will remain constant over the next 5 years). For you to be able to
purchase this stock at the end of 5 years, how much must you deposit in your bank account today, at t = 0?
a. $2,985.00
b. $4,291.23
c. $3,138.52
d. $3,704.18
e. $4,831.25
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
69. A financial analyst has been following Fast Start Inc., a new high-growth company. She estimates that the current
risk-free rate is 6.25 percent, the market risk premium is 5 percent, and that Fast Start’s beta is 1.75. The current
earnings per share (EPS0) is $2.50. The company has a 40 percent payout ratio. The analyst estimates that the
company’s dividend will grow at a rate of 25 percent this year, 20 percent next year, and 15 percent the following
year. After three years the dividend is expected to grow at a constant rate of 7 percent a year. The company is
expected to maintain its current payout ratio. The analyst believes that the stock is fairly priced. What is the current
price of the stock?
a. $16.51
b. $17.33
c. $18.53
d. $19.25
e. $19.89
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Chapter 7 – Socks (Equity) – Characteristics and Valuation
70. Assume an all equity firm has been growing at a 15 percent annual rate and is expected to continue to do so for 3
more years. At that time, growth is expected to slow to a constant 4 percent rate. The firm maintains a 30 percent
payout ratio, and this year’s retained earnings net of dividends were $1.4 million. The firm‘s beta is 1.25, the risk-free
rate is 8 percent, and the market risk premium is 4 percent. If the market is in equilibrium, what is the market value
of the firm‘s common equity (1 million shares outstanding)?
a. $6.41 million
b. $12.96 million
c. $9.18 million
d. $10.56 million
e. $7.32 million