Part 3 Valuation Basics
CHAPTER 7
EQUITY VALUATION
CHAPTER LEARNING OBJECTIVES
7.1 Identify the basic characteristics of equity securities (i.e., preferred shares
7.2 Explain how to value preferred shares.
7.3 Explain how to value common shares using the dividend discount model.
7.4 Explain how to value common shares using the price-earnings (P/E) ratio.
7.5 Apply the principles of fundamental valuation and relative valuation.
7.6 Explain how speculative price bubbles occur.
7.7 Explain how to value common shares using additional relative value ratios.
Equity Valuation 7 – 2
MULTIPLE CHOICE QUESTIONS
1. Which of the following is not a correct statement about equity securities?
a) No fixed maturity date.
b) Dividends are a tax-deductible expense for the issuer.
c) Shareholders pay lower taxes on dividends than they would on interest payments.
d) Ownership interests in an underlying entity.
2. Which of the following is not a true statement?
a) Common shareholders are the true owners of the corporation.
b) Common shareholders are the residual claimants of the corporation.
c) Common shareholders are entitled to the remaining assets before all other claims
have been satisfied in the case of liquidation of the corporation.
d) Common shareholders have the right to vote on major issues, such as takeovers,
corporate restructuring, and so on.
3. In case of bankruptcy and liquidation of assets, what is the order of the claimants?
a) Equity holders, debt holders, preferred shareholders
b) Debt holders, preferred shareholders, equity holders
c) Debt holders, equity holders, preferred shareholders
d) Debt holders, equity holders and preferred shareholders equally.
4. The value of a common stock today depends on:
a) the industry analysts.
b) the expected future dividends and the discount rate.
c) the expected future common earnings per share.
d) the number of authorized shares.
5. Which of the following is a FALSE statement about preferred shares?
a) Always have voting rights.
b) Dividends must be paid in entirety before the common shareholders can receive any
payments.
c) Have preference over common shares with respect to income and assets.
d) Provide the owner with a claim to a fixed amount of equity.
6. What are the sources of uncertainties in the valuation of common equities?
a) Discount rate only
b) Cash flow size and timing only
c) Cash flow size, timing, and discount rate
d) Cash flow size, timing, and risk-free rate
Equity Valuation 7 – 4
7. Use the following two statements to answer this question:
I) Dividends are a legal obligation of the firm.
II) Interest payments are a legal obligation of the firm only after the board of directors
declares them.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct, II is incorrect.
d) I is incorrect, II is correct.
8. The value of a stock increases as:
a) the required rate of return decreases.
b) the required rate of return increases.
c) the dividend growth rate increases.
d) a and c are both correct.
9. Which of the following is/are needed when the discounted cash flow approach is used
to value equity securities?
a) Estimate the expected future cash flows associated with the security.
b) Determine the appropriate discount rate based on an estimate of the risk associated
with the security.
c) Estimate the size and timing of the expected cash flows associated with the security.
d) All of these.
10. Traditional preferred shares
a) are often referred to as fixed-income investments.
b) have a maturity date.
c) pay dividends at irregular intervals.
d) pay dividends of various amounts.
11. If the required rate of return is higher than the dividend rate of a preferred share, the
par value is _________________ the current market value of the preferred share.
a) equal to
b) higher than
c) less than
d) independent of
12. A bond and a preferred share_________________________
a) both have a fixed payment.
b) both have the same risk profile.
c) always have a maturity date.
d) are claims on the debt of the firm.
13. Which of the following statements is TRUE?
a) Preferred shares will trade at a discount from par value when market rates are less
than the dividend rate.
b) Preferred shares will trade at a premium when the market rate exceeds the dividend
rate.
c) Preferred shares will trade at par when the dividend rate does not equal the market
rate.
d) The market prices of preferred shares increase when market rates decline, and vice
versa.
14. Ontario Transportation Inc. has issued $2.5 million in preferred shares with a par
value of $25 each and an annual dividend rate of 10 percent. The market value of the
preferred shares is ____________ if the required rate of return is 8 percent.
a) $3,125,000
b) $2,500,000
c) $2,000,000
d) $34,380,000 million
15. Wild Berries Inc.’s preferred shares have a par value of $60 and are selling for $50.
What is the required rate of return if the preferred shares pay an annual dividend of 6
percent?
a) 5.00%
b) 6.00%
c) 7.2%
d) 11.11%
16. Determine the market price of a $50 par value preferred share that pays annual
dividends based on a 4 percent dividend rate when the market rate is 5%?
a) $50
b) $40
c) $35
d) $60
17. Alpine Ski Equipment has 2 million preferred shares issued at a par value of $40.
The preferred shares are currently selling at $33.25 per share and the required rate is
8.42 percent. What is the dividend rate?
a) 7.00%
b) 8.42%
c) 9.00%
d) 10.13%
18. Montreal Growers Inc. issued 1 million preferred shares at a par value of $20 and
the dividend rate is 10%. If the risk-free rate is 4% and the risk premium is 3%, what is
the preferred share price?
a) $50.00
b) $28.57
c) $35.00
d) $14.00
19. Determine the required rate of return on preferred shares that provide a $10 annual
dividend if they are selling for $60?
a) 17.14%
b) 16.66%
c) 15.66%
d) 18.14%
20. The 1.2 million preferred shares of Mighty Machines Ltd., which pay a dividend rate
of 6.5 percent on a stated value of $40, are currently worth $42,000,000. What is the
risk premium associated with these preferred shares if the risk-free rate is 4.25 percent?
a) 1.97%
b) 2.25%
c) 2.57%
d) 3.18%
21. Infinity Inc. has 750,000 preferred shares outstanding, which pay a dividend rate of
5.25 percent. Currently, the market value of these preferred shares is $22.5 million and
the short-term government T-bills yield is 5 percent. What is the par value of these
shares if investors require a risk premium of 3.75 percent?
a) $7.14
b) $18.00
c) $30.00
d) $50.00
22. The current market value of the 500,000 preferred shares of Clumsy Sports Inc. is
$25 million. If the shares pay a quarterly dividend of $1.25 on a par value of $85 and
the risk premium is 4.5 percent, what is the implied risk-free rate?
a) 4.00%
b) 4.50%
c) 5.00%
d) 5.50%
23. The current market value of the 500,000 preferred shares of Clumsy Sports Inc. is
$25 million. If the shares pay an annual dividend of $5 on a par value of $85 and the
risk-free rate is 5.5 percent, what is the implied risk premium?
a) 4.00%
b) 4.50%
c) 5.00%
d) 5.50%
Equity Valuation 7 – 10
24. Manic Corporation issued 400,000 preferred shares with a book value of $10 million
three years ago. The preferred shares pay an annual dividend of $2. What is the
required return if the current market value of these preferred shares is $9.5 million?
a) 8.42%
b) 8.00%
c) 5.26%
d) 4.21%
25. Manic Corporation issued 200,000 preferred shares with a book value of $10 million
three years ago. If the required return is 8.42% and the current market value of these
preferred shares is $9.5 million, what is the annual dividend?
a) $4.00
b) $4.71
c) $2.50
d) Cannot be calculated
26. The Beautiful Mind Company’s preferred stock is selling for $30 per share. What is
the expected dividend of year four if the required rate of return is 7.5 percent?
a) $2.00
b) $2.25
7 – 11 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
c) $3.00
d) $3.25
27. The 800,000 preferred shares of Fantastic Services have a market value of
$9,192,000 and a book value of $10,000,000. What is the dividend rate if the risk-free
rate is 3.15 percent and the risk premium is 3.65 percent?
a) 7.40%
b) 7.25%
c) 6.80%
d) 6.25%
28. Use the following two statements to answer this question:
I) There is no requirement that common shares pay dividends at all.
II) The level of dividend payment of common shares is discretionary.
a) I is incorrect, II is correct.
b) I is correct, II is incorrect.
c) I and II are incorrect.
d) I and II are correct.
29. The rate of return required by investors is estimated as:
a) dividend yield plus expected capital gains yield.
b) dividend yield minus expected capital gains yield.
c) dividend yield / expected capital gains yield.
Equity Valuation 7 – 12
d) none of the above.
30. Use the following two statements to answer this question:
I) The DDM assumes that common shares are valued according to the present value of
their expected future dividends.
II) The DDM argues that the selling price at any point (say, time n) will equal the present
value of all the expected future dividends from period n to infinity.
a) I is incorrect, II is correct.
b) I is correct, II is incorrect.
c) I and II are incorrect.
d) I and II are correct.
31. Which of the following statements is TRUE?
a) The only cash flows that an investor will receive until he or she sells their shares will
be the dividends.
b) A firm’s residual earnings technically belong to the preferred shareholders.
c) Corporations generally pay all their earnings as dividends.
d) Corporations typically reinvest none of their earnings to enhance future earnings.
32. Which of the following is TRUE about the implicit assumption of the DDM that
“investors are rational”?
I) It assumes that at each period of time, investors react rationally and value the shares
based on what they rationally expect to receive next year.
II) It rules out “speculative bubbles” or what is colloquially known as the “bigger fool
theorem.”
a) I is correct, II is incorrect.
b) I is incorrect, II is correct.
c) I and II are correct.
d) I and II are incorrect.
33. Which of the following is not a correct statement of the Constant Growth DDM?
a) It holds only when growth in dividends is expected to occur at the same rate
indefinitely.
b) It holds only when kc < g.
c) It is a version of the dividend discount model for valuing common shares that
assumes that dividends grow at a constant rate indefinitely.
d) Only future estimated cash flows and estimated growth in these cash flows are
relevant.
34.The Dividend Discount Model (DDM) links common share prices to three important
fundamentals: corporate profitability, the general level of interest rates, and risk. All
else being equal, the DDM predicts that common share prices will be lower
a) when profits are high.
b) when interest rates are lower.
c) when risk premiums are lower.
d) None of the above
Equity Valuation 7 – 14
35. The dividend growth rate for a stable firm can be estimated as:
a) retention ratio * the return on equity (ROE).
b) retention ratio / the return on equity (ROE).
c) retention ratio +the return on equity (ROE).
d) retention ratio – the return on equity (ROE).
e) none of the above
36. Use the following two statements to answer this question:
I) A firm’s sustainable growth rate decreases with higher profit margins, higher asset
turnover, and higher debt.
II) A firm’s sustainable growth rate can be estimated by multiplying the earnings
retention ratio by the return on equity.
a) I is correct, II is incorrect.
b) I is incorrect, II is correct.
c) I and II are correct.
d) I and II are incorrect.
37. Which of the following is a FALSE statement about the DDM?
a) It does not work well for firms that are non-cyclical in nature and often display steady
growth in earnings and dividends.
7 – 15 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
b) It does not work well for firms in distress.
c) It does not work well for firms that are in the process of restructuring.
d) It does not work well for firms involved in acquisitions.
38. How much would you pay for a share of stock today, if you expect it will pay a
dividend of $2.50 each year and will sell for $58 one year from now? Assume your
required rate of return on this stock is 13 percent.
a) $60.50
b) $55.50
c) $53.54
d) $49.59
39. How much would you pay for a share of stock today if you expect it will pay a
dividend of $2.50 each year and will sell for $58 two years from now? Assume your
required rate of return on this stock is 13 percent.
a) $60.50
b) $55.50
c) $53.54
d) $49.59
40. You paid $20 for one share of HyperTension Inc. today. What is the expected one–
year holding period return if the stock pays a $1.25 dividend and sells for $21.50 one
year from now?
a) 6.25%
b) 7.50%
c) 11.50%
d) 13.75%
41. Jack had an investment return of –24 percent on a stock that he bought for $100 a
year ago. What is the sale price of the stock if he received a dividend of $1.75 during
the year?
a) $72.75
b) $74.25
c) $76.00
d) $77.75
42. Charlotte purchased a share for $50 a year ago. She received $2.40 in dividends
and sold the stock for $52. If the inflation rate over the year was 2.6 percent, her exact
real rate of return is
a) 6.04%
b) 8.8%
c) 11.4%
d) 16.28%
43. Which one of the following formulae is incorrect?
a) 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 = 𝑃1−𝑃0
𝑃0
b) 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑓+ 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
c) 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒
d) 𝑃0=𝐷1
𝑘
44. Toronto Skates Inc. is offering a dividend of $1 next year and the stock sells for $20.
If the required rate of return is 8 percent, what is the capital growth rate?
a) 5%
b) 13%
c) 3%
d) 12.5%
45. Poutine Professionals Inc. has just paid a dividend of $0.55 per share. The
dividends are expected to grow at an annual rate of 5 percent indefinitely. What is
today’s stock price if the required return is 12.5 percent?
a) $4.62
b) $7.33
c) $7.70
d) $11.55
Equity Valuation 7 – 18
46. According to the DDM, if a firm increases its retention rate what happens to the
firm’s share price assuming no dividend growth and no earnings growth?
a) The price will stay the same.
b) The price will increase.
c) The price will decrease.
d) Cannot be determined.
47. Toronto Skates Inc. is paying dividends on a regular basis with a constant growth
rate. The dividend last year was $ 1.00 and this year is $1.25. If the required rate of
return is 12%, what is the price of the stock?
a) $10.42
b) $8.33
c) 5.00
d) Cannot be calculated
48. BC Electrics Inc. pays a constant dividend of $2 every year. What will the stock sell
for three years from now if the required rate of return is 9 percent?
a) $22.22
7 – 19 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
b) $21.30
c) $25.70
d) $28.78
49. Prairies Oil Sands Inc. is expected to pay a dividend of $1 in one year. If the
dividend growth rate is 2 percent forever and the required return is 10 percent, what
should the stock be sold for five years from now?
a) $13.53
b) $13.80
c) $14.08
d) $14.62
50. The stock of Townships Ski Resorts Inc. just paid a dividend of $0.78. What is the
expected capital gains yield if the stock is selling for $28.25 today and the required rate
of return is 15 percent?
a) 13.62%
b) 12.30%
c) 11.91%
d) 10.73%
51. Toronto Skates Inc.’s common stock is selling at $22.22 per share. Investors expect
to receive a dividend of $1.80. The 90-day government T-bill yield is 4.3 percent. What
is the dividend growth rate if the risk premium on comparable companies is 6.2 percent?
a) 2.22%
b) 2.40%
c) 3.12%
d) 3.54%
52. Gadgets Inc. just paid a dividend of $1.55. It expects its earnings and dividends to
decline at a rate of 3 percent per year indefinitely. What is the value of the stock today
if the required return is 12.5 percent?
a) $9.70
b) $10.00
c) $16.32
d) $16.81
53. The common stock of Atlantic Fishing Ltd. currently sells for $48 per share. The
firm has a constant dividend growth rate of 6 percent. If the required rate of return is 15
percent, what is the expected dividend yield on the stock?
a) 6.00%
b) 8.49%
c) 9.00%
d) 15.00%