Finance Chapter 09 You Have Analyzed Three Risky Firms And

Chapter 9 The Valuation of Stock

TRUE/FALSE

future price appreciation.

dividends, future dividend growth, and the required return.

and past years’ dividends.

of return, the investor should buy the stock.

grow annually at the same rate.

risk premium.

decrease stock prices.

larger dividends.

to sales and price to book ratios.

and growth rate.

current prices of stocks reflect what the investment

community believes the stocks are worth.

purchasing high P/E stock should not produce superior

investment results.

purchasing low P/S stocks should produce superior

investment results.

purchasing companies with high cash flow should produce

superior investment results.

MULTIPLE CHOICE

of common stock depends on

1. the firm’s dividends

2. investors’ required rate of return

3. the prior year’s dividends

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. all of the above

stock pays a fixed $5 dividend, its value is

a. $100

b. $75

c. $50

d. $25

1. the firm’s earnings

2. the firm’s beta coefficient

3. the treasury bill rate (i.e., the risk–free rate)

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. all of the above

1. the firm’s beta declines

2. the firm’s beta increases

3. the risk–free rate declines

4. the risk–free rate increases

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

1. the firm’s dividends

2. the price of the stock

3. the firm’s per share earnings

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. all of the above

a. high P/E stocks should be purchased

b. low P/E ratio stocks are overvalued

c. a stock should be purchased if it is selling

near its historic low P/E

d. a stock should be purchased if it is selling

near its historic high P/E

suggests that

a. high price to book stocks are undervalued

b. low price to book stocks are overvalued

c. a stock should be purchased if it is selling near

its historic high price to book ratio

d. a stock should be purchased if it is selling near

its historic low price to book ratio

a. decrease stock prices

b. are required by the efficient market hypothesis

c. increase dividends

d. are associated with higher dividends

a. all investors would profit

b. prices indicate the proper valuation of securities

c. prices would adjust rapidly

d. an investor may consistently outperform the market

investment results according to the

a. weak form of the efficient market hypothesis

b. semi–strong form of the efficient market

hypothesis

c. strong form of the efficient market hypothesis

d. all forms of the efficient market hypothesis

a. the firm is generating cash

b. the firm has no earnings

c. the stock valuation is too high

d. the stock may be undervalued

analytical tool if

a. the firm is not generating cash

b. the firm is not generating earnings

c. the P/E ratio is too high

d. the dividend–growth model suggests the stock is

undervalued

value stocks. If this analysis is used, which of the

following is desirable?

a. a high P/E and a low price/sales ratio

b. a high P/E and a high price/sales ratio

c. a low P/E and a low price/sales ratio

d. a low P/E and a high price/sales ratio

a. the stock is overvalued

b. the firm’s assets are understated

c. the price of the stock is greater than the

accounting value of the firm

d. the accounting value of the firm is greater

than the market value of the firm

PROBLEMS

1. Your broker recommends that you purchase XYZ Inc. at

$60. The stock pays a $2.40 dividend which (like its per

share earnings) is expected to grow annually at 8 percent.

If you want to earn 12 percent on your funds, is this a

good buy?

2. If you purchase TrisCorp stock at $71 a share and the

firm pays a $5.20 dividend which is expected to grow at 7.5

percent, what is the implied annual rate of return on the

investment?

3. As an investor you have a required rate of return of 14

percent for investments in risky stocks. You have analyzed

three risky firms and must decide which (if any) to

purchase. Your information is

Firm A B C

Current dividends $1.00 $3.00 $7.50

Expected annual growth 7% 2% (–1%)

rate in dividends

Current market price $23 $47 $60

a. What is your valuation of each stock using the

dividend–growth model? Which (if any) should you buy?

b. If you bought Stock A, what is your implied rate of

return?

c. If your required rate of return were 10 percent, what

should be the price necessary to induce you to buy Stock A?

4. You know the following concerning a common stock:

EPS $3.00

Payout ratio 25%

P/E 10

Annual rate of growth of 6%

earnings and dividends

If you want to earn 10 percent, should you buy this stock?

What is the maximum price you should be willing to pay for

the stock?

5. The risk–free rate of return is 8 percent; the expected

rate of return on the market is 12 percent. Stock X has a

beta coefficient of 1.3, an earnings and dividend–growth

rate of 7 percent, and a current dividend of $2.40. If the

stock is selling for $35, what should you do?

6. Two stocks each pay a $1 dividend that is growing

annually at 8 percent. Stock A has a beta of 1.3; stock B’s

beta is 0.8.

a. Which stock is more volatile?

b. If treasury bills yield 6 percent and you expect the

market to rise by 12 percent, what is your risk–adjusted

required rate of return?

c. Using the dividend–growth model, what is the maximum

amount you would be willing to pay for each stock?

d. Why are your valuations different?

7. Presently, Stock A pays a dividend of $2.00 a share, and

you expect the dividend to grow rapidly for the next four

years at 20 percent. Thus the dividend payments will be

Year Dividend

1 $1.20

2 1.44

3 1.73

4 2.07

After this initial period of super growth, the rate of

increase in the dividend should decline to 8 percent. If

you want to earn 12 percent on investments in common stock,

what is the maximum you should pay for this stock?

SOLUTIONS TO PROBLEMS