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Chapter 08: Basic Stock Valuation
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.
a.
True
b.
False
ANSWER:
True
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.
a.
True
b.
False
ANSWER:
True
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.
a.
True
b.
False
ANSWER:
False
4. 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.
ANSWER:
c
5. 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.
a.
True
b.
False
ANSWER:
True
6. 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.
a.
True
b.
False
ANSWER:
True
7. 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.
ANSWER:
d
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8. 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.
a.
True
b.
False
ANSWER:
True
9. According to the basic FCF 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.
a.
True
b.
False
ANSWER:
False
10. Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its
operations.
a.
True
b.
False
Chapter 08: Basic Stock Valuation
ANSWER:
True
11. The free cash flow valuation model cannot be used unless a company doesn't pay dividends.
a.
True
b.
False
ANSWER:
False
12. Which of the following statements is CORRECT?
a.
Two firms with the same expected free cash flows and growth rates must also have the same value of
operations.
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 company has a weighted average cost of capital WACC = 12%, and if its free cash flows are expected to
grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%.
d.
The value of operations is the present value of all expected future free cash flows, discounted at the free cash
flow growth rate.
e.
The constant growth model takes into consideration the capital gains investors expect to earn on a stock.
ANSWER:
e
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13. If a company’s free cash flows are 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 company’s stock's dividend yield is 5%.
b.
The value of operations is expected to decline in the future.
c.
The company's WACC must be equal to or less than 5%.
d.
The company’s value of operations one year from now is expected to be 5% above the current price.
e.
The expected return on the company’s stock is 5% a year.
ANSWER:
d
14. Which of the following statements is NOT CORRECT?
a.
The free cash flow valuation model discounts free cash flows by the required return on equity.
b.
The free cash flow valuation model can be used to find the value of a division.
c.
An important step in applying the free cash flow valuation model is forecasting the firm's pro forma financial
statements.
Chapter 08: Basic Stock Valuation
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 free cash flow valuation model can be used both for companies that pay dividends and those that do not
pay dividends.
ANSWER:
a
15. 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 free cash flow valuation model, Vops =FCF1/(WACC − g), cannot be used for firms that have negative
growth rates.
d.
The free cash flow valuation model, Vops = FCF1/(WACC − g), can be used only for firms whose growth rates
exceed their WACC.
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.
ANSWER:
b
16. A company’s free cash flow was just FCF0 = $1.50 million. The weighted average cost of capital is WACC = 10.1%,
and the constant growth rate is g = 4.0%. What is the current value of operations?
a.
$23.11 million
b.
$23.70 million
c.
$24.31 million
d.
$24.93 million
e.
$25.57 million
POINTS:
1
17. Lance Inc.'s free cash flow was just $1.00 million. If the expected long-run growth rate for this company is 5.4%, if
the weighted average cost of capital is 11.4%, Lance has $4 million in short-term investments and $3 million in debt, and
1 million shares outstanding, what is the intrinsic stock price?
a.
$17.28
b.
$17.70
c.
$18.13
d.
$18.57
e.
$19.01
ANSWER:
d
18. Young & Liu Inc.'s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at
a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm's value of operations, in
millions?
a.
$948
b.
$998
c.
$1,050
d.
$1,103
e.
$1,158
ANSWER:
c
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19. The projected cash flow for the next year for Minesuah Inc. is $100,000, and FCF is expected to grow at a constant
rate of 6%. If the company's weighted average cost of capital is 11%, what is the value of its operations?
a.
$1,714,750
b.
$1,805,000
c.
$1,900,000
d.
$2,000,000
e.
$2,100,000
ANSWER:
d
20. Justus Motor Co.has a WACC of 11.50%, and its value of operations is $25.00 million. Justus's free cash flow is
expected to grow at a constant rate of 7.00%. What was the last free cash flow, FCF0 in millions?
a.
$0.95
b.
$1.05
c.
$1.16
d.
$1.27
Chapter 08: Basic Stock Valuation
e.
$1.40
ANSWER:
b
21. Judd Corporation has a weighted average cost of capital of 10.25%, and its value of operations is $57.50 million. Free
cash flow is expected to grow at a constant rate of 6.00% per year. What is the expected year-end free cash flow, FCF1 in
millions?
a.
$2.20
b.
$2.44
c.
$2.69
d.
$2.96
e.
$3.25
ANSWER:
b
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22. A company is expected to have free cash flows of $0.75 million next year. The weighted average cost of capital is
WACC = 10.5%, and the expected constant growth rate is g = 6.4%. The company has $2 million in short-term
investments, $2 million in debt, and 1 million shares. What is the stock's current intrinsic stock price?
a.
$17.39
b.
$17.84
c.
$18.29
d.
$18.75
e.
$19.22
POINTS:
1
23. 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.
a.
True
Chapter 08: Basic Stock Valuation
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Page 13
b.
False
ANSWER:
True
24. Which of the following statements is CORRECT?
a.
If a company has a WACC = 12% and its free cash flow is expected to grow at a constant rate of 5%, this
implies that the stock's dividend yield is also 5%.
b.
The free cash flow valuation model for constant growth, Vop = FCF1/(WACC − g), can be used to value firms
whose free cash flows are expected to decline at a constant rate, i.e., to grow at a negative rate.
c.
The value of operations of a stock is the present value of all expected future free cash flows, discounted at the
free cash flow growth rate.
d.
The constant growth model cannot be used for a zero growth stock, where free cash flows are 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.
ANSWER:
b
25. 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
Chapter 08: Basic Stock Valuation
horizon value (in millions) at t = 5?
a.
$719
b.
$757
c.
$797
d.
$839
e.
$883
ANSWER:
e
26. 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
d.
$972
e.
$1,021
ANSWER:
a
27. Decker Tires’ free cash flow was just FCF0 = $1.32. Analysts expect the company's free cash flow to grow by 30%
this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The WACC for this company 9.00%.
Decker has $4 million in short-term investments and $14 million in debt and 1 million shares outstanding. What is the best
estimate of the stock's current intrinsic price?
a.
$31.59
b.
$32.65
c.
$33.75
d.
$34.87
e.
$35.99
POINTS:
1
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28. Kinkead Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be −$10 million, but its FCF at t = 2
will be $20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost
of capital is 14%, what is the firm's value of operations, in millions?
a.
$158
b.
$167
c.
$175
d.
$184
e.
$193
POINTS:
1
29. The free cash flows (in millions) shown below are forecast by Parker & Sons. If the weighted average cost of capital is
11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions?
Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments).
Year:
1
2
Free cash flow:
−$50
$100
a.
$1,456
b.
$1,529
c.
$1,606
d.
$1,686
e.
$1,770
Chapter 08: Basic Stock Valuation
ANSWER:
a
30. Heath and Logan Inc. forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is
13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is expected to
remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions?
Year:
1
2
3
Free cash flow:
−$15
$10
$40
a.
$315
b.
$331
c.
$348
d.
$367
e.
$386
POINTS:
1
31. Reynolds Construction's value of operations is $750 million based on the free cash flow valuation model. Its balance
sheet shows $50 million of short-term investments that are unrelated to operations, $100 million of accounts payable,
$100 million of notes payable, $200 million of long-term debt, $40 million of common stock (par plus paid-in-capital),
and $160 million of retained earnings. What is the best estimate for the firm's value of equity, in millions?
a.
$429
b.
$451
c.
$475
d.
$500
e.
$525
ANSWER:
d
32. Based on the free cash flow valuation model, the value of Weidner Co.'s operations is $1,200 million. The company's
balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term
investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million
in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180 million in retained earnings, and
$800 million in total common equity. If Weidner has 30 million shares of stock outstanding, what is the best estimate of
the stock's price per share?
a.
$24.90
b.
$27.67
c.
$30.43
d.
$33.48
e.
$36.82
ANSWER:
b
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33. The value of Broadway-Brooks Inc.'s operations is $900 million, based on the free cash flow valuation model. Its
balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments
that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term
debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the
company has 25 million shares of stock outstanding, what is the best estimate of the stock's price per share?
a.
$23.00
b.
$25.56
c.
$28.40
d.
$31.24
e.
$34.36
ANSWER:
c
34. Based on the free cash flow valuation model, Bizzaro Co.'s value of operations is $300 million. The balance sheet
shows $20 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million
of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity.
Bizzaro has 10 million shares of stock outstanding. What is the best estimate of the stock's price per share?
