WEB CHAPTER 20—AN INTRODUCTION TO SECURITY VALUATION
TRUE/FALSE
1. Fundamentalists typically use the “Bottom-Up Approach” whereas technicians use the “Top-Down
Approach” to the valuation process.
2. Empirical studies have shown that the market factor has increased over time and now accounts for the
majority of an individual stock’s price variance.
3. The general economic influences would include inflation, political upheavals, monetary policy, and
fiscal policy initiatives.
4. Given an optimistic economic and stock-market outlook for a country, the investor should underweight
the allocation to this country in his/her portfolio.
5. The importance of an industry’s performance on an individual stock’s performance varies across
industries.
6. If the estimated value of an asset is greater than the market price, you would want to buy the
investment.
7. The most difficult part of valuing a bond is determining the required rate of return on this investment.
8. A preferred stock is a perpetuity.
9. Growth companies are those firms that consistently earn higher rates of return by assuming greater
amounts of risk.
10. The growth rate of dividends and profit margin are the main determinants of the P/E ratio.
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11. The dividend growth models are only meaningful for companies that have a required rate of return that
exceeds their dividend growth rate.
12. The three step valuation process consists of 1) analysis of alternative economies and markets, 2)
analysis of alternative industries and 3) analysis of industry influences.
13. The two components that are required in order to carry out asset valuation are 1) the stream of
expected cash flows and 2) the required rate of return.
14. The importance of an industry’s performance on an individual stock’s performance varies across
industries.
15. If the intrinsic value of an asset is greater than the market price, you would want to buy the investment.
16. The required rate of return is determined by 1) the real risk free rate, 2) the expected rate of inflation
and 3) liquidity risk.
17. The price of a bond can be calculated by discounting future coupons over the bonds life by the yield to
maturity.
18. An example of a relative valuation technique is the Price/Cash Flow ratio.
19. Discounted cash flow techniques for equity valuation may use one of the following: 1) dividends, 2)
Free cash flow or 3) coupons.
20. In dividend discount models (DDM) with supernormal growth, supernormal growth may continue
indefinitely.
21. The real risk free rate depends on the real growth in the economy and for short period by temporary
tightness or ease in capital markets.
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22. The risk premium is impacted by business risk, financial risk, and liquidity risk.
23. A bond typically pays interest payments every six months equal to the coupon rate times the face value
of the bond.
24. The value of preferred stock can be calculated by dividing its dividend by the required rate of return.
25. A relative valuation technique is appropriate to consider when you have a good set of comparable
entities.
26. The infinite period dividend discount model (DDM) can be used to value a supernormal growth
company.
MULTIPLE CHOICE
1. Which of the following is not a consideration in the three-step valuation process?
a.
Analysis of alternative economies
b.
Analysis of security markets
c.
Analysis of alternative industries
d.
Analysis of individual companies
e.
None of the above (that is, all are considerations in the three-step valuation process)
2. Which of the following is not considered a basic economic force?
a.
Fiscal policy
b.
Monetary policy
c.
Inflation
d.
P/E ratio
e.
None of the above (that is, all are basic economic forces)
3. The process of fundamental valuation requires estimates of all the following factors, except
a.
The time pattern of returns.
b.
The economy’s real risk-free rate.
c.
The risk premium for the asset.
d.
The times series of stock prices.
e.
The expected rate of inflation.
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4. Which of the following is correct?
a.
If estimated value > Market price, you should buy.
b.
If estimated value > Market price, you should sell.
c.
If estimated value < Market price, you should sell.
d.
If estimated value < Market price, you should buy.
e.
Choices a and c.
5. The value of a corporate bond can be derived by calculating the present value of the interest payments
and the present value of the face value at the bond’s
a.
Current yield.
b.
Coupon rate.
c.
Required rate of return.
d.
Effective rate.
e.
Prime rate.
6. Which securities can be valued by dividing the annual dividend by the required rate of return?
a.
Low coupon bonds
b.
Junk bonds
c.
Common stocks
d.
Preferred stocks
e.
Constant growth common stocks
7. According to the dividend growth model, if a company were to declare that it would never pay
dividends, its value would be
a.
Based on earnings.
b.
Based on expectations regarding.
c.
Higher than similar firms since it could reinvest a greater amount in new projects.
d.
Zero.
e.
Based on the capital asset pricing model.
8. Dividend growth is a function of what?
a.
Return on equity.
b.
The retention rate.
c.
The payout ratio.
d.
All of the above.
e.
None of the above.
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9. Growth rates of the (1) labour force, (2) average number of hours worked and (3) labour productivity
are the main determinants of a foreign country’s
a.
Dividend payout ratio.
b.
Beta.
c.
Real risk free rate.
d.
Nominal risk free rate.
e.
Risk premium.
10. The growth rate of equity earnings without external financing is equal to which of the following?
a.
Retention rate plus return on equity.
b.
Retention rate minus return on equity.
c.
Retention rate divided by return on equity.
d.
Retention rate times return on equity.
e.
Return on equity divided by retention rate.
11. Which of the following factors influence an investor’s required rate of return?
a.
The economy’s real risk-free rate (RFR)
b.
The expected rate of inflation (I)
c.
A risk premium
d.
All of the above.
e.
None of the above.
12. What is the P/E ratio is determined by?
a.
The required rate of return.
b.
The expected dividend payout ratio.
c.
The expected growth rate of dividends.
d.
Choices a and b.
e.
All of the above.
13. Which of the following statements regarding fundamental and relative valuation techniques is true?
a.
Both techniques require an appropriate estimate of the required rate of return and the
growth rate.
b.
Both techniques require an estimate of future cash flows and a discount rate.
c.
Both techniques require an estimate of future cash flows and a growth rate.
d.
Both techniques require an estimate of future cash flows, the required rate of return and a
growth estimate.
e.
All of the above.
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14. Which of the following is an underlying assumption of the constant growth dividend discount model
(DDM)?
a.
Dividends have a constant growth rate
b.
The constant growth rate of dividends will continue for an infinite time period
c.
The required rate of return is greater than the expected growth rate
d.
All of the above.
e.
None of the above.
Exhibit 20-1
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
A major retailer is reevaluating its bonds since it is planning to issue a new bond in the current market.
The firm’s outstanding bond issue has 8 years remaining until maturity. The bonds were issued with a
6.5% coupon rate (paid quarterly) and a par value of $1,000. The required rate of return is 4.25%.
15. Refer to Exhibit 20-1. What is the current value of these securities?
a.
$1149.94
b.
$433.15
c.
$1151.92
d.
$860.50
e.
$863.35
16. Refer to Exhibit 20-1. What will be the value of these securities in one year if the required return is
7%?
a.
$970.14
b.
$388.13
c.
$1031.15
d.
$1035.81
e.
$972.52
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Exhibit 20-2
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
A major manufacturer is reevaluating its bonds since it is planning to issue a new bond in the current
market. The firm’s outstanding bond issue has 7 years remaining till maturity. The bonds were issued
with an 8% coupon rate (paid quarterly) and a par value of $1,000. The required rate of return is 10%.
17. Refer to Exhibit 20-2. What is the current value of these securities?
a.
$900.18
b.
$1151.92
c.
$972.52
d.
$1113.63
e.
$904.00
18. Refer to Exhibit 20-2. What will be the value of these securities in one year if the required return is
6%?
a.
$1151.92
b.
$972.52
c.
$1100.15
d.
$900.18
e.
$936.72
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Exhibit 20-3
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
A large grocery chain is reevaluating its bonds since it is planning to issue a new bond in the current
market. The firm’s outstanding bond issue has 6 years remaining until maturity. The bonds were issued
with a 6% coupon rate (paid semiannually) and a par value of $1,000. Because of increased risk the
required rate has risen to 10%.
19. Refer to Exhibit 20-3. What is the current value of these securities?
a.
$656.40
b.
$899.00
c.
$822.70
d.
$569.50
e.
$962.00
20. Refer to Exhibit 20-3. What will be the value of these securities in one year if the required return
declines to 8%?
a.
$899.43
b.
$862.50
c.
$869.88
d.
$918.93
e.
$946.98
21. In 2009, Montpelier Inc. issued a $100 par value preferred stock that pays a 9% annual dividend. Due
to changes in the overall economy and in the company’s financial condition investors are now
requiring a 10% return. What price would you be willing to pay for a share of the preferred if you
receive your first dividend one year from now?
a.
$100
b.
$110
c.
$75
d.
$90
e.
$85
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22. In 2009, Smiths Corp. issued a $50 par value preferred stock that pays a 6% annual dividend. Due to
changes in the overall economy and in the company’s financial condition investors are now requiring a
7% return. What price would you be willing to pay for a share of the preferred if you receive your first
dividend one year from now?
a.
$42.86
b.
$30.00
c.
$31.54
d.
$33.38
e.
$38.37
23. In 2009, Venus Fly Co. issued a $75 par value preferred stock which pays a 7% annual dividend. Due
to changes in the overall economy and in the company’s financial condition investors are now
requiring a 5% return. What price would you be willing to pay for a share of the preferred if you
receive your first dividend one year from now?
a.
$125
b.
$84
c.
$91
d.
$145
e.
$105
24. In 2009, Swisten Inc. issued a $150 par value preferred stock that pays an 8% annual dividend. Due to
changes in the overall economy and in the company’s financial condition investors are now requiring
an 15% return. What price would you be willing to pay for a share of the preferred if you receive your
first dividend one year from now?
a.
$80
b.
$75
c.
$59
d.
$95
e.
$110
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25. Using the constant growth model, a decrease in the required rate of return from 15 to 13% combined
with an increase in the growth rate from 5 to 6% would cause the price to
a.
Rise more than 50%.
b.
Rise less than 50%.
c.
Remain constant.
d.
Fall more than 50%.
e.
Fall less than 50%.
26. Using the constant growth model, an increase in the required rate of return from 19 to 17% combined
with an increase in the growth rate from 11 to 9% would cause the price to
a.
Fall more than 2%
b.
Fall less than 2%.
c.
Remain constant.
d.
Rise more than 2%.
e.
Rise less than 3%.
27. Using the constant growth model, an increase in the required rate of return from 14 to 15% combined
with an increase in the growth rate from 6 to 7% would cause the price to
a.
Rise more than 1%
b.
Rise less than 1%.
c.
Remain constant.
d.
Fall more than 1%.
e.
Fall less than 1%.
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28. Using the constant growth model, an increase in the required rate of return from 17 to 20% combined
with an increase in the growth rate from 8 to 11% would cause the price to
a.
Rise more than 3%
b.
Rise less than 3%.
c.
Remain constant.
d.
Fall more than 3%.
e.
Fall less than 3%.
29. Using the constant growth model, an increase in the required rate of return from 14 to 18% combined
with an increase in the growth rate from 8 to 12% would cause the price to
a.
Fall more than 4%
b.
Fall less than 4%.
c.
Rise more than 4%
d.
Rise less than 4%.
e.
Remain constant.
Exhibit 20-4
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Davenport Corporation’s last dividend was $2.70 and the directors expect to maintain the historic 3%
annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will
increase to 5% for the next three years and the stock will then reach $25 per share.
30. Refer to Exhibit 20-4. How much should you be willing to pay for the stock if you require a 17%
return?
a.
$16.97
b.
$22.16
c.
$21.32
d.
$32.63
e.
$23.63
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31. Refer to Exhibit 20-4. How much should you be willing to pay for the stock if you feel that the 5%
growth rate can be maintained indefinitely and you require a 17% return?
a.
$22.16
b.
$19.28
c.
$21.32
d.
$23.63
e.
$25.46
Exhibit 20-5
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
The National Motor Company’s last dividend was $1.25 and the directors expect to maintain the
historic 4% annual rate of growth. You plan to purchase the stock today because you feel that the
growth rate will increase to 7% for the next three years and the stock will then reach $25.00 per share.
32. Refer to Exhibit 20-5. How much should you be willing to pay for the stock if you require a 16%
return?
a.
$17.34
b.
$18.90
c.
$19.09
d.
$19.21
e.
None of the above
33. Refer to Exhibit 20-5. How much should you be willing to pay for the stock if you feel that the 7%
growth rate can be maintained indefinitely and you require a 16% return?
a.
$11.15
b.
$14.44
c.
$14.86
d.
$18.90
e.
$19.24
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34. Ross Corporation paid dividends per share of $1.20 at the end of 1999. At the end of 2009 it paid
dividends per share of $3.50. Calculate the compound annual growth rate in dividends.
a.
52.17%
b.
34.28%
c.
23%
d.
19.17%
e.
11.29%
35. Hunter Corporation had a dividend payout ratio of 63% in 2009. The retention rate in 2009 was
a.
37%
b.
63%
c.
50%
d.
0%
e.
100%
36. The beta for the DAK Corporation is 1.25. If the yield on 30 year T-bonds is 5.65%, and the long term
average return on the S&P 500 is 11%. Calculate the required rate of return for DAK Corporation.
a.
12.34%
b.
7.06%
c.
13.74%
d.
5.35%
e.
5.65%
37. Micro Corp. just paid dividends of $2 per share. Assume that over the next three years dividends will
grow as follows, 5% next year, 15% in year two, and 25% in year 3. After that growth is expected to
level off to a constant growth rate of 10% per year. The required rate of return is 15%. Calculate the
intrinsic value using the multistage model.
a.
$5.56
b.
$66.4
c.
$49.31
d.
$43.66
e.
none of the above
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38. The P/E ratio for BMI Corporation 21, and the P/S ratio is 5.2. The industry P/E ratio is 35 and the
industry P/S ratio is 7.5. Based on relative valuation, what is the BMI?
a.
undervalued on the basis of relative P/E and relative P/S.
b.
overvalued on the basis of relative P/E and undervalued on the basis of relative P/S.
c.
undervalued on the basis of relative P/E and overvalued on the basis of relative P/S.
d.
overvalued on the basis of relative P/E and relative P/S.
e.
none of the above.
Exhibit 20-6
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Consider a firm that has just paid a dividend of $2. An analyst expects dividends to grow at a rate of
8% per year for the next five years. After that dividends are expected to grow at a normal rate of 5%
per year. Assume that the appropriate discount rate is 7%.
39. Refer to Exhibit 20-6. What are the dividends for years 1, 2, and 3?
a.
$2, $2.08, $2.16
b.
$2, $2.05, $2.10
c.
$2.16, $2.24, $2.32
d.
$2.16, $2.33, $2.52
e.
$2.07, $2.14, $2.21
40. Refer to Exhibit 20-6. What is the future price of the stock in year 5?
a.
$113.40
b.
$122.47
c.
$132.27
d.
$142.85
e.
$154.35
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41. Refer to Exhibit 20-6. What is the present value today of dividends for years 1 to 5?
a.
$4.06
b.
$10.28
c.
$12.40
d.
$14.52
e.
$10.0
42. Refer to Exhibit 20-6. What is the price of the stock today (P0)?
a.
$136.29
b.
$133.03
c.
$120.33
d.
$123.43
e.
$126.60
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Exhibit 20-7
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Consider a firm that has just paid a dividend of $1.5. An analyst expects dividends to grow at a rate of
9% per year for the next three years. After that dividends are expected to grow at a normal rate of 5%
per year. Assume that the appropriate discount rate is 7%.
43. Refer to Exhibit 20-7. What are the dividends for years 1, 2, and 3?
a.
$1.5, $2.0, $2.05
b.
$1.64, $1.78, $1.94
c.
$1.64, $1.94, $2.24
d.
$1.5, $2.40, $3.30
e.
$2.07, $2.14, $2.21
44. Refer to Exhibit 20-7. What is the future price of the stock in year 3?
a.
$81.75
b.
$84.81
c.
$92.56
d.
$101.85
e.
$111.16
45. Refer to Exhibit 20-7. What is the present value today of dividends for years 1 to 3?
a.
$4.67
b.
$3.08
c.
$5.67
d.
$4.5
e.
$1.53
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46. Refer to Exhibit 20-7. What is the price of the stock today (P0)?
a.
$84.81
b.
$87.81
c.
$91.09
d.
$94.32
e.
$97.61
47. Tayco Corporation has just paid dividends of $3 per share. The earnings per share for the company
was $4. If you believe that the appropriate discount rate is 15% and the long term growth rate in
dividends is 6%, and earnings is 6%, then what is the firm’s P/E ratio?
a.
8.33
b.
33.33
c.
44.44
d.
11.11
e.
None of the above
48. What is the value of a 10% semi-annual coupon bond with a par value of $1,000 that matures in 5
years and has a required rate of return of 9%?
a.
$1,021.95
b.
$1,038.90
c.
$1,039.56
d.
$1,064.18
e.
$1,078.23
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49. What is the value of a preferred stock that has a par value of $100, a required rate of return of 11%,
and pays a 7% annual dividend?
a.
$63.64
b.
$157.14
c.
$909.09
d.
$1,428.57
e.
$2,500.00
50. XCEL Corporation paid a dividend yesterday for $1.50. They expect to pay dividends annually at a
constant 6% annual growth rate indefinitely. If the required rate of return on this investment is 12%,
what is the current value of this common stock?
a.
$1.50
b.
$12.50
c.
$13.25
d.
$25.00
e.
$26.50
Exhibit 20-8
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Fast Grow Corporation is expecting dividends to grow at a 20% rate for the next two years. The
corporation just paid a $2 dividend and the next dividend will be paid one year from now. After two
years of rapid growth dividends are expected to grow at a constant rate of 9% forever.
51. Refer to Exhibit 20-8. If the required return is 14%, what is the value of Fast Grow Corporation
common stock today?
a.
$40.26
b.
$42.38
c.
$46.70
d.
$52.63
e.
$62.78
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52. Refer to Exhibit 20-8. Assume that the annual dividend grows at a constant rate of 9% indefinitely
instead of the supernormal growth. How much is the stock worth if dividends grow annually at 9%?
a.
$40.00
b.
$43.60
c.
$45.60
d.
$47.80
e.
$52.40