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CORPORATE FINANCE

ProbSet

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CORPORATE FINANCE ProbSet Chapter 7 (13ed.) – Stock Valuation

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Chapter 7 (13ed.) – Stock Valuation

1. A stock expects to pay a year-end dividend of $2.00 a share. Last year’s dividend has already been paid. The dividend is expected to fall 5 percent a year, forever. The company’s expected and required rate of return is 15%. Which of the following statements is most correct?

a. The company’s stock price is $10.

b. The company’s expected dividend yield 5 years from now will be 20 percent.

c. The company’s stock price 5 years from now is expected to be $7.74.

d. Both answers b and c are correct.

e. All of the above answers are correct.

2. The relationship between a stock’s required and expected rates of return determines the

security’s equilibrium price level. Which of the following is true?

At this equilibrium level, a stock’s required return will equal a bond’s coupon.

If the expected rate of return is less than the required rate, investors will desire to buy

the stock and there will be a tendency for the price to rise.

c. If the expected rate of return is greater than the required rate, investors will try to

purchase shares of the stock, which will drive the price up.

d. If the expected rate of return is less than the required rate, investors will desire to sell

the stock and there will be a tendency for the price to rise.

Both statement c and d are correct.

3. Which of the following statements regarding constant growth stock valuation is

most correct?

a. Assume that the required rate of return on a given stock is 12%. If the stock’s

dividend is growing at a constant rate of 4%, its expected dividend yield is 4% as well.

b. The expected capital gain yield on a stock is equal to the expected return less

the dividend yield.

A stock’s dividend yield must at least equal the expected growth rate.

All of the answers above are correct.

Answers b and c are correct.

4. Which of the following factors in the discounted cash flow (DCF) approach to

estimating the cost of common equity is the leastdifficult to estimate?

Expected growth rate, g.

Dividend yield, D1/Po.

Required return, Ks.

Expected rate of return, Ks

All of the above are equally difficult to estimate.

5. A stock is not expected to pay a dividend over the next four years. Five years from now,

the company anticipates that it will establish a dividend of $1.00 per share. Once the

dividend is established, the market expects that the dividend will grow at constant rate of 5

percent per year forever. The risk-free rate is 5 percent, the company’s beta is 1.2, and

the market risk premium is 5 percent. The required rate of return on the company’s stock is

expected to remain constant. What is the current stock price?

a. $7.36

b. $8.62

c. $9.89

d. $10.98

e. $11.53

6. ABC Company has been growing at a 10 percent rate, and it just paid a dividend of Do = .

$3.00. Due to a new product, ABC expect to achieve a dramatic increase in its short-run growth rate, to 20 percent annually for the next 2 years. After this time, growth is expected to return to the long-run constant rate of 10 percent. The company’s beta is 2.0, the required return on an average stock is 11 percent, and the risk-free rate is 7 percent. What should the dividend yield be today?

a. 3.93%

b. 4.60%

c. 10.00%

d. 7.54%

e. 2.33%

7. Albright Motors is expected to pay a year-end dividend of $3.00 a share.

The stock currently sells for $30 a share. The required (and expected) rate of return

on the stock is 16%. If the dividend is expected to grow at a constant rate, g, what is g?

13.00%

10.05%

6.00%

5.33%

7.00%

8. Cartwright Brothers’ stock is currently selling for $40. a share. The stock is expected to

pay a $2. dividend at the end of the year. The stock’s dividend is expected to grow at a

constant rate of 7 percent a year forever. The risk-free rate is 6 percent and the market

risk premium is also 6 percent. What is the stock’s beta?

a. 1.06

b. 1.00

c. 2.00

d. 0.83

e. 1.08

9. 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 is 8 percent, the expected return on the market, 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

10. Chadmark Corporation is expanding rapidly, and it currently needs to retain all of its earnings, hence it does not pay any dividends. However, investors expect Chadmark to begin paying dividends with the first dividend of $0.75 coming 2 years from today. The dividend should grow at a constant rate of 10 percent per year. If the required return on the stock is 16 percent, what is the value of the stock today?

11. HBT Corporation has never paid a dividend. Its current free cash flow is $1,200,000 and is expected to grow at a constant rate of 4%. The overall cost of capital is 10%. What is HBT’ value of operations (in millions)?

12. Assume that as investment manager of Maine Electric Company’s pension plan (which is exempt from income taxes), you must choose between Exxon bonds and GM preferred stock. The bonds have a $1,000 par value; they mature in 20 years; they have a 7% stated interest rate paid semi-annually; they are callable at Exxon’s option at a price of $1,150 after 5 years, and they sell at a price of $815.98 per bond. The Preferred stock is perpetuity: it pays a dividend of $1.50 each quarter, and it sells for $75 per share. Assume interest rates do not change. What is the most likely effective annual rate of return on the higher yielding security?

13. 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)?

14. Dozier Corp is a fast growing supplier of office products. Analysts project the following free cash flows (FCFs) during the next three years, after which FCF is expected to grow at a constant 7% rate. Dozier’s cost of capital is 13%.

Time 1 2 3

Free cash Flow ($mill) -$20 $30 $40

a. What is Dozier’s terminal, or horizon value?

b. Suppose Dozier has $10 million in marketable securities, $100 million in debt, and 10 million shares of stock. What is the price per share?

What is the current value of the operations

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