CORPORATE FINANCE

ProbSet

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?

  1. At
    this equilibrium level, a stock’s required return will equal a bond’s
    coupon.
  2. 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.

  1. 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.

  1. A
    stock’s dividend yield must at least equal the expected growth rate.
  2. All of
    the answers above are correct.
  3. 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?

  1. Expected
    growth rate, g.
  2. Dividend
    yield, D1/Po.
  3. Required
    return, Ks.
  4. Expected
    rate of return, Ks
  5. 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?

  1. 13.00%
  2. 10.05%
  3. 6.00%
  4. 5.33%
  5. 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