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Exam 9: Stocks and Their Valuation

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Question 1

True/False

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For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

A) True
B) False

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Question 2

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Which of the following statements is CORRECT, assuming stocks are in equilibrium?

A) The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.
B) Assume that the required return on a given stock is 13%. If the stock's dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well.
C) A stock's dividend yield can never exceed its expected growth rate.
D) A required condition for one to use the constant growth model is that the stock's expected growth rate exceeds its required rate of return.
E) Other things held constant, the higher a company's beta coefficient, the lower its required rate of return.

F) D) and E)
G) B) and C)

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Question 3

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Based on the corporate valuation model, Morgan Inc.'s total corporate value is $300 million. The balance sheet shows $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock's price per share?

Gay Manufacturing is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25) . The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate?

The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities.

Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? $\begin{array}{lrr}&\underline{\text {A}}& \underline{\text {B}}\\ \text { Beta } & 1.10 & 0.90 \\\text { Constant growth rate } & 7.00 \% & 7.00 \%\end{array}$

The preemptive right is important to shareholders because it

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? $\begin{array}{lcc}&\underline{\mathrm{A}} & \underline{\mathrm{B}}\\\text { Required return } & 10 \% & 12 \% \\\text { Market price } & \$ 25 & \$ 40 \\\text { Expected growth } & 7 \% & 9 \%\end{array}$

If in the opinion of a given investor a stock's expected return exceeds its required return, this suggests that the investor thinks

Based on the corporate valuation model, Wang Inc.'s total corporate value is $750 million. Its balance sheet shows $100 million 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?

Wall Inc. forecasts that it will have the free cash flows (in millions) shown below. If the weighted average cost of capital is 14% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the firm's total corporate value, in millions? $\begin{array} { l r r r } \text { Year } & 1 & 2 & 3 \\\hline \text { Free cash flow } & - \$ 20.00 & \$ 48.00 & \$ 54.00\end{array}$

Preferred stock is a hybrid-a sort of cross between a common stock and a bond-in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond.

A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = −5%) . If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT?

When a new issue of stock is brought to market, it is the marginal investor who determines the price at which the stock will trade.

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 stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth rate is g = 4.0%. What is the current stock price?

The Isberg Company just paid a dividend of $0.75 per share, and that dividend is expected to grow at a constant rate of 5.50% per year in the future. The company's beta is 1.15, the market risk premium is 5.00%, and the risk-free rate is 4.00%. What is the company's current stock price, P0?

Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT? $\begin{array}{lr}\text { Expected dividend, } \mathrm{D}_{1} & \$ 3.00 \\\text { Current Price, } \mathrm{P}_{0} & \$ 50 \\\text { Expected constant growth rate } & 6.0 \%\end{array}$

Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?

Goode Inc.'s stock has a required rate of return of 11.50%, and it sells for $25.00 per share. Goode's dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D0?