# Answers to Chapter 4: The Value of Common Stocks

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**Multiple Choice Questions**

1. If the Vol. 100s is reported as 10,233 in the Wall Street Journal quotation, then the trading volume for that day of trading is:

A) 10,233 shares

B) 102,330 shares

C) 1,023,300 shares

D) 10,233,000 shares

2. The dividend yield reported as Yld. % in The Wall Street Journal quotation is calculated as follows:

A) (dividends / hi)

B) (dividends / lo)

C) (dividends / close)

D) None of the above

3. The Wall Street Journal quotation for a company has the following values: Div: 2.28, PE: 19, Close: 75.30. Calculate the dividend pay out ratio for the company.

A) 58%

B) 12%

C) 75%

D) None of the above

4. If the Wall Street Journal Quotation for a company has the following values close: 26.00; Net chg: =+1.00; then the closing price for the stock for the previous trading day was?

A) $26

B) $25

C) $27

D) None of the above.

5. The value of a common stock today depends on:

A) Number of shares outstanding and the number of shareholders

B) The Wall Street analysts

C) The expected future dividends and the discount rate

D) Present value of the future earnings per share

6. Super Computer Company’s stock is selling for $100 per share today. It is expected that this stock will pay a dividend of 5 dollars per share, and then be sold for $120 per share at the end of one year. Calculate the expected rate of return for the shareholders.

A) 20%

B) 25%

C) 10%

D) 15%

7. PC Company stockholders expect to receive a year-end dividend of $10 per share and then be sold for $122 dollars per share. If the required rate of return for the stock is 20%, what is the current value of the stock?

A) $100

B) $122

C) $132

D) $110

8. Macrohard Company expects to pay a dividend of $6 per share at the end of year one, $8 per share at the end of year two and then be sold for $136 per share. If the required rate on the stock is 20%, what is the current value of the stock?

A) $100

B) $105

C) $110

D) $120

9. The constant dividend growth formula P0 = D1/(r-g) assumes:

A) The dividends are growing at a constant rate g forever.

B) r > g

C) g is never negative.

D) Both A and B

10. Casino Co. is expected to pay a dividend of $6 per share at the end of year one and these dividends are expected to grow at a constant rate of 8% per year forever. If the required rate of return on the stock is 20%, what is current value of the stock today?

A) $30

B) $50

C) $100

D) $54

11. WorldTour Co. has just now paid a dividend of $6 per share (Do), the dividends are expected to grow at a constant rate of 5% per year forever. If the required rate of return on the stock is 15%, what is the current value on stock, after paying the dividend?

A) $63

B) $56

C) $40

D) $48

12. The required rate of return or the market capitalization rate is estimated as follows:

A) Dividend yield + expected rate of growth in dividends

B) Dividend yield – expected rate of growth in dividends

C) Dividend yield / expected rate of growth in dividends

D) (Dividend yield) * (expected rate of growth in dividends)

13. Mcom Co. is expected to pay a dividend of $4 per share at the end of year one and the dividends are expected to grow at a constant rate of 4% forever. If the current price of the stock is $25 per share calculated the required rate of return or the market capitalization rate for the firms’ stock.

A) 4%

B) 16%

C) 20%

D) None of the above.

14. Dividend growth rate for a stable firm can be estimated as:

A) Plow back rate * the return on equity (ROE)

B) Plow back rate / the return on equity (ROE)

C) Plow back rate +the return on equity (ROE)

D) Plow back rate – the return on equity (ROE)

15. MJ Co. pays out 60% of its earnings as dividends. Its return on equity is 20%. What is the stable dividend growth rate for the firm?

A) 3%

B) 5%

C) 8%

D) 12%

16. Michigan Motor Company is currently paying a dividend of $1.50 per year. The dividends are expected to grow at a rate of 20% for the next three years and then a constant rate of 6 % thereafter. What is the expected dividend per share in year 5?

17. Great Lakes Co. is currently paying a dividend of $2.20 per share. The dividends are expected to grow at 25% per year for the next four years and then grow 5% per year thereafter. Calculate the expected dividend in year 6.

A) $5.37

B) $2.95

C) $5.92

D) $8.39

18. Y2K Technology Corporation has just paid a dividend of $0.40 per share. The dividends are expected to grow at 30% per year for the next two years and at 5% per year thereafter. If the required rate of return in the stock is 15% (APR), calculate the current value of the stock.

A) $1.420

B) $6.33

C) $5.63

D) None of the above

19. The NetTech Co. has just paid a dividend of $1 per share. The dividends are expected to grow at 20% per year for the next three years and at the rate of 5% per year thereafter. If the required rate of return on the stock is 15%(APR), what is the current value of the stock?

A) $18.14

B) $15.20

C) $12.51

D) None of the above

20. Lake Co. has paid a dividend $2 per share out of earnings of $4 per share. If the book value per share is $25, what is the expected growth rate in dividends (g)?

A) 16%

B) 12%

C) 8%

D) 4%

21. Lake Co. has paid a dividend $2 per share out of earnings of $4 per share. If the book value per share is $25 and is currently selling for $30 per share, calculate the required rate of return on the stock. (Use the calculated g from the previous problem to answer this question.)

A) 7.2%

B) 15.2%

C) 14.7%

D) 16.6%

22. Lake Co. has paid a dividend $3 per share out of earnings of $5 per share. If the book value per share is $40, what is the expected growth rate in dividends?

A) 12.5%

B) 8%

C) 5%

D) 3%

23. Lake Co. has paid a dividend $3 per share out of earnings of $5 per share. If the book value per share is $40 and the share value is 52.50 per share, calculate the required rate of return on the stock. (Use the calculated ‘g’ from the previous problem to answer this question)

A) 11%

B) 12%

C) 5%

D) 6%

24. The growth rate in dividends can be thought of as a sum of two parts. They are:

A) ROE and the Retention Ratio.

B) Dividend yield and growth rate in dividends

C) ROA and ROE

D) Book value per share and EPS

25. The value of the stock:

A) Increases as the dividend growth rate increases

B) Increases as the required rate of return decreases

C) Increases as the required rate of return increases

D) Both A and B

26. Company X has a P/E ratio of 10 and a stock price of $50 per share. Calculate earnings per share of the company.

A) $5 per share

B) $10 per share

C) $0.20 per share

D) $6 per share

27. Companies with higher expected growth opportunities usually sell for:

A) Lower P/E ratio

B) Higher P/E ratio

C) A price that is independent of P/E ratio

D) A price that the dependent upon the payment ratio

28. Which of the following formulas regarding earnings to price ratio is true:

A) EPS/Po = r[1+(PVGO/Po]

B) EPS/Po = r[1 – (PVGO/Po)]

C) EPS/Po = [r+(PVGO/Po)]

D) EPS/Po =[r(1+(PVGO/Po)]/r

29. Woe Co. is expected to pay a dividend or $4.00 per share out of earnings of $7.50 per share. If the required rate of return on the stock is 15% and dividends are growing at a current rate of 10% per year, calculate the percent value of the growth opportunity for the stock (PVGO).

A) $80

B) $50

C) $30

D) $26

30. Parcel Corporation is expected to pay a dividend of $5 per share next year, and the dividends pay out ratio is 50%. If the dividends are expected to grow at a constant rate of 8% forever and the required rate of return on the stock is 13%, calculate the present value of the growth opportunity.

A) $23.08

B) $64.10

C) $100

D) None of the above

31. A high proportion of the value a growth stock comes from:

A) Past dividend payments

B) Past earnings

C) PVGO (Present Value of the Growth Opportunities)

D) Both A and B

32. Generally high growth stocks pay:

A) High dividends

B) Low or no dividends

C) Erratic dividends

D) Both A and C

33. The following stocks are examples of growth stocks except:

A) Wal-Mart

B) Dell Computer

C) Microsoft

D) Chubb

34. The following stocks are examples of income stocks except:

A) Exxon Mobil

B) Wal-Mart

C) Chubb

D) Kellogg

E) All of the above

35. Which of the following stocks are growth stocks?

A) Dell Computer

B) AT&T

C) Duke Power

D) Exxon

E) None of the above

36. Which of the following stocks are income stocks?

A) Duke Power

B) Dell Computer

C) Microsoft

D) Wal-Mart

E) None of the above

37. The relationship between P/E ratio and market capitalization rate can be described by the following statements:

A) EPS/Po measures r, only if PVGO = 0

B) High P/E ratios indicate low r

C) There is no reliable association between the P/E ratio and r

D) A and C above

38. Universal Air is a no growth firm and has two million shares outstanding. It is expected to earn a constant 20 million per year on its assets. If all earnings are paid out as dividends and the cost of capital is 10%, calculate the current price per share for the stock.

A) $200

B) $100

C) $150

D) $50

39. Which of the following statements regarding free cash flow is true?

A) Free cash flow is always positive

B) Free cash flow is always negative

C) Free cash flow is the net cash flow to the shareholders after paying for future investments

D) None of the above

40. Discounted cash flow formulas work for the valuation of:

A) Stocks with constant dividend growth

B) Businesses

C) Stocks with super normal dividend growth

D) All of the above

41. The value of a business is given by:

A) PV = PV(free cash flows)

B) PV = PV(free cash flows) + PV (horizon value)

C) PV(free cash flows) – PV(horizon value)

D) None of the above

42. The present value of free cash flow is $5 million and the present value of the horizon value is $10 million. Calculate the present value of the business.

A) $5 million

B) $10 million

C) $15 million

D) None of the above

**True/False Questions**

T F 43. The New York Stock Exchange is the only stock market in the US.

T F 44. Shareholders receive cash from the firm in the form of dividends and capital gains.

T F 45. The return that is expected by investors from a common stock is often called its market capitalization rate.

T F 46. At each point in time, all securities in an equivalent-risk class are priced to offer the same expected return.

T F 47. The constant growth formula for stock valuation does not work for firms with negative growth (declining) rates in dividends.

T F 48. The market capitalization equals the dividend yield plus the growth rate in dividends for a constant dividend growth stock.

T F 49. The value of a share of common stock is equal to the discounted stream of free cash flow per share.

T F 50. The value of a share of common stock is equal to the discounted stream of earnings per share.

T F 51. There is a strong relationship between a stock’s price-earnings (P/E) ratio and its capitalization rate.

T F 52. Discounted cash flow approach can be used to value ongoing businesses.

**Essay Questions**

53. Explain the term “primary market.”

54. Explain the term “secondary market.”

55. Briefly explain the term “market capitalization rate.”

56. Discuss the general principle in the valuation of a common stock.

57. Discuss the term “price-earnings (P/E) ratio.”

58. Discuss the problems inherent in the valuation of a business.