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CHAPTER 8

STOCKS AND THEIR VALUATION

(Difficulty:
E = Easy,
M
=
Medium,
and T =

Tough)

Multiple Choice: Conceptual
Easy:
Required return
1

.

Increase.
Decrease.
Fluctuate.
Remain constant.
Possibly increase, possibly decrease, or possibly remain unchanged.

Required return
.

Diff: E

The stock is experiencing supernormal growth.
The stock should be sold.
The company is probably not trying to maximize price per share.
The stock is a good buy.
Dividends are not being declared.

Required return
.

Answer: d

If the expected rate of return on a stock exceeds the required rate,
a.
b.
c.
d.
e.

3

Diff: E

An increase in a firm’s expected growth rate would normally cause the firm’s required
rate of return to
a.
b.
c.
d.
e.

2

Answer: e

Answer: a

Diff: E

Stock A has a required return of 10 percent. Its dividend is expected to grow at a
constant rate of 7 percent per year. Stock B has a required return of 12 percent.
Its dividend is expected to grow at a constant rate of 9 percent per year. Stock A
has a price of $25 per share, while Stock B has a price of $40 per share. Which of
the following statements is most correct?
a. The two stocks have the same dividend yield.
b. If the stock market were efficient, these two stocks should have the same price.
c. If the stock market were efficient, these two stocks should have the same expected
return.
d. Statements a and c are correct.
e. All of the statements above are correct.

Chapter 8 - Page 1

Constant growth model
4

.

Answer: a

Diff: E

Which of the following statements is most correct?
a. The constant growth model takes into consideration the capital gains earned on a
stock.
b. It is appropriate to use the constant growth model to estimate stock value even if
the growth rate never becomes constant.
c. Two firms with the same dividend and growth rate must also have the same stock
price.
d. Statements a and c are correct.
e. All of the statements above are correct.

Constant growth model
5

.

Answer: a

Diff: E

Which of the following statements is most correct?
a. The stock valuation model, P0 = D1/(ks - g), can be used for firms which have
negative growth rates.
b. If a stock has a required rate of return ks = 12 percent, and its dividend grows at
a constant rate of 5 percent, this implies that the stock’s dividend yield is 5
percent.
c. The price of a stock is the present value of all expected future dividends,
discounted at the dividend growth rate.
d. Statements a and c are correct.
e. All of the statements above are correct.

Constant growth model
6

.

Which

The expected return on the stock is 5 percent a year.
The stock’s dividend yield is 5 percent.
The stock’s price one year from now is expected to be 5 percent higher.
Statements a and c are correct.
All of the statements above are correct.

Constant growth model
.

Diff: E

A stock’s dividend is expected to grow at a constant rate of 5 percent a year.
of the following statements is most correct?
a.
b.
c.
d.
e.

7

Answer: c

Answer: e

Diff: E

Stocks A and B have the same required rate of return and the same expected year-end
dividend (D1). Stock A’s dividend is expected to grow at a constant rate of 10 percent
per year, while Stock B’s dividend is expected to grow at a constant rate of 5 percent
per year. Which of the following statements is most correct?
a. The two stocks should sell at the same price.
b. Stock A has a higher dividend yield than Stock B.
c. Currently Stock B has a higher price, but over time Stock A will eventually have a
higher price.
d. Statements b and c are correct.
e. None of the statements above is correct.

Constant growth stock
8

.

N

Stock X has a higher dividend yield than Stock Y.
Stock Y has a higher dividend yield than Stock X.
One year from now, Stock X’s price is expected to be higher than Stock Y’s price.
Statements a and c are correct.
Statements b and c are correct.

Constant growth stock
.

Diff: E

Stock X and Stock Y sell for the same price in today’s market. Stock X has a required
return of 12 percent.
Stock Y has a required return of 10 percent.
Stock X’s
dividend is expected to grow at a constant rate of 6 percent a year, while Stock Y’s
dividend is expected to grow at a constant rate of 4 percent. Assume that the market
is in equilibrium and expected returns equal required returns. Which of the following
statements is most correct?
a.
b.
c.
d.
e.

9

Answer: c

Answer: e

Diff: E

N

Stock X is expected to pay a dividend of $3.00 at the end of the year (that is, D 1 =

Chapter 8 - Page 2

$3.00). The dividend is expected to grow at a constant rate of 6 percent a year. The
stock currently trades at a price of $50 a share.
Assume that the stock is in
equilibrium, that is, the stock’s price equals its intrinsic value.
Which of the
following statements is most correct?
a.
b.
c.
d.
e.

The required return on the stock is 12 percent.
The stock’s expected price 10 years from now is $89.54.
The stock’s dividend yield is 6 percent.
Statements a and b are correct.
All of the statements above are correct.

Constant growth model
10

.

Answer: e

Diff: E

Stock
X
has
a
required
return
of
12
percent,
a
dividend
yield
of
5 percent, and its dividend will grow at a constant rate forever.
Stock Y has a
required return of 10 percent, a dividend yield of 3 percent, and its dividend will
grow at a constant rate forever. Both stocks currently sell for $25 per share. Which
of the following statements is most correct?
a.
b.
c.
d.
e.

Stock X pays a higher dividend per share than Stock Y.
Stock X has a lower expected growth rate than Stock Y.
One year from now, the two stocks are expected to trade at the same price.
Statements a and b are correct.
Statements a and c are correct.

Chapter 8 - Page 3

class. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of common stock.Constant growth model and CAPM 11 . class. N Stock A has a beta of 1. and C. e. Will result in higher dividends per share. Answer: a Stock A must have a higher dividend yield than Stock B. All of the statements above are correct. Statements a and b are correct. An IPO occurs whenever a company buys back its stock on the open market. Stocks and bonds should have the same expected returns. the stocks may pay different dividends. is 6 percent. b. while Stock B has a beta of 0. e. regardless of All common stock. The risk-free rate is 6. c.9. c. Class A and Class B. Answer: d Assume that the stock market is semistrong-form efficient. d. Miscellaneous issues .Page 4 . If your uncle earns a return higher than the overall stock market. b.kRF. 12 Diff: E Answer: c Diff: E Which of the following statements is most correct? a. B. statements concerning stock classes is most correct? a. which is expected to grow at a constant rate of 7 percent a year. Allows management to sell additional shares below the current market price. b. Statements a and b are correct. b. If a market is weak-form efficient this implies that all public information is rapidly incorporated into market prices. Preemptive right 13 . Classified stock 14 . Diff: E Which of the following of three classes: A. Stock A must have a higher stock price than Stock B. Stock B’s dividend yield equals its expected dividend growth rate. Statements a and c are correct. regardless of None of the statements above is . kM . d. b. d. The preemptive right is not important to shareholders. All common stocks fall into one Most firms have several classes All common stock. the expected net present value from investing in the Chapter 8 . necessarily true. e. The market risk premium. If a company has two classes of common stock.3 percent. d.1. Is included in every corporate charter. d. Both stocks have a dividend. but the two classes must have the same voting rights. of common stock outstanding. but returns on stocks should exceed returns on bonds. d. You can expect to outperform the overall market by observing the past price history of an individual stock. In equilibrium all stocks should have the same expected returns. b. e. this means the stock market is inefficient. c. Efficient markets hypothesis 16 . Assume that the market is in equilibrium. For the average investor. e. Answer: b The preemptive right is important to shareholders because it a. Protects the current shareholders against dilution of ownership interests. c. c. Statements a and c are correct. Efficient markets hypothesis 15 Diff: E Answer: e Diff: E Which of the following statements is most correct? a. Which of the following statements is most correct? a. must have the same dividend privileges. must have voting rights. If a market is strong-form efficient this implies that the returns on bonds and stocks should be identical. statements is most correct? Diff: E Which of the following a. None of the above statements is correct. Answer: e Companies can issue different classes of common stock. c.

e. An individual who has inside information about a publicly traded company should be able to profit from this information in a strong-form efficient market. None of the statements above is correct. The required rates of return on stocks equal the required rates of return on bonds. b. All the statements above are correct. the expected net present value from investing in the stock market is the required return on the stock. this means that all stocks should have the same expected return. c. Answer: a Diff: E Which of the following statements is most correct? a. Weak-form market efficiency implies that recent trends in stock prices would be of no use in selecting stocks. d. d. The required rates of return on all stocks are the same and the required rates of return on stocks are higher than the required rates of return on bonds. If the stock market is semistrong-form efficient. Statements a and c are correct. Answer: e Diff: E Which of the following statements is most correct? a. If a market is weak-form efficient. If a market is weak-form efficient. e. c. Statements a and c are correct. b. stocks and bonds should have the same expected return. All of the statements above are correct.stock market is zero. None of the statements above is correct. None of the statements above is correct. If the stock market is weak-form efficient. Efficient markets hypothesis 20 . All of the statements above are correct. d. c. An individual who has information about past stock prices should be able to profit from this information in a weak-form efficient market. all stocks should have the same expected return. If the stock market is semistrong-form efficient. Answer: e Diff: E N Which of the following statements is most correct? a. b. Semistrong-form market efficiency means that stock prices reflect all public information. Answer: a Diff: E Most studies of stock market efficiency suggest that the stock market is highly efficient in the weak form and reasonably efficient in the semistrong form. this means that you can expect to beat the market by using technical analysis that relies on the charting of past prices. e. Market efficiency implies that all stocks should have the same expected return.Page 5 . Efficient markets hypothesis 21 . On the basis of these findings which of the following statements is correct? Chapter 8 . e. A trading strategy in which you buy stocks that have recently fallen in price is likely to provide you with returns that exceed the rate of return on the overall stock market. c. b. this means that prices rapidly reflect all available public information. statements is most correct? Diff: E Which of the following a. Efficient markets hypothesis 17 . For the average investor. None of the statements above is correct. If a market is strong-form efficient. Efficient markets hypothesis 22 . c. Statements a and c are correct. Answer: e Assume that the stock market is semistrong-form efficient. Efficient markets hypothesis 18 . d. Semistrong-form market efficiency implies that all private and public information is rapidly incorporated into stock prices. Efficient markets hypothesis Answer: c Diff: E 19 . e. Which of the following statements is most correct? a. d. b. then information about recent trends in stock prices would be very useful when it comes to selecting stocks. e.

Preferred stock concepts Answer: e Diff: E 23 . Preferred stock concepts 24 . Preferred stock provides steadier and more reliable income to investors than common stock. Answer: e Diff: E Which of the following statements is most correct? a. Chapter 8 . then Stock Y must sell for a higher price. d. b. Statements a and c are correct. while Stock Y has a required return of 12 percent. c. Common stock concepts 26 . d. The company’s stock price is $10. Statements a and c are correct. Statements a and b are correct.00). The company’s expected and required rate of return is 15 percent. The dividend is expected to fall 5 percent a year. One of the advantages of common stock financing is that a greater proportion of stock in the capital structure can reduce the risk of a takeover bid. d. One of the advantages of common stock financing is that a firm’s debt ratio will decrease. then Stock Y must have a lower expected capital gains yield than Stock X. Which of the following statements is most correct? a. One of the advantages to the firm associated with preferred stock financing rather than common stock financing is that control of the firm is not diluted. Statements b and c are correct. e. e. The company’s stock price 5 years from now is expected to be $7. forever (g = -5%).a. Information disclosed in companies’ most recent annual reports can be used to consistently beat the market. d. Statements b and c are correct. b. Common stock concepts 25 . The stock price for a company has been increasing for the past 6 months. e. Stock Y must have a higher dividend yield than Stock X. e. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate. Answer: e Diff: E A stock expects to pay a year-end dividend of $2. Answer: d Diff: E Which of the following statements is most correct? a. b. d. All of the statements above are correct. Statements a and c are correct. A firm with classified stock can pay different dividends to each class of shares.Page 6 . Most preferred stock is owned by corporations. All of the statements above are correct. b. Information you read in The Wall Street Journal today cannot be used to select stocks that will consistently beat the market. d. c. If Stock Y and Stock X have the same dividend yield. Which of the following statements is most correct? a. Preferred stockholders have priority over common stockholders. None of the statements above is correct.74. c. Statements a and b are correct. e. One of the advantages to the firm of financing with preferred stock is that 70 percent of the dividends paid out are tax deductible. c. The company’s expected dividend yield 5 years from now will be 20 percent. c. Declining growth stock 27 . b. A big advantage of preferred stock is that preferred stock dividends are tax deductible for the issuing corporation. On the basis of this information it must be true that the stock price will also increase during the current month.00 a share (D 1 = $2. c. All of the statements above are correct. b. Answer: e Diff: E Stock X has a required return of 10 percent. All of the statements above are correct. Which of the following statements is most correct? a. e.

Dividend yield and g 28 . If Stock A has a higher dividend yield than Stock B. c. the higher dividend yield will have a lower dividend growth rate. b. Stock B must have a higher dividend yield than Stock A. e. 29 Answer: d have the same per-share dividend. c. d. its expected capital gains yield must be higher than Stock B’s. Each investment’s expected return should equal its required return.Page 7 . c. Which of the following statements is most correct? a. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. Each investment should have the same expected return. Answer: c Diff: E Stocks A and B have the same price. have the same dividend yield. All of the statements above are correct. Stock A must have a higher dividend yield than Stock B. e. its expected capital gains yield must be lower than Stock B’s. which of the following statements is most correct? a. the higher dividend yield will have a higher dividend growth rate. but Stock A has a higher required rate of return than Stock B. Diff: E If two constant growth stocks have the same required rate of return and the same price. The The The The The two stocks two stocks two stocks stock with stock with Dividend yield and g . If Stock A has a lower dividend yield than Stock B. d. b. Each investment should have the same realized return. b. d. Market equilibrium 30 . Answer: b Diff: E N If markets are in equilibrium. e. Each investment’s expected return should equal its realized return. have the same dividend growth rate. Chapter 8 . which of the following will occur: a.

Assume that markets are semistrong-form efficient. which of the following statements is most correct? a. c. Answer: a Diff: M For markets to be in equilibrium. Past stock prices can be successfully used to forecast future stock returns. e. b. If the stock market is semistrong-form efficient. Market efficiency says that the actual realized returns on all stocks will be equal to the expected rates of return. Investors can outperform the market if they have access to information that has not yet been publicly revealed. Efficient markets hypothesis Answer: d Diff: M 35 . d. None of the statements above is correct. then the new equilibrium price of the stock will be higher (assuming dividends continue to grow at the constant growth rate). Investors may be able to earn returns above those predicted by the SML if they have access to information that has not been publicly revealed. e. If a stock’s beta increased but its growth rate remained the same. Answer: e Diff: M Which of the following statements is most correct? a. c. b. they may have different realized returns. b. Assume that markets are semistrong-form efficient. Chapter 8 . All stocks should have the same realized return. d. e. b.Medium: Market efficiency and stock returns 31 . Which of the following statements is most correct? a. An implication of the semistrong form of the efficient markets hypothesis is that you cannot consistently benefit from trading on information reported in The Wall Street Journal. None of the statements above is correct. for there to be no strong pressure for prices to depart from their current levels. is most correct? Answer: e Diff: M Which of the following statements a. this means the expected return on stocks and bonds should be the same. however. Bonds and stocks have the same expected return. Market equilibrium 36 . d. e. c. c. Answer: c Diff: M If the stock market is semistrong-form efficient. If the stock market is semistrong-form efficient. Efficient markets hypothesis 32 . d. If the stock market has been performing strongly over the past several months. c. All stocks should have the same expected return. stocks and bonds should have the same expected returns. Efficient markets hypothesis 33 . b. that is. All stocks should have the same expected returns. Answer: c Diff: M Which of the following statements is most correct? a. If the stock market is weak-form efficient this means you cannot use private information to outperform the market. d. stock prices are more likely to decline than increase over the next several months. In equilibrium. Efficient markets hypothesis 34 . Statements b and c are correct. e. this means that high-beta stocks should have the same expected return as low-beta stocks. All of the statements above are correct. Statements a and b are correct. Statements b and c are correct. Statements a and c are correct.Page 8 . Investors can expect to earn returns above those predicted by the SML if they have access to public information. Each common stock has an expected return equal to that of the overall market. but not strong-form efficient. None of the statements above is correct.

that is. When a corporation’s shares are owned by a few individuals who are associated with or are the firm’s management. k = k c.Page 9 . The required rate of return must equal the realized rate of return. A publicly owned corporation is simply a company whose shares are held by the investing public. None of the statements above is correct. Chapter 8 . When stock in a closely held corporation is offered to the public for the first time the transaction is called “going public” and the market for such stock is called the new issue market.  = d. that is. and yet not raise any additional new capital. k = k . The expected rate of return must be equal to the required rate of return. All three of the statements above must hold for equilibrium to exist. It is possible for a firm to go public.a. c. e. e. we say that the firm is “closely held. Going public establishes a true market value for the firm and ensures that a liquid market will always exist for the firm’s shares.  = k. k k = k. The past realized rate of return must be equal to the expected rate of return. which may include other corporations and institutions as well as individuals.” b. d. k b. Answer: c Diff: M Which of the following statements is false? a. is. that  . that is. Ownership and going public 37 .

A stock’s dividend yield can never exceed the expected growth rate. Diff: E A share of preferred stock pays a quarterly dividend of $2.50 each quarter. b. If the price of this preferred stock is currently $50. Constant growth model 39 . Which of the following statements is most correct? a. Assume that the required rate of return on a given stock is 13 percent. It has both common stock and non-participating preferred stock outstanding.50. The dividend yield on a stock is equal to the expected return less the expected capital gain. If you are willing to pay $20. $200 Preferred stock yield 42 Diff: E The Jones Company has decided to undertake a large project. d. b. $150 e.Dividend yield and g 38 . $120 c. b. d. 43 Answer: d Johnston Corporation is growing at a constant rate of 6 percent per year. d. e. d. e. Answer: c Diff: E 12% 18% 20% 23% 28% Preferred stock yield . c. What is the market value of the preferred stock? a. All of the statements above are correct. c. what should be the stock’s market value? a. 41 Answer: d Answer: a Diff: E A share of preferred stock pays a dividend of $0.00. stock price is expected to be $54 a share in one year. stock price is expected to be $57 a share in one year.00 for this preferred stock. The stock’s dividend is expected to grow at a constant rate of 8 percent a year. Multiple Choice: Problems Easy: Preferred stock value 40 . Answer: b Diff: M Which of the following statements is most correct? a. its expected dividend yield is 5 percent as well. what is the nominal annual rate of return? a. there is a need for additional funds. If the required return on this stock is currently 20 percent. The financial manager plans to issue preferred stock with a perpetual annual dividend of $5 per share and a par value of $30. Statements b and c are correct. $150 $100 $ 50 $ 25 $ 10 Preferred stock value . and the stock has a stated dividend of 10 percent of par. If the stock’s dividend is growing at a constant rate of 5 percent. c. c.Page 10 . $175 d. current dividend per share is $4. The cost of preferred stock (kp) is 8 percent. Consequently. e. e. Answer: d Diff: M The expected rate of return on the common stock of Northwest Corporation is 14 percent. $125 b. what is your nominal (not effective) annual rate of return? Chapter 8 . The stock currently sells for $50 a share. stock’s dividend yield is 7 percent. b. . The The The The The stock’s dividend yield is 8 percent. The par value of the preferred stock is $120.

14% Stock price 44 . 10% b.19 $ 75. The stock’s dividend is projected to increase at a constant rate of 7 percent per year.60 $34. What is the expected price of the stock 4 years from today? a. $36. 12% e. Your expectations are that you will not receive a dividend at the end of Year 1. The required rate of return on the stock. Diff: E Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years.a. c. is 10 percent. 6% d.25 at the end of Year 2.63 Chapter 8 . b. If your expected rate of return is 16 percent. but you will receive a dividend of $9. $164. d. e.39 $32.53 $118. how much should you be willing to pay for this stock today? a.35 $131. c.77 $30. d.Page 11 .29 $107.74 Future stock price--constant growth . k s. 45 Answer: d Answer: d Diff: E Womack Toy Company’s stock is currently trading at $25 per share.15 $28. b. e. In addition. you expect to sell the stock for $150 at the end of Year 2. 8% c.

Its dividend is expected to grow at a constant rate of 7 percent a year. 47 Answer: b Answer: a Diff: E A share of common stock has just paid a dividend of $2.Page 12 . Given this information.46 $ 9. and its required rate of return is 9 percent. and the stock’s required rate of return is 12 percent. The stock sells for $20 per share and its required rate of return is 11 percent. The stock’s year-end dividend is expected to be $2 a share (D 1 = $2. The stock is expected to pay a year-end dividend.09 $171.18 $13. eight years from now? a. Answer: e A stock is expected to pay a dividend of $0.00). d. and if investors require a 19 percent rate of return. c.61 $51.00. What is the growth rate. e. What is the expected price of the stock four years from today? a. D 1 = 0. D 1. Answer: a Waters Corporation has a stock price of $20 a share. What is the expected price of the stock seven years from now? a. 51 Diff: E $ 5. e.50 at the end of the year (i. If the expected long-run growth rate for this stock is 15 percent. The stock’s required rate of return is 15 percent and the stock’s dividend is expected to grow at the same constant rate forever.00 per-share dividend at the end of the year (D 1 = $1. what is the price of the stock? Chapter 8 .00). c..54 Future stock price--constant growth .50). Answer: a Trudeau Technologies’ common stock currently trades at $40 per share. The stock’s dividend is expected to grow at a constant rate g. d.Future stock price--constant growth 46 . c.11 Constant growth stock .00 $12. 48 Diff: E Allegheny Publishing’s stock is expected to pay a year-end dividend. What is the expected price of the stock five years from today (after the dividend D 5 has been paid)? In ˆ5 ? other words. The dividend is expected to grow at a constant rate.00. The dividend is expected to grow at a constant rate of 8 percent per year. $200. g. 49 Diff: E $28 $53 $27 $23 $39 Future stock price--constant growth .36 $10. what is the expected price of the stock. 50 Diff: E $48. d.38 $247. for this stock? a. Answer: b Diff: E 5% 6% 7% 8% 9% Constant growth stock . N McKenna Motors is expected to pay a $1. D1. e. b.e. b. b.05 $61.40 $61.60 $136. b. of $4. c. and the stock has a required return of 12 percent. what is P a. e. g. d. e.00 $185. b.86 Future stock price--constant growth . d. forever.67 $50. c. of $2 per share.

00 a share (D 1 = $3. $57.a.Page 13 .40 per share (D 0 = $2. If the company’s beta is 1.92 Constant growth stock 52 .’s most recent dividend was $2.14 $40.00 $44. 7. b. Diff: E Thames Inc.00).3. e. what is the price of the stock today? a.00% b.57 Constant growth stock . The dividend is expected to grow at a rate of 6 percent per year. 10. If the dividend is expected to grow at a constant rate.14 $57.33% e.40).25 $71. The stock currently sells for $30 a share. The risk-free rate is 5 percent and the return on the market is 9 percent. 5.00% d. c.86 $64. 53 Answer: e Answer: c Diff: E Albright Motors is expected to pay a year-end dividend of $3. $72.50 $62. d. 13. 6. b. d.00% Chapter 8 .06 $60. The required (and expected) rate of return on the stock is 16 percent. g. what is g? a.05% c. c.00 $68. e.

c. 55 Answer: d Answer: b Diff: E N A stock is expected to pay a $0. Answer: d A stock is expected to have a dividend per share of $0. c.02 $15.83 Constant growth stock . c. What is the expected price of the stock 10 years from today? a. The dividend is expected to grow at a constant rate of 7 percent per year.83 $21. what is P a.15 Constant growth stock . b. d.05 $ 0. Diff: E $12. and the stock’s required rate of return is 11 percent.64 $60.Page 14 . d. What is the expected price of the stock five years from today? a. The stock’s dividend is expected to grow at a constant rate of 7 percent per year.87 $0. e.52 $ 9.02 $0. on the stock? a.65 Chapter 8 . e.Constant growth stock 54 . $0. The dividend is expected to grow at a constant rate of 5 percent. and the stock has a required return of 12 percent. c.11 $15. 57 Diff: E $67.00 per share. $18. d.45). d.60 at the end of the year (D 1 = 0. D1. e.73 $16.45 dividend at the end of the year (D 1 = 0.25 $ 9. b. What is the expected year-end dividend. 56 Diff: E A stock with a required rate of return of 10 percent sells for $30 per share.60).00 $63. Answer: b Gettysburg Grocers’ stock is expected to pay a year-end dividend. of $2. b. The dividend is expected to grow at a constant rate of 4 percent a year. e.81 $51.95 $1. and the stock has a required return of 9 percent.90 $1. What is the expected price of the ˆ5 ?) stock five years from today? (That is. D 1.05 Constant growth stock . b.02 $12.15 $ 6.

c.33 $42.50 FCF model for valuing stock 62 Diff: E 1. e. $ 2. e. Klein’s required rate of return on equity (k s) is 12 percent. Answer: b Diff: E NOPREM Inc.49 $67.00 b. d.37 $21.47 $69. $ 1. The analyst estimates that Harkleroad’s free cash flow during the next year will be $25 million. The firm plans to issue an additional 1. then 6 percent for the following year. $90. d.98 $64.16 $58. e.Page 15 . What is the current stock price? a. The growth rate is expected to be 4 percent for 1 year. c. e. b. $10. Answer: b Cartwright Brothers’ stock is currently selling for $40 a share. the price is $100 per share.00 c.24 $18. The stock’s dividend is expected to grow at a constant rate of 7 percent a year forever.000 shares of stock outstanding.21 Beta coefficient . $ 0 e. Answer: d Your company paid a dividend of $2. is a firm whose shareholders don’t possess the preemptive right.08 New issues and dilution . 59 Answer: d Answer: d Diff: E N An analyst is trying to estimate the intrinsic value of the stock of Harkleroad Technologies.00 last year. The firm currently has 1. .25 $50. Since the shares will be offered to the public at large. What is the estimated per-share price of Harkleroad Technologies’ common stock? a. Harkleroad has $200 million of long-term debt and preferred stock. 5 percent the next year. What is the current price of Klein’s common stock? a. The analyst also estimates that the company’s free cash flow will increase at a constant rate of 7 percent a year and that the company’s WACC is 10 percent.00 2.00 0. 61 Diff: E $53. What is the stock’s beta? a.00 d.06 1.67 $ 5. b.11 $27. Klein’s growth rate is expected to be a constant 5 percent for 2 years.00 per share.Nonconstant growth stock 58 . The risk-free rate (kRF) is 6 percent and the market risk premium (kM – kRF) is also 6 percent.45 $60.00 $33. $21. The required rate of return on equity (k s) is 10 percent.75 Nonconstant growth stock . and 30 million outstanding shares of common stock. b. $ 5. and then the growth rate is expected to be a constant 7 percent thereafter. after which dividends are expected to grow at a rate of 10 percent forever. d. b. The stock is expected to pay a $2 dividend at the end of the year. d.83 1. c.00. what is the amount per share that old shareholders will lose if they are excluded from purchasing new shares? a.78 Chapter 8 .000 shares at $90. c. 60 Diff: E The last dividend paid by Klein Company was $1.

and that the company’s weighted average cost of capital is 11 percent.59 $18. and all other factors remain constant. d. The analyst estimates that the firm’s free cash flow will grow at a constant rate of 7 percent a year. The company currently has debt and preferred stock totaling $500 million.48 Chapter 8 . e. The firm has been experiencing a 6 percent annual growth rate. c. Answer: d Diff: E N An analyst estimating the intrinsic value of the Rein Corporation stock estimates that its free cash flow at the end of the year (t = 1) will be $300 million.69 $53. what will be the new stock price? (Use 4 decimal places in your calculations. e. d.) a. There are 150 million outstanding shares of common stock.00 $33.00 Medium: Changing beta and the equilibrium stock price 64 . b.67 $25.39 $22. Last year’s earnings per share. The risk-free rate is 8 percent. Answer: d Diff: M Ceejay Corporation’s stock is currently selling at an equilibrium price of $30 per share.Page 16 . $16. What is the intrinsic value (per share) of the company’s stock? a.00 and the dividend payout ratio is 40 percent. c.67 $50. were $4. b. and the market risk premium is 5 percent.33 $46. If market risk (beta) increases by 50 percent.FCF model for valuing stock 63 .25 $21. $16. E0.

The last dividend paid was $0. $66. Beta is 1. the return on the market is currently 12.05 b. e.  The expected growth rate increases to 6 percent. c.28 -$16.Page 17 .90 e.97 +$ 2. $55.75 percent.21 $19. The stock has a beta of 1. $ 56. the risk-free rate is 5 percent. kM – kRF.10 $24. The market risk premium.6.15 Nonconstant growth stock 68 Diff: M A stock that currently trades for $40 per share is expected to pay a year-end dividend of $2 per share. assuming the stock was in equilibrium before the changes occurred? a.01 $ 83. The required return on the market is 8 percent.  Beta rises to 1.11 -$ 4. The stock currently has a price of $40 a share. b.00 Constant growth stock . The expected growth rate for the firm is 4 percent.66 Nonconstant growth stock Answer: d Diff: M Chapter 8 . What should be the current common stock price? a.15 $551. MHI’s beta is 1.87 d. The stock has a beta of 1.28 $22. $59. What is the stock’s expected price seven years from today? a.17 $17. +$12. c.00 a share at the end of the year. c.05 $ 60. b. and the stock’s dividend is expected to grow at a constant rate of g percent a year. and the risk-free rate is 4 percent. 67 Answer: d Answer: a Diff: M Motor Homes Inc. The company’s last dividend was $1.2. e. e.78 Constant growth stock 66 . after which time there will be no growth (g = 0) in earnings and dividends. . Now assume the following changes occur:  The inflation premium drops by 1 percent. $51. Answer: c Diff: M N Yohe Technology’s stock is expected to pay a dividend of $2. is 7 percent and the risk-free rate is 5 percent. b. d.Equilibrium stock price 65 . d. What will be the change in price per share.  An increased degree of risk aversion causes the required return on the market to rise to 10 percent after adjusting for the changed inflation premium.5.87 +$ 6. d.23 c.3.80 per share. and the market risk premium is 5 percent. The dividend is expected to grow at a constant rate over time. $64. (MHI) is presently in a stage of abnormally high growth because of a surge in the demand for motor homes. What is the expected price of Yohe’s stock 5 years from today? a.26 $ 58.50. $15.2. Answer: b Diff: M You are given the following data:      The risk-free rate is 5 percent. The company expects earnings and dividends to grow at a rate of 20 percent for the next 4 years.

Page 18 . the company anticipates that it will establish a dividend of $1. e. Five years from now. c. What should be the company’s current stock price? a.e. Once the dividend is established. The required rate of return on the company’s stock is 12 percent.65 $16. The risk-free rate is 5 percent. b. b.33 $16.91 $18. the company’s beta is 1.2. Answer: d Diff: M Mack Industries just paid a dividend of $1.67 $19.00 per share (i. What is the current stock price? a. $ 7.98 $11.62 $ 9.00). the market expects that the dividend will grow at a constant rate of 5 percent per year forever.36 $ 8.53 Nonconstant growth stock 70 . and the market risk premium is 5 percent.. After two years the dividend is expected to grow at a constant rate of 5 percent.00). D5 = $1. c.89 $10. d. $12. e.20) and 15 percent next year.00 per share (D 0 = $1.69 . The required rate of return on the company’s stock is expected to remain constant. d. A stock is not expected to pay a dividend over the next four years. Analysts expect the company’s dividend to grow 20 percent this year (D1 = $1.67 Chapter 8 .

his company’s beta is approximately 1. The most recent dividend (D 0) was $0. the riskfree rate of interest is 6 percent. The stock’s beta is 1.14 $75.64 $37.2.17 $67. d. and the market rate of return is 11 percent. Diff: M $ 69.Page 19 .00 (D 4 = $5.921875). The risk-free rate is 8 percent and the market risk premium is 6 percent.Nonconstant growth stock 71 . Lee recently took his company public through an initial public offering.89 $30. Growth for his company is expected to be 40 percent for the first three years and then he expects it to slow down to a constant 15 percent.38 $ 86. after which time the dividend is expected to grow at a constant rate of 5 percent a year (D3 = $4. and it is anticipated that the dividend will grow at a constant rate of 8 percent a year thereafter.75. d.69 $59. and the stock’s beta is 1. e. Assuming the stock is fairly priced. $77. e. c.38 $100. the market risk premium is 6 percent. D2 = $0. c.05 Chapter 8 . D1 = $0. The risk-free rate is 4 percent. d. Based on the most recent returns.00).00 Nonconstant growth stock .00 per share dividend on its common stock at the end of the year (D1 = $3.96 $ 79.6875 and D4 = $4. e. what is its current stock price? a. He is expanding the business quickly to take advantage of an otherwise unexploited market.5. 72 Answer: a Answer: e Diff: M Stewart Industries expects to pay a $3.31 $ 72. b. Answer: a A stock is expected to pay no dividends for the first three years. and D3 = $0. The dividend is expected to grow 25 percent a year until t = 3. The dividend for Year 4 is expected to be $5.88 $93.51 $73. What is the current price of Lee’s stock? a. What is the company’s current stock price? a. 73 Diff: M R. that is. c.20 Nonconstant growth stock . E. b. b.5.00).29 $53. $29.

00 for the subsequent 2 years (D4 and D5). What should be the price of the stock today? a. 75 Answer: b Answer: e Diff: M Rogers Robotics currently (2003) does not pay a dividend. e. The stock’s dividend is expected to grow at a rate of 10 percent a year until three years from now (t = 3).94 Nonconstant growth stock .00 dividend two years from today (2005). c. After this time. b.41 $37.25 per share at the end of the year (D1 = $2. After that time the dividends will grow at a constant rate of 5 percent per year. d. the risk-free rate is 6 percent. The stock’s required rate of return is 11 percent.4. Answer: b Hadlock Healthcare expects to pay a $3. the company is expected to pay a $1. e. what is its current stock price? a.00 dividend at the end of the year (D 1 = $3. $52. e. Diff: M $49 $54 $64 $52 $89 Nonconstant growth stock .25). and the stock’s beta is 1.00 $32. d.20 $30. d. 76 Diff: M McPherson Enterprises is planning to pay a dividend of $2. The dividend is then expected to grow at a rate of 20 percent a year for the following three years.Page 20 . $22. c.Nonconstant growth stock 74 . c. it is expected to grow forever at a constant rate of 7 percent.00). Currently.50 $50. the stock’s dividend is expected to grow at a constant rate of 5 percent a year.91 $21.50 $40.16 Chapter 8 .80 $20. After the dividend is paid in 2008. What is the price of the stock today? a. The company is planning to pay the same dividend each of the following 2 years and will then increase the dividend to $3. However. b. If the required return on the company’s common stock is 11 percent per year. b. market risk premium (k M – kRF) is 5 percent.82 $28.

b. and that the stock’s beta is 1. is expected to pay its first dividend of $1.Nonconstant growth stock 77 .00). e.00 per share in five years (D 5 = $1. e.22 $94.97 $95. Answer: e A stock.3125.95 $20. $83.) a. b.27 $87.16 $85. 79 Diff: M Whitesell Technology has just paid a dividend (D0) and is expected to pay a $2.87 $69. c.00 pershare dividend at the end of the year (D 1). The analyst also estimates that the required rate of return on Cheyenne’s stock is 12. Diff: M $23. The stock has a required rate of return of 13 percent (k s = 0. What is the expected price of the stock today? a. After the dividend is established. d. After the third dividend.2 percent.5 percent.40 $84. and D3 = $4. What is the expected price of the stock two years from today? (Calculate the price assuming that D2 has already been paid. the dividend is expected to grow by 8 percent per year forever. $81. What is the price of the stock today? a.0000. c.25)4 = $4. D2 = $3.13).56 $18.63 $91. The dividend is expected to grow 25 percent a year for the following four years. b.02 Chapter 8 . it is expected to grow at an annual rate of 25 percent per year for the following three years (D8 = $1.8828).65 Nonconstant growth stock .7500. d. Assume that the risk-free rate is 5. 78 Answer: c Answer: d Diff: M An analyst estimates that Cheyenne Co.87 $30.Page 21 . the market risk premium is 4 percent.00  (1. e. the dividend will grow forever at a constant rate of 7 percent a year. d. c. (D5 = $2. will pay the following dividends: D1 = $3. After this time period.953125) and then grow at a constant rate of 5 percent per year thereafter. which currently does not pay a dividend.56 $67.72 $20.2.96 Nonconstant growth stock .

82 Diff: M Lewisburg Company’s stock is expected to pay a dividend of $1.7280). Diff: M $50.Nonconstant growth stock 80 . The stock’s beta is 1. The dividend is expected to grow 20 percent per year each of the following three years (D4 = $1.28 $30. Assume that the market is in equilibrium.14 $27. What is the price of the stock today? a.38 Chapter 8 . e.25 per share at the end of the year. c.. after which time the dividend is expected to grow at a constant rate of 7 percent per year. c. The dividend is expected to increase by 20 percent per year for each of the following two years. The stock has a required return of 10 percent. d.48 $32.38 $70. d. after which time it is expected to grow at a constant rate of 6 percent a year.61 $45. Answer: d Namath Corporation’s stock is expected to pay a dividend of $1.Page 22 . the market risk premium is 4 percent.11 $76.43 Nonconstant growth stock .00 $59. c. D 1 = $1.64 $45. What should be the price of the stock today? a.76 $84. $49. b. e.00 per share at the end of the year.e. What is the stock’s price today? a. After that.00).45 Nonconstant growth stock . e. 81 Answer: a Answer: b Diff: M N A stock is expected to pay a dividend of $1.2. b.56 $48.00 at the end of the year (i.71 $35. The stock’s required return is 11 percent. and the risk-free rate is 5 percent. b. $26.43 $46. d. The dividend is expected to grow 25 percent each of the following two years. the dividend is expected to increase at a constant rate of 8 percent per year.

Nonconstant growth stock
83

.

$ 75.00
$ 88.55
$ 95.42
$103.25
$110.00

Nonconstant growth stock
.

Diff: M

N

$28.58
$26.06
$32.01
$ 9.62
$27.47

Supernormal growth stock
.

Answer: a

A stock just paid a $1.00 dividend (D 0 = 1.00).
The dividend is expected to grow 25
percent a year for the next four years, after which time the dividend is expected to grow
at a constant rate of 5 percent a year. The stock’s required return is 12 percent. What
is the price of the stock today?
a.
b.
c.
d.
e.

86

Diff: M

$ 84.80
$174.34
$ 76.60
$ 94.13
$ 77.27

Nonconstant growth stock
.

Answer: a

Holmgren Hotels’ stock has a required return of 11 percent. The stock currently does
not pay a dividend but it expects to begin paying a dividend of $1.00 per share
starting five years from today (D5 = $1.00). Once established the dividend is expected
to grow by 25 percent per year for two years, after which time it is expected to grow
at a constant rate of 10 percent per year.
What should be Holmgren’s stock price
today?
a.
b.
c.
d.
e.

85

Diff: M

Garcia Inc. has a current dividend of $3.00 per share (D0 = $3.00). Analysts expect
that the dividend will grow at a rate of 25 percent a year for the next three years,
and thereafter it will grow at a constant rate of 10 percent a year. The company’s
cost of equity capital is estimated to be 15 percent. What is Garcia’s current stock
price?
a.
b.
c.
d.
e.

84

Answer: c

Answer: e

Diff: M

A share of stock has a dividend of D0 = $5. The dividend is expected to grow at a 20
percent annual rate for the next 10 years, then at a 15 percent rate for 10 more
years, and then at a long-run normal growth rate of 10 percent forever. If investors
require a 10 percent return on this stock, what is its current price?
a.
b.
c.
d.
e.

$100.00
$ 82.35
$195.50
$212.62
The data given in the problem are internally inconsistent, that is, the situa-tion
described is impossible in that no equilibrium price can be produced.
Supernormal growth stock
Answer: b Diff: M
87

.

ABC Company has been growing at a 10 percent rate, and it just paid a dividend of D0 =
$3.00. Due to a new product, ABC expects to achieve a dramatic increase in its shortrun 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 be the dividend yield (D1/P0) today?
a. 3.93%
b. 4.60%
c. 10.00%
d. 7.54%
e. 2.33%

Chapter 8 - Page 23

Supernormal growth stock
88

.

Undervalued by $3.03.
Overvalued by $3.03.
Correctly valued.
Overvalued by $2.25.
Undervalued by $2.25.

Supernormal growth stock
.

Diff: M

DAA’s stock is selling for $15 per share. The firm’s income, assets, and stock price
have been growing at an annual 15 percent rate and are expected to continue to grow at
this rate for 3 more years.
No dividends have been declared as yet, but the firm
intends to declare a dividend of D3 = $2.00 at the end of the last year of its
supernormal growth. After that, dividends are expected to grow at the firm’s normal
growth rate of 6 percent.
The firm’s required rate of return is 18 percent.
The
stock is
a.
b.
c.
d.
e.

89

Answer: b

Answer: b

Diff: M

Faulkner Corporation expects to pay an end-of-year dividend, D 1, of $1.50 per share.
For the next two years the dividend is expected to grow by 25 percent per year, after
which time the dividend is expected to grow at a constant rate of 7 percent per year.
The stock has a required rate of return of 12 percent. Assuming that the stock is
fairly valued, what is the price of the stock today?
a.
b.
c.
d.
e.

$45.03
$40.20
$37.97
$36.38
$45.03

Chapter 8 - Page 24

Supernormal growth stock
90

.

$ 42.60
$ 82.84
$ 91.88
$101.15
$110.37

Declining growth stock
.

Diff: M

$27.17
$ 6.23
$28.50
$10.18
$20.63

Stock growth rate
.

Answer: d

The Textbook Production Company has been hit hard due to increased competition. The
company’s analysts predict that earnings (and dividends) will decline at a rate of 5
percent annually forever. Assume that k s = 11 percent and D0 = $2.00. What will be
the price of the company’s stock three years from now?
a.
b.
c.
d.
e.

92

Diff: M

Assume that the average firm in your company’s industry is expected to grow at a
constant
rate
of
5
percent,
and
its
dividend
yield
is
4 percent. Your company is about as risky as the average firm in the industry, but it
has just developed a line of innovative new products, which leads you to expect that
its earnings and dividends will grow at a rate of 40 percent (D 1 = D0(1.40)) this year
and 25 percent the following year after which growth should match the 5 percent
industry average rate. The last dividend paid (D0) was $2. What is the stock’s value
per share?
a.
b.
c.
d.
e.

91

Answer: b

Answer: d

Diff: M

Berg Inc. has just paid a dividend of $2.00. Its stock is now selling for $48 per
share. The firm is half as risky as the market. The expected return on the market is
14 percent, and the yield on U.S. Treasury bonds is 11 percent. If the market is in
equilibrium, what growth rate is expected?
a. 13%
b. 10%
c. 4%
d. 8%
e. -2%

Stock growth rate
93

.

.

Diff: M

Grant Corporation’s stock is selling for $40 in the market.
The company’s beta is
0.8, the market risk premium is 6 percent, and the risk-free rate is 9 percent. The
previous dividend was $2 (D0 = $2) and dividends are expected to grow at a constant
rate. What is the stock’s growth rate?

a. 5.52%
b. 5.00%
c. 13.80%
d. 8.80%
e. 8.38%
Capital gains yield
94

Answer: e

Answer: c

Diff: M

Carlson Products, a constant growth company, has a current market (and equilibrium)
stock price of $20.00. Carlson’s next dividend, D1, is forecasted to be $2.00, and
Carlson
is
growing
at
an
annual
rate
of
6 percent. Carlson has a beta coefficient of 1.2, and the required rate of return on
the market is 15 percent. As Carlson’s financial manager, you have access to insider
information concerning a switch in product lines that would not change the growth
rate, but would cut Carlson’s beta coefficient in half. If you buy the stock at the
current market price, what is your expected percentage capital gain?
a.
b.
c.
d.
e.

23%
33%
43%
53%
There would be a capital loss.
Chapter 8 - Page 25

c. e.0% 4.6.31%. Diff: M Answer: e Diff: M Conner Corporation has a stock price of $32. c. e. D1 = $2.00.Page 26 gains gains gains gains gains yield yield yield yield yield = 7. Dividend yield = 4. The long-run growth rate for the company is a constant 7 percent. 3.8% 0% 8. P0 = $25.00% = 7. Answer: d Given the following information. Capital Capital Capital Capital Capital Chapter 8 .00. Dividend yield = 11.42). b.42 (D0 = $3.2% 2. kRF = 8%.57%. b. d.35 per share.57% = 10. calculate the expected capital gains yield for Chicago Bears Inc. k M = 15%. d.31% . What is the company’s capital gains yield and dividend yield? a.00%.00% = 7. Dividend yield = 7.5% Capital gains yield and dividend yield 96 .Capital gains yield 95 . Dividend yield = 10. The last dividend was $3.31% = 11. Dividend yield = 7.: beta = 0. Assume the stock is in equilibrium and exhibits constant growth. a.00%.00%.

Analysts expect that one year from now the company will have an EPS of $2. kM = 9%. c.5 4. a. e. $27.27 $48.00 36. kM. is percent.00.              Sales = 10. What price earnings ratio must the stock have one year from now so that investors realize their expected return? a. Calculate the current price per share for Cali Corporation. the expected return on the market. The future retention rate is expected to remain at percent of earnings. Variable cost per unit = $5. 70 percent its earnings in the business. Fixed costs = $10. Swanson Company has retained. Beta = 1. b. b.000.72 $59. c.0 4. so the stock’s current price is $80 per share.50. d. kd on outstanding bonds = 8%. Shares of common stock outstanding = 10. Growth rate = 8%. and long-run earnings growth is expected to be 10 percent. was $1. 44. b. is 8 percent.00 per share. Sales price per unit = $10. d.000 units. $22.50. c.000.0 6.0 5.25 4.000 shares. kRF.Expected return and P/E ratio 97 . the risk-free rate. 98 Answer: b Answer: d Diff: M You have been given the following projections for Cali Corporation for the coming year.22 $46. $33. D0.0.00.00. d.55 $53.76 Chapter 8 . Swanson’s beta is 2.00 36. Tax rate = 40%. Bonds outstanding = $15. on the average. $25.50.4. Diff: M of 70 If 12 is 5. 99 Diff: M Lamonica Motors just reported earnings per share of $2. The stock has a required return of 10 percent. $35.17 40.40. what the most likely market price and P/E ratio (P0/E1) for Swanson’s stock today? a.Page 27 . kRF = 5%. Answer: a During the past few years. The stock has a price earnings ratio of 40. $45. Dividend payout ratio = 60%.5 Stock price .67 Stock price and P/E ratio . e. and the most recent dividend. e. and it will pay its first dividend of $1.00.

b. assuming the “old” 5 percent growth rate. From the following data you find that the beta value associated with your firm has changed from an old beta of to a new beta of . While there have been several changes in financial markets during this period. a. This change had nothing to do with the move into plastics. and a 10. b. e.. but the inflation premium has increased from 4 percent to 6 percent.72 $42. 2. Assume that the market is in equilibrium.00. 2. and D0 = $2.50. $25.00 $37.67.  The expected growth rate has been re-evaluated by security analysts. what market price gives the investor a return consistent with the stock’s risk? a. Answer: d Diff: M The probability distribution for kM for the coming year is as follows: Probability 0.38 $56. 1. e.5 percent rate is considered to be more realistic than the previous 5 percent rate.0. d.  The next dividend.05 0. the price of the firm’s common stock subsequently declined from $40 per share to $30 per share. c. Much to your surprise.17 2. 1. and now the market risk premium is 3 percent instead of 2 percent. it would have occurred anyway. d. you have recently participated in an executive committee decision to enter into the plastics business. 1. was expected to be $2 per share. Answer: c Diff: M As financial manager of Material Supplies Inc.05% and Stock X has a beta of 2. you are anxious to determine how the market perceives the relevant risk of your firm.  The real risk-free rate is 2 percent.50 $21.50 3. c.67 Risk and stock value 101 .Page 28 . an expected constant growth rate of 7 percent.30 0.94 Chapter 8 .50.30 0.05 kM 7% 8 9 10 12 If kRF = 6.30 0.Beta coefficient 100 .00. D1.00 1. 1.00 3.  The risk aversion attitude of the market has shifted somewhat.

d.65 b.25 e.96 Future stock price--constant growth .64 d.54 Future stock price--constant growth .40 $41. The stock’s dividend is expected to grow at a constant rate of 5 percent a year. c. and the expected market return is kM = 0.00 a share (D1 = $2. What is the expected stock price ˆ5 ? five years from now. c. is 5 percent.00). e. $21. e. Thereafter.63 $72. and the company’s beta equals 1. $10. the risk-free rate is kRF = 0.Page 29 . e. e.00 a share (D1 = $3. The required rate of return on the company’s stock is expected to remain constant at 13 percent.08 c.06. However.4. and its dividend yield is 5 percent.99 $39.21 Chapter 8 . (kM – kRF). The dividend is expected to grow at a constant rate of 7 percent a year. The risk-free rate is 6 percent. what is P a. 103 Answer: b Answer: b Diff: M McNally Motors has yet to pay a dividend on its common stock. b. Answer: b Graham Enterprises anticipates that its dividend at the end of the year will be $2. b. $60. The stock has a beta of 0. $22. Answer: e A stock currently sells for $28 a share. The stock’s beta is 1. is 6 percent and the market risk premium.00).49 $70. The stock currently sells for $20.00 $76.00).32 $11.83 $47. d. What is the stock’s expected price five years from now? a. The dividend is expected to grow at some constant rate over time. kRF.00). the stock’s dividend is expected to grow at a constant rate of 5 percent a year.00 a share. the market risk premium is 5 percent. what ˆ4 ? is P a. Its dividend is growing at a constant rate. b.12).8. d. c.10 $63.43 $56. $35.00 dividend starting two years from now (D 2 = $1. 105 Diff: M $24. b. The required rate of return on the company’s stock is 12 percent (k s = 0.58 $96. What is the stock’s expected price four years from now. c.87 $13.49 $72.00 per share dividend on its common stock at the end of the year (D1 = $2. The risk-free rate.Future stock price--constant growth 102 . d. that is.58 $11. the company expects to pay a $1.62 $29. . Answer: b Diff: M Kirkland Motors expects to pay a $2.63 $12.78 Future stock price--constant growth 106 Diff: M $52.2.99 Future stock price--constant growth . What is the expected stock price five years from now? a. that is.11 $68. $36. 104 Diff: M Newburn Entertainment’s stock is expected to pay a year-end dividend of $3.12. What is the expected stock price seven years from now? a. $25.

62 Chapter 8 . The stock’s beta is 1. e.97 $ 65. $105. c.Page 30 . the risk-free rate is 4 percent.00 per share.50). b.59 $104. and it is expected to grow at a constant rate over time. The stock has a required rate of return of 14 percent and a dividend yield. The dividend is expected to grow at a constant rate of 6 percent a year. d.86 $133.79 $ 99. e.46 $40. of $2. What is the expected price of the stock five years from today? a. of 5 percent. What is the expected stock price eight years from today? a.54 $56. d. b.50 dividend at the end of the year (D 1 = $2. Diff: M Dawson Energy is expected to pay an end-of-year dividend. 108 Answer: b Answer: e Diff: M N A stock is expected to pay a $2.Future stock price--constant growth 107 .05 Future stock price--constant growth . $77. D 1/P0.02 $61.2.00 $51. and the market risk premium is 5 percent. c. D 1.

75 $ 43. Furthermore.  The company’s WACC is 10 percent. 2003. what is the predicted price of the stock today? a. Free cash flow is expected to grow at a constant annual rate of 6 percent a year. next year’s depreciation expense will be $75 million.  The company currently has 125 million shares of stock outstanding. b. In addition. and its before-tax cost of debt is 7 percent.T)] for the year 2004 is expected to be $400 million. Today is December 31. b. and no changes in net operating working capital are expected. $500 million of preferred stock.  The current market value of the company’s debt is $1. The company has $900 million of debt. $ 11. She estimates that the company’s operating income (EBIT) for the next year will be $800 million.00 $ 55. what should be the company’s stock price today? a. d.83 Chapter 8 . e. Answer: a Diff: M The following information applies to Addison Airlines:  After-tax. she predicts that Keane Investment will require $255 million in gross capital expenditures (gross expenditures represent capital expenditures before deducting depreciation) next year. d.4 billion. Using the free cash flow valuation method. Using the free cash flow valuation method.  No change is expected in the company’s net operating working capital. c.  The company’s cost of equity is 14 percent.Page 31 . operating income [EBIT(1 .  The company’s capital expenditures for the year 2004 are expected to be $160 million.FCF model for valuing stock 109 . The company’s WACC is 9 percent. its cost of equity is 14 percent. $ 40 $ 50 $ 25 $ 85 $100 FCF model for valuing stock 110 . c. e.50 $ 96. Answer: b Diff: M N A stock market analyst is evaluating the common stock of Keane Investment.  The company’s depreciation expense for the year 2004 is expected to be $80 million.33 $108. The firm’s tax rate is 40 percent. and has 200 million outstanding shares of common stock.  The company’s free cash flow is expected to grow at a constant rate of 5 percent per year.

e. Answer: e Diff: M N An analyst has collected the following information about Franklin Electric:          Projected EBIT for the next year $300 million. $ 87. The analyst estimates that the company’s weighted average cost of capital is 10 percent.34 $112. Market value of debt and preferred stock today $500 million. Number of shares outstanding today 20 million. Cost of equity 13%.55 $109.000 The analyst estimates that after three years (t = 3) the company’s free cash flow will grow at a constant rate of 6 percent per year. Projected capital expenditures for the next year $100 million.Page 32 . What is the (per-share) intrinsic value of the company’s common stock? a.00 $ 62. b. c.71 $ 25.FCF model for valuing stock 111 . What is the stock’s intrinsic value today? a. e. WACC 10%. The company’s free cash flow is expected to grow at a constant rate of 6 percent a year. estimated the company’s free cash flows for the following years: Year 1 2 3 N The analyst has Free Cash Flow $3. The analyst uses the corporate value model approach to estimate the stock’s intrinsic value. The company’s debt and preferred stock has a total market value of $25.31 $ 84.000 and there are 1. d.50 $212. d. Projected depreciation expense for the next year $50 million.50 $110.000 4.000 outstanding shares of common stock.50 FCF model for valuing stock 112 . Answer: b Diff: M An analyst is trying to estimate the intrinsic value of Burress Inc.34 $ 98. Projected increase in operating working capital next year $60 million. c.50 Chapter 8 . $ 78. b.000 5. Tax rate 40%.

and its current required rate of return is 12.00 per share. The company has a constant growth rate of 5 percent and a beta equal to 1.14 -$15. and the stock is in equilibrium. c. Answer: c Diff: T The Hart Mountain Company has recently discovered a new type of kitty litter that is extremely absorbent.78 Chapter 8 . beginning with the fourth year the firm’s competition will have access to the material. -$1.) a. Answer: c Diff: M Nahanni Treasures Corporation is planning a new common stock issue of five million shares to fund a new project. 6.96 $71.06 -$0. If market conditions remain unchanged.85 -$0. e. the decrease in growth in the fourth year will be accompanied by an increase in the dividend payout to 50 percent.Page 33 . The firm just paid a $1. Last year’s earnings were E0 = $2. the firm’s stock price dropped. by how much will the stock price change? (Hint: Use four decimal places in your calculations.6 percent. Last year’s earnings per share. It is expected that the firm will experience (beginning now) an unusually high growth rate (20 percent) during the period (3 years) it has exclusive rights to the property where the raw material used to make this kitty litter is found. b. 5. Nahanni’s long-term growth rate is 6 percent.88% e. and from that time on the firm will achieve a normal growth rate of 8 percent annually. c.5 percent. Diff: T Hard Hat Construction’s stock is currently selling at an equilibrium price of $30 per share. 8. d.85% b. and the market risk premium is 5 percent. The increase in shares will bring to 25 million the number of shares outstanding. b.06 in the market. How-ever. What should be the current price of the common stock? a.00 -$15. The risk-free rate is 8 percent. 18.33 +$ 7. During the rapid growth period. 13.00 per share (D0 = $2). d. If market risk (beta) increases by 50 percent. what is the change in the equilibrium stock price? a. When the new equity issue was announced. the firm’s cost of capital will increase to 13.77 -$1. 115 Answer: a Answer: c Diff: T Philadelphia Corporation’s stock recently paid a dividend of $2.5 percent with the new project. c. e. the firm’s dividend payout ratio will be relatively low (20 percent) in order to conserve funds for reinvestment. b.5. and the risk-free rate is 7 percent. However. Nahanni estimates that the company’s growth rate will increase to 6.77% d.63 Constant growth stock . what new constant growth rate will cause Philadelphia’s common stock price to remain unchanged? a.00 dividend and the stock sells for $16. $66.53% c.22 +$22. and the firm’s required return is 10 percent.66 -$0. E0.75. and the dividend payout ratio is 40 percent.54 $61. d.50 $87. but since the project is riskier than average. were $4. The required rate of return on the market is 15 percent. The firm has been experiencing a 6 percent annual growth rate.00.08 Tough: Risk and stock price 114 . and all other factors remain constant. Using the DCF growth model.New equity and equilibrium price 113 . Philadelphia is considering a change in policy that will increase its beta coefficient to 1.52% Supernormal growth stock 116 . -$ 7.

and it is expecting both earnings and dividends to grow by 0 percent in Year 2. The required return on Modular is 15 percent. Club has a required rate of return of 12 percent. e. The year-end dividend.87% 6. and the company expects to experience no growth for the next 2 years. What should be the price per share of Club stock at the end ˆ2 ? of the second year. just paid dividend D 0. P0 = $49.50.87.00% 8.953125. b. $19. In fact. Answer: c A financial analyst has been following Fast Start Inc. 119 Diff: T Club Auto Parts’ last dividend. D0.00 per share. Diff: T 5. $1. so you cannot afford the purchase price. She estimates that the current risk-free rate is 6. The stock currently trades at $50 per share. b. What is the stock’s expected constant growth rate after t = 4? In other words. the market risk premium is 5 percent. and.. P a.51 $17. After three years the dividend is expected to grow at a constant rate of 7 percent a year.25)3 = $1.50 Nonconstant growth stock 117 .25 percent. That is. D1? (Hint: Draw a time line and then set up and solve an equation with one unknown. the dividend is expected to grow by 25 percent per year for the next three years. b.Page 34 . you have limited resources now. the best that you can do now is to invest your money in a bank account earning a simple interest rate of 6 percent.55 Nonconstant growth stock . After this payment. and at a rate of 10 percent in Year 4 and thereafter. e. c.85 $2. and 15 percent the following year.98% 8. d.21 $19. D4 = $1. Answer: e Modular Systems Inc.25 $19. However. the dividend is expected to grow at a constant rate of X percent per year forever. However. 120 Diff: T It cannot be estimated without more data.47% 6.75. D1. Answer: b Mulroney Motors’ stock has a required return of 10 percent. After t = 4. The company has a 40 percent payout ratio.27% Preferred stock value . is expected to be $1. What is the expected value of the next dividend.85 Nonconstant growth stock . but where Chapter 8 . The analyst believes that the stock is fairly priced. c.35 $1. $93. D1. d. The analyst estimates that the company’s dividend will grow at a rate of 25 percent this year. and it sells at its equilibrium price. e.98 $25. was $0. b.48 $27. c. what is X? a. a new high-growth company. beginning with the fifth year.) a. it should attain a 10 percent growth rate that it will sustain thereafter. and that Fast Start’s beta is 1.e.33 $18. by 5 percent in Year 3. Club will grow at an annual rate of 5 percent in the third and fourth years. 20 percent next year. c.50.89 Stock growth rate .53 $19.08 $31. 118 Answer: b Answer: d Diff: T Assume that you would like to purchase 100 shares of preferred stock that pays an annual dividend of $6 per share. The company is expected to maintain its current payout ratio.35 $2. d. e. The current earnings per share (EPS0) are $2. 121 Diff: T $16.00(1. What is the current stock price? a. d.

what is the market value of the firm’s common equity (1 million shares outstanding)? a. d. e.138. b.00 b.75 per-share dividend at the end of the year.45 $50. the preferred stock is (Assume that this rate able to purchase this bank account today. at Answer: c Diff: T 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. Stock price--nonconstant growth 123 .704.32 million million million million million Multiple Part: (The following information applies to the next two problems.17 $10. $4.43 $53. c. the risk-free rate is 8 percent. The firm’s beta is 1.25 Firm value 122 . The firm maintains a 30 percent payout ratio. the dividend is expected to grow at a constant rate of 6 percent a year. Diff: M What is the expected price of the stock today? a. The dividend is expected to grow 25 percent the next year and 35 percent the following year.52 d. $47. it has a required annual rate of return of 12 percent. Because riskier. If the market is in equilibrium.4 million. how much must you deposit in your t = 0? a. $3. will remain constant over the next 5 years.23 c.50 $35.96 $ 9. growth is expected to slow to a constant 4 percent rate.291.10 Chapter 8 . b.56 $ 7. d.) Bridges & Associates’ stock is expected to pay a $0. $ 6. 124 Answer: b What is the expected price of the stock 10 years from today? a.58 $49. At that time. $4. After t = 3.50 Future stock price--constant growth . d.985.77 $34.interest is compounded daily (assume a 365-day year).75 $27.25. e. and this year’s retained earnings net of dividends were $1.) For you to be stock at the end of 5 years.41 $12. $3. N Answer: c Diff: M N $18. b. The company’s cost of common equity is 10 percent and it is expected to remain constant.46 $55. and the market risk premium is 4 percent.Page 35 . e. c. c.61 $30.831. $2.18 e.

$22.) An analyst is estimating the intrinsic value of the stock of estimates that the stock will pay a dividend of $1.84 $47. The dividend is expected to remain at this is. Xavier Company.00 e. e. After this time. c. D ˆ2 = D ˆ3 = D ˆ4 = $1. assume that the company’s free cash flow will grow at a constant rate of 7 percent a year and the company’s WACC equals 11 percent. $25.75 a share ˆ1 = $1. $26. b. the (that is. as those forecasted today.75 $27. e.75).91 d. The stock has a Answer: b Diff: M N ˆ0 ?) (That is.18 Chapter 8 .Page 36 . The market value of the company’s debt and preferred stock is $700 million.(The following information applies to the next two problems.87 (The following information applies to the next two problems.46 c. $20. Free cash flow 125 .50 Future stock price--nonconstant growth 128 .12 $59. $20.600 600 400 t = 3 $4. d. c.855). b. e. What is the expected intrinsic value of the stock one year from now. what is the intrinsic value of the company’s stock today? a.000 500 300 t = 2 $3. What is the stock’s intrinsic value today? a.93 b.15 $52. d. D required rate of return of 13 percent. Nonconstant growth stock 127 .) An analyst has put together the following spreadsheet to estimate the intrinsic value of the stock of Rangan Company (in millions of dollars): Sales NOPAT Net investment in operating capital* t = 1 $3. c. b. ˆ1 ?) what is P a. Answer: b $100 $200 $300 $400 $500 Diff: M N million million million million million FCF model for valuing stock .75 $24.75). The analyst at the end of the year (that level until 4 years from now dividend is expected to grow = $1. D ˆ5 forever at a constant rate of 6 percent a year (that is. 126 Diff: E Answer: b Using the free cash flow model. The company has 100 million outstanding shares of common stock.87 $58.50 $23.93 $22.500 750 500 *Net investment in operating capital = Capital expenditures + Changes in net operating capital – Depreciation. N What is the company’s free cash flow the first year (t = 1)? a. $46. just after the dividend has been paid at t = 1? (That is. what is P Answer: b Diff: M N Assume that the forecasted dividends and the required return are the same one year from now. $21. d. After Year 3 (t = 3).

Page 37 .CHAPTER 8 ANSWERS AND SOLUTIONS Chapter 8 .

We don’t have any of that information. dividends. 6. statement a is true. then the firms’ stock prices would differ. the other statements are false. Required return Answer: a Diff: E The total return is made up of a dividend yield and capital gains yield. Therefore. and the number of shares outstanding. B’s dividend yield must also be 3 percent. then its dividend yield is 12% . For Stock B. so its dividend yield must be lower because the firms have the same required rate of return. Constant growth model The correct answer is statement c. 4. 8. For Stock A. Constant growth model Answer: a Diff: E Statement a is true. g is different for the two stocks. Statement a would be true only if the dividend yield were zero. If a stock’s required return is 12 percent and its capital gains yield is 5 percent. the required return is 12 percent and its capital gains yield (g) is 9 percent. Statement b is false: ks = D1/P0 + g. Statement c is false. If the required rate of return differs for the two firms due to risk differences. 5 . Statement c is true.5% = 7%. Constant growth model Answer: e Diff: E Statement a is false: P0 = D1/(ks . Statement b is false. Market efficiency just means that all of the known information is already reflected in the price. For Stock X. we’ve been given no information about the dividend yield. Required return Answer: e Diff: E 2. the other statements are false. but the required return and expected dividend are the same. Constant growth model Answer: c Diff: E Statement c is true. and you can’t earn above the required return. 7. so the prices will be different also. the total required return is 10 percent and its capital gains yield (g) is 7 percent. the constant rate at which dividends are expected to grow is also the expected growth rate of the stock’s price. the others are false. statement e is the correct answer. Statement b is false. Therefore. The expected returns of the two stocks would be the same only if they had the same betas. The constant growth model is not appropriate for stock valuation in the absence of a constant growth rate. Required return Answer: d Diff: E 3.g). Therefore. The expected future dividends should be discounted at the required rate of return. A has a higher g. A’s dividend yield must be 3 percent. This would depend on betas. Statement c is false. Constant growth model Answer: a Diff: E Statement a is true. Therefore. ks = D1/P0 + g Answer: c Diff: E N .1.

06. From the information given and the CAPM equation. So. the price of Stock X will be higher than the price of Stock Y one year from today.9% and 11. statement a is correct. statement a is true. So.0. and Stock X has a higher dividend growth rate than Stock Y. 10. statements a and b are incorrect. D 1/P0 = $3. Therefore. If Stock Y has a required return of 10 percent and a dividend yield of 3 percent.9% and 4. the correct choice is statement e. and will be growing at the same rate this year. k s = D1/P0 + g = ˆ10 = $50(1. we can calculate its growth rate: ks = D1/P0 + g 12% = 5% + g 7% = g. One year from now. An IPO occurs when a firm goes public for the first time.06. we know that Stock A’s and Stock B’s required returns are 12. At a price of $50. P $89. we can calculate its growth rate: ks = D1/P0 + g 10% = 3% + g 7% = g. Therefore.06)10 = $3. statement b is also correct. respectively. statement c is the correct choice. So.04.06. so statement b must be false. Miscellaneous issues Answer: c Diff: E Statement c is true. Thus. Since both statements a and c are true. the dividend yields for Stock A and Stock B are 5. we cannot determine which stock has the higher price without knowing their expected dividends. statement c must also be true. . or D1/P0 = 0.10 = D1/P0 + 0. that both stocks have the same growth rate. respectively. Statement c is the exact definition of a preemptive right. we know that Stock B’s dividend yield doesn’t equal its expected dividend growth rate. so they will end up with the same stock price one year from now. the others are false.12 = D1/P0 + 0. their capital gains yields are equivalent to their dividend growth rates of 7%. Two classes of common stock can have different voting rights.00 = 6%. Therefore. as well as pay different dividends.7%. For Stock Y. So. The required return is equal to a dividend yield and a capital gains yield. Since both stocks X and Y have the same price today. We just showed above. That also makes statements d and e incorrect. from the answer given for statement a.54.00/$50 + 0. Since these are constant growth stocks. 9. or D1/P0 = 0. Since both stocks have the same price and Stock X has a higher dividend yield than Stock Y. They are starting at the same price today. the stocks will both trade at the same price. Constant growth model Answer: e Diff: E If Stock X has a required return of 12 percent and a dividend yield of 5 percent. Statement c is incorrect. both Stock X and Stock Y have the same dividend yield. 12.7%. ks = D1/P0 + g 0. 11. Constant growth model Answer: e Diff: E N The correct answer is statement e. Statement b is incorrect. So. Constant growth model and CAPM Answer: a Diff: E N The correct answer is statement a. so statement c is correct.06 = 12%.00/$50. its dividend per share must be higher. statement e is the correct choice.

Therefore. Therefore. not private. Efficient markets hypothesis Answer: d Diff: E 17. there is no reason to expect all stocks to have the same return. the buy-sell actions of those investors quickly bring market prices into equilibrium. is rapidly incorporated into stock prices. is already accounted for in the stock’s price. However. even insiders would find it impossible to earn abnormal returns in the stock market. statement a must be false. Efficient markets hypothesis Answer: e Diff: E Weak-form efficiency means that you cannot profit from recent trends in stock prices (that is. Preemptive right Answer: b Diff: E 14. In equilibrium. statement b is false. then the NPV of the stock must be equal to 0. So statement e is the correct answer. therefore. Statement a is false. statement c is also false. statement e is false. Therefore. stocks with more market risk should have higher expected returns than stocks with less market risk. The correct choice is statement e. Because bonds and stocks have different risk levels and tax implications. Therefore. Statement c is false. statement e is true. technical analysis doesn’t work). this describes semistrong-form efficiency. Similarly. The semistrong form of market efficiency says that all publicly available information. 16. statement a is false. Remember. statement c is false. Statement b is false. Markets can be efficient yet still price securities differently depending on their risks. there is no reason to expect them to have the same return. 18. Therefore. Efficient markets hypothesis Answer: e Diff: E Statements a through d are false. If it holds. It is impossible for the two to equal each other.13 . Semistrong-form market efficiency implies that only public information. we discount all future cash flows by the required return. 20 Efficient markets hypothesis Answer: c Diff: E Statement c is true. Stocks are usually riskier than bonds and should have higher expected returns. statement b must be false. Statement b is false for the same reason as statement a. some investors may be able to analyze and react more quickly than others to releases of new information. the other statements are false. whether publicly available or privately held. semistrong-form efficiency says that you cannot make abnormal profits by trading off publicly available information. Therefore. . riskier securities have higher required returns. Statement c is false. Efficient markets hypothesis Answer: e Diff: E Statement a is false. 19. when trying to find the price of a stock. Semistrong-form efficiency means that all public information is already accounted for in the stock price. including past price history. Classified stock Answer: e Diff: E 15. because different stocks have different risk levels. Net present value is stated in dollars and the required return is stated as a percent. statement d is true. Therefore. If the price is equal to the present value of those cash flows. Strong-form efficiency states that current market prices reflect all pertinent information. Therefore.

Common stock concepts Answer: d Diff: E Statements b and c are true. statement a is incorrect.00(0. Therefore. are tax deductible. Statement c is true. Preferred stock concepts Answer: e Diff: E 25.95)5] = $1. $10(0. Dividend yield and g Answer: c Diff: E . so statement c is incorrect.15 + 0. Therefore. then Y’s dividend yield must be larger than X’s. Div yield 5 = D6/P5 or [$2. Both stocks have the same k s and the same P0. Efficient markets hypothesis 21. but statement e is clearly false.. b. then the market is semistrong-form efficient not weak-form efficient. statement a is false.547562/$7. 28. Statement a is true. statement b is incorrect.g). Therefore. A greater proportion of common stock in the capital structure increases the likelihood of a takeover bid. If D1 and g are the same. Therefore. while Stock X has a dividend yield of 10 percent and a capital gains yield of 0 percent.95)5 = $7.74 = 20%. 27. In order for this to be true Y’s price must be lower than X’s. Dividend yield and g Answer: d Diff: E ks = D1/P0 + g. statement b is false. Efficient markets hypothesis Answer: a Answer: e Diff: E Diff: E N The correct answer is statement e. statement c is false. therefore. Stock Y could have a dividend yield of 0 percent and a capital gains yield of 12 percent. If the market is weak-form efficient. Different stocks will have different risk and will have different required and expected returns. Both statements a and b are true. then the correct answer is statement e.05) = $10. Statement d is true.00(0. all the statements are true. 29. P0 = $2/(0. the other statements are false. 23 . therefore. If the two stocks have the same dividend yield. 70 percent of dividends received.95)5]/[$10. Historical information cannot be used to beat the market under weak-form efficiency. and c are false. b. Therefore. then you cannot beat the market by using technical analysis or charting. Stock Y must have a higher expected capital gains yield than X because Y has the higher required return. Remember the DCF formula: P0 = D1/(ks . and we know that Y has a higher required return than X. Statement b is true. 26. statement d is the correct choice.74. not paid out. Preferred stock concepts Answer: e Diff: E 24. and c are not necessarily true. 22. Common stock concepts Answer: e Diff: E We don’t know anything about the dividends of either stock. Public information cannot be used to beat the market under semistrong-form efficiency. If prices rapidly reflect all available public information. Since statements a. but may have a different D1 and a different g. So statements a. Declining growth stock Answer: e Diff: E Statement e is the correct choice. statement e is the correct choice. Efficient markets hypothesis Answer: a Diff: E Statement a is true.

statement d is incorrect. statement b is correct. statement c is incorrect. If you are expecting a higher return than you require (given the level of risk) for a stock. The realized return is an historical return. Statement d is not necessarily true because the growth rate could go either way depending upon how high the dividend yield is. and if the dividend yield for Stock A is lower than Stock B’s. There is no reason that the expected return in the future should equal the return it has realized in the past. the other statements are false. Efficient markets hypothesis Answer: e Diff: M Statement e is the correct choice. the new stock price would be lower. 32. Therefore. It is what has already happened in the past. Semistrong-form efficiency implies that past stock prices cannot be used to forecast future returns. 30. Therefore. Realized returns are historical. depending on what is happening to oil prices. Statement e is also not necessarily true. you could use private information to outperform the market. Semistrong-form efficiency means that current market prices reflect all publicly available information. If beta increased. 35. the growth rate for Stock A must be higher to offset this. Efficient markets hypothesis Answer: c Diff: M 34. Statement c is true because if the required return for Stock A is higher than that of Stock B. Market equilibrium Answer: b Diff: E N The correct answer is statement b. If the expected return does not equal the required return. Therefore.” You will be getting a higher return than you require. Investments should not have the same realized returns. Market efficiency says nothing about the relationship between expected and realized rates of return. Different investments should have different expected returns. 31. but g remained the same. Efficient markets hypothesis Answer: e Diff: M Statement e is true.Statements a and b are both false because the required return consists of both a dividend yield (D1/P0) and a growth rate. If the stock market is weak-form efficient. Efficient markets hypothesis Answer: d Diff: M . and the stock price will adjust until its expected return equals its required return. the other statements are false. Market efficiency and stock returns Answer: c Diff: M Statement c is true. then the stock will be a “bargain. and all stocks have different price histories. statement a is incorrect. then markets are not in equilibrium. There is no reason for you to expect the same returns on all of your investments. This disequilibrium will not last. You will have a different expected return for an oil company stock than you would for an airline company stock. Statements a and b don’t mention the growth rate. Therefore. 33.

77.35.08 = $54.00/$20. kp = Dp/Vp = $2.06  $50 = $3. Dividend yield = 6%.10 = 10%. There is no growth in the dividend. Preferred stock yield Annual dividend = $0. P0 = $118. Market equilibrium Answer: a Diff: M 37. Solve this expression for Price = $150.00 P CF2 = 159.35.20 = $25. Preferred stock value Answer: d Diff: E Answer: d Diff: E Vp = Dp/kp = $5/0. I = 16.25. 44 . kp = Dp/Vp = $10/$50 = 0.36. 40 . Preferred stock yield Answer: c Diff: E Answer: a Diff: E Answer: d Diff: E Annual dividend = $2. 43 .25 ˆ2 = 150. Dividend yield and g Answer: b Diff: M 39.20 = 20%. Preferred stock value The dividend is calculated as 10%  $120 = $12. therefore. k s = Dividend yield + Capital gains. PMT = 0. the other statements are false.00 = 0. Dividend = 0. (1.25 = $118.50(4) = $10. 41 .25 Numerical solution: P0 = $159. (Note: Non-partici-pating preferred stockholders are entitled to just the stated dividend rate. FV = 159. Dividend yield = Dividend/Price.07)4 = $32. Stock price 0 ks | P0 = ? = 16% 1 | 0 2 Years | D2 = 9. 14% = Dividend yield + 8%. 45.35. We know that the cost of preferred stock is equal to the dividend divided by the stock price or 8% = $12/Price.16)2 Financial calculator solution: Inputs: N = 2. Future stock price = $50  1.00. Future stock price--constant growth Output: PV = -$118. A stock’s dividend yield can exceed the expected growth rate. Answer: d Diff: E The stock price will grow at 7 percent for 4 years. Statement b is true. . The stock’s required return must equal the sum of its expected dividend yield and constant growth rate. the other statements are false.) 42 .50(4) = $2. Constant growth model Answer: d Diff: M Statement d is true. $25  (1. Ownership and going public Answer: c Diff: M 38.

11 .11.14  $28.g) g = 5%.08)8 = $185.00.21665 = $48. Constant growth stock Answer: b Diff: E Answer: a Diff: E ks = D1/P0 + g g = ks .D1/P0 g = 0. Constant growth stock . g: ks = D1/P0 + g 9% = $2/$40 + g 0.108  $13. Step 2: Find P at t = 7: ˆ7 = P0(1 + g)7 P ˆ7 P ˆ7 P 48. If the growth rate is 8 percent. Future stock price--constant growth Step 1: Determine the constant growth rate. Future stock price--constant growth Step 1: Find g: P0 = D1/(ks .15 .04)5 = $40  1.07)4 = $13. P 50. dividends.12  0.08) = $100. 0.67.09.05)7 = $28. 51. 49.00(1.05 + g 0. 47. the price in 8 years will be: $100  (1.46 . Step 2: Determine the expected price of the stock 5 years from today: ˆ5 P = P0  (1 + g)n = $40  (1.g) $20 = $2/(0.04 = g.50 = = $10. P0 = Answer: e Diff: E N Dˆ1 $0. Answer: a Diff: E Answer: a Diff: E = $20(1.$1/$20 = 0.09 = 0.07)4 = $10. Future stock price--constant Answer: b growth Diff: E The stock price today is calculated as: $4/(0. its price will grow at the same rate as ˆ4 = P0(1. Future stock price--constant growth The price today.06 = 6%. So.12 .07 ks  g Since this is a constant growth stock.0.

00.10 .0.00(1.05)5 = $63. calculate today’s price: P0 = D1/(ks .07)5 = $12.g) $3/(0.12 .07)5 = $16. Step 2: Calculate the price of the stock 5 years from today.33D1 D1 = $0. g = 0.g) = $0.19 . P0 = D1/(ks .g) = $2.15) = $57. assuming g = 7% per year: ˆ5 P = P0  (1.81.90.00/(0. 0. 57.00  (1.05. 53. Step 2: Determine the price of the stock five years from today: ˆ5 = $50  (1.8 .g) and we have all the information except D1.07) $30 = 33. P Constant growth stock Answer: d Diff: E Step 1: Using the Gordon constant growth model.5%)1.05) = $50. so we input the data into this equation.09 . $2.16 – g) $3 $30g 6%.15 Constant growth stock Answer: e Diff: E The required rate of return on the stock: 5% + (9% .06 = $2. since it is a constant growth stock.P0 = 52.07) = $12. ks = 0. 56.50.8 g 54.09. D1 = $2. Constant growth stock We know that P0 = D1/ks . 55.57.3 = 10.06) = $60.544/(0.00. $30 = D1/(0.2%. Constant growth stock Answer: b Diff: E N .60/(0.0. The price of the stock today is $2.0.0.40  1.0.$30g $1. Constant growth stock Answer: b Diff: E Step 1: Calculate the price of the stock today.544. Constant growth stock P0 $30 $4.83. D1 = $2.102 . = = = = = Answer: c Diff: E Answer: d Diff: E D1/(ks .

47.07 0.56976 = P CFt 0 2.08. CF1 = 1. 1.07 84.47.00 P0 = ? 1 | g2 = 5% 2. given its current stock price.12)2 Financial calculator solution: Enter in CFLO register CF0 = 0.16.10  0. 1.0. Nonconstant growth stock 0 k = 12% | gs = 5% 1.12. Beta coefficient Answer: b Diff: E Step 1: Find ks = ks = ks = ks: D1/P0 + g $2/$40 + 0. you can find the price in 10 years. I = 10. 59.05 Diff: E 2 3 Years | | gn = 10% 1.1840.4770928 2.74 $1. 58.05. so you can use the Gordon constant growth model to calculate today’s price.10)2 (1.kRF)b .31504 ˆ3 = 82.11 .88480 Numerical solution: P0  60.05 $61. Nonconstant growth stock Time line: 0 k | g 1 = 10% = 4% 2.21275 1. Once you have today’s price.12 (1.74.4286(1. Step 1: Find the stock’s current price. and press NPV to get NPV = P0 = $50.1840 3 | gn = 7% 2. and press NPV to get NPV = P0 = $67.1840 $84.8848. and CF3 = 84. CF2 = 2.21275 ˆ2 = 60.12  0.7400 gs = 5% 1.4770928 0.00 P0 = ? CFt 0 Numerical solution: P0 = Answer: d 1 | 1.6375 = P 0.10)3 Enter in calculator: CF0 = 0. and CF2 = 61.45/(0.04)10 = $9.08 $2.1840 Diff: E 4 Years | 2.05 + = $50.10 61.8848    $67.10 (1. CF1 = 2. ˆ10 = P0(1 + g)n P = $6.1025 1.g) = $0. P0 = D1/(ks .08 Answer: d 2 | g3 = 6% 2.4286.04) = $6.52. Then enter I = 12.08 2. $2.16. Step 2: Find the stock’s price in 10 years.This is a constant growth stock. Step 2: Use the CAPM to find beta: ks = kRF + (kM .

333 .00 per share Dilution: Old shareholders lose $100 .06 + 0.10 – 0.000. So. 30.333.000 new shares @ $90 each + 90. Step 2: Solve for the original ks: Step 3: Solve for the original beta using the CAPM formula: (5%)b0.000 in debt and preferred stock.12 = 0.000 = $500.40  E0 = 0. and common stock. FCF model for valuing stock Answer: d Diff: E N Firm value = $25.$95 = $5.000. since the firm has a 40% payout ratio.000.000.0950. 61.60(1. FCF model for Answer: d valuing Diff: E stock N FCF1 = $300.11 – 0.5  b0 = 1.000.333. D1 = D0(1 + g) = $1.000 shares  $100 per share = $100.000. 11.333 = $21.000 = $633. preferred stock.333.000/150. P 64.000. including debt.000.000.00 = $1.000.000/(0.000/2.333.333.06) = $1.06(b) b = 1. ˆ0 = MV equity/# of shares P ˆ0 = $7.000.500.6960/$30 + 6% = 11. growth rate = 7%. b0 = 0.000/(0.60. This leaves an equity value of $833. stock + MV common equity $7.000. the price/share = 63 $633. 62.000 .000 = MV common equity.000 + MV common equity $7.5  0.67.7300 = 1.0. we subtract the $200.65% = 8% + b1 = 1.7300.000.07) = $7. This is the value of the whole company.333.500.07) = $833.000 shares = $95. Changing beta and the equilibrium stock price Answer: d Diff: M Step 1: Solve for D1: D0 = 0.000 P ˆ0 = $46.000. .000. Total MV assets = MV debt + MV pref. Step 4: Solve for the new beta: ks = D1/P0 + g = $1.000 Calculate new market share price: $190.65%. and WACC = 11%.11.000 New firm market value $190.6960.000 Plus 1.00 per share.000. Firm value = FCF1/(WACC – g) = $300.40  $4. From this. New issues and dilution Answer: b Diff: E Calculate current and new market value of firm after new stock issue: 1.$200.

06) = $22.kRF)b = 5% + (5%)1.11 .5%)1.g) $40 = $2.2 ks = 13.13475 .00 g = 0.084)5 P ˆ5 = $59.$16. Constant growth stock To find the stock price seven years from today.130 . that we have the constant growth rate.134 = $2/$40 + g 0. P Constant growth stock Answer: c Diff: M N First. 66.4%)1. Nonconstant growth stock Answer: a Diff: M . Equilibrium stock price Before: Diff: M Answer: d Diff: M ks = 5% + (8% .9%. we have $12. Solve for P0 = D1 /(ks .11.98.40 .69.11 .3 = 8.00/(0.65. we can find the stock’s expected price in Year 5: ˆ5 = P0(1 + g)t P ˆ5 = $40(1.80(1.80(1.$40g = $2.00  (1. P0 = After: Answer: b $0.089 . Now. P0 = $0.87. Step 2: Calculate the growth rate using the constant growth formula: P0 = D1/(ks . Step 5: Solve for the new ks using the CAPM: ks = 8% + (5%)1.06 = 6%.0.0.06 Hence. Step 6.04 ks = 4% + (10% . 67. we can determine the constant dividend growth rate: ks = D1/P0 + g 0.134 = 0.04) = $16.2 = 11%.87. Using the required return.40/$40.0950 = 13. we need to find the growth rate.4750%. 0.05 + g 0.4%. we must determine the firm’s required return: ks = kRF + (kM – kRF)b ks = 5% + (7%)1. Step 1: Calculate the required rate of return: ks = kRF + (kM .15.98 = -$4.00 g = $2.0. P 68.6960/(0.06)7 = $60.g) $4.084 = g.06) = $12.5 = 13%.1452  $60.g) = $1. Step 3: Determine the expected stock price seven years from today: ˆ7 = $40. 0.

0. and CF2 = 22.0 2.Time line: 0 ks | g s = 18% = 20% 1.05 = $1. . Output: NPV = $15.16 1.1104 3.2 = $1.20  1.449/(0.12)2 Financial calculator solution: Enter in CFLO register CF0 = 0. = Thus.17.67.6 = 18%.38. Finally.16.20 $1.15 = $1.667 = $10. find the stock price after two years: D1 = $1.20.16 gs = 20% 2.17.449.38. P0 = $15. D3 = $1.70. CF1 = 1.667.20.592 20. CF4 = 20.50 P0 = ? 1 | gs = 20% 1.98. CF2 = 2. CF1 = 1.3884 ks = 4% + (12. I = 18.12 (1. ˆ2 P = D3/(ks .1104 = 17. 69.4%)1.g) = $1.11)4 Nonconstant growth stock Answer: d Diff: M First.18 . The stock price is given by: ˆ4 P = D5 ks  g $1. Financial calculator solution: Inputs: CF0 = 0.592.12 .75% . D2 = $1. Next.05) = $20.2 = 11%. 1. Nonconstant growth stock Answer: d Diff: M The required return on the stock is given by: ks = kRF + RPM(b) ks = 5% + (5%)1.1104 5 Years | 3.0. determine the company’s current stock price: Numerical solution: P0  $1.80.38  $20. the current price is given by discounting the future price in Year 4 to the present at the required rate of return: P0 = 70. Then enter I = 12.80 2 | gs = 20% 2. CF3 = 2.592 ˆ4 = P CFt 0 3 | 4 | gn = 0% 3.05 = $16.08.15 = $1.11 .70   $18.20  1.3884.20.00 0. determine the dividends during the nonconstant growth period: D1 = $1. (1.00  1.80 Required rate of return: 2.38  1. $16.2780 0. D2 = $1.

71. ks = 6% + (11% . P0 = 72. find PV of P P0 = 73.3667.  1.00.and press NPV to get NPV = P0 = $18.305  $69. $0. The value of D1 = $3.5) = 17%.921875.75(1. determine value of the stock at t = 3: ˆ3 = D4/(ks .921875/(0.17 )3 = $77.47.0.0. the return on the stock.15) = $118.4)2 = $1. D2 = $3.058 + $118.31.3125. ˆ3 : Finally.00  D3 = $3. find the expected return ks: ks = 4% + 6%(1.4) = $1.14. $0.5) = 13%.25 = $3. we use the CAPM.05 + + 2 1. P Now find the present value of the supernormal growth dividends and the value of .08) = $100.4)3(1.058.05) = $70.6%)  1.75. $1. Nonconstant growth stock First.) Next.17 .0.05. $0.3667/(0.75  D4 = $4.4)3 = $2.13)3 Nonconstant growth stock Answer: e Diff: M To find ks. $100 = $69. 1.17 ) (1.12 .05 = $4.75(1.335 $1.13 .75(1.25 = $4.17 (1.6875.75(1.g) = $4.2 = 12%. (1. (Using the CAPM. Nonconstant growth stock Answer: a Diff: M Answer: a Diff: M ks = kRF + RPM(b) = 8% + 6%(1.15) = $2.6875 the dividends for Years 1 .4 are: 1.g = $2. The value of the stock at t = 3 is: ˆ3 = D4/(ks .67.335. D1 D2 D3 D4 = = = = $0.g) P = $5/(0.47 $2. ˆ3 P = D4/ks .

4) = 13%.05 = $3.11 .00.12 (1.3125   2 1.0. P0 = $3.kRF)b = 6% + 5%(1.11 (1. D2.g) P ˆ3 = $3. so D4 = $3.00 1.11 . and D3 = $2.11) (1. Nonconstant growth stock 2003ks = 13%2004 | | 0 P0 = ? Answer: e Diff: M 2005 2006 2007 2008 2009 | gs = 20% | gs = 20% | gs = 20% | gn = 7% | 1. D4.00  ˆ5 = $3.25 $3.25.525   2 1.05) P ˆ3 = $63.20 1. D3. The stock price at t = 5 is P The stock price today represents the sum of the present values of D 1.8115/(0.11) (1.48 ≈ $54.11)5 = $40.15/(0.00 $3. 1.00  $52.11) (1.30 $3. and the present value of P values at 11 percent.05. 75.12)3 = $59. 13  0. 76. Step 2: Find the stock price at t = 3 when growth becomes constant: ˆ3 = D4/(ks . and D3 = $3.50. Nonconstant growth stock Answer: b Diff: M Step 1: Calculate D1 through D4: Since the dividend grows at 10 percent a year for 3 years. 74.12) (1. D2 = $3.00 $3.84896 $1. ˆ5 . D 1 = $3.30.44 1.41. D3. Step 2: Calculate the dividends: .11) (1.11)3 = $54.728 1.50     2 3 4 1. Nonconstant growth stock Answer: b Diff: M We’re given D1.525. P0 = $3.15. The dividend starts to grow at 5 percent after t = 3. D4 and D5 = $3.25 $2.25 $2.63  $63.75 $4. D2. D5.11 (1.0.6875  $70.00 $3. Discount these dividends D1. D2.07 32.05) = $52.84896 30.63.the stock at t = 3.00. P Step 3: Find the current stock price: The current stock price (at t = 0) is the present value of the ˆ3 .8115.544 Step 1: Determine ks: ks = kRF + (kM . and P P0 = $2. Calculate D6 as $3.816  0 .

2)3(1.55729 ≈ $69.25 = $3.44 $1.0. . P0 = D2009 $1. CF3 = 4.125.125/1. CF2 = 3.13)3 P = $2.25 = $2.13  0.00. D3 = $2.2) = $1.8828125 + $87.25 = $2.00  1.90625/(1.50.25 = $3.84896 = ks  g 0.07 = $5.224609375.90625.8828125.00.56. D5 = $3.13)5 = $20.07 = $5.0592 + $63.13)2 + ($4. CF1 = 3.076823. Step 3: Now find the value of the stock in Year 2: Enter the following inputs in the calculator: CF0 = 0.125  1.8828125 + 87.50  1.g) P = $5.2)2 = $1. Nonconstant growth stock Answer: c Diff: M Step 1: Calculate the dividends each year: D1 = $2.13 .90625  1.5573  $69.90625. D5 = $3.076823)/(1.728  $30. D6 = $4. I = 13.07) = $87.25 = $3.13 (1.00(1.125. 77.224609375/(0. D2 = $2.D2005 D2006 D2007 D2008 D2009 Step 3: = = = = = Calculate P2008 (when growth becomes constant): P2008 = Step 4: $1.0.50.7655 + $3. $1. D4 = $3.224609375/(0.44.07 $0 $1.07) = $1.224609375.50  1.2)3 = $1.25 = $4.00. $1.00(1.125. $1.8828125.25 = $3.13) (1. Step 2: Find the stock’s value at Year 5: ˆ5 = D6/(ks .13) (1.076823.125  1.90625.56.00  1.8828125  1. Step 2: Find the stock’s value at Year 5: ˆ5 = D6/(ks .84896. and then solve for NPV = $69. $1. D6 = $4.13) (1.00(1.20 $1.13 . D3 = $2.00 $1.728.00(1.13 + $3.16.90625  1.07) = $87. D2 = $2. Financial calculator solution: Step 1: Calculate the dividends each year: D1 = $2.25 = $4.7326 = $69.g) P = $5.076823.8828125  1. Step 3: Now find the value of the stock in Year 2: ˆ2 = $3. D4 = $3.20.816     2 3 4 1.

6575/(0.6125 + $0. Step 3: Determine the value of the stock at Year 8: ˆ8 = D9/(ks – g) P = ($1. Nonconstant growth stock Answer: d Diff: M Diff: M Step 1: Calculate the dividend in Year 4.00/(1.25 = $1.3125 + $110. Step 2: Determine the dividends during the nonconstant period: D1 – D4 = $0. P ˆ P3 = D4/(ks .08) = $4.103)8 P0 = $0.953125 + $38. Step 2: ˆ3 : Calculate the expected stock price in Year 3.953125.0.8929)/(1. D6 = $1. Step 4: Calculate the expected price of the stock today: P0 = $1.122 + $3.103)6 + $1.25.78.2158  $87.g) = $4.3125  (1.5% + (4%  1.00.5625/(1.122 .05)/(0.6942 + $0.8929. .65.2) = 10.6469  $20.7867 + $18. D7 = $1. Step 3: Calculate the price of the stock today: P0 = $3.6738 + $2.694)/(1.5625.953125  1.5632 = $87.5535 P0 = $20.00/1.08) = $110. Nonconstant growth stock Answer: e Step 1: Find the cost of equity using the CAPM: ks = kRF + (kM – kRF)b = 5.75/(1.05) = $38. D5 = $1.122)3 = $2.122)2 + ($4.103 – 0.5625  1.6575.25 = $1.00  1.9788 + $81.22.694.25 = $1. D4: D4 = D3  (1 + g) = $4.25  1.3%. D8 = $1.103)5 + (1. 79.103)7 + ($1.

D4 = $1.200/(1.8% 1 | gs 1.098)2 + $1.098 + $1.07) = $66.20  1.9954 + 1.7280 + $66.098 . Step 4: Calculate the stock price at the end of Year 4: ˆ4 = D5/(k .728  1.098)3 + ($1.84896.0878 + $46. D3 = $1.6207 = $49.kRF)b = 5% + (4%)1. Answer: a = 9.6146  $49.80.8%.9107 + $0.2 = 9.000/1.098)4 = $0.07 = $1. Step 3: Calculate the required rate of return: ks = kRF + (kM . Step 5: Calculate the price of the stock today: NPV = $1.440.000.84896/(0.61.44  1.440/(1.728. Nonconstant growth stock Step 1: Diff: M Draw a time line: 0 k s | P0 = ? 81.2 = $1.200.0343)/(1.728 = 5 Years 7% | 1.2 = $1. D5 = $1.200 20% 3 | gs 1.0.000 = 2 20% | gs = 1.0343.84896 Step 2: Calculate the dividends for 5 years: D1 = $1.2 = $1.440 = 4 20% | gn 1.g) P = $1. D2 = $1  1. Nonconstant growth stock Answer: d Diff: M .

08) = $97. D2 = $1. Nonconstant growth stock Answer: b Diff: M N Step 1: Calculate dividends during the nonconstant period and the first year of constant growth: D1 = $1. 9440 ˆ3  P = 97.00  (1. D4 = $1.10) + $1.08 82.00  1.80.2786  $27.5625.0.6875.20 = $1.10)2 + ($1.76.00  (1. D4 = $1.20. Nonconstant growth stock Answer: c Diff: M .20 = $1.11  0.50/(1.1364 + $1.06 = $1.65625. Step 4: Calculate the price of the stock today: P0 = ($1. P0 = Alternatively. Step 3: Calculate the price of the stock at Year 3. D3 = $1.10)3 = $1.20)/(1.2397 + $74. enter the nonconstant dividends and the stock price at the point of time when growth becomes constant into your calculator as follows: CF0 = 0. Step 2: Calculate the dividends: D1 = $1. D2 = $1. CF2 = 1.25 $1.11 (1. CF1 = 1.00. D3 = $1.7563  $76.944. 83.28.25.50.25 = $1.28.65625 = = $33.20 0.25. CF3 = 33.944/(0.g) P = $1.08 = $1.125  $1. I = 11.3802 = $76.25)2  1.00.125 + 1.25 1.Step 1: Draw the time line: 0 ks = 10% 1 2 3 4 Years | | gs = 20% | gs = 20% | gn = 8% | P0 = ? 1.50 1. ˆ3 = P Step 3: D4 $1.9009 + $1.10 .25  1.9440 1 .80 + $97. Step 2: Calculate the price of the stock once growth is constant (which would be at the end of the third year).80 1.5625 = 34. 0.10  0.00 + + 2 1.3632 = $27. when it becomes a constant growth stock: ˆ3 = D4/(ks .25/1.5625) $1.80  1.0145 + $25.06 ks  g ($33.11) (1. and then solve for NPV = P0 = $27.50  1.11)3 = $0.25)2 = $1.25.125.

15  0.859375 ˆ3 = 128. CF1 = 3.6875.75 4. 1: Find D0 = D1 = D2 = D3 = the dividend stream to D3: $3.90625 P CFt 0 3.00.6875)(1.6875 4 Years | 6.765625.90625. the stock’s value: CF0 = 0.7500 ($3.7500.859375)(1. ks  g 0.25) = $5.10 134.25) = $4.00)(1.10) Pˆ3  3   $128.Time line: 0 ks | g s = 15% = 25% 3. CF2 = 4. and then solve for NPV = $95. ($3.4453125 0.00 P0 = ? 1 | gs = 25% 3. I = 15.42.4453125 = 6.859375 Step 2: ˆ3 : Find P Step 3: Find the NPV of the cash flows.75)(1. D (1  g) ($5.25) = $3.6875 gn = 10% 5.10 Nonconstant growth stock Answer: a Diff: M .75 2 | 3 | gs = 25% 4.765625 Step 84. CF3 = 134.6875 ($4.15  0.

CF1-4 = 0.875 = 1.71875. CF7 = 1. Pˆ7  Step 3: 85. CF5 = 1. D6 = $1.5625 8 | Years 1.4375. D8 = $1. and then solve for NPV = $84. D7.25.00.10 Pˆ7  $171. CF6 = 1.01 Step 1: Determine the dividends to be received: D5 = $1.71875 P 0.25 gs = 25% 7 | gn = 10% 1.2500.25  1. and P Enter the following input data in your calculator: CF0 = 0.71875 Pˆ7  0.11  0. As an investor today. D7 = $1.Time line: 0 ks = 11% |    P0 = ? 5 | gs = 25% 1.25 = $1.875 = 173.875. Nonconstant growth stock Answer: a Diff: M N . D6.5625 + 171. Step 2: Determine the value of the stock once dividend growth is constant: D8 ks  g $1.71875 ˆ7 = 171.80. I = 11.25 = $1.00  1.00.00 6 | 1. Determine the price of the stock today: ˆ7 .5625  1. you would be entitled to D5.5625.10 = $1.

05 39.25) = $2.6211 = P CFt 0 1. D4 = D3(1 + g) = $1. CF3 = 1.9531 2.0625.25) = $1. CF2 = 1.12 – 0.05) = $36.25(1.5625.5635. If k equals g.Time line: 0 ks | g s = 12% = 25% 1.12 . CF4 = 39. CF1 = 1.4414 ˆ4 = 36.5625(1. D3 = D2(1 + g) = $1.25 1. k must be greater than g for a reasonable application of the model.0. D1 = D0(1 + g) = $1.5635/(0. CF0 = 0. Solve for NPV = $28. D2 = D1(1 + g) = $1.25) = $1.58.9531. Step 2: Calculate constant. Supernormal growth stock Answer: b Diff: M .05) = $2.9531(1. enter the cash flows to determine the stock’s current price. and the numerical result is undefined. Using your financial calculator. D5 = D4(1 + g) = $2.4414.5635 2. ˆ4 P Step 3: 86. the denominator is zero. 1. k less than g implies a negative stock price. I = 12.00 P0 = ? 1 | gs = 25% 1.25 2 | gs = 25% 1.4414(1. 87 .5625.0625 Step 1: Calculate the dividends during the nonconstant growth period and the first dividend after that period. Supernormal growth stock Answer: e Diff: M The data in the problem are unrealistic and inconsistent with the require-ments of the growth model.25) = $1.5635 0.9531.25.9531 4 | gn = 5% 2.5625 5 Years | the stock price when the stock’s growth rate becomes = D5/(ks – g) = $2.00(1.5625 3 | gs = 25% 1.5768  $28.6211.2500.

$11.26.97 = $3.12 2. CF2 = 19.00 P0 = ? gs = 20% 3.752 0. Numerical solution: P0 = $3.26 Financial calculator solution: Inputs: CF0 = 0.60 2 | gn = 10% 4. P Inputs: CF0 = 0. CF1 = 0.07 + (0. P0  P Pˆ0  Financial calculator solution: ˆ0 : Calculate current expected price of stock.11 .60 $99.36 ks = 0.15 (1. P ˆ0 . CF2 = 99.0.18)3 ˆ0 .26.667.00 .00 . Dividend yield = $3.26 = 0. Supernormal growth stock Time line: 0 ks | g s 0 P0 = ? = 18% = 15% Answer: b 1 | 2 | 3 | 0 0 2.60%.07)2.15  0.18 (1.$11. 88.60%.15)2 Dividend yield = D1 $3.Time line: 0 ks | g s 1 | = 15% = 20% 3.60 3 | Years 4. P0  P 89. Output: NPV = $78. I = 18.10 99.03. I = 15. Stock is overvalued: $15.752 4.0 = 0.15 = 15%.667    $11.60. 1. Supernormal growth stock Step 1: Draw the time line for the stock: Answer: b Diff: M . CF1 = 3. P0 $78.60   4.18  0. Stock is overvalued: $15. Nj = 2. Output: NPV = $11.97.12 0.00 gn = 6% ˆ3 = 17.97.667 Numerical solution: $0 $0 $19.03.97 = $3.0460 = 4.667 = P CFt 0 0 0 Diff: M 4 Years | 2. ˆ0 = $11.18) (1. 2 1.36.97.60/$78.36  = $78.06 19.04 = P CFt 0 3.32 ˆ2 = 95.

375.80.00 P0 = ? 9% 40% Answer: b 1 2 g2 = 25% | | 2. 91.04 + 0.15625 = 2. Numerical solution: P0  $2.12 (1.15625   2 1.34375  1. D3.87500 2.8750  1.12 .71475 4 Years | 1.09 (1.5078125. and can sell the stock at t = 3 for $50. P0 = $82.375   $82.8750.375 ks = Dividend yield + g = 0.12)3  $1. Step 3: Calculate the stock’s expected price in Year 3: ˆ3 = D4/(ks .g) P = $2.34375.25 = $1. P0  90.805 3 | 1.875 $2. $1.12  0. Step 4: Calculate the value of the stock today: As an investor today.50  1.50 3. Output: NPV = $82.6290125 Diff: M . D2.25 = $2.50 $1. 1.34375  $50.3685  $40.00 ks = 11% gn = -5% 1 | 1.07 Calculate the stock’s dividends for Years 2-4: D2 = $1.90 2 | 1.07) = $50.05 CFt 0 2.5078125/(0.875 0. D4 = $2.3393  $1.4947  $37.675 95.80 gn = 5% Diff: M 3 Years | 3.09  9%. CF2 = 95.09)2 Financial calculator solution: Inputs: CF0 = 0.80 3.5078125 P 0.05 + 0.2025  $40.15625. D3 = $1.0.20.5000 1. you will get D1.07 = $2.675 ˆ2 = P = 91.09  0.0 ks = 12% | P0 = ? Step 2: 1 2 3 4 Years | | | | gs = 25% gs = 25% gn = 7% 1.12) (1.84. Supernormal growth stock Time line: 0 gks == 1 | 2.84. Declining growth stock Answer: d Time line: 0 | 2.80 $95. CF1 = 2.5078125 ˆ3 = 50.34375 2.15625. I = 9.84.

2kRF + 18% 0. Answer: c Diff: M . Calculate growth rate using ks: P0 = D0 (1 + g) ks .8 = 13.$48g = $2 + $2g $50g = $4 g = 0. Stock growth rate Answer: e Diff: M The required rate of return on the stock is 9% + (6%)0.5%.5 = 12.2 16% = kRF . Capital gains yield = g = 8%. 93. $48 = Required return equals total yield (Dividend yield + Capital gains yield).52 g = 8.g $2(1 + g) 0.kRF)1.875(0.95)3 = $10.11%)0.38%.138  g $5. 0. constant growth model.8%.$1.(-0. $20 Calculate kRF. ˆ0 = P ˆ3 P 92.08 = 8%.125 .90 $1. Stock growth rate Required rate of return: Answer: d Diff: M ks = 11% + (14% .90 = = $11.18. Capital gains yield Step 1: Calculate ks.1.$40g = $2 + $2g $42g = $3.52 .00 = 4.11 .16 = $11.5%.05) 0. we can solve for the growth rate as follows: Using the $2(1  g) 0. the required rate of return: ks = Step 2: $2 + 6% = 10% + 6% = 16%.2kRF = 2% kRF = 10%.875. the risk-free rate: 16% = kRF + (15% .16/$48.g $6 . Dividend yield = $2. $40 = 94 .

6 = 12.08 = 8%.13 .4285  43%. ks = 10%. 98. $25. Capital gains yield and dividend yield Answer: e Diff: M The capital gains yield is equal to the long-run growth rate for this stock (since it is a constant growth rate stock) or 7%. Expected return and P/E ratio Data given: $2.0.2%. 96.Step 3: Calculate the new stock price and capital gain: New ks = 10% + (15% .$20. Step 2: Calculate the P/E ratio one year from today: P/E = $87/$2.05 g = 0. the percentage capital gain is 43% calculated as follows: $28.40 = 36.00 0. $20.2%.6594.42  1.$80 $87 = P1.57 = = 0.31%. The dividend yield is $3.40.57 . To calculate the dividend yield. Stock price and P/E ratio Step 1: Diff: M Calculate the required rate of return: Answer: a Diff: M . P 0 = $80.00 P0 Capital gains yield = Total yield . $25 = Since the stock is growing at a constant rate.35 = 11.00.10%)0.10 = $1/$80 + (P1 .25×.6 = 13%. first determine D1 as $3.g $2.06 Therefore. ks = 8% + (15% .00 $25g = $1. Calculate dividend yield and use to calculate capital gains yield: Dividend yield = $2.Dividend yield = 12.00 ˆNew = P 95.00 D1 = = 0.00.2%.$80)/$80 8 = $1 + P1 . Answer: b EPS = $2.57.P0)/P0 0. g = Capital gains yield.8%)0.05 .042 = 4.g $3.2% . EPS1 = Step 1: Calculate the price of the stock one year from today: ks = D1/P0 + (P1 . D1 = $1.8% = 4. Alternative method: P0 = D1 ks . $2 = $28.00 $8.00 $20. 0.$25g = $2. Capital gains yield Answer: d Diff: M Required rate of return.6594/$32.122 .07 = $3. P/E = 40×. 97 .

000 1.000 $5  10.000 $10  10.08  $15.16  0.280 Then.65/0.8%) = 16%. Div = Net income  Payout = $23.3968.000 10. Stock price Step 1: Set up an income Sales Variable costs Fixed costs EBIT Interest EBT Taxes NI Answer: d Diff: M statement to find net income: $100. Note: Because these projections are for the coming year.968.50 E1 99. this dividend is D1.10)  $27. Step 2: Calculate the current market price: P0  Step 3: $1.200 0. Dividends/Share = Total dividend/# of shares outstanding = $13.0.800 15.6 = $13.50(1.10 Calculate the earnings and P/E ratio: D1 = $1.800 $ 23. $27.50.000 (Given) $ 40.520 0. $5.000 $ 38.ks = 8% + 2.000 50. or the dividend for the coming year. calculate the total amount of dividends.40  $38. E1 = $1.50(1.280  0.30 = $5.10) = $1.000 = $1.0(12% . 0.50. .30E1.65 = 0.50 P0 = = 5.968/10.

Diff: M . to find P 103.40. ks = 6. g = 0.05 D1.106 .02)bOld.10 = kRF + (RPM)bOld = 0. find P 0 = D1/(ks . 0.30(10%) + 0. P ˆ5 = $60(1.00/ (0.05%. Risk and stock value Calculate required return on market and stock: kM = 0.05(7%) + 0.07 Future stock price--constant growth Answer: b Diff: M First.0.1752.05%.08) = $53. $2(1.0 = 12.8) = 10%.72. Beta coefficient Answer: c Diff: M Answer: d Diff: M Calculate old required return and beta: $2 + 0.g). Step 3: Calculate stock price: P0 = D1/(kS .0.58.07)  $42.g) = $1.09 .0.172  3.05%)2.00 = $1.08.1205  0.6%.05) = $60.kRF)b = 0.05 = D1/$28 D1 = $1. P0 = $3. 2. bNew = 3. Future stock price--constant growth Answer: e The growth rate is the required return minus the dividend yield.30(9%) + 0. 1.90476(1.05% + (9. Step 2: Use the CAPM equation to find the required return on the stock: kS = kRF + (kM .105 = 0.38. Then.05% .10 – 0.90476. bOld = 2.10476.08 + (0.17.05 = 0. What is D1? 0.05 + (0. $40 0. $30 0.10.00. Note that D0 = 101 .13 . Calculate expected equilibrium stock price: Pˆ0  102. compound this at the 5% growth rate for 5 years ˆ5 .3968/(0.05)5 = $76.30(8%) + 0. find ks = 6% + 5%(0.10476 ks(New) = + 0.05)1.6.1752 = 0.100.06 + (0.05(12%) = 9. ks(old) = Calculate new required return and beta: $2.4 = 0.New = $1. Finally.05 = 0.106 = 10.105) = $2.03)bNew.

144 .54.g) = $2. Then.208/0.12 .g). 105. g: ks = D1/P0 + g 14% = 5% + g 9% = g.208.10.0. Step 2: Calculate the stock’s price today: P0 = D1/(ks .00(1. We therefore need D6.6%)1.g) = $1.32. Future stock price--constant growth Answer: b Step 1: Find the cost of equity: ks = 6% + (12% .12 . find D6 = $2.05)3 = $10.00/(0.09)5 = $61.12 .8051/(0.06 + 0. Future stock price--constant growth Answer: b Diff: M First. ˆ5 we can use the following formula: To find P ˆ = D /k P5 6 s .399354/0. Therefore P 106. Step 3: Calculate the stock’s price 5 years from today: ˆ5 = $40  (1. This is the stock’s growth rate. P 104.99. the stock price must grow by 9 percent per year for the next five .6383(1. Future stock price--constant growth Answer: b Diff: M To find the growth rate: ks = D1/P0 + g Therefore ks .D1/P0 = g 0.02) = $22. 107. The Year 7 price is given by: ˆ7 = D8/(ks .05)3 = $12.09) = $40. ˆ5 = D6/ks .02.02)5 = $2.08)7 = $2. D6 = D1(1 + g)5 = $2(1.00/(0.08.g) = $2. calculate ks = 0.05 = $47. P Future stock price--constant growth Step 1: Determine the stock’s capital gains yield.05) = $10.0.8051. It follows that: P5 = $2.545  $61.g) = $2. P Step 3: Find the value of the stock in Year 4: ˆ4 = P ˆ1 (1.6383.3152  $12.14 .12. P Answer: b Diff: M Diff: M If the stock price today is $40 and the capital gains yield is 9 percent.4 = 14.399354.05(1.07)5 = $2.0.What will be the Year 8 dividend? D8 = D1  (1 + g)7 = $1.07) = $56.40  (1.4%.$2/$20 = 0. Step 2: Find the value of the stock at the end of Year 1: ˆ1 = D2/(ks .2) = 0.0.

number of shares to find the current price per share.400 million = MVEquity + $1. P0  Step 3: 109.400 million MVEquity = $5. 108. Future stock price--constant growth Answer: e Step 1: Calculate the firm’s cost of equity: ks = kRF + (RPM)b = 4% + (5%)1. FCF model for valuing stock Step 1: Answer: a Diff: M Calculate the free cash flow amount: FCF1 = EBIT(1 .06)8 P = $99.T) + Depreciation - Capital Expenditures   Net   operating  working   capital    = $400 million + $80 million . Step 2: Calculate the firm’s stock price today: Diff: M N D1 ks  g $2.50  0.years.6155  $99. Divide by the .000 million/125 million = $40.10  0. = This is the total firm value today. This is today’s market value of the firm’s equity. Find the expected stock price eight years from today: ˆN = $62. Step 2: Calculate the firm value today using the constant growth corporate value model: Firm value = FCF1 WACC  g $320 0.06  $62.05 $320 = 0.$0 = $320 million.50  (1. because this stock is a constant growth stock. Step 3: Determine the market value of the equity and price per share: MVTotal = MVEquity + MVDebt $6.000 million.00.62.05 = $6.50.$160 million .400 million.10  0. $5.2 = 10%.50  (1 + g)N P ˆ8 = $62.

) FCF1 = EBIT(1 .500 N . Now.000 2 | 4. there was no change in net operating working capital. Value per share = Value of equity/# of shares Value per share = $8.000 4. 111.00.09 .600/200 Value per share = $43. FCF model for valuing stock Answer: b Diff: M Time Line: 0 | FCFs Continuing Value Total FCFs 0 10% 1 | 3. we must find the expected free cash flow to be generated next year.000 5. we must divide the total value of the firm’s equity by the number of shares outstanding.600 million. we can find the value of the entire firm since there is a constant growth assumption.0. (Remember.000 – ($900 + $500) Value of equity = $8.110. we must find the value of the firm’s equity.T) + Depreciation – Gross capital expenditures FCF1 = $800(1 .06 137.500 = 0.10 – 0.000 3. To find the value per share of stock.06) 132. Next.06) Value of firm = $10.0. Value of firm = FCF1/(WACC – g) Value of firm = $300/(0.000(1 + 0.000 3 | 5.4) + $75 – $255 FCF1 = $300 million. Value of equity = Value of firm – Value of debt and preferred stock Value of equity = $10. FCF model for valuing stock Answer: b Diff: M N First.000 million.

Change in price = $15.065 = = = = $15.50.000 shares = $84. FCF model for valuing stock Answer: e Diff: M N Step 1: Calculate the firm’s free cash flows (in millions of dollars) for the next year: FCF1 = EBIT(1 . less the market value of debt and preferred stock.T) + Dep – Cap Exp.84 as the value of the firm’s common equity.0.00(1 + gNew) $1.84 $25.065) $1. which was given in the problem.40) = $1.0. CF2 = 4000.MVD+P = $1.$16.750 million.60. New .07 0.06 $1.00(0.066 0.338.126 .84. the entire company is worth $109.06. So.85.gNew 0. New equity and equilibrium price Answer: c Diff: M Calculate new equilibrium price and determine change: $1. and then solve for NPV = Total value of firm = $109.000 = $84. 0.65%.06) D0 (1 + g) kˆs  + g = + 0.250 million.338.60(1.750 – $500 = $1.06 = 11.250/20 = $62. CF3 = 137500. I = 10. Step 2: Calculate total firm value (TFV) today: TFV = FCF1/(WACC – g) = $70/(0. b = 0.338. The value of its common stock is calculated as $84.84.06 = -$0.Enter the following data as inputs in the financial calculator: CF0 = 0.00(1. ˆs. 112. Answer: a Diff: T .  NOWC = $300(1 . Step 3: Calculate the firm’s equity value today by subtracting today’s market value of the firm’s debt and preferred stock: MVE = TFV .34/share.338. Risk and stock price Calculate the required rate of return: D0 = E0(Payout ratio) = $4.06) = = $16.06) D0 (1. leaves $109.84/1.338.21.73. Old = P0.10 – 0.135 . $30 P0 Calculate beta: 11.00(1.065 k P0.21 .06) = $1. 113.4) + $50 – $100 – $60 = $70 million. Step 4: Calculate the firm’s price per share today: P0 = MVE/# shares = $1. New 114 . $1.0. CF1 = 3000.65% = 8% + (5%)b. This.

05) D0 (1 + g) = = $15.5) = 1.75 = 0.456 E4 = 3.88 D2 = 0. Calculate the new expected equilibrium stock price: $1.08 0.6912 D4 = 1. P0 = $2(1.06765  6.07 + (0.21.15 = $17g g = 0.00 P0 = ? 10% 20% 1 gs = | E1 = 2.003    $71. Output: NPV = $71.095.54.1348  0. Supernormal growth stock Time line: ks = 0 gs = | E0 = 2. 1.54. P0 = $71.576 ˆ3  P CFt 0 0.15 .g Calculate the new required return and equilibrium growth rate: New ks = 0. 0.48 20% 3 g = 8% 4 Years n | | E3 = 3.67.08)1. P0 = $15 (Unchanged).48 $0.08)1. $15 $3.$2.19 .10 (1. 0. Answer: c Diff: T Calculate the initial required return and equilibrium price: ks = 0.10)3 Financial calculator solution: Inputs: CF0 = 0.86624 = 93.05 ks . Diff: T .696 = $22.48 Answer: c 20% 2 g = s | E2 = 2. CF3 = 94. 116.576.77%.003 Numerical solution: P0  $0.73248 D3 = 0.003.475%  13. 0.54.10)2 (1.07 + (0. CF2 = 0. CF1 = 0.48%.5 = 0.Calculate the new beta: bNew = 0.0 = $2g + $15g $1.40 D1 = 0.576 $94.06 Change in stock price = $22.67 .10  0.33.$30.0.86624 1.00. I = 10.576 94. Calculate the new required rate of return: ks = 8% + (5%)1.21 = $2(1 + g) + g.73(1.31 0. Constant growth stock ˆ0 = P 115.095 = 13.19 = 19%.48.00 = -$7.

606375 = 30.05)(1.15) (1.12  0.05) D4 = D3(1.319 0.117.10)D1 . CF2 = 30.15)3 (1.1886D1  17.606375 0.87025  $25.50 Answer: b 2 g = 2 | 0.15  0. CF1 = 0. Nonconstant growth stock Time line: 0 kgs == 12% 1 g 0% 1 1 | | 0.05)(1.87 D1 = ? = 0% Answer: e 2 g2 | D2 = D1 = 5% 3 gn = 10% 4 Years | | D3 = D2(1.15)3 $49.525 = 5% 4 gn = | 0. ˆ2 = $25.87     0.87  0. I = 12.5047D1 D1  $2.10)D1 D1 D1 (1.05)D1 $49.55125 10% Diff: T 5 Years | 0.15 (1.08. P 1.10 (1.85. Inputs: CF0 = 0. P 118.87025.08.10 2 1.12 (1. 0.10) D4 ˆ3 = P 0.10 P0 = $49.6904D1  15.10 0. ˆ3 = P (1.525  $30. Nonconstant growth stock Time line: 0 ks = 15% 1 g1 | | P0 = 49. Diff: T . Output: NPV = $25.15  0.08.525 30.50 ˆ2 = ? P ˆ4  P = 0% CFt 0 5% 3 g 2 | 0.87.525.7561D1  0.8696D1  0.50 0.87025 Numerical solution: ˆ2  $0.15  0.12)2 Financial calculator solution: Calculate the PV of the stock’s expected cash flows as of time = 2.

4) = $1.071875.00 1. Nonconstant growth stock Answer: c Diff: T Use the SML equation to solve for ks: ks = 0.53. D4 = $1.725.75) = 0. Calculate dividend per share: D0 = (EPS0)(Payout ratio) = ($2.071875 = CFt 0 1. CF2 = 1.725  1.2500 1. and then solve for NPV = $18.07)  $23.00.0625 + (0.07 = $1.796875 4 Years | 1. D2 = $1. D1 = $1. g4+ = ? Answer: b Diff: T .50  1.84575 1.2500 1.25. CF1 = 1.00  1. 120.50. ˆ3  $1. CF3 = 24.50.20 = $1.5000 24.50)(0.15  0.15  0. D3 = $1.15 = 15%.05)(1. use the cash flow register to calculate PV: CF0 = 0. Stock growth rate ks = 10%. I = 15%.25. P0 = $50.5000 1.00.07 Finally. P 0.119. Calculate the dividend and price stream (once the stock becomes a constant growth stock): D0 = $1.00.7250 P0 = ? 7% 23.725(1.84575.25  1.15 = $1.25 = $1.84575 0.07 Put all the cash flows on a time line: Time line: 0 ks = 15% 1 2 3 | gs = 25% | | gs = 20% gs = 15% | gn = 1. D1 = $1.796875.

10)2 + $1.6898 = [$1.00 .5625  (1. This is the price at t = 4. 0. Step 4: Determine the stock’s price at t = 4: The PV of the stock at t = 4 must be the future value of the difference between today’s price and the PV of the dividends through t = 4.5625/(1.953125/(1.25) = $1.953125.66898 – $1.45.6898.9091 + $1.953125 = $68.25) = $1.10)4 = $66.10 + $1.1739 + $1.953125 + $1.45 = $45.25  (1. D3 = $1. D2 = $1  (1. FV = $45.0331 + $1.55.87% = g. D1 = $1.Step 1: Draw the time line: 0 ks = 10% | g = 25% s 1 2 3 4 | g = 25% | g = 25% | g = 25% | g = ? s s s n 1.5625. Preferred stock value Time line: 0 EAR = 6.g) P ˆ4 = [D4(1 + g)]/(ks .25) = $1.3340 PVdiv = $4.25.12 .25 1.4501  $4.00.10)4 PVdiv = $0. Step 5: 121.64288g $4.00/1. Determine the constant growth rate: ˆ4 = D5/(ks .953125 5 | Years P0 = 50 Step 2: Calculate the dividends: g2-4 = 25%.g) P $66.$4.953125g $6.6898g = $1.10 – g) $6.64288 = g 6.66898 – $66. ˆ4 PV P = $50.5625 1.55(1.183% 1 | | PV = ? Answer: d 2 | 3 | 4 | Diff: T 5 Years | FV = 5.7158/$68.25/(1.00 1.953125(1 + g)]/(0.000 N umerical solution: $6 Pp = = $50.10)3 + $1. D4 = $1. Step 3: Calculate the present value of these dividends: PVdiv = $1.

7 = $2.60 P0 = ? CFt 0 Answer: c = 13% = 15% 1 | 0.000 = PV(1 + 0.0.7935 11. Deposit $3.704.3415625 (1. I = 13.17.18.000 = $9.10 .Amount needed to buy 100 shares: $50(100) = $5. I = 6. we need to determine the terminal value of the stock in Year 3.4 million/(1 . Stock price--nonconstant growth Answer: b Diff: M N First. P0 = $9. value 123.69 2 3 gs = 15% gn = | | 0.06/365)5(365) $5.3498) PV = $3. CF1 = 0. P .17  1.9375  1.182  -$3.13 . Note: If the financial calculator derived EAR is expressed to five decimal places it yields a PV = -$3. Firm value Time line: ks 0 gs | 0.3415625/(0.69 0.60. and D0: Net income = $1.7935.0%.704.4573 gs = 15% 4% Diff: T 4 Years | 0.7935 0.06 = 1.69.0 million.3 = $0.4573.000.06) P ˆ3 = $33.704.000. Output: PV = -$3.9375 (0.0. NOM% = 6.18313%.704.0 million  0.3415625) Now.18.704.912525 ˆ3 = 0.18.265625 (0. FV = 5000.265625  1.6 million. Calculate PV of deposit required today: Inputs: N = 5. PMT = 0. CF2 = 0.25 = 0.000.265625) D4 = 1.4 million/0. CF3 = 11. Output: EFF% = EAR = 6. using the Year 4 dividend: ˆ3 = D4/(ks – g) P ˆ3 = $1.000.949026 = 10. total dividends.949026 Calculate required rate of return: ks = 8% + (4%)1. Calculate net income.17.000 shares = $0.170. D0 = $600.payout ratio) = $1. Dividends = $2.35 = 1. Total market Shares = P0  outstanding = $9. Output: NPV = $9.5390625.18.18313. we must find the explicit forecasted dividends: D1 = 0. $5. Financial calculator solution: Inputs: CF0 = 0.04 0. Financial calculator solution: Convert the nominal interest rate to an EAR: Inputs: P/YR = 365.75  1.54473 P 0.9375) D3 = 1. 122.25 = 13.000/1.75 D2 = 0.000 = PV(1.

43.50.50)/(1. so the value of debt and preferred stock must be deducted to arrive at the value of the firm’s common equity.5390625 $0.9375 $0.415 million.07)/(0.50. the value of the firm today = $200/(1.75 + $26. FCF model for valuing stock Answer: b ˆF3 (1. 127.13)3 + ($1.11) + $200/(1.000 = $200.35  (1.T) + Depreciation – ΔNOWC – Capital expenditures = $500.07)]/0.415. Nonconstant growth stock Answer: b Diff: M N ˆ4 = D4(1 + g)/(ks – g) = $1. + ($250 + This is the value of the total firm (debt.75. P0 = Alternatively. P (1.75/(1.1449 million  $5. CF3 = 1.10) (1.687. So. P ˆ0 = $1.$300. 126. P 125. Free cash flow Answer: b Diff: E N Diff: M N FCF1 = EBIT(1 . enter all of the dividend cash flows along with the terminal value of the stock into the cash flow register and enter the 10% cost of equity to solve for the price of the stock today: CF0 = 0. The common equity has a value of $5. calculate the stock price in Year 10: ˆ10 = D11/(ks – g) P ˆ10 = $2.687.0. CF1 = 0.06)/(0.000.61.1493 = $27.0172.265625  $33.13)4 P .715 million. you could have taken the terminal value P ˆ10 : previous question and used the constant growth rate to find P ˆ10 = P ˆ3  (1 + g)7 P ˆ10 = $33.75 + + 2 1.5391  (1. use the constant growth formula and find the price in Year 10.13 + $1.13)2 + $1. CF2 = 0.43.11 – 0.000 .6818 + $0.06)8 = $2.265625 + 33. and equity).6059  $27. I/YR = 10.06)7 P ˆ10 = $50.04 = $6.07) = [($750 .415 million – $700 million = $4. So.($1.$500) ˆ3 = FC Using the FCF model.10 .61. P ˆ3 calculated in the Alternatively.11) 2 $6.10)3 = $0. and then solve for NPV = $27.000. In order to find the value in Year 10. preferred stock.000.000.06) = $26.10 (1. the price/share = $4.7748 + $26.8046875.13 – 0.25  1.5390625 = 34.9375. 124.06) P ˆ10 = $50. determine the dividend in Year 11: D11 = 0. this stock will be a constant growth stock.75(1.75/(1. Therefore.0172/(0. Future stock price--constant growth Answer: c Diff: M N In 10 years.11)3 = $5. which is the value of the firm at t = 3 after the dividend is received.15. Now.50)/(1.75  1.715 million/100 million = $47.75/1.

5487 + $1.4583  $21.3705 + $19.75/(1. Future stock price--nonconstant growth Answer: b ˆ1 = $1.13 + $1.50)/(1.ˆ0 = $1.3705 + $1.2128 + $17.75/1.50.75 + $26.13)2 + ($1. P 128.5487 + $1.4979  $22.13)3 P ˆ1 = $1.3263 P ˆ0 = $21.5787 P ˆ1 = $22. P Diff: M N .46.