Chapter 6
Stock Valuation

1. Holders of equity have claims on both income and assets that are secondary to the
TRUE
claims of creditors.
2. The tax deductibility of interest lowers the cost of debt financing, thereby causing the
TRUE
cost of debt financing to be lower than the cost of equity financing.
3. Preferred stock is a special form of stock having a fixed periodic dividend that must
FALSE
be paid prior to payment of any interest to outstanding bonds.
4. Cumulative preferred stocks are preferred stocks for which all passed (unpaid)
dividends in arrears must be paid in additional shares of preferred stock prior to the FALSE
payment of dividends to common stockholders.
5. The free cash flow valuation model determines the value of an entire company as the
present value of its expected free cash flows discounted at the firm’s weighted average TRUE
cost of capital.
6. A common stockholder has no guarantee of receiving any cash inflows, but receives
TRUE
what is left after all other claims on the firm’s income and assets have been satisfied.
7. To a buyer, an asset’s value represents the minimum price that he or she would pay
FALSE
to acquire it, while a seller views the asset’s value as a minimum share price.
8. If the expected return is less than the required return, investors will sell the asset,
TRUE
because it is not expected to earn a return commensurate with its risk.
9. If the expected return were above the required return, investors would buy the asset,
TRUE
driving its price up and its expected return down.
10. In valuation of common stock, the price/earnings multiple approach is considered
TRUE
superior to the use of book or liquidation values since it considers expected earnings.
11. The common stock book value model ignores the firm’s expected earnings potential
TRUE
and generally lacks any true relationship to the firm’s value in the marketplace.
12. Any action taken by the financial manager that increases risk will also increase the
TRUE
required return.
13. In common stock valuation, any action taken by the financial manager that increases
TRUE
risk will also increase the required return.
14. In common stock valuation, any action taken by the financial manager that increases
FALSE
risk contributes toward an increase in value.
15. In a stable economy, an action of the financial manager that increases the level of
expected return without changing risk should reduce share value, and an action that FALSE
reduces the level of expected return without changing risk should increase share value.
16. Interest paid to bondholders is tax deductible but interest paid to stockholders is not. FALSE
17. Interest paid to bondholders is tax deductible but dividends paid to stockholders are TRUE
not.
18. The dividend discount model indicates that the value of a stock is the present value of TRUE
the dividends it will pay over the investor's horizon plus the present value of the
expected stock price at the end of that horizon.
19. If investors believe a company will have the opportunity to make very profitable TRUE
investments in the future, they will pay more for the company's stock today.

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20. The dividend discount model should not be used to value stocks in which the dividend FALSE
does not grow.
21. According to the dividend discount model, a stock's price today depends on the FALSE
investor's horizon for holding the stock.
22. The dividend yield of a stock is much like the current yield of a bond. Both ignore TRUE
prospective capital gains or losses
23. The dividend discount model states that today's stock price equals the present value TRUE
of all expected future dividends
24. An excess of market value over the book value of equity can be attributed to going TRUE
concern value.
25. Securities with the same expected risk should offer the same expected rate of return. TRUE
26. The liquidation value of a firm is equal to the book value of the firm. FALSE
27. Market price is not the same as book value or liquidation value. TRUE
28. Market value, unlike book value and liquidation value, treats the firm as a going TRUE
concern.
29. At each point in time all securities of the same risk are priced to offer the same TRUE
expected rate of return
30. The constant growth model is an approach to dividend valuation that assumes a FALSE
constant future dividend.
31. The constant growth model is an approach to dividend valuation that assumes that TRUE
dividends grow at a constant rate indefinitely.
32. The free cash flow valuation model is based on the same principle as the P/E valuation FALSE
approach; that is, the value of a share of stock is the present value of future cash flows.
33. The free cash flow valuation model is based on the same principle as dividend TRUE
valuation models; that is, the value of a share of stock is the present value of future
cash flows.
34. The book value per share of common stock is the amount per share of common stock TRUE
that would be received if all of the firm’s assets were sold for their accounting value
and the proceeds remaining were divided among common stockholders.

1. What dividend yield would be reported in the financial press for a stock that currently
pays a $1 dividend per quarter and the most recent stock price was $40?
a) 2.5% b) 4.0%
c) 10.0% d) 15.0%
$1 dividend per quarter = $4 annually
$4/$40 = 10% dividend yield
2. How much should you pay for a share of stock that offers a constant-growth rate of
10%, requires a 16% rate of return, and is expected to sell for $50 one year from now?
a) $42.00 b) $45.00
c) $45.45 d) $47.00
The easiest way to solve this problem is to realize:
Expected return = expected dividend yield + expected capital appreciation
Then:
.16 = .06 + expected capital appreciation
.10 = expected capital appreciation
And
P1= 110% of P0
$50.00 = 1.1P0

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$45.45 = P0
3. 33. How is it possible to ignore cash dividends that occur far into the future when using
a dividend discount model? Those dividends:
a) will be paid to a different investor b) will not be paid by the firm
c) have an insignificant present d) ignore the tax consequences of
value. future dividends
4. If the dividend yield for year 1 is expected to be 5% based on the current price of $25,
what will the year 4 dividend be if dividends grow at a constant 6%?
a) $1.33 b) $1.49
c) $1.58 d) $1.67
.05  $25 = $1.25 = DIV1
Then, DIV4 = $1.25  (1.06) 3 = $1.49
5. The value of common stock will likely decrease if:
a) the investment horizon decreases. b) the growth rate of dividends
increases.
c) the discount rate increases. d) dividends are discounted back to the
present.
6. 36. When valuing stock with the dividend discount model, the present value of future
dividends will:
a) change depending on the time b) remain constant regardless of the
horizon selected. time horizon selected.
c) remain constant regardless of growth d) always equal the present value of the
rate. terminal price
7. Common stock can be valued using the perpetuity valuation formula if the:
a) discount rate is expected to remain b) dividends are not expected to
constant. grow.
c) growth rate in dividends is not d) investor does not intend to sell the
constant. stock.
8. What should be the price for a common stock paying $3.50 annually in dividends if the
growth rate is zero and the discount rate is 8%?
a) $22.86 b) $28.00
c) $42.00 d) $43.75

9. If next year's dividend is forecast to be $5.00, the constant-growth rate is 4%, and the
discount rate is 16%, then the current stock price should be:
a) $31.25 b) $40.00
c) $41.67 d) $43.33

10. What price would you expect to pay for a stock with 13% required rate of return, 4%
rate of dividend growth, and an annual dividend of $2.50 which will be paid tomorrow?
a) $27.78 b) $30.28
c) $31.10 d) $31.39

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11. What constant-growth rate in dividends is expected for a stock valued at $32.00 if next
year's dividend is forecast at $2.00 and the appropriate discount rate is 13%?
a) 5.00% b) 6.25%
c) 6.75% d) 15.38%

12. ABC common stock is expected to have extraordinary growth of 20% per year for 2
years, at which time the growth rate will settle into a constant 6%. If the discount rate is
15% and the most recent dividend was $2.50, what should be the approximate current
share price?
a) $31.16 b) $33.23
c) $37.42 d) $47.77

13. What would be the approximate expected price of a stock when dividends are expected
to grow at a 25% rate for 3 years, then grow at a constant rate of 5%, if the stock's
required return is 13% and next year's dividend will be $4.00?
a) $61.60 b) $62.08
c) $68.62 d) $79.44

14. What happens to a firm that reinvests its earnings at a rate equal to the firm's required
return?

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a) Its stock price will remain b) Its stock price will increase by the
constant. sustainable growth rate
c) Its stock price will decline unless d) Its stock price will decline unless
dividend payout ratio is zero. plowback rate exceeds required
return
15. What can be expected to happen when stocks having the same expected risk do not
have the same expected return?
a) At least one of the stocks becomes b) This is a common occurrence
temporarily mispriced indicating that one stock has more
PVGO
c) This cannot happen if the shares are d) The expected risk levels will change
traded in an auction market until the expected returns are equal
16. Dividends that are expected to be paid far into the future have:
a) great impact on current stock price b) Equal impact on current stock price
due to their expected size. as near-term dividends
c) lesser impact on current stock d) no impact on current stock price
price due to discounting because they are uncertain.
17. What is the expected constant-growth rate of dividends for a stock with current price of
$100, expected dividend payment of $10 per share, and a required return of 16%?
a) 6.00% b) 6.25%
c) 8.00% d) 10.00%
If the $10 dividend were divided by .10, it would equal the $100 price. Thus, 6% is the
only growth rate that will allow the denominator to equal .10
18. Which of the following is least assured for firms that plowback a portion of earnings
into the firm?
a) Growth in earnings per share b) Growth in dividends per share
c) Growth in book value of equity d) Growth in stock price
19. What should be the price of a stock that offers a $4 annual dividend with no prospects
of growth, and has a required return of 12.5%?
a) $8.50 b) $25.00
c) $32.00 d) $50.00
P = $4/.125
P = $32
20. What should be the stock value one year from today for a stock that currently sells for
$35, has a required return of 15%, an expected dividend of $2.80, and a constant
dividend growth rate of 7%?
a) $37.45 b) $37.80
c) $40.25 d) $43.05
$35  1.07 = $37.45, since dividends, price, and book value grow at 7%

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