Chapter 8.

Stock valuation

Multiple Choice Questions

1. The stock valuation model that determines the current stock price by dividing the next annual dividend amount by
the excess of the discount rate less the dividend growth rate is called the _____ model. B. dividend growth

2. Next year's annual dividend divided by the current stock price is called the: C. dividend yield.

3. The rate at which a stock's price is expected to appreciate (or depreciate) is called the
_____ yield. D. capital gains

4. A form of equity which receives no preferential treatment in either the payment of dividends or in bankruptcy
distributions is called _____ stock.
E. common

5. The voting procedure whereby shareholders may cast all of their votes for one member of the board is called _____
voting.
B. cumulative

6. The voting procedure where you must own fifty percent plus one of the outstanding shares of stock to guarantee
that you will win a seat on the board of directors is called _____ voting.
C. straight

7. The voting procedure where a shareholder grants authority to another individual to vote his or her shares is called
_____ voting.
E. proxy

8. Payments made by a corporation to its shareholders in the form of either cash or shares of stock are called:
C. dividends.

9. A _____ is a form of equity security that has a stated liquidating value.

E. preferred stock

10. The market in which new securities are originally sold to investors is called the _____
market.
E. primary

11. The market in which previously issued securities are traded among investors is called the
_____ market.
D. secondary

12. An agent who buys and sells securities from inventory is called
E. dealer.

13. An agent who arranges a trade between a buyer and a seller is called a:
A. broker
14. The owner of a NYSE trading license is called a(n) _____ of the exchange.
B. member
15. A member of the New York Stock Exchange who executes buy and sell orders from customers once
transmitted to the exchange floor is called a:
E. commission broker.

16. A member of the NYSE acting as a dealer in one or more securities on the exchange floor is called a:
C. specialist.

17. A floor broker is a NYSE member who:

C. executes orders on behalf of a commission broker.

18. A member of the NYSE who tries to anticipate price fluctuations and buys and sells accordingly for his or
her personal account is called a(n):
A. floor trader.

19. The electronic system used by the NYSE which enables orders to be transmitted directly to a specialist is called
the _____ system.
B. SuperDOT

20. The stream of customer buy and sell orders for securities is referred to as the:
C. order flow.

21. The specific location on the trading floor of the NYSE where a particular stock is traded is commonly referred to
as the:
D. specialist's post.

22. A securities market primarily comprised of dealers who buy and sell for their own inventories is generally
referred to as a(n) ___ market.
C. over-the-counter

23. An ECN is best described as:

D. a website which allows investors to trade directly with one another.

24. The inside quotes for a security are the:

C. highest bid quote and the lowest asked quote.

25. The Great Northern Fish Co. pays an annual dividend of $2 per share on its common stock. This dividend amount
has been constant for the past ten years and is expected to remain constant. Given this, one share of the firm's stock:
C. is valued as if the dividend paid is a perpetuity.

26. The common stock of Ruby Janes pays a constant annual dividend. Thus, the market price of Ruby Janes stock
will:
E. decrease when the market rate of return increases.

27. Billings Enterprises currently pays an annual dividend of $1.64 and plans on increasing that amount by 4 percent
each year. Chester's Fried Chicken currently pays an annual dividend of $1.75 and plans on increasing their dividend by
3 percent annually. Given this, it can be stated with certainty that the _____ of Billings Enterprises stock is greater than
the
_____ of Chester's Fried Chicken stock.
C. rate of capital gain; rate of capital gain

28. The dividend growth model:

I. assumes that dividends increase at a constant rate forever.
II. can be used to compute a stock price at any point in time.
III. states that the market price of a stock is only affected by the amount of the dividend.
IV. considers capital gains but ignores the dividend yield.
D. I and II only

29. The underlying assumption of the dividend growth model is that a stock is worth: B. the present value of
the future cash flows which it generates.

30. Assume you are using the dividend growth model to value stocks. If you expect the market rate of return to
increase across the board on all equity securities, then you should also expect the:
C. market values of all stocks to decrease.

31. Ernie's Auto Sales is a relatively new firm that is still in a period of rapid growth. The company plans on
retaining all of its earnings for the next four years. Five years from now, the company projects paying an annual
dividend of $.20 a share and then increasing that amount by 3.5 percent annually thereafter. To value this stock as of
today, you would most likely determine the value of the stock _____ years from today before determining today's
value.
B. 4

32. Stanwycke Publishers currently pays no dividend. The company is anticipating dividends of $0.68, $0.70, $0.85,
$.90, and $1 over the next five years, respectively. After that, the company anticipates increasing the dividend by 4
percent annually. The first step in computing the value of this stock today is to compute the value of the stock in year:
C. 5.

33. Supernormal growth refers to a firm that increases its dividend by:
B. a rate which is most likely not sustainable over an extended period of time.

34. The total rate of return earned on a stock is comprised of which two of the following?
I. current yield
II. yield to maturity III. dividend yield IV.
capital gains yield
E. III and IV only

35. The total rate of return on a stock can be positive even when the price of the stock depreciates because of
the:
C. dividend yield.
d. supernormal growth. e. real rate of return.

36. The two-stage growth model evaluates the current price of a stock based on the assumption the stock
will:
D. grow at a fixed rate for a period of time after which it will continue growing but at a different rate.

37. Which one of the following sets of dividend payments best meets the definition of two-stage growth as it
applies to the two-stage growth dividend model?
E. dividend payments which increase by 10 percent for three years followed by dividends which increase by 4
percent annually thereafter

38. Shareholders in a leveraged corporation generally have the right to:

C. elect the corporate directors.
39. Terri owns 45 shares of stock in Winsum Ventures and wants to win a seat on the board of directors. Winsum
Ventures has a total of 200 shares of stock outstanding. Each share receives one vote. Presently, the company is voting to
elect four new directors. Which one of the following statements must be true given this information?
D. If cumulative voting applies, Terri is assured one seat on the board.

40. Cantweiler Industries is owned by a group of shareholders who all vote independently and who all want personal
control over the firm. If straight voting is utilized, a shareholder:
A. must individually own sufficient shares to totally control the outcome of the entire election process if he or she is to
control the outcome of any one election.

41. Brownstone United has 1,000 shareholders and is preparing to elect three new board members. You do not own
enough shares to control the elections but are determined to oust the current leadership. Likewise, no other single
shareholder owns sufficient shares to personally control the outcome of the election. The most likely result of this
situation is a(n):
E. proxy fight for control of the firm.

42. Berber Mills has a capital structure which includes bonds, preferred stock, and common stock. The firm's
common stock shareholders are most to apt to have which of the following rights?
I. right to all the corporate profits
II. sole right to elect the corporate directors III. right to vote on
proposed mergers
IV. right to the residual assets in a liquidation
D. II, III, and IV only

43. The Denver Post has a general dividend policy whereby the firm pays a constant annual dividend of $1.50 per
share of common stock. The firm has 2,000 shares of stock outstanding. The company:.
B. must still declare each dividend before it becomes an actual company liability

44. The dividends paid by a corporation:

I. to an individual become taxable income of that individual.
II. reduce the taxable income of the corporation.
III. are declared by the chief financial officer of the corporation.
IV. to another corporation receive preferential tax treatment.
B. I and IV only

45. The owner of preferred stock:

A. is entitled to a distribution of income prior to the common shareholders.

46. A 7 percent preferred stock pays a total of _____ a year in dividends per share. Assume dividends are paid
quarterly.
B. $7.00

47. Preferred shareholders are granted:

A. the right to dividends prior to common shareholders.

48. In a liquidation, each share of 6 percent preferred stock is generally entitled to a liquidation payment of
_____ as long as there are sufficient funds available.
E.$100

49. Which of the following are correct statements concerning corporate dividends?
I. Dividends are generally treated as ordinary income for individual shareholders.
II. Dividends are a liability of a corporation only after they have been declared.
III. Dividends are a tax deductible expense once they have been paid.
IV. Dividends receive preferential treatment when they become corporate income.
C. I, II, and IV only

50. Which one of the following transactions occurs in the primary market?
D. the initial sale of MG stock to Katie by MG Enterprises

51. Which one of the following statements concerning dealers and brokers is correct? B. A dealer in market
securities pays the bid price when purchasing securities.

52. The actual owners of the New York Stock Exchange are the:
E. shareholders of the NYSE Group, Inc.

53. Which one of the following players on the floor of the New York Stock Exchange can be likened to part-time
help in that they are called to duty only when others are fully employed?
D. floor broker
e. commission broker

54. The post is a stationary position on the floor of the New York Stock Exchange where a
_____ is assigned to work.
B. specialist

55. The closing price of a stock is quoted at 42.55, with a P/E of 18 and a net change of 0.30. Based on this
information, which one of the following statements is correct?
C. Yesterday's closing price was $0.30 less than today's closing price.

56. Which one of the following correctly applies to the NYSE?

C. The NYSE is a public corporation with shares trading on the exchange floor.
d. The order flow is limited to 100 million shares per day.
e. Recently, the role of the floor broker has taken on increased significance.

57. The floor of the NYSE trading room:

A. includes an area commonly referred to as "the Garage".

58. Gerold's Travel Service just paid $1.79 to its shareholders as the annual dividend. Simultaneously, the company
announced that future dividends will be increasing by 3.2 percent. If you require a 10.5 percent rate of return, how much
are you willing to pay to purchase one share of this stock?
E.$25.31

59. Jessica's Pharmacy made two announcements concerning their common stock today. First, the company
announced the next annual dividend will be $1.48 a share. Secondly, all dividends after that will increase by 2.5 percent
annually. What is the maximum amount you should pay to purchase a share of this stock if your goal is to earn a 12
percent rate of return?
D. $15.58

60. How much are you willing to pay for one share of Delphia stock if the company just paid a $1.34 annual
dividend, the dividends increase by 2.8 percent annually, and you require a 14 percent rate of return?
C. $12.30

61. Textile Importers paid a $1.60 per share annual dividend last week. Dividends are expected to increase by 4
percent annually. What is one share of this stock worth to you today if your required rate of return is 13.5 percent?
B. $17.52

62. Elegante Homes stock traditionally provides a 16 percent rate of return. The company just paid an annual dividend
of $3.20 a share and is expected to increase that amount by 5 percent per year. If you are planning to buy 1,000 shares of
this stock next year, how much should you expect to pay per share if the market rate of return for this type of security is 9
percent at the time of your purchase?
E. $88.20

63. The Good Life offers a common stock that pays an annual dividend of $2 a share. The company has promised to
maintain a constant dividend. How much are you willing to pay for one share of this stock if you want to earn a 9 percent
return on your equity investments?
A. $22.22

64. The Row Boat has paid annual dividends of $.48, $0.60, and $0.62 a share over the past three years, respectively.
The company now predicts that it will maintain a constant dividend since its business has leveled off and sales are
expected to remain relatively constant. Given the lack of future growth, you will only buy this stock if you can earn at
least a 14 percent rate of return. What is the maximum amount you are willing to pay for one share of this stock today?
C. $4.43

65. The common stock of BJ's Auto Clinic sells for $38.25 a share. The stock is expected to pay $1.90 per share next
month when the annual dividend is distributed. BJ's has established a pattern of increasing their dividends by 2.5 percent
annually and expects to continue doing so. What is the market rate of return on this stock?
D. 7.47 percent

66. The current yield on Martin's Mills common stock is 3.6 percent. The company just paid a $1.80 dividend and
plans to pay $1.86 next year. The dividend growth rate is expected to remain constant at the current level. What is the
required rate of return on this stock?
E. 7.05 percent

67. Lake Shore Vineyards recently paid a $4.20 annual dividend on their common stock. This dividend increases at an
average rate of 4.2 percent per year. The stock is currently selling for $80.65 a share. What is the market rate of return?
E. 9.63 percent

68. Alaskan Foodstuffs just announced the annual dividend for this coming year will be $0.36 a share and all future
dividends are expected to increase by 4.5 percent annually. What is the market rate of return if the stock is currently
selling for $12.20 a share?
A. 7.45 percent

69. Shares of common stock of the Windy Farms offer an expected total return of 13.8 percent. The dividend is
increasing at a constant 4.2 percent per year. What is the dividend yield?
B. 9.60 percent

70. The common stock of Jesup's returned a nifty 24.6 percent rate of return last year. The dividend amount was
$0.40 a share which equated to a dividend yield of 0.6 percent. What was the rate of price appreciation for the year?
B. 24.0 percent
g = .246 .006 = .24 = 24.0 percent

71. RTF, Inc. common stock sells for $22 a share and pays an annual dividend that increases by 3.8 percent
annually. The market rate of return on this stock is 8.2 percent. What is the amount of the last dividend paid?
C. $0.93
72. The common stock of Flo's Flowers pays an annual dividend that is expected to increase by 3.6 percent per year.
The stock commands a market rate of return of 11.6 percent and sells for $37.80 a share. What is the expected amount of
the next dividend?
B. $3.02

73. The Home Market has adopted a policy of increasing the annual dividend on their common stock at a
constant rate of 3.75 percent annually. The firm is paying an annual dividend of $1.10 today. What will the
dividend be five years from now?
C. $1.32
D5 = $1.10 (1.0375)5 = $1.32

74. A stock pays a constant annual dividend and sells for $28.80 a share. If the market rate of return on this stock is
7.2 percent, what is the dividend amount?
C. $2.07

75. You have decided you would like to own some shares of the Clean Coal Company but
need a 16 percent rate of return to compensate for the perceived risk of such ownership. What is the maximum you are
willing to spend per share to buy this stock if the company pays a constant $1.75 annual dividend per share?
B. $10.94

76. The Herb Garden common stock sells for $43.70 a share and has a market rate of return of
11.6 percent. The company just paid an annual dividend of $1.42 per share. What is the dividend growth rate?
D. 8.09 percent e. 8.14 percent

77. KB Adventures will pay an annual dividend of $3.15 a share on their common stock next week. Last year, the
company paid a dividend of $3.00 a share. The company adheres to a constant rate of growth dividend policy. What will
one share of this common stock be worth ten years from now if the applicable discount rate is 12.5 percent?
D. $68.41

78. Tom's Health Clinic just paid a $4.40 annual dividend. The company has a policy of increasing the dividend by 4
percent annually. You would like to purchase 100 shares of stock in this firm but realize that you will not have the funds
to do so for another two years. If you require a 14 percent rate of return, how much will you be willing to pay for the 100
shares when you can afford to make this investment?
B. $4,949

79. Franktown Meats just announced that they are increasing the annual dividend to $1.75 and establishing a policy
whereby the dividend will increase by 2 percent annually thereafter. How much will one share of this stock be worth six
years from now if the required rate of return is 14.5 percent?
D.$15.77

80. Shares of Do Naught common stock are currently selling for $46.90. The last dividend paid was $2.21 per
share and the market rate of return is 15.8 percent. At what rate is the dividend growing?
C. 10.59 percent

81. Cellular Talk is a new firm in a rapidly growing industry. The company is planning on increasing its annual
dividend by 25 percent a year for the next three years and then decreasing the growth rate to 6 percent per year. The
company just paid its annual dividend in the amount of $0.80 per share. What is the current value of one share of this
stock if the required rate of return is 17 percent?
B. $12.14
82. J&J Exporters paid a $1.80 per share annual dividend last month. The company is planning on paying $2.00,
$2.50, $2.75, and $3.00 a share over the next four years, respectively. After that the dividend will be constant at $3.20
per share per year. What is the market price of this stock if the market rate of return is 13 percent?
D. $22.57

83. Nu-Tek, Inc. is preparing to pay their first dividend. They are going to pay $0.60, $1.20, and $1.50 a share over
the next three years, respectively. After that, the company has stated that the annual dividend will be $2 per share
indefinitely. What is this stock worth to you per share if you demand a 16 percent rate of return on stocks of this type?
E. $10.38

84. The Slim Waist announced today that they will begin paying annual dividends. The first dividend will be paid next
year in the amount of $.35 a share. The following dividends will be $.40, $.55, and $.70 a share annually for the
following three years, respectively. After that, dividends are projected to increase by 2.5 percent per year. How much are
you willing to pay to buy one share of this stock if your desired rate of return is 12 percent?
E. $6.27

85. Gloria's Boutique recently paid $1.65 as an annual dividend. Future dividends are projected at $1.68, $1.72, $1.76,
and $1.80 over the next four years, respectively. Beginning five years from now, the dividend is expected to increase by
2.5 percent annually. What is one share of this stock worth to you if you require an 11 percent rate of return on similar
investments?
B. $19.68

86. Su Lee's Cookware pays a constant dividend of $0.75 a share. The company announced today that they will
continue to pay this for another 3 years after which time they will discontinue operations. What is one share of this
stock worth today if the required rate of return is 18 percent?
A. $1.63

87. Bliley Plumbers pays no dividend at the present time. The company plans to start paying an annual dividend in
the amount of $0.20 a share for three years commencing three years from today. After that time, the company plans on
paying a constant $1 a share dividend indefinitely. How much are you willing to pay to buy a share of this stock if your
required return is 15 percent?
A. $3.66

88. The Coal Bin is in a downsizing mode. The company paid a $1.40 annual dividend last year. The company has
announced plans to lower the dividend by $.20 a year. Once the dividend amount becomes zero, the company will cease
all dividends and go out of business. You have a required rate of return of 18 percent on this particular stock given the
company's situation. What is the minimum price you would like to receive if you were to sell your shares in this firm
today?
C. $2.78

89. Simplicity is a relatively new firm that appears to be on the road to great success. The company paid their first
annual dividend yesterday in the amount of $0.15 a share. The company plans to double each annual dividend payment
for the next four years. After that time, they are planning on paying a constant dividend of $2.50 per share indefinitely.
What is one share of this stock worth today if the market rate of return on similar securities is 13.45 percent?
D. $14.22

90. The Music Hut just paid an annual dividend of $1.05 a share. The projected dividends for the next five years are
$1.07, $1.10, $1.15, $1.20, and $1.25, respectively. After that time, the dividends will be held constant at $1.40 per share.
What is this stock worth today at a 12.5 percent discount rate?
B. $10.29

91. Home Builders, Inc. is a very cyclical type of business which is reflected in their dividend policy. The firm pays a
$3.50 per share dividend every other year. The last dividend was paid last year. Four years from now, the company plans
to pay a $77 liquidating dividend per share. What is the current market value of this stock if the market rate of return is
18.5 percent?
C. $44.11

92. Last week, Northern Railways paid an annual dividend of $2.44 per share. The company has been reducing the
dividends by 15 percent each year. How much are you willing to pay to purchase stock in this company if your required
rate of return is 16 percent?
A. $6.69

93. Super Sounds is expecting a period of intense growth and has decided to retain more of their earnings to help
finance that growth. As a result, they are going to reduce the annual dividend by 20 percent a year for the next three
years. After that they will maintain a constant dividend of $1 a share. Last year, the company paid $2.25 as the annual
dividend per share. What is the market value of this stock if the required rate of return is 16 percent?
B. $7.36

94. Shirley's Cool Treats is expecting their ice cream sales to decline due to the increased interest in healthy eating.
Thus, the company has announced that they will be reducing their annual dividend by 4 percent a year for the next four
years. After that, they will maintain a constant dividend of $1 a share. Last year, the company paid $1.80 per share.
What is this stock worth to you if you require a 12 percent rate of return?
B. $10.27

95. Wenton & Straus wants to issue preferred stock that pays an annual dividend of $6 a share. The company has
determined that stocks with similar characteristics provide a 14.8 percent rate of return. What should the offer price
be?
C. $40.54

96. The preferred stock of West Coast Limited pays an annual dividend of $5.50 and sells for $52 a share. What is
the rate of return on this security?
D. 10.58 percent

97. Stu owns shares of Markley preferred stock which he says provides him with a constant
13.6 percent rate of return. The stock is currently priced at $51.47 a share. What is the amount of the dividend per share?
E. $7.00

98. Wilmington Importers preferred stock pays a $5 annual dividend. What is the maximum price you are willing to
pay for one share of this stock if your required return is 15.5 percent? A. $32.26

Essay Questions

99. What are the primary differences between NASDAQ and the NYSE?

The NYSE has a physical trading floor in New York City, is a dealer market, relies on specialists and brokers, and utilizes
the SuperDOT system. NASDAQ is an electronic network of dealers and utilizes a multiple market maker system.
NASDAQ has no physical trading floor.

100. What are the components of the total rate of return on a share of stock? Briefly explain each component.

The two components are the dividend yield and the capital gains yield. The dividend yield is the percentage of the
current stock price which is expected to be distributed next year as a dividend. The dividend yield is expressed as D t+1 /
Pt. The capital gains yield is the change in the stock price expressed as a percentage of the current stock value. The
capital gains yield is expressed as (Pt+1 Pt) / Pt.

101. Briefly explain the differences between preferred and common stock.
Common stockholders have the right to vote on corporate matters and have the right to receive the residual value of the
firm after all liabilities and preferred stockholders are paid in a liquidation. Preferred stockholders have a promised
dividend, may or may not have the right to collect dividends that have been passed, and typically will be rated much like
bonds. In a liquidation, preferred shareholders have a preference over common stockholders.

102. Explain whether it is easier to find the required return on a publicly traded stock or a publicly traded bond,
and explain why.

Bonds, unlike stocks, have a final maturity date and promised payments at fixed periods of time. Thus, once an
appropriate discount rate is established, valuing a bond is relatively simple. For stocks, the only valuation model we have
up to this point in the text is the dividend growth model which requires estimation of a dividend growth rate and also
requires that the growth rate be less than the required return. Normally, all of the information required to find the yield
on a publicly traded bond is publicly available while only the price and the most current dividend are available for
stocks.

103. A number of publicly traded firms pay no dividends yet investors are willing to buy shares in these firms.
How is this possible? Does this violate our basic principle of stock valuation? Explain.

The basic principle of stock valuation computes the value of a share of stock as the present value of all the expected
dividends on the stock. According to the dividend growth model, an asset that has no expected cash flows has a value of
zero. If investors are willing to purchase shares of stock in firms that pay no dividends, they must expect the firms will
begin paying dividends at some point in the future.

104. Explain the primary change that occurred in the structure of the NYSE in 2006 and how that change affected the
exchange members.

In 2006, the NYSE become a publicly owned corporation called NYSE Group, Inc. Exchange members no longer
purchase, or own, seats on the exchange. Members now purchase trading licenses which grant their owners the right to
transact trades on the floor of the exchange.