Investments An Introduction 12th

Edition Mayo Test Bank

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 Chapter 9 The Valuation of Stock

TRUE/FALSE

T 1. The expected return depends on future dividends and

future price appreciation.

T 2. The dividend-growth valuation model employs current

dividends, future dividend growth, and the required return.

F 3. The dividend-growth model includes both the current

and past years' dividends.

T 4. If the anticipated return exceeds the required rate

of return, the investor should buy the stock.

F 5. The dividend-growth model requires that dividends grow

annually at the same rate.

F 6. A higher beta decreases the required rate of return.

T 7. The required return includes the risk-free rate and a

risk premium.

T 8. An increase in the risk-free rate will tend to

decrease stock prices.

F 9. High P/E stocks should be preferred because they pay

larger dividends.

T 10. Value investors tend to prefer stocks with low price

to sales and price to book ratios.

F 11. The PEG ratio multiplies a stock’s earnings, price,

and growth rate.

T 12. The efficient market hypothesis suggests that the

current prices of stocks reflect what the investment
community believes the stocks are worth.

T 13. According to the efficient market hypothesis,

purchasing high P/E stock should not produce superior
investment results.

F 14. According to the efficient market hypothesis,

purchasing low P/S stocks should produce superior investment
results.
F 15. According to the efficient market hypothesis,
purchasing companies with high cash flow should produce
superior investment results.

MULTIPLE CHOICE

a 1. According to the dividend-growth model, the valuation

of common stock depends on
1. the firm's dividends
2. investors' required rate of return
3. the prior year's dividends
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. all of the above

c 2. If the required rate of return is 10 percent and the

stock pays a fixed $5 dividend, its value is
a. $100
b. $75
c. $50
d. $25

c 3. The risk-adjusted required rate of return includes

1. the firm's earnings
2. the firm's beta coefficient
3. the treasury bill rate (i.e., the risk-free rate)
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. all of the above

d 4. A stock's price will tend to fall if

1. the firm's beta declines
2. the firm's beta increases
3. the risk-free rate declines
4. the risk-free rate increases
a. 1 and 3
b. 1 and 4
c. 2 and 3
d. 2 and 4
c 5. A P/E ratio depends on
1. the firm's dividends
2. the price of the stock
3. the firm's per share earnings
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. all of the above

c 6. The use of P/E ratios to select stocks suggests that

a. high P/E stocks should be purchased
b. low P/E ratio stocks are overvalued
c. a stock should be purchased if it is selling
near its historic low P/E
d. a stock should be purchased if it is selling
near its historic high P/E

d 7. The use of price to book ratios to select stocks

suggests that
a. high price to book stocks are undervalued
b. low price to book stocks are overvalued
c. a stock should be purchased if it is selling near
its historic high price to book ratio
d. a stock should be purchased if it is selling near
its historic low price to book ratio

a 8. Higher required returns

a. decrease stock prices
b. are required by the efficient market hypothesis
c. increase dividends
d. are associated with higher dividends

d 9. If the financial markets were not efficient,

a. all investors would profit
b. prices indicate the proper valuation of securities
c. prices would adjust rapidly
d. an investor may consistently outperform the market

b 10. Use of P/E ratios will not produce superior

investment results according to the
a. weak form of the efficient market hypothesis
b. semi-strong form of the efficient market
hypothesis
c. strong form of the efficient market hypothesis
d. all forms of the efficient market hypothesis
d 11. A low price to sales ratio suggests
a. the firm is generating cash
b. the firm has no earnings
c. the stock valuation is too high
d. the stock may be undervalued

b 12. The price to sales ratio may be a preferred

analytical tool if
a. the firm is not generating cash
b. the firm is not generating earnings
c. the P/E ratio is too high
d. the dividend-growth model suggests the stock is
undervalued

c 13. Investors may use P/E and price/sales ratios to

value stocks. If this analysis is used, which of the
following is desirable?
a. a high P/E and a low price/sales ratio
b. a high P/E and a high price/sales ratio
c. a low P/E and a low price/sales ratio
d. a low P/E and a high price/sales ratio

c 14. Ifthe ratio of price to book exceeds 1.0,

a.the stock is overvalued
b.the firm's assets are understated
c.the price of the stock is greater than the
accounting value of the firm
d. the accounting value of the firm is greater
than the market value of the firm

PROBLEMS

1. Your broker recommends that you purchase XYZ Inc. at

$60. The stock pays a $2.40 dividend which (like its per
share earnings) is expected to grow annually at 8 percent.
If you want to earn 12 percent on your funds, is this a good
buy?

2. If you purchase TrisCorp stock at $71 a share and the

firm pays a $5.20 dividend which is expected to grow at 7.5
percent, what is the implied annual rate of return on the
investment?
3. As an investor you have a required rate of return of 14
percent for investments in risky stocks. You have analyzed
three risky firms and must decide which (if any) to
purchase. Your information is
Firm A B C
Current dividends $1.00 $3.00 $7.50
Expected annual growth 7% 2% (-1%)
rate in dividends
Current market price $23 $47 $60

a. What is your valuation of each stock using the dividend-

growth model? Which (if any) should you buy?

b. If you bought Stock A, what is your implied rate of

return?

c. If your required rate of return were 10 percent, what

should be the price necessary to induce you to buy Stock A?

4. You know the following concerning a common stock:

EPS $3.00
Payout ratio 25%
P/E 10
Annual rate of growth of 6%
earnings and dividends

If you want to earn 10 percent, should you buy this stock?

What is the maximum price you should be willing to pay for
the stock?

5. The risk-free rate of return is 8 percent; the expected

rate of return on the market is 12 percent. Stock X has a
beta coefficient of 1.3, an earnings and dividend-growth
rate of 7 percent, and a current dividend of $2.40. If the
stock is selling for $35, what should you do?
6. Two stocks each pay a $1 dividend that is growing
annually at 8 percent. Stock A has a beta of 1.3; stock B's
beta is 0.8.

a. Which stock is more volatile?

b. If treasury bills yield 6 percent and you expect the

market to rise by 12 percent, what is your risk-adjusted
required rate of return?

c. Using the dividend-growth model, what is the maximum

amount you would be willing to pay for each stock?

d. Why are your valuations different?

7. Presently, Stock A pays a dividend of $2.00 a share, and

you expect the dividend to grow rapidly for the next four
years at 20 percent. Thus the dividend payments will be
Year Dividend
1 $1.20
2 1.44
3 1.73
4 2.07

After this initial period of super growth, the rate of

increase in the dividend should decline to 8 percent. If you
want to earn 12 percent on investments in common stock, what
is the maximum you should pay for this stock?
SOLUTIONS TO PROBLEMS

1. V = D0(1 + g) = $2,40(1 + .08) = $64.80

k - g .12 - .08

The valuation (V) of the stock is $64.80. Since the current

price is $60, the stock is undervalued and should be bought.

2. The implied rate of return = D0(1 + g)/P + g

= $3(1 + .075)/$36 + .075 = .1646 = 16.46%

3. a. Valuation of Stock A:

$1(1 + .07) = $15.29

.14 - .07

Valuation of Stock B:
$3(1 + .02) = $22.50
.14 - .07

Valuation of Stock C:
$7.50[1 + (-0.01)] = $49.50
.14 - .07

All three are overpriced and should not be bought. (Note: a

company whose earnings and dividends are declining may still
be attractive if the price is right.)

b. The return on A is
$1(1 + .07)/$23 + .07 = 11.65%.

This return is less than the investor's required rate of

return of 14 percent. If a stock is overpriced, that implies
the expected (or implied) rate of return is less than the
required rate of return.

c. Valuation of stock A:
 $1(1 + .07) = $35.67
.1 - .07

If the required rate of return were lower, the valuation

would be higher. A previously overvalued stock may now be
viewed as being undervalued.

4. First, determine the dividend: $3 x .25 = $.75.

Second, determine the value of the stock:

$0.75(1 + .06) = $19.88
.1 - .06

Third, determine the current market price:

P/E x EPS = 10 x $3.00 = $30
Since the market price ($30) exceeds the valuation ($19.88),
the stock should not be purchased.

5. First, determine the required rate of return:

r = rf + (rm - rf)beta = .08 + (.12 - .08)1.3 = .132

Second, determine the value of the stock:

$2.40(1 + .07) = $41.42
.132 - .07
Since the stock is selling for $35, it is undervalued and
should be purchased.

6. a. Stock A is more volatile because it has a higher beta

coefficient (i.e., has more systematic risk).

b. Required return for Stock A:

r = rf + (rm - rf)beta = .06 + (.12 - .06)1.3 = .138

Required return for stock B:

r = rf + (rm - rf)beta = .06 + (.12 - .06)0.8 = .108

c. Valuation of stock A:

$1(1 + .08) = $18.52

.138 - .08

Valuation of stock B:
 $1(1 + .08) = $38.57
.108 - .08

d. Even though the dividends and growth rates are equal,

Stock A is riskier (higher beta) which reduces its value.

7. This problem illustrates the super-growth dividend

valuation model. The value of the dividends during the
period of super growth:

$1.20(.893) = $1.07
1.44(.797) = 1.15
1.73(.712) = 1.23
2.07(.636) = 1.32
Sum: $4.77

The value of the stock at the end of four years (i.e., at

the end of the period of super growth):

$2.07(1 + .08) = $55.89

.12 - .08

The value of the stock for the period after super-growth is

the present value of the above valuation: $55.89(.636) =
$35.55.

Value of the stock is the summation of the two values: $4.77

+ 35.55 = $40.32.