Deck 7: Equity Valuation

Question 1

Which of the following is incorrect regarding equity securities?

A) The owners are called shareholder.
B) They represent ownership interest in the underlying entity.
C) Both common stock and preferred stock are types of equity securities.
D) Dividends paid out on equity securities are considered a cost of doing business and are tax deductible.

Answer 1

Dividends paid out on equity securities are considered a cost of doing business and are tax deductible.

Question 2

Which of the following is incorrect?

A) Preferred stock always is issued with a maturity date.
B) Preferred stock is ownership of a corporation that has preference over common stock.
C) Most preferred stockholders have preference over common stockholders with respect to income and assets.
D) Preferred stock provides the owner with a claim to a fixed amount of equity that is established when the shares are first issued.
E) Usually, no payments can be made to common shareholders until preferred shareholders have been paid the dividends they are due.

Answer 2

Preferred stock always is issued with a maturity date.

Question 3

Which of the following is incorrect?

A) From the perspective of the company issuing securities, debt financing is a lower cost of financing because interest is deductible and dividends are not.
B) A dollar of income from debt is less risky than a dollar of income from equity for a given company because creditors have a claim to income and assets prior to shareholders.
C) From the perspective of the corporate investor, bonds are preferred to stocks because the interest income is at most partially taxable, whereas dividend income is taxed fully.
D) From the perspective of the individual investor, a dollar of income from dividends is preferred to a dollar of income from bonds for tax purposes because dividends are taxed at a lower rate than interest income.

Answer 3

From the perspective of the corporate investor, bonds are preferred to stocks because the interest income is at most partially taxable, whereas dividend income is taxed fully.

Question 4

Which of the following best describes straight preferred stock?

A) Preferred stock with a maturity.
B) Preferred stock with dividends that vary from period to period.
C) Preferred stock with an embedded option, such as convertibility or callability.
D) Preferred stock with no embedded option, for which the issuer promises to pay a fixed, periodic dividend.

Question 5

Which of the following statements is incorrect?

A) One of the common approaches to valuing common stock is the discounted cash flow approach, with its many variations.
B) Valuing common stock is more straightforward than valuing bonds or preferred stock because of the certainty of future cash flows to owners and the timing of such cash flows.
C) One of the common approaches to valuing common stock is the method of multiples, using the market's evaluation of the value of equity of similar companies to value a company's equity.
D) We generally value preferred stock using discounted cash flow methods, discounting the expected dividends at a discount rate that reflects the uncertainty associated with the payment of these dividends.

Question 6

The approach to valuing an entity or the equity of an entity by applying the market multiples of comparable companies is best described as the:

A) method of multiples.
B) required rate of return.
C) price-earnings approach.
D) discounted cash flow method.

Question 7

The minimum return that investors expect to earn on the investment in stock is best described as:

A) growth rate.
B) risk premium.
C) capital gains yield.
D) required rate of return

Question 8

If a company returns more than the required rate of return on a stock, what happens to the value of that stock?

A) The stock price falls.
B) The stock price rises.
C) The stock price stays the same.

Question 9

The government Treasury bond yield is 3% and the risk premium of Tri-Star Machinery is 5%. Tri-Star Machinery's common stock's required rate of return is closest to:

A) 2.00%
B) 3.00%
C) 5.00%
D) 8.00%

Question 10

The government Treasury bond yield is 3.5% and the risk premium of Self-Serve Yogurt is 6.5%. Self-Serve Yogurt's common stock's required rate of return is closest to:

A) 0.23%
B) 3.00%
C) 10.00%
D) 13.00%

Question 11

Which of the following is not a workable assumption in the constant growth dividend discount model?

A) r_e < g
B) No growth in dividends
C) Growth in dividends is expected to occur at the same rate indefinitely.

Question 12

When market rates are greater than the dividend rate, preferred shares will trade at:

A) par.
B) a discount.
C) a premium.

Question 13

When market rates are equal to the dividend rate, preferred shares will trade at:

A) par.
B) a discount.
C) a premium.

Question 14

When market rates are less than the dividend rate, preferred shares will trade at:

A) par.
B) a discount.
C) a premium.

Question 15

If a share of preferred stock has a face value of $30 and a dividend rate of 2.5%, the annual dividend on this stock is closest to:

A) $0.25
B) $0.75
C) $1.50
D) $2.50
E) $30.00

Question 16

Determine the required rate of return on preferred shares that provide a $4.00 annual dividend if they are presently selling for $50.

A) 4.5%
B) 5.0%
C) 5.4%
D) 8.0%

Question 17

Determine the required rate of return on preferred shares that provide a $7.00 annual dividend if they are presently selling for $65.

A) 4.4%
B) 5.0%
C) 7.0%
D) 10.8%

Question 18

The model for valuing common shares that assumes common shares are valued according to the present value of their expected future dividends is best described as:

A) required rate of return.
B) dividend discount model.
C) present value of a perpetuity.
D) free cash flow discount model.

Question 19

The version of the dividend discount model for valuing common shares that assumes that dividends grow at a constant rate indefinitely is best described as:

A) two-stage growth rate model
B) multistage dividend discount model
C) present value of growth opportunities
D) constant growth dividend discount model

Question 20

The value of a $30 par value preferred share that pays annual dividends based on a 6% dividend rate, when the market yield is 6%, is closest to:

A) $1.80.
B) $30.00.
C) $31.80.
D) $36.00.

Question 21

The value of a $30 par value preferred share that pays annual dividends based on a 6% dividend rate, when the market yield is 5%, is closest to:

A) $25.00.
B) $30.00.
C) $31.50.
D) $31.80.
E) $36.00.

Question 22

The value of a $30 par value preferred share that pays annual dividends based on a 6% dividend rate, when the market yield is 7%, is closest to:

A) $25.71.
B) $30.00.
C) $31.80.
D) $32.10.
E) $35.00.

Question 23

Use the constant growth dividend discount model to value the common stock of a company that is currently paying $1.00 per share in common stock dividends. Investors expect dividends to grow at an annual rate of 3% indefinitely, and they require a 6% return on the shares. The value of a share of stock is closest to:

A) $16.67.
B) $30.00.
C) $33.33.
D) $34.33.

Question 24

The market value of a company's shares is $15 each, the estimated dividend this year is $0.384, and the estimated long-term growth rate in dividends is 4 percent. The implied required rate of return on these shares is closest to:

A) 2.7%.
B) 4.0%.
C) 4.7%.
D) 6.7%.

Question 25

Consider the following information on a company:
The implied required rate of return on these shares is closest to:

A) 2.5%.
B) 5.0%.
C) 7.5%.
D) 7.625%

Question 26

The market value of a company's shares is $25 each, the estimated dividend next year is $0.70, and the estimated long-term growth rate in dividends is 5 percent. The implied required rate of return on these shares is closest to:

A) 2.2%.
B) 2.8%.
C) 5.0%.
D) 7.8%.

Question 27

PVGO = P₀ - (EPS₁ / r_e) is the formula for the:

A) retention ratio
B) capital gains yield
C) sustainable growth rate
D) present value of growth opportunities

Question 28

Using the constant growth dividend model with all else remaining equal, which of the following will not lead to an increase in the value of common shares?

A) An increase in the dividend
B) A decrease in the required rate of return
C) An increase in the required rate of return
D) An increase in the expected growth rate of dividends

Question 29

Which of the following will not lead to higher share prices when using the dividend discount model, with all else being equal?

A) Profits are high
B) Interest rates are lower
C) Interest rates are higher
D) Risk premiums are lower
E) Profits are expected to grow

Question 30

If a company currently pay $1.00 per share in dividends, investors expect annual growth in dividends to be 4 percent, and the estimated required rate of return to be 8%, the value of a share of stock of this company is closest to:

A) $12.50.
B) $25.00.
C) $26.00.

Question 31

If a company currently pays $1.00 per share in dividends, investors expect annual growth in dividends to be 4 percent, and the estimated required rate of return is 10%, the value a share of the company's stock is closest to:

A) $10.00.
B) $17.33.
C) $25.00.

Question 32

A company's sustainable growth rate, if it had an ROE of 10% and a dividend payout ratio of 30%, is closest to:

A) 3.0%.
B) 7.0%.
C) 10.0%.
D) 13.0%.

Question 33

If a company has an ROE of 7% and a dividend payout ratio of 25%, its sustainable growth is closest to:

A) 5.3%.
B) 7.0%.
C) 9.5%.
D) 25.0%.

Question 34

What method of common shares valuation would best be used for a start- up company?

A) No growth rate model
B) Present value of a perpetuity
C) Two-stage growth rate model
D) Constant growth dividend discount model

Question 35

Which of the following statements is incorrect?

A) The dividend discount model is well suited for companies that are growing at a steady and sustainable rate.
B) The dividend discount model works reasonable well for large corporations in mature industries with stable profits and an established dividend policy.
C) The dividend discount model is well suited for companies that pay dividends based on a stable dividend payout history that they want to maintain in the future.
D) The dividend discount model works well for many resource based companies, which are cyclical in nature and often display erratic growth in earnings and dividends.

Question 36

Which of the following situations does the dividend discount model work well for?

A) Companies involved in significant share repurchase arrangements.
B) Large corporations in mature industries with stable profits and an established dividend policy.
C) Companies in distress, companies that are in the process of restructuring, companies involved in acquisitions, and private companies.
D) Many resource based companies, which are cyclical in nature and often display erratic growth in earnings and dividends. In addition many of these companies (especially the smaller ones) do not distribute dividends to shareholders.

Question 37

The present value of growth opportunities for a company with a leading EPS of $2.00, a required rate of return of 6%, and a current stock price of $40, is closest to:

A) $2.40.
B) $6.67.
C) $33.33.
D) $40.00.
E) $46.67.

Question 38

The present value of growth opportunities for a company with a leading EPS of $1.00, a required rate of return of 5%, and a current stock price of $25, is closest to:

A) $1.25.
B) $5.00.
C) $20.00.
D) $25.00.
E) $30.00.

Question 39

Pizza Unlimited is expected to pay a dividend of $1.50 at the end of this year, a $2.00 dividend at the end of year 2, and a $2.50 dividend at the end of year 3. It is estimated that its dividends will grow at a constant rate of 4 percent per year thereafter. The market value of Pizza Unlimited' s common shares, if the required rate of return is 10 percent, is closet to:

A) $32.56.
B) $37.45.
C) $43.33.

Question 40

Closet Shelf, Inc. (CSI) is expected to pay a dividend of $2.00 at the end of this year, a $2.25 dividend at the end of year 2, and a $2.50 dividend at the end of year 3. It is estimated that its dividends will grow at a constant rate of 5 percent per year thereafter. If the required rate of return is 8 percent, the market value of CSI's common shares is closest to:

A) $69.46.
B) $75.23.
C) $87.50.

Question 41

The multiple that is considered sustainable over the long-term is best described as the:

A) justified P/E.
B) relative valuation.
C) price-earnings ratio.

Question 42

Valuing a company relative to other comparable companies is best described as the:

A) relative valuation
B) free cash flow model
C) dividend discount model
D) multi-stage growth model

Question 43

Which of the following best describes the Molodovsky effect?

A) Valuing a company relative to other comparable companies
B) Market value of an entity's debt and equity, less cash and cash equivalents
C) Valuation model for equity in which there are two stages, each with a different growth rate
D) Trailing P/E ratios of cyclical companies are overstated during low points of the economic cycle

Question 44

Assuming a growth rate of 4% and a required rate of return of 9%, the value of a common share of International Fashions stock, if the company has EPS of $1.50 and a payout ratio of 50%, is closest to:

A) $15.00.
B) $15.60.
C) $17.33.

Question 45

If a company has EPS of $2.50 and a payout ratio of 30%, assuming a growth rate of 5% and a required rate of return of 10%, the value of a common share of the company's stock is closest to:

A) $15.00.
B) $15.75.
C) $26.25.

Question 46

Which of the following is not a concern when estimating P/E ratios and future EPS?

A) The P/E ratio may be highly variable across an industry.
B) The P/E ratio can be difficult to compute and not readily available.
C) The volatile nature of earnings implies a great deal of volatility in P/E multiples.
D) The P/E ratio is uninformative when companies have negative or very small earnings.
E) Net income, and hence earnings per share, are susceptible to the influence of accounting choices and earnings management.

Question 47

The comparable companies have a price earnings ratio of 16. If the private company's earnings are $4 million, the value of the private company's equity is closest to:

A) $12 million
B) $16 million
C) $64 million
D) $640 million

Question 48

The comparable companies have a price earnings ratio of 15. If the private company's earnings are $3 million, the value of the private company's equity using the method of multiples is closest to:

A) $12 million.
B) $45 million.
C) $165 million.
D) $450 million.

Question 49

Which of the following is not considered a relative valuation multiple used in valuing common shares?

A) Price-to-sales ratio
B) Debt to equity ratio
C) Price-to-cash flow ratio
D) Enterprise value to EBIT ratio
E) Enterprise value to EBITDA ratio

Question 50

Cash flows of both stocks and bonds are legal obligations.

Question 51

Interest paid on bonds is tax deductible by the company paying the interest, while dividends paid on stock is not tax deductible by the company paying the dividends.

Question 52

Valuing equity is more challenging than valuing bonds because with bonds there is a legal commitment to paying interest and repaying the principal, but with equity there is no such commitment associated with dividends.

Question 53

The present value of a perpetuity formula is used to estimate the value of a share of preferred stock.

Question 54

The type of equity ownership that has a prior claim to income and assets of the company relative to other shareholders is common stock.

Question 55

There is an inverse relationship between the risk of a security being valued and the required rate of return for the security.

Question 56

The market value of preferred stock decreases when market rates decline.

Question 57

One of the assumptions of the dividend discount model is that investors are rational.

Question 58

Dividend yield is the return in the form of the appreciation or depreciation in the value of an asset.

Question 59

Capital gains yield is the return on a stock in the form of cash dividends; the ratio of the dividend per share to the value of the stock.

Question 60

b X ROE is the formula for sustainable growth rate.

Question 61

The retention ratio plus the dividend payout ratio equals 1.

Question 62

One of the reasons the discounted cash flow approach assuming multistage growth is used by analysts to value companies is the difficulty companies have maintaining an extremely high growth rate for long periods.

Question 63

The free cash flow approach to valuation is used alternatively to dividends, because dividends are discretionary and many firms may choose to not pay out the amount of dividends they could. Free cash flow is a measure of what a firm could pay out if it chose to.

Question 64

The sustainable growth rate is positively related to the payout ratio.

Question 65

The value of a share of common stock or preferred stock is the present value of expected future dividends.

Question 66

The method of valuation for common shares that compares the market values of similar companies relative to a common variable is called the dividend discount model.

Question 67

The P/E ratio can be viewed as a payback period - the higher the multiple, the longer the payback period and the more the investor is expecting earnings to increase.

Question 68

Market-to-book ratio can be calculated by take the market value of equity per share and dividing by the book value per share or taking the market capitalization and dividing by the book value of shareholders' equity.

Question 69

Enterprise value is also called the "takeover value" because this is what another entity would have to pay to purchase the company.

Question 70

List some of the difficulties in valuing common stock.

Question 71

ABC Company has a book value per share of $10 and a market value per share of $25 and 5 million shares outstanding. What is ABC Company's market capitalization and market to book ratio?

Question 72

Pure Water Systems has a book value per share of $30 and a market value per share of $50 and 10 million shares outstanding. What is Pure Water Systems' market capitalization and market to book ratio?

Question 73

Which of the following is not a characteristic of common stock?

A) Maturity
B) Voting rights
C) Dividend income

Question 74

A publicly-traded company cannot issue more than one class of common stock.

Question 75

In the dividend valuation model, the price of the stock is higher:

A) the higher the required rate of return.
B) the lower the expected dividend payment.
C) the higher the expected growth rate of dividends.

Question 76

A company with a current dividend of $1 per share, a required rate of return of 10 percent, and an expected growth rate of dividends of 5 percent, according to the dividend valuation model, will have a value of a share of stock closest to:

A) $10.5
B) $20.
C) $21.

Question 77

Which of the following is not a workable assumption in the dividend valuation model?

A) The growth of dividends is negative.
B) The growth of dividends exceeds the required rate of return.
C) The company pays a dividend, but this dividend is a constant amount.

Question 78

Suppose that dividends are expected to grow at a rate of 10 percent for the next two years, and then 5 percent thereafter. If the current dividend is $1 per share and the required rate of return is 8 percent, the value of a share of this stock is closest to:

A) $38.36
B) $44.66
C) $41.75

Question 79

Consider a company that currently has earnings of $4 per share. If these earnings are expected to grow at a rate of 5 percent per year for four years, and the typical P/E ratio for this industry is 20, the expected price of a share of this stock four years from now is closest to:

A) $92.61
B) $97.24
C) $102.10

Question 80

Suppose an analyst calculated a price-earnings ratio by dividing the current price by the earnings per share of a company for the past four quarters. This price earnings ratio is best described as a:

A) trailing P/E.
B) forward P/E.
C) backward P/E.