Question 1

Use the following two statements to answer this question:
I.The Dividend Discount Model (DDM)assumes that common shares are valued according to the present value of their expected future dividends.
II.The DDM argues that the selling price at any point (say, time n)will equal the present value of all the expected future dividends from period n to infinity.

Accepted Answer

The answer of Use the following two statements to answer...

Question 2

The Dividend Discount Model (DDM)links common share prices to three important fundamentals: corporate profitability, the general level of interest rates, and risk.All else being equal, the DDM predicts that common share prices will be lower

Accepted Answer

The Dividend Discount Model (DDM) predicts that common share prices will be higher when profits are high, when interest rates are lower, and when risk premiums are lower. Therefore, none of the provided options correctly describe a scenario where share prices would be lower according to the DDM.

Question 3

The dividend growth rate for a stable firm can be estimated as:

Accepted Answer

The dividend growth rate for a stable firm can be estimated as the product of the retention ratio and the return on equity (ROE). This is because the retention ratio represents the portion of earnings that are reinvested in the firm rather than paid out as dividends, and the ROE reflects the profitability of the firm's assets. Therefore, multiplying these two factors together provides an estimate of the firm's ability to sustain dividend growth over time.

Question 4

How much would you pay for a common share today if you expect it will pay a dividend of $2.50 each year and will sell for $58 two years from now? Assume your required rate of return on this share is 13.0%.

Accepted Answer

The value of the share today can be calculated using the dividend discount model for a period of two years, plus the expected sale price, all discounted back to the present value at the required rate of return. The formula for the present value (PV) of future cash flows is: PV = [D1 / (1 + r)^1] + [D2 / (1 + r)^2] + [P / (1 + r)^2], where D1 and D2 are the dividends in years 1 and 2, P is the sale price in year 2, and r is the required rate of return. Plugging in the given values: PV = [$2.50 / (1 + 0.13)^1] + [$2.50 / (1 + 0.13)^2] + [$58 / (1 + 0.13)^2] = $2.21 + $1.96 + $45.42 = $49.59.

Question 5

Which of the following is TRUE about the implicit assumption of the Dividend Discount Model (DDM)that "investors are rational"?
I.It assumes that at each period of time, investors react rationally and value the shares based on what they rationally expect to receive next year.
II.It rules out "speculative bubbles" or what is colloquially known as the "bigger fool theorem."

Accepted Answer

The Dividend Discount Model (DDM) implicitly assumes rational investor behavior, meaning investors value shares based on rational future dividend expectations (I is correct). It also inherently rules out speculative bubbles, aligning with the assumption that prices reflect rational expectations of future dividends, not speculative or irrational factors (II is correct).

Question 6

You paid $20 for one common share of HyperTension Inc.today.What is the expected one-year holding period return if the share pays a $1.25 dividend and sells for $21.50 one year from now?

Accepted Answer

To calculate the expected one-year holding period return, we have to consider both the dividend and the change in share price.

Dividend yield = Annual dividend / Purchase price = $1.25 / $20 = 6.25%
Capital gains yield = (Selling price - Purchase price) / Purchase price = ($21.50 - $20) / $20 = 7.5%

Expected one-year holding period return = Dividend yield + Capital gains yield = 6.25% + 7.5% = 13.75%

Therefore, choice D (13.75%) is the best answer.

Question 7

Jack had an investment return of -24.0% on a share that he bought for $100 one year ago.For how much did Jack sell the share assuming he received a dividend of $1.75 during the year?

Accepted Answer

To calculate the selling price, we need to take into account the investment return and dividend received.

Investment return of -24.0% means that Jack's share is now worth 76% of its original value:

$100 x (1 - 0.24) = $76

Adding the dividend of $1.75:

$76 + $1.75 = $77.75

Therefore, Jack sold the share for $77.75, which corresponds to choice B.

Question 8

Use the following two statements to answer this question:
I.There is no requirement that common shares pay dividends at all.
II.The level of dividend payment of common shares is discretionary.

Accepted Answer

Both statements are correct. Common shares do not have a guaranteed dividend payment, making the dividend payment discretionary and dependent on the company's financial health and board decisions.

Question 9

Which of the following statements is TRUE?

Accepted Answer

Until an investor sells their shares, the only cash flows they receive are dividends. However, this statement may not hold true in certain situations, such as when a company issues stock buybacks or stock dividends. Option B is incorrect because residual earnings belong to the common shareholders, not the preferred shareholders. Option C is untrue as corporations may choose to retain some earnings to finance growth and expansion, rather than paying out all of their earnings as dividends. Option D is also false because retaining earnings for reinvestment is one way for corporations to enhance future earnings.

Question 10

How much would you pay for a common share today, if you expect it will pay a dividend of $2.50 each year and will sell for $58 one year from now? Assume your required rate of return on this share is 13.0%.

Accepted Answer

Using the dividend discount model, we can calculate the present value of the stock as follows:
PV = (Dividend/1+R) + (Sale Price/1+R)
PV = (2.50/1+0.13) + (58/1+0.13)
PV = 2.21 + 51.33
PV = 53.54
Therefore, the maximum price to pay for this stock is $53.54. The best choice is C.

Question 11

Manic Corporation issued 200,000 preferred shares with a book value of $10 million three years ago.If the required return is 8.42% and the current market value of these preferred shares is $9.5 million, what is the annual dividend?

Accepted Answer

The answer of Manic Corporation issued 200,000 preferred shares with...

Question 12

The 800,000 preferred shares of Fantastic Services have a total current market value of $9,192,000 and a book value of $10,000,000.What is the dividend rate if the risk-free rate is 3.15% and the risk premium is 3.65%?

Accepted Answer

The answer of The 800,000 preferred shares of Fantastic Services...

Question 13

Manic Corporation issued 400,000 preferred shares with a book value of $10 million three years ago.The preferred shares pay an annual dividend of $2.What is the required return if the current market value of these preferred shares is $9.5 million?

Accepted Answer

The required return on preferred shares can be calculated using the formula: Required Return = Annual Dividend / Current Market Value. Here, the annual dividend is $2, and the current market value is $9.5 million for 400,000 shares, which means the market value per share is $9.5 million / 400,000 = $23.75. Plugging these values into the formula gives: Required Return = $2 / $23.75 = 0.0842 or 8.42%.

Question 14

The current market value of the 500,000 preferred shares of Clumsy Sports Inc.is $25 million.If the shares pay a quarterly dividend of $1.25 on a stated value of $85 and the risk premium is 4.50%, what is the implied risk-free rate?

Accepted Answer

The answer of The current market value of the 500,000...

Question 15

The rate of return required by equity investors is estimated as:

Accepted Answer

The rate of return required by equity investors is estimated as dividend yield (the current dividend rate divided by the current stock price) plus expected capital gains yield (the expected increase in the stock price). This is also known as the dividend discount model or the constant growth model.

Question 16

Which of the following is a FALSE statement about the Dividend Discount Model (DDM)?

Accepted Answer

The Dividend Discount Model (DDM) is actually most suitable for firms that are non-cyclical and display steady growth in earnings and dividends, making statement A false. The model is less effective for firms in distress, undergoing restructuring, or involved in acquisitions, as these conditions make it difficult to predict future dividends accurately.

Question 17

Use the following two statements to answer this question:
I.A firm's sustainable growth rate decreases with higher profit margins, higher asset turnover, and higher debt.
II.A firm's sustainable growth rate can be estimated by multiplying the earnings retention ratio by the return on equity.

Accepted Answer

Statement I is incorrect because a firm's sustainable growth rate actually increases with higher profit margins, higher asset turnover, and higher leverage (not decreases). Statement II is correct as the sustainable growth rate can indeed be estimated by multiplying the earnings retention ratio (the proportion of earnings not paid out as dividends) by the return on equity (ROE).

Question 18

Charlotte purchased a common share for $50 one year ago.She received $2.40 in dividends and then sold the share for $52.If the inflation rate over the year was 2.6%, her exact real rate of return is

Accepted Answer

The real rate of return adjusts the nominal return for the effects of inflation. Charlotte's nominal return includes both the dividend received and the capital gain from selling the share. The nominal return is calculated as: $$ \text{Nominal Return} = \frac{\text{Dividend} + (\text{Selling Price} - \text{Purchase Price})}{\text{Purchase Price}} \times 100\% $$ $$ \text{Nominal Return} = \frac{2.40 + (52 - 50)}{50} \times 100\% = 8.8\% $$ The real rate of return is calculated using the formula: $$ \text{Real Rate of Return} = \frac{1 + \text{Nominal Rate}}{1 + \text{Inflation Rate}} - 1 $$ $$ \text{Real Rate of Return} = \frac{1 + 0.088}{1 + 0.026} - 1 \approx 6.04\% $$

Question 19

The current market value of the 500,000 preferred shares of Clumsy Sports Inc.is $25 million.If the shares pay an annual dividend of $5 on a par value of $85 and the risk-free rate is 5.5 %, what is the implied risk premium?

Accepted Answer

First, you need to calculate the current yield on the preferred shares:
Current yield = Annual dividend / Market value per share
Current yield = $5 / ($85*0.5) = 0.0588 or 5.88%

Then, you can use the capital asset pricing model (CAPM) to calculate the implied risk premium:
CAPM = Risk-free rate + Beta * (Market return - Risk-free rate)

As there is no information on beta, we can assume that it is 1 (the market average). Also, we can assume that the market return is equal to the historical average market return of 10%.

Implied risk premium = CAPM - Risk-free rate
Implied risk premium = (10% - 5.5%) - 5.5% = 4.5%

Therefore, the implied risk premium for the 500,000 preferred shares of Clumsy Sports Inc. is 4.5%, which corresponds to choice B.

Question 20

Which of the following is NOT a correct statement of the Constant Growth DDM?

Accepted Answer

The correct inequality for the Constant Growth DDM is k_c > g, not < g. This is because the expected rate of return on equity (k) needs to be greater than the expected growth rate in dividends (g) for the model to be valid.

Quiz 7: Equity Valuation

The Dividend Discount Model (DDM) links common share prices to three important fundamentals: corporate profitability, the general level of interest rates, and risk.All else being equal, the DDM predicts that common share prices will be lower