Question 1

Ontario Ice Corporation has an expected profit margin of 10 percent,turnover ratio of 3,and a leverage ratio of 0.50.The firm expects an EPS of $3 next year and maintains a retention ratio of 60 percent.What should the stock sell for today if the required return is 15 percent?

Accepted Answer

Compute ROE = 10%*3*0.5 = 15%,G = 60%*15% = 9%,D₁ = $3*(1-60%)= $1.20,Then P₀ = $1.2/(15%-9%)=$20

Question 2

Which of the following is not true about the P/E ratio?

Accepted Answer

P/E ratios can work well for both high-growth companies and mature companies with stable earnings. The other options (A, C, and D) are all true statements about the limitations and challenges of using P/E ratios.

Question 3

Junkies Corporation has just paid a dividend of $0.90.Dividends are expected to grow at 20% for years one and two,15% for years three and four,10% for years five and six,and 5% thereafter.What is the expected dividend for year 10 if the required return is 18 percent?

Accepted Answer

D₁₀= $0.9*(1+20%)²*(1+15%)²*(1+10%)²*(1*5%)⁴ = $2.52

Question 4

MacLean Inc.currently pays no dividends.Today,the firm announced that it will pay its first dividend of $1 per share in four years,then $1.50 in each of the following three years,and the subsequent dividends are expected to grow at a constant rate of 5 percent per year.What is the stock price today if the risk-free rate is 4 percent and the risk premium associated with this stock is 6 percent?

Accepted Answer

Compute 11ea8229_3495_972b_bbd8_31db36c308cb_TB1726_11 then P₀ = ($1+$1.5*PVAF(10%,3))/(1+10%)⁴+[$1.5*(1+5%)/(10%-5%)]/(1+10%)⁷ = $19.40

Question 5

Which of the following statements is FALSE?

Accepted Answer

The statement C is false because a lower required rate of return actually leads to a higher P/E ratio, not lower. This is because the required rate of return is in the denominator of the P/E formula, so as it decreases, the value of the P/E ratio increases.

Question 6

Maniac Corporation just paid a dividend of $2 on its current EPS of $6.Its projected net profit margin,asset turnover,and leverage ratio are 12.5 percent,2.5,and 0.6,respectively.What is Maniac's required rate of return if the current price is $34.60?

Accepted Answer

Compute retention ratio = 1-$2/$6 = 66.667%,ROE = 12.5%*2.5*0.6 = 18.75%,G = 66.67%*18.75% = 12.5%,Then k_c = [$2*(1+12.5%)]/$34.6+12.5% = 19%

Question 7

Macaroni Inc.announced that it would pay the following dividends over the next five years: $0.50,$0.75,$1.50,$3,and $4.Afterwards,dividends will decline at a rate of 3 percent per year indefinitely.What is the firm's current stock price if the required rate of return is 13%?

Accepted Answer

P₀= $0.50/(1+.13)¹+$0.75/(1+.13)²+$1.50/(1+.13)³+$3.00/(1+.13)⁴+[($4.00+$4.00*(1-3%)/(13%+3%))/(1+.13)⁵] = $19.24

Question 8

Which one of the following is not a fundamental factor that affects the P/E ratio directly?

Accepted Answer

The preferred shares dividend does not directly affect the P/E ratio. The P/E ratio is primarily affected by factors such as the expected payout ratio, required rate of return, and expected growth of dividend for common shares.

Question 9

Dream Homes Corporation had net earnings of $200,000 this past year and paid $80,000 in dividends on the company's equity of $1,800,000.Dream Homes has 500,000 shares outstanding with a current market value of $5.What is the firm's present value of growth opportunities if the required rate of return is 10.08 percent?

Accepted Answer

Compute retention ratio =1−$80,000/$200,000 = 60%,ROE = $200,000/$1,800,000 = 11.1111%,G = 60%*11.11% = 6.6667%,EPS₁ = ($200,000/500,000)*(1+6.67%)= $0.4267,Then PVGO = $5−$0.4267/10.08% = $0.77

Question 10

Price-earnings (P/E)ratios can be estimated using which of the following?

Accepted Answer

Price-earnings (P/E) ratios can be estimated using the required rate of return, the expected growth rate of dividends, and the retention ratio. The required rate of return affects the discount rate applied to future earnings or dividends, influencing the P/E ratio. The expected growth rate of dividends impacts future earnings projections, thus affecting the P/E ratio. The retention ratio, which indicates the proportion of earnings not paid out as dividends, affects the amount of earnings reinvested in the company, potentially influencing future growth and thereby the P/E ratio.

Question 11

Which one of the following is a limitation of the P/E ratio?

Accepted Answer

The P/E ratio ignores the magnitude or sign of the earnings, which means that a company with a high P/E ratio might be overvalued or undervalued depending on whether its earnings are positive or negative.

Question 12

Suppose a firm has just reported an EPS of $2.50 and expects to maintain a dividend payout ratio of 40 percent.If the firm's price-earnings ratio is 9.3 and its return on equity is 12 percent,what is its required rate of return?

Accepted Answer

Compute retention ratio = 1 - 40% = 60% g = 12%*60% = 7.2%,D₀=2.5*0.4=1, P₀ = EPS1*justified PE ratio=2.5*(1+0.072)*9.3=2.68*9.3 r = D0*(1+g)/P +g r = [(1.072/2.68)/9.30]+7.2% = 11.50%

Question 13

VIP Corporation has just paid a dividend of $1.50.Dividends are expected to grow at 20% for the first three years and 10% for the following two years.What is the expected growth rate for the subsequent years if the stock is selling for $24.86 today and the required return is 17 percent?

Accepted Answer

Compute PV(D_1-5)= [1.5*(1.20)]/(1.17)¹+[$1.5*(1.20)²/(1.17)²]+[$1.5*(1.20)³/(1.17)³]+[$1.5*(1.20)³/(1.17)⁴] +[$1.5*(1.20)³*(1.10)²/(1.17)⁵]= $7.68679 P₅ = (24.86−7.68679)*1.17⁵ = 37.651364,then 37.65136431 = [1.5*1.2³*1.1²*(1+g)]/(0.17−g) 6.40−37.65g = 3.1363+3.1363g 3.2637 = 40.7863g g = 8%

Question 14

DH Corporation had net earnings of $200,000 this past year and paid $80,000 in dividends on the company's equity of $1,800,000.What is the growth rate of this company?

Accepted Answer

G = (1-80,000/200,000)*200,000/1,800,000 = 6.67%

Question 15

Suppose a firm's price/earnings ratio is 16.It has just paid a dividend of $1.80 per share to maintain a 45 percent payout ratio.What is the firm's current market price if its return on equity is 12 percent?

Accepted Answer

Compute g = 12%*(1-45%)= 6.60%,EPS₁ = [$1.80*(1+6.60%)]/45% = $4.264,Then P₀ = 16*$4.264 = $68.22

Question 16

DDM Company has an expected profit margin of 15 percent,turnover ratio of 2,and a leverage ratio of 0.5.The firm had an EPS of $2 and paid a dividend of $1.05 per share.What is DDM's sustainable growth rate?

Accepted Answer

Compute retention ratio = 1-$1.05/$2 = 47.5%,ROE = 15%*2*0.5 = 15%
then g= 47.5%*15% = 7.125%

Question 17

The market value and book value of Visual Image Inc.'s outstanding 2 million common shares are $60 million and $30 million,respectively.The company's recent net profit was $3,500,000.What is the company's sustainable dividend growth rate if it uses a dividend payout ratio of 60 percent?

Accepted Answer

Compute retention ratio = 1 - 60% = 40%,ROE = $3,500,000/$30,000,000 = 11.67% and then g = 40%*11.67% = 4.67%

Question 18

Suppose a firm has just reported an EPS of $2.50 and expects to maintain a dividend payout ratio of 40 percent.What is the firm's price-earnings ratio if its return on equity is 12 percent and the required return is 11.5 percent?

Accepted Answer

Compute retention ratio = 1- 40% = 60%,G = 12%*60% = 7.2% P/E = P₀/EPS = ($1.072/$2.68)/(11.5%-7.20%)= 9.30

Question 19

Which of the following statements is correct?

Accepted Answer

This is because investors are willing to pay a premium for higher growth opportunities, which is reflected in a higher P/E ratio. Companies with lower expected growth opportunities will have a lower P/E ratio because investors are not willing to pay as much for their earnings.

Question 20

Nunavut Beach Resort has a net income of $330,000 on sales of $2,200,000.The firm has total assets of $1,600,000,a book value of equity of $1,200,000,and a dividend payout ratio of 65 percent.What is the firm's current market value if the required return is 21 percent?

Accepted Answer

Retention ratio = 1-65% = 35%,ROE = $330,000/$2,200,000*$2,200,000/$1,600,000*$1,600,000/1,200,000 = 27.5% g = 35%*27.5% = 9.625%,D₁ = ($330,000*65%)*(1+9.625%)= $235,145.625, then P₀ = $235,145.625/(21%-9.625%)= $2,067,214.29

Quiz 7: Equity Valuation