Deck 8: Equity Valuation

Question 1

An overvalued investment is so expensive that we will not receive a fair return if we bought it.

Answer 1

True

Question 2

The importance of an industry's performance on an individual stock's performance varies across industries.

Answer 2

True

Question 3

Growth companies are those firms that consistently earn higher rates of return by assuming greater amounts of risk.

Answer 3

False

Question 4

The real risk-free rate depends on the real growth in the economy and can be affected for short time periods by temporary tightness or ease in the capital markets.

Question 5

A fair investment is one that gives us a return that is greater than the risk.

Question 6

The growth rate in equity without any external financing is determined by multiplying the payout ratio by the return on equity (ROE).

Question 7

If the estimated value of an asset is greater than the market price, you would want to buy the investment.

Question 8

Given an optimistic economic and stock-market outlook for a country, the investor should underweight the allocation to this country in his/her portfolio.

Question 9

In dividend discount models (DDM) with supernormal growth, supernormal growth may continue indefinitely.

Question 10

Those who employ the bottom-up approach start their search immediately at the company level.

Question 11

Within a specific market, the top-down analyst then searches for the best industries.

Question 12

Fundamentalists typically use the "Bottom-Up Approach", whereas technicians use the "Top-Down Approach" to the valuation process.

Question 13

The three-step valuation process consists of (1) analysis of alternative economies and markets, (2) analysis of alternative industries, and (3) analysis of industry influences.

Question 14

The two components that are required in order to carry out asset valuation are (1) the stream of expected cash flows and (2) the required rate of return.

Question 15

If the intrinsic value of an asset is greater than the market price, you would want to buy the investment.

Question 16

An undervalued investment is so expensive that we will not receive a fair return if we bought it.

Question 17

An equity investor's required rate of return is influenced by the economy's real risk-free rate, the expected rate of inflation, and a risk premium.

Question 18

The dividend growth models are only meaningful for companies that have a required rate of return that exceeds their dividend growth rate.

Question 19

Discounted cash flow techniques for equity valuation may use one of the following: (1) dividends, (2) free cash flow, or (3) coupons.

Question 20

The required rate of return is determined by (1) the real risk-free rate, (2) the expected rate of inflation, and (3) liquidity risk.

Question 21

As an analyst performs ratio analysis, he hopes to determine whether earnings represent cash flows and whether those cash flows will recur.

Question 22

A relative valuation technique is appropriate to consider when you have a good set of comparable entities.

Question 23

Which of the following is correct?

A) if estimated value > Market price, you should buy.
B) if estimated value > Market price, you should sell.
C) if estimated value < Market price, you should do nothing.
D) if estimated value < Market price, you should buy.
E) if estimated value > Market price, you should do nothing.

Question 24

The dividend discount model (DDM) can be used to value preferred stock by simply using a growth rate of zero in the DDM model.

Question 25

The infinite period dividend discount model (DDM) can be used to value a supernormal growth company.

Question 26

Which securities can be valued by dividing the annual dividend by the required rate of return?

A) low coupon bonds
B) junk bonds
C) common stocks
D) preferred stocks
E) constant growth common stocks

Question 27

Many analysts recommend that you should read an annual report forwards, that is, you would read the footnotes last.

Question 28

An example of a relative valuation technique is the Price/Cash Flow ratio.

Question 29

The growth rate of dividends and profit margin are the main determinants of the P/E ratio.

Question 30

The growth rate of equity earnings without external financing is equal to

A) retention rate plus return on equity.
B) retention rate minus return on equity.
C) retention rate divided by return on equity.
D) retention rate times return on equity.
E) return on equity divided by retention rate.

Question 31

The process of fundamental valuation requires estimates of all the following factors, EXCEPT for the

A) time pattern of returns.
B) economy's real risk-free rate.
C) risk premium for the asset.
D) times series of stock prices.
E) expected rate of inflation.

Question 32

Operating margins are defined as Operating Profit/Sales

Question 33

Growth rates of the (1) labor force, (2) average number of hours worked, and (3) labor productivity are the main determinants of a foreign country's

A) dividend payout ratio.
B) beta.
C) real risk free rate.
D) nominal risk free rate.
E) risk premium.

Question 34

According to the dividend growth model, if a company were to declare that it would never pay dividends, its value would be

A) based on earnings.
B) based on expectations regarding.
C) higher than similar firms because it could reinvest a greater amount in new projects.
D) zero.
E) based on the capital asset pricing model.

Question 35

The most appropriate discount rate to use when applying the Operating Free Cash Flows model is the firm's

A) required rate of return based on the capital asset pricing model (CAPM).
B) required rate of return based on the dividend discount model (DDM).
C) weighted average cost of capital (WACC).
D) historical cost of debt and equity.
E) All of these are correct.

Question 36

Quality financial statements are a good reflection of reality; accounting tricks and one-time changes are not used to make the firm appear stronger than it really is.

Question 37

Management may "under-reserve" in order to meet earnings expectations, or they may "over-reserve" in order to smooth future earnings.

Question 38

Which of the following is NOT considered a basic economic force?

A) fiscal policy
B) monetary policy
C) inflation
D) P/E ratio
E) All of these are basic economic forces.

Question 39

Which of the following is NOT a consideration in the three-step valuation process?

A) analysis of alternative economies
B) analysis of security markets
C) analysis of alternative industries
D) analysis of individual companies
E) All of these are considerations in the three-step valuation process.

Question 40

The gross margin is defined as Gross Profit/Sales.

Question 41

In 2018, Venus Fly Co. issued a $75 par value preferred stock that pays a 7 percent annual dividend. Due to changes in the overall economy and in the company's financial condition investors are now requiring a 5 percent return. What price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now?

A) $125
B) $84
C) $91
D) $145
E) $105

Question 42

In 2018, Swisten Inc. issued a $150 par value preferred stock that pays an 8 percent annual dividend. Due to changes in the overall economy and in the company's financial condition, investors are now requiring a 15 percent return. What price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now?

A) $80
B) $75
C) $59
D) $95
E) $110

Question 43

Ross Corporation paid dividends per share of $1.20 at the end of 1990. At the end of 2000, it paid dividends per share of $3.50. Calculate the compound annual growth rate in dividends.

A) 52.17 percent
B) 34.28 percent
C) 23 percent
D) 19.17 percent
E) 11.29 percent

Question 44

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The National Motor Company's last dividend was $1.25, and the directors expect to maintain the historic 4 percent annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 7 percent for the next three years and the stock will then reach $25.00 per share.
Refer to Exhibit 8.2. How much should you be willing to pay for the stock if you require a 16 percent return?

A) $17.34
B) $18.90
C) $19.09
D) $19.21
E) $20.35

Question 45

In 2018, Smiths Corp. issued a $50 par value preferred stock that pays a 6 percent annual dividend. Due to changes in the overall economy and in the company's financial condition, investors are now requiring a 7 percent return. What price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now?

A) $42.86
B) $30.00
C) $31.54
D) $33.38
E) $38.37

Question 46

Hunter Corporation had a dividend payout ratio of 63 percent in 1999. The retention rate in 1999 was

A) 37 percent.
B) 63 percent.
C) 50 percent.
D) 0 percent.
E) 100 percent.

Question 47

Micro Corp. just paid dividends of $2 per share. Assume that over the next three years dividends will grow as follows, 5 percent next year, 15 percent in year two, and 25 percent in year 3. After that growth is expected to level off to a constant growth rate of 10 percent per year. The required rate of return is 15 percent. Calculate the intrinsic value using the multistage model.

A) $5.56
B) $66.4
C) $49.31
D) $43.66
E) $35.21

Question 48

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Davenport Corporation's last dividend was $2.70, and the directors expect to maintain the historic 3 percent annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 5 percent for the next three years and the stock will then reach $25 per share.
Refer to Exhibit 8.1. How much should you be willing to pay for the stock if you require a 17 percent return?

A) $16.97
B) $22.16
C) $21.32
D) $32.63
E) $23.63

Question 49

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $2. An analyst expects dividends to grow at a rate of 8 percent per year for the next five years. After that dividends are expected to grow at a normal rate of 5 percent per year. Assume that the appropriate discount rate is 7 percent.
Refer to Exhibit 8.3. The future price of the stock in year 5 is

A) $113.40.
B) $122.47.
C) $132.27.
D) $142.85.
E) $154.35.

Question 50

Using the constant growth model, an increase in the required rate of return from 14 to 15 percent combined with an increase in the growth rate from 6 to 7 percent would cause the price to

A) rise more than 1%.
B) rise less than 1%.
C) remain constant.
D) fall more than 1%.
E) fall less than 1%.

Question 51

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $2. An analyst expects dividends to grow at a rate of 8 percent per year for the next five years. After that dividends are expected to grow at a normal rate of 5 percent per year. Assume that the appropriate discount rate is 7 percent.
Refer to Exhibit 8.3. The dividends for years 1, 2, and 3 are

A) $2, $2.08, and $2.16.
B) $2, $2.05, and $2.10.
C) $2.16, $2.24, and $2.32.
D) $2.16, $2.33, and $2.52.
E) $2.07, $2.14, and $2.21.

Question 52

Using the constant growth model, an increase in the required rate of return from 17 to 20 percent combined with an increase in the growth rate from 8 to 11 percent would cause the price to

A) rise more than 3%.
B) rise less than 3%.
C) remain constant.
D) fall more than 3%.
E) fall less than 3%.

Question 53

Using the constant growth model, a decrease in the required rate of return from 15 to 13 percent combined with an increase in the growth rate from 5 to 6 percent would cause the price to

A) rise more than 50 percent.
B) rise less than 50 percent.
C) remain constant.
D) fall more than 50 percent.
E) fall less than 50 percent.

Question 54

The beta for the DAK Corporation is 1.25. The yield on 30-year T-bonds is 5.65 percent, and the long-term average return on the S&P 500 is 11 percent. Calculate the required rate of return for DAK Corporation.

A) 12.34 percent
B) 7.06 percent
C) 13.74 percent
D) 5.35 percent
E) 5.65 percent

Question 55

Using the constant growth model, an increase in the required rate of return from 14 to 18 percent combined with an increase in the growth rate from 8 to 12 percent would cause the price to

A) fall more than 4%0
B) fall less than 4%.
C) rise more than 4%.
D) rise less than 4%.
E) remain constant.

Question 56

Using the constant growth model, an increase in the required rate of return from 19 to 17 percent combined with an increase in the growth rate from 11 to 9 percent would cause the price to

A) fall more than 2 percent.
B) fall less than 2 percent.
C) remain constant.
D) rise more than 2 percent.
E) rise less than 3 percent.

Question 57

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The National Motor Company's last dividend was $1.25, and the directors expect to maintain the historic 4 percent annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 7 percent for the next three years and the stock will then reach $25.00 per share.
Refer to Exhibit 8.2. How much should you be willing to pay for the stock if you feel that the 7 percent growth rate can be maintained indefinitely and you require a 16 percent return?

A) $11.15
B) $14.44
C) $14.86
D) $18.90
E) $19.24

Question 58

In 2018, Montpelier Inc. issued a $100 par value preferred stock that pays a 9 percent annual dividend. Due to changes in the overall economy and in the company's financial condition, investors are now requiring a 10 percent return. What price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now?

A) $100
B) $110
C) $75
D) $90
E) $85

Question 59

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Davenport Corporation's last dividend was $2.70, and the directors expect to maintain the historic 3 percent annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 5 percent for the next three years and the stock will then reach $25 per share.
Refer to Exhibit 8.1. How much should you be willing to pay for the stock if you feel that the 5 percent growth rate can be maintained indefinitely and you require a 17 percent return?

A) $22.16
B) $19.28
C) $21.32
D) $23.63
E) $25.46

Question 60

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $2. An analyst expects dividends to grow at a rate of 8 percent per year for the next five years. After that dividends are expected to grow at a normal rate of 5 percent per year. Assume that the appropriate discount rate is 7 percent.
Refer to Exhibit 8.3. The present value today of dividends for years 1 to 5 is

A) $4.06.
B) $10.28.
C) $12.40.
D) $14.52.
E) $10.0.

Question 61

What is the value to you of a 10 percent coupon bond with semi-annual coupon payments and a par value of $10,000 that matures in 20 years if you require an 8 percent return?

A) $9,652.89
B) $10,356.65
C) $11,359.03
D) $11,979.28
E) $12,385.62

Question 62

What is the value of a preferred stock that has a par value of $100, a required rate of return of 11 percent, and pays a 7 percent annual dividend?

A) $63.64
B) $157.14
C) $909.09
D) $1,428.57
E) $2,500.00

Question 63

Tayco Corporation has just paid dividends of $3 per share. The earnings per share for the company was $4. If you believe that the appropriate discount rate is 15 percent and the long-term growth rate in dividends is 6 percent, and earnings is 6 percent, then the firm's P/E ratio is

A) 8.33.
B) 33.33.
C) 44.44.
D) 11.11.
E) 10.10.

Question 64

The gross margin is defined as

A) Gross Profit/Sales.
B) Operating Profit/Sales.
C) Net Income/Sales.
D) Sales/Gross Profit.
E) Debt/Long-Term Capital.

Question 65

The P/E ratio for BMI Corporation is 21, and the P/S ratio is 5.2. The industry P/E ratio is 35, and the industry P/S ratio is 7.5. Based on relative valuation, BMI is

A) undervalued on the basis of relative P/E and relative P/S.
B) overvalued on the basis of relative P/E and undervalued on the basis of relative P/S.
C) undervalued on the basis of relative P/E and overvalued on the basis of relative P/S.
D) overvalued on the basis of relative P/E and relative P/S.
E) overvalued on the basis of relative P/E.

Question 66

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Fast Grow Corporation is expecting dividends to grow at a 20 percent rate for the next two years. The corporation just paid a $2 dividend, and the next dividend will be paid one year from now. After two years of rapid growth, dividends are expected to grow at a constant rate of 9 percent forever.
Refer to Exhibit 8.5. Assume that the annual dividend grows at a constant rate of 9 percent indefinitely instead of the supernormal growth. How much is the stock worth if dividends grow annually at 9 percent?

A) $40.00
B) $43.60
C) $45.60
D) $47.80
E) $52.40

Question 67

Which of the following statements regarding fundamental and relative valuation techniques is TRUE?

A) Both techniques require an appropriate estimate of the required rate of return and the growth rate.
B) Both techniques require an estimate of a discount rate.
C) Both techniques require an estimate of future cash flows and a discount rate.
D) Both techniques require an estimate of future cash flows and a growth rate.
E) Both techniques require an estimate of future cash flows, the required rate of return, and a growth estimate.

Question 68

A company's dividend last year was $3.00. Dividends are expected to grow indefinitely at 7 percent, and the required rate of return for the stock is 13 percent. What is the value of the stock today?

A) $2.83
B) $23.08
C) $24.69
D) $50.00
E) $53.50

Question 69

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $1.5. An analyst expects dividends to grow at a rate of 9 percent per year for the next three years. After that dividends are expected to grow at a normal rate of 5 percent per year. Assume that the appropriate discount rate is 7 percent.
Refer to Exhibit 8.4. The price of the stock today (P₀) is

A) $84.81.
B) $87.81.
C) $91.09.
D) $94.32.
E) $97.61.

Question 70

The Absolute Finance Company (AFC) earned $5 a share last year and paid a dividend of $2 per share. Next year, you expect AFC to earn $6 a share next year and continue its payout ratio. Assume that you expect to sell the stock for $45 a year from now. If you require a 13 percent return on this stock, how much would you be willing to pay for it?

A) $41.95
B) $43.21
C) $45.13
D) $46.72
E) $47.40

Question 71

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $1.5. An analyst expects dividends to grow at a rate of 9 percent per year for the next three years. After that dividends are expected to grow at a normal rate of 5 percent per year. Assume that the appropriate discount rate is 7 percent.
Refer to Exhibit 8.4. The dividends for years 1, 2, and 3 are

A) $1.5, $2.0, and $2.05.
B) $1.64, $1.78, and $1.94.
C) $1.64, $1.94, and $2.24.
D) $1.5, $2.40, and $3.30.
E) $2.07, $2.14, and $2.21.

Question 72

XCEL Corporation paid a dividend yesterday for $1.50. They expect to pay dividends annually at a constant 6 percent annual growth rate indefinitely. If the required rate of return on this investment is 12 percent, what is the current value of this common stock?

A) $1.50
B) $12.50
C) $13.25
D) $25.00
E) $26.50

Question 73

A company has a dividend payout ratio of 35 percent. If the company's return on equity is 15 percent, what is the expected growth rate if no new outside financing is used?

A) 4.50 percent
B) 5.25 percent
C) 7.75 percent
D) 8.25 percent
E) 9.75 percent

Question 74

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Fast Grow Corporation is expecting dividends to grow at a 20 percent rate for the next two years. The corporation just paid a $2 dividend, and the next dividend will be paid one year from now. After two years of rapid growth, dividends are expected to grow at a constant rate of 9 percent forever.
Refer to Exhibit 8.5. If the required return is 14 percent, what is the value of Fast Grow Corporation common stock today?

A) $40.26
B) $42.38
C) $46.70
D) $52.63
E) $62.78

Question 75

Operating margins are defined as

A) Gross Profit/Sales.
B) Operating Profit/Sales.
C) Net Income/Sales.
D) Sales/Gross Profit.
E) Debt/Long-Term Capital.

Question 76

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $2. An analyst expects dividends to grow at a rate of 8 percent per year for the next five years. After that dividends are expected to grow at a normal rate of 5 percent per year. Assume that the appropriate discount rate is 7 percent.
Refer to Exhibit 8.3. The price of the stock today (P₀) is

A) $136.29.
B) $133.03.
C) $120.33.
D) $123.43.
E) $126.60.

Question 77

What is the value of a 10 percent semi-annual coupon bond with a par value of $1,000 that matures in 5 years and has a required rate of return of 9 percent?

A) $1,021.95
B) $1,038.90
C) $1,039.56
D) $1,064.18
E) $1,078.23

Question 78

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $1.5. An analyst expects dividends to grow at a rate of 9 percent per year for the next three years. After that dividends are expected to grow at a normal rate of 5 percent per year. Assume that the appropriate discount rate is 7 percent.
Refer to Exhibit 8.4. The future price of the stock in year 3 is

A) $81.75.
B) $84.81.
C) $92.56.
D) $101.85.
E) $111.16.

Question 79

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $1.5. An analyst expects dividends to grow at a rate of 9 percent per year for the next three years. After that dividends are expected to grow at a normal rate of 5 percent per year. Assume that the appropriate discount rate is 7 percent.
Refer to Exhibit 8.4. The present value today of dividends for years 1 to 3 is

A) $4.67.
B) $3.08.
C) $5.67.
D) $4.5.
E) $1.53.

Question 80

All of the following are ways in which a firm can increase its growth rate of equity earnings without any external financing EXCEPT

A) decreasing its dividend payments.
B) increasing its retention ratio.
C) increasing its return on equity (ROE).
D) increasing its return on assets (ROA).
E) All of these are correct.