Deck 11: Introduction to Security Valuation

Question 1

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

Answer 1

True

Question 2

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

Answer 2

True

Question 3

A preferred stock is a perpetuity.

Answer 3

True

Question 4

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 5

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

Question 6

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 7

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

Question 8

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

Question 9

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

Question 10

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

Question 11

The price of a bond can be calculated by discounting future coupons over the bonds life by the yield to maturity.

Question 12

Empirical studies have shown that the market factor has increased over time and now accounts for the majority of an individual stock's price variance.

Question 13

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

Question 14

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

Question 15

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 16

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 17

The most difficult part of valuing a bond is determining the required rate of return on this investment.

Question 18

The general economic influences would include inflation, political upheavals, monetary policy, and fiscal policy initiatives.

Question 19

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

Question 20

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

Question 21

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 22

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 23

The P/E ratio is determined by

A)The required rate of return.
B)The expected dividend payout ratio.
C)The expected growth rate of dividends.
D)Choices a and b
E)All of the above

Question 24

The risk premium is impacted by business risk, financial risk, and liquidity risk.

Question 25

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

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

Question 26

The value of a corporate bond can be derived by calculating the present value of the interest payments and the present value of the face value at the bond's

A)Current yield.
B)Coupon rate.
C)Required rate of return.
D)Effective rate.
E)Prime rate.

Question 27

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

Question 28

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)None of the above (that is, all are considerations in the three-step valuation process)

Question 29

Which of the following factors influence an investor's required rate of return?

A)The economy's real risk-free rate (RFR)
B)The expected rate of inflation (I)
C)A risk premium
D)All of the above
E)None of the above

Question 30

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 31

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

A)Fiscal policy
B)Monetary policy
C)Inflation
D)P/E ratio
E)None of the above (that is, all are basic economic forces)

Question 32

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 33

A bond typically pays interest payments every six months equal to the coupon rate times the face value of the bond.

Question 34

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 35

The value of preferred stock can be calculated by dividing its dividend by the required rate of return.

Question 36

Dividend growth is a function of

A)Return on equity.
B)The retention rate.
C)The payout ratio.
D)All of the above.
E)None of the above.

Question 37

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 since it could reinvest a greater amount in new projects.
D)Zero.
E)Based on the capital asset pricing model.

Question 38

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

Question 39

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

Question 40

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 41

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 42

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%
B)Fall less than 4%.
C)Rise more than 4%
D)Rise less than 4%.
E)Remain constant.

Question 43

Exhibit 11.2
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
A major manufacturer is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 7 years remaining till maturity. The bonds were issued with an 8 percent coupon rate (paid quarterly) and a par value of $1,000. The required rate of return is 10 percent.
Refer to Exhibit 11.2. What is the current value of these securities?

A)$900.18
B)$1151.92
C)$972.52
D)$1113.63
E)$904.00

Question 44

Which of the following is an underlying assumption of the constant growth dividend discount model (DDM)?

A)Dividends have a constant growth rate
B)The constant growth rate of dividends will continue for an infinite time period
C)The required rate of return is greater than the expected growth rate
D)All of the above
E)None of the above

Question 45

Exhibit 11.3
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
A large grocery chain is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 6 years remaining until maturity. The bonds were issued with a 6 percent coupon rate (paid semiannually) and a par value of $1,000. Because of increased risk the required rate has risen to 10 percent.
Refer to Exhibit 11.3. What is the current value of these securities?

A)$656.40
B)$899.00
C)$822.70
D)$569.50
E)$962.00

Question 46

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 47

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 the above will increase the firm's growth rate without external financing

Question 48

Exhibit 11.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
A major retailer is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 8 years remaining until maturity. The bonds were issued with a 6.5 percent coupon rate (paid quarterly) and a par value of $1,000. The required rate of return is 4.25 percent.
Refer to Exhibit 11.1. What is the current value of these securities?

A)$1149.94
B)$433.15
C)$1151.92
D)$860.50
E)$863.35

Question 49

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%
B)Fall less than 2%.
C)Remain constant.
D)Rise more than 2%.
E)Rise less than 3%.

Question 50

Exhibit 11.4
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 11.4. 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 51

In 2004, 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 an 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 52

Exhibit 11.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
A major retailer is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 8 years remaining until maturity. The bonds were issued with a 6.5 percent coupon rate (paid quarterly) and a par value of $1,000. The required rate of return is 4.25 percent.
Refer to Exhibit 11.1. What will be the value of these securities in one year if the required return is 7 percent?

A)$970.14
B)$388.13
C)$1031.15
D)$1035.81
E)$972.52

Question 53

Exhibit 11.2
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
A major manufacturer is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 7 years remaining till maturity. The bonds were issued with an 8 percent coupon rate (paid quarterly) and a par value of $1,000. The required rate of return is 10 percent.
Refer to Exhibit 11.2. What will be the value of these securities in one year if the required return is 6 percent?

A)$1151.92
B)$972.52
C)$1100.15
D)$900.18
E)$936.72

Question 54

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%.
B)Rise less than 50%.
C)Remain constant.
D)Fall more than 50%.
E)Fall less than 50%.

Question 55

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 the above are appropriate depending on the situation

Question 56

In 2004, 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 57

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 future cash flows and a discount rate.
C)Both techniques require an estimate of future cash flows and a growth rate.
D)Both techniques require an estimate of future cash flows, the required rate of return and a growth estimate.
E)All of the above are true.

Question 58

In 2004, 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 an 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 59

Exhibit 11.3
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
A large grocery chain is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 6 years remaining until maturity. The bonds were issued with a 6 percent coupon rate (paid semiannually) and a par value of $1,000. Because of increased risk the required rate has risen to 10 percent.
Refer to Exhibit 11.3. What will be the value of these securities in one year if the required return declines to 8 percent?

A)$899.43
B)$862.50
C)$869.88
D)$918.93
E)$946.98

Question 60

In 2004, Venus Fly Co. issued a $75 par value preferred stock which 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 61

What is the value of a 10% 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%?

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

Question 62

Exhibit 11.7
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% per year for the next three years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
Refer to Exhibit 11.7. 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 63

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%
B)34.28%
C)23%
D)19.17%
E)11.29%

Question 64

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)none of the above.

Question 65

Exhibit 11.5
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 11.5. 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)None of the above

Question 66

Exhibit 11.7
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% per year for the next three years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
Refer to Exhibit 11.7. The dividends for years 1, 2, and 3 are

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

Question 67

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

A)$5.56
B)$66.4
C)$49.31
D)$43.66
E)none of the above

Question 68

Exhibit 11.6
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% per year for the next five years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
Refer to Exhibit 11.6. 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 69

Exhibit 11.6
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% per year for the next five years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
Refer to Exhibit 11.6. The price of the stock today (P₀) is

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

Question 70

Exhibit 11.7
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% per year for the next three years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
Refer to Exhibit 11.7. 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 71

Exhibit 11.6
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% per year for the next five years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
Refer to Exhibit 11.6. The dividends for years 1, 2, and 3 are

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

Question 72

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

Exhibit 11.6
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% per year for the next five years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
Refer to Exhibit 11.6. 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 74

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% and the long term growth rate in dividends is 6%, and earnings is 6%, the firm's P/E ratio is

A)8.33
B)33.33
C)44.44
D)11.11
E)None of the above

Question 75

Exhibit 11.5
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 11.5. 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 76

What is the value of a preferred stock that has a par value of $100, a required rate of return of 11%, 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 77

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

A)37%
B)63%
C)50%
D)0%
E)100%

Question 78

Exhibit 11.4
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 11.4. 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 79

Exhibit 11.7
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% per year for the next three years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
Refer to Exhibit 11.7. The price of the stock today (P₀) is

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

Question 80

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

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