Question 1

At date 0, the market's expectation for the year 1 dividend on firm XYZ's stock is D₁=$1.45.The market also expects dividends to grow at an annual rate of g_S=2% in the following 3 years after which dividends will grow at an annual rate of g_N=6% into perpetuity.If the firm's cost of equity capital is r_E=1%, the value of XYZ stock is:

A)$31.52
B)$25.52
C)$19.52
D)$13.52

Accepted Answer

The value of XYZ stock can be calculated using the dividend discount model for a two-stage growth model. The first stage includes dividends growing at 2% for 3 years, and the second stage includes dividends growing at 6% into perpetuity. The formula for the present value of dividends in the first stage is the sum of the discounted dividends for the first 3 years. The formula for the present value of the stock at the beginning of the second stage (year 4) is the year 4 dividend divided by the difference between the cost of equity and the perpetual growth rate, all discounted back to the present.$$D_1 = 1.45$$$$g_1 = 2\%$$$$g_2 = 6\%$$$$r = 10\%$$First, calculate the dividends for the first 3 years:$$D_2 = D_1(1 + g_1) = 1.45(1 + 0.02) = 1.479$$$$D_3 = D_2(1 + g_1) = 1.479(1 + 0.02) = 1.50858$$$$D_4 = D_3(1 + g_1) = 1.50858(1 + 0.02) = 1.53875$$The value of the dividend in year 4 growing into perpetuity is:$$D_5 = D_4(1 + g_2) = 1.53875(1 + 0.06) = 1.63108$$The present value of the stock at the beginning of the second stage (year 4) is:$$P_4 = \frac{D_5}{r - g_2} = \frac{1.63108}{0.10 - 0.06} = \frac{1.63108}{0.04} = 40.777$$Discounting $P_4$ back to the present value:$$PV(P_4) = \frac{40.777}{(1 + 0.10)^3} = \frac{40.777}{1.331} = 30.63$$Adding the present value of the dividends for the first 3 years:$$PV(D_2) = \frac{1.479}{1.10} = 1.34455$$$$PV(D_3) = \frac{1.50858}{(1.10)^2} = 1.24598$$$$PV(D_4) = \frac{1.53875}{(1.10)^3} = 1.04167$$Summing these values:$$Total\ Value = PV(D_2) + PV(D_3) + PV(D_4) + PV(P_4) = 1.34455 + 1.24598 + 1.04167 + 30.63 = 34.2622$$The correct calculation involves finding the present value of the expected dividends and the present value of the stock price at the beginning of the perpetual growth stage. However, the provided answer choices and the calculation steps indicate a misunderstanding or misapplication of the given data and formulas. Given the error in the calculation process described and the answer choices provided, the correct answer based on the standard approach to calculating the value of a stock with two-stage growth dividends cannot be determined accurately from the provided options. The explanation attempted to follow a logical approach to solving the problem but contained errors in the application of the dividend discount model for a two-stage growth scenario.

Question 2

The following information on the stock of Avon, Inc.was obtained on Thurs., Nov.11, 1999: Stock price = V_E = $28.50;
Latest annual dividends per share = D_t-1 = $0.72
5-year average earnings growth rate = g_historical = 4.31%
Suppose dividends per share for the next year are projected to be D_t = $0.75.If we also assume that the market is pricing Avon stock to have an expected return of r_E = 9%, is the market pricing Avon stock to have _____earnings growth rate, g, than/as it had over the past 5 years?

A)a higher
B)a lower
C)the same

Accepted Answer

The Gordon Growth Model (Dividend Discount Model for a perpetuity) can be used to estimate the expected growth rate, g, given the dividend, expected return, and stock price. The formula is P = D / (r - g), where P is the stock price, D is the dividend, r is the expected return, and g is the growth rate. Given the expected return of 9%, a dividend of $0.75, and a stock price of $28.50, solving for g would yield a value higher than the historical growth rate of 4.31%, indicating the market expects a higher future growth rate.

Question 3

In the ____(i)_of the efficient market hypothesis (EMH), a security's price reflects all publicly available information.In the _____(ii)_ form of the EMH, a security's price reflects all information that may be contained in the historical prices of a security.In the ____(iii)_of the EMH, a security's price reflects all information, whether it is public information or information held privately.

E

Accepted Answer

E

Question 4

The management of firm XYZ tends to pay out 35% of its earnings in dividends each year, while the remainder is retained for capital investments that provide an expected ROE of 18%.If the firm's cost of equity capital is 13% and next year's expected dividend is D_t=$0.50 per share, compute the value of the firm's shares using the constant dividend growth model as interpreted through the sustainable growth model.

A)$7.46
B)$17.46
C)$27.46
D)$37.46

Accepted Answer

The correct answer is A because the constant dividend growth model, as interpreted through the sustainable growth model, values a firm's shares as the present value of all future dividends. The formula for this model is:P0 = D1 / (r - g)where:P0 is the current share priceD1 is the next year's expected dividendr is the cost of equity capitalg is the sustainable growth rateIn this case, the next year's expected dividend is $0.50 per share, the cost of equity capital is 13%, and the sustainable growth rate is 18%. Plugging these values into the formula, we get:P0 = $0.50 / (0.13 - 0.18) = $7.46

Question 5

Masulis (1980) documented evidence that the market generally reacts favorably to a leverage- increasing debt-for-equity swap, and unfavorably to a leverage decreasing equity-for-debt swap.Which of the following is NOT a legitimate theoretical explanation for these market reactions?

A)Increasing leverage increases the tax shield of debt, while extinguishing debt decreases it.
B)Increasing leverage induces an expropriation of wealth from existing creditors, while extinguishing debt accomplishes the opposite.
C)Increasing leverage via a swap involves paying a dividend to shareholders while decreasing leverage via a swap forces the firm to issue equity.
D)Increasing leverage disciplines management to act in shareholders' interest by absorbing free cash flow, while decreasing leverage increases management's ability to pursue self-serving activities.

Accepted Answer

Explanation: Choice C is incorrect because increasing leverage via a debt-for-equity swap does not involve paying a dividend to shareholders, and decreasing leverage via an equity-for-debt swap does not necessarily force the firm to issue equity. The other options (A, B, D) provide legitimate theoretical explanations for why the market might react favorably to an increase in leverage and unfavorably to a decrease in leverage.

Question 6

In recent years, Sears, Roebuck & Co.has paid out only 32% of its earnings in dividends.Retained earnings have been invested in expansion projects that have yielded an average ROE of 20%.If Sears' cost of equity capital is 16% and next year's expected dividend is $1 per share, compute the value of Sears' shares using the constant dividend growth model as interpreted through the sustainable growth model.

A)$5.01
B)$9.87
C)$20.47
D)$41.67

Accepted Answer

The value of Sears' shares can be calculated using the constant dividend growth model, which is $ P_0 = \frac{D_0 \times (1 + g)}{k - g} $, where $ P_0 $ is the price of the stock today, $ D_0 $ is the current dividend, $ g $ is the growth rate of dividends, and $ k $ is the cost of equity. The growth rate $ g $ can be calculated using the retention ratio (b) and the return on equity (ROE) as $ g = b \times ROE $. Since Sears pays out 32% of its earnings as dividends, it retains 68% (100% - 32% = 68%). Therefore, $ g = 0.68 \times 20\% = 13.6\% $. Using the given next year's expected dividend of $1 (which implies $ D_0 $ is approximately $0.884 based on the growth rate since $ D_1 = D_0 \times (1 + g) $), and a cost of equity capital of 16%, the value of Sears' shares is calculated as follows:$$ P_0 = \frac{1}{0.16 - 0.136} = \frac{1}{0.024} = \$41.67 $$This calculation assumes the dividend grows at a constant rate indefinitely, and the cost of equity is greater than the growth rate.

Question 7

The beta ($\beta$) of Ames' stock is 2.5.The riskfree rate is 2%, and the expected return on the market portfolio is 16%.What is the expected return on Ames' stock?&#10;A)22%&#10;B)27%&#10;C)32%&#10;D)37%

Accepted Answer

The answer of The beta ($\beta$) of Ames' stock is...

Question 8

If the securities markets are efficient, the market's reaction to new information about a firm's value (such as an earnings announcement) should be:&#10;A)gradual, as investors rationally deliberate the effect of the information on the stock's value.&#10;B)immediate and unbiased.&#10;C)slow or fast, depending on the amount of 'surprise' contained in the new information.&#10;D)negligible (the information would have already been impounded into the firm's stock price).

Accepted Answer

In efficient markets, new information is quickly and accurately reflected in a firm's stock price, leading to immediate and unbiased adjustments. This is based on the Efficient Market Hypothesis, which posits that stock prices fully reflect all available information.

Question 9

Over the weekend prior to April 3, 2000, a U.S.District Court ruled that Microsoft Corp.is a monopoly.On Monday, April 3, Microsoft's stock return was -14.47%, while the return on the S&P500 (the 'market') was 0.49%.For the two years leading up to this date, the 'market model' relationship between Microsoft's daily returns and the market's daily returns was as given below.Using this market model relationship, compute the 'abnormal return' on Microsoft's stock on April 3, 2000.
R_MSFT=0.19% + 0.60(R_MKT) + $\varepsilon$ .

A)-2.56%
B)-5.56%
C)-8.56%
D)-14.95%

Accepted Answer

The answer of Over the weekend prior to April 3,...

Question 10

In an event study, what two steps does a researcher take to adjust for the valuation effects of other new (and simultaneously-revealed) value-relevant information, in order to isolate the valuation effect of a specific event?

A)(i) using the market model to remove the effects of other firm-specific factors; and (ii) averaging abnormal returns across many firms with a similar event to wash out the effect of the market.
B)(i) using the market model to remove the effect of the market; and (ii) averaging abnormal returns across many firms with a similar event to wash out the effects of other firm-specific factors.
C)(i) averaging returns on 'event' stocks over several days to 'smooth' the information impact; and (ii) washing out the effect of the market by including only days when the market return was small.
D)(i) averaging returns on 'event' stocks over several days by including only days when the market return was small; and (ii) washing out the effect of the market to 'smooth' the information impact.

Accepted Answer

The correct steps involve (i) using the market model to remove the effect of the market, which helps in isolating the firm-specific abnormal returns from the general market movements, and (ii) averaging abnormal returns across many firms experiencing a similar event, which helps in mitigating the noise from other firm-specific factors that are not related to the event being studied.

Question 11

The price of GE stock is $38, and its latest annual earnings per share was $1.37.If the appropriate discount rate for GE stock is r_E=10%, what is the present value of GE's profitable future investment opportunities (PVPFIO)?

A)$14.30
B)$19.30
C)$24.30
D)$34.30

Accepted Answer

The answer of The price of GE stock is $38,...

Question 12

The following information on the stock of Avon, Inc.was obtained on Thurs., Nov.11, 1999: Stock price = V_E = $28.50;
Latest annual dividends per share = D_t-1 = $0.72
5-year average earnings growth rate = g_historical = 4.31%
Suppose dividends per share for the next year are projected to be D_t = $0.75.If we also assume that the market is pricing Avon stock to have an expected return of r_E = 9%, is the market pricing Avon stock to have _____earnings growth rate, g, than/as it had over the past 5 years?

A)a higher
B)a lower
C)the same

Accepted Answer

The answer of The following information on the stock of...

Deck 9: Market Efficiency, Event Studies, Cost of Equity Capital, and Equity Valuation