42GitmanPrinciplesofFinance,EleventhEdition

Chapter7
StockValuation
.1

Learning Goals

1.

Differentiatebetweendebtandequitycapital.

2.

Discusstherights,characteristics,andfeaturesofbothcommonandpreferredstock.

3.

Describetheprocessofissuingcommonstock,includingventurecapital,goingpublicandthe
investmentbanker,andinterpretingstockquotations.

4.

Understandtheconceptofmarketefficiencyandbasiccommonstockvaluationusingzerogrowth,
constantgrowth,andvariablegrowthmodels.

5.

Discussthefreecashflowvaluationmodelandthebookvalue,liquidationvalue,andprice/earnings
(P/E)multiplesapproaches.

6.

Explaintherelationshipsamongfinancialdecisions,return,risk,andthefirmsvalue.

.2

True/False

1.

Holdersofequityhaveclaimsonbothincomeandassetsthataresecondarytotheclaimsof
creditors.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:ContrastingDebtandEquity

2.

Thetaxdeductibilityofinterestlowersthecostofdebtfinancing,therebycausingthecostofdebt
financingtobelowerthanthecostofequityfinancing.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:1
Topic:ContrastingDebtandEquity

3.

Preferredstockisaspecialformofstockhavingafixedperiodicdividendthatmustbepaidpriorto
paymentofanyinteresttooutstandingbonds.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2

43GitmanPrinciplesofFinance,EleventhEdition

Topic:FeaturesofPreferredStock

Chapter7StockValuation44

4.

Cumulativepreferredstocksarepreferredstocksforwhichallpassed(unpaid)dividendsinarrears
mustbepaidinadditionalsharesofpreferredstockpriortothepaymentofdividendstocommon
stockholders.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofPreferredStock

5.

Preferredstockisoftenconsideredaquasidebtsinceityieldsafixedperiodicpayment.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofPreferredStock

6.

Theamountoftheclaimofpreferredstockholdersinliquidationisnormallyequaltothemarket
valueofthepreferredstock.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofPreferredStock

7.

Cumulativepreferredstocksarepreferredstocksforwhichallpassed(unpaid)dividendsinarrears
mustbepaidalongwiththecurrentdividendpriortothepaymentofdividendstocommon
stockholders.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofPreferredStock

8.

Becausepreferredstockisaformofownershipandhasnomaturitydate,itsclaimsonincomeand
assetsaresecondarytothoseofthefirmscreditors.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofPreferredStock

9.

Oneadvantageofpreferredstockisitsabilitytoincreaseleverage,whichinturnwillmagnifythe
effectsofincreasedearningsoncommonstockholdersreturns.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofPreferredStock

10.

Apreferredstockholderissometimesreferredtoasaresidualowner,sinceinessenceheorshe
receiveswhatislefttheresidualafterallotherclaimsonthefirmsincomeandassetshavebeen
satisfied.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofPreferredStock

45GitmanPrinciplesofFinance,EleventhEdition

11.

Acallfeatureisafeaturethatallowspreferredstockholderstochangeeachshareintoastated
numberofsharesofcommonstock.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofPreferredStock

12.

Thecostofpreferredstockfinancingisgenerallyhigherthanthatofdebtfinancing.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofPreferredStock

13.

Thecostofpreferredstockfinancingisgenerallyhigherthanthatofdebtfinancingbecauseunlike
thepaymentofinteresttobondholders,thepaymentofdividendstopreferredstockholdersisnot
guaranteed,andinterestondebtistaxdeductiblewhereaspreferredstockdividendisnot.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofPreferredStock

14.

Theclaimsofequityholdersonthefirmsincomecannotbepaiduntiltheclaimsofallcreditors
havebeensatisfied.But,theclaimsoftheequityholdersonthefirmsassetshavepriorityoverthe
claimsofcreditorsbecausetheequityholdersaretheownersofthefirm.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:3
Topic:FeaturesofCommonStock

15.

Preemptiverightsallowcommonstockholderstomaintaintheirproportionateownershipinthe
corporationwhennewissuesaremade.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:FeaturesofCommonStock

16.

Stockrightsallowstockholderstopurchaseadditionalsharesofstockindirectproportiontothe
numberofsharestheyown.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:FeaturesofCommonStock

17.

ThecorporateVCfundsaresubsidiariesoffinancialinstitutions,particularlybanks,setuptohelp
youngfirmsgrowand,itishoped,becomemajorcustomersoftheinstitutions.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:3
Topic:VentureCapital

Chapter7StockValuation46

18.

Thesmallbusinessinvestmentcompanies(SBICs)arecorporationscharteredbythefederal
governmentthatcanborrowatattractiveratesfromtheU.S.Treasuryandusethefundstomake
venturecapitalinvestmentsinprivatecompanies.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:VentureCapital

19.

Theangelcapitalistsarewealthyindividualinvestorswhodonotoperateasabusinessbutinvestin
earlystagecompaniesinexchangeforaportionofequity.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:VentureCapital

20.

Thefreecashflowvaluationmodeldeterminesthevalueofanentirecompanyasthepresentvalue
ofitsexpectedfreecashflowsdiscountedatthefirmsweightedaveragecostofcapital.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:FreeCashFlowModel

21.

Acommonstockholderhasnoguaranteeofreceivinganycashinflows,butreceiveswhatisleft
afterallotherclaimsonthefirmsincomeandassetshavebeensatisfied.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:FeaturesofCommonStock

22.

Preferredstockthatprovidesfordividendpaymentsbasedoncertainformulasallowingpreferred
stockholderstoparticipatewithcommonstockholdersinthereceiptofdividendsbeyondaspecified
amountiscumulative.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
Topic:FeaturesofPreferredStock

23.

Althoughpreferredstockprovidesaddedfinancialleverageinmuchthesamewayasbonds,it
differsfrombondsinthattheissuercanpassadividendpaymentwithoutsufferingthe
consequencesthatresultwhenaninterestpaymentismissedonabond.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofPreferredStock

24.

Preemptiverightsallowexistingshareholderstomaintainvotingcontrolandprotectagainstthe
dilutionoftheirownership.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3

47GitmanPrinciplesofFinance,EleventhEdition

Topic:FeaturesofCommonStock

Chapter7StockValuation48

25.

AmericanDepositaryReceiptsareclaimsissuedbyU.S.banksrepresentingownershipofsharesof
aforeigncompanysstockheldondepositbytheU.S.bankintheforeignmarketandissuedin
dollarstoU.S.investors.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:AmericanDepositaryReceipts

26.

Treasurystockgenerallydoesnothavevotingrights,doesnotearndividends,anddoesnothavea
claimonassetsinliquidation.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:TreasuryStock

27.

TreasurystocksareclassBcommonandhavevotingrights.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:TreasuryStock

28.

Firmsoccasionallyrepurchasestockinordertochangetheircapitalstructureortoincreasethe
returnstotheowners.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:TreasuryStock

29.

Dilutionofownershipoccurswhenanewstockissueresultsineachpresentstockholderhavinga
largernumberofsharesand,thus,aclaimtoalargerpartofthefirmsearningsthanpreviously.
Answer: FALSE
LevelofDifficulty:4
LearningGoal:3
Topic:IssuingCommonStock

30.

Investorspurchaseastockwhentheybelievethatitisundervaluedandsellwhentheyfeelthatitis
overvalued.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:4
Topic:MarketEfficiency

31.

Inanefficientmarket,theexpectedreturnandtherequiredreturnareequal.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:MarketEfficiency

49GitmanPrinciplesofFinance,EleventhEdition

32.

Toabuyer,anassetsvaluerepresentstheminimumpricethatheorshewouldpaytoacquireit,
whileasellerviewstheassetsvalueasaminimumshareprice.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:4
Topic:MarketEfficiency

33.

Iftheexpectedreturnislessthantherequiredreturn,investorswillselltheasset,becauseitisnot
expectedtoearnareturncommensuratewithitsrisk.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:MarketEfficiency

34.

Iftheexpectedreturnwereabovetherequiredreturn,investorswouldbuytheasset,drivingitsprice
upanditsexpectedreturndown.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:4
Topic:MarketEfficiency

35.

Efficientmarkethypothesisisthetheorydescribingthebehaviorofanassumedperfectmarketin
whichsecuritiesaretypicallyinequilibrium,securitypricesfullyreflectallpublicinformation
availableandreactswiftlytonewinformation,and,becausestocksarefairlypriced,investorsneed
notwastetimelookingformispricedsecurities.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:4
Topic:MarketEfficiency

36.

Invaluationofcommonstock,theprice/earningsmultipleapproachisconsideredsuperiortotheuse
ofbookorliquidationvaluessinceitconsidersexpectedearnings.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:5
Topic:P/EMultipleApproach

37.

Thecommonstockbookvaluemodelignoresthefirmsexpectedearningspotentialandgenerally
lacksanytruerelationshiptothefirmsvalueinthemarketplace.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:BookValueApproach

38.

Anyactiontakenbythefinancialmanagerthatincreasesriskwillalsoincreasetherequiredreturn.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:6
Topic:RiskReturnRelationship

Chapter7StockValuation50

39.

Incommonstockvaluation,anyactiontakenbythefinancialmanagerthatincreasesriskwillalso
increasetherequiredreturn.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:RiskReturnRelationship

40.

Incommonstockvaluation,anyactiontakenbythefinancialmanagerthatincreasesriskcontributes
towardanincreaseinvalue.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:6
Topic:RiskReturnRelationship

41.

Inastableeconomy,anactionofthefinancialmanagerthatincreasesthelevelofexpectedreturn
withoutchangingriskshouldreducesharevalue,andanactionthatreducesthelevelofexpected
returnwithoutchangingriskshouldincreasesharevalue.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:6
Topic:RiskReturnRelationship

42.

Assumingthateconomicconditionsremainstable,anymanagementactionthatwouldcausecurrent
andprospectivestockholderstoraisetheirdividendexpectationsshoulddecreasethefirmsvalue.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:6
Topic:RiskReturnRelationship

43.

Unlikecreditors(lenders),equityholders(bothpreferredandcommonstockholders)areownersof
thefirm.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:ContrastingDebtandEquity

44.

Unlikeequityholders,creditorsareownersofthefirm.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1
Topic:ContrastingDebtandEquity

45.

Interestpaidtobondholdersistaxdeductiblebutinterestpaidtostockholdersisnot.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1
Topic:ContrastingDebtandEquity

51GitmanPrinciplesofFinance,EleventhEdition

46.

Interestpaidtobondholdersistaxdeductiblebutdividendspaidtostockholdersarenot.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:ContrastingDebtandEquity

47.

Inthecaseofliquidation,commonstockholdersarepaidfirst,followedbypreferredstockholders,
followedbybondholders.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1
Topic:ContrastingDebtandEquity

48.

Inthecaseofliquidation,bondholdersarepaidfirst,followedbypreferredstockholders,followed
bycommonstockholders.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:ContrastingDebtandEquity

49.

Preferredstockholdersareoftenreferredtoasresidualclaimants.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:ContrastingDebtandEquity

50.

Commonstockholdersareoftenreferredtoasresidualclaimants.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:ContrastingDebtandEquity

51.

Commonstockcanbeeitherprivatelyorpubliclyowned.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofCommonStock

52.

Likebonds,commonstockisusuallysoldwithaparvalue.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofCommonStock

53.

Likebonds,theparvalueonacommonstockisusedasabasisfordeterminingitsfixeddividend.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofCommonStock

Chapter7StockValuation52

54.

Thenumberofauthorizedsharesofcommonstockisalwaysgreaterthanorequaltothenumberof
outstandingsharesofcommonstock.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofCommonStock

55.

Thenumberofoutstandingsharesofcommonstockisalwaysgreaterthanorequaltothenumberof
authorizedsharesofcommonstock.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofCommonStock

56.

Supervotingsharesofcommonstockprovideshareholderswithtentimesthevotingpowerof
ordinarysharesofcommonstock.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:CommonStockVoting

57.

UndertheJobsandGrowthTaxReliefReconciliationActof2003,dividendsaresubjecttoa
maximumtaxrateof20percent.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofCommonStock

58.

UndertheJobsandGrowthTaxReliefReconciliationActof2003,dividendsaresubjecttoa
maximumtaxrateof15percent.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofCommonStock

59.

Aprospectusisanothertermforafirmsannualreportshowingthefirmsprospectsforthecoming
year.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
Topic:IssuingCommonStock

60.

Aprospectusisaportionofthesecurityregistrationstatementthatdescribesthekeyaspectsofthe
issue,theissuer,anditsmanagementandfinancialposition.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:IssuingCommonStock

53GitmanPrinciplesofFinance,EleventhEdition

61.

Anunderwrittenissueofcommonstockisoneinwhichthefirmpurchasesinsurancetocover
unexpectedlossessufferedbyshareholders.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:IssuingCommonStock

62.

Inacommonstockquotation,thetermYLDpercentstandsfordividendyieldandcanbefound
bydividingthestocksannualdividendbyitsPEratio.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
Topic:CommonStockQuotations

63.

Inacommonstockquotation,thetermYLDpercentstandsfordividendyieldandcanbefound
bydividingthestocksannualdividendbymostrecentclosingprice.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:CommonStockQuotations

64.

Inanefficientmarket,stockpricesadjustquicklytonewpublicinformation.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:EfficientMarketTheory

65.

Inaninefficientmarket,stockpricesadjustquicklytonewpublicinformation.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
Topic:EfficientMarketTheory

66.

Inaninefficientmarket,securitiesaretypicallyinequilibrium,whichmeansthattheyarefairly
pricedandthattheirexpectedreturnsequaltheirrequiredreturns.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
Topic:EfficientMarketTheory

67.

Inanefficientmarket,securitiesaretypicallyinequilibrium,whichmeansthattheyarefairlypriced
andthattheirexpectedreturnsequaltheirrequiredreturns.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:EfficientMarketTheory

Chapter7StockValuation54

68.

Ifamarketistrulyefficient,investorsshouldnotwastetheirtimetryingtofindandcapitalizeon
mispricedsecurities.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:EfficientMarketTheory

69.

Behavioralfinanceisagrowingbodyofresearchthatfocusesoninvestorbehavioranditsimpacton
investmentdecisionsandstockprices.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:EfficientMarketTheory

70.

Theconstantgrowthmodelisanapproachtodividendvaluationthatassumesaconstantfuture
dividend.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
Topic:ConstantGrowthValuationModel

71.

Theconstantgrowthmodelisanapproachtodividendvaluationthatassumesthatdividendsgrowat
aconstantrateindefinitely.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:ConstantGrowthValuationModel

72.

ThefreecashflowvaluationmodelisbasedonthesameprincipleastheP/Evaluationapproach;
thatis,thevalueofashareofstockisthepresentvalueoffuturecashflows.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:5
Topic:FreeCashFlowModel

73.

Thefreecashflowvaluationmodelisbasedonthesameprincipleasdividendvaluationmodels;
thatis,thevalueofashareofstockisthepresentvalueoffuturecashflows.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:FreeCashFlowModel

74.

Theliquidationvaluepershareofcommonstockistheamountpershareofcommonstockthat
wouldbereceivedifallofthefirmsassetsweresoldfortheiraccountingvalueandtheproceeds
remainingweredividedamongcommonstockholders.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:5
Topic:LiquidationValue

55GitmanPrinciplesofFinance,EleventhEdition

75.

Thebookvaluepershareofcommonstockistheamountpershareofcommonstockthatwouldbe
receivedifallofthefirmsassetsweresoldfortheiraccountingvalueandtheproceedsremaining
weredividedamongcommonstockholders.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:BookValue

.3

Multiple Choice Questions

1.

Equitycapitalcanberaisedthrough
(a) themoneymarket.
(b) theNYSEbondmarket.
(c) retainedearningsandthestockmarket.
(d) aprivateplacementwithaninsurancecompanyasthecreditor.
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:IssuingCommonStock

2.

Holdersofequitycapital
(a) ownthefirm.
(b) receiveinterestpayments.
(c) receiveguaranteedincome.
(d) haveloanedmoneytothefirm.
Answer: A
LevelofDifficulty:1
LearningGoal:1
Topic:FeaturesofCommonStock

3.

Asaformoffinancing,equitycapital
(a) hasamaturitydate.
(b) isonlyliquidatedinbankruptcy.
(c) istemporary.
(d) haspriorityoverbonds.
Answer: B
LevelofDifficulty:2
LearningGoal:1
Topic:FeaturesofCommonStock

Chapter7StockValuation56

4.

Theclaimsoftheequityholdersonincomehavepriorityover
(a) theclaimsofthepreferredstockholders.
(b) theclaimsofthecreditors.
(c) theclaimsoftheunsecuredcreditors.
(d) noone.
Answer: D
LevelofDifficulty:2
LearningGoal:1
Topic:FeaturesofCommonStock

5.

_________arepromisedafixedperiodicdividendthatmustbepaidpriortopayinganycommon
stockdividends.
(a) Preferredstockholders
(b) Commonstockholders
(c) Bondholders
(d) Creditors
Answer: A
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofPreferredStock

6.

Dividendsinarrearsthatmustbepaidtothepreferredstockholdersbeforepaymentofdividendsto
commonstockholdersare
(a) cumulative.
(b) noncumulative.
(c) participating.
(d) convertible.
Answer: A
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofPreferredStock

7.

An8percentpreferredstockwithamarketpriceof$110pershareanda$100parvaluepaysacash
dividendof_________.
(a) $4.00
(b) $8.00
(c) $8.80
(d) $80.00
Answer: B
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofPreferredStock

57GitmanPrinciplesofFinance,EleventhEdition

8.

Fromthecorporationspointofview,theadvantagesofissuingpreferredstockincludeallofthe
followingEXCEPT
(a) itsincreasedfinancialleverage.
(b) itsflexibledividendpolicy.
(c) itsexcellentmergersecurity.
(d) itsdifficultytoretire.
Answer: D
LevelofDifficulty:1
LearningGoal:2
Topic:FeaturesofPreferredStock

9.

Theadvantagesofissuingpreferredstockfromthecommonstockholdersperspectiveincludeallof
thefollowingEXCEPT
(a) seniorityofthepreferredstockholdersclaim.
(b) flexibility.
(c) useinmergers.
(d) increasedleverage.
Answer: A
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofPreferredStock

10.

Thecostofpreferredstockis
(a) lowerthanthecostoflongtermdebt.
(b) higherthanthecostofcommonstock.
(c) higherthanthecostoflongtermdebtandlowerthanthecostofcommonstock.
(d) lowerthanthecostofconvertiblelongtermdebtandhigherthanthecostofcommonstock.
Answer: C
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofPreferredStock

11.

AllofthefollowingfeaturesmaybecharacteristicofpreferredstockEXCEPT
(a) callable.
(b) nomaturitydate.
(c) taxdeductibledividends.
(d) convertible.
Answer: C
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofPreferredStock

Chapter7StockValuation58

12.

AllofthefollowingarecharacteristicsofpreferredstockEXCEPT
(a) itisoftenconsideredquasidebtduetofixedpaymentobligation.
(b) ithaslessrestrictivecovenantsthandebt.
(c) itgivestheholdervotingrightswhichpermitselectionofthefirmsdirectors.
(d) itsholdershavepriorityovercommonstockholdersintheliquidationofassets.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofPreferredStock

13.

ThefollowingarealldisadvantagesofpreferredstockEXCEPT
(a) seniorityofthepreferredstockholdersclaim.
(b) thecostofpreferredstockfinancingisgenerallyhigherthanthatofdebtfinancing.
(c) mostpreferredstocksoldmustbefixedratetocompetewithbonds.
(d) preferredstockisgenerallydifficulttosell.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofPreferredStock

14.

Afirmhasissuedcumulativepreferredstockwitha$100parvalueanda12percentannual
dividend.Forthepasttwoyears,theboardofdirectorshasdecidednottopayadividend.The
preferredstockholdersmustbepaid_________priortopayingthecommonstockholders.
(a) $0/share
(b) $12/share
(c) $24/share
(d) $36/share
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:CumulativePreferredStock

15.

Afirmhasanoutstandingissueof1,000sharesofpreferredstockwitha$100parvalueandan
8percentannualdividend.Thefirmalsohas5,000sharesofcommonstockoutstanding.Ifthestock
iscumulativeandtheboardofdirectorshaspassedthepreferreddividendforthepriortwoyears,
howmuchmustthepreferredstockholdersbepaidpriortopayingdividendstocommon
stockholders?
(a) $8,000
(b) $16,000
(c) $24,000
(d) $25,000
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:CumulativePreferredStock

59GitmanPrinciplesofFinance,EleventhEdition

16.

Aviolationofpreferredstockrestrictivecovenantsusuallypermitspreferredshareholdersto
(a) forcethecompanyintobankruptcy.
(b) selltheirshares.
(c) forcetheretirementofthepreferredstockatoraboveitsparvalue.
(d) forcethecompanytorepurchasethesharesatastatedamountbelowpar.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofPreferredStock

17.

Theopportunityformanagementtopurchaseacertainnumberofsharesoftheirfirmscommon
stockataspecifiedpriceoveracertainperiodoftimeisa
(a) stockoption.
(b) warrant.
(c) preemptiveright.
(d) stockright.
Answer: A
LevelofDifficulty:1
LearningGoal:3
Topic:FeaturesofCommonStock

18.

Anothertermsometimesappliedtoacommonshareholderisa
(a) fundamentalorbasicownerofthefirm.
(b) residualownerofthefirm.
(c) netownerofthefirm.
(d) reciprocalownerofthefirm.
Answer: B
LevelofDifficulty:1
LearningGoal:3
Topic:FeaturesofCommonStock

19.

Regardingthetaxtreatmentofpaymentstosecuritiesholders,itistruethat_________,while
_________.
(a) interestandpreferredstockdividendsarenottaxdeductible;commonstockdividendsaretax
deductible
(b) interestandpreferredstockdividendsaretaxdeductible;commonstockdividendsarenot
taxdeductible
(c) commonstockdividendsandpreferredstockdividendsaretaxdeductible;interestisnot
taxdeductible
(d) commonstockdividendsandpreferredstockdividendsarenottaxdeductible;interestis
taxdeductible
Answer: D
LevelofDifficulty:1
LearningGoal:3
Topic:ContrastingDebtandEquity

Chapter7StockValuation60

20.

Sharesofstockcurrentlyownedbythefirmsshareholdersarecalled
(a) authorized.
(b) issued.
(c) outstanding.
(d) treasuryshares.
Answer: C
LevelofDifficulty:1
LearningGoal:3
Topic:TreasuryStock

21.

IfafirmhasclassAandclassBcommonstockoutstanding,itmeansthat
(a) eachclassreceivesadifferentdividend.
(b) theparvalueofeachclassisdifferent.
(c) thedividendpaidtooneoftheclassesistaxdeductiblebythecorporation.
(d) oneoftheclassesisnonvotingstock.
Answer: D
LevelofDifficulty:1
LearningGoal:3
Topic:FeaturesofCommonStock

22.

Commonstockholdersexpecttoearnareturnbyreceiving
(a) semiannualinterest.
(b) fixedperiodicdividends.
(c) dividends.
(d) annualinterest.
Answer: C
LevelofDifficulty:1
LearningGoal:3
Topic:FeaturesofCommonStock

23.

AllofthefollowingareexamplesofmarketablesecuritiesEXCEPT
(a) commonstock.
(b) aTreasurybill.
(c) commercialpaper.
(d) anegotiablecertificateofdeposit.
Answer: A
LevelofDifficulty:1
LearningGoal:3
Topic:MarketableSecurities

61GitmanPrinciplesofFinance,EleventhEdition

24.

_________ishiredbyafirmtofindprospectivebuyersforitsnewstockorbondissue.
(a) Asecuritiesanalyst
(b) Atrustofficer
(c) Acommercialloanofficer
(d) Aninvestmentbanker
Answer: D
LevelofDifficulty:1
LearningGoal:3
Topic:InvestmentBanking

25.

Aspecialistinvolvedinanalyzingsecuritiesandconstructinginvestmentportfoliosiscalled
(a) aninvestmentbanker.
(b) acontroller.
(c) aninstallmentloanofficer.
(d) asecuritiesanalystorsecuritiesbroker.
Answer: D
LevelofDifficulty:1
LearningGoal:3
Topic:InvestmentBanking

26.

The_________aresometimesreferredtoastheresidualownersofthecorporation.
(a) preferredstockholders
(b) unsecuredcreditors
(c) commonstockholders
(d) securedcreditors
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:FeaturesofCommonStock

27.

Treasurystockresultsfromthe
(a) firmsellingstockforgreaterthanitsparvalue.
(b) cumulativefeatureonpreferredstock.
(c) repurchaseofoutstandingstock.
(d) authorizationofadditionalsharesofstockbytheboardofdirectors.
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:TreasuryStock

Chapter7StockValuation62

28.

Thepurposeofnonvotingcommonstockisto
(a) limitthevotingpowerofthemanagement.
(b) allowtheminorityinteresttoelectonedirector.
(c) raisecapitalwithoutgivingupanyvotingrights.
(d) givepreferenceondistributionofearningstothoseshareholderswhoownthestock.
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:CommonStockVoting

29.

Aproxystatementgivestheshareholdertheright
(a) ofonevoteforeachshareowned.
(b) togiveuptheirvotetoanotherparty.
(c) tomaintaintheirproportionateownershipinthecorporationwhennewcommonstockisissued.
(d) toselltheirshareofstockatapremium.
Answer: B
LevelofDifficulty:2
LearningGoal:3
Topic:CommonStockVoting

30.

Aproxybattleistheattemptby
(a) thecreditorsofabankruptfirmtoseizeassets.
(b) themanagementtodismisstheboardofdirectors.
(c) anonmanagementgrouptogaincontrolofthemanagementofafirmthroughthesolicitationof
asufficientnumberofcorporatevotes.
(d) theemployeestounionize.
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:CommonStockVoting

31.

Becauseequityholdersarethelasttoreceiveanydistributionofassetsasaresultofbankruptcy
proceedings,commonstockholdersexpect
(a) fixeddividendpayments.
(b) greatercompensationintheformofdividendsandrisingstockprices.
(c) allprofitstobepaidoutindividends.
(d) warrantstobeattachedtothestockissueasasweetener.
Answer: B
LevelofDifficulty:3
LearningGoal:3
Topic:FeaturesofCommonStock

63GitmanPrinciplesofFinance,EleventhEdition

32.

Theattemptbyanonmanagementgrouptogaincontrolofthemanagementofafirmbysolicitinga
sufficientnumberofproxyvotesiscalled
(a) hostiletakeover.
(b) supervotingshares.
(c) proxybattle.
(d) Noneoftheabove.
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:CommonStockVoting

33.

Thedisadvantagesofissuingcommonstockversuslongtermdebtincludeallofthefollowing
EXCEPT
(a) thepotentialdilutionofearnings.
(b) highcost.
(c) nomaturitydate.
(d) themarketperceptionthatmanagementthinksthefirmisovervalued,causingadeclineinstock
price.
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:ContrastingDebtandEquity

34.

TheparvalueoncommonstockhasallofthefollowingcharacteristicsEXCEPT
(a) agenerallylowvalue.
(b) somestatestaxaccordingtotheparvalue.
(c) indicatesthemarketvalueatwhichthestockwasoriginallysold.
(d) statedinthecorporatecharter.
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:FeaturesofCommonStock

35.

Afirmissued5,000sharesof$1parvaluecommonstock,receivingproceedsof$20pershare.The
accountingentryforthepaidincapitalinexcessofparaccountis
(a) $5,000.
(b) $95,000.
(c) $100,000.
(d) $0.
Answer: B
LevelofDifficulty:3
LearningGoal:3
Topic:AccountingforCommonStock

Chapter7StockValuation64

36.

Afirmissued10,000sharesof$2parvaluecommonstock,receivingproceedsof$40pershare.
Theaccountingentryforthepaidincapitalinexcessofparaccountis
(a) $200,000.
(b) $380,000.
(c) $400,000.
(d) $800,000.
Answer: B
LevelofDifficulty:3
LearningGoal:3
Topic:AccountingforCommonStock

37.

Afirmissued10,000sharesofnoparvaluecommonstock,receivingproceedsof$40pershare.The
accountingentryis
(a) $0inthecommonstockaccount.
(b) $0inthepaidincapitalinexcessofparaccount.
(c) $400,000inthecommonstockaccount.
(d) $400,000inthepaidincapitalinexcessofparaccount.
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:AccountingforCommonStock

38.

AdvantagesofissuingcommonstockversuslongtermdebtincludeallofthefollowingEXCEPT
(a) theeffectsofdilutiononearningsandvotingpower.
(b) nomaturity.
(c) increasesfirmsborrowingpower.
(d) nofixedpaymentobligation.
Answer: A
LevelofDifficulty:3
LearningGoal:3
Topic:ContrastingDebtandEquity

39.

AllofthefollowingarecharacteristicsofcommonstockEXCEPT
(a) votingrightswhichpermitselectionofthefirmsdirectors.
(b) claimsonincomeandassetswhicharesubordinatetothecreditorsofthefirm.
(c) fullytaxdeductibledividends.
(d) nofixedpaymentobligation.
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:FeaturesofCommonStock

65GitmanPrinciplesofFinance,EleventhEdition

40.

Stockrightsprovidethestockholderwith
(a) certainpurchaseprivilegesofadditionalstocksharesindirectproportionbasedontheirnumber
ofownedshares.
(b) therighttoelecttheboardofdirectors.
(c) cumulativevotingprivileges.
(d) theopportunitytoreceiveextraordinaryearnings.
Answer: A
LevelofDifficulty:3
LearningGoal:3
Topic:FeaturesofCommonStock

41.

Thepreemptiverightgivestheshareholdertheright
(a) ofonevoteforeachshareowned.
(b) togiveuptheirvotetoanotherparty.
(c) tomaintaintheirproportionateownershipinthecorporationwhennewcommonstockisissued.
(d) toselltheirshareofstockatapremium.
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:FeaturesofCommonStock

42.

TheinvestmentbankerdoesallofthefollowingEXCEPT
(a) makelongterminvestmentsforbankinginstitutions.
(b) beartheriskofsellingasecurityissue.
(c) actasamiddlemanbetweentheissuerandbuyerofanewsecurity.
(d) adviseclients.
Answer: A
LevelofDifficulty:3
LearningGoal:3
Topic:InvestmentBanking

43.

Afirmhasthebalancesheetaccounts,commonstock,andpaidincapitalinexcessofpar,with
valuesof$10,000and$250,000,respectively.Thefirmhas10,000commonsharesoutstanding.If
thefirmhadaparvalueof$1,thestockoriginallysoldfor
(a) $24/share.
(b) $25/share.
(c) $26/share.
(d) $30/share.
Answer: C
LevelofDifficulty:4
LearningGoal:3
Topic:AccountingforCommonStock

Chapter7StockValuation66

44.

Afirmhasthebalancesheetaccounts,commonstock,andpaidincapitalinexcessofpar,with
valuesof$40,000and$500,000,respectively.Thefirmhas40,000commonsharesoutstanding.If
thefirmhadaparvalueof$1,thestockoriginallysoldfor
(a) $11.50/share.
(b) $12.50/share.
(c) $13.50/share.
(d) $15.50/share.
Answer: C
LevelofDifficulty:4
LearningGoal:3
Topic:AccountingforCommonStock

45.

AllofthefollowingaretrueabouttheissuanceofnonvotingcommonstockEXCEPT
(a) ithasbeenissuedasadefenseagainstanunfriendlytakeover.
(b) ithasbeenissuedwhenthecorporationwishestoraisecapitalthroughthesaleofcommon
stock,butdoesnotwanttorelinquishitsvotingcontrol.
(c) ittendstoresultinunequalvotingrightsamongtheshareholders.
(d) ittendstoresultinthedilutionofvotingrightsofcurrentstockholders.
Answer: D
LevelofDifficulty:4
LearningGoal:3
Topic:CommonStockVoting

46.

Preferredstockisvaluedasifitwerea
(a) fixedincomeobligation.
(b) bond.
(c) perpetuity.
(d) commonstock.
Answer: C
LevelofDifficulty:1
LearningGoal:4
Topic:PreferredStockValuation

47.

Afirmhasanissueofpreferredstockoutstandingthathasastatedannualdividendof$4.The
requiredreturnonthepreferredstockhasbeenestimatedtobe16percent.Thevalueofthepreferred
stockis_________.
(a) $64
(b) $16
(c) $25
(d) $50
Answer: C
LevelofDifficulty:2
LearningGoal:4
Topic:PreferredStockValuation(Equation7.3)

67GitmanPrinciplesofFinance,EleventhEdition

48.

Afirmhasanexpecteddividendnextyearof$1.20pershare,azerogrowthrateofdividends,anda
requiredreturnof10percent.Thevalueofashareofthefirmscommonstockis_________.
(a) $120
(b) $10
(c) $12
(d) $100
Answer: C
LevelofDifficulty:2
LearningGoal:4
Topic:ZeroGrowthValuationModel(Equation7.3)

49.

Afirmhasanissueofpreferredstockoutstandingthathasastatedannualdividendof$4.The
requiredreturnonthepreferredstockhasbeenestimatedtobe16percent.Thevalueofthepreferred
stockis_________.
(a) $64
(b) $16
(c) $25
(d) $50
Answer: C
LevelofDifficulty:2
LearningGoal:4
Topic:PreferredStockValuation(Equation7.3)

50.

The_________isutilizedtovaluepreferredstock.
(a) constantgrowthmodel
(b) variablegrowthmodel
(c) zerogrowthmodel
(d) Gordonmodel
Answer: C
LevelofDifficulty:2
LearningGoal:4
Topic:PreferredStockValuation

51.

IntheGordonmodel,thevalueofthecommonstockisthe
(a) netvalueofallassetswhichareliquidatedfortheirexactaccountingvalue.
(b) actualamounteachcommonstockholderwouldexpecttoreceiveifthefirmsassetsaresold,
creditorsandpreferredstockholdersarerepaid,andanyremainingmoneyisdividedamongthe
commonstockholders.
(c) presentvalueofanongrowingdividendstream.
(d) presentvalueofaconstant,growingdividendstream.
Answer: D
LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel

Chapter7StockValuation68

52.

EmmyLou,Inc.hasanexpecteddividendnextyearof$5.60pershare,agrowthrateofdividendsof
10percent,andarequiredreturnof20percent.ThevalueofashareofEmmyLou,Inc.scommon
stockis_________.
(a) $28.00
(b) $56.00
(c) $22.40
(d) $18.67
Answer: B
LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

53.

Afirmhasexperiencedaconstantannualrateofdividendgrowthof9percentonitscommonstock
andexpectsthedividendpershareinthecomingyeartobe$2.70.Thefirmcanearn12percenton
similarriskinvolvements.Thevalueofthefirmscommonstockis_________.
(a) $22.50/share
(b) $9/share
(c) $90/share
(d) $30/share
Answer: C
LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

54.

Acommonstockcurrentlyhasabetaof1.3,theriskfreerateisanannualrateof6percent,andthe
marketreturnisanannualrateof12percent.Thestockisexpectedtogenerateaconstantdividend
of$5.20pershare.Atoxicspillresultsinalawsuitandpotentialfines,andthebetaofthestock
jumpsto1.6.Thenewequilibriumpriceofthestock
(a) willbe$37.68.
(b) willbe$43.33.
(c) cannotbedeterminedfromtheinformationgiven.
(d) willbe$33.33.
Answer: D
LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModelandCAPM(Equation7.4,Equation7.5,andEquation7.9)

55.

Acommonstockcurrentlyhasabetaof1.7,theriskfreerateis7percentannually,andthemarket
returnis12percentannually.Thestockisexpectedtogenerateaconstantdividendof$6.70per
share.Apendinglawsuithasjustbeendismissedandthebetaofthestockdropsto1.4.Thenew
equilibriumpriceofthestock
(a) willbe$55.83.
(b) willbe$43.23.
(c) willbe$47.86.
(d) cannotbedeterminedfromtheinformationgiven.
Answer: C
LevelofDifficulty:3
LearningGoal:4

69GitmanPrinciplesofFinance,EleventhEdition

Topic:ConstantGrowthValuationModelandCAPM(Equation7.4,Equation7.5,andEquation7.9)

Chapter7StockValuation70

56.

Accordingtotheefficientmarkettheory,
(a) pricesofactivelytradedstockscanbeunderorovervaluedinanefficientmarket,andbear
searchingout.
(b) pricesofactivelytradedstockscanonlybeundervaluedinanefficientmarket.
(c) pricesofactivelytradedstocksdonotdifferfromtheirtruevaluesinanefficientmarket.
(d) pricesofactivelytradedstockscanonlybeovervaluedinanefficientmarket.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:EfficientMarkets

57.

Economicallyrationalbuyersandsellersusetheirassessmentofanassetsriskandreturnto
determineitsvalue.Relativetothisconcept,whichofthefollowingistrue?
(a) Toabuyertheassetsvaluerepresentstheminimumpricethatheorshewouldpaytoacquireit.
(b) Toasellertheassetsvaluerepresentsthemaximumsaleprice.
(c) Toabuyertheassetsvaluerepresentsthemaximumpricethatheorshewouldpaytoacquireit.
(d) Theinteractionofbuyersandsellerscanresultinavaluethatdiffersfromthestockstruevalue.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:Risk,ReturnandMarketEfficiency

58.

Ifexpectedreturnislessthanrequiredreturnonanasset,rationalinvestorswill
(a) buytheasset,whichwilldrivethepriceupandcauseexpectedreturntoreachthelevelofthe
requiredreturn.
(b) selltheasset,whichwilldrivethepricedownandcausetheexpectedreturntoreachthelevelof
therequiredreturn.
(c) selltheasset,whichwilldrivethepriceupandcausetheexpectedreturntoreachthelevelof
therequiredreturn.
(d) buytheasset,sincepriceisexpectedtoincrease.
Answer: B
LevelofDifficulty:4
LearningGoal:4
Topic:Risk,ReturnandMarketEfficiency

59.

Iftheexpectedreturnisabovetherequiredreturnonanasset,rationalinvestorswill
(a) buytheasset,whichwilldrivethepriceupandcauseexpectedreturntoreachthelevelofthe
requiredreturn.
(b) selltheasset,whichwilldrivethepricedownandcausetheexpectedreturntoreachthelevelof
therequiredreturn.
(c) selltheasset,whichwilldrivethepriceupandcausetheexpectedreturntoreachthelevelof
therequiredreturn.
(d) selltheasset,sincepriceisexpectedtodecrease.
Answer: A
LevelofDifficulty:4
LearningGoal:4
Topic:Risk,ReturnandMarketEfficiency

71GitmanPrinciplesofFinance,EleventhEdition

60.

FollowingthetheoryoftheefficientmarkethypothesisallofthefollowingaretrueEXCEPT
(a) securitiesaretypicallyinequilibrium,meaningtheyarefairlypricedandtheirexpectedreturns
equaltheirrequiredreturns.
(b) theIvanBoeskysofthemarkethaveproventhatstocksarenotfullyandfairlypriced,so
investorsshouldspendtimesearchingformispriced(overorundervalued)stocks.
(c) atanypointintime,securitypricesfullyreflectallpublicinformationavailableaboutthefirm
anditssecurities,andthesepricesreactswiftlytonewinformation.
(d) sincestocksarefullyandfairlyprice,itfollowsthatinvestorsshouldnotwastetheirtimetrying
tofindandcapitalizeonmisspriced(underorovervalued)securities.
Answer: B
LevelofDifficulty:4
LearningGoal:4
Topic:EfficientMarkets

61.

_________inthebetacoefficientnormallycauses_________intherequiredreturnandtherefore
_________inthepriceofthestock,allelseremainingthesame.
(a) Anincrease;anincrease;anincrease
(b) Anincrease;adecrease;anincrease
(c) Anincrease;anincrease;adecrease
(d) Adecrease;adecrease;adecrease
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:RiskReturnRelationship

62.

_________isthevalueofthefirmsownershipintheeventthatallassetsaresoldfortheirexact
accountingvalueandtheproceedsremainingafterpayingallliabilities(includingpreferredstock)
aredividedamongcommonstockholders.
(a) Liquidationvalue
(b) Bookvalue
(c) TheP/Emultiple
(d) Thepresentvalueofthecommonstock
Answer: B
LevelofDifficulty:1
LearningGoal:5
Topic:BookValueofStock

63.

_________istheactualamounteachcommonstockholderwouldexpecttoreceiveifthefirms
assetsaresold,creditorsandpreferredstockholdersarerepaid,andanyremainingmoneyisdivided
amongthecommonstockholders.
(a) Liquidationvalue
(b) Bookvalue
(c) TheP/Emultiple
(d) Thepresentvalueofthedividends
Answer: A
LevelofDifficulty:1
LearningGoal:5

Chapter7StockValuation72

Topic:LiquidationValueofStock

73GitmanPrinciplesofFinance,EleventhEdition

64.

_________isaguidetothefirmsvalueifitisassumedthatinvestorsvaluetheearningsofagiven
firminthesamewaytheydotheaveragefirmintheindustry.
(a) Liquidationvalue
(b) Bookvalue
(c) TheP/Emultiple
(d) Thepresentvalueofthedividends
Answer: C
LevelofDifficulty:1
LearningGoal:5
Topic:P/EMultipleValuationApproach

65.

Theuseofwhichofthefollowingvaluationmethods,utilizedinvaluingcommonstock,issuperior
sinceitconsidersexpectedearnings.
(a) liquidationvalue
(b) bookvalue
(c) P/Emultiple
(d) presentvalueoftheinterest
Answer: C
LevelofDifficulty:2
LearningGoal:5
Topic:P/EMultipleValuationApproach

66.

Theuseofthe_________isespeciallyhelpfulinvaluingfirmsthatarenotpubliclytraded.
(a) liquidationvalue
(b) bookvalue
(c) P/Emultiple
(d) presentvalueofthedividends
Answer: C
LevelofDifficulty:2
LearningGoal:5
Topic:P/EMultipleValuationApproach

67.

ThecurrentpriceofDEFCorporationstockis$26.50pershare.Earningsnextyearshouldbe$2per
shareanditshouldpaya$1dividend.TheP/Emultipleis15timesonaverage.Whatpricewould
youexpectforDEFsstockinthefuture?
(a) $13.50
(b) $15.00
(c) $26.50
(d) $30.00
Answer: D
LevelofDifficulty:3
LearningGoal:5
Topic:P/EMultipleValuationApproach

Chapter7StockValuation74

68.

Whichofthefollowingtermstypicallyappliestocommonstockbutnottopreferredstock?
(a) Parvalue.
(b) Dividendyield.
(c) Legallyconsideredasequityinthefirm.
(d) Votingrights.
Answer: D
LevelofDifficulty:2
LearningGoal:1
Topic:ContrastingCommonandPreferredStock

69.

Keydifferencesbetweencommonstockandbondsincludeallofthefollowingexcept.
(a) Commonstockholdershaveavoiceinmanagement;bondholdersdonot.
(b) Commonstockholdershaveaseniorclaimonassetsandincomerelativetobondholders.
(c) Bondshaveastatedmaturitybutstockdoesnot.
(d) Interestpaidtobondholdersistaxdeductiblebutdividendspaidtostockholdersarenot.
Answer: B
LevelofDifficulty:3
LearningGoal:1
Topic:ContrastingCommonStockandBonds

70.

Keydifferencesbetweencommonstockandbondsincludeallofthefollowingexcept.
(a) Commonstockholdershaveavoiceinmanagement;bondholdersdonot.
(b) Commonstockholdershaveajuniorclaimonassetsandincomerelativetobondholders.
(c) Bondshaveastatedmaturitybutstockdoesnot.
(d) Dividendspaidtobondholdersaretaxdeductiblebutinterestpaidtostockholdersisnot.
Answer: D
LevelofDifficulty:3
LearningGoal:1
Topic:ContrastingCommonStockandBonds

71.

Whichofthefollowingisfalse?
(a) Thecommonstockofacorporationcanbeeitherprivatelyorpubliclyowned.
(b) Firmsoftenissuecommonstockwithnoparvalue.
(c) Preemptiverightsoftenresultinadilutionofownership.
(d) Afirmscorporatecharterindicateshowmanyauthorizedsharesitcanissue.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofCommonStock

75GitmanPrinciplesofFinance,EleventhEdition

72.

Whichofthefollowingisfalse?
(a) Thecommonstockofacorporationcanonlybepubliclyowned.
(b) Firmsoftenissuecommonstockwithnoparvalue.
(c) Preemptiverightshelptopreventadilutionofownershiponthepartofexistingshareholders.
(d) Afirmscorporatecharterindicateshowmanyauthorizedsharesitcanissue.
Answer: A
LevelofDifficulty:2
LearningGoal:2
Topic:FeaturesofCommonStock

73.

Aproxystatementis
(a) astatementgivingthevotesofastockholdertotheCEO.
(b) astatementgivingthevotesofastockholdertotheboardofdirectors.
(c) astatementgivingthevotesofastockholdertoanotherparty.
(d) noneoftheabove.
Answer: C
LevelofDifficulty:2
LearningGoal:2
Topic:CommonStockVoting

74.

AnADRis
(a) aclaimissuedbyaU.S.bankrepresentingownershipofsharesofaforeigncompanysstock
heldondepositbytheU.S.bankandisissuedindollarstoU.S.investors.
(b) aclaimissuedbyaforeignbankrepresentingownershipofsharesofaforeigncompanysstock
heldondepositbytheforeignbankandisissuedindollarstoU.S.investors.
(c) aclaimissuedbyaU.S.bankrepresentingownershipofsharesofaU.S.companysstockheld
ondepositbytheU.S.bankandisissuedindollarstoU.S.investors.
(d) noneoftheabove.
Answer: A
LevelofDifficulty:4
LearningGoal:2
Topic:AmericanDepositaryReceipt

75.

Preferredstockholders
(a) donothavepreferenceovercommonstockholdersinthecaseofliquidation.
(b) dohavepreferenceoverbondholdersinthecaseofliquidation.
(c) donothavepreferenceoverbondholdersinthecaseofliquidation.
(d) Twooftheabovearetruestatements.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:PreferredStockholderRights

Chapter7StockValuation76

76.

Whichofthefollowingisusuallyarightofapreferredstockholder?
(a) Righttoconvertsharestocommonstockondemand.
(b) Preemptiverighttoparticipateintheissuanceofnewcommonshares.
(c) Righttoreceivedividendpaymentsbeforeanydividendsarepaidtocommonstockholders.
(d) Righttosuecompanyinbankruptcyproceedingsifpromisedpreferreddividendsarenotpaid.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:PreferredStockholderRights

77.

Whichofthefollowingisnottypicallyafeatureofpreferredstock?
(a) Mostpreferredstockisnoncumulative.
(b) Mostpreferredstockiscumulative.
(c) Preferredstockisgenerallycallable.
(d) Preferredstockistypicallyconvertible.
Answer: A
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofPreferredStock

78.

Whichofthefollowingisnottypicallyafeatureofcommonstock?
(a) Mostcommonstockiscallable.
(b) Mostcommonstockiscumulative.
(c) Commonstockmayormaynotpaydividends.
(d) Morethanoneoftheabovestatementsisnottrueofcommonstock.
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofPreferredStock

79.

Agroupformedbyaninvestmentbankertosharethefinancialriskassociatedwithunderwriting
newsecuritiesisa(n)
(a) underwritingsyndicate.
(b) sellinggroup.
(c) investmentbankingconsortium.
(d) brokerpool.
Answer: A
LevelofDifficulty:2
LearningGoal:3
Topic:IssuingSecurities

77GitmanPrinciplesofFinance,EleventhEdition

80.

YouareplanningtopurchasethestockofTedsShedsInc.andyouexpectittopayadividendof$3
in1year,$4.25in2years,and$6.00in3years.Youexpecttosellthestockfor$100in3years.If
yourrequiredreturnforpurchasingthestockis12percent,howmuchwouldyoupayforthestock
today?
(a) $75.45
(b) $77.24
(c) $81.52
(d) $85.66
Answer: C
LevelofDifficulty:3
LearningGoal:4
Topic:BasicValuationModel(Equation7.2)

81.

NicoCorporationscommonstockisexpectedtopayadividendof$3.00foreverandcurrentlysells
for$21.42.Whatistherequiredrateofreturn?
(a) 10%
(b) 12%
(c) 13%
(d) 14%
Answer: D
LevelofDifficulty:2
LearningGoal:4
Topic:ZeroGrowthValuationModel(Equation7.3)

82.

ZackisconsideringpurchasingthestockofPepsiColabecausehereallylovesthetasteofPepsi.
WhatshouldZackbewillingtopayforPepsitodayifitisexpectedtopaya$2dividendinoneyear
andheexpectsdividendstogrowthat5percentindefinitely?Zackrequiresa12percentreturnto
makethisinvestment.
(a) $28.57
(b) $29.33
(c) $31.43
(d) $43.14
Answer: A
LevelofDifficulty:2
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

83.

NicoCorporationscommonstockcurrentlysellsfor$180pershare.Nicojustpaidadividendof
$10.18anddividendsareexpectedtogrowataconstantrateof6percentforever.Iftherequiredrate
ofreturnis12percent,whatwillNicoCorporationsstocksellforoneyearfromnow?
(a) $180.00
(b) $187.04
(c) $195.40
(d) $190.80
Answer: C
LevelofDifficulty:4
LearningGoal:4

Chapter7StockValuation78

Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

79GitmanPrinciplesofFinance,EleventhEdition

84.

TangshanChinaCompanysstockiscurrentlysellingfor$80.00pershare.Theexpecteddividend
oneyearfromnowis$4.00andtherequiredreturnis13percent.WhatisTangshansdividend
growthrateassumingthatdividendsareexpectedtogrowataconstantrateforever?
(a) 8%
(b) 9%
(c) 10%
(d) 11%
Answer: A
LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

85.

TangshanChinasstockiscurrentlysellingfor$160.00pershareandthefirmsdividendsare
expectedtogrowat5percentindefinitely.AssumingTangshanChinasmostrecentdividendwas
$5.50,whatistherequiredrateofreturnonTangshansstock?
(a) 7.3%
(b) 8.6%
(c) 9.5%
(d) 10.6%
Answer: B
LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

86.

NicoCustomCyclescommonstockcurrentlypaysnodividends.Thecompanyplanstobegin
payingdividendsbeginning3yearsfromtoday.Thefirstdividendwillbe$3.00anddividendswill
growat5percentperyearthereafter.Givenarequiredreturnof15percent,whatwouldyoupayfor
thestocktoday?
(a) $26.00
(b) $19.73
(c) $30.00
(d) $22.68
Answer: D
LevelofDifficulty:4
LearningGoal:4
Topic:VariableGrowthValuationModel(Equation7.6)

87.

JiasFashionsrecentlypaida$2annualdividend.Thecompanyisprojectingthatitsdividendswill
growby20percentnextyear,12percentannuallyforthetwoyearsafterthat,andthenat6percent
annuallythereafter.Basedonthisinformation,howmuchshouldJiasFashionscommonstocksell
fortoday?
(a) $54.90
(b) $60.80
(c) $66.60
(d) $69.30
Answer: C
LevelofDifficulty:4

Chapter7StockValuation80

LearningGoal:4
Topic:VariableGrowthValuationModel(Equation7.6)

81GitmanPrinciplesofFinance,EleventhEdition

Table7.1
YTD%CHG
5.1
88.

52WEEK
HI
LO
48.72 20.10

YLD
STOCK(SYM)
FORD(F)

Div
1.00

%
3.3

VOL
PE
100s
18
20,925

CLOSE
30.20

NET
CHG
0.56

AccordingtoTable7.1,Fordscommonstockmusthaveclosedat_________pershareonthe
previoustradingday.
(a) $29.64
(b) $30.76
(c) $30.99
(d) $31.55
Answer: B
LevelofDifficulty:2
LearningGoal:3
Topic:CommonStockQuotation

89.

AccordingtoTable7.1,theexpecteddividendpershareforFordis
(a) $0.25.
(b) $1.00.
(c) $2.00.
(d) $3.30.
Answer: B
LevelofDifficulty:2
LearningGoal:3
Topic:CommonStockQuotation

90.

ReferringtoTable7.1,ifweassumethatFordsdividendswillgrowatarateof10percentforever,
therequiredreturnonFordsstockwouldbe
(a) 7.4%.
(b) 8.9%.
(c) 11.0%.
(d) 13.6%.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:CommonStockQuotation

91.

BasedonTable7.1,Fordsearningspershareare
(a) $0.80.
(b) $1.21.
(c) $1.68.
(d) $1.91.
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:CommonStockQuotation

Chapter7StockValuation82

92.

BasedontheinformationgiveninTable7.1,thenumberofsharesofFordthatweretradedonthe
previousdaywas
(a) 2,092.
(b) 20,925.
(c) 209,250.
(d) 2,092,500.
Answer: D
LevelofDifficulty:2
LearningGoal:3
Topic:CommonStockQuotation

93.

NicoCorporationexpectstogeneratefreecashflowsof$200,000peryearforthenextfiveyears.
Beyondthattime,freecashflowsareexpectedtogrowataconstantrateof5percentperyear
forever.Ifthefirmsaveragecostofcapitalis15percent,themarketvalueofthefirmsstockis
$500,000,andNicohasahalfmillionsharesofstockoutstanding,whatisthevalueofNicosstock?
(a) $12.15
(b) $121.50
(c) $11.64
(d) $116.40
Answer: A
LevelofDifficulty:4
LearningGoal:5
Topic:FreeCashFlowValuationModel(Equation7.7andEquation7.8)

94.

Atyearend,TangshanChinaCompanybalancesheetshowedtotalassetsof$60million,total
liabilities(includingpreferredstock)of$45million,and1,000,000sharesofcommonstock
outstanding.Basedonthisinformation,Tangshansbookvaluepershareofcommonstockis
_________.
(a) $105.00
(b) $10.50
(c) $15.00
(d) $150.00
Answer: C
LevelofDifficulty:2
LearningGoal:5
Topic:BookValueofCommonStock

95.

Atyearend,TangshanChinaCompanybalancesheetshowedtotalassetsof$60million,total
liabilities(includingpreferredstock)of$45million,and1,000,000sharesofcommonstock
outstanding.IfTangshancouldsellitsassetsfor$52.5million,Tangshansliquidationvalueper
shareofcommonstockis_________.
(a) $15.00
(b) $7.50
(c) $52.50
(d) $75.00
Answer: B
LevelofDifficulty:3
LearningGoal:5

83GitmanPrinciplesofFinance,EleventhEdition

Topic:LiquidationValueofCommonStock

Chapter7StockValuation84

96.

Atyearend,TangshanChinaCompanybalancesheetshowedtotalassetsof$60million,total
liabilities(includingpreferredstock)of$45million,and1,000,000sharesofcommonstock
outstanding.Nextyear,Tangshanisprojectingthatitwillhavenetincomeof$1.5million.Ifthe
averagePEmultipleinTangshansindustryis15,whatshouldbethepriceofTangshansstock?
(a) $15.00
(b) $22.50
(c) $52.50
(d) $75.00
Answer: B
LevelofDifficulty:3
LearningGoal:5
Topic:PEMultipleValuationApproach

97.

TangshanChinasstockiscurrentlysellingfor$160.00pershareandthefirmsdividendsare
expectedtogrowat5percentindefinitely.Inaddition,TangshanChinasmostrecentdividendwas
$5.50.Iftheexpectedriskfreerateofreturnis3percent,theexpectedmarketreturnis8percent,
andTangshanhasabetaof1.2,Tangshansstockwouldbe_________.
(a) overvalued
(b) undervalued
(c) properlyvalued
(d) notenoughinformationtotell
Answer: A
LevelofDifficulty:4
LearningGoal:6
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

98.

TangshanChinasstockiscurrentlysellingfor$160.00pershareandthefirmsdividendsare
expectedtogrowat5percentindefinitely.Inaddition,TangshanChinasmostrecentdividendwas
$5.50.Iftheexpectedriskfreerateofreturnis3percent,theexpectedmarketpremiumis5percent,
andTangshanhasabetaof1.2,Tangshansstockwouldbe_________.
(a) overvalued
(b) undervalued
(c) properlyvalued
(d) Notenoughinformationtotell
Answer: A
LevelofDifficulty:4
LearningGoal:6
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

85GitmanPrinciplesofFinance,EleventhEdition

.4

Essay Questions

1.

SoppAccountingServiceshasanoutstandingissueof1,000sharespreferredstockwitha$100par
value,an8percentannualdividend,and5,000sharesofcommonstockoutstanding.Ifthestockis
cumulativeandtheboardofdirectorshaspassedthepreferreddividendforthelasttwoyears,how
muchmustpreferredstockholdersbepaidpriortopayingdividendstocommonstockholders?
Answer: $8,0002$16,000forthetwoprioryearsplus$8,000forthecurrentyear.
LevelofDifficulty:3
LearningGoal:2
Topic:FeaturesofPreferredStock

2.

Identifywhetherthekeycharacteristicdescribescommonstock(CS)orpreferredstock(PS).
_____
1. Sourceoffinancingwhichplacesminimumconstraintsonthefirm.
_____
2. Usedofteninmergers.
_____
3. Potentialdilutionofearningsandvotingpower.
_____
4. Fixedfinancialobligation.
_____
5. Increasesthefirmsborrowingpower.
_____
6. Mayhavecumulativeandparticipatingfeatures.
_____
7. Maybeconvertibleintoanothertypeofsecurity.
_____
8. Lasttoreceiveearningsordistributionofassetsintheeventofbankruptcy.
_____
9. Frequentlyincludesacallfeature.
Answers:
1.
2.
3.
4.
5.
6.
7.
8.
9.

CS
PS
CS
PS
CS
PS
PS
CS
PS

LevelofDifficulty:3
LearningGoal:3
Topic:FeaturesofPreferredandCommonStock
3.

FishnChipsRestaurants,Inc.hadearningsbeforeinterestandtaxesof$4,000,000lastyear.The
firmhasamarginaltaxrateof40percentandcurrentlyhasthefollowingcapitalstructure:
SourceofCapital
LongtermDebtat12%
PreferredStockat14%
CommonStockEquity
(2,000,000sharesoutstanding)

Amount
$8,000,000
8,000,000

Percentageof
TotalCapital
25%
25

16,000,000
$32,000,000

50
100%

Chapter7StockValuation86

(a) Calculatethefirmsaftertaxreturnonequity(ROE)andearningspershare(EPS).
(b) Ifthefirmretires$4,000,000ofpreferredstockusingtheproceedsfromanequalincreasein
longtermdebt,whatwouldhavebeentheaftertaxreturnonequity(ROE)andearningsper
share(EPS)?
(c) Ifthefirmretires$4,000,000ofpreferredstockusingtheproceedsfromthesaleof500,000
sharesofcommonstock,whatwouldhavebeentheaftertaxreturnonequity(ROE)and
earningspershare(EPS)?
Answers:
(a)
EBIT
$4,000,000
ROE** 1,824,000/24,000,000
Interest*
960,000
7.6%
EBT
$3,040,000
EPS*** 704,000/2,000,000
Taxes(40%)
1,216,000
$0.3520
EAT
$1,824,000
PreferredDiv
1,120,000
EAC
$704,000
*$8,000,0000.12$960,000
**ROENetProfitsafterTaxes/StockholdersEquity
(wherestockholdersequityincludespreferredstock).
***EPSEAC/Commonshareoutstanding
(b)
EBIT
Interest
EBT
Taxes(40%)
EAT
PreferredDiv
EAC

$4,000,000
1,440,000
$2,560,000
1,024,000
$1,536,000
560,000
$976,000

ROE
EPS

1,536,000/20,000,000
7.7%
976,000/2,000,000
$0.49

(c)
EBIT
Interest
EBT
Taxes(40%)
EAT
PreferredDiv
EAC
LevelofDifficulty:4
LearningGoal:3
Topic:ROEandEPS

$4,000,000
960,000
$3,040,000
1,216,000
$1,824,000
560,000
$1,264,000

ROE
EPS

1,824,000/24,000,000
7.6%
1,264,000/2,500,000
$0.51

87GitmanPrinciplesofFinance,EleventhEdition

4.

TheboardofdirectorsoftheNationalComputerCompanyhasdeclared$5.00commonstock
dividendandacceptedaplantofreezethedividendat$5peryearindefinitely.Whatisthevalueof
theNationalComputerCompanyscommonstockiftherequiredrateofinterestis15percent?
Answer: PD/k5/0.15$33.33
LevelofDifficulty:1
LearningGoal:4
Topic:ZeroGrowthValuationModel(Equation7.3)

5.

KingstonKitchenStuffhasrecentlysold1,000sharesof$6.75preferredstock.Whatisthevalueof
thestockassuming10percentrequiredrateofreturn?
Answer: PD/k6.75/0.10$67.50
LevelofDifficulty:1
LearningGoal:4
Topic:PreferredStockValuation(Equation7.3)

6.

TheFurCompanyhasbeenexperiencingseveralyearsoffinancialdifficultyand,thus,has
consideredmaintainingitsdividendpaymentat$2.50indefinitely.Whatisthevalueofitscommon
stockiftherequiredrateofreturnis8.5percent?
Answer: PD/k2.50/0.085$29.41
LevelofDifficulty:1
LearningGoal:4
Topic:ZeroGrowthValuationModel(Equation7.3)

7.

Inresponsetothestockmarketsreactiontoitsdividendpolicy,thePaperCompanyhasdecidedto
increaseitsdividendpaymentatarateof4percentperyear.Thefirmsmostrecentdividendis
$3.25andtherequiredrateofinterestis9percent.Whatisthemaximumyouwouldbewillingto
payforashareofthestock?
Answer: PD1/(kg)3.25(10.04)/(0.090.04)$67.60
LevelofDifficulty:2
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

8.

Afirmhasanexpecteddividendnextyearof$3.60andarequiredreturnof12percent.Calculate
thevalueofashareofcommonstockassumingazerogrowthrateofdividends.
Answer:

$3.60
$30
0.12

LevelofDifficulty:2
LearningGoal:4
Topic:ZeroGrowthValuationModel(Equation7.3)
9.

SmithJugglingEquipmenthasanoutstandingpreferredissueofstockwithaparvalueof$100and
anannualdividendof10percent(ofpar).Similarriskpreferredstocksareyieldingan11.5percent
annualrateofreturn.
(a) Whatisthecurrentvalueoftheoutstandingpreferredstock?
(b) Whatwillhappentopriceastheriskfreerateincreases?Explain.

Chapter7StockValuation88

Answers:
(a) $10/0.115$86.96
(b) Astheriskfreerateincreases,therequiredrateofreturnwillincreaseandtheprice
willdrop.
LevelofDifficulty:2
LearningGoal:4
Topic:PreferredStockValuation(Equation7.3)
10.

Tedhas10sharesoftheMensUnderwearCompany.Basedonthecompanysdividendpolicy,Ted
willreceiveatotalof$450ayearinperpetuity.Whatisthevalueofeachshareiftherateofinterest
is8percent?
Answer:
Dividendpershare450/10$45
PD/k45/0.08$562.50
LevelofDifficulty:2
LearningGoal:4
Topic:ZeroGrowthValuationModel(Equation7.3)

11.

TheBradshawCompanysmostrecentdividendwas$6.75.Thehistoricaldividendpaymentbythe
companyshowsaconstantgrowthrateof5percentperyear.Whatisthemaximumyouwouldbe
willingtopayforashareofitscommonstockifyourrequiredrateofreturnis8percent?
Answer:
D16.75(10.05)$7.09
PD1/(kg)7.09/(0.080.05)$236.33
LevelofDifficulty:2
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

12.

TheMedicalEquipmentCompanypaid$2.25commonstockdividendlastyear.Thecompanys
policyistoallowitsdividendtogrowat5percentperyearindefinitely.Whatisthevalueofthe
stockiftherequiredrateofreturnis8percent?
Answer: PD1/(kg)2.25(10.05)/(0.080.05)$78.67
LevelofDifficulty:2
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

13.

Mr.Arthurrecentlypurchasedablockof100sharesofBinghamCorporationcommonstockfor
$6,000.Thestockisexpectedtoprovideanannualcashflowofdividendsof$400indefinitely.
Assumingadiscountrateof8percent,howdoesthepriceMr.Arthurpaidcomparetothevalueof
thestock?
$400
$5,000
0.08
Mr.Arthurpaid$1,000morethanthevalueofthestock.

Answer: Thevalueofthestockis

LevelofDifficulty:3
LearningGoal:4
Topic:ZeroGrowthValuationModel(Equation7.3)

89GitmanPrinciplesofFinance,EleventhEdition

14.

TheCentralHeatingCompanyhasbeenverysuccessfulinthepastfouryears.Overtheseyears,it
paidcommonstockdividendof$4inthefirstyear,$4.20inthesecondyear,$4.41inthethirdyear,
anditsmostrecentdividendwas$4.63.Thecompanywishestocontinuethisdividendgrowth
indefinitely.Whatisthevalueofthecompanysstockiftherequiredrateofreturnis12percent?
Answer: FVIFg,34.63/4.001.158g5%
PD5/(kg)4.63(10.05)/(0.120.05)$69.46
LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)
Table7.2
Year
2003
2002
2001
2000
1999
1998

15.

Dividends($)
2.89
2.53
2.22
1.95
1.71
1.50

CharleneownsstockinacompanywhichhaspaidtheannualdividendsshowninTable7.2.
Calculatethegrowthrateofthesedividends.
Answer:

1.50
0.519
2.89
0.519PVIF
growthrate14%

LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)
16.

Calculatetheestimateddividendfor2004.(SeeTable7.2.)
Answer: ($2.89)(1.14)$3.29
LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

17.

Therequiredreturnisassumedtobe17percent.UsingtheGordonmodel,calculatethepershare
valueofthestock.(SeeTable7.2.)
Answer:

$3.29
$109.67
0.17 0.14

LevelofDifficulty:3
LearningGoal:4
Topic:ConstantGrowthValuationModel(Equation7.4andEquation7.5)

Chapter7StockValuation90

18.

DiamondHouseExportinghasabetaof1.50,theriskfreerateofinterestiscurrently12percent,
andtherequiredreturnonthemarketportfoliois18percent.Thecompanyplanstopayadividend
of$2.45pershareinthecomingyearandanticipatesthatitsfuturedividendswillincreaseatan
annualrateconsistentwiththatexperiencedoverthe20012003period
Year
2003
2002
2001

Dividend
2.32
2.21
2.10

EstimatethevalueofDiamondHouseExportingstock.
Answer:

ks 0.12 1.50(0.18 0.12)

0.21
growthrateofdividends:
2.23/2.10FVIF
1.1055%
$2.45
Po
$15.31
0.21 0.05

LevelofDifficulty:4
LearningGoal:4
Topic:CAPMandConstantGrowthValuationModel(Equation7.4,Equation7.5andEquation7.9)
19.

TheNationalXRayCompanypaid$2.00pershareincommonstockdividendslastyear.The
companyspolicyistoallowitsdividendtogrowat5percentfor4yearsandthentherateofgrowth
changesto3percentperyearfromyearfiveandon.Whatisthevalueofthestockiftherequired
rateofreturnis8percent?
Answer:
t
1
2
3
4

Do
$2.00
2.00
2.00
2.00

FVIF5%,t
1.050
1.102
1.158
1.216

Dt
$2.10
2.20
2.32
2.43

D52.43(10.03)$2.50
P2

2.50
1

$36.75
0.08 0.03 (1 0.08) ^ 4

Valueofstock$36.75$7.46$44.21
LevelofDifficulty:4
LearningGoal:4
Topic:VariableGrowthValuationModel(Equation7.6)

PVIF8%,t
0.926
0.857
0.794
0.735

PV
$1.94
1.89
1.84
1.79
P1$7.46

91GitmanPrinciplesofFinance,EleventhEdition

20.

Computethevalueofashareofcommonstockofacompanywhosemostrecentdividendwas$2.50
andisexpectedtogrowat3percentperyearforthenext5years,afterwhichthedividendgrowth
ratewillincreaseto6percentperyearindefinitely.Assume10percentrequiredrateofreturn.
Answer:
t
1
2
3
4
5

Do
$2.50
2.50
2.50
2.50
2.50

FVIF5%,t
1.030
1.061
1.093
1.126
1.159

Dt
$2.58
2.65
2.73
2.82
2.90

PVIF8%,t
0.909
0.826
0.751
0.683
0.621

PV
$2.35
2.19
2.05
1.93
1.80
P1$10.32

D62.90(10.06)$3.07
P2

3.07
1

$47.66
0.10 0.06
(1 0.10) ^ 5

Valueofstock$47.66$10.32$57.98
LevelofDifficulty:4
LearningGoal:4
Topic:VariableGrowthValuationModel(Equation7.6)
21.

NewmarketIndustriescurrentlyhas2,000sharesofcommonstockoutstanding.Thefirmhasassets
of$200,000andtotalliabilitiesincludingpreferredstockof$75,000.Calculatethebookvalueper
shareofNewmarketcommonstock.
Answer:

$200,000 $75,000
$62.50/share
2,000

LevelofDifficulty:1
LearningGoal:5
Topic:BookValueofCommonStock
22.

Basedonanalysisofthecompanyandexpectedindustryandeconomicconditions,Newmarket
Industriesisexpectedtoearn$4.60pershareofcommonstocknextyear.Theaverage
price/earningsratioforfirmsinthesameindustryis8.Calculatetheestimatedvalueofashareof
Newmarketcommonstock.
Answer: $4.60(8)$36.80/share
LevelofDifficulty:1
LearningGoal:5
Topic:P/EMultipleValuationModel

23.

Duetogrowingdemandforcomputersoftware,theLetterPerfectCompanyhashadavery
successfulyearandexpectsitsearningspersharetogrowby25percenttoreach$5.50forthisyear.
Estimatethepriceofthecompanyscommonstockassumingtheindustrysprice/earningratiois12.
Answer: P(P/E)(E)125.50$66
LevelofDifficulty:1
LearningGoal:5
Topic:P/EMultipleValuationModel

Chapter7StockValuation92

24.

InternationalToolsInc.(ITI)stotalassetsasrecordedonitsbalancesheetare$1,500,000.Whatis
thevalueoftheITIscommonstockifithas$950,000inliabilities,and7,500sharesofcommon
stockoutstanding?
Answer: P(1,500,000950,000)/7,500$73.33
LevelofDifficulty:1
LearningGoal:5
Topic:BookValueofCommonStock

25.

InternationalToolsInc.(ITI)hasestimatedthemarketvalueofitsassetstobe$1,250,000.Whatis
thevalueofITIscommonstockifithas$900,000inliabilities,$50,000inpreferredstock,and
7,500sharesofcommonstockoutstanding?
Answer: P(1,250,000900,00050,000)/7,500$40
LevelofDifficulty:1
LearningGoal:5
Topic:BookValueofCommonStock

26.

Afirmscommonstockcurrentlysellsfor$75pershare.Thefirmhastotalassetsof$1,000,000and
totalliabilities,includingpreferredstock,of$350,000.Ifthefirmhas10,000sharesofcommon
stockoutstanding,
(a) whatisthebookvalueofeachshareofcommonstock?
(b) isthestockovervaluedorundervaluedinthemarketplace?
(c) whatmightbethereason(s)foryouranswerin(b).
Answers:
(a)

$1,000,000 $350,000
$65/share
10,000

(b) overvalued
(c) marketvalueoftheassetsisgreaterthanthebookvalue.
LevelofDifficulty:2
LearningGoal:5
Topic:BookValueofCommonStock
27.

Afirmhascurrentassetsof$800,000,whichcanbeliquidatedat90percentofbookvalue.Total
liabilities,includingpreferredstock,equal$270,000.Thefirmhas15,000sharesofcommonstock
outstanding.Whatistheliquidationvaluepershareofcommonstock?
Answer:

$800,000(0.90) $270,000
$30/share
15,000

LevelofDifficulty:2
LearningGoal:5
Topic:LiquidationValueofCommonStock

93GitmanPrinciplesofFinance,EleventhEdition

28.

AntiqueReplicas,Inc.,hasabetaof1.40,theannualriskfreerateofinterestiscurrently10percent,
andtherequiredreturnonthemarketportfoliois16percent.Thefirmestimatesthatitsfuture
dividendswillcontinuetoincreaseatanannualcompoundrateconsistentwiththatexperiencedover
the20002003period.
Year
2000
2001
2002
2003

Dividend
$2.70
2.95
3.25
3.40

(a) EstimatethevalueofAntiqueReplicas,Inc.,stock.
(b) Alawsuithasbeenfiledagainstthecompanybyacompetitor,andthepotentiallosshas
increasedrisk,whichisreflectedinthecompanysbeta,increasingitto1.6.Whatisthe
estimatedpriceofthestockfollowingthefilingofthelawsuit.
Answers:
(a) ks0.101.4(0.160.10)0.184
growthrateofdividends$3.40/$2.701.259FVIF3,k8%
Po$3.40(1.08)/(0.1840.08)$35.31
(b) ks0.101.6(0.160.10)0.196
Po$3.40(1.08)/(0.1960.08)$31.66
LevelofDifficulty:4
LearningGoal:6
Topic:CAPMandConstantGrowthValuationModel(Equation7.4,Equation7.5andEquation7.9)
29.

TangshanChinasstockiscurrentlysellingfor$160.00pershareandthefirmsdividendsare
expectedtogrowat5percentindefinitely.Inaddition,TangshanChinasmostrecentdividendwas
$5.50.Theexpectedriskfreerateofreturnis3percent,theexpectedmarketreturnis8percent,and
Tangshanhasabetaof1.20.
(a) Whatistheexpectedreturnbasedonthedividendvaluationmodel?
(b) WhatistherequiredreturnbasedontheCAPM?
(c) WouldTangshanChinabeagoodinvestmentatthistime?Explain
Answers:
(a) ks[$5.50(1.05)]/$160.000.058.6%
(b) ks0.031.2(0.080.03)9%
(c) Theexpectedreturnis8.6percentbuttherequiredreturnis9percent.Basedonthis
information,Tangshanisovervaluedandwouldnotbeagoodinvestmentatthistime.
LevelofDifficulty:4
LearningGoal:6
Topic:CAPMandConstantGrowthValuationModel(Equation7.4,Equation7.5andEquation7.9)