Practice Week 1:

Valuation of Financial Securities

A. Short Answer Questions

Provide brief responses to the following questions.

1. Indicate whether the following statements are true or false. Provide a brief explanation in
each case.
a) In the constant dividend growth model, g refers to the growth rate of past dividends.
b) In the constant dividend growth model, we assume that (rE – g) must be greater than
or equal to zero.

2. Briefly explain how the price-earnings ratio of a stock will change if each of the following
factors changes as indicated, assuming other factors are unchanged.
a) The dividend growth rate increases.
b) The dividend retention rate decreases.
c) The earnings per share decreases.

3. Briefly explain the cash flows associated with a bond to the investor.

4. Briefly explain the term "yield to maturity."

5. What is the relationship between interest rates and bond prices?

B. Multiple Choice Questions

1. A 5-year treasury bond with a coupon rate of 8% has a face value of $1000. What is the
semi-annual interest payment?
A. $80
B. $40
C. $100
D. None of the above
2. A three-year bond has 8.0% coupon rate and face value of $1000. If the yield to maturity
on the bond is 10%, calculate the price of the bond assuming that the bond makes semi-
annual coupon interest payments.
A. $857.96
B. $949.24
C. $1057.54
D. $1000.00
3. CK Company stockholders expect to receive a year-end dividend of $5 per share and
then be sold for $115 dollars per share. If the required rate of return for the stock is 20%,
what is the current value of the stock?
A. $100
B. $122
C. $132
D. $110
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4. Deluxe Company expects to pay a dividend of $2 per share at the end of year-1, $3 per
share at the end of year-2 and then be sold for $32 per share. If the required rate on the
stock is 15%, what is the current value of the stock?
A. $28.20
B. $32.17
C. $32.00
D. None of the given answers
5. Casino Inc. is expected to pay a dividend of $3 per share at the end of year-1 (D1) and
these dividends are expected to grow at a constant rate of 6% per year forever. If the
required rate of return on the stock is 18%, what is current value of the stock today?
A. $25
B. $50
C. $100
D. $54
6. River Co. has paid a dividend $2 per share out of earnings of $4 per share. If the book
value per share is $25 and is currently selling for $40 per share, calculate the required
rate of return on the stock.
A. 15.2%
B. 7.2%
C. 14.7%
D. 13.4%
7. If interest rates on all maturities increase by one percent what will happen to the p
rice of these bonds?
a) The price of the shorter and longer maturity bonds will rise by the same percentage.
b) The price of the shorter and longer maturity bonds will fall by the same percentage.
c) The price of the shorter maturity bond will rise by a lower percentage than the rise in
price of the longer maturity bond.
d) The price of the shorter maturity bond will fall by a lower percentage than the fall in
price of the longer maturity bond.

C. Problems

1. Suppose Acap Corporation will pay a dividend of $2.80 per share at the end of this year
and $3.00 per share next year. You expect Acap’s stock price to be $52.00 in two years’
time. Assume that Acap’s expected return on equity is 10%.

a. What price would you be willing to pay for a share of Acap stock today if you
planned to hold the stock for two years? Show all calculations.
b. Suppose instead you plan to hold the stock for one year. What price would you expect to
be able to sell the shares for in one year’s time? Show all calculations.
c. Given your answer in part (b), what price would you be willing to pay for these
shares today if you planned to hold the stock for one year? How does this compare to
your answer in part (a)? Show all calculations.

2. Krell Industries has a share price of $22.00 today. If Krell is expected to pay a dividend
of $0.88 and its stock price is expected to grow to $23.54 at the end of the year, what is
Krell’s expected dividend yield and expected return on equity? Show all calculations.

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