Professional Documents
Culture Documents
Fundamentals of Corporate Finance 8th Edition Brealey Test Bank 1
Fundamentals of Corporate Finance 8th Edition Brealey Test Bank 1
Chapter 07
Valuing Stocks
1. The dividend discount model indicates that the value of a stock is the present value of the
dividends it will pay over the investor's horizon, plus the present value of the expected stock price
at the end of that horizon.
True False
2. An excess of market value over the book value of equity can be attributed to going concern
value.
True False
7-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
3. Securities with the same expected risk should offer the same expected rate of return.
True False
4. If investors believe a company will have the opportunity to make very profitable investments in the
future, they will pay more for the company's stock today.
True False
5. The dividend discount model should not be used to value stocks in which the dividend does not
grow.
True False
6. If the stock prices follow a random walk, successive stock prices are not related.
True False
7. The liquidation value of a firm is equal to the book value of the firm.
True False
8. Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout
ratio.
True False
9. If the market is efficient, stock prices should be expected to react only to new information that is
released.
True False
10. The intent of technical analysis is to discover patterns in past stock prices.
True False
11. Technical analysts have no effect on the efficiency of the stock market.
True False
12. Technical analysts would be more likely than other investors to index their portfolios.
True False
13. Market efficiency implies that security prices impound new information quickly.
True False
7-2
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
14. If security prices follow a random walk, then on any particular day the odds are that an increase
or decrease in price is equally likely.
True False
15. Fundamental analysts attempt to get rich by identifying patterns in stock prices.
True False
16. Strong-form market efficiency implies that one could earn above-average returns by examining
the history of a firm's stock price.
True False
17. Market value, unlike book value and liquidation value, treats the firm as a going concern.
True False
18. The dividend yield of a stock is much like the current yield of a bond. Both ignore prospective
capital gains or losses.
True False
19. The dividend discount model states that today's stock price equals the present value of all
expected future dividends.
True False
7-3
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
21. The sustainable growth rate represents the ____ rate at which a firm can grow:
22. Wilt's has earnings per share of $2.98 and dividends per share of $.35. What is the firm's
sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%?
A. 2.14%
B. 1.71%
C. 12.89%
D. 16.06%
24. For a firm that repurchases its stock, the dividend discount model might best be applied to the
firm's:
25. A firm has 120,000 shares of stock outstanding, a sustainable rate of growth of 3.8, and $648,200
in free cash flows. What value would you place on a share of this firm's stock if you require a 14%
rate of return?
A. $48.09
B. $52.96
C. $54.02
D. $61.58
7-4
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
26. As a result of its IPO, Facebook received:
27. If the general sentiment of investors is pessimistic, stock prices are more apt to:
A. increase significantly.
B. increase slightly.
C. remain constant.
D. decline.
28. What is the difference between a fundamental analyst and a technical analyst?
29. According to the semistrong form of market efficiency, when new information becomes available
in the market, the related stock prices will:
30. In the calculation of rates of return on common stock, dividends are _______ and capital gains
are ______.
7-5
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
31. What dividend yield would be reported in the financial press for a stock that currently pays a $1
dividend per quarter and the most recent stock price was $40?
A. 2.5%
B. 4.0%
C. 10.0%
D. 5.0%
32. Which of the following values treats the firm as a going concern?
A. Market value
B. Book value
C. Liquidation value
D. Both market and book values
33. If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year and the dividend payout ratio
is 40%, what is the stock's current price?
A. $24.30
B. $18.00
C. $22.22
D. $40.50
34. With respect to the notion that stock prices follow a random walk, several researchers have
concluded that:
35. What is the current price of a share of stock for a firm with $5 million in balance-sheet equity,
500,000 shares of stock outstanding, and a price/book value ratio of 4?
A. $2.50
B. $10.00
C. $20.00
D. $40.00
7-6
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
36. A firm's liquidation value is the amount:
37. Which one of the following is least likely to account for an excess of market value over book value
of equity?
38. Firms with valuable intangible assets are more likely to show a(n):
39. Which of the following is inconsistent with a firm that sells for very near book value?
40. A stock paying $5 in annual dividends currently sells for $80 and has an expected return of 14%.
What might investors expect to pay for the stock one year from now?
A. $82.20
B. $86.20
C. $87.20
D. $91.20
7-7
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
41. A stock currently sells for $50 per share, has an expected return of 15%, and an expected capital
appreciation rate of 10%. What is the amount of the expected dividend?
A. $2.50
B. $2.75
C. $3.00
D. $3.50
43. It is possible to ignore cash dividends that occur far into the future when using a dividend
discount model because those dividends:
44. If the dividend yield for year 1 is expected to be 5% based on a stock price of $25, what will the
year 4 dividend be if dividends grow annually at a constant rate of 6%?
A. $1.33
B. $1.49
C. $1.58
D. $1.67
45. Dani's just paid an annual dividend of $6 per share. What is the dividend expected to be in five
years if the growth rate is 4.2%?
A. $7.07
B. $7.37
C. $7.14
D. $7.44
7-8
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
46. The value of common stock will likely decrease if:
47. When valuing stock with the dividend discount model, the present value of future dividends will:
48. What should be the price for a common stock paying $3.50 annually in dividends if the growth
rate is zero and the discount rate is 8%?
A. $22.86
B. $28.00
C. $42.00
D. $43.75
49. What should you pay for a stock if next year's annual dividend is forecast to be $5.25, the
constant-growth rate is 2.85%, and you require a 15.5% rate of return?
A. $31.25
B. $38.87
C. $41.50
D. $42.68
50. What price would you pay today for a stock if you require a rate of return of 13%, the dividend
growth rate is 3.6%, and the firm recently paid an annual dividend of $2.50?
A. $27.55
B. $30.28
C. $26.60
D. $31.37
7-9
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
51. What constant-growth rate in dividends is expected for a stock valued at $32.40 if next year's
dividend is forecast at $2.20 and the appropriate discount rate is 13.6%?
A. 7.02%
B. 6.59%
C. 6.81%
D. 7.38%
52. What rate of return is expected from a stock that sells for $30 per share, pays $1.54 annually in
dividends, and is expected to sell for $32.80 per share in one year?
A. 15.03%
B. 14.28%
C. 14.09%
D. 14.47%
53. ABC common stock is expected to have extraordinary growth of 20% per year for 2 years, after
which the growth rate will settle into a constant 6%. If the discount rate is 15% and the most
recent dividend was $2.50, what should be the approximate current share price?
A. $31.16
B. $33.23
C. $37.39
D. $47.77
54. What would be the approximate expected price of a stock when dividends are expected to grow
at a 25% rate for 3 years, then grow at a constant rate of 5%, if the stock's required return is 13%
and next year's dividend will be $4.00?
A. $67.60
B. $62.08
C. $68.64
D. $73.44
55. A company with a return on equity of 15% and a plowback ratio of 60% would expect a constant-
growth rate of:
A. 4%.
B. 9%.
C. 21%.
D. 25%.
7-10
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
56. What is the plowback ratio for a firm that has earnings per share of $2.68 and pays out $1.75 per
share in dividends?
A. 28.20%
B. 34.70%
C. 66.67%
D. 71.80%
57. A positive value for PVGO suggests that the firm has:
58. Which of the following situations accurately describes a growth stock, assuming that each firm
has a required return of 12%?
59. Other things equal, a firm's sustainable growth rate could increase as a result of:
60. Under which of the following forms of market efficiency would stock prices always reflect fair
value?
A. Weak-form efficiency
B. Semistrong-form efficiency
C. Strong-form efficiency
D. Semiweak-form efficiency
7-11
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
61. Investors are willing to purchase stocks having high P/E ratios because:
62. Which of the following is least likely to contribute to going concern value?
63. What happens to a firm that reinvests its earnings at a rate equal to the firm's required return?
64. What can be expected to happen when stocks having the same expected risk do not have the
same expected return?
7-12
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
66. A stock is expected to pay dividends of $1.20 per share in Year 1 and $1.35 per share in Year 2.
After that, the dividend is expected to increase by 2.5% annually. What is the current value of the
stock at a discount rate of 14.5%?
A. $11.29
B. $10.87
C. $12.07
D. $13.39
67. Jefferson's recently paid an annual dividend of $1.31 per share. The dividend is expected to
decrease by 4% each year. How much should you pay for this stock today if your required return
is 16%?
A. $6.29
B. $5.74
C. $10.48
D. $11.57
68. Which one of the following is more likely to be responsible for a firm having a low PVGO?
69. What is the most likely value of the PVGO for a stock with a current price of $50, expected
earnings of $6 per share, and a required return of 20%?
A. $10
B. $20
C. $25
D. $30
70. What is the expected constant-growth rate of dividends for a stock with a current price of $87, an
expected dividend payment of $5.40 per share, and a required return of 16%?
A. 8.48%
B. 6.25%
C. 9.79%
D. 5.23%
7-13
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
71. Which of the following is true for a firm having a stock price of $42, an expected dividend of $3,
and a sustainable growth rate of 8%?
72. What is the value of the expected dividend per share for a stock that has a required return of
16%, a price of $45, and a constant-growth rate of 12%?
A. $1.80
B. $3.60
C. $4.50
D. $7.20
73. What is the required return for a stock that has a constant-growth rate of 3.3%, a price of $25, an
expected dividend of $2.10, and a P/E ratio of 14.4?
A. 12.40%
B. 10.92%
C. 11.70%
D. 11.26%
74. What should be the price of a stock that offers a $4.32 annual dividend with no prospects of
growth, and has a required return of 12.5%?
A. $0
B. $4.86
C. $34.56
D. $30.24
75. Technical analysts are most likely to be successful in a market that is considered to be:
A. semistrong-form efficient.
B. strong-form efficient.
C. less than weak-form efficient.
D. a random walk.
7-14
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
76. If The Wall Street Journal lists a stock's dividend as $1, then it is most likely the case that the
stock:
77. Suzi owns 100 shares of AB stock. She expects to receive a $238 in dividends next year. She
also expects the stock to sell for $46 a share one year from now. What is the intrinsic value of this
stock if the dividend payout ratio is 40% and the discount rate is 13.5%?
A. $38.19
B. $42.63
C. $40.53
D. $45.77
78. What is the minimum amount shareholders should expect to receive in the event of a complete
corporate liquidation?
79. If the price of a stock falls on 4 consecutive days of trading, then stock prices:
80. What should be the stock value one year from today for a stock that currently sells for $35, has a
required return of 15%, an expected dividend of $2.80, and a constant dividend growth rate of
7%?
A. $37.45
B. $37.80
C. $40.25
D. $43.05
7-15
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
81. The required return on an equity security is comprised of a:
82. What should be the current price of a share of stock if a $5 dividend was just paid, the stock has
a required return of 20%, and a constant dividend growth rate of 6%?
A. $19.23
B. $25.00
C. $35.71
D. $37.86
83. What should be the current price of a stock if the expected dividend is $5, the stock has a
required return of 20%, and a constant dividend growth rate of 6%?
A. $19.23
B. $25.00
C. $35.71
D. $37.86
84. Reinvesting earnings into a firm will not increase the stock price unless:
85. What proportion of earnings is being plowed back into the firm if the sustainable growth rate is 8%
and the firm's ROE is 20%?
A. 60%
B. 80%
C. 20%
D. 40%
7-16
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
86. How much of a stock's $30 price is reflected in PVGO if it expects to earn $4 per share, has an
expected dividend of $2.50, and a required return of 20%?
A. $0
B. $6
C. $8
D. $10
87. What is the expected constant-growth rate of dividends for a stock currently priced at $50, that
just paid a dividend of $4, and has a required return of 18%?
A. 3.41%
B. 5.50%
C. 9.26%
D. 12.5%
88. According to random-walk theory, what are the odds that a stock will increase in price after
having increased on two consecutive days of trading?
A. 0%
B. 25%
C. 50%
D. 100%
89. If the liquidation value of a corporation exceeds the market value of the equity, then the:
90. In a valuation of a nonconstant dividend growth stock, the terminal value represents the:
7-17
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
91. Which one of the following situations is most likely to occur today for a stock that went down in
price yesterday?
92. Based on the random walk theory, if a stock's price decreased last week, then this week the
price:
93. Research indicates that the correlation coefficient between successive days' stock price changes
is:
94. An analyst who relies on past cycles of stock pricing to make investment decisions is:
95. Janice has spent hours upon hours analyzing the last five years of financial statements of a firm
and has concluded that the firm's stock is currently underpriced. What type of analyst is Janice?
A. Fundamental analyst
B. Random-walker analyst
C. Technical analyst
D. Behavioral finance analyst
7-18
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
96. If it proves possible to make abnormal profits based on information regarding past stock prices,
then the market is:
A. weak-form efficient.
B. not weak-form efficient.
C. semistrong-form efficient.
D. strong-form efficient.
97. The study of published financial information on a company in order to make investment decisions
is known as:
A. technical analysis.
B. fundamental analysis.
C. efficiency analysis.
D. random pricing analysis.
A. relies on the same information as the technical analyst, but believes in the random walk.
B. studies a firm's financial statements to determine pricing inefficiencies.
C. believes that the market is strong-form efficient.
D. performs an unnecessary function, since markets are efficient.
99. Studies indicate that stocks of firms with the best earnings news outperform the stocks of firms
with the worst earnings news for at least six months. What type of market anomaly is this?
A. New-issue puzzle
B. Attitudes towards risk behavior
C. Earnings announcement puzzle
D. Probabilities belief
100.If no price change occurs in a stock on the day that it announces its next dividend, it can be
assumed that:
7-19
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
101.When investors are not capable of making superior investment decisions on a continual basis
based on past prices or public or private information, the market is said to be:
A. weak-form efficient.
B. semistrong-form efficient.
C. strong-form efficient.
D. fundamentally efficient.
102.Which group of investors is capable of earning consistent, superior profits if financial markets are
semistrong-form efficient? Ignore any legal considerations.
A. Technical analysts
B. Fundamental analysts
C. Company insiders
D. Mutual fund managers
103.Which one of these probably contributed the least to the dot.com bubble?
104.When new information becomes available in the market, evidence generally suggests that:
105.An example that specifically contradicts strong-form market efficiency in U.S. stock markets is
that:
7-20
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
106.Your broker suggests that you can make consistent, excess profits by purchasing stocks on the
20th of the month and selling them on the last day of the month. If this is true, then:
107.If a firm unexpectedly raises its dividend permanently and by a substantial amount, the firm's
stock price:
108.The statement that there are no free lunches on Wall Street suggests that:
Essay Questions
109.Explain why the market value of common stock often differs from its liquidation value or its book
value.
7-21
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
110.How can you reconcile the fact that whether an investor favors dividends or capital gains, the
investor should accept the dividend discount model as a determination of share value?
111.A stock offers an expected dividend of $3.50, has a required return of 14%, and has historically
exhibited a growth rate of 6%. Its current price is $35.00 and shows no tendency to change. How
can you explain this price based on the constant-growth dividend discount model?
112.Show numerically that the investment horizon has no bearing on current stock price. For your
illustration assume investment horizons of 2 versus 3 years and the following facts: The stock
has a required return of 17%, a growth rate of 7%, and has just paid a $3.74 dividend.
7-22
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
113.A firm expects earnings next year of $10.00 per share, has a plowback ratio of 35%, a return on
equity of 20%, and a required return of 15%. Mathematically illustrate the computation of the
current stock value and next year's expected stock value, assuming that growth is constant. Also
illustrate how the earnings plowback leads to the price increase.
114.Numerically illustrate the breakdown of the stock price between a firm's assets that are already in
place and its present value of growth opportunities. Assume next year's expected earnings are
$5.00 a share, the required rate of return is 13%, the return on equity is 17%, and the plowback
ratio is 45%.
115.Explain the relationships among the earnings-price (E/P) ratio, required rate of return, and
present value of growth opportunities.
7-23
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
116.How can an analyst feel comfortable in stating that the value of a stock is equal to the discounted
value of all future dividends when a company may pay dividends indefinitely and it is virtually
impossible to predict dividends beyond some reasonable horizon?
118.How do you estimate expected rates of return in the constant-growth dividend discount model?
7-24
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
119.What situation does a financial analyst face when there are many talented and competitive
fundamental analysts?
120.What are some common errors investors make in assessing the probability of uncertain
outcomes? How did such errors reinforce the dot.com boom?
7-25
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 07 Valuing Stocks Answer Key
1. The dividend discount model indicates that the value of a stock is the present value of the
dividends it will pay over the investor's horizon, plus the present value of the expected stock
price at the end of that horizon.
TRUE
2. An excess of market value over the book value of equity can be attributed to going concern
value.
TRUE
3. Securities with the same expected risk should offer the same expected rate of return.
TRUE
4. If investors believe a company will have the opportunity to make very profitable investments in
the future, they will pay more for the company's stock today.
TRUE
7-26
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
5. The dividend discount model should not be used to value stocks in which the dividend does
not grow.
FALSE
6. If the stock prices follow a random walk, successive stock prices are not related.
FALSE
7. The liquidation value of a firm is equal to the book value of the firm.
FALSE
8. Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout
ratio.
FALSE
9. If the market is efficient, stock prices should be expected to react only to new information that
is released.
TRUE
AACSB: Communication
7-27
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Market efficiency-foundations and types
10. The intent of technical analysis is to discover patterns in past stock prices.
TRUE
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Fundamental and technical analysis
11. Technical analysts have no effect on the efficiency of the stock market.
FALSE
12. Technical analysts would be more likely than other investors to index their portfolios.
FALSE
13. Market efficiency implies that security prices impound new information quickly.
TRUE
7-28
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
14. If security prices follow a random walk, then on any particular day the odds are that an
increase or decrease in price is equally likely.
TRUE
15. Fundamental analysts attempt to get rich by identifying patterns in stock prices.
FALSE
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Fundamental and technical analysis
16. Strong-form market efficiency implies that one could earn above-average returns by examining
the history of a firm's stock price.
FALSE
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Market efficiency-foundations and types
17. Market value, unlike book value and liquidation value, treats the firm as a going concern.
TRUE
18. The dividend yield of a stock is much like the current yield of a bond. Both ignore prospective
capital gains or losses.
TRUE
7-29
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Stock returns and yields
19. The dividend discount model states that today's stock price equals the present value of all
expected future dividends.
TRUE
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
21. The sustainable growth rate represents the ____ rate at which a firm can grow:
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
7-30
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
22. Wilt's has earnings per share of $2.98 and dividends per share of $.35. What is the firm's
sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%?
A. 2.14%
B. 1.71%
C. 12.89%
D. 16.06%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
24. For a firm that repurchases its stock, the dividend discount model might best be applied to the
firm's:
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
7-31
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
25. A firm has 120,000 shares of stock outstanding, a sustainable rate of growth of 3.8, and
$648,200 in free cash flows. What value would you place on a share of this firm's stock if you
require a 14% rate of return?
A. $48.09
B. $52.96
C. $54.02
D. $61.58
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-04 Interpret price-earnings ratios.
Topic: Initial public offerings
27. If the general sentiment of investors is pessimistic, stock prices are more apt to:
A. increase significantly.
B. increase slightly.
C. remain constant.
D. decline.
7-32
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
28. What is the difference between a fundamental analyst and a technical analyst?
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Fundamental and technical analysis
29. According to the semistrong form of market efficiency, when new information becomes
available in the market, the related stock prices will:
30. In the calculation of rates of return on common stock, dividends are _______ and capital gains
are ______.
7-33
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
31. What dividend yield would be reported in the financial press for a stock that currently pays a
$1 dividend per quarter and the most recent stock price was $40?
A. 2.5%
B. 4.0%
C. 10.0%
D. 5.0%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper.
Topic: Stock returns and yields
32. Which of the following values treats the firm as a going concern?
A. Market value
B. Book value
C. Liquidation value
D. Both market and book values
33. If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year and the dividend payout
ratio is 40%, what is the stock's current price?
A. $24.30
B. $18.00
C. $22.22
D. $40.50
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 07-04 Interpret price-earnings ratios.
7-34
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Topic: Stock valuation using multiples
34. With respect to the notion that stock prices follow a random walk, several researchers have
concluded that:
35. What is the current price of a share of stock for a firm with $5 million in balance-sheet equity,
500,000 shares of stock outstanding, and a price/book value ratio of 4?
A. $2.50
B. $10.00
C. $20.00
D. $40.00
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-04 Interpret price-earnings ratios.
Topic: Stock valuation using multiples
7-35
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
37. Which one of the following is least likely to account for an excess of market value over book
value of equity?
38. Firms with valuable intangible assets are more likely to show a(n):
39. Which of the following is inconsistent with a firm that sells for very near book value?
7-36
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
40. A stock paying $5 in annual dividends currently sells for $80 and has an expected return of
14%. What might investors expect to pay for the stock one year from now?
A. $82.20
B. $86.20
C. $87.20
D. $91.20
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Stock returns and yields
41. A stock currently sells for $50 per share, has an expected return of 15%, and an expected
capital appreciation rate of 10%. What is the amount of the expected dividend?
A. $2.50
B. $2.75
C. $3.00
D. $3.50
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Stock returns and yields
7-37
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Stock returns and yields
43. It is possible to ignore cash dividends that occur far into the future when using a dividend
discount model because those dividends:
44. If the dividend yield for year 1 is expected to be 5% based on a stock price of $25, what will
the year 4 dividend be if dividends grow annually at a constant rate of 6%?
A. $1.33
B. $1.49
C. $1.58
D. $1.67
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
7-38
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
45. Dani's just paid an annual dividend of $6 per share. What is the dividend expected to be in five
years if the growth rate is 4.2%?
A. $7.07
B. $7.37
C. $7.14
D. $7.44
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Constant-growth stock
47. When valuing stock with the dividend discount model, the present value of future dividends
will:
7-39
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
48. What should be the price for a common stock paying $3.50 annually in dividends if the growth
rate is zero and the discount rate is 8%?
A. $22.86
B. $28.00
C. $42.00
D. $43.75
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Perpetuities
49. What should you pay for a stock if next year's annual dividend is forecast to be $5.25, the
constant-growth rate is 2.85%, and you require a 15.5% rate of return?
A. $31.25
B. $38.87
C. $41.50
D. $42.68
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
7-40
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
50. What price would you pay today for a stock if you require a rate of return of 13%, the dividend
growth rate is 3.6%, and the firm recently paid an annual dividend of $2.50?
A. $27.55
B. $30.28
C. $26.60
D. $31.37
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
51. What constant-growth rate in dividends is expected for a stock valued at $32.40 if next year's
dividend is forecast at $2.20 and the appropriate discount rate is 13.6%?
A. 7.02%
B. 6.59%
C. 6.81%
D. 7.38%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
7-41
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
52. What rate of return is expected from a stock that sells for $30 per share, pays $1.54 annually
in dividends, and is expected to sell for $32.80 per share in one year?
A. 15.03%
B. 14.28%
C. 14.09%
D. 14.47%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Stock returns and yields
53. ABC common stock is expected to have extraordinary growth of 20% per year for 2 years,
after which the growth rate will settle into a constant 6%. If the discount rate is 15% and the
most recent dividend was $2.50, what should be the approximate current share price?
A. $31.16
B. $33.23
C. $37.39
D. $47.77
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Two-stage growth stock
7-42
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
54. What would be the approximate expected price of a stock when dividends are expected to
grow at a 25% rate for 3 years, then grow at a constant rate of 5%, if the stock's required
return is 13% and next year's dividend will be $4.00?
A. $67.60
B. $62.08
C. $68.64
D. $73.44
Price = $4/1.13 + ($4 × 1.25)/1.132 + ($4 × 1.252)/1.133 + [($4 × 1.252 × 1.05)/(.13 - .05)]/1.133
= $68.64
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Two-stage growth stock
55. A company with a return on equity of 15% and a plowback ratio of 60% would expect a
constant-growth rate of:
A. 4%.
B. 9%.
C. 21%.
D. 25%.
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
7-43
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
56. What is the plowback ratio for a firm that has earnings per share of $2.68 and pays out $1.75
per share in dividends?
A. 28.20%
B. 34.70%
C. 66.67%
D. 71.80%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
57. A positive value for PVGO suggests that the firm has:
58. Which of the following situations accurately describes a growth stock, assuming that each firm
has a required return of 12%?
7-44
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
59. Other things equal, a firm's sustainable growth rate could increase as a result of:
60. Under which of the following forms of market efficiency would stock prices always reflect fair
value?
A. Weak-form efficiency
B. Semistrong-form efficiency
C. Strong-form efficiency
D. Semiweak-form efficiency
61. Investors are willing to purchase stocks having high P/E ratios because:
7-45
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
62. Which of the following is least likely to contribute to going concern value?
63. What happens to a firm that reinvests its earnings at a rate equal to the firm's required return?
64. What can be expected to happen when stocks having the same expected risk do not have the
same expected return?
7-46
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
65. The terminal value of a share of stock:
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Dividend discount model
66. A stock is expected to pay dividends of $1.20 per share in Year 1 and $1.35 per share in Year
2. After that, the dividend is expected to increase by 2.5% annually. What is the current value
of the stock at a discount rate of 14.5%?
A. $11.29
B. $10.87
C. $12.07
D. $13.39
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Nonconstant-growth stock
67. Jefferson's recently paid an annual dividend of $1.31 per share. The dividend is expected to
decrease by 4% each year. How much should you pay for this stock today if your required
return is 16%?
A. $6.29
B. $5.74
C. $10.48
D. $11.57
AACSB: Analytic
Accessibility: Keyboard Navigation
7-47
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
68. Which one of the following is more likely to be responsible for a firm having a low PVGO?
69. What is the most likely value of the PVGO for a stock with a current price of $50, expected
earnings of $6 per share, and a required return of 20%?
A. $10
B. $20
C. $25
D. $30
With a 100% payout ratio, the stock would be valued at $30 ($6/.20 = $30). Thus, the $20 of
additional price must represent the PVGO.
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Net present value growth opportunity
7-48
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
70. What is the expected constant-growth rate of dividends for a stock with a current price of $87,
an expected dividend payment of $5.40 per share, and a required return of 16%?
A. 8.48%
B. 6.25%
C. 9.79%
D. 5.23%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
71. Which of the following is true for a firm having a stock price of $42, an expected dividend of
$3, and a sustainable growth rate of 8%?
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Stock returns and yields
7-49
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
72. What is the value of the expected dividend per share for a stock that has a required return of
16%, a price of $45, and a constant-growth rate of 12%?
A. $1.80
B. $3.60
C. $4.50
D. $7.20
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Constant-growth stock
73. What is the required return for a stock that has a constant-growth rate of 3.3%, a price of $25,
an expected dividend of $2.10, and a P/E ratio of 14.4?
A. 12.40%
B. 10.92%
C. 11.70%
D. 11.26%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Constant-growth stock
7-50
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
74. What should be the price of a stock that offers a $4.32 annual dividend with no prospects of
growth, and has a required return of 12.5%?
A. $0
B. $4.86
C. $34.56
D. $30.24
P = $4.32/.125 = $34.56
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Perpetuities
75. Technical analysts are most likely to be successful in a market that is considered to be:
A. semistrong-form efficient.
B. strong-form efficient.
C. less than weak-form efficient.
D. a random walk.
76. If The Wall Street Journal lists a stock's dividend as $1, then it is most likely the case that the
stock:
7-51
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
77. Suzi owns 100 shares of AB stock. She expects to receive a $238 in dividends next year. She
also expects the stock to sell for $46 a share one year from now. What is the intrinsic value of
this stock if the dividend payout ratio is 40% and the discount rate is 13.5%?
A. $38.19
B. $42.63
C. $40.53
D. $45.77
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Stock returns and yields
78. What is the minimum amount shareholders should expect to receive in the event of a complete
corporate liquidation?
79. If the price of a stock falls on 4 consecutive days of trading, then stock prices:
7-52
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
80. What should be the stock value one year from today for a stock that currently sells for $35,
has a required return of 15%, an expected dividend of $2.80, and a constant dividend growth
rate of 7%?
A. $37.45
B. $37.80
C. $40.25
D. $43.05
$35 × 1.07 = $37.45, since dividends, price, and book value grow at 7%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
82. What should be the current price of a share of stock if a $5 dividend was just paid, the stock
has a required return of 20%, and a constant dividend growth rate of 6%?
A. $19.23
B. $25.00
C. $35.71
D. $37.86
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
7-53
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
83. What should be the current price of a stock if the expected dividend is $5, the stock has a
required return of 20%, and a constant dividend growth rate of 6%?
A. $19.23
B. $25.00
C. $35.71
D. $37.86
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
84. Reinvesting earnings into a firm will not increase the stock price unless:
85. What proportion of earnings is being plowed back into the firm if the sustainable growth rate is
8% and the firm's ROE is 20%?
A. 60%
B. 80%
C. 20%
D. 40%
AACSB: Analytic
Accessibility: Keyboard Navigation
7-54
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Dividend discount model
86. How much of a stock's $30 price is reflected in PVGO if it expects to earn $4 per share, has an
expected dividend of $2.50, and a required return of 20%?
A. $0
B. $6
C. $8
D. $10
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Net present value growth opportunity
87. What is the expected constant-growth rate of dividends for a stock currently priced at $50, that
just paid a dividend of $4, and has a required return of 18%?
A. 3.41%
B. 5.50%
C. 9.26%
D. 12.5%
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Constant-growth stock
7-55
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
88. According to random-walk theory, what are the odds that a stock will increase in price after
having increased on two consecutive days of trading?
A. 0%
B. 25%
C. 50%
D. 100%
89. If the liquidation value of a corporation exceeds the market value of the equity, then the:
90. In a valuation of a nonconstant dividend growth stock, the terminal value represents the:
7-56
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
91. Which one of the following situations is most likely to occur today for a stock that went down in
price yesterday?
92. Based on the random walk theory, if a stock's price decreased last week, then this week the
price:
93. Research indicates that the correlation coefficient between successive days' stock price
changes is:
7-57
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
94. An analyst who relies on past cycles of stock pricing to make investment decisions is:
95. Janice has spent hours upon hours analyzing the last five years of financial statements of a
firm and has concluded that the firm's stock is currently underpriced. What type of analyst is
Janice?
A. Fundamental analyst
B. Random-walker analyst
C. Technical analyst
D. Behavioral finance analyst
96. If it proves possible to make abnormal profits based on information regarding past stock
prices, then the market is:
A. weak-form efficient.
B. not weak-form efficient.
C. semistrong-form efficient.
D. strong-form efficient.
7-58
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
97. The study of published financial information on a company in order to make investment
decisions is known as:
A. technical analysis.
B. fundamental analysis.
C. efficiency analysis.
D. random pricing analysis.
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Fundamental and technical analysis
A. relies on the same information as the technical analyst, but believes in the random walk.
B. studies a firm's financial statements to determine pricing inefficiencies.
C. believes that the market is strong-form efficient.
D. performs an unnecessary function, since markets are efficient.
99. Studies indicate that stocks of firms with the best earnings news outperform the stocks of firms
with the worst earnings news for at least six months. What type of market anomaly is this?
A. New-issue puzzle
B. Attitudes towards risk behavior
C. Earnings announcement puzzle
D. Probabilities belief
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Market efficiency-studies and challenges
7-59
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
100. If no price change occurs in a stock on the day that it announces its next dividend, it can be
assumed that:
101. When investors are not capable of making superior investment decisions on a continual basis
based on past prices or public or private information, the market is said to be:
A. weak-form efficient.
B. semistrong-form efficient.
C. strong-form efficient.
D. fundamentally efficient.
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Market efficiency-foundations and types
102. Which group of investors is capable of earning consistent, superior profits if financial markets
are semistrong-form efficient? Ignore any legal considerations.
A. Technical analysts
B. Fundamental analysts
C. Company insiders
D. Mutual fund managers
7-60
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
103. Which one of these probably contributed the least to the dot.com bubble?
104. When new information becomes available in the market, evidence generally suggests that:
105. An example that specifically contradicts strong-form market efficiency in U.S. stock markets is
that:
7-61
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
106. Your broker suggests that you can make consistent, excess profits by purchasing stocks on
the 20th of the month and selling them on the last day of the month. If this is true, then:
107. If a firm unexpectedly raises its dividend permanently and by a substantial amount, the firm's
stock price:
108. The statement that there are no free lunches on Wall Street suggests that:
7-62
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Essay Questions
109. Explain why the market value of common stock often differs from its liquidation value or its
book value.
A firm's liquidation value represents the excess valuation of its assets over its liabilities if the
firm ceased operations and all assets and liabilities were to be sold. Obviously, then, the
liquidation value will depend on the supply and demand for secondhand assets of this nature.
A firm's book value of equity equals all of the initial funds that were supplied by investors as
well as earnings that have been plowed back into the firm over time. Notice that this makes no
statement as to how profitably those earnings were reinvested. When comparing either of
these values to a firm's market value of equity, it is not surprising to find differences. If a firm
has been properly organized and serves customer needs, it will likely have value as a going
concern, which may easily boost market value higher than that of liquidation or book values.
Going-concern value can be the result of extra earning power over that of equally risky
companies, or intangible assets that offer unrecorded value, or the value of future investment
opportunities.
110. How can you reconcile the fact that whether an investor favors dividends or capital gains, the
investor should accept the dividend discount model as a determination of share value?
The first fact to be recognized is that equally risky firms should offer the same expected rate of
return. Next, recognize that the return to a common stock investor can come from either
dividends or capital gains. Then it becomes easier to envision that, for example, a firm with a
high payout may offer good current income, but that it will not be as likely to increase this
income in the future due to the lower plowback now. On the other hand, a firm with a low or
zero current payout doesn't offer much in a justification of value from current income, but is
supposedly investing in growth opportunities that will someday offer enhanced payout
potential. In reconciling these cases, common stock may offer a different time pattern of
dividends. That will of course have an effect on present value, but as long as investors with
different preferences can agree on a stock's fundamentals, they should place the same value
on the stock: the present value of all expected future dividends.
7-63
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
111. A stock offers an expected dividend of $3.50, has a required return of 14%, and has
historically exhibited a growth rate of 6%. Its current price is $35.00 and shows no tendency to
change. How can you explain this price based on the constant-growth dividend discount
model?
The constant-growth dividend discount model would indicate that this stock should currently
sell for $43.75, based on the following formula:
Although stocks can temporarily be out of equilibrium price, the fact that this stock price shows
no tendency to change suggests that investors do not expect the past growth rate of 6% to
continue into the future. Since there is no indication that the required rate of return has
changed, it appears that the company many anticipate fewer positive growth opportunities
than in the past. Therefore, the dividend yield has likely increased to its current 10% level, and
the overall market seems to expect a growth rate of 4% rather than the historical 6%.
AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
7-64
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
112. Show numerically that the investment horizon has no bearing on current stock price. For your
illustration assume investment horizons of 2 versus 3 years and the following facts: The stock
has a required return of 17%, a growth rate of 7%, and has just paid a $3.74 dividend.
AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
7-65
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
113. A firm expects earnings next year of $10.00 per share, has a plowback ratio of 35%, a return
on equity of 20%, and a required return of 15%. Mathematically illustrate the computation of
the current stock value and next year's expected stock value, assuming that growth is
constant. Also illustrate how the earnings plowback leads to the price increase.
Thus, both the dividend discount model and the current stock price increased by the growth
rate of 7% indicate that next year's value should be $86.94.
This can be confirmed by multiplying the expected plowback of $3.50 ($10 × .35) times the
return on equity of 20% to see that earnings should be $.70 higher in 2 years. This $.70 will be
subject to a 65% payout, which will increase dividends by $.455. Finally, $.455 translates into
a price increase of $5.68 when plugged into a dividend discount model, as can be seen by:
AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
114. Numerically illustrate the breakdown of the stock price between a firm's assets that are already
in place and its present value of growth opportunities. Assume next year's expected earnings
are $5.00 a share, the required rate of return is 13%, the return on equity is 17%, and the
plowback ratio is 45%.
P0 = $5/(.13 - 0) = $38.46
g = .17 × .45 = .0765
P0 = [$5 × (1 - .45)]/(.13 - .0765) = $51.40
PVGO = $51.40 - 38.46 = $12.94
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
7-66
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Net present value growth opportunity
115. Explain the relationships among the earnings-price (E/P) ratio, required rate of return, and
present value of growth opportunities.
The inverse of the price-earnings (P/E) ratio is the earnings-price (E/P) ratio. If the E/P ratio is
greater than the required return for the stock, the difference is typically attributed to the firm's
positive value of PVGO. If, on the other hand, the firm's E/P ratio is equal to its required rate of
return, the firm does not have growth opportunities that are expected to yield more than the
required rate of return given the risk of the stock. It is possible that the firm has a lower E/P
ratio than the required rate of return, in which case the firm is not even earning the rate of
return that is required for its risk level. This is numerically equivalent to the firm having
negative growth opportunities, and suggests that the firm either reorganize or liquidate.
116. How can an analyst feel comfortable in stating that the value of a stock is equal to the
discounted value of all future dividends when a company may pay dividends indefinitely and it
is virtually impossible to predict dividends beyond some reasonable horizon?
At most reasonable discount rates for common stock, say between 10% and 20%, the present
value of dividends to be received beyond some reasonable horizon, say 10 years, is quite low
in relation to the present value of dividends received to that point. For example, for a stock
expecting to pay a dividend of $2.00 with a growth rate of 5% and a required return of 15%,
approximately 60% of the present value of an infinite dividend stream is realized from the first
10 years of dividends. By 15 years, approximately 75% of the future value has been received.
These percentages can easily be proven by use of the constant growth dividend discount
model.
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Constant-growth stock
7-67
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
117. How does competition among investors lead to efficient markets?
The search for information and insightful analysis makes investor assessments of stock values
as reliable as possible. Since the rewards accrue to the investors who uncover relevant
information before it is reflected in stock prices, competition among these investors means that
there is always an active search for mispriced stocks. This competition between investors will
tend to produce an efficient market—that is, a market in which prices rapidly reflect new
information, and investors have difficulty making consistently superior returns. Of course, we
all hope to beat the market, but if the market is efficient, all we can rationally expect is a return
that is sufficient on average to compensate for the time value of money and for the risks we
bear.
The evidence for market efficiency is voluminous and there is little doubt that skilled
professional investors find it difficult to win consistently. Nevertheless, there remain some
puzzling instances where markets do not seem to be efficient. Some financial economists
attribute these apparent anomalies to behavioral foibles.
118. How do you estimate expected rates of return in the constant-growth dividend discount
model?
r = (DIV1/P0) + g
The required rate of return, r, is a market-determined rate related to the risk-free rate adjusted
upward for risk, given expectations of DIV1 and g. The stock price, P0, adjusts to equate the
market-expected rate with the required rate of return.
AACSB: Communication
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Constant-growth stock
7-68
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
119. What situation does a financial analyst face when there are many talented and competitive
fundamental analysts?
Fundamental analysts are paid to uncover stocks for which price does not equal intrinsic
value. If intrinsic value exceeds price, for example, the stock is a bargain and will offer a
superior expected return. But what happens if there are many talented and competitive
fundamental analysts? If one of them uncovers a stock that appears to be a bargain, it stands
to reason that others will as well, and there will be a wave of buying that pushes up the price.
In the end, their actions will eliminate the original bargain opportunity. To profit, an analyst's
insights must be different from those of other competitors, and he/she must act faster than
their competitors do. This is a tall order.
120. What are some common errors investors make in assessing the probability of uncertain
outcomes? How did such errors reinforce the dot.com boom?
Psychologists have found that when judging possible future outcomes, individuals commonly
look back to what has happened in recent periods and then assume that this is representative
of what may occur in the future. The temptation is to project recent experience into the future
and to forget the lessons learned from the more distant past. For example, an investor who
places too much weight on recent events may judge that glamorous growth companies are
very likely to continue to grow rapidly, even though very high rates of growth cannot persist
indefinitely.
A second common bias is that of overconfidence. Most of us believe that we are better-than-
average drivers, and most investors think that they are better-than-average stock pickers. We
know that two speculators who trade with one another cannot both make money from the deal;
for every winner there must be a loser. But presumably investors are prepared to continue
trading because each is confident that it is the other one who is the patsy.
You can see how such behavior may have reinforced the dot.com boom. As the bull market
developed, it generated increased optimism about the future and stimulated demand for
shares. The more that investors racked up profits on their stocks, the more confident they
became in their views and the more willing they became to bear the risk that the next month
might not be so good.
7-69
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Behavioral finance
7-70
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.