CHAPTER 7— STOCKS—CHARACTERISTICS AND VALUATION

TRUE/FALSE

1. The additional paid-in capital account represents the difference between a stock's par value and
the funds actually received from the sale of new common stock.
ANS: T DIF: Easy TOP: Additional paid-in capital
2. Founders' shares is a type of classified stock where the shares are owned by the firm's founders
and they retain the sole voting rights to those shares but have restricted dividends for a specified
time period.
ANS: T DIF: Easy TOP: Founders shares
3. A publicly owned corporation is simply a company whose shares are held by the investing public,
which may include other corporations and institutions.
ANS: T DIF: Easy TOP: Public company
4. After a new issue is brought to market it is the marginal investor who determines the price at
which the stock will trade.
ANS: T DIF: Easy TOP: Marginal investor and price
5. A stock's par value is equal to the market value of the stock on the last day of the fiscal year for a
firm.
ANS: F DIF: Easy TOP: Par value
6. The book value per share is computed by taking the sum of common stock, additional paid in
capital, and retained earnings and dividing the number by the number of shares outstanding.
ANS: T DIF: Easy TOP: Book value per share
7. A proxy fight is an attempt by a group to gain control of a firm by convincing its stockholders to
give the group the authority to vote their shares in order to elect a new management team.
ANS: T DIF: Easy TOP: Proxy fight
8. A preemptive right is a provision in the corporate charter or by laws that gives common
stockholders the right to purchase on a pro rata basis new issues of common stock.
ANS: T DIF: Easy TOP: Preemptive right
9. Preemptive rights are important to stockholders because they provide protection against a dilution
of value when new shares are issued.
ANS: T DIF: Easy TOP: Preemptive right
10. One advantage of using common stock as a source of funds is that common stock does not legally
obligate the firm to make payments to stockholders.
ANS: T DIF: Easy TOP: Common equity
11. One advantage of common stock as a source of funds is that the underwriting and distribution
costs of common stock are usually much lower than those for debt.
ANS: F DIF: Easy TOP: Common equity
129 Chapter 7  Stocks-Characteristics and Valuation

12. From a social welfare perspective, common stock is a desirable form of financing in part because
it involves no fixed charge payments. Its inclusion in a firm's capital structure makes the firm less
vulnerable to the consequences of unanticipated declines in sales and earnings than if only debt
were available.
ANS: T DIF: Medium TOP: Common stock and social welfare
13. When a firm issues new equity, market pressure applies first to the new shares issued and then to
existing shares. Subsequent to the new issue, the value of the new shares will rise to the
equilibrium price of the old shares.
ANS: F DIF: Medium TOP: Market pressure
14. When management controls more than 50% of the shares of the firm, they must be concerned
with the potential of a proxy fights than can lead to takeovers of the firm and the replacement of
management.
ANS: F DIF: Medium TOP: Takeover
15. The constant growth model used for evaluating the price of a share of common stock can also be
used to find the price of perpetual preferred stock or any other perpetuity.
ANS: T DIF: Easy TOP: Constant growth stock
16. According to the textbook model, under conditions of nonconstant growth, the discount rate
utilized to find the present value of the expected cash flows will be the same for the initial growth
period as for the normal growth period.
ANS: T DIF: Easy TOP: Supernormal growth stock
17. According to the basic stock valuation model, the value an investor assigns to a share of stock is
dependent upon the length of time the investor plans to hold the stock.
ANS: F DIF: Easy TOP: Stock valuation
18. Other things held constant, P/E ratios are higher for firms with high growth prospects. At the
same time, P/E's are lower for riskier firms, other things held constant. These two factors, growth
prospects and riskiness, may either be offsetting or reinforcing as P/E determinants.
ANS: T DIF: Medium TOP: Risk and P/E ratios

MULTIPLE CHOICE

1. The net income that firm earns can either be paid out to shareholders as __________ or can be
reinvested in the company as __________.
a. interest; additional paid-in capital
b. dividends; retained earnings
c. shares; capital stock.
d. capital gains; additional paid-in capital
e. interest; retained earnings
ANS: B DIF: Easy OBJ: TYPE: Conceptual
TOP: Retained earnings
2. What is the account that shows the difference between the stock's par value and what new
stockholders paid when they bought newly issued shares?
a. Retained earnings
 Chapter 7  Stocks-Characteristics and Valuation 130

b. Common equity
c. Additional paid-in-capital
d. Dividends
e. Initial public offering
ANS: C DIF: Easy OBJ: TYPE: Conceptual
TOP: Additional paid-in capital
3. Shareholders exert control of the management of the firm by
a. electing board members who can replace management.
b. directly replacing management with themselves.
c. buying shares in an IPO at a discounted price.
d. running the daily operations of the firm.
e. None of the above.
ANS: A DIF: Easy OBJ: TYPE: Conceptual
TOP: Control of the firm
4. Stock owned by the organizers of the firm who have sole voting rights is
a. preferred stock.
b. common equity.
c. founders' shares.
d. convertible equity.
e. retained earnings.
ANS: C DIF: Easy OBJ: TYPE: Conceptual TOP: Classes of stock
5. A corporation that is owned by a few individuals who are typically associated with the firm's
management is a __________ corporation.
a. private
b. public
c. diversified
d. closely held
e. listed
ANS: C DIF: Easy OBJ: TYPE: Conceptual
TOP: Closely held corporation

6. Certificates representing ownership in stocks of foreign companies, which are held in a trust bank
located in the country the stock is traded are called __________.
a. Certificates of Ownership
b. Foreign Stock Funds
c. Mutual Funds
d. American Depository Receipts
e. Investment Bankers
ANS: D DIF: Easy OBJ: TYPE: Conceptual TOP: ADRs
7. Velcraft Company has 20,000,000 shares of common stock authorized, but to date, has only
12,000,000 shares outstanding, each with a $1.00 par value. The company has $24,000,000 in
additional paid-in capital and retained earnings are $96,000,000. What is Velcraft's current book
value per share?
a. $1.00
b. $3.00
c. $11.00
d. $6.60
131 Chapter 7  Stocks-Characteristics and Valuation

e. $9.00
ANS: C
Construct a summary of the common stockholders' equity accounts:
Account balance
Common stock (20 million authorized, 12 million
outstanding, $1.00 par value) $ 12,000,000
Additional paid-in capital 24,000,000
Retained earnings 96,000,000
Total common stockholders' equity $132,000,000
Calculate the book value per share:
Book value per share = $132,000,000/12,000,000 = $11.00.
DIF: Easy OBJ: TYPE: Problem TOP: Book value per share
8. Blow Glass Corporation has 100,000 shares of stock outstanding, each with a par value of $2.50
per share. Blow Glass also has another 400,000 shares of stock that are shelf registered. Blow
Glass has retained earnings of $9,000,000 and additional paid-in capital of $1,000,000. What is
Blow Glass's book value per share?
a. $90.00
b. $100.00
c. $27.50
d. $102.50
e. $92.50
ANS: D
Common stock $ 250,000
Additional paid-in capital 1,000,000
Retained earnings 9,000,000
Total common stockholder's equity 10,250,000
Book value per share $10,250,000/100,000 = $102.50
DIF: Easy OBJ: TYPE: Problem TOP: Book value per share
9. Scubapro Corporation currently has 500,000 shares outstanding and plans to issue 200,000 more
shares in a seasoned equity offering. The current shareholders have preemptive rights on any new
issue of stock by Scubapro Corporation. An investor with 20,000 shares who exercises his
preemptive rights on the new stock issue will have the right to buy how many stocks?
a. 200,000 shares
b. 120,000 shares
c. 80,000 shares
d. 12,000 shares
e. 8,000 shares
ANS: E
Percent ownership 200,000/500,000 = 40%
Preemptive right shares 40%*(20,000) = 8,000 shares
DIF: Easy OBJ: TYPE: Problem TOP: Preemptive right
 Chapter 7  Stocks-Characteristics and Valuation 132

10. Micromain Company has 10,000,000 shares of common stock authorized and 8,000,000 shares
outstanding, each with a $1.00 par value. The firm's additional paid-in capital account has a
balance of $18,000,000. The previous year's retained earnings account was $124,000,000. In the
year just ended, Micromain generated net income of $16,000,000 and the firm has a dividend
payout ratio of 40 percent. What will Micromain's book value per share be when based on the
final year-end balance sheet?
a. $20.75
b. $15.00
c. $15.96
d. $19.95
e. $18.75
ANS: D
Construct a summary of the common stockholders' equity accounts:
(In millions) This Year Last Year
Common stock (10 million authorized, 8
million outstanding, $1.00 par value) $ 8.0 $ 8.0
Additional paid-in capital 18.0 18.0
Retained earnings 133.6 124.0
Total common stockholders' equity $159.6 $150.0
Addition to RE = $16,000,000 - 0.40($16,000,000) = $9,600,000.
Calculate the book value per share:
Book value per share = $159.6/8 million shares = $19.95.
DIF: Medium OBJ: TYPE: Problem TOP: Book value per share
11. Nahanni Treasures Corporation is planning a new common stock issue of five million shares to
fund a new project. The increase in shares will bring to 25 million the number of shares
outstanding. Nahanni's long-term growth rate is 6 percent, and its current required rate of return is
12.6 percent. The firm just paid a $1.00 dividend and the stock sells for $16.06 in the market. On
the announcement of the new equity issue, the firm's stock price dropped. Nahanni estimates that
the company's growth rate will increase to 6.5 percent with the new project, but since the project
is riskier than average, the firm's cost of capital will increase to 13.5 percent. Using the DCF
growth model, what is the change in the equilibrium stock price?
a. -$1.77
b. -$1.06
c. -$0.85
d. -$0.66
e. -$0.08
ANS: C
Calculate new equilibrium price and determine change:

Change in price = $16.06 - $15.21 = $0.85

DIF: Medium OBJ: TYPE: Problem TOP: New equity and equilibrium price
133 Chapter 7  Stocks-Characteristics and Valuation

12. Mesmer Analytic, a biotechnology firm, floated an initial public offering of 2,000,000 shares at a
price of $5.00 per share. The firm's owner/managers held 60 percent of the company's $1.00 par
value authorized and issued stock following the public offering. One month after the IPO, the
firm's board of directors declared a one-time dividend of $0.50 per share payable to all
stockholders, meaning that the owner/managers would receive an immediate dividend, in part out
of the pockets of the new public stockholders. What was the book value per share of the firm
before and after the special dividend was paid?
a. $2.60; $2.10
b. $2.60; $2.60
c. $2.60; $2.30
d. $1.60; $1.10
e. $1.60; $1.00
ANS: A
Calculate the total shares and amount of the special dividend:
Total shares = 2,000,000/(1 - 0.6) = 5,000,000.
Special dividend = 5,000,000 shares  $0.50 = $2,500,000.
Construct summary of common equity accounts:
Par value (5,000,000 shares  $1.00) $ 5,000,000
Additional paid-in capital
(2,000,000  ($5 - $1)) 8,000,000
Retained earnings (new issue) 0
Total stockholders' equity $13,000,000
Less special dividend (2,500,000)
Total stockholders' equity
after special dividend $10,500,000
Book value per shareBefore = $13,000,000/5,000,000 shares = $2.60.
Book value per shareAfter = $10,500,000/5,000,000 shares = $2.10.
DIF: Medium OBJ: TYPE: Problem TOP: IPO and special dividend
13. Assuming g will remain constant, the dividend yield is a good measure of the required return on a
common stock under which of the following circumstances?
a. g = 0
b. g > 0
c. g < 0
d. Under no circumstances.
e. Answers a and b are both correct.
ANS: A DIF: Easy OBJ: TYPE: Conceptual
TOP: Dividend yield and g
14. If the expected rate of return on a stock exceeds the required rate,
a. The stock is experiencing supernormal growth.
b. The stock should be sold.
c. The company is probably not trying to maximize price per share.
d. The stock is a good buy.
e. Dividends are not being declared.
ANS: D DIF: Easy OBJ: TYPE: Conceptual TOP: Required return
15. Which of the following statements is correct?
a. The constant growth DCF model can be used to value a stock only if the stock's dividends
 Chapter 7  Stocks-Characteristics and Valuation 134

are expected to grow forever at a constant rate which is less than the required rate of return
on the stock.
b. If the growth rate is negative, the constant growth DCF model cannot be used.
c. The constant growth DCF model may be written as k0 = D0/P0 + g.
d. The constant growth DCF model may be written as P0 = D0/(k + g).
e. The constant growth DCF model may be written as P0 = D0/(k - g).
ANS: A
Statement a is the condition necessary for the constant growth model. All the other statements are
false.
DIF: Easy OBJ: TYPE: Conceptual TOP: Constant growth model
16. Alpha's preferred stock currently has a market price equal to $80 per share. If the dividend paid
on this stock is $6 per share, what is the required rate of return investors are demanding from
Alpha's preferred stock?
a. 7.5%
b. 13.3%
c. 6.0%
d. $6.00
e. None of the above is a correct answer.
ANS: A DIF: Easy OBJ: TYPE: Conceptual TOP: Stock valuation
17. Ms. Manners Catering (MMC) has paid a constant $1.50 per share dividend to its common
stockholders for the past 25 years. MMC expects to continue this policy for the next two years,
and then begin to increase the dividend at a constant rate equal to 2 percent per year into
perpetuity. Investors require a 12 percent rate of return to purchase MMC's common stock. What
is the market value of MMC's common stock?
a. $14.73
b. $15.00
c. $15.58
d. $15.30
e. $12.20
ANS: A DIF: Medium OBJ: TYPE: Conceptual
TOP: Nonconstant growth stock
18. A share of perpetual preferred stock pays an annual dividend of $6 per share. If investors require
a 12 percent rate of return, what should be the price of this preferred stock?
a. $57.25
b. $50.00
c. $62.38
d. $46.75
e. $41.64
ANS: B
Vps = Dps/kps = $6/0.12 = $50.
DIF: Easy OBJ: TYPE: Problem TOP: Preferred stock value
19. A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock
is currently $50, what is the simple annual rate of return?
a. 12%
b. 18%
c. 20%
135 Chapter 7  Stocks-Characteristics and Valuation

d. 23%
e. 28%
ANS: C
Annual dividend = $2.50(4) = $10.
kps = Dps/Vps = $10/$50 = 0.20 = 20%.
DIF: Easy OBJ: TYPE: Problem TOP: Preferred stock yield
20. A share of preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00
for this preferred stock, what is your simple (not effective) annual rate of return?
a. 10%
b. 8%
c. 6%
d. 12%
e. 14%
ANS: A
Yearly dividend = $0.50(4) = $2.00.
kps = Dps/Vps = $2.00/$20.00 = 0.10 = 10%.
DIF: Easy OBJ: TYPE: Problem TOP: Preferred stock yield
21. The last dividend on Spirex Corporation's common stock was $4.00, and the expected growth rate
is 10 percent. If you require a rate of return of 20 percent, what is the highest price you should be
willing to pay for this stock?
a. $44.00
b. $38.50
c. $40.00
d. $45.69
e. $50.00
ANS: A

DIF: Easy OBJ: TYPE: Problem TOP: Stock price

22. You are trying to determine the appropriate price to pay for a share of common stock. If you
purchase this stock, you plan to hold it for 1 year. At the end of the year you expect to receive a
dividend of $5.50 and to sell the stock for $154. The appropriate rate of return for this stock is 16
percent. What should be the current price of this stock?
a. $137.50
b. $150.22
c. $162.18
d. $98.25
e. $175.83
ANS: A
 Chapter 7  Stocks-Characteristics and Valuation 136

Numerical solution:

DIF: Easy OBJ: TYPE: Problem TOP: Stock price

23. A share of common stock has a current price of $82.50 and is expected to grow at a constant rate
of 10 percent. If you require a 14 percent rate of return, what is the current dividend on this
stock?
a. $3.00
b. $3.81
c. $4.29
d. $4.75
e. $6.13
ANS: A

$4.40 = D0 (1.10)
D0 = $3.00.
DIF: Easy OBJ: TYPE: Problem TOP: Constant growth stock
24. The last dividend paid by Klein Company was $1.00. Klein's growth rate is expected to be a
constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent
forever. Klein's required rate of return on equity (ks) is 12 percent. What is the current price of
Klein's common stock?
a. $21.00
b. $33.33
c. $42.25
d. $50.16
e. $58.75
ANS: D
137 Chapter 7  Stocks-Characteristics and Valuation

Enter in CFLO register = 0, = 1.05, and = 61.74.

Then enter I = 12, and press NPV to get NPV = P0 = $50.16.
DIF: Easy OBJ: TYPE: Problem TOP: Nonconstant growth stock
25. You are given the following data:
(1) The risk-free rate is 5 percent.
(2) The required return on the market is 8 percent.
(3) The expected growth rate for the firm is 4 percent.
(4) The last dividend paid was $0.80 per share.
(5) Beta is 1.3.
Now assume the following changes occur:
(1) The inflation premium drops by 1 percent.
(2) An increased degree of risk aversion causes the required return on the market to go to 10
percent after adjusting for the changed inflation premium.
(3) The expected growth rate increases to 6 percent.
(4) Beta rises to 1.5.
What will be the change in price per share, assuming the stock was in equilibrium before the
changes?
a. +$12.11
b. -$4.87
c. +$6.28
d. -$16.97
e. +$2.78
ANS: B
Numerical solution:
Before: ks = 5% + (8% - 5%)1.3 = 8.9%.

After: ks = 4% + (10% - 4%)1.5 = 13%.

Hence, we have $12.11 - $16.98 = -$4.87.

DIF: Medium OBJ: TYPE: Problem TOP: Equilibrium stock price
26. You are considering an investment in the common stock of Cowher Corp. The stock is expected
to pay a dividend of $2 per share at the end of the year (i.e., 1 = $2.0 ). The stock has a beta equal
to 1.2. The risk-free rate is 6 percent. The market risk premium is 5 percent. The stock's dividend
is expected to grow at some constant rage, g. The stock currently sells for $40 a share. Assuming
the market is in equilibrium, what does the market believe the stock price will be at the end of
three years? (In other words, what is P3?)
a. $40.00
b. $42.35
c. $45.67
d. $46.31
e. $49.00
 Chapter 7  Stocks-Characteristics and Valuation 138

ANS: E
Step 1 Calculate ks:

ks = kRF + (RPM)
= 6% + (5%)1.2
= 12%.

Step 2 Calculate g:

7% = g

Step 3 Calculate :

= (1 + g)3
= $40(1.07)3
= $49.00
DIF: Medium OBJ: TYPE: Problem TOP: Future stock price
27. A firm expects to pay dividends at the end of each of the next four years of $2.00, $1.50, $2.50,
and $3.50. If growth is then expected to level off at 8 percent, and if you require a 14 percent rate
of return, how much should you be willing to pay for this stock?
a. $67.81
b. $22.49
c. $58.15
d. $31.00
e. $43.97
ANS: E
139 Chapter 7  Stocks-Characteristics and Valuation

Numerical solution:
P4 = ($3.50)(1.08) / (0.06) = $63.00
= $2.00 / (1.14) + $1.50 / (1.14) 2 + $2.50 / (1.14)3 + $3.50 / (1.14)4
+ $63.00 / (1.14)4
= $1.754 + $1.154 + $1.687 + $39.373 = $43.97.
Tabular solution:
= $2.00 (PVIF14%,1) + $1.50 (PVIF14%,2) + $2.50 (PVIF14%,3) + $66.50 (PVIF14%,4)
= $2.00(0.8772) + $1.50(0.7695) + $2.50(0.6750) + $66.50(0.5921)
= $43.97.
Financial calculator solution:
Inputs: = 0; = 2.00; = 1.50; = 2.50; = 66.50; I = 14.
Output: NPV = $43.969  $43.97. = $43.97.
DIF: Medium OBJ: TYPE: Problem TOP: Nonconstant growth stock
28. Eastern Auto Parts' last dividend was D0 = $0.50, and the company expects to experience no
growth for the next 2 years. However, Eastern will grow at an annual rate of 5 percent in the third
and fourth years, and, beginning with the fifth year, it should attain a 10 percent growth rate
which it should sustain thereafter. Eastern has a required rate of return of 12 percent. What should
be the present price per share of Eastern common stock?
a. $19.26
b. $31.87
c. $30.30
d. $20.83
e. $19.95
ANS: D
 Chapter 7  Stocks-Characteristics and Valuation 140

Tabular solution:

= $0.50(PVIFA12%,2) + $0.525(PVIF12%,3) + $0.5513(PVIF12%,4) + $30.32(PVIF12%,4)

= $0.50(1.6901) + $0.53(0.7718) + $0.55(0.6355) + $30.30(0.6355)
= $0.845 + $0.377 + $0.35 + $19.256 = $20.83.
Financial calculator solution:
Inputs: = 0; = 0.50; = 0.50; = 0.525; = 30.851; I = 12.
Output: NPV = $20.825  $20.83. = $20.83.
DIF: Medium OBJ: TYPE: Problem TOP: Nonconstant growth stock
29. The Satellite Building Company has fallen on hard times. Its management expects to pay no
dividends for the next 2 years. However, the dividend for Year 3, D3, will be $1.00 per share, and
the dividend is expected to grow at a rate of 3 percent in Year 4, 6 percent in Year 5, and 10
percent in Year 6 and thereafter. If the required return for Satellite is 20 percent, what is the
current equilibrium price of the stock?
a. $0
b. $5.26
c. $6.34
d. $12.00
e. $13.09
ANS: C
141 Chapter 7  Stocks-Characteristics and Valuation

Financial calculator solution

Inputs: = 0; = 0; Nj = 2; = 1.0; = 1.03; = 13.102.
Output: NPV = $6.34. = $6.34.
DIF: Medium OBJ: TYPE: Problem TOP: Nonconstant growth stock
30. A share of stock has a dividend of D0 = $5. The dividend is expected to grow at a 20 percent
annual rate for the next 10 years, then at a 15 percent rate for 10 more years, and then at a long-
run normal growth rate of 10 percent forever. If investors require a 10 percent return on this
stock, what is its current price?
a. $100.00
b. $82.35
c. $195.50
d. $212.62
e. The data given in the problem are internally inconsistent, i.e., the situation described is
impossible in that no equilibrium price can be produced.
ANS: E
The data in the problem are unrealistic and inconsistent with the requirements of the growth
model; k less than g implies a negative stock price. If k equals g, the denominator is zero, and the
numerical result is undefined. k must be greater than g for a reasonable application of the model.
DIF: Medium OBJ: TYPE: Problem TOP: Supernormal growth stock
31. You are considering the purchase of a common stock that just paid a dividend of $2.00. You
expect this stock to have a growth rate of 30 percent for the next 3 years, then to have a long-run
normal growth rate of 10 percent thereafter. If you require a 15 percent rate of return, how much
should you be willing to pay for this stock?
a. $71.26
b. $97.50
c. $82.46
d. $79.15
e. $62.68
ANS: A
 Chapter 7  Stocks-Characteristics and Valuation 142

Financial calculator solution

Inputs: = 0; = 2.60; = 3.38; = 101.054; I = 15.
Output: NPV = $71.26. = $71.26.
DIF: Medium OBJ: TYPE: Problem TOP: Supernormal growth stock
32. DAA's stock is selling for $15 per share. The firm's income, assets, and stock price have been
growing at an annual 15 percent rate and are expected to continue to grow at this rate for 3 more
years. No dividends have been declared as yet, but the firm intends to declare a dividend of D 3 =
$2.00 at the end of the last year of its supernormal growth. After that, dividends are expected to
grow at the firm's normal growth rate of 6 percent. The firm's required rate of return is 18 percent.
The stock is
a. Undervalued by $3.03.
b. Overvalued by $3.03.
c. Correctly valued.
d. Overvalued by $2.25.
e. Undervalued by $2.25.
ANS: B
143 Chapter 7  Stocks-Characteristics and Valuation

Financial calculator solution

Calculate current expected price of stock,

Inputs: = 0; = 0; Nj = 2; = 19.67; I = 18.

Output: NPV = $11.97. = $11.97.
Therefore, it is overvalued by $15.00 - $11.97 = $3.03.
DIF: Medium OBJ: TYPE: Problem TOP: Supernormal growth stock
33. Berg Inc. has just paid a dividend of $2.00. Its stock is now selling for $48 per share. The firm is
half as risky as the market. The expected return on the market is 14 percent, and the yield on U.S.
Treasury bonds is 11 percent. If the market is in equilibrium, what rate of growth is expected?
a. 13%
b. 10%
c. 4%
d. 8%
e. -2%
ANS: D
Numerical solution:
Required rate of return: ks = 11% + (14% - 11%) 0.5 = 12.5%.
Calculate growth rate using ks:

$6 - $48g = $2 + $2g (Multiply both sides by (0.125 - g)

$50g = $4
g = 0.08 = 8%.
Required return equals total yield (Dividend yield + Capital gains yield).
Dividend yield = $2.16/$48.00 = 4.5%; Capital gains yields = g = 8%.
DIF: Medium OBJ: TYPE: Problem TOP: Stock growth rate
 Chapter 7  Stocks-Characteristics and Valuation 144

34. You have a chance to purchase a perpetual security that has a stated annual payment (cash flow)
of $50. However, this is an unusual security in that the payment will increase at an annual rate of
5 percent per year; this increase is designed to help you keep up with inflation. The next payment
to be received (your first payment, due in 1 year) will be $52.50. If your required rate of return is
15 percent, how much should you be willing to pay for this security?
a. $350
b. $482
c. $525
d. $556
e. $610
ANS: C
This is the same as a constant growth stock (g = 5%) and can be evaluated using the Gordon
constant growth model:

DIF: Medium OBJ: TYPE: Problem TOP: Value of a "growing perpetuity"

35. Suppose you are willing to pay $30 today for a share of stock which you expect to sell at the end
of one year for $32. If you require an annual rate of return of 12 percent, what must be the
amount of the annual dividend which you expect to receive at the end of Year 1?
a. $2.25
b. $1.00
c. $1.60
d. $3.00
e. $1.95
ANS: C
Total yield = 12%.
Capital gains yield = ($32 - $30)/$30 = 6.67%.
Dividend yield = 12.0% - 6.67% = 5.33%.
Expected dividend = P0(Dividend yield) = $30(0.0533) = $1.60.
DIF: Medium OBJ: TYPE: Problem TOP: Dividend yield
36. Carlson Products, a constant growth company, has a current market (and equilibrium) stock price
of $20.00. Carlson's next dividend, D1, is forecasted to be $2.00, and Carlson is growing at an
annual rate of 6 percent. Carlson has a beta coefficient of 1.2, and a required rate of return on the
market is 15 percent. As Carlson's financial manager, you have access to insider information
concerning a switch in product lines which would not change the growth rate, but would cut
Carlson's beta which would not change the growth rate, but would cut Carlson's beta coefficient
in half. If you buy the stock at the current market price, what is your expected percentage capital
gain?
a. 23%
b. 33%
c. 43%
d. 53%
e. There would be a capital loss.
ANS: C
Step 1 Calculate ks, the required rate of return
145 Chapter 7  Stocks-Characteristics and Valuation

Step 2 Calculate kRF, the risk-free rate

16% = kRF + (15% - kRF)1.2
16% = kRF – 1.2kRF + 18%
0.2kRF = 2%
kRF = 10%

Step 3 Calculate the new stock price and capital gain

New ks = 10% + (15% - 10%)0.6 = 13%.

Therefore, the percentage capital gain is 43%

DIF: Medium OBJ: TYPE: Problem TOP: Capital gains

37. Given the following information, calculate the expected capital gains yield for Chicago Bears
Inc.: beta = 0.6; kM = 15%; kRF = 8%; = $2.00; P0 = $25.00. Assume the stock is in equilibrium
and exhibits constant growth.
a. 3.8%
b. 0%
c. 8.0%
d. 4.2%
e. None of the above.
ANS: D
Required rate of return, ks = 8% + (15% - 8%)0.6 = 12.2%.
Calculate dividend yield and use to calculate capital gains yield:

Capital gains yield = Total yield – Dividend yield = 12.2% - 8% = 4.2%.

Alternative method:

$3.05 - $25g = $2 (Multiply both sides by (0.122 - g))

$25g = $1.05
g = 0.042 = 4.2%
Since the stock is growing at a constant rate, g = Capital gains yield.
DIF: Medium OBJ: TYPE: Problem TOP: Capital gains yield
 Chapter 7  Stocks-Characteristics and Valuation 146

38. Over the past few years, Swanson Company has retained, on the average, 70 percent of its
earnings in the business. The future retention rate is expected to remain at 70 percent of earnings,
and long-run earnings growth is expected to be 10 percent. If the risk-free rate, kRF, is 8 percent,
the expected return on the market, kM, is 12 percent, Swanson's beta is 2.0, and the most recent
dividend, D0, was $1.50, what is the most likely market price and P/E ratio (P0/E1) for Swanson's
stock today?
a. $27.50; 5.0x
b. $33.00; 6.0x
c. $25.00; 5.0x
d. $22.50; 4.5x
e. $45.00; 4.5x
ANS: A
Step 1 Calculate the required rate of return

ks = 8% + 2.0(12% - 8%) = 16%

Step 2 Calculate the current market price

Calculate the earnings and P/E ratio

Step
3

= $1.50(1.10) = $1.65 = 0.30E1.

E1 = $1.65/0.30 = $5.50.

DIF: Medium OBJ: TYPE: Problem TOP: Stock price and P/E/ ratios
39. Yesterday BrandMart Supplies paid its common stockholders a dividend equal to $3 per share.
BrandMart expects to pay a $5 per share one year from today. After the $5 dividend is paid, the
company expects its growth rate will remain constant at 4 percent per year forever. If
BrandMart's investors demand a 12 percent rate of return, what should be the current market
price of the company's stock?
a. $62.50
b. $65.00
c. $62.27
d. $37.50
e. None of the above is correct.
ANS: A DIF: Medium OBJ: TYPE: Problem TOP: Stock valuation
147 Chapter 7  Stocks-Characteristics and Valuation

40. Philadelphia Corporation's stock recently paid a dividend of $2.00 per share (D0 = $2), and the
stock is in equilibrium. The company has a constant growth rate of 5 percent and a beta equal to
1.5. The required rate of return on the market is 15 percent, and the risk-free rate is 7 percent.
Philadelphia is considering a change in policy which will increase its beta coefficient to 1.75. If
market conditions remain unchanged, what new constant growth rate will cause the common
stock price of Philadelphia to remain unchanged?
a. 8.85%
b. 18.53%
c. 6.77%
d. 5.88%
e. 13.52%
ANS: C
Calculate the initial required return and equilibrium price
ks = 0.07 + (0.08)1.5 = 0.19 = 19%.

Calculate the new required return and equilibrium growth rate

New ks = 0.07 + (0.08)1.75 = 0.21.

3.15 – 2.0 = 2g + 15g (Multiply both sides by 15, combine like terms.)
1.15 = 17g
g = 0.06765  6.77%
DIF: Tough OBJ: TYPE: Problem TOP: Constant growth stock
41. Hard Hat Construction's stock is currently selling at an equilibrium price of $30 per share. The
firm has been experiencing a 6 percent annual growth rate. Last year's earnings per share, E 0,
were $4.00, and the dividend payout ratio is 40 percent. The risk-free rate is 8 percent, and the
market risk premium is 5 percent. If systematic risk (beta) increases by 50 percent, and all other
factors remain constant, by how much will the stock price change? (Hint: Use four decimal places
in your calculations.)
a. -$7.33
b. +$7.14
c. -$15.00
d. -$15.22
e. +$22.63
ANS: A
Calculate the required rate of return
D0 = E0(Payout ratio) = $4.00(0.40) = $1.60.

Calculate beta
11.65% = 8% + (5%)β; β = 0.73.
Calculate the new beta
New = 0.73(1.5) = 1.095.
Calculate the new required rate of return
 Chapter 7  Stocks-Characteristics and Valuation 148

ks = 8% + (5%)1.095 = 13.475%  13.48%.

Calculate the new expected equilibrium stock price

Change in stock price = $30 - $22.67 = $7.33 decrease.

DIF: Tough OBJ: TYPE: Problem TOP: Risk and stock price
42. The Hart Mountain Company has recently discovered a new type of kitty litter which is extremely
absorbent. It is expected that the firm will experience (beginning now) an unusually high growth
rate (20 percent) during the period (3 years) it has exclusive rights to the property where the raw
material used to make this kitty litter is found. However, beginning with the fourth year the firm's
competition will have access to the material, and from that time on the firm will achieve a normal
growth rate of 8 percent annually. During the rapid growth period, the firm's dividend payout
ratio will be relatively low (20 percent) in order to conserve funds for reinvestment. However, the
decrease in growth in the fourth year will be accompanied by an increase in dividend payout to 50
percent. Last year's earnings were E0 = $2.00 per share, and the firm's required return is 10
percent. What should be the current price of the common stock?
a. $66.50
b. $87.96
c. $71.53
d. $61.78
e. $93.50
ANS: C

Financial calculator solution:

Inputs: = 0; = 0.48; = 0.576; = 93.991; I = 10.
Output: NPV = $71.53. = $71.53.
DIF: Tough OBJ: TYPE: Problem TOP: Supernormal growth stock
149 Chapter 7  Stocks-Characteristics and Valuation

43. NYC Company has decided to make a major investment. The investment will require a
substantial early cash outflow, and inflows will be relatively late. As a result, it is expected that
the impact on the firm's earnings for the first 2 years will cause a negative growth of 5 percent
annually. Further, it is anticipated that the firm will then experience 2 years of zero growth, after
which it will begin a positive annual sustainable growth of 6 percent. If the firm's required return
is 10 percent and its last dividend, D0, was $2 per share, what should be the current price per
share?
a. $32.66
b. $47.83
c. $53.64
d. $38.47
e. $42.49
ANS: D

Financial calculator solution:

Inputs: = 0; = 1.90; = 1.805; Nj = 2; = 49.63; I = 10.
Output: NPV = $38.47. = $38.47.
DIF: Tough OBJ: TYPE: Problem TOP: Nonconstant growth stock
44. Club Auto Parts' last dividend, D0, was $0.50, and the company expects to experience no growth
for the next 2 years. However, Club will grow at an annual rate of 5 percent in the third and
fourth years, and, beginning with the fifth year, it should attain a 10 percent growth rate which it
will sustain thereafter. Club has a required rate of return of 12 percent. What should be the price
per share of Club stock at the beginning of the third year, P2?
a. $19.98
b. $25.06
c. $31.21
d. $19.48
e. $27.55
ANS: B
 Chapter 7  Stocks-Characteristics and Valuation 150

Financial calculator solution:

Calculate the PV of the stock's expected cash flows as of time = 2; thus, = 0; = 0.525,
which is D3; = 30.851, which is actually + .

Inputs: = 0; = 0.525; = 30.851; I = 12.

Output: NPV = $25.06. = $25.06.
DIF: Tough OBJ: TYPE: Problem TOP: Nonconstant growth stock
45. Modular Systems Inc. just paid dividend D0, and it is expecting both earnings and dividends to
grow by 0 percent in Year 2, by 5 percent in Year 3, and at a rate of 10 percent in Year 4 and
thereafter. The required return on Modular is 15 percent, and it sells at its equilibrium price, P 0 =
$49.87. What is the expected value of the next dividend, ? (Hint: Draw a time line and then set up
and solve an equation with the unknown, .)
a. It cannot be estimated without more data.
b. $1.35
c. $1.85
d. $2.35
e. $2.85
ANS: E

Numerical solution:
P0 = $49.87.
151 Chapter 7  Stocks-Characteristics and Valuation

$49.87 = 0.8696 = 0.7561 = 0.6904 = 15.1886

$49.87 = 17.5047
= $2.85.
DIF: Tough OBJ: TYPE: Problem TOP: Nonconstant growth stock
46. Laserclok Corporation paid a dividend for 50 years until it experienced financial difficulty three
years ago, at which time the dividend payment was suspended (that is, a dividend has not been
paid during the past three years). The company is now much stronger financially, but Laserclok
does not expect to pay a dividend for the next five years. Beginning six years from today, the
company will pay a dividend equal to $2.10, which is 5 percent greater than the last dividend paid
three years ago. After the dividend payments start again, Laserclok expects the dividend to
continue to be paid and to grow at a constant rate of 5 percent. If the appropriate market rate for
investments similar to Laserclok's stock is 15 percent, at what price should the stock currently be
selling in the financial markets?
a. $21.00
b. $10.44
c. $14.00
d. There is not enough information to answer the question.
e. None of the above.
ANS: B DIF: Tough OBJ: TYPE: Problem
TOP: Nonconstant growth stock

Financial Calculator Section

The following question(s) may require the use of a financial calculator.

47. Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for
1 year, 5 percent the next year, then 6 percent for the following year, and then the growth rate is
expected to be a constant 7 percent thereafter. The required rate of return on equity (k s) is 10
percent. What is the current price of the common stock?
a. $53.45
b. $60.98
c. $64.49
d. $67.47
e. $69.21
ANS: D
 Chapter 7  Stocks-Characteristics and Valuation 152

Enter in calculator = 0, = 2.08, = 2.1840, and = 84.8833.

Then enter I = 10, and press NPV to get NPV = P0 = $67.47.
DIF: Easy OBJ: TYPE: Financial Calculator TOP: Nonconstant growth stock
48. Garcia Inc. has a current dividend of $3.00 per share (D0 = $3.00). Analysts expect that the
dividend will grow at a rate of 25 percent a year for the next three years, and thereafter it will
grow at a constant rate of 10 percent a year. The company's cost of equity capital is estimated to
be 15 percent. What is the current stock price of Garcia Inc.?
a. $75.00
b. $88.55
c. $95.42
d. $103.25
e. $110.00
ANS: C

Step 1 Find the dividend stream to D3:

= $3.00
= ($3.00)(1.25) = $3.7500
= ($3.75)(1.25) = $4.6875
= ($4.6875)(1.25) = $5.8594

Step 2 Find :

Step 3 Find the NPV of the cash flows, the stock's value:
=0
153 Chapter 7  Stocks-Characteristics and Valuation

= 3.7500
= 4.6875
= 134.7654
I = 15
Solve for NPV = $95.42.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Nonconstant growth stock
49. Worldwide Inc., a large conglomerate, has decided to acquire another firm. Analysts are
forecasting a period (2 years) of extraordinary growth (20 percent), followed by another 2 years
of unusual growth (10 percent), and finally a normal (sustainable) growth rate of 6 percent
annually. If the last dividend was D0 = $1.00 per share and the required return is 8 percent, what
should the market price be today?
a. $93.70
b. $72.76
c. $99.66
d. $98.57
e. $68.87
ANS: B

Financial calculator solution:

Inputs: = 0; = 1.20; = 1.44; = 1.584; = 94.092; I = 8.
Output: NPV = $72.764  $72.76. = $72.76.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Supernormal growth stock
50. Assume that the average firm in your company's industry is expected to grow at a constant rate of
5 percent, and its dividend yield is 4 percent. You company is about as risky as the average firm
in the industry, but it has just developed a line of innovative new products which leads you to
expect that its earnings and dividends will grow at a rate of 40 percent. ( = D 0 ((1 + g) = D0
(1.40)) this year and 25 percent the following year, after which growth should match the 5 percent
industry average rate. The last dividend paid (D0) was $2. What is the value per share of your
firm's stock?
a. $42.60
 Chapter 7  Stocks-Characteristics and Valuation 154

b. $82.84
c. $91.88
d. $101.15
e. $110.37
ANS: B

ks = Dividend yield + g = 0.04 + 0.05 = 0.09  9%.

Financial calculator solution:
Inputs: = 0; = 2.80; = 95.375; I = 9.
Output: NPV = $82.84; = $82.84.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Stock valuation
51. Assume that you would like to purchase 100 shares of preferred stock that pays an annual
dividend of $6 per share. However, you have limited resources now, so you cannot afford the
purchase price. In fact, the best that you can do now is to invest your money in a bank account
earning a simple interest rate of 6 percent, but where interest is compounded daily (assume a 365-
day year). Because the preferred stock is riskier, it has a required annual rate of return of 12
percent (assume that this rate will remain constant over the next 5 years). For you to be able to
purchase this stock at the end of 5 years, how much must you deposit in your bank account today,
at t = 0?
a. $2,985.00
b. $4,291.23
c. $3,138.52
d. $3,704.18
e. $4,831.25
ANS: D

Numerical solution:
155 Chapter 7  Stocks-Characteristics and Valuation

Amount needed to buy 100 shares:

$50(100) = $5,000
$5,000 = PV(1 + 0.06/365)5(365)
$5,000 = PV(1.3498)
PV = $3,704.18.
Financial calculator solution:
Convert the simple interest rate to an EAR
Inputs: P/YR = 365; NOM% = 6. Output: EFF% = EAR = 6.183%.
Calculate PV of deposit required today
Inputs: N = 5; I = 6.183; FV = 5,000.
Output: PV = -$3,704.205  -$3,704.21.
Note: The numerical solution is used as the correct answer because of its greater precision. If the
financial calculator derived EAR is expressed to five decimal places it yields a PV = -3,704.18.
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Preferred stock value
52. A financial analyst has been following Fast Start Inc., a new high-growth company. She estimates
that the current risk-free rate is 6.25 percent, the market risk premium is 5 percent, and that Fast
Start's beta is 1.75. The current earnings per share (EPS0) is $2.50. The company has a 40 percent
payout ratio. The analyst estimates that the company's dividend will grow at a rate of 25 percent
this year, 20 percent next year, and 15 percent the following year. After three years the dividend
is expected to grow at a constant rate of 7 percent a year. The company is expected to maintain its
current payout ratio. The analyst believes that the stock is fairly priced. What is the current price
of the stock?
a. $16.51
b. $17.33
c. $18.53
d. $19.25
e. $19.89
ANS: C
a. Use the SML equation to solve for ks.
ks = 0.0625 + (0.05)(1.75) = 0.15 = 15%.

b. Calculate dividend per share, D0:

(EPS0)(Payout ratio) = D0
($2.50)(0.4) = $1.00.

c. Calculate the dividend and price stream (once the stock becomes a constant growth stock):

D0 = $1.00; D1 = $1.00  1.25 = $1.25; D2 = $1.25  1.20 = $1.50; D3 = $1.50  1.15 =

$1.725; D4 = $1.725  1.07 = $1.8458.

d. Put all the cash flows on a cash flow time line:

 Chapter 7  Stocks-Characteristics and Valuation 156

e. Finally, use the cash flow register to calculate PV:

= 0; = 1.25; = 1.50; = 24.797; I = 15%.
Solve for NPV = $18.53.
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Nonconstant growth stock
53. Assume an all equity firm has been growing at a 15 percent annual rate and is expected to
continue to do so for 3 more years. At that time, growth is expected to slow to a constant 4
percent rate. The firm maintains a 30 percent payout ratio, and this year's retained earnings net of
dividends were $1.4 million. The firm's beta is 1.25, the risk-free rate is 8 percent, and the market
risk premium is 4 percent. If the market is in equilibrium, what is the market value of the firm's
common equity (1 million shares outstanding)?
a. $6.41 million
b. $12.96 million
c. $9.18 million
d. $10.56 million
e. $7.32 million
ANS: C

Calculate required rate of return

ks = 8% + 4%(1.25) = 13.0%.
0
Calculate net income, total dividends, and D
Net income = $1.4 million / (1 – payout ratio)
= $1.4 million / 0.7 = $2.0 million
Dividends = $2.0 million  0.3 = $0.6 million
157 Chapter 7  Stocks-Characteristics and Valuation

D0 = $600,000 / 1,000,000 shares = $0.60

Financial calculator solution:
Inputs: = 0; = 0.69; = 0.794; = 11.469; I = 13.
Output: NPV = $9.18; = P0 = $9.18.
Total market value = P0  shares outstanding = $9.18  1,000,000 = $9,180,000.
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Firm valuation