Stocks and Their Valuation Answer Key Part 3

Nonconstant growth stock 74. Answer: b Diff: M McPherson Enterprises is planning to pay a dividend of $2.25 per share at the end of the year (D1 = $2.25). The company is planning to pay the same dividend each of the following 2 years and will then increase the dividend to $3.00 for the subsequent 2 years (D4 and D5). After that time the dividends will grow at a constant rate of 5 percent per year. If the required return on the company’s common stock is 11 percent per year, what is its current stock price? a. $52.50 b. $40.41 c. $37.50 d. $50.00 e. $32.94 Nonconstant growth stock 75. Answer: b Diff: M Hadlock Healthcare expects to pay a $3.00 dividend at the end of the year (D1 = $3.00). The stock’s dividend is expected to grow at a rate of 10 percent a year until three years from now (t = 3). After this time, the stock’s dividend is expected to grow at a constant rate 5 percent a year. The stock’s required rate of return is 11 percent. What is the price of the stock today? of a. $49 b. $54 c. $64 d. $52 e. $89 Nonconstant growth stock 76. Answer: e Diff: M Rogers Robotics currently (2003) does not pay a dividend. However, the company is expected to pay a $1.00 dividend two years from today (2005). The dividend is then expected to grow at a rate of 20 percent a year for the following three years. After the dividend is paid in 2008, it is expected to grow forever at a constant rate of 7 percent. Currently, the risk-free rate is 6 percent, market risk premium (kM – kRF) is 5 percent, and the stock’s beta is 1.4. What should be the price of the stock today? a. $22.91 b. $21.20 c. $30.82 d. $28.80 e. $20.16 Nonconstant growth stock 77. Answer: c Diff: M Whitesell Technology has just paid a dividend (D0) and is expected to pay a $2.00 per-share dividend at the end of the year (D1). The dividend is expected to grow 25 percent a year for the following four years, (D5 = $2.00 × (1.25)4 = $4.8828). After this time period, the dividend will grow forever at a constant rate of 7 percent a year. The stock has a required rate of return of 13 percent (ks = 0.13). What is the expected price of the stock two years from today? (Calculate the price assuming that D2 has already been paid.) a. $83.97 b. $95.87 c. $69.56 d. $67.63 e. $91.96 Nonconstant growth stock 78. a. b. c. d. e. $23.87 $30.56 $18.72 $20.95 $20.65 Nonconstant growth stock 79. Answer: e Diff: M A stock, which currently does not pay a dividend, is expected to pay its first dividend of $1.00 per share in five years (D5 = $1.00). After the dividend is established, it is expected to grow at an annual rate of 25 percent per year for the following three years (D8 = $1.953125) and then grow at a constant rate of 5 percent per year thereafter. Assume that the risk-free rate is 5.5 percent, the market risk premium is 4 percent, and that the stock’s beta is 1.2. What is the expected price of the stock today? Answer: d Diff: M An analyst estimates that Cheyenne Co. will pay the following dividends: D1 = $3.0000, D2 = $3.7500, and D3 = $4.3125. The analyst also estimates that the required rate of return on Cheyenne’s stock is 12.2 percent. After the third dividend, the dividend is expected to grow by 8 percent per year forever. What is the price of the stock today? a. $81.40 b. $84.16 c. $85.27 d. $87.22 e. $94.02 Nonconstant growth stock 80. Answer: a Diff: M Lewisburg Company’s stock is expected to pay a dividend of $1.00 per share at the end of the year. The dividend is expected to grow 20 percent per year each of the following three years (D4 = $1.7280), after which time the dividend is expected to grow at a constant rate of 7 percent per year. The stock’s beta is 1.2, the market risk premium is 4 percent, and the risk-free rate is 5 percent. What is the price of the stock today? a. $49.61 b. $45.56 c. $48.43 d. $46.64 e. $45.45 Nonconstant growth stock 81. Answer: d Diff: M Namath Corporation’s stock is expected to pay a dividend of $1.25 per share at the end of the year. The dividend is expected to increase by 20 percent per year for each of the following two years. After that, the dividend is expected to increase at a constant rate of 8 percent per year. The stock has a required return of 10 percent. What should be the price of the stock today? a. $50.00 b. $59.38 c. $70.11 d. $76.76 e. $84.43 Nonconstant growth stock 82. Answer: b Diff: M N A stock is expected to pay a dividend of $1.00 at the end of the year (i.e., D1 = $1.00). The dividend is expected to grow 25 percent each of the following two years, after which time it is expected to grow at a constant rate of 6 percent a year. The stock’s required return is 11 percent. Assume that the market is in equilibrium. What is the stock’s price today? a. $26.14 b. $27.28 c. $30.48 d. $32.71 e. $35.38 Nonconstant growth stock 83. Answer: c Diff: M 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 Garcia’s current stock price? a. $ 75.00 b. $ 88.55 c. $ 95.42 d. $103.25 e. $110.00 Nonconstant growth stock 84. Answer: a Diff: M Holmgren Hotels’ stock has a required return of 11 percent. The stock currently does not pay a dividend but it expects to begin paying a dividend of $1.00 per share starting five years from today (D5 = $1.00). Once established the dividend is expected to grow by 25 percent per year for two years, after which time it is expected to grow at a constant rate of 10 percent per year. What should be Holmgren’s stock price today? a. $ 84.80 b. $174.34 c. $ 76.60 d. $ 94.13 e. $ 77.27 Nonconstant growth stock 85. Answer: a Diff: M N A stock just paid a $1.00 dividend (D0 = 1.00). The dividend is expected to grow 25 percent a year for the next four years, after which time the dividend is expected to grow at a constant rate of 5 percent a year. The stock’s required return is 12 percent. What is the price of the stock today? a. $28.58 b. $26.06 c. $32.01 d. $ 9.62 e. $27.47 Supernormal growth stock 86. Answer: e Diff: M 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, that is, the situation described is impossible in that no equilibrium price can be produced. Supernormal growth stock 87. Answer: b Diff: M ABC Company has been growing at a 10 percent rate, and it just paid a dividend of D0 = $3.00. Due to a new product, ABC expects to achieve a dramatic increase in its short-run growth rate, to 20 percent annually for the next 2 years. After this time, growth is expected to return to the long-run constant rate of 10 percent. The company’s beta is 2.0, the required return on an average stock is 11 percent, and the risk-free rate is 7 percent. What should be the dividend yield (D1/P0) today? a. 3.93% b. 4.60% c. 10.00% d. 7.54% e. 2.33% Supernormal growth stock 88. Answer: b Diff: M 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 D3 = $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. Supernormal growth stock 89. Answer: b Diff: M Faulkner Corporation expects to pay an end-of-year dividend, D1, of $1.50 per share. For the next two years the dividend is expected to grow by 25 percent per year, after which time the dividend is expected to grow at a constant rate of 7 percent per year. The stock has a required rate of return of 12 percent. Assuming that the stock is fairly valued, what is the price of the stock today? a. $45.03 b. $40.20 c. $37.97 d. $36.38 e. $45.03 Supernormal growth stock 90. Answer: b Diff: M 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. Your 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 (D1 = 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 stock’s value per share? a. $ 42.60 b. $ 82.84 c. $ 91.88 d. $101.15 e. $110.37 Declining growth stock 91. Answer: d Diff: M The Textbook Production Company has been hit hard due to increased competition. The company’s analysts predict that earnings (and dividends) will decline at a rate of 5 percent annually forever. Assume that ks = 11 percent and D0 = $2.00. What will be the price of the company’s stock three years from now? a. $27.17 b. $ 6.23 c. $28.50 d. $10.18 e. $20.63 Stock growth rate 92. Answer: d Diff: M 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 growth rate is expected? a. 13% b. 10% c. 4% d. 8% e. -2% Stock growth rate 93. Answer: e Diff: M Grant Corporation’s stock is selling for $40 in the market. The company’s beta is 0.8, the market risk premium is 6 percent, and the risk-free rate is 9 percent. The previous dividend was $2 (D0 = $2) and dividends are expected to grow at a constant rate. What is the stock’s growth rate? a. 5.52% b. 5.00% c. 13.80% d. 8.80% e. 8.38% Capital gains yield 94. Answer: c Diff: M 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 the 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 that 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. Capital gains yield 95. Answer: d Diff: M Given the following information, calculate the expected capital gains yield for Chicago Bears Inc.: beta = 0.6; kM = 15%; kRF = 8%; D1 = $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. 2.5% Capital gains yield and dividend yield 96. Answer: e Diff: M Conner Corporation has a stock price of $32.35 per share. The last dividend was $3.42 (D0 = $3.42). The long-run growth rate for the company is a constant 7 percent. What is the company’s capital gains yield and dividend yield? a. Capital gains yield = 7.00%; Dividend yield = 10.57% b. Capital gains yield = 10.57%; Dividend yield = 7.00% c. Capital gains yield = 7.00%; Dividend yield = 4.31% d. Capital gains yield = 11.31%; Dividend yield = 7.00% e. Capital gains yield = 7.00%; Dividend yield = 11.31% Expected return and P/E ratio 97. Answer: b Diff: M Lamonica Motors just reported earnings per share of $2.00. The stock has a price earnings ratio of 40, so the stock’s current price is $80 per share. Analysts expect that one year from now the company will have an EPS of $2.40, and it will pay its first dividend of $1.00 per share. The stock has a required return of 10 percent. What price earnings ratio must the stock have one year from now so that investors realize their expected return? a. 44.00 b. 36.25 c. 4.17 d. 40.00 e. 36.67 Stock price and P/E ratio 98. Answer: a Diff: M During 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; 5.0× b. $33.00; 6.0× c. $25.00; 5.0× d. $22.50; 4.5× e. $45.00; 4.5× Stock price 99. Answer: d Diff: M You have been given the following projections for Cali Corporation for the coming year. • • • • • • • • • • • • • Sales = 10,000 units. Sales price per unit = $10. Variable cost per unit = $5. Fixed costs = $10,000. Bonds outstanding = $15,000. kd on outstanding bonds = 8%. Tax rate = 40%. Shares of common stock outstanding = 10,000 shares. Beta = 1.4. kRF = 5%. kM = 9%. Dividend payout ratio = 60%. Growth rate = 8%. Calculate the current price per share for Cali Corporation. a. $35.22 b. $46.27 c. $48.55 d. $53.72 e. $59.76 Beta coefficient Answer: c Diff: M 100. As financial manager of Material Supplies Inc., you have recently participated in an executive committee decision to enter into the plastics business. Much to your surprise, the price of the firm’s common stock subsequently declined from $40 per share to $30 per share. While there have been several changes in financial markets during this period, you are anxious to determine how the market perceives the relevant risk of your firm. Assume that the market is in equilibrium. From the following data you find that the beta value associated with your firm has changed from an old beta of to a new beta of . • The real risk-free rate is 2 percent, but the inflation premium has increased from 4 percent to 6 percent. • The expected growth rate has been re-evaluated by security analysts, and a 10.5 percent rate is considered to be more realistic than the previous 5 percent rate. This change had nothing to do with the move into plastics; it would have occurred anyway. • The risk aversion attitude of the market has shifted somewhat, and now the market risk premium is 3 percent instead of 2 percent. • The next dividend, D1, was expected to be $2 per share, assuming the “old” 5 percent growth rate. a. 2.00; 1.50 b. 1.50; 3.00 c. 2.00; 3.17 d. 1.67; 2.00 e. 1.50; 1.67 Risk and stock value Answer: d Diff: M 101. The probability distribution for kM for the coming year is as follows: Probability 0.05 0.30 0.30 0.30 0.05 kM 7% 8 9 10 12 If kRF = 6.05% and Stock X has a beta of 2.0, an expected constant growth rate of 7 percent, and D0 = $2, what market price gives the investor a return consistent with the stock’s risk? a. $25.00 b. $37.50 c. $21.72 d. $42.38 e. $56.94