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FIN350 ICW No. 3-Stock Valuation and Cost of Capital

rs = D1 / P0 (dividend yield) + g (capital gain yield)

rs = rRF + (rM – rRF) β

Firm value=FCF1/(WACC-g) if free cash flows grow at a constant rate

P=D1/(rs-g)=D0*(1+g)/(rs-g)

1. According to the dividend discount model, the current value of a stock is equal to the:

A) present value of all expected future dividends.

B) sum of all future expected dividends.

C) next expected dividend, discounted to the present.

D) discounted value of all dividends growing at a risk-free rate.

E) none of the above

2. The PDQ Company’s common stock is expected to pay a $3.00 dividend in the coming year. If investors require a 10% return and the growth rate in dividends is expected to be -5% (negative 5%), what will the market price of the stock be?

a. $20.00

b. $40.00

c. $30.00

d. $60.00

3. If a firm will produce the following constant growth free cashflows: FCF1=$10m at end of year 1, FCF2=$11m at the end of year 2, and so on with the growth rate g= 10%. If the weighted average cost of capital for the whole firm is 15% and the market value of debt is $20 million and there are 1 million shares of common stock outstanding, how much is the per share stock value?

a. $20.00

b. $30.00

c. $80.00

d. $60.00

e. $180.00

4. The stock of MTY Golf World has a constant dividend growth rate of 6% and just paid a dividend of $5.09. If the required rate of return is 12%, what is the current stock price?

A) $ 92.00

B) $ 89.92

C) $ 95.40

D) $ 99.80

AAEB

5. The price of a stock will likely increase if:

A) the investment horizon increases.

B) the growth rate of dividends increases.

C) the discount rate increases.

D) dividends are discounted back to the present.

6. If a stock’s P/E ratio is 14 at a time when earnings are $3 per year, what is the stock’s current price?

A) $4.50

B) $18.00

C) $32.22

D) $42.00

E) None of the above

P/E = 14

Then P = 14 x $3

Price = $42

7. How much should you pay for a share of stock now that offers a constant dividend growth rate of 10%, has a discount rate of 16%, and pays a dividend of $3 per share next year ?

A) $42.00

B) $45.00

C) $55.00

D) $50.00

E) none of the above

P0=D1/(r-g)=3/0.06=$50

|8. |The rate at which the stock price is expected to appreciate (or depreciate) is the: |

|A) |Current yield. |

|B) |Yield to maturity. |

|C) |Capital gains yield. |

|D) |Dividend yield. |

|E) |Earnings yield. |

9. 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

E) None of the above

BDDCD

Po = [pic]

10. What would be the current price of a stock when dividends are expected to grow at a 25% rate for three years, then grow at a constant rate of 5%, if the stock’s required return is 13% and next year dividend payment is $5 per share?

A) $61.60

B) $62.08

C) $81.68

D) $85.80

Po =[pic]=$85.80

11. You have discovered from looking at charts of past stock prices that if you buy just after a stock price has increased for five consecutive days, you make money every time! This is clearly a violation of _________ market efficiency. You also find that, based on insider information you obtain from your friend of Guggle CEO, you make money by trading Guggle stocks. This is clearly a violation of _________ market efficiency.

|A) |strong form; semi-strong form |

|B) |semi-weak form; weak form |

|C) |semi-strong form; strong form |

|D) |weak form; strong form |

|E) |weak form; semi-strong form |

12. According to the semi-strong form market efficiency, when you read from a newspaper (such as San Francisco Chronicle) that there is some good news you for a company, you should:

A) buy the stock as the price will rise in the following week

B) sell the stock as the price will drop in the following week

C) be indifferent between buying or selling the stock as the price should have already absorbed the good news.

D) feel guilty for not buying the stock earlier.

DDC

13. You purchase a stock expecting the price to rise 10% in the coming year. After one year, the stock has actually increased in value by 30%, due primarily to new information released during the year concerning unexpectedly higher sales. Which of the following describes this result?

A) This is a violation of weak form efficiency.

B) This is a violation of semi-strong form efficiency.

C) This is a violation of strong form efficiency.

D) This is not a violation of market efficiency.

14. You have discovered from looking at charts of past stock prices that if you buy just after a stock price has declined for three consecutive days, you make money every time! This is clearly a violation of _________ market efficiency.

A) weak form

B) semi-strong form

C) strong form

D) semi-weak form

15. You track the liquidity of companies and find that you can consistently earn unusually high returns by purchasing the shares of firms whose stock price falls below the book value of equity per share as indicated on the balance sheet. Which of the following describes this strategy?

A) This would not be a violation of market efficiency.

B) This would be a violation of weak form efficiency.

C) This would be a violation of semi-strong form efficiency.

16. Microsft, which is already a public company, plans to issue some additional new shares of its stock to the public to raise some fund to develop Windows 9. This transaction is a:

a) secondary market transaction

b) IPO (initial public offering).

c) Seasoned equity offering

DACC

17 One year ago, Ryan purchased one share of MP stock for $18.6. Today, Ryan sold these shares for $29.18 a share shortly before receiving a dividend of $1.86. No dividend is paid. What is Ryan’s capital gains yield on this investment?

a. 56.88 percent

b. 42.22 percent

c. 47.78 percent

d. 36.26 percent

e. 60.48 percent

18. One year ago, Ryan purchased one share of MP stock for $18.6. Today, Ryan sold these shares for $29.18 a share shortly before receiving a dividend of $1.86. No dividend is paid. What is Ryan’s dividend yield on this investment?

a. 56.88 percent

b. 12.22 percent

c. 47.78 percent

d. 36.26 percent

e. 10.00 percent

19. IBM did not issue new shares recently. Yesteday Joe bought 100 shares of IBM stock via his brokerage firm Charles Schwab. This transaction is a:

a) first market transaction

b) secondary market transaction

c) third market transaction

d) IPO market transaction.

Key: AEB What is SEO?

20. From the information in the graph below, what is the closing price of stock GSK on Dec 13, 2006?

[pic]

A) $45.79

B) $44.82

C) $45.29

D) $17.25

E) $130.78

21. (Same graph). If the stock market is efficient in the weak form, we should expect the price of GSK on the next trading day (Dec 14 2006) to:

a) appreciate by another 2.16%

b) decline by 2.16%

c) appreciate by 3.26%

d) decline by 3.26%

e) be most likely around $45.79.

22. If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the investor thinks

a. the stock is experiencing supernormal growth.

b. the stock should be sold.

c. the stock is a good buy.

d. management is probably not trying to maximize the price per share.

Expected return> requited return

23. If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium.

a. The expected return on the stock is 5% a year.

b. The stock’s price one year from now is expected to be 5% above the current price.

c. The price of the stock is expected to decline in the future.

If dividends grow at a constant rate, g= expected capital gain yield (that is, the percentage growth rate of stock price)

24. If you decide to buy 100 shares of Google, you would probably do so by calling your broker and asking him or her to execute the trade for you. This would be defined as a secondary market transaction, not a primary market transaction.

a. True

b. False

AECBA

|25. |A company has preferred stock outstanding which pays a dividend of $8 per share a year. The current price of the preferred stock|

| |is $75 per share. The yield to maturity on firms’ long term bond is 4.5%. What is the cost of preferred stock? |

|A) |6% |

|B) |7.5% |

|C) |10.67% |

|D) |8.5% |

|E) |8% |

|26. |A company has preferred stock outstanding which pays a dividend of $8 per share a year. The current price of the preferred stock|

| |is $75 per share. The yield to maturity on firms’ long term bond is 4.5%. What is the (pre-tax) cost of debt? |

|A) |6% |

|B) |7.5% |

|C) |10.67% |

|D) |4.5% |

|E) |8% |

27. For a multi-product firm, if a new project's beta is different from that of the overall firm, then the

A) project should be discounted at a rate commensurate with its risk level (which could be based on its beta)

B) project should be discounted using the overall firm's PE ratio.

C) project should be discounted at the Treasury-bill rate.

D) project should be discounted at 7.5%.

28.The market value of equity is $500 million. The market value of debt is $400 million. The total market value of the firm is $900 million. The cost of equity is 15%, the cost of debt is 10%, and the tax rate is 35%. What is the firm’s WACC?

A) 9.09%

B) 11.22%

C) 13.78%

D) 14.17%

29. If a firm uses the same company cost of capital for evaluating all projects with very different risks, which of the following is likely?

A. Rejecting good low risk projects

B. Accepting poor high risk projects

C. Both A and B

D. Neither A nor B

CDABC

30. Why are we interested in WACC in this course?

(a) WACC is an interesting name

(b) WACC is related to the amount of future cash flows of a project.

(c) WACC is the approximation of the discount rate used in capital budgeting

(d) WACC stands for “without Any Countable Cash”. That is an emergency issue for firm managers.

|31. |A common stock issue is currently selling for $100 per share. You expect the next dividend to be $3 per share. If the firm has a|

| |dividend growth rate of 10% that is expected to remain constant indefinitely, what is the firm's cost of equity? |

|A) |5% |

|B) |10% |

|C) |13% |

|D) |20% |

|E) |30% |

32.Which of the following may affect a firm’s cost of capital?

A) Interest rates

B) Tax rates.

C) The firm’s capital structure and dividend policy.

D) All above

33. Using the company cost of capital to evaluate a project is:

A. Always correct

B. Always incorrect

C. Correct for projects that are about as risky as the average of the firm's other assets.

34. The (pretax) cost of debt for a firm ____.

A) is always greater than the cost of equity

B) normally cannot be observed, directly or indirectly, in the marketplace

C) is equal to the yield to maturity on the firm's outstanding bonds

D) is greater than the average coupon rate on the firm's outstanding bonds

E) is equal to the average coupon rate on the firm's outstanding bonds

CCDCC

35. The cost of debt is equal to one minus the tax rate multiplied by the interest rate on new debt.

a. True

b. False

Rd*(1-T), Rd=YTM or interest rate, not coupon rate; coupon rate could be any arbitrary number. YTM (interest rate) is related to the bond’s risk.

36. The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not tax-deductible by the issuing firm.

a. True

b. False

37. Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

a. A Division B project with a 13% return.

b. A Division B project with a 12% return.

c. A Division A project with an 11% return.

d. A Division A project with a 9% return.

For (c), expected return=11%, > required return=10% (division A’s required return)

38. If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

a. become riskier over time, but its intrinsic value will be maximized.

b. become less risky over time, and this will maximize its intrinsic value.

c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.

If you use same WACC to evaluate all projects with different risk, likely you will favor risky projects; thus making firm become more risky over time.

“have an increasing WACC” because you may accept too many risky projects, making the firm become more and more risky over time.

Its intrinsic value (firm value) will not be maximized because manager’s decision may be wrong.

The correct approach is to use higher cost of capital (discount rates) for projects with higher risk and lower cost of capital (discount rates) for projects with lower risk.

AACC

39. Daves Inc. recently hired you as a consultant to estimate the company’s WACC. (1) The firm's bonds have a YTM of 7.51%. (2) The company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The firm consists of 35% debt and the balance is common equity. What is its WACC?

a. 7.16%

b. 7.54%

c. 7.93%

d. 8.35%

e. 8.79%

rd=YTM =7.51% rs=rRf+(rm-rRf)*beta=4.5+5.5*1.2=11.1%

WACC=Wd*rd*(1-T)+Wc*rs=0.35*7.51*(1-0.40)+0.65*11.1=8.79%

Key: E

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