10.1 Common Stock
1) The XYZ Company, whose common stock is currently selling for $40 per share, is expected to pay a $2.00 dividend in the coming year. If investors believe that the expected rate of return on XYZ is 14%, what growth rate in dividends must be expected?
2) The expected rate of return on a share of common stock whose dividends are growing at a constant rate (g) is which of the following?
A) (D1 + g)/Vc
B) D1/Vc + g
3) Green Company's common stock is currently selling at $24.00 per share. The company recently paid dividends of $1.92 per share and projects growth at a rate of 4%. At this rate, what is the stock's expected rate of return?
4) Common stockholders are essentially
A) creditors of the firm.
B) managers of the firm.
C) owners of the firm.
D) all of the above.
5) Butler, Inc.'s return on equity is 17% and management retains 75% of earnings for investment purposes. Based on this information, what will be the firm's growth rate?
6) If a company has a return on equity of 25% and wants a growth rate of 10%, how much of ROE should be retained?
7) ________ gives minority shareholders more power to elect board of directors.
A) Preemptive right
B) Majority voting
C) Proxy fights
D) Cumulative voting
8) You are evaluating the purchase of Cellars, Inc. common stock that just paid a dividend of $1.80. You expect the dividend to grow at a rate of 12% for the next three years. You plan to hold the stock for three years and then sell it. You estimate that a required rate of return of 17.5% will be adequate compensation for this investment. Calculate the present value of the expected dividends.
9) You are evaluating the purchase of Charbridge, Inc. common stock which currently pays no dividend and is not expected to do so for many years. Because of rapidly growing sales and profits, you believe the stock will be worth $51.50 in 3 years. If your required rate of return is 16%, what is the stock worth today?
D) $0.00 because stocks that do not pay dividends have no value.
10) CEOs naming friends to the board of directors and paying them more than the norm is an example of the
A) agency problem.
B) preemptive right.
C) majority voting feature.
D) proxy fights.
11) Little Feet Shoe Co. just paid a dividend of $1.65 on its common stock. This company's dividends are expected to grow at a constant rate of 3% indefinitely. If the required rate of return on this stock is 11%, compute the current value of per share of LFS stock.
12) Marshall Manufacturing has common stock which paid a dividend of $1.00 a share last year. You expect the stock to grow at 5% per year. If the appropriate rate of return on this stock is 12%, how much are you willing to pay for the stock today?
13) Marble Corporation's ROE is 17%. Their dividend payout ratio is 20%. The last dividend, just paid, was $2.58. If dividends are expected to grow by the company's sustainable growth rate indefinitely, what is the current value of Marble common stock if its required return is 18%?
14) Fris B. Corporation stock is currently selling for $42.86. It is expected to pay a dividend of $3.00 at the end of the year. Dividends are expected to grow at a constant rate of 3% indefinitely. Compute the required rate of return on FBC stock.
15) You are evaluating the purchase of Cool Toys, Inc. common stock that just paid a dividend of $1.80. You expect the dividend to grow at a rate of 12%, indefinitely. You estimate that a required rate of return of 17.5% will be adequate compensation for this investment. Assuming that your analysis is correct, what is the most that you would be willing to pay for the common stock if you were to purchase it today? Round to the nearest $.01.
16) A stock currently sells for $63 per share, and the required return on the stock is 10%. Assuming a growth rate of 5%, calculate the stock's last dividend paid.
17) A decrease in the ________ will cause an increase in common stock value.
A) growth rate
B) required rate of return
C) last paid dividend
D) both B and C
18) Acme Consolidated has a return on equity of 12%. If Acme distributes 60% of earnings as dividends, its expected growth rate will be
A) new 4.80%.
19) An investor is contemplating the purchase of common stock at the beginning of this year and to hold the stock for one year. The investor expects the year-end dividend to be $2.00 and expects a year-end price for the stock of $40. If this investor's required rate of return is 10%, then the value of the stock to this investor is
20) A firm just paid $2.00 on its common stock and expects to continue paying dividends, which are expected to grow 5% each year, from now to infinity. If the required rate of return for this stock is 9%, then the value of the stock is
21) An issue of common stock currently sells for $40.00 per share, has an expected dividend to be paid at the end of the year of $2.00 per share, and has an expected growth rate to infinity of 5% per year. The expected rate of return on this security is
22) Common shareholders have a claim on the company's assets
A) at any time, equal to the value of their shares.
B) only after the claims of debtholders and preferred shareholders have been satisfied.
C) after the claims of the preferred shareholders have been satisfied, but before the debt holders.
D) never. Common shareholders have no claim on the company's assets.
23) KDP's most recent dividend was $2.00 per share and is selling today in the market for $70. The dividend is expected to grow at a rate of 7% per year for the foreseeable future. If the market return is 10% on investments with comparable risk, should you purchase the stock?
A) No, because the stock is overpriced $1.33.
B) No, because the stock is overpriced $3.33.
C) Yes, because the stock is underpriced $1.33.
D) Yes, because the stock is underpriced $3.33.
24) An issue of common stock currently sells for $50.00 per share, has an expected dividend to be paid at the end of the year of $2.50 per share, and has an expected growth rate to infinity of 5% per year. If investors' required rate of return for this particular security is 12% per year, then this security is
A) overvalued and offering an expected return higher than the required return.
B) undervalued and offering an expected return higher than the required return.
C) overvalued and offering an expected return lower than the required return.
D) undervalued and offering an expected return lower than the required return.
25) You are considering the purchase of Miller Manufacturing, Inc.'s common stock. The stock is selling for $21.00 per share. The next dividend is expected to be $2.10, and you expect the dividend to keep growing at a constant rate. If the stock is returning 15%, calculate the growth rate of dividends.
26) ABC, Inc. just paid a dividend of $2. ABC expects dividends to grow at 10%. The return on stocks like ABC, Inc. is typically around 12%. What is the most you would pay for a share of ABC stock?
27) Marjen, Inc. just paid a dividend of $5. Marjen stock currently sells for $73.57. The return on stocks like Marjen, Inc. is around 10%. What is the implied growth rate of dividends.
28) Which investor incurs the greatest risk?
A) Mortgage bondholder
B) Preferred stockholder
C) Common stockholder
D) Debenture bondholder
29) What allows common stockholders the right to cast a number of votes equal to the number of directors being elected?
A) The majority voting provision
B) The casting feature
C) The cumulative voting provision
D) The proxy method
30) The shareholder can cast all votes for a single candidate or split them among various candidates through
A) proxy fights.
B) cumulative voting.
C) call provisions.
D) majority voting.
31) You are considering the purchase of common stock that just paid a dividend of $6.50 per share. Security analysts agree with top management in projecting steady growth of 12% in dividends and earnings over the foreseeable future. Your required rate of return for stocks of this type is 18%. How much should you expect to pay for this stock?
32) You are considering the purchase of Wahoo, Inc. The firm just paid a dividend of $4.20 per share. The stock is selling for $115 per share. Security analysts agree with top management in projecting steady growth of 12% in dividends and earnings over the foreseeable future. Your required rate of return for stocks of this type is 17.5%. If you were to purchase and hold the stock for three years, what would the expected dividends be worth today?
33) A share of common stock just paid a dividend of $3.25 per share. The expected long-run growth rate for this stock is 18%. If investors require a rate of return of 24%, what should the price of the stock be?
34) Common stockholders expect greater returns than bondholders because
A) they have no legal right to receive dividends.
B) they bear greater risk.
C) in the event of liquidation, they are only entitled to receive any cash that is left after all creditors are paid.
D) all of the above.
35) WSU Inc. is a young company that does not yet pay a dividend. You believe that the company will begin to pay dividends 5 years from now, and that the company will then be worth $50 per share. If your required rate of return on this risky stock is 20%, what is the stock worth today?
36) Common stockholders are essentially creditors of the firm.
37) Common stock represents a claim on residual income.
38) The growth rate of future earnings is determined by return on equity and the profit-retention rate.
39) The stockholder's expected rate of return consists of a dividend yield and interest.
40) When bankruptcy occurs, the claims of the common shareholders may go unsatisfied.
41) Cumulative voting gives each share of stock a number of votes equal to the number of directors being elected to the board.
42) The expected rate of return implied by a given market price equals the required rate of return for investors at the margin.
43) Stock valuation is more precise than bond valuation as stock cash flows are more certain.
44) The stock valuation model D1/(Rc - g) requires Rc > G.
45) Is the following common stock priced correctly? If no, what is the correct price?
Price = $26.25
Required rate of return = 13%
Dividend year 0 = $2.00
Dividend year 1 = $2.10
Growth rate = = 5%
Vcs = 2.10 /(.13 - .05)= $26.25
The stock is priced correctly.
46) The common stock of Cranberry, Inc. is selling for $26.75 on the open market. A dividend of $3.68 is expected to be distributed, and the growth rate of this company is estimated to be 5.5%. If Richard Dean, an average investor, is considering purchasing this stock at the market price, what is his expected rate of return?
R = (D/V) + g
R = ($3.68/$26.75) + .055
R = 19.26%
47) Tannerly Worldwide's common stock is currently selling for $48 a share. If the expected dividend at the end of the year is $2.40 and last year's dividend was $2.00, what is the rate of return implicit in the current stock price?
Rc = 2.40/48 + (2.40 - 2.00)/2.00
= .05 + .20
48) Draper Company's common stock paid a dividend last year of $3.70. You believe that the long-term growth in the dividends of the firm will be 8% per year. If your required return for Draper is 14%, how much are you willing to pay for the stock?
Answer: P0 = = = $66.60
49) Determine the rate of return on a $25 common stock that pays a dividend of $2.50 in year 1 and grows at a rate of 5%.
Answer: Kcs = + 5% = 10% + 5% = 15%
50) You are considering the purchase of AMDEX Company stock. You anticipate that the company will pay dividends of $2.00 per share next year and $2.25 per share the following year. You believe that you can sell the stock for $17.50 per share two years from now. If your required rate of return is 12%, what is the maximum price that you would pay for a share of AMDEX Company stock?
Vc = $2.00 PVIF12%,1 + $19.75 PVIF12%,2
= ($2.00)(.893) + ($19.75)(.797)
51) You can purchase one share of Sumter Company common stock for $80 today. You expect the price of the common stock to increase to $85 per share in one year. The company pays an annual dividend of $3.00 per share. What is your expected rate of return for Sumter stock?
$80.00 = +
$80.00 (1 + R) = $88.00
(1 + R) = = $1.10
R = .10
10.2 The Comparables Approach to Valuing Common Stock
1) If a stock has a much higher than normal P/E ratio, investors probably expect
A) slow growth in earnings.
B) rapid growth in earnings.
C) large increases in the price of the stock.
D) a declining stock price.
2) Which of the following factors will influence a firm's P/E ratio?
A) The investors' required rate of return
B) Firm investment opportunities
C) General market conditions
D) All of the above
3) The P/E ratio is calculated by dividing
A) the current stock price by stockholders' equity.
B) total assets by net income.
C) the current stock price by earnings per share.
D) the current stock price by operating cash flow per share.
4) The GAP's most recent earnings per share were $1.75. Analysts forecast next year's earnings per share at $1.88. If the appropriate P/E ratio is 15, a share of GAP stock should be valued at
5) The retail analyst at Morgan-Sachs values stock of the GAP at $38.00 per share. They are using the average industry "forward" P/E ratio of 17. Their forecasted earnings per share for next year is
D) There is not enough information calculate earnings per share.
6) Home Depot stock is currently selling for $75 per share. Next year's dividend is expected to be $1.56; next year's earnings per share are expected to be $4.16. Home Depot's P/E ratio is
7) McDonald's stock currently sells for $103. It's expected earnings per share are $5.50. The average P/E ratio for the industry is 24. If investors expected the same growth rate and risk for McDonald's as for an average firm in the same industry, it's stock price would
A) stay about the same.
D) there is not enough information.
8) If the ROE on a new investment is less than the firm's required rate of return
A) the investment increases the firm's value.
B) the investment leaves the firm's value unchanged.
C) the effect on the firm's value is unpredictable.
D) the investment reduces the firm's value.
9) Zorba's is a small chain of restaurants whose stock is not publicly traded. The average P/E ratio for similar restaurant chains is 16.5; the P/E ratio for the S&P 500 Index is 15.2. This year's earnings were $1.21 per share and next year's earnings are forecasted at $1.46 per share. A reasonable price for a share of Zorba's stock is
10) Apple stock is now selling for $460 per share. The P/E ratio based on current earnings is 10.98 and the P/E ratio based on expected earnings is 10.16. The expected growth rate in Apples earnings must be
11) The P/E ratio is the market price of a share of stock divided by book equity per share.
12) The higher a firm's P/E ratio, the more optimistic investors feel about the firm's growth prospects.
13) P/E ratios found in published sources or on the internet are always computed by dividing the next period's expected earnings into the current price of the stock.
14) The higher the investor's required rate of return, the higher the P/E ratio will be.
15) Walmart's current earnings per share of $5.02 are expected to grow at a rate of 17% per year for the next few years. Using a P/E ratio of 13.46, what is a reasonable value for a share of Walmart Stock.
Answer: A reasonable value for Walmart would be $5.02(1.17)(13.46)=$79.06 per share.
16) RAH Inc. is not publicly traded, but the P/E ratios of it's 4 closest competitors are 15, 15.3, 15.7, and 16.5. RAH's current earnings per share are $1.50. They are expected to grow at 6% for the next few years. What is a reasonable price for a share of RAH stock?
Answer: An appropriate P/E ratio would be an average of the 4 competitors:
(15 + 15.3 + 15.7 + 16.5)/4 = 15.625. A reasonable price would be $1.50(1.06)(15.625) = $24.84.
10.3 Preferred Stock
1) UVP preferred stock pays $5.00 in annual dividends. If your required rate of return is 13%, how much will you be willing to pay for one share?
2) Green Corp.'s preferred stock is selling for $20.83. If the company pays $2.50 annual dividends, what is the expected rate of return on its stock?
3) Sacramento Light & Power issued preferred stock in 1998 that had a par value of $85. The preferred stock pays a dividend of 5.75%. Investors require a rate of return of 6.50% today on this stock. What is the value of the preferred stock today? Round to the nearest $1.
4) Which of the following statements is true?
A) Preferred stockholders are entitled to dividends before common stockholders can receive dividends.
B) Preferred stock, like common stock, usually has no maturity; i.e., the corporation does not pay back the investment.
C) The market value of preferred stock, like bonds, will usually fluctuate in value primarily as the result of market rates of interest.
D) All of the above.
5) Which of the following statements concerning preferred stock is correct?
A) Preferred stock generally is more costly to the firm than common stock.
B) Most issues of preferred stock have a cumulative feature.
C) Preferred dividend payments are tax-deductible.
D) Preferred stock is a riskier form of capital to the firm than bonds.
6) World Wide Interlink Corp. has decided to undertake a large project. Consequently, there is a need for additional funds. The financial manager plans to issue preferred stock with an annual dividend of $5 per share. The stock will have a par value of $30. If investors' required rate of return on this investment is currently 20%, what should the preferred stock's market value be?
7) Davis Gas & Electric issued preferred stock in 1985 that had a par value of $50. The stock pays a dividend of 7.875%. Assume that shares are currently selling for $62.50. What is the preferred stockholder's expected rate of return? Round to the nearest 0.01%.
8) Murky Pharmaceuticals has issued preferred stock with a par value of $100 and a 5% dividend. The investors' required yield is 10%. What is the value of a share of Murky preferred?
9) Edison Power and Light has an outstanding issue of cumulative preferred stock with an annual fixed dividend of $2.00 per share. It has not paid the preferred dividend for the last 3 years, but intends to pay a dividend on the common stock in the coming year. Before Edison can pay a dividend on the common stock
A) preferred shareholders may cast all their votes for a single director.
B) preferred shareholders must receive dividends totaling $8.00 per share.
C) preferred shareholders must receive $2.00 per share.
D) will not necessarily receive any dividend.
10) Which of the following provisions is unique to preferred stockholders and usually NOT available to common stockholders?
A) Cumulative dividends feature
B) Voting rights
C) Fixed dividend
D) Both A and C
11) Piercing Publishers recently issued preferred stock with a fixed annual dividend of $3.00 per share. Investors require a 5% return on similar preferred stock issues. The stock is currently selling for $65. Is the stock a good buy?
A) Yes, as it is undervalued $5.
B) Yes, as it is undervalued $10.
C) No, as it is overvalued $5.
D) No, as it is overvalued $10.
12) Tri State Pickle Company preferred stock pays a perpetual annual dividend of 2 1/2% of its par value. Par value of TSP preferred stock is $100 per share. If investors' required rate of return on this stock is 15%, what is the value of per share?
13) Petrified Forest Skin Care, Inc. pays an annual perpetual dividend of $1.70 per share. If the stock is currently selling for $21.25 per share, what is the expected rate of return on this stock.
14) Horizon Communications stock pays a fixed annual dividend of $3.00. Because of lower inflation, the market's required yield on this preferred stock has gone from 12% to 10%. As a result
A) Horizon's dividend decreased by 6 cents.
B) The value of Horizon's preferred increased by $3.00.
C) The value of Horizon's preferred decreased by $5.00.
D) The value of Horizon's preferred increased by $5.00.
15) The required rate of return on TKF preferred has fallen from 5.75% at the time of issue to the present rate of 5%. The stock now sells for $115. What was the original price?
16) Preferred stock is similar to a bond in which of the following ways?
A) Preferred stock always contains a maturity date.
B) Both investments provide a fixed income.
C) Both contain a growth factor similar to common stock.
D) None of the above.
17) Solitron Manufacturing Company preferred stock is selling for $14. If it has a yearly dividend of $1, what is your expected rate of return if you purchase the stock at its market price (round your answer to the nearest .1%).
18) An decrease in the ________ will increase the value of preferred stock.
A) expected rate of return
B) life of the investment
C) dividend paid
D) both A and C
19) Texon's preferred stock sells for $85 and pays $11 each year in dividends. What is the required rate of return?
Answer: Required rate of return = = 0.129
20) What is the value of a preferred stock that pays a $2.10 dividend to an investor with a required rate of return of 6% (round your answer to the nearest $1)?
21) Which of the following formulas is appropriate to find the value of preferred stock with a fixed dividend?
A) Value of preferred stock = Annual Preferred Stock Dividend (1 + growth rate)/Market's Required Yield on Preferred Stock
B) Value of preferred stock = Annual Preferred Stock Dividend (1 + growth rate)/Market's Required Yield on Preferred Stock - growth rate
C) Value of preferred stock = Annual Preferred Stock Dividend/Market's Required Yield on Preferred Stock
D) Value of preferred stock = Annual Preferred Stock Dividend/Investor's Required Yield on Preferred Stock
22) An issue of preferred stock currently sells for $52.50 per share and pays a constant annual expected dividend of $2.25 per share. The expected return on this security is
23) Expected cash flow for a preferred stock primarily consists of
A) dividend payments.
B) changes in the price of the stock.
C) interest payments.
D) both A and B.
24) Preferred stock is similar to common stock in that
A) it has no fixed maturity date.
B) the nonpayment of dividends can bring on bankruptcy.
C) dividends are limited in amount.
D) both carry voting rights.
25) Profitable companies often prefer to issue debt rather than preferred stock because
A) debt creates less risk for the company.
B) interest payments are fixed but preferred shareholders expect dividends to grow.
C) preferred shares dilute the voting rights of common shareholders but bonds do not.
D) interest on debt is deductible for tax purposes, but preferred dividends are not.
26) In the event of bankruptcy, preferred stockholders and common stockholders have the same claim on the firm's assets.
27) A company may issue multiple classes of preferred stock.
28) The cumulative dividend feature is necessary to protect the rights of preferred stockholders.
29) Preferred stock cannot be retired.
30) To determine the value of a share of preferred stock, the discount rate used is the annual dividend percent.
31) The value of preferred shares is affected by changes in interest rates.
32) Miller/Hershey's preferred stock is selling at $54 on the market and pays an annual dividend of $4.20 per share.
a. What is the expected rate of return on the stock?
b. If an investor's required rate of return is 9%, what is the value of the stock for that investor?
c. Considering the investor's required rate of return, does this stock seem to be a desirable investment?
a. R = D/V
R = $4.20/54
R = 7.78%
b. V = D/R
V = $4.20/.09
V = $46.66
c. No, it is not a desirable investment.
33) Discuss two reasons why preferred stock would be viewed as less risky than common stock to investors.
Answer: Preferred stockholders are paid before common stockholders in the event of bankruptcy. Common stockholders, as the residual owners of a corporation, would receive any monies remaining after bondholder and preferred stock claims are satisfied. Preferred dividends are paid before common stock dividends in the normal course of business. In the event that a preferred dividend is not paid, it accumulates and dividends in arrears must be paid before any common stock dividends can be declared. Common shareholders take the risk that they will not receive dividends. The magnitude of the cash flows from preferred is also known where it is not known for common stock. Because cash flows are more certain, preferred stock would be considered less risky to the investor.
34) Determine the rate of return on a preferred stock that costs $50 and pays a $6 per share dividend.
K = Div = 6 = 12%
10.4 The Stock Market
1) An example of a primary market transaction is
A) a new issue of stock by Evergreen Solar.
B) a purchase of Microsoft stock on Nasdaq.
C) Target repurchasing some its own stock from an investor.
D) a sale of IBM stock on the NYSE.
2) The largest market stock exchange in the U.S. is
D) the CBOT.
3) Which of the following companies is most likely to trade on the New York Stock Exchange?
B) Genzyme Transgenics
C) Coca Cola
D) Tata Motors
4) Which of the following exchanges has the strictest listing requirements?
5) A small, newly listed technology company is most likely to be listed on
C) Nasdaq National Markets.
D) Nasdaq Capital Markets.
6) Listing requirements for the New York Stock Exchange include
B) market value.
C) breadth of ownership.
D) all of the above.
7) A block trade is a trade involving 10,000 or more shares by a single holder.
8) The NASDAQ trading floors are located in New York City.
9) Large, established technology companies such as Apple, Dell, Intel and Microsoft all trade on the NYSE.
10) Trading on the Nasdaq is done electronically and does not require a physical location.
11) In addition to stocks in individual companies, the AMEX conducts trading in such securities as ETFs and options.
12) Describe the major differences between the organized exchanges such as the NYSE and electronic networks such as Nasdaq.
Answer: The organized exchanges such as the New York Stock Exchange have a physical location and a trading floor where buyers and sellers of securities can meet face to face. An increasing percentage of NYSE and AMEX trades is, however, executed electronically. Nasdaq is an electronically linked network of traders that post bid and ask prices (the prices they are willing to pay or accept for securities) and the quantities they are willing to purchase or sell. There is no physical trading floor. Although companies trading on Nasdaq tend to be smaller and younger than those traded on the NYSE, Nasdaq listings do include some very large companies such as Microsoft and Apple.
13) Distinguish between primary stock market transactions and secondary stock market transaction.
Answer: When a company issues stock to the public for the first time, the event is known as an IPO or Initial Public Offering. Subsequent to the IPO, trading in the company's stock takes place on one of the major exchanges such as the NYSE or Nasdaq. In the great majority of these transactions, investors buy stock from other investors who wish to sell it, rather than directly from the company that issued it.