Chapter 7 iClickers

Multiple Choice Identify the choice that best completes the statement or answers the question. ____ 1. An increase in a firm's expected growth rate would cause its required rate of return to a. increase. b. decrease. c. fluctuate less than before. d. fluctuate more than before. e. possibly increase, possibly decrease, or possibly remain constant. 2. 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. e. dividends are not likely to be declared. 3. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks fall into one of three classes: A, B, and C. b. All common stocks, regardless of class, must have the same voting rights. c. All firms have several classes of common stock. d. All common stock, regardless of class, must pay the same dividend. e. Some class or classes of common stock are entitled to more votes per share than other classes. 4. 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 dividend yield is 5%. c. The price of the stock is expected to decline in the future. d. The stock's required return must be equal to or less than 5%. e. The stock's price one year from now is expected to be 5% above the current price. 5. For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then a. the expected future return must be less than the most recent past realized return. b. the past realized return must be equal to the expected return during the same period. c. the required return must equal the realized return in all periods. d. the expected return must be equal to both the required future return and the past realized return. e. the expected future returns must be equal to the required return. 6. A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth rate is g = 4.0%. What is the current stock price? a. $23.11 b. $23.70 c. $24.31

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d. $24.93 e. $25.57 ____ 7. Gay Manufacturing is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate? a. 6.01% b. 6.17% c. 6.33% d. 6.49% e. 6.65% 8. Reddick Enterprises' stock currently sells for $35.50 per share. The dividend is projected to increase at a constant rate of 5.50% per year. The required rate of return on the stock, rs, is 9.00%. What is the stock's expected price 3 years from today? a. $37.86 b. $38.83 c. $39.83 d. $40.85 e. $41.69 9. Carter's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return? a. 8.03% b. 8.24% c. 8.45% d. 8.67% e. 8.89%

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____ 10. Savickas Petroleum's stock has a required return of 12%, and the stock sells for $40 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% per year for the next 4 years, so D4 = $1.00(1.30)4 = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of X% per year forever. What is the stock's expected constant growth rate after t = 4, i.e., what is X? a. 5.17% b. 5.44% c. 5.72% d. 6.02% e. 6.34%

Chapter 7 iClickers Answer Section

MULTIPLE CHOICE 1. ANS: E PTS: 1 DIF: Easy OBJ: 7.7 NAT: AACSB: C; G TOP: Required return MSC: Conceptual 2. ANS: C PTS: 1 DIF: Easy OBJ: 7.7 NAT: AACSB: C; G TOP: Required return MSC: Conceptual 3. ANS: E PTS: 1 DIF: Medium OBJ: 7.2 NAT: AACSB: C; G TOP: Classified stock MSC: Conceptual 4. ANS: E Statement e is true, because the stock price is expected to grow at the dividend growth rate. PTS: 1 DIF: Medium TOP: Constant growth stock 5. ANS: E PTS: 1 NAT: AACSB: C; G MSC: Conceptual 6. ANS: E $1.50 D0 rs 10.1% g 4.0% D1 = D0(1 + g) = $1.56 $25.57 P0 = D1/(rs g) PTS: 1 DIF: Easy TOP: Constant growth valuation 7. ANS: E Expected dividend (D1) Stock price Required return Dividend yield Growth rate = rs D1/P0 = PTS: 1 DIF: Easy TOP: Constant growth rate 8. ANS: E Stock price $35.50 Growth rate 5.50% Years in the future 3 P3 = P0(1 + g)3 = $41.69 PTS: 1 DIF: Easy TOP: Constant growth: future price 9. ANS: E OBJ: MSC: DIF: TOP: 7.7 NAT: AACSB: C; G Conceptual Medium OBJ: 7.12 Market equilibrium

OBJ: 7.6 MSC: Problem $1.25 $32.50 10.5% 3.85% 6.65% OBJ: 7.6 MSC: Problem

NAT: AACSB: C; G

NAT: AACSB: C; G

OBJ: 7.6 MSC: Problem

NAT: AACSB: C; G

Pref. quarterly dividend Annual dividend = Qtrly dividend 4 = Preferred stock price Nom. required return = Annual dividend/Price = PTS: 1 DIF: Medium TOP: Preferred required return 10. ANS: E Stock price Paid dividend (D0) Short-run growth rate Required return Forecasted LR growth rate, X Year Dividend 0 $1.0000 1 30.0% $1.3000 OBJ: 7.11 MSC: Problem

$1.00 $4.00 $45.00 8.89% NAT: AACSB: C; G

$40.00 $1.00 30.0% 12.0% 6.34% Arbitrarily set at 5% initially. 2 30.0% $1.6900 3 30.0% $2.1970 4 30.0% $ 2.8561 53.6777 $56.5338 $35.9282 5 6.34% $3.0372

Terminal value = P4 = D5/(rs g5): Total CFs $1.3000 PV of CFs $1.1607 Stock price = $40.00

$1.6900 $1.3473

$2.1970 $1.5638

Must equal $40. Change the forecasted growth rate till reach $40.

We must solve for the long-run growth rate. We can forecast the dividends in Years 14, so they are inserted in the time line. We need a growth rate to find D5 and the TV. We begin with a guess of say 5.0%, which we insert in the forecast cell. We then find the PV of the forecasted CFs and sum them. If the sum equals the given price, then our growth rate would be correct. If not, we need to substitute in different g's until we find the one that works. We used Excel's Goal Seek function to simplify the process, but one could use trial and error. PTS: 1 DIF: Hard TOP: Nonconstant growth rate MSC: Problem OBJ: 7.8 NAT: AACSB: C; G KEY: Nonalgorithmic