Chapter Seven STOCK VALUATION

Placing a value on a share of common stock is a more challenging task than we faced in valuing
bonds. Remember that common stock represents an ownership stake in a firm and those
shareholders are paid after other suppliers of capital (primarily lenders) have been paid. So, the
cash flows available to shareholders can be fairly uncertain (i.e., risky). However, if investors
can form an expectation about the amount of dividends that will be paid per share in the future,
then we should be able to apply time value of money principles to find the price of stock.

If

Dt = dividend per share paid at year t.

ks = required rate of return on stock s.

Then

D1 D2 D∞
^ 0=
P + +. .. .. .+
1
( 1+k s ) 2
(1+ k s ) ( 1+k s )∞

In words, the current price of a share of stock should be the present value (PV) of its future
dividends discounted at the required rate of return for the stock.

Notice that the dividend cash flows are projected to go on forever. This reflects the fact that the
ownership claim of shareholdings has no maturity. Given the “forever” nature of the cash flows
from a share of stock, we generally try to forecast some type of systematic pattern for future
dividends to make the above equation more workable.

 Characteristics of common stocks

Ownership with residual claims

Advantages and disadvantages of common stock ownership

Advantages

Higher returns

Easy to buy and sell (liquidity)

Disadvantages

Higher risk

Less current income

 Valuation by comparables
Stocks with similar characteristics should sell for similar prices
 Book value: the net worth of common equity according to a firm’s balance sheet

Liquidation value: net amount that can be realized by selling the assets of a firm and
paying off the debt

Replacement cost: cost to replace a firm’s assets

Tobin’s q: the ratio of market value of the firm to replacement cost

P/E ratio approach

Price-to-sales ratio approach

Market-to-book value approach

Price-to-cash flow approach

Valuing a stock with no projected growth in dividends per share

D D D
P^ 0 = + +. .. .. .+
1
(1+k s ) (1+ k s )2 (1+k s )∞
Suppose that we are trying to value the stock of a firm that is expected to pay a “constant”
dividend over time. Then our equation above becomes

^ =D
P 0
ks

In mathematics, this type of equation represents the sum of a geometric progression. It is a fact
that this equation reduces to:

This equation solves for the value of perpetuity. Perpetuity is an equal payment at regular
intervals that lasts forever.

Assume that you are considering an investment in a stock that is expected to pay a constant
dividend of $3 per share forever and that you will receive your first dividend payment 1 year
from now. Further, you have determined that you require a 15% return on an investment in this
stock. What is the value of this stock?

$3
P^ 0 = =$ 20
0 .15
Note what happens to the price if investors require higher or lower rates of return on the stock. If
investors require a 20% return on an investment in this stock, the value would be only $15 ($3 /
0.20). On the other hand, if the required return on the stock is 10%, the stock’s value would be
$30 ($3 / 0.10). Sudden changes in investor’s required rates of return on buying stocks can cause
significant changes in the values of stock (this is one reason why actual stock prices can be
volatile).

We can also use the structure of this formula to find the expected rate of return on this stock (if
we know the “actual” price).
D
k^ s =
P0

Note that the price variable has “lost its hat”, while the return variable, k, has “put on a hat.” This
reflects that from this equation, we are using a known price (which does not have to equal the
“theoretical” price, P-hat) to solve for an “expected” rate of return (which does not have to equal
the “required” rate of return).

Suppose that this stock sells for $20 per share. What is its expected return based on this price?

$3
k^ s = =0 . 15
$ 20
Based on our earlier computation of the value of the stock, is it fairly priced?

Note that for a zero-growth stock, the expected return consists entirely of the stock’s dividend
yield, D1/P0. To illustrate this, calculate the price of this stock in 1 year (but immediately after
the dividend is paid).

$3
P^ 1 = =$ 20
0. 15
Note that the price 1 year from now is expected to be $20. Therefore, if you sold the share after 1
year, you would expect to receive no capital gain. Your entire expected return would be from the
$3 dividend received. If you plan to sell your share after 1 year, illustrate why the $20 at t=0 is a
fair price.

0 1
-20 23

What’s the PV of $23 received in 1 year discounted at 15% (annual compounding)?

Valuing a stock with constant growth in dividends per share

Our initial analysis of a “zero-growth” stock should provide you with a basic understanding of
the valuation process. However, an assumption of zero dividend growth is unrealistic for a large
majority of companies. Most companies constantly strive to find new profit opportunities for
their businesses. In other words, they are trying to “grow” and add value. If they are successful,
they will be more profitable and be able to pay larger dividends. Thus, we need a valuation
model that can incorporate growth.

Suppose the stock that we are evaluating just paid a $3 per share dividend (i.e., yesterday).
Future dividend payments on this stock are expected to grow at a rate of 5% forever. Investors
require a 15% return on an investment in this stock.

The expected dividend payment in 1 year = $3(1.05) = $3.15

The expected dividend payment in 2 years = $3(1.05)2 = $3.3075

The expected dividend payment in 3 years = $3(1.05)3 = $3.472875

And this pattern will continue on forever.

D 0 ( 1+ g )1 D 0 ( 1+ g)2 D 0 ( 1+ g)∞
^ =
P + +. .. . .+
0
( 1+k s )1 ( 1+ k s )2 ( 1+ k s )∞

It is a mathematical fact that this equation is equivalent to the following.

D 0 ( 1+ g ) D1
^ =
P =
0
k s −g k s −g

So, the value of the constant growth stock discussed above is

$ 3 (1+0. 05 ) $ 3. 15
P^ 0 = = =$ 31 .50
0 . 15−0. 05 0. 15−0. 05
As with the zero-growth case, the value equation may be manipulated to find the expected rate of
return on a constant growth stock (if the actual price is known). Assume that this stock trades at
$31.50 currently.

D1
k^ s = +g
P0

The first term is the expected dividend yield. The second term reflects the expected capital gains
yield.

$ 3 .15
k^ s = +0 . 05=0 . 10+0 . 05=0. 15
$ 31 .50
So, the expected return on this stock is composed of a dividend yield of 10% and an expected
capital gains yield of 5%. To see this, let’s calculate the expected price of this stock 1 year from
now (immediately after the first dividend has been paid).

$ 3 . 15(1+0 .05 ) $ 3. 3075

P^ 1 = = =$ 33 . 075
0 .15−0 .05 0. 15−0 .05
So, after 1 year, I expect a capital gain of $1.575 ($33.075 - $31.50) which is a 5% gain over my
purchase price of $31.50. Combining this capital gain with the dividend yield of 10%, the total
expected return is 15%.

How will the current price of the stock be impacted by changes in 1) the required rate of return,
or 2) the growth rate?

Suppose the required rate of return for this stock jumps to 20% from 15%.

$ 3 .15
P^ 0 = =$ 21. 00
0 .20−0 . 05
A rise in the required rate will cause stock price to fall, all else being equal. On the other hand, a
decrease in the required rate of return will cause stock price to increase, all else being equal.

Suppose the growth rate of dividends is suddenly projected to be 8% forever rather than 5%.

$ 3 (1+0. 08 ) $ 3 . 24
P^ 0 = = =$ 46 .29
0 . 15−0. 08 0. 15−0. 08
Clearly, a greater growth rate in dividends is good news for the stock price, while lower growth
rates will cause a decline in price. Please note that we are talking about permanent dividend
changes, not temporary manipulations by firm management trying to boost stock price. The
market should not be fooled by temporary changes!

Valuing a stock with non constant (supernormal) growth in dividends per share
Many companies go through rapid growth phases before maturing into more stable (and lower)
growth patterns. Note from the constant growth formula that growth cannot be greater than the
required rate of return forever (otherwise the formula would yield a negative stock value).
Therefore, if the growth rate is higher than the required rate of return for some period of time,
then we must alter our valuation procedure.

Suppose that the stock under consideration for investment just paid a $3 per share dividend, and
projects 25% growth in dividends for the next 3 years. After that point in time, dividends are
expected to grow at a 5% annual rate forever. Assume that the required rate of return on this
stock is 15%. What is the value of this stock?
The standard procedure to follow for valuing a non constant growth stock is as follows:

1) Find the PV of the dividends during the period of non constant growth.
2) Find the price of the stock at the end of the non constant growth period (using the constant
growth formula). Find the PV of this price.
3) Add the PV’s found in steps 1) and 2) to find the current value of the stock.

Step 1:

Expected dividend at year 1 = $3(1.25) = $3.75

Expected dividend at year 2 = $3(1.25)2 = $4.6875

Expected dividend at year 3 = $3(1.25)3 = $5.859375

PV of D1 (at 15%) = $3.26086957

PV of D2 (at 15%) = $3.54442344

PV of D3 (at 15%) = $3.85263417

Sum of PV of dividends during supernormal growth = $10.65792718

Step 2:

$ 5 . 859375(1+0 . 05) $ 6 .15234375

P^ 3 = = =$ 61 .5234375
0 .15−0 . 05 0 . 10

PV of value at year 3 (at 15%) = $40.45265883

Step 3:

P^ 0 =$ 10 .65792718+$ 40 . 45265883=$ 51 .11

So, a fair price for this stock is $51.11!

Stock Market Equilibrium (Overpriced and Underpriced stocks)

Suppose a stock’s computed value is different than the observed price of its stock. Then, we
would say that such a stock is mispriced (if the model used to value the stock is correct).

Assume that the stock we examined earlier with a value of $31.50 is observed to trade at $30.
This stock is underpriced (i.e., investors can buy the stock at a price less than its value).

Another way of looking at this is to calculate the expected return on the stock (as we did earlier).

D1 $ 3 .15
k^ s = + g= +0 . 05=0 .155
P0 $ 30
At a price of $30, this stock has an expected return of 15.5%. This is greater than the required
rate of return of 15%. The current market for this stock is out of equilibrium. The buying
pressure will force current price higher (thus decrease the expected return). Once price has
reached $31.50, the expected return equals the required return and the market for this stock is in
equilibrium.

Suppose instead that the stock is actually trading at $35. The price is greater than value;
therefore, the stock would be overpriced. Investors would rush to sell such a stock, driving its
price down to its fair value of $31.50.

Stock price and PVGO (present value of growth opportunity)

Dividend payout ratio (1-b) vs. plowback ratio (b, earnings retention ratio)

Price = no-growth value per share + PVGO

E1 E1
P0 = + PVGO
k , where k is the no-growth value per share

Example: assume E1 = $5.00, k = 12.5%, ROE = 15%

If D1 = $5.00, then g = 0% (g = ROE * b, b = 0)

P0 = 5/0.125 = $40.00

If b = 60%, then g = 15%*0.6 = 9%, D1 = 5*(1-0.6) = $2.00

P0 = $57.14 (from constant DDM)

PVGO = 57.14 – 40.00 = $17.14

(3) Life cycle and multistage growth models: the growth rates are different at different stages,
but eventually it will be a constant

Two-stage growth DDM

Example: Honda Motor Co.

Expected dividend in next four years:

$0.90 in 2009 $0.98 in 2010 $1.06 in 2011 $1.15 in 2012

Dividend growth rate will be steady beyond 2012

Assume ROE = 11%, b = 70%, then long-term growth rate g = 7.7%

Honda’s beta is 1.05, if the risk-free rate is 3.5% and the market premium is 8%, then k = 11.9%
(from CAPM)

Using constant DDM, P2012 = 1.15*(1 + 0.077) / (0.119 - 0.077) = $29.49

$29.49

$0.90 $0.98 $1.06 $1.15

2008 2009 2010 2011 2012

Discount all the cash flows to the present at 11.9%, V2008 = $21.88

Multistage growth DDM: extension of two stage DDM

 Alternative models
P/E ratio approach

If g = ROE*b, the constant growth DDM is

P0 1−b
=
E1 k −( ROE∗b ) , with k>ROE*b.

Since P/E ratio indicates firm’s growth opportunity, P/E over g (call PEG ratio) should be
close to 1.

If PEG ratio is less than 1, it is a good bargain. For the S&P index over the past

20 years, the PEG ratio is between 1 and 1.5.

Price-to-book ratio approach

Price-to-cash flow ratio approach

Price-to-sales ratio approach

 Free cash flow valuation approach

Free cash flow: cash flow available to the firm or to the shareholders net of capital
expenditures

Free cash flow to the firm (FCFF)

FCFF = EBIT*(1-tc) + depreciation – capital expenditures – increase in NWC

Use FCFF to estimate firm’s value by discounting all future FCFF (including a terminal
value, PT) to the present

Free cash flow to equity holders

 FCFE = FCFF – interest expense*(1-tc) + increases in net debt

Use FCFE to estimate equity value by discounting all future FCFE (including a terminal
value, PT) to the present

1. Dividend Yield. Favored stock will pay a dividend this year of $2.40 per share. Its dividend yield is 8
percent. At what price is the stock selling?

2. Constant-Growth Model. Waterworks has a dividend yield of 8 percent. If its dividend is expected to
grow at a constant rate of 5 percent, what must be the expected rate of return on the company’s
stock?

3. Rate of Return. Steady As She Goes, Inc., will pay a year-end dividend of $3 per share. Investors
expect the dividend to grow at a rate of 4 percent indefinitely.

a. If the stock currently sells for $30 per share, what is the expected rate of return on the stock?
 b. If the expected rate of return on the stock is 16.5 percent, what is the stock price?

4. Dividend Yield. BMM Industries pays a dividend of $2 per quarter. The dividend yield on its stock is
reported at 4.8 percent. What price is the stock selling at?

5. Stock Values. Integrated Potato Chips paid a $2 per share dividend yesterday. You expect the
dividend to grow steadily at a rate of 4 percent per year.

a. What is the expected dividend in each of the next 3 years?

b. If the discount rate for the stock is 12 percent, at what price will the stock sell?
c. What is the expected stock price 3 years from now?
d. If you buy the stock and plan to hold it for 3 years, what payments will you receive? What is the
present value of those payments? Compare your answer to (b).
6. Constant-Growth Model. A stock sells for $40. The next dividend will be $4 per share. If the rate of
return earned on reinvested funds is 15 percent and the company reinvests 40 percent of earnings
in the firm, what must be the discount rate?
7. Negative Growth. Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are
all shrinking at a rate of 10 percent per year.

a. If r = 15 percent and DIV1 = $3, what is the value of a share?

b. What price do you forecast for the stock next year?
c. What is the expected rate of return on the stock?

8. Nonconstant Growth. You expect a share of stock to pay dividends of $1.00, $1.25, and $1.50 in
each of the next 3 years. You believe the stock will sell for $20 at the end of the third year.

a. What is the stock price if the discount rate for the stock is 10 percent?
b. What is the dividend yield?

9. Constant-Growth Model. Here are data on two stocks, investor required return is 15 percent:

Stock A Stock B

Return on Equity 12% 10%

Earnings Per Share $2.00 $1.50

Dividends per share $1.00 $1.00

a. What are the dividend payout ratios for each firm?

b. What are the expected dividend growth rates for each firm?
c. What is the proper stock price for each firm?
11. The DAP Company has decided to make a major investment. The investment will
require a substantial early cash out-flow, 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 be a negative growth of
5% 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%. If the firm's cost of capital
is 10% and its current dividend (D0) is $2 per share, what should be the current price per share?

12. The Radley Company has decided to undertake a large new project. Consequently, there
is a need for additional funds. The financial manager decides to issue preferred stock which has
a stated dividend of $5 per share and a par value of $30. If the required return on this stock is
currently 20%, what should be the stock's current market value?
13. SNG's stock is selling for $15 per share. The firm's income, assets, and stock price have
been growing at an annual 15% 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 $2.00 dividend
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%. The firm's required rate of return is 18%. You should
buy or sell the bond?

14. BBP, Inc., has experienced a recent resurgence in business as it has gained new national
identity. Management is forecasting rapid growth over the next 4 years (annual rate of 15%).
After that, it is expected that the firm will revert to its historical growth rate of 2% annually. The
last dividend paid was $1.50 per share, and the required return is 10%. What is the current price
per share, assuming equilibrium?
15. The Club Auto Parts Company has just recently been organized. It is expected to
experience no growth for the next 2 years as it identifies its market and acquires its inventory.
However, Club will grow at an annual rate of 5% in the third and fourth years and, beginning
with the fifth year, should attain a 10% growth rate which it will sustain thereafter. The last
dividend paid was $0.50 per share. Club has a cost of capital of 12%. What should be the
present price per share of Club common stock?

16. A share of DRV, Inc., stock paid a dividend of $1.50 last year, and the dividend is
expected to grow at a constant rate of 4% in the future. The appropriate rate of return on this
stock is believed to be 12%. What should the stock sell for today?
17. The Pet Company has recently discovered a type of rock which, when crushed, is
extremely absorbent. It is expected that the firm will experience (beginning now) an unusually
high growth rate (20%) during the period (3 years) when it has exclusive rights to the property
where this rock can be 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 assume a normal growth rate
of 8% annually. During the rapid growth period, the firm's dividend payout ratio will be
relatively low (20%), to conserve funds for reinvestment. However, the decrease in growth will
be accompanied by an increase in dividend payout to 50%. Last year's earnings were $2.00 per
share (E0) and the firm's cost of equity is 10%. What should be the current price of the common
stock?

18. IT&M, Inc., a large conglomerate, has decided to acquire another firm. Analysts are
forecasting that there will be a period (2 years) of extraordinary growth (20%) followed by
another 2 years of unusual growth (10%), and that finally the previous growth pattern of 6%
annually will resume. If the last dividend was $1 per share and the required return is 8%, what
should the market price be today?
19. A share of DRV, Inc., stock paid a dividend of $1.50 last year, and the dividend is
expected to grow at a constant rate of 4% in the future. The appropriate rate of return on this
stock is believed to be 12%. Suppose DRV stock were selling for $25 today. What would be the
implied value of ks , assuming the other data remain the same?

20. The Canning 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% annually into the
foreseeable future. Assume that ks = 11% and D0 = $2.00. What will be the price of the
company's stock in three years?
21. IBM is currently selling at $65 per share. Next year's dividend is expected to be $2.60.
If investors on this particular day expect a return of 12% on their investment, what do they think
IBM's growth rate will be?

22. The MM 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 it is
expected to grow at a rate of 3% in Year 4, 6% in Year 5, and 10% in Year 6 and thereafter. If
the required return for MM Co. is 20%, what is the current equilibrium price of the stock?
23. Your brother-in-law, a stockbroker at Invest, Inc., is trying to sell you a stock with a
current market price of $20. The stock had a last dividend (D0) of $2.00 and a constant growth
rate of 8%. Your required return on this stock is 20%. From a strict valuation standpoint, you
should:

24. Negative Limited is expected to grow for four years at a rate of 50 percent. After four
years, the product fad is expected to decline, and Negative will grow at a negative growth rate of
5 percent. Negative currently pays a dividend of $1.00 per share and stockholders have a
required rate of return of 18 percent. What should be the market value for a share of Negative
Limited stock?
25. Dexter, Inc., has just paid a dividend of $2.00. Its stock is now selling for $48 per share.
The firm is half as volatile as the market. The expected return on the market is 14% and the
yield on U.S. Treasury bonds is 11%. If the market is in equilibrium, what rate of growth is
expected?
Practice Questions: Stock Valuation

1. If current price of stock is $25 and you hold it for one year and received dividend of $2.5. You
sold it at $27. How much return you received? Show dividend yield and capital gain separately.

2. If investor required return is 20% and capital gain is 8% how much dividend company should pay?

3. Current price of stock is $20 and expected price after one year is 22.5. If investor required return
is 18%. What percentage of dividend should company pay?

4. You own a stock that will start paying $0.50 annually at the end of the year. It has zero growth in
future. If the required rate of return is 14%, what should you pay per share?

5. You own a stock that will start paying $0.50 annually at the end of the year. It will then grow each
year at a constant annual rate of 5%. If the required rate of return is 14%, what should you pay
per share?

6. What should you pay for a stock assuming you expect the following: a dividend of $1.00 paid at
the end of years 1 and 2; cost of equity equal to 8 percent; and, a selling price of $31 at the end
of two years?

7. Assume that IBM is expected to pay a total cash dividend of $5.60 next year and that dividends
are expected to grow at a rate of 5% per year forever. Assuming annual dividend payments, what
is the current market value of a share of IBM stock if the required return on IBM common stock is
10%?

8. Consider the following for a firm. Its stock price (P0) is at $50, its payout ratio (POR) is 0.4, its EPS1
is $2.00, and its expected return on the money retained (i) is 0.10. What is investor’s required
rate of return?

9. You own a stock that is currently selling for $50. You expect a dividend of $1.50 next year and
you require a 12% rate of return. What is the dividend growth rate for your stock assuming
constant growth?
10. What would you pay for a stock expected to pay a $2.50 dividend in one year if the expected
dividend growth rate is zero and you require a 10% return on your investment?

11. What would you pay for a stock expected to pay a $2.25 dividend in one year if the expected
dividend growth rate is 3% and you require a 12% return on your investment?

12. You are considering investing in ICI. Suppose ICI currently paid $3 dividend and enjoying super
growth and expected to pay 30% more in dividends each year for 3 years. After these three
years the dividend growth rate is expected to be 2% per year forever. If the required return for
ICI common stock is 11%, what is a share worth today?

13. You are considering investing in ICI. Suppose ICI is currently undergoing expansion and is not
expected to change its cash dividend while expanding for the next 4 years. This means that its
current annual $3.00 dividend will remain for the next 4 years. After the expansion is completed,
higher earnings are expected to result causing a 30% increase in dividends each year for 3 years.
After these three years of 30% growth, the dividend growth rate is expected to be 2% per year
forever. If the required return for ICI common stock is 11%, what is a share worth today?
1. In the calculation of rates of return on common stock, dividends are _______ and capital gains
are _____.
A. guaranteed; not guaranteed
B. guaranteed; guaranteed
C. not guaranteed; not guaranteed
D. not guaranteed; guaranteed
2. What dividend yield would be reported in the financial press for a stock that currently pays a $1
dividend per quarter and the most recent stock price was $40?
A. 2.5%
B. 4.0%
C. 10.0%
D. 15.0%
3. Which of the following values treats the firm as a going concern?
A. market value
B. book value
C. liquidation value
D. none of the above.
4. If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year, what is the stock's current
price?
A. $4.50
B. $18.00
C. $22.22
D. $40.50
5. How many round lots were traded in a specific stock on a day in which 467,800 shares changed
hands?
A. 467.8 round lots
B. 4,678 round lots
C. 467,800 round lots
D. Price must be known to determine round lots.
6. The book value of a firm's equity is determined by:
A. multiplying share price by shares outstanding.
B. multiplying share price at issue by shares outstanding.
C. the difference between book values of assets and liabilities.
D. the difference between market values of assets and liabilities.
7. What is the current price of a share of stock for a firm with $5 million in balance-sheet equity,
500,000 shares of stock outstanding, and a price/book value ratio of 4?
A. $2.50
B. $10.00
C. $20.00
D. $40.00
8. If the liquidation value of a firm is negative, then:
A. the firm's debt exceeds the market value of assets.
B. the firm's debt exceeds the book value of equity.
C. the book value of assets exceeds the firm's debt.
D. the market value of assets exceeds the firm's debt.
9. A firm's liquidation value is the amount:
A. necessary to repurchase all shares of common stock.
B. realized from selling all assets and paying off its creditors.
C. a purchaser would pay for the firm in bankruptcy.
D. equal to the book value of equity.
10. Which of the following is least likely to account for an excess of market value over book value of
equity?
A. Inaccurate depreciation methods.
B. High rate of return on assets.
C. The presence of growth opportunities.
D. Valuable off-balance sheet assets.
11. Firms with valuable intangible assets are more likely to show a(n):
A. excess of book value over market value of equity.
B. high going-concern value.
C. low liquidation value.
D. low P/E ratio.
12. Which of the following is inconsistent with a firm that sells for very near book value?
A. Low current earning power
B. No intangible assets
C. High future earning power
D. Low, unstable dividend payment
13. The main purpose of a market-value balance sheet is to:
A. show an inflated value of the firm.
B. avoid the recording of certain liabilities.
C. value assets and liabilities without GAAP restrictions.
D. improve the credit rating of the firm.
14. A stock paying $5 in annual dividends sells now for $80 and has an expected return of 14%.
What might investors expect to pay for the stock one year from now?
A. $82.20
B. $86.20
C. $87.20
D. $91.20
15. Which of the following statements is correct about a stock currently selling for $50 per share
that has a 16% expected return and a 10% expected capital appreciation?
A. Its expected dividend exceeds the actual dividend.
B. Its expected return will exceed the actual return.
C. It is expected to pay $3 in annual dividends.
D. It is expected to pay $8 in annual dividends.
16. The expected return on a common stock is composed of:
A. dividend yield.
B. capital appreciation.
C. both dividend yield and capital appreciation.
D. capital appreciation minus the dividend yield.
17. Firms having a higher expected return have a higher:
A. level of expected risk.
B. dividend yield.
C. market value of equity.
D. degree of certainty concerning their returns.
18. How much should you pay for a share of stock that offers a constant growth rate of 10%,
requires a 16% rate of return, and is expected to sell for $50 one year from now?
A. $42.00
B. $45.00
C. $45.45
D. $47.00
19. 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 constant rate.
20. How is it possible to ignore cash dividends that occur far into the future when using a dividend
discount model? Those dividends:
A. will be paid to a different investor.
B. will not be paid by the firm.
C. have an insignificant present value.
D. ignore the tax consequences of future dividends.