Question 1

Ace Frisbee Corporation produces a good that is very mature in their product life cycles. Ace Frisbee Corporation is expected to pay a dividend in Year 1 of $3.00, a dividend in Year 2 of $2.00, and a dividend in Year 3 of $1.00. After Year 3, dividends are expected to decline at the rate of 2% per year. An appropriate required return for the shares is 8%. Using the multistage DDM, the shares should be worth ________ today.

Accepted Answer

The multistage Dividend Discount Model (DDM) calculates the present value of expected dividends. The dividends for the first three years are discounted individually, and the declining perpetuity from Year 4 onwards is calculated using the formula for a perpetuity with growth. The sum of these present values gives the share price today, which is approximately $13.07.

Question 2

Cache Creek Manufacturing Company is expected to pay a dividend of $4.20 in the upcoming year. Dividends are expected to grow at the rate of 8% per year. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. Investors use the CAPM to compute the market capitalisation rate on the shares, and the constant growth DDM to determine the intrinsic value of the shares. The shares are trading in the market today at $84.00. Using the constant growth DDM and the CAPM, the beta of the shares is ________.

Accepted Answer

The answer of Cache Creek Manufacturing Company is expected to...

Question 3

Brevik Builders has an expected ROE of 25%. Its dividend growth rate will be ________ if it follows a policy of paying 30% of earning in the form of dividends.

Accepted Answer

The dividend growth rate can be calculated using the formula:

Dividend payout ratio = Dividends / Earnings
Dividend growth rate = ROE x (1 - Dividend payout ratio)

Here, ROE is given as 25% and the dividend payout ratio as 30%. 
Dividend payout ratio = 0.30 = Dividends / Earnings

Therefore, Earnings / Dividends = 1 / 0.30 = 3.33

Since the formula for ROE is:

ROE = Net Income / Equity

We can say that, Equity / Net Income = 1 / ROE = 1 / 0.25 = 4

Earnings = Net Income x (1 - Dividend payout ratio) = Net Income x 0.70

Therefore, Equity / (Net Income x 0.70) = 3.33 or Equity / Net Income = 3.33 / 0.70 = 4.76

Thus, Equity = 4.76 x Net Income

Substituting this in the formula for ROE, we get:

25% = Net Income / (4.76 x Net Income)

Therefore, Net Income = 20.83333

Finally, the dividend growth rate can be calculated as:

Dividend growth rate = 25% x (1- 0.30) = 17.5%

Hence, the answer is C.

Question 4

Interior Airline is expected to pay a dividend of $3 in the upcoming year. Dividends are expected to grow at the rate of 10% per year. The risk-free rate of return is 4% and the expected return on the market portfolio is 13%. The shares of Interior Airline have a beta of 4.00. Using the constant growth DDM, the intrinsic value of the shares is ________.

Accepted Answer

The answer of Interior Airline is expected to pay a...

Question 5

Caribou Gold Mining Corporation is expected to pay a dividend of $6 in the upcoming year. Dividends are expected to decline at the rate of 3% per year. The risk-free rate of return is 5% and the expected return on the market portfolio is 13%. The shares of Caribou Gold Mining Corporation have a beta of -0.50. Using the constant growth DDM, the intrinsic value of the shares is ________.

Accepted Answer

The intrinsic value using the constant growth DDM is calculated as D1 / (r - g). Here, D1 = $6, r = risk-free rate + beta * (market return - risk-free rate) = 5% - 0.5 * (13% - 5%) = 1%, and g = -3%. The intrinsic value is $6 / (0.01 + 0.03) = $6 / 0.04 = $150.

Question 6

Grott and Perrin Ltd has expected earnings of $3 per share for next year. The firm's ROE is 20% and its earnings retention ratio is 70%. If the firm's market capitalisation rate is 15%, what is the present value of its growth opportunities?

Accepted Answer

The answer of Grott and Perrin Ltd has expected earnings...

Question 7

Caribou Gold Mining Corporation is expected to pay a dividend of $4 in the upcoming year. Dividends are expected to decline at the rate of 3% per year. The risk-free rate of return is 5% and the expected return on the market portfolio is 13%. The shares of Caribou Gold Mining Corporation have a beta of -0.50. Using the CAPM, the return you should require on the shares is ________.

Accepted Answer

The answer of Caribou Gold Mining Corporation is expected to...

Question 8

Todd Mountain Development Corporation is expected to pay a dividend of $3.00 in the upcoming year. Dividends are expected to grow at the rate of 8% per year. The risk-free rate of return is 5% and the expected return on the market portfolio is 17%. The shares of Todd Mountain Development Corporation have a beta of 0.75. Using the constant growth DDM, the intrinsic value of the shares is ________.

Accepted Answer

The answer of Todd Mountain Development Corporation is expected to...

Question 9

Westsyde Tool Company is expected to pay a dividend of $2.00 in the upcoming year. The risk-free rate of return is 6% and the expected return on the market portfolio is 12%. Analysts expect the price of Westsyde Tool Company shares to be $29 a year from now. The beta of Westsyde Tool Company's shares is 1.20. Using a one-period valuation model, the intrinsic value of Westsyde Tool Company shares today is ________.

Accepted Answer

According to the one-period valuation model, the intrinsic value of a stock is calculated as follows:

Intrinsic value = (Expected dividend / (1 + required rate of return)) + (Expected price - Current price) / (1 + required rate of return)

Plugging in the given values: 
- Expected dividend = $2.00 
- Required rate of return = risk-free rate + beta*(expected market return - risk-free rate) = 6% + 1.20*(12% - 6%) = 12.6% 
- Expected price = $29 
- Current price = unknown

Intrinsic value = ($2.00 / (1 + 0.126)) + ($29 - Current price) / (1 + 0.126)

To solve for the current price, we can rearrange the equation:

Current price = $29 - ($2.00 / (1 + 0.126)) * (1 + 0.126)

Current price = $27.39

Therefore, the intrinsic value of Westsyde Tool Company shares today is $27.39. Choice B is the correct answer.

Question 10

Assuming all other factors remain unchanged, ________ would increase a firm's price earnings ratio.

Accepted Answer

A reduction in investor risk aversion typically leads to higher stock prices as investors are willing to pay more for earnings, thus increasing the price earnings ratio.

Question 11

Firms with higher expected growth rates tend to have P/E ratios that are ________ the P/E ratios of firms with lower expected growth rates.

Accepted Answer

Firms with higher expected growth rates are generally associated with higher risk and higher potential returns, which can lead to higher P/E ratios compared to firms with lower expected growth rates.

Question 12

Lifecycle Motorcycle Company is expected to pay a dividend in Year 1 of $2.00, a dividend in Year 2 of $3.00, and a dividend in Year 3 of $4.00. After Year 3, dividends are expected to grow at the rate of 7% per year. An appropriate required return for the shares is 12%. Using the multistage DDM, the shares should be worth ________ today.

Accepted Answer

The multistage Dividend Discount Model (DDM) calculates the present value of expected dividends. The present value of dividends for the first three years is calculated separately, and then the present value of the perpetuity starting from Year 4 is added. The formula for the perpetuity is D4 / (r - g), where D4 is the dividend in Year 4, r is the required return, and g is the growth rate. The present value of these cash flows at a 12% discount rate gives the share price.

Question 13

Westsyde Tool Company is expected to pay a dividend of $1.50 in the upcoming year. The risk-free rate of return is 6% and the expected return on the market portfolio is 14%. Analysts expect the price of Westsyde Tool Company shares to be $29 a year from now. The beta of Westsyde Tool Company's shares is 1.20. Using the CAPM, an appropriate required return on Westsyde Tool Company's shares is ________.

Accepted Answer

The required return using CAPM is calculated as: Risk-free rate + Beta * (Market return - Risk-free rate) = 6% + 1.20 * (14% - 6%) = 15.6%.

Question 14

Firm A is high risk and Firm B is low risk. Everything else equal, which firm would you expect to have a higher P/E ratio?

Accepted Answer

The answer of Firm A is high risk and Firm...

Question 15

Rose Hill Trading Company is expected to have EPS in the upcoming year of $8.00. The expected ROE is 18.0%. An appropriate required return on the shares is 14%. If the firm has a plowback ratio of 70%, its dividend in the upcoming year should be ________.

Accepted Answer

Dividend payout ratio = (1 - plowback ratio) 
Dividend = EPS x Dividend payout ratio

Plowback ratio = 70%, therefore dividend payout ratio = 1 - 0.70 = 0.30

Dividend = $8.00 x 0.30 = $2.40

Therefore, the dividend in the upcoming year should be $2.40. Answer choice C is the correct answer.

Question 16

Value shares are more likely to have a PEG ratio ________.

Accepted Answer

Value shares are typically less expensive compared to growth shares and thus have a lower P/E ratio. Consequently, their PEG ratio is likely to be less than one, indicating that they offer good value for their earnings growth potential.

Question 17

Cache Creek Manufacturing Company is expected to pay a dividend of $3.36 in the upcoming year. Dividends are expected to grow at 8% per year. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. Investors use the CAPM to compute the market capitalisation rate, and the constant growth DDM to determine the value of the shares. The share is currently priced at $84.00. Using the constant growth DDM, the market capitalisation rate is ________.

Accepted Answer

Using the constant growth DDM, we can determine the market capitalisation rate as follows:

Market capitalisation rate = (Dividend / Price) + Growth rate 
= (3.36 / 84) + 8% 
= 12%

Therefore, the correct answer is B) 12%.

Question 18

A firm's earnings per share increased from $10 to $12, its dividends increased from $4.00 to $4.40, and its share price increased from $80 to $100. Given this information, it follows that ________.

Accepted Answer

The dividend payout ratio decreased because the earnings per share increased by 20% (from $10 to $12), while the dividends increased by only 10% (from $4.00 to $4.40).

Question 19

Flanders Ltd has expected earnings of $4 per share for next year. The firm's ROE is 8% and its earnings retention ratio is 40%. If the firm's market capitalisation rate is 15%, what is the present value of its growth opportunities?

Accepted Answer

The present value of growth opportunities (PVGO) is calculated as the difference between the price of the stock with growth and the price of the stock without growth. The growth rate (g) is ROE * retention ratio = 8% * 40% = 3.2%. The price without growth is earnings per share / market capitalization rate = $4 / 0.15 = $26.67. The price with growth is calculated using the Gordon Growth Model: $4 * (1 + 0.032) / (0.15 - 0.032) = $20.34. Therefore, PVGO = $20.34 - $26.67 = -$6.33.

Question 20

Todd Mountain development Corporation is expected to pay a dividend of $2.50 in the upcoming year. Dividends are expected to grow at the rate of 8% per year. The risk-free rate of return is 5% and the expected return on the market portfolio is 12%. The shares of Todd Mountain Development Corporation have a beta of 0.75. Using the CAPM, the return you should require on the shares is ________.

Accepted Answer

Using CAPM formula:

Required Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)
Required Return = 5% + 0.75 × (12% - 5%)
Required Return = 5% + 0.75 × 7%
Required Return = 5% + 5.25%
Required Return = 10.25%

Therefore, the return you should require on the shares is 10.25%.

Quiz 11: Equity Valuation