Chapter 18 Equity Valuation Models
72. Mature Products Corporation produces goods that are very mature in their product life
cycles. Mature Products Corporation is expected to pay a dividend in year 1 of $2.00, a dividend of $1.50 in year 2, and a dividend of $1.00 in year 3. After year 3, dividends are expected to decline at a rate of 1% per year. An appropriate required rate of return for the stock is 10%. The stock should be worth ______. A) $9.00 B) $10.57 C) $20.00 D) $22.22 E) none of the above
Answer: B Difficulty: Difficult
Rationale:
Calculations are shown below.
Yr. Dividend PV of Dividend @ 10% 1 $2.00 $2.00/1.10 = $1.8182 2 $1.50 $1.50/(1.10)2 = $1.2397 3 $1.00 $1.00/(1.10)3 = $0.7513 Sum $3.8092
P3 = 1.00 (.99) / [.10 - (-.01)] = $9.00; PV of P3 = $9/(1.10)3 = $6.7618; PO = $6.7618 + $3.8092 = $10.57.
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Chapter 18 Equity Valuation Models
73. Consider the free cash flow approach to stock valuation. Utica Manufacturing
Company is expected to have before-tax cash flow from operations of $500,000 in the coming year. The firm's corporate tax rate is 30%. It is expected that $200,000 of operating cash flow will be invested in new fixed assets. Depreciation for the year will be $100,000. After the coming year, cash flows are expected to grow at 6% per year. The appropriate market capitalization rate for unleveraged cash flow is 15% per year. The firm has no outstanding debt. The projected free cash flow of Utica Manufacturing Company for the coming year is _______.
A) $150,000 B) $180,000 C) $300,000 D) $380,000 E) none of the above
Answer: B Difficulty: Difficult
Rationale:
Calculations are shown below.
Before-tax cash flow from operations $500,000 -Depreciation $100,000 Taxable income $400,000 -Taxes (30%) $120,000 After-tax unleveraged income $280,000 After-tax unlevered income + dep $380,000 -New investment $200,000 Free cash flow $180,000
74. Consider the free cash flow approach to stock valuation. Utica Manufacturing
Company is expected to have before-tax cash flow from operations of $500,000 in the coming year. The firm's corporate tax rate is 30%. It is expected that $200,000 of operating cash flow will be invested in new fixed assets. Depreciation for the year will be $100,000. After the coming year, cash flows are expected to grow at 6% per year. The appropriate market capitalization rate for unleveraged cash flow is 15% per year. The firm has no outstanding debt. The total value of the equity of Utica Manufacturing Company should be
A) $1,000,000 B) $2,000,000 C) $3,000,000 D) $4,000,000 E) none of the above
Answer: B Difficulty: Difficult
Rationale: Projected free cash flow = $180,000 (see test bank problem 18.73); V0 =
180,000 / (.15 - .06) = $2,000,000.
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Chapter 18 Equity Valuation Models
75. A firm's earnings per share increased from $10 to $12, dividends increased from $4.00
to $4.80, and the share price increased from $80 to $90. Given this information, it follows that ________.
A) the stock experienced a drop in the P/E ratio B) the firm had a decrease in dividend payout ratio C) the firm increased the number of shares outstanding D) the required rate of return decreased E) none of the above
Answer: A Difficulty: Moderate
Rationale: $80/$10 = 8; $90/$12 = 7.5.
76. In the dividend discount model, _______ which of the following are not incorporated
into the discount rate?
A) real risk-free rate B) risk premium for stocks C) return on assets D) expected inflation rate E) none of the above
Answer: C Difficulty: Moderate
Rationale: A, B, and D are incorporated into the discount rate used in the dividend
discount model.
77. A company whose stock is selling at a P/E ratio greater than the P/E ratio of a market
index most likely has _________.
A) an anticipated earnings growth rate which is less than that of the average firm B) a dividend yield which is less than that of the average firm C) less predictable earnings growth than that of the average firm D) greater cyclicality of earnings growth than that of the average firm E) none of the above.
Answer: B Difficulty: Moderate
Rationale: Firms with lower than average dividend yields are usually growth firms,
which have a higher P/E ratio than average.
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Chapter 18 Equity Valuation Models
78. Which of the following would tend to reduce a firm's P/E ratio? A) The firm significantly decreases financial leverage B) The firm increases return on equity for the long term C) The level of inflation is expected to increase to double-digit levels D) The rate of return on Treasury bills decreases E) None of the above
Answer: C Difficulty: Moderate
Rationale: In times of high inflation, earnings are inflated; thus, P/E ratios decline.
79. Other things being equal, a low ________ would be most consistent with a relatively
high growth rate of firm earnings and dividends.
A) dividend payout ratio B) degree of financial leverage C) variability of earnings D) inflation rate E) none of the above
Answer: A Difficulty: Moderate
Rationale: Firms with high growth rates are retaining most of the earnings for growth;
thus, the dividend payout ratio will be low.
80. A firm has a return on equity of 14% and a dividend payout ratio of 60%. The firm's
anticipated growth rate is _________.
A) 5.6% B) 10% C) 14% D) 20% E) none of the above
Answer: A Difficulty: Easy
Rationale: 14% X 0.40 = 5.6%.
81. A firm has a return on equity of 20% and a dividend payout ratio of 30%. The firm's
anticipated growth rate is _________.
A) 6% B) 10% C) 14% D) 20% E) none of the above
Answer: C Difficulty: Easy
Rationale: 20% X 0.70 = 14%.
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Chapter 18 Equity Valuation Models
82. Sales Company paid a $1.00 dividend per share last year and is expected to continue to
pay out 40% of earnings as dividends for the foreseeable future. If the firm is expected to generate a 10% return on equity in the future, and if you require a 12% return on the stock, the value of the stock is ________.
A) $17.67 B) $13.00 C) $16.67 D) $18.67 E) none of the above
Answer: A Difficulty: Moderate
Rationale: g = 10% X 0.6 = 6%; P = 1 (1.06) / (.12 - .06) = $17.67.
83. Assume that at the end of the next year, Bolton Company will pay a $2.00 dividend per
share, an increase from the current dividend of $1.50 per share. After that, the dividend is expected to increase at a constant rate of 5%. If you require a 12% return on the stock, the value of the stock is ________.
A) $28.57 B) $28.79 C) $30.00 D) $31.78 E) none of the above
Answer: A Difficulty: Difficult
Rationale: P1 = 2 (1.05) / (.12 - .05) = $30.00; PV of P1 = $30/1.12 = $26.78; PV of D1
= 2/1.12 = 1.79; PO = $26.78 + $1.79 = $28.57.
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