Chapter 18 Equity Valuation Models
95. According to Peter Lynch, a rough rule of thumb for security analysis is that A) the growth rate should be equal to the plowback rate. B) the growth rate should be equal to the dividend payout rate. C) the growth rate should be low for emerging industries. D) the growth rate should be equal to the P/E ratio. E) none of the above.
Answer: D Difficulty: Moderate
Rationale: A rough guideline is that P/E ratios should equal growth rates in dividends or
earnings.
96. For most firms, P/E ratios and risk A) will be directly related. B) will have an inverse relationship. C) will be unrelated. D) will both increase as inflation increases. E) none of the above.
Answer: B Difficulty: Moderate
Rationale: In the context of the constant growth model, the higher the risk of the firm the
lower its P/E ratio.
97. Dividend discount models and P/E ratios are used by __________ to try to find
mispriced securities.
A) technical analysts B) statistical analysts C) fundamental analysts D) dividend analysts E) psychoanalysts
Answer: C Difficulty: Easy
Rationale: Fundamental analysts look at the basic features of the firm to estimate firm
value.
98. book value A) liquidation value B) replacement cost C) market value D) Tobin's Q
Answer: B Difficulty: Easy
Rationale: If the firm's market value drops below the liquidation value the firm will be a
possible takeover target. It would be worth more liquidated than as a going concern.
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Chapter 18 Equity Valuation Models
99. Who popularized the dividend discount model, which is sometimes referred to by his
name?
A) Burton Malkiel B) Frederick Macaulay C) Harry Markowitz D) Marshall Blume E) Myron Gordon
Answer: E Difficulty: Easy
Rationale: The dividend discount model is also called the Gordon model.
100. If a firm follows a low-investment-rate plan (applies a low plowback ratio), its
dividends will be _______ now and _______ in the future than a firm that follows a high-reinvestment-rate plan.
A) higher, higher B) lower, lower C) lower, higher D) higher, lower E) It is not possible to tell.
Answer: D Difficulty: Moderate
Rationale: By retaining less of its income for plowback, the firm is able to pay more
dividends initially. But this will lead to a lower growth rate for dividends and a lower level of dividends in the future relative to a firm with a high-reinvestment-rate plan. Figure 18.1 on page 615 illustrates this graphically.
101. The present value of growth opportunities (PVGO) is equal to
I) the difference between a stock's price and its no-growth value per share. II) the stock's price
III) zero if its return on equity equals the discount rate.
IV) the net present value of favorable investment opportunities.
A) I and IV B) II and IV C) I, III, and IV D) II, III, and IV E) III and IV
Answer: C Difficulty: Moderate
Rationale: All are correct except II the stock's price equals the no-growth value per
share plus the PVGO.
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Chapter 18 Equity Valuation Models
102. Which of the following combinations will produce the highest growth rate? Assume
that the firm's projects offer a higher expected return than the market capitalization rate.
A) a high plowback ratio and a high P/E ratio B) a high plowback ratio and a low P/E ratio C) a low plowback ratio and a low P/E ratio D) a low plowback ratio and a high P/E ratio E) Neither the plowback ratio nor the P/E ratio is related to a firm's growth.
Answer: A Difficulty: Moderate
Rationale: The firm will grow more rapidly if it retains earnings to invest in positive
NPV projects. As for the P/E ratio's relationship to growth, the growth rate will increase as long as the projects' expected returns are higher than the market capitalization rates. If the expected returns are lower than the market capitalization rates, the growth rate will fall.
103. Low P/E ratios tend to indicate that a company will _______, ceteris paribus. A) grow quickly B) grow at the same speed as the average company C) grow slowly D) P/E ratios are unrelated to growth E) none of the above
Answer: C Difficulty: Easy
Rationale: Investors pay for growth; hence a relatively high P/E ratio for growth firms.
104. Earnings managements is A) when management makes changes in the operations of the firm to ensure that
earning do not increase or decrease too rapidly.
B) when management makes changes in the operations of the firm to ensure that
earning do not increase too rapidly.
C) when management makes changes in the operations of the firm to ensure that
earning do not decrease too rapidly.
D) the practice of using flexible accounting rules to improve the apparent profitability
of the firm.
E) none of the above.
Answer: D Difficulty: Easy
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Chapter 18 Equity Valuation Models
105. A version of earnings management that became common in the 1990s was A) when management makes changes in the operations of the firm to ensure that
earning do not increase or decrease too rapidly.
B) reporting “pro forma” earnings”. C) when management makes changes in the operations of the firm to ensure that
earning do not increase too rapidly.
D) when management makes changes in the operations of the firm to ensure that
earning do not decrease too rapidly.
E) none of the above.
Answer: B Difficulty: Easy
106. GAAP allows A) no leeway to manage earnings. B) minimal leeway to manage earnings. C) considerable leeway to manage earnings. D) earnings management if it is beneficial in increasing stock price. E) none of the above.
Answer: C Difficulty: Easy
107. The most appropriate discount rate to use when applying a FCFE valuation model is the
___________.
A) required rate of return on equity B) WACC C) risk-free rate D) A or C depending on the debt level of the firm E) none of the above
Answer: A Difficulty: Easy
108. The most appropriate discount rate to use when applying a FCFF valuation model is the
___________.
A) required rate of return on equity B) WACC C) risk-free rate D) A or C depending on the debt level of the firm E) none of the above
Answer: B Difficulty: Easy
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Chapter 18 Equity Valuation Models
109. FCF and DDM valuations should be ____________ if the assumptions used are
consistent.
A) very different for all firms B) similar for all firms C) similar only for unlevered firms D) similar only for levered firms E) none of the above
Answer: B Difficulty: Easy
110. Siri had a FCFE of $1.6M last year and has 3.2M shares outstanding. Siri's required
return on equity is 12% and WACC is 9.8%. If FCFE is expected to grow at 9% forever, the intrinsic value of Siri's shares are ____________.
A) $68.13 B) $18.67 C) $26.35 D) $14.76 E) none of the above
Answer: B Difficulty: Moderate
Rationale: $1.6M/3.2M = $0.50 FCFE per share; .50*1.09 = .545; .545/(.12-.09) =
18.67
111. Zero had a FCFE of $4.5M last year and has 2.25M shares outstanding. Zero's required
return on equity is 10% and WACC is 8.2%. If FCFE is expected to grow at 8% forever, the intrinsic value of Zero's shares are ____________.
A) $108.00 B) $1080.00 C) $26.35 D) $14.76 E) none of the above
Answer: A Difficulty: Moderate
Rationale: $4.5M/2.25M = $2.00 FCFE per share; 2.00*1.08 = 2.16; 2.16/(.10-.08) =
108
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