Chapter Nine
Valuation of Common Stocks
This chapter contains 24 multiple choice questions.
Multiple Choice
1. In a quote listing of stocks, the ________ is defined as the annualized dollar dividend
divided by the stock’s price, and is usually expressed as a percentage.
(a) cash dividend
(b) dividend payout
(c) dividend coverage
(d) dividend yield
Answer: (d)
2. The value of common stock is determined by which of the following expected cash
flows?
(a) dividends and interest payments
(b) dividends and maturity value of stock
(c) dividends and net cash flows from operations of the firm
(d) interest payments and maturity value
Answer: (c)
3. The ________ of dividends is the most basic assumption underlying the discounted
dividend model.
(a) industry average
(b) non-constant growth
(c) constant growth
(d) variability
Answer: (c)
4. IOU stock is expected to pay a dividend of $1.67 a year from now, and its dividends are
not expected to grow in the foreseeable future. If the market capitalization rate is 7%,
what is the current price of a share of IOU stock?
(a) $11.69
(b) $23.86
(c) $116.90
(d) $238.60
Answer: (b)
5. Avacor stock is expected to pay a dividend of $1.89 a year from now, and its dividends
are expected to grow at a constant rate of 5% per year thereafter. If the market
capitalization rate is 14% per year, what is the current price of a share of Avacor stock?
(a) $13.50
(b) $18.90
(c) $21.00
(d) $37.80
Answer: (c)
6. In the DDM model, if D1 and k are held constant, what will happen to the price of a stock
if the constant growth rate gets higher?
(a) the price of the stock will be higher
(b) the price of the stock will hold constant
(c) the price of the stock will be lower
(d) it cannot be determined from the information given
Answer: (a)
7. Consider a firm called Nowhere Corporation, whose earnings per share are $12. The firm
invests an amount each year that is just sufficient to replace the production capacity that
is wearing out, and so the new investment is zero. The firm pays out all its earnings as
dividends. Calculate the price of a share of Nowhere Corporation stock, give that k =
14%.
(a) $168.00
(b) $166.67
(c) $85.71
(d) $82.40
Answer: (c)
8. What adds value to the current price of a share of stock is ________.
(a) growth per se
(b) tax advantages
(c) investment opportunities that earn rates of return > k
(d) all of the above
Answer: (c)
9. In order to evaluate the stock of The Rendell-Vine Corporation, an analyst uses the
constant growth discounted dividend model. Expected earnings of $12 per share is
assumed, as are an earnings retention rate of 70% and an expected rate of return on future
investments of 17% per year. If the market capitalization rate is 14% per year, what is the
implied net present value of future investments?
(a) $314.29
(b) $281.64
(c) $171.43
(d) $85.72
Answer: (d)
10. Firms with consistently high P/E multiples are interpreted to have either relatively
________ market capitalization rates or relatively ________ present value of value-added
investments.
(a) low; low
(b) high; high
(c) high; low
(d) low; high
Answer: (d)
11. In a ________ the company pays cash to buy shares of its stock in the stock market,
thereby reducing the number of shares outstanding.
(a) cash dividend
(b) share repurchase
(c) stock split
(d) a and b
Answer: (b)
12. SureBet Corporation has total assets with a market value of $15 million: $3 million in
cash and $12 million in other assets. The market value of its debt is $3 million; of its
equity $12 million. There are 1,000,000 shares of SureBet common stock outstanding,
each with a market price of $12. If SureBet distributes a cash dividend of $1.50 per share,
the market value of its assets and of its equity ________ by ________.
(a) increases; $1.5 million
(b) increases; $10.5 million
(c) decreases; $1.5 million
(d) decreases; $10.5 million
Answer: (c)
13. “Frictions” that can cause a firm’s dividend policy to have an effect on the wealth of
shareholders include:
(a) regulations
(b) taxes
(c) cost of external finance
(d) all of the above
Answer: (d)
14. From the perspective of a shareholder with regard to personal taxation, it is always
________ for the corporation to pay out cash by ________.
(a) better; cash dividends
(b) worse; cash dividends
(c) worse; share repurchases
(d) it varies according to the situation
Answer: (b)
15. Raising cash by issuing new stock is ________ to the corporation than raising cash by
foregoing the payments of dividends.
(a) is less costly
(b) is more costly
(c) is no different
(d) just as costly
Answer: (b)
16. Beazley Inc. just paid a dividend of $3.00 per share. This dividend is expected to grow at
a supernormal rate of 15 percent per year for the next two years. It is then expected to
grow at a rate of 6 percent per year forever. The appropriate discount rate for Beazley’s
stock is 17 percent. What is the price of the stock?
(a) $17.64
(b) $27.27
(c) $33.78
(d) $46.15
Answer: (c)
17. If you use the constant dividend growth model to value a stock, which of the following is
certain to cause you to increase your estimate of the current value of the stock?
(a) Decreasing the required rate of return for the stock
(b) Decreasing the estimate of the amount of next year’s dividend
(c) Decreasing the expected dividend growth rate
(d) All of the above
Answer: (a)
18. CarsonCorp just paid an annual dividend of $3.00. Dividends are expected to grow at a
constant rate forever. The price of the stock is currently $63.00. The required rate of
return for this stock is 15 percent. What is the expected growth rate of CarsonCorp’s
dividend?
(a) 5.00%
(b) 5.48%
(c) 6.33%
(d) 10.00%
Answer: (a)
19. A firm’s common stock is trading at $80 per share. In the past the firm has paid a constant
dividend of $6 per share. However, the company has just announced new investments that
the market did not know about. The market expects that with these new investments, the
dividends should grow at 4% per year forever. Assuming that the discount rate remains
the same, what will be the price of the stock after the announcement?
(a) $94.50
(b) $156.00
(c) $171.43
(d) $178.29
Answer: (d)
20. According to the constant growth model of stock valuation, capital appreciation in
common stock is a direct result of ________.
(a) growth in future dividends
(b) a reduction in the required rate of return
(c) growth in corporate assets
(d) a growth rate that exceeds the required rate of return
Answer: (a)
Questions 21 through 24 refer to the following information:
New competition in Acme Unlimited’s market is going to have an impact on the
growth of the firm’s dividends. A current dividend of $1.50 was paid yesterday, and
this dividend is expected to increase by 35% in the first year. After that point, the
growth in dividends is expected to “decay” to the firm’s long run constant growth of
5%. Such a “decay” process is one in which dividend growth declines by 10
percentage points per year up to the point where the expected constant rate of
dividend growth is reached. So, year 2 dividend will be 25 percent higher than year 1,
year 3 dividend will be 15 percent higher, and after year 3, dividends will grow by 5
percent forever. Assume that investors require a rate of return of 17 on Acme
Unlimited’s stock.
21. Calculate the dividend in year 2.
(a) $2.54
(b) $2.92
(c) $3.21
(d) $3.30
Answer: (a)
22. Calculate the dividend in year 4.
(a) $2.35
(b) $2.54
(c) $3.21
(d) $3.53
Answer: (c)
23. Determine the price of Acme Unlimited’s stock at the end of year 3 (just after the
dividend has been paid).
(a) $22.13
(b) $26.75
(c) $29.67
(d) $34.24
Answer: (b)
24. Calculate the current price of Acme Unlimited’s stock.
(a) $22.13
(b) $26.75
(c) $29.67
(d) $34.24
Answer: (a)
