Chapter 7 - Stock Valuation

Chapter
7
Stock Valuation
Learning Goal 1: Differentiate between debt and equity capital.
7.1.1) Holders of equity have claims on both income and assets that are secondary to the claims of
creditors.
Answer: TRUE
Topic: Contrasting Debt and Equity
7.1.2) The tax deductibility of interest lowers the cost of debt financing, thereby causing the cost of
debt financing to be lower than the cost of equity financing.
Answer: TRUE
7.1.3) Unlike creditors, equity holders are owners of the firm.
Answer: TRUE
7.1.4) Unlike equity holders, creditors are owners of the firm.
Answer: FALSE
7.1.5) Interest paid to bondholders is tax deductible but interest paid to stockholders is not.
Answer: FALSE
7.1.6) Interest paid to bondholders is tax deductible but dividends paid to stockholders is not.
Answer: TRUE
7.1.7) In the case of liquidation, common stockholders are paid first, followed by preferred
stockholders, followed by bondholders.
Answer: FALSE
7.1.8) In the case of liquidation, bondholders are paid first, followed by preferred stockholders,
followed by common stockholders.
Answer: TRUE
7.1.9) Equity capital can be raised through
A) the money market.
B) the NYSE bond market.
C) retained earnings and the stock market.
D) a private placement with an insurance company as the creditor.
Answer: C
Topic: Issuing Common Stock
230 Gitman · Principles of Managerial Finance, 12e
7.1.10) Holders of equity capital
A) own the firm.
B) receive interest payments.
C) receive guaranteed income.
D) have loaned money to the firm.
Answer: A
Topic: Features of Common Stock
7.1.11) As a form of financing, equity capital
A) has a maturity date.
B) is only liquidated in bankruptcy.
C) is temporary.
D) has priority over bonds.
Answer: B
7.1.12) If bankruptcy were to occur, stockholders would have prior claim on assets over
A) preferred stockholders.
B) secured creditors.
C) unsecured creditors.
D) no one.
Answer: D
7.1.13) Which of the following terms typically applies to common stock but not to preferred stock?
A) Par value.
B) Dividend yield.
C) Legally considered as equity in the firm.
D) Voting rights.
Answer: D
Topic: Contrasting Common and Preferred Stock
7.1.14) Key differences between common stock and bonds include all of the following EXCEPT
A) common stockholders have a voice in management; bondholders do not.
B) common stockholders have a senior claim on assets and income relative to bondholders.
C) bonds have a stated maturity but stock does not.
D) interest paid to bondholders is tax-deductible but dividends paid to stockholders are not.
Answer: B
Topic: Contrasting Common Stock and Bonds
7.1.15) Key differences between common stock and bonds include all of the following EXCEPT
A) common stockholders have a voice in management; bondholders do not.
B) common stockholders have a junior claim on assets and income relative to bondholders.
C) bonds have a stated maturity but stock does not.
D) dividends paid to bondholders are tax-deductible but interest paid to stockholders is not.
Answer: D
Topic: Contrasting Common Stock and Bonds
Chapter 7 Stock Valuation 231
Learning Goal 2: Discuss the rights, characteristics, and features of both common and
preferred stock.
7.2.1) Preferred stock is a special form of stock having a fixed periodic dividend that must be paid
prior to payment of any interest to outstanding bonds.
Answer: FALSE
Topic: Features of Preferred Stock
7.2.2) Cumulative preferred stocks are preferred stocks for which all passed (unpaid) dividends in
arrears must be paid in additional shares of preferred stock prior to the payment of dividends
to common stockholders.
Answer: FALSE
7.2.3) Preferred stock has characteristics of debt since it provides a fixed periodic cash payment.
Answer: TRUE
7.2.4) The amount of the claim of preferred stockholders in liquidation is normally equal to the
market value of the preferred stock.
Answer: FALSE
7.2.5) Cumulative preferred stocks are preferred stocks for which all passed (unpaid) dividends in
arrears must be paid along with the current dividend prior to the payment of dividends to
common stockholders.
Answer: TRUE
7.2.6) Because preferred stock is a form of ownership and has no maturity date, its claims on income
and assets are secondary to those of the firmʹs creditors.
Answer: TRUE
7.2.7) One advantage of preferred stock is its ability to increase leverage, which in turn will magnify
the effects of increased earnings on common stockholdersʹ returns.
Answer: TRUE
7.2.8) A preferred stockholder is sometimes referred to as a residual owner, since in essence he or she
receives what is leftthe residualafter all other claims on the firmʹs income and assets have
been satisfied.
Answer: FALSE
7.2.9) A call feature is a feature that allows preferred stockholders to change each share into a stated
number of shares of common stock.
Answer: FALSE
7.2.10) The cost of preferred stock financing is generally higher than that of debt financing.
Answer: TRUE
7.2.11) The cost of preferred stock financing is generally higher than that of debt financing because
unlike the payment of interest to bondholders, the payment of dividends to preferred
stockholders is not guaranteed, and interest on debt is tax-deductible whereas preferred stock
dividend is not.
Answer: TRUE
7.2.12) Although preferred stock provides added financial leverage in much the same way as bonds, it
differs from bonds in that the issuer can pass a dividend payment without suffering the
consequences that result when an interest payment is missed on a bond.
Answer: TRUE
7.2.13) Preferred stockholders are often referred to as residual claimants.
Answer: FALSE
7.2.14) Common stockholders are often referred to as residual claimants.
Answer: TRUE
7.2.15) Common stock can be either privately or publicly owned.
Answer: TRUE
7.2.16) Like bonds, common stock is usually sold with a par value.
Answer: TRUE
7.2.17) Like bonds, the par value on a common stock is used as a basis for determining its fixed
dividend.
Answer: FALSE
7.2.18) The number of authorized shares of common stock is always greater than or equal to the
number of outstanding shares of common stock.
Answer: TRUE
7.2.19) The number of outstanding shares of common stock is always greater than or equal to the
number of authorized shares of common stock.
Answer: FALSE
7.2.20) Supervoting shares of common stock provide shareholders with ten times the voting power of
ordinary shares of common stock.
Answer: FALSE
Topic: Common Stock Voting
7.2.21) Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividends are subject to a
maximum tax rate of 20 percent.
Answer: FALSE
7.2.22) Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividends are subject to a
maximum tax rate of 15 percent.
Answer: TRUE
7.2.23) ________ are promised a fixed periodic dividend that must be paid prior to paying any
common stock dividends.
A) Preferred stockholders
B) Common stockholders
C) Bondholders
D) Creditors
Answer: A
7.2.24) Dividends in arrears that must be paid to the preferred stockholders before payment of
dividends to common stockholders are
A) cumulative.
B) noncumulative.
C) participating.
D) convertible.
Answer: A
7.2.25) An 8 percent preferred stock with a market price of $110 per share and a $100 par value pays a
cash dividend of ________.
A) $4.00
B) $8.00
C) $8.80
D) $80.00
Answer: B
7.2.26) From the corporationʹs point of view, the advantages of issuing preferred stock include all of
the following EXCEPT
A) its increased financial leverage.
B) its flexible dividend policy.
C) its excellent merger security.
D) its difficulty to retire.
Answer: D
7.2.27) The advantages of issuing preferred stock from the common stockholderʹs perspective include
all of the following EXCEPT
A) seniority of preferred stockholderʹs claim over common stockholders.
B) flexibility.
C) use in mergers.
D) increased leverage.
Answer: A
7.2.28) The cost of preferred stock is
A) lower than the cost of long-term debt.
B) higher than the cost of common stock.
C) higher than the cost of long-term debt and lower than the cost of common stock.
D) lower than the cost of convertible long-term debt and higher than the cost of common
stock.
Answer: C
7.2.29) All of the following features may be characteristic of preferred stock EXCEPT
A) callable.
B) no maturity date.
C) tax-deductible dividends.
D) convertible.
Answer: C
7.2.30) All of the following are characteristics of preferred stock EXCEPT
A) it is often considered quasi-debt due to fixed payment obligation.
B) it has less restrictive covenants than debt.
C) it gives the holder voting rights which permit selection of the firmʹs directors.
D) its holders have priority over common stockholders in the liquidation of assets.
Answer: C
7.2.31) A firm has issued cumulative preferred stock with a $100 par value and a 12 percent annual
dividend. For the past two years, the board of directors has decided not to pay a dividend. The
preferred stockholders must be paid ________ prior to paying the common stockholders.
A) $ 0/share
B) $12/share
C) $24/share
D) $36/share
Answer: D
Topic: Cumulative Preferred Stock
7.2.32) A firm has an outstanding issue of 1,000 shares of preferred stock with a $100 par value and an
8 percent annual dividend. The firm also has 5,000 shares of common stock outstanding. If the
stock is cumulative and the board of directors has passed the preferred dividend for the prior
two years, how much must the preferred stockholders be paid prior to paying dividends to
common stockholders?
A) $ 8,000
B) $16,000
C) $24,000
D) $25,000
Answer: C
Topic: Cumulative Preferred Stock
7.2.33) A violation of preferred stock restrictive covenants usually permits preferred shareholders to
A) force the company into bankruptcy.
B) sell their shares.
C) force the retirement of the preferred stock at or above its par value.
D) force the company to repurchase the shares at a stated amount below par.
Answer: C
7.2.34) Which of the following is false?
A) The common stock of a corporation can be either privately or publicly owned.
B) Firms often issue common stock with no par value.
C) Preemptive rights often result in a dilution of ownership.
D) A firmʹs corporate charter indicates how many authorized shares it can issue.
Answer: C
7.2.35) Which of the following is false?
A) The common stock of a corporation can only be publicly owned.
B) Firms often issue common stock with no par value.
C) Preemptive rights help to prevent a dilution of ownership on the part of existing
shareholders.
D) A firmʹs corporate charter indicates how many authorized shares it can issue.
Answer: A
7.2.36) A proxy statement is
A) a statement giving the votes of a stockholder to the CEO.
B) a statement giving the votes of a stockholder to the board of directors.
C) a statement giving the votes of a stockholder to another party.
D) none of the above.
Answer: C
7.2.37) An ADR is
A) a claim issued by a U.S. bank representing ownership of shares of a foreign companyʹs
stock held on deposit by the U.S. bank and is issued in dollars to U.S. investors.
B) a claim issued by a foreign bank representing ownership of shares of a foreign companyʹs
stock held on deposit by the foreign bank and is issued in dollars to U.S. investors.
C) a claim issued by a U.S. bank representing ownership of shares of a U.S. companyʹs stock
held on deposit by the U.S. bank and is issued in dollars to U.S. investors.
Answer: A
Topic: American Depositary Receipt
7.2.38) Preferred stockholders
A) do not have preference over common stockholders in the case of liquidation.
B) do have preference over bondholders in the case of liquidation.
C) do not have preference over bondholders in the case of liquidation.
D) Two of the above are true statements.
Answer: C
Topic: Preferred Stockholder Rights
7.2.39) Which of the following is usually a right of a preferred stockholder?
A) Right to convert shares to common stock on demand.
B) Preemptive right to participate in the issuance of new common shares.
C) Right to receive dividend payments before any dividends are paid to common
stockholders.
D) Right to sue company in bankruptcy proceedings if promised preferred dividends are not
paid.
Answer: C
Topic: Preferred Stockholder Rights
7.2.40) Which of the following is not typically a feature of preferred stock?
A) Most preferred pay dividends that grow at a constant rate.
B) Most preferred stock is cumulative.
C) Preferred stock is generally callable.
D) Preferred stock is typically convertible.
Answer: A
7.2.41) Which of the following is not typically a feature of common stock?
A) Most common stock is callable.
B) Most common stock is cumulative.
C) Common stock may or may not pay dividends.
D) More than one of the above statements is not true of common stock.
Answer: D
7.2.42) C. Edward Accounting Services has an outstanding issue of 1,000 shares preferred stock with a
$100 par value, an 8 percent annual dividend, and 5,000 shares of common stock outstanding.
If the stock is cumulative and the board of directors has passed the preferred dividend for the
last two years, how much must preferred stockholders be paid prior to paying dividends to
common stockholders?
Answer: $8,000 × 2 = $16,000 for the two prior years plus $8,000 for the current year.
Learning Goal 3: Describe the process of issuing common stock, including venture capital,
going public, and the investment banker, and interpreting stock quotations.
7.3.1) The claims of equity holders on the firmʹs income can not be paid until the claims of all
creditors have been satisfied. But, the claims of the equity holders on the firmʹs assets have
priority over the claims of creditors because the equity holders are the owners of the firm.
Answer: FALSE
7.3.2) Preemptive rights allow common stockholders to maintain their proportionate ownership in
the corporation when new issues are made.
Answer: TRUE
7.3.3) Stock rights allow stockholders to purchase additional shares of stock in direct proportion to
the number of shares they own.
Answer: TRUE
7.3.4) Corporate venture capital funds are subsidiaries of financial institutions, particularly banks, set
up to help young firms grow and, it is hoped, become major customers of the institutions.
Answer: FALSE
Topic: Venture Capital
7.3.5) Small business investment companies (SBICs) are corporations chartered by the federal
government that can borrow at attractive rates from the U.S. Treasury and use the funds to
make venture capital investments in private companies.
Answer: TRUE
7.3.6) Angel capitalists or angels are wealthy individual investors who do not operate as a business
but invest in early-stage companies in exchange for a portion of equity.
Answer: TRUE
7.3.7) The free cash flow valuation model can be used to determines the value of an entire company
as the present value of its expected free cash flows discounted at the firmʹs weighted average
cost of capital.
Answer: TRUE
Topic: Free Cash Flow Model
7.3.8) A common stockholder has no guarantee of receiving any cash inflows, but receives what is left
after all other claims on the firmʹs income and assets have been satisfied.
Answer: TRUE
7.3.9) Preferred stock that provides for dividend payments based on certain formulas allowing
preferred stockholders to participate with common stockholders in the receipt of dividends
beyond a specified amount is called cumulative preferred stock.
Answer: FALSE
7.3.10) Preemptive rights allow existing shareholders to maintain voting control and protect against
the dilution of their ownership.
Answer: TRUE
7.3.11) American Depositary Receipts (ADRs) are claims issued by U.S. banks representing ownership
of shares of a foreign companyʹs stock held on deposit by the U.S. bank in the foreign market
and issued in dollars to U.S. investors.
Answer: TRUE
Topic: American Depositary Receipt
7.3.12) Treasury stock generally does not have voting rights, does not earn dividends, and does not
have a claim on assets in liquidation.
Answer: TRUE
Topic: Treasury Stock
7.3.13) Treasury stock is generally reclassified as class B common stock and has voting rights.
Answer: FALSE
7.3.14) Firms occasionally repurchase stock in order to alter capital structure or to increase the returns
to the owners.
Answer: TRUE
7.3.15) Dilution of ownership occurs when a new stock issue results in each present stockholder
having a larger number of shares and, thus, a claim to a larger part of the firmʹs earnings than
previously.
Answer: FALSE
7.3.16) A prospectus is another term for a firmʹs annual report showing the firmʹs prospects for the
coming year.
Answer: FALSE
7.3.17) A prospectus is a portion of the security registration statement that describes the key aspects of
the issue, the issuer, and its management and financial position.
Answer: TRUE
7.3.18) An underwritten issue of common stock is one in which the firm purchases insurance to cover
unexpected losses suffered by shareholders.
Answer: FALSE
7.3.19) In a common stock quotation, the term ʺYLD %ʺ stands for dividend yield and can be found by
dividing the stockʹs annual dividend by its PE ratio.
Answer: FALSE
Topic: Common Stock Quotations
7.3.20) In a common stock quotation, the term ʺYLD %ʺ stands for dividend yield and can be found by
dividing the stockʹs annual dividend by most recent closing price.
Answer: TRUE
7.3.21) The opportunity for management to purchase a certain number of shares of their firmʹs
common stock at a specified price over a certain period of time is a
A) stock option.
B) warrant.
C) pre-emptive right.
D) stock right.
Answer: A
7.3.22) Another term sometimes applied to a common shareholder is a
A) fundamental or basic owner of the firm.
B) residual owner of the firm.
C) net owner of the firm.
D) reciprocal owner of the firm.
Answer: B
7.3.23) Regarding the tax treatment of payments to securities holders, it is true that ________, while
________.
A) interest and preferred stock dividends are not tax-deductible; common stock dividends
are tax deductible
B) interest and preferred stock dividends are tax-deductible; common stock dividends are
not tax-deductible
C) common stock dividends and preferred stock dividends are tax -deductible; interest is not
tax-deductible
D) common stock dividends and preferred stock dividends are not tax-deductible; interest is
tax-deductible
Answer: D
7.3.24) Shares of stock currently owned by the firmʹs shareholders are called
A) authorized.
B) issued.
C) outstanding.
D) treasury shares.
Answer: C
7.3.25) If a firm has class A and class B common stock outstanding, it means that
A) each class receives a different dividend.
B) the par value of each class is different.
C) the dividend paid to one of the classes is tax deductible by the corporation.
D) one of the classes is probably non-voting stock.
Answer: D
7.3.26) Common stockholders expect to earn a return by receiving
A) semiannual interest.
B) fixed periodic dividends.
C) dividends.
D) annual interest.
Answer: C
7.3.27) All of the following are examples of marketable securities EXCEPT
A) common stock.
B) a Treasury bill.
C) commercial paper.
D) a negotiable certificate of deposit.
Answer: A
Topic: Marketable Securities
7.3.28) ________ is hired by a firm to find prospective buyers for its new stock or bond issue.
A) A securities analyst
B) A trust officer
C) A commercial loan officer
D) An investment banker
Answer: D
Topic: Investment Banking
7.3.29) A professional involved in analyzing securities and constructing investment portfolios is called
A) an investment banker.
B) a controller.
C) an installment loan officer.
D) a securities analyst or securities broker.
Answer: D
7.3.30) The ________ are sometimes referred to as the residual owners of the corporation.
A) preferred stockholders
B) unsecured creditors
C) common stockholders
D) secured creditors
Answer: C
7.3.31) Treasury stock results from the
A) firm selling stock for greater than its par value.
B) cumulative feature on preferred stock.
C) repurchase of outstanding stock.
D) authorization of additional shares of stock by the board of directors.
Answer: C
7.3.32) The purpose of nonvoting common stock is to
A) limit the voting power of the management.
B) allow the minority interest to elect one director.
C) raise capital without giving up any voting rights.
D) give preference on distribution of earnings to those shareholders who own the stock.
Answer: C
7.3.33) A proxy statement gives the shareholder the right
A) of one vote for each share owned.
B) to give up their vote to another party.
C) to maintain their proportionate ownership in the corporation when new common stock is
issued.
D) to sell their share of stock at a premium.
Answer: B
7.3.34) A proxy battle is the attempt by
A) the creditors of a bankrupt firm to seize assets.
B) the management to dismiss the board of directors.
C) a nonmanagement group to gain control of the management of a firm through the
solicitation of a sufficient number of corporate votes.
D) the employees to unionize.
Answer: C
7.3.35) Because equity holders are the last to receive any distribution of assets as a result of
bankruptcy proceedings, common stockholders expect
A) fixed dividend payments.
B) greater compensation in the form of dividends and/or rising stock prices.
C) all profits to be paid out in dividends.
D) warrants to be attached to the stock issue as a sweetener.
Answer: B
7.3.36) The attempt by a non-management group to gain control of the management of a firm by
soliciting a sufficient number of proxy votes is called
A) hostile takeover.
B) supervoting shares.
C) proxy battle.
Answer: C
7.3.37) The disadvantages of issuing common stock versus long -term debt include all of the following

EXCEPT
A) the potential dilution of earnings.
B) high cost.
C) no maturity date on which the par value of the issue must be repaid.
D) the market perception that management thinks the firm is over-valued, causing a decline
in stock price.
Answer: C
7.3.38) The par value on common stock has all of the following characteristics EXCEPT
A) a generally low value.
B) some states tax according to the par value.
C) indicates the market value at which the stock was originally sold.
D) stated in the corporate charter.
Answer: C
7.3.39) A firm issued 5,000 shares of $1 par-value common stock, receiving proceeds of $20 per share.
The accounting entry for the paid-in capital in excess of par account is
A) $5,000.
B) $ 95,000.
C) $100,000.
D) $0.
Answer: B
Topic: Accounting for Common Stock
7.3.40) A firm issued 10,000 shares of $2 par-value common stock, receiving proceeds of $40 per share.
The accounting entry for the paid-in capital in excess of par account is
A) $200,000.
B) $380,000.
C) $400,000.
D) $800,000.
Answer: B
7.3.41) A firm issued 10,000 shares of no par-value common stock, receiving proceeds of $40 per
share. The accounting entry is
A) $0 in the common stock account.
B) $0 in the paid-in capital in excess of par account.
C) $400,000 in the common stock account.
D) $400,000 in the paid-in capital in excess of par account.
Answer: C
7.3.42) Advantages of issuing common stock versus long-term debt include all of the following
EXCEPT
A) the effects of dilution on earnings and voting power.
B) no maturity.
C) increases firmʹs borrowing power.
D) no fixed payment obligation.
Answer: A
7.3.43) All of the following are characteristics of common stock EXCEPT
A) voting rights which permit selection of the firmʹs directors.
B) claims on income and assets which are subordinate to the creditors of the firm.
C) fully tax-deductible dividends.
D) no fixed payment obligation.
Answer: C
7.3.44) Stock rights provide the stockholder with
A) certain purchase privileges of additional stock shares in direct proportion based on their
number of owned shares.
B) the right to elect the board of directors.
C) cumulative voting privileges.
D) the opportunity to receive extraordinary earnings.
Answer: A
7.3.45) The preemptive right gives the shareholder the right
A) of one vote for each share owned.
B) to give up their vote to another party.
C) to maintain their proportionate ownership in the corporation when new common stock is
issued.
D) to sell their share of stock at a premium.
Answer: C
7.3.46) The investment banker does all of the following EXCEPT
A) make long-term investments for banking institutions.
B) bear the risk of selling a security issue.
C) act as a middleman between the issuer and buyer of a new security.
D) advise clients.
Answer: A
7.3.47) A firm has the balance sheet accounts, common stock, and paid -in capital in excess of par, with

values of $10,000 and $250,000, respectively. The firm has 10,000 common shares outstanding.
If the firm had a par value of $1, the stock originally sold for
A) $24/share.
B) $25/share.
C) $26/share.
D) $30/share.
Answer: C
7.3.48) A firm has the balance sheet accounts, common stock, and paid -in capital in excess of par, with

values of $40,000 and $500,000, respectively. The firm has 40,000 common shares outstanding.
If the firm had a par value of $1, the stock originally sold for
A) $11.50/share.
B) $12.50/share.
C) $13.50/share.
D) $15.50/share.
Answer: C
7.3.49) All of the following are true about the issuance of non -voting common stock EXCEPT

A) it has been issued as a defense against an unfriendly takeover.
B) it has been issued when the corporation wishes to raise capital through the sale of
common stock, but does not want to relinquish its voting control.
C) it tends to result in unequal voting rights among the shareholders.
D) it tends to result in the dilution of voting rights of current stockholders.
Answer: D
7.3.50) A group formed by an investment banker to share the financial risk associated with
underwriting new securities is a(n)
A) underwriting syndicate.
B) selling group.
C) investment banking consortium.
D) broker pool.
Answer: A
Topic: Issuing Securities
Table 7.1
52-WEEK YLD VOL NET

YTD %CHG HI HO STOCK (SYM) Div % PE 100s CLOSE CHG
-5.1 48.72 20.10 FORD (F) 1.00 3.3 18 20,925 30.20 -0.56
7.3.51) According to Table 7.1, Fordʹs common stock must have closed at ________ per share on the
previous trading day.
A) $29.64
B) $30.76
C) $30.99
D) $31.55
Answer: B
7.3.52) According to Table 7.1, the expected dividend per share for Ford is
A) $0.25.
B) $1.00.
C) $2.00.
D) $3.30.
Answer: B
7.3.53) Referring to Table 7.1, if we assume that Fordʹs dividends will grow at a rate of 10 percent
forever, the required return on Fordʹs stock would be
A) 7.4%.
B) 8.9%.
C) 11.0%.
D) 13.6%.
Answer: D
7.3.54) Based on Table 7.1, Fordʹs earnings per share are
A) $0.80.
B) $1.21.
C) $1.68.
D) $1.91.
Answer: C
7.3.55) Based on the information given in Table 7.1, the number of shares of Ford that were traded on
the previous day was
A) 2,092.
B) 20,925.
C) 209,250.
D) 2,092,500.
Answer: D
7.3.56) Identify whether the key characteristic describes common stock (CS) or preferred stock (PS).
_____ 1. Source of financing which places minimum constraints on the firm.
_____ 2. Used often in mergers.
_____ 3. Potential dilution of earnings and voting power.
_____ 4. Fixed financial obligation.
_____ 5. Increases the firmʹs borrowing power.
_____ 6. May have cumulative and participating features.
_____ 7. May be convertible into another type of security.
_____ 8. Last to receive earnings or distribution of assets in the event of
bankruptcy.
_____ 9. Frequently includes a call feature.
Answer: 1. CS
2. PS
3. CS
4. PS
5. CS
6. PS
7. PS
8. CS
9. PS
Topic: Features of Preferred and Common Stock
7.3.57) Zheng Senʹs Chinese Take-Out had earnings before interest and taxes of $4,000,000 last year.

The firm has a marginal tax rate of 40 percent and currently has the following capital structure:
Total Capital
Source of Capital Amount Percentage of
Long-term Debt at 12% $8,000,000 25%
Preferred Stock at 14% 8,000,00 25
Common Stock Equity
(2,000,000 shares outstanding) 16,000,000 50
$32,000,000 100%
(a) Calculate the firmʹs after-tax return on equity (ROE) and earnings per share (EPS).
(b) If the firm retires $4,000,000 of preferred stock using the proceeds from an equal increase in
long-term debt, what would have been the after -tax return on equity (ROE) and earnings per
share (EPS)?
(c) If the firm retires $4,000,000 of preferred stock using the proceeds from the sale of 500,000
shares of common stock, what would have been the after -tax return on equity (ROE) and
earnings per share (EPS)?
Answer: (a)
EBIT $4,000,000 ROE** = 1,824,000/24,000,000
Interest* 960,000 = 7.6%
EBT $3,040,000 EPS*** = 704,000/2,000,000
Taxes (40%) 1,216,000 = $0.3520
EAT $1,824,000
Preferred Div 1,120,000
EAC $ 704,000
* $8,000,000 × 0.12 = $960,000
** ROE = Net Profits after Taxes/Stockholdersʹ Equity
(where stockholdersʹ equity includes preferred stock).
*** EPS = EAC/Common share outstanding
(b)
EBIT $4,000,000 ROE = 1,536,000/20,000,000
Interest 1,440,000 = 7.7%
EBT $2,560,000 EPS = 976,000/2,000,000
Taxes (40%) 1,024,000 = $0.49
EAT $1,536,000
Preferred Div 560,000
EAC $ 976,000
(c)
EBIT $4,000,000 ROE = 1,824,000/24,000,000
Interest 960,000 = 7.6%
EBT $3,040,000 EPS = 1,264,000/2,500,000
Taxes (40%) 1,216,000 = $0.51
EAT $1,824,000
Preferred Div 560,000
EAC $1,264,000
Topic: ROE and EPS
Learning Goal 4: Understand the concept of market efficiency and basic common stock
valuation using zero-growth, constant-growth, and variable-growth
7.4.1) Investors purchase a stock when they believe that it is undervalued and sell when they feel that
it is overvalued.
Answer: TRUE
Topic: Market Efficiency
7.4.2) In an efficient market, the expected return and the required return are equal.
Answer: TRUE
7.4.3) To a buyer, an assetʹs value represents the minimum price that he or she would pay to acquire
it.
Answer: FALSE
7.4.4) If the expected return is less than the required return, investors will sell the asset, because it is
not expected to earn a return commensurate with its risk.
Answer: TRUE
7.4.5) If the expected return were above the required return, investors would buy the asset, driving
its price up and its expected return down.
Answer: TRUE
7.4.6) Efficient market hypothesis is the theory describing the behavior of an assumed ʺperfectʺ
market in which securities are typically in equilibrium, security prices fully reflect all public
information available and react swiftly to new information, and, because stocks are fairly
priced, investors need not waste time looking for mispriced securities.
Answer: TRUE
7.4.7) In an efficient market, stock prices adjust quickly to new public information.
Answer: TRUE
Topic: Efficient Market Theory
7.4.8) In an inefficient market, stock prices adjust quickly to new public information.
Answer: FALSE
7.4.9) In an inefficient market, securities are typically in equilibrium, which means that they are fairly
priced and that their expected returns equal their required returns.
Answer: FALSE
7.4.10) In an efficient market, securities are typically in equilibrium, which means that they are fairly
priced and that their expected returns equal their required returns.
Answer: TRUE
7.4.11) If a market is truly efficient, investors should not waste their time trying to find and capitalize
on mispriced securities.
Answer: TRUE
7.4.12) Behavioral finance is a growing body of research that focuses on investor behavior and its
impact on investment decisions and stock prices.
Answer: TRUE
7.4.13) The constant growth model is an approach to dividend valuation that assumes a constant
future dividend.
Answer: FALSE
Topic: Constant Growth Valuation Model
7.4.14) The constant growth model is an approach to dividend valuation that assumes that dividends
grow at a constant rate indefinitely.
Answer: TRUE
7.4.15) Preferred stock is valued as if it were a
A) fixed-income obligation.
B) bond.
C) perpetuity.
D) common stock.
Answer: C
Topic: Preferred Stock Valuation
7.4.16) A firm has an issue of preferred stock outstanding that has a stated annual dividend of $4. The
required return on the preferred stock has been estimated to be 16 percent. The value of the
preferred stock is ________.
A) $64
B) $16
C) $25
D) $50
Answer: C
Topic: Preferred Stock Valuation (Equation 7.3)
7.4.17) A firm has an expected dividend next year of $1.20 per share, a zero growth rate of dividends,
and a required return of 10 percent. The value of a share of the firmʹs common stock is
________.
A) $120
B) $10
C) $12
D) $100
Answer: C
Topic: Zero Growth Valuation Model (Equation 7.3)
7.4.18) A firm has an issue of preferred stock outstanding that has a par value of $100 and a 4%
dividend. If the current market price of the preferred stock is $50, the yield on the preferred
stock is ________.
A) 4.00%
B) 6.00%
C) 8.00%
D) none of the above
Answer: C
7.4.19) The ________ is utilized to value preferred stock.
A) constant growth model
B) variable growth model
C) zero-growth model
D) Gordon model
Answer: C
Topic: Preferred Stock Valuation
7.4.20) In the Gordon model, the value of the common stock is the
A) net value of all assets which are liquidated for their exact accounting value.
B) actual amount each common stockholder would expect to receive if the firmʹs assets are
sold, creditors and preferred stockholders are repaid, and any remaining money is
divided among the common stockholders.
C) present value of a non-growing dividend stream.
D) present value of a constant, growing dividend stream.
Answer: D
7.4.21) Emmy Lou, Inc. has an expected dividend next year of $5.60 per share, a growth rate of
dividends of 10 percent, and a required return of 20 percent. The value of a share of Emmy
Lou, Inc.ʹs common stock is ________.
A) $28.00
B) $56.00
C) $22.40
D) $18.67
Answer: B
Topic: Constant Growth Valuation Model (Equation 7.4 and 7.5)
7.4.22) A firm has experienced a constant annual rate of dividend growth of 9 percent on its common
stock and expects the dividend per share in the coming year to be $2.70. The firm can earn 12
percent on similar risk involvements. The value of the firmʹs common stock is ________.
A) $22.50/share
B) $9/share
C) $90/share
D) $30/share
Answer: C
7.4.23) A common stock currently has a beta of 1.3, the risk-free rate is an annual rate of 6 percent,
and the market return is an annual rate of 12 percent. The stock is expected to generate a
constant dividend of $5.20 per share. A toxic spill results in a lawsuit and potential fines, and
the beta of the stock jumps to 1.6. The new equilibrium price of the stock
A) will be $37.68.
B) will be $43.33.
C) will be $33.33.
D) cannot be determined from the information given.
Answer: C
7.4.24) A common stock currently has a beta of 1.7, the risk-free rate is 7 percent annually, and the
market return is 12 percent annually. The stock is expected to generate a constant dividend of
$6.70 per share. A pending lawsuit has just been dismissed and the beta of the stock drops to
1.4. The new equilibrium price of the stock
A) will be $55.83.
B) will be $43.23.
C) will be $47.86.
D) cannot be determined from the information given.
Answer: C
7.4.25) According to the efficient market theory,
A) prices of actively traded stocks can be under- or over-valued in an efficient market, and
bear searching out.
B) prices of actively traded stocks can only be under-valued in an efficient market.
C) prices of actively traded stocks do not differ from their true values in an efficient market.
D) prices of actively traded stocks can only be over-valued in an efficient market.
Answer: C
Topic: Efficient Markets
7.4.26) Economically rational buyers and sellers use their assessment of an assetʹs risk and return to
determine its value. Relative to this concept, which of the following is true?
A) To a buyer the assetʹs value represents the minimum price that he or she would pay to
acquire it.
B) To a seller the assetʹs value represents the maximum sale price.
C) To a buyer the assetʹs value represents the maximum price that he or she would pay to
acquire it.
D) The interaction of buyers and sellers can result in a value that differs from the stockʹs true
value.
Answer: C
Topic: Risk, Return and Market Efficiency
7.4.27) If expected return is less than required return on an asset, rational investors will
A) buy the asset, which will drive the price up and cause expected return to reach the level
of the required return.
B) sell the asset, which will drive the price down and cause the expected return to reach the
level of the required return.
C) sell the asset, which will drive the price up and cause the expected return to reach the
D) buy the asset, since price is expected to increase.
Answer: B
7.4.28) If the expected return is above the required return on an asset, rational investors will
A) buy the asset, which will drive the price up and cause expected return to reach the level
of the required return.
B) sell the asset, which will drive the price down and cause the expected return to reach the
C) sell the asset, which will drive the price up and cause the expected return to reach the
D) sell the asset, since price is expected to decrease.
Answer: A
7.4.29) Following the theory of the ʺefficient market hypothesisʺ all of the following are true EXCEPT
A) securities are typically in equilibrium, meaning they are fairly priced and their expected
returns equal their required returns.
B) insider trading scandals have proven that stocks are not fully and fairly priced; as a
result, it would be worthwhile for investors should spend time searching for mispriced
(over- or under-valued) stocks.
C) at any point in time, security prices fully reflect all public information available about the
firm and its securities, and these prices react swiftly to new information.
D) since stocks are fully and fairly price, it follows that investors should not waste their time
trying to find and capitalize on miss-priced (under- or over-valued) securities.
Answer: B
Topic: Efficient Markets
7.4.30) ________ in the beta coefficient normally causes ________ in the required return and therefore
________ in the price of the stock, all else remaining the same.
A) An increase; an increase; an increase
B) An increase; a decrease; an increase
C) An increase; an increase; a decrease
D) A decrease; a decrease; a decrease
Answer: C
Topic: Risk Return Relationship
7.4.31) You are planning to purchase the stock of Tedʹs Sheds Inc. and you expect it to pay a dividend
of $3 in 1 year, $4.25 in 2 years, and $6.00 in 3 years. You expect to sell the stock for $100 in 3
years. If your required return for purchasing the stock is 12 percent, how much would you pay
for the stock today?
A) $75.45
B) $77.24
C) $81.52
D) $85.66
Answer: C
Topic: Basic Valuation Model (Equation 7.2)
7.4.32) Nico Corporationʹs common stock is expected to pay a dividend of $3.00 forever and currently
sells for $21.42. What is the required rate of return?
A) 10%
B) 12%
C) 13%
D) 14%
Answer: D
7.4.33) Julian is considering purchasing the stock of Pepsi Cola because he really loves the taste of
Pepsi. What should Julian be willing to pay for Pepsi today if it is expected to pay a $2
dividend in one year and he expects dividends to growth at 5 percent indefinitely? Julian
requires a 12 percent return to make this investment.
A) $28.57
B) $29.33
C) $31.43
D) $43.14
Answer: A
7.4.34) Nico Corporationʹs common stock currently sells for $180 per share. Nico just paid a dividend
of $10.18 and dividends are expected to grow at a constant rate of 6 percent forever. If the
required rate of return is 12 percent, what will Nico Corporationʹs stock sell for one year from
now?
A) $190.80
B) $187.04
C) $195.40
D) $179.84
Answer: A
7.4.35) Tangshan China Companyʹs stock is currently selling for $80.00 per share. The expected
dividend one year from now is $4.00 and the required return is 13 percent. What is Tangshanʹs
dividend growth rate assuming that dividends are expected to grow at a constant rate forever?
A) 8%
B) 9%
C) 10%
D) 11%
Answer: A
7.4.36) Tangshan Chinaʹs stock is currently selling for $160.00 per share and the firmʹs dividends are
expected to grow at 5 percent indefinitely. Assuming Tangshan Chinaʹs most recent dividend
was $5.50, what is the required rate of return on Tangshanʹs stock?
A) 7.3%
B) 8.6%
C) 9.5%
D) 10.6%
Answer: B
7.4.37) Nico Custom Cyclesʹ common stock currently pays no dividends. The company plans to
begin paying dividends beginning 3 years from today. The first dividend will be $3.00 and
dividends will grow at 5 percent per year thereafter. Given a required return of 15 percent,
what would you pay for the stock today?
A) $25.33
B) $18.73
C) $29.86
D) $20.72
Answer: D
Topic: Variable Growth Valuation Model (Equation 7.6)
Question Status: Previous Edition
7.4.38) Jiaʹs Fashions recently paid a $2 annual dividend. The company is projecting that its
dividends will grow by 20 percent next year, 12 percent annually for the two years after that,
and then at 6 percent annually thereafter. Based on this information, how much should Jiaʹs
Fashions common stock sell for today if her required return is 10.5%?
A) $54.90
B) $60.80
C) $66.60
D) $69.30
Answer: C
7.4.39) The board of directors of the Scooter World, Inc. has declared $5.00 common stock dividend
and accepted a plan to freeze the dividend at $5 per year indefinitely. What is the value of the
Scooter Worldʹs common stock if the required rate of interest is 15 percent?
Answer: P = D/r = 5/0.15 = $33.33
7.4.40) Jiaʹs Kitchen Stuff has recently sold 1,000 shares of $6.75 preferred stock. What is the value of
the stock assuming 10 percent required rate of return?
Answer: P = D/r = 6.75/0.10 = $67.50
7.4.41) Aunt Tillyʹs Fur Company has been experiencing several years of financial difficulty and,
thus, has considered maintaining its dividend payment at $2.50 indefinitely. What is the
value of its common stock if the required rate of return is 8.5 percent?
Answer: P = D/r = 2.50/0.085 = $29.41
7.4.42) In response to the stock marketʹs reaction to its dividend policy, the Nicoʹs Toy Company has
decided to increase its dividend payment at a rate of 4 percent per year. The firmʹs most
recent dividend is $3.25 and the required rate of interest is 9 percent. What is the maximum
you would be willing to pay for a share of the stock?
Answer: P = D1/(r - g) = 3.25(1 + 0.04)/(0.09 - 0.04) = $67.60
7.4.43) Uncle Timʹs Inventions has an expected dividend next year of $3.60 and a required return of
12 percent. Calculate the value of a share of common stock assuming a zero growth rate of
dividends.
$3.60
Answer: = $30
0.12
7.4.44) Miaʹs Doll Company has an outstanding preferred issue of stock with a par value of $100 and
an annual dividend of 10 percent (of par). Similar risk preferred stocks are yielding an 11.5
percent annual rate of return.
(a) What is the current value of the outstanding preferred stock?
(b) What will happen to price as the risk-free rate increases? Explain.
Answer: (a) $10/0.115 = $86.96
(b) As the risk-free rate increases, the required rate of return will increase and the
price will drop.
7.4.45) Ted has 10 shares of the Menʹs Underwear Company. Based on the companyʹs dividend
policy, Ted will receive a total of $450 a year in perpetuity. What is the value of each share if
the rate of interest is 8 percent?
Answer: Dividend per share = 450/10 = $45
P = D/r = 45/0.08 = $562.50
7.4.46) The Bradshaw Companyʹs most recent dividend was $6.75. The historical dividend payment
by the company shows a constant growth rate of 5 percent per year. What is the maximum
you would be willing to pay for a share of its common stock if your required rate of return is
8 percent?
Answer: D1 = 6.75 (1 + 0.05) = $7.09
P = D1/(r - g) = 7.09/(0.08 - 0.05) = $236.33
7.4.47) Tinaʹs Medical Equipment Company paid $2.25 common stock dividend last year. The
companyʹs policy is to allow its dividend to grow at 5 percent per year indefinitely. What is
the value of the stock if the required rate of return is 8 percent?
Answer: P = D1/(r - g) = 2.25 (1 + 0.05)/(0.08 - 0.05) = $78.67
7.4.48) Colin recently purchased a block of 100 shares of Hayleyʹs Optical common stock for $6,000.
The stock is expected to provide an annual cash flow of dividends of $400 indefinitely.
Assuming a discount rate of 8 percent, how does the price Colin paid compare to the value of
the stock?
$400
Answer: The value of the stock is = = $5,000
0.08
Mr. Arthur paid $1,000 more than the value of the stock.
7.4.49) The Erie Heating Company has been very successful in the past four years. Over these years,
it paid common stock dividend of $4 in the first year, $4.20 in the second year, $4.41 in the
third year, and its most recent dividend was $4.63. The company wishes to continue this
dividend growth indefinitely. What is the value of the companyʹs stock if the required rate of
return is 12 percent?
Answer: FVIFg, 3 = 4.63/4.00 = 1.158 g = 5%
P = D5/(r - g) = 4.63 (1 + 0.05)/(0.12 - 0.05) = $69.46
Table 7.2
Year Dividends($)
2003 2.89
2002 2.53
2001 2.22
2000 1.95
1999 1.71
1998 1.50
7.4.50) Xiao Xin owns stock in a company which has paid the annual dividends shown in Table 7.2.
Calculate the growth rate of these dividends.
1.50
Answer: = 0.519
2.89
0.519 = PVIF
growth rate = 14%
7.4.51) Calculate the estimated dividend for 2004. (See Table 7.2.)
Answer: ($2.89)(1.14) = $3.29
7.4.52) The required return is assumed to be 17 percent. Using the Gordon model, calculate the per
share value of the stock. (See Table 7.2.)
$3.29
Answer: = $109.67
0.17 - 0.14
7.4.53) China America Manufacturing has a beta of 1.50, the risk-free rate of interest is currently 12
percent, and the required return on the market portfolio is 18 percent. The company plans to
pay a dividend of $2.45 per share in the coming year and anticipates that its future dividends
will increase at an annual rate consistent with that experienced over the 2001 -2003 period.
Year Dividend
2003 2.32
2002 2.21
2001 2.10
Estimate the value of China America Manufacturingʹs stock.
Answer: rs = 0.12 + 1.50(0.18 - 0.12)
= 0.21
growth rate of dividends:
2.23/2.10 = FVIF
1.105 5%
$2.45
Po = = $15.31
0.21 - 0.05
Topic: CAPM and Constant Growth Valuation Model (Equation 7.4, 7.5, and 7.9)
7.4.54) Julieʹs X-Ray Company paid $2.00 per share in common stock dividends last year. The
companyʹs policy is to allow its dividend to grow at 5 percent for 4 years and then the rate of
growth changes to 3 percent per year from year five and on. What is the value of the stock if
the required rate of return is 8 percent?
Answer:
t Do FVIF5%,t Dt PVIF8%,t PV
1 $2.00 1.050 $2.10 0.926 $1.94
2 2.00 1.102 2.20 0.857 1.89
3 2.00 1.158 2.32 0.794 1.84
4 2.00 1.216 2.43 0.735 1.79
P1 = $7.46
D5 = 2.43 (1 + 0.03) = $2.50
2.50 1
P2 = × = $36.75
0.08 - 0.03 (1 + 0.08)^4
Value of stock = $36.75 + $7.46 = $44.21
7.4.55) Compute the value of a share of common stock of Lexiʹs Cookie Company whose most recent
dividend was $2.50 and is expected to grow at 3 percent per year for the next 5 years, after
which the dividend growth rate will increase to 6 percent per year indefinitely. Assume 10
percent required rate of return.
Answer:
t Do FVIF5%,t Dt PVIF8%,t PV
1 $2.50 1.030 $2.58 0.909 $2.35
2 2.50 1.061 2.65 0.826 2.19
3 2.50 1.093 2.73 0.751 2.05
4 2.50 1.126 2.82 0.683 1.93
5 2.50 1.159 2.90 0.621 1.80
P1 = $10.32
D6 = 2.90 (1 + 0.06) = $3.07
3.07 1
P2 = × = $47.66
0.10 - 0.06 (1 + 0.10)^5
Value of stock = $47.66 + $10.32 = $57.98
Learning Goal 5: Discuss the free cash flow valuation model and the book value, liquidation
value, and price/earnings (P/E) multiple approaches.
7.5.1) In valuation of common stock, the price/earnings multiple approach is considered superior to
the use of book or liquidation values since it considers expected earnings.
Answer: TRUE
Topic: P/E Multiple Approach
7.5.2) The common stock book value model ignores the firmʹs expected earnings potential and
generally lacks any true relationship to the firmʹs value in the marketplace.
Answer: TRUE
Topic: Book Value Approach
7.5.3) The free cash flow valuation model is based on the same principle as the P/E valuation
approach; that is, the value of a share of stock is the present value of future cash flows.
Answer: FALSE
7.5.4) The free cash flow valuation model is based on the same principle as dividend valuation
models; that is, the value of a share of stock is the present value of future cash flows.
Answer: TRUE
7.5.5) The liquidation value per share of common stock is the amount per share of common stock that
would be received if all of the firmʹs assets were sold for their accounting value and the
proceeds remaining were divided among common stockholders.
Answer: FALSE
Topic: Liquidation Value
7.5.6) The book value per share of common stock is the amount per share of common stock that
would be received if all of the firmʹs assets were sold for their accounting value and the
proceeds remaining were divided among common stockholders.
Answer: TRUE
Topic: Book Value
7.5.7) ________ is the value of the firmʹs ownership in the event that all assets are sold for their exact
accounting value and the proceeds remaining after paying all liabilities (including preferred
stock) are divided among common stockholders.
A) Liquidation value
B) Book value
C) The P/E multiple
D) The present value of the common stock
Answer: B
Topic: Book Value of Stock
7.5.8) ________ is the actual amount each common stockholder would expect to receive if the firmʹs
assets are sold, creditors and preferred stockholders are repaid, and any remaining money is
divided among the common stockholders.
B) Book value
C) The P/E multiple
D) The present value of the dividends
Answer: A
Topic: Liquidation Value of Stock
7.5.9) ________ is a guide to the firmʹs value if it is assumed that investors value the earnings of a
given firm in the same way they do the average firm in the industry.
B) Book value
C) The P/E multiple
D) The present value of the dividends
Answer: C
Topic: P/E Multiple Valuation Approach
7.5.10) Which of the following valuation methods is superior to the others in the list since it considers
expected earnings?
A) liquidation value
B) book value
C) P/E multiple
D) present value of the interest
Answer: C
7.5.11) The use of the ________ is especially helpful in valuing firms that are not publicly traded.
A) liquidation value
B) book value
C) P/E multiple
D) present value of the dividends
Answer: C
7.5.12) The current price of DEF Corporation stock is $26.50 per share. Earnings next year should be $2
per share and it should pay a $1 dividend. The P/E multiple is 15 times on average. What price
would you expect for DEFʹs stock in the future?
A) $13.50
B) $15.00
C) $26.50
D) $30.00
Answer: D
7.5.13) Nico Corporation expects to generate free-cash flows of $200,000 per year for the next five
years. Beyond that time, free cash flows are expected to grow at a constant rate of 5 percent per
year forever. If the firmʹs average cost of capital is 15 percent, the market value of the firmʹs
debt is $500,000, and Nico has a half million shares of stock outstanding, what is the value of
Nicoʹs stock?
A) $2..43
B) $3.43
C) $1.43
D) $0.00
Answer: A
Topic: Free Cash Flow Valuation Model (Equation 7.7 and Equation 7.8)
7.5.14) At year end, Tangshan China Company balance sheet showed total assets of $60 million, total
liabilities (including preferred stock) of $45 million, and 1,000,000 shares of common stock
outstanding. Based on this information, Tangshanʹs book value per share of common stock is
________.
A) $105.00
B) $10.50
C) $15.00
D) $150.00
Answer: C
Topic: Book Value of Common Stock
outstanding. If Tangshan could sell its assets for $52.5 million, Tangshanʹs liquidation value per
share of common stock is ________.
A) $15.00
B) $7.50
C) $52.50
D) $75.00
Answer: B
Topic: Liquidation Value of Common Stock
outstanding. Next year, Tangshan is projecting that it will have net income of $1.5 million. If
the average PE multiple in Tangshanʹs industry is 15, what should be the price of Tangshanʹs
stock?
A) $15.00
B) $22.50
C) $52.50
D) $75.00
Answer: B
Topic: PE Multiple Valuation Approach
7.5.17) China Imports currently has 2,000 shares of common stock outstanding. The firm has assets of
$200,000 and total liabilities including preferred stock of $75,000. Calculate the book value per
share of China Imports common stock.
$200,000 - $75,000
Answer: = $62.50/share
2,000
7.5.18) Based on analysis of the company and expected industry and economic conditions, China
Imports is expected to earn $4.60 per share of common stock next year. The average
price/earnings ratio for firms in the same industry is 8. Calculate the estimated value of a share
of China Imports common stock.
Answer: $4.60(8) = $36.80/share
Topic: P/E Multiple Valuation Model
7.5.19) Due to growing demand for computer software, the Perry Company has had a very successful
year and expects its earnings per share to grow by 25 percent to reach $5.50 for this year.
Estimate the price of the companyʹs common stock assuming the industryʹs price/earning ratio
is 12.
Answer: P = (P/E)(E) = 12 × 5.50 = $66
Topic: P/E Multiple Valuation Model
7.5.20) Karinaʹs Caribbean Foods had total assets as recorded on its balance sheet are $1,500,000. What
is the value of the Karinaʹs common stock if it has $950,000 in liabilities, and 7,500 shares of
common stock outstanding?
Answer: P = (1,500,000 - 950,000)/7,500 = $73.33
7.5.21) Scooter World has estimated the market value of its assets to be $1,250,000. What is the value of
Scooter Wroldʹs common stock if it has $900,000 in liabilities, $50,000 in preferred stock, and
7,500 shares of common stock outstanding?
Answer: P = (1,250,000 - 900,000 - 50,000)/7,500 = $40
7.5.22) BFG, Inc. stock currently sells for $75 per share. The firm has total assets of $1,000,000 and total
liabilities, including preferred stock, of $350,000. If the firm has 10,000 shares of common stock
outstanding,
(a) what is the book value of each share of common stock?
(b) is the stock overvalued or undervalued in the marketplace?
(c) what might be the reason(s) for your answer in (b).
$1,000,000 - $350,000
Answer: (a) = $65/share
10,000
(b) overvalued
(c) market value of the assets is greater than the book value.
7.5.23) BFG has current assets of $800,000, which can be liquidated at 90 percent of book value. Total
liabilities, including preferred stock, equal $270,000. The firm has 15,000 shares of common
stock outstanding. What is the liquidation value per share of common stock?
$800,000(0.90) - $270,000
Answer: = $30/share
15,000
Topic: Liquidation Value of Common Stock
Learning Goal 6: Explain the relationships among financial decisions, return, risk, and the
firmʹs value.
7.6.1) Any action taken by the financial manager that increases risk will also increase the required
return.
Answer: TRUE
7.6.2) In common stock valuation, any action taken by the financial manager that increases risk will
cause an increase the required return.
Answer: TRUE
7.6.3) In common stock valuation, any action taken by the financial manager that increases risk will
cause an increase in value.
Answer: FALSE
7.6.4) An action on the part of a firm that increases the level of expected cash flows without a
corresponding increase in risk should reduce share value; An action that reduces the level of
expected cash flows without a corresponding decline in risk should increase share value.
Answer: FALSE
7.6.5) Assuming that economic conditions remain stable, any management action that would cause
current and prospective stockholders to raise their dividend expectations should decrease the
firmʹs value.
Answer: FALSE
expected to grow at 5 percent indefinitely. In addition, Tangshan Chinaʹs most recent
dividend was $5.50. If the expected risk free rate of return is 3 percent, the expected market
return is 8 percent, and Tangshan has a beta of 1.2, Tangshanʹs stock would be ________.
A) overvalued
B) undervalued
C) properly valued
D) not enough information to tell
Answer: A
dividend was $5.50. If the expected risk free rate of return is 3 percent, the expected market
premium is 4 percent, and Tangshan has a beta of 1.2, Tangshanʹs stock would be ________.
A) overvalued
B) undervalued
C) properly valued
D) not enough information to tell
Answer: B
7.6.8) Tangshan Antiques has a beta of 1.40, the annual risk -free rate of interest is currently 10

percent, and the required return on the market portfolio is 16 percent. The firm estimates that
its future dividends will continue to increase at an annual compound rate consistent with
that experienced over the 2000-2003 period.
Year Dividend
2000 $2.70
2001 2.95
2002 3.25
2003 3.40
(a) Estimate the value of Tangshan Antiques stock.
(b) A lawsuit has been filed against the company by a competitor, and the potential loss has
increased risk, which is reflected in the companyʹs beta, increasing it to 1.6. What is the
estimated price of the stock following the filing of the lawsuit.
Answer: (a) rs = 0.10 + 1.4(0.16 - 0.10) = 0.184
growth rate of dividends = $3.40/$2.70 = 1.259 FVIF3, r = 8%
Po = $3.40(1.08)/(0.184 - 0.08) = $35.31
(b) rs = 0.10 + 1.6(0.16 - 0.10) = 0.196
Po = $3.40(1.08)/(0.196 - 0.08) = $31.66
dividend was $5.50. The expected risk free rate of return is 3 percent, the expected market
return is 8 percent, and Tangshan has a beta of 1.20.
(a) What is the expected return based on the dividend valuation model?
(b) What is the required return based on the CAPM?
(c) Would Tangshan China be a good investment at this time? Explain
Answer: (a) rs = [$5.50(1.05)]/$160.00 + 0.05 = 8.6%
(b) rs = 0.03 + 1.2(0.08 - 0.03) = 9%
(c) The expected return is 8.6 percent but the required return is 9 percent. Based on
this information, Tangshan is overvalued and would not be a good investment at this
time.

Chapter 7 - Stock Valuation

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Chapter

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52-WEEK YLD VOL NET

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7.6.8) Tangshan Antiques has a beta of 1.40, the annual risk -free rate of interest is currently 10

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