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New Era University

College of Accountancy

FINANCIAL MANAGEMENT
Stock Valuation

Part I Theory

1. If the expected rate of return on a stock exceeds the required rate,
a. The stock is experiencing supernormal growth.
b. The stock should be sold.
c. The stock is a good buy.
d. Dividends are not being declared.

2. Stock A has a required return of 10 percent. Its dividend is expected to grow at a constant rate of 7
percent per year. Stock B has a required return of 12 percent. Its dividend is expected to grow at a
constant rate of 9 percent per year. Stock A has a price of P25 per share, while Stock B has a price of
P40 per share. Which of the following statements is true?
a. The two stocks have the same dividend yield.
b. If the stock market were efficient, these two stocks should have the same price.
c. If the stock market were efficient, these two stocks should have the same expected return.
d. All of the above

3. Which of the following statements regarding the constant growth model is true?
a. The constant growth model takes into consideration the capital gains earned on a stock.
b. It is appropriate to use the constant growth model to estimate stock value even if the growth rate
never becomes constant.
c. Two firms with the same dividend and growth rate must also have the same stock price.
d. The price of a stock is the present value of all expected future dividends, discounted at the
dividend growth rate.

4. A stocks dividend is expected to grow at a constant rate of 5 percent a year. Which of the following
statements is/are true?
I. The expected return on the stock is 5 percent a year.
II. The stocks dividend yield is 5 percent.
III. The stocks price one year from now is expected to be 5 percent higher.
a. I, II and III c. I and III only
b. I and II only d. III only

5. Stocks A and B have the same required rate of return and the same expected year-end dividend.
Stock As dividend is expected to grow at a constant rate of 10 percent per year, while Stock Bs
dividend is expected to grow at a constant rate of 5 percent per year. Which of the following
statements is true?
a. The two stocks should sell at the same price.
b. Stock A has a higher dividend yield than Stock B.
c. Currently Stock B has a higher price, but over time Stock A will eventually have a higher price.
d. None of the above

6. Stock X and Stock Y sell for the same price in todays market. Stock X has a required return of 12
percent. Stock Y has a required return of 10 percent. Stock Xs dividend is expected to grow at a
constant rate of 6 percent a year, while Stock Ys dividend is expected to grow at a constant rate of 4
percent. Assume that the market is in equilibrium and expected returns equal required returns. Which
of the following statements is true?
a. Stock X has a higher dividend yield than Stock Y.
b. Stock Y has a higher dividend yield than Stock X.
c. One year from now, Stock Xs price is expected to be higher than Stock Ys price.
d. Statements a and c are correct.

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7. Stock A has a beta of 1.1, while Stock B has a beta of 0.9. The market risk premium is 6 percent.
The risk-free rate is 6.3 percent. Both stocks have a dividend, which is expected to grow at a
constant rate of 7 percent a year. Assume that the market is in equilibrium. Which of the following
statements is true?
a. Stock A must have a higher dividend yield than Stock B.
b. Stock A must have a higher stock price than Stock B.
c. Stock Bs dividend yield equals its expected dividend growth rate.
d. All of the statements above are correct.

8. Stock X has a required return of 12 percent, a dividend yield of 5 percent, and its dividend will grow
at a constant rate forever. Stock Y has a required return of 10 percent, a dividend yield of 3 percent,
and its dividend will grow at a constant rate forever. Both stocks currently sell for P25 per share.
Which of the following statements is/are true?
I. Stock X pays a higher dividend per share than Stock Y.
II. Stock X has a lower expected growth rate than Stock Y.
III. One year from now, the two stocks are expected to trade at the same price.
a. I, II and III c. I and III only
b. I and II only d. III only

9. The preemptive right is important to shareholders because it:
a. allows management to sell additional shares below the current market price.
b. protects the current shareholders against dilution of ownership interests.
c. is included in every corporate charter.
d. will result in higher dividends per share.

10. Which of the following statements regarding efficient markets hypothesis is true?
a. If a market is strong-form efficient, this implies that the returns on bonds and stocks should be
identical.
b. If a market is weak-form efficient, this implies that all public information is rapidly incorporated
into market prices.
c. If your uncle earns a return higher than the overall stock market, this means the stock market is
inefficient.
d. None of the above

11. Which of the following statements regarding preferred stock is false?
a. One of the advantages to the firm associated with preferred stock financing rather than common
stock financing is that control of the firm is not diluted.
b. A big advantage of preferred stock is that preferred stock dividends are tax deductible for the
issuing corporation.
c. Preferred stock provides steadier and more reliable income to investors than common stock.
d. Most preferred stock is owned by corporations.

12. Which of the following statements regarding common stock is true?
a. One of the advantages of common stock financing is that a greater proportion of stock in the
capital structure can reduce the risk of a takeover bid.
b. A firm with classified stock can pay different dividends to each class of shares.
c. One of the advantages of common stock financing is that a firms debt ratio will decrease.
d. Statements b and c are correct.

13. A stock expects to pay a year-end dividend of P2.00 a share. The dividend is expected to fall 5
percent a year, forever. The companys expected and required rate of return is 15 percent. Which of
the following statements is true?
a. The companys stock price is P10.
b. The companys expected dividend yield 5 years from now will be 20 percent.
c. The companys stock price 5 years from now is expected to be P7.74.
d. All of the statements above are correct.

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14. Assume that the stock market is semistrong-form efficient. Which of the following statements is
true?
a. In equilibrium all stocks should have the same expected returns, but returns on stocks should
exceed returns on bonds.
b. You can expect to outperform the overall market by observing the past price history of a stock.
c. For the average investor, the expected net present value from investing in the stock market is
zero.
d. For the average investor, the expected net present value from investing in the stock market is the
required return on the stock.

15. Stocks A and B have the same price, but Stock A has a higher required rate of return than Stock B.
Which of the following statements is true?
a. Stock A must have a higher dividend yield than Stock B.
b. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be
higher than Stock Bs.
c. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be
lower than Stock Bs.
d. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B.

16. The expected rate of return on the common stock of Northwest Corporation is 14 percent. The
stocks dividend is expected to grow at a constant rate of 8 percent a year. The stock currently sells
for P50 a share. Which of the following statements is true?
a. The stocks dividend yield is 8 percent.
b. The stocks dividend yield is 7 percent.
c. The current dividend per share is P4.00.
d. The stock price is expected to be P54 a share in one year.

17. Which of the following statements is true?
a. Assuming that the required rate of return on a given stock is 13 percent, if the stocks dividend is
growing at a constant rate of 5 percent, its expected dividend yield is 5 percent as well.
b. The dividend yield on a stock is equal to the expected return less the expected capital gain.
c. A stocks dividend yield can never exceed the expected growth rate.
d. Statements b and c are correct.

18. An increase in a firms expected growth rate would usually cause its required rate of return to:
a. increase.
b. decrease.
c. remain constant.
d. possibly increase, possibly decrease, or possibly remain unchanged.

19. If markets are in equilibrium, which of the following will occur?
a. Each investments expected return should equal its realized return.
b. Each investments expected return should equal its required return.
c. Each investment should have the same expected return.
d. Each investment should have the same realized return.

20. Which of the following statements is false?
a. When a corporations shares are owned by a few individuals who are associated with or are the
firms management, we say that the firm is closely held.
b. A publicly owned corporation is simply a company whose shares are held by the investing
public, which may include other corporations and institutions as well as individuals.
c. Going public establishes a true market value for the firm and ensures that a liquid market will
always exist for the firms shares.
d. It is possible for a firm to go public, and yet not raise any additional new capital.

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Part II Problems

1. As financial manager of Material Supplies Inc., you have recently participated in an executive
committee decision to enter into the plastics business. Much to your surprise, the price of the firms
common stock subsequently declined from P40 per share to P30 per share. While there have been
several changes in financial markets during this period, you are anxious to determine how the market
perceives the relevant risk of your firm. Assume that the market is in equilibrium. Examine the
following data:
The real risk-free rate is 2%, but the inflation premium has increased from 4% to 6%.
The expected growth rate has been re-evaluated by security analysts, and a 10.5% rate is
considered to be more realistic than the previous 5% rate. This change had nothing to do with the
move into plastics; it would have occurred anyway.
The risk aversion attitude of the market has shifted somewhat, and now the market risk premium
is 3% instead of 2%.
The next dividend was expected to be P2 per share, assuming the old 5% growth rate.
The beta value associated with your firm has changed from an old beta of to a new beta of .
a. 2.00; 1.50 c. 2.00; 3.17
b. 1.50; 3.00 d. 1.50; 1.67

2. Hard Hat Constructions stock is currently selling at an equilibrium price of P30 per share. The firm
has been experiencing a 6 percent annual growth rate. Last years earnings per share were P4.00, and
the dividend payout ratio is 40 percent. The risk-free rate is 8 percent, and the market risk premium
is 5 percent. If market risk (beta) increases by 50 percent, and all other factors remain constant, by
how much will the stock price change?
a. P15.00 decrease c. P7.14 increase
b. P15.22 decrease d. P7.33 decrease

3. Newburn Entertainments stock is expected to pay a year-end dividend of P3.00 a share. The stocks
dividend is expected to grow at a constant rate of 5 percent a year. The risk-free rate is 6 percent and
the market risk premium is 5 percent. The stock has a beta of 0.8. What is the stocks expected price
five years from now?
a. P76.58 c. P72.11
b. P96.63 d. P68.96

4. Assume today is December 31, 2012. The following information applies to Addison Airlines:
After-tax, operating income [EBIT(1 - T)] for the year 2013 is expected to be P400 million.
The companys depreciation expense for the year 2013 is expected to be P80 million.
The companys capital expenditures for the year 2013 are expected to be P160 million.
No change is expected in the companys net operating working capital.
The companys free cash flow is expected to grow at a constant rate of 5 percent per year.
The companys cost of equity is 14 percent.
The companys WACC is 10 percent.
The current market value of the companys debt is P1.4 billion.
The company currently has 125 million shares of stock outstanding.
Using the free cash flow valuation method, what should be the companys stock price today?
a. P40 c. P25
b. P50 d. P85

5. Phil Corporations stock recently paid a dividend of P2.00 per share and the stock is in equilibrium.
The company has a constant growth rate of 5 percent and a beta equal to 1.5. The required rate of
return on the market is 15 percent, and the risk-free rate is 7 percent. Phil is considering a change in
policy that will increase its beta coefficient to 1.75. If market conditions remain unchanged, what
new constant growth rate will cause Phils common stock price to remain unchanged?
a. 8.85% c. 6.77%
b. 13.52% d. 5.88%


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6. Assume an all equity firm has been growing at a 15 percent annual rate and is expected to continue
to do so for 3 more years. At that time, growth is expected to slow to a constant 4 percent rate. The
firm maintains a 30 percent payout ratio, and this years retained earnings net of dividends were P1.4
million. The firms beta is 1.25, the risk-free rate is 8 percent, and the market risk premium is 4
percent. If the market is in equilibrium, what is the market value of the firms common equity (1
million shares outstanding)?
a. 12.96 million c. 9.17 million
b. 7.32 million d. 10.56 million

7. Assume that you would like to purchase 100 shares of preferred stock that pays an annual dividend
of P6 per share. However, you have limited resources now, so you cannot afford the purchase price.
In fact, the best that you can do now is to invest your money in a bank account earning a simple
interest rate of 6 percent, but where interest is compounded daily (assume a 365-day year). Because
the preferred stock is riskier, it has a required annual rate of return of 12 percent. (Assume that this
rate will remain constant over the next 5 years.) For you to be able to purchase this stock at the end
of 5 years, how much must you deposit in your bank account today?
a. P4,291.23 c. P3,138.52
b. P4,831.25 d. P3,704.18

8. Mulroney Motors stock has a required return of 10 percent. The stock currently trades at P50 per
share. The year-end dividend is expected to be P1.00 per share. After this payment, the dividend is
expected to grow by 25 percent per year for the next three years. After the fourth year, the dividend
is expected to grow at a constant rate of ___ percent per year forever.
a. 5.47% c. 6.98%
b. 6.87% d. 8.27%

9. A financial analyst has been following Fast Start Inc., a new high-growth company. She estimates
that the current risk-free rate is 6.25 percent, the market risk premium is 5 percent, and that Fast
Starts beta is 1.75. The current earnings per share are P2.50. The company has a 40 percent payout
ratio. The analyst estimates that the companys dividend will grow at a rate of 25 percent this year,
20 percent next year, and 15 percent the following year. After three years the dividend is expected to
grow at a constant rate of 7 percent a year. The company is expected to maintain its current payout
ratio. The analyst believes that the stock is fairly priced. What is the current stock price?
a. P17.33 c. P18.53
b. P19.89 d. P19.25

10. Club Auto Parts last dividend was P0.50, and the company expects to experience no growth for the
next 2 years. However, Club will grow at an annual rate of 5 percent in the third and fourth years,
and, beginning with the fifth year, it should attain a 10 percent growth rate that it will sustain
thereafter. Club has a required rate of return of 12 percent. What should be the price per share of
Club stock at the end of the second year?
a. P19.98 c. P19.48
b. P25.08 d. P27.55

11. The Hart Mountain Company has recently discovered a new type of kitty litter that is extremely
absorbent. It is expected that the firm will experience (beginning now) an unusually high growth rate
(20 percent) during the period (3 years) it has exclusive rights to the property where the raw material
used to make this kitty litter is found. However, beginning with the fourth year the firms
competition will have access to the material, and from that time on the firm will achieve a normal
growth rate of 8 percent annually. During the rapid growth period, the firms dividend payout ratio
will be relatively low (20 percent) in order to conserve funds for reinvestment. However, the
decrease in growth in the fourth year will be accompanied by an increase in the dividend payout to
50 percent. Last years earnings were P2.00 per share, and the firms required return is 10 percent.
What should be the current price of the common stock?
a. P93.50 c. P61.78
b. P87.96 d. P71.54


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12. Modular Systems Inc. just paid dividends, and it is expecting both earnings and dividends to grow by
0 percent in Year 2, by 5 percent in Year 3, and at a rate of 10 percent in Year 4 and thereafter. The
required return on Modular is 15 percent, and it sells at its equilibrium price of P49.87. What is the
expected value of the next dividend?
a. P2.85 c. P1.85
b. P2.35 d. P1.35

13. Nahanni Treasures Corporation is planning a new common stock issue of five million shares to fund
a new project. The increase in shares will bring to 25 million the number of shares outstanding.
Nahannis long-term growth rate is 6 percent, and its current required rate of return is 12.6 percent.
The firm just paid a P1.00 dividend and the stock sells for P16.06 in the market. When the new
equity issue was announced, the firms stock price dropped. Nahanni estimates that the companys
growth rate will increase to 6.5 percent with the new project, but since the project is riskier than
average, the firms cost of capital will increase to 13.5 percent. Using the DCF growth model, what
is the change in the equilibrium stock price?
a. P0.85 decrease c. P1.06 decrease
b. P0.66 decrease d. P1.77 decrease

14. A stock is expected to pay a P2.50 dividend at the end of the year. The dividend is expected to grow
at a constant rate of 6 percent a year. The stocks beta is 1.2, the risk-free rate is 4 percent, and the
market risk premium is 5 percent. What is the expected stock price eight years from today?
a. P99.62 c. P104.86
b. P65.79 d. P105.59

15. The probability distribution for expected return on the overall stock market for the coming year is as
follows:
Probability Expected return
.05
.30
.30
.30
.05
7%
8%
9%
10%
12%
If the risk-free rate is 6.05% and Stock X has a beta of 2.0, an expected constant growth rate of 7
percent, and current year dividend of P2, what market price gives the investor a return consistent
with the stocks risk?
a. P56.94 c. P21.72
b. P37.50 d. P42.38

16. You have been given the following projections for Cali Corporation for the coming year.
Sales = 10,000 units.
Sales price per unit = P10.
Variable cost per unit = P5.
Fixed costs = P10,000.
Bonds outstanding = P15,000.
Interest rate on outstanding bonds = 8%.
Tax rate = 40%.
Shares of common stock outstanding = 10,000 shares.
Beta = 1.4.
Risk-free rate = 5%.
Expected return on the overall stock market = 9%.
Dividend payout ratio = 60%.
Growth rate = 8%.
Calculate the current price per share for Cali Corporation.
a. P53.72 c. P48.55
b. P59.76 d. P46.27


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17. Noprem Inc. is a firm whose shareholders dont possess the preemptive right. The firm currently has
1,000 shares of stock outstanding; the price is P100 per share. The firm plans to issue an additional
1,000 shares at P90.00 per share. Since the shares will be offered to the public at large, what is the
amount per share that old shareholders will lose if they are excluded from purchasing new shares?
a. P10.00 c. P0
b. P2.50 d. P5.00

18. Carlson Products, a constant growth company, has a current market (and equilibrium) stock price of
P20.00. Carlsons next dividend is forecasted to be P2.00, and Carlson is growing at an annual rate
of 6 percent. Carlson has a beta coefficient of 1.2, and the required rate of return on the market is 15
percent. As Carlsons financial manager, you have access to insider information concerning a switch
in product lines that would not change the growth rate, but would cut Carlsons beta coefficient in
half. If you buy the stock at the current market price, what is your expected percentage capital gain?
a. 53% c. 33%
b. 43% d. 23%

19. Conner Corporation has a stock price of P32.35 per share. The last dividend was P3.42. The long-run
growth rate for the company is a constant 7 percent. What is the companys capital gains yield and
dividend yield?
a. Capital gains yield = 10.57%; Dividend yield = 7.00%
b. Capital gains yield = 7.00%; Dividend yield = 4.31%
c. Capital gains yield = 11.31%; Dividend yield = 7.00%
d. Capital gains yield = 7.00%; Dividend yield = 11.31%

20. During the past few years, Swanson Company has retained, on the average, 70 percent of its
earnings in the business. The future retention rate is expected to remain at 70 percent of earnings,
and long-run earnings growth is expected to be 10 percent. If the risk-free rate is 8 percent, the ex-
pected return on the market is 12 percent, Swansons beta is 2.0, and the most recent dividend was
P1.50, what is the most likely market price and P/E ratio for Swansons stock today?
a. P25.00 ; 5.0 c. P33.00 ; 6.0
b. P27.50 ; 5.0 d. P22.50 ; 4.5



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