Finance 123

CHAPTER 8
Stock Valuation
True/False
1. When a call provision is exercised, preferred stock is usually repurchased at a discount.

ANSWER: False
DIFFICULTY: Moderate
KEYWORDS: call provision
2. The use of a sinking fund for preferred stock in effect establishes a maturity date for the stock.
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: sinking fund
3. Stock valuation is more precise than bond valuation as stock cash flows are more certain.
ANSWER: False
KEYWORDS: stock valuation
4. Stock value is based entirely on historical cash flows.

ANSWER: False
DIFFICULTY: Easy
KEYWORDS: stock valuation
5. The stock valuation model D1/(Rc - g) requires Rc > G.

ANSWER: True
KEYWORDS: common stock value
6. Paid-in-kind preferred stock receives initial dividends of common stock.

ANSWER: False
KEYWORDS: paid-in-kind preferred stock
7. A call provision allows the issuer to buy its stock back from the investor.
ANSWER: True
8. When the firm decides to retain a portion of its earnings, the stockholders are indirectly investing in
the firm.
ANSWER: True
KEYWORDS: retention of earnings
9. A company may issue multiple classes of preferred stock.

ANSWER: True
KEYWORDS: classes of preferred stock
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10. Preferred stock, unlike bonds, cannot be converted into common stock.
ANSWER: False
KEYWORDS: convertible preferred
11. Common stockholders are essentially creditors of the firm.

ANSWER: False
KEYWORDS: common stockholders
12. Common stock represents a claim on residual income.

ANSWER: True
KEYWORDS: residual income
13. If you own shares of stock with a cumulative voting right, then you have the right of first refusal on
any subsequent issues.
ANSWER: False
KEYWORDS: cumulative voting
14. The growth rate of future earnings is determined by return on equity and the profit-retention rate.
ANSWER: True
KEYWORDS: growth rate
15. The stockholder’s expected rate of return consists of a dividend yield and interest.
ANSWER: False
KEYWORDS: stockholder’s expected rate of return
16. In order to determine the value of a share of preferred stock, the discount rate used is the annual
dividend percent.
ANSWER: False
KEYWORDS: discount rate
17. The common stock of a non-growth firm is valued in the same manner as its preferred stock.
ANSWER: True
KEYWORDS: non-growth common stock
18. It is quite common for firms that issue preferred stock to issue more than one series.
ANSWER: True
KEYWORDS: series of preferred stock
19. In the event of bankruptcy, preferred stockholders and common stockholders have the same claim
on the firm’s assets.
ANSWER: False
KEYWORDS: claim on assets, stockholders
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20. Common stockholders bear more risk than debtholders but less risk than preferred stockholders.
ANSWER: False
KEYWORDS: risk and common stock
21. Protective provisions reduce the cost of preferred stock to the issuing firm.
ANSWER: True
KEYWORDS: protective provisions
22. Investors value the ability to convert preferred stock into common stock.
ANSWER: True
KEYWORDS: convertible feature
23. Although a participating feature is desirable from the investor’s perspective, it is infrequently found
in preferred stock.
ANSWER: True
KEYWORDS: participating preferred
24. Preferred stock cannot be retired.

ANSWER: False
KEYWORDS: retiring preferred
25. The SEC discourages the issuance of preferred stock with a call provision.
ANSWER: False
26. When bankruptcy occurs, the claims of the common shareholders generally go unsatisfied.
ANSWER: True
KEYWORDS: bankruptcy
27. For minority shareholders, majority voting has an advantage over cumulative voting.
ANSWER: False
28. The cumulative feature is necessary to protect the rights of preferred stockholders.
ANSWER: True
29. Cumulative voting gives each share of stock a number of votes equal to the number of directors
being elected to the board.
ANSWER: True
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30. The preemptive right helps existing common shareholders protect their proportionate share of
ownership of the firm.
ANSWER: True
KEYWORDS: preemptive right
31. Internal growth, resulting in the growth of future earnings and the value of common stock, is the
relevant growth for valuing a firm’s common stock.
ANSWER: True
32. The expected rate of return implied by a given market price equals the required rate of return for
investors at the margin.
ANSWER: True
KEYWORDS: expected rate of return
Multiple Choice
33. UVP preferred stock pays $5.00 in annual dividends. If your required rate of return is 13%, how
much will you be willing to pay for one share?
a. $38.46
b. $26.26
c. $65.46
d. $46.38
ANSWER: a
KEYWORDS: preferred stock value
34. Green Corp.’s preferred stock is selling for $20.83. If the company pays $2.50 annual dividends,
what is the expected rate of return on its stock?
a. 8.33%
b. 12.00%
c. 2.50%
d. 20.00%
ANSWER: b
KEYWORDS: expected rate of return
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35. Sacramento Light & Power issued preferred stock in 1998 that had a par value of $85. The
preferred stock pays a dividend of 5.75%. Investors require a rate of return of 6.50% today on this
stock. What is the value of the preferred stock today? Round to the nearest $1.
a. $100
b. $85
c. $75
d. $16
ANSWER: c
36. Davis Gas & Electric issued preferred stock in 1985 that had a par value of $50. The stock pays a
dividend of 7.875%. Assume that shares are currently selling for $62.50. What is the preferred
stockholder’s expected rate of return? Round to the nearest 0.01%.
a. 6.30%
b. 7.88%
c. 10.25%
d. 5.02%
ANSWER: a
KEYWORDS: expected return
37. The quarterly dividends for adjustable rate preferred stock may be determined by:
a. the three-month Treasury bill rate.
b. the 10-year Treasury bond rate.
c. the 20-year Treasury bond rate.
d. all of the above.
ANSWER: d
KEYWORDS: preferred stock dividends
38. Preferred stock valuation usually treats the preferred stock as a:

a. capital asset.
b. perpetuity.
c. common stock.
d. long-term bond.
ANSWER: b
KEYWORDS: perpetuity
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39. Which is not a feature of preferred stock?
a. Cumulative
b. Convertibility
c. Arbitrage
d. Participating
ANSWER: c
KEYWORDS: features of preferred stock
40. Which statement is true?

a. Investors can sue the corporation if it does not pay the agreed-upon preferred dividend.
b. Preferred stock of a given company is less risky to the investor than corporate bonds of the
same corporation.
c. Most issues of preferred stock have a cumulative feature.
d. Preferred stock usually has a maturity that is less than the average maturity of bonds issued by
the same company.
ANSWER: c
41. Which statement is true?

a. Preferred stock is similar to corporate bonds because dividends on preferred stock, like interest
on bonds, are a tax-deductible expense to the corporation.
b. Preferred stock is similar to corporate bonds because the corporation usually pays the holders
of the securities a fixed amount.
c. Preferred stockholders are considered to be the true owners of corporations.
d. Preferred stockholders have priority over bondholders when it comes to the payment of
dividends.
ANSWER: b
42. The XYZ Company, whose common stock is currently selling for $40 per share, is expected to pay
a $2.00 dividend in the coming year. If investors believe that the expected rate of return on XYZ is
14%, what growth rate in dividends must be expected?
a. 5%
b. 14%
c. 9%
d. 6%
ANSWER: c
KEYWORDS: dividends growth
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43. The expected rate of return on a share of common stock whose dividends are growing at a constant
rate (g) is which of the following?
a. (D1 + g)/Vc
b. D1/Vc
c. D1/g
d. None of the above
ANSWER: d
44. Green Company’s common stock is currently selling at $24.00 per share. The company recently
paid dividends of $1.92 per share and projects growth at a rate of 4%. At this rate, what is the
stock’s expected rate of return?
a. 4.08%
b. 8.00%
c. 12.00%
d. 8.80%
ANSWER: c
45. Which of the following provisions is unique to preferred stockholders and usually not available to
common stockholders?
a. Cumulative dividends feature
b. Voting rights
c. Fixed dividend
d. Both a & c
ANSWER: d
KEYWORDS: preferred stock features
46. McMillen House of Books recently paid a $3 dividend on its preferred stock. Investors require a 6%
return on the stock. The stock is currently selling for $45. Is the stock a good buy?
a. Yes, as it is undervalued $5.
b. Yes, as it is undervalued $10.
c. No, as it is overvalued $5.
d. No, as it is overvalued $10.
ANSWER: a
47. Common stockholders are essentially:

a. creditors of the firm.
b. managers of the firm.
c. owners of the firm.
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ANSWER: c
KEYWORDS: common stock ownership
48. Preferred stock is similar to a bond because:

a. it has a maturity at which time the corporation repays par value.
b. it has a fixed amount to the investor.
c. it represents an ownership interest.
ANSWER: b
49. What feature allows preferred stockholders the right to receive dividends over and above the stated
dividend?
a. Cumulative
b. Convertible
c. Participating
d. Preemptive
ANSWER: c
KEYWORDS: participating preferred
50. Butler, Inc.’s return on equity is 17% and management retains 75% of earnings for investment
purposes. Based on this information, what will be the firm’s growth rate?
a. 4.25%
b. 22.67%
c. 44.12%
d. 12.75%
ANSWER: d
51. If a company has a return on equity of 25% and wants a growth rate of 10%, how much of ROE
should be retained?
a. 40%
b. 50%
c. 60%
d. 70%
ANSWER: a
KEYWORDS: retention rate
52. Which of the following affect the value of a share of preferred stock?
a. Dividend amount
b. Investors’ required rate of return
c. Maturity date
d. Dividend amount and investors’ required rate of return
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ANSWER: d
53. Style Corp. preferred stock pays $3.15. What is the value of the stock if your required rate of return
is 8.5% (round your answer to the nearest $1, and assume no transaction costs)?
a. $33
b. $23
c. $27
d. $37
ANSWER: d
54. Solitron Manufacturing Company preferred stock is selling for $14. If it has a yearly dividend of
$1, what is your expected rate of return if you purchase the stock at its market price (round your
answer to the nearest .1%, and assume no transaction costs)?
a. 25.0%
b. 14.2%
c. 7.1%
d. 9.3%
ANSWER: c
55. Bell Corp. has a preferred stock that pays a dividend of $2.40. If you are willing to purchase the
stock at $11 or below, what is your required rate of return (round your answer to the nearest .1%,
and assume that there are no transaction costs)?
a. 21.8%
b. 11.0%
c. 9.1%
d. 20.1%
ANSWER: a
56. What is the value of a preferred stock that pays a $2.10 dividend to an investor with a required rate
of return of 11% (round your answer to the nearest $1)?
a. $19
b. $23
c. $17
d. $21
ANSWER: a
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57. How is preferred stock affected by a decrease in the required rate of return?
a. The value of a share of preferred stock decreases.
b. The dividend increases.
c. The dividend decreases.
d. None of the above.
ANSWER: d
58. _________ gives minority shareholders more power to elect board of directors.
a. Preemptive right
b. Majority voting
c. Proxy fights
d. Cumulative voting
ANSWER: d
DIFFICULTY: Easy
59. Preferred stock is similar to a bond in the following way.

a. Preferred stock always contains a maturity date.
b. Both investments provide a constant income.
c. Both contain a growth factor similar to common stock.
d. None of the above.
ANSWER: b
60. The common stockholders are most concerned with:

a. the percentage of profits retained.
b. the size of the firm’s beginning earnings per share.
c. the risk of the investment.
d. the spread between the return generated on new investments and the investor’s required rate of
return.
ANSWER: d
KEYWORDS: common stockholder concerns
61. Tri State Pickle Company preferred stock pays a perpetual annual dividend of 2 1/2% of its par
value. Par value of TSP preferred stock is $100 per share. If investors’ required rate of return on
this stock is 15%, what is the value of per share?
a. $37.50
b. $15.00
c. $16.67
d. $6.00
ANSWER: c
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62. Petrified Forest Skin Care, Inc. pays an annual perpetual dividend of $1.70 per share. If the stock is
currently selling for $21.25 per share, what is the expected rate of return on this stock?
a. 36.13%
b. 12.5%
c. 8.0%
d. 13.6%
ANSWER: c
KEYWORDS: perpetuity return
63. You are evaluating the purchase of Cellars, Inc. common stock that just paid a dividend of $1.80.
You expect the dividend to grow at a rate of 12% for the next three years. You plan to hold the stock
for three years and then sell it. You estimate that a required rate of return of 17.5% will be adequate
compensation for this investment. Calculate the present value of the expected dividends. Round to
the nearest $0.10.
a. $4.90
b. $11.50
c. $9.80
d. $6.10
ANSWER: a
64. You are evaluating the purchase of Holdings, Inc. common stock that just paid a dividend of $1.80.
You plan to hold the stock for three years and then sell it. You expect the price of the company’s
stock to rise to $51.50 at the end of your three-year holding period. You estimate that a required
rate of return of 17.5% will be adequate compensation for this investment. Calculate the present
value of the expected future stock price. Round to the nearest $.25.
a. $64.00
b. $55.25
c. $31.75
d. $103.00
ANSWER: c
65. CEO naming friends to the board of directors and paying them more than the norm is an example of
the:
a. agency problem.
b. preemptive right.
c. majority voting feature.
d. proxy fights.
ANSWER: a
DIFFICULTY: Easy
KEYWORDS: agency problem
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66. Little Feet Shoe Co. just paid a dividend of $1.65 on its common stock. This company’s dividends
are expected to grow at a constant rate of 3% indefinitely. If the required rate of return on this stock
is 11%, compute the current value of per share of LFS stock.
a. $20.63
b. $21.24
c. $15.00
d. $55.00
ANSWER: b
67. Moo Moo Land Dairy Co. has net income of $450,000 this year. The book value of MML common
stock is $3 million dollars. The company’s dividend payout ratio is 60% and is expected to remain
this way. What is MML’s sustainable growth rate?
a. 3%
b. 9%
c. 6%
d. 10%
ANSWER: c
68. Marshall Manufacturing has common stock which paid a dividend of $1.00 a share last year. You
expect the stock to grow at 5% per year. If the appropriate rate of return on this stock is 12%, how
much are you willing to pay for the stock today?
a. $13.00
b. $15.00
c. $17.00
d. $19.00
ANSWER: b
69. Marble Corporation’s ROE is 17%. Their dividend payout ratio is 20%. The last dividend, just
paid, was $2.58. If dividends are expected to grow by the company’s sustainable growth rate
indefinitely, what is the current value of Marble common stock if its required return is 18%?
a. $14.33
b. $18.27
c. $47.67
d. $66.61
ANSWER: d
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70. Fris B. Corporation stock is currently selling for $42.86. It is expected to pay a dividend of $3.00 at
the end of the year. Dividends are expected to grow at a constant rate of 3% indefinitely. Compute
the required rate of return on FBC stock.
a. 10%
b. 33%
c. 7%
d. 4.3%
ANSWER: a
71. You are evaluating the purchase of Cool Toys, Inc. common stock that just paid a dividend of
$1.80. You expect the dividend to grow at a rate of 12%, indefinitely. You estimate that a required
rate of return of 17.5% will be adequate compensation for this investment. Assuming that your
analysis is correct, what is the most that you would be willing to pay for the common stock if you
were to purchase it today? Round to the nearest $.01.
a. $36.65
b. $91.23
c. $51.55
d. $74.82
ANSWER: a
72. What does a sinking fund provision in a preferred stock require a firm to do?
a. Pay a dividend only when the firm experiences an overdraft.
b. Set aside an amount periodically for the retirement of the preferred stock.
c. Pay dividends to preferred shareholders only when the firm has funds to do so.
d. Convert the preferred shares to bonds.
ANSWER: b
KEYWORDS: sinking fund
73. Preferred stock is similar to common stock in that:

a. it has no fixed maturity date.
b. the nonpayment of dividends can bring on bankruptcy.
c. dividends are limited in amount.
ANSWER: a
74. The expected rate of return for a common stock consists of:
a. growth.
b. current yield.
c. dividend yield.
d. both a and c.
e. all of the above.
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ANSWER: d
KEYWORDS: expected rate of return, common stock
75. An increase in the _________________ will increase the value of preferred stock.
a. expected rate of return
b. life of the investment
c. dividend paid
d. both a and c
ANSWER: c
76. A stock currently sells for $63 per share, and the required return on the stock is 10%. Assuming a
growth rate of 5%, calculate the stock's last dividend paid.
a. $1
b. $3
c. $5
d. $7
ANSWER: b
DIFFICULTY: Hard
KEYWORDS: last paid dividend
77. Valuing common stock relies on:

a. the risk-return trade-off.
b. the time value of money.
c. profits.
d. both a and b.
ANSWER: d
DIFFICULTY: Easy
KEYWORDS: principles for valuing common stock
78. A decrease in the _______________will cause an increase in common stock value.

a. growth rate
b. required rate of return
c. last paid dividend
d. both b and c
ANSWER: b
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79. Acme Consolidated has a return on equity of 12%. If Acme distributes 60% of earnings as
dividends, then we would expect the common shareholders’ investment in the firm and the value of
the common stock to grow by:
a. 4.80%.
b. 7.20%.
c. 12%.
d. 6%.
ANSWER: a
80. Common stock value is primarily based on:

a. expected dividends.
b. book value.
c. total assets.
d. both a and b.
ANSWER: a
DIFFICULTY: Easy
81. An investor is contemplating the purchase of common stock at the beginning of this year and to
hold the stock for one year. The investor expects the year-end dividend to be $2.00 and expects a
year-end price for the stock of $40. If this investor’s required rate of return is 10%, then the value
of the stock to this investor is:
a. $36.36.
b. $38.18.
c. $33.06.
d. $34.88.
ANSWER: b
82. A firm just paid $2.00 on its common stock and expects to continue paying dividends, which are
expected to grow 5% each year, from now to infinity. If the required rate of return for this stock is
9%, then the value of the stock is:
a. $50.00.
b. $40.00.
c. $54.50.
d. $52.50.
ANSWER: d
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83. An issue of preferred stock currently sells for $52.50 per share and pays a constant annual expected
dividend of $2.25 per share. The expected return on this security is:
a. 4.29%.
b. 0.04%.
c. 8.33%.
d. 13.33%.
ANSWER: a
84. Expected return for preferred stock consists of:

a. dividend yield.
b. growth.
c. interest income.
d. both a and b.
ANSWER: a
KEYWORDS: expected rate of return, preferred stock
85. An issue of common stock currently sells for $40.00 per share, has an expected dividend to be paid
at the end of the year of $2.00 per share, and has an expected growth rate to infinity of 5% per year.
The expected rate of return on this security is:
a. 5%.
b. 10.25%.
c. 13.11%.
d. 10%.
ANSWER: d
86. White Sink, Inc. just paid a dividend of $5.55 per share on its common stock, and the firm is
expected to generate constant growth of 12.25% over the foreseeable future. The common stock is
currently selling for $73.75 per share. The firm’s dividend payout ratio is 40%, and White’s
marginal tax rate is 40%. What is the rate of return that common stockholders expect? Round to the
nearest 0.1%.
a. 8.5%
b. 20.7%
c. 15.5%
d. 4.8%
ANSWER: b
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87. KDP’s most recent dividend was $2.00 per share and is selling today in the market for $70. The
dividend is expected to grow at a rate of 7% per year for the foreseeable future. If the market return
is 10% on investments with comparable risk, should you purchase the stock?
a. No, because the stock is overpriced $1.33.
b. No, because the stock is overpriced $3.33.
c. Yes, because the stock is underpriced $1.33.
d. Yes, because the stock is underpriced $3.33.
ANSWER: c
88. An issue of common stock currently sells for $50.00 per share, has an expected dividend to be paid
at the end of the year of $2.50 per share, and has an expected growth rate to infinity of 5% per year.
If investors’ required rate of return for this particular security is 12% per year, then this security is:
a. overvalued and offering an expected return higher than the required return.
b. undervalued and offering an expected return higher than the required return.
c. overvalued and offering an expected return lower than the required return.
d. undervalued and offering an expected return lower than the required return.
ANSWER: c
89. You are considering the purchase of Miller Manufacturing, Inc.’s common stock. The stock paid a
recent dividend of $2.00. The next dividend is expected to be $2.10. If the stock is returning 15%,
calculate its dividend yield.
a. 3%
b. 5%
c. 8%
d. 10%
ANSWER: d
KEYWORDS: dividend yield
90. Which of the following statements is false?

a. Preferred stock is similar to bonds in that the dividend of a preferred stock is fixed much like
the interest payment on a bond is fixed.
b. Preferred stockholders are entitled to dividends before common stockholders can receive
dividends.
c. Preferred stock, like common stock, usually has no maturity; i.e., the corporation does not pay
back the investment.
d. Preferred dividend payments are a tax-deductible expenditure.
e. The market value of preferred stock, like bonds, will usually fluctuate in value primarily as the
result of market rates of interest.
ANSWER: d
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91. Which of the following statements is true?
a. Preferred stock is similar to bonds in that the dividend of a preferred stock is fixed much like
the interest payment on a bond is fixed.
b. Preferred stockholders are entitled to dividends before common stockholders can receive
dividends.
c. Preferred stock, like common stock, usually has no maturity; i.e., the corporation does not pay
back the investment.
d. The market value of preferred stock, like bonds, will usually fluctuate in value primarily as the
result of market rates of interest.
e. All of the above.
ANSWER: e
92. Which of the following statements concerning preferred stock is correct?

a. Preferred stock generally is more costly to the firm than common stock.
b. Most issues of preferred stock have a cumulative feature.
c. Preferred stock cannot be convertible.
d. Preferred dividend payments are tax-deductible.
e. Preferred stock is a riskier form of capital to the firm than bonds.
ANSWER: b
93. World Wide Interlink Corp. has decided to undertake a large project. Consequently, there is a need
for additional funds. The financial manager plans to issue preferred stock with an annual dividend
of $5 per share. The stock will have a par value of $30. If investors’ required rate of return on this
investment is currently 20%, what should the preferred stock’s market value be?
a. $5
b. $10
c. $15
d. $20
e. $25
ANSWER: e
94. Preferred stock is similar to a bond because:

a. investors always receive their investment back at maturity.
b. investors receive fixed payments.
c. it represents ownership of a firm.
ANSWER: b
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a. Most preferred stock issues do not have a cumulative feature.
b. Preferred stock issues must have a call feature.
c. Preferred stock issues must have a sinking fund.
d. Preferred stock must have a par value.
e. None of the above.
ANSWER: d
96. Preferred stockholders:

a. have a right to receive dividends before common stockholders.
b. normally have voting rights.
c. generally receive a dividend that varies with the financial performance of the firm.
d. are secured creditors.
e. bear greater risk than common stockholders.
ANSWER: a
97. Which of the following serves to protect preferred stockholders from not receiving dividends to
which they are entitled?
a. The PIK feature
b. The participating feature
c. The cumulative feature
d. Convertibility
e. None of the above
ANSWER: c
98. ABC, Inc. just paid a dividend of $2. ABC expects dividends to grow at 10%. The return on stocks
like ABC, Inc. is typically around 12%. What is the most you would pay for a share of ABC stock?
a. $100
b. $110
c. $120
d. $130
ANSWER: b
99. Marjen, Inc. just paid a dividend of $5. Marjen stock currently sells for $73.57. The return on
stocks like Marjen, Inc. is typically around 10%. What is the dividend yield on the stock?
a. 1%
b. 3%
c. 5%
d. 7%
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ANSWER: d
KEYWORDS: dividend yield

a. Common stockholders are the true owners of a firm.
b. Capital obtained from the sale of common stock will ultimately be repaid by the corporation.
c. A corporation has a legal obligation to pay dividends on common stock.
d. Dividends on common stock usually do not grow.
e. Common stockholders have unlimited liability.
ANSWER: a
KEYWORDS: common stock features
101. Common stockholders are:

a. creditors of the firm.
b. managers of the firm.
c. owners of the firm.
d. debtors of the firm.
ANSWER: c
KEYWORDS: common stockholders
102. Which investor incurs the greatest risk?

a. Mortgage Bondholder
b. Preferred stockholder
c. Common stockholder
d. Debenture Bondholder
ANSWER: c
KEYWORDS: risk and common stock
103. What allows common stockholders the right to cast a number of votes equal to the number of
directors being elected?
a. The majority voting provision
b. The casting feature
c. The cumulative voting provision
d. The proxy method
ANSWER: c
104. What gives common stockholders the right to maintain a proportionate share of ownership in the
firm when new shares are issued?
a. The participating right
b. The cumulative right
c. The preemptive right
d. The proxy right
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ANSWER: c
KEYWORDS: preemptive right
105. The shareholder can cast all votes for a single candidate or split them among various candidates
through:
a. proxy fights.
b. cumulative voting.
c. call provisions.
d. majority voting.
ANSWER: b
DIFFICULTY: Easy
106. You are considering the purchase of common stock that just paid a dividend of $6.50 per share.
Security analysts agree with top management in projecting steady growth of 12% in dividends and
earnings over the foreseeable future. Your required rate of return for stocks of this type is 18%.
How much should you expect to pay for this stock?
a. $86
b. $94
c. $108
d. $121
e. $242
ANSWER: d
107. You are considering the purchase of Wahoo, Inc. The firm just paid a dividend of $4.20 per share.
The stock is selling for $115 per share. Security analysts agree with top management in projecting
steady growth of 12% in dividends and earnings over the foreseeable future. Your required rate of
return for stocks of this type is 17.5%. If you were to purchase and hold the stock for three years,
what would the expected dividends be worth today?
a. $12.60
b. $9.21
c. $17.12
d. $15.55
e. $11.46
ANSWER: e
108. A share of common stock just paid a dividend of $3.25 per share. The expected long-run growth
rate for this stock is 18%. If investors require a rate of return of 24%, what should the price of the
stock be?
a. $57.51
b. $62.25
c. $71.86
d. $63.92
e. $44.94
215
ANSWER: d
109. Common stockholders expect greater returns than bondholders because:

a. they have no legal right to receive dividends.
b. they bear greater risk.
c. in the event of liquidation, they are only entitled to receive any cash that is left after all
creditors are paid.
e. none of the above.
ANSWER: d
KEYWORDS: common stock features
110. Rival groups compete for voting power through which feature of common stock?
a. Proxies
b. Cumulative voting
c. Call provision
d. Residual ownership
ANSWER: a
DIFFICULTY: Easy
KEYWORDS: proxy fights
Short-Answer Questions
111. Compare and contrast preferred stock and common stock valuation.
ANSWER: In valuing both preferred stock and common stock, the focus is on valuing a perpetual
stream of cash flows. With common stock, however, the stream of cash flows is anticipated to grow at
some specified growth rate. Therefore, the total expected return of a common stock differs from that
of preferred stock in that it consists of not only a dividend yield but a growth rate as well.
KEYWORDS: common stock valuation, preferred stock valuation
112. Discuss two reasons why preferred stock would be viewed as less risky than common stock to
investors.
ANSWER: Preferred stockholders are paid before common stockholders in the event of bankruptcy.
Common stockholders, as the residual owners of a corporation, would receive any monies remaining
after bondholder and preferred stock claims are satisfied. Preferred dividends are paid before common
stock dividends. In the event that a preferred dividend is not paid, it accumulates and dividends in
arrears must be paid before any common stock dividends can be declared. Because cash flows are
more certain, preferred stock would be considered less risky to the investor.
KEYWORDS: preferred stock versus common stock
216
113. Determine the rate of return on a preferred stock that costs $50 and pays a $6 per share dividend.
ANSWER:
K = Div = 6 = 12%
Vg 50
114. Is the following common stock priced correctly? If no, what is the correct price?
Price = $26.25
Required rate of return = 13%
Dividend year 0 = $2.00
Dividend year 1 = $2.10
ANSWER:
Growth rate = 2.10 - 2.00 = 5%
–––––––––––––
2.00
Vcs = 2.10 = $26.25
.13 - .05
The stock is priced correctly.
115. Texon’s preferred stock sells for $85 and pays $11 each year in dividends. What is the expected rate
of return?
ANSWER:
Required rate of return = $11 = 0.129
$85
116. Draper Company’s common stock paid a dividend last year of $3.70. You believe that the long-term
growth in the dividends of the firm will be 8% per year. If your required return for Draper is 14%,
how much are you willing to pay for the stock?
ANSWER:
P0 = $3.70(1+.08) = $3.996 = $66.60
–––––––––––––– –––––––
0.14 - 0.08 0.06
217
117. Determine the rate of return on a $25 common stock that pays a dividend of $2.50 in year 1 and
grows at a rate of 5%.
ANSWER:
Kcs = 2.50 + 5% = 10% + 5% = 15%
25
118. You are considering the purchase of AMDEX Company stock. You anticipate that the company will
pay dividends of $2.00 per share next year and $2.25 per share the following year. You believe that
you can sell the stock for $17.50 per share two years from now. If your required rate of return is
12%, what is the maximum price that you would pay for a share of AMDEX Company stock?
ANSWER:
Vc = $2.00 PVIF12%,1 + $19.75 PVIF12%,2
= ($2.00)(.893) + ($19.75)(.797)
= $17.53
119. You can purchase one share of Sumter Company common stock for $80 today. You expect the price
of the common stock to increase to $85 per share in one year. The company pays an annual
dividend of $3.00 per share. What is your expected rate of return for Sumter stock?
ANSWER:
$80.00 = $3.00 + $85.00
1 + R (1 + R)
$80.00 (1 + R) = $88.00
(1 + R) = $88.00 = $1.10
$80.00
R = .10
120. Dink and Company’s preferred stock pays an annual dividend of $2.80. The shares have no
maturity date. You as an investor require a 7% return. What is the value of Dink’s preferred stock to
you?
ANSWER: V = $2.80/.07 = $40

121. Tannerly Worldwide’s common stock is currently selling for $48 a share. If the expected dividend at
the end of the year is $2.40 and last year’s dividend was $2.00, what is the rate of return implicit in
the current stock price?
ANSWER:
Rc = 2.40/48 + (2.40 - 2.00)/2.00
= .05 + .20
= 25%
218
122. Miller/Hershey’s preferred stock is selling at $54 on the market and pays an annual dividend of
$4.20 per share.
a. What is the expected rate of return on the stock?
b. If an investor’s required rate of return is 9%, what is the value
of the stock for that investor?
c. Considering the investor’s required rate of return, does this stock
seem to be a desirable investment?
ANSWER:
a. R = D/V
R = $4.20/54
R = 7.78%
b. V = D/R
V = $4.20/.09
V = $46.66
c. No, it is not a desirable investment.
123. The common stock of Cranberry, Inc. is selling for $26.75 on the open market. A dividend of $3.68
is expected to be distributed, and the growth rate of this company is estimated to be 5.5%. If
Richard Dean, an average investor, is considering purchasing this stock at the market price, what is
his expected rate of return?
ANSWER:
R = (D/V) + g
R = ($3.68/$26.75) + .055
R = 19.26%
219

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CHAPTER 8

1. When a call provision is exercised, preferred stock is usually repurchased at a discount.

4. Stock value is based entirely on historical cash flows.

5. The stock valuation model D1/(Rc - g) requires Rc > G.

6. Paid-in-kind preferred stock receives initial dividends of common stock.

9. A company may issue multiple classes of preferred stock.

11. Common stockholders are essentially creditors of the firm.

12. Common stock represents a claim on residual income.

24. Preferred stock cannot be retired.

38. Preferred stock valuation usually treats the preferred stock as a:

40. Which statement is true?

41. Which statement is true?

47. Common stockholders are essentially:

48. Preferred stock is similar to a bond because:

59. Preferred stock is similar to a bond in the following way.

60. The common stockholders are most concerned with:

73. Preferred stock is similar to common stock in that:

77. Valuing common stock relies on:

78. A decrease in the _______________will cause an increase in common stock value.

80. Common stock value is primarily based on:

84. Expected return for preferred stock consists of:

90. Which of the following statements is false?

92. Which of the following statements concerning preferred stock is correct?

94. Preferred stock is similar to a bond because:

96. Preferred stockholders:

100. Which of the following statements is true?

101. Common stockholders are:

102. Which investor incurs the greatest risk?

109. Common stockholders expect greater returns than bondholders because:

ANSWER: V = $2.80/.07 = $40

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