Stocks

Need to know  – the attributes of common stocks including the rights of shareholders, how to use the Constant Growth Model, how to value non-constant growth stocks, the basics of  market equilibrium and market efficiency, and the attributes and valuation of preferred stock.  On the final exam, this chapter typically has 3-5 questions; A CAPM problem, a constant growth stock valuation problem, a non-constant growth valuation problem, and 1-2 concept questions.

Questions:

1. Which of the following is likely to decrease the current price of a stock?
     a. Increasing the discount rate.
     b. Increasing the dividend.
     c. Increasing the number of years you plan to own the stock.
     d. Increasing the growth rate.
     e. None of the above are likely to decrease the current price of a stock.

2. The constant dividend growth model may be used to find the price of a stock in all of the following situations except:

a. when the expected dividend growth rate is less than the discount rate.
b. when the expected dividend growth rate is negative.
c. when the expected dividend growth rate is zero.
d. when the expected dividend growth rate is greater than the discount rate.
e. both b. and c. are correct.

3. Suppose a stock is not currently paying any dividends, and its management has announced that it will not pay a  dividend for at least five years, but that it does expect to start paying dividends sometime in the future. Under these conditions, which of the following statements is most correct?
a. Since it is expected to someday pay dividends, the value of the stock today can be found with this equation: P0 = D1/(k - g).
b. The value of the stock cannot be found, even theoretically, by finding the present value of the future expected dividends.
c. The value of the stock is zero.
d. The value of the stock is determined solely by bids from people who want to control the company in order to draw salaries.
e. The value of the stock could be found by discounted cash  flow procedures, but we would have to insert zeros for Dt until such time as we expect the company to begin paying dividends.

4. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is most correct?
a. All common stocks fall into one of three classes: A, B, and C.
b. Most firms have several classes of common stock outstanding.
c. All common stock, regardless of class, must have voting rights.
d. All common stock, regardless of class, must have the same dividend privileges.
e. None of the above statements is necessarily true.

5. Assuming g will remain constant, the dividend yield is a good measure of the required return on a common stock under which of the following circumstances?

a. g > 0.
b. g = 0.
c. g < 0.
d. Under no circumstances.
e. Answers a and b are both correct.

6.  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.
   e.  The preemptive right is important to bondholders but not to shareholders.
 

Problems:

1. ZAL Company's earnings and dividends are expected to remain unchanged for the next two years.   After 2 years, dividends are expected to grow at a 10 percent annual rate forever.  The last dividend paid was $3.00, and the required rate of return is 15 percent.  What should be the current market value of ZAL stock?
     a. $49.04
     b. $54.78
     c. $57.09
     d. $60.14
     e. None of the above is within $.50 of the correct answer.

2. What is the current price of a firm's 12 percent, $100 par value preferred stock with a required rate of return of 8%?
     a. $120
     b. $130
     c. $140
     d. $150
     e. $160

3. A firm's common stock is trading at $50 per share.  In the past the firm has paid a constant dividend of $5 per share.  However, the company has just announced new investments that the market did not know about.  The market expects that with these new  investments, the dividends should grow at 4% per year forever.  Assuming that the discount rate remains the same, what will be the price of the stock after the announcement?
     a. $86.67
     b. $50.00
     c. $52.00
     d. $44.65
     e. $83.33

4. Pern Corp. just paid an annual dividend of $2.00. Dividends are expected to grow at a constant rate forever. The price of the stock is currently $28.40. The required rate of return for this stock is 14 percent. What is the expected growth rate of Pern's dividend?

a. 6.50%
b. 6.96%
c. 7.48%
d. 8.37%
e. 19.66%

5. Niven Rings Inc. just paid a regular dividend of $1.50 per share. The regular dividend is expected to grow at a rate of 10 percent per year for the next three years, at a rate of 7 percent per year for the next two years, and after that at a rate of 4 percent per year forever. In addition to the regular dividend, Niven Rings is expected to pay a special dividend of $5.00 at the end of year 2.  (NOTE: A special  dividend is a one time only payment that will not recur. It is not considered in calculating the amount of future dividends). The appropriate discount rate is 14 percent per year.  What is the price of the stock?

a. $19.02
b. $21.67
c. $22.43
d. $22.86
e. $24.36

6. IBS Corporation has had dividends grow from $2.00 per share to $5.00 per share over the last 5 years (the $5.00 per share dividend was paid yesterday). This  compounded annual growth rate in dividends is expected to continue well into the foreseeable future. If the current market price of IBS's stock is $38.00 per share, what rate of return do investors expect to receive from buying IBS stock?
a. 13.16%
b. 15.80%
c. 33.27%
d. 35.91%
e. None of the above are within 50 basis points (a basis point is 1/100th of a percent) of the correct answer.

7. Tosev Inc. just paid a dividend of $2.00 per share. This dividend is expected to grow at a supernormal rate of 15 percent per year for the next two years. It is then expected to grow at a rate of 5 percent per year forever. The appropriate discount rate for Tosev's stock is 16  percent. What is the price of the stock?
a. $16.86
b. $20.13
c. $20.76
d. $22.72
e. $30.21

8.  Doors and Frames Co. is expected to pay a dividend of $2.20  per share next year.  The dividends are expected to grow at a rate of 9 percent forever.  A share in Doors and Frames Co. currently trades at $45.60.  Assuming the stock is in equilibrium, what is the investors' required rate of return?
   a.  15 percent
   b.  14.2 percent
   c.  13.8 percent
   d.  13 percent
   e.  11 percent

 

Answers:

Questions: 1.A (a variation on rate up implies price down), 2. D, 3. E,  4. Both C and E were accepted, in the United States all common stock should have some type of control/voting rights, in foreign countries, voting rights are not required, 5. E (constant growth model given nonsense answer when growth rate (g) > required return on stock (rs). 6. B,

 Problems:

1 B, A non costant growth problem, solve in three steps, 1) calculate the dividends during the non-constant growth period plus one constant growth dividend, D1-3, d2=3, d3=3.30, 2) Sell the stock as soon as growth becomes contant, P2=D3/(rs-g)=3.30/(.15-.10)=66, 3) Take the NPV @15 of the dividends and expected selling price, Cf0=0, C01=3, C02=3+66=69.

2. D, preferred stock is solved using the constant growth formula, P0=(D0*(1+g))/(rs-g), and since g=0, this simplifies to P0=D0/rs.

3. A, solve in two steps using the constant growth formula, 1) since stock is initially 0-growth, then rs = D0/P0 = 5/50, 2) use the rs from step 1 to solve, new  P0 = (5* (1+4%))/(rs-4%).

4. A, solve for g, where 14%= ((2*(1+g))/28.40) + g

5. D, Step 1, calculate the dividends for the non-contant growth period plus 1 dividend, a total of 4 dividends. Step 2, sell the stock as soon as growth become constant, P3 = D4/(10%-4%), Step 3, Take the NPV at 10% of the expected dividends and expected selling price,. CF0=0, C01=D1, C02=D2 + 5.00, C03=D3 + P3.

6. D, key step is to find the growth rate, using PV=-2, N=5, FV=5, PMT=0, and compute I/Y=growth rate.  Use the constant growth formula and g from step 1 solve for rs where rs = ((5* (1+g))/38) + g.

7. D. three steps, Calculate the dividends for the supernormal growth period plus one  dividend, D1=2.30, D2=2.65, D3=2.78, Step 2, sell the stock as soon as growth becomes constant, P2=D3/(rs-g)=2.78/(.16-.05)=25.24.  Step 3, take the NPV of the dividends and expected selling price at 16%, where CF0=0, C01=2.30, C02=2.64+25.24=27.88.

8. C, D1/P0+g = 2.20/45.60 + 9%=13.82%.