Subunit 1: Stock Valuation Methods

Q1. A company is projecting an annual growth rate for the foreseeable future of 9%. The most recent
dividend paid was $3.00 per share. New common stock can be issued at $36 per share. Using the constant
growth model, what is the approximate cost of capital for retained earnings?
A. 9.08%
B. 17.33%
C. 18.08%
D. 19.88%

Q2. A public company’s shareholders expect to receive a dividend 1 year from now of $20 per share.
Immediately after the dividend payout, analysts are expecting that the stock will trade at $244 per share. If
the investors have a required rate of return of 20%, what is the current value of the stock?
A. $220
B. $224
C. $244
D. $264

Q3. The common stock of a company is currently selling at $80 per share. The leadership of the company
intends to pay a $4 per share dividend next year. With the expectation that the dividend will grow at 5%
perpetually, what will the market’s required return on investment be for the common stock?
A. 5%
B. 5.25%
C. 7.5%
D. 10%

Q4. An analyst is in the process of determining what the current share price should be for a company. In
early January, the analyst collected the following information
. Dividend at end of current year = $1.00
. Yearly dividend increase = 5%
. Expected investor return = 10%
. Based on the data provided, the current share price should be
A. $21.00
B. $20.00
C. $7.00
D. $6.67
Q5. A corporation just paid a dividend of $2.00 per common share. Historical data indicate that dividends
grow at a steady rate of 5% per year. The required rate of return for investing in such stock is 18%. The
current value of one share of common stock is
A. $16.15
B. $15.38
C. $11.67
D. $11.11

Q6. The CFO of a publicly traded chemical manufacturer is in the process of evaluating the company’s
dividend policy in relation to shareholder value. The company’s dividend per share has been held constant
at $2.30 for the last 10 years. The CFO would like to implement a 5% yearly dividend growth policy at the
company starting next year. The CFO has determined that the required return in the market for the
company’s stock is 13%.
What is the forecasted value of the company stock in 5 years if the CFO’s dividend growth policy is
implemented?
A. $38.53
B. $36.69
C. $30.19
D. $23.71

Q7. A financial analyst is using the two-stage model of dividend growth to value a corporation that paid an
annual dividend last year of $4 per share. The annual dividend is assumed to grow at 10% per year for the
next 3 years and then grow at 5% per year thereafter. A 12% required return is assumed. Which change in
one of the assumptions would cause the analyst to find a higher value for the stock?
A. The required return is changed from 12% to 14%.
B. The growth rate is changed from 5% to 4%.
C. The 3-year assumption is changed to 5 years.
D. The 10% growth rate is changed to 8%.

Q8. Current-year earnings are $2.00 per share. Using a discounted cash flow model, the controller
determines that the common stock is worth $14 per share. Assuming a 5% long-term growth rate, the
required rate of return is which one of the following?
A. 20%
B. 15%
C. 10%
D. 7%
Q9. By using the dividend growth model, estimate the cost of equity capital for a firm with a stock price of
$30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate
of 10%.
A. 21.1%
B. 12.2%
C. 11.0%
D. 20.0%

Q10. The CFO of a publicly traded company is expecting to pay a dividend next year of $1.25 and projecting
that the price of the company’s stock will be $45 in 1 year. The CFO has determined that the required rate
of return for the company is 10%. Based on the data available, what is the value of one share of stock
today?
A. $42.05
B. $45.00
C. $46.25
D. $51.39

Q11. Stock A is currently trading at $50 per share. A financial analyst has collected the following
historical and current data for the stock.

A. $40.00
B. $44.00
C. $48.40
D. $53.24

Q12. A manufacturer of printers is attempting to determine its cost of common equity for cost of capital
purposes. The manufacturer’s long-term debt is rated AA by Standard & Poor’s. The manufacturer’s
common shares trade on the NASDAQ and the current market price is $26.87. The most recent yearly
common share dividend paid common shareholders was $1.04. The consensus forecast of security analysts
who follow the manufacturer’s common shares is that earnings growth will average 12.5% over the long
term. The manufacturer’s marginal income tax rate is 40%. Using the dividend discount model, what is the
manufacturer’s cost of equity capital for cost of capital purposes?
A. 9.82%
B. 10.11%
C. 16.37%
D. 16.85%

Q13. The common stock of a beverage company has a current market price of $34. The beverage company
is estimated to earn $2 per share in the next year. The average price/earnings ratio of companies in the
beverage industry is 15. Using the price/earnings ratio as the comparable valuation method, the beverage
company’s stock is
A. $2 undervalued.
B. $2 overvalued.
C. $4 undervalued.
D. $4 overvalued.

Q14. A corporation paid a dividend of $3 per share last year. If investors expected the dividend per share
to grow by 5% per year forever, what required return of investors is consistent with a current share price
of $63 per share?
A. 3%
B. 5%
C. 10%
D. 15%

Q15. What return on equity do investors seem to expect for a firm with a $50 share price, an expected
dividend of $5.50, a β of .9, and a constant growth rate of 4.5%?
A. 15.05%
B. 15.50%
C. 15.95%
D. 16.72%

Q16. Ten years ago, perpetual preferred shares with a par value of $50 and an annual dividend rate of 6%
were issued. Currently, there are no dividends in arrears. Since the issue date, interest rates have risen,
and the shares are now selling at $38. The market’s current required rate of return on these shares is
A. 4.56%
B. 6.00%
C. 7.89%
D. 15.7
 ANSWERS

Answer 1 (C) is correct.

The cost of capital can be found using the dividend discount model. In the calculation below, x is the cost
of capital.

Answer 2 (A) is correct.

One method of valuing stock is shareholder return, which measures the return on a purchase of stock.
Shareholder return is equal to the required rate of return. In this case, the current value of the stock is
equal to the beginning stock price. In the calculation below, x is the beginning stock price.

Answer 3 (D) is correct.

The dividend growth model estimates the cost of retained earnings using the dividends per share, the
market price, and the expected growth rate. The current dividend yield is 5% ($4 ÷ $80). Adding the growth
rate of 5% to the yield of 5% results in a required return of 10%.

Answer 4 (B) is correct.

The dividend discount model is a method of arriving at the value of a stock by using expected dividends per
share and discounting them back to present value. The formula is as follows: dividend per share ÷ (cost of
capital – dividend growth rate). Because the dividend at year end is given, the expected dividend does not
need to be calculated. Therefore, the current share price should be $20 [$1 ÷ (.10 – .05)].

Answer 5 (A) is correct.

The dividend discount model (also known as the dividend growth model) is a method of arriving at the
value of a stock by using expected dividends per share and discounting them back to present value. The
next dividend is calculated as $2.10 [$2.00 dividend × (1 + .05 growth rate)]. Thus, the current value of one
share of common stock is calculated as $16.15 [$2.10 next dividend ÷ (18% cost of capital – 5% dividend
growth rate)].

Answer 6 (A) is correct.

The dividend discount model (also known as the dividend growth model) is a method of arriving at the
value of a stock by using expected dividends per share and discounting them back to present value. The
expected dividend at the end of 5 years is calculated as $3.08221997 [$2.30 dividend × (1 + .05 growth
rate)6]. Thus, the forecasted value of one share of stock in 5 years is calculated as $38.53 [$3.08221997
next dividend ÷ (13% cost of capital – 5% dividend growth rate)].

Answer 7 (C) is correct.

This would cause the dividend growth in Years 4 and 5 to increase from 5% to 10%. The higher future cash
flows result in a higher value for the stock.

Answer 8 (A) is correct.

The current-year earnings per share are $2.00. In order to calculate the correct dividend per share amount
when given only the amount of the last annual dividend paid, it is necessary to adjust to the expected
dividend using the growth rate of the company. Thus, the dividends per share equal $2.10 [$2 × (1 + .05)].

The dividend discount model (also known as the dividend growth model) is a method of arriving at the
value of a stock by using expected dividends per share and discounting them back to present value. The
formula is as follows:

Answer 9 (D) is correct.

Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of
the next dividend and the current market price. Thus, the cost of equity capital is 20% [10% + ($3 ÷ $30)].
This model assumes that the payout ratio, retention rate, and the earnings per share growth rate are all
constant.

Answer 10 (A) is correct.

The value of one share of stock today is the price of the stock at the end of the year plus the dividend
received, discounted back 1 year by the required rate of return. Thus, the value of the stock at the end of
the year is $46.25 ($45 plus the $1.25 dividend). This must be discounted back to today to equal $42.05
($46.25 ÷ 1.10).

Answer 11 (D) is correct.

The constant growth dividend discount model is a method that arrives at the value of a stock by using
expected dividends per share and discounting them back to present value. The formula involves dividing
the expected dividends per share by the discount rate minus the dividend growth rate. The dividends are
expected to increase by 10% each year ($2.20 ÷ 2.00 = 110%; $2.42 ÷ 2.20 = 110%). Accordingly, the
calculation would be to divide the expected dividend of $2.662 [$2.42 × (1 + .10)] by a rate of 5% (15% –
10%). Thus, the value of Stock A in 20X3 is $53.24 ($2.662 ÷ .05).
Answer 12 (D) is correct.
Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of
the next dividend and the current market price. The next dividend is calculated as $1.17 [$1.04 dividend ×
(1 + .125 growth)]. Thus, the cost of equity capital is 16.85% [12.5% + ($1.17 ÷ $26.87)]. This model
assumes that the payout ratio, retention rate, and the earnings per share growth rate are all constant.

Answer 13 (D) is correct.

The starting point is to determine what the beverage company’s stock price should be using the average
price/earnings (PE) ratio of the beverage industry (15). Next, this amount is compared to the beverage
company’s current stock price ($34). The beverage company’s stock price is overvalued by the excess of its
current stock price over the industry adjusted stock price and vice-versa.

Answer 14 (C) is correct.

The dividend growth model estimates the cost of retained earnings using the dividends per share, the
market price, and the expected growth rate. The current dividend yield is 5% ($3.15 ÷ $63). Adding the
growth rate of 5% to the yield of 5% results in a required return of 10%.

Answer 15 (B) is correct.

Dividing the $5.50 dividend by the $50 share price produces an 11% dividend yield. Adding the 11% yield to
the 4.5% growth rate produces a total return of 15.5%. The beta coefficient is irrelevant.

Answer 16 (C) is correct.

The required rate of return on these shares is calculated by dividing the dividend by the market price. Thus,
$3 (6% × $50) must be divided by $38 to yield 7.89%.