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Principles of Finance > Chapter 9 - Stocks and Their Valuation > Flashcards

Chapter 9 - Stocks and Their Valuation Flashcards

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1
Q

What is a method to estimate the value of a share of stock by discounting all expected future dividend payments?

A

The dividend discount model (DDM)

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2
Q

What is DDM equal to?

A

PV

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3
Q

What calculator buttons do you use when calculating the DDM?

A

N, I, and PMT

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4
Q

Suppose that a stock will pay three annual dividends of $200 per year; the appropriate risk-adjusted discount rate, 𝑟𝑠, is 8%.

What is the value of the stock today using a calculator?

A 
N = 3
I = 8%
PMT = $200
PV = $515.42
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5
Q

What type of rate does the DDM use?

A

A constant rate

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6
Q

List the dividend discount model’s 2 critical assumptions

A
  1. Grow forever at a constant growth rate

2. The growth rate < the required rate of return, otherwise we have a negative stock price

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7
Q

What are the 2 formulas to find DDM using a constant growth rate?

A
  1. [D(0) (1 + growth rate)] / (req. ror - growth rate)

2. D(1) / (req. ror - growth rate)

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8
Q

What are the 2 formulas to find dividends yield?

A
  1. Dividends / Initial price per share

2. D(0) / P(0)

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9
Q

What is the formula to find capital gains yield?

A

(Stock price after year 1 / initial stock price) - 1

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10
Q

What is the formula to find total stock return?

A

Dividend yield + capital gains yield

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11
Q

What do we need to calculate with the constant growth model?

A

Terminal Value

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12
Q

What will the sum total of both PV of Dividends and PV of Terminal Value reflect?

A

The Fair Value of the Stock

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13
Q

What are the 3 steps to value common stock with a non constant growth rate?

A
  1. Calculate dividend value
  2. Calculate stock price per share
  3. Calculate PV and price
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14
Q

What is the formula to calculate D(1)?

A

D(0) x (1 + growth rate for D(1))

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15
Q

What is the formula to calculate D(2)?

A

D(1) x (1 + growth rate for D(2))

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16
Q

What is the formula to calculate stock price per share: P(2) using D(3) constant?

A

D(3) / (req. ror - gr D(3))

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17
Q

D(0) = 4.00, Req. RoR = 12%, GR D(1) = 20%, GR2 = 15%, GR3 = 10% Constant

Calculate dividends

A 
D(1) = 4(1+0.2) = 4.8
D(2) = 4.8(1+0.15) = 5.52
D(3) = 5.52(1+0.1) = 6.0702
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18
Q

D(0) = 4.00, Req. RoR = 12%, GR D(1) = 20%, GR2 = 15%, GR3 = 10% Constant

Calculate stock price per share using D(3) constant (6.0702)

A

P(2) = 6.0702 / (0.12 - 0.10) = 303.60

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19
Q

D(0) = 4.00, Req. RoR = 12%, GR D(1) = 20%, GR2 = 15%, GR3 = 10% Constant, D(1) = 4.8, D(2) = 5.52, D(3) = 6.0702

Calculate PV and Price

A

PV of D(1) = N = 1, I = 12%, FV = 4.80, PV = 4.2857
PV of D(1) = N = 2, I = 12%, FV = 5.52, PV = 4.4005
PV of P(2) = N = 2, I = 12%, FV = 303.60, PV = 242.0281

Price = 4.2857 + 4.4005 + 242.0281 = $250.7143

20
Q

Which of the following statements is CORRECT?

a. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years.
b. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, then the stock’s dividend yield is also 5%.
c. The stock valuation model, P0 = D1/(rs - g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.
d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.
e. The constant growth model cannot be used for a zero growth stock, wherein the dividend is expected to remain constant over time.

A

c. The stock valuation model, P0 = D1/(rs - g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.

21
Q

If a given investor believes that a stock’s expected return exceeds its required return, then the investor most likely believes that:

a. the stock is experiencing supernormal growth.
b. the stock should be sold.
c. the stock is a good buy.
d. management is probably not trying to maximize the price per share.
e. dividends are not likely to be declared.

A

c. the stock is a good buy.

22
Q

If a stock’s dividend is expected to grow at a constant rate of 5% a year, then which of the following statements is CORRECT? The stock is in equilibrium.

a. The expected return on the stock is 5% a year.
b. The stock’s dividend yield is 5%.
c. The price of the stock is expected to decline in the future.
d. The stock’s required return must be equal to or less than 5%.
e. The stock’s price one year from now is expected to be 5% above the current price.

A

e. The stock’s price one year from now is expected to be 5% above the current price.

23
Q

Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Price X = $25 Y = $25
Expected dividend yield X = 5% Y = 3%
Required return X = 12% Y = 10%

a. Stock Y pays a higher dividend per share than Stock X.
b. Stock X pays a higher dividend per share than Stock Y.
c. One year from now, Stock X should have the higher price.
d. Stock Y has a lower expected growth rate than Stock X.
e. Stock Y has the higher expected capital gains yield.

A

b. Stock X pays a higher dividend per share than Stock Y.

24
Q

Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Price X = $30 Y = $30
Expected dividend yield X = 6% Y = 4%
Required return X = 12% Y = 10%

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 X’s price is expected to be higher than Stock Y’s price.
d. Stock X has the higher expected year-end dividend.
e. Stock Y has a higher capital gains yield.

A

c. One year from now, Stock X’s price is expected to be higher than Stock Y’s price.

25
Q

Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT?

Expected dividend, D1 = $3.00
Current Price, P0 = $50
Expected constant growth rate = 6.0%

a. The stock’s required return is 10%.
b. The stock’s expected dividend yield and growth rate are equal.
c. The stock’s expected dividend yield is 5%.
d. The stock’s expected capital gains yield is 5%.
e. The stock’s expected price 10 years from now is $100.00.

A

b. The stock’s expected dividend yield and growth rate are equal.

26
Q

Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Beta A = 1.10 B = 0.90
Constant growth rate A = 7.00% B = 7.00%

a. Stock A must have a higher stock price than Stock B.
b. Stock A must have a higher dividend yield than Stock B.
c. Stock B’s dividend yield equals its expected dividend growth rate.
d. Stock B must have the higher required return.
e. Stock B could have the higher expected return.

A

b. Stock A must have a higher dividend yield than Stock B.

27
Q

The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is CORRECT?

a. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.
b. If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X.
c. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price.
d. The stocks must sell for the same price.
e. Stock Y must have a higher dividend yield than Stock X.

A

a. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.

28
Q

The expected return on Natter Corporation’s stock is 14%. The stock’s dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT?

a. The stock’s dividend yield is 7%.
b. The stock’s dividend yield is 8%.
c. The current dividend per share is $4.00.
d. The stock price is expected to be $54 a share one year from now.
e. The stock price is expected to be $57 a share one year from now.

A

d. The stock price is expected to be $54 a share one year from now.

29
Q

A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, then which of the following statements is CORRECT?

a. The company’s current stock price is $20.
b. The company’s dividend yield 5 years from now is expected to be 10%.
c. The constant growth model cannot be used because the growth rate is negative.
d. The company’s expected capital gains yield is 5%.
e. The company’s expected stock price at the beginning of next year is $9.50.

A

e. The company’s expected stock price at the beginning of next year is $9.50.

30
Q

Which of the following statements is CORRECT, assuming stocks are in equilibrium?

a. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.
b. Assume that the required return on a given stock is 13%. If the stock’s dividend is growing at a constant rate of 5%, then its expected dividend yield is 5% as well.
c. A stock’s dividend yield can never exceed its expected growth rate.
d. A required condition for one to use the constant growth model is that the stock’s expected growth rate exceed its required rate of return.
e. Other things held constant, the higher a company’s beta coefficient, the lower its required rate of return.

A

a. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.

31
Q

What is the formula to calculate req. ror using CAPM?

A

Risk-free RoR + beta(MRP)

32
Q

What is the formula to calculate the dividend value in 10 years?

A

D(0)(1+g)^10

33
Q

What is the formula to calculate the stock price per share in 10 years?

A

P(0)(1+g)^10

34
Q

What is the capital gains yield equal to?

A

The growth rate

35
Q

What is total return equal to?

A

The required rate of return

36
Q

Solve the problem:

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 9.0%, and the constant growth rate is g = 4.0%. What is the current stock price?

A 
D(1) = D(0) (1 + g)
D(1) = 1.50 (1 + 0.04)
D(1) = 1.56
P(1) = D(1) / (rs - g)
P(1) = 1.56 / (0.09 - 0.04)
P(1) = $31.20
37
Q

Solve the problem:

The risk free rate of return (rf) is 6%, market risk premium (MRP=(rm–rf)) is 4%, and JP Morgan Chase’s stock has a beta coefficient of 1.5. If the dividend expected during the coming year is $2.25 (D1), and if the growth rate is constant at 5%, at what price should JP Morgan Chase’s stock sell?

A 
RS = rf + b(MRP)
RS = 0.06 + 1.5(0.04)
RS = 12%
P(0) = D(1) / (rs - g)
P(0) = 2.25 / (0.12 - 0.05)
P(0) = $32.14
38
Q

Solve the problem:

Gray Manufacturing is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $22.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate?

A 
P(0) = D(1) / (rs - g)
22.50 = 1.25 / (0.105 - g)
22.50(0.105 - g) = 1.25
2.3625 - 22.50g = 1.25
-22.50g = -1.1125
g = 4.94%
39
Q

Solve the problem in equation form:

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 9.0%, and the constant growth rate is g = 4.0%. What is the dividend value in 10 years?

A 
D(10) = D(0)(1+g)^ # of years
D(10) = 1.50 (1 + 0.04) ^10
D(10) = 2.2204
40
Q

Solve the problem using a calculator:

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 9.0%, and the constant growth rate is g = 4.0%. What is the dividend value in 10 years?

A 
N = 10
I = 4%
PV = 1.5
FV = 2.2204
41
Q

Solve the problem in equation form:

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 9.0%, the stock price per share is P(0) = 31.20, and the constant growth rate is g = 4.0%. What is the stock price per share in 10 years?

A 
P(10) = P(0) (1 + g)^ # of years
P(10) = 31.20 (1 + 0.04) ^ 10
P(10) = 46.1836
42
Q

Solve the problem using a calculator:

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 9.0%, the stock price per share is P(0) = 31.20, and the constant growth rate is g = 4.0%. What is the stock price per share in 10 years?

A 
N = 10
I = 4%
PV = 31.20
FV = 46.1836
43
Q

Solve the problem:

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 9.0%, and the constant growth rate is g = 4.0%. Calculate capital gains yield.

A 
CGY = G
CGY = 4%
44
Q

Solve the problem:

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 9.0%, the stock price per share is $31.20, and the constant growth rate is g = 4.0%. Calculate dividends yield.

A 
DY = D(0) / P(0)
DY = 1.50 / 31.20
DY = 5%

OR

DY = rs - g
DY = 9% - 4%
DY = 5%
45
Q

Solve the problem:

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 9.0%, and the constant growth rate is g = 4.0%. Calculate the total return.

A 
TR = RS
TR = 9%

Principles of Finance (8 decks)

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