Test 1

Question 1

Chapter 10
MJ company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. What if instead, MJ Company decides to plow back 40% of the earnings at the firm’s current return on equity of 20%. Calculate the value of the stock before and after the plowback decision. (with and without growth)

Answer 1

D1 = 5.00
Ke = 0.12
ROE = 0.20
Plowback = 0.40 --> Div 60%

g = ROE x Plowback
= 0.20 x 0.40
= 8%

Without growth
P = Div / (Ke - g)
= 5 / (0.12 - 0)
= 41.67

With growth 
Div = 5 x 60%
= 3
P = Div / (Ke - g)
= 3 / (0.12 - 0.08)
= 3 / 0.04
= 75

Question 2

Ch
You get paid 300,000 every year for 20 years and 500,000 for 20 years after that. With a rate of 6% what would be the PV of the total amount?

Answer 2

n= 20 i= 6% using Appendix D
PVa = 300,000 (11.470)
= 3,441,000
PVa = 500,000 (11.470)
= 5,735,000
using Appendix B
PV = 5,735,000 (0.312)
= 1,789,320

3,441,000 + 1,789,320 = 5,230,320

Question 3

The company paid a dividend of $1.67 last year. Dividends are expected to grow at 20% over the supernormal growth period of 3 years. They will then grow at a normal constant rate (g)of 5%. The required rate of return (Ke) is 9%. Calculate the price of the stock.

Answer 3

D1 = 1.67
supernormal g = 0.20 (3 years)
g= 0.05 
Ke = 0.09
i = 9%
D1 = 1.67 x 1.20 = 2.00
2.00 (0.917) = 1.83     
D2 = 2.00 x 1.20 = 2.40 
2.40(0.842) = 2.02     
D3 = 2.40 x 1.20 = 2.88 
2.88(0.772)= 2.22
1.83 + 2.02 + 2.22 = 6.07    
D4 = 2.88 x 1.05 = 3.02 

P = Div / (Ke - g)
= 3.02 / (0.09 - 0.05)
= 3.02 / 0.04
= 75.50

P = 75.50 (0.772)
= 58.59

P = 58.69 + 6.07
= 64.36

Question 4

Fastco Inc. Expects a EPS of 2.50. The company has an ROE of 13% and plows back 60% of its earnings. If the required return is 12%, calculate the value of the shares using the appropriate dividend discount model

Answer 4

EPS = 2.50
ROE = 0.13
Plowback = 0.60 --> 0.40 Div
Ke = 0.12

g = ROE x Plowback
= 0.13 x 0.60
= 0.078

Div = 2.50 x 0.40
= 1

P = Div / (Ke- g)
= 1 / (0.12- 0.078)
= 1 / 0.042
= 23.81

Question 5

Dividends are paid out at $1.20 per share, with a required rate of return bieng 10%. Estimated 15% growth rate for the next three years, after that a normal growth rate of 6% is expected

Answer 5

Div = 1.20
Ke = 0.10
supernormal g = 0.15 (3 years)
g = 0.06

D1 = 1.20 x 1.15 = 1.38
1.38(0.909) = 1.25
D2= 1.38 x 1.15 = 1.59
1.59(0.826) = 1.31
D3 = 1.59 x 1.15 =1.83
1.83(0.751) = 1.37
1.25 +1.31 +1.37= 3.93
D4 = 1.83 x 1.06= 1.94

P = Div /(Ke - g)
= 1.94 / (0.10- 0.06)
= 1.94 / 0.04
= 48.50
P = 48.50 (0.751)
= 36.42
P= 36.42 + 3.93
= 40.35

Question 6

What is annuity due?

Answer 6

payment that is made at the beginning of period

Question 7

What is deferred annuity?

Answer 7

A annuity (payment) that its payment is due at a later time period

Question 8

What is a perpetuity?

Answer 8

A bond or security with no fixed maturity date

Question 9

What is the difference between single amount and annuity due?

Answer 9

Single amount is a single one time payment of a sum where as annuity due is a equal payment that is made every year for a certain number of years

Question 10

What is a security?

Answer 10

Financial Instruments that enable funds to move from suppliers to demanders through the financial system ex. stocks, bonds, shares

Question 11

What is the difference between Primary Markets vs. Secondary Markets?

Answer 11

Primary Markets have brand new securities that are being sold by a business and the profits go to them (the issuer) directly, where Secondary Markets are circulated securities and funds go to the seller (security issuer)

Question 12

What is the difference between Money Market and Capital Market?

Answer 12

Money Market are securities with maturities of one year or less (Ex. T-Bills (main one), Commercial paper, Asset backed securities) where Capital Markets have long-term securities (Bonds, Stocks, Common and Preferred Shares)

Question 13

Governments are also demanders in financial markets along with corporations. How do they raise money? What are some Government Securities?

Answer 13

By issuing debt securities aka Bonds

Question 14

What are some Corporate Securities?

Answer 14

Preferred Stock, Common Stock, Bonds

Question 15

What is Internal Funding vs. External Funding?

Answer 15

Internal Funding is when a company in turn plowsback their profits and reinvests it into their company as a form of raising money and external funding is when a company raises money by issuing financial securities

Question 16

What is a coupon?

Answer 16

The interest paid to bondholders

Question 17

What is par value?

Answer 17

the payment at the maturity

Question 18

What is another name for unsecured bond holders?

Answer 18

Debentures

Question 19

What is the order of priority of payment if a company is to “go under”

Answer 19

Senior/ Junior Secured debt holders, Senior and Subordinated Debentures, Preferred Stock, Common Stock

Question 20

What is a covenant?

Answer 20

promises made by a firm in the bond indenture

Question 21

Assume that Beta Corp borrows by issuing bonds that will mature in 15 years. The bonds have a coupon rate of 10%, paid annually. The 10% coupon rate is equal to the rate of return that investors expect to earn on a bond with this level of risk and time to maturity. (Assume bond is always $1000)

Answer 21

n = 15 years 
i = 10%
Coupon rate = 1000 x 0.10 
= 100
So payments of $100 are every year for 15 years and there is a 1000 par value at the end of the 15 years.
PVa = 100 (7.606)
= 760.60
PV = 1000 (0.239)
= 239
Bond price = 760.60 + 239 
= 999.60
= 1000 (rounded)
0    1    2    3             15
I-----I----I-----I-------------I
    100 100 100     100+1000

Question 22

HRK Industries Ltd. needs to raise $10 million in order to purchase new equipment. The company plans to issue 5 year bonds with a face value of $1,000 and a coupon rate of 6.3% (semi- annual payments). What is the price of the bond?

Answer 22

n = 5 years  x 2 (semi annually 
= 10 
i = 6.3%/ 2 (semi annually)
= 0.0315
1000 x 0.0315 = 31.50
Therefore, there is payments of 31.50 being paid every period on top of a value of 1000 after the 5 years 
PVa = A(1-(1 + i)^-n)/ i)
= 31.50 (1 - (1+ 0.0315) ^-10/ 0.0315)
= 31.50 (8.4652733878)
=266.66

PV = FV (1+ i )^-n
= 1000 (1+ 0.0315)^-10
= 1000 (0.7333438883)
= 733.34

Bond Price = 266.66 + 733.34
= 1000

Question 23

What is a Share price?

Answer 23

The market value of the shares of a company determined by buyers and seller s in the market place

Question 24

What is EPS?

Answer 24

The net earnings of a company dividend by the number of outstanding shares

Question 25

What is the sustainable growth rate equation?

Answer 25

ROE x Plowback = Growth rate

Question 26

What is the formula to find the Price of a share?

Answer 26

P = Div / (Ke - g)

Question 27

ABC Corp pays all of its earning out as dividends. Dividends are $4 annually. If the required rate of return is 10% what is the price of the shares?

Answer 27

Div = 4 
Ke = 0.10

P = Div/ (Ke - g)
= 4 / (0.10 - 0)
= 40

Question 28

Calculate the price of Blue Sky shares if:
Next year’s dividend (D1) will be $3.
Dividends are expected to grow at 8% in perpetuity.
The discount rate is 12%.

Answer 28

Div = 3
g = 0.08
Ke = 0.12

P = Div / (Ke - g)
= 3 / (0.12 - 0.08)
= 3 / 0.04)
= 75

Question 29

A firm will pay $4.00 dividend at the end of year one, has a share price of $50.00 and a constant growth rate of 5%. Compute required rate of return?

Answer 29

Div = 4
p= 50 
g = 0.05 

Ke = (Div/ P) + g
= (4 / 50) + 0.05
= 0.08 + 0.05
= 0.13