Valuation of Stocks and Bonds - Review Questions

Question 1

Mountainside Electric Company is expected to pay cash dividends amounting to $2 per share into the indefinite future and has a required rate of return of 10%. If the market price for the stock is currently at $18.50/share, is the stock overvalued, undervalued or fairly priced?

Answer 1

V=$2 / 10%=$20
. Since the price of the share is trading currently at $18.50, it is undervalued by $1.50 according to the zero growth dividend model.

Question 2

Why is the zero growth model useful when restricted to high-grade preferred stocks?

Answer 2

The zero growth model is useful when restricted to high-grade preferred stocks because the chance of a suspension of dividends is remote.

Question 3

Where is zero-growth DDM useful?

Answer 3

One particular case in which zero-growth model is quite useful is determining the intrinsic value of a share of high-grade preferred stock. In this case the zero-growth DDM will often be appropriate, because most preferred stock pays a fixed dollar-amount dividend that will not change as earnings per share change.

In addition, for high-grade preferred stock, dividends are expected to be paid regularly into the anticipated future, since preferred stocks do not have a fixed lifetime. If the application of the zero-growth model is restricted to high-grade preferred stocks, the model is useful because the chance of a suspension of dividends is remote.

Question 4

Kelley Promotions, Inc. paid a $1 per share dividend last year. Kelley Promotions is expected to grow the dividend at a rate of 4% per year indefinitely. Assuming a required rate of return of 8%, what is the value of the Kelley Promotions, Inc. stock? How would that compare to its current price of $29? (select all that are true.)

1) V = $26
2) V = $27
3) V = $28
4) Overvalued
5) Undervalued
6) Fairly priced

Answer 4

1) V = $26
4) Overvalued

V = $1(1 + .04)/(.08 - .04) = $26. $29 - $26 = $3. The stock is $3 overvalued.

Question 5

Rock Rulez Guitar Company paid dividends of $2 per share last year, with a forecast that dividends would grow by 6% per year indefinitely. The required rate of return on Rock Rulez was 10% and the current stock price was $38 per share. E0 was $4. What is the value of this stock?

Choose the best answer.

1) Overvalued
2) Undervalued
3) Fairly Priced

Answer 5

2) Undervalued

Calculate payout ratio = ($2/$4) = 50%. According to the equation indicating the normal price/earnings ratio = [(0.5)(1+0.06)]/(0.10 - 0.06) = 13.25. This is more than Rock Rulez Guitar’s actual price/earnings ratio of = $38/$4= 9.50. This means the stock is undervalued.

Question 6

A stock has expected earnings of $1.05 and a required rate of return (capitalization rate) of 8%. What is the intrinsic value of the stock?

Answer 6

$1.05/ .08
= $13.125

Question 7

Determine the fair value of a stock based on several metrics including Capitalization rate, P/E, P/S and P/fcf. The following are known:

Earnings per share are $2.50
The required capitalization rate is 13.9%
Sales per share are $25
Free cash flow per share is $4.50
P/E should be 7.2
P/S should be .72
P/fcf should be 4.0

1) Value based on capitalization rate
2) Value based on P/E
3) Value based on P/S
4) Value based on P/fcf

Answer 7

1) Value based on capitalization rate = $2.50 / .139 = $17.99

2) Value based on P/E = 7.2 × $2.50 = $18.00 value is 7.2 times earnings per share (EPS)

3) Value based on P/S = .72 × 25 = $18.00 value is 0.72 times sales per share

4) Value based on P/fcf = 4.0 × 4.50 = $18.00 value is 4 times free cash flow

Question 8

All of the following are liquidity ratios, EXCEPT:

(Check all that apply.)

1) Current ratio
2) Times-interest-earned ratio
3) Inventory turnover ratio
4) Quick (acid-test) ratio

Answer 8

2) Times-interest-earned ratio
3) Inventory turnover ratio

Times-interest-earned is a debt ratio. Inventory turnover is an activity ratio.

Question 9

XYZ Corporation will pay a dividend on common stock of $3.00 per share at the end of the year. The required return on the stock is 11.5%. If the firm has a constant growth rate of 8%, what is the intrinsic value of the stock?

1) $110.52
2) $72.52
3) $85.71
4) $123.45

Answer 9

3) $85.71

The intrinsic value is calculated using the formula: V=d1/(r-g). By substitution, V= $3.00/(.115-.08)= $85.71

Question 10

The Syntax Corporation paid a dividend of $2.25 per share. The dividend growth rate is 5%. If the stock is selling for $25.00 per share, what is the required return for this stock?

1) 14.44%
2) 6.75%
3) 6.23%
4) 5.52%

Answer 10

1) 14.44%

The value for the projected dividend will be: $2.25 x 1.05= $2.36. Then to solve for the discount rate:
r= (d1/P) + g= 2.36/25 + .05 = 14.44%

Question 11

ABC Corporation’s common stock is currently selling for $8 per share. James expects that the company will earn $0.75 per share in the next 12 months and will pay a dividend of $0.12 per share. He expects that dividends will grow at a rate of about 9% per year for the foreseeable future. James requires a rate of return of at least 13% before he will invest in ABC. Which of the following should be part of your advice to James as his planner?

1) The stock appears to be a good purchase at $10.
2) This stock has a justified P/E ratio of 6.2
3) This stock would be worth more if it had a higher dividend payout ratio.

(1) and (3) only
(1) and (2) only
(2) and (3) only
(3) only

Answer 11

(3) only

To calculate the justified P/E, take the payout ratio of 0.16 multiply by 1 + g, or 1.09 and divide by 0.04, the difference between James’ required rate of return and the expected dividend growth rate. This gives a justified P/E of 4.36. Therefore (2) is an incorrect statement. The constant dividend growth rate produces a value of only $0.12/(0.13 − .09)= $3.00. Therefore statement (1) is incorrect. Statement (3) is correct.

Question 12

An investor owns a bond with a coupon rate of 6% and 3 years to maturity. Comparable bonds are yielding 8%. What is the duration of this bond?

1) 2.38
2) 2.83
3) 3.56
4) 4.25

Answer 12

2) 2.83

The bond price is as follows: $60 is PMT, $1,000 is FV, 3 is number of periods, and 8 as interest rate gives a value of $948.46.

Pmt. # Pmt. Amount Present Value of the Cash FLow Present Value × Year
1 $60 $55.56=$60 / (1.08)1 $55.56×1=$55.56
2 $60 $51.44=$60 / (1.08)2(square) $51.44×2=$102.88
3 $1060 $841.46=$1,060 / (1.08)3(cube) $841.46×3=$2,524.38

                                                                             Total	                      $2,684.82

Duration=$2,684.82 / $948.46=2.83years