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Multiple Choice Questions

1. The accounting measure of a firm's equity value generated by applying accounting

principles to asset and liability acquisitions is called ________.

A. book value

B. market value

C. liquidation value

D. Tobin's q

Answer: A. book value

2. The price-to-sales ratio is probably most useful for firms in which phase of the industry life

cycle?

A. Start-up phase

B. Consolidation

C. Maturity

D. Relative decline

Answer: A. Start-up phase

3. If a firm increases its plowback ratio, this will probably result in _______ P/E ratio.

A. a higher

B. a lower

C. an unchanged

D. The answer cannot be determined from the information given.

Answer: D. The answer cannot be determined from the information given.

4. The value of Internet companies is based primarily on _____.

A. current profits

B. Tobin's q

C. growth opportunities

D. replacement cost

Answer: C. growth opportunities

5. New-economy companies generally have higher _______ than old-economy companies.

A. book value per share

B. P/E multiples

C. profits

D. asset values

Answer: B. P/E multiples

6. P/E ratios tend to be _______ when inflation is ______.

A. higher; higher

B. lower; lower

C. higher; lower

D. They are unrelated.

Answer: C. higher; lower

7. Which one of the following statements about market and book value is correct?

A. All firms sell at a market-to-book ratio above 1.

B. All firms sell at a market-to-book ratio greater than or equal to 1.

C. All firms sell at a market-to-book ratio below 1.

D. Most firms have a market-to-book ratio above 1, but not all.

Answer: D. Most firms have a market-to-book ratio above 1, but not all.

8. Earnings yields tend to _______ when Treasury yields fall.

A. fall

B. rise

C. remain unchanged

D. fluctuate wildly

Answer: A. fall

9. Which one of the following is a common term for the market consensus value of the

required return on a stock?

A. Dividend payout ratio

B. Intrinsic value

C. Market capitalization rate

D. Plowback ratio

Answer: C. Market capitalization rate

10. Which one of the following is equal to the ratio of common shareholders' equity to

common shares outstanding?

A. Book value per share

B. Liquidation value per share

C. Market value per share

D. Tobin's q

Answer: A. Book value per share

11. A firm has current assets that could be sold for their book value of $10 million. The book

value of its fixed assets is $60 million, but they could be sold for $95 million today. The firm

has total debt at a book value of $40 million, but interest rate changes have increased the

value of the debt to a current market value of $50 million. This firm's market-to-book ratio is

________.

A. 1.83

B. 1.5

C. 1.35

D. 1.46

Answer: A. 1.83

12. If a stock is correctly priced, then you know that ____________.

A. the dividend payout ratio is optimal

B. the stock's required return is equal to the growth rate in earnings and dividends

C. the sum of the stock's expected capital gain and dividend yield is equal to the stock's

required rate of return

D. the present value of growth opportunities is equal to the value of assets in place

Answer: C. the sum of the stock's expected capital gain and dividend yield is equal to the

stock's required rate of return

13. A stock has an intrinsic value of $15 and an actual stock price of $13.50. You know that

this stock ________.

A. has a Tobin's q value 1

Answer: B. will generate a positive alpha

14. Bill, Jim, and Shelly are all interested in buying the same stock that pays dividends. Bill

plans on holding the stock for 1 year. Jim plans on holding the stock for 3 years. Shelly plans

on holding the stock until she retires in 10 years. Which one of the following statements is

correct?

A. Bill will be willing to pay the most for the stock because he will get his money back in 1

year when he sells.

B. Jim should be willing to pay three times as much for the stock as Bill will pay because his

expected holding period is three times as long as Bill's.

C. Shelly should be willing to pay the most for the stock because she will hold it the longest

and hence will get the most dividends.

D. All three should be willing to pay the same amount for the stock regardless of their holding

period.

Answer: D. All three should be willing to pay the same amount for the stock regardless of

their holding period.

15. A firm that has an ROE of 12% is considering cutting its dividend payout. The

stockholders of the firm desire a dividend yield of 4% and a capital gain yield of 9%. Given

this information, which of the following statements is (are) correct?

I. All else equal, the firm's growth rate will accelerate after the payout change.

II. All else equal, the firm's stock price will go up after the payout change.

III. All else equal, the firm's P/E ratio will increase after the payout change.

A. I only

B. I and II only

C. II and III only

D. I, II, and III

Answer: A. I only

16. A firm cuts its dividend payout ratio. As a result, you know that the firm's _______.

A. return on assets will increase

B. earnings retention ratio will increase

C. earnings growth rate will fall

D. stock price will fall

Answer: B. earnings retention ratio will increase

17. __________ is the amount of money per common share that could be realized by breaking

up the firm, selling its assets, repaying its debt, and distributing the remainder to shareholders.

A. Book value per share

B. Liquidation value per share

C. Market value per share

D. Tobin's q

Answer: B. Liquidation value per share

18. An underpriced stock provides an expected return that is ____________ the required

return based on the capital asset pricing model (CAPM).

A. less than

B. equal to

C. greater than

D. greater than or equal to

Answer: C. greater than

19. Stockholders of Dogs R Us Pet Supply expect a 12% rate of return on their stock.

Management has consistently been generating an ROE of 15% over the last 5 years but now

believes that ROE will be 12% for the next 5 years. Given this, the firm's optimal dividend

payout ratio is now ______.

A. 0%

B. 100%

C. between 0% and 50%

D. between 50% and 100%

Answer: B. 100%

20. The constant-growth dividend discount model (DDM) can be used only when the

___________.

A. growth rate is less than or equal to the required return

B. growth rate is greater than or equal to the required return

C. growth rate is less than the required return

D. growth rate is greater than the required return

Answer: C. growth rate is less than the required return

21. Suppose that in 2012 the expected dividends of the stocks in a broad market index equaled

$240 million when the discount rate was 8% and the expected growth rate of the dividends

equaled 6%. Using the constant-growth formula for valuation, if interest rates increase to 9%,

the value of the market will change by _____.

A. -10%

B. -20%

C. -25%

D. -33%

Answer: D. -33%

22. You want to earn a return of 10% on each of two stocks, A and B. Each of the stocks is

expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends

is 6% for stock A and 5% for stock B. Using the constant-growth DDM, the intrinsic value of

stock A _________.

A. will be higher than the intrinsic value of stock B

B. will be the same as the intrinsic value of stock B

C. will be less than the intrinsic value of stock B

D. The answer cannot be determined from the information given.

Answer: A. will be higher than the intrinsic value of stock B

23. Each of two stocks, A and B, is expected to pay a dividend of $7 in the upcoming year.

The expected growth rate of dividends is 6% for both stocks. You require a return of 10% on

stock A and a return of 12% on stock B. Using the constant-growth DDM, the intrinsic value

of stock A _________.

A. will be higher than the intrinsic value of stock B

B. will be the same as the intrinsic value of stock B

C. will be less than the intrinsic value of stock B

D. The answer cannot be determined from the information given.

Answer: A. will be higher than the intrinsic value of stock B

24. You want to earn a return of 11% on each of two stocks, A and B. Stock A is expected to

pay a dividend of $3 in the upcoming year, while stock B is expected to pay a dividend of $2

in the upcoming year. The expected growth rate of dividends for both stocks is 4%. Using the

constant-growth DDM, the intrinsic value of stock A _________.

A. will be higher than the intrinsic value of stock B

B. will be the same as the intrinsic value of stock B

C. will be less than the intrinsic value of stock B

D. The answer cannot be determined from the information given.

Answer: A. will be higher than the intrinsic value of stock B

25. You are considering acquiring a common share of Sahali Shopping Center Corporation

that you would like to hold for 1 year. You expect to receive both $1.25 in dividends and $35

from the sale of the share at the end of the year. The maximum price you would pay for a

share today is __________ if you wanted to earn a 12% return.

A. $31.25

B. $32.37

C. $38.47

D. $41.32

Answer: B. $32.37

26. The market capitalization rate on the stock of Aberdeen Wholesale Company is 10%. Its

expected ROE is 12%, and its expected EPS is $5. If the firm's plowback ratio is 50%, its P/E

ratio will be _________.

A. 8.33

B. 12.5

C. 19.23

D. 24.15

Answer: B. 12.5

Dividend payout ratio = 1 - .5 = .5

Expected dividend = .5 × $5 = $2.50

Growth rate = .5 × 12% = 6%

Value = $2.50/(.10 - .06) = $62.50

P/E = $62.50/$5 = 12.5

27. The market capitalization rate on the stock of Aberdeen Wholesale Company is 10%. Its

expected ROE is 12%, and its expected EPS is $5. If the firm's plowback ratio is 60%, its P/E

ratio will be _________.

A. 7.14

B. 14.29

C. 16.67

D. 22.22

Answer: B. 14.29

Dividend payout ratio = 1 - .46 = .4

Expected dividend = .4 × $5 = $2

Growth rate = .6 × 12% = 7.2%

Value = $2/(.1 - .072) = $71.43

P/E = $71.43/$5 = 14.29

28. Weyerhaeuser Incorporated has a balance sheet that lists $70 million in assets, $45 million

in liabilities, and $25 million in common shareholders' equity. It has 1 million common shares

outstanding. The replacement cost of its assets is $85 million. Its share price in the market is

$49. Its book value per share is _________.

A. $16.67

B. $25

C. $37.50

D. $40.83

Answer: B. $25

29. Eagle Brand Arrowheads has expected earnings of $1.25 per share and a market

capitalization rate of 12%. Earnings are expected to grow at 5% per year indefinitely. The

firm has a 40% plowback ratio. By how much does the firm's ROE exceed the market

capitalization rate?

A. .5%

B. 1%

C. 1.5%

D. 2%

Answer: A. .5%

ROE = g/b = .05/.4 = 12.5%; k is given as 12%, so ROE - k = .5%

30. Gagliardi Way Corporation has an expected ROE of 15%. If it pays out 30% of its

earnings as dividends, its dividend growth rate will be _____.

A. 4.5%

B. 10.5%

C. 15%

D. 30%

Answer: B. 10.5%

b = 1 - .3 = .7

g = b × ROE = .7 × 15% = 10.5%

31. A preferred share of Coquihalla Corporation will pay a dividend of $8 in the upcoming

year and every year thereafter; that is, dividends are not expected to grow. You require a

return of 7% on this stock. Using the constant-growth DDM to calculate the intrinsic value, a

preferred share of Coquihalla Corporation is worth _________.

A. $13.50

B. $45.50

C. $91

D. $114.29

Answer: D. $114.29

32. Brevik Builders has an expected ROE of 25%. Its dividend growth rate will be

__________ if it follows a policy of paying 30% of earnings in the form of dividends.

A. 5%

B. 15%

C. 17.5%

D. 45%

Answer: C. 17.5%

g = .25(1 - .3) = .175

33. A firm is planning on paying its first dividend of $2 three years from today. After that,

dividends are expected to grow at 6% per year indefinitely. The stock's required return is

14%. What is the intrinsic value of a share today?

A. $25

B. $16.87

C. $19.24

D. $20.99

Answer: C. $19.24

Intrinsic value at time 2 = $2/(.14 - .06) = $25

Intrinsic value today = $25/(1.14)2 = $19.24

34. Rose Hill Trading Company is expected to have EPS in the upcoming year of $8. The

expected ROE is 18%. An appropriate required return on the stock is 14%. If the firm has a

plowback ratio of 70%, its dividend in the upcoming year should be _________.

A. $1.12

B. $1.44

C. $2.40

D. $5.60

Answer: C. $2.40

D1 = $8 (1 - .7) = $2.40

35. Rose Hill Trading Company is expected to have EPS in the upcoming year of $6. The

expected ROE is 18%. An appropriate required return on the stock is 14%. If the firm has a

plowback ratio of 70%, its intrinsic value should be _________.

A. $20.93

B. $69.77

C. $128.57

D. $150

Answer: C. $128.57

36. Cache Creek Manufacturing Company is expected to pay a dividend of $3.36 in the

upcoming year. Dividends are expected to grow at 8% per year. The risk-free rate of return is

4%, and the expected return on the market portfolio is 14%. Investors use the CAPM to

compute the market capitalization rate and use the constant-growth DDM to determine the

value of the stock. The stock's current price is $84. Using the constant-growth DDM, the

market capitalization rate is _________.

A. 9%

B. 12%

C. 14%

D. 18%

Answer: B. 12%

From the relationship k = (3.36/84) + .08 = .12

37. Grott and Perrin, Inc., has expected earnings of $3 per share for next year. The firm's ROE

is 20%, and its earnings retention ratio is 70%. If the firm's market capitalization rate is 15%,

what is the present value of its growth opportunities?

A. $20

B. $70

C. $90

D. $115

Answer: A. $20

Value with no growth = $3/.15 = $20

Growth rate = .7 × 20% = 14%

Value with growth = $3 × (1 - .7)/(.15 - .14) = $90

PVGO = $90 - 70 = $20

38. Ace Ventura, Inc., has expected earnings of $5 per share for next year. The firm's ROE is

15%, and its earnings retention ratio is 40%. If the firm's market capitalization rate is 10%,

what is the present value of its growth opportunities?

A. $25

B. $50

C. $75

D. $100

Answer: A. $25

Value with no growth = $5/.10 = $50

Growth rate = .4 × 15% = 6%

Value with growth = $5 × (1 - .4)/(.10 - .06) = $75

PVGO = $75 - 50 = $25

39. Annie's Donut Shops, Inc., has expected earnings of $3 per share for next year. The firm's

ROE is 18%, and its earnings retention ratio is 60%. If the firm's market capitalization rate is

12%, what is the value of the firm excluding any growth opportunities?

A. $25

B. $50

C. $83.33

D. $208

Answer: A. $25

Value with no growth = $3/.12 = $25

40. Flanders, Inc., has expected earnings of $4 per share for next year. The firm's ROE is 8%,

and its earnings retention ratio is 40%. If the firm's market capitalization rate is 15%, what is

the present value of its growth opportunities?

A. -$6.33

B. $0

C. $20.34

D. $26.67

Answer: A. -$6.33

Value with no growth = $4/.15 = $26.67

Growth rate = .4 × 8% = 3.2%

Value with growth = $4 × (1 - .4)/(.15 - .032) = $20.34

PVGO = $20.34 - 26.67 = -$6.33

41. Firm A is high-risk, and Firm B is low-risk. Everything else equal, which firm would you

expect to have a higher P/E ratio?

A. Firm A

B. Firm B

C. Both would have the same P/E if they were in the same industry.

D. There is not necessarily any linkage between risk and P/E ratios.

Answer: C. Both would have the same P/E if they were in the same industry.

42. Firms with higher expected growth rates tend to have P/E ratios that are ___________ the

P/E ratios of firms with lower expected growth rates.

A. higher than

B. equal to

C. lower than

D. There is not necessarily any linkage between risk and P/E ratios.

Answer: A. higher than

43. Value stocks are more likely to have a PEG ratio _____.

A. less than 1

B. equal to 1

C. greater than 1

D. less than zero

Answer: A. less than 1

44. Generally speaking, as a firm progresses through the industry life cycle, you would expect

the PVGO to ________ as a percentage of share price.

A. increase

B. decrease

C. stay the same

D. No typical pattern can be expected.

Answer: B. decrease

45. Cache Creek Manufacturing Company is expected to pay a dividend of $4.20 in the

upcoming year. Dividends are expected to grow at the rate of 8% per year. The risk-free rate

of return is 4%, and the expected return on the market portfolio is 14%. Investors use the

CAPM to compute the market capitalization rate on the stock and use the constant-growth

DDM to determine the intrinsic value of the stock. The stock is trading in the market today at

$84. Using the constant-growth DDM and the CAPM, the beta of the stock is _________.

A. 1.4

B. .9

C. .8

D. .5

Answer: B. .9

k = $4.20/$84 + .08 = .13

.13 = .04 + β(.14 - .04)

β = .09/.10 = .9

46. Westsyde Tool Company is expected to pay a dividend of $1.50 in the upcoming year.

The risk-free rate of return is 6%, and the expected return on the market portfolio is 14%.

Analysts expect the price of Westsyde Tool Company shares to be $29 a year from now. The

beta of Westsyde Tool Company's stock is 1.2. Using the CAPM, an appropriate required

return on Westsyde Tool Company's stock is _________.

A. 8%

B. 10.8%

C. 15.6%

D. 16.8%

Answer: C. 15.6%

k = .06 + 1.20(.14 - .06) = .156

47. Westsyde Tool Company is expected to pay a dividend of $2 in the upcoming year. The

risk-free rate of return is 6%, and the expected return on the market portfolio is 12%. Analysts

expect the price of Westsyde Tool Company shares to be $29 a year from now. The beta of

Westsyde Tool Company's stock is 1.2. Using a one-period valuation model, the intrinsic

value of Westsyde Tool Company stock today is _________.

A. $24.29

B. $27.39

C. $31.13

D. $34.52

Answer: B. $27.39

k = .06 + 1.2(.12 - .06) = .132

48. Todd Mountain Development Corporation is expected to pay a dividend of $2.50 in the

upcoming year. Dividends are expected to grow at the rate of 8% per year. The risk-free rate

of return is 5%, and the expected return on the market portfolio is 12%. The stock of Todd

Mountain Development Corporation has a beta of .75. Using the CAPM, the return you

should require on the stock is _________.

A. 7.25%

B. 10.25%

C. 14.75%

D. 21%

Answer: B. 10.25%

K = .05 + .75(.12 - .05) = .1025

49. Todd Mountain Development Corporation is expected to pay a dividend of $3 in the

upcoming year. Dividends are expected to grow at the rate of 8% per year. The risk-free rate

of return is 5%, and the expected return on the market portfolio is 17%. The stock of Todd

Mountain Development Corporation has a beta of .75. Using the constant-growth DDM, the

intrinsic value of the stock is _________.

A. 4

B. 17.65

C. 37.50

D. 50

Answer: D. 50

k = .05 + .75(.17 - .05) = .14

V0 = [3/(.14 - .08)] = 50

50. Generally speaking, the higher a firm's ROA, the _________ the dividend payout ratio

and the _________ the firm's growth rate of earnings.

A. higher; lower

B. higher; higher

C. lower; lower

D. lower; higher

Answer: D. lower; higher

51. Interior Airline is expected to pay a dividend of $3 in the upcoming year. Dividends are

expected to grow at the rate of 10% per year. The risk-free rate of return is 4%, and the

expected return on the market portfolio is 13%. The stock of Interior Airline has a beta of 4.

Using the constant-growth DDM, the intrinsic value of the stock is _________.

A. $10

B. $22.73

C. $27.78

D. $41.67

Answer: A. $10

k = .04 + .4(.13 - .04) = .4

V0 = [3/(.4 - .1)] = 10

52. Caribou Gold Mining Corporation is expected to pay a dividend of $4 in the upcoming

year. Dividends are expected to decline at the rate of 3% per year. The risk-free rate of return

is 5%, and the expected return on the market portfolio is 13%. The stock of Caribou Gold

Mining Corporation has a beta of .5. Using the CAPM, the return you should require on the

stock is _________.

A. 2%

B. 5%

C. 8%

D. 9%

Answer: D. 9%

k = .05 + .5(.13 - .05) = .09

53. Caribou Gold Mining Corporation is expected to pay a dividend of $6 in the upcoming

year. Dividends are expected to decline at the rate of 3% per year. The risk-free rate of return

is 5%, and the expected return on the market portfolio is 13%. The stock of Caribou Gold

Mining Corporation has a beta of .5. Using the constant-growth DDM, the intrinsic value of

the stock is _________.

A. $50

B. $100

C. $150

D. $200

Answer: A. $50

k = .05 + .5(.13 - .05) = .09

V0 = {6/[.09 - (-.03)]} = 50

54. Lifecycle Motorcycle Company is expected to pay a dividend in year 1 of $2, a dividend

in year 2 of $3, and a dividend in year 3 of $4. After year 3, dividends are expected to grow at

the rate of 7% per year. An appropriate required return for the stock is 12%. Using the

multistage DDM, the stock should be worth __________ today.

A. $63.80

B. $65.13

C. $67.95

D. $85.60

Answer: C. $67.95

V3 = $4 × (1.07)/(.12 - .07) = $85.60 is the value of D4, D5, . . . ∞

The total value at time 3 is $4 + 85.60 = $89.60

The discounted cash flows are

55. Ace Frisbee Corporation produces a good that is very mature in the firm's product life

cycles. Ace Frisbee Corporation is expected to pay a dividend in year 1 of $3, a dividend in

year 2 of $2, and a dividend in year 3 of $1. After year 3, dividends are expected to decline at

the rate of 2% per year. An appropriate required return for the stock is 8%. Using the

multistage DDM, the stock should be worth __________ today.

A. $13.07

B. $13.58

C. $18.25

D. $18.78

Answer: A. $13.07

V3 = $1× (0.98)/[.08 - (-.02)] = $9.80 is the value of D4, D5, . . . ∞

The total value at time 3 is $1 + 9.80 = $10.80

The discounted cash flows are

56. A firm's earnings per share increased from $10 to $12, its dividends increased from $4 to

$4.40, and its share price increased from $80 to $100. Given this information, it follows that

_________.

A. the stock experienced a drop in its P/E ratio

B. the company had a decrease in its dividend payout ratio

C. both earnings and share price increased by 20%

D. the required rate of return increased

Answer: B. the company had a decrease in its dividend payout ratio

57. Assuming all other factors remain unchanged, __________ would increase a firm's priceearnings ratio.

A. an increase in the dividend payout ratio

B. a reduction in investor risk aversion

C. an expected increase in the level of inflation

D. an increase in the yield on Treasury bills

Answer: B. a reduction in investor risk aversion

58. A company with an expected earnings growth rate which is greater than that of the typical

company in the same industry most likely has _________________.

A. a dividend yield which is greater than that of the typical company

B. a dividend yield which is less than that of the typical company

C. less risk than the typical company

D. less sensitivity to market trends than the typical company

Answer: B. a dividend yield which is less than that of the typical company

59. Everything else equal, which variable is negatively related to the intrinsic value of a

company?

A. D1

B. D0

C. g

D. k

Answer: D. k

60. Sanders, Inc., paid a $4 dividend per share last year and is expected to continue to pay out

60% of its earnings as dividends for the foreseeable future. If the firm is expected to generate

a 13% return on equity in the future, and if you require a 15% return on the stock, the value of

the stock is _________.

A. $26.67

B. $35.19

C. $42.94

D. $59.89

Answer: C. $42.94

g = (1 - .6) × 13% = 5.2%

D1 = $4 × (1.052) = $4.208

Intrinsic value = $4.208/(.15 - .052) = $42.94

61. A firm has PVGO of 0 and a market capitalization rate of 12%. What is the firm's P/E

ratio?

A. 12

B. 8.33

C. 10.25

D. 18.55

Answer: B. 8.33

P = E/k + 0; P/E = 1/.12 = 8.33

62. A firm has an earnings retention ratio of 40%. The stock has a market capitalization rate

of 15% and an ROE of 18%. What is the stock's P/E ratio?

A. 12.82

B. 7.69

C. 8.33

D. 9.46

Answer: B. 7.69

63. A common stock pays an annual dividend per share of $1.80. The risk-free rate is 5%, and

the risk premium for this stock is 4%. If the annual dividend is expected to remain at $1.80

per share, what is the value of the stock?

A. $17.78

B. $20

C. $40

D. None of these options

Answer: B. $20

P = $1.80/.09 = $20

64. Transportation stocks currently provide an expected rate of return of 15%. TTT, a large

transportation company, will pay a year-end dividend of $3 per share. If the stock is selling at

$60 per share, what must be the market's expectation of the constant-growth rate of TTT

dividends?

A. 5%

B. 10%

C. 20%

D. None of these options

Answer: B. 10%

k = D1/P0 + g

.15 = 3/60 + g

g = .10

65. A stock is priced at $45 per share. The stock has earnings per share of $3 and a market

capitalization rate of 14%. What is the stock's PVGO?

A. $23.57

B. $15

C. $19.78

D. $21.34

Answer: A. $23.57

66. A firm increases its dividend plowback ratio. All else equal, you know that

_____________.

A. earnings growth will increase and the stock's P/E will increase

B. earnings growth will decrease and the stock's P/E will increase

C. earnings growth will increase and the stock's P/E will decrease

D. earnings growth will increase and the stock's P/E may or may not increase

Answer: D. earnings growth will increase and the stock's P/E may or may not increase

67. A firm has a stock price of $54.75 per share. The firm's earnings are $75 million, and the

firm has 20 million shares outstanding. The firm has an ROE of 15% and a plowback of 65%.

What is the firm's PEG ratio?

A. 1.5

B. 1.25

C. 1.1

D. 1

Answer: A. 1.5

EPS = $75,000,000/20,000,000 = $3.75

P/E = $54.75/$3.75 = 14.6

g = .65 × 15% = .0975 = 9.75%

PEG = 14.6/9.75 = 1.5

68. ART has come out with a new and improved product. As a result, the firm projects an

ROE of 25%, and it will maintain a plowback ratio of .20. Its earnings this year will be $3 per

share. Investors expect a 12% rate of return on the stock.

At what price would you expect ART to sell?

A. $25

B. $34.29

C. $42.86

D. $45.67

Answer: B. $34.29

69. ART has come out with a new and improved product. As a result, the firm projects an

ROE of 25%, and it will maintain a plowback ratio of .20. Its earnings this year will be $3 per

share. Investors expect a 12% rate of return on the stock.

At what P/E ratio would you expect ART to sell?

A. 8.33

B. 11.43

C. 14.29

D. 15.25

Answer: B. 11.43

P/E = 34.29/3 = 11.43

70. ART has come out with a new and improved product. As a result, the firm projects an

ROE of 25%, and it will maintain a plowback ratio of .20. Its earnings this year will be $3 per

share. Investors expect a 12% rate of return on the stock.

What is the present value of growth opportunities for ART?

A. $8.57

B. $9.29

C. $14.29

D. $16.29

Answer: B. $9.29

PVGO = P0 - (EPS1/k) = 34.29 - (3/.12) = $9.29

71. ART has come out with a new and improved product. As a result, the firm projects an

ROE of 25%, and it will maintain a plowback ratio of .20. Its earnings this year will be $3 per

share. Investors expect a 12% rate of return on the stock.

What price do you expect ART shares to sell for in 4 years?

A. $53.96

B. $44.95

C. $41.68

D. $39.76

Answer: C. $41.68

P3 = P0 (1 + g)4 = 34.29(1.05)4 = 41.68

72. The EBIT of a firm is $300, the tax rate is 35%, the depreciation is $20, capital

expenditures are $60, and the increase in net working capital is $30. What is the free cash

flow to the firm?

A. $85

B. $125

C. $185

D. $305

Answer: B. $125

FCFF = 300(1 - .35) + 20 - 60 - 30 = $125 million

73. A firm reports EBIT of $100 million. The income statement shows depreciation of $20

million. If the tax rate is 35% and total capital expenditures and increases in working capital

total $10 million, what is the free cash flow to the firm?

A. $57

B. $65

C. $75

D. $95

Answer: C. $75

FCFF = 100(1 - .35) + 20 - 10 = $75 million

74. The free cash flow to the firm is $300 million in perpetuity, the cost of equity equals 14%,

and the WACC is 10%. If the market value of the debt is $1 billion, what is the value of the

equity using the free cash flow valuation approach?

A. $1 billion

B. $2 billion

C. $3 billion

D. $4 billion

Answer: B. $2 billion

Total value = 300/.10 = $3 billion

Equity value = $3 billion - 1 billion = $2 billion

75. If a firm has a free cash flow equal to $50 million and that cash flow is expected to grow

at 3% forever, what is the total firm value given a WACC of 9.5%?

A. $679.81 million

B. $715.54 million

C. $769.23 million

D. $803.03 million

Answer: C. $769.23 million

Total value = 50/(.095 - .03) = 769.23

76. The free cash flow to the firm is reported as $405 million. The interest expense to the firm

is $76 million. If the tax rate is 35% and the net debt of the firm increased by $50 million,

what is the free cash flow to the equity holders of the firm?

A. $405.6 million

B. $454.2 million

C. $505.8 million

D. $553.5 million

Answer: A. $405.6 million

FCFE = 405 - 76(1 - .35) + 50 = 405.6

77. The free cash flow to the firm is reported as $275 million. The interest expense to the firm

is $60 million. If the tax rate is 35% and the net debt of the firm increased by $33 million,

what is the free cash flow to the equity holders of the firm?

A. $269 million

B. $296 million

C. $305 million

D. $327 million

Answer: A. $269 million

FCFE = 275 - 60(1 - .35) + 33 = 269

78. The free cash flow to the firm is reported as $205 million. The interest expense to the firm

is $22 million. If the tax rate is 35% and the net debt of the firm increased by $25 million,

what is the approximate market value of the firm if the FCFE grows at 2% and the cost of

equity is 11%?

A. $2,168 billion

B. $2,445 billion

C. $2,565 billion

D. $2,998 billion

Answer: B. $2,445 billion

FCFE = 205 - 22(1 - .35) + 25 = 215.70

Value = (215.7×1.02)/(.11 - .02) = 2,445

79. The free cash flow to the firm is reported as $198 million. The interest expense to the firm

is $15 million. If the tax rate is 35% and the net debt of the firm increased by $20 million,

what is the approximate market value of the firm if the FCFE grows at 3% and the cost of

equity is 14%?

A. $1,950 billion

B. $2,497 billion

C. $2,585 billion

D. $3,098 billion

Answer: A. $1,950 billion

FCFE = 198 - 15(1 - .35) + 20 = 208.25

Value = (208.25 × 1.03)/(.14 - .03) = 1,950

80. Firm A has a stock price of $35, and 60% of the value of the stock is in the form of

PVGO. Firm B also has a stock price of $35, but only 20% of the value of stock B is in the

form of PVGO. We know that:

I. Stock A will give us a higher return than Stock B.

II. An investment in stock A is probably riskier than an investment in stock B.

III. Stock A has higher forecast earnings growth than stock B.

A. I only

B. I and II only

C. II and III only

D. I, II, and III

Answer: C. II and III only

81. A firm is expected to produce earnings next year of $3 per share. It plans to reinvest 25%

of its earnings at 20%. If the cost of equity is 11%, what should be the value of the stock?

A. $27.27

B. $37.50

C. $66.67

D. $70

Answer: B. $37.50

g = .25 × .20 = .05

D1 = $3(1 - .25) = $2.25

P0 = $2.25/(.11 - .05) = $37.50

82. Next year's earnings are estimated to be $5. The company plans to reinvest 20% of its

earnings at 15%. If the cost of equity is 9%, what is the present value of growth opportunities?

A. $9.09

B. $10.10

C. $11.11

D. $12.21

Answer: C. $11.11

g = .20 × .15 = .03

Value with growth = ($5 × .80)/(.09 - .03) = 66.67

Value without growth = $5/.09 = $55.56

PVGO = $66.67 - 55.56 = $11.11

83. Next year's earnings are estimated to be $6. The company plans to reinvest 33% of its

earnings at 12%. If the cost of equity is 8%, what is the present value of growth opportunities?

A. $6

B. $24.50

C. $44.44

D. $75

Answer: B. $24.50

g = .33 × .12 = .0396

Value with growth = ($6 × .67)/(.08 - .0396) = $99.50

Value without growth = $6/.08 = $75

PVGO = $99.50 - 75 = $24.50

84. When Google's share price reached $475 per share, Google had a P/E ratio of about 68

and an estimated market capitalization rate of 11.5%. Google pays no dividends.

Approximately what percentage of Google's stock price was represented by PVGO?

A. 92%

B. 87%

C. 77%

D. 64%

Answer: B. 87%

EPS = $475/68 = $6.985

PVGO = $475 - ($6.985/.115) = $414.26

$414.26/$475 = 87.21%

85. A firm has a stock price of $55 per share and a P/E ratio of 75. If you buy the stock at this

P/E and earnings fail to grow at all, how long should you expect it to take to just recover the

cost of your investment?

A. 27 years

B. 37 years

C. 55 years

D. 75 years

Answer: D. 75 years

EPS = $55/75 = $.73333 per year

Payback period = $55/$.73333 per year = 75 years

86. In what industry are investors likely to use the dividend discount model and arrive at a

price close to the observed market price?

A. Import/export trade

B. Software

C. Telecommunications

D. Utility

Answer: D. Utility

87. Estimates of a stock's intrinsic value calculated with the free cash flow methodology

depend most critically on _______.

A. the terminal value used

B. whether one uses FCFF or FCFE

C. the time period used to estimate the cash flows

D. whether the firm is currently paying dividends

Answer: A. the terminal value used

88. The greatest value to an analyst from calculating a stock's intrinsic value is _______.

A. how easy it is to come up with accurate model inputs

B. the precision of the value estimate

C. how the process forces analysts to understand the critical variables that have the greatest

impact on value

D. how all the different models typically yield identical value results

Answer: C. how the process forces analysts to understand the critical variables that have the

greatest impact on value

89. Which of the following valuation measures is often used to compare firms that have no

earnings?

A. Price-to-book ratio

B. P/E ratio

C. Price-to-cash-flow ratio

D. Price-to-sales ratio

Answer: D. Price-to-sales ratio

Test Bank for Essentials of Investments

Zvi Bodie, Alex Kane, Alan Marcus

9780078034695, 9789389957877, 9781264140251, 9781260316148, 9780073382401, 9780078034695, 9781260013924, 9780077835422