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Financial Management: Principles and Applications, 11e (Titman)

Chapter 10 Stock Valuation


10.1 Common Stock
1) The XYZ Company, whose common stock is currently selling for $40 per share, is expected to
pay a $2.00 dividend in the coming year. If investors believe that the expected rate of return on
XYZ is 14%, what growth rate in dividends must be expected?
A) 5%
B) 14%
C) 9%
D) 6%
Answer: C
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
2) The expected rate of return on a share of common stock whose dividends are growing at a
constant rate (g) is which of the following?
A) (D1 + g)/Vc
B) D1/Vc + g
C) D1/g
D) D1/Vc
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
3) Green Company's common stock is currently selling at $24.00 per share. The company
recently paid dividends of $1.92 per share and projects growth at a rate of 4%. At this rate, what
is the stock's expected rate of return?
A) 4.08%
B) 8.00%
C) 12.00%
D) 8.80%
Answer: C
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value

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4) Common stockholders are essentially:


A) creditors of the firm.
B) managers of the firm.
C) owners of the firm.
D) all of the above.
Answer: C
Diff: 2
Topic: 10.1 Common Stock
Keywords: voting rights
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) Butler, Inc.'s return on equity is 17% and management retains 75% of earnings for investment
purposes. Based on this information, what will be the firm's growth rate?
A) 4.25%
B) 22.67%
C) 44.12%
D) 12.75%
Answer: D
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
6) If a company has a return on equity of 25% and wants a growth rate of 10%, how much of
ROE should be retained?
A) 40%
B) 50%
C) 60%
D) 70%
Answer: A
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
7) ________ gives minority shareholders more power to elect board of directors.
A) Preemptive right
B) Majority voting
C) Proxy fights
D) Cumulative voting
Answer: D
Diff: 2
Topic: 10.1 Common Stock
Keywords: voting rights
Principles: Principle 4: Market Prices Reflect Information

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8) You are evaluating the purchase of Cellars, Inc. common stock that just paid a dividend of
$1.80. You expect the dividend to grow at a rate of 12% for the next three years. You plan to hold
the stock for three years and then sell it. You estimate that a required rate of return of 17.5% will
be adequate compensation for this investment. Calculate the present value of the expected
dividends. Round to the nearest $0.10.
A) $4.90
B) $11.50
C) $9.80
D) $6.10
Answer: A
Diff: 2
Topic: 10.1 Common Stock
Keywords: agency
Principles: Principle 3: Cash Flows Are the Source of Value
9) You are evaluating the purchase of Holdings, Inc. common stock that just paid a dividend of
$1.80, and the dividend will be $1.80 per share per year for the next ten years. You plan to hold
the stock for three years and then sell it. You expect the price of the company's stock to rise to
$51.50 at the end of your three-year holding period. You estimate that a required rate of return of
17.5% will be adequate compensation for this investment. Calculate the present value of the
expected future stock price. Round to the nearest $.25.
A) $64.00
B) $55.25
C) $31.75
D) $103.00
Answer: C
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
10) CEO naming friends to the board of directors and paying them more than the norm is an
example of the:
A) agency problem.
B) preemptive right.
C) majority voting feature.
D) proxy fights.
Answer: A
Diff: 2
Topic: 10.1 Common Stock
Keywords: agency
Principles: Principle 4: Market Prices Reflect Information

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11) Little Feet Shoe Co. just paid a dividend of $1.65 on its common stock. This company's
dividends are expected to grow at a constant rate of 3% indefinitely. If the required rate of return
on this stock is 11%, compute the current value of per share of LFS stock.
A) $20.63
B) $21.24
C) $15.00
D) $55.00
Answer: B
Diff: 1
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
12) Marshall Manufacturing has common stock which paid a dividend of $1.00 a share last year.
You expect the stock to grow at 5% per year. If the appropriate rate of return on this stock is
12%, how much are you willing to pay for the stock today?
A) $13.00
B) $15.00
C) $17.00
D) $19.00
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
13) Marble Corporation's ROE is 17%. Their dividend payout ratio is 20%. The last dividend,
just paid, was $2.58. If dividends are expected to grow by the company's sustainable growth rate
indefinitely, what is the current value of Marble common stock if its required return is 18%?
A) $14.33
B) $18.27
C) $47.67
D) $66.61
Answer: D
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value

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14) Fris B. Corporation stock is currently selling for $42.86. It is expected to pay a dividend of
$3.00 at the end of the year. Dividends are expected to grow at a constant rate of 3% indefinitely.
Compute the required rate of return on FBC stock.
A) 10%
B) 33%
C) 7%
D) 4.3%
Answer: A
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
15) You are evaluating the purchase of Cool Toys, Inc. common stock that just paid a dividend of
$1.80. You expect the dividend to grow at a rate of 12%, indefinitely. You estimate that a
required rate of return of 17.5% will be adequate compensation for this investment. Assuming
that your analysis is correct, what is the most that you would be willing to pay for the common
stock if you were to purchase it today? Round to the nearest $.01.
A) $36.65
B) $91.23
C) $51.55
D) $74.82
Answer: A
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
16) A stock currently sells for $63 per share, and the required return on the stock is 10%.
Assuming a growth rate of 5%, calculate the stock's last dividend paid.
A) $1
B) $3
C) $5
D) $7
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value

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17) A decrease in the ________ will cause an increase in common stock value.
A) growth rate
B) required rate of return
C) last paid dividend
D) both B and C
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value
18) Acme Consolidated has a return on equity of 12%. If Acme distributes 60% of earnings as
dividends, then we would expect the common shareholders' investment in the firm and the value
of the common stock to grow by:
A) 4.80%.
B) 7.20%.
C) 12%.
D) 6%.
Answer: A
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
19) An investor is contemplating the purchase of common stock at the beginning of this year and
to hold the stock for one year. The investor expects the year-end dividend to be $2.00 and
expects a year-end price for the stock of $40. If this investor's required rate of return is 10%, then
the value of the stock to this investor is:
A) $36.36.
B) $38.18.
C) $33.06.
D) $34.88.
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value

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20) A firm just paid $2.00 on its common stock and expects to continue paying dividends, which
are expected to grow 5% each year, from now to infinity. If the required rate of return for this
stock is 9%, then the value of the stock is:
A) $50.00.
B) $40.00.
C) $54.50.
D) $52.50.
Answer: D
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
21) An issue of common stock currently sells for $40.00 per share, has an expected dividend to
be paid at the end of the year of $2.00 per share, and has an expected growth rate to infinity of
5% per year. The expected rate of return on this security is:
A) 5%.
B) 10.25%.
C) 13.11%.
D) 10%.
Answer: D
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
22) White Sink, Inc. just paid a dividend of $5.55 per share on its common stock, and the firm is
expected to generate constant growth of 12.25% over the foreseeable future. The common stock
is currently selling for $73.75 per share. The firm's dividend payout ratio is 40%, and White's
marginal tax rate is 40%. What is the rate of return that common stockholders expect? Round to
the nearest 0.1%.
A) 8.5%
B) 20.7%
C) 15.5%
D) 4.8%
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value

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23) KDP's most recent dividend was $2.00 per share and is selling today in the market for $70.
The dividend is expected to grow at a rate of 7% per year for the foreseeable future. If the market
return is 10% on investments with comparable risk, should you purchase the stock?
A) No, because the stock is overpriced $1.33.
B) No, because the stock is overpriced $3.33.
C) Yes, because the stock is underpriced $1.33.
D) Yes, because the stock is underpriced $3.33.
Answer: C
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
24) An issue of common stock currently sells for $50.00 per share, has an expected dividend to
be paid at the end of the year of $2.50 per share, and has an expected growth rate to infinity of
5% per year. If investors' required rate of return for this particular security is 12% per year, then
this security is:
A) overvalued and offering an expected return higher than the required return.
B) undervalued and offering an expected return higher than the required return.
C) overvalued and offering an expected return lower than the required return.
D) undervalued and offering an expected return lower than the required return.
Answer: C
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
25) You are considering the purchase of Miller Manufacturing, Inc.'s common stock. The stock is
selling for $21.00 per share. The next dividend is expected to be $2.10, and you expect the
dividend to keep growing at a constant rate. If the stock is returning 15%, calculate the growth
rate of dividends.
A) 3%
B) 5%
C) 8%
D) 10%
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value

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26) ABC, Inc. just paid a dividend of $2. ABC expects dividends to grow at 10%. The return on
stocks like ABC, Inc. is typically around 12%. What is the most you would pay for a share of
ABC stock?
A) $100
B) $110
C) $120
D) $130
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
27) Marjen, Inc. just paid a dividend of $5. Marjen stock currently sells for $73.57. The return on
stocks like Marjen, Inc. is around 10%. What is the implied growth rate of dividends.
A) 1%
B) 3%
C) 5%
D) 7%
Answer: B
Diff: 3
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
28) Which investor incurs the greatest risk?
A) Mortgage bondholder
B) Preferred stockholder
C) Common stockholder
D) Debenture bondholder
Answer: C
Diff: 1
Topic: 10.1 Common Stock
Keywords: market required yield
Principles: Principle 2: There Is a Risk-Return Tradeoff
29) What allows common stockholders the right to cast a number of votes equal to the number of
directors being elected?
A) The majority voting provision
B) The casting feature
C) The cumulative voting provision
D) The proxy method
Answer: C
Diff: 2
Topic: 10.1 Common Stock
Keywords: voting rights
Principles: Principle 4: Market Prices Reflect Information
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30) The shareholder can cast all votes for a single candidate or split them among various
candidates through:
A) proxy fights.
B) cumulative voting.
C) call provisions.
D) majority voting.
Answer: B
Diff: 2
Topic: 10.1 Common Stock
Keywords: voting rights
Principles: Principle 4: Market Prices Reflect Information
31) You are considering the purchase of common stock that just paid a dividend of $6.50 per
share. Security analysts agree with top management in projecting steady growth of 12% in
dividends and earnings over the foreseeable future. Your required rate of return for stocks of this
type is 18%. How much should you expect to pay for this stock?
A) $86
B) $94
C) $108
D) $121
E) $242
Answer: D
Diff: 1
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 4: Market Prices Reflect Information
32) You are considering the purchase of Wahoo, Inc. The firm just paid a dividend of $4.20 per
share. The stock is selling for $115 per share. Security analysts agree with top management in
projecting steady growth of 12% in dividends and earnings over the foreseeable future. Your
required rate of return for stocks of this type is 17.5%. If you were to purchase and hold the stock
for three years, what would the expected dividends be worth today?
A) $12.60
B) $9.21
C) $17.12
D) $15.55
E) $11.46
Answer: E
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value

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33) A share of common stock just paid a dividend of $3.25 per share. The expected long-run
growth rate for this stock is 18%. If investors require a rate of return of 24%, what should the
price of the stock be?
A) $57.51
B) $62.25
C) $71.86
D) $63.92
E) $44.94
Answer: D
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
34) Common stockholders expect greater returns than bondholders because:
A) they have no legal right to receive dividends.
B) they bear greater risk.
C) in the event of liquidation, they are only entitled to receive any cash that is left after all
creditors are paid.
D) all of the above.
Answer: D
Diff: 2
Topic: 10.1 Common Stock
Keywords: NYSE
Principles: Principle 2: There Is a Risk-Return Tradeoff
35) WSU Inc. is a young company that does not yet pay a dividend. You believe that the
company will begin to pay dividends 5 years from now, and that the company will then be worth
$50 per share. If your required rate of return on this risky stock is 20%, what is the stock worth
today?
A) $40
B) $10
C) $20.09
D) $0.00
Answer: C
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value
36) Common stockholders are essentially creditors of the firm.
Answer: FALSE
Diff: 1
Topic: 10.1 Common Stock
Keywords: market required yield
Principles: Principle 2: There Is a Risk-Return Tradeoff
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37) Common stock represents a claim on residual income.


Answer: TRUE
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
38) The growth rate of future earnings is determined by return on equity and the profit-retention
rate.
Answer: TRUE
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
39) The stockholder's expected rate of return consists of a dividend yield and interest.
Answer: FALSE
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
40) When bankruptcy occurs, the claims of the common shareholders may go unsatisfied.
Answer: TRUE
Diff: 2
Topic: 10.1 Common Stock
Keywords: NYSE
Principles: Principle 2: There Is a Risk-Return Tradeoff
41) Cumulative voting gives each share of stock a number of votes equal to the number of
directors being elected to the board.
Answer: TRUE
Diff: 2
Topic: 10.1 Common Stock
Keywords: voting rights
Principles: Principle 4: Market Prices Reflect Information
42) The expected rate of return implied by a given market price equals the required rate of return
for investors at the margin.
Answer: TRUE
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value

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43) Stock valuation is more precise than bond valuation as stock cash flows are more certain.
Answer: FALSE
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value
44) The stock valuation model D1/(Rc - g) requires Rc > G.
Answer: TRUE
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value
45) Is the following common stock priced correctly? If no, what is the correct price?
Price
= $26.25
Required rate of return = 13%
Dividend year 0
= $2.00
Dividend year 1
= $2.10
Answer: Growth rate =

2.10 - 2.00
= 5%
2.00

Vcs = 2.10 = $26.25


.13 - .05
The stock is priced correctly.
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 3: Cash Flows Are the Source of Value
46) The common stock of Cranberry, Inc. is selling for $26.75 on the open market. A dividend of
$3.68 is expected to be distributed, and the growth rate of this company is estimated to be 5.5%.
If Richard Dean, an average investor, is considering purchasing this stock at the market price,
what is his expected rate of return?
Answer: R = (D/V) + g
R = ($3.68/$26.75) + .055
R = 19.26%
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value

13
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47) Tannerly Worldwide's common stock is currently selling for $48 a share. If the expected
dividend at the end of the year is $2.40 and last year's dividend was $2.00, what is the rate of
return implicit in the current stock price?
Answer: Rc = 2.40/48 + (2.40 - 2.00)/2.00
= .05 + .20
= 25%
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value
48) Draper Company's common stock paid a dividend last year of $3.70. You believe that the
long-term growth in the dividends of the firm will be 8% per year. If your required return for
Draper is 14%, how much are you willing to pay for the stock?
$3.70( .08)
$3.996
Answer: P0 =
=
= $66.60
0.06
0.14 - 0.08
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value
49) Determine the rate of return on a $25 common stock that pays a dividend of $2.50 in year 1
and grows at a rate of 5%.
Answer: Kcs =

2.50
+ 5% = 10% + 5% = 15%
25

Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value
50) You are considering the purchase of AMDEX Company stock. You anticipate that the
company will pay dividends of $2.00 per share next year and $2.25 per share the following year.
You believe that you can sell the stock for $17.50 per share two years from now. If your required
rate of return is 12%, what is the maximum price that you would pay for a share of AMDEX
Company stock?
Answer:
Vc = $2.00 PVIF12%,1 + $19.75 PVIF12%,2
= ($2.00)(.893) + ($19.75)(.797)
= $17.53
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value

14
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51) You can purchase one share of Sumter Company common stock for $80 today. You expect
the price of the common stock to increase to $85 per share in one year. The company pays an
annual dividend of $3.00 per share. What is your expected rate of return for Sumter stock?
Answer: $80.00 =

$85.00
$3.00
+
(1 R)
1 R

$80.00 (1 + R) = $88.00
(1 + R) =

$88.00
= $1.10
$80.00

R = .10
Diff: 2
Topic: 10.1 Common Stock
Keywords: dividend growth
Principles: Principle 1: Money Has a Time Value
10.2 The Comparables Approach to Valuing Common Stock
1) If a stock has a much higher than normal P/E ratio, investors probably expect:
A) slow growth in earnings.
B) rapid growth in earnings.
C) large increases in the price of the stock.
D) a declining stock price
Answer: B
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
2) Which of the following factors will influence a firm's P/E ratio?
A) The investors' required rate of return
B) Firm investment opportunities
C) General market conditions
D) All of the above
Answer: D
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
3) The P/E ratio is calculated by dividing:
A) the current stock price by stockholders' equity.
B) total assets by net income.
C) the current stock price by earnings per share.
D) the current stock price by operating cash flow per share.
Answer: C
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
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Principles: Principle 3: Cash Flows Are the Source of Value


4) The GAP's most recent earnings per share were $1.75. Analysts forecast next year's earnings
per share at $1.88. If the appropriate P/E ratio is 15, a share of GAP stock should be valued at:
A) $28.20.
B) $26.25.
C) $27.23.
D) $8.57.
Answer: A
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
5) The retail analyst at Morgan-Sachs values stock of the GAP at $28.00 per share. They are
using the average industry P/E ratio of 15. Their forecasted earnings per share for next year is:
A) $0.54.
B) $1.50.
C) $1.87.
D) There is not enough information calculate earnings per share.
Answer: C
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
6) Home Depot stock is currently selling for $30 per share. Next year's dividend is expected to
be $1.00; next year's earnings per share are expected to be $2.14. Home Depot's P/E ratio is:
A) .07.
B) 14.
C) 2.14.
D) 30.
Answer: B
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value

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7) McDonald's stock currently sells for $77.50. It's expected earnings per share are $4.50. The
average P/E ratio for the industry is 23.3. If investors expected the same growth rate and risk for
McDonald's as for an average firm in the same industry, it's stock price would:
A) stay about the same.
B) rise.
C) fall.
D) there is not enough information.
Answer: B
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
8) If the ROE on a new investment is less than the firm's required rate of return:
A) the investment increases the firm's value.
B) the investment leaves the firm's value unchanged.
C) the effect on the firm's value is unpredictable.
D) the investment reduces the firm's value.
Answer: D
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
9) Zorba's is a small chain of of restaurants whose stock is not publicly traded. The average P/E
ratio for similar restaurant chains is 16.5; the P/E ratio for the S&P 500 Index is 15.2. This year's
earnings were $1.10 per share; next's earnings are expected to be $1.21 per share. A reasonable
price for a share of Zorba's stock is:
A) $19.97.
B) $18.15.
C) $20.23.
D) $16.72.
Answer: A
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value

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10) Apple stock is now selling for $315.32 per share. The P/E ratio based on current earnings is
23.72 and the P/E ratio based on expected earnings is 17.48. The expected growth rate in Apples
earnings must be:
A) -26%.
B) 36%.
C) 7.6%.
D) 5.5%.
Answer: B
Diff: 3
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
11) The P/E ratio is the market price of a share of stock divided by book equity per share.
Answer: FALSE
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
12) The higher a firm's P/E ratio, the more optimistic investors' feel about the firm's growth
prospects.
Answer: TRUE
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
13) P/E ratios found in published sources or on the internet are always computed by dividing the
next period's expected earnings into the current price of the stock.
Answer: FALSE
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
14) The higher the investor's required rate of return, the higher the P/E ratio will be.
Answer: FALSE
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value

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15) Walmart's current earnings per share of $4.39 are expected to grow at a rate of 12% per year
for the next few years. Using a P/E ratio fo 12.5, what is a reasonable value for a share of
Walmart Stock.
Answer: A reasonable value for Walmart would be $4.39(1.12)(12.5)=$61.46 per share.
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
16) RAH Inc. is not publicly traded, but the P/E ratios of it's 4 closest competitors are 15, 15.3,
15.7, and 16.5. RAH's current earnings per share are $1.50. They are expected to grow at 6% for
the next few years. What is a reasonable price for a share of RAH stock?
Answer: An appropriate P/E ratio would be an average of the 4 competitors
(15+15.3+15.7+16.5)/4=15.625. A reasonable price would be $1.50(1.06)(15.625)=$24.84.
Diff: 2
Topic: 10.2 The Comparables Approach to Valuing Common Stock
Keywords: price/earnings ratio
Principles: Principle 3: Cash Flows Are the Source of Value
10.3 Preferred Stock
1) UVP preferred stock pays $5.00 in annual dividends. If your required rate of return is 13%,
how much will you be willing to pay for one share?
A) $38.46
B) $26.26
C) $65.46
D) $46.38
Answer: A
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
2) Green Corp.'s preferred stock is selling for $20.83. If the company pays $2.50 annual
dividends, what is the expected rate of return on its stock?
A) 8.33%
B) 12.00%
C) 2.50%
D) 20.00%
Answer: B
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value

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3) Sacramento Light & Power issued preferred stock in 1998 that had a par value of $85. The
preferred stock pays a dividend of 5.75%. Investors require a rate of return of 6.50% today on
this stock. What is the value of the preferred stock today? Round to the nearest $1.
A) $100
B) $85
C) $75
D) $16
Answer: C
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
4) Which of the following statements is true?
A) Preferred stockholders are entitled to dividends before common stockholders can receive
dividends.
B) Preferred stock, like common stock, usually has no maturity; i.e., the corporation does not pay
back the investment.
C) The market value of preferred stock, like bonds, will usually fluctuate in value primarily as
the result of market rates of interest.
D) All of the above.
Answer: D
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
5) Which of the following statements concerning preferred stock is correct?
A) Preferred stock generally is more costly to the firm than common stock.
B) Most issues of preferred stock have a cumulative feature.
C) Preferred dividend payments are tax-deductible.
D) Preferred stock is a riskier form of capital to the firm than bonds.
Answer: B
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: cumulative preferred
Principles: Principle 3: Cash Flows Are the Source of Value

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Copyright 2011 Pearson Education, Inc.

6) World Wide Interlink Corp. has decided to undertake a large project. Consequently, there is a
need for additional funds. The financial manager plans to issue preferred stock with an annual
dividend of $5 per share. The stock will have a par value of $30. If investors' required rate of
return on this investment is currently 20%, what should the preferred stock's market value be?
A) $10
B) $15
C) $20
D) $25
Answer: D
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
7) Davis Gas & Electric issued preferred stock in 1985 that had a par value of $50. The stock
pays a dividend of 7.875%. Assume that shares are currently selling for $62.50. What is the
preferred stockholder's expected rate of return? Round to the nearest 0.01%.
A) 6.30%
B) 7.88%
C) 10.25%
D) 5.02%
Answer: A
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
8) Murky Pharmaceuticals has issued preferred stock with a par value of $100 and a 5%
dividend. The investors' required yield is 10%. What is the value of a share of Murky preferred?
A) $100
B) $75
C) $50
D) $25
Answer: C
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value

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Copyright 2011 Pearson Education, Inc.

9) Edison Power of light has an outstanding issue of cumulative preferred stock with an annual
fixed dividend of $2.00 per share. It has not paid the preferred dividend for the last 3 years, but
intends to pay a dividend on the common stock in the coming year. Before Edison can pay a
dividend on the common stock
A) preferred shareholders may cast all their votes for a single director.
B) preferred shareholders must receive dividends totaling $8.00 per share.
C) preferred shareholders must receive $2.00 per share.
D) will not necessarily receive any dividend.
Answer: B
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: cumulative preferred
Principles: Principle 3: Cash Flows Are the Source of Value
10) Which of the following provisions is unique to preferred stockholders and usually NOT
available to common stockholders?
A) Cumulative dividends feature
B) Voting rights
C) Fixed dividend
D) Both A and C
Answer: D
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: cumulative preferred
Principles: Principle 3: Cash Flows Are the Source of Value
11) McMillen House of Books recently paid a $3 dividend on its preferred stock. Investors
require a 6% return on the stock. The stock is currently selling for $45. Is the stock a good buy?
A) Yes, as it is undervalued $5.
B) Yes, as it is undervalued $10.
C) No, as it is overvalued $5.
D) No, as it is overvalued $10.
Answer: A
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value

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Copyright 2011 Pearson Education, Inc.

12) Tri State Pickle Company preferred stock pays a perpetual annual dividend of 2 1/2% of its
par value. Par value of TSP preferred stock is $100 per share. If investors' required rate of return
on this stock is 15%, what is the value of per share?
A) $37.50
B) $15.00
C) $16.67
D) $6.00
Answer: C
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
13) Petrified Forest Skin Care, Inc. pays an annual perpetual dividend of $1.70 per share. If the
stock is currently selling for $21.25 per share, what is the expected rate of return on this stock.
A) 36.13%
B) 12.5%
C) 8.0%
D) 13.6%
Answer: C
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
14) Horizon Communications stock pays a fixed annual dividend of of $3.00. Because of lower
inflation, the market's required yield on this preferred stock has gone from 12% to 10%. As a
result:
A) Horizon's dividend decreased by 6 cents.
B) The value of Horizon's preferred increased by $3.00.
C) The value of Horizon's preferred decreased by $5.00.
D) The value of Horizon's preferred increased by $5.00.
Answer: D
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 1: Money Has a Time Value
15) Style Corp. preferred stock pays $3.15. What is the value of the stock if your required rate of
return is 8.5% (round your answer to the nearest $1, and assume no transaction costs)?
A) $33
B) $23
C) $27
D) $37
Answer: D
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
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Principles: Principle 3: Cash Flows Are the Source of Value


16) Preferred stock is similar to a bond in the following way.
A) Preferred stock always contains a maturity date.
B) Both investments provide a fixed income.
C) Both contain a growth factor similar to common stock.
D) None of the above.
Answer: B
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
17) Solitron Manufacturing Company preferred stock is selling for $14. If it has a yearly
dividend of $1, what is your expected rate of return if you purchase the stock at its market price
(round your answer to the nearest .1%, and assume no transaction costs)?
A) 25.0%
B) 14.2%
C) 7.1%
D) 9.3%
Answer: C
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
18) An decrease in the ________ will increase the value of preferred stock.
A) expected rate of return
B) life of the investment
C) dividend paid
D) both A and C
Answer: A
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
19) Texon's preferred stock sells for $85 and pays $11 each year in dividends. What is the
expected rate of return?
Answer: Required rate of return =

$11
= 0.129
$85

Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value

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Copyright 2011 Pearson Education, Inc.

20) What is the value of a preferred stock that pays a $2.10 dividend to an investor with a
required rate of return of 11% (round your answer to the nearest $1)?
A) $19
B) $23
C) $17
D) $21
Answer: A
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
21) Which of the following formulas is appropriate to find the value of preferred stock with a
fixed dividend?
A) Value of preferred stock = Annual Preferred Stock Dividend (1+ growth rate)/Market's
Required Yield on Preferred Stock
B) Value of preferred stock = Annual Preferred Stock Dividend (1+ growth rate)/Market's
Required Yield on Preferred Stock - growth rate
C) Value of preferred stock = Annual Preferred Stock Dividend/Market's Required Yield on
Preferred Stock
D) Value of preferred stock = Annual Preferred Stock Dividend/Investor's Required Yield on
Preferred Stock
Answer: C
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
22) An issue of preferred stock currently sells for $52.50 per share and pays a constant annual
expected dividend of $2.25 per share. The expected return on this security is:
A) 4.29%.
B) 0.04%.
C) 8.33%.
D) 13.33%.
Answer: A
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value

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23) Expected cash flow for a preferred stock primarily consists of:
A) dividend payments .
B) changes in the price of the stock.
C) interest payments.
D) both A and B.
Answer: A
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
24) Preferred stock is similar to common stock in that:
A) it has no fixed maturity date.
B) the nonpayment of dividends can bring on bankruptcy.
C) dividends are limited in amount.
D) all of the above.
Answer: A
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
25) How is preferred stock affected by a decrease in the required rate of return?
A) The value of a share of preferred stock decreases.
B) The dividend increases.
C) The dividend decreases.
D) The value of a share of preferred stock increases.
Answer: D
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
26) In the event of bankruptcy, preferred stockholders and common stockholders have the same
claim on the firm's assets.
Answer: FALSE
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
27) A company may issue multiple classes of preferred stock.
Answer: TRUE
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
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28) The cumulative dividend feature is necessary to protect the rights of preferred stockholders.
Answer: TRUE
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
29) Preferred stock cannot be retired.
Answer: FALSE
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
30) In order to determine the value of a share of preferred stock, the discount rate used is the
annual dividend percent.
Answer: FALSE
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
31) It is quite common for firms that issue preferred stock to issue more than one series.
Answer: TRUE
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
32) Miller/Hershey's preferred stock is selling at $54 on the market and pays an annual dividend
of $4.20 per share.
a. What is the expected rate of return on the stock?
b. If an investor's required rate of return is 9%, what is the value of the stock for that investor?
c. Considering the investor's required rate of return, does this stock seem to be a desirable
investment?
Answer:
a. R = D/V
R = $4.20/54
R = 7.78%
b. V = D/R
V = $4.20/.09
V = $46.66
c. No, it is not a desirable investment.
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
27
Copyright 2011 Pearson Education, Inc.

33) Discuss two reasons why preferred stock would be viewed as less risky than common stock
to investors.
Answer: Preferred stockholders are paid before common stockholders in the event of
bankruptcy. Common stockholders, as the residual owners of a corporation, would receive any
monies remaining after bondholder and preferred stock claims are satisfied. Preferred dividends
are paid before common stock dividends in the normal course of business. In the event that a
preferred dividend is not paid, it accumulates and dividends in arrears must be paid before any
common stock dividends can be declared. Common shareholders take the risk that they will not
receive dividends. The magnitude of the cash flows from preferred is also known where it is not
known for common stock. Because cash flows are more certain, preferred stock would be
considered less risky to the investor.
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
34) Determine the rate of return on a preferred stock that costs $50 and pays a $6 per share
dividend.
Answer: K = Div = 6 = 12%
Vg 50
Diff: 2
Topic: 10.3 Preferred Stock
Keywords: market required yield
Principles: Principle 3: Cash Flows Are the Source of Value
10.4 The Stock Market
1) An example of a primary market transaction is:
A) a new issue of stock by Evergreen Solar.
B) a purchase of Microsoft stock on Nasdaq.
C) Target repurchasing some its own stock from an investor.
D) a sale of IBM stock on the NYSE.
Answer: A
Diff: 2
Topic: 10.4 The Stock Market
Keywords: primary market
Principles: Principle 4: Market Prices Reflect Information
2) The largest market for bond trading is:
A) NYSE.
B) Nasdaq.
C) AMEX.
D) the CBOT.
Answer: A
Diff: 2
Topic: 10.4 The Stock Market
Keywords: Nasdaq
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Principles: Principle 4: Market Prices Reflect Information


3) Which of the following companies is most likely to trade on the New York Stock Exchange?
A) Dell
B) Genzyme Transgenics
C) Coca Cola
D) Tata Motors
Answer: C
Diff: 2
Topic: 10.4 The Stock Market
Keywords: NYSE
Principles: Principle 4: Market Prices Reflect Information
4) Which of the following exchanges has the strictest listing requirements?
A) AMEX
B) Nasdaq
C) NYSE
D) OTC
Answer: C
Diff: 2
Topic: 10.4 The Stock Market
Keywords: NYSE
Principles: Principle 4: Market Prices Reflect Information
5) A small, newly listed technology company is most likely to be listed on:
A) AMEX.
B) NYSE.
C) Nasdaq National Markets.
D) Nasdaq Capital Markets.
Answer: D
Diff: 2
Topic: 10.4 The Stock Market
Keywords: Nasdaq
Principles: Principle 4: Market Prices Reflect Information
6) Listing requirements for the New York Stock Exchange include:
A) profitability.
B) market value.
C) breadth of ownership.
D) all of the above.
Answer: D
Diff: 2
Topic: 10.4 The Stock Market
Keywords: NYSE
Principles: Principle 4: Market Prices Reflect Information

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7) A block trade is a trade involving 10,000 or more shares by a single holder.


Answer: TRUE
Diff: 2
Topic: 10.4 The Stock Market
Keywords: block trade
Principles: Principle 4: Market Prices Reflect Information
8) The AMEX specializes in relatively small, new technology companies.
Answer: FALSE
Diff: 2
Topic: 10.4 The Stock Market
Keywords: AMEX
Principles: Principle 4: Market Prices Reflect Information
9) Large, established technology companies such as Apple, Dell, Intel and Microsoft all trade on
the NYSE.
Answer: FALSE
Diff: 2
Topic: 10.4 The Stock Market
Keywords: Nasdaq
Principles: Principle 4: Market Prices Reflect Information
10) Trading on the Nasdaq is done electronically and does not require a physical location.
Answer: TRUE
Diff: 2
Topic: 10.4 The Stock Market
Keywords: Nasdaq
Principles: Principle 4: Market Prices Reflect Information
11) In addition to stocks in individual companies, the AMEX conducts trading in such securities
as ETFs and options.
Answer: TRUE
Diff: 2
Topic: 10.4 The Stock Market
Keywords: AMEX
Principles: Principle 4: Market Prices Reflect Information

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12) Describe the major differences between the organized exchanges such as the NYSE and
electronic networks such as Nasdaq.
Answer: The organized exchanges such as the New York Stock Exchange have a physical
location and a trading floor where buyers and sellers of securities can meet face to face. An
increasing percentage of NYSE and AMEX trades is, however, executed electronically. Nasdaq
is an electronically linked network of traders that post bid and ask prices (the prices they are
willing to pay or accept for securities) and the quantities they are willing to purchase or sell.
There is no physical trading floor. Although companies trading on Nasdaq tend to be smaller and
younger than those traded on the NYSE, Nasdaq listings do include some very large companies
such as Microsoft and Apple.
Diff: 2
Topic: 10.4 The Stock Market
Keywords: organized exchange
Principles: Principle 4: Market Prices Reflect Information
13) Distinguish between primary stock market transactions and secondary stock market
transaction.
Answer: When a company issues stock to the public for the first time, the event is known as an
IPO or Initial Public Offering. Subsequent to the IPO, trading in the company's stock takes place
on one of the major exchanges such as the NYSE or Nasdaq. In the great majority of these
transactions, investors buy stock from other investors who wish to sell it, rather than directly
from the company that issued it.
Diff: 2
Topic: 10.4 The Stock Market
Keywords: primary market
Principles: Principle 4: Market Prices Reflect Information

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