TBChap 007

Chapter 07
Valuing Stocks
True / False Questions
1. The dividend discount model indicates that the value of a stock is the present value of the
dividends it will pay over the investor's horizon, plus the present value of the expected stock price
at the end of that horizon.
True False
2. An excess of market value over the book value of equity can be attributed to going concern value.
True False
3. Securities with the same expected risk should offer the same expected rate of return.
True False
4. If investors believe a company will have the opportunity to make very profitable investments in the
future, they will pay more for the company's stock today.
True False
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5. The dividend discount model should not be used to value stocks in which the dividend does not
grow.
True False
6. If the stock prices follow a random walk, successive stock prices are not related.
True False
7. The liquidation value of a firm is equal to the book value of the firm.
True False
8. Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout
ratio.
True False
9. If the market is efficient, stock prices should be expected to react only to new information that is
released.
True False
10. The intent of technical analysis is to discover patterns in past stock prices.
True False
11. Technical analysts have no effect on the efficiency of the stock market.
True False
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12. Technical analysts would be more likely than other investors to index their portfolios.
True False
13. Market efficiency implies that security prices impound new information quickly.
True False
14. If security prices follow a random walk, then on any particular day the odds are that an increase or
decrease in price is equally likely.
True False
15. Fundamental analysts attempt to get rich by identifying patterns in stock prices.
True False
16. Strong-form market efficiency implies that one could earn above-average returns by examining
the history of a firm's stock price.
True False
17. Market value, unlike book value and liquidation value, treats the firm as a going concern.
True False
18. The dividend yield of a stock is much like the current yield of a bond. Both ignore prospective
capital gains or losses.
True False
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19. The dividend discount model states that today's stock price equals the present value of all
expected future dividends.
True False
Multiple Choice Questions
20. The growth of mature companies is primarily funded by:
A. issuing new shares of stock.
B. issuing new debt securities.
C. reinvesting company earnings.
D. increasing accounts payable.
21. The sustainable growth rate represents the ____ rate at which a firm can grow:
A. maximum; while maintaining a constant debt-equity ratio.
B. maximum; based solely on internal financing.
C. minimum; while maintaining a constant debt-equity ratio.
D. minimum; based solely on internal financing.
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22. Wilt's has earnings per share of $2.98 and dividends per share of $.35. What is the firm's
sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%?
A. 2.14%
B. 1.71%
C. 12.89%
D. 16.06%
23. The sustainable rate of growth:
A. increases as the dividend payout ratio increases.
B. must be moderate over the long-term even if it is high in the short-term.
C. assumes the debt-equity ratio will increase at the same rate as the growth rate.
D. must exceed the required rate of return to be used in the dividend discount model.
24. For a firm that repurchases its stock, the dividend discount model might best be applied to the
firm's:
A. dividends plus its repurchases.
B. repurchases rather than its dividends.
C. free cash flows.
D. pre-repurchase earnings per share.
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25. A firm has 120,000 shares of stock outstanding, a sustainable rate of growth of 3.8, and $648,200
in free cash flows. What value would you place on a share of this firm's stock if you require a 14%
rate of return?
A. $48.09
B. $52.96
C. $54.02
D. $61.58
26. As a result of its IPO, Facebook received:
A. less than half of its true value.
B. almost double its true value.
C. about 75% of its actual value.
D. about the maximum value that it could.
27. If the general sentiment of investors is pessimistic, stock prices are more apt to:
A. increase significantly.
B. increase slightly.
C. remain constant.
D. decline.
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28. What is the difference between a fundamental analyst and a technical analyst?
A. Only a fundamental analyst believes markets are inefficient.
B. A technical analyst focuses on financial statement analysis.
C. Only a technical analyst helps keep the market efficient.
D. A fundamental analyst analyzes information such as earnings and asset values.
29. According to the semistrong form of market efficiency, when new information becomes available
in the market, the related stock prices will:
A. remain unchanged because they already reflect this information.
B. accurately and rapidly adjust to include this new information.
C. adjust to accurately reflect this new information over the course of the next few days.
D. most likely increase because all new information has a positive effect on stock prices.
30. In the calculation of rates of return on common stock, dividends are _______ and capital gains are
______.
A. guaranteed; not guaranteed
B. guaranteed; guaranteed
C. not guaranteed; not guaranteed
D. not guaranteed; guaranteed
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31. What dividend yield would be reported in the financial press for a stock that currently pays a $1
dividend per quarter and the most recent stock price was $40?
A. 2.5%
B. 4.0%
C. 10.0%
D. 5.0%
32. Which of the following values treats the firm as a going concern?
A. Market value
B. Book value
C. Liquidation value
D. Both market and book values
33. If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year and the dividend payout ratio
is 40%, what is the stock's current price?
A. $24.30
B. $18.00
C. $22.22
D. $40.50
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34. With respect to the notion that stock prices follow a random walk, several researchers have
concluded that:
A. stock prices reflect a majority of available information about the firm.
B. successive price changes are predictable.
C. past stock price changes provide little useful information about current stock prices.
D. stock prices always rise excessively in January.
35. What is the current price of a share of stock for a firm with $5 million in balance-sheet equity,
500,000 shares of stock outstanding, and a price/book value ratio of 4?
A. $2.50
B. $10.00
C. $20.00
D. $40.00
36. A firm's liquidation value is the amount:
A. necessary to repurchase all outstanding shares of common stock.
B. realized from selling all assets and paying off all creditors.
C. a purchaser would pay to acquire all of the firm's assets.
D. shown on the balance sheet as total owners' equity.
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37. Which one of the following is least likely to account for an excess of market value over book value
of equity?
A. Inaccurate depreciation methods
B. High rate of return on assets
C. The presence of growth opportunities
D. Valuable off-balance sheet assets
38. Firms with valuable intangible assets are more likely to show a(n):
A. excess of book value over market value of equity.
B. high going-concern value.
C. low liquidation value.
D. low P/E ratio.
39. Which of the following is inconsistent with a firm that sells for very near book value?
A. Low current earnings
B. Few, if any, intangible assets
C. High future earning power
D. Low, unstable dividend payment
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40. A stock paying $5 in annual dividends currently sells for $80 and has an expected return of 14%.
What might investors expect to pay for the stock one year from now?
A. $82.20
B. $86.20
C. $87.20
D. $91.20
41. A stock currently sells for $50 per share, has an expected return of 15%, and an expected capital
appreciation rate of 10%. What is the amount of the expected dividend?
A. $2.50
B. $2.75
C. $3.00
D. $3.50
42. The expected return on a common stock is equal to:
A. [(1 + dividend yield) × (1 + capital appreciation rate)] - 1.
B. the capital appreciation rate + dividend yield.
C. (1 + capital appreciation rate)/(1 + dividend yield).
D. the capital appreciation rate - dividend yield.
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43. It is possible to ignore cash dividends that occur far into the future when using a dividend discount
model because those dividends:
A. will most likely be paid to a different investor.
B. will most likely not be paid.
C. have an insignificant present value.
D. have a minimal, if any, potential rate of growth.
44. If the dividend yield for year 1 is expected to be 5% based on a stock price of $25, what will the
year 4 dividend be if dividends grow annually at a constant rate of 6%?
A. $1.33
B. $1.49
C. $1.58
D. $1.67
45. Dani's just paid an annual dividend of $6 per share. What is the dividend expected to be in five
years if the growth rate is 4.2%?
A. $7.07
B. $7.37
C. $7.14
D. $7.44
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46. The value of common stock will likely decrease if:
A. the investment horizon decreases.
B. the growth rate of dividends increases.
C. the discount rate increases.
D. dividends are discounted back to the present.
47. When valuing stock with the dividend discount model, the present value of future dividends will:
A. change depending on the time horizon selected.
B. remain constant regardless of the time horizon selected.
C. remain constant regardless of the rate of growth.
D. always equal the present value of the terminal price.
48. What should be the price for a common stock paying $3.50 annually in dividends if the growth
rate is zero and the discount rate is 8%?
A. $22.86
B. $28.00
C. $42.00
D. $43.75
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49. What should you pay for a stock if next year's annual dividend is forecast to be $5.25, the
constant-growth rate is 2.85%, and you require a 15.5% rate of return?
A. $31.25
B. $38.87
C. $41.50
D. $42.68
50. What price would you pay today for a stock if you require a rate of return of 13%, the dividend
growth rate is 3.6%, and the firm recently paid an annual dividend of $2.50?
A. $27.55
B. $30.28
C. $26.60
D. $31.37
51. What constant-growth rate in dividends is expected for a stock valued at $32.40 if next year's
dividend is forecast at $2.20 and the appropriate discount rate is 13.6%?
A. 7.02%
B. 6.59%
C. 6.81%
D. 7.38%
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52. What rate of return is expected from a stock that sells for $30 per share, pays $1.54 annually in
dividends, and is expected to sell for $32.80 per share in one year?
A. 15.03%
B. 14.28%
C. 14.09%
D. 14.47%
53. ABC common stock is expected to have extraordinary growth of 20% per year for 2 years, after
which the growth rate will settle into a constant 6%. If the discount rate is 15% and the most recent
dividend was $2.50, what should be the approximate current share price?
A. $31.16
B. $33.23
C. $37.39
D. $47.77
54. What would be the approximate expected price of a stock when dividends are expected to grow at
a 25% rate for 3 years, then grow at a constant rate of 5%, if the stock's required return is 13% and
next year's dividend will be $4.00?
A. $67.60
B. $62.08
C. $68.64
D. $73.44
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55. A company with a return on equity of 15% and a plowback ratio of 60% would expect a constant-
growth rate of:
A. 4%.
B. 9%.
C. 21%.
D. 25%.
56. What is the plowback ratio for a firm that has earnings per share of $2.68 and pays out $1.75 per
share in dividends?
A. 28.20%
B. 34.70%
C. 66.67%
D. 71.80%
57. A positive value for PVGO suggests that the firm has:
A. a positive return on equity.
B. a positive plowback ratio.
C. investment opportunities with superior returns.
D. a high rate of constant growth.
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58. Which of the following situations accurately describes a growth stock, assuming that each firm has
a required return of 12%?
A. A firm with PVGO = $0.
B. A firm with investment opportunities yielding 10%.
C. A firm with investment opportunities yielding 15%.
D. A firm with PVGO < $0.
59. Other things equal, a firm's sustainable growth rate could increase as a result of:
A. increasing the plowback ratio.
B. increasing the payout ratio.
C. decreasing the return on equity.
D. increasing total assets.
60. Under which of the following forms of market efficiency would stock prices always reflect fair
value?
A. Weak-form efficiency
B. Semistrong-form efficiency
C. Strong-form efficiency
D. Semiweak-form efficiency
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61. Investors are willing to purchase stocks having high P/E ratios because:
A. they expect these shares to sell for a lower price.
B. they expect these shares to offer higher dividend payments.
C. these shares are accompanied by guaranteed earnings.
D. they expect these shares to have greater growth opportunities.
62. Which of the following is least likely to contribute to going concern value?
A. High liquidation value
B. Extra earning power
C. Future investment opportunities
D. Intangible assets
63. What happens to a firm that reinvests its earnings at a rate equal to the firm's required return?
A. Its stock price will remain constant.
B. Its stock price will increase by the sustainable growth rate.
C. Its stock price will decline unless the dividend payout ratio is zero.
D. Its stock price will decline unless the plowback rate exceeds the required return.
64. What can be expected to happen when stocks having the same expected risk do not have the
same expected return?
A. At least one of the stocks becomes temporarily mispriced.
B. This is a common occurrence indicating that one stock has more PVGO.
C. This cannot happen if the shares are traded in an auction market.
D. The expected risk levels will change until the expected returns are equal.
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65. The terminal value of a share of stock:
A. is similar to the maturity value of a bond.
B. refers to the share value at the end of an investor's holding period.
C. is the value received by investors upon liquidation of the firm.
D. is the price for shares traded through a dealers' market.
66. A stock is expected to pay dividends of $1.20 per share in Year 1 and $1.35 per share in Year 2.
After that, the dividend is expected to increase by 2.5% annually. What is the current value of the
stock at a discount rate of 14.5%?
A. $11.29
B. $10.87
C. $12.07
D. $13.39
67. Jefferson's recently paid an annual dividend of $1.31 per share. The dividend is expected to
decrease by 4% each year. How much should you pay for this stock today if your required return is
16%?
A. $6.29
B. $5.74
C. $10.48
D. $11.57
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68. Which one of the following is more likely to be responsible for a firm having a low PVGO?
A. ROE exceeds required return.
B. Plowback is very high.
C. Payout is very high.
D. Book value of equity is low.
69. What is the most likely value of the PVGO for a stock with a current price of $50, expected
earnings of $6 per share, and a required return of 20%?
A. $10
B. $20
C. $25
D. $30
70. What is the expected constant-growth rate of dividends for a stock with a current price of $87, an
expected dividend payment of $5.40 per share, and a required return of 16%?
A. 8.48%
B. 6.25%
C. 9.79%
D. 5.23%
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71. Which of the following is true for a firm having a stock price of $42, an expected dividend of $3,
and a sustainable growth rate of 8%?
A. It has a required return of 15.14%.
B. It has a dividend yield of 7.35%.
C. The stock price is expected to be $45 next year.
D. It has a capital appreciation rate of 7.14%.
72. What is the value of the expected dividend per share for a stock that has a required return of 16%,
a price of $45, and a constant-growth rate of 12%?
A. $1.80
B. $3.60
C. $4.50
D. $7.20
73. What is the required return for a stock that has a constant-growth rate of 3.3%, a price of $25, an
expected dividend of $2.10, and a P/E ratio of 14.4?
A. 12.40%
B. 10.92%
C. 11.70%
D. 11.26%
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74. What should be the price of a stock that offers a $4.32 annual dividend with no prospects of
growth, and has a required return of 12.5%?
A. $0
B. $4.86
C. $34.56
D. $30.24
75. Technical analysts are most likely to be successful in a market that is considered to be:
A. semistrong-form efficient.
B. strong-form efficient.
C. less than weak-form efficient.
D. a random walk.
76. If The Wall Street Journal lists a stock's dividend as $1, then it is most likely the case that the stock:
A. pays $1 per share per quarter.
B. paid $.25 per share per quarter for the past year.
C. paid $1 during the past quarter, with no future dividends forecast.
D. is expected to pay an annual dividend of $1 per share next year.
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77. Suzi owns 100 shares of AB stock. She expects to receive a $238 in dividends next year. She also
expects the stock to sell for $46 a share one year from now. What is the intrinsic value of this stock
if the dividend payout ratio is 40% and the discount rate is 13.5%?
A. $38.19
B. $42.63
C. $40.53
D. $45.77
78. What is the minimum amount shareholders should expect to receive in the event of a complete
corporate liquidation?
A. Market value of equity
B. Book value of equity
C. Zero
D. Shareholders may be required to pay to be liquidated.
79. If the price of a stock falls on 4 consecutive days of trading, then stock prices:
A. cannot be following a random walk.
B. can still be following a random walk.
C. are almost certain to increase the following day.
D. are almost certain to decrease the following day.
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80. What should be the stock value one year from today for a stock that currently sells for $35, has a
required return of 15%, an expected dividend of $2.80, and a constant dividend growth rate of
7%?
A. $37.45
B. $37.80
C. $40.25
D. $43.05
81. The required return on an equity security is comprised of a:
A. dividend yield and ROE.
B. current yield and a terminal value.
C. sustainable growth rate and a plowback yield.
D. dividend yield and a capital gains yield.
82. What should be the current price of a share of stock if a $5 dividend was just paid, the stock has a
required return of 20%, and a constant dividend growth rate of 6%?
A. $19.23
B. $25.00
C. $35.71
D. $37.86
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83. What should be the current price of a stock if the expected dividend is $5, the stock has a required
return of 20%, and a constant dividend growth rate of 6%?
A. $19.23
B. $25.00
C. $35.71
D. $37.86
84. Reinvesting earnings into a firm will not increase the stock price unless:
A. the new paradigm of stock pricing is maintained.
B. true depreciation is less than reported depreciation.
C. the firm's dividends are growing also.
D. the ROE of new investments exceeds the firm's required return.
85. What proportion of earnings is being plowed back into the firm if the sustainable growth rate is
8% and the firm's ROE is 20%?
A. 60%
B. 80%
C. 20%
D. 40%
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86. How much of a stock's $30 price is reflected in PVGO if it expects to earn $4 per share, has an
expected dividend of $2.50, and a required return of 20%?
A. $0
B. $6
C. $8
D. $10
87. What is the expected constant-growth rate of dividends for a stock currently priced at $50, that
just paid a dividend of $4, and has a required return of 18%?
A. 3.41%
B. 5.50%
C. 9.26%
D. 12.5%
88. According to random-walk theory, what are the odds that a stock will increase in price after having
increased on two consecutive days of trading?
A. 0%
B. 25%
C. 50%
D. 100%
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89. If the liquidation value of a corporation exceeds the market value of the equity, then the:
A. firm has no value as a going concern.
B. firm's stock will sell for book value.
C. firm is not taking advantage of available growth opportunities.
D. dividend payout ratio has been too high.
90. In a valuation of a nonconstant dividend growth stock, the terminal value represents the:
A. point at which the present value of future dividends equals zero.
B. maturity date of the stock.
C. present value of future dividends from that point on.
D. highest value that the stock will attain.
91. Which one of the following situations is most likely to occur today for a stock that went down in
price yesterday?
A. The stock will increase in price.
B. The stock will decrease in price.
C. The stock has a 30% chance of decreasing in price.
D. The stock has no predictable price-change pattern.
92. Based on the random walk theory, if a stock's price decreased last week, then this week the price:
A. will reverse last week's loss and go up.
B. will continue last week's decline.
C. will stand still until new information is released.
D. has an equal chance of going either up or down.
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93. Research indicates that the correlation coefficient between successive days' stock price changes is:
A. quite close to +1.
B. quite close to -1.
C. quite close to zero.
D. directly related to the stock's beta.
94. An analyst who relies on past cycles of stock pricing to make investment decisions is:
A. performing fundamental analysis.
B. relying on strong-form market efficiency.
C. assuming that the market is not even weak-form efficient.
D. relying on the random walk of stock prices.
95. Janice has spent hours upon hours analyzing the last five years of financial statements of a firm
and has concluded that the firm's stock is currently underpriced. What type of analyst is Janice?
A. Fundamental analyst
B. Random-walker analyst
C. Technical analyst
D. Behavioral finance analyst
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96. If it proves possible to make abnormal profits based on information regarding past stock prices,
then the market is:
A. weak-form efficient.
B. not weak-form efficient.
C. semistrong-form efficient.
D. strong-form efficient.
97. The study of published financial information on a company in order to make investment decisions
is known as:
A. technical analysis.
B. fundamental analysis.
C. efficiency analysis.
D. random pricing analysis.
98. A fundamental analyst:
A. relies on the same information as the technical analyst, but believes in the random walk.
B. studies a firm's financial statements to determine pricing inefficiencies.
C. believes that the market is strong-form efficient.
D. performs an unnecessary function, since markets are efficient.
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99. Studies indicate that stocks of firms with the best earnings news outperform the stocks of firms
with the worst earnings news for at least six months. What type of market anomaly is this?
A. New-issue puzzle
B. Attitudes towards risk behavior
C. Earnings announcement puzzle
D. Probabilities belief
100. If no price change occurs in a stock on the day that it announces its next dividend, it can be
assumed that:
A. the stock market is inefficient.
B. the dividend was reduced.
C. the market was expecting this information.
D. technical analysts are not following this stock.
101. When investors are not capable of making superior investment decisions on a continual basis
based on past prices or public or private information, the market is said to be:
B. semistrong-form efficient.
C. strong-form efficient.
D. fundamentally efficient.
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102. Which group of investors is capable of earning consistent, superior profits if financial markets are
semistrong-form efficient? Ignore any legal considerations.
A. Technical analysts
B. Fundamental analysts
C. Company insiders
D. Mutual fund managers
103. Which one of these probably contributed the least to the dot.com bubble?
A. Investors putting too much weight on recent performance
B. Investor risk aversion
C. Investor overconfidence
D. Professional managers desiring to outperform their competitors
104. When new information becomes available in the market, evidence generally suggests that:
A. insiders will be the only investors to gain.
B. it takes at least ten trading days for stock prices to adjust.
C. stock prices will adjust to the information rapidly.
D. transaction costs will erase any benefit of trading on the information.
105. An example that specifically contradicts strong-form market efficiency in U.S. stock markets is that:
A. excess profits are observed in cases of insider trading.
B. stock prices follow predictable patterns within each month.
C. random-walk behavior is reliable.
D. fundamental analysts outperform the S&P 500.
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106. Your broker suggests that you can make consistent, excess profits by purchasing stocks on the 20 th
of the month and selling them on the last day of the month. If this is true, then:
A. the market is only semistrong-form efficient.
B. the market violates even weak-form efficiency.
C. insiders will be the only investors to profit.
D. prices follow a random walk.
107. If a firm unexpectedly raises its dividend permanently and by a substantial amount, the firm's stock
price:
A. should rise, given dividend discount models.
B. should decline, given discounted cash flow analysis.
C. will remain constant, due to market efficiency.
D. remain constant, due to random-walk behavior.
108. The statement that there are no free lunches on Wall Street suggests that:
A. the market is strong-form efficient.
B. there is no return to technical or fundamental analysis.
C. security prices reflect all available information.
D. food stocks offer the lowest rates of return.
Essay Questions
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109. Explain why the market value of common stock often differs from its liquidation value or its book
value.
110. How can you reconcile the fact that whether an investor favors dividends or capital gains, the
investor should accept the dividend discount model as a determination of share value?
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111. A stock offers an expected dividend of $3.50, has a required return of 14%, and has historically
exhibited a growth rate of 6%. Its current price is $35.00 and shows no tendency to change. How
can you explain this price based on the constant-growth dividend discount model?
112. Show numerically that the investment horizon has no bearing on current stock price. For your
illustration assume investment horizons of 2 versus 3 years and the following facts: The stock has a
required return of 17%, a growth rate of 7%, and has just paid a $3.74 dividend.
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113. A firm expects earnings next year of $10.00 per share, has a plowback ratio of 35%, a return on
equity of 20%, and a required return of 15%. Mathematically illustrate the computation of the
current stock value and next year's expected stock value, assuming that growth is constant. Also
illustrate how the earnings plowback leads to the price increase.
114. Numerically illustrate the breakdown of the stock price between a firm's assets that are already in
place and its present value of growth opportunities. Assume next year's expected earnings are
$5.00 a share, the required rate of return is 13%, the return on equity is 17%, and the plowback
ratio is 45%.
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115. Explain the relationships among the earnings-price (E/P) ratio, required rate of return, and present
value of growth opportunities.
116. How can an analyst feel comfortable in stating that the value of a stock is equal to the discounted
value of all future dividends when a company may pay dividends indefinitely and it is virtually
impossible to predict dividends beyond some reasonable horizon?
117. How does competition among investors lead to efficient markets?
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118. How do you estimate expected rates of return in the constant-growth dividend discount model?
119. What situation does a financial analyst face when there are many talented and competitive
fundamental analysts?
120. What are some common errors investors make in assessing the probability of uncertain outcomes?
How did such errors reinforce the dot.com boom?
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Chapter 07 Valuing Stocks Answer Key
True / False Questions
1. The dividend discount model indicates that the value of a stock is the present value of the
dividends it will pay over the investor's horizon, plus the present value of the expected stock
price at the end of that horizon.
TRUE
AACSB: Reflective Thinking

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
Topic: Dividend discount model
2. An excess of market value over the book value of equity can be attributed to going concern
value.
TRUE

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock.
Topic: Market and book values
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3. Securities with the same expected risk should offer the same expected rate of return.
TRUE

Blooms: Understand
Topic: Risk and return relationship
4. If investors believe a company will have the opportunity to make very profitable investments in
the future, they will pay more for the company's stock today.
TRUE

Blooms: Understand
Difficulty: 1 Easy
5. The dividend discount model should not be used to value stocks in which the dividend does
not grow.
FALSE

Blooms: Understand
7-39
6. If the stock prices follow a random walk, successive stock prices are not related.
FALSE

Blooms: Understand
Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street.
Topic: Fundamental and technical analysis
7. The liquidation value of a firm is equal to the book value of the firm.
FALSE

Blooms: Understand
8. Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout
ratio.
FALSE

Blooms: Understand
Topic: Internal and sustainable growth rates
7-40
9. If the market is efficient, stock prices should be expected to react only to new information that
is released.
TRUE
AACSB: Communication
Blooms: Remember
Difficulty: 1 Easy
Topic: Market efficiency-foundations and types
10. The intent of technical analysis is to discover patterns in past stock prices.
TRUE
Blooms: Remember
Difficulty: 1 Easy
11. Technical analysts have no effect on the efficiency of the stock market.
FALSE

Blooms: Understand
7-41
12. Technical analysts would be more likely than other investors to index their portfolios.
FALSE

Blooms: Understand
Difficulty: 1 Easy
13. Market efficiency implies that security prices impound new information quickly.
TRUE

Blooms: Understand
Difficulty: 1 Easy
Topic: Market efficiency-implications
14. If security prices follow a random walk, then on any particular day the odds are that an increase
or decrease in price is equally likely.
TRUE

Blooms: Understand
Difficulty: 1 Easy
7-42
15. Fundamental analysts attempt to get rich by identifying patterns in stock prices.
FALSE
Blooms: Remember
Difficulty: 1 Easy
16. Strong-form market efficiency implies that one could earn above-average returns by examining
the history of a firm's stock price.
FALSE
Blooms: Remember
Difficulty: 1 Easy
17. Market value, unlike book value and liquidation value, treats the firm as a going concern.
TRUE

Blooms: Understand
Difficulty: 1 Easy
7-43
18. The dividend yield of a stock is much like the current yield of a bond. Both ignore prospective
capital gains or losses.
TRUE

Blooms: Understand
Topic: Stock returns and yields
19. The dividend discount model states that today's stock price equals the present value of all
expected future dividends.
TRUE
Blooms: Remember
Difficulty: 1 Easy
Multiple Choice Questions
7-44
20. The growth of mature companies is primarily funded by:
A. issuing new shares of stock.
B. issuing new debt securities.
C. reinvesting company earnings.
D. increasing accounts payable.
Blooms: Remember
Difficulty: 1 Easy
21. The sustainable growth rate represents the ____ rate at which a firm can grow:
A. maximum; while maintaining a constant debt-equity ratio.
B. maximum; based solely on internal financing.
C. minimum; while maintaining a constant debt-equity ratio.
D. minimum; based solely on internal financing.
Blooms: Remember
Difficulty: 1 Easy
7-45
22. Wilt's has earnings per share of $2.98 and dividends per share of $.35. What is the firm's
sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%?
A. 2.14%
B. 1.71%
C. 12.89%
D. 16.06%
Sustainable growth rate = ROE × plowback ratio

Sustainable growth rate = .182 × [($2.98 - .35)/$2.98]
Sustainable growth rate = .1606, or 16.06%
AACSB: Analytic
Blooms: Analyze
23. The sustainable rate of growth:
A. increases as the dividend payout ratio increases.
B. must be moderate over the long-term even if it is high in the short-term.
C. assumes the debt-equity ratio will increase at the same rate as the growth rate.
D. must exceed the required rate of return to be used in the dividend discount model.

Blooms: Understand
7-46
24. For a firm that repurchases its stock, the dividend discount model might best be applied to the
firm's:
A. dividends plus its repurchases.
B. repurchases rather than its dividends.
C. free cash flows.
D. pre-repurchase earnings per share.
Blooms: Remember
25. A firm has 120,000 shares of stock outstanding, a sustainable rate of growth of 3.8, and
$648,200 in free cash flows. What value would you place on a share of this firm's stock if you
require a 14% rate of return?
A. $48.09
B. $52.96
C. $54.02
D. $61.58
Price = [$648,200/(.14 - .038)]/120,000 = $52.96
AACSB: Analytic
Blooms: Analyze
7-47
26. As a result of its IPO, Facebook received:
A. less than half of its true value.
B. almost double its true value.
C. about 75% of its actual value.
D. about the maximum value that it could.
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-04 Interpret price-earnings ratios.
Topic: Initial public offerings
27. If the general sentiment of investors is pessimistic, stock prices are more apt to:
A. increase significantly.
B. increase slightly.
C. remain constant.
D. decline.

Blooms: Apply
Difficulty: 1 Easy
Topic: Behavioral finance
7-48
28. What is the difference between a fundamental analyst and a technical analyst?
A. Only a fundamental analyst believes markets are inefficient.
B. A technical analyst focuses on financial statement analysis.
C. Only a technical analyst helps keep the market efficient.
D. A fundamental analyst analyzes information such as earnings and asset values.
Blooms: Remember
29. According to the semistrong form of market efficiency, when new information becomes
available in the market, the related stock prices will:
A. remain unchanged because they already reflect this information.
B. accurately and rapidly adjust to include this new information.
C. adjust to accurately reflect this new information over the course of the next few days.
D. most likely increase because all new information has a positive effect on stock prices.

Blooms: Understand
7-49
30. In the calculation of rates of return on common stock, dividends are _______ and capital gains
are ______.
A. guaranteed; not guaranteed
B. guaranteed; guaranteed
C. not guaranteed; not guaranteed
D. not guaranteed; guaranteed

Blooms: Understand
31. What dividend yield would be reported in the financial press for a stock that currently pays a $1
dividend per quarter and the most recent stock price was $40?
A. 2.5%
B. 4.0%
C. 10.0%
D. 5.0%
Dividend yield = ($1 × 4)/$40 = .100, or 10.0%
AACSB: Analytic
Blooms: Apply
Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper.
7-50
32. Which of the following values treats the firm as a going concern?
A. Market value
B. Book value
C. Liquidation value
D. Both market and book values

Blooms: Understand
Difficulty: 1 Easy
33. If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year and the dividend payout
ratio is 40%, what is the stock's current price?
A. $24.30
B. $18.00
C. $22.22
D. $40.50
Price = 13.5 × $3 = $40.50
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Topic: Stock valuation using multiples
7-51
34. With respect to the notion that stock prices follow a random walk, several researchers have
concluded that:
A. stock prices reflect a majority of available information about the firm.
B. successive price changes are predictable.
C. past stock price changes provide little useful information about current stock prices.
D. stock prices always rise excessively in January.

Blooms: Understand
35. What is the current price of a share of stock for a firm with $5 million in balance-sheet equity,
500,000 shares of stock outstanding, and a price/book value ratio of 4?
A. $2.50
B. $10.00
C. $20.00
D. $40.00
Price = 4 × ($5,000,000/500,000) = $40
AACSB: Analytic
Blooms: Apply
7-52
36. A firm's liquidation value is the amount:
A. necessary to repurchase all outstanding shares of common stock.
B. realized from selling all assets and paying off all creditors.
C. a purchaser would pay to acquire all of the firm's assets.
D. shown on the balance sheet as total owners' equity.

Blooms: Understand
Difficulty: 1 Easy
37. Which one of the following is least likely to account for an excess of market value over book
value of equity?
A. Inaccurate depreciation methods
B. High rate of return on assets
C. The presence of growth opportunities
D. Valuable off-balance sheet assets

Blooms: Understand
7-53
38. Firms with valuable intangible assets are more likely to show a(n):
A. excess of book value over market value of equity.
B. high going-concern value.
C. low liquidation value.
D. low P/E ratio.

Blooms: Understand
39. Which of the following is inconsistent with a firm that sells for very near book value?
A. Low current earnings
B. Few, if any, intangible assets
C. High future earning power
D. Low, unstable dividend payment

Blooms: Understand
Difficulty: 1 Easy
7-54
40. A stock paying $5 in annual dividends currently sells for $80 and has an expected return of 14%.
What might investors expect to pay for the stock one year from now?
A. $82.20
B. $86.20
C. $87.20
D. $91.20
.14 = (P1 + $5 - 80)/$80

P1 = $86.20
AACSB: Analytic
Blooms: Analyze
41. A stock currently sells for $50 per share, has an expected return of 15%, and an expected capital
appreciation rate of 10%. What is the amount of the expected dividend?
A. $2.50
B. $2.75
C. $3.00
D. $3.50
Dividend yield = .15 - .10 = .05

Expected dividend = .05 × $50 = $2.50
AACSB: Analytic
7-55
Blooms: Analyze
42. The expected return on a common stock is equal to:
A. [(1 + dividend yield) × (1 + capital appreciation rate)] - 1.
B. the capital appreciation rate + dividend yield.
C. (1 + capital appreciation rate)/(1 + dividend yield).
D. the capital appreciation rate - dividend yield.

Blooms: Understand
Difficulty: 1 Easy
43. It is possible to ignore cash dividends that occur far into the future when using a dividend
discount model because those dividends:
A. will most likely be paid to a different investor.
B. will most likely not be paid.
C. have an insignificant present value.
D. have a minimal, if any, potential rate of growth.

Blooms: Understand
7-56
44. If the dividend yield for year 1 is expected to be 5% based on a stock price of $25, what will the
year 4 dividend be if dividends grow annually at a constant rate of 6%?
A. $1.33
B. $1.49
C. $1.58
D. $1.67
DIV4 = (.05 × $25) × 1.063 = $1.49
AACSB: Analytic
Blooms: Analyze
Topic: Constant-growth stock
45. Dani's just paid an annual dividend of $6 per share. What is the dividend expected to be in five
years if the growth rate is 4.2%?
A. $7.07
B. $7.37
C. $7.14
D. $7.44
DIV3 = $6 × 1.0425 = $7.37
AACSB: Analytic
Blooms: Analyze
7-57
46. The value of common stock will likely decrease if:
A. the investment horizon decreases.
B. the growth rate of dividends increases.
C. the discount rate increases.
D. dividends are discounted back to the present.

Blooms: Understand
Difficulty: 1 Easy
47. When valuing stock with the dividend discount model, the present value of future dividends
will:
A. change depending on the time horizon selected.
B. remain constant regardless of the time horizon selected.
C. remain constant regardless of the rate of growth.
D. always equal the present value of the terminal price.

Blooms: Understand
Difficulty: 1 Easy
7-58
48. What should be the price for a common stock paying $3.50 annually in dividends if the growth
rate is zero and the discount rate is 8%?
A. $22.86
B. $28.00
C. $42.00
D. $43.75
Price = $3.50/.08 = $43.75
AACSB: Analytic
Blooms: Apply
Topic: Perpetuities
49. What should you pay for a stock if next year's annual dividend is forecast to be $5.25, the
constant-growth rate is 2.85%, and you require a 15.5% rate of return?
A. $31.25
B. $38.87
C. $41.50
D. $42.68
Price = $5.25/(.155 - .0285) = $41.50
AACSB: Analytic
Blooms: Analyze
7-59
50. What price would you pay today for a stock if you require a rate of return of 13%, the dividend
growth rate is 3.6%, and the firm recently paid an annual dividend of $2.50?
A. $27.55
B. $30.28
C. $26.60
D. $31.37
Price = ($2.50 × 1.036)/(.13 - .036) = $27.55
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
51. What constant-growth rate in dividends is expected for a stock valued at $32.40 if next year's
dividend is forecast at $2.20 and the appropriate discount rate is 13.6%?
A. 7.02%
B. 6.59%
C. 6.81%
D. 7.38%
$32.40 = $2.20/(.136 - g); g = .0681, or 6.81%
AACSB: Analytic
Blooms: Analyze
7-60
52. What rate of return is expected from a stock that sells for $30 per share, pays $1.54 annually in
dividends, and is expected to sell for $32.80 per share in one year?
A. 15.03%
B. 14.28%
C. 14.09%
D. 14.47%
Expected return = ($32.80 + 1.54 - 30)/$30 = .1447, or 14.47%
AACSB: Analytic
Blooms: Analyze
7-61
53. ABC common stock is expected to have extraordinary growth of 20% per year for 2 years, after
which the growth rate will settle into a constant 6%. If the discount rate is 15% and the most
recent dividend was $2.50, what should be the approximate current share price?
A. $31.16
B. $33.23
C. $37.39
D. $47.77
Price = ($2.50 × 1.2)/1.15 + ($2.50 × 1.2 2)/1.152 + [($2.50 × 1.22 × 1.06)/(.15 - .06)]/1.152 = $37.39
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
Topic: Two-stage growth stock
54. What would be the approximate expected price of a stock when dividends are expected to
grow at a 25% rate for 3 years, then grow at a constant rate of 5%, if the stock's required return
is 13% and next year's dividend will be $4.00?
A. $67.60
B. $62.08
C. $68.64
D. $73.44
Price = $4/1.13 + ($4 × 1.25)/1.132 + ($4 × 1.252)/1.133 + [($4 × 1.252 × 1.05)/(.13 - .05)]/1.133 =
$68.64
AACSB: Analytic
7-62
Blooms: Analyze
Difficulty: 3 Hard
Topic: Two-stage growth stock
55. A company with a return on equity of 15% and a plowback ratio of 60% would expect a
constant-growth rate of:
A. 4%.
B. 9%.
C. 21%.
D. 25%.
g = .15 × .60 = .09, or 9%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
7-63
56. What is the plowback ratio for a firm that has earnings per share of $2.68 and pays out $1.75
per share in dividends?
A. 28.20%
B. 34.70%
C. 66.67%
D. 71.80%
Plowback ratio = ($2.68 - 1.75)/$2.68 = .3470, or 34.70%
AACSB: Analytic
Blooms: Analyze
57. A positive value for PVGO suggests that the firm has:
A. a positive return on equity.
B. a positive plowback ratio.
C. investment opportunities with superior returns.
D. a high rate of constant growth.

Blooms: Understand
Difficulty: 1 Easy
Topic: Net present value growth opportunity
7-64
58. Which of the following situations accurately describes a growth stock, assuming that each firm
has a required return of 12%?
A. A firm with PVGO = $0.
B. A firm with investment opportunities yielding 10%.
C. A firm with investment opportunities yielding 15%.
D. A firm with PVGO < $0.

Blooms: Understand
59. Other things equal, a firm's sustainable growth rate could increase as a result of:
A. increasing the plowback ratio.
B. increasing the payout ratio.
C. decreasing the return on equity.
D. increasing total assets.

Blooms: Understand
7-65
60. Under which of the following forms of market efficiency would stock prices always reflect fair
value?
A. Weak-form efficiency
B. Semistrong-form efficiency
C. Strong-form efficiency
D. Semiweak-form efficiency

Blooms: Understand
Difficulty: 1 Easy
61. Investors are willing to purchase stocks having high P/E ratios because:
A. they expect these shares to sell for a lower price.
B. they expect these shares to offer higher dividend payments.
C. these shares are accompanied by guaranteed earnings.
D. they expect these shares to have greater growth opportunities.

Blooms: Understand
Difficulty: 1 Easy
7-66
62. Which of the following is least likely to contribute to going concern value?
A. High liquidation value
B. Extra earning power
C. Future investment opportunities
D. Intangible assets

Blooms: Understand
63. What happens to a firm that reinvests its earnings at a rate equal to the firm's required return?
A. Its stock price will remain constant.
B. Its stock price will increase by the sustainable growth rate.
C. Its stock price will decline unless the dividend payout ratio is zero.
D. Its stock price will decline unless the plowback rate exceeds the required return.

Blooms: Understand
7-67
64. What can be expected to happen when stocks having the same expected risk do not have the
same expected return?
A. At least one of the stocks becomes temporarily mispriced.
B. This is a common occurrence indicating that one stock has more PVGO.
C. This cannot happen if the shares are traded in an auction market.
D. The expected risk levels will change until the expected returns are equal.

Blooms: Understand
Topic: Risk and return relationship
65. The terminal value of a share of stock:
A. is similar to the maturity value of a bond.
B. refers to the share value at the end of an investor's holding period.
C. is the value received by investors upon liquidation of the firm.
D. is the price for shares traded through a dealers' market.
Blooms: Remember
7-68
66. A stock is expected to pay dividends of $1.20 per share in Year 1 and $1.35 per share in Year 2.
After that, the dividend is expected to increase by 2.5% annually. What is the current value of
the stock at a discount rate of 14.5%?
A. $11.29
B. $10.87
C. $12.07
D. $13.39
Price = $1.20/1.145 + $1.35/1.1452 + [($1.35 × 1.025)/(.145 - .025)]/1.1452 = $10.87
AACSB: Analytic
Blooms: Analyze
Topic: Nonconstant-growth stock
67. Jefferson's recently paid an annual dividend of $1.31 per share. The dividend is expected to
decrease by 4% each year. How much should you pay for this stock today if your required
return is 16%?
A. $6.29
B. $5.74
C. $10.48
D. $11.57
Price = [$1.31 × (1 - .04)]/[.16 - (-.04)] = $6.29
AACSB: Analytic
7-69
Blooms: Analyze
68. Which one of the following is more likely to be responsible for a firm having a low PVGO?
A. ROE exceeds required return.
B. Plowback is very high.
C. Payout is very high.
D. Book value of equity is low.

Blooms: Understand
69. What is the most likely value of the PVGO for a stock with a current price of $50, expected
earnings of $6 per share, and a required return of 20%?
A. $10
B. $20
C. $25
D. $30
With a 100% payout ratio, the stock would be valued at $30 ($6/.20 = $30). Thus, the $20 of
additional price must represent the PVGO.
AACSB: Analytic
Blooms: Apply
7-70
70. What is the expected constant-growth rate of dividends for a stock with a current price of $87,
an expected dividend payment of $5.40 per share, and a required return of 16%?
A. 8.48%
B. 6.25%
C. 9.79%
D. 5.23%
$87 = $5.40/(.16 - g); g = .0979, or 9.79%
AACSB: Analytic
Blooms: Analyze
71. Which of the following is true for a firm having a stock price of $42, an expected dividend of $3,
and a sustainable growth rate of 8%?
A. It has a required return of 15.14%.
B. It has a dividend yield of 7.35%.
C. The stock price is expected to be $45 next year.
D. It has a capital appreciation rate of 7.14%.
Required return = $3/$42 + .08 = .1514, or 15.14%
AACSB: Analytic
7-71
Blooms: Apply
72. What is the value of the expected dividend per share for a stock that has a required return of
16%, a price of $45, and a constant-growth rate of 12%?
A. $1.80
B. $3.60
C. $4.50
D. $7.20
$45 = DIV1/(.16 - .12); Div1 = $1.80
AACSB: Analytic
Blooms: Analyze
7-72
73. What is the required return for a stock that has a constant-growth rate of 3.3%, a price of $25,
an expected dividend of $2.10, and a P/E ratio of 14.4?
A. 12.40%
B. 10.92%
C. 11.70%
D. 11.26%
$25 = $2.10/(r - .033); r = 11.70%
AACSB: Analytic
Blooms: Analyze
74. What should be the price of a stock that offers a $4.32 annual dividend with no prospects of
growth, and has a required return of 12.5%?
A. $0
B. $4.86
C. $34.56
D. $30.24
P = $4.32/.125 = $34.56
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
7-73
Topic: Perpetuities
75. Technical analysts are most likely to be successful in a market that is considered to be:
A. semistrong-form efficient.
B. strong-form efficient.
C. less than weak-form efficient.
D. a random walk.

Blooms: Understand
76. If The Wall Street Journal lists a stock's dividend as $1, then it is most likely the case that the
stock:
A. pays $1 per share per quarter.
B. paid $.25 per share per quarter for the past year.
C. paid $1 during the past quarter, with no future dividends forecast.
D. is expected to pay an annual dividend of $1 per share next year.

Blooms: Understand
Topic: Common stock features
7-74
77. Suzi owns 100 shares of AB stock. She expects to receive a $238 in dividends next year. She also
expects the stock to sell for $46 a share one year from now. What is the intrinsic value of this
stock if the dividend payout ratio is 40% and the discount rate is 13.5%?
A. $38.19
B. $42.63
C. $40.53
D. $45.77
Intrinsic value = [($238/100) + $46]/1.135 = $42.63
AACSB: Analytic
Blooms: Analyze
78. What is the minimum amount shareholders should expect to receive in the event of a complete
corporate liquidation?
A. Market value of equity
B. Book value of equity
C. Zero
D. Shareholders may be required to pay to be liquidated.

Blooms: Understand
Topic: Common stock features
7-75
79. If the price of a stock falls on 4 consecutive days of trading, then stock prices:
A. cannot be following a random walk.
B. can still be following a random walk.
C. are almost certain to increase the following day.
D. are almost certain to decrease the following day.

Blooms: Understand
80. What should be the stock value one year from today for a stock that currently sells for $35, has
a required return of 15%, an expected dividend of $2.80, and a constant dividend growth rate
of 7%?
A. $37.45
B. $37.80
C. $40.25
D. $43.05
$35 × 1.07 = $37.45, since dividends, price, and book value grow at 7%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
7-76
81. The required return on an equity security is comprised of a:
A. dividend yield and ROE.
B. current yield and a terminal value.
C. sustainable growth rate and a plowback yield.
D. dividend yield and a capital gains yield.

Blooms: Understand
Difficulty: 1 Easy
82. What should be the current price of a share of stock if a $5 dividend was just paid, the stock has
a required return of 20%, and a constant dividend growth rate of 6%?
A. $19.23
B. $25.00
C. $35.71
D. $37.86
Price = ($5 × 1.06)/(.20 - .06) = $37.86
AACSB: Analytic
Blooms: Analyze
7-77
83. What should be the current price of a stock if the expected dividend is $5, the stock has a
required return of 20%, and a constant dividend growth rate of 6%?
A. $19.23
B. $25.00
C. $35.71
D. $37.86
Price = $5.00/(.20 - .06) = $35.71
AACSB: Analytic
Blooms: Analyze
84. Reinvesting earnings into a firm will not increase the stock price unless:
A. the new paradigm of stock pricing is maintained.
B. true depreciation is less than reported depreciation.
C. the firm's dividends are growing also.
D. the ROE of new investments exceeds the firm's required return.

Blooms: Understand
7-78
85. What proportion of earnings is being plowed back into the firm if the sustainable growth rate is
8% and the firm's ROE is 20%?
A. 60%
B. 80%
C. 20%
D. 40%
8% = 20% × plowback; Plowback = 40%
AACSB: Analytic
Blooms: Apply
86. How much of a stock's $30 price is reflected in PVGO if it expects to earn $4 per share, has an
expected dividend of $2.50, and a required return of 20%?
A. $0
B. $6
C. $8
D. $10
PVGO = $30 - ($4/.2) = $10
AACSB: Analytic
Blooms: Analyze
7-79
87. What is the expected constant-growth rate of dividends for a stock currently priced at $50, that
just paid a dividend of $4, and has a required return of 18%?
A. 3.41%
B. 5.50%
C. 9.26%
D. 12.5%
$50 = $4(1 + g)/(.18 - g); g = 9.26%
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
88. According to random-walk theory, what are the odds that a stock will increase in price after
having increased on two consecutive days of trading?
A. 0%
B. 25%
C. 50%
D. 100%

Blooms: Understand
Difficulty: 1 Easy
7-80
89. If the liquidation value of a corporation exceeds the market value of the equity, then the:
A. firm has no value as a going concern.
B. firm's stock will sell for book value.
C. firm is not taking advantage of available growth opportunities.
D. dividend payout ratio has been too high.

Blooms: Understand
90. In a valuation of a nonconstant dividend growth stock, the terminal value represents the:
A. point at which the present value of future dividends equals zero.
B. maturity date of the stock.
C. present value of future dividends from that point on.
D. highest value that the stock will attain.

Blooms: Understand
Topic: Nonconstant-growth stock
7-81
91. Which one of the following situations is most likely to occur today for a stock that went down in
price yesterday?
A. The stock will increase in price.
B. The stock will decrease in price.
C. The stock has a 30% chance of decreasing in price.
D. The stock has no predictable price-change pattern.

Blooms: Understand
92. Based on the random walk theory, if a stock's price decreased last week, then this week the
price:
A. will reverse last week's loss and go up.
B. will continue last week's decline.
C. will stand still until new information is released.
D. has an equal chance of going either up or down.

Blooms: Understand
7-82
93. Research indicates that the correlation coefficient between successive days' stock price changes
is:
A. quite close to +1.
B. quite close to -1.
C. quite close to zero.
D. directly related to the stock's beta.

Blooms: Understand
94. An analyst who relies on past cycles of stock pricing to make investment decisions is:
A. performing fundamental analysis.
B. relying on strong-form market efficiency.
C. assuming that the market is not even weak-form efficient.
D. relying on the random walk of stock prices.

Blooms: Understand
7-83
95. Janice has spent hours upon hours analyzing the last five years of financial statements of a firm
and has concluded that the firm's stock is currently underpriced. What type of analyst is Janice?
A. Fundamental analyst
B. Random-walker analyst
C. Technical analyst
D. Behavioral finance analyst

Blooms: Understand
96. If it proves possible to make abnormal profits based on information regarding past stock prices,
then the market is:
B. not weak-form efficient.
C. semistrong-form efficient.
D. strong-form efficient.

Blooms: Understand
Difficulty: 1 Easy
7-84
97. The study of published financial information on a company in order to make investment
decisions is known as:
A. technical analysis.
B. fundamental analysis.
C. efficiency analysis.
D. random pricing analysis.
Blooms: Remember
Difficulty: 1 Easy
98. A fundamental analyst:
A. relies on the same information as the technical analyst, but believes in the random walk.
B. studies a firm's financial statements to determine pricing inefficiencies.
C. believes that the market is strong-form efficient.
D. performs an unnecessary function, since markets are efficient.

Blooms: Understand
7-85
99. Studies indicate that stocks of firms with the best earnings news outperform the stocks of firms
with the worst earnings news for at least six months. What type of market anomaly is this?
A. New-issue puzzle
B. Attitudes towards risk behavior
C. Earnings announcement puzzle
D. Probabilities belief
Blooms: Remember
Topic: Market efficiency-studies and challenges
100. If no price change occurs in a stock on the day that it announces its next dividend, it can be
assumed that:
A. the stock market is inefficient.
B. the dividend was reduced.
C. the market was expecting this information.
D. technical analysts are not following this stock.

Blooms: Understand
Difficulty: 1 Easy
7-86
101. When investors are not capable of making superior investment decisions on a continual basis
based on past prices or public or private information, the market is said to be:
B. semistrong-form efficient.
C. strong-form efficient.
D. fundamentally efficient.
Blooms: Remember
102. Which group of investors is capable of earning consistent, superior profits if financial markets
are semistrong-form efficient? Ignore any legal considerations.
A. Technical analysts
B. Fundamental analysts
C. Company insiders
D. Mutual fund managers

Blooms: Understand
Difficulty: 1 Easy
7-87
103. Which one of these probably contributed the least to the dot.com bubble?
A. Investors putting too much weight on recent performance
B. Investor risk aversion
C. Investor overconfidence
D. Professional managers desiring to outperform their competitors

Blooms: Understand
104. When new information becomes available in the market, evidence generally suggests that:
A. insiders will be the only investors to gain.
B. it takes at least ten trading days for stock prices to adjust.
C. stock prices will adjust to the information rapidly.
D. transaction costs will erase any benefit of trading on the information.

Blooms: Understand
Difficulty: 1 Easy
7-88
105. An example that specifically contradicts strong-form market efficiency in U.S. stock markets is
that:
A. excess profits are observed in cases of insider trading.
B. stock prices follow predictable patterns within each month.
C. random-walk behavior is reliable.
D. fundamental analysts outperform the S&P 500.

Blooms: Understand
106. Your broker suggests that you can make consistent, excess profits by purchasing stocks on the
20th of the month and selling them on the last day of the month. If this is true, then:
A. the market is only semistrong-form efficient.
B. the market violates even weak-form efficiency.
C. insiders will be the only investors to profit.
D. prices follow a random walk.

Blooms: Understand
7-89
107. If a firm unexpectedly raises its dividend permanently and by a substantial amount, the firm's
stock price:
A. should rise, given dividend discount models.
B. should decline, given discounted cash flow analysis.
C. will remain constant, due to market efficiency.
D. remain constant, due to random-walk behavior.

Blooms: Understand
108. The statement that there are no free lunches on Wall Street suggests that:
A. the market is strong-form efficient.
B. there is no return to technical or fundamental analysis.
C. security prices reflect all available information.
D. food stocks offer the lowest rates of return.

Blooms: Understand
Essay Questions
7-90
109. Explain why the market value of common stock often differs from its liquidation value or its
book value.
A firm's liquidation value represents the excess valuation of its assets over its liabilities if the firm
ceased operations and all assets and liabilities were to be sold. Obviously, then, the liquidation
value will depend on the supply and demand for secondhand assets of this nature. A firm's
book value of equity equals all of the initial funds that were supplied by investors as well as
earnings that have been plowed back into the firm over time. Notice that this makes no
statement as to how profitably those earnings were reinvested. When comparing either of these
values to a firm's market value of equity, it is not surprising to find differences. If a firm has
been properly organized and serves customer needs, it will likely have value as a going
concern, which may easily boost market value higher than that of liquidation or book values.
Going-concern value can be the result of extra earning power over that of equally risky
companies, or intangible assets that offer unrecorded value, or the value of future investment
opportunities.

Blooms: Understand
7-91
110. How can you reconcile the fact that whether an investor favors dividends or capital gains, the
investor should accept the dividend discount model as a determination of share value?
The first fact to be recognized is that equally risky firms should offer the same expected rate of
return. Next, recognize that the return to a common stock investor can come from either
dividends or capital gains. Then it becomes easier to envision that, for example, a firm with a
high payout may offer good current income, but that it will not be as likely to increase this
income in the future due to the lower plowback now. On the other hand, a firm with a low or
zero current payout doesn't offer much in a justification of value from current income, but is
supposedly investing in growth opportunities that will someday offer enhanced payout
potential. In reconciling these cases, common stock may offer a different time pattern of
dividends. That will of course have an effect on present value, but as long as investors with
different preferences can agree on a stock's fundamentals, they should place the same value on
the stock: the present value of all expected future dividends.

Blooms: Understand
Difficulty: 3 Hard
7-92
111. A stock offers an expected dividend of $3.50, has a required return of 14%, and has historically
exhibited a growth rate of 6%. Its current price is $35.00 and shows no tendency to change.
How can you explain this price based on the constant-growth dividend discount model?
The constant-growth dividend discount model would indicate that this stock should currently
sell for $43.75, based on the following formula:
P = $3.50/(.14 - .06) = $43.75
Although stocks can temporarily be out of equilibrium price, the fact that this stock price shows
no tendency to change suggests that investors do not expect the past growth rate of 6% to
continue into the future. Since there is no indication that the required rate of return has
changed, it appears that the company many anticipate fewer positive growth opportunities
than in the past. Therefore, the dividend yield has likely increased to its current 10% level, and
the overall market seems to expect a growth rate of 4% rather than the historical 6%.
P = $3.50/(.14 - .04) = $35
At a growth rate of 4%, the stock would be correctly priced at $35.00.
AACSB: Analytic
Blooms: Analyze
7-93
112. Show numerically that the investment horizon has no bearing on current stock price. For your
illustration assume investment horizons of 2 versus 3 years and the following facts: The stock
has a required return of 17%, a growth rate of 7%, and has just paid a $3.74 dividend.
2-year time horizon:
P = ($3.74 × 1.07)/1.17 + [($3.74 × 1.072)/(.17 - .07)]/1.17

P = $40.02
3-year time horizon:
P = ($3.74 × 1.07)/1.17 + ($3.74 × 1.072)/1.172 + [($3.74 × 1.073)/(.17 - .07)]/1.172

P = $40.02
AACSB: Analytic
Blooms: Analyze
7-94
113. A firm expects earnings next year of $10.00 per share, has a plowback ratio of 35%, a return on
equity of 20%, and a required return of 15%. Mathematically illustrate the computation of the
current stock value and next year's expected stock value, assuming that growth is constant. Also
illustrate how the earnings plowback leads to the price increase.
DIV1 = $10 × (1 - .35) = $6.50
g = .20 × .35 = .07
P0 = $6.50/(.15 - .07) = $81.25
P1 = ($6.50 × 1.07)/(.15 - .07) = $86.94
P1 = $81.25 × 1.07 = $86.94
Thus, both the dividend discount model and the current stock price increased by the growth
rate of 7% indicate that next year's value should be $86.94.
This can be confirmed by multiplying the expected plowback of $3.50 ($10 × .35) times the
return on equity of 20% to see that earnings should be $.70 higher in 2 years. This $.70 will be
subject to a 65% payout, which will increase dividends by $.455. Finally, $.455 translates into a
price increase of $5.68 when plugged into a dividend discount model, as can be seen by:
ΔP = $.455/(.15 - .07) = $5.69

P1 = $81.25 + 5.69 = $86.94
AACSB: Analytic
Blooms: Analyze
7-95
114. Numerically illustrate the breakdown of the stock price between a firm's assets that are already
in place and its present value of growth opportunities. Assume next year's expected earnings
are $5.00 a share, the required rate of return is 13%, the return on equity is 17%, and the
plowback ratio is 45%.
P0 = $5/(.13 - 0) = $38.46
g = .17 × .45 = .0765
P0 = [$5 × (1 - .45)]/(.13 - .0765) = $51.40
PVGO = $51.40 - 38.46 = $12.94
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
115. Explain the relationships among the earnings-price (E/P) ratio, required rate of return, and
present value of growth opportunities.
The inverse of the price-earnings (P/E) ratio is the earnings-price (E/P) ratio. If the E/P ratio is
greater than the required return for the stock, the difference is typically attributed to the firm's
positive value of PVGO. If, on the other hand, the firm's E/P ratio is equal to its required rate of
return, the firm does not have growth opportunities that are expected to yield more than the
required rate of return given the risk of the stock. It is possible that the firm has a lower E/P
ratio than the required rate of return, in which case the firm is not even earning the rate of
return that is required for its risk level. This is numerically equivalent to the firm having negative
growth opportunities, and suggests that the firm either reorganize or liquidate.

Blooms: Understand
7-96
116. How can an analyst feel comfortable in stating that the value of a stock is equal to the
discounted value of all future dividends when a company may pay dividends indefinitely and it
is virtually impossible to predict dividends beyond some reasonable horizon?
At most reasonable discount rates for common stock, say between 10% and 20%, the present
value of dividends to be received beyond some reasonable horizon, say 10 years, is quite low in
relation to the present value of dividends received to that point. For example, for a stock
expecting to pay a dividend of $2.00 with a growth rate of 5% and a required return of 15%,
approximately 60% of the present value of an infinite dividend stream is realized from the first
10 years of dividends. By 15 years, approximately 75% of the future value has been received.
These percentages can easily be proven by use of the constant growth dividend discount
model.
AACSB: Analytic
Blooms: Apply
7-97
117. How does competition among investors lead to efficient markets?
The search for information and insightful analysis makes investor assessments of stock values as
reliable as possible. Since the rewards accrue to the investors who uncover relevant information
before it is reflected in stock prices, competition among these investors means that there is
always an active search for mispriced stocks. This competition between investors will tend to
produce an efficient market—that is, a market in which prices rapidly reflect new information,
and investors have difficulty making consistently superior returns. Of course, we all hope to
beat the market, but if the market is efficient, all we can rationally expect is a return that is
sufficient on average to compensate for the time value of money and for the risks we bear.
The evidence for market efficiency is voluminous and there is little doubt that skilled
professional investors find it difficult to win consistently. Nevertheless, there remain some
puzzling instances where markets do not seem to be efficient. Some financial economists
attribute these apparent anomalies to behavioral foibles.

Blooms: Understand
7-98
118. How do you estimate expected rates of return in the constant-growth dividend discount
model?
In constant-growth business situations, if g is capitalized in the market in higher stock prices, r

may be a proxy for the market expected rate of return on similar risk situations.
The expected rate of return is a combination of the dividend yield, DIV 1/P0, and capital
appreciation rate, g, or:
r = (DIV1/P0) + g
The required rate of return, r, is a market-determined rate related to the risk-free rate adjusted
upward for risk, given expectations of DIV 1 and g. The stock price, P0, adjusts to equate the
market-expected rate with the required rate of return.
Blooms: Remember
7-99
119. What situation does a financial analyst face when there are many talented and competitive
fundamental analysts?
Fundamental analysts are paid to uncover stocks for which price does not equal intrinsic value.
If intrinsic value exceeds price, for example, the stock is a bargain and will offer a superior
expected return. But what happens if there are many talented and competitive fundamental
analysts? If one of them uncovers a stock that appears to be a bargain, it stands to reason that
others will as well, and there will be a wave of buying that pushes up the price. In the end, their
actions will eliminate the original bargain opportunity. To profit, an analyst's insights must be
different from those of other competitors, and he/she must act faster than their competitors do.
This is a tall order.

Blooms: Understand
7-100
120. What are some common errors investors make in assessing the probability of uncertain
outcomes? How did such errors reinforce the dot.com boom?
Psychologists have found that when judging possible future outcomes, individuals commonly
look back to what has happened in recent periods and then assume that this is representative
of what may occur in the future. The temptation is to project recent experience into the future
and to forget the lessons learned from the more distant past. For example, an investor who
places too much weight on recent events may judge that glamorous growth companies are
very likely to continue to grow rapidly, even though very high rates of growth cannot persist
indefinitely.
A second common bias is that of overconfidence. Most of us believe that we are better-than-
average drivers, and most investors think that they are better-than-average stock pickers. We
know that two speculators who trade with one another cannot both make money from the
deal; for every winner there must be a loser. But presumably investors are prepared to continue
trading because each is confident that it is the other one who is the patsy.
You can see how such behavior may have reinforced the dot.com boom. As the bull market
developed, it generated increased optimism about the future and stimulated demand for
shares. The more that investors racked up profits on their stocks, the more confident they
became in their views and the more willing they became to bear the risk that the next month
might not be so good.

Blooms: Understand
Topic: Behavioral finance
7-101

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Chapter 07

True / False Questions

at the end of that horizon.

decrease in price is equally likely.

the history of a firm's stock price.

expected future dividends.

Multiple Choice Questions

20. The growth of mature companies is primarily funded by:

A. issuing new shares of stock.

B. issuing new debt securities.

C. reinvesting company earnings.

D. increasing accounts payable.

A. maximum; while maintaining a constant debt-equity ratio.

B. maximum; based solely on internal financing.

C. minimum; while maintaining a constant debt-equity ratio.

D. minimum; based solely on internal financing.

23. The sustainable rate of growth:

A. increases as the dividend payout ratio increases.

B. must be moderate over the long-term even if it is high in the short-term.

A. dividends plus its repurchases.

B. repurchases rather than its dividends.

C. free cash flows.

D. pre-repurchase earnings per share.

26. As a result of its IPO, Facebook received:

A. less than half of its true value.

B. almost double its true value.

C. about 75% of its actual value.

D. about the maximum value that it could.

A. Only a fundamental analyst believes markets are inefficient.

B. A technical analyst focuses on financial statement analysis.

C. Only a technical analyst helps keep the market efficient.

D. A fundamental analyst analyzes information such as earnings and asset values.

in the market, the related stock prices will:

A. remain unchanged because they already reflect this information.

B. accurately and rapidly adjust to include this new information.

A. guaranteed; not guaranteed

C. not guaranteed; not guaranteed

D. not guaranteed; guaranteed

D. Both market and book values

A. stock prices reflect a majority of available information about the firm.

B. successive price changes are predictable.

D. stock prices always rise excessively in January.

500,000 shares of stock outstanding, and a price/book value ratio of 4?

36. A firm's liquidation value is the amount:

A. necessary to repurchase all outstanding shares of common stock.

C. a purchaser would pay to acquire all of the firm's assets.

D. shown on the balance sheet as total owners' equity.

A. Inaccurate depreciation methods

B. High rate of return on assets

C. The presence of growth opportunities

D. Valuable off-balance sheet assets

A. excess of book value over market value of equity.

B. high going-concern value.

C. low liquidation value.

D. low P/E ratio.

A. Low current earnings

B. Few, if any, intangible assets

C. High future earning power

D. Low, unstable dividend payment

appreciation rate of 10%. What is the amount of the expected dividend?

42. The expected return on a common stock is equal to:

A. [(1 + dividend yield) × (1 + capital appreciation rate)] - 1.

B. the capital appreciation rate + dividend yield.