Chapter 18 Equity Valuation Models
Multiple Choice Questions
1. ________ is equal to the total market value of the firm's common stock divided by (the replacement cost of the firm's assets less liabilities).
A) Book value per share B) Liquidation value per share C) Market value per share D) Tobin's Q E) None of the above.
Answer: D Difficulty: Easy
Rationale: Book value per share is assets minus liabilities divided by number of shares.
Liquidation value per share is the amount a shareholder would receive in the event of bankruptcy. Market value per share is the market price of the stock.
2. High P/E ratios tend to indicate that a company will _______, ceteris paribus. A) grow quickly B) grow at the same speed as the average company C) grow slowly D) not grow E) none of the above
Answer: A Difficulty: Easy
Rationale: Investors pay for growth; hence the high P/E ratio for growth firms; however,
the investor should be sure that he or she is paying for expected, not historic, growth.
3. _________ is equal to (common shareholders' equity/common shares outstanding). A) Book value per share B) Liquidation value per share C) Market value per share D) Tobin's Q E) none of the above
Answer: A Difficulty: Easy
Rationale: See rationale for test bank question 18.1
418
Chapter 18 Equity Valuation Models
4. ________ are analysts who use information concerning current and prospective
profitability of a firms to assess the firm's fair market value. A) Credit analysts
B) Fundamental analysts C) Systems analysts D) Technical analysts E) Specialists Answer: B Difficulty: Easy
Rationale: Fundamentalists use all public information in an attempt to value stock (while hoping to identify undervalued securities).
5. The _______ is defined as the present value of all cash proceeds to the investor in the
stock.
A) dividend payout ratio B) intrinsic value
C) market capitalization rate D) plowback ratio E) none of the above Answer: B Difficulty: Easy
Rationale: The cash flows from the stock discounted at the appropriate rate, based on the perceived riskiness of the stock, the market risk premium and the risk free rate, determine the intrinsic value of the stock.
6. _______ is the amount of money per common share that could be realized by breaking
up the firm, selling the assets, repaying the debt, and distributing the remainder to shareholders.
A) Book value per share
B) Liquidation value per share C) Market value per share D) Tobin's Q
E) None of the above Answer: B Difficulty: Easy
Rationale: See explanation for test bank question 18.1.
419
Chapter 18 Equity Valuation Models
7. Since 1955, Treasury bond yields and earnings yields on stocks were_______.
A) identical
B) negatively correlated C) positively correlated D) uncorrelated Answer: C Difficulty: Easy
Rationale: The earnings yield on stocks equals the expected real rate of return on the stock market, which should be equal to the yield to maturity on Treasury bonds plus a risk premium, which may change slowly over time. The yields are plotted in Figure 18.8.
8. Historically, P/E ratios have tended to be _________.
A) higher when inflation has been high B) lower when inflation has been high
C) uncorrelated with inflation rates but correlated with other macroeconomic variables D) uncorrelated with any macroeconomic variables including inflation rates E) none of the above Answer: B Difficulty: Easy
Rationale: P/E ratios have tended to be lower when inflation has been high, reflecting the market's assessment that earnings in these periods are of \artificially distorted by inflation, and warranting lower P/E ratios.
9. The ______ is a common term for the market consensus value of the required return on a stock.
A) dividend payout ratio B) intrinsic value
C) market capitalization rate D) plowback rate E) none of the above Answer: C Difficulty: Easy
Rationale: The market capitalization rate, which consists of the risk-free rate, the systematic risk of the stock and the market risk premium, is the rate at which a stock's cash flows are discounted in order to determine intrinsic value.
420
Chapter 18 Equity Valuation Models
10. The _________ is the fraction of earnings reinvested in the firm. A) dividend payout ratio B) retention rate C) plowback ratio D) A and C E) B and C
Answer: E Difficulty: Easy
Rationale: Retention rate, or plowback ratio, represents the earnings reinvested in the
firm. The retention rate, or (1 - plowback) = dividend payout.
11. The Gordon model A) is a generalization of the perpetuity formula to cover the case of a growing
perpetuity.
B) is valid only when g is less than k. C) is valid only when k is less than g. D) A and B. E) A and C.
Answer: D Difficulty: Easy
Rationale: The Gordon model assumes constant growth indefinitely. Mathematically, g
must be less than k; otherwise, the intrinsic value is undefined.
12. You wish to earn a return of 13% on each of two stocks, X and Y. Stock X is expected
to pay a dividend of $3 in the upcoming year while Stock Y is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The intrinsic value of stock X ______.
A) cannot be calculated without knowing the market rate of return B) will be greater than the intrinsic value of stock Y C) will be the same as the intrinsic value of stock Y D) will be less than the intrinsic value of stock Y E) none of the above is a correct answer.
Answer: D Difficulty: Easy
Rationale: PV0 = D1/(k-g); given k and g are equal, the stock with the larger dividend
will have the higher value.
421
Chapter 18 Equity Valuation Models
13. You wish to earn a return of 11% on each of two stocks, C and D. Stock C is expected to
pay a dividend of $3 in the upcoming year while Stock D is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The intrinsic value of stock C ______.
A) will be greater than the intrinsic value of stock D B) will be the same as the intrinsic value of stock D C) will be less than the intrinsic value of stock D D) cannot be calculated without knowing the market rate of return E) none of the above is a correct answer.
Answer: C Difficulty: Easy
Rationale: PV0 = D1/(k-g); given k and g are equal, the stock with the larger dividend
will have the higher value.
14. You wish to earn a return of 12% on each of two stocks, A and B. Each of the stocks is
expected to pay a dividend of $2 in the upcoming year. The expected growth rate of dividends is 9% for stock A and 10% for stock B. The intrinsic value of stock A _____.
A) will be greater than the intrinsic value of stock B B) will be the same as the intrinsic value of stock B C) will be less than the intrinsic value of stock B D) cannot be calculated without knowing the rate of return on the market portfolio. E) none of the above is a correct statement.
Answer: C Difficulty: Easy
Rationale: PV0 = D1/(k-g); given that dividends are equal, the stock with the higher
growth rate will have the higher value.
15. You wish to earn a return of 10% on each of two stocks, C and D. Each of the stocks is
expected to pay a dividend of $2 in the upcoming year. The expected growth rate of dividends is 9% for stock C and 10% for stock D. The intrinsic value of stock C _____.
A) will be greater than the intrinsic value of stock D B) will be the same as the intrinsic value of stock D C) will be less than the intrinsic value of stock D D) cannot be calculated without knowing the rate of return on the market portfolio. E) none of the above is a correct statement.
Answer: C Difficulty: Easy
Rationale: PV0 = D1/(k-g); given that dividends are equal, the stock with the higher
growth rate will have the higher value.
422