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Financial Reporting Study Guide

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1) When is using the P/E to value stock better than using the constant growth (also known as the DCF) model?

2) A stock will pay a dividend of $2.00 this coming year. The expected growth rate in dividends is 4% and the required rate of return is 12%. What is the indicated value of the common stock?

3) A company is slowly dying. It paid a dividend last year of $1.50, but dividends have a negative annual growth rate of 20%. The firm is expected to be out of business within 6 years. Would a rational investor purchase stock in this company? Why or why not?

4) Which component cost of capital is the most difficult to determine, and why?

5) A firm's preferred stock sells for $50, has a par value of $100, and pays an annual dividend of $5.00. The tax rate is 40%. What is the cost of preferred stock?

6) A firm's common stock just paid an annual dividend of $1.00 per share. The growth rate in dividends is 5% and the stock currently sells for $25.00. The firm's tax rate is 40%. Ignoring flotation costs, what is the cost of common equity?

7) What advantage does MIRR have compared to IRR? Is MIRR just as good as NPV, why or why not?

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This solution provides assistance with the questions regarding financial reporting.

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Question 1
Using the price earnings multiple in stock valuation is better that the discounted cash flow method when the company being valued has no plans to issue dividends in the immediate future - in this case there is no cash flow to discount back to the present. This scenario is usually common for companies in the growth phase cycle where they need to plow back all excess funds into expanding the business to ensure that the companies will be financially sustainable.

Question 2
Value of the common stock = $2*(1+4%)/(12%-4%) = $26

Question 3
As a rational investor I would still purchase the stock of this company as long as it is selling at an amount lower than ...

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