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Stocks and Growth

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1. Which of the following statements is CORRECT?
a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.
b. Two firms with the same expected dividend and growth rates must also have the same stock price.
c. It is appropriate to use the constant growth model to estimate a stock's value even if its
growth rate is never expected to become constant.
d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%.
e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

2. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?
A B
Price $25 $25
Expected growth (constant) 10% 5%
Required return 15% 15%
a. Stock A's expected dividend at t = 1 is only half that of Stock B.
b. Stock A has a higher dividend yield than Stock B.
c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A.
d. Since Stock A's growth rate is twice that of Stock B, Stock A's future dividends will always be twice as high as Stock B's.
e. The two stocks should not sell at the same price. If their prices are equal, then a
disequilibrium must exist.

3. Which of the following statements is CORRECT?
a. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.
b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm's common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock.
c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock.
d. One of the disadvantages to a corporation of owning preferred stock is that 70% of the
dividends received represent taxable income to the corporate recipient, whereas interest
income earned on bonds would be tax free. Estimated rs = 10.00% Actual Market Price, P0: $15.00
e. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer.

4. Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 25% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company's last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock?
a. $26.77
b. $27.89
c. $29.05
d. $30.21
e. $31.42

5. Your boss, Sally Maloney, treasurer of Fred Clark Enterprises (FCE), asked you to help her estimate the intrinsic value of the company's stock. FCE just paid a dividend of $1.00, and the stock now sells for $15.00 per share. Sally asked a number of security analysts what they believe FCE's future dividends will be, based on their analysis of the company. The consensus is that the dividend will be increased by 10% during Years 1 to 3, and it will be increased at a rate of 5% per year in Year 4 and thereafter. Sally asked you to use that information to estimate the required rate of return on the stock, rs, and she provided you with the following template for use in the analysis. (must be changed to force Calculated Price to equal the Actual Market Price)
Rapid growth Normal growth
Year 0 1 2 3 4 5
Dividend growth rate (insert correct values) 10% 10% 10% 5% 5%
Calculated dividends (D0 has been paid) $1.00 ? ? ? ? ?
TV3 = P3 = D4/(rs ? g4). Find using Estimated rs. ?
Total CFs ? ? ?
PVs of CFs when discounted at Estimated rs ? ? ?
Calculated Price = P0 = Sum of PVs = $0.00 A positive number will be here when dividends are estimated. The Calculated Price will equal the Actual Market Price once the correct rs has been found.
Sally told you that the growth rates in the template were just put in as a trial, and that you must replace them with the analysts' forecasted rates to get the correct forecasted dividends and then the estimated TV. She also notes that the estimated value for rs, at the top of the template, is also just a guess, and you must replace it with a value that will cause the Calculated Price shown at the bottom to equal the Actual Market Price. She suggests that, after you have put in the correct dividends, you can manually calculate the price, using a series of guesses as to the Estimated rs. The value of rs that causes the calculated price to equal the actual price is the correct one. She notes, though, that this trial-and-error process would be quite tedious, and that the correct rs could be found much faster with a simple Excel model, especially if you use Goal Seek. What is the value of rs?
a. 11.84%
b. 12.21%
c. 12.58%
d. 12.97%
e. 13.36%

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Solution Preview

Please see attachment.

1. Which of the following statements is CORRECT?
a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.
b. Two firms with the same expected dividend and growth rates must also have the same stock price.
c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant.
d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%.
e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

2. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?
A B
Price 25 25
Expected growth (constant) 10% 5%
Required return 15% 15%

a. Stock A's expected dividend at t = 1 is only half that of Stock B.
b. Stock A has a higher dividend yield than Stock B.
c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A.
d. Since Stock A's growth rate is twice that of Stock B, Stock A's future dividends will always be twice as high as Stock B's.
e. The two stocks should not sell at the same price. If their prices are equal, then a ...

Solution Summary

Stocks and growths for the constant growth model estimated is examined.

$2.19
See Also This Related BrainMass Solution

Valuation, Interest rates, Constant growth, Preferred stock value

See attached file for proper formatting.

Questions:

(5-2) "Short-term interest rates are more volatile than long-term interest rates, so short-term bond prices are more sensitive to interest rate changes than are long-term bond prices." Is this statement true or false? Explain.

(5-3) The rate of return you would get if you bought a bond and held it to its maturity date is called the bond's yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond's price and to its YTM? Does the length of time to maturity affect the extent to which a giving change in interest rates will affect the bond's price?

(5-5) A sinking fund can be set up in one of two ways. Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders.

Problems:

(5-1)
Bond Valuation with
Annual Payments
Jackson Corporation's bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds?

(5-4)
Determinant of
Interest Rates
The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-years Treasure securities? What is the yield on 3-years Treasure securities?

Questions:
(1) Discuss the value of foreign (non-United States) stocks in an investment portfolio. Do you want them? If so, which ones? Do you diversify the classes as you would domestic stock? If so, what classes would you select? Any countries you'd avoid? What about a stock index for foreign stocks...is this a good or bad idea?

(7-2) Two investors are evaluating General Electric's stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the risk of the stock. However, one investor normally holds stocks for 2 years and the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for General Electric's stock. True or false? Explain.

(7-3) A bond that pays interest forever and has no maturity date is a perpetual bond, also called a perpetuity or a consol. In what respect is a perpetual bond similar to (1) a no-growth common stock and (2) a share of preferred stock?

(7-4) People have argued that a stock's market price can deviate from its intrinsic value. Discuss the following question: If all investors attempt to behave in an entirely rational manner, could these differences still exist? In answering this question, think about information that's available to insiders versus outsiders, the fact that historical probabilities of financial events are "fuzzier" than probabilities related to physical items, and the validity of the concepts of animal spirits, herding, and anchoring.
Problems:
(7-2)
Constant Growth
Valuation
Boehm Incorporated is expected to pay a $1.50 per share dividend at the end of this year (i.e., D1 = $1.50). The dividend is expected to grow at a constant rate of 7% a year. The required rate of return on the stock, rs, is 15%. What is the value per share of Boehm's stock?

(7-4)
Preferred Stock
Valuation
Nick's Enchiladas Incorporated has preferred stock outstanding that pays a dividend of $5 at the end of each year. The preferred sells for $50 a share. What is the stock's required rate of return?

(7-6)
Constant Growth
Rate, g
A stock is trading at $80 per share. The stock is expected to have a year-end dividend of $4 per share (D1 = $4), and it is expected to grow at some constant rate g through-out time. The stock's required rate of return is 14%. If markets are efficient, what is your forecast of g?

Questions:

(1) From the reading you discovered that most firms rely on a mix of debt, preferred stock, and common equity. Since debt tends to be less risky to bondholders than equity is to stockholders, the cost of debt to the firm (r(d)) is lower than the cost of equity (r(s)). That said, since debt is less expensive than equity, briefly explain why firms tend not to rely upon all (100%) debt to fund their capital needs.

(9-2) How can the WACC be both an average cost and a marginal cost?

(9-3) How would each of the factors in the following table affect a firm's cost of debt, rd (1 - T); its cost of equity, rs; and its weighted average cost of capital, WACC? Indicate by a plus (+), a minus (-), or a zero (0) if the factor would raise, lower, or have an indeterminate effect on the item in question. Assume that all other factors are held constant. Justify your answer, but recognized that several of the parts probably have no single correct answer.

EFFECT ON:
rd (1 - T) rs WACC
a. The corporate tax rate is lowered.
b. The Federal Reserved tightens credit.
c. The firm uses more debt.
d. The firm doubles the amount of capital
it raises during the year.
e. The firm expands into a risky new area.
f. investors become more risk averse.

(9-4) Distinguish between beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a potential project. Of the three measures, which is theoretically the most relevant, and why?

(9-5) Suppose a firm estimates its overall cost of capital for the coming year to be 10 %. What might be reasonable cost of capital for average-risk, high risk, and low-risk projects?

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