CHAPTER 8

STOCKS, STOCK VALUATION, AND STOCK MARKET EQUILIBRIUM

True/False

Easy:
(8.1) Proxy Answer: a EASY
1
. A proxy is a document giving one party the authority to act for another
party, including the power to vote shares of common stock. A proxy can
be an important tool relating to control of the firm.

a. True
b. False

(8.1) Preemptive right Answer: a EASY

2
. The preemptive right gives current stockholders the right to purchase,
on a pro rata basis, any new shares sold by the firm. This right helps
protect current stockholders against both dilution of control and
dilution of value.

a. True
b. False

(8.1) Preemptive right Answer: b EASY

3
. If a firm's stockholders are given the preemptive right, this means that
stockholders have the right to call for a meeting to vote to replace the
management. Without the preemptive right, dissident stockholders would
have to seek a change in management through a proxy fight.

a. True
b. False

(8.1) Closely held stock Answer: a EASY

4
. When a corporation's shares are owned by a few individuals who are
associated with the firm's management, we say that the stock is "closely
held."

a. True
b. False

(8.1) Public company Answer: a EASY

5
. A publicly owned corporation is a company whose shares are held by the
investing public, which may include other corporations as well as
institutional investors.

a. True
b. False

Chapter 8: Stocks, Equilibrium True/False Page 271

 (8.2) Classified stock Answer: a EASY
6
. Classified stock differentiates different classes of common stock, and
using it is one way companies can meet special needs such as when owners
of a start-up firm need additional equity capital but don't want to
relinquish voting control.

a. True
b. False

(8.2) Founders' shares Answer: a EASY

7
. Founders' shares are a type of classified stock where the shares are
owned by the firm's founders, and they generally have more votes per
share than the other classes of common stock.

a. True
b. False

(8.4) Total stock returns Answer: b EASY

8
. The total return on a share of stock refers to the dividend yield less
any commissions paid when the stock is purchased and sold.

a. True
b. False

(8.4) Common stock cash flows Answer: a EASY

9
. The cash flows associated with common stock are more difficult to
estimate than those related to bonds because stocks only have residual
claims against the company.

a. True
b. False

(8.4) Stock valuation Answer: b EASY

10
. According to the basic DCF stock valuation model, the value an investor
should assign to a share of stock is dependent on the length of time he
or she plans to hold the stock.

a. True
b. False

(8.5) Constant growth model Answer: a EASY

11
. The constant growth DCF model used to evaluate the prices of common
stocks is essentially the same as the model used to find the price of
perpetual preferred stock or any other perpetuity.

a. True
b. False

Page 272 True/False Chapter 8: Stocks, Equilibrium

 (8.7) Nonconstant growth model Answer: a EASY
12
. According to the nonconstant growth model discussed in the textbook, the
discount rate used to find the present value of the expected cash flows
during the initial growth period is the same as the discount rate used to
find the PVs of cash flows during the subsequent constant growth period.

a. True
b. False

(8.11) Marginal investor and price Answer: a EASY

13
. When a new issue of stock is brought to market, it is the marginal
investor who determines the price at which the stock will trade.

a. True
b. False

(8.12) Efficient markets hypothesis Answer: b EASY

14
. If security markets were truly strong-form efficient, one could never
earn a realized return on a stock greater than the marginal investor's
expected (and required) rate of return on the stock.

a. True
b. False

Medium:
(8.1) Proxy fight Answer: b MEDIUM
15
. A proxy fight generally is a battle between management and a group of
stockholders who want to install a new management team that will operate
the firm differently, or possibly break it up or sell it. Under most
companies' bylaws, the dissident group must obtain 80% or more of the
votes in order to prevail.

a. True
b. False

(8.11) Stock market equilibrium Answer: b MEDIUM

16
. If two firms have the same current dividend and the same expected
dividend growth rate, their stocks must sell at the same current price
or else the market will not be in equilibrium.

a. True
b. False

Chapter 8: Stocks, Equilibrium True/False Page 273

Multiple Choice: Conceptual

Easy:
(8.4) Required return Answer: e EASY
17
. An increase in a firm’s expected growth rate would normally cause its
required rate of return to

a. Increase.
b. Decrease.
c. Fluctuate less than before.
d. Remain constant.
e. Possibly increase, possibly decrease, or possibly have no effect.

(8.4) Required return Answer: c EASY

18
. If in the opinion of a given investor a stock’s expected return exceeds
its required return, this suggests that

a. The investor thinks the stock is experiencing supernormal growth.

b. The investor thinks the stock should be sold.
c. The investor thinks the stock is a good buy.
d. The investor thinks management is probably not trying to maximize the
price per share.
e. The investor thinks dividends are not likely to be declared.

(8.5) Constant growth model Answer: c EASY

19
. Which of the following statements is CORRECT?

a. The constant growth model is often appropriate to evaluate start-up

companies that do not have a stable history of growth but are expected
to reach stable growth within the next year or so.
b. If a stock has a required rate of return rs = 12% and its dividend is
expected to grow at a constant rate of 5%, this implies that the stock’s
dividend yield is 5%.
c. The stock valuation model, P0 = D1/(rs - g), can be used for firms that
have expected negative, but constant, growth rates.
d. The price of a stock is the present value of all expected future
dividends, discounted at the dividend growth rate.
e. The constant growth model cannot be used for a zero growth stock, where
the dividend is expected to remain constant over time.

Page 274 Conceptual Questions Chapter 8: Stocks, Equilibrium

 (8.12) Efficient markets hypothesis Answer: b EASY

Chapter 8: Stocks, Equilibrium Conceptual Questions Page 275

20
. Which of the following statements is CORRECT?

a. Semistrong-form market efficiency implies that as soon as any public or

private information comes into being it is incorporated into stock prices.
b. Weak-form market efficiency implies that recent trends in stock prices
are of no use in predicting future stock prices.
c. Market efficiency implies that all stocks should have the same expected
return.
d. According to strong-form market efficiency, insiders would find it
possible to consistently earn abnormal returns in the stock market even
if they have superior knowledge about the company.
e. Studies of the Efficient Markets Hypothesis suggest that neither the
weak-form nor the semi-strong forms of efficiency hold, especially for
larger companies. However, the market appears to be strong-form
efficient because institutional traders make abnormal profits.

(8.12) Efficient markets hypothesis Answer: e EASY

21
. Which of the following statements is CORRECT?

a. The Efficient Markets Hypothesis suggests that the market does not price
stocks fairly; hence, managers should make decisions based on the
premise that firms' stocks are undervalued or overvalued.
b. An individual who has information about past stock prices would be able
to profit from this information if weak-form market efficiency exists.
c. An individual who has inside information about a publicly traded company
should be able to profit from this information if strong-form market
efficiency exists.
d. For the Efficient Markets Hypothesis to hold true, every individual
investor must be "rational."
e. Semistrong-form market efficiency means that stock prices reflect all
public, but not necessarily all private, information.

(8.12) Efficient markets hypothesis Answer: c EASY

22
. Most studies of stock market efficiency suggest that the stock market is
highly efficient in the weak form and reasonably efficient in the
semistrong form. (This is true.) Based on these findings, which of the
following statements is CORRECT?

a. Information disclosed in companies’ most recent annual reports can be

used to consistently beat the market.
b. The stock price for a company has been increasing for the past 6 months.
Based on this information, it must be true that the stock price will
also increase during the current month.
c. Information you read in The Wall Street Journal today cannot be used to
select stocks that will consistently beat the market.
d. Stock prices will respond whenever financial information is released to
the public. It does not matter whether this financial information had
been expected or not.
e. Managers who have inside information that is not available to the public
cannot consistently earn abnormal returns, i.e., returns that are higher
than those predicted by the SML.

Easy/Medium:

Page 276 Conceptual Questions Chapter 8: Stocks, Equilibrium

 (8.4) Required return Answer: b EASY/MEDIUM
23
. Stock A has a required return of 10% and a price of $25, and its
dividend is expected to grow at a constant rate of 7% per year. Stock B
has a required return of 12% and a price of $40, and its dividend is
expected to grow at a constant rate of 9% per year. Which of the
following statements is CORRECT?

a. If the stock market were efficient, these two stocks would have the same
price.
b. The two stocks have the same dividend yield.
c. If the stock market were efficient, these two stocks would have the same
expected return.
d. The two stocks have the same expected capital gains yield.
e. The two stocks have the same expected year-end dividend.

Medium:
(8.1) Preemptive right Answer: d MEDIUM
24
. The preemptive right is important to shareholders because it

a. Allows managers to buy additional shares below the current market price.
b. Will result in higher dividends per share.
c. Is included in every corporate charter.
d. Protects the current shareholders against a dilution of their ownership
interests.
e. Protects bondholders, and thus enables the firm to issue debt with a
relatively low interest rate.

(8.2) Classified stock Answer: e MEDIUM

25
. Companies can issue different classes of common stock. Which of the
following statements concerning stock classes is CORRECT?

a. All common stocks fall into one of three classes: A, B, and C.

b. All common stocks, regardless of class, must have the same voting rights.
c. All firms have several classes of common stock.
d. All common stock, regardless of class, must pay the same dividend.
e. Some class or classes of common stock may be entitled to more votes per
share than other classes.

(8.4) Dividend yield and g Answer: a MEDIUM

26
. Stocks A and B have the same price, but Stock A has the higher required
rate of return. Which of the following statements is CORRECT?

a. If Stock A has a lower dividend yield than Stock B, its expected capital
gains yield must be higher than Stock B’s.
b. Stock B must have a higher dividend yield than Stock A.
c. Stock A must have a higher dividend yield than Stock B.
d. If Stock A has a higher dividend yield than Stock B, its expected
capital gains yield must be lower than Stock B’s.
e. Stock A must have both a higher dividend yield and a higher capital
gains yield than Stock B.

Chapter 8: Stocks, Equilibrium Conceptual Questions Page 277

 (8.5) Declining constant growth stock Answer: e MEDIUM
27
. A stock is expected to pay a year-end dividend of $2.00, i.e., D1 =
$2.00. The dividend is expected to decline at a rate of 5% a year
forever (g = -5%). If the company’s expected and required rate of
return is 15%, which of the following statements is CORRECT?

a. The company’s current stock price is $20.

b. The company’s dividend yield 5 years from now is expected to be 10%.
c. The constant growth model cannot be used because the growth rate is
negative.
d. The company’s expected capital gains yield is 5%.
e. The company’s stock price next year is expected to be $9.50.

(8.5) Constant growth: dividend yield and g Answer: b MEDIUM

28
. If two constant growth stocks have the same price and the same required
rate of return, which of the following statements is CORRECT?

a. The two stocks must have the same dividend per share.
b. If one stock has a higher dividend yield, it will also have a lower
dividend growth rate.
c. The two stocks have the same dividend growth rate.
d. The two stocks have the same dividend yield.
e. The stock with the higher dividend yield will have the higher dividend
growth rate.

(8.5) Constant growth: dividend yield and g Answer: a MEDIUM

29
. Which of the following statements is CORRECT?

a. The dividend yield on a constant growth stock must be equal to the

stock's expected total return less its expected capital gains return.
b. Assume that the required return on a given stock is 13%. If the stock’s
dividend is growing at a constant rate of 5%, its expected dividend
yield is 5% as well.
c. A stock’s dividend yield can never exceed its expected growth rate.
d. A required condition for one to use the constant growth model is that
the stock’s expected growth rate exceeds its required rate of return.
e. Other things held constant, the higher a company’s beta coefficient, the
lower its required rate of return.

(8.5) Constant growth model Answer: a MEDIUM

30
. 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 rate must also have
the same stock price.
c. It is appropriate to use the constant growth model to estimate stock
value even if the 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.

Page 278 Conceptual Questions Chapter 8: Stocks, Equilibrium

 (8.5) Constant growth model Answer: e MEDIUM
31
. If a stock’s dividend is expected to grow at a constant rate of 5% a
year, which of the following statements is CORRECT?

a. The expected return on the stock is 5% a year.

b. The stock’s dividend yield is 5%.
c. The price of the stock is expected to decline in the future.
d. The stock’s required return must be equal to or less than 5%.
e. The stock’s price one year from now is expected to be 5% above the
current price.

(8.5) Constant growth model Answer: a MEDIUM

32
. Stocks A and B have the same required return and the same price, $25.
Stock A’s dividend is expected to grow at a constant rate of 10% per
year, while Stock B’s dividend is expected to grow at a constant rate of
5% per year. Which of the following statements is CORRECT?

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 passes 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 exists.

(8.5) Constant growth model Answer: c MEDIUM

33
. Stocks X and Y sell at the same price. Stock X has a required return of
12% while Y's required return is 10%. Stock X’s dividend is expected to
grow at a constant rate of 6% a year, while Stock Y’s dividend is
expected to grow at a constant rate of 4%. If the market is in
equilibrium so that expected returns equal required returns, which of
the following statements is CORRECT?

a. Stock X has a higher dividend yield than Stock Y.

b. Stock Y has a higher dividend yield than Stock X.
c. One year from now, Stock X’s price is expected to be higher than Stock
Y’s price.
d. Stock X has the higher expected year-end dividend.
e. Stock Y has a higher capital gains yield.

(8.5) Constant growth model Answer: b MEDIUM

34
. Stock X is expected to pay a dividend of $3.00 at the end of the year,
i.e., D1 = $3.00, and that dividend is expected to grow at a constant rate
of 6% a year. The stock currently trades at a price of $50 a share.
Assume that the stock is in equilibrium, that is, the stock’s price equals
its intrinsic value. Which of the following statements is CORRECT?

a. The stock’s required return is 10%.

b. The stock’s expected dividend yield and growth rate are equal.
c. The stock’s expected dividend yield is 5%.
d. The stock’s expected capital gains yield is 5%.

Chapter 8: Stocks, Equilibrium Conceptual Questions Page 279

 e. The stock’s expected price 10 years from now is $100.00.
(8.5) Constant growth model Answer: b MEDIUM
35
. Stock X has a required return of 12% and a dividend yield of 5%, and its
dividend is expected to grow at a constant rate forever. Stock Y has a
required return of 10%, a dividend yield of 3%, and its dividend is
expected to grow at a constant rate forever. Both stocks currently sell
for $25 per share. Which of the following statements is CORRECT?

a. Stock Y pays a higher dividend per share than Stock X.

b. Stock X pays a higher dividend per share than Stock Y.
c. One year from now, Stock X should have the higher price.
d. Stock Y has a lower expected growth rate than Stock X.
e. Stock Y has the higher expected capital gains yield.

(8.5) Constant growth model Answer: d MEDIUM

36
. The expected return on Northeast Corporation’s stock is 14%. The stock’s
dividend is expected to grow at a constant rate of 8%, and it currently
sells for $50 a share. Which of the following statements is CORRECT?

a. The stock’s dividend yield is 7%.

b. The stock’s dividend yield is 8%.
c. The current dividend per share is $4.00.
d. The stock price is expected to be $54 a share one year from now.
e. The stock price is expected to be $57 a share one year from now.

(8.5) Constant growth model and CAPM Answer: b MEDIUM

37
. Stock A has a beta of 1.1 and Stock B's beta is 0.9. The market risk
premium is 6%, and the risk-free rate is 6.3%. Both stocks have a
constant dividend growth rate of 7%. If the market is in equilibrium,
which of the following statements is CORRECT?

a. Stock A must have a higher stock price than Stock B.

b. Stock A must have a higher dividend yield than Stock B.
c. Stock B’s dividend yield equals its expected dividend growth rate.
d. Stock B must have the higher required return.
e. Stock B could have the higher expected return.

(8.10) Preferred stock concepts Answer: b MEDIUM

38
. Which of the following statements is CORRECT?

a. Preferred stockholders have a priority to income but not to liquidation

proceeds over bondholders in the event of bankruptcy.
b. The preferred stock of a given firm is generally less risky to investors
than the same firm’s common stock.
c. Corporations cannot buy the preferred stocks of other corporations.
d. Preferred dividends are not generally cumulative.
e. A big advantage of preferred stock is that dividends on preferred stocks
are tax deductible by the issuing corporation.

Page 280 Conceptual Questions Chapter 8: Stocks, Equilibrium

 (8.10) Preferred stock concepts Answer: b MEDIUM
39
. Which of the following statements is CORRECT?

a. A major disadvantage of financing with preferred stock is that preferred

stockholders typically have super-normal 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.
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 would be tax free.
e. One of the advantages to financing with preferred stock is that 70% of
the dividends paid out are tax deductible to the issuer.

(8.11) Market equilibrium Answer: b MEDIUM

40
. If markets are in equilibrium, which of the following will occur?

a. Each stock’s expected return should equal its realized return as seen by
the marginal investor.
b. Each stock’s expected return should equal its required return as seen by
the marginal investor.
c. All stocks should have the same expected return as seen by the marginal
investor.
d. The expected and required returns on stocks and bonds should be equal.
e. All stocks should have the same realized return during the coming year.

(8.11) Market equilibrium Answer: e MEDIUM

41
. For a stock to be in equilibrium, that is, for there to be no consistent
pressure for its price to depart from its current level, then

a. The expected future return must be less than the most recent past
realized return.
b. The past realized return must be equal to the expected return during the
same period.
c. The required return must equal the realized return in all periods.
d. The expected return must be equal to both the required future return and
the past realized return.
e. The expected future returns must be equal to the required return.

Chapter 8: Stocks, Equilibrium Conceptual Questions Page 281

 (8.12) Market efficiency and stock returns Answer: d MEDIUM
42
. Which of the following statements is CORRECT?

a. If a stock's beta increased but its growth rate remained the same, then
the new equilibrium price of the stock will be higher (assuming
dividends continue to grow at the constant growth rate).
b. Market efficiency says that the actual realized returns on all stocks
will be equal to the expected rates of return.
c. Weak-form efficiency suggests that tape watchers and chartists can earn
profits by discovering patterns as to when stock prices rise or fall.
d. An implication of the semistrong form of the efficient markets
hypothesis is that you cannot consistently benefit from trading on
information reported in The Wall Street Journal.
e. None of the statements above is correct.

(8.12) Efficient markets hypothesis Answer: d MEDIUM

43
. Which of the following statements is CORRECT?

a. If a market is strong-form efficient, this implies that the returns on a

firm's bonds and stocks should be identical.
b. If a market is weak-form efficient, this implies that all public
information is rapidly incorporated into market prices.
c. If your uncle earned a return higher than the overall stock market last
year, this is evidence that the stock market is inefficient.
d. If a market is weak-form efficient, this implies that analyzing its past
price history will not enable one to earn an above-normal rate of return
on the stock in the future.
e. If a market is strong-form efficient, this implies that all available
information is rapidly incorporated into market prices; however,
superior returns can consistently be earned on a stock through lots of
hard work. Few experts believe that this condition actually exists.

(8.12) Efficient markets hypothesis Answer: e MEDIUM

44
. Which of the following statements is CORRECT?

a. If the stock market is weak-form efficient, then one cannot outperform

the market even if he or she has private information.
b. If the stock market is semistrong-form efficient, then the expected
return on stocks and bonds must be the same.
c. If the stock market is strong-form efficient, then high beta stocks must
have the same expected return as low beta stocks.
d. Since the Efficient Markets Hypothesis assumes that markets behave as if
all investors were rational, it is not possible to have irrational
investors in a rational market.
e. Even though the Efficient Markets Hypothesis (EMH) assumes that markets
behave as if all investors were rational, under the EMH it is still
possible to have some irrational investors in a rational market.

Page 282 Conceptual Questions Chapter 8: Stocks, Equilibrium

 (8.12) Semistrong-form efficiency Answer: b MEDIUM
45
. If the stock market is semistrong efficient, which of the following
statements is CORRECT?

a. All stocks should have the same expected returns; however, they may have
different realized returns.
b. Investors can outperform the market if they have access to information
which has not yet been publicly revealed.
c. In equilibrium, stocks and bonds should have the same expected returns.
d. If the stock market has been performing strongly over the past several
months, stock prices are more likely to decline than increase over the
next several months.
e. All stocks should have the same expected return.

(8.12) Semistrong-form efficiency Answer: d MEDIUM

46
. Assume that markets are semistrong-form efficient. Which of the
following statements is CORRECT?

a. All stocks should have the same expected return.

b. All stocks should have the same realized return.
c. Past stock prices can be successfully used to forecast future stock
returns.
d. Investors' most likely returns are those predicted by the SML, but one
should not expect to do any better unless he or she has either good luck
or access to information that is not publicly available.
e. Investors should expect to earn more than the returns that are predicted
by the SML, because if they do not, they should not invest in the stock
market.

(8.12) Semistrong-form efficiency Answer: b MEDIUM

47
. Assume that markets are semistrong efficient, but not strong-form
efficient. Which of the following statements is CORRECT?

a. Each common stock has an expected return equal to that of the overall
market.
b. Investors may be able to earn returns above those predicted by the SML
if they have access to information which has not been publicly revealed.
c. Investors can expect to earn returns above those predicted by the SML if
they have access to public information.
d. Investors should expect to earn more than the returns that are predicted
by the SML, because if they do not, they should not invest in the stock
market.
e. Investors will never earn more during the coming year than the returns
that are predicted by the SML unless they have information that is not
available to most other investors.

Chapter 8: Stocks, Equilibrium Conceptual Questions Page 283

 (Comp: 8.1,8.2,8.5) Common stock concepts Answer: c MEDIUM
48
. Which of the following statements is CORRECT?

a. A tracking, or target, stock is the same as the stock of an independent

stand-alone company.
b. If a company has two classes of common stock, Class A and Class B, the
stocks may pay different dividends, but under all state charters the two
classes must have the same voting rights.
c. The preemptive right is a provision in the corporate charter that gives
common stockholders the right to purchase (on a pro rata basis) new
issues of the firm's common stock.
d. The stock valuation model, P0 = D1/(rs - g), cannot be used for firms
that have negative growth rates.
e. The stock valuation model, P0 = D1/(rs - g), can be used only for firms
whose growth rates exceed their required return.

(Comp: 8.4,8.11) Common stock concepts Answer: a MEDIUM

49
. Stock X has a required return of 10%, while Stock Y has a required
return of 12%. Which of the following statements is CORRECT?

a. If the market is in equilibrium, and if Stock Y has the lower expected

dividend yield, then it must have the higher expected growth rate.
b. If Stock Y and Stock X have the same dividend yield, then Stock Y must
have a lower expected capital gains yield than Stock X.
c. If Stock X and Stock Y have the same current dividend and the same
expected dividend growth rate, then Stock Y must sell for a higher price.
d. The stocks must sell for the same price.
e. Stock Y must have a higher dividend yield than Stock X.

Multiple Choice: Problems

Easy:
(8.5) Constant growth valuation Answer: c EASY
50
. A stock is expected to pay a dividend of $0.75 at the end of the year.
The required rate of return is rs = 12.5%, and the expected constant
growth rate is g = 8.5%. What is the current stock price?

a. $17.82
b. $18.28
c. $18.75
d. $19.22
e. $19.70

Page 284 Problems Chapter 8: Stocks, Equilibrium

 (8.5) Constant growth valuation Answer: e EASY

Chapter 8: Stocks, Equilibrium Problems Page 285

51
. A stock just paid a dividend of D0 = $1.75. The required rate of return
is rs = 12.0%, and the constant growth rate is g = 4.0%. What is the
current stock price?

a. $20.56
b. $21.09
c. $21.63
d. $22.18
e. $22.75

(8.5) Constant growth valuation Answer: d EASY

52
. A share of common stock has just paid a dividend of $2.00. If the
expected long-run growth rate for this stock is 5.0%, and if investors'
required rate of return is 10.5%, what is the stock price?

a. $35.39
b. $36.30
c. $37.23
d. $38.18
e. $39.14

(8.6) Expected dividend yield Answer: d EASY

53
. If D1 = $1.75, g (which is constant) = 4.5%, and P0 = $46, what is the
stock’s expected dividend yield for the coming year?

a. 3.26%
b. 3.43%
c. 3.61%
d. 3.80%
e. 3.99%

(8.6) Expected dividend yield Answer: b EASY

54
. If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the
stock’s expected dividend yield for the coming year?

a. 4.42%
b. 4.66%
c. 4.89%
d. 5.13%
e. 5.39%

(8.6) Expected return, dividend and capital gains yields Answer: a EASY
55
. If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the
stock’s expected capital gains yield for the coming year?

a. 6.50%
b. 6.83%
c. 7.17%
d. 7.52%
e. 7.90%

(8.6) Expected total return Answer: e EASY

Page 286 Problems Chapter 8: Stocks, Equilibrium

56
. If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the
stock’s expected total return for the coming year?

a. 7.54%
b. 7.73%
c. 7.93%
d. 8.13%
e. 8.34%

(8.6) Expected total return Answer: e EASY

57
. If D0 = $2.75, g (which is constant) = 3%, and P0 = $36, what is the
stock’s expected total return for the coming year?

a. 9.82%
b. 10.07%
c. 10.33%
d. 10.60%
e. 10.87%

(8.6) Constant growth rate Answer: e EASY

58
. McDonnell Manufacturing is expected to pay a dividend of $1.50 per share
at the end of the year (D1 = $1.50). The stock sells for $34.50 per
share, and its required rate of return is 11.5%. The dividend is
expected to grow at some constant rate, g, forever. What is the
equilibrium expected growth rate?

a. 6.46%
b. 6.63%
c. 6.80%
d. 6.97%
e. 7.15%

(8.6) Future price of a constant growth stock Answer: e EASY

59
. Ewert Enterprises' stock currently sells for $30.50 per share. The
stock’s dividend is projected to increase at a constant rate of 4.50%
per year. The required rate of return on the stock, rs, is 10.00%. What
is Ewert's expected price 3 years from today?

a. $31.61
b. $32.43
c. $33.26
d. $34.11
e. $34.81

Chapter 8: Stocks, Equilibrium Problems Page 287

 (8.6) Future price of a constant growth stock Answer: e EASY
60
. E. M. Roussakis Inc.'s stock currently sells for $45 per share. The
stock’s dividend is projected to increase at a constant rate of 3.75%
per year. The required rate of return on the stock, rs, is 15.50%. What
is Roussakis' expected price 5 years from now?

a. $48.88
b. $50.14
c. $51.42
d. $52.74
e. $54.09

(8.10) Preferred stock valuation Answer: e EASY

61
. Gary Wells Inc. plans to issue perpetual preferred stock with an annual
dividend of $6.50 per share. If the required return on this preferred
stock is 6.5%, at what price should the stock sell?

a. $90.37
b. $92.69
c. $95.06
d. $97.50
e. $100.00

Medium:
(8.5) Constant growth valuation: CAPM Answer: a MEDIUM
62
. The Zumwalt Company is expected to pay a dividend of $2.25 per share at
the end of the year, and that dividend is expected to grow at a constant
rate of 5.00% per year in the future. The company's beta is 1.15, the
market risk premium is 5.50%, and the risk-free rate is 4.00%. What is
the company's current stock price?

a. $42.25
b. $43.31
c. $44.39
d. $45.50
e. $46.64

(8.5) Constant growth valuation: CAPM Answer: a MEDIUM

63
. The Isberg Company just paid a dividend of $0.80 per share, and that
dividend is expected to grow at a constant rate of 6.00% per year in the
future. The company's beta is 1.25, the market risk premium is 5.00%, and
the risk-free rate is 4.00%. What is the company's current stock price?

a. $19.95
b. $20.45
c. $20.96
d. $21.49
e. $22.02

Page 288 Problems Chapter 8: Stocks, Equilibrium

 (8.5) Constant growth valuation: CAPM Answer: a MEDIUM

Chapter 8: Stocks, Equilibrium Problems Page 289

64
. Schnusenberg Corporation just paid a dividend of $0.65 per share, and
that dividend is expected to grow at a constant rate of 7.00% per year
in the future. The company's beta is 0.95, the required return on the
market is 10.50%, and the risk-free rate is 5.00%. What is the
company's current stock price?

a. $21.57
b. $22.11
c. $22.66
d. $23.22
e. $23.80

(8.5) Constant growth dividend Answer: b MEDIUM

65
. Goode Inc.'s stock has a required rate of return of 11.50%, and it sells
for $25.00 per share. Goode's dividend is expected to grow at a constant
rate of 7.00% per year. What was Goode's last dividend, D0?

a. $0.95
b. $1.05
c. $1.16
d. $1.27
e. $1.40

(8.5) Constant growth dividend Answer: b MEDIUM

66
. McLaughlin Inc.'s stock has a required rate of return of 10.50%, and it
sells for $67.50 per share. McLaughlin's dividend is expected to grow at
a constant rate of 7.00% per year. What is the expected year-end
dividend, D1?

a. $2.13
b. $2.36
c. $2.60
d. $2.86
e. $3.14

(8.6) Future price of a constant growth stock Answer: a MEDIUM

67
. Sorenson Corp.’s expected year-end dividend is D1 = $1.50, its required
return is rS = 12.00%, its dividend yield is 8.00%, and its growth rate
is expected to be constant in the future. What is Sorenson's expected
stock price in 7 years, i.e., what is P7?

a. $24.67
b. $25.91
c. $27.20
d. $28.56
e. $29.99

(8.8) Free cash flow model Answer: c MEDIUM

Page 290 Problems Chapter 8: Stocks, Equilibrium

68
. You must estimate the intrinsic value of Tsetseko Technologies’ stock.
Tsetseko's end-of-year free cash flow (FCF) is expected to be $17.50
million, and it is expected to grow at a constant rate of 7.00% a year
thereafter. The company’s WACC is 10.00%. Tsetseko has $125.00 million
of long-term debt plus preferred stock, and there are 15.00 million
shares of common stock outstanding. What is Tsetseko's estimated
intrinsic value per share of common stock?

a. $28.16
b. $29.33
c. $30.56
d. $31.78
e. $33.05

(8.8) Free cash flow model Answer: c MEDIUM

69
. You have been assigned the task of using the free cash flow model to
estimate Petry Corporation's intrinsic value. Petry’s WACC is 10.00%,
its end-of-year free cash flow (FCF) is expected to be $150.0 million,
the FCFs are expected to grow at a constant rate of 6.00% a year in the
future, the company has $200 million of long-term debt plus preferred
stock, and it has 50 million shares of common stock outstanding. What
is Petry's estimated intrinsic value per share of common stock?

a. $66.12
b. $68.52
c. $71.00
d. $73.49
e. $76.06

(8.10) Preferred required return Answer: e MEDIUM

70
. Carter's preferred stock pays a dividend of $1.00 per quarter. If the
price of the stock is $50.00, what is its nominal (not effective) annual
rate of return?

a. 7.23%
b. 7.41%
c. 7.61%
d. 7.80%
e. 8.00%

(8.10) Preferred required return Answer: e MEDIUM

71
. Clinton's preferred stock pays a dividend of $1.00 per quarter. If the
price of the stock is $50.00, what is its effective annual (not nominal)
rate of return?

a. 7.30%
b. 7.52%
c. 7.76%
d. 8.00%
e. 8.24%

Chapter 8: Stocks, Equilibrium Problems Page 291

Medium/Hard:
(8.7) Nonconstant growth valuation Answer: d MEDIUM/HARD
72
. WWW Servers just paid a dividend of D0 = $1.00. Analysts expect the
company's dividend to grow by 30% this year, by 10% in Year 2, and at a
constant rate of 5% in Year 3 and thereafter. The required return on
WWW's stock is 9.00%. What is the best estimate of the stock’s current
intrinsic value?

a. $31.50
b. $32.31
c. $33.14
d. $33.99
e. $34.84

Hard:
(8.7) Nonconstant growth valuation Answer: c HARD
73
. Rentz RVs Inc. (RRV) is presently enjoying relatively high growth because
of a surge in the demand for recreational vehicles. Management expects
earnings and dividends to grow at a rate of 25% for the next 4 years, after
which high gas prices 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.
RRV’s 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

(8.7) Nonconstant growth valuation Answer: b HARD

74
. The Upton Company's last dividend was $1.75. Its dividend growth rate
is expected to be constant at 18.00% for 2 years, after which dividends
are expected to grow at a rate of 6.00% forever. Upton's required
return (rs) is 12.00%. What is Upton's current stock price?

a. $37.15
b. $38.10
c. $39.06
d. $40.03
e. $41.03

Page 292 Problems Chapter 8: Stocks, Equilibrium

 (8.7) Nonconstant growth valuation Answer: a HARD
75
. The Wei Company's last dividend was $1.75. The dividend growth rate is
expected to be constant at 1.50% for 2 years, after which dividends are
expected to grow at a rate of 8.00% forever. Wei’s required return (rs)
is 12.00%. What is Wei's current stock price?

a. $41.83
b. $43.08
c. $44.38
d. $45.71
e. $47.08

(8.7) Nonconstant growth valuation Answer: d HARD

76
. The Nikko Company's last dividend was $1.50. The dividend growth rate
is expected to be constant at 15% for 3 years, after which dividends are
expected to grow at a rate of 6% forever. If Nikko's required return
(rs) is 11%, what is the company's current stock price?

a. $36.69
b. $37.82
c. $38.99
d. $40.20
e. $41.40

(8.7) Nonconstant growth rate--nonalgorithmic Answer: e HARD

77
. Prock Petroleum’s stock has a required return of 13%, and the stock
sells for $50 per share. The firm just paid a dividend of $1.00, and
the dividend is expected to grow by 30% per year for the next 4 years,
so D4 = $1.00(1.30)4 = $2.8561. After t = 4, the dividend is expected to
grow at a constant rate of X% per year forever. What is the stock’s
expected constant growth rate after t = 4, i.e., what is X?

a. 7.08%
b. 7.46%
c. 7.85%
d. 8.26%
e. 8.70%

Chapter 8: Stocks, Equilibrium Problems Page 293

 (8.7) Zero current div, nonconstant then constant growth Answer: d HARD
78
. You are an analyst studying Beranek Technologies, which was founded 10
years ago. It has been profitable for the last 5 years, but it has
needed all of its earnings to support growth and thus has never paid a
dividend. Management has indicated that it plans to pay a $0.50
dividend 3 years from today, then to increase it at a relatively rapid
rate for 2 years, and then to increase it at a constant rate of 8.00%
thereafter. Your forecast of the future dividend stream, along with the
forecasted growth rates, is shown below. Assuming a required return of
11.00%, what is your estimate of Beranek's current intrinsic value?

Year 0 1 2 3 4 5 6 7
Growth rate NA NA NA NA 50.00% 25.00% 8.00% 8.00%
Dividend $0.00 $0.00 $0.00 $0.50 $0.75 $0.94 $1.01 $1.09

a. $19.88
b. $20.39
c. $20.91
d. $21.44
e. $21.98

Very Hard:
(8.7) Nonconstant g, required return--nonalgorithmic Answer: d VERY HARD
79
. The S.P. Whitman Company's last dividend was $1.00. The dividend growth
rate is expected to be constant at 10% for 3 years, after which dividends
are expected to grow at a rate of 6% forever. The current stock price is
$15.00. What is Whitman's required return, rs? (Hint: Forecast the
dividends for Years 1 to 4. Then you must find the discount rate that
causes the PVs of the dividends at t = 1, t = 2, and t = 3 plus the price
at t = 3, P3, to equal the actual known price. However, you must first
estimate P3, and that requires an estimate of rs. You can make a guess as
to rs, find P3 using it, then discount the dividends and the estimated P3
at that rate. If the sum does not equal the known price, then change the
value used for rs, and continue until you get P0. This is a laborious,
time-consuming process with a calculator, but it's easy with Excel.)

a. 12.63%
b. 13.02%
c. 13.42%
d. 13.84%
e. 14.26%

Page 294 Problems Chapter 8: Stocks, Equilibrium

 CHAPTER 8
ANSWERS AND SOLUTIONS

Chapter 8: Stocks, Equilibrium Answers Page 295

Page 296 Answers Chapter 8: Stocks, Equilibrium
5. (8.1) Public company Answer: a EASY

1. (8.1) Proxy Answer: a EASY

2. (8.1) Preemptive right Answer: a EASY

3. (8.1) Preemptive right Answer: b EASY

4. (8.1) Closely held stock Answer: a EASY

6. (8.2) Classified stock Answer: a EASY

Chapter 8: Stocks, Equilibrium Answers Page 297

22. (8.12) Efficient markets hypothesis Answer: c EASY

26. (8.4) Dividend yield and g Answer: a MEDIUM

Statement a is true, because if the required return for Stock A is higher than that of Stock B, and if the
dividend yield for Stock A is lower than Stock B’s, the growth rate for Stock A must be higher to offset this.

24. (8.1) Preemptive right Answer: d MEDIUM

25. (8.2) Classified stock Answer: e MEDIUM

Page 298 Answers Chapter 8: Stocks, Equilibrium

32. (8.5) Constant growth model Answer: a MEDIUM

Statement a is correct, because if both stocks have the same price and the same required return, and A’s
growth rate is twice that of B, then A’s dividend and dividend yield must be half that of B. This point is
illustrated with the following example.

A B
g 10% 5%
r 15% 15%
Price $25 $25
Div. Yield 5% 10%
D1 $1.25 $2.50

Chapter 8: Stocks, Equilibrium Answers Page 299

36. (8.5) Constant growth model Answer: d MEDIUM

P1 = P0(1 + g) = $54. Therefore, d is correct. All the other answers are false.

37. (8.5) Constant growth model and CAPM Answer: b MEDIUM

Statement b is true, because Stock A has a higher required return but the stocks have the same growth rate,
so Stock A must have the higher dividend yield. Here are some calculations to demonstrate the point.

rRF beta RPM rStock

A 6.30% + 1.10 * 6.00% = 12.90%
B 6.30% + 0.90 * 6.00% = 11.70%

Div Yld g rStock

A D1/P0 + 7.00% = 12.90% D1/P0 = r  g = 5.90%
B D1/P0 + 7.00% = 11.70% D1/P0 = r  g = 4.70%

Page 300 Answers Chapter 8: Stocks, Equilibrium

47. (8.12) Semistrong-form efficiency Answer: b MEDIUM

Answer b is correct. c would be correct if we changed "public" to private. e is incorrect because some
investors will earn more than their equilibrium expected return in any given year simply by random chance.

48. (Comp: 8.1,8.2,8.5) Common stock concepts Answer: c MEDIUM

Statement a is false—for example, Hughes Aircraft was tracked as the Class H common stock of General
Motors (GMH). However, General Motors (GM) was the independent, stand-alone company and GMH
was the tracking stock. Statement b is false, because different classes of stock often have different voting
policies. Statement c is true. Statements d and e are false, because the constant growth model can be used
anytime as long as the constant growth rate is less than the required return (even if the growth rate is
negative).

49. (Comp: 8.4,8.11) Common stock concepts Answer: a MEDIUM

Since X has the lower required return, if Y has a lower dividend yield it must have a higher expected
growth rate.

Chapter 8: Stocks, Equilibrium Answers Page 301

 Long-run growth rate 5.0%
Required return 10.5%
D1 = D0(1 + g) = $2.10 Intermediate step used to find answer
P0 = D1/(rs – g) $38.18

53. (8.6) Expected dividend yield Answer: d EASY

D1 $1.75
g 4.5%
P0 $46.00
Dividend yield = D1/P0 = 3.80%

54. (8.6) Expected dividend yield Answer: b EASY

D0 $2.25
g 3.5%
P0 $50.00
D1 = D0(1 + g) = $2.33 Intermediate step
Dividend yield = D1/P0 = 4.66%

Page 302 Answers Chapter 8: Stocks, Equilibrium

58. (8.6) Constant growth rate Answer: e EASY

Expected dividend (D1) $1.50

Stock price $34.50
Required return 11.5%
Dividend yield 4.35%
Growth rate = rs – D1/P0 = 7.15%

59. (8.6) Future price of a constant growth stock Answer: e EASY

Stock price $30.50

Growth rate 4.50%
Years in the future 3
P3 = P0(1 + g)3 = $34.81

60. (8.6) Future price of a constant growth stock Answer: e EASY

Growth rate 3.75%

Years in the future 5

Chapter 8: Stocks, Equilibrium Answers Page 303

 rRF 4.0%
RPM 5.0%
g 6.0%
D1 = D0(1 + g) = $0.85 Intermediate step
rs = rRF + b(RPM) = 10.3% Intermediate step
P0 = D1/(rs – g) $19.95

64. (8.5) Constant growth valuation: CAPM Answer: a MEDIUM

D0 $0.65
b 0.95
rRF 5.0%
rM 10.5%
g 7.0%
D1 = D0(1 + g) = $0.70 Intermediate step
rs = rRF + b(rM – RRF) = 10.2% Intermediate step
P0 = D1/(rs – g) $21.57

Page 304 Answers Chapter 8: Stocks, Equilibrium

 Years in the future 7
P7 = P0(1 + g)7 $24.67

68. (8.8) Free cash flow model Answer: c MEDIUM

FCF1 $17.50
Constant growth rate 7.0%
WACC 10.0%
Debt & preferred stock $125
Shares outstanding 15
Total firm value = FCF1/(WACC – g) = $583.33 Intermediate step
Less: Value of debt & pf -$125.00
Value of equity $458.33 Intermediate step
Number of shares 15
Value per share = Equity value/Shares = $30.56

69. (8.8) Free cash flow model Answer: c MEDIUM

FCF1 $150.00

Chapter 8: Stocks, Equilibrium Answers Page 305