17. EBEE is expected to grow at a rate of 30% for the next five years. After that, competition is expected to lower EBEE's growth to a constant 7% indefinitely. The market risk premium is 6%, and the risk-free rate is 5%. EBEE's beta is 1.2, and the company just paid a dividend of $2.50. The current srock value of EBEE is closest to:
18. Beta Forever Inc. manufactures and distributes a line of VCRs. The company has fallen on hard times and although it will pay a $4 dividend in the next period, it expects dividends to decline by 3% per year thereafter. If the discount rate for the company is 9%, the current value of one share of Beta's common stock is closest to:
19. Titan Industries is not expected to pay a dividend until ten years from now, at which time it is expected to pay a dividend of $1.25 and increase tne dividend at a rate of 4% thereafter. If the required rate of return is 12%, the current value of Titan is closest to:
20. Viking Insurance forecasts earnings next year of $4.50 per share. Viking has a dividend payout ratio of 40%. The required return is 15%. Return on equity is 8.33%. The present value of growth opportunities and the value of the stock are closest to:
PVGQ Share value
21. An investor buys a stock he determines to be underpriced in the market. He estimates the required return on the stock to be 14%. If he expects that the stock will still be underpriced at the end of the year, the expected holding-period return:
C. could be less than, equal to, or greater than 14%.
Use the following information to answer Questions 22 and 23.
Sally Curten, CFA, has gathered the following information on Jameston Fiber Optics, Inc. (JFOI) and industry norms.
Selected Financial Data for 1FQ1 (in millions) Total sales: $2,044 (fiscal year 2007)
Total assets: $1,875 (FYE 2006)
Net income: $322 (fiscal year 2007)
Industry ratios: Net profit margin =15.7% Total asset turnover = 1.1 Return on equity = 40.5%
22. The return on equity for JFOI is closest to:
23. Using DuPont analysis, Curren determines thar the most influential factor(s) that management used to increase the ROE for JFOI compared to the industry is (are):
A. asset efficiency.
Use the following information to answer Questions 24 and 25.
Lisa Design pays a current annual dividend of €2.00 and is currently growing at a rate of 20%. This rate is expected to decline to 10% over four years and remain at that level indefinitely. The required rate of return for an investment in Lisa is 18%.
24. The current estimated value of Lisa Design using the H-model is closest to:
25. Suppose instead that the 20% growth rate is expected to persist for four years and then decline immediately to 10%, at which level it will remain indefinitely. The current estimated value of Lisa Design is closest to:
answers - concept checkers
1. A According to the CAPM, Feingolds required return is 4% + 1.2(7%) = 1 2.4%. The ex ante alpha is the difference between the expected return and the required return, or 15%
2. C The ex post alpha for AAA equals 15% - 12%, or a positive 3%. The ex post alpha for
3- A The value of a perpetuity (equal payments forever) is equal to annual cash flow divided by required return:
4. C The constant DDM can be used to solve for the required rate of return:
D0x(l+g) $2.50x1.08 r = —-—-—^ + g = —-+ 0.08 = 0.110=11.0%
5. A We are reversing the usual use of the CAPM equation to solve for the equity premium applicable to the market or index, given the beta. Usually we assume a beta and an equity market premium and solve for a required rate of return.
r = r,iskfrcc +3(equity risk premium)
6. C Residual income models are the best valuation method if the firm does not pay dividends, has negative free cash flow over the forecast horizon, and has transparent financial reporting and high earnings quality.
7. C The Gordon growth model equity risk premium (choice C) is appropriate for estimating the market risk premium. The geometric or arithmetic mean of the excess market returns (NOT the actual returns on the market itself, as in choices A and B) is also appropriate.
8. B Solve the following equation for g:
9. B Based on its fundamentals, Aerosail is most appropriately categorized as being in the transition phase. Multi-stage models are most appropriate for firms in the transition phase.
10. B Solve for the internal rare of return of the expected cash flows.
11. B Sustainable growth is equal to return on equity times retention ratio
SGR (AAA) = 0.30 x 0.40 = 0.120 = 12.0% SGR (TST) = 0.22 x 0.30 = 0.066 = 6.6%
12. C The required returns for the two companies based on the CAPM are calculated below.
AAA: r = 0.04 + 1.2(0.11 - 0.04) = 0.04 ♦ 0.084 = 0.124 TST: r = 0.04 * 0.9(0.11 - 0.04) = 0.04 ♦ 0.063 = 0.103
The current values of the rwo stocks using the constant DDM are calculated next. Sustainable growth is equal to return on equity times retention ratio: SGR (AAA) = 0.30 x 0.40 = 0.120 = 12.0% SGR (TST) = 0.22 x 0.30 = 0.066 = 6.6%
Current dividend is current EPS times payout ratio: D0 (AAA) = $2.50x(l-0.4) = $1.50 D0 (TST) = $4.60 x (l - 0.3) = $3.22
Value is calculated with the Gordon constant growth model:
13. A AAA's stock price today can be calculated using the two-stage model. Start by finding the value of the dividends during the high growth period of five years.
D, = D0(Ug)' = $1.50(1.2), = $ 1.800 D2= D0(Ug)2 = SI .50(1.2)2 = $2,160 D3= D0(Ug)3 = $1.50(1.2)3 = $2,592 D4 = D0(l+g)4 = $1.50(1.2)4 = $3.110
(Alternatively, you could use your financial calculators to solve for the future value to find Dj. D2, D3, and D4).
Next, find rhe value of the stock at the beginning of the constant growth period using the constant dividend discount model: P4 =
The easiest way to proceed is to use the NPV function in the financial calculator. CF0 = 0; CFj = 1.8; CF2 = 2.16; CF3 = 2.592; CF4 = 3.110 * 61.624 = 64.734 1= 12.4; NPV = 45.69
The value of the firm today is $45.69 per share.
14. C Using the APT model, the risk-free race is added to each stock's factor sensitivities multiplied by the risk premiums as follows:
AAA: 0.04 ♦ 0.63(0.048) + 0.47(0.031) + 0.7(0.045) + 0.98(0.038) + 0.05(-0.018) = 0.153
TST: 0.04 + 0.42(0.048) + 0.39(0.031) + 0.51(0.045) + 0.91(0.038) * 0.21(-0.018) = 0.126
15. C The estimated value of AAA using the H-model is calculated as follows:
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