invic

A firm has the following characteristics:

• Current share price $100.00.
• One-year earnings $3.50.
• One-year dividend $0.75.
• Required return 13%.
• Justified leading price to earnings 10.

Based on the dividend discount model, what is the firm’s assumed growth rate?

A) 12.4%.

B) 10.9%.

C) 8.6%.

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The assumed growth rate is 10.9%:

P0 / E1 = ($0.75/$3.50) / (0.13 – g) = 10, g = 10.86%

invic

A firm has the following characteristics:

• Current share price $100.00.
• Next year's earnings $3.50.
• Next year's dividend $0.75.
• Growth rate 11%.
• Required return 13%.

Based on this information and the Gordon growth model, what is the firm’s justified leading price to earnings (P/E) ratio?

A) 11.3.

B) 10.7.

C) 8.7.

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The justified leading P/E is 10.7:

P0 / E1 = ($0.75 / $3.50) / (0.13 – 0.11) = 10.714

invic

Stan Bellton, CFA, is preparing a report on TWR, Inc. Bellton’s supervisor has requested that Bellton include a justified trailing price-to-earnings (P/E) ratio based on the following information:
Current earnings per share (EPS) = $3.50.
Dividend Payout Ratio = 0.60.
Required return for TRW = 0.15.
Expected constant growth rate for dividends = 0.05.
TWR’s justified trailing P/E ratio is closest to:

A) 4.0.

B) 6.3.

C) 6.0.

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The dividend payout ratio (1 – b) is 0.60, so the retention ratio (b) is 0.4.

invic

If an asset’s beta is 0.8, the expected return on the equity market is 10.0%, and the appropriate discount rate for the Gordon model is 9.0%, what is the risk-free rate?

A) 5.00%.

B) 6.50%.

C) 2.50%.

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Required return = risk-free rate + beta (expected equity market return – risk-free rate)
9% = risk-free rate + 0.8(0.10 – risk-free rate)
9% = 0.08 + 0.2(risk-free rate)
1% / 0.2 = risk-free rate = 0.05 or 5%

invic

What is the value of a fixed-rate perpetual preferred share (par value $100) with a dividend rate of 11.0% and a required return of 7.5%?

A) $147.

B) $152.

C) $138.

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The value of the preferred is $147:

V0 = ($100par × 11%) / 7.5% = $146.67

invic

If the value of an 8%, fixed-rate, perpetual preferred share is $134, and the par value is $100, what is the required rate of return?

A) 8%.

B) 7%.

C) 6%.

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The required rate of return is 6%: V0 = ($100par × 8%) / r = $134, r = 5.97%

invic

A $100 par, perpetual preferred share pays a fixed dividend of 5.0%. If the required rate of return is 6.5%, what is the current value of the shares?

A) $100.00.

B) $76.92.

C) $88.64.

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The current value of the shares is $76.92:

V0 = ($100 × 0.05) / 0.065 = $76.92

invic

What is the value of a fixed-rate perpetual preferred share (par value $100) with a dividend rate of 7.0% and a required return of 9.0%?

A) $71.

B) $56.

C) $78.

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The value of the preferred is $78:

V0 = ($100par × 7%) / 9% = $77.78

invic

The Gordon growth model will NOT work when the:

A) growth rate is greater than or equal to the required rate of return.

B) required rate of return is greater than growth rate.

C) growth rate is less than the required rate of return.

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The Gordon growth model, P0 = DPS1/ (r - g), will not work if the growth rate is greater than or equal to the required rate of return.

invic

If the growth rate in dividends is too high, it should be replaced with:

A) a growth rate closer to that of gross domestic product (GDP).

B) the average growth rate of the industry.

C) the growth rate in earnings per share.

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A firm cannot, in the long term, grow at a rate significantly greater than the growth rate of the economy in which it operates. If the growth rate in dividends is too high, then it is best replaced by a growth rate closer to that of GDP.