Q9. If a stock sells for $50 that has an expected annual dividend of $2 and has a sustainable growth rate of 5%, what is the market discount rate for this stock?

A)   7.5%.

B)   9.0%.

C)   10.0%.

Q10. Regarding the estimates required in the constant growth dividend discount model, which of the following statements is most accurate?

A)   The model is most influenced by the estimates of "k" and "g."

B)   Dividend forecasts are less reliable than estimates of other inputs.

C)   The variables "k" and "g" are easy to forecast.

Q11. All else equal, if there is an increase in the required rate of return, a stock’s value as estimated by the constant growth dividend discount model (DDM) will:

A)   increase or decrease, depending upon the relationship between ke and ROE.

B)   increase.

C)   decrease.

Q12. An analyst has gathered the following data for Webco, Inc:

• Retention = 40%
• ROE = 25%
• k = 14%

Using the infinite period, or constant growth, dividend discount model, calculate the price of Webco’s stock assuming that next years earnings will be $4.25.

A)   $55.00.

B)   $125.00.

C)   $63.75.

Q13. Using the constant growth dividend discount model to value a firm whose growth rate is greater than its required return on equity would result in a value that is:

A)   finite but unknown.

B)   negative.

C)   infinite.

Q14. The constant-growth dividend discount model would typically be most appropriate in valuing a stock of a:

A)   rapidly growing company.

B)   new venture expected to retain all earnings for several years.

C)   moderate growth, "mature" company.

Q15. Which of the following statements about the constant growth dividend discount model (DDM) is FALSE?

A)   The constant growth DDM is used primarily for stable mature stocks.

B)   In the constant growth DDM dividends are assumed to grow at a constant rate forever.

C)   For the constant growth DDM to work, the growth rate must exceed the required return on equity.

Q16. A stock is expected to pay a dividend of $1.50 at the end of each of the next three years. At the end of three years the stock price is expected to be $25. The equity discount rate is 16 percent. What is the current stock price?

A)   $24.92.

B)   $17.18.

C)   $19.39.

Q17. Use the following information on Brown Partners, Inc. to compute the current stock price.

• Dividend just paid = $6.10
• Expected dividend growth rate = 4%
• Expected stock price in one year = $60
• Risk-free rate = 3%
• Equity risk premium = 12%

A)   $59.55.

B)   $57.70.

C)   $57.48.

Q9. If a stock sells for $50 that has an expected annual dividend of $2 and has a sustainable growth rate of 5%, what is the market discount rate for this stock? fficeffice" />

A)   7.5%.

B)   9.0%.

C)   10.0%.

Correct answer is B)        

k = [(D₁ / P) + g] = [(2/50) + 0.05] = 0.09, or 9.00%.

Q10. Regarding the estimates required in the constant growth dividend discount model, which of the following statements is most accurate?

A)   The model is most influenced by the estimates of "k" and "g."

B)   Dividend forecasts are less reliable than estimates of other inputs.

C)   The variables "k" and "g" are easy to forecast.

Correct answer is A)

The relationship between "k" and "g" is critical - small changes in the difference between these two variables results in large value fluctuations.

Q11. All else equal, if there is an increase in the required rate of return, a stock’s value as estimated by the constant growth dividend discount model (DDM) will:

A)   increase or decrease, depending upon the relationship between ke and ROE.

B)   increase.

C)   decrease.

Correct answer is C)

If k_e increases, the spread between k_e and g widens (increasing the denominator), resulting in a lower valuation.

Q12. An analyst has gathered the following data for Webco, Inc:

• Retention = 40%
• ROE = 25%
• k = 14%

Using the infinite period, or constant growth, dividend discount model, calculate the price of Webco’s stock assuming that next years earnings will be $4.25.

A)   $55.00.

B)   $125.00.

C)   $63.75.

Correct answer is C)

g = (ROE)(RR) = (0.25)(0.4) = 10%

V = D₁ / (k – g)

D₁ = 4.25 (1 ? 0.4) = 2.55

G = 0.10

K – g = 0.14 ? 0.10 = 0.04

V = 2.55 / 0.04 = 63.75

Q13. Using the constant growth dividend discount model to value a firm whose growth rate is greater than its required return on equity would result in a value that is:

A)   finite but unknown.

B)   negative.

C)   infinite.

Correct answer is B)

For the constant growth DDM to work k must be greater than g.

Q14. The constant-growth dividend discount model would typically be most appropriate in valuing a stock of a:

A)   rapidly growing company.

B)   new venture expected to retain all earnings for several years.

C)   moderate growth, "mature" company.

Correct answer is C)

Remember, the infinite period DDM has the following assumptions:

§   The stock pays dividends and they grow at a constant rate.

§   The constant growth rate, g, continues for an infinite period.

§   k must be greater than g. If not, the math will not work.

If any one of these assumptions is not met, the model breaks down. The infinite period DDM doesn’t work with growth companies. Growth companies are firms that currently have the ability to earn rates of return on investments that are currently above their required rates of return. The infinite period DDM assumes the dividend stream grows at a constant rate forever while growth companies have high growth rates in the early years that level out at some future time. The high early or supernormal growth rates will also generally exceed the required rate of return. Since the assumptions (constant g and k > g) don’t hold, the infinite period DDM cannot be used to value growth companies.

Q15. Which of the following statements about the constant growth dividend discount model (DDM) is FALSE?

A)   The constant growth DDM is used primarily for stable mature stocks.

B)   In the constant growth DDM dividends are assumed to grow at a constant rate forever.

C)   For the constant growth DDM to work, the growth rate must exceed the required return on equity.

Correct answer is C)

Dividends grow at constant rate forever.

Stock must pay dividends.

Constant growth DDM is used for mature firms.

k must be greater than g.

Q16. A stock is expected to pay a dividend of $1.50 at the end of each of the next three years. At the end of three years the stock price is expected to be $25. The equity discount rate is 16 percent. What is the current stock price?

A)   $24.92.

B)   $17.18.

C)   $19.39.

Correct answer is C)

The value of the stock today is the present value of the dividends and the expected stock price, discounted at the equity discount rate:
$1.50/1.16 + $1.50/1.16² + $1.50/1.16³ + $25.00/1.16³ = $19.39

Q17. Use the following information on Brown Partners, Inc. to compute the current stock price.

• Dividend just paid = $6.10
• Expected dividend growth rate = 4%
• Expected stock price in one year = $60
• Risk-free rate = 3%
• Equity risk premium = 12%

A)   $59.55.

B)   $57.70.

C)   $57.48.

Correct answer is B)

The current stock price is equal to (D₁ + P₁) / (1 + k_e). D₁ equals $6.10(1.04) = $6.34. The equity discount rate is 3% + 12% = 15%. Therefore the current stock price is ($6.34 + $60)/(1.15) = $57.70

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