LOS f: Estimate the dividend growth rate, given the components of the required return on equity and incorporating the earnings retention rate and current stock price.

Q1. If a company can convince its suppliers to offer better terms on their products leading to a higher profit margin, the return on equity (ROE) will most likely:

A)   increase and the stock price will increase

B)   increase and the stock price will decline.

C)   decrease and the stock price will increase.

Q2. Assuming a firm does not currently have excessive debt, a decrease in leverage will most likely cause the firm’s stock price to:

A)   remain the same.

B)   decrease.

C)   increase.

Q3. When a company’s return on equity (ROE) is 12% and the dividend payout ratio is 60%, what is the implied sustainable growth rate of earnings and dividends?

A)   4.0%.

B)   4.8%.

C)   7.8%.

Q4. Which of the following statements concerning security valuation is least accurate?

A)   A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on equity of 12%, and a 15% required return is worth $18.24.

B)   The best way to value a company with no current dividend but who is expected to pay dividends in three years is to use the temporary supernormal growth (multistage) model.

C)   The best way to value a company with high and unsustainable growth that exceeds the required return is to use the temporary supernormal growth (multistage) model.

Q5. Which of the following statements concerning security valuation is least accurate?

A)   ROA times one minus the dividend payout ratio is the firm's sustainable growth rate.

B)   If the firm's payout ratio is 40%, has a required return of 12%, and a dividend growth rate of 7%, the firm's price to earnings (P/E) ratio should be 8.

C)   The liquidity risk of countries refers to the size and activity of the country's capital markets.

Q6. Which of the following statements concerning security valuation is least accurate?

A)   Accounting methods may differ substantially between countries.

B)   If the return on new investments is less than the return the firm is earning on its existing investments, the firm is considered a growth firm.

C)   The business risk component of a country's risk premium is a function of the variability of economic activity in the country and the average operating leverage used by firms in the country.

Q7. A company’s payout ratio is 0.45 and its expected return on equity (ROE) is 23%. What is the company’s implied growth rate in dividends?

A)   12.65%

B)   10.35%

C)   4.16%

Q8. A company’s required return on equity is 15% and its dividend payout ratio is 55%. If its return on equity (ROE) is 17% and its beta is 1.40, then its sustainable growth rate is closest to:

A)   7.65%

B)   6.75%

C)   9.35%

LOS f: Estimate the dividend growth rate, given the components of the required return on equity and incorporating the earnings retention rate and current stock price.fficeffice" />

Q1. If a company can convince its suppliers to offer better terms on their products leading to a higher profit margin, the return on equity (ROE) will most likely:

A)   increase and the stock price will increase

B)   increase and the stock price will decline.

C)   decrease and the stock price will increase.

Correct answer is A)

Better supplier terms lead to increased profitability. Better profit margins lead to an increase in ROE. This leads to an increase in the dividend growth rate. The difference between the cost of equity and the dividend growth rate will decline, causing the stock price to increase.

Q2. Assuming a firm does not currently have excessive debt, a decrease in leverage will most likely cause the firm’s stock price to:

A)   remain the same.

B)   decrease.

C)   increase.

Correct answer is B)

The firm’s stock price will most likely fall for two reasons: 1) loss of the debt tax shelter; 2) decrease in the leverage multiplier, A/E, causing ROE to decline.

Q3. When a company’s return on equity (ROE) is 12% and the dividend payout ratio is 60%, what is the implied sustainable growth rate of earnings and dividends?

A)   4.0%.

B)   4.8%.

C)   7.8%.

Correct answer is B)

g = ROE × retention ratio = ROE × (1 – payout ratio) = 12 (0.4) = 4.8%

Q4. Which of the following statements concerning security valuation is least accurate?

A)   A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on equity of 12%, and a 15% required return is worth $18.24.

B)   The best way to value a company with no current dividend but who is expected to pay dividends in three years is to use the temporary supernormal growth (multistage) model.

C)   The best way to value a company with high and unsustainable growth that exceeds the required return is to use the temporary supernormal growth (multistage) model.

Correct answer is A)

A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on new investment of 12%, and a 15% required return is worth $20.64. The growth rate is (1 – 0.40) × 0.12 = 7.2%. The expected dividend is then ($1.50)(1.072) = $1.61. The value is then (1.61) / (0.15 – 0.072) = $20.64.

Q5. Which of the following statements concerning security valuation is least accurate?

A)   ROA times one minus the dividend payout ratio is the firm's sustainable growth rate.

B)   If the firm's payout ratio is 40%, has a required return of 12%, and a dividend growth rate of 7%, the firm's price to earnings (P/E) ratio should be 8.

C)   The liquidity risk of countries refers to the size and activity of the country's capital markets.

Correct answer is A)

One minus the dividend payout ratio is the firm’s retention rate. The sustainable growth rate is the firm’s return on equity (ROE) times the retention rate.

Q6. Which of the following statements concerning security valuation is least accurate?

A)   Accounting methods may differ substantially between countries.

B)   If the return on new investments is less than the return the firm is earning on its existing investments, the firm is considered a growth firm.

C)   The business risk component of a country's risk premium is a function of the variability of economic activity in the country and the average operating leverage used by firms in the country.

Correct answer is B)

If the return on new investments is greater than the return the firm is earning on its existing investments, the firm is considered to be a growth firm.

Q7. A company’s payout ratio is 0.45 and its expected return on equity (ROE) is 23%. What is the company’s implied growth rate in dividends?

A)   12.65%

B)   10.35%

C)   4.16%

Correct answer is A)

Growth Rate = (ROE)(1 – Payout Ratio) = (0.23)(0.55) = 12.65%

Q8. A company’s required return on equity is 15% and its dividend payout ratio is 55%. If its return on equity (ROE) is 17% and its beta is 1.40, then its sustainable growth rate is closest to:

A)   7.65%

B)   6.75%

C)   9.35%

Correct answer is A)

Growth rate = (ROE)(Retention Ratio)

= (0.17)(0.45)

= 0.0765 or 7.65%

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