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Reading 60: An Introduction to Security Valuation: Part II

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

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

B)   company with valuable assets not yet generating profits.

C)   moderate growth, "mature" company.

D)   rapidly growing company.

22.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)   negative.

B)   infinite.

C)   zero.

D)   finite but unknown.

23.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 to calculate the price of Webco’s stock assuming that next years earnings will be $4.25:

A)   $55.00.

B)   $25.50.

C)   $125.00.

D)   $63.75.


24.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.

B)   not change.

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

D)   decrease.


25.Regarding the estimates required in the constant growth dividend discount model, which of the following statements is most likely CORRECT?

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

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

C)   Modifications to the estimates of "k" and "g" result in minimal value fluctuations.

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

答案和详解如下:

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

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

B)   company with valuable assets not yet generating profits.

C)   moderate growth, "mature" company.

D)   rapidly growing company.

The correct answer was 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.


22.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)   negative.

B)   infinite.

C)   zero.

D)   finite but unknown.

The correct answer was A)

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


23.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 to calculate the price of Webco’s stock assuming that next years earnings will be $4.25:

A)   $55.00.

B)   $25.50.

C)   $125.00.

D)   $63.75.

The correct answer was D)

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


24.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.

B)   not change.

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

D)   decrease.

The correct answer was D)

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


25.Regarding the estimates required in the constant growth dividend discount model, which of the following statements is most likely CORRECT?

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

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

C)   Modifications to the estimates of "k" and "g" result in minimal value fluctuations.

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

The correct answer was B)

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

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