karoliukas

If the return on equity for a firm is 15% and the retention rate is 40%, the firm’s sustainable growth rate is closest to:

A) 15%.

B) 9%.

C) 6%.

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g = (RR)(ROE)
= (0.15)(0.40)
= 0.06 or 6%

karoliukas

REM Corp.’s return on equity (ROE) is 19.5% and its dividend payout rate is 45%. What is the company’s implied dividend growth rate?

A) 10.73%.

B) 19.5%.

C) 8.78%.

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g = (ROE)(RR)
g = (19.5)(1 − 0.45)
g = (0.195)(0.55)
= 0.1073 or 10.73%

karoliukas

In its latest annual report, a company reported the following:

Net income	= $1,000,000
Total equity	= $5,000,000
Total assets	= $10,000,000
Dividend payout ratio	= 40%

Based on the sustainable growth model, the most likely forecast of the company’s future earnings growth rate is:

A) 6%.

B) 12%.

C) 8%.

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g = (RR)(ROE)
RR = 1 − dividend payout ratio = 1 − 0.4 = 0.6
ROE = NI / Total Equity = 1,000,000 / 5,000,000 = 1 / 5 = 0.2
Note: This is the "simple" calculation of ROE. Since we are only given these inputs, these are what you should use. Also, if given beginning and ending equity balances, use the average in the denominator.
g = (0.6)(0.2) = 0.12 or 12%

Kingpin804

The required rate of return on equity used as an input to the dividend discount model is influenced by each of the following factors EXCEPT:

A) the stock's appropriate risk premium.

B) the expected inflation rate.

C) the stock's dividend payout ratio.

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A stock’s required rate of return is equal to the nominal risk-free rate plus a risk premium. The nominal risk-free rate is approximately equal the real risk-free rate plus expected inflation.

Kingpin804

The capital asset pricing model can be used to estimate which of the following inputs to the dividend discount model?

A) The expected inflation rate.

B) The expected growth rate in dividends.

C) The required return on equity.

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The capital asset pricing model is a rate of return model that can be used to estimate a stock’s required rate of return, given the nominal risk-free rate, the market risk premium, and the stock’s beta:
k = Rnominal risk free rate + (beta)(Rmarket - Rnominal risk free rate).

Kingpin804

Which of the following statements about the constant growth dividend discount model (DDM) in its application to investment analysis is least accurate? The model:

A) can’t be applied when g > K.

B) is best applied to young, rapidly growing firms.

C) is inappropriate for firms with variable dividend growth.

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The model is most appropriately used when the firm is mature, with a moderate growth rate, paying a constant stream of dividends. In order for the model to produce a finite result, the company’s growth rate must not exceed the required rate of return.

Kingpin804

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

A) rapidly growing company.

B) moderate growth, "mature" company.

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

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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.

Kingpin804

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

A) 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.

B) 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.

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.

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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.

Kingpin804

Which of the following is NOT an assumption of the constant growth dividend discount model (DDM)?

A) Dividend payout is constant.

B) ROE is constant.

C) The growth rate of the firm is higher than the overall growth rate of the economy.

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Other assumptions of the DDM are: dividends grow at a constant rate and the growth rate continues for an infinite period.

Kingpin804

Which of the following statements regarding price multiples is most accurate?

A) An advantage of the price/sales ratio is that it is meaningful even for distressed firms.

B) A disadvantage of the price/book value ratio is that it is not an appropriate measure for firms that primarily hold liquid assets.

C) A rationale for using the price/cash flow ratio is that there is only one clear definition of cash flow.

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The P/S ratio is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for the P/E and P/BV ratios, which can be negative. In the P/BV ratio book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Analysts use several different definitions of cash flow (CFO, adjusted CFO, FCFE, EBITDA, etc.) to calculate P/CF ratios.
When earnings are negative, the P/E ratio is meaningless.