Chapter 7 Test Questions

Question 1
KDP’s most recent dividend was $2 per share and is
selling today in the market for $70. The dividend is
expected to grow at a rate of 7% per year for the
foreseeable future. If the market return is 10% on
investments with comparable risk, should you
purchase the stock?
a. No, because the stock is overpriced $1.33
b. No, because the stock is overpriced $3.33
c. Yes, because the stock is underpriced $1.33
d. Yes, because the stock is underpriced $3.33
 Answer Question 1
Using the Gordon Growth equation. We take D1 =
$2*1.07 = $2.14 and divide it by (.1-.07) =
$71.33. Since the value of the stock is greater
than the price is a good buy (undervalued in the
market by $1.33 since it is selling for only $70).

Answer : C
 Question 2
The Extreme Reaches Corp. last paid a $1.50 per share annual
dividend. The company is planning on paying $3.00, $5.00,
$7.50, and $10.00 a share over the next four years,
respectively. After that the dividend will be a constant
$2.50 per share per year forever. What is the market price
of this stock if the market rate of return is 15 percent?
a. $17.04
b. $22.39
c. $26.57
d. $29.08
e. $33.71
 Answer Question 2
Below is the timeline used. We had to get the PV for the dividends in years
1-4 and find the value of the constant dividends after year 4 using the
Gordon Growth Formula shown in the table (note: g=0). We used our
calculators to find the PV of each year summing both the $10.00 dividend
and the $16.67 (value of all future dividends) in year 4 (remember: the
Gordon growth model gives you a value one period before the first
payment). Finally we just add them all together to get the final answer.

Time 0 1 2 3 4 5+
Dividend $3.00 $5.00 $7.50 $10.00 $2.50
Value of Future Dividends ($2.50/(.15-0)) $16.67
PV Each Year $2.61 $3.78 $4.93 $15.25
SUM of PV $26.57

Answer : C
 Question 3
Jim owns shares of Abco, Inc. preferred stock which
he says provides him with a constant 6.58 percent
rate of return. The stock is currently priced at
$45.60 a share. What is the amount of the dividend
per share?
a. $3.00
b. $3.15
c. $3.50
d. $3.54
e. $3.62
 Answer Question 3
For preferred stock the formula for price is
Price=Div/Int. Substituting for the variables
we know gives us Div = $45.60*6.58% = $3.00.

Answer : A
 Question 4
Rek Corp.’s preferred stock is selling for $53.83. If
the company pays $5.03 annual dividends,
what is the expected rate of return on its
stock?
a. 9.22%
b. 9.34%
c. 10.25%
d. 11.67%
e. None of the above
 Answer Question 4
For preferred stock the formula for price is
Price=Div/k. Substituting for the variables we
know gives us k = $5.03/$53.83 = 9.34%.

Answer : B
 Question 5
You are evaluating the purchase of Bell, Inc. common stock that just
paid a dividend of $4.60. You expect the dividend to grow at a rate of
10% for the next four years. You plan to hold the stock for four years
and then sell it. You estimate the price of the company’s stock to rise
to $59.37 at the end of your four-year holding period. A required rate
of return of 13% will be adequate compensation for this investment.
Given your assumptions, what is the current value of Bell stock?
Round to the nearest $0.01 (allow a couple of pennies of rounding)
a. $31.83
b. $53.62
c. $61.15
d. $67.97
e. None of the above
 Answer Question 5
Below is the timeline used. The dividends we know will grow at 10%
each year. Then we had to get the PV for the dividends in years 1-4
(year 4 also includes the estimated future value of the stock). We
used our calculators to find the PV of each year at the 13% discount
rate. Finally we just add them all together to get the final answer.
Time 0 1 2 3 4
Dividend   $5.06 $5.57 $6.12 $6.73
  Estimated Final Price of the Stock $59.37
PV Each Year   $4.48 $4.36 $4.24 $40.54
SUM of PV $53.62        

Answer : B
 Question 6
A stock currently sells for $75 per share, and the
required return on the stock is 10%. Assuming
a constant growth rate of 3%, calculate the
stock’s last dividend paid.
a. $5.25
b. $7.5
c. $2.25
d. $3.50
e. None of the above
 Answer Question 6
For this we use the Gordon Growth Formula.
We know that Price = D1 / (r - g). First we
rearrange to D1 and get: D1 = $75 * (.10 - .03) =
$5.25. Now we must solve for D0. We know
that D1 = D0 *(1+g). Now we get D0 =
$5.25/(1.03) = $5.10

Answer : E
 Question 7
The Big Dude Company, whose common stock is
currently selling for $50 per share, is expected to pay
a $4.00 dividend next year. If investors believe that
the expected rate of return on XYZ is 14%, what
constant growth rate in dividends must be expected?
a. 5%
b. 14%
c. 9%
d. 6%
e. None of the above
 Answer Question 7
For this we use the Gordon Growth Formula.
We know that Price = D1 / (r - g). Using
algebra to solve for g gives us g = r - D1/P.
Substituting the numbers we have gives us g =
.14 – ($4/$50) = 6%. Or, you could just try all
the options

Answer : D
 Question 8
An issue of common stock currently sells for $70 per share, has an
expected dividend to be paid at the end of the year of $5 per
share, and has an expected growth rate to infinity of 5% per year.
If investors’ required rate of return for this particular security is
12% per year, then this security is:
a. Overvalued and offering an expected return higher than the required
return
b. Undervalued and offering an expected return higher than the required
return
c. Overvalued and offering an expected return lower than the required
return
d. Undervalued and offering an expected return lower than the required
return
 Answer Question 8
For this we use the Gordon Growth Formula.
We know that Price = D1 / (r - g). Solving for
price gives us $5 / (.12 - .05) = $71.43. So the
security is undervalued which means that the
expected return is greater than the required
return.

Answer : B
 Question 9
Avocado Incorporated just paid a dividend of $3. An analyst
expects this dividend to grow at a rate of 12% for the next 3
years. After this initial growth stage, the firm is expected to
grow at a rate of 5% forever. The required return on this stock
is 8%. Given the analyst’s projections, what is the most you
should pay for this stock? (select the closest answer; there
may be up to $0.50 rounding error)
a. $13.11
b. $118.22
c. $126.89
d. $137.63
e. $147.67
 Answer Question 9
Below is the timeline used. The dividend in years 1 – 3 will grow at
12% as shown below and then at 5% forever. We had to get the PV
for the dividends in years 1-3 (year 3 also includes the estimated
future value of the stock). We used our calculators to find the PV of
each year at the 8% discount rate. Finally we just add them all
together to get the final answer.
Time 0 1 2 3 4
Dividend   $3.36 $3.76 $4.21 $4.43
Stock Value assuming constant growth
  rate $147.52  
PV Each Year   $3.11 $3.23 $120.45  
SUM of PV $126.79        

Answer : C