98 Chapter 5  Valuation Concepts

CHAPTER 5—VALUATION CONCEPTS

TRUE/FALSE

1. The market value of any real or financial asset, including stocks, bonds, or art work, can be found
by determining future cash flows and then discounting them back to the present.
ANS: F DIF: Easy TOP: Discounted cash flows
2. If a firm raises capital by selling new bonds, the buyer is called the "issuing firm," and the coupon
rate is generally set equal to the required rate.
ANS: F DIF: Easy TOP: Issuing bonds
3. When considering stock and bond valuation models, we implicitly assume that the marginal
investor is risk averse, which means that he or she requires a higher rate of return for a given
level of risk than a risk neutral individual, other things held constant.
ANS: T DIF: Easy TOP: Risk aversion
4. A 20-year original maturity bond with 1 year left to maturity has more interest rate price risk than
a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal
default risk and equal coupon rates.)
ANS: F DIF: Easy TOP: Interest rate risk
5. Regardless of the size of the coupon payment, the price of a bond moves in the opposite direction
from interest rate movements. For example, if interest rates rise, bond prices fall.
ANS: T DIF: Easy TOP: Prices and interest rates
6. Because short-term interest rates are much more volatile than long-term rates, you would, in the
real world, be subject to much more interest rate price risk if you purchased a 30-day bond than if
you bought a 30-year bond.
ANS: F DIF: Easy TOP: Interest rate risk
7. The constant growth model used for evaluating the price of a share of common stock can also be
used to find the price of perpetual preferred stock or any other perpetuity.
ANS: T DIF: Easy TOP: Constant growth stock
8. According to the textbook model, under conditions of nonconstant growth, the discount rate
utilized to find the present value of the expected cash flows will be the same for the initial growth
period as for the normal growth period.
ANS: T DIF: Easy TOP: Supernormal growth stock
9. According to the basic stock valuation model, the value an investor assigns to a share of stock is
dependent upon the length of time the investor plans to hold the stock.
ANS: F DIF: Easy TOP: Stock valuation
10. If security markets were truly strong-form efficient, you would never be able to realize a rate of
return on a security greater than the marginal investor's expected (or required) rate of return.
ANS: F DIF: Easy TOP: Efficient market hypothesis
99 Chapter 5  Valuation Concepts

11. A bond's value will increase as interest rates rise over time.
ANS: F DIF: Easy TOP: Bond value
12. You have just noticed in the financial pages of the local newspaper that you can buy a bond
($1,000 par) for $800. If the coupon rate is 10 percent, with annual interest payments, and there
are 10 years to maturity, you should make the purchase if your required return on investments of
this type is 12 percent.
ANS: T

Tabular solution:
Vd = $100 (PVIFA12%, 10) + $1,000 (PVIF12%, 10)
= $100 (5.6502) + $1,000 (0.3220) = $877.02.
Thus, the value is significantly higher than the market price and the bond should be purchased.
Financial calculator solution:
Inputs: N = 10; I = 12; PMT = 100; FV = 1,000.
Output: PV = -$887.00.
DIF: Medium TOP: Bond value
13. If two bonds have the same maturity and the same expected rate of return, but one has a higher
coupon, the price of the low coupon bond will be more affected by a given change in interest
rates.
ANS: T DIF: Medium TOP: Prices and interest rates
14. A bond with a $100 annual interest payment with five years to maturity (not expected to default)
would sell for a premium if interest rates were below 9% and would sell for a discount if interest
rates were greater than 11%.
ANS: T DIF: Medium TOP: Bond premium and discounts
15. Call provisions on corporate bonds are generally included to protect the issuer against large
declines in interest rates. They affect the actual maturity of the bond but not its price.
ANS: F DIF: Medium TOP: Callable bonds
16. Other things held constant, P/E ratios are higher for firms with high growth prospects. At the
same time, P/E's are lower for riskier firms, other things held constant. These two factors, growth
prospects and riskiness, may either be offsetting or reinforcing as P/E determinants.
ANS: T DIF: Medium TOP: Risk and P/E ratios
17. Bonds issued by BB&C Communications that have a coupon rate of interest equal to 10 percent
currently have a yield to maturity (YTM) equal to 8 percent. Based on this information, BB&C's
bonds must currently be selling at a premium in the financial markets.
ANS: F DIF: Medium TOP: Bond premium and discounts
 Chapter 5  Valuation Concepts 100

18. If a bond is callable, and if interest rates in the economy decline, then the company can sell a new
issue of low-interest-rate bonds and use the proceeds to "call" the old bonds in and have
effectively refinanced at a lower rate.
ANS: T DIF: Medium TOP: Call provision
19. If the yield to maturity (the market rate of return) of a bond is less than its coupon rate, the bond
should be selling at a discount; i.e., the bond's market price should be less than its face (maturity)
value.
ANS: F DIF: Medium TOP: Bond premium and discounts
20. If you buy a bond that is selling for less than its face, or maturity, value then the price (value) of
the bond will increase the maturity date nears if market interest rates do not change during the
life of the bond.
ANS: T DIF: Medium TOP: Bond value
21. If the prices of investment reflect existing information and adjust very quickly when new
information becomes available, then the financial markets have achieved informational efficiency.
ANS: T DIF: Medium TOP: Efficient market hypothesis
22. The longer the maturity of a bond, the more its price will change in response to a given change in
interest rates; this is called interest rate price risk.
ANS: T DIF: Medium TOP: Bond prices and interest rates
23. Bonds with long maturities expose the investor to high interest rate reinvestment risk, which is
the risk that income will differ from what is expected because the cash flows received from bonds
will have to be reinvested at different interest rates.
ANS: F DIF: Medium TOP: Bond prices and interest rates
24. If we have two bonds with a simple interest rate yield of 9% where one bond is compounded
quarterly and the other bond is compounded monthly, the bond compounded quarterly will have a
higher effective annual yield.
ANS: F DIF: Medium TOP: Bond yields
25. All else equal, a zero-coupon bond's price is more sensitive to changes interest rates than a bond
with a 10% annual coupon.
ANS: T DIF: Medium TOP: Bond prices and interest rates

MULTIPLE CHOICE

1. Assuming g will remain constant, the dividend yield is a good measure of the required return on a
common stock under which of the following circumstances?
a. g = 0
b. g > 0
c. g < 0
d. Under no circumstances.
e. Answers a and b are both correct.
ANS: A DIF: Easy OBJ: TYPE: Conceptual
TOP: Dividend yield and g
101 Chapter 5  Valuation Concepts

2. If the expected rate of return on a stock exceeds the required rate,

a. The stock is experiencing supernormal growth.
b. The stock should be sold.
c. The company is probably not trying to maximize price per share.
d. The stock is a good buy.
e. Dividends are not being declared.
ANS: D DIF: Easy OBJ: TYPE: Conceptual TOP: Required return
3. Which of the following statements is correct?
a. The constant growth DCF model can be used to value a stock only if the stock's dividends
are expected to grow forever at a constant rate which is less than the required rate of return
on the stock.
b. If the growth rate is negative, the constant growth DCF model cannot be used.
c. The constant growth DCF model may be written as k0 = D0/P0 + g.
d. The constant growth DCF model may be written as P0 = D0/(k + g).
e. The constant growth DCF model may be written as P0 = D0/(k - g).
ANS: A
Statement a is the condition necessary for the constant growth model. All the other statements are
false.
DIF: Easy OBJ: TYPE: Conceptual TOP: Constant growth model
4. If the stock market is semi-strong efficient, which of the following statements is correct?
a. All stocks should have the same expected returns; however, they may have different
realized returns.
b. In equilibrium, stocks and bonds should have the same expected returns.
c. Investors can outperform the market if they have access to information which has not yet
been publicly revealed.
d. if the stock market has been performing strongly over the past several months, stock prices
are more likely to decline than increase over the next several months.
e. None of the above statements is correct.
ANS: C
Statement c is correct; the semi-strong form of the EMH states that current market prices reflect
all publicly available information. Thus, if an investor had access to information which has not
yet been publicly revealed then he could outperform the market.
DIF: Easy OBJ: TYPE: Conceptual TOP: Efficient market hypothesis
5. Which of the following statements is most correct?
a. If two stocks are equally risky, the stock with the higher dividend yield is likely to have a
higher capital gain.
b. If two bonds are equally risky, the bond with the higher current yield is likely to have a
higher capital gain.
c. A bond's yield to maturity is also its internal rate of return.
d. Both b and c are correct.
e. Answers a, b, and c are all correct.
ANS: C
A stock's return consists of a dividend yield and a capital gains yield. If 2 stocks are equally risky,
by definition, they have the same return. Consequently, if stock A's dividend yield is higher than
Stock B's, then Stock B's capital gains yield will be higher than Stock A's. A bond's return
consists of current yield and a capital gains yield. For the same reason mentioned above, if Bond
A's current yield is higher than Bond B's, then Bond B's capital gains yield will be higher than
 Chapter 5  Valuation Concepts 102

Bond A's. By definition, a bond's YTM is its IRR; the rate that equates the bond's coupon and
principal payments to its present value.
DIF: Easy OBJ: TYPE: Conceptual TOP: Miscellaneous issues
6. Bonds issued by BB&C Communications that have a coupon rate of interest equal to 10.65
percent currently have a yield to maturity (YTM) equal to 15.25 percent. Based on this
information, BB&C's bonds must currently be selling at __________ in the financial markets.
a. par value
b. a discount
c. a premium
d. Not enough information is given to answer this question.
e. None of the above is a correct answer.
ANS: B DIF: Easy OBJ: TYPE: Conceptual
TOP: Bond premium and discounts
7. According to the efficient markets hypothesis (EMH), which form of market efficiency states that
all publicly available information, past and present, is already included in the price of financial
assets?
a. weak form
b. semi-strong form
c. strong form
d. None of the above, because the financial markets cannot be efficient.
ANS: B DIF: Easy OBJ: TYPE: Conceptual
TOP: Efficient market hypothesis
8. Alpha's preferred stock currently has a market price equal to $80 per share. If the dividend paid
on this stock is $6 per share, what is the required rate of return investors are demanding from
Alpha's preferred stock?
a. 7.5%
b. 13.3%
c. 6.0%
d. $6.00
e. None of the above is a correct answer.
ANS: A DIF: Easy OBJ: TYPE: Conceptual TOP: Stock valuation
9. If the yield to maturity (the market rate of return) of a bond is less than its coupon rate, the bond
should be
a. selling at a discount; i.e., the bond's market price should be less than its face (maturity)
value.
b. selling at a premium; i.e., the bond's market price should be greater than its face value.
c. selling at par; i.e., the bond's market price should be the same as its face value.
d. purchased because it is a good deal.
ANS: B DIF: Easy OBJ: TYPE: Conceptual
TOP: Bond premium and discounts
103 Chapter 5  Valuation Concepts

10. A 12-year bond that has a 12 percent coupon rate is currently selling for $1,000, which equals the
bond's face value. If interest is paid semiannually, the bond's yield to maturity is
a. equal to 12 percent.
b. greater than 12 percent.
c. less than 12 percent.
d. More information is needed to answer this question.
e. None of the above is correct.
ANS: A DIF: Easy OBJ: TYPE: Conceptual TOP: Bond yields
11. According to the efficient markets hypothesis (EMH), which form of market efficiency states that
all information about stocks and bonds, regardless of whether the information is public or private,
is already included in the price of financial assets?
a. weak form
b. semi-strong form
c. strong form
d. None of the above, because the financial markets cannot be efficient.
ANS: C DIF: Easy OBJ: TYPE: Conceptual
TOP: Efficient market hypothesis
12. Which of the following statements is correct?
a. Other things held constant, a callable bond would have a lower required rate of return than
a noncallable bond.
b. Other things held constant, a corporation would rather issue noncallable bonds than
callable bonds.
c. Reinvestment rate risk is worse from a typical investor's standpoint than interest rate price
risk.
d. If a 10-year, $1,000 par, zero coupon bond were issued at a price which gave investors a
10 percent rate of return, and if interest rates then dropped to the point where k d = YTM =
5%, we could be sure that the bond would sell at a premium over its $1,000 par value.
e. If a 10-year, $1,000 par, zero coupon bond were issued at a price which gave investors a
10 percent rate of return, and if interest rates then dropped to the point where k d = YTM =
5%, we could be sure that the bond would sell at a discount below its $1,000 par value.
ANS: E
A zero coupon bond will always sell at a discount below par, provided interest rates are above
zero, which they always are.
DIF: Medium OBJ: TYPE: Conceptual TOP: Bonds
13. Which of the following statements is correct?
a. Rising inflation makes the actual yield to maturity on a bond greater than the quoted yield
to maturity which is based on market prices.
b. The yield to maturity for a coupon bond that sells at its par value consists entirely of an
interest yield; it has a zero expected capital gains yield.
c. On an expected yield basis, the expected capital gains yield will always be positive
because an investor would not purchase a bond with an expected capital loss.
d. The market value of a bond will always approach its par value as its maturity date
approaches. This holds true even if the firm enters bankruptcy.
e. All of the above statements are false.
ANS: B DIF: Medium OBJ: TYPE: Conceptual TOP: Bond yields
 Chapter 5  Valuation Concepts 104

14. Which of the following statements is correct?

a. The discount or premium on a bond can be expressed as the difference between the
coupon payment on an old bond which originally sold at par and the coupon payment on a
new bond, selling at par, where the difference in payments is discounted at the new market
rate.
b. The price of a coupon bond is determined primarily by the number of years to maturity.
c. On a coupon paying bond, the final interest payment is made one period before maturity
and then, at maturity, the bond's face value is paid as the final payment.
d. The actual capital gains yield for a one-year holding period on a bond can never be greater
than the current yield on the bond.
e. All of the above statements are false.
ANS: A DIF: Medium OBJ: TYPE: Conceptual TOP: Bond concepts
15. If you buy a bond that is selling for less than its face, or maturity, value what will happen to the
price (value) of the bond as the maturity date nears if market interest rates do not change during
the life of the bond?
a. Because interest rates remain constant, nothing happens to the market value of the bond.
b. The price of the bond should decrease even further below the bond's face value because
the rates in the market are too high.
c. The price of the bond will increase as the bond gets closer to its maturity because the
bond's value has to equal its face value at maturity.
d. This question cannot be answered without additional information.
e. None of the above is a correct answer.
ANS: C DIF: Medium OBJ: TYPE: Conceptual
TOP: Bond prices and interest rates
16. Omega Software Corporation's bond is currently selling at a discount in the financial markets. If
the bond's yield to maturity is 11.5 percent, what is its coupon rate of interest?
a. greater than 11.5 percent
b. less than 11.5 percent
c. equal to 11.5 percent
d. There is not enough information to answer this question.
e. None of the above is a correct answer.
ANS: D DIF: Medium OBJ: TYPE: Conceptual
TOP: Bond coupon rate
17. Ms. Manners Catering (MMC) has paid a constant $1.50 per share dividend to its common
stockholders for the past 25 years. MMC expects to continue this policy for the next two years,
and then begin to increase the dividend at a constant rate equal to 2 percent per year into
perpetuity. Investors require a 12 percent rate of return to purchase MMC's common stock. What
is the market value of MMC's common stock?
a. $14.73
b. $15.00
c. $15.58
d. $15.30
e. $12.20
ANS: A DIF: Medium OBJ: TYPE: Conceptual
TOP: Nonconstant growth stock
105 Chapter 5  Valuation Concepts

18. Stephanie just purchased a corporate bond that matures in three years. The bond has a coupon
interest rate equal to 9 percent and its yield to maturity is 6 percent. If market conditions do not
change—that is market interest rates remain constant—and Stephanie sells the bond in 12
months, what will be her capital gain from holding the bond?
a. Positive; because she bought the bond for a discount, which means its price has to increase
as the maturity date nears.
b. Negative; because she bought the bond for a premium, which means its price has to
decrease as the maturity date nears.
c. Zero, because she must have bought the bond for par, which means its price will not
change as the maturity date nears.
d. This question cannot be answered, because the face (maturity) value of the bond is not
given.
e. None of the above is correct.
ANS: B DIF: Medium OBJ: TYPE: Conceptual TOP: Bond value
19. Which of the following is not true about bonds? In all of the statements, assume other things are
held constant?
a. Price sensitivity, that is, the change in price due to a given change in the required rate of
return, increases as a bond's maturity increases.
b. For a given bond of any maturity, a given percentage point increase in the interest rate (k d)
causes a larger dollar capital loss than the capital gain stemming from an identical
decrease in the interest rate.
c. For any given maturity, a given percentage point increase in the interest rate causes a
smaller dollar capital loss than the capital gain stemming from an identical decrease in the
interest rate.
d. From a borrower's point of view, interest paid on bonds is tax-deductible.
e. A 20-year zero-coupon bond has less reinvestment rate risk than a 20-year coupon bond.
ANS: B DIF: Tough OBJ: TYPE: Conceptual TOP: Bonds
20. If interest rates fall from 8 percent to 7 percent, which of the following bonds will have the
largest percentage increase in its value?
a. A 10-year zero-coupon bond.
b. A 10-year bond with a 10 percent semiannual coupon.
c. A 10-year bond with a 10 percent annual coupon.
d. A 5-year zero-coupon bond.
e. A 5-year bond with a 12 percent annual coupon.
ANS: A
Statement a is correct. The present value of the 10-year, zero-coupon bond at an 8 percent interest
rate is $463.19, while its value at a 7 percent interest rate is $508.34. The percentage change is
$45.15/$463.19 = 9.75%. If you work out the other percentage increases in values due to the
change in interest rates, you'll obtain the following results:
b. 10-year, 10% semiannual coupon: 6.80%.
c. 10-year, 10% annual coupon: 6.75%.
d. 5-year, zero-coupon: 4.76%.
e. 5-year, 12% annual coupon: 3.91%.
DIF: Tough OBJ: TYPE: Conceptual TOP: Bond value
 Chapter 5  Valuation Concepts 106

21. Which of the following statements is most correct?

a. If a bond's yield to maturity exceeds its coupon rate, the bond's current yield must also
exceed its coupon rate.
b. If a bond's yield to maturity exceeds its coupon rate, the bond's price must be less than its
maturity value.
c. If two bonds have the same maturity, the same yield to maturity, and the same level of
risk, the bonds should sell for the same price regardless of the bond's coupon rate.
d. Answers b and c are both correct.
e. None of the above answers are correct.
ANS: B
Statement b is correct. If a bond's YTM exceeds its coupon rate, the n, by definition, the bond
sells at a discount. Thus, the bond's price is less than its maturity value. Statement a is false.
Consider zero-coupon bonds. A zero-coupon bond's YTM exceeds its coupon rate (which is equal

to zero); however, its current yield is equal to zero which is equal to its coupon rate.

Statement c is false; a bond's value is determined by its cash flows: coupon payments plus
principal. If the 2 bonds have different coupon payments, their prices would have to be different
in order for them to have the same YTM.
DIF: Tough OBJ: TYPE: Conceptual TOP: Bond concepts
22. Which of the following statements is most correct?
a. All else equal, an increase in interest rates will have a greater effect on the prices of long-
term bonds than it will on the prices of short-term bonds.
b. All else equal, and increase in interest rate will have a greater effect on higher-coupon
bonds than it will have on lower-coupon bonds.
c. An increase in interest rates will have a greater effect on a zero-coupon bond with 10 years
maturity than it will have on a 9-year bond with a 10 percent annual coupon.
d. All of the above are correct.
e. Answers a and c are both correct.
ANS: E
Statements a and c are correct; therefore, statement e is the correct choice. The longer the
maturity of a bond, the greater the impact an increase in interest rates will have on the bond's
price. Statement b is false. To see this, assume interest rates increase from 7 percent to 10 percent.
Evaluate the change in the prices of a 10-year, 5 percent coupon bond and a 10-year, 12 percent
coupon bond. The 5 percent coupon bond's price decreases by 19.4 percent, while the 12 percent
coupon bond's price decreases by only 16.9 percent. Statement c is correct. To see this, evaluate a
10-year, zero-coupon bond and a 9-year, 10 percent annual coupon bond at 2 different interest
rates, say 7 percent and 10 percent. The zero-coupon bond's price decreases by 24.16 percent,
while the 9-year, 10 percent coupon bond's price decreases by only 16.33 percent.
DIF: Tough OBJ: TYPE: Conceptual TOP: Bond concepts
23. Which of the following statements is correct?
a. A 10-year bond would have more interest rate price risk than a 5-year bond, but all 10-
year bonds have the same interest rate price risk.
b. A 10-year bond would have more reinvestment rate risk than a 5-year bond, but all 10-year
bonds have the same reinvestment rate risk.
c. If their maturities were the same, a 5 percent coupon bond would have more interest rate
price risk than a 10 percent coupon bond.
107 Chapter 5  Valuation Concepts

d. If their maturities were the same, a 5 percent coupon bond would have less interest rate
price risk than a 10 percent coupon bond.
e. Zero-coupon bonds have more interest rate price risk than any other type bond, even
perpetuities.
ANS: C
Statement c is correct. For example, assume these coupon bonds have 10 years until maturity and
the current interest rate is 12 percent. The 5 percent coupon bond's value is $604.48, while the 10
percent coupon bond's value is $887.00. Thus, the lower coupon bond has more price risk than
the higher coupon bond. The lower the coupon, the greater the percentage of the cash flow that
will come in the later years (from the maturity value), hence, the greater the impact of interest
rate changes. Statement a is false—as we demonstrated above. Statement b is false—shorter-term
bonds have more reinvestment rate risk than longer-term bonds because the principal payment
must be reinvested sooner on the shorter-term bond. Statement d is false—as we demonstrated
earlier. Statement e is false because perpetuities have no maturity date; therefore, they have more
price risk than zero-coupon bonds. The longer a security's maturity, the greater its price risk.
DIF: Tough OBJ: TYPE: Conceptual TOP: Price vs. reinvestment rate risk
24. You have just purchased a 10-year, $1,000 par value bond. The coupon rate on this bond is 8
percent annually, with interest being paid each 6 months. If you expect to earn a 10 percent
simple rate of return on this bond, how much did you pay for it?
a. $1,122.87
b. $1,003.42
c. $875.38
d. $950.75
e. $812.15
ANS: C

Tabular solution:
Vd = $40 (PVIFA5%, 20) + $1,000 (PVIF5%, 20)
= $40 (12.4622) + $1,000 (0.3769) = $875.39.
Financial calculator solution:
Inputs: N = 20; I = 5; PMT = 40; FV = 1,000
Output: PV = -$875.38; Vd = $875.38.
DIF: Easy OBJ: TYPE: Problem TOP: Bond value—annual payment
25. Assume that you wish to purchase a 20-year bond that has a maturity value of $1,000 and makes
semiannual interest payments of $40. If you require a 10 percent simple yield to maturity on this
investment, what is the maximum price you should be willing to pay for the bond?
a. $619
b. $674
c. $761
d. $828
e. $902
ANS: D
 Chapter 5  Valuation Concepts 108

Tabular solution:
Vd = $40 (PVIFA5%, 40) + $1,000 (PVIF5%, 40)
= $40 (17.1591) + $1,000 (0.1420) = $828.36 = $828.
Financial calculator solution:
Inputs: N = 40; I = 5; PMT = 40; FV = 1,000.
Outputs: PV = -$828.41; Vd = $828.
DIF: Easy OBJ: TYPE: Problem TOP: Bond value—semiannual payment
26. A $1,000 par value bond pays interest of $35 each quarter and will mature in 10 years. If your
simple annual required rate of return is 12 percent with quarterly compounding, how much should
you be willing to pay for this bond?
a. $941.36
b. $1,051.25
c. $1,115.57
d. $1,391.00
e. $825.49
ANS: C

Tabular solution:
Vd = $35 (PVIFA3%, 40) + $1,000 (PVIF3%, 40)
= $35 (23.1148) + $1,000 (0.3066) = $1,115.62.
Financial calculator solution:
Inputs: N = 40; I = 3; PMT = 35; FV = 1,000.
Outputs: PV = -$1,115.57; Vd = $1,115.57.
DIF: Easy OBJ: TYPE: Problem TOP: Bond value—quarterly payment
27. A share of perpetual preferred stock pays an annual dividend of $6 per share. If investors require
a 12 percent rate of return, what should be the price of this preferred stock?
a. $57.25
b. $50.00
c. $62.38
d. $46.75
e. $41.64
ANS: B
Vps = Dps/kps = $6/0.12 = $50.
DIF: Easy OBJ: TYPE: Problem TOP: Preferred stock value
109 Chapter 5  Valuation Concepts

28. A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is
currently $50, what is the simple annual rate of return?
a. 12%
b. 18%
c. 20%
d. 23%
e. 28%
ANS: C
Annual dividend = $2.50(4) = $10.
kps = Dps/Vps = $10/$50 = 0.20 = 20%.
DIF: Easy OBJ: TYPE: Problem TOP: Preferred stock yield
29. A share of preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00
for this preferred stock, what is your simple (not effective) annual rate of return?
a. 10%
b. 8%
c. 6%
d. 12%
e. 14%
ANS: A
Yearly dividend = $0.50(4) = $2.00.
kps = Dps/Vps = $2.00/$20.00 = 0.10 = 10%.
DIF: Easy OBJ: TYPE: Problem TOP: Preferred stock yield
30. The last dividend on Spirex Corporation's common stock was $4.00, and the expected growth rate
is 10 percent. If you require a rate of return of 20 percent, what is the highest price you should be
willing to pay for this stock?
a. $44.00
b. $38.50
c. $40.00
d. $45.69
e. $50.00
ANS: A

DIF: Easy OBJ: TYPE: Problem TOP: Stock price

31. You are trying to determine the appropriate price to pay for a share of common stock. If you
purchase this stock, you plan to hold it for 1 year. At the end of the year you expect to receive a
dividend of $5.50 and to sell the stock for $154. The appropriate rate of return for this stock is 16
percent. What should be the current price of this stock?
a. $137.50
b. $150.22
c. $162.18
d. $98.25
e. $175.83
ANS: A
 Chapter 5  Valuation Concepts 110

Numerical solution:

DIF: Easy OBJ: TYPE: Problem TOP: Stock price

32. A share of common stock has a current price of $82.50 and is expected to grow at a constant rate
of 10 percent. If you require a 14 percent rate of return, what is the current dividend on this
stock?
a. $3.00
b. $3.81
c. $4.29
d. $4.75
e. $6.13
ANS: A

$4.40 = D0 (1.10)
D0 = $3.00.
DIF: Easy OBJ: TYPE: Problem TOP: Constant growth stock
33. The last dividend paid by Klein Company was $1.00. Klein's growth rate is expected to be a
constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent
forever. Klein's required rate of return on equity (k s) is 12 percent. What is the current price of
Klein's common stock?
a. $21.00
b. $33.33
c. $42.25
d. $50.16
e. $58.75
ANS: D
111 Chapter 5  Valuation Concepts

Enter in CFLO register = 0, = 1.05, and = 61.74.

Then enter I = 12, and press NPV to get NPV = P 0 = $50.16.
DIF: Easy OBJ: TYPE: Problem TOP: Nonconstant growth stock
34. Assume that a 15-year, $1,000 face value bond pays interest of $37.50 every 3 months. If you
require a simple annual rate of return of 12 percent, with quarterly compounding, how much
should you be willing to pay for this bond? (Hint: The PVIFA and PVIF for 3 percent, 60 periods
are 27.6748 and 0.1697, respectively.)
a. $821.92
b. $1,207.57
c. $986.43
d. $1,120.71
e. $1,358.24
ANS: B

Tabular solution: (PVIFA and PVIF are given in the problem.)

Vd = $37.50 (PVIFA3%, 60) + $1,000 (PVIF3%, 60)
= $37.50 (27.6748) + $1,000 (0.1697) = $1,207.51.
Financial calculator solution:
Inputs: N = 60; I = 3; PMT = 37.50; FV = 1,000
Output: PV = -$1,207.57; Vd = $1,207.57.
Note: Tabular solution differs from calculator solution due to interest factor rounding.
DIF: Medium OBJ: TYPE: Problem TOP: Bond value—quarterly payment
35. Due to a number of lawsuits related to toxic wastes, a major chemical manufacturer has recently
experienced a market reevaluation. The firm has a bond issue outstanding with 15 years to
maturity and a coupon rate of 8 percent, with interest being paid semiannually. The required
simple rate on this debt has now risen to 16 percent. What is the current value of this bond?
a. $1,273
b. $1,000
c. $7,783
d. $550
e. $450
ANS: D
 Chapter 5  Valuation Concepts 112

Tabular solution:
Vd = $40 (PVIFA8%, 30) + $1,000 (PVIF8%, 30)
= $40 (11.2578) + $1,000 (0.0994) = $549.71 = $550.
Financial calculator solution:
Inputs: N = 30; I = 8; PMT = 40; FV = 1,000.
Output: PV = -$549.69; Vd = $549.69 = $550.
DIF: Medium OBJ: TYPE: Problem TOP: Bond value—semiannual payment
36. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance
sheet figures to a market value basis. KJM Corporation's balance sheet as of January 1, 2001, is
as follows:
Long-term debt (bonds, at par) $10,000,000
Preferred stock 2,000,000
Common stock ($10 par) 10,000,000
Retained earnings 4,000,000
Total debt and equity $26,000,000
The bonds have a 4 percent coupon rate, payable semiannually, and a par value of $1,000. They
mature on January 1, 2011. The yield to maturity is 12 percent, so the bonds now sell below par.
What is the current market value of the firm's debt?
a. $5,412,000
b. $5,480,000
c. $2,531,000
d. $7,706,000
e. $7,056,000
ANS: A

Tabular solution
Vd = $20 (PVIFA6%, 20) + $1,000 (PVIF6%, 20)
= $20 (11.4699) + $1,000 (0.3118) = $541.20 per bond.
Since there are 10,000 bonds outstanding the total value of debt is $541.20 (10,000) = $5.412
million.
Financial calculator solution:
Inputs: N = 20; I = 6; PMT = 20; FV = 1,000.
Output: PV = -$541.20; Vd = $541.20.
DIF: Medium OBJ: TYPE: Problem TOP: Market value of bonds
113 Chapter 5  Valuation Concepts

37. You are the owner of 100 bonds issued by Euler, Ltd. These bonds have 8 years remaining to
maturity, an annual coupon payment of $80, and a par value of $1,000. Unfortunately, Euler is on
the brink of bankruptcy. The creditors, including yourself, have agreed to a postponement of the
next 4 interest payments (otherwise, the next interest payment would have been due in 1 year).
The remaining interest payments, for Years 5 through 8, will be made as scheduled. The
postponed payments will accrue interest at an annual rate of 6 percent, and they will then be paid
as a lump sum at maturity 8 years hence. The required rate of return on these bonds, considering
their substantial risk, is now 28 percent. What is the present value of each bond?
a. $538.21
b. $426.73
c. $384.84
d. $266.88
e. $249.98
ANS: D

Numerical solution:
Find the compounded value at Year 8 of the postponed interest payments.
FVDeferred interest = $80(1.06)7 + $80(1.06)6 + $80(1.06)5 + $80(1.06)4
= $441.83 payable at t = 8.
Now find the value of the bond considering all cash flows
Vd = $80(1/1.28)5 + $80(1/1.28)6 + $80(1/1.28)7 + $80(1/1.28)8 + $1,000(1/1.28)8
+ $441.83(1/1.28)8 = $266.86.
Tabular solution:
FVDeferred interest = $80(FVIFA6%,4)(FVIF6%,4) = $80(4.3746)(1.2625)
= 441.83.
Vd = $80(PVIFA28%,4)(PVIF28%,4) + $1,441.83(PVIF28%,8)
= $80(2.2410)(0.3725) + $1,441.83(0.1388)
= $66.78 + $200.13 = $266.91.
Financial calculator solution:
Calculate FV of deferred interest
Inputs: = 0; = 80; Nj = 4; = 0; Nj = 4; I = 6.
Output: NFV = $441.828.
Calculate vB, which is the PV of scheduled interest, deferred accrued interest, and maturity value
 Chapter 5  Valuation Concepts 114

Inputs: = 0; = 0; Nj = 4; = 80; Nj = 3; = 1,521.83; I = 28.

Output: NPV = $266.88; Vd = $266.88.
Differences in tabular and financial calculator solutions are due to rounding of interest rate table
figures.
DIF: Medium OBJ: TYPE: Problem TOP: Bond value
38. You are contemplating the purchase of a 20-year bond that pays $50 in interest each six months.
You plan to hold this bond for only 10 years, at which time you will sell it in the marketplace.
You require a 12 percent annual return, but you believe the market will require only an 8 percent
return when you sell the bond 10 years hence. Assuming you are a rational investor, how much
should you be willing to pay for the bond today?
a. $1,126.85
b. $1,081.43
c. $737.50
d. $927.68
e. $856.91
ANS: D

Tabular solution:
Vd10 = $50 (PVIFA4%, 20) + $1,000 (PVIF4%, 20)
= $50 (13.5903) + $1,000 (0.4564) = $1,135.915 = $1,135.92.

Vd = $50 (PVIFA6%, 20) + $1,135.92 (PVIF6%, 20)

= $50 (11.4699) + $1,135.92 (0.3118) = $927.675 = $927.68.
Financial calculator solution:
Calculate value of bond at Year 10
Inputs: N = 20; I = 4; PMT = 50; FB = 1,000.
Output: PV = -1,135.90.
Calculate value of bond at Year 0 using V10 as FV
Inputs: N = 20; I = 6; PMT = 50; FV = 1,135.90.
Output: PV = -$927.675 = $927.98; Vd = $927.68.
DIF: Medium OBJ: TYPE: Problem TOP: Bond value
39. JRJ Corporation recently issued 10-year bonds at a price of $1,000. These bonds pay $60 in
interest each six months. Their price has remained stable since they were issued, i.e., they still sell
for $1,000. Due to additional financing needs, the firm wishes to issue new bonds that would
have a maturity of 10 years, a par value of $1,000, and pay $40 in interest every six months. If
both bonds have the same yield, how many new bonds must JRJ issue to raise $2,000,000 cash?
a. 2,400
b. 2,596
c. 3,000
d. 5,000
e. 4,275
115 Chapter 5  Valuation Concepts

ANS: B

Tabular solution:
Since the old bond issue sold at its maturity (or par) value, and still sells at par, it yields (and the
yield on the new issue) must be 6 percent semiannually. The new bonds will be offered at a
discount:
Vd = $40 (PVIFA6%, 20) + $1,000 (PVIF6%, 20)
= $40 (11.4699) + $1,000 (0.3118) = $770.60.
Number of bonds = $2,000,000 / $770.60 = 2,595.38 = 2,596.
Financial calculator solution:
Inputs: N = 20; I = 6; PMT = 40; FV = 1,000.
Output: PV = -$770.60; Vd = $770.60.
Number of bonds: $2,000,000 / $770.60 = 2,596 bonds.*
* Rounded up to next whole bond.
DIF: Medium OBJ: TYPE: Problem TOP: Bond value
40. Assume that you are considering the purchase of a $1,000 par value bond that pays interest of $70
each six months and has 10 years to go before it matures. If you buy this bond, you expect to hold
it for 5 years and then to sell it in the market. You (and other investors) currently require a simple
annual rate of 16 percent, but you expect the market to require a rate of only 12 percent when you
sell the bond due to a general decline in interest rates. How much should you be willing to pay for
this bond?
a. $842.00
b. $1,115.81
c. $1,359.26
d. $966.99
e. $731.85
ANS: D
 Chapter 5  Valuation Concepts 116

Tabular solution:
Vd = $70 (PVIFA6%, 10) + $1,000 (PVIF6%, 10)
= $70 (7.3601) + $1,000 (0.5584) = $1,073.61.

Vd = $70 (PVIFA8%, 10) + $1,073.61 (PVIF8%, 10)

= $70 (6.7101) + $1,073.61 (0.4632) = $967.00.
Financial calculator solution:
Solve for Vd at Time = 5 (V5) with 5 years to maturity.
Inputs: N = 10; I = 6; PMT = 70; FV = 1,000.
Output: PV = $1,073.60.
Solve for Vd at Time = 0, assuming sale at Vd = $1,073.60.
Inputs: N = 10; I = 8: PMT = 70; FV = 1,073.60.
Output: PV = -$966.99; Vd = $966.99.
DIF: Medium OBJ: TYPE: Problem TOP: Bond value
41. You are willing to pay $15,625 to purchase a perpetuity which will pay you and your heirs $1,250
each year, forever. If your required rate of return does not change, how much would you be
willing to pay if this were a 20-year, annual payment, ordinary annuity instead of a perpetuity?
a. $10,342
b. $11,931
c. $12,273
d. $13,922
e. $17,157
ANS: C

Solve for required return, k. We know VPERPETUITY = thus

Tabular solution:
Calculate the value of the annuity using k = 8%
FVA = $1,250 (PVIFA8%, 20) = $1,250 (9.8181) = $12,272.63 = $12,273.
Inputs: N = 20; I = 8; PMT = -1,250.
Output: PV = $12,272.68 = $12,273.
Financial calculator section:
Inputs: N = 20; I = 8; PMT = -1,250.
Output: PV = $12,272.68  $12,273.
DIF: Medium OBJ: TYPE: Problem TOP: Value of a perpetuity
117 Chapter 5  Valuation Concepts

42. Cold Boxes Ltd. has 100 bonds outstanding (maturity value = $1,000). The required rate of return
on these bonds is currently 10 percent, and interest is paid semiannually. The bonds mature in 5
years, and their current market value is $768 per bond. What is the annual coupon interest rate?
a. 8%
b. 6%
c. 4%
d. 2%
e. 0%
ANS: C

Tabular solution:

$768 = (PVIFA5%, 10) + $1,000 (PVIF5%, 10) = (7.7217) + $1,000 (0.6139)

154.10 = (7.7217)

= $19.96 = $20

PMT $40 and coupon rate  4%.

Financial calculator solution:
Inputs: N = 10; I = 5; PV = -768; FV = 1,000.
Output: PMT = $19,955 (semi-annual PMT).
Annual coupon rate = PMT  2/M = $19,955  2/1,000 = 3.99% = 4%.
DIF: Medium OBJ: TYPE: Problem TOP: Bond coupon rate
43. The current price of a 10-year, $1,000 par value bond is $1,158.91. Interest on this bond is paid
every six months, and the simple annual yield is 14 percent. Given these facts, what is the annual
coupon rate on this bond?
a. 10%
b. 12%
c. 14%
d. 17%
e. 21%
ANS: D
 Chapter 5  Valuation Concepts 118

Tabular solution:
$1,158.91 = PMT (PVIFA7%, 20) + $1,000 (PVIF7%, 20)
= PMT (10,5940) + $1,000 (0.2584)
PMT = $900.51/10.5940 = $85.
Annual coupon rate = (2) ($85) / $1,000 = 17%.
Financial calculator solution:
Inputs: N = 20; I = 7; PV = -1,158.91; FV = 1,000.
Output: PMT = $85.00 (Semiannual PMT).
Annual coupon rate = $85 (2) / $1,000 = 17.0%.
DIF: Medium OBJ: TYPE: Problem TOP: Bond coupon rate
44. You are given the following data:
(1) The risk-free rate is 5 percent.
(2) The required return on the market is 8 percent.
(3) The expected growth rate for the firm is 4 percent.
(4) The last dividend paid was $0.80 per share.
(5) Beta is 1.3.
Now assume the following changes occur:
(1) The inflation premium drops by 1 percent.
(2) An increased degree of risk aversion causes the required return on the market to go to 10
percent after adjusting for the changed inflation premium.
(3) The expected growth rate increases to 6 percent.
(4) Beta rises to 1.5.
What will be the change in price per share, assuming the stock was in equilibrium before the
changes?
a. +$12.11
b. -$4.87
c. +$6.28
d. -$16.97
e. +$2.78
ANS: B
Numerical solution:
Before: ks = 5% + (8% - 5%)1.3 = 8.9%.

After: ks = 4% + (10% - 4%)1.5 = 13%.

Hence, we have $12.11 - $16.98 = -$4.87.

DIF: Medium OBJ: TYPE: Problem TOP: Equilibrium stock price
119 Chapter 5  Valuation Concepts

45. You are considering an investment in the common stock of Cowher Corp. The stock is expected
to pay a dividend of $2 per share at the end of the year (i.e., 1 = $2.0 ). The stock has a beta equal
to 1.2. The risk-free rate is 6 percent. The market risk premium is 5 percent. The stock's dividend
is expected to grow at some constant rage, g. The stock currently sells for $40 a share. Assuming
the market is in equilibrium, what does the market believe the stock price will be at the end of
three years? (In other words, what is P3?)
a. $40.00
b. $42.35
c. $45.67
d. $46.31
e. $49.00
ANS: E
Step 1 Calculate ks:

ks = kRF + (RPM)
= 6% + (5%)1.2
= 12%.

Step 2 Calculate g:

7% = g

Step 3 Calculate :

= (1 + g)3
= $40(1.07)3
= $49.00
DIF: Medium OBJ: TYPE: Problem TOP: Future stock price
46. A firm expects to pay dividends at the end of each of the next four years of $2.00, $1.50, $2.50,
and $3.50. If growth is then expected to level off at 8 percent, and if you require a 14 percent rate
of return, how much should you be willing to pay for this stock?
a. $67.81
b. $22.49
c. $58.15
d. $31.00
e. $43.97
ANS: E
 Chapter 5  Valuation Concepts 120

Numerical solution:
P4 = ($3.50)(1.08) / (0.06) = $63.00
= $2.00 / (1.14) + $1.50 / (1.14) 2 + $2.50 / (1.14)3 + $3.50 / (1.14)4
+ $63.00 / (1.14)4
= $1.754 + $1.154 + $1.687 + $39.373 = $43.97.
Tabular solution:

= $2.00 (PVIF14%,1) + $1.50 (PVIF14%,2) + $2.50 (PVIF14%,3) + $66.50 (PVIF14%,4)

= $2.00(0.8772) + $1.50(0.7695) + $2.50(0.6750) + $66.50(0.5921)
= $43.97.
Financial calculator solution:
Inputs: = 0; = 2.00; = 1.50; = 2.50; = 66.50; I = 14.
Output: NPV = $43.969  $43.97. = $43.97.
DIF: Medium OBJ: TYPE: Problem TOP: Nonconstant growth stock
47. Eastern Auto Parts' last dividend was D0 = $0.50, and the company expects to experience no
growth for the next 2 years. However, Eastern will grow at an annual rate of 5 percent in the third
and fourth years, and, beginning with the fifth year, it should attain a 10 percent growth rate
which it should sustain thereafter. Eastern has a required rate of return of 12 percent. What should
be the present price per share of Eastern common stock?
a. $19.26
b. $31.87
c. $30.30
d. $20.83
e. $19.95
ANS: D
121 Chapter 5  Valuation Concepts

Tabular solution:

= $0.50(PVIFA12%,2) + $0.525(PVIF12%,3) + $0.5513(PVIF12%,4) + $30.32(PVIF12%,4)

= $0.50(1.6901) + $0.53(0.7718) + $0.55(0.6355) + $30.30(0.6355)
= $0.845 + $0.377 + $0.35 + $19.256 = $20.83.
Financial calculator solution:
Inputs: = 0; = 0.50; = 0.50; = 0.525; = 30.851; I = 12.
Output: NPV = $20.825  $20.83. = $20.83.
DIF: Medium OBJ: TYPE: Problem TOP: Nonconstant growth stock
48. The Satellite Building Company has fallen on hard times. Its management expects to pay no
dividends for the next 2 years. However, the dividend for Year 3, D 3, will be $1.00 per share, and
the dividend is expected to grow at a rate of 3 percent in Year 4, 6 percent in Year 5, and 10
percent in Year 6 and thereafter. If the required return for Satellite is 20 percent, what is the
current equilibrium price of the stock?
a. $0
b. $5.26
c. $6.34
d. $12.00
e. $13.09
ANS: C
 Chapter 5  Valuation Concepts 122

Tabular solution:
= $1.00(PVIF20%,3) + $1.03(PVIF20%,4) + $1.092(PVIF20%,5) + $12.01(PVIF20%,5)
= $1.00(0.5787) + $1.03(0.4823) + $1.092(0.4019) + $12.01(0.4019)
= $0.579 + $0.497 + $0.439 + $4.827 = $6.34.
Financial calculator solution
Inputs: = 0; = 0; Nj = 2; = 1.0; = 1.03; = 13.102.
Output: NPV = $6.34. = $6.34.
DIF: Medium OBJ: TYPE: Problem TOP: Nonconstant growth stock
49. A share of stock has a dividend of D0 = $5. The dividend is expected to grow at a 20 percent
annual rate for the next 10 years, then at a 15 percent rate for 10 more years, and then at a long-
run normal growth rate of 10 percent forever. If investors require a 10 percent return on this
stock, what is its current price?
a. $100.00
b. $82.35
c. $195.50
d. $212.62
e. The data given in the problem are internally inconsistent, i.e., the situation described is
impossible in that no equilibrium price can be produced.
ANS: E
The data in the problem are unrealistic and inconsistent with the requirements of the growth
model; k less than g implies a negative stock price. If k equals g, the denominator is zero, and the
numerical result is undefined. k must be greater than g for a reasonable application of the model.
DIF: Medium OBJ: TYPE: Problem TOP: Supernormal growth stock
50. You are considering the purchase of a common stock that just paid a dividend of $2.00. You
expect this stock to have a growth rate of 30 percent for the next 3 years, then to have a long-run
normal growth rate of 10 percent thereafter. If you require a 15 percent rate of return, how much
should you be willing to pay for this stock?
a. $71.26
b. $97.50
c. $82.46
d. $79.15
123 Chapter 5  Valuation Concepts

e. $62.68
ANS: A

Tabular solution:

= $2.60(PVIF15%,1) + $3.38(PVIF15%,2) + $101.054(PVIF15%,3)

= $2.60(0.8696) + $3.38(0.7561) + $101.054(0.6575) = $71.26.
Financial calculator solution
Inputs: = 0; = 2.60; = 3.38; = 101.054; I = 15.
Output: NPV = $71.26. = $71.26.
DIF: Medium OBJ: TYPE: Problem TOP: Supernormal growth stock
51. DAA's stock is selling for $15 per share. The firm's income, assets, and stock price have been
growing at an annual 15 percent rate and are expected to continue to grow at this rate for 3 more
years. No dividends have been declared as yet, but the firm intends to declare a dividend of D 3 =
$2.00 at the end of the last year of its supernormal growth. After that, dividends are expected to
grow at the firm's normal growth rate of 6 percent. The firm's required rate of return is 18 percent.
The stock is
a. Undervalued by $3.03.
b. Overvalued by $3.03.
c. Correctly valued.
d. Overvalued by $2.25.
e. Undervalued by $2.25.
ANS: B
 Chapter 5  Valuation Concepts 124

Tabular solution:
Calculate expected price of stock, P3, at time = 3

= $2.00(PVIF18%,3) + $17.67(PVIF18%,3)
= $2.00(0.6086) + $17.67(0.6086) = $11.97 versus P0 = $15.
Therefore, it is overvalued by $15.00 - $11.97 = $3.03.
Financial calculator solution
Calculate current expected price of stock,

Inputs: = 0; = 0; Nj = 2; = 19.67; I = 18.

Output: NPV = $11.97. = $11.97.
DIF: Medium OBJ: TYPE: Problem TOP: Supernormal growth stock
52. Berg Inc. has just paid a dividend of $2.00. Its stock is now selling for $48 per share. The firm is
half as risky as the market. The expected return on the market is 14 percent, and the yield on U.S.
Treasury bonds is 11 percent. If the market is in equilibrium, what rate of growth is expected?
a. 13%
b. 10%
c. 4%
d. 8%
e. -2%
ANS: D
Numerical solution:
Required rate of return: ks = 11% + (14% - 11%) 0.5 = 12.5%.
125 Chapter 5  Valuation Concepts

Calculate growth rate using ks:

$6 - $48g = $2 + $2g (Multiply both sides by (0.125 - g)

$50g = $4
g = 0.08 = 8%.
Required return equals total yield (Dividend yield + Capital gains yield).
Dividend yield = $2.16/$48.00 = 4.5%; Capital gains yields = g = 8%.
DIF: Medium OBJ: TYPE: Problem TOP: Stock growth rate
53. You have a chance to purchase a perpetual security that has a stated annual payment (cash flow)
of $50. However, this is an unusual security in that the payment will increase at an annual rate of
5 percent per year; this increase is designed to help you keep up with inflation. The next payment
to be received (your first payment, due in 1 year) will be $52.50. If your required rate of return is
15 percent, how much should you be willing to pay for this security?
a. $350
b. $482
c. $525
d. $556
e. $610
ANS: C
This is the same as a constant growth stock (g = 5%) and can be evaluated using the Gordon
constant growth model:

DIF: Medium OBJ: TYPE: Problem TOP: Value of a "growing perpetuity"

54. Suppose you are willing to pay $30 today for a share of stock which you expect to sell at the end
of one year for $32. If you require an annual rate of return of 12 percent, what must be the
amount of the annual dividend which you expect to receive at the end of Year 1?
a. $2.25
b. $1.00
c. $1.60
d. $3.00
e. $1.95
ANS: C
Total yield = 12%.
Capital gains yield = ($32 - $30)/$30 = 6.67%.
Dividend yield = 12.0% - 6.67% = 5.33%.
Expected dividend = P0(Dividend yield) = $30(0.0533) = $1.60.
DIF: Medium OBJ: TYPE: Problem TOP: Dividend yield
 Chapter 5  Valuation Concepts 126

55. Carlson Products, a constant growth company, has a current market (and equilibrium) stock price
of $20.00. Carlson's next dividend, D1, is forecasted to be $2.00, and Carlson is growing at an
annual rate of 6 percent. Carlson has a beta coefficient of 1.2, and a required rate of return on the
market is 15 percent. As Carlson's financial manager, you have access to insider information
concerning a switch in product lines which would not change the growth rate, but would cut
Carlson's beta which would not change the growth rate, but would cut Carlson's beta coefficient
in half. If you buy the stock at the current market price, what is your expected percentage capital
gain?
a. 23%
b. 33%
c. 43%
d. 53%
e. There would be a capital loss.
ANS: C
Step 1 Calculate ks, the required rate of return

Step 2 Calculate kRF, the risk-free rate

16% = kRF + (15% - kRF)1.2
16% = kRF – 1.2kRF + 18%
0.2kRF = 2%
kRF = 10%

Step 3 Calculate the new stock price and capital gain

New ks = 10% + (15% - 10%)0.6 = 13%.

Therefore, the percentage capital gain is 43%

DIF: Medium OBJ: TYPE: Problem TOP: Capital gains

56. Given the following information, calculate the expected capital gains yield for Chicago Bears
Inc.: beta = 0.6; kM = 15%; kRF = 8%; = $2.00; P0 = $25.00. Assume the stock is in equilibrium
and exhibits constant growth.
a. 3.8%
b. 0%
c. 8.0%
d. 4.2%
e. None of the above.
ANS: D
127 Chapter 5  Valuation Concepts

Required rate of return, ks = 8% + (15% - 8%)0.6 = 12.2%.

Calculate dividend yield and use to calculate capital gains yield:

Capital gains yield = Total yield – Dividend yield = 12.2% - 8% = 4.2%.

Alternative method:

$3.05 - $25g = $2 (Multiply both sides by (0.122 - g))

$25g = $1.05
g = 0.042 = 4.2%
Since the stock is growing at a constant rate, g = Capital gains yield.
DIF: Medium OBJ: TYPE: Problem TOP: Capital gains yield
57. Over the past few years, Swanson Company has retained, on the average, 70 percent of its
earnings in the business. The future retention rate is expected to remain at 70 percent of earnings,
and long-run earnings growth is expected to be 10 percent. If the risk-free rate, k RF, is 8 percent,
the expected return on the market, kM, is 12 percent, Swanson's beta is 2.0, and the most recent
dividend, D0, was $1.50, what is the most likely market price and P/E ratio (P 0/E1) for Swanson's
stock today?
a. $27.50; 5.0x
b. $33.00; 6.0x
c. $25.00; 5.0x
d. $22.50; 4.5x
e. $45.00; 4.5x
ANS: A
Step 1 Calculate the required rate of return

ks = 8% + 2.0(12% - 8%) = 16%

Step 2 Calculate the current market price

Step 3 Calculate the earnings and P/E ratio

= $1.50(1.10) = $1.65 = 0.30E1.

E1 = $1.65/0.30 = $5.50.

DIF: Medium OBJ: TYPE: Problem TOP: Stock price and P/E/ ratios
 Chapter 5  Valuation Concepts 128

58. As financial manager of Material Supplies Inc., you have recently participated in an executive
committee decision to enter into the plastics business. Much to your surprise, the price of the
firm's common stock subsequently declined from $40 per share to $30 per share. While there
have been several changes in financial markets during this period, you are anxious to determine
how the market perceives the relevant risk of your firm. Assume that the market is in equilibrium.
From the following data you find that the beta value associated with your firm has changed from
an old beta of __________ to a new beta of __________.
(1) The real risk-free rate is 2 percent, but the inflation premium has increased from 4 percent to
6 percent.
(2) The expected growth rate has been re-evaluated by security analysts, and a 10.5 percent rate
is considered to be more realistic than the previous 5 percent rate. This change had nothing
to do with the move into plastics; it would have occurred anyway.
(3) The risk aversion attitude of the market has shifted somewhat, and now the market risk
premium is 3 percent instead of 2 percent.
(4) The next dividend, D1, was expected to be $2 per share, assuming the "old" 5 percent growth
rate.
a. 2.00; 1.50
b. 1.50; 3.00
c. 2.00; 3.17
d. 1.67; 2.00
e. 1.50; 1.67
ANS: C
Numerical solution:
Old required returns and beta

0.10 = kRF + (MRP)Old = 0.06 + (0.02)Old; Old = 2.00.

New required return and beta

= $1.905(1.105) = $2.105.

ks, New

0.175 = 0.08 + (0.03) New; New = 3.17.

DIF: Medium OBJ: TYPE: Problem TOP: Beta coefficient
59. The probability distribution for kM for the coming year is as follows:
Probability kM
0.05 7%
0.30 8
0.30 9
0.30 10
0.05 12
If kRF = 6.05% and Stock X has a beta of 2.0, an expected constant growth rate of 7 percent, and
D0 = $2, what market price gives the investor a return consistent with the stock's risk?
129 Chapter 5  Valuation Concepts

a. $25.00
b. $37.50
c. $21.72
d. $42.38
e. $56.94
ANS: D
Numerical solution:
Required return on market and stock
KM = 0.50 (7%) + 0.30 (8%) + 0.30 (9%) + 0.30 (10%) + 0.50 (12%) = 9.05%.
Ks = 6.05% + (9.05% - 6.05%) 2.0 = 12.05%.
Expected equilibrium stock price

DIF: Medium OBJ: TYPE: Problem TOP: Risk and stock value
60. Yesterday BrandMart Supplies paid its common stockholders a dividend equal to $3 per share.
BrandMart expects to pay a $5 per share one year from today. After the $5 dividend is paid, the
company expects its growth rate will remain constant at 4 percent per year forever. If BrandMart's
investors demand a 12 percent rate of return, what should be the current market price of the
company's stock?
a. $62.50
b. $65.00
c. $62.27
d. $37.50
e. None of the above is correct.
ANS: A DIF: Medium OBJ: TYPE: Problem TOP: Stock valuation
61. A corporation has an outstanding bond with the following characteristics:
Coupon interest rate 6.0%
Interest payments semiannually
Face value $1,000.00
Years to maturity 8
Current market value $ 902.81
What is the yield to maturity (YTM) for this bond?
a. 7.9%
b. 6.0%
c. 7.6%
d. 6.2%
e. None of the above is a correct answer.
ANS: C DIF: Medium OBJ: TYPE: Problem TOP: Bond yields
 Chapter 5  Valuation Concepts 130

62. Rick bought a bond when it was issued by Macroflex Corporation 14 years ago. The bond, which
has a $1,000 face value and a coupon rate equal to 10 percent, matures in six years. Interest is
paid every six months; the next interest payment is scheduled for six months from today. If the
yield on similar risk investments is 14 percent, what is the current market value (price) of the
bond?
a. $841.15
b. $1,238.28
c. $904.67
d. $757.26
e. $844.45
ANS: A DIF: Medium OBJ: TYPE: Problem
TOP: Bond value—semiannual payment
63. Devine Divots issued a bond a few years ago that has a face value equal to $1,000 and pays
investors $30 interest every six months. The bond has eight years remaining until maturity. If you
require a 7 percent rate of return to invest in this bond, what is the maximum price you should be
willing to pay to purchase the bond?
a. $761.15
b. $939.53
c. $940.29
d. $965.63
e. $1,062.81
ANS: B DIF: Medium OBJ: TYPE: Problem
TOP: Bond value—semiannual payment
64. Recently, Ohio Hospitals Inc. filed for bankruptcy. The firm was reorganized as American
Hospitals Inc., and the court permitted a new indenture on an outstanding bond issue to be put
into effect. The issue has 10 years to maturity and a coupon rate of 10 percent, paid annually. The
new agreement allows the firm to pay no interest for 5 years. Then, interest payments will be
resumed for the next 5 years. Finally, at maturity (Year 10), the principal plus the interest that was
not paid during the first 5 years will be paid. However, no interest will be paid on the deferred
interest. If the required return is 20 percent, what should the bonds sell for in the market today?
a. $242.26
b. $281.69
c. $578.31
d. $362.44
e. $813.69
ANS: D
131 Chapter 5  Valuation Concepts

Tabular Solution:

Vd = $100 (PVIFA20%, 10 - PVIFA30%, 5) + $1,500 (PVIF20%, 10)

= $100 (4.1925 - 2.9906) + $1,500 (0.1615)
= $120.19 + $242.25 = $363.44.
Financial calculator solution:
Method1. Cash flows:
Inputs: CF0 = 1; CF1 = 0; N = 5; CF2 = 100; Nj = 4; CF5 = 1,600; I = 20.
Output: NPV = $362.44. Vd = $362.44.

Method2. Time value discounting: (Calculate Vd as of Year 5, V5)

Inputs: N = 5; I = 20; PMT = 100; FV = 1,500.
Output: PV5 = -$901.878.
Calculate Vd or PV of V5
Inputs: N = 5; I = 20; FV = 901.878.
Output: PV = -$362.44. Vd = $362.44.
DIF: Tough OBJ: TYPE: Problem TOP: Bond value
65. You are offered a $1,000 par value bond which has a stepped-up coupon interest rate. The annual
coupon rate is 10 percent coupon, payable semiannually ($50 each 6 months) for the first 15
years, and then the annual coupon increases to 13 percent, also payable semiannually, for the next
15 years. The first interest payment will be made 6 months from today, and the $1,000 principal
amount will be returned at the end of Year 30. You currently have savings in an account which is
earning a 9 percent simple rate, but with quarterly compounding; this is your opportunity cost for
purposes of analyzing the bond. What is the value of the bond to you today?
a. $1,614.53
b. $1,419.18
c. $1,306.21
d. $1,250.25
e. $1,155.98
ANS: E

Financial calculator solution:

Step 1 Calculate the semiannual effective rate on the 9% account. We must discount the
semiannual payment bond with a semiannual effective rate. Match the semiannual
payment period with a semiannual rate, using the interest rate conversion feature:

Inputs: NOM% = 9.0/2 = 4.5%; P/YR = 2. Output: EFF% = 4.55%.

 Chapter 5  Valuation Concepts 132

Step 2 Use the semiannual effective rate to discount the bond cash flows:
Inputs: = 0; = 50; Nj = 30; = 65; Nj = 29; = 1065; I = 4.55.
Output: NPV = $1,155.98 = Vd.

The value of the stepped-up coupon bond is $1,155.98.

DIF: Tough OBJ: TYPE: Problem TOP: Bond value
66. Philadelphia Corporation's stock recently paid a dividend of $2.00 per share (D 0 = $2), and the
stock is in equilibrium. The company has a constant growth rate of 5 percent and a beta equal to
1.5. The required rate of return on the market is 15 percent, and the risk-free rate is 7 percent.
Philadelphia is considering a change in policy which will increase its beta coefficient to 1.75. If
market conditions remain unchanged, what new constant growth rate will cause the common
stock price of Philadelphia to remain unchanged?
a. 8.85%
b. 18.53%
c. 6.77%
d. 5.88%
e. 13.52%
ANS: C
Calculate the initial required return and equilibrium price
ks = 0.07 + (0.08)1.5 = 0.19 = 19%.

Calculate the new required return and equilibrium growth rate

New ks = 0.07 + (0.08)1.75 = 0.21.

3.15 – 2.0 = 2g + 15g (Multiply both sides by 15, combine like terms.)
1.15 = 17g
g = 0.06765  6.77%
DIF: Tough OBJ: TYPE: Problem TOP: Constant growth stock
67. Hard Hat Construction's stock is currently selling at an equilibrium price of $30 per share. The
firm has been experiencing a 6 percent annual growth rate. Last year's earnings per share, E 0,
were $4.00, and the dividend payout ratio is 40 percent. The risk-free rate is 8 percent, and the
market risk premium is 5 percent. If systematic risk (beta) increases by 50 percent, and all other
factors remain constant, by how much will the stock price change? (Hint: Use four decimal places
in your calculations.)
a. -$7.33
b. +$7.14
c. -$15.00
d. -$15.22
e. +$22.63
ANS: A
Calculate the required rate of return
D0 = E0(Payout ratio) = $4.00(0.40) = $1.60.
133 Chapter 5  Valuation Concepts

Calculate beta
11.65% = 8% + (5%)β; β = 0.73.
Calculate the new beta
New = 0.73(1.5) = 1.095.
Calculate the new required rate of return
ks = 8% + (5%)1.095 = 13.475%  13.48%.
Calculate the new expected equilibrium stock price

Change in stock price = $30 - $22.67 = $7.33 decrease.

DIF: Tough OBJ: TYPE: Problem TOP: Risk and stock price
68. The Hart Mountain Company has recently discovered a new type of kitty litter which is extremely
absorbent. It is expected that the firm will experience (beginning now) an unusually high growth
rate (20 percent) during the period (3 years) it has exclusive rights to the property where the raw
material used to make this kitty litter is found. However, beginning with the fourth year the firm's
competition will have access to the material, and from that time on the firm will achieve a normal
growth rate of 8 percent annually. During the rapid growth period, the firm's dividend payout
ratio will be relatively low (20 percent) in order to conserve funds for reinvestment. However, the
decrease in growth in the fourth year will be accompanied by an increase in dividend payout to 50
percent. Last year's earnings were E0 = $2.00 per share, and the firm's required return is 10
percent. What should be the current price of the common stock?
a. $66.50
b. $87.96
c. $71.53
d. $61.78
e. $93.50
ANS: C
 Chapter 5  Valuation Concepts 134

Tabular solution:

= $0.48(PVIF10%,1) + $0.576(PVIF10%,2) + $0.691(PVIF10%,3) + $93.30(PVIF10%,3)

= $0.48(0.9091) + $0.576(0.8264) + $0.691(0.7513) + $93.30(0.7513)
= $0.436 + $0.476 + $0.519 + $70.096 = $71.53.
Financial calculator solution:
Inputs: = 0; = 0.48; = 0.576; = 93.991; I = 10.
Output: NPV = $71.53. = $71.53.
DIF: Tough OBJ: TYPE: Problem TOP: Supernormal growth stock
69. NYC Company has decided to make a major investment. The investment will require a
substantial early cash outflow, and inflows will be relatively late. As a result, it is expected that
the impact on the firm's earnings for the first 2 years will cause a negative growth of 5 percent
annually. Further, it is anticipated that the firm will then experience 2 years of zero growth, after
which it will begin a positive annual sustainable growth of 6 percent. If the firm's required return
is 10 percent and its last dividend, D0, was $2 per share, what should be the current price per
share?
a. $32.66
b. $47.83
c. $53.64
d. $38.47
e. $42.49
ANS: D
135 Chapter 5  Valuation Concepts

Numerical solution:
= $1.90(PVIF10%,1) + $1.805(PVIFA10%,3)(PVIF10%,1) + $47.825(PVIF10%,4)
= $1.90(0.9091) + $1.805(2.4869)(0.9091) + $47.825(0.6830)
= $38.47.
Financial calculator solution:
Inputs: = 0; = 1.90; = 1.805; Nj = 2; = 49.63; I = 10.
Output: NPV = $38.47. = $38.47.
DIF: Tough OBJ: TYPE: Problem TOP: Nonconstant growth stock
70. Club Auto Parts' last dividend, D0, was $0.50, and the company expects to experience no growth
for the next 2 years. However, Club will grow at an annual rate of 5 percent in the third and
fourth years, and, beginning with the fifth year, it should attain a 10 percent growth rate which it
will sustain thereafter. Club has a required rate of return of 12 percent. What should be the price
per share of Club stock at the beginning of the third year, P2?
a. $19.98
b. $25.06
c. $31.21
d. $19.48
e. $27.55
ANS: B
 Chapter 5  Valuation Concepts 136

Tabular solution:

= $0.525(PVIF12%,1) + $0.551(PVIF12%,2) + $30.30(PVIF12%,2)

= $0.525(0.8929) + $0.551(0.7972) + $30.30(0.7972) = $25.06.
Financial calculator solution:
Calculate the PV of the stock's expected cash flows as of time = 2; thus, = 0; = 0.525,
which is D3; = 30.851, which is actually + .

Inputs: = 0; = 0.525; = 30.851; I = 12.

Output: NPV = $25.06. = $25.06.
DIF: Tough OBJ: TYPE: Problem TOP: Nonconstant growth stock
71. Modular Systems Inc. just paid dividend D0, and it is expecting both earnings and dividends to
grow by 0 percent in Year 2, by 5 percent in Year 3, and at a rate of 10 percent in Year 4 and
thereafter. The required return on Modular is 15 percent, and it sells at its equilibrium price, P 0 =
$49.87. What is the expected value of the next dividend, ? (Hint: Draw a time line and then set up
and solve an equation with the unknown, .)
a. It cannot be estimated without more data.
b. $1.35
c. $1.85
d. $2.35
e. $2.85
ANS: E
137 Chapter 5  Valuation Concepts

Numerical solution:
P0 = $49.87.

$49.87 = 0.8696 = 0.7561 = 0.6904 = 15.1886

$49.87 = 17.5047
= $2.85.
DIF: Tough OBJ: TYPE: Problem TOP: Nonconstant growth stock
72. The Florida Boosters Association has decided to build new bleachers for the football field. Total
costs are estimated to be $1 million, and financing will be through a bond issue of the same
amount. The bond will have a maturity of 20 years, a coupon rate of 8 percent, and has annual
payments. In addition, the Association must set up a reserve to pay off the loan by making 20
equal annual payments into an account which pays 8 percent, annual compounding. The interest-
accumulated amount in the reserve will be used to retire the entire issue at its maturity 20 years
hence. The Association plans to meet the payment requirements by selling season tickets at $10
net profit per ticket. How many tickets must be sold each year to service the debt, i.e., to meet the
interest and principal repayment requirements?
a. 5,372
b. 10,186
c. 15,000
d. 20,459
e. 25,000
ANS: B

Tabular solution:
Long way
Annual interest:
0.08 ($1,000,000) = $80,000.
Annual reserve:
FB = $1,000,000 = PMT (FVIFA8%, 20) = PMT (45.762),
PMT = $1,000,000/45.762 = $21,852.19 = $21,852 per year.
Total annual payment: $80,000 + $21,852 = $101,852.
Total number of tickets = $101,852/$10  10,186.*
* Rounded up to next whole ticket.
Short way
PV = $1,000,000 = PMT (PVIFA8%, 20).
 Chapter 5  Valuation Concepts 138

PMT = $1,000,000/9.8181 = $101,852.70.

Note: Short way works only if bond yield = investment rate.
Financial calculator solution:
Long way
Inputs: N = 20; I = 8; FV = 1.000.000.
Output: PMT = -$21,852.21.
Add coupon interest and reserve payment together
Annual PMTTotal = $80,000 + $21,852.21 = $101,852.21.
Total number of tickets = $101,852.21/$10.00 = 10,185.22  10.186.*
*Rounded up to next whole ticket.
Short way
Inputs: N = 20; I = 8; PV = 1,000,000; FV = 0.
Output: PMT = -$101,852.21.
Total number of tickets = $101,852.21/$10.00  10,186.*
* Rounded up to next whole ticket.
DIF: Tough OBJ: TYPE: Problem TOP: Loan amortization
73. Laserclok Corporation paid a dividend for 50 years until it experienced financial difficulty three
years ago, at which time the dividend payment was suspended (that is, a dividend has not been
paid during the past three years). The company is now much stronger financially, but Laserclok
does not expect to pay a dividend for the next five years. Beginning six years from today, the
company will pay a dividend equal to $2.10, which is 5 percent greater than the last dividend paid
three years ago. After the dividend payments start again, Laserclok expects the dividend to
continue to be paid and to grow at a constant rate of 5 percent. If the appropriate market rate for
investments similar to Laserclok's stock is 15 percent, at what price should the stock currently be
selling in the financial markets?
a. $21.00
b. $10.44
c. $14.00
d. There is not enough information to answer the question.
e. None of the above.
ANS: B DIF: Tough OBJ: TYPE: Problem
TOP: Nonconstant growth stock

Financial Calculator Section

The following question(s) may require the use of a financial calculator.

74. Tony's Pizzeria plans to issue bonds with a par value of $1,000 and 10 years to maturity. These
bonds will pay $45 interest every 6 months. Current market conditions are such that the bonds
will be sold to net $937.79. What is the YTM of the issue as a broker would quote it to an
investor?
a. 11%
b. 10%
c. 9%
d. 8%
e. 7%
ANS: B
139 Chapter 5  Valuation Concepts

Financial calculator solution:

Inputs: N = 20; PV = -937.79; PMT = 45; FV = 1,000
Output: I = 5.0% per period. kd = YTM = 5.0%  2 periods = 10%
DIF: Easy OBJ: TYPE: Financial Calculator TOP: Yield to maturity
75. The current market price of Smith Corporation's 10 percent, 10-year bonds is $1,297.58. A 10
percent coupon interest rate is paid semiannually, and the par value is equal to $1,000. What is the
YTM (stated on a simple, or annual, basis) if the bonds mature 10 years from today?
a. 8%
b. 6%
c. 4%
d. 2%
e. 1%
ANS: B

Financial calculator solution:

Inputs: N = 20; PV = -1,297.58; PMT = 50; FV = 1,000
Output: I = 3.0% per period. kd = YTM = 3.0%  2 periods = 6%
DIF: Easy OBJ: TYPE: Financial Calculator TOP: Yield to maturity
76. Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for
1 year, 5 percent the next year, then 6 percent for the following year, and then the growth rate is
expected to be a constant 7 percent thereafter. The required rate of return on equity (k s) is 10
percent. What is the current price of the common stock?
a. $53.45
b. $60.98
c. $64.49
d. $67.47
e. $69.21
ANS: D
 Chapter 5  Valuation Concepts 140

Enter in calculator = 0, = 2.08, = 2.1840, and = 84.8833.

Then enter I = 10, and press NPV to get NPV = P 0 = $67.47.
DIF: Easy OBJ: TYPE: Financial Calculator TOP: Nonconstant growth stock
77. A $1,000 par value bond sells for $1,216. It matures in 20 years, has a 14 percent coupon, pays
interest semiannually, and can be called in 5 years at a price of $1,100. What is the bond's YTM?
a. 6.05%
b. 10.00%
c. 10.06%
d. 8.59%
e. 11.26%
ANS: E

Financial calculator solution:

Inputs: N = 40; PV = -1,216; PMT = 70; FV = 1,000
Output: I = 5.6307  5.63% = kd/2. YTM 5.63%  2 = 11.26%
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Yield to maturity
78. You have just been offered a $1,000 par value bond for $847.88. The coupon rate is 8 percent,
payable annually, and interest rates on new issues of the same degree of risk are 10 percent. You
want to know how many more interest payments you will receive, but the party selling the bond
cannot remember. Can you determine how many interest payments remain?
a. 14
b. 15
c. 12
d. 20
e. 10
ANS: B
141 Chapter 5  Valuation Concepts

Financial calculator solution:

Inputs: I = 10; PV = -$847.88; PMT = 80. FV = 1,000
Output: N = 15 Years.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Interest payments remaining
79. Garcia Inc. has a current dividend of $3.00 per share (D 0 = $3.00). Analysts expect that the
dividend will grow at a rate of 25 percent a year for the next three years, and thereafter it will
grow at a constant rate of 10 percent a year. The company's cost of equity capital is estimated to
be 15 percent. What is the current stock price of Garcia Inc.?
a. $75.00
b. $88.55
c. $95.42
d. $103.25
e. $110.00
ANS: C

Step 1 Find the dividend stream to D3:

= $3.00
= ($3.00)(1.25) = $3.7500
= ($3.75)(1.25) = $4.6875
= ($4.6875)(1.25) = $5.8594

Step 2 Find :

Step 3 Find the NPV of the cash flows, the stock's value:
=0
= 3.7500
= 4.6875
 Chapter 5  Valuation Concepts 142

= 134.7654
I = 15
Solve for NPV = $95.42.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Nonconstant growth stock
80. Worldwide Inc., a large conglomerate, has decided to acquire another firm. Analysts are
forecasting a period (2 years) of extraordinary growth (20 percent), followed by another 2 years
of unusual growth (10 percent), and finally a normal (sustainable) growth rate of 6 percent
annually. If the last dividend was D0 = $1.00 per share and the required return is 8 percent, what
should the market price be today?
a. $93.70
b. $72.76
c. $99.66
d. $98.57
e. $68.87
ANS: B

Financial calculator solution:

Inputs: = 0; = 1.20; = 1.44; = 1.584; = 94.092; I = 8.
Output: NPV = $72.764  $72.76. = $72.76.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Supernormal growth stock
81. Assume that the average firm in your company's industry is expected to grow at a constant rate of
5 percent, and its dividend yield is 4 percent. You company is about as risky as the average firm
in the industry, but it has just developed a line of innovative new products which leads you to
expect that its earnings and dividends will grow at a rate of 40 percent. ( = D 0 ((1 + g) = D0
(1.40)) this year and 25 percent the following year, after which growth should match the 5 percent
industry average rate. The last dividend paid (D0) was $2. What is the value per share of your
firm's stock?
a. $42.60
b. $82.84
c. $91.88
143 Chapter 5  Valuation Concepts

d. $101.15
e. $110.37
ANS: B

ks = Dividend yield + g = 0.04 + 0.05 = 0.09  9%.

Financial calculator solution:
Inputs: = 0; = 2.80; = 95.375; I = 9.
Output: NPV = $82.84; = $82.84.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Stock valuation
82. Assume that McDonald's and Burger King have similar $1,000 par value bond issues outstanding.
The bonds are equally risky. The Burger King bond has interest payments of $80 paid annually
and matures 20 years from today. The McDonald's bond has interest payments of $80 paid
semiannually, and it also matures in 20 years. If the simple required rate of return, k d, is 12
percent, semiannual basis, for both bonds, what is the difference in current market prices of the
two bonds?
a. No difference.
b. $2.20
c. $3.77
d. $17.53
e. $6.28
ANS: D
 Chapter 5  Valuation Concepts 144

Financial calculator section:

Burger King Vd
Calculate EAR to apply to Burger King bonds using interest rate conversion feature, and
calculate the value VBK, of Burger King bonds:
Inputs: P/YR = 2; NOM% = 12. Output: EFF% = EAR = 12.36%
Inputs: N = 20; I = 12.36; PMT = 80; FV = 1,000. Output: PV = -$681.54
McDonalds
Inputs: N = 40; I = 6; PMT = 40; FV = 1.000
Output: PV = $699.07
Calculate the difference between the two bonds' PVs
Difference: Vd(McD) - Vd(BK) = 699.07 - 681.54 = $17.53
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Bond value
83. An 8 percent annual coupon, noncallable bond has ten years until it matures and a yield to
maturity of 9.1 percent. What should be the price of a 10-year bond of equal risk which pays an 8
percent semiannual coupon? Assume both bonds have a maturity value of $1,000.
a. $898.64
b. $736.86
c. $854.27
d. $941.08
e. $964.23
ANS: D
Step 1: Determine the interest rate to use in order to evaluate the semiannual bond's price:

In order for the 2 bonds to be of equal risk, their effective YTM must be equal. The
annual bond's nominal YTM = effective YTM = 9.1%. Thus, we need to calculate the
semiannual bond's nominal YTM.

With a financial calculator:

EFF% = 9.1
P/YR = 2
Solve for NOM% = 8.9019%.

Note that this is stated on an annual basis. To convert to a semiannual basis divide it
by 2:
8.9019%/2 = 4.451%.
145 Chapter 5  Valuation Concepts

Step 2: Calculate the semiannual bond's price:

N = 20
I = 4.451
PMT = 40
FV = 1,000
Solve for PV = $941.08.
DIF: Tough OBJ: TYPE: Financial Calculator
TOP: Bond value—semiannual payment
84. Fish & Chips Inc. has two bond issues outstanding, and both sell for $701.22. The first issue has a
coupon rate of 8 percent and 20 years to maturity. The second has an identical yield to maturity as
the first bond, but only 5 years until maturity. Both issues pay interest annually. What is the
annual interest payment on the second issue?
a. $120.00
b. $37.12
c. $56.42
d. $29.68
e. $11.16
ANS: B

Financial calculator solution:

Calculate YTM or kd for first issue
Inputs: N = 20; PV = -701.22; PMT = 80; FV = 1,000. Output: I = 12%
Calculate PMT on second issue using 12% = kd = YTM
Inputs: N = 20; PV = -701.22; FV = 1,000
Output: PMT = $37.116  $37.12
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Bond interest payments
85. A two-year zero-coupon Treasury bond with a maturity value of $1,000 has a price of $873.4387.
A one-year zero-coupon Treasury bond with a maturity value of $1,000 has a price of $938.9671.
If the pure expectations theory is correct, for what price should one-year zero-coupon Treasury
bonds sell one year from now?
a. $798.89
b. $824.66
c. $852.28
d. $930.23
e. $989.11
 Chapter 5  Valuation Concepts 146

ANS: D
First find the yields on one-year and two-year zero-coupon bonds, so you can find the implied
rate on a one-year bond, one year from now. Then use this implied rate to find its price.
1-year 2-year
N= 1 N= 2
PV = -938.9671 PV = -873.4387
PMT = 0 PMT = 0
FV = 1,000 FV = 1,000
Solve for I = 6.5% Solve for I = 7.0%
Therefore, if the implied rate = 

Now find the price of a 1-year zero, 1 year from now:

N =1
I = 7.5
PMT =0
FV = 1,000
Solve for PV = $930.23.
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Zeros and expectations theory
86. A four-year, zero-coupon Treasury bond sells at a price of $762.8952. A three-year, zero-coupon
Treasury bond sells at a price of $827.8491. Assuming the pure expectations theory is correct,
what does the market believe the price of one-year, zero-coupon bonds will be in three years?
a. $921.66
b. $934.58
c. $938.97
d. $945.26
e. $950.47
ANS: A

Step 1 Calculate the YTM for the 3-year zero:

N= 3
PV = -827.8491
PMT = 0
FV = 1,000
Solve for I = 6.5%

Step 2 Calculate the YTM for the 4-year zero:

N= 4
PV = -762.8952
PMT = 0
147 Chapter 5  Valuation Concepts

FV = 1,000
Solve for I = 7%

Step 3 Calculate the interest rate on a 1-year zero, 3 years from now:

 = 8.5%.

Step 4 Calculate the price of a 1-year zero 3 years from now:

N= 1
I= 8.5
PMT = 0
FV = 1,000
Solve for PV = $921.66.
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Zeros and expectations theory
87. Assume that you would like to purchase 100 shares of preferred stock that pays an annual
dividend of $6 per share. However, you have limited resources now, so you cannot afford the
purchase price. In fact, the best that you can do now is to invest your money in a bank account
earning a simple interest rate of 6 percent, but where interest is compounded daily (assume a 365-
day year). Because the preferred stock is riskier, it has a required annual rate of return of 12
percent (assume that this rate will remain constant over the next 5 years). For you to be able to
purchase this stock at the end of 5 years, how much must you deposit in your bank account today,
at t = 0?
a. $2,985.00
b. $4,291.23
c. $3,138.52
d. $3,704.18
e. $4,831.25
ANS: D

Numerical solution:

Amount needed to buy 100 shares:

$50(100) = $5,000
$5,000 = PV(1 + 0.06/365)5(365)
$5,000 = PV(1.3498)
PV = $3,704.18.
Financial calculator solution:
Convert the simple interest rate to an EAR
 Chapter 5  Valuation Concepts 148

Inputs: P/YR = 365; NOM% = 6. Output: EFF% = EAR = 6.183%.

Calculate PV of deposit required today
Inputs: N = 5; I = 6.183; FV = 5,000.
Output: PV = -$3,704.205  -$3,704.21.
Note: The numerical solution is used as the correct answer because of its greater precision. If the
financial calculator derived EAR is expressed to five decimal places it yields a PV = -3,704.18.
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Preferred stock value
88. A financial analyst has been following Fast Start Inc., a new high-growth company. She estimates
that the current risk-free rate is 6.25 percent, the market risk premium is 5 percent, and that Fast
Start's beta is 1.75. The current earnings per share (EPS 0) is $2.50. The company has a 40 percent
payout ratio. The analyst estimates that the company's dividend will grow at a rate of 25 percent
this year, 20 percent next year, and 15 percent the following year. After three years the dividend is
expected to grow at a constant rate of 7 percent a year. The company is expected to maintain its
current payout ratio. The analyst believes that the stock is fairly priced. What is the current price
of the stock?
a. $16.51
b. $17.33
c. $18.53
d. $19.25
e. $19.89
ANS: C
a. Use the SML equation to solve for ks.
ks = 0.0625 + (0.05)(1.75) = 0.15 = 15%.

b. Calculate dividend per share, D0:

(EPS0)(Payout ratio) = D0
($2.50)(0.4) = $1.00.

c. Calculate the dividend and price stream (once the stock becomes a constant growth stock):

D0 = $1.00; D1 = $1.00  1.25 = $1.25; D2 = $1.25  1.20 = $1.50; D3 = $1.50  1.15 =

$1.725; D4 = $1.725  1.07 = $1.8458.

d. Put all the cash flows on a cash flow time line:

149 Chapter 5  Valuation Concepts

e. Finally, use the cash flow register to calculate PV:

= 0; = 1.25; = 1.50; = 24.797; I = 15%.
Solve for NPV = $18.53.
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Nonconstant growth stock
89. Assume an all equity firm has been growing at a 15 percent annual rate and is expected to
continue to do so for 3 more years. At that time, growth is expected to slow to a constant 4
percent rate. The firm maintains a 30 percent payout ratio, and this year's retained earnings net of
dividends were $1.4 million. The firm's beta is 1.25, the risk-free rate is 8 percent, and the market
risk premium is 4 percent. If the market is in equilibrium, what is the market value of the firm's
common equity (1 million shares outstanding)?
a. $6.41 million
b. $12.96 million
c. $9.18 million
d. $10.56 million
e. $7.32 million
ANS: C

Calculate required rate of return

ks = 8% + 4%(1.25) = 13.0%.
Calculate net income, total dividends, and D0
Net income = $1.4 million / (1 – payout ratio)
= $1.4 million / 0.7 = $2.0 million
Dividends = $2.0 million  0.3 = $0.6 million
D0 = $600,000 / 1,000,000 shares = $0.60
Financial calculator solution:
Inputs: = 0; = 0.69; = 0.794; = 11.469; I = 13.
Output: NPV = $9.18; = P0 = $9.18.
Total market value = P0  shares outstanding = $9.18  1,000,000 = $9,180,000.
DIF: Tough OBJ: TYPE: Financial Calculator TOP: Firm valuation