Chapter (7): Stock Valuation

What is a “Stock”? an ownership share in a company.

What are the main Differences Between Debt (Bond) and Equity (Stock) ?

What is a Stock Valuation?

Common Stock Valuation Methods →

Zero Growth Model

Constant Growth Model
Variable Growth Model
Free Cash Flow Model
Other approaches to common stock valuation
 Questions Part
\
True or False
1) The most important factors influencing a stock's current price are its past earnings and
dividends.
Answer: FALSE
2) The key to the future financial success of a company lies in the sales growth and the net
profit margin.
Answer: TRUE
Answer: TRUE
4) A company's estimated future earnings and its P/E ratio can be used to estimate the stock's
future price.
Answer: TRUE
5) The estimated price of a stock in the future is important because it includes the projected
capital gain on the stock.
Answer: TRUE
6) The first step in predicting a stock's future price is to forecast profits.
Answer: FALSE
7) If net income rises, but the number of shares outstanding remains the same, EPS will rise.
Answer: TRUE
8) A temporary decline in earnings per share usually results in a temporary reduction of
dividends.
Answer: FALSE
9) A stock will be an attractive investment if the required rate of return exceeds the expected
rate of return.
Answer: FALSE
10) Both beta and the expected return on the market portfolio incorporate risk into the Capital
Asset Pricing Model.
Answer: TRUE
11) The required rate of return denotes the minimum rate of return an investor should expect.
Answer: TRUE
12) The required rate of return estimated by the Capital Asset Pricing Model is not suitable for
use in dividend valuation models.
Answer: FALSE
13) If the annual dividend on a stock never changes, its price will never change.
Answer: FALSE
14) The free cash flow to equity approach does not require that a stock pay dividends.
Answer: TRUE
15) The constant growth dividend valuation model works best for mature companies with a long record of paying
dividends.
Answer: TRUE
16) The free cash flow to equity approach does not require present value calculations.
Answer: FALSE
17) An option to purchase common stock is a type of Debt security.
Answer: FALSE
18) Holders of equity have claims on both income and assets that are secondary to the claims of creditors.
Answer: TRUE
19) The tax deductibility of interest lowers the cost of debt financing, thereby causing the cost of debt financing to
be lower than the cost of equity financing.
Answer: TRUE
20) Unlike creditors, equity holders are owners of the firm.
Answer: TRUE
21) Unlike equity holders, creditors are owners of the firm.
Answer: FALSE
22) Interest paid to bondholders is tax deductible but interest paid to stockholders is not.
Answer: FALSE
23) Interest paid to bondholders is tax deductible but dividends paid to stockholders is not.
Answer: TRUE
24) In the case of liquidation, common stockholders are paid first, followed by preferred stockholders, followed by
bondholders.
Answer: FALSE
25) In the case of liquidation, bondholders are paid first, followed by preferred stockholders, followed by common
stockholders.
Answer: TRUE
26) The free cash flow valuation model can be used to determines the value of an entire company as the present
value of its expected free cash flows discounted at the firm's weighted average cost of capital.
Answer: TRUE
27) The constant growth model is an approach to dividend valuation that assumes a constant future dividend.
Answer: FALSE
28) The constant growth model is an approach to dividend valuation that assumes that dividends grow at a constant
rate indefinitely.
Answer: TRUE
29) The free cash flow valuation model is based on the same principle as the P/E valuation approach; that is, the
value of a share of stock is the present value of future cash flows.
Answer: FALSE
30) The free cash flow valuation model is based on the same principle as dividend valuation models; that is, the
value of a share of stock is the present value of future cash flows.
Answer: TRUE
31) Any action taken by the financial manager that increases risk will also increase the required return.
Answer: TRUE
32) In common stock valuation, any action taken by the financial manager that increases risk will cause an increase
the required return.
Answer: TRUE
33) In common stock valuation, any action taken by the financial manager that increases risk will cause an increase
in value.
Answer: FALSE
34) Assuming that economic conditions remain stable, any management action that would cause current and
prospective stockholders to raise their dividend expectations should decrease the firm's value.
Answer: FALSE

MCQs
1) Equity capital can be raised through
A) the money market.
B) the NYSE bond market.
C) retained earnings and the stock market.
D) a private placement with an insurance company as the creditor.
Answer: C
2) Holders of equity capital
A) own the firm.
B) receive interest payments.
C) receive guaranteed income.
D) have loaned money to the firm.
Answer: A
3) As a form of financing, equity capital
A) has a maturity date.
B) is only liquidated in bankruptcy.
C) is temporary.
D) has priority over bonds.
Answer: B
6) Key differences between common stock and bonds include all of the following EXCEPT
A) common stockholders have a voice in management; bondholders do not.
B) common stockholders have a senior claim on assets and income relative to bondholders.
C) bonds have a stated maturity but stock does not.
D) interest paid to bondholders is tax-deductible but dividends paid to stockholders are not.
Answer: B
7) Key differences between common stock and bonds include all of the following EXCEPT
A) common stockholders have a voice in management; bondholders do not.
B) common stockholders have a junior claim on assets and income relative to bondholders.
C) bonds have a stated maturity but stock does not.
D) dividends paid to bondholders are tax-deductible but interest paid to stockholders is not.
Answer: D
8) Another term sometimes applied to a common shareholder is a
A) fundamental or basic owner of the firm.
B) residual owner of the firm.
C) net owner of the firm.
D) reciprocal owner of the firm.
Answer: B
7) The single most important issue in the stock valuation process is a company's
A) past earnings record.
B) historic dividend growth rate.
C) expected future returns.
D) capital structure.
Answer: C
9) The value of a stock is a function of
A) future returns.
B) historic dividend growth rate.
C) most recent earnings per share.
D) past returns.
Answer: A
11) Which of the following will affect the firm's future cash flows?
I. state of the economy
II. state of the industry
III. the firm's recent and current earnings
IV. new products in the firm's pipeline
A) I, II and III only
B) I, II and IV only
C) I, III and IV only
D) I, II, III and IV
Answer: B
14) Which of the following will most directly influence a company's market value?
A) the state of the economy
B) the book value of its assets
C) the use of financial leverage
D) its future cash flows
Answer: D
12) In the Capital Asset Pricing Model, which of the following factors are used to determine the
required rate of return?
I. the risk-free interest rate
II. future cash flows
III. expected return on the market portfolio
IV. beta
A) I and II only
B) I, II and III only
C) II, III and IV only
D) I, III and IV only
Answer: D
13) The most uncertain value used in the Capital Asset Pricing Model is
A) beta.
B) the risk-free rate.
C) expected return on the market.
D) all are equally uncertain.
Answer: C
20) One stock valuation model holds that the value of a share of stock is a function of its future dividends, and that
the dividends will increase at an annual rate which will remain unchanged over time. This stock valuation model is
known as the
A) approximate yield model.
B) holding period return model.
C) dividend reinvestment model.
D) constant growth dividend valuation model.
Answer: D
30) The variable-growth dividend valuation model
A) develops the value of a stock using the future value of dividends minus a rate of capital gain growth.
B) is valuable because it accounts for the general growth patterns of most companies.
C) is invalid if at any point in time the growth rate exceeds the required rate of return.
D) assumes the rate of dividend growth will vary indefinitely.
Answer: B
14) An investor should purchase a stock when
A) the market price exceeds the intrinsic value.
B) the expected rate of return equals or exceeds the required return.
C) the capital gains rate is less than the required return and no dividends are paid.
D) the market price is greater than the justified price.
Answer: B
46) All of the following are characteristics of common stock EXCEPT
A) voting rights which permit selection of the firm's directors.
B) claims on income and assets which are subordinate to the creditors of the firm.
C) fully tax-deductible dividends.
D) no fixed payment obligation.
Answer: C
The ________ is utilized to value preferred stock.
A) constant growth model
B) variable growth model
C) zero-growth model
D) Gordon model
Answer: C
58) In the Gordon model, the value of the common stock is the
A) net value of all assets which are liquidated for their exact accounting value.
B) actual amount each common stockholder would expect to receive if the firm's assets are sold, creditors and
preferred stockholders are repaid, and any remaining money is divided among the common stockholders.
C) present value of a non-growing dividend stream.
D) present value of a constant, growing dividend stream.
Answer: D
59) Emmy Lou, Inc. has an expected dividend next year of $5.60 per share, a growth rate of dividends of 10 percent,
and a required return of 20 percent. The value of a share of Emmy Lou, Inc.'s common stock is ________.
A) $28.00
B) $56.00
C) $22.40
D) $18.67
Answer: B
60) A firm has experienced a constant annual rate of dividend growth of 9 percent on its common stock and expects
the dividend per share in the coming year to be $2.70. The firm can earn 12 percent on similar risk involvements.
The value of the firm's common stock is
A) $22.50/share.
B) $9/share.
C) $90/share.
D) $30/share.
Answer: C
61) You are planning to purchase the stock of Ted's Sheds Inc. and you expect it to pay a dividend of $3 in 1 year,
$4.25 in 2 years, and $6.00 in 3 years. You expect to sell the stock for $100 in 3 years. If your required return for
purchasing the stock is 12 percent, how much would you pay for the stock today?
A) $75.45
B) $77.24
C) $81.52
D) $85.66
Answer: C
62) Nico Corporation's common stock is expected to pay a dividend of $3.00 forever and currently sells for $21.42.
What is the required rate of return?
A) 10%
B) 12%
C) 13%
D) 14%
Answer: D
63) Julian is considering purchasing the stock of Pepsi Cola because he really loves the taste of Pepsi. What should
Julian be willing to pay for Pepsi today if it is expected to pay a $2 dividend in one year and he expects dividends to
grow at 5 percent indefinitely? Julian requires a 12 percent return to make this investment.
A) $28.57
B) $29.33
C) $31.43
D) $43.14
Answer: A
64) Nico Corporation's common stock currently sells for $180 per share. Nico just paid a dividend of $10.18 and
dividends are expected to grow at a constant rate of 6 percent forever. If the required rate of return is 12 percent,
what will Nico Corporation's stock sell for one year from now?
A) $190.80
B) $187.04
C) $195.40
D) $179.84
Answer: A
65) Tangshan China Company's stock is currently selling for $80.00 per share. The expected dividend one year from
now is $4.00 and the required return is 13 percent. What is Tangshan's dividend growth rate assuming that dividends
are expected to grow at a constant rate forever?
A) 8%
B) 9%
C) 10%
D) 11%
Answer: A
66) Tangshan China's stock is currently selling for $160.00 per share and the firm's dividends are expected to grow
at 5 percent indefinitely. Assuming Tangshan China's most recent dividend was $5.50, what is the required rate of
return on Tangshan's stock?
A) 7.3%
B) 8.6%
C) 9.5%
D) 10.6%
Answer: B
67) Nico Custom Cycles' common stock currently pays no dividends. The company plans to begin paying dividends
beginning 3 years from today. The first dividend will be $3.00 and dividends will grow at 5 percent per year
thereafter. Given a required return of 15 percent, what would you pay for the stock today?
A) $25.33
B) $18.73
C) $29.86
D) $20.72
Answer: D
68) Jia's Fashions recently paid a $2 annual dividend. The company is projecting that its dividends will grow by 20
percent next year, 12 percent annually for the two years after that, and then at 6 percent annually thereafter. Based on
this information, how much should Jia's Fashions common stock sell for today if her required return is 10.5%?
A) $54.90
B) $60.80
C) $66.60
D) $69.30
Answer: C
69) Nico Corporation expects to generate free-cash flows of $200,000 per year for the next five years. Beyond that
time, free cash flows are expected to grow at a constant rate of 5 percent per year forever. If the firm's average cost
of capital is 15 percent, the market value of the firm's debt is $500,000, and Nico has a half million shares of stock
outstanding, what is the value of Nico's stock?
A) $2.43
B) $3.43
C) $1.43
D) $0.00
Answer: A
20) Patrick Company expects to generate free-cash of $120,000 per year forever. If the firm's required return is 12
percent, the market value of debt is $300,000, the market value of preferred stock is $70,000, and the company has
100,000 shares of stock outstanding. What is the value of Patrick's stock?
A) $6.30
B) $10.00
C) $7.00
D) $9.70
Answer: A
 Chapter (8): Cost of Capital
Define the following.

Term Definition
- Represents the firm’s cost of financing, and is the minimum rate of return that a project
Cost of Capital must earn to increase firm value.
- Reflects the total of the firm’s financing activities.
Sources of Long 1. Long - term debt
term Capital 2. Common stock equity (Common Stock + Retained Earnings)
is the financing cost associated with new funds through long-term borrowing. Typically, the
Cost of debt funds are raised through the sale of corporate bonds.
Are the funds actually received by the firm from the sale of a security.
Net Proceeds
Net Proceeds = Issuance Price – Flotation Cost
are the total costs of issuing and selling a security (if they exist). They include two
components:
Flotation costs - Underwriting costs : are compensation earned by investment bankers for selling
the security
- Administrative costs are issuer expenses such as legal, accounting, and printing
is the rate of return required on the stock by investors in the marketplace.
cost of common - There are two forms of common stock financing:
stock 1. Retained earnings
2. New issues of common stock
Weighted Average
- It reflects the expected average future cost of capital over the long run.
Cost of Capital
(WACC) - Non-negative and must equal to (Sum to) = 1
Book value are weights that use accounting values to measure the proportion of each type of capital
weights in the firm’s financial structure.
Market value are weights that use market values to measure the proportion of each type of capital in
weights the firm’s financial structure.
Historical weights are either book or market value weights based on actual capital structure proportions.
Target weights are either book or market value weights based on desired capital structure proportions

Practical Part

Calculating Before tax cost of debt (rd)

 After-Tax Cost of Debt.

Cost of common stock equity (rs)

 Cost of common stock equity (rs) = Cost of Retained Earnings (rr)

Cost of new issues of common stock equity (rn)

Weighted Average Cost of Capital (WAAC)

 True or False
1. The target capital structure is the desired optimal mix of debt and equity financing that most firms attempt to
achieve and maintain.
Answer: TRUE
2. The cost of capital is the rate of return a firm must earn on investments in order to leave share price
unchanged.
Answer: TRUE
3.The cost of capital is used to decide whether a proposed corporate investment will increase or decrease the
firm’s stock price.
Answer: TRUE
4. The cost of capital reflects the cost of funds over the long run measured at a given point in time, based on the
best information available.
Answer: TRUE
5.The cost of capital can be thought of as the rate of return required by the market suppliers of capital in order
to attract their funds to the firm.
Answer: TRUE
6. In general, floatation costs include two components, underwriting costs and administrative costs.
Answer: TRUE
7. Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a discount, or at
its par value.
Answer: TRUE
8. The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale
after paying for flotation costs and taxes.
Answer: FALSE
9.The cost of common stock equity may be measured using either the constant growth valuation model or the
capital asset pricing model.
Answer: TRUE
10. The cost of common stock equity is the rate at which investors discount the expected dividends of the firm
to determine its share value.
Answer: TRUE
11. The constant growth model uses the market price as a reflection of the expected risk-return preference of
investors in the marketplace.
Answer: TRUE
12. The cost of common stock equity capital represents the return required by existing shareholders on their
investment in order to leave the market price of the firm’s outstanding share unchanged.
Answer: TRUE
13. The cost of retained earnings is always lower than the cost of a new issue of common stock due to the
absence of flotation costs when financing projects with retained earnings.
Answer: TRUE
14. Since the net proceeds from sale of new common stock will be less than the current market price, the cost of
new issues will always be less than the cost of existing issues.
Answer: FALSE
15. The Gordon model is based on the premise that the value of a share of stock is equal to sum of all future
dividends it is expected to provide over an infinite time horizon.
Answer: FALSE
16. The cost of retained earnings to the firm is the same as the cost of an equivalent fully subscribed issue of
additional common stock.
Answer: TRUE
17. Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required by
investors as compensation for the firm’s nondiversifiable risk.
Answer: TRUE
18. Use of the Capital Asset Pricing Model (CAPM) in measuring the cost of common stock equity differs from
the constant growth valuation model in that it directly considers the firm’s risk as reflected by beta.
Answer: TRUE
19.The cost of new common stock is normally greater than any other long-term financing cost.
Answer: TRUE
20. The capital asset pricing model describes the relationship between the required return, or the cost of
common stock equity capital, and the nonsystematic risk of the firm as measured by the beta coefficient.
Answer: FALSE
21. The weighted average cost that reflects the interrelationship of financing decisions can be obtained by
weighing the cost of each source of financing by its target proportion in the firm’s capital structure.
Answer: TRUE
22. In computing the weighted average cost of capital, the historic weights are either book value or market value
weights based on actual capital structure proportions.
Answer: TRUE
23. In computing the weighted average cost of capital, the target weights are either book value or market value
weights based on actual capital structure proportions.
Answer: FALSE
24.In computing the weighted average cost of capital, from a strictly theoretical point of view, the preferred
weighing scheme is target market value proportions.
Answer: TRUE
25. The weighted average cost of capital (WACC) reflects the expected average future cost of funds over the
long run.
Answer: TRUE
1.The _________ is the rate of return required by the market suppliers of capital in order to attract their funds to
the firm.
(a) yield to maturity
(b) internal rate of return
(c) cost of capital
(d) gross profit margin
Answer: C
2.The firm’s optimal mix of debt and equity is called its
(a) optimal ratio.
(b) target capital structure.
(c) maximum wealth.
(d) maximum book value.
Answer: B
3.The _________ is a weighted average of the cost of funds which reflects the interrelationship of financing
decisions.
(a) risk premium
(b) nominal cost
(c) cost of capital
(d) risk-free rate
Answer: C
4.The _________ is the firm’s desired optimal mix of debt and equity financing.
(a) book value
(b) market value
(c) cost of capital
(d) target capital structure
Answer: D
5.The specific cost of each source of long-term financing is based on _________ and _________ costs.
(a) before-tax; historical
(b) after-tax; historical
(c) before-tax; book value
(d) after-tax; current
Answer: D
6.The _________ from the sale of a security are the funds actually received from the sale after _________, or
the total costs of issuing and selling the security, which have been subtracted from the total proceeds.
(a) gross proceeds; the after-tax costs
(b) gross proceeds; the flotation costs
(c) net proceeds; the flotation costs
(d) net proceeds; the after-tax costs
Answer: C
7.The before-tax cost of debt for a firm which has a 40 percent marginal tax rate is 12 percent. The after-tax
cost of debt is
(a) 4.8 percent.
(b) 6.0 percent.
(c) 7.2 percent.
(d) 12 percent.
Answer: C
8.The approximate before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond selling at $950 is
(a) 10 percent.
(b) 10.6 percent.
(c) 12 percent.
(d) 15.4 percent.
Answer: B
9.If a corporation has an average tax rate of 40 percent, the approximate, annual, after-tax cost of debt for a 15-
year, 12 percent, $1,000 par value bond, selling at $950 is
(a) 10 percent.
(b) 10.6 percent.
(c) 7.6 percent.
(d) 6.0 percent.
Answer: C
10.The approximate before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is
(a) 6 percent.
(b) 8.3 percent.
(c) 8.8 percent.
(d) 9 percent.
Answer: A
11.The cost of common stock equity is
(a) the cost of the guaranteed stated dividend.
(b) the rate at which investors discount the expected dividends of the firm.
(c) the after-tax cost of the interest obligations.
(d) the historical cost of floating the stock issue.
Answer: B
12. The cost of common stock equity may be estimated by using the
(a) yield curve.
(b) net present value method.
(c) Gordon model.
(d) DuPont analysis.
Answer: C
13. The cost of common stock equity may be estimated by using the
(a) yield curve.
(b) capital asset pricing model.
(c) internal rate of return.
(d) DuPont analysis.
Answer: B
14. The cost of retained earnings is
(a) zero.
(b) equal to the cost of a new issue of common stock.
(c) equal to the cost of common stock equity.
(d) irrelevant to the investment/financing decision.
Answer: C
15. The cost of new common stock financing is higher than the cost of retained earnings due to
(a) flotation costs and underpricing.
(b) flotation costs and overpricing.
(c) flotation costs and commission costs.
(d) commission costs and overpricing.
Answer: A
16.In calculating the cost of common stock equity, the model having the stronger theoretical foundation is
(a) the constant growth model.
(b) the Gordon model.
(c) the variable growth model.
(d) the capital asset pricing model.
Answer: D
17. A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return equals 6
percent. The estimated cost of common stock equity is
(a) 6 percent.
(b) 7.2 percent.
(c) 14 percent.
(d) 15.6 percent.
Answer: D
18. One major expense associated with issuing new shares of common stock is
(a) underwriting fees.
(b) legal fees.
(c) registration fees.
(d) underpricing.
Answer: D
19.Weighing schemes for calculating the weighted average cost of capital include all of the following EXCEPT
(a) book value weights.
(b) optimal value weights.
(c) market value weights.
(d) target weights.
Answer: B
20. A firm has determined its cost of each source of capital and optimal capital structure, which is composed of
the following sources and target market value proportions: