1 .Ifthe expected dividend payout ratio of a firm is expected to rise from 50percent to 55 percent, the cost of equity is expected to increase from 10percent to 11 percent, and the firm’s growth rate remains at 5 percent, whatwill happen to the firm’s price-to-equity (P/E) ratio? It will:
A)decline.
B)be unchanged.
C)increase.
The correct answerwas: A
Payout increases from50% to 55%, cost of equity increases from 10% to 11%, and dividend growth ratestays at 5%, the P/E will change from 10 to 9.16:
P/E = (D/E) / (k – g).
P/E0 = 0.50 / (0.10 –0.05) = 10.
P/E1 = 0.55 / (0.11 –0.05) = 9.16.
2 . When a company’sreturn on equity (ROE) is 12% and the dividend payout ratio is 60%, what is theimplied sustainable growth rate of earnings and dividends?
A)4.0%.
B)7.8%.
C)4.8%.
The correct answer wasC
g = ROE × retentionratio = ROE × (1 – payout ratio) = 12 (0.4) = 4.8%
3 . Theconstant-growth dividend discount model would typically be most appropriate invaluing a stock of a:
A)moderate growth,"mature" company.
B)rapidly growingcompany.
C)new venture expectedto retain all earnings for several years.
The correct answerwas: A
Remember, the infiniteperiod DDM has the following assumptions:
§ The stock pays dividends and they grow at aconstant rate.
§ The constant growth rate, g, continues foran infinite period.
§ k must be greater than g. If not, the mathwill not work.
If any one of theseassumptions is not met, the model breaks down. The infinite period DDM doesn’twork with growth companies. Growth companies are firms that currently have theability to earn rates of return on investments that are currently above theirrequired rates of return. The infinite period DDM assumes the dividend streamgrows at a constant rate forever while growth companies have high growth ratesin the early years that level out at some future time. The high early orsupernormal growth rates will also generally exceed the required rate ofreturn. Since the assumptions (constant g and k > g) don’t hold, theinfinite period DDM cannot be used to value growth companies.
4 . The capital assetpricing model can be used to estimate which of the following inputs to thedividend discount model?
A)The expectedinflation rate.
B)The expected growthrate in dividends.
C)The required returnon equity.
The correct answer wasC
The capital assetpricing model is a rate of return model that can be used to estimate a stock’srequired rate of return, given the nominal risk-free rate, the market riskpremium, and the stock’s beta:
k = Rnominal risk freerate + (beta)(Rmarket - Rnominal risk free rate).
5 . Using an infiniteperiod dividend discount model, find the value of a stock that last paid adividend of $1.50. Dividends are expected to grow at 6 percent forever, theexpected return on the market is 12 percent and the stock’s beta is 0.8. Therisk-free rate of return is 5 percent.
A)$26.50.
B)$34.57.
C)$32.61.
The correct answer wasB
First find therequired rate of return using the CAPM equation.
k = 0.05 + 0.8(0.12 -0.05) = 10.6%
$1.50(1.06) /(0.106 -0.06) = $34.57
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