1 . Assume that theexpected dividend growth rate (g) for a firm decreased from 5% to zero.Further, assume that the firm's cost of equity (k) and dividend payout ratiowill maintain their historic levels. The firm's P/E ratio will most likely:
A)become undefined.
B)decrease.
C)increase.
The correct answer wasB
The P/E ratio may bedefined as: Payout ratio / (k - g), so if k is constant and g goes to zero, theP/E will decrease.
2 . A firm is mostlikely to have pricing power if:
A)costs to exit theindustry are high.
B)its product isdifferentiated.
C)its market share ishigh.
The correct answer wasB
Firms offeringproducts that are differentiated in terms of quality and features are morelikely to have pricing power than firms that produce undifferentiated(commodity-like) products. High market share does not necessarily imply pricingpower; for example, if four firms each have 25% market share, none of them arelikely to have significant pricing power. High exit costs can createovercapacity in an industry and result in a high degree of price competition asfirms try to maintain production volume during a period of reduced demand.
3 . A preferredstock’s dividend is $5 and the firm’s bonds currently yield 6.25%. Thepreferred shares are priced to yield 75 basis points below the bond yield. Theprice of the preferred is closest to:
A)$90.91.
B)$5.00.
C)$80.00.
The correct answerwas: A
Preferred stock yield(Kp) = bond yield – 0.75% = 6.25% ? 0.75% = 5.5%
Value = dividend / Kp= $5 / 0.055 = $90.91.
4 . An analystgathered the following data for the Parker Corp. for the year ended December31, 2005:
§ EPS2005 = $1.75
§ Dividends2005 = $1.40
§ Beta Parker = 1.17
§ Long-term bond rate = 6.75%
§ Rate of return S&P 500 = 12.00%
The firm is expectedto continue their dividend policy in future. If the long-term growth rate inearnings and dividends is expected to be 6%, the forward P/E ratio for ParkerCorp. will be:
A)21.54.
B)12.31.
C)11.61.
The correct answer wasC
The required rate ofreturn on equity for Parker will be 12.89% = 6.75% + 1.17(12.00% ? 6.75%) andthe firm pays 80% (1.40 / 1.75) of its earnings as dividends.
Forward P/E ratio =0.80 / (0.1289 - 0.0600) = 11.61
Where r = requiredrate of return on equity, gn = growth rate in dividends (forever).
5 . Which of thefollowing is least likely an advantage of using price/sales (P/S) multiple?
A)P/S multiples aremore reliable because sales data cannot be distorted by management.
B)P/S multiplesprovide a meaningful framework for evaluating distressed firms.
C)P/S multiples arenot as volatile as P/E multiples and hence may be more reliable in valuationanalysis.
The correct answerwas: A
Accounting data onsales is used to calculate the P/S multiple. The P/S multiple is thought to bemore reliable because sales figures are not as easy to manipulate as theearnings and book value, both of which are significantly affected by accountingconventions. However, it is not true that "sales data cannot be distortedby management" because aggressive revenue recognition practices caninfluence reported sales.
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