1 .Ananalyst estimates the intrinsic value of a stock to be equal to ?1,567 pershare. If the current market value of the stock is ?1,487 per share, the stockis:
A)overvalued.
B)undervalued.
C)fairly valued.
The correct answer wasB
If a stock’s intrinsicvalue is greater than its market value, the stock is undervalued.
2 . Witronix is arapidly growing U.S. company that has increased free cash flow to equity anddividends at an average rate of 25% per year for the last four years. Thepresent value model that is most appropriate for estimating the value of thiscompany is a:
A)multistage dividenddiscount model.
B)Gordon growth model.
C)single stage freecash flow to equity model.
The correct answerwas: A
A multistage model isthe most appropriate model because the company is growing dividends at a higherrate than can be sustained in the long run. Though the company may be able togrow dividends at a higher-than-sustainable 25% annual rate for a finiteperiod, at some point dividend growth will have to slow to a lower, moresustainable rate. The Gordon growth model is appropriate to use for maturecompanies that have a history of increasing their dividend at a steady andsustainable rate. A single stage free cash flow to equity model is similar tothe Gordon growth model, but values future free cash flow to equity rather thandividends.
3 . All else equal, ifa firm’s return on equity (ROE) increases, the stock’s value as estimated bythe constant growth dividend discount model (DDM) will most likely:
A)increase.
B)not change.
C)decrease.
The correct answerwas: A
Increase in ROE: ROEis a component of g. As g increases, the spread between ke and g, or the P/Edenominator, will decrease, and the P/E ratio will increase.
4 . Assuming that acompany's return on equity (ROE) is 12% and the required rate of return is 10%,which of the following would most likely cause the company's P/E ratio to rise?
A)The firm's ROEfalls.
B)The inflation ratefalls.
C)The firm's dividendpayout rises.
The correct answer wasB
§ Decrease in the expected inflation rate. Theexpected inflation rate is a component of ke (through the nominal risk freerate). ke can be represented by the following: nominal risk free rate + stockrisk premium, where nominal risk free rate = [(1 + real risk free rate)(1 +expected inflation rate)] – 1.
§ If the rate of inflation decreases, thenominal risk free rate will decrease.
§ ke will decrease.
§ The spread between ke and g, or the P/Edenominator, will decrease.
§ P/E ratio will increase.
(An increase in thestock risk premium would have the opposite effect.)
§ Decrease in ROE: ROE is a component of g. Asg decreases, the spread between ke and g, or the P/E denominator, willincrease, and the P/E ratio will decrease.
§ Increase in dividend payout/reduction inearnings retention. In this case, an increase in the dividend payout willlikely decrease the P/E ratio because a decrease in earnings retention willlikely lower the P/E ratio. The logic is as follows: Because earnings retentionimpacts both the numerator (dividend payout) and denominator (g) of the P/Eratio, the impact of a change in earnings retention depends upon therelationship of ke and ROE. If the company is earning a higher rate on newprojects than the rate required by the market (ROE> ke), investors willlikely prefer that the company retain more earnings. Since an increase in thedividend payout would decrease earnings retention, the P/E ratio would fall, asinvestors will value the company lower if it retains a lower percentage ofearnings.
5 . Which of thefollowing is NOT a determinant of the expected price/earnings (P/E) ratio?
A)Expected dividendpayout ratio (D/E).
B)Average debt tocapital ratio (D/C).
C)Expected growth ratein dividends (g).
The correct answer wasB
The P/E ratio isdetermined by payout ratio D/E, required return Ke, and expected growth g.
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