Question

1) A firm with return on equity (ROE) less than its cost of capital:

A. would increase firm value by retaining all its earnings for growth of the firm

B. should pay out earnings to investors as dividends rather than retain earnings for growth

C. will generally have relatively high P/E ratios

D. all of the above

2) A company recently paid out a $4 per share dividend on their stock. Dividends are projected to grow at a constant rate of 5% into the future, and the required return on investment is 8%. The current price of a share of stock is:

A. $133.33

B. $140.00

C. $ 50.00

D. $ 72.35

3) A company recently paid out a $4 per share dividend on their stock. Dividends are projected to grow at a constant rate of 5% into the future, and the required return on investment is 8%. After one year, the holding period return to an investor who buys the stock right now will be:

A. 5%

B. 3%

C. 8%

D. 13%

4) ABC Corporation is expected to pay a dividend of $3.00 in the upcoming year. Dividends are expected to grow at the rate of 8% per year. The risk-free rate of return is 5% and the expected return on the market portfolio is 17%. The stock of ABC Corporation has a beta of 0.75. The current price of the stock is __________.

A. 4.00
B. 17.65
C. 37.50
D. 50.00

5) XYZ Company is expected to pay a dividend in year 1 of $2.00, a dividend in year 2 of $3.00, and a dividend in year 3 of $4.00. After year 3, dividends are expected to grow at the rate of 7% per year. An appropriate required return for the stock is 12%. The stock should be worth __________ today.

A. $63.80
B. $65.13
C. $67.98
D. $85.60

Answer 1

1) B. should pay out earnings to investors as dividends rather than retain earnings for growth

Since ROE is lower than cost of capital, funds should not be retained

2)Price of stock = Expected Dividend/(Required Return – Growth Rate)

= 4(1.05)/(8%-5%)

= $140

I.e. B

3)Price after one year = 4(1.05)²/(8%-5%) = $147

Holding period return = (4.2+147-140)/140 = 8%

I.e. c

4)Required rate of return = Risk free rate + beta*(Market Return – Risk free rate)

= 5% + 0.75(17%-5%)

= 14%

Hence, price of stock = 3/(14%-8%)

= $50

i.e. D

5)Stock Value = 2/(1.12) + 3/(1.12)² + 4/(1.12)³+ 4(1.07)/(12%-7%)(1.12)³

= $67.98

i.e. c.