Question

1) Which of the following statements is most correct?

Select one:

a. The constant growth model is often appropriate for companies that never pay dividend.

b. The constant growth model is often appropriate for companies that the dividend growth rate is larger than its required rate of return on stock.

c. The constant growth model is inappropriate for mature companies with a stable history of growth.

d. Two firms with the same dividend and growth rate should have the same stock price.

e. The constant growth model can be applied to companies that expect zero dividend growth rate.

2) A stock’s dividend is expected to grow at a constant rate of 5% a year. Which of the following statements is most correct?

Select one:

a. The net income of the firm is expected to grow at a constant rate of 5% a year.

b. The expected return on the stock is 5% a year.

c. The stock’s dividend yield is 5%.

d. The required return rate of the stock is 5% a year.

e. The stock’s price one year from now is expected to be 5% higher.

3) Use the following information to answer the next question.

• Thames Inc.'s most recent dividend was $2.40 per share. The dividend is expected to grow at 3% per year.

• The T-bill rate is 5% and the market return rate is 9%.

• The company's beta is 1.3.

What is the expected price of the stock two years later?

Select one:

a. $36.42

b. $72.14

c. $57.14

d. $37.83

e. $35.36

4) Use the following information to answer the next question.

·       The last dividend paid by Klein Company was $1.00.

·       Klein's growth rate is expected to be a constant 20% for 3 years, after which dividends are expected to grow at a rate of 4% forever.

·       Klein's required rate of return on equity is 10%.

What should be the current price of Klein's common stock?

Select one:

a. $36.84

b. $42.25

c. $50.16

d. $30.84

e. $26.08

5) Use the following information to answer the following question.

Analysts project the following free cash flows (FCFs) for Ezzell Corporation during the next 3 years, after which FCF is expected to grow at a constant 7% rate. Ezzell’s WACC is 12%. Ezzell has $100 in debt and 40 shares of stock.

Year 0	Year 1	Year 2	Year 3	Year 4
	-$50	$60	$35	???

What should be Ezzell’s current stock price?

Select one:

a. $14.98

b. $11.53

c. $12.98

d. $13.22

e. $9.22

Answer 1

1. a,b,c,d go against the assumptions of Gordon Model. Option e says that there is zero dividend growth rate or the dividend rate is constant, stable with no growth. This is one of the assumptions of the model. So answer is option e.

2. c. The stock's dividend yield is 5 %. Ideally the rate of return on equity should be higher than 5% for the Gordon model to be applicable.

3. Dividend at the end of 2 years = 2.4(1.03)^2 = 2.546

Dividend growth rate or g = 3% or 0.03

Required return on equity as per CAPM or r = Rf+Beta(Rm-Rf) = 0.05+1.3(0.09-0.05)= 0.102 or 10.2%

Stock price as per Gordon model = D1/(r-g) = 2.546(0.102 - 0.03) = 35.36

Answer is option e.

4. Answer is option e - 26.08 using the two stage discount model . Given growth rate for 3 years = 20% and growth rate there after = 4%. The discount rate is 10%.

Using the 2 stage model, Price of stock is derived in the following manner

1(1+0.20)/(1+0.10)^1 + 1(1+0.20)^2/(1+0.10)^2 + 1(1+0.20)^3/(1+0.10)^3 + (1(1+0.20)^3 (1+0.04)/(0.10-0.04))/(1+0.10)^3 = 26.08

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