An analyst is in the process of determining what the current share price should be for PaperToy, Inc. In early January, the analyst collected the following information on PaperToy, Inc.
? Dividend at end of current year = $1.00
? Yearly dividend increase = 5%
? Expected investor return = 10%
Based on the data provided, the current share price for PaperToy, Inc., should be
Answer (B) is correct. The dividend discount model is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The formula is as follows: Dividend per share ÷ (Cost of capital – Dividend growth rate). Because the dividend at year end is given, this amount need not be discounted. Therefore, the current share price for PaperToy should be $20 ($1 ÷ .10 – .05 .
A publicly traded corporation in an industry with an average price-earnings ratio of 20 has the following summary financial results.
Operating income 500,000
Net income 200,000
Shareholders’ equity 1,500,000
A competitor wishes to make a bid to acquire the stock of the company. What is the current market value?
Answer (B) is correct. The price-earnings ratio is expressed as the market price per share divided by the earnings per share. However, this can also be expressed as the total market price over the total earnings. Earnings (net income) are equal to $200,000, and the price-earnings ratio is equal to 20. Therefore, the market value can be solved for as follows: 20 = Market value ÷ $200,000 Market value = 20 × $200,000 = 4,000,000
How would a 5% stock dividend affect a company’s additional paid-in capital and retained earnings when declared?
Additional Paid-in Capital
Answer (D) is correct. Retained earnings is the cumulative accrual-basis income of the corporation, minus amounts paid out in cash dividends, minus amounts reclassified as additional paid-in capital from stock dividends. Thus, stock dividends increase additional paid-in capital and decrease retained earnings.
A corporation paid a dividend of $3 per share last year. If investors expected the dividend per share to grow by 5% per year forever, what required return of investors is consistent with a current share price of $63 per share?
Answer (C) is correct. The dividend growth model estimates the cost of retained earnings using the dividends per share, the market price, and the expected growth rate. The current dividend yield is 5% ($3 ÷ $63). Adding the growth rate of 5% to the yield of 5% results in a required return of 10%.
Wallace Corporation just paid a dividend of $2.00 per common share. Historical data indicate Wallace’s dividends grow at a steady rate of 5% per year. The required rate of return for investing in such stock is 18%. The current value of one share of Wallace’s common stock is
Answer (A) is correct. The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The next dividend is calculated as $2.10 [$2.00 dividend × (1 + .05 growth rate)]. Thus, the current value of one share of common stock is calculated as $16.15 [$2.10 next dividend ÷ (18% cost of capital – 5% dividend growth rate)].
The CFO of ChemGen Ltd., a publicly traded chemical manufacturer, is in the process of evaluating the company’s dividend policy in relation to shareholder value. ChemGen’s dividend per share has been held constant at $2.30 for the last 10 years. The CFO would like to implement a 5% yearly dividend growth policy at ChemGen starting next year. The CFO has determined that the required return in the market for ChemGen stock is 13%.
What is the forecasted value of ChemGen stock in 5 years if the CFO’s dividend growth policy is implemented?
Answer (A) is correct. The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The next dividend is calculated as $3.08 [$2.30 dividend × (1 + .05 growth rate)6]. Thus, the forecasted value of one share of stock in 5 years is calculated as $38.53 [$3.08 next dividend ÷ (13% cost of capital – 5% dividend growth rate)].
A stock began the month with a stock price of $50 per share, paid a dividend of $2 per share during the month, and ended the month with a price of $52 per share. What total return did investors earn on the stock during this month?
Answer (D) is correct. Investors earned $2 in dividends and $2 in stock appreciation. Therefore, they made $4 on the beginning price of $50, or 8%.
A financial analyst is using the two-stage model of dividend growth to value a corporation that paid an annual dividend last year of $4 per share. The annual dividend is assumed to grow at 10% per year for the next 3 years and then grow at 5% per year thereafter. A 12% required return is assumed. Which change in one of the assumptions would cause the analyst to find a higher value for the stock?
Answer (C) is correct. This would cause the dividend growth in Years 4 and 5 to increase from 5% to 10%. The higher future cash flows result in a higher value for the stock.
Buying a wheat futures contract to protect against price fluctuation of wheat would be classified as a
Answer (B) is correct. A cash flow hedge is an instrument designated as hedging the exposure to variability in expected future cash flows attributed to a particular risk.
An automobile company that uses the futures market to set the price of steel to protect a profit against price increases is an example of
Answer (B) is correct. A change in prices can be minimized or avoided by hedging. Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements. The automobile company desires to stabilize the price of steel so that its cost to the company will not rise and cut into profits. Accordingly, the automobile company uses the futures market to create a long hedge, which is a futures contract that is purchased to protect against price increases.