Test bank Solutions Fundamentals of Corporate Finance 3rd Edition
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Fundamentals of Corporate Finance, 3e (Berk/DeMarzo/Harford)
Chapter 10 Stock Valuation: A Second Look
10.1 The Discounted Free Cash Flow Model
1) The discounted free cash flow model ignores interest income and expense but adjusts for cash and debt
directly, if free cash flow is calculated based on EBIT.
Answer: TRUE
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
2) Year
Free Cash Flow
1
$12 million
2
$18 million
3
$22 million
4
$26 million
Conundrum Mining is expected to generate the above free cash flows over the next four years, after
which they are expected to grow at a rate of 6% per year. If the weighted average cost of capital is 12%
and Conundrum has cash of $80 million, debt of $60 million, and 30 million shares outstanding, what is
Conundrum's expected terminal enterprise value?
A) $413.4 million
B) $459.3 million
C) $505.3 million
D) $528.2 million
Answer: B
Explanation: B)
million
1
Diff: 2
Var: 15
Skill: Analytical
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
2
3) Year
Free Cash Flow
1
$12 million
2
3
4
$18 million $22 million $26 million
Conundrum Mining is expected to generate the above free cash flows over the next four years, after
which they are expected to grow at a rate of 5% per year. If the weighted average cost of capital is 11%
and Conundrum has cash of $85 million, debt of $65 million, and 30 million shares outstanding, what is
Conundrum's expected current share price?
A) $12.61
B) $16.40
C) $20.18
D) $20.81
Answer: A
Explanation: A) FCF5 = $26 million × (1 + 0.05) = $27.3 million; V 4 = $27.3 million / (0.11 - 0.05)
= $455.00 million; using a financial calculator, V0 = $358.36 million;
P0 = (358.36 + 85 - 65) / 30 = $12.61
Diff: 2
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
4) Year
Free Cash Flow
1
2
3
4
5
$22 million $26 million $29 million $30 million $32 million
General Industries is expected to generate the above free cash flows over the next five years, after which
free cash flows are expected to grow at a rate of 5% per year. If the weighted average cost of capital is 9%
and General Industries has cash of $15 million, debt of $45 million, and 80 million shares outstanding,
what is General Industries' expected current share price?
A) $7.78
B) $8.17
C) $9.34
D) $11.67
Answer: A
Explanation: A) FCF6 = $32 million × (1 + 0.05) = $33.6 million; V 5 = $33.6 million / (0.09 - 0.05)
= $840 million; using a financial calculator, V0 = 652.45;
P0 = $(652.45 + 15 - 45) million / 80 million = $7.78
Diff: 2
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
3
5) Gonzales Corporation generated free cash flow of $88 million this year. For the next two years, the
company's free cash flow is expected to grow at a rate of 10%. After that time, the company's free cash
flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average
cost of capital is 12% and Gonzales Corporation has cash of $100 million, debt of $300 million, and 100
million shares outstanding, what is Gonzales Corporation's expected terminal enterprise value in year 2?
A) $1384.24
B) $1245.82
C) $1107.39
D) $968.97
Answer: A
Explanation: A) FCF1 = $88 million × (1 + 0.1) = $96.8 million;
FCF2 = $88 million ×
= $106.48 million;
V2 = ($106.48 million × 1.04) / (0.12 - 0.04) = $1384.24 million
Diff: 2
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
6) Gonzales Corporation generated free cash flow of $81 million this year. For the next two years, the
company's free cash flow is expected to grow at a rate of 9%. After that time, the company's free cash flow
is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average cost
of capital is 11% and Gonzales Corporation has cash of $100 million, debt of $300 million, and 100 million
shares outstanding, what is Gonzales Corporation's expected free cash flow in year 2?
A) $1429.79 million
B) $86.61 million
C) $1572.77 million
D) $96.24 million
Answer: D
Explanation: D) FCF1 = 81 × (1 + 0.09) = 88.29;
FCF2 = $81 million ×
= $96.2361 million
Diff: 1
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
4
7) Gonzales Corporation generated free cash flow of $86 million this year. For the next two years, the
company's free cash flow is expected to grow at a rate of 10%. After that time, the company's free cash
flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average
cost of capital is 11% and Gonzales Corporation has cash of $100 million, debt of $275 million, and 100
million shares outstanding, what is Gonzales Corporation's expected current share price?
A) $14.37
B) $11.87
C) $12.49
D) $16.24
Answer: C
Explanation: C) FCF1 = $86 million × (1 + 0.1) = $94.6 million;
FCF2 = $86 million ×
= $104.06 million;
FCF3 = 104.06 million × (1 + 0.04) = $108.2224 million
V2 = $108.2224 million / (0.11 - 0.04) = $1546.03 million
using a financial calculator, V0 = $1424.48 million
P0 = (1424.48 million - 275 million + 100 million) / 100 million = $12.49
Diff: 2
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
5
8) Use the table for the question(s) below.
FCF Forecast ($ million)
Year
0
Sales
240
Growth versus Prior Year
EBIT (10% of Sales)
Less: Income Tax (37%)
Less Increase in NWC (12% of Change in Sales
Free Cash Flow
1
270
12.5%
27.00
(9.99)
3.6
13.41
2
290
7.4%
29.00
10.73
2.4
15.87
3
310
6.9%
31.00
11.47
2.4
17.13
4
325.5
5.0%
32.55
12.44
1.86
18.65
Banco Industries expect sales to grow at a rapid rate over the next three years, but settle to an industry
growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries. If
Banco industries has a weighted average cost of capital of 11%, $50 million in cash, $80 million in debt,
and 18 million shares outstanding, which of the following is the best estimate of Banco's stock price at the
start of year 1?
A) $6.52
B) $11.74
C) $13.04
D) $23.48
Answer: C
Explanation: C) FCF5 = $18.65 million × (1 + 0.05) = $19.5825 million;
V4 = $19.5825 million / (0.11 - 0.05) = $326.38 million;
using a financial calculator, V0 = $264.7655 million;
P0 = ($264.7655 million + 50 - 80) / 18 million = $13.04
Diff: 2
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
6
9) Use the table for the question(s) below.
FCF Forecast ($ million)
Year
0
Sales
240
Growth versus Prior Year
EBIT (10% of Sales)
Less: Income Tax (37%)
Less Increase in NWC (12% of Change in Sales
Free Cash Flow
1
270
12.5%
27.00
(9.99)
3.6
13.41
2
290
7.4%
29.00
(10.73)
2.4
15.87
3
310
6.9%
31.00
(11.47)
2.4
17.13
4
325.5
5.0%
32.55
(12.44)
1.86
18.65
Banco Industries expect sales to grow at a rapid rate over the next 3 years, but settle to an industry
growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries.
Banco industries has a weighted average cost of capital of 11%, $40 million in cash, $70 million in debt,
and 18 million shares outstanding. If Banco Industries can reduce its operating expenses so that EBIT
becomes 12% of sales, by how much will its stock price increase?
A) $3.27
B) $3.92
C) $5.72
D) $9.80
Answer: A
Explanation: A) Calculate FCF1 = $16.812 million, FCF2 = $19.524 million,
using a financial calculator,
million
Diff: 2
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
10) Which of the following is the appropriate way to calculate the price of a share of a given company
using the free cash flow valuation model?
A) P0 = Div1/(rE - g)
B) P0 = PV(Future Free Cash Flow of Firm) / (Shares Outstanding0)
C) P0 = [Div1 / (rE - g)] / (Shares Outstanding0)
D) P0 = (V0 + Cash0 - Debt0) / (Shares Outstanding0)
Answer: D
Diff: 1
Var: 1
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
7
11) If you want to value a firm that consistently pays out its earnings as dividends, the simplest model for
you to use is the ________.
A) enterprise value model
B) method of comparables
C) dividend-discount model
D) discounted free cash flow model
Answer: C
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
12) If you want to value a firm but do not want to explicitly forecast its dividends, the simplest model for
you to use is ________.
A) the discounted free cash flow model
B) the dividend-discount model
C) the enterprise value model
D) None of the above models can be used if you do not want to forecast dividends or use of debt.
Answer: A
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
13) Which of the following statements is FALSE?
A) The more cash a firm uses to repurchase shares, the less it has available to pay dividends.
B) Free cash flow measures the cash generated by a firm after payments to debt or equity holders are
considered.
C) We estimate a firm's current enterprise value by computing the present value (PV) of the firm's free
cash flow.
D) We can interpret the enterprise value of a firm as the net cost of acquiring the firm's equity, taking its
cash, and paying off all debts.
Answer: B
Explanation: B) FCF is cash generated by a firm before payments to debt and equity holders.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
8
14) Which of the following statements is FALSE?
A) A firm's weighted average cost of capital, denoted rwacc, is the cost of capital that reflects the risk of
the overall business, which is the combined risk of the firm's equity and debt.
B) Intuitively, the difference between the discounted free cash flow model and the dividend-discount
model is that in the divided-discount model, a firm's cash and debt are included indirectly through the
effect of interest income and expenses on earnings in the dividend-discount model.
C) We interpret rwacc as the expected return a firm must pay to investors to compensate them for the risk
of holding the firm's debt and equity together.
D) When using the discounted free cash flow model, we should use a firm's equity cost of capital.
Answer: D
Explanation: D) You should use the firm's weighted average cost of capital.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
15) Which of the following statements is FALSE?
A) The long-run growth rate gFCF is typically based on the expected long-run growth rate of a firm's
revenues.
B) Since a firm's free cash flow is equal to the sum of the free cash flows from the firm's current and
future investments, we can interpret the firm's enterprise value as the total net present value (NPV) that
the firm will earn from continuing its existing projects and initiating new ones.
C) If a firm has no debt, then rwacc equals the risk-free rate of return.
D) When using the discounted free cash flow model, we forecast a firm's free cash flow up to some
horizon, together with some terminal (continuation) value of the enterprise.
Answer: C
Explanation: C) If the firm has no debt, then rwacc = the cost of equity.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
16) What additional adjustments are required to find the share price, in case we are using the discounted
cash flow model?
Answer: Discounted cash flow model gives us the enterprise value, which needs to be adjusted for debt
and cash to arrive at the stock price.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
9
10.2 Valuation Based on Comparable Firms
1) In the method of comparables, the known values of a firm's cash flows are used to estimate the
unknown cash flows of a similar firm.
Answer: TRUE
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
2) Several methods should be used to provide an estimate of a stock's value since no single method
provides a definitive value.
Answer: TRUE
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
3) On a particular date, FedEx has a stock price of $89.27 and an EPS of $7.11. Its competitor, UPS, had an
EPS of $0.38. What would be the expected price of UPS stock on this date, if estimated using the method
of comparables?
A) $4.77
B) $7.16
C) $9.54
D) $10.50
Answer: A
Explanation: A) FedEx P/E = $89.27 / 7.11 = $12.5556;
Diff: 1
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
10
4) Which of the following statements concerning the valuation of firms using the method of comparables
is FALSE?
A) If two different firms generate identical cash flows, the Law of One Price will imply that both firms
have the same value.
B) Comparables adjust for scale differences when valuing similar firms.
C) Valuation multiples take into account differences in the risk and future growth between the firms
being compared.
D) Two firms that sell very similar products or offer very similar services will have different values if
they are of different sizes.
Answer: C
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
Use the figure for the question(s) below:
5) On a particular date, the above information concerning Office Depot, Incorporated, was given on
Google Finance. Its competitor, Staples Incorporated, had a stock price of $24.33. Which of the following
is closest to the EPS of Staples Incorporated if it is estimated using valuation multiples based on priceearnings ratios?
A) $1.58
B) $1.84
C) $2.63
D) $14.15
Answer: C
Explanation: C) EPS Staples = $24.33 / $9.26 = $2.63
Diff: 1
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
11
6) An investor estimates the value of a firm which manufactures cookware by examining the cash flows
of similar firms. Which of the following is assumed to be the same for these firms?
A) P/E
B) annual growth rates
C) payout rates
D) all of the above
Answer: D
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
7) Use the table for the question(s) below.
Name
Gannet
New York Times
McClatchy
Media General
Lee Enterprises
Average
Maximum
Minimum
Market
Capitalization
($ million)
6350
2423
675
326
267
Enterprise
Value
($ million)
10,163
3472
3061
1192
1724
P/E
7.36
18.09
9.76
14.89
6.55
11.33
+60%
-40%
Price/
Book
0.73
2.64
1.68
0.39
0.82
1.25
112%
-69%
Enterprise
Value/
Sales
1.4
1.10
1.40
1.31
1.57
1.35
+16%
-18%
Enterprise
Value/
EBITDA
5.04
7.21
5.64
7.65
6.65
6.44
+22%
-19%
The table above shows the stock prices and multiples for a number of firms in the newspaper publishing
industry. Another newspaper publishing firm (not shown) had sales of $600 million, EBITDA of $84
million, excess cash of $68 million, $18 million of debt, and 120 million shares outstanding. If the average
enterprise value to sales for comparable businesses is used, which of the following is the best estimate of
the firm's share price?
A) $6.45
B) $7.20
C) $7.17
D) $7.53
Answer: C
Explanation: C) Enterprise Value = 1.35 × $600 million = $810 million;
P0 = ($810 + $68 - $18) / 120 = $7.17
Diff: 1
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
12
8) Use the table for the question(s) below.
Name
Gannet
New York Times
McClatchy
Media General
Lee Enterprises
Average
Maximum
Minimum
Market
Capitalization
($ million)
6350
2423
675
326
267
Enterprise
Value
($ million)
10,163
3472
3061
1192
1724
P/E
7.36
18.09
9.76
14.89
6.55
11.33
+60%
-40%
Price/
Book
0.73
2.64
1.68
0.39
0.82
1.25
112%
-69%
Enterprise
Value/
Sales
1.4
1.10
1.40
1.31
1.57
1.35
+16%
-18%
Enterprise
Value/
EBITDA
5.04
7.21
5.64
7.65
6.65
6.44
+22%
-19%
The table above shows the stock prices and multiples for a number of firms in the newspaper publishing
industry. Another newspaper publishing firm (not shown) had sales of $640 million, EBITDA of $84
million, excess cash of $67 million, $14 million of debt, and 120 million shares outstanding. If the average
enterprise value to sales for comparable businesses is used, which of the following is the range of
reasonable share price estimates?
A) $6.27 to $8.86
B) $4.59 to $12.23
C) $1.15 to $1.53
D) $6.19 to $9.32
Answer: A
Explanation: A) Enterprise Value = 1.35 × $640 = $864 million;
P0 = ($864 million + $67 million - $14 million) / 120 = $7.64
Range is from 82% to 116% of estimate.
$7.64 × 0.82 = $6.27; $7.64 × 1.16 = $8.86
Diff: 1
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
13
9) Use the table for the question(s) below.
Name
Gannet
New York Times
McClatchy
Media General
Lee Enterprises
Average
Maximum
Minimum
Market
Capitalization
($ million)
6350
2423
675
326
267
Enterprise
Value
($ million)
10,163
3472
3061
1192
1724
P/E
7.36
18.09
9.76
14.89
6.55
11.33
+60%
-40%
Price/
Book
0.73
2.64
1.68
0.39
0.82
1.25
112%
-69%
Enterprise
Value/
Sales
1.4
1.10
1.40
1.31
1.57
1.35
+16%
-18%
Enterprise
Value/
EBITDA
5.04
7.21
5.64
7.65
6.65
6.44
+22%
-19%
The table above shows the stock prices and multiples for a number of firms in the newspaper publishing
industry. Another newspaper publishing firm (not shown) had sales of $620 million, EBITDA of $81
million, excess cash of $62 million, $11 million of debt, and 120 million shares outstanding. If the firm had
an EPS of $0.41, what is the difference between the estimated share price of this firm if the average priceearnings ratio is used and the estimated share price if the average enterprise value/EBITDA ratio is used?
A) -$0.08
B) -$0.13
C) -$1.27
D) -$1.39
Answer: B
Explanation: B) Price using price-earnings ratio = 11.33 × $0.41 = $4.6453;
using enterprise value / EBITDA ratio = 6.44 × $81 million = $521.64 million;
P0 = ($521.64 million + $62 million - $11 million) / 120 million = $4.77;
difference = $-0.13
Diff: 1
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
14
Use the table for the question(s) below.
Name
Gannet
New York Times
McClatchy
Media General
Lee Enterprises
Average
Maximum
Minimum
Market
Capitalization
($ million)
6350
2423
675
326
267
Enterprise
Value
($ million)
10,163
3472
3061
1192
1724
P/E
7.36
18.09
9.76
14.89
6.55
11.33
+60%
-40%
Price/
Book
0.73
2.64
1.68
0.39
0.82
1.25
112%
-69%
Enterprise
Value/
Sales
1.4
1.10
1.40
1.31
1.57
1.35
+16%
-18%
Enterprise
Value/
EBITDA
5.04
7.21
5.64
7.65
6.65
6.44
+22%
-19%
10) The table above shows the stock prices and multiples for a number of firms in the newspaper
publishing industry. Which of the following ratios would most likely be the most reliable in determining
the stock price of a comparable firm?
A) P/E
B) Price/Book
C) Enterprise Value/Sales
D) Enterprise Value/EBITDA
Answer: C
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
11) Which of the following is NOT an advantage of the valuation multiple method as compared to the
discounted cash flow method?
A) calculations based upon widely available information
B) based upon actual stock prices of real firms
C) does not rely on estimates of future cash flows
D) takes into account important differences between different firms
Answer: D
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
15
12) Which of the following statements is FALSE?
A) Even two firms in the same industry selling the same types of products, while similar in many
respects, are likely to be of different size or scale.
B) In the method of comparables, we estimate the value of a firm based on the value of other, comparable
firms or investments that we expect will generate very similar cash flows in the future.
C) Consider the case of a new firm that is identical to an existing publicly traded company. If these firms
will generate identical cash flows, the Law of One Price implies that we can use the value of the existing
company to determine the value of the new firm.
D) A valuation multiple is a ratio of some measure of a firm's scale to the value of the firm.
Answer: D
Explanation: D) A valuation multiple is a ratio of the value of the firm to some measure of the firm's
scale.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
13) Which of the following statements is FALSE?
A) The most common valuation multiple is the price-earnings ratio.
B) You should be willing to pay proportionally more for a stock with lower current earnings.
C) A firm's price-earnings ratio is equal to the share price divided by its earnings per share.
D) The intuition behind the use of the price-earnings ratio is that when you buy a stock, you are in a sense
buying the rights to the firm's future earnings, and differences in the scale of firms' earnings are likely to
persist.
Answer: B
Explanation: B) You should be willing to pay proportionally more for a stock with higher current
earnings.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
16
14) Which of the following statements is FALSE?
A) We can estimate the value of a firm's shares by multiplying its current earnings per share by the
average price-earnings ratio of comparable firms.
B) For valuation purposes, the trailing price-earnings ratio is generally preferred, since it is based on
actual not expected earnings.
C) Forward earnings are the expected earnings over the coming 12 months.
D) Trailing earnings are the earnings over the previous 12 months.
Answer: B
Explanation: B) For valuation purposes, the forward price-earnings ratio is generally preferred, since it is
based on the expected earnings.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
15) Which of the following statements is FALSE?
A) As the enterprise value represents the entire value of a firm before the firm pays its debt, to form an
appropriate multiple, we divide it by a measure of earnings or cash flows after interest payments are
made.
B) We can compute a firm's price-earnings ratio by using either trailing earnings or forward earnings
with the resulting ratio called the trailing price-earnings or forward price-earnings.
C) It is common practice to use valuation multiples based on a firm's enterprise value.
D) Using a valuation multiple based on comparables is best viewed as a "shortcut" to the discounted cash
flow method of valuation.
Answer: A
Explanation: A) As the enterprise value represents the entire value of a firm before the firm pays its debt,
to form an appropriate multiple, we divide it by a measure of earnings or cash flows before interest
payments are made.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
16) Which is the best valuation technique when using comparables?
Answer: No single technique provides a final answer regarding a stock's true value. All approaches have
their individual assumptions and the firm value is subject to those assumptions. So, the best technique is
to use several methods to identify a reasonable range for the value.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
17
10.3 Information, Competition, and Stock Prices
1) If you value a stock using a range of stock valuation methods and these valuations indicate a stock
price that is greater than its actual market price, it is most likely that the stock is under-valued.
Answer: FALSE
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
2) In an efficient market, investors will only find positive-NPV trading opportunities if they have some
form of competitive advantage over other investors.
Answer: TRUE
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
3) Valuation models use the relationship between share value, future cash flows, and the cost of capital to
estimate these quantities for a given firm. Realistically, for a publicly traded firm, what can we reliably
use such models to determine?
I. the firm's future cash flows
II. the firm's cost of capital
III. the firm's market price
A) I only
B) II only
C) III only
D) I and II
Answer: C
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
18
4) Praetorian Industries will pay a dividend of $2.50 per share this year and has an equity cost of capital
of 8%. Praetorian's stock is currently trading at $84 per share. By comparing Praetorian with similar firms,
an investor expects that its dividends will grow by up to 5% per year. What is the best next step that the
investor should take regarding Praetorian's stock?
A) Sell any Praetorian stock that she owns.
B) Short Praetorian's stock.
C) Revise Praetorian's equity cost of capital.
D) Revise her estimate of Praetorian's dividend growth.
Answer: D
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
5) On a certain date, Kastbro has a stock price of $37.50, pays a dividend of $0.64, and has an equity cost
of capital of 8%. An investor expects the dividend rate to increase by 6% per year in perpetuity. He then
sells all stocks that he owns in Kastbro. Given Kastbro's share price, was this a reasonable action?
A) No, since the constant dividend growth rate gives a stock estimate of $37.50.
B) No, since the constant dividend growth rate gives a stock estimate greater than $37.50.
C) Yes, since the constant dividend growth rate gives a stock estimate greater than $37.50.
D) No, since the difference between his calculated stock price and the actual stock price most likely
indicates that his estimate of dividend growth rate was incorrect.
Answer: D
Explanation: D) Calculated stock price = $0.64 / .06 = $10.67; actual stock price = $37.50. Difference =
$26.83.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
6) Which of the following is the best statement of the efficient markets hypothesis?
A) Investors with information that a stock had a positive net present value (NPV) will buy it, while
investors with information that a stock had a negative net present value (NPV) will sell it.
B) Investor's decisions are dependent on complete current information of a firm's cash flows and accurate
predictions of future cash flows.
C) Competition between investors works to make the net present value (NPV) of all trading opportunities
zero.
D) A share's price is the aggregate of the information of many investors.
Answer: C
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
19
7) Carbondale Oil announces that a well that it has sunk in a new oil province has shown the existence of
substantial oil reserves. The exploitation of these reserves is expected to increase Carbondale's free cash
flow by $100 million per year for eight years. If investors had not been expecting this news, what is the
most likely effect on Carbondale's stock price upon the announcement, given that Carbondale has 80
million shares outstanding, no debt, and an equity cost of capital of 11%?
A) no effect
B) rise by $5.15
C) rise by $6.43
D) rise by $7.72
Answer: C
Explanation: C)
per share
= $514.6123 million / 80 million = $6.43
Diff: 1
Var: 45
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
8) Advanced Chemical Industries is awaiting the verdict from a court case over whether it is liable for the
clean-up of wastes on a disused factory site. If it is liable, this will result in a reduction of its free cash
flow by $11 million per year for ten years. If it is not liable, there will be no effect. On the close of trading
the day before the announcement of the verdict, Advanced Chemicals was trading at $20 per share. Most
investors calculate that there is a 100% chance that Advanced Chemicals will have a verdict returned
against them. One investor, Jo, has performed extensive research into the outcome of the trial and
estimates that there is no chance Advanced Chemicals will have a verdict returned against them. Given
that Advanced Chemicals has 40 million shares outstanding and an equity cost of capital of 6% with no
debt, Jo's estimate of the value of a share of Advanced Chemicals would be how much more than the
market price?
A) $2.02
B) $20.81
C) $21.01
D) $21.62
Answer: A
Explanation: A)
Diff: 1
Var: 44
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
20
9) Aerelon Airways, a commercial airline, suffers a major crash. As a result, passengers are considered to
be less likely to choose Aerelon as their carrier, and it is expected free cash flows will fall by $15million
per year for five years. If Aerelon has 55 million shares outstanding, an equity cost of capital of 10%, and
no debt, by how much would Aerelon's shares be expected to fall in price as a result of this accident?
A) $0.93
B) $1.03
C) $1.14
D) $1.34
Answer: B
Explanation: B)
per share fall = $56.86 million / 55 million = $1.03
Diff: 1
Var: 50+
Skill: Analytical
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
10) Which of the following should be done by a manager wishing to raise his stock's price?
I. Focus on maximizing the present value (PV) of the free cash flow.
II. Focus on accounting earnings.
III. Focus on financial policy.
A) I only
B) II only
C) I and II
D) II and II
Answer: A
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
11) On a particular day, a mining company reveals that, due to new extraction technology, the extractable
yield from several of its nickel/lead mines has risen by 15%. Which of the following is the LEAST likely
consequence of such an announcement?
A) The price of the stock would rise.
B) Investors would determine that the estimates of the firm's value on the date prior to the announcement
were too high.
C) Investors would increase their forecast of future cash flows in that firm.
D) Investors would revise their estimates of the net present value (NPV) of the firm.
Answer: B
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
21
12) What are the implications of the efficient markets hypothesis for corporate managers regarding
accounting earnings?
Answer: Instead of focusing on accounting earnings, managers should focus on maximizing cash flows.
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
10.4 Individual Biases and Trading
1) Individual investors trade conservatively, given the difficulty of finding over-valued and under-valued
stocks.
Answer: FALSE
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
2) Individual investors who grow up and live during a time of high stock returns are more likely to invest
in stocks.
Answer: TRUE
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
3) Individual investors' tendency to trade too much based on the mistaken belief that they can pick
winners and losers better than investment professionals is known as ________.
A) the disposition effect
B) the investor attention hypothesis
C) the investor overconfidence hypothesis
D) the excessive trading costs hypothesis
Answer: C
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
22
4) A study of trading behavior of individual investors at a discount brokerage found that individual
investors ________.
A) trade very actively, despite the fact that their performance is actually worse because of trading costs
B) trade very conservatively, despite the fact that their performance is actually worse because of trading
costs
C) trade very actively, partly because their performance is better than the professionals' due to low
trading costs
D) trade very conservatively, partly because their performance is better than the professionals' due to low
trading costs
Answer: A
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
5) Disposition effect is the tendency of individual investors to ________.
A) trade too much based on the mistaken belief that they can pick winners and losers better than
investment professionals
B) buy stocks that have been in the news, advertised more, have very high trading volume, or recently
had extreme (high or low) returns
C) put too much weight on their own experience rather than considering historical evidence
D) hold on to stocks that have lost value and sell stocks that have risen in value since the time of purchase
Answer: D
Diff: 1
Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
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