PRACTICE QUESTIONS

1. A stock is currently selling for $40 a share. The stock is expected to pay a $2 dividend at the end of
the year. The stock’s dividend is expected to grow at a constant rate of 7 percent a year forever. The
risk-free rate (kRF) is 6 percent and the market risk premium (kM – kRF) is also 6 percent. What is the
stock’s beta?
Solution
Step 1: Find ks:
ks = D1/P0 + g
ks = $2/$40 + 0.07
ks = 0.12.
Step 2: Use the CAPM to find beta:
ks = kRF + (kM - kRF)b
0.12 = 0.06 + 0.06(b),,,,, b = 1.
2. A stock is expected to have a dividend per share of $0.60 at the end of the year (D1 = 0.60). The
dividend is expected to grow at a constant rate of 7 percent per year, and the stock has a required
return of 12 percent. What is the expected price of the stock five years from today? (That is, what is
P5?)
Solution
Step 1: Using the Gordon constant growth model, calculate today’s price:
P0 = D1/(ks - g)
= $0.60/(0.12 - 0.07)
= $12.00.
Step 2: Calculate the price of the stock 5 years from today, assuming g = 7% per year:
P5 = $12.00 (1.07)^5
= $16.83.
3. Assume that you plan to buy a share of ABD stock today and to hold it for 2 years. Your expectations
are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25
at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2. If your
expected rate of return is 16 percent, how much should you be willing to pay for this stock today?
4. Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for 1 year, 5
percent the next year, then 6 percent for the following year, and then the growth rate is expected to be a
constant 7 percent thereafter. The required rate of return on equity (ks) is 10 percent. What is the current
stock price?

5. An analyst is trying to estimate the intrinsic value of the stock of ABC Tech. The analyst estimates that the
company’s free cash flow during the next year will be $25 million. The analyst also estimates that the
company’s free cash flow will increase at a constant rate of 7% a year and that the company’s WACC is 10
percent. The company has $200 million of long-term debt and preferred stock, and 30 million outstanding
shares of common stock. What is the estimated per-share price of ABC Tech’s common stock?
6. An analyst estimating the intrinsic value of the company’s stock estimates that its free cash flow at the end of
the year (t = 1) will be $300 million. The analyst estimates that the firm’s free cash flow will grow at a
constant rate of 7 percent a year, and that the company’s weighted average cost of capital is 11 percent. The
company currently has debt and preferred stock totaling $500 million. There are 150 million outstanding
shares of common stock. What is the intrinsic value (per share) of the company’s stock?

7. You are given the following data: The risk-free rate is 5 percent. The required return on the market is 8
percent. The expected growth rate for the firm is 4 percent. The last dividend paid was $0.80 per share. Beta
is 1.3. Now assume the following changes occur due to inflation: The risk-free rate drops by 1 percent. An
increased degree of risk aversion causes the required return on the market to rise to 10 percent after
adjusting for the changed inflation premium. The expected growth rate increases to 6 percent. Beta rises to
1.5. What will be the change in price per share, assuming the stock was in equilibrium before the changes
occurred?
8. Yohe Technology’s stock is expected to pay a dividend of $2.00 a share at the end of the year. The stock
currently has a price of $40 a share, and the stock’s dividend is expected to grow at a constant rate of g
percent a year. The stock has a beta of 1.2. The market risk premium, kM – kRF, is 7 percent and the risk-free
rate is 5 percent. What is the expected price of Yohe’s stock 5 years from today?

Now calculate the price of stock in year 5, since we have constant growth rate ‘g’ now.

P5 = Po (1+g) ^ 5
= 40 (1+0.084) ^ 5 = $59.87

9. A stock is expected to pay no dividends for the first three years. The dividend for Year 4 is expected to be
$5.00 (D4 = $5.00), and it is anticipated that the dividend will grow at a constant rate of 8 percent a year
thereafter. The risk-free rate is 4 percent, the market risk premium is 6 percent, and the stock’s beta is 1.5.
Assuming the stock is fairly priced, what is its current stock price?

10. A company currently (2023) does not pay a dividend. However, the company is expected to pay a $1.00
dividend two years from today (2025). The dividend is then expected to grow at a rate of 20 percent a year for
the following three years. After the dividend is paid in 2028, it is expected to grow forever at a constant rate
of 7 percent. Currently, the risk-free rate is 6 percent, market risk premium (kM – kRF) is 5 percent, and the
stock’s beta is 1.4. What should be the price of the stock today?
11. A stock, which currently does not pay a dividend, is expected to pay its first dividend of $1.00 per share in five
years (D5 = $1.00). After the dividend is established, it is expected to grow at an annual rate of 25 percent per
year for the following three years and then grow at a constant rate of 5 percent per year thereafter. Assume
that the risk-free rate is 5.5 percent, the market risk premium is 4 percent, and that the stock’s beta is 1.2.
What is the expected price of the stock today?
12. A company’s stock is selling for $15 per share. The firm’s income, and stock price have been growing at an
annual 15 percent rate and are expected to continue to grow at this rate for 3 more years. No dividends have
been declared as yet, but the firm intends to declare a dividend of D3 = $2.00 at the end of the last year of its
supernormal growth. After that, dividends are expected to grow at the firm’s normal growth rate of 6
percent. The firm’s required rate of return is 18 percent. The stock is overvalued or undervalued?

13. Assume that the average firm in your company’s industry is expected to grow at a constant rate of 5 percent,
and its dividend yield is 4 percent. Your company is about as risky as the average firm in the industry, but it
has just developed a line of innovative new products, which leads you to expect that its earnings and
dividends will grow at a rate of 40 percent this year and 25 percent the following year after which growth
should match the 5 percent industry average rate. The last dividend paid (D0) was $2. What is the stock’s
value per share?
14. ABC Company has been hit hard due to increased competition. The company’s analysts predict that earnings
(and dividends) will decline at a rate of 5 percent annually forever. Assume that ks = 11 percent and D0 =
$2.00. What will be the price of the company’s stock three years from now?

15. Intel Inc, a constant growth company, has a current market (and equilibrium) stock price of $20.00. Intel’s
next dividend, D1, is forecasted to be $2.00, and it is growing at an annual rate of 6 percent. Intel has a beta
coefficient of 1.2, and the required rate of return on the market is 15 percent. As Intel’s financial manager,
you have access to insider information concerning a switch in product lines that would not change the growth
rate, but would cut Intel’s beta coefficient in half. If you buy the stock at the current market price, what is
your expected percentage capital gain?

Step 1: Calculate the required rate of return on equity

Ks = D1/Po + g = $2/(20) + 0.06 = 0.16 = 16%

16. Abc Motors reported earnings per share of $2.00. The stock has a price earnings ratio of 40, so the stock’s
current price is $80 per share. Analysts expect that one year from now the company will have an EPS of $2.40,
and it will pay its first dividend of $1.00 per share. The stock has a required return of 10 percent. What price
earnings ratio must the stock have one year from now so that investors realize their expected return?
17. Solar Energy Inc. is expected to pay an end-of-year dividend, D1, of $2.00 per share, and it is expected to grow
at a constant rate over time. The stock has a required rate of return of 14 percent and a dividend yield, D1/P0,
of 5 percent. What is the expected price of the stock five years from today?

18. A stock market analyst is evaluating the common stock of Inc. Investment. She estimates that the company’s
operating income (EBIT) for the next year will be $800 million. Furthermore, she predicts that Inc. Investment
will require $255 million in gross capital expenditures next year. In addition, next year’s depreciation expense
will be $75 million, and no changes in net operating working capital are expected. Free cash flow is expected
to grow at a constant annual rate of 6 percent a year. The company’s WACC is 9 percent, its cost of equity is
14 percent, and its before-tax cost of debt is 7 percent. The company has $900 million of debt, $500 million of
preferred stock, and has 200 million outstanding shares of common stock. The firm’s tax rate is 40 percent.
Using the free cash flow valuation method, what is the predicted price of the stock today?
19. A construction company’s stock recently paid a dividend of $2.00 per share (D0 = $2), and the stock is in
equilibrium. The company has a constant growth rate of 5 percent and a beta equal to 1.5. The required rate
of return on the market is 15 percent, and the risk-free rate is 7 percent. The company is considering a change
in policy that will increase its beta coefficient to 1.75. If market conditions remain unchanged, what new
constant growth rate will cause company’s common stock price to remain unchanged?