Prepared for the Spring 2001 IEM*IDEA/NSF Conference

The Iowa Electronic Markets

Stock Valuation

Curriculum using the IEM

By: Dr. Roger Ignatius

Associate Professor of Finance

Husson College

Dr. Thomas A. Rietz

Associate Professor of Finance

University of Iowa

April 2001

Student Evaluation

Multiple Choice Questions

General on the IEM in general and trading on the IEM

1. On what do the payoffs to the contracts traded on the IEM Computer Industry Returns market depend?

a. Stock prices relative to “cutoff” levels

b. Relative returns on stocks

c. True underlying valuations of stocks, independent of market valuations

d. All of the above

e. None of the above

2. The contracts you trade on the IEM for this class are based on:

a. the returns for entertainment industry stocks.

b. the returns for computer industry stocks.

c. the outcomes of elections.

d. the level of prices in the economy.

3. Predicting stock values can help in IEM trading because they:

a. can help explain past returns for stocks.

b. can help predict future returns for stocks.

c. determine completely the current price of a stock.

d. are based on past accounting numbers.

4. Contracts are created on the IEM through the following procedure:

a. Each trader gets contracts when he or she opens an account.

b. Contracts are created each time you make a purchase.

c. Contracts are created when traders buy bundles.

d. The number of contracts in the market is fixed and, therefore, no contracts are ever created.

5. If you think that AAPL is the most undervalued and will have the highest return over the next month among AAPL, IBM, MSFT and the S&P500, you should:

a. Try to buy AAPLm by placing an ask.

b. Try to buy AAPLm by placing a bid.

c. Try to sell AAPLm by placing an ask.

d. Try to sell AAPLm by placing a bid.

Questions on Principles of Valuation

6. Which valuation concept is defined as the depreciated value of assets minus the book value of outstanding liabilities?

a. Book Value

b. Liquidation Value

c. Market Value (P)

d. Intrinsic Value (V)

7. Which valuation concept is defined as the amount that would be raised if all assets were sold independently?

a. Book Value

b. Liquidation Value

c. Market Value (P)

d. Intrinsic Value (V)

8. Which valuation concept is defined as the value according to market price of outstanding stock?

a. Book Value

b. Liquidation Value

c. Market Value (P)

d. Intrinsic Value (V)

9. Which valuation concept is defined as the net present value of future cash flows (discounted at investors’ required rate of return)?

a. Book Value

b. Liquidation Value

c. Market Value (P)

d. Intrinsic Value (V)

10. What is book value?

a. The depreciated value of assets minus the value of outstanding liabilities

b. The amount that would be raised if all assets were sold independently

c. The value according to market price of outstanding stock

d. The net present value of future cash flows (discounted at investors’ required rate of return)

11. What is liquidation value?

a. The depreciated value of assets minus the value of outstanding liabilities

b. The amount that would be raised if all assets were sold independently

c. The value according to market price of outstanding stock

d. The net present value of future cash flows (discounted at investors’ required rate of return)

12. What is market value?

a. The depreciated value of assets minus the value of outstanding liabilities

b. The amount that would be raised if all assets were sold independently

c. The value according to market price of outstanding stock

d. The net present value of future cash flows (discounted at investors’ required rate of return)

13. What is intrinsic value?

a. The depreciated value of assets minus the value of outstanding liabilities

b. The amount that would be raised if all assets were sold independently

c. The value according to market price of outstanding stock

d. The net present value of future cash flows (discounted at investors’ required rate of return)

14. In an efficient market, which two valuation concepts should be the same?

a. Book value and liquidation value

b. Book value and market value

c. Liquidation value and intrinsic value

d. Market value and intrinsic value

15. You need to determine the discount rate to value stock of Walt’s Waffle Warehouse (WWW). You look it up on the Internet and find bWWW = 1.5. You determine that the risk free rate is 3% and the appropriate risk premium is 8%. What should the required return on WWW stock be?

Questions on the Constant Dividend Model

16. Steady Disbursements Incorporated (SDI) pays an annual dividend of $5.00, which is expected to remain constant. If the required return on SDI stock is 8%, what should the price of SDI stock be?

a. $40.00

b. $62.50

c. $160.00

d. Cannot be determined from the information given.

17. Steady Disbursements Incorporated (SDI) pays an annual dividend of $5.00, which is expected to remain constant. If the risk free rate is 3.5%, the market risk premium is 6% and the beta of SDI stock is 0.75, what should the price of SDI stock be?

a. $40.00

b. $62.50

c. $160.00

d. Cannot be determined from the information given.

18. Steady Disbursements Incorporated (SDI) pays an annual dividend of $5.00, which is expected to remain constant. If the price of SDI stock is $62.50, what return are investors demanding on SDI stock?

a. 8.00%

b. 12.50%

c. 31.25%

d. Cannot be determined from the information given.

19. Steady Disbursements Incorporated (SDI) pays an annual dividend, which is expected to remain constant. If the price of SDI stock is $62.50 and investors demand an 8% return, what is the dividend on SDI stock?

a. $0.1280

b. $5.0000

c. $7.8125

d. Cannot be determined from the information given.

20. Steady Disbursements Incorporated (SDI) pays an annual dividend, which is expected to remain constant. If the price of SDI stock is $62.50, the risk free rate is 3.5%, the market risk premium is 6% and the beta of SDI stock is 0.75, what is the dividend on SDI stock?

a. $0.1280

b. $5.0000

c. $7.8125

d. Cannot be determined from the information given.

21. If a stock is valued according to the constant dividend model, which of the following factors increases the value of the stock?

a. The stock’s dividend

b. The stock’s required return

c. The stock’s beta

d. All of the above

e. None of the above

22. Determine the price of a share of common stock of Intercontinental Ballistics Missiles (IBM) given that the company pays fixed constant dividends of $2.50 per share (annually) and has a required rate of return on equity of 15 percent.

23. What is the required rate of return on a share of common stock of Maxisoft if the fixed annual dividend is $2.00 and the price per share is $60?

24. Calculate the annual dividend on a share of common stock of Steaks R Us if the price per share is $50 and the required rate of return on equity is 10 percent.

25. A share of common stock of Pineapple Computers is valued at $40, the fixed annual dividend is $2.00 and the required rate of return on equity is 15 percent.

a. If the dividend stays fixed and the required rate of return changes as follows, what is the new value per share in each case?

Required Rate of Return

10%

12%

17%

20%

b. What do the calculations reveal about the relationship between the required rate of return and value per share, other factors remaining the same? What are some reasons for changes in the required rate of return for the company’s stock?

c. If the required rate of return stays constant while the annual dividend changes as follows, what is the effect on stock value?

Annual Dividend

$0.50

$1.00

$1.50

$2.50

$3.00

$5.00

d. What can you discern about the relationship between dividends and stock value, other things remaining constant? What are some reasons that companies might change their dividend payments?

Questions on the Constant Growth Model

26. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year, which is expected to grow at 3% per year forever. If the required return on SES stock is 8%, what should the price of SES stock be?

a. $64.38

b. $100.00

c. $103.00

d. Cannot be determined from the information given.

27. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year and is expected to pay $5.15 next year. If this growth rate continues forever and the required return on SES stock is 8%, what should the price of SES stock be?

a. $64.38

b. $100.00

c. $103.00

d. Cannot be determined from the information given.

28. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year, which is expected to grow at 3% per year forever. If the risk free rate is 3.5%, the market risk premium is 6% and the beta of SES stock is 0.75, what should the price of SDI stock be?

a. $64.38

b. $100.00

c. $103.00

d. Cannot be determined from the information given.

29. Steady Escalation Systems (SES) is expected to pay an annual dividend of $5.15 next year, which is expected to grow at 3% per year forever. If the price of SDI stock is $103.00, what return are investors demanding on SDI stock?

a. 4.85%

b. 5.00%

c. 8.00%

d. Cannot be determined from the information given.

30. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year, which is expected to grow at 3% per year forever. If the price of SDI stock is $103.00, what return are investors demanding on SDI stock?

a. 4.85%

b. 5.00%

c. 8.00%

d. Cannot be determined from the information given.

31. Steady Escalation Systems (SES) is expected to pay an annual dividend of $5.15 next year, which is expected to grow at a constant forever. If the price of SDI stock is $103.00 and investors are demanding an 8% return, what growth rate must investors be expecting on SDI stock?

a. 3.00%

b. 4.85%

c. 5.00%

d. Cannot be determined from the information given.

32. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year, which is expected to grow at a constant rate forever. If the price of SDI stock is $103.00 and investors are demanding an 8% return, what growth rate must investors be expecting on SDI stock?

a. 3.00%

b. 4.85%

c. 5.00%

d. Cannot be determined from the information given.

33. Steady Escalation Systems (SES) pays an annual dividend which is expected to grow at a constant rate of 3% forever. If the price of SES stock is $103.00 and investors demand an 8% return, what is the next dividend on SDI stock expected to be?

a. $3.09

b. $5.15

c. $8.24

d. Cannot be determined from the information given.

34. Steady Escalation Systems (SES) pays an annual dividend which is expected to grow at a constant rate of 3% forever. If the price of SES stock is $103.00 and investors demand an 8% return, what was the last dividend paid on SDI stock?

a. $3.00

b. $5.00

c. $8.00

d. Cannot be determined from the information given.

35. If a stock is valued according to the constant growth model, which of the following factors increases the value of the stock?

a. The stock’s dividend growth rate

b. The stock’s required return

c. The stock’s beta

d. All of the above

e. None of the above

36. Steady Escalation Systems (SES) had earnings last year of $7.50 per share and paid out $5.00 in dividends. If they have an ROE of 9%, what is their sustainable growth rate?

a. 2.50%

b. 3.00%

c. 33.33%

d. Cannot be determined from the information given.

37. All of the following are means of estimating a company’s growth rate except:

a. Historical average growth

b. Beta relative to the market risk premium

c. Average analysts’ estimated growth

d. Sustainable growth

e. Required return versus dividend yield.

38. Internet retailer, Mississippi.com, has earnings per share (EPS) of $2.00 and pays out $0.20 in annual dividends per share. Its return on equity, ROE, is 30%. What is the sustainable growth rate? If the required rate of return is 20%, what problems arise when using the Discounted Dividend Model (DDM)?

39. Retailer J.C. Dollar pays an annual dividend of $1.50 per share with an expected growth in dividends of 10 % each year. The required rate of return on equity is 20%. What is the value per share?

40. Moon Microsystems will pay a dividend of $1.00 per share and the growth rate in dividends is expected to be 8% each year. If the price per share is $25, what is the required rate of return on equity?

41. TLCFY paid a dividend of $1.20 per share.

a. The expected growth rate in dividends is 6% and the required rate of return is 20%. What is the value per share?

b. If the growth rate in dividends changes as follows while the other factors except price remain constant, calculate the new value per share in each case.

Growth Rate in Dividends

10%

15%
18%

c. What is the relationship between growth in dividends and value?

d. Repeat the exercise for changes in the required rate of return, other factors except price being held constant.

Required Rate of Return

10%

15%

25%

30%

e. What is the relationship between the required rate of return and value?

Questions on the Discounted Cash Flow Model

42. If one defines cash flows as those available to all investors, then the correct discount rate to use in the discounted cash flow model is:

a. The CAPM k to the stockholders

b. The WACC k to all investors

c. Either one because they should be the same for all companies

d. Neither one because they do not reflect the risks to cash flows