Question

1. The relevant variable a financial manager uses to measure retums is A) net income determined using generally accepted accounting principles. B) earnings per share minus dividends per share. C) cash flows. D) dividends. 2. You are considering the purchase of a common stock that paid a dividend of $2.00 yesterday. You expect this stock to have a growth rate of 15 percent for the next 3 years, resulting in dividends of D1 = $2.30, D2 = $2.645, and D3 = $3.04. The long-run normal growth rate after year 3 is expected to be 10 percent (that is, a constant growth rate after year 3 of 10% per year forever). If you require a 14 percent rate of return, how much should you be willing to pay for this stock? A) $89.75 B) $83.65 C) $56.46 D) $62.57 3. The yield to maturity on a bond is the rate of return that equates the present value of the bond's future cash flows with the bond's A) face value. B) market value. C) liquidation value. D) book value. 4. You purchased 500 shares of A.M.J. Inc. common stock one year ago for $50 per share. You received a dividend of $2 per share today and decide to take your profits by selling at $54.50 per share. Your required return is 18%. What is your percentage holding period return? A) 13.0% B) 9.0% C) 6.5% D) 4.0%

Answer 1

(1): The answer is “c” – cash flows.

This is because cash flow is a tangible concept and hence managers use the cash flow figures to compute all returns.

(2): The answer is “d” - $62.57

Price = D1/1.14 + D2/1.14^2 + D3/1.14^3 + P3/1.14^3

= 2.30/1.14 + 2.645/1.14^2 + 3.042/1.14^3 + [3.042*1.1/(14%-10%)]/1.14^3

= $62.57

(3): The answer is “b” – market value.

Yield to maturity is the total return that will be earned by someone who purchases a bond and holds it until its maturity date. It is also known as internal rate of return for a bond.

(4): The answer is “a” – 13%.

Return = [2 + (54.50-50)]/50 *100

= 6.50/50 * 100

= 13%