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Chapter 7 Test Questions

# Chapter 7 Test Questions - Chapter 7 Test Questions...

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Chapter 7 Test Questions

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Question 1 KDP’s most recent dividend was \$2 per share and is selling today in the market for \$70. The dividend is expected to grow at a rate of 7% per year for the foreseeable future. If the market return is 10% on investments with comparable risk, should you purchase the stock? a. No, because the stock is overpriced \$1.33 b. No, because the stock is overpriced \$3.33 c. Yes, because the stock is underpriced \$1.33
Answer Question 1 Using the Gordon Growth equation. We take D1 = \$2*1.07 = \$2.14 and divide it by (.1-.07) = \$71.33. Since the value of the stock is greater than the price is a good buy (undervalued in the market by \$1.33 since it is selling for only \$70). Answer : C

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Question 2 The Extreme Reaches Corp. last paid a \$1.50 per share annual dividend. The company is planning on paying \$3.00, \$5.00, \$7.50, and \$10.00 a share over the next four years, respectively. After that the dividend will be a constant \$2.50 per share per year forever. What is the market price of this stock if the market rate of return is 15 percent? a. \$17.04 b. \$22.39
Answer Question 2 Below is the timeline used. We had to get the PV for the dividends in years 1-4 and find the value of the constant dividends after year 4 using the Gordon Growth Formula shown in the table (note: g=0). We used our calculators to find the PV of each year summing both the \$10.00 dividend and the \$16.67 (value of all future dividends) in year 4 (remember: the Gordon growth model gives you a value one period before the first payment).

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