If a company has preferred stock, the cost of preferred equity used in the company’s weighted average cost of capital calculation is

A)   Ignored

B)   Equal to the preferred dividend rate

C)   Equal to the preferred dividend rate multiplied by 1 – marginal income tax rate

D)   Equal to the cost of equity capital

Answer: B

Rationale: WACC uses the preferred dividend rate as cost of preferred equity.

20. The proper discount rate when using the dividend discount valuation model is the:

A)   Weighted average cost of capital

B)   Cost of equity capital 

C)   Cost of debt capital

D)   Average borrowing rate

Answer: B

Rationale: Dividends accrue to common shareholders so the cost of equity capital should be used.

21. The dividend discount valuation model equates the current stock price to:

A)   All future expected dividends

B)   All future expected dividends discounted by the weighted average cost of capital

C)   All future expected dividends discounted by the cost of equity capital

D)   The current dividend divided by current earnings per share

Answer: C

Rationale: The DDM equates the value of company equity with the present value of all future dividends, using the cost of equity as the proper discount rate.

22. Investment Company forecasts a $1.45 dividend for 2013, $1.56 dividend for 2014 and a $1.65 dividend for 2015 for Malibu Corporation.  For all years after 2015, Investment Company forecasts that Malibu will pay a $1.75 dividend.  Using the dividend discount valuation model determine the intrinsic value of Malibu Corporation, assuming the company’s cost of equity capital is 8%.

A)   $25.44

B)   $21.88

C)   $18.12

D)   $21.36

Answer: D

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