CFA 2018 Quest bank 03 Discounted Dividend Valuation

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Test ID: 7440710

Discounted Dividend Valuation

Question #1 of 133

Question ID: 463100

ᅚ A) ᅞ B) ᅞ C)

Question #2 of 133

Question ID: 463117

ᅞ A) ᅞ B) ᅚ C)

If the growth rate in dividends is too high, it should be replaced with:

a growth rate closer to that of gross domestic product (GDP). the growth rate in earnings per share.

the average growth rate of the industry.

Explanation

A firm cannot, in the long term, grow at a rate significantly greater than the growth rate of the economy in which it operates. If

the growth rate in dividends is too high, then it is best replaced by a growth rate closer to that of GDP.

An analyst for a small European investment bank is interested in valuing stocks by calculating the present value of its future

dividends. He has compiled the following financial data for Ski, Inc.:

E

arnings per Share

(EPS)

Y

ea

r 0

$4.00

Y

ea

r 1

$6.00

Y

ea

r 2

$9.00

Y

ea

r 3

$13.50

Note: Shareholders of Ski, Inc., require a 20% return on their investment in the high growth stage comparedto12% in the stable growth stage.The dividend payout ratioof Ski, Inc., is expectedto be 40% for the nextthree years.After year 3, the dividend payout ratio is expectedto increase to 80% andthe expected earnings growth will be 2%. Using the information contained in the table, what is the value of Ski, Inc.'s, stock?

$43.04. $39.50.

$71.38.

Explanation

Thedividendsinthenextfour yearsare:

Year 1: 6 × 0.4 = 2.4

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Question #3 of 133

Question ID: 463067

Question #4 of 133

Question ID: 463095

Question #

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Question ID: 463030

Year 4:(13.5 × 1.02) × 0.8 = 11.016

Theterminalvalueofthefirm(in year 3)is11.016 / (0.12 − 0.02) = 110.16.Value per share = 2.4 / (1.2) + 3.6 / (1.2)+ 5.4 / (1.2) +

110.16 / (1.2) = $71.38.

The value per share for Burton, Inc. is $32.00using the Gordon Growth model.The company paid a dividendof $2.00last year.The estimates usedtocalculate the value have changed.Ifthe new required rate of return is 12.00% and expected growth rate in dividends is 6%, the value per share willincrease by:

4.17%. 9.51%. 10.42%.

Explanation

The value per share using the new estimates is $35.33 = [$2.0(1.06) / 0.12 - 0.06)] andthe percentage increase inthe value per share will be 10.42% = [(35.33 - 32.00) / 32.00] × 100%.

Ifthevalueofan 8%, fixed-rate, perpetual preferredshareis $134, andthe par valueis $100, whatisthe required rateof return?

6%.

8%.

7%.

Explanation

The required rateof returnis 6%:V = ($100par × 8%) / r = $134, r = 5.97%

Multi-stage growth modelscan becomecomputationally intensive. For this reasonthey areoften referredtoas:

quadratic models.

R-squaredmodels.

spreadsheetmodels.

Explanation

Thecomputationally intensivenatureofthesemodelsmakethema perfectapplicationfor aspreadsheet program, hencethename spreadsheetmodels.

1 2 3

3

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Question #

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QuestionID:463146

Question #7 of 133

QuestionID:463103

Question #

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QuestionID:463071

Which ofthefollowing is least likely a valid approach to determining theappropriate discount rate for a firm's dividends?

Capital asset pricing model (CAPM).

Arbitrage pricing theory (APT).

Free cash flow to firm (FCFF).

Explanation

FCFF isanother discounted cash flow model, nota method to determine required returns. Each of the other answersisa valid approach

to determining an appropriate discount rate.

Which of the following models would bemostappropriatefor afirmthatisexpectedto grow ataninitial rate of10%, declining steadily to 6% over a period offive years, andto remainsteady at 6% thereafter?

A two-stage model. TheGordon growth model. The H-model.

Explanation

The H-modelisthe bestanswer, asitavoidsanimmediatedrop to 6% likeatwo-stage would.TheGordon growth model wouldnot be appropriate.

Supposetheequity required rate of returnis10%, thedividend just paidis $1.00anddividendsareexpectedto grow atan annual rate of 6% forever. Whatistheexpected priceattheend of year 2?

$29.78. $27.07.

$28.09.

Explanation

Theterminalvalueis $29.78, andthatisthe priceaninvestor should be willing to pay attheend of year 2.Thecorrectanswer

isshown below.

Year Dividend

1 $1.0600

2 $1.1236

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Question #

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Question ID: 463107

Question #10 of 133

Question ID: 463058

Question #11 of 133

Question ID: 463111

V : $1.191/(0.10 - 0.06) = $29.78

Which ofthefollowing models would bemostappropriatefor afirmthatisexpectedto grow at 8% for thenextthree years, andat 6%

thereafter?

The H-model.

TheGordon growth model. Atwo-stagemodel.

Explanation

Afirmthatisexpectedto experiencetwo growth stages with afixed rate of growth for each stageshould beevaluated with atwo-stage dividenddiscountmodel.

Deployment Specialists paysacurrent(annual)dividend of $1.00andisexpectedto grow at20% for two yearsandthenat

4% thereafter.Ifthe required returnfor Deployment Specialistsis 8.5%, thecurrentvalue ofDeployment Specialistsisclosest

to:

$30.60. $33.28.

$25.39.

Explanation

Firstestimatetheamount ofeach ofthenexttwo dividendsandtheterminalvalue.Thecurrentvalueisthesum ofthe present

value ofthesecash flows, discountedat 8.5%.

Mostfirmsfollow a pattern of growth thatincludesseveralstages.Thesecondstage of growth is referredto asthe: H-stage.

maturestage.

transitionalstage.

Explanation

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Question #12 of 133

Question ID: 463097

Question #13 of 133

Question ID: 463060

Question #14 of 133

Question ID: 463118

Thesecondstageis often referredto asthetransitionalstage.During thisstage, thefirm's growth beginsto slow as

competitiveforces build.

TheGordon growth modelis wellsuitedfor:

utilities.

telecomcompanies.

biotech firms.

Explanation

Gordon growth modelis bestsuitedto firmsthat haveastable growth comparableto or lower thanthenominal growth ratein

theeconomy and have wellestablisheddividend payout policies. Utilities, with their regulated prices, stable growth and high

dividends, are particularly wellsuitedfor thismodel.

Ifastock expectsto pay dividends of $2.30 per sharenext year, whatisthevalue ofthestock ifthe required rate of returnis12% and theexpected growth rateindividendsis4%?

$29.90. $19.17. $28.75.

Explanation

Using theGordon growth model, thevalue per share = DPS / (r − g) = 2.30 / (0.12 − 0.04) = $28.75.

Acompany'sstock betais0.76, themarket returnis10%, andthe risk-free rateis4%.Thestock will pay no dividendsfor the firsttwo years, followed by a $1dividendand $2dividend, respectively.Aninvestor expectsto sellthestock for $10attheend

offour years. What priceisaninvestor willing to pay for thisstock?

$9.42. $10.16. $11.03.

Explanation

Thefirststep isto determinethe required rate of returnas4% + [(10% - 4%) × 0.76] or 8.56% per year.Thesecondstep isto

determinethe presentvalue ofallfutureexpectedcash flows, including theterminal $10stock price, discounted back four yearsto today.Thesolutionisshown below.

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Question #1

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Question ID: 463152

ᅞ A) ᅚ B) ᅞ C)

Question #1

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Question ID: 463116

YearCF

1 0

2 0

3 1

4 2

4 10

0/1.0856 + 0/(1.0856) + 1/(1.0856) + (2 + 10)/(1.0856) = $9.42

Ifafirm hasa return onequity of15%, acurrentdividend of $1.00, andasustainable growth rate of 9%, whatarethefirm'scurrent earnings?

$1.50. $2.50. $1.75.

Explanation

Theearningscan bedetermined by solving for earningsinthesustainable growth formula: 9% = [1 − ($1 / $Earnings)] × 0.15 or $1 / 0.4 = $Earnings = $2.50

Ananalyst hascompiledthefollowing financialdatafor ABC, Inc.:

ABC, Inc. Valuation Scenarios

Item Scenario 1 Scenario 2 Scenario 3 Scenario 4

Year 0 Dividends per Share $1.50 $1.50 $1.50 $1.50 Long-term Treasury Bond Rate 4.0% 4.0% 5.0% 5.0% Expected Return onthe S&P 500 12.0% 12.0% 12.0% 12.0%

Beta 1.4 1.4 1.4 1.4

g (growth ratein dividends) 0.0% 3.0%

Years1-3, g=12.0% After Year 3,

g=3.0%

Year 1, g=20% Year 2, g=18% Year 3, g=16% Year 4, g=9% Year 5, g=8% Year 6, g=7%

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Question #17 of 133

Question ID: 463138

Question #1

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Question ID: 463130

After Year 6, g=4%

If year 0 dividend is $1.50 per share, the required rate of return of shareholdersis15.2%, whatisthe value of ABC, Inc.'sstock price using the H-Model? Assumethatthe growth in dividends has been20% for the last 8 years, butisexpected to decline3% per year for the next 5 yearsto astable growth rate of 5%.

$20.95. $24.26. $19.85.

Explanation

Usethe H-Model to valuethe firm. The H-Model assumesthattheinitial growth rate (g) will decline linearly to thestable growth rate (g). The high growth period isassumed to last2H years. Hence, the value per share = DPS(1 + g) / (r − g) + DPS × H × (g − g) / (r − g)

(1.5 × 1.05) / (0.152 − 0.05) + [1.5 × (5 / 2) × (0.20 − 0.05)] / (0.152 − 0.05) 1.575 / 0.102 + 0.5625 / 0.102

15.44 + 5.51 = $20.95

If we know the forecast growth rates for a firm's dividendsand thecurrent dividendsand current value, wecan determinethe:

required rate of return.

sustainable growth rate. netmargin of the firm.

Explanation

Justas wecan determinethecurrent value of theshares fromthecurrent dividends, growth forecastsand required return, wecansolve for any one of themif we know the other three factors.

Giventhata firm'scurrent dividend is $2.00, the forecasted growth is 7% for thenexttwo yearsand 5% thereafter, and thecurrent value of the firm'ssharesis $54.50, whatisthe required rate of return?

Can't be determined.

10%. 9%.

Explanation

Theequationto determinethe required rate of returnissolvedthrough iteration.

a n

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Question #1

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Question ID: 463158

Question #20 of 133

Question ID: 472544

$54.50 = $2(1.07) / (1 + r) + $2(1.07) / (1 + r) + {[$2(1.07) (1.05)] / (r - 0.05)} / [(1 + r) Through iteration, r = 9%

Heather Callaway, CFA, isconcernedabouttheaccuracy of her valuation ofCrimsonGate, afast-growing

telecommunications-equipmentcompany that her firm ratesasatop buy.Crimsoncurrently tradesat $134 per share, and Callaway has puttogether thefollowing informationaboutthestock:

Most recentdividend per share $0.55

Growth rate, next2 years 30%

Growth rate, after 2 years 12%

Trailing P/E 25.6

Financialleverage 3.4

Sales $1198 per share

Assetturnover 11.2

Estimatedmarket rate of return 13.2%

Callaway'semployer, BatesInvestments, likesto useacompany'ssustainable growth rateasa key inputto obtaining the

required rate of returnfor thecompany'sstock. Crimson'ssustainable growth rateisclosestto:

13.2%.

16.6%.

14.8%.

Explanation

Sustainable growth rate = ROE × retention rate

Earnings per share = price / (P/E) = $134 / 25.6 = $5.23

The retention rate representsthe portion ofearningsnot paid outindividends. = (5.23 − 0.55) / 5.23 = 0.89 or 89% ROE = profitmargin × assetturnover × financialleverage

ROE = 5.23 / 1198 × 11.2 × 3.4 = 16.6% Sustainable growth rate = 89% × 16.6% = 14.8%

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Question #21 of 133

Question ID: 463093

Question #22 of 133

Question ID: 463066

Question #23 of 133

Question ID: 463155

ᅞ A) ᅞ B)

Which ofthefollowing dividenddiscountmodels(DDMs)ismostappropriatefor modeling amaturecompany?

H-model.

Gordon growth model. Two-stageDDM.

Explanation

TheGordon growth modelassumesthatdividends grow ataconstant rateforever.Itismostsuitedfor maturecompanies with

low to moderate growth ratesand well-establisheddividend payout policies.

A $100 par, perpetual preferred share paysa fixed dividend of 5.0%. If the required rate of returnis 6.5%, whatisthecurrent value of the shares?

$76.92. $88.64. $100.00.

Explanation

Thecurrentvalue ofthesharesis $76.92: V = ($100 × 0.05) / 0.065 = $76.92

Jax, Inc., paysacurrent dividend of $0.52and is projected to grow at12%. If the required rate of returnis11%, whatisthecurrent value based onthe Gordon growth model?

$58.24. $39.47.

unableto determine valueusing Gordonmodel.

Explanation

The Gordon growth model cannot beused if the growth rateexceedsthe required rate of return.

Thesustainable growth rate, g, equals:

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ᅚ C)

Question #24 of 133

Question ID: 463154

Question #2

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Question ID: 463115

earnings retention ratetimesthe return onequity.

Explanation

The formula for sustainable growth is: g = b × ROE, where g = sustainable growth, b = theearnings retention rate, and ROE equals return onequity.

Sustainable growth isthe ratethatearningscan grow:

indefinitely without altering the firm's capital structure. with thecurrentassets.

withoutadditional purchase of equipment.

Explanation

Sustainable growth isthe rate of earnings growth thatcan bemaintained indefinitely withouttheaddition of new equity capital.

Q-Partnersisexpectedto haveearningsinten years of $12 per share, adividend payout ratio of 50%, anda required return

of11%.Atthattime, ROE isexpectedto fallto 8% in perpetuity andthetrailing P/E ratio isforecastedto beeighttimes

earnings.Theterminalvalueattheend often yearsusing theP/E multipleapproach andDDM isclosestto: P/E multiple DDM

96.00 89.14

96.32 85.71

96.32 89.14

Explanation

TerminalValue = P/E × EPS = 8 × 12 = 96

D = 0.5 × 12 = 6 g = 0.50 × 0.08 = 4%

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Question #2

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Question ID: 463109

Question #27 of 133

Question ID: 463147

Question #2

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Question ID: 463032

Question #2

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Question ID: 463087

Themostappropriatemodelfor analyzing a profitable high-tech firmisthe:

three-stage dividend discount model (DDM). H-model.

zero growth cash flow model.

Explanation

Most of high-tech firms grow atvery high ratesandareexpectedto grow atthose ratesfor aninitial period.These ratesare expectedto declineasthefirm growsinsizeandlosesitscompetitiveadvantage. Ofthemodels provided, thethree-stage

DDM ismostappropriateto analyze high-tech firms because ofitsflexibility. H-modelmay not beappropriate, becausea

linear declinefromthe high growth rateto theconstant growth ratecannot beassumedandthedividend payout ratio isfixed.

Financialmodelssuch astheDDM representacornerstone ofequity valuationfromanacademicstandpoint.Butinthe real life, many analystsdo notusetheDDM.The least likely reasonfor thisis:

some of the assumptions required are impractical.

modern research hasshownthatmany ofthe oldstandbysdo not work. themodellackstheflexibility requiredto modelvaluesinthe real world.

Explanation

TheDDM requiresassumptionsthatmany analystsfindimpractical.Inaddition, themodellackstheflexibility to adaptto

changing circumstances.Both ofthese problemscan be overcome, to alargeextent, by using spreadsheetmodeling to

forecastcash flowsand other variables.

If aninvestor wereattempting to captureanasset'salpha returns, theexpected holding period return (HPR) would be: lower than the required return.

thesameasthe required return. higher thanthe required return.

Explanation

Alpha returnsare returnsinadditionto the required returns, so theexpected HPR would be higher thanthe required return.

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Question #30 of 133

Question ID: 463031

Question #31 of 133

Question ID: 463164

Currentshare price $100.00. Currentearnings $3.50. Current dividend $0.75. Growth rate11%. Required return13%.

Based onthisinformationand the Gordon growth model, whatisthe firm's justified trailing priceto earnings (P/E) ratio?

8.9. 11.3. 11.9.

Explanation

The justified trailing P/E is11.9:

P / E = [($0.75)(1 + 0.11)/$3.50] / (0.13 - 0.11) = 11.8929

Historical informationused to determinethe long-termaverage returns fromequity marketsmay suffer fromsurvivorship bias, resulting in:

deflating the mean return. inflating themean return. unpredictable results.

Explanation

Survivorship bias refersto the weeding out of underperforming firms, resulting inaninflated value for themean return.

Initsmost recent quarterly earnings report, Smith BrothersGarden Suppliessaidit plannedto increaseitsdividendatan annual rate of 5% for theforeseeablefuture.AnalystAnton Spearsisusing a required return of 9.5% for Smith Brothersstock.

Smith Brothersstock tradesfor $52.17 per shareandearned $3.01 per share over thelast12months.Thecompany paida

dividend of $2.15 per shareduring thelast12-month period, anditsdividend-growth ratefor thelastfive years was 9.2%.

Using theGordonGrowth model, theshare pricefor Smith Brothersstock ismost likely:

overvalued.

correctly valued.

undervalued.

Explanation

TheGordonGrowth modelisasfollows:

Value = [dividend × (1 + dividend growth rate)] / [required return − growth rate]

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Question #32 of 133

Question ID: 463143

Question #33 of 133

Question ID: 463148

Question #34 of 133

Question ID: 463038

ᅚ A) ᅞ B)

Value= [2.15 × 1.05] / [0.095 − 0.05] = 2.2575 / [0.095 − 0.05] = 50.17

Givenanequity risk premium of3.5%, aforecasteddividend yield of2.5% onthemarketindex anda U.S. government bond

yield of4.5%, whatistheconsensuslong-termearnings growth estimate?

5.5%.

10.5%.

8.0%.

Explanation

Equity risk premium = forecasteddividend yield + consensuslong termearnings growth rate - long-term government bond

yield. Therefore,

Consensuslong termearnings growth rate =

Equity risk premium - forecasteddividend yield + long-term government bond yield Consensuslong termearnings growth rate = 3.5% - 2.5% + 4.5% = 5.5%

Relativeto traditionalfinancialmodelslikethedividenddiscountmodel, the biggestadvantage ofspreadsheetmodeling is:

simplicity of computations. quantity ofcomputations.

accuracy ofcomputations.

Explanation

Computationsareno simpler or morecomplicated onaspreadsheetas opposedto acalculator.Accuracy tendsto be improved with theuse ofaspreadsheet, because youdon't haveto punch numbersinto acalculator atany stage. However, someonetruly concerned with accuracy cando afine job with acalculator.Thespreadsheetstands out whenitcomesto quantity.Analystscan programmany permutationsandscenariosinto aspreadsheet, using minutesto do what wouldtake

hours or evendays or weeks with acalculator.

Which of the following dividend discountmodels hasthe limitationthatasuddendecrease to the lower growth rateinthesecond stage may NOT be realistic?

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ᅞ C)

Question #3

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Question ID: 463039

Question #3

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Question ID: 463091

Questions #37

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H model.

Explanation

Thetwo-stage DDM hasthe limitationthatasudden decreaseto the lower growth rateinthesecond stagemay not be realistic. Further,

themodel hasthe difficulty intrying to estimatethe length of the high-growth stage.

Which ofthefollowing is least likelya potential problemassociated with thethree-stagedividenddiscountmodel(DDM)? The:

stable period payout ratio maybe too high resulting in an extremely low value. betainthestable periodistoo high, resulting inanextremely low stock value.

high-growth andtransitional periodsaretoo long, resulting inanextremely high stock

value.

Explanation

Ifthestable period payout ratio istoo low itmay resultinanextremely low value becausetheterminalvalue will belower due

to thesmaller dividends being paid out.

A firm hasthe following characteristics: Currentshare price $100.00. One-year earnings $3.50. One-year dividend $0.75. Required return13%.

Justified leading priceto earnings10.

Based onthe dividend discountmodel, whatisthe firm'sassumed growth rate?

12.4%.

8.6%.

10.9%.

Explanation

Theassumed growth rateis10.9%:

P /E = ($0.75/$3.50) / (0.13 - g) = 10, g = 10.86%

JulieDavidson, CFA, has recently been hired by a well-respected hedgefundmanager in New York asaninvestmentanalyst. Davidson's responsibilitiesin her new positioninclude presenting investment recommendationsto her supervisor, who isa

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Question #37 of 133

Question ID: 463045

Question #3

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Question ID: 463046

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Itisthe beginning of2006, andDavidson wantsusetheabovedatato identify which will havethe greatestexpected returns.

Shemustdetermine which valuationmodel(s)ismostappropriatefor thesetwo securities.Also, Davidsonmustforecast sustainable growth ratesfor each ofthecompaniesto assess whether or notthey wouldfit withinthefund'sinvestment parameters.

Using theGordon growth model(GGM), whatistheequity risk premium?

5.50%.

2.75%.

3.25%.

Explanation

TheGGM calculatesthe risk premiumusing forward-looking or expectationaldata.Theequity risk premiumisestimatedas the one-year forecasteddividend yield onmarketindex, plustheconsensuslong-termearnings growth rate, minusthelon g-term government bond yield. Notethat becauseequitiesareassumedto havealong duration, thelong-term government bond yieldservesasthe proxy for the risk-free rate.

Equity risk premium = 1.75% + 5.25% − 4.25% = 2.75%

(Study Session10, LOS 31.b)

Davidsonisfamiliar with theuse ofthecapitalasset pricing model(CAPM)andarbitrage pricing theory (APT)to estimatethe

required rate of returnfor anequity investment. However, therearesomelimitationsassociated with both modelsthatshould

beconsideredin her analysis. Which ofthefollowing is least likelyalimitation oftheCAPM and/or APT?

Riskpremium exposure,because it fails to consider the implications of an asset's sensitivity to the various risk factors in the market.

Inputuncertainty, becauseitisdifficultto estimatetheappropriate risk premiums

accurately.

Modeluncertainty, becauseitisunknowniftheuse ofeither modelistheoretically

correctandappropriate.

Explanation

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Question #42 of 133

Question ID: 463050

Question #43 of 133

Question ID: 463135

ᅞ A)

ᅚ B) ᅞ C)

Question #44 of 133

Question ID: 463040

(2.25) = 0.095 = 9.50%. (Study Session11, LOS 35.o)

Davidsondeterminesthat over the pastthree years, Samson hasmaintainedanaveragenet profitmargin of 8 percent, atotal

assetturnover of1.6, andaleverage ratio (equity multiplier) of1.39.Assuming Samsoncontinuesto distribute35 percent of

itsearningsasdividends, Samson'sestimatedsustainable growth rate(SGR)is:

17.8%.

11.6%.

6.2%.

Explanation

Utilizing thePRATmodel, where SGR isafunction of profitmargin(P), the retention rate(R), assetturnover (A)andfinancial leverage(T):

g = P × R × A × T

g = 0.08 × (1 − 0.35) × 1.6 × 1.39 = 0.116 = 11.6%. (Study Session11, LOS 35.o)

Which ofthefollowing groups ofstatistics providesenough datato calculateanimplied returnfor astock using thetwo-stage

DDM?

Short-term growth rate, long-term growth rate, stockprice, trailing 12-month profits.

P/E ratio, trailing 12-month profits, short-termPEG ratio, long-termPEG ratio, yield.

Yield, stock price, historicaldividend-growth rate, historical profit-growth rate.

Explanation

To calculateanimplied returnusing thetwo-stageDDM, weneedthestock price, thedividend, ashort-term growth rate, and

along-term growth rate.Inthecorrectanswer, wecanderivethestock pricefromtheP/E ratio and profits, thenderivethe

dividendfromthe priceandthe yield.GiventheP/E ratio, wecanalso distill growth ratesusing thePEG ratios.Admittedly,

earnings-growth ratesaren'tthesameasdividend-growth rates, butanalysts routinely useeither intheir models. Moreto the

point, thisisthe only answer in which wecancomeup with evenimperfectdatafor alltheneededvariables. Onechoicedoes

not provideus with a way to findthedividend.The other optiondoesnot giveustheneededshort-termandlong-term growth rates.

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Question #4

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Question ID: 463098

Question #4

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Question ID: 463079

terminal value is not sensitive to the estimates of growth rates.

initial high growth ratedeclineslinearly to thelevel ofstable growth rate.

payout ratio changesto adjustthechangesin growth estimates.

Explanation

Asuddendeclinein high growth rateintwo-stageDDM may not be realistic.This problemissolvedinthe H-model, asthe initial high growth rateisnotconstant, butdeclineslinearly over timeto reach thestable-growth rate.

Which of the following would NOT beappropriate for the Gordon growth model?

High-tech start-up firm with no dividends. Regulated utility company.

Mature, slow growth automotivemanufacturer.

Explanation

The Gordon growth model isinappropriate for a firm with supernormal growth thatcannot beexpected to continue. A multistagemodel is appropriate for such a firm.

Analyst LouiseDorgan has puttogether ashortfactsheet ontwo companies, Benson OrchardsandTerra Firma

Development.

BensonOrchards TerraFirma Development

Price/earnings ratio 18.5

Most recentdividend $0.56 per share $1.67 per share

Estimatedstock return 15%

Estimatedmarket return 13%

Beta 1.2 1.7

Trailing profits $5.16 per share

Stock-marketvalue $123million $1.678 billion

Shares outstanding 875 million

The risk-free rateis3.6%, andDorganestimatesthestock market'sequity risk premiumas7.5%.

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Question #47 of 133

Question ID: 463092

Question #4

8 of 133

Question ID: 463119

Benson Orchards Terra Firm

Development

No No

Yes No

Yes Yes

Explanation

To calculatea growth rateusing theGordonGrowth model, weusefour variables(one being the growth rateitself).If we have any three ofthevariables, wecansolvefor thefourth.Thefour variablesare:stock price, dividend, required return, and dividend growth rate.Thedata presentedaresufficientfor thecalculation ofthree ofthevariablesfor both companies. Benson Orchards

We know themost recentdividendandtheestimatestock return. FromtheP/E ratio andthetrailing profits, wecandetermine

thestock price. Fromthosethree pieces ofdata, wecancalculatethedividend growth rate. Terra Firma

We havethedividend. Wecandeterminethestock price by dividing marketvalue by shares outstanding. Wecanderivethe estimatedstock returnusing thecapitalasset pricing model. Fromthosethreestatistics, wecancreateaGordonGrowth

modelandsolvefor thedividend-growth rate.

Whatisthe value of a fixed-rate perpetual preferred share (par value $100) with a dividend rate of 11.0% and a required return of 7.5%?

$147. $138. $152.

Explanation

Thevalue ofthe preferredis $147: V = ($100par × 11%) / 7.5% = $146.67

Ananalyst has forecastthat Apex Company, which currently paysa dividend of $6.00, will continueto grow at 8% for thenexttwo years and thenata rate of 5% thereafter. If the required returnis10%, based onatwo-stagemodel whatisthecurrent value of Apex shares?

$127.78. $133.13. $126.24.

Explanation

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Question #4

9 of 133

Question ID: 463064

Question #

5 0 of 133

Question ID: 463160

Questions #

5

1 -56

of 133

Thecurrentvalue ofApex sharesis $133.13:

V = [($6 × 1.08) / 1.10] + [($6 × (1.08) ) / 1.10 ] + [ ($6 × (1.08) × 1.05) / (1.10 × (0.10 - 0.05))] = $133.13

IAM, Inc. hasacurrentstock price of $40.00andexpectsto pay adividendin one year of $1.80.Thedividendisexpectedto grow ataconstant rate of 6% annually.IAM hasa beta of0.95, themarketisexpectedto return11%, andthe risk-free rate of

interestis4%.Theexpectedstock pricetwo yearsfromtoday isclosestto: $43.49.

$41.03.

$43.94.

Explanation

Supergro hascurrent dividends of $1, currentearnings of $3, and asustainable growth rate of 10%. Whatis Supergro's return onequity?

15%.

12%. 20%.

Explanation

The ROE for Supergro can bedetermined by solving for ROE inthesustainable growth formula:

ROE = 10% / [1 - ($1/$3)] = 15%

Bernadine Nutting has justcompletedseveral rounds of job interviews with thevaluation group, AncisAssociates.Thefinal

hurdle beforethefirmmakes her an offer isaninterview with Greg Ancis, CFA, thefounder andsenior partner ofthe group.

Hetakes prideininterviewing all potentialassociates himself oncethey havemadeitthrough theearlier rounds ofinterviews,

and putscandidatesthrough a grueling series oftests.Assoonas Nutting enters his office, Ancistriesto overwhelm her with

financialinformation onavariety offirms, including AlphaBetaHydroxy, Inc., Turbo Financial Services, AultmanConstruction,

and Reality Productions.

He begins with AlphaBetaHydroxy, Inc., which tradesunder thesymbolABand hasanestimated beta of1.4.Thefirm

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currently pays $1.50 per year individends, butthe historicaldividend growth rate hasvariedsignificantly, asshowninthetable

below.

A

l

p

haBetaH

y

d

ro

xy,

Inc

.

Historical

Di

v

i

d

en

d

Growth

Y

ea

r

D

i

v

i

d

en

d

G

r

o

w

t

h

R

a

t

e

(

%

)

−

1 +

2

0 −

2 +58

−

3 −

2

7 −

4 −

1

9 −5

+

3

8 −6

+

1

7 −

7 an

d

ea

r

l

ie

r

+

3

Ancissaysthat, givenAB's wildly varying historicaldividend growth, he wantsto valuethefirmusing 3differentscenarios.The

Low-Growth scenario callsfor 3% annualdividend growth in perpetuity.The Middle-Growth scenario callsfor 12% dividend

growth in years1through 3, and3% annual growth thereafter.The High-Growth scenario specifiesdividend growth year by year, asfollows:

A

l

p

haBetaH

y

d

ro

xy,

Inc

.

High-Growth

Scenario

Y

ea

r

D

i

v

i

d

en

d

G

r

o

w

t

h

R

a

t

e

(

%

)

1

2

0

2

1

8

3

1

6

4

9

5

8

6

7

7 an

d

t

h

e

r

ea

f

t

e

r

4

Nutting suggeststhatthescenariosareincomplete, saying thatshe'dliketo includesomeadditionalassumptionsfor the

variousscenarios. For example, whileshe wouldestimatethe return onthe S&P 500to be12% regardless ofAB's

performance, she would wantto vary the outlook for interest ratesdepending onthescenario.Inspecific, she'dusealon g-termTreasury bond rate of4% for thelow-growth scenario, but raiseitto 5% for themiddleand higher-growth scenarios. Ancisthenmoves onto Turbo Financial Services.Ancis has beenfollowing Turbo for quitesometime because ofits

impressiveearnings growth. Earnings per share have grownatacompoundannual rate of19% over the pastsix years, pushing earningsto $10 per shareinthe year justended. Heconsidersthis growth ratevery high for afirm with acost of

equity of14%, anda weightedaveragecost ofcapital(WACC) of only 9%. He'sespecially impressedthatthefirmcanachieve

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Question #

5 3 of 133

Question ID: 463126

Question #

5 4 of 133

Question ID: 463127

Question #

55 of 133

Question ID: 463128

ᅞ A)

The required rate of returnis(r) = 0.04 + 1.4(0.12 − 0.04) = 0.152.

Thevalue per shareisDPS(1 + g ) / (r − g ) = [(1.50)(1.03)] / (0.152 − 0.03) = $12.66.

Thetwo-stageDDM modelismostsuitedto acompany that has onedividend growth ratefor aspecifiedtime periodandthen

shiftssuddenly to aseconddividend growth rate.That bestfitsthe Middle-Growth scenario.Inthe Middle-Growth scenario,

The required rate of returnis(r) = 0.05 + (1.4)(0.12 − 0.05) = 0.148. Thevalue per shareis:

Thetwo-stageDDM givesavaluefor ABthatis($16.44 − $12.66) = $3.78 higher thanthevalue given by theGordonGrowth Model.Thus Nutting"sstatementisalso incorrect.(Study Session11, LOS 35.l, m)

Whatistheimplied required rate of returnfor Reality Productions? 11.75%.

12.50%.

11.00%.

Explanation

The H-modelappliesto firms wherethedividend growth rateisexpectedto declinelinearly over the high-growth stageuntilit reachesitslong-runaverage growth rate.Thismostclosely matchestheanticipated pattern of growth for Reality Productions. The H-modelcan be rewritteninterms of r andusedto solvefor r giventhe other modelinputs:

r = D / P × [(1 + g) × [H × (g &£8722; g )] + g

Here, r = 1.5 / 30 × [(1 + 0.05) + [(6.0 / 2) × (0.10 &£8722; 0.05)] + 0.05 = 0.11(Study Session11, LOS 35.m)

Regarding thestatementsmade by Ancisand Nutting abouttheappropriateuses ofthe H-modelandthree-stageDDM: both are correct.

both areincorrect.

only oneiscorrect.

Explanation

Ancis'sstatementistechnically correct.Although three-stageDDM traditionally uses progressively lower growth ratesineach stage, thatisnotnecessary.Three-stageDDM applies when growth ratesvary inany manner, aslong asthey do so inthree

distinctstages. Nutting'sstatementisincorrect becausethe H-modelisnotappropriatefor acompany with sustaineddividend

growth atany level(high or not).The H-modelassumesthatthecompany'sdividend growth ratedeclineslinearly.(Study Session11, LOS 35.i)

Baseduponitscurrentmarketvalue, whatistheimpliedlong-termsustainable growth rate ofTurbo FinancialAdvisors? 19.0%.

0 n n

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Question #

56 of 133

Question ID: 463129

Question #

5 7 of 133

Question ID: 463131

Question #

58 of 133

Question ID: 463065

growth rate, Turbo isfairly valued.

Notethat ontheexam, itmay befaster to plug each growth rateinto theGordonGrowth Modelandthen plug each ofthose

terminalvaluesinto the basicmulti-stageformulathanto solvefor the growth rate.Thistrialanderror methodisespecially

effectiveif youstart with the "middle" growth rateandthendecide which valueto testnextdepending onthe results ofthefirst

calculation. For example, ifthefirst growth rate givesavaluefor thefirmthatistoo high, youcaneliminateallthe higher growth ratesandtry thenextlower one.(Study Session11, LOS 35.o)

Whatisthe presentvalue ofAultman'sfutureinvestment opportunitiesasa percentage ofthemarket price? 13.9%.

8.1%.

36.9%.

Explanation

The presentvalue ofthecompany'sfutureinvestment opportunitiesisalso knownasPVGO, which can becalculatedusing the

formula:Value = (E / r) + PVGO where:

E = earnings per share

r = required return

(E / r)isthevalue oftheassetsin place

Here, $22 = ($2.5 / 0.18) + PVGO

PVGO = $8.11

ThePVGO asa percentage ofthemarket priceequals($8.11 / $22.00) = 36.9%.(Study Session11, LOS 35.e)

Recentsurveys ofanalysts reportlong-termearnings growth estimatesas 5.5% andaforecasteddividend yield of2.0% onthe marketindex.Atthetime ofthesurvey, the20-year U.S. government bond yielded4.8%.According to theGordon growth

model, whatistheequity risk premium? 7.5%.

2.7%. 0.4%.

Explanation

Equity risk premium = 2.0% + 5.5% - 4.8% = 2.7%

A firmcurrently paysa dividend of $1.77, which isexpected to grow ata rate of 4%. If the required returnis10%, whatisthecurrent

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Question #

59 of 133

Question ID: 463035

ᅞ A) ᅞ B)

ᅚ C)

Question #

6 0 of 133

Question ID: 463150

$30.68. $29.50. $29.76.

Explanation

Thecurrentvalue ofthesharesis $30.68: V = [$1.77(1 + 0.04)] / (0.10 - 0.04)] = $30.68

Ifthethree-stagedividenddiscountmodel(DDM) resultsinextremely high value, the:

transition period is too short.

growth rateinthestable growth periodislower thanthat of grossnational product (GNP).

growth rateinthestable growth periodis probably too high.

Explanation

Ifthethree-stageDDM resultsinanextremely high value, either the growth rateinthestable growth periodistoo high or the

period of growth (high plustransition)istoo long.To solvethese problems, ananalystshouldusea growth ratecloser to GNP

growth anduseshorter high-growth andtransition periods.

Which ofthefollowing is NOTacomponent ofthesustainable growth rateformulausing theDuPontmodel? Earnings retention ratio.

EBIT/interestexpense.

Netincome/sales.

Explanation

SGR = b × ROE where:

b = earnings retention rate = (1 − dividend payout rate)

ROE = return onequity

The SGR isimportant becauseittellsus how quickly afirmcan grow with internally generatedfunds.Afirm's rate of growth is

afunction of both itsearnings retentionandits return onequity. ROE can beestimated with theDuPontformula, which presentsthe relationship betweenmargin, sales, andleverageasdeterminants of ROE.Inthe3-partversion oftheDuPont

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Question #

6 1 of 133

Question ID: 463063

Question #

6 2 of 133

Question ID: 463136

JAD just paidadividend of $0.80.Analystsexpectdividendsto grow at25% inthenexttwo years, 15% in yearsthreeand four, and 8% for year fiveandafter.Themarket required rate of returnis10%, andTreasury billsare yielding 4%. JAD hasa

beta of1.4.Theestimatedcurrent price of JADisclosestto: $29.34.

$45.91.

$25.42.

Explanation

JAD'sstock pricetoday can becalculatedusing thethree-stagemodel. Start by finding thevalue ofthedividendsfor thenext four years with thetwo differentdividend growth rates.

D

=

D (

1 +g

)

= $

0.

8 0(

1 .

2

5 )

= $

1 .00

D

=

D (

1 +g

)

= $

1 .00(

1 .

2

5 )

= $

1 .

2

5 D

=

D (

1 +g

)

= $

1 .

2

5 (

1 .

1

5 )

= $

1 .

43

7

5 D

=

D (

1 +g

)

= $

1 .

43

7

5 (

1 .

1

5 )

= $

1 .

65

31

(Alternatively, youcoulduse your financialcalculatorsto solvefor thefuturevalueto findD1, D2, D3, andD4.)

Nextfindthevalue ofthestock atthe beginning oftheconstant growth periodusing theconstantdividenddiscountmodel:

Theeasiest way to proceedisto usethe NPVfunctioninthefinancialcalculator. CF = 0; CF = 1.00; CF = 1.25; CF = 1.4375; CF = 1.6531 + 40.57 = 42.22 I = 12.4; NPV = 29.34

Thevalue ofthefirmtoday is $29.34 per share.

If the risk-free rateis 6%, theequity premium of thechosenindex is4%, and theasset's betais 0.8, whatisthe discount rateto beused inapplying the dividend discountmodel?

9.20%. 7.80%. 10.80%.

Explanation

1 0

2 1

3 2

4 3

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Question #

6 3 of 133

Question ID: 463141

Question #

6 4 of 133

Question ID: 463121

Question #

65 of 133

Question ID: 463122

The discount rate = risk-free rate + beta (returnexpected onequity market lessthe risk-free rate). Here, discount rate = 0.06 + (0.8 × 0.04) = 0.092, or 9.2%.

Aninvestor projectsthe price of astock to be $16.00 in one year and expected thestock to pay a dividend atthattime of $2.00. If the required rate of return onthesharesis11%, whatisthecurrent value of theshares?

$16.22. $15.28. $14.11.

Explanation

The value of theshares = ($16.00 + $2.00) / (1 + 0.11) = $16.22

Ananalyst has forecasted dividend growth for Triple Crown, Inc., to be 8% for thenexttwo years, declining to 5% over the following three years, and then remaining at 5% thereafter. If thecurrent dividend is $4.00, and the required returnis10%, whatisthecurrent value of Triple Crownshares based onathree-stagemodel?

$92.23. $91.11. $73.68.

Explanation

V = $4(1.08) / 1.10 + $4(1.08) / (1.10) + [$4(1 + 0.08) (3/2)(0.08 - 0.05) + $4(1.08) (1.05)] / [(1.10) (0.10 - 0.05)] = $92.23

James Malone, CFA, coversGNTX stock, which iscurrently trading at $45.00and just paidadividend of $1.40. Malone expectsthedividend growth rateto declinelinearly over thenextsix yearsfrom25% intheshort runto 6% inthelong run.

Maloneestimatesthe required return onGNTX to be13%. Using the H-model, thevalue ofGNTX isclosestto: $33.40.

$17.55.

$32.60.

Explanation

Theestimatedvalue ofGNTX using the H-modeliscalculatedasfollows:

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Question #

66 of 133

Question ID: 463083

Question #

6 7 of 133

Question ID: 463156

Question #

68 of 133

Question ID: 463151

Question #

69 of 133

Question ID: 463159

Tri-coat Paints hasacurrentmarket value of $41 per share with aearnings of $3.64. Whatisthe present value of its growth opportunities

(PVGO) if the required returnis 9%?

$0.56. $1.27. $3.92.

Explanation

ThePVGO is $0.56:

PVGO = $41 - ($3.64 / 0.09) = $0.56

Incomputing thesustainable growth rate of a firm, theearnings retention rateisequal to: 1 − (dividends / assets).

1 − (dividends / earnings). Dividends / required rate of return.

Explanation

Earnings retention rate = 1 − (dividends / earnings).

Dynamite, Inc., hascurrentearnings of $26, current dividend of $2, and a returned onequity of 18%. Whatisitssustainable growth?

14.99%.

16.62%. 13.37%.

Explanation

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Question #70 of 133

Question ID: 463137

Question #71 of 133

Question ID: 463144

Demonstratetheuse oftheDuPontanalysis of return onequity inconjunction with thesustainable growth rateexpression. Thefollowing statisticsareselectedfrom Kyle Star Partners(Kyle)financialstatements:

Sales $100million

NetIncome$15 million

Dividends $5 million

Total

Assets $150million

Total Equity $50million

Whatis Kyle'ssustainable growth rate?

33.3%.

20.0%.

24.5%.

Explanation

SGR = ROE × [(netincome − dividends) / netincome] = (15 million / 50million) × (15 million − 5 million) / 15 million

= 20.0%

Inusing thecapital asset pricing model (CAPM) to determinetheappropriate discount rate for discounted cash flow models (DCFs), the asset's betaisused to determinetheamount of:

risk-free rate applicable to the time period of the investment.

equity premium.

theexpected returninadditionto the return required by the risk of the position.

Explanation

Betameasuresthecorrelation betweentheequity market or index for which themarket risk premiumiscalculated and the particular asset

being valued. Betaisused to approximatethe proportion of theequity risk premiumapplicableto theasset (in relationto themarket or index used).

Giventhatafirm'scurrentdividendis $2.00, theforecasted growth is7%, declining over three yearsto astable 5% thereafter,

andthecurrentvalue ofthefirm'ssharesis $45, whatisthe required rate of return? 7.8%.

10.5%.

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Question #72 of 133

Question ID: 463110

Question #73 of 133

Question ID: 463132

Question #74 of 133

Question ID: 463080

Explanation

The required rate of returnis 9.8%.

r = ($2/$45) [(1 + 0.05) + (3/2)(0.07 - 0.05)] + 0.05 = 0.0980

Sincethe H-modelisanapproximationmodel, itis possibleto solvefor rdirectly withoutiteration.

In which of the following stagesisa firm most likelyto distributethe highest proportion of itsearningsinthe form of dividends?

Transition stage. Initial growth stage. Maturestage.

Explanation

Asa firmmatures, the forces of competition beginto deny it opportunitiesto earn greater thanthe required return. Faced with this situation, mostearningsare distributed to shareholdersas dividends. Analternate way of returning capital isthrough stock repurchases.

CAB Inc. just paid acurrent dividend of $3.00, the forecasted growth is 9%, declining over four yearsto astable 6% thereafter, and the current value of the firm'ssharesis $50, whatisthe required rate of return?

12.7%.

9.8%.

10.5%.

Explanation

The required rate of returnis12.7%.

r = ($3 / $50)[(1 + 0.06) + (4 / 2)(0.09 − 0.06)] + 0.06 = 12.7%

Sincethe H-modelisanapproximationmodel, itis possibleto solvefor rdirectly withoutiteration.

ZephraimAxelrod, CFA, istrying to determine whether Allegheny Mining isa goodinvestment. Hedecidesto usetheGordon

Growth modelto calculate how much dividend growth shareholderscanexpect.To thatend, hedeterminesthefollowing:

Share price: $18.12. Dividend: $0.32 per share. Beta:1.94.

Industry averageestimated returns:15%.

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Question #7

5 of 133

Question ID: 463061

Question #7

6 of 133

Question ID: 463036

Equity risk premium: 6.3%

Based only ontheinformationabove, theimplieddividend growth rateisclosestto:

19.89%.

10.27%.

15.68%.

Explanation

We havethe priceanddividend. Weneedthe required rate of returnto usetheGordonGrowth modelto calculateimplied dividend growth. Using thecapitalasset pricing model, the required return = risk-free rate + (beta × equity risk premium) =

17.72%.

Price = [dividend × (1 + dividend growth rate)] / [required return − growth rate]

18.12 = [0.32 × (1 + dividend growth rate)] / [0.1772 − dividend growth rate]

18.12 × [0.1772 − dividend growth rate] = 0.32 + 0.32 × dividend growth rate 3.2112 − 18.12 × dividend growth rate = 0.32 + 0.32 × dividend growth rate 2.8912 = 18.44 × dividend growth rate

1 = 6.3779 × dividend growth rate

Dividend growth rate = 15.68%

Aninvestor projectsthata firm will pay a dividend of $1.00 next year and $1.20 the following year. Attheend of thesecond year, the expected price of thesharesis $22.00. If the required returnis14%, whatisthecurrent value of the firm'sshares?

$18.73. $15.65. $19.34.

Explanation

Thecurrentvalue ofthesharesis $18.73:

V = $1.00 / 1.14 + $1.20 / (1.14) + $22.00 / (1.14) = $18.73

The H model will NOT bevery useful when:

a firm has a constant payout policy.

afirm haslow or no dividendscurrently.

afirmis growing rapidly.

Explanation

The H modelisusefulfor firmsthatare growing rapidly butthe growth isexpectedto decline gradually over timeasthefirm

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Question #77 of 133

Question ID: 463081

Question #7

8 of 133

Question ID: 463105

ᅞ A)

ᅚ B) ᅞ C)

Question #7

9 of 133

Question ID: 463070

getslarger andfacesincreasedcompetition.Theassumption ofconstant payout ratio makesthemodelinappropriatefor firms that havelow or no dividendcurrently.

Initsmost recent quarterly earnings report, Smith BrothersGarden Suppliessaidit plannedto increaseitsdividendatan annual rate of13% for theforeseeablefuture.AnalystClinton Spears hasanannual returntarget of15.5% for Smith Brothers stock. Hedecidesto usethedividend-growth rateto back outanother returnestimateto testagainst his. Smith Brothersstock tradesfor $55 per shareandearned $3.01 per share over thelast12months.Thecompany paidadividend of $2.15 per shareduring the12-month period, anditsdividend-growth ratefor thelastfive years was 9.2%.

Using theGordonGrowth model, the requiredannual returnfor Smith Brothersstock isclosestto:

17.42%.

13.47%.

19.18%.

Explanation

TheGordonGrowth modelisasfollows:

Price = [dividend × (1 + dividend growth rate)] / [required return − growth rate] 55 = [2.15 × 1.13] / [required return − 0.13]

55 = 2.4295 / [required return − 0.13]

22.6384 = 1 / [required return − 0.13] [Required return − 0.13] = 0.04417

Required return = 0.17417 = 17.42%

Thethree-stagedividenddiscountmodel(DDM)allowsfor aninitial period of:

highgrowth, a transitional period of stable growth and a final declininggrowth phase.

high growth, atransitional period ofdeclining growth andafinalstable growth phase. stable growth, atransitional period of high growth andafinaldeclining growth phase.

Explanation

Thethree-stageDDM combinesthefeatures ofthetwo-stageDDM andthe H model.Itallowsfor aninitial period of high growth, atransitional period ofdeclining growth andafinalstable growth phase.

(35)

Question #

8 0 of 133

Question ID: 463094

Question #

8 1 of 133

Question ID: 463134

Question #

8 2 of 133

Question ID: 463062

model is $32.03, whatisthe required rate of return?

8%. 7%. 9%.

Explanation

The required returnis 9%:r = [$1.22(1 + 0.05) / $32.03] + 0.05 = 0.09 or 9%.

Whatisthe value of a fixed-rate perpetual preferred share (par value $100) with a dividend rate of 7.0% and a required return of 9.0%?

$78. $56.

$71.

Explanation

Thevalue ofthe preferredis $78: V = ($100par × 7%) / 9% = $77.78

If weincreasethe required rate of returnused ina dividend discountmodel, theestimate of value produced by themodel will:

remain the same.

decrease. increase.

Explanation

The required rate of returnisused inthe denominator of theequation. Increasing this factor will decreasethe resulting value.

Aninvestor projectsthata firm will pay a dividend of $1.25 next year, $1.35 thesecond year, and $1.45 thethird year. Attheend of the third year, sheexpectstheassetto be priced at $36.50. If the required returnis12%, whatisthecurrent value of theshares?

$29.21. $32.78. $31.16.

Explanation

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Question #

8 3 of 133

Question ID: 463153

Question #

8 4 of 133

Question ID: 463099

Question #

85 of 133

Question ID: 463106

ᅚ A)

ᅞ B)

ᅞ C)

Thecurrentvalue ofthesharesis $29.21:V = ($1.25 / 1.12) + ($1.35 / (1.12) ) + ($1.45 / (1.12) ) + ($36.50 / (1 + 0.12) ) = $29.21

GreenGrow, Inc., hascurrentdividends of $2.00, currentearnings of $4.00anda return onequity of16%. Whatis GreenGrow'ssustainable growth rate?

9%. 6%.

8%.

Explanation

GreenGrow'ssustainable growth rateis 8%. g = [1 - ($2/$4)](0.16) = 8%

Applying the Gordon growth model to valuea firmexperiencing supernormal growth would resultin:

overstating the value of the firm. a zero value.

understating the value of the firm.

Explanation

Applying the Gordon growth model to such a firm would resultinanestimate of value based ontheassumptionthatthesupernormal growth would continueindefinitely. This would overstatethe value of the firm.

Whatisthe difference betweenastandard two-stage growth model and the H-model?

In the standard two-stage model, a fixed rate of growth is assumed for each stage, while the H-model assumes a linearly declining rate of growth in one stage.

The H-model assumesthatearnings will dip inthemiddle of each stageand returnto the previous rate by the period'send.

The H-model assumesaterminal value, whilethestandard two-stagemodel doesnot.

Explanation

The H-model providesanestimate of the firm's value based ontheassumptionthatthe rate of growth will change linearly over theinitial

stage.

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Question #

86 of 133

Question ID: 463163

Question #

8 7 of 133

Question ID: 463114

Question #

88 of 133

Question ID: 463088

ᅞ A) ᅚ B)

Thecurrentmarket price per sharefor High-on-the-Hog, Inc.is $52.50, andananalystisusing theGordonGrowth modelto

determine whether thisisafair price.Thecompany paidadividend of $3.00last year onearnings of $4.50ashare.Ifthe

required rate of returnis11.00% andtheexpected grown rateinearningsandindividendsis 5%, thecurrentmarket priceis most likely:

correctly valued.

undervalued.

overvalued.

Explanation

Thevalue per shareusing theestimatesis $52.50 = [$3.00(1.05) / 0.11 − 0.05)].

Kyle Star Partnersisexpectedto haveearningsin year five of $6.00 per share, adividend payout ratio of 50%, anda required

rate of return of11%. For year 6 and beyondthedividend growth rateisexpectedto fallto 3% in perpetuity. Estimatethe

terminalvalueattheend of year fiveusing theGordon growth model. $37.50.

$27.27.

$38.63.

Explanation

Thedividendfor year 5 isexpectedto be $3($6 times 50%).Thedividendfor year 6 isthenexpectedto be $3.00 × 1.03 = $3.09.Theterminalvalueusing theGordon growth modelistherefore:

terminalvalue = 3.09 / (0.11 − 0.03) = $38.625

P = D / (k − g)

A firm hasthe following characteristics: Currentshare price $100.00. Next year'searnings $3.50. Next year's dividend $0.75. Growth rate11%.

Required return13%.

Based onthisinformationand the Gordon growth model, whatisthe firm's justified leading priceto earnings (P/E) ratio?

8.7. 10.7.

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ᅞ C)

Question #

89 of 133

Question ID: 463034

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9 0 of 133

Question ID: 463033

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9 1 of 133

Question ID: 472543

11.3.

Explanation

The justifiedleading P/E is10.7:

P /E = (D / E ) / (r−g) = ($0.75 / $3.50) / (0.13 - 0.11) = 10.71

Freecash flow to equity models (FCFE) are most appropriate whenestimating the value of the firm:

to equity holders.

only for non-dividend paying firms.

to creditors of the firm.

Explanation

FCFE modelsattemptto estimatethe value of the firmto equity holders. Themodelstakeinto account futurecash flows dueto others, including debtand taxes, and amounts required for reinvestmentto continuethe firm's operations.

If anasset was fairly priced fromaninvestor's point of view, the holding period return (HPR) would be:

the same as the required return.

lower thanthe required return. equal to thealpha returns.

Explanation

A fairly priced asset would be onethat hasanexpected HPR justequal to theinvestor's required return.

ObsidianGlassCompany hascurrentearnings of $2.22, a required return of 8%, andthe presentvalue of growth opportunities(PVGO) of $8.72. Whatisthecurrentvalue of Obsidian'sshares?

$36.47. $10.94.

$27.75.

Explanation

Thecurrentvalueis $36.47.V = ($2.22 / 0.08) + $8.72 = $36.47

0 1 1 1

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9 2 of 133

Question ID: 463108

ᅞ A)

ᅞ B) ᅚ C)

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ᅚ A)

Ananalyst hascollectedthefollowing data ontwo companies:

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Hic

k

or

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C

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.

Lower

Elm

Inc

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FE

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Po

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v

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an

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gr

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w

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a

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i

t

a

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in

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st

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t

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ni

f

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t

D

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g

Which dividend-discountmodelisthebest optionfor valuing thetwo companies? Middle Hickory Lower Elm

Gordon

Growth Three-stage Two-stage GordonGrowth

Three-stage Two-stage

Explanation

Middle Hickory isintheinitial-growth phase, while Lower Elmisinthetransition phase.Thethree-stagemodelisappropriate

for new, fast-growing companies.Thetwo-stagemodelisappropriatefor companiesinthetransitional phase.

In whatstage of growth would a firmmost likely NOT pay dividends?

Declining stage. Initial growth stage. Transitionstage.

Explanation

During theinitial growth stage, the firmisableto exploit opportunitiesto earn greater thanthe required return. During thisstage, earnings are reinvested inthe growth opportunities rather than returned to theinvestors.

The volatility of equity returns requiresusto use data from long time periodsto computemean returns. One problemthatthiscausesis that: