RobertA

Given an equity risk premium of 3.5%, a forecasted dividend yield of 2.5% on the market index and a U.S. government bond yield of 4.5%, what is the consensus long-term earnings growth estimate?

A) 8.0%.

B) 10.5%.

C) 5.5%.

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Equity risk premium = forecasted dividend yield + consensus long term earnings growth rate – long-term government bond yield.Therefore,
Consensus long term earnings growth rate =
Equity risk premium - forecasted dividend yield + long-term government bond yield
Consensus long term earnings growth rate = 3.5% - 2.5% + 4.5% = 5.5%

RobertA

A firm pays a current dividend of $1.00 which is expected to grow at a rate of 5% indefinitely. If current value of the firm’s shares is $35.00, what is the required return applicable to the investment based on the Gordon dividend discount model (DDM)?

A) 8.00%.

B) 8.25%.

C) 7.86%.

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The Gordon DDM uses the dividend for the period (t + 1) which would be $1.05.
$35 = $1.05 / (required return – 0.05)
Required return = 0.08 or 8.00%

RobertA

If the expected return on the equity market is 10%, the risk-free rate is 3%, and an asset’s beta is 0.6, what is the appropriate equity risk premium for the asset in applying the Gordon growth model?

A) 6.40%.

B) 4.20%.

C) 9.00%.

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The asset’s equity risk premium is equal to it’s beta times the difference between the expected return on the equity market and the risk-free rate. Equity Risk Premium = 0.6(0.10 − 0.03) = 0.042 or 4.2%.

RobertA

GreenGrow, Inc., has current dividends of $2.00, current earnings of $4.00 and a return on equity of 16%. What is GreenGrow’s sustainable growth rate?

A) 9%.

B) 6%.

C) 8%.

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GreenGrow’s sustainable growth rate is 8%.

g = [1 – ($2/$4)](0.16) = 8%

RobertA

Sustainable growth is the rate that earnings can grow:

A) without additional purchase of equipment.

B) indefinitely without altering the firm's capital structure.

C) with the current assets.

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Sustainable growth is the rate of earnings growth that can be maintained indefinitely without the addition of new equity capital.

RobertA

The sustainable growth rate, g, equals:

A) pretax margin divided by working capital.

B) dividend payout rate times the return on assets.

C) earnings retention rate times the return on equity.

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The formula for sustainable growth is: g = b × ROE, where g = sustainable growth, b = the earnings retention rate, and ROE equals return on equity.

RobertA

In computing the sustainable growth rate of a firm, the earnings retention rate is equal to:

A) Dividends / required rate of return.

B) 1 − (dividends / assets).

C) 1 − (dividends / earnings).

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

RobertA

Dynamite, Inc., has current earnings of $26, current dividend of $2, and a returned on equity of 18%. What is its sustainable growth?

A) 16.62%.

B) 14.99%.

C) 13.37%.

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g = [1 − ($2 / $26)]0.18 = 16.62%

RobertA

Supergro has current dividends of $1, current earnings of $3, and a return on equity of 16%, what is its sustainable growth rate?

A) 12.2%.

B) 8.9%.

C) 10.7%.

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g = (1 – 1/3)(0.16) = 0.107

RobertA

Heather Callaway, CFA, is concerned about the accuracy of her valuation of Crimson Gate, a fast-growing telecommunications-equipment company that her firm rates as a top buy. Crimson currently trades at $134 per share, and Callaway has put together the following information about the stock:

Most recent dividend per share	$0.55
Growth rate, next 2 years	30%
Growth rate, after 2 years	12%
Trailing P/E	25.6
Financial leverage	3.4
Sales	$11.98 per share
Asset turnover	11.2
Estimated market rate of return	13.2%

Callaway’s employer, Bates Investments, likes to use a company’s sustainable growth rate as a key input to obtaining the required rate of return for the company’s stock.
Crimson’s sustainable growth rate is closest to:

A) 14.8%.

B) 13.2%.

C) 16.6%.

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Sustainable growth rate = ROE × retention rate
Earnings per share = price / (P/E) = $134 / 25.6 = $5.23
The retention rate represents the portion of earnings not paid out in dividends. = (5.23 − 0.55) / 5.23 = 0.89 or 89%
ROE = profit margin × asset turnover × financial leverage
ROE = 5.23 / 11.98 × 11.2 × 3.4 = 16.6%
Sustainable growth rate = 89% × 16.6% = 14.8%