HuskyGrad2010

The H model will NOT be very useful when:

A) a firm has a constant payout policy.

B) a firm is growing rapidly.

C) a firm has low or no dividends currently.

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The H model is useful for firms that are growing rapidly but the growth is expected to decline gradually over time as the firm gets larger and faces increased competition. The assumption of constant payout ratio makes the model inappropriate for firms that have low or no dividend currently.

HuskyGrad2010

Multi-stage dividend discount models can be used to estimate the value of shares:

A) only when the growth rate exceeds the required rate of return.

B) only under a limited number of scenarios.

C) under an almost infinite variety of scenarios.

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Multi-stage dividend discount models are very flexible, allowing their use with an almost infinite variety of growth scenarios.

HuskyGrad2010

Which of the following is least likely a potential problem associated with the three-stage dividend discount model (DDM)? The:

A) beta in the stable period is too high, resulting in an extremely low stock value.

B) high-growth and transitional periods are too long, resulting in an extremely high stock value.

C) stable period payout ratio may be too high resulting in an extremely low value.

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If the stable period payout ratio is too low it may result in an extremely low value because the terminal value will be lower due to the smaller dividends being paid out.

HuskyGrad2010

One of the limitations of the dividend discount models (DDMs) is that:

A) they are very sensitive to growth and required return assumptions.

B) they are conceptually difficult.

C) given the inputs, they are not very precise in their valuations.

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DDMs are very sensitive to the growth and required return assumptions, and it is often wise to interpret the value as a range rather than a precise dollar amount.

HuskyGrad2010

The debate over whether to use the arithmetic mean or geometric mean of market returns for the capital asset pricing model (CAPM):

A) has little practical effect because they are both very close.

B) was settled by the work of Harry Markowitz in 1972.

C) limits its usefulness in estimating the required return of an asset.

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There are several characteristics of the CAPM that limit its usefulness in determining the required returns, including the uncertainty whether we should use arithmetic or geometric means as the appropriate measure of long-term average returns

HuskyGrad2010

The volatility of equity returns requires us to use data from long time periods to compute mean returns. One problem that this causes is that:

A) inflation alters the value of the past returns.

B) the past is rarely an indication of the future.

C) equity premiums vary over time with perceived risk.

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The primary problem with using returns gathered over a long time period is that equity premiums vary over time with the market’s perception of risk and relative risk.

HuskyGrad2010

If an investor had determined that an asset’s market price was too high, (implying that it will soon fall) the expected holding period return (HPR) would be:

A) equal to the required return.

B) lower than the required return.

C) higher than the required return.

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If the investor determined that the asset’s price was too high, then the expected HPR would be less than the required return, and the asset would have a negative alpha.

HuskyGrad2010

Julie Davidson, CFA, has recently been hired by a well-respected hedge fund manager in New York as an investment analyst. Davidson’s responsibilities in her new position include presenting investment recommendations to her supervisor, who is a principal in the firm. Davidson’s previous position was as a junior analyst at a regional money management firm. In order to prepare for her new position, her supervisor has asked Davidson to spend the next week evaluating the fund’s investment policy and current portfolio holdings. At the end of the week, she is to make at least one new investment recommendation based upon her evaluation of the fund’s current portfolio. Upon examination of the fund’s holdings, Davidson determines that the domestic growth stock sector is currently underrepresented in the portfolio. The fund has stated to its investors that it will aggressively pursue opportunities in this sector, but due to recent profit-taking, the portfolio needs some rebalancing to increase its exposure to this sector. She decides to search for a suitable stock in the pharmaceuticals industry, which, she believes, may be able to provide an above average return for the hedge fund while maintaining the fund’s stated risk tolerance parameters.
Davidson has narrowed her search down to two companies, and is comparing them to determine which is the more appropriate recommendation. One of the prospects is Samson Corporation, a mid-sized pharmaceuticals corporation that, through a series of acquisitions over the past five years, has captured a large segment of the flu vaccine market. Samson financed the acquisitions largely through the issuance of corporate debt. The company’s stock had performed steadily for many years until the acquisitions, at which point both earnings and dividends accelerated rapidly. Davidson wants to determine what impact any additional acquisitions will have on Samson’s future earnings potential and stock performance.
The other prospect is Wellborn Products, a manufacturer of a variety of over-the-counter pediatric products. Wellborn is a relatively new player in this segment of the market, but industry insiders have confidence in the proven track record of the company’s upper management who came from another firm that is a major participant in the industry. The market cap of Wellborn is much smaller than Samson’s, and the company differs from Samson because it has grown internally rather than through the acquisition of its competitors. Wellborn currently has no long-term debt outstanding. While the firm does not pay a dividend, it has recently declared that it intends to begin paying one at the end of the current calendar year.
Select financial information (year-end 2005) for Samson and Wellborn is outlined below:

Samson:

Current Price:	$36.00
Sales:	$75,000,000
Net Income:	$5,700,000
Assets:	$135,000,000
Liabilities:	$95,000,000
Equity:	$60,000,000

Wellborn:

Current Price:	$21.25
Dividends expected to be received at the end of 2006:	$1.25
Dividends expected to be received at the end of 2007:	$1.45
Price expected at year-end 2007:	$27.50
Required return on equity:	9.50%
Risk-free rate:	3.75%

Other financial information:

One-year forecasted dividend yield on market index:	1.75%
Consensus long-term earnings growth rate:	5.25%
Short-term government bill rate:	3.75%
Medium-term government note rate:	4.00%
Long-term government bond rate:	4.25%

It is the beginning of 2006, and Davidson wants use the above data to identify which will have the greatest expected returns. She must determine which valuation model(s) is most appropriate for these two securities. Also, Davidson must forecast sustainable growth rates for each of the companies to assess whether or not they would fit within the fund’s investment parameters.Using the Gordon growth model (GGM), what is the equity risk premium?

A) 5.50%.

B) 2.75%.

C) 3.25%.

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The GGM calculates the risk premium using forward-looking or expectational data. The equity risk premium is estimated as the one-year forecasted dividend yield on market index, plus the consensus long-term earnings growth rate, minus the long-term government bond yield. Note that because equities are assumed to have a long duration, the long-term government bond yield serves as the proxy for the risk-free rate.
Equity risk premium = 1.75% + 5.25% − 4.25% = 2.75% (Study Session 10, LOS 35.b)

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Davidson is familiar with the use of the capital asset pricing model (CAPM) and arbitrage pricing theory (APT) to estimate the required rate of return for an equity investment. However, there are some limitations associated with both models that should be considered in her analysis. Which of the following is least likely a limitation of the CAPM and/or APT?

A) Model uncertainty, because it is unknown if the use of either model is theoretically correct and appropriate.

B) Input uncertainty, because it is difficult to estimate the appropriate risk premiums accurately.

C) Risk premium exposure, because it fails to consider the implications of an asset’s sensitivity to the various risk factors in the market.

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Both CAPM and APT consider the sensitivity of an asset’s return to various risk factors. CAPM measures an asset’s sensitivity relative to the market portfolio with beta, while APT measures an asset’s sensitivity to a variety of risk factors, such as investor confidence, time horizon, inflation, business-cycle and market-timing. (Study Session 10, LOS 35.c)

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Which of the following valuation models would be most appropriate in the valuation analysis of Wellborn Products?

A) The free cash flow model, because the firm does not have a steady dividend payment history.

B) The dividend discount model (DDM), because the hedge fund’s investment would represent a minority interest in the company.

C) The residual income approach, because the firm is likely to have negative free cash flow for the foreseeable future.

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Free cash flow models are appropriate for firms such as Wellborn that do not have a dividend payout history. (Study Session 11, LOS 39.a)

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Davidson needs to determine if the shares of Wellborn are currently undervalued or overvalued in the market relative to the shares’ fundamental value. The estimated fair value of Wellborn shares, using a two-period dividend discount model (DDM), is:

A) $21.25.

B) $25.29.

C) $27.58.

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The value of Wellborn using a two-period DDM is$1.25 / 1.095) + (($1.45 + $27.50) / 1.0952) = $25.29 (Study Session 11, LOS 39.b)

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As a part of her analysis, Davidson needs to calculate return on equity for both potential investments. What is last year’s return on equity (ROE) for Samson shares?

A) 17.10%.

B) 5.28%.

C) 9.50%.

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ROE can be calculated using the DuPont formula, which is:ROE = Net Income / Stockholder’s Equity
ROE = (net income / sales) × (sales / total assets) × (total assets / stockholders’ equity)
Therefore: ROE = (5,700,000 / 75,000,000) × (75,000,000 / 135,000,000) × (135,000,000 / 60,000,000) = (0.076) × (0.556) × (2.25) = 0.095 = 9.50%.(Study Session 11, LOS 39.n)

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Davidson determines that over the past three years, Samson has maintained an average net profit margin of 8 percent, a total asset turnover of 1.6, and a leverage ratio (equity multiplier) of 1.39. Assuming Samson continues to distribute 35 percent of its earnings as dividends, Samson’s estimated sustainable growth rate (SGR) is:

A) 17.8%.

B) 11.6%.

C) 6.2%.

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Utilizing the PRAT model, where SGR is a function of profit margin (P), the retention rate (R), asset turnover (A) and financial leverage (T):
g = P × R × A × T
g = 0.08 × (1 − 0.35) × 1.6 × 1.39 = 0.116 = 11.6%.(Study Session 11, LOS 39.n)

invic

Deployment Specialists pays a current (annual) dividend of $1.00 and is expected to grow at 20% for two years and then at 4% thereafter. If the required return for Deployment Specialists is 8.5%, the current value of Deployment Specialists is closest to:

A) $33.28.

B) $25.39.

C) $30.60.

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First estimate the amount of each of the next two dividends and the terminal value. The current value is the sum of the present value of these cash flows, discounted at 8.5%.

invic

An analyst has compiled the following financial data for 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 on the S&P 500	12.0%	12.0%	12.0%	12.0%
Beta	1.4	1.4	1.4	1.4
g (growth rate in dividends)	0.0%	3.0%	Years 1-3, 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% After Year 6, g=4%

What is the value of ABC, Inc.'s stock price using the assumptions contained in Scenario 4?

A) $26.66.

B) $22.22.

C) $18.52.

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The required rate of return is (r) = 0.05 + 1.4(0.12 − 0.05) = 0.148
The future dividends are predicted as the following:

Year	Dividend
0	1.50
1	1.50 × 1.2 = 1.80
2	1.80 × 1.18 =2.124
3	2.124 × 1.16 = 2.464
4	2.464 × 1.09 = 2.686
5	2.686 × 1.08 = 2.900
6	2.901 × 1.07 = 3.103
7	3.103 × 1.04 = 3.227

Now discount the dividend stream to get the value per share. Use the Gordon growth model to discount the constant growth after period 6. Value per share = (1.8 / 1.148) + (2.124 / 1.1482) + (2.464 / 1.1483) + (2.686 / 1.1484) + (2.900 / 1.1485) + (3.103 / 1.1486) + (3.227 / 1.1486(0.148 − 0.04)) = 22.22.