Which of the following is least likely a limitation of the two-stage dividend discount model (DDM)?

A) use of one required rate of return for both stages might overstate the value.

B) most of the value is due to the terminal value, which is very sensitive to the estimates of stable growth.

C) the length of the high-growth stage is difficult to measure.

Historical information used to determine the long-term average returns from equity markets may suffer from survivorship bias, resulting in:

A) inflating the mean return.

B) deflating the mean return.

C) unpredictable results.

Multi-stage growth models can become computationally intensive. For this reason they are often referred to as:

A) quadratic models.

B) spreadsheet models.

C) R-squared models.

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%.

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

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

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

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

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

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

A) $25.29.

B) $21.25.

C) $27.58.

A) 9.50%.

B) 17.10%.

C) 5.28%.

A) 17.8%.

B) 11.6%.

C) 6.2%.

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) higher than the required return.

C) lower than the required return.

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) equity premiums vary over time with perceived risk.

B) inflation alters the value of the past returns.

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

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.

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

A) they are conceptually difficult.

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

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

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

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

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) under an almost infinite variety of scenarios.

C) only under a limited number of scenarios.

The H model will NOT be very useful when:

A) a firm has low or no dividends currently.

B) a firm has a constant payout policy.

C) a firm is growing rapidly.

If the three-stage dividend discount model (DDM) results in extremely high value, the:

A) growth rate in the stable growth period is lower than that of gross national product (GNP).

B) growth rate in the stable growth period is probably too high.

C) transition period is too short.

The H-model is more flexible than the two-stage dividend discount model (DDM) because:

A) initial high growth rate declines linearly to the level of stable growth rate.

B) payout ratio changes to adjust the changes in growth estimates.

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

Which of the following dividend discount models has the limitation that a sudden decrease to the lower growth rate in the second stage may NOT be realistic?

A) Gordon growth model.

B) H model.

C) Two-stage dividend discount model.

Free cash flow to equity models (FCFE) are most appropriate when estimating the value of the firm:

A) to equity holders.

B) to creditors of the firm.

C) only for non-dividend paying firms.

If an asset was fairly priced from an investor’s point of view, the holding period return (HPR) would be:

A) equal to the alpha returns.

B) the same as the required return.

C) lower than the required return.

If an investor were attempting to capture an asset’s alpha returns, the expected holding period return (HPR) would be:

A) higher than the required return.

B) lower than the required return.

C) the same as the required return.