LOS d: Indicate the impact of discount rate sensitivity in valuation models.

Q1. At a CFA society function, Robert Chan comments to Li Chiao that the expected dividend growth rate for Xanedu Industries has decreased 0.5% from 6.0% to 5.5%. Chan claims that since Xanedu will maintain their historic dividend payout ratio (g) of 40% and cost of equity (k) of 12%. Xanedu's P/E ratio will also decrease by 0.5%. Is Chan correct?

A)   Yes, Xanedu's P/E ratio will increase by approximately 0.5%.

B)   No, Xanedu's P/E ratio will decrease by approximately 7.8%.

C)   No, Xanedu's P/E ratio will increase by approximately 7.8%.

Q2. At a CFA society function, Andrew Caza comments to Nanda Dhople that the expected dividend growth rate (g) for Zeron Enterprises Inc (ZEI) is expected increase 0.5% from 6% to 6.5%. Caza claims that since ZEI will maintain their historic dividend payout ratio (g) of 50% and cost of equity (k) of 10%, ZEI's P/E ratio will also increase by 0.5%. Is Caza correct?

A)   No, ZEI's P/E ratio will decrease by approximately 14.32%.

B)   Yes, ZEI's P/E ratio will increase by approximately 0.5%.

C)   No, ZEI's P/E ratio will increase by approximately 14.32%.

Q3. For which of the following firms is the Price/Earnings to Growth (PEG) ratio most appropriate for identifying undervalued or overvalued equities?

Firm A: Expected dividend growth = 6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm B: Expected dividend growth = ?6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm C: Expected dividend growth = 1%; Cost of equity = 12%; price-to-earnings (P/E) = 12.

A)   Firm C.

B)   Firm B.

C)   Firm A.

LOS d: Indicate the impact of discount rate sensitivity in valuation models. fficeffice" />

Q1. At a CFA society function, Robert Chan comments to Li Chiao that the expected dividend growth rate for Xanedu Industries has decreased 0.5% from 6.0% to 5.5%. Chan claims that since Xanedu will maintain their historic dividend payout ratio (g) of 40% and cost of equity (k) of 12%. Xanedu's P/E ratio will also decrease by 0.5%. Is Chan correct?

A)   Yes, Xanedu's P/E ratio will increase by approximately 0.5%.

B)   No, Xanedu's P/E ratio will decrease by approximately 7.8%.

C)   No, Xanedu's P/E ratio will increase by approximately 7.8%.

Correct answer is B)

Chan is not correct. P/E_Xanedu = payout ratio / (k - g)
When the expected dividend growth is 6%, P/E = 0.40 / (0.12 - 0.06) = 6.67
When the expected dividend growth is 5.5%, P/E = 0.40 / (0.12 - 0.055) = 6.15
The percentage change is (6.15 / 6.67) - 1 = -7.80%, representing a 7.80% decrease

Q2. At a CFA society function, Andrew Caza comments to Nanda Dhople that the expected dividend growth rate (g) for Zeron Enterprises Inc (ZEI) is expected increase 0.5% from 6% to 6.5%. Caza claims that since ZEI will maintain their historic dividend payout ratio (g) of 50% and cost of equity (k) of 10%, ZEI's P/E ratio will also increase by 0.5%. Is Caza correct?

A)   No, ZEI's P/E ratio will decrease by approximately 14.32%.

B)   Yes, ZEI's P/E ratio will increase by approximately 0.5%.

C)   No, ZEI's P/E ratio will increase by approximately 14.32%.

Correct answer is C)

Caza is not correct. P/E_ZEI = payout ratio / (k - g)
When the expected dividend growth is 6%, P/E = 0.50 / (0.10 - 0.06) = 12.50
When the expected dividend growth is 6.5%, P/E = 0.50 / (0.10 - 0.065) = 14.29
The percentage change is (14.29 / 12.50) - 1 = 14.32%, representing a 14.32% increase

Q3. For which of the following firms is the Price/Earnings to Growth (PEG) ratio most appropriate for identifying undervalued or overvalued equities?

Firm A: Expected dividend growth = 6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm B: Expected dividend growth = ?6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm C: Expected dividend growth = 1%; Cost of equity = 12%; price-to-earnings (P/E) = 12.

A)   Firm C.

B)   Firm B.

C)   Firm A.

Correct answer is C)

The formula for the PEG ratio is: PEG = (P/E) / g. It measures the tradeoff between P/E and expected dividend growth (g). For traditional growth firms, PEG ratios fall between 1 and 2. The general rule is that PEG ratios above 2 are indicative of overvalued firms (expensive), and PEG ratios below 1 are indicative of firms that are undervalued (cheap).

Firm A:	PEG = 2, indicating a stock that is appropriately priced.
Firm B:	The PEG ratio of firms with negative expected dividend growth is negative, which is meaningless. For Firm B, PEG = -2.
Firm C:	Firms with very low expected dividend growth are likely to have PEG ratios that unrealistically indicate overvalued stocks. For Firm C, PEG = 12.

bb