CFA Level 2 – Equity, Session 11-Reading 42
Discounted Dividend Valuation – LOS l
(Practice Questions, Sample Questions)
1. An analyst has forecasted dividend growth for Triple Crown, Inc., to be 8% for the next two years, declining to 5% over the following three years, and then remaining at 5% thereafter. If the current dividend is $4.00, and the required return is 10%, what is the current value of Triple Crown shares based on a three-stage model?
A) $92.23.
B) $73.68.
C) $91.11.
Explanation: A) V0 = $4(1.08) / 1.10 + $4(1.08)2 / (1.10)2 + [$4(1 + 0.08)2(3/2)(0.08 – 0.05) + $4(1.08)2(1.05)] / [(1.10)2(0.10 – 0.05)] = $92.23
2. An analyst has forecast that Hapex Company, which currently pays a dividend of .
00, will grow at a rate of 8%, declining to 5% over the next two years, and remain at that rate thereafter. If the required return is 10%, based on an H-model what is the current value of Hapex shares?
A) $126.24.
B) $131.17.
C) $129.60.
Explanation: C) The current value of Hapex shares is $129.60:
V0 = [$6(1 + 0.05) + $6(2/2)(0.08 – 0.05)] / (0.10 – 0.05) = $129.60
3. An analyst has forecast that Apex Company, which currently pays a dividend of $6.00, will continue to grow at 8% for the next two years and then at a rate of 5% thereafter.
If the required return is 10%, based on a two-stage model what is the current value of Apex shares?
A) $126.24.
B) $127.78.
C) $133.13.
Explanation: C) The current value of Apex shares is $133.13:
V0 = [($6 × 1.08) / 1.10] + [($6 × (1.08)2) / 1.102] + [ ($6 × (1.08)2 × 1.05) / (1.102 × (0.10 – 0.05))] = $133.13
4. UC Inc. is a high-tech company that currently pays a dividend of $2.00 per share. UC’s expected growth rate is 5%. The risk-free rate is 3% and market return is 9%.
What is the beta implied by a market price of $40.38?
A) 1.16.
B) 1.02.
C) 1.20.
Explanation: C) 40.38 = 2.10 / (r ? 0.05)
r = 2.10 / 40.38 + 0.05 = 0.1020
From CAPM:
r = 0.03 + b(0.09 ? 0.03)
0.1020 = 0.03 + 0.06b
b = 1.20
5. What is the price of the UC stock if beta is 1.12?
A) $9.72.
B) $42.37.
C) $44.49.
Explanation: C) From CAPM:
r = 0.03 + b(0.09 ? 0.03)
r = 0.03 + 1.12(0.06)
r = 0.0972
V0= D1 / (r ? g)
= 2.00(1 + 0.05) / (0.0972 ? 0.05)
= 2.10 / 0.0472 = $44.49
6. Assuming a beta of 1.12, if UC is expected to have a growth rate of 10% for the first 3 years and 5% thereafter, what is the price of UC stock?
A) $50.87.
B) $53.81.
C) $46.89.
Explanation: A) D1 = 2(1.10) = 2.20
D2 = 2.20(1.10) = 2.42
D3 = 2.42(1.10) = 2.662
D4 = 2.662(1.05) = 2.795
V3 = D4 / (r ? g)
= (2.795) / (0.0972 ? 0.05)
= 59.22
V0 = [2.20 / 1.0972] + [2.42 / (1.0972)2] + [(2.662 + 59.22) / (1.0972)3]
= $50.87
7. Assuming a beta of 1.12, if UC’s growth rate is 10% initially and is expected to decline steadily to a stable rate of 5% over the next three years, what is the price of UC stock?
A) $46.61.
B) $47.67.
C) $47.82.
Explanation: B) Given: D0 = 2.00; gL = 0.05; gS = 0.10; H = (3 / 2) = 1.50; and r = 0.0972
V0 = {[D0(1 + gL)] + [D0 × H × (gS ? gL)]} / (r ? gL)
V0 = [2(1.05) + 2(1.50)(0.10 ? 0.05)] / (0.0972 ? 0.05)
= 2.25 / 0.0472 = $47.67
8. Regarding the statements made by Ancis and Nutting about the correct valuation models and values for AB:
A) only Nutting is correct.
B) both are incorrect.
C) only Ancis is correct.
Explanation: B) Both Ancis’s and Nutting’s statements are incorrect.
The Gordon Growth Model assumes that dividends increase at a constant rate perpetually. That fits the Low-Growth scenario, not the Middle or High-Growth scenarios. Thus, Ancis’s statement is incorrect.
In the Low-Growth scenario:
The required rate of return is (r) = 0.04 + 1.4(0.12 ? 0.04) = 0.152.
The value per share is DPS0(1 + gn) / (r ? gn) = [(1.50)(1.03)] / (0.152 ? 0.03) = $12.66.
The two-stage DDM model is most suited to a company that has one dividend growth rate for a specified time period and then shifts suddenly to a second dividend growth rate. That best fits the Middle-Growth scenario. In the Middle-Growth scenario,
The required rate of return is (r) = 0.05 + (1.4)(0.12 ? 0.05) = 0.148.
The value per share is:
The two-stage DDM gives a value for AB that is ($16.44 ? $12.66) = $3.78 higher than the value given by the Gordon Growth Model. Thus Nutting’s statement is also incorrect.
9. What is the implied required rate of return for Reality Productions?
A) 12.50%.
B) 11.75%.
C) 11.00%.
Explanation: C) The H-model applies to firms where the dividend growth rate is expected to decline linearly over the high-growth stage until it reaches its long-run average growth rate. This most closely matches the anticipated pattern of growth for Reality Productions.
The H-model can be rewritten in terms of r and used to solve for r given the other model inputs:
r = D0 / P0 × [(1 + gL) × [H × (gS ? gL)] + gL
Here, r = 1.5 / 30 × [(1 + 0.05) + [(6.0 / 2) × (0.10 ? 0.05)] + 0.05 = 0.11
10. Regarding the statements made by Ancis and Nutting about the appropriate uses of the H-model and three-stage DDM:
A) both are correct.
B) only one is correct.
C) both are incorrect.
Explanation: B) Ancis’s statement is technically correct. Although three-stage DDM traditionally uses progressively lower growth rates in each stage, that is not necessary. Three-stage DDM applies when growth rates vary in any manner, as long as they do so in three distinct stages. Nutting’s statement is incorrect because the H-model is not appropriate for a company with sustained dividend growth at any level (high or not). The H-model assumes that the company’s dividend growth rate declines linearly.
11. Based upon its current market value, what is the implied long-term sustainable growth rate of Turbo Financial Advisors?
A) 0.3%.
B) 19.0%.
C) 4.0%.
Explanation: C) The implied long-term rate is the rate that will cause the present value of expected dividends to equal its current market value. Since Ancis provides specific growth rates for Turbo over the next three years, we can use a multi-stage dividend discount model and solve for the long-term growth rate that makes the present value equal to the current market value.
First, we calculate Turbo’s expected dividends.
D0 = $10.00 current EPS times the dividend payout ratio of 40%
D0 = $4.00 dividend per share in year 0.
Note that the 19% historical dividend growth rate is irrelevant to the current value of the firm. Since the dividend payout ratio is expected to remain constant at 40%, we can use the expected growth rate in earnings to estimate future dividends. EPS growth is forecast at 20% in year 1, 15% in year 2, and 10% in year 3.
Multiplying each year’s expected dividend times the relevant forecast growth rate, we calculate:
D1 = ($4.00 dividend in year 0) × (1.20) = $4.80
D2 = ($4.80 dividend in year 1) × (1.15) = $5.52
D3 = ($5.52 dividend in year 2) × (1.10) = $6.07
Discounting these back to their present value in year 0 using the cost of equity (the WACC is irrelevant), we find:
Present Value (D1 + D2 + D3) = ($4.80 / 1.141) + ($5.52 / 1.142) + ($6.07 / 1.143)
= $4.21 + $4.25 + $4.10
= $12.56
Thus, we know that $12.56 of the current $55.18 market value represents the present value of the expected dividends in years 1, 2 and 3. Therefore, the present value of the firm’s dividends for years 4 and beyond must equal ($55.18 – $12.56) = $42.62.
Since the present value of the firm’s dividends beginning in year 4 equals $42.62, the future value in year four will equal ($42.62 × 1.143) = $63.14.
Now that we know the value in year 4 of the future stream of steady-growth dividends, we can solve for the growth rate using the Gordon Growth Model:
P3 = [($6.07)(1 + x)] / (0.14 – x ) = $63.14
63.14 (0.14 – x) = 6.07 (1+x)
8.84 – 63.14x = 6.07 + 6.07x
2.77 = 69.21x
x = 0.04
The long-term growth rate that makes Turbo fairly valued is 4% per year.
12. What is the present value of Aultman’s future investment opportunities as a percentage of the market price?
A) 13.9%.
B) 36.9%.
C) 8.1%.
Explanation: B) The present value of the company’s future investment opportunities is also known as PVGO, which can be calculated using the formula: Value = (E / r) + PVGO
where:
E = earnings per share
r = required return
(E / r) is the value of the assets in place
Here, $22 = ($2.5 / 0.18) + PVGO
PVGO = $8.11
The PVGO as a percentage of the market price equals ($8.11 / $22.00) = 36.9%
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