CFA Level 2 - Equity Session 11 - Reading 42 Discounted Dividend Valuation - LOS b

CFA Level 2 - Equity Session 11-Reading 42 Discounted Dividend Valuation - LOS b (Practice Questions, Sample Questions) 1. The tangible price-to-earnings (P/E) and franchise P/E values for ACP, Inc. are closest to:Tangible P/E Franchise P/E A) 4.59 6.67B) 6.67 4.59 C) 9.09 2.08 {Explanation}: C — Tangible P/E = 1 / r, so, tangible P/E = 1 / 0.11 = 9.09 Franchise P/E is the product of the franchise factor (FF) and the growthfactor (G).That is, Franchise P/E = FF × G.The Franchise factor is computed as: FF = (1 / r) ? (1 / ROE)ROE = NI / equity, so for ACP, ROE = 4.20 / 28.47 = 0.1475FF = (1 / 0.11) - (1 / 0.1475) = 9.09 - 6.78 = 2.31 The growth factor, G, is calculated as: G = g / (r ? g)Where, the sustainable growth rate, g, is calculated as:g= retention rate × ROE = (1 ? payout ratio) × ROE= (1 ? 0.65) × 0.1475 = 0.052

So, G = 0.052 / (0.11 ? 0.052) = 0.90Franchise P/E = FF × G = 2.31 × 0.90 = 2.08 2. During his research, Reynolds has observed that many of the firms in the marine products industry are concerned about the impact that newtechnology will have on their future profitability. Specifically, these firmsare afraid that the competition resulting from new technologies willreduce their market share. Based on this observation, what stage of theindustry life cycle are the firms in the marine products industry mostlikely in? A) Growth. B) Mature. C) Decline {Explanation}: B —.For mature industries, the threat from new technologies is whether competitors that employ new technologies willhave a competitive advantage. In this situation, firms that do not use thenew technologies will either have to adopt the new technologies oracquire their competition in order to survive. 3. In addition to evaluating the five largest firms in the marine products industry, Lapke has asked Reynolds to conduct a valuation of a smallerfirm, one that is domiciled in an emerging market. They both agree thatthe emerging market firm’s value should be estimated as the presentvalue of the company’s expected future free cash flows discounted at

the appropriate weighted average cost of capital. They do not, however,agree on the appropriate method for incorporating country risks intothe analyses. Lapke believes that the discount rate should be adjustedto reflect country risk, but Reynolds holds the opinion that cash flowsshould be adjusted. During their discussion, the following twostatements are made. Reynolds' comment:The evidence on this issue suggests that country risks are bestincorporated into the valuation process by adjusting the cash flows in ascenario analysis rather than including them in the discount rate.Lapke's comment: Regardless of whether we adjust the discount rate orthe cash flows to reflect emerging market risk, both the nominal and realcash outflow associated with net working capital should be computed asthe change in nominal and real cash outflow from net working capital,respectively. With respect to these statements: A) both are correct.B) only Lapke is correct. C) only Reynolds is correct. {Explanation}: C. 4. Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. Charleston

Johnson expects the local government to be successful in bringinginflation under control, and anticipates that it will fall to 20% in thesecond year and 10% in the third year, where he expects inflation tostabilize. Johnson predicts that by year 3, Wavington will have nominalfree cash flow of $187 million growing at 4% annually in real terms. Inview of his optimistic outlook, he is considering an investment inWavington, and has calculated the real WACC for Wavington at 8%. Thenominal continuing value of Wavington in year 3 is closest to: A) $4,862. B) $4,675.C) $4,250. {Explanation}: A — The nominal growth rate for Wavington in the steady state is (1.10 × 1.04) – 1 = 14.4%. The nominal WACC in the steady state is(1.10 × 1.08) – 1 = 18.8%. The nominal continuing value for Wavington inyear 3 is: nominal continuing value = FCF3 × (1 + nominal growth rate) / (nominalWACC – nominal growth rate)nominal continuing value = 187 × (1.144) / (0.188 – 0.144)nominal continuing value = 213.9 / (0.044) = 4,862 5. Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. CharlestonJohnson expects the local government to be successful in bringinginflation under control, and anticipates that it will fall to 20% in thesecond year and 10% in the third year, where he expects inflation to

stabilize. Johnson asserts that the financial ratios of Wavington will bethe same in both the real and nominal approaches. With regard to thisstatement, Johnson is: A) correct because the underlying operations of the firm are unaffected by valuationmethodology. B) incorrect because cash flow forecasts in real terms are generallymore accurate than cash flow forecasts in nominal terms. C) correct because the rate of inflation used in calculating the components offinancial ratios is the same for all components. {Explanation}: B — In general, the ratios based on cash flow forecasts in real terms are accurate while ratios based on nominal forecasts areincorrectly estimated.