Answer Key

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.

- Miscellaneous Notes
- Chapter 13-15: Notes
- Chapter 6-9: Notes
- Real DB Versus Nominal GDP
- The Additional Problem of Economics
- A Model For Stratrgically Building Brand
- Brand as Image
- Types of Negotiable Instruments
- The Logic of Discounting
- Decisions Making Science
- Economic People
- Growing Perpetuity
- Economics Conditions
- International Accounting Standart
- History of the Concept Economy

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

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