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

CFA Level 2 - Equity Session 11-Reading 42 Discounted Dividend Valuation - LOS m (Practice Questions, Sample Questions) 1. If we increase the required rate of return used in a dividend discount model, the estimate of value produced by the model will: A) decrease. B) increase.C) remain the same. <Explanation> A) The required rate of return is used in thedenominator of the equation. Increasing this factor will decrease theresulting value. 2. If we know the forecast growth rates for a firm’s dividends and the current dividends and current value, we can determine the: A) required rate of return. B) net margin of the firm.C) sustainable growth rate. <Explanation> A) Just as we can determine the current value of theshares from the current dividends, growth forecasts and requiredreturn, we can solve for any one of them if we know the other threefactors.

3. Which of the following is least likely a valid approach to determining the appropriate discount rate for a firm’s dividends? A) Free cash flow to firm (FCFF). B) Capital asset pricing model (CAPM).C) Arbitrage pricing theory (APT). <Explanation> A) FCFF is another discounted cash flow model, not amethod to determine required returns. Each of the other answers is avalid approach to determining an appropriate discount rate. 4. In using the capital asset pricing model (CAPM) to determine the appropriate discount rate for discounted cash flow models (DCFs), theasset’s beta is used to determine the amount of: A) equity premium. B) the expected return in addition to the return required by the risk ofthe position.C) risk-free rate applicable to the time period of the investment. <Explanation> A) Beta measures the correlation between the equitymarket or index for which the market risk premium is calculated andthe particular asset being valued. Beta is used to approximate theproportion of the equity risk premium applicable to the asset (inrelation to the market or index used). 5. Analyst Kelvin Strong is arguing with fellow analyst Martha Hatchett. Strong insists that the dividend discount model can be used to calculatethe required return for a stock, though only if the growth rate remainsconstant. Hatchett maintains that while such models are useful forcalculating the value of a stock, they should not be used to calculaterequired returns. Who is CORRECT?

Strong Hatchett A) Incorrect Incorrect B) Correct IncorrectC) Incorrect Correct <Explanation> A) Dividend discount models can be used to calculaterequired returns, assuming you have the stock price, dividends, anddividend-growth rates, so Hatchett is wrong. Strong is right about thefact that a DDM can calculate required returns, but wrong about thegrowth rate assumption. Multistage dividend discount models canaccount for expected changes in the growth rate. 6. Which of the following groups of statistics provides enough data to calculate an implied return for a stock using the two-stage DDM? A) Short-term growth rate, long-term growth rate, stock price, trailing12-month profits. B) P/E ratio, trailing 12-month profits, short-term PEG ratio,long-term PEG ratio, yield. C) Yield, stock price, historical dividend-growth rate, historicalprofit-growth rate. <Explanation> B) To calculate an implied return using the two-stageDDM, we need the stock price, the dividend, a short-term growthrate, and a long-term growth rate. In the correct answer, we canderive the stock price from the P/E ratio and profits, then derive thedividend from the price and the yield. Given the P/E ratio, we canalso distill growth rates using the PEG ratios. Admittedly,earnings-growth rates aren’t the same as dividend-growth rates, butanalysts routinely use either in their models. More to the point, this isthe only answer in which we can come up with even imperfect data

for all the needed variables. One choice does not provide us with away to find the dividend. The other option does not give us theneeded short-term and long-term growth rates. 7. An investor buys shares of a firm at $10.00. A year later she receives a dividend of $0.96 and sells the shares at $9.00. What is her holdingperiod return on this investment? A) -0.4%. B) -0.8%.C) +1.2%. <Explanation> A) The holding period return = ($0.96 + $9.00 /$10.00) – 1 = –0.004 or –0.4% 8. Given that a firm’s current dividend is $2.00, the forecasted growth is 7%, declining over three years to a stable 5% thereafter, and the currentvalue of the firm’s shares is $45, what is the required rate of return? A) 7.8%. B) 9.8%. C) 10.5%. <Explanation> B) The required rate of return is 9.8%.r = ($2/$45) [(1 + 0.05) + (3/2)(0.07 – 0.05)] + 0.05 = 0.0980Since the H-model is an approximation model, it is possible to solvefor r directly without iteration. 9. Given that a firm’s current dividend is $2.00, the forecasted growth is 7% for the next two years and 5% thereafter, and the current value ofthe firm’s shares is $54.50, what is the required rate of return?

A) Can’t be determined. B) 9%. C) 10%. <Explanation> B) The equation to determine the required rate ofreturn is solved through iteration.$54.50 = $2(1.07) / (1 + r) + $2(1.07)2 / (1 + r)2 + {[$2(1.07)2(1.05)] /(r - 0.05)} / [(1 + r)2Through iteration, r = 9%