CFA CFA-Level-II Exam Prep
CFA Level II Chartered Financial Analyst (Page 27 )

Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.

Following an acquisition of a major competitor in 1992, O'Connor went public in 1993 and paid its first dividend in 1999. Dividends are paid at the end of the year. After 2008, dividends are expected to grow for three years at 11%: $2.13 in 2009, $2.36 in 2010, and $2.63 in 2011. The average of the arithmetic and compound growth rates are given in Exhibit 1. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts. O'Connor's annual dividend history is shown in Exhibit 1.


De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model.



The output from the regression appears in Exhibit 2.



De Jong determines that employing the CAPM to estimate the required return on equity suffers from the following sources of error:

• Estimation of the model's inputs (e.g., the market risk premium). The company's dividend payment schedule.
• The accuracy of the beta estimate.
• Whether or not the model is the appropriate one to use.

De Jong observes that two reputable statistical analysis firms estimate betas for O'Connor stock at 0.85 and 1.10. She concludes that the differences between her beta estimate and the published estimates resulted from her use of standard errors in her regression to correct for serial correlation; the other firms did not make a similar adjustment.

De Jong considers using adjusted beta in her analysis. Typically, her company uses 1/3 for the value of a0. However, in this case, she is considering using a0 = 1 /2. She determines that her adjusted beta forecast will be closer to the mean reverting level using this value than it would be using a value of 1/3.

The required return on equity (according to the CAPM) for O'Connor is closest to:

Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.

Following an acquisition of a major competitor in 1992, O'Connor went public in 1993 and paid its first dividend in 1999. Dividends are paid at the end of the year. After 2008, dividends are expected to grow for three years at 11%: $2.13 in 2009, $2.36 in 2010, and $2.63 in 2011. The average of the arithmetic and compound growth rates are given in Exhibit 1. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts. O'Connor's annual dividend history is shown in Exhibit 1.


De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model.



The output from the regression appears in Exhibit 2.



De Jong determines that employing the CAPM to estimate the required return on equity suffers from the following sources of error:

• Estimation of the model's inputs (e.g., the market risk premium). The company's dividend payment schedule.
• The accuracy of the beta estimate.
• Whether or not the model is the appropriate one to use.

De Jong observes that two reputable statistical analysis firms estimate betas for O'Connor stock at 0.85 and 1.10. She concludes that the differences between her beta estimate and the published estimates resulted from her use of standard errors in her regression to correct for serial correlation; the other firms did not make a similar adjustment.

De Jong considers using adjusted beta in her analysis. Typically, her company uses 1/3 for the value of a0. However, in this case, she is considering using a0 = 1 /2. She determines that her adjusted beta forecast will be closer to the mean reverting level using this value than it would be using a value of 1/3.

The value of one share of O'Connor stock in early 2009 using the two-stage dividend discount model (DDM) is closest to:

Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.

Following an acquisition of a major competitor in 1992, O'Connor went public in 1993 and paid its first dividend in 1999. Dividends are paid at the end of the year. After 2008, dividends are expected to grow for three years at 11%: $2.13 in 2009, $2.36 in 2010, and $2.63 in 2011. The average of the arithmetic and compound growth rates are given in Exhibit 1. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts. O'Connor's annual dividend history is shown in Exhibit 1.


De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model.



The output from the regression appears in Exhibit 2.



De Jong determines that employing the CAPM to estimate the required return on equity suffers from the following sources of error:

• Estimation of the model's inputs (e.g., the market risk premium). The company's dividend payment schedule.
• The accuracy of the beta estimate.
• Whether or not the model is the appropriate one to use.

De Jong observes that two reputable statistical analysis firms estimate betas for O'Connor stock at 0.85 and 1.10. She concludes that the differences between her beta estimate and the published estimates resulted from her use of standard errors in her regression to correct for serial correlation; the other firms did not make a similar adjustment.

De Jong considers using adjusted beta in her analysis. Typically, her company uses 1/3 for the value of a0. However, in this case, she is considering using a0 = 1 /2. She determines that her adjusted beta forecast will be closer to the mean reverting level using this value than it would be using a value of 1/3.

Assuming the market has also applied a two-stage DDM, and the market's consensus estimate of dividend growth and required return are the same as De Jong's, the market's consensus estimate of the duration of the high-growth period is most likely:

Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.

Following an acquisition of a major competitor in 1992, O'Connor went public in 1993 and paid its first dividend in 1999. Dividends are paid at the end of the year. After 2008, dividends are expected to grow for three years at 11%: $2.13 in 2009, $2.36 in 2010, and $2.63 in 2011. The average of the arithmetic and compound growth rates are given in Exhibit 1. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts. O'Connor's annual dividend history is shown in Exhibit 1.


De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model.



The output from the regression appears in Exhibit 2.



De Jong determines that employing the CAPM to estimate the required return on equity suffers from the following sources of error:

• Estimation of the model's inputs (e.g., the market risk premium). The company's dividend payment schedule.
• The accuracy of the beta estimate.
• Whether or not the model is the appropriate one to use.

De Jong observes that two reputable statistical analysis firms estimate betas for O'Connor stock at 0.85 and 1.10. She concludes that the differences between her beta estimate and the published estimates resulted from her use of standard errors in her regression to correct for serial correlation; the other firms did not make a similar adjustment.

De Jong considers using adjusted beta in her analysis. Typically, her company uses 1/3 for the value of a0. However, in this case, she is considering using a0 = 1 /2. She determines that her adjusted beta forecast will be closer to the mean reverting level using this value than it would be using a value of 1/3.

In what situation is it most appropriate for De Jong to employ a:

Dividend discount model? FCFE model?

Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.

Following an acquisition of a major competitor in 1992, O'Connor went public in 1993 and paid its first dividend in 1999. Dividends are paid at the end of the year. After 2008, dividends are expected to grow for three years at 11%: $2.13 in 2009, $2.36 in 2010, and $2.63 in 2011. The average of the arithmetic and compound growth rates are given in Exhibit 1. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts. O'Connor's annual dividend history is shown in Exhibit 1.


De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model.



The output from the regression appears in Exhibit 2.



De Jong determines that employing the CAPM to estimate the required return on equity suffers from the following sources of error:

• Estimation of the model's inputs (e.g., the market risk premium). The company's dividend payment schedule.
• The accuracy of the beta estimate.
• Whether or not the model is the appropriate one to use.

De Jong observes that two reputable statistical analysis firms estimate betas for O'Connor stock at 0.85 and 1.10. She concludes that the differences between her beta estimate and the published estimates resulted from her use of standard errors in her regression to correct for serial correlation; the other firms did not make a similar adjustment.

De Jong considers using adjusted beta in her analysis. Typically, her company uses 1/3 for the value of a0. However, in this case, she is considering using a0 = 1 /2. She determines that her adjusted beta forecast will be closer to the mean reverting level using this value than it would be using a value of 1/3.

Is De Jong correct about the sources of error in the C APM?