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Free CFA® CFA-Level-II Exam Braindumps (page: 33)

Page 33 of 181
PDF with 715 Questions

Yi Tang updates several economic parameters monthly for use by the analysts and the portfolio managers at her firm. If economic conditions warrant, she will update the parameters even more frequently. As a result of an economic slowdown, she is going through this process now.

The firm has been using an equity risk premium of 5.6%, found with historical estimates. Tang is going to use an estimate of the equity risk premium found with a macroeconomic model. By comparing the yields on nominal bonds and real bonds, she estimates the inflation rate to be 2.6%. She expects real domestic growth to be 3.0%. Tang does not expect a change in price/earnings ratios. The yield on the market index is 1.7% and the expected risk-free rate of return is 2.7%.

Elizabeth Trotter, one of the firm's portfolio Managers, asks Tang about the effects of survivorship bias on estimates of the equity risk premium. Trotter asks, "Which method is most susceptible to this bias, historical estimates, Gordon growth model estimates, or survey estimates?"
Tang wishes to estimate the required rate of return for Northeast Electric (NE) using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. She is using the following information to accomplish this:

•The risk-free rate of return is 2.7%.
•The expected risk premiums arc:



•The beta coefficient in the CAPM is estimated to be 0.63.
•The betas (factor sensitivities) for the three Fama-French factors are 1.00 for the market factor, -0.76 for the size factor, and -0.04 for the book-to-markct factor.

Trotter also asks Tang about adjusted betas. She says, "We use a formula for the adjusted beta where the adjusted beta = (2/3) (regression beta) + (1/3) (1.0). How do the adjusted betas compare to the original regression betas?"

Trotter has one final question for Tang. Trotter says, "We need to estimate the equity beta for VixPRO, which is a private company that is not publicly traded. We have identified a publicly traded company that has similar operating characteristics to VixPRO and we have estimated the beta for that company using regression analysis. We used the return on the public company as the dependent variable and the return on the market index as the independent variable. What steps do I need to take to find the beta for VixPRO equity? The companies have different debt/equity ratios. The debt of both companies is very low risk, and I believe I can ignore taxes."

What response should Tang give Trotter about estimating the equity beta for VixPRO?

  1. Estimate the beta for VixPRO by regressing the returns for VixPRO on an index of non-traded equity market securities.
  2. Estimate the VixPRO beta as the multiplying the public company beta times the ratio of the equity risk premium of the market to the risk-free rate of return.
  3. Estimate the unlevered beta for the public company based on its debt/equity ratio. Then use that unlevered beta and estimate the equity beta for VixPRO based on the VixPRO debt/equity ratio.

Answer(s): C

Explanation:

Unlever the beta for the public company (which we will denote PC). Assuming no taxes and no bond risk, this is:



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:

  1. 4.2%.
  2. 7.2%.
  3. 9.2%.

Answer(s): B

Explanation:

The beta of 1.04 is estimated from the slope coefficient on the independent variable (the return on the market) from the regression.



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:

  1. $58.55.
  2. $75.68.
    C $85.63.

Answer(s): B

Explanation:

The value of the stock in early 2009 is the present value of the future dividends. After 2011, dividends are expected to grow at the rate of 4%. The dividend that begins the constantly growing perpetuity is $2.63 x 1.04 = $2.74. You are toid to assume the appropriate discount rate is the cost of equity of 7.2% from Question 13. Note that for the third cash flow, we add the third dividend ($2.63) to the present value of the constantly growing perpetuity that begins in the fourth year = $2.74 / (0.072 - 0.04) = $85.63. This is valid since they both occur at the same point in time (i.e., at the end of the third year). Using a financial calculator we can estimate the value of one share of O'Connor stock as follows:

CFO = 0; C01 = $2.13; C02 = $2.36; C03 = $2.63 + $85.63 = $88.26; I = 7.2; CPT -> NPV = $75.68
(Study Session ll.LOS40.c)



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:

  1. less than three years.
  2. equal to three years.
  3. greater than three years.

Answer(s): A

Explanation:

De Jong's estimate of value of $75-68 from Question 14 (based on a high-growth period of three years) is greater than the market's consensus of $70.00, which means the market's consensus high-growth duration must be less than three years, all else equal. (Study Session II, LOS 40.c)



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