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CFA CFA-Level-II Exam Prep
CFA Level II Chartered Financial Analyst (Page 77 )

Updated On: 7-Sep-2026
Page 29 of 145
PDF with 715 Questions

De Jong continues her analysis of O'Connor. She is concerned that along with a dividend discount model approach she would also like to get a measure of the contribution that the key managers, Melanie and Arthur O'Connor, have made to the company's apparent ongoing success.

She considers using NOPAT and EVA to assess management performance. She believes that increasing invested capital to take advantage of projects with positive net present values increases both NOPAT and EVA.

However, De Jong decides to use residual income analysis instead. She provides the following justification for using the residual income model:

• The calculation of residual income depends primarily on readily available accounting data.
• The residual income model can be used even when cash flow is difficult to forecast.
• The residual income model does not depend on dividend payments or on positive free cash flows in the near future.
• The residual income model depends on the validity of the clean surplus relation.

She also considers the following assumptions about continuing residual income:
Assumption 1: Residual income is positive and continues at the same level year after year. Assumption 2: As return on equity approaches the cost of equity, residual income tends to zero.
Assumption 3: Residual income growth declines overtime and eventually reaches zero.

De Jong gathers recent financial information data on O'Connor, as shown in Exhibit I.



De Jong has also determined that at the beginning of 2008, O'Connor had total capital of
$324,000,000, of which $251,000,000 was debt and $73,000,000 was equity. The company's cost of debt before taxes is 7%, and the cost of equity capital is 8%. The company has a tax rate of approximately 34%. Weighted average cost of capital is 5.4%. Net operating profit after tax (before any adjustments) is $28,517,640.

De Jong is interested in obtaining the market's assessment of the implied growth rate in residual income and notes that the book value per share for O'Connor at the beginning of 2009 was $4.29, and the current market price is $70. She forecasts the return on equity (ROE) for 2009 to be 11.84%.

De Jong discusses her analyses with a colleague, who makes the following general statements:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

The implied residual income growth rate for 2009, based on the residual income model, is closest to:

  1. 7.75%.
  2. 8.16%.
  3. 8.82%.

Answer(s): A

Explanation:

We need to solve (or g in the relationship:

Solving for g, wc get g = 7.75%. (Study Session 12, LOS 43.g)



De Jong continues her analysis of O'Connor. She is concerned that along with a dividend discount model approach she would also like to get a measure of the contribution that the key managers, Melanie and Arthur O'Connor, have made to the company's apparent ongoing success.

She considers using NOPAT and EVA to assess management performance. She believes that increasing invested capital to take advantage of projects with positive net present values increases both NOPAT and EVA.

However, De Jong decides to use residual income analysis instead. She provides the following justification for using the residual income model:

• The calculation of residual income depends primarily on readily available accounting data.
• The residual income model can be used even when cash flow is difficult to forecast.
• The residual income model does not depend on dividend payments or on positive free cash flows in the near future.
• The residual income model depends on the validity of the clean surplus relation.

She also considers the following assumptions about continuing residual income:
Assumption 1: Residual income is positive and continues at the same level year after year. Assumption 2: As return on equity approaches the cost of equity, residual income tends to zero.
Assumption 3: Residual income growth declines overtime and eventually reaches zero.

De Jong gathers recent financial information data on O'Connor, as shown in Exhibit I.



De Jong has also determined that at the beginning of 2008, O'Connor had total capital of
$324,000,000, of which $251,000,000 was debt and $73,000,000 was equity. The company's cost of debt before taxes is 7%, and the cost of equity capital is 8%. The company has a tax rate of approximately 34%. Weighted average cost of capital is 5.4%. Net operating profit after tax (before any adjustments) is $28,517,640.

De Jong is interested in obtaining the market's assessment of the implied growth rate in residual income and notes that the book value per share for O'Connor at the beginning of 2009 was $4.29, and the current market price is $70. She forecasts the return on equity (ROE) for 2009 to be 11.84%.

De Jong discusses her analyses with a colleague, who makes the following general statements:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

Are the statements made by De Jong's colleague correct?

  1. Both statements are correct.
  2. Only Statement 1 is correct.
  3. Only Statement 2 is correct.

Answer(s): C

Explanation:

Only Statement 2 is correct. Residual income valuation is related to P/B. When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than 1. Statement 1 is not correct: residual income models recognize value earlier than other valuation models. (Study Session 12, LOS 43.e,k)



Valentine notes that a share of Trailblazer's stock is currently priced at $32. Moreover, she expects the dividend for next year to be $1.47 and forecasts that the price of one share of Trailblazer stock at the end of the year wilt be $35.
In her report, Valentine makes the following statements about Trailblazer dividends:

Statement 1: Trailblazer is expected to pay a dividend next year and will continue to do so for the foreseeable future.
Statement 2: The required rate of return for Trailblazer stock will likely exceed the growth rate of its dividends.
Statement 3: Trailblazer is in a mature sector of its industry, and accordingly, I expect dividends to decline to a constant rate of 4% indefinitely.
In speaking to a colleague at her firm, Valentine makes the following additional statements after her report is released:
Statement 4: Trailblazer has a 10-year history of paying regular quarterly dividends. Statement 5: Over a recent 10-year period, Trailblazer has experienced one 3-year period of consecutive losses and another period of two annual losses in a row but has been extremely profitable in the remaining five years.

Valentine is concerned about the theoretical validity of using the APT to obtain an estimate of the required rate of return on equity. She decides to attend a conference dealing specifically with estimation techniques that analysts can employ. At one of the conference seminars, the following points are made:

Statement 6: The APT is a better approach than the CAPM because even though the factor risk premiums are difficult to estimate, the CAPM is more problematic because it relies on a single market risk premium estimate, which in turn leads to greater input uncertainty.
Statement 7: Model uncertainty is a problem with the APT but not with the CAPM.
Valentine is also analyzing the stock of Farwell, Inc. Farwell shares are currently trading at $48 based on current earnings of $4 and a current dividend of $2.60. Dividends are expected to grow at 5% per year indefinitely. The risk-free rate is 3.5%, the market risk premium is 4.5%, and Farwell's beta is estimated to be 1.2.

Based on the APT model and the bond yield plus risk-premium (BYPRP) method, the discount rate Valentine should use in valuing the equity of Trailblazer is closest to:

Rate based on APT Rate based on BYPRP

  1. 8.40% 10.25%
  2. 4.90% 10.25%
  3. 8.40% 7.25%

Answer(s): A

Explanation:

Based on the APT, the appropriate discount rate for Trailblazer is:
E( ) = 3.5% + (0.81x1.91%)-(0.45xl.22%) + (0.24x3.47%) + (0.74x4.15%) = 8.4%
Based on the BYPRP method, the required return on Trailblazer's equity = 7.25% + 3% = 10.25%. (Study Session 10, LOS 35.d)



Valentine notes that a share of Trailblazer's stock is currently priced at $32. Moreover, she expects the dividend for next year to be $1.47 and forecasts that the price of one share of Trailblazer stock at the end of the year wilt be $35.
In her report, Valentine makes the following statements about Trailblazer dividends:

Statement 1: Trailblazer is expected to pay a dividend next year and will continue to do so for the foreseeable future.
Statement 2: The required rate of return for Trailblazer stock will likely exceed the growth rate of its dividends.
Statement 3: Trailblazer is in a mature sector of its industry, and accordingly, I expect dividends to decline to a constant rate of 4% indefinitely.
In speaking to a colleague at her firm, Valentine makes the following additional statements after her report is released:
Statement 4: Trailblazer has a 10-year history of paying regular quarterly dividends. Statement 5: Over a recent 10-year period, Trailblazer has experienced one 3-year period of consecutive losses and another period of two annual losses in a row but has been extremely profitable in the remaining five years.

Valentine is concerned about the theoretical validity of using the APT to obtain an estimate of the required rate of return on equity. She decides to attend a conference dealing specifically with estimation techniques that analysts can employ. At one of the conference seminars, the following points are made:

Statement 6: The APT is a better approach than the CAPM because even though the factor risk premiums are difficult to estimate, the CAPM is more problematic because it relies on a single market risk premium estimate, which in turn leads to greater input uncertainty.
Statement 7: Model uncertainty is a problem with the APT but not with the CAPM.

Valentine is also analyzing the stock of Farwell, Inc. Farwell shares are currently trading at $48 based on current earnings of $4 and a current dividend of $2.60. Dividends are expected to grow at 5% per year indefinitely. The risk-free rate is 3.5%, the market risk premium is 4.5%, and Farwell's beta is estimated to be 1.2.

The expected holding period return over the next year is closest to:

  1. 13.45%.
  2. 13.97%.
  3. 14.59%.

Answer(s): B

Explanation:

The expected holding period return is:

(Scudy Session 10, LOS 35.a)



Valentine notes that a share of Trailblazer's stock is currently priced at $32. Moreover, she expects the dividend for next year to be $1.47 and forecasts that the price of one share of Trailblazer stock at the end of the year wilt be $35.
In her report, Valentine makes the following statements about Trailblazer dividends:

Statement 1: Trailblazer is expected to pay a dividend next year and will continue to do so for the foreseeable future.
Statement 2: The required rate of return for Trailblazer stock will likely exceed the growth rate of its dividends.
Statement 3: Trailblazer is in a mature sector of its industry, and accordingly, I expect dividends to decline to a constant rate of 4% indefinitely.
In speaking to a colleague at her firm, Valentine makes the following additional statements after her report is released:
Statement 4: Trailblazer has a 10-year history of paying regular quarterly dividends. Statement 5: Over a recent 10-year period, Trailblazer has experienced one 3-year period of consecutive losses and another period of two annual losses in a row but has been extremely profitable in the remaining five years.

Valentine is concerned about the theoretical validity of using the APT to obtain an estimate of the required rate of return on equity. She decides to attend a conference dealing specifically with estimation techniques that analysts can employ. At one of the conference seminars, the following points are made:

Statement 6: The APT is a better approach than the CAPM because even though the factor risk premiums are difficult to estimate, the CAPM is more problematic because it relies on a single market risk premium estimate, which in turn leads to greater input uncertainty.
Statement 7: Model uncertainty is a problem with the APT but not with the CAPM.

Valentine is also analyzing the stock of Farwell, Inc. Farwell shares are currently trading at $48 based on current earnings of $4 and a current dividend of $2.60. Dividends are expected to grow at 5% per year indefinitely. The risk-free rate is 3.5%, the market risk premium is 4.5%, and Farwell's beta is estimated to be 1.2.

How many of the first three statements Valentine made concerning Trailblazer's dividends are consistent with assumptions of the Gordon growth model (GGM)?

  1. None.
  2. Two.
  3. Three.

Answer(s): C

Explanation:

All three statements are consistent with the assumptions of the Gordon growth model. Regarding Statement 3, there is nothing to prevent the growth rate from being negative. The model can still be applied in this case. (Study Session 11, LOS 40.d)



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