Security Analysis FIN6517

Diana wants to evaluate the stock of Eagle Inc., which is currently trading at $14.50 per share. She gathers the following information: Current book value per share = $9.50 ROE = 18% Expected EPS for Year 1-3 = ROE times beginning book value per share Dividend payout ratio = 40% Required rate of return on equity = 10% The company's residual income per share at the end of Year 3 is closest to:

$0.93 Year 1 ($) Year 2($) Year 3($) Beginning book value per share 9.50 10.53 11.67 Add: Forecasted EPS 1.71 1.90 2.10 Less: Forecasted dividends per share 0.68 0.76 0.84 Ending book value per share 10.53 11.67 12.93 Equity charge per share 0.95 1.05 1.17 Residual income per share 0.76 0.85 0.93

Ludo Company's preferred stock has a $100 par that pays a $12 annual dividend. The required return is 9%. Calculate the value of the preferred stock if it has a one-year maturity and pays dividends semiannually.

$102.81. The second choice is correct. The value of the preferred stock is computed as follows: (6/1.045) + (106/1.0452) = 102.81

Selected information regarding Tempra Capital is given below: Earnings before interest and tax = $950,125 Interest expense = $215,250 Fixed capital expenditures = $775,280 Depreciation expense = $290,155 Working capital investment = $321,255 Net borrowing = $540,290 Given a tax rate of 40%, free cash flow available to holders of common equity is closest to:

$174,835 FCFE = EBIT (1 − Tax rate) − Interest (1 − Tax rate) + Depreciation − FCInv − WCInv + Net borrowing FCFE = [950,125 (1 − 0.4)] − [215,250 (1 − 0.4)] + 290,155 − 775,280 − 321,255 + 540,290 FCFE = $174,835

Crimson Corporation pays a current annual dividend of $0.48. It is expected to grow by 15% for the next three years, and then decline linearly over six (6) years from 15% to 6%. It will grow at 6% thereafter. The required rate of return is 10%. Using a three-stage DDM, the value of the stock is closest to:

$19.81. The first step is to find the present value of the first three years of dividends: Year Dividend Present Value 0 $0.48 1 $0.55 $0.50 2 $0.63 $0.52 3 $0.73 $0.55 Total: $1.57 Then, use the H-model to value the remaining dividends for the second and third stages, setting the dividend for year 3 as D0: The present value of the year three value found using the H-model is: Finally, find the present value of the second and third stages and add it to the present value of the first stage: Choice A is the terminal value and choice C is the present value of the terminal value only, it does not include the present value of the D1 through D3.

Destiny Corp. has total invested capital of $5 million, with 40 percent of this being debt financed at 7 percent. The company's required return on equity is 11 percent. Destiny had EBIT of $1 million and was taxed at a rate of 36 percent. Destiny Corp's residual income for the period will be closest to:

$220,400. There are two possible approaches: find net operating profit after tax (NOPAT) and subtract the capital charge or find net income and subtract the equity charge. We will first do the approach using NOPAT and the capital charge. The capital charge is calculated as follows: Since this capital charge takes into account after-tax interest cost, we subtract the capital charge from NOPAT. But, we have EBIT and need NOPAT. When starting with EBIT, NOPAT is calculated as follows: The residual income is then found as follows: NOPAT $640,000 Less capital charge 419,600 Residual income $220,400 The alternative approach is to find net income and subtract the equity charge. The equity charge is calculated as follows: We need to now find the net income and then subtract this charge in order to get the residual income: EBIT $1,000,000 Less interest 140,000 (0.40)($5 million)(0.07) Pretax income (EBT) $860,000 Less taxes 309,600 $860,000 × 0.36 Net income $550,400 Less equity charge 330,000 Residual income $220,400

An analyst believes that Hawkeye Incorporated will have a trailing P/E of 15x and an earnings retention rate of 0.65 in eight years. The expected dividend in year eight is $0.56. The terminal value of the stock in year 8 is closest to:

$24.00. In the question, you're given a P/E of 15 and a dividend payout rate of 1 - 0.65 = 0.35. The analyst projects a dividend for year 8 of $0.56. Using the equation for the payout rate, dividend/earnings, $0.56/E = 0.35, then the earnings for year eight must be $0.56/0.35 = $1.60. Multiply this earnings estimate, $1.60, by 15 for a terminal value of $24. Choice A incorrectly multiplies the dividend in year 8, $0.56, by the P/E multiple of 15x. Choice B incorrectly divides the dividend by the retention ratio to determine earnings for year 8; instead of determining the payout ratio.

Panther Industries will pay a dividend of $0.75 per share this year. The dividend is expected to grow by 15% per year for the next three years, and then settle into a long-term growth rate of 8% indefinitely. The required rate of return is 12%. Using a two-stage DDM, the value of a share of Panther Industries' stock is closest to:

$24.29. Using the equation: We can find the value as: Choice A incorrectly discounts the terminal value by four periods, not three. Choice B omits growing the dividend in the terminal value calculation.

In 2014, American Faucet Corporation (AFC) had earnings before interest and taxes of $150 million and interest expense during the period was $20 million. AFC is subject to a tax rate of 35 percent. The book value and market value of AFC's common equity at the beginning of 2014 was $500 million and $700 million, respectively. AFC's debt had a book value of $200 million at the beginning and end of 2014 and the company pays 10 percent interest on its debt. The company's cost of equity capital is estimated to be 11.5 percent. Based on this information, AFC's residual income will be closest to:

$27.0 million. The capital charge on common equity is based on the book value of equity at the beginning of the year. Thus, the equity charge is $57.5 million ($500 million x 0.115). Using this and the other data, we can calculate AFC's residual income (in millions of USD) as follows: EBIT $150.0 Less: Interest expense 20.0 Pretax income $130.0 Less: Income tax expense (35%) 45.5 Net income $84.5 Less: Common equity charge 57.5 Residual income $27.0

Charlie Onlap, CFA, is an equity analyst using the dividend discount model to value the shares of Scios Corporation. Scios has just paid a dividend of $0.17 per share, and Onlap expects this dividend to grow at 12% for the next three years. At that time, the growth rate in dividends will begin to fall in a roughly linear fashion over the next five years to settle at a long-term growth rate of 2%. Onlap estimates a required return of 10% for the shares of Scios. Scios is expected to have long-term stable net profit margin of 5%, total asset turnover of 0.5x, financial leverage of 1.5x, and a payout ratio of 55%. The share price of Scios Corp is currently $2.50. Using Onlap's assumptions, the fair value of Scios shares is closest to:

$3.38. Given the expected linear decline in growth rates, the relevant model to use is the H-model. The H-model should be used at the point in time where the growth rate in dividends begins to decline, namely, time 3 before being discounted back to the present. Dividends at times 1, 2, and 3 should be discounted explicitly and added to the H-model value to achieve the present fair value of the shares. Dividend at time 0 = $0.17 Dividend at time 1 = $0.17 × 1.12 = $0.1904 Dividend at time 2 = $0.17 × 1.122= $0.2132 Dividend at time 3 = $0.17 × 1.123 = $0.2388 Using the H-model at time 3 gives the present value at time 3 of dividends that occur after time 3 as: Where: g = low long-term growth rate r = required return G = high initial growth rate H = half the period taken to transition from the high growth rate to the low growth rate. Hence, in this case: Then the present value of the shares is given by:

An analyst gathers the following information regarding Monaco Capital Inc.: Value obtained from FCFF model = $800 million Market value of cash and short-term investments = $90 million Book value of land held as an investment = $80 million Market value of land held as an investment = $120 million Bonds and notes outstanding = $325 million Number of shares outstanding = 200 million The value per share of Monaco's stock is closest to:

$3.43. Market value of non-operating assets = $90m + $120m = $210 million Total value of the firm = Value of operating assets + Value of non-operating assets Total value of the firm = $800m + $210m = $1,010 million Equity value = Total value − Value of debt Equity value = $1,010m − $325m = $685 million Stock price = $685m / 200m = $3.425 per share

An analyst is valuing a firm with book value of $17 per share, return on equity (ROE) of 10 percent, a required return on equity of 9 percent, and an earnings retention rate of 50 percent. The firm has 20 million common shares outstanding that are trading at $30 per share. In addition, it has debt outstanding that requires it to pay 6.5 percent interest. The debt is recorded at $350 million on the balance sheet and is trading at $400 million in the market. The firm's market value added (MVA) is closest to:

$310 million. Market value added is equal to the market value of the company minus the accounting book value of total capital. We need to first find the market and book value of the equity: Now MVA can be calculated:

McClean Corp. has in issuance 8% preferred securities with $50 par value. If investors require a return of 10% from the securities, the value of the preferred stock is closest to:

$40. The preferred shares will pay a dividend of 0.08 × $50 = $4 per share on a perpetual basis. The fair value of these securities at a required return of 10% will be $4 / 0.1 = $40.

The analyst looking at Catapult Company has been asked to revise his assumption that the shares will sell at a 30 percent premium over forecasted end of period book value. Instead, he has been told to assume that the ROE in year 4 will be 12.0 percent and that the ROE will slowly decline toward the cost of equity, which is estimated to be 10.2 percent. He believes that the persistence factor to use in his analysis is 0.70. In addition, the analyst decides to utilize his previous residual income projections of $1.33, $1.46, and $1.61 for years 1, 2, and 3, respectively, and his projected year 3 ending book value of $46.34. The current book value of the shares is $35.00. Assuming ROE will fade toward the cost of equity, the intrinsic value per share for Catapult that the analyst will calculate is closest to:

$40.15 We will first estimate the year 4 residual income by finding the projected year 4 earnings and the appropriate equity charge to apply. Now we use the following residual income model to find the intrinsic value:

A company has a target debt ratio of 40% of assets. In the most recent period, they have generated net income of $500 million, with the only noncash charge in the income statement being a depreciation charge of $100 million. The company invested $200 million in fixed assets, and working capital on the balance sheet increased by $50 million. The free cash flow to equity of the firm is closest to:

$410 million. Free cash flow to equity (FCFE) can be written as: FCFE = NI - (1 - DR)[(FCInv - Depreciation) + WCInv] = 500 - (1 - 0.4)[(200 - 100) + 50] = 500 - (0.6 × 150) = 410.

Use the following information to answer the next 3 questions: An analyst gathered the following information regarding Pluto Inc.: Expected EPS for 2011 = $4.25 Retention rate = 0.4 Required return = 11% Current stock price = $54.85 Dividends are paid out at the end of the year and are expected to grow at a rate of 5.5% forever. The intrinsic value of the stock at the end of 2010 is closest to:

$46.36. D2011 = $4.25 × (1 − 0.4) = $2.55 V2010 = 2.55 / (0.11 − 0.055) = $46.36

An analyst gathered the following information regarding Tetris Corporation: Net income = $650,000 Interest expense = $21,250 Depreciation expense = $32,500 Impairment of goodwill = $24,280 Amortization of long-term bond discounts = $6,255 Capital expenditures = $250,670 Proceeds from sale of long-term assets = $82,500 Working capital investment = $71,300 Given a tax rate of 35%, free cash flow to the firm is closest to:

$487,378 FCFF = NI + NCC + Int (1 − Tax rate) − FCInv − WCInv Fixed capital expenditure = 250,670 − 82,500 = $168,170 FCFF = 650,000 + (32,500 + 24,280 + 6,255) + [21,250 × (1 − 0.35)] − 168,170 − 71,300 FCFF = $487,377.5

Catapult Company has a current book value of $35 per share. As the result of an innovative product, the company earned an ROE of 14 percent. An analyst studying Catapult has estimated that the 14 percent ROE will continue for the next three years. At that point, he is uncertain what will happen to ROE, but he does observe that prior to last year, the share price was at a persistent 10 percent premium over book value, and he assumes this will be the case at the end of his three-year forecast. However, management has maintained an average market value over book value of 30 percent. The firm has a dividend payout ratio of 30 percent and the analyst estimates the cost of equity to be 10.2 percent. The intrinsic value per share for Catapult that the analyst will calculate is closest to:

$49.00 To find the intrinsic value, we must first determine the residual incomes during the forecast period and the book value at the end of the forecast period. Then we can apply the multistage model using premium over book value in the terminal value calculation: Year 1 2 3 Beginning book value (Bt - 1) $35.00 $38.43 $42.20 EPS (ROEt of 0.14 × Bt- 1) 4.90 5.38 5.91 Less: dividends (0.30 × EPS) 1.47 1.61 1.77 Ending book value (Bt) $38.43 $42.20 $46.34 EPS $4.90 $5.38 $5.91 Less: equity charge (rcBt- 1) 3.57 3.92 4.30 Residual income (RIt) $1.33 $1.46 $1.61 For the share price at the end forecast horizon, we estimate the value as being at a 30 percent premium to the book value at the end of the forecast horizon: Now we can use the residual income model that uses a share price premium to book value:

Higher C Corporation's (HCC) current book value is $25 per share. The company's ROE has been 18 percent for the last several years and is expected to continue indefinitely. HCC maintains a dividend payout ratio of 75 percent. The current risk-free interest rate is 3.0 percent and the equity risk premium is 8.0 percent. HCC's stock has a beta of 1.00. The intrinsic value of HCC's shares using a single-stage (constant growth) residual income model is closest to:

$52.00 To solve this problem, we must first calculate g and rc: Next, we use the single-stage RI model to estimate the intrinsic value per share:

Brian Neil, CFA, estimates the intrinsic value of the equity shares of the Bruce Group of companies. He collects the following information (as of December 31, 2011): Total assets (book value) $120,000 Total liabilities (book value) 55,000 Required rate of return 9.00% Average P/E, past five years 12.00 EPS, 2011 $5.00 Dividends, 2011 2.98 Expected dividends, 2016 3.80 The book value of the liabilities accurately reflects the market value. However, the market value of the assets is estimated at 105% of the reported value. Neil estimates the intrinsic value using three valuation methods: asset-based, price multiplier, and the Gordon growth model. The company has 1,000 outstanding shares. Based solely on the information given, the shares are least likely to be considered as fairly valued if the security is trading at: Correct Answer $57.00.

$57.00. Based on the information given, we can estimate the share value using three methods: assets-based valuation model, price multiplier model, and Gordon growth model. Asset-based valuation: Market value of the assets = $120,000 × 1.05 = $126,000 Adjusted book value of equity = $126,000 - 55,000 = $71,000 Estimated share price = $71,000 / 1,000 = $71.00 per share Price multiplier model: Estimated share price = 12.00 × $5.00 = $60.00 per share Gordon growth model: D5 = D0 (1 + g)5 $3.80 = $2.98 (1 + g)5 g ≈ 5.00% D1 = $2.98 (1 + 0.05) = $3.1290 Estimated share price = $3.1290 / (0.09 - 0.05) = $78.28 per share Therefore, the analyst will consider any value within the range of $60.00 and $78.22 as fairly priced.

Rest Manufacturing Company (RMC) has been well managed and earns a 10 percent net profit margin. An analyst following the company's stock has forecast the company's sales for 2015 and calculated the relationships of the firm's internal financials to sales ($ in millions): Sales $8,800.0 Up 10 percent Incremental FCI (FCI - Dep) 240.0 30 percent of sales increase Depreciation 120.4 The only non-cash charge (NCC) Change in working capital 100.0 12.5 percent of sales increase Net borrowing 136.0 40 percent of WCI and incremental FCI Using only this information as the starting point, the analyst's forecast 2015 FCFE will be closest to:

$676 million. First, calculate net income as the starting point for the FCFE calculation: NI=Sales x Net profit margin= 880 Next, calculate FCFE based on the net income calculation and remaining information: FCFR= NI-(1-DR)WCI-(1-DR)(FCI-Dep) Note that net borrowing includes borrowing to fund both WCI and incremental FCI.

An analyst has estimated that Diamond, Inc. had 2012 sales of $5,535 million, a 10.7 percent increase over the prior year. Historically, working capital increased by 14.9 percent of the dollar increase in sales and Diamond has an EBIT margin of 18 percent. In forecasting the 2012 FCFF, the working capital investment amount that the analyst estimates for the FCFF calculation is closest to:

$79.7 million and it reduces FCFF. Sales in the prior period were $5,000 million [$5,535 million / (1 + 0.107)]. The 2012 estimated sales represent an increase of $535 million ($5,535 - 5,000). The change in working capital used in the FCFF calculation is: Working capital investment decreases cash flows to the firm's capital providers, so this would be a $79.7 million downward adjustment to net income.

Use the following information to answer the next 2 questions: An analyst gathered the following information regarding Beta Corporation: Current dividend per share = $2.18 Next year's expected dividend growth rate of 30% is expected to decline linearly over the following 8 years to a long-term constant growth rate of 6%. Required rate of return on the company's stock is 11%. The value of the company's stock today is closest to:

$88.07. H model?

An analyst who estimates continuing residual income to be constant in perpetuity at the forecast horizon should use a persistence parameter of:

1. When forecasting continuing contestant residual income into perpetuity, an analyst should use a persistence parameter of 1, which represents the case of zero decay in residual income after the forecast horizon.

The historical raw beta of a company is observed to be 1.69 using daily regression over the past five years. The adjusted beta according to the Blume method is closest to:

1.46.The Blume method assumes that betas mean revert to a value of 1 over time. Hence, when estimating betas, the Blume method forecasts an adjusted beta of: 2/3 x raw beta + 1/3 x 1= adjusted beta.

Big Red Incorporated will pay a dividend of $0.32 next year on earnings per share of $2.00. The company's shareholders' equity is $75,000,000 and it has 5,000,000 shares outstanding. What is Big Red's sustainable growth rate?

11.2%The sustainable growth rate is g = (b, the mature retention rate) × (mature ROE). Start by finding the dividend payout, $0.32/$2.00 = 0.16. The retention rate is 1 - payout, or 1 - 0.16 = 0.84. To find the ROE, start by finding equity per share: $75 mil / 5 mil = $15 per share. The return per share on that equity per share is $2.00/$15.00 = 0.1333. Combine these numbers into the growth rate equation, g = b × ROE, and the growth rate equals 0.84 × 0.1333 = 0.112 = 11.2%.

An investor purchases shares of Zitsos Corp. for $50 a share. Zitsos pays a dividend of 50 cents per quarter and based on the capital asset pricing model (CAPM), the required return is 10 percent. At the end of one year, the investor sells his shares of Zitsos for $55 per share and has received the quarterly dividends of $0.50. The investor's realized holding period return is closest to:

14 percent. One way of thinking about realized holding return is in two components, dividend yield and price appreciation. The annual dividend on Zitsos is $2.00 ($0.50 × 4) and the annual dividend yield is $2/$50 = 4 percent. The one-year price appreciation from $50 to $55 is 10 percent. Thus, the investor's realized holding period return is 14 percent. In reality, the true return is higher than 14 percent, because the investor has the ability to invest the quarterly dividends and earn a return on them.

Byomkesh Kapoor is calculating the total firm value and common equity value for Indian Oil Corporation. He has assembled selected earnings data in Table 1 and balance sheet data relevant to free cash flow forecasts in Table 2. In addition, Kapoor has determined that the marginal corporate income tax rate was 10 percent during the last two periods. Table 1 Indian Oil Corporation Selected Income Statement Data (INR) 2013 2012 Depreciation 5,201 4,868 Operating EBIT 8,542 13,854 Interest expense 6,409 5,591 Table 2 Indian Oil Corporation Selected Balance Sheet Data (INR) 2013 2012 Net property, plant and equipment 78,906 73,535 Long-term borrowings 21,414 16,287 Current assets (excl cash) 127,795 120,494 Current liabilities 124,134 119,826 Kapoor's calculation for India Oil's 2013 working capital investment will be closest to:

2,990 INR. Working capital investment equals the change in current assets less the change in current liabilities: 2013 2012 Chg Current assets (excl cash) 127,795 120,494 7,301 Current liabilities 124,134 119,826 4,308 ∆CA - ∆CL 2,993

Redbird Corporation has earnings per share this year of $1.50 with a 33% payout rate. It has a steady long-term growth rate of 10%. The risk-free rate of return is 3%, the equity risk premium is 7%, and its beta against the market index is 1.20. The justified trailing P/E is closest to

25.7x. Start by finding next year's dividend. It will be based on earnings that grow by 10% and a 33% payout, so 1.50 × 1.10 × .33 = 0.54. The return on equity based on the information given is 11.4% [using CAPM 11.4% = 3% + (1.2)7%]. Using the Gordon growth model, the current stock value is estimated as: Divide the estimated value by current earnings, $38.57/$1.50, for a trailing P/E0 of 25.7x. Choice A incorrectly calculates P/E0 using the D0 in the denominator. Choice C usesE1 (grow earnings by 10%).

Besos, Inc. has normalized FCFE of 85 million Brazilian real (BRL) for the period just ended. The long-term real growth rate for Brazil is expected to be 3.5 percent with Besos' growing at a 1 percent higher rate as they expand internationally. Required returns and adjustments in percentages are: Real country rCE 7.00 Industry adjustment (0.75) Company size 0.43 Company debt 0.25 The value of Besos' equity is closest to:

3,650 million BRL.Adjusted rCE is: Real country rCE 7.00 Industry adjustment (0.75) Company size 0.43 Company debt 0.25 Adj rCE 6.93 The value of Besos' equity is: 85(1+.035+.01)/.0693-.0450

An analyst wants to calculate a forward-looking equity risk premium for U.S. equities. She has determined that the S&P 500 index has a current dividend yield of 1.5 percent and that the year-ahead dividend yield based on forecasted dividends is 2.1 percent. For the last two years, earnings growth for the stocks comprising the S&P has been 8.5 percent. The consensus long-term earnings growth is 3.5 percent and the current 20-year U.S. government bond yield is 2.0 percent. The forward-looking equity risk premium for U.S. equities is closest to:

3.6 percent.. Given the information provided, the Gordon growth model should be used:

A stock has a forward P/E ratio of 12 and a required rate of return of 12%. Which of the following is closest to the component of the P/E value that relates to growth opportunities?

3.7. The leading P/E ratio can be expressed as (1 / r) + (PVGO / E1), where (1 / r) is the value of the P/E for a no-growth company and (PVGO / E1) is the component of the P/E ratio that relates to growth opportunities. In this case: 12 = (1 / 0.12) + growth opportunities component 12 = 8.3 + growth opportunities component This implies the component of the P/E value that relates to growth opportunities is 3.7

ManBorg, Inc. has a current book value of $30.00. The firm's ROE is 14.0 percent and the dividend payout ratio is 40 percent. The cost of equity is 10.0 percent and the shares have a market price of $50.00. The implied growth rate priced into ManBorg's shares will be closest to:

4.0 percent. Using the constant growth (single-stage) residual income model, we can solve for the implied growth rate by using the current stock price as the value today:

Neil owns 350 cumulative voting shares of a company's 1,400 voting shares. Up to how many candidates can Neil vote if there are 20 candidates for directors?

5. The third choice is correct based on the CFAI curriculum.

Analyst Jack Pentes has calculated a 9.1 percent required return on a share of Cox Cars, assuming a beta of 1.1 and a risk-free rate of 3.0 percent. If Pentes is employing the capital asset pricing model, the equity risk premium he is assuming is closest to:

5.5 percent. The required return on shares of Cox Cars is equal to the current expected risk-free return + beta multiplied by an equity risk premium. Given all other inputs, we can solve for the equity risk premium (ERP): 0.091 - 0.03 +1.1(ERP) ERP = 5.5 percent

Saluki Industries stock trades at $25.57. The company will pay a dividend of $1.20 this year, and it is expected to grow at a constant rate indefinitely. The risk-free rate of return is 3%, the market risk premium is 8%, and the company's beta is 1.05. The implied growth rate of the company's dividends is closest to:

6.41%. Using the CAPM, the required rate of return is: Next, use the Gordon growth model, to find the growth rate: Choice B is the required rate of return; choice C miscalculates backing out growth rate.

An analyst has estimated the following information for a company: Expected earnings per share for next year = $9.00 Expected retention rate next year and onward = 33⅓% Projected dividend growth rate into the future = 4.0% The required return on the shares = 12.5% The fundamental forward price-to-earnings (P/E) ratio that the analyst will calculate is closest to: 4.0

7.8 The fundamental forward P/E ratio is calculated as follows: D1/E1/r-0g or Div Payout Ratio/r-g. so 1-.33/.125-.04

Laura Wilkins gathered the following information regarding Dux Co.: Number of common shares outstanding = 1.5 million Book value of the company's common stock = $12 million Market price per share = $22 Book value of the company's debt = $44 million Market value of the company's debt = $49.5 million Risk-free rate = 5.5% Equity market risk premium = 6.9% Beta = 1.18 Before-tax cost of debt = 7% Marginal tax rate = 40% The company's weighted average cost of capital (WACC) is closest to:

7.98%. Market value of the company's common stock = $22 × 1.5m = $33 Weight of equity in the capital structure = $33m/($33m + $49.5m) = 40% Weight of debt in the capital structure = $49.5m/($33m + $49.5m) = 60% Required return on equity = 0.055 + 1.18(0.069) = 13.642% WACC = [wd × rd × (1 − t)] + (we × re) WACC = [0.6 × 0.07 × (1 − 0.4)] + (0.4 × 0.13642) = 7.98%

Which of the following companies is most likely to have future positive residual income?

A company earning with a required return on equity that is less than its return on equity. A company with a book value per share greater than its justified price per share will have a justified P/B of less than one, which implies the company is expected to earn negative residual value. Answer B is correct since a company that earns a return on equity greater than its required return on equity will have positive residual income. Answer C is incorrect since all companies are expected to have a positive book value regardless of the level of residual income.

Residual income models are best described as which of the following types of valuation process?

Absolute. Residual income models are based on accounting earnings in excess of the opportunity cost of generating those earnings and valuing the company as the current book value plus the present value of residual income. As such, residual income models are absolute valuation models.

Ichiro Watanabe has recently been appointed head of the Investment Policy Committee for a pension fund in Johannesburg's Sandton financial district. Shortly after his appointment, Watanabe brought in Alan Mutombo, an analyst at the firm, for a discussion regarding his use of a residual income approach with proprietary adjustments to make value recommendations on common equity shares. Watanabe congratulated Mutombo on his stellar record of predicting investment success or failure and wanted to learn more about his proprietary adjustments for possible firm-wide application. In the course of the discussion, Watanabe asked Mutombo whether he makes the following adjustments: Adjustment 1: Amortize future goodwill expense. Adjustment 2: Subtract capitalized leases from total capital. Adjustment 3: Defer the capital charge on strategic investments. Which of the adjustments questioned by Watanabe would be most appropriate in a residual income (RI) analysis?

Adjustment 3. When doing a RI analysis, it is reasonable to defer the capital charge on strategic investments. In addition, the investment should be removed from total capital until it generates a return.

Which of the following would be the most likely use for a residual income model?

Determine goodwill impairment. Residual income can be used to test for goodwill impairment, and as a way to measure management's performance (i.e., has management added value) and determine executive compensation. A residual income model is not useful when we cannot identify the book value of equity (assets minus liabilities) because either assets or liabilities cannot be reasonably estimated.

Assuming a tax rate of 40%, a $100 increase in which of the following would increase FCFF and FCFE by $60 each?

EBIT. A $100 increase in EBIT will increase FCFF and FCFE by $60. A $100 increase in cash operating expenses will decrease FCFF and FCFE by $60. A $100 increase in accounts payable will increase FCFF and FCFE by $100.

Juan Diaz is contemplating investing in the stock of Indigo Inc., whose stock is currently trading for $18.99 per share. The company has recently commenced its operations and is not expected to pay any dividends for the next 4 years. The company's EPS currently stands at $2.75 and is expected to grow at a rate of 16% per annum over the next 4 years. Beginning in Year 5, the company's growth rate is expected to fall to 5% and remain at that level into perpetuity. From Year 5 onwards, Indigo is also expected to retain 60% of its earnings and distribute the rest as dividends. Given a required rate of return of 12%, the company's stock is currently most likely:

Fairly valued. E4 = 2.75 × 1.164 = $4.9793 E5 = 4.9793 × 1.05 = $5.2283 D5 = 5.2283 × (1 − 0.6) = $2.0913 V4 = D5 / (r − g) = 2.0913 / (0.12 - 0.05) = $29.8757 V0 = 29.8757 / 1.124 = $18.99

An analyst collects the following information regarding a company: Current FCFF $547 million Outstanding shares 409.23 million Equity beta 1.1 Risk-free rate 2% Equity risk premium 5.50% Cost of debt 3.50% Tax rate 35% Market value of debt $5,290 million Weight of debt in capital structure 15% Growth of FCFF 4% If the current share price is $30.79, using a single-stage FCFF model the analyst should conclude that the shares are:

Fairly valued. The cost of equity of the company will be, using the CAPM: Risk-free rate + (beta × equity risk premium) = 2% + (1.1. x 5.5%) = 8.05% Hence, the WACC of the company will be: (0.15 × 3.5% × (1 - 0.35)) + (0.85 × 8.05%) = 7.18% Then the next period's FCFF will be $547 million × 1.04 = $568.88, and using the single-stage Gordon growth model for FCFF, the value of the firm will be given by $568.88 / (0.0718 - 0.04) = $17,889 million. Hence, the value of equity = $17,889 million - $5,290 million = $12,599 million, giving a fair value per share of 12,599 / 409.23 = $30.79. Hence, the shares are fairly valued.

Which of the following appropriately considers a company's cash expenditures on new plant and equipment (incremental FCI)?

Free cash flow to the firm (FCFF). FCFF subtracts fixed capital investment (FCI) from net income (or other form of income stream). EBITDA fails to include even the replacement of capital (Dep), while CFO recognizes the cash flows associated with working capital, but does not consider FCI.

Which of the following is most likely to lead to a company's P/E multiple being higher than the market P/E multiple?

High earnings growth rates for the company relative to the market. A high beta would lead to a high required rate of return and therefore a lower P/E, so the first choice is not correct. Higher risk means a higher required rate of return, and therefore a lower P/E multiple, so the second choice is not correct. High growth generally leads to a high P/E, so the third choice is the correct answer.

Continuing residual income describes the residual income after the forecast period and it is often used as an input in a constant growth model to calculate a terminal value.

If residual income is forecast to be zero, then the forecast fundamental price-to-book value will be one. Under the residual income model, the fair value of a security is its book value plus the present value of future residual income. If the residual income is expected to be zero, then the security should be trading at book value and hence will have a fundamental price-to-book value of 1.

Bob Bernard, CFA, is an equity analyst who has been asked to review the equity valuation process at his firm. In particular, the investment committee of the firm has requested that Bernard explain the concept of going-concern value and liquidation value. Bernard makes the following statement to the committee: "Going-concern value for a company makes the assumption that the company will continue its business activities into the foreseeable future. Liquidation value is the value of the company if it were dissolved and its assets sold individually. The focus of valuation models should be the liquidation value since this will be a conservative estimate of value which is usually less than the going-concern value." Bernard's statement is:

Incorrect since models should focus on going-concern value to better reflect the economic value of the company. The definitions of going-concern value and liquidation value are correct. Valuation models should be based on going-concern value since the assumption is that the company will keep operating into the foreseeable future.

Which of the following is least likely to be a source of perceived mispricing for a valuation estimate of an equity security?

Intrinsic value. The difference between a valuation estimate and the prevailing market price, that is, the perceived mispricing of a security, is a combination of the true mispricing of the security (the true intrinsic value minus the prevailing price), plus the error of the estimate (the valuation estimate minus the intrinsic value).

The Gordon growth model is most likely to be used to value companies that are:

Mature.The Gordon growth model is applicable to companies that have stable growth in dividends, so the first choice is the best answer.

A company's cost of equity is the:

Minimum rate of return required by investors. The cost of equity is the minimum required rate of return (from a combination of dividends and capital gain) needed by investors for them to continue investing in the company.

Analyst Katherine Bryson is considering recommending the stock of Moosewood, a regional coffee shop chain. She should most likely begin her research by examining:

Moosewood's market share. To learn about a business, an analyst should research industry dynamics, as well as the company's competitive position and strategy. Knowing Moosewood's market share percentage, and whether it is rising or falling, is valuable in understanding its competitive position.

Natasha Knecht, CFA, is responsible for supervising a team of equity analysts and has asked the team to investigate contemporary methods in valuation, particularly free cash flow valuation. During a meeting reviewing their findings, various team members make the following comments: Comment 1: Free cash flow to the firm can be derived easily by taxing EBITDA and subtracting fixed and working capital investment Comment 2: Free cash flow to equity can be easily derived by taking net income, adding back noncash charges and subtracting fixed and working capital investment. How many of the comments are accurate?

None. Comment 1 is incorrect because it fails to add back the depreciation tax shield. Comment 2 is incorrect because it fails to consider net borrowing.

Neil Viebig, CFA, is a fixed-income analyst who is considering moving into the equity analysis side of his firm's business. He meets with Thorston Brealey, CFA, an equity analyst, to find out a little more about the applications of equity valuation. During the course of their meeting, Brealey makes the following two statements: Statement 1: "Equity valuation has a wide variety of applications, from individual stock selection to evaluating corporate event such as mergers, spin-offs, or IPOs." Statement 2: "An issue with equity valuation is the number of inputs required to carry out the valuation. If one of the inputs to the valuation process relating to the future performance of the company is missing, it is impossible to carry out any application of equity valuation techniques." How many of Brealey's comments are likely to be correct?

One. Statement 1 is true; all the listed applications are genuine applications of equity valuation. Statement 2 is not true—an analyst can extract current market expectations of a company's future performance from a valuation model by solving for which value of the fundamental of interest gives a model value equal to the current actual market price of the shares.

Consider the following statements: Statement 1: As long as a company's ROE is greater than the cost of capital, the intrinsic value estimate from the residual income model will be greater than the stock's current book value. Statement 2: Tobin's q equals the market value of the company's debt and equity divided by the replacement cost of the company's assets. Which of the following is most likely?

Only Statement 1 is incorrect. As long as a company's ROE is greater than the cost of equity, the intrinsic value estimate from the residual income model will be greater than the stock's current book value.

Consider the following statements: Statement 1: The rational efficient markets formulation argues that market prices represent the best available estimates of intrinsic value. Statement 2: Compared to investors in large cap profitable companies, an investor in distressed securities would be more concerned with liquidation value.

Only Statement 1 is incorrect. The rational efficient markets formulation argues that markets are not efficient. It asserts that investors will not incur the costs of gathering and analyzing market information if mispricings did not exist in the market.

Consider the following statements: Statement 1: Analysts prefer using the arithmetic mean over using the geometric mean to compute the historical equity market risk premium. Statement 2: Analysts prefer using the long-term government bond yield over the short-term government bond yield as the risk-free rate when computing the historical equity market risk premium. Which of the following is most likely?

Only Statement 2 is correct. Analysts prefer using the geometric mean over using the arithmetic mean to compute the historical equity market risk premium.

Kindly use the following information on Robin Manufacturing's shareholders' equity to answer questions i and ii: 2016 2015 2014 Total shareholders' equity 98.10 99.55 104.80 Net revenues 74.25 78.60 85.45 Net income 1.40 2.80 4.35 Net cash flow from operations 12.75 19.95 20.50 Outstanding shares 5.172 6.124 7.239 Stock price 13.55 16.10 10.50 How many of the following statements is/are true? Statement 1: The lagging P/E ratio for 2016 is 50.06. Statement 2: The lagging P/CF ratio for 2015 is 4.94. Statement 3: The lagging P/S ratio for 2014 is 0.94. Statement 4: The lagging P/B ratio for 2014 is 0.71.

Only two statements are true. The second choice is correct. To calculate the lagging price multiples, first divide the relevant fundamental measure by the number of shares outstanding to get per-share amounts, which are comparable to stock price. Then divide the stock price by this figure. The resulting numbers are as follows. Only Statements 1 and 2 are correct. Lagging Industry Ratios 2016 2015 2014 Price-to-earnings 50.06 35.21 17.47 Price-to-cash-flow 5.50 4.94 3.71 Price-to-sales 0.94 1.25 0.89 Price-to-book value 0.71 0.99 0.73

Andrea Barbee seeks a required return estimate that takes into consideration liquidity, market capitalization, and value. She would most likely select the:

Pastor-Stambaugh model. The Pastor-Stambaugh model is: It takes into consideration the three sensitivities listed in the question, as well size.

Which definition most accurately describes book value of a company's stock?

Principal of shares issued plus accumulated undistributed comprehensive income since inception. Book value of equity equals the principal of shares issued plus accumulated undistributed comprehensive income since inception. Present value of expected future cash flows defines intrinsic value, and collective expectations as to future dividends and share prices and the uncertainty of each, defines market value.

Which of the following best distinguishes private equity from public equity securities?

Private equity securities are likely to be restricted to institutional investors while public equity securities are likely to be offered to retail investors. Private equity securities are likely to be restricted only to institutional investors through private placements. Public equity securities are likely to be offered to all investors, including retail investors, through an exchange. Private equity securities are more likely to be appropriate for investors with longer investment horizons. Public equity securities likely represent a minority interest.

If a company raises its dividend and refinances its debt at a higher interest rate, the impact on free cash flow will be: FCFE FCFF A. Unchanged Unchanged B. Lower Unchanged C. Lower Lower

Row B Lower. Unchanged. An increase in dividend will not affect either FCFE or FCFF since payment of dividends is a use of free cash flow rather than a source of free cash flow. Higher interest charges will not affect FCFF, since it is calculated prior to any financing charges. FCFE is calculated post financing costs and, hence, will be lower in a higher interest rate environment.

An analyst expects the dividends of a company to fall by 15% for five years, when the company will undergo a restructuring and pay a special dividend to shareholders. Post the restructuring, dividends are expected to remain stable for five years before a period of sustainable growth of 3% begins in perpetuity. Which of the following approaches would most likely be best suited to value the company based on the present value of expected dividend payments?

Spreadsheet modeling. The company has a nonstandard pattern of dividends that would most easily be assessed using a spreadsheet model. While the Gordon growth model may be used to estimate a terminal value, it would be very cumbersome to value the other dividends prior to the period of perpetual growth without using a spreadsheet.

For which of the following types of investments is price-book ratio analysis most appropriate?

Stock analysis. Stock research is the most appropriate for use of the price-book ratio as a relative measure of value among similar stocks. This metric is much less useful in the other areas, as various sectors and asset classes each have their own unique underlying fundamentals and growth characteristics.

Under U.S. GAAP, which of the following adjustments would be required to get to FCFF when starting from net income but not when starting from CFO?

Subtracting investment in working capital. Investment in working capital is an adjustment that is required when starting from net income, but not when starting from CFO since CFO has already been adjusted to reflect changes in noncash working capital. Posttax interest needs to be added back to both net income and CFO under U.S. GAAP since interest paid is classified as CFO under U.S. GAAP. Fixed capital investment needs to be adjusted for whether starting from net income or CFO.

Bobcat Software has a dividend yield of 5% and a current growth rate of 12% per year. Growth is expected to decline linearly for 8 years until the company hits its mature growth rate of 4% per year. Using the H-model, the required rate of return is closest to:

The H-model can be rearranged to solve for r: Choice A incorrectly uses 8 instead of 4 as H in the formula. Choice C omits the final factor of 4% mature growth rate.

Who has the privilege to vote shares held in a sponsored depository receipt?

The investor that owns the depository receipt. Holders of sponsored depository receipts share the same voting and dividend rights as direct shareholders. For unsponsored depository receipts, the depository bank shares the same voting and dividend rights as direct shareholders.

A finance company has an issue of 5.0 percent, $100 par value, perpetual, nonconvertible, noncallable preferred shares outstanding. The required rate of return on similar issues is 4.75 percent. The intrinsic value of a preferred share is closest to:

The preferred stock's annual dividend is 0.05 × $100 = $5.00. The value of a preferred share is the dividend divided by the required rate of return: div/r = 5/.0475

Of the following statements, which is least likely a reason for a company to issue equity shares?

To pay dividends to shareholders. Companies do not issue equity capital to pay dividends to shareholders. Some companies systematically repurchase (i.e., retire) shares in place of paying dividends to satisfy investors seeking cash flow income.

Octimus Inc. has a $100 par fixed-rate perpetual preferred stock outstanding with a dividend of 7%. The stock is currently trading for $56.36. Given a required rate of return of 11%, the stock is most likely:

Undervalued. Dividend = 0.07 × $100 = $7 Value of preferred stock = 7 / 0.11 = $63.64 The stock's current market price is lower than its intrinsic value; therefore, it is undervalued.

Blackhawk Enterprises has the following financial information: 2014 ($ in millions) Revenue 150,750 Net income 14,851 Total assets 95,860 Shareholders' equity 62,134 Earnings per share 0.99 Dividends per share 0.30 The company's sustainable growth rate is closest to:

Using the PRAT model, the following answer is generated: 30.3% is the payout ratio and 23.9% is the return on equity.

Iguana Incorporated will pay a dividend of $0.48 this year. The dividend is then expected to grow by 14% a year for 3 years; it will be 6% per year after that. The required rate of return is 10%. The value of a share of Iguana Incorporated's stock is closest to:

Using the equation for the two-stage DDM, the value is: Choice B incorrectly discounts the terminal value by four periods, not three. Choice C is the present value of the terminal value; it excludes the present value of the early dividends.

Participating preference shares:

Will increase their dividend if the issuing company's profits rise above a prespecified level. Participating preference shares allow the holder to participate in increased profits according to a prespecified formula; this will be implemented by an increase in the dividend and possibly through a higher payment than face value if the company is liquidated..

Mikey Tan, CFA, wants to estimate the value of the following companies: Willis Apparel, a clothing business Headley Agency, an advertising firm Veronica Solutions, a software company For which firm is an asset-based valuation model most appropriate?

Willis Apparel. The first choice is correct. Asset-based valuation models are most reliable when a firm has primarily tangible short-term assets with ready market values.

An analyst is using a multistage residual income model where the expectation is that the ROE fades toward the cost of equity over time. The persistence factor the analyst will use for the fade will be closest to 1.0 for a company that has:

a strong leadership position. A firm with a strong leadership position in the industry would be likely to have a slower rate of fade. A persistence factor of 1.0 is representative of no fade, so the company's strong leadership position will likely have a persistence factor closer to 1.0. Low earnings retention means there is a high dividend payout ratio. When this is the case, very little is being retained to fund growth and it is likely that ROE will fade more quickly (low persistence factor) toward the cost of equity. When ROE has been extremely high, it is likely to fade quickly (low persistence factor) as it may not be sustainable.

An investor will most likely purchase a basket of depository receipts if she wants to:

add exposure to international markets.An investor who purchases a basket of depository receipts would most likely be seeking to add exposure to emerging markets. Depository receipts are a conduit for investors to make investments in non-domestic equity securities and would be unnecessary for an investor to add exposure to the domestic market. An investor seeking to reduce exposure to developed markets would sell a basket of depository receipts.

For an analyst using an asset-based valuation model, the intrinsic value of a common stock is most likely based on the estimated market value of the company's:

assets less all liabilities.Asset-based valuation models compute the intrinsic value of equity by subtracting the market value of all liabilities from the market value of the assets

The equity charge in a residual income calculation would most likely involve multiplying the required return on equity by the firm's:

book value of common equity. The equity charge equals the book value of equity multiplied by required return on common equity capital.

Present value models follow a fundamental belief in economics that individuals will defer consumption by investing in order to receive expected future benefits. Thus, the value of an investment in a stock is best captured by discounting the expected:

cash flows for the shares. Using the present value model known as the dividend discount model, analysts will discount the future dividends of the shares. These dividends represent the future benefits.

Practical application of discounting cash flows to present value utilizes nominal discount rates to discount nominal flows most likely because:

corporate tax rates and earnings are stated in nominal terms.The corporate tax rate and the pre-tax earnings on which they are levied are all stated in nominal terms. Note that cash flows stated in real terms reflect anticipated changes in purchasing power.

Alpha Company has issued new debt at the beginning of the current period. During that period, free cash flow to:

equity (FCFE) will increase by the borrowed amount.. FCFE includes changes in debt; the firm could issue debt and then distribute the proceeds to shareholders as a dividend (although this may not be considered best practice). Therefore, the new borrowing will increase FCFE by the borrowed amount during the period. Free cash flow to the firm's capital providers remains unchanged because the money was also borrowed from the providers of the firm's total capital.

An investor realized a gain on the sale of a non-dividend paying common stock. The difference between the realized return and the contemporaneous required return is best described as:

ex post alpha. The difference between the realized holding period return and the contemporaneous (period) required return is the realized ex post alpha (the abnormal return that actually occurred).

A price agreed to by a willing buyer and seller, both of whom are acting with free will and all available information, is most likely a:

fair market value.A fair market value is defined in the question. One might also think the answer could be an investment value, but that term applies when an investment is worth more than fair market value to a particular buyer.

Rambler Resources will pay a dividend of $0.60 this year. It is expected to pay $0.70 next year, $0.80 in two years, and $0.92 in three years for a compound annual growth rate (CAGR) of 15%. An analyst estimates the value of this stock using a three-stage DDM. He assumes the following: the growth rate will decline linearly to 8% over 7 years; the required rate of return is 12% and a fair value range is 10%. The current stock price is $22.00. Based on this information, the analyst concludes Rambler Resources is most likely:

fairly valued. The first step is to find the present value of the first three years of dividends: Year Dividend Present Value 0 $0.60 1 $0.70 $0.63 2 $0.80 $0.64 3 $0.92 $0.65 Total: $1.92 Then, use the H-model to value the remaining dividends for the second and third stages, setting the dividend for year 3 as D0: The present value of the year three value found using the H-model is: Finally, find the present value of the second and third stages and add it to the present value of the first stage: If the fair-value range is 10%, then the value can be between $21.25 ($23.61 × 0.90) and $25.97 ($23.61 × 1.10) to be considered to be fairly valued.

To consistently select stocks which outperform the market, an investor most likely must:

forecast inputs better than the overall market does. Investors who are successful over the long run routinely make superior predictions of model inputs. The choice of model is also important.

Godfrey Small, CFO for Jamaica Cement, Ltd., recently hired Dalmain Whitehall to oversee financial planning for the company. Small and Whitehall met to discuss several analysis projects at the beginning of the financial cycle for that year. Small believes he has identified a potential opportunity to repurchase the company's shares at below fair value and requests Whitehall to determine how Jamaica Cement's fair value compares with the market price of the shares. Small makes the following statements with regard to using the residual income method of determining fair value: Statement 1: From a theoretical standpoint, the residual income model is superior to a free cash flow model. Statement 2: We accelerate revenues to the current period and defer expenses until later periods, so relative valuation will not work. But residual income will work without adjustment. Statement 3: A dividend discount model will not work because we only payout 20 percent of net income as dividends and the model will work only when the payout ratio is much higher. With regard to Small's statements concerning why a residual income model should be used rather than other approaches, he is most likely:

incorrect in making all three statements. All three statements are incorrect. If applied consistently with consistent adjustments, a free cash flow model and a residual income model should come to the same value. Thus, Statement 1 is incorrect in stating that one is theoretically superior to the other. Statement 2 is incorrect because these aggressive accounting practices will require adjustment in whatever model is used. Statement 3 is incorrect in that a dividend discount model can be used with a low payout ratio—the offsetting effect is higher growth.

For the shares of Acme Inc., an analyst knows the market price and his estimate of the stock's value. To calculate the true mispricing for the stock, he must also know Acme's:

intrinsic value. The difference between an asset's market price and an analyst's calculation of intrinsic value is called a perceived mispricing and investors hope to profit from such mispricings. A mispricing, or VE - P, is equal to two elements. VE - P = (V - P) + (VE - V) Where VE is the estimated value, P is the market price, and V is the intrinsic value. The first element, V - P, is the true mispricing and it is the difference between the accurate but unknowable intrinsic value and the knowable market price. The second element, VE - V, is the difference between the analyst's estimated value and the accurate but unknowable intrinsic value. One would need to know the intrinsic value to calculate the true mispricing.

An analyst with high and low values for various input variables to a free cash flow to equity model believes that sales growth for Bella, Incorporated will be high for the first two years, decline slightly for the next two years, and remain consistent with world GDP growth thereafter. The analyst further believes that the market required return on equity will be greater during the periods of high growth, and less thereafter. The analyst decides to use the high and low values for sales growth only, but the analyst's supervisor cautions against this course of action. The best explanation for the supervisor's concern is that the effect of:

lower required return on the market will significantly increase the valuation. The best explanation for the supervisor's concern is that lower market required return on equity significantly affects valuation during the later years, especially in the terminal value calculation. Looking at the three-stage FCFE valuation formula: It becomes clear that the denominator of the terminal value equation will be extremely important to overall valuation, especially since the higher market required return on equity occurs for only the next two years. A higher market return will lead to a greater discount rate as rCE increases based on the discount rate formula: The lower rCE in the terminal value will lead to a much greater valuation for the company as the valuation multiplier (inverse of rCE - g) increases. You should be aware of opportunities to assess the sensitivity of various inputs to the equations used in valuation.

The current market price of a stock is $24.35. An analyst estimates the intrinsic value of the stock to be $18.00 to $22.00. The analyst would most likely state that the shares are:

overvalued. Since the current market price exceeds the upper limit of the analyst's estimate, the intrinsic value estimates indicate the shares are overvalued in the market.

Valuspend, Inc. has book value of $30.00 per share, ROE of 14 percent, required return of 12 percent, and a dividend payout ratio of 60 percent. Market price for Valuspend is currently $43.25. An analyst reviewing Valuspend using the residual income model and planning to hold the security indefinitely would most likely conclude that Valuspend is:

overvalued. To solve this problem, we must first calculate g: Next, we use the single-stage RI model to estimate the intrinsic value per share: The market price of $43.25 is approximately 10 greater than the calculated value of $39.38. Therefore, the shares are overvalued.

The dividend discount model is most appropriate when a company has dividends that:

represent a steady payout of earnings. A key assumption of the DDM is that there is an identifiable relationship between dividends and earnings, for example, if dividends are a consistent proportion of earnings and cash flows. Choices A and B are incorrect because these scenarios do not imply a meaningful relationship between dividends and earnings; a consistent dollar amount while predictable may be meaningless in relation to earnings and cash flow.

The accounting convention in IFRS, but not in U.S. GAAP, which will most likely result in a direct effect on common equity without passing through the income statement is:

revaluation of fixed assets. IFRS allows revaluation of fixed assets, which will affect common equity without passing through the income statement. The other choices will affect common equity in U.S. GAAP.

Assume a company has the following factor sensitivities and risk premiums: Factor Sensitivity Risk Premium Market 0.85 4.1 percent Size 1.30 3.4 percent Value -0.75 2.7 percent The shares of this company can most likely be described as being:

small-cap with a high price-to-book value ratio. The Fama-French model required return estimate is: The company has a positive size factor, which means it is smaller than average, and the negative value beta means the company's price-to-book value is larger than the average company. A higher price-to-book value than average represents a growth bias.

Continuing residual income would most likely be used to calculate:

terminal value. Continuing residual income describes the residual income after the forecast period and it is often used as an input in a constant growth model to calculate a terminal value.

Liquigas, an Italian company, has determined that the recession is ending and has forecast two years of above average growth followed by growth in line with world GDP thereafter. An analyst wishing to appropriately value the firm's FCFE based on these assumptions would most likely consider a:

two-stage FCFE model. The formula for the two-stage model is: This formulation allows for two years of growth at a higher rate in the first term of the equation, followed by a calculated terminal value based on constant growth in the second term of the equation.

Analyst Ruby Mole has derived a beta of 1.4 from a least squares regression to use in the capital asset pricing model, but she believes this figure is too high. She is most likely justified in adjusting the raw beta downwards because:

valuation is a future-looking effort so the adjustment makes the beta a more accurate prediction. Because valuation is a future-looking effort, raw betas may be adjusted so they more accurately predict future betas. Research shows that the future beta estimates have on average most often been found to be 1.0.

RandiCorp free cash flow to the firm was £1,495 million in 2012 and this cash flow is expected to increase at the world GDP growth rate of 3.5 percent, which has been constant for the last several years. An analyst estimate of RandiCorp's 2015 FCFF will be closest to:

£1,658 million.A 2015 forecast indicates three years of growth. Therefore, the estimated 2015 FCFF is calculated as follows:

Moda, Inc. has free cash flow to the firm (FCFF) of €130 million in the year just ended and weighted average cost of capital (WACC) of 12.7 percent. Moda expects its FCFF to grow at 3.5 percent indefinitely. Moda's value to all suppliers of capital will be closest to:

€1,463 million. The value of a firm to all capital suppliers is the value of the firm (VF), in this case using the Gordon Model formulation for constant growth:

Walker Corporation wishes to repurchase common shares in the market when they are significantly undervalued. In order to do that, the CFO wants to compare the market value of common equity with the fair value based on free cash flow analysis. Toward that end, an analyst has compiled the following information regarding the first forecast year of the planning period (currency in millions): Forecast free cash flow to equity (FCFE1) €620.00 Growth rate 10.0% Required return on equity 14.4% Using a single-stage valuation model, the analyst will calculate a value for Walker's common equity that is closest to:

€15.5 billion. FCFE*1+g)/rce-g = 620/.144-.10

Reeperbahn Corporation wishes to repurchase common shares in the market when they are significantly undervalued. In order to do that, the CFO wants to compare the market value of common equity with the fair value based on free cash flow analysis. Toward that end, a financial analyst has compiled the following information regarding the first forecast year of the planning period (currency in millions of EUR): Net income €440.00 Interest (1 - t) €110.00 WCI €75.00 Incremental FCI €166.67 Target debt ratio (DR) 40.00% Based on this information, the analyst will forecast Reeperbahn's first year free cash flow to equity (FCFE) will be closest to:

€295 million. Using the formula: Note that FCI less depreciation equals incremental cash flows, so the depreciation figure is not required to solve the problem. Also, an FCFE calculation beginning from net income does not need to subtract the unshielded portion of interest as unavailable to common equity capital providers (i.e., it is already subtracted out of net income).