CFA Exam Question of the Day

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2022-07-01

Question:
You are estimating the required return on equity for Company Z. You are given that the risk-free rate is 0.08% per year. You also have as annual risk premia: competition risk, 1.66%; business cycle risk, 1.66%; and management risk, 2.21%. Find the annual required return on equity.

Select an Answer:
5.61%
5.71%
5.51%
5.41%
5.81%
Rationale:
For the build-up approach to estimating the required return on equity,



Therefore, 0.08% + 1.66% + 1.66% + 2.21% = 5.61%.

2022-06-30

Question:
You are an analyst valuing firm F. You have forecasted dividends from firm F to be $0.91, $0.96, $1.00, $1.04, and $1.06 over the next five years. At the end of that five-year period, you expect the share price to be $60.94.

If your cost of equity is 14% per year, what is the fair value of the stock today?

Select an Answer:
$34.88
$34.62
$35.25
$35.03
$34.25
Rationale:
Using the formula:



We discount each dividend to the present by 14% each year. For example, in year one we obtain $0.91/1.14 = $0.80.

In the fifth year we discount the expected dividend and the expected future price. The present value of the forecasted dividends and the expected future price is $35.03.

2022-06-29

Question:
You are an analyst valuing firm F. You have forecasted dividends from firm F to be $1.19, $1.26, $1.33, $1.41, and $1.46 over the next five years. At the end of that five-year period, you expect the share price to be $59.42.

If your cost of equity is 9% per year, what is the fair value of the stock today?

Select an Answer:
$42.42
$41.12
$40.41
none of these answers
$43.95
Rationale:
Using the formula:



We discount each dividend to the present by 9% each year. For example, in year one we obtain $1.19/1.09 = $1.09.

In the fifth year we discount the expected dividend and the expected future price. The present value of the forecasted dividends and the expected future price is $43.75, none of the choices.

2022-06-28

Question:
Management Trayners, Inc. is considering buying Microminds, Inc.

You have the following information on them (assume data is in millions):

 MicromindsManagement Trayners
Cash$500$2,000
Property, plant, & equipment$1,000$4,000
Total assets$1,500$6,000
Equity$1,200$2,000
Net income$154$308
Cost of equity11%11%
Payout ratio100%100%

Find the value of the combined firm, MicroManagement, using the residual income valuation method.

Assume that new stock is issued to complete the transaction, and that GAAP accounting is used. Give your answer in millions.

Select an Answer:
$4,200
$2,018
$3,200
$3,800
$4,018
Rationale:
The first thing we need to do is calculate the value of Microminds using the residual income model.

We use the equation:



and find that the value of Microminds is $1,200 + $1,200 × (0.128333 − 0.11)/(0.11 − 0) = $1,400.

(ROE is $154/$1,200 = 0.128333; g = 0 because payout ratio = 100%.)

Therefore, Management Trayners will have to pay $200 over book value for Microminds, creating goodwill of $200. However, goodwill is no longer amortized under GAAP, so there is no charge to earnings (barring impairment of goodwill).

The new firm, MicroManagement, will have net income of $154 + $308 = $462.

The new firm's equity will be $3,400, because $1,400 in new stock will be issued to complete the transaction.

[NOTE: Another way to get the $3,400 figure is to calculate the difference between total assets and total liabilities of the combined company. Assets will include cash of $2,500, goodwill of $200, and PP&E of $5,000. This is a total of $7,700. The implied liabilities of Microminds ($300) and Management Trayners ($4,000) are unchanged, and total $4,300. The equity will then be $7,700 − $4,300 = $3,400.]

ROE will be $462/$3,400 = 13.5882353%.

Using the RIM valuation formula, we find that the value of the combined firm will be $3,400 + $3,400 × (0.135882353 − 0.11)/(0.11 − 0) = $4,200. Note, this answer is still in millions.

2022-06-27

Question:
Company X has a retention rate of 56%, a growth rate of 4%, and a required rate of return of 6%.

Find the justified leading P/E ratio.

Select an Answer:
23.0
21.0
24.0
22.0
20.0
Rationale:
The justified leading P/E ratio is given by the formula:



Here, 1 − b is the payout ratio. So, we get 0.44/(0.02) = 22.0.