CFA L2 Apostila 01 Exame 2018 - COMPLETA IMPRESSÃO

LOS 28.b Calculate/Interpret Return ConceptsSchweser B3 pg 15, CFAI V4 pg 58 Equity Risk Premium (ERP) Required Return for a Stock The ERP can be used to determine the requiredreturn for an individual security given its level ofsystematic risk Average equity Risk-free rate risk premium Ri  Rf   RM  Rf © Kaplan, Inc. Beta (systematic risk) 4LOS 28.b Calculate/Interpret Return ConceptsSchweser B3 pg 15, CFAI V4 pg 58 Strengths and Weaknesses of Estimating the ERP2. Forward-Looking ERP—utilizes current market conditions and expectations concerning economic and financial variables  Strength—does not require stationary  Weaknesses:  Requires frequent updates  Makes lots of assumptions© Kaplan, Inc. 6 ©2018 FK Partne

SS 09 - Equity InvestmentsLOS 28.b Calculate/Interpret Return ConceptsSchweser B3 pg 15, CFAI V4 pg 58 Strengths and Weaknesses of Approaches to Estimating the ERP1. Historical ERP—historical mean difference between broad market equity index and T-bill  Strength—objective and simple  Weaknesses:  Assumes stationary mean and variance of returns over time  Upwardly biased due to survivorship bias  Which risk-free rate to use?© Kaplan, Inc. 5LOS 28.b Calculate/Interpret Return ConceptsSchweser B3 pg 15, CFAI V4 pg 58 Forward-Looking ERP1. Gordon Growth Model E(R) = D1 / P0 + g = Y + g ERP = E(R) – Rf = Y + g – Rf2. Macroeconomic Model—use macroeconomic and financial variables such as inflation, earnings growth, and so forth (next slide)  Strength—robust results  Weakness—used only with developed countries© Kaplan, Inc. 7ers - Exame CFA 2

LOS 28.b Calculate/Interpret Return ConceptsSchweser B3 pg 15, CFAI V4 pg 58 Forward-Looking ERP Ibbotson-Chen (Macroeconomic Model) ERP = Y + [(1 + E(I))(1 + gR)(1 + PEG) – 1] – Rf Where: Y = dividend yield E(I) = Expected inflation PEG = PE growth due to market correction gR = Real growth rate (est. real GDP growth)© Kaplan, Inc. 8LOS 28.c Estimate Return ConceptsSchweser B3 pg 19, CFAI V4 pg 71CAPM: Single Factor Required Return on Equity Model Capital Asset Pricing Model (CAPM)Risk-free rate Expected equity risk premiumRi  Rf   RM  Rf  Single Factor Beta (systematic risk) ModelExample: Rf = 4%, ERP = 3.9%, β = 0.8, then:© Kaplan, Inc. Required return = 4 + 0.8(3.9) = 7.12% 10 ©2018 FK Partne

SS 09 - Equity InvestmentsLOS 28.b Calculate/Interpret Return ConceptsSchweser B3 pg 15, CFAI V4 pg 58 Forward-Looking ERP3. Survey—consensus of experts  Strength—easy to obtain  Weakness—wide disparity between opinions© Kaplan, Inc. 9LOS 28.c Estimate Return ConceptsSchweser B3 pg 19, CFAI V4 pg 71Multifactor Models of Required Return Multifactor Models: Use multiple factors to explain returns Required return = Rf + RP1 + RP2 + … + RPn  where RP = Risk premium = (sensitivity)×(factor) Factor sensitivity (factor loading)—asset’s sensitivity to a factor  Think: Beta (the one sensitivity in the CAPM) 11 Factor risk premium—return driver  Think: ERP (the single factor in the CAPM) © Kaplan, Inc.ers - Exame CFA 3

LOS 28.c Estimate Return ConceptsSchweser B3 pg 19, CFAI V4 pg 71Multifactor Models of Required Return Two types of models Arbitrage models  Fama-French  Pastor-Stambaugh  Arbitrage Pricing Model (BIRR version) Ad hoc model  Build-up (i.e., bond yield + risk premium)© Kaplan, Inc. 12LOS 28.c Estimate Return ConceptsSchweser B3 pg 19, CFAI V4 pg 71 Various Required Return on Equity Models Pastor-Stambaugh Model  Adds a liquidity factor to the Fama-French Model(Market index – Rf) Factor Sensitivity(Small – Big) returns 5% 1.1High B/M – Low B/M 3% 0.4Liquidity premium 2% –0.8 4% –0.1 Ri = 3% + 1.1(5%) + 0.4(3%) – 0.8(2%) – 0.1(4%) = 7.7% 14© Kaplan, Inc. ©2018 FK Partne

SS 09 - Equity InvestmentsLOS 28.c Estimate Return ConceptsSchweser B3 pg 19, CFAI V4 pg 71 Various Required Return on Equity Models Fama-French Model example:  Risk-free rate of 3%  Small Cap factors and sensitivities (Market index – Rf) Factor Sensitivity (Small – Big) returns 5% 1.1 3% 0.4 High B/M – Low B/M 2% –0.8 Ri = 3% + 1.1(5%) + 0.4(3%) – 0.8(2%) = 8.1% 13© Kaplan, Inc.LOS 28.c Estimate Return ConceptsSchweser B3 pg 19, CFAI V4 pg 71 Various Required Return on Equity Models Arbitrage Pricing Model: Competitor to CAPM  Factors not specified BIRR version is closest to accepted factors: 1. Investor confidence risk 2. Time horizon risk Do not 3. Inflation risk memorize 4. Business-cycle risk 5. Market-timing risk 15© Kaplan, Inc.ers - Exame CFA 4

LOS 28.c Estimate Return ConceptsSchweser B3 pg 19, CFAI V4 pg 71 Various Required Return on Equity Models Build-Up Method  Used with closely held companies  Used when beta estimates unobtainable  E(r) = Rf + ERP + size premium + company specific premium Inputs will be given Method does not use betas!© Kaplan, Inc. 16LOS 28.d Explain Return ConceptsSchweser B3 pg 24, CFAI V4 pg 73 Beta Estimation: Thinly Traded/Nonpublic FirmsFour-step procedure (called a pure play) 1. Identify a publicly traded firm with similar industry characteristics 2. Estimate the beta of the publicly traded firm using regression (last slide) → βE 3. Unlever the beta βunlevered = [1/(1+(D/Ecomp.firm))] βE 4. Relever beta βnonpublic = [1+(D/Enonpublic)] βunlevered D/E ratio of the nonpublic firm 18© Kaplan, Inc. ©2018 FK Partne

SS 09 - Equity InvestmentsLOS 28.d Explain Return ConceptsSchweser B3 pg 24, CFAI V4 pg 73 Beta Estimation: Public Firms Public company betas: Estimated w/ regression  Regress the company’s returns on the returns of the overall market index  Rcompany = α + β(Rmarket)  Index choice: S&P 500  Interval: Five years, monthly data  Beta drift: Observed tendency of a computed beta to migrate towards 1.0© Kaplan, Inc. 17LOS 28.e Describe Return ConceptsSchweser B3 pg 26, CFAI V4 pg 72 Strengths and Weaknesses of theRequired Rate of Return Approaches CAPM—simple, easy to compute, single factor model  Simplicity comes with potential loss of explanatory power Multi-factor models—higher explanatory power  More complex and expensive  Build up—simple 19  Ad hoc and uses historical values© Kaplan, Inc.ers - Exame CFA 5

Equity Valuation Other LOS For SS9These LOS are not covered in live class:LOS 27.a Define LOS 28.a DistinguishLOS 27.b Explain, Contrast LOS 28.f ExplainLOS 27.c Describe LOS 28.g ExplainLOS 27.d Describe LOS 28.h EvaluateLOS 27.e DescribeLOS 27.f DescribeLOS 27.g DescribeLOS 27.h Explain© Kaplan, Inc. 20 Discussion QuestionsQuestions 13 through 19 relate to Horizon Asset Management  Judy Chen is the primary portfolio manager of the global equities portfolio at Horizon Asset Management. Lars Johansson, a recently hired equity analyst, has been assigned to Chen to assist her with the portfolio.  Chen recently sold shares of Novo-Gemini, Inc. from the portfolio. Chen tasks Johansson with assessing the return performance of Novo-Gemini, with specific trade information provided in Exhibit 1.© Kaplan, Inc. 22 ©2018 FK Partne

SS 09 - Equity Investments Fixed Income Investments Equity Study Session 9 Discussion Questions CFA Institute Program Curriculum, Level II, Volume 4, page 98, Questions 13–19 Discussion QuestionsExhibit 1. Novo-Gemini, Inc. Trade Details1. Novo-Gemini shares were purchased for $20.75 per share.2. At the time of purchase, research by Chen suggested that Novo-Gemini shares were expected to sell for $29.00 per share at the end of a 3-year holding period.3. At the time of purchase, the required return for Novo-Gemini based upon the capital asset pricing model (CAPM) was estimated to be 12.6% on an annual basis.4. Exactly 3 years after the purchase date, the shares were sold for $30.05 per share.5. No dividends were paid by Novo-Gemini over the 3-year holding period.© Kaplan, Inc. 23ers - Exame CFA 6

Discussion Questions Chen explains to Johansson that, at the time of purchase, the CAPM used to estimate a required return for Novo- Gemini incorporated an unadjusted historical equity risk premium estimate for the US equity market. Chen notes that the US equities market has experienced a meaningful string of favorable inflation and productivity surprises in the past. She asks Johansson whether the historical equity risk premium should have been adjusted before estimating the required return for Novo-Gemini. For another perspective on the reward to bearing risk, Chen asks Johansson to calculate a forward looking equity risk premium for the US equity market using data on the S&P 500 index in Exhibit 2.© Kaplan, Inc. 24 Discussion QuestionsExhibit 3. Bezak, Inc.Pretax cost of debt 4.9%Long-term debt as a percent of total capital, at market value 25%Marginal tax rate 30%Bezak, Inc. beta 2.00Estimated equity risk premium 5.5%Risk-free rate 3.0% Lastly, Chen asks Johansson to evaluate Twin Industries, a privatelyowned US company that may initiate a public stock offering. Johanssondecides to adapt CAPM to estimate the required return on equity forTwin Industries. Using the MSCI / Standard & Poor’s Global IndustryClassification Standard (GICS), Johansson identifies a publicly tradedpeer company with an estimated beta of 1.09 that is much larger butotherwise similar to Twin Industries. Twin Industries is funded 49% by debt while the publicly traded peer company is funded 60% by debt. 2626© Kaplan, Inc. ©2018 FK Partne

SS 09 - Equity Investments Discussion QuestionsExhibit 2.  S&P 500 Index DataDividend yield, based on year-ahead aggregate 1.2%forecasted dividends 4%Consensus long-term earnings growth rate 3%20-year US government bond yield Chen is now considering adding shares of Bezak, Inc. to the portfolio. Chen asks Johansson to calculate Bezak’s weighted average cost of capital using the CAPM with the information provided in Exhibit 3.© Kaplan, Inc. 25 Discussion Questions Question 1313. Based upon Exhibit 1, the expected three-year holding period return for Novo-Gemini Inc., at the time of purchase was closest to: A. 39.76%. B. 42.76%. C. 44.82%. © Kaplan, Inc. 27ers - Exame CFA 7

Discussion Questions Question 1313. Based upon Exhibit 1, the expected three-year holding period return for Novo-Gemini Inc., at the time of purchase was closest to:A. 39.76%. 3-year expected holdingB. 42.76%. period returnC. 44.82%. = (29 / 20.75) – 1 = 0.3976 or 39.76% (Note that the return is not annualized!)© Kaplan, Inc. 28 Discussion Questions Question 1414. Based upon Exhibit 1, the realized three-year holding period return for Novo-Gemini Inc., was closest to:A. 39.76%. 3-year realized holdingB. 42.76%. period returnC. 44.82%. = (30.05 / 20.75) – 1 = 0.4482 or 44.82%© Kaplan, Inc. 30 ©2018 FK Partne

SS 09 - Equity Investments Discussion Questions Question 1414. Based upon Exhibit 1, the realized three-year holding period return for Novo-Gemini Inc., was closest to: A. 39.76%. B. 42.76%. C. 44.82%.© Kaplan, Inc. 29 Discussion Questions Question 1515. Based on the historical record of surprises in inflation and productivity, the historical equity risk premium for the US equity market, if it is used as an estimate of the forward-looking equity risk premium, should most likely be: A. left unchanged. B. adjusted upward. C. adjusted downward.© Kaplan, Inc. 31ers - Exame CFA 8

Discussion Questions Solution 15“Chen notes that the US equities market hasexperienced a meaningful string of favorableinflation and productivity surprises in the past.She asks Johansson whether the historical equityrisk premium should have been adjusted...”Historical mean return will be too high—henceaverage equity risk premium based on historicaldata will be biased upwards.Forward looking equity risk premium estimateshould be accordingly adjusted downward.© Kaplan, Inc. 32 Discussion Questions Question 1616. Based on Exhibit 2, the forward-looking estimate for the US equity risk premium is closest to: A. 2.2%. B. 5.8%. C. 8.2%.© Kaplan, Inc. 34 ©2018 FK Partne

SS 09 - Equity Investments Discussion Questions Solution 1515. Based on the historical record of surprises in inflation and productivity, the historical equity risk premium for the US equity market, if it is used as an estimate of the forward-looking equity risk premium, should most likely be: A. left unchanged. B. adjusted upward. C. adjusted downward.© Kaplan, Inc. 33 Discussion Questions Question 1616. Based on Exhibit 2, the forward-looking estimate for the US equity risk premium is closest to:A. 2.2%. Using Gordon growth model,B. 5.8%. ERP = Y + g – RfC. 8.2%. = 1.2% + 4% – 3% = 2.2% © Kaplan, Inc. 35ers - Exame CFA 9

Discussion Questions Question 1717. Based on Exhibit 3, and assuming interest on debt is tax-deductible, the weighted average cost of capital (WACC) for Bezak, Inc., is closest to: A. 10.87%. B. 11.36%. C. 13.61%.© Kaplan, Inc. 36 Discussion Questions Question 1818. The estimate of beta for Twin Industries is closest to: A. 0.44 B. 0.85 C. 0.89© Kaplan, Inc. 38 ©2018 FK Partne

SS 09 - Equity Investments Discussion Questions Question 1717. Based on Exhibit 3, and assuming interest on debt is tax-deductible, the weighted average cost of capital (WACC) for Bezak, Inc., is closest to: A. 10.87%. B. 11.36%. re = 3.0% + 2.0×5.5% = 14% C. 13.61%. WACC = (we×re) + [wd×rd×(1– t)] = (0.75×0.14) + [0.25×0.049×(1 – 0.3)]© Kaplan, Inc. = 11.36% 37 Discussion Questions Question 1818. The estimate of beta for Twin Industries is closest to: A. 0.44 D/E of peer = 0.6 / 0.4 = 1.50 B. 0.85 D/E of Twin = 0.49 / 0.51 = 0.96 C. 0.89 Beta of publicly traded peer = 1.09 Unlevered peer beta = 1.09 / (1+ D/E) = 1.09 / 2.50 = 0.436 Relevered beta with subject company D/E© Kaplan, Inc. = 0.436(1+ D/E) = 0.436(1.96) = 0.85 39ers - Exame CFA 10

Discussion Questions Question 1919. A potential weakness of Johansson’s approach to estimating the required return on equity for Twin Industries is that the return estimate:A. does not include a size premium.B. may overstate potential returns over the long- term.C. does not consider systematic risk arising from the economics of the industry.© Kaplan, Inc. 40 Discussion Questions Solution 1919. A potential weakness of Johansson’s approach to estimating the required return on equity for Twin Industries is that the return estimate:A. does not include a size premium.B. may overstate potential returns over the long- term.C. does not consider systematic risk arising from the economics of the industry.© Kaplan, Inc. 42 ©2018 FK Partne

SS 09 - Equity Investments Discussion Questions Solution 19 Peer company is from the same industry and hence reflects the economics of the industry (hence choice C is incorrect). The unlever/relever adjustment process accounts for leverage differences between the subject company and the peer. However, size differences are not accounted for. In this instance, the subject company is smaller and hence the estimated required return would be too low (hence choice B is incorrect).© Kaplan, Inc. 41 Fixed Income Investments Equityers - Exame CFA 11

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SS 09 - Equity Investmentsers - Exame CFA 12

Questions – SS09 - Equity Valuation Valuation ConceptsQuestions 1 - 6Jaden Hoyle is evaluating the MegaFood Market chain of grocery stores and Strinson Carburetors,a maker of automobile and industrial engine parts. MegaFood is publicly traded, while Strinson is aprivate company. Hoyle's firm, Janssen and Associates, is considering the purchase of a 50% equitystake in one or both of the companies, and may be willing to purchase the companies outright.Janssen only invests in companies with a weighted average cost of capital of less than 11%.Hoyle has assembled the following data on the two companies:The risk-free rate of return is 5.2%. Hoyle must make recommendations regarding both MegaFoodMarket and Strinson Carburetors.Hoyle does not have all of the data she needs and knows she will have to estimate some valuesusing the data she does possess. To help estimate the required return on equity for StrinsonCarburetors , Hoyle takes three actions:Action A: She selects a benchmark company, unlevers the beta of that company, then levers up theadjusted beta using Strinson's debt and equity allocation.Action B: She calculates a risk premium, then adds that premium to the yield to maturity of thecompany's long-term debt.Action C: She prepares a supply-side multifactor model considering expected inflation, expectedGDP growth, and expected changes in P/E ratio.Before she finishes her analysis of MegaFood Market and Strinson Carburetors, Hoyle must constructvaluation models for two other companies, Halberd Hardware, a maker of hand tools, and the JonesGroup, one of the world's largest consultants. She has assembled the following information abouteach company.Halberd Hardware Gary Halberd, the founder, still owns 85% of the company, and all the rest is in the hands of company directors and friends of Halberd who bought stakes 20 years ago. Halberd Hardware has publicly traded debt. Historical data on equity returns is sparse, as there have been very few trades over the last two decades. Halberd Hardware is headquartered in New York City. The company plans to go public in the next six months, with Gary Halberd selling 30% of his ownership interest.Jones Group Jones Group, one of the world's largest consulting companies, has been publicly traded for four years on the South Pittson Island stock market. Its ADR trades on the U.S. market. ______________________ 1 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

 South Pittson Island is a small island nation in the Mediterranean known for its business-friendly tax code.For her analysis of Halberd Hardware, Hoyle is considering three models to calculate the estimatedreturn. But she has already decided to use the Gordon Growth model to calculate the equity riskpremium.As soon as Hoyle finishes determining which models are best suited to her purposes, her boss comesinto the office and tells her to use the capital asset pricing model (CAPM) for all four of the companiesshe is reviewing. Hoyle is concerned about the effectiveness of the CAPM. With regards to JonesGroup, her three main worries are:Worry A: The need to use the country spread model to revise the equity risk premium. Worry B:The CAPM's effectiveness because of Jones Group's ADR.Worry C: The need to create a beta estimate using an unlevered beta.Question 1Assuming MegaFood Market has a required return on equity (ROE) of 13.6% and StrinsonCarburetors has a required ROE of 15.3%, what recommendation should Hoyle give her superiorsat Janssen regarding each company?MegaFood Market Strinson CarburetorsA) Don't buy the company Don't buy the companyB) Don't buy the company Buy the companyC) Buy the company Buy the companyQuestion 2Which of Hoyle's actions is least helpful in the calculation of required return on equity for StrinsonCarburetors? A) Action A. B) Action B. C) Action C.Question 3Which of the following is the best model for calculating Strinson Carburetors' required return? A) Capital asset pricing model. B) Fama-French model. C) Pastor-Stambaugh model.Question 4Hoyle wants to calculate an expected return for Halberd Hardware and Jones Group. She has accessto a variety of models, but her best option is: for Halberd for JonesA) build-up method country spread modelB) build-up method capital asset pricing modelC) bond-yield plus risk premium method capital asset pricing modelQuestion 5Hoyle wants to use a macroeconomic model to derive equity risk premiums for both HalberdHardware and Jones Group. Such a model is appropriate for:A) both Halberd Hardware and Jones Group.B) Halberd Hardware, but not Jones Group, because macroeconomic models don't work for nations like South Pittson Island.C) Jones Group, but not Halberd Hardware, because macroeconomic models don't work for closely held companies. ______________________ 2 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

Question 6Which of Hoyle's worries about using the CAPM for Jones Group is most justified? A) Worry A. B) Worry C. C) Worry B.Questions 7 - 9Joe Dentice has an opportunity to buy 5% of Gold Star Oil, Inc., a closely held oil company. He wants tovalue the company so as to make a decision on a fair price to pay for the investment.Question 7Consider the steps in the top down valuation approach as it is applicable for Gold Star. Denticeshould forecast the growth of: A) the overall economy, growth of the industry, and the growth rate of Gold Star. B) Gold Star, the growth of the oil industry, and then the growth of the overall economy. C) each firm in the oil industry, the growth rate of the oil industry, and the growth rate of the economy.Question 8Which of the following models would be most suitable to value Gold Star? A) Absolute valuation. B) Relative valuation. C) Liquidation value.Question 9Which discounts must be taken into account while valuing the investment opportunity? Joe shouldtake into account the: A) marketability, liquidity, and control premium in the valuation. B) marketability, liquidity, and minority discounts in the valuation. C) marketability, liquidity, and majority discounts in the valuation. ______________________ 3 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

______________________ 4 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

Answers – SS 09 - Equity Valuation Valuation ConceptsQuestions 1 - 6Questions 1The correct answer was B) Don't buy the company Buy the companyTo determine whether the investments fit Janssen's requirements, we must calculate the weightedaverage cost of capital. We have the target debt/equity ratio, from which we can derive thedebt/capital ratio needed to calculate WACC. Debt/capital = (debt / equity) / (1+ debt / equity)For MegaFood, the target debt/capital ratio is 25.93%. For Strinson, the target debt/capital ratio is43.82%. WACC = [debt / capital × required return on debt × (1 − tax rate)] + (equity / capital) ×required retu rn on equity.MegaFood WACC = [(25.93% × 9% × (1 − 42.8%)] + (1 − 25.93%) × 13.6% = 11.41%.Strinson WACC = [(43.82% × 6.5% × (1 − 31%)] + (1 − 43.82%) × 15.3% = 10.56%.For MegaFood, WACC is 11.41%, higher than the Janssen's 11% target. For Strinson, WACC is10.56%, below the target. Thus, Janssen should buy Strinson, but not MegaFood.Question 2The correct answer C) Action C.Action A is a useful method for calculating beta for private or thinly traded companies. With thatestimated beta, Hoyle has all the pieces needed to calculate required return using the capital assetpricing m odel. Action B reflects the bond-yield plus risk premium method for calculating requiredreturn on equity for companies with publicly traded debt. This strategy would provide Hoyle with atarget return. The model created in Action C is useful for estimatin g an equity risk premium. ButHoyle already has an equity risk premium.Question 3The correct answer was C) Pastor-Stambaugh model.Strinson is not publicly held, and its shares have little liquidity. The Fama -French model is usefulfor estimating returns, but the Pastor-Stambaugh model adds a liquidity factor to the Fama-Frenchmodel. As such, the Pastor- Stambaugh model is probably better for a company like Stinson becauseit takes liquidity into account. The CAPM requires the estimation of beta and is likely to be lessaccurate than th e other models.Question 4The correct answer was C) bond-yield plus risk premium method capital asset pricing modelBoth the build-up method and the bond-yield plus risk premium method work for thinly tradedcompanies. But the build-up method relies on historical estimates, so it wouldn't work well forHalberd, which has minimal historical data. Thus, the bond-yield plus risk premium method is thebest option. The country spread model is not designed to calculate an expected return, but insteadto adjust data from emerging markets for comparison with data from developed markets. Thequestion only provides two options, and the CAPM is the only mo del that would actually do therequired job for Jones.Question 5The correct answer was A) both Halberd Hardware and Jones Group.Macroeconomic models work for any market in which public equities represent a large enough shareof the economy that analysts can reasonably infer a relationship between economic factors andasset prices. Since South Pittson Island is known as a tax haven, it is likely that many othercompanies are domiciled there for the same reason Jones Group is, and the financial industry is alarge part of the economy. However, even if we don' t want to assume that South Pittson Island'seconomy is suitable for such models, we have another argument. Jones Group is one of the world'slargest consulting companies. Therefore, it is highly likely that it has significant operations in large,develope d markets. Macroeconomic models can be constructed to reflect data from those markets- and in fact, any such model should reflect that data.Question 6The correct answer was C) Worry B.Currency-translation issues are a concern for any company with operations in foreign countries. But _________________________ 1 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio

the country spread model is designed to adjust results from emerging markets using data fromdeveloped markets, assigning the proper amount of extra risk for the emerging market. Most taxhavens would not need to be treated as emerging markets. In addition, as one of the world's largestconsultancies, Jones Group must do a lot of business in the U.S. and other developed markets. Itis unlikely that results from a company like Jones Group would require the adjustments from thecountry spread model. Regarding beta: Since Jones is publicly traded, there is no need toextrapolate a beta using data from another company. Thus, there is no reason to unlever beta froma benchmark company, then relever it to reflect Jones' financial condition. The biggest concern isthe overall effectiveness of the CAPM. The model should work for Jones Group, but it hasweaknesses, most importa ntly its dependence on just one factor. Jones trades on at least twoexchanges, and any model depending on just one market index is not going to reflect the wholepicture.Questions 7 – 9Question 7The correct answer was A) the overall economy, growth of the industry, and the growth rate of GoldStar.The top down model for valuation would begin with analysis of the overall economy and theexpectation of thegrowth rate in the economy. Further, the impact of the expected growth rate of the economy onthe oil industry needs to be ascertained. The second component is the analysis of the oil industryin which Gold Star operates. That involves the determination of the competitive forces in theindustry and the future threats and opportunities faced by the industry. It also determines thevariables that determine the future profitability of the entire oil industry. The analyst then formsfuture expectations of these variables given the expectations about the overall economy. Theexpectations of variables determining the growth and profitability of the oil industry are then usedto determine the expectations of the overall growth of Gold Star. In the company analysis, theanalyst reviews the quality of earnings, financial ratios, management and intangibles to ascertainthe growth prospects for the company. The analyst then selects an appropriate model to value thecompany. Assumptions used in the valuation must be clea rly spelled out and updated to reflectnew information.Question 8The correct answer was A) Absolute valuation.Absolute valuation models or intrinsic value models such as the dividend growth rate model and thefree cash flow model value a company independent of peer valuation. The valuation is based on thepresent value of cash-flows for the specific company. Relative valuation models such as P/E ratiocompare the earnings multiple to that of similar companies to make a judgment about the valuation.If the P/E ratio is higher than peer company P/E ratio, it is said to be overvalued. Conversely , ifthe P/E ratio is lower than peer company P/E ratio, it is said to be undervalued. Caution should betaken to make sure that peer companies are indeed comparable. For the valuation of Gold Star,absolute valuation would be suitable since it is closel y held and hence market valuation is notavailable.Question 9The correct answer was B) marketability, liquidity, and minority discounts in the valuation.Since Gold Star is closely held, the investment is not easily marketable. Closely linked is the factthat the investment cannot be easily liquidated and the cost of selling the investment needs to bediscounted from the value. Finally, since only 5% of the stock is being invested in, the control ofthe operations of the company still remains with the m ajority shareholders. This lack of controlneeds to be quantified and discounted from Gold Star's valuation. _________________________ 2 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio

Fixed Income Investments Equity Study Session 10 Equity Valuation: Industry and Company Analysis in a Global Context 29. Industry and Company Analysis 30. Discounted Dividend ValuationLOS 30.a Compare/Identify Discounted DividendsSchweser B3 pg 62, CFAI V4 pg 201 Various Measures of Cash Flow in Valuation Measures of cash flow Dividends = cash paid to shareholders, used in DDM Free cash flow = cash available to pay shareholders; broader scope Residual income = economic profit Key point: Valuation metric (e.g., dividends orFCF) must be measurable and related to earningspower 2© Kaplan, Inc. ©2018 FK Partne



















LOS 30.f Calculate/Interpret Discounted DividendsSchweser B3 pg 71, CFAI V4 pg 222 Gordon and Justified P/Es Point: The GGM can also be used to calculate a justified fundamental price multiple As shown in SS11, rearrange GGM yields: D1 D1  justified leadingP0 = r –g P0 = E1 = 1– b E1 r –g r –g© Kaplan, Inc. 20LOS 30.h Describe/Justify Discounted DividendsSchweser B3 pg 74, CFAI V4 pg 225 DDM: Constant Growth (Gordon)Strengths: Used with broad market indexes (developed markets) Estimate g, r, and PVGO Supplement to more complex models (terminal value)© Kaplan, Inc. 22 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global ContextLOS 30.h Describe/Justify Discounted DividendsSchweser B3 pg 74, CFAI V4 pg 225 DDM: Constant Growth (Gordon)Suitability:  Company has history of paying dividends  Board of directors has a dividend policy that has an understandable and consistent relationship to profitability  Minority shareholder takes a non-control perspective  Mature firms, profitable but not fast growth© Kaplan, Inc. 21LOS 30.h Describe/Justify Discounted DividendsSchweser B3 pg 74, CFAI V4 pg 225 DDM: Constant Growth (Gordon) (cont.)Weaknesses: Value (V0) very sensitive to estimates of r and g Difficult to use with non-dividend-paying stocksModel selection: Minority perspective only  Not useful for valuing M&A© Kaplan, Inc. 23ers - Exame CFA 6

LOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 Multi-Stage DDM Models GGM assumption: Stable dividend growth rate forever  Problem: Unrealistic for most firms Solutions include:  Two-stage  H-Model, three-stage  Spreadsheet modeling Growth can be expressed in three distinct phases© Kaplan, Inc. 24LOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 Two-Stage DDM Assumes stages of growth:  First: Fixed period of supernormal growth  Then: Indefinite growth at normal level Useful in cases when growth rate is expected to drop suddenly:  Patent expiration  Firm enters mature phase of life cycle after a rapid growth stage© Kaplan, Inc. 26 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global ContextLOS 30.k Describe/Explain Discounted DividendsSchweser B3 pg 79, CFAI V4 pg 228 Terminal Value Terminal value = forecasted value at beginning of the final mature growth phase  Also known as the future sales price Two estimation methods to get Pn: 1. Apply trailing multiple (P/E) × forecasted EPSn 2. Gordon Growth Model: D(n+1) / (r – g) Pay attention to subscripts© Kaplan, Inc. 25LOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 Two-Stage DDM Problem: GGM constant g assumption unrealistic Solution: Assume rapid growth for n years, then long-term sustainable growth Two-stage Dividend growth (g) High rate % assumes a drop-off in Stable rate % growth Important! Stage1 n years Stage2 Time 27© Kaplan, Inc.ers - Exame CFA 7

LOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226Application: The Two-Stage Model Two stages of growth: 1. Initial high-growth phase 2. Perpetual stable-growth phase Two approaches: 1. Formula 2. Timeline Suggestion: Use the timeline—it provides the flexibility to solve many types of problems© Kaplan, Inc. 28LOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226Example: The Two-Stage Model Dividends of $2.50 and $4.00 at the end of each of the next two years Stage two constant growth = 4% Required return = 12% Calculate the value today© Kaplan, Inc. 30 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global ContextLOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 Application: The Two-Stage Model Methodology: 1. Individual estimation of supernormal dividends, followed by… 2. Calculation of a terminal value Note: Very important concept V0 = PV(dividends over first n years) + PV(terminal value) From Gordon Growth Model or price multiple© Kaplan, Inc. approach 29LOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226 Solution: The Two-Stage Model Dividend T1 T2growth (g) $2.50 $4.00 + $52 High P0 = $2.50 + $56.00  $46.88 rate % 1.12 1.122 Stable  $52  rate 4% $4.00  1.04 0.12 – 0.04© Kaplan, Inc. Stage1 2 years Stage2 Time 31ers - Exame CFA 8

LOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 The H-Model Assumes a gradual decay in g as firm matures over a transition period Dividend growth (g)High rate % Stable rate % Stage 1 Stage 2 Time n years© Kaplan, Inc. 32LOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 The H-Model FormulaMost recent Short-term high dividend growth rate H = Transition period / 2V0   D0  1 gL    D0  H   gS  gL     r  gL  r  gL Required return Long-term low growth rate© Kaplan, Inc. 34 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global ContextLOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 The H-Model (cont.) Problem: Two-stage model assumes high growth rate will suddenly drop The H-Model: More realistic assumption  Firm will start with high growth rate  Growth declines linearly over a transition period T = “2H” yearsNote: Only an approximation method; more accurate when H and (gs – gL) is small.© Kaplan, Inc. 33LOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226 Example: H-ModelBTeam Inc.:  Currently pays a dividend of $1.30.  Stage one growth rate is 25%.  Growth is expected to decay over five years.  Constant growth rate of 5% thereafter.  Required return is 14%.Calculate the intrinsic value of BTeam stock usingthe H-Model.© Kaplan, Inc. 35ers - Exame CFA 9

LOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226 Solution: H-Model gS D0  H  (gS  gL ) = $7.22 gL r  gL© Kaplan, Inc. $1.30  2.5  (0.25  0.05) 0.14  0.05 D0 (1  gL ) = $1.30  (1.05) = $15.17 r  gL 0.14  0.05 T5 T∞ P0 = $7.22 + $15.17 = $22.39 36LOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 DDM: Multi-Stage Models Three-stage model: Two approaches1. Three distinct phases, simply add an additional growth stage to the two-stage model  Growth, transition, and mature2. High-growth phase + H-model pattern  High followed by linearly declining followed by perpetual growth© Kaplan, Inc. 38 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global ContextLOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226 Solution: H-Model V0 = D0  1 gL    D0  H   gS – gL   r – gL $1.30  1.05   $1.30  5   0.25 – 0.05  2  = 0.14 – 0.05 = $22.39© Kaplan, Inc. 37LOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226 Example: Three-Stage With H-Model Netweb, Inc.  Current growth rate is 25%.  Supernormal rate is expected to last three years.  After three years, growth decays linearly to a sustainable 3% over the following seven years.  Last dividend was $0.30.  Required return is 10%. Calculate the value of Netweb’s shares today.© Kaplan, Inc. 39ers - Exame CFA 10

LOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226Solution: Three-Stage With H-ModelgS = 25% $0.375 $0.586 + $6.446 + $8.623 $0.586×3.5×(0.25 $0.469 – 0.03) 0.10 – 0.03 = $6.446gL = 3% $0.586×(1.03) = $8.623 0.10 – 0.03 T0 T1 T2 T3 T10 T∞© Kaplan, Inc. 40LOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226 Evaluation If the current market price of the stock is $15.00, determine if the stock is fairly valued/overvalued or overvalued by the market. Since the market price ($15.00) exceeds the model price ($12.48), the stock is overvalued by the market.© Kaplan, Inc. 42 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global ContextLOS 30.l,n Calculate/Interpret/Explain Discounted DividendsSchweser B3 pg 80, CFAI V4 pg 226 Solution: Three-Stage With H-Model 0 1 23 $12.49 $0.375 $0.469 $15.655P0  $0.375  $0.469  $15.655  $12.49 $0.586 + 1.1 1.12 1.13 $6.446 + $8.623© Kaplan, Inc. 41LOS 30.i Explain/Justify Discounted DividendsSchweser B3 pg 75, CFAI V4 pg 226 The Multi-Period Models Strengths  Ability to model many growth patterns  Solve for V, g, and r Weaknesses  Require high-quality inputs (GIGO)  Value estimates sensitive to g and r  Model suitability very important© Kaplan, Inc. 43ers - Exame CFA 11