CFA L2 Apostila 01 Exame 2018 - COMPLETA IMPRESSÃO

LOS 30.m Estimate Discounted DividendsSchweser B3 pg 85, CFAI V4 pg 239 GGM and Required Return: r Point: DDM can be used to find implied r  Drive model in reverse Solving GGM for r : r = D1 + g P0 Example: If expected dividends are $1.60 and the current price is $40 with expected growth of 9%  Then: Required return should be 13% 44© Kaplan, Inc.LOS 30.m Estimate Discounted DividendsSchweser B3 pg 85, CFAI V4 pg 239 H-Model and Required Return: r Example: Using our BTeam, Inc., data and a current market price of $30, we get:r  $1.30  1.05  5   0.25 – 0.05    0.05 $30.00   2     11.7%© Kaplan, Inc. 46 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global ContextLOS 30.m Estimate Discounted DividendsSchweser B3 pg 85, CFAI V4 pg 239 H-Model and Required Return: r Point: Given market price, drive H-model in reverse to get required return  r D0    P0  (1  gL )  H   gS – gL    gL  © Kaplan, Inc. 45LOS 30.m Estimate Discounted DividendsSchweser B3 pg 85, CFAI V4 pg 239 Example: Calculate rPrixm Inc. currently has a dividend yield of 4%.It is believed that the current earnings growthrate of 8% will linearly decline to long-termconstant rate of 4% over the next five years.The required rate of return on Prixm stockconsistent with this information is closest to:A. 8.56%B. 9.44%C. 10.23%© Kaplan, Inc. 47ers - Exame CFA 12

LOS 30.m Estimate Discounted DividendsSchweser B3 pg 85, CFAI V4 pg 239 Solution: Calculate rD0/P0 = 4%; gs = 0.08; gL = 0.04; H=5/2 = 2.50 r  0.04  1.04  2.50   0.08 – 0.04   0.04  0.0856 Answer: A) 8.56%© Kaplan, Inc. 48LOS 30.o Calculate/Interpret/Demonstrate Discounted DividendsSchweser B3 pg 89, CFAI V4 pg 241 Calculating SGR: ExampleCompute SGR for Green, Inc.:  Payout ratio = 25%  EPS = $1.00  BVPS = $10.00  ROE = 10% SGR = Retention rate (b) × ROE 50 SGR = (1 – DIV/EPS) × Net Inc./Equity SGR = (1 – 0.25) × 10% = 7.5%© Kaplan, Inc. ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global ContextLOS 30.o Calculate/Interpret/Demonstrate Discounted DividendsSchweser B3 pg 89, CFAI V4 pg 241 SGR: The Sustainable Growth Rate SGR (g) = sustainable growth rate in earnings and dividends if we assume the following:  Growth uses internally generated equity  Capital structure remains unchanged  Several key ratios held constant  Formula: g = retention rate (b) × NI/SE g = b × ROE© Kaplan, Inc. 49LOS 30.o Calculate/Interpret/Demonstrate Discounted DividendsSchweser B3 pg 89, CFAI V4 pg 241 SGR: The Sustainable Growth Rate Three-Part DuPont ROE Decomposition: ROE   net income    sales    assets   sales   assets   equity  ROE   net profit    asset    equity   margin   turnover   multiplier  Note: Always use beginning-of-year balance sheet numbers (unless told otherwise) Point: SGR = retention × ROE© Kaplan, Inc. 51ers - Exame CFA 13

LOS 30.o Calculate/Interpret/Demonstrate Discounted DividendsSchweser B3 pg 89, CFAI V4 pg 241 SGR Value Drivers and Their Impact1. Net income/sales measures profitability, higher margins result in a higher ROE2. Sales/total assets measures operational efficiency, higher turns result in higher ROE3. Assets/equity measures financial leverage via the equity multiplier based on the firm’s financing policies, higher leverage higher ROE© Kaplan, Inc. 52 Fixed Income Investments Equity Study Session 10 Discussion Questions CFA Institute Program Curriculum, Level II, Volume 4, page 255 Questions 16–21 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global Context Discounted Dividends Other LOS for SS10These LOS are not covered in live class: Reading 29: All LOS LOS 30.d Calculate, Interpret LOS 30.g Calculate LOS 30.j Explain LOS 30.p Evaluate© Kaplan, Inc. 53 Discussion QuestionsThe following information relates to Questions 16–21 Jacob Daniel is the chief investment officer at a US pension fund sponsor, and Steven Rae is an analyst for the pension fund who follows consumer/noncyclical stocks. At the beginning of 2009, Daniel asks Rae to value the equity of Tasty Foods Company for its possible inclusion in the list of approved investments. Tasty Foods Company is involved in the production of frozen foods that are sold under its own brand name to retailers.© Kaplan, Inc. 55ers - Exame CFA 14

Discussion Questions Rae is considering if a dividend discount model would be appropriate for valuing Tasty Foods. He has compiled the information in the following table for the company’s EPS and DPS during the last five years. The quarterly dividends paid by the company have been added to arrive at the annual dividends. Rae has also computed the dividend payout ratio for each year as DPS/EPS and the growth rates in EPS and DPS. Year EPS ($) DPS ($) Payout Growth in Growth in Ratio EPS (%) DPS (%) 2008 2.12 0.59 0.278 2.9 3.5 2007 2.06 0.57 0.277 2.5 5.6 2006 2.01 0.54 0.269 6.3 5.9 2005 1.89 0.51 0.270 6.2 6.3 2004 1.78 0.48 0.270 56© Kaplan, Inc. Discussion Questions Rae uses the CAPM to compute the return on equity. He uses the annual yield of 4 percent on the 10-year Treasury bond as the risk-free return. He estimates the expected US equity risk premium, with the S&P 500 Index used as a proxy for the market, to be 6.5 percent per year. The estimated beta of Tasty Foods against the S&P 500 Index is 1.10. Accordingly, Rae’s estimate for the required return on equity for Tasty Foods is 0.04 + 1.10(0.065) = 0.1115 or 11.15 percent.© Kaplan, Inc. 58 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global Context Discussion Questions Rae notes that the EPS of the company has been increasing at an average rate of 4.48 percent per year. The dividend payout ratio has remained fairly stable and dividends have increased at an average rate of 5.30 percent. In view of a history of dividend payments by the company and the understandable relationship dividend policy bears to the company’s earnings, Rae concludes that the DDM is appropriate to value the equity of Tasty Foods. Further, he expects the moderate growth rate of the company to persist and decides to use the Gordon growth model.© Kaplan, Inc. 57 Discussion Questions Using the past growth rate in dividends of 5.30 percent as his estimate of the future growth rate in dividends, Rae computes the value of Tasty Foods stock. He shows his analysis to Alex Renteria, his colleague at the pension fund who specializes in the frozen foods industry. Renteria concurs with the valuation approach used by Rae but disagrees with the future growth rate he used. Renteria believes that the stock’s current price of $8.42 is the fair value of the stock.© Kaplan, Inc. 59ers - Exame CFA 15

Discussion Questions Question 1616. Which of the following is closest to Rae’s estimate of the stock’s value:A. $10.08.B. $10.54.C. $10.62.© Kaplan, Inc. 60 Discussion Questions Question 1717. What is the stock’s justified trailing P/E based on the stock’s value estimated by Rae?A. 5.01.B. 5.24.C. 5.27.© Kaplan, Inc. 62 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global Context Discussion Questions Solution 1616. Which of the following is closest to Rae’s estimate of the stock’s value:A. $10.08.B. $10.54. C. $10.62.  V0  $0.59  1.053© Kaplan, Inc. 0.1115 – 0.053  V0  $10.62 61 Discussion Questions Solution 1717. What is the stock’s justified trailing P/E based on the stock’s value estimated by Rae?A. 5.01.B. 5.24. V0 (computed earlier) = $10.62C. 5.27. E0 (given) = $2.12 Trailing P/E (based on estimated value) = V0/E0 = 10.62 / 2.12 = 5.01© Kaplan, Inc. 63ers - Exame CFA 16

Discussion Questions Question 1818. Rae considers a security trading within a band of ±10 percent of his estimate of intrinsic value to be within a “fair value range.” By that criterion, the stock of Tasty Foods is:A. undervalued.B. fairly valued.C. overvalued.© Kaplan, Inc. 64 Discussion Questions Question 1919. The beta of Tasty Foods stock of 1.10 used by Rae in computing the required return on equity was based on monthly returns for the last 10 years. If Rae uses daily returns for the last 5 years, the beta estimate is 1.25. If a beta of 1.25 is used, what would be Rae’s estimate of the value of the stock of Tasty Foods?A. $8.64.B. $9.10.C. $20.13.© Kaplan, Inc. 66 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global Context Discussion Questions Solution 1818. Rae considers a security trading within a band of ±10 percent of his estimate of intrinsic value to be within a “fair value range.” By that criterion, the stock of Tasty Foods is:A. undervalued.B. fairly valued.C. overvalued.Fair valuation band = $10.62±1.06 or 9.56 – 11.68.P0 (given) = 8.42 is below the lower bound. Stock is undervalued.© Kaplan, Inc. 65 Discussion Questions Solution 19Higher beta results in higher discount rateand lower value.New r = 4% + (1.25×6.5%) = 12.13%  V0  $0.59  1.053  $9.10 0.1213 – 0.053 © Kaplan, Inc. 67ers - Exame CFA 17

Discussion Questions Solution 1919. The beta of Tasty Foods stock of 1.10 used by Rae in computing the required return on equity was based on monthly returns for the last 10 years. If Rae uses daily returns for the last 5 years, the beta estimate is 1.25. If a beta of 1.25 is used, what would be Rae’s estimate of the value of the stock of Tasty Foods?A. $8.64.B. $9.10.C. $20.13.© Kaplan, Inc. 68 Discussion Questions Solution 2020. Alex Renteria has suggested that the market price of Tasty Foods stock is its fair value. What is the implied growth rate of dividends given the stock’s market price? Use the required return on equity based on a beta of 1.10.A. 3.87% Stock is priced lower thanB. 5.30%.C. 12.1%. computed value → growth must be lower.  V0  8.42  $0.59  1 g 0.1115 – g© Kaplan, Inc.  g  3.87% 70 ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global Context Discussion Questions Question 2020. Alex Renteria has suggested that the market price of Tasty Foods stock is its fair value. What is the implied growth rate of dividends given the stock’s market price? Use the required return on equity based on a beta of 1.10. A. 3.87% B. 5.30%. C. 12.1%.© Kaplan, Inc. 69 Discussion Questions Question 2121. If Alex Renteria is correct that the current price of Tasty Foods stock is its fair value, what is the expected capital gains yield on the stock? A. 3.87% B. 4.25%. C. 5.30%. © Kaplan, Inc. 71ers - Exame CFA 18

Discussion Questions Solution 2121. If Alex Renteria is correct that the current price of Tasty Foods stock is its fair value, what is the expected capital gains yield on the stock?A. 3.87% Capital gains yieldB. 4.25%. = g = 3.87% (computed earlier). C. 5.30%. Rearranging GGM: r = D1/P0 + g© Kaplan, Inc. r = dividend yield + capital gains yield 72 Fixed Income Investments Equity ©2018 FK Partne

ers - Exame CFA SS 10 - Equity Valuation: Industry and Company Analysis in a Global Context Fixed Income Investments Equity Fixed Income Investments Equity 19

Fixed Income Investments Equity ©2018 FK Partne

SS 10 - Equity Valuation: Industry and Company Analysis in a Global Contexters - Exame CFA 20

Questions – SS10 - Equity Valuation Industry and Company Analysis and Discounted Dividend ValuationQuestions 1 – 6Julie Davidson, CFA, has recently been hired by a well-respected hedge fund manager in New Yorkas an investment analyst. Davidson's responsibilities in her new position include presentinginvestment recommendations to her supervisor, who is a principal in the firm. Davidson's previousposition was as a junior analyst at a regional money management firm. In order to prepare for hernew position, her supervisor has asked Davidson to spend the next week evaluating the fund'sinvestment policy and current portfolio holdings. At the end of the week, she is to make at leastone new investment recommendation based upon her evaluation of the f und's current portfolio.Upon examination of the fund's holdings, Davidson determines that the domestic growth stocksector is currently underrepresented in the portfolio. The fund has stated to its investors that it willaggressively pursue opportunities in this sector, but due to recent profit-taking, the portfolio needssome rebalancing to increase its exposure to this sector. She decides to search for a suitable stockin the pharmaceuticals industry, which, she believes, may be able to provide an above average returnfor the hedge fund while maintaining the fund's stated risk tolerance parameters.Davidson has narrowed her search down to two companies, and is comparing them to determinewhich is the more appropriate recommendation. One of the prospects is Samson Corporation, amid-sized pharmaceuticals corporation that, through a series of acquisitions over the past five years,has captured a large segment of the flu vaccine market. Samson financed the acquisitions largelythrough the issuance of corporate debt. The company's stock had performed steadily for many yearsuntil the acquisitions, at which point both earnings and dividends accelerated rapidly. Davidsonwants to determine what impact any additional acquisitions will have on S amson's future earningspotential and stock performance.The other prospect is Wellborn Products, a manufacturer of a variety of over-the-counter pediatricproducts. Wellborn is a relatively new player in this segment of the market, but industry insidershave confidence in the proven track record of the company's upper management who came fromanother firm that is a major participant in the industry. The market cap of Wellborn is much smallerthan Samson's, and the company differs from Samson because it has grown internally rather thanthrough the acquisition of its competitors. Wellborn currently has no long -term debt outstanding.While the firm does not pay a dividend, it has recently declared that it intends to begin paying oneat the end of the current calendar year.Select financial information (year-end 2005) for Samson and Wellborn is outlined below: ______________________ 1 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

It is the beginning of 2006, and Davidson wants use the above data to identify which will have thegreatest expected returns. She must determine which valuation model(s) is most appropriate for thesetwo securities. Also, Davidson must forecast sustainable growth rates for each of the companies to assesswhether or not they would fit withi n the fund's investment parameters.Question 1Using the Gordon growth model (GGM), what is the equity risk premium?A) 5.50%.B) 2.75%.C) 3.25%.Question 2Davidson is familiar with the use of the capital asset pricing model (CAPM) and arbitrage pricingtheory (APT) to estimate the required rate of return for an equity investment. However, there aresome limitations associated with both models that should be considered in her analysis. Which ofthe following is least likely a limitation of the CAPM and/or APT?A) Model uncertainty, because it is unknown if the use of either model is theoretically correct and appropriate.B) Risk premium exposure, because it fails to consider the implications of an asset's sensitivity to the various risk factors in the market.C) Input uncertainty, because it is difficult to estimate the appropriate risk premiums accurately.Question 3Which of the following valuation models would be most appropriate in the valuation analysis ofWellborn Products? A) The dividend discount model (DDM), because the hedge fund's investment would represent a minority interest in the company. B) The free cash flow model, because the firm does not have a steady dividend payment history. C) The residual income approach, because the firm is likely to have negative free cash flow for the foreseeable future.Question 4Davidson needs to determine if the shares of Wellborn are currently undervalued or overvalued inthe market relative to the shares' fundamental value. The estimated fair value of Wellborn shares,using a two -period dividend discount model (DDM), is:A) $27.69.B) $27.58.C) $25.29.Question 5As a part of her analysis, Davidson needs to calculate return on equity for both potentialinvestments. What is last year's return on equity (ROE) for Samson shares? A) 9.5%. ______________________ 2 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

B) 3.5%. C) 6.5%.Question 6Davidson determines that over the past three years, Samson has maintained an average net profitmargin of 8percent, a total asset turnover of 1.6, and a leverage ratio (equity multiplier) of 1.39. AssumingSamson continues to distribute 35 percent of its earnings as dividends, Samson's estimatedsustainable growth rate (SGR) is: A) 17.8%. B) 11.6%. C) 6.2%.Questions 7 - 12Bernadine Nutting has just completed several rounds of job interviews with the valuation group,Ancis Associates. The final hurdle before the firm makes her an offer is an interview with Greg Ancis,CFA, the founder and senior partner of the group. He takes pride in interviewing all potentialassociates himself once they have made it through the earlier rounds of interviews, and putscandidates through a grueling series of tests. As soon as Nutting enters his office, Ancis tries tooverwhelm her with financial information on a variety of firms, including AlphaBetaHydroxy, Inc.,Turbo Financial Services, Aultman Construction, and Reality Productions.He begins with AlphaBetaHydroxy, Inc., which trades under the symbol AB and has an estimatedbeta of 1.4. The firm currently pays $1.50 per year in dividends, but the historical dividend growthrate has varied significantly, as shown in the table below AlphaBetaHydroxy, Inc.Historical Dividend GrowthYear Dividend Growth Rate (%) −1 +20 −2 +58 −3 −27 −4 −19 -5 +38 -6 +17−7 and earlier +3Ancis says that, given AB's wildly varying historical dividend growth, he wants to value the firm using 3different scenarios. The Low-Growth scenario calls for 3% annual dividend growth in perpetuity. TheMiddle-Growth scenario calls for 12% dividend growth in years 1 through 3, and 3% annual growththereafter. The High -Growth scenario specifies dividend growth year by year, as follows:AlphaBetaHydroxy, Inc. High- Growth ScenarioYear Dividend Growth Rate (%)1 20 ______________________ 3 ©2018 FK Partners Todos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

2 18 3 16 4 9 5 8 6 77 and thereafter 4Nutting suggests that the scenarios are incomplete, saying that she'd like to include some additionalassumptions for the various scenarios. For example, while she would estimate the return on theS&P 500 to be 12% regardless of AB's performance, she would want to vary the outlook for interestrates depending on the scenario. In specific, she'd use a long-term Treasury bond rate of 4% forthe low-growth scenario, but raise it to 5% for the middle and higher- growth scenarios.Ancis then moves on to Turbo Financial Services. Ancis has been following Turbo for quite sometime because of its impressive earnings growth. Earnings per share have grown at a compoundannual rate of 19% over the past six years, pushing earnings to $10 per share in the year justended. He considers this growth rate very high for a firm with a cost of equity of 14%, and aweighted average cost of capital (WACC) of only 9%. He's especially impressed that the firm canachieve these growth rates while still maintaining a c onstant dividend payout ratio of 40%, whichhe expects the firm to continue indefinitely. With a market value of $55.18 per share, Ancisconsiders Turbo a strong buy.Ancis believes that Turbo will have one more year of strong earnings growth, with EPS rising by20% in the coming year. He then expects EPS growth to fall 5 percentage points per year for eachof the following two years, and achieve its long-term sustainable growth rate of 5% beginning inyear four.Finally, Ancis turns to Aultman Construction, trading at $22 per share (with current EPS of $2.50and a required return of 18%), and Reality Productions, which currently trades at $30 per share.Reality Production's current dividend is the same as AB's ($1.50), but the historical dividend growthrate has been a stable 10%. Dividend growth is expected to decline linearly over six years to 5%,and then remain at 5% indefinitely.Ancis begins the valuation test by asking Nutting to value AB with both the two -stage DDM modeland the GordonGrowth model, using the scenario most suited to each modeling technique. Nutting answers thatthe Gordon Growth model gives a valuation for AB that is $1.32 higher than the valuation using theDDM model. After reviewing her analysis, Ancis says that her valuation is incorrect because sheshould have applied the Gordon Growth model to the High-Growth scenario.Unhappy with her misuse of the Gordon Growth Model, Ancis asks Nutting to explain the appropriateuses of two other valuation tools: the H-model and three-stage DDM. She says that the H-model ismost suited to sustained high- growth companies while three-stage DDM is only appropriate tocompanies where the dividend growth rate is expected to decline in stages. Ancis says that three-stage DDM does not require a company's growth rate to decline - it could equally well apply when acompany's growth is expected to be higher in the final stage than in the first. Nutting loses the job.Question 7Which of the following statements is least accurate? The two-stage DDM is most suited for analyzingfirms that:A) are in an industry with low barriers to entry.B) own patents for a very profitable product.C) are expected to grow at a normalized rate after a fixed period of time.Question 8Regarding the statements made by Ancis and Nutting about the correct valuation models and valuesfor AB:A) both are incorrect. 4 ______________________ ©2018 FK Partners Todos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

B) only Ancis is correct. C) only Nutting is correct.Question 9What is the implied required rate of return for Reality Productions? A) 12.50%. B) 11.00%. C) 11.75%.Question 10Regarding the statements made by Ancis and Nutting about the appropriate uses of the H -modeland three-stage DDM: A) both are correct. B) both are incorrect. C) only one is correct.Question 11Based upon its current market value, what is the implied long-term sustainable growth rate of TurboFinancial Advisors? A) 0.3%. B) 19.0%. C) 4.0%.Question 12What is the present value of Aultman's future investment opportunities as a percentage of themarket price? A) 13.9%. B) 8.1%. C) 36.9%. ______________________ 5 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

______________________ 6 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

Answers – SS10 - Equity Valuation Industry and Company Analysis and Discounted Dividend ValuationQuestions 1 - 6Questions 1The correct answer was B) 2.75%.The GGM calculates the risk premium using forward-looking or expectational data. The equity riskpremium is estimated as the one-year forecasted dividend yield on market index, plus the consensuslong -term earnings growth rate, minus the long-term government bond yield. Note that becauseequities are assumed to hav e a long duration, the long-term government bond yield serves as theproxy for the risk-free rate.Equity risk premium = 1.75% + 5.25% − 4.25% = 2.75%Question 2The correct answer was B) Risk premium exposure, because it fails to consider the implications of anasset's sensitivity to the various risk factors in the market.Both CAPM and APT consider the sensitivity of an asset's return to various risk factors. CAPM measures an asset's sensitivity relative to the market portfolio with beta, while APT measures an asset'ssensitivity to a variety of risk factors, such as investor confidence, time horizon, inflation, business-cycle and market-timing.Question 3The correct answer was B) The free cash flow model, because the firm does not have a steadydividend payment history.Free cash flow models are appropriate for firms such as Wellborn that do not have a dividend payouthistory.Question 4The correct answer was C) $25.29.The value of Wellborn using a two-period DDM is: ($1.25 / 1.095) + (($1.45 + $27.50) / 1.0952)= $25.29Question 5The correct answer was A) 9.5%.ROE can be calculated using the DuPont formula, which is: ROE = Net Income / Stockholder's EquityROE = (net income / sales) × (sales / total assets) × (total assets / stockholders' equity)Therefore: ROE = (5,700,000 / 75,000,000) × (75,000,000 / 135,000,000) × (135,000,000 /60,000,000) = (0.076) × (0.556) × (2.25) = 0.095 = 9.5%.Question 6The correct answer was B) 11.6%.Utilizing the PRAT model, where SGR is a function of profit margin (P), the retention rate (R), assetturnover (A) and financial leverage (T):g=P×R×A×Tg = 0.08 × (1 − 0.35) × 1.6 × 1.39 = 0.116 = 11.6%.Questions 7 – 12Question 7The correct answer was A) are in an industry with low barriers to entry.The two-stage DDM is well suited to firms that have high growth and are expected to maintain itfor a specific period. The assumption that the growth rate drops sharply from high-growth in theinitial phase to a stable rate makes this model appropriate for firms that have a competitiveadvantage, such as a patent, that is expected to exist for a fixed period of time. The model is notuseful in analyzing a firm that is in an industry with low barriers to entry. Low barriers to entry arelikely to result in increased competition. Therefore, the length of the initial phase of the growthperiod is indeterminate and probably uneven. _________________________ 1 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio

Question 8The correct answer was A) both are incorrect.Both Ancis's and Nutting's statements are incorrect.The Gordon Growth Model assumes that dividends increase at a constant rate perpetually. That fitsthe Low-Growth scenario, not the Middle or High-Growth scenarios. Thus, Ancis's statement isincorrect.In the Low-Growth scenario:The required rate of return is (r) = 0.04 + 1.4(0.12 − 0.04) = 0.152.The value per share is DPS0(1 + gn) / (r − gn) = [(1.50)(1.03)] / (0.152 − 0.03) = $12.66.The two-stage DDM model is most suited to a company that has one dividend growth rate for aspecified time period and then shifts suddenly to a second dividend growth rate. That best fits theMiddle-Growth scenario. In the Middle-Growth scenario,The required rate of return is (r) = 0.05 + (1.4)(0.12 − 0.05) = 0.148. The value per share is:The two-stage DDM gives a value for AB that is ($16.44 − $12.66) = $3.78 higher than the valuegiven by the Gordon Growth Model. Thus Nutting\"s statement is also incorrect. /p>Question 9The correct answer was B) 11.00%.-The H-model applies to firms where the dividend growth rate is expected to decline linearly overthe high -growth stage until it reaches its long-run average growth rate. This most closely matchesthe anticipated pattern of growth for Reality Productions.-The H-model can be rewritten in terms of r and used to solve for r given the other model inputs: r= D0 / P0 × [(1 + gL) × [H × (gS - gL)] + gL-Here, r = 1.5 / 30 × [(1 + 0.05) + [(6.0 / 2) × (0.10 &£8722; 0.05)] + 0.05 = 0.11Question 10The correct answer was C) only one is correct.Ancis's statement is technically correct. Although three-stage DDM traditionally uses progressivelylower growth rates in each stage, that is not necessary. Three-stage DDM applies when growth ratesvary in any manner, as long as they do so in three distinct stages. Nutting's statement is incorrectbecause the H -model is not appropriate for a company with sustained dividend growth at any level(high or not). The H -model assumes that the company's dividend growth rate declines linearly.Question 11The correct answer was C) 4.0%.The implied long-term rate is the rate that will cause the present value of expected dividends toequal its current market value. Since Ancis provides specific growth rates for Turbo over the nextthree years, we can use a multi - stage dividend discount model and solve for the long-term growthrate that makes the present value equal to the current market value.First, we calculate Turbo's expected dividends.D0 = $10.00 current EPS times the dividend payout ratio of 40%D0 = $4.00 dividend per share in year 0.Note that the 19% historical dividend growth rate is irrelevant to the current value of the firm. Sincethe dividend payout ratio is expected to remain constant at 40%, we can use the expected growthrate in earnings to estimate future dividends. EPS growth is forecast at 20% in year 1, 15% in year2, and 10% in year 3.Multiplying each year's expected dividend times the relevant forecast growth rate, we calculate: D1= ($4.00 dividend in year 0) × (1.20) = $4.80D2 = ($4.80 dividend in year 1) × (1.15) = $5.52 D3 = ($5.52 dividend in year 2) × (1.10) = $6.07Discounting these back to their present value in year 0 using the cost of equity (the WACC isirrelevant), we find: Present Value (D1 + D2 + D3) = ($4.80 / 1.141) + ($5.52 / 1.142) + ($6.07 /1.143)= $4.21 + $4.25 + $4.10= $12.56Thus, we know that $12.56 of the current $55.18 market value represents the present value of theexpected dividends in years 1, 2 and 3. Therefore, the present value of the firm's dividends for _________________________ 2 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio

years 4 a nd beyond must equal ($55.18 - $12.56) = $42.62.Since the present value of the firm's dividends beginning in year 4 equals $42.62, the future valuein year four will equal ($42.62 × 1.143) = $63.14.Now that we know the value in year 4 of the future stream of steady-growth dividends, we cansolve for the growth rate using the Gordon Growth Model:P3 = [($6.07)(1 + x)] / (0.14 − x ) = $63.1463.14 (0.14 − x) = 6.07 (1+x)8.84 − 63.14x = 6.07 + 6.07x2.77 = 69.21xx = 0.04The long-term growth rate that makes Turbo fairly valued is 4% per year.We can check our calculation by plugging the 4% growth rate we just solved for into the GordonGrowth Model and then plugging that result into the basic multi-stage dividend discount model:P3 = [($6.07)(1 + 0.04)] / (0.14 − 0.04)P3 = 6.313 / (.10)P3 = 63.13(Note that this value varies from the previous calculation by 0.01 because of rounding error.)P0 = ($4.80 / 1.141) + ($5.52 / 1.142) + ($6.07 / 1.143) + ($63.13 / 1.143) = $55.18, which is thecurrent market value. At a 4% growth rate, Turbo is fairly valued.Note that on the exam, it may be faster to plug each growth rate into the Gordon Growth Model andthen plug each of those terminal values into the basic multi-stage formula than to solve for thegrowth rate. This trial and error method is especially effective if you start with the \"middle\" growthrate and then decide which value to test next depending on the results of the first calculation. Forexample, if the first growth rate gives a value for the firm that is too high, you can eliminate all thehigher growth rates and try the next lower one.Question 12The correct answer was C) 36.9%.The present value of the company's future investment opportunities is also known as PVGO, whichcan be calculated using the formula: Value = (E / r) + PVGOwhere:E = earnings per share r = required return(E / r) is the value of the assets in place Here, $22 = ($2.5 / 0.18) + PVGO PVGO = $8.11The PVGO as a percentage of the market price equals ($8.11 / $22.00) = 36.9%. _________________________ 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

Fixed Income Investments Equity Study Session 11 Equity Investments 31. Free cash flow valuation 32. Market based valuation 33. Residual income valuation 34. Private company valuationLOS 31.a Compare Free Cash Flow ValuationSchweser B3 pg 110, CFAI V4 pg 285Introduction to Free Cash Flow Dividends are the cash flows actually paid to stockholders. Free cash flow is the cash flow available for distribution each year after subtracting cash spent on working capital and fixed capital investments in the year (denoted WCInv, FCInv).© Kaplan, Inc. 2 ©2018 FK Partne

SS 11- Equity Investments Fixed Income Investments Equity Study Session 12 Equity Investments Valuation Models 31. Free Cash Flow ValuationLOS 31.a Compare Free Cash Flow ValuationSchweser B3 pg 110, CFAI V4 pg 285 FCF Defined FCFF (Free Cash Flow to the Firm)  Cash available to shareholders and bondholders after taxes, FCInv, and WCInv; pre-levered cash flow FCFE (Free Cash Flow to Equity)  Cash available to equity holders after payments to and inflows from bondholders; post-leverage cash flow  Not equal to dividends actually paid© Kaplan, Inc. 3ers - Exame CFA 1

LOS 31.a Compare Free Cash Flow ValuationSchweser B3 pg 110, CFAI V4 pg 285 Interpret FCF Strengths Strengths  Used with firms that have no dividends  Functional model for assessing alternative financing policies  Rich framework provides additional detailed insights into company  Other measures EBIT, EBITDA, and CFO either double count or omit important cash flows© Kaplan, Inc. 4LOS 31.a Compare Free Cash Flow ValuationSchweser B3 pg 110, CFAI V4 pg 285 FCFF vs. FCFE Firm value = FCFF discounted at WACC Equity value = FCFE discounted at required return on equity (r)  Use FCFE when capital structure is stable  Use FCFF when high or changing debt levels, negative FCFE Equity value = firm value – MV of debt© Kaplan, Inc. 6 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.a Compare Free Cash Flow ValuationSchweser B3 pg 110, CFAI V4 pg 285 Interpret FCF Limitations Limitations  If FCF < 0 due to large capital demands  Requires detailed understanding of accounting and FSA  Information not readily available or published© Kaplan, Inc. 5LOS 31.b Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 285 Ownership Perspective FCFE = control perspective  Ability to change dividend policy  Used in control perspective DDM = minority owner  No control  Used in valuing minority position in publicly traded shares© Kaplan, Inc. 7ers - Exame CFA 2

LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 FCF Formula References NI = Net income to common shareholders, after preferred dividend but before common dividends NCC = noncash charges Int(1 – t) = after-tax interest expense FCInv = net fixed capital investment WCInv = working capital investment Net borrowings = new debt – repayments© Kaplan, Inc. 8LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 Common Noncash Charges Non Cash Items Adj to NI Location Add I/S or CFO Depreciation & Amortization Add I/S Subtract (Add) I/S Impairment / write down Gains (losses) on asset sale Add (Subtract) I/S or early debt retirement Provision for restructuring Add* B/S expense (income) Add (Subtract) CFO ↑Deferred tax liability Amortization of bond *If unlikely to reverse 10 discount (premium)© Kaplan, Inc. ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 Noncash Charges (NCC) Applies to both FCFE and FCFF Represent adjustments for noncash decreases and increases in net income based on accrual accounting, but did not result in an outflow of cash  If noncash charges decrease net income, add back to net income  If noncash charges increase net income, subtract from net income© Kaplan, Inc. 9LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 Net Fixed Capital Investment (FCInv) Investments in fixed capital (FCInv) represent a cash out flow necessary to support the company’s current and future operations Viewed as a capital expenditure (Cap Ex) that reduces both FCFE and FCFF Expenditures can include acquisition of intangible items such as trademarks Care should be used with nonrecurring large acquisitions in forecasts© Kaplan, Inc. 11ers - Exame CFA 3

LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 Net FCInv Adjustments From statement of cash flows:Capex included in investing activities From balance sheet:1. No sales of fixed assets during the year: FCInv = End net PPE – Beg net PPE + Depreciation2. Sales of fixed assets during the year:FCInv = End net PPE – Beg net PPE + Depreciation+/– Loss/(Gain) on sale© Kaplan, Inc. 12LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 Working Capital Adjustments There is a direct relationship between changes in liabilities and changes in cash flow An increase in a liability account is a source (addition/plus) of cash A decrease in a liability is a use (negative/subtraction) of cash Opposite for assets—increase in asset is an outflow of cash© Kaplan, Inc. 14 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289Investment in Working Capital (WCInv) WCInv = (OCA ‒ OCL) OCA, OCL = Operating current assets and Lia Part of CFO Specifically excludes: Non- operating  Cash and cash equivalents  Short-term interest-bearing debt  Notes payable  Current portion of long-term debt© Kaplan, Inc. 13LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 Net Borrowing Adjustments Net borrowings only affect FCFE, not FCFF. Include issue repayment of:  Long-term debt  Notes payable  Current portion of long-term debt Cash flow = B/S change in debt instruments – amortized discounts + amortized premiums© Kaplan, Inc. 15ers - Exame CFA 4

LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 FCFF and FCFE Beginning With CFO Recall, CFO = NI + NCC – WCInv CFO is an after-interest starting point FCFF = CFO + Int(1 – t) – FCInv Subtracting after-tax interest and adding back net borrowing from the FCFF equations gives us the FCFE from CFO  FCFE = CFO – FCInv + net borrowing 16© Kaplan, Inc.LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 FCFF Beginning with EBIT To show the relation between EBIT and FCFF, start with the FCFF equation and assume that the noncash charge (NCC) is depreciation (Dep’n):  FCFF = NI + Dep’n + Int(1 – t) – WCInv – FCInv Net income (NI) can be expressed as:  NI = (EBIT – Int)(1 – t), rearranging  NI = EBIT(1 – t) – Int(1 – t)  FCFF = EBIT(1 – t) + Dep’n – WCInv – FCInv© Kaplan, Inc. 18 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 FCFF and FCFE Beginning With Net Income FCFF = NI + NCC – WCInv – FCInv + Int(1 – t) CFO FCFE = NI + NCC – WCInv – FCInv + net borrowing  FCFE = FCFF – Int(1 – t) + net borrowing 17© Kaplan, Inc.LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 FCFF Beginning with EBITDA To get FCFF from EBITDA (earnings before interest, taxes, depreciation, and amortization), use the formula for FCFF: FCFF = EBITDA(1–t) + Dep’n(t) – WCInv – FCInv We add back the NCC (depreciation) times the tax because we capture the tax benefit from deducting the depreciation; it represents the cash flow savings from the deduction Note any other NCC included before EBITDA will need to be added back (not shown in formula)© Kaplan, Inc. 19ers - Exame CFA 5

LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 FCFF Formula Review FCFF = NI + NCC + [Int(1 – t)] – WCInv – FCInv FCFF = CFO + [Int(1 – t)] – FCInv FCFF = [EBIT(1 – t)] + NCC – WCInv – FCInv FCFF = EBITDA(1 – t) + (Dep’n×t) – WCInv – FCInv Notice: No net borrowings!© Kaplan, Inc. 20LOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289Important Concept—FCFF and FCFE There is only one value for FCFF and only one value for FCFE The various equations are all different ways to get to the same value Use whichever equation is easiest with the data given in the problem© Kaplan, Inc. 22 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.c Explain Free Cash Flow ValuationSchweser B3 pg 111, CFAI V4 pg 289 FCFE Formula Review FCFE = NI + NCC – WCInv – FCInv + net borrowings FCFE = CFO – FCInv + net borrowings FCFE = FCFF – [Int(1–t)] + net borrowings© Kaplan, Inc. 21LOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289Cherry Corp. Balance Sheet: Example$m Actual 20x6 Projected 20x7Cash 64 73A/R 27 47Inventory 55 60Gross PP&EAccumulated dep’n 100 120Total assets (30) (30) 216 270Footnote disclosure reveals Cherry disposed of PP&E thathad a carrying value of $5m at the date of disposal.© Kaplan, Inc. 23ers - Exame CFA 6

LOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289Cherry Corp. Balance Sheet: Example$m Actual 20x6 Projected 20x7Accounts payable 70 50Accrued exp. 6 18Deferred tax liability 6 8Long-term debt 20 30Common stock 80 80Retained earnings 34 84Liabilities & equity 216 270© Kaplan, Inc. 24LOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289Cherry Corp. Income Statement: Example$m Actual 20x6 Projected 20x7EBIT 64 106Interest expense 4 6EBT 60 100Income tax provision 24 40Net Income 36 60Footnote disclosure reveals Cherry Corp’s tax rate to be 40%.Review of the MD&A reveals the fixed asset base isexpected to expand for the foreseeable future.© Kaplan, Inc. 26 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289 Cherry Corp. Income Statement: Example$m Actual 20x6 Projected 20x7Sales 130 200COGS 52 60Gross profit 78 140SG&A 11 34Depreciation 3 5Gain on disposal 0 5EBIT 64 106© Kaplan, Inc. 25LOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289 Cherry Corp. CFO: Solution CFO = NI + NCC – WCInv = $37m $60mNCC $m $m 20x6 20x7Depreciation +5 A/R 27 47Gain on asset –5 Inventory 55 60disposal A/P (70)Change in DTL +2 Acc exp. (6) (50)Total +2 Total (18) 6 39© Kaplan, Inc. WCInv = 39 – 6 = 25 27ers - Exame CFA 7

LOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289 Cherry Corp. FCInv: SolutionFormulaic approach: $m 20x7 20x6 Gross cost 120 100 Acc. Dep’n (30) (30) Net PPE 90 70FCInv = End net PPE – Beg net PPE + Depreciation+/– Loss/(Gain) on disposal= $20m© Kaplan, Inc. From I/S gain = $5m From I/S = $5m 28LOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289 Cherry CorpFCFF from NI and CFO Solution FCFF = NI + NCC + [Int(1 – t)] – WCInv – FCInv $20.6m = 60 + 2 + [6 (1 – 0.4)] – 25 – 20 FCFF = CFO + [Int(1 – t)] – FCInv $20.6m = 37 + [6 (1 – 0.4)] – 20© Kaplan, Inc. 30 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289Cherry Corp. Net Borrowing: Solution$m 20x6 20x7Long-term debt 20 30Short-term debt 0 0Total 20 30Look for interest bearing liabilities: Net borrowing = $10m Notes payable Current portion of finance leases Current portion of LTD© Kaplan, Inc. 29LOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289 Cherry Corp FCFE from NI and CFO Solution FCFE = (NI + NCC – WCInv) – FCInv + net borrowing $27m = (60 + 2 – 25) – 20 + 10 FCFE = CFO – FCInv + net borrowing $27m = 37 – 20 + 10© Kaplan, Inc. 31ers - Exame CFA 8

LOS 31.d Calculate Free Cash Flow ValuationSchweser B3 pg 118, CFAI V4 pg 289 Cherry Corp. FCFF and FCFE FCFE = FCFF – [Int(1 – t)] + net borrowing $27m = $20.6 – [$6 (1 – 0.4)] + 10© Kaplan, Inc. 32LOS 31.g Explain Free Cash Flow ValuationSchweser B3 pg 123, CFAI V4 pg 315Effect of Financing Decisions on FCFDividends FCFF FCFEShare repurchase NoneShare issue None None NoneChange in leverage None None None ST & LT effects partially offset*Note: Share repurchase/issue is use of FCF; not determinant *e.g., if leverage increases, FCFE higher in current year (net borrowing) and lower in future years (interest expense)© Kaplan, Inc. 34 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.e Describe Free Cash Flow ValuationSchweser B3 pg 122, CFAI V4 pg 310 Three Approaches to Forecast FCF Calculate historical FCF: Most common  Estimate FCF for current period  Apply growth rate FCF × (1 + g)n Forecast components of FCF:  Forecast each underlying component of free cash flow: net income, FCInv, NCC, and WCInv (tied to sales forecast) Assuming constant capital structure  FCFE = NI - [(1 - DR)×(FCInv - Dep)] – [(1-DR)×WCInv] DR = target debt-to-asset ratio© Kaplan, Inc. 33LOS 31.i Explain/Select/Justify Free Cash Flow ValuationSchweser B3 pg 124, CFAI V4 pg 320 Single-Stage FCFF Model Point: Analogous to Gordon Growth Model  Useful for stable firms in mature industries Two assumptions: 1. Constant growth rate g forever 2. Growth rate g is less than WACC Firm value0  FCFF1  FCFF0  (1 g) WACC  g WACC  g© Kaplan, Inc. 35ers - Exame CFA 9

LOS 31.i Explain/Select/Justify Free Cash Flow ValuationSchweser B3 pg 124, CFAI V4 pg 320 Single-Stage FCFE Model Point: Similar to FCFF/GGM model Often used with international firms, especially in high-inflation countries (use real rates) Equity value  FCFE1  FCFE0  (1 g) r g r g Required return on equity (CAPM, APT, Build-up)© Kaplan, Inc. 36LOS 31.j Estimate Free Cash Flow ValuationSchweser B3 pg 127, CFAI V4 pg 320 Problem: FCFF ValuationTykes Toys has a required return on equity of 15%, aWACC of 12%, and a marginal tax rate of 40%.FCFF is expected to grow at a constant rate of 4%after three years. Using the data below, what is thevalue of the firm? $m Year 1 Year 2 Year 3 CFO 400 500 600 WCInv 50 60 80 FCInv 200 250 300 Interest expense 15 15 20© Kaplan, Inc. 38 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 31.i Explain/Select/Justify Free Cash Flow ValuationSchweser B3 pg 124, CFAI V4 pg 320 Multi-Stage Models Four major variations: Base case: two-stage, 1. FCFF or FCFE? historical growth, 2. Two stages or three? FCFE with the GGM for terminal value 3. Total FCF or components of FCF? 4. Terminal value via GGM or P/E? Note: All are very similar Always: Value = PV of future cash flows discounted at appropriate required return© Kaplan, Inc. 37LOS 31.j Estimate Free Cash Flow ValuationSchweser B3 pg 127, CFAI V4 pg 320 Solution: FCFF Valuation $m Year 1 Year 2 Year 3 CFO 400 500 600 + Interest (1-–t) t) 9 9 12 -– FFCCInInvv =FFCCFFFF (200) (250) (300) 209 259 312 Firm V3 = $312(1.04)  $4,056m 0.12  0.04 Firm V0 = $209 $259  $312  $4,056  $3,502m 1.12  1.122 1.123© Kaplan, Inc. 39ers - Exame CFA 10

Fixed Income Investments Equity Equity Investments Valuation Models 32. Market-Based Valuation: Price and Enterprise Value MultiplesLOS 32.a Distinguish/Explain Price and EnterpriseSchweser B3 pg 154, CFAI V4 pg 367 Value Multiples Method of Comparables (cont.) Price scaled by a measure of value such as sales, net income, book value, or CF Compare relative to a benchmark multiple Choices for the benchmark value of a multiple include the multiple of a closely matched individual stock or the average (or median value) for the stock’s peer group of companies or industry© Kaplan, Inc. 42 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.a Distinguish/Explain Price and EnterpriseSchweser B3 pg 154, CFAI V4 pg 367 Value Multiples Method of Comparables The method of comparables involves using a price multiple to evaluate whether an asset is relatively fairly valued, relatively undervalued, or relatively overvalued in relation to a benchmark value of the multiple Most widely used method by analysts The economic rationale for the method of comparables Law of One Price© Kaplan, Inc. 41LOS 32.a Distinguish/Explain Price and EnterpriseSchweser B3 pg 154, CFAI V4 pg 367 Value MultiplesMethod of Forecasted Fundamentals Relates multiples to company fundamentals— growth, risk, and payout Based on discounted cash flow model Permits the analyst to explicitly examine how valuations differ across stocks and against a benchmark given different expectations for growth and risk© Kaplan, Inc. 43ers - Exame CFA 11