CFA Level 2 - Equity Reading 42: Discounted Dividend Valuation

CFA Level 2 - Equity Session 11-Reading 42 Discounted Dividend Valuation - LOS n (Practice Questions, Sample Questions) 1. Supergro has current dividends of $1, current earnings of $3, and a return on equity of 16%, what is its sustainable growth rate? A) 12.2%. B) 8.9%. C) 10.7% {Explanation — (C) g = (1 – 1/3)(0.16) = 0.107} 2. Dynamite, Inc., has current earnings of $26, current dividend of $2, and a returned on equity of 18%. What is its sustainable growth? A) 16.62%. B) 14.99%. C) 13.37%. {Explanation — (A) g = [1 ? ($2 / $26)]0.18 = 16.62%} 3. In computing the sustainable growth rate of a firm, the earnings retention rate is equal to: A) Dividends / required rate of return. B) 1 ? (dividends / assets). C) 1 ? (dividends / earnings). {Explanation — (C) Earnings retention rate = 1 ? (dividends / earnings).} 4. The sustainable growth rate, g, equals: A) earnings retention rate times the return on equity. B) pretax margin divided by working capital. C) dividend payout rate times the return on assets. {Explanation — (A) The formula for sustainable growth is: g = b × ROE, where g = sustainable growth, b = the earnings retention rate, and ROE equals return on equity.} 5. Sustainable growth is the rate that earnings can grow: A) without additional purchase of equipment. B) with the current assets. C) indefinitely without altering the firm's capital structure. {Explanation — (C) Sustainable growth is the rate of earnings growth that can be maintained indefinitely without the addition of new equity capital.} 6. GreenGrow, Inc., has current dividends of $2.00, current earnings of $4.00 and a return on equity of 16%. What is GreenGrow’s sustainable growth rate? A) 8%. B) 9%. C) 6%. {Explanation — (A) GreenGrow’s sustainable growth rate is 8%. g = [1 – ($2/$4)](0.16) = 8%} 7. If a firm has a return on equity of 15%, a current dividend of $1.00, and a sustainable growth rate of 9%, what are the firm’s current earnings? A) $1.50. B) $2.50. C) $1.75. {Explanation — (B) The earnings can be determined by solving for earnings in the sustainable growth formula: 9% = [1 ? ($1 / $Earnings)] × 0.15 or $1 / 0.4 = $Earnings = $2.50} 8. Which of the following is NOT a component of the sustainable growth rate formula using the DuPont model? A) Net income/sales. B) EBIT/interest expense. C) Earnings retention ratio. {Explanation — (B) SGR = b × ROE where: b = earnings retention rate = (1 ? dividend payout rate) ROE = return on equity The SGR is important because it tells us how quickly a firm can grow with internally generated funds. A firm’s rate of growth is a function of both its earnings retention and its return on equity. ROE can be estimated with the DuPont formula, which presents the relationship between margin, sales, and leverage as determinants of ROE. In the 3-part version of the DuPont model: ROE = (NI/sales)(sales/assets)(assets/equity)} 9. Demonstrate the use of the DuPont analysis of return on equity in conjunction with the sustainable growth rate expression. The following statistics are selected from Kyle Star Partners (Kyle) financial statements: Sales $100 million Net Income $15 million Dividends $5 million Total Assets $150 million Total Equity $50 million What is Kyle’s sustainable growth rate? A) 20.0%. B) 24.5%. C) 33.3%. {Explanation — (A) SGR = ROE × [(net income ? dividends) / net income] = (15 million / 50 million) × (15 million ? 5 million) / 15 million = 20.0%} 10. Supergro has current dividends of $1, current earnings of $3, and a sustainable growth rate of 10%. What is Supergro’s return on equity? A) 12%. B) 20%. C) 15%. {Explanation — (C) The ROE for Supergro can be determined by solving for ROE in the sustainable growth formula: ROE = 10% / [1 – ($1/$3)] = 15%}