CFA Practice Question

There are 96 practice questions for this study session.

CFA Practice Question

Beth is evaluating HRL Co. which started its business two years ago. Last year its growth was 14%. The risk-free rate is 4% and expected equity premium is 6%. Here is her forecast of the company's future dividend growth trend.

After considerable study, she has decided to use the following information in her valuation (as of the end of 2004):

  • Beta: 1.3.
  • 2004 dividend: $5.
  • The risk-free rate: 4%.
  • Expected equity premium: 6%.

What is the value of the HRL's stock?
Correct Answer: Company HRL can be valued using the three-stage DDM. Its growth is stable during the first two years. Then a period of linear transition is expected during 2007 - 2010 until the growth stabilizes at 8%. The required rate of return on HRL stock is rHRL = rf + beta x market premium = 0.04 + 1.3 x 0.06 = 0.118, or 11.8%.

We first calculate the value of HRL at the end of 2006 using the H-model with H= 2. VHRL2006 = [D2006 (1 + gL) + D2006 H(gS - gL)] / (r - gL) = [5 (1 + 0.14)2 (1 + 0.08) + 5 (1 + 0.14)2 x 2 x (0.14 - 0.08)] / (0.118 - 0.08) = $205.26.

We discount this value along with the first two dividends to find the sock's present value:

User Contributed Comments 9

User Comment
danlan2 We can not use H-Model from 2004, but can use it from 2006, since the growth rate change is not constant.
Smiley225 agree, possibly a typo. But use H-model to 2006 value, then PV back to 2004. Then dont forget to PV the 2 dividends in 2005 and 2006.
rhardin I worked this out using the cashflow function in my calculator and got 316.70. Did any one else try to work it out manually?
REITboy Worked it out manually, and got $170.34 based on the following CFs, beginning with C01: 5.70, 6.50, 7.31, 8.11, 8.89, and 9.60+272.63=282.23.
arudkov 2 EITboy - got almost the same (rounding influenced, CF1 5.675)
quanttrader use the H model from beg of yr 2007 to end of year 2010; ie H = 4 /2 =2. and then discount value back 2 years along with previous dividends.
quanttrader discount the H model terminal value by 2 periods (end of year 2006 to end of 2004), the 2006 dividend by 2 periods, and the 2005 dividend by 1 period.
philjoe I also got 170.34 doing it manually...
davidt876 you guys realise you're not supposed to be doing it 'normally' - right?

they explicitly ask you to calculate using the H-model on the exam, so you need to know how to use it. if you're not sure why the answers come out different, read the first 2 paragraphs of my answer on the previous question.
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