CFA Practice Question

CFA Practice Question

Consider the following annual growth forecasts for a common stock:

Growth in years 1-3 = 25%
Growth after year 3 = 15%

Assuming that the last dividend was $2.25 per share, and the required rate of return is 20% per year, what is the value of this common stock?
A. $63.78
B. $58.23
C. $65.82
Explanation: To determine the value of a common stock experiencing temporary supernormal growth, use the following equation: {V = {[d0 x (1 + gs)1] / k} + {[d1 x (1 + gs)2} + ... {dn x (1 + gs)n} + {[dn x (1 + gs)n x (1 + gn] / (k - g)} / (1 + k)n}}
where: V = the value of common stock at t0, d0 = the dividend at t0, d1 = the dividend at t1, dn = the dividend at tn, gs = the supernormal rate of growth, gn = the normal rate of growth, n = the time period "n", and k = the required rate of return.

In this example, there is a supernormal growth period of three years, during which the growth rate of this common stock is expected to grow at 25% annually. After this period of supernormal growth, the growth rate is anticipated to settle to a "normal" rate of 15%, and this rate is expected to remain stable indefinitely. The calculation of the value of this common stock is illustrated as follows: {V = {[$2.25 x (1.25)1] / (1.20)} + {[$2.25 x (1.25)2] / (1.20)2} + {[$2.25 x (1.25)3] / (1.20)3}{{[$2.25 x (1.25)3 x (1.15)1]/ (0.20 - 0.15)}/ (1.20)3} which can be deduced to the following: {V = [$2.34375 + $2.441406 + $2.543132 + $58.492025] = $65.82}

User Contributed Comments 19

User Comment
dealsoutlook long question and pretty hard as well
mulira try this
PCS= Div1/1+0.2+Div2/(1.02)^2+div3/(1.02)^3 +div4+ PCS4/(1.02)^4.
Where PCS4 = Div5/rce-g
grow div 1,2,3 by 25% and div4 by 15%.
jackwez D1!!! everytime!!! D1!!!
StanleyMo i was thinking should the after year 3 aka year 4 divide by (1.2)^4 rather than 3.
cwa4 StanleyMo, I thought the same and missed the q. On pg. 133 footnote b of reading 56 it describes why this year is used. In this case the third year is used because the valuation of the remaining stream is made at the end of the third year to reflect the dividend in year 4 and all future dividends.
tommyguard3 how are we supposed to remember this? anyone have any tricks?
tommyguard3 Only thing I found still isn't great

V = DoGs Nose over Kats Nose & DoGs Need of Goons over Kats without Goon over Kats Nose

-> V=(D x (1+gs)^n)/(1+k)^n)...+ (D x (1+gs)^n x (1+gn)/(k-g))/(1+k)^n
mary11 sigh... that is harder then the formula.
moneyguy Goon dogs cats birds fig tree driveway cats goon nose orange juice kitchen floor dogs cats

solve for dog
mjwoulf 90 seconds...come on!
SKIA nice one, moneyguy
jjhigdon Yea, the time is the most challenging part of this one. Easy and basic concept, but I made a math error somewhere trying to do it quickly...
kaulin Find your dividends:
Discount D4 to get price@T=3...5.05371/.2-.15
put into cash flow in calculator, use k (.2) as irr and solve for NPV
asalonga7 questions like these are the ones i would hope to get part marks for while in school - sometimes multiple choice sucks
praj24 Kaulin you LEGEND!
thebkr7 @Kaulin YOU SAVED THE DAY!!!
merc5559 @Kaulin!!!
Cain621 Thank you Kaulin
atlootah @Kaulin ur a G
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