CFA Practice Question

A consulting firm is currently under contract with a Busy Bus and Van Lines, Inc., and has agreed to formulate various financial reports and trend projections for the Company. During the most recent month, the consulting firm has been able to determine the following; Busy Bus and Van Lines currently pays out 30% of its net income as dividends, and this rate is expected to remain stable. Additionally, Busy has maintained a steady ROE of 15% for the last ten years, and this is also expected to remain stable. The risk-free rate of return is 5.35%, and the firm is in a 35% combined state/federal income tax rate. Finally, Busy Bus and Van Lines has informed the consulting firm that its shareholders require a 12.5% or greater rate of return, and the firm's common stock is priced at \$9.65.

Using the Retention Growth Rate method, which of the following most closely resembles the growth rate of Busy Bus and Van Lines, Inc.?
A. 19.5%
B. 15.85%
C. 10.5%
Explanation: When security analysts estimate growth rates, the Retention Growth Rate method is often the method employed. In estimating growth using this model, the retention rate (defined as the percentage of net income that is retained within the firm and not distributed as dividends), is multiplied by the figure for ROE. The calculation of the answer in this example is as follows: {[1 - payout ratio 30%] * ROE 15%}= 10.5%. This method is most useful when the growth rate or the components of the equation are expected to remain stable.

User Comment
chamad Too many data. We have to be careful with such questions. They're so time consuming!!!
hannovanwyk you just read the last part, determine what they ask, gun the formula down, and extract the necessary data.
takor That is well put, Hannovan. But when you run out of ammunition, you get confused what formula to gun down!
copus In some of these question, they give you a whole bunch of information, the half of which is not relevant. Watch out for these red herrings - if you know your formulas, it should be relatively easy to weed out the irrelevant information. Half the battle in this CFA is knowing the formulas (check out the CFA Level 1 Formula Sheet on this website)
JeffAu The other half is to skip the "essays"
cswisher Can anyone help clarify where to find the CFA Level 1 Formula Sheet that "copus" mentioned above? Thanks!
moneyguy @cswisher: On our homepage for analystnotes, select "study notes" and go to very bottom of all the notes. "Formula Sheet" can be found there.
MXXL g =Retention Rate * ROE

Retention Rate = 1 - (Dividend paid / Operating Profit After Tax)

30 percent of net income is paid as dividend, so Dividend Paid / Operating Profit After Tax (Also Net Icome in this case) = 0.3

So Retention Rate = 0.7

All we have to do now is to compute
g= Retention Rate * ROE = 0.7 * 0.15 = 0.105