# Thread: Sample CFA Level 2 question bank for June 2013 exam

1. Solution for 15th March (Equity):

Ans 1. B
Ans 2. A
Ans 3. B
Ans 4. C
Ans 5. C
Ans 6. B  Reply With Quote

2. @Konvexity# Sir, plz explain relationship b/w ROE, Stock price & Persistence factor (answer 5 & 6 for Solutions to Item set for 14-March)  Reply With Quote

3. 15th March Item Set:

1-b
2-b
3-a
4-b
5-c
6-c  Reply With Quote

4. Solutions to Item Set for 15-March

1. Correct Answer is B: Justified P/S ratio = Profit margin*Justified trailing P/E ratio. Growth rate = ROE*retention ratio = (120/600)*0.333 = 6.66%. Required return on equity = 6% + 0.8*10% = 14%. Justified trailing P/E ratio = (1-retention ratio)*(1+g)/(r-g) = (1-0.33)*(1+0.067)/ (0.14-0.067) = 9.69. Justified P/S ratio = 0.1*9.69 = 0.969.
2. Correct Answer is B: Justified P/B ratio = (ROE-g)/(r-g) = (0.20 – 0.067)/ (0.14-0.067) = 1.82.
3. Correct Answer is A: The stock is overvalued. The growth rate of industry is more than that of stock and also the required return on equity is lesser for industry than the stock. So, the only reason could be the overvalued stock.
4. Correct Answer is B: The PEG ratio implies that the impact of growth rate is linear on the stock while in fact the impact of the growth rate on the stock price is non-linear.
5. Correct Answer is C: Justified dividend yield = (r-g)/ (1+g). As we can clearly see that it is negatively related to the growth rate.
6. Correct Answer is B: The statement made by Roshan regarding the calculation of average industry multiples is wrong. The two best methods are to take median and weighted harmonic mean. Arithmetic mean is not a good measure as outliers impact the arithmetic mean the most  Reply With Quote

5. Item set for 16-March (Equity):

Philip Rodrigues Case Scenario

Philip Rodrigues is an analyst at Value Tigers. He is specialist in automobile sector. His fund manager has asked him to value few companies. He has to do absolute valuation rather than relative valuation. He is valuing Amazing Motors. The data about the company is given in Exhibit 1.

Exhibit 1

 Dividend paid last year \$2.5 million Common shares outstanding 500,000 Beta of the stock 1.2 Annual risk-free rate 4.0% Market risk premium 8.0% Earnings of the last year \$5 million Marginal tax rate 40.0% Profit margin 8.0% Asset turnover ratio 1.2 Financial leverage 1.5

The company has a long history of dividend payments. So, he decides to use dividend discount model to value the company. The company is a mature one and is expected to grow at a sustainable growth rate.
The value calculated by him comes out to be greater than the current market price of the stock. He shows his valuation results to his fund manager, Stephan Kinsella. Stephan finds the stock attractive and asks Philip to do scenario analysis on the stock. Philip asks him what all inputs he should change for the scenario analysis.
Stephan: As you have used Gordon growth model, it is most sensitive to the growth rate and the required return on equity. The higher is the spread between those, the lower is the value of the company. As the spread becomes narrow, the value of the stock rises sharply.
Philip: Okay. What other factors should I consider?
Stephan: Since you are using GGM (Gordon Growth Model), the only inputs to that model are current dividend, sustainable growth rate and the required return on equity. You can also use normalized earnings in your model to come out with the correct estimate of the dividends. One more thing you can look for is the present value of growth opportunities. The value of the company without growth opportunities will give us a base case for our analysis.
After doing scenario analysis, Philip allocates probability to the scenarios. He gives 20% probability to each worst case and best case scenario and 60% probability with the normal case scenario. The stock value after probability allocation comes out to be lower than the earlier calculations. However, the stock is still undervalued as compared to the market price.
Stephan asks Philip to calculate the implied rate of return provided by the market price so that they can look at the spread (margin of error) they can expect to earn by investing in that stock. The current stock price is \$65.5.
Philip calculates the spread. He also asks whether they are taking a majority stake in the firm or the minority stake and would that impact the valuation of the company.
Stephan: We are taking a minority stake. But there won’t be any impact in the value of the stock. In case of majority stake, we can change the disbursement of dividends policy and free cash flow is a better approach for valuation.

1. What is the sustainable growth rate for Amazing Motors?
a) 5.14%
b) 7.20%
c) 12.00%

2. What is the value of company per share using Gordon Growth model?
a) \$78.12
b) \$83.75
c) \$335.00

3. What is the present value of the growth opportunities per share?
a) \$10.22
b) \$46.99
c) \$221.36

4. Is Stephan accurate about the difference between the valuation of majority and minority stake?
a) Yes, because the value of stock will remain the same as there won’t be any impact on earnings on changing the stake
b) Yes, because the free cash flow approach and dividend discount model always give the same value
c) No, the value of majority stake is typically higher than the minority stake

5. What is the justified trailing P/E ratio of the company?
a) 8.37
b) 7.81
c) 6.55

6. How much spread they can expect to earn by investing in the company?
a) 1.23%
b) 1.44%
c) 1.78%  Reply With Quote

6. Originally Posted by Shubhojit @Konvexity# Sir, plz explain relationship b/w ROE, Stock price & Persistence factor (answer 5 & 6 for Solutions to Item set for 14-March) Originally Posted by Konvexity Institute Solutions to Item set for 14-March

1. Correct Answer is B: ROE for 2012-13 = 72/400 = 18%. ROE for 2013-24 = 18%. Residual income for 2013-14 = (0.18-0.12)*450 = \$27 million. The market value of equity = B0 + RI1/ (1+r- ω) = 450 + {27/ (1+0.12-0.8)} = \$534.375 million. Value of stock per share = 534.375/1.2 = \$445.31.
2. Correct Answer is B: The present value of the company’s expected economic profit = \$534.375 - \$450 =\$84.375 million.
3. Correct Answer is C: If the residual income persists forever, then the value of the company = 450 + (27/0.12) = \$675 million.
4. Correct Answer is C: According to clean surplus relation, the ending book value = 25 + 7 -5 = \$27. As the relation is violated, the ending book value can’t be equal to \$27.
5. Correct Answer is B: Rahul is incorrect about the driving factors. The higher is the spread between ROE and required return on equity, the higher is the stock price.
6. Correct Answer is B: High ROE is associated with lower persistence factor as it would be difficult for the company to manage a high ROE in the long-run.
Though Konvexity has given brief explanations , I hope this will help

Answer - 5 Regarding value of Equity I said.... I mean Rahul said - "The lower is the spread between ROE and required return on equity (r), the higher is the value of the equity." But as we know in valuation formula we have (ROE-r) in numerator . So the spread between ROE and r is directly proportional to value of equity. So Rahul was wrong. (gaawwddd I feel like I am too wrong over something when I say Rahul was wrong)

Answer - 6 Lower persistence factors will be associated with:
a- High accounting ROE - as explained by Konvexity, it would be difficult for the company to manage a high ROE in the long-run and it will eventually come to a long run mean. Decay will be faster if ROE is extreme high indeed making persistence factor lower.
b- Significant levels of non-recurring items
c- High accounting acruals

option b in the question oppose the point a here. So marked for least likely.    Reply With Quote

7. Solutions to Item set for 16-March

1. Correct Answer is B: Sustainable growth rate = PRAT = profit margin*retention ratio*asset turnover*leverage = 0.08*{(5-2.5)/5}*1.2*1.5 = 7.2%
2. Correct Answer is B: The value of the company = D1/ (ke-g). D1=D0*(1+g) = (2,500,000/500,000)*(1+0.072) = 5*1.072 = \$5.36. ke= 0.04 + 1.2*0.08 = 13.60%. Value of the company = 5.36/(0.136 – 0.072) = \$83.75
3. Correct Answer is B: The present value of growth opportunities = the value of stock with growth – the value of stock without growth = 83.75 – (E/ke) = 83.75 – (5,000,000/500,000)/0.136 = \$10.22.
4. Correct Answer is C: No, Stephan is not correct because the value of company can differ depending on the stake. The majority stakeholder can exercise more power and the company is generally more valuable to the majority stakeholder.
5. Correct Answer is A: The justified trailing P/E ratio = P/E0 = 83.75/10 = 8.375.
6. Correct Answer is C: Implied required rate of return = (D1/P) + g = (5.36/65.5) + 0.072 = 15.38%. The spread = 15.38% - 13.60% = 1.78%.  Reply With Quote

8. Item set for 17-March (Equity):

Ashish Joshi Case Scenario

Ashish Joshi is an equity analyst with DaulatGuru. His area of expertise is to value thinly traded companies. Brooklyn Inc. is also a thinly traded company. The company operates into energy distribution space. Mintax Limited is another company which also operates in the same sector. The details for Mintax Limited have been given in Exhibit 1.

Exhibit 1
Mintax Limited

 Required rate of return on equity 12.0% D/E ratio 0.667 Risk-free rate 6.0% Rate of return from the market 10.0% Marginal tax rate 40.0% Marginal before-tax cost of debt 10.0%

Ashish uses Mintax Limited as benchmark for Brooklyn Inc. and calculates the beta of Brooklyn Inc. The details for Brooklyn Inc. have been provided in Exhibit 2.

Exhibit 2
Brooklyn Inc.
 D/E ratio 0.8 Marginal tax rate 35.0% Marginal before tax cost of debt 10.5%

Ashish calculates the value of Brooklyn Inc. using that beta and finds out that the company is undervalued. He invests in the stock at \$12.5 per share.

Jachim Gobien is another analyst with DaultGuru. He has some doubts related valuation. He discusses those doubts with Ashish Joshi.

Jachim: I have been valuing conglomerate companies. I have observed that the overall value of company is less than the sum of the parts of the company. What is the reason behind that? As per my finance theory, the company value should be higher because of the low cost of financing and economies of scale.

Ashish: The conglomerate businesses generally trade at a discount. That is because of the ineffective capital budgeting. The company might also have pursued into unrelated businesses to hide the poor operating performance.

Jachim: I have used Fama French model to value the cost of equity for Yemex Inc. which is coming as 7.8%. But my fund manager is asking me to adjust the cost of equity for liquidity factor as well. The liquidity risk premium is 2.5% and the company’s factor beta towards liquidity is -0.3. Which model should I use to calculate the cost of equity?

Ashish: You should use Pastor-Stanbaugh model. That model accounts for the liquidity factor as well. The base value for the liquidity factor is one. But while calculating do check the other factor beta as well. They might get changed because of addition of one more variable in the regression equation.

Jachim: That thing I have already checked. There have been no changes in the factor betas for other variables. I was also studying an equity research report about a company which is going to liquidate. There were two different values for the company assuming normal liquidation and orderly liquidation. What is the difference between those two values?
Ashish: The orderly liquidation assumes that the company will be liquidated but in the ordered fashion and the value of the company using orderly liquidation is more than without orderly liquidation.

Jachim notices the Bloomberg screen on the system of Ashish. He notices that there has been sharp unexpected steepening of the Treasury yield curve in last few days. He has used one macroeconomic multifactor model to calculate the cost of equity of a stock. He takes leave from the company of Ashish to adjust the changes due to the steepening of curve in his macroeconomic multifactor model.

1. What is the asset beta for Mintax Limited?
a) 0.90
b) 1.07
c) 1.50

2. What is the cost of equity for Brooklyn Inc.?
a) 11.47%
b) 12.48%
c) 13.12%

3. What is the holding period return for Ashish if he sells the stock for \$18 per share after 2 years?
a) 20.00%
b) 22.00%
c) 44.00%

4. Which of the following statements made by Ashish Joshi is least accurate?
a) Regarding conglomerate discount
b) Regarding liquidation of a firm
c) Regarding Pastor-Stanbaugh model

5. What is the cost of equity for Yemex Inc. using Pastor-Stanbaugh model?
a) 7.05%
b) 8.55%
c) 10.3%

6. Which of the following risk factors is most likely to be affected by the steepening of the Treasury yield curve?
a) Confidence risk
b) Time horizon risk
c) Inflation risk  Reply With Quote

9. Interesting question...Ashish is our star analyst   Reply With Quote

10. Originally Posted by rahuldaga89 Though Konvexity has given brief explanations , I hope this will help

Answer - 5 Regarding value of Equity I said.... I mean Rahul said - "The lower is the spread between ROE and required return on equity (r), the higher is the value of the equity." But as we know in valuation formula we have (ROE-r) in numerator . So the spread between ROE and r is directly proportional to value of equity. So Rahul was wrong. (gaawwddd I feel like I am too wrong over something when I say Rahul was wrong)

Answer - 6 Lower persistence factors will be associated with:
a- High accounting ROE - as explained by Konvexity, it would be difficult for the company to manage a high ROE in the long-run and it will eventually come to a long run mean. Decay will be faster if ROE is extreme high indeed making persistence factor lower.
b- Significant levels of non-recurring items
c- High accounting acruals

option b in the question oppose the point a here. So marked for least likely.  @Rahul Daga :- Thanks a lot buddy..!! U explained points beautifully :-)  Reply With Quote

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