CFA CFA Level 1 CFA Level 1 Question of the Week: Equity Investments

# CFA Level 1 Question of the Week: Equity Investments

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• 2

Erica Crenshaw is analyzing the value of Mindshare Inc. at the end of 2012. Erica gathers the following financial information about Mindshare Inc.

Dividend in year 2012                                             \$3.40

Growth rate in dividend during the next two years    20%

Growth rate in dividend in year 3                              14%

Growth rate in dividend for year 4 and beyond          10%

Weighted average cost of capital                               13%

Cost of equity capital                                                15%

The value of Mindshare Inc.’s share is best estimated as:

• \$91.7
• \$96.4
• \$212.7
• 5

Sure @hardj!  So the dividend in time period 1 is actually 2013.  The question has a dividend paid in 2012, but is valuing the company at the end of 2012, so the 3.40 dividend was already paid.

And @simply_complex2 , the 4th and beyond formula is raised to the 3rd instead of the fourth because of the way the formula is designed.  The perpetuity valuing formula is set up to value the perpetuity at the beginning of the period.  The other dividends are being valued at the end of each period.  So the end of period 3 gets the same discount as the beginning of period 4.

Sometimes it helps me to visualize questions by setting them up in excel (also, I am a nerd and enjoy modeling things in excel!}.  Attached is an excel workbook that shows the calculation with an actual stream of dividends past year 4.

• 5

wm247, I would calc the cashflow and the terminal value first.  Then, I would use the CF input function in the calculator and compute the NPV.

• 4

@exam_whiz can you explain why the dividend in Time Period 1 is \$4.08 vs. \$3.40. I think I know the answer but I’m having trouble grasping the concept. The dividend paid at the end of 2012 (Year 1) was \$3.40. The dividend then grew by 20% to \$4.08 in 2013 (2nd year). Are you using \$4.08 in Time Period 1 since this is the future value in year 2 which is being discounted to its PV in Year 1?

• 4

I get \$91.7

CF1 = 3.4(1.2) = 4.08/(1.15) = 3.54783
CF2 = 4.08(1.2) = 4.896/(1.15)^2 = 3.70208
CF3 = 4.896(1.14) = 5.58/(1.15)^3 – 3.66894
CF4 and beyond = 5.58(1.10) = 6.13958/(.15-.10)= 122.7916/(1.15)^3 = 80.73727

3.54783+3.70208+3.66894+80.73727 = 91.65612

• 3

I got 95.83

• 3

can someone clarify why we would raise the 4& beyond calculation to the third power instead of the fourth?

• 2

@aylouis13, I used cost of equity as well and I believe that is the correct rate of return. In my opinion, the WACC should be used for FCFF or FCFE. Since we’re talking about dividends, it should be cost of equity as the rate of return.

• 1

I got \$91.78. Pretty sure I got this wrong, but I’m not sure where I went wrong! I used the cost of equity to discount back – should I have used the WACC?

• 1

What I don’t like with this kind of question is that no way on Earth I’m going to solve this within 1.5 minutes during the real exam environment… while ironically, I can solve this in my leisure if you give me like 10-15 minutes. 🙁