CFA CFA Level 1 Corporate Finance Questions

Corporate Finance Questions

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• 1

I have some questions for Level 1 for anyone who can help.

1.) So the discounted cash flow approach to cost of retained earnings is Ks = D1/P0 + g, where g = retention of net income divided by ROE. Aren’t we mixing apples and oranges here? We’ve got a market-based number (Dividend Yield (stemming from a stock’s market value)) blended with a book value (ROE). Am I to assume that the P0 piece is measured at cost? If not, how does this jive toward something helpful?

2.) When we compare projects with unequal lives, one method is the replacement chain method. Since the IRRs of the projects remain constant, why would I bother calculating a revised NPV for each project? Why wouldn’t I just go with the better IRR?

3.) Say a company sells 10 million widgets at \$10/widget, they have \$3/unit variable costs and \$50 million in fixed costs. DOL = change in EBIT/change in Sales, or DOL = (Q(P-V))/((Q(P-V))-F). Using the latter method, DOL = (10 million(10-3))/((10 million(10-3))-50 million) = 70 million / 20 million = 3.5.

Now let’s try the first method. Say sales drop to 80 million = Sales2. EBIT2 = 80 million – (\$3 * 8 million) – \$50 million = \$6 million. Ebit1 is unchanged = 100 million -(\$3 * 10 million) – \$50 million = 20 million.

DOL = (EBIT1 – EBIT2)/(Sales1-Sales2) = (20-6)/(100-80) = 14/20 = .7

.7 does not equal 3.5. What am i doing wrong?

• RaviVooda
Participant
• CFA Level 3
5

For Question-1, The growth rate(g) is RetentionRate multiplied with ROE [Not Divided by]

Yes, you are right. My question still stands. Aren’t we blending a market value measure with a book value measure?

I dont think we are mixing it, As per GGM if D1, g and K are known that is what the ideal price should be. (for a regular dividend paying company)

• RaviVooda
Participant
• CFA Level 3
3

For Question-2, We prefere NPV to IRR for three reasons.

1. IRR calculation is ineffective when we have both positive and negative cash flows. Such cash flows can give multiple IRR solutions. The advantage of NPV here is that it can handle multiple discount rates with out any problems.

2. For longer periods, the discount rate usually changes, So it is difficult to get same return for longer period. In such cases NPV gives better picture.

3. Say the discount rate of project is not known, then how will you say that your IRR is good or bad? because we say IRR is good if it is more than the discount rate. In such cases, we use NPV since we can directly say if NPV>0, the project is financially viable.

• 3

For Question-1, The growth rate(g) is RetentionRate multiplied with ROE [Not Divided by]

Yes, you are right. My question still stands. Aren’t we blending a market value measure with a book value measure?

• 3

On DOL I think you are confusing percentage changes with \$ figure changes.

DOL of 3.5 means that for a 20% drop in sales, you’ll experience a 20% * DOL = 20% * 3.5 = 70% drop in EBIT.

I think if you re-do your calculations using the ratio of percentages you’ll get a more sensible answer.

• RaviVooda
Participant
• CFA Level 3
1

For Question-1, The growth rate(g) is RetentionRate multiplied with ROE [Not Divided by]

• 1

My question still stands. Aren’t we blending a market value measure with a book value measure?

You are using a company’s ROE and retention rate to approximate the growth rate. A company can only grow if it has the capital to do so. If a company is not making any return (I.e. ROE is zero) then it cannot grow. If it is making a return, then growth will depend on how much of that return is kept within the company.

For example, if a company has starting equity of Â£100, and ROE of 10%, then at the end of the year the equity should be Â£110. Assuming 100% of this (Â£10) is paid out as a dividend, then equity drops back to Â£100. ROE is still 10%, so the company will make Â£10 the second year, and so on.

Now, assume that in the same example the company only pays 50% (Â£5) as a dividend. Equity would drop back to Â£105. Then in year 2, ROE of 10% would mean that equity grows to Â£115.5. Again, paying out half of the annual return as a dividend (Â£5.25) reduces equity to Â£110.25. Against the previous year equity value of Â£105 this shows growth of 5.0% (the same as in the RR x ROE equation).

• 0

My question still stands. Aren’t we blending a market value measure with a book value measure?

You are using a company’s ROE and retention rate to approximate the growth rate. A company can only grow if it has the capital to do so. If a company is not making any return (I.e. ROE is zero) then it cannot grow. If it is making a return, then growth will depend on how much of that return is kept within the company.

For example, if a company has starting equity of Â£100, and ROE of 10%, then at the end of the year the equity should be Â£110. Assuming 100% of this (Â£10) is paid out as a dividend, then equity drops back to Â£100. ROE is still 10%, so the company will make Â£10 the second year, and so on.

Now, assume that in the same example the company only pays 50% (Â£5) as a dividend. Equity would drop back to Â£105. Then in year 2, ROE of 10% would mean that equity grows to Â£115.5. Again, paying out half of the annual return as a dividend (Â£5.25) reduces equity to Â£110.25. Against the previous year equity value of Â£105 this shows growth of 5.0% (the same as in the RR x ROE equation).

I got it. That makes sense. I’m with you. Not only am I with you, but the implication to cost of capital is that a company that pays no dividend would basically have its ROE as its Kce.

Here’s where I’m still lost: to this ROE * retention figure that you have explained and on which I am totally clear, we get the total picture of Kce by adding in the dividend yield. That dividend yield…is that the (Dividend/share)/Market Price of stock? Or is that (Dividend/share)/Book price of stock? Because if it’s the former, we’re blending a market value (dividend yield) with a book value (ROE).

Thank you everyone for your help on this.

Can anyone help with DOL, DFL, DTL?

• 0

I haven’t read back through the text books, and did L1 a couple of years ago, but can I just check that what you’re trying to do is find out the intrinsic value of a share, and see if it’s over/under valued? Or are you looking at something else?