CFA CFA Level 2 Kaplan Equity Self-test question 8

Kaplan Equity Self-test question 8

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    • rhuang2
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      The growth rate of a firm is 25% and required return is 14%. Hence r-g is negative and GGM couldn’t be applied based only on the info given in the question. However, Kaplan’s answer says although single state GGM cannot be applied, switching to a multi-stage GGM is appropriate. but the question did not specify two different require rate of return. I think the answer implies that we must automatically assume a higher rate of return whenever we see a negative r-g. I think this is misleading…. What are your guy’s opinion? Can we just change assumptions like this on the test?

      Thanks,
      Ryan Huang.

    • Stuj79
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      Is there a “long term” growth rate explicitly given? Or a ROE and retention ratio to calculate a long term “g”?

      If not, then what growth rate are you supposed to use even in the multi-stage model?

      I would imagine (although don’t quote me on this) that in the FCA exam proper, there would be no ambiguity like this. Seems like a poor answer to me to just say “assume a higher rate of return”….I mean how are we supposed to calculate this magical “higher rate”?

    • rhuang2
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      Nope, except a long term required return of 14% plus a 25% near term growth rate given, there’s nothing else. That’s exactly why I thought the question is poorly formulated — how am I going to magically assume a higher rate. I’m going to send an error report to Kaplan (again…). Thanks.

    • Stuj79
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      Having reread your question, I think instead of assuming a higher rate of return, you should assume that the short term high rate growth will eventually have to slow down to a lower, long term growth rate.

      I mean was the question asking you to calculate anything specific, or was it just a conceptual question about which discount/valuation model to use (e.g. single stage vs multi stage)

      If it was juts a conceptual thing, then I can sort of see where they are coming from…still not a great question though.

      It’s difficult to comment fully without seeing the full question, along with multiple choice answers provided.

    • rhuang2
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      It’s a very long passage, but to shorten it, here it is: 

      Firm 2 is a major software manufacture that has a consistent track record of paying dividends that is related to its earnings. The firm is projected to have a growth rate of 25% for the next five years and has an estimated required rate of return of 14%. The valuation of Firm 2 will be included in a research report targeted toward common investors. 
      Q: Would it be appropriate to use a DDM to value firm 2? 
      A. Yes
      B. No, DDM is only used when an investor takes the perspective of a major shareholder
      C. No, because the dividend growth rate is higher than the required rate of return. 

      I just figured it’s rather a trick question that required me to assume I can assign a higher rate of return in the beginning. I would be surprised if the CFA institute uses this type of trickery so it should be Kaplan’s problem. At least I think all the questions were fair on Level 1. 

    • Stuj79
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      I don’t think you should assume a higher required rate of return at the start, I think you should assume a lower growth rate at the end. They mention 25% growth for 5 years – then stupidly I guess they assume you just assume that the growth rate after that is not only lower than 25%, but also lower than the required rate of return of 14%.

      I guess technically you can still use a DDM, you just use a multi stage one – but yeah, the question is pretty poorly written as it relies on assumptions. I mean wheat if the long term growth rate was 20%….then it wouldn’t work.

      Bad question in my opinion.

    • rhuang2
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      Thanks, I’ve filed a report with Kaplan. I feel their study  material is not as good as they were a couple of years ago — lots of errors. 

    • CFA_redemption_12713
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      I agree with Stuj79 here, think the key to the question is the 5 years, usually they’ll say 6% for the foreseeable future or something along those lines. I also agree that Kaplan isn’t as good as it has been, I’ve been mostly using the CFAI and then switching to the Kaplan Q bank when i get a few free moments at work. Anyone have an reccs on possible mock exams beyond CFAI/Kaplan that have worked well?

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