CFA Asset Valuation 3 — Questions and Answers
Question 1: In a two-stage dividend discount model, the terminal value at the end of Stage 1 is calculated using:
- The historical average dividend growth rate
- The Gordon Growth Model applied to Stage 2 dividends (Correct answer)
- The sum of all Stage 2 dividends discounted to Year 0
- The book value of equity at the end of Stage 1
Correct answer: The Gordon Growth Model applied to Stage 2 dividends
The terminal value applies the constant-growth Gordon model to the first dividend of Stage 2, then discounts it back.
Question 2: Which of the following best describes the concept of a 'margin of safety' in value investing?
- Buying securities with high momentum to outperform the market
- Purchasing an asset at a price significantly below its intrinsic value (Correct answer)
- Diversifying across asset classes to reduce volatility
- Selecting bonds rated above investment grade
Correct answer: Purchasing an asset at a price significantly below its intrinsic value
Margin of safety is the discount between market price and intrinsic value, providing a buffer against estimation errors.
Question 3: Residual income for equity valuation is defined as net income minus:
- Dividends paid to shareholders
- The equity charge (beginning book value × cost of equity) (Correct answer)
- Operating expenses and taxes
- Depreciation and amortization
Correct answer: The equity charge (beginning book value × cost of equity)
Residual income = Net income − (r_e × BV_equity_{t-1}), representing value created above the required return on equity.
Question 4: When the required rate of return equals the growth rate in the Gordon Growth Model, the stock value is:
- Equal to the next dividend divided by twice the growth rate
- Undefined because the denominator equals zero (Correct answer)
- Equal to the current dividend times the payout ratio
- Equal to book value per share
Correct answer: Undefined because the denominator equals zero
The denominator (k − g) becomes zero, making the formula undefined and implying infinite value, which is economically impossible.
Question 5: Which of the following is an example of an asset-based valuation approach?
- Discounting projected free cash flows at WACC
- Applying an EV/EBITDA multiple from peers
- Estimating net asset value by marking assets to fair value (Correct answer)
- Using a justified P/E based on dividend payout ratio
Correct answer: Estimating net asset value by marking assets to fair value
Asset-based valuation estimates equity value as fair value of assets minus fair value of liabilities, yielding NAV.
Question 6: A company has EBITDA of $50M and comparable firms trade at an EV/EBITDA of 8x. If the company has $60M of net debt, what is its estimated equity value?
- $400M
- $340M (Correct answer)
- $460M
- $240M
Correct answer: $340M
EV = 8 × $50M = $400M; Equity value = $400M − $60M net debt = $340M.
Question 7: In the context of bond valuation, duration measures:
- The average time to receive the bond's cash flows, weighted by present value (Correct answer)
- The probability of default over the bond's life
- The coupon rate relative to the par value
- The spread between a bond's yield and the risk-free rate
Correct answer: The average time to receive the bond's cash flows, weighted by present value
Duration is the present-value-weighted average time to receive all cash flows and approximates price sensitivity to yield changes.
CFA Asset Valuation 3
In a two-stage dividend discount model, the terminal value at the end of Stage 1 is calculated using: