CFA-Level-2 – Chartered Financial Analyst Level 2

Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.

Ferguson Department Stores, Inc.

FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.

At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18.

In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.

In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:

Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.

Statement 2: A high E/P implies the security is overpriced.

Given Emery's dividend forecast for FDS, is the H-model the appropriate valuation model to use to value FDS?

Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.

Ferguson Department Stores, Inc.

FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.

At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18.

In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.

In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:

Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.

Statement 2: A high E/P implies the security is overpriced.

Assuming that the cost of equity for FDS does not change, the present value of growth opportunities in the share price following the announcement that the company would be expanding its retail operations, using Emery's 2009 earnings forecast, is closest to:

De Jong continues her analysis of O'Connor. She is concerned that along with a dividend discount model approach she would also like to get a measure of the contribution that the key managers, Melanie and Arthur O'Connor, have made to the company's apparent ongoing success.

She considers using NOPAT and EVA to assess management performance. She believes that increasing invested capital to take advantage of projects with positive net present values increases both NOPAT and EVA.

However, De Jong decides to use residual income analysis instead. She provides the following justification for using the residual income model:

• The calculation of residual income depends primarily on readily available accounting data.

• The residual income model can be used even when cash flow is difficult to forecast.

• The residual income model does not depend on dividend payments or on positive free cashflows in the near future.

• The residual income model depends on the validity of the clean surplus relation.

She also considers the following assumptions about continuing residual income:

Assumption 1: Residual income is positive and continues at the same level year after year.

Assumption 2: As return on equity approaches the cost of equity, residual income tends to zero. Assumption 3: Residual income growth declines overtime and eventually reaches zero.

De Jong gathers recent financial information data on O'Connor, as shown in Exhibit I.

De Jong has also determined that at the beginning of 2008, O'Connor had total capital of $324,000,000, of which $251,000,000 was debt and $73,000,000 was equity. The company's cost of debt before taxes is 7%, and the cost of equity capital is 8%. The company has a tax rate of approximately 34%. Weighted average cost of capital is 5.4%. Net operating profit after tax (before any adjustments) is $28,517,640.

De Jong is interested in obtaining the market's assessment of the implied growth rate in residual income and notes that the book value per share for O'Connor at the beginning of 2009 was $4.29, and the current market price is $70. She forecasts the return on equity (ROE) for 2009 to be 11.84%.

De Jong discusses her analyses with a colleague, who makes the following general statements:

O'Connor's residual income and economic value added (EVA) for 2008 are closest to:

Residual income ;EVA