CFA CFA-Level-II Exam (page: 27)
CFA Level II Chartered Financial Analyst
Updated on: 09-Feb-2026

Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.

Following an acquisition of a major competitor in 1992, O'Connor went public in 1993 and paid its first dividend in 1999. Dividends are paid at the end of the year. After 2008, dividends are expected to grow for three years at 11%: $2.13 in 2009, $2.36 in 2010, and $2.63 in 2011. The average of the arithmetic and compound growth rates are given in Exhibit 1. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts. O'Connor's annual dividend history is shown in Exhibit 1.


De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model.



The output from the regression appears in Exhibit 2.



De Jong determines that employing the CAPM to estimate the required return on equity suffers from the following sources of error:

• Estimation of the model's inputs (e.g., the market risk premium). The company's dividend payment schedule.
• The accuracy of the beta estimate.
• Whether or not the model is the appropriate one to use.

De Jong observes that two reputable statistical analysis firms estimate betas for O'Connor stock at 0.85 and 1.10. She concludes that the differences between her beta estimate and the published estimates resulted from her use of standard errors in her regression to correct for serial correlation; the other firms did not make a similar adjustment.

De Jong considers using adjusted beta in her analysis. Typically, her company uses 1/3 for the value of a0. However, in this case, she is considering using a0 = 1 /2. She determines that her adjusted beta forecast will be closer to the mean reverting level using this value than it would be using a value of 1/3.

Is De Jong correct with respect to her conclusions regarding the causes of the differences between her beta estimate for O'Connor and the published beta estimates, and her strategy for adjusting her beta estimate to more quickly approach the mean reverting level of beta?

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 cash flows 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:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

Is De Jong correct about the likely effects on NOPAT and EVA from increasing invested capital to take advantage of projects with positive net present values?

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 cash flows 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:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

Are De Jong's justifications for using the residual income model correct?

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 cash flows 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:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

Which of De Jong's assumptions about continuing residual income is least appropriate!

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 cash flows 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:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

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