CFP - Investment Planning (17% of the exam) - Section D.32

Bond and stock valuation concepts

Bond pricing, yield to maturity, yield to call, current yield, duration and convexity; the dividend discount and Gordon growth models, price-to-earnings and other multiples, and intrinsic value versus market price. Items require the calculation and the decision it supports.

Dividend discount modelDuration

Practice question for this objective

Free sampleInvestment Planninghard

A 46 year old client with two children at secondary school asks a planner to value a mature utility share she is considering for her taxable account. The company has just paid an annual dividend of $2.40 a share, and dividends are expected to grow at a constant 5% a year indefinitely. The risk free rate is 4%, the equity market risk premium is 6%, and the share's beta is 1.2. Using the Capital Asset Pricing Model to set the required return and the constant growth dividend discount model to value the share, what is its intrinsic value?

AApproximately $40.65 Correct
BApproximately $22.50
CApproximately $38.71
DApproximately $50.40

Value a share with the constant growth dividend discount model, growing the current dividend one period first and discounting at the required return from the Capital Asset Pricing Model. The Capital Asset Pricing Model gives a required return of 4% plus 1.2 multiplied by 6%, which is 4% plus 7.2%, or 11.2%. The dividend just paid is a historic figure, so it must be grown one year: 2.40 multiplied by 1.05 gives $2.52. The constant growth model then divides that expected dividend by the required return less the growth rate: 2.52 divided by (0.112 less 0.050), or 2.52 divided by 0.062, which is $40.65. Skipping the growth step values the share at $38.71, understating it by about $1.94 a share.

Why A is correct: This grows the current dividend one year to $2.52 and divides it by the required return of 11.2% less the growth rate of 5%, giving 2.52 divided by 0.062, which is the correct application of the constant growth dividend discount model.

Why B is wrong: This divides next year's dividend by the 11.2% required return without subtracting the 5% growth rate, which values the share as a level perpetuity and ignores the rising dividend stream that is the whole point of the constant growth model.

Why C is wrong: This uses the $2.40 dividend that has already been paid rather than growing it one year to $2.52, which is the single most common error in this model, since the numerator must be the dividend expected one period from now.

Why D is wrong: This sets the required return at 10% by adding the market risk premium to the risk free rate without multiplying by the beta of 1.2, understating the discount rate for a share riskier than the market and inflating the value.

See more CFP practice questions, answers explained.

Exam traps in Investment Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

Yield to call is highest, then yield to maturity, then the current yield, and the coupon rate is lowest.
Why it is wrong: This is the ranking that applies to a bond trading at a discount to par, where the investor also earns a capital gain at redemption, and applying it here reverses the relationship because this bond trades at a premium and the holder will suffer a capital loss on redemption.
107,200 dollars, because the position gains 7.2 per cent when the market yield moves by one percentage point.
Why it is wrong: Tempting because the arithmetic uses the right magnitude. It is wrong on sign: bond prices move inversely to yields, so a yield rise produces a fall in value, not a gain of the same size.
A fall of roughly 0.80 per cent, because the price of an existing bond moves by the size of the change in yields, whatever the length of the holdings inside the fund.
Why it is wrong: Tempting because the yield change is the figure most visible in the problem. It is wrong because it ignores duration altogether, and duration is precisely what scales a given yield move into a price move, which is why a long fund and a short fund react so differently to the same tightening.

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