Question #70

The whole point of scenario analysis is the flexibility to modify the inputs to see how changes in one factor affect others. In order to perform scenario analysis, you must deviate from the core model. Increased precision on the inputs will increase the predictive power of almost any model. Spreadsheets reduce the likelihood of computational inaccuracies and allow analysts to more easily modify models to reflect many scenarios. (Module 20.3, LOS 20.o) Bernadine Nutting has just completed several rounds of job interviews with the valuation group, Ancis Associates. The final hurdle before the firm makes her an offer is an interview with Greg Ancis, CFA, the founder and senior partner of the group. He takes pride in interviewing all potential associates himself once they have made it through the earlier rounds of interviews, and puts candidates through a grueling series of tests. As soon as Nutting enters his office, Ancis tries to overwhelm her with financial information on a variety of firms, including Turbo Financial Services, Aultman Construction, and Reality Productions. Ancis then moves on to Turbo Financial Services. Ancis has been following Turbo for quite some time because of its impressive earnings growth. Earnings per share have grown at a compound annual rate of 19% over the past six years, pushing earnings to $10 per share in the year just ended. He considers this growth rate very high for a firm with a cost of equity of 14%, and a weighted average cost of capital (WACC) of only 9%. He's especially impressed that the firm can achieve these growth rates while still maintaining a constant dividend payout ratio of 40%, which he expects the firm to continue indefinitely. With a market value of $55.18 per share, Ancis considers Turbo a strong buy. Ancis believes that Turbo will have one more year of strong earnings growth, with EPS rising by 20% in the coming year. He then expects EPS growth to fall 5 percentage points per year for each of the following two years, and achieve its long-term sustainable growth rate of 5% beginning in year four. Finally, Ancis turns to Aultman Construction, trading at $22 per share (with current EPS of $2.50 and a required return of 18%), and Reality Productions, which currently trades at $30 per share. Reality Production's current dividend is $1.50, but the historical dividend growth rate has been a stable 10%. Dividend growth is expected to decline linearly over six years to 5%, and then remain at 5% indefinitely.