CFA Institute CFA-Level-II Exam - Topic 2 Question 110 Discussion

Actual exam question for CFA Institute's CFA-Level-II exam

Question #: 110
Topic #: 2

Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.

Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.

Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.

Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine Midwest News's required relurn on equity is presented in Exhibit 2.

The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.

Statement I: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.

Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.

Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.

Based on Exhibit 2 and using the build-up method, Midwest News's required return on equity is closest to:

A13.0%.

B13.8%.

C15.8%.

Show Suggested Answer

Suggested Answer: A

= risk-free rate + equity risk premium + size premiu + specific-company premiu

Control premium and marketability premium adjustments are not usually made in the required return on equity calculation, but rather directly to the estimated value. (Study Session 10, LOS 35.d)

by Sharan at Oct 28, 2025, 06:47 PM

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Narcisa

19 days ago

True, but I still think 15.8% is too high. The declining circulation worries me.

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Luis

24 days ago

I think the specific-company premium is crucial here. It affects the required return significantly.

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Regenia

1 month ago

I agree, but I’m leaning towards option B, 13.8%. It seems reasonable given the context.

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Eloisa

2 months ago

13.8% seems high for a declining circulation newspaper.

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Cyndy

2 months ago

Free cash flow model over dividend discount? Totally agree with that!

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Jerry

2 months ago

Wait, are we sure the equity risk premium is accurate?

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Irene

2 months ago

I think the build-up method is a solid choice for estimating returns!

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Dorothy

2 months ago

Haha, I bet the family members are hoping for a higher valuation. They're probably thinking, "Show me the money!"

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Sherron

2 months ago

I'd go with 13.0% - the equity risk premium looks reasonable, and the build-up method seems to be the best approach.

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Fatima

3 months ago

15.8%? That's a pretty hefty return. I wonder if the staff is being a bit too conservative in their calculations.

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Isabella

3 months ago

13.8% seems like a reasonable estimate given the information provided. The build-up method seems appropriate here.

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Leota

3 months ago

The required return on equity for Midwest News seems a bit high, but I guess the industry concerns and business risk justify it.

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Robt

3 months ago

I practiced a similar question about estimating required returns, and I think the specific-company premium is crucial for Midwest News's valuation.

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Kristian

3 months ago

I think the Gordon growth model is useful, but since Midwest News doesn't pay dividends, it might not be the best fit.

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William

3 months ago

This question is tricky. I feel like the build-up method is the right approach.

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Queenie

4 months ago

Midwest News has no debt? That's interesting.

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Bettina

4 months ago

I feel like I should trust Miller's statements, but I wonder if the free cash flow model really is better than the dividend discount model in this case.

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Scarlet

4 months ago

I remember we discussed the build-up method in class, but I'm not entirely sure how to apply it to Midwest News specifically.

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Alida

5 months ago

Whew, this is a lot of information to process. I'm going to take it step-by-step, making sure I understand each part of the question before moving on. I think if I stay focused and methodical, I can get the right answer.

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Judy

5 months ago

This is a tricky one, but I feel confident I can work through it. The key will be to carefully analyze the information about Freedom Corporation and use that to inform my estimates for Midwest News. I'll need to be thorough and double-check my work.

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Myra

5 months ago

Okay, I think I've got a good handle on this. The question is really testing our ability to apply the build-up method to estimate the required return on equity. I'll need to focus on calculating the appropriate equity risk premium and specific-company premium.

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Nan

5 months ago

I'm a bit confused by all the different valuation models and methods mentioned in the question. I'll need to make sure I fully understand the build-up method and how to apply it correctly to this situation.

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Edelmira

5 months ago

This looks like a pretty complex question, but I think I can tackle it. The key will be to carefully analyze the information provided in the exhibits and use the appropriate valuation models to estimate Midwest News's required return on equity.

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