HuskyGrad2010

Francine LeMond works as an equity analyst for MegaMax Investments, one of the world’s largest broker-dealers. LeMond has been tasked with analysis of remnants, or legacy stocks that were not recommended or purchased by MegaMax but are still part of client portfolios.
LeMond’s first chore of the day is to review some emerging-market equities in the Spencer portfolio. Financial results for all of the stocks appear strong, and the shares have gained substantially in value over the last year. But LeMond is concerned that the financials as stated do not accurately reflect the companies’ operations.
Emerging markets present special problems for equity analysts, and LeMond intends to adjust financial results for these equities to accommodate the following issues:

• The risk of political instability
• Vulnerability of the companies to privatization
• Limited availability of foreign and domestic investment capital
• Unusually high inflation

The first emerging-market company on LeMond’s list is Plicher, a company located in the African country of Llaho that makes construction equipment. In recent years Plicher’s sales and profits have soared, helped by a series of lucrative contracts to provide equipment for government road-building teams. In her analysis of Plicher, LeMond draws on the following information:

• The U.S. risk-free rate is 4%.
• The U.S. market-risk premium is 6.5%.
• The global market-risk premium is 9%.
• The Llaho inflation rate is 25%.
• The U.S. inflation rate is 3.5%.
• 10-year Treasury bonds yield 2.5% more than T-bills.
• The Llahoan government’s short-term bills pay a yield of 8.3%.
• Plicher’s marginal tax rate is 30%.
• Plicher’s equity value is $85.2 million.
• Plicher’s revenue estimate for the next 12 months is $146 million.
• Plicher’s assets are valued at $279.5 million.
• Plicher’s debt rating is A-, and its debt is valued at $194.3 million.
• On average, 10-year U.S. corporate bonds with rating of A- yield 1.3 % higher than a 10-year U.S. Treasury bond.
• On average, 10-year Plicher corporate bonds with a rating of A- yield 5.6% more than a 10-year U.S. Treasury bond.
• Worldwide, companies in Plicher’s industry typically have a beta of 1.6.
• Based on Plicher’s stock returns over the last five years, its beta is 3.4.

LeMond spends several hours preparing revised financial statements, ratios, and valuation estimates for Plicher. Just as she finishes, her boss, Peter Cavanaugh, drops a new project on her desk. Kenton Koncepts, a maker of aircraft parts, just announced a new strategic plan, and Cavanaugh wants to know whether MegaMax should upgrade the stock from its current Neutral rating.
With Kenton’s strategic plan are several pieces of information – a chart showing global aircraft orders and backlog over the last three years, detailed cost-cutting initiatives, a list of proposed plant upgrades, and a detailed list of Kenton’s products and the niches they address. LeMond prepares a short analysis of Kenton.
As her last assignment of the day, LeMond turns to remnants Quintile Fusion, Blevins, and Karnack Analysis, all of which represent large positions in the Adams account. Below are some characteristics of the companies and their industries:

Quintile Fusion	Blevins	Karnack Analysis
Equipment maker trying to branch out into business consulting	Sales growth rates above economic growth rate	Sales growth rates well above economic growth rate
Results in recent quarters have lagged economic growth rate	Uses size and price advantage to take market share	Has had trouble funding expansion
Concerned about rivals’ new products and services eating into its market share	Concerned about powerful brand losing momentum	Concerned about market acceptance of new products
Many rivals are growing huge through acquisitions	Profit margins in line with market average	Differentiates itself by specialization
Hedges raw-materials prices aggressively to reduce volatility of expenses	Information business spends little on manufacturing, much on personnel	Manufacturing facilities are expensive to build, and technical expertise difficult to find
	Hiring is easier than it once was because of a large number of new graduates – labor costs declining	Capacity utilization has increased sharply in recent years

Using the information she gathered on the three firms, LeMond drew conclusions about the industries in which all three companies operated and about the profitability and pricing power of each company.Which of the three remnants in the Adams account most likely has the greatest and least pricing power?

Greatest

Least

A) Karnack Analysis Blevins

B) Blevins Quintile Fusion

C) Karnack Analysis Quintile Fusion

Pricing power is difficult to ascertain without specific data, but the information presented above provides enough clues to deduce the proper order. Quintile Fusion appears to be a company in decline, reinventing itself, worried about rivals, and dependent on commodities for production. Both Blevins and Karnack Analysis appear to have more market leverage. Blevins’ concerns about its brand momentum, coupled with what appears to be fairly small barriers to entry, suggest pricing power is limited. Karnack differentiates by specialization, one key to charging high prices. Large barriers to entry, and a rise in capacity utilization suggests demand is rising faster than supply, potentially supporting higher prices. Concern about the acceptance of new products could be a negative indicator for prices, but Karnack has the most positive data regarding pricing power, and Quintile Fusion has the most negative data. (Study Session 11, LOS 37.f)

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Which of the following information on Kenton Koncepts is most valuable in the analysis of long-term?

Supply trends?

Profitability?

A) Order chart Product list

B) Order chart Cost-cutting initiatives

C) Plant upgrades Cost-cutting initiatives

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The list of plant upgrades is useful for estimating Kenton’s production, but an industrywide chart of orders and backlogs illustrates more than demand trends. By considering both orders and backlogs, an analyst can back into supply analysis and draw useful conclusions about the current supplies and industry production capacity. While cost-cutting initiatives will have an effect on profit margins, particularly in the short term, of more importance in the long term is the company’s ability to produce items the market wants. Kenton’s list of products and niches has substantial value for determining whether the company can continue to operate profitably. (Study Session 11, LOS 37.f)

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Based only on the information above, where do Blevins’ and Karnack Analysis’ industries fall on the business life cycle?

Blevins

Karnack Analysis

A) Growth Growth

B) Mature Growth

C) Mature Pioneer

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Blevins’ growth rate suggests it is not on the decline. In some ways Blevins looks like a growth company, but companies can post solid growth within a mature industry, particularly if they are taking market share. And Blevins’ profit margins and concerns about the erosion of an already powerful brand are characteristic of an established company in a mature industry. Karnack’s difficulty in funding expansion hints at high capital needs, and concerns about new products suggest it is in a pioneer industry. (Study Session 11, LOS 37.b)

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Which of the following issues will be least effectively addressed if LeMond simply adjusts the financial statements by reducing the cash flows of each company in the country by a set amount?

A) Unusually high inflation.

B) The risk of political instability.

C) Vulnerability of the companies to privatization.

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Inflation and political instability will have a similar effect on companies throughout a country. Some industries are more vulnerable to privatization than others, and simply reducing cash flows for all companies by a set amount will probably understate the cash flows of companies in industries not likely to be privatized. (Study Session 11, LOS 38.c)

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Plicher’s cost of equity is closest to:

A) 44.2%.

B) 38.4%.

C) 42.4%.

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The cost of equity = the risk-free rate + beta × market risk premium. First, the risk-free rate. We can’t use the U.S. risk-free rate, and Llaho bills may be illiquid or denominated in another currency. So we start with the 10-year Treasury yield, then add the difference between Llaho’s inflation and U.S. inflation.

4% + 2.5% + 25% − 3.5% = 28%.

For beta, we use the industry beta, not the beta derived from stock returns. The market risk premium is the global premium.
Thus, the cost of capital is 28% + 1.6 × 9% = 42.4%. (Study Session 11, LOS 38.d)

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Assume for this question only that the cost of equity is 25.4% and the local risk-free rate is 15%. Plicher’s weighted average cost of capital is closest to:

A) 15.67%.

B) 10.15%.

C) 18.64%.

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The weighted average cost of capital equals (equity / assets) × cost of equity + (debt / assets) × after-tax cost of debt.
We have equity, assets, debt, and cost of equity values. To calculate the cost of debt, we start with the local risk-free rate plus the U.S. credit spread on comparable debt, or 15% + 1.3% = 16.3%. Then we multiply 16.3% by (1 – marginal tax rate). 16.3% × 70% = 11.41%.
Here is the entire equation:

($85.2 million / $279.5 million) × 25.4% = 7.74%.
($194.3 million / $279.5 million) × 11.41% = 7.93%.
7.74% + 7.93% = 15.67%.

(Study Session 11, LOS 38.d)

HuskyGrad2010

Renee LeClair, CFA, FRM, is estimating the cost of capital for 3 small companies in emerging market countries. Assume a U.S. inflation rate of 2%, a 10-year U.S. government bond yield of 5%, and a market risk premium of 2%.

Company	ROA	Beta
AAA	13.05%	1.60
BBB	12.90%	1.20
CCC	12.85%	1.30

Company	Country	Local Inflation
AAA	Penance Sands	4.35%
BBB	Misty Land	5.00%
CCC	Happy Valley	4.75%

Which company has the highest cost of equity?

A) BBB.

B) AAA.

C) CCC.

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Start by calculating each country’s risk-free-rate:
Risk-free-rate = 10 yr. U.S. govt bond + (local inflation – U.S. inflation)
The risk free rate for each country is:

Penance Sands	7.35% = 5% + 4.35% − 2%
Misty Land	8.00% = 5% + 5.00% − 2%
Happy Valley	7.75% = 5% + 4.75% − 2%

The cost of equity = risk-free rate + beta(market risk premium)
The cost of equity for each company is:

AAA	10.55% = 7.35% + 1.6(2%)
BBB	10.40% = 8.00% + 1.2(2%)
CCC	10.35% = 7.75% + 1.3(2%)

AAA’s high beta offsets Penance Sand’s low inflation, yielding the highest cost of equity

HuskyGrad2010

Country risk for an emerging market company is generally incorporated into the:

A) credit risk premium.

B) market-risk premium.

C) sovereign risk premium.

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The sovereign risk premium consists of both credit and country-risk premiums.

HuskyGrad2010

Country-risk premiums tend to:

A) become part of the local government risk-free rate.

B) increase when government credit issues grow.

C) decrease toward zero over the long run as emerging markets become integrated into the global market.

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Over the long run, it is assumed that the country-risk premium will approach zero as the emerging market becomes integrated into the international markets.