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LOS b: Calculate nominal and real-term financial projections in order to prepare a discounted cash flow valuation of an emerging market company. ffice ffice" />
Q1. Tim Reynolds, CFA, works for an investment research firm that is currently in the process of analyzing the global marine products industry. Reynolds’ supervisor, Mike Lapke, CFA, expects there to be significant consolidation among the 50 firms in the marine products industry as a result of mergers among its smaller firms. Lapke is particularly interested in how the expected consolidation activity will affect the five largest firms within the industry, which include two ffice:smarttags" />U.S. companies, two British companies, and one Japanese firm.
The two U.S. firms are U.S. Marine, Inc., and Atlantic Coastal Products, Inc. The British firms are Royal Crown Industries, LTD and Liontrust, PLC, and the Japanese firm is Bandai Oceanographic Industries, LTD. Currently the total worldwide revenue for this industry is $640 billion. Lapke has collected data for the five firms identified above along with more detailed data of two U.S. firms that he is following more closely.
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Company |
Revenue (in billions) |
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U.S. Marine, Inc. (USM) |
$64.7 |
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Atlantic Coastal Products, Inc (ACP) |
$50.0 |
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Royal Crown Industries, LTD |
$45.6 |
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Liontrust, PLC |
$37.5 |
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Bandai Oceanographic Ind. , LTD |
$18.0 |
Selected financial data (in billions):
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USM Inc. |
ACP Inc. |
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Sales |
$64.70 |
$50.00 |
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EBIT |
9.68 |
6.00 |
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EBT |
7.75 |
5.84 |
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NI |
4.36 |
4.20 |
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Assets |
95.40 |
73.36 |
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Equity |
21.90 |
28.47 |
|
Payout Ratio |
0.45 |
0.65 |
|
Required rate of return (r) |
15% |
11% |
The three-firm and five-firm concentration ratios are closest to:
Three-firm Five-firm
A) 74.28% 100.00%
B) 25.05% 33.72%
C) 33.72% 74.28%
Correct answer is B)
The three-firm (five-firm) concentration ratio represent the collective market share of three (five) firms with the greatest total sales in the industry.
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Three-firm concentration ratio |
= (64.7 + 50 + 45.6) / 640 = 160.30 / 640 |
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= 0.2505 = 25.05% |
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Five-firm concentration ratio |
= (64.7 + 50 + 45.6 + 37.5 + 18) / 640 = 215.80 / 640 |
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= 0.3372 = 33.72% |
(Study Session 11, LOS 37.c)
Q2. The tangible price-to-earnings (P/E) and franchise P/E values for ACP, Inc. are closest to:
Tangible P/E Franchise P/E
A) 9.09 2.08
B) 4.59 6.67
C) 6.67 4.59
Correct answer is A)
Tangible P/E = 1 / r, so, tangible P/E = 1 / 0.11 = 9.09
Franchise P/E is the product of the franchise factor (FF) and the growth factor (G).
That is, Franchise P/E = FF × G.
The Franchise factor is computed as: FF = (1 / r) ? (1 / ROE)
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ROE |
= NI / equity, so for ACP, ROE = 4.20 / 28.47 = 0.1475 |
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FF |
= (1 / 0.11) - (1 / 0.1475) = 9.09 - 6.78 = 2.31 |
The growth factor, G, is calculated as: G = g / (r ? g)
Where, the sustainable growth rate, g, is calculated as:
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g |
= retention rate × ROE = (1 ? payout ratio) × ROE |
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= (1 ? 0.65) × 0.1475 = 0.052 |
So, G = 0.052 / (0.11 ? 0.052) = 0.90
Franchise P/E = FF × G = 2.31 × 0.90 = 2.08 (Study Session 11, LOS 37.e)
Q3. Lapke is concerned that the marine products industry may be near full capacity. With this in mind, Lapke asked Reynolds to estimate capacity utilization for the industry based on the manufacturing demand forecast presented below.
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Projections for the year ending: |
2008 |
2009 |
2010 |
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Available capacity (in 100,000 units) |
450 |
492 |
496 |
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Expected demand (in 100,000 units) |
275 |
308 |
360 |
Based on his forecasts, the industry capacity utilization for 2008 and 2010 is closest to:
2008 2010
A) 62.60% 72.58%
B) 61.11% 72.58%
C) 72.58% 61.11%
Correct answer is B)
The formula for capacity utilization is: capacity utilization = expected demand / available capacity
Capacity utilization for 2008 is: 275 / 450 = 61.11%
Capacity utilization for 2010 is: 360 / 496 = 72.58%. (Study Session 11, LOS 39.e)
Q4. During his research, Reynolds has observed that many of the firms in the marine products industry are concerned about the impact that new technology will have on their future profitability. Specifically, these firms are afraid that the competition resulting from new technologies will reduce their market share. Based on this observation, what stage of the industry life cycle are the firms in the marine products industry most likely in?
A) Growth.
B) Mature.
C) Decline.
Correct answer is B)
For mature industries, the threat from new technologies is whether competitors that employ new technologies will have a competitive advantage. In this situation, firms that do not use the new technologies will either have to adopt the new technologies or acquire their competition in order to survive. (Study Session 11, LOS 39.b)
Q5. In addition to evaluating the five largest firms in the marine products industry, Lapke has asked Reynolds to conduct a valuation of a smaller firm, one that is domiciled in an emerging market. They both agree that the emerging market firm’s value should be estimated as the present value of the company’s expected future free cash flows discounted at the appropriate weighted average cost of capital. They do not, however, agree on the appropriate method for incorporating country risks into the analyses. Lapke believes that the discount rate should be adjusted to reflect country risk, but Reynolds holds the opinion that cash flows should be adjusted. During their discussion, the following two statements are made.
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Reynolds' comment: |
The evidence on this issue suggests that country risks are best incorporated into the valuation process by adjusting the cash flows in a scenario analysis rather than including them in the discount rate. |
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Lapke's comment: |
Regardless of whether we adjust the discount rate or the cash flows to reflect emerging market risk, both the nominal and real cash outflow associated with net working capital should be computed as the change in nominal and real cash outflow from net working capital, respectively. |
With respect to these statements:
A) both are correct.
B) only Lapke is correct.
C) only Reynolds is correct.
Correct answer is C)
Reynolds’ comment is correct. Evidence does suggest that country risks are best captured by adjusting cash flows using scenario analysis rather than adjusting the discount rate. Reasons that provide support for this argument include the following.
§ Country risks are diversifiable and should not be included in the cost of capital.
§ Firms respond differently to country risk, so a general discount rate cannot be applied uniformly to all firms.
§ Country risk is often asymmetrical in the down-only direction. Cash flow adjustments are more appropriate for capturing this type of risk distribution.
§ Managers can identify the specific factors that affect cash flows and plan to mitigate these risks by adjusting the cash flow forecasts.
Lapke’s comment is not correct. The nominal cash outflow associated with net working capital (NWC) is equal to the change in nominal NWC. The real cash outflows from NWC, however, are not equal to the change in real NWC.
The change in nominal net working capital does appropriately capture the cash flow effect, but the holding period loss on the beginning real working capital is ignored. To illustrate, suppose real and nominal NWC is 100 at the beginning of the year. During the year, inflation is 15%, but real NWC doesn’t change. That means ending real NWC is still 100 and nominal NWC increases by 15% to 115. The change in real NWC is zero and the change in nominal NWC is 15. The nominal cash flows associated with the change in NWC are 15, but the real cash flows are not 0; instead, they are calculated as 15 / 1.15 = 13.04. This 13.04 is the holding period loss that real NWC experienced over the one-year holding period. Real NWC at the end of the year is only worth 100 / 1.15 = 86.96 in beginning-of year units of local currency because the inflation rate is 15%. In order to replenish the NWC back to 100 in real terms at the end of the year, the company has to invest 13.04 real units of local currency; that represents the real cash flows associated with the investment in real NWC. (Study Session 11, LOS 40.c)
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发表于 2009-3-6 14:46
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