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Which combination of business cycle stage and related attractive investment is least appropriate?

Recovery

Interest-sensitive stocks

Economy slows

Bonds

Late upswing

Bonds

In a recovery, appropriate investments would be stocks and commodities, in response to the economic upswing. Interest-sensitive investments would not be appropriate since interest rates would likely rise as the economy picks up.

Which description of analysts’ attempts to forecast economic growth is most accurate?

A)	Analysts who can identify the various stages of the business cycle better than others have the opportunity to earn excess risk-adjusted returns.

B)	Expected real economic growth is the most important variable to analyze in a country because it is the one that can be predicted most accurately.

C)	Long-run forecasts focus on predicting turning points in the business cycle.

Long-run forecasts focus on predicting long-run growth. Short-run forecasts focus on the business cycle, even though they are difficult to make with any degree of success. Economic growth is the most important variable to analyze because it has the most impact on risk and return, even though it is difficult to forecast.

Which combination of business cycle stage and related attractive investment is least appropriate?

Recovery

Commodities

Late cycle recession

Bonds

Economy slows

Interest-sensitive stocks

Late in a recession, appropriate investments would be stocks and commodities, in preparation for the economic upswing. Bonds would not be appropriate since interest rates would likely rise as the economy picks up.

Steven Adams, assistant investment director for the U.S.-based Orange Group, is charged with selecting investments in a number of foreign countries. At the moment, he is buying interest-sensitive stocks in Jackland and commodities in Jundland. Jackland and Jundland are most likely in what stages stage of the business cycle?

slowing economy

recovery

early upswing

recession

late upswing

early upswing

Interest-sensitive stocks are most attractive during the late upswing and the period in which the economy slows. Jackland is most likely in one of those two stages. Commodities are most appealing during the recession and recovery cycles. The only juxtaposition of those periods is the answer in which Jackland’s economy is slowing and Jundland’s economy is in recovery.

There are five firms in an industry. The market shares for firms one through five are 10%, 15%, 20%, 25%, and 30%, respectively. The Herfindahl index for the:

A)	industry is low, suggesting intense competition.

B)	industry is 0.225.

C)	two largest firms in the industry is 0.152.

A Herfindahl index of more than 0.18 is an indication of low competition (concentrated industry players) in the industry. A Herfindahl index of less than 0.1 is an indication of intense competition in the industry.

The Hartfactor Corporation is a producer of specialized medical devices, and has historically earned excess returns on a risk-adjusted basis. Which of the following is least likely to be characteristic of Hartfactor Corp. and its industry?

A)	A large number of suppliers.

B)	A Herfindahl index of 0.05.

C)	High cooperation.

A Herfindahl index of 0.05 is considered a highly competitive industry, which is not likely to be characteristic of a company earning excess returns. A large number of suppliers means low supplier bargaining power and high industry cooperation, both of which increase producer returns.

Ginormous Technologies, Ltd. has a return on equity (ROE) of 14% and a required rate of return of 9%. Which statement is least likely to be characteristic of Ginormous and its industry?

A)	It is a full flow-through firm.

B)	It has a positive franchise factor.

C)	The Herfindahl index is 0.02.

Ginormous is earning an excess return (its ROE is higher than its required rate of return), and thus it is unlikely to be in a highly competitive industry (a Herfindahl index of less than 0.1). A firm with ROE higher than the required rate of return has a positive franchise factor, thus the higher its earnings retention ratio, the higher its franchise P/E. The lower a firm’s inflation flow-through the lower the valuation, so full flow-through would likely be characteristic of a firm earning excess returns.

A)	As the number of suppliers increases, the value of the producer decreases.

B)	Vertical integration may mitigate some risk of value chain competition.

C)	Higher product standardization increases investment risk.

As the number of suppliers increases, suppliers have less pricing power and thus less ability reduce return to the producer. The value of the producer increases, not decreases. Higher product standardization increases buyer power and thus investment risk. Vertical integration along the value chain may mitigate competition for a firm.

The plastic shoe industry is comprised of six firms. Two have 30% market share each and the other four each have 10% market share. Which description of the Herfindahl index and market concentration in the plastic shoe industry is most accurate?

The Herfindahl index is: (0.10² × 4) + (0.30² × 2) = 0.22 This is higher than 0.18, the minimum threshold for high concentration.

A)	Expected GDP in the home country.

B)	Competitive advantage.

C)	Value chain.

Country analysis is analysis of economic growth in the home country. The value chain and competitive advantage are both parts of industry analysis. Competitive advantage is important in selecting where to produce a good or service as part of an industry analysis, but less important for analyzing economic growth in the home country as part of country analysis.

Which combination of type of analysis and related approach is the least appropriate?

Country analysis

GDP forecast

Country analysis

Herfindahl index

Industry analysis

Value chain analysis

The Herfindahl index is used in competitive analysis of an industry, not in country analysis. GDP is used in country analysis. Industry analysis uses both value chain and industry life cycle approaches.

Which statement best applies to the relationship between country and industry analysis?

A)	Economic growth in the home country can have less impact on a multinational firm than global industry conditions.

B)	Global demand analysis is a key component of country analysis.

C)	Co-opetition can become problematic in country analysis during periods of strong economic growth.

Global demand analysis is part of industry, not country, analysis. Co-opetition becomes problematic in periods of weak, not strong, economic growth.

Jessica Riendeau follows both Globalanacing Ltd. and Lowprofitious Corp. She has determined that Globalancing consistently has a higher valuation than Lowprofitious. Which of the following is least likely to be characteristic of the relationship between Globalancing and Lowprofitious and their respective home countries and industries?

Full flow-through firm

Passes along 70% of its
country's inflation

No vertical integration

Vertically integrated

Low inflation rate country

High inflation rate country

Vertical integration can mitigate some value chain risk, and is consequently associated with higher, not lower, valuation. A low inflation rate, full flow-through of inflation, and a positive franchise factor are all associated with higher valuation.

George Quayle teaches an entry-level business class at 8 a.m. on Mondays, Wednesdays, and Fridays at Southern Coastal Idaho Polytechnic. This morning, Quayle plans to introduce his students to strategies for market analysis. He starts the class out with a discussion of competition and its effect on industries as well as individual stocks. Halfway through the class, Quayle passes out a handout listing the characteristics of markets in which investors are able to earn above-average returns. Here are some of the characteristics listed on the handout:

After finishing up his discussion of competition, Quayle makes the following statement about economic growth: “The most important driver of economic growth is technological advancement. When growth slows, private-sector innovators see opportunities and work even harder to develop products people can use. This dynamic can continue indefinitely, preventing the economy from regressing to a long-run steady growth rate.”

The 9 a.m. investing class has been studying the business cycle. Today, Quayle breaks down the business cycle, discussing the characteristics of all five stages: recovery, early upswing, late upswing, economy slows, and recession. Quayle explains how each stage of the business cycle is generally accompanied by a particular set of economic cues. He then quizzes the class on the signs of each stage, and which investments perform well during each stage. The students are then given the following information and asked to identify the business-cycle stage being described.

After the quiz, Quayle ends the study of the business cycle and moves on to valuing stocks. He begins with a discussion of the franchise value, stating that only when a firm’s return on equity (ROE) exceeds its cost of capital should it reinvest in itself rather than distribute profits back to shareholders. As an introduction to the concept of franchise value, Quayle tells the students to calculate the intrinsic price-to-earnings (P/E) value for Golden Goblets, a stemware company. Golden Goblets earns an ROE of 15.4% and has a payout ratio of 28%. The required market return on equity is 14.6%, and the risk-free rate is 7.5%.

In Quayle’s 10 a.m. accounting class, he explains the vagaries of international accounting systems that don’t always match U.S. standards. Quayle discusses the global moves toward “convergence,” or efforts to move International Accounting Standards Board and U.S. Financial Accounting Standards Board requirements together.

Next, Quayle tackles the problems U.S. analysts face in interpreting the financial statements of foreign firms. He says foreign financial reports are more difficult for U.S. analysts to handle than domestic statements, and presents four chief reasons for that difficulty:

Finally, Quayle gives his students an assignment to research what would happen if US GAAP changed to treat all leases as capital leases.

The intrinsic P/E value is the sum of the tangible P/E value and the franchise P/E value.
To calculate the tangible P/E value, we divide 1 by the 14.6% required rate of return, for a value of 6.85.
To calculate the franchise P/E value, we multiply the franchise factor (FF) by the growth factor (G).
FF = (1 / rate of return) ? (1 / ROE) = 0.36.
G = sustainable growth rate / (rate of return ? sustainable growth rate).
Sustainable growth rate = ROE × retention ratio = 15.4% × 72% = 11.09%.
G = 11.09% / (14.6% ? 11.09%) = 3.16.
Franchise P/E value = 0.36 × 3.16 = 1.14.
Intrinsic P/E value = 6.85 + 1.14 = 7.99.

(Study Session 11, LOS 36.c)

A)	Many countries’ financial-reporting rules are arcane or confusing.

B)	Not all countries enforce regulations with enough vigor to ensure reliable financial statements.

C)	Some companies do not publish their financial reports in English.

Many accountants have said that U.S. financial-reporting rules are arcane and confusing compared to other countries’ rules. The other statements are accurate and support Quayle’s assertion about the difficulty of analyzing foreign financial reports relative to U.S. reports. (Study Session 11, LOS 36.a)

A)	Moderate bargaining power for buyers.

B)	A government that tends to intervene.

C)	A Herfindahl index value of more than 0.2.

A Herfindahl index value of more than 0.2 suggests a market or industry is not too competitive. In such markets, it is easier for individual companies to generate profits and for investors in such companies to earn superior returns. Markets with strong barriers to entry or in which buyers do not have a lot of bargaining power are also likely to provide high returns. Government intervention is a more difficult issue. Sometimes it boosts investment returns, sometimes it hurts them. Intervention does not necessarily mean assistance. (Study Session 11, LOS 36.b)

If U.S. GAAP changed to treat all leases as capital leases, all operating leases, which are currently reflected on the income statement as an expense, would instead move to the balance sheet, where they would be recorded as assets and liabilities. The resulting change in the treatment on the income statement would be to decrease net income during the early years of the lease, and increase net income over the later years of the lease. Total net income over the life of the lease will be the same, regardless of classification. Thus, the overall income effect on the average firm is uncertain. Capital leases are typically accounted for as long-term assets and liabilities, but the principal portion of lease payments due in the coming year are current liabilities. This would decrease the current ratio. (Study Session 7, LOS 26.d)

The new growth theory holds that innovation and increased efficiency can keep an economy growing at a rate higher than the theoretical long-run steady state. (Study Session 11, LOS 36.b)

Economy slows

Recovery

Economy slows

Early upswing

Recession

Late upswing

During the start of the economic slowdown, interest rates often decline, boosting bond prices and lifting interest-sensitive stocks. Rates often fall during the recession as well, but bonds don’t normally perform well during that stage. Real estate is most attractive in the early stage of the upswing. That is also the period in which we are likely to see the strongest gains in consumer confidence. (Study Session 11, LOS 36.b)

In assessing the risks in a global industry analysis, which of the following tasks is the most important? Analysts should:

A)	assess which firms in the industry are most likely to be profitable.

B)	determine which firms in the industry are the most efficient producers.

C)	examine the level of competition between industry firms.

The level of competition is a key issue that needs to be addressed since it will affect the level of potential returns and investment risk. Both remaining tasks are either irrelevant or very secondary to the central analysis.

Which of the following statements about performing a global industry analysis is least accurate?

A)	Holding excess capacity is an effective way to mitigate against the threat of new entrants.

B)	In general, as the number of buyers in an industry increases, the buyer power decreases.

C)	In general, as the number of suppliers in an industry decreases, the bargaining power of each individual supplier decreases.

As the number of suppliers decreases, the suppliers gain more power and have the ability to raise their prices of their product (their product serves as an input to another product). Both remaining statements are true.

Stage A	Stage B
Interest rates are falling Bonds and some stocks perform well	Consumer confidence improves Real estate performs well