Question 4

James Sigmund, CFA, is the Head of International Equity for Pell Global Advisors (PGA). Sigmund is considering investing in the country of Zuflak as part of an emerging market portfolio. Sigmund is aware of the risks in investing in emerging markets and is preparing a valuation report regarding this investment. He estimates that Zuflak government debt would be rated BB, and has gathered the following market information for use in analyzing Zuflak.

To assist in his analysis of Zuflak, Sigmund has asked Stefano Testorf, CFA, to estimate a value for Kiani Corporation (Kiani), Oleg Industries (Oleg), and Malik Incorporated (Malik) - the three primary companies domiciled in Zuflak that Sigmund has determined to have adequate liquidity for inclusion in PGA’s client portfolios. Testorf gives Sigmund a rough draft of his report and tells Sigmund that in order to account for country specific emerging market risks, he used a probability-weighted scenario analysis to adjust cash flows. Sigmund asks him, “Why didn’t you simply adjust the discount rate?” Testorf replies with three reasons:

• Reason 1:  The country risk attributable to Zuflak can be diversified away according to modern finance theory, and should not be included in the cost of capital.

• Reason 2:  Companies in emerging markets tend to exhibit wild price swings both up and down, therefore adjusting cash flows is the best way to account for these symmetrical country risks.

• Reason 3:  Although Kiani, Oleg, and Malik are all domiciled in Zuflak, each of these companies will tend to respond differently to country risks. This makes it virtually impossible to adjust the discount rate for country specific risk and come up with an accurate valuation estimate.

After careful analysis by Sigmund and his team, Sigmund decides that he wants to have exposure to Zuflak in his international portfolios. He is still unsure however, what the best way would be to establish the exposure. Sigmund discusses his concerns with Steve Solak, another portfolio manager with PGA. Solak suggests that Sigmund consider using a closed-end country fund to invest in Zuflak. Solak hands Sigmund a copy of a note that he had provided to a client listing facts about country-specific closed end funds. The note contained the following statements:

1. Closed-end country funds provide an excellent means to access local foreign markets. Even nations that have restrictions on foreign investment are sometimes accessible using closed-end country funds.

2. Closed-end country funds issue a fixed number of shares and are a great way to diversify a U.S.-dollar stock portfolio because of their low correlation with the U.S. stock market.

Sigmund thanks Solak for the information and heads back to his office. As he is leaving, Solak asks him if he would have time later that afternoon to discuss the use of American Depository Receipts (ADRs).

Part 1)
What is the best estimate of the country risk premium for Zuflak?

Part 2)
To determine a valuation estimate for Oleg, Testorf assumes that local investors require a 5 percent real rate of return on companies with similar risk to Oleg. What is Oleg’s price-to-earnings (P/E) ratio, if the company has an inflation flow-through rate of 65 percent?

Part 3)
In regard to Testorf’s reasons for incorporating emerging market risk into the valuation of Zuflak by adjusting cash flows rather than adjusting the discount rate, which of the following is TRUE?

Part 4)
Due to the high inflation rate of the local country, Testorf calculates the return on invested capital (ROIC) for Kiani by revaluing the company’s fixed assets. In comparing the performance of Zuflak to other local companies, the ROIC calculation should:

Part 5)
With regard to Solak’s note concerning closed end-country funds:

Part 6)
Which of the following statements regarding American Depository Receipts (ADRs) is TRUE?

答案如下

Question 4

Part 1)
Your answer: B was incorrect. The correct answer was A) 0.25%.

Because a U.S. denominated local government bond does not exist, the following formula must be used to calculate the country risk premium:

Local government bond yield (non–US dollar denominated)
- U.S. 10 year T-bond yield
- Inflation differential between local country and U.S.
- Yield spread between comparably rated U.S. corporate and U.S. T-bond yields
= Country Risk Premium

Country Risk Premium = 11.50 – 4.50 – (6.50-3.00) – (7.75-4.50)
= 11.50 – 4.50 – 3.50 – 3.25
= 0.25

Note that if a U.S. denominated local government bond did exist, we would use that bond in our calculation and would not include the inflation differential.

Part 2)
Your answer: B was incorrect. The correct answer was D) 13.75.

P₀/E₁ = 1 / [real required return + (1 – inflation flow-through rate) × inflation rate]
= 1 / [0.05 + (1-.65) × 0.065]
= 1 / [0.05 + 0.02275]
= 1 / 0.07275 = 13.75

Part 3)
Your answer: B was incorrect. The correct answer was A) Reasons 1 and 3 support Testorf’s cash flow adjustment, but reason 2 does not.

Although emerging market risk can be incorporated into the valuation process either by adjusting the discount rate (required return), or by adjusting cash flows in a scenario analysis, evidence suggests that country risks can be best captured through cash flow adjustment. The four arguments that support adjustments to cash flow rather than adjusting the discount rate are:

• Country risks are diversifiable. Modern finance theory states that country risks can be diversified away, and therefore should not be included in the cost of capital. Testorf’s first reason is correct.

• Companies respond differently to country risk. A general discount rate cannot be applied uniformly to every company valuation in the country because it would not capture the different operating characteristics of the company that could be captured by adjusting the cash flows. Testorf’s third reason is correct.

• Country risk is one-sided. Emerging markets have a tendency for companies to exhibit one-sided (down only) risk profiles. Therefore, the risks are asymmetrical and adjusting the cash flows best captures these asymmetrical risks. Testorf’s second reason is incorrect.

• Identifying cash flow effects aids risk management. Managers tend to identify specific factors affecting cash flow and plan to mitigate their risks by adjusting cash flows rather than adjusting the discount rate.

Part 4)
Your answer: B was incorrect. The correct answer was D) exclude goodwill.

When calculating ROIC, excluding goodwill is useful for comparing different local companies and evaluating trends. Goodwill can distort the comparison when firms have differing levels of goodwill. ROIC that includes goodwill measures returns generated by the firm’s acquisitions based on the use of its investors’ capital, and is used for determining whether or not the company earned an acceptable rate of return over its cost of capital. Note that revaluation is also important here. ROIC including revaluation of fixed assets measures the company’s operating performance, and is also useful for comparing different companies and evaluating trends.

Part 5)
Your answer: B was incorrect. The correct answer was C) statement 1 is correct, statement 2 is incorrect.

Closed-end country funds provide a simple way to access local foreign markets while achieving international diversification. One of the advantages of closed-end country funds is that investors often have greater access to emerging markets, even those from countries that tend to restrict foreign investment. This is due to the fact that redemptions are less of a concern to the emerging market government because the number of shares of the fund is fixed, and redemptions do not result in capital outflows. Statement 1 on Solak’s note is correct.

One of the disadvantages of closed-end country funds is that they may trade at a significant discount premium or discount to their NAV. Although the actual performance of the stock within the closed end fund may have a low correlation with the U.S. market, the NAV of the fund may be highly correlated with the U.S. market, thus reducing the benefit of international diversification. Statement 2 on Solak’s note is incorrect.

Part 6)
Your answer: C was incorrect. The correct answer was B) Level 1 ADRs are not required to comply with SEC registration and reporting requirements.

ADRs are classified according to three levels:

• Level 1 ADRs are the most basic type, trade only on the OTC market, and are not required to comply with SEC registration and reporting requirements.

• Level 2 ADRs are listed on an exchange and meet the registration requirements of the SEC.

• Level 3 ADRs are the most prestigious type in which an issuer floats a public offering of ADRs on a U.S. exchange. This enables the issuer to raise capital in the U.S. financial markets.

For large institutional investors, it is generally more costly to purchase ADRs than to directly purchase shares in the local market because the local market may provide more liquidity. Although they are denominated in dollars, their primary disadvantage is that they do not eliminate the inherent currency and economic risks associated with the shares of a foreign country.