Equity Valuation【 Reading 38】Sample emerging, 2012, expressed, company

tango_gs

When valuing an emerging market company using cash flows expressed in both nominal and real terms:

A) both valuations are not reliable.

B) both valuations are identical.

C) each valuation differs by the inflation differential.

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In order to adjust for the influences of inflation, company cash flows will require restatement in both nominal and real terms. Construct historical and forecasted financial statements in both nominal and real terms. Calculate the nominal cash flows and convert them to real terms. Discount the nominal and real cash flows to determine their respective valuations for both terms. The valuations under both terms should be identical.

tango_gs

With respect to emerging market companies, which of the following macroeconomic variables has the most impact on the estimation of cash flows?

A) Inflation.

B) Country risk.

C) Political risk.

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Emerging markets are characterized by high inflation. Inflation affects the financial statements by creating distortions in non-monetary assets (i.e. property, plant, equipment and inventories). Cash flow projections used in valuations, as well as most financial ratios, will also be distorted.

tango_gs

order to properly measure the cash flows of an emerging market company to consider the impact of inflation, one starts the process by constructing the:

A) historical and forecasted financial statements in both nominal and real terms.

B) historical financial statements using the temporal method.

C) forecasted financial statements using the current method.

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Construct historical and forecasted financial statements in both nominal and real terms. Historical financial statements are translated to real terms by using the current method. Forecasted financial statements in real terms are then created and then converted to nominal terms. Finally, calculate the nominal cash flows and convert them to real terms.

tango_gs

An analyst is calculating ratios from nominal financial statements. The company is domiciled in an emerging market with high inflation. Which of the following effects is least likely?

A) Solvency ratios, such as debt to assets, will be too low.

B) Fixed asset turnover will be overstated.

C) Operating margins will be overstated.

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Solvency ratios, such as debt to assets, will be too high as assets are understated. Fixed asset turnover will be overstated because fixed assets do not capture inflation effects in a timely manner, but sales do reflect the effect of inflation. Operating margins will be overstated as sales reflect inflation but depreciation does not.

tango_gs

Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. Charleston Johnson expects the local government to be successful in bringing inflation under control, and anticipates that it will fall to 20% in the second year and 10% in the third year, where he expects inflation to stabilize. Johnson predicts that by year 3, Wavington will have nominal free cash flow of $187 million growing at 4% annually in real terms. In view of his optimistic outlook, he is considering an investment in Wavington, and has calculated the real WACC for Wavington at 8%. The nominal continuing value of Wavington in year 3 is closest to:

A) $4,675.

B) $4,862.

C) $4,250.

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The nominal growth rate for Wavington in the steady state is (1.10 × 1.04) – 1 = 14.4%. The nominal WACC in the steady state is (1.10 × 1.08) – 1 = 18.8%. The nominal continuing value for Wavington in year 3 is:

nominal continuing value = FCF3 × (1 + nominal growth rate) / (nominal WACC – nominal growth rate)
nominal continuing value = 187 × (1.144) / (0.188 – 0.144)
nominal continuing value = 213.9 / (0.044) = 4,862