Equity Valuation【 Reading 36】Sample health, industry, business, currency

sabaruch

Frank Palmer, CFA, is preparing a report on the tobacco industry for investors in his home country of Molvania. Molvania is a small coastal country of approximately 15 million inhabitants that is run by a strong monarchy headed by reigning King Alexander III. The country is blessed with warm summers and moderate winters and has a thriving tourist industry. The country’s main industry, however, is tobacco. Molvania has adopted the U.S. dollar as its currency of business.
Despite numerous health-related problems, lawsuits, and rising prices associated with tobacco products, there is still something attractive about tobacco—strong earnings. Legal battles continue to affect the tobacco industry, however. Smokers stricken with cancer and other smoking-related health problems have tried to pool their complaints together in large class-action lawsuits. Nevertheless, the global industry continues to maintain its profitability even if growth is limited. Tobacco sales in Molvania are dominated by Royal Tobacco Incorporated (RTI) and Universal Tobacco Products Incorporated (UTP). These two large companies control 80% of the domestic market. In 1998, Molvania established a 51% state-owned tobacco company through a joint venture with RTI and UTP. The plan was for the new entity, Molvania Tobacco International (MTI), to develop a thriving export business and to become known around the world. A handful of smaller companies continued to compete domestically and held the remaining 20% of the home market but did little or no export business.
A unique aspect of the Molvanian tobacco industry is that, along with its rich supply of tobacco plants—considered by experts to produce the best tobacco in the world—there is a special hand-rolling skill which enables local manufacturers to produce a premium product. This ability is passed from generation to generation in what amounts to a closely guarded secret that permits high quality output. Indeed, several South American and Caribbean-based companies have made numerous unsuccessful attempts to acquire the Molvanian skill. There are several strong international competitors that produce premium brand products and have well-developed distribution networks. However, Molvanian tobacco products are generally considered to be among the best anywhere. To maintain control, MTI decided to appoint an exclusive group of dealers around the world to distribute Molvanian tobacco products. Only these select dealers would have access to the Molvanian supply. In addition, MTI was responsible for all marketing efforts worldwide. A recent government survey determined that by the end of last year, the export business accounted for more than one-half of the dollar volume of the Molvanian tobacco industry.
Even though many of the country’s plantations were originally state-owned, King Alexander bowed to the will of the majority and permitted tobacco farmers to buy land through low cost loans with the understanding that partial repayment could be made through higher-yielding harvests.
Palmer makes the following two statements regarding the threat of substitutes within the industry:

Statement 1:	Substitutes exist, but this threat is relatively low due to the premium nature of Molvania’s products.
Statement 2:	The threat should be considered as very low due to the existence of competitors who also make premium products.

Palmer is evaluating the price sensitivity and the bargaining power of buyers and makes the following statements in his report.

Statement 3:	Since a premium product is being offered, price sensitivity is relatively less important.
Statement 4:	Due to the presence of other competitors worldwide, pricing issues cannot be ignored.

Which of the following is least likely to be a barrier to entry in the Molvanian tobacco industry?

A) The supply of labor is limited due to the skill required.

B) The country is small, making land difficult to acquire.

C) Cigarette consumption has declined in recent years.

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The supply of labor is limited due to the skill required. The country is small, making land difficult to acquire. Moreover, the state is strongly involved and controls the export business. It would be extremely difficult to penetrate the tobacco industry in Molvania. (Study Session 11, LOS 36.a)

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Which of the following is most accurate regarding the bargaining power of buyers (the select group of tobacco dealers) and buyers’ bargaining leverage?

A) Buyers have very little leverage since they are appointed by the majority state-owned company and have little or no access to additional supply.

B) Buyers have significant leverage because they purchase the tobacco products.

C) Buyers have leverage because they have the ability to initiate lawsuits against the industry.

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Buyers have very little leverage, since they are appointed by the majority state-owned company and have little or no access to additional supply. (Study Session 11, LOS 36.a)

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Palmer concludes that the bargaining power of suppliers is high because tobacco farmers have some control over the harvest and have a measure of control over the volume of tobacco produced. Which of the following additional factors, when considered in conjunction with the factor Palmer cites, best supports the conclusion that the bargaining power of suppliers is moderate instead of high?

A) Molvanian manufacturers have managed to protect their relative advantage in producing hand-rolled tobacco products.

B) Smaller companies within Molvania have little or no export business.

C) Much of the industry is either state-controlled or influenced by two large domestic companies.

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In terms of supply, there are two opposing forces at work. Tobacco farmers control the harvest, and they may have a measure of control over the volume of tobacco produced, as Palmer notes. However, much of the industry is either state-controlled or influenced by two large domestic companies, which is consistent with less supplier bargaining power. When these facts are taken into consideration, the conclusion that the bargaining power of suppliers is moderate is a reasonable one. (Study Session 11, LOS 36.a)

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Which statement most accurately portrays the rivalry among existing competitors in the industry? Rivalry among existing competitors in the industry is:

A) very high.

B) moderate.

C) very low.

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Rivalry among existing competitors in the industry is moderate. While it is limited domestically, the export business is substantially more competitive due in large part to several international companies having well-developed distribution networks. (Study Session 11, LOS 36.d)

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Are Palmer’s statements regarding the threat of substitutes within the industry correct or incorrect?

A) Both statements are correct.

B) Only statement 2 is correct.

C) Only statement 1 is correct.

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Substitutes exist, but this threat is relatively low due to the premium nature of Molvania’s products, so Statement 1 is correct. The threat should not be considered as very low due to the existence of competitors who also make premium products, so Statement 2 is incorrect. (Study Session 11, LOS 36.b)

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Are Palmer’s statements regarding price sensitivity and bargaining power of buyers correct or incorrect?

A) Both statements are correct.

B) Only statement 3 is correct.

C) Only statement 4 is correct.

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Since a premium product is being offered, price sensitivity is of limited importance, so Statement 3 is correct. On the other hand, due to the presence of other competitors worldwide, pricing issues cannot be ignored, so Statement 4 is also correct. (Study Session 11, LOS 36.b)

pacmandefense

Cost-effective video streaming service has impacted the business of video disk rental companies. This is most likely a change in which Porter’s force?

A) Bargaining power of buyers.

B) Bargaining power of suppliers.

C) Threat of substitutes.

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Changes in technology altered the price-performance dynamics of video delivery industry. Video-streaming increased the threat of substitutes to video rental business.

pacmandefense

Zipla Inc is an emerging bio-tech company specializing in neurological diseases. One of Zipla’s drug, Apsia is scheduled to go off patent protection later this year. This change would most likely bring out changes in which Porter’s force?

A) Bargaining power of suppliers.

B) Threat of new entrants.

C) Bargaining power of buyers.

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Upon expiration of patent protection, threat of new entrants increases. Bargaining power of suppliers may not be affected (not enough information) and bargaining power of buyers would change only if new firms enter the market.

pacmandefense

Karla Hanover, CEO of Marshall Computers, is gloating during a board meeting. “It’s been a wonderful year, people. First, we received a tax break from the state that allows us to reduce our manufacturing costs. Second, we drove our longtime competitor, Roseland Technology, out of business. Third, we patented a new processor 30% faster than those of our rivals.”
Which of the three victories Hanover cited is least likely to give the firm a lasting advantage over its competitors?

A) The demise of a competitor.

B) The new, faster processor.

C) The tax break.

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Government action and technological advancements don’t generally have a lasting effect on an industry. However, such company-specific factors as a state tax break and a patented new technology can strengthen one company at the expense of others. However, the elimination of a rival could result in new competitors entering the market. As such, it is least likely to provide a lasting competitive advantage.

pacmandefense

Martin Kemp, owner of a fast-growing food distributor with one of the state’s largest truck fleets, wants to buy up most of its smaller trucking rivals in an effort to increase its scale and efficiency, thus fattening profit margins. Two of Kemp’s advisers warn that the strategy could backfire.
Bart Able says: “If you clear out the competition and increase profit margins, the business could draw the attention of larger companies that have so far stayed out of this region.”
Andrea Baker says: “If you raise prices on truck shipping, more customers will opt to ship in their food by train.”
Both Able and Baker conclude that Kemp’s acquisition strategy could actually end up reducing profit margins. Which arguments are valid?

A) Only Baker’s.

B) Both Able’s and Baker’s.

C) Only Able’s.

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Both Able and Baker offer legitimate reasons why an acquisition strategy might not result in sustainable margin improvement. Both may turn out to be wrong, but their arguments have merit

pacmandefense

According to Porter, there are two fundamental questions that determine competitive strategy. Of these two questions, the one that the firm has the most control over is whether the:

A) firm can position itself to have a competitive advantage.

B) industry is profitable.

C) industry is attractive.

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The firm typically has little control over the industry’s long-term attractiveness, but it has a great deal of control over its choice of competitive position.

pacmandefense

The choice of competitive strategy is driven by two fundamental questions. These fundamental questions involve:

A) industry attractiveness and competitive advantage.

B) industry attractiveness and profitability.

C) competitive advantage and industry growth.

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According to Porter, the two key questions in determining a competitive strategy involve industry attractiveness and competitive advantage.

pacmandefense

Automation can help a firm improve its competitive position by affecting:

A) new entrants to the industry.

B) suppliers’ bargaining power.

C) the threat of substitutes.

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Automating production can make it more expensive for rivals to enter the market, increasing the width of a company’s economic moat. Automation on its own will not affect the threat of substitutes or increase suppliers’ bargaining power.

pacmandefense

Zanzibar Zanies, a novelties manufacturer, faces a number of competitive problems. It decides to use the six-step process to determine how Porter’s five forces affect its industry. Zanzibar just finished identifying competitors, buyers, suppliers, potential entrants, and potential substitutes. The next step is to:

A) assess possible changes in each force.

B) analyze the industry structure and determine how each of the five forces affect pricing.

C) determine the strength or weakness of each of the five forces.

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The process of identifying competitors, buyers, suppliers, potential entrants, and substitutes is Step 2 of the process. Step 3 is to determine the strength or weakness of the forces

pacmandefense

Strawline, Inc. manufactures straws using a new technology which allows straws to be made with an 11% reduction in costs. According to Porter’s model, which of the following is most likely?

A) Strawline’s increased profit margins will allow it to increase financial leverage.

B) Any initial advantage will eventually be eliminated as competitors adopt the same technology.

C) Strawline’s increased profit margins will allow it to decrease financial leverage.

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New technology does not offer a lasting advantage since the technology is available to all of Strawline’s current and potential competitors.