HuskyGrad2010

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 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.

Projections for the year ending:	2008	2009	2010
Available capacity (in 100,000 units)	450	492	496
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%

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The formula for capacity utilization is: capacity utilization = expected demand / available capacityCapacity utilization for 2008 is: 275 / 450 = 61.11%
Capacity utilization for 2010 is: 360 / 496 = 72.58%. (Study Session 11, LOS 37.e)

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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) Decline.

C) Mature.

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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 37.b)

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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.

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.
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 Reynolds is correct.

C) only Lapke is correct.

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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 38.c)

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Reynolds has been provided with the information contained in Tables 1 and 2 below, where the estimated value of the emerging market firm is presented based on a five-year cash flow forecast.

Table 1: Real Valuation of Emerging Market Firm

	Today	Year 1	Year 2	Year 3	Year 4	Year 5
Real FCF		117	152	155	158	162
Real continuing value						2,550
Total annual real cash flow		117	152	155	158	2,712
PV value factor (8%)		0.925926	0.857339	0.793832	0.73503	0.680583
PV of annual real cash flow		108	130	123	116	1846
Real firm value	2,323

Table 2: Nominal Valuation of Emerging Market Firm

	Today	Year 1	Year 2	Year 3	Year 4	Year 5
Nominal FCF		133	211	258	317	387
Nominal continuing value						6,155
Total annual nominal CF		134	211	259	318	6,542
Real WACC		0.08	0.08	0.08	0.08	0.08
E(Inflation)		0.35	0.15	0.15	0.15	0.15
Nominal WACC		0.458	0.242	0.242	0.242	0.242
PV factor		0.685871	0.552231	0.444631	0.357996	0.288241
PV of annual nominal CF		92	117	115	114	1,885
Nominal firm value	2,323

Note in Table 2 that the expected inflation rate is 35% in year 1 and 15% in years 2 through 5. Which of the following most accurately reflects the effect of an increase in inflation to 35% over years 2 through 5 on firm value in both real and nominal term?

Real Value

Nominal Value

A) No change Decreases by at least 323

B) Decreases by at least 323 Decreases by at least 323

C) No change No change

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There is no need to go through the tedious and painful process of crunching through all the numbers to answer this question because firm value estimates should be the same regardless of whether they are based on real or nominal forecasts. Therefore, they should both change by the same amount when the inflation forecast changes.
While the question does not require you to know why this is the case, the following two reasons are offered to those of you who might be interested.

• Depreciation in nominal terms increases by less than the increase in inflation, but nominal EBITDA increases by the increase in inflation, so EBITA and taxes in nominal terms increase.  That means real taxes increase, which leads to a decrease in real NOPLAT and free cash flow, causing value to decrease.
• The investment in real working capital also increase when the inflation rate increase because the "holding period loss," increases.  This also reduces free cash flow therefore firm value.

(Study Session 11, LOS 38.b)

HuskyGrad2010

Which is not an appropriate step in adjusting for emerging market risks?

A) Estimate cash flows for a series of scenarios.

B) Estimate a market price using probability-weighted scenario analysis.

C) Increase the discount rate.

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Evidence suggests country risks are better captured by adjusting cash flows to account for emerging market risks rather than adjusting the discount rate. Analysts should estimate cash flows for a series of scenarios and then estimate a market price using probability-weighted scenario analysis.

HuskyGrad2010

The best way to incorporate country risk into emerging market company valuations is by adjusting the:

A) cash flows.

B) risk-free rate.

C) discount rate.

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Evidence suggests that country risks can be best captured by adjusting cash flows in a scenario analysis rather than including them into the discount rate.
The four arguments that support adjustments to cash flow rather than adjusting the discount rate are:

• Country risks are diversifiable.

• Many factors directly affect cash flows.

• Companies respond differently to country risk.

• Country risk is one-sided risk.

HuskyGrad2010

Chris Luke, CFA, is a senior analyst for Wilder International Investment Corporation (WIIC). Luke has been assigned to review companies in the country of Quijinn, for potential investment opportunities.Quijinn is a small, emerging country with a high rate of inflation. Luke has identified a potential investment opportunities in Quijinn, Giett Manufacturing. To prepare for his analysis of the company, Luke asks junior analyst Jaina Antilles, a Level II CFA candidate, to put together the information shown in Figure 1.

Figure 1

Country	Quijinn
Forecasted real GDP growth	4.0%
Market risk premium	5.0%
Historical real returns for companies with average risk	12.0%
Inflation Rate	8.5%

Antilles applies a real valuation model to Giett Manufacturing. Antilles recognizes that emerging market risks, such as the high inflation rate in Quijinn, require adjustments in the valuation process. Antilles tells Luke, “I am considering adjusting the required return I am using for discounting Giett’s cash flows. Companies in an emerging market tend to respond differently to country risks, and the best way to account for the difference is adjusting the discount rate.” Luke replies, “I do not think that adjusting the discount rate is going to be helpful in your process. Country risk is an example of systematic risk that cannot be diversified, and is therefore going to already be included in Giett’s cost of capital.”Antilles is preparing a valuation analysis of Giett Manufacturing and decides to use a real valuation approach that adjusts for Quijinn’s high rate of inflation. Antilles identifies four components of the valuation model that are impacted by her approach:

Component 1: Cash taxes
Component 2: Capital Spending
Component 3: Net working capital
Component 4: Depreciation

Which of the components does Antilles’ real valuation approach provide the least accurate answer?

A) Components 1 and 4.

B) Components 1 and 3.

C) Components 2 and 3.

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A real valuation approach estimates value using real cash flows that are discounted at the real required return. Using a real valuation approach will create realistic capital spending forecasts and the terminal value of the company will be calculated correctly – therefore components 2 and 4 will be calculated correctly. However, a real valuation approach will incorrectly calculate cash taxes, which are based on nominal financial statements, as well as net working capital. Components 1 and 3 will be calculated incorrectly. Inflation affects beginning working capital differently as compared to change in working capital during the year. Hence we cannot apply one index rate for the entire working capital.

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Regarding their discussion about adjusting the discount rate to account for emerging market risks in valuing Giett Manufacturing:

A) Antilles’ statement is incorrect; Luke’s statement is incorrect.

B) Antilles’ statement is correct; Luke’s statement is incorrect.

C) Antilles’ statement is incorrect; Luke’s statement is correct.

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Both Antilles and Luke make incorrect statements. Although Antilles is accurate that companies respond differently to country risks, this is an argument for adjusting cash flows – not the discount rate. A general discount rate cannot be applied to every company within a country because every company has different operating characteristics. These different operating characteristics are best captured by adjusting forecasted cash flows. Luke is also incorrect. Country risks are examples of unsystematic risks that are diversifiable, and therefore should not be included in the cost of capital. Again, adjusting cash flows is a better way to reflect the impact of country risk.

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Luke and Antilles decide to calculate a value for the various companies they are analyzing by applying a country risk premium to the company's WACC, but want to avoid over-estimating the country risk premium by comparing CAPM to historical real returns. Assume for this question only that real GDP growth is a good proxy for the real risk free rate. What is the appropriate country risk premium to use for Quijinn?

A) 3.0%.

B) 4.0%

C) 8.0%

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Analysts often over estimate the country risk premium in emerging markets. One method used to avoid this is to compare expected returns implied by the CAPM to historical real returns. The historical real returns of average risk companies (beta = 1.0) should be approximately real risk free rate + market risk premium + country risk premium.12.0% = 4.0% + 5.0% + country risk premium
country risk premium= 3.0%

Although a calculation was required for this question, the real goal is to see the importance of making "reality checks" of your country risk premium estimates. If the country risk premium implied by expected returns differs significantly from the country risk premium implied by historical returns, expected returns could be very inaccurate.

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One of the best ways to capture the impact of various macroeconomic variables on an emerging market company’s valuation is to develop:

A) a historical financial statement using the temporal method.

B) an inflationary cash flow forecast under nominal and real terms.

C) a probability-weighted scenario analysis of cash flows.

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Better cash flow estimates for an emerging market company can be determined by using probability-weighted scenario analysis. This involves assigning probability estimates to the economic/operating states that the company is likely to encounter and making adjustments to its cash flows. Scenario analysis is an important tool in understanding the effects of different macroeconomic variables on the cash flows of an emerging market company. Scenario analysis involves assigning probabilities to various operating environments an emerging market company is likely to encounter.

HuskyGrad2010

An analyst is attempting to estimate the weighted average cost of capital (WACC) for an emerging market manufacturer. The emerging market country has experienced high inflation in recent years. She estimates each component of WACC as follows:

• Risk-free rate: 10-year U.S. government bond yield + inflation differential between the local market and U.S. market.
• Beta: From a regression of the manufacturer's stock returns on the country's market equity index.
• Market risk premium: 6.0%, which is the geometric average nominal risk premium on the country's equity index over the past 12 years.
• Pre-tax cost of debt: local risk-free rate plus the credit spread on U.S. corporate bonds rated B+.
• Marginal tax rate: 35%, which reflects all government taxes that are applied to interest expense on corporate bonds.
• Capital structure weights: Average capital structure weights for global industry competitors.

With respect to the cost of equity capital and the WACC, the analyst has overestimated:

A) both of these.

B) one of these.

C) neither of these.

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The analyst has most likely correctly estimated the risk free rate, the pre-tax cost of debt, the marginal tax rate, and the capital structure weights. However, she has most likely incorrectly estimated the market risk premium and beta. The best recommendation for estimating the market risk premium is to use a long-term average risk premium on a global market index. The topic review suggests a range of 4.5% to 5.5%. The market risk premium is overestimated using 6.0% based on recent risk premiums in the equity markets. Beta should be estimated based on a regression of the industry's stock returns on a global market index. The analyst has overestimated both beta and the market risk premium. The result is that she has also overestimated the cost of equity capital and the WACC.

HuskyGrad2010

Francine LeMond works as an equity analyst for MegaMax Investments, one of the world’s largest broker-dealers. LeMond has been tasked with analysis of remnants, or legacy stocks that were not recommended or purchased by MegaMax but are still part of client portfolios.
LeMond’s first chore of the day is to review some emerging-market equities in the Spencer portfolio. Financial results for all of the stocks appear strong, and the shares have gained substantially in value over the last year. But LeMond is concerned that the financials as stated do not accurately reflect the companies’ operations.
Emerging markets present special problems for equity analysts, and LeMond intends to adjust financial results for these equities to accommodate the following issues:

• The risk of political instability
• Vulnerability of the companies to privatization
• Limited availability of foreign and domestic investment capital
• Unusually high inflation

The first emerging-market company on LeMond’s list is Plicher, a company located in the African country of Llaho that makes construction equipment. In recent years Plicher’s sales and profits have soared, helped by a series of lucrative contracts to provide equipment for government road-building teams. In her analysis of Plicher, LeMond draws on the following information:

• The U.S. risk-free rate is 4%.
• The U.S. market-risk premium is 6.5%.
• The global market-risk premium is 9%.
• The Llaho inflation rate is 25%.
• The U.S. inflation rate is 3.5%.
• 10-year Treasury bonds yield 2.5% more than T-bills.
• The Llahoan government’s short-term bills pay a yield of 8.3%.
• Plicher’s marginal tax rate is 30%.
• Plicher’s equity value is $85.2 million.
• Plicher’s revenue estimate for the next 12 months is $146 million.
• Plicher’s assets are valued at $279.5 million.
• Plicher’s debt rating is A-, and its debt is valued at $194.3 million.
• On average, 10-year U.S. corporate bonds with rating of A- yield 1.3 % higher than a 10-year U.S. Treasury bond.
• On average, 10-year Plicher corporate bonds with a rating of A- yield 5.6% more than a 10-year U.S. Treasury bond.
• Worldwide, companies in Plicher’s industry typically have a beta of 1.6.
• Based on Plicher’s stock returns over the last five years, its beta is 3.4.

LeMond spends several hours preparing revised financial statements, ratios, and valuation estimates for Plicher. Just as she finishes, her boss, Peter Cavanaugh, drops a new project on her desk. Kenton Koncepts, a maker of aircraft parts, just announced a new strategic plan, and Cavanaugh wants to know whether MegaMax should upgrade the stock from its current Neutral rating.
With Kenton’s strategic plan are several pieces of information – a chart showing global aircraft orders and backlog over the last three years, detailed cost-cutting initiatives, a list of proposed plant upgrades, and a detailed list of Kenton’s products and the niches they address. LeMond prepares a short analysis of Kenton.
As her last assignment of the day, LeMond turns to remnants Quintile Fusion, Blevins, and Karnack Analysis, all of which represent large positions in the Adams account. Below are some characteristics of the companies and their industries:

Quintile Fusion	Blevins	Karnack Analysis
Equipment maker trying to branch out into business consulting	Sales growth rates above economic growth rate	Sales growth rates well above economic growth rate
Results in recent quarters have lagged economic growth rate	Uses size and price advantage to take market share	Has had trouble funding expansion
Concerned about rivals’ new products and services eating into its market share	Concerned about powerful brand losing momentum	Concerned about market acceptance of new products
Many rivals are growing huge through acquisitions	Profit margins in line with market average	Differentiates itself by specialization
Hedges raw-materials prices aggressively to reduce volatility of expenses	Information business spends little on manufacturing, much on personnel	Manufacturing facilities are expensive to build, and technical expertise difficult to find
	Hiring is easier than it once was because of a large number of new graduates – labor costs declining	Capacity utilization has increased sharply in recent years

Using the information she gathered on the three firms, LeMond drew conclusions about the industries in which all three companies operated and about the profitability and pricing power of each company.Which of the three remnants in the Adams account most likely has the greatest and least pricing power?

Greatest

Least

A) Karnack Analysis Blevins

B) Blevins Quintile Fusion

C) Karnack Analysis Quintile Fusion

Pricing power is difficult to ascertain without specific data, but the information presented above provides enough clues to deduce the proper order. Quintile Fusion appears to be a company in decline, reinventing itself, worried about rivals, and dependent on commodities for production. Both Blevins and Karnack Analysis appear to have more market leverage. Blevins’ concerns about its brand momentum, coupled with what appears to be fairly small barriers to entry, suggest pricing power is limited. Karnack differentiates by specialization, one key to charging high prices. Large barriers to entry, and a rise in capacity utilization suggests demand is rising faster than supply, potentially supporting higher prices. Concern about the acceptance of new products could be a negative indicator for prices, but Karnack has the most positive data regarding pricing power, and Quintile Fusion has the most negative data. (Study Session 11, LOS 37.f)

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Which of the following information on Kenton Koncepts is most valuable in the analysis of long-term?

Supply trends?

Profitability?

A) Order chart Product list

B) Order chart Cost-cutting initiatives

C) Plant upgrades Cost-cutting initiatives

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The list of plant upgrades is useful for estimating Kenton’s production, but an industrywide chart of orders and backlogs illustrates more than demand trends. By considering both orders and backlogs, an analyst can back into supply analysis and draw useful conclusions about the current supplies and industry production capacity. While cost-cutting initiatives will have an effect on profit margins, particularly in the short term, of more importance in the long term is the company’s ability to produce items the market wants. Kenton’s list of products and niches has substantial value for determining whether the company can continue to operate profitably. (Study Session 11, LOS 37.f)

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Based only on the information above, where do Blevins’ and Karnack Analysis’ industries fall on the business life cycle?

Blevins

Karnack Analysis

A) Growth Growth

B) Mature Growth

C) Mature Pioneer

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Blevins’ growth rate suggests it is not on the decline. In some ways Blevins looks like a growth company, but companies can post solid growth within a mature industry, particularly if they are taking market share. And Blevins’ profit margins and concerns about the erosion of an already powerful brand are characteristic of an established company in a mature industry. Karnack’s difficulty in funding expansion hints at high capital needs, and concerns about new products suggest it is in a pioneer industry. (Study Session 11, LOS 37.b)

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Which of the following issues will be least effectively addressed if LeMond simply adjusts the financial statements by reducing the cash flows of each company in the country by a set amount?

A) Unusually high inflation.

B) The risk of political instability.

C) Vulnerability of the companies to privatization.

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Inflation and political instability will have a similar effect on companies throughout a country. Some industries are more vulnerable to privatization than others, and simply reducing cash flows for all companies by a set amount will probably understate the cash flows of companies in industries not likely to be privatized. (Study Session 11, LOS 38.c)

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Plicher’s cost of equity is closest to:

A) 44.2%.

B) 38.4%.

C) 42.4%.

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The cost of equity = the risk-free rate + beta × market risk premium. First, the risk-free rate. We can’t use the U.S. risk-free rate, and Llaho bills may be illiquid or denominated in another currency. So we start with the 10-year Treasury yield, then add the difference between Llaho’s inflation and U.S. inflation.

4% + 2.5% + 25% − 3.5% = 28%.

For beta, we use the industry beta, not the beta derived from stock returns. The market risk premium is the global premium.
Thus, the cost of capital is 28% + 1.6 × 9% = 42.4%. (Study Session 11, LOS 38.d)

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Assume for this question only that the cost of equity is 25.4% and the local risk-free rate is 15%. Plicher’s weighted average cost of capital is closest to:

A) 15.67%.

B) 10.15%.

C) 18.64%.

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The weighted average cost of capital equals (equity / assets) × cost of equity + (debt / assets) × after-tax cost of debt.
We have equity, assets, debt, and cost of equity values. To calculate the cost of debt, we start with the local risk-free rate plus the U.S. credit spread on comparable debt, or 15% + 1.3% = 16.3%. Then we multiply 16.3% by (1 – marginal tax rate). 16.3% × 70% = 11.41%.
Here is the entire equation:

($85.2 million / $279.5 million) × 25.4% = 7.74%.
($194.3 million / $279.5 million) × 11.41% = 7.93%.
7.74% + 7.93% = 15.67%.

(Study Session 11, LOS 38.d)

HuskyGrad2010

Renee LeClair, CFA, FRM, is estimating the cost of capital for 3 small companies in emerging market countries. Assume a U.S. inflation rate of 2%, a 10-year U.S. government bond yield of 5%, and a market risk premium of 2%.

Company	ROA	Beta
AAA	13.05%	1.60
BBB	12.90%	1.20
CCC	12.85%	1.30

Company	Country	Local Inflation
AAA	Penance Sands	4.35%
BBB	Misty Land	5.00%
CCC	Happy Valley	4.75%

Which company has the highest cost of equity?

A) BBB.

B) AAA.

C) CCC.

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Start by calculating each country’s risk-free-rate:
Risk-free-rate = 10 yr. U.S. govt bond + (local inflation – U.S. inflation)
The risk free rate for each country is:

Penance Sands	7.35% = 5% + 4.35% − 2%
Misty Land	8.00% = 5% + 5.00% − 2%
Happy Valley	7.75% = 5% + 4.75% − 2%

The cost of equity = risk-free rate + beta(market risk premium)
The cost of equity for each company is:

AAA	10.55% = 7.35% + 1.6(2%)
BBB	10.40% = 8.00% + 1.2(2%)
CCC	10.35% = 7.75% + 1.3(2%)

AAA’s high beta offsets Penance Sand’s low inflation, yielding the highest cost of equity

HuskyGrad2010

Country risk for an emerging market company is generally incorporated into the:

A) credit risk premium.

B) market-risk premium.

C) sovereign risk premium.

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The sovereign risk premium consists of both credit and country-risk premiums.

HuskyGrad2010

Country-risk premiums tend to:

A) become part of the local government risk-free rate.

B) increase when government credit issues grow.

C) decrease toward zero over the long run as emerging markets become integrated into the global market.

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Over the long run, it is assumed that the country-risk premium will approach zero as the emerging market becomes integrated into the international markets.