Reading 40- LOS g ～ Q4－8

4.Global Investments Research Institute (GIRI) is a Canadian firm that gathers international data and conducts research on various industries throughout the world. The firm specializes in conducting top-down analysis emphasizing economic and industry data for international investments.

Joseph Mathias, an analyst for GIRI, is putting together a research report detailing the competitive environment of the toy manufacturing industry in India. In preparation for his report and analysis, Mathias has compiled the following data on the five toy manufacturing firms in India:

Figure 1: Toy Manufacturing Industry Data for India

§ Inflation rate in India = 6%, inflation flow-through rate in India = 80%

§ Inflation rate in Canada = 4%, inflation flow-through rate in Canada = 80%

As Mathias is analyzing the Indian toy industry data for his report, Beatrice Hiatt, another analyst at GIRI, stops by his office. Hiatt tells Mathias that she has been working on a project involving growth theory and how different countries create value through the growth rate in output. During the course of their conversation, the following statements are made:

Mathias: “As the amount of capital deployed in the Indian toy industry increases, diminishing returns are not likely because they will be offset by gains from experience with the production process.”

Hiatt: “The savings rate in India supports the long-term growth rate in GDP, but not the long-term level of GDP.”

GIRI uses the Herfindahl index to summarize the degree of competition within an industry. Given the data provided above, the Herfindahl index for the toy industry in India is:

A)   0.285, indicating low concentration.

B)   0.015, indicating free concentration.

C)   0.285, indicating high concentration.

D)   0.015, indicating average concentration.

The correct answer was C)

The calculation for the Herfindahl index is as follows:

Herfindahl index (H) = 0.15² + 0.10² + 0.05² + 0.30² + 0.40²

= 0.0225 + 0.01 + 0.0025 + 0.09 + 0.16 = 0.285

A low H (below 0.1) suggests that the industry is competitive and no dominant firms exist. A high H (above 0.18) suggests a high level of concentration, potentially less competition, and an incentive for firms to cooperate with one another.

5.GIRI calculates both a franchise price-to-earnings (P/E) value and an intrinsic P/E value for individual firms in their research reports. The franchise P/E and intrinsic P/E respectively for Firm B are:

A)   20.43; 27.10.

B)   6.67; 36.68.

C)   50.02; 20.43.

D)   43.35; 50.02.

The correct answer was D)     

Tangible P/E value = 1/r = 1/0.15 = 6.667 Franchise factor = FF = 1/r – 1/ROE = 1/0.15 – 1/0.22 = 6.667 – 4.545 = 2.122 Sustainable growth rate = g = ROE × b = 0.22(1-0.35) = 0.143 Growth factor = G = g/(r-g) = 0.143/(0.15-0.143) = 20.429 Franchise P/E value = FF × G = 2.122(20.429) = 43.350 The franchise P/E reflects the growth in the P/E value.

Intrinsic P/E value = Tangible P/E value + Franchise P/E value = 6.667 + 43.35 = 50.02. The intrinsic P/E is the sum of the static, or tangible P/E value and the growth in the P/E value (franchise P/E).

6.Mathias is comparing the effects of inflation on the value of firm D and of similar firms around the world. While researching the toy manufacturing industry, Mathias has discovered that a local Canadian toy manufacturer has financial characteristics that are virtually identical with those of firm D. Assume investors require a real rate of return of 8 percent for firms similar to firm D. What is the estimated P/E ratio for firm D, and is the value of the Canadian firm likely higher or lower than firm D?

A)         10.87                 Lower

B)         10.87                 Higher

C)          7.81                  Higher

D)          7.81                   Lower

The correct answer was B)

Firm D has an inflation flow-through rate of 80 percent, meaning that the firm can only pass 80 percent of inflation through to its earnings. The estimated P/E ratio for Firm D is calculated as:

P₀/E₁ = 1 / [real required return + (1 – inflation flow-through rate) × inflation rate]

= 1 / [0.08 + (1 - 0.80) × 0.06]

= 1 / [0.08 + 0.012]

= 1 / 0.092 = 10.8696

All other things being equal, the higher the inflation flow-through rate, the higher the value of the firm. Also, the higher the inflation rate, the lower the value of the firm’s shares if full inflation pass-through does not occur. If Firm D and the Canadian firm both have inflation flow-through rates of 80 percent, then the value of the Canadian firm must be higher because the inflation rate in Canada is lower (4 percent vs. 6 percent). We can confirm this by calculating the estimated P/E ratio for the Canadian firm:

P₀/E₁ = 1 / [real required return + (1 – inflation flow-through rate) × inflation rate]

= 1 / [0.08 + (1 - 0.80) × 0.04]

= 1 / [0.08 + 0.008]

= 1 / 0.088 = 11.36

7.In regard to the conversation between Mathias and Hiatt about growth theory:

A)   Mathias’ statement and Hiatt’s statement are both examples of neoclassical growth theory.

B)   Mathias’ statement is an example of endogenous growth theory, while Hiatt’s statement is an example of neoclassical growth theory.

C)   Mathias’ statement is an example of neoclassical growth theory, while Hiatt’s statement is an example of endogenous growth theory.

D)   Mathias’ statement and Hiatt’s statement are both examples of endogenous growth theory.

The correct answer was D)

Endogenous growth theory assumes that marginal output does not always decline with increased capital. Diminishing returns may be offset by the benefits gained from production experience or a movement along the learning curve or other factors. Endogenous growth theory also suggests that in the long term, equilibrium between total savings and required investment to maintain capital is not attainable because of the offset of the gains over the diminishing returns. As a result, this assumes that the savings rate supports the long-term growth rate in GDP, but not the long-term level of GDP. Both Mathias’ statement and Hiatt’s statement are examples of endogenous growth theory.

Neoclassical growth theory takes the position that as more capital is added, less marginal output is created from that capital (diminishing marginal returns). Neoclassical theory also suggests that there is an equilibrium in the long term between savings and required investment due to the effects of diminishing marginal returns. To maintain equilibrium, the country’s savings rate must support the long-term level of GDP, but the savings rate does not support the long-term growth rate in GDP.

8.Which of the following is least likely to be characteristic of a firm earning excess risk-adjusted return and its industry?

A)   A full flow-through firm.

B)   A franchise factor equal to zero.

C)   ROE in excess of the required rate of return.

D)   Significant barriers to entry.

The correct answer was B)

The higher the franchise factor, the higher the firm valuation. A zero franchise factor is not likely to be associated with a firm earning excess returns. Full flow-through, significant barriers to entry and ROE greater than the required rate of return all raise valuation, other things equal.