Equity Valuation【 Reading 35】Sample purchase, suppliers, one, 2012, company

bapswarrior

Laura’s Chocolates, is a maker of nut-based toffees. The company holds shares in one of its suppliers, and wants to know what the holding period return was last year.

January 1 (purchase date)	$40
December 31	$45
Dividend paid (December 31)	$5
Cost of equity	11%
Cost of debt	8%
Debt : equity	1:3

What is the holding period return (ignore taxes)?

A) 12.50%.

B) 25.00%.

C) 22.50%.

---

bapswarrior

To determine the present value of an investment based on a future estimate of the investment’s value, an analyst should use the:

A) discount rate.

B) required return.

C) internal rate of return.

---

The discount rate is the rate used to find the present value of an investment.

bapswarrior

In an efficient market, a mutual fund’s required return is the same as the:

A) internal rate of return.

B) holding period return.

C) net asset value return.

---

The internal rate of return (IRR) is the rate that equates the value of the discounted cash flows to the current price of the security. In an efficient market, where securities are properly priced, the IRR and required return are the same.

bapswarrior

Ben Jacobs, CFA, is attempting to calculate a historical equity risk premium. His first estimate uses geometric mean equity returns and long-term bond yields. His second estimate uses arithmetic mean returns and short-term bond yields. The effect of the changes in methodology in the second estimate, relative to the first, will:

A) both increase the size of the risk premium.

B) both decrease the size of the risk premium.

C) have offsetting effects.

---

Switching from a geometric mean to an arithmetic mean will increase the mean equity return. All else being equal, that will increase the estimated risk premium. When the yield curve slopes upward, short-term bonds yield less than long-term bonds. Thus, the equity risk premium estimate will be larger when short-term bond rates are used.

bapswarrior

An analyst attempting to derive the equity risk premium for a stock starting from the required return for that stock would find which of the following statistics least useful?

A) The stock’s beta.

B) Historical 10-year Treasury bond rates.

C) The stock’s estimated return.

---

The required return for a stock is equal to the risk-free return plus beta times the equity risk premium. An analyst starting from the required return would need beta and a risk-free rate. Historical 10-year T-bond rates can be used as an estimate of the risk-free rate. Since the analyst is starting with the required return, estimated returns are not needed.

bapswarrior

The equity risk premium is the difference between:

A) the estimated equity return and the risk-free return.

B) estimated equity returns and estimated bond returns.

C) the required equity return and the risk-free return.

---

The equity risk premium reflects the return in excess of the risk-free rate that investors require for holding stocks. It is derived by subtracting the risk-free return from the required return.

sabaruch

Equity analyst Yasmine Cordova of Substantial Securities is trying to determine the investment appeal of shares of Maxwell Mincemeat, a small food company. Cordova has assembled the following data about the company:

• Internal rate of return: 9.4%.
• Maxwell’s 20-year bond yield to maturity: 7.9%.
• Maxwell’s two-year bond yield to maturity: 6.1%.
• Treasury bill yield: 3.4%.
• Maxwell’s estimated beta: 2.1.
• Maxwell’s 20-year bonds are priced at $102.65.
• Maxwell’s two-year bonds are priced at $101.47.
• Estimated return of Russell 2000 Index: 12.3%.
• Substantial’s credit analyst estimates that Maxwell’s equity warrants a premium of 4.9% over its bonds.

Cordova wants to make sure her estimates are accurate, so she decides to calculate the estimated required return in two ways. She opts for the bond-yield plus risk premium method and the capital asset pricing model. To check her work, she wants to compare the estimates derived under each method. The difference between the required returns is closest to:

A) 5.30%.

B) 9.29%.

C) 5.89%.

---

The capital asset pricing model uses the following equation:

Required return = risk-free rate + beta × equity risk premium

To calculate the required return under CAPM, use the Russell 2000 index return, the beta, and the risk-free rate.

Required return = 3.4% + 2.1 × (12.3% − 3.4%) = 22.09%.

The bond-yield model uses the following equation:

Required return = yield to maturity on long-term bonds + risk premium.

Required return = 7.9% + 4.9% = 12.8%.

The difference between the two estimated required returns is 9.29%.

sabaruch

Jaden Hoyle is evaluating the MegaFood Market chain of grocery stores and Strinson Carburetors, a maker of automobile and industrial engine parts. MegaFood is publicly traded, while Strinson is a private company. Hoyle’s firm, Janssen and Associates, is considering the purchase of a 50% equity stake in one or both of the companies, and may be willing to purchase the companies outright. Janssen only invests in companies with a weighted average cost of capital of less than 11%.
Hoyle has assembled the following data on the two companies:

	MegaFood Market	Strinson Carburetors
Beta	0.87
Market value of equity	$173 million	$993 million
Market value of debt	$38 million	$567 million
Marginal tax rate	42.8%	31%
Target debt/equity rating	35%	78%
Equity risk premium		4.6%
Required return on debt	9%	6.5%

The risk-free rate of return is 5.2%. Hoyle must make recommendations regarding both MegaFood Market and Strinson Carburetors.
Hoyle does not have all of the data she needs and knows she will have to estimate some values using the data she does possess. To help estimate the required return on equity for Strinson Carburetors, Hoyle takes three actions:
Action A: She selects a benchmark company, unlevers the beta of that company, then levers up the adjusted beta using Strinson’s debt and equity allocation.
Action B: She calculates a risk premium, then adds that premium to the yield to maturity of the company’s long-term debt.
Action C: She prepares a supply-side multifactor model considering expected inflation, expected GDP growth, and expected changes in P/E ratio.
Before she finishes her analysis of MegaFood Market and Strinson Carburetors, Hoyle must construct valuation models for two other companies, Halberd Hardware, a maker of hand tools, and the Jones Group, one of the world’s largest consultants. She has assembled the following information about each company. Halberd Hardware

• Gary Halberd, the founder, still owns 85% of the company, and all the rest is in the hands of company directors and friends of Halberd who bought stakes 20 years ago.
• Historical data on equity returns is sparse, as there have been very few trades over the last two decades.
• Halberd Hardware is headquartered in New York City.
• The company plans to go public in the next six months, with Gary Halberd selling 30% of his ownership interest.

Jones Group

• Jones Group, one of the world’s largest consulting companies, has been publicly traded for four years on the South Pittson Island stock market. Its ADR trades on the U.S. market.
• South Pittson Island is a small island nation in the Mediterranean known for its business-friendly tax code.

For her analysis of Halberd Hardware, Hoyle is considering three models to calculate the estimated return. But she has already decided to use the Gordon Growth model to calculate the equity risk premium.
As soon as Hoyle finishes determining which models are best suited to her purposes, her boss comes into the office and tells her to use the capital asset pricing model (CAPM) for all four of the companies she is reviewing. Hoyle is concerned about the effectiveness of the CAPM. With regards to Jones Group, her three main worries are: Worry A: The need to use the country spread model to revise the equity risk premium.
Worry B: The CAPM’s effectiveness because of Jones Group’s ADR.
Worry C: The need to create a beta estimate using an unlevered beta.
Assuming MegaFood Market has a required return on equity (ROE) of 13.6% and Strinson Carburetors has a required ROE of 15.3%, what recommendation should Hoyle give her superiors at Janssen regarding each company?

MegaFood Market

Strinson Carburetors

A) Don’t buy the company Buy the company

B) Don’t buy the company Don’t buy the company

C) Buy the company Buy the company

To determine whether the investments fit Janssen’s requirements, we must calculate the weighted average cost of capital. We have the target debt/equity ratio, from which we can derive the debt/capital ratio needed to calculate WACC. Debt/capital = (debt / equity) / (1+ debt / equity)
For MegaFood, the target debt/capital ratio is 25.93%. For Strinson, the target debt/capital ratio is 43.82%.
WACC = [debt / capital × required return on debt × (1 − tax rate)] + (equity / capital) × required return on equity.
MegaFood WACC = [(25.93% × 9% × (1 − 42.8%)] + (1 − 25.93%) × 13.6% = 11.41%.
Strinson WACC = [(43.82% × 6.5% × (1 − 31%)] + (1 − 43.82%) × 15.3% = 10.56%.
For MegaFood, WACC is 11.41%, higher than the Janssen’s 11% target. For Strinson, WACC is 10.56%, below the target. Thus, Janssen should buy Strinson, but not MegaFood.
(Study Session 10, LOS 35.g)

---

Which of Strinson’s actions is least helpful in the calculation of required return on equity for Strinson Carburetors?

A) Action B.

B) Action A.

C) Action C.

---

Action A is a useful method for calculating beta for private or thinly traded companies. With that estimated beta, Hoyle has all the pieces needed to calculate required return using the capital asset pricing model. Action B reflects the bond-yield plus risk premium method for calculating required return on equity for companies with publicly traded debt. This strategy would provide Hoyle with a target return. The model created in Action C is useful for estimating an equity risk premium. But Hoyle already has an equity risk premium. (Study Session 10, LOS 35.b)

---

Which of the following is the best model for calculating Strinson Carburetors’ required return?

A) Fama-French model.

B) Pastor-Stambaugh model.

C) Capital asset pricing model.

---

Strinson is not publicly held, and its shares have little liquidity. The Fama-French model is useful for estimating returns, but the Pastor-Stambaugh model adds a liquidity factor to the Fama-French model. As such, the Pastor-Stambaugh model is probably better for a company like Stinson because it takes liquidity into account. The CAPM requires the estimation of beta and is likely to be less accurate than the other models. (Study Session 10, LOS 35.c)

---

Hoyle wants to calculate an expected return for Halberd Hardware and Jones Group. She has access to a variety of models, but her best option is:

for Halberd

for Jones

A) build-up method country spread model

B) build-up method capital asset pricing model

C) bond-yield plus risk premium method capital asset pricing model

---

Both the build-up method and the bond-yield plus risk premium method work for thinly traded companies. But the build-up method relies on historical estimates, so it wouldn’t work well for Halberd, which has minimal historical data. Thus, the bond-yield plus risk premium method is the best option. The country spread model is not designed to calculate an expected return, but instead to adjust data from emerging markets for comparison with data from developed markets. The question only provides two options, and the CAPM is the only model that would actually do the required job for Jones. (Study Session 10, LOS 35.c)

---

Hoyle wants to use a macroeconomic model to derive equity risk premiums for both Halberd Hardware and Jones Group. Such a model is appropriate for:

A) both Halberd Hardware and Jones Group.

B) Jones Group, but not Halberd Hardware, because macroeconomic models don’t work for closely held companies.

C) Halberd Hardware, but not Jones Group, because macroeconomic models don’t work for nations like South Pittson Island.

---

Macroeconomic models work for any market in which public equities represent a large enough share of the economy that analysts can reasonably infer a relationship between economic factors and asset prices. Since South Pittson Island is known as a tax haven, it is likely that many other companies are domiciled there for the same reason Jones Group is, and the financial industry is a large part of the economy. However, even if we don’t want to assume that South Pittson Island’s economy is suitable for such models, we have another argument. Jones Group is one of the world’s largest consulting companies. Therefore, it is highly likely that it has significant operations in large, developed markets. Macroeconomic models can be constructed to reflect data from those markets – and in fact, any such model should reflect that data.
While Halberd is closely held, that status should not affect a macroeconomic model, which looks at broad factors that affect both public and private companies. We need not have a beta or historical trading data to use such a model. (Study Session 10, LOS 35.c)

---

Which of Hoyle’s worries about using the CAPM for Jones Group is most justified?

A) Worry B.

B) Worry A.

C) Worry C.

---

Currency-translation issues are a concern for any company with operations in foreign countries. But the country spread model is designed to adjust results from emerging markets using data from developed markets, assigning the proper amount of extra risk for the emerging market. Most tax havens would not need to be treated as emerging markets. In addition, as one of the world’s largest consultancies, Jones Group must do a lot of business in the U.S. and other developed markets. It is unlikely that results from a company like Jones Group would require the adjustments from the country spread model. Regarding beta: Since Jones is publicly traded, there is no need to extrapolate a beta using data from another company. Thus, there is no reason to unlever beta from a benchmark company, then relever it to reflect Jones’ financial condition. The biggest concern is the overall effectiveness of the CAPM. The model should work for Jones Group, but it has weaknesses, most importantly its dependence on just one factor. Jones trades on at least two exchanges, and any model depending on just one market index is not going to reflect the whole picture. (Study Session 10, LOS 35.f)

sabaruch

Analyst Charlie Howell, CFA, is trying to calculate the required return on equity for Yazz Jazz, a maker of saxophones. However, Yazz Jazz operates in a country with rapidly changing inflation rates. Which method should Howell use?

A) Build-up.

B) A multifactor model.

C) Bond-yield plus risk premium.

---

The build-up method assigns premiums based on company size and other company-specific factors. It is designed for use on closely held companies and does not take inflation changes into account. The bond-yield method adds a risk premium to the yield on the company’s publicly traded debt. The bond yields will reflect inflation indirectly, but the model does not easily adjust for inflation changes. For taking rapid inflation changes into account, a multifactor model works the best.

sabaruch

Analyst Charlie Howell, CFA, has constructed two models for determining the required return on equity for Yazz Jazz, a saxophone maker. One takes the company’s size into account, the other takes the shares’ liquidity into account. Which of the following pairs of equity-return models require the use of:

Size

Liquidity

A) Build-up Pastor-Stambaugh

B) Capital asset pricing model Fama-French

C) Build-up Fama-French

---

The build-up method takes into account a company’s size and is usually applied to closely held companies for which beta is not available. The Pastor-Stambaugh method is a modified version of the Fama-French factor model that considers liquidity.