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%.

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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)

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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.

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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)

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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.

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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)

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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

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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)

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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.

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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)

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

A) Worry B.

B) Worry A.

C) Worry C.

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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.

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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

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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.

sabaruch

Morgan Bondillo, CFA, is attempting to calculate the value of Smith Sprockets. She is using a supply-side model to estimate the equity risk premium and a build-up model to estimate returns.
Based on the strategies Bondillo is using, Smith Sprockets is least likely to:

A) be closely held.

B) need its beta adjusted for drift.

C) be located in a developed market.

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Supply-side models work best in developed countries, where public equities represent a significant share of the economy, suggesting that there is a relationship between macroeconomic variables and asset prices. The use of a supply-side model suggests Smith Sprockets is in a developed market. Build-up models are generally used for closely held companies for which betas are not easy to obtain. Bondillo’s use of a build-up model suggests Smith Sprockets is probably closely held. Betas of public companies must be adjusted for drift. However, since the use of the build-up method suggests the company is closely held and has no beta available, beta drift is probably not relevant for Smith Sprockets.

sabaruch

Senior analyst James Matin is instructing a room full of new hires in the finer points of equity valuation. He makes two statements:

Statement 1:	“When the return you expect for a stock doesn’t match the required return, make sure you calculate a convergence yield and build that into your valuation model.”
Statement 2:	“When you estimate the equity return of a thinly traded company, the Pastor-Stambaugh model is a better option than the Fama-French model.”

Do the statements represent good advice?

Statement 1

Statement 2

A) No Yes

B) Yes No

C) Yes Yes

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Statement 1 is not good advice because in some cases market inefficiencies will prevent the price from converging with intrinsic value. As such, Matin’s advice is not sound. Statement 2 is good advice, as the Pastor-Stambaugh model adds a liquidity factor to the traditional Fama-French model. Such a liquidity factor would be useful in the analysis of a thinly traded stock.

sabaruch

Types of estimates of the equity risk premium are least likely to include:

A) macroeconomic model estimates.

B) ex-ante estimates.

C) extemporized estimates.

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There are four types of estimates of the equity risk premium: historical estimates, forward-looking (ex-ante) estimates, macroeconomic model estimates, and survey estimates.

sabaruch

There is a multistep process used to estimate the beta of nonpublic companies. What extra step must be taken to use the process on thinly traded public companies?

A) No extra step must be taken.

B) Beta must be reduced using a liquidity factor.

C) Beta must be adjusted to reflect debt and equity levels.

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The same procedure is used for both nonpublic and thinly traded public companies. Beta is adjusted to reflect debt and equity levels for both types of companies. The procedure for estimating beta for private or thinly traded public companies does not involve a liquidity factor.

sabaruch

In the process of estimating beta for a private company, unlevering the beta calculated for the publicly traded comparable company accomplishes what goal?

A) Establishing a baseline level of leverage.

B) Isolating market risk.

C) Improving the accuracy of the estimate in the event that the private company’s debt is of low quality.

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Market risk, also known as systematic risk, is the risk common to all assets within a certain class. Deleveraging the beta strips out the company-specific risk related to the target company’s leverage, thereby isolating market risk. Beta calculations do not require a baseline level of leverage. The equation for calculating beta for private companies assumes the company in question has high-grade debt. The deleveraging process will not help if the assumption is incorrect

sabaruch

Adjusted beta for public companies compensates for:

A) leverage.

B) changes in the market’s growth rate.

C) drift.

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An adjusted beta is a weighted average of the estimated beta and either 1.0 (the average for all stocks) or a peer mean (the beta of similar firms). The objective of an adjusted beta measure is to compensate for beta drift, or the tendency of beta to revert to 1.0 (or the industry average).