Equity Valuation【 Reading 38】Sample emerging, 2012, expressed, company

tango_gs

When valuing an emerging market company using cash flows expressed in both nominal and real terms:

A) both valuations are not reliable.

B) both valuations are identical.

C) each valuation differs by the inflation differential.

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In order to adjust for the influences of inflation, company cash flows will require restatement in both nominal and real terms. Construct historical and forecasted financial statements in both nominal and real terms. Calculate the nominal cash flows and convert them to real terms. Discount the nominal and real cash flows to determine their respective valuations for both terms. The valuations under both terms should be identical.

tango_gs

With respect to emerging market companies, which of the following macroeconomic variables has the most impact on the estimation of cash flows?

A) Inflation.

B) Country risk.

C) Political risk.

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Emerging markets are characterized by high inflation. Inflation affects the financial statements by creating distortions in non-monetary assets (i.e. property, plant, equipment and inventories). Cash flow projections used in valuations, as well as most financial ratios, will also be distorted.

tango_gs

order to properly measure the cash flows of an emerging market company to consider the impact of inflation, one starts the process by constructing the:

A) historical and forecasted financial statements in both nominal and real terms.

B) historical financial statements using the temporal method.

C) forecasted financial statements using the current method.

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Construct historical and forecasted financial statements in both nominal and real terms. Historical financial statements are translated to real terms by using the current method. Forecasted financial statements in real terms are then created and then converted to nominal terms. Finally, calculate the nominal cash flows and convert them to real terms.

tango_gs

An analyst is calculating ratios from nominal financial statements. The company is domiciled in an emerging market with high inflation. Which of the following effects is least likely?

A) Solvency ratios, such as debt to assets, will be too low.

B) Fixed asset turnover will be overstated.

C) Operating margins will be overstated.

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Solvency ratios, such as debt to assets, will be too high as assets are understated. Fixed asset turnover will be overstated because fixed assets do not capture inflation effects in a timely manner, but sales do reflect the effect of inflation. Operating margins will be overstated as sales reflect inflation but depreciation does not.

tango_gs

Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. Charleston Johnson expects the local government to be successful in bringing inflation under control, and anticipates that it will fall to 20% in the second year and 10% in the third year, where he expects inflation to stabilize. Johnson predicts that by year 3, Wavington will have nominal free cash flow of $187 million growing at 4% annually in real terms. In view of his optimistic outlook, he is considering an investment in Wavington, and has calculated the real WACC for Wavington at 8%. The nominal continuing value of Wavington in year 3 is closest to:

A) $4,675.

B) $4,862.

C) $4,250.

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The nominal growth rate for Wavington in the steady state is (1.10 × 1.04) – 1 = 14.4%. The nominal WACC in the steady state is (1.10 × 1.08) – 1 = 18.8%. The nominal continuing value for Wavington in year 3 is:

nominal continuing value = FCF3 × (1 + nominal growth rate) / (nominal WACC – nominal growth rate)
nominal continuing value = 187 × (1.144) / (0.188 – 0.144)
nominal continuing value = 213.9 / (0.044) = 4,862

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.