Q: 1
Jane Bowman, CFA, and Frank Shrum, CFA, are analysts for Brookstonc Advisors. Brookstone
recommends investments in United States and global markets. Bowman and Shrum are responsible
for analyzing investments and conducting cyclical analysis in developed and emerging markets.
Bowman is examining the country of Waltonia for a possible investment. Currently, the country's
economy is beginning to recover from a recession. Businesses have increasing confidence in the
economy, inflation is falling, the government is stimulating the economy, and the economy has just
started to expand. Bowman identifies this is as the recovery stage of the business cycle and states
that since inflation is falling, investors should put their money in bonds.
In terms of the business cycle, Waltonia has grown slower than its neighboring country of Bergamo,
where the economy is in the early stages of an upswing. Bergamese businesses are confident and
inventories are increasing. Bowman states that an investment in commodities or stocks would be
advised because when the economy grows, these assets will rise in price.
Shrum is examining the value of a company in the United States using the franchise value model. In
it, he will generate an intrinsic P/E ratio that can be multiplied against the firm's projected earnings
to derive a value for the company. The intrinsic P/E value consists of the tangible P/E value, which
represents the firm's static value, and a franchise P/E value which represents the firm's growth value.
The franchise P/E value then consists of the franchise factor, which incorporates the required return
on new investments, and the growth factor, which factors in the present value of the excess return
from new investments. He applies this analysis to the firm of Salisbury Materials, which has the
following characteristics:
Return on Equity 20%
Dividend Payout Ratio 40%
Required Return on Equity 16%
In light of the increased inflation in the United States due to increased commodity prices. Bowman is
examining the effect of inflation on the P/E ratio. She states that when there is not full-flow-through
of inflation, a firm in a low inflation country will have a higher P/E ratio than one in a high inflation
country. She provides the following example of inflation flow-through. If the real required return is
9%, inflation is 4%, and the inflation flow-through rate is 80%, then the P/E ratio will be 10.2.
Shrum states that when valuing an emerging market, an investor should adjust their projections for
the higher inflation risk. He states that the analyst should adjust the cash flows rather than the
discount rate for the increased risks from emerging markets, such as political risk and
macroeconomic risk. Bowman adds that there are several arguments that can be made and makes
the following statements.
Statement 1: One argument is that companies respond differently to the risk in their country. For
example, exporters would benefit from a weaker local currency but importers would be hurt by a
depreciating local currency. Adjusting the discount rate by the same amount for all companies within
a country would misstate the influence of country risk on each company.
Statement 2: Additionally, country risk is one-sided and asymmetric in that the country risk to foreign
investors is much greater than that to local investors. So if a single discount rate were used to
discount cash flows, then the valuations would be inaccurate for either the foreign investors or the
local investors.
Shrum follows up with Bowman's analysis. He states that an alternative to adjusting the cash flows is
to calculate a weighted average cost of capital for the emerging country firm and add a country risk
premium to it. This discount rate would then be applied against unadjusted cash flows to value the
emerging market firm. Regarding this analysis, he makes the following statements.
Statement 3: When estimating the percent of debt and equity in the capital structure, the market
value of the firm's debt and equity should be used, not the book value.
Statement 4: The beta will be needed to obtain the cost of equity capital in the CAPM. The beta
should be estimated for the company by regressing the company's returns against a well diversified
global index, not the local market index.
Regarding Bowman's statements on inflation flow-through and the calculated P/E ratio, are both
statements correct?
Options
Discussion
No comments yet. Be the first to comment.
Be respectful. No spam.
One of Pedad's other equity analysts, Marie Swift, CFA, recently held a meeting with Armor to
discuss a relatively new model the firm is implementing to determine the P/E ratios of companies
that Pedad researches. Swift explains that the model utilizes a cross-sectional regression using the
previous year-end data of a group of comparable companies' P/E ratios against their dividend payout
ratios (r), sustainable growth rates (g), and returns on equity (ROE). The resulting regression equation
is used to determine a predicted P/E ratio for the subject company using the subject company's most
recent year-end data. Swift has developed the following model, which has an R-squared of 81%, for
the meat packing industry (16 companies):
Predicted P/E = 2.74 + 8.21(r) + 14.21(g) + 2.81(ROE)
(STD error) (2.11) (6.52) (9.24) (2.10)
After Swift presents the model to Armor, she points out that models of this nature are subject to
limitations. In particular, multicollinearity, which appears to be present in the meat packing industry
model, can create great difficulty in interpreting the effects of the individual coefficients of the
model. Swift continues by stating that in spite of this limitation, models of this nature generally have
known and significant predictive power across different time periods although not across different
stocks.
Based on Exhibit 1, the justified price-to-sales ratio of Baker, Inc. is closest to:
Scott reads the Delicious's revenue recognition footnote found in Exhibit 2.
Exhibit 2: Revenue Recognition Footnote
_________________________________________________________________________________
_
in
millions__________________________________________________________________________
Revenue is recognized, net of returns and allowances, when the goods are shipped to customers and
collectability is assured. Several customers remit payment before delivery in order to receive
additional discounts. Delicious reports these amounts as unearned revenue until the goods are
shipped. Unearned revenue was €7,201 at the end of 2009 and €5,514 at the end of 2008.
Delicious operates two geographic segments: Europe and Mexico. Selected financial information for
each segment is found in Exhibit 3.
At the beginning of 2009, Delicious entered into an operating lease for manufacturing equipment. At
inception, the present value of the lease payments, discounted at an interest rate of 10%, was 6300
million. The lease term is six years and the annual payment is 669 million. Similar equipment owned
by Delicious is depreciated using the straight-line method and no residual values are assumed.
Scott gathers the information in Exhibit 4 to determine the implied "stand-alone" value of Delicious
without regard to the value of its U.S. associate.
Using the data found in Exhibit 1 and the extended DuPont equation, which of the following best
describes the impact on Delicious's return on equity (ROE) for 2009 of eliminating the investment in
the U.S. associate?
Hoskins is also examining data for the country of Semeria. Semeria is an emerging country that has
benefited from recent changes in the political environment as well as technological advances. Its
economy is growing rapidly, and changes in the Semerian economy and society have resulted in
more opportunities for women. The Semerian economy has experienced 17 consecutive quarters of
positive growth in GDP, which is unprecedented in Semerian history. Interest rates have increased
over time because businesses have been borrowing heavily to invest in new machinery and
technologies. Most economists are forecasting further increases in interest rates in Semeria.
It has long been Platinum's policy that its economists use long-term economic growth trends to
forecast future economic growth, stock returns, and dividends in a country. Lanning is examining the
economy of Tiberia. Tiberia has a population of 11 million and is located in northern Africa. Its
economy is diversified, and its main exports are agricultural products and heavy machinery. The
country's economy has been growing at an annual rate of 6.2% for the past ten years, in part because
of technological advances in the manufacture of heavy equipment. These advances involve the use of
computer-operated welding machines that have made the manufacture of heavy equipment less
expensive. Lanning is worried, however, that the 6.2% GDP growth rate may not be sustainable and is
considering advising Platinum's portfolio managers to decrease their portfolio allocations in the
country. Before doing so, he will consult with Hoskins.
The classical growth theory is most likely to predict that Tiberia's long-run future GDP per capita will:
Which of the following terms best describes the response of consumers to the auto safety
regulation?
In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and
asset write downs.
In response to questions from a colleague, Emery makes the following statements regarding the
merits of earnings yield compared to the P/E ratio:
Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either
negative or close to zero.
Statement 2: A high E/P implies the security is overpriced.
According to FDS's price-to-sales ratio for 2008, based on the post-expansion announcement stock
price, FDS is:
2. The Neoclassical Growth Era o/Alphia (1951-1990)
During the neoclassical growth period, Alphia experienced a period of great economic growth. For
example, from 1986 to 1990, Alphia's capital per hour of labor grew at a 9% annual rate, while real
GDP grew at 7% per annum.
Also, Alphia was able to achieve economic growth rates and income levels comparable with many of
its neighboring countries during the neoclassical growth period. Alphian scientists, together with the
engineering department of the University of Ullom, provided access to the finest technology in the
world. In addition, Alphia opened up its equity markets to outside investors and allowed its currency
to float. Dr. Satish believes that, given time, these capital market improvements should allow the
Alphian economy to achieve an economic growth rate and per capita income level comparable to any
country in the world.
To understand the role of technology in the growth of the Alphian economy (using neoclassical
growth theory assumptions), the following table was developed to show the increased productivity
of Alphian farmers using disease resistant grains. Assume new disease resistant grain technology was
introduced into the Alphian farm economy at Point A.
3. The New Growth Era (1991-Today)
Since the Alphian energy crises of the late 1980s, the economy has been in transition. The AEDA goal
is to have more than 50% of Alphian GDP coming from what we now call knowledge capital based
industries by the year 2020. Given the large and growing population and their constant need for
health care, the pharmaceutical industry was Alphia's first knowledge capital based industry. Dr.
Satish believes that a focus on knowledge capital will enhance the long term growth prospects of
Alphia's economy.
According to the classical growth theory, Alphia would:
Smith has discovered that WMC has a small subsidiary in Ukraine. The Subsidiary follows IAS
accounting rules and uses FIFO inventory accounting. The Ukrainian subsidiary was acquired ten
years ago and has been fully integrated into WMC's operations. WMC obtains funding for the
subsidiary whenever the company finds profitable investments within Ukraine or surrounding
countries. According to forecasts from economists, the Ukrainian currency is expected to depreciate
relative to the U.S. dollar over the next few years. Local currency prices are forecasted to remain
stable, however.
One of the managers at WMC asks Smith to analyze a third subsidiary located in India. The manager
has explained that real interest rates in India over the last three years have been 2.00%, 2.50%, and
3.00%, respectively, while nominal interest rates have been 34.64%, 29.15%, and 25.66%,
respectively. Smith requests more time to analyze the Indian subsidiary.
Which of the following statements regarding the consolidation of WMC's Ukrainian subsidiary for the
next year is least likely correct? As compared to the temporal method, the Ukrainian subsidiary's
translated:
Which of the following best describes the regulation being considered by the Wakullian government
for the electrical utility industry?
Other information to be considered • Exchange rates (CAD/USD) 
• Beginning inventory for fiscal 2008 had been purchased evenly throughout fiscal 2007. The company uses the FIFO inventory value method. • Dividends of USD 25,000 were paid to the shareholders on June 30, 2008. • All of the remaining inventory at the end of fiscal 2008 was purchased evenly throughout fiscal 2008. • All of the PP&E was purchased, and all of the common equity was issued at the inception of the company on October 1, 2004. No new PP&E has been acquired, and no additional common stock has been issued since then. However, they plan to purchase new PP&E starting in fiscal 2009. • The beginning retained earnings balance for fiscal 2008 was CAD 1,550,000. • The accounts payable on the fiscal 2008 balance sheet were all incurred on June 30, 2008. • The U.S. subsidiary's operations are highly integrated with the main operations in Canada. • The remeasured inventory for 2008 using the temporal method is CAD 810,000. • All monetary asset and liability balances are the same as they were at the end of the 2007 fiscal year, except that long-term debt was USD 467,700. • Costs of goods sold under the temporal method in 2008 is CAD 1,667,250. Suppose the parent uses the all-current method to translate the subsidiary for fiscal 2008. Will return on assets and net profit margin in U.S. dollars before translation be the same as, or different than, the translated Canadian dollar ratios? 
Other information to be considered • Exchange rates (CAD/USD) 
• Beginning inventory for fiscal 2008 had been purchased evenly throughout fiscal 2007. The company uses the FIFO inventory value method. • Dividends of USD 25,000 were paid to the shareholders on June 30, 2008. • All of the remaining inventory at the end of fiscal 2008 was purchased evenly throughout fiscal 2008. • All of the PP&E was purchased, and all of the common equity was issued at the inception of the company on October 1, 2004. No new PP&E has been acquired, and no additional common stock has been issued since then. However, they plan to purchase new PP&E starting in fiscal 2009. • The beginning retained earnings balance for fiscal 2008 was CAD 1,550,000. • The accounts payable on the fiscal 2008 balance sheet were all incurred on June 30, 2008. • The U.S. subsidiary's operations are highly integrated with the main operations in Canada. • The remeasured inventory for 2008 using the temporal method is CAD 810,000. • All monetary asset and liability balances are the same as they were at the end of the 2007 fiscal year, except that long-term debt was USD 467,700. • Costs of goods sold under the temporal method in 2008 is CAD 1,667,250. Are Hally's statements regarding foreign currency translation correct?