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0statestheriskfactorsfbraninvestmentinthecompany;and
odiscosesanypotentiaIcohfictsofinteestsfhcedbytheanalyst.
AnaIystshaveanobIigationtopovidesubstantiveandmealigfUIcontent.CFAIstitutemembershaveanadditionaIoverridingesponsibiIitytoadhetotheCFAlnstituteCodeofEthics
andreIevantspecificStandardsofPofbssionaIConduct.
RekreIceS
Burch,TimothyR.,andVikramNanda.2003.DMsionaIDiversityandtheCongIomerateDiscount:EvidencefomSpinoffS.,,jbwqFW?cmECooivoI.70,no.:6998.ComeII,Bradfbrd.200l.IstheResponseofAnalyststolnfbmationConsistentwithFundamentaIValuation?TheCaseoflntelFh7cmMJge,voI.30,no.I:II3l36.Graham,Beniamin,andDavidLDodd.934cMsMcGrawHiIlProfbssionalPublishing.Grossman,Sanfbrd,andJosephStigIitzg80.OthelmpossibilityoflnfbmationalIyEcientMarkets,,ecEbooReWew,voI.70,no.3:393408.jensen,MichaeIC,andWiiamHMeckIing.l976.TheoyofthePil.m:ManageiaIBehaviol.,AgencyCostsandOwnershipStructure.,,jbrqFcEcooJcs,vol.3,no.4:305360.Lamont,OwenA.,andChristopherPoIk2002.DoesDiversificationDestroyVaIue?EvidencehomthelndustryShocks.,,jbqFcEcooics,voI.63,no:57.Lee,CharesM.C.,JamesMyers,andBhaskaranSwaminathan.g9gWhatistheItinsicValueoftheDow?,,jbq.ce,voI.54no.5:l69374.
MerriLynchCo.2006jsjOFtJcoSJvey.QuantitativeStrategy:GIobaISecuritiesResearchEconomicsGroup.Mo0dy,s.2000.PgEBI7n4PeUpeive.Moody,snvestorsServiceGIobalCreditResearch.MuIfbrd,ChaIesW.,andEugeneF.Comiskey2005.Ceve
CtJs7FOwCpoigU7coveigSibeFcmPeJybmce.Hoboken,NJ:JohnWiIeySons.Porter,MichaeIE.lg85.eCopevedvgeCegdSsiJZgStpeoPe:bceNewYork:PreePressRepublishedwithnewintroductioninlgg8Porter,MichaeIE.2008.TheFiveCompetitivePorcesthatShapeStrategy.,,HbJdBsiessReview,voI.86,no.l:7893.SchiIit,Howard,andJeremyPerIe.200.cSeigJs;fbwoDeecAccoGiCksdFcibJRepos,3rdedition.NewYork:McGrawHiII.SloanRichardG.>gg6.DoStockPricesFuIyRef>ect
B.ExpIaiIwhethermakingagoing-concernassumptionwouldaffCctthevaIuepIacedonacompany,sinventory.
.ExpIainhowtheprocedurefbrusingavaIuationmodeItoinfbrmaketexpectationsaboutacompany,sfUturegrowthdiffbrsfiomusingthesamemodeItoobtainanindependentestimateofva>ue
5ExampIe,basedonastudyofInteICorpoationthatusedapsentvaluemodeIComeII200,examinedwhatfilturevenuegowthrateswereconsistentwithlnteI,sstockpiceof$6>50justpriortoitseamingsannouncementand$433lonIyfivedaysIater.TheexampIestates,Usingaconservativeyowdiscountrate,CorneIIestimatedthatntel,spicebefbretheannouncement$6>50,wasconsistentwithafbrecastedgrowthrateof20percentayearfbthesubsequent0yearsandthen6peqcentperyeartheaffer.,,DiscusstheimpIicationsofusingahigherdiscountratethanComeIdid.
6.Discusshowunderstandingacompany,sbusiness(thefirststepinequityvaluation)mightbeuseMinperfbrmingasensitivityanaIysisreIatedtoavaIuationofthecompany.
7lnaresearchnoteontheordinaIysharesoftheMilanFashionGroupMFGdatedeaIyJu>y2007whenarecentpricewase773andprqectedannuaIdividendsweree0.05,anana!yststatedatagetpriceofe9.20ThereseaIhnotedidnotdiscusshowthetagetpricewasobtainedorhowitshouldbeinterpreted.AssumethetagetpricerepresentstheexpectedpriceofMFG.WhatfUrtherspecihcpiecesofinfbrmationwouldyouneedtofbrmanopinioonwhetherMFGwasfairIyvaIued,overvaIued,oundervaIued?
8.YouarereseahingXMICorporationXMIXMIhasshownsteadyearningspershareglowth(l8percentayearduringtheIastsevenyears)andtradesataveIPyhighmu>tipIetoeamingsitsPEiscunntIy40percentabovetheaveragePEfbragroupofthemostcomparabIestocks.XMIhasgeneraIIygownthroughacquisition,byusingXMIstocktopurchaseothercompanieswhosestocktradedatIowerP/EsIninvestigatingthefinancialdiscIosuresoftheseacquiredcompaniesandtalkingtoindust
Statement>AnaIystsatGuardianCapitaIseektoidentifymispricing,reIyingonpriceeventuaIIyconvergingtointrinsicvaIue.However,convergenceofthemarketpricetoananaIySt,sestimateofintrinsicvaIuemaynotlappenwithinthepoltfbiomanagesinvestmenttimehoizon.So,besidesevidenceofmispricing,anaIystsshouIdIookfbr
thepresenceofapaticuIarmaketocorporateeventthatis,acataIystthatwiIIcausethemaketpIacetoeevaIuatethesuectfirm,spospects.
Statcmet2Anactiveinvestmentmanagel.attemptstocaptuepositiveaIphaButmispricingofassetsisnotdirectIyobservabletistheefbreimp0rtantthatyouunderstandthepossibIesourcesofpeceivedmispicing.,,
Statement3oitsdistssedsecuitiesfUnd,GualdianCapitaIscreensitsinvestabIeuniverseofsecuritiesfbcompaniesinfmancialdistress.,,
Statement4 oritscoreequityftlnd,GuadianCapitalseIectsfinaHciaIIysoundcompaniesthatareexpectedtogeneratesignificantpositivefiPeecashf>owfiPomcorebusinessoperationswithinamuItiyeafbrecasthorizon.,,
Statement5 GuardianCapitaI,sreseachprocessrequiresanaIyststoevaluatethel?easonablenessoftheexpectationsimpIiedbythemarketpricebycomparingthemarket,simpliedexpectationstohisoheownexpectations.,,
ARel.theorientationmeeting,thedirectorofresearchasksRichardsontoeva>uatethreecompaniesthataeretaiIersofmen,scIothing:DiamondCo.,RenaissanceCIothing,andDeIuxeMen,sWear
RichardsonstashisanaIysisbyevaIuatingthechaacteristicsofthemen,sretaiIcIothingindusny.HendsfbwbaierstonewetaiIentrants,highintraiHdustlyrivaIlyamongretaiIers,IowproductsubstitutioncostsfbrcustomersandalargenumberofwhoIesaIecIothingsuppIiers.
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WhiIeconductinghisanalysis,RichardsondiscoversthatRenaissanceCIothingincludedthreenon-recurringitemsintheirmostecenteaningsreIease:apositivelitigationsettIement,aonetimetax@reditandthegainonthesaIeofanon-operatingasset.
Toestimateeachfirm,sintrinsicvaIue,Richardsonappiesappropiatediscountratestoeachfirm,sestimatedfi.eecashfowsoveratenyeartimehorizonandtotheestimatedvalueofthermattheendoftheten-yearhorizonMicheIeLee,ajuniortechno>ogyanalystatGuardian,asksthedirectorofresearchfbradviceastowhichvaIuationmodeltousefbrVEOA,afastgrowingsemiconductocompanythatisrapidIygainingmarketshare.
ThedirectoofsearchstatesthatthevaIuationmodelseIectedmustbeconsistentwiththe
chaacteisticsofthecompanybeingvaued.,,
LeeteIIsthedirectorofsearchthatVEOAiSnotexpectedtobepofitabIefbrseveraImoreyeas.
Accodingomanagementguidance,whenthecompanyturnspoftab!e,itwiIIinvestinnewproductdeveIopment;asaresuIt,itdoesnotexpecttoinitiateadividendfbranextendedperiodoftimeLeeaIsonotesthatsheexpectsthatcertainlargecompetitorswiIIbecomeinterestedinacquiigVEGAbecauseofitsexcelIentgowthprospects.ThedirectorofreseachadvisesLeetocohsidethatinhervaluation.
9. BasedonStatement2,whichofthefbIlowingsourcesofperceivedmispricingdoactiveinvestmentmanagersattempttoidentify?Thediffbrencebetween:
A.intrinsicvaIueandmarketpice.
BestimatedintrinsicvaIueandmakctpriceC.intrinsicvalueandestimatedintinsicvaIue.
l0.WithrespecttoStatements3and4,whichofthefbIowingmeasuresofvaluewouIdthedistressedsecuritiesfimd,saIaIystconsiderthatacoreequityfUndanaIystmightignore?
AFairvalue
BLiquidationvaIueCFairmarketvaIue
ll.WithrespecttoStatement4,whichmeasureofvaIueisosIevantfbrtheanaIystofthefUnddescribed?
A.Liquidationva>ueB.InvestmentvaIue
C.Going-concemvaIue
>2.AccordingtoStatement5,ana>ystsareexpectedtousevaIuationconceptsandmodelsto:AvaIueprivatebusinesses.B.renderfairnessopinionsCextractmaketexpectations.
l3.BasedonRichardson,sindustyanaIysis,whichofthefbIIowingchamcteristicsofmen,sretacothingretaiIingwouIdposveaffbctitspotability?Thatindusny,s:
A.ennycostsB.substitutioncosts.
C.numberofsuppIiers.
l4.WhichofthefbIowingstatementsabouttherepo!tedearningsofRenaissanceCIothingisoscce?ReIativetosustainabIeeamings,reportedeamingsare!ikely:
Aunbiased.
Bupwardbiased.C.downwaIdbiased.
I5.WhichvaIuationmodeIisRichadsonappIyinginhisanalysisoftheretaiIers?A.ReIativevalue
BAbso>utevalue
C.Sumoftheparts
6.WhichvaIuationmodeIwouldthediectorofreseachos!ikcbrecommendLeeusetoestimatethevaIueofVEGA?
A.Freecashf>ow
B.DMdenddiscount
CP/EreIativevaIuation
S0lIti0IS
.ThestatementisfawedinatIeasttwoways.Pist,activeinvestorsbeIievethastockpricesdonotawaysaccuratelyrefectaeIevantinfbrmationonthesecuity;fbrsuchinvestors,knowIedgeofequityvaluationmodeIsisimportantfbridentifyinginvestmentoppotunitiesbecausetheyrepresentawaytotransIatetheinvesto,sfbrecastsintovaIueestimatesfbcomparisonwithmaketprices.Thus,the6aII,,inainvestors,,ismisleading.Second,not
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2.
3
4.
5.
6.
7.
8.
48
aIlequitiesaepublicIytradedandhavemarketprices,andthemostrecentmarketpricecanbestaIefbrthemanypublicequitiesthattradeonIyinquentIy
NomattehowdiIigenttheanaIyst,someunceaityaIwaysexistsconcerningItheaccuracyoftheaa!yst,sfbrecastsand2whetheanintrinsicvaIueestimateaccountsfbrasourcesofriskrefectedinmarketprice.Thus,knowIedgeofastock,sinvestmetchaacteisticsisaIwaysincompIete.ThepracticaIconsequencesarethataninvestorcanonIyestimateintinsicvalueandactivesecurityseIectioncarriestheriskofmakingmistakesinestimatingvalue
A.LiquidationvaIueistypicaIIynotreIevanttoestimatingintrinsicvaluefbrprofitabIecompaniesbecause,ingeneraI,vaIuewouIdbedestroyedbyseIIingsuchacompany,sassetsindMduaIIy.Statedanotheway,thevaIueaddedbybeingagoingconcenisare!evantinvestmentchaacteristicthatanintrinsicvaIueestimatewoud
ecognlze.
B.AgoingconcernassumptiongeneraIyinceasesthevaIueplacedonacompany,sinventoIyreIativetonotmakingthatassumption.UsuaIIy,inventorythatcanbesoIdinthecompany,seguIardistributionchanneIswouIdreaIizehigheramountsthaninventorythatmustbesoIdimmediateIybecauseacompanyisbeingliquidated
ThekeydiffbnceisthatfbrinfbringinvestorexpectationsthemaketpriceisusedasthemodeIinput{brvaIuewhereasfbrobtaininganindependentestimateofvalue,vaIueisIehastheunknowninthemodeI.lntheIattercase,vaIueisestimatedbasedontheanaIyst,sestimatesfbrthevariabIesthatdeterminevaIue.
Considerthepresentva>ueofasinglecashf>ow.iedgrowthrateconsistentwithapriceof$6l.50wouIdhavebeenhigherthanthe20percengrowthrateestimatedbyComelIAnunderstandiIgofthecompany,sbusinessfaciIitatesafbcusonthekeybusinessaspectsthataffbctvaIue,andfiomapracticalperspective,highIightstheciticaIinputstoafbecastthatshouIdbetestedusingsensitivityanalysis.
Youneedtoknow>)thetimehorizonfbrthepricetargetand2)therequiredrateofretumonMFGThepricetargetof6g20representsapotentiaI20percentretunfiDminvestinginthestockifthetimehorizonisoneyear,cacuIatedas69.206005E7.73.0097;withoutatimefiame,however,youcannotevaIuatetheattractivenessofthatreturnGiventhatthetimefiPamefbrtheetumisestabIished,youneedtohaveanestimateoftherequiredrateofretunoverthesametimehorizon.
Iftheexpectedreturnofg.7pel.centexceedsthesecurity,srequiredeturnfbrthesamehorizon-inotherwords,iftheshare,sexpectedaIphaispositive-thenMFGwouIdappeartobeundervaIued.
A.AcceIeratingthepaymentofexpenseseducestheacquiredcompanies,IastreportedplBacquisitioncashfowAcceIeratingexpensecognitionreducestheacquiredcompanies,astrepotedpreacquisitioneamings.XM,scashfowandeaningsgrowthrateSfbIIowingtheacquisitionswouldbeexpectedtobebiasedupwardsbecauseofthedepressedIevelsfbrtheacquirees.
g.
B.ThatisanexampIeofareIativevaluationmodeIothemethodofcomparabIes,whichcompaesacompany,smarketmuItipIetothemultipesofsimiIarcompanies.
AiscoITect.ThediffbencebetweenthetuealbutunobservabeintrinsicvaIueandtheobservedmarketpricecontibutestotheabnormaIetlnoalphawhichistheconcernofactiveinvestmentmanagels
l0.Biscorect.ThemeasueofvaIucthedistessedsecuitiesfUnd,sanaIystwouldconsider
thatthecoreequityfllndanaIystmightignoreisIiquidationvaIue.TheIiquidationvaIueofacompanyisitsvaIueifitweredissolvedanditsassetssoIdindividuaIIy.
CiscorIct.Foritscoequityfhnd,GualdianCapitaIscensitsinvestabIeuniverseofsecuritiesfbfwecapitaIizedcompaniesthatareexpectedtogeneratesignificantfUturefiecashfowomcorebusinessopeations.TheconcernwithfUturefiecashfowsimpliesthatgoing-concernva!ueisreIevant.
l2.CiscorrectMarketpricesfecttheexpectationsofinvestorsaboutthefitureperfbrmanceofcompanies.TheanaIystcanevaIuatethereasonabIenessoftheexpectationsimpIiedbythemarketpricebycomparingthemarket,simpIiedexpectationstohisownexpectatioIs.ThispmcessassumesavaIuationmodel,asdiscussedinthetext
3Ciscorrect.Themen,sretaiIcIothingindustryischaracterizedbyaIaenumberofwhoIesaIeclothingsuppIiers.Whenmanysuppliesoftheproductsneededbyindustryparticipantsexist,competitionamongsuppIiesshouIdIimittheirabiIitytoaiseinputpices.Thusthe>argenumberofsuppIiersisafactorthatshou}dpositiveIyaffbctindustrypofitability.
l4.Biscorrect.Theeffbctsoffavorab!enonlccurringeventsinreportedearningswouIdtendtobiasreportedearningsupwardreIativetosustainabIeeamingsbecausenon-recurringitemsarebydefinitionnotexpectedtorepeat.RenaissanceCIothingincludedthreenon-recurringitemsintheirmostrecentearningsreIeasethataIIledtohigherearningsfbrthecunentpeiod:apositiveitigationsettIement,aonetimetaxcredit,andthegainonthesaIeofanon-operatingasset
>5.Biscorrect.AnabsoIutevaIuationmodeIisamodeIthatspecifiesanasset,sintrinsicva}ue.ThemostimportanttypeofabsoIuteequityvaIuationmodelsarepresentvaIuemodeIs(aIsoreferredtoasdiscountedcashf>owmodeIs)andthemodeIdescribedbyRichardsonisofthattype.
6Aiscorrect.ThebroadcriteriafbrmodeIseIectionaethatavaIuationmodeIbecosistentwiththecharacteisticsofthecompanybeingvaIued,appropriategiventheavaiIabiIityandqualityofthedataandconsistentwiththepurposeofthevaIuation.VEGAcurentIyhasnegativeearnings,makingtheuseofP/EreIativevaIuationdifficultifnotimpossible.AsVEGAdoesnotpayadividendandisnotexpectedtofbthefbseeabIefUture;thiswouIdmaketheappIicationofadividenddiscountmodeIpobIematic.However,theIackofadividendwouIdnotbeanobstacIetoeecashfIowvaIuation.Furthermore,thedictorofreseachhasadvisedthatthepossibiIitythatcompetitorsmayseektoacquilcVEGAbetakenintoaccountinvaIuingVEGA.Thereadingstatesthatfi.eecashf>owvaIuationcanbeappropriateinsuchcircumstancesThus,thedirectorofsearchwouIdbemostikeIytorecommendfiQeecashf>owvaIuation.
4g
Mornmgstar.2007.Stocks,Bonds,BiIIs,andInfIation.,,2007hiIEtoyebook.Chicago:MorningstaLInc.
Pastor,Lubos,andRobertF.Stambaugh2003.LiquidityRiskandExpectedStockRetums.,,bqPocEooUjvollll,no.3;64268a
SchoIesMyon,andJosephT.WiIiams.l977.EstimatingBetasmNonsynchronousData.jbqmycEooJcs,vol.5,no.3:30g327.
Strong,Norman,andZinzhongGXu.l9g7.ExplainingtheCossSectionofUKExpectedStockRetums,,BAccoRevew,vol2g,nol:23.
Stux,IvanEl9g4EamingsGrowth:TheDIiverofEquityVaIue.,,MoIganStanleyGbbEv!0DeVCsMB.
Vanna,JayanthR.,andSamirKBama.2006.AFirstCutEstimateoftheEquityRiskPremiuminIndia.,,IndianInstituteofManagementAhmedabadWorkingPaperNo.Z006-06-04
PacticePbIems
CoIIight20llCFAInstitute
ACanadabasedinvestobuysshaesofTorontoDominionBankToonto:TDTOfbrC$72.08onl5October2007withtheintentofholdingthemfbrayear.ThedividendratewasC21lperyear.TheinvestoactuaIyselstheshareson5NovemberZ007fbrC$6g.52TheinvestornotesthefbI>owingadditionalfhcts:
Nodividendswerepaidbetween5Octobeand5November
TherequiredretumonTDTOequitywas8.7percentonanannualbasisand0.l6lpercentonaweeklybasis.
AStatethelengthsoftheexpectedandactua>hoIding-periods.
B.GiventhatTDTOwasfhiriypIiced,caIcuIatethepnceappreciationretum(capita!gainsyieId)anticipatedbytheinvestorgivenhisinitialexpectationsandinitialexpectedholdingperiod
CCaIcuIatetheinvestor,sreaIizedretum.
DCalcu}atetherealizedaIpha.
Z.TheestimatedbetasfbrAOLTimeWarneNYSEAOL,JP.MorganChaseCompany(NYSE:JPM)andTheBoeingCompany(NYSE:BA)are2.50,l.50,and0.80,respectively.TheriskeerateofItumis4.35percentandtheequityriskpremiumis8.04percent.CaculatetherequidratesofremrnfbrthesethreestocksusingtheCAPM.
3TheestimatedfactorsensitivitiesofTeraNovaEnergytoFamaFrenchfhctorsandtheriskpremiaassociatedwiththosefhctorsaregiveninthetablebe>ow:
g9
l0()
Fact0SensitMtyRiSkPemhum
Marketfhctor
Sizefacto
Valuefactor
l20
-0.50
0.l5
4.5
27
4.3
ABased0ntheFamaFrenclmodeI,caIcuIatetherequiedretumfbTeraNova
EnegyusingtheseestimatesAssumethattheTreasuybiIlateis47pecent.
BDescribetheexpectedstyleCharactelowingfhctsdescribeLarsen&ToubroLtd,scomponentcostsofcapitaIandcapitalstructure.BasedontheinfbrmatioHgiven,calcu>ateLarsen&Toubro,sWACC
C0mponentC0stsoCapita!
CostofequitybasedontheCAPMPretaxcostofdebt:
Taxrate:
TaIgetweightincapitaIstmcture:
(%)
l5.6
8.28
30
Equity80,Debt20
ThefowinginfmationeIatestQuestions712
Anequityindexisestabishedin200lfbracountrythathasreativeIyecentyestablishedamarketeconomy.Theindexvendorconstructedretumsfbrthefiveyearspnorto200lbasedonihcinitiaIgroupofcompaniesconstimtingtheindexin200lOver2004to2006aseriesofmilitaIyconfFontationsconcemingadisputedbordedisruptedtheeconomyandfinancialarkets.ThedisputeisconclusiveIyarbitratedattheendof2006.Intotal,tenyearsofequitymaketetunhistoyisavaiIableasofthebeginningof2007.Thegeometncmeanemrnelativetol0yeargovernmentbondretumsoverl0yearsis2percentperyear.ThefbIwarddMdendyieIdontheindexispecent.Stockretunsover2004to2006reflectthesetbacksbuteconomistspedictthecountrywilbeonapathofa4percentreaGDPgrowthrateby
>=
200g.EamingsinthepubIiccooatesectoareexpectedtogrowata5perceltpeyeaeaIgrowthrate.Consistentwiththat,themarketPEratioisexpectedtogowatlpercentperyearAIthoughinflationiscurrentlyhighat6percentperyear,theIongtemfbcastisfbrainf>ationrateof1percentperyear.AIthoughtheyieIdcurvehasusuallybeenupwardsloping,currentIythegovemmentyieIdcuIeisinveIted,attheshort-end,yieIdsaregpercentandatl0-yearmaturities,yieldsare7percent.
7Theinclusionofindexretumspnorto200lwou>dbeexpectedto:
Abiasthehistoricaequityriskpremiumestlmateupwads.
Bbiasthehistorica!equityriskpremiumestlmatedownwards.
Chavenoeffectonthehistoricalequityriskpremiumestimate.
8Theeventsof2001to2006wouIdbeexpectedto:
AbiasthehistoricalequityriskpremiumestimateupwardS.
Bbiasthehistoricalequityriskpremiumestimatedownwards.
Chavenoeffbctonthehistorica>equityriskpremiumestimate
9Inthecurrentinterestrateenvironment,usingareqUiredretumestimatebasedontheshort-termgovemmentbondrateandahistoricalequityriskpremiumdefinedintermsofashort-termgovemmentbondratewouldbeexpectedto:
AbiasIongtemequiedetumonequityestimatesupwards.
B.biasongtemrequiredretumonequityestlmatesdownwards.
Chavenoeffbctonlong-termrequiredretumonequityestimates.
I0AsupplysideestimateoftheequityriskpremiumaspresentedbyTheIbbotson-CheneamingsmodeIisces!to:
A3.2percent.
B40percent.
C4.3percent.
11.Commonstockissuesintheabovemarketwithaveragesystematicriskareostohaverequiredratesofreturn:
Abetween2percentand7percent.
Bbetween7andgpercent.
C9percentorgreater.
l2.WhichofthefbIIowingstatementsisoscqe?IftwoequityissueshavethesamemarketriskbutthefirstissuehashigherIeverage,greateriquidity,andahigherrequiedretum,thehigherequiredretumosketheresultofthefirstissue,s:
Agreater!iquidity >0I
>02
Bhigherevemge.
Chigherleverageandgreateiquidity.
Questions13though19eIatetoHiznAssetIVIanagement1
JudyChenistheprimaIyportfb>iomanageroftheglobalequitiesportfblioatHorizonAssetManagement.LarsJohansson,acentIyhiredequityanaIyst,hasbeenassignedtoChentoassistherwiththepoItfbli
ChenrecentIysoIdsharesofNovoGemini,Inc.fi.omthepofbIiChentasksJohanssonwithassessingtheretumperfbnnanceofNovo-Gemini,withspecifictradeinfbnnationprovidedinExhibit>
ExhibitlN0V0GeminMcTmdeDetai!s
1NovoGeminishareswerepurchasedfbr20.75pershare
2AtthetimeofpurchaseresearchbyChensuggestedthatNovo-GeminishareswereexpectedtoseIlfbr29.00peshareattheendofa3-yearhodingperiod
3Atthetimeofpuchase,theequiredetumfbrNovoGeminibaseduponthecapitaIassetpricihgmode>(CAPM)wasestimatedtobel2.6%onananhuaIbasis.
Exactly3yearsaferthepuchasedate,thesharesweresoldfbr30.05pershare.
5NodividendswerepaidbyNovoGeminioverthe3yearholdingperiod.
ChenexplainstoJohanssonthat,atthetimeofpurchase,theCAPMusedtoestimatearequiredretumfbrNovoGeminiincoIporatedanunaustedhistoricaIequityriskpmiumestimatefbrtheUSequitymarket.ChennotesthattheUSequitiesmarkethasexpenencedameaningfillstrmgoffavorableinflationandproductMtysurpIisesinthepast.SheasksJohanssonwhetherthehistorica!equityriskpemiumshouIdhavebeenadiustedbefbreestimatingtheIquiredretumfbrNovo-Gemini.
Foranotherperspecnveontheewardtobeanngrisk,ChenasksJohanssotocaIculatea
fbrwardlookingequityriskpremiumfbrtheUSequitymarketusingdataontheS&P500indexinExhibitZ
Exhibit2SP500ldexDt
DMdendyield,basedonyearaheadaggregatefbecasteddividends
Consensuslong-termeamingsgrowthrate
Z0-yearUSgovemmentbondyieId
l2%
4%
3%
ChenisnowconsideingaddingshaIcsofBezak,Inc.totheportfbIio.ChenasksJohanssontocaIculateBezak,sweightedaveragecostofcapitaIusingtheCAPMwiththeinfbnnatlonprovidedinExhibit3.
EXhibit3Bezak,Ic
Pretaxcostofdebt
Long-termdebtasapercentoftotalcapitaI,atmaIketvalueMarginaItaxrate
Bezak,Inc.beta
EstimatedequityIiskpremiumRisk-hPeerate
49%
25%
30%
2.00
5.5%
3.0%
Last>yChenasksJohanssontoevaluateTwinIndustries,aprivatelyownedUScompanythatmayinitiateapublicstockoffbIing.JollanssondecidestoadaptCAPMtoestimatetherequiredretumonequityfbrTwinIndustries.UsingtheMSCI/Standard&Poor,sGlObaIIndustIyCIassificationStandadGICS,JohanssonidentifiesapubIicIytadedpeecompanywithanestimatedbetaofl09thatismuchagerbutotherwisesimiIartoTwinIndustries.TwinIndustriesisfilnded4g%bydebtwhilethepublic>ytradedpeercompanyishmded60%bydebt.
I3BaseduponExhibitl,theexpectedthree-yearho>dingperiodretumfbrNovo-GeminiInc.atthetimeofpurchasewasc/b$cs/to:
A3g.76%
B12.76%
C4482%
MBasedupoExhibit,thereaIizedthreeyearholdingperiodetumfbNovoGeminiIncwascsesto:
A3g.76
B12.76%
C44.82
I5BasedonthehistoricalrecordofSurprisesininf>ationandproductivity,thehistoricalequityriskpremiumfbrtheUSequitymarket,ifitisusedasanestimateofthefbrward-lookingequityriskpemium,shouIdoybe:
A>eftunchanged
B.adiustedupwardl03
l04
Cad>usteddownwa!d
16BasedonExhibit2,thefbrwardookingestimatefbrtheUSequityriskpremiumisCsestO:
A2.2%
B5.8%
C8.2%
l7BasedonExhibit3,andassuminginteestondebtistaxdeductible,theweightedaveragecostofcapitaWACCfbrBezak,Inc.iscscsto:
Al0.87%.
Bll36.
cl3.6l%.
18TheestimateofbetafbrTwinIndustriesiscseto
A0.14
B0.85
C.0.8g.
l,ApotentialweaknessofJohansson,sapproachtoestimatingtherequiredreturnonequityfbTwinIndustriesisthattheretumestimate:
Adoesnotincudeasizepremium.
Bmayoverstatepotentialretumsovertheongtem.
Cdoesnotconsidesystematicriskaisingfi.omtheeconomicsoftheindustIy
slutins
1
ATheexpectedhoIdingwasoneyear.TheactuaIhoIdingpenodwasom5October2007to5November2007whichisthreeweeks.
BGivenfairpIicingtheexpectedreturnequalstherequiredreturn,87percentTheexpectedpriceappreciationeturnovertheinitiaanticipatedoneyearholdingpeiodmustbeequaltotheequiedretumminusthedividendyield,2.l72.08002g3or2.93percent.Thusexpectedpriceappreciationretumwas8.7%-2.g3%=5.77percent.
C.ThereaIizedeturnwas6g.527Z0872.08003552ornegative3.55percentoverthreeweeksTherewasnodividendyieldreturnovetheactualhoIdingpeiod.
DTherequiredremmoverathreeweekhodingperiodwasl.00l6l0.484percent.UsingtheanswertoCthereaizedalphawas35520484.036percentor=404percent.
2PorAOLTimeWameI;therequiredretumis
lRFEMRF4352508245
3
RFERM-RFl35I500435l2=>6.1>%
ForBoeingtherequiredretUrnis
.FERMF4.3580843564l0.78
AThePamaFrenchmodelgivestherequiredretumas
TbiraleSensiMyoeIuilymMcacorxEquily
pmiumScMyoizelhcorxSieikpemium
ScnsiMyloucloxVa!ueiskpemi!m
ForTerraNovaEnergy,therequidretumis
4.7l.20x45-050x2.75x4.34.75.4l.350.6i
8.l
BTeIaNovaEnergyappearstobeaIargecap,growthoriented,highmarketriskstockasindicatedbyitsnegativesizebeta,negativevaluebeta,andmaketbetaabovel0.
4Theequiredreturnisgivenby 105
>06
.0015020.07545.530
ThisexampIeindicatesthatNewmontMininghasarequiredretumof3percent.WhenbetaisnegativeanassethasaCAPMrequiredrateofretumthatisbeowtheriskfeerate.CasesofequitieswithnegativebetasarerelativeIyrare.
5BiscorrectTheFamaPrenchmodeIincorporatesmarketsize,andvaIueIiskfhctorsOnepossibleinterpretationofthevalueIiskfhctoristhatitrelatestofinancialdistress
6LarsenToubroLtd,sWACCisl3.6percentcacuIatedasfblows
EqIity Debt WACC
WeightAheTaxCost
WeightxCost
0.80
l5.6%
l2.48% +
020
l0.30828
l.l6% =l3.6#%
7Aiscoect.Thebackfillingofindexreturnsusingcompaniesthathavesurvivedtotheindexconstmctiondateisexpectedtointroduceapositivesurvivoshipbiasintoreturns
8Biscorrect.Theeventsof2004to2006depressedshareetumsbutlarenotapersistentfbatueofthestockmaketenvironment,2werenotoffSetbyotherpositiveeventswithinthehistoricalrecord,and3)haveledtorelativelylowvaluationleveIs,whichareexpectedtorebound.
9Aiscorrect.TherequiredreturnreflectsthemagnitudeofthehistoricaIequityriskpremium,whichisgeneraIyhighewhenbasedonashoIt-terminteestrateasasultofthenomalupwardslopingyiedcurve,andthecuIentva!ueoftheratebeingusedtorepresenttheriskfTeerate.TheshorttermrateiscuentlyhighethantheIongtemrate,whichwi>la>soincreasetherequiredretumestimateTheshort-terminterestrate,howeve,overstatesthelongtemexpectedinfationate.UsingtheshoItte.minteestrate,estimatesofthelong-termrequiredretumonequitywillbebiasedupwards.
l0.CiScon.ect.AccoIdingtothismode
Here
EINFL
ECREPS
ECP
EIC
pilnP00,U
Bysubstitution,weget:
+00|IMl05I 0070.I30.07013or4perccn
11Ciscorrect.Basedonalong-termgovemmentbondyieldof7percent,abetaofl,andanyoftheriskpremiumestimatesthatcanbecaIculatedfomthegivenseg,a2percenthistoricalriskpremiumestimateor4.3percentsuppIysideequityriskpremiumestimate),theIcquiredrateofreturnwouIdbeatleastgpecentBasedonusingashorttermrateofgpercent,Cisthecorrectchoice.
1ZBiscorrect.AIle>seequaI,thefirstissue,sgreater>iquiditywou>dtendtomakeitsrequiredremrnIowerthanthesecondissue,s.However,therequiredretumonequityincreasesasleverageincreases.Thefirstissue,shigherrequiredretummustresultfibmitshigherleverage,morethanoffSettingtheeffbctofitsgeaterIiquiditygiventhatbothissueshavethesamemarketrisk
13AiscorrectThisistheexpected3yearholdingperiodretum,calcuatedas:
3yearexpectedreturnV0P0P029.0020.7520.7539.76.
Ciscorrect.ThereaIizedholdingperiodretum(notethatnodividendswerepaidduringthe3-yearholdingperiod)is1482%.Specifically,thereaIized3-yearho>dingperiodiscalculatedascaIculatedas:
3yearrealizedretumPHP0030.0520.7520.754482.
14
15Ciscorrect.AstringoffhvorableinfationandproductivitysurpnsesmayresultinasenesofhighetumsthatincreasethehistoicaImeanestimateoftheequityisk
G
premlumTomitigatethatconcem,theanalystmayaustthehistoricaIestimate
downwardbasedonanindependentfbIward->ookingestimate.
16.AiscorrectGiventhedatapresented,theequityriskpremiumcanbeestimatedas:
EquityriskpremiumdMdendyieIdontheindexbasedonyeaaheadaggregatefbecasteddividendsandaggegatemaketvalueconsensusIongtermeamingsgowthrate-currentlong-termgovemmentbondyie>dTheequityriskpremium=l.2%+40%302.Z.
17.Biscorrect.TheweightedaveragecostofcapitalistakingthesumpoductofeachcomponentofcapitalmutipIiedbythecomponent,saRertaxcost.
First,estimatethecostofequityusingtheCAPM:
Costofequity=Risk-fiFeerate+
Costofequity=3.0%+=>4%
Now,ca>cula
I08
WeightARerTaxCost
WeightxAherTaxCost
075
l0.5%
0.25
(>-030)x4g%0.8575% =ll.36%
8.Biscorect.Thestepstoestimatingabetafbranontadedcompanyare
SteplSeIectthecomparabIebenchmark
Step2Estimatebenchmark,sbeta
Step3UnIeverthebenchmak,sbeta
StepqLeverthebetatoref>ectthesuqectcompany,sfinancia>Ieverage
Thebetaofthebenchmarkpeercompanydataisgivenas>.0g.Next,thisbetaneedstobellnlevered,caIcu>atedas;
!
l
0.60
0.40
0136,or04
(l.00)
Then,theunleveredbetaneedstobeIeveeduptorefectthefinanciaIIeverageofTwinlndustries,ca>cu>atedas:
II.
.I08549,o0.85
19AiscorrectJohanssonintendstoestimatearequiredretumonequityusingamodifiedCAPMapproachTwinIndustriesisstatedtobesmalIerthanthechosenproxybenchmarkbeingusedandthereisnosizepremiumaustmentintheCAPMamework;thefiFameworkaquststhebetafbrIeveragediffbrencesbutthisdoesnotaqustfbrf>rmsizedifferences.Thebuild-upmethodmaybem0reappropnateasitincludestheequitylilfnPmimnlnhRnmnTeHdditionaIDremiaohenbasedonfactorssuchassizeandriskpremiumandoneormoreadditionaIpremia,operceivedcompany-specificrisk
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