Social Regulations: objectives

(Question)
Which of the following statements regarding objectives of social regulations are less accurate:

1. Social regulations may be used to ensure that consumers are protected with safe products at a fair price.
2. Social regulations may be used to toward a goal of environmental protection.
3. Social regulations may be used to used to promote safer working conditions.

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Answer: A

The objective of social regulation is a better quality of life through safer products, a less polluted environment, and improved working conditions. Fair pricing is the objective of economic regulation.

Capture Hypotheis

• The regulatory decisions favor the industry (e.g. drug industry); this can be due to the fact that the regulatory bodies tend to have members who used to work in the industry.
• (e.g.) Due to the level of scientific knowledge needed, many regulartory bodies for the pharmaceutical industry are dominated by former drug company executives and scientists.
• Regulatory decisions will favor industry because the industry has greater economic resouces and incentives than consumers.

Creative Response

In a creative response, the regulated parties conform to the letter(i.e., rule itself), but NOT the intent of the law.

(e.g.)
When the automobile industry was required to increase the fuel efficiency of passenger vehicles, it increased the weight of some vehicles so more could be classified as trucks, instead of passenger vehicles. The trucks were not subject to the regulation, and as a result, fuel efficiency actually declined in the country due to the heavier weight of trucks.

Autoregressive Conditional Heteroskedasticity (ARCH)

(Question)

Squared Residuals Regression

	Coefficient	Standard Error	p-value
Intercept	3.00	0.577	0.01
Lagged residual  squared	0.28	0.185	0.31

From the data provided above, for a 5% level of significance, one should conclude that his or her AR(1) model exhibits:

A. no autocorrelation.
B. no autoregressive conditional heteroskedasticity (ARCH).
C. no multicollinearity.

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Answer: B

Autoregressive conditional heteroskedasticity refers to an autoregressive equation which the variance of the errors terms is heteroskedastic. (i.e., error variance is not constant.) The presence of ARCH is tested with the following regression:
e_t² = β₁ + β₂ * e_t-1² + v_t

which serves as a proxy for:

var(e_t) = β₁ + β₂ * var(e_t-1) + v_t

The exhibit above indicates that the slope estimate in the ARCH equation is not significant (the t-statistic for the slope estimate of the ARCH equation is not significant.) Therefore, the squared error does not depend on its lagged value (i.e., if the slope value is zero, then the error variance equals the constant β₁, which indicates no conditional heteroskedasticity in the AR model). ARCH is not present.

Misspecified model: a variable grows at a constant rate over time

sales_t = b₀ + b₁t + e_t

sales_t: quarterly sales
b₀: intercept term
b₁: slope
t: time variable (quarter number)
e_t: random error

The equation above might be misspecified; especially, actual sales have been increasing at a fairly constant rate over time.

Which of the following data transformations should be applied to the dependent variable in the equation above to best address the concern on the misspecification?

A. Lagged transformation.
B. Logarithmic transformation.
C. First difference transformation.

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Answer: B

A logarithmic transformation of the dependent variable is the most appropriate transformation to apply when the variable grows at a constant rate over time:

ln(sales_t) = a^* + b^*t + e_t

The slope of this equation (b^*) equals the nominal constant rate. The effective rate equals e^b*-1.

ln(sales_t) = a^* + b^*t + e_t
ln(sales_t-1) = a^* + b^*(t-1) + e_t

ln(sales_t) - ln(sales_t-1) = b^*
ln((sales_t)/(sales_t-1)) = ln(e^b*)

(sales_t)/(sales_t-1) = e^b*
(sales_t)/(sales_t-1) - 1 = e^b* - 1: effective rate

Standard III(A) Loyalty, Prudence and Care

(Question)
Would either following compensation arrangement to reward a broker for client referrals violate the CFA Institute Standards of Professional Conduct?

• Doubling the commissions paid on trades executed through the broker on the referral accounts
• Paying the broker a cash referral fee for each additional TIM account opened by the broker's referral.

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• The increased commission would be a violation,
• but each referral fee would NOT.

Doubling the commission paid to the broker would be a violation of Standard III(A) Duties to Clients - Loyalty, Prudence and Care. Client brokerage is strictly an asset of the client and must be used for the benefit of clients in research that will assist the investment manager in the investment decision-making process. Client brokerage CANNOT be used as a reward for bringing clients to an investment manager and to do so is a misappropriation of client assets.


Cash referral fees are acceptable, so long as the referral arrangement is fully disclosed to the clients in advance of opening their accounts. This disclosure allows the client to evaluate any potential conflict(s) of interest in the referral process.

Swap: Credit risk

• "Because currency swaps almost always include netting agreements and interest rate swaps can be structured to include mark-to-market agreements, we can significantly reduce the credit risk of these swap instruments by negotiating swap contracts that include these respective features. When negotiating these features is not possible, credit risk can be reduced by using off-market swaps that do not require an initial payment from our firm."

(Question)
Evaluate the statements regarding the firm's ability to mitigate the credit risk inherent in currency swaps and interest rate swaps. It is only correct regarding:

A. netting agreements.
B. mark-to-market agreements.
C. off-market swap contracts.

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Answer: B

Drecresing credit risk

	Currency swaps	Interest rate swaps	Equity swaps	Interest rate swaps	Off-market swaps
Netting payments	N/A	Yes	Yes
Mark-to-market agreements		Yes
No initial payment?

Using off-market swaps is not generally a method to reduce credit risk. If the firm enters into an off-market swap in which they do not owe a payment, then a payment is owed to the firm by the counterpary. This would actually increase credit risk since the counterparty could potentially default on the initial payment.

Currency Swap

USD/MXN

Time			USD/MXN
Inception of the contract			$0.0893
180 days later			$0.0850

Term structure of interest rates: Inception of the contract

Time Period		U.S. Interest Rates	Mexican Interest Rates
360 days		4.0%	5.0%
720 days		4.5%	5.2%

Term structure of interest rates: 180 days later

Time Period		U.S. Interest Rates	Mexican Interest Rates
180 days		4.2%	5.0%
540 days		4.8%	5.2%

Currency swap

Item
Interest rates			USD fixed - MXN fixed
Maturity			2 years (720 days)
Notional principal			$100 million
Payment			annual

Fixed Rate

Time Period		USD payer	MXN payer
Inception		4.40% (*2)	5.07% (*1)
180 days later

(*1)
(1-1/(1+5.2%*720/360))/(1/(1+5.0%*360/360)+1/(1+5.2%*720/360))
= (1-1/(1+5.2%*2))/(1/(1+5.0%)+1/(1+5.2%*2))
= (1-1/1.104)/(1/1.05+1/1.104)
= 0.05069... = 5.07%

(*2)
f_USD,0 = (1-(1/(1+4.5%*720/360)))/((1/(1+4.0%*360/360)+(1/(1+4.5%*720/360)))
= (1-1/(1+9.0%))/(1/(1+4.0%)+1/(1+9.0%))
= 0.04394.. = 4.4%

Cash flows

Time Period		USD payer	MXN payer
Inception
In the middle			56.8 million (MXN) (**1)
Maturity

(**1) 100 million (USD) *5.07% / $0.0893(USD/MXN) = 56.8 million (MXN)

Present Value

Time Period		USD payment	MXN payment	Value to USD payer
Inception
180 days later		101.69 million (***1)	97.48 million USD (***2)	97.48 - 101.69 = -4.21 million USD

(***1)
4.4%*100/(1+4.2%*180/360)+(4.4%*100+100)/(1+4.8%*540/360)
=4.4/(1+2.1%)+104.4/(1+7.2%)
= 101.6975... = $ 101.69 million

(***2)
Z_{MXN,360D,t=180D} = 1/(1+5%*(180/360)) = 1/1.025
Z_{MXN,720D,t=180D} = 1/(1+5.2%*(540/360)) = 1/1.078

The present value of the fixed payments plus the principal is:
5.07% * 1 * (1/1.025+1/1.078) + 1*1/1.078 = 1.02413...  = 1.0241 (per 1 MXN)

Apply this to notional principal and convert at current exchange rate:
1.0241 (per 1 MXN) * 100 million (USD) / 0.0893 (USD/MXN) * 0.0850 (USD/MXN)
= 1.0241 * 100 / 0.0893 * 0.0850
= 97.4787234...= 97.48 million USD

(plannded amortization class) CMO and MBS

(Question) An endowment fund.

• MBS
• "Because the cash requirements of the endowment fund fluctuate directly with interest rates, the cash flows provided from the MBS will provide adequate protection against cash shortfalls arising from differences in the timing of cash needs and cash sources."
• CMO
• "In addition, we can further reduce uncertainty surrounding the timing of cash flows by purchasing planned amortization class CMOs, which are securities issued against pools of MBS."
• CMBS
• "CMBS were not presented due to the unacceptable risk profile of the comparable CMBS trading in the market place."

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MBS and (plannded amortization class) CMO

Interest rate		↓	↑
Cash requirements of the endowment fund		↓	↑
MBS:
Prepayment		↑	↓
Cash flow from an MBS		↑(*1)	↓(*2)

(*1) Cash flows to be realized earlier than expected.
(*2) Delaying expected cash flows.

• MBS
• The statement is incorrect.
• If the endowment fund has cash flow needs that vary directly with interest rates, it will need a source of funds that varies in the same way.
• Planned amortization class CMOs
• The statement is correct.
• The structure gives these securities a relatively predictable life.

CMBS and MBS

(Question)
Which of the following statements regarding the difference between the risk profiles of an MBS and a comparable CMBS is least accurate?

A. Relatively illiquid CMBS properties will increase the degree of balloon risk to the investor.
B. Contraction risk for a CMBS is significantly lower if the issue contains a defeasance provision.
C. Shortfalls in cash flow from the underlying properties of a CMBS can be augumented by the sale of the properties or the borrowers' other assets.

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Answer: C

Commercial mortgage-backed securities (CMBS) are collateralized using non-recourse loans on commercial (i.e., income-producing) properties. Non-recourse means that the only cash flow support provided from the loan comes from the ability of the property to generate income and from the value of the property itself. The lender cannot seize personal assets of the borrower to satisfy any portion of the unpaid obligation.

Balloon risk: The risk that a borrower will not be able to make a balloon (lump sum) payment at maturity due to a lack of funding.

Defeasance (provision): It voids a bond or loan when the borrower sets aside cash or bonds sufficient enough to service the borrower's debt. The borrower sets aside cash to pay off the bonds, therefore the outstanding debt and cash offset each other on the balance sheet and don't need to be recorded.

Required Return Estimate Factors: control premium

Exhibit: Required Return Estimate Factors

Risk-free rate			3.5%
Equity risk premium			4.0%
Small size premium			3.5%
Specific-company premium			2.0%
Beta			1.2
Growth rate			3.0%

(Question)
The required return estimate that is calculated from the Exhibit above reflects all adjustments needed to make an accurate valuation of the company.

Is this statement correct?

---

Answer: No, it's incorrect.

An issue not described in the Exhibit is control premium. Any control premium adjustment is normally added directly to a company's value estimate.

Gordon Growth Model (GGM)

(Question)Which of the following is NOT an input used to estimate a company's equity risk premium based on the Gordon Growth Model (GGM)?

A. Dividend yield on the market index.
B. Current long-term government bond yield.
C. Expected growth in the market index's P/E ratio.

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Answer: C

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The Gordon growth model calculates the equity risk premium by starting with the dividend yield on the market index, adding the consensus long-term earnings growth rate and subtracting the current long-term government bond yield. The expected growth in the market index's P/E ratio is an input used in the macroeconomic model.

P₀ = D₁/(r_e - g)

Equity risk premium = Dividend yield on the market index + Long-term earnings growth rate - Current long-term government bond yield

Venture Capital Fund: price per share

A Venture Capital Fund

			shares
Founders			SF=2.5 (millions)
Venture capital (investors)			SV=?

A Venture Capital Fund

item			$ amount
Venture capital financing (INV)			9 (millions)
Post-money valuation (POST)			90 (millions)

The ownership proportion of the venture capital (VC) investor f_V
= INV/POST
= 9/90 = 10%

S_F/S_V=f_F/f_V=(1-f_V)/f_V
S_V = S_F * f_V/(1-f_V) = 2.5 * 0.10/(1-0.10)

The price per share for the venture capital investor is:
POST/(S_F+S_V) = 90/(2.5+2.5 * 0.10/(1-0.10)) = $32.4 per share

Venture Capital Fund: Paid-in capital, Percentage management fee, Carried Interest, NAV before/after Distributions

A Venture Capital Fund

item			amount
Comitted capital			$195 (millions)
%Carried interest			20%

A Venture Capital Fund

Year	Called-Down($)	Mgmt Fees($)	Op. Results($)
2006	30	0.45	-10
2007	25	0.83	55
2008	75	1.95	75
2009	0	1.95	62.304

A Venture Capital Fund

Year		Paid-in capital(*1)	% mgmt fee (*2)	NAV before Distributions	Carried Interest (*3)	Dist.	NAV after Distributions (*6)
2006		30	0.45/30 =1.50%	30-0.45-10 =19.55	0	0	19.55
2007		30+25 =55	0.83/55 =1.5091%	19.55+25-0.83+55 =98.72	0	0	98.72
2008		55+75 =130	1.95/130 =1.50%	98.72+75-1.95+75 =246.77	10.354(*4)	0	246.77-10.354 =236.416
2009		130	1.95/130 =1.50%	236.416-1.95+62.304 =296.77	10(*5)	0	296.77-10 =286.77

Mgmt Fees = Management Fees
Op. Results = Operating Results
Dist. = Distributions

(*1) Paid-in capital = ΣComitted capital called-down
(*2) Percentage management fee = Management Fee/Paid-in Capital
(*3) When NAV before distributions > Committed capital for the first time, Carried Interest is calculated.
Carried Interest(t) = (NAV before distributions(t) - Committed capital(t)) * %Carried interest
Only if (NAV before distributions(t) - Committed capital(t)) > 0, Carried interest(t) is calculated.

Then, after that, %Carried Interest is applied to the change in NAV before distributions.

(*4) (246.77-195)*20% = 10.354
(*5) (296.77 - 246.77) * 20% = 10

(*6) NAV after Distributions = NAV before Distributions - Carried Interest - Distributions

Capital budgeting project: Discount rate

(Question)
We are making inappropriate investment decisions since the discount rate used to evaluate all potential projects is the firm's weighted average cost of capital.

Which of the following would best correct the discount rate problem described in the statement above?

A. Use the firm's marginal cost of capital to evaluate all potential projects.
B. Use a beta specific to each potential project to determine the appropriate discount rate.
C. Use the cost of firm's equity capital to discount the cash flows of all potential subjects.

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Answer: B

When evaluating potential capital investment projects, the discount rate should be adjusted for the risk of the project under consideration. This is frequently accomplished by determining a project beta and using this beta in the CAPM security market line equation: r_i = R_F + β_i[E(R_M)-R_F]. Project betas can be determined in a number of ways including using proxy firms with operations similar to the project under consideration, estimating an accounting beta, or through cross-sectional regression analysis. Whatever method used to determine the discount rate, it should be clear that the weighted average cost of capital (WACC) is only appropriate for projects with risk similar to the overall firm. If a project is more (less) risky than the overall firm, the discount rate used to evaluate the project should be greater (less) than the firm's WACC.

Capital budgeting project: Sunk cost and Economic impact from increased competition

The cash flow projections are flawed since they fail to include costs incurred in the search for projects or the economic consequences of increased competition resulting from highly profitable projects.

Is this comment accurate?

---

Answer: No, it's incorrect.

• The capital budgeting process should NOT consider sunk costs (i.e., past costs that do NOT affect the cash flows of the project) such as costs to find investment projects.
• The cash flow projections should consider the economic impact from increased competition resulting from highly profitable investment projects.

Capital budgeting project: capital rationing system

(Question)
The capital rationing system being utilized is fundamentally flawed since, in some instances, projects that do not increase earnings per share are selected over projects that do increase earnings per share.

Is this comment correct?

---

Answer: No, incorrect.

Earnings per share (EPS) is not a suitable criteria to evaluate capital budgeting projects. Under capital rationing, a firm selects the projects that increase the value of the firm by the greatest amount (i.e., have the highest NPV) subject to the capital constraints of the firm's budget. It is perfectly possible that projects that increases EPS will NOT get selected while selecting the project with the highest NPV (if its capital budget will allow it) since it adds more value.

Scenario analysis

(Question)
Which of the following best describes how a replacement project should implement scenario analysis to analyze the replacement project?

A. Generate a base case, high, and low estimate of NPV by changing only the most sensitive cash flow variable.
B. Generate a base case, high, and low estimate of NPV by changing only the discount rate applicable to the project.
C. Generate a base case, high, and low estimate of NPV by simultaneously changing sales, expense, and discount rate assumptions for each case.

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Answer: C

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In scenario analysis, the analyst simultaneously changes several key variables to generate several different scenarios. Generally, three scenarios are created: (1) worst case, (2) most likely, and (3) optimistic. For the worst case scenario, for example, the analyst will use the slowest growth in sales, highest growth in expenses, and highest discount rate to derive an NPV under the worst of all possible situations.
A similar approach is used to generate the optimistic scenario, but the best possible growth in each of the variables is used.
The most likely is simply what the analyst thinks are the most reasonable assumptions for the discounted cash flow forecast under normal conditions. Using the different cases, the analyst can assess the risk of the project.

After-tax cash flow for a replacement project

A project would replace a portion of a company's equipment with new machinery expected to last three years.

Current machinery

item			$ amount
Book value			120,000
Market value			195,000

New machinery

item			$ amount
Cost			332,000
ΔCurrent assets			190,000
ΔCurrent liabilities			80,000

Δ means the change in the dollar amount.

Tax rate = 40%
Time horizon of the project = 3 years

New machinery

	Existing Equipment	The project	Increment
Annual sales	523,000	708,000	708,000-523,000 = 185,000
Cash operating expenses	352,000	440,000	440,000-352,000 = 88,000
Annual depreciation	40,000	110,667	110,667-40,000 = 70,667
Accounting salvage value	0	0	0
Expected salvage value	90,000	113,000	113,000-90,000 = 23,000

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(Question)
Assuming that working capital will be recaptured at the end of the project, what is the final period after-tax cash flow for the project?

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Recaptured working capital at the end of the project = ΔCurrent assets - ΔCurrent liabilities
= 190,000 - 80,000 = 110,000

Because the project is a replacement project, the incremental cash flows must be calculated.

Total cash flow in the final period
= Project cash flows + Return of net working capital + After-tax sale of fixed capital used in the project
= (185,000-88,000-70,667)*(1-40%) + 70,667
+ 110,000
+ (23,000 - 0)*(1-40%)
= 210,266.8

Divestiture

(Question)
A company decides to sell its interest in a joint venture. This is the fifth divestiture in the last five years. Which of the following statements is least likely accurate regarding this sale? The divestiture:

A. may be signaling a poor operating choice and prior bad acquisitions.
B. could be used to manage earnings by lowering the company's overall debt level.
C. is sending a positive signal that management is able to sell assets at a good price.

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Answer: C

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Divestiture should be a rare event. A divestiture usually send a negative signal. It is unlikely that investors want management to sell profitable assets.

Proportionate consolidation method and Equity method

Income Statement

Company	C	J	C (Proportionate consolidation)		C (Equity)
Revenue	3,115	421	3,115+50%*421 = 3,325.5	>	3,115
COGS	2,580	295	2,580+50%*295 = 2,727.5	>	2,580
SG&A	316	50	316+50%*50 = 341	>	316
EBIT	3,115-2,580-316 =219	421-295-50 =76	3,325.5-2,727.5-341 = 257
Interest expense	47	8	47+50%*8 =51	>	47
Equity in earnings of J	22		(*1)		22
Pretax income	194	68	(219-47)+50%*68 =206
Income tax	60	24	60+50%*24 =72
Net income	134	44	206-72 =134	=	134

C: company which owns 50% of a joint venture company
J: joint venture company

Balance Sheet

Company	C	J	C (Proportionate consolidation)		C (Equity)
Assets
Cash	118	13	118+50%*13 = 124.5
Accounts receivable	390	50	390+50%*50 = 415
Inventory	314	41	314+50%*41 = 334.5
Property	1,007	131	1,007+50%*131 =1,072.5
Investment	37.5		(*1)
Total Assets	1,866.5	235	(1,866.5-37.5)+50%*235 =1,946.5	>	1,866.5
Liabilities
Accounts Payable	274	35	274+50%*35 =291.5
Long-term debt	719	125	719+50%*125 =781.5
Total Liabilities	274+719 = 993	35+125 = 160	993+50%*160 =1,073	>	993
Equity
Equity	873.5	75	(873.5-37.5)+50%*75 =873.5	=	873.5
Total Equity	873.5	75	873.5	=	873.5
Total Liabilities and Equity	1,866.5	235	(1,866.5-37.5)+50%*235 =1,946.5	>	1,866.5

(*1) The investment in J is not included as an asset under proportionate consolidation.

Proportionate Consolidation Method


Current Ratio = Current Asset / Current Liability
= (Cash + Accounts Receivable + Inventory) / Accunts Payable
= (124.5 + 415 + 334.5) / 291.5 = 3.0

Interest Coverage Ratio = EBIT / Interest Expense

= (Revenue - COGS - SG&A) / Interest Expense

= (3,325.5 - 2,727.5 - 341) / 51 = 5.0

Long-term debt-to-equity Ratio = Long-term debt / Equity

= 781.5 / 873.5 = 0.89

Equity Method

Long-term debt-to-equity Ratio = Long-term debt / Equity

= 719 / 873.5 = 0.82

Monetary Policy

Monetary Policy

Monetary policy in the U.S.			expansionary (unexpected)
Economic growth			↑
Inflation			↑
Imports			↑
USD			↓(depreciation)

Fiscal Policy

Fiscal Policy

Fiscal policy in the U.S.			expansionary (unexpected)
Real interest rate			↑
USD			↑(appreciation)
Economic growth			↑
Inflation			↑
Imports			↑
USD			↓(depreciation)
USD			↑(appreciation) (*)

(*) Financial capital is more mobile than the goods market so the overall short-run effect would be for the dollar to appreciate.

OAS

OAS

OAS reflects:
yield difference due to the embedded option?			No
credit risk?			Yes
liquidity risk?			Yes
(different assumption concerning the) volatility of interest rates?			Yes

FCFF and FCFE: change in dividends and additional debt issue

FCFF = NI + NCC + Int(1-t) - NWInv - FCInv
FCFE = FCFF - Int(1-t) + Net Borrowing

NI = (EBIT - Int)(1 - t)

FCFF = (EBIT - Int)(1 - t) + NCC + Int(1-t) - NWInv - FCInv = EBIT(1 - t) + NCC - NWInv - FCInv
FCFE = EBIT(1 - t) + NCC - NWInv - FCInv - Int(1-t) + Net Borrowing

FCFF and FCFE: change in dividends and additional debt issue

	Dividend establishment	Additional debt issue
FCFF	No effect	No effect (*)
FCFE	No effect	(1) By issuing debt issue: FCFE↑ = FCFF→ - Int(1-t) + Net Borrowing↑ (2) By coupon payments thereafter: FCFE↓ = FCFF→ - Int↑(1-t) + Net Borrowing (**)

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[Explanation 1]

(*)
FCFF = EBIT(1 - t) + NCC - NWInv - FCInv
There is no impact from the additional debt issue. (e.g. Int, Net Borrowing)

(**)
By issuing debt issue:
FCFE↑ = FCFF→ - Int(1-t) + Net Borrowing↑

By coupon payments thereafter:
FCFE↓ = FCFF→ - Int↑(1-t) + Net Borrowing

It will initially increase FCFE by the amount of debt issued
and then reduce FCFE thereafter by the after-tax interest expense.

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[Explanation 2]

(*)
Before the debt issue:
FCFF = NI + Int(1-t) + NCC - NWInv - FCInv

After the debt issue:
FCFF'
= (NI-ΔInt*(1-t)) + (Int+ΔInt)(1-t) + NCC - NWInv - FCInv
= NI + Int(1-t) + NCC - NWInv - FCInv = FCFF


(**)
Before the debt issue:
FCFE = FCFF - Int(1-t) + Net Borrowing

After the debt issue:
FCFE'
= FCFF' - (Int+ΔInt)(1-t) + (Net Borrowing+ΔNet Borrowing)
= FCFF - Int(1-t) + Net Borrowing+(ΔNet Borrowing- ΔInt(1-t))
= FCFE + (ΔNet Borrowing- ΔInt(1-t))

FCFE' > FCFE
∵usually ΔInt(1-t) < ΔNet borrowing
(ΔNet Borrowing- ΔInt(1-t)) > 0

Total firm value

Total firm value = Value of operating assets(*1) + Value of non-operating assets

(*1) (e.g.) FCFFs discounted by WACC

If a firm has non-operating assets (e.g., land held for investment) on its balance sheet, the value of these assets must be added to the value of the operating assets (determined using the present value of the FCFFs and terminal value) to find the total firm value.

free cash flow valuation models: advantages

An analyst prefers to use free cash flow analysis to value investments. Which of the statements below is least accurate in describing the advantages of free cash flow valuation models?

A. Accouting issues limit the usefulness of reported earnings, while free cash flow is adjusted for these issues.
B. Determining free cash flow is easier than dividends.
C. A company must generate free cash flow to grow in the long run.

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Answer: B

An analyst must review the cash flows from a company's operating, investing, and financing activities to generate a useful free cash flow, while dividends are simply set by the board of directors. Analysts use free cash flow whenever an investor takes a control perspective, such as in the event of an acquisition. The P/E model is considered weak because accounting issues can impact earnings. Companies that do not generate free cash flow in the long run are in financial trouble.

free cash flow valuation models: advantages

	Free cash flow	Dividend
Accounting issues?	Less likely	-
Control perspective?	Yes (e.g. acquisition)	No
Easier to determine?	No	Yes (*)

(*) simply set by the board of directors

Liquidation value

If a possible target company is "not a sustainable business model", an acquiring company would estimate the possible target company's value using:

A. balance sheet value.
B. going concern value.
C. liquidation value.


Answer: C

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If the company's business model is not sustainable, the liquidation value is more appropriate than its value as a going concern (which could be negative). Balance sheet value is an accounting concept, not a valuation concept.

Labor productivity (Real wage rate)

(e.g.) The Classical Growth Era

Economic growth figures (millions except for per hour figures - inflation adjusted)

	1947	1950
Real GDP	$100	$180
Capital per hour of labor	$220	$220
Hours labor	20	21

For 1950,
Labor productivity = Real wage rate = Real GDP / Hours labor
= $180 / 21 = $8.57

Temporal method: realized and unrealized gains or losses on nonmonetary assets

Temporal method: realized and unrealized gains or losses on nonmonetary assets

		Temporal method
Realized gains or losses on	nonmonetary assets	Recognized (*)
Unrealized gains or losses on	nonmonetary assets	NOT recognized

(*) in operating profits through depreciation and COGS

Convertible bond: reverse split

Convertible bonds: revere split

		Before and after the reverse split
# of shares outstanding (ratio)		2 → 1 (one for two split)
Market price of the common stock		x 2 (double)
Total market value of the stock		No change
Conversion ratio of the convertible bond		x 0.5
Conversion value of the convertible bond = Stock price * Conversion ratio		No change
Market conversion price		No change

Conversion ratio = Par value / Conversion price

Conversion value = Price of the common stock * Conversion ratio
= Price of the common stock * (Par value / Conversion price)
= (x2) * (x0.5) = (No change)

Convertible bond: Limited downside risk associated with a convertible bond

• "Because the straight bond value will provide a floor for the value of the convertible bond, downside risk is limited to the difference between the market price of the bond and the straight value."
• If interest rates are NOT expected to change:
• then the straight value of the bond will NOT change (ignoring the change in value resulting from the passage of time).
• If the straight bond value does NOT change, then downside risk is indeed limited to the difference between the price paid for the conversion bond and the straight bond value.
• If interest rates rise as the price of the common stock falls,
• the conversion value will fall and the straight bond value will fall, exposing the holder of the convertible bond to more downside risk.

Hard put and Soft put

Hard put and Soft put

Redeemable through the issuance of:	Soft put	Hard put
Cash	OK	OK
The company's subordinated notes	OK	-
The company's common stock	OK	-
Treasury notes	-	-

• Soft put
• A bond with an embedded soft put is redeemable through the issuance of cash, subordinated notes, common stock, or any combination of these three securities.
• Hard put
• A bond with a hard put is only redeemable using cash.

Convertible bond: Conversion ratio, Market conversion price, Market conversion premium per share, and Premium payback period

Convertible bonds

Par value		$1,000
Conversion price		$55.56
Market price		$947
Coupon rate		7.25%

Stock (underlying of the convertible bond above)

Price		$50.00
Dividends per share		$1.80

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Conversion ratio = Par value / Conversion price = $1,000 / $55.56 = 18

Market conversion price = Market price (CB) / Conversion ratio = $947 / 18 = $52.61

Market conversion premium per share = Market conversion price - Market price (underlying stock) = $52.61 - $50.00 = $2.61


Premium payback period(*) = (Market conversion premium per share)/(Favorable income differential per share)
(*) How many years it would take to recover the premium per share

Favorable income differential per share = (Coupon rate * Par value - (Conversion ratio * Dividends per share))/Conversion ratio = (Coupon rate * Par value)/Conversion ratio - Dividends per share = (7.25% * $1,000)/18 - $1.80 = $2.23

Premium payback period = $2.61/$2.23 = 1.17 years

Persistence of abnormal earnings

Identify which characteristic indicates a higher persistence of abnormal earnings:

A. Low dividend payout.
B. Low price-to-earnings ratio.
C. High dividend yield.


Answer: A

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• It is difficult for a company to maintain a high ROE because of competition. The persistence factor will be lower for those companies.
• A company that has a low dividend payout has greater growth opportunities than a company with a higher dividend payout. The greater growth opportunities should support a higher persistence factor. (i.e. higher persistence of abnormal earnings)

Residual Return on Capital (RROC)

Residual Return on Capital (RROC)
= EVA / Capital
= Economic Profit/ Capital
= (NOPAT - $WACC) / Capital

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(e.g.)
NOPAT = $42 million
Capital (Total adjusted capital base) = $200 million
WACC = 12.0%

$WACC = WACC * Capital = 12.0% * $200 million = $24 million

Residual Return on Capital (RROC) = ($42 million - $24 million)/$200 million = 18/200 = 9.00%

Residual income

Residual income

Value of available-for-sale securities				↓
Other comprehensive income (OCI) section of stockholders' equity				↓
Net income				↑(*1)
ROE				↑
Book value				- (*2)
Residual income				↑ (*3)

(*1) A decrease in the value of the available-for-sale securities that bypasses the income statement would artificially increase net income and, consequently, ROE.

(*2) Book value is unaffected as the decrease is accounted for in the OCI section of the shareholders' equity.

(*3) due to higher ROE

U.S. GAAP: hyperinflationary economy

A foreign subsidiary in a hyperinflationary economy:

Year	t-3	t-2	t-1	3-year
Real interest rate	2.00%	2.50%	3.00%
Nominal interest rate	34.64%	29.15%	25.66%
Inflation	(1+34.64%) /(1+2.00%)-1 = 32%	(1+29.15%) /(1+2.50%)-1 = 26%	(1+25.66%) /(1+3.00%)-1 = 22%	(*1)102.91%

(*1) (1+32%)(1+26%)(1+22%) - 1 = 102.91%

A foreign subsidiary in a hyperinflationary economy:

			U.S.GAAP	IFRS
test: hyperinflationary economy?			Yes (*2)	Yes
			Temporal
Subsidiary: Functional currency			Parent's reporting currency
Inflation-adjusted value of the nonmonetary assets and liabilities of the foreign subsidiary			No (*5)	Yes (*3)
Translation losses			(*4)	(*4)
(1) Subsidiary's financial statement adjustment for inflation			No: nonmonetary assets and liabilities	Yes
(2) Net purchasing power gain or loss recognition?				Yes(I/S)
(3) Then, the subsidiary is translated into the parent's currency.			Temporal	All-current

(*2) 3-year cumulative inflation rate > 100%

(*3) IFRS accounting standards allow the parent to translate an inflation-adjusted value of the nonmonetary assets and liabilities of the foreign subsidiary at the current exchange rate, removing most of the effects of high inflation on the value of the nonmonetary assets and liabilities in the reporting currency.

(*4) In a hyperinflationary environment, the parent company can reduce translation losses by:

• reducing its net monetary assets or
• increasing its net monetary liabilities.

In order to do this, the parent should issue debt denominated in the subsidiary's local currency and invest the proceeds in fixed assets for the subsidiary to use in its operation.

(*5) NOT restated for inflation.

Current Rate Method and Temporal Method

• Local means a country where the foreign subsidiary operates.
• Local currency prices (or local inventory cost): constant → no difference between LIFO and FIFO
• Local currency: ↓ (depreciation vs. domestic/home/base/reporting currency)
• Exchange rate (DC/FC)
• C: Current
• A: Average
• H: Historical
• Then C < A < H

Table

Foreign subsidiary	Temporal		Current rate
Revenues	(A)		(A)
COGS	(H)	>	(A)
Gross profit margin = (Revenues - COGS) / Revenues	(A-H)/A	<	(A-A)/A

Nonmonetary assets: Realized and Unrealized Gain under Temporal Method

Temporal method

	gain/loss	Temporal	Through
Nonmonetary assets	Realized	Recognized	Depreciation COGS
Nonmonetary assets	Unrealized	NOT recognized

Net monetary liability exposures

Net monetary liability exposures

Method	Current method	Temporal method
Nonmonetary assets	(C)	(H)
Nonmonetary liabilities	(C)	(H)
Monetary assets	(C)	(C) (*)
Monetary liabilities	(C)	(C) (*)
Equity	(H)	(H)
Exposure	Equity (H) Assets (C) = Liabilities (C) + Equity (H) + Translation gain or loss	Cash and accounts receibable - Current liabilities - Long-term debt >0: Net monetary assets <0: Net monetary liabilities

(H) Historical exchange rate
(C) Current exchange rate

(*) Only the monetary assets and liabilities are exposed to changing exchange rates.

Since very few assets are considered to be monetary (mainly cash and receivables), most firms have net monetary liability exposures.

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Temporal Method

Net monetary exposures	FC appreciation	FC depreciation
Liabilities	loss	gain
Assets	gain	loss

Merger: Acquirer's Gain and Share Price of the combined company

Table

Company	A (acquirer)	T (target)	AT (merged company)
Number of shares	117.6 (millions)	213.1 (millions)
Stock price per share	$68	$35

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(Question 1)
Cash is paid to acquire the target company's shares.

Assuming that the estimate of the value of the merged companies is correct, calculate the acquirer's gain from the merger. Cash paid to the target company is $45 (given) * 213.1 (million) = 9,589.5 (million).


V_AT = $17,500 (millions) (given)

V_AT = V_A + V_T + S - C

where:
V_AT = the combined value of the firm
V_A = the value of the acquirer before the merger
V_T = the value of the target before the merger
S = the synergistic value from the merger
C = the cash paid to the target

Acquirer's gain = S - (P_T - V_T)

where:
S = the synergistic value from the merger
P_T = the price paid for the target; P_T = C, if only cash is paid to acquire the company.
V_T = the value of the target before the merger

S = V_AT - V_A - V_T + C = $17,500 - 117.6 * $68 - 213.1 * $35 + $9,589.5 = 11,634.2

Acquirer's gain
= S - (P_T - V_T)
= V_AT - V_A - V_T + C - (C - V_T)
= V_AT - V_A
= $17,500 - 117.6 * $68 = $9,503.2 million

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(Question 2)
The acquirer's stock is offered to acquire the target company's shares.
Assume that the acquirer A offers 63 million shares of its stock, rather than cash, to acquire the target company T. The price of the combined company is:

Total AT shares = 117.6 + 63 = 180.6 million

S = 11,634.2 (given; derived in Question 1)

V_AT = V_A + V_T + S - C = 117.6 * $68 + 213.1 * $35 + $11,634.2 - 0 = $27,089.5 million
Share price_AT  = V_AT / Total AT shares = 27,089.5/180.6 = $149.9972

Business Combinations

Business Combinations

	IFRS	U.S. GAAP
Historically used accounting methods	(1) purchase method (2) pooling-of-interests method (*)	(1) purchase method (2) pooling-of-interests method
Currently required accounting methods	acquisition method	acquisition method

(*) AKA uniting-of-interests method under IFRS

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Pooling-of-interests method

• combined the ownership interests of the two firms and viewed the participants as equals--neither firm acquired the other.
• The assets and liabilities of the two firms were simply combined.
• The two firms are combined using historical book values.
• Operating results for prior periods are restated as though the two firms were always combined.
• Ownership interests continue, and former accounting bases are maintained.
• Fair values played no role in accounting for a business combination.
• The actual price paid was suppressed from the balance sheet and income statement.

Foreign bond return when the foreign country's economic activity improves

Foreign bond return when the foreign country's economic activity improves

A foreign country's economic activity		improves
Real interest rate		↑
Bond price in the foreign nation		↓
Foreign currency (against investor's home/base currency)		↑(appreciation)
Total P&L on the bond in the investor's home/base currency		FC appreciation - bond price return (*)

(*) The increase in rates depresses bond prices, but the appreciation of the foreign currency will offset the loss on the bond.

Currency exposure of a foreign stock investment

The Correlation of the stock price to a change in the value of the local currency.

Currency exposure of a foreign stock investment

Correlation	Local stock price	Local currency
Positive	decrease ↓	depreciate (against investor's home/base currency)
Negative	increase ↑	depreciate (against investor's home/base currency)

sensitivity between euro-denominated and dollar-denominated returns

(Question)
A regression indicates the sensitivity between euro-denominated and dollar-denominated returns is -0.3. Calculate what impact a 5% drop in the euro relative to the U.S. dollar would have on overall bond portfolio returns.

Total portfolio = USD 25,000,000,000
Weight of foreign investments = 15%
Weight of bonds in foreign investments (euro-denominated bonds) = 40%

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(Answer)
Δeuro = -0.05 (5% drop in EUR vs. USD means -5% return in USD terms from the EUR exposure.)
sensitivity = -0.3

Euro-denominated bonds = USD 25,000,000,000 * 15% * 40% = USD 1,500,000,000

Euro-denominated bonds * Δeuro * sensitivity
= USD 1,500,000,000 * (-0.05) * (-0.3)
= USD 22,500,000 (increase)

Misspecified Functional Form

By pooling across two (or more) very different sample periods, the regression is an example of a misspecified functional form.

In this case, one should:

• run separate regressions for each subperiod, or
• employ dummy variables to control for the structural shift.