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Gary Smith, CFA, has been hired lo analyze a specialty tool and machinery manufacturer, Whitmore Corporation (WMC). WMC is a leading producer of specialty machinery in the United States. At the end of 2006, WMC purchased York Tool Company (YTC), an Australian firm in a similar line of business. YTC has partially integrated its marketing functions within WMC but still maintains control of its operations and secures its own financing. Following is a summary of the income statement and balance sheet for YTC (in millions of Australian dollars - AUD) for the past three years as well as exchange rate data over the same period.
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 related to the consolidation of V/MC's Indian subsidiary is least likely correct?
U .S . accounting standards define a hyperinflationary economy as one in which the three-year cumulative inflation rate exceeds 100%. The Indian economy can be characterized as hyperinflationary. The inflation rate over the past three years can be calculated as follows:
year 1 inflation = [(I + 0.3464) / (1 + 0.020)] - 1 = 32%year 2 inflation = [(I + 0.2915) / (1 + 0.025)1 - 1 = 26%
year 3 inflation = [(1 + 0.2566) / (1 + 0.030)] - 1 = 22%
cumulative three-year inflation = (1.32)(1.26)(1.22) - 1 = 103%
U .S . accounting standards allow the use of the temporal method, with the functional currency being the parents reporting currency, when a foreign subsidiary is operating in a hyperinflationary environment. IAS accounting standards allow the parent to translate an inflation-adjusted value of the nonmonetary assets and liabilities of the foreign subsidiary at the current inflation rate, removing most of the effects of high inflation on the value of the nonmonetary assets and liabilities in the reporting currency. 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 operations. (Study Session 6, LOS 23-0
Janice Palmer, CFA, is an international equity analyst at a large investment management firm catering to high net worth U .S . investors. She is assisted by Morgan Greene and Cathy Wong. Both Greene and Wong have prepared their preliminary security selections and are meeting along with Palmer today for detailed security analysis and valuation. They have narrowed their focus to a few closed-end country funds and some firms from Switzerland, Germany, the U.K. and the emerging markets.
The initial decision is to choose between closed-end country funds and direct investment in foreign stock markets. Wong is in favor of country funds because:
1. Country funds provide immediate diversification.
2. Buying country funds is a better choice than direct investment for most emerging markets.
However, Wong has observed a premium to NAV that is prevalent in closed-end country funds. Wong is curious as to how the observed premiums would affect investments in such instruments.
In contrast to Wong, Greene is more inclined towards individual stocks and has started looking into their financial statements. One firm Greene is analyzing is a German conglomerate. Kaiser Corp. Kaiser has a history of growing by acquiring high-growth firms in niche markets. Exhibit 1 provides key financial information from Greene's analysis of Kaiser Corp.
Exhibit 1: Financial information---Kaiser Corp.
While going through their sample of emerging market stocks, Wong observed that these markets in general have high inflation and that sales for the stocks were extremely seasonal. Wong compensated by adjusting reported sales growth in the emerging market firms by deflating the sales using annual inflation adjustments. Wong also made upward adjustments to reported depreciation figures.
Wong suggested to her colleagues that they add a country risk premium to the discount rate they were using to evaluate emerging market stocks. She further suggested that they estimate country risk premiums by calculating the spread between the yield of U .S . government bonds and that of similar maturity local bonds.
Subsequently they started working on the financial projections for Emerjico, Inc., an emerging market stock. Their assumptions are given in Exhibit 2.
Exhibit 2: Key Assumptions---Emerjico
In response to Wong's curiosity about the effects of the NAV premium on country fund investments, Palmer is least likely to suggest that the premiums:
The closed-end country fund premiums ro net asset value are themselves very volatile and add to the risk of the fund. They tend to decrease as die country liberalizes foreign access to their financial markets. However, the fund premiums do not add to the return of the fund. (Study Session 10, LOS 34,g,i)
Zi Wang is a senior buy-side equity analyst with Shandong Securities. Wang must review the work of several of his junior colleagues before investment recommendations go to the Shandong portfolio managers. One recommendation from a junior analyst is given in Exhibit 1.
This same junior analyst e-mailed Wang, saying "I'm in a meeting and hate to bother you. I don't have my calculator or computer with me. We have a British stock with a current 4.00 dividend that is expected to grow at 40% per year for two years and then forever after at 6%, If we assume a required return of 12%, what is the value of this stock?"
in a few minutes, Wang e-mails him back: "The British stock is worth 110.42"
The junior analyst sends back a second e-mail. "Thanks. If we can buy this stock for 90, what rate of return would we get? Assume the same dividend pattern as in my first e-mail."
Wang replies to the second e-mail: "I used trial and error and found an expected rate of return for the British stock of 12%."
One of Shandong's portfolio managers asks Wang to clarify the PVGO (present value of growth opportunities) concept for him. Wang tells him, "PVGO is the part of a stock's total value that comes from future growth opportunities. PVGO is conventionally estimated as the market value per share minus the book value per share."
The Shandong portfolio manager quickly follows up with two more requests. He says, "I need a couple of favors. First, could you describe the sustainable growth rate concept for us? We've been arguing about it among ourselves. And, second, could you review some highlighted phrases from a research report we received from one of our investment bankers? We aren't sure that the analyst who wrote this report is very competent." The highlighted phrases are:
Phrase 1: When calculating the justified P/E ratios based on a constant growth model like the Gordon model, the forward P/E should be greater than the trailing P/E.
Phrase 2: A free cash flow approach might be preferable when the company's cash flows differ substantially from dividends or the investor takes a control perspective.
Phrase 3: When the required rate of return increases, the value of a share of stock should decrease even if the stock's dividend has a negative growth rate.
How should Wang describe sustainable growth? "The sustainable growth rate is the rate of dividend and earnings growth that can be sustained for a given return on equity assuming that:
Sustainable growth is growth that can be achieved by retaining some earnings and keeping the capital structure (debt to equity) constant. (Study Session 11, LOS 40.o)
Martha Garret, CFA, manages fixed income portfolios for Jones Brothers, Inc. (JBI). JBI has been in the portfolio management business for over 23 years and provides investors with access to actively managed equity and fixed-income portfolios. All of JBI's fixed-income portfolios are constructed using U .S . debt instruments. Garret's primary portfolio responsibilities are the Quasar Fund and the Nova Fund, both of which are long fixed-income portfolios consisting of Treasury securities in all maturity ranges. The Quasar Fund holdings as of March 15 are provided in Exhibit 1. A comparison of key rate durations for the Quasar Fund and Nova Fund is provided in Exhibit 2.
Of particular importance to Garret and her colleagues is the degree of interest rate risk exposure unique to each portfolio under JBI's management. Driving the increased awareness of the portfolios' interest rate exposure is the double digit growth in assets under management that JBI's fixed-income portfolios have experienced in the last five years. Interest in the company's fixed-income portfolios continues to grow and as a result, all portfolio managers are required to attend weekly meetings to discuss key portfolio risk factors. At the last meeting, Miranda Walsh, a principal at JBI, made the following comments:
"The variance of daily interest rate changes has been trending higher over the last three months leading us to believe that a period of high volatility is approaching in the next twelve to eighteen months. However, the reliability is questionable since the volatility estimates were derived using an option pricing model, which assumes constant interest rates."
"Also, the Treasury spot rate curve currently has a similar shape to the yield curve on Treasury coupon securities, which, according to the market segmentation theory of interest rate term structure, indicates a relatively high level of demand from investors for intermediate term securities. Overzealous trading by investors unwilling to move into other maturity ranges may create mispricing and opportunities for arbitrage."
After the meeting, Walsh and JBI's other principals met to discuss a new international portfolio opportunity. At Walsh's suggestion, the principals selected Garret as the lead portfolio manager for the new fund, which will be titled the Atlantic Fund. One of the other portfolio managers, Greg Terry, CFA, suggested to Garret that she utilize the LIBOR swap curve as a benchmark for the Atlantic fund rather than using local government yield curves. Terry justifies his suggestion by claiming that "the lack of government regulation in the swap market makes swap rates and curves directly comparable between different countries despite fewer maturity points with which to construct the curve as compared to a government yield curve. Furthermore, credit risk in the swap curves of various countries is similar, thus avoiding the complications associated with different levels of sovereign risk embedded in government yield curves.'' Intrigued by the idea of using the swap curve, Garret has her assistant begin gathering a range of current and forward LIBOR rates.
Assume that Bond A is currently callable at 105 and will be callable at 103 in six months. If the yield curve experiences a negative butterfly shift over the next month, which of the following results is most likely to be observed?
Bond A is priced at par value. A negative butterfly shift would increase the humped nature of the yield curve, either through a bigger increase in intermediate rates than short and long rates or a smaller decrease in intermediate rates than short- and long-term rates. Because Bond A has a much lower duration than Bond C, a yield curve shift would have more of a price impact on Bond C than Bond
A . Long-term investors would not be drawn to such a short-term bond unless the yield shift created significant mispricing, which is unlikely. Choice C is the only answer that accurately reflects a possible result of a negative butterfly shift. Bond A would increase in price if the shift saw short-term rates falling more than intermediate rates. The increase in price will be limited, however, by the call price and thus the callable bond would experience price compression (usually observed at low interest rates). The interest rate decrease would be consistent with a negative butterfly shift. (Study Session 14, LOS 53.a)
MediSoft Inc. develops and distributes high-tech medical software used in hospitals and clinics across the United States and Canada. The firm's software provides an integrated solution to monitoring, analyzing, and managing output from a variety of diagnostic medical equipment including MRls, CT scans, and EKG machines. MediSoft has grown rapidly since its inception ten years ago, averaging 25% growth in sales over the last decade. The company went public three years ago. Twelve months after their IPO, MediSoft made two semiannual coupon bond offerings, the first of which was a convertible bond. At the time of issuance, the convertible bond had a coupon rate of 7.25%, par value of $1,000, a conversion price of $55.56, and ten years until maturity. Two years after issuance, the bond became callable at 102% of par value. Soon after the issuance of the convertible bond, the company issued another series of bonds which were putable, but contained no conversion or call features. The putable bonds were issued with a coupon of 8.0%, par value of $1,000, and 15 years until maturity. One year after their issuance, the put feature of the putable bonds became active, allowing the bonds to be put at a price of 95% of par value, and increasing linearly over five years to 100% of par value. MediSoft's convertible bonds are now trading in the market for a price of $947 with an estimated straight value of $917. The company's putable bonds are trading at a price of $1,052. Volatility in the price of MediSoft's common stock has been relatively high over the last few months. Currently the stock is priced at $50 on the New York Stock Exchange and is expected to continue its annual dividend in the amount of $1.80 per share.
High-tech industry analysts for Brown & Associates, a money management firm specializing in fixed-income investments, have been closely following MediSoft ever since it went public three years ago. In general, portfolio managers at Brown & Associates do not participate in initial offerings of debt investments, preferring instead to see how the issue trades before considering taking a position in the issue. Since MediSoft's bonds have had ample time to trade in the marketplace, analysts and portfolio managers have taken an interest in the company's bonds. At a meeting to discuss the merits of MediSofVs bonds, the following comments were made by various portfolio managers and analysts at Brown & Associates:
"Choosing to invest in MediSoft's convertible bond would benefit our portfolios in many ways, but the primary benefit is the limited downside risk associated with the bond. Since the straight 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."
"Decreasing volatility in the price of MediSoft's common stock as well as increasing volatility in the level of interest rates are expected in the near future. The combined effects of these changes in volatility will be a decrease in the price of MediSoft's putable bonds and an increase in the price of the convertible bonds. Therefore, only the convertible bonds would be a suitable purchase."
Evaluate the portfolio managers' comments regarding the changes in the values of MediSoft's bonds resulting from changes in the volatility of the company's common stock and the volatility of interest rates. The managers were:
Decreasing volatility of common stock prices would devalue any options related to the stock. The convertible bond contains an embedded call option on the stock which would experience a decrease in value. Increasing interest rate volatility would increase the value of options related to interest rates. MediSofts convertible bond is also callable and the value of the call on the bond would increase. The total value of the convertible bond is as follows: convertible bond value = straight value + call on stock - call on bond. The combined effect of the changes in the values of the options is a decrease in the value of the convertible bond. Thus the statement regarding the volatility effects on MediSofts convertible bonds is incorrect. The value of the putable bond can be summarized as follows: putable bond value = option-free value + put on bond. The increase in put option value resulting from the increase in interest rate volatility would increase the value of the putable bond. Therefore, the statement regarding the volatility effects on MediSofts putable bonds is also incorrect. (Study Session 14, LOS 54.j)
