CFA Level 2 - Equity Session 11 - Reading 41 Valuation in Emerging Markets - LOS b

CFA Level 2 – Equity, Session 11-Reading 41

Valuation in Emerging Markets – LOS b
(Practice Questions, Sample Questions)

1. The tangible price-to-earnings (P/E) and franchise P/E values for ACP, Inc. are closest to:

Tangible P/E Franchise P/E

A) 4.59 6.67
B) 6.67 4.59
C) 9.09 2.08

[Explanation: C) Tangible P/E = 1 / r, so, tangible P/E = 1 / 0.11 = 9.09

Franchise P/E is the product of the franchise factor (FF) and the growth factor (G).
That is, Franchise P/E = FF × G.

The Franchise factor is computed as: FF = (1 / r) ? (1 / ROE)

ROE = NI / equity, so for ACP, ROE = 4.

20 / 28.47 = 0.1475

FF = (1 / 0.11) – (1 / 0.1475) = 9.09 – 6.78 = 2.31

The growth factor, G, is calculated as: G = g / (r ? g)
Where, the sustainable growth rate, g, is calculated as:
g= retention rate × ROE = (1 ? payout ratio) × ROE
= (1 ? 0.65) × 0.1475 = 0.052

So, G = 0.052 / (0.11 ? 0.052) = 0.90
Franchise P/E = FF × G = 2.31 × 0.90 = 2.08]
2. During his research, Reynolds has observed that many of the firms in the marine products industry are concerned about the impact that new technology will have on their future profitability. Specifically, these firms are afraid that the competition resulting from new technologies will reduce their market share.

Based on this observation, what stage of the industry life cycle are the firms in the marine products industry most likely in?

A) Growth.
B) Mature.
C) Decline.

[Explanation: B) For mature industries, the threat from new technologies is whether competitors that employ new technologies will have a competitive advantage. In this situation, firms that do not use the new technologies will either have to adopt the new technologies or acquire their competition in order to survive]
3. In addition to evaluating the five largest firms in the marine products industry, Lapke has asked Reynolds to conduct a valuation of a smaller firm, one that is domiciled in an emerging market. They both agree that the emerging market firm’s value should be estimated as the present value of the company’s expected future free cash flows discounted at the appropriate weighted average cost of capital. They do not, however, agree on the appropriate method for incorporating country risks into the analyses. Lapke believes that the discount rate should be adjusted to reflect country risk, but Reynolds holds the opinion that cash flows should be adjusted. During their discussion, the following two statements are made.

Reynolds’ comment:
The evidence on this issue suggests that country risks are best incorporated into the valuation process by adjusting the cash flows in a scenario analysis rather than including them in the discount rate.
Lapke’s comment: Regardless of whether we adjust the discount rate or the cash flows to reflect emerging market risk, both the nominal and real cash outflow associated with net working capital should be computed as the change in nominal and real cash outflow from net working capital, respectively.
With respect to these statements:

A) both are correct.
B) only Lapke is correct.
C) only Reynolds is correct.

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

A) $4,862.
B) $4,675.
C) $4,250.

[Explanation: A) The nominal growth rate for Wavington in the steady state is (1.10 × 1.04) – 1 = 14.4%. The nominal WACC in the steady state is (1.10 × 1.08) – 1 = 18.8%. The nominal continuing value for Wavington in year 3 is:
nominal continuing value = FCF3 × (1 + nominal growth rate) / (nominal WACC – nominal growth rate)
nominal continuing value = 187 × (1.144) / (0.188 – 0.144)
nominal continuing value = 213.9 / (0.044) = 4,862]
5. Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. Charleston Johnson expects the local government to be successful in bringing inflation under control, and anticipates that it will fall to 20% in the second year and 10% in the third year, where he expects inflation to stabilize. Johnson asserts that the financial ratios of Wavington will be the same in both the real and nominal approaches. With regard to this statement, Johnson is:

A) correct because the underlying operations of the firm are unaffected by valuation methodology.
B) incorrect because cash flow forecasts in real terms are generally more accurate than cash flow forecasts in nominal terms.
C) correct because the rate of inflation used in calculating the components of financial ratios is the same for all components.

[Explanation: B) In general, the ratios based on cash flow forecasts in real terms are accurate while ratios based on nominal forecasts are incorrectly estimated.]