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Question
In applying the CAPM in estimating the cost of capital in an emerging market, explain the three problems in estimating an appropriate risk-free rate and the recommended solution.
Answer
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Related questions
Q:
The best method for understanding how much value a bank is creating in its different product lines is:
a) Free cash flow analysis.
b) Ratio analysis.
c) Economic spread analysis.
d) Net income analysis.
Q:
Which of the following is NOT true concerning loan losses for a bank?
a) They are among the most important value drivers in retail banking.
b) Default losses are strongly correlated with overall economic growth.
c) They are among the most important value drivers in wholesale banking.
d) A bank’s historical additions to loan loss provisions are a poor indicator of future loan losses.
Q:
Which of the following correctly ranks the sources of income for European banks over the period 1988–2013?
a) Commission income > interest income > trading income.
b) Interest income > commission income > trading income.
c) Commission income > trading income > interest income.
d) Trading income > interest income > commission income.
Q:
The four-step approach for valuing cyclical companies requires a minimum of two scenarios. If an analyst is using only two scenarios, how should they be constructed?
Q:
Contrast the first step in the valuation process of an established company and a high-growth company. Explain the reason for the difference in approaches.
Q:
An analyst computes the intrinsic values and probabilities for each of the indicated scenarios in the following table. Determine the expected value per share. a) 13.00
b) 16.00
c) 16.80
d) 17.50
Q:
Which of the following is the recommended method for dealing with the uncertainty of high-growth companies?
a) Real options.
b) Risk premium approach.
c) Monte Carlo simulation.
d) Probability-weighted scenarios.
Q:
As long as international investors have access to an emerging market’s local investment opportunities, local prices will be based on an international cost of capital.
Q:
In a two-scenario model of an emerging market, it is recommended that the analyst create a base-case set of forecasts and a set of forecasts associated with a period of economic distress. Which of the following best represents the range of probability weights to assign the economic distress scenario?
a) 5 to 10 percent.
b) 10 to 20 percent.
c) 20 to 30 percent.
d) 30 to 40 percent.
Q:
Using a scenario approach, an analyst finds that the estimated value of a company is $800. The business-as-usual scenario forecasts a cash flow of $40 starting next year and then growing at 6 percent forever. The cost of capital in that scenario is 10 percent. Given this information, what is the implied risk premium to add to the cost of capital to make the analyst’s results consistent with the country risk premium discounted cash flow (DCF) approach?
a) 0.80 percent.
b) 1.00 percent.
c) 1.20 percent.
d) 1.25 percent.
Q:
For emerging markets, the recommended input for the risk-free rate for computing beta is:
a) The domestic government bond rate.
b) The average of the inflation rates of developed nations.
c) The average of the government bond rates of developed nations.
d) The U.S. Treasury bond rate plus the local inflation rate minus the U.S. inflation rate.
Q:
When calculating gross investments, it is appropriate to add the increase in the foreign-currency translation reserve to capital expenditures to obtain the actual cash spent on capital investments.
Q:
An analyst should make financial projections of income statements and balance sheets for a valuation in a high-inflation environment by simply projecting all items on a nominal basis.
Q:
In early years, for a given company with a positive profit, ROIC with capitalized R&D will be higher than that with expensed R&D.
Q:
A firm that capitalizes R&D has more opportunity to manipulate short-term earnings compared to a firm that expenses R&D.
Q:
Which of the following company types is most likely to have operating leases as an off-balance-sheet liability?
a) A financial services company.
b) A company with few fixed assets.
c) A company that uses large, easily transferable assets.
d) An established company whose age is greater than 20 years.
Q:
Since interest costs, expected returns on plan assets, and amortization of losses are part of the compensation expenses for a firm, they should be considered to be a part of NOPLAT.
Q:
If there is no line item for prepaid pension assets or unfunded pension liabilities on a firm’s balance sheet, this means the firm’s pension plan is fully funded.
Q:
Analysts in the investment banking industry multiply rental expenses by 8 times to approximate asset value. Although based on reasonable assumptions, the method is very simple and can both overvalue and undervalue the leased assets.
Q:
The interest rate for operating lease adjustments is usually higher than the firm’s cost of debt.
Q:
When computing cash flows for a company with operating leases, an analyst should add back the lease depreciation to NOPLAT.
Q:
What are (1) the WACC before adjustment for leases and (2) the WACC after adjustment for leases? a) WACC before adjustment for leases = 8.63 percent; WACC after adjustment for leases = 6.98 percent. b) WACC before adjustment for leases = 6.63 percent; WACC after adjustment for leases = 6.98 percent. c) WACC before adjustment for leases = 6.93 percent; WACC after adjustment for leases = 8.63 percent. d) WACC before adjustment for leases = 8.63 percent; WACC after adjustment for leases = 8.98 percent.
Q:
Although a company’s ROIC will change following the adjustment for operating leases, its valuation should not change.
Q:
With respect to operating leases, adjusting the financial statements makes ROIC and free cash flow independent of capital structure choices, specifically whether to lease, own, or borrow.
Q:
An analyst’s appropriate adjustments for operating leases would be to increase assets, increase liabilities, and increase operating income.
Q:
List the three recommended steps in assessing the impact of nonoperating expenses and incorporating their information in cash flow forecasts.
Q:
If litigation charges recur frequently and grow with revenue, the analyst should treat the charges as operating.
Q:
Identify warranty reserves as operating or nonoperating and as an asset or a liability. Explain how the required treatment of warranty reserves determines the relationship between cash and accrual-based taxes.
Q:
Human resources costs should be allocated to business units based on the number of employees in the units.
Q:
CEO salaries should be allocated to business units based on the number of employees in the units.