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CFA Level II Chartered Financial Analyst Questions 100–104 (page: 42)

Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.



Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.

Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.
Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine Midwest News's required relurn on equity is presented in Exhibit 2.



The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.

Statement 1: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.
Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.

Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.

Based on Exhibit 2 and using the build-up method, Midwest News's required return on equity is closest to:

Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.



Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.
Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.
Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine Midwest News's required relurn on equity is presented in Exhibit 2.



The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.

Statement 1: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.
Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.

Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.
Using the single-stage residual income model and assuming the I required return on equity is 15%, the value of Midwest News is closest to: (use information in Exhibits I and 2)

Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.



Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.

Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.
Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine Midwest News's required relurn on equity is presented in Exhibit 2.



The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.

Statement 1: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.
Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.

Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.

Miller has made two statements, one concerning the required return estimate, and the other concerning the relative merits of the free cash flow model versus the dividend discount model. Are Miller's statements correct?

Rogcrt Markets is the nation's third largest retail grocery chain, and usually has the largest or second largest market share in every city in which it competes. In its most successful large cities, Rogert has as much as a 25% market share, although its share is sometimes greater in small cities. Rogert is known for its excellent customer service and has a wide variety of grocery selections in almost every part of its stores. Its profit margins on sales are slightly above industry averages, and its return on assets and return on equity are above average.
Rogert has an equity beta of 0.78 and a debt-to-capital ratio of approximately 50%. Recent economic difficulties, including higher commodity prices and higher unemployment, resulted in lower profit margins for Rogert. Still, Rogert's decline in profit margin was less than for its competitors. Rogert did not experience substantial losses of sales from customers switching to lower-priced competitors as its market share remained substantially constant.

Zephine Markets is one of Rogert's smaller competitors. Zephine operates in roughly 15% of the same cities as Roger. Zephine is publicly traded, and one of the members of Rogert's board of directors has asked the staff to evaluate an acquisition of Zephine. The staff believes that Zephine is slightly underpriced and that it could be acquired for a 20% premium over its current price. In recommending against the acquisition, staff member Pierre Chiraq says:

"I agree that eliminating Zephine as a rival would probably enhance our profit margins. However, I am skeptical about this acquisition. First, because our market share is almost never dominant, much of the benefit of eliminating a smaller rival will be shared by our other rivals. They will free- ride on our investment. Second, if our profit margins do increase, wc will eventually attract new rivals into our markets. And finally, our cost of capital should increase substantially because the firm will be diversifying horizontally instead of vertically, increasing the firm's risk."

Over the last several years, grocery industry growth has tended to follow the general economy. The competitors in the industry, like Rogert, compete for market share in a stable industry. The industry's cyclical behavior has shown stable performance in both the ups and downs of the business cycle.

In assessing Rogert's competitive position, Chiraq makes comments about the threat of new entrants:

"My concern about new entrants into our business is low for several reasons. Economies of scale are achievable at a low size of operations relative to that of our firm. Our brand identity is high in the markets in which we compete. And, finally, access to distribution channels is difficult to achieve in the grocery business. While there are many competitive forces that concern mc, new entrants is low on my list."

Finally, the staff discusses industry changes that might have a negative effect on Rogert's industry position. Three phenomena are mentioned that could have such an effect. They are:

1. Industry growth rates are low and declining;
2. Several suppliers are sponsoring national television advertisements for their products;
3. The government has approved a new method of extending the shelf life of fruits and vegetables.

Which of Porter's five forces most likely accounts for Rogert's above-average profitability?

Rogcrt Markets is the nation's third largest retail grocery chain, and usually has the largest or second largest market share in every city in which it competes. In its most successful large cities, Rogert has as much as a 25% market share, although its share is sometimes greater in small cities. Rogert is known for its excellent customer service and has a wide variety of grocery selections in almost every part of its stores. Its profit margins on sales are slightly above industry averages, and its return on assets and return on equity are above average.

Rogert has an equity beta of 0.78 and a debt-to-capital ratio of approximately 50%. Recent economic difficulties, including higher commodity prices and higher unemployment, resulted in lower profit margins for Rogert. Still, Rogert's decline in profit margin was less than for its competitors. Rogert did not experience substantial losses of sales from customers switching to lower-priced competitors as its market share remained substantially constant.

Zephine Markets is one of Rogert's smaller competitors. Zephine operates in roughly 15% of the same cities as Roger. Zephine is publicly traded, and one of the members of Rogert's board of directors has asked the staff to evaluate an acquisition of Zephine. The staff believes that Zephine is slightly underpriced and that it could be acquired for a 20% premium over its current price. In recommending against the acquisition, staff member Pierre Chiraq says:

"I agree that eliminating Zephine as a rival would probably enhance our profit margins. However, I am skeptical about this acquisition. First, because our market share is almost never dominant, much of the benefit of eliminating a smaller rival will be shared by our other rivals. They will free- ride on our investment. Second, if our profit margins do increase, wc will eventually attract new rivals into our markets. And finally, our cost of capital should increase substantially because the firm will be diversifying horizontally instead of vertically, increasing the firm's risk."

Over the last several years, grocery industry growth has tended to follow the general economy. The competitors in the industry, like Rogert, compete for market share in a stable industry. The industry's cyclical behavior has shown stable performance in both the ups and downs of the business cycle.

In assessing Rogert's competitive position, Chiraq makes comments about the threat of new entrants:

"My concern about new entrants into our business is low for several reasons. Economies of scale are achievable at a low size of operations relative to that of our firm. Our brand identity is high in the markets in which we compete. And, finally, access to distribution channels is difficult to achieve in the grocery business. While there are many competitive forces that concern mc, new entrants is low on my list."

Finally, the staff discusses industry changes that might have a negative effect on Rogert's industry position. Three phenomena are mentioned that could have such an effect. They are:

1. Industry growth rates are low and declining;
2. Several suppliers are sponsoring national television advertisements for their products;
3. The government has approved a new method of extending the shelf life of fruits and vegetables.

Rogert's success can be attributed to: