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CFA Level II Chartered Financial Analyst Questions 125–129 (page: 47)

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



Based on the spread between local bonds and U.S. Treasuries, is Wong's suggestion of adding a country risk premium to the discount rate being used appropriate or not? Adding a country risk premium is:

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




Palmer has analyzed the planned capital expenditures and fixed asset accounting for Emerjico. Based on her analysis, she estimates that real depreciation expense can be 12.5% of future real revenues. The nominal projection for net operating profit less adjusted taxes (NOPLAT) for Year 2 is closest to:

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, Wrang 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.
Upon review, should Wang accept the estimated intrinsic value and investment recommendation for Aussie Shipping?

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, Wrang 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.

Is Wang's estimate of the British stock price correct?

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, Wrang 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.

Is Wang's estimate of the expected rate of return for the British stock approximately correct?