Jane Bowman, CFA, and Frank Shrum, CFA, are analysts for Brookstonc Advisors. Brookstone recommends investments in United States and global markets. Bowman and Shrum are responsible for analyzing investments and conducting cyclical analysis in developed and emerging markets.
Bowman is examining the country of Waltonia for a possible investment. Currently, the country's economy is beginning to recover from a recession. Businesses have increasing confidence in the economy, inflation is falling, the government is stimulating the economy, and the economy has just started to expand. Bowman identifies this is as the recovery stage of the business cycle and states that since inflation is falling, investors should put their money in bonds.
In terms of the business cycle, Waltonia has grown slower than its neighboring country of Bergamo, where the economy is in the early stages of an upswing. Bergamese businesses are confident and inventories are increasing. Bowman states that an investment in commodities or stocks would be advised because when the economy grows, these assets will rise in price.
Shrum is examining the value of a company in the United States using the franchise value model. In it, he will generate an intrinsic P/E ratio that can be multiplied against the firm's projected earnings to derive a value for the company. The intrinsic P/E value consists of the tangible P/E value, which represents the firm's static value, and a franchise P/E value which represents the firm's growth value. The franchise P/E value then consists of the franchise factor, which incorporates the required return on new investments, and the growth factor, which factors in the present value of the excess return from new investments. He applies this analysis to the firm of Salisbury Materials, which has the following characteristics:
Return on Equity 20%
Dividend Payout Ratio 40%
Required Return on Equity 16%
In light of the increased inflation in the United States due to increased commodity prices. Bowman is examining the effect of inflation on the P/E ratio. She states that when there is not full-flow- through of inflation, a firm in a low inflation country will have a higher P/E ratio than one in a high inflation country. She provides the following example of inflation flow-through. If the real required return is 9%, inflation is 4%, and the inflation flow-through rate is 80%, then the P/E ratio will be 10.2.
Shrum states that when valuing an emerging market, an investor should adjust their projections for the higher inflation risk. He states that the analyst should adjust the cash flows rather than the discount rate for the increased risks from emerging markets, such as political risk and macroeconomic risk. Bowman adds that there are several arguments that can be made and makes the following statements.
Statement 1: One argument is that companies respond differently to the risk in their country. For example, exporters would benefit from a weaker local currency but importers would be hurt by a depreciating local currency. Adjusting the discount rate by the same amount for all companies within a country would misstate the influence of country risk on each company.
Statement 2: Additionally, country risk is one-sided and asymmetric in that the country risk to foreign investors is much greater than that to local investors. So if a single discount rate were used to discount cash flows, then the valuations would be inaccurate for either the foreign investors or the local investors.
Shrum follows up with Bowman's analysis. He states that an alternative to adjusting the cash flows is to calculate a weighted average cost of capital for the emerging country firm and add a country risk premium to it. This discount rate would then be applied against unadjusted cash flows to value the emerging market firm. Regarding this analysis, he makes the following statements.
Statement 3: When estimating the percent of debt and equity in the capital structure, the market value of the firm's debt and equity should be used, not the book value.
Statement 4: The beta will be needed to obtain the cost of equity capital in the CAPM. The beta should be estimated for the company by regressing the company's returns against a well diversified global index, not the local market index.
Are Bowman's statements correct regarding the appropriate investments in the countries of Waltonia and Bergamo?
- Yes.
- No, bonds are not the appropriate investment in Waltonia.
- No, commodities and stocks are not the appropriate investment in Bergamo.
Answer(s): B
Explanation:
Bowman correctly states that the economy of Walconia is in the recovery stage of the business cycle. However, in the recovery stage, commodities, stocks, and other risky assets should be invested in to take advantage of the economic expansion, not bonds as she states.
She is correct regarding the appropriate investment in Bergamo. When an economy is in the early stages of an upswing, investing in commodities and stocks is appropriate as the economy expands. (Study Session 11, LOS 36.b)