Answers - Reading 17 Cost of Capital, Advanced Topics

Question #1 of 11 Question ID: 1480223 Candace Elwince is attempting to calculate the required return of Skeun Inc., a machine-tool manufacturer in a small Eastern European country. Elwince has solid data from the German market but is not sure how to account for the exchange-rate risk Skeun investors would face. Her best choice for creating a risk premium is the: A) difference between the bond yields of both markets. B) Gordon Growth model. C) difference between the inflation rates of both markets. Explanation The country spread model suggests an analyst can approximate the risk premium between a developed market and an emerging market by subtracting the bond yields in the developed market from yields in the emerging market. (Module 17.2, LOS 17.d) Question #2 of 11 Question ID: 1480218 Currently the market index stands at 1,190.45. Firms in the index are expected to pay cumulative dividends of 35.71 over the coming year. The consensus 5-year earnings growth forecast for these firms is expected to increase to 6.2% up from last year's forecast of 4.5%. The long-term government bond is yielding 5.0%. According to the Gordon growth model, what is the equity risk premium? A) 2.5%. B) 1.2%. C) 4.2%. Explanation Equity risk premium = (35.71 / 1,190.45) + (6.2%) – 5.0% = 4.2% (Module 17.2, LOS 17.c) Question #3 of 11 Question ID: 1480216 Q Quest o : 80 6 An analyst attempting to derive the equity risk premium for a stock starting from the required return for that stock would find which of the following statistics least useful? A) Historical 10-year Treasury bond rates. B) The stock’s beta. C) The stock’s estimated return. Explanation The required return for a stock is equal to the risk-free return plus beta times the equity risk premium. An analyst starting from the required return would need beta and a riskfree rate. Historical 10-year T-bond rates can be used as an estimate of the risk-free rate. Since the analyst is starting with the required return, estimated returns are not needed. (Module 17.2, LOS 17.c) Question #4 of 11 Question ID: 1480224 The country risk rating model: A) determines a risk premium for an emerging market. B) determines a risk premium for any foreign market. C) depends on forecasts of exchange rates. Explanation The country risk rating model begins with a model from a developed country, then modifies that model with inputs from an emerging market to derive a risk premium for the emerging market. Forecasts of exchange rates may well be part of the model, but they are not a requirement. (Module 17.2, LOS 17.d) Question #5 of 11 Question ID: 1480222 When attempting to build a risk premium into the required returns of stocks in a developing country, an analyst should use the: A) modified Gordon Growth model. B) country’s weighted average cost of capital. C) country spread model. Explanation The country spread model uses data from a developed market, then adjusts it using the difference between the bond yields for the emerging and developed markets. Neither a modified Gordon Growth model nor a weighted average cost of capital will do this job. (Module 17.2, LOS 17.d) Question #6 of 11 Question ID: 1480220 Equity analyst Yasmine Cordova of Substantial Securities is trying to determine the investment appeal of shares of Maxwell Mincemeat, a small food company. Cordova has assembled the following data about the company: Internal rate of return: 9.4%. Maxwell's 20-year bond yield to maturity: 7.9%. Maxwell's two-year bond yield to maturity: 6.1%. Treasury bill yield: 3.4%. Maxwell's estimated beta: 2.1. Maxwell's 20-year bonds are priced at $102.65. Maxwell's two-year bonds are priced at $101.47. Estimated return of Russell 2000 Index: 12.3%. Substantial's credit analyst estimates that Maxwell's equity warrants a premium of 4.9% over its bonds. Cordova wants to make sure her estimates are accurate, so she decides to calculate the estimated required return in two ways. She opts for the bond-yield plus risk premium method and the capital asset pricing model. To check her work, she wants to compare the estimates derived under each method. The difference between the required returns is closest to: A) 5.30%. B) 5.89%. C) 9.29%. Explanation The capital asset pricing model uses the following equation: Required return = risk-free rate + beta × equity risk premium To calculate the required return under CAPM, use the Russell 2000 index return, the beta, and the risk-free rate. Required return = 3.4% + 2.1 × (12.3% − 3.4%) = 22.09%. The bond-yield model uses the following equation: Required return = yield to maturity on long-term bonds + risk premium. Required return = 7.9% + 4.9% = 12.8%. The difference between the two estimated required returns is 9.29%. (Module 17.2, LOS 17.d) Question #7 of 11 Question ID: 1480215 The equity risk premium is the difference between: A) the required equity return and the risk-free return. B) estimated equity returns and estimated bond returns. C) the estimated equity return and the risk-free return. Explanation The equity risk premium reflects the return in excess of the risk-free rate that investors require for holding stocks. It is derived by subtracting the risk-free return from the required return. (Module 17.1, LOS 17.a) Question #8 of 11 Question ID: 1480217 Ben Jacobs, CFA, is attempting to calculate a historical equity risk premium. His first estimate uses geometric mean equity returns and long-term bond yields. His second estimate uses arithmetic mean returns and short-term bond yields. The effect of the changes in methodology in the second estimate, relative to the first, will: A) both decrease the size of the risk premium. B) have offsetting effects. C) both increase the size of the risk premium. Explanation Switching from a geometric mean to an arithmetic mean will increase the mean equity return. All else being equal, that will increase the estimated risk premium. When the yield curve slopes upward, short-term bonds yield less than long-term bonds. Thus, the equity risk premium estimate will be larger when short-term bond rates are used. (Module 17.2, LOS 17.c) Question #9 of 11 Question ID: 1480221 In the process of estimating beta for a private company, unlevering the beta calculated for the publicly traded comparable company accomplishes what goal? A) Establishing a baseline level of leverage. B) Isolating market risk. C) Improving the accuracy of the estimate in the event that the private company’s debt is of low quality. Explanation Market risk, also known as systematic risk, is the risk common to all assets within a certain class. Deleveraging the beta strips out the company-specific risk related to the target company's leverage, thereby isolating market risk. Beta calculations do not require a baseline level of leverage. The equation for calculating beta for private companies assumes the company in question has high-grade debt. The deleveraging process will not help if the assumption is incorrect. (Module 17.2, LOS 17.d) Question #10 of 11 Question ID: 1480225 Junior analyst Quentin Haggard is struggling with a required return calculation. His main concern is compensating for exchange rate fluctuations between the country where his company is based and the home country of a portfolio of stocks he is analyzing. Haggard should calculate the return in his home country's currency, then adjust: A) for expected changes in the foreign country’s inflation rate. B) for expected changes in the foreign country’s currency value. C) the beta to account for exchange-rate fluctuations. Explanation The proper method of compensating for changes in exchange rates is to calculate the required return in the home currency, then adjust the return using forecasts for changes in the exchange rate. (Module 17.2, LOS 17.d) Question #11 of 11 Question ID: 1480219 Types of estimates of the equity risk premium are least likely to include: A) ex-ante estimates. B) macroeconomic model estimates. C) extemporized estimates. Explanation There are four types of estimates of the equity risk premium: historical estimates, forward-looking (ex-ante) estimates, macroeconomic model estimates, and survey estimates. (Module 17.2, LOS 17.c)