CFA Level 2 - Equity Reading 41: Valuation in Emerging Markets

University:
CFA Institute
Course:
CFA Level 2 | Equity
Academic year:

2023
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377

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6
Author:

anon

CFA Level 2 - Equity Session 11-Reading 41 Valuation in Emerging Markets - LOS d (Practice Questions, Sample Questions) 1. Country-risk premiums tend to: A) become part of the local government risk-free rate. B) decrease toward zero over the long run as emerging markets become integrated into the global market. C) increase when government credit issues grow. B: Over the long run, it is assumed that the country-risk premium will approach zero as the emerging market becomes integrated into the international markets. 2. Country risk for an emerging market company is generally incorporated into the: A) credit risk premium. B) market-risk premium. C) sovereign risk premium. C: The sovereign risk premium consists of both credit and country-risk premiums. 3. Pricing power is difficult to ascertain without specific data, but the information presented above provides enough clues to deduce the proper order. Quintile Fusion appears to be a company in decline, reinventing itself, worried about rivals, and dependent on commodities for production. Both Blevins and Karnack Analysis appear to have more market leverage. Blevins’ concerns about its brand momentum, coupled with what appears to be fairly small barriers to entry, suggest pricing power is limited. Karnack differentiates by specialization, one key to charging high prices. Large barriers to entry, and a rise in capacity utilization suggests demand is rising faster than supply, potentially supporting higher prices. Concern about the acceptance of new products could be a negative indicator for prices, but Karnack has the most positive data regarding pricing power, and Quintile Fusion has the most negative data. Which of the following information on Kenton Koncepts is most valuable in the analysis of long-term? Supply trends? Profitability? A) Order chart Cost-cutting initiatives B) Plant upgrades Cost-cutting initiatives C) Order chart Product list C: The list of plant upgrades is useful for estimating Kenton’s production, but an industrywide chart of orders and backlogs illustrates more than demand trends. By considering both orders and backlogs, an analyst can back into supply analysis and draw useful conclusions about the current supplies and industry production capacity. While cost-cutting initiatives will have an effect on profit margins, particularly in the short term, of more importance in the long term is the company’s ability to produce items the market wants. Kenton’s list of products and niches has substantial value for determining whether the company can continue to operate profitably. 4. Based only on the information above, where do Blevins’ and Karnack Analysis’ industries fall on the business life cycle? Blevins Karnack Analysis A) Growth Growth B) Mature Pioneer C) Mature Growth B: Blevins’ growth rate suggests it is not on the decline. In some ways Blevins looks like a growth company, but companies can post solid growth within a mature industry, particularly if they are taking market share. And Blevins’ profit margins and concerns about the erosion of an already powerful brand are characteristic of an established company in a mature industry. Karnack’s difficulty in funding expansion hints at high capital needs, and concerns about new products suggest it is in a pioneer industry. 5. Which of the following issues will be least effectively addressed if LeMond simply adjusts the financial statements by reducing the cash flows of each company in the country by a set amount? A) Unusually high inflation. B) The risk of political instability. C) Vulnerability of the companies to privatization. C: Inflation and political instability will have a similar effect on companies throughout a country. Some industries are more vulnerable to privatization than others, and simply reducing cash flows for all companies by a set amount will probably understate the cash flows of companies in industries not likely to be privatized. 6. Plicher’s cost of equity is closest to: A) 44.2%. B) 38.4%. C) 42.4%. C: The cost of equity = the risk-free rate + beta × market risk premium. First, the risk-free rate. We can’t use the U.S. risk-free rate, and Llaho bills may be illiquid or denominated in another currency. So we start with the 10-year Treasury yield, then add the difference between Llaho’s inflation and U.S. inflation. 4% + 2.5% + 25% ? 3.5% = 28%. For beta, we use the industry beta, not the beta derived from stock returns. The market risk premium is the global premium. Thus, the cost of capital is 28% + 1.6 × 9% = 42.4%. 7. Assume for this question only that the cost of equity is 25.4% and the local risk-free rate is 15%. Plicher’s weighted average cost of capital is closest to: A) 10.15%. B) 18.64%. C) 15.67%. C: The weighted average cost of capital equals (equity / assets) × cost of equity + (debt / assets) × after-tax cost of debt. We have equity, assets, debt, and cost of equity values. To calculate the cost of debt, we start with the local risk-free rate plus the U.S. credit spread on comparable debt, or 15% + 1.3% = 16.3%. Then we multiply 16.3% by (1 – marginal tax rate). 16.3% × 70% = 11.41%. Here is the entire equation: ($85.2 million / $279.5 million) × 25.4% = 7.74%. ($194.3 million / $279.5 million) × 11.41% = 7.93%. 7.74% + 7.93% = 15.67%. 8. An analyst is attempting to estimate the weighted average cost of capital (WACC) for an emerging market manufacturer. The emerging market country has experienced high inflation in recent years. She estimates each component of WACC as follows: Risk-free rate: 10-year U.S. government bond yield + inflation differential between the local market and U.S. market. Beta: From a regression of the manufacturer's stock returns on the country's market equity index. Market risk premium: 6.0%, which is the geometric average nominal risk premium on the country's equity index over the past 12 years. Pre-tax cost of debt: local risk-free rate plus the credit spread on U.S. corporate bonds rated B+. Marginal tax rate: 35%, which reflects all government taxes that are applied to interest expense on corporate bonds. Capital structure weights: Average capital structure weights for global industry competitors. With respect to the cost of equity capital and the WACC, the analyst has overestimated: A) one of these. B) neither of these. C) both of these. C: The analyst has most likely correctly estimated the risk free rate, the pre-tax cost of debt, the marginal tax rate, and the capital structure weights. However, she has most likely incorrectly estimated the market risk premium and beta. The best recommendation for estimating the market risk premium is to use a long-term average risk premium on a global market index. The topic review suggests a range of 4.5% to 5.5%. The market risk premium is overestimated using 6.0% based on recent risk premiums in the equity markets. Beta should be estimated based on a regression of the industry's stock returns on a global market index. The analyst has overestimated both beta and the market risk premium. The result is that she has also overestimated the cost of equity capital and the WACC