Concept Checkers Ldz
1. Eric Gao, CFA, is an international portfolio manager. He is evaluating the prospects of companies in India, which is an emerging market country. He has identified several companies, one of which is a large international exporter named Jasmine Ltd. Gao is concerned with inflation and country risk, but he believes that after his adjustments for country risk, the expected returns are attractive enough to warranr investing in Jasmine. Gao is preparing a valuation on Jasmine for presentation to his investment committee. The following information was obtained on Jasmine (U.S. dollars in nominal terms):
Nominal required return = 14% Real required return = 8%
Present value of nominal cash flows discounted at 14% = $16.75 billion
Present value of real cash flows discounted at 14% = $12.25 billion
Present value of nominal cash flows discounted at 8% = $23.78 billion
The present value of the real cash flows discounted at 8% is closest to:
2. In a scenario analysis of the effect of country risks on the value of a company located in an emerging market, the appropriate methodology is to adjust the expected cash flows rather than the discount rate because country risks are:
A. systematic risks that are already in the discount rate.
B. systematic risks that cannot be diversified away.
C. unsystematic risks that can be diversified away.
3. The most appropriate way to forecast real ner working capital cash flows for valuation purposes in emerging markets is to calculate the change in:
A. historical real net working capital.
B. nominal net working capital times the appropriate inflation index.
C. nominal net working capital divided by the appropriate inflation index.
4. An analyst collects the following data from a forecast of cash flows in a valuation of an emerging markets company.
• Real net working capital in year 0 = 250
• Real net working capital in year 1 - 258
• Nominal net working capital in year 0 = 250
• Nominal net working capital in year I = 386
Real investment in net working capital in year 1 is closest to:
5. Use the cash flow forecasts from Trainers International example in the topic review to answer this question. The real and nominal return on invested capital (ROIC), which is equal to NOPLAT divided by beginning-of-year invested capital, in year 2 are closest to:
A. 35% Real ROIC and 35% Nominal ROIC.
B. 35% Real ROIC and 53% Nominal ROIC.
C. 53% Real ROIC and 53% Nominal ROIC.
6. Use the cash flow forecasts from Trainers International example in the topic review to answer this question. The ratios of net PPE to revenues in year 2 in both real and nominal terms are closest to:
7. Use the cash flow forecasts from Trainers International example in the topic review to answer this question. The ratios of net working capital to revenues in year 2 in both real and nominal terms are closest to:
8. In an emerging markets valuation an analyst uses the following formula to calculate free cash flow (FCF):
FCF = NOPLAT- net capital expenditures - change in net working capital
Using this formula, is the analyst most likely to over- or underestimate?
A. Overestimate FCF and overestimate firm value.
B. Correctly estimate FCF and correctly estimate firm value.
C. Underestimate FCF and underestimate firm value.
challenge problems
Use the cash flow forecasts from Trainers International example in the topic review to answer this question. What is the most likely effect of an increase in inflation to 30% in years 2 through 4 on firm value in real terms and nominal terms?
Real terms Nominal terms
A. Decrease by 296 Decrease by 296
B. Increase by 296 No change
C. Decrease by 296 No change
10. Vernon LeFluer, CFA, is attempting to estimate the weighted average cost of capital (WACC) for Slidnek Manufacturers, which is domiciled in the emerging markets country of Watsonia. Slidnek bonds have comparable credit risk to a B + rating in the United States. Watsonia has experienced high inflation in recent years. He estimates each component of WACC as follows:
• Risk-free rate: 10-year U.S. government bond yield.
• Beta: From regression of global industry returns from Slidnek's industry on a global market equity index.
• Market risk premium: 1.5%, which is the geometric average nominal risk premium on a Watsonian 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 Watsonian government taxes that are applied to interest expense on corporate bonds.
• Capital structure weights: Average capital structure weights for global industry competitors.
Adam Johns, CFA, is LeFluer's manager. Johns believes that LeFluer has used the wrong estimate of several of the WACC components, and that LeFluer has most likely underestimated the cost of equiry capital and the WACC.
Are LeFluer's calculations most likely correct?
A. Correct cost of equity and correct WACC.
B. Correct cost of equity and incorrect WACC.
C. Incorrect cost of equity and incorrect WACC.
Answers - Concept Checkers
1. B The nominal cash flows discounted at the nominal rate should be equal to the real cash flows discounted at the real rate.
2. C Country risks are diversifiable, which means they are unsystematic risks.
3. C The nominal cash outflow associated wirh net working capital is equal to the change in nominal net working capiral, but the real cash outflow from net working capital is not equal to the change in real net working capital. The best way to address this issue in emerging markets valuation is to calculare nominal working capital cash flows (equal to the change in nominal ner working capiral) and convert co real cash flows using the inflation index. Converc by dividing nominal working capital cash flows by the inflation index.
4. B The change in nominal net working capital is 386 - 250 = 136. The change in real ner working capital with 50% inflation is 136 / 1.50 = 91.
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