Reference no: EM13495166

Part -1:

1.The DuPont formula defines the net return on shareholder's equity as a function of the following components:

• Operating margin
• Asset turnover
• Interest burden
• Financial leverage
• Income tax rate

Using only the data in the following table shown below:

a. Calculate each of the five components listed above for 2010 and 2014, and calculate the return on equity (ROE) for 2010 and 2014, using all of the five components. Show calculations.

b. Briefly discuss the impact of the changes in asset turnoverand financial leverage on the change in ROE from 2010 to 2014.

Income Statement Data                    2010                2014

Revenues                                             $542                $979

Operating income                               38                    76

Depreciation and amortization          3                      9

Interest expense                                 3                      0

Pretax income                                     32                    67

Income taxes                                       13                    37

Net income after tax 1                       9                      30

Balance Sheet Data                           2010               2014

Fixed assets                                         $41                  $70

Total assets                                         245                  291

Working capital                                  123                  157

Total debt                                            16                    0

Total shareholder's equity                  159                  220

2. David Wright, CFA, an analyst with Blue River Investments, is considering buying a Montrose Cable Company corporate bond. He has collected the following balance sheet and income statement information for Montrose as shown in Exhibit 10.10. He has also calculated the three ratios shown in Exhibit 10.11, which indicate the bond that is currently rated "A" according to the firm's internal bond-rating criteria shown in Exhibit 10.13. Wright has decided to consider some off-balance sheet items in his credit analysis, as the off-balance sheet items on each of the ratios found in Exhibit 10.11.

a. Calculate the combined effect of the three off-balance sheet items in Exhibit 10.12 on each of the following three financial ratios shown in Exhibit 10.11.

i. EBITDA/interest expense

ii. Long/term debt/equity

iii. Current assets/current liabilities

The bond is currently trading at a credit premium off 55 basis points. Using the internal credit yield premium incorporates the effect of the off-balance sheet items.

b. State and justify whether or not the current credit yield premium compensates Wright for the credit risk of the bond based on the internal-bond rating criteria found in Exhibit 10.13.

Exhibit 10.10 Montrose Cable Company Year Ended March 31, 2011

(US$ Thousands)

Balance Sheet

Current assets                                                 $4,735

Fixed assets                                                                 43,225

    Total assets                                                             $47,960

Current liabilities                                                        $4,500

Long-term debt                                                           10,000

   Total liabilities                                                         $14,500

Shareholder's equity                                                   33,460

   Total liabilities and shareholder's equity                $47,960

Income Statement

Revenue                                                                      $18,500

Operating and administrative expenses                    14,050

Operating income                                                       $4,450

Depreciation and amortization                                  1,675

Interest expense                                                         942

Income before income taxes                                      $1,833

Taxes                                                                           641

Net Income                                                                 $1,192

Exhibit 10.11 Selected Ratios and Credit Yield Premium Data for Montrose

EBITDA/interest expense                                            4.72

Long-term debt/equity                                               0.30

Current assets/current liabilities                                1.05

Credit yield premium over U.S. Treasuries                55 basis points

Exhibit 10.12 Montrose Off

Balance

Sheet Items

• Montrose has guaranteed the long-term debt (principal only) of an unconsolidated affiliate. This obligation has a present value of $995,000.
• Montrose has sold $500,000 of accounts receivable with recourse at a yield of 8 percent
• Montrose is a lessee in a new noncancelable operating leasing agreement to finance transmission equipment. The discounted present value of the lease payments is $6,144,000 using an interest rate of 10 percent. The annual payment will be 1,000,000.

Exhibit 10.13 Blue River Investments: Internal Bond

Rating Criteria and Credit Yield Premium Data

Bond Rating

Interest Coverage (EBITDA/interest expense)

Leverage

Current Ratio (Current assets/current liabilities)

Credit Yield Premiumover U.S. Treasuries (in basis points)

AA                           5.00 to 6.00      0.25 to 0.30                               1.15 to 1.25                                                          30 bps

A                             4.00 to 5.00      0.30 to 0.40                               1.00 to 1.15                                                          50bps

BBB                         3.00 to 4.00      0.40 to 0.50                               0.90 to 1.00                                                          100bps

BB                           2.00 to 3.00 0.50 to 0.60                    0.75 to 0.90                                                          125bps

Part -2:

1. Over the long run, you expect dividends for BBC in Problem 4 to grow at 8 percent and you require 11 percent on the stock. Using the infinite period DDM, how much would you pay for this stock?

2. The Shamrock Dogfood Company (SDC) has consistently paid out 40 percent of its earnings in dividends. The company's return on equity is 16 percent. What would you estimate as itsi dividend growth rate?

3. What P/E ratio would you apply if you learned that SDC had decided to increase its payout to 50 percent? (Hint: This change in payout has multiple effects.)

Part -3:

4. Currently, the dividend=payout ratio (D/E) for the aggregate market is 60 percent, the required return (k) is 11 percent, and the expected growth rate for dividends (g) is 5 percent.

a. Compute the current earnings multiplier

b. You expect the D/E payout ratio to decline to 50 percent, but you assume there will be no other changes. What will be the P/E?

c. Starting with the initial conditions, you expect the dividend-payout ratio to be constant. The rate of inflation to increase by 3 percent and the growth rate to increase by 2 percent. Compute the expected P/E.

d. Starting with the initial conditions, you expect the dividend-payout ratio to be constant, the rate of inflation to decline by 3 percent, and the growth rate to decline by 1 percent. Compute the expected P/E.

7. Given the three EPS estimates in Problem 6, you are also given the following estimates related to the market earnings multiple:

Pessimistic      Consensus       Optimistic

D/E                                          0.65                 0.55                 0.45

Nominal RFR                           0.10                 0.09                 0.08

Risk premium                          0.05                 0.04                 0.03

ROE                                         0.11                 0.13                 0.15

a. Based on the three EPS and P/E estimates, compute the high, low, and consensus intrinsic market value for the S&P Industrials Index in 2013.

b. Assuming that the S&P Industrials Index at the beginning of the year was priced at 2.050, compute your estimated rate of return under three scenarios from Part a. Assuming your required rate of return is equal to the consensus, how would you weigh the S&P Industrials Index in your global portfolio?

8. You are analyzing the U.S. equity market based upon the S&P Industrials Index and using the present value of free cash flow to equity technique. Your inputs are as follows:

Beginning FCFE: $80

K = 0.09

Growth Rate:

Year 1-3:                     9%

         4-6:                     8%

         7 and beyond:    7%

a. Assuming that the current value for the S&P Industrials Index is 2,050, would you underweight, overweight, or market weight the U.S. equity market?

b. Assume that there is a 1 percent increase in the rate of inflation - what would be the market's value, and how would you weigh the U.S. market? State your assumptions.

Part -4:

4. Evaluate your industry in terms of the five factors that determine an industry's intensity of competition. Based on this analysis, what are your expectations about the industry's profitability in the short run (1 or 2 years) and the long run (5 to 10 years)?

5. Using Standard and Poor's Analysts' Handbook or another source, plot the latest 10-year history of the operating profit margin for the S&P Industrials Index, or another aggregate market series versus and industry of your choice. Is there positive, negative, or zero correlation?

7. Prepare a table listing the variables that influence the earnings multiplier for your chosen industry and the market index series for the most recent 10 years.

a. Do the average dividend-payout ratios for your industry and market index differ? How should the dividend payout influence the difference between the multipliers?

b. Based on the fundamental factors, would you expect the risk for this industry to differ from that for the market? In what direction, and why? Calculate the industry beta using monthly data for five years. Based on the fundamental factors and the computed systematic risk, how does this industry's risk compare to the market? What effect will this difference in risk have on the industry's multiplier relative to the market multiplier?

c. Analyze and discuss the different components of growth (retention rate, total asset turnover, total assets/equity, and profit margin) for your chosen industry and a market index during the most recent 10 years. Based on this analysis, how would you expect the growth rate for your industry to compare with the growth rate for the market index? How would this difference in expected growth affect the multiplier?

Part -5:

6. Lauren Entertainment, Inc., has an 18 percent annual growth rate compared to the market rate of 8 percent. If the market multiple is 18, determine P/E ratios forLauren Entertainment, Inc., assuming beta is 1.0 and you feel it can maintain its superior growth rate for:

a. The next 10 years.

b. The next 5 years.

7. You are given the following information about two computer software firms and the S&P Industrials:

_______                Company A      Company B      S&P Industrials

P/E ratio                            30.00               27.00               18.00  

Expected annual growth rate   0.18         0.15                 0.07    

Dividend yield                   0.00                 0.01                 0.02

a. Compute the growth duration of each company stock relative to the S&P Industrials.

b. Compute the growth duration of Company A relative to Company B.

c. Given these growth durations, what determines your investment decision?

8. The value of an asset is the present value of the expected returns from the asset during the holding period. An investment will provide a stream of returns during this period, and it is necessary to discount this stream of returns at an appropriate rate to determine the asset's present value. A dividend valuation model such as the following is frequently used:

Pi = D1 / (ki -gi)   where:

Pi = the current price of Common Stock i

D1 = the expected dividend in period 1

ki = the required rate of return on Stock i

gi = the expected constant-growth rate of dividends for Stock i

a. Identify the three factors that must be estimated for any valuation and explain why these estimates are more difficult to derive for common stocks than for bonds.

b. Explain the principal problems involved in using a dividend valuation model to value:

(1)  Companies whose operations are closely correlated with economic cycles.

(2)  Companies that are of very large and mature.

(3)  Companies that are quite small and are growing rapidly.

Assume that all companies pay dividends.

10. The constant-growth dividend discount model can be used both for the valuation of companies and for the estimation of the long-term total return of a stock.

Assume: $20 = price of a stock today

            8% = expected growth rate of dividends

            $0.60 = annual dividend one year forward

a. Usingonly the preceding data, compute the expected long-term total return on the stock using the constant-growth dividend discount model.

b. Briefly discuss three disadvantages of the constant-growth dividend discount model in its application to investment analysis.

c. Identify three alternative methods to the dividend discount model for the valuation of companies.

11. An analyst expects a risk-free return of 4.5 percent, a market return of 14.5 percent, and the returns for Stocks A and B that are shown below.

Annual Cash Flow from Lease

End of Year                                  

1                            $ 0

2 lease receipts     15,000

3 lease receipts     25,000

4 sales proceeds   $100,000

Present Value of $ 1                                                                    

Periods      6%                   8%                   10%                 12%    

1                0.943               0.926               0.909               0.893

2                0.890               0.857               0.826               0.797              

3                0.840               0.794               0.751               0.712

4                0.792               0.735               0.683               0.636

5                0.747               0.681               0.621               0.567

Stock Information

Stock          Beta                 Analyst's Estimated Return

A                1.2                   16%

B                0.8                   14%

a. Show on a graph.

(1) where stocks A and B would plot on the security market line (SML) if they were fairly valued using the capital asset pricing model (CAPM).

(2) where stocks A and B actually plot on the same graph according to the  returns estimated by the analyst and shown Stock Information above.

b. State whether stocks A and B are undervalued or overvalued if the analyst uses the SML for strategic investment decisions.

Discussion

I. Determine whether a steel company or a retail food chain would have a greater business risk. Provide support for your rationale.

II. Select one of the limitations of ratio analysis and indicate why you believe it is a major concern when predicting future financial performance.

III. Discuss the proposition that differences in the performance of various firms within an industry limit the usefulness of industry analysis. Provide an example of an industry where this statement holds true.

IV. Analyze an industry that you believe is in stage 2 of the industry life cycle. Provide evidence that supports your analysis.

V. From the e-Activity and based on the growth company selected, assess why it is a growth stock and if that status is sustainable.

VI. Evaluate whether or not P/E is an effective indicator of a growth stock. Suggest an alternative.

VII. Assess the gaps with the availability of information related to international markets, industries, and stocks. Recommended a strategy for investment professionals to analyze foreign markets given the data limitations.

VIII. Discuss how foreign countries' accounting differences make foreign analysis difficult and whether or not adopting a global accounting standard will elevate this difficulty. Provide support for your answer.