1 - c
2 - c
3 - b
4 - a
5 - b
6 - b
1 - c
2 - c
3 - b
4 - a
5 - b
6 - b
Good standard questions... Thanks Konvexity Institute & DG :-)
Sol. for 14-March (Equity) shud be:-
Answer-1 # B
Answer-2 # C
Answer-3# A
Answer-4 # C
Answer-5 # B
Answer 6# A
@Konvexity:- can u plz elaborate answer for Q 4 & 5 from Item Set for 13-March.
Solutions to Item set for 14-March
1. Correct Answer is B: ROE for 2012-13 = 72/400 = 18%. ROE for 2013-24 = 18%. Residual income for 2013-14 = (0.18-0.12)*450 = $27 million. The market value of equity = B0 + RI1/ (1+r- ω) = 450 + {27/ (1+0.12-0.8)} = $534.375 million. Value of stock per share = 534.375/1.2 = $445.31.
2. Correct Answer is B: The present value of the company’s expected economic profit = $534.375 - $450 =$84.375 million.
3. Correct Answer is C: If the residual income persists forever, then the value of the company = 450 + (27/0.12) = $675 million.
4. Correct Answer is C: According to clean surplus relation, the ending book value = 25 + 7 -5 = $27. As the relation is violated, the ending book value can’t be equal to $27.
5. Correct Answer is B: Rahul is incorrect about the driving factors. The higher is the spread between ROE and required return on equity, the higher is the stock price.
6. Correct Answer is B: High ROE is associated with lower persistence factor as it would be difficult for the company to manage a high ROE in the long-run.
Item set for 15-March (Equity):
Rohan Pinto Case Scenario
Rohan Pinto is an equity research analyst working in Gamma Hedge Company. He gives calls to the traders based on the relative valuation models. He is calculating the different justified price multiples from the data given in Exhibit 1 and comparing those with the actual multiples.
Exhibit 1
Data for AXL Software
Profit margin 10.00% Earnings $120 million Dividends paid $80 million Book value of equity at the beginning of the year $600 million Risk-free rate 6.00% Market risk premium 10.00% Beta of the stock 0.8 Common outstanding shares 60 million
The stock of the company is trading at $20 per share. The average multiples of the industry are given in Exhibit 2.
Exhibit 2
Industry Data
P/E multiple 7.56 P/B multiple 1.52 P/S multiple 0.86 Average required return on equity 13.5% Average growth rate in industry 8.0%
Rohan Pinto is concerned about the relevance of the price multiple. He discusses the various factors which can lead to the difference in price multiples across firms with Roshan Pinto. Roshan Pinto is his colleague and also a CFA level II candidate.
Rohan: AXL software has higher price multiples than the industry average. Can we say that it is overpriced?
Roshan: Higher or lower price multiples do not necessarily mean that the stock is overvalued or undervalued. The multiples can be high/low because of the higher/lower expected growth rate and lower/higher required rate of return.
Rohan: Is there any multiple which can get rid of the above problems mentioned by you?
Roshan: There is a multiple PEG which divides the P/E by the growth rate to take care of the growth.
Rohan: I have complied the price multiple ratio of various companies. How should I calculate the industry average price multiple?
Roshan: You can either use median or the arithmetic mean. Those two methods are most suitable. But you must remove the outliers first as they can impact the averages.
Rohan: How are various price multiples related to growth rate?
Roshan: All price multiples are positively related to the growth rate except one.
1. What is the justified P/S multiple for AXL software?
a) 0.909
b) 0.969
c) 1.045
2. What is the justified P/B ratio of AXL software?
a) 1.82
b) 3.26
c) 5.26
3. The P/E ratio of AXL software stock is higher than that of industry average. Use exhibit 2 to tell the most likely reason for the difference in the P/E ratio?
a) The stock is overvalued with respect to the industry
b) The difference in P/E is due to the higher growth rate of AXL software than the industry average growth rate
c) The difference in P/E is due to the lower required rate of return demanded on AXL software than the industry average required rate of return
4. Which of the following statements is least accurate about the PEG ratio?
a) Keeping all other things constant, the higher is the PEG ratio, the overvalued the stock is relative to the benchmark
b) The PEG ratio implies that the impact of growth rate is non-linear on the stock price while in fact the impact of growth rate is linear on the stock price
c) The PEG ratio doesnâ€™t differentiate the stocks according to the riskiness of the business. A less risky stock can have a higher PEG ratio than a more risky stock and both can be properly valued
5. Which of the price multiple is negatively related to the growth rate?
a) Price to book value ratio
b) Price to cash flow ratio
c) Dividend yield ratio
6. Which of the following statements made by Roshan is least accurate?
a) Regarding the reasons behind the difference between the price multiples
b) Regarding the calculation of average industry multiples
c) Regarding the calculation of PEG ratio
Question No- 4: Whenever there are deferred tax assets or liabilities, we should only treat them in calculating noncash charges if they are not expected to reverse. If they are expected to reverse in the near future, then they should be ignored. Deferred tax assets lead to an increase in income but actually they are noncash item. So, they should be decreased from the net income to get FCFF. But if they are expected to reverse, then we know that in future the deferred tax assets account will decrease and there will be and there would be a balancing entry leading to increase in FCFF. So, they are ignored. An analyst should add only persistent factors of FCFF and not the one which are expected to reverse and offset each other.
Question No- 5: Suppose a bond has been issued at $95 and its face value is $100 and the it has 5 years to maturity. At the end of 5 year, the company has to pay the face value and they will also pay regular coupon payment at the end of each period. Now it is an accounting practice to amortize the bond discount. The amortization would lead to a decrease in net income but actually it is a noncash charge just like depreciation. Here, suppose the company will subtract net income by $1 each year. No cash is getting spent on that. So, it should be added back to NI to get FCFF. The interest paid is a cash expense and it should be ignored while calculating the noncash items.
Ans to Item set for 15-March (Equity):
1. c
2. b
3. b
4. a
5. b
6. b
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