2015 CFA Level 2 Book 4 Equity QA

0statestheriskfactorsfbraninvestmentinthecompany;and

odiscosesanypotentiaIcohfictsofinteestsfhcedbytheanalyst.

AnaIystshaveanobIigationtopovidesubstantiveandmealigfUIcontent.CFAIstitutemembershaveanadditionaIoverridingesponsibiIitytoadhetotheCFAlnstituteCodeofEthics

andreIevantspecificStandardsofPofbssionaIConduct.

RekreIceS

Burch,TimothyR.,andVikramNanda.2003.DMsionaIDiversityandtheCongIomerateDiscount:EvidencefomSpinoffS.,,jbwqFW?cmECooivoI.70,no.:6998.ComeII,Bradfbrd.200l.IstheResponseofAnalyststolnfbmationConsistentwithFundamentaIValuation?TheCaseoflntelFh7cmMJge,voI.30,no.I:II3l36.Graham,Beniamin,andDavidLDodd.934cMsMcGrawHiIlProfbssionalPublishing.Grossman,Sanfbrd,andJosephStigIitzg80.OthelmpossibilityoflnfbmationalIyEcientMarkets,,ecEbooReWew,voI.70,no.3:393408.jensen,MichaeIC,andWiiamHMeckIing.l976.TheoyofthePil.m:ManageiaIBehaviol.,AgencyCostsandOwnershipStructure.,,jbrqFcEcooJcs,vol.3,no.4:305360.Lamont,OwenA.,andChristopherPoIk2002.DoesDiversificationDestroyVaIue?EvidencehomthelndustryShocks.,,jbqFcEcooics,voI.63,no:57.Lee,CharesM.C.,JamesMyers,andBhaskaranSwaminathan.g9gWhatistheItinsicValueoftheDow?,,jbq.ce,voI.54no.5:l69374.

MerriLynchCo.2006jsjOFtJcoSJvey.QuantitativeStrategy:GIobaISecuritiesResearchEconomicsGroup.Mo0dy,s.2000.PgEBI7n4PeUpeive.Moody,snvestorsServiceGIobalCreditResearch.MuIfbrd,ChaIesW.,andEugeneF.Comiskey2005.Ceve

CtJs7FOwCpoigU7coveigSibeFcmPeJybmce.Hoboken,NJ:JohnWiIeySons.Porter,MichaeIE.lg85.eCopevedvgeCegdSsiJZgStpeoPe:bceNewYork:PreePressRepublishedwithnewintroductioninlgg8Porter,MichaeIE.2008.TheFiveCompetitivePorcesthatShapeStrategy.,,HbJdBsiessReview,voI.86,no.l:7893.SchiIit,Howard,andJeremyPerIe.200.cSeigJs;fbwoDeecAccoGiCksdFcibJRepos,3rdedition.NewYork:McGrawHiII.SloanRichardG.>gg6.DoStockPricesFuIyRef>ect

B.ExpIaiIwhethermakingagoing-concernassumptionwouldaffCctthevaIuepIacedonacompany,sinventory.

.ExpIainhowtheprocedurefbrusingavaIuationmodeItoinfbrmaketexpectationsaboutacompany,sfUturegrowthdiffbrsfiomusingthesamemodeItoobtainanindependentestimateofva>ue

5ExampIe,basedonastudyofInteICorpoationthatusedapsentvaluemodeIComeII200,examinedwhatfilturevenuegowthrateswereconsistentwithlnteI,sstockpiceof$6>50justpriortoitseamingsannouncementand$433lonIyfivedaysIater.TheexampIestates,Usingaconservativeyowdiscountrate,CorneIIestimatedthatntel,spicebefbretheannouncement$6>50,wasconsistentwithafbrecastedgrowthrateof20percentayearfbthesubsequent0yearsandthen6peqcentperyeartheaffer.,,DiscusstheimpIicationsofusingahigherdiscountratethanComeIdid.

6.Discusshowunderstandingacompany,sbusiness(thefirststepinequityvaluation)mightbeuseMinperfbrmingasensitivityanaIysisreIatedtoavaIuationofthecompany.

7lnaresearchnoteontheordinaIysharesoftheMilanFashionGroupMFGdatedeaIyJu>y2007whenarecentpricewase773andprqectedannuaIdividendsweree0.05,anana!yststatedatagetpriceofe9.20ThereseaIhnotedidnotdiscusshowthetagetpricewasobtainedorhowitshouldbeinterpreted.AssumethetagetpricerepresentstheexpectedpriceofMFG.WhatfUrtherspecihcpiecesofinfbrmationwouldyouneedtofbrmanopinioonwhetherMFGwasfairIyvaIued,overvaIued,oundervaIued?

8.YouarereseahingXMICorporationXMIXMIhasshownsteadyearningspershareglowth(l8percentayearduringtheIastsevenyears)andtradesataveIPyhighmu>tipIetoeamingsitsPEiscunntIy40percentabovetheaveragePEfbragroupofthemostcomparabIestocks.XMIhasgeneraIIygownthroughacquisition,byusingXMIstocktopurchaseothercompanieswhosestocktradedatIowerP/EsIninvestigatingthefinancialdiscIosuresoftheseacquiredcompaniesandtalkingtoindust

Statement>AnaIystsatGuardianCapitaIseektoidentifymispricing,reIyingonpriceeventuaIIyconvergingtointrinsicvaIue.However,convergenceofthemarketpricetoananaIySt,sestimateofintrinsicvaIuemaynotlappenwithinthepoltfbiomanagesinvestmenttimehoizon.So,besidesevidenceofmispricing,anaIystsshouIdIookfbr

thepresenceofapaticuIarmaketocorporateeventthatis,acataIystthatwiIIcausethemaketpIacetoeevaIuatethesuectfirm,spospects.

Statcmet2Anactiveinvestmentmanagel.attemptstocaptuepositiveaIphaButmispricingofassetsisnotdirectIyobservabletistheefbreimp0rtantthatyouunderstandthepossibIesourcesofpeceivedmispicing.,,

Statement3oitsdistssedsecuitiesfUnd,GualdianCapitaIscreensitsinvestabIeuniverseofsecuritiesfbcompaniesinfmancialdistress.,,

Statement4 oritscoreequityftlnd,GuadianCapitalseIectsfinaHciaIIysoundcompaniesthatareexpectedtogeneratesignificantpositivefiPeecashf>owfiPomcorebusinessoperationswithinamuItiyeafbrecasthorizon.,,

Statement5 GuardianCapitaI,sreseachprocessrequiresanaIyststoevaluatethel?easonablenessoftheexpectationsimpIiedbythemarketpricebycomparingthemarket,simpliedexpectationstohisoheownexpectations.,,

ARel.theorientationmeeting,thedirectorofresearchasksRichardsontoeva>uatethreecompaniesthataeretaiIersofmen,scIothing:DiamondCo.,RenaissanceCIothing,andDeIuxeMen,sWear

RichardsonstashisanaIysisbyevaIuatingthechaacteristicsofthemen,sretaiIcIothingindusny.HendsfbwbaierstonewetaiIentrants,highintraiHdustlyrivaIlyamongretaiIers,IowproductsubstitutioncostsfbrcustomersandalargenumberofwhoIesaIecIothingsuppIiers.

16

WhiIeconductinghisanalysis,RichardsondiscoversthatRenaissanceCIothingincludedthreenon-recurringitemsintheirmostecenteaningsreIease:apositivelitigationsettIement,aonetimetax@reditandthegainonthesaIeofanon-operatingasset.

Toestimateeachfirm,sintrinsicvaIue,Richardsonappiesappropiatediscountratestoeachfirm,sestimatedfi.eecashfowsoveratenyeartimehorizonandtotheestimatedvalueofthermattheendoftheten-yearhorizonMicheIeLee,ajuniortechno>ogyanalystatGuardian,asksthedirectorofresearchfbradviceastowhichvaIuationmodeltousefbrVEOA,afastgrowingsemiconductocompanythatisrapidIygainingmarketshare.

ThedirectoofsearchstatesthatthevaIuationmodelseIectedmustbeconsistentwiththe

chaacteisticsofthecompanybeingvaued.,,

LeeteIIsthedirectorofsearchthatVEOAiSnotexpectedtobepofitabIefbrseveraImoreyeas.

Accodingomanagementguidance,whenthecompanyturnspoftab!e,itwiIIinvestinnewproductdeveIopment;asaresuIt,itdoesnotexpecttoinitiateadividendfbranextendedperiodoftimeLeeaIsonotesthatsheexpectsthatcertainlargecompetitorswiIIbecomeinterestedinacquiigVEGAbecauseofitsexcelIentgowthprospects.ThedirectorofreseachadvisesLeetocohsidethatinhervaluation.

9. BasedonStatement2,whichofthefbIlowingsourcesofperceivedmispricingdoactiveinvestmentmanagersattempttoidentify?Thediffbrencebetween:

A.intrinsicvaIueandmarketpice.

BestimatedintrinsicvaIueandmakctpriceC.intrinsicvalueandestimatedintinsicvaIue.

l0.WithrespecttoStatements3and4,whichofthefbIowingmeasuresofvaluewouIdthedistressedsecuritiesfimd,saIaIystconsiderthatacoreequityfUndanaIystmightignore?

AFairvalue

BLiquidationvaIueCFairmarketvaIue

ll.WithrespecttoStatement4,whichmeasureofvaIueisosIevantfbrtheanaIystofthefUnddescribed?

A.Liquidationva>ueB.InvestmentvaIue

C.Going-concemvaIue

>2.AccordingtoStatement5,ana>ystsareexpectedtousevaIuationconceptsandmodelsto:AvaIueprivatebusinesses.B.renderfairnessopinionsCextractmaketexpectations.

l3.BasedonRichardson,sindustyanaIysis,whichofthefbIIowingchamcteristicsofmen,sretacothingretaiIingwouIdposveaffbctitspotability?Thatindusny,s:

A.ennycostsB.substitutioncosts.

C.numberofsuppIiers.

l4.WhichofthefbIowingstatementsabouttherepo!tedearningsofRenaissanceCIothingisoscce?ReIativetosustainabIeeamings,reportedeamingsare!ikely:

Aunbiased.

Bupwardbiased.C.downwaIdbiased.

I5.WhichvaIuationmodeIisRichadsonappIyinginhisanalysisoftheretaiIers?A.ReIativevalue

BAbso>utevalue

C.Sumoftheparts

6.WhichvaIuationmodeIwouldthediectorofreseachos!ikcbrecommendLeeusetoestimatethevaIueofVEGA?

A.Freecashf>ow

B.DMdenddiscount

CP/EreIativevaIuation

S0lIti0IS

.ThestatementisfawedinatIeasttwoways.Pist,activeinvestorsbeIievethastockpricesdonotawaysaccuratelyrefectaeIevantinfbrmationonthesecuity;fbrsuchinvestors,knowIedgeofequityvaluationmodeIsisimportantfbridentifyinginvestmentoppotunitiesbecausetheyrepresentawaytotransIatetheinvesto,sfbrecastsintovaIueestimatesfbcomparisonwithmaketprices.Thus,the6aII,,inainvestors,,ismisleading.Second,not

47

2.

3

4.

5.

6.

7.

8.

48

aIlequitiesaepublicIytradedandhavemarketprices,andthemostrecentmarketpricecanbestaIefbrthemanypublicequitiesthattradeonIyinquentIy

NomattehowdiIigenttheanaIyst,someunceaityaIwaysexistsconcerningItheaccuracyoftheaa!yst,sfbrecastsand2whetheanintrinsicvaIueestimateaccountsfbrasourcesofriskrefectedinmarketprice.Thus,knowIedgeofastock,sinvestmetchaacteisticsisaIwaysincompIete.ThepracticaIconsequencesarethataninvestorcanonIyestimateintinsicvalueandactivesecurityseIectioncarriestheriskofmakingmistakesinestimatingvalue

A.LiquidationvaIueistypicaIIynotreIevanttoestimatingintrinsicvaluefbrprofitabIecompaniesbecause,ingeneraI,vaIuewouIdbedestroyedbyseIIingsuchacompany,sassetsindMduaIIy.Statedanotheway,thevaIueaddedbybeingagoingconcenisare!evantinvestmentchaacteristicthatanintrinsicvaIueestimatewoud

ecognlze.

B.AgoingconcernassumptiongeneraIyinceasesthevaIueplacedonacompany,sinventoIyreIativetonotmakingthatassumption.UsuaIIy,inventorythatcanbesoIdinthecompany,seguIardistributionchanneIswouIdreaIizehigheramountsthaninventorythatmustbesoIdimmediateIybecauseacompanyisbeingliquidated

ThekeydiffbnceisthatfbrinfbringinvestorexpectationsthemaketpriceisusedasthemodeIinput{brvaIuewhereasfbrobtaininganindependentestimateofvalue,vaIueisIehastheunknowninthemodeI.lntheIattercase,vaIueisestimatedbasedontheanaIyst,sestimatesfbrthevariabIesthatdeterminevaIue.

Considerthepresentva>ueofasinglecashf>ow.iedgrowthrateconsistentwithapriceof$6l.50wouIdhavebeenhigherthanthe20percengrowthrateestimatedbyComelIAnunderstandiIgofthecompany,sbusinessfaciIitatesafbcusonthekeybusinessaspectsthataffbctvaIue,andfiomapracticalperspective,highIightstheciticaIinputstoafbecastthatshouIdbetestedusingsensitivityanalysis.

Youneedtoknow>)thetimehorizonfbrthepricetargetand2)therequiredrateofretumonMFGThepricetargetof6g20representsapotentiaI20percentretunfiDminvestinginthestockifthetimehorizonisoneyear,cacuIatedas69.206005E7.73.0097;withoutatimefiame,however,youcannotevaIuatetheattractivenessofthatreturnGiventhatthetimefiPamefbrtheetumisestabIished,youneedtohaveanestimateoftherequiredrateofretunoverthesametimehorizon.

Iftheexpectedreturnofg.7pel.centexceedsthesecurity,srequiredeturnfbrthesamehorizon-inotherwords,iftheshare,sexpectedaIphaispositive-thenMFGwouIdappeartobeundervaIued.

A.AcceIeratingthepaymentofexpenseseducestheacquiredcompanies,IastreportedplBacquisitioncashfowAcceIeratingexpensecognitionreducestheacquiredcompanies,astrepotedpreacquisitioneamings.XM,scashfowandeaningsgrowthrateSfbIIowingtheacquisitionswouldbeexpectedtobebiasedupwardsbecauseofthedepressedIevelsfbrtheacquirees.

g.

B.ThatisanexampIeofareIativevaluationmodeIothemethodofcomparabIes,whichcompaesacompany,smarketmuItipIetothemultipesofsimiIarcompanies.

AiscoITect.ThediffbencebetweenthetuealbutunobservabeintrinsicvaIueandtheobservedmarketpricecontibutestotheabnormaIetlnoalphawhichistheconcernofactiveinvestmentmanagels

l0.Biscorect.ThemeasueofvaIucthedistessedsecuitiesfUnd,sanaIystwouldconsider

thatthecoreequityfllndanaIystmightignoreisIiquidationvaIue.TheIiquidationvaIueofacompanyisitsvaIueifitweredissolvedanditsassetssoIdindividuaIIy.

CiscorIct.Foritscoequityfhnd,GualdianCapitaIscensitsinvestabIeuniverseofsecuritiesfbfwecapitaIizedcompaniesthatareexpectedtogeneratesignificantfUturefiecashfowomcorebusinessopeations.TheconcernwithfUturefiecashfowsimpliesthatgoing-concernva!ueisreIevant.

l2.CiscorrectMarketpricesfecttheexpectationsofinvestorsaboutthefitureperfbrmanceofcompanies.TheanaIystcanevaIuatethereasonabIenessoftheexpectationsimpIiedbythemarketpricebycomparingthemarket,simpIiedexpectationstohisownexpectatioIs.ThispmcessassumesavaIuationmodel,asdiscussedinthetext

3Ciscorrect.Themen,sretaiIcIothingindustryischaracterizedbyaIaenumberofwhoIesaIeclothingsuppIiers.Whenmanysuppliesoftheproductsneededbyindustryparticipantsexist,competitionamongsuppIiesshouIdIimittheirabiIitytoaiseinputpices.Thusthe>argenumberofsuppIiersisafactorthatshou}dpositiveIyaffbctindustrypofitability.

l4.Biscorrect.Theeffbctsoffavorab!enonlccurringeventsinreportedearningswouIdtendtobiasreportedearningsupwardreIativetosustainabIeeamingsbecausenon-recurringitemsarebydefinitionnotexpectedtorepeat.RenaissanceCIothingincludedthreenon-recurringitemsintheirmostrecentearningsreIeasethataIIledtohigherearningsfbrthecunentpeiod:apositiveitigationsettIement,aonetimetaxcredit,andthegainonthesaIeofanon-operatingasset

>5.Biscorrect.AnabsoIutevaIuationmodeIisamodeIthatspecifiesanasset,sintrinsicva}ue.ThemostimportanttypeofabsoIuteequityvaIuationmodelsarepresentvaIuemodeIs(aIsoreferredtoasdiscountedcashf>owmodeIs)andthemodeIdescribedbyRichardsonisofthattype.

6Aiscorrect.ThebroadcriteriafbrmodeIseIectionaethatavaIuationmodeIbecosistentwiththecharacteisticsofthecompanybeingvaIued,appropriategiventheavaiIabiIityandqualityofthedataandconsistentwiththepurposeofthevaIuation.VEGAcurentIyhasnegativeearnings,makingtheuseofP/EreIativevaIuationdifficultifnotimpossible.AsVEGAdoesnotpayadividendandisnotexpectedtofbthefbseeabIefUture;thiswouIdmaketheappIicationofadividenddiscountmodeIpobIematic.However,theIackofadividendwouIdnotbeanobstacIetoeecashfIowvaIuation.Furthermore,thedictorofreseachhasadvisedthatthepossibiIitythatcompetitorsmayseektoacquilcVEGAbetakenintoaccountinvaIuingVEGA.Thereadingstatesthatfi.eecashf>owvaIuationcanbeappropriateinsuchcircumstancesThus,thedirectorofsearchwouIdbemostikeIytorecommendfiQeecashf>owvaIuation.

4g

Mornmgstar.2007.Stocks,Bonds,BiIIs,andInfIation.,,2007hiIEtoyebook.Chicago:MorningstaLInc.

Pastor,Lubos,andRobertF.Stambaugh2003.LiquidityRiskandExpectedStockRetums.,,bqPocEooUjvollll,no.3;64268a

SchoIesMyon,andJosephT.WiIiams.l977.EstimatingBetasmNonsynchronousData.jbqmycEooJcs,vol.5,no.3:30g327.

Strong,Norman,andZinzhongGXu.l9g7.ExplainingtheCossSectionofUKExpectedStockRetums,,BAccoRevew,vol2g,nol:23.

Stux,IvanEl9g4EamingsGrowth:TheDIiverofEquityVaIue.,,MoIganStanleyGbbEv!0DeVCsMB.

Vanna,JayanthR.,andSamirKBama.2006.AFirstCutEstimateoftheEquityRiskPremiuminIndia.,,IndianInstituteofManagementAhmedabadWorkingPaperNo.Z006-06-04

PacticePbIems

CoIIight20llCFAInstitute

ACanadabasedinvestobuysshaesofTorontoDominionBankToonto:TDTOfbrC$72.08onl5October2007withtheintentofholdingthemfbrayear.ThedividendratewasC21lperyear.TheinvestoactuaIyselstheshareson5NovemberZ007fbrC$6g.52TheinvestornotesthefbI>owingadditionalfhcts:

Nodividendswerepaidbetween5Octobeand5November

TherequiredretumonTDTOequitywas8.7percentonanannualbasisand0.l6lpercentonaweeklybasis.

AStatethelengthsoftheexpectedandactua>hoIding-periods.

B.GiventhatTDTOwasfhiriypIiced,caIcuIatethepnceappreciationretum(capita!gainsyieId)anticipatedbytheinvestorgivenhisinitialexpectationsandinitialexpectedholdingperiod

CCaIcuIatetheinvestor,sreaIizedretum.

DCalcu}atetherealizedaIpha.

Z.TheestimatedbetasfbrAOLTimeWarneNYSEAOL,JP.MorganChaseCompany(NYSE:JPM)andTheBoeingCompany(NYSE:BA)are2.50,l.50,and0.80,respectively.TheriskeerateofItumis4.35percentandtheequityriskpremiumis8.04percent.CaculatetherequidratesofremrnfbrthesethreestocksusingtheCAPM.

3TheestimatedfactorsensitivitiesofTeraNovaEnergytoFamaFrenchfhctorsandtheriskpremiaassociatedwiththosefhctorsaregiveninthetablebe>ow:

g9

l0()

Fact0SensitMtyRiSkPemhum

Marketfhctor

Sizefacto

Valuefactor

l20

-0.50

0.l5

4.5

27

4.3

ABased0ntheFamaFrenclmodeI,caIcuIatetherequiedretumfbTeraNova

EnegyusingtheseestimatesAssumethattheTreasuybiIlateis47pecent.

BDescribetheexpectedstyleCharactelowingfhctsdescribeLarsen&ToubroLtd,scomponentcostsofcapitaIandcapitalstructure.BasedontheinfbrmatioHgiven,calcu>ateLarsen&Toubro,sWACC

C0mponentC0stsoCapita!

CostofequitybasedontheCAPMPretaxcostofdebt:

Taxrate:

TaIgetweightincapitaIstmcture:

(%)

l5.6

8.28

30

Equity80,Debt20

ThefowinginfmationeIatestQuestions712

Anequityindexisestabishedin200lfbracountrythathasreativeIyecentyestablishedamarketeconomy.Theindexvendorconstructedretumsfbrthefiveyearspnorto200lbasedonihcinitiaIgroupofcompaniesconstimtingtheindexin200lOver2004to2006aseriesofmilitaIyconfFontationsconcemingadisputedbordedisruptedtheeconomyandfinancialarkets.ThedisputeisconclusiveIyarbitratedattheendof2006.Intotal,tenyearsofequitymaketetunhistoyisavaiIableasofthebeginningof2007.Thegeometncmeanemrnelativetol0yeargovernmentbondretumsoverl0yearsis2percentperyear.ThefbIwarddMdendyieIdontheindexispecent.Stockretunsover2004to2006reflectthesetbacksbuteconomistspedictthecountrywilbeonapathofa4percentreaGDPgrowthrateby

>=

200g.EamingsinthepubIiccooatesectoareexpectedtogrowata5perceltpeyeaeaIgrowthrate.Consistentwiththat,themarketPEratioisexpectedtogowatlpercentperyearAIthoughinflationiscurrentlyhighat6percentperyear,theIongtemfbcastisfbrainf>ationrateof1percentperyear.AIthoughtheyieIdcurvehasusuallybeenupwardsloping,currentIythegovemmentyieIdcuIeisinveIted,attheshort-end,yieIdsaregpercentandatl0-yearmaturities,yieldsare7percent.

7Theinclusionofindexretumspnorto200lwou>dbeexpectedto:

Abiasthehistoricaequityriskpremiumestlmateupwads.

Bbiasthehistorica!equityriskpremiumestlmatedownwards.

Chavenoeffectonthehistoricalequityriskpremiumestimate.

8Theeventsof2001to2006wouIdbeexpectedto:

AbiasthehistoricalequityriskpremiumestimateupwardS.

Bbiasthehistoricalequityriskpremiumestimatedownwards.

Chavenoeffbctonthehistorica>equityriskpremiumestimate

9Inthecurrentinterestrateenvironment,usingareqUiredretumestimatebasedontheshort-termgovemmentbondrateandahistoricalequityriskpremiumdefinedintermsofashort-termgovemmentbondratewouldbeexpectedto:

AbiasIongtemequiedetumonequityestimatesupwards.

B.biasongtemrequiredretumonequityestlmatesdownwards.

Chavenoeffbctonlong-termrequiredretumonequityestimates.

I0AsupplysideestimateoftheequityriskpremiumaspresentedbyTheIbbotson-CheneamingsmodeIisces!to:

A3.2percent.

B40percent.

C4.3percent.

11.Commonstockissuesintheabovemarketwithaveragesystematicriskareostohaverequiredratesofreturn:

Abetween2percentand7percent.

Bbetween7andgpercent.

C9percentorgreater.

l2.WhichofthefbIIowingstatementsisoscqe?IftwoequityissueshavethesamemarketriskbutthefirstissuehashigherIeverage,greateriquidity,andahigherrequiedretum,thehigherequiredretumosketheresultofthefirstissue,s:

Agreater!iquidity >0I

>02

Bhigherevemge.

Chigherleverageandgreateiquidity.

Questions13though19eIatetoHiznAssetIVIanagement1

JudyChenistheprimaIyportfb>iomanageroftheglobalequitiesportfblioatHorizonAssetManagement.LarsJohansson,acentIyhiredequityanaIyst,hasbeenassignedtoChentoassistherwiththepoItfbli

ChenrecentIysoIdsharesofNovoGemini,Inc.fi.omthepofbIiChentasksJohanssonwithassessingtheretumperfbnnanceofNovo-Gemini,withspecifictradeinfbnnationprovidedinExhibit>

ExhibitlN0V0GeminMcTmdeDetai!s

1NovoGeminishareswerepurchasedfbr20.75pershare

2AtthetimeofpurchaseresearchbyChensuggestedthatNovo-GeminishareswereexpectedtoseIlfbr29.00peshareattheendofa3-yearhodingperiod

3Atthetimeofpuchase,theequiredetumfbrNovoGeminibaseduponthecapitaIassetpricihgmode>(CAPM)wasestimatedtobel2.6%onananhuaIbasis.

Exactly3yearsaferthepuchasedate,thesharesweresoldfbr30.05pershare.

5NodividendswerepaidbyNovoGeminioverthe3yearholdingperiod.

ChenexplainstoJohanssonthat,atthetimeofpurchase,theCAPMusedtoestimatearequiredretumfbrNovoGeminiincoIporatedanunaustedhistoricaIequityriskpmiumestimatefbrtheUSequitymarket.ChennotesthattheUSequitiesmarkethasexpenencedameaningfillstrmgoffavorableinflationandproductMtysurpIisesinthepast.SheasksJohanssonwhetherthehistorica!equityriskpemiumshouIdhavebeenadiustedbefbreestimatingtheIquiredretumfbrNovo-Gemini.

Foranotherperspecnveontheewardtobeanngrisk,ChenasksJohanssotocaIculatea

fbrwardlookingequityriskpremiumfbrtheUSequitymarketusingdataontheS&P500indexinExhibitZ

Exhibit2SP500ldexDt

DMdendyield,basedonyearaheadaggregatefbecasteddividends

Consensuslong-termeamingsgrowthrate

Z0-yearUSgovemmentbondyieId

l2%

4%

3%

ChenisnowconsideingaddingshaIcsofBezak,Inc.totheportfbIio.ChenasksJohanssontocaIculateBezak,sweightedaveragecostofcapitaIusingtheCAPMwiththeinfbnnatlonprovidedinExhibit3.

EXhibit3Bezak,Ic

Pretaxcostofdebt

Long-termdebtasapercentoftotalcapitaI,atmaIketvalueMarginaItaxrate

Bezak,Inc.beta

EstimatedequityIiskpremiumRisk-hPeerate

49%

25%

30%

2.00

5.5%

3.0%

Last>yChenasksJohanssontoevaluateTwinIndustries,aprivatelyownedUScompanythatmayinitiateapublicstockoffbIing.JollanssondecidestoadaptCAPMtoestimatetherequiredretumonequityfbrTwinIndustries.UsingtheMSCI/Standard&Poor,sGlObaIIndustIyCIassificationStandadGICS,JohanssonidentifiesapubIicIytadedpeecompanywithanestimatedbetaofl09thatismuchagerbutotherwisesimiIartoTwinIndustries.TwinIndustriesisfilnded4g%bydebtwhilethepublic>ytradedpeercompanyishmded60%bydebt.

I3BaseduponExhibitl,theexpectedthree-yearho>dingperiodretumfbrNovo-GeminiInc.atthetimeofpurchasewasc/b$cs/to:

A3g.76%

B12.76%

C4482%

MBasedupoExhibit,thereaIizedthreeyearholdingperiodetumfbNovoGeminiIncwascsesto:

A3g.76

B12.76%

C44.82

I5BasedonthehistoricalrecordofSurprisesininf>ationandproductivity,thehistoricalequityriskpremiumfbrtheUSequitymarket,ifitisusedasanestimateofthefbrward-lookingequityriskpemium,shouIdoybe:

A>eftunchanged

B.adiustedupwardl03

l04

Cad>usteddownwa!d

16BasedonExhibit2,thefbrwardookingestimatefbrtheUSequityriskpremiumisCsestO:

A2.2%

B5.8%

C8.2%

l7BasedonExhibit3,andassuminginteestondebtistaxdeductible,theweightedaveragecostofcapitaWACCfbrBezak,Inc.iscscsto:

Al0.87%.

Bll36.

cl3.6l%.

18TheestimateofbetafbrTwinIndustriesiscseto

A0.14

B0.85

C.0.8g.

l,ApotentialweaknessofJohansson,sapproachtoestimatingtherequiredreturnonequityfbTwinIndustriesisthattheretumestimate:

Adoesnotincudeasizepremium.

Bmayoverstatepotentialretumsovertheongtem.

Cdoesnotconsidesystematicriskaisingfi.omtheeconomicsoftheindustIy

slutins

1

ATheexpectedhoIdingwasoneyear.TheactuaIhoIdingpenodwasom5October2007to5November2007whichisthreeweeks.

BGivenfairpIicingtheexpectedreturnequalstherequiredreturn,87percentTheexpectedpriceappreciationeturnovertheinitiaanticipatedoneyearholdingpeiodmustbeequaltotheequiedretumminusthedividendyield,2.l72.08002g3or2.93percent.Thusexpectedpriceappreciationretumwas8.7%-2.g3%=5.77percent.

C.ThereaIizedeturnwas6g.527Z0872.08003552ornegative3.55percentoverthreeweeksTherewasnodividendyieldreturnovetheactualhoIdingpeiod.

DTherequiredremmoverathreeweekhodingperiodwasl.00l6l0.484percent.UsingtheanswertoCthereaizedalphawas35520484.036percentor=404percent.

2PorAOLTimeWameI;therequiredretumis

lRFEMRF4352508245

3

RFERM-RFl35I500435l2=>6.1>%

ForBoeingtherequiredretUrnis

.FERMF4.3580843564l0.78

AThePamaFrenchmodelgivestherequiredretumas

TbiraleSensiMyoeIuilymMcacorxEquily

pmiumScMyoizelhcorxSieikpemium

ScnsiMyloucloxVa!ueiskpemi!m

ForTerraNovaEnergy,therequidretumis

4.7l.20x45-050x2.75x4.34.75.4l.350.6i

8.l

BTeIaNovaEnergyappearstobeaIargecap,growthoriented,highmarketriskstockasindicatedbyitsnegativesizebeta,negativevaluebeta,andmaketbetaabovel0.

4Theequiredreturnisgivenby 105

>06

.0015020.07545.530

ThisexampIeindicatesthatNewmontMininghasarequiredretumof3percent.WhenbetaisnegativeanassethasaCAPMrequiredrateofretumthatisbeowtheriskfeerate.CasesofequitieswithnegativebetasarerelativeIyrare.

5BiscorrectTheFamaPrenchmodeIincorporatesmarketsize,andvaIueIiskfhctorsOnepossibleinterpretationofthevalueIiskfhctoristhatitrelatestofinancialdistress

6LarsenToubroLtd,sWACCisl3.6percentcacuIatedasfblows

EqIity Debt WACC

WeightAheTaxCost

WeightxCost

0.80

l5.6%

l2.48% +

020

l0.30828

l.l6% =l3.6#%

7Aiscoect.Thebackfillingofindexreturnsusingcompaniesthathavesurvivedtotheindexconstmctiondateisexpectedtointroduceapositivesurvivoshipbiasintoreturns

8Biscorrect.Theeventsof2004to2006depressedshareetumsbutlarenotapersistentfbatueofthestockmaketenvironment,2werenotoffSetbyotherpositiveeventswithinthehistoricalrecord,and3)haveledtorelativelylowvaluationleveIs,whichareexpectedtorebound.

9Aiscorrect.TherequiredreturnreflectsthemagnitudeofthehistoricaIequityriskpremium,whichisgeneraIyhighewhenbasedonashoIt-terminteestrateasasultofthenomalupwardslopingyiedcurve,andthecuIentva!ueoftheratebeingusedtorepresenttheriskfTeerate.TheshorttermrateiscuentlyhighethantheIongtemrate,whichwi>la>soincreasetherequiredretumestimateTheshort-terminterestrate,howeve,overstatesthelongtemexpectedinfationate.UsingtheshoItte.minteestrate,estimatesofthelong-termrequiredretumonequitywillbebiasedupwards.

l0.CiScon.ect.AccoIdingtothismode

Here

EINFL

ECREPS

ECP

EIC

pilnP00,U

Bysubstitution,weget:

+00|IMl05I 0070.I30.07013or4perccn

11Ciscorrect.Basedonalong-termgovemmentbondyieldof7percent,abetaofl,andanyoftheriskpremiumestimatesthatcanbecaIculatedfomthegivenseg,a2percenthistoricalriskpremiumestimateor4.3percentsuppIysideequityriskpremiumestimate),theIcquiredrateofreturnwouIdbeatleastgpecentBasedonusingashorttermrateofgpercent,Cisthecorrectchoice.

1ZBiscorrect.AIle>seequaI,thefirstissue,sgreater>iquiditywou>dtendtomakeitsrequiredremrnIowerthanthesecondissue,s.However,therequiredretumonequityincreasesasleverageincreases.Thefirstissue,shigherrequiredretummustresultfibmitshigherleverage,morethanoffSettingtheeffbctofitsgeaterIiquiditygiventhatbothissueshavethesamemarketrisk

13AiscorrectThisistheexpected3yearholdingperiodretum,calcuatedas:

3yearexpectedreturnV0P0P029.0020.7520.7539.76.

Ciscorrect.ThereaIizedholdingperiodretum(notethatnodividendswerepaidduringthe3-yearholdingperiod)is1482%.Specifically,thereaIized3-yearho>dingperiodiscalculatedascaIculatedas:

3yearrealizedretumPHP0030.0520.7520.754482.

14

15Ciscorrect.AstringoffhvorableinfationandproductivitysurpnsesmayresultinasenesofhighetumsthatincreasethehistoicaImeanestimateoftheequityisk

G

premlumTomitigatethatconcem,theanalystmayaustthehistoricaIestimate

downwardbasedonanindependentfbIward->ookingestimate.

16.AiscorrectGiventhedatapresented,theequityriskpremiumcanbeestimatedas:

EquityriskpremiumdMdendyieIdontheindexbasedonyeaaheadaggregatefbecasteddividendsandaggegatemaketvalueconsensusIongtermeamingsgowthrate-currentlong-termgovemmentbondyie>dTheequityriskpremium=l.2%+40%302.Z.

17.Biscorrect.TheweightedaveragecostofcapitalistakingthesumpoductofeachcomponentofcapitalmutipIiedbythecomponent,saRertaxcost.

First,estimatethecostofequityusingtheCAPM:

Costofequity=Risk-fiFeerate+

Costofequity=3.0%+=>4%

Now,ca>cula

I08

WeightARerTaxCost

WeightxAherTaxCost

075

l0.5%

0.25

(>-030)x4g%0.8575% =ll.36%

8.Biscorect.Thestepstoestimatingabetafbranontadedcompanyare

SteplSeIectthecomparabIebenchmark

Step2Estimatebenchmark,sbeta

Step3UnIeverthebenchmak,sbeta

StepqLeverthebetatoref>ectthesuqectcompany,sfinancia>Ieverage

Thebetaofthebenchmarkpeercompanydataisgivenas>.0g.Next,thisbetaneedstobellnlevered,caIcu>atedas;

!

l

0.60

0.40

0136,or04

(l.00)

Then,theunleveredbetaneedstobeIeveeduptorefectthefinanciaIIeverageofTwinlndustries,ca>cu>atedas:

II.

.I08549,o0.85

19AiscorrectJohanssonintendstoestimatearequiredretumonequityusingamodifiedCAPMapproachTwinIndustriesisstatedtobesmalIerthanthechosenproxybenchmarkbeingusedandthereisnosizepremiumaustmentintheCAPMamework;thefiFameworkaquststhebetafbrIeveragediffbrencesbutthisdoesnotaqustfbrf>rmsizedifferences.Thebuild-upmethodmaybem0reappropnateasitincludestheequitylilfnPmimnlnhRnmnTeHdditionaIDremiaohenbasedonfactorssuchassizeandriskpremiumandoneormoreadditionaIpremia,operceivedcompany-specificrisk

109

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