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 marketsbecome integrated into the global market. C) increase when government credit issues grow. <Explanation> B: Over the long run, it is assumed that thecountry-risk premium will approach zero as the emergingmarket 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. <Explanation> C: The sovereign risk premium consists of bothcredit and country-risk premiums. 3. Pricing power is difficult to ascertain without specific data, but the information presented above provides enough clues to deducethe proper order. Quintile Fusion appears to be a company indecline, reinventing itself, worried about rivals, and dependent oncommodities for production. Both Blevins and Karnack Analysisappear to have more market leverage. Blevins’ concerns about itsbrand momentum, coupled with what appears to be fairly small
barriers to entry, suggest pricing power is limited. Karnackdifferentiates by specialization, one key to charging high prices.Large barriers to entry, and a rise in capacity utilization suggestsdemand is rising faster than supply, potentially supporting higherprices. Concern about the acceptance of new products could be anegative indicator for prices, but Karnack has the most positivedata regarding pricing power, and Quintile Fusion has the mostnegative data.Which of the following information on Kenton Koncepts is mostvaluable in the analysis of long-term?Supply trends? Profitability? A) Order chart Cost-cutting initiativesB) Plant upgrades Cost-cutting initiatives C) Order chart Product list <Explanation> C: The list of plant upgrades is useful forestimating Kenton’s production, but an industrywide chart oforders and backlogs illustrates more than demand trends. Byconsidering both orders and backlogs, an analyst can back intosupply analysis and draw useful conclusions about the currentsupplies and industry production capacity. While cost-cuttinginitiatives will have an effect on profit margins, particularly inthe short term, of more importance in the long term is thecompany’s ability to produce items the market wants. Kenton’slist of products and niches has substantial value fordetermining whether the company can continue to operateprofitably. 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 <Explanation> B: Blevins’ growth rate suggests it is not on thedecline. In some ways Blevins looks like a growth company, butcompanies can post solid growth within a mature industry,particularly if they are taking market share. And Blevins’ profitmargins and concerns about the erosion of an already powerfulbrand are characteristic of an established company in a matureindustry. Karnack’s difficulty in funding expansion hints athigh capital needs, and concerns about new products suggest itis in a pioneer industry. 5. Which of the following issues will be least effectively addressed if LeMond simply adjusts the financial statements by reducing thecash 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. <Explanation> C: Inflation and political instability will have asimilar effect on companies throughout a country. Someindustries are more vulnerable to privatization than others,and simply reducing cash flows for all companies by a setamount will probably understate the cash flows of companiesin industries not likely to be privatized. 6. Plicher’s cost of equity is closest to: A) 44.2%.B) 38.4%. C) 42.4%. <Explanation> 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 ordenominated in another currency. So we start with the 10-yearTreasury yield, then add the difference between Llaho’sinflation and U.S. inflation. 4% + 2.5% + 25% ? 3.5% = 28%.For beta, we use the industry beta, not the beta derived fromstock 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 ofcapital is closest to: A) 10.15%.B) 18.64%. C) 15.67%. <Explanation> C: The weighted average cost of capital equals(equity / assets) × cost of equity + (debt / assets) × after-tax costof debt. We have equity, assets, debt, and cost of equity values. Tocalculate the cost of debt, we start with the local risk-free rateplus 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. Theemerging market country has experienced high inflation in recentyears. She estimates each component of WACC as follows: Risk-free rate: 10-year U.S. government bond yield + inflationdifferential between the local market and U.S. market.Beta: From a regression of the manufacturer's stock returns on thecountry's market equity index.Market risk premium: 6.0%, which is the geometric averagenominal risk premium on the country's equity index over the past12 years.Pre-tax cost of debt: local risk-free rate plus the credit spread onU.S. corporate bonds rated B+.Marginal tax rate: 35%, which reflects all government taxes thatare applied to interest expense on corporate bonds.Capital structure weights: Average capital structure weights forglobal industry competitors.With respect to the cost of equity capital and the WACC, the analysthas overestimated: A) one of these.B) neither of these. C) both of these. <Explanation> C: The analyst has most likely correctlyestimated the risk free rate, the pre-tax cost of debt, themarginal tax rate, and the capital structure weights. However,she has most likely incorrectly estimated the market riskpremium and beta. The best recommendation for estimatingthe market risk premium is to use a long-term average riskpremium on a global market index. The topic review suggests arange of 4.5% to 5.5%. The market risk premium isoverestimated using 6.0% based on recent risk premiums in theequity markets. Beta should be estimated based on a regressionof the industry's stock returns on a global market index. Theanalyst has overestimated both beta and the market risk
premium. The result is that she has also overestimated the costof equity capital and the WACC