Samuel Edson, CFA, portfolio manager for Driver Associates, employs a multifactor model to evaluate individual stocks and portfolios. Edson examines several possible risk factors and finds two that are priced in the marketplace. These two factors are investor sentiment (IS) risk and business cycle (BC) risk. Edson manages three equity portfolios (A, Bt and Q and derives the following relationships for each portfolio, as well as for the S&P 500 stock market index:
Portfolios A and B are well-diversified, while C is a less than fully diversified, value-oriented portfolio. FJS is the surprise in investor sentiment, and FBC is the surprise in the business cycle. Surprises in the risk factors are defined as the difference between the actual value and the predicted value.
Exhibit 1 provides data for the actual and predicted values for the investor sentiment and business cycle risk factors.
Driver Associates uses a two-factor Arbitrage Pricing Model to develop equilibrium expected returns for individual stocks and portfolios:
Edson's supervisor, Rosemary Valry, asks Edson to interpret the intercept of the multifactor equation for Portfolio A (0.175). Edson should respond that the intercept equals:
The intercept in a macroeconomic factor model equals the expected return for the portfolio examined in the model (assuming no surprises in the macroeconomic variables). The factors in the multifactor equations, F}S and FBC, are factor 'surprises,' which by definition are expected to equal zero (i.e., by definition, zero 'surprise' is 'expected'). So, by assumption, FIS and fBC are expected to equal zero. Therefore, the expected return for Portfolio A equals its intercept (17.5%). (Study Session 18, LOS 64.j)
Factor Analytics Capital Management makes portfolio recommendations using various factor models. Mauricio Rodriguez, a Factor Analytics research analyst, is examining the prospects of two portfolios, the FACM Century Fund (CF) and the FACM Esquire Fund (EF).
The variance of returns are identical for the two funds. The estimates in Exhibit 1 were derived for CF and EF using monthly data for the past five years.
Supervisor Barbara Woodson asks Rodriguez to use the Capita! Asset Pricing Model (CAPM) and a multifactor model (APT) to make a decision to continue or discontinue the EF fund. The two factors in the multifactor model are not identified. To help with the decision, Woodson provides Rodriguez with the capital market forecasts in Exhibit 2.
After examining the prospects for the EF portfolio, Rodriguez derives the forecasts in Exhibit 3.
Rodriguez also develops a 2-factor macroeconomic factor model for the EF portfolio. The two factors used in the model are the surprise in GDP growth and the surprise in Investor Sentiment. The equation for the macro factor model is:
During an investment committee meeting, Woodson makes the following statements related to the 2-factor macroeconomic factor model.
Statement 1: An investment combination in CF and EF that provides a GDP growth factor beta equal to one and an Investor Sentiment factor beta equal to zero will have lower active factor risk than a tracking portfolio consisting of CF and EF.
Statement 2: When markets are in equilibrium, no combination of CF and EF will produce an arbitrage opportunity
In their final meeting, Rodriguez informs Woodson that the CF portfolio consistently outperformed its benchmark over the past five years. Rodriguez makes the following comments to Woodson: "The consistency with which CF outperformed its benchmark is amazing. The difference between the CF monthly return and its benchmark return was nearly always positive and varied little over time."
Based on the data provided in Exhibits 2 and 3, should Rodriguez recommend that Factor Analytics continue to invest in the EF fund using the:
CAPM? 2-factorAPT?
The equations for the CAPM and a 2-factor APT, respectively, are:
Note thai the beta estimate for EF in Exhibit 1 from the market model is an estimate of the historical beta based on historical data. The question asks you to use the forecast beta from Exhibit 3.
Rodriguez forecasts that the EF fund return will equal 12%, which exceeds the CAPM required return. Therefore, Rodriguez predicts that the EF portfolio return will exceed its CAPM required return (a signal to continue investing in EF). But the forecast EF return (12%) is less than the 2-factor APT model required return of 155% (a signal to sell or not continue investing in EF). (Study Session 18, LOS 64.e,l,n)
Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.
Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.
Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.
Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine Midwest News's required relurn on equity is presented in Exhibit 2.
The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.
Statement I: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.
Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.
Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.
Based on Exhibit 2 and using the build-up method, Midwest News's required return on equity is closest to:
= risk-free rate + equity risk premium + size premiu + specific-company premiu
Control premium and marketability premium adjustments are not usually made in the required return on equity calculation, but rather directly to the estimated value. (Study Session 10, LOS 35.d)
Michael Robbins, CFA, is analyzing Universal Home Supplies, Inc. (UHS), which has recently gone through some extensive restructuring.
Universal Home Supplies, Inc.
UHS operates nearly 200 department stores and 78 specialty stores in over 30 states. The company offers a wide range of products, including women's, men's, and children's clothing and accessories as well as home furnishings, electronics, and other consumer goods. The company is considering cutting back on or eliminating its electronics business entirely. UHS manufactures many of its own apparel products domestically in a large factory located in Kentucky. This central location permits shipping to distribution points around the country at reasonable costs. The company operates primarily in suburban shopping malls and offers mid- to high-end merchandise mainly under its own private label. At present more than 70% of the company's customers live within a 10-minute drive of one of the company's stores. Web site activity measured in dollar sales volume has increased by over 18% in the past year. Shares of UHS stock are currently priced at $25. Dividends are expected to grow at a rate of 6% over the next eight years and then continue to grow at that same rate indefinitely. The company has a cost of capital of 10.2%, a beta of 0.8, and just paid an annual dividend of $1.25.
UHS has faced serious cash flow problems in recent years as a consequence of its strategy to pursue an upscale clientele in the face of increased competition from several "niche retailers." The firm has been able to issue new debt recently and has also managed to extend its line of credit. The two financing agreements required a pledge of additional assets and a promise to install a super-efficient inventory tracking system in time to meet holiday shopping demand.
Robbins is asked by his supervisor to carefully consider the advantages and drawbacks of using the price-to-sales ratio (P/S) and to determine the appropriate valuation metrics to use when returns follow patterns of persistence or reversals.
Robbins also estimates a cross-sectional model to predict UHS's P/E:
predicted P/E = 5 - (10 x beta) + [3 x 4-year average ROE(%)]
+ [2 X 5-ycar growth forecast(%)]
Robbins should conclude that a key drawback to using the price-to-sales (P/S) ratio in the investment process is that P/S is:
Among the choices given, the only drawback to the P/S ratio is that it is susceptible to manipulation if management should choose to act aggressively with respect to the recognition of revenue. (Study Session 12, LOS 42.c)
GigaTech Inc. is a large U .S .-based technology conglomerate. The firm has business units in three primary categories: hardware manufacturing, software development, and consulting services. Because of the rapid pace of technological innovation, GigaTech must make capital investments every two to four years. The company has identified several potential investment opportunities for its hardware manufacturing division. The first of these opportunities, Tera Project, would replace a portion of GigaTech's microprocessor assembly equipment with new machinery expected to last three years. The current machinery has a book value of $120,000 and a market value of $195,000. Tcra Project would require purchasing machinery for $332,000, increasing current assets by 5190,000, and increasing current liabilities by $80,000. GigaTech has a tax rate of 40%. Additional pro forma information related to the Tera Project is provided in the following table:
Analysts at GigaTech have noted that investment in the Tera Project can be delayed for up to nine months if managers at the company decide this is necessary. However, once the capital investment is made, the project will be necessary to maintain continuing operations. Tera Project can be scaled up with more equipment requiring less capital than the original investment if results are meeting expectations. In addition, the equipment used in Tera Project can be used in shift work if brief excess demand is expected.
GigaTech is also considering expanding its software development operations in India. Software development equipment must be continually replaced to maintain efficiency as newer and faster technology is developed. The company has identified two mutually exclusive potential expansion projects, Zeta and Sigma. Zeta requires investing in equipment with a 3-year life, while Sigma requires investing in equipment with a 2-year life. GigaTech has estimated real capital costs for the two projects at 10.58%. GigaTech expects inflation to be approximately 4.0% for the foreseeable future. Nominal cash flows and net present values for the Zeta and Sigma projects are provided in the following table:
Recently, GigaTechs board of directors has become concerned with the firm's capital budgeting decisions and has asked management to provide a detailed explanation of the capital budgeting process. After reviewing the report from management, the board makes the following comments in a memo:
* The capital rationing system being utilized is fundamentally flawed since, in some instances, projects that do not increase earnings per share are selected over projects that do increase earnings per share.
* The cash flow projections are flawed since they fail to include costs incurred in the search for projects or the economic consequences of increased competition resulting from highly profitable projects.
* We are making inappropriate investment decisions since the discount rate used to evaluate all potential projects is the firm's weighted average cost of capital.
Which of the following would best correct GigaTech's discount rate problem described in the board of director's memo?
When evaluating pocential capital investment projects, the discount rate should be adjusted for the risk of the project under consideration. This is frequently accomplished by determining a project beta and using this beta in the CAPM security market line equation: + [E( ) - ]. Project betas can be determined in a number of ways including using proxy firms with operations similar to the project under consideration, estimating an accounting beta, or through cross-sectional regression analysis. Whatever method used to determine the discount rate, it should be clear that the weighted average cost of capital (WACC) is only appropriate for projects with risk similar to the overall firm. If a project is more (less) risky than the overall firm, the discount rate used to evaluate the project should be greater (less) than rhe firm's WACC. (Study Session 8, LOS 27-e)
