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Ernie Smith and Jama! Sims are analysts with the firm of Madison Consultants. Madison provides statistical modeling and advice to portfolio managers throughout the United States and Canada.
In an effort to estimate future cash flows and value the Canadian stock market. Smith has been examining* the country's aggregate retail sales. He runs two autoregressive regression models in an attempt to determine whether there are any patterns in the data, utilizing nine years of unadjusted monthly retail sales data. One model uses a lag one variable and the other adds a lag twelve variable. The results of both regressions are shown in Exhibits 1 and 2.
Sims has been assigned the task of valuing the U .S . stock market and uses data similar to the data that Smith uses for Canada. He decides, however, that the data should be transformed. He takes the natural log of the data and uses it in the following model:
Smith and Sims are concerned that the data for Canadian retail sales may be more appropriately modeled with an ARCH process. Smith states, that in order to find out, he would take the residuals from the original autoregressive model for Canadian retail sales and then square them.
Sims states that these residuals would then be regressed against the Canadian retail sales data using the
where e represents the residual terms from the original regression and X represents the Canadian retail sales data. If is statistically different from zero, then the regression model contains an ARCH process.
Smith also examines the quarterly inflation data for an emerging market over the past nine years. He models the data using an autoregressive model with a lag one independent variable which he finds is statistically different from zero. He wonders whether he should also include lag two and lag four terms, given the magnitude of the autocorrelations of the residuals shown in Exhibit 4, assuming a 5% significance level. The critical t-values, assuming a 5% significance level and 35 degrees of freedom, are 2.03 for a two-tail test and 1.69 for a one-tail test.
where: FF is the Federal Funds rate in the United States (US), and BY is the bond yield in the European Union (E) and Great Britain (B).
Before he runs this regression, he investigates the characteristics of the dependent and independent variables. He finds that the Federal Funds rate in the United States and the bond yield in Great Britain have a unit root but that the bond yield in the European Union does not. Furthermore, the Federal Funds rate in the United States and the bond yield in Great Britain are cointegrated but the Federal Funds rate in the United States and the bond yield in the European Union are not.
Regarding Smith's emerging market regression, should lag two and lag four terms be included in the regression?
Neither the lag two term nor the lag four term should be included. To determine the significance of the autocorrelation of the residuals, we need the standard error, which is calculated as one over the square root of the number of observations. There are 36 quarters of inflation data. One quarter is lost because we have a lag one term, so there are 35 observations in the regression. Therefore, the standard error is = 0.1690.
The critical f-value is 2.03 for a two-tail test, so none of the ^-statistics indicate that the autocorrelations are significantly different from zero. Therefore we do not need to include additional lag terms. (Study Session 3, LOS 13.d)
A client of Colby Nash, CFA, wants to add an alternative asset class to his portfolio. However, the client is concerned that any investment in hedge funds may be far riskier and generate lower returns than is generally expected. Nash believes the client's attitude toward hedge funds was influenced by negative press coverage regarding fraud perpetrated by a few funds. Nash decided to conduct his own research on the risk/reward characteristics of hedge funds. Nash generated a report (shown in Exhibit 1) comparing several hedge fund strategies and a traditional investment benchmark; the S&P 500 index. Each hedge fund strategy is represented by an individual fund, which is used to measure risk and return over a ten year period. Nash also created a correlation matrix between hedge funds and the S&P 500 index, shown in Exhibit 2.
In addition to the statistics presented in the exhibits above, Nash created a hedge fund index to evaluate each fund's performance. Nash recognized the fact that several shortcomings exist in creating an adequate hedge fund index. To that end, Nash created an index in which all the hedge funds included in the index agreed to provide data that can be verified by Nash. Nash also set up strict rules for inclusion and removal of hedge funds into and out of the hedge fund index.
As a further improvement to his research, Nash created a positive risk-free rate benchmark to evaluate each hedge fund. However, his review of academic research indicated thar the positive risk-free rate benchmark is only appropriate for a limited number of hedge fund strategies. The current risk-free rate is 4%.
Nash conducted a personal interview with the portfolio manager of the Fixed Income Arbitrage hedge fund. The portfolio manager disclosed that he exploited pricing inefficiencies between fixed income securities while hedging exposure to interest rate risk. The portfolio manager utilizes a convergence trading strategy, which assumes that the price difference between two similar assets will narrow in the future. The portfolio manager is willing to invest in illiquid bonds if the opportunity presents itself.
in reviewing the correlation matrix (Exhibit 2), Nash concluded that the Fixed Income Arbitrage hedge fund would be an ideal addition to his client's current traditional investment portfolio. Nash's rationale was that a low correlation between the hedge fund and the S&P 500 index will assure that the fund's returns will be positive when the returns of the index are negative.
After reviewing Nash's research, the Director of Research at his firm inquired why he did not examine the value at risk (VAR) measure for the various hedge fund strategies. Nash stated that VAR is an ineffective statistical measure of risk when a hedge fund has high turnover or frequent changes in its strategy. In addition, Nash stated his belief that when the only input is historical data, VAR does not provide a reliable estimate of future risk.
Nash evaluated the hedge fund strategies using the positive risk-free rate benchmark. The positive risk-free rate benchmark would be most appropriate for:
The positive risk-free rate benchmark can be justified by the fact that arbitrage strategies should be market neutral. A market neutral fund should earn the risk-free rate. The Equity Market Neutral hedge fund employs a strategy that is closest to a pure risk-free arbitrage. The investor expects the manager to use her skill to generate a return greater than the risk-free rate. It should be understood that the Equity Market Neutral hedge fund manager must take on some type of risk to generate excess returns. (Study Session 13, LOS 49-b)
Ivan Johnson is reviewing the investment merits of BioTLab, a fast-growing biotechnology company. BioTLab has developed several drugs, which arc being licensed to major drug companies. BioTLab also has several drugs in phase III trials (phase III trials are the last testing stage before FDA approval). Johnson notes that two drugs recently received approval which should provide BioTLab solid revenue growth and generate predictable cash flow well into the future. Based on the potential for the two drugs, BioTLab's estimated annual cash flow growth rate for the next two years is 25%, and long-term growth is expected to be 12%. Because of BioTLab's attractive investment opportunities, the company does not pay a dividend. BioTLab's current weighted average cost of capital is 15% and its stock is currently trading at $50 per share. Financial information for BioTLab for the most recent 12 months is provided below:
* Net working capita! excluding cash increased from $7,460,000 to $9,985,000;
* Book value increased from $81,250,000 to $101,250,000.
* BioTLab currently has no debt.
* Research facilities and production equipment were purchased for $8,450,000.
* BioTLab held non-operating assets in the amount of $875,000.
* Net income for the 12 months was $20,000,000.
* BioTLab has a marginal tax rate of 40%.
* Noncash charges for depreciation and restructuring for the 12 months were $1,250,000.
BioTLab's management has indicated an interest in establishing a dividend and will fund new drug research by issuing additional debt.
Johnson also reviews a competitor to BioTLab, Groh Group, which has a larger segment operating in a highly cyclical business. The Groh Group has a debt to equity ratio of 1.0 and pays no dividends. In addition, Groh Group plans to issue bonds in the coming year.
Which model would be most appropriate in valuing the Groh Group?
The FCFF model is better than the FCFE model in valuing debt laden, cyclical companies and companies with a changing capital structure. Since Groh Group does not pay a dividend, the DDM model would be the least appropriate model to value the company. (Study Session 12, LOS 41.b,h)
Jenna Stuart is a financial analyst for Deuce Hardware Company, a U .S . company that reports its results in U .S . dollars. Wayward Distributing, Inc., is a foreign subsidiary of Deuce Hardware, which began operations on January 1,2007. Wayward is located in a foreign country and reports its results in the local currency called the Rho. Selected balance sheet information for Wayward is shown in the following table.
Stuart has been asked to analyze how the reported financial results of Wayward will be affected by the choice of the all-current or temporal methods of accounting for foreign operations. She has gathered the following exchange rate information on the $/Rho exchange rate:
* Spot rate on 1/01/08: $0.35 per Rho
* Spot rate on 12/31/08: $0.45 per Rho
* Average spot rate during 2008: $0.42 per Rho
Will the all-current method report a translation gain or loss for 2008, and will that gain or loss be reported on Deuce's income statement or the balance sheet?
Exposure under the all-current method is equity. Beginning equity is positive ($4,000) and the change in equity during the year is positive ($6,000 - $4,000 = $2,000). Because the Rho appreciated during the year, the all-current method will report a translation gain for 2008. Under the all-current method gains and losses are reported as part of the cumulative translation adjustment in the equity section of the balance sheet. (Study Session 6, LOS 23.d,e)
High Plains Tubular Company is a leading manufacturer and distributor of quality steel products used in energy, industrial, and automotive applications worldwide.
The U .S . steel industry has been challenged by competition from foreign producers located primarily in Asia. All of the U .S . producers are experiencing declining margins as labor costs continue to increase. In addition, the U .S . steel mills arc technologically inferior to the foreign competitors. Also, the U .S . producers have significant environmental issues that remain unresolved.
High Plains is not immune from the problems of the industry and is currently in technical default under its bond covenants. The default is a result of the failure to meet certain coverage and turnover ratios. Earlier this year, High Plains and its bondholders entered into an agreement that will allow High Plains time to become compliant with the covenants. If High Plains is not in compliance by year end, the bondholders can immediately accelerate the maturity date of the bonds. In this case. High Plains would have no choice but to file bankruptcy.
High Plains follows U .S . GAAP. For the year ended 2008, High Plains received an unqualified opinion from its independent auditor. However, the auditor's opinion included an explanatory paragraph about High Plains' inability to continue as a going concern in the event its bonds remain in technical default.
At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO) filed the necessary certifications required by the Securities and Exchange Commission (SEC).
To get a better understanding of High Plains' financial situation, it is helpful to review High Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit 2.
Exhibit 2: Selected Financial Footnotes
1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to significantly exceed the industry average. Sales are recognized when a firm order is received from the customer, the sales price is fixed and determinable, and collectability is reasonably assured.
2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the first-in, first-out method been used, inventories would have been $152 million and $143 million higher as of December 31,2008 and 2007, respectively.
3. Effective January 1, 2008, High Plains changed its depreciation method from the double-declining balance method to the straight-line method in order to be more comparable with the accounting practices of other firms within its industry. The change was not retroactively applied and only affects assets that were acquired on or after January 1,2008.
4. High Plains made the following discretionary expenditures for maintenance and repair of plant and equipment and for advertising and marketing:
5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its accounts receivable, with recourse, to an unrelated entity. All of the receivables were still outstanding at year end.
6. High Plains conducts some of its operations in facilities leased under noncancelable capital leases. Certain leases include renewal options with provisions for increased lease payments during the renewal term.
7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively.
Which of the following statements about evaluating High Plains financial reporting quality is least accurate?
It appears thai High Plains manipulated its earnings upward in 2008 to avoid default under its bond covenants. However, the higher earnings are lower quality as measured by the cash flow accrual ratio. Because of the estimates involved, a lower weighting should be assigned to the accrual component of High Plains' earnings. Extreme earnings (including revenues) tend to revert to normal levels over time (mean reversion). (Study Session 7, LOS 25.b,e)
