MediSoft Inc. develops and distributes high-tech medical software used in hospitals and clinics across the United States and Canada. The firm's software provides an integrated solution to monitoring, analyzing, and managing output from a variety of diagnostic medical equipment including MRls, CT scans, and EKG machines. MediSoft has grown rapidly since its inception ten years ago, averaging 25% growth in sales over the last decade. The company went public three years ago. Twelve months after their IPO, MediSoft made two semiannual coupon bond offerings, the first of which was a convertible bond. At the time of issuance, the convertible bond had a coupon rate of 7.25%, par value of $1,000, a conversion price of $55.56, and ten years until maturity. Two years after issuance, the bond became callable at 102% of par value. Soon after the issuance of the convertible bond, the company issued another series of bonds which were putable, but contained no conversion or call features. The putable bonds were issued with a coupon of 8.0%, par value of $1,000, and 15 years until maturity. One year after their issuance, the put feature of the putable bonds became active, allowing the bonds to be put at a price of 95% of par value, and increasing linearly over five years to 100% of par value. MediSoft's convertible bonds are now trading in the market for a price of $947 with an estimated straight value of $917. The company's putable bonds are trading at a price of $1,052. Volatility in the price of MediSoft's common stock has been relatively high over the last few months. Currently the stock is priced at $50 on the New York Stock Exchange and is expected to continue its annual dividend in the amount of $1.80 per share.
High-tech industry analysts for Brown & Associates, a money management firm specializing in fixed-income investments, have been closely following MediSoft ever since it went public three years ago. In general, portfolio managers at Brown & Associates do not participate in initial offerings of debt investments, preferring instead to see how the issue trades before considering taking a position in the issue. Since MediSoft's bonds have had ample time to trade in the marketplace, analysts and portfolio managers have taken an interest in the company's bonds. At a meeting to discuss the merits of MediSofVs bonds, the following comments were made by various portfolio managers and analysts at Brown & Associates:
"Choosing to invest in MediSoft's convertible bond would benefit our portfolios in many ways, but the primary benefit is the limited downside risk associated with the bond. Since the straight value will provide a floor for the value of the convertible bond, downside risk is limited to the difference between the market price of the bond and the straight value."
"Decreasing volatility in the price of MediSoft's common stock as well as increasing volatility in the level of interest rates are expected in the near future. The combined effects of these changes in volatility will be a decrease in the price of MediSoft's putable bonds and an increase in the price of the convertible bonds. Therefore, only the convertible bonds would be a suitable purchase."
Subsequent to purchasing one of the putable bonds for his portfolio, one of the managers at Brown & Associates realized that the bond contained a soft put. Which of the following securities cannot be used to redeem the bond in the event the bond becomes putable?
A bond with an embedded soft put is redeemable through the issuance of cash, subordinated notes, common stock, or any combination of these three securities. In contrast, a bond with a hard put is onlv redeemable using cash. (Study Session 14, LOS 54,,))
Arnaud Aims is assisting with the analysis of several firms in the retail department store industry. Because one of the industry members, Flavia Stores, has negative earnings for the current year, Aims wishes to normalize earnings to establish more meaningful P/E ratios. For the current year (2008) and six previous years, selected financial data are given below. All data are in euros.
Aims wishes to estimate normalized EPS for 2008 using two different methods, the method of historical average EPS and the method of average rate of return on equity. He will leave 2008 EPS and ROI out of his estimates. Based on his normalized EPS estimates, he will compute a trailing P/E for 2008. The stock price for Flavia Stores is 26.50.
Aims is also looking at price-to-book ratios as an alternative to price-to-earnings ratios. Three of the advantages of P/B ratios that Aims recalls are:
Advantage 1: Because book value is a cumulative balance sheet account encompassing several years, book value is more likely to be positive than EPS.
Advantage 2: For many companies, especially service companies, human capital is more important than physical capital as an operating asset.
Advantage 3: Book value represents the historical purchase cost of assets, as well as accumulated accounting depreciation expenses. Inflation and technological changes can drive a wedge between the book value and market value of assets.
Aims used a constant growth DDM to establish a justified P/E ratio based on forecasted fundamentals. One of his associates asked Aims if he could easily establish a justified price-to-sales (P/B) ratio and price-to-book (P/B) ratio from his justified P/E ratio. Aims replied, "I could do this fairly easily)
If I multiply the P/E ratio times the net profit margin, the ratio of net income to sales, the result will be the P/S ratio. If I multiply the P/E ratio times the return on equity, the ratio of net income to book value of equity, the result will be the P/B ratio."
Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to investigate these two investment criteria further.
Finally, Aims makes two comments to his associate about valuation ratios based on EBITDA and on dividends.
Comment 1: EBITDA is a pre-interest-expense figure, so I prefer a ratio of total equity value to EBITDA over a ratio of enterprise value to EBITDA .
Comment 2: Dividend yields are useful information because they are one component of total return. However, they can be an incomplete measure of return, as investors trade off future earnings growth to receive higher current dividends.
Are Aims's two comments about the dividend yield and EBITDA ratios correct?
Comment 1 about EBITDA ratios is incorrect. EBITDA is a pre-interest variable, so it is a flow available to all suppliers of capital, not just common shareholders. The comment about dividend yields is reasonable. (Study Session 12, LOS 42.q,r)
Yummy Doughnuts (YD) sells a variety of doughnuts and other related items through both company-owned locations and franchise locations. YD has experienced significant growth over the past five years. However, barriers to entry are low and competition is increasing.
Linda Haas, CFA, follows YD for Gibraltar Capital. Gibraltar Capital prides itself on its thorough fundamental analysis of investment opportunities. The company uses a bottom-up approach to the investment process. Haas's security selection process utilizes residual income models to determine a stock's intrinsic value. Haas obtains YD's 2008 financial statements shown in Exhibit 1. In addition, Haas provides supporting information about YD's financials and other related material found in Exhibit 2.
Haas makes the following statements during her YD presentation to the investment committee.
Statement 1: Based on ROE mean reversion, YD's continuing residual income is assumed to decline to zero over time.
Statement 2: The residual income model states that if YD's ROE equals its equity cost of capital, then YD's intrinsic value will equal its book value per share.
Haas notes that the multi-stage residual equity income model captures more detail in calculating YD's intrinsic value. An assumption of the model is that ROE fades to the cost of equity over time, which is known as a persistence factor (varying from 0 to 1). Identify which characteristic indicates a higher persistence of abnormal earnings.
It is difficult for a company to maintain a high ROE because of competition. The persistence factor will be lower for those companies. A company that has a low dividend payout has greater growth opportunities than a company with a high dividend payout. The greater growth opportunities should support a higher persistence factor. (Study Session 13, LOS 43.J)
Yummy Doughnuts (YD) sells a variety of doughnuts and other related items through both company-owned locations and franchise locations. YD has experienced significant growth over the past five years. However, barriers to entry are low and competition is increasing.
Linda Haas, CFA, follows YD for Gibraltar Capital. Gibraltar Capital prides itself on its thorough fundamental analysis of investment opportunities. The company uses a bottom-up approach to the investment process. Haas's security selection process utilizes residual income models to determine a stock's intrinsic value. Haas obtains YD's 2008 financial statements shown in Exhibit 1. In addition, Haas provides supporting information about YD's financials and other related material found in Exhibit 2.
Haas makes the following statements during her YD presentation to the investment committee.
Statement 1: Based on ROE mean reversion, YD's continuing residual income is assumed to decline to zero over time.
Statement 2: The residual income model states that if YD's ROE equals its equity cost of capital, then YD's intrinsic value will equal its book value per share.
Based on Exhibits 1 and 2, YD's weighted average cost of capital (WACC) is closest to:
Note: Capitalizing R&D expense will increase YDs book value. However, the market value used in calculating YD s WACC is not impacted.
(Study Sessions 7 and 10, LOS 26.a and 35.h)
Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.
At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.
As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:
Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U .S . government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.
Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.
Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.
Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.
Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.
If the spot-rate curve experiences a parallel downward shift of 50 basis points:
The sum of a portfolios key rate durations is the effective duration of the portfolio. Each of the portfolios has an effective duration of five, so a parallel shift in the yield curve will have the same effect on each portfolio, and each will experience the same price performance. {Study Session 14, LOS 53.f)
