Question: 1
Mary Pierce, CFA, has just joined The James Group as a fixed income security analyst. Pierce has taken over for Katy Williams, who left The James Group to start her own investment firm. Pierce has been reviewing Williams's files, which include data on a number of securities that Williams had been reviewing.
The first file had information on several different asset-backed securities. A summary schedule that Williams had prepared is shown in Exhibit 1.
Exhibit 1: Summary Schedule
The second file included the following schedule of information relating to a specific CMO thai Williams had been considering. Exhibit 2 reflects the results of a Monte Carlo simulation based on 15% volatility of interest rates. This security is stil! available, and Pierce needs to evaluate the investment merit of any or all of the listed tranches.
A third file contained notes Williams had laken at a seminar a couple of months ago on valuing various types of asset-backed and mortgage-backed securities. These notes included the following comments that Pierce found interesting:
"Cash flow yield (CFY) is one method of valuing mortgage-backed securities. An advantage of the CFY is that it does not rely on any specific prepayment assumptions. An important weakness of CFY is the assumption that interim cash flows will be reinvested at the CFY. This is rarely true for mortgage-backed securities."
"Cash flow duration is similar to effective duration, but its weakness is that it fails to fully account for changes in prepayment rates as cash flow yields change. Empirical duration suffers two disadvantages as a measure of interest rate exposure: reliance on theoretical formulas and reliance on historical pricing data that may not exist for many mortgage-backed securities."
"The recent increase in the default rate for subprime adjustable rate mortgages can be traced to the structure of these loans. The negative amortization feature of these loans basically gave the borrower an at-the-money call option on their property. Once the property decreased in value, this call option was worthless, and the borrower had no incentive to make any additional payments."
Based on Williams's summary information on asset-backed securities. Pierce has decided to purchase the securities based on the LL Home Equity Loans because these securities offered the highest nominal spread, and therefore the best return. Williams believes the risk of the ABS securities is similar based on their credit ratings. Pierce's purchase decision is:
Question: 2
Sampson Aerospace is a publicly-traded U .S . manufacturer. Sampson supplies communication and navigation control systems to manufacturers of airplanes for commercial and government use. The company operates two divisions: Commercial Operations and Government Operations. Revenues from the Government Operations division comprise 80% of Sampson's total company revenues. Revenues for other companies in the industry are also driven primarily by sales to the U .S . government.
Sampson has gained a reputation for offering unique products and services. Sampson's market share has been increasing, and its net profit margin is among the highest in its industry.
As part of its business strategy, Sampson seeks out opportunities to enhance internal growth by acquiring smaller companies that possess new technologies that would allow Sampson to offer unique products and services. To this end, Sampson CEO, Drew Smith, recently asked his acquisitions team to consider the purchase of a controlling interest in either NavTech or Aerospace Communications, both software applications firms. Smith provides his acquisitions team with an aerospace analyst's industry report that addresses many key issues within the industry. Selected passages from the report are reproduced below:
Sales in the aerospace electronics industry depend primarily on government military spending, which, in turn, depends on defense budgets. Sales depend on commercial travel to a much lesser extent. The government defense spending budget outlook is fairly bleak as the current administration is looking for ways to reduce the budget deficit. We feel the commercial airline segment has more upside than downside, especially as the global economy improves, so we might see a gradual shift in industry focus toward the commercial airline sector. Companies that already have a foothold in the commercial sector are well-positioned to grow during the global recovery. Even so, companies in this industry will remain highly sensitive to government spending for their revenues. Research and development costs are high and the industry is highly capital intense. While there are only a few companies in this industry, good opportunities exist, especially for companies that have developed sustainable profits through wise acquisitions, cost containment, and the ability to secure long-term government contracts.
Sampson Aerospace recently announced that it is reducing its investment return assumption on its pension assets from 6% to 5%, and that it has entered negotiations to possibly acquire controlling equity interests in communications software firms, NavTech and Aerospace Communications. NavTech recently has decided to capitalize a significant portion of its research and development expense, and Aerospace Communications has restructured and reclassified many of its leases from operating to financial leases. Sampson CEO Drew Smith recently announced that Sampson had dropped out of negotiations with Knowledge Technologies, claiming it was likely not a sustainable business model.
Consensus forecasts for NavTech and Aerospace Communications are presented in Exhibit 1.
Which of the following is most likely a negative factor in assessing the profitability of Sampson over the medium to long term?
Question: 3
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
Suppose for this question only that Stuart decides to use the all-current method to translate Wayward's results into U .S . dollars. Is it likely that the quick ratio and the interest coverage ratio will be the same or different in Rho before translation and in U .S . dollars after translation?
Question: 4
Delicious Candy Company (Delicious) is a leading manufacturer and distributor of quality confectionery products throughout Europe and Mexico. Delicious is a publicly-traded firm located in Italy and has been in business over 60 years.
Caleb Scott, an equity analyst with a large pension fund, has been asked to complete a comprehensive analysis of Delicious in order to evaluate the possibility of a future investment.
Scott compiles the selected financial data found in Exhibit 1 and learns that Delicious owns a 30% equity interest in a supplier located in the United States. Delicious uses the equity method to account for its investment in the U .S . associate.
Scott reads the Delicious's revenue recognition footnote found in Exhibit 2.
Exhibit 2: Revenue Recognition Footnote
__________________________________________________________________________________
in millions__________________________________________________________________________
Revenue is recognized, net of returns and allowances, when the goods are shipped to customers and collectability is assured. Several customers remit payment before delivery in order to receive additional discounts. Delicious reports these amounts as unearned revenue until the goods are shipped. Unearned revenue was 7,201 at the end of 2009 and 5,514 at the end of 2008.
Delicious operates two geographic segments: Europe and Mexico. Selected financial information for each segment is found in Exhibit 3.
At the beginning of 2009, Delicious entered into an operating lease for manufacturing equipment. At inception, the present value of the lease payments, discounted at an interest rate of 10%, was 6300 million. The lease term is six years and the annual payment is 669 million. Similar equipment owned by Delicious is depreciated using the straight-line method and no residual values are assumed.
Scott gathers the information in Exhibit 4 to determine the implied "stand-alone" value of Delicious without regard to the value of its U .S . associate.
If Delicious were to treat the operating lease as a finance lease, its interest coverage ratio for 2009 would be closest to:
Question: 5
Zi Wang is a senior buy-side equity analyst with Shandong Securities. Wang must review the work of several of his junior colleagues before investment recommendations go to the Shandong portfolio managers. One recommendation from a junior analyst is given in Exhibit 1.
This same junior analyst e-mailed Wang, saying "I'm in a meeting and hate to bother you. I don't have my calculator or computer with me. We have a British stock with a current 4.00 dividend that is expected to grow at 40% per year for two years and then forever after at 6%, If we assume a required return of 12%, what is the value of this stock?"
in a few minutes, Wang e-mails him back: "The British stock is worth 110.42"
The junior analyst sends back a second e-mail. "Thanks. If we can buy this stock for 90, what rate of return would we get? Assume the same dividend pattern as in my first e-mail."
Wang replies to the second e-mail: "I used trial and error and found an expected rate of return for the British stock of 12%."
One of Shandong's portfolio managers asks Wang to clarify the PVGO (present value of growth opportunities) concept for him. Wang tells him, "PVGO is the part of a stock's total value that comes from future growth opportunities. PVGO is conventionally estimated as the market value per share minus the book value per share."
The Shandong portfolio manager quickly follows up with two more requests. He says, "I need a couple of favors. First, could you describe the sustainable growth rate concept for us? We've been arguing about it among ourselves. And, second, could you review some highlighted phrases from a research report we received from one of our investment bankers? We aren't sure that the analyst who wrote this report is very competent." The highlighted phrases are:
Phrase 1: When calculating the justified P/E ratios based on a constant growth model like the Gordon model, the forward P/E should be greater than the trailing P/E.
Phrase 2: A free cash flow approach might be preferable when the company's cash flows differ substantially from dividends or the investor takes a control perspective.
Phrase 3: When the required rate of return increases, the value of a share of stock should decrease even if the stock's dividend has a negative growth rate.
Which of the three phrases in the investment banker's report is least likely to be correct?
