Explanation:
The growth relative to GDP growth method compares a company’s growth rate to the forecasted growth rate of nominal or real GDP.
Explanation:
At first, because the P/E multiple of Pet Food Company is greater than the peer group median, 17 > 14, Pet Food appears overpriced relative to its peers. In order for the analyst to believe that the company is undervalued, it is likely that qualitative factors and fundamentals favor the subject company over its peers. Qualitative factors refer to adjustments that could be made to the raw P/E ratio, which simply divides the stock price by earnings per share. For example, a less risky business, more conservative accounting for sales recognition, or more favorable capital structure could explain the P/E multiple difference.
Choice “a” is incorrect. If the market undervalues risk in the peer group, it would ascribe a higher price and P/E to the peer group rather than to Pet Company. If qualitative factors favored the peer group over Pet Food, the analysts would probably determine that Pet Food was overvalued, consistent with its relative P/E ratio being greater than the peer group’s ratio.
Choice “c” is incorrect. If the market overvalues growth in the industry sector, inflated stock prices for the peer group industry would result. This would likely lead to the analyst describing Pet Food Company stock as overvalued, not undervalued.
Explanation:
This is an example of a merger to take advantage of complementary resources. The smaller firms would not be in a position to realize their market potential if required to establish comprehensive distribution networks from scratch.
Choice “a” is incorrect. It is not in the best interests of shareholders for management to seek growth through mergers to improve their power and prestige in the business community.
Choice “b” is incorrect. Although diversification does reduce risk, this is not specific to within-company diversification efforts – unless investors’ market diversification opportunities are restricted. Diversification has been shown to be easier and cheaper for stockholders than individual corporations. Markets frequently apply holding company discounts for expansions made in the name of “risk reduction.”
Explanation:
The constant-growth free cash flow to common equity model assumes, by definition, a constant growth rate.
Choice “a” is incorrect. This is the definition of the multi-stage free cash flow model; a period of fast growth followed by a slower, steadier growth rate forever.
Choice “c” is incorrect. This would require a multi-stage free cash flow model. Each period’s free cash flow during the declining growth would be discounted and then the terminal value is found when growth reaches zero.
Explanation:
This argument states cash flow factors that make the immediate infusion of cash a positive outcome, given the expansion requirements and pending placement.
Choice “a” is incorrect. This is an argument of poor fit of division, a belief that the division’s assets can be more profitably managed by those specializing in that particular line of business. When this is the case, a company is more likely to divest the assets than to acquire the competitors that can operate the divisions more profitable.
Choice “c” is incorrect. This is a form of involuntary divestiture that can be ordered by either the Federal Trade Commission (“FTC”) or the Justice Department. The instruction occurs after a merger or acquisition has been agreed on and is the result of the combined firm’s impact on market share and competition. The question relates specifically to planning for the stock offering; any acquisition is speculative at this stage.
Explanation:
This represents an accurate statement as the price does differ. The same formulas are used to price forward and futures. This is only true if the cash flows in the margin accounts and resulting interest earnings or charges are ignored. These cash flows do create subtle differences. The second part of the statement is also correct. Futures (and forward) prices equal:
Choice “a” is incorrect. First, the futures and spot will be equal at contract expiration (the convergence principal). Second, they could be equal if the risk-free discounting rate and dividend yield happened to exactly offset each other. Also, the current futures price is not a simple projection of what the market expects the asset to be worth at a future date, because the contract reflects a risk-free return and the asset reflects a risky asset return.
Choice “b” is incorrect. The value of a futures contract resets to zero at mark-to-market, while the value of a forward can be either positive (above futures value of zero) or negative (below futures value of zero).
Explanation:
Because an asset that receives floating-rate payments is likely to have a lower duration than an asset that receives fixed-rate payments, an interest rate swap position that pays fixed and receives floating would most likely decrease the duration of a fixed-income portfolio.
Explanation:
P/E does not make economic sense with an insignificantly small (or zero, or negative) denominator.
Choice “b” is incorrect. Absolute valuation models (rather than relative valuation models) use cash flow forecasts.
Choice “c” is incorrect. This is a shortcoming of the absolute valuation models rather than the relative valuation models.
Explanation:
A stock purchase is more likely when the target is hostile to the proposed merger because an asset purchase would ordinarily involve negotiations between two mutually agreeable parties. A poison pill is a pre-offer defense. If one were in place, it would be employed, but if it existed it is far less likely that a hostile merger would ever be proposed. Hence, greenmail is a more likely defense mechanism because it is a post-offer takeover defense.
Explanation:
The CDS upfront payment may either be from the protection buyer to the seller, or vice-versa. If the credit spread is equal to the coupon rate, the upfront payment can be zero. CDS are valued by calculating the difference between the present value of the protection leg, versus the present value of the payment leg. The amount of upfront payment depends on the difference between the credit spread on the reference obligation and the CDS coupon rate, and hence need not be higher for a high-yield bond compared to an investment grade bond.
Explanation:
Empirical studies have shown management at private companies that formerly were public have a greater focus on the long-term, even if long-term planning affects short-term profitability. Management at public companies, in contrast, has to deal with quarterly reporting requirements, which place constant pressure on management to produce consistent, stable earnings in the short-term.
Choice “a” is incorrect. Public reporting requirements have become more stringent and expensive in recent years. These requirements, however, do not necessarily confer a significant advantage to a private company versus a public company.
Choice “c” is incorrect. Many public companies display entrepreneurship. Private companies do not have an inherently greater ability to be entrepreneurial than public companies. The higher degree of leverage in a company owned by a private equity firm, in fact, may prevent management from taking reasonable risk.
Explanation:
RMSE is a measure of error hence the lower the better. It should be calculated on the out-of-sample data i.e. the data not directly used in the development of the model. This measure thus indicates the predictive power of our model.
Explanation:
Volatility and option value are positively related, so a decrease in volatility will cause a decrease in the option price for both calls and puts.
Explanation:
The country risk rating model begins with a model from a developed country, then modifies that model with inputs from an emerging market to derive a risk premium for the emerging market. Forecasts of exchange rates may well be part of the model, but they are not a requirement.
Explanation:
Cannibalization effects existing companies with a decrease in sales, which, in turn, will decrease profits.
Explanation:
Vega is a measure of the change in the option price caused by a change in volatility of the return on the underlying asset.
Choice “a” is incorrect. Delta is a measure of the change in the option’s price caused by a change in the underlying asset price.
Choice “b” is incorrect. Rho is a measure of the change in the option price caused by a change in interest rates.
Explanation:
The general form of the two-factor APT model is: E(RPort) = RF = λ1β1 + λ2β2, where the λ’s are the factor risk premiums and the β’s are the portfolio’s factor sensitivities. Substituting the appropriate values, we have:
RPort = 0.03 + 0.02(−1.2) + 0.03(0.80) = 3.0%
Explanation:
When the actual futures price is above the theoretical futures price, a cash-and-carry arbitrage should be performed. To do this, the arbitrageur should buy the cheapest to delivery Treasury bond and sell the overpriced futures contract.
Choice “a” is incorrect. Reverse cash-and carry should be performed when the actual futures price is below the theoretical futures price.
Choice “b” is incorrect. Buying both assets is not arbitrage, it is double exposure.
Exam Hint: When the “actual price” of any asset is low it should be bought, and when the “actual price” is high it should be sold. Remember to, “buy low, sell high!!”
Explanation:
If there is a decrease in the underlying stock price, the value of a call, which is the right to buy the stock would decrease in value and the ability to sell a stock at a set price in light of a market decline increases the value of the put.
Choice “a” is incorrect. An increase in the underlying stock price increases the value of a call and decreases the value of a put.
Choice “c” is incorrect. A decrease in volatility impacts both the call and the put in the same direction; it decreases the value of both options.
Explanation:
Because the FRA is based on an interest rate, this interest rate is not ‘‘earned’’ until the maturity of the Eurodollar deposit. However the present value of the coupon exchanges is made at contract expiration.
Choice ‘‘a’’ is incorrect. The short position in an FRA is equivalent to a pay floating, receive fixed position, not vice versa. Thus, this position benefits when interest rates decrease. In an FRA, the long position pays the fixed FRA rate, and effectively receives the floating rate.
Choice ‘‘b’’ is incorrect. In an FRA, the underlying is simply an interest rate, typically a rate on a Eurodollar time deposit. In an FRA the long position agrees to pay the fixed FRA rate and receive the actual spot rate at the time the FRA expires. Thus, the long position will benefit when short-term rates increase.
Explanation:
Supermajority amendments are a common preventative step to block mergers.
Choice “b” is incorrect. Poison puts are offered to bondholders, not shareholders. Poison puts are an earlier stage amendment allowing bondholders the right to demand repayment in the event of a hostile takeover. Poison pills are offered to shareholders. Poison pills are put in place pre-offer to refuse control to the bidding company. This is done by triggering a generous share issue to existing shareholders.
Choice “c” is incorrect. An asset restructuring is the least viable form of takeover defense for this situation. Restructuring assets is largely a post-offer defense.
Explanation:
CDS fixed payments are customarily set at a fixed annual rate of 1% for investment-grade debt or 5% for high-yield debt. Fixed payments are made by the CDS buyer to the CDS seller. The protection buyer is obligated to make regular payments until maturity of the CDS or until default (whichever occurs first).
Explanation:
Expanded CAPM adds premiums for size and firm-specific risk. CAPM may not be appropriate for private firms because beta is usually estimated from public firm returns. The build-up method adds an industry risk and other risk premiums to market rate of return; it is used when betas for comparable public firms are not available.
Explanation:
Since the P/E ratio was 12 and EPS was $4, the price of the stock was $48 (12 × 4). After removing the nonrecurring gain, earnings will be $94.5 million (126 − 31.5). We know the number of shares is 31.5 million (126 Million ÷ 4). So the new EPS number is 3 (94.5 million ÷ 31.5 million) and new P/E ratio is 16 (48 ÷ 3).
Explanation:
An underlying assumption of the Black-Scholes-Merton model is that the risk-free interest rate is known and is constant over the life of the option.
Choice “a” is incorrect. An underlying assumption of the Black-Scholes-Merton model is that volatility of the underlying asset’s returns is known and is constant over the life of an option.
Choice “b” is incorrect. The Black-Scholes-Merton model ignores transaction costs, such as commissions.
Explanation:
The collateral yield is the return on the cash used to collateralize the futures position and is independent of the futures price.
Explanation:
Only held-to-maturity securities are reported on the balance sheet at amortized cost.
Choice “b” is incorrect. Available-for-sale securities are reported at fair value. Under both IFRS and U.S. GAAP, available-for-sale securities differ from securities classified as fair value through profit or loss in that unrealized gains & losses on available-for-sale securities do not impact the income statement, but rather affect the shareholder’s equity portion of the balance sheet directly.
Choice “c” is incorrect. Trading securities are reported at fair value.
Explanation:
It is important that we check for correlations across variables before we run a simulation, in order to identify variables that are likely to be correlated with each other. After identifying correlated variables, we can address the issue by either choosing only one of the inputs to vary, or by explicitly building that correlation into the simulation.
Explanation:
Given relatively well-known cash flow streams, the discounted cash flow method of valuation is most appropriate. The contracts securing revenue streams and fixing variable costs create strong arguments for relying on this method of valuation.
Choice “b” is incorrect. One advantage of comparable transaction analysis over comparable company analysis is that takeover premiums are incorporated into the multiples found from actual transactions of businesses bought or sold. However, the issue with using this approach as with using comparable company analysis is that comparables do not seem like an option given the unique nature of the business. Basing a valuation on similar businesses may help, but would not be most appropriate given the advantage of well-known cash flows of the target.
Choice “c” is incorrect. The question emphasizes that the manufacturer is unique. Thus, basing a valuation on comparable companies does not sound like an ideal choice. Given a lack of comparables, calculating a takeover premium also does not sound feasible.
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