Web Problems - · PDF fileTOY INDUSTRY CHARACTERISTICS Industry Life Cycle 1. U.S. toy sales grew by 5 percent compounded annually over the past 10 years. However, toy sales

CHAPTER 9

1. CFA Examination Level IIThe arbitrage pricing theory (APT) and the capital asset pricing model (CAPM) have received muchattention from practitioners and academicians for use in asset pricing and valuation.a. Explain the difference between APT and the CAPM with respect to:

(1) investor utility functions(2) distribution of returns(3) the market portfolio

b. Explain one conceptual difference between the APT and the CAPM other than those listed in Part a.2. Describe the three risk factors specified by the Fama and French multifactor model. How do these

factors differ from those used in macroeconomic-based approaches to risk factor development suchas that used by Chen, Roll, and Ross?

3. CFA Examination Level IIIMultifactor models of security returns have received increased attention. The arbitrage pricing the-ory (APT) probably has drawn the most attention and has been proposed as a replacement for thecapital asset pricing model (CAPM).a. Briefly explain the primary differences between the APT and the CAPM.b. Identify the four systematic factors suggested by Roll and Ross that determine an asset’s riskiness.

Explain how these factors affect an asset’s expected rate of return.

CHAPTER 10

1. CFA Examination Level IIPatricia Bouvier, CFA, is an analyst following Telluride. In reviewing Telluride’s 1999 annual re-port, Bouvier discovers the following footnotes:Footnote (1) During the fourth quarter of 1999, Telluride changed its accounting policy from ex-

pensing to capitalizing software expenditures. The amount capitalized in 1999 was $15 million,including $12 million that had been expensed during the first three quarters of the year.

Footnote (2) On December 31, 1999, Telluride established a restructuring charge of $20 million ofwhich $8 million was for severance pay for workers who would be terminated in the year 2000and $12 million was for the write down of assets on December 31, 1999.

Footnote (3) Telluride leases assets under an operating lease that expired on December 31, 1999.The lease renewal terms required Telluride to capitalize the lease, which has a present value of$50 million. The amount of the monthly lease payment does not change.

Indicate, for each of the three footnotes, the effect of the adjustments on the financial ratios shownin the following template for:i. the year 1999

ii. the year 2000 compared to adjusted 1999

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TEMPLATE FOR QUESTION 1

Effect on 1999 Effect on 2000 Ratio Compared to Ratio Ratio (circle one) Adjusted 1999 Ratio (circle one)

Footnote (1)

Operating Cash Flow/Sales Increase IncreaseDecrease DecreaseNo Effect No Effect

Net Income/Sales Increase IncreaseDecrease DecreaseNo Effect No Effect

Sales/Net Fixed Assets Increase IncreaseDecrease DecreaseNo Effect No Effect

Footnote (2)



Sales/Net Fixed Assets Increase IncreaseDecrease DecreaseNo Effect No Effect

Footnote (3)



Sales/Net Fixed Assets Increase IncreaseDecrease Decrease

No Effect No Effect

2. CFA Examination Level IICandidates should use Exhibits 10.1, 10.2, and 10.3 to answer Question 2.

One of the companies that Jones is researching is Mackinac Inc., a U.S.-based manufacturingcompany. Mackinac has released its June 2001 financial statements, which are shown in Exhibits10.1, 10.2, and 10.3.

Note: Assume all financial information remains unchanged from 1999 through 2000, except that refer-enced in the footnotes above.

Answer this question using the following template. (18 minutes)

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Sales $250,000Cost of Goods Sold 125,000

Gross Operating Profit $125,000Selling, General, and Administrative Expenses 50,000

Earnings Before Interest, Taxes, Depreciation,and Amortization (EBITDA) $ 75,000

Depreciation and Amortization 10,500

Earnings Before Interest and Taxes (EBIT) $ 64,500Interest Expense 11,000

Pretax Income $ 53,500Income Taxes 16,050

Net Income $ 37,450Shares Outstanding 13,000Earnings Per Share (EPS) $ 2.88

Exhibit 10.1 Mackinac Inc. Annual Income Statement for the Year Ended June 30, 2001(In Thousands, Except Per-Share Data)

Current Assets:

Cash and Equivalents $ 20,000

Receivables 40,000

Inventories 29,000

Other Current Assets 23,000

Total Current Assets $112,000

Noncurrent Assets:

Property, Plant, and Equipment $145,000

Less: Accumulated Depreciation (43,000)

Net Property, Plant, and Equipment $102,000

Investments 70,000

Other Noncurrent Assets 36,000

Total Noncurrent Assets $208,000

Total Assets $320,000

Current Liabilities:

Accounts Payable $ 41,000

Short-Term Debt 12,000

Other Current Liabilities 17,000

Total Current Liabilities $ 70,000

Exhibit 10.2 Mackinac Inc. Balance Sheet as of June 30, 2001 (In Thousands)

Continued


Jones is particularly interested in Mackinac’s sustainable growth and sources of return.a. Calculate Mackinac’s sustainable growth rate. Show your calculations.

Note: Use June 30, 2001, year-end balance sheet data rather than averages in ratio calculations.(4 minutes)

b. Name each of the five components in the extended DuPont System and calculate a value for eachcomponent for Mackinac.

Note: Use June 30, 2001, year-end balance sheet data rather than averages in ratio calculations.(10 minutes)

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Noncurrent Liabilities:

Long-Term Debt $100,000

Total Noncurrent Liabilities $100,000

Total Liabilities $170,000

Shareholders’ Equity:

Common Equity $ 40,000

Retained Earnings 110,000

Total Equity $150,000

Total Liabilities and Equity $320,000

Exhibit 10.2 Mackinac Inc. Balance Sheet as of June 30, 2001 (In Thousands)(continued)

Cash Flow from Operating Activities:

Net Income $ 37,450

Depreciation and Amortization 10,500

Change in Working Capital:

(Increase) Decrease in Receivables ($ 5,000)

(Increase) Decrease in Inventories (8,000)

Increase (Decrease) in Payables 6,000

Increase (Decrease) in Other Current Liabilities 1,500

Net Change in Working Capital ($ 5,500)

Net Cash from Operating Activities $42,450

Cash Flow from Investing Activities:

Purchase of Property, Plant, and Equipment ($15,000)

Net Cash from Investing Activities ($15,000)

Cash Flow from Financing Activities:

Change in Debt Outstanding $ 4,000

Payment of Cash Dividends (22,470)

Net Cash from Financing Activities ($18,470)

Net Change in Cash and Cash Equivalents $ 8,980

Cash at Beginning of Period 11,020

Cash at End of Period $20,000

Exhibit 10.3 Mackinac Inc. Cash Flow Statement for the Year Ended June 30, 2001 (In Thousands)


CHAPTER 13

1. CFA Examination Level IIScott Kelly, a U.S.-based equity analyst, is analyzing the toy industry to determine which companieswill be most competitive. He has determined that the U.S. toy industry is relatively mature and thatrevenue and earnings growth are slowing. His report contains the following statements:• I recommend that we invest in toy companies with a substantial percentage of revenues derived

from non-U.S. sales.• Companies selected for the portfolio should derive a large portion of revenues from the largest

discount toy retailer.• I am particularly interested in a start-up company that has an exciting new toy coming out based

on a very popular television show.• Although MasterToy has the dominant market share, I feel that smaller companies will have bet-

ter opportunities for growth in a mature market.

State whether each of Kelly’s statements is valid or not valid. Cite two industry characteristics bynumber from the following exhibit to support your decision. [16 minutes]

TOY INDUSTRY CHARACTERISTICS

Industry Life Cycle1. U.S. toy sales grew by 5 percent compounded annually over the past 10 years. However, toy sales

in the United States were down 4 percent last year. Growth of toy sales is expected to be 1.5–3.0percent annually for the next five years.

2. Non-U.S. toy sales grew by 7 percent compounded annually over the past 10 years. Sales growthis expected to be 7–8 percent for the next five years.

3. The toy industry is in a period of rapid consolidation. Companies faced with slower internalgrowth are considering acquisitions to enhance growth.

Demographics4. The birth rate in the United States is expected to decline by 3 percent annually for the next three

years.5. The birth rate in Europe and Asia is expected to increase by 2 percent annually for the next three

years.6. Age demographics are important drivers of demand both in the United States and in target non-

U.S. markets (only 3 percent of the world’s children live in the United States). Per capita con-sumption of toys in non-U.S. markets is lower than in the United States.

Consumer Preference7. Brand names are one of the keys to success in both U.S. and non-U.S. markets. Consumers show

a preference for products manufactured by well-regarded companies.8. Marketing studies indicate that even technologically superior products will be hard to sell when

manufactured by a company without a brand name or without a substantial advertising budget tosupport the product.

9. The top companies dedicate a large amount of money to focus groups and marketing studies inorder to accurately gauge consumer preference.

Market Share10. The world’s two largest toy manufacturers (MasterToy and FunToyz) control more than 75 per-

cent of the U.S. market. No other manufacturer represents more than 5 percent in market share.Economies of scale are important for production, advertisement, and promotion.

11. The larger companies in the industry have the ability to develop lucrative and cost-effective ad-vertising in all media sectors. They have better bargaining power versus the competition and aremore able to negotiate prime-time advertisements.

12. Marketing studies show that sales of products associated with hit movies and television showsare much higher than for competing products without the entertainment tie-in.

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Retail Environment/Distribution13. A major discount toy retailer’s inventory-reduction program has negatively affected earnings for

the group. This distribution channel has been critical to success in the past, accounting for a largepercentage of sales. The company has adopted a new inventory control system in order to oper-ate more efficiently.

14. To reduce dependence on traditional retail channels, companies are diversifying into direct mailand Internet commerce.

15. Global distribution of product is an essential component of long-term growth for industry leaders.

Diversification16. Diversification is a key to success. A niche product can quickly lose its appeal. Typically, compa-

nies that rely on one or two key products fail when popularity fades.17. The top two toy manufacturers have a highly diversified product mix.

CHAPTER 14

1. CFA Examination Level I (adapted) Mulroney recalled from her CFA studies that the constant-growth dividend discount model (DDM)was one way to arrive at a valuation for a company’s common stock. She collected current dividendand stock price data for Eastover and Southampton, shown in Table 14.1.a. Using 11 percent as the required rate of return (i.e., discount rate) and a projected growth rate of 8

percent, compute a constant-growth DDM value for Eastover’s stock and compare the computedvalue for Eastover to its stock price indicated in Table 14.1. Show calculations. [10 minutes]

Mulroney’s supervisor commented that a two-stage DDM may be more appropriate for companiessuch as Eastover and Southampton. Mulroney believes that Eastover and Southampton could growmore rapidly over the next three years and then settle in at a lower but sustainable rate of growth be-yond 2004. Her estimates are indicated in Table 14.2.b. Using 11 percent as the required rate of return, compute the two-stage DDM value of Eastover’s stock

and compare that value to its stock price indicated in Table 14.1. Show calculations. [15 minutes]

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Current Share Current Dividends 2002 EPS Current BookPrice per Share Estimate Value per Share

Eastover (EO) $ 28 $ 1.20 $ 1.60 $ 17.32

Southampton (SHC) 48 1.08 3.00 32.21

S&P Industrials 1100 16.00 48.00 423.08

Table 14.1 Current Information

Next 3 Years Growth Beyond(2002, 2003, 2004) 2004

Eastover (EO) 12% 8%

Southampton (SHC) 13% 7%

Table 14.2 Projected Growth Rates

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c. Discuss two advantages and three disadvantages of using a constant-growth DDM. Briefly discusshow the two-stage DDM improves upon the constant-growth DDM. [10 minutes]

2. CFA Examination Level IIn addition to the dividend discount model (DDM) approach, Mulroney decided to look at theprice/earnings ratio and price/book ratio, relative to the S&P Industrials, for both Eastover andSouthampton. Mulroney elected to perform this analysis using 1997–2001 and current data.a. Using the data in Table 14.3 and Table 14.4, compute both the current and the five-year (1997–2001)

average relative price/earnings ratios and relative price/book ratios for Eastover and Southampton.Discuss each company’s current relative price/earnings ratio as compared to its five-year averagerelative price/earnings ratio and each company’s current relative price/book ratio as compared toits five-year average relative price/book ratio. [10 minutes]

b. Briefly discuss one disadvantage for each of the relative price/earnings and relative price/bookapproach to valuation. [5 minutes]

Chapter 14 7

EASTOVER COMPANY (EO)

1996 1997 1998 1999 2000 2001

Earnings per share $ 1.27 $ 2.12 $ 2.68 $ 1.56 $ 1.87 $ 0.90

Dividends per share 0.87 0.90 1.15 1.20 1.20 1.20

Book value per share 14.82 16.54 18.14 18.55 19.21 17.21

Stock price

High 28 40 30 33 28 30

Low 20 20 23 25 18 20

Close 25 26 25 28 22 27

Average P/E 18.93 14.23 9.93 18.63 12.33 27.83

Average price/book 1.63 1.83 1.53 1.63 1.23 1.53

SOUTHAMPTON COMPANY (SHC)

1996 1997 1998 1999 2000 2001

Earnings per share $1.66 $3.13 $3.55 $5.08 $2.46 $1.75

Dividends per share 0.77 0.79 0.89 0.98 1.04 1.08

Book value per share 24.84 27.47 29.92 30.95 31.54 32.21

Stock price

High 34 40 38 43 45 46

Low 21 22 26 28 20 26

Close 31 27 28 39 27 44

Average P/E 16.63 9.93 9.03 7.03 13.23 20.63

Average price/book 1.13 1.13 1.13 1.23 1.03 1.13

S&P INDUSTRIALS

5-Year Average1996 1997 1998 1999 2000 2001 (1997–2001)

Average P/E 15.83 16.03 11.13 13.93 15.63 19.23 15.23

Average price/book 1.83 2.13 1.93 2.23 2.13 2.33 2.13

Table 14.3

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3. CFA Examination Level IAt year-end 1991, the Wall Street consensus was that Philip Morris’ earnings and dividends wouldgrow at 20 percent for five years after which growth would fall to a market-like 7 percent. Analystsalso projected a required rate of return of 10 percent for the U.S. equity market.a. Using the data in Table 6 and the multistage dividend discount model, calculate the intrinsic

value of Philip Morris stock at year-end 1991. Assume a similar level of risk for Philip Morrisstock as for the typical U.S. stock. Show all work. [7 minutes]

b. Using the data in Table 14.5, calculate Philip Morris’ price/earnings ratio and the price/earningsratio relative to the S&P Industrials Index as of December 31, 1991. [3 minutes]

c. Using the data in Table 14.5, calculate Philip Morris’ price/book ratio and the price/book ratiorelative to the S&P Industrials Index as of December 31, 1991. [3 minutes]

4. CFA Examination Level Ia. State one major advantage and one major disadvantage of each of the three valuation methodolo-

gies you used to value Philip Morris stock in Question 13. [6 minutes]b. State whether Philip Morris stock is undervalued or overvalued as of December 31, 1991. Sup-

port your conclusion using your answers to previous questions and any data provided. (The past10-year average S&P Industrials Index relative price/earnings and price/book ratios for PhilipMorris were 0.80 and 1.61, respectively.) [9 minutes]

5. CFA Examination Level IIYour supervisor has asked you to evaluate the relative attractiveness of the stocks of two very simi-lar chemical companies: Litchfield Chemical Corp. (LCC) and Aminochem Company (AOC). AOCalso has a June 30 fiscal year end. You have compiled the data in Table 14.6 for this purpose. Use aone-year time horizon and assume the following:• Real gross domestic product is expected to rise 5 percent;• S&P Industrials expected total return of 20 percent;• U.S. Treasury bills yield 5 percent; and• 30-year U.S. Treasury bonds yield 8 percent.a. Calculate the value of the common stock of LCC and AOC using the constant-growth dividend

discount model. Show your work. [5 minutes]b. Calculate the expected return over the next year of the common stock of LCC and AOC using the

capital asset pricing model. Show your work. [5 minutes]c. Calculate the internal (implied, normalized, or sustainable) growth rate of LCC and AOC. Show

your work. [5 minutes] d. Recommend LCC or AOC for investment. Justify your choice by using your answers to a, b, and c

and the information in Table 14.6. [10 minutes]6. CFA Examination Level II

Westfield Capital Management Company’s equity investment strategy is to invest in companies with lowprice-to-book ratios, while taking into account differences in solvency and asset utilization. Westfield isconsidering investing in the shares of either Jerry’s Department Stores (JDS) or Miller Stores (MLS).a. Calculate each of the following ratios for both JDS and MLS. Use only the financial data in

Table 14.7. Show your work. [6 minutes](1) Price-to-book ratio(2) Total-debt-to-equity ratio(3) Fixed-asset utilization (turnover)

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Current Current Dividends 2002 EPS Current Book Share Price per Share Estimate Value per Share

Eastover (EO) $ 28 $ 1.20 $ 1.60 $ 17.32Southampton (SHC) 48 1.08 3.00 32.21S&P Industrials 1100 16.00 48.00 423.08

Table 14.4 Current Information

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1991 1981

Income Statement

Operating revenue $56,458 $10,886

Cost of sales 25,612 5,253

Excise taxes on products 8,394 2,580

Gross profit $22,452 $ 3,053

Selling, general, and administrative expenses 13,830 1,741

Operating income $ 8,622 $ 1,312

Interest expense 1,651 232

Pretax earnings $ 6,971 $ 1,080

Provision for income taxes 3,044 420

Net earnings $ 3,927 $ 660

Earnings per share $4.24 $0.66

Dividends per share $1.91 $0.25

Balance Sheet

Current assets $12,594 $ 3,733

Property, plant, and equipment, net 9,946 3,583

Goodwill 18,624 634

Other assets 6,220 1,230

Total assets $47,384 $ 9,180

Current liabilities $11,824 $ 1,936

Long-term debt 14,213 3,499

Deferred taxes 1,803 455

Other liabilities 7,032 56

Stockholders’ equity 12,512 3,234

Total liabilities and stockholders’ equity $47,384 $ 9,180

Other Data

Philip Morris:

Common shares outstanding (millions) 920 1,003

Closing price common stock $80.250 $6.125

S&P Industrials Index:Closing price 417.09 122.55Earnings per share 16.29 15.36Book value per share 161.08 109.43

Table 14.5 Philip Morris Corporation: Selected Financial Statement and Other Data–YearsEnding December 31 ($ Millions Except Per-Share Data)


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Table 14.8 Jerry’s Department Stores: Data extracted from March 31, 1997, FinancialStatement Footnotes

Litchfield Chemical (LCC) Aminochem (AOC)

Current stock price $50 $30

Shares outstanding (millions) 10 20

Projected earnings per share (fiscal 1996) $4.00 $3.20

Projected dividend per share (fiscal 1996) $0.90 $1.60

Projected dividend growth rate 8% 7%

Stock beta 1.2 1.4

Investors’ required rate of return 10% 11%

Balance sheet data (millions) Long-term debt $100 $130Stockholders’ equity $300 $320

Table 14.6

JDS MLS

Sales $21,250 $18,500

PP&E $ 5,700 $ 5,500

Short-term debt $ 0 $ 1,000

Long-term debt $ 2,700 $ 2,500

Common equity $ 6,000 $ 7,500

Issued and outstanding shares as of 3/31/97 250 400

Per-share market price on 5/30/97 $ 51.50 $ 49.50

Table 14.7 Jerry’s Department Stores and Miller Stores: Selected Financial Data at March 31, 1997 (In Millions Except Per-Share Data)

1. The Company conducts the majority of its operations from leased premises, which include distri-bution centers, warehouses, offices, and retail stores. Future minimum lease payments for non-cancelable real and personal property operating leases are as follows:


2. During the fiscal year ended March 31, 1997, the Company sold $800 million of its accounts re-ceivable with recourse, all of which were outstanding at year end.

3. Merchandise inventory. Substantially all merchandise inventory is valued at the lower of cost(first-in, first-out) or market.

4. Substantially all of the Company’s employees are enrolled in Company-sponsored defined-contribution profit sharing and retirement savings plans.

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Operating Leases($ in Millions)

1997 $ 2591998 2131999 1832000 1602001 144Thereafter 706

Total minimum lease payments $1,665

Present value of lease payments $1,000

Weighted-average interest rate 10%

ABO PBO

Vested $1,550 $1,590Nonvested 40 210

Total $1,590 $1,800

Plan assets at fair value = $3,400Accrued pension per 3/31/97 balance sheet = $0

1. The Company’s real estate policy is to own its stores; thus, the Company has no operating leases.2. The Company does not sell or securitize its accounts receivable.3. All inventories are valued on the last-in, first-out (LIFO) cost basis. As of March 31, 1997, invento-

ries were $700 million lower than they would have been had the first-in, first-out (FIFO) cost ba-sis been used.

4. Actuarial present value of accumulated (ABO) and projected (PBO) benefit obligation for its pen-sion plan at March 31, 1997, was as follows ($ in millions):

Table 14.9 Miller Stores: Data extracted from March 31, 1997, Financial Statement Footnotes

b. Select, based on Part a, the company that best meets Westfield’s investment criteria. Justifyyour choice. [4 minutes]

c. Describe, based on Table 14.8 and Table 14.9, the balance sheet adjustments in each of thefollowing areas required to enhance the comparability of JDS and MLS. (A total of four ad-justments is required.) [8 minutes](1) Leases(2) Sale of receivables with recourse


(3) Inventory valuation method(4) Pensions

d. Calculate each of the following ratios for both JDS and MLS using the adjusted financial datafrom Part c. Ignore any income tax effects. Show your work. [12 minutes](1) Book value per common share(2) Total-debt-to-equity ratio(3) Fixed-asset utilization (turnover)

e. Select, based on Part d, the company that best meets Westfield’s investment criteria. Justify yourchoice. [4 minutes]

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Note: Questions 7 – 11 are all related.

Note: Questions 8 through 11 relate to QuickBrush Company and SmileWhiteCorporation. A total of 73 minutes is allocated to these questions. Use thefirst few minutes to review Table 14.11, Table 14.12, and Table 14.13; Exhibit14.2 and Exhibit 14.3; and the questions themselves.

7. CFA Examination Level IIJanet Ludlow is preparing a report on U.S.-based manufacturers in the electric toothbrush industryand has gathered the information shown in Table 14.10 and Exhibit 14.1.

Ludlow’s report concludes that the electric toothbrush industry is in the maturity (i.e., late) phaseof its industry life cycle.a. Select and justify three factors from Table 14.10 that support Ludlow’s conclusion. [6 minutes]b. Select and justify three factors from Exhibit 14.1 that refute Ludlow’s conclusion. [6 minutes]

Year 1992 1993 1994 1995 1996 1997

Return on equity

Electric toothbrush 12.5% 12.0% 15.4% 19.6% 21.6% 21.6%industry index

Market index 10.2 12.4 14.6 19.9 20.4 21.2

Average P/E

Electric toothbrush 28.53 23.23 19.63 18.73 18.53 16.23

industry index

Market index 10.2 12.4 14.6 19.9 18.1 19.1

Dividend payout ratio

Electric toothbrushindustry index 8.8% 8.0% 12.1% 12.1% 14.3% 17.1%

Market index 39.2 40.1 38.6 43.7 41.8 39.1

Average dividend yield

Electric toothbrush industry index 0.3% 0.3% 0.6% 0.7% 0.8% 1.0%

Market index 3.8 3.2 2.6 2.2 2.3 2.1

Table 14.10 Ratios for Electric Toothbrush Industry Index and Broad Stock Market Index


8. CFA Examination Level IIAfter describing the electric toothbrush industry, Janet Ludlow’s report focuses on two companies,QuickBrush Company and SmileWhite Corporation. Her report concludes:

QuickBrush is a more profitable company than SmileWhite, as indicated by the 40 percent sales growth andsubstantially higher margins it has produced over the last few years. SmileWhite’s sales and earnings aregrowing at a 10 percent rate and produce much lower margins. We do not think SmileWhite is capable ofgrowing faster than its recent growth rate of 10 percent whereas QuickBrush can sustain a 30 percent long-term growth rate.

a. Criticize Ludlow’s analysis and conclusion that QuickBrush is more profitable (as defined byreturn on equity (ROE)) than SmileWhite and that it has a higher sustainable growth rate. Useonly the information provided in Table 14.11 and Table 14.12. Support your criticism by calcu-lating and analyzing:• the five components that determine ROE.• the two ratios that determine sustainable growth. [20 minutes]

b. Explain how QuickBrush has produced an average annual earnings per share (EPS) growth rateof 40 percent over the last two years with an ROE that has been declining. Use only the informa-tion provided in Table 14.11. [8 minutes]

Chapter 14 13

• Industry Sales Growth—Industry sales have grown at 15–20 percent per year in recent years andare expected to grow at 10–15 percent per year over the next three years.

• Non-U.S. Markets—Some U.S. manufacturers are attempting to enter fast-growing non-U.S.markets, which remain largely unexploited.

• Mail Order Sales—Some manufacturers have created a new niche in the industry by selling elec-tric toothbrushes directly to customers through mail order. Sales for this industry segment aregrowing at 40 percent per year.

• U.S. Market Penetration—The current penetration rate in the United States is 60 percent ofhouseholds and will be difficult to increase.

• Price Competition—Manufacturers compete fiercely on the basis of price, and price wars withinthe industry are common.

• Niche Markets—Some manufacturers are able to develop new, unexploited niche markets inthe United States based on company reputation, quality, and service.

• Industry Consolidation—Several manufacturers have recently merged, and it is expected thatconsolidation in the industry will increase.

• New Entrants—–New manufacturers continue to enter the market.

Exhibit 14.1 Characteristics of the Electric Toothbrush Manufacturing Industry

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December December December1995 1996 1997

Income Statement

Revenue $3,480 $5,400 $7,760

Cost of goods sold 2,700 4,270 6,050

Selling, general, and admin. expense 500 690 1,000

Depreciation and amortization 30 40 50

Operating income (EBIT) $ 250 $ 400 $ 660

Interest expense 0 0 0

Income before taxes $ 250 $ 400 $ 660

Income taxes 60 110 215

Income after taxes $ 190 $ 290 $ 445

Diluted EPS $ 0.60 $ 0.84 $ 1.18

Average shares outstanding (000) 317 346 376

December December December 3-Year1995 1996 1997 Average

Financial Statistics

COGS as % of sales 77.59% 79.07% 77.96% 78.24%

SG&A as % of sales 14.37 12.78 12.89 13.16

Operating margin 7.18 7.41 8.51

Pretax income/EBIT 100.00 100.00 100.00

Tax rate 24.00 27.50 32.58


Balance Sheet

Cash and cash equivalents $ 460 $ 50 $ 480

Accounts receivable 540 720 950

Inventories 300 430 590

Net property, plant, and equipment 760 1,830 3,450

Total assets $2,060 $3,030 $5,470

Current liabilities $ 860 $1,110 $1,750

Total liabilities $ 860 $1,110 $1,750

Stockholders’ equity 1,200 1,920 3,720

Total liabilities and equity $2,060 $3,030 $5,470

Market price per share $21.00 $30.00 $45.00

Book value per share $ 3.79 $ 5.55 $ 9.89

Annual dividend per share $ 0.00 $ 0.00 $ 0.00

Table 14.11 Quickbrush Company: Financial Statements—Yearly Data ($000 Except Per-Share Data)


Chapter 14 15


Income Statement

Revenue $104,000 $110,400 $119,200

Cost of goods sold 72,800 75,100 79,300

Selling, general, and admin. expense 20,300 22,800 23,900

Depreciation and amortization 4,200 5,600 8,300

Operating income $ 6,700 $ 6,900 $ 7,700

Interest expense 600 350 350

Income before taxes $ 6,100 $ 6,550 $ 7,350

Income taxes 2,100 2,200 2,500

Income after taxes $ 4,000 $ 4,350 $ 4,850

Diluted EPS $ 2.16 $ 2.35 $ 2.62

Average shares outstanding (000) 1,850 1,850 1,850

December December December 3-Year1995 1996 1997 Average

Financial Statistics

COGS as % of sales 70.00% 68.00% 66.53% 68.10%

SG&A as % of sales 19.52 20.64 20.05 20.08

Operating margin 6.44 6.25 6.46

Pretax income/EBIT 91.04 94.93 95.45

Tax rate 34.43 33.59 34.01


Balance Sheet

Cash and cash equivalents $ 7,900 $ 3,300 $ 1,700

Accounts receivable 7,500 8,000 9,000

Inventories 6,300 6,300 5,900

Net property, plant, and equipment 12,000 14,500 17,000

Total assets $33,700 $32,100 $33,600

Current liabilities $ 6,200 $ 7,800 $ 6,600

Long-term debt 9,000 4,300 4,300

Total liabilities $15,200 $12,100 $10,900

Stockholders’ equity 18,500 20,000 22,700

Total liabilities and equity $33,700 $32,100 $33,600

Market price per share $ 23.00 $ 26.00 $ 30.00

Book value per share $ 10.00 $ 10.81 $ 12.27

Annual dividend per share $ 1.42 $ 1.53 $ 1.72

Table 14.12 Smilewhite Corporation: Financial Statements—Yearly Data ($000 Except Per-Share Data)


10. CFA Examination Level IIJanet Ludlow’s firm requires all its analysts to use a two-stage dividend discount model (DDM) andthe capital asset pricing model (CAPM) to value stocks. Using the CAPM and DDM, Ludlow hasvalued QuickBrush Company at $63 per share. She now must value SmileWhite Corporation.a. Calculate the required rate of return for SmileWhite using the information in Table 14.13 and the

CAPM. Show your work. [6 minutes]Ludlow estimates the following EPS and dividend growth rates for SmileWhite:

First 3 years: 12 percent per yearYears thereafter: 9 percent per year

b. Estimate the intrinsic value of SmileWhite using the data from Table 14.12 and Table 14.13 andthe two-stage DDM. Show your work. [12 minutes]

c. Recommend QuickBrush or SmileWhite stock for purchase by comparing each company’sintrinsic value with its current market price. Show your work. [6 minutes]

d. Describe one strength of the two-stage DDM in comparison with the constant-growth DDM.Describe one weakness inherent in all DDMs. [6 minutes]

16 Web Problems

Revenue Will rise 30% from 1997

Cost of goods sold (as % of sales) 3-year historical average

Selling, general, and administrative expense (as % of sales) 3-year historical average

Depreciation and amortization 2% of 1997 property, plant, and equipment

Interest expense Zero

Tax rate 34%

Shares outstanding No change

Exhibit 14.2 Forecast Assumptions: Quickbrush 1998 EPS

QuickBrush SmileWhite

Beta 1.35 1.15

Market price $45.00 $30.00

Intrinsic value $63.00 ?

Notes:

Risk-free rate 4.50%Expected market return 14.50%

Table 14.13 Valuation Information: December 1997

CFA®

CFA®

9. CFA Examination Level IIIn her forecast of 1998 earnings per share for QuickBrush Company, Janet Ludlow has made theassumptions shown in Exhibit 14.2:

Construct a 1998 projected income statement for OuickBrush using the percent-of-sales forecast-ing method based on 1997 data in Table 14.11 and the assumptions in Exhibit 14.2 below. [6 minutes]


Chapter 14 17

QuickBrush SmileWhite

Goodwill The company amortizes goodwill The company amortizes goodwillover 20 years. over 5 years.

Property, plant, and equipment The company uses a straight-line The company uses an accelerateddepreciation method over the depreciation method over theeconomic lives of the assets, economic lives of the assets,which range from 5 to 20 years which range from 5 to 20 forfor buildings. buildings.

Accounts receivable The company uses a bad debt The company uses a bad debtallowance of 2 percent of accounts allowance of 5 percent ofreceivable. accounts receivable.

Exhibit 14.3 Notes to the 1997 Financial Statements

CFA®

CFA®

Note: Use Tables 14.14, 14.15, and 14.16 for Questions 12 and 13.

12. CFA Examination Level IIA company that Jones is researching is Mackinac Inc., a U.S.-based manufacturing company. Mack-inac has released its June 2001 financial statements, which are shown in Tables 14.14, 14.15, and 14.16.Jones is particularly interested in Mackinac’s sustainable growth and sources of return.a. Calculate Mackinac’s sustainable growth rate. Show your calculations. [4 minutes] Note: Use June 30, 2001, year-end balanced sheet data rather than averages in ratio calculations.b. Name each of the five components in the extended DuPont System and calculate a value for each

component for Mackinac. [10 minutes]Note: Use June 30, 2001, year-end balance sheet data rather than averages in ratio calculations.

Sales $250,000

Cost of goods sold 125,000

Gross operating profit $125,000

Selling, general, and administrative expenses 50,000

Earnings before interest, taxes, depreciation, $ 75,000and amortization (EBITDA)

Depreciation and amortization 10,500

Earnings before interest and taxes (EBIT) $ 64,500

Interest expense 11,000

Pretax income $ 53,500

Income taxes 16,050

Net income $ 37,450

Shares outstanding 13,000

Earnings per share (EPS) $ 2.88

Table 14.14 Mackinac Inc. Annual Income Statement for the year ended June 30, 2001(In Thousands, Except Per-Share Data)

11. CFA Examination Level IIThe information in Exhibit 14.3 comes from the 1997 financial statements of QuickBrush Companyand SmileWhite Corporation:

Determine which company has the higher quality of earnings by discussing each of the threenotes. [9 minutes]


18 Web Problems

Current Assets

Cash and equivalents 20,000

Receivables 40,000

Inventories 29,000

Other current assets 23,000

Total current assets $112,000

Noncurrent Assets

Property, plant, and equipment $145,000

Less: accumulated depreciation (43,000)

Net property, plant, and equipment $102,000

Investments 70,000

Other noncurrent assets 36,000

Total noncurrent assets $208,000

Total assets $320,000

Current Liabilities

Accounts payable $ 41,000

Short-term debt 12,000

Other current liabilities 17,000

Total current liabilities $ 70,000

Noncurrent Liabilities

Long-term debt $100,000

Total noncurrent liabilities $100,000

Total liabilities $170,000

Shareholders’ Equity

Common equity $ 40,000

Retained earnings 110,000

Total equity $150,000

Total liabilities and equity $320,000

Table 14.15 Mackinac Inc. Balance Sheet as of June 30, 2001 (In Thousands)

Cash Flow from Operating Activities

Net income $37,450

Depreciation and amortization 10,500

Change in Working Capital

(Increase) decrease in receivables ($ 5,000)

(Increase) decrease in inventories (8,000)

Table 14.16 Mackinac Inc. Cash Flow Statement for the Year Ended June 30, 2001(In Thousands)

Continued


Chapter 14 19

13. CFA Examination Level IIMackinac has announced that it has finalized an agreement to handle North American production ofa successful product currently marketed by a foreign company. Jones decides to value Mackinac us-ing the dividend discount model (DDM) and the free cash flow to equity (FCFE) model. After re-viewing Mackinac’s financial statements in Tables 14.14, 14.15, and 14.16 and forecasts related tothe new production agreement, Jones concludes the following:• Mackinac’s earnings and FCFE are expected to grow 17 percent per year over the next three

years before stabilizing at an annual growth rate of 9 percent.• Mackinac will maintain the current payout ratio.• Mackinac’s beta is 1.25.• The government bond yield is 6 percent and the market equity risk premium is 5 percent.a. Calculate the value of a share of Mackinac’s common stock using the two-stage DDM. Show

your calculations. [8 minutes]b. Calculate the value of a share of Mackinac’s common stock using the two-stage FCFE model.

Show your calculations. [8 minutes]Jones is discussing with a corporate client the possibility of that client acquiring a 70 percent interestin Mackinac.c. Discuss whether the dividend discount model (DDM) or free cash flow to equity (FCFE) model

is more appropriate for this client’s valuation purposes. [3 minutes]

CFA®

Note: Questions 14 through 18 relate to Rio National Corp. A total of 72 minutes isallocated to these questions. Candidates should answer these questions in theorder presented. Exhibits 14.4 through 14.8 relate to Rio National.

14. Rio National Corp. is a U.S.-based company and the largest competitor in its industry. Exhibits 14.4through 14.7 present the financial statements, which are prepared according to U.S. GenerallyAccepted Accounting Principles (U.S. GAAP), and related information for the company. Exhibit 14.8presents relevant industry and market data.

Change in Working Capital

Increase (decrease) in payables 6,000

Increase (decrease) in other current liabilities 1,500

Net change in working capital ($ 5,500)

Net cash from operating activities $42,450

Cash Flow from Investing Activities

Purchase of property, plant, and equipment ($15,000)

Net cash from investing activities ($15,000)

Cash Flow from Financing Activities

Change in debt outstanding $ 4,000

Payment of cash dividends (22,470)

Net cash from financing activities ($18,470)

Net change in cash and cash equivalents $ 8,980

Cash at beginning of period 11,020

Cash at end of period $20,000


20 Web Problems

Revenue $300.80

Total Operating Expenses (173.74)

Operating Profit 127.06

Gain on Sale 4.00

Earnings before Interest, Taxes, 131.06

Depreciation and Amortization (EBITDA)

Depreciation and Amortization (71.17)

Earnings Before Interest and Taxes (EBIT) 59.89

Interest (16.80)

Income Tax Expense (12.93)

Net Income $ 30.16

Exhibit 14.5 Rio National Corp. Summary Income Statement for theYear Ended 31 December 2002 (U.S. $ Millions)

2002 2001

Cash $ 13.00 $5.87

Accounts Receivable 30.00 27.00

Inventory 209.06 189.06

Current Assets $252.06 $221.93

Gross Fixed Assets 474.47 409.47

Accumulated Depreciation (154.17) (90.00)

Net Fixed Assets 320.30 319.47

Total Assets $572.36 $541.40

Accounts Payable $ 25.05 $ 26.05

Notes Payable 0.00 0.00

Current Portion of Long-term Debt 0.00 0.00

Current Liabilities $ 25.05 $ 26.05

Long-term Debt 240.00 245.00

Total Liabilities $265.05 $271.05

Common Stock 160.00 150.00

Retained Earnings 147.31 120.35

Total Shareholders’ Equity $307.31 $270.35

Total Liabilities and Shareholders’ Equity $572.36 $541.40

Exhibit 14.4 Rio National Corp. Summary Balance Sheets on 31 December (U.S. $ Millions)


Chapter 14 21

Note 1: Rio National had $75 million in capital expenditures during the year.

Note 2: A piece of equipment that was originally purchased for $10 million was sold for$7 million at year-end, when it had a net book value of $3 million. Equipment salesare unusual for Rio National.

Note 3: The decrease in long-term debt represents an unscheduled principal repayment;there was no new borrowing during the year.

Note 4: On 1 January 2002, the company received cash from issuing 400,000 shares of com-mon equity at a price of $25.00 per share.

Note 5: A new appraisal during the year increased the estimated market value of land heldfor investment by $2 million, which was not recognized in 2002 income.

Exhibit 14.6 Rio National Corp. Supplemental Notes for 2002

Dividends Paid (U.S. $ millions) $3.20

Weighted Average Shares Outstanding during 2002 16,000,000

Dividend per Share $0.20

Earnings per Share $1.89

Beta 1.80

Note: The dividend payout ratio is expected to be constant.

Exhibit 14.7 Rio National Corp. Common Equity Data for 2002

Risk-free Rate of Return 4.00%

Expected Rate of Return on Market Index 9.00%

Median Industry Price/Earnings (P/E) Ratio 19.90

Expected Industry Earnings Growth Rate 12.00%

Exhibit 14.8 Industry and Market Data 31 December 2002

The portfolio manager of a large mutual fund comments to one of the fund’s analysts, Katrina Shaar:

“We have been considering the purchase of Rio National Corp. equity shares, so I would like you to analyzethe value of the company. To begin, based on Rio National’s past performance, you can assume that thecompany will grow at the same rate as the industry.”

A. Calculate the value of a share of Rio National equity on 31 December 2002, using the Gordongrowth model and the capital asset pricing model. Show your calculations. [6 minutes]

B. Calculate the three components of Rio National’s return on equity for the year 2002, using theDuPont model. Show your calculations.Note: Your calculations should use 2002 beginning-of-year balance sheet values. [6 minutes]

Note: Question 14 has three parts (A, B, C) for a total of 16 minutes.


C. Calculate the sustainable growth rate of Rio National on 31 December 2002.Note: Your calculations should use 2002 beginning-of-year balance sheet values. [4 minutes]

22 Web Problems

Note: Question 15 has three parts (A, B, C) for a total of 20 minutes.

15. While valuing the equity of Rio National Corp., Katrina Shaar is considering the use of either cashflow from operations (CFO) or free cash flow to equity (FCFE) in her valuation process.A. State two adjustments that Shaar should make to cash flow from operations to obtain free cash

flow to equity. Explain why it is necessary to make each of the two adjustments when valuingthe equity of a firm.Note: No calculations are required. [4 minutes]

Shaar decides to calculate Rio National’s FCFE for the year 2002, starting with net income.B. Determine, for each of the five supplemental notes given in Exhibit 14.6:

i. Whether a net positive adjustment, a net negative adjustment, or no adjustment should bemade to net income to calculate Rio National’s free cash flow to equity for the year 2002

ii. The dollar amount of the adjustment, if anyNote: The five supplemental notes given in Exhibit 14.6 are reproduced in the Template forQuestion 15-B.

Answer Question 15-B in the Template below. [10 minutes]C. Calculate Rio National’s free cash flow to equity for the year 2002. Show your calculations.

Note: Your calculations should start with net income. [6 minutes]

TEMPLATE FOR QUESTION 15-B

Determine, for each of thefive supplemental notes,

whether a net positive adjustmenta net negative adjustment, or

no adjustment should be madeto net income to calculate

Five supplemental Rio National’s free cash flow to Determine the dollarnotes given in equity for the year 2002 amount of theExhibit 5-3 (circle one for each note) adjustment, if any

Note 1: Rio National had $75million in capital expendituresduring the year.

Note 2: A piece of equipmentthat was originally purchasedfor $10 million was sold for$7 million at year-end, whenit had a net book value of$3 million. Equipment salesare unusual for Rio National.

Positive

Negative

No Adustment

$

Positive

Negative

No Adustment

$

Continued


Chapter 14 23

16. In the process of gathering data to value the equity of Rio National Corp. using a price-multiple ap-proach, one of Katrina Shaar’s associates has suggested that the earnings per share (EPS) reportedby Rio National may need to be converted to normalized (underlying) earnings.A. Determine, for each of the supplemental notes 2 through 5 given in Exhibit 14.6, the dollar

amount of the adjustment, if any, that should be made to pretax income to calculate Rio Na-tional’s normalized (underlying) net income for the year 2002.Note: The five supplemental notes given in Exhibit 14.6 are reproduced in the Template forQuestion 16-A. Note 1 in the Template for Question 16-A is completed as an example.

Answer Question 16-A in the Template provided on page 24. [4 minutes]

Shaar has revised slightly her estimated earnings growth rate for Rio National and, using normal-ized (underlying) EPS, now wants to compare the current value of Rio National’s equity to that ofthe industry, on a growth-adjusted basis. Selected information about Rio National and the industryis given in Exhibit 14.9.B. State whether, compared to the industry, Rio National’s equity is overvalued or undervalued on a

P/E-to-growth (PEG) basis, using normalized (underlying) earnings per share. Justify yourresponse with one reason. Show your calculations.Note: Your response should assume that the risk of Rio National is similar to the risk of theindustry. [4 minutes]

Positive

Negative

No Adustment

$

Note 3: The decrease in long-term debt represents anunscheduled principal repay-ment; there was no newborrowing during the year.

Note 4: On January 1, 2002,the company received cashfrom issuing 400,000 shares ofcommon equity at a price of$25.00 per share.

Note 5: A new appraisalduring the year increasedthe estimated market valueof land held for investment by$2 million, which was notrecognized in 2002 income.

Note: The five supplemental notes given in Exhibit 14-6 are reproduced in the Template.

Note: Question 16 has two parts (A, B) for a total of 8 minutes.

Positive

Negative

No Adustment

$

Positive

Negative

No Adustment

$


24 Web Problems

Rio National

Estimated Earnings Growth Rate 11.00%Current Share Price $25.00Normalized (underlying) EPS for 2002 $1.71Weighted Average Shares Outstanding during 2002 16,000,000

Industry

Estimated Earnings Growth Rate 12.00%Median Price/Earnings (P/E) Ratio 19.90

Exhibit 14.9 Selected Information Rio National Corp. and Industry

TEMPLATE FOR QUESTION 16-A

Determine, for each of the supple-mental notes 2 through 5 given in

Exhibit 14.6, the dollar amount of the adjustment, if any, that should be

made to pretax income to calculate Five supplemental notes given in Rio National’s normalized (underlying)Exhibit 14.6 net income for the year 2002

Example: Example:

Note 1: Ratio National had $75 million in capital $ No adjustmentexpenditures during the year.

Note 2: A piece of equipment that was originally $purchased for $10 million was sold for $7 million at year-end, when it had a net book value of $3 million. Equipment sales are unusual for Rio National.

Note 3: The decrease in long-term debt represents $an unscheduled principal repayment; there was no new borrowing during the year.

Note 4: On 1 January 2002, the company $received cash from issuing 400,000 shares of common equity at a price of $25.00 per share.

Note 5: A new appraisal during the year $ increased the estimated market value of land held for investment by $2 million, whichwas not recognized in 2002 income.

Note: The five supplemental notes given in Exhibit 16-6 are reproduced in the Template. Note 1 in the Template iscompleted as an example.



Chapter 14 25

17. As part of her valuation process, Katrina Shaar has collected the following comparative informationabout Rio National Corp. and its primary competitor.

1. Rio National’s gross margin is 57 percent, up from 55 percent a year ago. Managementattributes this improvement to cost reductions from continuous efforts to achieve manufactur-ing efficiencies.

2. Rio National is the largest company in the industry. The next largest competitor isGracemoor Inc., which has positioned itself as having high quality products and excellentcustomer service. Gracemoor’s gross margin is 62 percent, which is the highest gross marginin the industry.

3. Rio National’s customer base is:Large volume retailers 45%Ready to assemble product manufacturers 32%Other 23%

Although Rio National is the largest company in the industry, it has relatively few customers.Gracemoor is a substantially smaller company than Rio National but has several times thenumber of customers.

4. Rio National’s management noted that most of Rio’s customers are highly price sensitive, soRio has found it quite difficult to increase prices. These customers, however, have consis-tently purchased in large volumes. Rio’s management believes the Rio’s average selling priceis 20 percent below Gracemoor’s average selling price.

A. Identify the competitive strategy being employed by Rio National and Gracemoor, respectively.Cite two facts about each company that are consistent with that company’s identified strategy.

Answer Question 17-A in the Template provided below. [8 minutes]

TEMPLATE FOR QUESTION 17-A

Identify the competitive Cite two facts about each companystrategy being employed by that are consistent with thatRio National and Gracemore, company’s identified strategy

respectively (circle one for eachcompany)

Cost Leadership

Cost Focus

Rio National Differentiation

Differentiation Focus

Buyer Bargaining Power

Cost Leadership

Cost Focus

Gracemoor Differentiation

Differentiation Focus

Buyer Bargaining Power

1.

2.

1.

2.


26 Web Problems

“Gracemoor Inc. Announces Merger with Remalco Corporation”

Jeff Fedor, President of Gracemoor Inc., and John Rutt, President of Remalco Corporation, arepleased to announce that the firms have reached an agreement to merge operations. The combinedentity, GraceMalco, will have over $250 million in annual revenues and will employ 1,500 people inthree locations.

“The merger of the operations will allow us to reorganize and update manufacturing operations, result-ing in substantial manufacturing cost reductions. GraceMalco will continue the high level of customerand technical support that has been integral to Gracemoor’s prior success but the new company willalso be able to expand the lower margin, high volume consumer markets that have been Remalco’sfocus over the last three years,” said Fedor, the new president of GraceMalco.

After reading the press release, Shaar calls both Rio National and GraceMalco for more details andobtains the following comments:• From Rio National’s Vice President of Investor Relations:

“We believe that the market is large and there is room for more than one company to pursuethe strategy that we have chosen.”

• From the new President of GraceMalco:“Our merged firm will be able to pursue multiple strategies and compete more effectivelyagainst Rio National.”

B. Discuss one threat each that the merger may pose to the sustainability of the competitive strate-gies of the following two companies: [4 minutes]i. Rio National

ii. GraceMalco

A few weeks later, Shaar is reviewing several current e-mail newsletters that focus on this industry.One of the newsletters contains a press release entitled “Gracemoor Inc. Announces Merger withRemalco Corporation.” An extract from this press release is shown below.

Extract from Gracemoor Inc. Press Release

18. The management of Rio National Corp. has now announced the signing of a new marketing agree-ment that will allow the company to sell its products in Southeast Asia. Sophie Delourme, an ana-lyst at Euro-International Co., is analyzing the effect of this announcement on her estimated value ofRio National’s equity. She uses the H-model in her valuation process and has identified the follow-ing inputs:• Rio National’s earnings growth rate is expected to be 30.0 percent in 2003, declining over a five-

year period to a constant growth rate of 12.0 percent in 2008 and thereafter.• Because of the change in risk, the required rate of return (cost of equity) for Rio National is ex-

pected to be 13.5 percent.• The dividend per share for 2002 was $0.20.• The dividend payout ratio is expected to be constant.A. Calculate the estimated value of a share of Rio National’s equity on 31 December 2002, using

the H-model. Show your calculations. [6 minutes]Delourme presents her analysis to her supervisor and concludes:

“Except in rare circumstances, the H-model’s estimated value will be a close approximation toestimated values generated by multi-stage dividend growth models that explicitly forecast divi-dends each year.”

B. State whether Delourme’s conclusion is correct or incorrect. Justify your response with onereason. [4 minutes]



Chapter 16 27

19. After Rio National Corp. announced the new marketing agreement to sell its products in SoutheastAsia, several analysts revised their 2003 outlook for Rio National. Reflecting the new marketingagreement, the current consensus 2003 earnings per share is $2.19 and the current consensus 12-month target share price is $50.00.

Sophie Delourme observes that Rio National’s share price rose from $25.00 to $37.00 after thenew agreement was announced. She believes that Rio National’s required rate of return (cost of eq-uity) is 13.5 percent.

Calculate the present value of growth opportunities (PVGO) reflected in Rio National’s shareprice after the agreement was announced. Show your calculations. [6 minutes]

CHAPTER 16

1. CFA Examination Level IIIGiselle Donovan is the newly appointed Chief Financial Officer of Bontemps International (BI), animport/export firm conducting a worldwide trading business from its principal office in New York.BI is a financially healthy, rapidly growing firm with a young workforce. All liabilities are denomi-nated in U.S. dollars. Its ERISA-qualified defined-benefit pension plan is structured as follows:

Percent Prior YearAllocation Total Return

Higher-Risk Asset Classes

U.S. equities (large capitalization) 35% 10.0%

U.S. equities (small capitalization) 10 12.0

International equities 5 7.0

Total equities 50%

Lower-Risk Asset Classes

U.S. Treasury bills (1-year duration) 10% 4.5

U.S. intermediates and mortgage-backed

securities (4-year duration) 39 1.0

U.S. long-term bonds (10-year duration) 1 19.0*

Total fixed income 50%

Total 100% 10.0%

Present value of plan liabilities $298 million

Market value of plan assets $300 million

Surplus $ 2 million

Duration of liabilities 10 years

Actuarial return assumption 7.0%

BI Board’s long-term total return objective 9.0%

*Income element 7.0%, gain element 12.0%.

The Board is concerned about the pension portfolio’s downside risk and wants to adopt a formal pol-icy for rebalancing the plan’s assets in response to fluctuations in market values. Donovan asks youto review the major strategies that the Board should consider. You are aware of three strategies used

CFA®

Note: Question 19 has one part for a total of 6 minutes.


28 Web Problems

to reallocate between higher-risk and lower-risk assets: “Constant Mix,” “Constant Proportion,” and“Buy and Hold.”a. Describe the primary characteristics of each of these three strategies as they relate to changes in

market values. Identify the market environment in which each strategy should provide the bestrelative performance.

b. Recommend one strategy for the Board’s consideration, taking their concerns into account. Justifyyour choice.

CHAPTER 18

1. CFA Examination Level IIThe shape of the U.S. Treasury yield curve appears to reflect two expected Federal Reserve reduc-tions in the Federal Funds rate. The first reduction of approximately 50 basis points (BP) is expectedsix months from now, and the second reduction of approximately 50 BP is expected one year fromnow. The current U.S. Treasury term premiums are 10 BP per year for each of the next three years(out through the three-year benchmark.)

You agree that the two Federal Reserve reductions described will occur. However, you believethat they will be reversed in a single 100 BP increase in the Federal Funds rate 21⁄2 years from now.You expect term premiums to remain 10 BP per year for each of the next three years (out throughthe three-year benchmark.)a. Describe or draw the shape of the Treasury yield curve out through the three-year benchmark.

(Note to Candidates: Be sure to label your axes and relevant data points carefully.) [4 minutes]b. State which term structure theory supports the shape of the U.S. Treasury yield curve described

in Part a. Justify your choice. [6 minutes]Kent Lewis, an economist, also expects two Federal Reserve reductions in the Federal Funds

rate but believes that the market is too optimistic about how soon they will occur. Lewis believesthat the first 50 BP reduction will be made 1 year from now and that the second 50 BP reductionwill be made 11⁄2 years from now. He expects these reductions to be reversed by a single 100 BPincrease 21⁄2 years from now. He believes that the market will adjust to reflect his beliefs whennew economic data are released over the next two weeks.

Assume you are convinced by Lewis’s argument and are authorized to purchase either the two-year benchmark U.S. Treasury or a Cash/three-year benchmark U.S. Treasury barbell weightedto have the same duration as the two-year U.S. Treasury.

c. Select an investment in either the two-year benchmark U.S. Treasury (bullet) or the Cash/three-year benchmark U.S. Treasury barbell. Justify your choice. [5 minutes]

2. CFA Examination Level IIICharles Investment Management, Inc., a fixed-income manager of U.S.-only portfolios, has pro-vided significant excess returns for its clients through duration and sector management. The firmdefines sectors as either government bonds or corporate bonds. Several of the manager’s clients haveasked the firm about the possibility of investing in international fixed-income markets. These clientsmention the favorable performance of these markets, as exemplified by the “international fixed-income aggregate index” in the accompanying table. The clients are asking Charles to transfer thesame management techniques that it has successfully applied in the U.S. market to internationalfixed-income markets.

ANNUALIZED RATES OF RETURN

Bond Index One Year Five Years

International fixed-income aggregate index, unhedged 1.0% 15.9%

International fixed-income aggregate index, hedged 6.5 7.2

CFA®

CFA®


Chapter 18 29

3. CFA Examination Level IIThe following are the average yields on U.S. Treasury bonds at two different points in time:

CFA®

CFA®

YIELD TO MATURITY

Term to Maturity January 15, 19XX May 15, 19XX

1 year 7.25% 8.05%

2 years 7.50% 7.90%

5 years 7.90% 7.70%

10 years 8.30% 7.45%

15 years 8.45% 7.30%

20 years 8.55% 7.20%

25 years 8.60% 7.10%

a. Assuming a pure expectations hypothesis, define a forward rate. Describe how you would calcu-late the forward rate for a three-year U.S. Treasury bond two years from May 15, 19XX, usingthe actual term structure provided. [3 minutes]

b. Discuss how each of the three major term structure hypotheses could explain the January 15,19XX, term structures shown. [6 minutes]

c. Discuss what happened to the term structure over the time period and the effect of this change onU.S. Treasury bonds of 2 years and 10 years. [5 minutes]

d. Assume that you invest solely on the basis of yield spreads and, in January 19XX, acted upon theexpectation that the yield spread between 1-year and 25-year U.S. Treasuries would return to amore typical spread of 170 basis points. Explain what you would have done on January 15,19XX, and describe the result of this action based upon what happened between January 15,19XX, and May 15, 19XX. [7 minutes]

4. CFA Examination Level IIIEmily Maguire, manager of the actively managed nongovernment bond portion of PTC’s pensionportfolio, has received a fact sheet containing data on a new security offering. It will be a bondissued by a U.S. corporation but denominated in Australian dollars (A$), with both principal andinterest payable in that currency.

The terms of the offering made in June 1992 are as follows:• Issuer—Student Loan Marketing Association (SLMA—a U.S. government sponsored corpora-

tion)• Rating—AAA• Coupon Rate—8.5 percent payable quarterly• Price—par• Maturity—June 30, 1997 (noncallable)• Principal and interest payable in Australian dollars (A$)As an alternative, Maguire finds that five-year U.S. dollar pay notes issued by SLMA yield 6.75 percent.

She prepares an analysis directed at several specific questions, beginning with the following tableof economic data for Australia and the United States.

a. Infer from the preceding table the effect of changes in the U.S. dollar on international fixed-in-come returns for U.S. investors in the past one-year and five-year periods. [6 minutes]

b. Explain why the firm’s techniques to generate excess returns through duration and sector man-agement in U.S. fixed-income markets may not be transferrable to international fixed-incomemarkets. [6 minutes]


30 Web Problems

Assuming that interest rates fall 100 basis points in both the U.S. and Australian markets over thenext year, identify which of these two bonds will increase the most in value, and justify your answer.[7 minutes]

5. CFA Examination Level IIITMP is working with the officer responsible for the defined-benefit pension plan of a U.S. company.She has come to the firm for advice on what she calls “the key elements of non-U.S. dollar fixed-income investing.”

The following information, based on TMP’s assessment of the Italian market, has been developedto illustrate the process by which market and currency expectations are integrated.

LIRA/$(US) EXCHANGE RATE

Expected RateCurrent Rate in Three Months

L1500/$1.00 (US) L1526/$1.00 (US)

ITALIAN GOVERNMENT SECURITIES DATA

Expected YieldModified Current Current to Maturity in

Security Duration Price Yield to Maturity Three Months

Bill 0.25 100.00 12.50% 12.50%

Note 6.00 100.00 10.00% 9.00%

Based on the information provided, calculate the expected return (in U.S. dollars) on each securityover the three-month period. [9 minutes]

6. CFA Examination Level IDuring 1990, Disney issued $2.3 billion face value of zero coupon subordinated notes that resultedin gross proceeds of $965 million. The notes• mature in 2005;• can be exchanged for cash by the note holder at any time for the U.S. dollar equivalent of the cur-

rent market value of 19.651 common shares of Euro Disney per $1,000 face value of notes; and• are callable at any time at their issuance price plus accrued interest.On March 11, 1993, Disney called the notes at a price of $483.50, which is equivalent to a yield tomaturity of 6 percent. On the call date, Euro Disney common stock traded at a price of 86.80 Frenchfrancs per share and the currency exchange rate for U.S. dollars ($US) to French francs (Ffr) was:

$US/FFR FFR/$US

Exchange rate .1761 5.6786

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UNITED STATES AUSTRALIA

Major Economic Indicators 1990 1991 1992E 1990 1991 1992E

Real GNP (annual change) 1.1% 20.5% 2.2% 1.6% 20.5% 3.0%

Consumer expenditures (annual change) 0.9% 0.0% 1.0% 1.1% 20.2% 2.0%

Inflation (annual change) 5.4% 4.2% 3.4% 7.3% 3.2% 3.9%

Long-bond yield (end of year) 8.1% 7.2% 7.0% 9.8% 10.0% 10.2%

Trade balance (U.S. $ billions) 2100 283 280 230 220 275


Chapter 18 31

7. CFA Examination Level IITable 18.1 shows prices as a function of yields for four tranches of a collateralized mortgage obliga-tion (CMO).

YIELD (%)

CMO Tranche 6.0 6.5 7.0 7.5 8.0

T-1 111.5 105.5 100.0 95.0 90.5

T-2 107.5 104.0 100.0 95.5 90.5

T-3 112.0 105.5 100.0 95.5 92.0

T-4 104.5 102.0 100.0 98.5 97.5

Table 18.1 Prices for Four CMO Tranches at Selected Yields

a. Calculate the effective duration of Tranche T-3. Assume that the relevant current yield is 7.0 per-cent. Show your work. [5 minutes]

b. Identify the tranche with the negative convexity. Calculate the effective convexity of this tranche.Show your work. [5 minutes]

Table 18.2 shows the option-adjusted spread for four different mortgage pass-through securities.

c. Identify which of the patterns of option-adjusted spreads shown in Table 18.3 is plausible if theassumed interest rate volatility is 12 percent rather than the 8 percent assumed in Table 18.2. Jus-tify your choice. [5 minutes]

Option-Adjusted Spread Security (in Basis Points)

A 43

B 70

C 89

D 99

Table 18.2 Mortage Pass-Through Option-Adjusted Spreads (Assuming Interest RateVolatility of 8 Percent)

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a. Calculate, as of the call date,(1) the price of a share of Euro Disney expressed in U.S. dollars; and(2) the exchange value (conversion value) of a $1,000 face value note in U.S. dollars.

[6 minutes]b. On July 21, 1993, Disney issued, at par, $300 million of 100-year bonds with a coupon rate of

7.55 percent. The bonds are callable in 30 years at 103.02. From Disney’s point of view, statethree disadvantages of calling the zero coupon notes and effectively replacing part of that debtcapital with the issue of 100-year bonds. [8 minutes]


32 Web Problems

CHAPTER 19

1. CFA Examination Level III (adapted) Hans Kaufmann is a global fixed-income portfolio manager based in Switzerland. His clients areprimarily U.S.-based pension funds. He allocates investments in the United States, Japan, Germany,and the United Kingdom. His approach is to make investment allocation decisions among these fourcountries based on his global economic outlook. To develop this economic outlook, Kaufmann ana-lyzes the following five factors for each country: real economic growth, inflation, monetary policy,interest rates, and exchange rates.

When Kaufmann believes that the four economies are equally attractive for investment purposes,he equally weights investments in the four countries. When the economies are not equally attractive,he overweights the country or countries where he sees the largest potential returns.Table 19.1 through Table 19.5 present relevant economic data and forecasts.a. Indicate, before taking into account currency hedging, whether Kaufmann should overweight or

underweight investments in each country. Justify your position. [15 minutes]b. Briefly describe how your answer to Part a might change with the use of currency-hedging tech-

niques. [5 minutes]

1996 1997 1998 1999E

United States 3.0% 2.9% 2.4% 2.7%Japan 4.7 2.4 3.2 3.4Germany 2.0 2.5 1.5 2.1United Kingdom 3.4 3.0 3.4 2.3

Table 19.1 Real GDP (Annual Changes)

1996 1997 1998 1999E


Table 19.2 GDP Deflator (Annual Changes)

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OPTION-ADJUSTED SPREAD (IN BASIS POINTS)

Security Pattern A Pattern B

A 213 103

B 20 120

C 49 129

D 69 129

Table 18.3 Mortage Pass-Through Option-Adjusted Spreads (Assuming Interest RateVolatility of 12 Percent)


Chapter 19 33

2. CFA Examination Level IIIPTC’s Investment Committee has decided to allocate 50 percent of the pension plan portfolio’sfixed-income investment to non-U.S. government bonds (i.e., bonds representing non-U.S. sover-eign credits). For a number of reasons, BAG—the Committee’s consultant—has recommendedagainst using a pure dedication approach to management of the bonds. Instead, it has presented thecommittee with three alternative strategies for consideration, accompanied by the 15-year historicalperformance data for each strategy shown in Table 19.6.a. Based on the management strategy characteristics set forth in Table 19.6, as well as your general

knowledge, identify and explain three advantages of each strategy as an alternative for the In-vestment Committee to consider. In developing your response, regard yourself as a strong advo-cate as you explain the advantages of each of the three alternatives. [15 minutes]

b. Identify and explain one key disadvantage of each of the three strategies. [5 minutes]PTC has now decided to index the segment of the fixed-income portfolio to be invested in non-U.S.government bonds, using the Salomon Brothers World Government Bond Index as the benchmarkportfolio. Assume this index includes the sovereign credits of nine major countries in the followingproportions:

1996 1997 1998 1999E


Table 19.4 Long-Term Interest Rates (Annual Rates)

1996 1997 1998 1999E

United States (dollars) 1.00 1.00 1.00 1.00Japan (yen) 130.10 121.50 111.40 108.35Germany (marks) 1.95 1.80 1.60 1.52United Kingdom (pounds) 0.67 0.60 0.58 0.59

Sources: International Monetary Fund.

Table 19.5 Exchange Rates (Currency per U.S. Dollars)

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1996 1997 1998 1999E


Table 19.3 Narrow Money (MI) (Annual Changes)


34 Web Problems

Several members of the Investment Committee favor use of the full replication approach to indexingthe non-U.S. government bonds, while the chairman favors use of the stratified sampling approach.As the BAG representative assigned to the PTC account, you have been asked to assist the commit-tee in choosing between the two indexing methods.

Average Average Top Average Bottom StandardReturns Decile Returnsa Decile Returnsb Deviation

Annualized Annualized Annualized of Returns

Strategy CharacteristicsActive management 12.9% 15.6% 6.8% 18.6%

Duration shifts + or – 40% ofSalomon WGB Indexc

Deviations from country allocationbenchmarks in Index areunrestricted

Transactions permitted for anymanagement purpose

Fee: 35 basis points/yearPassive management 11.8% 12.8% 10.7% 16.0%

Duration shifts + or – 5% ofSalomon WGB Indexc

Country allocation deviations limitedrelative to index proportions

Transactions permitted only for replacement of deteriorating credits

Fee: 15 basis points/yearIndexed management 11.3% 12.0% 11.0% 14.9%

Match return of Salomon WGB Indexc

No duration shifts permittedTransactions allowed only for

portfolio rebalancingFee: 6 basis points/year

aTop decile returns are simple average of the 10 best manager records in BAG’s 100-manager universe.bBottom decile returns are a simple average of the 10 worst manager records in BAG’s 100-manager universe.cSalomon Brothers World Government Bond Index (WGB)

Table 19.6 15-Year Historical Universe Performance

Country Weighting

Australia 2%

Canada 8

Denmark 2

France 11

Germany 19

Japan 37

The Netherlands 8

Switzerland 2

United Kingdom 11


Chapter 19 35

c. Describe and evaluate each of these two indexing alternatives for the purpose of creating andmanaging a bond portfolio intended to represent the Salomon Brothers World Government BondIndex benchmark. [10 minutes]

d. Evaluate the appropriateness of using the Salomon Brothers World Government Bond Index as abenchmark for purposes of monitoring PTC’s non-U.S. portfolio exposures in relation to its pen-sion benefit liability exposures. [5 minutes]

3. CFA Examination Level IIAs a new employee at Clayton Asset Management, Emma Bennett has been assigned to evaluate thecredit quality of BRT Corporation bonds. Clayton holds the bonds in its high-yield bond portfolio.The following information is provided to assist in the analysis.

BRT Corporation is a rapidly growing company in the broadcast industry. It has grown primarilythrough a series of aggressive acquisitions.

Early in 1996, BRT announced it was acquiring a competitor in a hostile takeover that woulddouble its assets but also increase debt burdens. The credit rating of BRT debt fell from BBB to BB.The acquisition reduced the financial flexibility of BRT but increased its presence in the broadcast-ing industry.

Now, mid-1997, BRT has announced its merging with another large entertainment company.The merger will alter BRT’s capital structure and place it as a leader in the broadcast industry. Theearly 1996 acquisition combined with this merger will increase the total assets of BRT by a factorof four. A large portion of the total assets are intangible, representing franchise and distributionrights.

Although the outlook for the broadcasting industry remains healthy, large telecommunicationcompanies attempting to enter the broadcasting industry are keeping competitive pressures high.

Laws and regulations also promote the competitiveness of the environment, but initial start-upcosts make it difficult for new companies to enter the industry. Large capital expenditures are re-quired to maintain and improve existing systems as well as to expand current business.

For Bennett’s analysis, she has been provided with the financial data shown in Table 19.7 through Table 19.10.a. Calculate the following ratios using the projected 1997 financial information:

(1) Operating income to sales(2) Earnings before interest and taxes to total assets(3) Times interest earned(4) Long-term debt to total assets [4 minutes]

Projected1993 1994 1995 1996 1997

Current assets $ 654 $ 718 $2,686 $ 2,241 $ 5,255Net fixed assets 391 379 554 1,567 2,583Other assets (Intangibles) 2,982 3,090 3,176 8,946 20,435

Total assets $ 4,027 $ 4,187 $6,416 $ 12,754 $ 28,273Current liabilities $ 799 $ 876 $ 966 $ 1,476 $ 3,731Long-term debt 2,537 2,321 2,378 7,142 15,701Other liabilities 326 292 354 976 349Total equity 365 698 2,718 3,160 8,492

Total liabilities and equity $ 4,027 $ 4,187 $6,416 $ 12,754 $ 28,273

Table 19.7 BRT Corporation Balance Sheet Data at Year End—December 31 (In Millions)

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36 Web Problems

Projected1993 1994 1995 1996 1997

Operating income to sales (%) 14.0% 18.2% 19.2% 10.2% *Sales to total assets 0.39 times 0.41 times 0.31 times 0.32 times 0.33 timesEarnings before interest

and taxes to total assets 5.5% 7.4% 6.0% 3.3% *Times interest earned 0.76 times 1.04 times 2.48 times 1.55 times *Long-term debt to total assets 63.0% 55.4% 37.0% 55.9% *

Table 19.9 BRT Corporation Selected Financial Ratios

AVERAGE RATIOS BY RATING CATEGORY

AA A BBB BB B CCC CC

Financial RatiosOperating income to sales (%) 16.2 13.4 12.1 10.3 8.5 6.4 5.2Sales to total assets 2.50 times 2.00 times 1.50 times 1.00 times 0.75 times 0.50 times 0.25 times Earnings before interest and

taxes to total assets 15.0% 10.0% 8.0% 6.0% 4.0% 3.0% 2.0%Times interest earned 5.54 times 3.62 times 2.29 times 1.56 times 1.04 times 0.79 times 0.75 timesLong-term debt to total assets 19.5% 30.4% 40.2% 51.8% 71.8% 81.0% 85.4%

Bond Credit Spread InformationCurrent yield spread in basis points

over 10-year Treasuries 45 55 85 155 225 275 350

Table 19.10 Clayton Asset Management Credit Rating Standards

Projected1993 1994 1995 1996 1997

Net sales $1,600 $1,712 $2,005 $4,103 $9,436Operating expenses 1,376 1,400 1,620 3,683 8,603

Operating income $ 224 $ 312 $ 385 $ 420 $ 833Interest expense 296 299 155 270 825Income taxes 20 42 130 131 4

Net income $ (92) $ (29) $ 100 $ 19 $ 4

Earnings per share ($ 0.86) ($ 0.24) $ 0.83 $ 0.09 $ 0.01Average price per share $26.30 $34.10 $ 4.90 $40.10 $40.80Average shares outstanding 107 120 121 198 359

Table 19.8 BRT Corporation Income Statement Data—Years ending December 31 (In Millions Except Per-Share Data)


Chapter 20 37

CHAPTER 20

1. CFA Examination Level IICurrent equity call prices for Furniture City are contained in the following table. In reviewing theseprices, Jim Smith, CFA, notices discrepancies between several option prices and basic option pric-ing relationships.

Identify three different apparent pricing discrepancies in the table. Identify which of the basic op-tion-pricing relationships each discrepancy violates. (Note: The fact that option contracts do not al-ways trade at the same time as the underlying stock should not be identified as a discrepancy.)

2. CFA Examination Level IIIOn June 1, 1987, an institutional portfolio manager is managing a $1 million portfolio consisting ofU.S. government bonds. Currently, the portfolio is fully invested in one bond issue—Government8% Bonds due June 1, 2002, selling at a market price of 100.

The manager is concerned about the outlook for interest rates over the next six months. The man-ager believes interest rates will move significantly with probabilities favoring a strong rise in rates,

CLOSING PRICESFURNITURE CITY EQUITY CALL OPTIONSMAY 31, 1997

EXPIRATION MONTH

Stock Close Strike June July August September

1191⁄2 110 87⁄8 12 1⁄2 15 18

1191⁄2 120 11⁄2 33⁄4 3 41⁄4

1191⁄2 130 1 21⁄4 27⁄8 5

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b. Discuss the effect of the 1997 merger on the creditworthiness of BRT through an analysis of eachof the ratios in Part a. [8 minutes]

BRT Corporation 10-year bonds are currently rated BB and are trading at a yield to maturity of 7.70percent. The current 10-year Treasury note is yielding 6.15 percent.c. State and justify, based on your work in Parts a and b, the information in Tables 19.9 and 19.10,

and the introduction, whether Clayton should hold or sell the BRT Corporation bonds in its port-folio. Include a discussion of two qualitative factors. [10 minutes]

Ratio 1997 1998 1999

Sturdy MachinesCash flow/total debt (%) 37.3 31.0 33.0Total debt/capital (%) 38.2 40.1 41.3Pretax interest coverage (3) 4.2 2.3 1.1

Patriot ManufacturingCash flow/total debt (%) 34.6 38.0 43.1Total debt/capital (%) 40.0 37.3 34.9Pretax interest coverage (3) 2.7 4.5 6.1

Table 19.11 Financial Information


38 Web Problems

a. Describe the financial futures-based strategy needed and explain how the strategy allows Delsingto implement her allocation adjustment. No calculations are necessary.

b. Compute the number of each of the following needed to implement Delsing’s asset allocationstrategy:(1) Bond futures contracts (2) Stock index futures contracts

Information for Futures-Based Strategy

Bond portfolio modified duration 5 years

Bond portfolio yield to maturity 7%

Basis point value (BPV) of bond futures $97.85

Stock index futures price $1,378

Stock portfolio beta 1.0

CFA®

but a strong decline is also possible. For the next six-month holding period, the manager’s goal is tostructure a portfolio that will be substantially protected from a rate rise but that will also participatein any market advances.

Other available investment instruments are the following:(1) Futures Contract on Government 8 percent Bonds, due 6/l/02

Futures expiration 12/1/87

Futures current price $101

Contract size $100,000

(2) Option Contracts on Government 8 Percent Bonds, due 6/l/02 expiring 12/1/87

Option Strike Price Market Price Contract Size

Calls 100 4.00 $100,000

Puts 100 2.00 $100,000

(3) Treasury bills maturing 12/1/87, yielding 3 percent for six months.a. Assume that the manager wishes to maintain the current bond holding. Design an option strategy

that will achieve the manager’s goal of protecting against an interest rate rise while also partici-pating in any market advances.

b. Assume that the manager is willing to maintain or sell the current bond holding. With availableinstruments already listed, design two alternative portfolio structures that accomplish the samegoal.

c. Based on the following put-call parity relationship, calculate which of the two strategies designedin Part b should be implemented:

Put Price 5 Call Price 2 Bond Price 1 (Present Value of Exercise Price)

3. CFA Examination Level IIIJanice Delsing, a U.S.-based portfolio manager, manages an $800 million portfolio ($600 million instocks and $200 million in bonds). In reaction to anticipated short-term market events, Delsingwishes to adjust the allocation to 50 percent stock and 50 percent bonds through the use of futures.Her position will be held only until “the time is right to restore the original asset allocation.” Delsingdetermines a financial futures-based asset allocation strategy is appropriate. The stock futures indexmultiplier is 250, and the denomination of the bond futures contract is $100,000. Other informationrelevant to a futures-based strategy is given in the following exhibit.


Chapter 21 39

CHAPTER 21

1. CFA Examination Level III (2004)The Glover Scholastic Aid Foundation has received a €20 million global government bond portfoliofrom a Greek donor. This bond portfolio will be held in euros and managed separately from Glover’sexisting U.S. dollar-denominated assets. Although the bond portfolio is currently unhedged, theportfolio manager, Raine Sofia, is investigating various alternatives to hedge the currency risk of theportfolio.

The bond portfolio’s current allocation and the relevant country performance data are given inExhibits 21.1 and 21.2. Historical correlations for the currencies being considered by Sofia are givenin Exhibit 21.3. Sofia expects that future returns and correlations will be approximately equal tothose given in Exhibits 21.2 and 21.3.A. Calculate the expected total annual return (euro-based) of the current bond portfolio if Sofia de-

cides to leave the currency risk unhedged. Show your calculations.B. Explain, with respect to currency exposure and forward rates, the circumstance in which Sofia

should use a currency forward contract to hedge the current bond portfolio’s exposure to a givencurrency.

C. Determine which one of the currencies being considered by Sofia would be the best proxy hedgefor Country B bonds. Justify your response with two reasons.

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c. Discuss one advantage and one disadvantage of using each of the following for asset allocation:(1) Financial futures (2) Index put options

One month later, the yield to maturity on comparable bond portfolios has increased by 10 ba-sis points and the stock index has risen by $28.

d. Calculate the percentage return (from price changes only) for the past month, assuming:(1) Delsing executed the 50/50 asset allocation strategy using futures.(2) Delsing did not execute the strategy but instead preserved her original long-term asset allocation.

4. a. Use combinations of payoff diagrams similar to those shown in Exhibits 21.10–21.12 to demon-strate why the “synthetic put” version of the put-call-spot parity condition must hold in an arbi-trage-free capital market.

b. Once again using the appropriate payoff diagrams, provide an explanation for the put-call-forward parity relationship of the following equation:

5. You are a market maker in derivative instruments linked to KemCo stock. In addition to acting as adealer in KemCo call options, put options, and forward contracts, you also spend part of your timesurveying other dealers in the industry looking for arbitrage profit opportunities. Currently, themarket-clearing (i.e., zero-value) contract price for a KemCo forward contract with nine months tomaturity is $45. Also, an average of the last few trades involving nine-month KemCo puts with a$45 exercise price revealed a contract price of $3.22.a. If the nine-month T-bill is priced to yield an annual return of 6.5 percent, what bid-ask spread

would you quote for a nine-month KemCo call option struck at a price of $45? In establishingthis spread, first calculate the theoretical no-arbitrage price for the contract and then round thisprice up (or down) to the nearest one-eighth of a dollar for your ask (or bid) quote.

b. Given the prevailing market prices for the forward and put option contracts, what should be thefair market value of KemCo stock at the present time?

S0 5F0, I

(1 1 RFR)r


40 Web Problems

CFA®

Currency € (Greece) A B C D

€ (Greece) 1.00 20.77 0.45 20.57 0.77

A – 1.00 20.61 0.56 20.70

B – – 1.00 20.79 0.88

C – – – 1.00 20.59

D – – – – 1.00

Exhibit 21.3 Historical Currency Correlation Table (1998–2003, Weekly Observations)

Country Allocation (%) Maturity (years)

Greece 25 5

A 40 5

B 10 10

C 10 5

D 15 10

Exhibit 21.1 Glover Scholastic Aid Foundation Current Allocation Global Government Bond Portfolio

5-year 10-year LiquidityExcess Excess Unhedged of 90-day

Cash Bond Bond Currency CurrencyReturn Return Return Return Forward

Country (%) (%) (%) (%) Contracts

Greece 2.0 1.5 2.0 – Good

A 1.0 2.0 3.0 24.0 Good

B 4.0 0.5 1.0 2.0 Fair

C 3.0 1.0 2.0 22.0 Fair

D 2.6 1.4 2.4 23.0 Good

Exhibit 21.2 Country Performance Data (in local currency)

2. CFA Examination Level II (2002)Pamela Itsuji, a currency trader for a Japanese bank, is evaluating the price of a six-month Japaneseyen/U.S. dollar currency futures contract. She gathers the currency and interest rate data shown inExhibit 21.4.

A. Calculate the theoretical price for a six-month Japanese yen/U.S. dollar currency futurescontract, using the data in Exhibit 21.4 and Japanese yen as the local currency. Show yourcalculations.

Itsuji is also reviewing the price of a three-month Japanese yen/U.S. dollar currency futurescontract, using the currency and interest rate data shown in Exhibit 21.5. Because the three-


Chapter 21 41

month Japanese interest rate has just increased to 0.50 percent, Itsuji recognizes that anarbitrage opportunity exists and decides to borrow $1 million U.S. dollars to purchase Japan-ese yen.B. Calculate the yen arbitrage profit from Itsuji’s strategy, using the data in Exhibit 21.5. Show

your calculations.

Japanese Yen/U.S. Dollar Spot Currency Exchange Rate ¥ 124.30000/$1.00000

Six-month Japanese Interest Rate 0.10%

Six-month U.S. Interest Rate 3.80%

Exhibit 21.4 Currency Exchange Rate and Six-Month Interest Rate Data Japan and U.S.

Japanese Yen/U.S. Dollar Spot Currency Exchange Rate ¥ 124.30000/$1.00000

New Three-month Japanese Interest Rate 0.50%

Three-month U.S. Interest Rate 3.50%

Three-month Currency Futures Contract Value ¥123.26050/$1.00000

Exhibit 21.5 Currency Exchange Rate and Three-Month Interest Rate Data Japan and U.S.

CFA®

3. CFA Examination Level II (2004)Maria VanHusen suggests to Sandra Kapple that using forward contracts on fixed income securitiescan be used to protect the value of the Star Hospital Pension Plan’s bond portfolio against the risinginterest rates that Kapple expects. VanHusen prepares the following example to illustrate for Kapplehow such protection would work:• A 10-year bond with a face value of $1,000 is issued today at par value. The bond pays an annual

coupon.• An investor intends to buy this bond today and sell it in six months.• The six-month risk-free interest rate today is 5.00% (annualized).• A six-month forward contract on this bond is available, with a forward price of $1,024,70. The

contract is not an off-market forward contract.• In six months, the price of the bond, including accrued interest, will be $798.40 as a result of a

rise in interest rates.A. Based on VanHusen’s example:

i. State whether the investor should buy or sell the forward contract to protect the value of thebond against rising interest rates during the holding period.

ii. Calculate the value of the forward contract for the investor at the maturity of the forwardcontract. Show your calculations.

iii. Calculate the change in value of the combined portfolio (the underlying bond and the appro-priate forward contract position) six months after contract initiation. Show your calculations.

Kapple tells VanHusen, “Your example does not address the credit risk that will exist at the expira-tion date of the forward contract.”B. Determine if credit risk exists for each of the following parties in VanHusen’s example:

i. Buyer of the forward contractii. Seller of the forward contractJustify each of your responses with one reason.


42 Web Problems

4. CFA Examination Level II (2004)Sandra Kapple asks Maria VanHusen about using futures contracts to protect the value of the StarHospital Pension Plan’s bond portfolio if interest rates rises as Kapple expects.

VanHusen states:• “Selling a bond futures contract will generate positive cash flow in a rising interest rate environ-

ment prior to the maturity of the futures contract.”• “The cost of carry causes bond futures contracts to trade for a higher price than the spot price of

the underlying bond prior to the maturity of the futures contract.”Indicate whether each of VanHusen’s two statement is accurate or inaccurate. Support each of yourresponses with one reason.

5. There are currency futures contracts that allow for the exchange of Mexican pesos and U.S. dollars,while other contracts allow for the exchange of Swiss francs and U.S. dollars. If I am an investorbased in Zurich, explain how I could use these contracts to convert the payoff to a peso-denominatedasset back into francs in two months.

6. It is March 1, and you are a new derivatives trader making a market in forward contracts in Com-modity W. One month ago (February 1), you began your operations with the following transactions,which are described from your perspective:• With Client A: (1) Short a June 1 forward for 10,000 units at a contract price of $25.50/unit.

(2) Long a September 1 forward for 15,000 units at a contract price of $26.20/unit.• With Client B: (3) Short a September 1 forward for 25,000 units at a contract price of $26.40/unit.

Your current (i.e., March 1) contract price quotes are as follows:

Contract Bid Ask

June $24.95 $25.15

September 25.65 25.85

The appropriate discount is 9 percent per annum.a. If Client A just called you wanting to unwind both of its contracts, calculate a fair cash amount

that can be used in settlement today. Would you pay or receive this amount?b. If these contracts had been exchange-traded futures contracts instead of OTC forward contracts,

how would this settlement amount need to be adjusted (assuming the same March 1 contractprices)?

c. Calculate the dollar amount you would lose if Client B called you to default its contractual obliga-tion. (Hint: Compute this amount in the same manner you calculated the net settlement in Part a.)

d. At the time you negotiated the three original agreements (i.e., February 1) did you have any priceexposure on the September contracts? If so, what type of future price movements would be harm-ful to your net profit on the expiration date?

7. The corporate treasurer of XYZ Corp. manages the firm’s pension fund. On February 15, 1993, thetreasurer is informed that the pension fund will be required to sell its $100 million (face value) Trea-sury bond portfolio on August 15, 1993, because of a pending change in the structure of the plan.

The portfolio consists entirely of a single bond issue with a maturity date of August 2019. Thebond pays coupons of 71⁄4 percent and is currently priced at 97–12. This corresponds to a yield of7.479 percent. These T-bonds were originally purchased at par, so the current price reflects a modestcapital loss. The treasurer is concerned that further weakness in the dollar could raise market ratesand exacerbate this loss before the August sale date.

Your task is to construct a hedge using T-bond futures to offset, or at least reduce, the risk expo-sure. Assume an August 1993 futures contract exists with the quoted price of 101–04 and a refer-ence yield to maturity of 7.887 percent (based on an 8 percent coupon and 20 years to maturity). Tocomplete the task, construct a numerical example to show the optimal number of contracts neces-sary to provide the desired price protection.

CFA®


Loan Initiated First Loan Payment (9%) Second Payment and Futures Contract Expires and Principal

a. Formulate Johnson’s September 20 floating-to-fixed-rate strategy using the Eurodollar futurescontracts discussed in the preceding text. Show that this strategy would result in a fixed-rate loan,assuming an increase in the LIBOR rate to 7.8 percent by December 20, which remains at 7.8percent through March 20. Show all calculations.

Johnson is considering a 12-month loan as an alternative. This approach will result in two additionaluncertain cash flows, as follows.

Chapter 21 43

LOAN TERMS

September 20, 1999 December 20, 1999 March 20, 2000

• Borrow $100 million at • Pay interest for first • Pay back principalSeptember 20 LIBOR1200 three months plus interestbasis points (BPS) • Roll loan over at

• September 20 LIBOR 5 7% December 20LIBOR1200 BPS

a. Assuming that interest rates do not change between February and August 1993, what will be thevalue of the T-bond portfolio? Briefly explain why this differs from the current value of $97.375million.

b. As of August 1993, calculate the respective durations of the bond issue in the portfolio and thebond underlying the futures contract. Using the current yields to maturity, translate these intomodified duration form. (Note: In your computation, recall that T-bonds pay semiannual interest.)

c. Assuming that the yield beta (bt ) between the instruments is equal to one, calculate the numberof futures contracts required to form the optimal hedge. In this calculation, keep in mind that theface value of the bond underlying the futures contract is $100,000

8. CFA Examination Level IIIGeorge Johnson is considering a possible six-month $100 million LIBOR-based, floating-rate bankloan to fund a project at the following terms. Johnson fears a possible rise in the LIBOR rate byDecember and wants to use the December Eurodollar futures contract to hedge this risk. Thecontract expires December 20, 1999, has a U.S. $1 million contract size, and a discount yield of 7.3percent.

Johnson will ignore the cash flow implications of marking to market, initial margin requirements,and any timing mismatch between exchange-traded futures contract cash flows and the interestpayments due in March.

CFA®

Loan Initiated First Payment (9%) Second Payment Third Payment Fourth Payment and Principal

9/20/99 12/20/99 3/20/00 6/20/00 9/20/00

b. Describe the strip hedge that Johnson could use and explain how it hedges the 12-month loan(specify number of contracts). No calculations needed.


44 Web Problems

FORMULAS FOR OPTION VALUATION

Where: Where:U 5 1.2214 erDt 5 1.06184

Where:U 5 up movement factorD 5 down movement factorPu 5 probability of an upward price movement

Pu 5e rDt 2 DU 2 D

D 51U

U 5 es"Dt

CFA®

CHAPTER 22

1. CFA Examination Level IIIYou have decided to buy protective put options to protect the U.S. stock holdings of one of GlobalAdvisers Company’s (GAC) portfolios from a potential price decline over the next three months.You have researched the stock index options available in the United States and have assembled thefollowing information:

Average DailyStock Current Strike Trading Index Index Underlying Value Price Put Volume Option Value of One Put of Put Premium of Puts

S&P 100 $365.00 $100 times index 365 $10.25 10,000S&P 500 390.00 $100 times index 390 11.00 4,000NYSE 215.00 $100 times index 215 6.25 1,000

CFA®

(For each stock index option, the total cost of one put is the put premium times 100.)

Beta vs. S&P 500 Correlation with Portfolio

Portfolio 1.05 1.00S&P 100 0.95 0.86S&P 500 1.00 0.95NYSE 1.03 0.91

a. Using all relevant data from the preceding tables, calculate for each stock index option both thenumber and cost of puts required to protect a $7,761,700 diversified equity portfolio from loss.Show all calculations.

b. Recommend and justify which stock index option to use to hedge the portfolio, including refer-ence to two relevant factors other than cost.

You know that it is very unlikely that the current stock index values will be exactly the same as theput strike prices at the time you make your investment decision.c. Explain the importance of the relationship between the strike price of the puts and the current

index values as it affects your investment decision.d. Explain how an option pricing model may help you make an investment decision in this situation.

2. CFA Examination Level IIA stock index is currently trading at 50.00. The annual index standard deviation is 20 percent. PaulTripp, CFA, wants to value two-year index options using the binomial model. To correctly value theoptions, he needs the following formulas. The annual risk-free interest rate is 6 percent. Assume nodividends are paid on any of the underlying securities in the index.


Chapter 22 45

DISCOUNT FACTORS

5.00 Percent 6.00 Percent 7.00 Percent

Period 1 0.95123 0.94176 0.93239

Period 2 0.90484 0.88692 0.86936

Period 3 0.86071 0.83527 0.81058

a. Construct a two-period binomial price tree for the stock index.b. Calculate the value of a European-style index call option with an exercise price of 60.00.c. Calculate the value of a European-style index put option with an exercise price of 60.00.

3. Suppose the current contract price of a futures contract on Commodity Z is $46.50 and the expira-tion date is in exactly six months (i.e., T 5 0.5). The annualized risk-free rate over this period is 5.45percent and the volatility of futures price movement is 23 percent, which is equal to that of the un-derlying commodity.a. Calculate the values for both a call option and a put option for this futures contract, assuming

both have an exercise price of $46.50 and a six-month expiration date.b. Suppose the market prices for these contracts agree with the values you computed in Part a. You

decide to buy the call option and sell the put option. What sort of position have you just created?Under what circumstances (i.e., for what view of subsequent market conditions) would it makesense for an investor to create such a position?

4. CFA Examination Level IIIKen Webster manages a $100 million equity portfolio benchmarked to the S&P 500 index. Over thepast two years, the S&P 500 index has appreciated 60 percent. Webster believes the market is overval-ued when measured by several traditional fundamental/economic indicators. He is concerned aboutmaintaining the excellent gains the portfolio has experienced in the past two years but recognizes thatthe S&P index could still move above its current 668 level. Webster is considering the following optioncollar strategy:• Protection for the portfolio can be attained by purchasing an S&P 500 index put with a strike

price of 665 (just out of the money).• The put can be financed by selling two 675 calls (farther out of the money, for every put purchased).• Because the combined delta of the two calls is less than 1 (that is, 2 3 0.36 5 0.72), the options

will not lose more than the underlying portfolio advances.

The information in the following table describes the two options used to create the collar.

CFA®

OPTIONS TO CREATE THE COLLAR

Characteristics 675 Call 665 Put

Option price $4.30 $8.05Option implied volatility 11.00% 14.00%Option’s delta 0.36 0.44Contracts needed for collar 602 301

Notes:• Ignore transaction costs • S&P 500 historical 30-day volatility 5 12.00%• Time to option expiration 5 30 days


46 Web Problems

CHAPTER 23

1. If the fixed rate on a five-year, plain vanilla swap is currently 8 percent, what would happen ifyou (a) bought a five-year cap agreement with an exercise rate of 7 percent and (b) sold a five-year,7 percent floor agreement? Use the concept of cap-floor-swap parity to describe the kind of positionyou have created and discuss whether or not a front-end cash payment would be necessary andwhether you or your counterparty would receive it.

2. Corporation XYZ seeks USD 100 million, five-year fixed-rate funding. The firm is confident that itcan issue a 61⁄2 percent coupon bond (semiannual payments) at par value. Since the five-year, on-the-run U.S. Treasury issue yields 6.00 percent, this funding could be attained at 50 basis points overTreasuries—a reasonable spread given XYZ’s strong credit rating. The corporate treasurer wouldlike to explore the possibility of issuing a floating-rate note (FRN), possibly a structured note, anduse the interest rate swap market to create synthetic fixed-rate funding.

As the bank relationship officer working with the treasurer, you check with your Capital MarketsGroup to determine that in the current market the following FRNs could be launched for XYZ at parvalue:

Type Reset Formula LIBOR = 5.75%: Initial Coupon

“Straight floater” LIBOR 1 0.10% 5.85%“Bull floater” 12.75% 2 LIBOR 7.00“Bear floater” (2 3 LIBOR) 2 6.40% 5.10

a. Describe the potential returns of the combined portfolio (the underlying portfolio plus the optioncollar) if after 30 days the S&P 500 index has (1) risen approximately 5 percent to 701.00, (2)remained at 668 (no change), and (3) declined by approximately 5 percent to 635.

b. Discuss the effect on the hedge ratio (delta) of each option as the S&P 500 approaches the levelfor each of the potential outcomes listed in Part a.

c. Evaluate the pricing of each of the following in relation to the volatility data provided: (1) theput, (2) the call, and (3) the collar.

d. Explain the term wasting asset in the context of the suggested collar strategy and discuss itseffect on Webster’s management of the portfolio.

5. CFA Examination Level II (2003)Michael Weber, CFA, is analyzing several aspects of option valuation, including the determinants ofthe value of an option, the characteristics of various models used to value options, and the potentialfor divergence of calculated option values from observed market prices.A. State, and justify with one reason for each case, the expected effect on the value of a call option

on common stock if each of the following changes occurs:i. The volatility of the underlying stock price decreases

ii. The time to expiration of the option increasesUsing the Black-Scholes option-pricing model, Weber calculates the price of a three-month call op-tion and notices the option’s calculated value is different from its market price. A colleague verifiesthat Weber’s methodology and results are correct.B. With respect to Weber’s use of the Black-Scholes option-pricing model, and given that his

methodology and results are correct.i. Discuss one reason why the calculated value of an out-of-the-money European option may

differ from that same option’s market price.ii. Discuss one reason why the calculated value of an American option may differ from that

same option’s market price.

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Chapter 23 47

The FRNs are each based on six-month USD LIBOR and make semiannual coupon payments inarrears. Assume that the flotation costs for the fixed-rate bond and various FRNs are the same (andcan therefore be ignored in the comparison). Also, assume that all rates are quoted on a semiannualbond basis so that no day-count conversions need be made.

You also check with the Derivatives Group to ascertain the rates at which XYZ could executefive-year, semiannual settlement plain vanilla swaps:

a. What specific swap transactions are needed to transform each of the FRNs into a synthetic fixedrate?

b. What synthetic fixed rate can be attained by each of the structures? For which possible levels ofLIBOR is a fixed-rate attained?

c. What other derivative instrument(s) would be needed to obtain a truly fixed rate?d. Which structure would you recommend for XYZ?e. What types of investors might be interested in acquiring a bear floater? If an investor’s motive

was to hedge exposure to LIBOR, what might its balance sheet look like?3. CFA Examination Level III

On June 30, 1996, Help for Students (HFS) Foundation owns $10 million (face amount) of 6 per-cent coupon SteelCo. bonds, currently priced at par, which it must hold to maturity on June 30,1998, two years from now. John Ames, HFS’s fixed-income manager, expects that the yield curve,now normal in shape (i.e., positively sloped), will undergo an upward shift and invert sometime priorto maturity. He wishes to enter into a swap on the $10 million notional amount of the holding to takeadvantage of this yield curve forecast. Assume that HFS’s policy permits such action.

Bank’s Bid Bank’s Offer

TSY + 34 BP TSY + 38 BP

where TSY = 6.00%

SELECTED JUNE 30, 1996, MARKET DATA

Price Yield

September 1996 Eurodollar future 94.9 5.1%

2-year swap fixed rate n/a 5.5

CFA®

a. Identify and explain an interest rate swap arrangement that could achieve Ames’s goal in thisparticular instance. Base your response on the preceding data and assume quarterly cash flows.

b. Describe the direction and calculate the amount of the first quarterly cash flow (on September30, 1996) under this arrangement. (Note: Assume that 90-day spot LIBOR on June 30, 1996,equals the September 1996 Eurodollar futures contract settlement yield.)

c. Explain the effect of the interest rate swap created in Part a on the sensitivity of HFS’s portfoliovalue to interest rate changes.

d. Describe the role of the Eurodollar forward rate curve in pricing the fixed-rate payment side ofthe interest rate swap created in Part a.

e. Identify a strategy that would use options to replicate the position of a fixed-rate payer in a swapand explain how this strategy would accomplish its purposes. (Assume no transaction costs.)

4. CFA Examination Level II (2002)Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to manage thecompany’s financial risks.

Two years ago, Rone is issued a $25 million (U.S.$), five-year floating rate note (FRN). TheFRN pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is non-callableand will be repaid at par at maturity.

CFA®


48 Web Problems

CHAPTER 24

1. CFA Examination Level III (2002)Maxwell Arnold recently joined Top-Mark Investments Inc. (TMI) as a senior analyst. TMI is aconservative institution, which has invested only in equities and fixed income securities.

Recently, TMI’s returns have been lower than those of its competitors. A member of TMI’s In-vestment Committee tells Arnold that alternative assets might be used to enhance TMI’s perfor-mance. However, the Investment Committee has not changed its traditional aversion to risk. TheCommittee asks Arnold to evaluate investing in hedge funds or controlled-risk equity strategies toincrease returns without excessive exposure to risk.

Arnold’s report to the Committee contains the following statements:1. Classic hedge funds tend to use long and short positions in publicly traded securities, with

the primary goal of being market-neutral. This strategy allows such funds to focus on stockselection.

CFA®

Scott expects interest rates to increase and she recognizes that Rone could protect itself againstthe increase by using a pay-fixed swap. However, Rone’s Board of Directors prohibits both shortsales of securities and swap transactions. Scott decides to replicate a pay-fixed swap using a combi-nation of capital market instruments.A. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe the required

transactions.B. Explain how the transactions in Part A are equivalent to using a pay-fixed swap.

5. CFA Examination Level II (2002)Rich McDonald, CFA, is evaluating his investment alternatives in Ytel Incorporated by analyzing aYtel convertible bond and Ytel common equity. Characteristics of the two securities are given inExhibit 23-1.A. Calculate, based on Exhibit 23-1, the:

i. Current market conversion price for the Ytel convertible bondii. Expected one-year rate of return for the Ytel convertible bond

iii. Expected one-year rate of return for the Ytel common equityNote: Your responses should ignore taxes and transaction costs.

One year has passed and Ytel’s common equity price has increased to $51 per share. Also, over theyear, the interest rate on Ytel’s non-convertible bonds of the same maturity increased, while creditspreads remained unchanged.B. Name the two components of the convertible bond’s values. Indicate whether the value of each

component should decrease, stay the same, or increase in response to the:i. Increase in Ytel’s common equity price

ii. Increase in interest rates

Characteristic Convertible Bond Common Equity

Par Value $1,000 —-

Coupon (Annual Payment) 4% —-

Current Market Price $980 $35 per share

Straight Bond Value $925 —-

Conversion Ratio 25 —-

Conversion Option At any time —-

Dividend —- $0

Expected Market Price in One Year $1,125 $45 per share

Exhibit 23.1 Ytel Incorporated Convertible Bond and Common Equity Characteristics

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Chapter 25 49

CFA®

2. Like classic hedge funds, current hedge funds are privately organized, pooled investmentvehicles that use leverage. Unlike classic hedge funds, current hedge funds also take posi-tions in derivatives on publicly traded securities.

3. Macro funds use forward and futures contracts to take investment positions in currency,bond, and/or equity markets. Because the currencies and indexes in which macro funds tradeare closely correlated, these funds are able to use very high levels of leverage.

4. Hedge fund managers often use complicated computer models to manage their portfolios.Errors in analyzing data or recording positions can lead on delta, gamma, and vega risks.

A. Indicate one inaccuracy in each of Arnold’s statements.The Committee also asks Arnold to investigate potential risks inherent in hedge fund strategies:Arnold focuses on three such risks:• Liquidity risk• “Herd” risk• Redemption risk

In his report to the Committee, Arnold concludes that liquidity risk and “herd” risk are importantperformance factors in hedge fund investing, but that redemption risk is not an important factorbecause of the structure of hedge funds.B. Indicate whether Arnold’s conclusion about the importance of each of the three risks is correct or

incorrect. Justify each of your responses with one reason.2. CFA Examination Level III (2002)

Maxwell Arnold is also preparing a report about controlled-risk equity strategies for the InvestmentCommittee of Top-Mark Investments Inc. He decides to compare the use of long-only, long-short(market-neutral), and equitized long-short strategies. Arnold knows that his report to the Committeemust address the following questions:

1. Is the long or the short side of a long-short strategy more likely to allow a manager to profitfrom security mispricings, and why?

2. What is the manager’s value-added or payoff from a market-neutral strategy, and what arethe components of the payoff?

3. How do a long-only strategy and a long-short strategy differ with regard to the importance ofbenchmark holdings if the investor is particularly concerned about the residual risk of eachstrategy?

4. How might a manager equitize a long-short strategy without disturbing current portfolioholdings?

5. How do risk levels differ between long-only and long-short management in terms of maxi-mum potential losses?

6. When implementing international long-short strategies, are correlations between strategyreturns or country market returns more important to consider, and why?

Formulate one correct response to each of Arnold’s questions.

CHAPTER 25

1. A fund had an overall performance value of –0.50 percent using the Fama performance technique.Discuss whether the manager of this fund could have experienced a positive selectivity value andunder what conditions that value might have occurred.

2. A portfolio has an R2 with the market of 0.95 and a selectivity value of 2.5 percent. Would youexpect this portfolio to have a positive or a negative net selectivity value? Explain.

3. CFA Examination Level IIIYou have been asked to evaluate the performance of two portfolios: Good Samaritan Hospital’sendowment assets and estate fund of the recently deceased Mrs. Mary Atkins, which has just beentransferred in a bequest to Good Samaritan. The existing Good Samaritan endowment assets(excluding the Atkins estate) have been managed by an investment counseling firm with an incomeobjective of approximately 5 percent annually. The returns from this portfolio and from Mrs. Atkins’portfolio are shown in the following table:

CFA®


50 Web Problems

a. Calculate the risk-adjusted return of each of the two equity-only portfolios. Compare thesereturns to each other and to the S&P 500, and explain the significance of any differences.

b. List and briefly comment on three factors that could account for the difference in reportedperformance between Mrs. Atkins’ and Good Samaritan’s total portfolios.

Latest Fiscal Year BetaTotal Return

Good Samaritan existing endowment assets

—Equity only 11.8% 1.20

—Total portfolio 8.4

Mrs. Atkins’ portfolio

—Equity only 10.7% 1.05

—Total portfolio 5.1

S&P 500 Index 9.9%

Lehman Bond Index 3.4

90-day Treasury bills 7.8

Municipal Bond Index 1.4


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