Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is FreedomCorporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine MidwestNews's required relurn on equity is presented in Exhibit 2.The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.Statement I: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.Using the single-stage residual income model and assuming the I required return on equity is 15%, the value of Midwest News is closest to: (use information inExhibits I and 2)
Robert Williams is a junior analyst at Anderson Brothers, a large Wall Street brokerage firm. He reports to Will McDonald, the chief economist for AndersonBrothers. McDonald provides economic research, forecasts, and interpretation of economic data to all of Anderson's investment departments, as well as the firm's clients. McDonald has asked Williams to analyze economic trends in the country of Bundovia. The currency of Bundovia is the Bunco (BU).Williams first analyzes the effect of rising nominal Bundovian interest rates relative to U.S interest rates on the supply and demand for BU. He determines that the increase in Bundovian nominal interest rates would increase the demand for BU and, because the BU supply curve is upward sloping, the BU will appreciate and the equilibrium quantity of BU will increase proportionately.Bundovia has announced plans to impose either a tariff or a quota on semiconductor imports from the United States. McDonald also asks Williams to analyze the potential effect on Bundovian Semiconductors, the dominant semiconductor manufacturer located in Bundovia. Currently, Bundovian Semiconductors is not competitive in the global semiconductor market because its higher production costs make it unable to generate profits at the current world market price. Williams concludes that the imposition of either a tariff or quotas would benefit Bundovian Semiconductors. The company would become competitive with foreign producers in its domestic semiconductor market because imports would be reduced and domestic production would rise.Exhibit 1 shows the trend in the average BU/USD exchange rate over the past three years.Williams asks the bank for a GBP/SFr cross rate.From the same bank, Williams receives the following forward rate quotes in the USD/GBP market:"¢ 30-day forward rate: USD/GBP = USD/GBP = 2.0045 - 55"¢ 60-day forward rate: USD/GBP = USD/GBP = 2.0075 - 85Williams has uncovered a potential arbitrage opportunity in the foreign exchange markets. The current spot rate is $2.00 per BU. The Bundovian risk-free interest rate is 3%, and the one-year forward rate is $2.10 per BU. The U.S. risk-free rate is 5%.Is Williams correct in his conclusions that Bundovian Semiconductors would benefit from the imposition of a tariff or quota?
Tamara Ogle, CFA, and Isaac Segovia, CAIA, are portfolio managers for Luca's Investment Management (Luca's). Ogle and Segovia both manage large institutional investment portfolios for Luca's and are researching portfolio optimization strategies.Ogle and Segovia begin by researching the merits of active versus passive portfolio management. Ogle advocates a passive approach, pointing out that on a risk- adjusted basis, most managers cannot beat a passive index strategy. Segovia points out that there will always be a need for active portfolio managers because as prices deviate from fair value, active managers will bring prices back into equilibrium. They determine that Treynor-Black models permit active management within the context of normally efficient markets.Ogle decides to implement Treynor-Black models in her practice and starts the implementation process. In conversations with her largest client's risk manager,Jim King, FRM, she is asked about separation theorem in relation to active portfolio management. She responds that separation theorem more properly relates to asset prices deviating from and gravitating toward their theoretical fair price. King next asks Ogle about the differences between the Sharpe ratio and the information ratio and the difference between the security market line (SML) and the capital market line (CML).After reallocating her client portfolios based on using the Treynor-Black model, Ogle discusses the results with Segovia. Ogle states that she is satisfied with the current methodology, but given her preference for passive management, she is still concerned about relying on analyst's forecasts. Segovia tells Ogle that he will research methods for modifying the Treynor-Black model to account for analyst forecasts.Which of the following is most accurate regarding the separation theorem?
Samuel Edson, CFA, portfolio manager for Driver Associates, employs a multifactor model to evaluate individual stocks and portfolios. Edson examines several possible risk factors and finds two that are priced in the marketplace. These two factors are investor sentiment (IS) risk and business cycle (BC) risk. Edson manages three equity portfolios (A, Bt and Q and derives the following relationships for each portfolio, as well as for the S&P 500 stock market index:Portfolios A and B are well-diversified, while C is a less than fully diversified, value-oriented portfolio. FJS is the surprise in investor sentiment, and FBC is the surprise in the business cycle. Surprises in the risk factors are defined as the difference between the actual value and the predicted value.Exhibit 1 provides data for the actual and predicted values for the investor sentiment and business cycle risk factors.Driver Associates uses a two-factor Arbitrage Pricing Model to develop equilibrium expected returns for individual stocks and portfolios:Valry is concerned that the economy did not perform as originally predicted by Driver Associates. She informs Edson that the returns for all the portfolios will likely differ from their expected returns. Use the multifactor equation (1) and the data provided in Exhibit 1 to find the revised returns for Portfolio A.
MPT Associates (MPTA) is an investment advisory firm that makes asset allocation and stock selection recommendations for its clients. MPTA currently manages three portfolios: X, Y, and Z. Portfolio X is the mean-variance efficient market portfolio. Portfolio Y is the portfolio of risky assets with minimum variance. Portfolio Z consists exclusively of 90-day Treasury bills. The three portfolios have the following characteristics:Expected return for Portfolio X =15%Standard deviation of returns for Portfolio X = 20%Expected return for Portfolio Y = 7%Standard deviation of returns for Portfolio Y = 5%Expected return on Portfolio Z = 5%Recently, MPTA was contacted simultaneously by two clients: Danielle Burk and Derek Kitna. Burk and Kitna have known each other since college and are both currently working for the same company.Burk currently owns a $100,000 portfolio which she is holding in her Roth IRA retirement account. Her investment strategy is a passive approach. Her retirement portfolio has the following risk-return characteristics:Expected return on Burk's portfolio = 10%Standard deviation of returns on Burk's portfolio = 12%Kitna requests advice from MPTA on the proper valuation of two stocks that he is considering. Kitna is interested in determining the fair value of shares of LongDrives, Inc. (LDI), a manufacturer of state-of-the-art golf clubs, and of Cell Chip Technologies (CCT), a manufacturer of cell phone chip processors. MPTA maintains a database of analyst forecasts and finds that the I -year consensus analyst forecast return for the CCT stock equals 15% and the LDI stock equals 13%.After lengthy conversations with both Burk and Kitna, MPTA decides to advise both of them to use the capital market line, security market line, and capital asset pricing mode! as their primary analytical tools.MPTA's senior executives are analyzing trends in asset pricing over the past several decades. They conclude that in the period 1998-1999, there was a bubble in stock prices. Stock prices subsequently corrected, however, from 2000-2001. They believe that the downward trend in stock prices from 2002-2003 was an overcorrection; that is, prices fell significantly below fundamental values.MPTA executives have been discussing the use of the Treynor-Black model with the investment consultants, Benesh Associates. The advisors at Benesh recommend that each investor be allocated a combination of a passive portfolio and an actively managed portfolio, depending on the investor's risk and return preferences. In his presentation on the Treynor-Black model, David Benesh, the principal at Benesh Associates, makes the following statements:Statement 1: With respect to the actively managed portfolio, the Treynor-Black model will allocate more funds to securities with large alphas and low systematic risk.Statement 2; The capital asset pricing model assumes that short selling of securities is unrestricted and that unlimited borrowing at the risk-free rate is allowed. If these assumptions are violated, then the relationship between expected return and beta might not be linear. Unlike the theoretical capital asset pricing model, theTreynor-Black model avoids this problem because it does not consider short positions in securities.In further discussion, Benesh recommends that MPTA consider subscribing to the investment newsletters of two independent equity analysts: Jack Nast andElizabeth Tackacs. Their alphas, residual risk, and correlation between forecasted and realized alphas arc provided in the table below.Kitna has hired MPTA to evaluate the CCT stock and to make a valuation recommendation. In order to determine if the CCT stock is undervalued, overvalued, or properly valued, MPTA must first determine the appropriate value for the CCT beta. Given a CCT beta of 1.5, what is the conclusion that MPTA should make about the value of CCT based on the consensus analyst forecast of CCT returns?
