Volume 4 Question Review

What is the final term in the multistage residual income method where RI fades over time?

(ET−rB) / (1+r−ω)/ (1+r)^T−1

Describe the following Momentum Indicators: a - Earnings Surprise b - Scaled Earnings surprise c - standardized unexpected earnings (SUE) d - relative strength

1 - Earnings Surprise: aka Unexpected earnings, is the difference between reported earnings and expected earnings: UEt=EPSt-E(EPST) 2 - Scaled Earnings Surprise: Earnings surprise scaled by the variability in analyst estimates. Measured by dividing unexpected earnings by std dev of analysts forecasts Scaled Earnings Surprise=UEt/std(forecasts) 3 - Standardized Unexpected Earnings (SUE): scales the earnings surprise relative to past earnings surprise. For instance if a stock has an earnings surprise of .1 and std deviation of past surprises is .4, then earnings surprise is relatively small to past forecast errors. Measured as current earnings surprise divided by standard deviation of past earning surprise: SUE=UEt/std (UEn) 4 - Relative Strength: is a technical indicator that compares a stocks performance during a period either with its own past performance or with the performance of some group of stocks. RSI is based on the premise that patterns of persistence or reversal may exist in stock returns

The market price of Bond B2 is €1,090. If the bond is purchased at this price and there is a default on Date 3, how do you calculate the rate of return to the bond buyer?

1) Find the recovery amount at time three! This is the exposure at time 3 x the recovery rate at time 3 2) Find IRR by plugging in to financial calculator and using IRR function where: CFo = price of bond C1 = coupon C2 = coupon C3 = recoverable amount Solve for IRR!

How do you calculate common shareholders equity?

= Assets - liabilities - value of preferred shares

If the credit spread increases how do you calculate the profit for the buyer of the protection?

= change in spread in bps x duration x notional principal

What is a benefit of the residual income model over other approaches? A. The analyst need not adjust the book value of common equity for non-recurring items. B. The analyst need not adjust book value of common equity for off-balance-sheet items. C. The interest expense in the residual income model correctly captures the cost of debt capital.

A is correct. Although it is important to adjust income for non-recurring items, these adjustments do not need to be made to the book value because they are already reflected in the value of the assets. B is incorrect. It is necessary to adjust for off-balance sheet items C is incorrect. It is a weakness of residual income that interest expense may not reflect the true cost of debt capital.

Hybrid Security

A security that has characteristics like stock and bonds - an example could be a preferred stock.

Classify whether the following should be analyzed using a portfolio approach, statistical approach or loan by loan approach: A. book of loans in short-term structured finance vehicles with granular, homogeneous assets B. medium-term, granular, and heterogeneous obligations, such as auto ABS C. discrete or non-granular heterogeneous portfolios, such as CMBS

A. statistical approach - short-term structured finance vehicles with granular, homogeneous assets tend to be evaluated using a statistical-based (not portfolio-based) approach to the existing book of loans. B. portfolio based approach - A portfolio-based approach is used for medium-term granular and homogeneous obligations because the portfolio is not static but changes over time. C. A loan by loan approach

A company has a required rate of return of 7.35% and a constant growth rate of 3.5% a year indefinitely. Assume that Company ABC stock is fairly valued, then which of the following would most likely be true? A. The total return of ABC stock will be 10.85%. B. The dividend yield of ABC stock will be 3.85%. C. The stock price of ABC will grow at 7.35% annually.

B is correct. In the Gordon growth model, Total return = Dividend yield + Capital gains yield (i.e., constant growth rate). When a stock is fairly valued, the expected total return will equal the required return or discount rate (i.e., 7.35%). In the case of ABC, the total return is 7.35% and the capital gains yield is 3.5%. Therefore, the dividend yield is 7.35% − 3.5% = 3.85%.

When calculating equity charge for residual income should you use beginning or end of period equity value?

Beginning of period equity value!! multiply this by the required return on equity to get the equity charge subtract from net income to get residual income

Which of the following could be used as a good indicator of the risk and liquidity of money market securities during the recent past? Z-spread. TED spread. Libor-OIS spread.

C is correct - The Libor-OIS spread is considered an indicator of the risk and liquidity of money market securities. This spread measures the difference between Libor and the OIS rate.

You use a monte carlo the valuation and find that the value generated does not equal the market price of the bond. To correct the problem you would most likely: A. adjust the volatility assumption. B. increase the number of simulations. C. add a constant to all interest rates on all paths.

C is correct. Using a Monte Carlo simulation, the model will produce benchmark bond values equal to the market prices only by chance. A constant is added to all interest rates on all paths such that the average present value for each benchmark bond equals its market value.

All else equal an increase in interest rate volatility will result in the greatest increase in value for which of the following bonds: A. option free bond B. callable bond C. putable bond

C putable bond is correct Regardless of the type of option, an increase in interest rate volatility results in an increase in option value. Because the value of a putable bond is equal to the value of the straight bond plus the value of the embedded put option, the putable bond will increase in value if interest rate volatility increases. Put another way, an increase in interest rate volatility will most likely result in more scenarios where the put option is exercised, which increases the values calculated in the interest rate tree and, thus, the value of the putable bond.

Busted convertibles

Convertible bonds where the embedded call option is so far out of the money that a small change in the price of the companies common stock will have a minimum impact on the value of the convertible bonds. Therefore, the bonds will resemble option-free bonds, also known as busted convertibles.

How do you arrive at EBITDA given net income?

EBITDA = Net income (from continuing operations) + Interest expense + Taxes + Depreciation + Amortization.

How do you discount a coupon paying bond with the spot rate?

Each cash flow should be discounted at the spot rate corresponding to its maturity!! CANNOT USE THE SAME SPOT RATE FOR EVERYTHING! Can only use the same spot rate when the bond does NOT pay a coupon

T/F: Actual default probabilities include the default risk premium associated with the uncertainty in the timing of the possible default loss.

False

T/F: Like the dividend discount model, in the RI model you need to multiply RI by the growth rate?

False! V = Bo + RI/(r-g) where RI = (ROE - r)Bo RI = E - rBo

T/F: The capital asset pricing model (CAPM) captures company specific and market risk.

False! . CAPM only incorporates a single risk premium for market risk (beta); it does not incorporate company-specific (idiosyncratic) risk.

T/F: The PVGO correctly reflects the value of PRBI's options or future opportunities to invest, but it ignores the value of its real options (i.e., options for modifying or abandoning its current projects).

False! PVGO reflects not only the value of a company's options to invest, captured by the word "opportunities," but also the value of the company's options to time the start, adjust the scale, or even abandon future projects. This element is the value of the company's real options (options to modify projects, in this context).

T/F: In the calculation of standardized unexpected earnings (SUE), the magnitude of unexpected earnings is typically scaled by the standard deviation of analysts' earnings forecasts?

False! SUE is unexpected earnings scaled by the standard deviation in past unexpected earnings (not the standard deviation of analysts' earnings forecasts, which is used in the calculation of the scaled earnings surprise).

T/F: use P/EBITDA over EV/EBITDA if these ratios conflict?

False! Use EV/EBITDA P/EBITDA does not take into account differences in the use of financial leverage.

T/F: An arbitrage-free approach would discount each interest payment to the present using the corresponding rate on the yield curve. Therefore, in a positively sloped yield curve, the last interest coupon and principal payments at maturity would be discounted at a rate equal to the yield-to-maturity, while the discount rates applied to the annual interest payments prior to maturity would be lower than the discount rate applied to the cash flows occurring at maturity?

False! coupon-paying bond can be thought of as a portfolio of zero-coupon bonds, each valued separately at the spot interest rate derived from the spot curve. The yield-to-maturity calculation reflects the traditional approach to valuing bonds, where all cash flows are discounted at the same rate as if the yield curve were flat. In a positively sloped yield curve, the spot rate at maturity will be higher than the yield-to-maturity.

T/F: Residual income = NI - dividends ?

False!! must use equity charge (required return x beginning value of equity) in order to calculate residual income

T/F: you can price a bond using par rates?

False!! you should use the par rate to find the spot rates and then price the bond accordingly

How do you determine the value of a company with natural resources?

Find market value of natural resources and add the book value of other assets, then subtract the book value of debt

T/F: If the CAPM method is used to estimate the discount rate with a beta estimate based on public companies with operations and revenues similar to a private company, then a small stock premium should be added to the estimate.

If the CAPM is used with public companies with similar operations and similar revenue size, as stated, then the calculation likely captures the small stock premium and should not be added to the estimate. Small stock premiums are associated with build-up models and the expanded CAPM, rather than the CAPM per se

How do you calculate total return using the gordon growth rate model?

In the Gordon growth model, Total return = Dividend yield + Capital gains yield (i.e., constant growth rate). When a stock is fairly valued, the expected total return will equal the required return or discount rate

How does leverage effect FCFF?

Increase in leverage increases the tax savings

how do you calculate net borrowing?

Is the change in debt on the balance sheet!!

If implied growth rate is greater than sustainable growth rate, is a companies stock over or undervalued?

Overvalued!

Will a callable or putable bond price decrease when interest rate volatility decreases?

Putable price will decrease as recall putable bond = straight bond + option value both the call option and put option value will decrease but because callable bond = straight bond - option value, its price will actually increase

How do you calculate the growth component of the leading P/E using PVGO?

Rearrange to find: P0/E1 = [1/r] + [PVGO/E1] 1/r captures the no-growth component of P/E and PVGO/E1 captures the growth component of the P/E. The company with the highest PVGO/E1 has the highest growth component!

Given: Last year: COGS = 30% sales This year: COGS will experience 8% inflation rate Average price increase per unit = 5% Average volume growth = -3% What is this years forecasted gross profit margin?

Revenue growth = (1 + Price increase for revenue) × (1 + Volume growth) − 1 = (1.05) × (0.97) − 1 = 1.85%. COGS increase = (1 + Price increase for COGS) × (1 + Volume growth) − 1 = (1.08) × (0.97) − 1 = 4.76%. Forecasted revenue = Base revenue × Revenue growth increase = 100 × 1.0185 = 101.85. Forecasted COGS = Base COGS × COGS increase = 30 × 1.0476 = 31.43. Forecasted gross profit = Forecasted revenue - Forecasted COGS = 101.85 − 31.43 = 70.42. Forecasted gross profit margin = Forecasted gross profit/Forecasted revenue = 70.42/101.85 = 69.14%

How do you calculate the risk neutral probability of default?

Set the current price equal to: Price given no default(1-p) + price given default x p And then discount this to the present value

Molodovsky effect

The Molodovsky Effect is the imperial observation by Nicholas Molodovsky that at the bottom of an economic cycle, P/E ratios are high, and earnings are low. However, at the top of an economic cycle where there is an economic boom, the P/E ratios are low, and earnings are high

You use a binomial tree model and the spot rates to value a bond. The price you get using the spot rates equals the market price of the bond, however the binomial tree model gives you a different price. What is the most likely explanation?

The binomial tree model is incorrect because both methodologies should value the bonds equally. The binomial tree is based on the spot rate curve and a no arbitrage condition, therefore any option-free bond should have the same value whether using the spot rate curve or the binomial tree.

What is the difference between the current conversion price and the market conversion price?

The current conversion price = par value / conversion ratio The market conversion price = market value of bond / conversion ratio ** must find the conversion ratio first using the par value in order to find the market conversion price

market value invested capital

The market value of debt and equity.

What is the upfront payment/premium of a CDS?

This is the difference between the standard rate and the spread which gets paid upfront by one of the parties of the contract as % of notional principal Upront premium = (Credit spread - standard rate) x Duration

T/F: Arbitrage-free term structure models use observed market prices of a reference set of financial instruments, assumed to be correctly priced, to model the market yield curve.

True

T/F: Calibrating an interest rate tree requires an iterative process that ensures that the upper and lower rates are consistent with the volatility assumption, the interest rate model, and the observed market value of the benchmark bond. The cash flows of the bond are discounted using the interest rate tree, and if this doesn't produce the correct price, another pair of forward rates is selected and the process is repeated

True

T/F: Companies with extreme accounting rates of return typically have low persistence factors. Companies with strong market leadership positions and low dividend payouts are likely to have high persistence factors.

True

T/F: Equilibrium term structure models are factor models that seek to describe the dynamics of the term structure by using fundamental economic variables that are assumed to affect interest rates.

True

T/F: Even though equilibrium models require fewer parameters to be estimated relative to arbitrage-free models, arbitrage-free models allow for time-varying parameters. In general, this allowance leads to arbitrage-free models being able to model the market yield curve more precisely than equilibrium models.

True

T/F: If the stock is fairly priced in the market as per the Gordon growth model, the stock price is expected to increase at g, the expected growth rate in dividends. Therefore, the expected capital gains yield is equal to the growth rate

True

T/F: Many convertible bonds contain a call option that can be exercised if the common stock price rises to more than the conversion price, resulting in a forced conversion (bondholders must either convert and accept shares or accept a fixed call price). Forced conversion prevents bondholders from continuing to receive coupon payments at the expense of current shareholders.

True

T/F: PEG does not factor in differences in risk

True

T/F: The Fed model concludes that the market is undervalued when the market's current earnings yield is greater than the 10-year Treasury bond yield.

True

T/F: The PEG ratio accounts for different rates of growth between two companies but not for different levels of risk.

True

T/F: The middle node at time t for an interest rate tree will be close to the implied forward rate at time t?

True

T/F: With structural models, for example, it is difficult to measure the default barrier. For reduced form models, a disadvantage is that they don't explain the reasons for default, which can be a surprise that does not typically happen in practice

True

T/F: the excess earnings method would rarely be applied to value a private company's equity when it is not needed to value intangibles

True

T/F: when finding P/E you should use diluted earnings per share?

True

T/F: Structural models predict why a default may occur and are based on the balance sheet structure, and can be interpreted in terms of options

True - can infer the value of each firms assets through their market data

T/F: Annual (stock) dividend payments below the threshold dividend have no effect on the conversion price.

True - however if they are above the threshold dividend the company distributes more "wealth" to their shareholder than accepted by the bondholders. Therefore the conversion ratio has to be adjusted upwards which results in an lower conversion price. Adjusting the conversion price downwards results in the convertible bondholder receiving more common shares (dividing by lower #) when converting to common.

T/F: Excess spread, which is additional return built into the transaction, is the primary form of protection in consumer ABSs

True - recall Excess spread is the surplus difference between the interest received by an asset-based security's issuer and the interest paid to the holder

T/F: Covered bonds that are issued by financial institutions usually have higher credit ratings than the issuing institutions have.

True because of the additional collateral protection,

T/F: DDM can help value companies that are repurchasing shares if dividend growth rate can be adjusted appropriately?

True!

T/F: The yield-to-maturity, of a bond should be a weighted average of the spot rates used in the valuation of the bond. Because the bond's largest cash flow occurs at time T, it will have a greater weight than the other spot rates in determining YTM?

True!

T/F: probability of default reflects risk-neutral probabilities of default, not actual historical probabilities

True!

T/F: the value of a convertible bond equals the value of the otherwise identical option-free bond plus the value of the conversion (call) option given to the bondholder, whereas the value of a callable bond equals the value of the otherwise identical option-free bond minus the value of the call option given to the issuer.

True!

T/F: The CAPM is a widely accepted approach for estimating the required return on equity. However, for individual securities such the idiosyncratic risk can overwhelm the market risk, thereby making beta a poor predictor of the stock's future average return.

True! In portfolios, the idiosyncratic risk of individual securities tends to offset against each other leaving largely beta (market) risk. For individual securities, idiosyncratic risk can overwhelm market risk and, in that case, beta may be a poor predictor of future average return. Thus the analyst needs to have multiple tools available.

T/F: The bond yield plus risk premium method incorporates the yield to maturity of a company's debt?

True! Bond yield plus risk premium cost of equity = Yield to maturity on the company's long-term debt + Risk premium.

T/F: the effective duration of the option-free bond can be larger than that of the putable bond.

True! The value of a putable bond cannot fall below the put price, whereas the value of the option-free bond can.

T/F: A persistence factor of 1 assumes that residual income will remain constant in perpetuity?

True! Thus would discount the terminal value by r, and then discount to PV If the residual income is expected to decline then you would use a persistence factor of less than 1

T/F: The sustainable growth rate model assumes that the growth will be financed with the issuance of debt and only internally generated equity will be used to maintain a target capital structure. No additional common equity will be issued. The ROE is assumed to be a constant during this period.

True!!

What is the single stage residual income equation assuming constant growth?

Vo=Bo+ (ROE-r) /(r - g) *Bo

T/F: If NOPAT/Assets is greater than WACC did the company achieve a positive residual income?

YES!

How do you find working capital investment?

[Current assets - cash] - [current liabilities - debt] Take the assets minus liab from above and then that change from prior years to find wcinv

What are the 3 requirements to create a binomial interest rate model?

current benchmark interest rates an assumption about interest rate volatility. an assumption regarding the interest rate model / term structure

the yield curve, which is currently flat, is expected to become upward sloping how does this affect the price of a putable bond?

increases the price as the put option is worth more now

How do you calculate market value added?

market value of debt + market value of equity - accounting book value of debt and equity

How do you calculate expected exposure when given an interest rate tree?

multiply the probability of each node plus the dividend (if any) * essentially the number you find before discounting to the previous node*

reduced-form credit models

predict WHEN a default may occur based on statistical methods. Default is considered an exogenous variable that occurs randomly, economic reasons for default are not explained. Model relies on publicly available information thus access to internal information is not required.

TED spread

the difference between the 3-month London Interbank Offer Rate (LIBOR), a rate at which banks can borrow from one another, and the 3-month T-bill rate. It signifies a level of risk in lending to banks.