This one might take a few minutes. I’ll post answers in an hour or so, let folks play if they want to. I was doing fine on the single questions but got brutalized here. Jaden Hoyle is evaluating the MegaFood Market chain of grocery stores and Strinson Carburetors, a maker of automobile and industrial engine parts. MegaFood is publicly traded, while Strinson is a private company. Hoyle’s firm, Janssen and Associates, is considering the purchase of a 50% equity stake in one or both of the companies, and may be willing to purchase the companies outright. Janssen only invests in companies with a weighted average cost of capital of less than 11%. Hoyle has assembled the following data on the two companies: MegaFood Market Strinson Carburetors Beta 0.87 1 Market value of equity $173 million $993 million Market value of debt $38 million $567 million Marginal tax rate 42.8% 31% Target debt/equity rating 35% 78% Equity risk premium 0 4.6% Required return on debt 9% 6.5% The risk-free rate of return is 5.2%. Hoyle must make recommendations regarding both MegaFood Market and Strinson Carburetors. Hoyle does not have all of the data she needs and knows she will have to estimate some values using the data she does possess. To help estimate the required return on equity for Strinson Carburetors, Hoyle takes three actions: Action A: She selects a benchmark company, unlevers the beta of that company, then levers up the adjusted beta using Strinson’s debt and equity allocation. Action B: She calculates a risk premium, then adds that premium to the yield to maturity of the company’s long-term debt. Action C: She prepares a supply-side multifactor model considering expected inflation, expected GDP growth, and expected changes in P/E ratio. Before she finishes her analysis of MegaFood Market and Strinson Carburetors, Hoyle must construct valuation models for two other companies, Halberd Hardware, a maker of hand tools, and the Jones Group, one of the world’s largest consultants. She has assembled the following information about each company. Halberd Hardware * Gary Halberd, the founder, still owns 85% of the company, and all the rest is in the hands of company directors and friends of Halberd who bought stakes 20 years ago. * Historical data on equity returns is sparse, as there have been very few trades over the last two decades. * Halberd Hardware is headquartered in New York City. * The company plans to go public in the next six months, with Gary Halberd selling 30% of his ownership interest. Jones Group * Jones Group, one of the world’s largest consulting companies, has been publicly traded for four years on the South Pittson Island stock market. Its ADR trades on the U.S. market. * South Pittson Island is a small island nation in the Mediterranean known for its business-friendly tax code. For her analysis of Halberd Hardware, Hoyle is considering three models to calculate the estimated return. But she has already decided to use the Gordon Growth model to calculate the equity risk premium. As soon as Hoyle finishes determining which models are best suited to her purposes, her boss comes into the office and tells her to use the capital asset pricing model (CAPM) for all four of the companies she is reviewing. Hoyle is concerned about the effectiveness of the CAPM. With regards to Jones Group, her three main worries are: Worry A: The need to use the country spread model to revise the equity risk premium. Worry B: The CAPM’s effectiveness because of Jones Group’s ADR. Worry C: The need to create a beta estimate using an unlevered beta. Assuming MegaFood Market has an expected return on equity (ROE) of 13.6% and Strinson Carburetors has an expected ROE of 15.3%, what recommendation should Hoyle give her superiors at Janssen regarding each company? MegaFood Market Strinson Carburetors A) Don’t buy the company Don’t buy the company B) Don’t buy the company Buy the company C) Buy the company Buy the company Which of Strinson’s actions is least helpful in the calculation of required return on equity for Strinson Carburetors? A) Action B. B) Action A. C) Action C. Which of the following is the best model for calculating Strinson Carburetors’ required return? A) Fama-French model. B) Pastor-Stambaugh model. C) Capital asset pricing model. Hoyle wants to calculate an expected return for Halberd Hardware and Jones Group. She has access to a variety of models, but her best option is: for Halberd for Jones A) bond-yield plus risk premium method capital asset pricing model B) build-up method country spread model C) build-up method capital asset pricing model Hoyle wants to use a macroeconomic model to derive equity risk premiums for both Halberd Hardware and Jones Group. Such a model is appropriate for: A) Jones Group, but not Halberd Hardware, because macroeconomic models don’t work for closely held companies. B) Halberd Hardware, but not Jones Group, because macroeconomic models don’t work for nations like South Pittson Island. C) both Halberd Hardware and Jones Group. Which of Hoyle’s worries about using the CAPM for Jones Group is most justified? A) Worry B. B) Worry A. C) Worry C.
Most ridiculous vignette… My head is spinning reading all that data and calculating WACC for the 2 companies… 
I would be happy if I made 1/6 here. My thougts… Q1.B WACC of MFM is > 11% WACC of SC < 11% So reject MFM and accept SC. Q2.C ActionC – as were do we get expected changes in P/E (or rather P) of a Private company? ActionA – is awesome-> get beta, unlever, and then lever with d/e of private firm ActionB – YTM + RP works too Q3.A? Beta for private copany not available, so CAPM gone for a toast No liquidity as it’s private – so PS model also gone Q4. C? country spread model directly eliminates option B. So guessing between A and C Q.5. B? I think we cant use macroeconomic models for Pittson Island, where do we get GDP? Inflation? Unemp rate estimates from? Q6.A? No need to lever/unlever beta as Jones is Public (option c gone.) So it’s between A and B. WorryB is more general than worryA. So worryB – ansA?
bannisja, is this one from schweser qbank?
Now with regards to Q1: they provide a little bit of data to be able to calculate rce from scratch like beta, etc. etc. but is it a general rule that when they provide Return on Equity on Equity questions - they mean Rce? I took it to be the literal ROE from FSA days - and did not take that into the picture at all… and got the wrong choice obviously… Q2: C agree choice C is the least required. Q 3 is B - Pastor Straumbaugh is the model to be used - because it is Privately held so you need to apply a Liquidity factor which only this model has. Q4: A --> build up method requires historic information, which is not available for halberd. Q 5 = Macroeconomic can be applied anywhere I believe. GDP etc. should be available since it is for an island nation… So choice C - can be applied for both companies. Q6: ADR brings in Foreign currency related risk. So it is the higher worry factor. B.
back from the dog walk, happy to chat any of these out- i had a poor showing. MegaFood Market Strinson Carburetors A) Don’t buy the company Don’t buy the company B) Don’t buy the company Buy the company C) Buy the company Buy the company Your answer: C was incorrect. The correct answer was B) Don’t buy the company Buy the company To determine whether the investments fit Janssen’s requirements, we must calculate the weighted average cost of capital. We have the target debt/equity ratio, from which we can derive the debt/capital ratio needed to calculate WACC. Debt/capital = (debt / equity) / (1+ debt / equity) For MegaFood, the target debt/capital ratio is 25.93%. For Strinson, the target debt/capital ratio is 43.82%. WACC = [debt / capital × required return on debt × (1 − tax rate)] + (equity / capital) × required return on equity. MegaFood WACC = [(25.93% × 9% × (1 − 42.8%)] + (1 − 25.93%) × 13.6% = 11.41%. Strinson WACC = [(43.82% × 6.5% × (1 − 31%)] + (1 − 43.82%) × 15.3% = 10.56%. For MegaFood, WACC is 11.41%, higher than the Janssen’s 11% target. For Strinson, WACC is 10.56%, below the target. Thus, Janssen should buy Strinson, but not MegaFood. (Study Session 10, LOS 36.h) Which of Strinson’s actions is least helpful in the calculation of required return on equity for Strinson Carburetors? A) Action B. B) Action A. C) Action C. Your answer: B was incorrect. The correct answer was C) Action C. Action A is a useful method for calculating beta for private or thinly traded companies. With that estimated beta, Hoyle has all the pieces needed to calculate required return using the capital asset pricing model. Action B reflects the bond-yield plus risk premium method for calculating required return on equity for companies with publicly traded debt. This strategy would provide Hoyle with a target return. The model created in Action C is useful for estimating an equity risk premium. But Hoyle already has an equity risk premium. (Study Session 10, LOS 36.b) Which of the following is the best model for calculating Strinson Carburetors’ required return? A) Fama-French model. B) Pastor-Stambaugh model. C) Capital asset pricing model. Your answer: B was correct! Strinson is not publicly held, and its shares have little liquidity. The Fama-French model is useful for estimating returns, but the Pastor-Stambaugh model adds a liquidity factor to the Fama-French model. As such, the Pastor-Stambaugh model is probably better for a company like Stinson because it takes liquidity into account. The CAPM requires the estimation of beta and is likely to be less accurate than the other models. (Study Session 10, LOS 36.d) Hoyle wants to calculate an expected return for Halberd Hardware and Jones Group. She has access to a variety of models, but her best option is: for Halberd for Jones A) bond-yield plus risk premium method capital asset pricing model B) build-up method country spread model C) build-up method capital asset pricing model Your answer: B was incorrect. The correct answer was A) bond-yield plus riskpremium method capital asset pricing model Both the build-up method and the bond-yield plus risk premium method work for thinly traded companies. But the build-up method relies on historical estimates, so it wouldn’t work well for Halberd, which has minimal historical data. Thus, the bond-yield plus risk premium method is the best option. The country spread model is not designed to calculate an expected return, but instead to adjust data from emerging markets for comparison with data from developed markets. The question only provides two options, and the CAPM is the only model that would actually do the required job for Jones. (Study Session 10, LOS 36.d) Hoyle wants to use a macroeconomic model to derive equity risk premiums for both Halberd Hardware and Jones Group. Such a model is appropriate for: A) Jones Group, but not Halberd Hardware, because macroeconomic models don’t work for closely held companies. B) Halberd Hardware, but not Jones Group, because macroeconomic models don’t work for nations like South Pittson Island. C) both Halberd Hardware and Jones Group. Your answer: A was incorrect. The correct answer was C) both Halberd Hardware and Jones Group. Macroeconomic models work for any market in which public equities represent a large enough share of the economy that analysts can reasonably infer a relationship between economic factors and asset prices. Since South Pittson Island is known as a tax haven, it is likely that many other companies are domiciled there for the same reason Jones Group is, and the financial industry is a large part of the economy. However, even if we don’t want to assume that South Pittson Island’s economy is suitable for such models, we have another argument. Jones Group is one of the world’s largest consulting companies. Therefore, it is highly likely that it has significant operations in large, developed markets. Macroeconomic models can be constructed to reflect data from those markets – and in fact, any such model should reflect that data. While Halberd is closely held, that status should not affect a macroeconomic model, which looks at broad factors that affect both public and private companies. We need not have a beta or historical trading data to use such a model. (Study Session 10, LOS 36.d) Which of Hoyle’s worries about using the CAPM for Jones Group is most justified? A) Worry B. B) Worry A. C) Worry C. Your answer: A was correct! Currency-translation issues are a concern for any company with operations in foreign countries. But the country spread model is designed to adjust results from emerging markets using data from developed markets, assigning the proper amount of extra risk for the emerging market. Most tax havens would not need to be treated as emerging markets. In addition, as one of the world’s largest consultancies, Jones Group must do a lot of business in the U.S. and other developed markets. It is unlikely that results from a company like Jones Group would require the adjustments from the country spread model. Regarding beta: Since Jones is publicly traded, there is no need to extrapolate a beta using data from another company. Thus, there is no reason to unlever beta from a benchmark company, then relever it to reflect Jones’ financial condition. The biggest concern is the overall effectiveness of the CAPM. The model should work for Jones Group, but it has weaknesses, most importantly its dependence on just one factor. Jones trades on at least two exchanges, and any model depending on just one market index is not going to reflect the whole picture. (Study Session 10, LOS 36.g)
and yes ali, schweser Question ID#: 104142
how to find the weight of debt and equity for Question 1 25.93% came from where?
they gave in the answer debt/capital = D/E / (1+D/E) WACC = [debt/capital x req return on debt x (1-t) + equity/capital x req return on equity] plug, chug. were these formulas that i had at my fingertips? not so much. i made a notecard today though.
So if D/E is 0.5 if E is 1, D must be 0.5 D + E = A; so D/A = 0.5 / (1 + 0.5) and hence D/A = D/E / (D/E + 1)
it is may be Saturday night or I am stupid: show me the calculation how did 25.63% come from: Debt is 38 and Equity is 173. Debt/Capital = D/E/ 1+D/E = 38/173 / 1+ 38/173 0.2197 / 1.2197 = .1801
it is based on the target d/e ratio target d/e = .35 so d/total capital = .35/1.35 = .2583
D/E = 35% D/E = 35/100 D = 35 E=100 A = 130 D/A = 35/135 = 0.259259
alright bro you proved me stupid…thanks for the calculation
boston take a chill. We will talk offline. It’s Sat night and St Patrick’s weekend.
I don’t get the answer for the first part. I used the market values, specifically, market value of the firm of Mega = 173 + 38 = 211 and the same for Strinson. The answer I got is that both should not be bought. Isn’t that the correct way to calculate WACC?
we always take the target rate if it is given and not market rate.
cfaboston28 Wrote: ------------------------------------------------------- > we always take the target rate if it is given and > not market rate. Is this stated anywhere in the text?
Shouldn’t they say the “required” returns are 13.6% and 15.3%, not the “expected” returns. You could technically expect a firm’s ROE to be different from its required return couldn’t you?
the use of ROE term (Return on equity) also threw me off, which is why I asked the question - does use of Return on equity on “equity” related item sets in the examination mean “RCE”?
It seems that they are saying “expected ROE” is the same as Cost of Equity…which is a little strange isn’t it?