Just watched Schweser Video and read the book: Here’s my two cents on what we need to know. A lot of this is from Schweser 1. Emerging Markets often have high inflation and therefore we need to value differently. One important note: Ratios based on cash flow forecasts in real terms are accurate while ratios based on nominal forecasts are incorrectly estimated 2. Must match apples to apples, therefore must estimate real cash flows at real rate and nominal cash flows at nominal rate. Remember that both estimates will arrive at the same value. 3. Three issues that require attention: – Income taxes are paid based on nominal earnings, not real earnings. —The real cash outflow from NWC is not equal to the change in real NWC. ----Nominal capital expenditures are difficult to forecast using an assumed relationship between nominal sales and nominal capital expenditures because the relationship is not constant when inflation is high. The steps in valuing an emerging markets company on a real and nominal basis are: Forecast real revenue, EBITDA, invested capital, and EBITA. Forecast nominal revenue, EBITDA, invested capital, and NOPLAT. Forecast real NOPLAT (which is EBITA *(1-T)) Forecast nominal and real free cash flows. Estimate firm value using a free cash flow model in both real and nominal terms by discounting real cash flows at the real WACC and nominal cash flows at the nominal WACC. 4. There are two ways of incorporating emerging market risk into the valuation process. The first is to adjust the cash flows in a scenario analysis, and the second is to adjust the required return. There are four arguments that support adjustments to cash flow rather than adjusting the discount rate: a) Country risks are diversifiable (and so not reflected in WACC) b) Companies respond differently to country risk. (a shoe company may be more volatile than a steel company) c) Country risk is one-sided risk. d) Identifying cash flow effects aids in risk management. 5. Use the following guidelines to estimate WACC for an emerging markets company: The risk-free rate equals 10-year U.S. government bond yield plus the inflation differential between the local economy and the U.S. Beta is estimated as the industry beta from a globally-diversified market index. The long-term global market risk premium is approximately 4.5% to 5.5%. Pre-tax cost of debt equals the local risk-free rate plus the credit spread on comparably-rated U.S. corporate debt. Marginal tax rate should reflect local taxes that are applied to interest expense on debt. Capital structure weights are approximated by industry average weights. 6. If we’re using unadjusted cash flows to value an emerging market company, we need to add a country risk premium to the company’s WACC in order to arrive at the appropriate discount rate to reflect the extra risk associated with the emerging market. Unfortunately, there are no simple metrics for estimating this country risk premium, so instead you should be aware of some important issues to take into account when estimating the country risk premium. Do not use the sovereign risk premium to estimate the country risk premium. The reason is that the volatility specific to the company’s cash flow will usually be different than the volatility of government bond payments. Recognize that country risk premiums will vary widely across different analysts, so you need to understand the underlying forecasts that are part of the valuation analysis. For example, high country risk premiums are often associated with aggressive growth forecasts. The larger forecasted cash flows are therefore discounted at a higher cost of capital, and the result is a value estimate similar to that supplied by an analyst using a lower country risk premium and lower growth forecasts. Analysts often overestimate the country risk premium, so make sure you understand the valuation implications of a significantly higher than normal country risk premium. One way to do that is to compare the expected returns implied by the CAPM model to historical real returns in the country. Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27 percent inflation over the next year. Charleston Johnson expects the local government to be successful in bringing inflation under control, and anticipates that it will fall to 20 percent in the second year and 10 percent in the third year, where he expects inflation to stabilize. Johnson predicts that by year 3, Wavington will have nominal free cash flow of $187 million growing at 4 percent annually in real terms. In view of his optimistic outlook, he is considering an investment in Wavington, and has calculated the real WACC for Wavington at 8 percent. The nominal continuing value of Wavington in year 3 is closest to: A) $4,250. B) $4,675. C) $5,348. D) $4,862. An analyst is attempting to estimate the weighted average cost of capital (WACC) for an emerging market manufacturer. The emerging market country has experienced high inflation in recent years. She estimates each component of WACC as follows: Risk-free rate: 10-year U.S. government bond yield + inflation differential between the local market and U.S. market. Beta: From a regression of the manufacturer’s stock returns on the country’s market equity index. Market risk premium: 6.0%, which is the geometric average nominal risk premium on the country’s equity index over the past 12 years. Pre-tax cost of debt: local risk-free rate plus the credit spread on U.S. corporate bonds rated B+. Marginal tax rate: 35%, which reflects all government taxes that are applied to interest expense on corporate bonds. Capital structure weights: Average capital structure weights for global industry competitors. Has the analyst overestimated the cost of equity capital and the WACC? Cost of equity? WACC? A) Yes No B) No Yes C) Yes Yes D) No No
Nice write up. Bookmarking this.
cdawg12 , whats the explanation for this… i cant figure the 1st question out… sigh
ahmad…u need to find the value at time 3, so take the 187 * (1.04)*(1.10) —this is adjusting for inflation. then find the nominal WACC which would be 1.08* 1.10. Use the single stage growth formula to find the value at time 3. Answer is D. Sorry would expand this more, but im spent.
What’s the answer to the second question?
I think both beta and market risk premium are overstated. So answer is C). Use global industry beta. Beta: From a regression of the manufacturer’s stock returns on the country’s market equity index. Market risk premium: 6.0%, which is the geometric average nominal risk premium on the country’s equity index over the past 12 years.