ChapterSeven

PrinciplesofMarketValuation

Thischaptercontains30multiplechoicequestions，10shortproblemsand5longerproblems.

MultipleChoice

Inregardtoanasset，the________isdefinedastheprocesswell-informedinvestorsmustpayforitinafreeandcompetitivemarket.

analystvalue

technicalvalue

competitivevalue

fundamentalvalue

Answer：(d)

Incorporatefinancedecisionmaking，anextremelyimportantruleistochoosetheinvestmentthat________currentshareholders?wealth.

minimizes

maximizes

provideszerochangein

jeopardizes

Answer：(b)

Inassetvaluation，themethodusedtoaccomplishtheestimationdependsonthe________.

numberofparticipants

qualityofcalculatinginstruments

richnessoftheinformationsetavailable

geographiclocation

Answer：(c)

The________statesthatinacompetitivemarket，iftwoassetsareequivalent，theywilltendtohavethesamemarketprice.

LawofRealInterestRates

LawofOnePrice

LawofPriceEquivalency

LawofFutures

Answer：(b)

TheLawofOnePriceisenforcedbyaprocesscalled________，thepurchaseandimmediatesaleofequivalentassetsinordertoearnasureprofitfromadifferenceintheirprices.

swapping

maximization

arbitrage

speculation

Answer：(c)

________referstothetotalityofcostssuchasshipping，handling，insuring，andbrokerfees.

Shippingcosts

Transactioncosts

Installationcosts

Insurancecosts

Answer：(b)

TheLawofOnepriceisastatementaboutthepriceofoneasset________thepriceofanother.

absoluteto

relativeto

multipliedby

independentof

Answer：(b)

Ifanentityborrowsatalowerrateandlendsatahigherrate，thisisanexampleof________.

opportunityarbitrage

interest-ratearbitrage

exchangearbitrage

nominalarbitrage

Answer：(b)

Ifarbitrageensuresthatanythreecurrenciesarefreelyconvertibleincompetitivemarkets，then:

itisenoughtoknowonlyoneexchangeratetodeterminethethird

wecanestimatetwoexchangeratesbasedononeexchangerateonly

itisenoughtoknowtheexchangeratesbetweenanytwoinordertodeterminethethird

itisnecessarytoknowallthreerates

Answer：(c)

Supposeyouhave$15,000inabankaccountearninganinterestrateof4%peryear.Atthesametimeyouhaveanunpaidbalanceonyourcreditcardof$6,000onwhichyouarepayinganinterestrateof17%peryear.Whatarbitrageopportunitydoyouface?

$240peryear

$600peryear

$780peryear

$1,020peryear

Answer：(c)

IfthedollarpriceofJapaneseYenis$0.009594perJapaneseYenandthedollarpriceofChineseYuanis$0.1433perChineseYuan，whatistheJapaneseYenpriceofaChineseYuan?(i.e.，JPY/CNY)

0.001375JPY/CNY

0.066950JPY/CNY

9.594JPY/CNY

14.936419JPY/CNY

Answer：(d)

Ifthedollarpriceofguildersis$0.5634perGuilderandthedollarpriceofEurosis$1.5576perEuro，whatistheEuropriceoftheGuilder?(i.e.，EUR/ANG)

0.361700EUR/ANG

0.877552EUR/ANG

2.764643EUR/ANG

5.634EUR/ANG

Answer：(d)

Supposethepriceofgoldis51.09Britishpoundsperounce.Ifthedollarpriceofgoldis$100perounce，whatwouldyouexpectthedollarpriceofaBritishpoundtobe?

$1.95733perGBP

$1.5109perGBP

$0.5109perGBP

$0.4891perGBP

Answer：(a)

Questions14-18refertothefollowingexchangeratetable.Toanswer14-18youwillhavetofillinthemissingexchangerates.

U.S.Dollar

(USD)

Peso(MXN)

Euro(EUR)

CdnDlr(CAD)

U.S.Dollar

$1

Peso

10.398

Euro

0.6420

CdnDlr

1.0003

WhatistheEuro/Pesoexchangerate?(i.e.，EUR/MXN)

0.617426EUR/MXN

0.641807EUR/MXN

6.675516EUR/MXN

16.196262EUR/MXN

Answer：(a)

WhatistheCdnDlr/Euroexchangerate?(i.e.，CAD/EUR)

0.641807CAD/EUR

1.558099CAD/EUR

6.420CAD/EUR

16.196262CAD/EUR

Answer：(b)

WhatistheEuro/CdnDlrexchangerate?(i.e.，EUR/CAD)

0.3583EUR/CAD

0.641807EUR/CAD

1.558099EUR/CAD

10.394EUR/CAD

Answer：(b)

WhatisthePeso/CdnDlrexchangerate?(i.e.，MXN/CAD)

0.096201MXN/CAD

0.641807MXN/CAD

10.394882MXN/CAD

16.196262MXN/CAD

Answer：(c)

WhatisthePeso/Euroexchangerate?(i.e.，MXN/EUR)

0.617426MXN/EUR

6.675516MXN/EUR

15.581112MXN/EUR

16.196262MXN/EUR

Answer：(d)

YouaretravellinginFarOutwhereyoucanbuy130kranes(akranebeingtheunitofcurrencyofFarOut)withaU.S.dollaratofficialFarOutbanks.Yourtourguidehasarelativewhodabblesintheblackmarketandthisparticularrelativewillsellyoukranesforjust$0.00833eachontheblackmarket.Howmuchwillyouloseorgainbyexchanging$200ontheblackmarketinsteadofgoingtothebank?

youwouldgainapproximately1,660kranes

youwouldloseapproximately1,660kranes

youwouldgainapproximately1,990kranes

youwouldloseapproximately1,990kranes

Answer：(d)

Inestimatingthevalueofashareofafirm?sstock，asimplemodelisto:

divideEPSbyaP/Emultiple

multiplyEPSbyaP/Emultiple

multiplyEPSbyEAT

divideEPSbymarketvalue

Answer：(b)

Afirm?searningspershareare$6andtheindustryaverageP/Emultipleis9.Whatwouldbeanestimateofthevalueofashareofthefirm?sstock?

$54.00

$45.00

$1.50

$0.67

Answer：(a)

Thevalueoftheassetasitappearsinthefinancialstatementiscalledtheasset?s________.

marketvalue

fixedvalue

bookvalue

expectedvalue

Answer：(c)

Considerthefollowingstockmarketreactiontotheinformationcontainedinacompany?sannouncement.Acorporationhasjustannouncedthatitmustpursuetheissuanceofcompanyequity.Wecouldexpecttosee________inthepriceofcompanystock.

arise

adrop

arapidrise

zerochange

Answer：(b)

Considerwhatthestockmarketreactiontothefollowingannouncementwouldbe.Acorporationhasjustannouncedthatitisengaginginastocksplitofthecompany?sshares.Wecouldexpecttoseea________intheoverallmarketcapitalizationrateanda________inthepriceofcompanystock.

rise；drop

drop；rise

rise；drop

rise；drop

Answer：(a)

The________isthepropositionthatanasset?scurrentpricefullyreflectsallpubliclyavailableinformationaboutfutureeconomicfundamentalsaffectingtheasset?svalue.

publicmarketshypothesis

efficientmarketsexchangerates

fundamentalvalueproposition

efficientmarketshypothesis

Answer：(d)

Themarketpriceofanassetreflectsthe________ofallanalysts?opinionswithheavierweightsonanalystswhocontrollargeamountsofmoneyandonthoseanalystswhohavebetterthanaverageinformation.

bestestimate

weightedaverage

highestestimate

lowestestimate

Answer：(b)

Assumethattheworldwiderisk-freerealrateofinterestis4%peryear.InflationinDenmarkis9%peryearandintheUnitedStatesitis7%peryear.Assumingthereisnouncertaintyaboutinflation，whataretheimpliednominalinterestratesdenominatedinDanishkroneandinU.S.dollars，respectively?

16.63%(DKK)；13.50%(USD)

13.50%(DKK)；16.63%(USD)

13.36%(DKK)；11.28%(USD)

11.28%(DKK)；13.36%(USD)

Answer：(c)

The________theorystatesthattheexpectedrealinterestrateonrisk-freeloansisthesameallovertheworld.

nominalinterest-rateparity

realinterest-rateparity

efficientinflationrateparity

efficientmarketrate

Answer：(b)

________statesthatexchangeratesadjustsoastomaintainthesame?real?priceofa?representative?basketofgoodsandservicesaroundtheworld.

Purchasingpowerparity

Efficientmarketshypothesis

Marketvaluationmodel

Exchangerateequity

Answer：(a)

Assumethattheworldwiderisk-freerealrateofinterestis5%peryear.InflationinAustraliais9%peryearandinGreatBritainitis12%peryear.Assumingthereisnouncertaintyaboutinflation，whataretheimpliednominalinterestratesdenominatedinAustraliandollarsandGreatBritainpounds，respectively?

22.08%(AUD)，11.45%(GBP)

11.45%(AUD)，22.08%(GBP)

17.60%(AUD)，14.45%(GBP)

14.45%(AUD)，17.60%(GBP)

Answer：(d)

ShortProblems

Supposeyouhave$20,000inabankaccountearninganinterestrateof4%peryear.Atthesametimeyouhaveanunpaidbalanceonyourcreditcardof$7,000onwhichyouarepayinganinterestrateof18%peryear.Whatisthearbitrageopportunityyouface?

Answer：Youcouldtake$7,000outofyourbankaccountandpaydownyourcreditcardbalance.Youwouldgiveup4%peryearininterestearnings($280)butyouwouldsave18%peryearininterestexpenses($1,260).Sothearbitrageopportunityisworth$980peryear.

Fillinthemissingexchangeratesinthefollowingtable:

U.S.Dollar

Euro

DanishKrone

JapaneseYen

U.S.Dollar

$1

1.5576

0.2088

0.009594

Euro

0.6420

DanishKrone

4.7898

JapaneseYen

104.23

Answer:

U.S.Dollar

Euro

DanishKrone

JapaneseYen

U.S.Dollar

$1

1.5576

0.2088

0.009594

Euro

0.6420

1Euro

0.1340

0.006159

DanishKrone

4.7898

7.46074

1Krone

0.45954

JapaneseYen

104.23

162.35

21.761

Yen1

YouobservethatthedollarpriceoftheMexicanpesois$0.09618andthedollarpriceoftheCanadiandollaris$0.9997.WhatmusttheexchangeratebetweentheMexicanpesoandtheCanadiandollarbefortheretobenoarbitrageopportunity?

Answer: CAD/MXN=0.09618

0.9997

=0.096208CAD/MXN

Supposethattheexchangerateis$0.2970totheIsraelishekel.Howcouldyoumakearbitrageprofitswith$10,000ifthedollarpriceofgoldis$200perounceandtheshekelpriceis750ILSperounce?

Answer：Take$10,000andbuy50ouncesofgoldat$200perounce.Sell50ouncesofgoldinIsraelfor37,500ILS(750ILSperounce).Take37,500ILSandexchangeitintodollarsworth$11,137.50.Thearbitrageprofitis$1,137.50.

YouaretravellinginFarOutwhereyoucanbuy150kranes(akranebeingtheunitofcurrencyinFarOut)withaU.S.dollaratofficialFarOutbanks.Yourtourguidehasarelativewhodabblesintheblackmarketandthisparticularrelativewillsellyoukranesforjust$0.00685eachontheblackmarket.Howmuchwouldyougainorlosebyexchanging$300ontheblackmarketinsteadofgoingtothebank?

Answer:

Ontheofficialmarket：$300x150kranes=45,000kranes

Ontheblackmarket：$300x1/0.00685kranes=43,796kranes

Hence，youwouldlose1,204kranes.

Afirm?searningspershareare$5.50andtheindustryaverageP/Emultipleis8.Whatwouldbeanestimateofthevalueofashareofthefirm?sstock?Isitpossibleforfirmsbeingclassifiedinthesameindustrytohavedifferentprice/earningsmultiples?

Answer:

Estimatedvalueshareofstock =firm?sEPSxIndustryaverageP/E

=$5.50x8

=$44.00

FirmsclassifiedasbeinginthesameindustrymayhavedifferentopportunitiesforgrowthinthefutureandmaythereforedifferintheirP/Emultiples.

TheP/EmultipleofBHMCorporationiscurrently5，whiletheP/EratiooftheS&P500is10.Whatreasonscouldaccountforthisdifference?

Answer:

BHM?sreportedearningsmaybehigherthantheyareexpectedtobeinthefuture，ortheymaybeinflatedduetospecialaccountingmethodsusedbyBHM.

BHMmayberiskierthantheS&P500eitherbecauseitisinarelativelyriskyindustryorhasarelativelyhigherdebtratio.

ThepriceofHubrisCo.stockrecentlyjumpedwhentheCEOforthecompanyannouncedanincreaseddividendpaymentfortheyear.Whatmightaccountforsuchamarketreaction?

Answer：Themarketmaybelievethecompany?sfutureprospectslookverybright(thatis，higherearnings，lessrisk，soundgrowth，etc.)andthatthecompanycansustainsuchanearningsgrowth.

Assumethattheworldwiderisk-freerealrateofinterestis4%peryear.Denmarkhasanexpectedrateofinflationof9%peryearandinSpainhasanexpectedrateofinflationof14%peryear.Assumingthereisnouncertaintyaboutinflation，whataretheimpliednominalinterestratesdenominatedinKronerandEuros?

Answer: Denmark：nominalinterestrate=(1.04)x(1.09)?1

=13.36%peryear

Spain：nominalinterestrate =(1.04)x(1.14)?1

=18.56%peryear

Assumethattheworldwiderisk-freerealrateofinterestis4%peryear.TheUnitedKingdomhasanexpectedrateofinflationof8%peryearandinBelgiumitis10%peryear.Assumingthereisnouncertaintyaboutinflation，whataretheimpliednominalinterestratesdenominatedinPoundsSterlingandEuros?

Answer: UnitedKingdom：nominalinterestrate =(1.04)x(1.08)?1

=12.32%peryear

Belgium：nominalinterestrate =(1.04)x(1.10)?1

=14.40%peryear

LongerProblems

Let?sassumethatyouhaveoperatedyourownbusinessfor18years.Forthemostrecentfiscalyear，saleswere$15million.NetIncomeforthemostrecentfiscalyearwas$1.5million.Thebookvalueofyourbusinesswas$11million.Recently，afirmwhichisengagedinsimilaractivitiestoyourownwassoldandthefollowinginformationwasmadepublic:

MultipleofBookValue 0.8x

MultipleofNetIncome 11x

MultipleofSales 0.7x

Howwouldyoudetermineanappropriaterangeofvalueforyourcompany?

Ithascometoyourattentionthatyourcompanyhasfutureinvestmentopportunitiesthatwouldbelessprofitablethanthecompetingcompanyabove.Whatdoesthissayaboutthevaluationofyourcompany?

Answer：a) MultipleofSales：0.7x=$15millionx0.7=$10.5million

MultipleofNetIncome：11x=$1.5millionx11=$16.5million

MultipleofBookValue：0.8x=$11millionx0.8=$8.8million

b) Thevaluationofyourcompanywouldbeatthelowerendoftherange.

BHMstockistradingfor$47pershareontheNYSEand$45pershareontheSydneyStockExchange.AssumethatthecostsofbuyingandsellingBHMstockarenegligible.

Howcanyoumakeanarbitrageprofit?

OvertimewhatwouldyouexpecttohappentostockpricesinNewYorkandSydney?

NowassumethatthecostofbuyingandsellingsharesofBHMare2%pertransaction.Howdoesthisaffectyouranswers?

Answer：a) YoucouldbuyBHMstockinSydneyandsimultaneouslysellitinNewYork.Yourarbitrageprofitwouldbe$2pershare.

Thepriceswouldbecomeequal.

Therecouldremaina2%discrepancybetweenthepriceswhichwouldbe$1.84inthisinstance.

Supposeyouhave$50,000inabankaccountearninganinterestrateof3.5%peryear.Atthesametimeyouhaveanunpaidbalanceonyourcreditcardof$13,000onwhichyouarepayinganinterestrateof21%peryear.Whatisthearbitrageopportunityyouface?

Answer：Youcouldtake$13,000outofyourbankaccountandpaydownyourcreditcardbalance.Youwouldgiveup3.5%peryearininterestearnings($455)butyouwouldsave21%peryearininterestexpenses($2,730).Sothearbitrageopportunityisworth$2,275peryear.

ThequotesfromHubrisBankandModestyBankaregivenbelow:

HubrisBank: 106Yen/$

ModestyBank: 104Yen/$

Answerthefollowingquestionsbasedonthesefigures.

Ifweassumenotransactioncosts，thereisevidentlyanopportunityforarbitragehere.Ifanarbitrageurstartedwith$10,000，exactlyhowwould(s)hemakeprofitsandhowmuchprofitwould(s)hemake?

Asmanytradersengageinarbitragewhodoyouexpecttoseeintheabovequotesatthesetwobanks?

Ifthereisa1%transactioncostfortransactionsistherestillanopportunityforarbitrage?

Answer:

HubrisBank：106Yen/$ ModestyBank：104Yen/$

AtHubrisBank，buyYenwithdollars(Yenarecheaper).

AtModestyBank，buydollarswithYen(dollarsarecheaper).

Startwith$10,000:

AtHubrisBank：$10,000x106Yen/$=1,060,000Yen

AtModestyBank：1,060,000Yenx1$/104Yen=$10,192.31

Youmakeaprofitof$192.31.

TheYenwill