Question: Analyze the Advantages and Disadvantages of the Various Financial and Operating

CFA LEVEL 2 - TEST BANK WITH SOLUTIONS

Question: Analyze the advantages and disadvantages of the various financial and operating changes that a company can make to manage its sustainable growth.

Answer:

The first step in solving the excess growth problem is to determine if the situation is temporary or permanent. If temporary, further borrowing may be the simple solution. If longer-term, some combination of the strategies described below will be necessary:

1. Sell New Equity - If the company is willing and able to raise new equity capital by selling shares, its sustainable growth problems vanish. The increased equity, plus whatever added borrowing is possible as a result of the increased equity, is a source of cash with which to finance further growth. The potential problems with this strategy are:

A. Poorly developed or non-existent equity markets make equity difficult to sell, basically make the shares illiquid.

B. Limited access to the services of an investment banker to sell the shares, which is especially true for small concerns.

C. Many companies may prefer not to sell equity, opting instead for internal sources, depreciation and increases in retained earnings as sources of corporate capital.

2. Increase leverage - Increasing leverage raises the amount of debt the company can add for each dollar of retained profits. There are limits to the use of debt financing: all companies have a creditor-imposed debt capacity that restricts the amount of leverage the firm can employ. Moreover, as leverage increases, the risks borne by owners and creditors rise, as do the costs of securing additional capital.

3. Reduce the Payout Ratio - A cut in the payout ratio raises sustainable growth by increasing the proportion of earnings retained in the business. In general, owners' interest in dividend payments varies inversely with their perceptions of the company's investment opportunities. If owners believe that the retained profits can be put to productive use within the company, they will forego current dividends in favor of higher future ones. Alternatively, if a firm's investment opportunities do not promise attractive returns, a dividend cut will anger shareholders, resulting in a

stock price decline.

4. Profitable Pruning - Profitable pruning sells off marginally performing operations to invest the money into the remaining businesses. This approach recognizes that when a company spreads its resources across too many products, it may be unable to compete effectively in any. Profitable pruning reduces sustainable growth problems in two ways: it generates cash directly through the sale of marginal businesses, and it reduces actual sales growth by eliminating some of the sources of the growth.

5. Profitable pruning can also be applied to a single-product company. In this case, slow-paying customers and/or slow-turning inventory is eliminated. This can eliminate sustainable growth problems in three ways: It frees up cash; it increases asset turnover; and it reduces sales.

6. Sourcing - This option involves deciding whether to perform an activity in-house or to purchase it from an outside vendor. Sourcing more and doing less in-house may increase sustainable growth rate. Sourcing releases assets that would otherwise be tied up in performing an activity, and it increases asset turnover; both of which serve to diminish growth problems. The key to effective sourcing is determining where the company's unique abilities lie, and sourcing out tasks that are not core to the business.

7. Pricing - An obvious inverse relationship exists between price and volume. When revenue growth is too high in relation to a company's financing ability, it may have to raise prices to reduce growth. If the higher prices increase the profit margin, the rate of sustainable growth may increase.

8. Merger - When all else fails, it may be necessary to look for a partner. Two types of companies are capable of supplying the needed cash: a mature company (a cash cow) looking for profitable investments for its excess cash flow and a conservatively financed company that would bring liquidity and borrowing capacity to the cash needy firm.

Question: Explain the computation of a firm's effective tax rate.

Answer:

Permanent differences, which are difference between the way that the tax code measures income and the way that financial statements report income that never reverses itself, affect the provision for taxes in the income, the tax expense, which is calculated as:

(Projected income before taxes - Permanent differences) x tax rate

Timing differences, which are difference between the time that the tax code recognizes either an income or an expense item and the time at which the financial statements record the item, appear in the balance sheet as Deferred Taxes. Deferred taxes are tax obligations that are expected to be

paid when the timing differences are reversed. Deferred taxes in any fiscal year are calculated as:

(Cumulative timing differences) x (tax rate)

A tax payment for a given year equals the tax expense minus the increase in the deferred tax account.

When analyzing the tax accounts, the objective is to estimate three elements:

1. The permanent differences that the firm will have between its taxable

income and reported income.

2. The timing differences.

3. The tax rate to which the firm will be subject.

The first step in determining these elements is the calculation of:

Effective tax rate = Tax expense/Income before taxes

Question: Evaluate the most commonly found indenture provisions.

Answer:

Utility Indentures

1. "Security" specifies the property upon which there is a mortgage lien and the ranking of the new debt relative to outstanding debt is specified. Generally, new bonds rank equally with all other bonds outstanding under the mortgage. Certain features of older provisions have become archaic,

hindering the efficiency of running a business. Therefore, a company will attempt to retire old debt in order to eliminate the more restrictive covenants not included in current offerings.

2. "Issuance of Additional Bonds" establish the conditions under which the company may issue additional first mortgage bonds and is often based upon a debt test and/or earnings test. The debt test generally limits the amount of bonds that may be issued under the mortgage to a certain percentage of net property or net property additions, the principal amount of retired bonds, and deposited cash. The earnings test restricts issuance of additional bonds under the mortgage unless earnings for a particular period cover interest payments at a specified level.

3. "Maintenance and Replacement (M&R) Fund" ensure that the mortgaged property is maintained in good operating condition, thereby maintaining its value.

4. "Redemption Provision," or call provision specifies when and under what prices a company may call its bonds. Refunding is an action by a company to replace outstanding bonds with another debt issue sold at a lower interest expense.

5. "Sinking Fund" is an annual obligation of a company to pay an amount of cash to a trustee in order to retire a given percentage of bonds. This requirement can often be met with actual bonds or with pledges of property. The obligation can be met by the stated percentage of each issue outstanding, by cash, or by applying the whole requirement against one issue or several issues.

6. Other Provisions. These include events of default, mortgage modification, security, limits on borrowing, priority, and the powers and obligations of the trustee.

Industrial Indentures

1. "Negative Pledge Clause" provides that a company cannot create or assume liens to the extent that more than a certain percentage of consolidated net tangible assets without giving bondholders the same security.

2. "Limitation on Sale and Leaseback Transactions" provide protection for the bondholder against the company selling and then leasing back assets that provide security for the holder. This provision requires that assets or cash equal to the property sold and leased back be applied to the retirement of the debt in question or used to acquire another property for the security of the bondholders.

3. "Sale of Assets or Merger" protect bondholders in the event of the sale of substantially all of the company's assets by requiring that the debt be retired or assumed by the merged company.

4. "Dividend Test" establishes rules for the payment of dividends so bondholders will be assured that the company will be not be drained by dividend payments.

5. Debt Test: This provision limits the amount of debt that may be issued by establishing a maximum debt/assets ratio.

Financial Indentures

1. "Sinking Fund and Refunding Provisions" specify sinking fund and refunding provisions. Generally, finance issues with a short maturity are non-callable, whereas longer issues provide 10-year call protection.

2. "Dividend Test" is the most important provision for a bondholder of a finance subsidiary. It restricts the amount of dividends that can be upstreamed to the parent from the subsidiary, thereby protecting the bondholder from the parent draining the subsidiary.

3. "Limitation on Liens" restrict the degree to which a company can pledge its assets without giving the same protection to the bondholder.

4. "Restriction on Debt Test" limit the amount of debt the company can issue and is generally stated in terms of assets and liabilities although an earnings test is sometimes used.

Question: Compare market-based forecasts with model-based forecasts of foreign exchange rates.

Answer:

In a fixed rate system, forecasters focus on governmental decision making,since the decision to devalue or revalue a currency is political. In a floating rate system, where there is little or no government intervention, currency forecasters use market or model based forecasts. In a market-based forecast, exchange rates are forecast by looking at interest and forward rates. In general, the forward rate is used as the unbiased predictor for future spot rates. This can only be used to predict exchange rates for up to a year in advance, since forward contracts generally don't exist for periods beyond one year. Interest rate differentials are used to predict exchange rates after one year.

The two main model-based forecasting tools are fundamental and technical analysis. Fundamental analysis looks at macroeconomic variables and policies that might affect a currency. These variables include inflation and interest rates, national income growth and changes in the money supply. For example, if the current inflation rates and spot rates for two currencies are known, then the future spot rate can be predicted using PPP. The problem with fundamental analysis is that it is difficult to predict which variables are the right ones, and then to predict what these variables will do in the future. If the fundamental values the analyst calculates are the same as the values that the market calculates, then because of efficient markets exchange rates will already reflect these calculations. In addition, there is generally a lag between the time that changes in variables are expected to occur and when these variables actually impact exchange rates.

Technical analysis focuses on past price and volume movements to forecast exchange rates. This can only be successful if there are price patterns that are discernable and then repeated so traders can take advantage of them. In charting, analysts look at graphs to spot price patterns and with trend analysis, trend-following systems are used to predict price trends.

Question: Identify factors and potential developments that would alter investors' expectations.

Answer:

Equity market valuations should rise over time from lower inflation and longer recoveries. Lower inflation boosts what investors are willing to pay for a dollar of earnings by increasing the quality of earning and the confidence that future earnings forecasts will be realized. Longer recoveries boost equity valuation by causing peak or near peak earnings to persist for a longer portion of the

overall business cycle.

Real interest rates are likely to remain volatile, with larger increases needed to slow an overheating economy and bigger reductions needed to generate recoveries from recession.

On the upside of the cycle, Federal Reserve officials are likely to have to tighten monetary policy by a greater increment to exert the same restraint on economic activity.

On the downside, bigger reductions in real interest rates will be necessary to generate a sustainable recovery. In addition, nominal rates will fall by an even greater magnitude as disinflation will persist longer, pushing down nominal interest rates. Cyclical reductions in bond yields should last longer. Bond yields normally decline during recessions and drift down further during early expansions as inflation continues to move down. As bouts of disinflation last longer, declines in bond yields will also persist.

The average level of credit spreads will be lower over the entire cycle, but the trough-to-peak changes in credit spreads will be larger. Lenders not expecting a recession will ease up on credit standards and demand smaller default premiums during the extended period of the recovery. However when the recession does occur, the widening in spreads is likely to be sharper.

Two risks may prevent this business cycle from being the longest ever:

1. Higher than expected economic growth in 1997 risks a downturn in 1998 because wages would rise and monetary policy would tighten.

2. A shock from abroad such as unusually weak economic activity elsewhere or an unusually strong dollar increases the chances of a recession in 1998.

Question: Describe the courses of action that a company could take when actual growth exceeds sustainable growth.

Answer:

The first step in solving the excess growth problem is to determine how long the situation will continue. If the problem is temporary, additional borrowing may be the simple solution. When the actual growth rate falls below the sustainable rate, the firm will be able to generate enough cash. If the problem is deemed to be longer-term, some combination of the strategies described below will be necessary.

1. Sell New Equity - If the company is willing and able to raise new equity capital by selling shares, its sustainable growth problems vanish. The increased equity, plus whatever added borrowing is possible as a result of the increased equity, is a source of cash with which to finance further growth. The potential problems with this strategy are:

A. Poorly developed or non-existent equity markets in some areas of the world make equity difficult to sell, basically making the shares illiquid.

B. Small companies may have limited access to the services of an investment banker to sell the shares, making it difficult to place a new issue.

C. Many companies may prefer not to sell equity, opting instead for internally generated funds, such as depreciation and increases in retained earnings, as sources of corporate capital.

2. Increase leverage - Increasing leverage raises the amount of debt the company can add for each dollar of retained profits. There are limits to the use of debt financing. All companies have a creditor-imposed debt capacity that restricts the amount of leverage the firm can employ. Moreover, as leverage increases, the risks borne by owners and creditors rise as do the costs of securing additional capital.

3. Reduce the Payout Ratio - A cut in the payout ratio raises the sustainable growth rate by increasing the proportion of earnings retained in the business. In general, owners' interest in dividend payments varies inversely with their perceptions of the company's investment opportunities. If owners believe that the retained profits can be put to productive use within the company, they will forego current dividends in favor of higher future ones. Alternatively, if a firm's investment opportunities do not promise attractive returns, a dividend cut will anger shareholders and result in a decline in stock price.

4. Profitable Pruning - Profitable pruning sells off operations that are performing marginally to generate cash to invest in the remaining businesses. Profitable pruning reduces sustainable growth problems in two ways: it generates cash directly through the sale of marginal businesses, and it reduces actual sales growth by eliminating some of the sources of the growth.

Profitable pruning can also be applied to a single-product company. In this case, slow-paying customers and/or slow-turning inventory are eliminated. This can eliminate sustainable growth problems in three ways: by freeing up cash, by increasing asset turnover, and by reducing sales.

5. Sourcing - Sourcing more and doing less in-house may increase sustainable growth rate. Sourcing releases assets that would otherwise be tied up in performing an activity, and it increases asset turnover; both of which serve to diminish growth problems.

6. Pricing - When revenue growth is too high in relation to a company's financing ability, it may have to raise prices to reduce growth. If the higher prices increase the profit margin, the rate of sustainable growth may increase.