CFA LEVEL 2 - TEST BANK WITH SOLUTIONS

Question: Analyze the advantages and disadvantages of the various

fnancial and operating changes that a company can make to manage its
sustainable growth.
Answer:
The frst 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 Euity - If the company is willing and able to raise new euity capital
by selling shares, its sustainable growth problems vanish. The increased euity,
plus whatever added borrowing is possible as a result of the increased euity, is a
source of cash with which to fnance further growth. The potential problems with
this strategy are:
!. "oorly developed or non-existent euity mar#ets ma#e euity di$cult
to sell, basically ma#e the shares illiuid.
%. &imited access to the services of an investment ban#er to sell the
shares, which is especially true for small concerns.
'. (any companies may prefer not to sell euity, opting instead for
internal sources, depreciation and increases in retained earnings as
sources of corporate capital.
). !ncrease leverage - Increasing leverage raises the amount of debt the
company can add for each dollar of retained profts. There are limits to the use of
debt fnancing: all companies have a creditor-imposed debt capacity that restricts
the amount of leverage the frm can employ. (oreover, as leverage increases, the
ris#s borne by owners and creditors rise, as do the costs of securing additional
capital.
*. "educe the #ayout "atio - ! 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 profts
can be put to productive use within the company, they will forego current
dividends in favor of higher future ones. !lternatively, if a frm+s investment
opportunities do not promise attractive returns, a dividend cut will anger
shareholders, resulting in a
stoc# price decline.
,. #roftable #runing - "roftable pruning sells o- marginally performing
operations to invest the money into the remaining businesses. This approach
recogni.es that when a company spreads its resources across too many products,
it may be unable to compete e-ectively in any. "roftable 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.
/. "roftable pruning can also be applied to a single-product company. In this case,
slow-paying customers and0or slow-turning inventory is eliminated. This can
Norman Cheung 1 AllenResources_Q&A_Level 2
eliminate sustainable growth problems in three ways: It frees up cash1 it increases
asset turnover1 and it reduces sales.
2. Sourcing - This option involves deciding whether to perform an activity in-
house or to purchase it from an outside vendor. 3ourcing more and doing less in-
house may increase sustainable growth rate. 3ourcing releases assets that would
otherwise be tied up in performing an activity, and it increases asset turnover1
both of which serve to diminish growth problems. The #ey to e-ective sourcing is
determining where the company+s uniue abilities lie, and sourcing out tas#s that
are not core to the business.
4. #ricing - !n obvious inverse relationship exists between price and volume.
5hen revenue growth is too high in relation to a company+s fnancing ability, it
may have to raise prices to reduce growth. If the higher prices increase the proft
margin, the rate of sustainable growth may increase.
6. $erger - 5hen all else fails, it may be necessary to loo# for a partner. Two
types of companies are capable of supplying the needed cash: a mature company
7a cash cow8 loo#ing for proftable investments for its excess cash 9ow and a
conservatively fnanced company that would bring liuidity and borrowing capacity
to the cash needy frm.
Question% E&plain the computation of a frm's e(ective ta& rate.
Answer:
"ermanent di-erences, which are di-erence between the way that the tax code
measures income and the way that fnancial statements report income that never
reverses itself, a-ect the provision for taxes in the income, the tax expense, which
is calculated as:
7"ro:ected income before taxes - "ermanent di-erences8 x tax rate
Timing di-erences, which are di-erence between the time that the tax code
recogni.es either an income or an expense item and the time at which the
fnancial statements record the item, appear in the balance sheet as ;eferred
Taxes. ;eferred taxes are tax obligations that are expected to be
paid when the timing di-erences are reversed. ;eferred taxes in any fscal year
are calculated as:
7'umulative timing di-erences8 x 7tax rate8
! tax payment for a given year euals the tax expense minus the increase in the
deferred tax account.
5hen analy.ing the tax accounts, the ob:ective is to estimate three elements:
1. The permanent di-erences that the frm will have between its taxable
income and reported income.
). The timing di-erences.
*. The tax rate to which the frm will be sub:ect.
The frst step in determining these elements is the calculation of:
<-ective tax rate = Tax expense0Income before taxes
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Question% Evaluate the most commonly found indenture provisions.
Answer:
UTILITY INDENTURES
1. >Security> specifes the property upon which there is a mortgage lien and the
ran#ing of the new debt relative to outstanding debt is specifed. ?enerally, new
bonds ran# eually with all other bonds outstanding under the mortgage. 'ertain
features of older provisions have become archaic,
hindering the e$ciency 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 o-erings.
). >Issuance of Additional Bonds> establish the conditions under which the
company may issue additional frst mortgage bonds and is often based upon a
debt test and0or 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 specifed level.
*. >Maintenance and Replacement (M&R) Fund> ensure that the mortgaged
property is maintained in good operating condition, thereby maintaining its value.
,. >Redemption Provision,> or call provision specifes when and under what
prices a company may call its bonds. @efunding is an action by a company to
replace outstanding bonds with another debt issue sold at a lower interest
expense.
/. >Sinin! 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 reuirement 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 reuirement against one issue or several issues.
2. "t#er Provisions. These include events of default, mortgage modifcation,
security, limits on borrowing, priority, and the powers and obligations of the
trustee.
INDUSTRIAL INDENTURES
1. >$e!ative Pled!e %lause> 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.
). >&imitation on Sale and &ease'ac (ransactions> provide protection for the
bondholder against the company selling and then leasing bac# assets that provide
security for the holder. This provision reuires that assets or cash eual to the
property sold and leased bac# be applied to the retirement of the debt in uestion
or used to acuire another property for the security of the bondholders.
*. >Sale of Assets or Mer!er> protect bondholders in the event of the sale of
substantially all of the company+s assets by reuiring that the debt be retired or
assumed by the merged company.
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,. >)ividend (est> establishes rules for the payment of dividends so bondholders
will be assured that the company will be not be drained by dividend payments.
/. )e't (est: This provision limits the amount of debt that may be issued by
establishing a maximum debt0assets ratio.
FINANCIAL INDENTURES
1. >Sinin! Fund and Refundin! Provisions> specify sin#ing fund and refunding
provisions. ?enerally, fnance issues with a short maturity are non-callable,
whereas longer issues provide 1A-year call protection.
). >)ividend (est> is the most important provision for a bondholder of a fnance
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.
*. >&imitation on &iens> restrict the degree to which a company can pledge its
assets without giving the same protection to the bondholder.
,. >Restriction on )e't (est> 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% )ompare market*based forecasts with model*based forecasts
of foreign e&change rates.
Answer:
In a fxed rate system, forecasters focus on governmental decision ma#ing,since
the decision to devalue or revalue a currency is political. In a 9oating rate system,
where there is little or no government intervention, currency forecasters use
mar#et or model based forecasts. In a mar#et-based forecast, exchange rates are
forecast by loo#ing 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 di-erentials are
used to predict exchange rates after one year.
The two main model-based forecasting tools are fundamental and technical
analysis. Bundamental analysis loo#s at macroeconomic variables and policies that
might a-ect a currency. These variables include in9ation and interest rates,
national income growth and changes in the money supply. Bor example, if the
current in9ation rates and spot rates for two currencies are #nown, then the future
spot rate can be predicted using """. The problem with fundamental analysis is
that it is di$cult 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 mar#et calculates, then because of
e$cient mar#ets exchange rates will already re9ect these calculations. In addition,
there is generally a lag between the time that changes in variables are expected
to occur and when these variables actually impact exchange rates.
Technical analysis focuses on past price and volume movements to forecast
exchange rates. This can only be successful if there are price patterns that are
Norman Cheung 4 AllenResources_Q&A_Level 2
discernable and then repeated so traders can ta#e advantage of them. In charting,
analysts loo# at graphs to spot price patterns and with trend analysis, trend-
following systems are used to predict price trends.
Question% !dentify factors and potential developments that would alter
investors' e&pectations.
Answer:
<uity mar#et valuations should rise over time from lower in9ation and longer
recoveries. &ower in9ation boosts what investors are willing to pay for a dollar of
earnings by increasing the uality of earning and the confdence that future
earnings forecasts will be reali.ed. &onger recoveries boost euity valuation by
causing pea# or near pea# earnings to persist for a longer portion of the
overall business cycle.
@eal interest rates are li#ely to remain volatile, with larger increases needed to
slow an overheating economy and bigger reductions needed to generate
recoveries from recession.
Cn the upside of the cycle, Bederal @eserve o$cials are li#ely to have to tighten
monetary policy by a greater increment to exert the same restraint on economic
activity.
Cn 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 disin9ation will persist longer, pushing down nominal
interest rates. 'yclical reductions in bond yields should last longer. %ond yields
normally decline during recessions and drift down further during early expansions
as in9ation continues to move down. !s bouts of disin9ation 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-pea# changes in credit spreads will be larger. &enders not expecting a
recession will ease up on credit standards and demand smaller default premiums
during the extended period of the recovery. Dowever when the recession does
occur, the widening in spreads is li#ely to be sharper.
Two ris#s may prevent this business cycle from being the longest ever:
1. Digher than expected economic growth in 1EE4 ris#s a downturn in 1EE6
because wages would rise and monetary policy would tighten.
). ! shoc# from abroad such as unusually wea# economic activity elsewhere or an
unusually strong dollar increases the chances of a recession in 1EE6.
Question% +escribe the courses of action that a company could take when
actual growth e&ceeds sustainable growth.
Answer%
The frst 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. 5hen the actual growth rate falls below the sustainable rate,
the frm 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
Norman Cheung 5 AllenResources_Q&A_Level 2
necessary.
1. Sell $ew *+uity - If the company is willing and able to raise new euity capital
by selling shares, its sustainable growth problems vanish. The increased euity,
plus whatever added borrowing is possible as a result of the increased euity, is a
source of cash with which to fnance further growth. The potential problems with
this strategy are:
!. "oorly developed or non-existent euity mar#ets in some areas
of the world ma#e euity di$cult to sell, basically ma#ing the
shares illiuid.
%. 3mall companies may have limited access to the services of an
investment ban#er to sell the shares, ma#ing it di$cult to place a
new issue.
'. (any companies may prefer not to sell euity, opting instead for
internally generated funds, such as depreciation and increases in
retained earnings, as sources of corporate capital.
). Increase levera!e - Increasing leverage raises the amount of debt the
company can add for each dollar of retained profts. There are limits to the use of
debt fnancing. !ll companies have a creditor-imposed debt capacity that restricts
the amount of leverage the frm can employ. (oreover, as leverage increases, the
ris#s borne by owners and creditors rise as do the costs of securing additional
capital.
*. Reduce t#e Payout Ratio - ! 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 profts can be put to productive use within the company, they will forego
current dividends in favor of higher future ones. !lternatively, if a frm+s
investment opportunities do not promise attractive returns, a dividend cut will
anger shareholders and result in a decline in stoc# price.
,. Pro,ta'le Prunin! - "roftable pruning sells o- operations that are performing
marginally to generate cash to invest in the remaining businesses. "roftable
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.
"roftable pruning can also be applied to a single-product company. In this case,
slow-paying customers and0or 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.
/. Sourcin! - 3ourcing more and doing less in-house may increase sustainable
growth rate. 3ourcing releases assets that would otherwise be tied up in
performing an activity, and it increases asset turnover1 both of which serve to
diminish growth problems.
2. Pricin! - 5hen revenue growth is too high in relation to a company+s fnancing
ability, it may have to raise prices to reduce growth. If the higher prices increase
the proft margin, the rate of sustainable growth may increase.
Norman Cheung 6 AllenResources_Q&A_Level 2
4. Mer!er - 5hen all else fails, it may be necessary to loo# for a partner. Two
types of companies are capable of supplying the needed cash: a mature company
7a cash cow8 and a conservatively fnanced company that would bring liuidity and
borrowing capacity to the cash needy frm.
Question% +iscuss the weaknesses and di,culties of using ratio analysis
to evaluate a company.
Answer%
There are three primary methods by which ratios are :udged:
1. )-$#A"!N. "A/!-S )"-SS SE)/!-NA001
This involves comparing a ratio in a particular frm to the same ratio in other
similar frms. The ob:ective is to determine if the ratio that is being analy.ed is
too high or too low in comparison to the norm. 3ince there are no completely
identical frms, an analyst decides how tight the criteria should be between
frms. The tighter the criteria the better. Dowever, guidelines that are too
specifc will eliminate many comparables.
If an abnormal ratio is discovered, it may simply be a result of the frm+s uniue
policies, and is thereby no reason for concern.
). /2E /!$E SE"!ES -3 /2E 3!"$'S "A/!-S
!s mentioned above, the problem with comparing ratios cross sectionally is that
no two frms are identical. Cne way to correct this problem is to the use the frm
to establish the norm for the di-erent ratios, which is done by analy.ing the time
series of the frm+s ratios. This is accomplished by comparing a ratio over time
and examining its trend. The reasoning behind this method is that since each
frm+s uniue features determine its ratios, reviewing trends in the ratios can
identify changes in the frm+s operations.
!lthough this method is an improvement over the cross sectional comparison
method, it still has the following problems:
First, intentional and unintentional changes in a frm+s policies lead to the
changes in the ratio that cannot be unraveled by an outside analyst. Bor
example, a decline in a frm+s gross margin may result from a variety of reasons,
and because fnancial statements summari.e events, trends are not easy to
interpret.
Second, in9ation may cause false trends among various ratios because fnancial
reporting is done on a historical-cost basis. Bor example, depreciation expense
will probably re9ect the cost of assets that are several years old, and since the
cost of goods sold for an industrial frm includes these depreciation charges, the
gross-margin ratio may appear to >improve> over time.
Finally, the use of past ratios as the norm against current ratios may disguise
problems, or even strengths, of the frm.
Thus, a complete ratio analysis should include both a cross-sectional and a time-
series comparison of ratios.
*. /2E E)-N-$!) !N/E"#"E/A/!-N -3 "A/!- )2AN.ES AN+ +E4!A/!-NS
The ratios that are obtained for a frm should be compared to our economic
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understanding of the frm+s environment, business, policies, and e-ectiveness.
This is what di-erentiates a technically correct but uninformative fnancial
statement analysis from an analysis that provides insights into the frm+s
operations and allows accurate prediction of its future fnancial performance.
Question% )ompare and contrast the monthly prepayment option
embedded in an $5S with a callable or putable bond and with a non*
callable bond.
Answer%
!n investor+s ris# can be illustrated using the concept of convexity. 5hen interest
rates decline sharply, convexity becomes negative. In a mortgage pool, an
increasing portion of the mortgages in the pool prepays. 5hen interest rates
decline below the coupon rate, most people prepay and the price-yield relationship
experiences negative convexity in this area.
Bor higher interest rates, negative convexity also may occur, or there will at least
be less positive convexity than is the case with bonds. The reason for this is that
people who might want to upgrade their house or to relocate are discouraged to
do so because of the much higher payments on the new home. In this case,
prepayments are below what would normally occur, which is #nown as extension
ris#. ;uration of the instrument increases and if the term structure is upward-
sloping, the value decline is more than occurs with a fxed-rate, stated-maturity
bond.
The possibility of negative convexity in a high interest environment ma#es
mortgage securities very di-erent from a noncallable, fxed-income security for
which positive convexity prevails. 5ith all other things constant, for signifcant
interest-rate changes, a mortgage security will perform more poorly than a fxed-
rate stated maturity bond.
Question% State and describe the two main model*based currency
forecasting tools.
Answer%
The two main model-based forecasting tools are fundamental and technical
analysis. Bundamental analysis loo#s at macroeconomic variables and policies that
might a-ect a currency. These variables include:
1. in6ation
). interest rates
*. national income growth
,. changes in the money supply
Bor example, if the current in9ation rates and spot rates for two currencies are
#nown, then the future spot rate can be predicted using """. The problem with
fundamental analysis is the di$culty in predicting which variables are the right
ones, and then predicting what these variables will do in the future. If the
calculated fundamental values are the same as the values that the mar#et
calculates, the exchange rates will already re9ect 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.
Norman Cheung 8 AllenResources_Q&A_Level 2
Technical analysis focuses on past price and volume movements toforecast
exchange rates. This can only be successful if:
1. There are price patterns that are discernable
). "rice patterns are repeated so traders can ta#e advantage of
them
In charting, analysts loo# at graphs to spot price patterns. In trend analysis, trend-
following systems are used to predict price trends.
Question% /he idea that recessions will be more infreuent but will have
greater fnancial implications when they do occur has a number of
implications for 7.S. markets. 8hat are they9
Answer%
<uity mar#et valuations should rise over time from lower in9ation and longer
recoveries. &ower in9ation boosts what investors are willing to pay for a dollar of
earnings by increasing the uality of earning and the confdence that future
earnings forecasts will be reali.ed. &onger recoveries boost euity valuation by
causing pea# or near pea# earnings to persist for a longer portion of the overall
business cycle.
@eal interest rates are li#ely to remain volatile, with larger increases needed to
slow an overheating economy and bigger reductions needed to generate
recoveries from recession. Cn the upside of the cycle, Bederal @eserve o$cials are
li#ely to have to tighten monetary policy by a greater increment to exert the same
restraint on economic activity. Cn 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 disin9ation will persist for longer,
pushing down nominal interest rates.
'yclical reductions in bond yields should last longer. %ond yields normally decline
during recessions and drift down further during early expansions as in9ation
continues to move down. !s bouts of disin9ation 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-pea# changes in credit spreads will be larger. &enders not expecting a
recession will ease up on credit standards and demand smaller default premiums
during the extended period of the recovery. Dowever when the recession does
occur, the widening in spreads is li#ely to be sharper.
Question: 8hat is the di(erence between capital market integration and
capital market segmentation9
Answer%
%apital maret inte!ration refers to the fact that real interest rates are largely
determined by global supply and demand for money. If capital mar#ets are
segmented, then real interest rates are determined by local credit conditions.
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In segmented mar#ets, the real interest rate in the F.3. is based on national
demand and supply. The real rate in the rest of the world is based on the rest of
the world supply and demand. Bor example, suppose the F.3. real rate is higher
than the real rate outside the F.3.
If mar#ets are integrated, this will cause capital to 9ow into the F.3., decreasing
the F.3. real interest rate and increasing the rest of the world real interest rate. In
integrated capital mar#ets, the home real interest rate depends on economic
events around the world. Today+s capital mar#ets are well integrated, meaning
there are only small real interest rate di-erentials.
@eal interest di-erentials are usually caused by currency or political ris#. Bor
example, a real interest rate di-erential could exist if investors strongly desire
domestic assets to avoid currency ris#, even if the expected real return on foreign
assets were higher.
Question: +istinguish between the spot and forward markets for foreign
e&change.
Answer:
Trading currencies occurs in foreign exchange mar#ets, whose primary function is
to facilitate international trade and investment. ! foreign exchange mar#et is the
intermediary that allows trading of one currency for another.
In the spot mar#et, currencies are traded for immediate delivery, generally within
two wor#ing days, while in the forward mar#et currencies are bought or sold for
future delivery. !bout 2AG of transactions are spot purchases and sales, about
1AG are forward contracts, and the remaining *AG are swaps, which involve both
spot deliveries and forward contracts.
(a:or participants in the foreign exchange mar#et include large commercial ban#s,
foreign exchange bro#ers, commercial customers such as multinational
corporations, and government central ban#s. Boreign exchange bro#ers are
specialists in matching clients+ supply and demand needs. %ro#ers receive a
commission on all transactions and supply information about buy and sell rates.
In the forward mar#et, the ma:or players are arbitrageurs, traders, hedgers and
speculators. !rbitrageurs ma#e the mar#et more e$cient by see#ing out
di-erences in interest rates between countries. They use forward contracts to try
to ma#e ris#-free profts by exploiting these di-erences.
Traders use forward contracts to reduce ris# on export or import orders by
purchasing or selling the currency that will be needed at some future date.
Dedgers, primarily multinational frms, use forward contracts to protect the home
currency value of foreign-currency denominated assets and liabilities on their
company balance sheets. These actions >loc# in> a currency price, reducing, or
even eliminating ris#. 3peculators, on the other hand, actively
expose themselves to ris# by buying or selling currencies forward to beneft from
exchange rate 9uctuations.
Question% +iscuss the characteristics of a swaption.
Norman Cheung 10 AllenResources_Q&A_Level 2
Answer:
! swaption is an option on a swap that can be either !merican or <uropean in
form.
Receiver Swaption
! receiver swaption gives the holder the right to enter a particular swap
agreement as the fxed-rate receiver 7pay 9oating8.
! receiver swaption is similar to a call option a bond that pays a fxed rate of
interest. !ssuming the option is <uropean, the holder will exercise the option if at
expiration, interest rates are lower than the fxed rate of the swap. The owner then
receives a seuence of fxed interest payments in exchange for ma#ing a
seuence of 9oating rate payments at the new lower rate of interest.
Therefore, a receiver swaption is in-the-money if prevailing interest rates are less
than the fxed rate of the swap.
Payer Swaption
! payer swaption gives the holder the right to enter a particular swap agreement
as the fxed rate payer 7receive 9oating8.
! payer swaption is similar to a put option on a bond that pays a fxed rate of
interest. !ssuming the option is <uropean, the holder will exercise the option if at
expiration, interest rates are higher than the fxed rate of the swap. The owner
then receives a seuence of 9oating interest payments at the new higher rate of
interest in exchange for ma#ing a seuence of
fxed payments at the lower fxed rate.
Therefore, a payer swaption is in-the-money if prevailing interest rates are greater
than the fxed rate of the swap.
Question% Analyze the competitive advantage and competitive strategy
of a company.
Answer%
'ompetition is at the core of the success or failure of companies. 'ompetition
determines the appropriateness of a company+s activities and their ability to
contribute to its performance.
Two basic factors determine a company+s c#oice of competitive strate!y:
1. Its relative competitive position within its industry, and
). the attractiveness of its industry with respect to long-term proftability and the
factors that determine it.
! frm in a very attractive industry may still not earn attractive profts if it has
chosen a poor competitive position. Cn the other hand, a frm in an excellent
competitive position may be in a poor industry that has little chance of being very
proftable.
Industry attractiveness and competitive position can be shaped by the frm, which
ma#es the choice of competitive strategy very challenging.
Norman Cheung 11 AllenResources_Q&A_Level 2
(ichael "orter describes the competitive forces that determine the attractiveness
of an industry and how to implement the principal strategies to achieve
competitive advantage. 'ompetitive advantage is created when the value a frm is
able to create for its buyers exceeds the frm+s cost of creating it. Halue is what
buyers are willing to pay for, and superior value stems from o-ering lower prices
than competitors for euivalent benefts or providing uniue benefts that more
than o-set a higher price. "orter+s boo# describes two 'asic types of
competitive advanta!e:
1. )ost leadership, whereby a frm o-ers lower prices for the same product
benefts, and
). +i(erentiation, whereby buyers are willing to pay more for uniue benefts
that a frm o-ers.
Question% +i(erentiate between spot :cash; and futures prices and
e&plain the why the basis must converge to zero at e&piration.
Answer%
The spot price, also referred to as cash price or current price, is the price of a good
for immediate delivery. The future price, that which will be paid at a specifc future
date, is related to the cash price.
The basis is the relationship between the cash price of a good and the futures
price for the same good. The basis is calculated as the current cash price for a
particular commodity at a specifed location, minus the price of a particular futures
contract for the same commodity at the same location.
basis < current cash price * futures price
Iote that the basis calculated in considering futures prices may di-er, depending
upon the geographic location of the spot price that is used to compute the basis.
?enerally, the basis is used in reference to the di-erence between the cash price
and the nearby futures contract. There is, however, a basis for each outstanding
futures contract, and this basis will often di-er in systemic ways, depending upon
the maturities of the individual futures contracts.
In a normal mar#et, prices for more distant futures are higher than for nearby
futures. In an inverted mar#et, distant futures prices are lower than for the prices
for contracts nearer to expiration. <ven though the spot and futures prices may be
uite variable over time, the basis tends to have low variability. Fnderstanding this
aspect of the basis is very important for
hedgers and speculators.
5hen a futures contract is at expiration, the futures price and the spot price of the
commodity must be the same 7the basis must be .ero8, except for minor
discrepancies due to transportation and other transaction costs. This behavior of
the basis over time is #nown as convergence, and is consistent with the no-
arbitrage reuirement.
Question% Analyze competitive forces that a(ect the proftability of a
company.
Answer%
Norman Cheung 12 AllenResources_Q&A_Level 2
The frst fundamental determinant of a frm+s proftability is industry
attractiveness. 'ompetitive strategy must grow from a sophisticated
understanding of the rules of competition that determine an industry+s
attractiveness. The ultimate goal of competitive strategy is to cope with and
change those rules in favor of the frm+s. In any industry, whether it is domestic or
international, the rules of competition are embodied in fve competitive forces:
1. The entry of new competitors
). The threat of substitutes
*. The bargaining power of buyers
,. The bargaining power of suppliers
/. The rivalry among the existing competition
These forces determine the ability of frms in an industry to earn rates of return on
investment in excess of the cost of capital. The strength of these forces varies
from industry to industry. Bor example, in the pharmaceutical industry, all forces
are favorable so many competitors earn attractive profts. Jet in an industry where
pressure from one or more forces is intense, such as rubber or steel, few
companies earn attractive returns even with the best of management.
The fve forces collectively determine industry proftability because they in9uence
the prices, costs and reuired investment of frms in an industry--the elements of
return on investment. !ll industries di-er in the individual and collective strengths
of these forces and therefore, industries di-er in inherent proftability. The strength
of each of the fve forces is a function of industry structure, which is relatively
stable, but can change over time as an industry evolves. The industry trends that
are the most important for strategy are those that a-ect industry
structure.
Birms are not prisoners of their industry structure, however. Through their
strategies, frms can in9uence the fve forces and therefore shape industry
structure, ma#ing it either more or less attractive. There have been many
successful strategies that have changed the rules of competition through this
method. Jet such strategies are a double-edged sword since a frm can destroy
industry structure and proftability as readily as it can improve it. Bor example, a
frm that creates an improved product may undercut entry barriers or increase the
competitive rivalry, but may undermine the long-run proftability of an industry.
Birms pursuing strategic choices without considering the long-term conseuences
of industry structure are termed >destroyers.> These frms are either: attempting to
fnd ways to overcome competitive disadvantage, have serious problems and are
see#ing desperate solutions, or are frms that are so >dumb> that they do not #now
their costs or have unrealistic assumptions about the future.
The ability of frms to shape industry structure places a particular burden on
industry leaders. &eaders+ actions can have a disproportionate impact on structure,
because of their si.e and in9uence over buyers, suppliers and other competitors.
!t the same time, leaders+ large mar#et shares guarantee that anything that
changes overall industry structure will a-ect them as well. &eaders, therefore,
must stri#e a balance between its own competitive position and the health of the
entire industry.
Question% 0ist the common causes of a decline in earnings uality.
Answer:
Norman Cheung 13 AllenResources_Q&A_Level 2
Cne of the ob:ectives of a uality of earnings analysis is to determine when there
has been a decline in the uality of earnings. The following items are some of the
more common causes of a decline in earnings uality:
1. !doption of less conservative accounting principles. Bor example, switching
from &IBC to BIBC in an in9ationary environment, or changing from accelerated
depreciation to straight line depreciation. This would also include capitali.ing costs
that were previously expensed.
). !doption of less conservative accounting estimates, such as decreasing
estimates of warrantee costs, bad debts, etc.
*. Cne-time transactions resulting in a recogni.ed gain, such as sale of real estate.
,. <arly0aggressive revenue recognition - this is generally accompanied byan
increase in accounts receivable 7beware of sale of receivables8.
/. @eduction of costs which increase this year+s net income and may a-ect future
earnings power - such as, research and development, advertising or maintenance
costs.
2. Increasing proportion of income arising from peripheral activities 7not central
operations8 - such as investment income.
4. Incurring extra costs to ma#e sure a merger ualifes for pooling of interest, so
goodwill will not have to be recorded 7goodwill results in lower future income as it
is amorti.ed8.
6. ;ecrease in inventory turnover, which may indicate production or mar#eting
problems not yet recorded in income.
E. 5rite-o- of investments soon after they are made.
1A. Increasing fnancial leverage to point where ris# is signifcantly increased.
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Norman Cheung 14 AllenResources_Q&A_Level 2