authors. Full Test Bank Chapter 31 Emerging Markets

Chapter: Chapter 31: Emerging Markets

Multiple Choice

1. For emerging markets, the recommended market input for computing beta is:

a) A small-cap index.

b) A median-cap index.

c) A global market index.

d) An index of non-investment-grade bonds.

Response: []

2. For emerging markets, the recommended input for the risk-free rate for computing beta is:

a) The domestic government bond rate.

b) The average of the inflation rates of developed nations.

c) The average of the government bond rates of developed nations.

d) The U.S. Treasury bond rate plus the local inflation rate minus the U.S. inflation rate.

Response: []

3. Which of the following are reasons an analyst should allow for changes in cost of capital in an emerging market?

I. Reforms in the tax system.

II. Changes in the cost of debt.

III. Evolving inflation expectations.

IV. Changes in a company’s capital structure.

a) I and II only.

b) I, III, and IV only.

c) II and IV only.

d) I, II, III, and IV.

Response: []

4. Which of the following best represents the relevance of purchasing power parity (PPP) when analyzing companies in emerging markets?

a) PPP does not hold between emerging and developed economies.

b) PPP holds over the long run, and exchange rates will adjust to inflation differentials.

c) PPP holds over the long run, but exchange rates will not adjust to inflation differentials.

d) It is not clear whether PPP holds, because there is not yet enough evidence one way or the other.

Response: []

5. Given the following information for a company in a developing market, estimate the value of the company. The cash for the next year is estimated to be either $200 in the business-as-usual scenario or $50 in the distress scenario. The probabilities of the scenarios are 80 percent and 20 percent, respectively. The expected perpetual growth rate in each case is 5 percent per year, and the cost of capital is 11 percent. The value of the company is closest to:

a) $1,654.55

b) $2,500.00

c) $2,833.33

d) $3,333.33

Response: [Since the growth rate in both scenarios is 5 percent, the value of the firm is: Value = (0.8 × 200 + 0.2 × 50)/(0.11 – 0.05) = 2,833.33]

6. Using a scenario approach, an analyst finds that the estimated value of a company is $800. The business-as-usual scenario forecasts a cash flow of $40 starting next year and then growing at 6 percent forever. The cost of capital in that scenario is 10 percent. Given this information, what is the implied risk premium to add to the cost of capital to make the analyst’s results consistent with the country risk premium discounted cash flow (DCF) approach?

a) 0.80 percent.

b) 1.00 percent.

c) 1.20 percent.

d) 1.25 percent.

Response: [The risk premium would be found from solving $800 = 40/(0.10 + p – 0.06). Manipulating this algebraically gives: p = 0.01 = 40/800 – 0.10 + 0.06]

7. In a two-scenario model of an emerging market, it is recommended that the analyst create a base-case set of forecasts and a set of forecasts associated with a period of economic distress. Which of the following best represents the range of probability weights to assign the economic distress scenario?

a) 5 to 10 percent.

b) 10 to 20 percent.

c) 20 to 30 percent.

d) 30 to 40 percent.

Response: []

8. Which of the following is NOT an argument against the country risk premium approach?

a) Most country risks, including expropriation, devaluation, and war, are largely diversifiable.

b) Risks apply unequally to companies in a given country.

c) There is no systematic method to calculate a country risk premium.

d) It is bound to be below the growth rate, and that limits its application.

Response: []

True/False

9. As long as international investors have access to an emerging market’s local investment opportunities, local prices will be based on an international cost of capital.

Response: []

10. For estimating the cost of capital in emerging markets, other models are superior to the capital asset pricing model (CAPM).

Response: [The CAPM may not be a very robust model for the less integrated emerging markets, but there is no better alternative model today. Furthermore, it is likely to become a better predictor of equity returns worldwide as markets continue to become more integrated.]

Short Answer

11. In applying the CAPM in estimating the cost of capital in an emerging market, explain the three problems in estimating an appropriate risk-free rate and the recommended solution.

The solution is to start with a risk-free rate based on the 10-year U.S. government bond yield and then add to this the projected difference over time between U.S. and local inflation. The result is an estimate of the nominal risk-free rate in local currency.]