LevelⅡ
 

　　Vacations Unlimited Inc. (VU)， a U.S.-based tourism company， has a majority stake in Yucatan Resorts， a Mexican firm that owns and operates luxury resorts along Mexico‘s Caribbean coast.Because most of its client base consists of U.S. tourists， Yucatan Resorts’ revenues are denominated in U.S. dollars. Yucatan Resorts converts all U.S. dollar receipts into Mexican pesos through the foreign exchange market. Yucatan Resorts‘ operating costs are all denominated in pesos and assumed to increase in line with the Mexican inflation rate， and the firm’s assets and liabilities are all denominated in pesos. Yucatan Resorts‘ shares trade on the Mexican stock exchange and are also denominated in pesos.George Davies， VU’s Chief Financial Officer， is considering increasing VU‘s investment in Yucatan Resorts. He is aware， however， that the Mexican inflation rate has been higher than the inflation rate in the U.S. and that the Mexican peso has been depreciating against the U.S. dollar.Davies is concerned that a continuation of these trends might reduce Yucatan Resorts’ profitability. He asks Iris Hamson， a financial analyst at VU， to investigate the relationship between Yucatan Resorts‘ share price， nominal exchange rates between the peso and the dollar，and inflation rates in Mexico and the U.S. Hamson states：“Based on Yucatan Resorts’ sources of revenues and costs， and given that purchasing power parity is unlikely to hold， I conclude that Yucatan Resorts‘ local currency exposure will be characterized by a negative correlation between Yucatan’s share price (measured in pesos) and the value of the peso.”

　　A. Define local currency exposure.

　　(3 minutes)

　　B. State whether Hamson‘s conclusion about Yucatan Resorts’ local currency exposure is

　　correct or incorrect. Justify your response with one reason.

　　(3 minutes)

 QUESTION 2 HAS TWO PARTS (A， B) FOR A TOTAL OF 9 MINUTES.

　　Iris Hamson is evaluating international fixed income investments for Vacations Unlimited Inc.She notes that Standard & Poor‘s (S&P) assigns separate and distinct credit ratings to each national government’s local currency debt and foreign currency debt.

A. State whether a national government‘s local currency debt credit rating or foreign currency debt credit rating is generally lower. Justify your response with one reason why the default risk is higher on the type of debt that is generally lower-rated.

　　(3 minutes)

　　S&P uses several risk factor categories in determining sovereign credit ratings. Hamson contends that three S&P risk factor categories are most important： 1) income and economic structure， 2) fiscal flexibility， and 3) price stability. Based on her country research， she has compiled the following list of characteristics of Mexico：

　　1. National， regional， and local governments that generally possess competitive tax structures and the ability to control spending

　　2. A strong banking sector that reflects conservative lending practices and generally high asset quality

　　3. A history of prudent monetary and exchange-rate policies pursued by an independent central bank

　　4. An external balance sheet that is conservatively structured and an excellent track record of timely debt service payments

　　5. A recent Presidential election that was marked by wide voter participation in response to a popular platform of economic reforms

　　6. Favorable trends in foreign direct investment and export growth that appears to be sufficient to lessen any potential balance-of-payments pressures in the future

　　7. A market economy that exhibits average wealth levels overall but a concentration of wealth that results in a large difference between the rich and the poor

　　B. Select from Hamson’s list the characteristic of Mexico that most directly relates to each of the three S&P risk factor categories.

　　Note： Your selections should NOT include any characteristic more than once； only the characteristic reference numbers (1 through 7) are needed for your selections.

　　While valuing the equity of Rio National Corp.， Katrina Shaar is considering the use of either cash flow from operations (CFO) or free cash flow to equity (FCFE) in her valuation process.

　　A. State two adjustments that Shaar should make to cash flow from operations to obtain free cash flow to equity. Explain why it is necessary to make each of the two adjustments when valuing the equity of a firm.

　　Note： No calculations are required.

　　(4 minutes)

　　Shaar decides to calculate Rio National‘s FCFE for the year 2002， starting with net income.

　　B. Determine， for each of the five supplemental notes given in Exhibit 5-3：

　　i. Whether a net positive adjustment， a net negative adjustment， or no adjustment should be made to net income to calculate Rio National’s free cash flow to equity for the year 2002

　　ii. The dollar amount of the adjustment， if any

　　Note： The five supplemental notes given in Exhibit 5-3 are reproduced in the Template for Question 6-B.

　　(10 minutes)

　　C. Calculate Rio National‘s free cash flow to equity for the year 2002. Show your calculations.

　　Note： Your calculations should start with net income.

　　(6 minutes)

　　The management of Rio National Corp. has now announced the signing of a new marketing agreement that will allow the company to sell its products in Southeast Asia. Sophie Delourme，an analyst at Euro-International Co.， is analyzing the effect of this announcement on her estimated value of Rio National‘s equity. She uses the H-model in her valuation process and has identified the following inputs：

　　Rio National’s earnings growth rate is expected to be 30.0 percent in 2003，declining over a five-year period to a constant growth rate of 12.0 percent in 2008 and thereafter.

　　Because of the change in risk， the required rate of return (cost of equity) for Rio National is expected to be 13.5 percent.

　　The dividend per share for 2002 was $0.20.

　　The dividend payout ratio is expected to be constant.

　　A. Calculate the estimated value of a share of Rio National‘s equity on 31 December 2002，using the H-model. Show your calculations.

　　(6 minutes)

　　Delourme presents her analysis to her supervisor and concludes：

　　“Except in rare circumstances， the H-model’s estimated value will be a close approximation to estimated values generated by multi-stage dividend growth models that

　　explicitly forecast dividends each year.”

　　B. State whether Delourme‘s conclusion is correct or incorrect. Justify your response with one reason.

　　(4 minutes)

　　After Rio National Corp. announced the new marketing agreement to sell its products in Southeast Asia， several analysts revised their 2003 outlook for Rio National. Reflecting the new marketing agreement， the current consensus 2003 earnings per share is $2.19 and the current consensus 12-month target share price is $50.00.

　　Sophie Delourme observes that Rio National‘s share price rose from $25.00 to $37.00 after the new agreement was announced. She believes that Rio National’s required rate of return (cost ofequity) is 13.5 percent.

　　Calculate the present value of growth opportunities (PVGO) reflected in Rio National‘s share price after the agreement was announced. Show your calculations.

　　(6 minutes)

　　Michael Weber， CFA， is analyzing several aspects of option valuation， including the determinants of the value of an option， the characteristics of various models used to value options， and the potential for divergence of calculated option values from observed market prices.

　　A. State， and justify with one reason for each case， the expected effect on the value of a call option on common stock if each of the following changes occurs：

　　i. The volatility of the underlying stock price decreases

　　ii. The time to expiration of the option increases

　　(4 minutes)

　　Using the Black-Scholes option-pricing model， Weber calculates the price of a three-month call option and notices the option‘s calculated value is different from its market price. A colleague verifies that Weber’s methodology and results are correct.

　　B. With respect to Weber‘s use of the Black-Scholes option-pricing model， and given that his methodology and results are correct：

　　i. Discuss one reason why the calculated value of an out-of-the-money European option may differ from that same option’s market price.

　　ii. Discuss one reason why the calculated value of an American option may differ from that same option‘s market price.

　　(4 minutes)