Equity Investments B: Industry and Company Analysis

• Topic 01

  Industry Analysis and Competitive Dynamics

  60 questions
• Topic 02

  Company Analysis and Financial Modelling

  96 questions
• Topic 03

  Equity Securities Types

  87 questions
• Topic 04

  Return and Risk in Equity Markets

  60 questions
• Topic 05

  ESG in Equity Analysis

  102 questions
• Topic 06

  Active vs. Passive Equity Strategies

  93 questions
• Topic 07

  Global Equity Markets

  81 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. A financial model for a software company shows: Year 1 FCF = USD 50m; Year 2 FCF = USD 80m; Year 3 FCF = USD 110m; Years 4-10 stable at USD 130m; Terminal growth rate = 2.5%; WACC = 10%. An analyst uses this FCF model to calculate enterprise value. Which additional step is required to arrive at equity value per share?

   • A
     Divide enterprise value directly by total shares outstanding without adjusting for debt, because FCF is already stated after interest payments
   • B
     Subtract net debt (total debt minus cash) from enterprise value to get equity value, then divide by diluted shares outstanding to get equity value per share
     Correct answer
   • C
     Multiply enterprise value by the equity risk premium to convert a firm value into an equity-holder value
   • D
     Add net debt to enterprise value to arrive at equity value, because debt increases the total claim on the company's assets
   Explanation

   A DCF model of FCF to the firm (FCFF) discounted at WACC produces enterprise value — the value of the entire firm to all capital providers. To derive equity value, subtract net debt (debt minus cash), which represents the senior claims of debt holders. Divide by diluted shares outstanding to get intrinsic equity value per share. This is the standard bridge from enterprise value to equity value: EV − Net Debt = Equity Value.

2. An allocator is comparing two active equity managers. Manager P has generated a consistent annual information ratio of 0.85 over five years with an annual tracking error of 4%. Manager Q has an information ratio of 0.60 over three years with a tracking error of 10%. The allocator seeks to maximise risk-adjusted active return within a fixed tracking error budget of 5%. Which analysis best supports the allocation decision?

   • A
     Manager Q is preferred because the absolute active return implied by a 0.60 IR and 10% tracking error is 6%, which exceeds Manager P's implied 3.4%
   • B
     Manager P is preferred only if the five-year track record is statistically significant; a three-year record for Manager Q is insufficient to compare IRs
   • C
     Both managers are equivalent for the allocator's purpose because the information ratio already adjusts for tracking error
   • D
     Manager P is preferred: a higher IR of 0.85 indicates more active return per unit of active risk, and the 4% tracking error fits within the 5% budget without scaling; Manager Q's 10% tracking error would need to be scaled down, diluting the active return
     Correct answer
   Explanation

   Within a fixed tracking error budget of 5%, the manager with the higher IR generates more active return per unit of active risk. Manager P's 4% tracking error already fits the budget and delivers IR = 0.85, implying about 3.4% active return. Manager Q's 10% tracking error exceeds the budget; if the manager were scaled down to 5% tracking error (by blending with a passive position), the active return would also halve to approximately 3.0%. Manager P's higher IR and in-budget tracking error make it the superior choice.

3. An investor holds equities in an emerging market where the central bank maintains capital controls limiting foreign investor currency conversions to \$500,000 per month. The investor needs to liquidate a \$5 million position to meet redemptions. How do the capital controls affect the investor's effective currency risk relative to a comparable investment in a developed market?

   • A
     Capital controls apply primarily to bond investors; equity investors can typically repatriate proceeds more freely because equity is classified differently from fixed income under most capital control regimes.
   • B
     Capital controls have no effect on currency risk for equity investors because equities are priced in local currency regardless of convertibility.
   • C
     Capital controls create a forced holding period that exposes the investor to prolonged exchange rate volatility and the risk of further control tightening, compounding the currency risk beyond simple exchange rate fluctuation
     Correct answer
   • D
     The investor faces identical currency risk to a developed market investment because the \$500,000 monthly limit means full repatriation will eventually occur.
   Explanation

   Capital controls transform currency risk from a single-point exposure (convert at today's rate) to a multi-period sequential exposure. The investor must convert \$500,000 per month over ten months to exit the full \$5 million position. During this ten-month liquidation window, the exchange rate can move adversely, and the controls themselves may be tightened further, slowing repatriation even more. This forced holding period means the investor bears exchange rate uncertainty for far longer than intended, and the inability to exit promptly eliminates the option value of converting immediately when conditions are favourable. Developed market investors can always convert their full position at current rates with no such constraint.