CFA LEVEL 2 - TEST BANK WITH SOLUTIONS SOLUTI ONS
Question: Question: Analyz Analyze e the advant advantage ages s and disadv disadvant antage ages s of the variou various s nancial and operating changes that a company can make to manage its sustainable growth. Answer : The frst step in solving the excess excess growth problem is to determine i the situation is temporary or permanent. I temporary, urther borrowing may be the simple solution. I longer-term, some combination o the strategies described below will be necessary necessar y: 1. Sell New Euity Euity - I 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 o the increased euity, is a source o cash with which to fnance urther 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 o an investment ban#er to sell the shares, which is especially true or small concerns. '. (any (any compan companie ies s may pree preerr not to sell sell euit euity, y, opting opting instea instead d or internal internal sources, sources, deprecia depreciation tion and increase increases s in retaine retained d earnings earnings as sources o corporate capital. ). !ncrease !ncrease leverage leverage - Incr Increas easing ing leve leverag rage e raises raises the the amount amount o debt debt the the company can add or each dollar o retained profts. There are limits to the use o debt fnancing: all companies have a creditor-imposed debt capacity that restricts the amount o leverage the frm can employ. employ. (oreover, as leverage increases, increases, the ris#s borne by owners and creditors rise, as do the costs o securing additional capital. *. "educe the #ayout "atio "atio - ! cut in the payout ratio raises sustainable growth by increasi increasing ng the proportion proportion o earning earnings s retaine retained d in the business. business. In general, general, owners+ interest in dividend payments varies inversely with their perceptions o the company+s investment opportunities. I owners believe that the retained profts can can be put put to prod produc ucti tive ve use use with within in the the comp compan any, y, they they will will or orego ego curr curren entt divide dividend nds s in avor avor o highe higherr utur uture e ones. ones. !lt !lter ernat native ively, ly, i a frm+s frm+s inves investme tment nt oppo opport rtun unit itie ies s do not not prom promis ise e attr attrac acti tive ve retur eturns ns,, a divi divide dend nd cut cut will will ange angerr shareholders, resulting in a stoc# price decline. . #rotable #rotable #runing #runing - "rof "roftab table le prunin pruning g sells sells o marg margina inally lly peror perormin ming g operation operations s to invest invest the money money into the remainin remaining g business businesses. es. This approach approach recognies that when a company spreads its resources across too many products, it may may be unable unable to compe compete te eecti eective vely ly in any. "roft "roftabl able e prunin pruning g reduc reduces es sustainable growth problems in two ways: it generates cash directly through the sale o marginal businesses, and it reduces actual sales growth by eliminating some o the sources o the growth. /. "roftable pruning can also be applied to a single-product company. In this case, slow-p slow-pay aying ing custo customer mers s and0or and0or slow-t slow-tur urnin ning g invent inventory ory is elimin eliminat ated. ed. This This can Norman Cheung
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AllenResources_Q&A_Level AllenResources_Q&A_Level 2
eliminate sustainable growth problems in three ways: It rees up cash it increases asset turnover and it reduces sales. 2. Sourcing - This option involves deciding whether to perorm an activity inhouse or to purchase it rom an outside vendor. 3ourcing more and doing less inhouse may increase sustainable growth rate. 3ourcing releases assets that would otherwise be tied up in perorming an activity, and it increases asset turnover both o which serve to diminish growth problems. The #ey to eective 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. I the higher prices increase the proft margin, the rate o sustainable growth may increase. 6. $erger - 5hen all else ails, it may be necessary to loo# or a partner. Two types o companies are capable o supplying the needed cash: a mature company 7a cash cow8 loo#ing or proftable investments or 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 rm's e(ective ta& rate. Answer : "ermanent dierences, which are dierence between the way that the tax code measures income and the way that fnancial statements report income that never reverses itsel, aect the provision or taxes in the income, the tax expense, which is calculated as: 7"roected income beore taxes - "ermanent dierences8 x tax rate Timing dierences, which are dierence between the time that the tax code recognies either an income or an expense item and the time at which the fnancial statements record the item, appear in the balance sheet as ;eerred Taxes. ;eerred taxes are tax obligations that are expected to be paid when the timing dierences are reversed. ;eerred taxes in any fscal year are calculated as: 7'umulative timing dierences8 x 7tax rate8 ! tax payment or a given year euals the tax expense minus the increase in the deerred tax account. 5hen analying the tax accounts, the obective is to estimate three elements: 1. The permanent dierences that the frm will have between its taxable income and reported income. ). The timing dierences. *. The tax rate to which the frm will be subect. The frst step in determining these elements is the calculation o: <ective tax rate = Tax expense0Income beore taxes Norman Cheung
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AllenResources_Q&A_Level 2
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 o the new debt relative to outstanding debt is specifed. ?enerally, new bonds ran# eually with all other bonds outstanding under the mortgage. 'ertain eatures o older provisions have become archaic, hindering the e$ciency o running a business. Thereore, a company will attempt to retire old debt in order to eliminate the more restrictive covenants not included in current oerings. ). >Issuance of Additional Bonds> establish the conditions under which the company may issue additional frst mortgage bonds and is oten based upon a debt test and0or earnings test. The debt test generally limits the amount o bonds that may be issued under the mortgage to a certain percentage o net property or net property additions, the principal amount o retired bonds, and deposited cash. The earnings test restricts issuance o additional bonds under the mortgage unless earnings or 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. @eunding 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 o a company to pay an amount o cash to a trustee in order to retire a given percentage o bonds. This reuirement can oten be met with actual bonds or with pledges o property. The obligation can be met by the stated percentage o each issue outstanding, by cash, or by applying the whole reuirement against one issue or several issues. 2. "t#er Provisions. These include events o deault, mortgage modifcation, security, limits on borrowing, priority, and the powers and obligations o 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 o consolidated net tangible assets without giving bondholders the same security. ). >imitation on Sale and ease'ac ransactions> provide protection or the bondholder against the company selling and then leasing bac# assets that provide security or the holder. This provision reuires that assets or cash eual to the property sold and leased bac# be applied to the retirement o the debt in uestion or used to acuire another property or the security o the bondholders. *. >Sale of Assets or Mer!er > protect bondholders in the event o the sale o substantially all o the company+s assets by reuiring that the debt be retired or assumed by the merged company.
Norman Cheung
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AllenResources_Q&A_Level 2
. >ividend est > establishes rules or the payment o 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 o debt that may be issued by establishing a maximum debt0assets ratio. FINANCIAL INDENTURES
1. >Sinin! Fund and Refundin! Provisions> speciy sin#ing und and reunding 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 or a bondholder o a fnance subsidiary. It restricts the amount o dividends that can be upstreamed to the parent rom the subsidiary, thereby protecting the bondholder rom 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 o debt the company can issue and is generally stated in terms o 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, orecasters ocus 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 orecasters use mar#et or model based orecasts. In a mar#et-based orecast, exchange rates are orecast by loo#ing at interest and orward rates. In general, the orward rate is used as the unbiased predictor or uture spot rates. This can only be used to predict exchange rates or up to a year in advance, since orward contracts generally don+t exist or periods beyond one year. Interest rate dierentials are used to predict exchange rates ater one year. The two main model-based orecasting tools are undamental and technical analysis. Bundamental analysis loo#s at macroeconomic variables and policies that might aect a currency. These variables include in9ation and interest rates, national income growth and changes in the money supply. Bor example, i the current in9ation rates and spot rates or two currencies are #nown, then the uture spot rate can be predicted using """. The problem with undamental 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 uture. I the undamental values the analyst calculates are the same as the values that the mar#et calculates, then because o e$cient mar#ets exchange rates will already re9ect these calculations. In addition, there is generally a lag between the time that changes in variables are expected to occur and when these variables actually impact exchange rates. Technical analysis ocuses on past price and volume movements to orecast exchange rates. This can only be successul i there are price patterns that are Norman Cheung
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AllenResources_Q&A_Level 2
discernable and then repeated so traders can ta#e advantage o them. In charting, analysts loo# at graphs to spot price patterns and with trend analysis, trendollowing systems are used to predict price trends. Question% !dentify factors and potential developments that would alter investors' e&pectations. Answer : <uity mar#et valuations should rise over time rom lower in9ation and longer recoveries. &ower in9ation boosts what investors are willing to pay or a dollar o earnings by increasing the uality o earning and the confdence that uture earnings orecasts will be realied. &onger recoveries boost euity valuation by causing pea# or near pea# earnings to persist or a longer portion o the overall business cycle. @eal interest rates are li#ely to remain volatile, with larger increases needed to slow an overheating economy and bigger reductions needed to generate recoveries rom recession. Cn the upside o the cycle, Bederal @eserve o$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 all 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 drit down urther during early expansions as in9ation continues to move down. !s bouts o disin9ation last longer, declines in bond yields will also persist. The average level o 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 deault premiums during the extended period o 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 rom 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# rom abroad such as unusually wea# economic activity elsewhere or an unusually strong dollar increases the chances o 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. I the problem is temporary, additional borrowing may be the simple solution. 5hen the actual growth rate alls below the sustainable rate, the frm will be able to generate enough cash. I the problem is deemed to be longer-term, some combination o the strategies described below will be Norman Cheung
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AllenResources_Q&A_Level 2
necessary. 1. Sell $ew *+uity - I the company is willing and able to raise new euity capital by selling shares, its sustainable growth problems vanish. The increased euity, plus whatever added borrowing is possible as a result o the increased euity, is a source o cash with which to fnance urther growth. The potential problems with this strategy are: !. "oorly developed or non-existent euity mar#ets in some areas o the world ma#e euity di$cult to sell, basically ma#ing the shares illiuid. %. 3mall companies may have limited access to the services o an investment ban#er to sell the shares, ma#ing it di$cult to place a new issue. '. (any companies may preer not to sell euity, opting instead or internally generated unds, such as depreciation and increases in retained earnings, as sources o corporate capital. ). Increase levera!e - Increasing leverage raises the amount o debt the company can add or each dollar o retained profts. There are limits to the use o debt fnancing. !ll companies have a creditor-imposed debt capacity that restricts the amount o leverage the frm can employ. (oreover, as leverage increases, the ris#s borne by owners and creditors rise as do the costs o securing additional capital. *. Reduce t#e Payout Ratio - ! cut in the payout ratio raises the sustainable growth rate by increasing the proportion o earnings retained in the business. In general, owners+ interest in dividend payments varies inversely with their perceptions o the company+s investment opportunities. I owners believe that the retained profts can be put to productive use within the company, they will orego current dividends in avor o higher uture ones. !lternatively, i 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 perorming 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 o marginal businesses, and it reduces actual sales growth by eliminating some o the sources o 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 reeing 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 perorming an activity, and it increases asset turnover both o 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. I the higher prices increase the proft margin, the rate o sustainable growth may increase.
Norman Cheung
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AllenResources_Q&A_Level 2
4. Mer!er - 5hen all else ails, it may be necessary to loo# or a partner. Two types o companies are capable o 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 obective is to determine i the ratio that is being analyed 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. I an abnormal ratio is discovered, it may simply be a result o the frm+s uniue policies, and is thereby no reason or 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 or the dierent ratios, which is done by analying the time series o 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 eatures determine its ratios, reviewing trends in the ratios can identiy changes in the frm+s operations. !lthough this method is an improvement over the cross sectional comparison method, it still has the ollowing 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 rom a variety o reasons, and because fnancial statements summarie events, trends are not easy to interpret. Second , in9ation may cause alse trends among various ratios because fnancial reporting is done on a historical-cost basis. Bor example, depreciation expense will probably re9ect the cost o assets that are several years old, and since the cost o goods sold or an industrial frm includes these depreciation charges, the gross-margin ratio may appear to >improve> over time. Finally , the use o past ratios as the norm against current ratios may disguise problems, or even strengths, o the frm. Thus, a complete ratio analysis should include both a cross-sectional and a timeseries comparison o ratios. *. /2E E)-N-$!) !N/E"#"E/A/!-N -3 "A/!- )2ANES AN+ +E4!A/!-NS The ratios that are obtained or a frm should be compared to our economic
Norman Cheung
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AllenResources_Q&A_Level 2
understanding o the frm+s environment, business, policies, and eectiveness. This is what dierentiates a technically correct but uninormative fnancial statement analysis rom an analysis that provides insights into the frm+s operations and allows accurate prediction o its uture fnancial perormance.
Question% )ompare and contrast the monthly prepayment option embedded in an $5S with a callable or putable bond and with a non* callable bond. Answer % !n investor+s ris# can be illustrated using the concept o convexity. 5hen interest rates decline sharply, convexity becomes negative. In a mortgage pool, an increasing portion o the mortgages in the pool prepays. 5hen interest rates decline below the coupon rate, most people prepay and the price-yield relationship experiences negative convexity in this area. Bor higher interest rates, negative convexity also may occur, or there will at least be less positive convexity than is the case with bonds. The reason or this is that people who might want to upgrade their house or to relocate are discouraged to do so because o the much higher payments on the new home. In this case, prepayments are below what would normally occur, which is #nown as extension ris#. ;uration o the instrument increases and i the term structure is upwardsloping, the value decline is more than occurs with a fxed-rate, stated-maturity bond. The possibility o negative convexity in a high interest environment ma#es mortgage securities very dierent rom a noncallable, fxed-income security or which positive convexity prevails. 5ith all other things constant, or signifcant interest-rate changes, a mortgage security will perorm more poorly than a fxedrate stated maturity bond.
Question% State and describe the two main model*based currency forecasting tools. Answer % The two main model-based orecasting tools are undamental and technical analysis. Bundamental analysis loo#s at macroeconomic variables and policies that might aect a currency. These variables include: 1. ). *. .
in6ation interest rates national income growth changes in the money supply
Bor example, i the current in9ation rates and spot rates or two currencies are #nown, then the uture spot rate can be predicted using """. The problem with undamental analysis is the di$culty in predicting which variables are the right ones, and then predicting what these variables will do in the uture. I the calculated undamental 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
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AllenResources_Q&A_Level 2
Technical analysis ocuses on past price and volume movements toorecast exchange rates. This can only be successul i: 1. There are price patterns that are discernable ). "rice patterns are repeated so traders can ta#e advantage o them In charting, analysts loo# at graphs to spot price patterns. In trend analysis, trendollowing systems are used to predict price trends.
Question% /he idea that recessions will be more infreuent but will have greater nancial 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 rom lower in9ation and longer recoveries. &ower in9ation boosts what investors are willing to pay or a dollar o earnings by increasing the uality o earning and the confdence that uture earnings orecasts will be realied. &onger recoveries boost euity valuation by causing pea# or near pea# earnings to persist or a longer portion o 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 rom recession. Cn the upside o 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 all by an even greater magnitude as disin9ation will persist or longer, pushing down nominal interest rates. 'yclical reductions in bond yields should last longer. %ond yields normally decline during recessions and drit down urther during early expansions as in9ation continues to move down. !s bouts o disin9ation last longer, declines in bond yields will also persist. The average level o 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 deault premiums during the extended period o 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 reers to the act that real interest rates are largely determined by global supply and demand or money. I capital mar#ets are segmented, then real interest rates are determined by local credit conditions.
Norman Cheung
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AllenResources_Q&A_Level 2
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 o the world is based on the rest o the world supply and demand. Bor example, suppose the F.3. real rate is higher than the real rate outside the F.3. I 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 o 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 dierentials. @eal interest dierentials are usually caused by currency or political ris#. Bor example, a real interest rate dierential could exist i investors strongly desire domestic assets to avoid currency ris#, even i the expected real return on oreign assets were higher.
Question: +istinguish between the spot and forward markets for foreign e&change. Answer : Trading currencies occurs in oreign exchange mar#ets, whose primary unction is to acilitate international trade and investment. ! oreign exchange mar#et is the intermediary that allows trading o one currency or another. In the spot mar#et, currencies are traded or immediate delivery, generally within two wor#ing days, while in the orward mar#et currencies are bought or sold or uture delivery. !bout 2AG o transactions are spot purchases and sales, about 1AG are orward contracts, and the remaining *AG are swaps, which involve both spot deliveries and orward contracts. (aor participants in the oreign exchange mar#et include large commercial ban#s, oreign 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 inormation about buy and sell rates. In the orward mar#et, the maor players are arbitrageurs, traders, hedgers and speculators. !rbitrageurs ma#e the mar#et more e$cient by see#ing out dierences in interest rates between countries. They use orward contracts to try to ma#e ris#-ree profts by exploiting these dierences. Traders use orward contracts to reduce ris# on export or import orders by purchasing or selling the currency that will be needed at some uture date. Dedgers, primarily multinational frms, use orward contracts to protect the home currency value o oreign-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 orward to beneft rom exchange rate 9uctuations.
Question% +iscuss the characteristics of a swaption.
Norman Cheung
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AllenResources_Q&A_Level 2
Answer : ! swaption is an option on a swap that can be either !merican or
Question% Analyze the competitive advantage and competitive strategy of a company. Answer % 'ompetition is at the core o the success or ailure o companies. 'ompetition determines the appropriateness o a company+s activities and their ability to contribute to its perormance. Two basic factors determine a company+s c#oice of competitive strate!y : 1. Its relative competitive position within its industry, and ). the attractiveness o its industry with respect to long-term proftability and the actors that determine it. ! frm in a very attractive industry may still not earn attractive profts i 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 o being very proftable. Industry attractiveness and competitive position can be shaped by the frm, which ma#es the choice o competitive strategy very challenging.
Norman Cheung
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AllenResources_Q&A_Level 2
(ichael "orter describes the competitive orces that determine the attractiveness o 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 or its buyers exceeds the frm+s cost o creating it. Halue is what buyers are willing to pay or, and superior value stems rom oering lower prices than competitors or euivalent benefts or providing uniue benefts that more than oset a higher price. "orter+s boo# describes two 'asic types of competitive advanta!e: 1. )ost leadership, whereby a frm oers lower prices or the same product benefts, and ). +i(erentiation, whereby buyers are willing to pay more or uniue benefts that a frm oers. 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 reerred to as cash price or current price, is the price o a good or immediate delivery. The uture price, that which will be paid at a specifc uture date, is related to the cash price. The basis is the relationship between the cash price o a good and the utures price or the same good. The basis is calculated as the current cash price or a particular commodity at a specifed location, minus the price o a particular utures contract or the same commodity at the same location. basis < current cash price * futures price ote that the basis calculated in considering utures prices may dier, depending upon the geographic location o the spot price that is used to compute the basis. ?enerally, the basis is used in reerence to the dierence between the cash price and the nearby utures contract. There is, however, a basis or each outstanding utures contract, and this basis will oten dier in systemic ways, depending upon the maturities o the individual utures contracts. In a normal mar#et, prices or more distant utures are higher than or nearby utures. In an inverted mar#et, distant utures prices are lower than or the prices or contracts nearer to expiration.
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AllenResources_Q&A_Level 2
The frst undamental determinant o a frm+s proftability is industry attractiveness. 'ompetitive strategy must grow rom a sophisticated understanding o the rules o competition that determine an industry+s attractiveness. The ultimate goal o competitive strategy is to cope with and change those rules in avor o the frm+s. In any industry, whether it is domestic or international, the rules o competition are embodied in fve competitive orces: 1. The entry o new competitors ). The threat o substitutes *. The bargaining power o buyers . The bargaining power o suppliers /. The rivalry among the existing competition These orces determine the ability o frms in an industry to earn rates o return on investment in excess o the cost o capital. The strength o these orces varies rom industry to industry. Bor example, in the pharmaceutical industry, all orces are avorable so many competitors earn attractive profts. Jet in an industry where pressure rom one or more orces is intense, such as rubber or steel, ew companies earn attractive returns even with the best o management. The fve orces collectively determine industry proftability because they in9uence the prices, costs and reuired investment o frms in an industry--the elements o return on investment. !ll industries dier in the individual and collective strengths o these orces and thereore, industries dier in inherent proftability. The strength o each o the fve orces is a unction o industry structure, which is relatively stable, but can change over time as an industry evolves. The industry trends that are the most important or strategy are those that aect industry structure. Birms are not prisoners o their industry structure, however. Through their strategies, frms can in9uence the fve orces and thereore shape industry structure, ma#ing it either more or less attractive. There have been many successul strategies that have changed the rules o 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 o an industry. Birms pursuing strategic choices without considering the long-term conseuences o 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 uture. The ability o frms to shape industry structure places a particular burden on industry leaders. &eaders+ actions can have a disproportionate impact on structure, because o their sie 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 aect them as well. &eaders, thereore, must stri#e a balance between its own competitive position and the health o the entire industry. Question% 0ist the common causes of a decline in earnings uality. Answer:
Norman Cheung
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AllenResources_Q&A_Level 2
Cne o the obectives o a uality o earnings analysis is to determine when there has been a decline in the uality o earnings. The ollowing items are some o the more common causes o a decline in earnings uality: 1. !doption o less conservative accounting principles. Bor example, switching rom &IBC to BIBC in an in9ationary environment, or changing rom accelerated depreciation to straight line depreciation. This would also include capitaliing costs that were previously expensed. ). !doption o less conservative accounting estimates, such as decreasing estimates o warrantee costs, bad debts, etc. *. Cne-time transactions resulting in a recognied gain, such as sale o real estate. .
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Norman Cheung
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AllenResources_Q&A_Level 2
