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408 Part FOUR Security Analysis


14. Universal Auto is a large multinational corporation headquartered in the United States.
For segment reporting purposes, the company is engaged in two businesses: production
of motor vehicles and information processing services.
The motor vehicle business is by far the larger of Universal™s two segments. It
consists mainly of domestic United States passenger car production, but it also includes
small truck manufacturing operations in the United States and passenger car production
in other countries. This segment of Universal has had weak operating results for the past
several years, including a large loss in 1997. Although the company does not reveal the
operating results of its domestic passenger car segments, that part of Universal™s
business is generally believed to be primarily responsible for the weak performance of
its motor vehicle segment.
Idata, the information processing services segment of Universal, was started by
Universal about 15 years ago. This business has shown strong, steady growth that has
been entirely internal: No acquisitions have been made.
An excerpt from a research report on Universal prepared by Paul Adams, a CFA
candidate, states: “Based on our assumption that Universal will be able to increase
prices significantly on U.S. passenger cars in 1998, we project a multibillion dollar
profit improvement . . .”
a. Discuss the concept of an industrial life cycle by describing each of its four phases.
b. Identify where each of Universal™s two primary businesses”passenger cars and
information processing”is in such a cycle.
c. Discuss how product pricing should differ between Universal™s two businesses,
based on the location of each in the industrial life cycle.
15. Adams™s research report (see problem 14) continued as follows: “With a business
expansion already underway, the expected profit surge should lead to a much higher
price for Universal Auto stock. We strongly recommend purchase.”
a. Discuss the business cycle approach to investment timing. (Your answer should
describe actions to be taken on both stocks and bonds at different points over a
typical business cycle.)
b. Assuming Adams™s assertion is correct (that a business expansion is already
underway), evaluate the timeliness of his recommendation to purchase Universal
Auto, a cyclical stock, based on the business cycle approach to investment timing.
16. Janet Ludlow is preparing a report on U.S.-based manufacturers in the electric
toothbrush industry and has gathered the information shown in Tables 11.5 and 11.6.
Ludlow™s report concludes that the electric toothbrush industry is in the maturity (i.e.
late) phase of its industry life cycle.
a. Select and justify three factors from Table 11.5 that support Ludlow™s conclusion.
b. Select and justify three factors from Table 11.6 that refute Ludlow™s conclusion.
17. General Weedkillers dominates the chemical weed control market with its patented
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product Weed-ex. The patent is about to expire, however. What are your forecasts for
changes in the industry? Specifically, what will happen to industry prices, sales, the
profit prospects of General Weedkillers, and the profit prospects of its competitors?
What stage of the industry life cycle do you think is relevant for the analysis of this
market?
18. The following questions have appeared on CFA examinations.
a. Which one of the following statements best expresses the central idea of
countercyclical fiscal policy?
(1) Planned government deficits are appropriate during economic booms, and
planned surpluses are appropriate during economic recessions.
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Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition




409
11 Macroeconomic and Industry Analysis


Year 1992 1993 1994 1995 1996 1997
TA B L E 11.5
Return on equity
Ratios for Electric
Electric toothbrush
Toothbrush Industry
Index and Broad industry index 12.5% 12.0% 15.4% 19.6% 21.6% 21.6%
Stock Market Index Market index 10.2 12.4 14.6 19.9 20.4 21.2
Average P/E
Electric toothbrush
industry index 28.5 23.2 19.6 18.7 18.5 16.2
Market index 10.2 12.4 14.6 19.9 18.1 19.1
Dividend payout ratio
Electric toothbrush
industry index 8.8% 8.0% 12.1% 12.1% 14.3% 17.1%
Market index 39.2 40.1 38.6 43.7 41.8 39.1
Average dividend yield
Electric toothbrush
industry index 0.3% 0.3% 0.6% 0.7% 0.8% 1.0%
Market index 3.8 3.2 2.6 2.2 2.3 2.1



• Industry sales growth”Industry sales have grown at 15“20% per year in recent years and
TA B L E 11.6 are expected to grow at 10“15% per year over the next three years.
Characterstics of the • Non-U.S. markets”Some U.S. manufacturers are attempting to enter fast-growing non-
Electric Toothbrush
U.S. markets, which remain largely unexploited.
Manufacturing
• Mail order sales”Some manufacturers have created a new niche in the industry by
Industry
selling electric toothbrushes directly to customers through mail order. Sales for this
industry segment are growing at 40% per year.
• U.S. market penetration”The current penetration rate in the United States is 60 percent
of households and will be difficult to increase.
• Price competition”Manufacturers compete fiercely on the basis of price, and price wars
within the industry are common.
• Niche markets”Some manufacturers are able to develop new, unexploited niche markets
in the United States based on company reputation, quality, and service.
• Industry consolidation”Several manufacturers have recently merged, and it is expected
that consolidation in the industry will increase.
• New entrants”New manufacturers continue to enter the market.




(2) The balanced budget approach is the proper criterion for determining annual
budget policy.
(3) Actual deficits should equal actual surpluses during a period of deflation.
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(4) Government deficits are planned during economic recessions, and surpluses are
utilized to restrain inflationary booms.
b. The supply-side view stresses that:
(1) Aggregate demand is the major determinant of real output and aggregate
employment.
(2) An increase in government expenditures and tax rates will cause real income
to rise.
(3) Tax rates are a major determinant of real output and aggregate employment.
(4) Expansionary monetary policy will cause real output to expand without causing
the rate of inflation to accelerate.
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition




410 Part FOUR Security Analysis


c. Based on historical data and assuming less-than-full employment, periods of sharp
acceleration in the growth rate of the money supply tend to be associated initially with:
(1) Periods of economic recession.
(2) An increase in the velocity of money.
(3) A rapid growth of gross domestic product.
(4) Reductions in real gross domestic product.
d. Which one of the following propositions would a strong proponent of supply-side
economics be most likely to stress?
(1) Higher marginal tax rates will lead to a reduction in the size of the budget deficit
and lower interest rates because they expand government revenues.
(2) Higher marginal tax rates promote economic inefficiency and thereby retard
aggregate output because they encourage investors to undertake low productivity
projects with substantial tax-shelter benefits.
(3) Income redistribution payments will exert little impact on real aggregate supply
because they do not consume resources directly.
(4) A tax reduction will increase the disposable income of households. Thus, the
primary impact of a tax reduction on aggregate supply will stem from the
influence of the tax change on the size of the budget deficit or surplus.
e. Which one of the following series is not included in the index of leading economic
indicators?
(1) New building permits; private housing units.
(2) Net business formulation.
(3) Stock prices.
(4) Inventories on hand.
f. How would an economist who believes in crowding out complete the following
sentence? “The increase in the budget deficit causes real interest rates to rise, and
therefore, private spending and investment
(1) Increase.”
(2) Stay the same.”
(3) Decrease.”
(4) Initially increase but eventually will decrease.”
g. If the central monetary authorities want to reduce the supply of money to slow the
rate of inflation, the central bank should:
(1) Sell government bonds, which will reduce the money supply; this will cause
interest rates to rise and aggregate demand to fall.
(2) Buy government bonds, which will reduce the money supply; this will cause
interest rates to rise and aggregate demand to fall.
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1. Find the Industry Profile from Market Insight (www.mhhe.com/edumarketinsight)
for the biotechnology and the water utility industries. Compare the price-to-book
ratios for the two industries. (Price-to-book is price per share divided by book value
per share.) Do the differences make sense to you in light of the different stages of
these industries in terms of the typical industry life cycle?
2. Compare the price-to-earnings (P/E) ratios for these industries. Why might biotech
have a negative P/E ratio in some periods? Why is its P/E ratio (when positive) so
much higher than that of water utilities? Again, think in terms of where these
industries stand in their life cycle.
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition




411
11 Macroeconomic and Industry Analysis


(3) Decrease the discount rate, which will lower the market rate of interest; this will
cause both costs and prices to fall.
(4) Increase taxes, which will reduce costs and cause prices to fall.



WEBMA STER
Economic Forecasts
Standard & Poor™s provides economic forecasts for both the overall economy and
individual sectors. Go to http://www.standardandpoors.com/Forum/MarketAnalysis/
index.html to review Standard and Poor™s Economic Outlook for April 2002.
After viewing the report, answer the following questions:
1. What impact did the increase in oil prices in the first quarter of 2002 have on
predictions of consumer spending?
2. How did added expenditures for security affect the projections of economic
performance?
3. What potential indirect effect associated with security was noted?
4. What did the economist suggest for overall S&P 500 return for the 2000s?
5. How does this compare with 1990s?
6. Detailed forecasts are available for economic series for 2002 through 2005.
Analyze the forecast percentage changes for the following series; GDP ,
Consumer Spending, Equipment Investment, Nonresidential Construction,
Residential Construction, and CPI.



1. The downturn in the auto industry will reduce the demand for the product in this economy. The SOLUTIONS TO
economy will, at least in the short term, enter a recession. This would suggest that:

< Concept
a. GDP will fall.
b. The unemployment rate will rise. CHECKS
c. The government deficit will increase. Income tax receipts will fall, and government
expenditures on social welfare programs probably will increase.
d. Interest rates should fall. The contraction in the economy will reduce the demand for credit.
Moreover, the lower inflation rate will reduce nominal interest rates.
2. Expansionary fiscal policy coupled with expansionary monetary policy will stimulate the economy,
with the loose monetary policy keeping down interest rates.
3. A traditional demand-side interpretation of the tax cuts is that the resulting increase in after-tax
income increased consumption demand and stimulated the economy. A supply-side interpretation is
that the reduction in marginal tax rates made it more attractive for businesses to invest and for
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individuals to work, thereby increasing economic output.
4. a. Newspapers will do best in an expansion when advertising volume is increasing.
b. Machine tools are a good investment at the trough of a recession, just as the economy is about to
enter an expansion and firms may need to increase capacity.
c. Beverages are defensive investments, with demand that is relatively insensitive to the business
cycle. Therefore, they are good investments if a recession is forecast.
d. Timber is a good investment at a peak period, when natural resource prices are high and the
economy is operating at full capacity.
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Essentials of Investments, Companies, 2003
Fifth Edition




12
EQUITY VALUATION



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