FINM 2416 Asset Pricing Topic 5: Macroeconomic and Industry Analysis

FINM2416 ASSET PRICING

TOPIC 5 –MACROECONOMIC AND INDUSTRY ANALYSIS

TUTORIAL QUESTIONS

PROBLEM SETS (CH17)

2. If you believe the U.S. dollar will depreciate more dramatically than do other investors,
what will be your stance on investments in U.S. auto producers?

4. What are the differences between bottom-up and top-down approaches to security
valuation? What are the advantages of a top-down approach?

5. What characteristics will give firms greater sensitivity to business cycles?

10. Consider two firms producing smart phones. One uses a highly automated robotics
process, whereas the other uses workers on an assembly line and pays overtime when there is
heavy production demand.
a. Which firm will have higher profits in a recession? In a boom?
b. Which firm's stock will have a higher beta?

11. Here are four industries and four forecasts for the macroeconomy. Match the industry to
the scenario in which it is likely to be the best performer.

12. In which stage of the industry life cycle would you place the following industries? (Note:
There is considerable room for disagreement concerning the “correct” answers to this
question.)
a. Oil well equipment
b. Computer hardware
c. Computer software
d. Genetic engineering
e. Railroads

16. General Weedkillers dominates the chemical weed control market with its patented
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?

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FINM 2416 Asset Pricing Topic 5: Macroeconomic and Industry Analysis

17. Your business plan for your proposed start-up firm envisions first-year revenues of
$120,000, fixed costs of $30,000, and variable costs equal to one-third of revenue.
a. What are expected profits based on these expectations?
b. What is the degree of operating leverage based on the estimate of fixed costs and
expected profits?
c. If sales are 10% below expectation, what will be the decrease in profits?
d. Show that the percentage decrease in profits equals DOL times the 10% drop in sales.
e. Based on the DOL, what is the largest percentage shortfall in sales relative to original
expectations that the firm can sustain before profits turn negative?
f. What are break-even sales at this point?
g. Confirm that your answer to (f) is correct by calculating profits at the break-even level
of sales.

Use the following case in answering Problems 22–25: Mary Smith, a Level II CFA
candidate, was recently hired for an analyst position at the Bank of Ireland. Her first
assignment is to examine the competitive strategies employed by various French wineries.

Smith's report identifies four wineries that are the major players in the French wine industry.
Key characteristics of each are cited in Table 17A. In the body of Smith's report, she includes
a discussion of the competitive structure of the French wine industry. She notes that over the
past 5 years, the French wine industry has not responded to changing consumer tastes. Profit
margins have declined steadily and the number of firms representing the industry has
decreased from 10 to 4. It appears that participants in the French wine industry must
consolidate in order to survive.

Smith's report notes that French consumers have strong bargaining power over the industry.
She supports this conclusion with five key points, which she labels “Bargaining Power of
Buyers”:
• Many consumers are drinking more beer than wine with meals and at social occasions.
• Increasing sales over the Internet have allowed consumers to better research the wines,
read opinions from other customers, and identify which producers have the best prices.
• The French wine industry is consolidating and consists of only 4 wineries today
compared to 10 wineries 5 years ago.
• More than 65% of the business for the French wine industry consists of purchases from
restaurants. Restaurants typically make purchases in bulk, buying four to five cases of
wine at a time.
• Land where the soil is fertile enough to grow grapes necessary for the wine production
process is scarce in France.

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FINM 2416 Asset Pricing Topic 5: Macroeconomic and Industry Analysis

After completing the first draft of her report, Smith takes it to her boss, RonVanDriesen, to
review. VanDriesen tells her that he is a wine connoisseur himself, and often makes
purchases from the South Winery. Smith tells VanDriesen, “In my report I have classified the
South Winery as a stuck-in-the-middle firm. It tries to be a cost leader by selling its wine at a
price that is slightly below the other firms, but it also tries to differentiate itself from its
competitors by producing wine in bottles with curved necks, which increases its cost
structure. The end result is that the South Winery's profit margin gets squeezed from both
sides.” VanDriesen replies, “I have met members of the management team from the South
Winery at a couple of the wine conventions I have attended. I believe that the South Winery
could succeed at following both a cost leadership and a differentiation strategy if its
operations were separated into distinct operating units, with each unit pursuing a different
competitive strategy.” Smith makes a note to do more research on generic competitive
strategies to verify VanDriesen's assertions before publishing the final draft of her report.

22. If the French home currency were to greatly appreciate in value compared to the English
currency, what is the likely impact on the competitive position of the East Winery?
a. Make the firm less competitive in the English market.
b. No impact, since the major market for East Winery is England, not France.
c. Make the firm more competitive in the English market.

23. Which of Smith's points effectively support the conclusion that consumers have strong
bargaining power over the industry?

24. Smith notes in her report that the West Winery might differentiate its wine product on
attributes that buyers perceive to be important. Which of the following attributes would be
the most likely area of focus for the West Winery to create a differentiated product?
a. The method of delivery for the product.
b. The price of the product.
c. A focus on customers aged 30 to 45.

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