Estimating Hugo Boss's Equity Value Hugo Boss AG is a German designer, manufacturer, and distributer of men's and women's clothing, operating in the higher end of the clothing retail industry. During the period of 2004-2017, the company consistently earned returns on equity in excess of 20 percent, with peaks around 50 to 60 percent, grew its book value of equity (before special dividends) by 5 percent per year, on average, and paid out 65-80 pecent of its profit as dividends. On March 29, 2018, before the publication of the first-quarter results, when Hugo Boss's 69 million common shares trade at about 71 per share, an analyst produces the following forecasts for Hugo Boss. Income Statement (millions) 2018E 2019E 2020E Revenue 2,800 2,925 Profit before Interest and Tax 345 380 3,100 420 Interest Expense 10 5 5 Profit before Tax 335 375 415 Tax Expense 90 100 110 Profit/Loss 245 275 305 Balance Sheet 2017R 2018E 2019E 2020E NOA 1,160 1,195 1,250 1,325 Investment Assets 55 60 60 65 Business Assets 1,215 1,255 1,310 1,390 Shareholder's Equity 915 970 1,040 1,130 Current and Non-current Debt 300 285 270 260 Investment Capital 1,215 1,255 1,310 1,390 Assume that Hugo Boss's cost of equity is 10 percent. 1. Calculate the free cash flow to equity, abnormal profits, and abnormal profit growth for years 2018- 2020. 2. Assume that 2021 Hugo Boss AG liquidates all its assets at their book values, uses the proceeds to pay off debt, and pays out the remainder to its equity holders. What does this assumption imply about company's: Free cash flow to equity holders in 2021 and beyond? Abnormal profits in 2021 and beyond? Abnormal profit growth in 2021 and beyond? 3. Estimate the value of Hugo Boss's equity on March 29, 2018 using the above forecasts and assump- tions. Check that the discounted cash flow model, the abnormal earnings model and the abnormal earnings growth model yield the same outcome. Question 5: Portfolio Performance Evaluation; International Diversification I. Your uncle invested $1,000,000 in a portfolio consisting of both equity shares and bonds at the end of 2013. He did not buy nor sell any securities thereafter. The following table provides end of the year market values of the portfolio together with the dividend income and coupon income generated by it for the five years ending in 2018: Year Market value of the portfolio 2013 $1,000,000 2014 $1,200,000 2015 $1,100,000 2016 $1,350,000 2017 $1,150,000 2018 $1,200,000 (i) Dividend income Coupon income $110,000 $50,000 $90,000 $50,000 $120,000 $50,000 $80,000 $50,000 $90,000 $50,000 (ii) Calculate the annual rates of return for the five years ending in 2018. Calculate the arithmetic average return and the geometric average return for the portfolio for the five-year period ending in 2018. (iii) Given your answer to (ii) above, which measure of average return is more useful in predicting the future performance of your uncle's portfolio? Explain why. II. You are evaluating the performance of two fund managers to help a client understand their strengths and weaknesses in security selection and asset allocation. The data relevant to the performance of these two fund managers and those of a benchmark portfolio are given in the following table: Manager/Benchmark Manager A Manager B Benchmark portfolio Total return Return attributable to security selection Return attributable to asset allocation 6% -2% 8% 4% 5% -1% 5% -0.2% 5.2% III. Assume that the data for managers A and B reflect average performance over the most recent five years and both managers actively manage their portfolios. Briefly describe one strength and one weakness for each manager. A globally diversified portfolio faces a lower market risk than a domestically diversified portfolio. Examine the above statement with reference to possible benefits of international diversification. Use an appropriate graph to illustrate. Consider a homogeneous good industry (such as an agricultural product) with just two firms and a total market demand Q = 400-P, so the inverse demand is P = 400 - Q. Suppose both firms have a constant marginal cost equal to $100 per unit of output and a fixed cost equal to $10,000. One simple way to depict rivalry in a duopoly (2 firms) is the Cournot model. This model is reasonable in agricultural markets where firms choose production (plantings) in advance and the market price is determined later after the crop is harvested. In the Cournot model, we imagine that the two firms simultaneously choose their production or quantity and that demand (market clearing) determines the price given each firms' quantity. (a) Suppose (hypothetically) that the second firm produces 0 units, and the first firm anticipates this, so the first firm is the only seller. How much will the first firm produce (in this case the first firm acts as a monopolist and sets output where MR = MC)? Hint: The first firm's inverse demand is P = 400-(Q1 +Q2), but since Q2 = 0 we can write this as P = 400-Q1 and so MR = 400-2Q1. Mathematically this problem is the same as a monopoly problem. What quantity will firm 1 choose? What price will it charge? What are the producer surplus and profit? (b) Now suppose instead that the second firm produces exactly 100 units, and that the first firm anticipates this. The total output is the first firm's output, Q1, plus 100, so substituting Q1 + 100 for QT in the inverse demand implies that P = 300 Q1. That is if firm 1 produces Q1 it expects the price to be 300-Q1. This implies that MR = 300-Q2. How much will firm 1 produce (set MR = MC)? What price will clear the market given the total output Q1 + Q2? What are the producer surplus and profit? (c) Explain intuitively why neither firm wants to change their production if each is producing 100 (Q1 = Q2 = 100)? Note that your are explaining why Q1 Q2 = 100 is a Cournot-Nash equilibrium). (d) Calculate the total producer surplus (both firms) and consumer surplus in parts (a) and (b). Why is consumer surplus higher with 2 firms than with one firm? (e) Intuitively, why is the deadweight loss smaller with two firms than with only one firm?