Gertrude Fromm is a transportation sector analyst at Tucana Investments. She is conducting an analysis of Omikroon, N.V., a hypothetical European engineering company that manufactures and sells scooters and commercial trucks.
Omikroon’s petrol scooter division is the market leader in its sector and has two competitors. Omikroon’s petrol scooters have a strong brand name and a well-established distribution network. Given the strong branding established by the market leaders, the cost of entering the industry is high. But Fromm anticipates that small, inexpensive, imported petrol-fueled motorcycles could become substitutes for Omikroon’s petrol scooters.
Fromm uses ROIC as the metric to assess Omikroon’s performance.
Omikroon has just introduced the first electric scooter to the market at year-end 2019. The company’s expectations are as follows:
Competing electric scooters will reach the market in 2021.
Electric scooters will not be a substitute for petrol scooters.
The important research costs in 2020 and 2021 will lead to more efficient electric scooters.
Fromm decides to use a five-year forecast horizon for Omikroon after considering the following three factors:
Factor 1:
The annual portfolio turnover at Tucana Investments is 30 percent.
Factor 2:
The electronic scooter industry is expected to grow rapidly over the next 10 years.
Factor 3:
Omikroon has announced it would acquire a light truck manufacturer that will be fully integrated into its truck division by 2021 and will add 2 percent to the company’s total revenues.
Fromm uses the base case forecast for 2020 shown in Exhibit 1 to perform the following sensitivity analysis:
The price of an imported specialty metal used for engine parts increases by 20 percent.
This metal constitutes 4 percent of Omikroon’s cost of sales.
Omikroon will not be able to pass on the higher metal expense to its customers.
Exhibit 1
Omikroon’s Selected Financial Forecasts for 2020 Base Case (euro millions)
Petrol Scooter Division Commercial Truck Division Electric Scooter Division Total
Sales 99.05 45.71 7.62 152.38
Cost of sales 105.38
Gross profit 47.00
Operating profit 9.20
Omikroon will initially outsource its electric scooter parts. But manufacturing these parts in-house beginning in 2021 will imply changes to an existing factory. This factory cost EUR7 million three years ago and had an estimated useful life of 10 years. Fromm is evaluating two scenarios:
Scenario 1:
Refit the existing factory for EUR27 million.
Scenario 2:
Sell the existing factory for EUR5 million. Build a new factory costing EUR30 million with a useful life of 10 years.
Using Porter’s five forces analysis, which of the following competitive factors is most likely to have the greatest impact on Omikroon’s petrol scooter pricing power?
A. Rivalry
B. Threat of substitutes
C. Threat of new entrants
,Correct Answer:
B. Threat of substitutes
Not Selected
Feedback
General feedback
B is correct. Small, inexpensive, imported petrol-fueled motorcycles are substitutes for petrol scooters and could increasingly have an impact on Omikroon’s petrol scoter pricing power.
Which factor best justifies the five-year forecast horizon for Omikroon selected by Fromm?
A. Factor 1
B. Factor 2
C. Factor 3
Correct Answer:
B. Factor 2
FeedbackGeneral feedback
B is correct. The electric scooter market is expected to grow rapidly, so the contribution of Omikroon’s new electric scooter division is forecast to expand significantly over the next 10 years. A is incorrect because the investment company’s portfolio turnover is not relevant for forecasting Omrikoon’s future results. C is incorrect because the light truck division is expected to add only 2% to total revenues in the future.
Based on Omikroon’s expectations, the gross profit margin of Omikroon’s electric scooter division in 2021 is most likely to be affected by:
A. competition.
B. research costs.
C. cannibalization by petrol scooters.
, Not Selected
Feedback
General feedback
A is correct. Competition from other electric scooter manufacturers is expected to begin in one year. After this time, competing electric scooters could lead to lower demand for Omikroon’s electric scooters and affect Omikroon’s gross profit margin.
Fromm’s sensitivity analysis will result in a decrease in the 2020 base case gross profit margin closest to:
A. 0.55 percent.
B. 0.80 percent.
C. 3.32 percent.
Correct Answer:
A. 0.55 percent.
, Not Selected
Feedback
General feedback
A is correct. The sensitivity analysis consists of an increase of 20 percent in the price of an input that constitutes 4 percent of cost of sales. Change in gross profit margin because of that increase is calculated as the change in cost of sales because of price increase divided by sales:
= (Cost of sales × 0.04 × 0.2)/Sales
= (105.38 × 0.04 × 0.2)/152.38
= 0.0055 or 0.55%
To validate the forecast for rapid growth in the electronic scooter market over the next 10 years, Fromm speaks to the management of Omikroon and investor relations of ZeroWheel, a competitor. Which behavioral bias is Fromm most likely subject to?
A. Confirmation
B. Conservatism
C. Overconfidence
Correct Answer:
A. Confirmation
Feedback
General feedback
A is correct. The management of Omikroon and investor relations of ZeroWheel are almost certainly biased in favor of expecting strong growth for the markets they participate in. To evaluate the forecast, Fromm should seek more independent sources and balance the biased sources with sources biased in the opposite direction or an analyst who is more skeptical.
Based on Exhibit 2, forecasted interest expense will reflect changes in Chrome’s debt level under the forecast assumptions used by:
A. Candidate A.
B. Candidate B.
C. Candidate C.
Feedback
General feedback
A is correct. In forecasting financing costs, such as interest expense, the debt/equity structure of a company is a key determinant. Accordingly, a method that recognizes the relationship between the income statement account (interest expense) and the balance sheet account (debt) would be a preferable method for forecasting interest expense when compared with methods that forecast based solely on the income statement account. By using the effective interest rate (interest expense divided by average gross debt), Candidate A is taking the debt/equity structure into account. B and C are incorrect because Candidate B (who forecasts 2020 interest expense to be the same as 2019 interest expense) and Candidate C (who forecasts 2020 interest expense to be the same as the 2017–19 average interest expense) are not taking the balance sheet into consideration.
