Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.
Ferguson Department Stores, Inc.
FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.

William Rogers, a fixed-income portfolio manager, needs to eliminate a large cash position in his portfolio. He would like to purchase some corporate bonds. Two bonds that he is evaluating are shown in Exhibit I. These two bonds are from the same issuer, and the current call price for the callable bond is 100. Assume that the issuer will call if the bond price exceeds the call price.
Rogers is also concerned about increases in interest rates and is considering the purchase of a putable bond. He ants to determine how assumed increases or decreases in interest rate volatility affect the value of the straight bonds and bonds with embedded options. After Rogers performs some analysis, he and his supervisor, Sigourney Walters, discuss the relative price movement between the two bonds in Exhibit 1 when interest rates change significantly
During the discussions, Rogers makes the following statements:
Statement 1: If the volatility of interest rates decreases, the value of the callable bond will increase.
Statement 2: The noncallable bond will not be affected by a change in the volatility or level of interest rates.
Statement 3: When interest rates decrease, the value of the noncallable bond increases by more than the callable bond.
Statement4: If the volatility of interest rates increases, the value of the putable bond will increase.

Rogers obtained the prices shown in Exhibit b using software that generates an interest rate lattice. He uses his software to generate the interest rate lattice shown in Exhibit 2.
Exhibit 2: Interest Rate Lattice (Annualized Interest Rates)

Jason Bennett is an analyst for Valley Airlines (Valley), a U .S . firm. Valley owns a stake in Southwest Air Cargo (Southwest), also a U .S . firm. The two firms have had a long-standing relationship. The relationship has become even closer because several of Valley's top executives hold seats on Southwest's Board of Directors.
Valley acquired a 45% ownership stake in Southwest on December 31, 2007. Acquisition of the ownership stake cost $9 million and was paid in cash. Valley's stake in Southwest is such that management can account for the investment using either the equity method or the acquisition method. While Valley's management desires to fairly represent the firm's operating results, they have assigned Bennett to assess the impact of each method on reported financial statements.
Immediately prior to the acquisition. Valley's current asset balance and total equity were $96 million and $80 million, respectively. Southwest's current assets and total equity were $32 million and $16 million, respectively.
While analyzing the use of the equity method versus the acquisition method, Bennett calculates the return on assets (ROA) ratio. He arrives at two conclusions:
Statement 1: Compared to the acquisition method, the equity method results in a higher ROA because of the higher net income under the equity method.
Statement 2: Compared to the acquisition method, the equity method results in a higher ROA because of the smaller level of total assets under the equity method.
In order to get a better picture of Valley's operating condition, Bennett is also considering the use of proportionate consolidation to account for Southwest. He makes the following statements regarding the acquisition method and a proportionate consolidation:
Statement 3: Both methods are widely accepted under the provisions of U .S . GAAP and International Financial Reporting Standards (IFRS).
Statement 4: Both methods report the same level of assets on the parent's balance sheet.
Statement 5: Both methods report all of Southwest's liabilities on the parent's balance sheet.
In addition. Valley has always wanted to pursue its goal of vertical integration by expanding its scope of operations to include the manufacturing of airline parts for its own airplanes. Therefore, it established a subsidiary, Mountain Air Parts (Mountain), in Switzerland on January 1,2008. Switzerland was chosen as the location for economic and geographical diversification reasons. Mountain will operate as a self-contained, independent subsidiary. Local management in Switzerland will make the majority of operating, financing, and investing decisions.