Debbie Angle and Craig Hohlman arc analysts for a large commercial bank, Arbutus National Bank. Arbutus lias extensive dealings in both the spot and forward foreign exchange markets. Angle and Hohlman are providing a refresher course on foreign exchange relations for its traders. Unless indicated otherwise, Angle tells the traders to assume that real interest rates arc equivalent throughout the world.
Angle uses a three country example from North America to illustrate foreign exchange parity relations. In it, the Canadian dollar is expected to depreciate relative to the U .S . dollar and the Mexican peso. Nominal, one year interest rates in the United States are 7% and are 13% in Mexico. From this data and using the uncovered interest rate parity relationship, Angle forecasts future spot rates.
During their presentation, Hohlman discusses the effect of monetary and fiscal policies on exchange rates. He cites a historical example from the United States, where the Federal Reserve shifted to an expansionary-monetary policy to stimulate economic growth. This shift was largely unanticipated by the financial markets because the markets thought the Federal Reserve was more concerned with inflationary pressures. Hohlman states that the effect of this policy was an increase in economic growth and an increase in inflation. The cumulative effect on the dollar was unchanged, however, because, according to Hohlman, an increase in U .S . economic growth would strengthen the dollar whereas an increase in inflation would weaken the dollar.
Regarding U .S . fiscal policies, Hohlman states that if these were unexpectedly expansionary, real interest rates would increase, which would produce an appreciation of the dollar. But, Hohlman adds, an increase in the federal budget would encourage imports such that the overall short-run effect would be for a decrease in the value of the dollar.
Using this same historical example, Angle discusses capital flows and the effect on the balance-of-payments components. Angle makes the following statements:
Statement 1; Differences in real interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies, and they will appreciate relative to the currencies of countries whose available real rates of return are low.
Statement 2: The flow of foreign capital into U .S . investments, net of outflows of U .S . capital, is measured by the financial account. In the case of an expansionary fiscal policy, the financial account will increase and move towards a surplus.

Chris Darin, CFA, works as a sell-side senior analyst and vice president for a large Toronto brokerage firm researching mainly hedge funds and alternative investments. Darin recently hired Simon Nielsen for the position of junior analyst at the firm. Although Nielsen does not have experience evaluating hedge funds, Darin hired him mainly for his previous experience at a discount brokerage firm and for his passion for the industry. Darin frequently mentors Nielsen on market trends, investment styles, and on risks inherent in alternative investment vehicles. In a recent conversation, Darin makes the following statements:
Statement 1: One way to measure hedge fund investment performance is through Jensen's alpha. A portfolio with negative Jensen's alpha would plot above the Security Market Line (SML).
Statement 2: Both the Sharpe ratio and Jensen's alpha can be used to measure risk-adjusted hedge fund returns. Oneof the advantages is comparability between the two methods since both calculate return relative to systematic risk.
Their conversation later shifts to discussing hedge fund classifications and how derivatives affect hedge fund performance measurement. Nielsen mentions that put options are often more advantageous than short selling in a market neutral strategy because of their asymmetric returns.
The following week Darin asks Nielsen to research potential problems and biases in hedge fund indexes and general risks inherent in investing in hedge funds. Nielsen compiles the information and presents the following findings:
1. One of the data problems in hedge fund indexes is that managers often do not disclose negative fund performance.
2. The historical performance of hedge funds that are recently added to an index is often added to the past performance of the index.
3. Long/short equity hedge funds are subject to equity market risk. This risk is typically greater than with equity market neutral or risk arbitrage funds due to the higher standard deviations and market correlations inherent in long/short funds.
4. Fixed income arbitrage funds are also subject to equity market risk. These funds are short Treasuries and long high-credit-risk bonds. In an economic downturn the short position in Treasuries provides a buffer against the long position and provides a net gain.
Finally, the two discuss the risk-free rate and various risk measures in hedge fund performance evaluation. Darin explains that even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Nielsen does not understand and asks him to clarify. Darin further states that risk measures such as Value at Risk have several limitations as a risk measurement tool.
Nielsen's findings on long/short equity funds and fixed income arbitrage strategies, respectively, are:

Kevin Rathbun, CFA, is a financial analyst at a major brokerage firm. His supervisor, Elizabeth Mao, CFA, asks him to analyze the financial position of Wayland, Inc. (Wayland), a manufacturer of components for high quality optic transmission systems. Mao also inquires about the impact of any unconsolidated investments.

Marsha McDonnell and Frank Lutge are analysts for the private equity firm Thorngate Ventures. Their primary responsibility is to value the equity of private firms in developed global economies. Thorngate's clients consist of wealthy individuals and institutional investors. The firm invests in and subsequently actively manages its portfolio of private firms.
During a discussion with junior analysts at the firm, McDonnell compares the characteristics of private firms with that of public firms and makes the following statements:
Statement 1: Private firms typically have higher risk premiums and required returns than public firms because private firms are usually smaller and thus thought to be riskier. Furthermore, the lack of access to liquid public equity markets can limit a private firm's growth.
Statement 2: Because of their higher risk, private firms may not be able to attract as many qualified applicants for top positions as public firms. Due to the higher risk, the managers they do attract tend to have a shorter-term view of the firm and their tenure at the firm, compared to public Firm managers. As a result, the private firm may neglect profitable long-term projects.
Due to its considerable success, Thorngate has recently attracted a substantial inflow of capital from investors. To deploy that capital, McDonnell and Lutge are considering the purchase of Albion Biotechnology. Albion is using advances in biotechnology for application in the pharmaceutical field. The analysts are primarily interested in Albion because the firm's research team is developing a drug that Thomgate's current pharmaceutical firm is also working on. McDonnell estimates that combining research teams would result in advances that no pharmaceutical competitor could match for at least two years. The firm is currently owned by its founders, who are familiar to Lutge through previous social contacts. Lutge hopes to avoid a competitive bidding process for the firm, because its founders have not advertised the firm's sale publicly.
McDonnell is also examining the prospects of Balanced Metals, a metal fabrication firm. Thorngate currently does not have any manufacturing firms in its portfolio, and Balanced would provide needed exposure. The growth in sales at Balanced has been impressive recently, but it is expected to slow considerably in the years ahead due to increased competition from overseas firms. The firm's most valuable assets are its equipment and factory, located in a prime industrial area.
Balanced was previously considered for possible purchase by a competitor in the metal fabrication industry. Although (he sale was not consummated, McDonnell has learned that the firm estimated that costs could be reduced at Balanced by eliminating redundant overhead expenses. McDonnell has obtained the following financial figures from (he Balanced Metals CFO as well as the previously estimated synergistic savings from cost reductions. Capital expenditures will equal depreciation plus approximately 4% of the firm's incremental revenues.
Current revenues $22,000,000
Revenue growth 7%
Gross profit margin 25%
Depreciation expense as a percent of sales 1%
Working capital as a percent of sales 15%
SG&A expenses $5,400,000
Synergistic cost savings $1,200,000
Tax rate 30%
Lutge is valuing a noncontrolling equity interest in Jensen Gear, a small outdoors equipment retailer. Jensen has experienced healthy growth in earnings over the past three years. However, given its size and private status, Lutge does not expect that Jensen can be easily sold. To obtain the appropriate price multiple for the Jensen valuation, he has prepared a database of price multiples from the sale of entire public and private companies over the past ten years, organized by industry classification. Using historical data, Lutge estimates a control premium of 18.7% and discount for lack of marketability of 24%.
To obtain the cost of capital for Jensen, Lutge uses a cost of capital database that includes public company betas, cost of equity, weighted average cost of capital, and other financial statistics by industry. Given Jensen's small size, Lutge obtains a size premium using the smallest size decile of the database. McDonnell examines Lutge's cost of capital calculations and makes the following statements.
Statement 1: I am concerned about the use of this database. The estimation of the size premium may result in an undervaluation of the Jensen equity interest.
Statement 2: The use of betas and the CAPM from the database may be inappropriate, [f so, Lutge should consider using the build-up method where an industry risk premium is used instead of beta.
Which of the following best describes the standard of value that McDonnell and Lutge will apply to Albion Biotechnology?