CHARTERED INSTITUTE OF STOCKBROKERS
QUESTIONS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
March 2014
Level 2
SECTION A: MULTI CHOICE QUESTIONS
Corporate Finance (1 – 13)
1.
Emerald Limited had an outlay of N50 million, a present value of future cash flow
of N63.136 million and an NPV of N13.136 million. What is the profitability index
of the project?
A. 0.79
B. 1.00
C. 1.26
D. 0.66
2.
Assume the cost of capital of FOB Company Limited is 10%. If the company has a
capital structure that is 50% debt and 50% equity, its before-tax cost of debt is
5%. And its marginal tax rate is 20%, then its cost of equity capital is
___________
A. 14%
B. 12%
C. 16%
D. 10%
3.
GMB Assurance Plc uses the residual dividend approach in determining its
dividend policy. Using the following information, what is the expected dividend?
Earnings:
Debt:
Capital budget:
Optimal capital structure:
A.
B.
C.
D.
N1.6 million
N20 million
N1 million
Debt/Equity of 1/3
N850,000
N1,260,00
N650,000
N1,350,000
4.
Drogba Plc has an irredeemable debenture of N1 million with 7% rate of interest
and no other fixed commitments. The company has a total profit of N250,000 per
annum. What is the income gearing of the company?
A. 20%
B. 15%
C. 39%
D. 7%
5.
Which of the following are factors limiting debt financing?
I.
II.
III.
IV.
Legal limit imposed by a company’s article of association.
The rate of interest charged.
Covenant restriction issued by lender on additional debt.
The effect of borrowing on return to equity.
A.
B.
C.
D.
I, II and IV only.
I and III only.
I and IV only.
All of the above.
6.
Which of the dividend scenarios best reflects a stable dividend policy?
A. Maintaining a constant dividend payout ratio of 40% to 50%.
B. Maintaining the dividend at N1.00 per share for several years.
C. Increasing the dividend at the company’ long term earnings growth rate of
5%.
D. All of the above.
7.
The most common motivation for a merger is the creation of _________, in which
the whole of the combined company will be worth more than the sum of its parts.
A. Creeping takeovers.
B. Eliminating minority interest.
C. Synergy.
D. Golden parachutes.
8.
Sunday Mba who recently won the most valuable player (MVB) at the just
concluded Africa Nation’s Cup received N2,000,000 and decided to invest the
whole amount in order to purchase a choice building at Lekki in 5 years time. The
actuarist estimated the cost of the structure to be N3,222,100 at the time.
What interest rate can he negotiate with his banker to afford the apartment?
A. 9%
B. 10%
C. 7%
D. 13%
9.
A ___________ is a call option to buy a stated number of shares of stock at a
specified price issued by companies in the process of raising capital.
A. Convertible bond.
B. Corporate bond.
C. Warrant.
D. Preferred stock.
10. Which of the following statements regarding capital budgeting and strategic
planning is true?
A. Capital budgeting and strategic planning are bottom-up processes.
B. Capital budgeting and strategic planning are top down processes.
C. Capital budgeting is a top-down process, while strategic planning is a
bottom-up process.
D. Capital budgeting is a bottom-up process, while strategic planning is a topdown process.
11. The investors may prefer companies which repurchase their shares instead of
paying a cash dividend when __________
A. Capital gains are taxed at lower rates than dividends.
B. Capital gains are taxed at the same rate as dividends.
C. The company needs more quality equity to finance capital expenditure.
D. All of the above.
12. Which of the following will affect international capital budgeting for a
multinational firm?
I. Foreign project appraisal.
II. Political risk.
III. Foreign exchange exposure.
A.
B.
C.
D.
I and II only.
I and III only.
None of the above.
All of the above.
13. The market for venture capital refers to ___________
A. Private financial market place for providing equity investment for small,
start-up firms.
B. Bond market.
C. Market for providing equity to well-established firms.
D. All of the above.
Equity Valuation and Analysis (14 – 26)
14. An investor gathers the following data for a company:
Net profit margin
Total assets
Total liabilities
Net income
Dividends paid
2%
N200m
N120m
N10m
N2m
The company’s estimated dividend growth rate (in %) is closest to __________
A. 8.0
B. 10.0
C. 12.5
D. 17.5
15. A company’s N100 par perpetual preferred stock has a dividend rate of 7% and
required rate of return 11%. The company’s earnings are expected to grow at a
constant rate of 3% per year. If the market price per share for the preferred
stock is N75, the preferred stock is most appropriately described as being
__________
A. Undervalued by N36.36
B. Overvalued by N11.36
C. Properly valued.
D. Undervalued by N15.13
16. In the year just ended AB plc reported EPS of N140 and paid dividend of N40 per
share. Earnings and dividends are expected to grow at 5% p.a. to infinity. You
buy the company shares at N420 per share, ex-dividend. If you require a return
of 15% p.a, what will be the required selling price, after holding the stock for five
years, which will satisfy your expectations?
A. N845
B. N676
C. N536
D. N620
17. The issue of differences in accounting conservatism between companies is best
addressed when companies are compared using which of the following ratios?
A. Price-to-earnings.
B. Price-to-cash flow.
C. Price-to-book value.
D. None of the above.
18. The
A.
B.
C.
D.
value of equity of a leveraged firm can be calculated by __________
Discounting free cash flows from operations using the cost of capital.
Discounting free cash flows from operations using the cost of equity.
Discounting free cash flows to equity using the cost of capital.
Discounting free cash flows to equity using cost of equity.
19. A large manufacturing company is in a competitive industry. It has aboveaverage investment opportunities and its return on investments has been above
the required rate of return. The firm retains a large portion of earnings to fund its
superior investment projects. The company is best characterized as a
___________
A. Growth company.
B. Cyclical company.
C. Speculative company.
D. None of the above.
20. All else equal, a decrease in the expected rate of inflation will most likely result in
a decrease in __________
A. The real risk-free rate.
B. The nominal risk-free rate.
C. Both real and nominal risk-free rates.
D. None of the above.
21. A company has initiated the process of selling unproductive land representing 5%
of its total assets and using the proceeds to buy back its ordinary shares. Holding
other factors constant, these actions by the company will most likely result in a
_________
A. Higher ROE.
B. Higher operating margin.
C. Lower sustainable growth.
D. Lower financial leverage.
22. Which of the following is the most appropriate reason for using a free-cash-flowto-equity (FCFE) model to value equity of a company?
A. FCFE is a measure of the firm’s dividend paying capacity.
B. FCFE models provide more accurate valuation than the dividend discount
models.
C. A firm’s borrowing activities could influence dividend decisions but they would
not impact FCFE.
D. None of the above.
23. Data that helps to compute expected growth rates of companies are furnished
below:
Dividend payout ratio
Company 1
37.5%
Company 2
40.0%
12%
1.6
10.0%
2.0
Return on assets
Financial leverage
Which of the following best describes the expected growth rate of Company 1?
The expected growth rate of company 1 compared to Company 2 is __________
A. Lower.
B. Higher.
C. The same.
D. More information needed.
24. An analyst gathers the following data about a company and the market:
Earnings per share-most recent year
N2.00
Expected growth rate of dividends
Dividend payout ratio
5.10%
60%
Stock’s beta
Market risk premium
Risk-free rate
1.5
5.60%
4.20%
Company’s weighted average cost of capital
12.00%
Using the dividend discount model, what is the company’s price per share (in N)
closest to?
A. 16.00
B. 16.80
C. 18.28
D. 19.40
25. Koko Plc generates annual ROE of 24%. If the required return is 12% and annual
growth rate is 6%, what is the current P/B?
A. 2
B. 3
C. 4
D. 6
26. If the expected return of the market portfolio is 18% and a stock with a beta of
1.00 pays a dividend yield of 6%, what must the market believe is the expected
rate of price appreciation (capital gain yield) of the stock?
A. 18%
B. 24%
C. 15%
D. 12%
Fixed Income Valuation and Analysis (27 – 40)
27. When yield volatility
__________
Callable
A. Increase
B. Decrease
C. Increase
D. Decrease
increases, the values of a callable and putable bond will
Putable
Increase.
Decrease.
Decrease.
Increase.
28. Which of the following statements regarding mortgage-backed securities (MBs)
and collateralized mortgage obligations (CMOs) is most likely correct?
A. MBs are created from CMOs.
B. Creating CMOs does not reduce the overall prepayment risk of a mortgage
pass through security.
C. The prepayment option of an MBs benefits the security holder.
D. The cash flows received on the MBs are quite similar to those of a callable
company bond.
29. The liquidity theory of the term structure of interest rates projects that the
normal shape of the yield curve will be __________
A. Upward sloping.
B. Downward sloping.
C. Flat.
D. Variable.
30. Which ratio group measures the firm’s ability to generate enough cash flow
through its earnings to meet its debt and lease obligations?
A. Short-term solvency ratios.
B. Capitalization ratios.
C. Coverage ratios.
D. Profitability ratios.
31. Which of the following statements regarding indenture covenant is false?
A. Indenture may restrict borrowings by subsidiaries.
B. Limitations on stock repurchases may be included in indentures.
C. Covenants generally are structures to restrict the payment of cash and stock
dividends.
D. A negative covenant may place a limitation on the amount of money used to
repurchase stock.
32. An endowment’s fixed income portfolio comprises three bonds whose market
values, par values, coupon rates, and durations are given in the following table:
Bond 1
Bond 2
Bond 3
Market value
N500,000
N1,200,000
N300,000
Par value
N580,000
N1,100,000
N320,000
Coupon rate
Duration
11.0%
6.2
6.9%
8.1
9.0%
2.9
What is the portfolio’s duration closest to?
A. 5.73
B. 6.31
C. 6.85
D. 7.54
33. Jasper Ltd sold its receivables to a special purpose vehicle, JTL Ltd, created by
Jasper for that purpose. If JTL sells securities backed by the receivables, the
credit rating associated with those securities will most likely be based on the
_________
A. Creditworthiness of JTL.
B. Creditworthiness of Jasper.
C. Collateral and credit enhancement mechanisms used.
D. None of the above.
34. If the value of a Treasury bond was lower than the value of the sum of its part
(stripped cash flows) you could ___________
A. Profit by buying the stripped cash flows and reconstituting the bond.
B. Not profit by buying the stripped cash flows and reconstituting the bond.
C. Profit by buying the bond and creating strips.
D. (B) and (C) above.
35. Which of the following statement is correct about floating rates note?
A. A floating rate note has a duration that is close to zero.
B. A floating rate has high interest rate risk.
C. An inverse floating rate note is positively related to reference rate.
D. The coupon rate of a floater is equalled to the reference rate only.
36. You want to immunize a liability occurring in 10 years with two bonds; bond K
has a maturity of 5 years and duration of 4 years; bond P has a maturity of 15
years and duration of 12 years. The weight of the portfolio invested in bond K,
respectively P are _________ and __________
A.
B.
C.
D.
K
75%
50%
25%
40%
P
25%
50%
75%
60%
37. You manage a bond portfolio. Your client wants to reduce the reinvestment risk
over time. If he does not have any definite forecast over the future movements of
interest rates, what strategy will you apply?
A. Barbell strategy.
B. Bullet strategy.
C. Butterfly strategy.
D. Ladder strategy.
38. The redeemable bond issuance of XYZ Limited has a modified duration of 11.
Which one of the following statements regarding the bond is true?
A. If the market yield increases by 1% the bond's price will decrease by N55
B. If the market yield increases by 1% the bond's price will increase by N55
C. If the market yield increases by 1% the bond's price will decrease by N110
D. If the market yield increases by 1% the bond's price will increase by N110
39. Consider a five year bond with a 7% coupon that has a present YTM of 8%. If
interest rates remain constant, one year from now the price of this bond will be
___________
A. Higher.
B. Lower.
C. The same.
D. Cannot be determined.
40. The coupon of a convertible bond is, in general, lower than the coupon of a
straight bond. Why?
A. Because a convertible is less risky.
B. Because normally, the rating of convertible bond is higher.
C. Because the lower coupon is compensated by the premium of the
conversion’s option.
D. None of the above answers is correct.
Total = 40 marks
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
IBTT Limited is the target of a takeover bid by TransNations Limited. What are the
potential benefits and drawbacks to the shareholders of IBTT Limited, if TransNations
Limited succeeds in its bid, and decides to finance the takeover by issuing its shares to
the shareholders of IBTT Limited?
(3 marks)
Question 3 – Equity Valuation and Analysis
‘A negative Economic Value Added (EVA) for the year implies that the firm has not
earned enough during the year to cover its cost of capital, and the value of the firm has
declined’. Do you agree with this statement? Briefly justify.
(3 marks)
Question 4 – Fixed Income Valuation and Analysis
Because of financial stress, the bonds of Connect Telecoms Ltd have been downgraded
by Moody’s from A to BBB. What is the predicted effect on the bonds’ price, and the
bonds’ yield to maturity? Justify.
(4 marks)
SECTION C: ESSAY TYPE, CALCULATION AND/OR CASE STUDY QUESTIONS
Question 5 – Corporate Finance
Tissan Limited is a new entrant into the Nigerian Automobile Industry. The company
seeks to position itself strongly in the market in the next few years to take advantage
of the huge opportunities in the sector in view of the recent automobile policy of the
Federal Government that provides a range of incentives for new entrants into the
industry.
Mike Sule, ACS, is the company’s Financial Analyst and has the responsibility of
assessing the various options available for the company to raise capital in the very near
future. He therefore needs some initial information.
Mike has calculated the asset betas of Tissan, and of similar companies in the industry.
They all have an asset beta (βs) of 1.3. However, while all other companies in the
industry are debt-free, Tissan currently had a Debt/ Equity ratio of 62%.
5(a) Assume that Tissan targets a Debt/Equity ratio of 35% for its capital structure
and given that riskless interest rate is 2.5%; equity risk premium is 5%; loan
interest rate is 5% and marginal corporate tax rate is 42%, calculate an
appropriate weighted average cost of capital (WACC) for the company.
(5 marks)
5(b) Mike’s approach is to use Tissan’s internal earnings forecasts to calculate an
appropriate share price for the company. He has estimated the company’s Free
Cash Flows (FCF) for a 5-year period from 2014 to 2018 (in N’ million) as
summarized below:
2014
-1,342
2015
-1,107
2016
-730
2017
-140
2018
396
5(b1) Assuming a WACC of 9.0%, find the present value (as of 31 December
2013) of the FCF for the period 2014 to 2018.
(2 marks)
5(b2) To calculate residual value (terminal value), Mike assumed a FCF growth
rate of 5% from 2019 onwards. Find the present value of the residual
value (as of 31 December 2013).
(2 marks)
5(b3) Find an appropriate theoretical share price for Tissan. Assume there are no
surplus funds, and the company currently has 15 million ordinary shares in issue.
(3 marks)
5(c) From his analysis, Mike concludes that it is not desirable to raise additional equity
capital at the current share price level. Describe two fundraising options for Tissan other
than additional equity capital, taking into account its current capital structure. Discuss
both the rationality of and the risk associated with those options.
(4 marks)
Question 6 –Equity Valuation and Analysis
Yaro Soundhead, an analyst, is assigned the responsibility of placing value on Model
Furniture Ltd (MFL). MFL specializes in producing bespoke office and home furniture for
the “high and mighty” throughout the country and along the ECOWAS sub-region. Your
investment firm has been offered 60% stake in the company – hence the need for
valuation.
You have collected the following financial data of MFL for the most recent two years:
Table 1
Model furniture Ltd
Summary Statement of Income Year ended 31 December
(₦’000 except for share data)
2013
Revenues
194,850
8,425
2012
171,930
- Depreciation
-
- Other Operating costs
-124,500
-119,270
61,925
44,715
EBIT
- Interest expense
Income before taxes
- Taxes at 30%
Profit after tax (PAT)
-
2,425
-
7,945
-
715
59,500
44,000
-17,850
-13200
41,650
30,800
Table 2
Model Furniture Ltd
Statement of Financial Position (₦’000)
Assets
Non – Current assets
2013
32,500
2012
20,231
9,750
11,645
Inventory
15,476
13,940
Cash and bank
11,775
9,920
69,501
55,736
Receivables
Liabilities and Equity
Short term loan (payable within 12 months)
1,500
2,000
Accounts payable
2,040
4,250
Non-Current Loan
4,511
9,745
Total Liabilities
8,051
15,995
61,450
39,741
69,501
55,736
EPS
₦4.17
₦3.08
DPS
₦1.50
₦1.50
Equity
The number of shares has remained constant over the last five years and dividend per
share has also remained constant at N1.50 over the period.
6(a) Determine whether using the Gordon dividend growth model to value MFL’s equity
is appropriate or inappropriate. Justify your response on the assumptions of the
Gordon growth model and other relevant information in the scenario.
(2 marks)
6(b) The Managing director of the investment firm is of the view that Yaro should
make use of the free cash flow to the firm (FCFF) model, based on a singlestage annual growth rate of cash flow. He recommends the following formula to
value MFL’s equity:
(Vo) as of 31 December 2013:
FCFFo x (1+g)
Vo =
- BVDo
r-g
FCFFo = free cash flow to the firm in 2013
g
= constant annual growth rate of cash flow
r
= required rate of return for equity
BVDo = book value of debt as at December 2013
Required:
Indicate whether Yaro’s use of each of the following two variables: (i) r and (ii)
BVDo in the above formula for Vo is appropriate or inappropriate.
(2 marks)
6(c) State, for any inappropriate variable, the variable that Yaro should use in his
formula for Vo
(1 mark)
6(d) It is finally decided that Yaro should make use of the free cash flow to equity
(FCFE) model. Calculate MFL’s free cash flow to equity (FCFE) for 2013 (show all
workings).
(4 marks)
6(e) You have now collected the following additional information relevant for the
valuation:
Risk free rate
Market risk premium
Target debt-to-asset ratio
4%
8%
D
0.2
E+D
Appropriate asset beta
Effective tax rate
Beta of debt
0.64
30%
0
6(e1) Using the target debt-to-asset ratio, compute the appropriate rate of
return needed for the valuation of MFL (Round your answer to nearest 1%
and Show your workings).
(3 marks)
6(e2) Assuming the FCFE in December 2013 is N20 million. The FCFE will grow
at 15% for the following 4 years (i.e. 2014, 2015, 2016 and 2017) and
2.50% p.a. for the indefinite future. What is the total value of MFL’s
equity using the FCFE valuation approach?
Note: if you could not calculate the appropriate rate of return in 6(e1)
above, assume a rate of 10%
(4 marks)
Question 7 – Fixed Income Valuation and Analysis
One of your very important clients works with a highly respected private company in
kano. He is due for retirement in 10 years. At the point of his retirement, it is
projected that the balance of his mortgage will be N23,078,999. He plans to pay off
the mortgage on retirement.
To fund the payment, he has been investing on series of zero-coupon bonds each with
face value of N3,000,000. Five different bonds are involved. The bonds are designed
to mature at interval of every 2 years commencing from the end of 2nd year for the
next 10 years (total of 5 receipts).
Assume that the market yield for all instruments and for all maturities is 10% p.a
7(a) Explain very carefully why zero-coupon bond is often considered an ideal financial
instrument for immunizing a future liability.
(3 marks)
7(b) Calculate the present value of the given assets and liability of your client. What is
the net surplus today?
(5 marks)
7(c) Determine the modified duration of the assets and the liability.
(3 marks)
7(d) Assuming 75 basis points reduction in market yield, what will be the appropriate
change in the net value of your client’s assets and liability? Comment on your
result.
(3 marks)
7(e) Looking at your calculation of surplus in 7(b) above, your client is not comfortable
with the figure. After punching the calculator, he tells you that he requires a
minimum surplus of N198,000.
Calculate the approximate percentage change in yield that will guarantee such a
surplus. Be precise as to the direction of the change.
(4 marks)